An Insider's Guide to Basics of Investing
Investing is a simple concept that many have complicated over the years. Investing is committing money to an endeavor with the expectation of accumulating more money. Easiest way to think of money is to picture each dollar as a personal soldier that has a sole purpose of going out to war and coming back with other soldiers that now fight for you. Some battles are short-term in nature, which means the investments last less than one year. Other times, battles are long-term and last greater than one year.
There are countless investment vehicles that your soldiers can use to go to battle: Stocks, bonds, mutual funds, ETFs, commodities, currencies, and real estate. Often times these terms are tossed around in a manor that leaves the general public confused. My goal is to explain these vehicles are simply as possible.
Buying a stock means you are buying partial ownership of a company. By owning a share of a company, you own a portion of the company’s assets and have a claim on its future earnings. There are two ways to make money with stocks. One, stock appreciation, means the stock you own increases in value. Two, a dividend, is a way for a company to give a portion of its earnings to shareholders. Increasing shareholder value is the main goal of a publicly traded company. The basic goal of investing in stocks is to buy stocks when they are inexpensive and sell them when they have increased in value.
Bonds are one of the most common investments but often times they are overlooked for riskier and therefore more lucrative investments. A bond is simply a loan given to a company or government by an investor. By issuing a bond a company or government borrows money from investors who are in return paid interest on the money they’ve loaned. Companies and governments issue bonds frequently to fund projects or ongoing expenses. Investors use bonds to preserve the money they have while also generating additional income. Bonds are typically viewed as a less risky alternative to stocks and are commonly used to diversify an investment portfolio. As an example, let’s say the City of Harrisburg, Pennsylvania wants to issue bonds to raise money to build a new stadium on City Island. Each bond is a loan for $1,000, which the City promises to pay back in ten years. To make the deal more attractive to investors, the City will pay an annual interest rate of 5%, which, in the bond world, is also known as a coupon rate. An investor buys the bond at face value for $1,000. Let’s fast forward, each year the City pays each investor $50 during the length of the bond (10 years). At maturity, the investor returns his bond and the City returns the investor’s $1,000 principal investment. Because a bond offers regularly scheduled payments and the return of invested principal, bonds are often viewed as a more predictable and stable form of investing. Compare regular payments of a bond to the experience of owning a stock. With stocks, although returns are typically greater, profits and losses are driven by market forces and are considerably less predictable. Of course, like any investment, bonds are not without risk. One risk that bond investors face is the possibility that the he issuer defaults on paying back the principal. This exact scenario has happened to many companies and governments in recent history.
A mutual fund is a collective investment that pools together the money of a large number of investors to purchase a variety of securities, like stocks or bonds. When you purchase a share in a mutual fund, you have a small stake of all investments included in that fund. Picture a mutual fund as a basic of investments. When you purchase a share in a mutual fund, you are buying one share of this basket, and therefore have a stake in one small fraction of all the investments in that fund. Mutual funds can benefit investors in several ways. Mutual funds are a simple way to make a diversified investment. Most are managed by a financial professional, and because of the wide variety of mutual funds, they allow investors to participate in a wide variety of investments.
Exchange Traded Funds
An exchange traded fund, or ETF, is an investment that trades like a stock. ETFs, like other funds, pull together money from investors into a basket of different investments, including stocks, bonds, and other securities. By spreading the money into different securities, ETFs can generally provide investors with diversification, which can help balance risk, and because ETF shares are traded on a stock exchange, they’re simple to buy and sell. Just like there are a variety of mutual funds, there are a variety of different ETFs, each with different objectives. Some buy a variety of stock and bonds, some replicate the performance of the stock index, like the Dow Jones Industrial Average or S&P 500, and others track the progress of a particular market sector like technology or pharmaceuticals.
Can you recall seeing gold coin commercials, or discussions of oil prices rising? These are related to commodity investing. Commodity investing is a way for investors to speculate on the price of raw materials. Some examples of commonly traded commodities include: precious metals, like gold, energy resources, like crude oil, and agricultural products, like corn. When investors invest in commodities, they don't actually buy the physical product. Instead, they trade commodity futures contracts or shares of exchange traded funds (ETFs). Futures contracts allow investors to speculate on the changing price of a commodity. These contracts are generally leveraged, meaning that with just a small investment, investors can control a much larger amount of a particular commodity. Because of this, futures contracts have potential for very high returns, but they are also very risky. Due to this high-risk, investors who trade futures contracts are generally more advanced and active traders. Commodity ETFs, on the other hand, can be less volatile than futures contracts, and are often a more passive, low maintenance investment.
Currency trading is also known as foreign exchange (Forex) and is the largest financial market, therefore it plays a vital role in the global economy. Each day, trillions of dollars trade hands in this market. Forex participants include governments, businesses, and individual investors. Governments use forex to implement policy. Whether borrowing money, lending money, or offering aid, a country needs to convert its currency into another foreign currency. Businesses participate in forex to facilitate international trade. Businesses require forex to convert payments for goods and services bought overseas, or to exchange payments from international customers into their preferred (legal reporting) currency. Advanced investors use the forex market to speculate on changes in currency prices. Currency prices change almost constantly during the week because the forex market is open 24 hours a day, excluding weekends. During the week it has to be open because of the global nature of the economy. Investors profit when they buy a currency and its price increases. Investors can also sell or short a currency in anticipation of a price decrease.
Currencies trade in two pairs, which means the value of one currency is always stated as the value of another currency. Even though there are two currencies involved, the pair acts like a single entity similar to a stock or commodity. For example, an advanced investor thinks the US economy is going to grow faster than Europe’s and as a result, she thinks the US Dollar will strengthen against the Euro. She can buy the Euro US Dollar pair to speculate on her assumption. If the pair rises in value, she’ll make money. Conversely, if the pair falls, she’ll experience a loss. Investors buy and sell currency pairs using margin. The process of buying and selling investments with margin is much different form the process of buying or selling an investment like a stock. Margin is borrowed money used to purchase securities in a margin account. The amount of margin you’ll need varies between currency pairs and the size of a trade. Currency pairs typically trade in specific quantities known as lots. There are several different lot sizes. The two most common are “standard” and “mini.” The margin requirements for mini lots are approximately $100 and standard lots are around $1,000. These margin seem like a small dollar amount but it’s important to understand that the lots are highly leveraged. Leverage is using a small amount of money to control a very large amount of currency. Most forex investors buy and sell currency pairs using leverage. Leverage is a key feature of this market. The leverage associated with currency pairs is one of the biggest benefits of the forex market, but it’s also one of the biggest risks. Leverage gives advanced investors the potential to make large profits or large losses. That’s because losses from investments using leverage can grow exponentially and spiral out of control. But if investors manage risk and limit leverage, they could possibly capture the benefits of forex investing. These benefits include the ability to trade 24 hours a day and capitalize on difference market trends. The sheer size of the forex market means it can easily influence other asset classes such as stocks, bonds and commodities. For example, if the US Dollar experiences a down tick, it impacts commodities because they’re typically priced in US Dollars. This in turn raises the cost of goods and is inflationary. As a result, interest rates may rise, causing bond prices to fall. All of this can impact the stock market. As you can see, one change in the forex market can have a ripple effect across several markets. Because the forex market is the world’s largest financial market, it sets the foundation for how other asset classes perform. The forex market’s widespread influence may appeal to investors who are interested in global economics. These advanced investors like learning about other countries, their currencies, how these pieces all fit together, and how the global economy works. Investors who are less interested in learning about connections between various global markets should avoid this advanced investing vehicle.
Another advantageous investment is in real estate. In order to keep this current blog short, you’ll have to check back for the intricacies of real estate investing. The main perk of real estate investing is that an investor can use debt to finance the purchase of property. Over time as the investor makes payments on the debt, he is increasing his equity in a positive cash-flow generating asset. There are two main ways to make money with real estate. One, property appreciation, which means the property increases in value over time as the investor manicures the property and entice others to do the same of neighboring properties. Two, positive cash-flow, this is achieved through regular lease payments (generally increasing annually) levied on renters of the investor’s property. There are many specific situations that can complicate real estate as an investment, but these complications can make this investment option extremely lucrative when added to an investment portfolio in mass quantities. Generally, the secret that the rich don’t want others to know is that we use the other methods of accumulating wealth, described above, in order to purchase positive cash-flowing assets. For example, the rich invest in stocks that appreciate and use the proceeds as a downpayment on an apartment complex. Over time, with the aid of increasing rents and positive cash flows, this investor is able to purchase another apartment complex. Over time, one or several investors may be able to control the rents of an entire city, and in doing so will expand their empire.
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