Over the last few months, as I’ve told our friends and family about my plans to write a book on saving for financial independence, I’ve learned a great deal about what people know and don’t know about saving and investing. Whatever career you have, its easy to fall into the trap that other people know what you know. For me, spending twenty five years in the investment industry has made me think that everyone knows the basics about equities, bonds, mutual funds, annuities, etc. Not so! Regardless of age, education or experience, it seems most folks will benefit from a little information about these investment vehicles. I’ll start with equities.
Equities is another word for stocks. Stock is what is issued to the owners of a business. The business might be a small family affair or a large multi-national corporation. Stock is a convenient way to denominate how much of the business each individual owns . The term equity comes into play, because that is what you own when you own stock. It is a similar concept to owning your home. The amount of value that your home is worth minus the value that is owed to the bank in your mortgage is called equity. As a stock, or equity, owner you have the right to vote on significant issues facing the company, collect dividends and participate in the change in value of the company, as denominated by the value of the stock, according to how much you own.
Like with your home, there are no limitations to the value of the equity you hold in a business. It can go up and it can go down. Most people own equity in the form of publicly traded stocks of companies rather than closely held family businesses. The value of the stock of a publicly traded company is determined by all the participants in the stock market and is affected by a wide variety of factors. Over the long term the company’s ability to continue to earn profits will be the primary driver of the value of the equity in the business. However day to day, week to week and sometimes even year to year, the value of a company’s stock may fluctuate widely on seemingly unrelated issues. Things like whether interest rates may rise, whether Greece will exit the European Union or where ISIS will attack next are just a few things that may not have a direct impact on the business you own, but may still be reflected in the value of the company stock.
Stock in a single company is among the most risky investments you can hold. The value can change dramatically over both short and long time periods. If you own stock in the company where you work as a substantial part of your savings, it is a very risky investment. Sure, you may know a great deal about the company where you work and believe it to be a fine and safe business. That might even be true, but that won’t stop the daily onslaught of news from turning your investment into a nasty roller coaster ride. And it may be that you don’t know all you need to about the company where you work. The employees of Enron certainly did not.
To tame the ups and downs of a single company’s stock value, known as volatility, investors generally combine the stocks of many companies to create an investment portfolio. If the stocks are in different industries, the daily gyrations in the value of each company is unlikely to be in synch with the others, and some of the value changes will offset each other. The result is that the change in value for the entire portfolio is less than the change in the value of any one company’s stock. This effect is called diversification.
It is difficult for most people to create a diversified portfolio, so the alternative is to share a portfolio with other people. This is accomplished by buying shares of a mutual fund. Mutual funds are professionally managed investment portfolios. Mutual fund companies take the money invested by many people and pool it to create an investment portfolio.These can hold just about any kind of investment, but equity mutual funds hold the stock of companies. How many different companies they own depends on the manager and what they are trying to accomplish. Investment options in employer sponsored retirement plans are generally mutual funds (or closely related cousins).
Even with a diversified portfolio, equity investments are risky. So why own them? Equity investments have historically provided the highest investment returns over long periods of time. “Long periods of time” is an important qualifier. In general to minimize the risk of loss you would need to be willing to have equity investments for at least ten years.
So equity investments are not a good idea for the money you are planning to use to go to Cabo or for a down payment on a home, or for college tuition if your kid is in high school. However, they are a great idea for investing for goals that are further out, like retirement. For money that you won’t be spending in the next ten years, equity investments are a critical tool in making your money grow and last.