Yesterday, I posted a rather long introduction to personal finance. Today I am going to go one step further into financial assets. Financial assets are different from real assets like homes, properties, cars, jewelry, wine, etc. Financial assets are basically pieces of dirty paper or more likely bits floating around on the internet that say you are the owner of something. I am going to dig into equities a little more thoroughly.
Equities are stocks. Stocks are issued by companies that are trying to grow their business. When a business is started it is funded by “Angel Investors.” These are usually doctors or dentists who pony up some cash for 5-10% of the company. As the company gets going a little bit, venture capitalists come in and offer rounds of financing. Again they take a percentage of the company for their troubles. Eventually a successful company will decide to go public. This offers liquidity for the founders and early investors, allows them to raise more money, and the public takes on the risk inherent in any business.
Once a company is public, the value of that company is a function of its earnings, earnings growth or unfortunately some esoteric metrics like number of subscribers. Be careful if you don’t know how a company is making money. The higher a company’s earnings the more it is worth. A common metric is Price/Earnings (P/E) ratio. For some industries this is 15X. If a company has earning of $1/share annually and the price per share is $15, the P/E ratio would be 15. An investor makes money as earnings grow from $1 annually to $1.33 annually and the share price moves from $15 to $20. An investor would also make money if the company offers a dividend. A dividend of 5 cents/quarter (20 cents/year) on a $20 stock would be a 1% return. That is about what you are making on CDs.
Cap is short for market capitalization, the number of shares outstanding multiplied by the share price. Small caps would be under $2B (Collectors Universe, CLCT, $101M). Mid caps go from $2B to $10B (Groupon, GRPN, $3.55B). Large caps are over $10B (Merck, MRK, $132B).
Small caps are more volatile, meaning they are more likely to grow and also more likely to shrink. An exposure to small caps offer some increased returns in times of a growing economy. Large caps offer more steady returns and hold up better in a recession, but do not grow quickly in times of a growing economy. Mid caps are in the middle.
International stocks provide some diversification if for example Asia’s economy is growing while the USA’s economy is shrinking. However more and more the world economies are affected by one another. If the US stumbles, world economies will be affected. For a current example, look at what is happening in Cyprus.
To invest in stocks, set up a brokerage account with Vanguard, Fidelity, Scottrade, etc. and transfer cash from a bank account to the brokerage account. Next pick a stock, decide how many share you want to buy and place a market order (current price when you click the mouse) or a limit order (if the stock is trading at $14.85, you could place a limit order at $14.80 and it may go through). You can buy an Exchange Traded Fund (ETF) the same way. ETF’s provide exposure to a sector (gold, oil, S&P 500) and are bought and sold like stocks.
Mutual funds and Index funds are a little different. They can still be in your brokerage account. However trades are closed at the end of the day. If you want to buy the Vanguard Dividend Growth Fund (VDIGX), make sure your brokerage company offers it, find out the minimum investment ($3000) and buy $xx,xxx dollars worth of the fund. You can hold fractional shares.
Diversification is usually a good thing. By owning 20 different stocks from different sectors you can have a diversified portfolio. If you don’t like stock picking, buy 2 or 3 different funds. If don’t want to do any research by a target of life cycle fund. The further out the date, the more aggressive the fund is. The closer the date is, the less aggressive the fund is.
To research stocks and stock funds, get on the internet. All of the information you could ever need is there. Past performance is an indicator of future results, but there are no guarantees. To quote Clint Eastwood, “If you want a guarantee, buy a toaster.”