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.”
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