Basic Primer on Investing: Part I

So most of us have jobs now and may want to start putting some money aside for retirement/buying a house/that realdoll that is going to replace the embarrassment of trying to date. So I thought I would use my supposed expertise to explain some concepts etc that some people might not know about. I’m sure many of you already know many of the things I’m going to say, so just skim on. Part II will be more strategy related.

I’ll try to start at the most basic level and work my way up.

Bond – a bond is a promise to deliver a specified amount of money at a specific date. For example, $100 on December 1, 2009. Bonds are used to raise money in the short term in exchange for long-term debt. A bond that pays $100 in the future (a ‘face value’ of $100) will sell for less than $100 today. Bonds are issued by the US government (the least risky bonds) as well as corporations (with varying degrees of risk). If the company should go bankrupt, bond investors have the first claim on any company assets to repay their debts, so bonds are generally less risky than stocks, as all bond debt must be repaid before stockholders can make a claim.

Stock – popularly regarded as nothing more than a piece of paper that changes in value, stocks actually represent a share of ownership in a company, with rights to affect its decisions, enjoy its profits, and claim its assets, in proportion to the share of ownership. If you own enough of a company’s stock, you control the company. If a company goes out of business, you can go and claim assets, be they leftover inventory or office furniture, in proportion to your share of ownership. (In reality the company will sell all of these assets to pay off its debtors, and distribute remnants among the stockholders). Stocks can vary greatly in value over the short term, and are generally seen as more risky assets than bonds. Stocks and bonds are the two most important types of investable assets.

Inflation – Inflation can have a huge effect on the value of your savings. Inflation represents the tendency of the purchasing power of money to decline over time (an artifact of the United States banking system). That is, $20 today will buy you a lot more than $20 thirty years from now will. Inflation is why putting all your money in a mattress is not a good idea. Stocks represent hard assets and profits made from selling them (at a price that is effected by inflation), so in the long run inflation will have little effect on stocks, although short run effects can be very strong. Bonds, which represent fixed nominal values of money, are very strongly and permanently affected by inflation. If inflation increases, the value of that $100 payment in the future goes down.


Return – Return is simply the change in value of your investment. If you paid $90 for that bond, when it pays $100 you have gotten about a 11% return. This is usually expressed in annual terms, so if it took two years for you to get that $100, your annual returns were about 5.5% (which isn’t very good). These are almost always ‘nominal’ returns, meaning they are just in the increase in the NUMBER of dollars, not the actual value (which is decreased by inflation every year). Inflation usually sits around 3-4% in the United States, so that bond was paying 1.5% to 2.5% a year in real terms, which, again, is not very good.

Risk – Risk represents the chance you’ll lose an amount of the value of your investment. Usually you have to take on greater risk to expect a greater return. However, you don’t want to take on too much extra risk just for a slightly better return, as you’ll be boned in the long run. How much risk to take on is very much up to the individual investor.

Volatility – Volatility is the day-to-day change in an asset’s value over time. Stocks are very volatile, in that, while the market as a whole usually goes up, it can change in value by a percentage point in more every day. This can turn your hair gray if you pay extremely close attention to the value of your stock every day, as it can go down for no discernable reason and keep going down, only to go UP even more the next week. “Day traders” supposedly make their fortunes trading on volatility.

Stock Index – Indices are an easy way to track the overall stock market. Simply put, they are weighted averages of a number of stocks on the market. Some indices track only specific kinds of companies, like agricultura or biotechnology. Other indices simply track a large number of the largest companies, or as many stocks as reliable pricing information is available for. Common Indices are: NASDAQ, Dow Jones Industrial Average, the S&P 500, the Russell 1000, the Russell 2000, and the Wilshire 5000. There are many more.

S&P 500 – The S&P 500 essentially the 500 largest publicly-owned companies in the United States, with a few exceptions. While there are more than 5000 stocks in the entire market, 80% of the value of all stocks in the country is represented by these 500 companies, so it is a very easy way to track how corporate America is valued at any time.

Mutual Fund – A mutual fund is a pool of money contributed by a large number of investors, managed by a professional. This professional will buy and sell stocks with this pooled money in an attempt to make more money, according to various strategies and theories. Supposedly this way private investors can have access to top-grade investment advice, and see ‘market beating’ returns. In reality, giving huge piles of money to a professional who loves money provides a massive incentive for him to find ways to take the money, and most mutual funds are poor investments, nevertheless, mutual funds are how most private investors get involved in the stock market.

Index Fund – Similar in construction to the Mutual fund, and Index fund simply tries to replicate a specific index. A S&P 500 Index fund will try to buy a portfolio of stocks that very closely matches the S&P performance, if not exactly replicating its distribution.

Load – Some mutual funds charge a ‘load’ fee when you first put money into them. This essentially is a percentage of the money you have given them, which they just take home and buy nice cars with. The simply fact that very many successful mutual funds charge no load at all should be enough to prove that charging a load fee is nothing more than a bald cash-grab by mutual fund managers.

Management Fee/Expense ratio – The expense ratio is how much of a mutual funds assets go to commissions, kickbacks to your corrupt stockbroker for not telling you about no-load or low-fee funds, advertising so that the mutual fund can sucker more people into investing in them, and legitimate expenses like payroll, office space, research costs, etc. For example, a fund with the relatively high expense ratio of 2% spends 2% of whatever amount of assets you have given them, every year. That means they have to get an average return of 2% in order to avoid LOSING money, before they can even start making you any money. Generally, funds with lower expense ratios are more profitable for investors, which should come as no surprise, since they have lower hurdles to jump to break even and start making profits.

Capital Gains – Sadly, the government wants its cut, so whenever you make a profit on selling a stock, you incur capital gains tax, to the tune of several tens of percents of your profit. This can be an issue if you have very high turnover.

Turnover – A mutual fund manager is constantly trying to make a profit in the short-run, selling stocks he thinks will go down, and buying the ones he thinks will go up. Every time he sells a stock that has gone up, that is capital gains. Many mutual funds are managed as if capital gains were not taxed, so they can further reduce their performance by building up a lot of capital gains tax in this way. A fund’s turnover is the percentage of its assets that are sold on an annual basis. So a firm that has a turnover of 50% a year will typically sell all of its stocks and buy new ones every two years. A very low (~15%) turnover usually means that the manager is picking stocks for the long run, with an eye to long-term returns, which is a very good thing for his investors. Poorly-constructed index funds, or funds following poorly-constructed indexes can see a lot of turnover as they constantly struggle to match the index. This, along with expense ratio, is far more important than historical returns in gauging where to invest.

That does it for now

In part II I will cover a generalized investment strategy and part III will be an overview of different types of retirement accounts.