Stocks

What is a stock? It’s simply a share of ownership in a company.  You make money off of the dividends or buy selling it for a higher price (called a capital gain).

What are dividends? They are basically a share in the profits that are given out periodically. Dividends are nice, but it is important not to lose the forest for the trees. A few things to watch out for:

1)      Dividends aren’t free. If a stock is trading at 10 and declares a .50 dividend, its price drops to 9.50. The stock basically paid itself dividends out of its share price.

2)      Dividends are taxed at a higher rate than capital gains.

3)      If the stock has declared 2.50 worth of dividends over the course of a year, but the overall price of the stock has declined by 3.00, you are net negative, even accounting for the dividend. Don’t let a small dividend distract you from a large drop in price.

It’s important to note just how much expectation play into things. If a stock is trading at 75 and its annual earnings are $1.50 a share, it has a price/earnings ratio of 75/1.5 or 50. This is higher than average and indicates that the stock might be overpriced, meaning it’s earnings don’t justify such a price. However, if investors are especially optimistic about future prospects of the company, the stock still may go up higher from there.

Also, keep in mind that, from an investor standpoint, much of the investing today is done through index funds, as opposed to individual stocks. These represent shares of ownership in a larger basket of stocks. For instance, and S&P 500 index fund is meant to mimic the movement of the S&P 500, which represents the 500 of the largest companies  in the United States. Indexes and index funds can be built around themes such as a country or a the size of a company.

Bonds

Bonds are loans. You buy a bond and you are therefore entitled to interest. Bonds can be grouped according to how they structure their interest and can be broadly put into two categories.

1)      Zero Coupon-Sold at a discount and pays no interest. Instead of interest, you are paid back “at par” (face value) at the end of the term of the bond. So, as an example, a $1000 bond with a 10 year term could be sold for $650. At the end of the ten year term, the investor gets $1000.

2)      “Regular” bond-pays interest at fixed intervals. For example, a $1000 bond with a 10 year term that pays 6% on a semi-annual basis would pay $30 to the investor twice a year. At the end of the term, the $1000 principal is also paid pack to the bondholder.

Bonds can also be grouped by their issuer.

1)      U.S. Government-Generally considered to be the safest investment out there, though people with a dismal view of the government and current spending might disagree.

2)      Foreign bonds-Can be very conservative or very risky depending on the government issuing them.

3)      Municipal bonds-Bonds issued by states, counties and cities. Generally, they are exempt from federal tax and most state and local tax. They are often considered relatively conservative, but can vary depending on the prospects of the government issuing them. Detroit municipal bonds are probably riskier (and therefore pay a higher rate of interest) than Dallas bonds.

4)      Corporate Bonds-Bonds issued by companies. Risk varies greatly depending whether the issuer is conservative or speculative. Speculative corporate bonds are called “junk bonds”.

Real Estate

Real Estate is land and buildings. Similar to stocks, you can make money by buying low and selling high (capital gain) or through rent.

Concrete, actionable investment advice on real estate is beyond the scope of this website. However, there are a few things to keep in mind. REITs are “real estate investment trusts”. These are real estate investments that are “securitized”, meaning they trade on an exchange like stocks. REITs can be grouped based on what they own: mortgages, health care facilities, commercial properties, etc. It takes money to operate these, so they have fees, as a mutual fund would. Furthermore, they tend to roughly follow the movements of the stock market. Therefore, investing in REITs is likely to give you much different returns and risk/reward than buying real estate directly and a lot less control. It’s said that all real estate is local, this isn’t necessarily the case with REITs. It isn’t necessarily better or worse, just different.

Also, note that buying real estate directly normally requires a higher initial investment and/or debt in the form of a mortgage. REITs can be purchased for a much smaller amount and with no debt.

Precious Metals

Modern currency is “fiat”. Meaning it is backed, not by a precious metal, but by the government that issues it. As opposed to paper or numbers on a computer screen, precious metals are said to have “intrinsic value” due to scarcity, jewelry uses and industrial applications. In reality, part of this value is psychological, it’s likely just a smaller piece of the puzzle than in the case of fiat money.

The United States used some variation of gold standard (or the gold and silver standard) until 1971. Whether this is a good or a bad thing is beside the point at the moment. Precious metals investing is challenging, because oftentimes the risk vs reward is poor and they can go through years of declines before the good times arrive. Additionally, the declines can be steep (as in the case of silver in 2011). A few things to keep in mind:

Investment in gold and silver is generally based on one idea: the government is inflating the money supply and gold and silver will hold their values better than fiat money. A few things to keep in mind:

1)      This is generally true. Fiat money tends to lose its value quickly.

2)      Many would argue that assets like stocks and real estate hold their values even better than precious metals and are even better protectors (or “hedges”) against inflation.

Lastly, many people hold precious metals because of pessimistic doomsday scenarios. If that is the case, it makes little sense to hold “paper” gold or silver, held through futures contracts or mutual funds. Those people are banking on societal collapse, yet assuming that in that scenario, gold held in a vault in London will do them some good. Whatever your motives are, at least make them consistent and sensible.

Final word: precious metals investing, whatever it’s merits, is not necessarily safe or conservative. Tread carefully. Anything can happen.

Options

These are contacts that give the holder the right, but not the obligation, to sell or buy at a predetermined price. Think about it like a movie ticket you buy in advance for $10. It gives you the right to a seat at the movie, but if in the meantime, someone invites you on a hot date, you can skip the flick and just will be out the $10.

Options are generally sold in lots of 100 for a fraction on the price of ownership of the underlying stock. Let’s say that ABC Corp’s stock is currently (Oct 2016)  trading at 55. The right to buy 100 shares of ABC Corp in July 2017 at 75 a share might be currently selling for 1.25 a share, or $125 total for the lot. This is relatively cheap because  the likelihood of this being a profitable investment is small. Most likely, the stock will be trading a lower than 75 in July and an right to buy at 75 would be worthless. It would like a customer demanding to pay $15 to see a movie priced at $10.

However, if the stock was trading at 90, you could exercise the option and purchase the a stock worth 90 for 75.

Futures Contracts

These obligate a party to buy or sell an asset at a predetermined date and price. They are often be used to trade physical commodities such as cattle, gold, sugar or coffee, but futures contracts also exist on financial instruments like bonds and currency.

Also, some people use futures and commodities almost interchangeably. Futures are a financial instrument. Commodities, as stated above,  are physical things you can buy and sell. Futures contracts are the way commodities are commonly traded.

 

 

For further study:

(General investing book): Investing for Dummies by Eric Tyson-It won’t turn you into a master investor, but you can get a good foundation with this book.

(Bonds book) All About Bonds, Bond Mutual Funds and Bond ETFs by Esme Faerber-Dry, but informative. Also, it’s almost impossible to make the subject of bonds “not dry”.

(Real Estate Website) Bigger Pockets-They publish some good books, too.

Futures, options and precious metal books are likely not the best focuses for the beginning investor. Futures and options tend to be complicated and/or risky. That being said, there will be some reading suggestions later on in the momentum section that involve futures investing.

As for precious metals, spending effort to learn how to trade them is probably not the best use of time, as you might be better off to think of them as a buy and hold asset. Instead, the investor might be best served by learning about basic economics and/or an asset allocation strategy such as the Permanent Portfolio (asset allocation is covered below). Craig Rowland and J.M. Lawson wrote a great book on the Permanent Portfolio called The Permanent Portfolio: Harry Browne’s Long Term Investment Strategy. Enacting the strategy may or may not be the best course of action, but the information is fantastic and there is a lot about great economics and general investing info in the book.