Mutual Funds, ETFs and CEFs.

There are a lot of different ways to invest your money. Buying individual stocks is one of the most well-known, but probably isn’t the best for most people. In fact it can be downright scary when you’re just starting out. That’s because when you’re first starting out you may only be able to buy one stock. Then your entire portfolio is tied to this one stock. If the company has a rough time and the stock goes down you could lose a lot of money. At least in the short run. That’s why I usually recommend that new investors don’t start with only one stock. Instead, start with a few hundred.

How do you start with a few hundred stocks when you can only afford to buy one? With an investment that includes a lot of stocks. Mutual funds, Exchange Traded Funds and Closed End Funds are three examples. Each of these can be bought and sold by new investors at most brokerage firms. They each include many different stocks. So what are they and how do you use them?

Mutual Fund.

Mutual funds are one of the best places to start for new investors. A mutual fund pulls money from a lot of different investors. The fund manager then uses that money to buy different stocks based on the fund’s goal. There are mutual funds that focus on S&P 500 stocks, utility stocks, medical stocks, and pretty much any other type of stock. There are also mutual funds the focus on investing in real estate, bonds and even insurance.

To buy into a mutual fund you invest whatever amount you want. Most funds have a minimum amount to start. The money is then pulled with other peoples’ money to buy the stocks. You can buy in at any time, and when you want your money back you sell the fund. When you buy in you buy based on the amount of money that you want to invest. Not based on the current share price. Most funds have a minimum of 2500-3000 dollars. Some funds though can have minimums upwards of 100,000 dollars or more.

Fees vary from fund to fund. With some you have to pay a fee to get in, some collect a fee when you sell and most collect an annual fee. The annual fee is collected out of the fund itself, so you don’t really see it. It will be reflected in the growth of the fund though.

Exchange Traded Fund (ETF).

Exchange traded funds are similar to mutual funds except that you buy them like a stock. So instead of investing a certain amount of money you buy the number of shares that you want. This can be a good place to start when you’re first starting to invest since you can buy as few or as many shares as you want. That may be less expensive than reaching the minimum to buy into a mutual fund.

Otherwise ETFs work the same as a mutual fund. They own stock in many companies so they help diversify your investments. ETFs generally follow an index like the S&P 500, so fees are low, and the price can be more predictable.

Closed End Fund (CEF).

Closed end funds are kind of a cross between ETFs, mutual funds and regular stocks. There are two ways to invest in them. You can invest when they are created or buy the shares after market. For today we’re only going to look at investing in them after they are created. When a CEF is created they pull together the investors’ money and use that to buy stock. The company is incorporated and they issue shares like a regular company. So it’s kind of like a company that just owns stock. Then they sell the shares just like any company. You can then buy and sell the shares just like any stock. The company isn’t involved with people buying and selling its shares. It only maintains its investments. Unlike mutual funds it doesn’t take in any new money. You buy shares from someone who already owns some. Just like a stock the value of the CEF goes up and down.

The advantage of a CEF over a mutual fund is that a mutual fund has to deal with money coming in from investors and money going out that investors want. CEFs don’t have new money coming in and they don’t have to pay out money to investors that want to withdraw money. Because of this they don’t have to maintain cash incase an investor wants to withdraw some money. They also don’t have to incur additional expenses to buy new shares when new money is invest, or sell shares when money is withdrawn. CEFs do have maintenance expenses just like mutual funds and ETFs, and like those it’s pulled directly from the CEF, so you only see them in the fund’s performance. Beyond expenses, another difference between CEFs and mutual funds is that since the share price of a CEF goes up and down like any stock, sometimes it is actually lower than the value of the stocks that it owns. Buying at this time can be like buying the stocks it owns on discount.

There are a lot of ways to begin investing. Before you start any investing, though, be sure to read the prospectus. Do your due diligence. Make sure that the investment is sound. Starting with options like the three in this article can be a great way to diversify your money. That will help your money stay safer and more stable through market ups and downs.

 

Have you used any of these three? What was your experience? What would you recommend to new people that are just starting out?

How you actually make money in the stock market.

How you’re told it works

You always hear in the media about people playing the stock market. You hear about people making it big by buying and selling at the right time. You also hear about day trading where people are trying to make money on the price difference of a few cents during the day. But is this really how true wealth is made in the stock market? No. It’s not. Actually a big NO. Sometimes it works out, but more often than not this is how people lose a lot of money in the market. It’s also why people think the stock market is just one big casino.

 

How it really works

You make money in the stock market from 2 things: appreciation and dividends. You make money because the stock price goes up and because companies pay dividends to their shareholders. How is that different than what I said before? Well, it’s in how you pick your stocks and what you do with them once you have them. I don’t actually like that term. I should say, it’s how you choose your investments.

 

Even though you can make money in the stock market by buying a stock and selling it when it goes up, true wealth is made when you buy a strong company that grows. Strong companies make more money than they spend. Since they make more money than they spend they can send some of that back to the stock holders. That’s one way you make money. The second is that since they make more money than they spend they can spend money on growing the company. This means that their profits will grow over time, the company will be more valuable and the stock price will go up.

 

How do you make that work for you?

The short answer is to buy a strong company when the stock price is currently less than what the company is truly worth. Ideally you read the company’s financial statements to find a company that is solid. Then wait for the price to dip. Buy the stock and hold onto it forever. This can work well with companies like Johnson & Johnson, Coca-Cola, and Exxon. The companies prices go up and down all the time, but the companies keep making money. Check out my post on Hubpages called Shortcuts to Finding Great Companies to Invest In. In it I talk about a few strategies to help save time for finding companies to invest in.

In that article I have three basic steps.

Step 1 Buy blue chip stocks.

These are companies that have been making essential products for years. Generally decades and sometimes a century or more. I recommend using the dividend aristocrats as a starting place for a list of stocks that meet this step. Another good source is Dave Fish’s US Dividend Champions spreadsheet. It’s available at dripinvesting.org. This is a list of all the US companies that have been raising their dividends for at least 25 years.

Step 2 Buy companies that are paying their owners.

Stick with companies that are paying a dividend. And not just any dividend. Stick with companies that are paying a dividend in the 3% or more range and that have been increasing their dividend for at least 25 years. I also recommend making sure that they have been increasing it every year by more than inflation.

Step 3 Buy it on sale.

Buy the stocks when they are valued less than they are typically priced or worth. One method is to buy when their PE ratio dips. I like to watch for stocks to dip below their historic median PE ratio. You could also use the Gordon discount model to buy when the price is less than the price the formula indicates. A third option is to buy when the market capitalization is less than the value of the company’s assets.

 

These types of strategies help people make true wealth in the market. While you can buy a stock and get lucky in that it’ll shoot up one day, if you follow these steps you can more reliably create true lasting wealth in the stock market. A good resource is Benjamin Grahams – The Intelligent Investor. I recommend anyone that wants to buy individual stocks read this book at least once. The book is about different strategies to value a company and find a company that has a stock price that is less than the value of what the company physically owns. The concepts extend beyond that though, and can be used to find companies that are selling at a discount.

The Power of Index Funds.

The other day I talked a little bit about investing in my Intro to Investing post. In that post I talked a little bit about what investing in the stock market is and some basic things you should know before you start. One of the things that I mentioned was index funds. These are a great way to get started in investing. They offer a great way to protect your money and still see growth in the long term. Today I’ll go over what they are and how to use them as well as why you would want to.

 

Mutual Funds

First, index funds are a special type of mutual fund. A mutual fund is an investment that just combines the money from a lot of investors, then uses that money to buy a bunch of different investments. Mutual funds usually have a theme. For example, there are mutual funds that invest in tech stocks. Those funds collect all the money from people that want to buy in. Then they use that money to buy stocks in companies like Google, Facebook, Apple, and other technology companies. There are also mutual funds that invest in healthcare companies, banks, utilities and just about any other type of investment you can think of.

Mutual funds are run by professional money managers. They evaluate the different investment options and buy and sell to meet the fund’s goals. Typically this means that the fund managers evaluate the profitability of different companies in the fund’s theme to find the best way to allocate the fund’s money to both maximize the potential profit and minimize the risks.

Advantages

Mutual funds have several advantages. The two greatest are security and expertise. Mutual funds typically invest in a large number of companies at once. In many cases hundreds or thousands of companies. This is very difficult to do when you are just starting out and don’t have millions of dollars to invest. This type of diversification can protect you in the case where one company goes out of business. If you can only buy three stocks if one company goes out of business then you could lose a third of your money. However, if you have a mutual fund that owns stock in hundreds of companies then the loss of one company won’t be noticed as much since the growth of the others will typically offset the loss. The mutual fund managers are typically experts in their field. They know a lot about the industry that they are investing in. They also know a lot about the companies they are investing in. They stay current on industry trends and read the financial reports published by the companies. This makes them uniquely qualified to pick appropriate investments in their industry. This can help because they will have a better understanding of how a company is making their money as well as the future prospects that company has. This means that they can more wisely pick how they will invest the mutual fund’s money.

Disadvantages

There are a few disadvantages to mutual funds. They can offer a false sense diversification, and they can grow less than other investments. While mutual funds invest in a lot of different companies and offer security against one company failing, mutual funds don’t offer protection against the group failing. For example, if you owned a mutual fund invested in oil stocks and the gas price drops then the price of the mutual fund will drop as well. So the fund protects you from the failure of one company, but not the drop in an entire sector. You can protect yourself from this by investing in more than one type of mutual fund. And it may be a good idea to sell the fund entirely if an industry is going away. The other major disadvantage is that they may grow slower. This is because not only do all the high performing companies make up for the low performing companies, but the low performing companies do drag down the high performing ones. So, by investing in a mutual fund you will have a lower return than if you invested completely in the high performing companies. The problem with this is that it is nearly impossible to predict who the high performing companies are 100% of the time. It’s also impossible to know when to sell and move on to the next company. Most people will accept slightly lower returns for the protection of diversification.

Index Funds

Index funds are a special kind of mutual fund. Like mutual funds they invest in a lot of different companies. The thing with index funds is that they tie themselves to a particular index. For example, there are S&P 500 index funds. These funds simply buy each of the companies in the S&P 500 using the same weighted average that the index uses. This means that the fund will go up and down pretty much matching the index. And since the S&P 500 has historically gone up and average of 9-10% a year, your investments will too.

Advantages

There are several advantages to using index funds. In addition to the advantages of using mutual funds the biggest advantage of using an index fund is cost savings. Since index funds track an existing index the fund managers don’t need to do extensive research on companies, or spend as much time on managing the investments. They simply buy the stocks based on the index. Since most of the time-consuming work is done for them the fees for index funds are typically very low. The reduced fees result in greater profits. Most actively managed mutual funds have fees that are many times the amount of the index funds. The returns on index funds are also more reliable. Since many indexes have been around for a long time it is easy to see how the indexes have grown on average. This is a good indication of how the index fund will grow.

Disadvantages

Index funds do have some disadvantages. The main disadvantage is that index funds track very large trends. This means that they rarely see big growth. So while growth will be more predictable than most other funds the growth won’t be as high as some funds. Index funds are also tied to what is in the index. Even if a fund manager knows that a company is doing poorly they can’t sell the stock as long as it remains in the index. For example, during the dot-com boom and bust the Nasdaq was heavily technology companies. So a Nasdaq index would have been heavily invested in technology stocks. As the bust happened any Nasdaq index fund would have held onto the stocks of those failing companies until they were removed from the index. An actively managed fund could have sold those stocks earlier.

 

When it comes down to it mutual funds in general and index funds in particular are great investments for first time investors. This is where I wish I had started years ago when I first started investing. Instead, I bought several random stocks I thought looked good. Most lost money. If I had invested in an index fund like the S&P 500 then it would have gone up and down over the years, but in the end would have grown 9-10% per year.

 

Index funds allow you to invest in a lot of companies which protects you from any one company failing. It also lets you see more predictable growth with your money. You don’t have to worry about trying to read a company’s financial statements. You don’t have to worry about picking the right company among the thousands of companies selling stocks. You just have to pick an index that historically grows. One example is the S&P 500. These are the 500 biggest companies in the US. Companies like Apple, Coca-Cola, and 3M. There are several index funds that track this index. Another is the Russel 2000. This index tracks small companies. They tend to have higher growth, but they are also more volatile. So you’ll see lots of dips and lots of spikes. For new investors and people who don’t want to spend their time studying financial reports this is definitely the way to go.

 

Do you invest in index funds? What do you think about it?

Introduction to Investing.

In my post From Zero to Millionaire I talked about 5 phases that you work through to go from nothing to having financial freedom. The exact order varies from person to person and the amount of time each person spends in each phase varies. The phases also overlap. But anyone that reaches financial security will pass through each one. The five phases are Make More Money, Save It, Pay Off the Debt, Invest, and Create. I talked a little about each of those, but there is a lot more. It would take books and books worth of information to truly cover each one well. Perhaps I’ll do that one day. Today I want to talk about the fourth one, investing.

 

This is a very basic introduction to investing. The goal here is to get you thinking about what is involved and how it works. I don’t recommend opening an account after reading only this post. This post should just give you a starting place as you learn more about it.

 

What is investing?

Investing is putting your money to work with the idea that you will receive profit later. This could be using your money to pay for college on the idea that you’ll be able to get a higher paying job in the future, or maybe using your savings to start a business. In the context of this site. I’ll usually mean buying stocks in the stock market on the idea that company will share the profits through dividends and stock price growth so that later on you’ll have more money than what you invested. That’s the part I’m going to talk about today.

 

What are stocks?

I’ll start with an example. If you start a company, you own 100% of the company. Say your company needs money to grow, so you decide to bring in a friend that knows the business. You agree to give your friend 50% of the company for the money they invest. Now each of you own half the company. Another way to put it is that the ownership of the company is in two parts. One part owned by you and one part owned by your friend. Each of you has one of the two shares in the company. So each of you has the rights to one share of the future profits to the company. Each share of the company is stock in the company. In this example the company is divided up into 2 equal parts.

 

For large companies like Coca-Cola the company is divided up into millions of parts. Each part is sold as a stock. So when you buy a stock you are part owner in the company. The stock represents ownership in the company.

 

What is the stock market?

Some companies are publicly traded. This means that the stock in the company can be bought and sold by the general public through one of a few exchanges. The stock market is where you go to buy and sell shares in the publicly traded companies. Another term for it is stock exchange. Most industrialized countries have at least one stock exchange. Investopedia has a great article on what a stock market is. The US has several including the New York Stock Exchange and NASDAQ. The London Stock Exchange Group, The Japan Exchange Group and The Shanghai Stock Exchange round out the largest five in the world. At each of these exchanges you can buy and sell stocks in different companies as well as corporate and government bonds and other securities. Each exchange has different companies listed so you may have to look in different places to buy the specific stocks that you want.

 

Why would I want to buy stocks?

As part owner in the company you are entitled to a portion of the future earnings of the company. So theoretically when the company makes money you either get some of it or the value of what you own goes up. Sometimes both. Companies sometimes pay out a portion of the profits as a dividend. Usually the rest is reinvested back into the company to help it grow. So as part owner of the company you get a dividend check and the value of the share of stock that you own goes up as the company grows. For most well established companies it’s a little of both.

 

Different companies do have different plans. Different industries, business classifications and security types have different laws and customs on how this works. Some will pay higher dividends, but have little to no growth. Others focus on growth and may pay no dividend. For example, a local utility company may not be growing much since they serve a defined, limited area. So they will typically give a higher percentage of their profits back to the owners. On the other side is a brand new company in a new industry. Like Google when they first started. They have a lot of room to grow, so instead of giving the owners a dividend they put all of the profits back into helping the company grow in different ways. But that’s a subject for a different post.

 

The main reason to buy stock is because you can make significant money in the long term. Those gains can also be fairly safe. It is dependent on proper research to find good companies that are worth more than the price of the stock would suggest.

 

How much is a stock worth?

There are two answers to this question. The first is theoretical. The second is what happens in real life. Theoretically a stock is worth the value of the company divided up by the total number of shares of stock. Then an adjustment is made based on what is expected in the future. Some of these are easy to calculate. The value of the company tends to be all of the assets minus all of the liabilities. That number is called the liquidation value. That’s what you’d have if you sold everything the company had. Stocks aren’t priced based solely on the liquidation value since companies typically make money. So the price usually includes anticipated earnings. This part is harder to calculate. It also is a little different for different people. But in broad generalizations established companies tend to trade for about 20 times what they earn per year. So a company that makes 2 dollars for every share of stock the company has will tend to trade for about $40 per share. This, of course, varies by industry and many other factors.

 

In the real world stock pricing isn’t this straight forward. If it was then stock prices would be very stable and there would be very few stock market bubbles and busts. But real world stock prices are not stable. Sometimes they can be very volatile. And every few years we have booms and busts. In the real world stocks are still priced based on the value of the company and the anticipated future earnings. However, in the short term stock prices are also based on emotion. People get excited on an idea driving up the price of a stock to higher than the company could possibly make. Other times temporary bad news may cause people to sell driving the price down to below what the company is worth. The market is pretty self-correcting over the long term, though. So you can use the company value model to set an ideal price and buy when it goes below that price.

 

Why do people think the stock market is gambling?

The stock market is volatile. It goes up and down. Seemingly on a whim. The stock price of companies with great ideas fly high then drop suddenly. Then you hear about stock market crashes. All this can make it look like the stock market is just one big casino. With all these ups and downs it really does seem crazy to buy stocks.

 

The truth of it comes down to research, diversification and patience. Making an error in one of these can make buying stock more of a gamble. All companies that have the stock listed on the US stock exchanges have to publish their financial reports. In these reports you can see where their money is coming from and where it is going. By reading through these reports you can see if the company really is making money. You can also see if the amount of money they’re making justify the price of the stock. The dot com bubble from the early 2000s are an example of research error. What happened there is that the dot com companies were not making any money, but they had ideas that sounded great. People bought the stock driving up the price. When the companies never showed a profit they went bankrupt because they couldn’t pay their bills. The stock crashed. Make sure that the company you buy stock in is actually making money and has a workable plan to continue to make money.

 

The second error is diversification. Unfortunately you can’t know everything that is going to happen. Enron is a great example of this error. Enron seemed like a good company that was making money, however their financial reports were fraudulent. When it was discovered that they weren’t actually making money and couldn’t sustain the fraud any longer the company collapsed and its stock is now worthless. When buying stocks it’s a good idea to buy several different companies in several industries that make their money in different ways. This way if there is a problem with one company or industry then you don’t lose all of your money. This is a great reason to start your investing by investing in mutual funds. Especially index funds.

 

Patience is required in the stock market. Prices go up and down constantly. Usually based on the current emotions. In the long run though stock will be worth what the company is worth. Once you have found a good company you don’t want to sell the stock just because the stock takes a dip. Selling a stock when it goes down is how you lose money. For example, between December of 2007 and March of 2009 Coca-Cola stock went from being over $30 per share to under $20 per share. The company didn’t lose a third of its business. It still produced and sold Coke and its other brands all over the world making a nice profit. The price went down because all the other stocks went down and people were selling. The value of the company hadn’t change. Since then the stock has not only returned to $30 per share, but is at over $45 per share. It can be scary to see the value of your stock go down. If you’ve done your research and you know the company is solid then you just need to have the patience to wait until the market corrects itself.

 

So, what should I buy and when?

The short answer is to buy high value companies when their stock is on sale. I’ll cover this sort of thing in other posts, but you’ll want to estimate what you feel a company is worth. Then buy the stock when it is below that amount. This is easier said than done. It requires research. Read the financial reports of companies that you like. Make sure they are actually making money. Compare their reports to their competitors. Estimate what is a sustainable stock price. Then just watch and wait for the price to come down, if it’s higher than your estimate. Then buy the stock.

 

Now for a more realistic answer. I usually recommend people start with mutual funds. So if you’ve never owned a stock before and you want to get started I recommend buying a mutual fund. But not just any fund. Buy an index fund. Something like Vanguard’s S&P 500 index fund. Or Fidelity’s S&P 500 index fund. There are a lot of different versions of these with different brokerage firms. These funds invest in the 500 largest companies in the US. That gives you diversification of owning 500 different companies’ stocks as well as stability since these are the largest and most established companies. Some of which have been around for well over a hundred years. Buy it whenever you can and just leave it there to grow until you retire. The value will go up and down each day, but over the long term it will go up more than down.

 

That’s the basic information about stocks and the stock market. I’ll cover this and different parts in more detail eventually. Have you started investing in stocks yet? What would you like to know or wish you had been told?