Investing, that’s not for me, you might think. Or maybe you don’t believe in the value it can bring. This article is an introduction to investing in stocks and bonds, and also covers index funds and index tracking ETFs. Those can be used to invest in a broadly diversified portfolio.
An Introduction to Investing
Let’s start with the basics. To get comfortable with investing your hard-earned money, you must first truly know what investing actually means.
Investing is the practice of buying appreciating or income yielding assets. In much simpler terms, you use money to buy things that make you more money in return.
The key words here are appreciating and income yielding. Just buying stuff doesn’t count as investing. Later on in this article I will briefly cover alternative investments, but for now please don’t consider that € 500 bottle of whisky an investment.
Then What Makes An Asset Investment-Worthy?
So what does it mean for assets to be appreciating, or yielding income? An appreciating asset might for example be a piece of ownership of a company, also called shares or stock. If the company does well, and makes a profit, part of that profit is yours. Because we can expect companies to make future profits, we can attach a value to the shares of that company. And when the company grows and makes more profit every year, the value of their shares will increase as more investors seek to be owners of this company.
An asset can also yield income. That means that it’s not necessarily the increase in value that you’re looking for, but frequent payouts. For example, these can come in the form of interest payments on a loan you gave to someone. Since the interest rate is agreed upon, we can speak of fixed income investing here. Every month or year the person or company you gave the loan to will pay you a certain amount of interest. Another form of income investing might be rental real estate, which is buying property to rent it out. Once the tenants sign the lease and move in, they’ll start paying you a monthly rent.
The fact that stocks and real estate are mentioned here as examples of asset classes you can invest in, doesn’t mean that just purchasing shares or property count as an investment. If you buy something without having the fundamentals in place, it looks more like speculating, or just plain gambling. An example there would be buying penny stocks, in the hope they go up. Another example is buying real estate at the top of the bubble, where rents cannot cover expenses, hoping you can sell the property later for a higher price.
So Which Asset Classes Can You Invest In?
We’ve seen that investing means putting your money in appreciating or income generating assets. When you start investing, there are tons of different asset classes you might have heard of. Here, we’ll pick apart a few of them.
Stocks, or shares, are a piece of ownership of a company. That is the case for publicly traded companies, but also for a lot of private companies. The difference between the two is that you cannot easily trade shares of private companies. Usually you have to go through the notary, whereas if you want to trade shares in a publicly listed company you can go through your favourite brokerage and buy or sell very easily.
So stocks represent a tiny fraction of ownership of a company. Why would you want that? First of all, when investing in stocks you usually do so in the hope of growing your investment. As the company grows and makes more profit, it gets more valuable. That means that more investors want to own a piece of it, and since stock prices are the result of supply and demand, a higher demand means that the price goes up.
But aiming for higher prices is not the only reason to invest in stocks. Not all companies can grow 10% a year. For younger companies that may not be a problem, for the older, established organisations that’s hard. These companies usually make a decent profit, but have a hard time expanding their businesses. Instead of reinvesting their profits, they might choose to pay out dividends to their shareholders. That may mean that every month, the shareholders receive a cash payout. This dividend is a form of income that can help grow your wealth as well. Some companies are in between, they might pay out a moderate amount of dividend.
We’ve also briefly discussed bonds before. A bond is nothing more than a promise to pay back a loan, usually with interest. You can see your mortgage as a form of a bond. When you needed money to buy your home, the bank gave you the money in return for a note stating the agreement, usually a payback period of 30 years with an interest rate.
Bonds can be given out by both governments and companies. When a company needs capital, they might choose to do so via debt instead of equity. They then borrow money from the market, by giving out bonds. Say they need a million euros, they might give out a thousand bonds with a face value of a thousand euros. The interest rate is usually a fixed percentage that is payed out every quarter or every year. At the end of the duration, the bond pays the final interest payment but also returns the capital.
That means that when you invest in bonds, you have some security, because your money will be returned. Of course, you are risking that the company goes bankrupt or otherwise cannot pay you back, but usually bonds are considered safe investments. Especially government bonds are very safe. Imagine the government being unable to pay you back. That would result in chaos, maybe even war, and that’s way worse than not getting your money.
Most bonds are traded on the secondary market and you can trade them via most brokers. It’s not necessary to buy a bond and hold it to maturity when you receive the principal value back. The value for which bonds are traded is set by the market, by supply and demand. So even when the face value of the bond is EUR 1,000 (most are) the actual value may be different. That is because the bond pays a fixed interest rate, and that makes it more or less valuable to investors.
Say, a bond pays out 10% in yearly interest, you buy it, and then interest rates drop to 5%. Suddenly, you cannot buy fixed income that’s yielding 10% anymore, but your bond is still paying 10%! That makes it valuable, investors are willing to pay more for that bond because it has a high interest rate. But when demand goes up, so goes the price, so the thousand euro face value might now be traded for close to double that amount. Instant profit for you when you sell!
So when interest rates go down, bond prices usually go up. Vice versa, when rates go up, bonds go down.
Real estate is another asset class that investors might use to grow their capital over time. Private individuals like us, the financial independence community, might have experience in real estate through their homes. We have the tendency to buy our homes instead of renting. However, one might choose to also invest in property.
For example, you might buy a small apartment and rent it out. The idea is simple, you buy something, put a tenant in there, and every month they pay you rent. After you’ve paid for all costs, and maybe the mortgage, you are left with a profit that is your profit. That way, you receive a monthly cash flow, the loan gets paid down, and hopefully the property goes up in value. That’s a win-win-win. However, this type of investing requires more capital than just investing in stocks or bonds. Also, it can take up a lot more time. However, for investors willing to put in the time and capital it may be a very rewarding investment.
You can also buy houses that are in a bad shape and need work. You perform the work and then sell it. That is called flipping, and is considered a form of real estate investing. I would consider it more of a job than investing, but some people have the time and skills to pull this of and can make a lot of money!
Real estate is a popular form of investing, because it offers a few pillars of wealth generation. The first is cash flow from rent, the second is appreciation of the property, and the third is the loan being paid down. In some countries there’s a fourth pillar; tax benefits.
Alternative Investment Classes
Besides stocks, bonds, and real estate, there are a lot of other assets you can put your money in. Now please do not read this section and think it’s cool to put all of your money in bitcoin or old cars. I just included it to be complete.
A special type of investments are hedge funds. These are usually actively managed investment funds where the fund manager tries to hedge the portfolio’s positions against losing money. However, by protecting the downside of your investment you are usually giving up a lot of the upside potentials.
Besides that, these funds are usually very, very expensive. You could easily pay 2% per year in management fees on top of entry and exit fees.
Private equity is another form of investing where the fund raises money from investors, and then goes to buy companies. Only part of the deals is funded with investor’s money, the rest of it is borrowed. Often, the capital structure of a deal will be 70% debt (the bank’s money) and 30% equity (investor’s money).
The way these funds make money is simple. You look for companies that you can buy that provide enough free cash flow for you to be able to pay the interest on the debt that you take on. Then when you take over the company, you keep it under management for a couple of years, usually 3-7 years.
During that time you aggressively grow the company, with the goal of selling it after a couple of years. When you sell, you pay back the money you borrowed and return your investors and yourself a very hefty return. Of course, PE deals are usually exclusive to large investment firms and wealthy individuals. It’s hard for the regular Joe to participate in these deals.
Peer to peer lending is a form of crowdfunding where a business borrows money from the crowd. As an individual you can participate in these schemes by investing money in loans that business use to raise capital. They will pay you back and you’ll receive interest. It’s like investing in bonds but in a more direct way.
Cryptocurrencies are very volatile by nature and can be traded for great profits, or great losses!
Art can be a store of wealth. The amount of money rich people pay for paintings they will never hang is ever increasing. But make sure to buy the right piece of art, do your due diligence. Or you know, just buy index funds.
Usually cars are a money drain. They cost money when you buy them, they decline in value, then you drive them which costs gas money, and if you drive them too much you have to repair them. On the other hand, you could be lucky and buy a car, store it, never drive it and in a few decades from now it could be worth millions. As you might read between the lines, this is not a real investment advice.
Another type of investing like that is whisky. You can sometimes pick up limited editions of certain whiskies that are way overpriced, but might triple in value when people like them and all bottles are sold out. I know a guy who is a total whisky freak. He usually buys two bottles of a limited edition he thinks he’ll like, drinks one bottle and stores the second. Then after a year or two he checks whether it is worth anything, and most of the times he can sell it for at least double what he paid for it. Free whisky!
The Case Against Stock Picking
After reading all of the above I hope you came to the realisation that you will need to invest at least in stocks, most likely bonds as well. However, which companies are you investing in?
It might be tempting to invest in companies you like. “Ooh, I have the new iPhone and it’s great so I will buy shares in Apple”. Or “I really like what Elon Musk is trying to do with electric cars so I invest in Tesla”. These reasons are very common, but dangerous. The fact that you like a company says nothing about it’s ability to generate a profit. And profit is what we’re after as investors. Sure, you might be lucky and bought Apple in 2000 when it was a couple dollars per share, and sold it this month for 200+ dollars per share and be very rich now.
Can you look into the future?
But be honest, how realistic is that? Can you look into the future? I wish I could but I’m sure I can’t. And no, people who tell you they can, by doing technical analysis on stocks also don’t!
So, if you don’t know the future and you can only use knowledge you have today, what should you do? At least you want to diversify your holdings. Say you invested all of your money in Apple, and instead of going x200 they go x0. Bankrupt. Gone. Not only will there not be a shiny new iPhone next year, your life savings are gone.
Say you invested half your money in Apple, half your money in Shell. One of the companies goes bankrupt, the other one survives and grows a little. Boom, half your money is gone! So instead of buying shares in two companies, it’s best to buy shares in thousands of companies! Diversify to as many companies as you can, to all kinds of industries, geographical locations, currencies, company sizes.
Why would you want to buy all companies? Because over the long term, in general, the market as a whole has always moved up. In fact, if you look at this chart from the American S&P 500 index you’ll see that the last few recessions are still very much visible, but the recessions from the 80s and 90s are barely noticable. They are but blimps in the chart. In one or two decades from now the same will happen to the 2009 recession. That is the power of compounding growth. Even though we face recessions every few years, in general the market is moving up faster than inflation.
So if the whole market generally moves up, and we cannot predict which companies are going to over perform or under perform the index, we should just buy the entire index right? That’s right, that’s why we have index funds and index tracking ETFs available!
Introducing Index Funds and ETFs
As you have read above there is no need to research and trade individual stocks. A good way to diversify is to buy all publicly listed stocks. However, purchasing thousands of individual shares will be very costly, and time consuming. However, this is what a lot of people do. An introduction to investing would not be complete without a chapter on index funds.
What If You Could Purchase All Stocks At Once?
Then you would be diversified across all kinds of industries, locations, company sizes and more. You would own shares in thousands of companies, possible more than 10,000! If one of them goes bankrupt, so what? You wouldn’t even notice it. Because of your vast diversification across markets, you are protected against crashes in the oil sector, financial services, or technologie. If pharma companies fail, then you still have dozens of other markets where you’re automatically invested in.
What happens when war breaks out on a continent? The economies of those countries are decimated. Not so good for a stock investor. So when you purchase shares in all companies on Earth, you are also hedging against geographical risks like war.
Then there’s currency risk. What if all your investments are in one major currency that collapses? That would be bad right? Now if you own the global stock market, you might have a lot of shares denominated in US dollars, but also in euros, pounds, Swiss francs, yens. Even more than that, a lot of companies that you invest in are spread out themselves. Apple is one of the largest companies that you can invest in, and their shares are denominated in dollars. However, they also sell a lot of phones and computers in Europe and Asia, in other currencies. So even though their shares are in dollars, the actual return you can make on an investment is based on the currencies a company makes their revenue in.
The title of this segment is “what if you could purchase all stocks at once?” Yea, what if I tell you you can? You can buy index funds that immediately give you exposure to worldwide equities across all markets and locations.
What Is an Index Fund?
An index fund is simply a large pool of money, managed passively by a company like Vanguard or Blackrock, that invests this pool of money in shares or bonds to track an index. Investors put money in these funds, and the fund manager purchases stock according to an index. This can be the S&P 500, the Eurostoxx 600, or something else.
Say we have a hypothetical stock index, made up of three companies, A, B, and C. The index is market weighted, which means that companies that are more valuable make up a larger share of the index. Now this index consists of 50% A, 30% B and 20% C. An investor puts in a 1,000 euros into the index fund. The fund manager now automatically purchases 500 euros worth of stock A, 300 euros in stock B and 200 in stock C. You, as an investor, hold a certain amount of shares in this index fund, but you actually have exposure to all the shares that the index funds invests in. When the index returns 10%, so does your investment.
Because the management of these index funds is very passive, they are cheap to operate and therefore cheap to invest in. That means that you pay less to invest, and get a higher return than in most actively managed funds.
What Is an ETF?
Now that we now what an index fund is, we might touch ETFs as well. You might have heard about ETFs and maybe confuse them with index funds. Although they are pretty similar, they are not the same.
An index fund is simply a large pool of money that is managed by a fund manager, who invests this money in an index. An ETF might do the same, but instead of pooling your money in a large fund, you are actually buying a share on the stock market. ETF stands for Exchange Traded Fund, so this is an actual share, or fund, that you can trade in.
The underlying value of an ETF is the portfolio the fund managers invest in, that’s what makes ETFs so similar to index funds. Where index funds by definition are only passively managed funds that track indices, an ETF can invest in anything.
There are ETFs that are like index funds and just follow the S&P 500 or the global stock market. There are ETFs that target specific sectors, say finance, or technology companies. You have ETFs that invest in commodities like oil or gold and the list goes on and on.
So even thought ETFs can be used to invest in anything, we like to use them to invest in cheap, broadly diversified stock indices, just like we do with index funds. Here in The Netherlands is not so easy to participate in cheap index funds as it might be in the USA for example, but we can invest in most of their ETF equivalents.
How Do I Buy These Funds?
Buying index funds and ETFs is done through your bank, a stock broker, or directly via a fund company like Vanguard.
Usually, at least in The Netherlands, banks are pretty expensive, also they don’t offer as much choice in funds as some brokers do. I have done some investing through my bank, but stopped doing so because of the costs and poor choice of funds.
That’s why I like investing through brokers. Especially through the really cheap discounted brokers like DeGiro. They offer not that much service, but what they do they do quite well and for very low fees. You could go to the more expensive brokers that offer services like automatic rebalancing to make your portfolio even easier to maintain, but for me that’s not worth it.
I don’t have experience with investing directly through fund managers. Here in The Netherlands it’s not possible to open an account through Vanguard directly but in other countries this might be a good choice, depending on costs and the funds offered of course.
How To Create a Lazy Portfolio
As a small time investor, and I don’t mean to belittle you, you want an easy portfolio. One that doesn’t take too much time to maintain. Ideally, you want something that you can just put your money in every month and forget about it.
The way I like to setup my portfolio is first determine the overall allocation of your investments. What would be the ratio between stocks and bonds for example? You have to come up with that yourself, but say we go with 80/20. Then I can invest 80% of my money in stocks, and 20% in bonds.
Then I decide on what funds to invest in. Can I invest in one single fund and be done with it? Something like the ETF “VWRL” to invest in more than 3,000 large and mid cap stocks worldwide? In that case I just buy VWRL with 80% of my investment money.
Maybe I can invest in VTI (total US stock market) and VXUS (total non-US stock market), a combination that is cheaper than VWRL, to buy almost 10,000 companies for very low fees. What percentage US and non-US will you invest in? 50/50? Or maybe 70/30? Whatever the case, just split your money that is earmarked for stocks according to the fund allocation you can think of and be done with it.
The same goes for bonds. Pick a bond fund, and buy it with the 20% you allocated for bonds. Now you have created a stock portfolio that consists of two or three funds, is very cheap, and easy to maintain. All that is left is to earn your monthly salary, and put as much of your salary away into your investments.
So this introduction to investing is coming to an end. It has been by far my longest article of all times with almost 4,000 words, and I really hope you like it. It is filled with information on the principles of investing. If you think your friends or family benefit from reading this, please share it with them. You can use the buttons below or you can spread the word about Fire The Boss at parties :-). Just don’t make your friends feel sick of you telling them how awesome this site is.
Let’s get the discussion started: do you already invest or think about investing? Has this article been of any help to you? Let me know in the comments below!