Investing For the Beginner
The financial and stock market crisis that erupted in September, 2008, still makes headlines as it continues to impact lives around the world. The news over the past 16 months has been hard to take for the most veteran investors. So what is the investing newcomer to think and to do? Despite recent events in the stock market, there are some viable, straightforward, and conservative ways to dip the toes into the investing waters, and to come through it with the toes still attached.
Stocks and Bonds and Mutual Funds, Oh, My!
There has never been a time where the individual investor has so many choices: stocks, bonds, mutual funds, exchange-traded funds (ETFs), currencies, real estate investment trusts (REITs), options, commodities, precious metals, fine art, fine wines, vintage automobiles, sports memorabilia, collectibles. There is also no shortage of hawkers telling you that now is the time for their particular investment, and that for a relatively small investment unimaginable profits are yours. The stark reality is that the novice investor, and a significant portion of experienced investors, lose money; a lot of money.
The first thing that the new investor needs to know is that every one of the above investments can make money and they can lose money. So how does one figure out where to start and with what? Treat investing as you would any other new topic that you want to learn and master: start simply. That ordinarily means start investing with stocks, because you have a single company on which to focus your education and money. A simple way to start is to pick a company from among those with whom you conduct regular business. Do you grocery shop at Safeway? Do you buy appliances or tools at Sears? What about buying clothes at Macy’s or JC Penney? Maybe you’re more upscale and buy handbags at Coach. Each of those retailers is a publicly traded company whose stock is readily traded on the major exchanges.
But here is where a simple stock gets more complicated. How do you know which of the above stocks is the right one to choose? Will Safeway be a better stock investment than Macy’s? Will it be better than Coach? To figure out the answers to these questions you will have to research the stocks from among which you will make your choice. What kind of research should you do?
There are two distinct schools of investment analysis: fundamental and technical. Fundamental analysis looks at a company’s business aspects such as revenue, expenses, debt, earnings, business growth, liabilities; technical analysis looks at stock trading statistics such as price trends, volume trends, and chart patterns. Whatever analysis technique you choose will require you to become educated so that you can develop informed insight into your particular stock investment. The good news is that there is no shortage of information with which to educate oneself. The bad news is that even after you do educate yourself you have to apply what you’ve learned; there’s no guarantee that you’ll apply it correctly.
So What’s a Newbie To Do?
We said earlier to start simply, and that ordinarily meant start by investing in stocks. But there is an investment vehicle simpler than stocks: index funds. An index fund is a mutual fund that is constructed to behave as one of the major stock indexes: the Dow Jones Industrial Average, the Standard & Poors 500 Index, and the NASDAQ 100 Index, being the most notable. These index funds are simpler because you don’t have to figure out how a particular stock is going to behave, or what will drive price movement. An interesting fact to consider is that approximately 80% of a stock’s price movement is due to general stock market action; that means that only 20% of the price movement is due to aspects particular to that stock or its industry sector. So why not just try to figure out what the general market is going to do? That will take care of roughly 80% of the movement of whatever stock you would analyze; why spend all that extra time analyzing the stock just to figure out 20% of the movement?
Index funds belong to a class of mutual funds called exchange-traded funds, or ETFs; these are mutual funds that trade actively just as stocks do. A traditional mutual fund invests in a group of stocks, but the fund’s share price (called its Net Asset Value, or NAV) is calculated after the market close each trading day. This is because the price of each stock in the fund fluctuates throughout the day; if the fund owns ten to fifteen stocks, it would be extremely difficult to calculate the fund value instantaneously. So the mutual fund shares don’t trade during the business day; their value is set after the market close, and you redeem your shares at the previous day’s NAV.
Exchange-traded funds invest in a group of stocks just as a traditional mutual fund; they also include additional investment vehicles, such as options. The big difference from a traditional mutual fund is that ETF shares trade actively throughout the day just as any other individual stock; the share price is set by the buy-sell action on the particular exchange where the fund trades, thus the name “exchange-traded fund”. There are ETFs for all of the major market indices and there are ETFs for major market sectors, such as industrials, financials, technology, semiconductors, and there are ETFs for major commodities, such as oil and gold. This opens new opportunities for the average investor who wouldn’t normally venture into commodities; you can now treat these commodities just as you would any other stock. If you think that the price of gold is going to rise in the future, you can buy shares of a gold-ETF whose share price will move in conjunction to the price movement of gold. You can do the same for crude oil.
Finding a Fund for You
Sticking with our initial principle to start simply, we suggest beginning with one of the two oldest index ETFs: the Dow Diamonds (ticker symbol DIA), which is constructed identically to the Dow Jones Industrial Average; the S&P Depositary Receipts fund (ticker symbol SPY), which is constructed identically to the S&P 500 Index. These ETFs allow you to “trade the market” instead of trading a single stock.
The Dow Jones Industrial Average contains 30 of the largest and most well-known US companies, such as IBM, AT&T, Intel, and Microsoft. Since there are only 30 stocks, the average is susceptible to sharp price moves if one or two of the thirty stocks has a larger than normal price movement. The S&P 500 Index contains 500 of the top US companies, making this index much less susceptible to the extreme price movements of a few stocks. If you want to have more dynamic price movements, known as volatility, so that you have the potential for greater gains (and losses!), you might want to trade the DIA; if you want less volatility so that there is slightly better predictability, you would be more comfortable trading the SPY.
Where Do You Go From Here?
A good way to start with either of the suggested index ETFs is to closely follow the underlying market indices (Dow Jones Industrial Average or the S&P500 Index) to become familiar with how these indices behave over time. You should also follow the ETFs to understand how they behave relative to their market index. Finally, you should begin your research into your selected ETF. Determine if you want to use fundamental or technical analysis techniques, and dig in.