Summary - gentle intro to investing
All three parts in one little post.
This post is meant for review of concepts after you’ve read the gentle intro to investing, not for initial learning. I hope it helps. The Vocabulary & further resources post has links for all the jargon we’ve introduced.
Part 1
Stocks
Shares, stock, shares of stock, and equity are all similar terms about owning pieces of a company.
An initial public offering (IPO) is when a company first sells shares to the public in order to raise money. After the company sells its shares, investors buy and sell shares with one another.
The total value of all of a company’s shares is the company’s market capitalization, usually shortened to market cap. In recent years, Apple has usually had the world’s largest market cap.
Shares represent a claim to the company’s assets and future profits. Share prices reflect investors’ beliefs about the value of that claim, and share prices shift constantly as investors transact at different prices.
The value of each share doesn’t convey any information about the company. Stock splits can divide shares into pieces to reduce the share price to a more reasonable number.
Tickers like AAPL help uniquely identify a stock.
Bonds
A bond is an asset representing debt, and purchasing a bond gives you the right to periodic coupon payments from the bond issuer as well as payment of the face value when the bond finally matures.
The predictable coupon payments of bonds are why they’re also known as fixed income. Bonds are issued (sold) by governments and government-related entities, as well as companies.
Individual stocks and bonds vary greatly in their risk but, as a whole, bonds have less risk and less long-term return than stocks. If a bond issuer fails to pay its bondholders in full and on time, this is referred to as default.
Bonds that are less likely to be paid back in full command higher expected returns to accompany their risk. US Treasury bonds are extremely safe, whereas corporate bonds and municipal bonds are less safe. Corporate bonds are divided into two broad categories based on credit quality: investment-grade bonds (with comparatively low risk) and high-yield bonds (also known as junk bonds).
Bonds are highly varied, which lets you select the degree and type of risk you want. While stocks do vary in risk, there’s no such thing as a “safe stock”.
The rest
There are two basic ways for a company to raise money: debt and equity. Going public streamlines the processes of selling equity (by issuing additional shares) and borrowing money (by issuing bonds).
Rather than manage a complex portfolio of individual stocks and bonds, you can diversify and simplify in a single step by purchasing shares of an investment fund.
Part 2
An index is like a list of directions for an index fund, showing which stocks it needs to own and in what proportions. An index fund is committed to matching the index portfolio regardless of its performance.
Many index funds are market cap-weighted (often abbreviated to cap-weighted). Cap-weighted funds hold each stock in proportion to its market cap. The S&P 500 is one example of a cap-weighted index.
Investing in an index fund is often called “passive investing”. If a fund doesn’t track an index, it’s “actively managed”. Active funds may trade stocks according to a manager’s personal discretion or by using a systematic strategy. Active funds typically benchmark their performance against an index.
Actively managed equity funds perform worse, on average, than a reasonable index benchmark. It’s very difficult to select active equity funds that will outperform in the future. Bond funds are a mixed bag, and selecting successful active bond funds in advance is significantly easier.
There are several reasons why the bulk of actively managed funds underperform a passive approach. One important reason is that investors are competing to place their money with the most talented managers. Managers who show signs of skill are rewarded with more money, but as a fund grows, it becomes more and more difficult for the manager to outperform.
Most index funds aren’t exactly passive, because they favor some stocks over others like active funds. Even the creators of the S&P 500 make many subjective decisions.
Once you’ve decided to invest in stocks, the most passive approach is to buy a fund with a global, market cap-weighted portfolio (like Vanguard’s fund VT). But even if you decide to buy a passive stock portfolio, you still have to make many active decisions as an investor.
Part 3
Brokerage account
A brokerage account is the standard investing account, with no limit on how much money you can contribute and invest. The investments are taxable, which is why I’ll sometimes call it a “taxable account” for clarity. At the moment I recommend opening a brokerage account with Fidelity or Schwab, but especially Fidelity due to its automation features.
ETFs and mutual funds
A fund can be structured as a mutual fund or an exchange-traded fund (ETF). Both can be actively managed or track an index: the fund structure has no inherent relationship with the management style.
For practical purposes, the NAV (net asset value) of a fund can be considered equivalent to its share price (see the footnote for differences, if you’re curious).
Because ETFs are exchange-traded like stocks, many aspects of ETFs and stocks are shared. They both trade at varying prices throughout the day and have a bid-ask spread. Their shares are traded discretely (i.e., in wholes not in fractions).
Mutual funds can be transacted only once per day, and there is no bid-ask spread. Some of them have a minimum initial investment. You can buy or sell any dollar amount, since you’re transacting directly with the fund instead of trading shares on an exchange.
Every ETF is available in every brokerage account, whereas mutual funds have limited availability. You have to be aware of the possibility of certain fees in mutual funds that ETFs never have. Stock ETFs are more tax-efficient than stock mutual funds.
Capital gains and dividends
You experience a capital gain when an asset you own rises in value. The share price of a fund rises when its holdings increase in value.
An ex-dividend date (AKA ex-date) is declared in advance of a cash dividend. Those who own shares of a stock at the end of the day before the ex-date will receive the upcoming dividend on the payment date. The share price falls on the ex-date, by slightly less than the dividend amount (due to tax effects). You can automatically reinvest your dividends.
Aside from a cash dividend, the most common distribution from a fund is a capital gains distribution. It represents the taxable, realized net gains that a mutual fund is required to pass on to its shareholders at least once per year. Stock ETFs have a lower tax burden because they almost never have to distribute capital gains. The distinction isn’t as important for bond funds, because bond ETFs sometimes have to distribute capital gains.
Total return
Total return is the key performance measure of any security. It’s the combination of capital gains plus all distributions, assuming immediate reinvestment of distributions.
More about funds
Some brokers (like Fidelity) allow you to buy fractional shares of ETFs.
The expense ratio on a fund’s webpage shows the fees that are automatically withdrawn from the fund. Active funds charge higher expense ratios than mainstream index funds.
A basis point is a convenient way to express a hundredth of a percentage point.
As with stocks, a fund can split its shares. Less commonly, stocks and funds can also conduct a reverse split to combine shares if the price is extremely low.
Mutual funds have distinct tickers that are always five letters ending in an X. ETF tickers have two to four letters and are not distinguishable on sight from stock tickers, which have one to five letters.
Investing is easy now
Investing has never been so accessible, with such low fees. Commissions for trading US stocks and ETFs have been zero since 2019. You can own the global stock market for six basis points by purchasing shares of VT. Congrats on living in the present.
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That’s all! Here are links to:
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