Welcome to Part I of MAXuniversity

February 14, 2007

We're glad you're here. Consider this first part an investing primer. In it, we'll talk about what investing is, cover some important investing concepts, and discuss some popular investment options. We're not going to tell you about how you should pay off your credit cards before you start investing (you should), or suggest ways to save money like cutting your own hair (you shouldn't). We are going to assume you're reading this because you have some extra cash lying around (either a lot or a little) and would like to figure out how best to invest it.

First, you shouldn't start investing with the intention of getting rich overnight. In the investment game, no adage is more appropriate than "Slow and Steady Wins the Race." Your objective should be a 10-12% return per annum for most of your pre-retirement years. Spectacular? Not like the recent market performance. But even a 10% return per year for twenty-five years increases the value of an investment tenfold, and that ain't bad.

That said, let's get to the good stuff.

What is investing?

To oversimplify a bit (we're pretty simple people), investing is using the money you have to try to make more money. It's the exact opposite of consumption, more commonly referred to as buying stuff. When you plunk down money for a new television, you do so because you want to watch Oprah or Monday Night Football. You have no illusions that you will get any value from the purchase besides the ability to watch TV. You certainly don't expect to resell the television for a higher price sometime down the road, or to be able to rent it to some guy who can't afford to buy a television of his own. That's consumption.

You invest, on the other hand, because you think you can sell your investment for a future profit (like a stock), or because you think your investment will produce some kind of income (like a house you can rent), or a little of both.

Risk vs. Reward

To a certain extent, investing is trying to predict the future. A safe investment is one in which the future outcome is more certain. A riskier investment is one in which the future is less so. When you put money in a bank CD (certificate of deposit), you're literally guaranteed to get your money back, plus a little interest. Because they're so safe, you're not going to make a heck of a lot of money investing in a CD. What comes with a CD's low risk is a low return.

Other investments aren't so safe. If you invest in, say, a llama farm, there are a whole host of things that could cause the farm to fail and you to lose some or all of your investment. Nobody likes the taste of llama-burgers, your herd is stolen by llama rustlers, there's a llama wool glut on the market, whatever. Because of the higher risk associated with this kind of investment, you'd expect a higher rate of return than from a CD. One of the keys to successful investing is putting your money in investments where the risk level is appropriate for the potential return.

Investment Options

We've divided the investment options listed below into two categories. "The Bad Ones" are investment vehicles we think the average person would be wise to stay away from. "The Good Ones," - real estate, stocks, bonds, and mutual funds - are the investments we think offer the greatest chance for success.

The Bad Ones

Precious metals, heating oil, frozen concentrated orange juice concentrate, pork bellies, any other kind of bellies – The rules of the commodities game seem pretty simple: You think the price of something like gold, heating oil or pork bellies is going to go up. Some other guy thinks the price is going to go down. You make a contract with the other guy (through a broker who makes a commission no matter what happens). If you're right, you get his money; if you're wrong, he gets your money. O.K., you may be thinking, odds are 50/50 (less the broker commission, of course). Could be worse, right? Not really. Chances are the other guy does commodities trading for a living, and knows something about the commodities market that you don't. In fact, this guy probably knows a bunch of things about the commodities market you don't. Do yourself a favor. If you're considering investing in commodity futures, think again. You'll be much better off going to Las Vegas. You'll still lose a bunch of money, but at least you'll get to see Wayne Newton.

Beanie babies, baseball cards, superman comics, etc. - Collectibles. We're all for buying 'em… if you want to put them on your mantle piece and show them off to your friends when they come over. But as investments, collectibles aren't so hot. They have no potential for earnings or income. They offer the buyer only one way to make money - the hope that in the future someone will pay more for it then the buyer did. Don't get us wrong, this does happen. But for every $20,000 stamp or $10,000 comic book you hear about, there are piles and piles of tag sale junk that aren't worth much of anything. If you have fun with collectibles, go ahead an buy them. Just don't expect them to make you rich - you'll probably end up disappointed.

Schemes hatched by your hare-brained brother-in-law - Never invest in any scheme in which your hare-brained brother-in-law is involved. You will lose every cent of your money, guaranteed. And while we're at it, include schemes of your hare-brained father-in-law, hare-brained cousins, hare-brained friends, hare-brained cousin's hare-brained friends, and anyone else, hare-brained or not, you know, meet on the street, talk to on the phone, or come in contact with in any way. The point is that you should stick to mainstream investments like stocks, bonds, and mutual funds. It's just too hard for regular people to judge the value of obscure investment opportunities (heck, most of the time it's too hard for professional investors to do it).

The Good Ones:

Real Estate - Purchasing a home should be most people's main investment goal. Over the long haul the value of real estate almost always goes up. It rarely drops 50% in price a few months after you buy it like individual stocks can. There are also many tax advantages to owning your own home. Besides, you can live in a house. No matter how much Microsoft stock you own, you can't raise a family in their offices in Seattle (actually, if you owned a lot of the stock, you could vote yourself in to run the place, and then do whatever you want, including changing the slogan for Windows Vista to "Hold the pickles hold the lettuce, Janet Reno - you can't get us"… but I digress).

Bonds - Bonds are a tradable form of debt, or money that a company or a government owes. Let's say your city decides to build a new dog racing track. The going rate for new dog tracks in your neck of the woods is $1 million dollars, and your city just doesn't have that kind of cash lying around. So they do what a lot of people do when they want to buy something they can't afford: they borrow. And the way they borrow is by selling bonds.

When an investor buys one of these dog track bonds, they are buying a promise made by your city to repay the borrowed money in a certain time period and at a certain rate of interest. Buying these bonds is considered a very low risk investment. Your city isn't going anywhere (unless it is hit with one hell of a tornado), and chances are it's going to have enough money from taxes, parking tickets, and dog race gambling proceeds to pay any money it owes.

Most large corporations also issue debt in the forms of bonds. Corporate bonds are a bit riskier than state, local, or federal government debt because companies may not earn enough to pay the money back. Different corporations have different risk levels. Those whose perceived ability to pay back loans is less than other bond-issuing companies will issue bonds with a higher yield. The riskiest of all are called junk bonds: bonds issued by not so creditworthy companies that pay higher interest rates because of the greater risk of these companies defaulting on their loan payments. The risk/reward tradeoff is very obvious in bonds: The higher the chance that the debtor may not be able to make payments, the higher the bond's yield to maturity.

Here are the good points about bonds:

  1. Low risk - United States Government Bonds are extremely low-risk investments. Barring the collapse of the government, you're guaranteed to get paid exactly what the bond promises, when it promises. Bonds from big established companies like General Motors and IBM are just slightly less safe than government bonds (slightly less safe works out to about a 1% higher interest rate). If you invest in U.S. Government or any highly-rated corporate bonds (bonds are rated for safety by bond rating companies), there is very little chance you will lose even a little bit of your money over the life of the bond.
  2. Income you can count on - Most types of bonds pay what's called a coupon - the interest on the money you've lent, usually every six months. You can bank on this bond income arriving in your mailbox when it's supposed to for the duration of the bond's term.

But investing in bonds does have some drawbacks:

  1. Low risk - "Hey, you listed 'low risk' under both 'good points' and 'bad points'!" Right you are. The safety of bonds is both a good thing and a bad thing. Remember what we said earlier about risk vs. reward? Well, buying bonds is about as low-risk as investing gets - with the less-than-stellar returns to prove it. Currently, (currently being late 2007,) U.S. Government 30-year bonds are yielding an annual rate of about 5%. For every $1,000 worth of bonds you buy, you'll make $50 per year. That's not too bad, and for some of your money bonds are probably a great choice. But there are investments out there, like certain stocks and stock mutual funds, that are just a little bit riskier than bonds but with far better potential returns.
  2. Interest rate fluctuations - When interest rates fall, people who lent money (bought bonds) at a higher rate are very happy because this increases the value of their bonds. The opposite happens when rates go up. Wouldn't you rather own a bond paying interest of 6% per year than 5%? So would everyone, making the market price of the 5% bond lower than the 6% bond. This effect is worse the longer the life of the bond, because while losing that 1% deference for a year is not that bad, losing it for 30 years is a very unpleasant thing. This is why owning long term bonds is great when rates fall, but awful when rates rise.

Individual stocks - While bonds are tradable debt, stocks are tradable ownership (a.k.a. equity). Stocks represent shares of ownership in a company that can be bought and sold. When you own a stock, you own a piece of the company which issued it. If that company does well, your stock will probably go up in value. If the company performs poorly, the stock can go down. If the company goes bankrupt, you'll probably lose the whole enchilada - the whole enchilada in this case representing all the money you've invested.

Here are the good points about stocks:

  1. You own a piece of the action - Stocks represent ownership, bonds represent money you've lent. Owning a piece of a company that grows fast can be very rewarding. Would you rather have had Microsoft owe you 8% a year in interest over the last 10 years, or owned its stock that's gone up in value 20-fold?
  2. Time is on your side (yes it is) - If you have a long-term investment strategy, a diversified portfolio of stocks almost always beats out a portfolio of bonds. The long-term return (over the last 70 or so years) on stocks is around 11%. Bonds have returned about half that. As long-term investments, stocks have historically been pretty tough to beat.

OK, you ask, what are the bad points about stocks? There are a few:

  1. Time. Specifically Your Lack of It. Picking good stocks is not that easy. To invest properly you should research and analyze a wide range of factors, including the potential company's price-to-earnings ratio, its management team, its growth and earnings projections, market share, etc. Then do just as much work on its current and potential competition. And this isn't a one-time event. To manage a portfolio of individual stocks correctly, you should be constantly updating your research on the companies whose stocks you hold. It's not that picking good individual stock is impossible; in fact, knowing how to research companies is a great skill to have. But if you are going to invest in individual stocks, you should be prepared to spend a lot of time sitting at your computer, reading financial publications and financial statements, etc., - time we hope you can think of about seven thousand better ways to spend. (If you can't, drop us a line. We'd be glad to suggest just a few.)
  2. Difficulty with diversification - Diversification is the investment equivalent of not putting all your eggs in one basket. It's one of the things that makes mutual funds such an appealing investment (more on that later). By spreading your money among many different investments, the chances of them all going south at once is pretty remote. If one goes down, chances are another will go up. It is difficult for an individual investor to build and maintain an adequately diversified stock portfolio. It means having money in a wide range of domestic and foreign stocks, as well as bonds and money markets. This level of diversification allows you to invest at a fairly high-risk level and get a relatively stable return. Assuming you could actually do enough research to pick all these stocks and bonds - and assuming you could actually buy most of these securities domestically - it would be almost impossible for an investor with a moderate amount of money to purchase them in lots that were efficient from a trading perspective. To own a small piece of hundreds of different securities worldwide would require a portfolio of several hundred thousand dollars at the very minimum.
  3. Transaction costs - When you buy or sell a stock, you have to go through a broker, the intermediary between you and the security you want to buy. Buying and selling stocks can produce very high transaction costs (read: brokerage commissions and market maker profits) for the relatively small trades the individual investor would have to do to maintain a diversified portfolio.
  4. Long, protracted bear markets - For all the hoopla about long-term performance, stocks can be bad investments. Real bear markets (the likes of which we haven't seen since the '70s) can take years to shake out. There have been 10-25 year stretches where people have made nothing in the market. The Japanese market, even counting recent gains, is still down over 50% from the highs it hit over 10 years ago. Bottom line, if you overpay for a stock, it may take a long time for the fundamentals to catch up with the hype you bought. Fortunately for all of us, really bad bear markets are a rare event (knock on wood).

Mutual Funds - Mutual funds are one of America's most popular investment vehicles, and with good reason. They solve many of the problems inherent in other investment vehicles by offering individual investors inexpensive access to expert management and easy diversification. Part II of MAXuniversity focuses solely on mutual funds: what they are, how they work, and why they may just be the best choice for you. Read on!