Asset Primer I: Stocks (2024)

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Hopefully you have started your financial path to, and possibly have already achieved, becoming a Capitalist.

Regardless of where you are in this journey at some point you will have a certain amount of money “sitting on the sidelines” and ready to be deployed as your untiring worker.

One of the scariest decisions is to take that hard-earned, and even harder to save, money and send it out in the world in hopes that not only will it return back to you but also bring more of its friends along in the process.

With so many investing opportunities out there an investor can be overwhelmed and easily suffer what is called analysis paralysis.

In essence a potential investor is paralyzed by indecision due to the fact that there are so many opportunities out there.

“Twenty years from now you will be more disappointed by the things that you didn’t do than by the ones you did do.” -Mark Twain

In order to make the investing world more manageable it is crucial to break it down into more manageable components, called asset classes.

The big three asset classes are Stocks, Bonds, and Real Estate, each with it’s own pros and cons for a potential investor.

Before you invest in anything, you truly have to understand it in order to avoid my foolish mistake 4a.

I feel a primer is therefore necessary to give you a very basic overall lay of the land.

Stocks:

Buying stocks is in essence buying a share/equity stake in a company or companies.

Pros: Over longer timeframes has resulted in greater returns than bonds

Cons: More volatile than bonds/real estate.

There are many ways to categorize stocks:

1. Geographic location
   • Domestic (US based)
   • International
     • Developed
       • More economically advanced/stable countries (which can include such countries as Canada, Germany, the U.K., Australia, New Zealand and Japan)
     • Emerging
       • Countries which are rapidly developing but do not have stable mature capital markets and have typically lower per capita income levels (Brazil, Russia, India, and China, Portugal, Ireland, Italy, Greece, Spain can fall in this category)
2. Market capitalization
   • Large cap (>$10 billion) and Mega cap (>$200 billion)
     • Tend to be more stable/less volatile or risky
   • Mid cap ($2-$10 billion)
     • Considered less risky than small cap stocks, more risky than large cap stocks.
     • More growth potential than large cap stocks
   • Small cap (<$2 billion)
     • Riskier/more volatile than mid and large cap stocks
     • Can outperform large cap stocks when emerging from a recession but typically underperform during recession
     • Have an even riskier subset of micro-cap ($50 million-$2 billion) and nano-cap (<$50 million)
3. Market Sectors
   • Stocks can be classified into sectors by the types of companies they represent
     • Financials: Banks, insurance companies, investment companies, etc.
     • Utilities: Gas, Electric, and water companies
       • Typically known for paying higher dividends
     • Consumer Discretionary: Companies dealing with media, retailers, consumer service providers, apparel
     • Consumer Staples: Companies dealing primarily with basic necessities such as food and beverage
       • In economic turndown retain value longer and are considered defensive plays
     • Energy: Companies dealing with gas and oil exploration, refineries
     • Healthcare: Health management firms, biotechnology companies, medical device manufacturers
     • Industrials: Construction companies, Aerospace, Machinery, Defense
     • Technology: Information technology firms, Electronics, software
     • Telecom: Wireless providers, cable, internet
     • Materials: Mining, refining, chemical, forestry related services
     • Real Estate: Residential, Industrial, and Retail
4. Individual stocks vs Mutual Funds
   • An investor can invest in a single company or purchase a mutual fund that can hold hundreds or thousands of companies
     • Individual stock
       • Pros: Typical transaction cost is at time of purchase and time of sale. If lucky enough to pick the right company can see massive gains
       • Cons: Lacks diversification so if market forces shift or company goes bankrupt can lose it all
     • Mutual funds:
       • Pros: Allows broad diversification and minimizes risk compared to individual stocks
       • Subtypes:
         • Passively managed: Follows a broad based stock index and essentially trends with the market rather than trying to beat it
         • Actively managed: A fund manager/team trying to anticipate market trends and beat the overall market
           • Studies have shown that very few actively managed funds consistently beat index/passively managed funds.
             
           • Higher ongoing costs (expense ratio)
           • WARNING: Beware of mutual funds that give commissions to the salesperson selling them (these are referred to as front loads) which can typically cost 5% of your initial investing amount.
             • Can raise questions if the financial advisor has ulterior motive putting you into these funds versus lower cost ones

As previously mentioned there are so many options available to an investor that it seems daunting.

In any given time period there can be winners and there can be losers.

It would be great if we can know beforehand which horses to bet on but this is not the case.

Sectors come into and then fall out of favor throughout history.

So what is an investor to do?

I feel one of the best ways to have your portfolio exposed to stocks is by investing in the entire market passively.

In 1976 Jack Bogle, gave a gift to the individual investor by creating a Vanguard index fund, the Vanguard 500.

By purchasing this one mutual fund with far lower expense ratios than the more common (at the time) actively managed funds, an investor had an equity share of the top 500 US companies.

Today in addition to this original fund, Vanguard (and many other companies) have created total index funds (for Vanguard it is VTI) which essentially allows to invest in every company in the stock market based on their market capitalization.

For the US domestic stock component of my portfolio the Vanguard Total Index fund is a major component.

Similarly there are total international stock index funds such as Vanguard Total International Stock Index Fund (VGTSX) that offer the same benefit but in an international arena.

With a total index fund as my core, I do not have to worry on which sectors will be winners (or losers) that year, for I will have exposure to them all and in the end it will balance out.

As the following chart clearly demonstrates, the trajectory of the stock market long term is always upwards.

One does not have to be greedy and try to beat the market.

If an investor is patient and stays the course, great wealth can be achieved by just following the market.

This passive total index approach to stock investment has been endorsed by what most consider the greatest active investor of our time, the wizard of Omaha, Warren Buffet, who won a million dollar bet backing index passive investing against active investing.

In fact in a 2014 letter to his shareholders of Berkshire Hathaway, Warren Buffet detailed plans of leaving cash to a trust for his wife’s benefit with instructions to place 90% in index funds and 10% in bonds.

Unless you are the next Warren Buffet, I suggest you follow a similar course.

A passive total index mutual fund is also a primary component in one of the more popular and simpler portfolio allocations, the Boglehead’s 3 fund portfolio.

Superpower Take-home Points:

1. Don’t suffer analysis paralysis and take no action towards investing in the face of overwhelming choices
2. Eliminate the desire to try and beat the market. Instead create wealth by following/indexing the market which has always shown an upward trajectory
3. Beware of fees, hidden or otherwise and potential motives of those selling particular funds (commission based front-loaded funds)
4. Rather than try and pick individual stocks that carry high risk, diversify with mutual funds and follow Warren Buffet’s advice of passive indexing

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