Now let’s continue the discussion we started earlier about investing…

“Be fearful when others are greedy. Be greedy when others are fearful.”

Warren Buffett

Earlier we introduced stocks and bonds as well as mutual funds and ETFs. Let’s expand a bit more on these investments and introduce some important concepts to help understand the basics of investing money.

What are stocks?

As previously mentioned, shares of stock represent a small piece of ownership in a company. These shares are listed on an exchange where they can be traded with other people or companies. An exchange is like an electronic version of a street market. Stock originally comes from companies that “go public”, meaning they sell shares of their stock to institutions and individuals. They do this to raise money so they can grow their business.

You buy and sell shares of stocks through a brokerage account. It’s like a bank account but provides access to these exchanges where you can buy and sell stocks and other securities or investments. The brokerage account is also where you hold these positions.

Stocks have a “ticker” or identifier. Apple is “AAPL”, Nike is “NKE”, Netflix is “NFLX”. Sometimes they change. Facebook used to be “FB” but then the company changed its name to Meta and the ticker is now “META”.

You can only buy shares in companies that are public. Private companies that you might be familiar with, such as Bluestone Lane or Joe & The Juice, don’t have shares listed to invest in. Someday they might “go public” to raise money to expand, but for now, they are privately held.

How do you make (or lose) money in stocks?

If a company returns some of its profits to its shareholders, you’ll receive a dividend. For example, if you own 100 shares of AAPL and it pays a fifty-cent dividend per share, then you’ll receive $50. It will be deposited in your brokerage account.

Dividends are one way to make money investing in stocks but most people invest with the expectation for the stock price to appreciate. The price of a stock reflects what people in the market are willing to buy and sell it at. If the company is successful, grows its business, and earns more money, then people are willing to pay more for a share and the price will go up. This can be significant for a consistently successful company over the long term. For example, Apple’s stock is up about 70 times since they announced the iPhone in early 2007. You would have gained a lot more from the price increase than the dividends they paid along the way.

Big established companies that are very profitable but are not growing that much might be attractive for the opposite reason. Their price might move up or down a bit here and there but they pay consistent dividends so you earn good income from them. Some examples are energy stocks, banks, or large conglomerates like GE or IBM. In fact, now that Apple is so big, you might make more in the future from dividend payments than from the price increase, even though in the past it was a fast-growing stock.

What are bonds?

Bonds are a different way companies raise money. They are loans a company takes out by selling bonds to the public. These usually pay a fixed interest rate, called a coupon, so don’t have the price gain potential that stocks have but also are less risky since they have “seniority” over stocks. That means the coupon payments have to be made before they can pay out dividends to stockholders.

Companies aren’t the only organizations to raise money by selling bonds. Governments - federal, state, and local - will also sell bonds. Government bonds pay a lower interest than corporate bonds because they are safer - the government guarantees the payments (in most cases) so they don’t need to pay as high an interest rate to borrow money as a corporation does.

Is “cash” just, well, “cash”?

You will see also “cash” referred to as a type of investment. This doesn’t literally mean cash you’d keep in your pocket or in a savings account. It means cash-like investments that are essentially risk-free, such as short-term Treasuries. Since these are backed by the US government, they don’t have the risk of default or of not being paid back. They do earn interest, however, so are usually part of an investment portfolio.

“Don’t look for the needle in the haystack. Just buy the haystack!”

John Bogle

There are over 6,000 public stocks traded in the US and hundreds of thousands of corporate bonds available. Sifting through all of these to find good opportunities is an impossible task. There are professionals who will do this and pool them together into funds. Then instead of buying stock or bonds in an individual company, you are buying a share of the pool that may contain dozens or hundreds of different stocks or bonds.

Of course, these funds aren’t guaranteed to do any better than you might, and they also charge fees for the work they do so that takes away from your potential gain.

But there are also funds that don’t need to do any real work to pick their stocks. They just buy the same ones that are part of an index. So an S&P 500 fund just owns shares in the 500 largest US companies. Or a Bloomberg US Aggregate Bond fund owns roughly the 10,000 largest corporate bonds in the Bloomberg index. Since the fund managers are just using a published list to determine which stocks or bonds to own, they don’t need a big research staff and thus their costs are much lower and the funds have very low fees. When you invest in funds that track a major index, it’s like you are buying a very small piece of the entire economy.

Buying a number of investments or pools of investments is a form of diversification

We mentioned stocks, bonds, and cash earlier. Over the last 100 years or so, stocks have returned an average of about 10% a year, bonds about 5%, and cash about 3%. As we’ll soon see, in any one one year it can vary a lot, but those are pretty typical averages.

Since stocks have the potential to grow in price significantly, why not put all your money into stocks? Well, that introduces the concept of risk vs. reward or the risk-reward tradeoff…

No free lunch

Here’s a chart of different types of investment classes or asset classes, showing their average long-term return and their risk, expressed in the typical annual percentage move (the standard deviation of their price changes).

You can see that to achieve higher returns you have to be willing to accept more risk, but note that the relationship curves downward and is not linear. That means the additional risk grows faster than the additional return so you have to be cautious about investing in high-return securities.

From this chart it might appear that you have only a few types of investment choices and none of them may be in the ideal spot on the curve where you would be most comfortable. But you can use a combination of different types of investments to achieve a mixed result that will fall somewhere else on this curve.

For example, if you choose to put 75% of your investments in Large-cap stocks and 25% in Corporate bonds, that portfolio would fall roughly on the curve between those two points, closer to the Large-cap point. This process of choosing different portions of your money in different types of investments is called asset allocation.

We’ve covered a lot of details about investing. Let’s now wrap all of that up into some straightforward advice in terms of managing your investments.

Three investment approaches

Let’s look at three approaches to investing that build on the ideas we’ve discussed.

“The biggest risk of all is not taking one.”

Mellody Hobson

In terms of investing, if you were to distill all the things we’ve discussed so far and implement the simplest approach that would require the least amount of time to manage, the recommendation would be:

Putting 100% in the stock market might sound a little scary, but consider your situation. You are young, you have cash on hand, and shouldn’t need to dip into your investment portfolio, thus you can afford to take the most risk at this point.

This is the exact strategy that Warren Buffet recommended in his 2013 letter to shareholders. He said to put 90% in an S&P 500 Index fund and 10% in cash but since you will already have an emergency cash fund set aside, they are effectively the same thing.

A second approach, that requires only slightly more effort, is to introduce an asset allocation layer across stocks and bonds. In this model, you’d maybe put 90% in stocks and 10% in a large bond index fund or ETF like AGG. Then each year when you put your additional accumulated savings in, you’d split it up to reach that target allocation after adding in the additional money, like the previous example we walked through.

This is slightly more work but since you only need to rebalance once a year, it’s not a big deal. And it will get you more familiar with the practice of asset allocation, rebalancing, and averaging.

You can also shift from the first model into this model down the road, say in your 30s when you don’t feel as comfortable with 100% in stocks. Plus, you can expand this approach into other asset classes at that time, say real estate, commodities, or international equities.

You could stay with this model your entire life and as you get older and closer to retirement, just shift more of the stock allocation into bonds and also into cash, targeting to have maybe an allocation of 60% stocks, 30% bonds, and 10% cash near retirement.

Approach 3

The third approach is probably only something you’d consider if you really find investing interesting and want to spend more time and attention on it. You could set aside a portion of your portfolio to invest in a few individual stocks. You should start small, putting no more than a quarter of your portfolio and shifting it into 3-5 stocks that you are interested in. That’s enough to make a difference if one of them does really well but also small enough that if one of them crashes, it won’t set you back too much. Fewer than 3 stocks are risky because you’ll end up with too much money in one position. And more than 5 stocks start to become a lot of work to stay on top of them, plus the positions will be small enough that a big gain won’t have much of an impact on your overall portfolio.

This approach will require more time to keep up to date with the stocks in case something changes and you might want to reconsider the investment. You should review your portfolio each quarter instead of annually to see if any of the reasons you originally bought any of the stocks has changed, in which case you might want to sell a position.

With individual stock positions, there will be more ups and downs in your portfolio. It’s easier to get anxious and make a rash decision, which you want to avoid when investing for the long term. That’s why this approach isn’t for everyone.

I recommend starting with the first approach and then over time you can grow into the second and even third approach as you develop more interest.