Thursday, December 29th, 2016

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Invest in What? Stocks vs. Index Shares

For some people, coming across an expression like "index share" is like discovering a flattened spider in your book – Eeuuuch!! But there’s nothing very horrifying going on here. Our title simply lists two types of investment opportunities. Let’s take a look at each…

When you buy a stock, you’re getting a small piece of an individual corporation. In effect, you become part owner of the business, and you may profit from ownership through dividends (cash or stock) and/or capital appreciation (the market value of your stock rising). Of course you can lose money too, if the value declines.

Historically, stocks have been a rewarding long-term wealth-building tool, averaging about a 14% annual return since the end of World War II, while bonds averaged 6.2%. The flip side is that – as many people discovered in 1929, 1973, and 2000, for example – they can be very volatile as well.

The three main United States stock markets are the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the National Association of Securities Dealers Automated Quotation System (NASDAQ). When people ask, "What did the market do today?" they’re usually referring not to the stock market as a whole but to one of these exchanges – or to one of the major market indexes.

Of these, the most prominent are the Dow Jones Industrial Average ("the Dow"), which tracks the stock of 30 very large industrial companies, and Standard & Poor’s 500 ("the S&P 500"), which represents almost three quarters of the total domestic US stock market.

Investors categorize stocks according to both their style as perceived by the marketplace, and the size of the company itself. Growth stocks are shares in fast-growing companies that reinvest a large portion of their earnings in an effort to expand and become more profitable.

Because of aggressive profit-reinvestment, they tend to pay small or no dividends and investors buy them because they hope to make money on capital appreciation. Value stocks are generally older, more established companies that are relatively out of favor with investors. The "value" label suggests that their potential may have been underestimated.

Stocks are also classified as Large Capitalization (where the company has a market value of $5 billion or more), mid-cap (between $1 billion and $5 billion), and small-cap (less than $1 billion). The market capitalization of a company is essentially the price of its shares multiplied by the number of shares.

An index share is part of a fund (actually a "unit investment trust" – as we’ll see there’s a difference) that’s set up to automatically mimic the behavior and return of a standard benchmark, like the S&P 500 or the Dow.

Instead of clever people trying to "beat the benchmark" with headline-making returns, fairly simple computer programs exactly follow the benchmark. A return that’s very close to the chosen benchmark is almost guaranteed. Sounds boring, doesn’t it? Not when you see the numbers.

It turns out that outperforming a benchmark index like the S&P 500 is amazingly hard to do (consistently, in the long run), even for those guys ordering the lobster and champagne. And, because the easy-to-manage index share saves you a couple of percent on every transaction (computers almost never eat lobster), it’s even harder than that (after taking fees into account) for mutual funds to hand you more capital gain than you can make in index shares.

Okay, we’ve been a teeny bit unfair so far. To be precise, there are actively managed mutual funds, passive funds, and index shares. The active funds spend about 2% of their value per year on lobster lunches and other necessities; the passive funds, which try to mimic an index, cut this down to around half of one percent. But the cost of running your index shares is about half of that.

It’s the cheapest way of tying your investment to a major index of stocks, with all the diversification that that implies. Also, because the rules for these "ETFs" (Exchange-Traded Funds) are different than for mutual funds, index shares don’t have to make a capital gains distribution. Good news for long term ShareBuilders who want to avoid adding to taxable income before selling.

The best-known index shares are "Spiders" (shares in the S&P 500: SPY) and "Diamonds" (shares in the Dow: DIA). But ShareBuilder currently offers 68 different index shares, so it’s easy to create a group of them representing different major sectors of the American (and world) economy.

Which investment (or combination of investments) is right for you? It depends on many things, including your investment objectives, investment window, risk tolerance, financial situation (obligations, need for liquidity, etc.), tax-bracket, investment experience, and so forth. There’s no one answer, just a lot of options.

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