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Sunday, October 26th, 2014


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Diversifying, Bonds, Options, & Dollar Cost Averaging

This article is part of our 52 week journey through Bill’s latest book, The Graduate’s Guide to Life and Money. Each week, a full excerpt from his book will be presented from beginning to end. To get your copy of his book, visit www.TheGraduatesGuide.com.

Make Your Money Work for You
So now you have maximized your 401(k) and your IRA, you have your debt paid off, your emergency fund is set and you are finally ready to get into some serious investing on your own, the Wall Street way. Where should you begin? The best place to start is with a mutual fund.

Some of you are probably thinking, “Why start with a mutual fund? That’s what I have my IRA invested in.” Remember, the money you are investing now is nothing more than personal savings. This is the money you will use to supplement your retirement or buy a new car or a vacation home. You don’t want to lose the first part of your hard earned savings right away in some oil scheme. I’m not talking about putting all of your money in a mutual fund, just the first part. Once you have a decent balance established, you can begin to move money into other riskier ventures. At this point you may want to look into real estate or individual stocks. Perhaps you would like to diversify into corporate or government bonds, depending on your age and risk tolerance. If you have enough money and you really like to play with fire you could even get into commodities and options trading.

Since there are entire books devoted to these riskier types of trades, I am not going to get into too much detail, but I will give you an idea of what they are.

Diversify: All Your Eggs in One Basket
We have all heard the expression, “Don’t put all your eggs in one basket.” This statement definitely applies to the world of investing. You always hear about people making millions of dollars by investing in individual stocks. Some people have made a fortune by sticking with one company throughout their lives (Microsoft, Wal-Mart, Google). So what is wrong with doing the same thing? Sure it’s riskier, but people do it.  Well, let’s not forget about the people who invested all their money in Enron, FannieMae, or Kmart. If you like to gamble in Vegas with large amounts of money, perhaps putting all of your money into one stock is the way to go. Otherwise you want to diversify.

Why should you diversify? I’m not going to bore you with complicated graphs and statistics, but let’s just say your risk of losing all of your money when you own stock from at least 13 different companies is way less than if you own the stock of just one. This is how it works. If you own, for the sake of simplicity, 20 stocks, with the same amount of money invested in each company, and two of the companies go completely out of business, you have only lost 10% of your money. If you would have all of your money in any one of these two companies, you would have lost 100% of your money. Now, assume that three more of the stocks stayed the same, five went up by 10%, five went up by 15% and the remaining five went up by 25%, your total “portfolio” would have still increased by 2.5%, despite the two companies that went under completely. The key to protecting yourself is to diversify.

So how do you diversify? If you try to buy the stocks from 20 different companies, it would cost you a fortune in transaction fees, besides the fact that you could only afford a few shares of each company. There is a much better way to diversify. We call them mutual funds. Mutual funds are basically a large “portfolio” of various investments. Since many people own pieces of a mutual fund, all of their invested money is used to buy a larger share of each investment and it allows the mutual fund manager to purchase many different types of investments to create a diverse investment vehicle.

There are many types of mutual funds. Some invest in stocks, some in bonds, others invest in both. There are also real estate mutual funds and many more. Each fund must follow a set of basic rules that only allows them to invest in certain types of assets. For instance, a growth mutual fund manager would be looking to purchase shares of companies that are expected to grow, so the growth fund will probably not have the stock from larger well-established firms such as General Electric or Coca-Cola.

To invest in a mutual fund, you would go through an investment firm, such as Charles Schwab, Vanguard, etc. They would set you up with an account after you invest a minimum amount and perhaps set up a way to automatically contribute every month. The mutual fund manager takes your money, adds it to the money that is coming from other investors, and purchases either more shares of stock the fund already owns or perhaps shares of stock in companies that are new to the fund.

One important issue with mutual funds is how the investment firm makes money. There are several types of fees that can be charged by mutual funds. There are no-load funds, low-load funds and load-funds. A load is another term for a fee. A load can be charged at the beginning of an investment or when you withdraw your money. If you are charged a front-load fee, for every dollar you invest, a few cents comes off the top right away for fees. So your investment has to earn a decent return just so you can break even. Back-loads are fees charged if you withdraw your money within a certain time period, usually seven years. For instance, you may be charged 5% if you withdraw your money within the first year, 4.5% during the second year, 4% during the third year, etc.

I prefer no-load funds, but keep in mind there are still fees involved, even in no-load funds; after all, the investment companies have to stay in business. There are annual fees that may be charged. You definitely want to stay away from funds that charge more than 2% in annual fees. After all, if you earn 8%, but pay 2% in fees, you are only really getting 6%. That is before any tax consequences are considered. The lower the fees the better. Of course, don’t get so caught up in finding the lowest possible annual fees that you forget to see whether the mutual fund is right for you, or even if the fund has been performing well. What good is the lowest fee, if the fund is losing money?

Okay, so let’s talk a little more about mutual funds. There are several types of funds, which can be broken up into different fund styles. The styles really describe the styles of the managers of the fund. The style can be based on an index, investment strategy, a particular sector, company size, on bonds only, or a money market.

I prefer to invest in index mutual funds. An index fund simply holds a portfolio that represents a major index, such as the S&P 500 Stock Index or the Russell 3000. The advantage of the index fund is that the fees are usually lower since the manager does not have to work as hard to actively manage the fund. Since the goal is to imitate the index it is following, most of the guesswork is removed. There is no real statistical evidence that a professionally managed fund earns a better return for the amount of risk involved than an index fund.

Growth funds are managed to purchase stocks of firms that are expected to grow big over the next few years. Growth funds are riskier, because while they may return big, they may also fall big. Expect a lot of volatility with these funds as the value may go way up and way down from one year to the next. Value funds hold shares of companies the managers of the fund feels are undervalued in some way by the current market. They use all types of complex measurements and formulas, but the point is, they feel the market is currently undervaluing the stock at the moment, and they expect the market to eventually see the error of its ways, and bid up the price.

You can also look into sector funds. For instance, if you believe the health sector is on its way up, but are not quite sure which companies will be the winners, you could invest in a health sector fund, which will invest in the stocks of various firms within the healthcare sector. There are funds for almost every sector available.

Company size is usually split between large-cap, mid-cap and small-cap funds. All this tells us is the relative size (or capitalization) of the company relative to the market. Most large-cap funds invest in companies with market capitalization of $8 billion or more, while mid-cap funds stay above $1 billion and small-cap fall below $1 billion. Large-cap funds are the least volatile, but also results in lower returns. The smaller the capitalization, generally the more volatility, but the greater potential for growth and returns.

Bonds
Bonds come in all shapes and sizes. You can get everything from low-yield treasury bonds that are backed by the full-faith of the federal government to junk bonds, which are high-risk bonds issued by companies with credit problems. Government bonds include those issued by federal, state and local governments, while corporations issue corporate bonds. Bonds are rated according to their credit worthiness, much like we have our own credit score. Moody’s and MorningStar are the two major credit-scoring companies in the bond market. The better a company’s credit rating, the lower the risk they impose to the investor. In return, they will be able to get a lower interest rate.

From your perspective, bonds are like loans in reverse. You give a large chunk of money to a corporation (say $10,000) and they make monthly or quarterly payments to you in the form of interest. At the end of the bond term, say 20 years, you get your principal back.  One of the biggest drawbacks of purchasing bonds is that you lose the benefit of automatic compounding interest. You see, if you receive a payment from a bond every six months, you have to reinvest it at the same rate to enjoy the benefits of compounding. That is one of the reasons to invest in a bond fund instead of individual bonds. The bond fund manager can use the interest payments of the investors and collectively purchase more bonds.

In many ways bonds can work like stocks. Once you buy a bond, you are not necessarily stuck with it until maturity. You can sell the bond in a secondary market, similar to the stock market. In fact, you may have purchased it in this same market. Some people invest in bonds for a period of time, and then sell the bond to get money out for various things such as a vacation, education, etc. The question is how much can you get out of a bond when you sell it? That depends on the rating of the bond, the interest rates at the time and the coupon rate. As interest rates rise, the value of existing bonds falls. Why is that? If you have a bond that pays 5% interest, and new bonds are issued paying 10% interest, why would anyone be willing to buy your bond? They would want the new ones that are paying 10% interest. So how do you sell your bond in this case? You sell it at a discount. If you have a $10,000 bond and you sell it for less than $10,000 then you are selling it at a discount.

Let’s say you have a 10% bond and the interest rates fall to 5%. Now the value of your bond just increased. After all, everyone wants to buy your 10% bond, since all the new ones are only paying 5%. In this case you will sell your bond at a premium. Your $10,000 bond will sell for more than $10,000.

Options
Buying and selling options is perhaps the closest thing to legalized gambling, next to state lotteries. With options big money can be made and big money can be lost. It is not uncommon for a person to make $20,000 in one day with options trading… and then lose $25,000 the next day. By no means should anyone try options trading based on the information I am giving you. If you want to seriously trade in options, there are appropriate books available that discuss the topic in detail. I am just giving you an overview.

Instead of purchasing a $50 stock, you could purchase an option, for say $5, which gives you the right to buy that same stock for $47. At first this may not make sense, because you paid $5 for something only worth $3 (If you would purchase the stock for $47 and sell it at $50, it’s current value, you would make $3, but the option cost you $5, so you essentially lose $2).

At this point your option is “out of the money,” that is, it is worth less than it’s cost. You are probably wondering how this gives you any advantage… why not just buy the $50 stock? Well, if the stock increases in value by 10%, it is now worth $55. You could turn in your option at this point, pay $47 for the stock and sell it at the current market price of $55. You just made $8 profit, minus the $5 cost of the option, which means you netted a gain of $3. Big deal you say? Look at it this way. The stock price only went up 10%, but you made a 60% return on your money. How? You only invested $5, but earned a $3 return on your money.

To make this example clearer, let’s compare two scenarios dollar for dollar. Matt and Pat each have $50. For simplicity sakes, let’s ignore brokerage fees. Matt buys one share of ABC stock for $50. Pat buys 10 options, each $5, which give her the right to purchase the stock for $47 per share (total cost to each Matt and Pat is $50). If the stock’s price increases by 10% to $55 and Matt sells his share, he made a total of $5, or 10% return on his money. Not bad Matt. Pat, on the other hand, exercises her 10 options and buys the 10 shares for $47 each and sells them for $55 each. Pat just made $30 compared to Matt’s $5. Pat got a 60% return on her money. Sorry Matt.

You might be thinking, “Wow, that’s amazing. Why doesn’t everyone just buy options?” Two reasons. First, not every stock has an option attached to it. Second, the losses can be more significant if the stock decreases in value. Using the same example, if the stock decreases by 10% to just $45, then Matt loses $5 or 10% of his investment. Pat, on the other hand, loses the entire $50 since her options are now worthless (the stock costs less than the price her option allows her to purchase it). Pat lost 100% of her investment. Sorry Pat.

Dollar Cost Averaging
The easiest way to save money is to put away the same amount each month or each pay period. One of your regular monthly expenses should be your savings. When you invest in the stock market, you can expect stock prices will fluctuate. Dollar cost averaging is a way to let you invest without really worrying about what the individual prices of the stocks are at any given moment. Essentially you put the same amount of money in your investment every month (or pay period) no matter if the price is up or down. When the prices are up, the same $100 will buy you fewer shares, but at least your overall account has gown since the price increased. When the price goes down, it is like buying the same shares on sale.

Consider the following example. You invest $100 per month into the ABC mutual fund. The shares cost $20 each when you start investing so you own five shares. Next month you contribute the same amount, $100, but the shares fell to $10 each. Your account balance went down since the shares decreased, but now you are able to buy 10 shares at $10 each, so you own a total of 15 shares. When the price recovers to $20 per share the next month, your account balance is up to $300! You only contributed $200 so far and the price is the same as it was when you started, yet you have earned $100. Also, you will contribute $100 since you do so every month, which buys you five more shares. Next month the price increases to $25 per share, so your account balance is $400! This month your $100 savings will only buy four shares, leaving you with a total of 24 shares and an account balance of $600.

Bill Pratt is a former credit card executive turned student-advocate. He is the author of Extra Credit: The 7 Things Every College Student Needs to Know About Credit Debt & Ca$h and The Graduate’s Guide to Life and Money. Bill speaks at colleges to educate and entertain students about real-life issues in money, leadership, and success. His goal is to help students succeed personally and financially so they can improve the lives of those around them. You can learn more at www.ExtraCreditBook.com or www.TheGraduatesGuide.com.

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3 Responses to Diversifying, Bonds, Options, & Dollar Cost Averaging

  1. Bobby says:

    Great breakdown. Mutual funds are often overlooked as being too vanilla for discretionary investment…which they’re not.

  2. Alfredo says:

    From Mexico.
    Congratulation, good job!
    Very understandable reading

  3. Twiet says:

    This is such a great article! It explains everything in simple language and examples. I recommend it to everyone who is trying to understand personal investment.

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