investments explained simply

Investments Explained Simply

It’s surprising how many people know nothing about investments like stocks and bonds, even though these types of financial instruments are serious catalysts for the growth of the overall economy. I’m going to explain the world of stocks and bonds in the simplest ways that I can.

Stocks

Stocks are basically pieces of companies. You can own pieces of google, apple, amazon and your other favorite businesses by purchasing stocks. Typically, businesses that are as big as these have millions of shares (another term for stocks). When you purchase a stock, you’re not just buying something that you expect to magically increase in value with time, but you’re buying a piece of a business that you expect to do well.

There are two ways you make money with stocks. Sometimes this business you buy will return their profits back to shareholders (you, the owner of the stock share). When you get money for owning stocks, that is called a dividend. The other way you can make money from a stock is when you sell it. The business might be more valuable within a year, causing the stock price to rise higher. When you sell the stock, you realize profits, or capital gains. Dividends and capital gains are the two ways you make money with stocks.

Stocks can be very volatile. The value of a stock can fall completely down to zero if the business fails but it can also rise meteorically if it is doing well. It’s not uncommon for some individual stocks to fall 10-60% within a day and go right back up again. Stocks can be very good for long-term growth of your money but can be risky in the short-term because of its volatility. For this reason, you should not invest in stocks unless you expect to be in the market for at least 5 years.

Bonds

Bonds are basically contracts where you give a “loan” to companies. So, for $1000, you can buy a bond from companies, or even the government. The government and companies will use that money you loan them to fund their projects, while you get a promise to get paid a certain percentage each year.

Assuming the company agreed to give you back 4% of the 1000 every year for 10 years, you’d receive 40 dollars every year for owning that bond. You will typically get paid that total amount in pieces on a semi-annual basis, $20 two times a year. By the end of the 10 years, the government or company will give you back your original amount, the $1000.

Bonds that are qualified as investment grade are typically less risky than stocks. You will get paid for as long as the company is alive, even if it is doing poorly. The only way you may not get paid is if the business goes out of business and doesn’t have enough money to distribute to lenders (you). This is different from stocks – if your stock went down to zero, you are entitled to nothing. But a company going bankrupt means you still have claims to the money you lent them. Usually bonds are good for cash flow – you get paid money directly more consistently than with stocks which you may have to sell to benefit from as much.

Mutual Funds

You may have heard a lot about mutual funds a lot but what exactly are they? Imagine mutual funds are a grocery cart of stocks or bonds that you hire someone to pick out for you. They’ll do the hard work of figuring out the best items (stocks/bonds) to put in. You can even get specialized baskets of stocks/bonds, like one that only picks the largest companies, or one that picks the smallest, high-potential companies. Mutual funds automatically diversify your portfolio compared to individual stocks and bonds by investing in multiple companies. If you had put a large portion of your money into just one stock (would you believe how many business owners put all their eggs into one business basket?), then you are susceptible to the risk that the business goes bust and you lose all your money. By diversifying between multiple stocks or bonds, your money has less risk of volatility while stabilizing the return potential of your money.

Mutual funds employ the use of stock picking managers, meaning it is an “active” fund. Many investors buy mutual funds with an expectation that this grocery cart of stocks or bonds will do better than anything they could pick out on their own. Typically, to have someone manage your investments on an active basis, mutual funds can take up to 1% a year or more away from your returns. This can be a poor choice that eats into your returns over the long term, compared to “index funds”, which I will discuss next.

Index Funds

Index funds are a type of mutual fund. The difference is that this grocery of stocks or bonds are made to copy the market. Instead of having someone pick out the investments on an “active” basis, a broad range of many stocks or bonds are put into a basket without much thought put into it.

The S&P 500 for example, is a very popular benchmark index fund that you will see mentioned in the investment world. It’s a collection of 500 biggest companies in the stock market. No sophisticated stock picking there at all yet everyone follows the S&P 500. They follow it because it represents the “market”. The S&P 500 is typically seen as a general measure of how the entire market is doing overall.

But why would anyone be interested in any index fund if they can get a manager to pick stocks for them? Doing as well as the “market”, or basically everyone else sounds unappealing to some.

However, studies have shown that index funds, funds that follow the market in a “passive” style, often do better than general mutual funds that are managed by an active manager.

This is partly because mutual funds typically charge up to 1% in fees every year while index funds charge extremely low prices that can go as low as 0.05%. To put this into perspective, imagine you had $500k to either put into a mutual or index fund. You would get charged $5000 per year on a mutual fund that charges 1% per year, while an index fund might charge 0.10%, which would only cost $500. Because you automatically save $4500 every year, this can make a huge difference on your long-term investment returns. For this reason, index funds are extremely popular in many investment management portfolios.

ETFs

Exchange-traded Funds, are increasingly popular investments and deservedly so. If index funds are a grocery basket of stocks and bonds, imagine that an ETF is an agreement that breaks apart that grocery basket index fund into many little pieces. ETFs feature a similar portfolio style as index funds with its passive investing, with the added benefit of lower prices.

As an example, the S&P 500 index fund currently costs over $2400 in mid-2017. The SPDR ETFs, which copies the S&P 500, can cost as little $15-100+. Buying just one ETF that costs $50 means you are indirectly investing in potentially hundreds of different stocks and bonds, which may normally cost thousands to do directly. This makes ETFs a very accessible investment vehicle that naturally diversifies your portfolio beyond the risk you would normally take from buying just a few expensive stock or bonds.

As a final point, diversification between different stocks and bonds will lower your risk but it will also stabilize your return potential, meaning that you will likely produce less returns for mitigating the risk. However, consider that investment management is about helping you reach your goals within the safest manner possible rather than chasing an absolute high return without regard to risk. Many investors make the mistake of chasing high potential returns without factoring in the risk they take to do it. When investing, make sure that you are not taking more risk than necessary and that your investment strategy is in line with your goals.

By reading this, you should be able to understand the basics of investing. Let me know if you have questions.

Liked This Post? Here’s my recommendation on which investing platforms are the best to use.

However, is graduate school worth it from a financial perspective?

If you’re thinking about going to graduate school because you believe your career and earnings potential will grow, that may very well be true. But what many don’t consider as thoroughly is the opportunity cost of those few years without full-time work and the amount of debt they would have to take on to fund their higher education.

In general, from what I’ve seen, it makes no sense to go to an expensive graduate school that will leave you with $100k+ in debt, MOST of the time. However, there are some cases that do make sense.

If you are thinking about graduate school, it might be worth it if you meet these conditions:

Going to graduate school might be worth it if:

You are interested in the prestige of having a graduate degree and the network you’ll build (like marrying a rich person on the way, or doing business with them in some format later).

You know for sure the field you pick is something you want to do long-term and that you will be successful in that field for the next 20+ years.

Might be worth it if your median starting salary will be comparatively high to the debt that will be taken on.

You are willing to work part-time while in that expensive grad school to help pay bills and build some savings.

You are okay with delaying full-time earnings for a few years and have a plan to survive in the meanwhile without taking on too much debt.

You accept the possibility that the future job income isn’t guaranteed and that that everything might turn out worse than expected (just like college).

Some rules of thumb are to not borrow more than your expected salary after graduation. If you wanted to get risky, I would say don’t borrow more than double of your expected salary. Otherwise, you may effectively be mortgaging off your ability to fund other goals in life like having a prosperous retirement.

Here are some reasons why you should not go to graduate school:

You want to just “have” the degree. Why would you spend years of your life to get a degree in something you might not necessarily even use? This ties into the prestige part, if you just want the title and societal recognition, you should evaluate whether forgoing 2-3 years of full-time work + any loans you have to take on, is worth getting a graduate degree. To some it’s worth it, but I’m not sold. That time could have been used way more efficiently to achieve any goals you had taken the time to set.

You’re not sure what to do after college, so you figure you might as well go to graduate school. This is one of the worst reasons to go to grad school. Graduate school is for people who know that they want to be in that career for a long time. Your time to test out different fields was in college. You’re in the real world now. The kind of loans you take in graduate school are usually tougher with higher interest rates and higher payments, so you need to know what you’re signing on for. If you go in with a naïve mentality that “everything’s gonna be alright”, maybe, but why would you risk jeopardizing yourself like that without really knowing what you’re getting into. How would you handle the other things in life such as buying a house or managing hundreds of thousands in savings if you ever did get up to that point.

You “THINK” graduate school means you’re going to make a lot more money. If you can’t tell me the median salary of new graduates and the percentage of people who actually get the job you want at your graduate school of interest, you aren’t looking into this seriously enough. Some careers will pay you $40k for being an undergrad and those careers will pay you $50k a year as a grad student, after you take on $150k in loans. Do you think that would really be worth it? Any good investor knows that if you really want to take advantage of compound interest, you should have more money from the beginning than later. All your money is going to be going away to student loan payments instead if your salary doesn’t end up being high enough. Maybe that’s why so many law school graduates are struggling since they didn’t really research the industry low median salary for graduates. There’s literally an entire graphic website describing in detail how shady most law schools are and how badly they can ruin someone’s financial life with high debt and low income. All because these students didn’t know.

You need to analyze from all perspectives whether a graduate degree is worth it. Failing to make a complete analysis on your decision is the kind of stuff that gets people into trouble. Don’t be that person who knowingly walks into the abyss and regrets not looking into it closely enough.

In general, you should know how much you’re going to pay monthly for student loans after graduation before you take on any loans. And this is all assuming you’re getting conventional federal loans, private loans are a different territory. Make sure you look for whichever scholarships you can get. Negotiate your financial aid package with the schools you get accepted into, leverage the offers you have from other schools. If it’s possible, don’t do the dorms at the school, look for the cheapest housing spaces possible and handle that aspect yourself as much as you can. Finally, if your heart is still set on graduate school, consider looking into the schools with the best “ROI”, or return on investment. That means these schools have high salary and employment for their graduates and low after graduation debt. If you know you want to achieve financial success in your life, and that you are interested in having an easy time getting rich, then this would be a quick call.

For some people who are really interested in their field, it actually will be worth it to go to an expensive school. There will inevitably be winners at a lot of these expensive schools. But in terms of pure statistical chances, not even factoring the kind of raw talent, perseverance and inevitably luck, that will come into play, your ability to do financially well can be much better through other options.

Formal education isn’t necessarily the answer to your success after all. If you want an edge in your career or earning potential, you can always develop your own curriculum with books, articles, seminars, research, etc. The idea that you NEED formal education to become more knowledgeable is dinosaur-like thinking in an age when most of the answers to your questions are one google search away.

Whatever you do, make sure that you have thoroughly analyzed the reasons behind graduate school. Have serious conversations with people who are willing to tell you the truth, not just give you superficial support even though they might not at all understand or care what you are planning. Talk to multiple professionals in your field who just graduated and will be honest with you, not the ones who’ve already been doing it 10-20 years. A lot can change quickly in that time span and you don’t want to be left with hands empty because of something you didn’t know.

So, there you have it, my graduate school cost-benefit analysis.

Tag: money