[Today we have another guest post, this one from Tony at Trading Slugger. Tony’s blog focuses a lot on investing, so I was excited to take the opportunity to have him give a sort of beginner’s guide to investing. Also, if you’re interested, read my take on whether you should invest in straight up stocks. Hope you enjoy it!]
In this post we’re going to cover the basics of various “financial securities”, which is basically just a fancy name for different investment options. These financial securities range from simple investments, which are frequently bought and sold by retail investors, to complicated investments, which should only be touched by those who have done their homework AND have years of trading experience.
Aside from covering the basics of these financial securities, I’ll also state the relative advantages and disadvantages of other securities. Let’s start with mutual funds.
Mutual funds are, according to Wikipedia “a type of professionally managed collective investment scheme that pools money from many investors to purchase securities.” OK, so the official definition of a mutual fund is a fund in which many investors pool their money, which a fund manager takes to select various investments.
There are many different types of mutual funds. Each mutual fund states what market the fund focuses on. For example, a mutual fund that focuses on the S&P 500 will buy shares of stocks that belong to the S&P 500. A mutual fund that focuses on tech stocks will buy shares of tech stock companies. A mutual fund that focuses on emerging Asian nations will purchases shares in Asian companies.
To purchase these shares, the mutual fund hires a mutual fund manager, who “selects” which shares to buy and sell. More often than not, the mutual fund manager doesn’t really do much at all. Unlike a hedge fund manager (an investment fund for the wealthy – or at least those with more than $2 million), a mutual fund manager doesn’t really need to make tough investment decisions. If his mutual fund’s mandate is to invest in the S&P 500, then the mutual fund “manager” will probably just buy every single stock in the S&P 500 and call it a day.
In essence, despite all the fluff about how mutual funds are “professionally managed”, reality proves that 99% of mutual funds do no better than their respective benchmarks. This means that S&P 500 mutual funds are really managed for superior returns. If the S&P 500 gains 15% this year, then 99% of S&P 500 mutual funds will gain approximately 15% as well.
I worked for a year in a financial advisory firm, selling mutual fund to clients. Let me tell you, it wasn’t fun. The problem with a lot of mutual funds is that they charge hefty Deferred Service Charges (DSC), which lock you in for a certain time period. Here’s how these lock-ins work. Let’s say that Mutual Fund XYZ has a $350 lock-in on a $10,000 investment. The condition is that if you sell your mutual fund shares before a certain date, the mutual fund will charge you part of that $350. This effectively locks in investors for a certain amount of time because investors don’t want to lose that $350.
Now this DSC is a cheap psychological trick. Investors become so focused on that seemingly large $350 (which, in terms of $10,000, is a cheap 3.5%) that they forget the bigger picture. They forget that the market can easily move more than 5% in a week, rendering the seeming large $350 DSC small in comparison. Using a small DSC, mutual funds can insure that their investors remain locked in (willingly) despite massive market price changes that under normal circumstances would cause most investors to sell their holdings.
Thus, I would never buy/sell mutual funds. Mutual funds don’t outperform their respective index benchmarks, and they charge hefty fees to pay for mutual fund managers and other personnel.
ETFs are Exchange Traded Funds. Most ETFs track an index (e.g. a stock index like the S&P 500) or a certain sector, e.g. tech stocks, financial stocks, commodities, etc.
The premise behind ETFs is simple. Most mutual funds are lying when they say that they can “outperform the index”. Since this is a lie, why bother fabricating it as the truth? ETFs don’t employ fund managers. They straight up buy an index’s stocks to simulate the index. This means that since the S&P 500 has 500 stocks, an S&P 500 ETF will literally buy all of those 500 stocks and pool them together, resulting in one single stock (the ETF) that effectively tracks the S&P’s price changes day by day.
For example, if the S&P fell 3.2% today, than an S&P 500 ETF will also fall 3.2%. If the S&P rises 0.8%, then the ETF will mimic this price change and rise 0.8% as well.
So why are ETFs increasing in popularity? Because it fits the purposes of different investors and traders. Passive index investors like ETFs because they allow investors to effectively match the performance of an index without being charged hefty fees (ETFs are sold like normal stocks, thus the only fees you’re charged are tiny brokerage fees). Traders such as myself like ETFs because they allow us to touch previously untouchable markets. For example, the Russell 2000 (a stock index) is comprised of 2000 different stocks. Prior to the invention of ETFs, if I wanted to trade the Russell 2000 I would literally have to buy/sell all of those 2000 stocks. As you can imagine, this is an insane hassle. Now that we have ETFs, I can easily “buy and sell” the Russell 2000 via the ETF.
Options are highly complex financial instruments that I do not trade. An option is not the same as a stock: you are not buying or selling anything. A stock is a physical piece of ownership in a company. On the other hand, an option is the “right but not the obligation to buy or sell a stock at a future date” (hence the name “option”). An option does not have a “price”. Rather, it has a “premium”.
Buying an option (a “call option”) means that you expect prices to go up in the future. Selling an option (a “put” option) means that you expect prices to fall in the future. To pay for this “right but not the obligation”, each option carries a premium. This is the minimum amount that the price must change for you to make a profit. For example, let’s say you’re buying an option on Apple stock. Apple current trades at $100 per share. The premium might be $7. To make a profit, not only does Apple’s price have to go up, it must go up by at least $7 (the amount of the premium), or else you’ve lost money.
I have traded futures several times in the past. Futures are a lot less complicated than options. In short, futures are highly leveraged financial instruments that track underlying markets. There are futures for many different markets and indexes. The one I trade – the futures for the S&P 500 – is leveraged 5 times. This means that for every $1 change in the value of the S&P, my futures contract changes $5.
Although futures are less complicated than options, they should not be touched by ordinary investors. The volatility in futures is insane, and unless you’re trading this full time, it’s hard to stomach waking up one morning and seeing $20,000 down the drain.
Thank you for reading this beginner’s guide to investing. I’m Tony, and feel free to check out my blog