Chapter 13: The Smart Money
Gary Burns (TV interviewer): “So you're saying, Mr. Gardiner, if the Stock Market collapses, and unemployment keeps increasing, that this is just another season, so to speak, in the garden?”
Chance the Gardener: “Yes. In a garden, things grow – but first some things must wither; some trees lose their leaves before they grow new leaves... And if you give your garden a lot of love, and if you work very hard and have a lot of patience, in the proper season you will see it grow to be very beautiful...”
– Being There (1979)
Here is something you might hear: Investing is like driving a car. You don't need to know engines and transmissions. You rely on the engineers and mechanics to make sure your car works as it should. Likewise, don't worry about what goes on inside your investments. They were designed by experts. Trust the financial engineers to have gotten it right.
I really don't like this argument. It's patronizing. It's a bad analogy because financial engineering is not like mechanical or electrical engineering. And most people actually do know the major components of a car. They certainly learn where the gas pedal and the brakes are.
So, to keep from skidding off the road, anyone who invests should know the following basic types of securities that are bought and sold in the financial markets.
Stocks
If you own a stock, you own a piece of a company. Stocks come in shares, because each one entitles you to a share of the company’s profits and a vote when the company elects its board of directors. In Chapter 5 we saw how an individual’s net worth represents the difference between the assets and liabilities on their balance sheet. It’s the same with companies. A share of stock is a share of a company’s net worth—its assets minus its liabilities. Another word for net worth is equity, so stocks are often referred to as equities.
Companies are public if they have listed their shares on a stock exchange so that anyone can buy or sell them. The price at which shares are traded changes all the time depending on supply and demand. Companies on the stock exchanges are often identified by their ticker symbols. For example, Apple's symbol is AAPL, Facebook’s FB, Netflix’s NFLX.
Although some stock exchanges are physical locations such as the New York Stock Exchange, these days most buying and selling happens electronically. You and I can trade public stocks on most exchanges from our computer if we have a brokerage account.
To track how the overall stock market is doing, people came up with stock indices. The granddaddy of indices is the Dow Jones Industrial Average, which is a group of 30 large companies that are representative of the American economy. The index tracks the change in the average of these companies’ stock prices. [27] The other two indices to be aware of are the Standard and Poor’s 500 (S&P 500) index, which is composed of about 500 of the largest companies, and the Nasdaq Composite index. This index consists of all the stocks listed on the Nasdaq, an electronic stock exchange favored by many tech companies.
Many companies pay dividends to their shareholders. The idea is that dividends are a way to pay some of the company’s profits to shareholders in cash, but it is completely up to the company whether and how much to pay. There is no obligation to pay dividends, and a lot of companies don’t. Especially growing companies often choose to put their profits back into the business rather than pay dividends.
Over the long term, stock prices have gone up, though there have been big declines, some of which lasted for years. What makes the stock market go up? The best explanation is that the value of companies increases with economic growth. This does not help with predicting what the market will do tomorrow, next week, or even next year. In fact, over the short term, the chances of the market going up or down are close to even (like flipping a coin). Sure, if you look at the news there are always many “explanations” for market movements. But they always explain the past, never the future.
Bonds
Bonds are a different animal from stocks. As we saw, when you buy a stock you buy a little piece of a company. You don’t know whether you’ll receive dividends and whether the company will be a successful business that increases in value. When you buy a bond you are making a loan. The bond is an I.O.U. that promises specific interest payments and the principal back at the end. This is known as the maturity date.
The biggest borrower (called an issuer of bonds) is the U.S. Government. It regularly issues Treasury securities to pay for government spending. These "Treasurys" are bonds that can have maturities between one month and thirty years. [28].
Companies also issue bonds, as do state and municipal governments and other entities. Most people consider Treasurys to be the safest bonds because the risk that the U.S. government won’t pay back its debt is very small.
When people talk about interest rates going up or down, they are often talking about the interest rate on Treasurys. Directly or indirectly, most other interest rates are influenced by Treasury interest rates. That’s true for both interest you earn, for example on corporate bonds and savings accounts, and for interest you pay on mortgages, student loans, and other debt.
Just as with stocks, people calculate indices to track different groups of bonds. But the more common way to look at the bond market is the Treasury yield curve, which is simply a snapshot of Treasury interest rates with different maturities. Here is what the yield curve looked like on March 15, 2021:
Interest rates change every day and the prices of bonds fluctuate accordingly. When interest rates go up, bond prices go down, and when interest rates go down, bond prices go up. [29]
Remember certificates of deposit (CDs)? We went over them when talking about savings accounts in Chapter 4 (Money in the Bank). CDs are also a little like bonds: they pay you a pre-determined amount of interest for a pre-determined period of time. But they are insured by the federal government (the FDIC) and therefore are guaranteed to pay back the principal. This makes them a good alternative to bonds when you want to have your savings available at a particular time in the future.
Inflation-Protected Bonds
In Chapter 1 we talked about the role of money as a store of value, and how inflation reduces the value of money over time. One of the main reasons for investing is to make sure that savings don’t get eaten away by inflation.
Historically, investing in the stock market has beaten inflation by a lot. But that’s not true over every period, nor is it guaranteed in to be the case in the future. If you want to be sure that your savings keep up with inflation there are two types of bonds that do just that. Both are issued by the government.
The first is a special Treasury called Treasury Inflation Protected Securities or TIPS. Just like regular Treasurys, TIPS come with different maturities. But with TIPS, the principal of the bond increases with inflation. They start out with the same principal as every other new Treasury, $1,000 per bond. But unlike regular Treasurys, which pay back the same principal of $1,000 at maturity, the principal of TIPS increases by the amount of inflation. If inflation in the second year is 2%, the principal increases to $1,020. The interest rate on TIPS is low, even zero sometimes, but your money is guaranteed to keep pace with inflation.
The second is a type of savings bond. (We met savings bonds when talking about saving for education expenses.) Series I Savings Bonds, or I-Bonds for short, keep up with inflation by paying an interest rate that is equal to the rate of inflation plus some small, fixed amount. I-Bonds can’t be bought in a brokerage account. You need to buy them directly from the Treasury Department. You can easily open an account to do this at TreasuryDirect.
Mutual Funds and ETFs
We’re going to switch gears now to two types of investments that should be the workhorses of your portfolio: mutual funds and exchange traded funds (ETFs). [30] In both cases you are buying shares in a fund that in turn owns many other stocks, bonds, and other sometimes other financial instruments. You end up owning not one stock or bond, but tiny slices of hundreds or thousands of stocks or bonds with a single purchase.
Funds are managed by investment companies who charge fees to put them together and make sure they stick to their investment objectives. Those fees are reflected in the funds’ expense ratios, which are expressed as a percentage of the assets in the fund. When you buy a fund, its expense ratio is the percentage of your money that goes to pay for managing the fund each year. Recall the importance of keeping expense ratios to a minimum from the discussion on compounding.
There are thousands of mutual funds and ETFs to choose from. You can ignore most of them. In the next chapter I will give you a short list of low-cost index funds, so called because they hold the stocks (or bonds) that make up a particular index. They don’t try to pick winners or losers; they just try to match the performance of the index. They are all you need to get started investing.
Everything else
There is a vast universe of specialized mutual funds, ETFs, and other investments that I haven’t covered. These are the bread and butter—or rather the Ferraris and yachts—of the investment business. As the jargon gets fancier and the sales pitch slicker, the costs go up.
Here are some investing strategies (and buzzwords) that you might encounter but aren't worth paying extra for:
Dividend or “income” strategies
Small-cap, mid-cap, large-cap, value, or growth strategies
“Smart beta” such as “momentum,” “quality,” and other “long-short” strategies
Managed futures, tactical allocation, managed volatility, market neutral, risk parity strategies
What else? In uncertain times people sometimes want to own gold. There is a sense of security about it. You feel rich just holding it. But planning to sell it at a profit during retirement to buy groceries is risky. Gold and other commodities have very volatile prices and, contrary to what you might hear, haven't done a good job protecting against inflation.
Bitcoin? We talked about bitcoin as a currency in Chapter 1. As an investment it's highly speculative and largely unproven over longer periods of time. You will hear stories from crypto evangelists who say bitcoin is the future. You'll hear others scoff and dismiss it out of hand. It has had more staying power than the pessimists expected, but nobody really knows what the future of crypto will be. Your call.
Real estate? Not for most people, for three reasons. One, if you own your home, you are already investing in real estate with each mortgage payment. Two, people who make a lot of money in real estate are those who are in that business: developers, landlords, fund managers. These are jobs, not investments. Three, you already get a healthy slug of real estate investments as part of your stock index funds.
The day may come when you’re eligible for membership in a special club: you can be an accredited investor. [31]. Now your broker’s eyes will really light up because he can sell you “alternative” investments: private real estate funds, hedge funds, venture capital, or private equity, among other things. The pitch: You too can be part of the “smart money”! The truth: Unless you are already worth many millions or have special connections you will not get ground-floor access to the next Amazon or Facebook. But you will pay large hidden costs, give up access to your money when you want it, and be kept in the dark about exactly what it is invested in.
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