Getting Started with Investing

“Worry about my stocks is keeping me awake nights. What should I do?” (Small investor)

“Sell down to the sleeping point.” (J.P. Morgan.)

Morgan’s comment above expresses a central truth of investing. Most investments are uncertain. Investors stand to lose as well as gain. There are exceptions but, as with much of life, higher risk means more potential reward. There are safe investments such as government guaranteed bank accounts, but they don’t pay much (sometimes less than inflation). The investments that might pay off the best are also those most likely to lose money.

“In investing money, the amount of interest you want should depend on whether you want to eat well or sleep well.” (J. Kenfield Morley)

Because of the relationship between potential gain and risk, every potential investor should begin with a careful self-evaluation, determining just how much risk he can tolerate. There is a good self-evaluation test in Chapter 14 Burton Malkiel’s book, _A Random Walk Down Wall Steet_ (pp346-347 in the 2003 printing). Don’t even think of starting a serious investment program without this step.

Once you have a good idea of how much risk you can tolerate, look at the various investment opportunities available. There are a lot of them nowadays, too many to list here. However you should look at at least the following:

Government guaranteed bank accounts. At least in the U.S. it just doesn’t get any safer this.

Government bonds. These are also very safe. In addition, they have the advantage of avoiding many taxes, but in exchange the intrerest paid is lower than for fully taxed investments. If you are in a high tax bracket they may be an advantage for you. If your tax bracket is low you are probably better off to invest in something fully taxable and pay the taxes. A CPA or other tax adviser can help decide how much the tax exemption will help you.

Industrial bonds. These are essentially a loan to some company and are traded on an open market. Most brokerage firms can help you find lots of them. Terms will vary, sometimes the company can pay off early if it decides to do so. Bonds in a company are safer than stock in that same company because the bonds have a higher priority for company income than do stocks. However in most cases their potential pay-off is less than that of stocks. Bonds are not completely safe, though. If the company fails, it may default and pay pennies on the dollar (if that). There are bond rating companies that rate how safe bonds are for different companies, all the way from AAA (very safe), down to C (in default, recovery unlikely). Lower grade bonds are often called “junk bonds” and have a relatively high chance of default. Of course the higher the rating, the less interest the bond will pay.

The stock market (often just called “the market”). You can invest in the market carefully or you can gamble on it. I recommend careful investment. Here again, there is an direct relation between risk and potential return. Solid, low-risk companies attract investors who want safety and are willing to pay more for the potential gains in order to get have a safer investment

What you are doing when you buy stock in a company is buying a small part of that company. You then have a right to either re-sell your part of the company (hopefully at a profit), or to perhaps receive part of the profits in the form of a dividend. The stock market exists to facilitate buying and trading the small segments of companies called shares of stock. If the company does well, investors (owners) do well. If the company has financial trouble, investors will lose money.

There are several ways to invest in the market. I will say right up front that for beginning investors I recommend index funds. This is a particular type of mutual fund which has low management fees and usually does quite well. (More on this below.)

A mutual fund is a fund that buys shares in lots of companies, often hundreds. This reduces risk because if one company has problems, the fund still has stock in others to make up for it. Essentially it dilutes the loss. Of course it also dilutes the gains since if one company does exceedingly well, that gain is mixed in with other companies that did not do as well. If you buy a mutual fund, you accept a smaller potential gain in exchange for a lower risk than if you buy stock in one or a few companies. There are two basic kinds of mutual funds, managed and index.

A managed fund has one or more managers who try to be experts in the stocks they are buying. As professionals, they study the market full time and try to decide which stocks to buy and which to sell. In exchange they take a cut of the money. Unfortunately, even for professionals, it is the devil’s own task to predict which stocks will do well so these funds seldom beat the market average. Some do well for a few years but most then fall back to average or below. There is a certain amount of randomness in such things and managed funds are often either the beneficiaries or victims of that randomness.

An index fund buys all the stocks in a stock index. There are several of these, but the best known are the Dow-Jones Industrial Average of 30 major stocks, and the Standard and Poor’s 500 average of 500 stocks. There are also indexes of small stocks and other categories. What they have in common is that the index is an attempt to be representative of either the market as a whole or of a specialized segment of it.` Because index funds do not require much management time, the part you pay for management is much less than for a managed fund. With the combination of low fees for index funds and difficulty of picking good stocks, index funds often do better than managed funds.

Well, this article is long enough. I may write another on individual stocks later but this is a beginning. Few new investors are going to buy stocks in individual companies anyway.