Should I Buy Stocks Now?

Should I Buy Stocks Now?

Many, if not most, financial advisers recommend accumulating wealth from a diversified set of investments including stocks.  An investor can add stocks to her/his portfolio by purchasing stocks from an individual company or from buying mutual funds.  With the stock market down double digits since the beginning of 2020, some experts say stocks are “on sale” and now is a good time to buy, but just over half of Americans report they own stocks. This is down from 62% prior to the 2007/8 recession and it includes ownership of stocks that are contained within retirement funds and mutual funds, as well as individual stocks.  Common reasons to not buy stocks/mutual funds are (1) stocks are complicated and I don’t know how to get started, and (2) stocks are too risky.  Let’s review both of these drawbacks.

Stocks are Complicated

All too often, some of my friends and family are reluctant to purchase stocks because they do not understand the stock market.   Even some of my most intelligent friends shy away from financial conversations that involve the stock market because they do not want to appear ignorant.

If you did not learn about investing in school or from your parents, how can you figure this out?  How do you convert your dollars into stocks?  How do you learn which stocks are worthwhile?  Should you purchase individual stocks or mutual funds and, by the way, what exactly are mutual funds?

Investment Clubs Help You Buy Stocks

You can learn about many of these topics in a fun way by forming an investment club with like-minded friends and/or family.  Since 2004, I have been a member of Take Stock, a ladies’ investment club.  Our club is one of the 4,000 investment clubs of the National Association of Investors Corp. (NAIC).  The NAIC was formed in 1951 as a 501(c)(3) nonprofit organization with the aim of teaching individuals how to become successful long-term investors.  Originally, the NAIC’s focus was investing in common stocks, but, with the popularity of 401(k)s and other retirement plans, the NAIC has added education about stock and bond mutual funds.

The NAIC (also more recently known as Better Investing) stresses four principles for successful, long-term investing:

  1. Invest regularly, regardless of market conditions;
  2. Reinvest all earnings;
  3. Invest in growth companies (and growth mutual funds); and
  4. Diversify to reduce risk.

What Information Can I Get from NAIC/BI?

NAIC/Better Investing (NAIC/BI) provides many tools and resources to help individuals as well as investment clubs learn about investing.  There is a stock selection guide (SSG) that organizes companies’ performance information to allow you to determine for yourself whether a particular company is a stock you want to purchase and the price is reasonable.  Some of the free resources offered by NAIC/BI include:

  • Over 100 free stock investing videos;
  • An introduction to stock investing that explains the SSG;
  • How to start your own investment club;
  • Investor education articles;
  • Stories from members; and
  • 90-day free membership.

How My Club Works

My club was formed in 1999. It is comprised of nine women who meet monthly in each other’s homes.  Of the nine members, the one with the longest tenure is a charter member and the most recent arrival has been in our club for just over one year.   During our meetings, we review our club’s portfolio (currently stocks of twelve companies), discuss stocks to research for possible future purchase, and vote on any companies that we have already researched. It is not required that you meet in members’ homes—you could choose to meet at your local library, a restaurant, etc.  We typically meet in the evening on the second Tuesday of each month and the hostess for that month provides a light meal.  Every July, we meet at a local park for a summer concert and we bring our families/friends.

Monthly “dues” are used to invest in stocks and your ownership is based upon what percentage of the total portfolio you have invested through your paid dues.  The monthly dues are in multiples of $25 (i.e., $25, $50, $75 etc.) and there is a monthly minimum of $25.

I highly recommend forming or joining an investment club.  You’ll have the opportunity to learn more about the stock market, to learn more about individual companies that you and your club research, and you’ll get to know your friends and acquaintances better.  The best part is you’ll have fun while investing in your financial well-being and you will all become richer by enhancing your friendship.

One Final Caveat

If you are new to investing you will probably want to invest the portion of your money that you will not need in the near term, such as a down payment on a home you wish to  purchase three or more years from now, your children’s education fund, or your retirement fund.  Your rainy-day fund should be kept in more liquid investments that can be accessed quickly.

So now that you know you can have fun and learn about the stock market, you may still be reluctant to buy stocks due to the risk involved.  Let’s review this objection to increasing your wealth. . .

Stocks Are Too Risky

One of the primary concerns about owning stocks is the risk inherent in these investments.  What if I invest my money in the stock market and the stock market crashes as we have seen since Covid-19 or like we saw in 2008/2009?  While it is true that declines of 15+% in your investment portfolio are not desirable, it is also true that in every case where the stock market has had a large decrease, the stock market more than made up for the declines in the months and years following the drop.

As of this writing (April 30, 2020), since the beginning of 2020, the Dow Jones Industrial Average (Dow) is down about 18% and the S&P 500 is down about 11%.   While not good news, if you were invested in the market during 2019, you would still be ahead because the Dow rose more in 2019 than the current 2020 drop. (Dow added 22% and the S&P 500 added 28% during 2019).

We have likely heard the old adage:  risk is reward. That is, the more reward that is sought, the more risk that must be taken.  If you are desirous of the smallest risk possible, then you would probably choose to park your money in (for example) savings bonds or certificates of deposit which will guarantee you a reward albeit a small one.  If you prefer more reward, then you will likely choose to invest some of your portfolio into the stock market.  Let’s look at an example of how a specific risk tolerance manifests into investment growth.

Risk-Reward Comparison

Five years ago, assume you invested $1,000 with (1) small risk (investing in a certificate of deposit), (2) medium risk (investing in an S&P 500 mutual fund) or (3) high risk (investing in only one individual stock).  Here are the results:

 

CD:  “low” riskS&P 500: “medium” riskAmerican: “high” riskApple:   “high” risk

5/1/15

 $1,000 $1,000 $1,000

 $1,000

12/31/19 $ 1,073 $1,531 $633

 $2,376

4/30/20

 $1,077 $1,395 $298

 $2,209

5-year return

7.7%39.5%-70.2%

120.9%

4.75-year return (through 12/31/19, 0pre-Covid)

7.3%

53.1%-36.7%

137.6%

 

Takeaways from this Exercise

Here are the key takeaways from this table.

  • The lowest-risk investment provides a 7.7% return over five years. This is based on investing $1,000 over a period of five years at current CD rates of 1.5% per year.  Note that while the original investment of $1,000 grows over the five years, it is growing less than the rate of inflation over the five years so you have “lost ground” by investing in a CD.    Over this same five-year period, the Consumer Price Index rose by 8.9%, higher than the 7.7% earned in the CD; thus, your buying power is less since the cost of goods has risen by 8.9% while your investment grew at 7.7%.
  • The medium-risk investment provides a much better return than low risk. You would have earned nearly 40% over the five-year period.
  • The high-risk investment was defined as investing in only one single stock. As you can see, if you chose American Airlines for your one stock, you would have lost 70% of your investment.  However, if you had chosen Apple as your one stock, you would have more than doubled your money and earned a 121% return over five years.

Keep in mind that the results above include the effects of the drop in the stock market from COVID-19.  If we look instead at year end 2019 — before the effects of COVID-19 — we see returns of 7.3% (CD), 53% (S&P 500), -37% (AAL), and 138% (AAPL).

Your Risk Appetite

If your risk appetite is miniscule, then you would probably want to avoid the stock market altogether and put your money into certificates of deposit.   This will not bring wealth to you but it will give you peace of mind.  If you have more tolerance for risk, then investing in the stock market by diversifying your stocks is a much better way to accumulate wealth.   As shown in the example above, it is possible to earn more from investing in high-growth stocks, but it is also virtually impossible to pick which individual stocks will generate above average future growth.  The medium-risk option will usually provide much better returns over the long terms than will the low risk-option.

How I Built My Wealth

Stocks—primarily mutual funds with a variety of individual stocks—have contributed to my personal wealth accumulation.  I recommend including stocks in your assets and joining or forming an investment club with friends and family can be a fun way to further your wealth.  Good luck!

 

Kay Rahardjo, FCAS, MAAA is an actuary and risk management professional. She retired from The Hartford in 2014 from her role as Senior Vice President and Chief Operational Risk Officer. She developed and taught an operational risk management course at Columbia University.

Mutual Funds and ETFs

Mutual-Funds-and-ETFs

Mutual fund and ETFs (exchange-traded funds) allow you to invest in securities without having to select individual positions. Instead, the fund manager makes the decisions as to when to buy and sell each security. As such, a fund is an easy way for new or busy investors to participate in financial markets. This post will help you learn about the different types of funds, their pros and cons and other considerations of owning mutual funds and ETFs.

What is a Mutual Fund?

A mutual fund is pool of money collected from the investors in the fund. The investors own shares in the mutual fund itself, but not in the individual securities owned by the fund. However, other than closed-end funds discussed below, an investor’s return is his or her share of the returns of the aggregation of the returns of the individual securities owned by the mutual fund. That is, if, on average, the securities in the mutual fund issue dividends of 3% and appreciate by 2%, fund owners will receive a dividend distribution equal to 3% of the value of their share of the pool plus the value of their ownership share will increase by 2%.

Most mutual funds also issue capital gain distributions once or twice a year. If the mutual fund had a gain on the aggregate amount of securities sold in the year, it will often distribute the amount of the gain to investors as a capital gain distribution in proportion to their ownership shares in the pool.

Mutual funds can be purchased directly from the fund manager or through a broker. Most mutual funds are not traded on exchanges. Purchases and sales of mutual funds occur once a day, with all buyers and sellers receiving the same price which is equal to the net asset value of the underlying assets. (See below for more information and exceptions.)

What is an ETF?

Exchange-traded funds or ETFs have several characteristics in common with mutual funds:

  • They are pools of money collected from their investors.
  • Investors share in the returns of the aggregation of the individual securities.
  • ETFs can hold a wide range of securities, including stocks, bonds and commodities.

These are a few of the ways in which ETFs differ from mutual funds:

  • They are exchange-traded securities (as implied by their name), so they can be bought and sold any time the exchange is open. As such, the price you pay or receive when you buy or sell an ETF can vary over the course of a day.
  • While many mutual funds have a minimum investment requirement, most ETFs do not.

Types of Mutual Funds and ETFs

There are many features of mutual funds and ETFs that are important in determining the best funds for your portfolio. Almost all of these features apply to both mutual funds and ETFs.

Active vs. Passive Management

An actively managed fund has a fund manager who is responsible for selecting the securities that will be owned by the fund. The manager decides when to buy and sell each security.  By comparison, the securities owned by a passively managed fund are determined so that the performance of the fund tracks a certain basket of assets.

Index funds are a common type of passively managed funds.   An index fund is a mutual fund or ETF that has a goal of matching the performance of an index, such as the S&P 500, the Dow Jones Industrial Average or the Fidelity US Bond Index.

There are other passively managed funds whose trades are determined so as to produce returns similar to a certain segment of a market, such as a particular industry or region of the world, that may or may not have an index that measures those returns.

Securities Owned

Funds can own a wide variety of securities – everything from stocks and bonds to commodities, among others. As you are looking for a fund, you’ll want to decide what type of security you are seeking.

Geography

Most funds focus on a specific geography. Many mutual funds focus on US investments, while others purchase securities from within a region of the US, the whole world or segments thereof, such as the developed world excluding the US. While I hold most of my North American equity positions in individual companies, I use mutual funds to diversify my portfolio globally.

Market Segment

Just as funds focus on a specific geography, they sometimes invest in one or more market segments.   Some funds focus on a specific industry, such as natural resources or technology or financial companies. If you think a particular industry is going to benefit from trends in the economy, such as healthcare as the population ages, you might want to buy a fund that focuses on the healthcare industry. On the other hand, you might want to avoid healthcare stocks if you think that the healthcare industry might be at risk of significant disruption from changes in the government’s role in healthcare.

Other funds focus on the size of companies.  For example, an S&P 500 Index fund only buys positions in companies in the S&P 500 which, by definition, are large.  Other funds focus on middle-sized companies (middle-sized capitalization of mid-cap) or smaller companies (small-cap).

Another “industry” on which many funds focus is municipal bonds. These funds invest in bonds issued by municipalities. In many cases, interest from municipal bonds and municipal bond funds is not taxed by the Federal government or in the state in which the municipality is located. For example, if you buy a bond issued by the City of Baltimore, it is likely that it will not be taxed at all if you are a Maryland resident.

Appreciation vs. Dividends

Some funds focus on high-dividend investments, while others focus on appreciation in the value of the securities they own. You can learn the focus of a fund by looking at its details either in a summary or its prospectus. Funds that focus on high-dividend yields often have “high-dividend” in their name, but not always. The type of return targeted by funds you purchase will impact the specific securities owned by the fund. In addition, the type of return impacts the taxes you will pay (discussed below).

Growth vs. Value

Companies are often categorized between growth and value, reflecting the two primary reasons that stock prices increase. The stock price of a growth company is expected to increase because the company will increase its profits. By comparison, the stock price of value company is expected to grow because its valuation, often measured by the price-to-earnings or P/E ratio, is considered low and likely to return to normal.

Closed-end vs. Open-end Funds

Most funds are open-end funds. The price you pay for these funds is equal to the market value of the securities owned by the fund divided by the number of shares outstanding.   This price is known as the Net Asset Value. You can buy shares from and sell shares back to the fund owner at any time at the net asset value.

A closed-end fund differs in that the number of shares available is fixed when the fund is first created. When you buy and sell shares in a closed-end fund, the other party to the transaction is another investor, not the fund owner.  In fact, closed-end fund shares trade in the same manner as if the fund were a company. As such, the price is not the net asset value, but rather has a market value that reflects not only the net asset value but also investors views of the future performance of the fund.

I found Investopedia to have some great information about open-end funds and closed-end funds.

Advantages and Disadvantages of Mutual Funds and ETFs

The biggest advantage of mutual funds and ETFs is the ease with which you can diversify your portfolio, especially in asset classes or market segments with which you are unfamiliar. I think index-based ETFs are a terrific way for new investors to participate in markets. As I mentioned above, I use mutual funds for international stocks, as I don’t know enough about economies and market conditions outside the US, much less about individual companies, to make informed buying decisions.

A drawback to actively-managed funds is that they tend to underperform the market. That is, there are not many money managers who can consistently produce returns that exceed their target benchmarks. This difference is even greater when returns are reduced for fees paid by investors (discussed later in this post).

There are many sources for statistics about mutual fund returns. CNBC states that, in every one of the nine years from 2010 through 2018, more than half of actively managed large-cap funds produced returns less than the S&P 500. The same article also indicates that 85% of those funds underperformed the S&P 500 over a ten-year period and 92% underperformed over a 15-year period. As such, care should be taken when investing in actively managed funds. If you are looking for funds that will produce returns similar to broad market indices, such as the S&P 500, an index fund might be a better choice.

Income Taxes

There are four types of returns that are taxed when you own mutual funds or ETFs that hold stocks or bonds held in taxable accounts. Funds held in tax-deferred or tax-free accounts will have different tax treatment. The taxable returns on other types of funds will depend on the types of returns generated by the underlying assets.

Capital Gains

When you sell your ownership position in a fund, the difference between the amount you paid when you bought it and the amount you received when you sell it is a capital gain.   The taxation of short-term capital gains (related to securities owned for less than one year) is somewhat complicated in the US. Long-term capital gains are taxed in the same manner as dividends in the US, at 15% for most people. In Canada, capital gains are taxed at 50% of the rate that applies to your wages.

Interest

When you own a bond fund, interest paid by the issuers of the bonds owned by the fund is taxable in the year the interest payment was made. In the US and Canada, interest held in taxable accounts is taxed at the same rate as wages, except for certain municipal and government bonds which may be exempt from state or Federal taxes.

Dividends

Dividends paid by companies owned by a fund are taxable in the year the dividends payments are made. For most people in the US, there is a 15% Federal tax on dividends from investments held in a taxable account plus any state taxes. In Canada, dividends are taxed at the same rate as wages.

Capital Gain Distributions

Over the course of a year, a mutual fund may sell some of its assets. The capital gains earned from those assets are distributed to owners as capital gain distributions. Capital gain distributions are taxed in the same manner as capital gains.

Fees

There are generally three types of fees that can affect your returns on ETFs and mutual funds: front-end loads, operating expenses and commissions. Schwab identifies two other hidden costs that are a bit more obscure, so I’ll refer you to its post on this topic if you want more information.

Front-End Loads

Some mutual funds require you to pay a fee when you make a purchase. The fee is usually a percentage of your investment. For example, you would pay $10 for every $1,000 you invest in a fund with a 1% front-end load. If you purchased this fund, its total return on the underlying investments would need to be 1% higher over the entire period over which you owned it than the same fund with no front-end load for you to make an equivalent profit.

Funds that don’t have a front-end load are called no-load funds.

Operating Expenses

Mutual funds and ETFs, even those that are passively managed, have operating expenses. The operating expenses are taken out of the pool of money provided by investors. Every fund publishes its annual operating expense load, so you can compare them across funds. Funds with higher expense loads need to have higher returns on the underlying investments than fund with lower expense loads every year for you to make an equivalent return.

ETFs tend to have much lower operating expense loads than mutual funds. Similarly, passive funds tend to have lower operating expense loads than actively managed funds.

Commissions

If you purchase a mutual fund or ETF through a broker, you may pay a commission both when you buy the fund and when you sell it. A commission is a fee paid to the broker for the service it provides allowing you to buy and sell securities. Many brokers have recently reduced or eliminated commissions on many ETFs. If you purchase the mutual fund or ETF directly from the fund manager, you will not pay a commission.

Dividend Reinvestment

Many funds allow you to automatically reinvest distributions (i.e., interest, dividends and capital gain distributions). Although it includes all types of distributions, it is often called dividend reinvesting or reinvestment. It is a great way to ensure that all of your returns stay invested, as you don’t have to keep track of the payment dates on any distributions so you can reinvest them.

I have a few cautions about dividend reinvestment.

First, you want to reevaluate your choice of fund periodically. If you blindly reinvest all of your dividends and something changes that makes the fund a poor fit for your portfolio, automatic dividend reinvestment will cause you to have more money invested in something that you don’t want.

Second, you’ll want to be aware of the tax implications of dividend reinvestment – one of which is helpful and one of which requires some care – if you hold the fund in a taxable account.

Increased Cost Basis

As indicated above, when you sell a fund, you pay capital gains tax on the difference between your proceeds on sale and what you paid for the fund. The distributions that you reinvest are considered part of what you paid for the fund. You’ll need to take care to keep track of the amounts you’ve reinvested, as they increase your cost basis (the amount you paid) and decrease your capital gains tax.

Taxes on Distributions

Even if you reinvest your distributions, you need to pay taxes on them in the year in which they were paid. As such, if 100% of your distributions are automatically reinvested, you’ll need to have cash available from another source to pay the income taxes on the distributions.

Selecting Mutual Funds and ETFs

There are thousands of mutual funds and ETFs from which to choose. Here are my thoughts on how you can get started.

Set your Goals

  1. Determine what type of fund you are seeking. Are you trying to focus on a small niche or the broader market?
  2. Narrow down the type of fund that will meet your needs. Do you want an actively managed fund or a passive one? Are you interested in an open end or closed end fund?  Do you want the fund to look for growth companies or those with low valuations?

Identify Some Funds

  1. Once you’ve narrowed down the type of fund you’d like, you can use a screener to help you further narrow down your choices. Most large brokerage firms, as well as many independent entities, have mutual fund and ETF screeners. For example, Morningstar, a global investment-research and investment-services firm, has a free screener (after you sign up at no charge) at this link.
  2. Look at the ratings of the funds that are identified. The entity assigning the ratings usually expects higher rated funds to perform better than lower rated funds.
  3. Look at the historical returns. While past performance is never a guarantee of future performance, funds that have done well in the past and have consistent management and strategy may do well in the future.
  4. Read the details of the fund either on the fund manager’s web site or in the prospectus. Look to see if the objectives of the fund are consistent with your objectives. Make sure the types of securities the manager can purchase are in line with what you would like to buy. The names of some funds can be much narrower than the full range of securities the manager is allowed to buy. Find out if the fund management and objectives have been stable over time. Some funds can change their objectives on fairly short notice, potentially exposing you to risks you may not want to take or lower expected returns that you desire. To learn more about reading a prospectus, check out the article on Page 9 of this on-line magazine.
  5. Compare the fees among the funds on your list. If the underlying assets are similar and are expected to produce the same returns, funds with lower fees are more likely to provide you with higher returns (after expenses) than funds with higher fees. Don’t forget to look at both front-end loads and annual operating expense ratios.
  6. Select a strategy for buying your mutual funds or ETFs, such as dollar-cost averaging, waiting for a price drop or buying at the market price.

Make a Decision

  1. Buy a position in the fund(s) that best fit your requirements. As indicated above, you can buy most funds either through a broker (which can sometimes add a commission to your expenses) or directly from the fund manager.
  2. Last, but not least, be sure to monitor your positions to make sure that the fund objectives, holdings, management and fees remain consistent with your objectives.