Investing in the stock market can often be intimidating and confusing… but it doesn’t have to be. There are so many terms that are involved with the market that honestly, you don’t really need to know. They are just fancy jargon that investment bankers throw at you to make them feel like they are better than you… and to confuse you enough to give them your hard earned money.
You might think that it’s probably for the best that someone else manages your money, but that’s not always true. Most of the time, these investment bankers only offer the funds that give them the highest commission, and they are the funds that often have the highest expense ratios, which eat away at your money long term.
So how can we stop this? The answer is pretty simple. Learn!
As I mentioned earlier, there are an incredible amount of stock market terms that you really don’t need to know. Sure, they may help with different types of strategies. But what we need to know for now is the simple terms. The investing terms that will get you comfortable in researching and investing in the market.
So let’s dive into some simple investing terms and the different stock market investments to get your started investing today.
The stock market is an exchange where individuals can purchase equity in companies. That equity comes from purchasing stock, which gives you a small piece of ownership in that business.
The stock market is full of different types of indexes like the Dow Jones and S&P 500
The Stock Market is made up of different types of indexes. The two mentioned above are the Dow Jones and the S&P 500.
An index is an indicator for global and country-specific economies.
Along with the two indexes above and the Nasdaq, are the three most broadly followed indexes by the media and investors.
The Dow is one of the oldest and most well-known indexes in the world. It is comprised of the 30 largest and most influential companies in the United States.
The Dow includes companies such as Apple, McDonalds and Walmart. All well known names in today’s world.
The Dow moves every day based on how the stocks that it is comprised on move.
Indexes are a better indicator of the overall stock market’s health than individual stocks for a few reasons.
- It accounts for numerous companies in various sectors, giving the index and overall idea of how the market is performing
- If Apple decreases by 5% tomorrow, it isn’t a tell-tale sign that the market is in trouble, it just means that Apple stock is struggling on the day. The Dow may have 15 stocks that are down on the day, and 15 stocks that are up on any given day. It is called an average for a reason, folks.
Anyways, let’s move on.
The S&P 500 other known as the “Standard and Poor’s 500” index is an index that holds 500 of the top companies in the U.S stock market.
The S&P holds approximately 80% of the total value of the US market. For that reason, it is seen as the best indicator of the market as a whole.
The Nasdaq Composite is the exchange on which the world’s largest technology stocks are traded.
It includes industries such as biotech, semiconductors, software and others.
Unlike the two mentioned above, the Nasdaq includes mainly only technology companies and also carries some securities with low market caps, which aren’t as great of an indicator of how well the market is or isn’t doing.
Indexes Wrap Up
Overall, knowing what stocks are in each index isn’t incredibly important news, but it’s useful knowledge to have.
Understanding that if these indexes are down on the day, most stocks are probably down as well. That doesn’t mean that they definitely are, since every stock moves independently of one another, but indexes are a great indicator of the overall state of the market.
Now let’s dig into the different types of investments.
As mentioned above, stocks are a piece of the equity in a company that you want to own.
What is equity?
Equity, by definition, is Assets minus Liabilities.
If a company has $2 million in assets and $1.5 million in liabilities, it has $500,000 in equity.
Equity is further broken down into items such as common stock, retained earnings and net income. But let’s save the accounting lesson for later.
When you own a piece of equity in the company through common stock, you own a piece of the company. Meaning you have a right to the share of the profits.
Much like everything else in the world, there are pros and cons to owning stocks
- When a stock increases after you buy it, you can sell if for a profit. This is called Capital Gains
- Some companies will offer dividends to their shareholders, which is a share of the monthly, quarterly or annual profits just for owning the stock. Free money!
- Easy to buy and sell. Most brokerage accounts offer free trading which means you realistically could buy and sell a stock on the same day to earn a quick gain.
- So many choices! Stocks give you an opportunity to buy some of your favorite companies and grow your money while investing in them.
- Just as there are capital gains, there are capital losses which is when you buy a stock and sell it for less than you purchased it for.
- A company can take away their dividend whenever they want. We are seeing this now with companies due to COVID-19
- Sometimes it is difficult to find the right stock to buy and it can become overwhelming
- Lack of diversity. Often investors will own too many of one stock, or too much of one sector, etc., etc. Diversifying is key when investing.
I personally love investing in stocks. I personally think of it this way.
My phone service is AT&T (ticker symbol: T). If I own 100 shares of T for an entire year, I will get $200+ in dividends just for holding the stock.
I can either reinvest that back into AT&T so they can make me more money, or I can use my dividends from AT&T to pay off my phone bill WITH AT&T! That’s fun.
Mentioned above briefly with AT&T being T, ticker symbols are a short grouping of letters to track a stock in the market.
They are usually up to 4 letters (some are 5 but we’ll get into that) and often make up the company’s name.
Some examples are:
Amazon (AMZN), Apple (AAPL), Nike (NKE) and Microsoft (MSFT)
Exchange Traded Funds
Exchange Traded Funds (ETFs) are investments traded on the stock exchange much like stocks are.
The difference is, they are a holding (or a fund) of a group of stocks, commodities or bonds.
ETFs give you the ability to buy a group of stocks in a certain industry, index or sector.
For example, VOO is a ETF that holds stocks in the S&P 500. Investing in this ETF will limit your exposure to too much of one stock.
If IBM has a bad year, you aren’t as over-exposed through VOO as you would be if you owned IBM stock.
ETFs are a great way to diversify your portfolio and limit your risk.
The downside of owning an ETF is that they come with fees, as the fund is constantly buying and selling stocks in the background, leading to an increase in commission fees.
ETFs range in expense ratio, some high, some low.
Another con is that you some of the shares in the ETF may be in unknown and unproven companies. When you buy Microsoft stock, you know you’re getting a great company.
However, when you own an ETF, 5%-10% of the shares owned may be in higher risk companies.
When it comes to ETFs, make sure to do your research on what stocks are included, how diversified it is, and most importantly, low fees.
Mutual funds are another way that you can diversify your portfolio. They are very similar to ETF’s in the sense that they offer a wide range of assets to help you diversify.
The largest difference between ETFs and Mutual Funds is while ETF’s trade like stocks and fluctuate during the day, Mutual Funds are priced at the end of the day based on the underlying value of the fund’s holdings.
Mutual Funds are typically a long term investment vehicle, to be bought in your IRA’s or 401k’s, since you cannot trade it intraday. They are active funds, meaning that there is a fund manager buying and selling assets in the background, trying to beat the market.
This is different from ETFs because those are passively managed and will follow a specific index.
This has pros and cons, of course. While sometimes a Mutual Fund can beat the market, it is very common for them not to. The human element involved in a Mutual Fund often leads to buying bad assets, selling too early, buying at the wrong time, etc. Plus, all of the active buying and selling increases commission fees, which leads to a higher expense ratio than ETFs.
Since Mutual Funds are actively managed, they also require a minimum balance to buy into. Take for example, if you wanted to buy into Vanguard 500 Index Fund (VFINX), you would need a $3,000 minimum investment.
So to recap, Mutual Funds are actively managed, have higher expense ratios and often don’t beat the market. Are they the right investments for everyone? Maybe not. But everyone’s investment strategy is different. For those who don’t want to do Mutual Funds, what’s another option for long term investing?
Before we get into Index Funds, it’s important to note that Index Funds ARE Mutual Funds.
The largest difference between Mutual Funds and Index Funds is that Index Funds are passively managed, a lot like ETFs. This leads to much lower expense fees as there is not active trading every day by the fund manager.
Most Index Funds will follow a specific index, like the S&P 500 or the Dow Jones Industrial Average.
Meaning that ideally, your investments will grow and shrink with the market. But taking into account reinvested dividends and interest, it will outgrow the market in the long run.
Keep in mind that Index Funds, since they are Mutual Funds, also have a high initial investment minimum. After you meet this minimum (often over $1,000), you can add smaller amounts daily.
Mutual Funds vs. Index Funds vs. ETFs
To bring it all together. Let’s look at the difference between the three using real life examples (all prices are as of 5/14/2020 pre-market)
Index Funds vs. ETFs
You can see that even though they follow the same broad index, they are different prices. Why is that?
Index Funds and Mutual Funds are traded based on the net ass value (NAV) of the underlying securities. This updates daily, but does not fluctuate intra-day.
ETF’s on the other hand, trade like stocks. As you can see in VOO’s chart, you can look at “1D” or the daily chart. This isn’t possible for VFINX since it does not trade intraday.
This leads to a small fluctuation in price in the ETF from the actual net asset value, since traders and investors in the market will fluctuate the price.
Index Funds generally have a similar expense ratio to ETFs, in this case though, the Index Fund’s expense ratio is .11% and the ETF’s is .03%. Generally speaking, it is great to have expense ratios in the .03%-.06% range, which most Index Funds and ETF’s offer.
As we spoke about earlier, Index Funds are Mutual Funds. But let’s look at the difference between two tickers.
As you can see, they have very similar top holdings in their portfolios. I’m using these as an example because Mutual Funds follow a broad grouping of stocks, while Index Funds follow a specific index, so we won’t find two that align exactly, but this is close enough.
If you prefer to have more Tesla in your holdings, you’d probably pick the right. If you decide you want more Berkshire Hathaway, the left is better.
But there are also other important factors that go into investment decisions, and that is up to your research, risk tolerance and overall strategy.
Let’s look at the other statistics of both funds.
One thing to note is the expense ratio and yield.
The expense ratio in the VFIAX (index fund) is only .04%, while in VWUSX is .39%. That extra .35% might not seem like a lot, but will eat away at your account over time.
Yield is the percent of the fund price that is given to the shareholder through dividends. A higher yield is generally better than a lower yield.
In this case, the Index Fund also offers a higher dividend yield than the Mutual Fund.
Overall, I personally prefer Index Funds over Mutual Funds, but again, it all depends on your strategy and your risk tolerance.
One other thing to note is the difference between the two Index Funds used in these examples.
VFIAX and VFINX.
They are two different Index Funds with very similar prices. This means that there may be a small variance in the weighting of each asset in the portfolio.
One thing to notice is the differences in the expense ratio.
So while Index Funds are generally better than Mutual Funds, there are also Index Funds that may be better for you than others.
If you have made it this far, congratulations. It isn’t easy stuff. But it is important to understand the different types of stock market investments you can buy and what they are.
There are other investments such as bonds, commodities, real estate investment trusts and more, but I wanted to give a brief overview to at least get you started.
If you would like to learn more, here is a list of my favorite finance and stock market related books that taught me a ton of valuable knowledge.
As Warren Buffet says, never bet against America. Over the last 100+ years of the US stock market, the overall trajectory has always been up. Sure there are down years, like in 2020, but these are the best times to think long term, buy the best companies in the world at “discounted prices” and set yourself up for your financial future.