Basically Part 1
A recently widowed woman visited our office not long ago asking for help understanding her investment portfolio. Fortunately, she was in good financial shape but I was struck by some of her questions. While I strive for clarity both in person and in print, at one point she asked me what an index fund was. That made me wonder if I’m doing as well as I’d like in unraveling the complexities of investing. I’ve decided to focus my next few articles on basics. Hopefully, my thoughts will be easily understandable.
Mathematician Harry Markowitz won a Nobel Prize in 1990 for his exploration of the concept that investment portfolios might benefit from containing a mixture of stocks and bonds. His original article appeared in a mathematics journal in the early 1950’s and from the very start, he assumed that everyone knew what stocks and bonds were. If I may, let me share the newly-coined concept of ownership vs loanership to explain how these two approaches to investing differ.
Basically, buying stock in a company means that you become an owner – in the case of a large company, perhaps one of thousands of owners. The return on your investment will vary, depending on how well the company does and when you decide to sell your shares. On the other hand, loaning money to a company for a specific period of months or years earns you interest: your investment is returned at a pre-determined time along with an agreed-upon amount of interest. Loaning money to a company or government is called buying a bond. Loaning to a bank is buying a CD and to an insurance company, buying an annuity.
So the obvious question is, if the rate of return on a bond is guaranteed, why would anyone accept the risks associated with becoming an owner by buying stock? The answer is the potential for capital appreciation. As with any investment, the greater the inherent risk, the greater the potential for return.
Typically, a company becomes available for public ownership when it has grown as far as it can with the capital that the founder has readily available. When Sam Walton started Wal-Mart, he used his savings and that of friends and family. He also borrowed from people and banks but soon the interest on those loans became too much for the company to pay. He was adding stores constantly and needed money to continue, so he sold shares of the company to the public. These investments were not subject to periodic interest payments so the company was able to invest its cash in opening more stores.
I think stock investing is best considered as a long term strategy, choosing a stock in anticipation that the company will grow and become more profitable. So, an owner/stockholder should be more concerned about the business’ products and management, its future possibilities than immediate financial gains. If a company fares well, especially compared to its competitors, its value is likely to increase and all owners/stockholders benefit from that growth.
Back in the early 1970’s, it wasn’t obvious that there was a lot of money to be made selling things to small town customers at lower prices. But that basic concept made Sam Walton’s family rich along with many Wal-Mart shareholders. Of course, the opposite can also happen. An owner/stockholder can also lose money, up to whatever amount was originally invested. Nearly 50 years after the founding of Wal-Mart, Sears, Penney’s and K-Mart are still trying to figure out how to compete. Montgomery Ward was unable to do so and went out of business.
The difficulties that other retailers have had competing with Wal-Mart highlights a second concern about investing in stocks – knowing when to sell. Many investors made money with those other retailers before Wal-Mart arrived on the scene but it can be very difficult to judge when to take your profits (or when to cut your losses) in a particular stock.
Not to put too fine a point on it, but it’s simply not possible to time the market accurately enough to buy at the lows and sell at the highs with any consistency. If you doubt this assertion, see how well you’re able to predict day-to-day gasoline prices at your nearest station. We hear about oil prices everyday on the news but implementing that data and knowing just when to fill-up is much more an art than it is a science.
I’ll discuss the process of choosing a company in which to invest next time.