Basically (Part 2)......
If an investor decides that stock ownership seems like a workable strategy for making money over time, how does she or he decide which company to become an owner of, i.e. which stock to purchase? Choices abound. There are shares of around 8,000 companies currently available on US exchanges and at least that many more on foreign exchanges. Along with the numerous choices, there’s apparently no end to the TV and radio shows, newspaper columns, investment newsletters, blogs and assorted pundits telling you which stock to buy. Could they all be right?
Of course not, but you might be able to choose stocks based on what you already know. Many early investors in Wal-Mart lived in the middle of the country, far from Wall Street where the company was basically unknown. People who shopped at the stores liked the broad selection and low prices. They were among the first non-family investors to see that the formula might work as an investment too. As I’ve mentioned, it certainly did.
Advertisers spend millions of dollars every year trying to discover what you already know: the places you shop and the products you buy. How do you spend your leisure time? Does your family like going to Disney parks and movies or have a Netflix subscription (or both)? Do you prefer one grocery over another or one brand? It was this sort of everyday insight that led Arkansas shoppers to invest in Wal-Mart before the financial professionals in New York had even heard of the company.
Another example? I have a friend who’s an ear, nose and throat physician. Some years ago, a salesperson introduced him to Breathe Right® strips in the hope that he’d recommend them to patients who had trouble breathing at night. My friend was moderately interested, the more so when he started seeing professional athletes wearing them during games. Many of us saw the strips on TV and wondered what they were but he already knew. He was given an early look at a product which became very successful and continues to make money for Glaxo Smith Kline. What he learned through his profession gave him additional insight as an investor.
If you aren’t comfortable picking individual stocks, there’s an alternative: the mutual fund. Briefly, a mutual fund is a pooled investment which enables a group of individuals to combine their resources to utilize the services of a professional investment manager. Actually, such funds are started by a manager (or management group), then shares are sold to investors with everyone hoping the shares can be re-sold later at a profit. Although they’ve been around in one form or another since the 1700’s, the first modern mutual fund was founded in Boston in 1924. The typical mutual fund is actively managed, which means that individual securities are bought and sold in hopes of enhancing investment returns. There are over 10,000 to choose from today, providing at least one for every conceivable asset management theory. These continuously offered or open end mutual funds are by far the most popular investment choice in the country. Chances are your retirement plan offers a range of such funds for you to choose from.
Although mutual funds provide immediate diversification with a single investment, they have a potential drawback from a tax perspective. Funds are required to pay out essentially all of their earnings to investors every year, even earnings which are reinvested in additional shares of the fund. That means that investors must pay taxes on money they haven’t received as opposed to owners of individual stocks who decide when to sell, thus when taxes are due. This is not an issue in retirement accounts (and sometimes becomes a blessing later when shares can be sold with at least some of the taxes pre-paid) but it’s certainly something to be considered as investment decisions are being made.
Not surprisingly, the investment industry has come up with a solution to the tax issue: the Exchange Traded Fund (ETF). Available since the mid-90’s, there are now over 1,700 to choose from. The law treats ETFs differently than it does open end funds. Each ETF share is considered a security by itself, so tax considerations come into play only when an ETF share is sold, just like a stock. Like traditional mutual funds, there are numerous investment approaches represented in the ETF universe. Unlike a traditional mutual fund, ETFs are generally not actively managed, commonly holding the same securities all the time. While there are many broadly diversified ETFs, the category is best known for those funds which are more sharply focused than the typical mutual fund. You can invest in a very thin slice of the market, making for a finely calibrated investment.
In the next article in this series, we’ll take a look at another type of fund along with market indexes, or averages. Until then, let’s close with the words of Warren Buffet’s teacher, Ben Graham: "The individual investor should act consistently as an investor and not as a speculator."