Some of the questions that you have been getting most are how do you invest and what is a Portfolio, so what I've decided to put together on investing and it's probably best to start with the very basics. We'll slowly but surely work our way up to covering things like stocks versus bonds, mutual funds versus ETFs, asset allocation, portfolios, and more. So, if those words sound intimidating, don't worry.
We're going to focus on the investment of money but we hear people talking about making investments with things other than money all the time, so for example maybe little Billy invested a lot of time reading about cars and engineering because he liked watching car races on TV. This likely increased his enjoyment level when watching those races so while this is not a financial investment for the purpose of our guide, we do see the same framework of what investing is.
Investing, in general, is the committing of resources into some endeavor or thing in the expectation of a positive return. In Billie's case, the resource he was committing was his time. The endeavor or thing was reading books and doing research online about cars and engineering. And his return was an increased level of enjoyment when watching car races. Now let's look at a financial investment which is what the rest of our guide will be focusing in on. In this case the resource being committed is going to be money, the endeavor or thing is going to be a financial investment, which can be stocks, bonds, investment funds, real estate, and more, and the return is the difference between the money we end up with versus the money we put in.
So, let's look at a simple example let's say Amal walks into her bank and says I want to invest $100. A salesperson at the bank might help Amal invest that one hundred dollars into a mutual fund which is a type of investment vehicle and don't worry if you don't know that term. It's okay we'll get to it later in the series but let's look at three possible outcomes after one year. In outcome 1 the value of our holding in this mutual fund has increased to 110 dollars, in outcome to the value of holding in this mutual fund hasn't changed and is still one hundred dollars, and in outcome three the value of holdings in this mutual fund is now ninety dollars. So, she's either had a return of plus ten percent, 0%, or negative ten percent. So, going back to our definition of investing. Amal committed resources, in this case financial resources, or money totaling one hundred dollars into an endeavor or thing, in this case the mutual fund which is a type of financial investment, in the expectation of a positive return. We showed three possible return scenarios and saw that it was possible to have a positive return a flat return or a negative return. ok so now we have a working definition of what investing is in general and I've given you a bit of a hint that sometimes it might not work out in the way you might expect you can consider this like dipping our toes into one of the most famous and fundamental concepts in investing: risk versus return.
We are going to tackle another fundamental question: why invest in the first place?
Well, there are two main reasons; reason number one to protect the purchasing power of your money and reason number two to grow your wealth in order to spend more money later retire earlier.
Let's take a closer look at reason number one, protecting the purchasing power of your money. Imagine it's the beginning of 2017 and you're going grocery shopping. Let's assume that every time you go grocery shopping you buy the exact same items, every week like clockwork now to work with a round number let's say that this cart of groceries costs exactly 100 dollars this first week of 2017 and for now let's also say that we decide to take another $100 and simply stuff it under a mattress for the time being and we'll revisit this in a moment now. We know that over the course of time prices change for the items in our grocery cart and for the most part prices tend to rise over time. This is known as inflation which is defined as the general increase in the prices of goods and services over time so if we fast-forward to the first week of the following year 2018, the cart of groceries that we buy every single week without fail might now cost 102 dollars due to inflation so if we go and pull out the $100 that we put under the mattress at the beginning of 2017 we would no longer be able to buy the entire cart of groceries. If we take our 100 dollars and divide by the new cost of the cart of groceries 102 dollars, we find that we would only be able to buy ninety-eight-point-zero-four percent of our standard cart of groceries. Our original 100 dollars has lost purchasing power. If we won our original 100 dollars to keep buying the same standard cart of groceries, we have to invest and earn a rate of return equal to the rate of inflation. So, if inflation was 2% per year, we would need to earn 2% per year on our money just to May contain our purchasing power so that's one reason people may want to invest.
The second main reason people may want to invest is to grow their money faster than inflation in the hopes of increasing their lifestyle or retiring early. Let's run through a few examples but this time with a time period of twenty years and this time let's say inflation is one percent per year and in all cases, we are starting with $100. In scenario one, we just put the money under the mattress where it earns nothing. In scenario two, we put the money into a savings account that earns one percent per year and in scenario three, we put the money into an aggressive set of investments that earn 6% per year.
In Scenario one, our $100 doesn't grow so we still have $100 at the end of 20 years but with inflation running 1% per year for 20 years, our standard cart of groceries would now be priced at $122.2. $100 divided by $122.2 equals 0.82 that means we could only buy 0.82 standard carts of groceries after 20 years.
In scenario two, our $100 grows at 1% per year and ends up being worth $122.2 which means we can buy exactly one standard cart worth of groceries. Our purchasing power has been maintained.
In scenario three, our $100 grows at six percent per year and ends up being worth $320.71. If we divide $320.71 by $122.2, we get 2.63 that means we could buy 2.63 three carts worth of groceries. Our purchasing power has been increased and by quite a bit now. We have some options; we could increase our standard of living by buying fancier groceries or we could keep buying the same gross and have money left over for other things; these other things could be
anything like vacations fancier cars or the ability to stop working earlier and any combination of all these things.
Okay, we'll stop here because it's easier to work with smaller chunks of information at a time but I know that at this point many people are thinking well why wouldn't you just take the aggressive investment option and earn 6% all the time. Hopefully, you're already thinking that there must be some kind of catch and you're right. We're going to talk about the trade-off between rate of return and risk, to give you a hint it's imperative for you to understand that the potential of higher returns necessarily comes at the expense of more risk.
Investing in Stock:
When you think of investing, the first thing that comes into mind is this complicated world of the stock market. With so many charts and numbers, it's easy to get confused, so let's break it down and try to make a sense out of it.
Let's say you have built a business, but now you need some more money to expand or maybe you just want a private jet. Where do you get the money from? Here is an idea for you, why don’t you break down your company and sell part of it while you keep the majority to stay in charge. That's what stock market is for, and this process is known as Initial Public Offering (IPO) But how much money can you make?
Let’s take an example of Mark Zuckerberg's little toy - Facebook. It went public in 2012 with 337 million shares at a price of 38 dollars a share. Not bad, right?! But, when he realized that, that there are so many more people who want a piece of his pie, he added another 84 million shares (421 million). And guess what? He sold every single one of them. And raised 16 billion dollars. He literally became a billionaire in just a few hours. In fact, the stock price increased to 45 dollars within the first day of trading. It seems like Facebook was doing great, but it was too early to celebrate because it felt back to 38 by the end of the day, and that was just the beginning. The bad news was just starting. In the next few weeks, the stock crashed to as low as 20 dollars. Twice smaller than its original price. Now, to understand what's happening here, we have to get to the root of the stock market.
In the past, stocks were acquired primarily for dividends. Theoretically, when you a buy a stock, you become the owner of that company. Which means that you like any other owner have the right to the profit of the company. Congratulations, you have purchased 10 Facebook stocks in January of 2017, and you are now the owner of Facebook exactly like Mark, and I am not kidding. So, your company (Facebook) makes 15.934 Billion dollars, how much of that belongs to you?! At the end of the day, you have spent 1300 dollars to buy your 10 stocks. (Facebook stock price in January 2017) But let’s first take a look at how much stocks are there in total. It turns out that there are almost 3 billion of them (2.956 Billion). I doubt that your 10 stock matters now. But let's be optimistic. Because, if we divide the net income on the numbers of shares, each stock should earn a little over 5 dollars (5.39= 15.934 Billion/ 2.956 Billion), by the way, that's known as EPS (earnings per share). In other words, your 10-stock supposed to earn you almost 54 dollars (53.9). Not bad, right? But that's just hypothetically, in practice, you get absolutely nothing! The board of directors is the one who is going to decided what to do with this money. And their first priority is to fill their pockets and expand the company, so no one really cares about your 10 stocks. But don’t worry, not everyone is a scammer like Mark Zuckerberg.
For example, last year Apple paid 13 billion dollars in dividends (12.769 B) or 2.5 dollars
for each stock (2.46). Of course, it's not much for a stock that costs 170 bucks, but something is always better than nothing. However, today, it doesn’t really matter how much the company pays as much as the price of the stock. Apple's stockholders experienced a 33% gain within a single year! That's way better than market's average. (from $120 to $160) You probably have already heard that Apple is the first company to cross a trillion-dollar valuation because its stock price crossed 200 dollars. But what if I told you that until June of 2014, Apple stock price was 645 dollars. Does that mean, that the company was already valued at more than 3 trillion dollars? Oh, god, this stock market is so freaking complicated.
Let me explain. There is something called stock splits. Each stock was split into 7 pieces, and the prices were decreases proportionally (92.7 dollars). Technically nothing really changed, but now more people can afford the stock and join the community of Apple investors. Since the stock now costs 92 dollars. But not all companies do that, some prefer to only work with serious people such as Warren Buffett. His company Berkshire Hathaway has never split their stocks. that's why it only has 1.68 million shares, in comparison Apple has 5 billion (4.91 Billion) That's why a single buffet's stock (Berkshire Hathaway) cost over 300K dollars. I guess most of us will never join buffets secret investors society. But don’t worry, Buffett wouldn’t mind taking your money as well. That's why he created class B shares which are more affordable (200usd).
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