I think it’s good to review some key vocabulary to understanding how to invest. I’m going to keep things as simple as possible and only define the terms in context to investing. If you want to know more, google it and read more on wikipedia.
Annual Percentage Rate. It’s usually written as a percentage such as 5%.
If you invest $100 for a year at an APR of 5%, you will have $105 at the end of 1 year.
It means earning interest on interest. In terms of investing it’s a fabulous thing.
If you invest $100 for 2 years at 5%, you might think you will end up with $110 at the end of 2 years, but that's if you didn't earn compound interest. You will actually have closer $110.50 depending how frequently the interest is paid out to you.
Over long periods of time, compound interest can make a big difference.
Invest $100 at 5% for 30 years with no compounding and you'll have $250 in 30 years.
Invest $100 at 5% for 30 years with continuous compounding and you’ll have $448 in 30 years. That’s 79% more money!
The loss of buying power expressed as a percentage. You know how prices of stuff in general keep going up like for basic goods such as a dozen eggs? Why inflation occurs is hard to pin point, but for the purposes of investing, lets just say it’s at about 3% a year on average in the US.
On average, that $100 item you want will cost $103 next year. That means, if you're stashing your cash under you mattress, you're losing about 3% buying power a year! Even more reason to invest it!
Standard & Poor’s 500 Index is one of the most famous indexes that tracks 500 large companies in the American stock market. It’s basically a number that tracks those 500 companies as an aggregate to determine the general condition of the American stock market. It is also used as a measuring stick as well to see how other industries and stocks might be doing compared to this standard index of top companies.
The S&P 500 over its history has gone up on average 10% a year! It’s fairly volatile though as it actually went like -40% in 2008. So volatile investments work better over long periods of time.
Stocks and Bonds
Stocks for our conversation purposes is an investment in a company whether it’s direct ownership by buying the stock directly or through another financial vehicle such as an ETF or mutual fund (more on this below). The company does well or there is more demand for the stock, the price goes up.
Bonds are loans. You buy a bond, you loan out money. When you loan out money, you expect to receive interest for your loan. It’s not zero risk, but generally less risky than stocks and therefore, your returns will be lower than stocks. Stocks on average have a higher rate of return, but comes with more volatility.
ETF and Mutual Funds
Exchange-Traded Funds and Mutual Funds are purchasable financial products you can buy that generally is like buying a collection of stocks, bonds, and/or other assets. The differences are small, but ETF behave more like stocks as they can be purchased throughout the day and the price will fluctuate during the day as well. Mutual Funds prices are calculated at the end of the day and then purchases/sales are done.
What’s important to know about both of these are there are fees to managing these types of assets since they involve more work in calculating and managing the basket of assets they represent. The fee is generally called management fees or expense ratio and some are rip-offs!
The ETF VOO and the Mutual Fund SNPBX both track the S&P 500 index. That means if the S&P 500 goes up 1% on a given day, then both VOO and SNPBX would go up about 1%. But VOO has fee of 0.04% and SNPBX has a fee of 1.38%! You would be paying 34.5x more for SNPBX than VOO and they do the same thing!!! That means if the S&P 500 went up 10% in a year, if you owned VOO, you would have made 9.96%, but if you owned SNPBX you would have made only 8.62%. One is robbing you blind!
Active vs Passive Management
Active management is when an individual or team actively picks stocks for a client. Passive management is rather than trying to pick individual winning stocks, you just buy an index fund such as VOO. Time and time again, these active management professionals cannot beat the passive management style.
Some years, some active management professionals will do better than passive, but if you look at the data over long periods of time, basically, you’re better off going with an index fund. If these professional stock pickers can’t outperform just buying the S&P 500 index fund, then I as a casual long term investor can’t reasonably expect to do this either. Just go with passive funds!
If that’s not reason enough, the greatest investor of all the time, Warren Buffett, has stated in his will that his family’s money must be placed in a low cost index fund.
Let’s Get Going!
Now that we have some basics down, let’s get started!