Investing 101

This evening I had a lengthy, perhaps unproductive conversation with my best friend about investing.  She wants to have a nest egg for the future.  She also does not want to spend all of the money that she has recently been able to acquire.  Most importantly, she knows she is interested in investing, not just saving.  Unfortunately, she does not know a lot about investing, but I gave her a quick crash course.

STOCKSWe talk about stocks all the time that as often as not the exact definition and even the concept can escape us.  Just to clarify, stock are slices of ownership in a corporation.  The ownership is split among thousands of investors, so the ownership is less than 1% of the company, but the performance of the stock reflects the success of the company, so if the company is turning a beautiful profit, your stock should reflect your proportion of ownership in the form of a dividend.  Stocks pay dividends quarterly (sometimes less often like semi-annually or annually) to their owners.

Unfortunately, if a company is trading at $10/share, then investing only $100 to buy 10 shares is counter-productive (transaction costs alone would eliminate profits), so you would have to invest $1,000 to buy 100 shares and even then, you would only have shares in one company.  At that rate, you would need at least $10,000 to invest in 10 different companies in order to maintain any adequate portfolio, and even then, ten companies is not a lot if you were investing strictly in stocks.

Therefore, I classify stocks as a rich-man's game.  There are exceptions to that classification, and E*trade insists that everyone from smart-ass toddlers to their butlers should participate.  Personally, I disagree.

BONDS
Whereas stocks are ownership in a corporation, bonds are the antithesis.  They are company-issued debt.  If a company needs an influx of cash, they will offer a 10-year bond (for example) and they would pay interest monthly on the bond, then pay the principal of the bond at maturity.  While stocks fluctuate greatly with the success of the company to which it is associated, bonds have no variation.  Therefore, they are a far more stable investment.

However, buying bonds has the same issue as above.  If it is a $10,000 bond, then an investor would put the $10,000 out first, and then it would build.  In the bond market, the price may trade below (or even above) the face value of the bond itself in which case terms like "premium" and "discount" come into play, but to keep it simple, a bond is company debt repaid at a later date and you benefit from monthly (sometimes quarterly) interest.  The interest payments in bonds are similar to dividends in stocks.

MUTUAL FUND
The downside to both investments is that it requires a lot of money to begin investing.  This deterrent would prevent several hundred thousands of people from investing if not for a mutual fund.  A mutual fund was once defined to me as an investment vehicle where a group of people pool their money to invest in the stock market with the benefit of diversification and professional management, neither of which they could achieve individually.

Instead of an individual coming up with $10,000 to buy 10 stocks of 10 corporations trading at $10/share, a group can achieve this same feat and, even better, they can easily surpass those numbers.  Mutual funds allow an individual to achieve genuine market diversification through a relatively small investment.  In terms of which stocks to buy and when to sell them, each fund has a professional money manager to make those decisions to the otherwise uninformed shareholders.

The best benefit of mutual funds is their flexibility in terms of starting costs.  While stocks trade at specific prices per share, and investors can only purchase whole shares, mutual funds can sell fractions of shares.  Therefore, if a mutual fund were trading at $10, an investor could buy 12 and a half shares for $125.  Although most investors undervalue this benefit, the beauty comes in with simplified reinvestment when the fund pays dividends.

INDEX FUND
As you may have guessed, professional management is not cheap.  Mutual funds have many fees, sometimes called loads such as "front-end loads," to pay the professionals for their expertise and effort.  Obviously, this is a sweet deal for the money manager but it adversely affects shareholders, especially since the market is too unpredictable and mutual funds require daily attention to the point that money managers do not add as much value to the fund as investors may suspect.

The idea is to "beat the market," i.e. earn returns in excess of the growth of the economy (or losses less than the market declines), but only half of the money managers succeed, and when they succeed, it is usually not by a substantial amount.  Therefore, John Bogle ascertained that a mutual fund could seek to match the performance of the markets and it would not need professional management.  This theory turned into the first index fund and John Bogle later founded The Vanguard Group, where I was employed for most of the past 10 years.

BALANCED FUND
Another type of investment vehicle combines all the aforementioned vehicles.  It is a balanced fund, and they can be issued in a number of ways.  It could be a mutual fund that invests strictly in other mutual funds (e.g. "fund of funds").  If those funds include bond funds (which buy numerous bonds and replace those bonds when other bonds mature), then it would be a balanced fund.  The balanced fund may invest in index funds exclusively.

The benefit of a balanced fund (whether it is indexed or not) is that its focus is on the allocation.  If it's allocation is 70% stock and 30% bonds, then it is going to re-balance daily.  Throughout this blog, I expressed the importance of asset allocation and periodic re-balancing.

MY FAVORITE INVESTMENT
Now that we have all those terms defined, it seems that this new information should be put to some use. Therefore, I figured I could share my single favorite investment and explain why it is my favorite. It is the Vanguard STAR Fund, which is an actively managed balanced fund. The term "actively managed" means it is not an index fund. The mutual fund invests in 11 other mutual funds (all held by Vanguard) so it has exposure to stocks (60%) and bonds (40%) through 20 independently managed sub-portfolios with different yet complementary investment strategies. Also, it has a minimum initial investment of $1,000 (the average at Vanguard is $3,000).

But the real reason this fund is my favorite is that it puts the principles of a solid investment allocation first, and its returns are far less volatile than investments strictly in stocks or strictly in bonds. I never appreciated how useful this discipline was until I saw comparisons of hypothetical investments of $10,000 over the course of 10 years for this fund, compared to the Vanguard Total Stock Market Index Fund and the Vanguard Total Bond Market Index Fund. The difference was astounding because when the markets went up, this fund went up. When the markets went down, this fund went down. Contrasted mostly against the Vanguard Total Stock Market Index Fund, its declines were not nearly as drastic yet its gains seemed to be on par with the index fund. In other words, it had all the upside potential while minimizing the downside risk.

I put two months salary into the STAR Fund a while back because I was curious whether, if at an arbitrary point in the unforeseeable future, my investment balance would be more or less than two months salary at my job. I call it my "Engagement Ring Fund" for obvious reasons, but the investment experiment is virtually worthless to me now since I quit my job, so the comparison is no longer a gauge of time.  Also, I've given up on finding a spouse so my arbitrary point in the unforeseeable future is irrelevant to me (P.S., please never use this blog for advice on love).

Included to the right are four charts showing the comparison of the Vanguard STAR Fund to its Total Bond Market Index Fund (Investor shares), Total Stock Market Index Fund (Investor shares), and the Prime Money Market Fund. The charts are from various 10-year periods, including January 2009, February 2009, May 2009, and November 2011.

As you may remember from personal experience or reading prior entries here, the stock markets took a sharp nosedive in late 2008, which bottomed out in March 2009. Additionally, the Tech Bubble busted in March 2000, and then the markets dropped further after September 11, 2001, reaching a bottom in November 2002 if I recall correctly.

Obviously, the Prime Money Market Fund was not phased by any of the volatility since it is a stable value fund. The Total Bond Market Index Fund went through its share of rewards and challenges over 10 years. But note the similarities in the Total Stock Market Index Fund to the STAR Fund. When things were bad, they were worse for the Total Stock Market Index Fund. When things were good, they seemed to be equally good for both funds. This is why the fund is my single favorite investment.

When I started working at Vanguard, I had a joke about the fund's name. It was STAR but, as far as we knew, it did not stand for anything. However, I suggested that the fund should be a pre-starter fund (a starter fund is the first investment selection for your portfolio) so the letters S-T-A-R represented the beginning of the word "Starter." Looking back now, I think it was a ridiculous yet valid observation.