Demystifying The Market
As financial advisors, we try to educate clients to help them on their path to financial fitness. However, one of our largest downfalls is our need to over-complicate things to show our intelligence. We use industry jargon and speak about things that are foreign to most. As a result, our goal of educating meets very little progress. This is especially true when it comes to the stock market and bond market.
At Patriot, as fee-only fiduciaries, we pride ourselves on transparency and clear, effective communication. Fee-only means our clients pay us directly, and it is the only compensation we receive. Additionally, a fiduciary must always act in your best interest.
So….what are the markets?
The stock and bond market are some of the mostly poorly understood financial planning topics. They are vastly sensationalized by the media and shrouded in mystery by industry professionals. Again, we’re here to provide clear, effective communication and education. You need to know what stocks and bonds are and how they all work together in the markets.
What are stocks and bonds?
On the most basic level stocks and bonds are both vehicles to allow individuals to invest in companies.
What are stocks/equities?
Stocks represent ownership in a publicly held company, allowing investors to share in their future financial performance. Companies typically go public to raise capital so they can expand and grow. Companies use an initial public offering (IPO) to do so. A recent example is Snapchat. With an IPO, financial analysts evaluate the number and price of shares that will be issued based on their estimated value of the company. An investment bank will then take on the task of underwriting, or taking ownership of the shares to sell them to the public, hence “Initial Public” offering. This results in additional funds for the company and ownership for investors.
As a side note, ownership in stocks is considered equity in that company. This is why we often refer to stocks as “equities.”
However, most market activity for stocks takes place in the secondary market. Here, investors trade securities on the market among themselves. Shares of stock are purchased from another investor at a price determined by market makers. Current bids (offers to buy) and asks (offers to sell) determine that price.
Your return on investment from stocks really boils down to a couple things:
Company Fundamentals – A company’s actual performance is the greatest contributor to growth. Stock prices will ebb and flow with the financial health of a company, based on it’s financial statements. The overall goal is to establish the “intrinsic” value of the company, or what analysts think it is worth.
When a company is doing well, it could pay out profits to shareholders in the form of dividends. Or, it could reinvest profits in hopes of growing and increasing the value of it’s stock. However, it’s important to always view both together as the total return on your investment. Over the long-term, company fundamentals and the economic impact on those fundamentals drives performance.
Speculation & Behavioral Impact – In more short-term periods, volatility can be greatly affected by speculation on current events and the behavior of investors. An advisor can look at a portfolio objectively and take the emotion out of it. This provides a great benefit over the long-term. It’s important to weather the ups and downs of the market, instead of jumping in and out with emotional decisions. This causes a “behavior gap,” which is the gap between an investment’s return and the investor’s return.
In fact, a recent Vanguard study analyzed the personal performance of more than 58,000 portfolios over five years ended December 31, 2012. Investors who made emotional changes to their portfolio during that tumultuous period in the market averaged 1.31% less than those who stayed the course. That said, it’s about TIME IN the market, not TIMING the market. This is a huge piece of our investment philosophy.
What are bonds?
Bond’s represent debt obligations, or a form of borrowing for a company. The company simply decides how much money they want to raise and then issue the bonds. They are essentially taking a loan out from investors and promising regular interest payments. They also repay the face amount when the bond matures or comes due. After the initial issuance, the bonds trade on the secondary market.
Just as with stocks, short-term fluctuations can occur due to speculation and investor behavior. Aside from that, bond values are typically a function of the terms of the bond issue. These include the bond’s face value, coupon rate, maturity, credit quality, etc.. Interest rates have a large impact on bond performance as well. Typically as interest rates rise, bond values decline and vice versa. Additionally, the longer the maturity, the more dramatic the impact of interest rate changes. This is why short-term bonds tend to fair better in rising rate environments. Conversely, long-term bonds tend to fair better in decreasing rate environments. The value of a bond can also move due to changes in the financial health of the bond’s issuer. Due to the fixed periodic payments, we often refer to bonds as “fixed income” investments.
What are the best ways to own stocks and bonds?
We’ve covered stocks and bonds. Looking at the bigger picture, let’s discuss the most common ways to own both:
Mutual funds – With a mutual fund, many investors invest in a “fund. ” The manager of that fund then invests in various securities (stocks and bonds). Each investor shares in the performance of the overall fund. These funds typically invest in hundreds and thousands of stocks and/or bonds. “Shares” trade at the end of each day based on the calculated Net Asset Value (NAV) at market close. The NAV is a weighted price of all underlying positions.
Exchange Traded Funds (ETFs) – ETFs are very similar to mutual funds, with a couple key differences. Instead of shares trading at the end of each day, they trade during market hours just like a stock. This gives you more flexibility with trading and transparency. You’ll know exactly what you’re paying for it when you trade. With a mutual fund, you don’t know the price until after the markets close.
Index Funds – With either mutual funds or ETFs, you can invest in “index” funds. These are “passively” managed funds. As such, the manager mimics particular index, such as the S&P 500. Conversely, “actively” managed funds try to pick individual positions they believe will outperform the index. Research, such as SPIVA, has shown that this is a poor approach. These actively managed funds do not fare well compared to their benchmark. This is why we utilize low cost index funds to capture the market return, instead of trying to beat it.
What are indices and the investment universe?
All publicly traded stocks and bonds make up a massive global market. Picture every single company on the planet. Now picture all the stocks and bonds they have issued to raise capital and ultimately grow their business.
The indices tracked by index funds are all subsets of this global environment. For example, there is a MSCI All Country World Index All Cap Index. This index consists of large, mid, small, and micro cap stocks across 47 developed and emerging market countries. It includes over 14,000 stocks and covers over 99% of the “global equity investment opportunity set.” However, indices typically cover a more specific subset of that global environment, such as the S&P 500. This index includes the 500 largest companies in the U.S. and is representative of U.S. large cap stocks.
When we utilize index funds, we capture different segments of the global market, or different asset classes. Allocating a portfolio among those asset classes is the art and science behind proper investment management.
How do they all work together for me?
Now think of capitalism, where business owners openly compete for consumers business so they can grow and thrive. Globally, there are thousands of companies you can invest in. Additionally, you have a constantly growing population. As they join the consumer market, they naturally add to the growth of those companies. At a very simple, basic level, this is why advisors are confident over the long-term markets will always go up. This isn’t a guarantee, just a very strong statement regarding human progress and our desire to succeed.
I hope this overview of the global market is enlightening. I also hope it helps demystify the investment universe in the eyes of investors. It is one of our greatest resources to help build wealth. As such, it is important to understand and be comfortable with how all the pieces come together. If you have any questions or are interested in our approach, please contact us.