Over the past few weeks, I’ve received a number of reader questions asking about the basics of investing. I appreciated these questions since understanding the basics is foundational to making the right money decisions. As I often remind my clients, understanding the basics puts you ahead of more than 90% of investors and can set you on the path of financial success for the rest of your life.
One of the best ways to describe the basics of investing is to compare it to a birthday cake (I wish I could compare it to my favorite kakosh cake, but, alas, that analogy just doesn’t work as well). There are four main components of a traditional birthday cake: The actual cake, the frosting, sprinkles, and a cherry on top. Let’s jump into the analogy since I’m sure readers are getting hungry for some knowledge.
Cake: The cornerstone of any birthday cake is the cake itself. There is no debate about this. Without it, you may have an impractical and unappetizing mess of ingredients on top of each other, but it certainly isn’t a cake.
The analogous essential cake part of every investor’s portfolio is a combination of stocks, bonds, and cash. Let’s discuss and define each one of these areas of the market or asset classes.
Stocks: Stocks represent an ownership stake in a company. For example, Coca-Cola is a large company that issues stocks. If a member of the public buys one of those stocks, they own a piece of the Coca-Cola company. If Coke goes up in value, the stockholders will make money by owning a share of a more valuable company. They can sell their stock for a higher price than they originally paid to buy it. Conversely, if it goes down, they will lose money. Additionally, Coke offers a dividend, which is a cash distribution, to stockholders. That means stockholders are actually paid part of the profits for owning the company while they wait for it to go up in value.
Technically, stocks have unlimited upside. That’s why they may be the best vehicle for long-term investors who need their money to outpace inflation over that long period. However, stocks can also go bankrupt or remain stagnant for a decade or more. This is why stocks are risky and investors need to be prudent when choosing what stocks to own.
Bonds: Bonds are a loan made by an investor to a borrower. The borrower is usually a company or government entity. Bonds are used by companies, municipalities, and states to finance projects and operations. Investors that own bonds typically receive the principal of their loan at a specified due date or maturity date. In addition, over the course of the holding period the investor receives interest payments to compensate them for lending out their money.
Bonds come in many shapes and sizes. Some are very conservative, like Treasury bonds issued by the U.S. government. Other bonds are riskier, with a higher potential for default, like those issued by companies that are not in a strong place financially. Typically, the bond portion of an investor’s portfolio is considered more conservative and serves as a ballast for the more volatile stock portion of their portfolio. This is why many investors have most of their bond exposure in high quality, relatively conservative bonds.
Bond returns typically don’t outpace the rate of inflation over the long-term. Therefore, consistently maintaining too much bond exposure may cause an investor to lose buying power and limit their nest egg’s growth potential. However, as an investor approaches the date when they need to withdraw from their invested funds, it may make sense to decrease the risk in their portfolio. This can be accomplished by shifting more of their exposure to high quality bonds instead of stocks.
Cash: Cash is the least exciting investment and usually has the lowest returns since it carries the least amount of risk. However, cash plays a key role in any investor’s portfolio, and is particularly crucial for retirees. As folks are approaching retirement, having a cushion of cash (possibly 2 to 3 years’ worth of expense money) can help mitigate the risk of the market plummeting right before someone needs their money. In such an unfortunate scenario, retirees can withdraw cash without needing to liquidate their investments that have plummeted in value. This cash cushion early in retirement is crucial to helping ensure that investors don’t outlive their money.
Once investors understand the basic stock, bonds, and cash concepts, the key is deciding what percentage of their investments should be in each asset class. The answer to that depends on age, risk tolerance, and personal circumstances.
Frosting: Frosting is the second most important part of any birthday cake. Without it the final cake can be a real dud. Frosting comes in many flavors: vanilla, chocolate, strawberry, and many more. There is not one right type of frosting, but having some is important.
The frosting within an investor’s portfolio are the sub-asset classes to stocks, bonds, and cash that help keep the portfolio adequately diversified. They may also help increase the probability of a better risk-adjusted return if executed correctly. For example, investors should consider having exposure to both US stocks and overseas stocks, large company stocks and small company stocks, they may even want to emphasize a particular industry of stocks like real estate or technology. This also applies to bonds. An investor may want a mix of tax-free state municipal bonds, US government bonds, corporate bonds, and even overseas bonds. Furthermore, depending on the investors’ goals they may want bonds that mature in a year, five years, or ten years.
The underlying principle is that if one area of the stock or bond market is lagging, then another area will be performing well. This yin and yang relationship between various investments helps maintain portfolio harmony even during market volatility. It will also keep your emotions in check during challenging economic environments.
Sprinkles: Sprinkles add a little pizazz to the cake. They don’t add much flavor, but some folks get excited by them. The sprinkles in your portfolio are akin to stock “factors”. This is really getting into the weeds on a topic that can get quite nuanced and is also not super important.
Many stocks can be categorized by different characteristics known as factors. Factors involve targeting specific drivers of return across asset classes. These categories include value, momentum, low volatility, and quality, to name just a few. I’d spend time discussing each of these factors if they were important, but they are not… just like the sprinkles. If you’ve mastered the first two sections, then adding some factors can be harmless fun.
Cherry on top: The maraschino cherry on top of most birthday cakes is unnecessary. They are usually taken off immediately and discarded, unless one grandpa or uncle in the family is willing to eat it. The other 99% of people are appalled by its distinct taste and lack of contribution to the cake itself.
The maraschino cherry equivalent within a portfolio are all the latest fads of the day, things that sound exciting, may have had their day in the sun, but are usually extremely high risk and don’t always have a solid investment thesis behind them. These include, but are not limited to, Cryptocurrency, NFTs, hard money lending, option strategies, and IPOs. I would also argue that most retail investors don’t need exposure to hedge funds, private equity, or real estate syndication deals. All these products or strategies fall under the purview of gambling and don’t belong in the typical investor’s portfolio. Sure, there are exceptions to this rule, but if you are reading this you are probably not the exception.
Eating your cake: The basics of investing involve understanding the important asset classes to include in your portfolio and knowing what you should avoid. The final component is the correct implementation. The best way to eat cake is from a plate with a fork or spoon. A plate with a utensil makes the consumption of cake efficient and less messy.
Similarly, the simplest and most efficient way to implement your portfolio is using mutual funds or Exchange Traded Funds (ETFs). They are liquid, easy to buy and sell, and allow you to buy a whole basket of stocks and bonds within one fund so you stay diversified to help limit risk. Deciding which funds or ETFs to purchase does require some education. That is beyond the scope of a 1,400-word article. You can research that online on your own or hire someone to help you.
In my upcoming article I will discuss the basics of financial planning utilizing the “bucket approach.”
