One of the most frequently asked questions as it pertains to personal finance and financial planning is whether or not the stock market matters, and the answer is that it absolutely does! Whether most people realize it or not they are investors in the stock and bond markets via retirement options; virtually all 401(k) or otherwise constructed retirement funds are almost entirely allocated toward different types of equity (stock) and debt (bond) options. This has become even more true in a post financial crisis environment dominated by low interest rates. In addition to this, many people are looking for ways to put their money to work for them, and investing in the stock market is often seen as a viable option to accomplish this goal. Especially pertinent for the millennials entering the workforce, who are investing almost a decade younger than Boomers did, is to fully understand what exactly they are investing their money into.
Let’s dig a little deeper into what exactly is meant when people discuss “the market,” and take a more in-depth look at what exactly that means for you, your investments, and your finances overall. Two of the most commonly cited and studied stock markets are in the United States, but I feel it is worth mentioning what exactly the stock market represents. In general, the stock market is a composite that is made up of the individual stocks that are traded on these exchanges. Drilling a little deeper, the term exchanges summarizes the primary purpose of these institutions and tools for investors and traders alike; they provide a common market for buyers and sellers to collaborate and determine a set price to exchange shares.
The Markets
The most often cited market that we hear about is “The Dow,” which is short for The Dow Jones Industrial Average (DJIA). The name is actually a pretty accurate description of what this market actually is, it is simply a weighted average of 30 large, traditionally industrial, corporations. Believe it or not there is not a definite formula for determining which 30 companies are included in this average; the editors of The Wall Street Journal decide which 30 stocks should be included in the DJIA. While there are no strict rules, there are some general guidelines that include the following. These firms must be large, reputable enterprises that constitute a large portion of the economic activity in the United States. Just to repeat, all that “The Dow” is, is a weighted average of 30 large company stocks. That doesn’t really sound like a metric of small business or consumer financial health, now does it?
In addition to the DJIA there are the: the S&P 500 containing the 500 largest, by market capitalization stocks, that are publicly traded in the United States; the Nasdaq listing over 3,000 stocks (as of most current information), focusing primarily on technology and growth stocks, but not limited to U.S. companies, and the Russell 2000 that focuses primarily on smaller cap stocks. Together these four stock market averages are the most closely tracked, monitored, and fretted over indicators of economic activity in the United States. These markets are also often times referred to as the “equity markets,” and what that means is that these are the platforms where the equity shares of corporations are traded. For our purposes the equity we will be discussing is the common stock of the corporation, we will save the preferred stock and bond conversations for their own areas.
Obviously if you are investing in either individual stocks, bonds, or index funds you want to pay at least some attention to how the market is performing over time. This holds true even if you are not a short-term investor; the fluctuations in the marketplace will impact your returns and the value of your holdings. Additionally, and this is an important point to remember is that everyone with a retirement plan is invested in the stock market to a certain extent. Even if you do not want to become a financial expert, and would rather focus on other things, the simple fact remains that the changes in the market impact your life.
But first…Before you go and start running around looking to day trade and get your Wall Street fix in for the day, let’s take a step back and remember that most of the “trading” is now done by computers that can move faster than any human ever could dream of. Investment banks, hedge funds, and wealthy individuals have access, on average, to technology and tools that everyone else can only dream about. You cannot successfully trade against a machine programmed by highly complicated algorithms and hope to come out on top most of the time. With that said, and before any major depression kicks in, the stock market has returned, on average, 8 percent over the last 75 years. That means that over time, if you are patient and invest prudently in index funds (more on those in a minute) then your money will grow quite a bit. Day trading, however, is not something recommended in this book, nor is it something that most people should realistically think about; the profitability just really is not there for individual retail investors anymore.
Stocks and investment comes in a wide variety of different forms, and just like you would want to know what types of beer are available at a certain restaurant or bar, you should be equally as curious as to what type of investment vehicles are at your disposal. Alright, maybe you can be a little bit more interested in the beers, especially if you are a craft beer junkie, but you should at least be a bit interested in what your money is doing. Let’s take a look at some common types of investments, key terminology, and what it all really means for you.
Equities—equities are a term that is bantered around in a many publications and media outlets, but what does it actually mean for you and your money? Equity, as it is referred to in the context of stock ownership and shareholders means that the shareholders of the organization own that particular organization. In essence, during the initial public offering (IPO), which is the first time an organization offers shares for purchase, the organization trades cash for ownership percentages of the company. The most important aspect of corporate ownership, for most people, is that if you own shares of an organization that pays cash dividends you are entitled to receive these dividends merely because you own the shares as of the dividend date of record (when the organization basically tallies up who owns their shares). Now, unless you are actively trading stocks, which again is not a recommendation, you really will not have to worry about paying too much attention to these dates, so let’s take a look at an example of just what dividends are:
Company ABC pays dividends quarterly of $0.50 per share of common stock, which comes to an even $2 annually. If you own 1,000 shares of Company ABC you are entitled to $2,000 of cash dividends—pretty neat huh?
Now, while you do owe taxes on this dividend income it is important to note that this income is almost as passive as it can get; you receive cash merely for owning shares! Even more interesting is if you reinvest your dividends to purchase more shares, called a dividend reinvestment plan, DRIP for short, automatically applies your dividends to purchase more shares of the organization, which enables you to collect even more dividends when and if you opt out of the program at a future date. Again, while there are taxes associated with this income, it still is income; the more you know.
Index funds—index funds and their cousin, ETFs, have come to dominate the investment environment for both individuals and larger institutional investors, and the reasoning behind this shift is relatively straight forward. Simply put, the more you pay in fees and active management services the less money you have to actually save and invest; this explains the rise of index funds. Index funds, by default, are comprised in such a manner that they track the performance of a well-known index, such as the S&P 500 or the Dow Jones Industrial Average. What sets these types of funds apart, however, is the low fees typically charged on the investments allocated to these funds.
Every dollar or percentage point paid in fees is a dollar or percent of your money that you are not gaining the use of—keep that in mind as you select which investment option is best for you.
Dividends (again)—dividends are a very interesting phenomenon amongst publicly traded corporations, because for every dollar that the corporation spends on dividends it actually reduces the retained earnings and negatively impacts the cash flow of the corporation. Looking at this strictly from a dollars and cents point of view it makes no sense for a company to ever pay out cash dividends. So why do they do so? In order to keep the shareholders (owners) of the organization happy. Mentioned earlier, dividends are cash payments that are made by the corporation to its shareholders, that is, the people that own shares. Setting up a dividend friendly investment portfolio might be the right path for you if you are seeking to build up a passive income stream.
Bonds—bonds might be one of the most often misunderstood investment options available in the marketplace today. In essence, bonds are corporate debt that has been issued by the company to the marketplace—think of it as a type of mortgage. The organization receives cash up-front, but has to pay it back, with interest, over the life of the loan. Organizations of all types and sizes can issue bonds; corporations, not-for-profit entities, and governmental bodies all issue different types of debt instruments for a variety of reasons. Whether used to fund capital expansion and facilities, share buybacks, or other organizational purposes, these debt instruments represent another option for investors and to build up your financial wellness.
Depending on the type of bonds you purchase, you might be able to earn interest income tax free, especially on municipal types of debt. This subset of bonds is usually issued to finance the construction of a toll road, and so are usually backed by some sort of revenue stream. While it is always prudent to consult a financial advisor familiar with your situation before investing in any instrument, it is inarguable that these types of debt have grown more popular in recent years.
Now, as stated above, while the stock market does matter it is important to not get too wrapped up in the day-to-day gyrations of the stock market as you build your financial wellness plan over time. It is important to keep in mind that entire media companies exist solely because individuals and organizations seek to follow the day-to-day movements of individual companies and their share prices. That is fine, but you must keep in mind that the information, and urgency with which that information is conveyed, is more often than not oriented to make people trade more frequently. With every trade and change in ownership, however, come fees and taxes which eat into your overall return as well as the total amount you have saved.
Interest rates—interest rates are simultaneously very straight forward while also being a tad complicated, and that is because changes in interest rates have ripple effects that can be quite different depending on whether or not they are viewed from an individual or organizational point of view. From a personal finance point of view lower interest rates help if you are a borrower, whether it be for a car, home, or education, but if you are trying to save money lower rates will make your efforts that much more difficult. Conversely, higher rates help you build up savings more rapidly, but if you are on the other side of things (owing money to a third party) you will end up paying more in interest than you otherwise might. This inherent contradiction is one of the primary reasons why interest rates and interest rate policy have become such hot button issues during the last several years. Depending on the point of view you approach the issue from, you might be a fan of lower rates, higher rates, or even change your mind over time. This brings us to our next topic—the inherent wrinkle in these discussions.
The Wrinkle
It is important to keep in mind that the relationship and reaction to different interest rate policies are not always consistent for individuals and organizations, and that there always is the possibility of unintended consequences. For example, if interest rates are low (which they have been since the financial crisis), organizations are motivated to borrow funds (increase their leverage) to take advantage of low interest rates, but not might be as motivated to use those funds for capital projects, but why? In order to undertake and profitably operate a project or series or projects the organization must be able to earn a rate of return that is higher than the rate it cost the company to fund it. If interest rates are very low, basically zero, the organization does not have the ability to earn 5–6 percent on a project through growth. Why would anyone pay that much over what it cost when interest rates are so low?
This is a prime example of one of the primary themes of this book, and that is that finance, economies, and business concepts in general are multifaceted, complicated, and can (and should) always be analyzed from multiple points of view. When you are building your personal financial plan, and trying to construct a way that you can improve your financial situation it is imperative that you realize this fact early. What is always good for a business, large or small, and what is good for an individual might be very different things. In fact, what is good for an individual in one situation might not benefit someone else in a slightly different situation. As with many things, the answer depends on a variety of factors; make sure you know your situation and what you are hoping to accomplish.
Read Everything
Your parents were right in the fact that the more you read the more you know about different things, places, topics, and people. While we are going to go through a short list of online and print resources that are at your disposal, the overall theme that I am trying to hammer home here is that you have to read everything you possibly can about business and finance in order to understand it. When I am teaching an introductory level course, or high level overview course of accounting, the reaction is almost always the same from my students. In nearly every class I have ever taught there is always someone who asks “why do debits have to equal credits,” or why do assets have to equal liabilities plus owner’s equity, or “why is the aggregate demand curve drawn that way.” Regardless of the specific question or specific student the underlying question, often unspoken, is almost always the same. In essence, what my students are asking me is how they can relate to these accounting and economic concepts so that they “just make sense.” The problem with a lot of these ideas and concepts, however, is that they are not always intuitive and you cannot just “pick them up” with occasional effort and interest.
The same thing applies to your personal finances, that is, the terms, concepts, and ideas that we have been discussing and talking about are not just going to click and make sense for you unless you put the time and effort into learning them. Think of it like this—if you are putting together a fantasy football team you need to do your homework, dig past the headline news, and really find out what is important to you. Business and economic news is often dominated by a few major headlines during the day, usually centered around large corporate stories, interest/currency news, or something to do with commodities. Earnings season, when organizations publish results for the quarter or year most recently ended, can be even more distracting. This is why it is so important for you to not only read from a variety of sources when you are researching your ideas, but also to do so on a consistent basis. Like any other skill learning how and what to read, from the perspective of your personal finances, is something that you are going to have to practice and work at. To be blunt about it, if you have time to check Instagram, Twitter, Facebook, and Reddit throughout the day, and send some funny memes to your friends (which I’m guilty of doing as well), then you can probably allocate 15 to 20 min to serious business reading throughout the day. Carving out even just a few minutes for serious and focused reading can make a big difference when you are trying to make a decision that will impact your finances and your financial future.