Welcome to Part Two of Investing’s Two Basic Options.
In my previous blog post, I looked at the first option in investing: lending money. Today, let’s tackle investments in which you become an owner.
When you put your money into a venture as a part-owner, you generally have a far bigger potential upside than you do with any of the lending options, as documented in William Bernstein’s classic book The Four Pillars of Investing, a must-read for anyone who wants to invest in the stock market.
That’s the good news. The more sobering news is that the higher potential returns come with big risks: no guarantees and volatility, among others. Here are some of the options:
Private Businesses – You can buy a chunk of ownership, typically through shares, in private businesses looking to raise funds or to bring in expertise they don’t currently have. You come to an agreement with the owner(s) in a Shareholders Agreement outlining how much money you’re investing, each party’s responsibilities, how you will benefit if all goes well (i.e. the upside), and your exposure (i.e. the downside). The extent of your success, or failure, depends on how well the company does.
Individual Stocks – When you buy stock, you’re buying a small ownership stake in a publicly-listed company. Stocks are constantly traded on Exchanges. In Canada, the most substantial Exchange is the Toronto Stock Exchange – the third largest in North America behind the New York Stock Exchange and the Nasdaq.
Mutual Funds – Professionally managed funds which pool money from many investors to purchase securities like stocks, bonds, and other equities. By buying mutual funds, you gain a small ownership stake in multiple companies, bonds, and other equities.
Index Funds – Same idea as mutual funds, except the bit about active management. Index funds hold stocks in the same proportion as the index it tracks. An index simply represents a specific segment of the market or a specified basket of funds.
An index fund mirroring the S&P 500, for example, would track the 500 largest companies in the US by holding stocks in the same proportion as the S&P. The S&P/TSX Composite Index tracks roughly 300 of Canada’s largest companies, and so on.
Exchange-Traded Funds (ETFs) – These are securities that track an index, or a basket of assets, and are traded like a common stock on Exchanges.
Real Estate – The purchase of property for the purpose of making money, either through positive cash flow (ideally/optimistically every) month and/or through appreciation (i.e. the increase in the value of the property over time).
As I said at the beginning of this article, the potential returns associated with ownership are typically higher than those associated with lending money. The catch is that along with those higher potential returns comes more risk. One of the factors that ups the risk is volatility.
What is volatility?
Let me ask you a question: Do you have a teenager in the house? Then you likely understand volatility. You know, the bit where you wake up to a bear in the house, then a while later you have your lovely soul back and you think he/she is awesome; that is, until you ask them to pick up the mass of stuff on their bedroom floor and they erupt.
Or you leave the door to their bedroom open after picking up their laundry and they go into verbal convulsions when they find out. My god, you’re the worst parent ever!
Or maybe they got home from school and you asked them how their day was. What’s with the interrogation already?!
Two hours later, you’re cool again and they’re chatting amiably.
The next day, same question, entirely different response. You shake your head.
And so it is with stocks.
Volatility, then, is the unpredictable swing up and down. The greater the volatility, the bigger the highs and lows. Here’s the problem: Nobody can predict what will happen from one week to the next – there are no crystal balls – though many pretend they can and they try to get you to pay for their predictions, to your detriment. As William Bernstein points out, “It is a fact that, from time to time, the markets and investing public go barking mad.” You won’t know when it’s going to happen, you just know that it will at some point.
Don’t let this scare you away from investing. The thing to do is to learn how to measure risk and to mitigate it in order to get the best results. Bernstein’s book is a great place to start.