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.

OWNING

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.

• Pros: This allows you to get in on the ground floor of businesses with a solid future ahead of them, particularly if there’s the possibility of going public. You can select an industry or business in which you have some expertise.
• Cons: The risk involved depends on the strength of the business, the industry, and the leaders. None of your capital is guaranteed, nor is the return. The lows can be as massive as the potential highs.

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.

• Pros: Over the long run, stocks often offer the highest return of any security. It’s also easy to buy small stakes in any publicly-traded company you like, provided you have enough money to buy shares. For example, at the time of writing, Apple shares are trading at roughly $224 US per share. If you received $100 for your birthday and you want to buy some stock, you’ll need to pick another company with a lower share price, pray for a drop in prices sometime soon, or wait for more cash gifts.
• Cons: Trying to pick winning stocks has been shown to be a losing proposition in the long run (Nortel, anyone?) especially when compared with indexing (see below). Pick any number of authors, investors, and researchers who reference the data on this:
  • Jack Bogle, The Little Book of Common Sense Investing (or, frankly, anything he’s ever written).
  • Warren Buffet in multiple interviews including this one.
  • William Bernstein, The Four Pillars of Investing (referenced above).
  • Daniel Solin, The Smartest Investment Book You’ll Ever Read
  • Tony Robbins, Money, Master the Game
  • Larry E. Swedroe, Playing the Winner’s Game
• Another con: When you buy individual stocks, you’re unlikely to get broad diversification, which proves essential in mitigating risk. Your transaction costs also go up with every individual purchase, thereby reducing your returns.

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.

• Pros: You have better diversification, depending on the fund, than you would through purchasing individual stocks and bonds. Also, the cost to get into a mutual fund can be lower than purchasing individual stocks.
• Another pro: unlike common stocks, you buy mutual funds in dollar amounts of your choosing, even if that means buying an uneven number of shares (i.e. fractional shares).
• Cons: Canada has the world’s costliest mutual funds. With Management Expense Ratios (i.e. fees to run the fund) often in the 2% – 3% range, that’s a huge bite out of your retirement funds given the impact of compounding. Ouch! Fees matter a great deal for your returns. The lower the better.
• Another con: Mutual funds are actively managed – a lot of buying and selling – which means higher fees and potentially lower tax efficiency, all of which acts as a drag on returns. Just delve into any of the books mentioned above for more details.

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.

• Pros: You get broad diversification at a low cost (typically much lower MERs than mutual funds) because there is no active management. The index simply mirrors the performance of the companies, or bonds, that it tracks.
• Other pros: They are tax efficient because of the low turnover. In addition, you can invest any dollar amount you want and it will be fully invested, unlike ETFs (below).
• Cons: There aren’t many. Some critics say that since index funds track the market, you’re stuck with losing funds when the market goes down. Since the data clearly show that passive investing is more effective than active investing over the long term (i.e. fund managers typically do a bad job of picking winning stocks beyond the short term), this isn’t much of a con.

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.

• Pros: They tend to be lower cost than index funds. Since fees have such a large impact on returns, this can make a big difference once your portfolio reaches the six-figure mark and beyond. They also offer broad diversification and passive management, much like index funds.
• Other pro: Since they’re sold on Exchanges, they can be traded at any time during the trading day.
• Cons: There are typically costs involved to buy and sell ETFs, which can get expensive, particularly for smaller portfolios. Also, since they are traded on Exchanges, they can only be purchased through a brokerage (i.e. your own account) or a financial advisor, meaning they’re not as user-friendly as index funds.

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).

• Pros: Investing in real estate can be lucrative over the long run if done well. Many of the world’s wealthiest individuals have substantial real estate holdings. It’s clearly a popular vehicle for wealth accumulation, one which I’ve employed for more than a decade now.
• Cons: The list is quite long:
  • The cash requirements to purchase real estate are high, typically 5% to 40% of the value of the property, depending on a number of factors (e.g. commercial vs residential; strength of the property and buyer, etc).
  • There is no guarantee that the property will grow in value. In some parts of Canada, values dropped significantly (i.e. 20%+) after the 2008 financial crisis, and they have not bounced back.
  • Many factors can have an adverse effect on cash flow (i.e. tenant damage, economic downturns, rental rules, unforeseen repair costs, etc.)
  • The asset isn’t liquid. Selling typically requires many months and can involve significant costs.
  • Dealing with tenants can be is a challenge. There can be a pretty big PITA factor here. If you offload the task to a management company, you then have to manage the manager, plus you incur additional costs.

A word about volatility

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.