The Optometrist’s Guide to Investing 101
Chapter 1: What is an Investment and Basic Investing Terms
What is an Investment?
NOT an Investment(s)
(3) Mutual Funds
(4) Exchange-Traded Fund (ETFs)
(6) Real Estate
(7) Hedge Funds
(8) Private Equity
(9) Rare Material with High Demand relative to Supply
(1) Currencies like the Yen
(2) Cryptocurrency like Bitcoin
(3) Multi-Level Marketing (MLM)
(4) Your personal house
(5) Cars and baseball cards
(6) Appliances and household items
(7) The lottery/gambling
The Merriam Webster dictionary defines the word “investment” as the outlay of money usually for income or profit: capital outlay. In modern times, the word investment has been used, overused and many times, misused.
Take a look at the chart above. Notice that amongst these items listed under “Investment,” each one has the ability to produce value, whether it is through income, equity or perceived value by a fellow consumer.
While none of the items under the “Not an Investment” side of the chart have intrinsic value as we have defined above, remember that certain items can be used to make money (and subsequently lose money), such as crypto-currency or gambling. However, they do not qualify for our traditional definition of an investment. These items are based mostly on speculation and chance, rather than their ability to generate income.
Ok, let's start with some basic investing terminology so we can have a solid foundation and understand investing lingo.
"Crypto-currency or gambling do not qualify for our traditional definition of an investment. These items are based mostly on speculation and chance, rather than their ability to generate income"
What is a Stock?
Shares of ownership in a company are sometimes referred to as stock equity. There are many different ways to own stock of a company or multiple companies like buying a simple S&P 500 index, where you can share in the profits (and losses) of a specific company - like Apple.
There are 4 basic ways to own a stock:
(1) Individual Stock Purchase
You buy shares of a specific company through a brokerage. This is often considered higher risk because you are placing all your money into a SINGLE company. So yes, there is a chance that the small company will be the next Apple, but it can also go bankrupt like Lehman Brothers (Remember the Recession/Housing Crash of 2008).
Buying individual stocks require a great amount of research, constant diligence with financial reports & current events, and a higher risk tolerance. Most 401K plans don’t even allow participants to buy individual stocks anyway due to the high risk factor.
So for many investors, new and even the most experienced, we DO NOT recommend individual stocks. If picking stocks peaks your interest, we recommend devoting no more than 10% of your portfolio to it.
"Buying individual stocks require a great amount of research, constant diligence with the financial reports... So for many investors, new and even the most experienced, we DO NOT recommend individual stocks. If picking stocks peak your interest, we recommend devoting no more than 10% of your portfolio to it."
(2) Mutual Funds
A mutual fund is a basket that contains a wide range of investments such as stocks, bonds or a particular asset class like real estate or technology. There can even be a socially responsible mutual fund that only invests in ethical or environmental companies.
So what is so great about a mutual fund? Well, in one single transaction, investors are able to purchase a neatly packaged collection of investments. It allows for instant, easy diversification (exposure to a lot of different companies) that lets you avoid buying stocks one by one. The fund is actively controlled by a professional fund manager at a fee of usually 0.25-1%, but can be as high as 2.5%.
(3) Exchange-Traded Funds (ETFs)
Identical to index funds which are passive and low-cost, but you have more options with specific indices, such as healthcare only. Also, you can sell/trade/buy ETFs at any time during market opening times, similar to an individual stock. The great thing about an ETF is that since it trades like a stock, investors can purchase them for a smaller share prices that are often less than the $1000+ minimum investments that many mutual funds require.
Note: There is usually an ETF version of popular mutual funds, for example:
The Vanguard S&P 500 Index Admiral Mutual fund (VFIAX), which requires a minimum of $3,000, might not be practical for some new investors, so they offer the Vanguard S&P 500 ETF (VOO) which mimics the same return, but can be bought at a per share price.
(4) Index Fund
A stock can be purchased within a stock Index or part of a mutual fund and this is generally the safest way to own a stock. We always recommend low-cost, passive index funds such as Total stock index fund (tracks all the US stocks) or an S&P 500 Index fund (tracks the top 500 companies in the USA).
- Extremely low cost ~0.09%. The average 10 years Return for Stock Index is ~10%.
- There are many types of indexes that can track anything! From technology to real estate but the most popular index out there is definitely the S&P 500 Index!
"The great thing about Index ETF funds is that since it trades like a stock, investors can purchase them for a smaller share price that is often less than the $1000+ minimum investments that many mutual funds require. Great for beginners with minimal cash"
What is a Bond?
Basically, a subset of loans made to companies and the government, but is a part of a larger loan amount. Bonds can usually range in maturity (when it gets paid out) from 1 year to 25 years, in which the borrower (ex: US Government) agrees to pay back the loans to investors in full with interest, which is the gain. Average Return for Bonds is ~2-3%.
Bonds usually have very low return and are considered to be “safe.” It serves one purpose, to reduce volatility within a portfolio during times of market lows. Again, similar to a Total Stock Index, we recommend doing a simple, low cost, passive Total Bond Market index mutual fund.
What is an Expense Ratio?
This is what the mutual or Index fund charges its investor for management per year, usually in the form of a percentage (or basis point). This includes the management (depending on how complex the assets in the funds are) and operating administrative fees. This is extremely important to know because it takes away from your net gain. Remember that this is in ADDITION to a typical financial advising fee (AUM) of 1-2% if you decide to hire a financial advisor.
Example: An actively managed mutual fund can have an expense ratio of 1.80% (or 180 basis points) vs. a passively-managed index fund can have an expense ratio of 0.02% (or 2 basis point).
"Knowing your expense ratio or total fee cost is is extremely important because it takes away from your net gain. Remember that this is in ADDITION to a typical financial advising fee (AUM) of 1-2% if you decide to hire a financial advisor. Fees matters a lot!"
What is an Asset Allocation?
This is a breakdown of your overall investment portfolio. An asset can refer to an investment type such as stock, bonds or other commodities like gold/silver. For most investors, they will mainly have stocks and bonds within their portfolio, with a significant majority being in stocks.
Example: For a young investor in his late 20s or early 30s, his portfolio might be typically 90% stocks and 10% bonds. Stock investments can come in many forms and might be further divided into index stock funds, emerging market stocks, international stocks etc. We will go into more in asset allocation later.
What are Asset Classes?
This is basically a group of investments that are similar to each other and have common trends in the market. The 2 major asset classes are stocks and bonds. Other less common asset classes can include money market, commodities (such as gold/silver), REITs (real estate investment trust). We will primarily focus on stocks and bonds in this guide.
Why Are Low Cost & Passive Stock Index Funds (ETF) The Best Route?
As the billionaire Warren Buffet would say, “By periodically investing in an index fund, the know-nothing investor can actually outperform most investments professionals”
An index fund’s sole objective is to mirror the performance of a market index such as the popular Standard & Poor’s 500 (S&P 500 which tracks the 500 of largest publicly traded companies in the USA). Other indices like the Total Stock Market Index track the entire US stock market consisting of 3,550 companies.
Index funds are essentially run by computer algorithms which are programmed to automatically track the market’s up and down peaks. Computerized robots don’t require the same high salary as wall-street hedge managers, so they are significantly cheaper (or even zero cost like in Fidelity), thus those savings are passed along to you. Statistics show that investors pay nearly 9X more in fees for actively managed mutual funds which charge an average of 0.78% per year, while the average index fund’s cost is 0.09%
This is a stark contrast to the investment objective of actively managed mutual funds which try to “beat the market’s return” (or try to outperform the SP 500 index). But in order to do that, they need to hire a fund manager to pick and choose the investments within the fund. The cost of the management, in addition to the trading costs, administration, marketing, etc will essentially come out of your net investments return.
This is why the majority of actively managed mutual funds will greatly under-perform the S&P 500 index over many years, after accounting for fees and cost of the funds.
Therefore, any investor should choose an index fund which will drastically grow your portfolio over time.
5 Reasons Why a Passive Index fund is the Best
(1) Low cost fee ~0.09% (compared to active fund fee~0.78%)
(2) Better performance with (near) guaranteed market return
Studies shows that over 10 years, index fund will outperform 80% of its actively-managed funds, after accounting for fees. The great thing about index fund is that you will always get the market return since you are betting on the whole market! If the market is up 28%, great! If it is down 10%, no worries since everyone is down as well.
(3) More Tax-efficient
Since the turnover of trading is so low within a index fund, this means fewer capital gains distributions, so less tax to investors.
(4) Less time-consuming
You don’t have to spend any time researching individual stocks or following companies. For high-earning doctors like us, our time is much better spent seeing patients or improving our practices.
(5) Less Risky
When you invest in an index fund, you eliminate a lot of harmful behaviors as an investor such as trying to chase the next Apple by putting a large amount of your capital into one single stock. With an index fund, that choice is taken away by forcing you to invest in the whole market.
Remember that financial terms, just like eye anatomy, have their own language. So, having a solid grasp of these terms will help you be a more successful investor and help to increase the complexity of your portfolio if desired.