This episode describes stocks, bonds, and commodities and then amps it up. It not only covers them, but also discusses stock indices, exchanges, how these assets are traded, and what kind of risk they typically present. The episode then covers deeper topics like how to value a company, how the stock indices measure different things, and what can happen when a country defaults. It even discusses the deficiencies in certain stock indices, like the DOW. This is a perfect starter episode to somebody who wants to get their feet wet with investing, or wants to get a deeper understanding of the basics.
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You can find the script of this podcast at the bottom of the E-mail.
Here is the script that was used in today’s episode.
Note: I don’t follow scripts word-for-word as they can sound unnatural, but the episodes do closely follow them.
The basics amped up – More than just stocks, bonds, mutual Funds, ETFs, index funds, and what we can expect
This is episode 1 in the series of how to create a better investment and retirement portfolio. In this episode, we’re going to take the basics of stocks, bonds, etc and amp them up. We’re going to talk about what stocks, bonds, commodities, mutual funds, index funds, and ETFs are, but also what we can expect from them and how they work.
So to start, let’s talk about stocks. This is something all of us have heard of it in the media and friends. We know of Apple, Google, and so on. But what is a stock? Well a stock is a certificate of ownership in a company. What does that mean? You actually own a piece of the company. And the unit of stock is called a share. So if we’re saying we’re going to buy stocks, we’re actually buying shares in companies. And if you own at least one share in a company, you are a shareholder. This makes you a part owner in the company. Cool huh? So for $82 you can own a piece of Facebook. Zuckerberg status…. Well I mean 1 share means you own .000000036% of Facebook and Zuckerburg owns 20%, but screw it, we’re cooler.
So how did we figure out how much of Facebook you would own? Well each company out there breaks up their companies into shares. And as we mentioned, when you buy those shares, or stock, you own a piece of the company. So each company has something called “outstanding shares.” These are the total number of shares that make up a company. In Facebook’s example, they have approx. 2.8 billion outstanding shares. So if you bought all of those shares, you would own 100% of the company. Since we only bought 1 share of Facebook we divide 1 by 2.8 billion to get what percent of facebook that we own.
Since we’re on this topic, you have probably heard of companies like Facebook being two-hundred -billion dollar company. Have you ever wondered how they came up with that number? Well there is actually a mathematical and accounting reasoning behind it! You know how we discussed 2.8billion shares make up facebook? Well if we know how much each of those shares are worth, then we know how much the company is worth. Because if we can buy all of those shares, then we can own 100% of the company!
And luckily we know what price the shares are trading it. If you look up the share price of Facebook using Tiingo or Yahoo, it will give you the last price Facebook was traded at. At the time of this podcast it was approximately $81. So if we take $81 dollars a share, and multiply it by the number of shares that exist, about 2.8 billion, we see it’s worth about $225 billion dollars.
Now there is one more super important topic we should talk about before we move away from companies. This is a concept called a Dividend. Now that you own a company, you may have more cash than you need. And sitting on all that cash can be unproductive, so wouldn’t you like to get paid for owning the company? After all, CEOs and management pay themselves salary, and you’re taking a risk too and own a piece of the company. Wouldn’t it be nice to get an income too?
And so when you’re looking up a company, you may sometimes see something called a dividend. This is the cash you receive just for holding the company. Typically this is paid once a quarter, or once every three months. Now a dividend yield, is simply taking the total dividends paid in the last year and dividing it by the share price. So what you are measuring is, what percent are you being paid for holding that stock? The performance of stocks and other investments are measured by what percent return they give you. When you go to a bank, they tell you how much interest you’re being paid for holding money with them. Now right now, these days, a bank may give you 0.10% if you’re lucky. But if we look at Apple, we get paid 1.5%!
The reason is that stocks are higher risk than putting money in a bank. What if Apple drops 5%? Well, I’m guessing you wont care if Apple gives you 1.5% because you’re down 5%! Overall, you’re down 3.5%. But if it goes up 5%, you’re now up 6.5%.
So why do companies pay dividends and why should you care? The assumed investing knowledge says that if a stock goes up, and you get paid a dividend, it’s better for your portfolio because it helps stabilize things. Like if Apple goes down 5%, you’re actually only down 3.5% because of a dividend. And if it goes up 5% then you’re actually up 6.5% because of the dividend. And the reason companies pay it, is because they don’t really know what else to do with all the earnings they have. It’s like when you get paid from your work. You put some away toward savings, retirement, mortgages, etc….but what do you do with the money you have left over? You enjoy it!
There are few more nuances with dividends will touch upon in a couple episodes from now, but let’s just take a moment and pause! It’s a lot of information at once.
Okay enough pausing. I got bored.
So there are thousands and thousands of stocks out there, but how are they organized? Well each stock can be traded on something you’ve probably heard of called stock exchanges. A couple examples are the New York Stock Exchange, NYSE, or Nasdaq. On these exchanges you can buy and sell stocks because shares are very standardized unified documents across each company. Share # 2,500 isn’t going to be different than share # 543,221. So to you, it doesn’t matter which share you have because, when it comes to owning a company, the shares for each company listed on an exchange are the same. Trading stocks are what we call exchange-traded. They are uniform and traded on exchanges that anybody can access.
So we talked a lot about companies, what we can do to measure certain metrics, and how they are organized on exchanges. But what are things like the Dow, the S&P, and the Nasdaq Composite, which is different than the Nasdaq exchange. You may often hear things like the Dow was down 300 points today.
Well each of these is called a stock index, and together are stock indices. They are a measure of the stock market and can are used as measures of the health of economies. The DOW, the S&P, the Nasdaq composite are all comprised of a grab bag of companies that try to measure the broad market or a market segment. So if the S&P or DOW are said to be up or down 3%, it means the market is getting stronger or weaker. They’re very important measures for policy makers, government agencies, corporations, and retirement and investment portfolios. So let’s touch upon the most commonly you hear about.
The first is called the DOW Jones Industrial average, or DOW for short. It’s made up of 30 very large stable companies that represent different sectors. For example, a few stocks in the DOW are Microsoft, Goldman Sachs, Coaca-Cola, Verizon, Pfizer, and McDonalds.
Many of us have heard of the S&P, especially used by professionals. By why is that? Before we continue let’s just bring up a couple things that many people in the industry consider a major flaw with the Dow. The first is that it’s only 30 big companies, which doesn’t really represent the broad market. The second is that it is price-weighted.
In an index, each stock represents a portion of the index. When something is price-weighted, it means that the price determines how much of the index it makes up. For example, if the Dow was 10 stocks, and each stock was $10/share, they would all represent 10% of the Dow.
And here’s the odd part and the bigger reason why some people consider the DOW to be flawed. Remember how we discussed that Facebook was worth $225 billion? How we took the total number of shares available then multiplied it by how much each share was worth?
What if we took out the number of shares available and just considered $81. Well guess what the price of Chipotle is right now, it’s $670/share. But if we take the number of shares available in Chipotle it’s only about 30 million. Remember facebook had 2.8bn shares. Okay to get the value of Chipotle, we take 30million shares and times it by the share price, we get that Chipotle is worth $20 billion dollars.
So chipotle is less than 10% the size of Facebook. But, its share price is 8 times bigger than Facebook. So we can’t just look at the share price to see how big a company is. We have to consider how many shares exist. If Chipotle split itself into more and more pieces, and now had a billion shares outstanding, is it worth any less? No not at all. The share price will be lower, but it’s still worth the same.
But if we were using the Dow, Chipotle would have an 8 times as big impact in the DOW than would Facebook…even though it’s less than 1/10th of the size. This is a big flaw.
But the S&P 500, uses the market cap, or size of the company to determine how much each stock comprises the index. This is called value-weighted or capitalization-weighted. So in the S&P 500, Facebook is 10 times bigger than Chipotle, which makes more sense. IN addition, the S&P is made up of 500 stocks, not 30 so it represents a bigger market. This is why many professionals consider the S&P 500 a better measure of the market compared to the DOW.
The next index we often hear about is the NASDAQ. Remember how the NASDAQ was an exchange? The NASDAQ composite is different, it’s an index that is made up of over 3,000 stocks that are traded on the NASDAQ exchange. Now this exchange was the first one that allowed online trading. Over time, many tech companies moved into the NASDAQ exchange, which means it tends to be tech heavy. While all sorts of industries make up the NASDAQ, many people associate it with more of a tech feel.
Now there is one more exchange I want to mention that doesn’t get brought up every so often. And that is the Russell 2000. It represents 2000 of the smaller companies. Whereas the S&P 500 represents large companies, typically called large capitalization companies, or “large-cap” the Russell 2000 represents small capitalization companies, or “small cap.” Remember that market capitalization referes to the size of the company. In FB’s case it was $225 billion and in Chipotle’s case it was $20bn. These would both be considered large-cap companies. The Russell 2000 gives a general indication of health for smaller companies.
So now that we’ve talked all about stocks, where they are traded, and how to measure the health of the economy, let’s move onto bonds.
Sorry, I’m trying to add some excitement to bonds.
Ok! Onto bonds. So with stocks, when you own shares, you are investing in the company. When you buy bonds from a company, you are lending them money. You are a lendor. So if you own stock, youre an investor, and if you own a bond, you are a lender. When you take out a mortgage or a loan, the bank is lendor. When you buy a bond, you are lending money to a company, the federal government, or a local government.
When you get a loan from a bank, you pay an interest rate. Likewise when you buy a bond, you get paid interest too. SO a bond is broken up into the principal amount, the amount of money you lent the company or government, and the interest, what you make for lending out that money. On top of this, like a mortgage or loan, the bond matures and the debt no longer exists once it reaches what we call “maturity.” This is another key difference from stocks. Stocks do not have an end date, they exist as long as the company exists.
Let’s talk about bankruptcy. It’s not something we like to talk about, but let’s do it. If a company liquidates, you as a bondholder are first entitled toward the company’s assets to get back your loan. Only after bondholders are taken care of, do stockholders then get what’s left. Because of this, bonds are generally considered safer investments than stocks.
A common concept, and generally, a higher risk investment should give you the opportunity for a higher reward. So if you are investing in a new company that just formed a week ago, you could probably assume it had a higher risk than let’s say McDonalds. So if McDonalds came up to you versus a new store that opened a week ago, who would you expect is a higher risk? Now people generally want to be paid for that risk, so if it’s higher risk you will ask for a higher interest rate. Whereas McDonalds may get a loan for 3.5%, you may charge the new store 6%.
Banks do the same thing with us when we go to them with a loan request. The difference is that we as individuals, each have a credit score. That credit score determines whether or not what we can get a loan and what risk the lender sees in us. If we are higher risk as determined by a low credit score, they will charge us a higher interest rate. People who issue bonds have something similar called a “credit rating.” There are a few ratings agencies who are in the business of evaluating and scoring companies and governments to determine what their risk is.
The ratings are:
AAA – the highest rating
AA – second highest rating
A – third highest
And from BBB to B.
Typically below BB, it is considered a junk bond and that just means it’s a very high risk bond. Basically, there is a higher likelihood you may not get your money back if you lend to them. Junk bonds yield higher rates because of this risk.
I know a common question I had, was “well if a company like Ford goes bankrupt, there are assets you can take from them. What if a country goes bankrupt? Can you just take the country’s stuff? This is actually a really complicated topic, but it seems like a country defaulting on it’s bonds, doesn’t mean you can invade it. What it does mean, is that the country will have a much much harder time raising money next time around because they lost their reputation. When you are buying bonds from a country, you are doing it on the, quote “full faith and credit” of that country.
This is why it’s a big deal if a country defaults. Right now there is a big case going on between Argentina and a hedge fund. Argentina defaulted on its bonds for a second time since 2001 and the hedge fund refused to accept less money for the bonds than what it was owed. This led to a U.S. court saying Argentina couldn’t pay current bond holders until it paid the hedge fund first. The fund also tried to impound the country’s warships. This is turning into a messy case and many people have questioned the ethics of it all. Can certain countries hold other countries financially hostage? How does it affect the country trying to govern?
This is why so much money is poured into this – so hopefully people can avoid these situations.
There are some other nuances about credit ratings, and a lot of these firms in charge or rating bonds came under flak in 2008. This is a more complex topic we will speak about in a future episode.
So now we have explained what a bond is, how they are generally priced, and how they are rated, let’s talk about how they are organized.
As an individual investor, you probably will not personally trade bonds. The reason is because there many many bonds out there, each with different characteristics. Additionally, they require a lot of money to purchase. Because of this, active trading in bonds is typically meant for people who do it professionally and have the backing of a lot of money and investors. Because of this, most bonds are traded directly between institutions like banks and mutual funds. This is done, in what is called the Over-the-counter market, or OTC market, not through an exchange. Whereas an exchange you can see everything that happens and what other people do, the OTC is not nearly as transparent. It’d be kind of like if you called a friend up and sold some of your furniture to him. So typically when we trade bonds, we do so through mutual funds, index funds, and ETFs. If you don’t know what those are, that’s fine because we’re going to explore them in part 2 of this series.
I’m going to end this episode with a quick story: my second year on Wall street, I traded U.S. treasuries –basically bonds issued by the government. It was a really fun and exciting time. I remember my 2nd week on the job I got yelled at for fourteen straight hours once…yeahh haha. It was so fast paced that there were days I would forget to eat lunch. You would have to announce every time you had to go to the bathroom so somebody could take your spot.
I also had to pull an all-nighter trading on that desk when the U.S. presidential election happened. See whereas stocks and bonds issued by companies are often moved by announcements by the companies, bonds issued by governments are often moved by political events. The following year, I was trading bonds again globally at a hedge fund but we took a quantitative approach so it was a lot more relaxed. I got more sleep during those times and I didn’t have to announce when I had to use the bathroom….gooood times
We wont get too much into commodities here, just enough so you aren’t like me when I first started wondering how in the world people could measure the changes of the price of oil so quickly.
Did you know you can trade live cattle? There a ton of commodities you can trade. Typically we think of gold, silver, oil, maybe natural gas. But you can also trade, cocoa, coffee, hogs, corn, and even orange juice. So these are traded on vehicles called futures. What these contracts are is that you enter an agreement to buy or sell the commodity at a future date. For example, you may buy July 2015 crude oil futures, which mean in July 2015, you will actually buy 1,000 barrels of oil per contract you own. Where did I get the 1,000 number from? Well you know how we said shares between companies are the same which let us trade them on exchanges? The same is true for commodities. Each commodity has it’s own contract and the contract for WTI, a type of crude oil, specifies 1,000 barrels.
So if you see the price of oil on TV, they are typically quoting the futures price. The price per barrel for 1,000 barrels. And because these contracts are exchange traded, it’s easy to see the price fluctuations for these commodities.
ANd finally, trading these commodities does offer benefits for people. Say you’re a corn farmer and you need to plan your expenses for the next year. Well, because the price of corn may fluctuate a lot, you may want to lock in a price so you can plan your budget. In order to do so, you may sell corn futures. This way, you know when the contract settles, you will be able to ship out your corn for the price you sold your contract for.
At the same time, if you just want to speculate on the price of corn, you don’t actually want to own it…or what we call “take delivery” you want to sell out of your corn. So if you forget to get rid of your corn contract before it expires, you may find yourself getting a call from somebody asking you where to ship the thousands of bushels of corn.
So with that, I hope you enjoyed part 1 of the amped up basics. If you have any feedback please E-mail me at [email protected]. In the next episode, we’re going to talk about commodities, mutual funds, index funds, etcs and so on.