Investing Ep. 2: Recipe For Success
In the last episode on Investing, we looked at what the stock market is, how to think about investing, and broke down the common jargon around stocks. In this episode, we'll dive deeper into the fundamentals of investments, and see how you can start thinking about what investing means for you 🎩.
Specifically, we'll be talking about common investment assets, and how each of them compare in terms of risk/return. Just like a company's assets are all the things of value they own (net of debt), your investment assets are all the things of value that you own (net of debt). Investment assets are usually grouped into asset classes, which is just a group of related investment assets. The assets within an asset class are typically related to each-other in terms of their return (i.e. the amount of $$ you make per $$ you commit) and risk (i.e. how confidently you can expect to receive the return).
Typically, an investment with a higher risk will have a higher return, because you're essentially being compensated for the increased uncertainty of getting a payoff.
As an investor, you will have to take on some level of risk or uncertainty in order to make a return. Even though there are no guarantees in investing, there are key concepts in investing that can help you make smart investing decisions that align with your goals.
To kick things off, let's take a deep-dive into some of the most common asset classes!
Common Asset Classes
In the last article, we only looked at one asset type, being stocks. Here we'll break down stocks and other common asset types more thoroughly to understand their general behavior.
Stocks are the most widely known of investment assets, and we spent some time thinking about how stocks work in Episode 1. In short: stocks are portions of ownership of the value of a public company that is bought/sold in specific places (i.e. exchanges).
How You Make Money
The 2 main ways that you make 💰from stocks are:
Selling a stock you own for more than you originally bought it for.
Receiving dividends (i.e. a % of the company's profits).
Risk vs. Return
The amount you make from selling stocks or receiving dividends is affected by supply and demand: if the demand for a company's product or service goes down, so will their stock price. That could in turn affect how much you could receive in dividends, because lower prices usually negatively impact revenue.
The average return of this asset class is usually modeled after the S&P 500, since it represents a large-portion of the U.S. total Market Cap in stocks. Data from 1980-2018 show that average annual returns have been around 13%, with fluctuations in the range of roughly +38% to -37% for a given year (oscillating very frequently).
Types of Stocks
There are a number of ways to categorize stocks, so let's look at them across a few common dimensions to get a sense for how they function:
If you're fuzzy on what Market Capitalization is, check out Episode 1. The purpose of breaking up stock based on the "company price-tag" is: historically, companies with smaller market cap's tend to grow faster because they have more room to grow → have higher price fluctuation (i.e. higher risk). Larger market cap companies are usually more mature/stable.
Stocks in this category are usually broken up into the following (the exact boundaries may change over time):
Large Cap: Market Cap ≥ $10 billion (e.g. Apple, Walmart).
Mid Cap: Market Cap between $2 and $10 billion (e.g. Luckin Coffee, Popular Inc).
Small Cap: Market Cap between $300 million and $2 billion (e.g. TiVo Corp, Papa John's).
A big factor for stocks is the location of the company whose stocks you're trading. As with Market Cap, the general trend is that "bigger is safer, but grows slower", but which countries fall into which bucket varies greatly. In general, countries are segmented based on factors like how big their share of global Market Cap is or how high the average income (i.e. per-capita)of citizens is. The general buckets that countries fall under:
Developed Markets: Countries that are the "most developed" economically (e.g. U.S., Australia, Japan).
Emerging Markets: Countries that are in rapid "growth and development" (e.g. Brazil, Russia, India).
Frontier Markets: The highest growth/lowest development portion of Emerging Markets (e.g. Colombia, Indonesia, Vietnam)
This is the most subjective of the categories, because it involves having some belief of what you think a company is "truly worth" in the "long-term". There are 2 primary categories:
Growth: These stocks are in companies that you think will beat industry averages in the long-run. Think of these like "underdogs", where you're betting on their future potential.
Value: These stocks are trading "at a discount" to what the company is "actually worth". Think of these like "bargain stocks", where you're betting on the market to eventually realize the actual value of the company.
If you own bonds, you're essentially providing a loan. As with any loan, there's usually an interest rate (the coupon) that the person taking out the loan has to pay in addition to the amount being loaned (the principal). These loans have to be paid within a certain period of time (the maturity date).
How You Make Money
You make money from bonds in essentially the same ways as stocks:
Selling the bond to other investors.
Collecting interest payments (like dividends, but more reliable).
Risk vs. Return
While supply/demand can affect bond prices similarly to stocks, there are also other factors specific to bonds:
Bond Receivers Probability of Defaulting → Like any loan, the more likely the person receiving the bond is to pay it back, the lower the interest rate. There are bond credit ratings that help determine risk of defaulting (essentially their credit score).
Federal Interest Rate → If the interest rate goes down, bond prices usually go up. Think of the interest rate as the "average bond interest rate": if it goes down, relative to what it was, interest rates on bonds just became "more valuable" (and vice-versa).
Maturity Date → The longer the bond, the more time for things to go wrong (i.e. higher risk). It also locks up your money (i.e. liquidity) for a lot longer, so making that sacrifice usually mean higher returns.
Like the stock market, bonds' overall performance is measured against an investment index (in this case, Barclays Aggregate U.S. Bond Index). Between 1980 and 2018, bonds had an average annual return of ~8%, fluctuating between +33% and -3% (usually staying close to the average), so bonds are considered a less risky/lower return asset class as compared to stocks.
Types of Bonds
Bonds also have categories that help us think about how they function as an investment asset, so let's look at some of the broad categories:
We talked about how stocks are slices of a company's Equity; well Corporate bonds are essentially slices of a company's Liabilities to help fund business goals. You can buy both domestically or internationally! These bonds are usually higher risk than government bonds (since companies going out of business isn't uncommon), and therefore also usually have higher coupons.
Just like companies, governments also need money to finance their projects/operations, and bonds are one of the ways governments raise money (other than taxes). There are many different types of government bonds, each varying mainly by the size of the governing body and what the bonds are used for. Here are some of the common types in the U.S:
Treasury Bonds → Bonds issued by the U.S. Department of Treasury for funding needs by the Federal Government (e.g. paying interest on national debt). These can be further sub-divided into T-Bonds (long-term funding), T-Notes (operations costs), and T-Bills (short-term needs), in increasing order of average maturity. These payments will pretty much always get made, because the bonds are backed by the entire U.S. government 🇺🇸, making them some of the lowest risk bonds.
Municipal Bonds → Bonds issued by state and local governments to pay for specific projects (e.g. building roads, schools, etc.) These sit between Corporate bonds and Treasury bonds in terms of riskiness, because there is a non-zero % chance that these local governments can go bankrupt.
This category of investments is slightly less common for the average investor, but can be good options to diversify your investments (more on that later). Two of the common asset classes in this category are real-estate (e.g. flipping houses, being a landlord) and commodities (betting on the price of natural resources like gold, corn, and even uranium). The core of these assets are still tied to supply/demand, but the process of owning them is usually more complex. If these topics interest you, definitely let us know and we'll do a deep-dive in future editions 🏊🏻♂️
Comparing Asset Classes
Now that we know a bit about the common asset classes, let's compare them at a high level to see how the different risk/returns of each category compare with one another. To help us do that, we'll be drawing on data from Wealthfront (an investment platform) that did some intense statistics on these different asset classes (note: they've broken down Stocks/Bonds into different sub-categories):
On the x-axis, we have "volatility" (a measure of risk that's essentially the standard deviation of the returns), and on the y-axis, we have "expected annual return" (using a technique called the Capital Asset Pricing Model that adjusts annual returns for volatility).
The general trend of bonds (green) being riskier than stocks (blue) is reflected in the the overall clustering of these assets (though even Emerging Market Bonds, which invest in debt from developing countries, can be as risky as some types of stocks!). The alternative asset-classes (Commodity/Real-Estate) seem to be generally riskier and higher return than bonds and most types of stocks, whereas different types of stocks have a larger spread of risk vs. return relative to other asset classes.
Key Investment Principles
Now that we know about some of the most common asset classes, let's think about how we can plan out our investments! The key idea is the idea of an investment portfolio. If asset classes are the ingredients, your portfolio is how you mix them all together to get a happy, wealthy life 👨🏻🍳.
Constructing a portfolio can get very complicated, so we'll ground some of the key concepts with the help of two imaginary investors: Alex and Taylor. Alex is 25, has a stable source of income, and wants to save for when they retire at 65. Taylor is 55, and is 10 years away from retiring, but knows about the magic of ✨ compound interest ✨, and doesn't want to just have their savings sitting in a low-interest savings account. How might we go about creating Alex and Taylor's investment portfolio?
At the highest level, you have some amount of savings in cash, and you want to figure out how much of that cash should (a) stay cash in your bank account and (b) go into the different asset classes. You can use budgeting to figure out (a), and the process of figuring out (b) is called asset allocation. It's deciding how much of each ingredient (asset) we want to use in our recipe (portfolio)!
To help us figure out Alex and Taylor's asset allocation, we'll take a look at some example stock/bond allocations from Vanguard (well-known brokerage).
Since Alex has 40 years until they retire (a long time-horizon), then having at least half of their portfolio in stocks (if not more) makes sense. Why? Because even though year-to-year the value of their portfolio will fluctuate, over the course of several decades, Alex will get a pretty sizable return. Choosing whether to go higher or lower in stock allocation would also depend on Alex's risk-tolerance: if they went 100% stocks, would have to be OK with the possibility of losing over 40% of their portfolio in a given year.
If Alex's situation can't afford high potential losses in a given year (e.g. unstable income source), they should go with a higher bond allocation since it's historically more stable year-to-year.
Taylor can't afford to have a year that could have a >40% loss (100% in stocks) the same way Alex can, because Taylor has only 10 years to recover those losses. Having at least half of their money in bonds which pay interest can help protect against huge short-term losses.
However, like Alex, risk-tolerance also plays a factor. If Taylor wants a higher return than 5.3% with 100% bonds and is comfortable taking on the higher risk, they should shift over a portion of their portfolio into stocks.
Asset allocation is a very personal decision that should be informed by your goals. Saving for retirement and have several decades before then? You probably can afford to be riskier. Hoping to rely on your portfolio for income in the short-term? You probably can't afford to be super risky.
After learning about asset allocation, Alex decided to go with 75% stocks/25% bonds and Taylor decides to go with 25% stocks/75% bonds for their asset allocations.
Figuring out our investment goals is a key first step, but are there ways that we can be smart about the assets that we choose? One principle that's core to investing is the idea of diversification. If asset allocation is coming up with a recipe, then diversification is making sure that recipe can still be made even if one of the ingredients is spoiled🤢.
This term was popularized by Nobel prize winner Harry Markowitz in his Modern Portfolio Theory. By combining different asset classes and types within asset classes in a single portfolio, you can both mitigate risk and optimize expected return.
Let's look at the example Harry gives:
The x-axis shows risk measured by the standard deviation of different portfolios while the y-axis is average annual returns. The lines are the range of risk/reward values for different allocations with mixes of different assets.
The blue-line shows the "least diversified" portfolio, where the only asset classes we have are stocks and bonds. The returns grow slowly as we ramp up risk.
The green-line shows diversification across asset class, where in addition to stocks and bonds, we also have REITs (i.e. real-estate) and Emerging Market stocks. Compared to the blue-line, once we hit >6% risk, our returns grow dramatically, where the same amount of risk gives us way more return.
The red-line shows diversification both across and within asset class, where the stocks themselves vary by Market Cap, and the Emerging Market stocks vary by size. This helps lower risk at the lower end of the return scale, and raise return at the higher end of the risk scale.
So let's say Alex/Taylor read about diversification, and thought "hey! this sounds awesome but how do I go about it?" One thing they should keep in mind is the idea of asset correlation. Let's look at a very 🌈 colorful 🌈chart to help us understand this (also from the Wealthfront white paper):
This chart shows how common assets relate to each other. Having high asset correlation (closer to green) means that if one asset goes down, the other is likely to follow. If Alex wanted to diversify their portfolio, they could look into diversifying their stocks with Emerging Market vs Dividend Stocks (0.84 correlation) and their bonds with US Corporate Bonds vs Emerging Market Bonds (0.43 correlation).
Let's say Alex invested $1000 in a portfolio that's 75% stocks ($750) and 25% bonds ($250). After the first year, stocks are down 13% and bonds are up 3%. Sad returns for that year, but not something Alex wasn't emotionally prepared for! However: Alex's asset allocation is completely out of whack. They now have $652.5 in stocks and $257.5 in bonds, which is 71.7% stocks and 28.3% bonds. This asset allocation is not the risk/return level that Alex initially wanted.
This problem is called asset drift, and it's when the market conditions change your asset allocation. Sometimes this is not what you want, and the ways that you make the allocation reflect your goals is by rebalancing and can be done by either (a) selling assets in one category and buying in another or (b) putting more money into the categories that are lacking.
Wow! That was a lot of work just to create/maintain a portfolio. Not only do you have to figure out an appropriate asset allocation, but you have to do your research to diversify properly, and rebalance every so often to make sure you're on track. So. Much. Work! Well, fear not, because there are tools that you can use to incorporate these principles with minimal effort and therefore more time to live your best life.
Mutual Funds: mutual funds are essentially pools of money that are managed by professional investors to hopefully get a better return for the people who contribute to the fund. These funds will actively make sure that the risk/return of a particular fund meets the needs of its customers, with diversification, rebalancing, and a host of other techniques.
Index Funds: a type of mutual fund that is is designed to mimic popular investment indices (e.g. S&P 500) or specific benchmarks set by the brokerage offering the fund (e.g. Vanguard Total Stock Market Index). These offer the ability to diversify within asset classes easily by getting exposure to entire markets.
Exchange Traded Funds (ETFs): An ETF is much like an Index Fund, but are traded like stocks. Similar to index funds, they typically follow popular invest indices, but have more opportunity to fluctuate since they're bought/sold on exchanges.
Actively managed mutual funds are the most costly option, because you're paying for the fund managers time and effort to help you reach your financial goals (annual fees usually between 1-3% of your total investment). Index funds and ETFs tend to be cheaper than mutual funds, but their exact cost depends on the cost of the fund (called the expense ratio) and how actively you're buying/selling ETFs (which can rack up trading costs).
While we spent our time going through Alex/Taylor's portfolio, there are a multitude of tools out there that can help you start exploring portfolios that could be right for you:
There are a lot of recommended portfolios out there that you can explore if you're interested in taking a deeper dive into the nitty-gritty!
Phew! This was definitely one of the more dense/technical editions, so if you didn't understand everything 100% that's OK (we're not investing experts, so you don't have to be either!) If you remember anything from this episode, remember these key takeaways:
Investing is all about building and maintaining your portfolio, which is your investment game-plan that reflects your goals and risk-tolerance.
Stocks, Bonds, and alternative assets are what you can invest in, and have different risks/returns associated with them.
Diversification, Asset Allocation, and Rebalancing are the principles guiding how you invest, with options like Mutual Funds/Index Funds/ETFs to help get these principles automatically.
In the next episode, we'll go more in-depth into the how of investing so that you have the tools you need to actually start investing.
Disclaimer: The content on Young, Not Broke is for informational and educational purposes only and should not be construed as professional financial advice. Should you need such advice, consult a licensed financial or tax advisor.