We already decided, in part I of this series, that we want to have financial control of our own future. That’s awesome!
We already know what’s the difference between bonds (debt) and stocks (equity). But there is a very important concept that we have to address before moving on: the two main types of stocks.
- Common stocks
- Preferred stocks
It’s very probable that you have already heard of sweet Dividends: money stockholders receive from the company they have invested in.
Well, one of the biggest differences between common and preferred stocks is the priority of stockholders for receiving dividends.
If the company had a great net profit, they could decide to issue dividends.
The ones receiving dividends first are preferred stockholders and, if there was any money left, then also common stockholders would receive dividends.
Dividends are not mandatory for companies. Do your own research about the company’s financial policies before buying a piece of their business.
Another important difference is that if a company goes bankrupt and liquidates, the common stockholders will not receive money until the creditors, bondholders, and preferred stockholders are paid.
So, why even bothering to buy common stocks?
Having more risk, common stocks benefit from having a bigger yield compared to preferred stocks. Those willing to tank the uncertainty will have a bigger reward.
Lastly, common stockholders can vote for the company’s board of directors. In that way, they have influence on the company’s decisions. So, if you were interested in taking control of a company, you would be interested in buying common stocks.
Don’t risk it that hard
When it comes to successful people that have made their wealth through investments (like Warren Buffet), we have always heard that they bought a considerable amount of stocks in X company, and then, after some time, they re-sold the stocks for more money.
We have a bias towards buying stocks for increasing our wealth because media has shown us successful people that have done so.
They don’t show the enormous amount of people that have lost their money by investing just in single stocks. And, since we just see the successful ones buying and selling stocks, we tend to think that is the route to pursue.
This is known as survival bias: Neglecting individuals that didn’t have a positive outcome, even if they followed the same steps of the successful ones.
The reality is that investing in stocks is like a roller coaster: sometimes it revalorizes and sometimes their price drops drastically.
What can we do to avoid the risky part of investing in stocks? The answer is diversification: Not putting all your investment eggs in one basket.
Although you can choose several stocks from a variety of companies, the reality is that it’s very complicated.
Before investing in any individual stock, no matter how great a company you think it is, you need to understand the company’s line of business, strategies, competitors, financial statements, and price-earnings ratio versus the competition, among many other issues.
Selecting and monitoring good companies take lots of research, time and discipline.
Not so sexy investments
For those who have a busy life, and don’t want to spend hours doing research, there is a good method of investment: Mutual funds.
Mutual funds take the money invested by people like you and me and pool it in a single investment portfolio in securities, such as stocks (several of them) and bonds. The portfolio is then professionally managed.
If you want to just invest in stocks, but you still want to be covered by the fund’s diversification, Stocks mutual funds are the ones for you. As the name suggests, they invest primarily or exclusively in stocks.
All funds that exist charge some annual fees.
Don’t worry! Nowadays those fees are not as high as they use to be.
Thanks to new robo-advisors (digital platforms that provide automated algorithm-driven financial planning services with little to no human supervision), fees can be very low.
There are lots of mutual funds. Some of them are:
- Index funds: Closely replicate the performance of their benchmark index (like S&P 500), as it moves up and down.
- Exchange Traded Funds (ETF): Are in many ways similar to mutual funds, specifically index funds, except that ETFs are traded on stock exchanges (like stocks).
- Hedge funds: Are oriented to affluent investors and typically charge steep fees: 1,0% to 1,5% annual management fee plus a 20% cut of the annual fund returns.
We rarely see rich people talking about mutual funds, and you won’t get rich by investing in them.
Their diversification reduces the volatility of every security that compounds the investment portfolio. Therefore, if a stock skyrockets (like Amazon stocks since 2015), it won’t have an effect as big as if you had invested in just that one stock.
However, it is a good mean to invest more safely. Furthermore, it has a bigger yield than certificate of deposits (CD): where you commit to lend your money to the bank for a specific length of time (perhaps 6 months or even a year) in exchange of a small interest rate.
Since your investments will have less fluctuations, your annual yield will be more stable. Amassing a good amount of money won’t depend that much on stochastic events.
Your best friend when you decide to invest in mutual funds is going to be time. It will compound your investment year by year if you’re patient enough.
Don’t let survival bias play at you! Be smart and take intelligent financial decisions.
In the next part, we will talk about two silent killers: inflation and taxes. It’s vital to know how to defend from them!