My Comments: I teach that investment risk is OK if you also have the ability to manage that risk. That happens if you have the discipline necessary to develop a rudimentary level of financial literacy. Reading these words from James Dennin is a good start. On the right side of this page is a link that allows you to schedule a phone conversation with me if you are so inclined.
By James Dennin \ January 11, 2017
When it comes to the stock market, young people are getting seriously mixed messages.
On one hand, you maybe know you’re supposed to own stocks — or at least you know that when your money goes into a retirement account like a 401(k), a good portion of it should be going into equities, aka the stock market.
At the same time, fearful memories of the financial crisis and the people who lost everything in the market downturn still loom large: Only 52% of Americans hold stocks according to Gallup, matching a record low.
Are these stock-shy Americans behaving irrationally?
There’s no doubt that the risks of investing in stock are real, if sometimes overblown. And it doesn’t help that for every person claiming the market is safer than ever is another sounding the alarm that the sky is falling.
But the short answer is yes, Americans and especially millennials need to hold more stocks than they currently do — not just to meet retirement goals but also to start building wealth outside of their paychecks. And when you’re investing for the long term, you can actually tune out much of the the day-to-day noise. So, to get started, turn off the news — and focus on the basics.
The very first step in becoming an investor is learning the terminology.
Start with “ticker symbols”: those little one- to five-letter symbols running across the bottom of CNBC. Stock brokers invented ticker symbols to save space on the little streams of paper that printed out the latest quotes. Not exactly of great use to would-be stock traders in the digital age.
Some of these are fairly intuitive. If you wanna buy Apple stock, you look for the symbol AAPL. Some are a little trickier to spot. Macy’s, for instance, is just M. Some really try to be clever, like the Sealy corporation, which sells mattresses and trades under the symbol ZZ. And funds (like Vanguard Total Stock Market, aka VTI) that hold bundles of stocks have tickers, too.
It’s good to know what tickers are in general, but you don’t have to go around memorizing them. Indeed, the fact that traders still use this shorthand is a vestige of history that makes investing seem more impenetrable than it is.
So what should you be focusing on? And how do you get started?
Let’s say you’ve already taken some super preliminary steps: You’ve paid your rent and funded your 401(k), you’ve put away a few months expenses into your emergency fund, and you still have about $1,000 (or even just $100) left to play with this month after food and fun.
It’s easier than ever to put that cash into the stock market, by setting up accounts with cheap, low-to-no-minimum online brokerages like OptionHouse (or free ones like Robinhood).
But before you start buying stocks or funds willy nilly, you have a little more homework to do: To help you figure out what to buy, here are 3 major “investing 101” terms you need to know, and what they mean.
Diversification is a very simple idea that steers a lot of decision-making in the investing world; it is essentially how people try to manage and mitigate risk when they invest.
To use an example, the best way to get rich quickly in the stock market in one given day or year might be to put every cent into one company.
If you were investing on Dec. 7, 2001, one of those stocks would have been Enron. Shares of Enron stock quadrupled — meaning investors got a huge payday — after it emerged from bankruptcy, even as most analysts agreed that the shares weren’t even as valuable as the paper they were written on.
Thing is, many investors didn’t realize they were sinking their cash into what would become one of the most scandal-plagued companies of the decade. If you were unfortunate enough to buy many shares of Enron stock when it was at its peak price of $90.75? You might have then seen your savings wiped out when the share price fell to $0.67.
In other words, buying stocks is like betting, and with single stock bets you can win big — but you can also lose big. Diversification is about finding a middle ground: If you hold more than a single stock (or even a single type of stock), you’re more likely to balance bad bets with good ones.
A diverse portfolio should have a mix of stock styles and types — as well as non-stock assets like bonds. Your stock holdings should include a diversity of industries (so, not just tech stocks) and geographies (not just American companies), as well as a mix of value and growth stocks, a mix of small- and big-company stocks.
The thinking is that what’s good for some assets is always going to be bad for some others — and vice versa.
Want diversification the lazy way?
Find three low-cost, diversified funds that include hundreds of stocks (and bonds) across industries and geographies. Then set it and forget it.
2. Price-to-earnings or P/E ratio
The 12-month trailing price to earnings ratio (or the forward P/E ratio, if you’re using projected estimates) is probably the second most important concept to understand, since it’s one of the most common ways traders try to determine how attractive a stock is.
Just like with cars, there are old stocks that no one really gets excited about — and there’s new names everyone knows as the latest hotness.
When a stock is popular, people are willing to pay more money for it. At the risk of oversimplifying it, the P/E ratio is essentially a way of measuring the hype factor and how much that is inflating prices above the underlying value.
To calculate the P/E, divide a stock’s price by the amount of money the company earns off of each share of stock. If a stock is trading at a high price relative to actual earning, there’s a decent chance it might be overhyped.
On the flip side, a stock trading well below the average historical P/E ratio of roughly 15 might be something of a bargain. That’s especially true since the current average P/E for the stock market is relatively high, at about 26.
To build on the previous section, the lesson here is to not just pay attention to the diversification of your portfolio but also the valuations.
There are exceptions to every rule of thumb, but avoiding inflated valuations (of which P/E ratios are one type) will help you become a better investor.
So pay attention to the average P/E of the stocks inside before you buy a fund. And remember that the overall average P/E for the stock market matters too — the whole thing could be historically overpriced at a given moment.
When the market takes a dip? That could be a buying opportunity.
3. Sharpe ratio
A final measure that will help you invest is what’s called the Sharpe ratio.
Very simply, it’s a means of calculating how attractive a stock or portfolio is, taking into account both how risky it is and how high your possible returns are.
In other words, it’s a way of calculating what’s called a “risk-adjusted return.”
Generally speaking, the higher the Sharpe ratio, the more attractive the rate of risk-adjusted return.
Conversely, if a company has a negative Sharpe ratio, it means that you probably could have gotten a similar return while also investing in less risky stuff.
To give you an example, the trailing 3-year Sharpe ratio for a Vanguard Fund for international dividend stocks is 0.66.
That’s lower than the 0.83 ratio for the S&P 500 over that same period, according to Morningstar. But it’s still a lot better than the Guggenheim Solar ETF (TAN), which has a Sharpe ratio of -0.51.
Does this mean you should never invest in international stocks or solar energy companies?
But if you are shy about risk, the Sharpe ratio is a helpful tool for sorting the biggest gambles from the smaller ones. At the end of the day, investing in the stock market is a type of gambling, no matter how “safe” your investment.
As long as you consistently remember that — and only invest with money you can afford to lose — you’ll be in a good place.
Because, just as with gambling, you could also always win.