How to evaluate Securities investments
I want to take a break from my normal real estate discussions in order to talk about how to evaluate Securities investments. I get asked about stocks, bonds, and the Thrift Savings Plan, enough that I thought it was time to create some content!
A “Security” is a tradeable, negotiable financial instrument that holds monetary value. It represents an ownership position in publicly-traded corporations through stocks, bonds, or options (source).
I want to discuss securities first for two reasons. First, your Thrift Savings Plan contributions are Securities investments, and will most likely be the first real investment you make. Secondly, you will hear a LOT of people talk about investing in the stock market, and you need to know the good and bad side of that in order to avoid falling prey to bad investment advice, or strategies.
The two main types of Securities are equities and debts.
Equity securities represent an ownership interest held by shareholders, such as owning stocks. Typically there is no regular payment amount with these, although many companies pay an annual dividend to their investors. You will get to receive any profit from the value of your stocks increasing, minus capital gains tax, when you sell.
Debt Securities represent money that is borrowed and must be repaid, such as bonds or certificates of deposit. You will receive a guaranteed rate of return over the course of time you agree to invest in these assets. This method does not allow you to benefit from profit generated, but you don’t have the risk of losing money when investing in things like government-backed bonds.
There are hybrid versions of these like convertible bonds or equity warrants, but you don’t need to worry about these during this overview.
The Stock Market
You have undoubtedly heard about investing in the stock market. When you purchase a share of stock you are purchasing a small ownership interest in that company. There are a lot of cool ways to invest in the stock market, here are some of the ways you should understand.
You need to be sure you do some research before purchasing individual stocks. Too many people buy stocks based on “Ooh that one is going up, I need to buy” or “Ooh that stock just dropped, I need to buy before it comes back up”. While both of these strategies could have some advantages, you should never buy stocks based solely on past performance.
As with everything in life, past performance does not predict future performance.
If you’re playing a game with two dice, and the number three has been rolled a lot, you still shouldn’t bet that a three will be rolled next. Statistically 7 is the most commonly rolled number, then 6, then 5, 4…see where I’m going here. Just because the three had been rolled a lot, does not mean it will continue to be. You should always try to remove emotions from your investments in order to remain as objective as possible about your decision to buy, or sell, stocks.
When it comes to stocks, investing in the short term can be lucrative, but I believe it is much better to invest for the long haul. Invest in companies that you plan to hold forever, that is how the wealthiest Securities investors I can name purchase, and you should too.
Price-To-Earnings (P/E) Ratio
The Price-To-Earnings ratio is one of the first things I look at when evaluating a company. This ratio measures the current share price relative to its per-share earnings in order to value a company.
This is a great way to evaluate the value of a company’s stock in an apples-to-apples comparison with other companies.
P/E ratio is the market value per share, divided by the earnings per share.
If a company is currently trading at a P/E multiple of 15x, that means investors are willing to pay $15 for every $1 of current earnings. The higher the P/E ratio, the more likely a company is to be overvalued.
That being said, a high P/E ratio isn’t always a bad thing. It can mean that investors are extremely bullish* about that company.
I like this number because it is a very easy way to look at a company and figure out how expensive each share is, relative to how much money the company is making.
*For the record, bullish means investors think the market is going to go up in value, and bearish means they believe it will trend downwards. This comes from the terms bull-market (trending up) and bear market (trending down).
Dividends are when a company distributes a portion of its earnings to its investors.
For example, if you own $100 worth of Coca-Cola stock, and they were paying a 7% dividend yield, you would get paid $7 over the course of that year, for your ownership in their country. Imagine if you owned $1,000,000 worth of those same stocks, you could get paid $70,000 in dividends!
When building your investment portfolio I recommend that you reinvest every penny you get paid in dividends. In the example above you could take that $7 and reinvest it into Coca-Cola, or another company, in order to produce even more in dividend returns the following year.
Dividends are the stock-markets version of the cash flow that real estate investors target when buying properties. It doesn’t get too much more passive than dividend returns.
That being said, companies can change their dividend return at a moment’s notice. In April of 2020 a lot of companies slashed, or eliminated their dividend ratio when the economy slowed to a halt. They did this in order to hoard cash from their profits to brace for the rough patch ahead, which was a smart move for these companies.
I definitely like dividend stocks, and automatically reinvesting the returns from their dividend yield, but you need to understand these aren’t guaranteed.
The Company and Competition
Perhaps the most forgotten piece of analyzing a stock is to really understand the company. A lot of investors focus on the charts, the dividends, the news, etc. and seem to completely forget that the stock represents a company as a whole.
Don’t forget to analyze the company, and not just their stock. You should have an idea of how the company is going, and whether or not they are in a good industry. Investing in Taxi companies when Uber and Lyft were growing, wouldn’t have been a good idea.
Make sure you understand the company, and its competition. Are they gaining market share, or getting beaten by their competition? Is the company in a growing market, or a dying industry?
These are important questions to ask yourself if you’re planning to invest in a company long-term (and you should be) rather than short term.
Index vs Mutual funds vs Exchange-Traded Funds (ETFs)
A Mutual fund is a financial vehicle with a pool of money collected from many investors to purchase Securities investments like stocks, bonds, etc. Mutual fund trades close at the end of the trading day, and mutual funds are actively managed.
An Exchange-Traded Fund (ETF) is similar to a mutual fund, except that they are actively traded throughout the day, and ETFs are passively traded
An index fund is a type of mutual fund, or ETF, with a portfolio, built to mirror the makeup of a financial market index such as the Standard and Poor’s 500 Index (S&P 500).
All of these fund types have their place, but you need to do your research. You should know exactly what kind of Securities your fund invests in, what their expense ratio is, and how risky the fund is.
I definitely like index funds because of their incredibly low fee structure, and the fact that you can purchase shares of an index fund that follows the entire market. I like the idea of investing in the market as a whole because I’m confident that in the long run our economy will continue to do very well!
The TSP has several index funds, and that is one of the reasons the TSP is able to maintain such low expenses.
401k and Individual Retirement Accounts (IRAs)
401k and Individual Retirement Accounts are tax-advantaged Securities investments.
These accounts operate like the TSP we already discussed in great detail, so I’ll keep it brief here. A lot of IRA and 401k funds invest in a mix of mutual funds, index funds, bonds, etc.
The most popular 401k funds are target-date funds. These are a mix of stock and bond investments that adjust as you get closer to your target date. For example, if you plan to retire in 2060, the target date fund will have a much riskier portfolio in 2020, and gradually purchase a larger percentage of bonds as it inches closer to 2060. This will keep you from losing a large portion of your retirement fund if the market dips right before you begin taking withdrawals.
Now that you understand the basics of these fund types, make sure you do your homework before choosing a fund to invest in.
IRA’s are not limited to just Securities investments though. There are Self-Directed IRAs (SDIRA) that allow you to invest in real estate, or lend money to people, and other creative investment strategies.
While these are really cool, they are also fairly advanced, and beyond the scope of this book. Just be cautious when people try to convince you to roll your TSP balance over to their SDIRA. You need to ask what their compensation is for doing that, and what their fees are. A lot of financial advisors make money off convincing you to move your money into their accounts, and it might not always be in your best interest to do so.
In my opinion, 401k and IRA accounts are some of the best investments you can make because of the tax advantages!
Options trading is a much more advanced way of trading stocks. This is where you can purchase an option to buy a stock at $20/share if it jumps to $25/share, this is a “call option”. If it goes up in value, you execute your option, and make money. If the stock drops in value, you only lost the money you paid to buy the option, and not the full amount you would have invested if you bought the stock outright.
You can also buy an option to sell a stock at $20/share if it drops to $15/share, this is a “put option”.
Don’t worry about this too much for now. Options are cool, but not necessary, and not worth messing with until you have a strong understanding of the stock market.
A bond is a fixed income instrument that represents a loan made by an investor or a borrower. These are typically corporate or governmental and used to finance projects and operations.
Bonds are a great Securities investment because they are a guaranteed interest rate, and you receive a fixed return on your investment for the duration of ownership.
While the rate of return is often lower than you could return in other investments, it is guaranteed, and you won’t lose money.
Bonds are a great way to hedge your portfolio against risk.
I mentioned in the TSP section that lifecycle funds are great because they gradually transition from high risk/reward, to lower risk/reward as you get closer to retirement. They do this by gradually making bonds a larger portion of your investment portfolio.
Back in the day you could earn a pretty decent return by investing in bonds. Those days are behind us, and who knows if the yield they provide will ever go back up in value.
That being said, bonds are a great way to hedge against recessions. I wouldn’t rely on them to build wealth, but if you amass a large amount of wealth, and want to ensure you never lost money, bonds are the way to do it!
There are several different methods of Securities investments throughout the market. Just make sure you do your research, and don’t get wrapped up in making impulse (emotional) decisions based on daily stock price volatility.