Stocks and Bonds: The Fundamentals

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Stocks and Bonds

 

As an investor, it is important to gain an understanding (no matter how generalized) of what you are investing in.  Let’s start with stocks and bonds (and cash).  What are they?

 

Stocks

Stocks are typically ownership shares in a company.  As an owner of a stock, you are technically an owner of the company.  Pause, and let that sink in.  Think about all the stocks you may own (individually or in a mutual fund) and then say to yourself, “I own that company”.

As an owner you accept the many risks that could result.  On the other hand, your expected return for the risk associated with ownership is greater; and you usually get to participate in the earnings of those companies in the meantime.

Stocks are the most effective tool for those seeking to accumulate new wealth over time. But along with higher expected returns, they also expose us to a much bumpier ride (volatility), and increased uncertainty that we may not ultimately achieve our goals (market risk).

 

Bonds

Bonds are a form of debt.  If a company or government needs to raise money, they’ll often ask to borrow it.  Now, pause and let that idea sink in.  If you own a U.S. Treasury bond, for example; you have loaned the government money.

In return for lending money, as an investor you are entitled to an interest rate to make it worth your while.  Because bonds are often secured by property and governed by a specific agreement, they typically are considered less of a risk, and as a result they usually return less over time than compared to stocks.

Bonds are a good tool for dampening that ‘bumpy’ ride and serving as a safety net for when market risks are realized. They can also contribute modestly to a portfolio’s overall expected returns, but we don’t consider this to be their primary role.

 

Cash – While we talk about stocks and bonds as the two primary forms of investment, what is your alternative.  Probably cash.  So what is the problem with cash?

Simple, as an investment, in the face of inflation, cash and cash equivalents are expected to actually lose buying power over time, but they’re great to have on hand for near-term spending needs.

 

Summary

A simple guide for stocks, bonds, and cash:

  Expected Long-Term Returns Highest Purpose
Stocks (Equity) Higher Building wealth
Bonds (Fixed Income) Lower Preserving wealth
Cash Negative (after inflation) Spending wealth

 

By keeping your attention focused on the larger principles guiding investment in stocks and bonds, it becomes easier to recognize that each type of investment in your overall portfolio serves a specific purpose in your total wealth management plan.

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

You, The Market, and The Prices You Pay

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Have you ever heard the expression: Together, we know more than we do alone.

It is simple and powerful. It also describes the market, really well.

 

You, the Market and the Prices You Pay.

When it comes to investing (or anything in life worth doing well) it helps to know what you’re facing. In this case, that’s “the market.” How do you achieve every investor’s dream of buying low and selling high in a crowd of highly resourceful and competitive players? The answer is to play with rather than against the crowd, by understanding how market pricing occurs.

 

The Market: A Working Definition

Technically, “the market” is a plural, not a singular place. There are markets for trading stocks, bonds, sectors, commodities, real estate and more, in the U.S. and around the globe. For now, you can think of these markets as a single place, where opposing players are competing against one another to buy low and sell high.

 

Granted, this “single place” is huge, representing an enormous crowd of participants who are individually AND collectively helping to set fair prices every day. That’s where things get interesting.

 

 

Group Intelligence: We Know More Than You and I

Before the academic evidence showed us otherwise, it was commonly assumed that the best way to make money in what seemed like an ungoverned market was by outwitting others at forecasting future prices and trading accordingly.

 

Unfortunately for those who are still trying to operate by this outdated strategy, a simple jar of jelly beans illustrates why it’s an inherently flawed approach. Academia has revealed that the market is not so ungoverned after all. Yes, it’s chaotic, messy and unpredictable when viewed up close. But it’s also subject to a number of important forces over the long run.

 

One of these forces is group intelligence. The term refers to the notion that, at least on questions of fact, groups are better at consistently arriving at accurate answers than even the smartest individuals in that same group … with a caveat: each participant must be free to think independently, as is the case in our free markets. (Otherwise peer pressure can taint the results.)

 

Writing the Book on Group Intelligence

In his landmark book “The Wisdom of Crowds,” James Surowiecki presented and popularized the enormous body of academic insights on group intelligence.

 

Take those jelly beans, for example. In one experiment, 56 students guessed how many jelly beans were in a jar that held 850 beans. The group’s guess – i.e., the aggregated average of the students’ individual guesses – came relatively close at 871. Only one student in the class did better than that. Similarly structured experiments have been repeated under various conditions; time and again the group consensus was among the most reliable counts.

 

 

Now apply group wisdom to the market’s multitude of daily trades. Each trade may be spot on or wildly off from a “fair” price, but the aggregate average incorporates all known information contributed by the intelligent, the ignorant, the lucky and the lackluster. Thus the current prices set by the market are expected to yield the closest estimate for guiding one’s next trades. It’s not perfect mind you. But it’s assumed to represent the most reliable estimate in an imperfect world.

 

Your Take-Home

Understanding group intelligence and how it governs efficient market pricing is a first step in more consistently buying low and selling high in free capital markets. Instead of believing the discredited notion that you can regularly outguess the market’s collective wisdom, you are better off concluding that the market is doing a better job than you can at forecasting prices. Your job then becomes efficiently capturing the returns that are being delivered.

 

But that’s a subject for a future Evidence Based Investment Insights. Next up, we’ll explore what causes prices to change. Chances are, it’s not what you think.

 

Evidence-Based Investment Series #2: Ignoring The Siren Song Of Daily Market Prices

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Let Markets Work For You

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Let Markets Work For You

The Market

The ‘Market’ as we refer to it, is the collective embodiment of every person willing to buy or sell something.  In the investment world, the ‘Market’ typically refers the ‘Stock Markets’ where stocks (usually ownership shares of companies) are bought and sold.  Millions upon millions of people participate in the buying and selling of stocks each day around the world.

 

The Mixing Bowl

Every single market participant (investor) has a view of how a stock should be priced, they then act accordingly, either buying, selling, or doing nothing.  The effect this has on the market is that the price of a stock at any given point in time incorporates all the information which the millions of investors have.  The market essentially acts like a mixing bowl; mixing opinions from around the globe into one final product; a price.

 

Your Choice

Your choice as an investor is to either compete and outguess the collective knowledge of all the other investors, or harness the power of their knowledge and embrace the prices set by the market. Let markets work for you.

 

 

For more information see our post: You, The Market, and The Prices You Pay

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

 

Image Attribution: Dimensional Fund Advisors

What is Evidence-Based Investing?

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What is Evidence-Based Investing???

Evidence-based investing is an approach to investing that seeks to participate in the available global markets in a low cost and highly diversified manner.  More than any other approach, we feel this method of investing rigorously incorporates the best available information on how markets have delivered long-term wealth to patient investors.  Many investors may be familiar with terms such as “passive” or “index” investing, and it’s becoming easier for individual investors to gain cost-effective exposure to globally diversified market returns. – An evidence-based investing approach incorporates many strengths of passive/index investing, while eliminating some of its inherent weaknesses, and incorporating a focus in investment areas that have demonstrated potential long-term advantage.

 

A Brief History of Indexing

To understand how evidence-based investing works today, it’s helpful to review where it came from. Before there was any form of passive investing, there was active investing. Active investors try to profit by predicting where and when they’re going to experience future gains and losses, and proactively trade in and out of securities, sectors or markets to stay one step ahead. While the idea may seem appealing, there are reams and decades of academic evidence demonstrating that the tactic simply doesn’t reliably work, especially after factoring in costs.

 

In the early 1970s, the first index funds were formed to offer investors a better choice. As the name implies, an index fund buys and holds the securities tracked by a particular index, which is seeking to reflect the performance of a particular asset class. For example, the earliest index funds tracked the popular S&P 500 Index – which in turn tracks the asset class of U.S. large-company stocks. Over time, additional index funds (and similar Exchange Traded Funds, or ETFs) have emerged to track a host of other indices, representing a wide range of asset classes.

 

Many index funds are well-suited alternatives to actively managed funds, offering tighter control over the actions that academic evidence indicates are critical to expected outcomes:

 

Asset allocation – How you allocate your portfolio across various market asset classes plays a far greater role in varying your long-term portfolio performance than does the individual securities you hold.

 

Global diversification – Through broad and deep diversification, the sum of your whole risk can actually be lower than its individual parts.

 

Cost control – The less you spend implementing a strategy, the more you get to keep.

 

Inherent Weaknesses in Index Investing

So far, so good. But there are at least a couple inherent weaknesses to index funds.

 

Index Dependency – Most index funds are generally cost-effective compared to active strategies. But, by definition, they track an index. Whenever that index “reconstitutes” by changing the underlying stocks it is following, the funds tracking it must do so as well – and quickly. In a classic display of supply-and-demand pricing, this generates a buy high, sell low environment as index fund managers must queue up to simultaneously sell stocks that have been removed from the index and buy stocks that have been added.

 

Compromised Composition – Asset class investing is based on the premise that particular market asset classes exhibit particular return characteristics over time. For example, academic evidence has demonstrated that the stocks of distressed, small-companies are perceived as riskier than stocks of thriving, large-companies. So investors demand – and have by and large received – a premium return for investing in these riskier factors.

 

An index seeks to accurately proxy the asset class it is targeting. But it’s still just a proxy. The S&P 500, for example, tracks only 500 U.S. large company stocks out of the more than 16,000 large companies counted in the 2010 U.S. Census. Tracking an index enables pretty good exposure to a targeted asset class, but there’s room for improvement by a fund manager who can capture a larger, more accurate representation of the asset class being targeted.

 

The Advancement of Evidence-Based Investing

It didn’t take long before academically minded innovators from around the globe sought to improve on the best traits of index funds and eliminate their weaknesses. In fact, many of these thought leaders were the same early adapters who introduced index fund investing to begin with. The results are evidence-based investment funds, which offer us several advantages:

 

Index-independence – Evidence-based fund managers have freed themselves from tracking popular indexes. Instead, they have established their own parameters for cost-effectively investing in the lion’s share of the securities within the asset class being targeted. This reduces the need to place undesirable trades at inopportune times simply to track an index; it allows them to employ more patient trading strategies and scales of economy to achieve better pricing.

 

Improved Concentration – Untethering themselves from popular indexes also enables evidence-based fund managers to more aggressively pursue targeted risk factors; for example, an evidence-based small-cap value fund has more flexibility to hold smaller and more value-tilted holdings than a comparable index fund. This provides us with more refined control as we construct clients’ portfolios according to their individual risk/return goals.

 

Focusing on Innovative Evidence – We firmly believe that investors are best served when we make it a top priority to heed the evidence on how markets have delivered long-term wealth. Evidence-based investing shifts the emphasis from tracking an index, to continually improving our understanding of the market factors that contribute to the returns we are seeking. By building portfolios using fund managers who apply this same evidence to their fund constructions, we feel we can make best use of the academic insights we already know, while efficiently incorporating credible new ones as they emerge.

 

A Final Word: Investor Behavior

In many respects, the most important factor driving your investments has nothing to do with market factors. It has to do with your state of mind. To build or preserve sustainable wealth in ever-volatile markets calls for a disciplined outlook based on: (1) adhering to a long-term plan, (2) managing market risks and (3) minimizing the costs involved.

 

To help you achieve and sustain this challenging level of investment discipline, we take it as our honor and our duty to assist you in investing according to reason, based on the best available evidence on how markets work. That’s evidence-based investing.

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.