Last episode, we talked about the key principles of investing. This episode, we’re going to get a bit more granular by talking about equities.
Before I mentioned that risk was categorized based on how many participants there are in an instrument (few vs. many) as well as the type of risk event (individual vs. universal). Well, there is a third risk category — the instruments themselves!
Typically, we split instruments into two broad classes: equities and fixed income. These classes represent the risk profile and types of rights an instrument gives you. Since we’ll be talking about fixed income in the next part, I’ll just mention what defines an equity for now.
An equity is broadly defined by two aspects: ownership of a firm and high riskiness. By ownership of the firm, we primarily mean a right to profits and performance. Profits are typically disbursed as dividends, or small per share cash payments given out to shareholders after earnings reports. Performance, on the other hand, is essentially a guarantee that the stock price will go up as the firm performs well (Actually, the way markets are set up, the firms don’t get to decide this — but regulation is set up in such a way that it will happen anyway).
When we understand equity as ownership in a firm, it’s easier to understand the high riskiness part of this equation as well. Think about how risky entrepreneurship is — you’re betting on an idea, and putting in loads of work that might lead to squat. As an equity investor, you’re sharing the load of that risk, as when a company does go to squat your investment does as well. Such is not quite the same with a fixed income investment, as we’ll see in the next part.
So, how do we deal with this risk? In the last part I mentioned to you the idea of diversification, or buying a large basket of stocks to lower your risk. You might be thinking that buying a large basket of stocks would be quite expensive, and you’re right — fortunately, the market as a better tool for us!
In order to diversify, we’ll instead use mutual funds and ETFs, or “exchange-traded funds”. Funds are essentially a big package of different stocks, priced at a single stock’s price. This will help us solve our diversification problem, while still giving us the freedom to choose things such as industry or stock type. The main difference between mutual funds and ETFs is that mutual funds are only obtainable through a retirement account such as a 401k, whereas an ETF is obtainable on an exchange just like any other stock. This leads to some key advantages and disadvantages for both.
For mutual funds, you’ll get tax treatment depending on what account you put it into. As an example, a traditional IRA is tax-deferred, whereas a Roth IRA is tax-forward. In other words, for traditional IRA you pay tax during retirement, whereas with Roth you pay tax now. This can lead to tax cost savings depending on your current income, and where you see the tax being worth in the future. The unfortunate side effect is that there’s a lot less choices for your mutual fund — you are usually forced to choose the funds that your account developer chooses for you as your “selection”, which is much more limited than an ETF.
For ETFs, you are given a lot of freedom on what you can select. You will have to pay standard taxes, however dividends are tax free, and because of this you’ll see a lot more dividend disbursements on ETFs than standard stocks. The main downside of ETFs are mostly that a higher knowledge is required — for mutual funds you have the help of the fund manager and the account developer, but with ETFs you’re all on your own for research. Think of it as the same trade-off between buying a prebuilt computer and building one on your own.
Anyway, I think that sums up the basics on equities pretty well. For next week, we’ll be diving into the second major financial instrument class — fixed income. See you then!