Stocks and Index Shares Demystified
For some people, coming across an expression like "index share" is like discovering a flattened spider in your book — Eeuuuch!! But there's nothing very horrifying going on here. Our title simply lists two types of investment opportunities. Let's take a look at each…
When you buy a stock, you're getting a small piece of an individual corporation. In effect, you become part owner of the business, and you may profit from ownership through dividends (cash or stock) and/or capital appreciation (the market value of your stock rising). Of course you can lose money too, if the value declines.
Historically, stocks have been a rewarding long-term wealth-building tool, averaging about a 14% annual return since the end of World War II, while bonds averaged 6.2%. The flip side is that — as many people discovered in 1929, 1973, and 2000, for example — they can be very volatile as well.*
The three main United States stock markets are the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the National Association of Securities Dealers Automated Quotation System (NASDAQ). When people ask, "What did the market do today?" they're usually referring not to the stock market as a whole but to one of these exchanges — or to one of the major market indexes. Of these, the most prominent are the Dow Jones Industrial Average ("the Dow"), which tracks the stock of 30 very large industrial companies, and Standard & Poor's 500 ("the S&P 500"), which represents almost three quarters of the total domestic US stock market.
Investors categorize stocks according to both their style as perceived by the marketplace, and the size of the company itself. Growth stocks are shares in fast-growing companies that reinvest a large portion of their earnings in an effort to expand and become more profitable. Because of aggressive profit-reinvestment, they tend to pay small or no dividends and investors buy them because they hope to make money on capital appreciation. Value stocks are generally older, more established companies that are often perceived as being relatively out of favor with investors. The "value" label suggests that their potential may have been underestimated.
Stocks are also classified as large capitalization (where the company has a market value of $5 billion or more), mid-cap (between $1 billion and $5 billion), and small-cap (less than $1 billion). The market capitalization of a company is essentially the price of its shares multiplied by the number of shares.
An index share is part of a registered investment company (a mutual fund) that's set up to automatically mimic the behavior and return of a standard benchmark, like the S&P 500 or the Dow. Instead of clever people trying to "beat the benchmark" with headline-making returns, fairly simple computer programs track the benchmark. Sounds boring, doesn't it? Not when you see the numbers.
It turns out that outperforming a benchmark index like the S&P 500 is amazingly hard to do (consistently, in the long run), even for those guys ordering the lobster and champagne. And, index funds generally have low expense ratios (computers almost never eat lobster), because their portfolios are not actively managed and turnover is practically nil.
While actively managed funds spend about 1.5% of their value per year on lobster lunches and other necessities, index funds cut this down to around half of one per cent. According to Morningstar (March 2006), for investment companies reporting an expense ratio, 93% of actively managed mutual funds have an average ratio of 1.39%, while ETFs have an average ratio of .39%. Expense ratios of index mutual funds more closely resemble those of ETFs .
An exchange-traded fund (ETF), like any index mutual fund, attempts to replicate the performance of a particular market index. But, unlike a traditional mutual fund, an ETF has a limited number of shares, and is trade and priced like any stock on an exchange. ETFs provide diversity, and yet are both cost-and tax-efficient due to their passive management style. But ShareBuilder currently offers more than 200 different ETFs, so it's easy to create a group of them representing different major sectors of the American (and world) economy .
Which investment (or combination of investments) is right for you? It depends on many things, including your investment objectives, investment window, risk tolerance, financial situation (obligations, need for liquidity, etc.), tax-bracket, investment experience, and so forth. There's no one answer, just a lot of options. To learn more about particular stocks and ETFs, go to Research.
Professional traders who play the market’s daily peaks and troughs are a bad, bad model for the private ShareBuilder. The ShareBuilder has clear long-term goals and is prepared to stick with short-term losses in order to be there for possible long-term gains. Will Rogers said that the secret of wealth was to “buy low and sell high.” Actually, that’s the secret of getting rich quick. The secret to wealth is to buy solid companies and sell a long time from now when you really need the money.
Psychologically, sticking to a long-term investment policy is tough, but for most non-professional investors it’s the right thing to do. All investments will suffer losses because of market cycles. If you can’t deal with that, psychologically, you’re simply bound to do exactly the opposite of what long-term gain requires — selling on the down-swing and buying into something “better” that is currently in an upswing. Hence “bargain hunting,” by checking daily or weekly figures, is both useless to the wise investor and the most powerful way to drive that irrational fear of short-term loss.
As a ShareBuilder, you shouldn’t consider selling just because “the market’s doing poorly right now.” In fact, that’s not a good reason to sell. With few exceptions, you should be thinking about selling an investment only (1) on that unfortunate occasion when you have real evidence that you were wrong about a particular investment’s long-term viability, or (2) on that very special occasion when it’s time to realize some cash and enjoy your share.