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Mutual fund vs stock; A guide to choosing to making the right choice

Here is the ultimate dilemma a beginner investor faces; ‘stocks or mutual funds?’ That is, which one should a beginner investor choose to invest his/her money in.

Before we move on to answer that question (Yes, I will settle that debate once and for all), let’s look at mutual funds and stocks in detail and understand how they make money.

Mutual funds vs stocks

First off, mutual funds and stocks are interconnected. Because most mutual funds are comprised of stocks. These mutual funds that are comprised of stocks are known as equity mutual funds.

Now, let’s lay out the differences between a mutual fund and a stock.

A mutual fund pools money from investors to buy securities. The securities mostly vary between stocks and other fixed-income securities like bonds. A stock represents a portion of the underlying company. By owning a stock, you’re owning a portion of the company.

Mutual funds have Net Asset value (NAV), which is the fund’s market value per share. Which is roughly the equivalent of the share price of an individual stock.

Mutual fund investors make money when they sell the shares of the fund. And if it is a mutual fund that is focused on dividend stocks, you might receive a dividend once in a while. The same goes for stocks; you make money when you sell the stock, and when the company issues dividends.

These are just a few of the basic differences between a mutual fund and a stock. However, when it comes to deciding which investment vehicle should you choose, it all comes down to one thing and one thing only.

How much money is it going to make?

And certainly, it’s not that simple. But your objective as an investor is to grow your money. So naturally, you should choose what’s best for that.

Keeping that in mind, let’s look at the two factors that determine your profit; returns and cost. The returns are the money you make from your investment. Cost is what you should be willing to spend to achieve the expected return. Cost includes both the money you spend towards fees and commissions and the time you spend on doing the necessary due diligence.

Let’s analyze mutual funds and stocks based on these factors.

Returns; Mutual funds vs stocks

Mutual funds pool in money from investors to buy assets – mostly stock. And they aim to maximize returns for the investor. Generally, mutual funds are actively managed funds. They are run by finance professionals who are known as mutual fund managers. A fund manager decides where to invest and how much to invest.

Stocks, on the other hand, can be bought by anyone with money and a brokerage account. And they can do that either passively or actively.

One of the factors that investors associate with returns is risk. Now, the amount of risk that an investor can tolerate varies from person to person. I am fine with having my stocks go down 30%-50% at times. I can live with that. But that might not be the case for every investor.

People mostly choose mutual funds as they see them as a less risky investment. But guess what? They also generate lower returns.

Individuals tend to assume that mutual funds are the better option. Especially in terms of returns, as they are managed by finance professionals. Well, let’s take a look at these numbers;

averga return of mutual funds in the US

As you can see over the last 10 years, mutual funds have had an annual average return of 12.02%. Over the same period, S&P 500 has had an average return of 13.6%.

And there’s more.

Take a look at this data from S&P Dow Jones;

Over a 15 year period, 92% of large-cap mutual funds have failed to beat the market.

Yes, that’s right – 92%.

Don’t forget that this is despite paying the fund manager huge fees every year. This goes to say, if you choose mutual funds you’re likely to underperform the market in the long run. Mostly because mutual funds tend to be conservative about their investment choices. They care more about reducing the downside risk than growing money.

But that’s not the case with individual stocks. If you pick the right stocks for your investment strategy, you can enjoy significantly higher returns than the market average.

Take Apple, for example, a $1,000 investment made in June 2011 would be worth $11,628.19, as of June 2021. That’s a 1,062.82% gain in just 10 years.

Costs: Mutual funds vs stocks 

Costs include both the money you spend towards fees and commissions, and the time you spend on research.

Mutual funds are created by financial institutions and regulated by the Securities and Exchange Commission. And they are run by financial professionals known as fund managers. They decide which companies to invest in. By investing in a mutual fund, you’re just following suit.

Also, every mutual fund has something called an expense ratio. You can think of it as a management fee. It is the amount you need to pay as fees for investing in the mutual fund. It is represented as a portion of your mutual fund investment. For example, if you invest $10,000 in a mutual fund, and the fund has an expense ratio of 2%, you’ll pay $200 annually towards fees.

The fees must be paid no matter what. Even if the fund is underperforming the market.

Stocks, on the other hand, don’t cost you much apart from the stock price itself. Earlier, there were all kinds of fees and commissions associated with buying stocks. But with the arrival of discount brokers like TD Ameritrade and WeBull, you can buy stocks with zero commission. And unlike mutual funds, you can choose your stocks.

And even if you don’t want to buy individual stocks, there are better alternatives to mutual funds. Take an index fund for example. Index funds are passively managed funds that track and index. Which means you’ll get the same returns as that of the market index. And fees are less compared to mutual funds. You could also go for exchange-traded funds (ETFs)

Time: Mutual fund vs stock

If we talk about time spent, researching stocks can take up quite a bit of time. Especially, if you’re relatively new to investing. But despite what the mainstream media tells you, you don’t need to know everything from the oil prices to the latest trends in the market. To successfully pick individual stocks you only have to know the basics of how a company operates. Specifically, how they make money and how they spend their money.

Of course, that’s not all. You would need to learn to find information from Annual Reports, Form 10-Ks, etc. But the point is, it can be done. You don’t need to have a degree in finance to do that. Just plain old common sense is enough.

However, it is true that mutual fund investments do not take up as much time as you need with researching individual stocks. But in the long term, it’s worth it, as your returns are likely to significantly outperform the market average and the returns from mutual funds.

And we shouldn’t forget taxes. Mutual funds are not particularly great for your capital gains taxes. Capital gains tax is generally incurred when you sell your investment and make a profit. But mutual funds buy and sell stocks throughout the year. That means, even if you don’t buy or sell your mutual fund shares, you’ll still incur taxes. Even when the mutual fund is not making good returns, you might incur capital gains taxes due to the nature of the fund.

But with stocks, you’ll only incur taxes when you sell stocks and when you receive dividends. And long term investments are taxed at a lower rate than short-term investments. So if you hold on to your investments longer, you’ll make more money and you can pay less in taxes.

Bottomline

Both stocks and mutual funds help you in building up a diversified portfolio. But the key difference is as a mutual fund investor you’re likely to underperform the market in the long run. Mainly due to high fees, and relatively poor returns.

But if you’re not sure about how you can start with individual companies, check out our 8-step Beginners Guide. It has a list of 20 stocks that you can confidently own for the next 20 years.

Trading vs. Investment; Which one should you choose?

Investing and trading are two very different methods of attempting to profit in the financial markets.

Investing is used by investors to achieve higher returns over a longer time. Traders, on the other hand, use both rising and falling markets to enter and leave positions more quickly, resulting in smaller, more frequent profits.

So what should you choose?

In this article, we’ll discuss the differences between trading vs. investment and what could be the lucrative option for you.

What is Trading?

Buying and selling stocks or other securities in a short period to make quick profits is referred to as trading. Traders think in terms of weeks, days, or even minutes, whereas investors typically think in years. Stocks, commodities, currencies (forex), and other financial instruments are common trading examples.

Traders are divided into four groups:

  • Position Trader: Positions are kept for a time ranging from months to years.
  • Swing Trader: Positions are held for a period ranging from days to weeks under swing trading.
  • Day Trader: Positions are held and sold within the same trading day
  • Scalp Traders: Positions are held for seconds to minutes at a time. 

The fundamental principle of trading is to “Buy low, sell high”.

Experience traders also use strategies such as reverse trading and short-selling, in an attempt to make bigger profits.

What Does ‘Investing’ Mean? 

Traditionally, investing involves the purchase of stocks or other financial instruments that are intended to provide profits over a long period of time. Stocks, bonds, funds, and other investment vehicles are the most popular choices for investing.

Market fundamentals, such as price-to-earnings ratios and management projections, are often more important to investors. An investor aims to build a well-balanced portfolio of stocks and bonds that provide returns in the form of price appreciation, dividends, and interest income.

What are the Key Differences Between Trading and Investing? 

Here are the key differences between long-term investing and trading.

Time period 

Investing is a strategy based on the buy-and-hold premise. Investors invest their money into the market for years, decades, or even longer.

Whereas, trading involves owning stocks for a short period. It could be for a week or even just a single day.

Capital Growth

Investing is the practice of building money over time using price appreciation and dividends of high-quality equities in the stock market.

On the other hand, traders keep an eye on the market’s stock price change. Traders may sell their stocks if the price rises. Simply said, trading is the ability to time the market.

Risk

Investing takes time to master since it is an art. It has a lower risk and lower return in the short term, but if held for a longer length of time, compounding interest and dividends result in higher returns.

Trading, on the other hand, has a larger risk and bigger potential reward in the short term because the price might go high or low in a short time.

Focus 

In investing all financial decisions are based on an investor’s belief in the company’s expansion plans.

Traders tend to ignore what the company does in favor of focusing solely on the stock price and trade frequency.

Investment Strategy

Investors conduct their study and invest only once they are entirely convinced of a company’s potential.

Stock trading is more inclined to invest in stocks based on suggestions from friends, other stock market traders, the media, and other third-party sources.

What are the Pros and Cons of Stock Trading? 

There are benefits and drawbacks to trading summarized below. Let’s start with the pros:

Hassle-Free

The difficulty of waiting a long time for rewards has been avoided-thanks to online stock market trading and share trading platforms. You can virtually instantly execute a trade using online platforms. When trading stocks in the stock market, time is of the essence, the ability to execute online trading portals quickly is a benefit to many stockholders.

Low – Commissions

Thanks to recent advances in computing and the internet, large commissions on any trading stock are now a thing of the past. Online stock trading is an appealing option in terms of economics, with the most advanced trading technology and the lowest commissions.

And here is the biggest disadvantage of stock trading;

You May Lose money Easily

Many people believe that trading is the simplest way to profit in the stock market, but it is also the simplest way to lose money.

A study by the U.S. Securities and Exchange Commission of forex traders found 70% of traders lose money every quarter on average, and traders typically lose 100% of their money within 12 months.

What are the Pros and Cons of Investing You Must Know? 

Let’s start with the reasons why individuals should invest in the stock market.

1. Long-Term Returns

Investing is likely to yield favorable long-term returns. Historically stocks have outperformed all assets in the long run. While the stock market has always been volatile, it has always recovered from downturns, corrections, and crashes.

For instance, in the last 50 years, the S&P 500 has had an average annual return of 10.83%. This means, if you had invested $10,000 into an S&P 500 fund in 1970, the investment would be worth $2.13 million today.

2. Hassle-Free Buying

The introduction of discount brokers has made it easy to buy stocks. All you need is a brokerage account. Once you are done creating an account, you can buy stocks instantly.

3. No need for an Investment Degree

One of the biggest pros of stock investing is that it does not require an investment degree to be successful. You can invest passively and still have nearly the same returns as the stock market as a whole.

S&P 500 index funds are ideal for investors who prefer to take a passive approach to investing. When you buy in an index fund like this, you’re investing in hundreds of equities all at once. You don’t have to bother about researching which stocks to invest in or choosing whether to buy or sell specific shares because the fund does all of that for you.

Disadvantages of Investing 

Here are the cons of investing you cannot ignore;

1. Requires patience

You can get wealthy with stocks, but it will take years or decades. So, if you’re looking to get rich overnight, sorry but that’s not going to happen.

2. Stock Market is Volatile

The stock market is indeed volatile. It has always risen through time, although not in a straight line. There will be lots of corrections and crashes along the way. Thus, you must have the courage to not panic and sell in a panic when they occur.

3. You Might Break Your Bank 

Another but important demerit of stock investing is that if you don’t know what you’re doing, you could lose a lot of money, if not all of it. There are numerous methods to lose money in stocks, as well as numerous common investment blunders to avoid like purchasing equities on a margin using borrowed funds, being unable to pay off high-interest debt before beginning to invest, predicting the market’s movement, and more.

Bottomline 

The approaches, risk, and time involved in investing and trading are the most significant distinctions. Investing is a long-term strategy with lower risk, whereas trading is a short-term strategy with high risk.

If reducing exposure to volatility and achieving long-term returns are your primary objectives, long-term investment is the way to go.

What are the Key Takeaways? 

– Investing is a long-term gain solution to the markets that are frequently used for things like retirement plans.

– Trading entails using short-term techniques to increase profits on a daily, monthly, or quarterly basis.

– Traders will want to make transactions that would help them benefit rapidly from volatile markets, whilst investors are more inclined to look for long-term gains.

Safety margin; How to ensure returns from your stocks

“Value investing is trying to buy a dollar for fifty cents”

– Warren Buffett

The core principles of value investing revolve around the price at which an investor purchases securities. Because for value investors, what they buy is equally important as how much they buy it for.

That’s where the margin of safety comes in.

What is the margin of safety?

The margin of safety is a principle in value investing that encourages investors to buy stocks at a price significantly below their fair value. The term margin of safety was coined by Benjamin Graham, who is also known as the father of value investing. However, the term was popularized by his student and one of the most popular investors ever, Warren Buffett.

The margin of safety aims to reduce the downside risk of an investment, thereby increasing the chances of making a profit.

How does Margin of Safety work?

Calculating intrinsic value (also known as fair value) is the first step in determining the safety margin. It is calculated by taking various aspects of the underlying business into account; assets and earnings, management, industry outlook, etc.

Once you have the intrinsic value of a stock, you can set the margin of safety. The safety percentage varies from one investor to another, based on their risk tolerance. Some go for a margin of safety of 20%, meaning they set their target purchase price 20% below the stock’s intrinsic value. Meanwhile, some investors go for a higher margin of more than 50%.

Remember, it’s not 20% below its market price, but 20% below its intrinsic value. For example, suppose AMD trades at $100 a share, and as per your calculations, it has an intrinsic value of $80. So that means AMD is trading above its intrinsic value.

So an investor looking for a margin of safety of 20%, would set his/her target price at $64, 20% below its intrinsic value, $80. That means, the investor purchasing at $64 is likely to see an upside of more than 25%, as he has managed to buy the stock significantly lower than its market price.

However, it also means that the investor will need to wait for a while for the stock to come down to the discounted price of $64 from $100. At the same time, he also needs to make sure such a drop is not the result of deteriorating fundamentals.

Because often it could be due to a problem in the underlying business. If you go ahead and buy the discounted stock without re-analyzing the fundamentals you may end up in a value trap.

Using the Margin of safety

The margin of safety is incredibly useful in limiting downside risk. The margin of safety ignores the stock price. Instead, it looks at the intrinsic value of the stock and applies a discount on it, thus setting the target purchase price.

This highly increases your chance of making a profit from the stock. Take the case of AMD, for instance. AMD is currently trading at $100. If you can wait long enough to buy it at the price of $64, which is the target price as per margin of safety, you’ll enjoy a good profit from the stock.

At the same time, it also reduces the chance of incurring a loss. As you’re buying the stock for a price significantly below its market value, it’s unlikely that you’ll incur a loss.

Warren Buffet explains it perfectly; “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing”.

Buffett is trying to say that you shouldn’t buy a stock that’s worth $100 for $90. You need to leave more room for human error in valuation, extreme volatility, or just bad luck in the market. So you buy it for $80 or $70, leaving sufficient room for error. And that’s how the margin of safety works.

Intrinsic value

To understand the margin of safety, let’s see how the intrinsic value of a stock is calculated. Some use discounted cash flow to calculate the intrinsic value, while some others take advantage of metrics such as Earning power value, absolute PE, or even the Graham formula.

But the truth is, intrinsic value is highly subjective. No matter how many variables you use, there’ll always be assumptions.

Hence, the margin of safety.

Because, what if the assumptions are wrong? How do you make sure that your assumptions don’t hurt your investment?

So you focus on the price you pay.

We make sure there is enough room to cushion any downfall, in the event our assumptions turn out to be wrong. So instead of trying to buy at its fair value, like regular investors, value investors apply a margin of safety of 20% – 30% and buy the stock.

Warren Buffett and Margin of safety

Even though Ben Graham coined the term, it was Buffett who popularized the concept.

The margin of safety perfectly aligns with the value investing philosophy Warren Buffett so profusely preaches. While value investing is aimed at finding undervalued stocks, the margin of safety acts as an additional cushion, to limit the downside.

The market price or share price has little or no significance when it comes to the margin of safety, It is calculated purely based on what it’s worth, that is intrinsic value. So even if the stock is currently trading below its intrinsic value, the margin of safety would still be applied to the intrinsic value.

Bottomline

The margin of safety is one of those concepts that most investors gladly ignore. Thanks to social media, investors these days only care about what’s hot – stocks and industries alike. But as a long-term investor, your objective is not to look for what’s hot. But look for stocks that can provide value to your portfolio. And that’s what value investing is all about.

And the margin of safety is will help you make sure you take care of the downside risk as well.

Happy investing!

And if you’d like to know the 20 stocks we think you can hold for the next 20 years, check out our bestselling book The 8-Step Beginner’s Guide to Value Investing.

Why do we need the stock market? Function and importance

The answer is simple.

The stock market provides companies access to money.

That is the primary reason we need stock markets.

But that’s not the only reason.

Let’s take a look at what constitutes a stock market and why do we need it.

What are stocks?

Before we dive deeper into the stock market, it’s essential to understand stocks. Thankfully, it’s not that hard.

Let’s say four friends wanted to start a company, so they put in equal amounts of money for the initial capital. All of them will be given shares that represent the ownership of the company.

The number of shares each person will receive depend on the amount of money they put in. In this case, they all will receive the same number of shares as all of them put in equal amounts of money.

Owning shares means you have a chance of receiving a portion of the profits the company might make in the future. Now, this is not guaranteed. Because the company might never make profits, and even if they do, they might decide not to distribute profits among shareholders.

But if the company decides to distribute profits, each shareholder will receive a portion of the profits, in proportion to the number of shares they own.

The company always keeps track of who owns its shares and how many. So that if in future they decide to pay out profits as dividends they’ll know who to pay.

And the stock is transferable. Why is that so important?

Because it means that if you own stock shares of one company, you can hand them over to another individual or organization, in exchange for money. You can also gift your stock shares to your friends or family, or your children could inherit them.

The stock market exists because the stock is transferable.

Why would someone buy stocks?

Individuals invest in companies (by buying shares) to make profits.

When you invest in a company, there are two ways you can potentially make a profit. The first one is through capital appreciation. That means selling shares for a price, more than you bought them for, and pocketing the difference.

Over time, stocks tend to rise in value. The S&P 500 – an index that tracks the performance of the stocks of the 500 largest companies in the US – has a produced an average annual return of 13.6% in the last 10 years. And investors make money off of this price appreciation.

The second is through cash payouts called dividends.

Like I mentioned earlier, companies might distribute a portion of their profits among shareholders. The amount each shareholder will receive will be relative to the number of shares he/she owns. These payouts can act as an active income from your investments.

There are many more reasons why people buy stocks, but these are the most common.

What is the stock market?

The stock market serves as a marketplace for stocks.

The stock market refers to financial institutions that facilitate the transfer of shares from one party to another. The stock market makes it easy for people to buy and sell stock shares.

Why is this so important?

Every transaction – whether it’s goods, services, or money, involves a certain level of uncertainty. The buyer might be uncertain about the quality of the goods, whereas the seller might be worried whether the buyer will pay in time.

The same goes for transactions of shares. The stock market lowers that uncertainly surrounding the buying and selling of shares, by providing a common marketplace for all participants – known as stock exchanges.

If you would like to know more about how the stock market works, read this article.

Stock exchange

A stock exchange is where the trading (buying and selling) of the shares happens. Market participants (individual and institutional investors) use the stock exchange to place orders to buy or sell. All the orders (to buy or sell shares) are processed at the stock exchange, and the shares and the cash is delivered to the respective participant.

New York Stock Exchange (NYSE) is one of the oldest and largest stock exchanges in the world. Stock exchanges in the US are regulated by the Securities and Exchange Commission (SEC). The institution oversees the smooth functioning of exchanges.

The stock market makes sure that you are free to buy and sell shares whenever you want. Institutions like the SEC lowers the uncertainty around investing in companies and protect investors from fraud and manipulation.

What if there was no stock market?

Buying and selling stocks won’t be easy

To begin with, investors would have a hard time buying and selling stocks. The whole investing process will be complex and expensive. You would need to approach the companies directly to buy shares. And every time you want to sell shares you will need to find a buyer on your own.

As a result, people will be very unwilling to invest in companies as they are not sure whether or not they can get their money back, let alone profits.

Funds will be hard to access

It’s worse for companies.

An initial public offering (IPO) is when a company’s shares are made available to the public to buy for the first time. An IPO has the potential to bring in a lot of funds to a company. And if the company is already well known at the time of its IPO, the company will be able to raise a significant amount of money.

But this won’t happen if there is no stock market.

And companies might decide to issue new shares in the future to raise capital. This opportunity gives them access to funds from the public, and they can access them as and when it seems necessary.

Needless to say, if there is no stock market, companies can forget about these funds.

So they’ll need to find and approach investors who would be willing to provide funds in exchange for money. It will be time-consuming and expensive. And companies won’t have access to large amounts of money. So they’ll be forced to look at alternate sources for capital.

This means they’ll have to take on debt; they’ll need to borrow money – large amounts, to grow the business. And that could be a burden later on, especially for newer businesses.

And due to the lack of sufficient capital, company growth will substantially slow down. As it would be hard for them to expand their business, introduce new products/services, or invest in R&D without enough money to spare. Also, if it’s a competitive market, the company might end up losing its customers and could potentially go out of business.

Now, let’s talk about the overall economy.

Economy and the stock market

Many of the largest publicly traded companies we see today grew their businesses using the funds they raised from the public through the stock market. And these companies might not exist today if it wasn’t for an active stock market and a large number of enthusiastic investors.

When these companies grow, naturally there will be more revenue, which means they’ll hire more people, which will grow the business. All of this means that the government will receive more money in taxes.

Don’t believe me? Check this out;

The US government received $230.2 billion in corporate taxes, in FY2019. Most of that money could disappear if there was no stock market.

So no stock market means fewer jobs, less income, fewer taxes, all of which will result in a weaker economy.

Bottomline

Financial markets are viewed as an indicator of the overall economy of the country; an active stock market shows a robust economy and vice versa. An active stock market can help individuals grow their wealth and companies grow their businesses.

To know more about how you can grow your wealth through investing, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.

Invest in index funds; A complete beginners guide for 2021

 “Don’t look for the needle in the haystack. Just buy the haystack!” 

That’s John Bogle, on the importance of index funds.

John Bogle was the founder and Chief Executive of The Vanguard Group. Most of all, he was the biggest proponent of index funds.

To understand how big of a deal this introduction was, you need to know what an index fund is, and how they have helped individuals invest, over the years.

What is an index fund?

An index fund (also known as an index mutual fund) is a fund that tracks a market index. A market index is a hypothetical portfolio of stocks that represent a certain section of the stock market. Often market indices represent the stock market as a whole. For example, S&P 500 is the most popular index in the US. It tracks the 500 largest public companies in the US. When you hear people say the market was down today, they’re likely to be referring to a broad market index.

So an index fund that tracks the S&P 500 will have shares of all the 500 companies in the index. By doing so, the index fund is trying to replicate the performance of the market index.

Index mutual funds are passively managed. The funds are automated to make adjustments according to the shifts in value in the underlying companies. 

Since the funds are not actively managed, the fees tend to be lower than actively managed funds. On the other hand, actively managed funds usually have a fund manager and a team of analysts, who are constantly trying to find new opportunities, in an attempt to beat the market. As a result, they usually have higher fees associated with them.

Traditionally, there are two types of index funds – Stock index funds and bond index funds. As the name goes, stock index funds track a stock market index (like S&P 500), a bond index fund tracks a bond market index (a market index that tracks the price of bonds, like the Bloomberg Barclays U.S. Aggregate Bond Index).

Why are index funds popular?

These are some of the reasons why index funds are so popular.

Easy to invest

Most individuals put off investing because they don’t have the time to do the research that is essential in making informed investment decisions. Also, many have a hard time understanding all the jargon that comes with the stock market. So people put off investing altogether. This is where index funds come in.

Index funds provide you a hands-off approach to investing. Even if you have no clue how the stock markets work, you could invest in index funds and still get around 8%-10% return annually. Because that’s the average annual return of the S&P 500, during the last 10 years. And since the index funds by definition are the market average, that’s the return you will receive.

Low-cost index funds

This is another aspect that makes index funds so great. Index funds are less expensive compared to other funds. On average, low-cost index funds annually charge 0.02% – 0.2% of your total investment. Whereas mutual funds charge 0.5% – 2.5% of your investment.

You must be wondering why we’re losing our heads over some fractions of a percentage. Do they really matter?

You bet they do.

In fact, these small fractions can have a massive difference in the long run. Consider this; assume you invest $10,000 in two funds that charge 0.5% and 2.5% of your investment, respectively. Assuming you get an annual return of 10%, this is how your investments will look like in 20 years.

a table comparing investment growth relative to different expense ratios

As the table illustrates, the $10,000 invested in the fund that charges 2.5%, will be worth $46,022 in 20 years. Not bad, right?

Actually, it is bad.

Not in itself, but compared to the other $10,000 invested in an index fund that charges 0.5%. After 20 years, it would be worth $61,159 – a 33% improvement over the more expensive fund.

There’s another reason why passively managed index funds are the better option when compared to actively managed funds. A 2018 report from S&P Dow Jones Indices suggests that more than 92 percent of active fund managers in large companies were unable to beat the market over a 15-year period.

This means with actively managed funds, you’re paying more money, only to underperform the market.

Diversification

A major advantage of investing in index funds is that you are diversifying your investments. As I mentioned, market indices usually consist of several companies that belong to different industries and sectors. So with index funds, you’re diversified from the get-go. For example, SPY is an exchange-traded fund (ETF) that tracks the S&P 500. ETFs work basically the same way an index fund does. So when you buy one share of SPY, you own shares of 500 companies.

This immediate diversification leads to less risk. As your investment is sprawled across companies from different sectors, you’re less likely to suffer losses. And even if you do, your losses should be balanced by your gains from other stocks in the fund.

Remember the quote at the beginning? That’s another reason why investors choose index funds. Instead of looking for the next big winner among thousands of stocks (needle in hay), you can buy an index fund (the hay), and make sure that you don’t miss out on the winners.

Disadvantages of index funds

Since we talked about all the good things that make index funds a popular form of investment, I feel like we should look at the other side of the coin too.

When it comes to the demerits of index funds, these are what I can think of;

Average returns

With index funds, you’ll only ever make average returns. That is because the performance of the market index is considered the market average. Since that is the performance your index fund tries to match, you’ll end up with the same returns. So it’s unlikely that you’ll ever beat the market.

Less choice with stocks

When you invest in an index fund, you’ll be investing in several different stocks; you might be interested in some of those, not so much with other ones. Your choice is limited with index funds. You’ll likely end up owning stock you’d rather not own.

Moreover, you might miss out on certain stocks that may not be a part of any index, but you believe has a huge potential.

How to invest in index funds?

The first step to investing in an index fund is choosing one.

A couple of things to be kept in mind while choosing an index fund are expense ratio, tracking error, and the index that it tracks.

Underlying index

When you’re investing in an index fund, you’re basically investing in the underlying index. So it’s important to identify which index is worth investing in. Generally, people go with index funds that track a broad market index such as the S&P 500, or the Dow Jones Industrial Average (DJIA). You also have the option to choose indices that focus on specific sectors. Even better, you have index funds that track the index of global stocks – like Vanguard Total International Stock Market (NASDAQ: VXUS).

Expense ratio

It is the amount you’ll be charged annually, for investing in the fund. It is expressed as the percentage of the amount you invest. For example, if you invest $10,000 into a fund with an expense ratio of 0.02%, you’ll be charged $2 every year. Like I mentioned earlier, the average annual expense ratio for index funds is around 0.02% – 0.2%.

As illustrated earlier in the article, the more the expense ratio, the less the returns.

Tracking difference

Basically, tracking difference is the difference in the index fund’s performance to that of the underlying index. If a market index produces an annual return of 10%, and the index fund produces 9.8%, the tracking difference is -0.2% (9.8% – 10%).

The negative value indicates that the index fund is underperforming the market index it tracks. So when the tracking difference is positive, the index fund is outperforming the market. Usually, the tracking difference tends to be marginal.

Once you decide which index fund you want to invest in, you can open a brokerage account with, either a broker or the mutual fund company that issues the index fund. Since you’ll likely make more investments in the future, it’s better to go with the broker. Once your brokerage account is up, you can transfer funds electronically and invest in the index fund.

Bottomline

If you are looking to grow your money, but don’t have the time to do the necessary research, index funds are the way to go. You can also choose index ETFs because it also works pretty much the same way. Index funds are certainly a lot better than mutual funds, as index funds charge lower fees and over the long run, they generate better returns.

That being said, there is something I would like to bring your attention to.

As it turns out, most index fund investors seem to be individuals who’d rather invest in individual stocks but don’t have the time nor the resources to do so.

Well, the truth is, if you can spend just 20 mins a day, you can achieve market returns substantially higher than the market average – just by using what you already know. To know more, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.

Dividend investing for beginners; A guide to passive income

“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”

— Robert G. Allen

There are a lot of misconceptions when it comes to investing in the stock market. Investing is the same as trading or gambling, or it is a get-rich-quick scheme – to name a few. Not only are these misleading, but they also lead people away from the most effective way of growing your money. Investing – in a nutshell – is a proven way to build wealth over a long period of time. There’s data that goes back decades that proves this. Consider this for example; if you had invested $8,000 in the S&P 500 index in 1980, your investment would be nominally worth approximately $783,086.76 in 2021.

So let’s break it down.

There are two ways you can make money in the stock market  – capital appreciation and dividends. In simpler terms, the first way to make money is where you sell stock shares more than you bought them for. For example, you buy Apple stock at $50 a share, and sell when the share price hits $120 a share, and pocket the difference.

The second way to make money is through dividends. A dividend is a cash payout by the company to its shareholders. A portion of a company’s earnings is distributed to shareholders in the form of dividends as a token of appreciation for investing in the company. The payouts are made at frequent intervals  – usually annually or quarterly, although there are some stocks that pay a monthly dividend. So you invest in dividend stocks and get paid frequently.

Keep in mind that, apart from cash dividends, there are other types of dividends such as stock dividends, property dividends, etc. However, within the scope of this article, we’ll be only discussing cash dividends.

Dividends are a great way to generate passive income, as there’s virtually no effort involved in earning dividends. Hence, investors often look for stocks that pay dividends, in order to generate returns on top of the capital gains from the stock. This strategy is referred to as dividend investing.

Let’s dive deeper into it.

What is dividend investing?

As I said, investors buy dividend-paying stocks to increase their profits, generate passive income or compound their returns over time. Investing in dividend-paying stocks allows investors to generate cash from their stocks, at virtually no extra cost or effort. Also, dividend stocks act as a hedge against market volatility. The reason is, whether it’s a bull or bear market, dividend-paying stocks will ensure returns for your portfolio. Especially in a bear market, when you see your investments lose value, it’s good to have a consistent income that can alleviate the impact.

However, bear in mind that not all stocks pay a dividend. Instead of paying shareholders, the company might reinvest earnings into R&D, expansion, or acquiring businesses. And that can drive up the price – which ultimately benefits the shareholders. Whether or not to pay dividends is determined by the board of directors. For instance, Amazon has never paid a dividend, and perhaps they never will. Despite that, the stock has produced returns of 193,521.39%. So not paying a dividend alone, does not make it a bad investment.

Whether it’s retirement planning, long-term wealth creation, or whatever the goal may be, dividend stocks are an integral part of every investor’s portfolio.

Look for these criteria in dividend stocks

Now you know what dividend stock investing is. Let’s take a look at how you can find the best dividend stocks for your investment portfolio.

When it comes to selecting stocks that pay dividends these are some metrics to look at:

Dividend yield

Dividend yields are the first metric investors look at when assessing potential dividend stocks. It is the annualized dividend, expressed as a percentage of the stock price. So if a company pays a total dividend of $5 a share and the share price is $100, the dividend yield is 5%. The higher the dividend yield the more you get in dividends.

But there’s a catch here.

High dividend yields are not always ideal. Because you see, when calculating the dividend yield, the dividend that was paid in the previous year is taken into consideration. So a decline in stock price will result in a higher dividend yield. Novice investors might see this as a great dividend-paying stock when actually it isn’t.

So investors should ideally look at more metrics to get a clearer picture of the company.

Payout ratio

The dividend payout ratio or simply – payout ratio – is a measure of how much of a company’s earnings are distributed to shareholders as dividends, in a year. It is calculated by dividend paid divided by net income and expressed in percentage. For instance, if Apple pays 24% of its net income in dividends, then Apple’s payout ratio is 24%. It can also be calculated by dividing dividend per share by earnings per share (EPS).

The idea is to find companies that have a high yield but only pay out a sustainable portion of their income. For example, Apple only pays out 24% of its net income.

As for an ideal ratio, consider investing in companies that pay not more than 55% of their net income. This makes sure that they can keep paying dividends consistently without having to compromise reinvestments in the business.

How to find the best dividend-paying stocks

The first step is to identify great dividend stocks.

Select dividend stocks

There are a couple of ways to go about this. The easiest way is to start with a stock screener. Most online brokers have inbuilt stock screeners that are based on different investment strategies. You can find the dividend screener there.

Once you have a list of potential stocks for your dividend investing strategy, it’s time to do a deep analysis of each stock.

Look for the payout ratio

Now that you know about dividend yields and payout ratios, it’s time to put them to use. I have already explained why looking only at dividend yield can trick you into investing in yield traps. So ideally you should look at the payout ratio when evaluating stocks. Remember, you are looking for a good payout ratio, at the same time you want it to be sustainable. Meaning, you don’t want the payout ratio to be too high or too low.

It mostly depends on the industry and the company. If it’s a large company and it is in an industry where you don’t need to invest large amounts of money into R&D, or capital expenditures, it makes sense to pay out a significant amount of your earnings to shareholders. Coca-Cola is an example of this.

Whereas it does not make sense for a biotech company to pay out a substantial amount of its earnings since a biotech company needs huge investments in R&D, capital expenditures, etc. to succeed in the industry.

So ideally you should look for a payout ratio between 1% to 35% for a mature company. Mature companies are the ones that dominate their respective industries. Coca-Cola, P&G, Johnson, and Johnson are some examples. Certainly, there are exceptions. Coca-Cola pays out 73% of its earnings as dividends since they have a superior cash flow.

The point is, it’s a little tricky to narrow it down to a specific number when it comes to the payout ratio. As a rule of thumb, you should stick to companies that pay no more than 55% of their earnings.

Dividend growth and past payouts

Another aspect to consider is how well the company has paid out dividends in the past. Have they been consistent with dividend payouts? More importantly, have they been consistently increasing their dividend payouts? Because there are companies that pay a dividend only when they have a good year. Sometimes, companies make a one-time dividend payment. On the other hand, growing companies might cut dividends now and then to expand their operations. So it’s quite important to look at how well the company has paid dividends in the past. Even though past performance does not guarantee future results, it gives you an impression of where the company is heading.

If a company has been consistently paying dividends and has also been increasing payouts, you are looking at a healthy company with good earnings growth and a potential dividend stock for your portfolio. AT&T is an example of this. Not only has it paid dividends consistently, but it has also been increasing payouts since 1987. Currently, AT&T yields 7.15%.

Some companies have been increasing their dividend payouts consistently for over 50 years. These companies are known as the Dividend Kings. P&G, Coca-Cola, and 3M are examples of Dividend kings. Then some companies have been doing this for 25 consecutive years, they are known as Dividend Aristocrats. McDonald’s, Kimberly-Clark, and Realty Income are some examples. There’s also Dividend Achievers who have increased their payouts for the last 10 years. Microsoft, Visa, and Nike are examples of Dividend Achievers.

Bottom line – focus on the combination of payout ratio and past dividend appreciation – growth and consistency are what we’re looking for. It should tell you how healthy the business is, and how likely it will continue to pay and increase its dividends.

Here’s something to help you; 

Dividend growth investing is a popular strategy when it comes to growing your money. But we have barely touched upon the most important aspects. To understand more about how a combination of capital gains and dividend income can grow your money exponentially, check out our guide to Dividend Growth Investing. This will give you a head start with your dividend investment strategy, and much more.

Frequently asked questions

How do I start investing in dividends?

You can start by selecting a dividend stock using the metrics we discussed above. Once you buy the stock, you’ll be notified when the dividends are distributed to the shareholders. Note that the brokerage may deposit the cash from dividend, directly to your bank account. Some brokers allow you to reinvest those dividends. Check with your brokerage to know more.

Are dividends good for beginners?

Yes, dividends are good for beginner investors. Dividend stocks allow you to generate a return on your investment, with less due diligence. You can start with Dividend Kings, Dividend Aristocrats, or Dividend Achievers.