Investing 101

Podcast Transcript

Every day, hundreds of billions of dollars worth of investments are bought and sold around the world. Most of these transactions are conducted by investment banks and other large institutions.

Many, if not most, of these organizations act on behalf of other actors, often individual investors.

However, many people avoid investing because it seems complicated, and they don’t understand how it works.

Learn more about investing and some of its basic concepts on this episode of Everything Everywhere Daily.

I have a wide range of people who listen to this podcast. Some are in grade school, and others work at universities.

That means that some of you are going to be very familiar with investing and might even work in the industry. What I’ll be covering in this episode is probably going to seem very basic to you.

However, there are also quite a few people who aren’t investors and don’t know much at all about investing. If you are one of these people, maybe you have seen financial news coverage, and they use terms that you aren’t familiar with.

In this episode, I’m going to cover some of the basic concepts surrounding investing and investments. The goal here is not to provide any particular investment advice, there are plenty of people out there who do that, but rather to give you some tools so you can figure this out yourself.

So, let’s start with the fact that all investments are in assets.

An asset is anything that you own. There are tangible and intangible assets. Assets can include your house, stocks, bonds, cash, artwork, baseball cards, or real estate.

When you invest, you hope that the assets you purchase appreciate in value.

Some assets depreciate in value as well. If you own a car or a computer, they will probably depreciate over time as they are used and new models replace them.

There are also liabilities. Liabilities are usually in the form of debt. Someone else’s liability can be someone else’s asset and vice versa.

For investing purposes, there are several different types of asset classes you can invest in.

The biggest category that you are probably familiar with are securities. Securities are any sort of contractual asset that is issued by a corporation or government entity.

Securities include stocks, bonds, and any financial derivative based on these contractual assets, such as mutual funds, warrants, and options.

Stocks are partial ownership in a company. A single share of stock represents a small percentage of ownership. The amount of ownership a share of stock represents will vary from company to company, depending on the number of shares outstanding.

If you multiply the price per share of stock with all of the number of shares outstanding, you will get the total market capitalization of the company.

Some companies have different classes of stock. For example, a company might have Class A stock, which gives voting privileges, and Class B stock, which provides simple rights to dividends.

Each category of stock may have a different price.

Stock prices, in theory, are supposed to reflect the company’s future earnings. A company that has good future prospects should be reflected in the stock price. Again, this is the theoretical reason for a stock price, and there might be a lot more that goes into the decision to buy or sell a stock that has nothing to do with expected future earnings.

A company’s profits can be distributed back to its shareholders in one of two ways.

The first is via dividends. This is literally a distribution of cash to shareholders on a per-share basis.

The second, and what is usually a more popular option today, is via stock buybacks. Instead of distributing cash, the company will buy its own stock shares on the open market, removing them from circulation. The total value of the company should remain the same, but it will be split amongst a smaller number of outstanding shares, thus increasing the price per share.

This has become a more popular option because, unlike dividends, it isn’t a taxable event.

The price-to-earnings ratio, or P/E ratio, is the price of a stock divided by its earnings. This ratio is often used to determine if a stock is over or under priced. P/E ratios have gone up over time, and different industries have different P/E ratios.

In addition to buying individual stocks, you can buy shares of portfolios of stocks. These are called mutual funds. There are many different types of mutual funds. Some are just diversified stock portfolios. Some mutual funds focus on specific industries.

One special type of fund is an index fund which is designed to replicate the performance of a specific financial market index, such as the S&P 500, Dow Jones Industrial Average, or NASDAQ. An index fund should go up and down in conjunction with the value of the particular stock index.

Index funds are widely considered to be one of the easiest ways to invest in stocks.

Stock options give the holder the right, but not the obligation, to buy or sell a stock at a specified price, known as the strike price, before a certain date. They are often given to employees as a form of compensation. If the stock price of a company does well, then an employee could potentially make a great deal of money.

The other major category of securities are bonds.

Bonds are known as fixed-income securities. They are basically loans in which money is raised from the public rather than from a bank. An organization that wants to raise money will issue bonds that pay a fixed interest rate for a set period of time.

For example, you might buy a $1000 bond at 5% annual interest, which will last for 10 years. Every ever year, you will receive 5% of the principal amount, or $50, and then at the end of the bond’s term you will get back the original $1000.

A bond can be sold at any time. The value of the bond is a set formula based on the length of the bond remaining, its interest rate, and the current interest rate.

If interest rates go down, the value of a bond will go up, and if interest rates go up, the value of a bond will go down. The reason for this is simple. If you have a bond that pays 5% and interest rates increase to 6%, then putting your money in a higher-interest investment becomes more attractive.

Almost all bonds today are electronic. However, in the past, bonds were physical documents. Coupons were attached to the bond which could be redeemed for interest payments.

Some physical bonds were bearer bonds. Bearer bonds could be cashed by whoever held the physical object. They offered the ability to hide and physically transfer enormous amounts of money without being traced.

Some bonds are convertible, meaning they may be converted into stock.

Some bonds can also be called in. The bond issuer can buy back the outstanding bond at market prices. The US Federal Government will often call in higher-interest bonds and then sell lower-interest bonds.

The other main category of assets are commodities.

A commodity is a basic good used in commerce that is interchangeable with other goods of the same type.

The quality of a given commodity may differ slightly, but it is essentially uniform across producers. There are two major types of commodities:

Hard commodities, such as gold, oil, and rubber, are natural resources that are mined or extracted.
Soft Commodities are Agricultural products or livestock such as corn, wheat, coffee, sugar, and cattle.

Average individual investors usually do not invest in commodities directly. They are often bought and sold by corporate consumers and producers of the goods.

Commodities lack what is known as counterparty risk. Counterparty risk refers to the possibility that the other party in a financial transaction may fail to fulfill their obligations. This might be a company failing, not meeting revenue projections or not paying their debt.

That is something you don’t have to worry about if you purchase commodities.

Commodities are often sold in what are known as futures contracts. The provides investors a means of speculation, and produces are means of reducing risk.

A farmer might way to sell a futures contract for wheat so they know exactly what price they will get for their crop months before it is harvested. This eliminates the risk of a price drop at the expense of a future price increase.

Some commodities, such as gold or bitcoin, can be invested in via a exchange-traded fund or ETF. An ETF can allow investors to invest in something without actually having to hold the product physically.

Commodity traders of oil or wheat for example, seldom take control of the actual physical products. The end customer would be an oil refinery or a food processing company.

Beyond securities and commodities, there are other assets you can invest in. The largest category would be real estate. Real estate is usually considered its own thing rather than a commodity because each piece of real estate is unique.

For most people who are home owners, their home is the most valuable thing that they own. Other people buy multiple homes and try to flip the property at a higher value after fixing the house. Other people will rent the property to turn it into a streaming revenue source.

Some real estate, such as buildings in Manhattan, can be great investments, but they are extremely difficult to buy and are out of reach for most people.

That is why REITs were established. REITs, or Real Estate Investment Trusts, are companies that own, operate, or finance income-generating real estate, allowing investors to buy shares and earn dividends from real estate investments without having to buy properties directly.

Other items, such as artwork and collectibles are considered investments, but they are very niche. It is usually only very wealthy people who can invest in such objects due to their high prices.

However, there are also mutual fund-type companies that allow people to invest in fine art where you can make smaller investments for a share a painting.

One final class of asset that is relatively new are digital assets such as Bitcoin. There is still a lot of work to be on regulating digital assets, but as of right now some are considered to be commodities and some are securities.

Bitcoin is considered to be a commodity because of its distributed and open-source nature. No one person or company controls Bitcoin or produces it.

Almost every other digital asset is considered to be a security because there is some person or entity behind such a coin that benefits

One thing that has to be considered for every investment is how liquid it is.

Liquidity refers to how quickly and easily an asset can be bought or sold in the market without affecting its price.

Stocks and bonds are rather liquid in that they can be sold quickly on public exchanges…..assuming you sell when the markets are open.

Real estate is a notoriously illiquid asset. Selling real estate can take weeks or even months to find a buyer and then handle all the legal paperwork.

Likewise, commodities also tend to be somewhere in the middle. You can usually find buyers when commodity exchanges are open, but if they aren’t open, you are out of luck.

There is a lot you can learn about investing and finance. What I covered in this episode just scratches the surface of what there is to know on the subject.

That being said, if you know what the topics I brought up are, you will have a much easier time finding assets to invest in and finding someone who can help you make investing decisions.