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How Do Stock Markets Work? How To Invest Successfully In 2021

How Do Stock Markets Work? Investing in stocks is a great way to make money and build wealth over a period of time. However, many people are still at a loss when it comes to understanding how does the stock market work? When it comes to investing in the stock market, a lot of people tend to avoid it because of the risks involved. A recent study shows that only 14% of American families are invested in stocks, and just 52% are invested in stocks through their 401(K) plan, usually in the form of mutual funds.

Like with most things that people don’t understand, fear of investing in the stock market is understandable. Fears tend to focus on the major declines in the market, such as during the financial crisis in 2008. From October 2007 to February 2009 the S&P 500 index lost 53% of its value. It did recover however, and those who held their investments or invested more, were rewarded, when by 2013 the S&P 500 was up by 88% from its 2009 low. 

Recently, the COVID-19 pandemic also prompted losses in the stock market. Investors labeled March 9th 2020 as ‘Black Monday’ because there was a 12-13% decline in global markets. However, this was a short-lived bear market as stocks bounced back in April 2020 and gained through the rest of the year, hitting all-time highs through the later half of the year. The point being that if you’re not familiar with these events and were invested in the stock market, you would have likely panicked and sold during that time, causing losses and missing out on the gains afterwards.

The volatility of the stock market’s performance, plus all the confusing jargon that surrounds it, tends to discourage potential investors. Still, the stock market remains one of the best vehicles for building wealth. The first step towards becoming savvy with stock market investing is understanding how it works. 

What is Stock? 

A stock is also known as a ‘share’ or ‘equity’ of a publicly traded company. Although, private companies also issue shares, when people mention stocks they are generally referring to publicly traded stock. It represents a proportionate claim of a company’s assets and earnings. When someone becomes a shareholder, it means that they own a portion of a company.

How much of a company that a shareholder holds is equal to the number of shares held as a proportion of a firm’s total outstanding shares. For instance, if you buy 150,000 shares of a corporation with one million outstanding shares, it means that you have 15% ownership in it. 

There are two types of stock: Common stock and preferred stock. Common stock is what is popularly referred to as “equities.” It refers to stock that’s typically held by founders, employees, and ordinary investors. These shares come with benefits; for instance, owners of such shares have voting rights.

Shareholders have a say in corporate meetings like AGMs (annual general meetings) or the board of directors’ election. Common stock is the type of stock that most investors buy and sell on the stock exchange.

Preferred shares come with a higher claim on assets and ownership, unlike common stock. For instance, in the event of liquidation, owners of preferred shares will receive dividends and be paid for their shares, before common shareholders. Preferred shares tend to have a fixed dividend, unlike common stock. Also, owners of preferred shares do not have any voting rights. 

Common stock can be subdivided further depending on voting rights. Although the share structure for common shares generally dictate that all shareholders of common shares have voting rights, some companies have stock classes with different voting rights attached to each class. For example, Class A shares may have ten votes per share, whereas Class B may have one vote per share. This classification helps founders have control over their fortunes and strategic direction. 

How Does  The Stock Market Work

Why Do Companies Issue Stock? 

One of the main ways that startup companies and other companies continue to expand into their next phase of growth is to obtain large amounts of capital. One way they get this capital is through selling shares (also known as equity financing).

As the company establishes itself, it will need more capital to facilitate its ongoing operations and outwork its strategic plans. The firm can do this through an initial public offering (IPO). This move changes the company’s status from a private firm with a few shareholders to a publicly-traded company with many shareholders. An IPO also allows early investors to partially cash out and usually receive a significant return for being early investors. 

Once a company lists its shares on the stock exchange and trading commences, the price of the shares fluctuate, as investors and traders assess its price, based on a variety of factors. 

How Does The Stock Market Work? 

The stock works market similar to an auction in that buyers and sellers negotiate a price to buy and sell shares. This ‘auction’ used to be done physically in a stock exchange, however, all of the transactions now take place electronically through computer networks–which makes it faster than an auction and available to nearly anyone.

Stocks are added to an exchange through an initial public offering (IPO), which  is when a private company offers a new stock issuance to the public. During an IPO companies target major investors like pension funds, mutual funds, hedge funds, and other institutional investors who manage large pools of funds. This is known as the primary market.

The secondary market focuses solely on trading among investors. This is where individual investors buy shares of individual companies. Hedge Funds, pensions, and other institutional investors also participate in the secondary market. 

Most people don’t realize it but the secondary market is what most people are thinking of when they talk about stocks and the stock market. It includes the New York Stock Exchange (NYSE), Nasdaq, and all other major exchanges worldwide. 

How Stock Prices Are Set

Stock prices can be volatile as they are fundamentally controlled by the law of supply and demand. Some of the factors that shape the demand for a stock include world events, investors’ confidence, company profits, plus many others. The most common way that share prices are set is through an auction process where buyers place ‘bids’ and sellers place ‘offers’. A bid is a quoted price from an investor who wishes to buy the stock. An offer (or ask) is the price at which someone wishes to sell. A trade is made when the bid and ask match. 

As mentioned, the law of supply and demand affects shares. When the number of buyers who want to buy stock exceeds the sellers, the prices go up. The reverse is true; when there are more sellers  than the buyers, the prices decrease. 

Still, there’s more to the share price, and it would be best if you avoid investing based on emotions. Market commentators frequently comment on the state of emotions in the stock market, which oscillate between fear and greed. Some people get emotional and want to buy shares once they experience a huge gain, thinking that prices will continue to rise, but buying at a time like this is risky.

A good example of this is the recent run-up of the price of Gamestop Corp (GME) stock. The price of these shares peaked in January 2021 after individual investors drove the price up. Traders holding  short positions rushed to buy more stock in a bid to cushion themselves from the losses. These actions triggered a frenzy of buying that increased the prices of the stock. But now, those shares have lost a significant amount of value and there are a lot of investors who are sitting on large losses as they bought at the peak. 

A way that investors track the performance of the stock market is through watching a ‘market index’ such as the Dow Jones Industrial Average, also known as the ‘Dow’ market index. The Dow tracks the the performance of the 30 largest, industrial companies (by market capitalization) listed on stock exchanges in the US.

There are a number of indexes that follow various companies which represent different aspects of the economy and different industries. The S&P 500 follows the 500 largest companies which make up a cross-section across the 11 sectors of the stock market. The Nasdaq index on the other hand includes all of the stocks that are listed on the Nasdaq exchange. The Nasdaq tends to be referred to as the tech index as the majority of the largest tech companies are listed on the Nasdaq, such as Amazon, Facebook and Alphabet (Google).

What Is The Stock Exchange? 

The stock exchange is a secondary market where buyers and sellers transact. It is important to note that companies do not buy and sell stock as part of their day-to-day operations. Investors do not buy the stock directly from the company they’re investing in. Rather, they buy the shares from another shareholder. Likewise, when selling shares, an investor doesn’t sell them back to the company; they are sold to another investor. Some of the main stock exchanges where shares are bought and sold in the US are New York Stock Exchange (NYSE) and the Nasdaq. 

There are also other major stock exchanges throughout the world, many of which are connected electronically, such as Japan’s Nikkei, Australia’s ASX, Canada’s TSX, London’s FTSE, and many others. 

A more loosely regulated over-the-counter exchange which is also referred to as a bulletin board and goes by the acronym OTCBB. However, these stocks tend to be riskier as the companies listed do not comply with strict regulations, as is the case in major exchanges. 

How Do Stock Markets Work

Why Invest In The Stock Market?

History shows that over time the stock market generates investment returns that are superior to those from most other asset classes. Stock returns come in the form of dividends and capital gains. A capital gain occurs when you sell a stock at a higher price than the price you initially paid for it. Alternatively, a dividend is the share of profit that a firm distributes to its shareholders in the form of a cash payment. 

Most retail investors are attracted to stocks from popular consumer companies, such as the fabled FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google). Although these companies offer some tantalizing prospects, the truth is that you won’t always get high returns and it’s important to build a balanced portfolio that meets your risk profile and investment objectives.

If you are an investor with lower tolerance for risk or are getting closer to retirement when you’re going to want a steady stream of cash flow, then you should opt for stocks that have a long-history of paying substantial dividends. To track the market and the price of various stocks, check out websites such as Google Finance or Yahoo Finance.

Related: Dividend Investing: How To Invest In High Dividend Stocks

When Do Markets Open 

What time does the  stock market open in the U.S.? If you plan to become an active trader, it’s important to understand when the stock market opens and closes. The U.S. stock market, including the main stock exchanges like NYSE and Nasdaq, are open from 9:30 am to 4:00p.m E.T., from Monday through Friday. 

Still, some trades occur outside the regular hours and occur over electronic communication networks (ECNS). These networks allow buyers and sellers to connect directly without the involvement of a middle person. 

There are pre-market and after-hours trading sessions, also referred to as extended markets. For Nasdaq, the pre-market trading hours run from 4:00 am to 9:30 am Eastern Time Zone. Certain brokers have different pre-market and after-hours trading times, for instance, the T.D. Ameritrade permits pre-market trading from 8:00 am to 9:15 am. It’s important to note that volatility tends to be higher in after-hours periods. 

When Do Markets Close 

Overall, stock markets are closed for most of the holidays and all the federal holidays. The stock market is also closed over the weekends as well as the evening. The closing times for various stock markets vary across the globe. Some of the main stock market exchanges include:

  • London Stock Exchange
  • Australian Stock Exchange 
  • Tokyo Stock Exchange 
  • Shanghai Stock Exchange
  • Toronto Stock Exchange 
  • Hong Kong Stock Exchange

Trading generally takes place from Monday to Friday each week. Canada’s Toronto Stock Exchange closes by 4:00 pm E.T. In Asia, trading hours for the main exchanges, like the Shanghai Stock Exchange and the Tokyo Stock Exchange, start at 9:30 am and close at 3.00 pm local time. The Hong Kong stock exchange starts at 9:30 am local time and closes at 4 pm. 

In Europe, the trading hours start at 8 am and close at 5:30 pm local time.  

How to Invest in Stocks

There are numerous ways to invest in the stock market. Some of the most common ways an investor may choose to invest, is to buy stocks directly through an exchange or indirectly, by investing in a mutual fund or ETF (Exchange Traded Fund). There are also various accounts such as a brokerage account or tax-advantaged accounts through which investors can buy and sell shares.

Buying and Selling shares

The process to buy or sell shares is fairly straight forward, and there are a number of brokerages which provide commission free trades such as WeBull.  We have a complete how-to guide on how to get started investing in stocks here. Which provides all the information you need to get started.

Investing Strategy

Although the process to buy and sell shares is fairly straight forward, your individual investing strategy is the most important aspect to investing. Choosing the right strategy for your investment portfolio will help avoid losses and unnecessary risk taking.  It’s important that your investing strategy aligns with your goals and that you’re not constantly buying and selling shares if your goals are long-term and retirement focused.

Risks of Stock Market Investing

There are a number of risks associated with investing but that doesn’t mean that you shouldn’t buy stocks. It’s a matter of understanding the risks and taking the necessary steps to mitigate the risks that can be mitigated.  Here are some of the risks that should be considered.

Concentration Risk

One of the risks that investors can mitigate against is concentration risk. It’s important to not be overly concentrated in individual stocks, or just a few. Keeping a diverse portfolio is a way to reduce concentration risk.

Volatility Risk

Investing in stocks comes with the knowledge that the price of individual stocks can and will move up and down, just as the whole stock market changes as traders and investors buy and sell. A way that investors can somewhat mitigate volatility is to invest in large ‘blue chip’ stocks and larger mutual funds which are well diversified.

Credit Risk

Credit risk is the risk that in the event of a bankruptcy or liquidation of a company that common stock shareholders will be last to be paid. This risk can be mitigated by investing in companies with low debt levels. It can be difficult to look at an individual company and understand whether it’s debt is too much, so comparing it to competitors in the same industry can help to provide a better picture of a company’s financials and debt load.

The Bottom Line

The general concept of the stock market is fairly straightforward and it’s even easier to get started in  investing in stocks. The best part about investing in stocks is that you can start with only a small amount of capital. Although investing in stock indeed comes with risk, it remains one the best way to grow your wealth. It’s about managing the risks and building a portfolio that’s in line with your objectives and risk profile. The sooner you start investing in stocks, the better your chances of achieving financial freedom. 

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ETFs Vs Index Funds: Which Is The Better Investment in 2021?

When looking at ETFs vs index funds there are a number of differences and similarities. It helps to know what an ETF and index fund are to best understand the differences between them. An index fund is a fund (usually a mutual fund but can also be an ETF) which tracks an index such as the S&P 500 or Dow Jones. An ETF (Exchange traded fund) is a fund that trades similarly to a stock, through a brokerage account, and is an investment fund which holds a number of assets, which can follow an index but could also be invested in other assets depending on the strategy of the ETF. They can both play an important role in an investor’s portfolio and understanding the similarities and differences will help to ensure they’re used well, when building a portfolio.

Key Features of ETFs 

ETFs (Exchange Traded Funds) are chosen by both passive and active investors because of their flexibility and the variety of options they provide. ETFs can hold investments such as stocks, bonds, commodities, or mirror the performance of a benchmark index (aka index fund). They can be structured to track anything, from an individual commodity’s price to a large, diverse collection of securities, and can also be leveraged such up to 2x or 3x the value of the underlying asset. Investors tend to use ETFs to build exposure to specific sectors in the market, such as utilities, healthcare, technology, etc.

The term ‘exchange-traded’ is important and a key feature, as ETFs are traded on exchanges the same way as stocks and can be traded throughout the day. Conversely, mutual funds are settled and traded once per day, at the end of the trading day.

An investor should consider adding ETFs to their portfolio if:

  • Want to purchase through a brokerage account. 
  • You want tax efficiency, as there is not a lot of buying and selling within a passively managed ETF which means lower capital gains taxes. 
  • You want exposure to certain sectors or don’t want to build a portfolio yourself, from individual stocks.
  • Flexibility to invest in individual sectors or assets without buying the ‘whole market’ like with an index fund.

Key Features of Index Funds 

Index funds are purchased directly through investment companies, unlike ETFs that are purchased through an exchange, like stocks on the stock market. One of the main reasons investors favour index funds is that they tend to be hands-off, low-cost, and easy to invest in as they are usually purchased through an Investment Advisor. Unlike ETFs, this investment vehicle doesn’t have trading commissions but usually has other fees and costs.

An investor should consider index mutual funds to their portfolio if:

  • They want the entire investing process managed by someone else. Index mutual funds can be purchased through an Investment Advisor who can help you determine which fund(s) are right for you. 
  • They are looking for a long-term investment that doesn’t need a lot of attention to manage. A ‘set-and-forget’ type of investment.
  • Don’t want to have to worry about diversification risk as you’re investing in the ‘whole market’.
ETFs vs Index Funds

What Do ETFs And Index Funds Have In Common? 

Index funds were first developed and made available for investment in 1976. They were developed and introduced by Jack Bogle, who launched the first index fund known as the Vanguard 500 Index mutual fund which emulated the S&P 500 index. 

ETFs on the other hand were developed in 1993. Over the years ETFs have become increasingly popular. One of the reasons for this is due to their structure which gives them a number of advantages over mutual index funds. For starters, ETFs generally have a passive management style which results in lower expense ratios, unlike mutual funds. Even so, there are some merits to mutual funds which make them a favorite of retail investors.

Some of the features that they have in common are:

Diversification: Both index funds and ETFs are funds that are invested in a number of different assets so they can both provide good diversification to any portfolio.

Management: ETFs and index funds are both managed funds. Most ETFs and index funds are passively managed, meaning that the managers aren’t actively researching and analysing stocks and tend to stick to either the investment strategy of the fund or what stocks are in the index that they are following. Compared to other mutual funds which tend to be actively managed.

Fees: Both ETFs and index funds tend to have lower fees than actively managed mutual funds, which is one of the main features that has made them so popular. In an actively managed fund (like mutual funds), as mentioned there are professional portfolio managers which make the investment decisions which means that there are more expenses in an actively managed fund which means higher fees. But in the case of passively managed investments such as an index fund (and most ETFs), there are lower fees, also known as the expense ratio. In 2019, the average annual expense ratio for actively managed funds was 0.66%, whereas, for passively managed funds, the ratio was 0.13%.

 

ETFs vs Index Funds

What Are The Differences Between ETFs and Mutual Funds? 

The main difference between ETFs and index funds are the fees and how each type of fund is purchased. Since you can buy and sell ETFs like stocks, you have to pay a commission each time you trade. Depending on the broker and the amount being invested the commissions can add up over time and reduce your investment’s return (some brokerages offer commission-free ETFs). Index funds, on the other hand, are sold without commissions but have loading fees, generally when the fund is sold. These loading fees vary between companies and it’s important to understand all fees before investing index funds or ETFs.

Dividend distribution is another factor that differentiates index funds from ETFs. Whereas you can choose to reinvest the dividends paid by index funds directly back into the fund, you cannot do the same with ETF dividends. But in saying that, once an investor receives dividends paid by an ETF they can choose to purchase more shares if they wish.   

Investors should also bear in mind the annual expense ratios. As a rule of thumb, the higher the expense ratio, the lower the investor’s total returns. Generally, ETFs have a lower expense ratio than index mutual funds. This is an important consideration as the fees are paid regardless of the performance of the fund.

Initially, ETFs used to have the edge over index funds as you could start investing in ETFs with as little as one share. But more and more companies are lowering or eliminating the minimum investment requirement for investing in index funds.

Index funds and ETFs also differ in terms of tax. Although both vehicles are tax-efficient, an index mutual fund will incur less capital gains taxes than an actively managed ETF as there is less buying and selling happening within the fund.

Lastly, ETFs are more liquid than index funds. As mentioned earlier, you can buy and sell ETFs anytime the stock market is open. But with index funds, you’ll have to wait after the end of the trading day, when the market closes, for a purchase or sale to settle. This means that the investor doesn’t know the price at which they sold or purchased until the next day. Markets usually close at 4 p.m EST so any transaction will settle after 4pm. This is important if considering actively trading ETFs or index funds, but for long-term investors, it’s not as important.

Related: Index Funds Investing For Beginners, Stocks For Beginners: The Complete Guide

ETFs and Index Funds: Which Should You Choose? 

Both mutual funds and ETFs can fall into the bracket of index investing because, depending on which fund is chosen they track an underlying benchmark index. One of the reasons that index funds are popular is that they often beat actively managed funds in the long run. In the short-term, sector specific ETFs can provide excellent returns and outperform a passively managed mutual fund or ETF, if economic and market conditions support the sector.

Both index funds and ETFs depend on a passive investment strategy. This strategy is not designed to beat the market and therefore removes the risk of losing to the benchmark index. Investors applaud ETFs because they bring diversification. But it’s important to note that diversification doesn’t mean that ETFs are not vulnerable to volatility. If you opt to go for ETFs, the idea is to understand what the ETF index is tracking and the underlying risks associated with it.

If investing over the long-term, then index funds are should likely make up at least part of your portfolio. But if an investor sees an opportunity in a specific sector which is likely to outperform in the short-term then it could be advantageous to invest in a sector specific ETF. There’s no right and wrong answer when it comes to choosing between index funds and ETFs, the choice between the two comes down to a few factors which are different for every investor: fees, risk profile and overall investment strategy. The strategy with choosing either is about creating a portfolio that meets your needs, which could mean holding both.

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Buying On Margin: What It Is, Risks Involved And 6 Factors To Consider

Buying on margin is a high-risk investment strategy that investors use to amplify their returns, but margin can be a double edged sword. It entails borrowing money from a bank or broker to purchase securities. There are instances where an investor may want to purchase stocks, bonds, or a fund, but they don’t have enough capital as it’s tied up in other investments or they have a very strong conviction about the investment they’re making and want to invest as much as they possibly can. In that case, the investor can approach a bank or a broker and borrow the extra money they need to purchase the asset. The purchased stock, in turn, becomes collateral for the loan. 

A Closer Look Into Buying On Margin

Buying on margin or margin trading is a sophisticated process that carries enormous risks. The investor is making a speculative decision with borrowed money, and no bank or broker wants to lose money. As such, investors are required to open a margin account.

The NYSE (New York Stock Exchange) and Financial Industry Regulatory Authority (FINRA) require investors to deposit a minimum of $2,000 in cash or securities when opening a margin account. Some brokerages may ask for a higher deposit, and there are other regulations that the investor must meet. Also, a lot of brokerages require a minimum income and holdings in an account before they’ll consider providing a margin account. If an investor meets all of the criteria to open an account, the process is the same as opening a regular brokerage account for the most part. 

Generally, margin trading carries the risk of amplified losses. An investor could incur losses which require them to put up more capital or securities as collateral for their loan, known as a ‘Margin Call’. If an investor does not put up the required capital, the broker can sell part or all the portfolio, without the investor’s permission, to get their money back. Alternatively, if a security increases in value, buying on margin provides the opportunity to up to double the returns on the investor’s capital.

Example of Buying On Margin 

Suppose an investor deposits $10,000 into their account. The Federal Reserve Board requires an investor to put up to 50% of the purchase price, which means that this investor can borrow an additional $10,000. The investor then has $20,000 to invest. If the security increases by 10%, the investor would stand to make $2,000 less any interest owed on the borrowed $10,000. The interest rate on margin loans are generally a bit higher than commercial interest rates, and are currently around the 5-7% range (annually). 

What Happens When You Lose A Margin Trade?  

In the case of a loss, the investor faces a ‘Margin Call’. A margin call is when an investor makes losses, which lower the amount in their margin account. In such a case, the broker would ask the investor to add funds to the margin account to get the maintenance margin. As the investor and broker start investing with the same amount of money usually. For instance, in the example stated above, the investor puts $10,000 in the account, and the broker puts $10,000. If the stock price rises and falls, the underlying amount the investor holds changes. 

If the stock declines, the investor’s amount declines and not that of the broker. E.g. If the account declines from $20,000 to $17,000, then $7,000 belongs to the investor, and $10,000 still belongs to the broker. If it declines further, the broker will issue a margin call. In that case, the investor would be required to deposit the amount needed for the account. 

There are a few things that you need to bear in mind:

a). There are legal limits to margin trading – For example, in the U.S., the Federal Reserve Board requires an investor to fund at least 50% of the security’s price. 

b). There are instances where the brokerage sets a limit on how much you can borrow – This limit is dependent on factors such as your investing history and financial situation. 

c). Not all securities qualify for a margin trade – The Government has set limits on the kinds of securities that can be purchased on margin. This limit serves to shield investors from making risky bets. For example, the Government does not allow investors to buy over-the-counter securities, initial public offerings, and penny stocks on margin. Individual brokerages may have more restrictions. 

Buying On Margin

How To Buy On Margin 

The steps involved to buy on margin are fairly straight forward and essentially the same as buying through a brokerage account without margin. The initial steps include opening a margin account and funding the account. The Government requires a deposit minimum of $2,000 for margin accounts but each brokerage will likely have their own requirements.

After funding the account, the broker provides an amount of margin that can be accessed. This is different for every investor as margin access is based on individual credit history, application, etc. It’s important to note that the broker determines the minimum for the initial and maintenance margins at their discretion. Once all the steps to open the account have been completed, then it’s just a matter of investing and managing the risk by having leverage. 

An important step to note is that once an investor begins margin trading, they’re responsible for ensuring that there’s enough money in the account for maintenance margin. The maintenance margin is the minimum amount required to keep your account open. Failure to hit the maintenance margin will lead to a margin call. 

Risks Involved with Buying On Margin 

One of the most obvious risks associated with margin trading is the risk of losses. An investor can never be 100% sure that a stock will rise. Should the investment decline and is subsequently sold, the investor will have to pay the borrowed money back. 

Another risk is the cost of interest. The broker charges interest on the borrowed funds. Typically, the interest is calculated daily, but most brokers will post it to accounts once a month. Since the interest is determined daily, it may be challenging to buy and hold the stock over the long term. That’s why margin trading is almost exclusively reserved for short sales, and short-term trading. 

Lastly, one of the most significant risks with margin trading comes with the risk of margin call. Remember that if your account loses too much money because of losses (regardless of whether the investments are sold or not), the broker will issue a margin call. In some cases, the broker may liquidate all the securities in a margin account without consent to pay back the margin loan.

The minimum margin required according to FINRA (Financial Industry Regulatory Authority) is 25% as a minimum but brokerages can range from 25 – 40%. To calculate at what level a margin call will be made, take the total margin loan value and then subtract the maintenance margin requirement from 1 and divide the total investable amount by that number. 

For example, say an investor has $10,000 to invest and is able to secure a margin account with $10,000 of margin, for a total amount to invest of $20,000. The maintenance margin in this example will be 25%, so $10,000 / (1-.25) = $13,333. This is the level the total account would have to decline to before a margin call is made. 

Who Should Buy On Margin? 

Buying on margin is definitely not for beginner investors. The process is intricate and works best for investors with experience in trading. Also, this strategy requires an individual with  a high risk tolerance. Most investors do not have this risk tolerance or the excess capital to risk, especially those who are investing with their retirement funds. 

Factors To Consider When Buying On Margin 

Although buying on margin is high-risk, it can help increase returns. But before using this strategy, there are some factors to consider: 

1. Approach margin trading wisely

The rule of thumb is that you should never invest more than you cannot afford to lose. Suppose an investor borrows $5,000 to purchase $10,000 worth of stock. The investor should bear in mind that any losses will be increased two-fold. Therefore, investors should only invest what they can comfortably lose. 

2. Borrow less than the allowed limit 

Using all the money available in your account is very risky and should be avoided. The best strategy is to not utilise the entire margin amount available as this substantially increases the risk of a potential margin call.

Buying On Margin

3. Use margin on short-term trades only 

A margin loan is similar to other loans as you are required to pay interest. The longer it takes to pay this loan, the more interest that’s paid. That’s why it’s best to use margin trade for short-term trades and opportunities. 

4. Be selective in what securities you buy on margin

As with any investment, it’s important to research what you’re investing in before investing. This is even more critical when trading on margin, considering that losses could be devastating. Therefore, investors should stay away from speculative stocks and investments. 

5. Know when to stop

An investor may buy on margin and be successful, which is the goal. But it’s best not to let confidence increase risk tolerance, as that’s a recipe for disaster. The best way to approach margin trading is to set limits and stick to them. 

6. Know About The Broker’s Margin Requirements

Every broker has its unique set of requirements for buying on margin. For instance, some brokers have different maintenance margins and margin call rules depending on the type of asset. Therefore, before making any trade, know the maintenance margin requirements that apply and set up risk parameters correspondingly. 

The Bottom Line

Buying on margin should be done with an abundance of caution. Although returns can be nearly doubled with this strategy, the losses can also be doubled. In addition to the risk of loss, the borrowed funds also have interest attached to them, which amplifies the risk of losses. For an experienced investor, this buying on margin can be a valuable tool. The secret is to use it prudently and not use margin against the entire value of the portfolio or with funds that can’t afford to be lost (such as a retirement account). Lastly, remember to invest wisely and always complete a lot of research before investing. 

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Mutual Funds Vs. Stock: Which Is The Better Option in 2021?

Mutual funds vs. stock – when people think about investing, usually what comes to mind are mutual funds and stocks. There’s a good reason for this, as investing in stocks and mutual funds are some of the most popular ways to invest. If you have a 401k through your workplace, you’re likely invested in stocks and mutual funds already. If you’re new to investing or just want to understand mutual funds vs. stock better there are key differences but also some similarities.  

Mutual Funds 

Mutual funds pool funds from a group of investors and invest them into different securities such as stocks, money market, bonds, etc. Each fund has its own objectives which determine the type of investments they invest in. Each fund is also managed by a professional team who research and analyse all of the holdings in the fund. The hands-off aspect and fact that there is a professional managing the fund, make mutual funds very popular with investors.  In 2019, 46.4% of households in the U.S held investments in mutual funds. Here are some of the benefits:

Diversification 

If you ask any investment professional, they’ll tell you that diversification is one of the key ways to reduce risk. It’s not a good idea to put all your eggs in one basket, such as purchasing only one company’s stock. But when you diversify your portfolio, you shield yourself from concentration risk. If one investment performs poorly, the other investments may perform better over the same period, thereby lessening the impact of poor performance on your portfolio.

Unlike investing in individual stocks, investing even in a single mutual fund will provide access to a diverse pool of securities, sometimes as many as 50 or 60+ different securities within one mutual fund. This is not something an average investor has the knowledge or skill set to accomplish on their own and it would require a significant amount of capital to achieve this with individual stocks, whereas a mutual fund can usually be invested in with as little as $1,000.

Fees 

Generally, there are numerous fees associated with investing in mutual funds. There can be upfront fees, or fees on the backend when you sell. There can also be annual management fees. It’s important to understand all the fees associated with a fund as they can sometimes be as high as 3-4% which will eat away a large portion of any gains you may have. Stick with low-cost mutual funds with total fees of around 1-2% as just because a fund has higher fees, does not mean that it’s a better fund or that it will outperform other funds. 

Convenience 

The main reason why people opt for mutual funds is convenience. Instead of individually purchasing shares and doing all the research involved, you can find a mutual fund that lines up with your investment objectives and risk profile and get started. Whatsmore, with a mutual fund, you leave the research and decision-making up to the fund manager. 

Investing individually in stocks is time-consuming. You have to research and keep an eye on the market to find the right companies to invest in. Some people devote their entire lives to the stock market and still only achieve mediocre results. This is mostly due to not understanding some of the fundamentals of investing but of course, a mutual fund doesn’t guarantee you that you’ll not lose money. But with mutual funds, you avoid losing time making some complicated decisions about your investments. 

Mutual funds provide options that cater to every type of investor. Some of the types of funds available include:

Growth Funds – These focus on investing in companies that have demonstrated above-average growth and are in sectors of the market where there is long-term growth expected.

Sector funds – These funds invest in companies within a specific industry or sector, such as utilities, financials, tech, etc.

Index funds – These funds build a portfolio that tries to match or track a market index. These funds track indexes such as the Dow Jones, S&P 500, FTSE, etc.

Value funds – These focus on long-term investors who are looking to invest in companies that are currently undervalued in the market but still have good long-term prospects.

Bond funds – Bond funds invest in government and corporate bonds, plus other debt instruments.

Although mutual funds are popular, they come with their own risks and disadvantages, and an investor needs to understand as much as possible before investing. Some of the disadvantages are: 

  • Annual expense ratios – For instance, if you invest in a mutual fund with a 1% expense ratio, you’ll pay $10 per year for every $1,000 invested. 
  • Minimum Investment – Most funds require a minimum investment of $1,000 or more. 
  • Liquidity – Mutual funds only trade at the close of everyday, unlike stocks and ETFs which trade throughout the day and it could take a few days for a transaction to settle. 
  • Tax Efficiency – Typically, mutual funds are not tax efficient, due to buying and selling within the fund. 

With the risks and disadvantages, this doesn’t necessarily mean that mutual funds aren’t good investments, it’s simply a matter of understanding the characteristics of the investment so that they can be mitigated or ensure they align with the investor’s overall strategy.  

Learn how to invest in mutual funds, here.

Mutual Funds Vs. Stock

Stocks 

Many people have an understanding of mutual funds through their 401(k) and they have likely heard or invested in stocks as well. For most investors though, they may not have extensive knowledge about stocks, and how they differ from mutual funds and how they can be a powerful addition to their portfolio.

Most investors have tried their hand at investing in stocks or received a ‘hot tip’ from someone claiming the stock they just invested in is the next Apple or Facebook. Without the right knowledge, investing like this will likely leave a bitter taste in their mouth and they will shy away from investing because they got burnt.  

Understanding the fundamentals and characteristics of stocks will help ensure that you make the right choices when adding stocks to your portfolio. 

Individual stocks give you the ability to ‘customize’ your portfolio. 

Some investors consider mutual funds “handcuffs” designed for the masses. As with individual stocks, you learn how to understand risk and manage your portfolio depending on your needs and objectives. This individualized approach gives you a chance to customize your portfolio better. You also get greater flexibility, as if there are any economic changes, you can quickly make adjustments to your investments. 

Some investors argue that mutual funds have the risk of over-diversification. Since funds often target many securities to diversify, they end up over-diversifying, which in turn dilutes returns. 

Manage your tax liability with individual stocks

One disadvantage with mutual funds is that you have to pay taxes on your capital gains. But with individual stocks and bonds, you can manage your tax liability through careful planning. By controlling your capital gains by timing when to buy and sell. 

Individual stocks can provide a larger income stream 

With interest rates so low, there are concerns that bond funds may fail to live up to the promise of “fixed income.” This is because the yield on most bond funds is hovering around 2% which also is around the current inflation rate. But there are other options such as building a portfolio that produces dividends. Good, stable dividend stocks currently have rates around 3 – 5% which is well above inflation and can provide a reliable income stream. 

Stocks are More Transparent Than Funds 

Unlike mutual funds, investing in stocks is more transparent as you have direct access to each holding in your portfolio. This transparency allows you to make any changes that you want, whenever you want. Therefore, if you don’t like how the company is performing, you can choose to sell your shares and invest in something else.

Learn more about investing in stocks here.

Mutual Funds Vs. Stock Which is Better? 

The reality is that investing is complicated, and there are many factors to consider when deciding how to invest, and besides mutual funds and stocks there are numerous other options. But, if you are trying to choose between the two; the real answer boils down to your investment goals and your risk profile. 

Both stocks and mutual funds come with risks. The risks are varied and the key to successful investing is managing risk. So it’s important to understand the individual risks associated with investing in stocks and mutual funds.

If you don’t want to invest the time to learn everything that’s involved with investing in individual stocks and have a professional fund manager take care of everything then mutual funds will likely fit your investment style better. If you want to learn more about, risk management, complete your own research and be more involved with choosing the components of your portfolio, then consider investing in stocks. 

As indicated out earlier, what you invest in also depends on your timeframe, risk-reward, and expenses. If you’re investing for the long-term, which most people are, then either stocks or mutual funds are great choices, if your time frame is shorter, say less than 5-10yrs then it would be best to look at stocks as they are more liquid and there are less fees so transactions cost less than mutual funds which can have loading fees which are due upon selling shares.

The investment type you choose also depends on the type of fees and expenses you’re willing to take up. This also includes tax implications; for instance, you are liable for capital gains tax every time you sell stocks. However, the good news is that you can avoid this tax by buying stock through a tax-deferred account such as an IRA. There are 2 types of capital gains to keep in mind. 

Short-term capital gains, which occur when a stock is held for less than 12 months. These gains are taxed as ordinary income. Which usually means the taxes are higher than on long-term capital gains. 

Something else to consider are brokerage fees. Purchasing stocks you will likely have to pay some sort of brokerage fee. There are plenty of low-cost online brokerages out there, such as Etrade, Ameritrade, Webull and Robinhood. 

The Bottom Line

Everyone’s investment goals and decisions are different. That said, every investor has to decide what works for them and what are the most important factors to them, before investing. Maybe fees are not important but having the comfort of a professional portfolio manager is, or maybe understanding all aspects of every company before investing is the most important thing. Regardless of what’s important to you, and whether you choose mutual funds mutual funds vs. stock, the most important thing you can do for your financial future is to just start investing. 

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The Best Way of Investing Money in 2021

When it comes to your hard-earned money, finding the right investment should always be a top priority. Understanding the best way to invest your money will not only ensure you invest the best way for your goals, but it also helps you understand the returns you can expect from your investments. The overall goal of any investment is to see your money grow, so choosing an investment that aligns with your goals, objectives and risk tolerance is the best way of investing money. 

When getting started, there are four main questions to consider before making your money working for you:

  1. What are your investment goals?
  2. What is your risk appetite? 
  3. What is your investment timeframe? 
  4. Which platform/vehicle will you choose?

The Best Way of Investing Money:

1. Investment Goals

When deciding to invest, it’s always important to have a reason and be able to answer “why” you’re investing. It helps physically write your goals down as it makes your them more tangible and you can refer back to them later. If you’re investing with your significant other it can be a great exercise to do this together, it helps you both be on the same page and if you’re both working towards your goals, you’ll get there that much faster.

Writing down goals also helps to make them ‘more real’ and helps you stay on track to achieving them. Some examples of investment goals can be you want to be able to have X in income during retirement, or be able to retire with X amount by a certain age, or you want to be able to send your children to college. These types of specific goals mean you can set up a specific plan to achieve them, as opposed to more vague goals like; I want to be rich, or I want to be a millionaire.

Take away: When you outline and write down your goals, it makes it easier to come up with an investment strategy on how to achieve them. 

2. Risk Appetite

Your risk appetite is the risk that you are willing to take in order to achieve your investment goals. All investments come with a risk but some have more risk than others. Before choosing an investment you need to be able to determine what those risks are for that particular investment and whether they align with your risk profile and whether you’re willing to accept those risks or if they can be mitigated. 

Take away: Risk is an important consideration when determining whether an investment is suitable to include in your investment portfolio. 

3. Investment Timeframe

Similar to investments which have different risks, investments also have different timeframes. Some investments are better as shorter-term investments, while others are long-term investments. When choosing an investment, you need to consider how long you intend to keep your investment because there are investments that are safer and are better suited to be shorter-term investments (under 7 years), such as some bonds, fixed income and savings products. Whereas other investments such as stocks and real estate are better utilised for long-term investing (7 years or more)  the time frame is also another factor to take into consideration when looking at the risk of an investment.

Take away: Choose investment which has a timeframe that aligns with your goals and investing time horizon. 

To learn more about short and longterm investments, click here.

4. Where to Invest

After you’ve decided on your investment goals, risk profile, and time horizon. It’s time to choose which vehicle you use to hold your investments in. If you’re investing for retirement it would make sense to choose a 401k or IRA, or if you’re investing for your children’s education look at a 529 education plan. Otherwise if your goals are more immediate or if they aren’t related to retirement, it means opening a brokerage account, such as an account with Webull.

Take away: Align your investments with the appropriate investment vehicle to achieve your investment goals and take advantage of tax incentives if applicable.

Safer Investments

If you’re more of a conservative investor or getting closer to retirement, there are a number of investments to choose from that are safer and can help reduce the risk of losing your capital. It’s important to keep in mind that although an investment is safer, the downside is that you won‘t receive the same returns when compared to riskier investments. 

High Interest Savings Account

The difference between a high-yield savings account from a traditional savings account is what its name implies – higher interest rates on the balance in the account. If you currently have your money sitting in a traditional savings account it’s worth moving it into a high interest savings account.

The only catch with high interest accounts is that there are usually a few rules around how the account is used, such as a maximum number of withdrawals allowed during a month, or a minimum deposit each month, but if you do some research you’ll find an account which is suitable to your circumstances.  

Certificate of Deposits

Certificate of Deposits (CDs) are a type of savings account where you agree not to make any withdrawals from your initial deposit for a given period of time and in exchange you receive interest on that deposit at the end of the period. 

The appeal behind CDs is that your original investment is guaranteed and so is the return and since it is federally-backed, it makes it one of the safest forms of investment. 

CDs are ideal if you plan on parking your money for a short period of time, usually less than 12-18 months. As currently interest rates on CDs are so low that it’s not worth keeping your money invested in CDs for a long time. If you’re wanting a safer return but for longer than 12 months, a good idea would be to look at a bond fund.

Treasury Bills, Notes and Bonds

Treasury Bills or T-Bills are debt instruments issued by the US government. They are short-term investments with maturity dates that range from a few weeks to 364 days. In essence, T-bills are risk-free and the reason is because they are backed by the US government. Interest is not paid but a return is earned by the bonds being purchased at less than face value.

Treasury Notes are also debt instruments like T-bills but they are longer in duration, from a minimum of 1 year up to 10 years. Markets tend to focus on the yield of the 10 year Treasury note as an indicator of investor confidence.

Treasury Bonds are also similar to T-bills and notes but they differ in that they pay interest every 6 months and have a duration of 30 years.

Corporate Bonds

Corporate bonds are an attractive alternative to Treasury securities as they have a higher yield than treasuries and can provide diversification to a portfolio as an investor can choose to invest in bonds across various industries. Other attractive features are that corporate bonds are also liquid and less volatile than stocks, along with paying regular interest payments every 6 months. The easiest and best way to invest in corporate bonds is to buy into a bond fund, either through a mutual fund or through an ETF.

Riskier Investments

Real Estate Investment Trust (REITs)

REITs are publicly traded units of a trust that holds real estate. There are numerous types of REITS and most specialise in a specific type of property, such as malls, multi-family, office or industrial real estate. These trusts provide a way for retail investors to invest in commercial real estate without the large capital outlay to buy property directly, or the work involved with managing the property themselves. REITs are also attractive because of the cashflow and distributions they provide. Most REITs pay distributions quarterly or monthly. This makes them attractive to investors who are building a portfolio which provides good cash flow.   

To invest in REITs, you can purchase shares through your broker the same way stocks are purchased. In terms of performance, REITs provide a stable source of cash flow and risk-adjusted returns. Other advantages that make REITs attractive to investors are that they are liquid and can be used in a portfolio to hedge against inflation.

The Best Way of Investing Money

Stocks

When investing in the stock market, there are literally thousands of different stocks to choose from and dozens of strategies on which types of stocks to own and invest in. When selecting stocks it’s important to choose a broad range of stocks from different industries and to also ensure that you aren’t too highly concentrated in a single stock. It’s also important to select good quality companies and stay away from speculative ‘hot’ stocks, as those usually end in disaster. We have an article on stocks for beginners, which goes into depth on how to start investing in stocks and what to watch out for.

Index Funds

Index Funds are an ideal investment for beginner and advanced investors alike. The strategy of using index funds as a primary investment strategy has grown in recent years. One of the appeals behind index funds is that by investing in them you’re essentially ‘buying the entire market’ meaning you’re investing in every stock that the stock index is made up of.

This is appealing as then you’re well diversified and you have exposure to all sectors of the market, which means that you’re always invested in the well performing sectors of the market, at all times. The stock market has a long history of returns as well, so this helps with forecasting and planning future investment returns and what an investor can expect. 

Another advantage to investing in index funds is that it’s a passive form of investing. Most index fund investors utilise a dollar cost averaging strategy to invest in index funds. This strategy essentially sets your investing on ‘auto-pilot’ and utilises the compounding effects of time to build wealth. Although it’s a boring strategy sometimes the simple things are the best things and when it comes to investing in index funds via a dollar cost averaging method, that definitely is the case as there are hundreds of thousands if not millions of investors utilising this method for investing. 

As index funds follow a stock index it means that they are passively managed. So even though there is a professional manager which has created the index fund, they aren’t actively researching new stocks or buying and selling within the fund, unless there is a change in which stocks are included in the underlying index. This means that as the index fund is passively managed the expenses associated with maintaining the fund are lower than an actively managed fund. This translates into much lower expense ratios compared to other funds which is one of the other reasons investors love index funds.

To learn more about index funds, click here.

Mutual Funds

Mutual Funds are another popular investment which are similar to index funds in that they are a fund created from pool capital from numerous investors who then use it to invest in stocks, bonds, or money market instruments to create an investment portfolio. The fund is managed by a professional portfolio manager who makes decisions on how to invest the capital in the fund, in line with the objectives of the fund. 

An advantage to investing in an actively managed mutual fund is that all the research and work around which stocks, bonds etc. to choose, is all done by the manager and team who oversee the fund. This can make investing in mutual funds more of a passive investment choice. 

As mutual funds are actively managed, it means that there are many different types of funds out there, so if you’re looking to invest your money in a certain way, chances are that you will be able to find a mutual fund which has the investments or strategy you’re looking for.

Learn more about mutual funds here.

Understand how to invest in mutual funds with our step-by-step guide here.

Exchange Traded Funds (ETFs)

Exchange Traded Funds (ETF’s) have developed into a popular alternative to investing in mutual funds. This is because they can be invested in through a regular brokerage account, the same way as stocks. ETFs are very similar to mutual funds and there is an ETF for nearly every investing strategy out there.

As mentioned above, index funds have become popular in recent years and most people invest in index funds by buying ETFs. They are easy to invest into and are very liquid because they trade just like stocks. They can also be traded throughout the day and investors can get live price information unlike mutual funds which only update the unit or share price at the end of the day. 

ETFs can hold a basket of assets, similar to a mutual fund. This basket of assets can include stocks, bonds, commodities or currencies. ETFs can also target one specific commodity or currency which can make them attractive to investors who are looking for a pure-play investment in a particular asset.

An ETF also has several other advantages such as tax efficiency and lower fees. Unlike mutual funds that only disclose the funds’ holdings monthly or quarterly, ETFs have transparency to see what the funds holdings are everyday. 

Learn more about mutual funds vs ETFs here.

5. Structuring a Portfolio

After determining your investment goals, risk profile and investment time frame another important aspect to not overlook is how you structure your portfolio. It’s important to get this correct as there are a number of things to consider such as diversification and asset mix. There are different types of portfolios and experts have varying opinions as to which what constitutes a conservative, moderate and aggressive portfolio but here are some of the most common portfolio mixes:

  • Conservative: 70% Bonds or ‘Fixed Income’; 30% Stocks or ‘Risk Assets’ 
  • Moderate: 60% Bonds or ‘Fixed Income’; 50% Stocks or ‘Risk Assets’
  • Aggressive: 15% Bonds or ‘Fixed Income’; 85% Stocks or ‘Risk Assets’

Depending on who you ask depends on what the specific percentages are for each asset class but this gives a general guideline as to generally what each portfolio consists of.

Learn more about how to build an investment portfolio here.

6. Alternative Investments

Alternative investments are the riskiest class of investment which can provide much higher returns but also have significantly more risk. These investments should only ever make up a small portion of an investor’s portfolio, even for the most aggressive investors. 

Initial Public Offerings (IPOs)

You have probably heard someone talk about the hot IPO (initial public offerings) they just invested in or heard of a company going public. An IPO is the process of a private corporation offering shares to the public in the form of a new stock issuance. When a company goes public, it is able to raise funds and use those funds to fund their expansion plans or pay down debt. 

For investors, an IPO presents reward and risk. The reward is that you are able to ‘hopefully’ purchase shares of stock at a lower price than what it will trade for when it’s floated on the market. So if the company performs well during its IPO, you can realize significant gains on your investment. The risk in an IPO comes from uncertainty. Because the company’s shares are going public for the first time, an investor does not know how the company is going to perform and consequently, how your investment is going to perform. You either could earn big or lose big. Investors should approach investing in IPOs with caution. 

Venture Capital

Venture capital is when investors put up capital or funds to invest in small and start-up companies that have a potential for tremendous growth, thus equally tremendous returns. However, the risks are much higher too. 

Since the investors provide high dollar value of capital to small companies, due diligence is performed to check the overall operation of the company, the management, products, future growth plans, etc. This is done after a business plan is created by the company for investors to review.

Venture capital investors are also more likely to play an active role in the business until the time of exit which is usually in four to six years, usually through an IPO, acquisition, or even a merger. 

The Bottom Line

There are many different ways of investing money and there are also a lot of different aspects to take into consideration before choosing an investment and building a portfolio. It’s important to understand your own risk tolerance, investment goals and timeline. If you invest with this in mind you’ll always be choosing the best way of investing money.

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The Ultimate Guide On How To Invest In Mutual Funds in 2021

Investing in mutual funds is a great way to grow your wealth. There are a variety of different mutual funds available and a few different ways of how to invest in mutual funds. With tech and the internet continuing to advance at a rapid pace, it’s now easier than ever to get started. 

As with most financial decisions, it helps to seek advice from an investment professional or financial advisor, but investing can also be done on your own. Regardless of how you decide to get started, it’s still important to arm yourself with the proper knowledge before investing in mutual funds or any other investment.

What is a Mutual Fund?

A mutual fund is a professionally managed fund, which consists of money from numerous investors which is pooled and is used to purchase stocks, bonds, and other assets. The money is managed by a portfolio manager who oversees all the purchasing of stocks, bonds, and other securities based on the fund’s strategy. The investors, in turn, get a share of the profits from the investments. 

Although the first mutual fund was created in 1924, mutual funds didn’t become very popular until the 1980s and 1990s. This investment vehicle grew in popularity because the funds are professionally managed, so the investor doesn’t have to do the research, analysis and asset allocation themselves. The fund managers research on behalf of their investors and select a mix of investments based on the fund’s specific objectives. This is why there are different types of funds such as those that focus on dividend stocks, indexes, growth stocks, fixed-income (bonds), hybrid funds, etc. 

Which Type of Mutual Fund Is Best For You? 

Right now, there are literally thousands of mutual funds that are available to investors. Since there are so many, they are broadly categorized into:

  1. Equity funds (mainly stocks)
  2. Fixed Income (Bonds)
  3. Money market (short-term debt)

Each of these fund types has sub-categories that meet the interest of their target investors. For example, if you’re an investor with a passion for technology, you may choose a technology mutual fund like Fidelity Select IT Services Portfolio (FBSOX). Similarly, an investor looking to invest in fixed income, may want to choose a bond fund that is focussed on government bonds. 

As with all investments, the most crucial factor to consider when deciding which mutual fund to invest in are the risk levels. How much risk are you willing to take, what is your risk profile? Fixed income investments like bond funds are typically less risky than stock funds. Yet, there’s more to it than risk. Other factors that you need to consider are:

  • The minimum amount required to invest in a fund. 
  • The assets under management (this can give an indication of liquidity of the fund look at funds with at least $1B+ in assets)
  • The historic performance of the fund (look at the average 5yr and 10yr returns)
  • Your investment objectives
  • The duration of time you want to invest in the fund. 
  • Whether you want an actively or passively managed fund. 
  • Look at the management fees, compare to similar funds.

How Mutual Funds Make Money 

In 2019, about 46.4% of households in the U.S had invested in mutual funds. People are drawn to mutual funds because they are simple, affordable, and offer great diversification. Instead of taking the time to build a portfolio by investing in one stock at a time, the professional managers behind each fund do it for you. Whatsmore, mutual funds are highly liquid, making them easy to buy and sell. These funds make you money in three ways. 

Dividends

When the securities in a portfolio earn profits, these profits are sometimes distributed to the investors through dividends. It is up to you to decide whether you want to receive your distributions directly or if you want them reinvested. Unless you need the cash flow to live off of, experts advise you to reinvest the dividends to continue building your wealth. Investing consistently for a long period of time is important as the compounding effect will provide tremendous returns in the long-run. 

Capital Gains 

Capital gains are made when a fund sells a security that has increased in price (also check out capital loss). Most funds distribute their capital gains to investors. You can also take your capital gain distributions and re-invest them. 

Net Asset Value (NAV)

This refers to a fund’s market value. As a fund increases in value, so does the value of its shares. Although an increase in the overall fund value is what investors are seeking, it’s not possible to recognize these gains until the shares are sold.

It is important to note that mutual funds can lose money as well. As with all investments, mutual funds come with a level of risk. The securities held by the fund can decline in value, which in turn can mean lower dividends and potential capital losses. Checking the funds’ past performance is one way you can shield yourself from losing money. If the fund or the manager has a history of poor performance, then consider a different fund. It’s also worth considering building a portfolio with a few different mutual funds, instead of investing in a single fund to avoid overconcentration in one fund. 

How To Invest In Mutual Funds

How To Invest In A Mutual Fund

Choosing to invest in mutual funds is one of the best financial moves that you can make to build your wealth. But before we delve into the buying process, it would help if we took a keen look into the factors that you need to consider when choosing the best mutual fund. 

What Are Your Goals And Risk Tolerance? 

As mentioned earlier, you need to determine your risk tolerance and goals for investing. Are you looking for long-term capital gains, or is a passive income more important for you? Do you need the money to put your children through college, or are you enjoying money for retirement? Identifying your goals is the first step towards choosing the right mutual fund. 

The next step is to consider your risk tolerance and time frame. Maybe you are a conservative investor, and you want an investment without much risk of losing your principle. If so, you must balance your expectations for returns against your risk tolerance level. The time frame refers to how long you want to hold on your investments. Mutual funds can be subject to withdrawal fees. So if you wish to access your funds in a short time frame, it might be better to choose a different investment vehicle like an ETF. 

Understand the difference between an ETF and Mutual Fund here.

Which Are Best? Passive or Actively Managed Funds? 

There are distinctions between actively managed and passively managed funds that can have impacts on returns so investors should note the differences.

Actively Managed funds 

These funds have portfolio managers who actively decide the type of securities and assets to put in the fund. The managers of active funds do a great deal of research on assets to consider what sectors of the economy to invest in and will generate great returns, in line with the fund’s objectives. 

Actively managed funds generally seek to outperform a particular benchmark index, depending on the type of fund. The expense ratio for active funds ranges from 0.6% to 1.5%. Which tend to be higher than passively managed funds. But there are benefits for opting for an actively managed fund. For instance, your funds are in the hands of a professional portfolio manager as they continually analyze the stocks and bonds in the fund and monitor market and economic conditions.

Since they are professionals, the managers can avoid investments in sectors that are overvalued and allocate capital to sectors that are undervalued and are set to outperform. Active managers can also take steps to protect returns by selling assets if they spot issues in the market. 

Passively Managed Funds

Passively managed funds, often known as Index funds, tend to track and duplicate a benchmark index’s performance. The manager does not use their discretion to determine whether they should switch gears and pursue a safer investment. What they do is that they follow the Index (very much like an auto-pilot). The expense ratio can be as little as 0.15%, and the fees are generally lower than actively managed funds. 

Passive funds offer the benefit of a well-diversified fund. Since they do not trade as frequently as actively managed funds, they do not create taxable income unless there is a rebalance or change to the underlying index. 

Passively managed funds have two main advantages over active funds. For starters, they have lower expense ratios and secondly, they have lower capital gains distributions. What this means is greater tax efficiency, unlike actively managed funds and lower overall fees paid by the investor.

Presently, there’s a debate on which one is better. Should you go for the passive or actively managed approach? A recent report showed that over the past five and fifteen year periods, no more than 16% of managers in any category of actively managed funds beat their respective benchmarks. Still, no index fund ever performs better than the index fund that they are following. In the second half of 2019, passively managed funds still prevailed in terms of performance despite gains by actively managed funds. This means that passively managed funds are a better choice for more conservative investors who do not necessarily want to take the risks to outperform the market. 

Review Historic Returns

Checking out a manager’s past results requires you to review their track record and see if the fund manager has delivered results consistent with the general market returns. Whatsmore, checking out the fund’s historical trend gives you insight into how a manager performs and can be an indication of performance going forward. 

Volatility is also something to consider when reviewing a fund’s historical returns, have there been years of tremendous gains and then equally as great losses? Or are the returns fairly consistent year to year? This is also an important consideration to keep in mind.

Understand the Fund’s Style of Investment 

Generally, there are two main types of funds, which are growth and income funds. If you are a long-term investor, then growth and capital appreciation funds are your best bet for building wealth. It’s worth noting that these funds are riskier as they hold most of their assets in stocks and particularly growth orientated stocks which can be more volatile. 

Growth funds also do not pay dividends. Therefore, if you are looking for a fund that will provide you income, you should opt for an income fund. Income funds are focused on stocks and assets that produce an income as the main driver of their returns. These types of funds are popular with investors in or approaching retirement. 

Another type of popular investment for those investors who are investing for the long-term but are more risk averse is to choose a balanced fund. Which is usually a mix of assets that are growth orientated and income producing.

Fees & Loads

Fees are the way that mutual funds make money and pay professionals to manage the portfolio. So you need to understand the different types of fees that come with investing in mutual funds. 

The first fee that you’re likely to incur is the load fee. There are the front-end load fees that you incur when you buy shares in the fund. Also, there’s the back-end load fee you pay when you sell the fund’s shares. Both load fees can range from 3% to 8.5%. Another fee that you incur which is called a level-load fee. This is an annual charge that’s deducted from the assets of the fund. 

You can also get a no-load fund which means that they do not charge fees. Still, these funds have other charges like a high expense ratio. Other funds have 12b-1 fees that are included in the share price. These types of fees can be as low as 0.75% of the funds’ average annual assets under management. 

The Size of the Fund

Does the size of a mutual fund affect its performance? Well, in 1999, the size of the Fidelity Magellan Fund reached 100 billion in assets. This huge size led to a negative performance of the fund, and the fund was forced to change its investment process to accommodate its large investment inflow. 

Typically, as a fund grows, its performance suffers, especially if it’s a small-cap focused fund. But in saying that if a fund is too small there could be issues with liquidity if there is a sudden drop in the market and you need to cash out. Also, if a fund is very small it may be  an indication that it is fairly new, and it’s always advisable to invest in a fund that has good historical performance. 

Other Factors

Aside from the factors mentioned, investors should utilize leading investment research platforms like Morningstar to review fund performance. Morningstar has a grading process that ranks funds based on their investment strategy, managers’ longevity, expense ratios, and other factors. This rating category ranges from gold, silver, bronze, and neutral rating. Although it’s tempting to judge mutual funds based on their current performance, you should look at other factors like the fund’s history in terms of performance, fees and risk profile as to whether it fits within your overall investment strategy. 

How To Buy Mutual Funds 

The first step to investing in mutual funds is to decide whether you want to go with an actively managed or passive fund. This decision should be made based in-line with your risk profile and investment objectives. 

The next step is to do your research and determine the amount you want to invest. Depending on the fund type, some have no investment minimum, and there are others with a minimum ranging from $500 to $10,000.

Mutual funds can be invested in directly through an investment management company, such as, Vanguard, Fidelity, etc. Or if you contribute to an employer-sponsored account like the 401(k), then there’s a likelihood that you’re already investing in mutual funds. Alternatively, you can buy mutual funds from an online brokerage.

Lastly, you should set up a plan that helps you continue investing regularly. Investing shouldn’t be a one-time event. It takes discipline, consistency and time to build wealth.

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What Is Compound Interest And How To Calculate It In 2021?

What is compound interest? Compound interest or compounding interest is a great way to make your money work for you. It occurs when you put money in the bank and over a period of time the principal amount accumulates through interest earnt. The interest in the next period is then earned on the initial principal amount plus any previously accumulated interest. 

Compound interest is calculated based on the initial principal, and the accumulated interest from previous periods. It is believed that the concept originated from 17th century Italy and loosely refers to “interest on interest.” This concept makes your money grow faster than simple interest. But how quickly your money grows depends on a number of factors like bank balance, rate, and the number of times your bank pays interest or “compounds,” which is known as the “compounding period.” As a rule of thumb, the higher the compounding period the higher the interest earned.

The positive turnaround of compound interest is the reason that it’s also referred to as the “miracle of compound interest.” In fact, it is reported that Albert Einstein called it the 8th wonder of the world. 

Unfortunately, most people don’t understand what compound interest is all about. A study by ValuePenguin showed that 69% of Americans don’t understand this money term. But this is an important concept that you have to grasp if you want your wealth to snowball. 

There’s so much more to learn about compound interest, and today, we will help you learn more about this financial term. 

What Is The Formula For Calculating Compound Interest? 

Compound interest is something that you can take advantage of if you have a high interest savings account. Yet one of the things that you need to do is learn how to calculate compound interest. 

Let’s start with the concept of interest. When you deposit cash into your interest-earning account your money earns interest depending on the set interest rate. For instance, if you deposit $100 that’s to earn an interest of 7% per annum, you would gain $7 after a year. But what happens the following year? That’s where compounding interest applies. With compound interest, you earn interest on your initial deposit and on the interest that you’ve just earned. Therefore, you’ll get more interest in the second year than before because your account balance is now $107 and not $100. Notice that you didn’t make any deposits but your earnings increased. 

Year 1: Your $100 earned $7 giving you $107. 

Year 2: The $107 earns a 7% interest and your balance after a year is $114.49

Year 3: Your balance of $114.49 earns 7% interest giving you $122.29

The example above is based on yearly compounded interest. However, many online banks compound their interest monthly. The formula for compounded interest is:

Initial principal amount plus future interest e.g. the $7 in our example above, minus the present principal value or amount. 

= [P (1 + i)n] – P

Where:

P – Is the Principal. 

i – Nominal annual interest rate in percentage. 

n – number of compounding periods. 

Suppose you take a 3-year loan of $20,000 at an interest rate of 5% that compounds annually. What would be the amount of compounded interest? In this case, it would be:

$20,000 [(1 + 0.05)3 – 1] = $20,000 [1.157625 – 1] = $1,576.25

You can see from the formula that compound interest takes into consideration the accumulated interest in previous periods. This interest is not the same in all three years. Instead, it accrues until you get the sum of $1,576.25 in all three years. 

When completing the calculations, you need to bear in mind some of the key compound interest variables. They are:

  • Interest – Loans, investments, savings, all they accrue interest. When it comes to compounded interest, we are talking about the interest rate that you earn or are charged. 
  • Principal – The money that you start with or the initial money that you deposit or borrow. 
  • Frequency of compounding – The pace or the rate at which the interest compounds, and can either be monthly, daily, or weekly. It is important for you to understand this factor when taking out a loan or when you start saving. 
  • Deposits and withdrawals – This factor influences how your money works for you in the long-run. You need to determine how frequently you’ll make deposits or withdraw. 
  • Duration – This refers to the period in which you plan to have the account or pay off the loan. 

An alternative formula that you can use is:

A = P (1 + [r / n]) ^ nt

Where:

A– stands for the amount of money accumulated over a given time. 

P- Principal

r- Annual interest rate in decimal. 

n- the number of times interest is compounded annually. 

t- the time or period the deposit lasts in the account. 

For example, let’s say that you deposited $10,000 into a savings account with a 5% interest that’s compounded monthly for 10 years. In this example, P is $10,000, r is 0.05, n is 12, t is 10. Now, let’s put these figures into the formula. 

A = P (1 + [r / n]) ^ nt

A = 10,000 (1 + [.05 / 12]) ^ (12 * 10)

A = 10,000 (1.00417) ^ (120)

A = 10,000 (1.64767)

A = 16,476.7

The Compounding Periods 

A key factor that affects the compounding formula is the compounding period. The golden rule here is that the higher the number of compounding periods the greater the interest. The table below shows the difference that a compounding period can make on a loan that has an interest rate of 6% over a 4-year time-frame. 

What Is Compound Interest

Microsoft Excel is one of the tools that you can use to calculate compounding interest. You can learn more here on how to go about it. You can also use a number of free online compound interest calculators and some handheld calculators as well. One online compound calculator that you can use can be found here. This tool is easy to use and helps you calculate your annual compounded interest. Once you input the relevant data, you get results that show you the interest earned, daily interest, and future value. 

Investor.gov is another platform that gives you a free tool for calculating compounded interest. This site is under the U.S and Securities Exchange Commission (SEC) and offers a user-friendly compound interest calculator. A key feature of this calculator is that it allows you to key in monthly additional deposits to the principal. This feature is helpful for calculating earnings if you deposit additional monthly savings. 

There’s also The Calculator Site.com where you can make the calculations in different currencies. Whatsmore you can factor in monthly deposits or withdrawals and make inflation-adjusted increases to monthly deposits and withdrawals automatically.  

How To Find a Compounding Period

You can compound interest on any given schedule, be it daily, weekly, monthly. However, each financial instrument has its standard compounding schedule. For example, the standard frequency for a CD is daily, monthly, or semi-annually. Most savings accounts and money market accounts have a daily compounding schedule. 

The most common compounding schedule for home mortgage loans, credit cards, personal business loans, or home equity loans is monthly. It is important to note that it is only when the interest is actually credit or added to the present balance that it begins to earn additional interest in that account. 

Some banks have a continuously compounding interest, which is an extreme rate of compounding. In this case, your money earns interest at every possible instant. Still, there’s a mathematical limit and the funds don’t accrue more than the daily compound interest unless you want to withdraw the cash on the same day. 

Continuous compounding interest is dangerous if you’re a borrower. 

Rule 72 

The rule 72 is another strategy that you can use to make estimates about compound interest. The rule here is to look at the rate you earn and the length of time you’ll earn that rate. Next, multiply the interest rate with the number of years. If you get 72, then you have the right factors that will double your money. 

Example: If you deposit $1000 in your savings and earn 5% APY, how long will it take for you to have $2000 in your account? 

You get the answer by figuring out how to get 72. 72 divided by 5 is 14.4. Therefore, it will take you 14.4 years to double your money. 

Example 2: You have $1000 now and want to grow your money to $2000 in 15 years. What rate must you earn to reach your goal? 

Again, you have to find your way to 72 using the information provided. Since 72 divided by 15 is 4.8, you need approximately 4.8% APY to reach your target. 

How Compound Interest Affects Your Savings 

Have you ever been concerned that you won’t have enough savings for retirement or for your child’s college? Luckily, compound interest is one of the ways that you can get your savings to help you out. All you have to do to get started is max out your Roth IRA (As of 2021, $6000 is the limit and $7000 for those who are 50 years or older). Next, we recommend you contribute to your employer-sponsored 401(k) especially if there’s a matching policy (This is essentially free money!). 

Also, you can contribute to an account like a SEP IRA if you’re self-employed. 

The aim is for you to contribute as much as you can, even if you’ll start with as little as $25 to $100 per month. With compound interest, time is your friend, so the earlier you start the better. 

Let’s look at this example. 

Amy, Ben, and Charles experience the same 7% return on their funds. But there’s a difference in their compounding period. For Amy, she started saving at age 18 years with a deposit of $5,000 per year. However, she stopped saving at age 28 at which point she had $50,000 in total. Ben on the other hand begins investing at age 28 with $5,000. He invests an annual amount of $5,000 until he retires at 58 years of age. Therefore after 30 years of investing, Barney has $150,000 in his account. 

Charles is the most diligent saver. He invests $5,000 at 18 years of age and persists until he turns 58. After investing for 40 years, Charles has a total of $200,000 in his account. 

You can see that Ben’s account has three times as much as Amy’s, because Amy only saved for 10 years, whereas Ben saved for 30 years. This scenario shows the power of compound interest on savings. 

The best out of the three is Charles as he never stops investing. As a result, he ends up with an amount that’s a lot higher than Amy or Ben’s. You can see how slow and steady his path to wealth appears. Charles began saving early and committed himself to save $5,000 each year. 

That’s the secret to compound interest. You have to start saving early, so that you can set the ball rolling to wealth accumulation. 

Does Compound Interest Affect Credit Card Balances? 

Now that we know how compound interest affects savings, we need to look at how it works within credit cards. 

Credit card issuers use compound interest to determine how much interest they should charge their customers. The monthly interest charges accrued by customers depends on your average daily balance, plus the interest rate that compounds daily. 

Let’s say you recently went shopping and it cost you $5,000 on a brand new credit card. This new card has a billing cycle of 31 days and a 25% APR on purchases compounding daily. In this case, your first step towards calculating compound interest is to calculate your daily interest rate from your purchase APR. Next, multiply the daily rate by your average daily balance of $5,000. Lastly, multiply the result by days in your billing cycle to get the interest charge for that month. Below is the formula. 

  1. Divide the 25% APR Purchase by the days in a year

0.25 / 365 = 0.00068493 daily periodic rate

  1. Multiply that figure by the daily average balance 

0.00068493 x $5,000 = $3.42465753

  1. Multiply the result with the number of days in your billing cycle to get your monthly interest charge 

$3.42465753 x 31 = $106.16

At the beginning of January, you would have a balance of about $5,106.16. If you were diligent in paying interest and made timely payments of $125 each month, then the balance would never increase or decrease. Paying more than your monthly interest lowers the amount that you have to pay. However,  if you only pay small amounts like $25, you’ll never be able to manage the compounded interest, as your payments are not helping you reduce the outstanding principal let alone the interest that is accumulating. You have to pay more than your monthly interest charges to lower your balance. 

It is important to note that if you commit to paying your credit card in full each month by the due date rather than carrying a balance, you won’t have to pay any interest on your purchases. 

Pros & Cons of Compounding Interest

Compound interest has its advantages and disadvantages. Some of the positives of compound interest is the snowballing effect on money. Now that you understand how compound interest works, you can see that it has a positive effect on your savings. However, it’s important to understand that compounding interest when it comes to credit cards and financial loans can cause you financial harm. So, it is important to be cautious of this when carrying balances on credit cards. For instance, some mortgages compound daily whereas other compound annually. Which one would you go for? A yearly compound interest of 12% per year is better than a daily compound of 12.75% 

Cons of Compounding Interest

Compounding interest unfortunately can work against you if you have a high-interest loan like a credit card debt. The only time this concept works to your advantage is in investments. However it is important to manage compounded interest  when it comes to debt because if you’re not careful you can lose money. What that means is that if you miss a payment by a day the interest rate due compounds. Therefore, it’s up to you to time your monthly payments and try to control them from increasing. 

Compound interest helps lenders and harms borrowers. The credit card monthly repayments are designed to help you keep borrowing and in turn pay high amounts of interest. 

To conclude, compounded interest can be really beneficial when it comes to investing. In fact, compound interest is a powerful force that dates back to the times of the Roman empire, and the ancient city of Babylon. In modern times, famous investors like Warren Buffett used this tactic to build wealth. There’s no doubt that people will continue to use this strategy for a long time to come. 

If you want to build wealth too, then you should use this strategy. 

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Stocks For Beginners: Ultimate Guide To Successful Investing 2021

Understanding stocks for beginners is important when it comes to investing. This is because investing in stocks is a great way to build wealth over time. It’s also one of the easiest ways to start investing. Even if you’ve never purchased stocks before and don’t know anything about the stock market, it’s possible to get started with as little as $1,000 and a bit of knowledge.

Many people shy away from investing in stocks because they think either you need to be rich first or they have a fear that they’ll lose all their money. That usually comes from a place of not understanding the stock market and how stocks work. Below we unpack the basics of investing in stocks for beginners and provide you the information you need to get started.

What is a Stock Exchange?

If you’re interested in investing in stocks you likely have already heard of a stock exchange. The easiest way to think of a stock exchange is a marketplace for buyers and sellers of stocks. When you open a brokerage account and purchase stock, you’re buying the stock through a stock exchange (such as the New York Stock Exchange (NYSE) or the NASDAQ) from someone who wants to sell their stock. The price of the stock is based on an auction method, where bidders choose what price they want to pay (offer price) and sellers offer stock at the price they’re willing to sell at (ask price).

What is the Difference Between Stocks and ETFs

Stocks are a type of equity investment. Companies become publicly traded when they issue shares of their stock in order to raise funds for continued expansion and growth. When you purchase stock, you become a part owner of that company. ETFs are another popular method of investing and are definitely worth considering when building an investment portfolio.

Common Shares

Common shares are the most commonly traded form of stock and what most people hold in their portfolios. Holding common stock means that you own a piece of that company and as a shareholder are entitled to vote at the annual shareholders meeting of that company, but you don’t necessarily have to vote or participate if you don’t want to.

ETFs (Exchange Traded Funds)

Exchange Traded Funds (ETFs) are funds that can consist of multiple asset classes and are traded on a stock exchange in the same manner as common shares. ETFs are a great way to diversify your portfolio as they are made up of numerous investments such as stocks, bonds, commodities or currencies. They are developed by professional portfolio managers and some ETFs are actively managed meaning that the portfolio managers monitor and make changes to the asset allocation within the fund or they are passively managed meaning that once the fund is created the asset allocation pretty much stays the same. 

Some of the most popular ETFs are index funds, which are essentially funds which track stock indexes such as the S&P 500 or Dow Jones. These types of investments have been very popular with investors as they mirror the index so the investment returns will be the same as the index. Investing in index funds is usually paired with the investing method of dollar-cost averaging, which is investing a set amount at regular intervals. 

Ways to Make Money in the Stock Market

Making money in the stock market can be accomplished a few different ways, depending on your investing style and strategy.  Below are a couple of the main ways to make money in the stock market:

Buy Low, Sell High (Capital Gains)

The most common advice for any beginner investor in the stock market is to buy at a low price and sell at a higher price. This concept is straightforward, but not always as easy to accomplish as this essentially what everyone is aiming to do. This is particularly difficult to achieve in the short-term as a day trader or swing trader. To get the most out of buying low and selling high, it’s best to hold your shares for a long-time as over the long-term you’re way more likely to see stock price increases, particularly if you’re invested in good quality companies with a long track record.

Dividends

Not all stocks pay dividends, but if your investment goals include earning an income from your portfolio then be sure to choose at least some dividend stocks for your portfolio. Companies who are well established and have been around for a long time are the ones that tend to pay dividends. Look for companies such as banks, utility companies and others such as telecoms and railroads.

Investment Strategies for Beginners

Investment Goals

It’s important to determine what it is that you want to achieve with your investments. Without goals, you don’t know how much you need to invest and what returns you need to make to get there. It’s also very difficult to stay motivated and continue investing.  

When you invest in stocks, you should be able to list out your targets. For example, do you plan to earn a certain amount of income from your investments every year? Are you looking at a long-term capital appreciation over a long-time period? Or do you have a shorter-term goal like investing for your children’s college which is just a few years away? Depending on your investment goals, your investment strategy should align accordingly. 

Choosing an Investment Strategy

All investments come with risk. Depending on your goals and your risk tolerance, you should apply the most appropriate investment strategy that works for you. When choosing an investment strategy it’s important to keep a few things in mind.

If it sounds too good to be true, it is. 

This is especially true in investing, the average return for the S&P over the past 40 years or so, is around 9-10% per year, if anyone that tries to tell you that they have an investment strategy that can provide returns significantly better than that, it’s best to be skeptical. Professional portfolio managers and hedge-funds rarely achieve consistent returns above 20% per year on their portfolios. 

Look at historical returns

Historical returns can be used as a guide to understand how the stock has traded in the past. Was there a lot of volatility? Does the stock have a long track record of consistent dividend payments? Does the dividend payout grow every year? What was the biggest loss in a single year and how often do down years occur? These are all questions that can be considered when looking at the historical performance of a stock.

Learn some fundamental metrics

There are a lot of different metrics that investors use but here are some of the most common ones. Metrics such as debt to equity, P/E (Price-to-earnings), dividend payout and price-to-book value ratios are all great to use when evaluating stocks. These will help you determine which companies within an industry are better than its competitors.

Before you decide on which stocks to buy, it is important that you have an understanding of the basic metrics of evaluating a good business. It is not enough that you can buy stocks at a cheap price and what you’ll find out is that share price is irrelevant as the metrics are what determine whether a stock is worth investing in. You must always consider how the company is going to perform in the future and what risks the company may encounter, such as new technology or competition which may cause the company to underperform, which will affect your investment.

Stocks for Beginners

Basic Terminology

Price to Earnings Ratio (PE Ratio)

The PE Ratio is used by investors to determine what the value of a stock is as compared to the company’s earnings. In order to determine the PE Ratio, simply divide the current stock price by the Earnings Per Share (EPS). 

The PE ratio is the most popular and widely used metric by investors and stock analysts in order to determine stock valuation. It’s helpful when comparing stocks in the same industry and also when comparing a stock to its historic valuation.

Price-to-Book Ratio 

The price-to-book ratio (P/B ratio) is used to compare a company’s market capitalization to its book value. It’s calculated by dividing the company’s share price by its book value. 

Book value is calculated by taking the company’s total assets minus any intangible assets, such as patents, goodwill, etc. and liabilities. 

The price-to-book ratio is useful as it compares a company’s market value to its book value. This can help an investor determine the value of a company and whether the price of the stock is overvalued compared to other companies in the same industry. 

Payout Ratio

If you are interested to know how sustainable a company’s dividend payment is, you can do so using a payout ratio. The payout ratio is computed as total dividends divided by the net income of the company. 

Keep in mind that when a company which has a high payout ratio it means that the company is paying the majority of its earnings out instead of investing them into the business. It also means that there is limited room for a company to raise its dividend unless its earnings increase. 

Bull vs Bear Market 

Bull Market

A Bull Market is a situation wherein the stock market is on the rise, the economy is strong, and employment is high. 

Bear Market

In contrast, a Bear Market usually signifies a decline in the economy and employment levels are falling and the price of stocks are falling. 

We have a full explanation on a Bull vs Bear market here. 

What to Avoid

Knowing what to avoid when investing in stocks is almost more important than choosing the right investment. There are pitfalls to be aware of when beginning to invest in stocks for the first time. Investing is as much about reducing risk as it is finding a good investment. There are a number of things to avoid as a beginner investor to ensure you don’t take on more risk without realising it.  Here are some of things to avoid when beginning to invest in stocks:

1. Buying stocks without proper research

Before investing in anything, it is always advisable that you do your research and understand what you’re investing in. Understanding what a company does and its financial situation is essential to understanding whether a company is worth investing in.

2. Initial Public Offering (IPO)

Investing in IPOs is never advisable for beginner investors. As it’s difficult to value IPOs and once the shares start trading they can be very volatile. Beginner investors are often tempted to invest in IPOs because they can often provide great returns, but it isn’t always the case. 

3. Impatience

Investing is a long-term commitment. There is always temptation when your investments aren’t providing the returns you expect to start looking for a quicker way to build wealth. Market conditions can sometimes cause your investments to underperform and it can take a while before the market returns to growth. Don’t be impatient, stick to your investing strategy, stay within your risk tolerance and you’ll see results eventually.

4. Attempting to invest based on perfect market timing

First of all, you will not be able to time the market perfectly. No one can, and it’s a fools game to try to time the market. As a beginner stock investor you’ll lose money if you start guessing where the market is going to go. Stay invested for the long-term as we know that over the past number of decades the stock market continues to rise.  Utilising a strategy such as dollar cost averaging can help you eliminate the risk of investing at the top of the market. By investing regular sums of money at regular intervals you’ll likely buy at the top of the market sometimes but also at the bottom of the market at other times.  

5. Investing based on emotions

There are two things that drive the stock market, fear and greed. Fear is a dangerous emotion and if you’re not careful can cause you significant losses. People tend to get fearful when the stock market drops and they want to sell because they don’t want to incur losses. But this is the point when you should be holding onto your stock and trying to buy more, as you’re getting the same stock you already own, but at a discount.

There’s a saying that ‘pigs get fat and hogs get butchered’, this is a bit of a crude saying but it’s to illustrate that being greedy will be your downfall. This is very important to understand when investing in stocks as a beginner. Don’t be greedy with trying to get the biggest return possible or trying to squeeze every dollar out of a stock that has seen a large gain. It’s more important to know where a company is headed and what the future holds for the company as the stock price will align to the company’s prospects eventually, whether up or down. You’ll never get the timing correct to sell at the very top of the market. 

When you make decisions for your portfolio based on your emotions, you will likely forget your investment plans, the fundamentals that we have outlined here and will likely make an error in judgement and risk losing money in your portfolio. So stick to your investment plan and don’t be fearful and sell when the market drops or be greedy and buy more shares when the market is at its peak.

6. Failure to Diversify

Diversification simply means not putting all your eggs in one basket. The reason that diversification is important is that if you have a stock that suddenly drops 30% it could be devastating if that single stock makes up nearly half or more of your portfolio. But if it was only 5% of your portfolio, it would barely affect the overall performance of your portfolio. Diversification reduces risk and helps to avoid significant losses and volatility in an investor’s portfolio. 

7. FOMO (Fear of Missing Out)

In this day and age with social media and being connected more than ever, it’s easy to feel FOMO, even when it comes to investing. This comes back to not making emotional decisions when investing. There are always more opportunities out there, so stick to what you know, what you understand, stay consistent and you’ll build your wealth over time.

How to get started when it comes to stocks for beginners

Now you have a great overview of the basics of investing in stocks. The next step is to open a brokerage account and get started! There are a variety of brokers to choose from, such as WeBull, TD Ameritrade, Fidelity or Vanguard. They all have their pros and cons. If you’re wanting to compare brokerages, take a look at our comparison articles below:

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Traditional Vs Roth IRA: Which Is Best For You In 2021

Individual Retirement Account (IRA) is the main retirement savings plan. Aside from the 401(K) plan, most people are encouraged to open IRA accounts. However, there is a difference between the traditional IRA, established in 1974, and its younger counterpart Roth IRA which was introduced in 1997. 

Traditional vs Roth IRA have some similarities and differences. Understanding what each brings to the table is the first step towards choosing which one is right for you. 

Background on Traditional Vs Roth IRA 

IRA’s are tax-advantaged vehicles designed to help you with investment and long-term savings. The key difference between the two vehicles is tax breaks. With Roth IRA, you contribute funds after you’ve paid income tax. So, once you reach retirement, you’ll withdraw the funds tax-free. On the other hand, a traditional IRA allows you to contribute funds that have not been taxed or the so-called pre-tax income. But withdrawals after retirement are taxable. 

When deciding between Roth and traditional IRA, the first question you should ask yourself is, “Do you think your tax rate in the future will be higher or lower?” 

If you can answer this question upfront, you can decide which IRA will work for you. If you anticipate a higher tax bracket after retirement, then you can opt for a Roth IRA because of its delayed tax benefit. Alternatively, if you expect lower rates after retirement, a traditional IRA is better because it has an upfront tax advantage. 

It can be difficult to determine your tax rate in retirement, especially if you’re just starting out in the workforce. But the good news is that there are plenty of ways for you to figure out which one works for you. 

The IRA Rules of Eligibility 

The IRA rules for eligibility are the first step towards deciding which IRA type works best for you. Your income will determine whether you qualify for a Roth. One point to note is that traditional IRA deductibility is restricted if you or your spouse have a 401(k). 

Currently, anyone who works or earns an income can contribute to a traditional IRA regardless of their age. For Roth IRA, your contributions are never tax-deductible. But, your modified adjusted gross income must be $184,000 or less if you’re married or are filing jointly. If you’re single or filing separately, your gross income must be $117,000 or less; those who make more than these figures can still make partial contributions. Click here for more on eligibility for Roth IRA. 

If you want a Roth IRA but don’t qualify, then there’s a backdoor Roth IRA that can help you get one. 

Understanding Roth IRA 

Similar to other qualified retirement plan accounts, the money you put within a Roth IRA grows tax-free. A Roth account is less restrictive in several ways. For starters, you can make contributions at any age provided that you’re earning an income. You can maintain your Roth IRA account indefinitely, and there are no required minimum distributions, as is the case for traditional IRA and 401(K). 

An account holder can fund their Roth IRA from several sources. They include Transfers, Spousal IRA contributions, regular contributions, conversions, and rollover contributions. The rules state that all regular IRA contributions are made in cash, and you cannot deposit in the form of securities or assets. However, the funds contributed can be invested in various investment vehicles such as mutual funds, money market funds, stocks, bonds, ETFs, and CDs. 

The IRS limits how much can be deposited in an IRA. For instance, in 2020 and 2021, the maximum amount an individual can contribute is $6000. However, people aged 50 years and above can contribute $7000. 

Roth IRAs have no required minimum distributions. Whatsmore, there are no penalties if you withdraw before age 59½. But there’s a 10% Federal tax charge on withdrawals or earnings. 

Opening A Roth IRA 

You can open a Roth IRA account with an institution that has received IRS approval to offer IRA accounts. Such institutions include banks, brokerage companies, federally insured credit unions, savings and loan associations. Most people opt for brokers to open their Roth IRA. 

Once you open an account, you need to make contributions before the tax filing deadline, which is April 15th, the following year. It is important to note that there are no tax extensions. The institution will give you two main documents. They are:

  1. The IRA disclosure statement
  2. The IRA adoption agreement and plan document. 

These documents help you understand how your account operates as not all institutions have the same package. Some IRA providers have an extensive list of investment options, whereas others are more restrictive. Almost every institution offers a different fee structure for Roth IRA, which can significantly impact your investment returns. 

When choosing an IRA provider, you need to consider your risk tolerance and investment preference. If you want to be an active investor and make many trades, you can opt for a provider with lower trading costs. Some providers have an extensive array of stocks and ETFs for their investors; it all depends on what you want in your account. 

There’s so much more for you to consider. For instance, you need to be aware that some providers have higher minimum account balances than others. If you plan to open your IRA account with your bank, you should check if it comes with additional banking products. 

Understanding Traditional IRA 

A traditional IRA allows you to contribute pre-tax income towards investments that can grow tax-deferred. The IRS does not determine capital gains or dividends on income taxes until the individual makes a withdrawal. Moreover, you can contribute up to 100% of any earned compensation up to a specified maximum amount. Income thresholds may also affect your investment. For instance, your contributions to your traditional IRA may be tax-deductible depending on your income, tax-filing status, and other factors. Stewards of the IRA account hold the funds in different investment vehicles depending on the offerings available and the account holder’s instructions. 

As previously stated, contributions in a traditional IRA are tax-deductible. For example, if an individual contributes $7000 to their IRA, they can claim that amount as a deduction on their income tax return, and the IRS will not apply income tax to those funds. However, if one withdraws funds from their account during retirement, the IRS stipulates that the withdrawals are taxed at their ordinary income tax rate. 

In 2019, the IRS, under the Secure Act, removed the age restrictions on contributions to traditional IRA accounts. Therefore, anyone – regardless of age, qualifies just as long as you earn an income. But there are restrictions to contributions, as stated earlier. If you are under 50 years, the maximum that you can contribute is $6,000, and if you’re over 50, the most that you can contribute is $7,000. 

The main benefit you get from Traditional IRA is tax deductions for contributions and tax-deferred investment compounding. Moreso, you get the chance to invest in any stock, bond, or mutual fund that you want. 

Key Similarities & differences Between Traditional Vs Roth IRA

The Roth and traditional IRA offer you an excellent chance to plan for your future. However, there are marked differences that you need to consider before settling on one. One of the key differences is tax breaks. Both investment vehicles provide generous tax breaks, and the only difference is the timing. With a traditional IRA, your contributions are tax-deductible on both State and Federal returns for each year that you contribute. As a result, your contributions, or as they are commonly known as distributions, are taxed at your income tax rate. 

Contributions to your traditional IRA lower your adjusted gross income. This, in turn, helps you qualify for other tax incentives such as, student loan interest reduction or child tax credit. 

Simply put, Roth IRA is the opposite of a traditional IRA. Therefore, you don’t get a tax deduction when you contribute, so your adjusted gross income is not affected. As a result, the withdrawals you make in retirement are tax-free because you pay the tax bill upfront. 

The maximum contribution for both investment vehicles is $6,000 and $7,000 (if you’re over 50). Both Roth and traditional IRA have no age restriction. But remember that contribution eligibility differs. 

The second key difference between Roth and traditional IRA is income limits. If you have a 401(K) or another employer plan, your traditional IRA contributions are limited. If for example, you participate in an employer-sponsored program like the 401(k), and your filing as a single person, you would only qualify to make a full contribution to a traditional IRA if your modified adjusted gross income (MAGI) was $66,000 or less. If you’re married, then the limit is $105,000 or less. The IRS does not allow deductions if your MAGI is $76,000 if you’re single or $125,000 if you’re married. The best you can get is partial deductions. 

Roth IRAs also have income eligibility restrictions. 

The other key difference between the two accounts is distribution rules. A traditional IRA requires you to practice due diligence in making the required minimum distributions (RMDs). There are also mandatory tax withdrawals from your funds at age 72. 

Roth IRAs, on the other hand, have no minimum distributions. You’re not required to withdraw your funds at any age. This rule is what makes the Roth IRA the best investment vehicle. Also, there is no income tax on withdrawals, and users are required to take distributions or else roll the account into another IRA of their own. 

Pre-retirement withdrawals also vary. If you withdraw before the retirement age, you’ll incur taxes and a 10% early withdrawal penalty. However, there are special circumstances where you can avoid the penalty, for example, in the event of a disability or if you want to pay for higher education. Conversely, you can withdraw from Roth IRA tax-free at any time. 

Different rules apply if you want to withdraw your earnings. The Roth IRA is your best bet if you want to avoid taxes and an early 10% withdrawal penalty. But you must have the Roth for at least five years before making a withdrawal. If you want to withdraw sooner from your Roth IRA, you can do so if your meet the requirements below:

  • You’re at least 59 ½ years old.
  • The reason for the withdrawal is financial hardship or disability. 
  • Your beneficiary or estate makes the withdrawal after your death. 
  • You need the money for a first-time home purchase, certain medical costs, or education expenses. 

Table Showing The Differences Between Roth & Traditional IRA 

Key Features Roth  IRA Traditional  IRA 
2020-2021 contribution limits $6,000 for all contributors; $7,000 if you are 50 years and above. $6,000 for all contributors; $7,000 if you are 50 years and above.
2021 Income Limits Eligible individuals who have a MAGI of less than $140,000 if you are single (phase out begins at $122,000). If it’s a joint account as a married couple, the MAGI is $208,000 (phase out starts at $196,000). No income limits as anyone can contribute. But tax deductibility is based on income limits and whether you participate in other employment plans. 
Age Limits. No age limit on contributions. No age limit on contributions. 
Tax CreditAvailable for “saver’s tax credit.” Available for “saver’s tax credit.” 
Withdrawal Rules You can withdraw at any time without incurring tax or a penalty fee. If you withdraw five years after your first contribution and at age 59½, then your withdrawals are tax free. Withdrawals begin at age 59½, and you incur a tax and penalty fee. 
Tax Treatment No tax deductions on contributions. Tax free earnings and withdrawals in retirement. Tax deduction in your yearly contributions. Ordinary income taxes owed on individuals. 
Required Minimum Distribution None for the account owner. Still, beneficiaries are subject to the RMD rules. Distributions must begin at age 72 for account owners. Also, beneficiaries are expected to adhere to the RMD rules. 
Extra Benefits After five years, you can withdraw upto $10,000 penalty-fee to cover certain events, for example, first-time home buyer expenses. There are special instances where you can make early withdrawals, such as hardships, higher education costs. Up to $10,000 penalty-free withdrawals to cover first-time home-buyer expenses. Qualified education and hardship withdrawals are also available.

Which One Should You Go For? Roth or IRA? 

Two factors that you need to consider when deciding between the two vehicles is your future income and your income tax bracket. What this means is that you have to determine if the tax rate you pay on your Roth IRA contributions today will be more or less than the rate of distributions you’ll pay for your traditional IRA later. 

We are accustomed to the norm that gross income declines in retirement and taxable income sometimes does not. Think it over, you’ll be collecting (and possibly owing taxes on) social security benefits and you may acquire income from the investment. In general, think about your tax bracket after you retire. If you think that you’ll be in a higher tax bracket, then Roth IRA is your best option. You’ll pay taxes now at a lower rate and withdraw later on tax-free. If you perceive that you’ll be in a lower tax bracket, a traditional IRA makes financial sense. You’ll get tax benefits today as you’re in a higher tax bracket and pay taxes later at a reduced rate. 

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Bull Vs Bear Market Fully Explained To Invest Wisely In 2021

When you hear the words bull vs bear, the first thing that comes to mind is a dual between the two animals. Bulls and bears are famous for their ferocity, and the thought of such a match is exciting. However,  in this case, when we refer to bull vs bear, we are talking about market conditions that can affect your investments. 

Bull Vs Bear Market Explained:

What is A Bull Market? 

A bull market means that the market is on the rise. It occurs when the major stock markets like Dow Jones industrial average or S&P 500 rise by at least 20% from a recent low. When you hear the term “bull market” in the investment world, it means that the economic environment is growing and thriving. Whatsmore, the unemployment rate is low, and the economy is strong. Such conditions give people the money to invest and encourage investors. 

The last bull market started on March 9th, 2009 and went all the way up to March 2020. According to the norm, bull markets usually start after a fall. In 2020, the downturn came about due Covid-19 fears. By April 2020, the stock market started showing signs of improvement. 

A bull market can last for a few months or continue for several years. The last bull market prior to Covid-19 hitting, lasted about ten years and resulted in more than 400% stock market growth. 

Typically, bull markets last longer than bear markets. Within the last 91 years, bull markets have occurred for 78% of the time.

What Are the Main Signs of A Bull Market? 

Some of the key signs to look for are:

Rising stock prices – When the major stocks begin to rise, investors get confident in the market. 

High Domestic Product (GDP) – A high GDP is a good indicator that the economy is thriving. This is because a high GDP means that the consumers are spending. 

Low unemployment rates – A bull market is an indicator that there are more jobs in the marketplace. 

Other notable bull markets that have occurred in the past include: 

  1. Post-WWII – The years during and after WWII experienced bull market conditions. The U.S economy thrived after the soldiers returned from the war. 
  2. The 1980s and 2000 – The stock market rose by an average of 600% during one of the world’s longest bull markets. That’s from 1980 to early 2000. 
  3. Presently – The U.S has been experiencing bull market conditions since April 2020

Bull vs Bear Market

What Is A Bear Market? 

A bear market is the opposite of a bull market. In this case, the market conditions are on the decline. Major share indices like the Dow Jones and the S&P 500 fall by at least 20% from a recent high. The share prices are on a downward trend, unemployment rises, and firms start laying off employees. Such market conditions discourage investors, and most of them opt to sell stocks instead of buying. 

There’s another market condition known as a correction that’s not to be confused with a bear market. A correction occurs when there’s at least a 10% fall in shares. But corrections are short-term, and Bear markets tend to be long-periods of negative growth. 

Two of the worst bear markets to have ever occurred in the U.S are the Great Depression and the Great Recession. The Covid-19 Pandemic triggered a bear market as the Dow Jones Industrial Average (DJIA) fell for the first time after 10 years. The DJIA was approaching 30,000, but the Pandemic’s impact led to a fall of under 19,000 in a few short weeks. On March 12th, 2020, the S&P also declined, triggering one of the worst bear markets in history. 

Some of the key indicators of a bear market are:

Falling market prices – A lot of people hesitate to buy a stock, which presents a great opportunity for a potential investor as prices are depressed. 

Job loss – Low employment is solid proof of a bear market. 

More “short” stock trading – When investors borrow shares and sell them immediately, hoping to purchase them later at a lower price so they can return them to the lender and keep the difference. It’s a bearish move that benefits an investor. 

On a positive note, studies show that bear markets don’t last long. A study by Morningstar revealed that the average bear market lasts for 1.4 years. Whatsmore, the average cumulative loss from a bear market is 41%. 

To summarize, a bear market means that the market is down, whereas a bull market means that the market is up. 

How Did the Two Market Conditions Get Their names? 

The names were adopted from the way each animal behaves. When a bull wants to attack, it squats its legs, swings its head upwards, and positions its sharp horns for the attack. When you observe a bull, you’ll notice that they are lively and ferocious, very much like an experienced investor. The bear, on the other hand, is seen as a “lazy” creature. This is because it likes to hibernate for long periods of time. When a bear attacks, it squats downwards, very much like the downward trend of a recession. 

There’s the belief that both terms date back to the Elizabethan period and ancient Rome. In those days, the two creatures were used for bloody bear-and-bull baiting shows where they fought for people’s entertainment. Over time, their association was used to refer to the behavior of the market. 

What The Bull & Bear Market Mean to An Investor 

It is important for any investor, be it a passive investor, beginner, or an active investor, to understand how the two market conditions affect their investments. Mostly, the two market conditions are characterized by the direction of stock prices. However, there are other characteristics that you should consider. 

First, the supply and demand for securities behave differently in each market condition. A bull market has a strong demand and weak supply for securities. What this means is that many investors want to buy securities but are not willing to sell. This condition leads to a rise in share prices as investors compete to obtain the available equity. 

However, in a bear market, a high number of investors are willing to sell rather than buy. Share prices drop as more people are willing to sell rather than buy. 

Another key characteristic is a change in economic activity. The stock market and the economy are strongly linked because the shares being sold belong to businesses in the market. Since a bear market is associated with a weak economy, most enterprises don’t record huge profits because customers are not spending. The decline in profits affects the market value of stocks. 

The reverse occurs in a bull market. People in the bull market have money and are willing to spend it. This, in turn, drives and strengthens the economy. 

The bull and bear conditions also affect the investor’s psychology. Since market behavior is impacted and influenced by how individuals discern and react to its behavior, investor psychology and sentiment will affect how the market progresses. Stock market performance and investor psychology are intertwined. Investors have a positive sentiment in a bull market and are willing to invest. Conversely, in a bear market, investors have a negative sentiment and hesitate to invest. Investors move their funds out of equities and into fixed-income securities, as they wait for a positive turn in the stock market. 

So what should you do as an Investor? 

In a bull market, your best bet is to take advantage of the rising shares by buying the ones on demand and selling them when their prices peak. Losses are minor and temporary in a bull market. Therefore, an investor can actively and confidently invest in more equity with a higher chance of earning a good return. 

However, in a bear market, you face a higher chance of incurring a loss. Shares are continuously losing value, and no one can figure out when it will end. If you decide to invest, you are likely to incur a loss before the turnaround occurs. Your safe bet is short-selling and making safe investments like fixed-income securities. 

Alternatively, you can turn to defensive stocks in bear market conditions. These are stocks whose performance is minimally impacted by changing trends in the market. As such, they are stable in all economic conditions (be it a boom or a gloom). Defensive stocks come from government-owned industries such as utilities. 

As stated earlier, investors also stand to gain from the falling prices in a bear market. You can do this through short-selling, buying put-options, or exchange-traded funds. 

The Bottom Line

Both Bull and Bear markets have a significant influence on your investment. Therefore, it would help if you avoided knee-jerk reactions whenever there’s a change in the market conditions. Rather, look at the long-term market performance and gauge it. Small movements in the market are likely to be a correction. On that note, not all long-term conditions signify a bull or a bear market, as there are instances when the market stagnates for a long period of time. 

Stagnations are characterized by a series of up and down movements that cancel out gains and losses, leading to a flat market trend. Understanding all of these instances will take time. But in the end, you should remember that history has shown us that the stock market has always bounced back, even though it may take some time. Make sure that you keep your emotions out of the investment to avoid rash decisions in the event of changes in market conditions. 

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