Stocks versus funds? Growth versus value? This confounding market has sent many of us back to the basics. Here are some answers to questions you might be asking.
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It’s downright nasty out there. Jobs keep disappearing. Scared consumers have stuffed money under mattresses instead of spending or investing.
We’re all getting back to basics like friends, family and frugality. In the market, old hands have been forced to reconsider their basic assumptions, and newer investors wonder whether anything they’ve learned thus far still holds.
To help sort through the confusion, here are my answers to 10 simple (and not-so-dumb) questions we have to be able to answer before we can move ahead.
1. Should I own stocks?
This may seem like a candidate for Dumb Question of the Year in the midst of a precarious rally following an epic bear market that saw a fall of 50% from its high. But the answer is the same as it has always been: Yes, you should own stocks, assuming you are saving for a long-range goal like retirement or college tuition. Over the long run, stocks do better than other investments.
But here’s a good basic rule of thumb: Don’t put or keep money in stocks if you need it in less than five years. (Read "When’s the right time to invest?" for more on this.)
2. How do I know what a stock is really worth?
In the short term, what a stock is worth is exactly what someone will pay for it today. But that doesn’t help you invest for tomorrow.
The value gauge used most often by the pros is the price-earnings ratio. To calculate the ratio, take the current price of a stock and divide it by its earnings for a year. If a stock trades for $50 and is expected to earn $1 a share next year, it trades for a P/E ratio of 50.
Investing guru John Neff counted it as one of the key tools behind the 13.7% average annual returns he produced while he managed the Windsor Fund (VWNDX) from 1964 to 1995.
This ratio tells you whether a stock is cheap, meaning that it trades for a lower P/E than stocks of similar companies. But the biggest insight from the ratio, Neff says, is that it tells you what kind of growth other investors expect. If their expectations are too high, they’re willing to pay more, and the P/E ratio will be high.
For example: If one stock trades for a P/E of 50 and another trades for a P/E of 10, it means investors are willing to pay five times as much for a dollar of earnings at the first company. That’s usually because they expect earnings to grow much more rapidly at the first company. Neff reasoned that since investors have higher expectations for that stock, it runs a higher risk of crashing if it posts disappointing results, writes John Reese in his recent book "The Guru Investor."
Neff, as a value investor, favored cheap stocks of companies that were so disliked that people wouldn’t pay much for them. They had extremely low P/E ratios — often in the single digits. He knew that bad news wouldn’t drive them much lower and that any improvement would drive them much higher.
3. What’s a PEG ratio?
So-called growth investors prefer stocks in fast-moving sectors such as technology, which tend to have high P/E ratios because of higher growth expectations.
They compare a company’s P/E to its expected growth rate. Generally, a company is considered fairly valued if its P/E is the same as its growth rate. And it’s considered cheap if the P/E is below the growth rate. This ratio of P/E to expected growth is called the PEG ratio.
The PEG ratio helped one of the world’s most successful investors ever — Peter Lynch — produce 29.2% annual growth at Fidelity Investment’s Magellan Fund (FMAGX) when he managed it from 1977 to 1990.
4. How much do dividends matter?
Cautious investors love companies that send profits to shareholders. Companies that pay dividends tend to be in more-stable sectors, such as consumer staples or utilities, and they pay investors through good market times and bad. And with so many of us suspicious about Wall Street, dividends are real money you can trust more than forecasts or projections.
When shopping for dividend plays, though, avoid the trap. If dividend yields — dividend divided by stock price — are sky-high, it could be because the stock price has tanked or because of some serious problem not yet revealed. Troubled companies eventually cut their dividends. Be suspicious of a yield over 10%. (Read "Stocks that pay you to own them" for more.)
5. Should I buy individual stocks or mutual funds?
These days, some experts say single stocks are simply too risky for most investors. The real answer depends on how much time you have.
If you go with stocks, you’re going to need a portfolio of at least a dozen and probably more. A variety keeps you diversified, so that problems in one company or sector won’t wipe you out. You also need the time to understand and track those stocks; if you don’t, you’re speculating, not investing.
Mutual funds let investors pool their resources so that a professional money manager can invest for them. The problem here is that the returns posted by most mutual fund managers trail the market, partly because of their fees. (Read "Are fund managers worth their pay?" for more.)
You also get a tax bill as they buy and sell and, hopefully, collect capital gains.
A solution is to go with index funds that invest in a broad basket of stocks such as the S&P 500 Index ($INX). The fees are lower, and you get the diversification you need. Plus the stocks are traded less often, so the tax burden is usually lower.
6. What’s the difference between a mutual fund and an ETF?
With a mutual fund, you give your money to a fund company, which then invests it in such things as stocks or bonds. The fund’s value is calculated once a day, after the markets have closed. An ETF, or exchange-traded fund, is a basket of stocks, bonds or commodities that usually follows an index and that you can buy and sell throughout the day, just like a stock.
ETFs typically have lower expenses and fees, but, as with a stock, you have to pay a commission to buy them. Because you control sales, you have more control over when you’ll get a tax bill for taking profits.
7. Why can’t I time the market?
It looks easy because stocks go up and down so regularly. If you could consistently buy on the dips and sell into the rallies, you could retire in no time. Unfortunately, even most pros find it hard to time the market. Most hedge funds did horribly last year, for example.
There are two basic reasons it’s difficult. First, predicting what’s going to happen next at a company or in the economy is only half the problem. You also have to predict investor expectations, because they set market prices as much as anything else, points out Axel Merk of Merk Mutual Funds. Predicting what a large crowd is going to think next is virtually impossible.
It’s also tough not to get caught up in the emotion of the moment. When everyone is bullish and stocks are rising, you’re likely to do the same and stay in the market too long. Likewise, at market bottoms, things are typically so gloomy that you won’t want to put money into stocks. Because markets tend to move up over long periods, the best thing is to spend time in the market rather than try to time the market. (Read more in "The 5 biggest 401k mistakes.")
8. What is dollar-cost averaging?
A simple way to deal with the fact that you can’t time the market is to dollar-cost average. Put the same amount of money into the market at the same time every week, month or quarter.
True, you’ll rarely get the best prices. But you won’t always buy at the worst time either — at the top, when it is easiest to buy because you feel most confident. Instead, you’ll get an average of the prices of stocks over time, which is better than what would happen if you just followed your emotions. (Read "Wade into the market? Or plunge?")
9. What are bonds?
Bonds are loans — to companies or governments. They typically offer regular interest payments every quarter through what’s known as coupons. Then when the bonds expire, or reach maturity, you get your original loan back.
Bonds are generally safer than stocks. But returns tend to be lower, and they do carry risks. Bonds issued by companies carry credit risk. That means companies could do so badly that they go out of business and can’t pay you back.
Bonds also present interest-rate risk. Once a bond has been issued, its price in the market will move in the opposite direction of interest rates. When rates go up, the prices of existing bonds have to fall so that they offer a higher return to anyone who wants to buy them at that point.
None of this matters if you buy a bond outright and plan to hold it until the loan is repaid. Your gain is the interest — or coupon — that you signed up for at the start.
But if you buy bond mutual funds, it’s a different matter. The value of the fund is affected by the prices of bonds in the fund. If interest rates go up, the price of the bonds in your fund will sink, and so will the value of your fund. The fund value could then stay down for a long time, depending on how your fund manager reacts.
10. Should I own gold?
At its best, gold serves as a store of value for the times when things get so bad that all other assets, such as stocks, bonds and home values, are falling apart. Look at it as a kind of insurance.
But unless you are a gold bug or a survivalist who also keeps a year’s supply of food and water on hand at all times, it doesn’t make sense to have more than about 5% of your wealth in gold. The reason: Gold prices are extremely volatile, and it’s tough to predict where they are going next.
Historically, gold prices go up when the dollar sinks, when oil prices rise and sometimes when inflation heats up. But since predicting any of those trends is tough, it doesn’t make sense for most average investors to hold gold as a play on those themes.
How should you own gold? The survivalists like bullion buried in the backyard. But for most people, gold is costly to store, and commissions are high. The gold ETFs make more sense for a portfolio. ( Read "Why gold prices will keep rising" for more.)
And there you have it: 10 basic answers and some rules to hold on to at a time when nothing seems particularly simple. They won’t bring your portfolio back overnight, but they might help you get back on track.
Looking for other answers or have your own rules to offer? Post your questions or comments on the Your Money message board, and I’ll consider them for a future column.
At the time of publication, Michael Brush did not own or control shares of any fund mentioned in this column.
Updated Sept, 25, 2009