Budgeting, Financial Planning, Goals, Investing, Planning
In our last post, we kicked off our two part series of addressing the money tasks you’re avoiding and the steps you can take to make progress. Today, we’re covering four additional areas that you can make headway in your financial life.
4. Open an IRA
How many times have you sat down at the dinner table and said to your spouse, “After we eat, let’s open an IRA.” Yeah, probably never. When you actively contribute to your workplace retirement account, invest in a separate portfolio, and funnel money into your savings account, it can be difficult to open – let alone manage – another account.
IRAs are a great addition to your retirement savings journey. They afford more flexibility and control over your investment options, fees, and providers making it an excellent complement to an existing 401(k).
Traditional IRAs operate similarly to your workplace plan. Contributions are pre-tax, investments grow tax-free, and distributions are taxed as ordinary income. To add more tax-efficiency into your retirement planning, it’s also good to consider investing in a Roth IRA.
You fund a Roth IRA with after-tax dollars, the money grows tax-free, and qualified distributions remain tax-free in retirement. This tax-advantage is hugely beneficial for retirees to keep their tax bill at bay. While that might not be your top priority right now, it will pay off later on. You will probably make more money as you advance in your career, which increases your tax liability. By paying taxes in a lower tax bracket now, you end up saving money in the long run by not paying them later.
Roth IRAs do carry income thresholds. In 2020, those making over $139,000 (if filing single) or $206,000 (if married filing jointly) aren’t eligible to make direct contributions. If you want to fund a Roth, it must be done with a conversion from your traditional 401(k) account. Conversions have important tax responsibilities, so consult your tax advisor before initiating.
5. Establish a 529 Plan
When it comes to saving for your child’s education, the earlier the better. A 529 plan can be the impetus of your savings journey. 529 plans are tax-advantaged savings plans for education costs. While contributions are after-tax, gains grow tax-free and remain tax-free for qualified educational expenses like tuition, fees, books, and supplies.
529 plans differ from state to state, and many allow non-residents to establish an account. Be sure to shop around for plans with reasonable fees, investment options, and contribution limits.
Many families use this vehicle to plan for college costs, but 529 plans can also be used for K-12 expenses. The SECURE Act also instituted a provision letting account holders withdraw up to $10,000 tax-free dollars for student loan repayment.
Adding another investment account to your arsenal requires careful planning and attention. Think about the following:
- How much can you reasonably expect to save now?
- Do you plan on using the funds for K-12, college, or both?
- Are you sacrificing your retirement savings to fund the 529?
Knowing how much you can save and how you intend to spend the money can help you make a reasonable plan. Remember, there is no loan for retirement. Saving for education is a wonderful gift, but it should only be done after your retirement accounts are funded.
6. Ask for the Raise You Deserve
There are few conversations more uncomfortable than asking your boss for a raise. It may be especially difficult during COVID-19 where many businesses have made budget, staff, and other office cuts. But the work you do is incredibly valuable, and if you’re overdue for a raise, now is the time to ask for it.
A raise can help you accelerate your financial plan, giving you additional resources to pay down debt, save for retirement, and fund long-term (or short-term) savings goals. Before knocking on your boss’s door (or sending a Zoom invite), be sure you have prepared the following:
- Comparable salary for your position and experience at your company and its competitors.
- Concrete accomplishments you’ve made while in your role.
- Positive feedback from team members, stakeholders, or supporting business units.
- Your desired salary increase. Our tip is to start a little higher to give room for negotiation.
It’s also wise to alert your boss to the nature of your conversation before the meeting, that way you’ll both be ready to discuss your request. Send an email saying you’d like to set up a meeting to discuss your compensation, for example.
7. Revisit Your Goals
Financial planning is too often seen as a one and done task. But financial wellness takes time, engagement, and sometimes even revisions to get right and progress forward. We encourage you to look at your financial goals today. Notice how they may have changed, especially this year, and also how they haven’t. Ask yourself:
- What progress has been made on each of your goals? Celebrate your accomplishments – even small milestones – to help boost motivation and inspire progress.
- Are there any intentional changes you need to make? Perhaps extending the timeline on short-term goals to accommodate any losses and fluctuations this year?
Let your goals inspire the progress you wish to see in your financial life. Returning to your goals can be enlightening and provide the motivation you need to stay the course.
We discussed many financial housekeeping items today. If you have any questions or need help moving forward on any of these, please reach out to our team. We love helping people prioritize and take control of their financial life.
Budgeting, Financial Planning, Goals, Planning
Money is a tool; a tool that can help you shape, design, and live the life you want. Way too often, people talk about money as the destination, when it’s really a medium to facilitate the journey. Financial planning can take your money game up a notch by bringing clarity, strategy, and intention to your financial life. It can illuminate your priorities and get you thinking about money differently. A healthy financial plan gives you the tools to take control of your finances and start living your life with passion, purpose, and freedom.
So what’s the value of a financial plan? Let’s take a look.
Provides Confidence and Clarity
One reason money can be so hard to manage is we don’t talk about it enough. Society tells us money is a taboo, private matter. We avoid it with our parents, change the subject with our partners, skirt the details with our friends, and are embarrassed to bring it up at work. But that’s not how it’s supposed to be.
Financial literacy doesn’t come out of thin air. It has to be discussed and fleshed out to get right.
Financial planning can give you the tools, resources, and confidence to conduct your financial life on solid footing. This information not only illustrates where you are, it also provides intentional moves to get where you want to be.
A financial plan looks at your assets and liabilities, short-term and long-term needs, as well as your goals to structure your finances in a way that suits you. Want to retire early? A financial plan can define your current savings plan, investment allocations, risk profile, desired lifestyle, projected expenses, and more to achieve that goal.
Financial planning shatters many allusions you might have about how money works. The right plan can help you invest, make better spending and savings plans, and develop healthy financial habits. It gives you the confidence to use your money in the best ways possible.
Prevents Costly Mistakes
Losing money is never pleasant, especially when it could have been avoided. Financial planning can help bypass mistakes and unnecessary errors in your money life. This could come in many forms:
- Negative spending habits
- Little to no emergency fund
- Inadequate investment vehicles
- Improper risk management and insurance coverage
- Making emotional financial decisions
- Overpaying on taxes
- Acquiring unnecessary debt
- Incurring penalties and fees
Let’s look at a few of these examples more in-depth.
Tax Planning. A proactive tax plan can save you thousands of dollars every year. It can help leverage your investments, make the most out of capital gains and losses, and lower your taxable income. You can accomplish this task in several ways like strategic charitable giving, maxing out your retirement accounts, tax-loss harvesting, and more. Without a tax plan, you could increase your tax bill and potentially incur needless penalties.
Financial planning brings essential tax-efficiency to your financial choices. With the right plan, your tax needs are baked into your financial choices.
Emotional Investment Choices. A top mistake we’ve seen this year is investors making emotional decisions in the market. Volatility is one thing, but the bear market in March was tough for many people. Even those with a financial plan struggled to stick to their carefully crafted strategy. Emotional decisions, especially investment ones, can be quite costly. Pulling yourself out of the market could lead to an onslaught of tax responsibilities and derail your progress.
When you have a financial plan and an advisor you trust, you’re in a better position to weather market ups and downs. You will have an investment strategy that already accounts for your risk tolerance, capacity, time horizon, and goals. While you’ll still experience volatility, you’ll be in a better position to handle those swings.
Inadequate Emergency Fund. Your emergency fund protects against unforeseen circumstances like job loss, medical bills, unexpected travel, home malfunctions, and more. During the pandemic, many people drew from their emergency fund to cover an income dip or medical expenses. Without this cash reserve, you might have to resort to credit cards, personal loans, or family loans which could put additional strain on already difficult times.
A healthy financial plan ensures all of your bases are covered in an emergency. This means having at least 3-6 months of living expenses earmarked in a highly-liquid account, maintaining proper insurance coverage, and building the right cash-flow management.
Gives Access to Funds with Lower Fees
Let’s face it, investors hate fees. Fees can comprise a significant portion of your investment portfolio, especially for novice investors who may not know the fee structure of certain mutual funds and/or broker/dealer investment strategies. But these elements are crucial to keeping fees low, so you can enjoy more of the returns.
A financial planner can illuminate these fees and carve a path that makes the most sense for you. Your professional can explain different management strategies and highlight the best ones for your needs. Most advisors who promote low-cost investing operate under passive investment management.
Instead of picking and choosing individual investments with high hopes of timing the market, passive management zeroes in on underlying indexes and benchmarks like the S&P 500. This strategy tracks these indexes and builds a portfolio that mirrors its activity. Since the funds are tracking an index, costs are much lower. Why?
- The advisor isn’t cherry-picking investments. That cuts down on time and advisor fees.
- Most funds have a trading fee. The less buying and selling, the smaller the fees.
- Access to lower-cost investments like index funds and ETFs.
Helps You Negotiate Raises
Are you long overdue for a raise? Asking for a raise can be an uncomfortable subject, but it’s critical to take control of your financial wellness. Our team knows broaching a pay raise – even when your experience and skills warrant it – can be a challenge. This is especially true for women.
A Randstad survey found 60% of women have never negotiated their salary with an employer and would rather look for employment elsewhere. But this number isn’t from lack of trying. A Marketplace-Edison Research poll found that men and women both ask for raises with similar frequency, 37% for men and 36% for women. However, only 72% of women who ask for a raise get one, compared to 82% of men.
With women already at a disadvantage with the wage and wealth gap, it is essential to advocate for their value and worth in the workplace. Here are some tools to help you ask for the raise you deserve:
- Do Your Research
- What is the market salary for your position, skills, and experience? What is a comparable salary internally but also externally? Knowing what other professionals at your level are paid can provide a benchmark for your salary.
- Communicate Your Accomplishments
- Even though you know the value you bring to the office every day, it’s vital to accurately communicate those accomplishments to your superior. Give specific examples, point to demonstrated success, and find examples of positive impact and growth.
- Set Yourself, and Your Company Up for Success
- Let your boss know you want to schedule a meeting to discuss your position and compensation. This courtesy will give you both time to prepare.
- Know what you are willing to walk away with.
- Don’t sell yourself short.
A raise can have a notable impact on your finances. It can help you save for your future, like increasing retirement contributions or investing in the market. A raise can also impact short-term goals like building an emergency fund, supplementing tuition payments for your child, or funding that dream vacation.
Affords Peace of Mind
Money can be stressful. Striking the right balance between saving, spending, and investing is a challenge, but the right advice can put you on the path to success. Managing money has many moving parts, making it critical to have someone in your corner to help structure your finances in a way that’s true to you.
Financial planning offers peace of mind, a state easily forgotten in the whirlwind this year has been. With a financial plan you can rest easy knowing your money is working for you, and knowing you’re taking care of your present and future needs.
We love helping people take control of their money and find financial freedom. Get in touch with us today.
Financial Planning, Investing, Planning
Welcome back to the third part of our investment lexicon series. In part one, we introduced the concept of financial markets and discussed their broad reach. In part two, we looked at the U.S. stock market and its many intricacies, including what it is, ways of tracking it, and strategies to approach investing in it. Today, we’ll explore the ways you can participate in the stock market, namely the creation and management of your investment portfolio. What is your portfolio? What is it made of and how can you customize it to fit your needs? Let’s get to it.
Breaking Down a Portfolio
Your investments need a place to live. A portfolio is the place where you house and manage your investments. It consists of all your securities including stocks, bonds, cash, real estate, commodities, mutual funds, exchange-traded funds (ETFs), and more.
Your portfolio is where you customize your investments to suit your needs. It’s how you acquire, sell, and manage your assets, and is your small piece of the market. Portfolios are managed by individuals, money managers, or financial planners, and an investor can have multiple portfolios that serve distinct purposes.
When creating a portfolio, it’s important to keep your risk tolerance, investment goals, and time horizon in mind. A portfolio for a conservative investor will look completely different from an aggressive or moderate investor and that’s good. Your portfolio really should be tailored and customized to your needs and properly adhere to your risk comfort level.
An Overview of Securities
A security refers to something with financial value that can be bought or sold. This is a broad category that encompasses many aspects of the financial market including stocks, bonds, ETFs, and mutual funds. The goal of securities is for companies to raise money in order to keep them running. There are different categories securities fall into: equity and debt.
Equity securities give the investor ownership rights. The most common type of equity security is stock. Most equity securities don’t pay investors regularly in the form of dividends (but this isn’t always the case), and investors tend to make money on capital gains (i.e. the sale of the security at a higher price than the original purchase price).
Debt securities don’t represent ownership, they represent money that is borrowed and will be paid back at a later date. Great examples are bonds and certificates of deposit (CDs). Debt securities often pay investors interest and are usually issued for a certain period of time at which point the investor can reclaim them.
What is Stock?
Stock is a type of investment that represents ownership of a given company. When you buy stock, you are purchasing a share (or shares) in a company that supplies the company with an influx of capital. The goal for companies is to raise money to continue operations and expand their enterprise; the goal for investors is to support companies that will grow in value and eventually make the investor money when the shares are sold.
Public corporations allot a certain number of shares for sale on the stock market. Investors then buy and sell shares on the market with the hope of profits. Many investors hold onto their stock hoping the price (and value) will rise, but that doesn’t always happen, of course. Sometimes companies lose money or go out of business completely which makes stocks a riskier form of investing.
There are two main types of stocks:
- Common stocks are shares of a public company and the most prevalent form of stock investing. Dividends are possible but not guaranteed and shareholders have voting rights. Common stock carries more risk but tends to outperform its preferred counterpart.
- Preferred stocks pay fixed dividends to investors. This fixed-income security often sits in between common stocks and bonds in terms of risk level. The downside is shareholders don’t often have voting rights which eliminates their “say” in the company.
Stocks also have other categories like company size, style, industry, and location.
It’s key to create a strategy around your stock holdings and understand that in order to make a greater profit, it often means holding onto the stock for a longer period of time. With higher volatility, stocks are a good long-term investment as investors have time to weather market fluctuations.
What is a Bond?
A bond is a type of debt security with a structure similar to a loan. When you buy a bond, you are loaning money to a company or government who has promised to pay it back at a certain time. Bonds are considered fixed-income securities because they pay their investors interest, either variable or fixed, along the way.
Bonds are used by corporations and the government alike to help fund their ventures and are often publicly traded. The price of bonds varies depending on many factors. These include the time it takes to mature (i.e. when the bondholder will receive the face value of the bond), and the credit quality of the bond issuer — meaning the likelihood that the bond issuer will repay the loan.
Bonds that pay higher interests to investors often have lower credit ratings, meaning a higher chance of default and longer maturity time frames. Those types of bonds are known as high-yield bonds. The highest quality bonds have good credit ratings and are known as investment grade, and these are backed by the U.S government or extremely stable companies.
Bonds are subject to change based on interest rates. Each bond’s sensitivity to interest rate fluctuations differ but it’s relevant to know they exist. Bonds come in a few different categories:
- Corporate bonds, which are issued by companies
- Municipal bonds, which are issued by cities
- Government bonds, which are issued by the government
- Agency bonds, which are issued by agencies
Each type carries its own set of risks, rules, and regulations. In general, bonds are a safer form of investing but they generate much lower returns compared to the stock market. For example, stock market returns tend to be about double bond returns.
What is a Mutual Fund?
A mutual fund is an opportunity for multiple investors to pool money together that goes towards a certain basket of securities. Mutual funds are operated by money managers and are designed to achieve a certain investment goal.
These funds are a good way to invest in multiple companies at once without having to purchase individual shares of each. One share in a mutual fund represents a broader investment in the market as a whole because mutual funds have a mix of investments like stocks and bonds. The value of a mutual fund is determined by the market capitalization or total value of the fund.
What is an Index Fund?
An index fund is a type of mutual fund designed to track larger market indices like the S&P 500. By investing in an index fund, you can gain broad market exposure while also keeping costs low. How are costs so much lower? You won’t face as many operating costs and your portfolio won’t change as much.
This can be done through passive investment (remember that strategy from part two?). Passive investing takes market timing out of the mix and focuses on the long-term strategy of market holdings. With an index fund, the account manager builds a fund that tracks or mirrors a particular index; this takes out the guesswork and gives investors a more reliable form of investing.
It’s hard to say for sure which method produces the highest returns. In recent years, however, passive investment strategies have been more cost-effective and produced higher returns than actively managed funds which are more costly to operate. Remember, finding the right investment plan for you can be done by assessing your goals, building a portfolio that aligns with your risk appetite, and keeping your investment timeline in mind.
Fees to Learn
Most types of investing will cost you something and you should know the different types of fees you may be responsible for. Before investing in any fund, read the prospectus. This document outlines all fees the fund will charge you, keeping you more informed. Of course, your financial advisor should also make you aware of these fees, but it’s always good to do due diligence.
The first fee to know is an expense ratio. This represents the fee you’ll pay for the management and operation costs of the fund. Some funds have high expense ratios whereas others are much lower.
Keep in mind expense ratios are often taken out as percentages of your returns, so the lower the fee, the better your net returns.
Sometimes funds will have unexpected fees, most notable 12-1b fees for marketing and fund promotion. This fee can’t exceed 1% but it can still add up.
Index funds tend to have much lower expense ratios than actively managed funds, coming in around 0.02% as opposed to .75% or higher.
The Bottom Line
Understanding the different elements of your portfolio can empower your investing strategy decisions and inform the types of investments you choose to buy. Have questions? Give us a call today. We’re happy to walk you through your current portfolio, and help tailor your strategy to better achieve your goals.
Disclosure: Abacus Wealth Partners, LLC (Abacus) is an SEC registered investment adviser with its principal place of business in the State of California. Abacus may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. This brochure is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Abacus with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Abacus, please contact us or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).
This is not an offer to sell any type of security, and there is no investment currently available through Abacus. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell this security. This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Information was based on sources we deem to be reliable, but we make no representations as to its accuracy. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this article will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.
For additional information about Abacus, including fees and services, send for our disclosure brochure as set forth on Form ADV from us using the contact information herein. Please read the disclosure brochure carefully before you invest or send money.
Cash Flow, Investing, Planning
Welcome back to the second part of our investment lexicon series.
By now you have a good understanding of what the market is, how the stock market works, and different methods of tracking market performance. Now it’s time to look at some key tools to keep in mind when investing in the stock market.
Remember, each strategy has its pros and cons so the best way to maximize them is working with a financial planner who’ll help your portfolio reflect the right risk with your financial goals. Let’s jump in.
Diversification
Diversification is a risk management strategy that seeks to ensure your portfolio isn’t over- or underexposed in a certain area. The goal of diversification is for your portfolio assets to balance each other out by maximizing profit and minimizing risk. This is done by ensuring the securities in your portfolio react differently to market conditions in order to maintain that balance.
You can diversify your portfolio across asset classes, within assets, and also geographically (think both domestic and foreign markets). The easiest way to view diversification is in terms of asset classes. Just think, your portfolio could be a mix of stocks, bonds, commodities, real estate, exchange-traded funds (ETFs), and more. Adding another layer, the stocks in your portfolio can be across economic sectors like pharmaceuticals, finance, and petroleum.
Asset Allocation
Building on diversification, asset allocation is an investment strategy that builds your portfolio by weighing an adequate amount of risk for your goals. Asset allocation evaluates how your portfolio is created and the specific securities you are investing in. For example, a more aggressive portfolio might have 80% stocks and 20% bonds.
These stocks and bonds can also be diversified across industries and other markets — so asset allocation and diversification are not mutually exclusive, rather, they work in harmony.
Dollar-Cost Averaging
This strategy helps curb a bad financial habit: timing the market. Dollar-Cost Averaging (DCA) allows an investor to divide the total amount of investment money into smaller, periodic purchases. The goal is to avoid market timing, harness volatility, and hopefully see a better return.
DCA is a great long-term strategy that helps investors build wealth over time. One prime example is a 401(k). You make payroll contributions to this account on a cyclical basis which distributes funds to your portfolio and increases your savings over time. But this strategy can also be used outside of retirement savings accounts like mutual funds or ETFs.
High-Level Investment Strategies to Keep in Mind
Investment strategies are really the fun part. They allow you to customize a plan based on your unique needs and let you approach investing in a way you’re most comfortable with. Let’s review a few that are ideal for new investors.
Active vs Passive Investing
These are two completely different approaches to money management. Each has its pros and cons, though many professionals today encourage the lower-cost passive form of investing.
Active investing is what it sounds like: it actively approaches buying, selling, and trading securities to earn maximum return. This type of investing requires a portfolio manager and often a team of analysts who alter, adjust, and move securities in real-time with the goal of a larger return.
But this type of investment philosophy has some significant downsides. To start, the management fees alone are often overwhelming, not to mention the added fees for buying and selling assets. There are also important tax considerations with this approach which usually results in a higher tax bill.
Passive investing, on the other hand, is a sound alternative that has been proven to match or outperform its active counterpart. Whereas active investing is attuned to short-term market fluctuations, passive investing is a long-term plan. With a passive investment approach, the actual buying and selling of securities is limited and investors rely more on long-term projections than market timing.
Passive investing has many benefits including low cost, increased transparency, and tax efficiency. But critics say it isn’t as flexible and doesn’t offer as great of returns. Active investing gives the investor more freedom to potentially see larger returns, but it also incurs much higher fees and risk.
Growth vs Value
Another dichotomy in the investment world is the difference between growth and value approaches to investing. While both growth and value are desirable aspects of any portfolio, many investors lean one way or another depending on their needs.
A growth investment strategy focuses on companies that are predicted to grow faster than the rest. The hope is the company will grow through additional hires and acquisitions which will lead to added profit, but that isn’t always the case. This style of investing carries more risk and is better suited to investors with a high-risk tolerance and a long investment time horizon.
Value investing takes a different approach. This type of investment looks for companies who fly under the radar, meaning their stock price might not actually represent the true value of the company. Value stocks tend to be safer investments and usually pay dividends to shareholders.
Essentially, growth stocks, since they are more established and more expensive, carry greater risk. Value stocks tend to be more cost-effective and have less risk attached. The type of stock that is right for you comes down to your risk tolerance, investment goals, tax plan, and investment horizon.
Building Your Strategy
There are many different investing strategies out there, and you need to find one that supports your unique goals. Each person’s investment needs may change, so it’s important to know the different ways you can invest. Remember, you can always alter your investment plan as your needs evolve.
In fact, it’s important to update your plan as you move through significant life stages. This is where working with a financial planner helps. Together, you can evaluate short- and long-term goals and adjust strategies based on your current life stage. Want to learn more? Reach out! We’d love to talk to you.
Stay tuned for our next series installment, where we’ll explore the different types of investments in your portfolio!
Disclosure: Abacus Wealth Partners, LLC (Abacus) is an SEC registered investment adviser with its principal place of business in the State of California. Abacus may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. This brochure is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Abacus with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Abacus, please contact us or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).
This is not an offer to sell any type of security, and there is no investment currently available through Abacus. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell this security. This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Information was based on sources we deem to be reliable, but we make no representations as to its accuracy. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this article will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.
For additional information about Abacus, including fees and services, send for our disclosure brochure as set forth on Form ADV from us using the contact information herein. Please read the disclosure brochure carefully before you invest or send money.
Financial Planning, Goals, Investing, Planning
In your quest for financial wellness, you have probably heard countless times the importance of investing as part of a well-rounded financial plan. While this is true, most articles don’t tell you how to invest wisely, what role investments play in your wealth-building journey or even what the Market can tell you.
We understand that you want to invest in a way that’s aligned with your goals and values. But you can’t do that without a clear understanding of what the financial market is, how it operates, and strategies to approach it. In this three-part series, each piece will provide a more holistic understanding of investing and how it works with your financial plan.
Today, we’ll be defining and demystifying the market to give you a more comprehensive view of how investing works.
Breaking It Down
The first thing to define is what we mean when we talk about “the market.” In most news stories and media outlets, it is often referring to the activity of the U.S stock market. But the financial market as a whole is far more comprehensive and includes any medium through which securities can be traded.
While the stock market is one facet, it is far from the only one. Other types include bonds, derivatives, foreign exchange, and commodities. Each of these serves a different purpose, either gaining capital or offsetting risk. They are public which makes them a great place to set transparent pricing and knowledge about trading.
Most of what you will need to know about your investments centers around the stock market.
What is the Stock Market?
It is a subset of a financial market where successful corporations seek expansion (a.k.a cash) through investors. Stocks are shares of ownership in a particular public company that are sold to investors, and profits happen when the company does well and increases its earnings. This is the bare bones of how the stock market functions.
What does it mean for you when it is doing well or is floundering (like during the global pandemic)? For the general state of these activities, we turn to two tough animals: a bull and a bear. Each of these represent a different phase of the market and economy.
The Bull Market
Bull indicates rising stock prices. But beyond this, a bull market is a term often reserved for rising prices over long stretches of time — like what was seen before the global pandemic crash in March.
While there is no set criteria to trigger a bull market, it’s often associated with the rule of 20:
- 20% rise in stock prices
- This rise proceeds a 20% fall in prices
- The rise precedes another 20% drop
These are hard to predict and there’s no prescription for how long they last; it could be months or even years. We experienced the largest bull market run in history from 2009 to March 11, 2020. These market conditions happen when the economy is strong, there is a solid gross domestic product, decreased unemployment, and overall optimistic investor morale.
The Bear Market
Bear indicates falling stock prices — a day all investors know will come but hate when it does anyway. Although there are no hard and fast rules, they are often marked by at least a 20% drop in stock prices. A market correction, on the other hand, is more in line with a 10% drop in prices. In bear markets, the economy tends to slow down along with a spike in unemployment numbers.
How did these animals become an economic metaphor for market health? It has to do with each animal’s preferred method of attack: a bull plunges its horns in the air, a bear swipes its paws downward. Interesting tidbit for your next Zoom family party.
Understanding Market Volatility
You may hear talk about market volatility and wonder what that really means. Market volatility measures the fluctuation of stock prices. If the volatility is low, there is little change; but when volatility is high, big changes can be expected.
How is volatility measured?
Since volatility is a matter of statistics, it’s usually measured by the standard deviation or variance between the returns of a specific security (stock, bond, etc.) or market index across a certain time frame. Time is a crucial factor when it comes to volatility as the volatility of something can be measured in days, weeks, years, etc.
So when talking about volatility on a larger scale, we are really talking about risk. If a security has higher volatility, it is often a riskier asset than one with lower volatility. Since volatility looks at the statistical return of a specific asset or index, it’s important to understand how it works and what influence it may have on your risk tolerance and portfolio management.
Introducing Market Indexes
An index helps indicate market movement by tracking a certain basket of securities. These securities are monitored for performance and intended to represent a certain part of the market. Each index has different weighting systems to measure progress.
Indices are a great way to get a sense of what the market is doing. While there are several indices out there, the two most popular are the DOW and the S&P 500.
The DJIA
The Dow Jones Industrial Average (DJIA) index tracks 30 blue-chip stocks representing the major market sectors like IT, pharmaceuticals, finance, chemical, and more. The only sectors it doesn’t represent are utilities and transportation (which have their own index).
The DJIA is a price-weighted index, meaning overall performance is primarily determined by the price of the stocks within the index. This type takes the price of all stocks in the index and divides it by the number of companies to get the index’s value. This means a higher-priced stock gets more weight than a lower-price stock, making a change in stock prices an important determinant of its performance.
The S&P 500
Unlike the DOW which tracks 30 stocks, the S&P 500 tracks 500 stocks across all economic sectors. To enter this index a company has to meet specific criteria:
- It must be a U.S company
- It must reach market capitalization of at least 8.2 billion (as of 2020)
- 50% of the stock must be available to the public
- Four consecutive quarters of positive earnings are required
- Possesses positive liquidity
The S&P 500 is weighted differently than the DOW. It tracks the market capitalization of all companies in the index. This just means the index tracks the total value of a company (in terms of the market) measured by stock price and number of shares.
Which Is More Reliable?
Indices are designed to represent the market as a whole, making a comprehensive view important. The S&P 500 tracks more securities and also looks at the total market value of each company (as opposed ascertaining true value with just the stock prices). These factors make it more reliable than the DJIA, giving investors a better overview of market activity.
The Bottom Line
The financial market is a fascinating arena and an excellent way to help you reach your goals. But before investing, it’s important to know how the system works so you and your financial advisor can create a portfolio that truly reflects your needs.
Look for Part Two of our series where we delve into types of investing strategies!
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