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Indices

Something I like about writing to educate is that it really makes you stop and think about what you’re writing and, if someone really knows what you’re talking about.

I started writing a post on something else and realized that I was using terminology that I hadn’t even described. The point of my blog/site is that it’s a one stop shop that uses the most basic examples for people to understand so I had to rewind and go back to this a step and write this post.

The term index is used a lot in the financial world. You may have heard things like ‘the S&P is up’ or ‘the Dow is down’ but what are they and what do they mean...

An index is designed to be an indicator of how a particular industry or section of the market is performing. It helps make spot check reference to the market and allows people to explain and predict broad trends in the index.

Examples are our best friend...

S&P 500

The S&P 500 tracks the 500 largest publicly traded companies in the USA. It puts them all together in a basket and from there, one can track how the overall market is performing.

People like it because of its diversity and depth.

The space a company takes up in the index is relative to its size as a company (the big tech companies - Amazon, Google etc all represent a larger amount in the index because they’re bigger).

Dow Jones Industrial Average

The DJIA is very similar to the S&P500 in that it tracks a number of stocks. In this case though, a lot less that the S&P - the dow only does 30.

The 30 companies are the largest blue chip stocks (established, stable, and well-recognized companies) that are publicly traded. \

So, when you hear someone say ‘the s&p is up’ then it means, on average of 500 companies, is performing well. The is the same with the Dow but, when someone mentions the Dow performance - it represents a much smaller, more concentrated number of stocks.

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FUNd

If you follow any kind of financial news the chances are you will have heard of a ‘Fund’... but what is it and why do people invest in them?

There are many different types of fund - Hedge, Mutual, Exchange Traded, Index to name but a few and, while they all have different investing methodologies so all intrinsically similar.

You and I, as individual investors, can trade a company's stock, bonds, commodities etc. on a public market (like the stock exchange).

However, there are investment companies which offer to pool our money into ‘Funds’. We give the investment company our hard earned money and they will bundle it together and trade on our behalf. The aim/hope is that they get positive returns from this money which is good for us - we make money and don’t really have to do ay work ourselves.

So that’s all a fund is... a pool of money from different sources. It means that (hopefully) the returns are greater because there is more money invested and, because the fund invests in different companies and/or sectors then, the returns of are not affected by fluctuations in a single stock.

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The Stock Market

A market is somewhere you go to buy and sell goods. For example, a supermarket is where you go to buy and sell food, drink etc.

So it should come to no surprise that a stock market is where someone goes to buy/sell stocks.

It is where potential investors/buyers go because they want to buy a stock.

It is where sellers of stocks to go if they have stocks they want to sell.

It is important to note that the company (whose shares you are buying and selling) are not involved in this example. Only other investors.

The price of stocks is determined on supply and demand of said stock - if demand it high then the price of the stock will be high.

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Interest Rates

In short, Interest Rate are the cost/price of borrowing money.

If we think about it, everything has a price.

You pay a cleaner to clean and you pay a taxi driver to drive you. In the same way, you pay a bank to lend you money.

The bank lends you money with the understanding that you will give it back... plus a little bit extra (everything has a price).

The money you pay the bank to lend you money is the interest rate.

What does this mean?

Interest Rates are always in the headlines.

Very broadly, a lower interest rate is is usually the sign of an unhealthy economy because the banks are trying to encourage people to spend more money to stimulate the economy by charging you less you borrow money.

A higher interest rate means borrowing money/debt is more expensive long term because the interest you pay back to the bank is higher.

Example

Two people, two loans, two banks, two interest rate...

In this examples, I am using an interest that is incurred monthly. It can also be yearly.

If Banky Bank loads you $100 at a 1% interest rate, then after one month you will owe $101. When the interest rates are this low - it encourages people to borrow more money because it’s cheaper. Of course, you still have to pay the money back and, there is a cost associated with it but, it’s a lot less than the example below.

If Banky Bank loans you $100 with a 10% monthly interest rate, than after one month you will owe them $110.

This is good for Banky Bank because they make some money. Plus if they make that deal with 15 people, and they don't pay the bank back immediately, they’ve got an extra $10 from 14 people to make up for the $100 that they lent on you.

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Bonds Examples

Now that you know some stuff about bonds, let’s look at a simple example.

James’ Cleaning Company (JCC) needs money to buy more cleaning equipment and to expand into other markets. JCC has already given away 30% of ownership by issuing shares. James, the founder and CEO, decides he doesn’t want to give away any more ownership of his company and  the bank won’t lend him the money so JCC decides to issue bonds.

JCC decides that it needs to raise $1000. It believes that it can pay it back in 10 years. For ease, we will assume a 10% annual interest rate and the bond maturation (when the investor will receive his initial $100 he/she loans to JCC) is in 10 years.

JCC finds 10 people who are willing to buy 1 bond for $100 each. 

Geff is one of these people. He buys 1 bond, for $100, the annual interest rate is 10% and the maturation is 10 years.

Every year, Geff will receive 10% of the money he loaned to JCC ($100). Hopefully, we all know that 10% of 100 is 10. So every year, Geff will receive $10 from JCC.

Year 1 - Geff receives $10.

Year 2 - Geff receives $10. 

Year 3 - Geff receives $10.

Year 4 - Geff receives $10.

… 

Year 10 - Geff receives $10 + $100 (his iniital investment)

Was this a good investment for Geff?

He lent $100 and got it all back. 

On top of that he received $10 every year for 10 years.

All in all, Geff made an additional $100 ($10 x 10 years) AND got the money back. So yes, this is a great investment. Almost too good to be true.

Spoiler alert: It’s never this simple in real life and yeah, the example was too good to be true.

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Bonds continued

Why would a company issue bonds? 

They need money. 

They might need this money to build a new factory, to open a new shop or to spend more on research - there are many reasons why they would need the money but, at the heart of it, they just need the money. 

Why not issue more stock?

So they don’t have to give away any ownership in the company. 

As we have seen, issuing shares to raise money is a very viable way of conducting business but you have to give away some ownership which a lot of companies don’t want to. 

To oversimplify it, bonds are an  “easy” way for the company to raise money - the only obligation they have is to pay you back the money you loaned them, plus the interest. They still maintain undiluted ownership.

Ok ok ok ok.... So why don’t they take a loan from the bank?

When the corporation needs money they usually need A LOT. I am talking hundreds of millions. If a bank was to lend a corporation this much it would be very risky for the bank to do. If the corporation suddenly went bankrupt and was unable to pay it back, the bank would probably go bankrupt too. 

By issuing bonds, the corporation is effectively crowdsourcing a loan. They are giving bonds to thousands of people. The risk is spread out - no one person or bank assumes all the risk and the corporation still gets the money it needs. For the investors (the ones loaning the money by buying the bonds), it’s a way to invest your money relatively safely.  

So I am always going to get paid? They sound too good to be true. What’s the catch?

With bonds, you know that you’re going to get your money back at the end of the agreed upon time (unless the company goes bankrupt), plus interest.

There isn’t really a catch but more, a managing of expectations. 

The amount of interest a bond issuer pays is based on the likelihood that they can pay back the bond. The “safer” the corporation (bond issuer) is and, more likely to pay it back, the lower the interest rate will be. If you are feeling more risky then you can loan money to corporations who will pay a much higher interest rate but there is also a higher chance that the company may not be around in a few years to give you your money back.

When you see a bond’s rate - the higher the interest rate, the higher the risk. 

Why would people invest in Bonds if the rate is so low?

They’re considered a safe investment. You are guaranteed that money plus interest at the agreed upon time. You know what you’re getting and they’re stable.

If you buy shares in a company, yes, they can rise but they can also fall. For example, in 2008, some companies lost 75% of their value. If you bought a share in a company for $100 in 2007 and the next year it was worth $25 would you be able to afford that loss?

With a bond, you’re not going to experience any dramatic swings in prices like that. You are just going to get regular payments with the amount you lent at the end. If there was another financial crash, regardless of what happened to the company's stock price, you’re still getting paid.

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Bonds

What is a bond and how do they work?

In short, a bond is a way of lending money. It is a loan between an investor (you) and a corporation. You, the investor, lend money, to the corporation, for a certain amount of time, and get it back with interest. 

So it’s just a loan?

Yes, but as we know, the finance world doesn’t like to make it easy for others to understand. I don’t want to complicate things but I am going to have to with some fancy wordplay...

Yes, a bond is a loan, plain and simple. The only spicy part is using the word ‘bond’ and ‘loan’. 

You loan the corporation money ‘in the form of a bond’. As a concrete example, if Company A, raised $100 million, by issuing bonds they issued $100 million worth of bonds.

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Why do stocks exist?

Rather than give you a long winded, jargon filled explanation, I think it is best and, most easily explained, with and example.

In short, companies will trade ownership for money.

James starts a cleaning company. James’s Cleaning Company (JCC). Now the problem is, James has no money and thus, doesn’t have anything to clean with - no brooms, window cleaner, mops... nothing. The only thing he has is a positive attitude and a love for cleaning. James also wants to put some advertisements on Facebook and Instagram so that he can target people who might want to use JCC. Again, he has no money to do this.

Rather than go to the bank and get a loan, and get himself in debt. James decides to sell part of JCC to his friends. In return for an ownership stake in JCC, they will give him money for the shares and he can use that money to buy equipment and put some adverts online. This act of selling shares in JCC is called ‘issuing stock’.

To make this easy, James thinks that the total value of JCC is worth $100. James wants to keep most of it to himself but decides that he is willing to give up 30% which, thanks to some nice easy numbers, is $30. James decides that 1 share is worth $1. Thus, is is going to give away $30 worth of stock.

James sells 10 shares to Jovo for $10.

James sells 10 shares to Sarah for $10.

James sells 10 shares to Margaret for $10.

So, who owns the company now?

James owns 70%. His shares are worth $70.

Jovo owns 10%.

Sarah owns 10%.

Margaret owns 10%.

In exchange for giving away 30% of his company. James, now has $30. He goes and buys some new cleaning stuff and also puts some adverts online to attract some new customers.

This is the crux of why companies issue shares. They need money for stuff. An online company might need the money to pay for servers, a pharmaceutical company might want the money to invest into research so the create more drugs.

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Da fuq are stocks?

You hear a lot of people talk about ’stocks’, and it’s in the news and sounds cool so lets actually talk about what they are, how they work, why companies give them away and, how they make you money.

Firstly, it’s important to note that the word ‘stock’ is interchangeable with the word ‘share’ and, both refer to ownership in a company.

If you own 1 stock, or share, of a company, you own a part of that company.

How much you of the company you own through the stock, depends on the total number of shares the company has issued (how many little pieces it has split itself into).

When you own stock or shares in a company you are referred to as a ‘shareholder’ or, sometimes albeit less commonly, a ‘stockholder’. You, literally, hold the shares and stocks (ingenious right)!?

In the past, you would have been given a little piece of paper saying that you own a piece of that company. It is now all done digitally, and rather than being given a piece of paper you will see it through an app or your desktop (more on this later).

Let’s round this off with a quick example to make it super duper clear.

1. James goes online to buy 1 share of Amazon. 

2. He is now an ‘Amazon shareholder’ (you can replace any Amazon with any company - Google, Apple, Gamestop).

Easy right?

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Why Invest

In short, so future you can have more money than present you. 

And, just in case you were wondering WHY future you would want more money than present you, other than to build your wealth, here is a list of a few reasons:

To beat inflation. 

Retirement 

To hit your financial goals

The aim of investing is to generate money in the future by putting your money into financial products whose value will grow. The way that you generate cash is by:

The value of your investments increasing. 

Through Dividends.

Payouts from Bonds. 

Through the sale of the company, you have invested in. 

Would you rather

Let’s play a game of ‘Would you rather’

It’s December 31st, 2019 and, you have $1000 saved that you don’t need right now. You could do several things with it: 

Leave it in a Chequing account.

Invest it

Put it in a Savings account. 

Now it’s December 31st, 2020 and, depending on how you chose to use that money you could have:

a) $1000

b) $1180

c) $1000.50 

Would you rather have a, b or c?

I am going to guess you chose, b, of course, who wouldn’t want an extra $180 that they didn’t have at the start of the year and, given I am writing about investing in the stock market, those 18% returns, are from investing the money in the stock market. 

How did I get those numbers?

This is what would happen if you left your money in your checking account. You wouldn’t lose any money, but you certainly wouldn’t make any. That money would be the exact same amount as it was when you started. 

This is what would happen if you invested your money in a stock market index tracker fund (this one specifically is the S&P 500 which focuses on the top 500 companies that are listed on stock exchanges in the USA)

This is what would happen to your money if you placed your money in a bank’s Savings Account (in this case the CIBC eAdvantage® Savings Account which offers an interest of 0.05% - they call this a high rate of interest which is asinine). Your money would hardly grow at all. In fact, after fees, you would probably have less money than you started with)

Clearly, hindsight is a wonderful thing but, what I am trying to highlight is that, with interest rates at record lows, you need to actually do something with your money, if you want to grow your wealth, beat inflation and save for your financial goals/retirement. Your bank won’t provide you with a great savings rate. You have to look further afield (hint: rhymes with binvest). 

There is a lot to unpack from this, and I will endeavour to do so in subsequent posts. Hopefully, I have given you, the reader, a very high-level overview of why investing is a good thing, how your money can grow, and, with awful interest rates, the other alternatives for your money don’t offer you much.