Lesson 1: Funds, Stocks, Performance, and the Investment Ladder

In Lesson 0, we discussed:

1. The stock market versus the economy
2. The stock market versus a market of stocks

In Lesson 1, we will discuss:

1. Active-managed mutual funds versus passively-managed index funds versus stock-picking
2. Absolute performance versus relative performance
3. The investment ladder and where stocks fall on it

So let's get going.

1. Active-managed mutual funds versus passively-managed index funds versus stock-picking

We need to break this up into two sections, first mutual funds versus index funds, then funds versus stocks.

Most actively-managed mutual funds actually fail to beat their index benchmarks (many use the $SPX), whereas passively-managed index funds typically replicate the exact performance of an index within a few basis points (for those non-versed in bond-speak, 100 basis points = 1%, so 1bp = 0.01%). I've heard from several source something like 2/3 of active funds fail to beat their index benchmarks. Plus, the active funds charge you much higher fees than the passive funds (typically 2-5x more). So, let me ask you this. Why in the world would you want to pay more for less performance? You're better off just buying passive funds versus active funds. If you don't have the time and/or desire to follow the markets closely, stick with index funds.

But that's not why you're reading my blog,and it's not why I'm writing. I believe picking individual stocks is more rewarding and less risky, though it is defnitely much more work. Look at 2008. If you were in all index funds, you were down probably about 40% (likely even more if you were in mutual funds). A decent active trader lost far less money last year, and the best were up last year (I was up last year).

Hedge funds are a whole other topic for another time.

2. Absolute performance versus relative performance

Relative performance is how well you do at something relative to some benchmark. Absolute performance is how well you actually do at said thing. So, if I was up say 10% last year and the market as we said was down 40%, then my absolute performance is +10%, but my relative performance is +50% (the difference between mine and the market).

I'm not a big believer in relative performance. I always laughed when I heard mutual fund managers say that you should give them your money because they only lost 30% last year while the rest of the market lost 40%. Sure, the manager had good relative performance, but a 30% loss is still a 30% loss. No matter how you try to rationalize it, you still have 30% less money than you did before the start of the year, and that's just not ok.

I believe absolute performance is what counts. But, on a trade-by-trade basis, this does not mean that all profitable trades were good trades and all losing trades were bad trades. This will be a deeper topic for another time.

3. The investment ladder and where stocks fall on it

This basically seeks to answer the question of what a share of stock actually represents. There's a certain hierarchy to investment in a company. This hierarchy is important because it establishes an order to investment in the company. The higher up the ladder you are, the more likely you are to get more of your money back. Basically, there are three major levels on this ladder.

On top are the actual business concerns. These would typically be say banks who lend to the company or other outstanding business-related liabilities. I'm not going to say much more about this level because that's not my level.

In the middle are the bondholders. I need to say a bit more here, but not too much more. See, a bond is basically a contract between the issuer (the company) and the lender (the bond investor) that has the lender loaning the company x dollars to be repaid by y date compounding at a z% annual rate. The company issues these through an investment bank. There are various classes of bonds with various special considerations, but this is the basic premise.

And on the bottom are the stockholders. Again, this is issued through an investment bank and there are several classes of stock, broken up into basically preferred stock at the higher end and common stock at the lower end. A share of stock is, in a manner of speaking, a share of ownership in the company, so shareholders get actual voting rights on corporate matters. Each share represents some percentage of the float (all the shares out in the market right now). Companies can 'retire' shares by buying them back on the open market (many do this because there is no better use for the money, they believe their stock is cheap, or because they want to improve performance - less shares outstanding means more earnings per share). Preferred stock tends to be less liquid, meaning there are less shares out there to trade, may have better voting rights, and tend to pay higher dividends than common stock (meaning they pay more money per share to the shareholder throughout the year). When you type in the ticker UTX to represent United Technologies, you are looking at the common stock, which is trading somewhere around $50 or so.

There is a fourth level of the ladder known as options, but these will be the topic of many later discussions. In a nutshell, an option is a contract that gives the holder of the contract the right to buy/sell (typically 100) shares of a company's common stock at a certain price by a certain date. The contracts with the right to buy are known as calls and the ones with the right to sell are known as puts, so the act of simply buying a call is a bullish play on a stock, but buying a put is bearish. Options are a derivative asset, meaning their value is calculated based upon some other asset. Since they involve shares of a company's common stock, they are a derivative asset of common stock. There's so much more to say about these, but I've said enough for today. :-p

In Lesson 2, we'll look at an introduction to the two basic methods of analyzing a stock, namely fundamental analysis and technical analysis. Just a simple overview of what they are and how they relate to one another.

Positions: long $SPX and UTX in 401k