Mutual Funds vs. Stocks (Part I)

In a previous article the “It’s easy as P.I.E” method was discussed in detail. If one were to set a long term goal of achieving a certain level of net worth or retiring at a certain age, the first order of business would be to specifically plan the action steps needed to reach that goal. Secondly, once this plan was created then each step would need to be implemented in a way in which every action taken would be an advance toward goal completion. Very few would argue that investing in both mutual funds and stocks are vital implementation steps toward achieving extraordinary financial success. Many realize this, yet most are not willing to take the time to educate themselves about these two very powerful wealth creating avenues. Thus, many so called “investors” become “gamblers” leaving their portfolios to fate or in the hands of investment “professionals.” In these next few articles, I will provide a basic overview of each investment allowing you to see how each can be incorporated to benefit your personal portfolios. The first of this two-part series will cover stocks.

Stocks Overview

The concept behind a stock is simple, but at the same time very powerful. When you own a share of stock in a company, you literally own a portion (albeit very small) of the company. The primary reason a company issues stock to its employees and the public is because it provides another means for raising capital. Issuing stock also provides another advantage for the company in that money raised from the stock is interest-free. Also, the company doesn't have to guarantee any return to the purchaser. For this reason, issuing stock to generate capital is known as an equity financing. This is in contrast to debt financing, where a company must pay back money raised in the form of a bond or outstanding loans.

Common Stock vs. Preferred Stock

These are the two types of stock that are issued to stockholders and each has its own distinct advantages and disadvantages.

Common Stock

This is the type of stock that people are referring to in their everyday usage of the word from an investing standpoint. There are two primary advantages of common stock: dividends and capital appreciation. Oftentimes, when a company has increased profits for a period of time (i.e. quarterly), the shareholders reap the rewards in the form of dividend payments. The downside is that companies are not required to pay out dividends to common stockholders even if they have garnered a profit. Capital appreciation or capital gain is another advantage of common stock investments. The shareholder can simply buy stock at certain price and then sell it at an appreciated price for a profit. The reverse, however, presents a disadvantage in that shareholders can lose money if the stock depreciates in value. Lastly, an owner in a company's common stock is entitled one vote per each share owned on issues related to company management and business structure.

Preferred Stock

Preferred stock differs mainly from common stock in that it is much more stable but doesn't offer as much potential for great returns. The chief advantage is that preferred stock owners are guaranteed dividends that fall in line with market interest rate levels and not company performance, like that of common stockholders. In the event that a company liquidates, preferred stockholders are the first ones to receive any company assets (before common stockholders) left over after company debts have been paid. Unlike common stockholders, owners of preferred stock are not entitled to any voting rights on company issues.

Investment Philosophies

Value Investing

This is the method that is frequently employed by investment tycoons Benjamin Graham and Warren Buffett. Since the 1960's, Buffett's investments have generated almost a 22% return, doubling that of the average return of the market over the same time period. The concept behind value investing lies in looking for subtleties, whether it be in the company's business structure or day-to-day operations, that give the company value or future growth potential not seen in the present. This is known as looking at a company's intrinsic value. Oftentimes an investment made on this philosophy is done so without regard to how the market is currently doing. Using this type of investment strategy requires great skill since you must identify underlying intangible factors that suggest the company in question is undervalued.

Robert Kiyosaki’s 20-10-5 Cycle

This is another investing technique that author and successful real estate investor Robert Kiyosaki discussed in his book Who Took My Money? Kiyosaki suggested that markets operate in various cycles and that one can use this method to anticipate the rise and fall of these markets. He notes that every twenty years, the stock market is on a high and one can usually expect above average returns on their investments. Every ten years, the commodities market (gold, silver, etc.) is the dominant player. Lastly, he pointed out that every five years a major crisis would occur greatly affecting the markets. Based on his theory, right now is an excellent time to jump into the stock market. The last major catastrophe we had that affected all markets (especially commodities) was that of Hurricane Katrina in 2003. Although this method isn't an exact formula for success, it can be used as a tool for gauging when to buy, hold or sell securities that you own.