Refresh the Basics

January 6, 2014

Investment Newsletter for the end of December, 2013

I wish to refresh the basics.  It never hurts to remember the core issues.  I also have several new clients.

A share of stock is an ownership right in a company.  For example, if I were to own one share of Intel that means I own a very very tiny fraction of the company.  Intel currently has just under 5 billion shares.  Intel originally issued shares to raise money for operations.  They split several times since then.  The value of the company has gone up as the company has grown.  With profits have come accumulating assets.  Since the company is worth more money, my teeny tiny fraction is worth more money,

The splits do not increase the value of what I have.  Stock splits have absolutely no impact on how much my investment is worth.  If a company is worth $100 million and it has one million shares, each share is worth $100.  If you have 100 shares, your investment is worth $10,000.  If now the company declares a 2 for 1 stock split, they will add 100 shares more into your hands.  You now have 200 shares instead of the old 100 shares.  As a whole, the company now has two million shares instead of the old one million shares.  But, the company is still worth what it was, $100 million.  Sales have not gone up.  Profit is the same.  Assets are the same.  Nothing has changed except on paper.  Since the company is still worth $100 million but now there are two million shares, each share is now worth $50.  Your 200 shares is now worth the same $10,000 you had before.

A mutual fund is a collection of many different stocks. The fund may have stock of 100 or more companies.  Instead of owning $10,000 of Intel, you would $10,000 of mutual fund xxx.  The mutual fund may have thousands of owners.  This mutual fund would accumulate your cash as well as all the other owners.  It would then buy some Intel, some Microsoft, something else, etc.  Mutual funds serve to reduce risk.  You can now indirectly own pieces of 100 companies without being rich.

The mutual fund is a for profit enterprise.  They charge a fee for accumulating stocks and owners into a big pot.  Some mutual fund companies use expensive managers and claim that they are experts at picking stocks. These funds are called actively managed.  They are typically sold by commissioned representatives.  They almost always have either a big front end fee (nearly all of which goes to the salesman) or a back end fee if you try to leave before a certain number of years (also called a deferred sales charge).    They also have a high ongoing fee of as much as 2% per year.

Other mutual funds claim that there is no such thing as special expertise at picking stocks.  They do not know what the next winning stock is going to be.  They try to match the market or a component of the market as inexpensively as possible.  They buy big baskets of stocks with some predefined characteristic, such as all the small cap value stocks in the market.  These funds are called passively managed or index funds.  There is no front fee, no back fee, no commissioned salesman, and an ongoing fee of .5% per year or less.  The two best mutual fund companies of this type are Vanguard and DFA.  I heavily use both company’s products when designing portfolios.  I also believe that there is no such thing as special expertise.  I also do not collect commissions.

I hope you all had a good holiday.  May this next year be as profitable as the last.  Thank-you for your business.

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