Investing is not as complicated as it seems. With the right approach, doubling or even tripling your money could be in your future! Realizing this Michael, a recently employed 17-year-old, tried to figure out easy ways to get started with investing. Before he could start investing, however, he needed to understand the basics.
Know Your Jargon:
ETF: An exchange-traded fund, or ETF, is a basket of investments like stocks or bonds. There are different types of ETFs including index ETFs, Bond ETFs Sector ETFs, international ETFs, thematic ETFs, and commodity ETFs.
Bond: A bond is a contract between two parties, you are the lender, and the other party is the borrower. A bond guarantees that when you (the lender) give a principal (starting amount) of money the borrower will return that money after a certain period (indicated by the type of bond you invest in) and pay back added interest that is gained over the amount of time as well (known as the coupon rate).
Mutual Fund: Mutual funds let you pool your money with other investors to “mutually buy stocks, bonds, and other investments. They are run by professional money managers who decide which securities to buy (stocks, bonds, etc) and when to sell them.
Liabilities/Assets: Liabilities are what you owe, and assets are what you own.
Liquidity: how quickly and easily a financial asset or security can be converted into cash without losing significant value.
So firstly, what even is a stock? A stock is a piece of ownership in a company; you usually buy a certain amount of shares of a company. Think of it as buying a tiny slice of a huge pie; that pie being the company itself. When the company performs well, the value of your slice increases. Conversely, if the company doesn't do well, the value might decrease. Stocks are one of the most common ways people invest their money, and they can offer significant returns over time.
Now understanding this, Michael knows that stocks come with a high rate of return (the rate at which your slice of the pie increases) as the value of your share increases, however, he also understands that there is high risk since stocks are very volatile and not as stable. Because of this, he wonders if there are ways that he can mitigate the risk successfully, that is where Diversification comes into play.
The Importance of Diversification
Diversification means not putting all your eggs in one basket. Instead, you spread your investments across different types of assets – stocks, bonds, mutual funds, real estate, or even newer areas like cryptocurrency. This strategy helps to mitigate risk because if one investment performs poorly, others might do well, balancing your portfolio. Understanding the importance of diversification is crucial to creating long-term wealth and becoming a successful investor. Continuing his journey, Michael decides to invest in stocks, a mutual fund, and a 10-year treasury bond.
Understanding Risk Tolerance
Michael is 17, meaning he has a head start on his investing journey. He has more time to recover from risky investment decisions and losses. However, that is not the case for everyone. Understanding your risk tolerance, and how much risk you are willing to take for the possibility of a higher return rate, is key to creating long-term wealth and becoming a successful investor. It is important to invest within your portfolio and your comfort zone and not be swayed by the promise of high returns without considering the possible losses.
The Role of Financial Ratios in Investment Analysis
Now that he knows the basic aspects and logistics of investing, Michael wants to learn how to make more informed decisions to maximize returns on investments. A commonly used investment analysis strategy involves financial ratios. Here are some of the most widely used ratios:
Price-to-Earnings Ratio (P/E Ratio): This ratio compares a company's stock price to its earnings per share. A high P/E ratio could mean a company is overvalued, or investors are expecting high growth rates in the future.
Debt-to-Equity Ratio (D/E Ratio): This measures a company's financial leverage by comparing its total liabilities to its shareholder equity. A high D/E ratio could indicate a company is using debt to fuel growth, which can be risky.
Return on Equity (ROE): ROE shows how effectively a company is using its assets to create profits. A higher ROE indicates a more efficient company in generating profits from its assets.
Price-to-Book Ratio (P/B): This ratio compares a company's market capitalization to its book value. It provides insight into what shareholders are paying versus the company's net assets. Lower values can indicate undervalued stocks, but this can vary by industry.
Current Ratio: This liquidity ratio measures a company's ability to pay short-term obligations or those due within one year. It is calculated by dividing current assets by current liabilities. A ratio over 1 indicates that the company has more current assets than current liabilities, suggesting better financial health.
Earnings Per Share (EPS): EPS is a portion of a company's profit allocated to each outstanding share of common stock. It's a marker of a company's profitability. A higher EPS indicates more value because investors will pay more for a company's shares if they think the company has higher profits relative to its share price.
Dividend Yield: For income-focused investors, the dividend yield is a key metric. It shows how much a company pays out in dividends each year relative to its stock price. While not a measure of profitability, it gives an idea of the income you might expect from an investment.
Using the basics of investing and learning about financial ratios, Michael, alongside additional contributions, was able to generate a good return on his investments. By diversifying his portfolio, stocks included in his initial investment that were too volatile, had their loss mitigated by other assets and by using financial ratios he was able to analyse and invest in certain securities that would generate a good return.
Investing, no matter how small, is the first step to financial freedom. Like Michael, with the right approach and understanding of the basic aspects of investing, you can be a successful investor.
Commentaires