POINT-COUNTERPOINT

Six Investment Approaches

How should you invest your money? There’s no shortage of opinions on the subject, no shortage of advice. All too often, however, such opinions and advice are based on a selective presentation of the facts, perhaps colored by the advice-giver’s motives and affected by day-today news and fads.

One person will tell you that stocks are the solution. Another will insist that mutual funds give you the most for your money. A third will tell you to bet on bonds. Others will espouse exchange traded funds (ETFs), opt for options, or become fascinated by futures.

Investing is not just a theoretical exercise. You have, or will have, money that you want to invest. In fact, need is probably a more accurate word. You need (or will soon need) to invest the money that you have earned, saved, and/or inherited so that you can meet your financial goals, responsibilities, and commitments. And you would like to understand as much as possible about this sometimes confusing but vitally important subject.

So, how should you invest your money? As a warm-up for our voyage through the world of financial markets, we’ll begin by looking a bit more closely at some of the most common answers to this question. Then we’ll take you, one step at a time, through what you need to know in order to arrive at your own answer—the one that is best for you.

Stocks

Many market advisors urge investors to invest in good stocks. There is a great diversity of opinion, however, on what constitutes a good stock. Some analysts favor the stocks of large corporations, such as the 30 stocks that constitute the Dow Jones Industrial Average (DJIA) or the 500 stocks that make up the Standard & Poor’s (S&P) 500 Index. Others argue the merits of small, fast-growing companies (sometimes called growth stocks), while still others believe in an approach that looks for value in stocks that are currently out of favor.

Standard & Poor’s (S&P) 500 Index

Index of large capitalization stocks.

Mutual Funds

Other analysts believe in the value of mutual funds. Mutual funds are investment companies, that is, companies that invest in stocks, bonds, and other financial instruments such as futures and options. Funds offer a number of advantages, including professional money management and portfolio diversification. Analysts who favor funds will often argue that the average individual investor is likely to do better by choosing a few good funds than by trying to manage a portfolio on his or her own. They are better off, the argument goes, choosing an outstanding mutual fund with a great track record and a really smart portfolio management team.

diversification

Investing in a broad range of securities to lower risk and/or enhance return.

Mutual funds also have their share of critics, including prominent members of the fund industry. The two most frequent criticisms are that average costs are too high and average performance is too low. One of the ways that the fund industry has responded is to offer an increasing number of index funds. These are funds designed to match the return on an index such as the Dow Jones Industrial Average or the S&P 500. Typically, the costs associated with index funds are significantly lower, while the performance is designed to closely track the index. After all, indexes are the barometers of Wall Street. Their minute-by-minute fluctuations are watched by many millions of investors all over the world, while hundreds of millions hear, watch, or read about them to learn how the market did.

Bonds

Bonds have their advocates as well. Some analysts point out that investing a portion of one’s wealth in bonds is a good way to diversify a stock portfolio, while others emphasize the security of principal and interest payments offered by bonds of high credit quality. Still others point to the tax advantages of bonds, especially municipal bonds.

On the negative side, critics believe that bonds do not offer a good return relative to stocks and that they have their own risks, including default risk, sensitivity to interest rates, currency exchange rates, and the business cycle.

ETFs

Exchange traded funds (ETFs) are similar to index-based mutual funds, however, they trade on stock exchanges and may be purchased or sold throughout the day at or close to their net asset value. Among their potential advantages are liquidity, tax efficiency, and generally lower costs. These features have made them extremely popular and among the fastest growing segments of the investment business.

On the other hand, some critics argue that ETFs encourage speculation and that the costs associated with frequent trading can be extremely high. Another potential problem is the proliferation of ETFs into so many obscure indexes and trading ideas with the result that liquidity and market cap evaporate.

Options

Options can be used in a variety of ways, ranging from portfolio risk reduction to outright speculation. Most options are short-term investments and must be monitored closely. Advocates of options for individual investors commonly point to the potential for spectacular returns through financial leverage, though sometimes they are marketed as a way of “insuring” your portfolio against a market downturn. Critics contend that the cost of trading options is frequently very high for individual investors and that most individuals who use options to speculate lose money.

Futures

Futures have many of the same uses as options, with similar potential for high returns arising from leverage. Unlike options, however, futures bear the added risk of margin calls. For this reason, futures investments must be monitored very closely. An alternative to direct investment in futures is a managed futures account, which is like a mutual fund for futures. Costs of managed futures can be much higher than those for mutual funds. Furthermore, while some managed futures have had spectacular returns for a year or more, critics contend that most managed futures accounts, particularly the ones available to the general public, are poor investments.

Summary

This chapter reviewed some frequently heard arguments, pro and con, for the six major classes of investment vehicles: stocks, mutual funds, bonds, ETFs, options, and futures. In the succeeding sections of this book, we will examine these vehicles in far greater detail.