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STOCK MARKET BASICS FOR NEWBIES – 9

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AN INTRODUCTION TO CRYPTOCURRENCY

Cryptocurrency, Bitcoin, Elon Musk, digital currencies, Etherium, Mark Cuban, fiat currency, NFT’s and the list goes on. Following the world of investing is a challenge today, with everyone being obsessed with these new and confusing terms and concepts. You are forgiven if you have thrown your hands in the air and said, “I have no idea what is going on so I will simply bury my head in the sand and hope it all goes away!” Understanding cryptocurrencies may be difficult for newbies but that has not eliminated the world of opinions being expressed by famous and infamous voices alike. On the one hand, the world is being brought to an end with digital currencies and we will all return to the stone age while others tell us this is the dawning of a new age. Yes, I have my opinion but that is not the point of this session. We are here to understand this world and let you form YOUR own opinion.

We promised a shallow dive into this world and consequently; we leave a lot of the more detailed information for further research. We will include several links for those of you who are interested in more information. According to Investopedia, these are the keys to understanding cryptocurrencies:

“KEY TAKEAWAYS

  • A cryptocurrency is a form of digital asset based on a network that is distributed across a large number of computers. This decentralized structure allows them to exist outside the control of governments and central authorities.
  • The word “cryptocurrency” is derived from the encryption techniques which are used to secure the network.
  • Blockchains, which are organizational methods for ensuring the integrity of transactional data, are an essential component of many cryptocurrencies.
  • Many experts believe that blockchain and related technology will disrupt many industries, including finance and law. 
  • Cryptocurrencies face criticism for a number of reasons, including their use for illegal activities, exchange rate volatility, and vulnerabilities of the infrastructure underlying them. However, they also have been praised for their portability, divisibility, inflation resistance, and transparency.”

What does that mean in plain language? Let’s use Bitcoin as the leading cryptocurrency for explanation purposes. In an excellent article in MoneyWeek, March 1, 2021 Dominic Frisby wrote, “Bitcoin is a new system of money designed for the internet. Let’s shorten that to: bitcoin is money for the internet. The internet is, essentially, a borderless medium. I’m in the UK. I can communicate with someone in the US, Australia, South America, Asia or Africa as instantly as though they were in my own country. I can send them messages, photos, videos, any kind of content, and they receive it instantly. Yet, until bitcoin, I couldn’t send them money with the same ease. I would have to go through Paypal, or a bank or a credit card company. There would be foreign exchange costs, money transfer costs, regulatory processes.

With bitcoin I can send money across the net, direct from person A to person B, just as I send messages. It might be tiny sums, but it could also be billions. (For example, only recently, I saw that somebody had transferred 14,892 bitcoins. That’s over half a billion dollars in value. I know that that value was transacted – the transaction was broadcast on the blockchain. But I have no idea who sent the money, or to which location it was sent. I rather suspect it was Elon Musk – but who knows? I also know that the cost of the transfer was a few dollars, and that the transfer was almost instantaneous).”

Another point that is important to understand about digital currencies and Bitcoin in particular is that there is a finite number of Bitcoins available, which is why we see the value fluctuating so much. With conventional currencies, there is no finite number. Central banks and governments simply crank up the printing presses and increase the number of dollars, euros, etc. with no restraints or controls. We have seen this happen during the pandemic as countries around the world tried to prop up businesses and individuals by simply passing out more money to help them survive. While it may not be polite to ask, you might wonder where the money came from?

Let’s look at this in everyday terms. Suppose you have 10 apples and there are no other apples in the entire world. The value of your apples is determined by the demand of the market. In other words, the more people who want to have an apple, the higher the value of the 10 apples you hold. Now suppose that someone else comes along and they have also got 10 apples. What happens to the value of your 10 apples now that there are twice as many? It would make sense that the value of your apples will drop in half. In simplistic terms, the same happens with money. If you double the money supply (the number of dollars in existence), what is the real value of the money you currently hold?

Simply put, crypto, or digital currencies, are an alternative to existing currencies, like dollars and euros. The biggest difference is that governments or central banks do not control digital currencies and for those institutions, this represents an enormous challenge and risk to their control over our financial lives.

Many articles and opinion pieces talk much about the technology that creates digital currency and we will look at that in the next section. We will also look at some investing possibilities if you are interested in how you can take part in this new world. In the meantime, I encourage you to take a look at the links provided above to become more familiar with something that does not seem to go away – no matter how much some people wish it would.

STOCK MARKET BASICS FOR NEWBIES – 8

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EXCHANGE TRADED FUNDS

What is an ETF? ETF stands for Exchange Traded Fund, and what are they and how do they work? Are they something a newbie should look at as a legitimate possibility to invest their money? As we mentioned in the previous section, there are some similarities between mutual funds and ETF’s. One of the important similarities is that they both represent a basket of similar securities that could be equities (stocks) or bonds or both. When we mention similar securities, we are referring to sectors of the economy. So, most ETF’s will reflect a particular business area like the mining, energy, financial or technology sections. These are only examples, as we divide the economy into dozens of different areas.

One of the bigger differences between mutual funds and ETF’s is that mutual funds are actively managed by professional money market people and ETF’s are not. What does this mean? As we learned previously, the active management of mutual funds adds to the cost of owning mutual funds and we, as investors, pay for that in yearly fees charged to the funds we own. What that means in dollars and cents is that if we purchase $10,000.00 worth of mutual funds, then every year they will charge the value of our investment approximately 3% or $300.00 for the management services, administration and marketing. We have to rely on the professional managers to earn over that amount in order to increase the value of our investment.

ETF’s mimic existing investment groups such as the Standard and Poors 500, the various sub-indices of the stock market like the mining, technology and other categories that make up the overall market. Let’s try to put this in plain language. If you are reading this information, then you are probably also more aware of some business news that is provided by the various news outlets. You may be familiar with the terms Dow Jones Index and Toronto Stock Exchange Index. The newscaster will solemnly inform us that the “Index” has gone up or down by a certain number of points today. This is just a snapshot of what the investing world did in a general sense during the day. If the index reading is down, that only represents the specific stocks that are part of the index, it does not mean that every company trading on the exchange was down.

We have various stock market indices, which are then broken down into many sub-indices that are composed of specific companies in that sector. Specifically, if we were looking at the mining sector sub index, then it comprises the major mining companies in the country. The stock market would track the price of those major companies, and the index would reflect the combined prices and report them daily. Not every mining company is included in this index, and the stock exchange changes them from time to time. They are only the senior well-known companies. The company that creates an ETF would buy shares in each of those companies represented in the same ratio that the stock exchange used to create their index. If the stock exchange removes or adds another company, the ETF does the same. They require no management or research to do this. It is simply adjusting to reflect the stock market index itself. The upside of this for the investor in ETF’s is that the management fees are significantly lower than for mutual funds. They are often below 1% as compared to the 3% range for mutual funds.

There are hundreds of choices in ETF’s that reflect many investment niches. You can buy an ETF that follows commodity prices like gold or foreign stock markets, niches like bonds, utility stocks, energy stocks and so many more. The downside for the investor, and the opportunity to keep more of their money by lower fees, is that the investor has to take some responsibility for finding appropriate ETF’s. Through their own reading and thinking, they will want to determine what parts of the economy they feel comfortable investing in. We should emphasize that an ETF is a basket of companies, so it mollifies the risk. If one company goes down substantially, its effect on the overall value of the ETF is not as significant. Conversely, if a company goes up significantly, it also does not affect the overall value substantially either. In this case, there is safety in numbers for the investor while they enjoy the benefits of participating in a market segment that they have some knowledge of because of their own investigation.

In summary, mutual funds and Exchange Traded Funds are excellent investment opportunities for the new investor who wants to take part but also wants to keep their risks low. We should mention that not only “new” investors use these investment vehicles, but many very large funds like pension plans use them as well. Sometimes the number of choices can overwhelm, but if you consider your personal investment goals and knowledge and use these as a starting point, you will do well. A quick point about investment goals: consider these four points, safety, income, growth and risk. As you think about these four principles of investing, assign a percentage to each area that you are comfortable with. Naturally, the four percentages should add up to 100. We will talk more about this later on, but you could use this personal information as a guideline to your comfort in buying stocks or any kind of investment.

ETF’s and mutual funds are an excellent method for people to gradually increase their savings over time as they periodically invest money every month or so.

We will take a very shallow dive into the cryptocurrency market next to give you an idea about what they are and how they work.

STOCK MARKET BASICS FOR NEWBIES – 6

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BONDS

“The name’s Bond… James Bond.” Sorry, but I just couldn’t resist. This installment is about bonds that trade on the stock market. A bond is a way for a company or government to raise funds by promising to repay those people who buy them on a set date in the future and in the meantime, pay them a fixed rate of interest. It is an instrument of debt, unlike James Bond, who is an instrument of death, sorry again. Please don’t unfriend me.

We consider bonds one of the safest and most stable forms of investment and financial planners often recommend that up to 60% of your investment portfolio should be in bonds. Let’s look at some aspects of bonds that will be of interest to you (pun intended).

The principal amount of a bond offering is normally in the millions of dollars. Individuals can usually purchase bonds in multiples of a thousand dollars. Institutional investors like pension funds, insurance companies, mutual funds, banks and others will buy large blocks of bonds however, the smaller investor can do the same in smaller quantities if they want. When a bond is first issued, it will carry a competitive interest rate based on the prevailing rates and the safety of the organization issuing the bond. Governments use this form of raising capital frequently and depending on the country, state, province, or municipality that is doing it, the interest rate reflects the ability of the issuer to repay the principal amount and maintain the interest payments. The stronger the institution offering the bonds for sale, the lower the interest rate needs to be.

Government bonds are safe because their ability to pay is almost 100%. A government can raise taxes on their citizens and companies in an unlimited fashion, so there is almost no chance they will renege on their financial responsibilities. Keep in mind, that is not true of every country in the world, and that kind of approach may lead to many other consequences that are beyond our scope in this article.

CRYPTOCURENCY OR DIGITAL CURRENCY ARE TOPICS THAT ARE GETTING INCREDIBLE TRACTION IN THE FINANCIAL WORLD AND IN EVERYDAY NEWS REPORTS RIGHT NOW. IF THERE IS ENOUGH INTEREST, I WILL DEVOTE THE NEXT SEGMENT OF THIS SERIES TO EXPLAINING DIGITAL CURRENCY. I HAD NOT PLANNED TO DO THIS BUT THERE IS INCREDIBLE INTEREST BECAUSE THERE ARE OVER 1500 DIFFERENT DIGITAL CURRENCIES AND PEOPLE ARE WONDERING – IS IT TOO LATE? CAN OR SHOULD I GET INVOLVED? HOW? ARE THE RISKS AS BIG AS I HAVE HEARD? SARCASM ALERT: DON’T TELL YOUR BANKER OR MUTUAL FUND REP THAT YOU ARE GOING TO LEARN ABOUT DIGITAL CURRENCY, THEY WILL TELL YOU THAT JUST LEARNING ABOUT IT WILL CAUSE YOU TO LOSE YOUR HOUSE ALONG WITH YOUR MIND!

You recall that we talked about “yield” when we discussed common and preferred shares, and that becomes a very important part of any explanation of bonds. We have learned that yield is simply the percentage that you, the investor, will receive from the organization that you have invested your money in. However, it is important to understand that risk must be considered. The higher the risk, the higher the initial interest rate or yield. If the market judges one investment to be riskier than another, then the investor will demand a higher rate of return or higher yield. This is clear in the interest offered by a federal government compared to the interest rate that is demanded from a municipality who is also offering a bond for sale. The municipal rate is higher because the risk is greater. The municipality has a much smaller tax base to cover their bond obligations.

Let’s suppose that our fictional company, Orange, plans to build a new manufacturing plant and wants to offer a $1,000,000 bond for sale to potential buyers. How would they become an attractive investment for you and I? We would need to do some comparisons with other opportunities like putting our money into a savings account or buying a federal government bond instead. If we could safely invest our money at 2% elsewhere but Orange wants to attract some of that money, they will need to make the yield or interest rate more attractive because the risk is higher for a small company.

One other thing we will cover regarding bonds since they, like stocks, trade on the stock market. Let’s pretend that we bought $1,000 bond from Orange and they are paying an interest rate of 3%. We have decided that we want to sell it, but interest rates have gone up and a similar bond would need to offer a yield or interest rate of 6% in order to be successful in raising the capital. What happens? Why would someone pay $1,000 for a bond and only get a return of 3% when they could get double that return on a different one? In order to sell our bond, we will need to compensate the buyer by lowering the $1,000 bond price so that they will get a 6% return. Just like common stock, all investment opportunities become a function of risk and reward. The opposite is also true, if interest rates drop then we would expect the price of the bond would increase.

This is a very rudimentary explanation of how bonds work and like everything else in the investment world, you will want to do more research on your opportunities before plunging in. Another source of investment industry knowledge is an online site called Investopedia and gaining knowledge before taking action will help you avoid being “shaken, not stirred”. I know – enough!

We will continue to explore the world of investing and the stock market and the many options that are available for the person who wants to grow their financial nest egg in the next segment. You can receive this information directly to your inbox by subscribing to this blog. Of course, we welcome your comments and we would never share your information with anyone else.