Equity markets in practice
Investors can own stocks directly or through funds. Understanding fees, diversification, and market history helps make sense of equity investing. This lesson is educational, not personal investment advice.
Mutual funds and ETFs
Mutual funds pool money from many investors to buy diversified portfolios, priced once a day. Exchange-traded funds (ETFs) also hold diversified baskets but trade on exchanges throughout the day like stocks. Both let small investors diversify cheaply.
Active versus passive investing
Active funds try to beat the market by selecting stocks; passive (index) funds track an index such as the S&P 500. Research such as S&P's SPIVA reports consistently finds that most active funds underperform their benchmark indexes over long periods after fees. Index funds now hold a very large share of US fund assets.
Fees matter
Fund fees, expressed as an expense ratio, compound over time. A 1% annual fee versus a 0.05% fee on a 100,000-dollar portfolio growing at 7% for 30 years can reduce the final value by over 150,000 dollars. Low costs are one of the few reliable advantages investors can control.
Investment styles
Growth stocks are companies expected to grow earnings quickly, often with high P/E ratios; value stocks trade at low prices relative to earnings or book value. Large-cap, mid-cap, and small-cap refer to company size. Dividend stocks emphasise steady payouts. Historically, different styles have led in different periods.
Bull markets, bear markets, and crashes
A bull market is a sustained rise in prices; a bear market is a decline of 20% or more from a peak. Major crashes include 1929, 1987 (when the Dow fell about 22.6% in one day), 2000-2002 (the dot-com bust), 2008-2009 (the financial crisis), and the rapid COVID-19 crash of early 2020, followed by a swift recovery.
Behavioural pitfalls
Investors often buy after prices have risen and sell in panic after falls, locking in losses. Overconfidence, herding, loss aversion, and checking portfolios too often can lead to poor decisions. Studies of investor returns often find they earn less than the funds they own because of poorly timed buying and selling.
Corporate actions
Companies return cash to shareholders through dividends and share buybacks. Stock splits increase the number of shares without changing total value. Mergers and acquisitions can raise or lower share prices. Shareholders vote on major matters at annual meetings, often by proxy.
Worked example
Two investors each put 10,000 dollars into funds earning 7% a year before fees for 30 years. One pays 0.05% a year, ending with about 75,000 dollars; the other pays 1.05%, ending with about 56,000 dollars. The higher fee consumed roughly a quarter of the final value, illustrating how costs compound.
Key takeaways
Mutual funds and ETFs offer cheap diversification. Most active funds underperform index funds after fees over long periods. Fees compound and significantly reduce long-term wealth. Styles include growth, value, size, and dividend investing. Bear markets are declines of 20% or more; major crashes occurred in 1929, 1987, 2000-2002, 2008-2009, and 2020. Behavioural mistakes hurt returns. Dividends, buybacks, splits, and mergers are common corporate actions.
Flashcard
Pooled diversified portfolio
Check your understanding
Why do index funds often outperform most actively managed funds over long periods?