Personal finance skills part 3
Personal Finance Skills Part 3
Investing and common investing instruments
Investing in general has become easy for everyone and at the end of the day, the only thing you need is an internet connection and an online banking ID. You can buy any instruments you want in just a couple of minutes on many trading websites. Succeeding in it is a hard task.
When you start investing, you should have some kind of an investment strategy, that you can follow throughout the journey. It refers to a plan that guides investors to achieve financial and investment goals. The plan usually includes capital, investing time, goals, risk tolerance, and effort required to implement the strategy. They should be re-evaluated every once in a while as the situations change.
Once you have determined a plan, you can start filling up your portfolio with instruments according to your strategy.
Bonds, also known as fixed-income instruments, serve as a way for governments and companies to raise money by borrowing from investors. They are typically issued for specific projects, and in exchange, the bond issuer promises to repay the investment with interest over a specific period.
Credit agencies evaluate certain types of bonds, such as corporate and government bonds, to determine their quality. These ratings help assess the likelihood of investors receiving their repayment. Bond ratings are commonly divided into two main groups: investment grade (higher rated) and high yield (lower rated).
Major types of bonds are corporate bonds (companies issue to raise capital), municipal bonds (cities, towns or states raise money for public projects), and government bonds. Bonds have a certain date when the issuer will pay it back so you need to commit to the investment. Higher-rated bonds (for example government bonds) tend to have a smaller risk since there is a high chance they can pay it back. (Blackrock n.d)
Bonds are a good way to diversify the portfolio towards smaller risk and since 1926, government bonds have returned between 5 % and 6 % yearly. (Tretina 2023)
Stocks (also known as equities) are the best-known investment instruments and they allow you to buy a share of ownership in a company. Companies join the public markets in order to raise capital for their operations by selling shares of their company. The price of the stock is driven by price and demand. If there is high demand, the price goes up and vice versa.
The units of the stock are called shares and when you buy them, you will become a shareholder. Being a shareholder grants you the right to vote in shareholder meetings, receive dividends if they are distributed, and the ability to sell your shares to other investors. (Hayes 2023)
Stock markets exist all over the world and are often divided geographically. They are open for 8 hours per day but because of the time difference, there is almost always a stock exchange open on weekdays. The market only sleeps during weekends. The most known stock indexies in Finland are OMX Helsinki 25 (25 most traded stocks in Finland), S&P 500 (500 biggest companies in USA), and Nikkei 225 (225 most traded stocks in Japan).
Like the world, the stock markets are connected. If for example S&P 500 drops a lot in 1 day, most likely other stock indexies will drop as well. It is because companies are heavily dependent on each other. (Juntunen 2023)
When you invest in individual stocks, your primary aim is to outperform the market index. Even many experienced investment experts struggle to outperform this benchmark, so the question arises: how could an individual investor do so? Over a 15-year span, approximately 90 % of actively managed funds were unable to win the index’s performance. These fund managers are usually well-educated investors who dedicate their entire workday to trying to achieve better results than the overall stock market.
Given the difficulty investment professionals face in consistently beating the market, it’s not an easy task to do better in achieving superior outcomes. (Rosenberg 2023)
Stock investing requires a deep understanding of the markets and the individual stock. Unless you do the homework, investing will turn into gambling and you might and most likely face losses. The main basics of stock investing can be divided into 4 categories: Understanding the markets, understanding the “business” of companies, understanding geographical importance, and understanding key figures. Just to list a few, good questions to ask are:
What does the company do? What part of its business brings the most revenue? Whether the company have customers on which it is so dependent that profitability would fall significantly if it lost them? How the company’s business and cash flows are distributed geographically? What does the company’s income statement, balance sheet, and statement of cash flow look like?
Does the company have some competitive advantages like special patents or new revolutionary business strategies? Does the company have good leaders who bring new innovative things to the table? (Tincher 2023)
Like the indexies, individual stocks are extremely connected globally. The majority of companies listed in the Finnish stock exchange work globally and Finnish investors often have the illusion that they have an advantage when investing in a domestic company because they understand the domestic market and Finland better. But do they actually know what the companies do here in Finland? The company might be founded in Finland and their office might be as well, but do they actually operate in Finland?
Let’s say you want to invest in Finnish stocks (like the majority of Finns do), and you buy KONE. Kone is a Finnish company but in 2021, 66 % of their equipment was sold to China, so actually they are heavily dependent on the Chinese markets, not Finnish markets. If China does well, Kone most likely will do well, and vice versa. (Juntunen 2023)
When investing into stocks, there are 2 ways to gain profit:
A dividend is a form of payment, that companies give to investors as a reward for investing in a company’s ownership. It also helps companies to maintain investor’s trust. This payment typically comes from the company’s profits after subtracting all expenses. Investors tend to run after high dividends but often forget that when the company pays dividends, they are not investing their profits in developing the company into a more profitable company. It might mean that the company does not know how to effectively use the extra money, which might reflect on the stock’s price in the future.
Companies might hide a lousy business situation by raising dividends and giving the impression, that the company is doing well. A good way to evaluate dividend-paying stocks is by counting, what percentage, if any, the company pays of its profits as dividends. The dividend payout ratio is determined by dividing the annual dividend per share by the earnings per share (EPS). If the % is lower than 50 (which means that the company is paying half of its profits as dividends), it could be considered a good option. (Hayes 2023)
- Capital gain
Capital refers to the initial amount of money invested. Therefore, a capital gain signifies a profit realized when an investment is sold at a price higher than its original purchase cost. Investors only realize capital gains when they sell their investments and secure profits. (Hayes 2023)
In stock markets, there is also a possibility to gain money from stock going down. Shorting stocks means you’re betting that a company’s stock price will go down.
You borrow shares of a company’s stock from someone, you sell those borrowed shares at the current high price, later, you buy back the same number of shares, hopefully at a lower price and then you return the borrowed shares to the original owner.
If the stock’s price drops like you thought, you make a profit from the difference in prices. But if the stock goes up, you could lose money. It’s like borrowing a toy from a friend, selling it when it’s popular, and then buying it back when it’s not as cool. If your prediction is right, you win; if not, you might lose.
It is considered more risky, since in theory, the price of a stock can rise infinitely so you could lose the entire investment. The brokerage firm will most likely automatically sell the position at -100 % and you will not have to pay more. If not, you will receive a margin call to transfer more cash into your account or otherwise it will be shut down. (Langager 2021)
To conclude, individual stocks offer a direct opportunity for investors to own a piece of specific companies. While potentially rewarding, investing in individual stocks comes with its own set of risks and rewards. Careful research, understanding financial metrics, and staying informed about market trends are essential for making informed decisions. Whether seeking growth, dividends, or a combination of both, investing in individual stocks requires diligence, patience, and a long-term perspective.
An investing fund is a collective pool of money gathered from multiple investors to be managed by professionals with expertise in investing. The goal of an investing fund is to grow the pooled funds by making strategic investments in various assets, such as stocks, bonds, real estate, or other financial instruments.
Investing funds come in different types, including mutual funds, exchange-traded funds (ETFs), hedge funds, and more. Each type has distinct characteristics, investment strategies, and levels of risk.
When you invest in a fund, you’re essentially buying shares or units of the fund. The fund manager or management team makes decisions on how to invest the pooled money, aiming to achieve the fund’s stated objectives, whether it’s growth, income, or a specific market focus.
Investing funds offers individual investors the opportunity to access a diversified portfolio of assets without needing to personally manage each investment. This diversification helps spread risk across different assets, potentially reducing the impact of poor-performing investments on the overall fund’s performance.
Investing in mutual funds has become an extremely popular choice for many new and also professional investors. The diversification helps spread risk, making it appealing to investors who want exposure to different markets without needing to pick individual securities. (Investor.gov)
Actively managed funds vs. index funds
Index funds are investment funds designed to mirror a specific benchmark index, like the S&P 500 or the Nasdaq 100.
When you invest in an index fund, your money is allocated to purchase shares in all the companies included in that index. This provides you with a diversified portfolio, that includes a large variety of stocks, inside of the index.
Active management is unnecessary when it comes to the buying and selling activities within an index fund that automatically mirrors an index. If a stock is part of the index, it will also be included in the fund’s holdings. Since there is no active management of the portfolio, the fund’s performance relies solely on the price changes of the individual stocks within the index, rather than someone actively making trading decisions. This approach to investing in indexes is known as a passive investment strategy.
Based on the S&P Indices versus Active (SPIVA) scorecard, just 6.6 % of funds achieved better returns than the S&P 500 over the past 15 years, with fewer costs. (Gravier 2023)
Actively managed funds
Some mutual funds are managed by experienced professionals who make investment decisions based on thorough research and analysis with the main goal, of beating the index. This expertise can attract investors who may not have the time or knowledge to manage their investments directly. The big setback with actively managed mutual funds is, that it can cost you a lot of money in a long period of time. The fees can range from 0.75% to even 3.5 % and those investment costs may appear insignificant at first, but they have a significant impact as they accumulate and compound alongside your investment returns. Essentially, you’re not just losing the small amount you pay in fees; you’re also missing all of the potential growth that money could have generated over many years.
Suppose you have $100,000 invested. If your investment account yielded a 6 % annual return over the next 25 years without any costs or fees, you’d eventually have around $430,000.
However, if you were charged an annual fee of 2 %, after 25 years, your investment would only be worth approximately $260,000.
In essence, the 2 % you paid each year would eat nearly 40 % of your final account value. Suddenly, that 2 % doesn’t seem as inconsequential, does it? Historically, passively managed funds also tend to outperform actively managed funds with less costs. (Vanguard)
In conclusion, the main difference between index funds and actively managed funds lies in their investment approach, costs, and management style, which ultimately impact their performance and risk profiles. Index funds are known for their simplicity, low costs, and ability to closely track benchmark indices, while actively managed funds offer the potential for outperformance but often come with higher fees and less predictability. Investors should carefully consider their financial goals, risk tolerance, and investment strategy when choosing between these two options. Managed and hedge funds also have the possibility to use leverage and short stocks, so they have the ability to play around during different market situations and potentially, gain the best out of it.
Compound interest vs. simple interest
Simple interest, as the name implies, is calculated annually as a percentage of the initial principal amount. To calculate simple interest, you can just multiply the principal amount by the annual interest rate and the number of years for which the money is either invested or borrowed.
Traditional mortgages, car loans, and personal loans typically involve simple interest payments when borrowing money. However, as an investor, encountering simple interest is relatively uncommon, although investing in bonds can result in earning simple interest as long as you hold the security.
For instance, if you were to borrow $1,000 and the interest rate is a simple 7 % for a duration of five years, you would pay a total of $350 in simple interest over the course of the loan. (Hartill 2022)
Compound interest, on the other hand, is interest that includes the initial principle and all of the accumulated interest from previous periods. This means that every time your investments are compounded, it compounds the whole amount and not only the original principle. Compound interest might and will have a slow start, but in the long run, it will give the investors long-term growth and a big advantage when compared to simple interest. The true magic happens in the long term like it is seen in the chart below. (Hartill 2022)
Simple interest is what borrowers usually like and compound interest is a great thing for investors but can be a big financial problem for people in debt. Simple interest is calculated once a year based on the initial amount of money you have. Compound interest can be calculated more frequently, like daily or monthly. (Hartill 2022)
Taxation (in Finland)
In Finland, we need to pay taxes for almost everything. Investing is no exception and the taxes will eat a big chunk of the profits gained during the investing period.
In 2024, capital income tax is 30 % and 34 % on income above €30,000. Capital income includes gains from the sale of shares, dividend income, income from mutual fund shares, and rental income. A capital gain arises when a listed share is sold at a higher price than it was bought for. The capital gain is calculated by deducting from the selling price the cost of acquisition and the expenses incurred in generating the gain.
The capital gain is tax-free if the sales price of the listed shares does not exceed €1 000 and you have no other income from the sale of the asset for the tax year.
From 2016 onwards, capital losses can be deducted from taxation. If you have more capital losses than capital income, the deduction for capital losses is carried forward to the next five years. So, for the years 2023-2027, you can deduct the capital gains from the 2022 capital losses. You can also deduct transaction fees and other fees that relate to investments (e.g. membership of an investing website etc.)
Check if your portfolio before the turn of the year. There is still time to sell any loss-making shares and use the losses as a capital gains deduction for 2023.
There is no need to change the content of your portfolio, as you can buy back the same shares. However, you should exercise a certain degree of caution. This is because it is possible that the capital losses incurred may not be deductible for tax purposes if the same shares are immediately repurchased. For example, if you sell 1 000 shares in Kone at a loss and buy back 1 000 shares “in the same second”, the tax administration may interpret the transaction as being done to avoid tax. To be on the safe side, buy back the same shares the next day. If, on the other hand, you buy shares in a different company for the same amount, there is no risk that the capital losses will not be deductible.
The dividend received from investments is partly tax-free and partly taxable capital income. For an individual, 85 % of the dividend received is taxable capital income and 15 % is exempt income. The listed company distributing the dividend withholds 25.5 % of the dividend before paying the dividend. (Sijoittaja. fi 2022) (Vero 2023)
In the landscape of personal finance, the principles of saving money and investing are two main pillars that have the potential to shape our financial future. Through this essay, I’ve explained the profound importance of understanding and implementing these concepts to secure a more prosperous future.
Personal finance is not only about managing dollars and cents; it’s about using the resources we have in such a way that they work for us and not against us. Savings serve as the foundation of personal finances, providing a safety net for unexpected challenges and empowering us with the resources to catch the opportunities as they arise. But, as we’ve seen, the true magic of saving lies in its potential to serve as capital for investing, what builds us, a secure and bright future.
Putting money aside for investing is like building a bridge between being financially safe and creating wealth. It’s like shifting from just reacting to money problems and barely staying afloat to being active and using the power of making money grow with interest and the way markets change to improve our financial situation. When we save some of the money we make, regularly and with a clear purpose, we’re basically getting ready for our financial future.
Investing, as we’ve discussed, is a wide-ranging area. It can involve various things like regular stocks and bonds, real estate, or even starting a business. But what connects all these different options is the main idea: we’re making our money work for us, so it can grow more than if we only saved it. Investments can potentially grow faster than the rising cost of living, inflation and create extra income without much effort, and, in the long term, help us build wealth.
Moreover, investing is not a simple task. It demands informed decision-making, a clear understanding of risk tolerance, and a strategic approach that aligns with our financial goals.
Despite the possible problems, risks, and complicated stuff, learning about money and deciding to save and invest is a good use of our time and effort. These things help us take control of our financial future and plan for a time when we’re not only financially safe but also able to make our dreams come true.
To conclude everything, managing our money isn’t just a fixed thing; it’s a journey that changes as our lives and goals change. This journey includes saving money, which is like the beginning, and then investing, which comes after. Together, they make a strong foundation for financial success. With knowledge, self-control, and thinking about the long term, we can succeed in this journey. We’re not just aiming for financial security; we’re also chasing our dreams and goals.
So, let’s start this journey with a clear purpose because it’s a path that doesn’t just lead to financial safety but also to making our dreams come true.
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