6. What to invest in?

 

The “Beating the Market” articles concluded that seeking “excess returns” (also called alpha) is a complex and difficult task that the mindful individual investor should avoid in favor of simpler investing approaches.  Although it’s a nice fantasy, for most individual investors, beating the market is not necessary to achieve long term goals like a comfortable retirement.  While this covers what not to do, we still need to define specific actions that are indicated by a mindfully simple investing approach, which is the purpose of the next two articles on what to invest in:

But first we need to define a few basic concepts.

Definitions

A quick review of the internet and popular investing books shows that most of the discussion of investments for individual investors boils down to three basic options: stocks, bonds, and cash.  Other options exist, the most obvious of which is real estate, and these are discussed briefly in Article 9.  The main reason that I focus on stocks, bonds, and cash is that other investments tend to be more complex and often have significantly higher uncertainties and risks without a clear history of correspondingly exceptional returns (see Article 9 for details).  Let’s start with a brief review of each of the main three investment types.

Stocks – Stocks represent ownership in company as well as a claim on part of the company’s assets and earnings.  Large and small companies from around the world issue stocks related to every imaginable type of commerce.  Although stocks are a simple concept, there is a vast array of stocks available to the individual investor.  Also, there are different flavors of stocks such as “common” and “preferred”, but we don’t need to get into all those details right now.

I focus here on stocks of publically traded companies rather than privately held company ownership (e.g., a small business owner), which is a highly investor-specific and varied type of investment beyond the scope of this website.  (However, it’s worth noting that privately held ownership should be factored into your overall investment plans.  Because private ventures are often much more risky and have correspondingly greater potential returns, you should always evaluate your overall balance of risk and return across the entirety of your investments to make sure your plans are comprehensive and objective.)

Bonds – Bonds represent debt owed by the bond issuer (the entity seeking the loan) to you, the bond purchaser (the lender or creditor).  Companies and various levels of government can issue bonds.  All bonds include a defined period of time over which the loan will take place (like 1, 5, 10, or 30 years) and interest that will be paid (and with what frequency) to the bond purchaser during that period.  Like stocks, there are many flavors of bonds including federal government bills, notes, and bonds; local government (e.g., municipal) bonds; foreign government bonds; and various types of corporate or private bonds.  Most bonds also have a credit quality rating, which is an estimate of the future risk that the bond issuer could fail to make regular payments or pay back the loan at the end of the period.  For example, U.S. federal government bonds are generally the highest quality, while some types of corporate bonds issued by weaker companies are often referred to as “junk bonds” because of their high risks.  As with other investments, higher risk means higher return in the form of higher interest payments during the life of the bond.

Cash – You already know what cash is, but I want to broaden the definition of cash for this discussion.  Beyond what’s in your wallet, cash is also any investment vehicle that is highly liquid (meaning you can convert it into cash in hand without much delay or hassle) and pays very little interest or other return.  So, this can include your bank account, money market accounts, and similar deposit holdings that usually return interest in small amounts, particularly with today’s low interest rates.

Departing further from the typical definition of cash, I also include relatively short term bank certificates of deposit (CDs) as a type of cash.  Certificates of deposit provide a relatively low rate of interest at the end of a specified period.  You can withdraw your money prior to the end of that period but with a specified penalty.  Some certificates of deposit have pretty long periods (like five years), but for inclusion in our cash category here, I am mostly focused on shorter-term certificates of deposit (3 years or less).

It’s worth noting that some money market accounts currently return 1% annually for deposits as little as $10,000.  And current 1 to 3 year CD rates for substantial deposits range between 1 and 2%.  This may not sound like much, but these low returns may actually be competitive with expected future returns on some other low risk options as detailed more in Article 6.2.

A mindful discussion

Also, before moving on to the more detailed articles, I would like to remind readers why both the Article 5 series and the Article 6 series are mostly an analysis of data and history.  As discussed in Article 2, mindfulness is synonymous with rationality and empiricism and is not confined to simply handling our emotions better.  In many ways, these articles resemble more an application of science to investing rather than an application of the philosophy of mindfulness, but as I also mention in Article 2, those two perspectives share much in common.