Part 2: How Wall Street Organizes Stocks and Bonds
Since 2008, we have heard negative news about Wall Street. While much of it is true, we can be thankful for one Wall Street historical contribution. In Part 2, we continue our journey of discovering what Wall Street has already done to make investing simple. Understanding the organization of the stock and bond markets provides an advantage: once it’s understood how stocks and bonds are categorized, creating an investing portfolio becomes straightforward. The financial industry can be overwhelming and complicated, but the stock and bond market set-up and substructure are straightforward.
The Stock Market
Stocks. Companies issue stocks to raise money by selling shares to the public. When we purchase a “share” or a stock, we literally own a tiny portion of the company. We become shareholders. If the company grows and prospers, so will we, the shareholders. Owning shares brings an opportunity to participate in the company’s growth. Don’t you think that’s cool? It’s us, regular shareholders, and, along with the “big guys and gals,” California State Teachers Retirement System, the 2nd largest teachers’ pension plan, Yale endowment and hundreds of other large financial institutions also participate in the same shareholder growth.
The stock market. After the initial selling of stocks the trading among the shareholders begins. An exchange is a physical (or a virtual location using online trading technology) where stocks are bought and sold by individuals or institutions. The most famous and largest physical exchange in the world, the New York Stock Exchange (NYSE), is located at 11 Wall Street in lower Manhattan, New York City.
Investors buy and sell shares listed with these major exchanges:
- New York Stock Exchange
- National Association of Securities Dealers Automatic Quote (NASDAQ) a network of computers that execute trades electronically.
- American Stock Exchange
How the Stock Market is Organized
History. In 1884, journalist Charles Dow created a chart to reduce the confusion and monitor the progress of the stock market overtime. In order to comprehend market trends and the broad economy with a consistent measuring tool, he tracked twelve representative stocks (10 railroads and two industrials). He named his chart the Dow Jones Industrial Average, or the “DOW.”
Over the last century the DOW expanded to what it represents today: thirty of the largest American corporations. These businesses represent a cross section of industries. My mother worked for Minnesota Mining and Manufacturing Company (3M) and invested in its employee stock purchasing program. 3M is one of the oldest members of the DOW.
The DOW number represents the average of the thirty corporations’ stock prices, closing on May 29, 2015 at 18,010. This average is derived from the daily overall gain or loss in value. It’s not important to know the calculation for our purposes, but as Charles Dow envisioned, it’s a snapshot of how the stock market and the economy are performing.
Millions of businesses. According to the Census Bureau, the United States’ business community ranges in size from tiny “mom and pop” shops with no employees to enormous multinational corporations employing tens of thousands of people. The Small Business Administration reports more than 27 million businesses. Only a tiny fraction offer stocks, about 5,000 companies. The rest are either too small or have not “gone public”.
Going Public. Private companies “go public” to raise money by issuing stock, and inviting investors to own part of the business. After a company secures the approval of the Securities and Exchange Commission’s regulations to sell shares, an Initial Public Offering is issued to the public. From then on it’s listed in one of the exchanges above and is called a publicly-traded company.
Share Prices. As with any piece of property, the seller and buyer determine the share price. It’s nothing complicated—both agree on a price and a trade is completed. The “supply and demand” principle applies. In the broadest terms, if there are more buyers of a stock than sellers, the price increases until a buyer agrees to pay the higher price. If the price continues to increase until there are no more buyers, then the price has to decline back to a level where buyers will come back. History provides several exceptions: during the boom times such as the 1920s, 1990s and early 2000s, maniac buyers would pay excessively high prices in the face of experts warning them that prices cannot be supported by the company’s financial fundamentals. The technology bubble in the late 1990s and the recent 2008 real estate bubble are clear examples. On the other hand, if there are more sellers than buyers, the price declines until someone agrees to purchase the cheaper shares. If the prices continue to decline, potential buyers will get nervous about their portfolio decreasing in value. Many will panic and sell to keep from losing, which leads to even lower prices. This can lead to crashes such as when the DOW went way down to 6,547 in March, 2009 (almost 3 times below the DOW today!).
Stock prices are established by a complicated set of circumstances that baffle the experts, and are beyond my amateur explanation here. All we need to know as long-term investors, is that prices rise and so does our portfolio and when prices decline our portfolio will decline as well. By the end of this series discovering how to set up an investment portfolio to take advantage of the ups and downs of the stock market overtime will be shown. Warren Buffett is famously known for buying cheap shares at a value during severe bear markets when stocks are falling precipitously, when most other investors are trying to avoid more losses. Mr. Buffett’s views “rock-bottom” prices as an opportunity as he believes the investment will eventually increase over the long-term. He is right when thinking over long periods of time. He has become the most famous investor of all-time by purchasing cheap shares, the exact opposite of the panicky crowd (YouTube Candid Camera).
Asset Classes
Domestic. The stock market contains millions of shares offered by thousands of publicly traded companies. With so much information to digest, how can we decide which company to invest in? Isn’t choosing among all these shares and thousands of different companies more complicated than buying a car? Yes. But Wall Street addresses this complication by classifying groups of companies called asset classes, which reduces thousands of stocks choices down to a group of six core asset classes.
The most famous and historical asset class of the largest American corporations is represented by the Standard and Poor’s (S&P 500) Index. Its origins are traced back to 1860 when William Poor published his comprehensive book about the financial and operational systems in the United States stock market. The capital (value of total stock shares) size of each of those 500 companies gives them weight in their placement of an asset class–large-cap, mid-cap or small-cap.
Large-cap is an abbreviation for large-capitalization. Capitalization is calculated by multiplying the number of a company’s shares outstanding by its stock price per share. Currently, Apple is the largest American corporation measured by the biggest market capitalization and qualifies to be listed in the S&P 500. The following three major categories (or indexes) provide size guidelines for the roughly five thousand companies, that offer stocks:
- Large-Cap (Capitalization) Index: the S&P 500 Index, each company is worth more than $10 billion.
- Mid-Cap Index: $1 billion to $10 billion
- Small-Cap Index: $100 million to $1 billion
Another way to view the 5,000 companies is to know there are about 500 large-cap, 500 mid-cap, and 2,000 small-cap companies. The remaining companies have a smaller capitalization and are not counted in the major asset classes. A Wall Street committee selects companies for inclusion in an asset class based on their capitalization and other factors. As their capitalization grows or shrinks, their inclusion (or exclusion) in either small, medium or large-cap asset class is based on this value.
The total worth of each company determines which of the three asset classes it belongs to. My mother’s employer, Minnesota Mining and Manufacturing Company (3M), for example, has about 715 million shares owned by individual investors and institutions all over the world. At today’s April 15, 2015 price, a share costs $166.00. Multiply 715 million total shares by the price: 715,000,000 x $166.00 = about $118 billion of capitalization. It has enough value to qualify as a large-cap.
3M is one of the 500 large-cap companies. When we invest in the S&P 500 large-cap index, we own 3M, Apple, Exxon and 497 other large-cap companies. Recall in Part One when I said that diversification involves investing in many companies. Categorizing companies by size allows us to buy a diversified collection of companies’ stock in a single index. Large-cap is one asset class. We want to invest in the three asset classes available in the domestic stock market (The remaining asset classes will be discussed).
The S&P 500 Index is one fundamental example of diversification and should be one core holding in our portfolios. Table 1 shows the three basic domestic asset classes.
The DOW Jones Industrial Average (DJIA) and the S&P 500 are universally followed by analysts working in brokerage firms and banks to track the broad economy and all of its complex machinations. It gives a picture of the broad economy since it measures 500 businesses, including the 30 in the DJIA.
Each asset class changes as some companies’ capitalization changes or–as in the infamous Enron bankruptcy case–they’re removed from the asset class and from the stock market. Fortunately, bankruptcies and capitalization adjustments have minimal effects on the entire index because of the built-in diversification of many companies over different industries.
Diversification is a powerful antidote against excessive risk and we investors should want as much as possible. The next asset classes under discussion represent the economic force of international markets and the global economy. They offer different demographics and industries, which provide increased opportunities to grow our portfolio.
The World Stock Market
International Asset Classes. Some Americans remain leery of the risk associated with investing in foreign countries. This article addresses this risk while encouraging people to have a strategy no matter where they invest. Ignoring international opportunities focuses your portfolio to only on the United States economy. This is short-sighted. Diversification is a crucial strategy, and international exposure will strengthen your portfolio by increasing diversification and thus, reducing risk. Once again, Wall Street and the exchanges around the world have created asset classes to assist with diversification. Table 2 illustrates the two primary international stock market asset classes: developed markets and emerging markets.
For your information, small-cap, mid-cap and large-cap international asset classes are available for investors from mutual fund companies and investment banks. It is beyond the scope of this article to discuss the complexity and the merit of including these additional asset classes in your portfolio. Here is an excellent video about international investing, “be truly diversified.”
The Bond Market
A bond is the one investment most people consider safe. Since WWII, we have heard “Invest in America, Buy U.S. Savings Bonds.” “Buy War Bonds,” was a rallying call celebrated by President Roosevelt to fund that war. Table 3 illustrates these three basic bonds.
Just as we invest in different stock asset classes, we invest in government sponsored, corporate and international bonds. A corporation raises money by issuing bonds as well as issuing stocks. Instead of the bondholder owning part of the company the investor lends money to the corporation. In return, an investor earns a yield or interest payment plus the face value of the bond at the end (or maturity date) of the bond agreement.
The decision to purchase individual bonds versus a bond fund is debatable. Industry giant The Vanguard Group published an article about this important decision (Vanguard will be discussed in Part IV). Owning a bond fund requires less time to manage than individual bonds. I don’t want the hassle and time of driving to a bank, buying individual bonds, and then returning to the bank to cash them at maturity and then repeating the process.
Thankfully, bond purchases can be executed from your home computer. The best location to purchase bonds directly from the government can be found at Treasury Direct. Treasury Direct.gov has everything you want to know about federal government bonds. In Part IV, I will discuss how to include corporate bond funds in your portfolio.
Summary: Core Investments for Every Portfolio
Each asset class increases and decreases in value, not always at the same time. Bond values fluctuate, but less than stocks. Larry Swedroe and Russell Wild each wrote an excellent book on bond investing. We have to expect some economic boom and bust cycles which affect our investments. But we should aim for a comfortable balance. The advantage of this balance between stockss and bonds is that over time there is steady growth.
Allow me to assure you…there is nothing new or revolutionary with investing in global stock and bond asset classes discussed here. I am merely reporting what I have read in many personal finance books (links to Lazy Portfolio Authors in Part 4) and through our experience of living through two of the greatest stock market crashes in history. As previously mentioned, most large institutional firms have invested in these asset classes, successfully for decades. Pension plan trustees must follow federal pension laws which protect and set minimum standards to grow the fund so that an adequate benefit is available for the pensioners (Click here for additional information about institutional investing). If the trustees invest in just one asset class or a savings account that pays little interest, they will not meet those federal pension guidelines and those benefits might be jeopardized. If you are employed by a corporation, government or public school district and have a pension plan, consider yourself lucky. Part of your salary is already being invested in these same asset classes and that is the primary reason why the benefit is higher than Social Security.
Next we will discuss the crucial stock and bond balance, known as the stock/bond allocation split.