The advisors at Ruedi Wealth closed out 2020 with four more “Investing 101” columns that appeared in The News-Gazette’s Business Extra Section. Make sure to look for them every Sunday, but just in case you missed them in December, the columns are below.
The Dow, S&P 500, and Nasdaq
Paul R. Ruedi, CFP®
People who pay attention to financial media will notice they often hear about three different proxies for the stock market: the Dow Jones, the S&P 500, and the Nasdaq. Each of the three are examples of what are called stock indexes – a combination of specific stocks that is used to measure performance of that entire group of stocks. Though the three are often used to discuss the performance of the US stock market as a whole, and there is some overlap as far the companies they include, these three indexes are different from each other and none of them perfectly capture the performance of the US stock market.
The Dow Jones Industrial Average or “the Dow” for short, is an index that includes thirty of the largest companies in America. These companies span a variety of industries and tend to be established companies with strong brands people would likely recognize like Apple, Visa, Coca-Cola, and McDonalds. Since these large companies are pillars of the American economy and stock market, the Dow is often used as a proxy for the US stock market. But with only 30 giant companies, it doesn’t reflect the performance of a large portion of the stock market.
The Standard and Poor’s 500 Index or “S&P 500” for short includes 505 of the largest companies in America. This includes the giant, household name stocks of the Dow, as well as hundreds of other well-established companies that, although they are large companies, people likely wouldn’t have heard of. Though more diversified than the Dow, it suffers from the same shortcomings as far as capturing US stock performance, as it leaves out the many medium-sized and small companies that make up the US stock market as well.
The Nasdaq Composite Index includes all the stocks that trade on the electronic Nasdaq stock exchange. It includes over 3,000 stocks, everything from large tech companies like Apple down to very small companies. Though more diversified than the Dow and S&P as far as the number of companies, the Nasdaq is highly skewed towards technology companies, and is better used as a proxy for US technology stocks than US stocks as a whole.
These are just three of many different indexes people use to track stock performance. None of these are a perfect proxy for US stocks, much less the experience of globally-diversified stock investors. It is important for investors to understand that the performance of their portfolio will be different than these three indexes, and they should not be concerned when it is.
Employee Stock Ownership Plans
David Ruedi, CFP®
One way employers can incentivize employees to do a good job and grow the revenues of the company is by making them owners of the company as well. This is often done using what is called an Employee Stock Ownership Plan, or “ESOP” for short.
An ESOP is a trust fund for the purpose of holding stock designated for the employees in the plan. The trust owns the stock of the employer, which it allocates to employees over time as part of their compensation. Employees pay no tax on the ESOP shares allocated to them, but are later taxed when the funds are distributed.
These contributions “vest” over time – employees own their ESOP stock in proportion to how long they have worked for the company. Any vested shares are paid out after you leave the company, on a schedule that depends on the manner in which you left. If you reach the normal retirement age set by the plan, or the company decides to end the ESOP, your shares vest immediately.
When it comes time to take a distribution from the plan, the company can either purchase the vested shares from an employee and pay out cash, or enable the employee to sell the stock on the market if it is a publicly-traded company. Distributions may be made all at once or in equal payments over a five-year period, and are taxed at your ordinary income tax rate. Getting money out of the plan while you are still employed is usually difficult, if not impossible.
ESOPs are required to have a provision that allows employees to diversify after certain requirements have been met, usually the employee reaching age 55 and 10 years of service. A person who qualifies may elect to diversify up to 25% of his or her account balance in the following 5 years, and up to 50% in the 6th year. How a company allows employees to diversify is up to them. They can offer other investment options (at least three) within the ESOP, distribute the election proceeds, or transfer them to a 401(k) or other defined contribution plan.
ESOPs can be a great way to align the interests of employees with an employer, and provide employees with another way to automatically invest and build their wealth. If employees must contribute their own money to participate in the plan, they should weigh this benefit against the risk of tying both their personal income and investment portfolio to the same company, which has the potential to devastate their finances.
Paul R. Ruedi, CFP®
It is not uncommon for investors, especially investors in the United States, to only hold stocks from their home country in their investment portfolios. Though there are some good reasons to have some degree of a “home bias” in your investment portfolio, investing entirely in one country, even a large country like the United States, is probably not the best approach.
According to statista.com, the United States makes up just over half of the world’s stock market capitalization (the total dollar amount of stocks available for investment). That is a lot for a single country, but by investing only in the United States you are ignoring almost half of the global stock market! By investing outside the US, investors can diversify across thousands of additional companies in many different countries.
Stocks from countries outside the US are divided into two groups: companies in “developed” markets and companies in “emerging” markets. Developed international markets are politically stable countries with well-established economies and stock markets. These are countries like England, Japan, Canada, Australia, Hong Kong, and Germany.
Emerging markets have comparatively less-established economies or less transparent investment infrastructure. Emerging market countries are generally considered riskier for investors than developed international markets. These are countries like Mexico, Brazil, Russia, India, and Taiwan. China, in spite of its large population and economy is still considered an emerging market.
You can invest in developed international countries and emerging markets companies using index funds dedicated to each of those two asset classes. It is also very common to see both internationally developed and emerging markets companies lumped together to provide access to the whole world (minus the US) in a single fund. There are even mutual funds and ETFs that own the entire globe; US stocks, international developed stocks, and emerging markets stocks, all in a single fund.
Investors should understand that a globally diversified portfolio will behave differently than the common benchmarks that are tracked on TV, almost all of which only represent US stocks. Performance differences between US stocks and international/emerging stocks will happen, and though they are cyclical they cannot be predicted with any consistency. US stocks have been the strong performer over the past decade, but the decade prior the tables were turned as US stocks experienced a “lost decade.”
Though investing outside the US may feel outside of some investors’ comfort zones, investing in developed international markets and emerging markets is essential if they want to be fully diversified. Over the long-term, this diversification should provide a smoother ride for investors than investing in a single country.
Bull and Bear Markets
Paul R. Ruedi, CFP®
A couple of the oldest and most used examples of financial jargon are “Bull” and “Bear” markets. In a general sense, they are just another way of saying the market has been predominantly going up or down. The choice of animals to describe stock market movements may seem strange, but there is some sense to it. As bulls charge with their horns up, a “bull” market occurs when stock prices rise. Bears charge with their heads down, so naturally a “bear” market describes when stock prices are falling.
Stock movements up or down must technically meet certain criteria to be considered a bull or bear market. A bear market is defined as a decline of 20% or greater, though on average stock prices fall over 30% during a bear market and can even fall as much as 50% or more. Technically speaking, a market drop of 19% would not be considered a bear market. A smaller decline between 10% and 20% is called a “correction.”
There is no universal metric to define a bull market, but generally speaking, a bull market occurs when the stock market has risen at least 20%. A bull market is often considered “confirmed” when stock prices reach new all-time highs.
2020 was a historic year for many reasons. The longest bull market in history, which began in March 2008, came to an end in late February when the market peaked before rapidly declining. From late February until it bottomed out on March 23, the S&P 500 Index fell over 30% during what was the shortest bear market in history. From that point the market came screaming back and was confirmed as a bull market when the S&P 500 made new highs in August.
Though it is tempting to try to own stocks during bull markets and avoid them during bear markets, this year has been a perfect example of why that is almost impossible to do successfully. Though turning points seem obvious after the fact, there are no obvious signals or warning signs that allow investors to make changes to their portfolio in advance.
The key to successful investing is to understand that all bear markets, though scary, are temporary interruptions along a seemingly permanent path of growth in the stock market. Investors must understand their discipline will be tested by bear markets, but they will need to stick to their investments at all times in order to fully reap the rewards of bull markets.