Beautiful and Smart: they ask Great Questions
We have three teenage granddaughters. One lives within minutes of our home and two live a couple of hours away. This week the two that live in Illinois sent me four questions. The questions can be summarized as follows: 1) Noelle: “What determines a shares value?”; 2) Noelle: “How do I know when I’m paying too much for a share?”; 3) Noelle: “How do I know when to sell a share?”; and 4) Mia: “You mentioned some specific ETFs that we shouldn’t buy because they’re preferred shares and bond funds. what is the difference between those and stock funds, and why should we not be buying the bond funds?”
Mia’s Question First: She asks about Preferred Stock and Bond ETFs
What are preferred shares ETFs and bond funds? Both of these investments focus on income. Preferred shares have more “safety” than common shares because preferred shareholders are more likely to be guaranteed their dividend if a company has to stop paying dividends during hard times. The preferred share dividend has a priority. However, you give up something when you buy preferred stock.
Usually, you won’t see much growth in the price of the preferred shares. Also, depending on the economy and interest rates, the value of your shares could decrease. When you are young, you should invest more for growth and less for just income. Preferred shares have a place in my accounts, because I am retired and don’t really need fantastic growth.
Bonds and Bond Funds
When you buy a bond, you are buying an investment in a loan to a municipal government (like a city), to a hospital, or to a business. Bonds, like preferred stock shares, are a good income investment, but they are prone to the same weaknesses of preferred shares. When you are young you don’t need bonds either. In fact, less than 1% of my investments are in bonds or bond funds. They are not going to grow, but they do pay a dividend. Buying a bond is like loaning money to your sister and charging her interest. She might pay you, but she might not. There is risk in owning bonds, including that the bond might become worthless if they cannot pay you interest.
What determines a share’s value?
That is a very good question, Noelle. Many things contribute to the price of a share. Think about it as a supply and demand problem. If everyone wants toilet paper, but there isn’t much toilet paper available, the companies that make toilet paper and the stores can charge more for the toilet paper.
Prices go up when demand increases. If demand drops, prices often drop too. If a business is earning a lot of money and if their profits are increasing every year, and they have more-and-more customers, and they are paying more dividends from their profits, then many investors will want to buy shares. When more people want the shares, the price often goes up. The hard part is knowing how high is too high. At some point, wise investors will sell some of their shares. If everyone starts selling, and there aren’t any buyers, the price of the shares could drop very quickly.
How do I know when I’m paying too much for a share?
There is no easy answer to this question, Noelle. Two years ago, some advisors were saying that Apple (AAPL) shares were too expensive. They were telling people to sell their shares in AAPL. They were very wrong. But they could have been right, at least for the short-term. Think long-term. Do you think Apple will continue to innovate and gain more customers? I do. I still buy Apple shares and I sell them when I am ready to take some profits.
If you are a long-term investor, you should focus more on the quality of the investment and less on whether or not today’s price is a good deal or not. One way to help avoid over-paying is to buy shares gradually. Therefore, if you think Ford (ticker = F) is a good long-term investment. You might enter a buy limit order to buy 10 shares at $14 per share. If the price the next week drops to $13.75 per share, you might buy another five shares. One mistake investors make is buying all of the shares they want in a single buy order. It is often good to wait to buy on a day when the shares are going down. I do that all the time.
There is one measurement you should learn about. It is called the price/earnings ratio. It is often abbreviated P/E ratio. The P/E ratio tells you how much one investment costs compared to a similar investment. If two equally good investments are being compared, and one has a smaller number for the P/E ratio, then it may be a better long-term investment. This is not, however, the best way to determine if an investment is a good one or not. It is best to ask for advice from more experienced investors like your dad or me.
How do I know when to sell a share?
I wrote a series of blog posts in February 2020 about this very topic. If you go to my blog and in the search box type, “SELLING INVESTMENTS RULE” you will see six different blog posts that explain this in more detail. In my next post I will talk about the six rules in one blog post, so you can wait for that one, or you can try reading the six I already wrote. Here is what they look like: