Thoughts On Investing, Steve Jobs, And You

"Save and invest."

This is advice we commonly hear from our earliest years; either from our parents, a teacher, professor, mentor, or adviser. And with those words, we are introduced to the subject of investing. Later, you may hear about the market. As in, "The market was up (or down) today!" Finally, sooner or later you will likely hear someone either bragging about, or bemoaning the state of, their portfolio.

But what, exactly, is investing? What is the market? What is a portfolio? What does it all mean?

There are many highly technical definitions of investing to which I could point you. In fact, I just did, via the link in the last sentence. Here, though, is a very simple one to ponder:

When you commit a dollar today with the expectation of receiving more than a dollar tomorrow.

I hope that simple sentence captures the basic essence of investing. If you have no expectation of that dollar being worth more tomorrow, you might as well spend it today. Why? Because, almost without exception, a dollar is worth more today than tomorrow due to inflation. Think about the Starbucks Grande coffee you paid $2.25 (Update: $2.45 as of mid-2016) for this morning which was only $1.50 a couple of years back. Oversimplified, that is inflation at work.

For purposes of this article, I am also going to carve out one more distinction; saving vs. investing. You could simply put your money in a bank account. This is a form of investing as well. But for the purposes of this article, we are going to specifically talk about something more adventurous. You want to take some portion of your savings out of the bank and invest it.

In this brief primer, we will touch on four concepts.

Ideas
Capital
Risk
The Market

This will not be a lengthy treatise, filled with mathematical formulas or lengthy explanations. I hope, though, that it will be enough to give you a basic understanding of what is going on, as well as whet your appetite to learn more.

Ideas

This first point may have come as a surprise. When you think about investing, your first thought may have been about companies. For example, you may wish to invest in Apple, Inc. (AAPL). At the most fundamental level, however, companies are based on ideas.

It was no accident that I picked Apple to explain this point. When you think of Apple, you likely also think of Steve Jobs, one of the true geniuses of our time. And when you really think about Steve Jobs, you likely make the connection to ideas.

Let me feature just one. On October 23, 2001, Apple unveiled the iPod. The iPod was far from the first portable digital music player on the market. By the late-1990s many companies had already offered MP3 players. However, these generally were burdened by serious limitations; from minimal storage capacity to poor user interfaces.

Apple's iPod literally revolutionized the device. With a newly-developed 1.8-inch 5GB hard drive from Toshiba and an iconic scroll-wheel interface which enabled the user to quickly scan and access the thousands of songs the device could hold, the iPod became a runaway hit. (For more on the history and development of the iPod, see this article from Macworld.com.)

But the iPod was not merely a standalone project. More or less concurrently, Apple also developed the iTunes Music Store. It was really the first time that an online music store had been successfully created. Users were able to purchase and download both entire albums and single songs to the iTunes software and, in turn, their iPod.

What is the point of all of this in the context of investing, and this article? Simply, to share a real-world example of the concept that everything starts with an idea. Ideas, when combined, become companies, which ultimately produce the products and services we use each day.

Ultimately, the popularity of the iPod has decreased over time. A huge reason is that Apple later integrated its capabilities into another iconic device; the iPhone. Again, an idea that became a product that revolutionized yet another market.

Now, if you happen to be the next Steve Jobs, one option you have is to invest in your ideas. Start a company, produce something, and reap the benefits. The reality is that most of us, however, will not come up with such great ideas. Not everyone has Steve Jobs' unique genius to conceive of something like the iPod, iTunes or iPhone. However, we can invest in the company he helped to create. If you choose to invest in Apple, you essentially express your belief that the products and services this company offers will be able to provide a return on your investment. In other words, that a dollar invested today will be worth more than a dollar in the future.

Capital

This brings us to the second concept; that of capital. Capital is basically just the flow of money available in the marketplace, money that you and other investors can make available to a company if you believe in the value of their products and services. Companies, in turn, use this capital to turn their ideas into products and services.

In general, companies raise capital in the marketplace in two forms; Debt or Equity.

Debt
Debt, as the name implies, essentially takes the form of a loan. In the case of corporations, this is typically done by issuing bonds. When a corporation issues a bond, they basically promise that, in return for you giving them a dollar today, they will periodically offer you income in the form of coupons and return your original dollar at the end of a specified term, known as maturity. Please feel free to read my related article for an in-depth explanation of bonds.

Equity
In contrast, equity represents an ownership share in the company. Unlike a bond, however, there is no promise to pay on the part of the company. In fact, should the company fail, bondholders are first in line to be repaid with whatever funds are available. On the other hand, as an owner, you will share proportionately in the future success of the company, If the company's products and services are successful, you will reap handsome financial rewards. Please feel free to read my related article for an in-depth explanation of stocks.

A Simple Example
To help you conceptualize the difference between debt and equity, consider the following simple example.

A good friend of yours is a talented baker. His cakes, cookies and various other pastries are better than anything offered commercially in your area. In fact, he already sells small batches to various grocery stores and they sell out faster than he can produce them. Encouraged by the response he is receiving, your friend decides to go big time, to start his own business. You believe in him, his work ethic, organizational skills and--most of all--the product. However, he needs $100,000 to get started; to rent an appropriate facility, purchase equipment, and hire employees.

You approach your friend and tell him that you would love to invest in his business. He replies: "Great! Here is my plan. To raise the $100,000 I need, I am going to offer two friends the ability to invest in my company. Each investment will be $50,000. The first option will be a five-year loan. I will sign an agreement to pay 10% interest, paid twice a year. At the end of the five years, I will repay the $50,000. The second option will be a 10% ownership share in my company. I won't be able to pay any dividends because I will need to reinvest the money to grow my business. However, my business plan projects that, in 5 years, I will have two baking locations and 10 retail outlets. At that point, the business should be generating $3 million per year in revenue with a 10% profit margin, or $300,000 per year of income. I'm offering you first choice. How would you like to invest?"

As you doubtless immediately recognize, the first option is like owning a bond. The second is like owning a stock. If you select the first, you know exactly what to expect. You expect to receive a payment of $2,500 twice a year and get your original investment of $50,000 back in 5 years.

With the second option, you aren't guaranteed anything. No payments have been specified. Further, if the business fails, the friend who grants the $50,000 loan will be repaid first, before you get a penny. On the other hand, look ahead 5 years. In fact, look ahead 10 years. Remember, you are a 10% owner of the business. Let's say that in 5 years the business was valued at $2.5 million. Your 10% share would be worth $250,000, as opposed to the $75,000 you would have received from the interest on that 5-year loan together with the return of your original capital. What if, in 10 years, the business is valued at $10 million? By now, you have likely grasped that this is the equivalent of owning stock in a company.

Risk

Both in my simple definition of investing, and several times since, I have used the words "expect" or "expectation." That word reflects something known as risk.

Simply put, risk recognizes that we live in a world with a lot of unknowns. There is a possibility that things will work out well, both in terms of the macro environment as well as our specific company. There are also any number of things that could go wrong. For a simple look at risk, consider the following two pictures. I grabbed these from Yahoo Finance on the day this article was written.

This first picture shows the yield currently being paid by U.S. Treasury Bonds.

This second picture shows the yield currently being paid by various Corporate Bonds.

If you compare them carefully, you will notice a couple of things.

In both cases, the longer the term of the bond, the greater the yield.
In the case where the U.S. Treasury bond and the corporate bond are of the same maturity (e.g. 5 years), the yield on the corporate bond is higher. Further, the lower the credit rating of the corporate bond (e.g. A vs. AA vs. AAA), the higher the yield.

You can read about the specifics in more detail in my previously-linked article on bonds. Essentially, the variance in yield reflects that there is more risk inherent in a bond with a 5-year term than a 1-year term, and also that there is judged to be greater risk in a bond issued by a single corporation than in one issued by the U.S. government. The difference in yield is how the market compensates investors for taking on added risk.

With that background, take a look at some very interesting data from a classic investment resource, the Ibbotson SBBI 2009 Classic Yearbook, as featured in this link.

Over a period of 82 years, this simple chart helps you to understand, and visualize, the risk/reward characteristics of some prominent U.S. asset classes. Clearly, the greater the average return you hope to achieve, the more risk you have to take on to do so.

Please see this article for a discussion of how ETFs can help you to manage this risk. It will also serve to introduce the concept of portfolios.

The Market

In our final section, let's briefly put it all together.

When we talk about the market, we are talking about the capital markets in total. It is the market that can help us evaluate the merits of an investment we may be considering.

In the simple example I presented in the 'Capital' section, I proposed a friend offering you either a 10% yield over 5 years or 10% ownership in the company in exchange for a investment of $50,000. Taking a look at that chart of historical returns in the previous section, and setting friendship aside for a second, would you take either of those offers? Or would you invest your hard-earned money somewhere else?

Remember, no investment stands in total isolation. One must always ask the question: "Where else could I invest my money? Is what I am considering a better deal, or worse?" It is the market that can help you do that.

Summary And Conclusion

In this brief primer, we have talked about the notion that, when you invest, ultimately you are investing in ideas. You are doing so by providing capital that can help turn those ideas into products and services. Along the way, you must evaluate the level of risk you are assuming, and whether the potential rewards justify that risk. And finally, that the market is a valuable tool in helping you analyze this, in comparison to what you could earn from investing your money elsewhere.

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