Ask the Fool
Funds vs. Stocks
Q: Is it best to invest only in mutual funds to avoid losing money in stocks? — D.G., New Orleans
A: You can make mistakes and lose money (or just not grow your money much) with many mutual funds, too.
The simplest way to invest in stocks for the long term is to stick to low-fee, broad-market index funds, such as ones that track the S&P 500 index of 500 big American companies. Invest a lump sum, or keep adding to your investment regularly, but either way, hang on through thick and thin. It’s important to not sell in a panic, as many people do when the market temporarily swoons.
It’s very possible to make blunders with mutual funds, such as buying ones that have soared after one unusually good year, only to watch them underperform in subsequent years. Other mistakes include buying funds that charge high annual fees or that have high turnover rates due to fund managers buying and selling too often.
For the lowest fees and turnover rates, your best bets are index funds.
Q: Do single people need life insurance? — P.R., St. Joseph, Michigan
A: They often don’t. Life insurance exists primarily to protect anyone who depends on you financially, such as a spouse, your kids, your parents or perhaps even your business. If your kids are grown and no one would be hurt financially by your demise, you don’t need it.
It’s usually best to buy term life insurance, and just for the term over which you’ll need it. Don’t buy insurance as an investment, because you can end up with insurance you don’t need and an investment that’s less profitable than many alternatives, such as stocks.
It’s best to buy stocks when they’re undervalued. But figuring out whether a stock is undervalued is easier said than done. Even smart investors can disagree on how to decide. One handy metric offering a rough idea of valuation is a stock’s price-to-earnings (P/E) ratio.
You can find P/E ratios for stocks already calculated for you at financial websites, but doing the math yourself is fairly easy: To calculate a P/E, take the stock’s current price per share, and divide it by the earnings per share (EPS) over the past 12 months. (For a forward-looking P/E, divide by the expected EPS over the coming year.)
For example, imagine that Holy Karaoke Inc. (ticker: HYMNS) is trading at $48 per share. If its EPS for the last four reported quarters (“trailing 12 months”) totals $3, divide $48 by $3, and you’ll get a P/E of 16. A P/E ratio will rise when the stock’s price increases or EPS falls — and vice versa. So if Holy Karaoke is trading for $48 but its EPS is only $2, its P/E ratio will be 24 ($48 divided by $2).
The P/E ratio tells you how much you’d pay per dollar of earnings if you bought the stock. In finance-speak, a stock with a P/E of 24 might be referred to as “trading at a multiple of 24.”
When assessing a company’s P/E, compare its trailing and forward-looking P/Es. If it’s expected to report higher earnings next year (a good thing), the forward P/E ratio should be lower. (Note that P/E ratios are not calculated for unprofitable companies, as they have no earnings and you can’t divide by zero.)
In general, the lower the P/E, the more attractive the stock’s valuation. P/E ranges can vary by industry, so it’s best to compare a stock’s P/E with those of peers in its industry, or with its own five-year average P/E. Also, don’t focus too much on that particular ratio. Look at other numbers as well, such as revenue and earnings growth rates, profit margins, debt levels and the trends you see in each.