Questions New Investors Are Afraid to Ask: Part 2
Last week, I wrote about the investing concepts people need to understand but often hesitate to ask about—things like asset allocation, diversification, and risk. But if you’re unclear on a concept, I say ask. And ask again if you have more questions.
The same goes for types of investments. Stocks and bonds might seem pretty basic, but there’s a lot to understand about the different types and why one might be a better choice than another. So this week, I want to discuss what to look for when choosing investments.
Starting with stocks
A share of stock is a portion of ownership in a company, allowing you to participate in a company’s growth. While owning stocks carries the risk of loss as well as the potential for gain, historically it has been one of the best ways to build wealth over time.
When you choose a specific stock, however, you have to look closely. Here are some things to consider:
- Market capitalization—Companies vary by size, or market capitalization, which is the total value of outstanding shares of a company’s stock. Apple currently has the largest market capitalization in the world and is a great example of a large-cap stock. But there are also small-cap and mid-cap stocks.
- Style—Getting more detailed, there are two basic styles of stock: growth and value. A growth stock is considered poised for a rapid rise (think high tech); a value stock is considered underpriced for its earnings and long-term prospects.
- Sector and industry—Stocks are also generally divided into 11 sectors (such as information technology, utilities, and health care) and 69 industries within those sectors (such as retailing, banks, and building products).
- International/Domestic—You can invest in companies based in the U.S. or abroad. International markets can be further divided into developed markets (such as Japan or the U.K.) and emerging markets (such as China or India).
The ideal is to invest in a globally diversified mix of stocks of all of the above. This helps control risk, although it certainly doesn’t ensure a profit or eliminate risk. Sounds challenging, but don’t get discouraged. Here’s where mutual funds and exchange-traded funds (ETFs) come in, which I’ll get into in just a bit.
Moving into bonds
Bonds operate much like an IOU; you lend money to a company, government, or government agency and, in return, you receive a promise of repayment, plus interest, at specific dates. Bonds complement stocks and are particularly useful for retirees as they can provide a predictable income stream. They’re generally less volatile than stocks but not without risk.
There are many types of bonds (for example, corporate, government, and municipal), each of which carries varying degrees of different types of risk, including:
- Default risk—if the issuer defaults on its promises of repayment or goes bankrupt, and you won’t get your money back,
- Interest rate risk—if interest rates rise, and the value of your bond goes down,
- Purchasing power risk—if the price and/or interest you receive loses value relative to inflation.
In general, bonds that have the highest risk have the highest yield and the longest maturity. For example, a long-term bond from a start-up company would be high risk, and even higher if it had an unclear future or was already heavily indebted. U.S. Government bonds, which include Treasury bonds, notes, and bills, are considered the safest. Shorter-term bonds are less volatile than longer-term bonds but generally have a lower yield.
To help clarify the risks, credit rating agencies issue a grade, or credit rating, to virtually every corporate or government bond. Keep in mind that these ratings can change after you buy.
Giving a nod to cash and its equivalents
Cash isn’t only the balance in your savings account; it can also be a type of investment. Cash investments, also called cash equivalents, are low risk but have minimal potential for return. Think CDs, Treasury bills, and money market funds.
Thinking about the plusses and minuses, cash is great for stability and liquidity, but it’s not the best choice for building long-term wealth. In fact, returns may well be lower than the inflation rate. Therefore, if you have too much of your money in cash, it could be harder to meet your long-term goals.
Making the most of mutual funds and exchange traded funds (ETFs)
If you’re thinking it’s time-consuming and complicated to evaluate all the choices—you’re right. Luckily, mutual funds and ETFs can help simplify the process because they do much of the choosing and monitoring of individual securities for you.
- Mutual funds—A mutual fund pools money from many investors and invests in a broad range of securities. That way, you can achieve a certain level of diversification without having to choose each individual security. Be careful, though, because the amount of diversification you achieve depends on the mutual fund(s) you choose (there are stock funds, bond funds, money market funds, and funds that invest in all of these). Mutual funds are professionally managed, so you don’t have to follow the day-to-day market. There are two fundamentally different approaches to consider: passive and active. Passively managed funds, known as index funds, are designed to track—rather than beat—a specific index such as the S&P 500®. (The S&P 500 index tracks the performance of 500 large companies representing nearly 80% of the total U.S. market.) Actively managed funds, on the other hand, strive to beat the market. While active management may result in better performance than an index, it’s no guarantee, and higher costs may result in worse performance. You can mix and match passive and active strategies based on your preferences.
- ETFs—With an ETF, you own a single security representing a basket of underlying securities that track an index. The main difference between mutual funds and ETFs is the way they’re traded: mutual fund trades are processed at the end of the day; ETFs trade like stocks any time during the trading day. ETFs are also professionally managed—most passively similar to index mutual funds—but there are some actively managed ETFs.
Another important consideration is cost. Index funds generally have low fees; actively managed funds can cost a pretty penny. In the case of small-cap or international markets, active managers may have better odds to beat an index, but low costs are still important. However you invest, the advantages of low-cost investing compound and can make a big difference in your returns over time.
Always read the prospectus to understand the fee structure and how your money is invested. Lastly, even if a mutual fund or ETF has low fees, you may be charged a commission when you buy or sell.
Taking the next step
There are other types of investments, but stocks, bonds, and cash are the core building blocks of an investment portfolio to implement asset allocation and diversification. Next week, I’ll talk about types of accounts, taxes, and staying on top of your investments. Then you should be ready to get started!
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