Stocks, Bonds and Cash

What is a stock?

A stock—also called an equity security—represents a share of ownership in a company. A few basic types of stocks include:

• Large-cap—generally understood as the largest 5 percent of domestic companies in terms of capitalization
   
• Mid-cap—the next largest 15 percent of domestic companies in terms of capitalization
   
• Small-cap—the remaining 80 percent of companies
   
• International—foreign (non-U.S.) companies

Capitalization is the total stock market value of all shares of a company's stock. This is calculated by multiplying the stock price by the number of shares outstanding.

There are actually two primary classes of stock:

• Common stock is a share of ownership that you buy when you invest in a company. Owning common stock typically entitles owners to vote at shareholder meetings and receive dividends (if the company chooses to pay them). If you hold common stock you're in a position to share in the company's success or feel the lack of it.
   
• Preferred stock acts much more like a bond than common stock. It pays a fixed yield, and the prices tend to be less volatile than common stock, but also provides less potential for total return. Preferred stockholders usually don't have voting rights, but they receive dividend payments before common stockholders do, and have priority over common stockholders if the company goes bankrupt.

How stocks are characterized

You might also hear about the style of a stock, or a reference to what industry or sector a stock is in. Here's basically what this means:

• Style refers to whether a stock is considered to be a growth investment (with earnings and share price expected to grow rapidly) or a value investment (believed to be underpriced and a good value).
   
• Sector and industry refer to a commonly used classification system in which stocks are generally divided into 11 sectors (information technology, telecom services, utilities, health care, financials, industrials, consumer discretionary, consumer staple, materials and energy) and 68 industries within those sectors (examples include food and drug, retailing, banks, building products, etc.).

To make investing easier when you're first starting out, think about investing in a mutual fund or exchange traded fund (ETF) as opposed to an individual stock.

What is a bond?

A bond is like an IOU. You lend a borrower some money, and in return you receive a promise of repayment, plus interest, at a set date. There are many types of bonds with varying degrees of risk, including the following:

• Corporate bonds are issued by corporations seeking to raise capital. In general, they offer the highest yield but also have the highest risk.
   
• Municipal bonds, also called "munis," are issued by state or local governments. They are popular among investors in high tax brackets, thanks to the fact that they usually are not subject to federal taxes and also may not be subject to state taxes.
   
• Government bonds are issued by the U.S. Treasury or other federal agencies. Treasury bonds (10- to 30-year maturity), Treasury notes (1- to 10-year maturity), and Treasury bills (90-day to 12-month maturity) ("T-bills") are backed by the full faith and credit of the U.S. government and considered the safest of debt instruments. While they are free from state taxes, they are subject to federal taxes. Most other bonds issued by federal agencies are not guaranteed by the federal government, but they are still considered high-quality investments.

How bonds are rated

Bonds are rated to help investors understand how risky they are. So before you buy a bond, it's important to understand its rating and understand that ratings can change.

Bonds are rated on their credit quality by major rating systems like Standard & Poor's and Moody's. The ratings are based on the likelihood that the bond issuer will default, failing to pay its obligation to investors.

Here's the basic rating system:

• AAA by Standard & Poor's (Aaa by Moody's)—highest-quality bonds
   
• BBB or higher by S&P (Baa or higher by Moody's)—investment-grade bonds, for consideration by prudent investors
   
• Below this threshold—riskier but higher yielding bonds, often referred to as "junk bonds"
   
• RD or lower by S&P—bonds already in default

Not surprisingly, lower-quality bonds generally offer higher returns as an incentive to purchase in spite of the higher risk.

What are cash and cash investments?

These types of investments are low-risk and offer lower returns, but they're smart for shorter-term goals, day-to-day expenses and emergency funds. They include the following:

Cash—

• Checking and savings accounts are good for day-to-day expenses and an emergency reserve. Be sure to seek out an account with a competitive interest rate, but watch out for minimum-balance requirements and fees.

Cash investments—

• Shorter-term CDs and T-bills can be attractive short-term investments if you have a specific timeline and value a certain return. These investments tend to pay slightly more interest but typically must be held for periods of three to 12 months
  .
• Longer-term CDs, ultra-short bond funds and stable value funds are other options to consider for allocation of your cash.

The pros and cons of cash and cash investments

Keeping money in cash is appropriate if you need to get to it quickly.

But when it comes to your long-term goals, cash and cash investments present another kind of risk: inflation risk. That's because the low returns you're likely to get may very well be lower than the rate of inflation. In effect, you may be losing money—and limiting the opportunity to reach your goals.

To avoid keeping too much money in these categories and having too much inflation risk, stick to the percentage of cash recommended by your asset allocation plan, and keep at least three to six months of living expenses in an emergency fund in case something unexpected happens.