Stocks, bonds and cash are the building blocks of your portfolio.
It's important to understand the different types of stocks and bonds and why one may be a better choice than another.
Mutual funds and exchange-traded funds can simplify your investment selection.
Last week I talked about investing concepts that people want to understand but are too often afraid 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 don't completely understand.
The same goes for types of investments. Stocks and bonds might seem pretty basic but there's more to understanding the different types and why one might be a better choice than another. So this week, I want to give you some insight into what to look for when choosing investments.
Starting with stocks
Topline, a share of stock is a share of ownership in a company as well as a share of possible profit. Owning stock is a great way to participate in a company's growth potential. And while owning stocks carries a certain amount of risk—there are no guarantees and past performance can’t predict future results—historically they're the best way to grow your money over time.
When it comes to choosing a specific stock, however, you have to look closely. Companies vary by size, or market capitalization, which is the total value of all the shares of a company's stock. Apple, currently with the largest market capitalization in the world, is a great example of a large cap stock. But there are also small—cap and mid-cap stocks—plus foreign stocks, representing companies based outside the U.S.
Getting more granular, there are two 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. Going even deeper, stocks are generally divided into 10 sectors (information technology, telecom services, utilities, health care, financials, industrials, consumer discretionary, consumer staples, materials and energy) and 67 industries within those sectors (such as retailing, banks, and building products).
The ideal is to invest in a diversified mix of stocks of different sizes, styles, sectors, industries and countries. This helps control risk, but it doesn’t ensure a profit or eliminate the potential for loss. Sounds complex, 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
You've probably heard of fixed-income investments. These investments generally pay a specific interest rate over a certain time period and promise to return your principal at maturity. A bond is right up there at the top of the fixed income list. A bond is like an IOU. You lend money and, in return, you receive a promise of repayment, plus interest, at a set date.
Bonds complement stocks because they focus on income rather than growth. And they're generally less volatile. This can be particularly appealing to older investors seeking to create a regular income stream.
That's not to say there isn't some 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 (the risk the issuer will go bankrupt and you won’t get your money back), interest rate risk (the risk that market interest rates will rise and the value of your bond will go down), and purchasing power risk (the risk that you will lose ground relative to inflation).
In general, corporate bonds offer the highest yield potential at the highest risk. U.S. Government bonds, which include Treasury bonds, notes and bills, are considered the safest. Bonds are rated so you'll have a sense of the risk before you buy.
Making the most of mutual funds and exchange traded funds (ETFs)
At this point you're probably thinking it's impossible to evaluate all the choices—and you're right. Luckily, there are mutual funds and ETFs that can do much of the choosing and monitoring for you.
A mutual fund pools money from many investors and invests in a broad range of securities—offering a certain amount of diversification without having to choose individual stocks. But you still have to do some work because there are several types of mutual funds—stock funds, bond funds and blended funds that invest in both. There are also sector specific funds. The amount of diversification you get depends on the mutual fund(s) you choose. A good choice for many new investors is a broad-based stock fund.
Mutual funds are professionally managed, so you don’t have to spend time following the day-to-day market. But 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. Actively managed funds, on the other hand, strive to beat the market. An important consideration is cost: index funds generally have low fees; actively managed funds can cost a pretty penny. The added cost can be justified—for example in the case of a small-cap or international fund when market information may be more difficult to obtain—but make sure before you buy. Always read the prospectus to understand the fee structure and how your money is invested.
An ETF is another way to simplify choices. With an ETF, you own a single security representing a basket of stocks that tracks 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 funds. They generally also have low fees but may charge a commission when you buy or sell.
Giving a nod to cash and its equivalents
Cash isn't only the balance in your savings account; it's also a type of investment. Cash investments, also called cash equivalents, are low risk but have low return potential. Think CDs, Treasury bills and money market funds.
Like any other investment, cash has its plusses and its minuses. It can be great for providing stability and liquidity, but if you’re trying to build long-term wealth, it’s not the best choice. The low returns may well be lower than the rate of inflation. In effect, you could lose money—and limit the opportunity to reach your goals. Once again, it comes down to finding the mix that best suits your needs.
Taking the next step
These basic investments are the building blocks you need to implement the concepts in the previous column. 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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