Types of Investments: Stocks
How do Stocks Work?
When you buy a company's stock, you're purchasing a share of ownership in that business. You become one of the company's stockholders or shareholders. Your percentage of ownership in a company also represents your share of the risks taken and profits generated by the company. If the company does well, your share of its earnings will be proportionate to how much of the company's stock you own. The flip side, of course, is that your share of any loss will be similarly proportionate to your percentage of ownership.
The role of stocks in your portfolio
Though past performance is no guarantee of future results, stocks historically have had greater potential for higher long-term total returns than cash alternatives or bonds. However, that potential for greater returns comes with greater risk of volatility and potential for loss. You can lose part or all of the money you invest in a stock. Because of that volatility, stock investments may not be appropriate for money you count on to be available in the short term. You'll need to think about whether you have the financial and emotional ability to ride out those ups and downs as you try for greater returns.
The universe of stocks offers enormous flexibility to construct a stock portfolio that is tailored to your needs. There are many different types of stock, and many different ways to diversify your stock holdings. For example, you can sort through stocks by industry, by company size, by location, and by growth prospects or income.
Growth stocks are usually characterized by corporate earnings that are increasing at a faster rate than their industry average or the overall market. Income stocks (for example, utilities
or financial companies) generally offer higher dividend yields than market averages. Value stocks are typically characterized by selling at a low price relative to a company's sales, earnings, or book value.
These are only some of the many ways in which stocks can be identified, and your financial professional can help you decide which might be more appropriate for you than others. With stocks, it's especially important to diversify your holdings. That way, if one company is in trouble, it won't have as much impact on your overall return as it would if it represented your entire portfolio.
Advantages
Historically, have had greater potential for higher long-term total return than cash or bonds
Easy to buy and sell
Can provide capital appreciation as well as income from dividends
Ownership rights
Trade-offs
Poor company performance can affect dividends and share value
Greater risk to principal
May not be appropriate for short-term investment
Subject to market volatility
Types of Investments: Bonds
How do bonds work?
When you buy a bond, you're basically buying an IOU. Bonds, sometimes called fixed-income securities, are essentially loans to a corporation or governmental body. The borrower (the bond issuer) typically promises to pay the lender, or bondholder, regular interest payments until a certain date. At that point, the bond is said to have matured. When it reaches that maturity date, the full amount of the loan (the principal or face value) must be repaid. A bond typically pays a stated interest rate called the coupon, a term that dates back to the days when a bondholder had to clip a coupon attached to the bond and mail it in to receive each interest payment.
Most bonds pay interest on a fixed schedule, usually quarterly or semiannually, although some pay all interest at maturity along with the principal. There are two fundamental ways that you can profit from owning bonds. The most obvious is the interest that bonds pay. However, you can also make money if you sell a bond for more than you paid for it. As with any security, bond prices move up and down in response to investor demand; they also are sensitive to changes in interest rates. Bonds redeemed prior to maturity may be worth more or less than their original cost, and those that seek to achieve higher yields also involve a higher degree of risk.
The role of bonds in your portfolio
One of the most important reasons that investors choose bonds is for their steady and predictable stream of income through interest payments. Bonds have traditionally been important for retirees for this reason. Also, though they are not risk-free--for example, a bond issuer could default on a payment or even fail to repay the principal--bonds are considered somewhat less risky than stocks. In part, that's because a corporation must pay interest to bondholders before it pays dividends to its shareholders. Also, if it declares bankruptcy or dissolves, bondholders are first in line to be compensated.
The bond market often behaves very differently from stocks. For example, when stock prices are down, investors often prefer bonds because of their relative stability and interest payments. Also, when interest rates are high, bond returns can be attractive enough that investors decide not to assume the greater risk of stocks. Interest from bonds can help balance stock fluctuations and increase a portfolio's stability. And because a bond's face value gets repaid upon maturity, you can choose a bond that matures when you need the money. Some bonds are exempt from federal or state and local income tax. This can be appealing to investors in high tax brackets.
Advantages
Generally, a predictable stream of income
Income typically higher than cash investments
Relatively lower risk compared to stocks
Low correlation with stock market
Trade-offs
Risk of default
Bond values fluctuate with interest rates
Generally, lower potential returns compared to stocks
Types of Investments: Cash
Cash and cash alternatives
In daily life, cash is all around you, as currency, bank balances, negotiable money orders, and checks. However, in investing, "cash" is also used to refer to so-called cash alternatives: investments that are considered relatively low-risk and can generally be converted to cash quickly. Some examples of cash alternatives include savings accounts, money market accounts, certificates of deposit, guaranteed investment contracts (GICs), government savings bonds, U.S. Treasury bills, Eurodollar certificates of deposit, and commercial paper.
Using cash alternatives
Because of their conservative nature, cash alternatives involve a lower level of risk. However, there is a trade-off for their relative safety: Their potential return is not as high as investments that involve more risk. By focusing solely on playing it safe, you may limit your investment income, especially over longer time periods. Cash alternatives can be useful in many ways. First, they can provide relative stability. While cash alternatives can't assure you of a gain or protect you from losses, they are generally considered safer than other asset classes, such as stocks or bonds. Also, they can provide income on cash that would otherwise be idle. They can serve as a ready source of cash to pay bills or make purchases. For example, cash alternatives can help preserve money earmarked for a down payment or a family vacation. Readily available cash also can help you cope in a financial emergency. Finally, cash alternatives can serve as a temporary parking place when you're not sure where to invest.
Advantages
Professional money management
Small investment amounts
Diversification
Liquidity
Trade-offs
Fluctuating share values
Some money kept in cash for fund liquidity needs
Potential tax inefficiency
Mutual fund fees and expenses
Investing Through Mutual Funds and ETFs
You can invest in all three major asset classes through mutual funds, which pool your money with that of other investors. Each fund's manager selects specific securities to buy based on a stated investment strategy.
Mutual funds offer two key benefits. Because most mutual funds own dozens or hundreds of securities, you achieve greater diversification than buying a few individual securities on your own. Also, the fund manager's expertise is part of what you pay for in buying mutual fund shares.
A mutual fund may invest in one of the three major asset classes, or combine them. For example, a balanced fund typically includes stocks and bonds. With an actively managed mutual fund, the fund manager buys and sells specific securities, trying to beat a benchmark index such as the S&P 500. A passively managed or index fund tries to match the return of a specific index by holding only the securities included in that index.
Like index funds, exchange traded funds (ETFs) typically invest in a group of securities represented in a specific index, and the way they're organized means that expenses typically are lower than those of actively managed mutual funds. But you must pay a brokerage commission whenever you buy or sell ETFs, so your overall costs could be higher, especially if you trade frequently.
Advantages
Professional money management
Small investment amounts
Diversification
Liquidity
Trade-offs
Fluctuating share values
Some money kept in cash for fund liquidity needs
Potential tax inefficiency
Mutual fund fees and expenses
Note: Before investing in a mutual fund or ETF, carefully consider its investment objectives, risks, fees and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing. Mutual funds and ETFs are subject to market fluctuation, risk, and loss of principal. When sold, investments may be worth more or less than their original cost
Asset Allocation
The combination of investments you choose can be as important as your specific investments. The mix of various asset classes, such as stocks, bonds, and cash alternatives, account for most of the ups and downs of a portfolio's returns.
Deciding how much of each you should include is one of your most important tasks as an investor. That balance between potential for growth, income, and stability is called your asset allocation. It doesn't guarantee a profit or insure against a loss, but it does help you manage the level and type of risks you face.
Balancing risk and return
Ideally, you should strive for an overall combination of investments that can help to minimize the risk you take in trying to achieve a targeted rate of return. This often means balancing more conservative investments against others that are designed to provide a higher return but that also involve more risk. For example, let's say you want to get a 7.5% return on your money. Your financial professional tells you that in the past, stock market returns have averaged about 10% annually, and bonds roughly 5%. One way to try to achieve your 7.5% return would be by choosing a 50-50 mix of stocks and bonds. It might not work out that way, of course. This is only a hypothetical illustration, not a real portfolio, and there's no guarantee that either stocks or bonds will perform as they have in the past. But asset allocation gives you a place to start. Many publications feature model investment portfolios that recommend generic asset allocations based on an investor's age. These can help jump-start your thinking about how to divide up your
Many ways to diversify
When financial professionals refer to asset allocation, they're usually talking about overall classes: stocks, bonds, and cash or cash alternatives. However, there are others that also can be used to complement the major asset classes once you've got those basics covered. They include real estate and alternative investments such as hedge funds, private equity, metals, or collectibles. Because their returns don't necessarily correlate closely with returns from major asset classes, they can provide additional diversification and balance in a portfolio.
Even within an asset class, consider how your assets are allocated. For example, if you're investing in stocks, you could allocate a certain amount to large-cap stocks and a different percentage to stocks of smaller companies, or allocate based on geography. Bond investments might be allocated by various maturities, with some money in bonds that mature quickly and some in longer-term bonds. Or you might favor tax-free bonds over taxable ones, depending on your tax status and the type of account in which the bonds are held.
Monitoring your portfolio
Even if you've chosen an asset allocation, market forces may quickly begin to tweak it. For example, if stock prices go up, you may eventually find yourself with a greater percentage of stocks in your portfolio than you want. If they go down, you might worry that you won't be able to reach your financial goals. The same is true for bonds and other investments.
Do you have a strategy for dealing with those changes? Of course you'll probably want to take a look at your individual investments, but you'll also want to think about your asset allocation. Just like your initial investing strategy, your game plan for fine-tuning your portfolio periodically should reflect your investing personality.
Even if you're happy with your asset allocation, remember that your circumstances will change over time. Those changes may affect how well your investments match your goals. At a minimum, you should periodically review the reasons for your initial choices to make sure they're still valid. Also, some investments, such as mutual funds, may actually change over time; make sure they're still a good fit.
Note: Asset allocation and diversification don't guarantee a profit or insure against a loss. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.
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