Understanding the basics of investing can seem intimidating. We’ll sort through the essentials here in a simple, understandable way.
The most common investments have traditionally been stocks and bonds. Today, the options are a bit more complex. The best way to begin is to review the basic building blocks of investing.
Common Stocks are a partial ownership in a company. Share prices go up or down depending on the success of the company, both present and perceived or expected in the future. Stocks (with some exceptions) are usually liquid, meaning they generally trade on the stock exchange daily, often can be easily sold and proceeds received within a few days. Stocks are considered to be more volatile than bonds.
Preferred Stocks are less volatile than common stocks yet more volatile than bonds. They often pay a good dividend, and are generally a good source of yield for retirees.
Bonds are a form of an IOU. The investor loans money to the issuer of the bond and, in turn, gets paid a certain interest rate for the duration of the loan. At maturity, the full principle amount is repaid. Bonds have traditionally been used to provide a steady income stream for retirees.
Mutual Funds are a basket of stocks, bonds, or other asset types, created and managed by professional fund managers. A mutual fund can contain a single type of asset, such as utilities, dividend-paying stocks, or global bonds, or can be a blend of various types of stocks and bonds; there are many thousands of funds in existence. They are open-ended and can be bought or sold daily, making them very liquid.. Many investors leave the investing to the experts, which is why funds are so popular. Fund managers evaluate their holdings regularly and make buy and sell changes within the fund as they deem necessary.
Exchange Traded Funds (ETFs) are also a basket of stocks, bonds or other types of assets, similar to mutual funds. The major difference is that once an ETF is created, the holdings within the basket of a particular ETF are changed infrequently. Another name for this is passive investing, compared to mutual fund management which is active investing: where the turnover is greater. Since less time is spent managing the portfolio, ETFs have lower fees than mutual funds. There is much disagreement about which is the better way to invest: active or passive. There is no clear answer to this debate.
Hedge Funds are portfolios managed by professional investors, with two major differences. Hedge funds can short a position, meaning they bet the stock will go down instead of up. Hedge funds tend to be less liquid; they are privately managed, not traded on an exchange, and redeeming out of a fund may take a few months. Often, there is a significant minimum dollar investment.
These are just a few basic types of assets. There are also commodities, real estate and others which we will not discuss for purposes of this article, as they are considered riskier assets.
There are different ways to gain exposure to a certain category. For example, if an investor is interested in investments that pay a yield, they might consider bonds, a bond fund, preferred stocks or common stocks that pay an above average dividend, or a particular ETF comprised of high yielding stocks. The investor might invest in a mutual fund that is comprised of dividend payers. So many options! If possible, it is helpful to consult with a financial advisor to evaluate these choices.
Next, we move to the subject of asset allocation. What does that mean? Simply put, asset allocation is the amount of each asset that you put in a portfolio. Studies show that a diversified portfolio minimizes the risk of “putting all your eggs in one basket.” Often, people discuss an allocation of say 70/30 or 50/50, which means a ratio of stocks to bonds (or fixed income). Advisors use various metrics to decide how to allocate a portfolio based on an investor’s age, risk profile and investment objectives. Before making an investment or building a portfolio, there are many variables to consider, including income or growth, preservation of assets, estate or long-term planning goals, time horizon, and how much risk you can afford.
As the iconic investor Benjamin Graham wrote in his classic book The Intelligent Investor, “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”