If you are an inexperienced investor or just feel you need a refresher course, this tutorial will help you with the basics. If you can arm yourself with some basic investing knowledge, you will be able to make better investment decisions and/or ask better questions of your investment advisor. Investing simply isn't as complicated as most people think. It does take some effort to educate yourself about how to manage your money, but once you know the basics, it's really not that difficult. If you decide to use someone to advise you on investing, still read this section because the more you understand about investing, the better you will be able to work with your advisor.
What Do You Want Your Money To Do For You? The first step is to determine what goals you have for your money. Accumulating enough money to be able to retire comfortably is certainly a goal for all working-age people. Everyone should be concerned with retirement, even those who are a couple of decades away from it. There are also other common goals besides retirement that people have for their money. You may have a goal for something more immediate, such as buying a car or taking a vacation. Saving for a house or saving for college for the kids are other common goals. Once you're retired, your financial goals will focus on having enough income to live comfortably and be able to keep up with inflation. Take a moment now to summarize the financial goals you have
When Do You Want To Achieve Your Goals? Once you have determined your financial goals, you next need to decide how soon you want to reach each one of them. If you plan to need money for a goal within three years – to buy a car for example – consider that a short-term goal. A long-term goal is eight or more years. Consider anything in between as a medium-term goal. Because, as we'll see later, the time when you need your money to meet your goals will be very important for making your investment choices.
Typically, we have goals in all three of these areas – short-term, medium-term, and long-term. All of us are at different stages of our lives and so our goals are different. Therefore, our strategies for investing will often need to change as we move through life. One of the most important factors in deciding where to invest your money is how soon you are going to need it. For short-term goals, safety is the most important factor; with money you'll be spending soon you don't want its value to drop just before you need it. For long-term goals, growth is important; your money needs to increase in value enough to stay ahead of inflation. Deciding how much of each you need – how much safety and how much growth – is one of the most important parts of deciding how to invest your money.
There is a third factor that is important to many people: income. Just as you earn a paycheck, your investments can earn money for you that can be spent on day-to-day expenses or reinvested. When you retire, income becomes a more important goal to pay living expenses, but growth is also important to help you keep up with inflation throughout your retirement. Deciding where to put your money means thinking about those three things: safety, growth and income. When you expect to need a certain part of your savings in just two or three years, you need to keep that money safe. You don't want the value of those savings to go up and down a lot. On the other hand, when your investment goals are long term, say over eight years away, then you want to focus on some combination. Perhaps you'd want some growth to help build your savings and some income to help balance out the ups and downs of investing for growth.
Three Investor Profiles. We need to discuss further how growth, income, and safety fit into your investing strategy. To help with this, consider three typical hypothetical situations. Each of these people has a different set of needs for their money, is at a different stage of their lives, and each needs to use a different approach to investing.
Profile 1: Frank
Financial goals: New car; contributing to company retirement plan
Frank believes that his biggest concern is income in order to buy a new car. He is like a lot of people his age; he is focusing primarily on short-term goals.
But what about his investment future? He may want to buy a house in a few years. If so, that would be a medium-term goal. At his age, Frank may not be thinking very much about retirement, but he should be. He has a long time for his money to grow for retirement if he starts saving for it now. Even if it's just a modest amount now, savings can make a big difference in how much he has when he retires.
Profile 2: Janet
Status: Single; one child age sixteen
Financial goals: College tuition for her son; saving for retirement; replacing worn-out car
Janet is thinking right now primarily about sending her son to college. She also knows that she needs to save for her retirement. At her age, of course, she needs to think of growth for her retirement goals since it's a still a long time off. College is another situation. She will probably need a combination of growth and income for her medium-term goal of getting the child through college. She also has some short-term goals, in other words, goals that need to be paid for within three years. Her son will be entering college in a couple of years, and she needs to replace her car soon. She'll need to set aside some money for the car and the first couple of years of college in a safe place.
Since Janet is a single parent, you may think she should be pretty conservative with her money. She certainly does need safety for her short-term goals, but for her long-term goals, she'll need to focus on growth so that she won't lose ground to inflation.
Profile 3: Earl and Jennifer
Ages: Close to retirement; no children living at home
Financial goal: Retirement
Earl and Jennifer are five years from retirement and are worried about safety – protecting their nest egg. They know they are going to need to live off their investments when they retire, so they don't want to take any risks with them. For Earl and Jennifer, retirement seems like a short-term goal. But think about it. What happens if they live into their nineties – that's another thirty years! For Earl and Jennifer, retirement fits into short-term, medium-term, and long-term goals. So even when you are very close to retirement, you still need to consider it as a long-term goal as well as a short-term goal, because you are likely to need that money to last for a long time. Retirees need to invest for both income (to pay their living expenses) and growth (so that they can keep up with ever-rising living costs later in life).
Risk Is Not A Four-Letter Word. No one wants to risk losing money, especially losing money on investments. But there are two kinds of risk: the kind you can see and the kind you can't. The kind you can't see is the risk that comes from inflation and what it means to the buying power of your dollars. Here's an example. At a 3½ percent inflation rate per year, your cost of living doubles every twenty years. It could go higher than that, although we all hope it will be lower. Alas, we can't predict these things, so it's best to err a bit on the high side when it comes to inflation estimates. At a 3½ percent annual inflation rate, for every $20 you spend today, you'll need $40 in twenty years, and double that again for the next twenty years. In forty years, for the $20 you need today, you'll need $80 to purchase the same items.
So let's consider someone at age forty-five whose living expenses are $50,000 today. Assuming he retires in twenty years when he is sixty-five, he'll need to spend $100,000 for the same expenses if inflation averages 3½ percent per year. In another twenty years when he's 85 and still going strong, he will need $200,000 to enjoy the same purchasing power that he had forty years earlier. While your living expenses will almost certainly decline when you retire, the important thing to remember is that whatever your spending level might be, it will increase each year throughout your retirement due to inflation.
Here's another example that looks at inflation a little differently. It shows how inflation affects purchasing power. Someone who is planning for retirement figures that, in addition to Social Security, she'll need $25,000 in income for living expenses when she retires. Now $25,000 happens to be just what her retirement income is expected to be. So she thinks she's in good shape. But consider how inflation can affect the purchasing power of her $25,000 over her retirement years. If inflation is 3½ percent per year, after less than seven years our retiree has seen her purchasing power drop to $20,000. After twenty years, her purchasing power can be cut in half. So that $25,000 of income, which looked so good at retirement, could be worth far less in terms of purchasing power later in life if the money supporting that income fails to at least keep up with inflation.
These numbers are pretty scary, I admit. But they show how much risk is involved in just letting your money sit and not grow enough to outpace inflation. Some fear investing because they can see the stock market go up and down and interest rates go up and down. That's the kind of risk you can see. So they think they should put their money somewhere where it will be safe, but that pays low interest. If you don't take into account what you can't see from inflation, you will really be missing the boat.
Now you may conclude that there is a risk in everything. And there is, but you can minimize the risk that you can see – the visible risk from investments. Inflation is an invisible risk – you can't see it and you have no control over it and everyone has to deal with it. You actually have more control over visible risk – that is the kind you have when you invest in stocks and bonds – because you can control how much and what kind of risk you take. There are several ways to reduce your amount of visible risk.
The Three Main Types of Investments. As we have seen, one of the most important factors in deciding where to put your money is how soon you'll need it. Do you need your money to grow over the long term? Do you need it to produce income? Do you want it to stay safe because you'll need it fairly soon?
There are three main types of investments, each geared mostly toward one of the three key things you need from your money: growth, income, and safety. I say mostly, because an investment behaves very differently over the short term – say two to three years – than it does over the long term, say eight years or more. The same investments can behave very differently over different periods. The three basic kinds of investments are short-term investments, bonds, and stocks.
So when would a short-term investment be a good choice? If you are going to buy something in the next year or two, it's good to know the money will be there when you need it. Also, when you eventually retire, you might want to invest some of your retirement money in short-term investments to meet your living expense needs over the following year or so. On the other hand, if you're not going to need the money within a few years, you may not want to keep it in a short-term investment, because that involves much more invisible risk from inflation. Remember how inflation cuts your buying power over time? That's the danger with short-term investments. In effect, you are losing money – losing purchasing power – without even realizing it.
Bonds usually pay more interest than short-term investments, but like stocks, their prices can change. When interest rates decline, bond prices rise. But when interest rates rise, bond prices will likely decline. (The way interest rate changes affect bond prices is difficult for investors to visualize. This will help: think of a seesaw, with interest rates on one seat and bond prices on the other. If interest rates rise, that side of the seesaw rises, and the bond price side descends, or declines, and vice versa. That means that if you have money in bonds, the overall value of that investment could go down even though you are receiving interest income.) Bond interest rates stay fixed until the bond matures – that's why they are often called "fixed-income investments." But their prices go up and down depending on what interest rates in general do. The longer the bond's maturity – that is the longer until the loan will be repaid in full – the more the price can go up and down.
As a group, stocks go up and down in value more than any other type of investment over the short term. But over time, stocks have been one of the few types of investments that have beaten inflation. There's no guarantee that what has happened in the past will continue in the future, of course, but the average yearly return on stocks has been a little over 10 percent. Historically, stocks have grown much faster than bonds and short-term investments.
People are often afraid of stocks because they hear about bear markets or stock market crashes. And that should be a concern to anyone who will need the money within just a few years. But over the long run, there is more risk of losing money to inflation if you don't invest in stocks. Yes, the visible risk of stocks periodically losing value is higher in the short-term than other investments, but with proper investment allocation, you can protect yourself from those risks and from loss from inflation. That's why most investors need a generous dollop of stocks in their investment holdings. Working age people should almost always should have a majority of their money in stocks, because they will need their investments to grow so that it will last them for the decades of TR (time remaining).
Mutual Funds. Many people think mutual funds are a fourth kind of investment in addition to short-term investments, bonds, and stocks. They actually are not. Mutual funds are a way to put money into the three types of investments that were discussed above. Mutual funds are a way that individuals can help protect themselves against the risks of investing in just one company or with one lender. They allow you to pool your money with other investors. Then the fund manager buys one of the three types of investments to concentrate on and picks many different stocks, or many different bonds, or many different short-term investments. Some mutual funds invest in both stocks and bonds.
Each fund has its own way of trying to make money, called its "investment objective." Based on those guidelines, a professional manager decides which stocks and/or bonds to buy. Stock mutual funds and bond mutual funds are pretty much self-explanatory. As I mentioned, some funds invest in both stocks and bonds – balanced mutual funds for example. A money market fund is a mutual fund that buys short-term investments.
One other investment term that is important to understand is total return. Total return includes not only income earned from an investment through interest paid by bonds and short-term investments or dividends paid by some stocks, but also any increase or decrease in the price of the investment. For example, if you get 6 percent interest on a bond, but the price of the bond drops 10 percent, your total return is minus 4 percent - bummer. On the other hand, if you get 6 percent interest on a bond and its price rises by 8 percent, your total return is plus 14 percent. Total return, rather than simply the interest or the dividend that an investment pays, is the best way to compare different types of investments and to evaluate how your investments have performed.
Managing Investment Risk Through Diversification. Now that you understand the various kinds of investments, it's time to look at managing the risk that each poses. The best way to manage risk is to put time on your side. While younger generation family members may think you're as old as Methuselah, we know that your money is going to have to last you a long time. Investing for long periods means that you have a long time to ride out the ups and downs experienced by the stock market. As I noted earlier, stocks go up and down in the short term, but the historical trend over time has been up.
Second, avoid putting all your eggs in any one basket. This is known as "diversification." If you don't understand diversification, bear with me for a couple of minutes and you'll get the drift. There are three components of diversification.
Diversification Part I: Investing in all three types of investments – short-term investments, bonds, and stocks. First, you can control your investment risk by investing in all three types of investments: stocks, bonds and short-term investments. The fancy term for this is asset allocation or investment allocation, which really means nothing more than how you divvy up your savings among the three types of investments.
Combining the three major types of investments can help minimize risks because if one type is doing badly, another may be doing quite well. That way, you don't have to do everything right, you just have to do more right than wrong. If everything is in one basket, you have only one chance to get it right. While investment allocation does not guarantee against a loss, it can help you minimize both the visible risk – that investments and stocks and bonds will periodically decline in value – and the invisible risk of inflation. Remember, stocks are generally for growth, bonds are generally for income, and short-term investments are generally for short-term safety to meet financial needs that you will have in the near future. Allocating your investments properly by putting your eggs in a variety of baskets is crucial to minimizing both kinds of risk, but there's more to successful investment diversification than simply putting money into each of the three types of investments, which is explained next.
Diversification Part II: Spreading your money among the various categories of short-term investments, bonds, and stocks. As you may be aware, there are a variety of different categories of short-term investments, bonds, and stocks. For example, bonds may be issued by corporations, states and municipalities, and last but certainly not least, the U.S. government, which is world-renowned for its borrowing zeal. Just as the three types of investments periodically go through good and bad times, so do the various categories within each investment type vary in their relative performance. By further spreading your money out among these categories, you can further diversify your investments. Before moving on to Part III, here are descriptions of the most important categories of short-term investments, bonds, and stocks along with some suggestions for investing in each.
Top tip for investing in short-term investments. The key to investing successfully in short-term investments is, very simply, to shop around for the best interest rate. Since these securities are very safe relative to each other, the trick is to find the highest return. At any point in time, one or a couple of categories may be paying a greater rate of interest than the others, so it pays to keep abreast of the interest rates paid by the various categories of short-term investments.
Bonds come in different maturities. Sorry to complicate matters a bit more, but this is one situation where complexity begets better investment opportunity. Bonds and bond mutual funds are not only categorized according to the type of bonds that the fund will invest in as discussed above - municipals, governments, and corporates, but they are also divided up according to the approximate length of maturity of the individual bonds or the bonds that the manager puts into the portfolio. There are three maturity levels:?
Top tip for investing in bonds. I suggest that you invest your bond money in bonds or bond funds with varying maturities. In other words, some of the money will go into a short- or intermediate-term bond fund and some will go into a long-term bond fund. There is method in my madness, however. One of the most widely-accepted strategies for investing in bonds is called "laddering maturities." Rather than putting all of your money into single maturity bonds or bond funds - be it short, intermediate, or long - laddering maturities means investing in mutual funds or individual bonds with a variety of maturities. By owning bonds with varying maturities, you reduce somewhat the risk of losing a lot of principal because of a change in interest rates. For example, if you have all of your bond money in long-term bonds and interest rates rise, you could stand to lose quite a bit of principal value. That's because the longer the maturity of a bond or bond fund, the more the principal changes (both downward and upward) in reaction to a change in interest rates. On the other hand, if you had laddered your maturities by owning some short- and/or intermediate-term bonds or bond funds as well, you wouldn't have been hit as badly as a result of a rise in interest rates.
Stocks are commonly classified according to the value of the stock, called its "capitalization." Capitalization is simply the number of shares issued by the corporation multiplied by the current market value of the stock. For example, a stock that has 100,000,000 shares outstanding and is currently trading at $50. per share would have a market capitalization or "cap" of $5 billion. The parameters as to whether a stock is classified as large, mid-sized, or small vary considerably depending on who's doing the talking. But how the three categories of U.S. stocks are categorized is less important than what they can offer an investor who's interested in diversifying and making money. One such taxonomy is:
- Large-cap: Market capitalization over $10 billion
- Mid-cap: Market capitalization between $2 billion and $10 billion
- Small-cap: Market capitalization below $2 billion
Top tip for investing in stocks. It's hard to go wrong in the stock market over the long run by spreading your stock money around among these four categories. At any point in time some categories are doing better than others, but it's impossible for anyone to predict, although a lot of people try, and they usually end up poorer for their efforts. So the best thing to do is to have some money in each category. Once you come to the epiphanic moment where you realize that non one can accurately predict the future, you'll understand why that's the best strategy for winning the stock market game.
Diversification Part III: Investing in different securities within each category. When you diversify by investing in many different stocks or bonds instead of just one, you reduce the impact of any one stock's or any one bond's eroding your money. You're spreading around your risk. The most efficient way to do this is with mutual funds, which automatically invest in many, if not hundreds of different individual securities. It's also fine to invest in individual stocks and bonds, but in order to be diversified you'll need to hold onto several individual stocks in different industries (financial services, energy, technology, for example) and several different bonds with different issuers (corporations, U.S. government, municipalities, for example). Many investors don't have enough capital to properly diversify with individual securities, but they can with mutual funds.
By disseminating your money among the various investments types and categories, you will always have at least some money in investment areas that are thriving while avoiding having too much money in areas that are diving. That's the essence of diversification.
Last, but by no means least in your investment tutorial, the way you divide up your investments is up to your own circumstances and judgment, but it is terribly important to your long-term investment success. So devote some time to thinking about the best way to divvy up your investments. It will be time well spent.