Investing is simply
the process of acquiring assets that you hope will grow in value. Investments
can include owning a home, owning a business, owning real estate or having
money in savings accounts and CDs union. This article addresses investing
in stocks and bonds and various ways to own them.
Owning a share
of stock is owning a portion of the company. If you buy 100 shares
of General Electric stock, you actually own a portion of GE. You
can profit by owning shares when the company pays a dividend or
if the value of the shares increases while you own them. You can
also lose money if the value of the shares goes down before you
When you own
a bond, you are lending money to the company or institution issuing
the bond. You profit when you receive interest payments and if the
value of the bond increases while you own it. You can lose money
if interest payments are not made, if the principal of the bond
is not repaid when it is due or if the value of the bond falls and
you sell the bond.
When you buy
mutual funds, you are buying shares in a company that in turn owns
stocks in other companies or owns bonds issued by other companies
or institutions. By investing in mutual funds, you get the professional
services of the mutual fund manager who decides where and when to
invest. You profit when the mutual fund distributes dividends (and
capital gains and interest) and if the value of your mutual fund
shares increases because of the increases in the underlying values
of the stocks and bonds it owns.
There are several
ways you can own investments. Most people start out with individual
accounts set up at brokerage firms or mutual fund companies, in
their IRAs and through their company retirement plan. If you invest
through an individual account, the income (dividends, interest and
capital gain distributions) from the account is taxable. If the
investments are within an IRA or a qualified plan, you will probably
not owe any tax on the returns until you take funds out.
that there are risks with investing.
When you make
the decision to invest, you are leaving the world of insured and
guaranteed returns found with savings accounts and CDs from a bank
or credit union. The values of stocks rise and fall depending on
the success of the company and the overall direction of the stock
market. The value of bonds can rise and fall depending on changes
in interest rates and the financial condition of the institution
issuing the bonds. In return for taking these risks, you hope to
earn returns greater than what you would have earned in a savings
account or with a CD.
in your expectations.
The year of
2008 was a bad one for stocks with the S&P 500 index falling
38% while it has risen each year since then. Over the 20-year period
ending in 2016, the average total return for large company stocks
(comparable to the S&P 500 index) was 7.7%. The best year (2013)
had a return of over 32% and the worst year was 2008 when the return
was a negative 37%. While the bull market of 1995 to 1999 produced
average returns of over 28% and the bear market of 2000 to 2002
(and 2008) saw the market fall by over one third, returns during
those years were well outside the long-term average returns.
Take a long
from investing will vary greatly from year to year. It is only by
viewing your investments as long-term can you hope to earn returns
to justify the risks. For example, over the past 20 years, the average
returns for large company stocks was 8.2%, but during that period
the best year was 1996 when these stocks had total returns of over
33% and the worst year was 2008, when the return was a negative
37%. Trying to guess the near term direction of the market or an
individual stock's price is foolish.
Use an asset
You should also
consider how you divide your investments among the different types
of investments. How you divide your investments among stocks, bonds
and cash investments is called asset allocation. It can serve as
a logical starting point for your investment strategy. Individuals
should base their asset allocation on their time horizon and risk
tolerance. Here are some sample allocations based on age.
You will note
that the chart shows younger individuals having more stocks with
the percentage being reduced over time. This is only logical. While
you are younger, you can take a longer term approach - you have
more time to recover from declines in your investments and you have
more time to try to participate in the long term performance trends
of different types of investments.
in this chart are only sample guidelines and you may want to vary
from them depending on your feelings about risk and other aspects
of your situation.
If you are investing
in stocks, you should try to have investments in at least 3 or 4
stocks in at least 4 or 5 industries. A portfolio of 15 technology
stocks is not diversified. A portfolio of one stock in each of 15
different industries probably also is not a good example of diversification.
A portfolio of more than 25 or 30 stocks can make it difficult to
stay aware of what each company is doing.
over different stocks in different industries reduces the risk that
the particular stock you choose in a good industry turns out to
be the wrong one. It also reduces the risk that you invested in
the wrong industry.
to reduce your risk is to make your investments over a period of
time. That way, you assure yourself that you are not investing all
your money at the top of a bull market cycle. You may miss some
appreciation if the market continually goes up, but that seldom
happens. Remember, no one can predict short-term movements in the
stock market with any degree of accuracy.
your investments over 4 to 6 months, you will eliminate the risk
of making all your purchases when stocks are at their highest points.
There are two types of risk that this strategy reduces. First, it
reduces the risk of losing a significant part of your money quickly.
Many people dread making an investment and then seeing the value
go down dramatically. By spreading out your buying, this will not
The other risk
you can reduce by spreading out your investments is price volatility.
By taking this approach, the average price for the stocks you buy
will probably reflect the average market values for that period.
the diversification benefits of mutual funds.
When you buy
mutual fund shares, you are buying into a broad portfolio of stocks
that the portfolio manager has selected. In addition, most mutual
funds offer a system of purchasing called "dollar cost averaging."
With this, you buy an equal dollar amount of shares on a periodic