Sunday, June 2, 2013

Investment Primer: stocks and bonds

This is the second post in my investment series.  The first post is about saving to invest and can be found here

Most investments fall into one of these three main asset classes:  stable value investments (cash), stocks (equity), or bonds (fixed income).

Stable Value Investments (Cash)
These include Money Market accounts, Certificates of Deposit (CDs), and U.S. Treasury Bills.  These are essentially loans to a financial institution which pay you interest on your money.  Stable value investments are generally very safe, have little to no risk, and generally earn very little return compared with other investments.

Today I will be talking mostly about stocks and bonds.

Stocks (Equity)
Stocks represent an ownership interest in a corporation.  When you buy stock in a corporation, you buy fractional shares (ownership) in that company.  Corporations use money from your stock purchase to fund their business.  As a partial owner of the company, you share in both the company’s profits and losses.  When a company profits or loses money, the value of your stock share increases or decreases. 

Stocks typically have much higher returns than other safer investments like bonds and Money Market accounts.  The trade off for having higher returns is that there is more risk involved.  

In the short-term, the returns on stocks can rise and fall dramatically.  In the short term, riding the stock market can be an up and down, bumpy ride.  Some companies can go bankrupt and your stock shares can drop in value to $0.  The stock market can crash.  It has already crashed several times in its history.  The stock market can also go for years without providing any significant returns.

This being said, the long-term trend of the stock market has always been to go up over time, even after each stock market crash.  After the recession, the tech bubble, the housing crisis, the US debt ceiling, and after every major disaster, the market has always recovered and continued to grow.  

In the unlikely event that the stock market crashes and does not recover, no investment will be safe.  You might as well invest in guns, ammo, gold coins, and non-perishable food like the doomsday preppers.

Over time, the value of stock prices follows the trend of the economy and continues to grow.  So far the S&P 500 is up over 15% and the Dow is up over 16% since January 1st 2013 to May 31st, 2013.  Bank savings rates however continue to be less than 1%.

Types of stocks

Large Capitalization (Large Cap) Stocks
These stocks include large well-established companies generally with assets over $10 billion dollars.  Large cap stocks are usually less volatile and often pay regular dividends.

Mid Capitalization (Mid Cap) Stocks
These mid-sized companies have assets between $2 billion and $10 billion.  Mid cap stocks tend to be more volatile than large cap stock, but have the potential to see more long term growth.  More risk is involved here than with large cap investing.

Small Capitalization (Small Cap) Stocks
These small companies have assets between $300 million and $2 billion.  Small cap stocks are typically more volatile than both large and mid cap stocks.  The trade-off is that growth in small cap stocks may be greater than large and mid cap stocks.

There are other size classifications of stocks including: Mega, Micro, and Nano cap.  The cap terms are relative and can change whenever companies grow or shrink in size. 

International / Global Stocks
Stocks in non-U.S. companies aren’t always linked with the U.S. economy, so owning international stocks can be a way to diversify a portfolio.  International stocks are much more volatile than domestic U.S. stocks, but they can offer greater rewards.  The general consensus is to hold around 20% to 40% of your stocks in International stocks (I hold 30%).  

Investment style
Stocks can also be classified based on styles: Growth, Value, or Blend

Growth stocks are companies that grow their profits at a very fast rate and are expected to produce above-average earnings growth.

Value stocks are companies that tend to trade at a discount relative to their value.  These stocks are considered under valued, with the stock price likely to rise in the future.

Investing in stocks

The need for money during retirement outweighs the risks associated with investing in the stock market, which has and continues to be the best performing investment class.

It’s important to understand that no stock investment is guaranteed and that past performance is no guarantee of future results. 

In 2008, many investors lost 50% or more of their investment value in a matter of weeks.  Worried investors who sold stock shares or reduced investment contributions at the lowest point in 2008 truly lost out on their investments.  They bought stocks when the value was HIGH and sold when the value was LOW.  They sat on the sidelines holding their cash, while investors who stayed invested watched their investment accounts recover and explosively grow.  Investors that hung onto their portfolios and continued to invest have experienced an unprecedented surge in the value of their stocks. 

It’s usually not a good idea to invest all of your money into just one company, since your entire investment performance is tied to that of one company.  If the company does poorly or if there is speculation that a company is doing poorly, the value of your stock would likely fall.  If the company goes bankrupt, you could lose your entire investment. 

Investing in stock mutual funds can help you easily diversify ownership in much more companies than you can buy on your own.  A single index fund can hold hundreds or even thousands of stocks in its portfolio.

Bonds (Fixed Income)
Bonds are loans issued by government entities or companies.  When you buy a bond, you are lending money to the organization that issues it.  The company in return promises to pay interest payments to you for a specific amount of time.  Bonds are essentially an IOU or promissory note.  The full amount of the bond is repaid when the bond matures.  

Although bonds are considered more stable than stocks, they still have risks.  Bond prices rise and fall in response to interest rate fluctuations.  Also when purchasing individual bonds, there may be risk that the bond issuer may not be able to repay you for their debt. 

Investing in Bonds

Because stock prices can be risky, can decline, or be stagnant for long periods of time, allocating some of your investments to bonds is considered a necessary element of your total portfolio.

While bonds don’t produce the type of higher returns that stocks do, they are more stable and less volatile.  Bonds can help stabilize a portion of your portfolio during the stock market ups and downs.

Just like you can own stock index funds that hold hundreds to thousands of stocks, you can also own bond funds, which can hold thousands of bonds within the fund.  By owning bond funds instead of individual bonds, you can increase diversification and convenience, without worrying about the risk of any individual bond defaulting.

Bond and bond fund values move in the opposite direction of interest rates.  When interest rates increase, the value of bonds decreases.  And when interest rates fall, bond and bond fund prices rise.  

The next step

In the next post, I discuss risk assessment, asset allocation, and diversification.

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