At a glance:
Reasons to invest
Summary of investing 101
So you've got some money to invest! Now, what are you going to do with it?
There are so many choices. Which ones are right for you?
The key to successful investing is having an investment plan based upon your short-, intermediate-, and long-range goals. Then select suitable investments to meet those goals.
Some investments are better than others for generating income. Others are better for long-range growth. Some provide tax advantages. There are many different types of investments and each type has its own set of unique characteristics. Key characteristics and concepts we will cover in this course are:
Strategies for investing
The more you learn about the different types of investments, the better off you will be when it comes time to make investment choices for your portfolio.
If you had to come up with a single reason why investing is important, it would be so you can achieve your future financial goals. With the exception of those young adults who begin their independent life with substantial assets, most of us will be required to save a portion of our income as well as invest it wisely to help us meet our future financial needs.
Let's take a little closer look at a few important reasons to invest.
Reason 1: Grow your money through compounding
Who doesn't like to see their money grow over time? Most people do, so they have an opportunity to use this money in the future to cover a need or want.
Compound interest is interest added to the principal (the amount you deposited or invested) of a deposit so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding.
The most common accounts that pay interest are savings, money markets, and certificates of deposit. It can also be referred to as compound growth. The same compounding principal applies for compound growth but the types of products used are stocks and mutual funds. More on those products shortly.
A more informal definition for compound interest is, "The money you invest makes money, and the money you make on the money you invest makes money, and so on."
The earlier you start investing, the more powerful the investing typically is. Take a look at the chart below to see how compounding works.
Reason 2: Inflation
Inflation can be defined as the rate at which the general level of prices for goods and services is rising, which in turn means the purchasing power of currency is falling. It simply means that the things we buy will generally increase in price in the future. Our cost of living will rise. Therefore our money today won't be worth as much in the future.
Inflation is stated as a percentage. Over the last 100 years the inflation rate averaged approximately 3%. So on average, the cost of living, or how much we pay for goods and services in a year, increased by 3%. In number terms, it means for every $10,000 we spend on goods and services this year, we will need to spend $10,300 (a 3% increase) in order to purchase the same goods and services next year.
Reason 3: Achieve your goals
Investing wisely will help you increase the likelihood of achieving your financial goals. Most of us look forward to having enough money to cover the needs we have over our lifetime. Many of our future needs have a price tag associated with them, and it is a combination of saving and investing that helps make these goals a reality. Review the list of goal categories detailed below and ask yourself which of these may be important to you:
Major purchases like home, car, furnishings, remodeling project, boat, snowmobile, four-wheeler.
Start a business: This takes money/capital to lease or buy a building, purchase equipment, advertise, hire employees, etc.
Family: Are children in your future? While having children can be one of the greatest joys in life, children increase your expenses for the basics like food, clothing, and utilities. If you want to help pay for college for your children, you will need to save and invest additional dollars.
Additionally, if you need or want to help cover expenses for family members in need, be sure to invest to cover these future needs.
Reason 4: Financial independence
Often called retirement, this is likely the most expensive goal you will need to provide for during your life. When you retire, you are responsible for paying yourself an income for the rest of your life, which is hopefully 20–30 years depending on when you choose to retire. For most, the two primary sources of income during retirement are:
Social Security: the amount of income you receive from Social Security directly corresponds to the amount of Social Security tax withheld from your income during your earning years. Social Security payments were never intended to provide the majority of someone's retirement income. Those who live only on Social Security generally have a tight budget.
Investments: the majority of a retiree's income comes from money specifically saved and invested for retirement. This is money that you and/or your employer have contributed to an investment plan with a goal of accumulating money that can be tapped to produce income for you during retirement. These investment plans generally are in the form of a qualified retirement plan where participants receive tax benefits while they are contributing to the plan and employers contribute to the plan. Oftentimes, individuals will have other investment accounts in addition to their retirement plans.
Understanding how much you can withdraw each month during retirement from your investment account(s) is critical to ensuring you don't outlive your assets. If you withdraw too much money each month, you risk running out of money.
Investing is all about preparing to accumulate funds for a planned future expense. For most, the investment objective during the working years is growth. During retirement the investment objective changes to generating income from the investments you have accumulated during your working years.
Before you rush to your broker and start buying, you have some thinking and planning to do. To choose from the growing universe of investment choices, you have to understand which types of investments are the best match for your goals and your investment personality. The potential risks and rewards can differ greatly based on the investment option.
Cash investments are low-risk, low-return and highly liquid investment options. When an investment is liquid, it means the investor can easily withdraw or redeem their money in a very short period of time (e.g., the same day). The most common type of cash investment is a savings account at a bank or credit union. The money you deposit in this account is guaranteed to not lose value, offers a low rate of interest, and can be withdrawn at any time.
Cash investments are generally used to meet short-term goals and needs of three years or less. Common uses of savings accounts are to create an emergency fund for unexpected expenses or save for a known short-term expense planned within the next three years.
Other common types of cash investments are short-term certificates of deposit and short-term government securities. Securities can be bought and sold and are investments where you have a record of your proof of ownership. Cash investments may provide a slightly higher interest rate for committing your dollars for a specific investment term. Additionally, they are very safe investments.
The primary risk associated with cash investments is inflation. Because cash investments provide safety of principal and liquidity, they offer a very low rate of return, often lower than the rate of inflation. Using cash investments for longer-term investments means your money will not likely keep pace with the rising cost of living.
Cash investments have had an average rate of return of 2.98% over the last 30 years ending December 31, 2018. Inflation has averaged 2.6% over the same period.
The interest you earn on a savings account or similar cash investment is taxed as ordinary income at the state (if you are required to pay state taxes) and federal levels. Ordinary income is income you earn through wages and interest on savings and investments. Refer to the tax course for more detail on tax rates.
When you invest in a bond you are lending money to the US government, a corporation (like IBM or Amazon), or a municipality (like the city of Chicago or Denver). In other words, these entities are borrowing money from you to help them pay for programs, new projects, and ongoing business operations.
Similar to a loan, when you invest in a bond you receive interest from the bond issuer. Interest is stated as an annual interest rate or yield and is paid each year until the bond's maturity date. The maturity date is the date the bond issuer is scheduled to repay the principal amount you invested in the bond.
Let's use an example of investing in a US government bond to bring this concept to life.
The US government issues bonds with terms ranging from less than one year to as long as 30 years. When you invest in an individual US government bond, the US government guarantees repayment of your principal if you hold the bond until it matures.
The interest you are paid on the US government bond is based on current interest rates at the time of purchase and the term of the bond.
Review the example below illustrating how a bond investment works for an investor.
Bonds are generally used to meet intermediate to long-term needs. Because bonds pay periodic interest, they are commonly used by investors who need income, like retired individuals.
Additionally, long-term investors often allocate a percentage of their investment dollars to bonds to maintain a more moderate risk profile. In general, high-quality bonds are considered safer investments than stocks.
Interest rate risk. When you purchase a bond you take on interest rate risk.
For example, let's say you invest in a bond paying a fixed interest rate of 4% over the next five years. What happens if interest rates change? If after one year interest rates have risen to 5%, you own a bond that is only paying 4%.
Clearly, 4% is not as good as 5%, but you are stuck with this rate for four more years while others can invest in the new bond at 5%. On a $10,000 bond, you are only earning $400 per year in interest while others are earning $500.
In short, when you buy a bond you are accepting the risk that interest rates could change and you could lose out on the opportunity to earn a higher rate over the term you own the bond. In our example above, if for some reason you needed to sell your bond, no new investor would be willing to buy your lower interest-rate bond when they could simply go buy the higher interest rate bond.
In order to convince someone to buy your bond they would demand a discount on the price of your bond because they would be giving up $100 per year in interest for four years. They would only be willing to pay you $9,600 for your bond that will be worth $10,000 when it matures.
This is how they make up for the $400 less in interest.
Credit risk. Investors take on credit risk when they purchase a bond that is not issued by the US government. Corporate and most municipal bonds do not guarantee repayment of your principal. In the US, credit risk is associated primarily with corporate and municipal bond issuers.
It is important to evaluate the corporation's or municipality's ability to pay its debt — that is, to make all interest and principal payments on time and in full.
Most corporate and municipal bonds carry a credit rating provided by a rating agency such as Standard & Poor's or Moody's. Bonds are rated on a scale starting at AAA, AA, A, BBB, BB and so on.
Bonds rated BBB or higher are considered investment grade and are generally prudent investments because the corporation or municipality has a strong likelihood of paying the interest and principal to investors on time and in full.
Bonds with lower ratings increase the risk of the issuer defaulting and not being able to pay their investors their principal and interest.
Municipal bonds have a unique quality compared to government and corporate bonds. The interest they pay to investors is exempt from federal income taxes. This is attractive for individuals in higher income tax brackets and can often provide them with a higher after-tax interest amount when compared to government and corporate bonds.
Bonds have had an average return of 5.98% over the last 30 years ending December 31, 2018. Inflation has averaged 2.6% over the same period.
A stock is an investment product that represents ownership in a company or corporation. When you purchase stock you receive shares of ownership from the company. In most cases these shares are held in some form of an investment account electronically on your behalf.
By investing in a public company, stock owners have the opportunity to participate in the growth and prosperity of that company. Companies issue/sell stock to create capital—or more simply stated, to raise money, to build new factories, develop new products, improve technology, etc.
A company's goal is to increase its profits by putting its shareholders' money to work effectively.
Stock investors have the opportunity to grow their money in one of two ways generally. When an investor purchases a stock, he or she pays a specific dollar amount for each share based on the value of each share on the day of the purchase.
When purchasing a stock, an investor believes the company will increase its profits in the future and in turn, the stock's value will increase. The investor can then sell the stock at a profit. This profit is called a capital gain.
A second way a stock investor can make money is when corporations share some of their profits by paying a dividend to all shareholders. Dividends are generally paid by more mature companies that have relatively stable earnings and don't have a need to reinvest all of their profits to expand their company. Dividends can be very powerful if reinvested over time in new shares of stock.
When you are considering buying a stock, it is important for you to understand the company well so you can make an informed decision. Think as if you were buying the entire company and ask questions about the company to help you make your decision. Here are some questions to help you get started:
What are the company's products and are they in demand?
How is the company's industry performing as a whole?
How has the company performed in the past?
Do they have a strong, experienced leadership team?
Are operating costs low or too high?
Is the company in heavy debt?
What are the obstacles and challenges the company faces?
Is the stock undervalued?
If you choose to purchase the stock you will need to continually ask these questions to ensure you still want to own it. Monitoring your investments is an important part of the investment process.
Stocks are generally used to meet longer-term financial goals. Most investors should be prepared to hold their stock investments for a minimum of 5 to 10 years.
Stock prices change on a daily basis and are subject to many different types of risks that can affect their price. Therefore, investors must be willing to accept the ups and downs of a stock price over a period of time in an effort to see a company grow and have its stock price increase.
Over the long haul, stocks have outperformed every other type of investment. They have also kept ahead of inflation. This is because the returns on stocks are not fixed, as the returns of many other investments are. Stocks have unlimited earning capacity.
Stocks also have much greater risks than cash and bonds. Your investment in a stock has no guarantees, and you could lose principal. If you invested in a stock that performed poorly and ended up going out of business, you could lose the entire investment you made. We will discuss ways to invest wisely in stocks to help reduce this risk of loss and enhance the opportunity for quality returns.
Let's take a look at the most common risks that impact stocks.
Company risk: the risk that you will lose money simply because the company you chose to invest in performs poorly. This type of risk could include slumping sales, poor management, rising costs of material, or dramatic events such as a strike or a natural disaster such as a fire.
Economic risk: the risk that an overall downturn in the economy will result in lower sales and profits (and consequently a lower stock price) for the corporations you invested in.
Systemic risk: the risk that a breakdown of the American or global financial system will cause panic selling and major losses for investors, no matter what type of investments they hold.
Market risk: the risk that you'll have to sell stocks when the markets are down.
Stocks have had an average return of 11.12% over the last 30 years ending December 31, 2018. Inflation has averaged 2.6% over the same period.
Gains. If you sell a stock for more than the price you purchased it for, you will realize a capital gain. There are two types of gains for tax purposes.
Short-term capital gains: If you sell a stock you have held for one year or less, any profit you make is considered a short-term capital gain. Short-term capital gains are taxed at the same rate as your ordinary income.
Long-term capital gains: If you hold your stock for longer than one year and sell it for a profit, you will realize a long-term capital gain. You can benefit from a reduced tax rate on these types of gains. Currently, the long-term capital gains tax rates are 0, 15, and 20 percent for most taxpayers. If your ordinary tax rate is already less than 15 percent, you could qualify for the 0 percent long-term capital gains rate.
Dividends. Most qualified dividends are taxed the same as long-term capital gains.
Diversification and mutual funds
When you're ready to begin investing, the concept of diversification is critical. You've probably heard the expression "Don't put all your eggs in one basket." This simple concept is important to helping you protect your investment portfolio as well as create opportunities for growth.
Let's consider an example. A stock investor could invest in one company or multiple companies.
The risk of investing in one company is that the value of your investment will completely depend on the performance of that single company. While the company being invested in has the opportunity to provide a significant return, they also could fail and the stock could become worthless.
By investing in multiple stocks, investors have the potential to reduce their exposure to loss.
Stock investors should also consider investing in different types of stocks. Stocks can be categorized by the size of the company, as well as the type of industry the company competes in.
In general, small and midsized companies grow at faster rates than large companies.
Therefore the value of their stocks has the potential to outperform stocks of large companies. By investing in a variety of different industries, investors can diversify the risk of one or two specific industries performing poorly and having a significant negative impact on their overall stock portfolio.
This same concept holds true for bond investors. Most bond investors purchase a variety of different types of bonds with different maturity dates, interest rates, and credit quality.
For example, the risk of putting all of your money into a government bond with an interest rate of 2% that matures in 10 years can be significant. If after two years interest rates have risen to 4%, the bond investor will miss out on the opportunity to earn twice the amount of interest that new bond investors are earning. And if they decide to sell their bond they will have to sell it at a discount to make up for the low interest rate.
By investing in multiple government bonds with short, intermediate, and long-term maturity dates, an investor will have funds available at a variety of different dates to take advantage of the potential of earning a higher interest rate.
Mutual funds: Pre-packaged investing
Many investors are comfortable with the risks of investing in stocks and bonds but are not confident in their abilities to select a well-diversified portfolio of these types of securities. Mutual fund investments were created decades ago to provide a solution to this problem.
Mutual funds are a simple, convenient way to invest in stocks, bonds, and cash-type securities. They provide investors access to professional management and broad diversification. In essence, you and many other investors with a similar investment objective are hiring a well-trained group of investment professionals to build a portfolio of securities (e.g., stocks and bonds) for you.
Mutual funds are ready-made portfolios of securities designed to achieve specific investment goals. When you buy shares in a mutual fund, you and the other investors participate in the gains and losses of the fund's investments. All mutual funds come with a prospectus that gives you all the details you need to know in order to make an informed investment decision.
Mutual fund benefits
A mutual fund is a fund that raises money from investors to invest in stocks, bonds, and other securities. It is a package made up of several individual investments. When those investments gain or lose value, you gain or lose as well. When they pay dividends, you get a share of them. Mutual funds also offer professional management and diversification. They do much of your investing work for you.
Professional management. Most investors turn to mutual funds because they do not have the time, knowledge, and capability to research and select stocks and bonds to purchase in order to build their personal investment portfolio. Mutual funds are professionally managed by a team of portfolio managers who are supported by various investment professionals such as research analysts.
These professionals continuously monitor the economy, stock and bond markets, the interest rate environment, and the political environment and make decisions regarding how these variables affect the securities in the mutual fund. Additionally they spend a significant amount of their time researching companies they currently invest in or are considering investing in to determine their prospective outlook for continued and growing profitability.
At the end of the day, investors are paying the mutual fund managers to determine what securities to buy and when to buy them, as well as when to sell them.
Diversification. When you buy shares in a mutual fund, your money is invested in dozens or even hundreds of securities covering different industries that meet the fund's objective.
It would typically be difficult for an individual to own a portfolio that matches the diversification you'd find in a mutual fund.
Owning a diverse mix of securities doesn't eliminate risk, but it can reduce it because the ups and downs of individual securities may offset each other.
A built-in feature. Diversification is built in to mutual funds. Mutual funds collect money from many investors, pool it, and then buy different securities. These investments may include stocks, bonds, and cash-type investments. How much of each type of investment a fund buys depends on what the fund's objective is. If the objective is growth, the fund may choose more stocks. If it is to pay its shareholders steady income, it may choose bonds and other interest- or dividend-paying securities.
Advantages of diversifying. Diversification lets you spread investment risk over several companies, industries, and types of securities. By investing in different types of securities, you also minimize the risks inherent in each market. When one market goes down, another may go up. Stocks, bonds, and other assets do not all rise and fall together. Therefore, when you have several different securities in your fund and one of them performs poorly, that one will not overly hurt the whole fund.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.
Convenience. One of the advantages of mutual funds is that they make it easy for you to buy and sell shares on your own.
Most mutual fund shares can be purchased directly from the fund, through a financial advisor or an employer-sponsored retirement plan.
Many investors choose to work with a financial advisor to obtain advice on how to construct a portfolio of mutual funds based on their goals. In return for their advice and guidance, investment advisors receive a commission or fee.
To purchase a mutual fund, you will need to complete an application form. You can also set up an automatic investment plan when you complete your fund application and have money withdrawn from your bank or credit union account each month and sent to the fund.
You can redeem shares by contacting the fund company or your financial advisor and requesting to redeem shares. Many funds allow you to redeem shares over the telephone, but some require written requests. The fund's prospectus, a document that describes the fund's investments and performance, also explains your options for redeeming shares.
Mutual fund fees and expenses
Each mutual fund's prospectus will outline the fees and expenses they charge investors. Be sure you understand these fees before making an investment. Fees can be categorized broadly as follows.
Sales charge: Some mutual funds charge an upfront sales charge when you purchase the fund.This is also referred to as the load. The sales charge varies based on what mutual fund you select, how much you invest, and what type of fund you purchase.
A general range of loads is 1–5% of the amount you invest. This fee is in place to compensate an advisor who is providing you guidance or advice.
There are many mutual fund options available to be purchased with no "load" (that is, sales charge). This type of mutual fund is sold directly to individual investors and generally does not include investment advice. If you are a do-it-yourselfer, this is likely the route you would take to purchase mutual funds.
Expense ratio: All mutual funds charge their investors ongoing fees to pay for the expenses associated with running the mutual fund. The costs are used to pay the investment manager of the fund and to cover marketing and operating expenses.
This fee is expressed as a percentage and can range from as low as .05% to over 2% depending on the fund you purchase. You are not billed for this fee. It is taken out automatically and reduces your return.
A high expense ratio can have a significant impact on the growth of your money. Many investment experts would recommend investing in funds with an expense ratio below 1%.
Actively managed funds vs. index funds
To this point we have been discussing managed funds. They are considered actively managed funds because there are a group of investment professionals buying, selling and monitoring the securities in the portfolio for you. They react to what's going on in the financial markets and make changes to the portfolio as they see fit.
You have probably heard of popular stock indices like the Dow Jones Industrial Average or the S&P 500. These indices comprise a "basket" of stocks from US companies.
The S&P 500 represents 500 large companies having their stock listed on the major stock exchanges. Examples of stocks in the index are Apple, General Electric, AT&T, and Facebook.
The price of the index is calculated based on the collective prices of the 500 stocks in the index. The S&P 500 is considered one of the best representations of the U.S. stock market, and a bellwether for the U.S. economy.
Investors can choose to invest in index funds also. Index funds are passively managed, which means that their portfolios mirror the components of a market index. In essence, they are on auto-pilot.
For example, the well-known Vanguard 500 Index fund is invested in the 500 stocks of the Standard & Poor's 500 Index. By investing in this type of an index fund, you will own a portion of the 500 stocks in the fund. Investors invest in index funds to take advantage of their low fees (due to no investment manager), ease of purchase, and because they feel the fund will perform as well or better compared to actively managed funds.
There are risks involved in mutual fund investing, so make sure you review your fund's prospectus carefully and compare its performance to similar funds to make sure you're getting the best deal.
Asset allocation involves identifying how much of your investment portfolio will be distributed amongst various asset classes or types of investments like stocks, bonds, and cash.
When determining what percentage of your investment dollars to allocate to stocks, bonds, and cash, consider the factors listed below.
Generally speaking, the longer the investor's time horizon (length of time to invest), the more aggressive they can be with allocating investment dollars to growth investments like stocks. While stock prices can experience large swings up and down over a short period of time like one year, they have generally performed well and demonstrated a very low probability of loss when held over longer periods of time.
Determining risk tolerance is a very personal decision for each investor. Some investors are simply more conservative than others. A good way to consider how much risk you are willing to take is to determine how much volatility you are willing to accept in your portfolio. This can be evaluated by determining how much you would be willing to see the value of your portfolio decline without needing to sell and take a loss.
The type of an investment goal an investor has often should dictate what type of risk they take on in their investment portfolio. For example, if an investor needs money for their child's college education in 10 years, they may choose a more conservative or moderate approach to investing. While 10 years is considered a long-term investment time frame, the investor will need to withdraw funds at a specific time in the future to pay for college expenses. They don't have the luxury of riding out a downturn if their child's tuition bill is due.
Conversely, someone who is investing for retirement 30 years from now can afford to be more aggressive with their investment portfolio. Even if their portfolio is experiencing a downturn in the first year of their retirement, they don't have a need to withdraw all of their retirement savings at once. So the bulk of their dollars will have an opportunity to weather the downturn.
Asset allocation and diversification often are thought of as the same thing. However, they are different concepts. As we just learned, asset allocation is associated with determining how much you will allocate to an asset class like stocks, bonds, and cash. Diversification is associated with the allocation of investment dollars within each of those asset classes. For example, within the stock allocation, investments could be diversified into stocks based on the size of the company: 50% large, 30% mid, and 20% small-sized companies. This further reduces risk within each asset class.
Asset allocation portfolio examples
As we have discussed, before making any investment decisions be sure you are comfortable with your strategy and the risks involved with your portfolio. Again, many investors work with a financial advisor to develop and implement an investment plan.
Summary of Investments
Developing an investment plan is a key driver in achieving your future goals. The more you build your knowledge about the different types of investments, their risks, and opportunity for growth, the more likely you are to build an investment portfolio you are comfortable with.
Be sure to keep the following factors in mind before making decisions to buy investments:
Financial goals, time horizon and risk tolerance level.
Asset allocation strategy: how much will you invest in stocks, bonds, and cash?
Diversification: how will you diversify your investment dollars in each of your asset allocation categories to ensure you don't have "all of your eggs in one basket"?
Are you a do-it-yourself investor or do you prefer to work with a financial advisor?
Take time to answer these questions and then begin the process of developing your personal investment plan. It can be very rewarding watching your hard-earned dollars grow over time so that you can achieve the financial success you desire.
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.