Dear Readers: April 16, I talked about investing concepts that people want to understand but are too often afraid to ask about — things such as asset allocation, diversification and risk. But if you’re unclear on a concept, I say ask.
The same goes for types of investments. Stocks and bonds may seem pretty basic, but there’s more to understanding the different types and why one might be a better choice than another. So this week, I want to give you some insight into what to look for when choosing investments.
Starting With Stocks
A share of stock is a share of ownership in a company, as well as a share of possible profit. Owning stock is a great way to participate in a company’s growth potential. And though owning stocks carries a certain amount of risk — there are no guarantees, and past performance can’t predict future results — historically they’re the best way to grow your money over time.
When it comes to choosing a specific stock, however, you have to look closely. Companies vary by size, or market capitalization, which is the total value of all the shares of a company’s stock. Apple, currently with the largest market capitalization in the world, is a great example of a large-cap stock. But there are also small-cap and mid-cap stocks — plus foreign stocks, representing companies based outside the U.S.
Getting more granular, there are two styles of stock: growth and value. A growth stock is considered poised for a rapid rise (think high tech); a value stock is considered underpriced. Going even deeper, stocks are generally divided into 10 sectors (information technology, telecom services, utilities, health care, financials, industrials, consumer discretionary, consumer staples, materials and energy) and 67 industries within those sectors (such as retailing, banks and building products).
The ideal is to invest in a diversified mix of stocks of different sizes, styles, sectors, industries and countries. This helps control risk, but it doesn’t ensure a profit or eliminate the potential for loss. Sounds complex, but don’t get discouraged. Here’s where mutual funds and exchange-traded funds come in, which I’ll get into in just a bit.
Moving Into Bonds
You’ve probably heard of fixed-income investments. These investments generally pay a specific interest rate over a certain time period and promise to return your principal at maturity. A bond is right up there at the top of this list. A bond is like an IOU. You lend money, and in return, you receive a promise of repayment, plus interest, at a set date.
Bonds complement stocks because they focus on income rather than growth. And they’re generally less volatile. This can be particularly appealing to older investors seeking to create a regular income stream.
That’s not to say there isn’t some risk. There are many types of bonds (for example, corporate, government and municipal), each of which carries a varying degree of different types of risk, including default risk (the risk the issuer will go bankrupt and you won’t get your money back), interest rate risk (the risk that market interest rates will rise and the value of your bond will go down) and purchasing power risk (the risk that you will lose ground relative to inflation).
In general, corporate bonds offer the highest yield potential at the highest risk. U.S. government bonds — which include Treasury bonds, notes and bills — are considered the safest. Bonds are rated, so you’ll have a sense of the risk before you buy.
Making the Most of Mutual Funds and ETFs
At this point, you’re probably thinking it’s impossible to evaluate all the choices — and you’re right. Luckily, there are mutual funds and exchange-traded funds, which can do much of the choosing and monitoring for you.
A mutual fund pools money from many investors and invests in a broad range of securities — offering a certain amount of diversification without your having to choose individual stocks. But you still have to do some work because there are several types of mutual funds — stock funds, bond funds and blended funds, which invest in both. There are also sector-specific funds. The amount of diversification you get depends on the mutual funds you choose. A good choice for many new investors is a broad-based stock fund.
Mutual funds are professionally managed, so you don’t have to spend time following the day-to-day market. But there are two fundamentally different approaches to consider: passive and active. Passively managed funds, known as index funds, are designed to track — rather than beat — a specific index, such as the Standard & Poor’s 500. Actively managed funds, on the other hand, strive to beat the market. An important consideration is cost. Index funds generally have low fees; actively managed funds can cost a pretty penny. The added cost can be justified — for example, in the case of a small-cap or international fund, for which market information may be more difficult to obtain — but make sure before you buy. Always read the prospectus to understand the fee structure and how your money is invested.
An exchange-traded fund is another way to simplify choices. With an ETF, you own a single security representing a basket of stocks that tracks an index. The main difference between mutual funds and ETFs is the way they’re traded. Mutual fund trades are processed at the end of the day; ETFs trade like stocks, at any time during the trading day. ETFs are also professionally managed — most passively, similar to index funds. They generally also have low fees but may charge a commission when you buy or sell.
Giving a Nod to Cash and Its Equivalents
Cash isn’t only the balance in your savings account; it’s also a type of investment. Cash investments, also called cash equivalents, are low-risk but have low return potential. Think certificates of deposit, Treasury bills and money market funds.
Like any other investment, cash has its pluses and its minuses. It can be great for providing stability and liquidity, but if you’re trying to build long-term wealth, it’s not the best choice. The low returns may well be lower than the rate of inflation. In effect, you could lose money — and limit the opportunity to reach your goals. Once again, it comes down to finding the mix that best suits your needs.
Taking the Next Step
These basic investments are the building blocks you need to implement the concepts in the previous column. Next week, I’ll talk about types of accounts, taxes and staying on top of your investments.
Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER ™ is president of the Charles Schwab Foundation and author of “It Pays to Talk.” You can e-mail Carrie at askcarrie@schwab.com.