If you’ve read “Investing 101 (Part 1),” you understand why investing is so important. Now, let’s move on to ways of actually investing your money. For simplicity’s sake, I’ll cover only a few major types of asset classes or investment options: cash, bonds, and stocks.
Most people are familiar with this asset category. Cash includes the dollars you hold in your wallet; in your checking account, savings account, or money market account; or even under your mattress. Typically, cash accounts are the safest type of investment and therefore offer lower returns than stocks or bonds do. However, the amount you set aside in cash vehicles can be a cushion to fall back on when life’s unexpected expenses or emergencies arise. Let’s refer back to the Rule of 72 discussed in “Investing 101 (Part 1).” If you invested $5,000 in cash vehicles averaging 2 percent return a year, it would take approximately 36 years (72 divided by 2) to double your original investment to $10,000.
The best way to describe a bond is to think of it like a loan. You loan your money to the government or to a company, and in return they pay you interest for the term of that loan. Typically bonds are considered conservative investments because you can choose the length and term of the bond, and know exactly how much money you will get back at the end of the term, or “maturity.”
There are many types of bonds: government bonds, corporate bonds, short-term bonds, long-term bonds, municipal and inflation-protected bonds, etc. Generally bonds are less risky than stocks and the only way you lose money on one is if the company or government issuing the bond defaults on their obligations. Historically, bonds have an annual average total return of 6.3 percent.* Again, using the Rule of 72, if you invested $5,000 in bonds that average 6 percent return a year, it would take you about 12 years to double your original investment to $10,000. Better than cash, but still not great.
Bonds are subject to market risk and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, and bonds are subject to availability and change in price.
A stock is partial ownership in a company. When you buy a stock, you buy a piece of the company. So if the company does well, you do well. Likewise, if the company tanks, your stock tanks.
Just like bonds, there are many types of stocks because there are many different types of companies out there. Large company stock (large cap), mid cap stock, small cap stock, international stock, emerging stock, tech stock, etc. Historically, stocks have an annual average return of 10.8 percent.** However, remember that with more return comes more risk. So when investing in stocks, keep in mind that you have to be able to handle the extra risk or volatility to reap the potential reward in the long run.
Using the Rule of 72, if you invested $5,000 in stocks that average 10 percent return over time, it would take you about 7.2 years to double your original investment to $10,000. What if you invested that money for longer? By the end of 36 years, you could potentially have $160,000. Compare that to the $10,000 you would have after 36 years if you left your money in cash investments. You can see why taking on extra risk can become worth it in the long run.
Now that you know the basic types of investments, let’s talk about how to choose which investment is right for you. This is where diversification comes in. Diversification boils down to not keeping all your eggs in one basket. To wit, you don’t usually invest all your money in only one stock or one bond. It’s just too risky. When you diversify your money, you allocate it to different assets: stocks, bonds, and cash. This helps protects you against significant losses in any one area and can potentially provide a safeguard against risks like inflation and severe market fluctuations.
Finding the right mix of stocks, bonds, and cash comes down to your risk tolerance and goals for the money. If you are more conservative, then you will want more cash and bonds in your portfolio, as opposed to stock. If you are more aggressive and investing for long-term goals (10 years+), you can take on more risk to hopefully yield more return on your money, and therefore hold more stock in your portfolio.
One of the easiest ways to diversify your money is by investing in mutual funds, which can provide exposure to hundreds of stocks or bonds in one investment vehicle. You could build a fully diversified portfolio — one that encompasses multiple asset classes — by owning just one broadly diversified mutual fund. Just remember that no amount of diversification can guarantee you'll turn a profit or protect you from losses in a declining market.
Tune in next month for “Investing 101 (Part 3).” I’ll explain the types of mutual funds that may be right for you and how to actually start investing your money.
Brittney Castro is a member of the DailyWorth Connect program. Read more about the program here.
* Source: J.P. Morgan Asset management using data from Barclays Capital U.S. Aggregate Bond index 1950-2011
** Source: J.P. Morgan Asset management using data from S&P 500 index from 1950-2011
The examples in this article are hypothetical and are not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing. The Standard & Poor’s 500 Index is capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The S&P 500 is an unmanaged index and cannot be invested into directly.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.