The Quick and Dirty on Investments
Stocks, Mutual Funds, and Bonds, oh my! Most of us have heard of one or more of these investments. But what are they, exactly? When I mention these terms to my clients, I begin to see their eyes glaze over. And I cannot blame them. They sound intimidating and few people can explain them in a way that is easily understood. I am, however, going to give it a shot!
To start, the most common investments you will likely hear are Mutual Funds, Stocks, Bonds, ETFs, and even Cash. They all play a role in planning not only for retirement, but also achieving your short, intermediate, and long-term goals. I will explain each one in a way even a 12-year old can understand (at least I hope!).
A stock (also known as an equity) represents ownership in a company. If you own one share of company stock, you own a piece of that company. Pretty cool, huh? Maybe you have heard of the Dow Jones, S&P 500, or the NASDAQ? These are the most commonly known stock market indexes. Large, well-known public companies can be found (bought or sold) on one of these. Please note, they are not the only places where you can buy or sell stock, but I am trying to keep things simple. The price of each stock changes many times per day (up or down) and is based on the market’s valuation of that company. Believe me, stocks are not for the faint of heart and should be chosen only after careful research and consideration. Stocks should be viewed as long-term investments.
In its simplest terms, a bond is debt. When you purchase a bond, you are loaning money to a corporation, government, or other entity. For example, Company X wants to buy new equipment, but does not want to (or cannot) use existing cash to pay for it. The company may issue a bond asking for $10,000 (price), paying 3% (interest) for 10 years (term). If you buy this bond, the company will pay you interest at set intervals, usually quarterly. Once 10 years has passed, the buyer will receive his/her $10,000 back. Keep in mind, the bond is only as strong as its issuer, so be sure you research the company or entity before purchasing. You can check its rating from any of the following agencies: Standard & Poor’s, Moody’s, and Fitch. A bond can be purchased with a 1-year term even up to 30 years. Depending on the maturity date, a bond can be viewed as a short, intermediate, or long-term investment.
Cash can also serve a purpose when investing, particularly if you need the funds in the short term (within 3 years). Savings accounts and CDs are the most common accounts to keep cash. While cash is not affected during a stock market downturn, in a low interest rate environment, it can be a risk to your purchasing power (inflation). For example, if the cost of living is increasing by 2.5% each year and your savings account is earning 1%, you are essentially “losing money”. In a low interest rate environment like we are today, it can be incredibly difficult to find a good return in cash.
A mutual fund is made up of a combination of the above-mentioned investments. You can even buy mutual funds that invest in real estate and gold! You have probably seen mutual funds in your employer retirement plan (401k, 403b, SIMPLE IRA, 457b). Mutual funds tend to be less volatile than owning an individual company stock because mutual funds own several stocks and bonds, thereby spreading the risk across multiple areas of the economy. Mutual funds are viewed as intermediate to long-term investments.
ETF (Exchange Traded Fund)
I saved the ETF for last because it is probably the least familiar term on this list. An ETF is a hybrid between a mutual fund and a stock. They are comprised of several investments like mutual funds, but price and trade like a stock. They are fairly low-cost investments. You are likely to see these at a large brokerage firm where you can purchase them inside an IRA, Roth IRA, or Brokerage (taxable account). ETFs should be viewed as intermediate to long-term investments like mutual funds and stocks.
When determining the types of investments to purchase, diversification is key. You may have heard the term “don’t put all of your eggs in one basket.” This applies to investing as well! Using a combination of stocks, bonds, cash, and various mutual funds and ETFs provides some downside protection if one particular investment is not doing so well. It is also important to take into consideration your age, tax bracket, goals, lifestyle, timeframe, and ability to tolerate risk (the ups and downs of the market). All investments carry some form of risk and past performance is no guarantee of future results. When in doubt, please consult a financial professional.
To review and learn even more, please stay tuned for a webinar on Investing Basics in the next few weeks!