Investing in stocks has handily outperformed investing in bonds, Treasury bills, gold or cash over the long term. In the short term, one or another asset may outperform stocks, but overall, stocks have historically been the winning path, but what exactly they are
- Bonds-The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi-annually). The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply “Treasuries.” Two features of a bond – credit quality and duration – are the principal determinants of a bond’s interest rate. Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range.
- Treasury Bill – T-Bill-For example, let’s say you buy a 13-week T-bill priced at $9,800. Essentially, the U.S. government (and its nearly bulletproof credit rating) writes you an IOU for $10,000 that it agrees to pay back in three months. You will not receive regular payments as you would with a coupon bond, for example. Instead, the appreciation – and, therefore, the value to you – comes from the difference between the discounted value you originally paid and the amount you receive back ($10,000). In this case, the T-bill pays a 2.04% interest rate ($200/$9,800 = 2.04%) over a three-month period
But there are so many ways to invest in stocks. Individual stocks, mutual funds, index funds, ETFs, domestic, foreign – how can you decide what is right for you? This article will address several issues that you, as a new (or not-so-new) investor, might want to consider so that you can rest more easily while letting your money grow.
What about RISK!?
You may be eager to get started so that you, too, can make those fabulous returns you hear so much about. But slow down and take a moment to contemplate some simple questions. The time spent now to consider the following will save you money down the road.
What kind of person are you? Are you a risk taker, willing to throw money at a chance to make a lot of money, or would you prefer a more “sure” thing? What would be your likely response to a 10% drop in a single stock in one day or a 35% drop over the course of a few weeks? Would you sell it all in a panic?
The answers to these and similar questions will lead you to consider different types of equity investments, such as mutual or index funds versus individual stocks. If you are naturally not someone who takes risks, and feel uncomfortable doing so but still want to invest in stocks, the best bet for you might be mutual funds or index funds. This is because they are well diversified and contain many different stocks. This reduces risk – and doesn’t require individual stock research.
- Mutual Fund-An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers, who invest the fund’s capital and attempt to produce capital gains and income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.
- Index Fund-“Indexing” is a passive form of fund management that has been successful in outperforming most actively managed mutual funds. While the most popular index funds track the S&P 500, a number of other indexes, including the Russell 2000 (small companies), the DJ Wilshire 5000 (total stock market), the MSCI EAFE (foreign stocks in Europe, Australasia, Far East) and the Barclays Capital Aggregate Bond Index (total bond market) are widely used for index funds. Investing in an index fund is a form of passive investing. The primary advantage to such a strategy is the lower management expense ratio on an index fund. Also, a majority of mutual funds fail to beat broad indexes, such as the S&P 500.
How Much Time and Interest Do You Have for Investing?
Should you invest in funds, stocks or both? The answer depends on how much time you wish to devote to this endeavor. Careful selection of mutual or index funds would let you invest your money, leaving the hard work of picking stocks to the fund manager. Index funds are even simpler in that they move up or down according to the type of company, industry or market they are designed to track.
Fund Manager-The individuals involved in fund management (mutual, pension, trust funds or hedge funds) must have a high level of educational and professional credentials and appropriate investment managerial experience to qualify for this position. Investors should look for long-term, consistent fund performance with a fund manager whose tenure with the fund matches its performance time period.
The whole point of investing in a fund is to leave the investment management function to the professionals. Therefore, the quality of the fund manager is one of the key factors to consider when analyzing the investment quality of any particular fund.
Individual stock investing is the most time-consuming as it requires you to make judgments about management, earnings and future prospects. As an investor, you are attempting to distinguish between money-making stocks and financial disaster. You need to know what they do, how they make their money, the risks, the future prospects and much more.
Therefore, ask yourself how much time you have to devote to this enterprise. Are you willing to spend a couple of hours a week, or more, reading about different companies, or is your life just too busy to carve out that time? Investing in individual stocks is a skill, which, like any other, takes time to develop.
It is best that you not be exposed to only one type of asset. For instance, don’t put all of your money in small biotech companies. Yes, the potential gain can be quite high, but what will happen to your investment if the Food and Drug Administration starts rejecting a higher percentage of new drugs? Your entire portfolio would be negatively impacted.
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It is better to be diversified across several different sectors such as real estate (a real estate investment trust is one possibility), consumer goods, commodities, insurance, etc., rather than focus on one or two or three, as above. Consider diversifying across asset classes as well by keeping some money in bonds and cash, rather than being 100% invested in stocks. How much to have in these different sectors and classes is up to you, but being invested more broadly lessens the risk of losing it all at any one time.
A Portfolio for Beginners
If you are just starting out, think seriously about investing most of your money in a couple of index funds, such as one tracking the broad market (e.g. the S&P 500) and one that gives some international exposure. Maybe adding one that tracks small companies (e.g. the Russell 2000) would give your portfolio a boost.
A portfolio consisting of those three would give plenty of diversification, provide the steadier performance of large companies and be spiced up a bit with both international companies and small caps.
A Portfolio with Individual Stocks
If you are investing in individual stocks, a portfolio of 12 to 20 well-chosen ones will give you plenty of diversification and probably will not be too many to follow regularly. However, you will need to ensure that you fully understand each company, from its businesses to its risks. If you plan to invest in only stocks, make sure to spread the funds across different sectors such as health care, technology, small cap and big cap.
If you don’t have the time or desire to pick as well as follow that many stocks, consider investing in a mixture of index funds and individual stocks. Another consideration, especially if starting out with limited funds, is that investing in 12 to 20 stocks may not be feasible. Therefore, having the majority of your money in funds would provide the stabler returns they tend to generate. Adding in maybe a half dozen individual stocks could give your portfolio an extra kick.
Time to Invest
Once you’ve determined the shape of your portfolio, it is time to invest. Find a broker you are comfortable with, either an online broker or one with a local office or both. Call and talk with this person if necessary. Then fill out the paperwork, deposit some money and open an account.
After deciding what to buy, don’t buy all at once: enter slowly. What if you invested all your money just before a market downturn? Being in the red that quickly wouldn’t do much for your confidence. Plan to take several months to invest all of your money to minimize any market timing risk. Finally, remember to set aside time each week to review or catch up on the news for your investments.
As your experience grows, your asset allocation decisions will probably change. You could adjust your portfolio on a regular basis, say every year or so, by selling some of one type of investment and buying more of another. You could also adjust your portfolio by adding additional funds to those areas in which you want to increase exposure.
These additional funds can be used to expand the number of securities you hold or can be added to existing holdings. Do this on a regular basis and before you realize it, you’ll have a substantial portfolio that will help fund your retirement, pay for a second home or meet whatever goals you set when you started your investing journey.
- Asset Allocation-There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, your selection of individual securities is secondary to the way you allocate your investment in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results.Asset-allocation mutual funds, also known as life-cycle, or target-date, funds, are an attempt to provide investors with portfolio structures that address an investor’s age, risk appetite and investment objectives with an appropriate apportionment of asset classes. However, critics of this approach point out that arriving at a standardized solution for allocating portfolio assets is problematic because individual investors require individual solutions.
In the end
Before you jump into the stock market, spend some time thinking about what you want to accomplish and how to do that while staying within your risk tolerance levels. Also consider how much time you have to devote to investing. Doing this before committing those first dollars will go a long way toward protecting you from the emotional roller coaster of investing first one way, then another, never really knowing why you are changing your mind. Careful thought before and during your investing career will do more to help your results than trying to chase the latest hot stock. After all, it’s your money – you should know what you are doing with it and why.