Savings: The Basics of Investing

While current obligations and financial emergencies may make it hard to prioritize savings at certain points in our lives, many people put off saving for retirement (or any other need) not because they cannot afford it, but because they are overwhelmed with the options and terminology. Putting off saving can have compounding effects, not only because it’s easy for days to become weeks, then years and even decades, but because the effects of reinvested earnings mean that, by retirement age, a dollar invested at age 25 will grow more than one invested at 35 and far more than one invested at 45 or 55.

Once you’ve begun saving, the options for how to invest that money can be overwhelming. While nobody can predict future returns, this article goes over the basics of some guidelines for understanding the vocabulary and choosing what types of investments to make with your retirement plan and other savings accounts.
 

Stocks, Bonds, and Other Investment Choices

When you buy a stock, you are buying a small share of ownership in a company. The price of that share is determined by market forces – more people wanting to buy shares of that company than sell them will raise the price whereas fewer buyers and many sellers will lower it. In the long run, if a company does well, the demand for ownership of that company would be expected to increase and the stock value to rise. A company that is struggling will generally see its stock price decline. If the company fails and has no underlying assets, the stockholder owns a piece of nothing and the stock becomes worthless. Since companies can and do fail, holding individual stocks can be very risky. If an investor has enough invested to diversify, or spread his or her risk among several different companies, different industries, different size stocks and different types of stocks, risks can potentially be reduced. Although it can reduce the risk to your portfolio of a catastrophic loss, diversification alone does not guarantee a profit or protect against the possibility of loss.

A bond, in contrast, is a unit of debt rather than ownership. When a company issues bonds, they are taking out a loan from investors, with a promise to make regular interest payments for the term of the loan and to pay out the amount borrowed in full at the conclusion of the loan term. As with other types of loans, the company has a contractual obligation to pay this money back. The value of the bond may fluctuate on the open market, but even when the value declines, companies are still required to make interest payments. While issuers (especially high-yield or “junk bond” issuers) do sometimes default, or fail to make interest payments to bondholders, a company would need to be insolvent and in the bankruptcy process to be legally allowed to stop paying. Even then, bondholders’ claims against assets are above those of stockholders’ and they can be more likely to recover some of their principal during the bankruptcy process. The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Bonds are subject to inflation risk (the risk that inflation will make each fixed payment worth less over time), interest-rate risk (the risk that market interest rates will rise above the rate on existing bonds), and credit risks (which includes the risk that the individual issuer will not be able to pay). Due to interest rate risk, as interest rates rise, bond prices typically fall, which can adversely affect a bond fund's performance.

For those who are not wealthy enough to own many individual stocks and bonds without incurring very high trading costs, mutual funds and electronically traded funds (also known as ETFs) offer a way to buy a portion of a portfolio that holds the stock and/or bonds of many different companies. By buying a share of a mutual fund, you own a small amount of each investment the fund owns in the same proportion that the fund itself owns them.

Mutual funds are not guaranteed or insured by any bank or government agency--even mutual funds sold by banks. Before investing in a mutual fund, carefully consider its investment objectives, risks, fees, and expenses, which are included in the prospectus available from the fund. Read it carefully before investing. The return and principal value of a mutual fund fluctuates with changes in market conditions. Shares when sold may be worth more or less than their original cost.

Most funds specialize in a specific type of investment, or asset class. Generally stocks are broken down into asset classes based on the company’s size (large, mid, or small “cap” or capitalization) or region (such as US, international, or emerging markets). Some funds may have more targeted objectives, focusing on a particular industry or a single foreign country. Bonds funds are usually specified by their term (when the principal payment is due) and their sensitivity to changes in the interest rate (also called “duration”). There are also bond funds that focus on high-yield bonds (which have a higher interest rate and a higher risk of default), international bonds, and other more specialized categories.

For individual investors, the major difference between mutual funds and ETFs is that mutual funds are generally open-ended, meaning that shares are either issued or redeemed by the fund itself. The fund prices the underlying assets at the close of the market each day, and any orders to buy or sell entered during the market day are executed by the fund itself. ETFs, on the other hand, are purchased from and sold to other investors on a stock exchange, like an individual stock. They require opening an account, such as a brokerage account, that can hold the shares, and can incur trading costs and commissions. Once purchased, their underlying expenses are sometimes (but not always) less than those of mutual funds. They may also be more tax-efficient, for investors who are not holding the fund within an IRA, 401(k), or other tax-deferred account. As with a mutual fund, before investing in an ETF, carefully consider its investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing.