Below are summaries of some basic principles you should understand when evaluating an investment opportunity or making an investment decision. Rest assured, this is not rocket science. In fact, you’ll see that the most important principle on which to base your investment education is simply good common sense.You’ve decided to start investing. If you’ve had little or no experience, you’re probably apprehensive about how to begin. Even after you’ve found a trusted financial advisor, it’s wise to educate yourself, so you can evaluate his or her advice and ask good questions. The better you understand the advice you get, the more comfortable you will be with the course you’ve chosen.
Don’t be intimidated by jargon
Don’t worry if you can’t understand the experts in the financial media right away. Much of what they say is jargon that is actually less complicated than it sounds. You’ll learn it soon enough, and there is no reason to wait to invest until you know everything.
IRAs hold investments–they aren’t investments themselves
As a preliminary matter, let’s address a source of confusion that immediately throws many new investors off: If you have an individual retirement account (IRA), a 401(k), or other retirement plan at work, you should recognize the distinction between that account or plan itself and the actual investments you own within that account or plan. Your IRA or 401(k) is really just a container that holds investments and has special tax advantages. Folks often get confused when that distinction is not pointed out.
Understand stocks and bonds
Almost every portfolio contains one or both of these kinds of assets.
If you buy stock in a company, you are literally buying a share of it from an existing owner who wants to sell. You become an owner, or shareholder, of the company. As such, you take a stake in the company’s future. If the company prospers, there’s no limit to how much your share can increase in value. If the company fails, you can lose every dollar of your investment.
If you buy bonds, you’re lending money to the company (or governmental body) that issued the bonds. You become a creditor, not an owner, of the bond issuer. The bond is your IOU. As a lender, your return is limited to the interest rate and terms under which the bond was issued. You can still lose the amount of the loan (your investment) if the company or governmental body fails, but the risk of loss to creditors (bondholders) is generally less than the risk for owners (shareholders). This is because, to stay in business, a company must maintain as good a credit rating as possible, so creditors will usually pay on time if there is any way at all to do so. In addition, the law favors bondholders over shareholders in the event of bankruptcy.
As a matter of jargon, stocks (and stock mutual funds) are referred to as equity investments, while bonds (and mutual funds containing bonds) are often called investments in debt.
Diversify–don’t put all your eggs in one basket
This is the most important of all investment principles, as well as the most familiar and sensible.
Consider using several different classes of investments for your portfolio. Examples of investment classes include stocks, bonds, mutual funds, art, and precious metals. These classes are often further broken down according to more precise investment characteristics (e.g., stocks of small companies, stocks of large companies, bonds issued by cities, bonds issued by the U.S. Treasury).
Investment classes often rise and fall at different rates and times. Ideally, in a diversified portfolio of investments, if some are losing value during a particular period, others will be gaining value at the same time. The gainers help offset the losers, and the total risk of loss is minimized. The goal is to find the right balance of different assets for your portfolio. This process is called asset allocation.
Within each class you choose, consider diversifying further among several individual investment options within that class. For example, if you’ve decided to invest in the drug industry, it might be wise to make smaller investments in Company A, Company B, and Company C, rather than put all your chips on one of them.
Recognize the tradeoff between the risk and return of an investment
For present purposes, we define risk as the possibility of losing your money, or that your investments will produce lower returns than expected. Return, of course, is your reward for making the investment. Return can be measured by an increase in the value of your initial investment principal and/or by cash payments directly to you during the life of the investment. There is a direct relationship between investment risk and return.
When someone proposes an investment and suggests otherwise, we know, “it’s too good to be true.” Invariably, the lowest-risk investments will be among the lowest-returning at any given time (e.g., a federally guaranteed bank certificate of deposit). The highest-risk investments will offer the chance for the highest returns (e.g., stock in an Internet start-up company that goes from $12 per share to $150, then down to $3).
Between the extremes, every investor searches to find a level of risk–and corresponding expected return–that he or she feels comfortable with.
Understand the difference between investing for growth and investing for income
As an investor, you face an immediate choice: Do you want growth in the value of your original investment over time, or is your goal to produce predictable, spendable current income–or a little of both?
Consistent with this investor choice, investments are frequently classified or marketed as either growth or income oriented. U.S. Treasury notes, for example, provide regular interest payments, but if you spend that money, of course, your original investment cannot grow.
In contrast, investing in a new software company, for example, will typically produce no immediate income. New companies generally reinvest any income in the business to make it grow. If they are successful, the value of your stake in the company should likewise grow over time.
There is no right or wrong answer to the “growth or income” question. Your decision should depend on your individual circumstances and needs (e.g., your need, if any, for income today, or your need to accumulate a college fund, not to be tapped for 15 years).
Understand the power of compounding on your investment returns
To help make an educated “growth or income” decision, you should have a feel for the result of either approach. With an investment made primarily for the production of current income, you’ll know in advance the size and timing of payments to expect.
To evaluate the “growth” approach, you’ll need to appreciate the concept of compounding. Compounding is what happens when you “let your money ride.” Unlike the income investor, who usually takes his or her money “off the table” as the checks arrive, the growth investor lets investment returns remain invested, thereby earning a “return on the returns.”
A simple example of compounding occurs with a bank certificate of deposit that is allowed to roll over each time it matures. Interest earned in one period becomes part of the investment itself, earning interest in subsequent periods. In the early years of an investment, the benefit of compounding on overall return is not exciting. As the years go by, however, a “rolling snowball” effect seems to operate, and the compounding’s long-term boost to investment return becomes dramatic.