Friday, February 13, 2009

Don't Be Afraid of Investment Terms You Don't Understand - Part 2

Tip #68 - Don't Be Afraid Of Investment Terms - Part 2. In part 1 of this series, we discussed how you should not be afraid of investment terms that you don’t understand. You just need to take the time to learn what they mean and invest in what you know. We discussed some simple ways to earn interest on your money: savings accounts, money market accounts, and certificates of deposit. All three of those are low-risk investments. You have no chance of losing your principal (or the amount you put into the account or certificate. And all three are generally insured by the FDIC). Now we’re going to learn some other terms for more complicated investments: stocks, bonds, and mutual funds. All three of these types of investments are riskier than the ones we discussed last time. None are insured, and there is a chance that you can lose all or part of your initial investment.

Stocks are the first investment we will talk about. A stock is essentially a part ownership in a company. On a simplistic basis, if a company is worth $100,000 and sells 1,000 shares of stock, each share is worth $100. If you buy 2 shares for $200 and hold onto them for a year, the worth of your stock can go up or it can go down. If the business is worth $300,000 at the end of the year then each of your shares of stock is worth $300 so now your total value is now worth $600. However, if the worth of the business goes down to $50,000 at the end of the year then each of your stock shares is now worth $50 for a total of $100. People buy shares of stock in a business whose worth they think will increase. They general buy stock from a stock broker. You should have some knowledge about the nature of the industry the company is involved in, how well the company is run, the state of the economy, etc. before buying stock in a company. It is possible to lose every last dollar that you have invested in a stock. And it is also possible to make a huge return. In general, buying shares of stock in one particular company is pretty risky. It’s like putting all of your eggs in one basket.

Bonds are the next investment that we will talk about. When you buy a bond, you are basically loaning money to the federal government, a city or town, or a corporation issuing the bond. It’s different than stocks because you don’t own any part of the company, town, or federal governmnt. If you want to invest in bonds, you buy a bond for a certain amount and you are promised a greater amount at a set date in the future. Like CDs, the risk with bonds is that the inflation rate will go up. Your interest rate on your bond does not go up with it and you are locked in until the term is up. Also, each bond carries its own risk – that is how likely the entity will be to pay off the bond when it comes due. The federal government is extremely likely to make good on its bonds so its bonds usually pay the least interest. Cities and towns’ bonds are called municipal bonds. These are pretty safe as well (and they are actually rated according to how risky they are. The higher the rating the safer it is, and generally the lower the rate of return is). The riskiest type of bond is a corporate bond because it’s possible that a corporation may not have the ability to pay you back when the bond comes due. Therefore, in general, corporate bonds’ returns will be greater than government ones. Corporate bonds are also rated according to their riskiness. It should also be noted that there are some tax advantages to buying bonds from the federal government and municipalities, which makes them an attractive investment to some people. In general, buying bonds are less risky than investing in stocks.

Mutual funds are the last investment that we will talk about. Investing in mutual funds are a way of buying stocks and bonds in larger quantity so that you are not invested in just one or two stocks or one or two bonds. This is called diversifying. As an individual, it is hard to buy hundreds of different stocks or bonds unless you are dealing with a very large amount of money. But the advantage to buying many stocks or bonds is that all of your eggs are not in one basket, so to speak. A good way to achieve this diversification is to buy a mutual fund. Mutual funds are administered by private companies and are run by investment managers. Essentially, the investment manager creates a fund by buying several stocks or bonds (or a combination of the two) that he thinks will do well. As an investor, you buy shares in his fund. Now instead of owning just one or two stocks, you indirectly own a small share in many stocks (or bonds). So if one company does badly, it doesn’t make your whole investment go down the tube. There are hundreds of types of mutual funds with a wide range of risk – some with a lot of risk (considered aggressive growth) and some considered less risk (conservative funds). However, all mutual funds carry risk because potentially you can lose all of your investment. On the other hand, they can provide a great investment return that far surpasses inflation. And they are a good alternative to investing directly in individual stocks.

Those are the last three types of investments terms that I will talk about. There are many variations of these investments and different investment products and financial terms that I haven’t mentioned. The basic investment choices you have for earning money on your savings are savings accounts, money market accounts, certificates of deposit, stocks, bonds, and mutual funds. Now that you have an understanding of some basic investment terms, in part 3 of this series we will discuss how to choose which investments you should put your hard-earned money in.

In Real Life (IRL) – I was given federal savings bonds as gifts from relatives and friends of my parents on special occasions. Those were not fun gifts for a child. They couldn’t be spent right away and the value on the face of the bond (such as $100) wasn’t really $100 for another 7 years or so. They were put aside to grow and turned in when they matured. These federal savings bonds were low-risk investments, but they were my first foray into an investment that wasn’t essentially an account from a bank. I did not invest in my first mutual fund until I was in my mid-twenties and I didn’t invest in an individual stock until my late twenties. I’ll share my story with you about my initial hesitation about buying into a mutual fund where I could potentially lose my initial investment.

I was in my mid-twenties sitting on the beach during our family vacation when I had a discussion with my father (a saver a person who enjoys investing money and discussing investments) and my brother (who is an accountant and financial planner and for the record, a much riskier investor than I was or ever will be). They were asking me where I was putting my money that I was saving each month. I told them it was going into some CDs and that I had bought some bonds. They both immediately told me that I should be investing in mutual funds – accounts that could potentially pay me a much greater return on my investment. No, I told them. I am scared. I don’t want to lose the money I invest into it. At the time – this was the early 1990’s - stock mutual funds were averaging 10% to 15% per year returns. They tried their best to convince me, but I was too scared to see my account value go up rather than down. I liked safe. I was used to safe, and I was happy with a smaller return as long as I had no chance of losing my money.

They persisted until finally my dad said, “If it goes down in value, I will pay you the money back.” Looking back, I actually think that’s a pretty succinct sentence to sum up my financial life – my dad would always be there for us if we needed help. That allayed my fears a bit so I said I would try it. They assured me that the mutual fund they were recommending was not too aggressive and that it would do fine. And it did. Each month I mailed off a check to the mutual fund company and each year at year-end I would evaluate the results. 12% increase one year, 10% the next. Fifteen percent after that. These were results I could get used to! This went on for several years and then the returns slowed down, and in recent years they have even turned negative (hmm…I wonder if that offer from my dad is still good?). I am much more comfortable with financial risk now. I have my investments diversified, so if one is not doing well, I at least have others that are. But it took me a long time to get to that point. And the first step to getting there is to learn some of these investment words you don't know. I’ll share in my next post how I started buying my own stocks!

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