Investing Basics

We all have financial goals in life: retire comfortably, pay for college, nice things for our family, a dream home. The reality is, spending less than we make is not enough to reach many of these goals. We have to do more than that. And rather than working harder, it’s best to work smarter. That’s where investing comes in. Let's dig into some investing basics to get you started.

I believe that stocks can get you the most bang for your buck. They’re one of the best ways to make your investment money work the hardest. There’s no huge mystery in investing in the stock market, and you don’t need any special degree to become a savvy investor. What you do need is patience, and a game plan.

There are several kinds of investment vehicles that should be considered for their strengths and understood for their weaknesses.

An Overview of some
Typical Types of Investments

Stocks – ownership interest in a company.

When a company is private, the founders own it. The percentage each partner owns depends upon how much each invested in the business.

When the company gets large enough, the owners may decide to “go public” and sell portions of the company to the investing public. This is when shares of stock are created.

When you buy a stock, you become one of the owners of that business. The value of the stock will go up and down over time, in tandem with the success of the underlying business. The better the business does, the more money you’ll make as a partial owner.

PROs of owning stocks vs other investment vehicles: stocks provide the highest rate of return on your money. Over the long term, no other type of investment performs better.

CONs: stocks are the most volatile of investments. Bad timing can easily sink your returns, and there is never any guarantee that you’ll make a positive return. Education and research, diversification, and a long-term approach are some of the ways to reduce the risk of stock investing, and to enjoy the financial rewards of your money working harder for you.

Bonds – in the simplest sense, bonds are loans. When you purchase a bond, you are lending money to an institution. That institution, in return, will pay you interest on your money. Each bond has a time-frame, or maturity date, and, as long as the institution does not go bankrupt, you’ll be paid back your principal at the end of that term.

There are two types of bonds: government bonds, issued and guaranteed by the United States Treasury (or by the government of a foreign country if outside the US), and offering low risk and modest return; and corporate bonds, issued by businesses and carrying both higher risk and return (due to the possibility of default).

Keep in mind: interest rates usually have a direct affect on bond values. When the prevailing rates rise, the market value of bonds tends to fall, and vice versa. The best way to counteract this risk is to hold the bonds until maturity.

PROs: lower risk and relative safety deserve a place in your portfolio.

CONs: your money can be tied up a long time in bonds, and the price of their relative safety is lower returns (as compared to other types of investments). Also, investing in corporate bonds requires as much homework as investing in stocks, yet generally have lower returns.

CDs – certificates of deposit are a safe savings vehicle because your principal is protected: you will not lose any of the money you put in. These serve well as rainy day funds because of their extremely low risk.

However, CDs are not as liquid as a savings or money market account. Your money is tied up until the CD matures. The longer the maturity, the higher the interest you’ll earn. Keep in mind that, even if waiting for a longer term CD is not a problem, the rate of return for CDs is simply not high enough for long-term growth of your investment.

Certificates of deposit can serve your portfolio very well for a portion of your “Safe” money, especially when set up in several “laddered” CDs. A CD ladder allows you to access some of your money at regular intervals without penalty, so that it will be more easily accessible when needed. Here’s how it works:

Instead of putting all your money into one CD, you buy several. If you had $5,000 to invest, you would purchase a $1,000 one-year CD, a $1,000 two-year CD, a $1,000 three-year CD, a $1,000 four-year CD, and a $1,000 five-year CD.

When the one-year CD matures, you reinvest that money in a five-year CD. When the two-year CD matures, you reinvest that money in a five-year CD, and so on. This gives you the ability to reinvest at better rates. Some of your money will always be less than 360 days from maturity, giving you the opportunity to either withdraw some of your money, if necessary, or to snag higher rates if they appear.

Mutual Funds – a large basket of stocks and/or bonds, managed by a professional, and owned by a pool of investors. Mutual funds make investing easy because someone else does all the work. However, you do have to pay for the convenience through various fees involved.

A key advantage to owning shares of a mutual fund is that it is less volatile than owning stocks, in that the stocks within the fund will balance each other out. As such, returns may not be as good as owning individual stocks. Also, there is no guarantee that you’ll receive positive returns. Investing in a mix of funds, as well as a mix of stocks, is a prudent strategy to help offset risk and maximize returns.

Real Estate – owning land, residential or commercial properties is usually a huge investment. Real estate tends to go up in value, but it will decline at times as well. (Especially after a long housing boom and subsequent bust!)

PROs: Real estate investing can be very lucrative, provided you get in at the right time, can afford to hold onto it for a long time, and have the time and/or resources to properly maintain and care for the property.

CONs: real estate taxes will eat into your returns and must be considered. Also, real estate is highly illiquid – you can’t get your money back out of it in a hurry if you need it.

Collectibles -- an asset of limited supply that is sought for the perception of high value. Stamps, antiques, coins, vintage automobiles, and works of art are among the many things typically classified as collectibles.

The main market for collectibles resides squarely among people who like collectibles. Collectibles are often regarded by investors as hedges against inflation because they tend to maintain their value or appreciate when general prices are rising.

The collectibles market is a very tricky investment arena for inexperienced investors, and pose the problem of the potential lack of liquidity.

Commodities -- physical goods such as gold, oil, metal, timberland, art, or grain with varying market values, and running purely on supply and demand. The commodities market is bought and sold through futures contracts, requiring more knowledge and experience than the novice investor possesses.

More Investing Basics You Should Know

The Power of Compounding -- compounding is a core aspect of good personal finance and a big reason why people with money end up with even more money. Time is an asset money can’t buy, so compounding works its best magic when you start young. You can literally turn pocket change into riches with time and the power of compounding.

Remember the Debt Snowball? The power of compounding works the same way, only rather than increasingly paying off debt, you increasingly grow your nest egg.

Here’s how it works: Say you invest $500 in an account earning 10% a year. At the end of the year, you’ve made $50 on your investment, and you reinvest it back into the fund. Now you have $550, earning 10%, making you $55 the second year. After reinvesting your earnings, you now have $605, earning 10%. The resulting $60.50 reinvested becomes $665.50, which earns you $66.55 by the fourth year.

See how your earnings increase every year? It may seem slow and pointless at first, but watch what happens:

• Year 5 you have $732.05

• Year 6 bumps it up to $805.26

• Year 7: $885.78

• Year 8: $974.36

• Year 9: $1071.79

• Year 10: $1178.97, having doubled your original return ($50) and more than doubled your original investment. And this is without having added a cent more to your investment of $500.

• By year 15, you’d have $1898.75 – almost four times your original investment.

• By year 20, $3057.95, six times what you put in! If you had socked away $5000 to start with, in 20 years it would be worth over $30,000!

Now that’s making your money work for you -- working smarter, not harder!

Compounding is a function of return and time, so the sooner you start, the better. Typically, a 3 to 7 percent is realistic, but time is a commodity that only diminishes. Therefore, the younger you are, the more time you have to make compounding really work for you.

Also, the more you save, the more you can let compounding work its magic. Even a little goes far: you could start with as little as $20 a month. Stay disciplined, and make saving a priority.

Compounding only works if you allow your investment capital to grow. It takes time to see the wonders of compounding returns. Most of the growth comes at the very end, so be patient.

When you start young, invest wisely, and leave your money alone over the long term, compounding will snowball your money.

-- A dividend is an agreed upon amount per share that the fund or company pays its shareholders. A sort of Thank You, if you will, for owning shares. If you buy 82 shares, you’ll be paid for owning 82 shares. Nice! What you’re doing is investing in a business, and then getting paid by that business.

Personally, I love dividends! I’m surprised how long it took me to really understand how dividends work. I never really understood it until I began investing myself (rather than using a financial planner) and saw how my buy-in price affected my dividend yield.

Example: if XYZ Co. pays 4.5 cents/share once a quarter, and you own 100 shares, you will be paid $4.50 per quarter. After four quarters (one year), you’ll have been paid $18.

Your dividend yield depends upon how much you paid for those 100 shares.

Here’s how it works: Let’s say you purchased 100 shares of XYZ Co. at market for $10.25/share. That means you paid $1025 for your shares. This is your principal. To figure your annual dividend yield, you divide your yearly dividends (in our example, $18) by the principal you paid (your invested amount, in this case $1025). 18 divided by 1025 = 1.75%. This is your annual dividend yield.

Now let’s back up and say you notice that the price per share has been bouncing up and down, so instead of jumping in and buying 100 shares at market (in our example, $10.25), you decide to wait until the price drops to $10/share. You put in a limit order of 100 shares at $10/share and wait. A week or two later, XYZ Co. drops to $10/share and you pick up 100 shares. Now your invested amount (your principal) is $1000 (rather than $1025 like our previous example). The dividend is still 4.5 cents/share (the agreed-upon amount), and you still earn $4.50 on your 100 shares each quarter. But your dividend yield has changed, because $18 divided by $1000 is 1.8%. It may be only .05% more than in the previous example, but you’re still getting more bang for your buck, and when you get compounding to work for you as well, over time, this small difference will add up to a big difference!

Here’s another way to understand how your buy-in price affects your yield. Let’s say you have $1500 to invest, and you want to earn dividend income on it. You do your research, and find a solid fund that pays 8.5 cents a month in dividends. (Yes, they’re out there!) The current share price on that fund is $12.30. Your $1500 will buy you 122 shares. You will be paid $10.37 (122 x .085) each month, or $124.44/year, for owning those shares. $124.44 divided by $1500 equals 8.3%. Awesome!

Now let’s say you decided to wait for a better price before buying. The price drops to $12/share, and your $1500 buys you 125 shares. You will be paid $10.63 (125 x .085) each month, adding up to $127.56/year, or an 8.5% dividend yield. Even more awesome!

Picking up more shares with the money you’ve got can really start to add up. Even better: put the power of compounding (see above) to work also, and watch your investment and your dividends steadily grow!

The key is to watch what’s happening in the markets so that you can take advantage of price dips, but you don’t want to miss an opportunity if the share price keeps going up. It’s a bit of an art. Limit orders (see below) help keep you from jumping in too soon and force you to slow down and practice patience. This is a good thing!

At Market
-- An order to buy or sell securities immediately at the current market price. Market prices fluctuate throughout the trading day.

Limit Order -- An order to buy or sell securities at a specific price. This is done with the intention of achieving a better entry or exit price than is available at the time of the order, or to ensure the specific amount of principal that will be invested.

For example: You have $7500 in your brokerage account that you want to move into a particular stock fund. The market price of the fund is $75.00/share at the time of your order. You could put in an order for 100 shares, which should cost you $7500.00. Perfect! But if, as you’re placing your order, the market price shoots up to 75.86, it will cost you $7586.00, which is more than you had to invest!

I think it’s better to buy a security with a limit order so that you can control how much you’ll be investing in it. I only use a market order when there’s a very good reason to hurry up and get out. Even if I like the market price, I still use a limit order, because it’s gone the wrong way on me often enough using a market order (up when buying, or down when selling). And being a small investor, every penny counts, so utilizing some control really pays off.

(Remember, you also need to figure in the transaction cost required by your broker. That’s how he gets paid to take care of you, but forgetting this cost can mess up your numbers. Be sure you know what your transaction costs are, as they vary from broker to broker. Always figure it into your overall cost when placing an order.)

Continue to More Investing Basics for an explanation
of portfolio management terms.

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When you're familiar with the basics and ready to invest,
read Start Investing as guide for the novice investor.