Types Of Investments
Basically there are five different types of investments:
Real Estate: If you own your home, you are an investor. In fact, your home is probably the biggest single investment you’ll ever make. Historically, real estate always appreciates. How fast depends on the local market. But when you sell your home, you can usually expect to make a profit.
Bonds: Bonds are debt obligations issued by corporations and governments. They are for a fixed sum and pay interest. They have a maturity date, the date when the issuer must pay back the loan. Bonds carry a burden of risk of default and are rated for their safety by two organizations: Standard & Poors and Moody. S&P rates bonds from AAA to D, with AAA being the safest. Moody rates bonds from Aaa to C, with Aaa being the safest.
Government bonds include Treasury Bills, T-Notes and Treasury Bonds, obligations issued by federal government agencies such as Fannie Maes, Ginnie Maes and Sallie Maes, and savings bonds. In addition, state and local municipalities issue tax-free bonds. Corporate bonds are issued by businesses. There are also bond mutual funds.
When you buy a stock, you buy a portion of a corporation. A business, when it incorporates, authorizes a certain number of shares of the corporation. Each share represents an equal portion of ownership in the corporation. Shares of brand new corporations have a par value- the value printed on the face of the stock certificate- but that number quickly becomes irrelevant. What is relevant is how much investors are willing to pay for the share. That is its selling price and represents the market value of the share. In addition, a share has a book value. The book value is the value of the assets of the corporation, should the corporation be dissolved and the assets sold off.
Futures, Options And Commodities:These are all highly risky investments in which you guess or speculate at the future prices. They are not for the average investor.
What About Risk?
When it comes to investments, risk is related to reward. The general rule is the greater the risk, the higher the reward. But you can’t assume this will always be true. A poor quality investment is a poor quality investment, period.
When considering risk, here are some factors to consider:
Expected Return: It’s impossible to gauge exactly how much an investment will actually return to you. Almost every prospectus, in fact, contains a statement something like “past performance is no guarantee of future success.” But on the whole, unless something major changes, such as a change in a mutual fund’s manager or a fire in a plant, an investment’s returns averaged over several previous years will give you some idea how the investment will do in the future.
Volatility: The value of stocks and bonds fluctuates, depending on the market and the individual investment. It is measured by the volatility index. The volatility index indicates how much a stock or bond’s value varies from its average price. It is quoted in + or – dollars. An investment with high volatility is a riskier investment.
Real Return: Inflation has a big impact on investments. During the 1970’s, for example, bond and CD interest rates were very high. But the country was also suffering under double digit inflation. To determine the real return, subtract inflation rate from your gross return. So the real return on a 16% CD during a 12% inflation period would be only 4%.
How to Reduce Risk
The best way to reduce your risk is with a balanced portfolio. Rather than placing “all of your eggs in one basket,” diversify your investments. The key to a balanced portfolio is acquiring the right combination of assets. This is where a professional financial planner can help.
Another way to reduce risk is to invest for the long term. Historically, the market has always risen, despite day to day fluctuations and periodic “corrections.” Investing for the long term lets you take the slightly higher risks you need to beat inflation and earn a higher return.
With Dollar-Cost Averaging, you invest exactly the same amount every week, month, quarter or year, regardless of the market. This gets you into the investment habit. You build your build investment steadily, without putting too much or too little at the wrong time. Because the market has grown approximately 10% annually, this type of investing averages out the highs and lows of the market and you usually end up paying less per share.
How Much Risk Is Right For You?
How much risk you can afford depends on four factors:
Your Stage of Life.
The needs and demands on your income differ depending on whether you’re just starting out, raising a growing family, putting children through college, in your prime earning years or getting ready for retirement.
People with lots of discretionary income can afford to take greater risks with their money than people who are just getting by or who depend on their investments for their income.
The more assets you currently have, the more risk you can probably afford to take.
Some people are comfortable with high levels of risk. Others aren’t. Don’t do anything you’re not comfortable with.
How Much Risk Is Right For You? Take our Investor Profile Test and find out.
Buy Low. Sell High.
“Buy low. Sell high” is one of the oldest maximums of investing in stocks. But it’s impossible to determine exactly the right time to buy or sell.
The best way to gauge a stock’s or mutual fund’s performance is to compare it to a benchmark. For the whole market, the two indexes most investors use are the Dow Jones Industrial Average (“the Dow”) or Standard & Poor’s 500 Stock Index (“the S&P 500”). The various industries and market segments also have their own indexes.
What Are You Really Earning?
When you’re considering an investment, you need to take into account how the rate of inflation effects your investment. A 10% investment during a period where inflation is 3%, for example, yields only 7%.