The specifics of investing can get complicated and hairy, but there are some basic rules that every investor — and especially young investors — should follow. One of those rules is actually one of the golden rules of investment:
“THOU SHALT DIVERSIFY THY PORTFOLIO”
Usually bankers won’t say it that way, but that’s how it’s written in the ancient texts of personal finance. Archaic diction aside, it’s important to allocate your assets into different types of investments, both to protect your portfolio from the volatility of the stock market, and to increase the return on your investment beyond what a bond could provide.
Most young financiers, however, don’t know the difference between investment categories. So for all you aspiring retirees, here is a breakdown of investment types:
If stocks are the hare of the investment world, fixed income investments are the proverbial tortoise. The idea is that you lend a bank, corporation, or government agency a certain amount of money for a certain amount of time, and in return the borrower pays you interest. While the risk is very low for these investments, interest rates are typically low, and aren’t high output — which is why fixed income investments are perfect for long-term investing.
Fixed income investments can be held inside or outside retirement accounts (IRA’s)and include:
- Bonds: Bonds have the most potential for risk, and vary by the stalwartness of the issuing corporation and the time it takes for the bond to mature
- Bond mutual funds: A portfolio of bonds managed by professionals to achieve an investors objective
- Certificates of deposit: A guaranteed account that pays interest for borrowing money from an investor for a given period of time. The interest rate determines the return, and can either be fixed or variable.
If fixed income investments are the family sedans of the investment world, stocks are the exotic sports cars. Historically they provide higher returns, but they are also associated with much higher risk and require a certain amount of tolerance for the unexpected.
At the most basic level, stocks represent partial ownership of a company, and can increase a stakeholder’s wealth in one of two ways:
- Capital gains: When you sell your stocks for more than you paid for them, you are making capital gains.
- Income: When a company is doing well it pays dividends to its stockholders — meaning it pays them cash according to the amount of stock they hold and how valuable the stock is at the time. Stock value fluctuates over time, however, and don’t always pay well. In fact, stocks can sometimes be in the negative.
You can include stocks in your investment portfolio in two basic ways:
- Direct investing: Purchasing individual stocks, for which you’ll need a brokerage account. Brokerage services help you decide which individual stocks to invest in, based on in-depth research. When investing directly, it’s best to invest in several stocks across several different industries, and avoid putting more than 10% of your portfolio in any one stock. This will reduce your risk of losing your investment.
- Indirect investing: Turning the purchasing decisions over to professionals at mutual funds, who diversify your portfolio and protect you from risk (as much as possible) from afar. All mutual funds charge a fee for their services, but some also have sales charges (called loads) which can get expensive.
Ideally, you want both stock and fixed income investments, so that your portfolio is diverse and insulated as much as possible from the volatility of the market.
This is a guest post by Eliza Morgan who is a full time blogger. She specializes in writing about business credit cards. You can reach her at: elizamorgan856 at gmail dot com.