The idea of investing is somewhat simple; however the process, concepts and terms can be rather complex and confusing.
What is the difference between a stock and a bond? Why invest if there is a “risk”? Overwhelmed? Intimidated? Don’t be. You don’t have to know everything there is to know about investing to get started, but there are some basic fundamentals that you should get familiar with.
Let’s start with the basics. First, when you commit your money to something with the hopes of a financial return or profit, you are known as an investor. Secondly, when you invest, you acquire things of value that can at some point, be converted to cash, or assets to put it simply. Assets can be separated into different categories based on similar characteristics and behaviors in the marketplace, These are called asset classes. Now seems like a good time for a shining, defining moment.
What is an asset class?
These are the things that make up the bulk of your portfolios. Consider them as “building blocks”.
A stock is actually pretty simple – it’s a share in the ownership of a company, so when you purchase stocks in a company, you become a part owner of the business. The more stock you acquire, the higher your ownership stake in the company becomes. Stocks are more volatile than other assets, but have historically provided higher long-term returns. By investing in different stocks from different industries, companies, and company sizes, and countries within the stock asset class, for example, you improve the chances for growth because your savings won’t rely on any one particular stock.
If you know what an IOU is, then a bond is basically an IOU or a loan that is given to a company by you. When you purchase a bond you’re essentially acting as a bank – you’re lending your own money out to a borrower with the expectation to be paid back in full with interest on a specified date. Bonds can be considered as “fixed income” because the rate of interest is typically set in advance and lenders can expect scheduled interest payments over the life of the bond.
We all know what cash is, so there’s not a major reason to go into a deep explanation. Cash provides a useful benchmark for all investment. Ultimately, investments that don’t beat cash have failed. Cash also provides a safe haven for funds when markets are rocky or looking overvalued. Some funds also trade in currencies to boost their returns from cash when interest rates are low, like now. Cash is considered the safest asset class of all because of its lack of volatility, as it’s very unlikely that cash would lose value. The big downside is that over the long term cash usually delivers smaller returns than bonds — and far smaller returns than equities.
Mutual funds are essentially a collection of the assets listed above. When you buy into a mutual fund, you’re basically pooling your money with a group of investors in order to buy into a diversified group of stocks, bonds, and other assets. Mutual funds help to reduce the impact of loss and at the same time, they do not make your potential gain as substantial as a stock might.
Each asset class has unique characteristics that influence your return. The purpose of having all asset classes represented in your portfolio is to take advantage of the different strengths of each class. For this reason alone, it’s not a bad idea to diversify*, or rather put your money into several assets within your portfolio in order to “spread risk”.
You may now be asking “what do you do with these asset classes?” The answer to that is simple – you make an investment; but before you go putting your money into any one of the above-mentioned assets, you must first be aware that all investments carry some level of risk, whether big or small. Even cash, as safe as it is, is subject to some level of risk, due to inflation, but that’s a topic to be discussed later. Risk is that level of uncertainty when investing. There’s the chance that you could gain and equally, you could potentially lose, nothing is guaranteed.
At the end of the day, the goal is to find the right mix of investments for yourself. This is called diversifying. By diversifying, you reduce the risk that poor performance in a single stock sector or the stock market could have on the return of your whole portfolio. Keep in mind that diversifying your portfolio doesn’t guarantee that you’ll profit from your endeavors, but you may reduce the likelihood of all your investments declining at once.
*Using diversification/asset allocation as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss in declining markets.
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