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Investing
Investing:
Learning the Basics
Making
money in stocks, bonds and mutual funds.
Over
the long term: Stocks have
historically outperformed all other investments.
From 1926 to 1999, the stock market returned an average annual 11.4
percent gain. The next best performing asset class was bonds, which
returned 5.1 percent. Real estate is also another good investment.
Stocks short term: can be hazardous to
your financial health.
If you thought the Dow's 554-point drop on Oct. 28, 1997 was rough,
consider the 508-point drop 10 years earlier, on Oct. 19, 1987. The
1997 decline was a mere 7.2 percent, while the 1987 crash, the worst
one-day drop in stock market history. Chopped 22.6 percent off the
value of stocks in a mere six-and-a-half hour trading day.
Risky investments are not for everyone.
Investors demand a higher rate of return for taking greater risks.
That's one reason that stocks, which are perceived as riskier than
bonds, tend to return more than bonds. It also explains why long-term
bonds pay more than short-term bonds. The longer investors have to wait
for their final payoff on the bond, the greater the chance that
something will intervene to erode the investment's value.
The biggest single determiner of stock prices is
earnings.
Over the short term, stock prices fluctuate based on everything from
interest rates to investor sentiment to the weather. But over the long
term, what matters is earnings. If a stock's earnings rise
substantially over the course of 10 years, so will its share price. A
bad year for bonds looks like a day at the beach for stocks.
In 1994, the worst year for bonds in recent history, intermediate term
Treasury securities fell just 1.8 percent, and the following year they
bounced back 14.4 percent. By comparison, in the 1973-74 crash, the Dow
Jones industrial average fell 44 percent. It didn't return to its old
highs for more than three years or push significantly above the old
highs for more than 10 years!
Rising interest rates are not good for bonds.
When interest rates go up, bond prices fall. Why? Because bond buyers
won't pay as much for an existing bond with a fixed interest rate of 6
percent as they will for a new one that is paying, say, 7 percent or
more. Conversely, when interest rates fall, bond prices go up in
lockstep fashion. And the effect is strongest on bonds with the longest
term, or time to maturity. That is, long-term bonds get hit harder than
short-term bonds when rates climb, and gain the most when rates fall.
Inflation: The biggest threat to your
long-term investments.
While a stock market crash can knock the stuffing out of your stock
investments, so far-knock wood, the market has always bounced back and
gone on to new heights. However, inflation, which has historically
stripped 3.2 percent a year off the value of your money, rarely gives
back what it takes away. That's why it's important to put your
retirement investments where they'll earn the highest long-term
returns.
U.S. Treasury bonds: are as close to a
save investment as an investor can get.
The conventional wisdom is that the U.S. Government is unlikely ever to
default on its bonds, partly because the American economy has
historically been fairly strong and partly because the government can
always print more money to pay them off if need be. As a result, the
interest rate of Treasuries is considered a risk-free rate, and the
yield of every other kind of fixed-income investment is higher in
proportion to how much more risky that investment is perceived to be.
A
word of caution, even the U.S. Government is not powerful enough to
overrule the laws of economics. If the government ever did get
desperate enough to print lots of extra cash to pay off bonds, that
would generate soaring inflation and make the bonds, paid-off though
they may be, worth less than investors expected.
Always diversified your portfolio: It’s
less risky than a portfolio that is concentrated in one or a few
investments.
Diversifying that is, spreading your money among a number of different
types of investment vehicles. Lessens your risk because even if some of
your holdings go down, others go up, or vice versa. On the flip side, a
diversified portfolio is unlikely to outperform the market by a big
margin for exactly the same reason.
Index mutual funds often outperform actively
managed funds.
In an index fund, the manager sets up his portfolio to mirror a market
index, such as Standard & Poor's 500-stock index. Rather than
actively picking which stocks to purchase. And by the strange math of
mutual funds, average is often enough to beat the majority of
competitors among actively managed funds. One reason: Few actively
managed funds can consistently outperform the market by enough to cover
the cost of their generally higher trading fees.
NOTE: You will find
our book recommendations at the bottom of the page.
The biggest bull market in it’s history.
Between 1990 and 1999 the Dow
alone more than quadrupled.
While
stocks have not always performed so extraordinarily, compounding at a
dazzling 18.1 percent annual rate for that time period. They have
usually been the best performing asset class over time. Since 1926,
stocks have returned an annual average of 10.7 percent. Over the same
period, government bonds returned 5.3 percent, and "cash," the term
used to describe Treasury bills and other short-term investments, has
returned just 3.8 percent. If you're investing for the long-term, which
just about everybody does now that 401(k) plans are the rage, then
stocks are the place to be.
But
if you're looking to invest money you may need in a year or two, the
stock market can be downright dangerous. Look no further than the Dow's
554-point drop (7.2 percent loss) on October 28, 1997, and the
508-point drop on Oct. 19, 1987, a harrowing (22.6 percent loss) to see
what a difference a day can make. Then those bloody bear markets, like
1973-74, when the Dow fell 44 percent, and March 2000-September 2001,
when the NASDAQ Composite fell 72 percent, to remind you that the
market is not always the best place to invest in!
Bonds of course are another story. And while they won't give your
portfolio the kind of kick that stocks will, nor are they likely to
give it the same kind of thrashing. In 1994, the worst single year for
bonds in recent history, intermediate-term government bonds (Treasury
securities with maturates of 7-10 years) fell just 1.8 percent. And in
a good year, like the one that immediately followed, they bounced back
an impressive 14.4 percent.
Stock market movers
Do
not worry about the short-term swings, if your in for the long haul.
While
the stock market often seems to behave like a manic-depressive who's
been off his medication, in fact it's quite rational, most of the time.
Information about the economy and the prospects of specific companies
comes in, and the market reacts. Sometimes those reactions are extreme,
but they usually sift down to a handful of causes.
So
why does the market seem so erratic? Because life in general is
unpredictable. A war here, a hurricane there. These things can occur
without much warning, having effects on the economy that no one could
anticipate.
What's really hard to explain is why the market can ignore obvious
problems for a long time and then suddenly overreact. Here's the
reason: Investors have a hard time gauging the magnitude of problems.
Take the dramatic reaction to the Asian crisis in 1997 and the tumult
that followed in 1998. Though the experts knew that Asian banks had
been overextended for years, few realized how serious the problem was
until Thailand devalued its currency in the summer of 1997. Suddenly
investors reassessed, and the market took a 544-point, one-day dive,
only to recover most of that ground the very next day. Likewise, when
the Russian government, which everyone knew was teetering, defaulted on
its debt a year later, the market was thrown into another tailspin.
But if you ignore the occasional surprises that coil the market and
focus instead on its long-term behavior, you'll find three factors are
key:
Earnings growth
Over periods of five years or more, stock prices closely track
corporate profit growth. And the longer the stretch of time, the more
important earnings trends are. Indeed, since World War II, an estimated
90 percent of the stock market's gain has come from profit growth. As
profits add up over time, the scale tips and prices rise, regardless of
how investors have voted in any given day, month or year.
Interest rates
In the short run, changes in interest rates can be more important than
earnings. When rates go up, all other things being equal, investors
tend to pull money out of stocks and put it into bonds and other
fixed-income investments because the returns there are so attractive.
That brings stock prices down, and sends bond prices higher. On the
other hand, when interest rates come down again, once more with other
things equal, then investors tend to shift money into stocks, reversing
the previous trend.
Money
flows
Demographics, tax laws and savings patterns all affect the rate at
which money flows into stocks (these are a few of the "other things").
That can raise or depress stock prices. The best example in the past
decade has been the growth of 401(k) accounts. As baby boomers took
advantage of these and other tax-deferred retirement havens to shore up
their inadequate savings, the flow of money into mutual funds, where
most 401(k) assets reside, gave stocks an extra boost.
Playing the bond game
Bonds
are more predictable than stocks, but only barely.
Bonds
at their best are basically boring, which is probably a virtue. You
loan money to a corporation or government agency, like the Treasury
Department, and the borrower agrees to pay it back at a fixed rate of
interest (sometimes known as the coupon) over a fixed period of time
(the term or maturity). If they don't pay it back, which happens
occasionally, that's when things get exciting. But unless you get your
kicks poring through hundreds of pages of legalese, you probably don't
want to be around when that happens.
Generally, the longer the maturity of a bond, the higher the coupon.
For example, the spread between five-year Treasury notes and 30-year
bonds is often a full percentage point or two. Why? Because the longer
the term of the bond, the longer its owner will be left earning a low
rate if interest rates in general rise. And the greater the risk, the
greater the reward.
The interest rate a bond pays is directly related to the riskiness of
the bond. Treasury bonds, for example, are as close to a sure thing as
you can get in the world of bonds, since Uncle Sam can always print
more money to pay them off. (Even the feds aren't immune to the laws of
economics, though; if the government ever did print lots of extra cash
to pay off its bonds, that would cause inflation to soar and make the
bonds worth less.)
At the other end of the spectrum, however, are low-grade corporate
bonds, known as high-yield or junk bonds, which have coupons that are
several percentage points higher because of the risk that the
corporations that issue them might stumble. In between are several
varieties of mortgage-backed security, such as Fannie Maes, Ginnie Maes
and so forth. As well as investment-grade corporate bonds from large,
blue-chip companies. The grades come from outfits like Standard &
Poor's and Moody's, which rate the riskiness of most non-Treasury
bonds.
One additional quirk to bonds: If they are issued by a state, county or
city agency, their interest earnings are usually free from federal
taxes. These municipal or muni bonds pay less than taxable bonds in
nominal terms. But for investors in a high federal tax bracket (say,
the 31 percent bracket or higher), they often return more after taxes
than to comparable taxable bonds. If you happen to live in the
municipality or state that issues the bond, it may also be exempt from
state and/or local tax, which is an added benefit. Similarly, bonds
issued by the federal government are exempt from state and local taxes,
but the tax rates are lower and the benefit is too.
While bond prices tend to fluctuate less than stock prices, they aren't
risk-free. If interest rates rise, bond prices will fall. Why? As new
bonds paying higher rates become available on the market, the price of
older bonds falls proportionately so that the interest they pay is the
same as that of a comparable new bond.
Here's a simplified example of how it works: Let's say that you paid
$1,000 for a 30-year bond that yielded 7 percent interest, or $70 a
year. A year later, the rate for a comparable new bond falls to 5
percent, which means it yields just $50 a year. Your old bond is now
going to be worth more, because investors are willing to pay more to
get a $70-a-year income stream than they will to get $50 a year. How
much more? Since the interest rate of your bond is now 40 percent
higher than normal, its new price will be about $1,400, or 40 percent
more than you paid for it. And its yield? Exactly 5 percent, since $70
a year is 5 percent of $1,400. (Note: the equation is not quite that
simple, since your bond now has only 29 years left to maturity and will
be matched to other 29-year bonds, not new 30-year issues.) Conversely,
if rates jump from 7 percent to 9 percent, meaning new bonds are paying
$90 a year interest, the value of your bond will fall to about $778,
because your bond's $70 annual interest is 9 percent of $778.
Eventually, of course, when the bond matures, it will be worth $1,000
again. However, its value will move up and down in the meantime,
depending on what interest rates do. And the longer the time to
maturity of a bond, the more dramatically its price moves in response
to rate changes. That is, long-term bonds get hit harder than
short-term bonds when rates climb, and gain the most in value when
rates fall.
As a result, bond buyers tend to
be divide into two classes: Investors (or speculators), who
hope to make money thanks to a decline in interest rates, send bond
prices higher. And savers, who buy bonds and hold them to maturity as a
way to earn a guaranteed rate of return.
Fundamentals of mutual funds
Mutual
funds offer a simple way to diversify your portfolio.
If
you don’t have enough money to create a diversified stock or bond
portfolio on your own, you need the advantage of being able to pool
your money together with that of a lot of other investors. Then, a
professional money manager can invest that pool of money across enough
investments to reduce the risk of being wiped out by any single bad
bet.
That's how a mutual fund operates.
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The fund is essentially a corporation whose sole business is
to collect and invest money. You join the pool by buying
shares in the fund. Your money is then invested by a team of
professionals, who research stocks, bonds or other assets
and then place the money as wisely as they can. The managers
charge an annual fee, generally 0.5 percent to 2.5 percent
of assets, plus other expenses. |
That puts a drag on your total return, of course. But in
exchange, you get professional direction and instant
diversification. Factors that have helped propel the number of funds
to something over 10,000.
There are several flavors of mutual funds. Funds that impose a sales
charge. Taking a cut of any new money that comes into the fund, or a
cut of withdrawals, are called load funds. Those that do not
have sales charges are called no-load funds. Funds can also be
divided into open- and closed-end funds. Open-end funds will
sell shares to anyone who cares to buy; essentially, they are willing
to invest any new money that the public wishes to pump into the fund.
Their share price is determined by the value of the underlying
investments, and is calculated anew each evening after the close of the
U.S. markets. Closed-end funds, on the other hand, issue a
limited number of shares that then trade on the stock exchange like
stocks.
Funds
also can be broken down by their investment strategy.
Here's a quick overview of some
of the principal types
Index funds
When people talk about the long-term performance of stocks, they're
usually talking about the Dow Jones industrial average, the Standard
and Poor's 500-stock index, or some other broad market index. Funds
based on the S&P 500, by definition, will never outperform the
market. But because they are so cheap to run, you'll typically pay just
$2 a year in expenses for every $1,000 invested compared to $14 a year
for the average stock fund, they outperform the vast majority of
actively managed funds over time.
Growth funds
Invest in the stock of companies whose profits are growing at a rapid
pace. Such stocks typically rise more quickly than the overall market,
and fall faster if they don't live up to investors' expectations.
Value funds
Value-oriented fund managers buy companies that appear to be cheap,
relative to their earnings. In many cases, these are mature companies
that send some of their earnings back to their shareholders in the form
of dividends. Funds that specifically target such income-producing
investments are often called equity-income or growth-and-income
funds.
Others
Since there is a lot of overlap in the stocks held in each of these
fund types, you'll need to branch out to get any kind of meaningful
diversification. That's where the more aggressive funds, like aggressive
growth funds, capital appreciation funds, small-cap
funds, mid-cap funds and emerging growth funds,
among others, fit in. Typically, these funds, which tend to be more
volatile than large-cap funds, pursue one or more of the following
strategies:
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Invest in smaller companies,
where earnings aren't as reliable as at bigger firms but where the
potential for gains (and losses) is higher.
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Invest in pricey, high-growth
stocks.
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Invest in stocks that are in
"hot" industries, such as technology or health-care.
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Invest in just a handful of
companies.
International
Funds that invest outside the U.S. come in three basic flavors. The
first, international funds, typically buy stocks in larger
companies from relatively stable regions like Europe and the Pacific
Rim. Global funds do likewise, but they can also invest heavily
in the U.S. And emerging market funds invest in riskier
regions, like Latin America, Eastern Europe and Asia.
Bond funds
Finally, these tend to be segmented across the risk spectrum, with
those that specialize in Treasury securities being the safest (and the
lowest-yielding) and those that specialize in junk bonds being the
riskiest but offering the highest yield. They also divide according to
whether the bonds they hold are taxable or tax-free. One thing to
remember: When the market is headed down, funds that invest in
Treasuries tend to rise in value and investors flock to the safest
investments around. Likewise, when the market is going up, junk bonds
funds tend to do the best, as the better things are for business, the
more likely that even the riskiest bond bets will pay off.
The inflation factor
Think
a market crash is the biggest danger to investors? Think again.
Let's
say the market takes a 30 percent dive over the next year. Every time
you check your stocks or stock mutual funds, you're going to feel the
pain. Likewise, if interest rates rise, your bonds won't let you forget
it. But nowhere on your bank or brokerage statement, or anywhere else,
for that matter, are you likely to get a report on what inflation is
doing to the real value of your holdings. So if your money is stowed in
a "safe" investment, like a low-yielding savings or money market
account, you'll never see how inflation is gobbling up virtually all of
your return. Here are some things to keep in mind:
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At an average annual growth rate
of 11.4 percent a year, stocks will double your money about every six
years. Factor in inflation, which has historically run at about 3.1
percent annually, and it will take closer to ten years to double your
actual buying power.
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Likewise, bonds, which have
historically grown at 5.1 percent annually, will double your money
every 13 1/2 years. After inflation, however, it will take 35 years.
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And talk about risk, if your
money is in cash (which is how money market accounts are known in the
investment world), you'll have to wait 19 years for the nominal value
of your account to double, assuming the cash earns the historical 3.7
percent annual return. But even your grandchildren won't see the real
value of your money double. The reason? After inflation, it will take
139 years.
Whenever your adding up your
gains or losses for a given period of time, you have to add in the
effects of inflation to understand how much further ahead or behind you
really are.
Books on Investing!
Investing:
Learning the Basics
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