If you already know about mutual funds, stocks, and bonds, great. But if you think CDs just play music and ETFs are a government agency, please do not skip this article. All five of these popular investment vehicles deserve a place in the average investor’s portfolio.
Table of Contents
Common stock provides investors with an ownership interest in a company. Shares represent and are often referred to as, the equity of a company. Investors can buy and sell shares on stock exchanges – entities that exist primarily to provide a marketplace for the shares. Stocks are traded constantly during business hours -from 9:30 a.m. to 4 p.m.
Eastern Time most weekdays – with prices changing from one second to the next. In the long term, stock prices tend to rise when companies increase sales and profits. In the short term, however, stocks can fluctuate based on factors such as general economic trends, news from competing companies, government actions, and a variety of other factors.
At the end of August 2013, Microsoft shares were selling for $33.40, with about 8.44 billion shares outstanding. If you multiply the number of shares by the price per share, you get $282 billion – the market capitalization of the stock, often abbreviated to market cap.
An investor who buys 50 Microsoft shares for about $1,670 would own a tiny fraction of one of the largest companies in the world. When more people want to buy a particular stock than sell it, prices rise. As you can read in any economics textbook, prices often rise when products become scarce and demand for them increases.
The stock market will not run out of Microsoft stock if it becomes popular for some reason, but when the number of buyers exceeds the number of sellers, the imbalance creates scarcity and drives up the price. The same principle applies on the other side – an oversupply of stocks and a shortage of buyers cause prices to fall.
The performance of stock prices shows how important the market is – and how important you are as an investor – because markets determine the value of stocks. The World Bank estimated the value of all U.S. company stocks at the end of 2012 at $18.7 trillion – more than five times the value of companies in the next largest markets, China and Japan.
With more than 5,000 U.S. companies whose shares trade – not to mention hundreds of foreign companies whose shares trade in this country – stock investors can get into nearly every facet of the economy.
Not all stocks behave the same way, which means they can play different roles in your portfolio. Here are some classifications that every stock investor should know:
Investors tend to set values for stocks relative to their earnings (or sales, or cash flows, etc). If a stock that earned $100 million over the last year trades at 10 times earnings, its market cap is 10 times $100 million, or $1 billion. In most cases, investors focus on per-share numbers.
For example, if the company earning $100 million has 100 million shares outstanding, it earns $1 per share. A price/earnings ratio of 10 prices the stock at $10 per share.
Many academic studies have shown that stocks with low price/earnings ratios relative to the rest of the market tend to outperform. Value-oriented investors gravitate toward value stocks—companies that trade at a discount relative to their earnings or some other operating statistic.
Stocks with above-market growth in sales or profits tend to outperform their peers. These stocks tend to cost more (higher price/earnings ratios, etc.) than other stocks, as many investors will pay a premium for growth.
At first blush, the idea that both high-growth stocks and value stocks can outperform sounds like a contradiction. But within such a massive system as the stock market, investors have found more than one way to make a profit. You may hear pundits touting the benefits of growth overvalue, or vice versa. While everyone is entitled to an opinion, this choice mostly comes down to personal preference.
Over the very long haul, value stocks tend to outperform growth stocks. Growth stocks have outperformed value stocks over the last decade, yet value stocks have managed higher returns in 7 of the last 10 years. Whether you invest in value stocks, growth stocks, or both, the beauty is that you can make money, regardless of personal preference, if you choose wisely.
Large-capitalization (large-cap) stocks
The name tells the story. Since investors tend to set values for stocks relative to earnings, companies with massive profits can sport enormous market capitalizations. Stocks of large companies tend to be less volatile, and investors often consider them safer than smaller stocks.
Stocks of smaller companies have historically delivered higher returns than stocks of large companies—again, at the cost of higher risk. What constitutes a small-cap stock? It depends on who you ask, as there is no market consensus on where lies the cutoff point between small and large. A commonly cited dividing line is $3 billion, with anything smaller classified as a small-cap.
Because of their different risk-return profiles, investors should treat large-cap and small-cap stocks as separate asset classes. In general, you should own a blend of large-cap and small-cap stocks in the equity portion of your portfolio.
Sure, you could stuff the portfolio with only large caps or stick to just small caps, but you might end up with a lower rate of return (the large-cap option) or higher risk (the small-cap option) than you desire.
Because economic trends vary from country to country, at times U.S. stocks will thrive while the rest of the world limps along, and vice versa. As a rule, investors consider U.S. stocks safer than foreign stocks. This belief stems, at least in part, from the size and liquidity of the stock market and that U.S. accounting rules require greater disclosure of financial data than most other countries.
Many investors purchase foreign stocks to diversify their portfolios. You can reduce portfolio volatility and thus reduce risk by blending assets that don’t move in the same direction all the time.
In addition, you can sometimes boost returns by purchasing stocks of companies in emerging markets like China and India, where the economies grow far faster than in the United States. Of course, those emerging-market stocks come with—you guessed it—more risk.
Pros of Stocks
- Variety. With the stocks of more than 5,000 companies trading on U.S. exchanges, investors can buy into almost any business they choose.
- Flexibility. Stocks trade all day long, which allows investors to buy and sell at specific levels and attempt to play short-term price moves. (The risky strategy of timing intraday fluctuations is called day trading. Even professionals make plenty of mistakes day trading, and beginners shouldn’t mess with it.)
- High returns. Stocks tend to outperform bonds and other income-oriented investments.
Cons of Stocks
- Volatility. Stock prices fluctuate more than bond prices. However, investors must accept that risk if they wish to tap into stocks’ potentially excellent returns.
- Complex analysis. The stock analysis involves looking at a number of statistics, gauging trends, and estimating future growth rates. It takes time and effort, which might explain, at least in part, the popularity of mutual funds.
- Vigilance required. Because stock prices can change so quickly, and because they often respond sharply to news about the company or the market, investors must pay close attention to them.
Learn more about stock market basics.
Just as stock investors buy equity in a company, bond investors buy debt. Companies and governments issue bonds, collecting cash—the bond’s face value or par value—upfront from investors. The issuers agree to make interest payments, usually semiannually, for a set time before paying the money back.
In most cases, the payment remains the same for the life of the bond. For this reason, bonds and other securities that make regular payments are classified as fixed-income. In later chapters, during the discussion about how to craft a portfolio, you’ll read about seeking a balance between equities and fixed-income (or stocks and bonds).
Estimates vary regarding the size of the U.S. bond market—which contains debt issued by corporations, the federal government, and municipalities—but most peg the bond market at roughly twice the size of the stock market.
Bonds come in many varieties. Here are a few of the most common:
- Corporate bonds. Debt issued by corporations.
- Treasury bonds. Debt issued by the U.S. Treasury and backed by the full faith and credit of the federal government. Investors both in the United States and overseas generally consider Treasury bonds free of default risk.
- Agency bonds. Debt is issued by agencies connected to the federal government. While such bonds don’t technically have the backing of the U.S. Treasury, most investors assume they have an extremely low risk of default.
- Municipal bonds. Debt issued by states, municipalities, or agencies connected to states or municipalities, such as water systems. In most cases, the interest payments from these bonds are not subject to federal income taxes.
- High-yield bonds. Also known as junk bonds, any securities with a speculative-grade rating fall into this group. Remember the concept: “High risk, high return. Low risk, low return.”
- Convertible bonds. Companies can issue bonds that, under certain conditions, convert into stock.
- Variable-rate bonds. In some cases, bond issuers make interest payments that fluctuate based on changes in a benchmark interest rate.
When you buy a bond, you make a bet on the creditworthiness of the issuer. If a bond issuer can no longer cover the payments, it may default on the bond, leaving investors in the lurch. The risk of default is known as credit risk.
Credit-rating agencies—Standard & Poor’s, Moody’s, and Fitch Ratings—assess the creditworthiness of companies and governments that issue bonds and assign them ratings. Those ratings reflect the agencies’ opinions on the likelihood that the issuer will default. For example, S&P’s ratings range from AAA to D, with everything BBB- and higher classified as investment-grade. The agency considers every bond with a rating of BB+ or lower speculative grade.
Standard & Poor’s issues AAA ratings only for the financially strongest companies. Fewer than 15 countries and only four companies earn AAA ratings from S&P.
Many stocks pay dividends, but over the long haul stock investors generate most of their return from price appreciation—the change in the price of the stock. Bonds don’t work that way. Their prices will change, but most investors choose bonds because of their interest payments.
Because issuers pay back the bonds at the end of their term, also known as maturity, bond prices tend to revert to the face value of the bond as the maturity date nears. Assuming an investor purchases a bond, collects the interest payments, and then recoups the face value of the bond at maturity, the changes to a bond’s price along the way don’t mean anything.
Unlike stock prices, which tend to fluctuate based on economic and company news, bonds respond mostly to interest rates or changes in a company’s perceived credit risk. If a company reports a strong quarter with higher-than-expected profits, the stock price might rise while the bonds remain steady.
But if the company announces it has borrowed a lot of money and credit analysts begin to doubt its ability to satisfy its obligations, the company’s bonds could lose value.
Bond prices react to changes in interest rates because their fixed payments look more attractive when interest rates fall and less attractive when rates rise.
For example, suppose Acme Widget issues $1 billion in 10-year bonds at 5% during a period when the 10-year Treasury yields 3.5%. Since investors can collect a 3.5% yield without risking default, Acme’s 1.5% higher interest rate serves as compensation to investors for absorbing the credit risk.
If Treasury yields rise to 4.5%, the appeal of Acme’s bonds declines; investors demand more than 0.5% for taking on the credit risk of the corporate bond. As a result, Acme’s bonds likely dip in price, possibly to a point where they yield roughly 1.5% more than Treasury bonds. The reverse would happen if Treasury yields declined—Acme could lower its rates accordingly and still be seen as a risk worth taking.
Long-term bonds tend to react to changes in interest rates more strongly than short-term bonds. Remember, bond prices tend to revert to par value as they near maturity. A bond that matures in three months won’t see its value change much even if interest rates migrate, because in three months the issuer will redeem it for its face value.
But a bond that matures in 20 years—and has 40 semiannual coupon payments to make before maturity—will react more violently to changes in interest rates, especially as investors reprice the bond to take into account its yield relative to the market.
Pros of Bonds
- Steady income. Bonds appeal to investors who seek an income stream from their investments. While many stocks pay dividends, few deliver the yield investors can receive from bonds.
- Safety. While bond prices do fluctuate, they don’t gyrate with the same regularity as stocks. In general, bonds are considered safer than stocks.
- Diversification. Bonds offer substantial diversification benefits when paired with stocks in a portfolio. Because bonds tend to take their cues from interest rates rather than the economy or the stock market, they often move in a different direction than stocks.
Cons of Bonds
- Low returns. Over long periods of time, bonds tend to underperform stocks.
- Trading difficulty. While the bond market is massive, it lacks the transparency of the stock market. Investors can’t just check on the price of their bonds at the Yahoo! Finance website and make instantaneous trades. Discount brokers don’t buy and sell bonds at all, and investors seeking to purchase a bond generally must either go through more expensive brokers or contact the bank that makes the market for that bond.
- Complex analysis. Bond analysis hinges on assessing an issuer’s creditworthiness, a task few people have the training to do well. Most individual investors get their bond exposure through mutual funds, allowing professional credit analysts to do the legwork.
3. Mutual Funds
Mutual funds pool the assets of multiple investors, providing buying power that exceeds that of all but the wealthiest individuals.
Suppose you have $10,000 to invest. If you try to spread the money around into 50 stocks, commission costs alone might cripple you. But invest that same $10,000 in a mutual fund that owns 50 stocks, and you’ve purchased a tiny piece of each of those companies without the expense or hassle of acquiring them individually.
Professional money managers decide when the fund buys and sells, and all of the investors win or lose together. If a mutual fund returns 10% in a year, every investor who owned the fund at the start of that year will see the same 10% return on his investment.
At the end of 2012, investors worldwide had $26.8 trillion invested in mutual funds, with $13.0 trillion of those funds in the hands of U.S. money managers, according to the Investment Company Institute (ICI). Of that $13 trillion invested in U.S. mutual funds, 45% was in stock funds and 26% was in bond funds.
Stock and bond mutual funds come in two flavors:
- Passively managed funds. Often called index funds, passively managed funds attempt to match the performance of an index. Indexes—such as the well-known S&P 500 Index of large-company stocks—are baskets of securities constructed to approximate the investment returns of a slice of the financial markets. Most indexes don’t change their component stocks often.
- Actively managed funds. Unlike passively managed funds, actively managed funds buy and sell securities in an effort to exceed the return of their benchmark—usually an index or group of indexes.
It’s tough to overstate the importance of mutual funds as an investment vehicle. In the United States alone, more than 92 million people own mutual funds, often through retirement plans. Additionally, most 401(k) retirement plans invest workers’ assets in mutual funds, so if you participate in a company-sponsored retirement plan, you probably already own funds.
Pros of Mutual Funds
- Professional management. Most individuals don’t know much about analyzing investments because of a lack of interest, a lack of training, or both. When you purchase a mutual fund, you’re hiring an expert to manage your money.
- Choice. With nearly 9,000 traditional mutual funds on the market, just about any investor can find a fund to address her investment goals.
- Diversification. Portfolios containing a variety of stocks or bonds tend to be less volatile than an individual stock or bond. Mutual-fund managers use their buying power to purchase multiple securities, which in most cases provide diversification.
Cons of Mutual Funds
- Costs. Every mutual fund charges fees. If a broker tells you his fund doesn’t charge a fee, hang up the phone immediately because he’s lying. Remember that expert you hired when you purchased the mutual fund? He doesn’t work for free. In addition, some funds charge fees called loads, collecting extra money to compensate the salesperson or investment company.
- Complacency. Mutual-fund investors often assume that since they have a professional managing a diversified basket of stocks, they can sit back and relax. Don’t make that mistake.
- Poor returns. Last year, only about a third of actively managed mutual funds outperformed their benchmarks. Plenty of academic studies suggests this trend isn’t new and that fund fee deserve much of the blame. While the chronic underperformance shouldn’t scare you away from mutual funds, it should hammer home the importance of choosing your funds wisely.
4. Exchange-Traded Funds
According to the ICI, at the end of 2012 investors had about $1.34 trillion parked in exchange-traded funds, often called ETFs. ETF assets equate to barely more than 10% of the value of traditional mutual funds, but these types of investments continue to grow in popularity. ETF assets have more than tripled since 2006, while the number of ETFs on the market rose to 1,239 in 2012, up from 359 at the end of 2006.
ETFs operate much like mutual funds in that they commingle the resources of many investors to purchase a basket of stocks, bonds, or both. However, ETFs differ from traditional mutual funds in a few important ways:
- Trading on exchanges. As the name suggests, these funds trade on the same exchanges like stocks. ETF prices change from second to second, just like stock prices.
- Mostly index funds. While a few ETF managers actively manage their funds in an attempt to top benchmarks, the bulk of them tracks indexes.
- Greater transparency. Unlike traditional mutual funds—which the SEC requires to disclose their holdings quarterly—ETFs must disclose daily. Of course, since indexes don’t change their holdings often, most ETFs don’t either.
Pros of Exchange-Traded Funds
- Convenient trading. Unlike the way mutual funds reprice at the end of the day and trade only at that price during the following day, ETF prices rise and fall intraday like stocks.
- Hedging. Investors can buy and sell options on ETFs, just as they can on most stocks. Beginning investors should probably avoid options, but the freedom to buy and sell options that ETFs allow has contributed to their popularity.
- Trading costs. Many brokers charge more to trade mutual funds than stocks. When investors buy or sell exchange-traded mutual funds, they pay the same commissions charged for stock trades.
Cons of Exchange-Traded Funds
- Fund expenses. Remember that every mutual fund charges fees. However, because ETFs trade like stocks, investors frequently treat them like stocks and forget about those fees. And ETFs rarely draw much attention to the fees they collect.
- Selection. Most ETFs track indexes, meaning they’re passively managed. While some ETFs use active managers, investors seeking active management will find few options among ETFs.
- Perceived complexity. While ETFs look like mutual funds in most respects, many investors shy away from them. A 2010 study by Mintel Comperemedia, a consulting firm, revealed that nearly 60% of investors chose not to purchase ETFs because they didn’t understand how they worked.
5. Certificates of Deposit
Traditional certificates of deposit (CDs) act as enhanced savings accounts. Investors give money to a bank, which then agrees to pay a fixed interest rate—generally for a period of five years or less.
While investors can withdraw cash from a savings account at any time, CDs require them to keep the funds at the bank until the maturity date. Because of this limitation, they tend to pay more interest than typical savings accounts.
CDs can’t replace any of the other investments mentioned in this chapter. They simply provide you with a means to generate more interest on your cash holdings than you’d get from a bank savings account or a brokerage account.
Pros of Certificates of Deposit
- Safety. Like other bank accounts, CDs are insured for up to $250,000 by the Federal Deposit Insurance Corporation (FDIC) in the event the bank fails. Brokerage accounts do not receive FDIC coverage, though the Securities Investor Protection Corporation (SIPC) does provide similar, if less comprehensive, protection.
- No fluctuation. Because your funds remain in cash, they won’t decline in value.
- Simplicity. If you understand savings accounts, you already know a lot about how CDs work.
Cons of Certificates of Deposit
- Low returns. While CDs generally offer more interest than bank savings accounts, they’ll lag behind all of the other investment classes discussed in this chapter over the long haul.
- No liquidity. CDs tie up your cash for a period of time. You can access the money if you need it, but you’ll pay an early withdrawal penalty or forfeit some of the interest.
- Separate accounts. Most investors purchase stocks, bonds, and mutual funds from institutions other than banks. If you keep your cash in a bank CD, you must keep it at the bank, which means you can’t redeploy it to purchase stocks or bonds until you transfer the money to a brokerage account.
6. Alternative Assets
For the most part, new investors should steer clear of anything other than the securities discussed in the preceding pages. Once you dip your toe into the market, you might hear about other investment options, including the following:
Nearly 100 commodities trade on markets worldwide. They include natural resources such as oil, metals, and lumber as well as agricultural goods such as corn, soybeans, and cattle. Investors can gain commodity exposure by purchasing stock in companies that deal in those commodities, or they can invest directly via a futures contract. Futures contracts allow investors to buy or sell commodities and other assets for predetermined prices in the future.
These derivatives allow stock or ETF investors to bet on whether shares will rise or fall without buying the shares themselves. Suppose a stock trades for $50 per share. If you believe the shares will rise, you might purchase a call option that gives you the right to purchase the shares at $55.
When the stock tops $55, you can either purchase the stock at a discount or sell the call option at a profit. Put options allow similar bets to the downside.
These entities pool investor money as mutual funds do, but they tend to pursue unusual or esoteric strategies. Hedge funds, lightly regulated and often secretive, frequently take on massive risks.
Investors purchase precious metals as a hedge against inflation, or as a backstop to protect wealth against a catastrophe, assuming that when disaster wracks the financial markets, metals such as gold will retain their value.
While investors can make money in collectibles, most lack the market expertise to profit consistently.
Real estate can diversify a portfolio of stocks, and it acts as a hedge against inflation, tending to rise in value during periods when inflation erodes the price of financial assets. However, if you already own a home, you probably have enough exposure to real estate.
Of course, plenty of investors appreciate the inflation protection and total-return potential of real estate and would like to buy-in. However, because pieces of real estate cost so much, few individuals have the funds to directly invest in the property beyond their personal residences.
You can’t buy shares of a piece of property on a public market. If you seek real estate exposure, consider real estate investment trusts (REITs). These companies buy, sell, and manage real estate, and their trust units trade on exchanges like stocks.
7. Weighing the Options
No matter how thoroughly you analyze the options for potential investment, no matter how much care you take in crunching the numbers, no matter how much time you put into studying the stock market and the forces that affect it, you’re going to make mistakes. A lot of them.
Don’t panic. Nobody gets it right all the time. In fact, excessive boasting about returns and success rates is among the best ways a beginner can spot the posers. Boasters become particularly aggressive during bull markets—when many stocks are hitting new highs.
Legendary investor Warren Buffett once wrote, “Only when the tide goes out do you discover who’s been swimming naked.” If you listen to the wrong voice, you’ll end up high, dry, and possibly embarrassed when the market corrects.
And don’t kid yourself—it always corrects. So before you buy into some pundit’s foolproof plan, do some of your own work. In the next few chapters, we’ll talk about what you can do to better your chances of picking winners—starting with valuation.