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Fundamentals
of Investing
Investing is simply
the process of acquiring assets that you hope will grow in value. Investments
can include owning a home, owning a business, owning real estate or having
money in savings accounts and CDs union. This article addresses investing
in stocks and bonds and various ways to own them.
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Fundamentals
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Related
articles
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Some basics
Owning a share of stock is owning a portion of the company. If you
buy 100 shares of General Electric stock, you actually own a portion
of GE. You can profit by owning shares when the company pays a dividend
or if the value of the shares increases while you own them. You
can also lose money if the value of the shares goes down before
you sell them.
When you own
a bond, you are lending money to the company or institution issuing
the bond. You profit when you receive interest payments and if the
value of the bond increases while you own it. You can lose money
if interest payments are not made, if the principal of the bond
is not repaid when it is due or if the value of the bond falls and
you sell the bond.
When you buy
mutual funds, you are buying shares in a company that in turn owns
stocks in other companies or owns bonds issued by other companies
or institutions. By investing in mutual funds, you get the professional
services of the mutual fund manager who decides where and when to
invest. You profit when the mutual fund distributes dividends (and
capital gains and interest) and if the value of your mutual fund
shares increases because of the increases in the underlying values
of the stocks and bonds it owns.
There are several
ways you can own investments. Most people start out with individual
accounts set up at brokerage firms or mutual fund companies, in
their IRAs and through their company retirement plan. If you invest
through an individual account, the income (dividends, interest and
capital gain distributions) from the account is taxable. If the
investments are within an IRA or a qualified plan, you will probably
not owe any tax on the returns until you take funds out.
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Financial
Market Indicators
The
Dow Jones Industrial Average
Investing
in Bonds
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Some common
sense rules
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| Understand
that there are risks with investing. When you make the decision
to invest, you are leaving the world of insured and guaranteed returns
found with savings accounts and CDs from a bank or credit union. The
values of stocks rise and fall depending on the success of the company
and the overall direction of the stock market. The value of bonds
can rise and fall depending on changes in interest rates and the financial
condition of the institution issuing the bonds. In return for taking
these risks, you hope to earn returns greater than what you would
have earned in a savings account or with a CD. |
Interest
Rate Risk |
| Be
realistic in your expectations. The year of 2008 was a bad one
for stocks with the S&P 500 index falling 38% while it rose over
26% in 2009 and 15% in 2010. Over the 10-year period ending in 2010,
the average total return for large company stocks (comparable to the
S&P 500 index) was 1.4%. The best year (2003) had a return of
over 28% and the worst year was 2008 when the return was a negative
37%. While the bull market of 1995 to 1999 produced average returns
of over 28% and the bear market of 2000 to 2002 (and 2008) saw the
market fall by over one third, returns during those years were well
outside the long-term average returns. |
Review
Your Investment Portfolio |
| Take
a long term approach. The returns from investing will vary greatly
from year to year. It is only by viewing your investments as long-term
can you hope to earn returns to justify the risks. For example, over
the past 20 years, the average returns for large company stocks was
8.43%, but during that period the best year was 1995 when these stocks
had total returns of over 37% and the worst year was 2008, when the
return was a negative 37%. Trying to guess the near term direction
of the market or an individual stock's price is foolish. |
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Use an asset
allocation strategy.
You should also consider how you divide your investments among the
different types of investments. How you divide your investments
among stocks, bonds and cash investments is called asset allocation.
It can serve as a logical starting point for your investment strategy.
Individuals should base their asset allocation on their time horizon
and risk tolerance. Here are some sample allocations based on age.
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Sample
Asset Allocations
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| Age |
Stocks |
Bonds |
Cash |
| 20's |
70% |
20% |
10% |
| 30's |
65% |
25% |
10% |
| 40's |
60% |
30% |
10% |
| 50's |
50% |
40% |
10% |
| 60's |
30% |
55% |
15% |
You will note
that the chart shows younger individuals having more stocks with
the percentage being reduced over time. This is only logical. While
you are younger, you can take a longer term approach - you have
more time to recover from declines in your investments and you have
more time to try to participate in the long term performance trends
of different types of investments.
The numbers
in this chart are only sample guidelines and you may want to vary
from them depending on your feelings about risk and other aspects
of your situation.
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Asset
Allocation |
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Diversify
your investments. If you are investing in stocks, you should
try to have investments in at least 3 or 4 stocks in at least 4
or 5 industries. A portfolio of 15 technology stocks is not diversified.
A portfolio of one stock in each of 15 different industries probably
also is not a good example of diversification. A portfolio of more
than 25 or 30 stocks can make it difficult to stay aware of what
each company is doing.
Spreading ownership
over different stocks in different industries reduces the risk that
the particular stock you choose in a good industry turns out to
be the wrong one. It also reduces the risk that you invested in
the wrong industry.
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Building
a Stock Portfolio
Portfolio
Diversification
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Diversify
your timing. Another way to reduce your risk is to make your
investments over a period of time. That way, you assure yourself
that you are not investing all your money at the top of a bull market
cycle. You may miss some appreciation if the market continually
goes up, but that seldom happens. Remember, no one can predict short-term
movements in the stock market with any degree of accuracy.
By spreading
your investments over 4 to 6 months, you will eliminate the risk
of making all your purchases when stocks are at their highest points.
There are two types of risk that this strategy reduces. First, it
reduces the risk of losing a significant part of your money quickly.
Many people dread making an investment and then seeing the value
go down dramatically. By spreading out your buying, this will not
happen.
The other risk
you can reduce by spreading out your investments is price volatility.
By taking this approach, the average price for the stocks you buy
will probably reflect the average market values for that period.
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Consider
the diversification benefits of mutual funds. When you buy mutual
fund shares, you are buying into a broad portfolio of stocks that
the portfolio manager has selected. In addition, most mutual funds
offer a system of purchasing called "dollar cost averaging."
With this, you buy an equal dollar amount of shares on a periodic
basis.
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Investing
in Mutual Funds
Dollar
Cost Averaging
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