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Investing 1.01: The Basics
The following is intended as a brief introduction to the basics of investing. There are many excellent books on the subject and we suggest you visit your local library or bookstore to build your understanding of investing. Here is the most fundamental thing you should know: investors get paid for putting their money at risk. The safest investments don't pay investors very well. The more risk an investor takes, the greater is the potential for both increased returns and loss of capital.
Savings accounts are offered by banks, savings and loan associations (S&L's) and credit unions. The interest rates paid to investors on savings accounts are typically very low because the funds are safe and can be withdrawn at any time without penalty. These accounts are not really a good deal for investors because the purchasing power of the dollar has historically declined every year (this is known as inflation), by about the same amount as the interest rate earned on money in savings accounts. So investors are well advised not to keep more money in savings accounts than might be needed in a short-term emergency. Most savings accounts are guaranteed to $100,000 by the Federal Deposit Insurance Corporation (FDIC), an agency of the Federal government. This means that if the bank or S&L should go out of business, investors are protected up to $100,000.
Many banks and S&L's offer slightly higher interest rates to investors who are willing to commit to leaving their funds on deposit for some specific period of time. These accounts go by many different names such as "time-deposits" or certificates of deposit also known as "CD's." Banks and S&L's are willing to pay somewhat higher interest on these accounts because they will have the money for a specific time, and they impose a significant penalty should the investor withdraw funds early.
A mutual fund is a company that makes investments on behalf of those who buy the fund's shares. A share is a certificate of ownership in a company or fund. A money-market fund is a mutual fund that invests in CD's and other short-term investments offered by banks, S&L's, governments, and corporations. Money-market funds pay interest rates that can change daily and are about the same as CD's but investors can redeem their shares at any time without penalty. This is daily liquidity. Some of the investments a money-market fund makes may be governement guaranteed, but others may not be, and the shares of the fund itself carry no guarantee of safety. Nonetheless, money-market funds have become widely accepted as a safe place to "park" funds awaiting investment, or funds that may be needed for some purpose in the near future.
Mutual funds may invest in one kind or in many different kinds of investments. The most popular mutual funds invest in stocks of companies. Stocks are also sometimes called equities. Companies issue stock to raise money to grow their business. Once a company's shares have been sold in an initial public offering (IPO) to raise capital, they are bought and sold on a stock exchange or electronically over-the-counter by investors seeking to profit from an increase in the price of the shares. The shares of the biggest well-known blue-chip companies are usually assumed to be safer than those of unseasoned small companies, but many small company stocks, while risker, have greater potential to rise dramatically in price.
Many mutual funds invest in fixed-income investments such as bonds issued by governments and corporations. A bond is a fixed interest security under which the issuer contracts to borrow money, agrees to repay the bondholder on a stated date in the future, and agrees to make interest payments either semi-annually or annually. Bonds mature when the principal is due to be repaid to the bondholder. Bonds that mature in less than five years are described as short term, between six and 15 years as medium term, and longer than 15 years as long term. The risk of owning a bond is that the issuer will default by missing interest payments or by being unable to repay the principal at maturity. The higher the perceived credit-worthiness of a bond issuer, the less interest the issuer must offer investors in order to borrow money. The safest fixed-income securities are generally accepted to be those of the U.S. government.
There are several reasons a small investor should choose to buy mutual funds rather than individual stocks and bonds. With a limited amount of money to invest, a small investor could purchase only a few individual securities, but the same amount of money can buy participation in mutual fund portfolios that include hundreds of stocks and/or bonds. This diversification affords the small investor a measure of safety he can't achieve on his own. If a bond or stock in the fund's portfolio should become worthless, because those securities make up a very small part of the overall portfolio, the mutual fund investor is little affected. On the other hand, if the investor held those securities individually as part of a small portfolio, the impact of those events could result in significant loss. So, generally speaking, there's safety in diversification. The more, the better.
An index is an average value of many securities that makes it easy to compare price fluctuations from day to day in a specific stock or bond market. Changes in index averages expressed in percentage terms make it easy to compare the change in one market to the change in another. The best-known and oldest index is the Dow Jones Industrial Average of 30 large, well-known blue-chip companies whose shares trade on the New York Stock Exchange. Until recently, it was not possible to invest in an average, but several mutual funds have created stock and bond portfolios that duplicate market indexes. When investors buy these funds, they are in essence buying market averages. Mutual funds that invest in market index portfolios are said to be passively managed. Mutual funds that employ managers to pick and choose securities in the effort to do better than the averages are said to be actively managed.
That's a brief overview that should give you the general background you need to understand much of the information contained on our Web site.
Source: http://www.fundadvice.com
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