I have worked in the financial services industry for close to 30 years and like many other industries, technology has made it easier and more affordable for everyone to access. Changes in regulations and the ability to quickly send out information and analyze it has made investing a much more level playing field for everyone. This environment has really made it a great time for everyone to start learning about investing. This article is to help define some terms so you understand some of the basics and we can build on that over time. Investing, even for beginners is not as complicated as many might think it is.
Bonds represent a loan made to a Government or a company. Governments and company’s get rated based on their credit worthiness just like you and me. These ratings are listed as letters instead of numbers so the highest credit rating is AAA and the lowest is CCC. The lower the credit rating the higher the interest payment a borrower will pay to the lender and the lower the credit rating there is a higher risk of not getting the money you lent repaid back to you. There are certainly more details I can go into and will in additional posts but this is the basic premise of investing in a Bond. You, the investor are buying someone else’s loan that was made to that government or company and are receiving the interest payments for the remaining life of the loan. At the maturity date you should receive the principal amount, originally lent, paid back to you. The life of a loan can be anywhere from 3 months or 30 years depending on whether its to a Government or corporate borrower. The value of these loans fluctuate depending on the amount of interest you receive from the borrower relative to current interest rates as well as other factors. The values of bonds do not fluctuate to the same degree as stocks do so bonds are viewed usually as more stable investments. There are ways to purchase bonds directly from the US Government but to own a group of bonds investors can buy Mutual Funds or Exchange Traded Funds (ETFs) which I will go into more detail about in another article.
At its core, stocks represent a share of ownership in a publicly traded company. They are bought and sold on stock exchanges and investors earn money when the stock price increases and if the company pays a dividend. The investor can also lose money if the stock price falls below the price they purchased it for. When private companies get large enough, they can “go public” with an IPO (Initial Public Offering) and sell a portion of the company they own to public investors for an initial set price. Then that company will now be listed on a public stock exchange. There are few ways to invest in stocks which also can be called equities. Investors can open a brokerage account and buy individual companies that they think will grow in value over time or they can invest in a portfolio of stocks through a MF (Mutual Fund) or an ETF (Exchange Traded Fund). As I mentioned above, I will be going into more detail about Mutual Funds and Exchange traded funds in another article so you can understand the differences between the two and make decisions as to which one is right for you.
Investors and Financial Analysts often talk about Stocks and Bonds in terms of sectors they belong to. These sectors are an easy way to group bonds and stocks together with common characteristics. For instance, Bond sectors are usually classified as Governments, Corporates, Mortgages, or Agencies to name a few and this represents who the borrowers are. They can be further sliced into the credit quality such as AAA, AA, or BBB for example.
Stocks are classified by industrial sectors, like Technology, Healthcare, and Finance to name a few as well as the size of the company such as small, mid and large companies. This helps describe how different areas of the stock or bond market has performed and makes it easier to summarize or understand.
The Concept of Risk
All investing involves risk and so its helpful if you understand what types of risks exist so you can make the decision as to the amount and type of risk you are willing to take. Risk is often described as the price swing or price volatility of an investment. The higher the swing or volatility there is, the higher the possibility of high positive returns or losing money as well. As I mentioned before the price swings in Bonds are less then Stocks so you can lose less money but you will also earn less as well. Another type of risk is company specific risk or security specific risk. This means that it can be more risky to own a single bond or stock versus a group or portfolio of bonds and stocks. Basically, by owning a group of bonds or stocks the large price swings of any one investment will get smoothed out by the price movements of the other investments. An important concept in thinking about how much risk you are willing to take is what do you need the money for and how many years can you leave it invested. The longer the time frame generally speaking, you should be able to handle more risk since you can stay invested during a downturn. Often one of the worst things an investor can do is sell their stocks during a general recession. Investing can be emotional when all markets are falling and we have our hard earned money invested. The problem is if you don’t need the money immediately you can stay invested and markets will recover in time. Its harder to make up the losses if you sell investments during a downturn and decide later to reinvest after the market has bounced back.
This is only the beginning
Now that you understand the basics of bonds and stocks and the general idea of risk we can grow from there. The end goal is to combine them in a way that will smooth out the returns and grow your investments over time.