Investing can seem very complicated if you’re not familiar with all the financial lingo.
If you’re wondering how to understand your investments, these 3 steps will get you well on your way.
- Your money is divided among into stocks, bonds and cash type investments based on your goals, desired risk and time frame.
- The stocks and bonds are bought in your account in either individual stocks and bonds, or funds of stocks and bonds.
- At least once a year the amount in each category is adjusted to equal the percentages you want in each category since the amounts would have fluctuated during the year.
I was fortunate enough to have a father that taught me this almost four decades ago when I first began investing.
In this post, I will expand on these 3 steps. Knowing these basics can help you understand your investments whether you have money managed by a financial advisor, a family member or in a retirement fund. This simple model is the foundation for the huge majority of individual investors and financial advisors.
Remember, when you understand something you feel more peaceful and confident about it.
For me personally, now, I like to buy what is undervalued, and sell what has become more expensive. This is called a tactical investing approach. When a set asset allocation is used as in the above example, I call this static investing since the percentages invested stay about the same each year.
But the foundation for understanding your investments begins with understanding how asset allocation works since this is how most investment portfolios are managed by both professionals and individuals.
The amount of money you want to invest is divided among into stocks, bonds and cash type on investments based on your goals, time frame and desired risk level. Each category has a percentage of the total. This is called your “asset allocation”.
What Are Stocks and Bonds?
Stocks represent ownership of a company. When you own a stock, you own a tiny little piece of that company.
Bonds represent a company borrowing money from investors who buy their bonds. When you own a company’s bonds, you have made them a tiny little loan.
Subcategories of Stocks and Bonds
Sometimes, an investment strategy may simply invest in one category of stocks and bonds.
The amount that is put into stocks and bonds, however, isn’t usually put into just one type of stock and one type of bond. Instead, the stocks and bonds are divided into subcategories. The subcategories represent different types of stocks and bonds.
Here are some stock subcategories:
- Small company stocks
- International stocks
- Health Care Stocks
- Brazil Stocks
- Large Company Stocks
- Value Stocks
The same is true with bonds. Here are some examples of subcategories of bonds.
- Treasury Bonds
- Corporate Bonds
- Intermediate Term Bonds
- International Bonds
- European Bonds
- Municipal Bonds
- High Yield Bonds
There are more categories. Don’t get overwhelmed though, because there are really only 2 or 3 major subcategories.
Sometimes categories are combined. For example, you may have Small Company Technology Stocks, or Foreign High Yield Bonds.
If you already have a portfolio, you probably already have some of these categories. Just remember is that there are two major categories to understand, stocks and bonds.
Compare concept this to a dessert recipe. You may add a teaspoon of cinnamon. You know it’s a spice. That is the main category for the ingredient, but you don’t need to know everything about cinnamon to use it. You just need to know that overall it enhances the taste, it’s a little sweet, and it is often used for desserts.
Why Invest in Stocks and Bonds?
The main reason you invest in stocks is the expectation that they will increase in value while you own them. Stocks grow over very long periods of time, or at least they have in the past. This is because the company issuing the stock makes more money.
Some companies pay out the money they make to their shareholders (you). These are called dividends.
So, stocks are owned so they will go up in value, or so you can get their dividends, or both. The different subcategories explained above influence whether the stocks will be owned mostly for increasing in value, or to collect the dividends.
On the other hand, most bonds pay interest to the bond holders. Just like stocks swing in value, the value of bonds can swing up and down, too.
Now you know what kind of investments there are, and also why people would own the 2 major kinds of investments. This is the core of investing. Everything else circles back to this foundation.
If you stop reading now, you would know a lot that would help you understand your investments.
But the next concept is really important.
Stocks Vs Funds
Instead of an investor having to buy a lot of different stocks, index funds were created. Index funds also investors to buy a group of stocks in one purchase.
Here is an example. If you want to invest $100,000 in stocks, you’d probably want to buy several companies instead of just 1 or 2 companies. This will allow you to spread (reduce) your risk in case one of the companies runs into trouble. Instead, you may decide to buy 25 stocks, but that is a lot of research. Plus, you’ll have to pay commissions on 25 different stock purchases, and handle all the trades.
Instead, you can buy an index that represents 500 large company stocks in the US called the S&P 500 index. Nowadays, most investing is done with index funds. There is an index for just about everything, including all the categories and subcategories I listed above.
You can imagine how much more diversified your risk is when you buy index funds. Plus, you only have to pay commissions on buying the index fund.
Most financial advisors put their clients in funds these days, many of them index funds as opposed to funds that have someone picking individual stocks like the old days. Believe it or not, studies consistently show that the vast majority of managed stock funds do worse than the index.
This means that index investing is easy and can be very successful. It’s not a cop out for someone who doesn’t want to take the time to learn to invest properly.
You may be wondering: With all that diversification, does this mean your stocks won’t go down in value? Unfortunately, the answer to that question is this: If you own the stocks over several years, they will almost certainly decrease in value, depending on how long you own them.
Why Do Stocks Go Down in Value?
Earlier I wrote that people buy company stocks because the stock will go up in value as the company makes more money.
But the amount of money a company makes is naturally tied to how much money consumers are spending. When consumers are spending less, company profits decline for most companies, and vice versa.
The amount of money consumers make and spend is tied to the economy. Sometimes the economy is expanding, and sometimes the economy slows down for a period.
When this happens, stocks fall. First, stocks fall because the companies are making less money. This makes the stock market fall. Then, stocks fall more because simply stocks are falling! Everybody wants to get their money out of the stock market before it falls more.
When stocks fall by less than 20% from the highest point, this is called a correction. When stocks fall more than 20% this is called a bear market which is much worse. Sometimes, stocks fall over 50% during bear markets!
Sometimes stocks fall for other reasons, like a crisis in a another country, or a financial threat, but usually stocks fall every few years for the reason I just explained.
The bad thing is that even the stocks of the companies whose profits haven’t fallen fall, too. This is because stocks tend to move as a whole not based on the merits of a single company. The good thing is that stocks in companies who continue to have solid earnings drop less than companies whose earnings fall.
So, the bad thing is that stocks fall, sometimes a lot. The good thing is that over long time periods they increase in value. The other good thing is that you can buy more stocks after a bear market when they are cheap!
What Makes Bonds Fall?
I’m so glad you asked?
Bonds can fall for several reasons, but one of the main reasons bonds fall is that interest rates have risen.
Here’s why: If you bought a $1000 bond that paid you 8% interest, and the Federal Reserve rose interest rates to 12%, your bonds would, of course, be worth less. This is because investors can buy newer bonds that pay 12% interest.
Why should they pay full price for your bonds that pays less interest? They won’t, so the value of your bonds decline, and if you wish to sell them you’ll get less than you paid for them. Of course, you could just keep them and collect the lower 8% interest.
Bonds have a time frame associated with them, like 10 years or 30 years. The longer the bond is for in years, the more the bonds will fall when interest rates rise.
This is because the bond buyer is stuck with that lower interest rate for a longer time.
But here is the good thing about bonds. Most bonds pay interest income which gives investors a good reason to own them.
And another good thing about bonds is this: When stocks fall, investors tend to want safer investments. This makes them want to own US Treasury Bonds, so the price of these bonds go up when stocks go down. This doesn’t always happen, but it usually does.
This ties beautifully back to asset allocation in step 1 above. You’ll remember how you had some money in stocks, and some money in bonds based on your desired asset allocation? This is because the expectation is that when one (stocks or bonds) drops the other will go up.
In other words, they will move in opposite directions. In investing lingo, this is called “non correlated” so it can sound complicated, but it really isn’t, right?
Understanding Your Investments Summary
Now you know the difference between stocks and bonds, why you might own each, and why they each go up and down. You know that you can buy an index fund instead of individual stocks.
Hopefully this helps you understand your investments better. To take the next step, do this:
- Label each investment that you have as either a stock or a bond.
- Then add up the total you have in each category.
- Total both stocks and bonds.
- Divide the amount in category by the total invested.
Now you know your current asset allocation. If you’re not happy with it, you can adjust it.
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