Investing has its own language — and if you’re a new investor, it’s easy to get confused. Many of the terms may make you feel like you’re ordering off a menu you don’t understand. If you can’t identify the food on your plate, then your appetite — and possibly your health — suffers.
When you’re picking investments from your company retirement plan’s menu, you don’t necessarily need to be fluent in investor-speak. But if you don’t know what you’re investing in, your portfolio could get indigestion. Knowing the basics of the most common investment types can keep you from reaching for the antacid tablets.
Investments come in more flavors than what’s in the case at your average ice cream store and have a way of overwhelming many investors. If you’re looking to increase your understanding of investments, a good place to initially focus on is defining and comparing the two main investment categories (known as asset classes): stocks and bonds.
Stocks make you an owner.
Companies sell shares of stock to investors to bring in more money than they can make just by selling their products or services — and they use this money to fund investments or expansion. When you buy stock, you are buying an ownership stake in the company. It’s why stocks are also called “equities.” You’re getting an equity stake in the business.
As a part owner, you share in the fortunes (positive and negative) of the company. If the company does well and grows, your stock shares may go up in value. The opposite can also happen, which is one of the risks of buying stocks — it’s possible (although not very likely in most cases) to lose all your money. This is why diversification is important. What if you have all your stocks in one company or industry and it goes south? You’re at a greater risk of losing everything than if you own stocks of several companies in a variety of industries.
The value of just about any investment will go up and down over short time periods. This is called volatility, and stocks tend to have more volatility than bonds. But this higher volatility also gives stocks the potential to grow in value over time, which is why stocks have had better performance than bonds over the long haul.
Bonds make you a lender.
A bond is a type of “I.O.U.” issued by a government agency or corporation as a way to raise money for specific needs. When you buy a bond, you are lending your money to the bond issuer and in return, you receive interest payments at a specific (fixed) interest rate over a specific (fixed) time period. This is why bonds are called “fixed income” investments. At the end of the bond term, the issuer pays back what you originally paid for the bond.
The known interest payments and terms tend to make bonds less risky than stocks. But bonds don’t have the ability to grow in value the same way stocks do, so their average long-term performance tends to be lower than stocks. A bond’s value also changes over time, but generally not as much as the typical stock. It’s worth noting however, that if a company is in trouble, bond holders are ahead of stock holders in the line to be paid.
Mutual funds are baskets of stocks and bonds.
A mutual fund is a collection (or portfolio) of stocks, bonds and other investments that are managed by a professional team. Individual investors buy shares in a mutual fund and everyone’s money is pooled. The managers buy and sell the investments in the fund’s portfolio with the aim of increasing its value over time.
When you buy shares in a mutual fund, your money gets spread out across all the fund’s investments. Some mutual funds may own dozens of stocks and bonds, some hundreds. Some funds only invest in stocks. Others only invest in bonds. You can research mutual funds online by searching for the fund’s ticker symbol.
Keep your options open.
Stocks and bonds both have pros and cons. Consider including both in your investment portfolio. For many investors, mutual funds are one of the easiest ways to do that.