Investing Basics You Should Know

Investing Basics You Should Know

Here's a helpful post from our partners at InvestingAnswers: 

"All you need is love," the Beatles sang.

Granted, that was in 1967, and they were a lot younger then.

About 20 years later, however, a much wiser George Harrison recording added, "But it's going to take money / a whole lotta spending money. / It's gonna take plenty of money / To do it right."

Life does indeed take a lot of cash. For most of us, of course, that means working for a living. And even though our paychecks can take care of the bills, no one builds real wealth without investing.

Unfortunately, the idea of investing scares the heck out of a lot of people. Some think they don't have enough money to get started. Others are scared of the math. A sizable percentage is too afraid that they'll make a mistake and lose everything. And many would-be investors who don't suffer from any of those fears or misconceptions are staggered by the overwhelming amount of information.

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As I am fond of saying, it doesn’t have to be this way.

Many people who have had great success in the market and built immense wealth have mastered only a few basics. The bottom line is investing is only as difficult as you choose to make it. If you want to, you can make money in the market and build a more secure financial future.

You'll need to know a few basics. We'll cover those. But as important as those investing tenets are, it's every bit as important to study yourself as it is to study the market. We'll walk through a few steps to evaluate both your goals and your risk tolerance. By the time we're through, you'll have a clear understanding of the basic investments available to individuals and you'll also have a sense of your own individual style. From there, you can devise a plan to achieve your goal.

Last point: That George Harrison song where he talks about money? He also makes another point. It takes time. Make sure you give yourself some time to let all this information sink in. When you have, remember that returns, too, take time.

Let's not waste any. Let's keep moving!

Bonds and Debt Investments

Individual investors have two broad choices when it comes to investing: debt and equity. We'll cover debt investments first.

The stock market tends to get the most attention, but there is a lot more debt than equity in the world. The global debt market is over twice as large as the global stock market, and there are plenty of places for investors to park their money.

One of the most common forms of debt is the bond. A bond is simply a promise by a borrower to repay a borrowed sum of money at a predetermined point in the future. There are innumerable variations on the theme, but the basic idea is always the same: The lender charges rent for the use of the money, which we call "interest." Big companies and governments (tax districts, cities, states, and the federal government) raise billions upon billions of dollars selling bonds to investors.

Bonds have a coupon rate and a maturity date. By looking at the bond you can tell how much interest it will pay and when the borrower will return the par value of the bond. Almost all bonds initially sell for a $1,000 par value. Some of these instruments, cleverly named zero-coupon bonds, have no coupons. They sell at a steep discount and pay no interest until maturity, when they are redeemed atface value.

Risk Tolerance

Like all investments, debt has risks. The biggest risk is that the person, business or government you lent your money to will be unable to pay you back. This is known as default risk. A default occurs when a borrower doesn't pay.

The other major risk is bankruptcy risk, which is the likelihood that the company fails outright. The good news for bondholders is that they will typically get something in the event of a bankruptcy. They are known as "senior" creditors, and all "subordinate" or "junior" creditor have to get in line behind them. Incidentally, shareholders are dead last in the pecking order. In a best-case scenario, they will get pennies on the dollar. In most cases, they get nothing.

To address both default and bankruptcy risk, credit-rating agencies like Standard & Poor's and Moody's Investor Service research the entity issuing the debt and issue an opinion on its credit worthiness. Based on these ratings (and on market conditions) the interest rate will be set. The more risk, the more return.

If you're going to lend a large, well-established company like Pfizer (NYSE: PFE) some money by buying one of its bonds, don't expect a very high rate of interest. Why? Because Pfizer's financial footing is very strong. In fact, it has the strongest possible rating on its debt, AAA. Let's assume it pays 5% a year to borrow money.

A startup drug maker with a shakier balance sheet and a lighter income statement might well have to pay twice that in interest to borrow money from bondholders, who will demand a higher rate to compensate them for their risk.

[If you want to read more about the risks of bond investing, click here to read about The 3 Most Deadly Misconceptions About Bonds.]

Suitability

Bonds are often referred to as "fixed-income securities" because the rate of return is, well, fixed -- it's static, printed right there on the bond. From an asset allocation standpoint, most investors move a greater percentage of their holdings into the safe harbor of bonds as they age to protect their wealth. They sacrifice the potentially higher returns from stocks for the predictability and stability of bonds.

Investment-grade bonds -- those with a certain minimum rating -- are generally considered to be safer than stocks and are suitable for risk-averse investors. They offer a relatively lower return than equities or less credit-worthy bonds.

For most investors, corporate bonds are best purchased through low-cost mutual funds. Individuals can buy some government bonds directly from the federal government, typically through a bank. Individual bonds typically require a large capital investment, which may make them unsuitable for smaller investors.

[Learn more about buying government bonds directly from the federal government by reading How to Buy U.S. Government Bonds Using TreasuryDirect]

The Bond Price-Yield Relationship

Investors can buy and sell bonds to one another in what's known as the "secondary" market. (The primary market is between the issuer of the bonds and the initial purchasers.)

Bond math can be challenging, and performing some of these calculations, or worse, reading about performing these calculations, would send most newbie investors running for the hills. So we're going to skip most of that. But there is a critical relationship between yield and price that all investors must master.

Happily, it's simple: Price and yield always move in opposite directions. When one goes up, the other goes down. This is one rule that cannot be broken.

The reason this rule is so critical to understand is that nothing is constant in the financial markets. Prices change by the nanosecond as investors respond to whatever is going on in the world, especially if the news affects Wall Street's view on the future of interest rates.

[The Federal Reserve is in charge of setting the federal funds rate, which impacts other important interest rates. To learn more, click here to read Twelve Powerful People Control Your Destiny -- What Are They Trying to Tell You?]
Let's say a Company XYZ has a solid "AA" rating from the good folks at S&P.  XYZ hits a rough patch and loses a marquee CEO. After a couple of less-than-stellar earnings reports and some worrisome SEC filings, S&P says it is going to put the XYZ's AA rating "under review."
And here is the thing: Bondholders are nervous types. Even if nothing turns out to be wrong, they may begin to lose confidence in the company's ability to repay its debt.

Now, there are plenty of other bonds out there to buy, so investors decide to sell their bonds and buy something else. Normally, this would be no problem. After all, XYZ is a solid corporate citizen. It has a good reputation and a relatively strong balance sheet, plus a decent credit rating. But Wall Street has been reading the news about the company, too, and since it's not been great news, investors are reluctant to pay full price for the bonds.

So investors try to sell their bonds, which they paid par value for. These bonds have a coupon rate of 6.75%, which means they pay $67.50 a year in interest. (Bonds typically pay twice a year.) But with all the bad news in the press, they can't get $1,000 for the bonds. No one will buy them for that. So, in accordance with the law of supply and demand, there's only one way to sell them -- cut the price. Let's assume the bonds sold for $900.

What has changed? Only the owner. The coupon rate is the same, the par value is the same. Only now, when the bondholder receives his $67.50 in interest, it won't be measured against a $1,000 purchase price, it will be measured against a $900 purchase price. Remember, as price goes down, yield goes up. The original yield was 6.75%. But now, with the reduced price the yield is 7.5%.

Why? Pure math: $67.50 divided by $1,000 is 6.75%, whereas $67.50 divided by $900 is 7.50%. As prices fall, yields rise.

Though bond prices can and do fall on company news individually, they tend to move lockstep in a group with interest rates in general. When interest rates go up, bond prices of bonds fall. When rates go down, bond prices rise. That's a good rule of thumb to remember, but the most important take-away with bonds is simply to remember than price and yield move in opposite directions.

[Use our Yield to Call (YTC) Calculator to measure your annual return if you hold a particular bond until its first call date.]

Owning Companies By Buying Stock

While bonds are an important part of any portfolio, when it comes to investing, most people are interested in the stock market.

Stocks, also known as equities, are eensy-weensie ownership interests in corporations. If you own one, 100 or 100 million shares of Exxon Mobil (NYSE: XOM), you can call yourself an owner of the company.

Why do we buy stocks? Because economies, most of the time anyway, grow. That means businesses have the opportunity to likewise increase their revenue and earnings as time goes by. Businesses exceptionally good at responding to or creating demand can do even better.

The average return for the Standard & Poor's 500 index since 1965 is +10.7%, which means an investor can double his money roughly every seven years. That's a far better return than with asavings account, CD or most bonds.

That return reflects the overall market -- the S&P 500 is an index that tracks general pricing trends of the entire universe of domestic stocks. An individual stock may be able to exceed this return, and perhaps dramatically so. Particularly volatile stocks may go up or down 10.7% in a single day. For traders, these stocks can be a gold mine. But trading is not for the risk-averse or faint of heart.

Stockholders get more than just the potential for increased earnings and higher stock prices. They also may be entitled to cash, paid in the form of dividends.

Dividends, the great investor Benjamin Graham wrote, are the primary purpose of the corporation.  Dividends are usually paid once a quarter. When this dividend is multiplied by four and then divided by the stock's price, the resulting figure is known as the dividend yield.

For instance, say you purchased 100 shares of stock at $50 a share. You paid $5,000 for these shares. Each quarter, you receive a $1 per share dividend, which adds up to $200 a year. These shares yield 4.0%. (200/5000 = 0.04). Dividend yield is vital to investors who build portfolios to generate cash income.

In addition to dividends, shareholders are also asked to vote on important decisions, such as electing a board of directors. Some investors actually buy stock precisely so they can have a direct say in the management of its affairs. These "activist shareholders" accumulate shares and form alliances with other shareholders for the express purpose of changing the way the company does business.

Suitability

Stocks are suitable for investors with moderate to high risk tolerance and can usually accommodate a variety of time frames, from the extreme short term to several decades.

Stocks are primarily purchased using a brokerage account or through mutual funds, either in a regular account or some type of tax-deferred retirement plan such as a 401(k) or IRA. In many cases, stocks can also be purchased directly from the company through its transfer agent. These plans, known as dividend reinvestment plans (DRIPs) or direct stock purchase plans (DSPPs), can be an inexpensive and effective way to build a sizable nest egg.

Low-cost online brokerage accounts have revolutionized the market. Individual investors now have access to sophisticated trading software, excellent investment research and instant trade execution. It is possible to fund an account and buy stock in the same day. In most cases all you need is your name, address, Social Security number and a little startup money.

Owning a stock is and should be considered ownership of a business. A share of stock isn't just a piece of paper, it's part of a living thing, a viable profit-making enterprise.

Stock Picking for Beginners

Now, of course, the question is undoubtedly how you, too, can get in on the ground floor of the next Wal-Mart (NYSE: WMT)Coca-Cola (NYSE: KO) or Apple (Nasdaq: AAPL). And there indeed are a number of ways to evaluate a stock, typically either through fundamental or technical analysis. Studying the theories and mechanics of technical analysis can go on for a lifetime. But let's not get ahead of ourselves. For beginners, it's just as important to understand how the price of a share of stock is determined.

First, understand this simple truth: Stocks are all valued simply based on whatever someone else is willing to pay for them.

That's it.

If you want to set the price of GE (NYSE: GE) shares, you can do it by either buying them or selling them. Investors set prices, not the stock exchange, not the government and not the companies themselves. It's you and me.

Risk Tolerance

"This above all," Polonius says to Laertes, "to thine own self be true."

That's not bad investing advice. The first thing an investor has to do is to determine what type of investments he would be comfortable with.

There are two and possibly three elements to this.

The first is optional, and that's morality. Some people are opposed to investing their money in companies whose businesses they find objectionable. For instance, an environmentalist may object to a chemical company's record of improperly disposing of potentially hazardous waste. A physician might prefer to forgo buying tobacco company shares.

The second and third steps, however, are unavoidable. Even so, many investors skip them. And every investor who does winds up feeling something that is never good when you're looking at the balance in your brokerage account: Surprise.

So, pay attention.

Investors must buy securities they understand. They must fully appreciate the downside risk and the likelihood of it occurring. Buying a stock because that's what everyone is buying is foolish. Never purchase anything if you don't know exactly what you are buying and precisely what the risk is.

Keep in mind the purpose of understanding your investments is not to edify you and make you a more well-rounded person. It's to help you evaluate whether the risk is appropriate. If you have $10,000 to invest, would you be more comfortable with a bond fund that you know is going to yield 6.5%, an S&P 500 index fund that has an even chance of meeting its long-term 10.7% average return, or would you like to use that hard-earned $10K to buy a participation in an exploratory oil well that has only a 25% of being successful (and a 75% chance that you will lose every dime)?

Now, there is no correct answer to that question. But there is a right answer for you. Do you understand the risk and return potential? Could you sleep at night with your choice? And will the anticipated return help you achieve your goals. If it does, then you're ready to buy. If not, let the money sit until you can confidently and comfortably answer those questions.

The other element of choosing investments vehicle is diversification. And while most investors also skip this part, if you do, the outcome won't just surprise, it will outright shock.

The first reaction among investors trying to follow the "know what you are buying" tenet is to buy companies who businesses they understand. Thus bankers like to buy banks and nurses like to buy health-care companies.

The problem is that most industries are cyclical. They have boom and bust periods. If all your resources are tied up in health-care assets and health-care assets have a terrible year, you're going to lose ground. But let's be clear: When I say "ground," I mean "money."

So while it's fine to buy companies you are interested in, you also need to add other assets that expose you to other potential returns. A good portfolio is a tailored basket of appropriate risks that isn't overly dependent on one sector to deliver the desired return.

The Importance of Goals

Steven R. Covey, author of the bestselling "Seven Habits of Highly Effective People," says no one should begin any journey without the end in mind. In other words, you need a goal. If you aim for nothing, you'll hit it.

A good goal needs to meet three criteria. First, it should be time-based. Goals need deadlines.

Second, a good goal should be quantifiable. You have to lay out exactly what you want to accomplish and how you will measure your results to gauge your success.

Finally, your goal should be achievable. There's no use setting a goal that you'd like to fly over the Empire State Building by your 30th birthday because there is not chance that's going to happen.

This is important to keep in mind when you're setting financial goals. If your goal is to turn $25,000 into a $1 million, that's great. But recognize that you need +20% annual returns for 20 years to reach it. Attempting the same goal in 10 years is unrealistic, and you're just setting yourself up for disappointment.

The reason for setting goals is because financial success builds on financial success. Much of what we would like to do -- save for a home, send a child to college, open a small business, take a trip -- are achievable even for people of modest means, provided they have a good plan and a lot of discipline and patience. To that end, I recommend that before you start investing, you establish a series of financial goals.

First, come up with something you'd like to do in the next 12 months. This is not so much an investing goal as a way to force you to budget your money and plan your expenses.

Second, establish a five- or ten-year goal. For a recent college graduate, this might be a $25,000 down payment on a home.

And, finally, your long-term financial goal should always be a comfortable retirement at 75% of your last working year salary, independent of Social Security, and accessible at age 59 1/2. That sounds like a tall order, but it's something you absolutely can do.

In the meantime, I invite you to continue exploring the educational articles and tutorial materials here at InvestingAnswers. 

And, of course, many happy returns.

InvestingAnswers' mission is to empower people to build and protect their wealth. The site--one of the web's premier financial education sites--offers hundreds of articles, videos, columns and tutorials, as well as the most user-friendly financial dictionary on the Internet. Visit them at InvestingAnswers.com.

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