Investing Basics: Stocks, Bonds, and Cash
Before you even begin to explore what you want to invest in, I believe it’s incredibly important to spend some time considering why you’re investing in the first place and then chart out your financial goals. If you don’t know what you are investing for and what you are trying to accomplish, it’s incredibly difficult to choose how to invest. How you should invest for retirement is entirely different from how you should invest for a near-term home purchase and planning for those goals will dictate the majority of your investment decisions. When it finally does come time to invest, ideally, you should work with a professional to decide what the appropriate allocation is given your personal situation and mental tolerance for risk. To have that conversation, however, it helps to have a basic understanding of your investment options. With that in mind, let’s take a quick look at the most common options available.
Stocks, also known as “equity,” are forms of ownership. When you purchase a stock you become an owner of that company. Returns come in the form of dividends and appreciation. Bonds, also known as “fixed income,” are IOUs. They are loans to an entity in exchange for interest and return of principal. They come in all shapes and sizes and are considered more conservative investments than stocks because they take priority in the capital structure. This means that if an entity goes bankrupt, bondholders are paid back before stockholders. Cash can be dollar bills under your mattress, cash in your bank account, or money market funds earning lower rates of interest. Cash is often an appealing investment choice because it isn’t volatile, however, cash can actually be a really poor investment choice because it loses value over time. If average inflation is 2.5% but cash is only earning .25% in the bank, over time your dollar fails to keep up with how much more expensive things are getting.
Stocks and bonds can be characterized in a variety of ways. Stocks may be characterized by geography, with international stocks being stocks of companies in developed countries whereas emerging stocks would be those of companies in developed countries. Stocks may also be characterized by the type or size of the company. A value-based investment would be one in a long-standing company such as Ford, GE, or Coca-Cola, while a growth based investment would be one in a quickly growing company (think tech companies). When you see an investment characterized as large-, mid-, or small-cap, the size of the company is being communicated ("cap" is short for capitalization). Long-, intermediate, and short-term communicate the length of time it takes for a bond to mature.
Investments can also be packaged together in the form of mutual funds or exchange-traded funds (ETFs). Both options allow you to diversify with the main difference being that mutual finds price only once at the end of the day, while ETFs price throughout the day, much like stocks (they’re also typically simpler and cheaper). Diversification is a fancy word for spreading out risk. Put simply, when you add investments that are different from each other, you mitigate the risk of one asset experiencing a significant drop. For example, if you’re only invested in one holding and that holding drops 50%, your portfolio also drops 50%. If you’re invested in 20 different assets (after 20-30, the benefits of diversification start to level off) and one asset drops 50%, your portfolio only drops 10% and that drop may be offset by gains in the other holdings.
While these are very basic definitions of a vast and complex investing universe, they provide the backbone for many investment options and can be helpful to understand when it comes to evaluating any investment advice you’re offered.