Investing your hard-earned cash can help you work toward important goals in your life, whether you want to buy a new home, take a dream vacation or—perhaps most important of all—make sure you’re financially secure when you retire. Yet, earlier this year we surveyed 2,000 Americans to ask them about their attitudes toward saving money, and our initial findings found that 38% of women and 32% of men were worried that they weren’t making the right investments.
If you don’t feel confident in your portfolio, part of the problem could be that investment terms and concepts can be confusing and even mysterious. That’s why we created this plain-English guide to some of the basic investing terms.
Stocks vs. Bonds vs. Cash
These three basic types of investment will likely form the bulk of your portfolio. Each one can help your nest egg grow, but beware of the risks too:
● Stocks—Some companies sell stock to raise money to run their operations. Buying stock gives you a small piece of ownership in the company. Stocks are sold by “shares,” whose price can rise and fall. If you purchase a stock at $10 a share, but the share price rises to $20 over time, the value of your investment doubles and you can sell shares at a profit. But if the share price drops, the stock’s value does too.
● Bonds—Buying bonds is like making a loan to a company or government. You don’t own shares; instead, the bond issuer promises to pay you interest annually, then return your initial investment after a predetermined period. But you can lose your money if a bond issuer goes bankrupt.
● Cash—The bills in your wallet are cash, but this term also refers to money you keep in safe investment instruments such as high yield savings accounts, money market accounts, certificates of deposit and Treasury bills.
Dividends
Dividends are paid to shareholders to distribute revenue. Although not all stocks pay dividends, this is one way to get a return on your investment. If you’re looking to invest in dividend stocks, keep in mind the dividend yield and the dividend payout ratio. The dividend yield is the annual dividend divided by the stock price, which you generally want to be around 4%. The dividend payout ratio is the portion of the company’s net income that goes toward dividends, which you generally want to be around 80%.
Asset Allocation
Deciding what portion of your investment portfolio you should devote to stocks, bonds and cash is called asset allocation. The way you choose to divide your assets will depend on your tolerance for risk (see next term), your age and other factors. An investment advisor can help you with this process.
Risk Tolerance
Do you like playing it safe in life, as a rule? Or are you willing to take a risk in exchange for the potential of a big payoff in the end? Your answer describes your risk tolerance, a key factor in forming your investment strategy. Communicating your risk tolerance to an investment advisor can help create the best portfolio for you.
Rebalancing
Ensuring that your investment portfolio grows at a comfortable level of risk requires occasional fine tuning, known as rebalancing. For example, if your stocks soared last year, you might want to sell off some risky assets and use the proceeds to buy bonds or shore up your cash reserves. Also, you may become more averse to risk as you age or your life circumstances change, so rebalancing your portfolio can help guarantee that your asset allocation provides security.
Compound Interest
What if you could earn money on your earnings? You expect to receive interest on a savings account deposit, of course. But with compound interest, that extra cash is added to your original deposit when interest is calculated. Over time, that can really add up, especially if you have a high yield savings account. Compound interest is one of the best arguments for starting to make regular deposits into a retirement account early, if you aren’t already, and sticking to the plan.
Dollar-Cost Averaging
You can “play the market” by buying stocks when they’re cheap, then selling shares at a profit if their price rises. But what if the stock’s value plummets? A safer strategy is to use dollar-cost averaging. With this strategy, you purchase a set amount of a stock or other asset at regular intervals, such as once a month. Its price will likely fluctuate, but over time your cost per share will average out.
Nonfinancial Assets
Your home and other real estate (if you hold the mortgage), your car and other valuable stuff you own are your nonfinancial assets. Have your own business? Your tools and equipment are nonfinancial assets too, and so is any intellectual property you hold (such as a patent).
Initial Public Offering
Some privately owned companies decide to “go public,” that is, offer shares of the firm for sale on the stock market. The first time these shares become available—so anyone can buy them—is called an initial public offering, or IPO.
Buying and Selling Stocks
The simplest way to buy or sell a security (that is, a stock or bond) is to execute the deal immediately, regardless of its price, which is a transaction known as a market order. But some savvy investors use other strategies, including the following:
● Limit order—In this case, you only want to buy or sell a security if it reaches a price you set or better (lower if you’re buying or higher if you’re selling).
● Stop order—This type of order, also called a stop-loss order, asks for a stock to be purchased or sold once it reaches a specific price.
● Buy stop order—You can also buy a security when it reaches a specified price that’s set above the current market price. A sell stop order is similar but set at a value below the current market price.
Active and Passive Investing
Active investors like to follow the stock market daily, buying securities from companies that look promising and selling shares if a firm appears to be struggling. Passive investors are in for the long haul—they buy a stock with the belief that it will gain value over time, and they hold onto shares even when the market turns rocky. Some investors have a bit of both styles.
Mutual Funds
A mutual fund invests in many different companies with the goal of following a certain strategy, which might be aggressive (with the potential for hefty returns or losses) or conservative (less risky, with more modest returns). A manager actively buys and sells stock to follow the investment strategy. Because mutual funds tend to be active investments, the professional management comes with fees that will affect your overall return.
Index Funds
An index fund is often (but not always) a mutual fund that invests in a set group of companies, such as the S&P 500 Index, which includes the 500 largest firms listed on U.S. stock exchanges. The logic is that the portfolio “mimics” the securities of the index as a whole and the performance of the index fund will match the performance of the overall stock market. Because index funds are passively managed, management fees are lower.
Exchange-Traded Funds
Some index funds are exchange-traded funds (ETFs), whose value fluctuates during trading sessions, unlike index funds, which only reset their value once a day. ETFs can be bought and sold like stocks. and typically offer low expense ratios and fewer broker commissions.
Pretax Retirement Saving
To encourage Americans to sock away cash for their golden years, several retirement savings plans are available. Traditional IRAs let you make contributions toward retirement that can lower your overall tax burden today (though you pay tax on the money later on, when you begin withdrawing it). If you work at a for-profit company, your employer may offer a 401(k) plan, which takes a slice of your paycheck each week (which your employer may even match) and deposits it in a retirement fund. (Again, taxes are deferred until you take distributions of the money you save.) If you are employed by a nonprofit, they may offer a similar plan, known as a 403(b).
Annuities
There are many different types of annuities, which can help you pay the bills in retirement. Annuities are offered by insurance companies, as well as by some banks and other financial services firms. Generally speaking, an annuity is an agreement between you and the seller. You pay a lump sum of money up front or in installments over a period of time. In return, you receive a payout in the future, in the form of regular income for the rest of your life.
Timothy Gower is an award-winning journalist whose work has appeared in more than two dozen major magazines and newspapers, including Prevention, Reader’s Digest, Esquire, Men’s Health, and The New York Times.