In part two of investing for financial independence I’m going to cover some of the more basic investments that a novice investor may be considering. Being an investor in the stock market, mutual funds, bonds or other investment vehicles shouldn’t be an intimidating experience. I’d like to take the mystery out of these investment types with this primer so that you can become an informed investor on your path towards financial independence.
Stocks are usually the first thing that comes to mind when anyone thinks of investing. At it’s very simplest, stocks are purchasing a small part of the company you are investing in. Stocks fall in a variety of categories, all of which are important to consider when making an investment. You goals and objectives should dictate what types of stocks you have in your portfolio should you choose to make direct investments in stocks.
Stocks are broadly categorized as Income, growth or value stocks. An Income Stock is one that generates dividends which are typically paid out on a quarterly basis. A value stock is one whose share price is low relative to their fundamentals (earnings, sales, assets etc.). Growth stocks are defined companies that the investment community feels has significant growth potential.
One classification of stocks is how large or “capitalized” the company is. This reflects the overall value of the company in terms of how much stock has been issued and what the stock is selling for. The terms you’ll typically see are Small, Medium and Larger “Cap”. Small Cap companies typically have a market value of less than $250 million while large Cap companies have a value of more than $10 Billion. You’ll see variations to this theme with terms such as “Nano Cap” (tiny companies) and “Mega Cap” (Extremely large companies) but the important thing to remember is that as a rule of thumb, the larger the company, the less volatility you can expect to see. Another classification for stocks that you’ll encounter is whether the stock is considered an Income, Growth or Value stock.
The most important thing to remember about Stocks is how risky they are. Generally the classifications a stock falls under can give you a clue as to the level of risk a stock has. As a rule, small Cap are riskier than medium cap and both are riskier than large cap stocks. Similarly, Value Stocks carry more risk than Growth stocks and both are riskier than Income stocks.
Bonds are a debt security issued by corporations and governments, similar to an IOU. Bonds pay a fixed interest rate for the life or term of the bond. Once a bond reached it’s term, the principal (also called face or par value) will be returned to the owner of the bond. There are a variety of different bonds issuers. US Government, Municipal, Corporate, mortgage backed are among a few of the types of bonds that are available to the investor.
Bonds pay a fixed interest rate on a pre-determined basis. The interest paid on mos bonds is taxable, with the exception of municipal bonds which provide interest that can be tax free on a federal as well as a local basis (depending on where you live and where the bond is issued). Bonds are sold at Face Price (Also called Par value).
Bonds are also traded on the market but rarely at their face value. The market price of a bond will vary depending on the present value of the bond. The bonds present value is predominantly determined by the par value of the bond, the length of maturity and current interest rates.
Here’s quick example of this. A bond that pays a higher interest rate than the market will sell at a premium to it’s par value. One that pays a lower interest rate than the current market rate will sell at a discount. the length of maturity also impacts the price of a bond, the longer a bond has to mature then the greater that market fluctuations will affect that bond.
Bonds are also rated in terms of their risk level. Moody’s, Standard & Poor’s and Fitch are companies that are universally looked at for their ratings on bond issues. All three of them use a similar rating system to rate bonds. The ratings range from AAA to D. AAA is considered investment grade and extremely low risk D would be a company in default. The lower the rating, the higher the risk the bond represents. Low rated bonds typically pay higher interest rates because of the risk associated with the bond.
Mutual funds are probably the ideal way for anyone who wants to invest but doesn’t have the time or the inclination to do research individual investments. Mutual funds typically have different investment objectives. Growth, Value, Income are just some examples of the types of Mutual Funds that are available. There are mutual funds that are based on stocks as well as bonds.
Mutual funds are run and managed by professional money managers. The fund managers target their investments and strategies towards fulfilling the key objective of the fund. Having an investment professional manage these funds takes much of the investment load off of the individual investor. The research, buying and selling as well as other tasks that make for responsible investing are being done by a professional money manager rather than yourself.
There is one key item to look for when deciding on which mutual funds to invest in. That is whether a fund is no-load or a loaded fund. A loaded fund is simply one that comes with wither a front or back end commission. Front or back defining when the commission is paid, either when you buy it sell it. I prefer to avoid loaded funds as the performance between loaded and unloaded funds is very similar.
Another potential cost to look for when researching funds is the management fee, also called a 12b-1 fee also called an expense ratio. These fees can range anywhere from a fraction of a percent to 2% or more. Over time, these expense ratios can eat away at your gains. My preference is to invest in funds that have an expense ratio of less than .5% but i will consider funds with expense ratios up to 1% if they have a solid track record with above average performance.
Mutual funds can be invested in directly with large financial institutions that manage funds. Some of the larger well known companies that manage funds include Fidelity, T. Rowe Price and Vanguard. Funds can also be purchased in your individual brokerage accounts, 401k’s and IRA’s. The one limitation of investing in funds within individual brokerage accounts is that your brokerage my not offer the fund that you may be interested in. In that case you would have to use a different brokerage account or invest directly with the Financial institution managing the fund.
Mutual funds usually have a minimum investment required, which with some funds can be pretty steep. I’ve seen some funds with a minimum investment required of $10,000, and they can go higher than that. Most of the funds have a much lower minimum if the investment is being done from a retirement account.
A final word on investing, whether you are investing in Stocks, Bonds or mutual funds, Do Your Homework! Understand what your investment style is, what your risk tolerance and objectives are and research the investment vehicles that fit your requirements. Approach investing with the understanding that patience is key and that rash spur of the moment decisions are why most individual investors take a huge loss. Best of luck…..
If you haven’t already, part one of investing for financial Independence can be reached here: http://wisedollar.org/investing-part-one/