The pros and cons of stocks, bonds, and cash. The concept of asset allocation is explained.
In this topic, you'll learn:
An investment can be almost anything - from coins to collectibles. But when investing money for long-term goals like retirement, most people choose to buy investments that are highly "liquid," meaning they can be converted to cash quickly. For example, stocks can typically be sold in any quantity and at any time for a low transaction fee. On the other hand, illiquid investments like real estate, art, or even classic cars, can be sold, but the process takes longer and the ultimate value can be difficult to predict. Popular types of investments include stocks, bonds, and cash-like certificates of deposit / share certificates or money market funds.
Stocks
A share of stock is an investment that represents a certain percent of ownership in a company. For example, a company may have one million shares of stock outstanding, so owning 100 shares means that you own 0.01% of the entire company. If the company is growing, the stock is worth more money. If the company is shrinking, it is worth less. Some companies even pay a dividend, or cash payment, to stock owners each year.
As long as a company is publicly traded, you can buy shares. But owning just one stock can be risky - what happens if the company is mismanaged and the value drops to zero? You could lose all of your investment.
To reduce the risk of putting all their money in one company, many people purchase a group of stocks known as a mutual fund. These investments could be made of the stocks in a certain type of business (like transportation) or it could be a group of companies that are a certain size (like the 500 largest companies).
Many mutual funds are managed, meaning there is someone making decisions about which stocks to buy and sell in an attempt to make the most money. Others are passive index funds, meaning they simply track established groups of stocks. Examples of stock indexes would be the S&P 500 (500 largest stocks in the USA), the Dow Jones Industrial Average (30 large companies), and the Russell 2000 (2,000 of the smallest publicly traded companies). There are thousands of actively managed funds and hundreds of index funds to choose from.
Bonds
A bond is a type of loan you make to a company or municipality where you earn interest. When you purchase a bond, you are loaning money to the company, government agency, municipality or other large organization that issues the bond. The rate of return on the bond is the rate of interest the bond issuer agrees to pay in exchange for the loan. The higher the risk of the issuer not repaying the loan, the higher the return. The lower the risk, the lower the return. Many investors buy treasury bonds, which are backed by the US Government and carry very low default risk - meaning the government is highly unlikely to fail to repay the loan. Because of this low risk, they typically offer lower interest rates than other bonds. However, like all bonds, their market value can fluctuate if interest rates change.
Like stocks, bonds can be bought individually or as part of a fund. Since the purchase requirement of bonds can be in the thousands or hundreds of thousands of dollars, most individual investors buy mutual funds that purchase bonds. These funds allow investors to spread risk among many different issuers and to purchase a bond investment for a low dollar amount.
Cash Investments
Bank certificates of deposit, money market funds, and interest-bearing savings accounts are all considered cash investments. These investments are chosen primarily as a way of preserving (rather than growing) wealth. The interest offered by these accounts has sometimes been similar to the overall rate of inflation, though this varies depending on economic conditions. For this reason, they are often viewed primarily as a way to reduce - rather than eliminate - the impact of inflation, while keeping risk low.
Some cash investments, such as certificates of deposit (also known as share certificates at credit unions) offered by federally insured institutions, offer a fixed rate of return for the term of the deposit - meaning the rate is set when you open the account and does not change.
Other cash investments, like money market funds, offer a variable rate that can fluctuate. Keep in mind that certificates typically require you to leave your money on deposit for a set period, which can range from a few months to several years. If you withdraw funds before the maturity date, you may face an early withdrawal penalty that could reduce your earnings. Also, note that coverage limits apply to federally insured deposits - consult your institution for details.
A Note on Asset Allocation
Because each of the main three types of investment assets involve different levels of risk and reward, you will often hear the term "asset allocation" in regard to investment planning. Asset allocation simply means the percentage of your entire investment portfolio that is invested in each of the three main asset categories. Younger investors, who have years before retirement, typically choose a higher percentage of stock ownership - this offers greater opportunity for growth, but also more risk. As investors get older and preserving savings becomes more important than rapid growth, they may gradually transition to a majority of bonds and cash as they approach retirement.
Please see our Retirement Savings Ideas topic for more information on asset allocation.
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