After we have established 6 months’ worth of saving in a bank for our emergency fund, what do we do with our remaining savings? Finance experts will tell us that if we want our money to grow, leaving the extra money in a bank will not take us anywhere. So, the best strategy is to invest your extra money.
Now the question arises, without proper financial literacy, how do we know where can we invest our money? In this post, I will tell you some of the asset types where you can invest your money.
Also, you will learn why diversification is very important for investing. By diversification, we mean, having a variety of assets so that if one asset doesn’t do well, you don’t lose all your money. This will also allow you to minimize risks from fluctuations in return from each asset class.
Let’s begin by understanding an asset class!
Asset class means a group of assets that display similar features. These assets will have similar risks and give you similar returns. They are also usually subject to similar tax laws.
There are several types of asset classes, such as
- stocks or equities,
- fixed income assets (bonds and CDs),
- mutual funds, ETFs
- Cash and cash equivalents like money market funds
- commodities like gold and silver, oil, etc
- real estate (property)
Asset class and allocation are very important concepts in investing. They help you diversify your investment, so you can have a well-balanced portfolio. I will cover more on asset allocation in another post.
In this post, I will cover the first two types of assets
Stocks
Stocks are the shares in a company. People who buy a company’s stock actually get a share of ownership in that company. Companies typically issue their stock in the Initial public offering (IPO) to raise money (capital) for its growth.
Stocks or shares mean the same and I am using them interchangeably throughout this post. Similarly, you can either say stockholders or shareholders, they are the same.
When we buy stocks, we get payments in the form of dividends. When the company is doing well and earning profits, it pays its stockholders a share in the profit called dividends.
Another way we get earnings from stocks is when the share price of that company increases, also called capital appreciation. This could be due to the company’s good earnings or any positive news in the company. The company’s share price reacts to the news as the market values its worth more now.
Is there a safer way to invest in stocks?
The answer is yes if you follow certain rules.
The first thing to understand is that finance theory and the supporting research show that no one can beat the market. Even seasoned investors, like, Warren Buffet don’t recommend cherry-picking a few stocks, esp. for someone who is not a very risk-taking person.
A company’s shares can fluctuate a lot due to various reasons. People who think they can predict a company’s performance and hence its share price doesn’t know finance theory that well.
Most of the time, people don’t have enough time to research individual companies. Also, investing in a variety of companies to make a truly diversified portfolio may require a lot of money.
A good strategy for a new investor is to invest in an index fund that mimics the market such as an S&P 500 in the US. An index fund is a type of mutual fund that buys all the stocks that make up the market index in the same proportion. So, the money that you earn from investing in an index fund will be very similar to the return on the index it mimics.
Another key feature of Index funds is that they generally follow a passive, rather than active, style of investing. This means they maximize returns over the long period by not buying and selling securities very often.
Because index funds are diversified, you don’t lose money when some stocks don’t do well. Index funds mimic the market and are less volatile and over the long term (like 10 years or more), they give good returns. Don’t put all your eggs in one basket rule should be the most important thing to follow when investing.
The second way to minimize risks is to use a strategy called dollar cost averaging, where you invest a fixed $ amount every period, monthly, weekly, etc.
I didn’t want to make this post super long that you loose interest, so if you want to learn about dollar cost averaging, you can read my post here.
Let’s quickly turn to our fixed-income assets. The first one is bonds.
Bonds
Unlike stocks, if you buy a bond of a company, it doesn’t give you ownership in that company. Bonds are actually a loan a company takes to raise capital.
Both individual companies and the government need to raise money and thus, issue bonds. Thus, when we buy bonds, we get interest payments on the money we loan to a company or the government. Along with interest payments, at the end of our loan period called “term”, we also get our Principal amount back.
Bonds are part of fixed-income investments. As the name suggests, they give a fixed amount of income with regular interest payments until maturity.
Other fixed income assets include Certificates of deposits (CDs), municipal bonds, t-bills and t-bonds.
Just like stocks, we can invest in fixed-income securities directly, or through Electronically traded funds called ETFs and mutual funds or index funds.
As a bond owner, you bear less risk and you will get the interest amount, irrespective of how the company performs.
Thus, a good part of owning a bond is that, if a company does bad and goes bankrupt, the bondholders still will get their money back. The company can pay them by selling their assets such as their buildings, factories, etc.
However, this is not the case with shareholders. During bankruptcy, the stock price of the company crashes to a very low mark, and shareholders could lose all of their investments.
Treasury bonds are considered very safe investment options. It is like lending money to the US government.
Stocks usually pay more than a bond, but owning a stock is riskier than owning a bond. So, your decision to invest in stocks or bonds should depend on how quickly you want to grow your money and how much risk you are willing to take.
So which one should we invest in?
The answer is in everything. We all should have a diversified portfolio, consisting of stocks, bonds, and other assets, like commodities, real estate as well. Although this post covered investment in stocks and bonds, we can have a portfolio with more types of assets.
Your age and risk tolerance will determine the percentage of each asset you should keep in your portfolio. For younger people, investments in bonds shouldn’t be the main part of the portfolio, simply because they don’t pay as much as stocks do.
However, as we approach retirement age, our ability to bear risks falls. So, more investments in fixed-income assets like bonds, should be done later in life.
I hope you found this post useful. Stay tuned for my next post on asset allocation and diversification.
Disclaimer: The information presented here is for educational purposes only. I am not a financial advisor and do not provide investment advice. I recommend you consult a qualified financial advisor to make investment decisions.
