Investing your money basics
Learn the basics of investing with these tips on how to make money in stocks, bonds and mutual funds.
1. Over the long term, stocks have historically outperformed all other investments.
Stocks have historically provided the highest returns of any asset class -- close to 10% over the long term. The next best performing asset class is bonds. Long-term U.S. Treasurys have returned an average of more than 5%.
2. Over the short term, stocks can be hazardous to your financial health.
On Dec. 12, 1914, stocks experienced the worst one-day drop in stock market history -- 24.4% . Oct. 19, 1987, the stock market lost 22.6%. More recently, the shocks have been prolonged and painful: If you had invested in a Nasdaq index fund around the time of the market's peak in March 2000 you would have lost three-fourths of your money over the next three years. And in 2009, stocks overall lost a whopping 37%.
3. Risky investments generally pay more than safe ones (except when they fail).
Investors demand a higher rate of return for taking greater risks. That's one reason that stocks, which are perceived as riskier than bonds, tend to return more. It also explains why long-term bonds pay more than short-term bonds. The longer investors have to wait for their final payoff on the bond, the greater the chance that something will intervene to erode the investment's value.
4. The biggest single determiner of stock prices is earnings.
Over the short term, stock prices fluctuate based on everything from interest rates to investor sentiment to the weather. But over the long term, what matters are earnings.
5. A bad year for bonds looks like a day at the beach for stocks.
In 1994, intermediate-term Treasury securities fell just 1.8%, and the following year they bounced back 14.4%. By comparison, in the 1973-74 crash, the Dow Jones industrial average fell 44%. It didn't return to its old highs for more than three years or push significantly above the old highs for more than 10 years.
6. Rising interest rates are bad for bonds.
When interest rates go up, bond prices fall. Why? Because bond buyers won't pay as much for an existing bond with a fixed interest rate of, say, 5% because they know that the fixed interest on a new bond will pay more because rates in general have gone up.
Conversely, when interest rates fall, bond prices go up in lockstep fashion. And the effect is strongest on bonds with the longest term, or time, to maturity. That is, long-term bonds get hit harder than short-term bonds when rates climb, and gain the most when rates fall.
7. Inflation may be the biggest threat to your long-term investments.
While a stock market crash can knock the stuffing out of your stock investments, so far -- knock wood -- the market has always bounced back and eventually gone on to new heights. However, inflation, which has historically stripped 3.2% a year off the value of your money, rarely gives back what it takes away. That's why it's important to put your retirement investments where they'll earn the highest long-term returns.
8. U.S. Treasury bonds are as close to a sure thing as an investor can get.
The conventional wisdom is that the U.S. government is unlikely ever to default on its bonds - partly because the American economy has historically been fairly strong and partly because the government can always print more money to pay them off if need be. As a result, the interest rate of Treasurys is considered a risk-free rate, and the yield of every other kind of fixed-income investment is higher in proportion to how much riskier that investment is perceived to be. Of course, your return on Treasurys will suffer if interest rates rise, just like all other kinds of bonds.
9. A diversified portfolio is less risky than a portfolio that is concentrated in one or a few investments.
Diversifying -- that is, spreading your money among a number of different types of investments -- lessens your risk because even if some of your holdings go down, others may go up (or at least not go down as much). On the flip side, a diversified portfolio is unlikely to outperform the market by a big margin.
10. Index mutual funds often outperform actively managed funds.
In an index fund, the manager sets up his portfolio to mirror a market index -- such as Standard & Poor's 500-stock index -- rather than actively picking which stocks to purchase. It is surprising, but true, that index funds often beat the majority of competitors among actively managed funds. One reason: Few actively managed funds can consistently outperform the market by enough to cover the cost of their generally higher expenses.