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Bonds – Debt
Grouped under the general category called fixed-income securities, the term bond is commonly used to refer to any securities that are founded on debt. When you purchase a bond, you are lending out your money to a company or government. In return, they agree to give you interest on your money and eventually pay you back the amount you lent out.
The main attraction of bonds is their relative safety. If you are buying bonds from a stable government, your investment is virtually guaranteed, or risk-free. The safety and stability, however, come at a cost. Because there is little risk, there is little potential return. As a result, the rate of return on bonds is generally lower than other securities. (The Bond Basics tutorial will give you more insight into these securities.)
Stocks – Equity
When you purchase stocks, or equities, as your advisor might put it, you become a part owner of the business. This entitles you to vote at the shareholders’ meeting and allows you to receive any profits that the company allocates to its owners. These profits are referred to as dividends.
While bonds provide a steady stream of income, stocks are volatile. That is, they fluctuate in value on a daily basis. When you buy a stock, you aren’t guaranteed anything. Many stocks don’t even pay dividends, in which case, the only way that you can make money is if the stock increases in value – which might not happen.
Compared to bonds, stocks provide relatively high potential returns. Of course, there is a price for this potential: you must assume the risk of losing some or all of your investment. (For additional reading, see Stock Basics tutorial and Guide to Stock Picking Strategies.)
Mutual Funds
A mutual fund is a collection of stocks and bonds. When you buy a mutual fund, you are pooling your money with a number of other investors, which enables you (as part of a group) to pay a professional manager to select specific securities for you. Mutual funds are all set up with a specific strategy in mind, and their distinct focus can be nearly anything: large stocks, small stocks, bonds from governments, bonds from companies, stocks and bonds, stocks in certain industries, stocks in certain countries, etc.
The primary advantage of a mutual fund is that you can invest your money without the time or the experience that are often needed to choose a sound investment. Theoretically, you should get a better return by giving your money to a professional than you would if you were to choose investments yourself. In reality, there are some aspects about mutual funds that you should be aware of before choosing them, but we won’t discuss them here. (You can, check out the details in the Mutual Fund Basics tutorial.)
You might be familiar with the risk-reward concept, which states that the higher the risk of a particular investment, the higher the possible return. But, many investors do not understand how to determine the level of risk their individual portfolios should bear. This article provides a general framework that any investor can use to assess his or her personal level of risk and how this level relates to different investments.
Risk-Reward Concept
This is a general concept underlying anything by which a return can be expected. Anytime you invest money into something there is a risk, whether large or small, that you might not get your money back. In turn, you expect a return, which compensates you for bearing this risk. In theory the higher the risk, the more you should receive for holding the investment, and the lower the risk, the less you should receive.
For investment securities, we can create a chart with the different types of securities and their associated risk/reward profile.
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Although this chart is by no means scientific, it provides a guideline that investors can use when picking different investments. Located on the upper portion of this chart are investments that offer investors a higher potential for above-average returns, but this potential comes with a higher risk of below-average returns. On the lower portion are much safer investments, but these investments have a lower potential for high returns.
Determining Your Risk Preference
With so many different types of investments to choose from, how does an investor determine how much risk he or she can handle? Every individual is different, and it’s hard to create a steadfast model applicable to everyone, but here are two important things you should consider when deciding how much risk to take:
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Investment Risk Pyramid
After deciding on how much risk is acceptable in your portfolio by acknowledging your time horizon and bankroll, you can use the risk pyramid approach for balancing your assets.
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This pyramid can be thought of as an asset allocation tool that investors can use to diversify their portfolio investments according to the risk profile of each security. The pyramid, representing the investor’s portfolio, has three distinct tiers:
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Personalizing the Pyramid
Not all investors are created equally. While others prefer less risk, some investors prefer even more risk than others who have a larger net worth. This diversity leads to the beauty of the investment pyramid. Those who want more risk in their portfolios can increase the size of the summit by decreasing the other two sections, and those wanting less risk can increase the size of the base. The pyramid representing your portfolio should be customized to your risk preference.
It is important for investors to understand the idea of risk and how it applies to them. Making informed investment decisions entails not only researching individual securities but also understanding your own finances and risk profile. To get an estimate of the securities suitable for certain levels of risk tolerance and to maximize returns, investors should have an idea of how much time and money they have to invest and the returns they are looking for.
by Investopedia Staff
Basic Types of Portfolios
In general, aggressive investment strategies – those that shoot for the highest possible return – are most appropriate for investors who, for the sake of this potential high return, have a high risk tolerance (can stomach wide fluctuations in value) and a longer time horizon. Aggressive portfolios generally have a higher investment in equities.
The conservative investment strategies, which put safety at a high priority, are most appropriate for investors who are risk averse and have a shorter time horizon. Conservative portfolios will generally consist mainly of cash and cash equivalents, or high-quality fixed-income instruments.
To demonstrate the types of allocations that are suitable for these strategies, we’ll look at samples of both a conservative and a moderately aggressive portfolio.
Note that the terms cash and the money market refer to any short-term, fixed-income investment. Money in a savings account and a certificate of deposit (CD), which pays a bit higher interest, are examples. (You can read more about the money market in the Money Market Tutorial.)
The main goal of a conservative portfolio strategy is to maintain the real value of the portfolio, or to protect the value of the portfolio against inflation. The portfolio you see here would yield a high amount of current income from the bonds and would also yield long-term capital growth potential from the investment in high quality equities.
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A moderately aggressive portfolio is meant for individuals with a longer time horizon and an average risk tolerance. Investors who find these types of portfolios attractive are seeking to balance the amount of risk and return contained within the fund.
The portfolio would consist of approximately 50-55% equities, 35-40% bonds, 5-10% cash and equivalents.
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You can further break down the above asset classes into subclasses, which also have different risks and potential returns. For example, an investor might divide the equity portion between large companies, small companies and international firms. The bond portion might be allocated between those that are short-term and long-term, government versus corporate debt, and so forth. More advanced investors might also have some of the alternative assets such as options and futures in the mix. As you can see, the number of possible asset allocations is practically unlimited.
Why Portfolios?
It all centers around diversification. Different securities perform differently at any point in time, so with a mix of asset types, your entire portfolio does not suffer the impact of a decline of any one security. When your stocks go down, you may still have the stability of the bonds in your portfolio.
There have been all sorts of academic studies and formulas that demonstrate why diversification is important, but it’s really just the simple practice of “not putting all your eggs in one basket.” If you spread your investments across various types of assets and markets, you’ll reduce the risk of catastrophic financial losses.
We’ve introduced many topics in this tutorial:
- Investing is about making your money work for you.
- Reinvesting your earnings allows you to take advantage of compounding.
- Each investor is different in his or her objectives and risk tolerance.
- There isn’t just one strategy that can be used to invest successfully.
- Each investment vehicle has its own unique characteristics.
- Diversifying investments in a portfolio helps to manage risk.
Together, all these points make up a foundation of knowledge with which any investor should be comfortable. However, these concepts mean nothing unless you can put them into practice. It’s great to know that compounding accelerates your investment earnings, but the real question is how do you take advantage of compounding and actually make money? In this section we’ll go over an example that demonstrates how to put all of what you’ve learned into action.
The Strategy
For our example, let’s look at a fictional investor named Melanie. Melanie is a twenty-something who is relatively new to investing. Melanie knows that she wants to invest, but isn’t sure just how to do it. Her knowledge of finances is good, but she has no desire to spend her free time poring over financial statements (or losing sleep because of her investments).
After checking out this tutorial and reading more about stocks and mutual funds, Melanie learns that there are two basic styles of portfolio management: passive and active. Each of these styles results from a different approach to the market. The goal of active management is to select securities that will perform better than the overall market. For example, when a mutual fund manager analyzes a company’s financial statements to determine if the stock is suitable for the fund, he or she is actively managing the portfolio.
A passive investor on the other hand has no desire to try to beat the market. Instead, relying on the stock market’s history of increasing over the long term, the passive investor, perhaps believing that trying to beat the market is too much work or even futile, will simply purchase a security such as an index fund, which mirrors a benchmark used to track the performance of a market.
Melanie decides that passive investing is more her style, so her investment vehicle of choice is the S&P 500 index fund. This is a mutual fund that is indexed to the S&P 500, which is composed of the 500 largest companies in the U.S.
Why an index fund?
- Buying an index fund is passive investing, so Melanie is still free to have a life and doesn’t have to worry about picking stocks.
- Melanie gets instant diversification (because the fund owns many different kinds of stocks) without having to invest huge sums of money. Most index funds can be set up with an investment of $1,000 or less.
- Most importantly, the fees are far less than the cost of the average mutual fund. These lower fees are another advantage of passive investing. Because the fund does not have to pay some hotshot (and expensive) MBA fund manager to pick stocks, an index fund is often cheaper than any other mutual fund. (For more on this, see the Index Investing tutorial.)
Melanie doesn’t just stop with her initial purchase. She uses an automatic payment plan with which she invests 10% of her paycheck every month. Investing a fixed amount every single month makes use of dollar cost averaging. By putting in, say, $100 each month (rather than a large amount once a year), Melanie sometimes buys when the prices of the units of the fund are higher, and sometimes when prices are lower. In the end, the purchase prices average out. The best thing about dollar cost averaging, though, is that it gets Melanie into the habit of saving every single month. Just about any fund company or bank will let you invest like this with an automatic payment plan.
Putting the Concepts to Work
And that’s about all there is to it. It’s pretty simple stuff, actually. And despite the ease of setting up a strategy like this, it allows Melanie to follow all the principles we’ve been discussing:
- Her money is definitely being put to work, and she is becoming part owner of the 500 biggest companies in the U.S.
- With no additional work on her end, she can reinvest all the money that gets paid out in dividends, which allows her to see the benefits of compounding over time, even more so if she sets this fund up in a retirement plan that allows her investment to grow without being taxed immediately
- It’s easy! This fits Melanie’s preference to avoid the work of picking stocks. Those who do want to develop an eye for stocks, however, can get started with an index fund and then eventually work their way into more active strategies over time. (For further reading, see Guide to Stock Picking Strategies.)
- A strategy like this can be molded to meet an investor’s objectives and asset allocation. In Melanie’s case, she has a time horizon of more than 20 years, so she is comfortable being completely in equities. If an investor is not comfortable with being just in stocks, it’s easy enough to buy a bond index fund. It would still offer the low costs of indexing, and allow you to customize your asset allocation. (For more on this, see Being Lazy With A Couch Potato Portfolio.)
Please remember the above points are not meant to give you personal advice. We’ve already talked about how there is no one-size-fits-all approach. The point of this example is to give you a more tangible look at how an investor might implement the ideas discussed in this tutorial.
Perhaps most importantly, indexing in the long term doesn’t do any damage. There are plenty of ways to lose money, whether in speculative investments or through excessive fees in mutual funds. On the other hand, it’s possible to be too risk averse. If you put your savings under a mattress, we guarantee it’s not going to increase in value.
There are many other alternatives out there. We strongly encourage you to explore them and see what works for you. But, for the average investor, the smart route includes saving regularly, keeping investment expenses down and being in the market for the long term. Whatever you do, keep the principles we’ve discussed in mind, and never stop trying to learn more.
