higher risk of default and the higher likelihood that you’ll lose your investment.
Longer-term maturity, which compensates for the risk that you’ll be unhappy with the bond’s interest rate if interest rates move up.
Callability, which retains an organization’s or company’s right to buy back (pay off) the issued bonds before the bonds mature.
Companies like to be able to pay off early if they’ve found a cheaper way to borrow the money. Early payback is a risk to bondholders because they may get their investment money returned to them when interest rates have dropped.
Diversifying: A smart way to reduce risk
Diversification is one of the most powerful investment concepts. It requires you to place your money in different investments with returns that aren’t completely correlated. Now for the plain-English translation: With your money in different places, when one of your investments is down in value, the odds are good that at least one other is up.
You can look at the benefits of diversification in two ways:
Diversification reduces the volatility in the value of your whole portfolio. In other words, when you diversify, you can achieve the same rate of return that a single investment can provide but with reduced fluctuations in value.
Diversification allows you to obtain a higher rate of return for a given level of risk.
Chapter 2
Fund Pros and Cons
IN THIS CHAPTER
I’m not sure where the mutual in mutual funds comes from; perhaps it’s so named because the best funds allow many people of differing economic means to mutually invest their money for:
Easy diversification
Access to professional money managers
Specific investment objectives in particular types of securities
No matter where the word came from, mutual funds and exchange-traded funds, like any other investment, have their strengths and weaknesses that you need to know about before you invest your money. This chapter discusses the advantages and disadvantages of funds.
Getting a Grip on Funds
A mutual fund is a collection of investment money pooled from many investors to be invested for a specific objective. When you invest in a fund, you buy shares and become a shareholder of the fund. The fund manager and a team of assistants determine which specific securities (for example, types of stocks or bonds) they should invest the shareholders’ money in to accomplish the objectives of the fund and keep shareholders happy.
A misconception some investors hold regarding mutual funds is that they all invest in stocks and, therefore, are too risky. They don’t, and they’re not. By using funds, you can invest in a whole array of securities, ranging from money market funds to bonds, stocks, and even real estate. And even within a specific class of investments such as stocks, which have greater short-term volatility, there’s a range of different types of stocks and therefore risk.
All funds aren’t created equal. Some funds, such as money market funds, carry virtually zero risk that your investment will decline in absolute value (but the purchasing power could indeed be eroded by inflation). Bond funds that invest in shorter-term bonds don’t generally budge by more than several percentage points per year. And you may be surprised to find out in Chapter 13 that some conservative stock funds aren’t that risky if you can plan on holding them for a decade or more.
They allow you to diversify your investments — that is, invest in many different industries and companies instead of in just one or two; and funds let you achieve this diversification with small dollar amounts — something that wouldn’t be possible otherwise. By spreading the risk over a number of different securities representing different industries and companies, funds lessen your portfolio’s instability and the chances of a large permanent loss.
They enable you to hire the best money management firms and managers in the country to manage your money.
They are the ultimate couch potato investment! However, unlike staying home and binge watching your favorite series or playing video games, investing in funds can pay you big financial rewards.
What’s really cool about funds is that when you understand them, you realize they can help you meet many different financial goals. Maybe you’re building up an emergency savings stash of three to six months’ living expenses (a prudent idea, by the way). Perhaps you’re saving for a home purchase, retirement, or future educational costs. You may know what you need the money for, but you may not know how to protect the money you have and make it grow.
Don’t feel badly if you haven’t figured out a long-term financial plan or don’t have a goal in mind for the money you’re saving. Many people don’t have their finances organized, which is why I write books like this one! I talk more specifically in Chapter 3 about the kinds of goals funds can help you accomplish.
Financial intermediaries
A
