savings account, certificate of deposit, or a money market mutual fund.) We cover each in our first Baseline Basics call-out box.
Baseline Basics: Understanding the Asset Classes
To be a successful investor, you need to be an informed investor. For starters, you should have a basic understanding about the risks and rewards of three fundamental asset classes—stocks, bonds, and cash instruments. We'll discuss the asset classes in more detail further on in this book, but for now, an introduction is sufficient.
Asset classes
An asset is simply something of monetary value. In finance, asset classes are types of investments that offer different combinations of risks and rewards.
Stocks
Stocks represent ownership. If you own a share of Google stock, then you are a part-owner of Google. That gives you the right to vote on certain policy issues, and it means that you share in the company's business results. If the company does well, you can benefit in two ways: (1) The value of your stock rises, so you could sell it at a profit if you so desire, and (2) The company passes along profits to you and the other owners in the form of a dividend. On the other hand, if the company does poorly, your stock can fall in value and dividend payouts can be cut or ceased altogether. In the worst case, the company could go bankrupt and leave your stock utterly worthless.
What makes a company do well or poorly? There are many variables. A company with prudent management, a sound business strategy in an attractive industry, and high-quality products or services that steadily sell is likely to do well. But other, external forces will also affect a company's prospects. These forces include interest rates and other economic factors, new technologies, competition, government regulation and legislation, and customer preferences. In addition to all those pragmatic influences, a company's stock can rise or fall due to investor sentiment, which is fickle and more difficult to forecast than the weather. In addition, even the smartest company leaders can make mistakes that affect the stock price. As such, many people view stocks as the riskiest investment among the three asset classes.
Stocks are risky—over the short term. As traders constantly second-guess each other about market trends and analysts make predictions, stock prices jump around from day to day and month to month. However, over long periods, stocks as a group have rewarded investors more than any other investment. Since 1926 through 2019, stocks have provided average annual returns of 10.3% a year.
A final note: Stocks are often called equities.
Bonds
A bond is essentially an IOU. When you buy a bond, you are lending your money to the issuer, typically a company, a government agency, or state or local municipality. The issuer is promising to pay you a stated amount of interest on the loan and to return the money at a certain time (the maturity date). When you buy a typical bond, you know in advance how much money you are going to receive in interest and when it is going to come; that's why bonds are called fixed income investments. (You'll often hear a bond's interest rate called the coupon—a term dating to when investors actually clipped coupons from paper bonds and presented them to get their interest.)
Though bond holders are creditors, rather than owners, they care about the soundness of the company or agency that issued the bond because that affects their prospects for payment of interest and repayment of principal at maturity. U.S. Treasury bonds are considered the safest investment in the world because they are backed by the full faith and credit of the U.S. government. Most established companies can be counted on to pay the interest on their bonds and repay the principal at maturity, no matter how their stock prices are faring.
Retirees who need a steady source of income tend to favor bond investments because of the periodic interest payments they provide. But you don't have to be a retiree to appreciate the stabilizing force that bonds can provide in an investment portfolio. As I'll explain later, many stock investors also hold bonds to help smooth out the inevitable fluctuations in the value of their overall investment portfolios.
But bonds have risks. The worst-case scenario is default: The bond issuer runs into trouble and can't pay you the promised interest or return your principal. Fortunately, defaults are relatively uncommon. A much more immediate risk involves bond prices. Existing bonds are constantly being traded on the market, and their value changes along with market interest rates. That's no problem for you if you don't need to sell your bond before its maturity date, but for those who do need to sell, the changing prices can result in losses. Also, if you invest in a bond mutual fund, your share price and the income payments you receive will fluctuate based on the ups and downs of the underlying bonds and as the fund buys and sells its holdings.
Finally, there is the invisible risk of inflation. There have been periods when the interest paid on bonds did not keep up with rising prices, so that bond investors were steadily losing purchasing power. At one point in the 1970s, bonds were facetiously known as certificates of confiscation.
Cash
You may think of cash as the bills in your wallet, your Venmo balance, or change in your car's cup holder, but it's something a little different in investing. Cash investments are very short-term IOUs issued by governments, corporations, banks, or other financial institutions. Bank deposit accounts and money market mutual funds are among the most popular forms of cash investments. Cash investments have been the least volatile of the three major asset classes historically, which means they are a safer choice than stocks or bonds if your biggest priority is not losing money. But they have also provided the lowest returns. Cash investments are said to have good liquidity because it's generally possible to withdraw your cash immediately and without penalty, but their disadvantage is that they will provide a return that keeps you just about in line or maybe slightly above inflation. While cash investments are a useful vehicle for emergency funds or money that will be needed just around the corner, they don't belong in your long-term investment account.
As you can see, there are trade-offs with each of the asset classes, so you'll need to set your objectives before deciding how to invest. If you want to reach for the greater potential returns that are offered by stocks, you must be willing to also accept their increased risk. If you want to opt for the greater safety of cash instruments, you must be willing to accept lower returns.
You need to know a little about some of the places to invest, including banks, mutual fund providers, financial advisors, and brokerage firms. You'll need to understand the benefits of tax-advantaged accounts, such as IRAs and 401(k) plans. In this book, I'll explain why mutual funds and exchange-traded funds (ETFs) are the best long-term investment vehicles for the bulk of your serious money. Chapter 8 is devoted to a full explanation of funds and ETFs.
You need to know what risk means. And here's a case where many people assume they already know all about it. But as we'll see, in investing, the obvious risk isn't always the most dangerous one.
You need to know yourself as an investor. You can make all kinds of wise investments and adhere to a sound long-term strategy, but still find yourself unable to sleep at night for worry when the markets are down. Life is too short for that! There are many ways for you to invest at a level of risk with which you can live, and I'll be discussing them in Chapter 11.
