Investing is simply an attempt to use money to make more money over time. On this page you
certainly won't learn everything you need to know about investing, but you'll at least be
exposed to many of the major investment tools and strategies. With basic knowledge in hand,
you'll be able to see how you can use your money to grow create your retirement assets.
Investment concepts are deceptively simple - it is easy to learn the basics but very difficult
to master the details. It's recommended that you seek the advice of a professional financial planner
when it comes time to make your investment decisions.
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For most folks, their primary investment is their home. Everyone has to live somewhere,
the cost is a tax write-off, and real estate prices have grown steadily throughout history
(but not without some ups and downs).
The problem with using a house as an investment strategy to fund retirement is that
the house has to be sold in order to get the equity from it. Most folks would
like to stay in their house after retirement so selling it would be done only no
other sources of income are exhausted.
There are, of course, many exceptions to this generalization. Many folks have a
large equity in their home that is needed to fund retirement and selling the home to
gain access to the money is a key part of their strategy for funding retirement.
Aside from a home, there are four basic sources of income that are typically used
to finance retirement.
- Personal savings
- Social Security
- Employment (partial coverage of expenses)
Of these, only personal savings and pension funds are available for investing
by the retiree. Although the stock market gets a great deal of attention, it
is only one of many ways in which money may be invested. Other options include:
- Certificates of Deposits (CDs)
- Securities (stock, bonds, and mutual funds)
- Property (houses and commercial real estate which often escalate faster than inflation)
- Businesses (bought while under duress, brought to solvency, and then sold at a profit)
- Collectables (coins, paintings, gold, etc.)
Each of these are characterized by the returns they can earn, by the level of risk involved,
and by the type of special knowledge that is required to become a successful investor.
Of these, only CDs provide a guaranteed rate of return at no risk to the investor. The
return is usually in the 2%-4% range and the principal is insured by the US Government.
Other than the low interest rate, CDs also have the downside that the investment must
be left made for an extended period of time (months to years). The investment may
be cashed in early but with penalties for early withdrawal.
The other investment opportunities offer the potential for greater return on
investment but at greater risk - including possible loss of the investment money itself.
Property, businesses, and collectables are types of investments which require the investor
to develop very specialized knowledge and which may not be available in all locales. They
can be very risky but also can offer the greatest returns.
Because of the problems with the other types of investments, the vast majority of investors
choose to invest in securities. There are other advantages as well:
- Easy access (transactions are just a phone call or web site away)
- Inexpensive, readily available education (books, magazines, web sites, ...)
- Low entry fee (you can become an investor with just hundreds of dollars)
- Liquidity (part of all of the investment can be easily and quickly converted to cash)
While there is risk of losing the investment money it's more typical that securities
will gain money over long periods of time, at a greater rate than CDs. The value of securities
can move up and down daily but move in general trends over long periods of time. As you've
probably heard, the secret to success is to buy securities when they price is low then sell them
when their price is high - buy low, sell high.
If there is a sweet spot in the securities market, then 6%-10% tends to be the return on investment
that most investors are willing to accept. These figures exceed inflation by a respectable margin, which
is necessary for an the investment principal to grow, and are available from many securities
with acceptable risk.
For the protection of investors, the offer and sale of securities are managed by
government agencies. These agencies are discussed later in this page.
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These definitions are provided simply to help the beginning retirement investor. If
you're already familiar with the terminology of investment you can skip this section.
Investing simply means purchasing something today whose value you hope will increase in
the future. The word investment is used to refer to the item that was purchased.
For example, you buy a rare coin for $100 and hope that in a few years time you can sell the coin
(the investment) for more than the $100. It can be a little confusing because the transaction
itself (the purchase of the coin) is called an investment, whereas the coin itself is the investment.
The $100 you spend on the purchase may be called your capital or principal. The two words
don't mean exactly the same thing but are often used interchangeably to describe the amount
of money you have made in an investment.
If you sell the coin for $110 then you have made a profit of $10. The $10 is also known
as the interest you earned on the investment. The $10 is also sometimes referred to as capital gain
on the investment.
The ratio of profit to the original investment is 10/100 = 0.10 or 10%. The 10% is said to be your rate of
return or your interest rate. Both terms are used interchangeably.
- Investment - something purchased with the intent to sell at a price greater than the purchase price
- Principal - the amount of money you spend to purchase the investment
- Interest - the profit (in dollars) you gain from the sale of an investment
- Interest Rate - the profit ratio (expressed in %) of the interest divided by the principal
- Return on Investment - same as interest
- Rate of Return - same as interest rate
Even when an investment is not sold the terms can still be applied. For example, if an investment grows
in value (the price it could be sold for), it is said to have achieved a rate of return even though
the investment is not sold. It is common for investments to kept for years and the rate of return is
used as a measure of how well the investment is performing (growing in size).
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When a company needs financial help it can chose to borrow the money (such as from a bank) or they can
opt to raise funds by selling stocks in the company to investors. Stocks are simply a share in the
ownership of a company.
As a stockholder, an investor owns part of the company and as such has a claim on the company's
assets and earnings. If a company has sold 1000 share of stock, then the stockholder
owns 1/1000th of the company. It is not unusual for a company to have sold millions of shares.
The terms stocks and shares are used interchangably.
If the company makes a profit they distribute those earnings to stockholders in the form of a dividend -
a cash payment to the stockholder.
If the company is sold the profits on the sale are distributed to the stockholders (although, sometimes
the purchasing company offers their own stock in lieu of a cash payment).
The board of directors of a company are employed to manage the business, but the company is wholly owned
by its shareholders. Annual meetings of stockholders are held which allow the stockholders to meet with
the board and to voice their opinions on matters affecting the company. Issues vital to the company may
be presented to the stockholders for a vote, where ownership of a share entitles the shareholder to vote
on company matters in proportion to their share holding.
The word equity refers to ownership of something. For that reason stock are sometimes referred to as
equity stocks. It is also common for the word equity to used alone to mean stocks.
Companies start out as privately owned. "Going public" refers to the decision by the company to issue stock,
usually for the purpose of acquiring funds for expansion. The first sale of stock to the public is called
an Initial Public Offering (IPO).
Once stocks are sold to investors, the investors can trade (sell stocks to one another) without the
approval or intervention of the company who issued the stocks. These trades are made through
organizations known as exchanges. Most countries have one or more exchanges. Collectively
the exchanges are known as the secondary market to distinguish them from the sales of stocks directly
from the companies. Most of the world's share transactions take place in secondary markets.
Of the five most important exchanges in the world, three are in the U.S., one in England, and
one in Hong Kong.
- The New York Stock Exchange
Called the "Big Board", this is the largest and most prestigious exchange in the world.
It was founded in 1792 and is the home of the largest companies in America,
including General Electric, McDonald's, Citigroup, Coca-Cola, Gillette, and Wal-mart.
Trades between buyers and sellers are made in a NYSE facility (on the 'floor'). An NYSE
"specialist" acts as the facilitator between floor brokers, who represent buyers and sellers of
stocks (usually investment firms through whom individual investors normally operate).
Computers are used to confirm trades and are increasingly being used to replace
- The Nasdaq
The second largest exchange in the U.S. Unlike the NYSE, Nasdaq has no facilities.
It is an example of an over-the-counter (OTC) market, where trading is done via
computer and telecommunication networks. Once considered a lesser market, it is the home
of major technology companies such as Microsoft, Intel, and Cisco.
- American Stock Exchange (AMEX)
The third largest exchange in the U.S. It was bought out in 1998 by the same folks who
own Nasdaq (National Association of Securities Dealers). Almost all trading now on the AMEX
is in small-cap stocks and derivatives.
- London Stock Exchange
The major European stock exchange.
- Hong Kong Stock Exchange
The major Asian stock exchange.
There are a few other facts about the stock market that are worth knowing about:
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Rather than sell ownership through the sale of stocks, a company might choose to borrow the money instead.
A bond is simply a loan made to a company. Unlike a mortgage which uses payments to gradually retire the
debt, bonds issue regular interest payments (the interest rate is referred to as the coupon) to the bond
owner. The bond value (called the face value) is repaid to the lender on a specific date (called the
For example if you buy a bond with a face value of $1000, a coupon of 5% and a maturity of ten years
you will receive a check for $50 each year (actually, most bonds pay semi-annually) and at the end
of year ten you will get your $1000 back.
Bonds are known as fixed-income securities because you know the exact amount of cash you'll get back,
provided you hold the security until maturity.
Bonds are consider to be a debt security, rather than an equity security (stocks). Bonds do not provide
ownership in the company nor do they enable the bond holder to vote on company decisions as stockholders are allowed
The primary advantage of being a bond holder is that bonds have a higher claim on assets than that of shareholders.
In the case of bankruptcy a bondholder will get paid before a shareholder does. Likewise, the interest on the
bond is paid before dividends are issued to stockholders.
On the negative side, the bondholder does not share in profits. So if a company does very well the stockholder will
benefit whereas the bond holder will get limited (fixed) returns on their investments.
Investors chose bonds over stocks when they want to minimize risks. A bond, however, is not risk free. If a company
goes bankrupt there may or may not be enough assets to recover the price of the bonds. What is available goes to bond
holders before stockholders, but neither is guaranteed to recover their original investment.
Because of their greater stability, bonds are a favorite investment during retirement. Stocks are used to maximize
the net worth available at retirement, then the wealth is re-invested in bonds to stabilize the value. The use of
bonds to stabilize net worth is actually used at any time during an investor life where asset stability is valued
over potential growth - such as during times of fixed income (out of work, attending college, etc.).
As noted throughout this site, most personal financial advisors advocate maintaining a diversified portfolio - combining
stocks and bonds to meet the changing needs of investors throughout their lives. Generally, portfolios will contain
large amounts of stocks (equities) in an investor's early life, then shift into a majority of bonds at retirement to
provide less risky, fixed incomes.
Bonds are generally come in three varieties, according to their source - government, municipal, and corporate.
- Government Bonds
Bonds issued by the U.S. government are considered very safe. Debt of stable countries are also
considered safe. Developing countries also issues bonds, but which carry substantial risk.
There are three types of U.S. government bonds (fixed income securities), depending on their time to maturity.
Securities from the U.S. Government are known as Treasuries.
- maturing in less than one year. Also called T-Bills
- maturing in one to ten years.
- maturing in more than ten years.
- Municipal Bonds
Considered slightly more risky than treasuries, municipal bonds are issued by cities which rarely go bankrupt.
The major advantage municipal bonds (called 'munis') is that the returns are free from federal tax. Local
governments also sometimes make its debt non-taxable for residents, making some municipal bonds completely tax free.
These conditions can make municipal bonds a good investment for after-tax purchases.
- Corporate Bonds
A company can issue bonds just like it can issue stock. Because corporations are more likely to go bankrupt
than governments, they offer higher yields, particularly as the credit rating of the company goes down.
Corporate bonds are typically issued for <5, 5-12, and >12 years.
The decision making process for bonds is more complicated than that of buying/selling stocks. The following
factors are involved:
For bond buyers, yield is the primary criteria for making a purchase decision. You want to par as little as possible
of the par value of a bond.
- Face Value - the amount the bond can be cashed in for on maturity date (also called par value or principal)
- Price - the current value for which a bond can be bought/sold
- Coupon - periodic interest payment against the face value of a bond
- Yield - purchase price / face value
- Yield to Maturity - yield of the bond if held to maturity (calculation includes coupons received after purchase if the bond is held to maturity.
For bond owners, who are locked into the interest rate, high prices (low yields) are important to benefit from
sales of our bond in the future.
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A mutual fund is essentially a company which has purchased a collection of stocks and/or bonds. Investors
purchase shares in the mutual fund. A full-time, professional manager for the mutual fund uses the money
to invest in selected stocks and/or bonds. The investor is a part owner of the mutual fund, not of the
individual stocks or bonds that were purchased by the mutual fund manager.
The manager also is responsible for distribution of gains to the mutual fund stockholders.
Those gains can come from dividends on stocks and interest on bonds owned by the mutual fund. They can also come
from the sale of securities (stocks and bonds) that have increased in price since their purchase by the fund.
Just like stocks and bonds, mutual fund share prices vary with time and investors can buy/sell the shares just as they can
buy/sell stocks and bonds.
The availability of a professional manager is one reason investors turn to mutual funds. With a manager
in place, individuals do not have to personally oversee individual transactions. This service comes with
a fee but is considered by many to be worth the cost, particularly when spread out over a large group of
The more popular reason for owning mutual funds is to reduce risk through diversification. A mutual
fund manager invests in many stocks and bonds, reducing the risks that a failure of any one security
could significantly affect the mutual fund share values. It's not unusual for a mutual fund to own
hundreds of different securities - something an individual investor would not be able to do.
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A 401k program is a voluntary retirement plan in which individuals may invest a certain percentage of their pretax
pay. The invested money, and any growth from the investment, are not taxed until the funds are withdrawn.
The program is managed by the employee's company, but the employee is typically given various investment options
for managing their own funds.
Each company can set a limit on the amount of pre-tax money that can be put into a 401k program. Many companies
also chose to match some portion of their employee's contributions. Matching funds are essentially free money
and financial planners almost always recommend that an individual invest in the 401k program to at least the level
of matching provided by their employer.
The government places restrictions on when and how funds can be withdrawn from a 401k program.
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Not everyone has access to a company provided 401k program. For such cases there are
a variety of Individual Retirement Accounts (IRAs), each offering different tax and
income benefits. Like 401k programs, growth from the investments in an IRA are not
taxed until the funds are withdrawn. However, the various IRA types have different
rules on whether pre- or post-tax pay may be contributed to the accounts. There are
many other differences as well - enough to recommend the use of a professional
financial planner to help determine which IRA can fit into your retirement plan.
- Traditional IRAs
- Roth IRAs
- SEP IRAs
- SIMPLE IRAs
IRAs must be established with an institution that has received IRS approval to offer IRAs.
These include banks, brokerage companies, federally-insured credit unions, saving & loan associations,
and any other IRS-approved institution.
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Certificates of Deposit (CDs) are essentially savings accounts which earn a fixed
interest. CDs offer slightly higher interest than savings accounts but also require
that the deposit be left for a specified time, ranging from 6 months to 10 years or more.
If the deposit is removed early, a penalty is paid which can significantly reduce the
rate of return on the CD.
CDs offer the lowest of all major investment strategies, with rates of return only in the
2%-4% range. However, they are insured against loss by the U.S. government, so they are also the
safest investment strategy.