Investing Basics

Investing means using the money you have to build a portfolio of assets that you expect to grow in value over time, provide current income, or, in some cases, provide both growth and income. Done wisely, investing can help you meet your financial goals—paying for a college education, enjoying a comfortable retirement, buying a home, or whatever is important to you.

Investing even a small amount on a regular basis has the potential to produce positive results over the long term. For example, investing just $96 a week for 30 years can add up to more than $400,000 if you have an average annual return of 6%. Return, which is typically reported as a percentage of the amount you invested, is the combination of change in an investment’s market value, up or down, plus any income it has provided.

There are two things to keep in mind about return:

• It isn’t guaranteed. While it could be 6% or higher, it could also be less, or even negative, in some years, reducing the annual average.
• To select investments to meet your goals, you need to understand what the choices are, the return that’s possible with different choices, and the risks you’ll take.

Investment Overview

There are three core investment categories, called asset classes: stocks, bonds, and cash.

• Stocks are ownership shares in a corporation.
• Bonds are loans to a corporation or government.
• Cash investments include certificates of deposit (CDs) and US Treasury bills.

To invest, you typically buy and sell through a brokerage firm account. In some cases, you can buy directly from the issuer. In others, you invest through an account in a plan offered by your employer or the state where you live.

You can purchase individual investments or invest indirectly by choosing mutual funds or exchange traded funds (ETFs) that own stocks, bonds, or cash—or sometimes a combination of asset classes. The combination of assets you own makes up your investment portfolio.

Investment Accounts

Just as there are different types of investments, there are different types of investment accounts.

You can invest as much as you can afford in a taxable account each year, purchase any investments you choose, and withdraw as you wish. You pay tax on investment earnings and on capital gains from selling investments for more than you paid to buy them. Most dividends and all capital gains on investments you’ve owned for more than a year are taxed at a lower federal rate than your ordinary income.

You may have tax-deferred accounts for your retirement savings. You pay no tax on earnings in these accounts as they accumulate and, in many cases, no tax on the money that’s invested. The amount you can invest is subject to an annual cap, which is adjusted from time to time to reflect inflation. When you take money out, usually after you retire, it’s taxed at the same rate you pay on your ordinary income. Annual withdrawals are mandatory after you turn 73, and there’s a penalty if you withdraw before 59½.

You may choose tax-exempt accounts to invest for retirement, education, or healthcare expenses. You invest after-tax income in all except a healthcare account. If you follow the rules, no tax is due on the earnings as they accumulate or when you withdraw. But, there may be restrictions on how much you can invest each year and how you use the withdrawals.

Choosing Investments

As you evaluate an investment for your portfolio, you consider it on its own merits and how it complements the investments you already own. For example, if you hold a number of stocks issued by large, well-known companies, you may decide to choose the stock of a smaller or newer company to add variety.

You’ll also want to consider a number of personal factors, including your financial goals, your time frame, and your risk tolerance, as you make your selections. For example, a stock mutual fund that’s appropriate for a retirement account may not be a good choice when you’re trying to accumulate a down payment for a home.

The issues in this case are liquidity and volatility. The term liquidity refers to how quickly you could convert an investment to cash with little or no loss of value. Volatility is a measure of how quickly and how often an investment’s price changes. You don’t need liquidity in a retirement account, but you probably do in an account you’re planning to withdraw from in the near future. Since volatility tends to flatten out over time, it’s not a concern in retirement accounts but is if you have a short time frame.

You’ll also want to look at an investment’s risk/return profile. In brief, that is the level of return can you expect for the degree of risk you are taking. For example, insured bank investments pose very limited risk, but they tend to provide a smaller return than investments, such as stocks, that expose you to more risk. Conversely, taking more risk means greater potential return.