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Education > Introduction to Investment
INVESTMENT BASICS

To cover the fundamental investment concepts you will need to understand to make basic decisions about your portfolio. These include:

  Risk vs. Return
  Your Time Horizon
  Diversification
  Economics
  Investment Returns
  Evaluating Your Portfolio


RISK VERSUS RETURN TRADEOFF

Investment vehicles vary in terms of risk, from the safer money market securities to the highly volatile futures and commodity offerings. In general, the amount of risk investors take will correspond with the return they can potentially earn. In other words, high risk generally correlates with high return and lower risk with lower return. Where an investor's portfolio falls on the risk spectrum should reflect the particular investor's:

  Long term goals
  Immediate need for money
  Age 
  Risk tolerance

Investing should not be considered a gamble - with careful planning it is possible to both manage your risk and make money.


UNDERSTANDING YOUR TIME HORIZON

When you're investing for a specific goal, like college or retirement, the amount of time that stands between now and the date you'll need the money will help determine your investment strategy. The reason time horizon plays such a big part in investing is that investments that fluctuate in value have the potential to produce larger returns over time.

If you can tolerate a high degree of fluctuation-that means leaving the money invested through all the ups and downs-you can seek greater potential returns. Then as you move closer to your goal, you can begin to move the money into more stable investments so the money will be there when you need it.

Generally, stocks produce higher returns with greater fluctuation, bonds offer moderate returns with little or no fluctuation, and cash generates low returns with zero fluctuation. Although investment returns can never be predicted in advance, it's helpful to make some assumptions so you'll know how much you need to save and invest to reach your goal. Some common assumptions in use today are 12% returns for stocks, 8% for bonds, and 4% for cash.


DIVERSIFICATION REDUCES RISK

If there’s one thing just about everybody in the investment world agrees upon, it's the benefits of diversification. Simply stated, diversification involves spreading your money around instead of plunking it all into a single investment. Why do this? Because the investment you think will do the best may not. Investments produce varying returns, and by having your money spread out, you reduce the risk of concentrating too much of your portfolio in the wrong one.


UNDERSTANDING REAL-WORLD ECONOMICS

Once you start investing, you will see that real-world economics can be much more fascinating than the theoretical kind. The key concepts you should know as an investor are the economic activity, interest rates and bonds, interest rates and stocks, inflation rates, unemployment rates and information sources.


INVESTMENT RETURNS

When you make an investment, you are buying a security that either promises, or offers the potential, to generate cash. This cash is considered the return on your investment. The type of cash an investment generates can tell you a lot about how certain the returns are and how much risk is involved.

Yield
The word "yield" is primarily used by banks to describe the amount of interest you'll receive on a certificate of deposit or other type of account. There's little guesswork here. The bank tells you in advance what you'll be earning, and you can pretty much count on it.

Interest
This is similar to yield. In the investment world it refers primarily to bonds. If you buy a $10,000 bond that pays Bo/o interest, you'll receive interest payments of $800 per year until the bond matures, at which time you get your $10,000 back. In most cases the interest amount is stated in advance, so you know going in what your return on investment will be.

Dividends (stocks)
A stock dividend is a quarterly check that some companies pay to shareholders. Dividends are declared each quarter and can go up or down but usually don't change very much. Similar to bond interest, you can usually count on stock dividends, especially when you invest in large, established companies that take their responsibilities to shareholders seriously. Compared to capital gains (see below), dividends usually represent a very small part of a shareholder's overall return on investment. High-growth companies generally don't pay dividends at all, preferring to reinvest any extra cash back into the company.

Capital gains

This is the most lucrative part of investing. It's also the most uncertain. If you buy 100 shares of a stock at $25 and sell those shares at $40, you're investing $2,500 and getting back $4,000, minus trading costs. The difference of $1,500 is called a capital gain. The opposite of a capital gain is a capital loss. This would happen if you bought the stock at $25 and sold it for $15. Whenever you invest in a stock, you can never know in advance what your capital gain (or loss) will be. This is the part that scares people about stocks. It's also where your research will come in handy. But the fact remains that no amount of knowledge will enable you to predict stock prices in advance. Investing in stocks is always based on an educated guess; it's never a sure thing.

Dividends (mutual funds)
Some mutual funds call their distributions to shareholders "dividends," even though they are primarily made up of capital gains from the sale of stocks in the portfolio. These "dividends" cannot be estimated in advance and are just as uncertain as any capital gain (or loss) you might receive from owning individual stocks.

Total return
This is all the money you end up with. In the case of stocks, it's the combination of dividends and capital gains. In the case of bonds, it's interest and capital gains.


HOW TO EVALUATE YOUR PORTFOLIO

When considering which type of financial product to purchase, it is important to first calculate how the assets you currently own are distributed. This is a relatively simple calculation.

1- First find the total value of your portfolio.
2- Divide that number by the value of your holdings in each asset class.
3- This will give you a percentage of the total you have devoted to each particular class.
4- Based on what you have learned about the different asset classes and then factoring in your own investment objectives,
you should be able to make informed decisions about where to invest your dollars going forward.

Let's look at an example. A portfolio is worth $100,000 and contains only stocks and mutual funds. The stock value is nearly $75,000, whereas the mutual funds are at $25,000. That means that the total portfolio is weighted very heavily in stocks in relation to other holdings - 75o/o to 25o/o to be precise. If what the investor is looking for is an aggressive strategy and has a high-risk tolerance this may be an appropriate strategy. If, on the other hand, the investor is looking to invest more conservatively, then reconsidering the weighting of the portfolio is in order.


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