Last segment we discussed in very general terms considerations for building an investment strategy. In this segment we will build on that by being a bit more specific in how you can apply those building blocks given an infinite number of investment choices.
Because we want to stay relatively simple here we will skip all the exotic investments and focus on three major types: Stocks, Bonds, and Cash.
When you own stock in a corporation you literally own a part of that company. It may only be a few shares and therefore a very small part, but it’s part ownership nonetheless. That doesn’t mean that you can go into the headquarters and start telling the CEO what to do or carry out a computer since you technically own part of the company, it simply means that you have a share in the present and future earnings.
In very broad terms, if the corporation has positive net income then the shareholders may be paid a dividend, which is a portion of the net income of the company on a per share basis. There are different types of stock, but the type we are most interested in is common stock. Common stock not only has the potential to earn dividends, but common shareholders may also vote on certain things within the company. You may also hear stocks called “equities” because owning stock implies that you have equity in the company.
There are all sorts of methods for valuing stocks to determine if they’re over valued or undervalued, however those are beyond the scope of this discussion. There are many different classes (e.g. small cap, mid cap, large cap, growth, income, etc.) of common stock that have different levels of risk associated with them. We will discuss these classes more when we talk about diversification and risk management.
Also called “debt instruments”, bonds are basically how companies and all levels of government borrow money. Essentially when you buy a bond you are loaning money and in return you will theoretically receive interest payments plus your original principal (the amount you “loaned”) back when the bond matures. In practice bonds are rarely purchased and held to maturity, they are generally bought and sold on the secondary market many times over throughout the life of the bond, which means that even the face value of the bond can fluctuate in value. This is a profound oversimplification of how bonds work and as with stocks there are valuation methods for determining whether a particular bond is a good purchase or not, but at least you have a basic understanding of the difference between stocks and bonds which is all you need for our purposes.
In the context of personal finance when someone says they have a certain percentage of cash in their portfolio it doesn’t mean that they have it stuffed in their mattress, it simply means that they are invested in a “cash” type investment. These are usually characterized by the fact that the principal (the amount you invested) does not fluctuate in value. People generally consider money markets (although technically the value of money market shares can decrease in value, in practice they are almost always stable), CDs, and plain vanilla savings accounts as cash investments.
So, now you know all you need to invest right? Well, not exactly. This was just a very superficial survey of some of the more common vehicles. When advising clients my general rule of thumb was that unless they had specific financial knowledge or had a very high net worth and were willing to take on stock analysis as a hobby they should probably stick with mutual funds. We will cover those in the next segment.