Investing, Money Basics.

1. Over the long term, stocks have historically outperformed all other investments.

Stocks have historically provided the highest returns of any asset class — close to 10% over the long term. The next best performing asset class is bonds. Long-term U.S. Treasurys have returned an average of more than 5%.

2. Over the short term, stocks can be hazardous to your financial health.

On Dec. 12, 1914, stocks experienced the worst one-day drop in stock market history — 24.4% . Oct. 19, 1987, the stock market lost 22.6%. More recently, the shocks have been prolonged and painful: If you had invested in a Nasdaq index fund around the time of the market’s peak in March 2000 you would have lost three-fourths of your money over the next three years. And in 2009, stocks overall lost a whopping 37%.

3. Risky investments generally pay more than safe ones (except when they fail).

Investors demand a higher rate of return for taking greater risks. That’s one reason that stocks, which are perceived as riskier than bonds, tend to return more. It also explains why long-term bonds pay more than short-term bonds. The longer investors have to wait for their final payoff on the bond, the greater the chance that something will intervene to erode the investment’s value.

4. The biggest single determiner of stock prices is earnings.

Over the short term, stock prices fluctuate based on everything from interest rates to investor sentiment to the weather. But over the long term, what matters are earnings.

5. A bad year for bonds looks like a day at the beach for stocks.

In 1994, intermediate-term Treasury securities fell just 1.8%, and the following year they bounced back 14.4%. By comparison, in the 1973-74 crash, the Dow Jones industrial average fell 44%. It didn’t return to its old highs for more than three years or push significantly above the old highs for more than 10 years.

6. Rising interest rates are bad for bonds.

When interest rates go up, bond prices fall. Why? Because bond buyers won’t pay as much for an existing bond with a fixed interest rate of, say, 5% because they know that the fixed interest on a new bond will pay more because rates in general have gone up.

Conversely, when interest rates fall, bond prices go up in lockstep fashion. And the effect is strongest on bonds with the longest term, or time, to maturity. That is, long-term bonds get hit harder than short-term bonds when rates climb, and gain the most when rates fall.

7. Inflation may be the biggest threat to your long-term investments.

While a stock market crash can knock the stuffing out of your stock investments, so far — knock wood — the market has always bounced back and eventually gone on to new heights. However, inflation, which has historically stripped 3.2% a year off the value of your money, rarely gives back what it takes away. That’s why it’s important to put your retirement investments where they’ll earn the highest long-term returns.

8. U.S. Treasury bonds are as close to a sure thing as an investor can get.

The conventional wisdom is that the U.S. government is unlikely ever to default on its bonds – partly because the American economy has historically been fairly strong and partly because the government can always print more money to pay them off if need be. As a result, the interest rate of Treasurys is considered a risk-free rate, and the yield of every other kind of fixed-income investment is higher in proportion to how much riskier that investment is perceived to be. Of course, your return on Treasurys will suffer if interest rates rise, just like all other kinds of bonds.

9. A diversified portfolio is less risky than a portfolio that is concentrated in one or a few investments.

Diversifying — that is, spreading your money among a number of different types of investments — lessens your risk because even if some of your holdings go down, others may go up (or at least not go down as much). On the flip side, a diversified portfolio is unlikely to outperform the market by a big margin.

10. Index mutual funds often outperform actively managed funds.

In an index fund, the manager sets up his portfolio to mirror a market index — such as Standard & Poor’s 500-stock index — rather than actively picking which stocks to purchase. It is surprising, but true, that index funds often beat the majority of competitors among actively managed funds. One reason: Few actively managed funds can consistently outperform the market by enough to cover the cost of their generally higher expenses.

 

 

Pros and cons of different investments

The 1990s enjoyed the biggest bull market in U.S. history. During the decade the Dow more than quadrupled.

While stocks, as represented by the S&P 500, have not always performed so extraordinarily — compounding at a dazzling 15.3% annual rate for that time period — they have usually been the best performing asset class over time.

Since 1926, stocks have returned nearly 10% — and that included the most recent horrendous bear market. Over the same period, government bonds returned 5.4%. (This according to the folks at Ibbotson Associates in Chicago.) In other words, if you’re investing for the long-term, stocks are the place to be.

But if you’re looking to invest money you may need in a year or two, the stock market can be downright dangerous. Look no further than the Dow’s 777-point drop on Sept. 29, 2008. Or the 554-point drop on Oct. 27, 1997, and the 508-point drop on Oct. 19, 1987 — a harrowing 22.6% loss — to see what a difference a day can make.

Then there are those bloody bear markets, like 1973-74, when the Dow fell 45%. In 2008, the total stock market lost 37%.

To cite a severe example, if you had bought the stocks in the Dow Jones industrial average at their peak in early 1966, you wouldn’t have made any significant profit until mid-1983 — more than 17 years later. Even that was better than if you’d bought in the pre-crash peak of 1929. After that, it took until 1954 for the market to regain all it lost in the Depression. As for the market woes of the early 2000s, it would take more than five years using an historical average rate of return, for the Dow to return to its glory-day levels from its October 2002 low.

Bonds, of course, are another story. While they won’t give your portfolio the kind of kick that stocks will, nor are they likely to give it the same kind of thrashing. In 2009, the worst single year for bonds in recent history, intermediate-term government bonds (that is, Treasury securities with maturities of 7 to 10 years) fell 9%.

 

Stock values and why they change

From 2000 through 2002, bonds outperformed stocks every year — a historic “three-peat” that hadn’t been seen in the modern investment era that began in 1929.

While the stock market often seems to behave like a manic-depressive who’s been off his medication, in fact it’s quite rational most of the time.

Information about the economy and the prospects of specific companies comes in, and the market reacts. Sometimes those reactions are extreme, but they usually sift down to a handful of causes.

So why does the market seem so erratic? Because life in general is unpredictable. A war here, a hurricane there. These things can occur without much warning, having effects on the economy that no one could anticipate.

What’s harder to explain is why the market can ignore obvious problems for a long time and then suddenly overreact. Here’s one explanation: Investors have a hard time gauging the magnitude of problems.

But if you ignore the occasional surprises that roil the market and focus instead on its long-term behavior, you’ll find corporate earnings and interest rates are key.

Earnings growth

Over periods of five years or more, stock prices closely track corporate profit growth. The longer the stretch of time, the more important earnings trends are. Indeed, since World War II, an estimated 90% of the stock market’s gain has come from profit growth. As profits add up over time, the scale tips and prices rise, regardless of how investors have voted in any given day, month or year.

Interest rates

In the short run, changes in interest rates can be more important than earnings. When rates go up, all other things being equal, investors tend to pull money out of stocks and put it into bonds and other fixed-income investments because the returns there are so attractive.

That brings stock prices down, and sends bond prices higher. On the other hand, when interest rates come down again, once more with other things equal, then investors tend to shift money into stocks, reversing the previous trend.

Note, however, that the operative phrase above is “other things equal.” In real life, other things are rarely equal, and so this relationship — while true in general terms — is hardly perfect.

 

The value of investing in bonds

Bonds at their best are basically boring, which is probably a virtue.

You loan money to a corporation or government agency, like the Treasury Department, and the borrower agrees to pay it back at a fixed rate of interest (sometimes known as the coupon) over a fixed period of time (the term or maturity).

Typically, the longer the maturity of a bond, the higher the coupon. For example, the spread between 5-year Treasury notes and 30-year bonds is often a full percentage point or two. Why? Because the longer the term of the bond, the longer its owner will be left earning a low rate if interest rates in general rise. The greater the risk, the greater the reward.

Similarly, the interest rate a bond pays is directly related to the riskiness of the bond. Treasury bonds, for example, are as close to a sure thing as you can get in the world of bonds, since Uncle Sam can always print more money to pay them off. (Even the feds aren’t immune to the laws of economics, though. If the government ever did print lots of extra cash to pay off its bonds, that would cause inflation to soar and make the bonds worth less.)

At the other end of the spectrum, however, are low-grade corporate bonds, known as high-yield or junk bonds, which have coupons that are several percentage points higher because of the risk that the corporations that issue them might stumble. In between are investment-grade corporate bonds from large, blue-chip companies. The job of grading bonds comes from outfits like Standard & Poor’s and Moody’s, which rate the riskiness of most non-Treasury bonds.

One additional quirk to bonds: If they are issued by a state, county or city agency, their interest earnings are usually free from federal taxes. These municipal — or muni — bonds pay less than taxable bonds in nominal terms. But for investors in a high federal tax bracket, they often return more after taxes than comparable taxable bonds. If you happen to live in the municipality or state that issues the bond, it may also be exempt from state and/or local tax — an added benefit. Similarly, bonds issued by the federal government are exempt from state and local taxes, but the tax rates are lower and the benefit is too.

Although bond prices tend to fluctuate less than stock prices, they aren’t risk-free. If interest rates rise, bond prices will fall. Why? As new bonds paying higher rates become available on the market, the price of older bonds falls proportionately so that the interest they pay is the same as that of a comparable new bond. That’s worth remembering in the current environment, in which interest rates in the United States have hovered around their lowest levels in decades.

Here’s a simplified example of how it works: Let’s say that you paid $1,000 for a 30-year bond that yielded 7% interest, or $70 a year. A year later, the rate for a comparable new bond falls to 5%, which means it yields just $50 a year. Your old bond is now going to be worth more, because investors are willing to pay more to get a $70-a-year income stream than they will to get $50 a year.

Since the interest rate of your bond is now 40% higher than normal, its new price will be about $1,400, or 40% more than you paid for it. And its yield? Exactly 5%, since $70 a year is 5% of $1,400. (Note: the equation is not quite that simple, since your bond now has only 29 years left to maturity and will be matched to other 29-year bonds, not new 30-year issues.)

Conversely, if rates jump from 7% to 9%, meaning new bonds are paying $90 a year interest, the value of your bond will fall to about $778 — because your bond’s $70 annual interest is 9% of $778.

Eventually, of course, when the bond matures, it will be worth $1,000 again. However, its value will move up and down in the meantime, depending on what interest rates do. The longer the time to maturity of a bond, the more dramatically its price moves in response to rate changes. That is, long-term bonds get hit harder than short-term bonds when rates climb, and gain the most in value when rates fall.

As a result, bond buyers tend to divide into two classes: investors (or speculators), who hope to make money thanks to a decline in interest rates that sends bond prices higher; and savers, who buy bonds and hold them to maturity as a way to earn a guaranteed rate of return.

 

Mutual fund fundamentals

The theory behind mutual funds is simple: you need the advantage of being able to pool your money together with that of a lot of other investors. Then, a professional manager can invest that money across enough investments to reduce the risk of being wiped out by any single bad bet.

That’s how a mutual fund operates. The fund is essentially a corporation whose sole business is to collect and invest money. You join the pool by buying shares in the fund. Your money is then invested by a team of professionals, who research stocks, bonds or other assets and then place the money as wisely as they can.

The managers charge an annual fee — generally 0.5% to 2.5% of assets — plus other expenses. That puts a drag on your total return, of course. But in exchange, you get professional direction and instant diversification, factors that have helped propel the number of funds to 7,600 in 2010, according to the Investment Company Institute.

There are several flavors of mutual funds. Funds that impose a sales charge — taking a cut of any new money that comes into the fund, or a cut of withdrawals — are called load funds; those that do not have sales charges are called no-load funds.

Funds can also be divided into open- and closed-end funds. Open-end funds will sell shares to anyone who cares to buy; essentially, they are willing to invest any new money that the public wishes to pump into the fund. Their share price is determined by the value of the underlying investments and is calculated anew each evening after the close of the U.S. markets. Closed-end funds, on the other hand, issue a limited number of shares that then trade on the stock exchange like stocks. The price of such shares can fluctuate above or below the actual value of the underlying shares held within the portfolio.

Funds also can be broken down by their investment strategy. Here’s a quick overview of some of the principal types; we’ll have more to say in later Money Essentials lessons:

Index funds

When people talk about the long-term performance of stocks, they’re usually talking about the Dow Jones industrial average, the Standard and Poor’s 500-stock index, or some other broad market index. Funds based on the S&P 500, by definition, will never outperform the market. But because they are so cheap to run — you’ll typically pay just $2 a year in expenses for every $1,000 invested compared to $14 a year for the average stock fund — they outperform the vast majority of actively managed funds over time.

Growth funds

These invest in the stock of companies whose profits are growing at a rapid pace. Such stocks typically rise more quickly than the overall market — and fall faster if they don’t live up to investors’ expectations.

Value funds

Value-oriented fund managers buy companies that appear to be cheap, relative to their earnings. In many cases, these are mature companies that send some of their earnings back to their shareholders in the form of dividends. Funds that specifically target such income-producing investments are often called equity-income or growth-and-income funds.

Sector funds

Sector and specialty funds concentrate their assets in a particular sector, such as technology or financials. There’s nothing wrong with that approach, as long as you remember that a hot performing sector one year could crash the following year.

Others

Since there is a lot of overlap in the stocks held in each of these fund types, you’ll need to branch out to get any kind of meaningful diversification. That’s where the more aggressive funds, like aggressive growth funds, capital appreciation funds, small-cap funds, midcap funds, and emerging growth funds, fit in. Typically, these funds, which tend to be more volatile than large-cap funds, pursue one or more of the following strategies:

– Invest in smaller companies, where earnings aren’t as reliable as at bigger firms but where the potential for gains (and losses) is higher.

– Invest in pricey, high-growth stocks.

– Invest in stocks that are in “hot” industries, such as technology or health care.

– Invest in just a handful of companies.

International

Funds that invest outside the U.S. come in three basic flavors. The first, international funds, typically buy stocks in larger companies from relatively stable regions like Europe and the Pacific Rim. Global funds do likewise, but they can also invest heavily in the United States. Emerging market funds invest in riskier regions, like Latin America, Eastern Europe and Asia.

Bond funds

These tend to be segmented across the risk spectrum, with those that specialize in Treasury securities being the safest (and the lowest yielding) and those that specialize in junk bonds being the riskiest but offering the highest yield. They also divide according to whether the bonds they hold are taxable or tax-free.

One thing to remember: When the market is headed down, funds that invest in Treasurys tend to rise in value and investors flock to the safest investments around. Likewise, when the market is going up, junk-bond funds tend to do the best, as the better things are for business, the more likely that even the riskiest bond bets will pay off.

Understanding how inflation works

Let’s say the market takes a 30% dive over the next year. Every time you check your stocks or stock mutual funds, you’re going to feel the pain. Likewise, if interest rates rise, your bonds won’t let you forget it.

Nowhere on your bank or brokerage statement, however, are you likely to get a report on what inflation is doing to the real value of your holdings. If your money is stowed in a “safe” investment, like a low-yielding savings or money market account, you’ll never see how inflation is gobbling up virtually all of your return.

Here are some points to bear in mind:

– At an average annual growth rate of 9.8% a year, stocks will double your money in a little over seven years. Factor in inflation, which has historically run at about 3% annually, and it will take more than 10 years to double your actual buying power.

– Likewise, bonds, which have historically grown at roughly 5.4% annually, will double your money every 12 years. After inflation, however, it will take 26 years.

– If your money is in cash, you’ll have to wait 23 years for the nominal value of your account to double, assuming the cash earns the historical 3% annual return. But even your grandchildren won’t see the real value of your money double.

That’s why, whenever you add up your gains or losses for a given period of time, you have to add in the effects of inflation to understand how much further ahead or behind you really are.