Investment Basics: Understanding Key Principles
It is important to understand some basic investment principles before putting your money into the stock market. This knowledge helps you make informed investment decisions and ensures your investments align with your goals, time horizon, and risk tolerance.
Let’s review some fundamental investment types: stocks, bonds, mutual funds, and cash alternatives. These investments carry varying levels of risk and potential for return.
Stocks (Equities)
Stocks represent ownership in a company. When you buy shares, you own a piece of that company. The difference between the price you paid and the current price determines your gain or loss in value. Stocks, also called equities, offer the highest potential for growth, but their prices fluctuate, meaning you can also lose money.
Stock Categories
Stocks can be categorized in two primary ways: style and size.
-
By Style:
- Growth Stocks – Companies experiencing rapid growth in share prices, revenue, profits, or cash flow.
- Value Stocks – Stocks that are considered undervalued by the market, with the potential for price appreciation as other investors recognize their worth.
- Income Stocks – Stocks that provide regular dividend payouts, offering investors a steady income stream.
-
By Size (Market Capitalization)
Market capitalization, or market cap, is the total value of a company’s shares. It is calculated by multiplying the number of outstanding shares by the current share price.- Large Cap – Established companies with high market value.
- Mid Cap – Medium-sized companies with growth potential.
- Small Cap – Smaller, riskier companies with high potential for growth but increased volatility.
Bonds (Fixed Income Investments)
Bonds are essentially loans to an organization, corporation, or government entity. In return, investors receive interest payments and the repayment of principal at maturity. Bonds tend to carry lower risk than stocks but also offer lower growth potential.
Types of Bonds
- Corporate Bonds – Issued by private and public corporations.
- Municipal Bonds (Munis) – Issued by state and local governments.
- U.S. Treasuries – Issued by the U.S. Department of the Treasury.
Bond Duration & Maturity
- Short-term – Matures in less than 3 years.
- Medium-term – Matures in 3 to 10 years.
- Long-term – Matures in 10 years or more.
Cash Alternatives
Cash alternatives include short-term securities with maturity periods of 90 days or less. These investments focus on preserving capital while providing a steady return. They carry the lowest risk but offer minimal growth potential.
Examples:
- Money Market Funds
- Stable Value Products
Mutual Funds
A mutual fund pools money from multiple investors to purchase a mix of stocks, bonds, and other assets. These funds are professionally managed and aim to achieve specific investment objectives, such as growth or stability.
Types of Mutual Funds
- Stock Funds – Invest primarily in stocks.
- Bond Funds – Invest primarily in bonds.
- Money Market Funds – Invest in short-term securities issued by corporations or government entities.
- Target Date Funds – Adjust their investment mix over time, becoming more conservative as the target date (often a retirement year) approaches.
Choosing the Right Investment for You
When deciding on investments, consider the following factors:
✔ Risk tolerance – How much risk are you comfortable with?
✔ Return potential – What level of returns are you seeking?
✔ Fees – What are the associated costs of the investment?
✔ Liquidity – How easily can you access your money?
✔ Time horizon – When will you need to access the funds?
✔ Diversification – How well are your investments spread across different asset classes?
It may also be beneficial to consult with a financial advisor to ensure your investment choices align with your personal financial goals.
