We all remember the famous line: “Lions, tigers, and bears. Oh my!” Dorothy and Toto were afraid of being attacked by one of the dangerous and mysterious animals of the forest in the land of Oz. Just as Dorothy was afraid when trying to navigate her way to the Emerald City, many of us are afraid when trying to navigate the financial road (or Narrow Bridge) to financial security. As we try to find our way to our own financial Emerald City, we have to navigate the terror of stocks, bonds, and funds. Oh my!
First, the most well known investment option is stock. A share of stock represents a fractional ownership in a company. The return on stock is generated through a dividend and/or a change in share price. If you buy a share of stock for $1, receive a .05 per share dividend, and later sell for $1.05, you have made .10 per share, or 10%. Usually people do not buy only one share of stock in a company, but you can if you want to or if the price is really high. There is a thought of safety in large company stock, though the risk can lead to price variations depending on the company.
Bonds are often mysterious and scary to the average person, but you read this, so you are not average anymore. A bond is an instrument created by a company as a way to raise funds through debt. In other words, if you buy a bond you are loaning a company money. Most bonds are for $1,000 and give you a fixed coupon, or interest payment, throughout the life of the bond, most commonly 20 years. At the end, you get your $1,000 back and can keep the interest you earned. State and local government have bonds called municipal, or muni, bonds. Those are generally tax free and pay a lower interest rate. The risk in bonds is that a company will go bankrupt, like General Motors or Chrysler recently did, and will stop paying the coupon and, rarely, keep your $1,000. The terms of the bond are always set by the company before it is sold. Bonds can be bought or sold on a secondary bond market through most brokerage firms.
Mutual funds are a common investment, though most people do not really understand what they are. A mutual fund is created when a lump of investors put in funds to buy an assortment of stocks. The price per share of a mutual fund is calculated by dividing total assets (stocks, bonds, cash, and other instruments) by the number of outstanding shares. If you buy into a fund, you are the owner of a portion of the total assets, depending on how much you buy in for. Funds are only as good as the people who manage them. They are an easy way to build a diverse portfolio, but are not guaranteed to gain. There are also fees associated with mutual funds. These fees are generally load fees (purchase or sale) and annual marketing and administration fees.
Hedge funds are like mutual funds, but are not regulated by the government to the same standards as mutual funds. As such, they are only appropriate for wealthy investors with a lot to lose. Though there is a possibility of a big gain, there is also a large opportunity for loss. Most hedge funds require very large investments to join in.
Exchange Traded Funds, called ETFs, and Index funds are another fund option. ETFs and index funds work like mutual funds, but are mirrored to major indices such as the Dow Jones average, the NASDAQ composite index, the S&P 500, and the Russell 3000. There are many more. Because the funds just track an existing index, fees are usually very low. This is a good way to get started investing in funds.
Many other fund options exist, but are usually just types of mutual funds. These include bond funds, stock funds, foreign stock funds, emerging markets funds, government treasury funds, and funds that buy other funds. You can also short sell a stock, where you bet on it going down in price. You can buy options on a stock, where you have the ability to buy it later at a predetermined price. You can trade commodities, such as cattle, corn, or coffee. Some bonds are called mortgage backed securities. Those let you buy into a share of ownership in the future payments of people’s mortgages. You can invest in almost anything.
The most important thing to remember is to invest responsibly. If you don’t understand it, don’t buy into it. If you do not know what risks are involved, pick something else. If you are really interested, do lots of research. Each stock is different, each bond is different, and each fund is different. Do your homework and you can make a lot of money. Invest recklessly and you can lose everything. Be smart and have fun. Just make sure you don’t lose all the time. If you do, a bank savings account might be the best bet for you.