The Determined Dollar

Asset Classes: How to Start Investing, Part Two

asset-classesIn part 1, we talked about why it’s important to start investing by saving for retirement, and your options for investing within tax-advantaged plans like your 401K and IRA. Today, it’s all about asset classes.

The goal of this investing series is to give you a broad overview to provide context and a basic foundation of knowledge so that you can read more advanced material and understand what the heck they’re talking about.

There are three basic asset classes: stocks, bonds, and cash.

Cash Investments

Cash is the most familiar, so let’s start there. Your two basic investment vehicles with cash are CDs (certificates of deposit) and money market accounts.

With CDs, you invest a certain amount and commit to leaving the money there until the CD matures.  You can find 6-month CDs, 1-year CDs, and even 3 and 5 year CDs.

The longer term the longer you choose, the higher the interest rate is.  However, CDs don’t earn very much interest (1-2.8% depending on current interest rates).

If you invest in a CD, make sure it’s FDIC insured.

The other type of cash investment is called a money market account. Think of it like a high interest savings account. The risk of this investment is considered negligible, basically risk-free.

Money Market accounts earn about 1.8% at the time of this writing. That’s low for an investment, but not bad since it’s almost no risk! I keep my emergency fund in a money market account to get the best interest rate.

Investing in Stocks

The next type of asset class is stocks, also called equities.  When you own a share of stock, that means you own a small piece of that company.

If you watch the show Shark Tank, you see the Sharks bargain for a percentage of equity (ownership) in a company in exchange for their investment.

It’s the same concept when you buy stock. You are literally buying a portion of ownership of the company, although that portion is a fraction of a percentage point.

Investing in the stock market is an essential component to a healthy retirement portfolio. On average the market has returned over 10%, the highest average return for any asset class.

Of course, with higher potential reward is higher risk. For understanding what I mean by risk, here’s an article that puts it into perspective.

Stock Risk

Buying single stocks-  holding ownership of a few individual companies-  is extremely risky. if you were to put most of your money in only a few companies, and one or two of those companies went broke, then you would go broke with them!

That’s where the stock mutual fund comes in handy.

A mutual fund is like having a bucket with thousands of companies’ stocks, and lots of people invest in this bucket. Instead of owning shares of just one stock, you can own shares of a mutual fund.

This maximizes your return but minimizes risk. Then who cares if a few companies fail out of the thousands that you’ve invested your money with?

Some examples of stock mutual funds are Vanguard’s Total Stock Market Index Fund, T. Rowe Price’s Global Technology Fund, And Fidelity’s International Index Fund.

(Vanguard, T Rowe Price, and Fidelity are three of the largest and most reputable investment firms that you can open an IRA with and invest in any of the mutual funds that they offer.)

A total stock market index fund is what it sounds like.  When you invest in one of these funds, you are buying a little piece of every single stock in the entire market.

A technology fund includes companies in the technology sector.

An international fund contain stocks from other countries.

There are thousands of mutual funds out there to choose from (next week I’ll teach you the criteria for picking good ones).

And you can diversify even more by investing in a few different mutual funds categories. This is why Dave Ramsey recommends a combination of growth stock, aggressive growth stock, growth and income, and international stock mutual funds.

The bottom line is, you need to invest in stock mutual funds and be very diversified to minimize risk and maximize the return on your investment.

Investing in Bonds

My grandmother purchased some municipal (state and local government) bonds for me when I was a baby. Now that they have matured 30 years later, I can cash them in for the full value.

30 years ago, bonds were actual pieces of paper, just like cash, and heaven forbid you lose it! Today, it’s all done electronically.

A bond is a loan that you make to a corporation or to the government. Like stocks, there are also mutual funds for bonds (called bond mutual funds).

An example of a government bond is the 10 Year Treasury Note.

An example of a corporate bond fund is the Payden Corporate Bond Fund (their names aren’t super creative).

When you buy a bond, the government or corporation is promising to pay you back what you lent plus interest. So if you purchased $10,000 worth of bonds at a 3% interest rate with a 10 year maturity date, you will make 3% annually on your $10,000 each year for 10 years.

After 10 years, you get your $10,000 back.

On average, bonds earn around 5% interest.

However, investing in bonds is not risk-free. You have to take into account credit risk and interest rate risk.

Bond Risk

Treasury bonds- a type of government bond- are guaranteed because the treasury can print more money! Literally. It’s the U.S. Treasury, that’s what they do!

Treasury bonds are considered to have zero credit risk. That means no matter what, you will get your 3% and your money back when the bond matures (or whatever rate you purchased it at). But there is interest risk (I’ll get to that in a second).

Corporations, however, can’t print more money, right? Standard and Poor’s credit rating system is like a FICO score for bonds; it lets you know how credit-worthy a corporation is. This credit rating is a big factor in deciding which bonds or bond funds to purchase.

Bond mutual funds help minimize risk, too. Just like stock mutual funds reduce risk through diversification, investing in hundreds of different bonds through a bond mutual fund reduces credit and interest rate risk, since your eggs aren’t in one basket.

So what is interest rate risk? Well, as interest rates go up, bond prices go down. As interest rates go down, bond prices go up.

Here is an example: say you purchase a bond for $10,000 with a 10 year maturity, at 4% interest. If interest rates rise to 6%, and you want to sell your bond, no one will buy it for $10,000 because they don’t want to earn 4% when they can purchase a new bond and earn 6%. So the bond might only sell for $9,300, even though you invested $10,000.

Conversely, if interest rates went down to 3%, now you’re holding a bond earning 4%, so you can sell that bond for more than $10,000.

Choosing Your Asset Class Allocation

Your asset allocation is the combination of stocks, bonds, and cash investments that comprise your investment portfolio.

Cash carries the lowest risk but the lowest potential reward.

Bonds carry lower risk and lower potential reward.

Stocks carry higher risk and higher potential reward.

Depending on how close to retirement you are (aka when you need the money), and what you are comfortable with, you’ll want to choose a combination of stocks, bonds, and cash that make sense for you.

Personally, I’m invested all in stocks right now (this isn’t a professional recommendation, I’m just telling you what I’ve got going on).

I have a high risk tolerance because I understand normal market cycles, I don’t panic when the market dips, and I’m 30 years away from retirement, so my investments have plenty of time to recover from market downturns.

If I were only five years out from retirement, I’d be much more cautious and would want to be more balanced, like 50% stocks and 50% bonds, for example. A portfolio with equal or almost equal value of stocks and bonds is called a balanced portfolio.

And when I do retire, I’ll be even more conservative (read: have less in stocks and more in bonds, maybe some cash) because the goal will be to preserve what I’ve gained and earn modest growth, not to aggressively gain more.

So those are your three asset classes: stocks, bonds, and cash. The more you learn about each of these three asset classes, the more equipped you’ll be to choose the right mix of asset classes for your investment portfolio.