Mutual Funds For Dummies. Eric Tyson
target="_blank" rel="nofollow" href="#fb3_img_img_9d5f9484-a4da-5ca0-9844-52bfdb0e98c0.png" alt="Tip"/> Should you prefer a bank account because your investment (principal) is insured? No. Savings accounts and money market funds have essentially equivalent safety, but money market funds tend to offer higher yields. Chapter 11 provides more background on money market funds.
Bonds
Bonds are the most common lending investment traded on securities markets. Bond funds also account for about 20 percent of all mutual fund assets and about 15 percent of all exchange-traded funds. When issued, a bond includes a specified maturity date — the date when your principal is repaid. Also specified when a bond is issued is the interest rate, which is typically fixed (meaning it doesn’t change over time).
Bonds, therefore, can fluctuate in value with changes in interest rates. If, for example, you’re holding a bond issued at 2 percent and the market level of interest rates increases to 4 percent for newly issued similar bonds, your bond will decrease in value. Why would anyone want to buy your bond at the price you paid if it yields just 2 percent when they can get a similar bond yielding 4 percent somewhere else? (See Chapter 12 for more information.)
Bonds differ from each other in the following ways:
The type of institution to which you’re lending your money: Institutions include state and local governments (municipal bonds), the federal government (Treasuries), mortgage holders (the Government National Mortgage Association, or GNMA), and corporations (corporate bonds). Foreign governments or corporations can also issue bonds. The taxability of the interest paid by a bond is tied to the type of entity issuing the bond. Corporate, mortgage, and foreign government bond interest is fully taxable. Interest on government bonds issued by U.S. entities is usually free of state and/or federal income tax.
The credit quality of the borrower to whom you lend your money: The probability that a borrower will pay you the interest and return your entire principal on schedule varies from institution to institution. Bonds issued by less-creditworthy institutions tend to pay higher yields to compensate investors for the greater risk that the loan will not be fully repaid.
The length of maturity of the bond: Short-term bonds mature in a few years, intermediate bonds in around 5 to 10 years, and long-term bonds within 30 years. Longer-term bonds generally pay higher yields, but their value is more sensitive to changes in interest rates.
Stocks
Stocks are the most common ownership investment traded on securities markets. They represent shares of ownership in a company. Companies that sell stock to the general public (called publicly held companies) include aircraft manufacturers, automobile manufacturers, banks, computer software producers, ecommerce companies, food manufacturers, hotels, mining companies, oil and gas firms, publishers, restaurant chains, supermarkets, wholesalers, and many types of other (legal) businesses!
When you hold stock in a company, you share in the company’s profits in the form of annual dividends (although some companies don’t pay dividends) as well as in an increase (you hope) in the stock price if the company grows and makes increasing profits. That’s what happens when all is going well. The downside is that if the company’s business declines, your stock can plummet or even go to $0 per share.
Besides occupying different industries, companies also vary in size. In the financial press, you often hear companies referred to by their market capitalization, which is the total value of their outstanding stock. This is what the stock market and the investors who participate in it think a company is worth.
You can choose from two very different ways to invest in bonds and stocks. You can purchase individual securities, or you can invest in a portfolio of securities through a mutual fund or exchange-traded fund. I discuss stock funds in Chapter 13 and individual securities (and other alternatives to funds) in Part 2.
Overseas/international investments
Overseas or international investment is a potentially misleading category. The types of overseas investment options, such as stocks and bonds and real estate, aren’t fundamentally different from your domestic options. However, international investments are often categorized separately because they come with a different set of risks and rewards.
Diversification: International securities markets don’t move in lockstep with U.S. markets, so adding foreign investments to a domestic portfolio generally offers you a smoother ride over the long term.
Growth potential: When you confine your investing to U.S. securities, you’re literally missing a world of opportunities. The majority of investment opportunities are overseas. If you look at the total value of all stocks and bonds outstanding worldwide, the value of U.S. securities is now in the minority (at about 40 percent). The United States isn’t the world — and some overseas economies are growing faster.
Some people hesitate to invest in overseas securities because they feel that doing so hurts the U.S. economy and contributes to a loss of U.S. jobs. Fair enough. But I have two counterarguments:
If you don’t profit from the growth of economies and companies overseas, someone else will. If money is to be made there, Americans may as well make some of it.
The United States already participates in a global economy — making a distinction between U.S. companies and foreign companies is no longer appropriate. Many companies headquartered in the United States also have overseas operations. Some U.S. firms derive a large portion of their revenue and profits from their international divisions. Conversely, many firms based overseas also have operations in the United States. Increasing numbers of companies are worldwide operations.
Real estate
Perhaps the most fundamental of ownership investments, real estate has made many people wealthy. Not only does real estate produce consistently good rates of return (averaging around 8 to 9 percent per year) over long investment periods, but you can also purchase it with borrowed money. This leverage helps enhance your rate of return when real estate prices are rising.
As with other ownership investments, the value of real estate depends on the health and performance of the economy, as well as on the specifics of the property that you own:
If the local economy grows and more jobs are being produced at higher wages, real estate should do well.
If companies in the community are laying off people and excess housing is sitting vacant because of previous overbuilding, rents and property values are likely to fall.