So you’re ready to start investing. That’s great. Putting your money to work with a successful investing strategy is the foundation to generating long-term wealth.
Whether you realize it or not, you’re going to be building a financial portfolio. But what exactly does that mean?
ANATOMY OF A PORTFOLIO
What is a financial portfolio? Simply put, it’s a collection of financial assets. It could include stocks, bonds, cash and cash equivalents, or alternative investments. These are called “asset classes.” You’ll want to have a mix of different asset classes in your portfolio to balance the potential for growth and the risk that you’ll lose money.
Stocks are essentially a small piece, or share, of a company. You make money in stocks when the company pays a portion of its profit in dividends or when the value of the company increases and you can sell your share for more than you paid for it. (Just imagine if you’d bought Amazon stock 10 years ago.)
Stocks are generally a way to grow the amount of money you invest. In fact, stocks as a whole have earned around 10 percent per year since 1928. But their values can fluctuate pretty widely, making them an investment with higher risk — especially in the short term.
Bonds are investments in debt. Through bonds, you loan money to a bond issuer, typically a corporation or government. The terms of the bond establish when the bond matures (when it can be exchanged for cash) and the interest that it will accrue. Though you can purchase bonds directly from an issuer, bonds can also be bought and sold on exchanges in the same way that stocks are traded.
Bonds are typically considered safer investments compared to stocks; their values do not fluctuate as widely as the value of stocks can. Of course, because bonds carry less risk, they also offer less reward in the form of how much you can earn on an investment in them.
Alternative investments are anything that has value that could grow in price or provide income. This could include real estate (which you could buy directly or through a real estate investment trust known as a REIT) or commodities — which are investments in things like oil or gold.
Because alternative investments can be complicated and risky, it’s best to work with a financial pro before including these in your portfolio.
It typically makes the most sense to focus your pay-off efforts on the highest interest rate debt first.
Cash and cash equivalents are more or less exactly what they sound like. They are a portion of a portfolio consisting of cash (which can be both domestic and foreign currency) as well as any other investment that can be easily converted into cash such as certificates of deposit, money market funds and short-term government bonds.
Cash and cash equivalents typically return little profit in a portfolio, but they are an important component of any portfolio nonetheless. In addition to covering emergencies, having cash on hand allows you to make an investment in a timely manner should an opportunity present itself.
Funds are in some ways portfolios themselves. Funds collect money from individual investors and then invest based on the fund’s design. A mutual fund, for instance, may invest in certain types of stocks, bonds or other investments — perhaps in a certain region of the world. An exchange-traded fund (ETF) is designed to have very similar performance to a certain index, like the S&P 500 or NASDAQ.
Funds are a good way to buy a lot of different stocks, bonds or other investments without having to buy all the individual pieces yourself.
Ultimately, what you put in a portfolio depends on your tolerance for risk. If you invest heavily in stocks, you may make more in the long run than someone who just invests in bonds. But in the short term, you could also lose more. When constructing a portfolio, you’ll want to think through how much risk you’re willing to take.
All investments carry some level of risk including the potential loss of principal invested.
With fixed income securities, such as bonds, interest rates and bond prices tend to move in opposite directions. When interest rates fall, bond prices typically rise and conversely when interest rates rise, bond prices typically fall. This also holds true for bond mutual funds. When interest rates are at low levels there is risk that a sustained rise in interest rates may cause losses to the price of bonds or market value of bond funds that you own. At maturity, however, the issuer of the bond is obligated to return the principal to the investor. The longer the maturity of a bond or of bonds held in a bond fund, the greater the degree of a price or market value change resulting from a change in interest rates (also known as duration risk). Bond funds continuously replace the bonds they hold as they mature and thus do not usually have maturity dates, and are not obligated to return the investor’s principal. Additionally, high yield bonds and bond funds that invest in high yield bonds present greater credit risk than investment grade bonds. Bond and bond fund investors should carefully consider risks such as: interest rate risk, credit risk, liquidity risk and inflation risk before investing in a particular bond or bond fund. With fixed income securities, such as bonds, interest rates and bond prices tend to move in opposite directions.