Investment Basics

When you’re investing for a specific goal, like college or retirement, the amount of time that stands between now and the date you’ll need the money will help determine your investment strategy. The reason time horizon plays such a big part in investing is that investments that fluctuate in value have the potential to produce larger returns over time.
If you can tolerate a high degree of fluctuation—that means leaving the money invested through all the ups and downs—you can seek greater potential returns. Then as you move closer to your goal, you can begin to move the money into more stable investments so the money will be there when you need it.
Generally, stocks produce higher returns with greater fluctuation, bonds offer moderate returns with little or no fluctuation, and cash generates low returns with zero fluctuation. Although investment returns can never be predicted in advance, it’s helpful to make some assumptions so you’ll know how much you need to save and invest to reach your goal. Some common assumptions in use today are 12% returns for stocks, 8% for bonds, and 4% for cash.
So let’s say you’re investing for your two-year-old child’s college expenses. At this point you can invest their entire college fund in stocks because there’s enough time to ride out any ups and downs before you’ll need the money. Around the time they graduate from junior high school you’ll want to start moving some of the money out of stocks and into bonds whose maturity dates coincide with the four years of college. Then a year or so before you have to start writing tuition checks, you’ll liquidate enough bonds and put the cash into a money market fund to cover upcoming expenses.

If there’s one thing just about everybody in the investment world agrees upon, it’s the benefits of diversification. Simply stated, diversification involves spreading your money around instead of plunking it all into a single investment. Why do this? Because the investment you think will do the best may not. Investments produce varying returns, and by having your money spread out, you reduce the risk of concentrating too much of your portfolio in the wrong one.

Once you start investing, you will see that real-world economics can be much more fascinating than the theoretical kind. Here are some of the key concepts you should know about as an investor.
Economic activity. The gross domestic product (GDP) is the broadest measure of the economy’s performance. It is the Commerce Department’s estimate of the total dollar value of all goods and services produced in this country. What’s important about the GDP is not the number itself, but the change from one quarter to the next. This tells the rate at which our economy is growing. Growth that’s too slow suggests lower corporate profits and lower stock prices. Growth that’s too fast suggests high inflation and likely intervention by the Federal Reserve Board to raise interest rates. For several years now we’ve been in what’s called a “Goldilocks” economy—not too hot, not too cold—in other words, just right for investing.
Interest rates and bonds. The main interest rate to watch is the 10-year Treasury rate, which is currently around 6.0%. The reason this particular interest rate is important is that it is set by the marketplace, as opposed to the federal funds rate, which the government establishes. The marketplace is anticipatory, meaning it reflects changes before they occur. So changes in the 10-year Treasury rate reflect the market’s economic outlook. A rise in interest rates causes bond prices to fall. Why? Because bond interest payments are fixed, so if rates rise, the price is discounted to yield what the marketplace is now demanding.
Interest rates and stocks. Interest rate increases are also bad for stocks because it means companies will have to pay a higher price for capital, which hurts corporate earnings. A drop in interest rates is usually a very positive sign. You can follow interest rate activity by reading the “Credit Markets” section each day in The Wall Street Journal.
Inflation. The inflation rate is measured by the consumer price index (CPI). It is stated as a percentage and tells the rate at which prices are rising. The inflation rate directly affects interest rates and economic growth, so it is watched very closely. But because the CPI reveals the inflation rate after the fact, great attention is placed on certain leading indicators.
Unemployment rates. A key leading indicator right now is the unemployment rate. With unemployment at all-time lows, the greatest fear is that wages will rise, setting in motion a spiral of rising prices. You can get current information on the consumer price index at www.bls.gov .
Information sources. What’s important about any economic data is not the numbers themselves, but how the marketplace perceives the numbers. To stay on top of the latest thinking, read Business Week’s “Business Outlook” section. Also, the front page of the Monday edition of The Wall Street Journal features an insightful analysis of a particular aspect of the economy.

hen you make an investment, you are buying a security that either promises, or offers the potential, to generate cash. This cash is considered the return on your investment. The type of cash an investment generates can tell you a lot about how certain the returns are and how much risk is involved.
Yield. The word “yield” is primarily used by banks to describe the amount of interest you’ll receive on a certificate of deposit or other type of account. There’s little guesswork here. The bank tells you in advance what you’ll be earning, and you can pretty much count on it.
Interest. This is similar to yield. In the investment world it refers primarily to bonds. If you buy a $10,000 bond that pays 8% interest, you’ll receive interest payments of $800 per year until the bond matures, at which time you get your $10,000 back. In most cases the interest amount is stated in advance, so you know going in what your return on investment will be.
Dividends (stocks). A stock dividend is a quarterly check that some companies pay to shareholders. Dividends are declared each quarter and can go up or down but usually don’t change very much. Similar to bond interest, you can usually count on stock dividends, especially when you invest in large, established companies that take their responsibilities to shareholders seriously. Compared to capital gains (see below), dividends usually represent a very small part of a shareholder’s overall return on investment. High-growth companies generally don’t pay dividends at all, preferring to reinvest any extra cash back into the company.
Capital gains. This is the most lucrative part of investing. It’s also the most uncertain. If you buy 100 shares of a stock at $25 and sell those shares at $40, you’re investing $2,500 and getting back $4,000, minus trading costs. The difference of $1,500 is called a capital gain. The opposite of a capital gain is a capital loss. This would happen if you bought the stock at $25 and sold it for $15. Whenever you invest in a stock, you can never know in advance what your capital gain (or loss) will be. This is the part that scares people about stocks. It’s also where your research will come in handy. But the fact remains that no amount of knowledge will enable you to predict stock prices in advance. Investing in stocks is always based on an educated guess; it’s never a sure thing.
Dividends (mutual funds). Some mutual funds call their distributions to shareholders “dividends,” even though they are primarily made up of capital gains from the sale of stocks in the portfolio. These “dividends” cannot be estimated in advance and are just as uncertain as any capital gain (or loss) you might receive from owning individual stocks.
Total return. This is all the money you end up with. In the case of stocks, it’s the combination of dividends and capital gains. In the case of bonds, it’s interest and capital gains.