Investing Basics

Investing is “the act of committing money or capital to an endeavor with the expectation of obtaining an additional income or profit.”  Many people turn to investing to help buy a home, save for a child’s college tuition, or build their retirement. The value of stocks, bonds, and other securities varies with market conditions. There are no guarantees that you will make money from your investments. 

The goal of investing is putting together a collection of assets such as stocks, bonds, mutual funds, and real estate that generates the highest possible annual income at the lowest possible risks. Most of this income is paid to the investor to use in their everyday lives. 

Ohio Laborers Benefits cannot tell you what investments to make, however, the text below provides unbiased information to help you evaluate your choices. For more information on investing, visit the U.S Securities and Exchange Commission

Stocks

Stocks are a type of security that gives stockholders a share of ownership in a company. There are many different ways to invest in stocks. Investors buy stocks for various reasons, including capital appreciation, dividend payments, and the ability to vote shares and influence the company. A company will issue stocks to get more money for paying off debt, launching new products, expanding into new markets or regions, and enlarging facilities or building new ones. 

There are two main types of stock: common stock and preferred stock. Common stock entitles owners to vote at shareholder meetings and receive dividends. With preferred stocks, stockholders usually don’t have voting rights, but they receive dividend payments before common stockholders do and have priority over common stockholders if the company goes bankrupt and its assets are liquidated. 

Both common and preferred stocks can be part of one or more of the following categories.

  • Growth stocks have earnings growing at a faster rate than the market average. The rarely pay dividends and investors buy them in the hope of capital appreciation. Example: a technology start-up company
  • Income stock pays dividends consistently. Investors buy them for the income they generate. An established utility company is likely to be an income stock. 
  • Value stocks have a low price-to-earnings (PE) ratio, meaning they are cheaper to buy than stocks with a higher PE. Value stock may be growth or income stock, and their low PE ratio may reflect the fact that they have fallen out of favor with investors for some reason. People buy value stocks in the hope that the market has overreacted and the stock’s price will rebound.
  • Blue-chip stocks are shares in large, well-known companies with a solid history of growth. They generally pay dividends.

Another way to categorize stocks is by the size of the company, as shown in its market capitalization. There are large-cap, mid-cap, and small-cap stocks. Shares in very small companies are sometimes called “micro-cap” stocks. The very lowest priced stocks are known as “penny stocks.” These companies may have little or no earnings. Penny stocks do not pay dividends and are highly speculative.

Benefits/Risks

Stocks offer investors the greatest potential for growth (capital appreciations) over the long-term. Investors willing to stick with stocks over long periods of time, generally have been rewarded with strong, positive returns. But stock prices move up and down on a regular basis. There are no guarantees that the company whose stock you hold will grow and do well, so you can lose the money you invest in stock. If a company goes bankrupt, common stockholders are the last to get a share in the proceeds – which may end up being nothing. The company’s bondholders are paid first. Next is the preferred stockholders. 

Even when companies aren’t in danger of failing, their stock prices may fluctuate. As a whole, large companies tend to lose money about one out of every three years on average. If you have to sell shares on a day when the stock prices are below the price you paid for the shares, you will lose money on the sale.  Stock prices can be affected by factors inside the company, such as a faulty product, or by events the company has no control over, such as political or market events. 

Usually stocks are just one part of an investor’s portfolio. If you are young and saving for a long-term goal such as retirement, you may want to hold more stocks than bonds. Investors nearing or in retirement may want to hold more bonds than stocks. It really depends on your personal situation. Speaking with a financial adviser can help you decide your best course of action. 

Bonds

A bond is a debt security. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time. The bond issuers may be a government, municipality, or corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it “matures,” or comes due after a set period of time. 
 
Investors buy bonds due to their predictable income stream. Bonds typically pay twice a year. If the bonds are held to maturity, bondholders get back the entire principal, so they are a way to preserve capital while investing. Bonds are also a possible way to help offset exposure to more volatile stock holdings. Companies, governments, and municipalities issue bonds to get money for providing operating cash flow, financing debt, or funding capital investments in schools, highways, hospitals, and other projects.
 
A bond’s credit quality and time to maturity are the principal determinants of a bond’s coupon rate. If the issuer has a poor credit quality, the risk of default is greater, and these bonds pay more interest. Bonds with a very long maturity date tend to pay a higher interest rate because the bond holder is more exposed to interest rate and inflation risks. 
 
Credit ratings for a company and its bonds are generated by credit rating agencies like Stand and Poor’s, Moody’s, and Fitch Ratings. The very highest quality bonds are called investment grade, and include debt issued by the U.S. government and very stable companies. Bonds not considered investment grade, but are not in default, are called high-yield or junk bonds. These bonds have a higher risk of default in the future and investors demand a higher coupon payment to compensate them for that risk. 
 

There are three main types of bonds:

Corporate bonds – debt securities issued by private and public corporations

  • Investment-grade – these bonds have a higher credit rating, implying less credit risk than high-yield corporate bonds. 
  • High-yield – these bonds have a lower credit rating, implying higher credit risk than investment-grade bonds, and therefore offer higher interest rates in return for the increased risk. 

Government bonds – these are issued by the U.S Department of the Treasury on behalf of the federal government. They carry the full faith and credit of the U.S government, making them a safe and popular investment. 

  • Treasury Bills – short-term securities maturing in a few days to 52 weeks
  • Notes – Longer-term securities maturing within ten years
  • Bonds – Long-term securities that typically mature in 30 years and pay interest every six months
  • TIPS – Treasury Inflation-Protected Securities are notes and bonds whose principal is adjusted base on changes in the Consumer Price Index. TIPS pay interest every six months and are issued with maturities of five, ten, and 30 years. 

Municipal bonds – these are bonds issued by state and local governments. In the United States, municipal bonds are ofter tax-free.

  • General obligation bonds – these are not secured by any assets. They are instead backed by the “full faith and credit” of the issuer – which has the power to tax residents to pay bondholders.
  • Revenue bonds – Instead of taxes, these bonds are backed by revenues from a specific project or  source, such as highway tolls or lease fees. Some revenue bonds are “non-recourse,” meaning that if the revenue stream dries up, the bondholders do not have a claim on the underlying revenue source. 
  • Conduit bonds – Governments will sometimes issue municipal bonds on behalf of private entities such as non-profit colleges and hospitals, These “conduit’ borrowers typically agree to repay the issuer, who pays the interest and principal on the bonds. If the conduit borrower fails to make a payment, the issuer usually is not required to pay the bondholders.  

Benefits/Risks

Bonds can provide a means of preserving capital and earning a predictable return. They can provide a steady stream of income from interest payments prior to maturity. The interest from municipal  bonds generally is exempt from federal income tax and may be exempt from state and local taxes for residents in the states where the bond is issued. However, as with any investment, bonds have risks. 
 
  • Credit risk – the issuer my fail to timely make interest or principal payments and thus default on its bonds.
  • Interest rate risk – interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount. 
  • Inflation risk – inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest. 
  • Liquidity risk – this refers to the risk that investors won’t find a market for the bond, potentially preventing them from buying or selling when they want. 
  • Call risk – the possibility that a bond issuer retires a bond before its maturity date, something an issuer might do it interest rates decline, much like a homeowner might refinance a mortgage to benefit from lower interest rates. 

Common Investment Terms

American Callable bond – can be deemed by the issuer at any time prior to its maturity and usually pays a premium when the bond is called.

Bonds – a type of fixed income investment in which the bond issuer borrowers money from an investor.

Broker – a person who acts as an intermediary between the buyer and the seller of a security, insurance product, or mutual fund, often paid by commission. The terms broker, broker/dealer, and dealer are often used interchangeably.

Callable bond – a bond that can be redeemed by the issuer prior to its maturity.

Capital appreciation – when a stock rises in price

Coupon date – the dates on which the bond issuer will make interest payments. Payments can be made in any interval, but the standard is semiannual payments.

Coupon rate – the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage.

Deep-Discounted bond – a bond that sells at a significant lesser value than par. The bond sells at a discount to par and has a coupon rate significantly less than the prevailing rate of fixed-income securities with a similar risk profile.

Deflation – (opposite of inflation) – a decline in the prices of goods and services

Diversification – the practice of spreading money among different investments to reduce risk, such as investing in different companies in various industries or in several different types of investments, Diversification does not ensure profit or protect against loss in a declining market.

Dividend payments – when a company distributes some of its earnings to stockholders

Equity – the ownership interest of shareholders in a corporation.

Face value – the money amount the bond will be worth at maturity; also the reference amount the bond issuer uses when calculating interest payments.

Foreign Currency Convertible bond – a type of convertible bond issued in a currency different than the issuer’s domestic currency.

Inflation – (opposite of deflation) – the overall general upward price movement of goods and services in an economy.

Inflation risk – the risk that an investment will not generate a higher rate of return than the rate of inflation and that the investment will lose real purchasing power.

Issue price – the price at which the bond issuer originally sells the bond.

Maturity date – the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.

Mutual Fund – an investment that combines money from shareholders and invests it in numerous securities, including stocks, bonds, and short-term money market instruments. As open-ended investments, most mutual funds continuously offer new shares to investors.

NASDAQ – the National Association of Securities Dealers Automated Quotation is an American stock exchange. The NASDAQ composites index measures the performance of more than 3,000 U.S. and non-U.S. companies traded on the NASDAQ stock market.

Portfolio – a collection of securities, such as stock, bonds, or mutual fund shares, owned by an individual or an organization.

Put bond – a bond that allows the bondholder to force the issuer to repurchase the security at specified dates before maturity.

Return – the profit (or loss) earned (incurred) through investing.

Securities – assets, such as stocks, bonds, etc., that allow the investor to participate in earnings, distribution of property, or other assets of the corporation issuing the security.

Share – a representation of ownership in a corporation, mutual fund, or some other type of financial investment.

Shareholder/Stockholder – an investor who owns shares in a mutual fund or any other company.

Straight bond – a bond that pays interest at regular intervals, and at maturity pays back the principal that was originally invested.

Stocks – shares of a corporation. Also known as “equities,” they give the investor an ownership  and interest in the company issuing the stock. Owners are usually entitled to receive dividends and vote on important company matters.

Mutual Funds

A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates. 

Mutual funds are popular with investors, as they offer a few interesting perks. This includes professional management, diversification, affordability, and liquidity. Typically mutual funds come with fund managers who do the research for you. They select the securities and monitor their performances. Mutual fund also generally invest in a range of companies and industries, helping lower your risk if one company fails. Most mutual funds set a relatively low dollar amount for initial investment and subsequent purchases. Investors can easily redeem their shares at any time, for the current net asset value (NAV) plus any redemption fees. 

Most mutual funds fall into one of four main categories – money market funds, bond funds, stock funds, and target data funds. Each group has its own features, risks, and rewards. 

Money Market funds have relatively low risks. By law they can invest only in certain high-quality, short-term investments issued by US corporations, federal, state, and local governments. 

Bond funds have higher risks than money market funds, because they typically aim to produce higher returns. With how many different types of bonds available, the risks and rewards of bond funds can vary dramatically. 

Stock funds invest in corporate stocks. Not all stock funds are the same. For example:

  • Growth funds focus on stocks that may not pay a regular dividend but have potential for above-average financial gains. 
  • Income funds invest in stocks that pay regular dividends
  • Index funds track a particular market index such as the Standard & Poor’s 500 Index. 
  • Sector funds specialize in particular industry segment
Target date funds hold a mix of stocks, bonds, and other investments. The mix will gradually shift according to the fund’s strategy over time. Target date funds (or lifecycle funds) are designed for individuals with particular retirement dates in minds. 
 

Benefits/Risks

Mutual funds offer professional management and potential diversification. They also offer three different ways to earn money. A fund may earn income from dividends on stock or interest on bonds. The fund then pays the shareholders nearly all the income, less expenses. The price of securities in a fund may increase. when a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, the fund distributes these capital  gains, minus any capital losses, to investors. If the market value of a fund’s portfolio increase, after deducting expenses, then the value of the fund and its shares increase. The higher NAV reflects the higher value of your investment. 
 
All funds carry some level of risk. You may lose some or all of the money you invest with a mutual fund. Securities held by the mutual fund may go down in value. Dividends or interest payments may also change as market conditions change. A fund’s past performance does not predict future returns. But past performance can tell you how volatile or stable a fund has been over a period of time. The more volatile the fund, the higher the investment risk. 

Understanding Fees

Buying and selling stocks, bonds, and mutual funds involve fees. A direct stock plan or a dividend reinvestment plan may charge you a fee for that service. Brokers who buy and sell stocks for you charge a commission. A discount brokerage charges lower commission than what you would pay for a full service brokerage, however, you usually have to do your own research and choose investments by yourself. A full-service brokerage costs more, but the higher commissions pay for investment advice based on that firm’s research.

Funds pass along the costs of running mutual funds to investors by charing fees and expenses. These can vary from fund to fund. A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even a small difference in fees can mean large differences in returns over time. Mutual fund cost calculators are available to compute how the costs of different mutual funds add up over time and affect your returns. The Financial Industry Regulatory Authority (FINRA) Fund Analyzer offers information and analysis on over 18,000 mutual funds, exchange traded funds (ETFs) and exchange traded notes (ETNs). This tool estimates the value of the funds and impact of fees and expenses on your investment and also allows you the ability to look up applicable fees and available discounts for funds.

Avoiding Fraud

Corporate bonds, mutual funds and stocks in public companies are registered with the U.S Securities and Exchange Commission (SEC), and in most cases, public companies are required to file reports to the SEC quarterly and annually. Annual reports include financial statements that have been audited by an independent audit firm. Information on public companies can be found on the SEC’s EDGAR system. Be wary of any person who attempts to sell non-registered bonds. Most municipal securities issued after July 3, 1995 are required to file annual financial information, operating data, and notices of certain events with the Municipal Securities Rulemaking Board (MSRB). This information is available free of charge online at emma.msrb.org. If the municipal bond is not filed with MSRB, this could be a red flag. Before you invest, be sure to read the prospectus and the required shareholder reports. Additionally, the investment portfolios of mutual funds are managed by separate entities know as “investment advisers” that are registered with the SEC. Always check that the investment adviser is registered before investing.

Source: Investor.gov