Understanding Bonds:
Many people are surprised to learn that bonds are just loans we make to others and they work exactly the same way that loans made to you work: Your home's mortgage, for example, is a loan to you. The lending institution buys the house and you pay them back some principal and interest over time until the entire loan is paid off. It's just the reverse with a bond and other fixed income securities: you turn your money over to the organization that wants it and they pay you back.
Fixed income securities include:
o Corporate bonds
o Government bonds
o Savings accounts
o Checking accounts
o Short term investments (called CDs in the US)
The nice thing about fixed income securities is that you always know how much you're going to get (usually). On a 6% bond, paid monthly, you can calculate exactly how much you'll get each and every month. It won't waver. Also, many bonds are guaranteed, usually they are backed by the assets of the company issuing them. There is still a risk that you could lose all of your money with a bond but it is minimized compared to equity investments.
The bigger risk that fixed income investments have is that they often pay a fairly low rate of interest. That means that inflation could strip away any income you earn from them. Since inflation generally rises at 3% each year, you need to take that into account when you consider what investments to make. Many people make this mistake. Listen to one former investment adviser's story:
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True stories |
"People really feel the need to have liquidity for 'just in case' emergencies. There's nothing wrong with that. Unfortunately, I saw so many people keep thousands of dollars in their bank accounts for emergencies that never came. Over the years I learned a few things: I learned that emergencies do happen. But I also learned that people usually keep far more than they really needed to on hand. That was an expensive decision. A better option for so many would have been to keep some money in their bank account - say just a couple thousand dollars for immediate needs and the month's expenses. In many cases, a line of credit it is available and dedicated only to emergencies is a far better use of their money. The fees are so minimal and that way they can take the thousands they would never use and put it into a safe, well performing investment." -Former investment adviser |
Because fixed income investments are so safe and pay a regular amount, they make ideal investments for people who are retiring. After retirement, there may or may not be a pension. Fixed income securities help to ensure - or increase - any income available in a safe, predictable way.
How to Make Money with Bonds:
The secret to making money with bonds is to use a laddering technique. Rather than simply sinking all of your money into one giant bond, spread your money out over several bonds maturing at different times. The goal is to put all of your money into several bonds so that one matures every year but you maximize your return (since longer bonds usually have a higher interest rate). Here is a detailed example:
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Imagine that you have $100,000. Let's divide it up into five piles of $20,000 and mark them A, B, C, D, and E. Take A-$20,000 and put it into a 5 year bond returning 7%. Take B-$20,000 and put it into a 4 year bond returning 6% Take C-$20,000 and put it into a 3 year bond returning 5% Take D-$20,000 and put it into a 2 year bond returning 4% Take E-$20,000 and put it into a 1 year bond returning 3% The following year, when E-$20,000 matures, put it into a 5 year bond returning 7%. The following year, when D-$20,000 matures, put it into a 5 year bond returning 7%. The following year, when C-$20,000 matures, put it into a 5 year bond returning 7%. The following year, when B-$20,000 matures, put it into a 5 year bond returning 7%. The following year, when A-$20,000 matures, put it back into a 5 year bond returning 7%. The following year, when E-$20,000 matures, put it back into a 5 year bond returning 7%. Etc. (Please note, the percentages here are used for illustrative purposes only and do not necessarily reflect an actual fixed income security). |
This laddering technique allows you to maximize the returns on your investments by putting your money into the highest returning investments on an ongoing basis. And you don't have to do it on a 5 year rotation. you could divide the same initial amount and ladder it in $25,000 segments over 4 years or $10,000 segments over 10 years or $5,000 segments over 20 years. it all depends on your goals, your age, and what other income you have coming in.
Which Bonds Should I Buy?
Bonds are rated by several services. Often, they are graded with letters A, B, C, D, E or AAA, AA, A, BBB, BB, B. and so on. Bonds are something you will need to go to a broker for, because they cannot be bought simply by going online and finding a company that sells them for you. As well, bonds have many clauses and additional factors that you should be aware of and it takes a licensed professional to understand them. (Some of these clauses include buy-back options so the issuing company can pay off your bond right away if they suddenly get a lot of money).
Most good investment advisors will rarely sell you a bond that is marked less than B (or BB, depending on the rating service used). Those bonds are very safe. Of course, like all investments, the riskier the bond, the more interest it pays but the greater the chance that you'll lose your money.
If you are aging and want to increase your bond holdings, stick with safe bonds that pay monthly or every two months. Put an increasingly large amount of your money into these fixed income investments.
When Should I Sell?
Although this answer might change under some economic circumstances, the general answer is "never." Hold good bonds through to maturity and enjoy collecting the fixed income. Chances are, that's why you got them in the first place and if you are nearing retirement, you need that fixed income. Sometimes, you might be charged a fee for selling earlier than the maturity date.
One time when it is acceptable to sell earlier might be if interest rates climb much higher than the fixed interest security you have. If your money is locked away in a bond paying 5% and suddenly interest rates climb to 10%, it could be worth your while to sell, pay the small early-selling fee, and put your money into a 10% bond. Again, this is something you will have to discuss with an investment professional who understands bonds.
Success tips:
o Increase your fixed income holdings the closer you get to retirement.
o If you are a young person with a good job and good prospects, don't hold any bonds. or very many. Even if you don't like risk, there are good safe options for you like blue chip securities or mutual funds. Perhaps keep some money in a CD (for example if you are saving for a down-payment for a house, you want to keep your money near but not locked away for too long).
Mutual Funds
Understanding Mutual Funds
Mutual funds are baskets of investments that are professionally managed.Like an equity, you make money from a mutual fund through dividends and through the rise in price from the buy price to the sell price -- it's a combination of both where you earn your money. (We'll talk more about this in a moment).
There are a few subtle differences in how you buy mutual funds (like whether you own a portion of the stock at all or just a membership into the mutual fund) but all you really need to know is that you hand your money (through your broker) to the professional money manager. That money manager adds the money to the pot of money from other investors like you, then buys investments with it.
Mutual funds can be made up of just fixed income securities (often called a "bond fund") or just equity securities or a combination of both. Mutual funds can be specialized according to industry (like a "Resources fund" which might hold mostly investments in lumber, oil, diamonds, nickel, and other mined resources) or by region (like an "emerging markets fund" which specializes in investments in countries whose economies are developing. like China, India, Malaysia, and Indonesia). For the conscientious investor, there are ethical mutual funds (which don't invest in companies that have anything to do with tobacco, alcohol, gambling, or firearms) and there areenvironmental funds which only invest in companies that have a concern for the environment.
Mutual funds offer a number of great advantages that you simply don't get from other investments:
o By their nature they are automatically diverse, even if the mutual fund is specialized by industry or region.
o They are professionally managed, which means you can sip lemonade by the swimming pool and still have the assurance that your stocks are going to perform reasonably well.
o They are fairly liquid, which means you can get at them when you need to, if you need to, and you will likely pay just a small fee to pull your money out.
o They have very good returns in many economies. not only because they are diverse and professionally managed, but because the investments can be swapped out for better ones.
o You have choices. there are many mutual funds available and it is sometimes easier for investors to learn what they need to know about mutual funds than it is to learn what they need to know about a stock or bond.
How to make money with mutual funds:
Another way to make money with mutual funds is through constant, faithful depositing.
If you want to have a good, solid, stable, safe, well-performing investment portfolio, forget about stocks and bonds: buy three mutual funds from the same company and hold onto them. Keep faithfully putting money into those funds each and every month. You will be surprised to see how much they grow over time. not just from your faithful input but also from the dividends that return.
Which mutual funds should I buy?
There are online sites that sell a variety of mutual funds. These are often discount brokers. You can go through your regular broker for these, but because of the advantages already built in with mutual funds, you can save some money and just go through a discount broker.
Choose 3 funds from the same fund company and buy them. Sometimes fund companies will group together recommended funds to buy. If you're not sure, select a low risk, medium risk, and high risk fund and put a percentage of your money in each one (a greater percentage in the funds that you match your risk level).
If you want to get started with just one fund, consider your risk level. For low risk investors, a bond fund is a great fund because it combines the safety and fixed income of a bond but often earns a higher rate of interest than any single bond that you can get (because bond funds use an extensive laddering approach and are also able to get good deals on bonds).
For medium risk investors, find some good quality balanced or "income and growth" funds and invest in those. They perform well and are very safe investments.
When should I sell?
Success Tips:
1. The buy and hold strategy is a powerful strategy with mutual funds.
2. Buy three funds from the same company.
3. Reinvest all income back into the fund to keep your portion growing
Other Investments
What kind of other investments are there?
There are so many other types of investments. The three mentioned are the best types of investments for someone who has little or no experience with the stock market. Over time, you may find other investments you want to get into as well. And you may make some good money from these investments.
Remember to always keep your risk level at a comfortable level for you. Choose a good base of stable, well-performing investments as a starting point and periodically add some of these higher risk/higher reward investments when it's suitable for you.
Futures
Futures are the future cost of a raw material. This is the commodity market and it is a much higher risk to invest in than stocks. In fact, some investors consider the stock market to be something you can master with research while the commodity market to closer to gambling. Fortunes are made and lost in commodities regularly.
There are many types of commodities that are sold, including:
Coffee
Oil
Wheat
Livestock
Lumber
Here's a basic description of how it works:
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Imagine you're a farmer and you own one pig. Each year you raise one pig and bring it to market to sell to someone who will turn that pig into bacon or ham. Some years you're thrilled to see that your pig sells for $100. Other times you're shocked to discover that the market is only paying $25 for your pig. You know that you can only break even if you earn $50 for that pig so months before you bring the pig to market you make arrangements with a company who often buys your pig from you. You tell the company that you will bypass the market and sell directly to them, provided they pay you $60 for the pig. You and the company agree and you go about your routine of raising your pig. Months go by. You're happy to have a locked in price. Other pig farmers are worried that the price might go down. Other farmers are hopeful that the price might go up. All you want is your $60. When the day comes, you walk your pig from your farm toward the butcher. You pass the market. How will you feel if you discover that pigs are selling for $70? You might shrug and think that the $10 difference was well worth the peace of mind you had all year. What if pigs were selling for $20? Of course you'd be thrilled that you are earning $40 more than the market is paying. What if pigs are going for a whopping $160? You might be disappointed. Let's assume that pigs are going for $70. You sell your pig and the company agrees to pay $60 again the following year. The company is happy to save $10 over the market price and you're happy to get close to market price and have that assurance of a locked in price all year. With your $60 in your pocket you go back to your farm to start raising another piglet. |
Of course it's far more complicated than that but that's a start toward understanding commodities. It's an agreement today on the future price of a raw material.
Do not jump into commodity investing if you have never invested before. Try your hand, first, on stock market investments and slowly educate yourself on commodity investments. As you educate yourself, find one commodity that you feel you'd like to learn about and learn all you can about that one commodity. Learn when its busy season and slow seasons are and why people buy it and what they do with it.
Remember, stocks and bonds are tied to a company. So a company's fortunes can rise and fall because of the choices of the market and the people who run the company. A commodity, though, also has weather as a factor. As a stock owner, you have a say in how a business is run. As a commodity owner, you have little say in how the weather helps or ruins your investment.
Options
Options are stock purchases and sales where you commit to a price and a date that you will buy or sell a stock at. This is an advanced investment option and often you are given the choice when signing up for an account whether or not you want to trade with this style of investing. It is complicated so we will only give a brief explanation here:
If you are 'bullish' on a stock, you may want to buycalls on the stock. When you buy a call option, you pay a premium to the seller for the right to buy a stock at a specific price in a specific month. (For example, if you think the price will go up, you might buy a call option. If the price does go up, you can exercise your right and buy the stock at that price. If the price goes down, you don't have to exercise your right.) For example, Intel (INTC) may be trading at $50.00 right now. You think it will go up to 70 in the next 3 months because of good earnings. However, you can't afford to buy the actual stock, or can't afford to tie up your cash in the actual stock. So you decide to by a 3-month call for Intel at the price of $60. This call option you're buying is considered out of the money, and will be pretty cheap. Now, if the stock in 3 months stays at $50.00, your contracts will de-value, and will be zero at the time of expiration. However, if the stock swings up to 60 or even hits 70 or higher, your contracts will now be in the money, and wow, you can either A. sell your option contracts which will be worth quite a bit of money (as long as it's before the expiration date). Or B. you can exercise your right to actually buy the stock at 60.
If you are 'bearish' on a stock, you may want to buyputs on a stock. A put option is the reverse of a call option. A put option contract gives the holder the right but not the obligation to sell a specified quantity of a particular commodity or other interest at a given price (the "strike price") prior to or on a future date. When you buy a put option, you pay a premium for the right to sell a stock at a specific price in a specific month. (For example, if you think the price is going down, you might buy a put option. If the price does drop, you can exercise your right to sell the stock at the price specified. If the price goes down, you don't have to exercise your right).
As a buyer of puts and calls you have the right to exercise the option (to buy or sell). People also sell puts and calls contracts themselves, as options market has their own marketplace to trade (CBOE). You could literally just trade options, and never deal directly with the actual stocks. Intense and Risky.
Confused yet? That's just the simple description! There are other factors involved. If you want to go for these types of investing styles, get to know how the regular stock market works first and make small forays into this market (sometimes called the "derivative market") with smaller amounts of money to start.
Other Investments
There are many other investments that you can make. Not all of them are necessarily stock market investments and don't always have to be done through a broker.
Art: buy it low, sell it high, and it looks nice while it hangs on your wall.Real Estate: Real estate is a great investment because it is safe and usually rises. The cost can be prohibitive but if you choose wisely, it can be huge reward down the road.
