Chapter 3: Investing: Your Options, Your Risks, Your Rewards

Transcription

1 Chapter 3: Investing: Your Options, Your Risks, Your Rewards Page 1 of 10 Chapter 3: Investing: Your Options, Your Risks, Your Rewards In This Chapter What is inside a mutua fund? What is a stock? What is a bond? What is a money market or cash investment? Are you getting ready to join the mutua fund cub? Some 83 miion Americans own a mutua fund, according to the Investment Company Institute. Before you join this seect group, however, it s important to understand the investments that mutua funds make. Mutua funds come in a variety of favors. You woudn t buy a car without ooking under the hood. This chapter pops open the hood on mutua fund investments. It expains how mutua funds are invested and the advantages mutua funds have to offer you as a potentia investor. Stocks, Bonds, or Cash? Congrats! In Chapter 2, "Mutua Funds: To Own or Not to Own?" you probaby came up with money you didn t even know you had. Before you get excited and punk down a that cash, you need to know about a the critters that can hang out in a mutua fund. In Chapter 1, "The Ten Commandments of Mutua Fund Investing," we mentioned that you normay can buy stocks, bonds, or cash investments directy from a stockbroker. Stockbrokers have one word for a this stuff: securities. A mutua fund may invest in one type of security or a mix of different kinds of securities. Technobabbe Securities is a stockbroker s word for stocks, bonds, or cash investments. A mutua fund's vaue rises or fas rapidy or sowy depending on the types of securities investments it makes. (The exception are money market mutua funds, which are designed to maintain a constant $1-per-share vaue.) The foowing sections describe the kinds of securities you' find in a mutua fund and how each security affects how much money you make from your mutua fund investment. Taking Stock fie://j:\macmiancomputerpubishing\chapters\ib900.htm 3/22/01

2 Chapter 3: Investing: Your Options, Your Risks, Your Rewards Page 2 of 10 Stocks provide a way for a company to raise money. The company ses stock shares in exchange for money used to grow the business by buying new equipment or by performing research and deveopment, for exampe. If you or your mutua fund own shares of a company's stock, you're a big shot. Not ony are you part owner of that company, but you aso might get to share in its earnings, which may be distributed to sharehoders in the form of dividends. If the mutua fund owns shares of a particuar dividend-paying stock, it pays these dividends to you, based on the number of mutua fund shares you own. Technobabbe Stock is a type of investment that buys ownership in a corporation in exchange for a portion of that company's earnings and assets. Dividends are profits that a corporation or mutua fund distributes to its owners. If the company profits, it's good news. The share price of the stock can increase, which, in turn, hikes the vaue of its shares. The company's board of directors may vote to increase the dividends they pay sharehoders. Unfortunatey, the opposite can aso happen. If the company does poory, the vaue of the stock may decine, and dividends may be cut or eiminated entirey. Individua stocks are probaby one of the riskiest investments for individuas and mutua funds. Stock funds may earn or ose a ton of money before you have a chance to bink your eye. News You Can Use The two major types of stocks are common and preferred. If you own preferred stock, you receive dividends before common stockhoders do. You aso get preferred treatment over common stockhoders when, shoud the company fai, you need to get investment back. Preferred stocks tend to pay sighty higher dividends than common stock, but the share price usuay doesn't rise as much. Most individua stockhoders and mutua funds own common stock. Bond Basics A bond is an I.O.U. issued by a company, city, county, state, federa government, or its agencies. When you buy a bond, you are ending money to the bond issuer. In exchange for the oan, the issuer promises to repay the money on a specific date, known as the maturity date. If you or your mutua fund own a bond, you, as ender, receive fixed periodic interest payments. Technobabbe fie://j:\macmiancomputerpubishing\chapters\ib900.htm 3/22/01

3 Chapter 3: Investing: Your Options, Your Risks, Your Rewards Page 3 of 10 A bond is a oan made by bond buyers to a bond issuer (often a corporation, city, town, state, or even the federa government). The maturity date is the date the bond is due to mature. The face vaue, or the face amount of a bond, is the doar amount you get at maturity. Bonds are issued at a minimum of $1,000, which is aso known as the face vaue or principa. After you buy your bond, you or your mutua fund can hod it to maturity and get the principa back, or you can se it before maturity. Bonds can be tricky to understand. There are three ways that describe how much interest income you wi receive from a bond. It s important to understand them a so you don t get mixed up ater when you begin to invest in bond mutua funds: The coupon rate, which we ca the stated interest rate, tes you the interest payment in doars that you wi receive from the bond as a percentage of the bond s face vaue. Suppose, for exampe, you buy a newy issued bond for $1,000 and it has a coupon rate of 7 percent. That means you receive a tota of $70 in interest income from the bond for the year. Year in and year out, you wi coect $70 from the bond unti it matures. Then, you get your $1,000 back. Bonds have two yieds. The current yied is based on the current market price of the bond, which can fuctuate based upon market conditions. Suppose a bond with a face vaue of $1,000 drops in price to $900. It sti earns $70 a year in interest income, based on the bond s stated interest rate. As a resut, the current yied of the bond is $70 divided by $900, or 7.78 percent. You aso have to consider a bond s yied to maturity. Bonds typicay pay semiannua interest over a specific time period. That means the interest generay compounds twice a year unti it matures. The yied to maturity of a bond is the yied you get if you hod it for the entire term, assuming compound interest. Technobabbe The current yied of a bond is the annua interest you get on a bond, divided by the changeabe market price (as opposed to the bond s face vaue). The yied to maturity is the annua rate, factoring interest compounding, that the bond pays if you hod it to maturity. The coupon rate is how much interest you get based on an annua percentage of the bond s face vaue. How Bonds Are Cassified Bonds issued by the United States government are backed by the "fu faith and credit" of Unce Sam. Corporate bonds are not. Once you go beyond Unce Sam, you have to make sure you invest in financiay strong companies. That s why it s important to ook at bond credit ratings. News You Can Use fie://j:\macmiancomputerpubishing\chapters\ib900.htm 3/22/01

4 Chapter 3: Investing: Your Options, Your Risks, Your Rewards Page 4 of 10 You may aready be famiiar with U.S. Savings Bonds. These bonds operate differenty from most other bonds we discuss. U.S. Savings Bonds are sod at haf the price marked on the face of the bond. However, unike most traditiona bonds, savings bonds have a variabe rate, subject to change every six months. Pus, interest is automaticay credited monthy, and you ose three months worth of interest if you cash out within five years. At this writing, savings bonds paid 5.73 percent ess than one-year Treasury bis but more than 30-year Treasury bonds. But they coud prove more attractive in the ong run if rates head up. Certain companies, such as Standard & Poor's and Moody's, rate the financia strength of bond issuers based on the abiity of companies to repay principa and interest on time. The highest quaity bonds are rated AAA. Bonds rated beow singe A stand a greater chance of faiing to repay their debts during tough economic times. Uness you're a seasoned investor, you might want to stay cear of investing in bonds with ower ratings or mutua funds that invest in them. Other Bond Risks When you buy bonds or invest in bond funds, you not ony have to ook at the issuer's financia strengths, but you aso must dea with changing bond prices. Chapters 12, "Bonding: Investing with Bond Funds," and 13, "Choosing the Right Bond Fund," discuss the risks and ratings of bonds in more detai, but it is important to note that you can get into troube even with the highest-quaity bonds if you're not carefu. Interest rates and bond prices move in opposite directions, so it's not aways a time for rejoicing if interest rates head up. It means that your bonds are osing vaue if their coupon rates (stated interest rates) are ess than the going rates. Put yoursef in a bond buyer's shoes. If you coud buy a newy issued bond paying a stated interest rate of 7.5 percent by investing $1,000, you certainy woudn't offer Joe Bidde the same $1,000 for his bond paying a stated rate of 6.5 percent, woud you? Uness you can buy the bond for ess money, it's simpy not worth putting up your hard-earned cash for a ower yied. That's exacty how the big bond traders think. Moreover, the onger the term (time to maturity) of the bond, the riskier it appears to the bond investor and the ess it is vaued. Why? The onger the term, the greater the period an investor has to worry about the threat of rising interest rates. If interest rates rise 1 percent, a 2-year Treasury note (which is just another word for a short-term bond) oses neary 2 percent in vaue. By contrast, a 30-year Treasury bond oses about 12 percent in vaue. Chapter 14, "Buiding Your Weath with Stock Funds," shows you exacty how much rate shifts can affect bond prices. Beieve it or not, bond investors might aso get their principa back faster than they'd ike. That's because issuers might have the right to ca their bonds or return the bondhoder's principa. Bonds get caed when interest rates fa. The issuer then ses ower-yieding bonds and reduces its interest payments. Most peope invest in bond funds for income and safety. You are ending companies, or Unce Sam, money when you invest in a bond or bond fund. In return you get interest income pus your initia investment, or principa, is returned at maturity. By contrast, when you invest in stocks, you are the owner of a company and share in its profits. As a resut, if a company is increasingy profitabe, its fie://j:\macmiancomputerpubishing\chapters\ib900.htm 3/22/01

5 Chapter 3: Investing: Your Options, Your Risks, Your Rewards Page 5 of 10 stock price tends to rise. You don t get that kind of growth when you invest in bonds. Historicay, stocks have grown at an annua rate of around 11 percent over the past 70 years. By contrast, bonds have grown at neary 6 percent annuay. Kinds of Bonds a Fund May Own You can typicay find the foowing variety of bonds in your mutua fund if it invests in bonds: U.S. Treasury bonds, issued by Unce Sam U.S. government agency bonds, issued by agencies of the federa government, such as the Government Nationa Mortgage Association or Ginnie Mae Municipa bonds, issued by state and oca governments Corporate bonds, issued by companies Internationa bonds, issued by foreign corporations or governments There are a wide variety of bond funds to pick from. Depending on your financia situation, there are bond funds to meet your needs. Money Market or Cash Cash money market investments are short-term oans to banks, governments, or companies. Athough they re considered the east risky types of securities, there s sti a chance with a cash investment that you might not get back your principa, or origina investment. One of the most common cash investments is a CD or time deposit, such as the type you might aready have at your oca bank. However, unike most of us, mutua funds generay invest in these in amounts of $1 miion or more. Going It Aone The good news is that any of the securities just discussed has the potentia to earn more (and in some cases, much more!) than your od, faithfu savings account. The bad news, as we warned you earier, is that none of these securities is quite as ow-risk as Federa Deposit Insurance Corp. (FDIC) insured savings accounts and CDs. You ve probaby heard the horror stories yoursef. Joe Bidde s stockbroker has inside information on a company that makes 3D video games. "Buy the stock," the stockbroker whispers. "Doube your money in a coupe of days. Buy now and se when everybody gets wind of this dea." Aha! Joe empties his bank account and buys 500 shares at $10 a share for a tota investment of $5,000. The next day he opens the newspaper. "Video Games Cause Creepy Sime Disease," the headine announces. Wham! The next day, everyone ses. The stock s price punges to $5 a share. Worried that it soon coud drop to zero, Joe aso ses. His oss is $2,500, or haf of his investment. A simiar situation coud happen with a bond if Joe happens to invest in a weak company that fas on tough times. Suppose that Joe, based on his stockbroker s advice, invests $5,000 in a new bond issued fie://j:\macmiancomputerpubishing\chapters\ib900.htm 3/22/01

6 Chapter 3: Investing: Your Options, Your Risks, Your Rewards Page 6 of 10 by the same 3D video game company. Investors get wind of the fact that the company might have a tough time paying back interest and principa to the bondhoders. Bondhoders tie up the stockbroker s phone ines a day trying to se their bonds. The price of the bonds drops, and Joe is worried it coud get worse. Joe ses his bond for $4,000 $1,000 ess than he paid for it. The Mutua Fund Advantage With so many peope investing in mutua funds, you'd think there has to be a good reason, right? Actuay, there are severa. The foowing sections show why mutua funds are so we-suited to amost everyone, and why they stack up so favoraby when compared with other types of investments. Mutua Funds Are Diversified When you invest in a mutua fund, you don't need to worry so much that you're investing in one dud company or bond issuer. As mentioned earier in this book, most funds own a arge number of investments. In other words, they're diversified. If one investment owned by the fund performs poory, there's sti hope that the others might ray. At east, you're ess ikey to ose as much. Federa aws give you some added protection. A diversified mutua fund is required to invest in at east 16 companies. The Securities & Exchange Commission (SEC) says that no more than 25 percent of a diversified mutua fund's assets are aowed to be in a singe stock or bond issuer. Meanwhie, no more than 5 percent of the remaining 75 percent of the fund's assets can be in any one company. A mutua fund aso can't own more than 10 percent of the outstanding voting stock of a company in which it invests. A these requirements contain an awfu ot of numbers. But it can be great news if just one of your mutua fund's hodings happens to tank! Technobabbe Diversified means a fund's assets are spread among a arge number of different investments. Suppose a fund owns 50 different stocks, incuding Computer Chip, Inc. One day, there is terribe news about Computer Chip, Inc., and the stock price drops 5 percent. That's a big oss for a stock! The other 49 stocks don't drop in price, however. In fact, some rise. At the end of the day, that Computer Chip, Inc., oss didn't put much of a dent in the vaue of the fund. Whew! Mutua funds aso reieve you of a major workoad. Who has time nowadays to pay the stock market or find a company with a great credit record? Not ony that, but by the time we peons hear about a great investment, it's generay too ate to profit from it. The Wa Street pros se us the hot tips and bank their whopping profits. Where does that eave us? In the hoe. Enter mutua funds... You Get Your Own Investment Pro With a mutua fund, you get your own highy trained hired gun (or guns) working fu-time to ensure that you make money. The fund manager, or portfoio manager, has a the investment research at his or her fingertips and even visits companies before investing in them. This individua often earns a fie://j:\macmiancomputerpubishing\chapters\ib900.htm 3/22/01

7 Chapter 3: Investing: Your Options, Your Risks, Your Rewards Page 7 of 10 high saary pus a bonus at year s end if a fund performs better than simiar funds. This gives the fund manager a high eve of incentive to ensure that the fund does we. Some funds have a team of portfoio managers. You May Get Higher Returns With a mutua fund, you have greater potentia to grow your money over the ong term than you do in a bank. After a, ook at the securities that mutua funds invest in. Historicay, stocks have earned 10 percent annuay, bonds have earned more than 5 percent annuay, and pain od CDs have earned about 3 percent annuay. (Of course, we won t discuss the pidding yieds on savings accounts right now.) However, once again, the vaue of your mutua fund fuctuates with changing market conditions, so it s possibe that you can aso ose money with these investments. Mutua Funds Pay You Back What a mutua fund earns on its investments is utimatey passed on to you as distributions. You can receive three types of distributions from a fund: 1. When the fund owns bonds, it earns interest income. 2. When a fund owns stocks, it earns dividends. The dividends are a share of company profits that are paid periodicay to its sharehoders. 3. When the fund ses either stock or bond investments at a profit, the profits are caed capita gains. Technobabbe Distributions are dividends and capita gains distributed by mutua funds to their sharehoders. Interest income represents earnings you receive from bonds, CDs, or other debt securities. Capita gains are profits on the sae of securities. You can receive your distributions in cash, or you can have your mutua fund reinvest the money to buy more shares in the fund. You Get Your Money Whenever You Want It You can buy and se a or part of your mutua fund whenever you want. Just ca the fund or your stockbroker to-free and give your directions on a tape-recorded ine. You generay can get your cash in a coupe of days. (In fact, many funds even give you a book of checks when you purchase them.) You Have a Fund Famiy Many mutua fund famiies offer investors a wide variety of mutua funds. The funds may invest in different kinds of stocks, bonds, or cash equivaents based on different investment objectives. When fie://j:\macmiancomputerpubishing\chapters\ib900.htm 3/22/01

8 Chapter 3: Investing: Your Options, Your Risks, Your Rewards Page 8 of 10 one investment company owns a number of mutua funds, those funds are considered part of a fund famiy. The T. Rowe Price Group of Funds, Batimore, for exampe, has more than 45 different stock and bond funds in its famiy of funds. Mutua fund famiies make investing easy. As your money situation, or the market, changes, you can switch from one fund to another. Technobabbe A variety of funds avaiabe to investors from one investment management company may be known as a fund famiy. You Can Go to the "Supermarket" Don t want to imit your mutua investments to a singe mutua fund famiy? Today, you can go to the "supermarket." We re not taking about the pace you buy watermeons and potatoes. Rather, brokerages such as Chares Schwab and Fideity, as we as banks, et you seect from a number of mutua fund famiies through their specia mutua fund "supermarkets." The advantage is that athough you might pay a itte more for your fund (we' get into the bad news fees in Chapter 7, "The Cost of Investing"), you get one singe statement. You aso can switch investments with one phone ca to a broker. Mutua Funds Are Easy to Reach If you're investing within a fund famiy or through a broker, you can typicay ca to-free and switch from one fund to another as investment conditions or your financia needs change. Generay, there is no charge. Most fund famiies wi aso send you free how-to bookets to hep you invest wisey. The materia is educationa, but don't forget that the fund famiies want your business. It aways pays to do independent homework. You can aso go onine and get a the information you need about the mutua fund famiy and its stabe of funds. There are cacuators and educationa materias you can print out. Some fund groups aso post interviews with fund managers so you get a fee for what's happening. A few et you take a peek at the fund's hodings onine. You Don t Have to Be Rich As we tod you earier, you don't need beaucoup bucks to invest in a mutua fund. Athough you might need severa thousand doars to invest in individua stocks and bonds, you can get started in a mutua fund with as itte as $100. With most funds, however, you need to make an initia investment of $500 to $1,000. Mutua Funds Are Highy Reguated Mutua funds are reguated by both the SEC and your own state's reguators. The funds are required to report their financia activities to these agencies. Meanwhie, mutua funds are aso required to send sharehoders financia reports. Often, reports are consoidated for a fund group or famiy. Therefore, if you own more than one mutua fund in a fund group or famiy, you won't necessariy need to keep track of a hundred different pieces of paper. fie://j:\macmiancomputerpubishing\chapters\ib900.htm 3/22/01

9 Chapter 3: Investing: Your Options, Your Risks, Your Rewards Page 9 of 10 Money Matters Unike safer investments, such as CDs from banks, which are reguated by the Federa Deposit Insurance Corp., you re not guaranteed your origina investment back with a mutua fund. Before investing, it s critica to investigate the quaity of a mutua fund s investments. You Can Save for Your Retirement Mutua funds are a great way to save for retirement. When you open your mutua fund account, you can set it up as an Individua Retirement Account (IRA). Often IRAs have ower minimum investments. With this retirement pan, which you earn more about in Chapter 24, "Saving for Important Life Goas," not ony do you get the benefits of mutua fund investment profits, but aso you might get to deduct annua contributions from your income on your federa tax return. Meanwhie, you pay no taxes on your earnings unti you retire. You can aso invest in the new Roth IRA, which is aso discussed in Chapter 24. You might think of a Roth IRA as an upside-down version of the IRA. Your annua contributions are not tax deductibe. However, at retirement, you get to take money out of your Roth IRA tax-free. Mutua funds work simiary in other retirement pans. Sef-empoyed individuas can use mutua funds in their Simpified Empoyee Pension Pans (SEPs) or Keogh pans. Companies may set up 401 (k) investment pans for their empoyees. Your 401(k) retirement pan contribution, which often is matched by an empoyer, is taken off the top of your saary. With a 401(k) pan, you might be abe to ower the income tax you pay on your wages, and the earnings grow tax-deferred. We go into more detai in Chapter 25, "Care and Feeding of Your 401(k)." You can have as many mutua funds as you want in your retirement account, and you can switch back and forth between those funds. You must keep your money in your retirement account mutua funds, however. If you move it into mutua funds outside the account, the IRS may consider it a withdrawa from your retirement pan and sock you with taxes on the amount withdrawn. You Get Automatic Investment and Withdrawas You know how you can have your paycheck automaticay deposited in your checking account. You can do the same with your mutua fund. As itte as $50 a month can be automaticay withdrawn from your checking account and invested in your mutua fund. If you re retired and need income, you can arrange to receive monthy checks from your mutua fund, in addition to having your mutua fund automaticay reinvest distributions to buy more shares in your fund. You can aso arrange to invest the distributions of one fund automaticay into another fund, provided that it is in the same famiy. The Least You Need to Know The kinds of securities a mutua fund invests in affects the vaue of the mutua fund. Mutua funds invest in stocks, bonds, or cash equivaents. Some invest in a three. They are fie://j:\macmiancomputerpubishing\chapters\ib900.htm 3/22/01

10 Chapter 3: Investing: Your Options, Your Risks, Your Rewards Page 10 of 10 professionay managed and we diversified. Unike a typica FDIC-insured account, there s aways a chance you can ose much of your origina investment in a mutua fund. With stocks, you own a piece of a company. You can quicky make a ot of money, but you aso can ose big. Bonds are ike oans to companies or governments. Copyright Macmian USA. A rights reserved. fie://j:\macmiancomputerpubishing\chapters\ib900.htm 3/22/01