ABCs of investing

When you first start thinking about investing - whether it's because you're eligible to contribute to a retirement plan at work or decide to open an investment account on your own - you may feel overwhelmed by all the decisions you have to make. For instance, you're probably asking yourself whether stock or bonds are a better choice for you, or if you should choose mutual funds that invest in either of these assets. And beyond figuring out which types of investments are most appropriate, how do you choose among the thousands of individual securities and funds available?

But at the core of most of the critical choices you make as an investor are a few basic principles, or ABCs. Mastering these ABCs - such as risk and return, compounding, and how inflation affects your portfolio - and understanding how they apply to your own financial goals and circumstances can help guide you through many of your most important investing choices.

Investing vs. Saving

Saving and investing aren't the same - although they both play a role in your financial plan. While they both involve setting aside some of your income for the future, saving often refers to putting money in the bank - in savings and money market accounts - while investing means buying stocks, bonds, mutual funds, and other uninsured assets (certificates of deposit and U.S. Treasury bills fall somewhere in between).

When you save, you're preserving your money for a later time. When you invest, you're taking some risk that you believe will make it possible for your investment to grow in value over time. While investing can help you achieve your long-term goals, saving is an effective way of managing your money to meet short-term needs and to provide a safety net for emergency expenses.

Liquidity

Liquidity is one of the key differences between savings and investments.

Savings are liquid. That means you can withdraw cash with little or no loss of value any time you need the money. If your account is worth $1,500, that's the amount you can take out. With bank CDs, you can usually retrieve your full principal, although you may lose some interest if you withdraw before the term ends.

But investing doesn't mean tying up your money. In fact, you have almost as much liquidity, or ability to turn your investments into cash, with most stocks, bonds, and mutual funds as you do with a bank or mutual fund money market account. That's because if you need money, you can always sell these investments through your brokerage firm. And in the case of mutual funds, you can often sell them back to the issuer directly.

The difference is that the investments may have decreased in value, either from a previous price or since you bought them. If you sell when the price is down, you may lose some principal.

Brokered CDs, which are issued by banks but are sold through brokers, may be less liquid than bank CDs. For instance, you may not be able to withdraw your funds even if you're willing to pay a penalty. However, some brokers will purchase your CD and sell it to another client at market price. That means you may receive less - or more - than you paid for it.

Risk & Return

Understanding the relationship between risk and return is essential to understanding why people make some of the investment decisions they do.

First is the principle that risk and return are directly related. The greater the risk that an investment may lose money, the greater its potential for providing a substantial return. By the same token, the smaller the risk an investment poses, the smaller the potential return it will provide.

For example, a startup business could become bankrupt, or it could become a multimillion-dollar company. If you invest in the stock of this company, you could lose everything or make a fortune. In contrast, a blue chip company is less likely to go bankrupt, but you're also less likely to get rich by buying stock in a company with millions of shareholders.

The second principle is that if you can get a better-than-average return on an investment with less risk, you may be willing to sacrifice potentially greater return to avoid greater risk. That's sometimes the case when interest rates go up. Investors pull their money out of stocks, which are more risky, and put it in bonds, which are less risky, because they're not giving up much in the way of potential return and they're gaining more safety.

The third principle is that you can balance risk and return in your overall portfolio by making investments along the spectrum of risk, from the most to the least. Diversifying your portfolio in this way means that some of your investments have the potential to provide strong returns while others ensure that part of your principal is secure.

Compounding

Time is your biggest ally as an investor. That's because the more time you have to invest, the longer your investment can compound, or grow in value.

Compounding is a financial phenomenon that makes time work in your favor. It's what happens when your investment earnings are added to your principal, forming a larger base on which earnings may accumulate. And as your investment base gets larger, it has the potential to grow faster.

All in the timing

The younger you are when you start investing, the more you will benefit from compounding. Let's say you begin investing at age 25, putting $200 a month in a tax-deferred retirement plan earning 9%. Your friend starts investing in the same plan at 45, but puts away twice as much money as you - $400 a month. At age 65, you will both have invested a total of $96,000, but your investment would have grown to $884,000, while your friend's investment would be worth only $268,000. The reason your investment has grown so much more than your friend's - even though you both invested the same amount of money - is because of 20 extra years of compounding.

Inflation

You can think of inflation in two ways:
Persistent increases in the costs of goods and services
Persistent decreases in the buying power of the dollar

Either way, inflation is the opposite of stable prices, and over time can erode the purchasing power of your money. For example, you can buy somewhat less with a dollar today than you could have bought five years ago, and significantly less than you could have bought fifty years ago. So if you have the same amount of income each year, your purchasing power gradually shrinks.

The inflation rate varies from year to year, and since 1926 has averaged 3% annually. That includes the high point, in 1980, when it hit 14%, and several periods of disinflation, when inflation hovered around 1% and prices remained steady. Several years have also witnessed deflation, when the cost of goods and services actually dropped. While deflation seems to increase your buying power, it's often accompanied by rising unemployment and falling production - which can create serious economic problems.

Many factors influence the rate of inflation, from overall economic conditions and consumer spending to monetary policy and the political outlook.

Yield

Yield is the total amount of income you earn on an investment each year as a percentage of what you spent to buy it.

A bond's yield is the interest the bond pays divided by its price. If you buy a 10-year $1,000 bond paying 6% and hold it until it matures, you'll earn $60 a year for ten years - an annual yield of 6%, or the same as the interest rate.

A stock's yield is the dividend per share divided by its current price per share. If a company whose stock is selling for $40 a share pays an annual dividend of 80 cents a share, the stock's yield is 2%. However, while all bonds have a yield, only those stocks that pay dividends have yields.

Leverage

Leverage is a technique that allows you to use a small amount of your own money to make an investment that you expect to increase in value. In that way, leverage can increase your buying power and give you control of potentially valuable assets. Leverage is more common than you may think. For instance, when you take a mortgage, you're using leverage to pay for something you can't buy with the cash you have on hand. When the mortgage is paid off, you get to keep any profit you make in selling the property.

You can also leverage stock investments by buying on margin. In this case, you use some of your own money and borrow the balance of the stock's cost from your broker. If the stock increases in price, you can sell at a profit, return the amount you borrowed plus interest, and pocket the rest.

Because you're putting up less of your own money, the return on your investment can be much larger using leverage than it would be without leverage. For example, if you use $5,000 of your own money and $5,000 of borrowed money to make a $10,000 investment you sell for $15,000, your return is $5,000 on a $5,000 investment, or a 100% return. If you'd used all of your own money, you'd realize $5,000 on a $10,000 investment, or a 50% return.