Clients regularly have questions about investing. Words like stocks, bonds, allocation, rebalancing, and others get tossed around all the time. When sitting with a client recently, we discussed the difference between stocks and bonds and other concepts. The client walked away from our conversation feeling that she had a much better understanding of these types of investments.
Many of us invest with the expectation of a future return that allows us to build wealth and reach our financial goals. As we think about beginning to invest or seek more information about investing, these terms and concepts could be helpful.
Stocks: To own stock in a publicly traded company is to be a shareholder. It means to have an equity stake in the company and be a part owner. This ownership comes with certain rights, such as voting for the board of directors or sharing in the profits in the form of dividends.
Bonds: To own a bond is to own debt. As a bond investor, we lend money to a government entity or a corporation. The expectation is that the borrower is going to make regular interest payments and at the end of some term, return the entire principal we lent to them. As an example, in 2014 voters in the Tahoe Truckee Unified School District approved Measures E and U. These measures allowed the school district to issue bonds to fund school site improvements. Interest continues to be paid and when the bonds mature in 2033, the bondholders are scheduled to have their original investment returned.
Mutual Fund and Exchanged Traded Fund (ETF): These are the most widely used investment vehicles. They are similar in that they allow investors to pool their money with others to invest in a diversified portfolio of stocks, bonds, or other assets. There could be hundreds or thousands of stocks, bonds, or both in a mutual fund or ETF. Owning shares in a fund means owning a small portion of each of the underlying assets. This is a straightforward way to hold a small number of investments yet be spread across many asset classes.
Investment Risk: It does not matter where we put our money — there are always risks. We could bury cash in the backyard, but if our money is not growing and inflation is rising, we are losing purchasing power. We could invest in the stock of a poorly run company, and if it goes bankrupt, its stock is rendered worthless, or it could become unable to make interest payments and default. These are just a few of the risks to consider when deciding to invest. The Cal-Neva Lodge & Casino is one example of an investment gone wrong. The developer had secured financing in 2013 for a major renovation by offering a form of investment opportunity. Due to a series of delays, the developer was unable to complete the improvements and ran out money. The lender that provided the financing was left with no alternative but to sue the developer in an effort to recover some of the investment.
Diversification is an attempt to reduce investment risk. It is the concept that owning different investment types will reduce the chances that poor performance of any single investment will cause your portfolio to implode.
Asset Allocation is at the heart of diversification. It is the practice of dividing investments among different assets such as stocks, bonds, cash, and others. Because these asset classes tend to move in opposite directions, when mixed together they can reduce investment risk.
Time Horizon is the period of time you plan to hold an investment. Generally speaking, a short time horizon is 2 years or less, and a long time horizon is more than 7 years. Typically, the shorter your time horizon, the more conservative your allocation should be.
Investment Objective can help inform our time horizon. If we are saving for a wedding or a home down payment that is just a couple of years out, that is a short time horizon. On the other hand, if we are saving for a child’s education or the day we stop working, that could be a decade or more away. That is considered a long time horizon.
Risk Tolerance simply refers to the risk an investor is willing to take. It is human nature to have a high-risk tolerance when markets are rising. Our risk tolerance is really tested when markets drop 20% or 30%. The lower our risk tolerance, the more conservative our allocation should be.
Rebalancing is a strategy that has been shown to reduce risk. As time goes on and markets move up and down, your chosen asset allocation could drift. For example, if you started with 75% stocks, 22% bonds, and 3% cash, a year later you may be at 80% stock, 19% bonds, and 1% cash. Rebalancing is a systematic approach of returning to your target allocation of 75% stocks, 22% bonds, and 3% cash. It forces you to sell stocks that have appreciated and take profits while buying bonds that are at a discount — the strategy of buy low and sell high.
Compounding Interest is your money working for you. It is the concept that the interest earned on your investments will in turn earn interest. Thereby each time interest is earned, it is earned on an ever-growing principal amount.
The Rule of 72: Luca Pacioli, an Italian mathematician born in the 15th century, first described the Rule of 72 to explain exponential growth. In finance, it is used to demonstrate the power of compounding interest. It is an easy way to calculate how long it takes for money to double with a given interest rate. Just take the number 72 and divide it by the interest rate you expect to earn. That number gives you the approximate number of years it will take for your investment to double.
With this knowledge, it is time to think about the future and take action. If you are just starting out or you have been managing your own investments for a while, this information will allow you to review your portfolio. Tools provided by online brokerages such as Vanguard, Fidelity, and others will enable you to perform an analysis and make recommended allocation changes where appropriate.
If you are not comfortable managing your own investments and planning for future goals and needs, seek the advice of a Certified Financial Planner™ professional. A CFP® can be found at letsmakeaplan.org.
Whether you are seeking professional advice or going it alone, it is important to consider these concepts as part of a broad investment strategy. Stay focused on your future goals and realize that history shows markets may temporarily fall only to resume a permanent upward trend.
~ John Manocchio is a CFP® Professional with Pacific Crest Wealth Planning serving the Truckee/North Lake Tahoe region. He lives in Truckee with his wife and two sons.