how to do it TM

Money & Business

Investing Basics
published by Barnes & Noble

Wealth made easy.

Although a savings account is never a bad idea, the only way to build your wealth
significantly over time is to invest. And it’s far easier than you think: even the
simplest investing plan can boost your net worth and secure your financial future.

• Learn the basics of risk, return, compounding, and diversification

• Choose investments that are the right risk level for you

• Recognize the pros and cons of stocks, bonds, mutual funds, and ETFs

Types of Investments Stock Exchange (NYSE), the NASDAQ, and the American
What’s an Investment? This guide covers four major investment products: Stock Exchange (AMEX). Bonds are also sold on various
An investment is an asset—such as a stock or a bond— exchanges; ETFs are generally sold on the AMEX.
that an investor buys in order to build wealth over time. The • Stocks: Investments in a specific publicly traded Though professional traders and market makers at
value of an investment can rise or fall based on a number of corporation, such as Google or PepsiCo. Publicly traded the exchanges facilitate some of the pricing and trading of
factors, from supply and demand to the state of the overall companies issue shares of their stock to the general investments, a substantial portion of trading occurs elec-
economy. Investors buy investments with the intention of public. Each share represents a fractional percentage tronically. The U.S. government’s Securities and Exchange
selling them later for a higher price. of ownership in the company. Commission (SEC) enforces strict legal standards that
Some investments, such as real estate property, pre- • Bonds: Loans that investors make to corporations and govern the investment products traded on each exchange.
cious metals, fine art, and collectibles, are assets that the governments. The corporation or government then
owner possesses and, in many cases, can physically use. makes fixed interest payments to the bond investor How Investors Buy Investment Products
The types of investments that this guide covers are invest- over a set period of time, called a term. At the end As an individual investor, you don’t buy and sell investment
ment products—nonphysical assets such as stocks and of the term, the investor also gets back the original products directly on the various exchanges. Instead, you
bonds, which for most investors are more convenient and investment amount, called the principal. buy them through middlemen, such as brokers, brokerage
easier to sell than physical assets such as real estate. • Mutual funds: Investments that pool money from houses, and other financial professionals who are called
many investors and invest it in a specific set of stocks registered representatives. First, you set up an investment
Why Invest? or bonds. A type of mutual fund called an index fund account and place cash in it. Then you can place orders
Investing is the most effective way to build your wealth at attempts to mimic the performance of a specific through a broker or brokerage house to buy or sell spe-
rates that exceed those of inflation, the economic phenom- market index, a group of investments that serves as a cific investments. When these orders are executed (filled or
enon that causes the prices of goods and services to rise benchmark for the performance of other investments. completed), the cash in your investment account converts
over time. Inflation doesn’t change the amount of money For instance, an S&P 500 ® index fund tries to replicate into a certain amount of the investment product bought,
you have, but it does erode your purchasing power, the the performance of the S&P 500, a well-known index and investments sold convert back into cash in the account.
amount of goods and services you can buy with your money. of 500 of the most widely held U.S. stocks. As investments in the account rise or fall in value, the ac-
Since 1925 or so, inflation in the United States has averaged • Exchange traded funds (ETFs): ETF are funds that count balance adjusts accordingly, usually once per day.
3% per year, while the average savings account has paid an track indexes (as index mutual funds do) but are
interest rate of about 2%. During the same period of time, bought and sold like stocks. Names and Symbols of Investment Products
the return, or the annual rate of growth, of U.S. stocks has All investment products have a given name and are repre-
averaged about 10%. If those trends continue: How Investing Builds Wealth sented by a symbol.
Investing builds wealth in two main ways:
• Due to inflation, in 30 years you’d need $2,427.26 to • The symbols used to represent stocks, mutual
equal the purchasing power of $1,000 today. • Growth: Growth investors aim to buy investments that funds, and ETFs are called ticker symbols and consist
• $1,000 kept in a savings account would grow to will increase in value over time, so they can then sell of 1–5 letters. For instance, the ticker symbol for
$1,811.36 after 30 years, trailing the effect of inflation. the investments later for a higher price. Starbucks stock is SBUX.
• $1,000 invested in stocks today would grow to • Income: Income investors aim to buy investments • The symbols used to represent bonds are called
$17,449.40 over 30 years, easily allowing you to outpace that provide regular cash payments. These payments CUSIPs and usually consist of nine numbers and
the effects of inflation over that time period. can take several forms. For instance, some stocks pay letters. For example, a bond issued recently by the
dividends, a portion of a company’s earnings paid New York City government had a CUSIP of 649660JR9.
$20,000
directly to the company’s shareholders. Most bonds Stocks also have nine-digit CUSIPs, but these are rarely
$16,000 pay interest, periodic cash payments that investors used, since ticker symbols are simpler to remember.
receive in exchange for buying the bond.
$12,000
Shares and Amounts of Investment Products
$8,000
Some investments provide only growth; others provide only Some investments, such as bonds and mutual funds,
income. Some, such as dividend-paying stocks, provide a are bought and sold in dollar amounts. Others, such as
$4,000 mixture of growth and income. stocks and ETFs, have a specific share price that changes
constantly as the supply and demand for the shares shifts
0
5 10 15
years
20 25 30 Types of Investing Markets throughout the trading day. Mutual funds also have a spe-
Investment products are traded—bought and sold—on cific share price, but it changes only once per trading day—
stocks the growth of $1,000 invested in stocks or
savings a savings account compared to the effect of exchanges, also called markets. For instance, stocks are after the markets close and the value of all the mutual
inflation 3% inflation over 30 years sold on various stock exchanges, such as the New York fund’s holdings is recalculated.
 www.quamut.com Investing Basics

The correlation between risk tolerance and age isn’t 100% Conservative Asset Allocation
Risk and Risk Tolerance ironclad. Other factors, such as your personal life situa-
Before you begin making investments, it’s essential to un- tion and upcoming financial obligations, can have a major cash equivalents 70%
derstand some of the basic principles of investing—namely, impact on your risk tolerance. For instance, a young couple bonds 20%
risk, return, volatility, and risk tolerance. saving to buy a home within the next five years might seem stocks 10%
to have a high risk tolerance, based on their age. Even so,
Investment Risk, Return, and Volatility they should probably consider their risk tolerance low, since
Risk refers to the uncertainty of an investment’s return. they’ll need to use the money they’re investing to buy a
Some investments, such as savings accounts, have guar- home within five years.
anteed returns and therefore carry no risk. Others, such as Moderate Asset Allocation
stocks, carry a lot of risk. The return on any particular stock Your Personal Response to Risk
is always uncertain: depending on the performance of the In addition to the risk that you can accept based on your
stocks 50%
company, its stock could double in value, or it could become time horizon, risk tolerance also includes how you feel per-
cash equivalents 30%
worthless. Volatility is the degree to which the value of an sonally about taking risks and losing money. 01low.ai
bonds 20%
investment tends to fluctuate over time.
• If you avoid risk in everyday life or worry easily:
• Risk and volatility tend to correlate with investment Even if you have a long time horizon, it still might be
returns: the higher the risk of an investment, the higher best for you to avoid buying risky investments such as
its volatility and potential returns. stocks. Though your returns will potentially be lower, Aggressive Asset Allocation
you’ll get the benefit of lower volatility and less stress.
Over short periods of time (five years or less), investments • If you enjoy risk and don’t worry easily: You should
stocks 75%
with high risk and volatility have the greatest chance of feel comfortable investing for growth exclusively—
bonds 15%
losing value. For instance, a stock worth $5 today might be assuming you have a long time horizon. 02moderate.ai cash equivalents 10%
worth $2 tomorrow. Over longer periods of time, though, in-
vestments with high risk and volatility tend to have a greater
chance of increasing in value than low-risk investments. Asset Allocation and Diversification
An investment portfolio is a collection of various types of
Risk Tolerance investments. You should build your investment portfolio
Risk tolerance refers to the amount of risk that you, person- based on your risk tolerance and two other fundamental Diversification
ally, are comfortable accepting in your investments. To posi- principles: asset allocation and diversification. Just as you should own investments in various asset
tion yourself to benefit from your investments, you need to classes, it’s also important to own various investments
determine your risk tolerance. Asset Allocation within each asset class. For instance, rather than own just
03high.ai
Investments fall into various asset classes, such as stocks, one stock, such as Google or Pepsi, you should own several
How to Determine Your Risk Tolerance bonds, cash equivalents, precious metals, and so on. Asset stocks. And rather than own just one type of stock, such
Two important factors that affect your risk tolerance are allocation is the process of determining the percentage of as technology stocks, you should own stocks from various
your time horizon and your personal response to risk. your investment portfolio that each asset class should oc- industries. This practice, known as diversification, has been
cupy, based on your risk tolerance. proven to decrease risk without compromising returns over
Your Time Horizon the long term.
Your time horizon is the amount of time you have before Why Should You Allocate Your Assets?
you’ll need the money you’ve invested. Time horizon has a Each asset class provides you with a different level of risk,
direct relationship to risk tolerance: and different levels of potential return. Owning just one as- Should You Be Investing?
set class, such as stocks, would be risky, because the value It’s crucial to invest only with money that you won’t need
• The longer your time horizon, the greater your risk of your entire portfolio would depend entirely on the perfor- in the immediate future. If you invest with money that you
tolerance, since short-term changes in an investment’s mance of that asset class. With asset allocation, your port- might need, you may be forced to sell at a time when your
value won’t affect you. Investors with long time folio will benefit when one asset class booms and will lose investments have temporarily declined in value. To deter-
horizons (10 years or more) generally have a high risk only a portion of its value if another asset class crashes. The mine whether you have enough money to begin investing
tolerance. These investors should usually invest for overall purpose of asset allocation is to reduce volatility, so now, assess your financial situation as follows:
growth by buying stocks almost exclusively. that thriving investments in one asset class potentially out-
• The shorter your time horizon, the lower your risk weigh losing investments in other asset classes. 1. Cover your monthly expenses: Invest only money
tolerance, since a short-term dip in the value of an that’s left over after you pay all of your monthly
investment might occur just when you had planned to Sample Asset Allocations Based on Risk Tolerance expenses, including mortgage and car payments, credit
use that money to finance a major purchase. Investors The following charts below offer suggested asset alloca- card bills, and all utilities. If you have an outstanding
with moderate time horizons (5–10 years) generally tions for investors with high, moderate, and low risk toler- credit card balance and are making only minimum
have a moderate risk tolerance and should invest ances. For instance, based on these allocations, if you have monthly payments, pay off that balance entirely before
for growth and income by investing in stocks, bonds, $10,000 to invest and have a high risk tolerance, you might you begin to invest.
and cash equivalents (such as certificates of deposit put $7,500 into stocks, $2,000 into bonds or real estate, and 2. Consider short-term expenses: If you may face any
(CDs), which are almost always risk-free). Investors keep $500 in a money market fund. major expenses within the next 1–3 years, such as
with short time horizons (1–5 years) generally have a a college education or the purchase of a home, put
low risk tolerance and should invest almost entirely the money designated for those expenses into cash
for income by buying bonds and cash equivalents. equivalents, such as savings accounts or certificates

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 www.quamut.com Investing Basics

of deposit (CDs), which ensure that your principal The size of the commission is usually much higher for orders
won’t lose value (up to certain limits). placed by brokers or via telephone than for trades that you How to Invest in Stocks
3. Establish an emergency fund: Before you start make online. Commissions for online trades range from There are roughly 10,000 publicly traded companies on the
investing, set aside an emergency fund equal to 3–6 about $7–30 per trade, whereas commissions for broker- U.S. stock markets alone. Though you can buy the individual
months’ worth of living expenses. An emergency fund and phone-based transactions can be hundreds of dollars. stocks of any of these companies, most beginning investors
protects you from having to sell your investments to Always compare commission rates before choosing a find that researching and selecting a handful of individual
cover unexpected expenses, such as an unforeseen broker or brokerage. Because broker commissions are so stocks to buy among thousands of potential candidates
layoff or medical bills that result from an accident. high, for most individual investors it makes more financial is too risky and time-consuming to be practical, let alone
sense to invest through the online services of a brokerage profitable. Instead, another strategy for beginners—as well
If you don’t have money left over after following these house than to pay for a full-service broker. as for most seasoned investors—is to buy stocks through
steps, then you probably shouldn’t be investing at this time. mutual funds and ETFs (see How to Invest in Mutual Funds
If you do have money left over, then you’re ready to get How to Set Up an Investment Account and How to Invest in ETFs).
started investing. To set up an investment account: But even if you don’t buy any individual stocks, it’s still
essential to know the basic principles of stock investing. If
1. Choose a brokerage house or a full-service broker with you’re determined to research and buy individual stocks,
How to Get Started Investing whom you’d like to open an account. this section explains the basics to help you get started.
To get started investing, you first must choose the type of 2. Fill out an application for the type of account you’d
investment account you want and the broker or broker- like to set up. Most investment account applications Why Invest in Stocks?
age firm you want to work with. Once you’ve made these consist of a few forms that ask for your name, address, Buying stocks can help you build wealth in two ways:
decisions, you can set up an investment account and start Social Security number, and other basic information.
making investments. 3. Make an initial deposit into your account through • Capital appreciation: Occurs when a stock’s share
cash, check, or wire transfer. The amount required to price increases as demand for the shares grows.
Types of Investment Accounts establish an account varies but usually starts at $1,000. Share-price increases can happen for a variety of
An investment account is a special type of financial ac- reasons, such as growth in the company’s profits,
count in which you can buy, sell, and hold investments. Most major brokerages allow you to set up an account a strong overall economy, or as a result of pure
There are two main types of investment accounts: in person (if they have retail locations), by mail, over the speculation. If share prices rise, shareholders who
phone, or online. If you complete your application by phone bought the stock at lower prices can sell at higher
• Brokerage accounts: Also known as taxable or online, you may still have to fill out and mail in physical prices for a profit.
accounts, these accounts enable you to invest and forms with your signature to establish your account. • Dividends: Some companies—often older, more
withdraw any amount of money at any time, for any established companies—return a portion of their
purpose. You must pay income taxes on all dividends Setting Up a Retirement Account profits to investors as dividends instead of reinvesting
received and capital gains taxes on all assets sold at a If you’re setting up a retirement account, you’ll need to those funds back into the business. Dividends can be
profit (see Investing and Taxes). specify which type of retirement account you’d like to es- paid in cash or in additional shares of the company’s
• Retirement accounts: These accounts allow your tablish. Certain retirement accounts, such as 401(k)s and stock. A stock’s dividend yield is the ratio of the
money to grow without taxation on dividends or 403(b)s, can be established only at your workplace, where- dividend to the stock price: for example, a stock that
investment gains, which can significantly improve as others, such as Traditional IRAs and Roth IRAs, can be has a $100 share price and pays annual dividends of $5
returns. But retirement accounts have some built-in established directly through a broker or brokerage house. per share has a dividend yield of 5%. The dividend yield
restrictions—you can add only a fixed amount each changes over time as share prices fluctuate.
year to these accounts, and you face penalties if you How to Place Investment Orders
withdraw money early (usually before age 59 1/2). Once you’ve set up an investment account, you can place The Main Types of Stocks
The most popular types of retirement accounts are orders to buy (and later sell) investment products. Investors use a number of different methods to classify and
Traditional IRAs, Roth IRAs, 401(k)s, and 403(b)s. For group stocks:
more on retirement plans and retirement investing, see • If you’re working with a broker: You’ll confirm your
the Quamut guide to 401(k)s & IRAs, available in Barnes order with your broker, usually over the phone. He • Growth vs. value
& Noble bookstores and online at www.quamut.com. or she will then place orders on your behalf for the • Company size (or market cap)
investments that you’d like to buy or sell. • Industry group (or sector)
Brokers and Brokerage Houses • If you’re working with a brokerage: You’ll log on to • Geographic location (domestic vs. international)
As an individual investor, you can buy and sell investments your brokerage’s website or call their toll-free number
only if you have an account with a full-service broker to place your order. To place an order, you’ll need to Growth Stocks vs. Value Stocks
(called a broker for short) or a brokerage house (often know the name and/or ticker symbol of the investment Investors divide stocks into two broad categories: growth
called simply a brokerage). and the amount that you’d like to buy or sell. stocks and value stocks.

• Full-service broker: An independent local professional Should You Hire an Investment Advisor? • Growth stocks: Growth companies tend to be newer,
or a full-service agent employed at a brokerage house. If you’re a knowledgeable investing enthusiast who enjoys rapidly expanding companies whose sales growth and
A broker works with you one-on-one over the phone managing your own money, you may do well managing your earnings growth are expected to outpace that of the
or in person to make investment decisions, and places investment accounts yourself. But if you know little about market as a whole. Though share prices of growth
orders on your behalf to buy and sell investments. investing and have no interest in learning much more about stocks may rise more quickly than share prices of value
Brokerage houses that employ full-service brokers it, then it’s probably worth the time and money required to stocks, growth stocks are considered riskier than value
include A. G. Edwards, Merrill Lynch, and Morgan hire an investment advisor. An advisor can help you: stocks because they tend to be priced at a premium to
Stanley. You can find independent local brokers by the overall market and rarely pay dividends.
searching online or in your yellow pages. • Decide whether to open a brokerage account, • Value stocks: Value investors look for companies
• Brokerage house: A firm that provides investment retirement account, or both whose stock appears to be undervalued relative to
services to individual investors. Rather than provide one- • Determine your risk tolerance underlying fundamentals (key company statistics
on-one investment advice, most brokerages allow you to • Build a diversified portfolio such as sales, earnings, dividend yield, and so on).
place your own orders over the phone or online to buy • Place orders to buy and sell investments Value stocks often are older companies that pay
and sell investments. They also often provide proprietary dividends and tend to be less risky and volatile than
investment-related data and research reports to help Investment advisors charge commissions, an hourly rate, growth stocks, though they also tend to offer less
you make your own investment decisions. Some of and/or an annual fee based on the value of the investments opportunity for large returns. Value investors must be
the most popular brokerages include Fidelity, Charles that they manage. For advice on how to interview and careful to avoid value traps—stocks that appear to be
Schwab, Vanguard, T. Rowe Price, and TD Ameritrade. select an advisor, consult your state’s securities licensing undervalued but actually are suffering from serious
department, the National Association of Security Dealers problems in their company or industry, which have in
Commissions (www.nasd.org), or the U.S. government’s Securities and turn depressed their stock price.
All brokers and brokerage houses charge commissions Exchange Commission (www.sec.gov). These organizations
(transaction costs) for placing orders to buy or sell invest- can verify whether an investment advisor is licensed, has Investors with low risk tolerances tend to prefer the relative
ments. Commissions may be charged as a percentage of the received complaints, or has committed violations. safety and reliable income of value stocks, whereas more
total value of the transaction or as a flat fee per transaction. risk-tolerant investors tend to favor growth stocks.
 www.quamut.com Investing Basics

Company Size (Market Cap) though growing rapidly, are much less stable—either politi- convert to 10 shares of Google stock. A commission for
A company’s market capitalization, or market cap, is the cally or economically or both. These less stable countries the trade will also be deducted from your account.
total value of a company’s publicly traded stock. Market cap are termed emerging markets and can be very risky.
equals the number of publicly available shares multiplied by If You’re Trading Online through a Brokerage
the current share price. For example, a company with 10 How to Research and Analyze Stocks 1. You’ll place the order directly with the brokerage by
million shares outstanding and a share price of $10 has a Fundamental analysis is the process of analyzing a com- logging into your account online and filling out a stock
market cap of $100 million. A company’s market cap fluctu- pany’s financial results to determine its prospects for the order form. To fill out the form, you’ll need to know the
ates as its share price moves up or down. future and to assess whether its stock is fairly valued. The number of shares you wish to buy, the ticker symbol,
goal of fundamental analysis is to find bargain stocks, or and the type of order you prefer (explained below).
The Five Market Cap Categories stocks whose share prices are below where the market 2. The brokerage will send your order to the exchange,
Stocks can be placed into five general groups based on the should be pricing them. When investors refer to a com- where a person or a computer will fulfill the order.
size of their market cap. (Note that the specific market cap pany’s fundamentals, they mean the company’s financial 3. You’ll receive an email confirming that your order has
ranges included in these descriptions often vary.) well-being, as determined by three main factors: been placed, then a follow-up when your order executes.
4. In your investment account, $4,000 will immediately
• Mega-cap stocks: Giant companies with market • Profits (earnings): The total amount of money the convert to 10 shares of Google stock. A commission for
caps over $100 billion, such as General Electric and company actually earns after expenses the trade will also be deducted from your account.
Microsoft. Mega-caps, along with some large-caps, are • Debt: The company’s outstanding financial obligations
also known as blue-chip stocks. to suppliers, banks, and so on Types of Stock Orders
• Large-cap stocks: Companies with market caps of • Assets: The company’s valuable property, including There are two types of orders you can use when buying or
$10–100 billion. Large-cap stocks are typically well- cash, inventory, real estate, and so on selling a stock:
known household names, such as Apple.
• Mid-cap stocks: Companies with market caps of Investment Statistics and Ratios • Market order: You agree to buy or sell a particular
$2–10 billion. Examples of mid-cap companies include With data on earnings, debt, and assets, you can use a stock at the price specified by the market.
Hilton Hotels and Urban Outfitters. variety of simple statistics and ratios to assess a company’s • Limit order: You specify the maximum price at which
• Small-cap stocks: Companies with market caps of fundamentals and determine whether a company’s stock you’re willing to buy, or the minimum price at which
$100 million–$2 billion. Many small-cap stocks are of is worth buying. The most commonly used of these ratios you’re willing to sell.
companies whose names you probably wouldn’t know. and statistics are:
• Micro-cap stocks: Companies with market caps under Commissions are generally lower for market orders than
$100 million. These stocks often trade on markets other • Earnings per share (EPS): The portion of a company’s for limit orders, but market orders are also riskier and the
than the NASDAQ, AMEX, or NYSE. These markets, profits that each share of the company’s stock price difference is rarely substantial enough to justify the
known as the OTCBB (over-the-counter bulletin board) contains. To calculate it, divide a company’s profits increased risk. It’s a good idea to use limit orders every time
or pink sheets, are less rigorously regulated by the SEC by the number of publicly traded shares. If all other you buy or sell stock. Use market orders only if you abso-
than the more popular exchanges, which makes buying factors are equal, given two stocks with similar profits, lutely must sell your shares of a stock, regardless of price.
these stocks very risky. investors tend to favor the stock with fewer publicly
traded shares, and therefore higher EPS.
To provide a more precise description of a company, inves- • Price-to-earnings (P/E) ratio: A ratio that compares a How to Invest in Bonds
tors often combine the growth-value classification with company’s share price to its current EPS. To calculate Bonds are a type of lending investment in which investors
market cap, resulting in descriptions of stocks as “large-cap it, divide the company’s share price by the company’s loan money to bond issuers, which are usually corporations
growth, “ “small-cap value,” and so on. EPS. Companies with lower P/E ratios relative to those or federal, state, local governments, or quasi-government
of other stocks in the same industry tend to be good agencies (such as mortgage lenders Fannie Mae or Freddie
Market Cap and Risk values, assuming that all other factors are equal. Mac). Investors buy bonds for two main reasons:
Market cap and risk tend to correlate in the following ways: • Beta: A measure of a stock’s historical volatility
relative to the broader market’s volatility, which is • Income: Bonds pay investors fixed quarterly, monthly,
• Smaller-cap stocks tend to be more risky but often represented by a beta of 1. Stocks with betas greater semiannual, or annual interest payments.
have higher prospects for growth and significant share- than 1 are more volatile than the broader market—they • Return of principal: Bonds return the entire principal
price increases. tend to move up and down in price more often and in (original investment amount) back to the investor after
• Larger-cap stocks tend to be less risky but usually offer greater extremes than the market. Stocks with betas of a certain period of time.
less chance of huge growth and returns. less than 1 tend to be less volatile.
In the short term, bonds are generally less volatile and risky
Although these rules generally hold, they’re not always You don’t need to calculate these ratios and stats on your than stocks—but not as risk-free as cash-equivalent invest-
true. For example, Google was already a large-cap company own. A faster way is to use financial websites that aggre- ments such as CDs or money market accounts. As a result,
when it went public in 2004, yet its stock price still rose tre- gate and publish these data as they become available and bond returns tend to be higher than those of cash equiva-
mendously over the following year. On the other hand, the calculate the most helpful ratios and stats for you. Among lents, but not as high as stock returns over the long term.
pharmaceutical mega-cap Merck plunged more than $100 the best sources for stock-related reports, data, and stats Investors typically buy bonds as a counterweight to stocks,
billion in value over the period from 2000–2005. is Yahoo! Finance (finance.yahoo.com). since bonds tend to rise in value when stocks decline.

Sector How to Buy and Sell Stocks Bond Basics

Stocks can also be classified by industry, or sector—the Once you decide to trade (buy or sell) a particular stock, Before you invest in bonds, familiarize yourself with some
general type of business in which the company is involved. the process will differ slightly based on whether you’re basic bond terminology:
For example, major industry/sector groups include tech- working with a full-service broker or an online brokerage.
nology, healthcare, utilities, financial, consumer goods, For instance, if you want to buy 10 shares of Google at $400 • Par value: The face-value price of the bond that the
industrial goods, and so on. Stocks within a given industry per share: investor will eventually receive back as principal
or sector often share certain predictable traits, such as how • Coupon rate: The interest rate that the bond pays.
quickly they grow and whether they pay dividends. For a If You’re Trading through a Broker For instance, a bond with a par value of $1,000 and an
more extensive list of industries, see the Industry Center on 1. You’ll contact your broker and tell him or her you want annual coupon rate of 9% will pay $90 a year.
Yahoo! Finance at biz.yahoo.com/ic/ind_index.html. to buy 10 shares of Google. • Maturity date: The date on which the bond issuer
2. Your broker will ask you the highest price per share will return the principal to the lender and stop making
Domestic Stocks vs. International Stocks you’re willing to pay for the shares. interest payments. The length of time until a bond’s
U.S.–based investors have the opportunity to include both 3. Your broker will place the order with a brokerage. maturity date—also known as the bond’s term—can
domestic (U.S.–based) and international (foreign-based) 4. The brokerage will send your order to the exchange, be anywhere from less than a year to 30 years. Usually,
companies in their portfolio. International stocks can help where either a person, known as a market maker or the longer the term, the higher the coupon rate.
to diversify a portfolio. However, they also carry risks re- specialist, or a computer will fulfill the order. • Callability: Callable bonds give the issuer the right to
lated to foreign exchange rates and political stability. 5. The exchange will send back confirmation once your recall the bond, pay back principal, and stop paying
Some foreign economies, such as those of western Eu- order executes, or is filled. interest at a point in time before the maturity date. All
rope, Australia, and Japan, are well-established, developed 6. In your investment account, $4,000 will immediately
economies. Others, such as Brazil, Russia, India, and China,
 www.quamut.com Investing Basics

corporate and state or local government bonds specify Munis are also state- and local-tax–free to investors who Mutual Fund Expense Ratios
whether they can be called and how soon they can be reside in the states or locales that issue the munis they Running a mutual fund costs money. Expenses include
called. Federal bonds are never callable. own, which makes some munis triple-tax-free, or entirely everything from fund manager salaries to office supplies to
free from tax. Due to these tax savings, munis tend to offer transaction costs for buying and selling securities. A fund’s
Like stocks, bonds are bought and sold through brokers and much lower interest rates than Treasuries. expense ratio is an annual fee, expressed as a percentage,
brokerage houses, both of which usually add a markup of that’s charged to shareholders to cover the fund’s overall
1–5% to the par value of the bonds they sell. So a bond with Corporate Bonds operating expenses. Many investors make the mistake of
a par value of $100 might sell for $102. Corporate bonds are bonds issued by corporations. Cor- disregarding expense ratios because they seem so small—
porate bonds tend to have higher yields than government usually 0.15–2.00% or so. This mistake can cost thousands
Classifying Bonds by Term bonds and munis due to their higher risk of default—com- of dollars over time.
Bonds are often grouped based on their terms: panies go bankrupt more often than governments. Even so,
the bonds of many companies—especially AAA-rated com- How Expense Ratios Impact Fund Returns
• Short-term: Bonds with terms of 0–3 years panies such as ExxonMobil or General Electric—have very Consider the impact of expense ratios on $10,000 invested
• Intermediate-term: Bonds with terms of 3–10 years low default risk. In general, the higher a company’s credit for 20 years in the two funds below:
• Long-term: Bonds with terms of 10 years or more rating, the lower the coupon rate of its bonds. All corporate
bonds are subject to federal, state, and local taxes. Fund A Fund B
Credit Risk and Interest Rate Risk
Expense ratio 0.18% 1.50%
On the surface, bonds seem like a great deal—you get paid TIPS
to lend money, and then you get back all the money you Treasury inflation-protected securities, known as TIPS, are Annual rate of return 10% 10%
lent. But bonds do present two unique types of risk: credit a special type of Treasury note or bond that offers protec- Value after 20 years $65,107.17 $51,120.46
risk and interest rate risk. tion from inflation. Every year, the government adjusts the
Expenses paid $1,010.11 $7,256.55
par value of these bonds based on the consumer price in-
Credit Risk dex (CPI) —a measure of inflation. If the CPI rises 4% in one Though the ratios differ by only 1.32%, over 20 years that
The riskiness of a bond depends in part on the bond issuer’s year, so too will the par value of these bonds for investors difference adds up to $6,246.44 in additional fees.
creditworthiness, the likelihood that the issuer will in fact who hold them to maturity. At maturity, investors receive
make good on its promise to pay interest and return the the original par value of the bond or the inflation-adjusted Active Funds vs. Passive (Index) Funds
investor’s principal. When you buy an individual bond, par value—whichever is higher. The interest that TIPS pay All mutual funds break down into one of two types: actively
there’s rarely a 100% guarantee that you’ll receive your in- is based on the inflation-adjusted par value, which means managed funds and passively managed funds.
terest payments and your principal. If a bond issuer suffers you’re likely to receive higher interest payments if inflation
a major financial crisis, such as bankruptcy, it may default, rises. TIPS are generally subject to federal income tax but • Actively managed funds: Managers of actively
or fail to meet its obligations to its investors. are free from state and local taxes. managed funds use their expertise and research to
Individual bonds have bond ratings that rank the cred- hand-pick the fund’s investments on an ongoing,
itworthiness of their issuers. The safest issuers have A High-Yield (“Junk”) Bonds “active“ basis in order to maximize returns.
ratings, such as A, AA, or AAA. For instance, a AAA rat- High-yield bonds, or “junk” bonds, are corporate bonds • Passively managed funds: Passively managed funds,
ing—the highest rating—suggests a default risk of less that have a high risk of default and therefore pay high an- or index funds, attempt to mimic the performance
than 1%. Riskier issues have ratings with Bs, Cs, or Ds (D nual coupon rates, often in excess of 10%. Junk bonds are of a particular market index, a group of investments
means the issuer is in default). In general, the higher the very risky and should be approached with great caution. that serves as a benchmark for the performance of
bond’s default risk, the higher the coupon rate. other investments. For instance, an index fund that
Should You Buy Individual Bonds? mirrors the S&P 500 ® index will hold most of the stocks
Interest Rate Risk Like stocks, bonds can be purchased either individually or included in the S&P 500 index in the same proportion
Bond prices move in the opposite direction of prevailing as part of bond mutual funds or ETFs. Though bonds are an in which they compose the actual index.
interest rates—when interest rates rise, bond prices fall, important part of virtually any investment portfolio, buying
and vice versa. Bonds react this way because higher inter- individual bonds takes a considerable time and effort and is Actively managed funds tend to have higher expense ratios
est rates make bonds with coupon rates below prevailing usually best left to professionals. If you do want to try buy- than index funds: the average expense ratio for an actively
interest rates less attractive to buyers. ing individual bonds, it’s best to stick to Treasuries only. For managed fund is 1.50%, while most index funds have ex-
most investors, though, the safest, cheapest, and easiest pense ratios below 0.25%.
The Most Common Types of Bonds way to buy bonds is through bond mutual funds and ETFs.
Of the many types of bonds on the market, the five most Why Most Actively Managed Funds Aren’t Worth It
common are government bonds, municipal bonds, corpo- A number of studies have shown that during periods of at
rate bonds, TIPS, and high-yield (“junk”) bonds. How to Invest in Mutual Funds least five years, only 33% of actively managed funds that in-
A mutual fund is a type of investment that pools money vest in securities like those in the S&P 500 actually beat the
Government Bonds from a group of investors and then invests that money in a performance of the S&P 500 index. This makes index funds
Government bonds are bonds issued by local, state, or specific set of investments, such as stocks or bonds. Mutual the best bet for most individual mutual fund investors.
federal governments. Government bonds issued by the U.S. fund companies, such as Vanguard, Fidelity, and T. Rowe
government are called Treasuries. The interest that Treasur- Price, create mutual funds and employ professional fund Load Funds vs. No-Load Funds
ies pay is subject to federal income tax but is state-tax–free. managers to oversee and adjust each mutual fund’s hold- Loads are fees that mutual funds charge investors in addi-
The three main types of Treasuries are: ings as market conditions change. tion to standard mutual fund fees, such as expense ratios.
When you buy a mutual fund, you buy shares, each of Load funds charge these fees, whereas no-load funds
• Treasury bills: Have terms of 1 month to 1 year; also which represents a fraction of the investments owned by don’t. Though you might think that load funds could get
called T-bills the mutual fund. For instance, if a fund owns 50 stocks, and away with charging additional fees only if they outper-
• Treasury notes: Have terms of 2–10 years you own several dozen shares of the mutual fund, you own a formed no-load funds, in fact studies have shown that
• Treasury bonds: Have terms of 10–30 years fractional share of each of those 50 stocks. When the overall most load funds both underperform no-load funds and cost
value of the fund’s holdings increases or decreases, so does more in fees along the way. With thousands of inexpensive
Treasuries are considered very safe bonds with virtually the value of your shares. no-load funds available, there’s just no good reason to buy
no default risk. The debt of stable foreign governments is load funds.
similarly safe but carries currency risk, the prospect of a How to Buy and Sell Mutual Funds
change in interest payments based on fluctuating currency On the stock markets, shares of stocks change hands con- The Main Types of Mutual Funds
rates. Government bonds of developing countries, however, stantly throughout the standard trading day. Buying and The three major categories of mutual funds are stock funds,
are considered very risky due to the combination of cur- selling mutual funds works differently: though you can place bond funds, and money market funds. Additionally, bal-
rency risk and political instability that may lead to default. orders to buy and sell funds through brokers or brokerages anced funds include both stocks and bonds in one fund,
at any time during the trading day, your orders are not filled while REIT funds invest in real estate companies.
Municipal Bonds until trading ends at 4:00 p.m. each day. This delay occurs
Municipal bonds, also known as munis, are bonds issued because each mutual fund must tally up the value of its un- Stock Funds
by state and local governments or government agencies. derlying securities—the net asset value (NAV) —at the end Stock funds, or equity funds, invest in the stocks of publicly
The interest that munis pay is not subject to federal tax. of each day to determine the fund’s new share price. traded companies. These funds are further classified by
 www.quamut.com Investing Basics

market capitalization (market cap), investment style, sec- Should You Invest in Mutual Funds? • Trading flexibility: ETFs can be bought and sold
tor, and geographic location. Some funds combine several All investors face the question of whether to buy individual throughout the trading day, unlike mutual funds.
classifications within one fund. investments, such as stocks and bonds, or to buy mutual • Innovative indexes: ETF companies can create
funds. There are three major reasons why investing in mu- and track indexes not offered by mutual funds. For
• Market cap: Stock funds often focus on buying tual funds is a better choice for many investors. instance, the PowerShares Value Line Industry Rotation
companies whose market caps all fall within one of the ETF contains an index of stocks that adjusts quarterly
five market cap ranges (micro-, small-, mid-, large-, and • Increased diversification and reduced risk: based on whichever stock sector is most in favor.
mega-cap). In general, the smaller the market cap, the Mutual funds allow you to build a thoroughly diverse
greater the risk and potential reward. investment portfolio and reduce the risk by owning just Why Buy Mutual Funds Instead of ETFs?
• Investment style: The term “style” in the context of a few different types of funds. Despite the many advantages of ETFs, there are a few rea-
stock mutual funds refers to whether the fund invests • Cost: Whereas you pay commissions and other sons why mutual funds might still be your best choice.
in growth or value stocks. Blend funds invest in a mix transaction costs every time you buy or sell individual
of growth and value stocks. stocks and bonds, you can buy most mutual funds • Transaction costs: As with stocks, you’ll have to
• Sector: Sector funds invest solely in companies that without incurring any transaction costs at all. pay a commission each time you buy or sell an ETF. If
do business in a particular industry, such as energy, • Convenience: To build a portfolio of individual stocks you’d like to buy your investments gradually, in stages,
healthcare, or technology. and bonds as diverse as you can create through mutual without paying commissions each time, no-load mutual
• Geographic location: Some stock funds invest only in funds, you’d need to spend hours researching and funds are a better choice than ETFs because you won’t
businesses based in particular regions, such as Latin monitoring your holdings on a weekly basis. have to pay any transaction fees.
America, Europe, or even specific countries. • Selection: If you’re looking for a particular type of
Mutual Funds vs. ETFs investment for which no ETF exists, your only choice
Bond Funds Once you’ve decided to buy mutual funds rather than in- might be a mutual fund.
Bond funds own baskets of corporate or government dividual stocks or bonds, there’s another key question you
bonds. If you buy a bond fund, you get the predictable per- need to ask before you buy a mutual fund—should you buy
formance and returns of the underlying bonds that the fund a comparable ETF instead? (For help answering that ques- Investing and Taxes
owns, but without the hassle of buying individual bonds. tion and for more on ETFs, see How to Invest in ETFs.) Nearly all investments are subject to local, state, and fed-
What you don’t get, though, is a guaranteed return of your eral taxes. To invest profitably, you must understand how
principal. Bond funds break down into a variety of subcat- How to Decide Which Mutual Funds to Buy taxes impact your gains and losses.
egories based on term, issuer, tax status, and region. The two most important factors to consider before you
buy a mutual fund are fees and returns. Only one statistic Capital Gains
• Term: Some bond funds buy only short-term, among the dozens of figures that mutual fund companies A capital gain occurs when you sell an investment for more
intermediate-term, or long-term bonds. publish annually will tell you what you need to know about than your cost basis—the total you paid to acquire the
• Issuer: Some bond funds buy government bonds, a fund’s fees and performance: total return after taxes and investment. For example, if you buy stock that costs $5,000
municipal bonds, or corporate bonds. expenses. This statistic shows the return that fundholders after commissions, then sell those shares later for $6,500,
• Tax status: Taxable bond funds hold bonds that have made on their investment after all taxes and expenses your capital gain is $1,500. That gain is subject to capital
require owners to pay taxes on interest income; tax- are taken into account. When researching a fund’s total gains tax, which, as of 2007, can range from 15–35%.
exempt funds hold bonds that pay tax-free interest. return after taxes and expenses, be sure to heed these two
Taxable bond funds, however, pay higher interest rates guidelines as well: Long-Term vs. Short-Term Capital Gains
than tax-exempt bond funds. The capital gains tax rate you pay depends on how long you
• Region: Region bond funds, or foreign bond funds, • Avoid “hot” funds: Consider the fund’s total return held (owned) the investment before selling it.
buy bonds issued by governments or corporations after taxes and expenses over the past 5–10 years,
in specific regions or countries other than the U.S. not just the past year or so. And remember that past • Investments held for a year or more are considered
Investors tend to favor foreign bond funds that focus performance is no guarantee of future results. long-term capital gains and are subject to a capital
on regions (or countries) with stable political and • Look for low expense ratios: Never buy an index gains tax of 15% (as of 2007) for most investors. Lower-
economic climates, such as Europe and Japan. fund with an expense ratio above 0.50% or an actively income investors may pay as little as 5%.
managed fund with an expense ratio above 1.50%. • Investments held for less than a year are
Fund companies often offer bond funds that combine two considered short-term capital gains and are subject to
or more of these classifications. For instance, a long-term ordinary income tax rates, which can reach 35%.
government bond fund would own bonds issued by federal How to Invest in ETFs
or state governments with terms of 10 years or more. ETFs (exchange-traded funds) are index funds that trade Because long-term capital gains are usually subject to much
like stocks—they offer the broad diversification of mutual lower tax rates than short-term gains, it almost always pays
Money Market Funds funds with the instant liquidity of stocks. to hold on to investments for longer than one year.
Money market funds invest in short-term debt instruments
that pay interest. Fund companies often recommend these Types of ETFs Available Capital Losses
funds to clients as an alternative to savings accounts, since The few hundred available ETFs don’t yet rival the selection If you sell a stock for less than its cost basis, you incur a
money market funds: offered by the thousands of mutual funds on the market. capital loss. Keep track of your losses: you can use them to
Even so, an equivalent ETF exists for virtually every type offset your capital gains tax for a given year. For example:
• Are nearly as risk-free as savings accounts of index fund, including ETFs that track indexes of stocks,
• Offer higher interest rates than savings accounts bonds, real estate, commodities, specific sectors and in- • If you buy a stock for $12,000 and sell it later for
dustries, and so on. $10,000, your capital loss is $2,000.
Though money market funds are very safe, they’re not a • If you incur that loss the same year in which you sold
great place to keep money long-term if you intend to grow How to Buy and Sell ETFs another stock for a $2,000 capital gain, the gain and
your principal. ETFs are offered by traditional mutual fund companies and loss would cancel each other out—you would not be
by financial firms that specialize in ETFs, such as iShares required to pay any capital gains tax.
Balanced Funds (www.ishares.com), PowerShares (www.powershares.com), • If your capital loss was larger than your gain, you’d also
Balanced funds invest in a mix of stocks and bonds. Buying and Rydex (www.rydex.com). Like individual stocks, ETFs be able to carry forward that loss to offset gains you
such a fund can be a simple, convenient way to build a bal- each have a ticker symbol and can be bought and sold might incur in future years.
anced investment portfolio with just one holding. through a broker or brokerage house at any time throughout
the trading day. Offsetting strategies can be complex, so consult a tax
REIT Funds advisor before selling any investment for a significant gain
REITs (real estate investment trusts) are corporations that Why Buy ETFs Instead of Mutual Funds? or loss.
develop and/or manage real estate properties. REIT funds There are three reasons to consider ETFs instead of funds:
are mutual funds that invest exclusively in the stocks of
these corporations. Investors buy REITs as a way of includ- • Low expenses: ETFs typically have low expense
ing real estate in their investment portfolios without actu- ratios, many of which are even lower than those of
ally having to own real estate property. comparable index mutual funds.