Clients often have questions about investing. Terms like stocks, bonds, allocation, and rebalancing are frequently mentioned, yet rarely understood in full. Recently, I sat down with a client to discuss the differences between stocks and bonds, along with other key concepts. After our conversation, she felt much more confident about her investments.
For most of us, the goal of investing is to build wealth and reach our financial objectives. Whether you’re starting out or seeking more information, understanding these fundamental terms and concepts is crucial.
Stocks
Owning stock in a publicly traded company means you’re a shareholder. This gives you an equity stake in the company, effectively making you an owner. With this ownership comes rights, such as voting for the board of directors and sharing in profits through dividends.
Bonds
When you invest in bonds, you’re lending money to a government entity or corporation. In return, the borrower promises to pay regular interest and return your principal at the end of the bond’s term. A local example is the Tahoe Truckee Unified School District, which issued bonds in 2014 to fund school improvements. Bondholders are set to receive their principal when the bonds mature in 2033.
Mutual Funds and Exchange-Traded Funds (ETFs)
These popular investment vehicles allow investors to pool their money to invest in a diversified portfolio of stocks, bonds, or other assets. By owning shares of a mutual fund or ETF, you indirectly own small portions of a variety of underlying assets. This offers a simple way to diversify across different asset classes.
Investment Risk
Every investment carries some level of risk. Even if you bury cash in your backyard, inflation can erode its value over time. Investing in a poorly managed company could result in bankruptcy, rendering its stock worthless. One notable example of investment risk is the Cal-Neva Resort and Casino. In 2013, a developer secured financing for renovations, but after several delays, they ran out of money, leaving the lender in a lawsuit to recover losses.
Diversification
This strategy helps reduce risk by spreading investments across different asset types. It ensures that if one investment performs poorly, others might perform better, balancing out your portfolio.
Asset Allocation
A key principle of diversification, asset allocation involves dividing your investments among different assets—such as stocks, bonds, and cash. Since these asset classes often move in opposite directions, a well-mixed portfolio can reduce overall risk.
Time Horizon
This refers to the amount of time you plan to hold an investment. A short-term horizon is usually less than two years, while a long-term horizon is more than seven years. The shorter your time horizon, the more conservative your investment strategy should be.
Investment Objective
Your goal determines your time horizon. If you’re saving for something short-term, like a wedding or a home down payment, you have a short time horizon. However, saving for a child’s education or retirement could involve a decade or more of planning, making it a long-term horizon.
Risk Tolerance
Risk tolerance refers to the level of risk you’re comfortable with. While many investors feel confident during market gains, a real test of tolerance comes when the market declines by 20% or more. If your risk tolerance is low, a more conservative portfolio is likely more appropriate.
Rebalancing
Over time, your portfolio’s asset allocation can drift due to market fluctuations. For instance, a portfolio that started with 75% in stocks, 22% in bonds, and 3% in cash might shift to 80% stocks, 19% bonds, and 1% cash. Rebalancing involves adjusting your portfolio back to its original allocation, effectively forcing you to sell high and buy low.
Compound Interest
This is the concept of your money working for you. The interest earned on your investments generates its own interest, which compounds over time, accelerating the growth of your principal.
The Rule of 72
An easy way to estimate how long it will take for your money to double is by using the Rule of 72. Divide 72 by your expected annual interest rate, and the result gives you the approximate number of years required for your investment to double.
Each of these topics is more nuanced than can be fully covered here. One of my clients recently expressed how helpful it was to have these concepts explained in simple terms, allowing her to align her investments with both her present and future goals.
Whether you're just starting out or have been managing your own investments for years, understanding these basics will help you better assess your portfolio in light of sound investment theory. Tools from online brokerages like Vanguard and Fidelity can also assist in analyzing and adjusting your allocation.
If managing your own investments feels overwhelming, consider seeking advice from a Certified Financial Planner™ (CFP®) professional. You can find a CFP® at letsmakeaplan.org.
Whether working with an advisor or going it alone, remember these concepts are vital to a successful investment strategy. Stay focused on your long-term goals, and remember that while markets may experience temporary drops, history shows they tend to resume an upward trend over time.
Reference herein to any specific commercial products, process, or service by trade name, trademark, manufacturer, or otherwise, does not necessarily constitute or imply its endorsement, recommendation, or favoring by Commonwealth Financial Network®.
This article is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. Please consult your financial advisor prior to making financial decisions.
The financial professionals of Pacific Crest Wealth Planning are Investment Adviser Representatives with/and offer advisory services through Commonwealth Financial Network®, a Registered Investment Adviser. This communication is strictly intended for individuals residing in the United States.
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