Investing Basics: Taking on Risk for Possible Higher Returns

Many of us start out as savers, favoring bank products such as savings accounts and certificates of deposit, where we shouldn’t ever lose money. But, eventually, we will likely cross the line into the world of investing, where there’s the potential for higher returns, but also the risk that the investment could lose value. Whenever you take that first step, make sure you thoroughly understand what you’re investing in. Let’s take a look at the basics of investing in bonds and stocks.

Basics of Investing in Bonds

When you put money in a CD or a savings account, you’re lending money and, in return, you earn interest. As an investor, you can also lend money in return for regular interest by purchasing bonds. But unlike with a CD or a savings account, there’s a danger the value of your bonds could fall below the price you paid.

In issuing bonds, a corporation or government entity will commit to making interest payments for a certain number of years, before returning the bond’s principal value.* Let’s say you buy a $1,000 ten-year bond at par value on the day it is issued and it has a 5% yield. You should receive $50 a year until you get your $1,000 back a decade later, when the bond matures and the principal value is returned to investors.

In reality, bond investing is often more complicated than this simple example suggests. For instance, you might buy the same $1,000 par value bond after it’s been trading for three years and it is now priced at $1,070. You will still get the $50 a year in interest, but the current yield will be just 4.67% and, at maturity, you will get back $70 less than the price you paid.

This highlights an important fact about investing in bonds: When their price goes up, their yield goes down, and vice versa. It’s important to keep that in mind, especially if interest rates are rising. Those higher rates can drive down the price of your bonds, especially bonds maturing in ten years or more. (This should be a consideration only, since fluctuations in value due to interest rate movements would not affect the par value when held to maturity.)

You also need to pay careful attention to credit quality, that is, the measurement of the issuer’s creditworthiness – the ability to make interest payments and return the principal at maturity. So bond issuers with a lower credit quality may have a higher probability of defaulting on their interest payments. In addition, consider call features, which allow an issuer to redeem bonds before maturity. If a bond has a call feature, an issuer may use it, for example, if they feel they can buy them back and issue new bonds carrying a lower interest rate.

Investing in Stocks — 101

While bonds involve lending money, investing in stocks gives you the chance to become an owner. That means higher potential returns, but also greater risk. When you purchase shares of a company, you buy a piece — albeit a very small piece — of that company. You can potentially benefit from its success through a higher share price and possibly regular dividends. But the value of the stock can decline for several reasons, such as if the company gets into financial difficulty or doesn’t perform as well as investors expect, or the markets overall decline in value.

How could you diversify? Stocks come in two basic styles: growth and value. Growth stocks can appear expensive, based on yardsticks like their share price-to-earnings ratio, but investors may be willing to pay that high price because they expect rapid revenue and earnings growth. Meanwhile, value stocks get that label because some investors believe their share price doesn’t fully reflect the company’s current fundamentals.

Growth and value stocks will often shine at different times, which is why you might want to consider holding both in your portfolio. For the same reason, investors will diversify by size, endeavoring to own a mix of large, midsize and small-company stocks, and also by industry sector. For instance, healthcare companies and makers of consumer staples (think cleaning products, breakfast cereal and tobacco) may enjoy better stock market performance toward the beginning of an economic downturn, while consumer discretionary companies (think auto makers, hotels and restaurants) may outperform at the start of a recovery.

Finally, investors might add foreign shares to their portfolio. The diversification that foreign stocks offer is due, in part, to the fact that foreign stocks don’t necessarily move up and down in lockstep with U.S. shares. But it’s also due to currency swings. When the U.S. economy and stock market are having a rough time, the dollar might fall in the foreign-exchange market and that would likely bolster the value of your foreign stocks. On the other hand, foreign stocks can have additional risk due to the currency swings working against them.

Next Steps — Creating a Portfolio

So should you invest in stocks or bonds? Investors are often encouraged to hold both because, as with different parts of the financial markets, these two key financial assets don’t always move up and down in tandem.

Bonds historically have fared better when the economy is slowing, because interest rates often decline, pushing up bond prices. Conversely, they can decline in value during economic expansions, as inflation picks up and the demand for borrowed money drives up interest rates. Meanwhile, stocks often follow the opposite pattern, declining when the economy is slowing and rising when overall economic growth is strong.

Keep in Mind to Diversify Among Stocks and Bonds. Because it’s extremely risky to bet heavily on any one stock or bond, investors tend to buy a slew of different stocks or bonds, either directly or through mutual funds. This diversification won’t stop you from losing money, but it has the potential to reduce the swings in your stock or bond portfolio’s overall value, as some shares may hold up well when others are suffering.

There are several ways to look at the diversification of your portfolio. For example, you can diversify among one asset class, such as stocks or bonds, or a combination of the two. You can also broaden your diversification among other asset classes. When looking within an asset class, you can also diversify by looking at which sectors to select and the industries within those sectors and the individual securities to select within an industry, including the size (market value).