Basics of Investing Your Money: Stocks, Bonds, and Deposit Accounts
Basically, the more risk an investor takes, the higher rate of return they expect on their investments. Needless to say, a riskier investment may not turn out the way you would like. If you're going to take a risk, make it a calculated risk - one you can withstand if it doesn't go your way.
The safer the investment, the lower the return an investor will receive. The safest investments around are federally insured (up to $250,000) accounts like certificates of deposit and savings accounts. You place your money in these types of accounts and receive a rate of interest from the bank. Returns on these types of accounts have varied greatly over the past 40 years but overall are lower than stock returns.
Back in the 1970's and early 1980's CD rates on 1 year certificates of deposit were in the double digits - around 13 percent. These days the best CD rates on 1 year certificates of deposit are just above 1.00 percent. The same is true for savings rates - back then rates were as high as 13 percent while the best savings rates right now are at 1.00 percent.
Over the very long term, stocks and mutual funds have historically outperformed all other investments at around 10 percent on average. Bonds are the second best performing investment at around 5 percent on average. There are also risks to investing in stocks and mutual funds since over the past 12 years there have been two periods of major stock declines.
Investors receive better returns with stocks and mutual funds but having to much exposure to risk can have a detrimental effect on an investor's portfolio. There have been recent periods of major market declines of 30 percent to 75 percent. The NASDAQ Composite Index was over 5,000 in the year 2000, fell over 75 percent and is currently just above 3100 - never fully recovered from the all-time high.
Some believe future market returns will be nowhere near the historical average. Robert Shiller, best known for the Case/Shiller Housing index, believes future stock market returns will be near 4 percent over the next decade. What drives stock prices are companies' earnings - the better the earnings the higher the stock prices.
If you're not an experienced stock market investor, you should let the pros handle your investments by investing in mutual funds. Professional money managers manage mutual funds and mutual funds are comprised of a collection of stocks in individual companies. You can easily compare mutual funds based on markets and your risk tolerance. As with other investments, the riskier the mutual fund the higher the returns (or losses) may be.
Bonds are safer than stocks and there are many different types of bonds. There are U.S. Treasuries issued by the federal government, there are municipal bonds issued by states/cities and bonds issued by individual companies. When bond interest rates move higher, bond prices move lower. The reason being is that investors in bonds won't pay as much for an existing bond with a fixed interest rate of, say, 3 percent because they know that the fixed interest on a new bond will be higher because interest rates have gone higher. When interest rates fall, bond prices move higher.
The biggest threat to any investment is inflation. You have to stay ahead the rate of inflation to be a successful investor. Inflation causes you to lose purchasing power, what a dollar buys today won't be able to buy tomorrow. Remember, the most successful investors have a diversified portfolio, limit their risk and are able to receive returns higher than the inflation rate.