Step 2: Learn the Different Types of Investments
Knowledge is power. Even if you don't plan on personally managing your individual investments, it pays to know the details about the most common types of investment instruments: stocks, bonds and mutual funds.
When you buy stock, you're buying partial ownership in a company. Stocks are sold as shares, and every shareholder is entitled to a percentage of the company's annual profits called a dividend. But most people don't buy stocks for the dividends. They buy them as long- or short-term investments.
The price of a share of stock is constantly changing. Stock prices go up and down based on the value of a company on paper and the perceived value of a company in the eyes of investors.
The golden rule for investing in stock is to buy when the price is low and sell when the price is high. This is easier said than done. Unless you have ESP, it's very difficult to predict when a stock has reached its lowest or highest price. The best you can do is invest in companies that you're sure are going to grow. For example, if Microsoft releases particularly weak sales numbers after Christmas, its stock price will probably go down. But since Microsoft is such a successful company, it's probably safe to assume that the price will rebound quickly and keep growing. This is an opportunity to buy Microsoft stock for a relatively cheap price and sell it later for a profit.
Historically, the stock market has grown on an average of between 10 and 12 percent a year. This is why many financial advisors consider stock an excellent long-term investment. The stock market is also attractive for short-term, higher-risk investors. With stock prices changing every minute, there's tremendous potential for a quick profit or an equally quick loss.
Another investment tool, bonds are considered some of the safest investment securities around. This is because a bond is essentially a loan. In this case, the investor is the one who's loaning the money. The most common bond is a Treasury bond or a T-bill. When you buy a T-bill, you're loaning money to the United States government at a fixed interest rate. You can also by bonds from local governments -- municipal bonds -- and businesses -- corporate bonds. Because bonds are such safe investments, they carry some of the lowest interest rates.
With a mutual fund, your money is pooled together with cash from thousands of other investors to buy a portfolio of stocks, bonds and other securities. A mutual fund is run by a team of professional money managers.
The advantage of mutual funds is that they give you instant diversity in your investments. For a beginning investor, it would be very expensive and time-consuming to make lots of individual stock and bond purchases, and we'll talk more about these fees later. With mutual funds, your money is invested in a balanced portfolio of stocks and bonds without incurring fees for each purchase.
Stocks, bonds and mutual funds are the most common investments, but certainly not the only ones. Real estate investment trusts (REITs) are companies that own and manage a portfolio of real estate properties and mortgages. By investing in an REIT, you're entitled to a cut of the company's profits. Stock futures are contracts to buy or sell a certain amount of stock on a specific date. You can also trade international currencies on the foreign exchange market known as forex. The list goes on and on.
But if you're just getting started as an investor, it's best not to leap into complicated, high-risk investment instruments. Stick with stocks, bonds and mutual funds for now and learn more about the other options as you go.
The person who will help you devise and execute your investment strategy is your broker. Let's talk about how to choose a broker in the next section.