Investing 101: Core concepts
(MoneyWatch) "Investors have a weak grasp of elementary financial concepts," according to a report from the Securities Exchange Commission and the Library of Congress that underscores the poor state of financial literacy among Americans. The report finds that many investors do not understand the concept of diversification and are "not fully aware of investment costs and their impact on investment returns." Given that better money management is among the most popular New year's resolutions, now is a perfect opportunity to get back to basics and brush up on these core investment concepts.
Diversification means more than simply "don't put too many eggs in one basket." The point is not to load up your investment and retirement accounts with a lot of stock funds, but to make sure you have a mix of different types of assets that, over time, act differently from one another. Note that I emphasized "over time," because when markets crash, investors tend to sell everything in sight (remember fall 2008 through spring 2009?). Over a longer time horizon, diversification actually works to reduce overall risk levels.
A great example of the efficacy of diversification is the 2000s, also known as the "lost decade" for investors. During the 10-year period from 2000-'10, if you had invested only in the S&P 500 index of U.S. stocks and had reinvested all of your dividends, you would have earned an annualized return of 1.4 percent. Since that is less than the rate of inflation for that decade, you would have lost money overall.
The results improve dramatically if you had diversified your investments among different types of stocks and bonds. Carl Richards of The New York Times crunched the numbers and found that if you had invested in 60 percent stocks (split equally among the S&P 500, the Russell 2000 index of small stocks, the Dow Jones US REIT real estate stock index, the MSCI EAFE international stock index and the MSCI Emerging Markets stock index) and in 40 percent fixed income (Barclays U.S. government intermediate-term bond index), then you would have earned an annualized return of 7.83 percent. How you determine the right investment mix for your portfolio depends on your risk tolerance and how easily you wish to access your funds.
Since the majority of retirement investing is conducted with mutual funds, it's important to understand how funds work and to take into account the impact of fees and costs on returns. Mutual funds are pooled investments made up of a variety of assets -- U.S. and foreign stocks, bonds, commodities, etc. Unlike individual stocks, mutual funds are priced only once per day at the market close.
Funds can be actively or passively managed. Active funds invest in a manner that is consistent with the stated objective of the fund -- i.e., large or small cap, growth or value, U.S. or international. Passive funds are static baskets of assets, which invest in the companies that comprise a specific index. Changes to the fund only occur when there is a change in the relevant index.
Regardless of whether you buy a no-load fund directly from a fund company or through a broker, you pay an annual management fee to the fund company that is taken out of the dollars in your account. That fee is a percentage of the assets that you have invested in the fund and varies from fund to fund. Commissions or "loads" are fees that you pay to a broker, adviser, banker or insurance salesman who sells you a mutual fund. These fees are paid in addition to the annual management fee. Loads are paid in three basic ways: up front when you purchase the fund (A-share); on the back end, when you sell a fund (B-share); or on an ongoing basis while you own the fund (C-share). Total fees reduce your return, so reducing costs is an easy way to add to your bottom line.
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