A Beginner's Guide to Investments

If you're new to investing, you may benefit by knowing how stocks, bonds, mutual funds and exchange-traded funds (ETFs) work. Don't worry. It’s not as complicated or overwhelming as you may think. Here are the basics.

What is a stock?

To raise money, many companies offer "shares" of stock for investors to buy. When you buy shares, you own part of the company. Besides participating in the company’s financial fortunes, shares give you the right to vote on management and other issues. Investors trade shares daily, they buy shares other investors want to sell, or they offer their own shares for sale.

There are two ways to make money from stocks:

1. Your shares can rise in value.

   Share prices may rise when a company improves its profits or investors think the company has a good chance of doing better in the near future.

    

   For example, if you buy 10 shares priced at $25 each, you pay $250 (potentially plus brokerage fees). If the share price rises by 20%, to $30, your investment is now worth $300. (You would only “realize” that gain if you sell your shares for that price.)

   However, a share price can drop if the company is not doing well. To use our example, if the share price drops by 25%, to $20 per share, your 10 shares are now worth only $200—so you can lose money when investing in stocks. In fact, while a stock’s price can rise without limits, it’s possible that it can fall to $0.

2. You may receive a dividend.

   Some companies pay part of their profits to people who own shares of their stock. Usually, these dividends are paid quarterly or annually.

Dividends are not guaranteed. Investors who want dividends often look for companies that have a history of paying regularly, or even increasing their dividend payouts. Dividends may be paid in cash, but many investors choose to have them reinvested in the stock automatically. This enables them to buy more shares and take further advantage of the company’s prospects

What is a bond?

When companies or governments (or their agencies) need to borrow money, they may issue bonds for sale. When you buy a bond, you are loaning money to the issuer; in return, the issuer agrees to pay a set rate of interest (usually monthly) until the bond’s maturity date, when they repay the original “face” amount of the bond. Bonds are usually backed by the issuer’s ability to repay (for corporate bonds, that’s based on profits to be earned in the future).

Bonds are priced at $100 or $1,000 each (some are offered with a discount or premium to their face value). So if you buy 10 corporate bonds at $100 each, you will loan the company $1,000. If the bonds pay 10%, you would expect to earn $100 per year for as long as you hold the bond or until it matures.

Even so, many bonds trade on the “secondary” market—investors buy and sell them before they mature, so their prices and interest rates can vary. In fact, bond prices usually have an “inverse” relationship to interest rates: When one rises, the other falls, and vice versa.

Also, the value of bonds and the interest rates (yields) they pay are often due to their issuers’ credit quality—those alphabetic and numeric grades assigned by rating agencies like Standard & Poor’s and Moody’s. Like your personal credit score, bond ratings reflect the issuers’ creditworthiness and ability to repay their loans. Corporate bonds are generally considered a bit riskier than government bonds; in return, they usually pay higher interest rates. (Some low-rated companies offer “high-yield,” aka “junk,” bonds to entice investors and compensate for their greater risk of defaulting on their loans.)

A bond’s interest rate can also reflect its term—in general, the farther away the maturity date, the greater the risk (and the more the bond is likely to pay out in return). For example, short-term U.S. Treasury bonds—considered among the safest investments on the market—mature in one year and typically pay less interest than long-term (30-year) Treasuries. For safety, many bond investors seek government bonds or solid companies with a high credit quality and a consistent track record of making their payments.

How do mutual funds work?

You can buy shares in a mutual fund. Mutual funds combine your money with that of many a other investors to buy and sell stocks, bonds and other securities from many issuers. Here's an example: If 1,000 investors put $1,000 each in a mutual fund, the fund has $1,000,000 to work with. The fund’s manager uses that money to invest in hundreds or even thousands of securities. That “diversification” spreads your risk—it means that trouble with one investment won’t affect the whole portfolio. But while it can help smooth your ride, diversification doesn’t guarantee profits or protect against loss, especially in a falling market.

Many mutual funds specialize in certain types of investments, industries or geographic areas. Also, most are “actively” managed: Their managers seek investments they believe will outperform similar investments (based on “benchmark indexes” like the S&P 500^®, which tracks large U.S. stocks). Due to the extra research involved, actively managed funds usually charge higher operating fees than “passively” managed funds, which aim only to match the performance of the index they track. Also, mutual fund shares are traded once a day, after the general stock market closes at 4 p.m. ET.

How do exchange-traded funds work?

Like mutual funds, exchange-traded funds (ETFs) pool investors' money to buy and sell securities. The key difference: Like stocks, ETF shares trade on exchanges throughout the day, so their prices can change often.

Also, most ETFs are passively managed: They try to mimic the performance of an index. That can represent a section of the market as broad as U.S. stock or as narrow as robotics companies. Because they already know what securities are in the indexes they track, passively managed funds generally charge less in annual operating expenses (some even charge $0) than actively managed funds.

Footnotes

Kevin Johnston is a financial writer who writes about personal finance and investments, as well as financial management and planning. He has written for The New York Daily News, The New York Post, The San Francisco Chronicle and The Houston Chronicle.

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