Investment Basics: Stocks, Bonds and Funds
There are really three kinds of investments that make money over the medium to long-term; shares in companies (or equities), bonds, and property. Property will not be discussed as an investment, as it tends to be something people typically do themselves.
Stocks or shares represent ownership of a company. As a shareholder, an investor owns a portion of the company's assets and profits. With ownership, however, comes risk. Stockholders assume the primary risk; if a business does poorly the share price can fall, sometimes to zero if a company fails. Stockholders also stand to realise the greatest returns if it succeeds. Think of Jeff Bezos, who is one of the richest people in the world because he owns (through shareholdings) a large part of a very successful company.
Bonds are issued by companies or governments and are debt obligations. Instead of borrowing money from the bank, they "borrow" from investors via the capital markets. A bond will pay a rate of interest for a fixed time period, at the end of which, the initial investment (principal) is paid back. The interest rate will depend largely on the duration of the bond and the credit rating of the issuer. A Russian taxi company will pay investors a much higher return than the US Government because there is a risk that the taxi company will not pay back the initial principal.
As individuals, we all face two problems concerning both types of investments: the expertise and time needed to select the right stocks and bonds and enough funds to achieve an acceptable spread of risk. The answer is a mutual fund or unit trust, which allows you to pool your money with other investors and pass it on to a professional investment team at a large Fund Management Company. The Fund Managers literally spend all day long monitoring the markets to find the best possible investments in line with the fund's investment strategy and risk profile. They also decide when to buy and sell the various securities to take advantage of opportunities and minimize losses.
The Fund Manager's job is also to ensure that the fund is exposed to a broad enough base of components to ensure growth and minimize risk. Each fund sometimes holds hundreds of different stocks or bonds, spread across many different countries, industries and companies. Investors in funds are able to own a properly diversified portfolio with a relatively small amount of capital. Setting up a similar portfolio individually can take a lot of time and require a very large amount of capital to obtain similar levels of diversification.
Funds are easy to invest into on a regular basis and once set up and involve almost no paperwork. Managed (or Asset Allocation) Funds eliminate the need to choose which funds to buy and sell, or how much of your portfolio to allocate to stock funds and how much to bond funds as each have different merits. With a Managed Fund, the Fund Managers alter the geographic mix and allocation of stocks, bonds and bank deposits depending on market conditions. By choosing a good Managed Fund, you should be able to sleep soundly at night secure in the knowledge that a vigilant team is always looking after your portfolio.
A well selected Managed Fund combined with regular automatic savings will mean that your future financial security will not be left to chance.