Fundamentals of Investing

Investing is simply the process of acquiring assets that you hope will grow in value. Investments can include owning a home, owning a business, owning real estate, or having money in savings accounts and CDs at a bank or credit union. This article addresses investing in stocks and bonds and various ways to own them.

Some basics

Owning a share of stock is owning a portion of the company. If you buy 100 shares of General Electric stock, you actually own a portion of GE. You can profit by owning shares when the company pays a dividend or if the value of the shares increases while you own them. You can also lose money if the value of the shares goes down before you sell them.

When you own a bond, you are lending money to the company or institution issuing it. You earn interest payments and benefit if the bond’s value increases while you hold it. However, you can lose money if interest payments are missed, the principal isn’t repaid when due, or if the bond’s value declines and you sell it.

When you buy mutual funds, you are purchasing shares in a company that, in turn, owns stocks in other companies or holds bonds issued by other companies or institutions. By investing in mutual funds, you receive the professional management services of the fund manager, who decides where and when to invest. You benefit when the mutual fund distributes dividends (along with capital gains and interest) and if the value of your mutual fund shares rises because of increases in the underlying stocks and bonds it owns.

There are several ways to own investments. Most people start with individual accounts at brokerage firms or mutual fund companies, in their IRAs, and through their employer retirement plans. If you invest through an individual account, the income (dividends, interest, and capital gain distributions) is taxable. If the investments are within an IRA or a qualified plan, you probably won’t owe any taxes on the returns until you withdraw the funds.

Some common-sense rules

Understand that there are risks with investing. When you decide to invest, you leave behind the world of insured and guaranteed returns offered by savings accounts and CDs from banks or credit unions. The value of stocks fluctuates based on a company’s success and the overall movement of the stock market. Bond values can also change depending on interest rate shifts and the financial health of the issuing institution. In exchange for these risks, you aim to earn higher returns than you would with a savings account or a CD.

Be realistic in your expectations. The year 2008 was tough for stocks, with the S&P 500 index dropping 38%. Over the 20-year period ending in 2024, the average total return for large company stocks (similar to the S&P 500) was 9.80%. The highest return was in 2013, with over 32%, and the lowest was in 2008, with a negative 37%. Although the bull market from 1995 to 1999 produced average returns of over 28%, and the bear market from 2000 to 2002 (and 2008) saw the market fall by more than one-third, those years’ returns were significantly below the long-term average.

Take a long-term approach. Returns from investing can vary significantly each year. Only by viewing your investments as long-term can you hope to earn returns that justify the risks. Trying to predict the short-term direction of the market or an individual stock’s price is unwise.

Use an asset allocation strategy. You should also think about how you split your investments among different types. How you divide investments among stocks, bonds, and cash is called asset allocation. It can be a helpful starting point for your investment plan. People should base their asset allocation on their time horizon and risk tolerance. Here are some example allocations based on age.

Sample Asset Allocations

Age	Stocks	Bonds	Cash
30’s	65%	25%	10%
40’s	60%	30%	10%
50’s	50%	40%	10%
60’s	30%	55%	15%

You will notice that the chart shows younger individuals holding more stocks, with that percentage decreasing over time. This makes sense. When you’re young, you can take a longer-term approach—you have more time to recover from investment dips and more time to participate in the long-term growth trends of various investments.

The numbers in this chart are only sample guidelines, and you may want to vary them depending on your risk tolerance and other aspects of your situation.

Diversify your investments.If you are investing in stocks, aim to hold investments in at least 3 or 4 stocks across 4 or 5 industries. A portfolio of 15 technology stocks is not sufficiently diversified. Similarly, a portfolio of one stock in each of 15 different industries may also lack proper diversification. Having more than 25 or 30 stocks can make it hard to keep track of what each company is doing.

Spreading ownership over different stocks in different industries reduces the risk that the particular stock you choose in a good industry turns out to be the wrong one. It also reduces the risk that you invested in the wrong industry.

Diversify your timing. Another way to lower your risk is to spread out your investments over time. This way, you ensure you’re not putting all your money in at the peak of a bull market. You might miss some gains if the market keeps rising, but that rarely happens. Remember, no one can predict short-term stock market movements with certainty.

Spreading your investments over 4 to 6 months helps you avoid buying all your stocks when prices are at their peak. This strategy reduces two main risks: first, the chance of losing a large portion of your money quickly, which many fear after seeing investments drop sharply. By investing gradually, you avoid this problem.

The other risk you can lower by diversifying your investments is price volatility. By using this approach, the average price of the stocks you buy will likely mirror the overall market values during that period.

Consider the diversification benefits of mutual funds. When you buy mutual fund shares, you are investing in a broad portfolio of stocks selected by the portfolio manager. Additionally, most mutual funds offer a purchase system called “dollar cost averaging.” With this, you buy an equal dollar amount of shares at regular intervals.