Fundamentals of Investing

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

Some basics

Owning a share of stock means owning a portion of the company. If you buy 100 shares of General Electric stock, you own a portion of GE. You can profit from owning shares when the company pays a dividend or when 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 that issued it. You profit when you receive interest payments and when the bond’s value rises while you own it. You can lose money if interest payments are not made, if the bond’s principal is not repaid when it is due, or if the bond’s value falls and you sell it.

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

There are several ways to hold investments. Most people start with individual accounts at brokerage firms or mutual fund companies, as well as IRAs and company retirement plans. If you invest through an individual account, the income (dividends, interest, and capital gain distributions) from the account is taxable. If the investments are held within an IRA or a qualified plan, you will probably not owe any tax on the returns until you withdraw funds.

Some common-sense rules

Understand that investing carries risk. When you decide to invest, you are leaving the world of insured and guaranteed returns found in savings accounts and CDs at a bank or credit union. Stock prices rise and fall depending on a company’s performance and the overall direction of the stock market. Bond values can rise and fall in response to changes in interest rates and the financial condition of the issuing institution. In return for taking these risks, you hope to earn returns greater than what you would have earned in a savings account or with a CD.

Be realistic in your expectations. The year 2008 was bad for stocks, with the S&P 500 index falling 38%. Over the 20-year period ending in 2025, the average total return for large company stocks (comparable to the S&P 500 index) was 10.9%. The best year (2013) had a return of over 32%, and the worst was 2008, when the return was a negative 37%.  While the bull market of 1995 to 1999 produced average returns of over 28%, and the bear market of 2000 to 2002 (and 2008) saw the market fall by over one-third, returns during those years were well outside the long-term average.

Take a long-term approach. The returns on your investments will vary significantly from year to year. Only by viewing your investments as long-term can you hope to earn returns that justify the risks. Trying to guess the market’s near-term direction or an individual stock’s price is foolish.

Use an asset allocation strategy. You should also consider how you divide your investments among different types of investments. The way you divide your investments among stocks, bonds, and cash is called asset allocation. It can serve as a logical starting point for your investment strategy. Individuals should base their asset allocation on their time horizon and risk tolerance. Here are some sample allocations by age.

Sample Asset Allocations

You will note that the chart shows younger individuals holding more stocks, with the percentage decreasing over time. This is only logical. While you are younger, you can take a longer-term approach—you have more time to recover from declines in your investments and to participate in the long-term performance trends of different types of investments.

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

Diversify your investments.If you are investing in stocks, you should try to invest in at least 3 or 4 stocks in at least 4 or 5 industries. A portfolio of 15 technology stocks is not diversified. A portfolio of one stock in each of 15 different sectors is probably also not a good example of diversification. A portfolio of more than 25 or 30 stocks can make it challenging to know what each company is doing.

Spreading ownership across different stocks in different industries reduces the risk that the particular stock you choose in a good sector is the wrong one. It also reduces the risk that you invested in the wrong industry.

Diversify your timing. Another way to reduce your risk is to spread your investments over time. That way, you assure yourself that you are not investing all your money at the top of a bull market cycle. You may miss some appreciation if the market continually goes up, but that seldom happens. Remember, no one can predict short-term movements in the stock market with any degree of accuracy.

By spreading your investments over 4 to 6 months, you will eliminate the risk of making all your purchases when stocks are at their highest. This strategy reduces two types of risk. First, it reduces the risk of losing a significant portion of your money quickly. Many people dread investing and then seeing the value go down dramatically. By spreading out your buying, this will not happen.

Price volatility is the other risk you can reduce by spreading out your investments. By taking this approach, the average price for the stocks you buy will probably reflect the average market value for that period.

Consider the diversification benefits of mutual funds. When you buy mutual fund shares, you buy into a broad portfolio of stocks that the portfolio manager has selected. In addition, most mutual funds offer a purchasing method called “dollar cost averaging.” With this, you buy an equal dollar amount of shares at regular intervals.