Understanding your basic investments
- Alan Lavine and Gail Liberman
Cardinal rule when you invest the family's money. Never invest in anything you don't understand.
Example: We've often advised keeping about six months worth of income in cash before you start investing your hard-earned money. But did you know that by cash, we don't necessarily mean to keeping dollar bills sitting under your mattress!
We mean short-term investments that mature in about three months or less. These types of investments are considered among the lowest risk because there's very little time to lose any money. Plus, if you have an emergency, they should be maturing in time to cover your immediate needs.
Cash investments may include things like U.S. Treasury bills, money market mutual funds and short-term bank accounts.
Your lowest-risk cash investments are Treasury bills, because they are directly backed by the U.S. government. Next, in the low-risk category: Bank deposits. Bank deposits are insured to $100,000 per person per bank by the U.S. government-backed Federal Deposit Insurance Corp.
Although cash investments generally are among the lowest risk, they have two major drawbacks: Over time, they have earned the least among basic investments--an average of 3 percent annually. There's a chance these investments may not keep up with the rate of inflation, or escalating prices. Inflation averages about 3 percent annually. That's why it's important to consider other investments.
Bonds are similar to loans. You borrow a certain amount from either a company, the U.S. government or a municipality for a specific term at a specific interest rate. At maturity, you get back your principal. Plus you receive interest payments, generally semiannually. Because bonds can be longer term than cash investments, they have more time to decline in value. So they're definitely higher-risk investments than cash investments.
On the other hand, historically, bonds have returned a little more than cash--an average of 5.5 percent annually over the past seven decades, according to Ibbotson Associates, Chicago.
Bonds generally are lower-risk than stocks. Reason: If the bond issuer goes belly-up, bond-holders get priority over stockholders when it comes to getting repaid from remaining assets.
Besides the fact that the issuer of a bond could go belly-up, there are some added risks with bonds. They are: If you must sell a bond prior to maturity, you could lose money. Reason: Bond yields move in the opposite direction of interest rates. So if rates rise, the actual value of the bond could drop if you go to sell it. Of course, the opposite also could happen.Issuers reserve the right to "call" bonds. This means you'd have to cash it in prior to maturity. If this happens, you'll get your principal back. But you'll have to reinvest your money at lower rates--something you might not wish to do.
With a stock, you're part owner of a corporation. Stocks are among the riskiest investment categories because you're sharing in the company's profits and losses. Plus, you get no government guarantee. On the other hand, stocks have performed about the best of the three investment categories over time.
Since 1926, stocks have grown at an annual rate of nearly 11 percent, according to Ibbotson Associates. That's substantially more than bonds and cash investments. The bad news: At any given moment, you could lose your shirt from a stock investment!
So which should you consider? Again, it's important to keep at least six months worth of income in cash to cover immediate needs. But it's a good idea to diversify among stocks and bonds.
Want to get fancy? It might not hurt to own some gold or real estate as inflation hedges.
By owning a wide variety of investments, you frequently can boost your return, yet lower your risk.
Spouses Gail Liberman and Alan Lavine are syndicated columnists. Their latest book is "Rags to Retirement (Alpha Books)." You can e-mail them at MWliblav@aol.com.
To read more columns, please visit the column archive.