Please remember that everything you read here is simply my own personal opinion on the matter. Never believe everything you read, and always form your own conclusions.
The most important concept in the market is the concept of risk-return. The idea is that the making riskier investments produce higher potential returns. For example, a junk bond might be paying 10% interest when a grade AAA bond might be paying 3%, but the risk you take when purchasing the junk bond is that the issuing company might default on it, causing the entire investment to be lost. The market prices in risk... that is why the junk bond has such a high interest rate, because nobody would buy it otherwise. But what people almost universally forget is that risk-return is a long-term statistical effect. To take advantage of risk-return you have to have a long investment time horizon, and even with a longer horizon larger events (such as the savings and loan crisis) can come along and bite you in the ass. Just because the market prices in risk doesn't mean you can't still lose! In that regard it is always a good idea to be somewhat conservative even if you have a 30 year investment horizon. The use of leverage, particularly a mutual fund which uses leverage, increases the risk regardless of how safe the underlying positions are. Similarly the use of Margin greatly increases risk regardless of how safe the underlying investments are.
The second most important thing you need to understand is the concept of diversification. Diversification is a well known but often misunderstood mechanism. Diversification has two effects: First, it serves to statistically narrow the effect of risk. For example, instead of buying one risky investment you would buy ten smaller risky investments. This provides a statistical effect which narrows your likely losses as well as your likely gains without really changing the risk-return proposition you are taking. That is, in such a scenario you could still lose your whole investment, you just aren't as likely to making ten smaller risky investments that must all fail verses a single risky investment that might fail. The second effect of diversification is to mitigate the level of risk itself. If you make several investments each with a different level of risk you tend to average out the risk. People come up with all sorts of schemes to try to offset risk in one market by investing in another and I talk about that a little in later sections.
Diversification is often mis-interpreted. As occured in the 2008 crash many people thought they were diversified because they had a hopper of bond funds, a hopper of income funds, a hopper of stock funds, and so forth, but all their hoppers wound up crashing together because all the funds were using leverage. Leverage adds risk no matter how safe the underlying securities are. Proper diversification is not just sector diversification, but also risk diversification.
Finally, do not use margin borrowing to invest, period!. Margin works like leverage, but many investments, particularly mutual funds, are already leveraged. If you use margin to buy leveraged funds you are taking a huge risk. I do not recommend using margin at all, for anything, even if purchasing unleveraged assets like stocks. Do not trade any of the so-called 'Ultra' funds. These funds are frauds, plain and simple. They cannot be used for anything other then circumventing margin rules and day-trading. They cannot, for example, be used to hedge anything.
You've probably heard the concept of 'short term' and 'long term' investing. This is rather too simplified a way of thinking about it. Instead what you really need to do is consider your investment horizon for each portion of your portfolio separately. For example, lets say you have $55,000 in the bank but you've bought a $25,000 car and taken out a 5-year loan to pay it off, and lets say your other expenses are on the order of $2,000 a month which are covered just fine by your job but you want at least 6 months sustainability in case you lose your job. $25K out of your $55K must be geared towards dealing with your car loan (over 5-years) and $12K out of your $55K must be geared towards your 6 months of sustainability in case you lose your job, leaving only $55K - $25K - $12K = $18K in money that you can put towards a long term investment horizon.
In the above example your investment horizon for $25K of your money is 5 years, the investment horizon for $12K of your money is 6 months, and the investment horizon for $18K of your money is put towards retirement, say 30 years from now.
What you need to do is break down your portfolio into three pieces (with this example) and treat each piece as having a separate investment time horizon. Generally speaking (and diversification non-withstanding), the shorter your investment time horizon the less risk you should take with the money. This might mean, using the above example, that you might need to keep 3 months worth of emergency sustainability ($6K) as cash and put the other $6K for the second three months in a recurring 3-month CD. Of the $25K geared towards dealing with your car loan you might decide to keep 1-year's worth as cash ($5K) and put the remaining $20K in 1, 2, 3, and 4-year CD's ($5K in each). The stock market, say like a DOW or S&P tracking fund (DIA and SPY) might be appropriate for the $18K you have available for long-term investing. 'CD' in this example is interchangeable with an unleveraged income mutual fund. Beware of leveraged mutual funds or trusts... they are far riskier and more suited to 5-30 year time horizons and not for short term income, even though they typically generate higher yields.
For those investments taking on more risk you might decide that a higher level of risk is appropriate. Take the car-loan for example. You could decide to keep the 1-year CD but instead of putting $5K in 2, 3, and 4-year CDs you might decide that a short or intermediate-term bond fund is more appropriate... higher potential returns at the risk of an occassional (but hopefully small) loss. When you make that sort of decision what you are really saying is two things. First, "If this investment goes south I can recover from it before I need to use that money to pay my car loan". And, second, "I don't depend on getting a particular interest rate in the short term for this investment so I am willing to risk it to get a potentially better return over the time period".
Diversification becomes more important as your investments become riskier. You likely would feel very comfortable with a single bank account, after all the government insures your deposits for $100,000! But riskier investments require more thought, and some diversification is probably a good idea. If we revisit the $18K in the above example that was set aside for 'long term' investing diversification could be as simple as deciding to put some of that $18K in a bond fund instead of putting it all into the stock market.
A standard internet brokerage account gives you lots of ways to manage risk, which said another way means it gives you lots of ways to shoot yourself in the foot even WITHOUT options trading. So my advice is: don't enable options trading, at least not if your goal is to save for retirement. If your goal is to gamble then, by all means, use options. I outline typical investment vehicles below. These investment vehicles are loosly arranged from low risk to high risk.
A standard savings account at a bank is insured up to $250K by the U.S. Government, is very liquid (you can move money into and out of it easily), and consequently a very safe investment. Of course, savings accounts usually get very low interest rates. You generally want to keep as little cash in a standard savings or checking account as you need for month-to-month expenses.
Banks offer Certificates of Deposit. A CD is basically an investment vehicle where you give the bank your money for it to used for a certain fixed period of time. In return the Bank guarentees you a fixed interest rate over that period of time and returns your principle plus interest at the end of the period. That's a CD in a nutshell. You sacrifice liquidity (you can't touch the money for the time period) in order to get a better interest rate. The longer the period you select, the better the interest rate the bank provides. The U.S. government guarantees CDs up to 250K, but keep in mind that the guarantee is for the cumulative assets in you bank account + all your CDs, not for each individual CD.
CDs are good short-term savings vehicles. Money markets generally do better in periods of high interest rates but in periods of very low interest rates (such as now), banks have been able to offer better returns with CDs over money markets.
I do not consider CDs to be good medium or long-term savings vehicles primarily because you lock your money up for too long a period of time at what is still a fairly low interest rate verses riskier investments. CDs are great for holding emergency stashes, like the 3-months of emergency money in the example I've been using. You can throw a chunk of money into a short-term CD, set it up to automatically renew, and forget about it.
Money market funds are not guarenteed by the government but they are still considered extremely safe instruments because they invest in extremely short term cash loans used primarily by banks. Interest rates are generally, but not always, better then a standard Bank savings account and in periods of high interest rates money market funds almost universally beat CDs. There is one minor downside to a money market in that the interest rate can fluctuate quite a bit and you can even lose money occassionally. But due to the low risk such losses do not occur very often and when they do occur they are typically very small (as a rule of thumb you won't lose more then one month's worth of normal interest in a month, so if such events occur recovery is swift). For all intents and purposes a money market is as good as or better then a savings account.
Most brokerages will automatically invest the free cash in your account in a money market and make withdrawls and desposits as necessary when you make or cash out investments, and most brokerage accounts also allow you to write checks out of the account directly. I use a brokerage account for all my check writing because it allows me to manage my free cash balances pretty much how I please. If I am not happy with the money market I move some of the cash into a CD or short term bond fund.
It is possible to purchase Bonds directly. A Bond is a debt obligation issued by a government or corporation which needs to borrow money and is willing to pay a certain amount of interest (called the coupon rate) over a fixed period of time. Bonds are rated according to their risk of default. Bonds with low risk ratings offer lower interest rates while bonds with high risk ratings must offer higher interest rates. Junk bonds are bonds that offer very high interest rates but which are also incredibly risky.
The primary advantage of purchasing a number of high quality bonds directly is that you can always choose to hold the bond until its maturity, which guarentees you the coupon rate regardless of how interest rates move in the wider world. This means that directly purchased high-quality bonds tend to have lower risks then a bond fund would have. Bond funds are priced according to the current market value of the bonds in their portfolios and the current market value of a bond is heavily influenced by current interest rates.
Unfortunately there are a number of disadvantages to purchasing bonds directly. The biggest one is that your investment time horizon may not give you the flexibility to purchase the longer-term bonds that bond funds are able to purchase, resulting in your directly purchased bonds having a lower coupon rate (a lower guarenteed yield) then you would be able to get through a bond fund. The second disadvantage is that a directly purchased bond is not very liquid. There is no guarentee that you can sell your bond on the secondary market, for example, or if you can you might be forced to sell it at a loss. If you buy a bond you should be prepared to hold it until maturity. The third disadvantage is hassle. It takes a certain degree of effort to put together good bond portfolio yourself verses simply buying into a bond fund. Finally, the company issuing the bond can default on it, so there is the potential of losing your entire investment. If you decide to purchase individual bonds, diversify by purchasing several issued by different companies.
Bond funds are mutual funds which specialize in bonds. From the point of view of risk short and intermediate term bond funds tend to be less risky then stock funds, while long term bond funds tend to be as risky as stock funds. Bond funds are sensitive to interest rates. When interest rates go down the market value of a bond fund tends to go up, even though in the long term its yield is likely to go down. This is because the bonds already held in the bond fund become more valuable due to having higher coupon rates then current interest rates. When interest rates go up the market value of a bond fund tends to go down, even though in the long term its yield is likely to go up. This is because the bonds already held in the bond fund become less valuable due to having lower coupon rates then new bonds would have issued at current interest rates.
Because of this see-saw effect (the short term market value goes in the opposite direction of the longer term yield), bond funds tend to be less volatile then stock funds. In particular, short and intermediate term bond funds are far less risky then stock funds and many investors, including myself, consider them excellent replacements for CDs in the 1-5 year range because they are also far more liquid then a CD. Long term bond funds are more speculative since they take far longer to recover from a change in interest rates then short and intermediate-term bond funds.
Now there are many types of bond funds. The generalization I am making is for high-quality municiple and corporate bond funds. Municiple bonds (Munis for short) are bonds issued by municipalities like states, counties, and cities, and are less risky then corporate bond funds which are bonds issued by corporations. Corporate bonds have higher yields (to offset the additional risk) and investors typically choose between a Muni and a Corp bond fund based on whether they want tax-exempt or taxable dividends. Choosing between the two depends on whether you are investing from an IRA or a 401K or from a normal brokerage account, and depends on what tax bracket you are in.
Not all bond funds are the same! You can easily shoot yourself in the foot with a speculative bond fund. Remember what happened to the Junk Bond market? The assumption that bond funds are less risky then stock funds only holds water for certain types of bond funds. So called high-yield bond funds tend to invest in low quality bonds and junk bonds and have far higher risks. I recommend investing only in bond funds which invest in high quality bonds.
Crash of 2008 addendum - Leveraged Bond Funds carry more risk. Some bond funds are leveraged, some or not. Leveraged funds generate higher dividends but carry more risk. Leveraged funds were destroyed in crash (50% loss in many cases) even though the underlying securities that they held were safe. This does not mean that a leveraged fund is to be avoided for a recovery play, however. The main thing to look for is a fund that has at least a 5-year track record and does not show signs of NAV erosion (where the NAV steadily declines over a long period of time, even when the overall market is good).
Bond funds are not bonds. If you purchase a non-callable high quality bond you can always hold it until maturity and receive its coupon rate in interest. Bond Funds, however, are priced according to the current market value of their underlying bonds which fluctuate as interest rates change. Putting together a portfolio of bonds is fairly time consuming and not as liquid as simply buying into a Bond Fund but you should not forget the additional risk Bond Funds entail. Bond Funds often generate better interest rates then you would otherwise be able to obtain within the bounds of your investment horizon and this offsets the additional risk considerably, at least in regards to bond funds that target high quality bonds.
Finally (whew!) you should keep in mind that a bond fund produces interest which is typically paid to you in the form of significant monthly dividends. Just looking at the price graph of a bond fund does not in any way tell you how well it performs. The graph could be going up and down but the actual performance when dividends are taken into account will often turn that fluctuating graph into a fairly stable rising graph. The only way to compare bond fund performance is to look at a growth chart for the fund. A growth chart measures the growth of a theoretical investment over a period of time and takes dividends (which are major component of a Bond fund) into account.
The interest produced by bonds and bond funds are subject to varying levels of taxation depending on the type of bonds, so you should be aware of tax consequences when investing in bond and bond funds outside of your retirement account.
Index funds are trusts or mutual funds designed to mirror the performance of an index. For example, DIA is "Diamonds Trust", which mirrors the performance of the DOW, SPY mirrors the S&P, and VBIIX attempts to mimic the Lehman brother's intermediate bond index. Index funds have approximately the same risk as the indexes they mirror. Generally speaking a stock index will have less risk then a stock fund and a bond index will have less risk then a bond fund for its category simply because 90% of mutual funds can't beat their related indexes, but you should not construe this as meaning an index fund is somehow safer. Someone investing in, say, SPYders at the height of the internet bubble would still have lost quite a bit of wealth though perhaps not as much as if they had invested in, say, a basket of internet stocks instead.
Owning individual stocks requires paying considerble attention to your portfolio but frankly I prefer it (and index funds) over mutual funds. If you are just starting out then I recommend purchasing stocks only in high quality, large-cap companies (with over 1 billion in assets), which produce some dividend. For example, as of December 2008 IBM produces a 2.4% dividend. Different stocks are suitable for different points in your investment time horizon. Stocks which produce no dividends are long-term (10-30 year) plays. Stocks which produce small dividends are better for 5-15 year plays. Stock which produce substantial dividends are best once you retire or to augment your income while you are still working, if you need it to live & play.
Stock funds are mutual funds that invest in stocks. A stock fund will tend to have higher risk then a bond fund, but not always. Even an Index Fund carries risk (and not necessarily all that diversified either if you examine how an index like the DOW is made up!). Someone who invested in a DOW-tracking fund when the DOW was at 11,000 is still hurting today several years after the crash.
Stock Funds are classified in various ways in a manner similar to Bond Funds, but the delineation between the types of stock funds is far less precise and far more difficult to define. Just as you can have stocks which produce or do not produce dividends, you can have Stock Funds which focus on a dividend producing stock portfolio, or the reverse, or some blend. There are many categories of stock funds and each category focuses on a different strategy for picking stocks. Again, since 90% of stock funds cannot beat their related indexes I recommend buying into index funds and ignoring most of the non-index stock fund offerings out there, with few exceptions.
Stock funds can be leveraged or non-leveraged. Under no circumstances should you ever invest in a leveraged stock fund.
The first thing you need to know about mutual funds is that there are literally thousands of them, 90% of them can't even approach the returns of their related sector indexes, and many do not generate the good long-term returns required to justify their high fees. Unless you know exactly what you are looking at you should stick to some basic rules of thumb when purchasing a mutual fund of any type:
(1) Purchase only no-load funds. A no-load fund has no front-end or back-end sales charge and no defered sales charge. Load funds generally have sales charges that can eat up to 5% of your principle and fund performance graphs often do not take sales charges (especially back-end or deferred sales charges) into account.
(2) The industry allows funds with 12B-1 fees of up to 0.25% to be called 'no-load' funds. A true no-load fund has no 12B-1 fee but the main thing to look for is that the 12B-1 fee plus the total expense ratio not exceed 1%. If the two together exceed 1% the fund managers are making a personal killing off of your money and you shouldn't buy the fund.
(3) Generally speaking you want to look for funds with low expense ratios. The expense ratio should definitely be less then 1%. The expense ratio on index funds should almost universally be less then 0.6%.
(4) Mutual fund rankings with time periods of less then 5 years are completely bogus. Never buy a mutual fund *solely* because it is high on the top-25 performance list for a short period of time like a year. Only the long term performance numbers have any real meaning.
If you have a 1000 people, and half of them bet on RED and half on BLACK, then after the first round 500 people will win. If of the 500 half bet on RED and the other half bet on BLACK then 250 of the original 1000 will have won twice in a row. After six rounds you will still have 15 people who, through pure chance, won six times in a row. Now are you going to believe one of those individuals if they tell you that they can always win at roulette? No, it was pure luck, and pure luck is what you normally get when you look at a top-25 list of mutual funds. The phrase "Past peformance does not guarentee future results" takes on real meaning in this context and it applies to virtually any mutual fund that doesn't have a 5-year or better track record.
(5) Longer Fund Manager Tenures generally indicate more stable funds. Beware funds which have inexperienced managers.
(6) Beware funds with low total assets. Fraud is potentially an issue with small funds.
(7) Beware so-called high-yield funds. The designation 'high yield' is another way of saying that the fund is trying to increase performance through increased risk, often through purchases of junk bonds or risky stocks, and this risk could very well be unreasonable for your purposes.
(8) Beware of funds whos long-term (5-year) graphs show clear a erosion of their net asset value (NAV), even when the market is good. Do this by bringing the fund up on Yahoo, selecting the 5-year graph, then comparing it against the DOW.
(9) Beware of leveraged funds as well as all closed-end funds or trusts. I stay away from them for the most part.
Once you have narrowed down your list of prospects you should look at the growth charts for the prospects. In particular look at the volatility.. that is, areas of the chart where the value of the investment goes down instead of up, and note how long it takes the fund to recover its value after a loss. Generally speaking, funds with low risks should look like a rising curve on the growth chart and occassional dips should recover quickly. A short-term quality corporate bond fund should not have dips that last more then a year. An intermediate term quality corporate bond fund should not have dips that last more then two years, and a long term quality corporate bond fund should show definite recoveries after a dip though it might take it several years to do so. If you observe the growth chart for bond funds that specialize in higher-yielding bonds you will almost certainly note the greater volatility in the graph and the fact that the higher yield funds entail significantly greater risks. Growth charts make risk understandable because you can see the volatility with your own eyes. Normal market charts which do not account for dividends are impossible to interpret, at least in regards to bond funds. Stock funds, even income-producing stock funds, tend to have far lower dividends then bond funds which make normal market charts more useful.
Taxable events can create big headaches, especially if you are in a high tax bracket. Most bonds produce monthly dividends based on their yield and there are only two ways, short of going with more esoteric securities like master-limited-partnerships, to avoid paying taxes on these dividends: (1) you can avoid taxes by investing through a retirement account and (2) you can avoid taxes by investing in municiple bonds and municiple bond funds.
So far in this document I've made stocks out to be very risky beasts compared to bonds, now I am going to turn the table and provide a reason for taking on the risk a stock or stock fund entails. The reason is: Capital Appreciation does not produce high dividends and does not get taxed until you cash out the stock. If you choose stocks which do not produce dividends then you are said to be choosing a "Growth" stocks. That is you depend on the value of the stock increasing. So even though stocks tends to be far more volatile (and thus risky) then bonds, many stocks have the advantage of being able to appreciate tax-free and this is worth a considerable amount of risk.
All things being equal, if you have a stock which appreciates 5% a year and you have a bond which produces 5% a year in dividends, the stock will be the more flexible and possibly the more profitable investment after you take taxes into account.
You can control your investment time horizon with equities by chosing stocks which produce a higher or lower dividend yield. Typically stocks which produce high dividend yields grow more slowly over the long term (30 year period), and stocks which produce lower dividend yields grow more quickly over the long term. Even if you choose a stock which produces dividends you can still choose to reinvest those dividends, resulting in similar long-term growth verses stocks which do not produce dividends. Dividend producing stocks tend to be of higher quality (since they can afford to pay the dividend) and thus lower risk, but dividends also produce income which will be taxed.
If you have retired you want to have sufficient dividend-producing stocks and other income-producing instruments to generate 100% of the cash flow you need to live indefinitely. You should only have pure equity (non dividend-producing) positions if the rest of your portfolio is able to achieve this level of income. Since you need the income to live, you are paying taxes on it either way.
Inflation is a big deal to investment professionals, but it is often over-emphasized. You should always consider the effect inflation has on Bond Funds due to its effect on the current market value of a bond, but many investors are in circumstances where they don't actually have to worry about the erosion of their capital due to inflation.
The most direct example I can think of is anyone who has a home mortgage. If your primary monthly expenditure is your mortgage payment then for all intents and purposes inflation takes a back seat to the interest rate of your mortgage. If you have a 30 year fixed mortgage at 5% then your investment goals for the next 20 years should be to beat 5%, regardless of the national inflation rate.
There are other ways to beat inflation. For one thing, do not carry variable-rate debt such as credit-card debt. And remember way near the beginning of this article where I talk about money markets doing better during periods of high inflation? You could very well see one of your least risky investment vehicles yielding your greatest profits, which argues for more liquidity (and argues against holding individual bonds or long-term bond funds). If inflation is a worry to you it only takes small adjustments to your strategy to prepare for and deal with the possibility of inflation occuring.
If there is any single answer to the question of why diversification is important.. why you should not put all your money into stock or all your money into bonds then the above example should make things crystal clear to you. Diversification is a hedge against unexpected trends, unexpected events, and situations that would otherwise cripple you had you not diversified. It is human nature to look back at something and say "If only I did this, then I would be rich" or "If only I put ALL of my money into that one stock, then I would be rich". The reality is that hind sight is always 20-20 and if you actually tried to do something that phenominally stupid you might as well spend your money at a casino instead of in the investment arena, because you would be gambling away your entire future in exchange for a single roll of the dice.
You will notice that I have not yet told you what percentage of your assets I think you ought to put into cash, money market, stocks, bonds, etc etc etc. I haven't said and I am not going to say, because figuring straight percentages without regard for your personal situation is a dumb way to plan your future. What I recommend is that you re-read the section on calculating your investment time horizon and that you apply it to your situation, taking into account the fact that your investment time horizon is constantly changing as you grow older and as your circumstances change. I think you will find that a good chunk of your assets fall fairly neatly into their places on the risk curve and that will make your decisions with regards to the remainder far clearer to you.