Wealth made easy.

Although a savings account is never a bad idea, the only way to build your wealth significantly over time is to invest. And its far easier than you think: even the simplest investing plan can boost your net worth and secure your financial future.

Learn the basics of risk, return, compounding, and diversification Choose investments that are the right risk level for you Recognize the pros and cons of stocks, bonds, mutual funds, and ETFs

Whats an Investment?
An investment is an assetsuch as a stock or a bond that an investor buys in order to build wealth over time. The value of an investment can rise or fall based on a number of factors, from supply and demand to the state of the overall economy. Investors buy investments with the intention of selling them later for a higher price. Some investments, such as real estate property, precious metals, fine art, and collectibles, are assets that the owner possesses and, in many cases, can physically use. The types of investments that this guide covers are investment productsnonphysical assets such as stocks and bonds, which for most investors are more convenient and easier to sell than physical assets such as real estate.

Why Invest?
Investing is the most effective way to build your wealth at rates that exceed those of inflation, the economic phenomenon that causes the prices of goods and services to rise over time. Inflation doesnt change the amount of money you have, but it does erode your purchasing power, the amount of goods and services you can buy with your money. Since 1925 or so, inflation in the United States has averaged 3% per year, while the average savings account has paid an interest rate of about 2%. During the same period of time, the return, or the annual rate of growth, of U.S. stocks has averaged about 10%. If those trends continue:

Due to inflation, in 30 years youd need $2,427.26 to equal the purchasing power of

$1,000 today. $1,000 kept in a savings account would grow to $1,811.36 after 30 years, trailing the

effect of inflation. $1,000 invested in stocks today would grow to $17,449.40 over 30 years, easily allowing

you to outpace the effects of inflation over that time period.

Types of Investments
This guide covers four major investment products:

Stocks: Investments in a specific publicly traded corporation, such as Google or

PepsiCo. Publicly traded companies issue shares of their stock to the general public. Each share represents a fractional percentage of ownership in the company.

Bonds: Loans that investors make to corporations and governments. The corporation or

government then makes fixed interest payments to the bond investor over a set period of time, called a term. At the end of the term, the investor also gets back the original investment amount, called the principal.

Mutual funds: Investments that pool money from many investors and invest it in a

specific set of stocks or bonds. A type of mutual fund called an index fund attempts to mimic the performance of a specific market index, a group of investments that serves as a benchmark for the performance of other investments. For instance, an S&P 500 index fund tries to replicate the performance of the S&P 500, a well-known index of 500 of the most widely held U.S. stocks.

Exchange traded funds (ETFs): ETF are funds that track indexes (as index mutual

funds do) but are bought and sold like stocks.

How Investing Builds Wealth

Investing builds wealth in two main ways:

Growth: Growth investors aim to buy investments that will increase in value over time,

so they can then sell the investments later for a higher price. Income: Income investors aim to buy investments that provide regular cash payments.

These payments can take several forms. For instance, some stocks pay dividends, a portion of a companys earnings paid directly to the companys shareholders. Most bonds pay interest, periodic cash payments that investors receive in exchange for buying the bond. Some investments provide only growth; others provide only income. Some, such as dividend-paying stocks, provide a mixture of growth and income.

Types of Investing Markets

Investment products are tradedbought and soldon exchanges, also called markets. For instance, stocks are sold on various stock exchanges, such as the New York Stock Exchange (NYSE), the NASDAQ, and the American Stock Exchange (AMEX). Bonds are also sold on various exchanges; ETFs are generally sold on the AMEX. Though professional traders and market makers at the exchanges facilitate some of the pricing and trading of investments, a substantial portion of trading occurs electronically. The U.S. governments Securities and Exchange Commission (SEC) enforces strict legal standards that govern the investment products traded on each exchange.

How Investors Buy Investment Products

As an individual investor, you dont buy and sell investment products directly on the various exchanges. Instead, you buy them through middlemen, such as brokers, brokerage houses, and other financial professionals who are called registered representatives. First, you set up an investment account and place cash in it. Then you can place orders through a broker or brokerage house to buy or sell specific investments. When these orders are executed (filled or completed), the cash in your investment account converts into a certain amount of the investment product bought, and investments sold convert back into cash in the account. As investments in the account rise or fall in value, the account balance adjusts accordingly, usually once per day.

Names and Symbols of Investment Products

All investment products have a given name and are represented by a symbol.

The symbols used to represent stocks, mutual funds, and ETFs are called ticker

symbols and consist of 15 letters. For instance, the ticker symbol for Starbucks stock is SBUX.

The symbols used to represent bonds are called CUSIPs and usually consist of nine

numbers and letters. For example, a bond issued recently by the New York City government had a CUSIP of 649660JR9. Stocks also have nine-digit CUSIPs, but these are rarely used, since ticker symbols are simpler to remember.

Shares and Amounts of Investment Products

Some investments, such as bonds and mutual funds, are bought and sold in dollar amounts. Others, such as stocks and ETFs, have a specific share price that changes constantly as the supply and demand for the shares shifts throughout the trading day. Mutual funds also have a specific share price, but it changes only once per trading day after the markets close and the value of all the mutual funds holdings is recalculated.

Risk and Risk Tolerance

Before you begin making investments, its essential to understand some of the basic principles of investing namely, risk, return, volatility, and risk tolerance.

Investment Risk, Return, and Volatility

Risk refers to the uncertainty of an investments return. Some investments, such as savings accounts, have guaranteed returns and therefore carry no risk. Others, such as stocks, carry a lot of risk. The return on any particular stock is always uncertain: depending on the performance of the company, its stock could double in value, or it could become worthless. Volatility is the degree to which the value of an investment tends to fluctuate over time.

Risk and volatility tend to correlate with investment returns: the higher the risk of an

investment, the higher its volatility and potential returns. Over short periods of time (five years or less), investments with high risk and volatility have the greatest chance of losing value. For instance, a stock worth $5 today might be worth $2 tomorrow. Over longer periods of time, though, investments with high risk and volatility tend to have a greater chance of increasing in value than low-risk investments.

Risk Tolerance
Risk tolerance refers to the amount of risk that you, personally, are comfortable accepting in your investments. To position yourself to benefit from your investments, you need to determine your risk tolerance.

How to Determine Your Risk Tolerance

Two important factors that affect your risk tolerance are your time horizon and your personal response to risk.

Your Time Horizon

Your time horizon is the amount of time you have before youll need the money youve invested. Time horizon has a direct relationship to risk tolerance:

The longer your time horizon, the greater your risk tolerance, since short-term

changes in an investments value wont affect you. Investors with long time horizons (10 years or more) generally have a high risk tolerance. These investors should usually invest for growth by buying stocks almost exclusively.

The shorter your time horizon, the lower your risk tolerance, since a short-term dip in

the value of an investment might occur just when you had planned to use that money to finance a major purchase. Investors with moderate time horizons (510 years) generally have a moderate risk tolerance and should invest for growth and income by investing in stocks, bonds, and cash equivalents (such as certificates of deposit (CDs), which are almost always risk-free). Investors with short time horizons (15 years) generally have a low risk tolerance and should invest almost entirely for income by buying bonds and cash equivalents. The correlation between risk tolerance and age isnt 100% ironclad. Other factors, such as your personal life situation and upcoming financial obligations, can have a major impact on your risk tolerance. For instance, a young couple saving to buy a home within the next five years might seem to have a high risk tolerance, based on their age. Even so, they should probably consider their risk tolerance low, since theyll need to use the money theyre investing to buy a home within five years.

Your Personal Response to Risk

In addition to the risk that you can accept based on your time horizon, risk tolerance also includes how you feel personally about taking risks and losing money.

If you avoid risk in everyday life or worry easily: Even if you have a long time

horizon, it still might be best for you to avoid buying risky investments such as stocks. Though your returns will potentially be lower, youll get the benefit of lower volatility and less stress.

If you enjoy risk and dont worry easily: You should feel comfortable investing for

growth exclusivelyassuming you have a long time horizon.

Asset Allocation and Diversification

An investment portfolio is a collection of various types of investments. You should build your investment portfolio based on your risk tolerance and two other fundamental principles: asset allocation and diversification.

Asset Allocation
Investments fall into various asset classes, such as stocks, bonds, cash equivalents, precious metals, and so on. Asset allocation is the process of determining the percentage of your investment portfolio that each asset class should occupy, based on your risk tolerance.

Why Should You Allocate Your Assets?

Each asset class provides you with a different level of risk, and different levels of potential return. Owning just one asset class, such as stocks, would be risky, because the value of your entire portfolio would depend entirely on the performance of that asset class. With asset allocation, your portfolio will benefit when one asset class booms and will lose only a portion of its value if another asset class crashes. The overall purpose of asset allocation is to reduce volatility, so that thriving investments in one asset class potentially outweigh losing investments in other asset classes.

Sample Asset Allocations Based on Risk Tolerance

The following charts below offer suggested asset allocations for investors with high, moderate, and low risk tolerances. For instance, based on these allocations, if you have $10,000 to invest and have a high risk tolerance, you might put $7,500 into stocks, $2,000 into bonds or real estate, and keep $500 in a money market fund.

Conservative Asset Allocation

Moderate Asset Allocation

Aggressive Asset Allocation

Diversification
Just as you should own investments in various asset classes, its also important to own various investments within each asset class. For instance, rather than own just one stock, such as Google or Pepsi, you should own several stocks. And rather than own just one type of stock, such as technology stocks, you should own stocks from various industries. This practice, known as diversification, has been proven to decrease risk without compromising returns over the long term.

Should You Be Investing?

Its crucial to invest only with money that you wont need in the immediate future. If you invest with money that you might need, you may be forced to sell at a time when your investments have temporarily declined in value. To determine whether you have enough money to begin investing now, assess your financial situation as follows:

1.

Cover your monthly expenses: Invest only money thats left over after you pay all of

your monthly expenses, including mortgage and car payments, credit card bills, and all utilities. If you have an outstanding credit card balance and are making only minimum monthly payments, pay off that balance entirely before you begin to invest.

2.

Consider short-term expenses: If you may face any major expenses within the next 1

3 years, such as a college education or the purchase of a home, put the money designated for those expenses into cash equivalents, such as savings accounts or certificates of deposit (CDs), which ensure that your principal wont lose value (up to certain limits).

3.

Establish an emergency fund: Before you start investing, set aside an emergency

fund equal to 36 months worth of living expenses. An emergency fund protects you from having to sell your investments to cover unexpected expenses, such as an unforeseen layoff or medical bills that result from an accident. If you dont have money left over after following these steps, then you probably shouldnt be investing at this time. If you do have money left over, then youre ready to get started investing.

How to Get Started Investing

To get started investing, you first must choose the type of investment account you want and the broker or brokerage firm you want to work with. Once youve made these decisions, you can set up an investment account and start making investments.

Types of Investment Accounts

An investment account is a special type of financial account in which you can buy, sell, and hold investments. There are two main types of investment accounts:

Brokerage accounts: Also known as taxable accounts, these accounts enable you to

invest and withdraw any amount of money at any time, for any purpose. You must pay income taxes on all dividends received and capital gains taxes on all assets sold at a profit (see Investing and Taxes).

Retirement accounts: These accounts allow your money to grow without taxation on

dividends or investment gains, which can significantly improve returns. But retirement accounts have some built-in restrictionsyou can add only a fixed amount each year to these accounts, and you face penalties if you withdraw money early (usually before age 59 1/2). The most popular types of retirement accounts are Traditional IRAs, Roth IRAs, 401(k)s, and 403(b)s. For more on retirement plans and retirement investing, see the Quamut guide to 401(k)s & IRAs, available in Barnes & Noble bookstores and online at www.quamut.com.

Brokers and Brokerage Houses

As an individual investor, you can buy and sell investments only if you have an account with a full-service broker (called a broker for short) or a brokerage house (often called simply a brokerage).

Full-service broker: An independent local professional or a full-service agent employed

at a brokerage house. A broker works with you one-on-one over the phone or in person to make investment decisions, and places orders on your behalf to buy and sell investments. Brokerage houses that employ full-service brokers include A. G. Edwards, Merrill Lynch, and Morgan Stanley. You can find independent local brokers by searching online or in your yellow pages.

Brokerage house: A firm that provides investment services to individual investors.

Rather than provide one-on-one investment advice, most brokerages allow you to place your own orders over the phone or online to buy and sell investments. They also often provide proprietary investment-related data and research reports to help you make your own investment decisions. Some of the most popular brokerages include Fidelity, Charles Schwab, Vanguard, T. Rowe Price, and TD Ameritrade.

Commissions
All brokers and brokerage houses charge commissions (transaction costs) for placing orders to buy or sell investments. Commissions may be charged as a percentage of the total value of the transaction or as a flat fee per transaction. The size of the commission is usually much higher for orders placed by brokers or via telephone than for trades that you make online. Commissions for online trades range from about $730 per trade, whereas commissions for broker- and phone-based transactions can be hundreds of dollars. Always compare commission rates before choosing a broker or brokerage. Because broker commissions are so high, for most individual investors it makes more financial sense to invest through the online services of a brokerage house than to pay for a full-service broker.

How to Set Up an Investment Account

To set up an investment account: 1. Choose a brokerage house or a full-service broker with whom youd like to open an account. 2. Fill out an application for the type of account youd like to set up. Most investment account applications consist of a few forms that ask for your name, address, Social Security number, and other basic information.

3. Make an initial deposit into your account through cash, check, or wire transfer. The amount required to establish an account varies but usually starts at $1,000. Most major brokerages allow you to set up an account in person (if they have retail locations), by mail, over the phone, or online. If you complete your application by phone or online, you may still have to fill out and mail in physical forms with your signature to establish your account.

Setting Up a Retirement Account

If youre setting up a retirement account, youll need to specify which type of retirement account youd like to establish. Certain retirement accounts, such as 401(k)s and 403(b)s, can be established only at your workplace, whereas others, such as Traditional IRAs and Roth IRAs, can be established directly through a broker or brokerage house.

How to Place Investment Orders

Once youve set up an investment account, you can place orders to buy (and later sell) investment products.

If youre working with a broker: Youll confirm your order with your broker, usually

over the phone. He or she will then place orders on your behalf for the investments that youd like to buy or sell.

If youre working with a brokerage: Youll log on to your brokerages website or call

their toll-free number to place your order. To place an order, youll need to know the name and/or ticker symbol of the investment and the amount that youd like to buy or sell.

Should You Hire an Investment Advisor?

If youre a knowledgeable investing enthusiast who enjoys managing your own money, you may do well managing your investment accounts yourself. But if you know little about investing and have no interest in learning much more about it, then its probably worth the time and money required to hire an investment advisor. An advisor can help you:

Decide whether to open a brokerage account, retirement account, or both Determine your risk tolerance Build a diversified portfolio Place orders to buy and sell investments

Investment advisors charge commissions, an hourly rate, and/or an annual fee based on the value of the investments that they manage. For advice on how to interview and select an advisor, consult your states securities licensing department, the National Association of Security Dealers (www.nasd.org), or the U.S. governments Securities and Exchange Commission (www.sec.gov). These organizations can verify whether an investment advisor is licensed, has received complaints, or has committed violations.

How to Invest in Stocks

There are roughly 10,000 publicly traded companies on the U.S. stock markets alone. Though you can buy the individual stocks of any of these companies, most beginning investors find that researching and selecting a handful of individual stocks to buy among thousands of potential candidates is too risky and timeconsuming to be practical, let alone profitable. Instead, another strategy for beginnersas well as for most seasoned investorsis to buy stocks through mutual funds and ETFs (see How to Invest in Mutual Funds and How to Invest in ETFs).

But even if you dont buy any individual stocks, its still essential to know the basic principles of stock investing. If youre determined to research and buy individual stocks, this section explains the basics to help you get started.

Why Invest in Stocks?

Buying stocks can help you build wealth in two ways:

Capital appreciation: Occurs when a stocks share price increases as demand for the

shares grows. Share-price increases can happen for a variety of reasons, such as growth in the companys profits, a strong overall economy, or as a result of pure speculation. If share prices rise, shareholders who bought the stock at lower prices can sell at higher prices for a profit.

Dividends: Some companiesoften older, more established companiesreturn a

portion of their profits to investors as dividends instead of reinvesting those funds back into the business. Dividends can be paid in cash or in additional shares of the companys stock. A stocks dividend yield is the ratio of the dividend to the stock price: for example, a stock that has a $100 share price and pays annual dividends of $5 per share has a dividend yield of 5%. The dividend yield changes over time as share prices fluctuate.

The Main Types of Stocks

Investors use a number of different methods to classify and group stocks:

Growth vs. value Company size (or market cap) Industry group (or sector) Geographic location (domestic vs. international)

Growth Stocks vs. Value Stocks

Investors divide stocks into two broad categories: growth stocks and value stocks.

Growth stocks: Growth companies tend to be newer, rapidly expanding companies

whose sales growth and earnings growth are expected to outpace that of the market as a whole. Though share prices of growth stocks may rise more quickly than share prices of value stocks, growth stocks are considered riskier than value stocks because they tend to be priced at a premium to the overall market and rarely pay dividends.

Value stocks: Value investors look for companies whose stock appears to be

undervalued relative to underlying fundamentals (key company statistics such as sales, earnings, dividend yield, and so on). Value stocks often are older companies that pay dividends and tend to be less risky and volatile than growth stocks, though they also tend to offer less opportunity for large returns. Value investors must be careful to avoid value trapsstocks that appear to be undervalued but actually are suffering from serious problems in their company or industry, which have in turn depressed their stock price. Investors with low risk tolerances tend to prefer the relative safety and reliable income of value stocks, whereas more risk-tolerant investors tend to favor growth stocks.

Company Size (Market Cap)

A companys market capitalization, or market cap, is the total value of a companys publicly traded stock. Market cap equals the number of publicly available shares multiplied by the current share price. For

example, a company with 10 million shares outstanding and a share price of $10 has a market cap of $100 million. A companys market cap fluctuates as its share price moves up or down.

The Five Market Cap Categories

Stocks can be placed into five general groups based on the size of their market cap. (Note that the specific market cap ranges included in these descriptions often vary.)

Mega-cap stocks: Giant companies with market caps over $100 billion, such as

General Electric and Microsoft. Mega-caps, along with some large-caps, are also known as blue-chip stocks.

Large-cap stocks: Companies with market caps of $10100 billion. Large-cap stocks

are typically well-known household names, such as Apple. Mid-cap stocks: Companies with market caps of $210 billion. Examples of mid-cap

companies include Hilton Hotels and Urban Outfitters. Small-cap stocks: Companies with market caps of $100 million$2 billion. Many small-

cap stocks are of companies whose names you probably wouldnt know. Micro-cap stocks: Companies with market caps under $100 million. These stocks often

trade on markets other than the NASDAQ, AMEX, or NYSE. These markets, known as the OTCBB (over-the-counter bulletin board) or pink sheets, are less rigorously regulated by the SEC than the more popular exchanges, which makes buying these stocks very risky. To provide a more precise description of a company, investors often combine the growth-value classification with market cap, resulting in descriptions of stocks as large-cap growth, small-cap value, and so on.

Market Cap and Risk

Market cap and risk tend to correlate in the following ways:

Smaller-cap stocks tend to be more risky but often have higher prospects for growth and

significant share-price increases. Larger-cap stocks tend to be less risky but usually offer less chance of huge growth and

returns. Although these rules generally hold, theyre not always true. For example, Google was already a large-cap company when it went public in 2004, yet its stock price still rose tremendously over the following year. On the other hand, the pharmaceutical mega-cap Merck plunged more than $100 billion in value over the period from 20002005.

Sector
Stocks can also be classified by industry, or sectorthe general type of business in which the company is involved. For example, major industry/sector groups include technology, healthcare, utilities, financial, consumer goods, industrial goods, and so on. Stocks within a given industry or sector often share certain predictable traits, such as how quickly they grow and whether they pay dividends. For a more extensive list of industries, see the Industry Center on Yahoo! Finance at biz.yahoo.com/ic/ind_index.html.

Domestic Stocks vs. International Stocks

U.S.based investors have the opportunity to include both domestic (U.S.based) and international (foreign-based) companies in their portfolio. International stocks can help to diversify a portfolio. However, they also carry risks related to foreign exchange rates and political stability. Some foreign economies, such as those of western Europe, Australia, and Japan, are well-established, developed economies. Others, such as Brazil, Russia, India, and China, though growing rapidly, are much less stableeither politically or economically or both. These less stable countries are termed emerging markets and can be very risky.

How to Research and Analyze Stocks

Fundamental analysis is the process of analyzing a companys financial results to determine its prospects for the future and to assess whether its stock is fairly valued. The goal of fundamental analysis is to find bargain stocks, or stocks whose share prices are below where the market should be pricing them. When investors refer to a companys fundamentals, they mean the companys financial well-being, as determined by three main factors:

on

Profits (earnings): The total amount of money the company actually earns after

expenses Debt: The companys outstanding financial obligations to suppliers, banks, and so on Assets: The companys valuable property, including cash, inventory, real estate, and so

Investment Statistics and Ratios

With data on earnings, debt, and assets, you can use a variety of simple statistics and ratios to assess a companys fundamentals and determine whether a companys stock is worth buying. The most commonly used of these ratios and statistics are:

Earnings per share (EPS): The portion of a companys profits that each share of the

companys stock contains. To calculate it, divide a companys profits by the number of publicly traded shares. If all other factors are equal, given two stocks with similar profits, investors tend to favor the stock with fewer publicly traded shares, and therefore higher EPS.

Price-to-earnings (P/E) ratio: A ratio that compares a companys share price to its

current EPS. To calculate it, divide the companys share price by the companys EPS. Companies with lower P/E ratios relative to those of other stocks in the same industry tend to be good values, assuming that all other factors are equal.

Beta: A measure of a stocks historical volatility relative to the broader markets volatility,

which is represented by a beta of 1. Stocks with betas greater than 1 are more volatile than the broader marketthey tend to move up and down in price more often and in greater extremes than the market. Stocks with betas of less than 1 tend to be less volatile. You dont need to calculate these ratios and stats on your own. A faster way is to use financial websites that aggregate and publish these data as they become available and calculate the most helpful ratios and stats for you. Among the best sources for stock-related reports, data, and stats is Yahoo! Finance (finance.yahoo.com).

How to Buy and Sell Stocks

Once you decide to trade (buy or sell) a particular stock, the process will differ slightly based on whether youre working with a full-service broker or an online brokerage. For instance, if you want to buy 10 shares of Google at $400 per share:

If Youre Trading through a Broker

1. 2. 3. Youll contact your broker and tell him or her you want to buy 10 shares of Google. Your broker will ask you the highest price per share youre willing to pay for the shares. Your broker will place the order with a brokerage. The brokerage will send your order to the exchange, where either a person, known as a

4. 5.

market maker or specialist, or a computer will fulfill the order. The exchange will send back confirmation once your order executes, or is filled.

6. In your investment account, $4,000 will immediately convert to 10 shares of Google stock. A commission for the trade will also be deducted from your account.

If Youre Trading Online through a Brokerage

1.

Youll place the order directly with the brokerage by logging into your account online and

filling out a stock order form. To fill out the form, youll need to know the number of shares you wish to buy, the ticker symbol, and the type of order you prefer (explained below). 2. The brokerage will send your order to the exchange, where a person or a computer will fulfill the order. 3. Youll receive an email confirming that your order has been placed, then a follow-up when your order executes. 4. In your investment account, $4,000 will immediately convert to 10 shares of Google stock. A commission for the trade will also be deducted from your account.

Types of Stock Orders

There are two types of orders you can use when buying or selling a stock:

Market order: You agree to buy or sell a particular stock at the price specified by the

market. Limit order: You specify the maximum price at which youre willing to buy, or the

minimum price at which youre willing to sell. Commissions are generally lower for market orders than for limit orders, but market orders are also riskier and the price difference is rarely substantial enough to justify the increased risk. Its a good idea to use limit orders every time you buy or sell stock. Use market orders only if you absolutely must sell your shares of a stock, regardless of price.

How to Invest in Bonds

Bonds are a type of lending investment in which investors loan money to bond issuers, which are usually corporations or federal, state, local governments, or quasi-government agencies (such as mortgage lenders Fannie Mae or Freddie Mac). Investors buy bonds for two main reasons:

Income: Bonds pay investors fixed quarterly, monthly, semiannual, or annual interest

payments. Return of principal: Bonds return the entire principal (original investment amount) back

to the investor after a certain period of time.

In the short term, bonds are generally less volatile and risky than stocksbut not as risk-free as cashequivalent investments such as CDs or money market accounts. As a result, bond returns tend to be higher than those of cash equivalents, but not as high as stock returns over the long term. Investors typically buy bonds as a counterweight to stocks, since bonds tend to rise in value when stocks decline.

Bond Basics
Before you invest in bonds, familiarize yourself with some basic bond terminology:

Par value: The face-value price of the bond that the investor will eventually receive back

as principal Coupon rate: The interest rate that the bond pays. For instance, a bond with a par

value of $1,000 and an annual coupon rate of 9% will pay $90 a year. Maturity date: The date on which the bond issuer will return the principal to the lender

and stop making interest payments. The length of time until a bonds maturity datealso known as the bonds termcan be anywhere from less than a year to 30 years. Usually, the longer the term, the higher the coupon rate.

Callability: Callable bonds give the issuer the right to recall the bond, pay back

principal, and stop paying interest at a point in time before the maturity date. All corporate and state or local government bonds specify whether they can be called and how soon they can be called. Federal bonds are never callable. Like stocks, bonds are bought and sold through brokers and brokerage houses, both of which usually add a markup of 15% to the par value of the bonds they sell. So a bond with a par value of $100 might sell for $102.

Classifying Bonds by Term

Bonds are often grouped based on their terms:

Short-term: Bonds with terms of 03 years Intermediate-term: Bonds with terms of 310 years Long-term: Bonds with terms of 10 years or more

Credit Risk and Interest Rate Risk

On the surface, bonds seem like a great dealyou get paid to lend money, and then you get back all the money you lent. But bonds do present two unique types of risk: credit risk and interest rate risk.

Credit Risk
The riskiness of a bond depends in part on the bond issuers creditworthiness, the likelihood that the issuer will in fact make good on its promise to pay interest and return the investors principal. When you buy an individual bond, theres rarely a 100% guarantee that youll receive your interest payments and your principal. If a bond issuer suffers a major financial crisis, such as bankruptcy, it may default, or fail to meet its obligations to its investors. Individual bonds have bond ratings that rank the creditworthiness of their issuers. The safest issuers have A ratings, such as A, AA, or AAA. For instance, a AAA ratingthe highest ratingsuggests a default risk of less than 1%. Riskier issues have ratings with Bs, Cs, or Ds (D means the issuer is in default). In general, the higher the bonds default risk, the higher the coupon rate.

Interest Rate Risk

Bond prices move in the opposite direction of prevailing interest rateswhen interest rates rise, bond prices fall, and vice versa. Bonds react this way because higher interest rates make bonds with coupon rates below prevailing interest rates less attractive to buyers.

The Most Common Types of Bonds

Of the many types of bonds on the market, the five most common are government bonds, municipal bonds, corporate bonds, TIPS, and high-yield (junk) bonds.

Government Bonds
Government bonds are bonds issued by local, state, or federal governments. Government bonds issued by the U.S. government are called Treasuries. The interest that Treasuries pay is subject to federal income tax but is state-taxfree. The three main types of Treasuries are:

Treasury bills: Have terms of 1 month to 1 year; also called T-bills Treasury notes: Have terms of 210 years Treasury bonds: Have terms of 1030 years

Treasuries are considered very safe bonds with virtually no default risk. The debt of stable foreign governments is similarly safe but carries currency risk, the prospect of a change in interest payments based on fluctuating currency rates. Government bonds of developing countries, however, are considered very risky due to the combination of currency risk and political instability that may lead to default.

Municipal Bonds
Municipal bonds, also known as munis, are bonds issued by state and local governments or government agencies. The interest that munis pay is not subject to federal tax. Munis are also state- and local-taxfree to investors who reside in the states or locales that issue the munis they own, which makes some munis tripletax-free, or entirely free from tax. Due to these tax savings, munis tend to offer much lower interest rates than Treasuries.

Corporate Bonds
Corporate bonds are bonds issued by corporations. Corporate bonds tend to have higher yields than government bonds and munis due to their higher risk of defaultcompanies go bankrupt more often than governments. Even so, the bonds of many companiesespecially AAA-rated companies such as ExxonMobil or General Electrichave very low default risk. In general, the higher a companys credit rating, the lower the coupon rate of its bonds. All corporate bonds are subject to federal, state, and local taxes.

TIPS
Treasury inflation-protected securities, known as TIPS, are a special type of Treasury note or bond that offers protection from inflation. Every year, the government adjusts the par value of these bonds based on the consumer price index (CPI)a measure of inflation. If the CPI rises 4% in one year, so too will the par value of these bonds for investors who hold them to maturity. At maturity, investors receive the original par value of the bond or the inflation-adjusted par valuewhichever is higher. The interest that TIPS pay is based on the inflation-adjusted par value, which means youre likely to receive higher interest payments if inflation rises. TIPS are generally subject to federal income tax but are free from state and local taxes.

High-Yield (Junk) Bonds

High-yield bonds, or junk bonds, are corporate bonds that have a high risk of default and therefore pay high annual coupon rates, often in excess of 10%. Junk bonds are very risky and should be approached with great caution.

Should You Buy Individual Bonds?

Like stocks, bonds can be purchased either individually or as part of bond mutual funds or ETFs. Though bonds are an important part of virtually any investment portfolio, buying individual bonds takes a considerable time and effort and is usually best left to professionals. If you do want to try buying individual

bonds, its best to stick to Treasuries only. For most investors, though, the safest, cheapest, and easiest way to buy bonds is through bond mutual funds and ETFs.

How to Invest in Mutual Funds

A mutual fund is a type of investment that pools money from a group of investors and then invests that money in a specific set of investments, such as stocks or bonds. Mutual fund companies, such as Vanguard, Fidelity, and T. Rowe Price, create mutual funds and employ professional fund managers to oversee and adjust each mutual funds holdings as market conditions change. When you buy a mutual fund, you buy shares, each of which represents a fraction of the investments owned by the mutual fund. For instance, if a fund owns 50 stocks, and you own several dozen shares of the mutual fund, you own a fractional share of each of those 50 stocks. When the overall value of the funds holdings increases or decreases, so does the value of your shares.

How to Buy and Sell Mutual Funds

On the stock markets, shares of stocks change hands constantly throughout the standard trading day. Buying and selling mutual funds works differently: though you can place orders to buy and sell funds through brokers or brokerages at any time during the trading day, your orders are not filled until trading ends at 4:00 p.m. each day. This delay occurs because each mutual fund must tally up the value of its underlying securitiesthe net asset value (NAV)at the end of each day to determine the funds new share price. Mutual Fund Expense Ratios Running a mutual fund costs money. Expenses include everything from fund manager salaries to office supplies to transaction costs for buying and selling securities. A funds expense ratio is an annual fee, expressed as a percentage, thats charged to shareholders to cover the funds overall operating expenses. Many investors make the mistake of disregarding expense ratios because they seem so smallusually 0.152.00% or so. This mistake can cost thousands of dollars over time.

How Expense Ratios Impact Fund Returns

Consider the impact of expense ratios on $10,000 invested for 20 years in the two funds below:

Fund A Expense ratio Annual rate of return Value after 20 years Expenses paid 0.18% 10% $65,107.17 $1,010.11

Fund B 1.50% 10% $51,120.46 $7,256.55

Though the ratios differ by only 1.32%, over 20 years that difference adds up to $6,246.44 in additional fees.

Active Funds vs. Passive (Index) Funds

All mutual funds break down into one of two types: actively managed funds and passively managed funds.

Actively managed funds: Managers of actively managed funds use their expertise and

research to hand-pick the funds investments on an ongoing, active basis in order to maximize returns.

Passively managed funds: Passively managed funds, or index funds, attempt to

mimic the performance of a particular market index, a group of investments that serves as a benchmark for the performance of other investments. For instance, an index fund that mirrors the S&P 500 index will hold most of the stocks included in the S&P 500 index in the same proportion in which they compose the actual index. Actively managed funds tend to have higher expense ratios than index funds: the average expense ratio for an actively managed fund is 1.50%, while most index funds have expense ratios below 0.25%.

Why Most Actively Managed Funds Arent Worth It

A number of studies have shown that during periods of at least five years, only 33% of actively managed funds that invest in securities like those in the S&P 500 actually beat the performance of the S&P 500 index. This makes index funds the best bet for most individual mutual fund investors.

Load Funds vs. No-Load Funds

Loads are fees that mutual funds charge investors in addition to standard mutual fund fees, such as expense ratios. Load funds charge these fees, whereas no-load funds dont. Though you might think that load funds could get away with charging additional fees only if they outperformed no-load funds, in fact studies have shown that most load funds both underperform no-load funds and cost more in fees along the way. With thousands of inexpensive no-load funds available, theres just no good reason to buy load funds.

The Main Types of Mutual Funds

The three major categories of mutual funds are stock funds, bond funds, and money market funds. Additionally, balanced funds include both stocks and bonds in one fund, while REIT funds invest in real estate companies.

Stock Funds
Stock funds, or equity funds, invest in the stocks of publicly traded companies. These funds are further classified by market capitalization (market cap), investment style, sector, and geographic location. Some funds combine several classifications within one fund.

Market cap: Stock funds often focus on buying companies whose market caps all fall

within one of the five market cap ranges (micro-, small-, mid-, large-, and mega-cap). In general, the smaller the market cap, the greater the risk and potential reward.

Investment style: The term style in the context of stock mutual funds refers to

whether the fund invests in growth or value stocks. Blend funds invest in a mix of growth and value stocks.

Bond Funds

Sector: Sector funds invest solely in companies that do business in a particular industry,

such as energy, healthcare, or technology. Geographic location: Some stock funds invest only in businesses based in particular

regions, such as Latin America, Europe, or even specific countries.

Bond funds own baskets of corporate or government bonds. If you buy a bond fund, you get the predictable performance and returns of the underlying bonds that the fund owns, but without the hassle of buying individual bonds. What you dont get, though, is a guaranteed return of your principal. Bond funds break down into a variety of subcategories based on term, issuer, tax status, and region.

Term: Some bond funds buy only short-term, intermediate-term, or long-term bonds. Issuer: Some bond funds buy government bonds, municipal bonds, or corporate bonds.

Tax status: Taxable bond funds hold bonds that require owners to pay taxes on interest

income; tax-exempt funds hold bonds that pay tax-free interest. Taxable bond funds, however, pay higher interest rates than tax-exempt bond funds.

Region: Region bond funds, or foreign bond funds, buy bonds issued by governments

or corporations in specific regions or countries other than the U.S. Investors tend to favor foreign bond funds that focus on regions (or countries) with stable political and economic climates, such as Europe and Japan. Fund companies often offer bond funds that combine two or more of these classifications. For instance, a long-term government bond fund would own bonds issued by federal or state governments with terms of 10 years or more.

Money Market Funds

Money market funds invest in short-term debt instruments that pay interest. Fund companies often recommend these funds to clients as an alternative to savings accounts, since money market funds:

Are nearly as risk-free as savings accounts Offer higher interest rates than savings accounts

Though money market funds are very safe, theyre not a great place to keep money long-term if you intend to grow your principal.

Balanced Funds
Balanced funds invest in a mix of stocks and bonds. Buying such a fund can be a simple, convenient way to build a balanced investment portfolio with just one holding.

REIT Funds
REITs (real estate investment trusts) are corporations that develop and/or manage real estate properties. REIT funds are mutual funds that invest exclusively in the stocks of these corporations. Investors buy REITs as a way of including real estate in their investment portfolios without actually having to own real estate property.

Should You Invest in Mutual Funds?

All investors face the question of whether to buy individual investments, such as stocks and bonds, or to buy mutual funds. There are three major reasons why investing in mutual funds is a better choice for many investors.

Increased diversification and reduced risk: Mutual funds allow you to build a

thoroughly diverse investment portfolio and reduce the risk by owning just a few different types of funds.

Cost: Whereas you pay commissions and other transaction costs every time you buy or

sell individual stocks and bonds, you can buy most mutual funds without incurring any transaction costs at all.

Convenience: To build a portfolio of individual stocks and bonds as diverse as you can

create through mutual funds, youd need to spend hours researching and monitoring your holdings on a weekly basis.

Mutual Funds vs. ETFs

Once youve decided to buy mutual funds rather than individual stocks or bonds, theres another key question you need to ask before you buy a mutual fundshould you buy a comparable ETF instead? (For help answering that question and for more on ETFs, see How to Invest in ETFs.)

How to Decide Which Mutual Funds to Buy

The two most important factors to consider before you buy a mutual fund are fees and returns. Only one statistic among the dozens of figures that mutual fund companies publish annually will tell you what you need to know about a funds fees and performance: total return after taxes and expenses. This statistic shows the return that fundholders have made on their investment after all taxes and expenses are taken into account. When researching a funds total return after taxes and expenses, be sure to heed these two guidelines as well:

Avoid hot funds: Consider the funds total return after taxes and expenses over the

past 510 years, not just the past year or so. And remember that past performance is no guarantee of future results.

Look for low expense ratios: Never buy an index fund with an expense ratio above

0.50% or an actively managed fund with an expense ratio above 1.50%.

How to Invest in ETFs

ETFs (exchange-traded funds) are index funds that trade like stocksthey offer the broad diversification of mutual funds with the instant liquidity of stocks.

Types of ETFs Available

The few hundred available ETFs dont yet rival the selection offered by the thousands of mutual funds on the market. Even so, an equivalent ETF exists for virtually every type of index fund, including ETFs that track indexes of stocks, bonds, real estate, commodities, specific sectors and industries, and so on.

How to Buy and Sell ETFs

ETFs are offered by traditional mutual fund companies and by financial firms that specialize in ETFs, such as iShares (www.ishares.com), PowerShares (www.powershares.com), and Rydex (www.rydexfunds.com). Like individual stocks, ETFs each have a ticker symbol and can be bought and sold through a broker or brokerage house at any time throughout the trading day.

Why Buy ETFs Instead of Mutual Funds?

There are three reasons to consider ETFs instead of funds:

Low expenses: ETFs typically have low expense ratios, many of which are even lower

than those of comparable index mutual funds. Trading flexibility: ETFs can be bought and sold throughout the trading day, unlike

mutual funds. Innovative indexes: ETF companies can create and track indexes not offered by

mutual funds. For instance, the PowerShares Value Line Industry Rotation ETF contains an index of stocks that adjusts quarterly based on whichever stock sector is most in favor.

Why Buy Mutual Funds Instead of ETFs?

Despite the many advantages of ETFs, there are a few reasons why mutual funds might still be your best choice.

Transaction costs: As with stocks, youll have to pay a commission each time you buy

or sell an ETF. If youd like to buy your investments gradually, in stages, without paying commissions each time, no-load mutual funds are a better choice than ETFs because you wont have to pay any transaction fees.

Selection: If youre looking for a particular type of investment for which no ETF exists,

your only choice might be a mutual fund.

Investing and Taxes

Nearly all investments are subject to local, state, and federal taxes. To invest profitably, you must understand how taxes impact your gains and losses.

Capital Gains
A capital gain occurs when you sell an investment for more than your cost basisthe total you paid to acquire the investment. For example, if you buy stock that costs $5,000 after commissions, then sell those shares later for $6,500, your capital gain is $1,500. That gain is subject to capital gains tax, which, as of 2007, can range from 1535%.

Long-Term vs. Short-Term Capital Gains

The capital gains tax rate you pay depends on how long you held (owned) the investment before selling it.

Investments held for a year or more are considered long-term capital gains and are

subject to a capital gains tax of 15% (as of 2007) for most investors. Lower-income investors may pay as little as 5%.

Investments held for less than a year are considered short-term capital gains and

are subject to ordinary income tax rates, which can reach 35%. Because long-term capital gains are usually subject to much lower tax rates than short-term gains, it almost always pays to hold on to investments for longer than one year.

Capital Losses
If you sell a stock for less than its cost basis, you incur a capital loss. Keep track of your losses: you can use them to offset your capital gains tax for a given year. For example:

If you buy a stock for $12,000 and sell it later for $10,000, your capital loss is $2,000. If you incur that loss the same year in which you sold another stock for a $2,000 capital

gain, the gain and loss would cancel each other outyou would not be required to pay any capital gains tax.

If your capital loss was larger than your gain, youd also be able to carry forward that

loss to offset gains you might incur in future years. Offsetting strategies can be complex, so consult a tax advisor before selling any investment for a significant gain or loss.