Investment Basics

investment-basics

Most American investors lack basic financial literacy, according to a report from the Securities and Exchange Commission. Many investors don’t understand elementary financial concepts, such as compound interest, inflation and the difference between stocks and bonds. Some don’t understand important financial concepts such as diversification, and investment costs and their impact on investment returns.

In order to be a successful investor, you don’t have to be an expert, but you should at least understand investment basics. The purpose of this site isn’t to teach those basic concepts. It assumes you know them. If you don’t, I recommend you check out www.investopedia.com, take a college course, or pick up one of the many books on investing.

This quiz will test your knowledge of the key concepts covered here.

What Determines Your Investment Returns?

Your overall returns will be affected by a number of factors:

The risk-reward tradeoff of your assets.

A key principle of investing is that assets with higher returns tend to have higher risk and vice versa. Stocks are riskier than bank money market funds but have much higher returns over the long run.

The performance of each of your individual asset types.

When you assemble a diversified portfolio of assets, the sum total of your portfolio performance will be determined by how each individual asset performs.

Your allocation to different asset-class types.

For example, if you allocate most of your portfolio to stocks,  over the long run your returns will likely be higher than if you put most of your money in less risky assets like CDs or money market funds.

Your time horizon and trading activity.

The longer you hold a given asset, the less the likelihood of loss. If you trade in and out of various investments, you run the risk of buying high and selling low.

Costs you incur to buy and hold the assets.

Savvy investors know that low-cost mutual funds outperform high-cost funds over time. The biggest determinant of superior mutual fund returns over the long run isn’t past performance, it’s fund expenses.

Taxes.

Lots of trading in and out means the potential for capital gains and losses. Taxes can eat up a significant chunk of your net returns, depending on how tax efficient your investments are and your tax bracket. It’s important to optimize your investments for tax efficiency.

How well you stick to your plan.

I’ve learned the hard way that too much activity, i.e. changing plans, changing investment holdings, and buying and selling, reduces returns. As you will learn on this site, the average investor is too active. Less is more. Create a good plan and stick to it!

What are Major Asset Classes?

Before you decide where to invest your money, you need to understand the basic asset classes that are available to you. Most investors think of just stocks and bonds. There is much more to it:

Major Asset Classes

I’ve identified six major asset classes. There is no universal categorization of asset classes. You will find others. Why would you want to use all or any of these? The fundamental reason is that by diversifying across asset classes, you can increase your returns while lowering your risk of loss. More on this later. 

If you aren’t already familiar with each of these asset classes, I recommend you learn the basics. Investopedia or a simple web search will get you there.

Each of these asset classes may be broken down into sub-asset class types with different characteristics, risk and return:

Sub-Asset Classes

Each asset class and sub-asset class has different benefits, as depicted below.

Alternative Assets

The majority of investors focus on three asset classes – stocks, bonds and cash. “Alternative Assets” are defined by most experts as assets other than these. The potential benefit is to provide greater portfolio diversification with higher risk-adjusted returns. Advanced investors most commonly own alternative assets such as commodities, hedge funds, private equity, and currencies. Here is a good place to learn more about alternative asset classes.

It isn’t necessary to invest in alternative assets to do well with your investments. In fact, there is considerable debate among investment pros about the value of these investments, as you can see later on this site.

The excellent book “Alternative Investments,” by Larry Swedroe includes the following, along with his opinions on their relative merit. I provide my own opinion under Selecting Your Assets.

Alternative Assets

Go to the Next Article: Investment Returns

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