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Even a small nest egg should be divided among several investment options.
It is never too late to start saving money! In today's competitive investing environment there are many options open to you, the investor. With all of these options, which is right for you? The answer is all of them. Anyone who is looking to maximize his or her investment portfolio should have different types of investments.
Several years ago a study was done about the performance of investment portfolios, concluding that only four elements contribute to investment results: choice of individual security, market timing, cost, and asset allocation. The most important of these was asset allocation, because 95% of the investment results were attributed to how money was divided among types of investment (stocks, bonds, or cash). Asset allocation, or diversification, means dividing your assets among several investments to minimize your risk and maximize your return.
The simplest and safest way to save your money is in a savings account. Although a savings account has a relatively low rate of return when compared to other forms investments, it is insured by the federal government for up to $100,000. This guarantees your money to be safe in the event of bank failure, fire, flood, or any other event. Another advantage of a savings account is that the funds within it are relatively liquid, or easily converted to cash. To compare savings account rates of various banks in the United States, visit the Bankrate.com Compare Money Market and Savings Account Rates web page.
Another way to make your money grow in a relatively safe environment is through the use of certificates of deposit, or CDs. These are purchased for as little as $500, but generally cost $1,000, $5,000, or $10,000. A CD generally returns a fixed rate of interest over a specific amount of time. These are interest-bearing, Federal Deposit Insurance Corporation (FDIC) insured debt instruments and are good short- to medium-term investments. For advice on selecting a CD, see the U.S. Securities and Exchange Commission (SEC) article Certificates of Deposit: Tips for Investors.
A U.S. Savings Bond is a registered, non-transferable bond issued and backed by the U.S. government. Savings bonds have values ranging from $50 to $10,000, with a maximum purchase of $30,000 in one calendar year. A savings bond purchased after May 2005 has a fixed rate of interest, which is announced twice a year in May and October. There are three types of savings bond: the Series EE, the Series HH, and the I Bond.
Series EE Savings Bond – Available at most banks and through payroll deduction, the Series EE bonds are purchased at 50% of their face value, which is the amount the bond is worth when it matures. These types of bonds are exempt from state and local taxes, meaning you don't pay any taxes on the earnings received from this type of investment. A Series EE bond's value is guaranteed to at least double (i.e., be redeemable at its face value) at its maturity date of 20 years. If after 20 years of earning interest at the fixed rate, the bond does not double in value, the U.S. Treasury will make a one-time adjustment at original maturity to make up the difference. A Series EE bond can be held after the original maturity and earn interest for up to 30 years, with the earnings payable upon redemption. This type of bond can be redeemed no earlier than 12 months after its issue date. If it is redeemed before five years have passed, the holder will not receive the interest for the three months prior to redemption.
Series HH Savings Bond – The Series HH savings bonds, which were issued in denominations from $500 to $10,000, were discontinued in August 2004. Series HH bonds mature in 10 years, with the interest paid twice a year via check or an electronic funds transfer to the bondholder's bank account. Like other savings bonds, the interest earned on a Series HH bond is exempt from state and local taxes.
I Savings Bond – These bonds are similar to Series EE bonds. They range in value from $50 to $10,000 and can be redeemed after 12 months, with a 30-year maturity. However, unlike the Series EE bonds, I bonds are issued at 100% face value and their return is adjusted for inflation. The I bond earnings rate is a combination of a fixed rate and an inflation rate that is based on the Consumer Price Index (CPI). The interest rates are announced every six months, on May 1 and October 1.
The final type of savings investment is U.S. Treasury Securities. There are four types: Treasury Bills (T-Bills), Treasury Bonds (T-Bonds), Treasury Notes (T-Notes), Treasury Inflation-Protected Securities (TIPS) and Separate Trading of Registered Interest and Principal Securities (STRIPS).
T-Bill – A negotiable debt obligation issued by the U.S. government and backed by its full faith and credit, having a maturity of one year or less. T-Bills are exempt from state and local taxes. T-Bills are auctioned at a discount from face value, in increments of $1,000, up to $5 million, or 35% of the total value of the lot in the auction offering. One can either buy a T-Bill at a fixed interest rate set at the auction (noncompetitive bidding) or specify the desired rate (competitive bidding). Competitive bidders will not receive an interest rate greater than the rate determined at the auction.
T-Bond – New T-Bonds are sold twice a year at auctions, and bond reissues are auctioned twice a year, making a total of four T-Bond auctions per year. They are available in increments of $1,000, up to $5 million, or 35% of the total value of the lot in the offering.. They carry the same guarantees as a T-Bill, but with a longer maturity of 30 years. Interest on T-Bonds is paid twice a year. Competitive bids must go through a bank or broker; you can place a noncompetitive bid directly with the Treasury.
T-Note – A T-Note is similar to a T-Bond with an earlier maturity (between two and ten years).
TIPS – These are securities that are adjusted for inflation, using the Consumer Price Index. The TIPS principal increases if there is inflation, and decreases if there is deflation. TIPS pay interest every six months. They have maturity dates of 5, 10, or 20 years and are sold in increments of $1,000. At maturity, TIPS are redeemed either at their face value or their inflation-adjusted principal, whichever is greater.
STRIPS – These are Treasury securities that have the interest (paid every six months) stripped from the principal value of the bond or note. The two new securities (principal only and interest only) are then sold to investors. The principal only STRIP is also known as a zero coupon bond. These are sold at a discount to their face value. You cannot buy STRIPS directly from the Treasury Department; you must get them from a broker.
See the Frequently Asked Questions about Treasury Bills, Notes, Bonds, and TIPS at the Bureau of the Public Debt website.
All of the investment options listed above are quite safe, offering relatively low returns on the initial investment. If you wish for higher returns, you have to take greater risk when investing your money. The following are types of investments that are riskier, but also have the possibility of gaining much higher earnings.
A stock investment may provide the best long-term rate of return, but has a tendency to fluctuate over short and medium time periods. By purchasing shares of a common stock, you are becoming a part owner of the company. If the company does well over time, the value of the stock should go up. About 80% of large companies distribute a portion of their profits to shareholders in the form of dividends, a taxable payment declared by a company's board of directors and given to its shareholders out of the company's current or retained earnings. A dividend is usually given as cash, but it can also take the form of stock or other property. The advantage of stock investments is that, over the long run, the market will continue to grow. It is absurd to think that, over time, the world's economy will shrink. If you are willing to keep your money invested in a stock regardless of the market cycles, you will find that stocks tend to pay the highest rewards. Any assets you won't need for 10 or more years should be invested into stocks.
For an investment that is under 10 years in length, you should consider a lower risk asset like a bond. The rate of return for a bond is about half that of stocks, so over the long run bonds will become an opportunity cost to you, the investor. When you purchase a bond, you loan money to a company or a governmental unit. In exchange for the loan to the company, the borrower, or bond issuer, promises to repay the initial investment with interest. The price of a bond will fluctuate as the interest rates fluctuate. When investing in municipal bonds, which are used to finance capital projects for the public good, investors will receive a lower rate of return in exchange for having income exempt from federal income tax. A "Junk Bond" is a type of speculative high-risk, high-interest rate bond; the default rate is much higher on these types of bonds. The amount of bonds that you should hold should be directly related to the amount of income you will need over the short run.
Perhaps the safest type of higher-risk investment is the mutual fund. A mutual fund is an investment corporation that pools together investor's money to purchase stocks and bonds. The advantage offered by this type of investment is that it is diverse and not dependent on the performance of a single stock or bond. Over the years, mutual funds have been an attractive investment offering not only convenience and diversity, but also a record of performance to the individual investor. When you choose a mutual fund, you should consider your tolerance for risk, need for returns, and the timeframe in which you intend to invest. As with all investment options, there are many different types of mutual funds that you, the investor, may choose:
No-Load Funds – This is a type of fund that is sold without a fee. These are generally sold directly from the fund rather than through an intermediary, who would add a fee for the services rendered.
Large Cap Funds – These are comprised of companies that have a large capitalization, or sum of a corporation's long-term debt, stock, and retained earnings. These funds include the "blue chip" stocks, and their performance has averaged 10 to 11% return each year for a half century.
Small Cap Funds – Composed of companies having small capitalization. These funds tend to include start-up companies whose stock prices have done well in recent years. If you were looking for tomorrow's Microsoft, these funds would be the place to look.
Utilities Funds – Investments made in America's utility companies. Traditionally, these have been the steadiest and most conservative investments. In recent years, with the strong performance of telecommunications stocks and the gradual deregulation of many utility investments, a higher risk has been taken on utilities, which, in turn, can mean more reward.
Money Market Funds – An open mutual fund, which invests only in money markets. A money fund only invests in highly liquid, short-term debt securities, such as commercial paper, negotiable certificates of deposit, and Treasury Bills. These investments carry a maturity of one year or less, and often are 30 days or less. These tend to be safe, highly liquid investments. In recent years, money market mutual funds have gained popularity as an alternate savings vehicle.
Market Neutral Funds – An investment vehicle for the investor who wants to grow capital at a reasonable rate with reduced exposure to market fluctuations. The manager of a market neutral fund tries to provide a consistent return (hopefully exceeding T-bill rates by at least 3 percent) regardless of the performance of the stock market overall. There are many methods to do this, including hedging — combining long (buying stock in anticipation that its price will rise) and short (selling stock with the expectation of buying it back at a lower price) positions. For more information, see the PathToInvesting.org article Market Neutral Funds and the MarketWatch.com article Market-neutral Funds Mirror Hedge-like Strategies.
For more information about mutual funds, see the SEC article Invest Wisely: An Introduction to Mutual Funds.
The single biggest investment for the average investor, real estate, is quite often overlooked. Just like any other investment, a home can either appreciate or depreciate in value. Real estate investment is not limited to home ownership, though. One can purchase a publicly traded Real Estate Investment Trust, REIT, which is similar to a mutual fund in operation except that it invests in real estate. REIT investing tends to be a complicated investment option. Before you consider this as investment vehicle, you may want to do some research. For more information about REITs, visit the website of the National Association of Real Estate Investment Trusts.
There are other types of investments available to you, but most often these tend to be high-risk. One of these is Futures Contracts, which are commitments to buy or sell a specific amount of a commodity at a specific future date and price. These are very speculative investments and should only be used by those with the financial means to take such a high risk. If you choose to practice this type of investment, the allocation should never be more than a small part of your portfolio. Another of these high-risk investments is through the purchase and sale of fine art and collectibles (for example, coins, stamps, antiques, or sports memorabilia). This is a type of investment that can be a hobby, as oftentimes there is great satisfaction in building a collection. The problem with owning fine art and collectibles as an investment is that they pay no interest or dividends. The return on your investment is dependent on an increase in value over a long period of time. The rewards and losses both have the potential for being great.
The key objective of asset allocation is to produce liberal returns over time while taking the very minimum possible risk to generate them. As you decide where to invest your money, you must consider the following factors — yield, risk, and liquidity. It is now time to decide which markets to enter and which to avoid. After this is done, you must then decide what portion of your assets to put in each class, cash or cash equivalents, stocks, bonds, and real restate, in order to reach your goals. How you allocate your assets among these classes is a critical investment decision, as 95% of your portfolio's performance is attributed to asset allocation.
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