The Fundamentals of Investement Basics

You hear of many different types of investments, from mutual funds to unit trusts. But they are all derived from three basic asset categories:

• Cash
  The great advantage of cash and cash equivalents is that funds are readily accessible, or liquid. Cash equivalents also maintain a high degree of liquidity, but allow you the potential to earn interest, returns and/or dividends. Certificates of deposit (CDs) and Treasury bills are two of the most common and widely used cash equivalents.
• Bonds
  Bonds, meanwhile, are debt instruments issued by a company or government to finance a certain aspect of its operation. When you invest in bonds, you are essentially lending money to the bond issuer, entitling you to receive interest on that loan, and a repayment of principal when the bond matures. Bonds come in a number of incarnations, including U.S. Treasury bonds, municipal bonds and corporate bonds.
• Stocks
  Stocks round out the basic asset classes. Shares of stock represent ownership in a corporation. Stocks fall under many categories, depending on the size of the company, its prospects, and the state of the markets. These categories include growth stocks, value stocks (based on potential for growth), and large-, mid-, and small-capitalization stocks (related to the size of the company).

Making the Investment Decision

Your main considerations as an investor, besides choosing which vehicles are right for you, lie in the areas of risk management, taxes and inflation, and asset allocation.

Risk

Risk is the possibility that you may lose some or all of your investment in real terms, or that your investment may not increase in value. Several factors may influence the amount of risk you can comfortably accept, including your age, family situation, income, time horizon and financial goals.

Before investing, it is important to determine your risk tolerance:

• Are you willing to tolerate greater volatility for potentially higher returns, or
• Do you place more emphasis on quality, with less risk?

Inflation

Inflation and taxes are two factors always on the minds of investors. Inflation is the persistent increase in the cost of goods and services, and the reason why the same loaf of bread that costs you $1.00 today will probably cost you $1.05 next year. For your purchasing power to grow in “real” terms, your returns must outpace the inflation rate.

Taxes

Additionally, taxes must be a consideration. There are investments available that are both taxable and tax-free; others are tax-deferred or tax-deductible. The differences are significant, but not as dizzying as they seem.

Asset Allocation

Asset allocation refers to the diversification of your portfolio across all the different classes of assets. The goal of effective asset allocation is to develop an appropriate mix of investments based on your specific investment objectives that maximizes performance potential with an acceptable level of investment risk. The goal is more consistent returns, lower volatility and a greater chance of achieving financial objectives.