5 Things Every Investor Should Know

What we’ll cover:

• Stocks, bonds, ETFs and mutual funds are the basic building blocks of many investment portfolios
• Investing involves risk, and it’s important to focus on the long term
• Diversification can help manage investment risk
• How you choose to invest depends on your goals, time horizon and risk tolerance
• Investment accounts are subject to tax rules 

If you have a 401(k), IRA or brokerage account, you’re probably no stranger to the world of investing. Perhaps, you’ve even had the chance to branch out and invest in the finer things in life such as art, collectible cars and wine. (Fancy!) Whatever the assets, investing can give you potential opportunities to grow your wealth and build the financial future you’ve envisioned for yourself. 

Whether you’re a novice or an old hand, there are some investing fundamentals that everyone should know. Some of the things we’ll go over might sound rudimentary, but these important (and timeless) basics can help you make informed decisions about your money and build your confidence as an investor.

1. Stocks, bonds, ETFs and mutual funds are the basic building blocks of many investment portfolios

The number of investment choices out there can be overwhelming, especially if you’re still somewhat new to investing. Many people choose to invest through professionally managed funds or portfolios, which usually means they don’t have to handpick individual securities on their own. (A real time saver.) 

Because stocks, bonds, mutual funds and ETFs are the basic building blocks of many investment portfolios, let’s do a quick review of the differences between these types of assets:

• Stocks. When you purchase a stock, you own a piece or a “share” of a company. Stocks are also sometimes referred to as “equities.” When the company makes a profit, they typically distribute dividends to their stockholders. Dividend payments may come in the form of cash or additional shares.
• Bonds. A bond is a loan from an investor to an organization or entity (like a corporation or the government) that’s looking to raise money to help pay for certain projects – think of it as an IOU. Bonds are a type of “fixed income” investment because they typically provide a predictable rate of income in the form of interest payments.
• Exchange-Traded Funds (ETFs). An ETF is a type of financial product that’s made up of a large collection of stocks, bonds or other types of securities. For example, an ETF can contain a variety of bonds (bond ETF), stocks (stock ETF) or a mix of both (multi-assets ETFs). 
• Money Market Mutual Funds. A mutual fund is where investors pool their money together to invest in a portfolio of securities. A money market mutual fund typically invests in high-quality (translation: low risk of default) debt instruments, such as certificates of deposit (CDs) and U.S. Treasury notes with short maturity dates. 

2. Investing involves risk, and it’s important to focus on the long term

Some people might hold back from investing more of their money in the financial markets because it’s generally riskier than keeping your money in deposit accounts like savings accounts or CDs. And let’s be honest, none of us like losing money to a bad investment or a volatile market.

With savings accounts, you can earn interest on your deposits; institutions typically compound interest daily, monthly or annually. And if you have an account in a FDIC member bank, your money is federally insured up to a certain amount. The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.

You’re probably thinking: Why would anyone want to put money (or more money) into something when you could potentially lose it? That’s a fair question. 

Think of it this way: While there’s potential for losses with investments, there’s also the possibility that you’ll see some nice gains. And a large part of investing is about figuring out how to properly balance risk and reward and which risk management strategies make the most sense for you. 

Sure, watching financial markets go up and down can be nerve-wracking, but keep in mind that periods of market turmoil are normal and expected. That’s why it’s important to take the long view with investing and not let short-term market volatility distract you from your long-term money goals (like retirement, wealth building, etc.). 

Generally speaking, staying invested for the long haul puts you in a good position to reach your goals.

3. Diversification can help manage investment risks

When it comes to deciding where to invest our hard-earned money, we would all love to have a “sure thing.” But as we mentioned earlier, investing involves risk, so a key to success is learning how to manage that risk in a smart way. 

One common risk management strategy that you’re probably familiar with is diversification. This is where you divvy up your money across different types of investments or assets, in order to help spread out your investment risks. You may know the saying: Don’t put all your eggs in one basket – that’s the basic idea behind diversification.

While it might sound like a basic strategy, it’s a powerful one. By investing in a mix of assets, like bonds, stocks and ETFs, your portfolio is less likely to be completely wiped out if some assets are impacted by market volatility. If a certain class of assets isn’t doing well, other assets in your portfolio might be able to help cushion the blow.

In other words, diversification can help limit your exposure to the risks of any one particular type of investment. Think about it this way – if you only invest in the stocks of one company, you risk losing your entire investment if the company goes under. 

An important note here: While diversification can help minimize risk, it can’t eliminate all risks. Just as diversification doesn’t guarantee gains, it also doesn’t completely shield you from losses. There’s no such thing as a perfectly safe investment, and if anyone tries to tell you otherwise, be wary. 

Learn more: What Does Diversification Mean Anyway?

4. How you choose to invest depends on your time horizon and risk tolerance 

Time horizon may sound like a concept straight out of a sci-fi novel, but it simply refers to the amount of time you’re planning on staying invested. And how long you plan on holding on to your investments typically depends on your age, investment strategies and financial goals.

People who won’t need to tap into their investments for a while – for instance, those who are a long way from retirement – would generally have a longer time horizon than, say, people who are investing money for a home down payment that’s five years down the road. 

If you already have a time horizon in mind, another question to consider is how much risk are you willing to take on in your investments? That is, what’s your risk tolerance? 

Risk tolerance varies from person to person, so it’s important to understand your personal level of comfort when it comes to investing your money.

Both your time horizon and risk tolerance could help determine the appropriate mix of investments in your portfolio – or how you divvy up your money among stocks, bonds and other securities.

For instance, near-retirees are likely more risk-averse than someone who is still decades away from retirement. This is because near-retirees may need to start withdrawing from their retirement account soon, so their investment portfolio might hold more low-risk or stable assets such as bonds.

On the other hand, an investor who is farther out from retirement and has a higher tolerance for risk may choose to hold more stocks than bonds in their portfolio. The rationale is that investors with a longer time horizon have time to weather the stock market’s fluctuations in hopes of earning higher returns over the long term.

Now this isn’t to say bonds are better than stocks or vice versa – both of them could play a role in your portfolio. How you split your money between bonds and stocks (or among other types of assets) will depend on your personal financial goals as well as the factors we mentioned above, like risk tolerance and time horizon.

5. Investment income may be taxable

Taxes – they’re not the most exciting topic, we know. But we’re bringing them up because they are an important aspect of investing. Each year your investment firm or account provider will send you any relevant tax information about your holdings.

Keep in mind that investment taxes can be complex. There are different tax rules for different types of investment income (see IRS Publication 550). Don’t hesitate to ask for help from a tax professional to understand which specific rules may apply to you.

Learn More: Investing and Taxes: Some Basics to Know

The bottom line

Investing offers opportunities for you to put your money to work. Whether you’ve been investing for long or a relatively newcomer, it’s important to know your goals and ask yourself a few key questions like what are you investing your money for? How long do you want to stay invested? How much risk are you willing to undertake? 

Your answers could help you choose an investment plan that’s best aligned with your financial goals. And if you have questions or concerns, enlist the help of a professional investment advisor. They could go over what we’ve covered today in more detail and help you to invest confidently for your future.