Accounting for dummies: The basics of investing

Posted on Nov 5 2013 - 9:16pm by Bjorn Slater, Business and Ads Manager

By Bjorn Slater, Business Editor

Many people think that retirement planning means sticking a portion of their monthly paycheck into a retirement savings account, but what a lot of people don’t realize is that there are safe ways to plan for retirement by investing in the stock market.

According to http://money.cnn.com, stocks have outperformed any other traditional asset class and provided the highest returns in the long run, close to 10 percent, which is two to four percent higher than the annual return on an average retirement savings account. Bonds are the next highest, followed by Treasury Department at about five percent. This excludes more complex asset classes such as derivatives, swaps, exchange-traded funds (ETF) and futures which require a little more in-depth study to use as investing tools.

Retirement can come a lot sooner if retirement savings and stock market investments are combined, maximizing your annual return. A lot of people get blinded by fear when it comes to the stock market — it’s easy to think their money is safest behind a big vault door in a bank rather than pumped into some company that could go bankrupt if the market tanks.

However, banks can go bankrupt just as easily as companies, as witnessed during the financial crisis of 2008 with Washington Mutual Bank. Its assets were valued at over $300 billion at the time and it was still necessary for JPMorgan Chase Bank to acquire the bank and cover nearly $31 billion in losses when it went under, according to http://www.britannica.com.

That’s not to say investing in the stock market is safer, there is still the risk that a company will go under, but one of the key ideas of finance is the higher the risk, the higher the reward. There are a lot of things to consider before choosing a stock, bond or Treasury note to invest in, so here are a few things to keep in mind:

1. Get to know a company before buying stock

Researching companies before investing is easy to do and may help people get an understanding of what they might get for their money. Google Finance and Yahoo Finance are both great tools for researching stocks because they have historical data, company profiles, competitors, industry analysis, analyst opinions and more.

Reading about a company’s past is a great way to get an indication of future performance, and although reading through pages of historical data from a company isn’t fun for everyone, the time investment will pay off in the long run.

2. Diversify

Risk isn’t a bad thing, as mentioned earlier the higher the risk the higher the potential for reward. That being said, being exposed to unnecessary risk may damage finances in the future. Unnecessary risk can be avoided by diversifying our investment portfolio. The number varies, but the general opinion in finance is a portfolio needs to have a minimum of 20 different stocks from different industries for it to be considered “well-diversified.”

By investing in multiple companies the returns average out and so does the risk, so investing in one risky company can be offset by investing in a trustworthy, or “value” stock such as Coca-Cola that produces consistent returns each year. Then if the risky company takes off the portfolio return is greatly increased, and if it starts producing negative returns they are at least partially offset by the consistent performance of the value stock.

3. Invest early and often

It might seem easiest to just throw a lump sum into a portfolio and leave it there to grow, but in order to earn the best return possible people should consider putting any cash that can be spared after contributing to their retirement savings account into stocks in their portfolio. By adding money to investments on a regular basis investors can take advantage of well-performing stocks by buying more and more shares whenever possible.

Dividends can be a great way to keep up on investments. Most stable companies, I used Coca-Cola as an example earlier, send out a portion of their earnings to investors, usually on a quarterly basis, to make up for the lack of growth. Sometimes it could be a penny per share, other times it’s more, but investors who set aside dividends for reinvestment have a guaranteed lump of cash to invest every three months.

4. Don’t forget about bonds and Treasury notes

Bonds and Treasury notes have had historically lower returns than stocks, but using the old the higher the risk the higher the reward adage we can deduce that bonds and Treasury bills are less risky. This makes them a valuable addition to any portfolio since purchasing long-term bonds may produce similar returns to those of a value stock.

Bonds are essentially a loan that investors make to a company. Investors are paid interest on the loan during the bond’s life, then at its maturity date they receive the full amount of the loan back. The return on a bond is essentially the interest rate that the company pays people who invest in bonds. When a company goes bankrupt, it first has to pay off as much of its outstanding loans as it can which includes repaying investors who purchased bonds, making them much safer than investing in stock.

Treasury notes and Treasury bills are special in that they can be purchased directly from the government, as well as from institutional banks, and they are considered zero risk investments. They are a form of bond, so basically a loan to the government, but the risk of default is zero because if the government doesn’t have enough money to pay back the loan they can simply print more.

These are just some very basic tips to keep in mind when investing, and in no way guarantee success. They are intended to help reduce risk and inform people about what kinds of options a new investor could consider. Google and Yahoo Finance both have guides for new investors, and sites like www.investopedia.com are great resources for researching finance terminology and techniques.