Saving and Investing: Your Choices

What are investments all about?

When you make an investment, you are giving your money to a company or an enterprise, hoping that it will be successful and pay you back with even more money.

Why Some Investments Make Money and Others Don't

You can potentially make money in an investment if

• The company performs better than its competitors.
• Other investors recognize it's a good company, so that when it comes time to sell your investment, others want to buy it.
• The company makes profits, meaning they make enough money to pay you interest for your bond, or maybe dividends on your stock.

You can lose money if

• The company's competitors are better than it is.
• Consumers don't want to buy the company's products or services.
• The company's officers fail at managing the business well, they spend too much money, and their expenses are larger than their profits.
• Other investors to whom you would need to sell think the company's stock is too expensive given its performance and future outlook.
• The people running the company are dishonest. They use your money to buy homes, clothes, and vacations instead of using your money on the business.
• The people running the company lie about any aspect of the business, for example
  • They claim past or future profits that do not exist.
  • They claim it has contracts to sell its products when it doesn't.
  • They make up fake numbers on their finances to dupe investors.
• The brokers who sell the company's stock manipulate the price so that it doesn't reflect the true value of the company. After they pump up the price, these brokers dump the stock, the price falls, and investors lose their money.
• For whatever reason, you have to sell your investment when the market is down.

Types of Investments

What follows are some kinds of investments you may consider making.

Stocks and Bonds

Many companies offer investors the opportunity to buy either stocks or bonds. The following example shows you how stocks and bonds differ.

Say you believe that a company that makes automobiles may be a good investment. Everyone you know is buying one of its cars, and your friends report that the company's cars rarely break down and run well for years. You either have an investment professional investigate the company and read as much as possible about it, or you do it yourself.

After your research, you're convinced it's a solid company that will sell many more cars in the years ahead. The automobile company offers both stocks and bonds. With the bonds, the company agrees to pay you back your initial investment in 10 years, plus pay you interest twice a year at the rate of 8% a year.

If you buy the stock, you take on the risk of potentially losing a portion or all of your initial investment if the company does poorly or the stock market drops in value. You also may see the stock increase in value beyond what you could earn from the bonds. If you buy the stock, you become an owner in part of the company.

You wrestle with the decision. If you buy the bonds, you will get your money back plus the 8% interest a year. You think the company will be able to honor its promise to you on the bonds, because it has been in business for many years and doesn't look like it could go bankrupt. The company has a long history of making cars, and you know that its stock has gone up in price by an average of 9% a year, plus it has typically paid stockholders a dividend of 3% from its profits each year.

You take your time and make a careful decision. Only time will tell if you made the right choice. You'll keep a close eye on the company and keep the stock as long as the company keeps selling a quality car that consumers want to drive, and it can make an acceptable profit from its sales.

Mutual Funds and Exchange-Traded Funds (ETFs)

Because it is sometimes hard for investors to become experts on various businesses—for example, what the best steel, automobile, or telephone companies are—investors often depend on professionals who are trained to investigate companies and recommend companies that are likely to succeed.

Since it takes work to pick the stocks or bonds of the companies that have the best chance to do well in the future, many investors choose to invest in mutual funds and exchange-traded funds (ETFs).

What are mutual funds and ETFs?

A mutual fund or ETF is a pool of money run by a professional or group of professionals called the investment adviser. In a managed fund, after investigating the prospects of many companies, the fund's investment adviser will pick the stocks or bonds of companies and put them into a fund.

Investors can buy shares of the fund, and their shares rise or fall in value as the values of the stocks and bonds in the fund rise and fall. Investors may typically pay a fee when they buy or sell their shares in the fund, and those fees in part pay the salaries and expenses of the professionals who manage the fund.

Even small fees can and do add up and eat into a significant chunk of the returns a mutual fund is likely to produce, so you need to look carefully at how much a fund costs, and think about how much it will cost you over the amount of time you plan to own its shares. If two funds are similar in every way except that one charges a higher fee than the other, you'll make more money by choosing the fund with the lower annual costs. To easily compare mutual fund costs, you can use the Securities and Exchange Commission's (SEC's) mutual fund cost calculator at Link opens in a new windowhttps://www.sec.gov/investor/tools/mfcc/mfcc-intsec.htm.

Mutual Funds and ETFs Without Active Management

One way that investors can obtain for themselves nearly the full returns of the market is to invest in an index fund. This is a fund that does not attempt to pick and choose stocks of individual companies based upon the research of the fund managers or try to time the market's movements. An index fund seeks to equal the returns of a major stock index, such as the Standard & Poor 500, the Wilshire 5000, or the Russell 3000. Through computer-programmed buying and selling, an index fund tracks the holdings of a chosen index, and so shows the same returns as an index, minus of course, the annual fees involved in running the fund. The fees for index mutual funds and ETFs generally are much lower than the fees for managed mutual funds.

Historical data shows that index funds have, primarily because of their lower fees, enjoyed higher returns than the average managed mutual fund. However, like any investment, index funds involve risk.

Watch turnover to avoid paying excess taxes.

To maximize your fund returns, or any investment returns, know the effect that taxes can have on what actually ends up in your pocket. Funds that trade quickly in and out of stocks will have what is known as high turnover. While selling a stock that has moved up in price does lock in a profit for the fund, this is a profit for which taxes have to be paid. Turnover in a fund creates taxable capital gains, which are paid by the fund shareholders.

All funds are now mandated by the SEC to show both their before- and after-tax returns. The differences between what a fund is reportedly earning and what a fund is earning after taxes are paid on the dividends and capital gains can be quite striking. If you plan to hold funds in a taxable account, be sure to check out these historical returns in the fund prospectus to see what kind of taxes you might be likely to incur.