Over the years I’ve come to realize I grew up with a smart group of friends. It’s sometimes strange to think that we have grown up to become doctors, lawyers, engineers and economists. While I’ve always felt a little intimidated when they said words like myocardial infarction (heart attack) or jurisprudence (theory and philosophy of law), I recently noticed that they sometimes feel just as lost when I start talking about finance.
Like many in my profession, I take for granted my knowledge of personal finance and expect everyone to know and understand the basics when I start talking. Because of this, I’ve decided it’s time to take a step back, and get back to basics. In conjunction with National 401(k) day, which is tomorrow, I want to discuss some basic elements as they relate to investing and 401(k)s.
Before you start to invest, it would make sense to first define investing. Investing is the act of committing money or capital to something with the expectation of receiving additional income or profit.
The main types of investments people make are stocks (which represent ownership in a business) and bonds (which represent a loan you make to a company or government).
A portfolio is a combination of different types of investments that you have purchased. For most investors, the portfolio will consist of different stocks, bonds and cash positions (like a money market or stable value option). An investment portfolio can also include real, tangible items like art and gold coins.
Portfolios can be aggressive, in which they are more heavily invested in stocks, conservative, in which they are more heavily invested in bonds and cash or anywhere in between. Determining this mix of investments for your portfolio is usually done by answering an investor profile questionnaire that looks at your time horizon, your investment goals and how you would behave under different situations.
Diversification is a strategy that allows you to manage the risk in your portfolio. One way to diversify, as mentioned above, is to hold different types of investments like stocks, bonds and cash.
You can look to diversify further by holding different types of stocks and bonds. In the stock segment, you can diversify into more risky stocks or towards more conservative stocks. You can buy stocks that are geared towards growth (like technology companies) or more value-oriented companies (like utility companies).
In the bond market you can buy bonds that mature (get paid off) very soon, or that don’t mature for 30+ years. You can buy different kinds of bonds from governments, or buy bonds that have been issued by corporations. All these bonds will come with different levels of risk and will help to diversify your portfolio.
After reading about all the different types of stocks and bonds you can buy, it’s normal to feel overwhelmed and think you’ll never have enough money to buy enough individual investments to be diversified. That’s where mutual funds come to the rescue. A mutual fund is a type of investment that pools your money with that of other investors to buy a basket of investments for a relatively low price. Through a mutual fund you can gain access to hundreds of different stocks and bonds all in one place. This convenience is part of the reason why mutual funds are the most common type of investment offered in 401(k) plans.
An important thing to remember about mutual funds is that they come in different shapes and sizes. Some will invest in all different types of securities, while others will focus on specific types of stocks or bonds. When you are building a portfolio of mutual funds, it is important to make sure you know what area of the market your fund(s) invest in to be sure you are diversified. If you happen to buy 3 funds that all invest in large-cap growth stocks, you haven’t really diversified your portfolio.
So the next time you are in a conversation and start using big words that pertain to your career or field, try to remember that other people may not even know the basics. While many of us are too proud to admit to our friends when we don’t understand something, the advisers at Smart401k want to remind you that there’s no such thing as a dumb question. So feel free to call (877.627.8401) or email (firstname.lastname@example.org) us anytime you have a question or concern.
Senior Investment Adviser
Any other basic terms you feel beginners should know? Let us know in the comment section
Smart401k is a web-based investment advisory service providing unbiased recommendations to help people invest in employer-sponsored retirement plans. Smart401k provides service to nearly 11,000 clients who collectively have more than $2 billion in assets. Plan participants receive personalized, fund-specific investment recommendations and the support of professional investment advisers available to discuss all investment questions. Based in Overland Park, KS, Smart401k is online at Smart401k.com.