There are three basic types of investments, also known as
asset classes, all of which we are going to discuss. These investments are
stocks, bonds and cash.
You can buy stocks and bonds as individual investments, or
you can invest in them by buying mutual funds or exchange traded funds (ETFs)
that own stocks, bonds or a combination of the two. If you invest in cash, you
can put money into bank accounts and money market mutual funds or you can buy
what are known as cash equivalents: US Treasury bills, Certificates of Deposit
and similar investments.
While you may not think of bank accounts as investments
because they currently pay such a low rate of interest, technically any time
you use money to make more money, you are investing. On the other hand, stock-based
vehicles have been the more profitable investment over time.
Buying stock makes you a part owner of the corporation that
issued the stock. In the past, stocks have offered one of the greatest long-term
investment returns, in large part because of the strength of the US economy
which has been reflected in the growth of US corporations and the price
appreciation of corporate stocks.
When a company prospers, investors who own its stock can
make money in two ways:
Current income, if
the company pays part of its earnings to shareholders as dividends;
appreciation, if the price of its shares increases.
Since there is no limit as to how much a company can earn or
how high its stock price can go, there is no limit as to how much return a
stock investment can provide. Similarly, there is no limit as to how long you
can own a stock and continue to benefit from its increasing value either
through dividend income or price appreciation. You might also think about
stocks as a way to build your estate by leaving them to your heirs in your will
or through a trust.
Stocks, also known as equity investments because they give
you ownership, can pose risk as well as the opportunity for profit. That's
because their price fluctuates in response to what is happening in the company
that issued the stock, in the industry of which the company is a part, and in
the economy as a whole.
If you sell a stock at a time when the stock market or an
individual stock price is down, you might have little or no profit, and you
could even lose some, most, or all of your principal investment.
There are two reasons why a stock's price goes up or down.
The first is the future financial outlook of the company
issuing the stock. If it seems likely that a company's earnings will grow at a
healthy rate, investors will probably be willing to pay higher prices to own
its stock. On the other hand, if it seems that the company is struggling to
grow its sales and earnings, investors will be less interested in owning the
stock and its price may drop or, at best, remain relatively stable.
The second reason a stock's price goes up or down is related
to the general state of the stock market. If the market is booming, stock
prices typically go up. But if the market is falling, many stocks often drop in
price, regardless of the future financial prospects of individual companies.
While it is very difficult to anticipate the
general movement of the stock market accurately, investors can study the market
by reading about it in the Selection and Opinion section of The Value Line
Investment Survey. You can study individual stocks using the information
provided on the Value Line page. We know of no source that gives more concise
and detailed information.
Professional analysts and individual investors tend to
change their expectations about individual corporate earnings in response to
new information about the health of the economy in general.
If investors expect boom times, they are often willing to
pay increasingly higher prices across the board for stocks. But if they expect
a recession to occur, they will assume that many businesses will suffer
slowdowns and earn less money. In this case, stock valuations are likely to
For example, if the economy is weak and people are being
laid off, or are afraid of being laid off, they are less likely to be buying
new cars. So investors will lower their expectations for automakers' earnings.
Similarly, if fewer cars are being manufactured, automakers will buy less
steel. That means steel companies can be expected to earn less.
How does that translate into investment decisions?
In this scenario, the stock prices of automobile and steel
manufacturing companies are likely to decline as investors shy away from them.
In a serious recession, prices of stocks in vulnerable
sectors will continue to drop and drag the entire stock market down. But in a
more typical situation, when the price drops to a certain level, investors once
again see the stock as a promising opportunity to make money and begin to buy
again. A parallel situation typically develops with the automobiles themselves:
Since they are not selling, the company lowers the prices. In all but the worst
economic conditions, this encourages people to buy. An upward swing of the
economy begins and investors who have bought stock in the automobile company
when its price was depressed see the price, and their returns, begin to climb.
Investors also know that every business is not affected
equally by a recession. Even in a recession, people still brush their teeth. So
the earnings of companies that manufacture toothpaste probably won't suffer as
much during a recession as those companies in the automobile and steel sectors.
That means that their stock prices aren't likely to drop as far and may even
remain strong since they represent one place to make money unless the economy
as a whole slips into a deep recession or a depression.
On the other hand, when times get better, people don't brush
their teeth any more than they did when times were bad. So unless the
toothpaste company can introduce new products or increase the price of the
toothpaste significantly, its earnings are not likely to increase in a boom
period as rapidly as earnings in more cyclical industries.
Fluctuations in interest rates usually affect the stock
market. That's partly because the level of interest rates affects the appeal of
stocks versus bonds. When interest rates are high, bonds are more attractive
relative to stocks: when interest rates are low, bonds become less attractive
relative to stocks. But it's also because a change in the level of interest
rates can affect corporate profits.
Higher interest rates often mean lower profits. If interest
rates rise, companies have to pay more to borrow the money they need to grow.
Eventually that translates into higher prices for their goods and services and,
often, slower sales, especially if consumers are buying on credit and have to
pay higher interest rates themselves to borrow. Potential customers may decide
they can't afford to buy.
The eventual decline in corporate sales and earnings is
something investors anticipate as soon as interest rates go up. The result is
that stock prices may go down even before the effects of the increased interest
rates are actually felt on the company's bottom line.
The reverse happens when interest rates fall. Company
borrowing costs are lower, so their profits on the same level of sales will be
higher. And customers who buy on credit are more comfortable buying if they are
paying lower rates, so they buy more. That increases sales and ultimately means
higher corporate profits. Higher profits typically result in higher stock
In this situation as well, investors are usually ready to
pay higher prices for stocks as soon as interest rates drop in anticipation of
the cycle of increased profits.
Bonds are financial obligations of corporations, governments,
or government agencies. The issuer usually pays periodic interest to the
bondholder and is obligated to repay the value of the bond at a specified time
(known as the maturity date).
Short-term bonds normally have maturities of less than one
year. Intermediate-term bonds normally mature in two to ten years. Long-term
bonds normally run more than 10 years.
Bonds are generally described as less risky investments than
stocks, since, if you buy a bond when it is issued and hold it until it
matures, you normally get regular income and your investment capital back. The
risk you take—in addition to the possibility that rising inflation will
undercut the buying power of the interest income you earn—is that the issuer
may not be able to meet its obligation to pay the interest and repay the loan.
This is known as credit risk.
However, since bonds are rated by independent rating
companies, you can buy highly rated bonds that pose virtually no danger of
But bonds constantly fluctuate in value, so that if you need
to liquidate your bond investment during its term, you might have to sell for
less than you paid. That is known as market risk.
Bonds are generally considered a smart way to diversify an
investment portfolio, since in most years they perform differently from stocks
and in some periods when stocks are depressed, bonds can provide a positive
There are two primary reasons why bond prices fluctuate, and
why you might not get back the full amount of the principal you paid to buy a
bond if you have to sell before the bond matures.
The first reason is that people change their expectations
about the ability of the bond's issuer—the company, government or agency that
borrowed the money—to meet its obligations to pay interest and/or repay the principal.
The more worried they are, the less willing they will be to pay for the bond.
The increased risk investors take when they buy low-rated bonds also explains
why these bonds typically pay a higher rate of interest than bonds that are
The second reason is changing interest rates. If interest
rates go up, the price of existing bonds, including the ones you hold, goes
down. But if interest rates go down, the price of existing bonds will go up.
Some examples of bond fluctuations:
Suppose you spent $1,000 for a bond paying 5.75% interest,
or $57.50 a year. That interest is fixed for the term of the loan.
If the interest rates go up to 6%, investors won't be
interested in bonds on which they'll earn less than 6%. But they will be
willing to pay less than the face value, or the $1,000 you spent for the bond
you own. Specifically, they'll pay enough less—in this case $958.33—so that the
$57.50 they receive as interest equals the going rate of 6%.
To find the current price of a bond with a fixed interest
payment, use the following formula:
Bond Price X Fixed Interest Rate = Annual Interest
In our example: $1,000 X 5.75% = $57.50
Now, if interest rates rise to 6%, the value of the bond
which pays annual interest of $57.50 is:
Bond Price X 6.00% = $57.50
Bond Price = $57.50/0.06 = $958.33
If on the other hand, rates fall, let's say, to 5%, the
following will happen
Bond Price X 5.00% = $57.50
Bond Price = $57.50/0.05 = $1,150.00
Whatever price investors pay for a bond—its face value at
the time it is issued, a discounted price when interest rates on new bond
increase, or a premium price when interest rates drop—the amount that's repaid
at maturity is the face value, typically $1,000.
For example, whether you pay $958, $1,000 or $1,150 in the
bond market, you will get back $1,000 if you own the bond when it comes due.
You have to take that situation into account if you are considering buying
bonds after they are issued. Specifically what you want to know is the bond's
"Yield to Maturity," which factors in the amount of time left in the
bond's term as a way to evaluate what you will earn on your investment.
"Yield to Maturity" measures the annual rate of
return an investor will receive from both the interest to be paid and any
appreciation or depreciation expected when the bond matures (is paid off).
Those figures are available from your investment advisor
and, for certain bonds, available from financial news sources.
Next in Value Line University: Investment Strategies