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Roadmap to Riches

how to invest your 401(k)

The Instruments: Three Classic Assets – Cash, Bonds and Stocks

What are Your Choices When it Comes to Investments?

Like the basic food groups, there are three basic categories of investment that include money market funds, bonds, and stocks. There are other asset classes such as real estate and oil, and then hard assets like gold.

However, looking back to the turn of the century, company stocks have performed the best of all of investment groups.

The average stock has generated returns about six percent higher per year than the average rate of return on savings accounts or 30-day United States treasury notes.
With the exception of the 1970’s, stocks have increased in value faster even than the values of people’s homes.

Cash

The advantage of this asset class is that we know we will not lose money and that we are guaranteed to make at least something in interest each year. That “something” may not be very much. For many years in the past, the government has paid as little as 1% per year in interest on its short-term bonds
We know that inflation robs our savings of any value they might have gained by accumulating the small percent of interest paid by money market funds.

Bonds

A bond typically pays a higher rate of interest than cash because bonds are “loans” for longer periods of time. A typical bond might have a maturity of ten years, which means that it constitutes a ten-year loan. Because loans of this duration involve more risk, interest rates paid are higher than what the U.S. Government pays on the 30 and 60 day notes (a note is just a bond with very short maturity).
So-called “junk bonds” are very high risk bonds or essentially loans to companies that were considered to be really risky from the beginning. Risk, remember, is a measure of the possibility of losing money. People buy junk bonds anyway, however, because these bonds pay interest rates in some cases of between 14% and 18% per year. At these rates, the theory goes, it doesn’t matter if a few companies go “belly-up” making the bonds worthless. The high interest on the ones that survive would more than compensate.

The Important Difference Between Long-Term Bonds and Cash

Cash, then, involves virtually no risk. The interest rate paid on very short-term loans is just about the rate of inflation, because lenders (savers like us) are taking no risk and only want to receive enough interest to keep us in line with our inevitable erosion of money value due to inflation.

Bonds involve a longer-term commitment and because of this they pay higher interest rates than short-term notes.

It is possible for a portfolio of bonds to go down in value even though there are no defaults and all interest is paid currently. This happens when interest rates in the open market have risen and the original bonds owned by the fund are paying at their original rate.
The value of those bonds in the open market would go down because they now compete with new bonds that pay a higher rate.
By the same mechanism, bond mutual funds can rise in value if interest rates on the open market happen to fall. When market rates fall, those original bonds paying a higher rate are suddenly worth more money if we wanted to sell them.
Bond mutual funds, like stock funds, are totally valued every business day based on the market value that day of every single bond in the fund.

Stocks
Stocks are the pieces of paper or certificates that represent one’s ownership interest in a company. “I own stock in that company” means that the person has stock certificates or proof of ownership kept safe somewhere. The American stock market has yielded rewards over time that has been far in excess of any other form of investment.

Owning stocks has proven to be an effective hedge against inflation and is one of the best techniques for harnessing the “magic” of compound interest.
Owning a share of stock in a company means that we actually own a part of that business. A large company can be thought of as a huge pizza with its ownership divided up into as many as 20 million slices. Each slice, known as a share, may sell for $20 today. Tomorrow, however, a share may sell for more or less money depending upon demand for that company’s shares or the demand for shares in general. Someone buying a share today for $20 may be able to sell it tomorrow for $22 (a ten percent profit) or it may only be salable for $18...a ten percent loss.

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