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| Home > Investment Stategy >Choosing Investments |
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| Choosing Investments |
| Before you choose your investments, consider your financial goals. You may have a long-term goal in mind like retirement, or you may have something near-term in mind, like buying a new car. |
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| What are your investment options? |
Mutual funds invest primarily in three types of securities: stocks, bonds and cash-like securities. Each has a place in your investment portfolio. You'll use more of one and less of another depending on your financial goal and your answers to 3 questions:
- Is the date you need the money flexible or fixed?
- Will you invest a lump sum or save periodically?
- How much volatility can you handle?
Let's look at what stocks, bonds and cash-like securities are, and how they can fit into your portfolio. |
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| Stocks and stock funds |
When a company needs to grow or expand, it may sell part of its ownership to the public in the form of shares (stock). In exchange for the money received from the sale, the company gives shareholders a portion of its future profits, as well as a measure of its decision-making power. When a mutual fund buys stocks, the fund's shareholders become part owners of the companies that issued those stocks.
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| Stocks and stock funds |
Stock prices can change greatly from day to day, depending on the supply and demand for the stock. If many investors want to buy the stock, the price may go up. If fewer investors are interested in buying the stock, the price may go down.
Not all stock funds are alike. A stock fund's risk and return depend on the types of companies it buys. Pure growth funds buy companies that are expected to grow rapidly. These companies tend to use their profits to finance future growth rather than paying them out as dividends. Other stock funds invest more conservatively, favouring large, established companies that pay reliable dividends which provide income that can reduce the fund's volatility.
Benefits of investing for growth. People invest in stock funds because they hope their investment will have grown substantially when they finally sell it. Over the long term, stock funds have outperformed bond funds and money market funds and have been the best hedge against inflation.
In order to enjoy the benefits of investing in stock funds, you should maintain a long-term view. While stocks have produced the greatest returns over time, stock prices fluctuate, sometimes widely.
Do stock funds make sense for you? That depends on your answers to the 3 questions we posed before. If your time frame is flexible, you might be able to wait out any temporary downward price movements in the value of your stock fund. On the other hand, if your time frame is fixed, and especially if it's short, volatile investments such as stock funds can be risky.
While volatility is not of great concern to the average long term, buy-and-hold investor, it can be worrisome to people who check fund prices daily and can't get a good night's sleep when a stock fund is losing value. Using rupee-cost averaging rather than a lump-sum approach to buying and selling investments helps ameliorate the average person's discomfort. |
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| Bonds and fixed-income funds |
A bond is a negotiable IOU, or debt security, issued by a corporation, government or government agency. When investors buy a bond, they're lending a certain sum of money (principal) to the bond issuer for a specified time period (term).
In return, the issuer promises to:
- Make regular interest payments during the term at a rate set when the bond is issued.
- Repay the face value of the bond on the maturity date.
About maturity. A bond's maturity indicates when its issuer is required to repay the principal. Bonds are classified in 3 general maturity ranges:
- Short-term—usually less than 3 years
- Intermediate-term—between 3 and 10 years
- Long-term—greater than 10 years
In general, the longer the maturity, the higher the bond's interest rate. This is to compensate you for the risk of tying up your money at a fixed-interest rate for a longer period of time.
How interest rates affect prices. Between the time you buy a bond or bond fund and the time you sell it the value of your principal will fluctuate. Generally, when interest rates go up, bond prices move lower-and when they move down, bond prices move higher. As you might expect, the best time to invest in bonds generally is when interest rates are declining. Typically, the longer a bond's maturity, the higher the interest-rate risk, or the more sensitive its price will be to interest rate changes.
Can you lose money investing in bonds? People mistakenly assume that the word "fixed-income" means they can't lose money owning a bond. But, the interest rate that the issuer pays is the only part of the investment that is "fixed." The value of your principal, on the other hand, has the ability to increase or decrease depending on whether interests rates move up or down.
It's different with bond funds. The fund typically doesn't hold all the bonds until they mature. When you buy a bond fund, you get diversification because the fund owns many bonds, not just one. This diversification helps protect you from credit risk—the risk that the issuer fails to make timely interest payments or to repay principal. However, this means that the income you receive from the fund fluctuates along with your principal, as the fund buys and sells bonds paying different rates of interest.
Types of bonds. There are many types of fixed-income securities to choose from. Funds will often emphasize one type or another to help investors meet their investment objectives.
- Government securities issued by the Indian government are considered the most credit worthy of all debt instruments-since they are backed by the full faith and credit of the government. Treasury bonds, bills and notes have a wide range of maturities
- Corporate bonds are issued by companies in order to finance projects ranging from building a new plant to modernising at a current location. Risk and return vary, depending on the financial strength of a corporation. Bonds issued by corporations with lower credit quality generally pay a higher rate of interest to compensate investors for the higher repayment risk.
- State government bonds are issued by local governments in order to finance a variety of projects, ranging from water systems and public schools, to hospitals and police protection. State government bonds are generally considered to be relatively low risk investments, second only to securities issued by the federal government and its agencies. However, within state government bonds themselves, there is a wide range of credit quality.
These bonds are exempt from federal taxes and, in the state of issue, often free of state and local income tax as well. Before choosing a tax-free fund, you should consider the equivalent taxable yield-what a taxable investment would have to yield before taxes to equal the tax-free yield of a particular tax-free bond investment.
Do bond funds make sense for you. Nearly all investors can benefit from having a portion of their portfolio allocated to bonds. Even for investors whose primary objective is long-term growth, bonds can play an important role in building a well-diversified portfolio.
Let's go back to the questions we posed earlier. First is your time frame. Bond funds offer greater potential return than cash-equivalent investments such as money market funds, But they can be riskier than money market funds for people with very short time frames and for those who need to withdraw all their money on a fixed date.
Bond funds provide diversification and can be a key element in your asset allocation strategy to combat the volatility of stocks, While bond prices and returns can fluctuate, over the long haul bond funds have been less volatile than stock funds, For people who are very risk averse, while bond funds lag behind stock funds as an inflation fighter, they are better than cash-equivalent investments are at preserving your purchasing power.
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| Cash-equivalent investments and money market funds |
In many respects, most money market instruments are just short-term versions of bonds. They are short-term, high-quality, fixed-income securities, such as Treasury bills, short-term bank certificates of deposit (CDs), and commercial paper issued by corporations. The average maturity of a money fund's portfolio must be 90 days or less to help protect against interest rate risk. The income money funds provide is generally determined by short-term interest rates.
Do money market funds make sense for you? Money funds provide you with current income and seek to preserve your principal. Because of their stability, money funds are often used for emergency cash reserves or for a very short-term financial goal.
Cash-equivalent investments and money market funds are the least volatile of the investment types we discussed and are therefore ideal for people with extremely low risk tolerance. However, the income from this type of investment is only slightly higher than interest rates offered by banks on savings accounts making them poor choices to combat the damage inflation inflicts on your purchasing power.
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| Risk and reward go hand-in-hand |
When choosing investments, remember the tradeoff between risk and return. The higher the return you seek, the more risk you'll need to accept. There's no such thing as a low risk-high return investment.
As always, you will want to consult your financial advisor about how fixed income funds could play a role your investment strategy.
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