Ever wondered how bonds work or what “styles” of stock investments are available to investors? Proper diversification is key to your investing strategy. Here’s a list of key terms related to investing and diversification that may come in handy. If you don’t see a term here you’d like defined, send a note to info@northfinancialadvisors.com to have this article updated.
Equity Markets
Stocks: Companies can raise money by issuing stock. Investors can purchase stock, becoming a full or partial owner of a company. Investors benefit from an increase in value of an investment and share in investment losses too. Values of stocks can fluctuate widely and there are no guarantees that you will make money or receive your principal back. There is high risk but also a potential for higher returns.
Market Capitalization: The stock price times the total outstanding shares. It’s a way to classify the size of publicly traded companies.
Small Cap Stocks: Companies with smaller market capitalizations — between $300 million and $2 billion. A benchmark of the Russell 2000 is generally used as a comparison for small cap stocks. Small caps add diversity to your portfolio because there is greater growth potential, but there is oftentimes more volatility.
Mid Cap Stocks: Companies with mid-size market capitalizations — between $2 and $10 billion. Mid caps add diversity to your portfolio because they have slightly less volatility on average than small cap indexes but still offer high growth potential since the companies in this range have been around for a while, but are still fairly young.
Large Cap Stocks: Companies with a market cap greater than $10 billion. A benchmark of the S&P 500 is usually what’s used as a comparison for large cap stocks. Large cap companies tend to have been around a lot longer and have more stability and are more likely to pay predictable dividends. The large cap stocks with the greatest market cap are referred to as “Blue Chip” stocks.
Growth Stocks: Growth stocks refer to companies in an industry where there is the potential for much higher earnings growth than the rest of the economy and market. Growth stocks may be newer companies and they pay fewer dividends. Some companies within an index like the S&P 500 are considered growth companies, so you will get exposure by investing in a broad index. Some mutual funds and ETFs specialize in selecting investments that are growth stocks.
Value Stocks: Value stocks refer to companies who may be undervalued relative to their earnings and dividends offered. This undervaluation is attractive because there’s a chance for higher returns in the long run. Just like with growth stocks, by investing in broader indexes you will be investing in some value stocks too. Some mutual funds and ETFs create funds that attempt to find and invest in only value stocks.
Dividend / Income Stock Funds: Some companies that have been around a really long time don’t grow sales and earnings as much from year to year, but they have a steady and predictable profit from quarter to quarter. They tend to pay a predictable dividend which can come in handy, especially during times of volatility in the stock market. A type of income fund is a real estate fund.
Real Estate Stock Funds: Some funds specialize in real estate investment trusts or REITs. This business structure requires real estate companies — oftentimes commercial real estate such as malls, nursing homes and/or storage facilities — to pay out all taxable earnings as dividends to shareholders. This is beneficial to the REITs because they will pay less in taxes, thereby shifting the tax burden to shareholders. While you can expect higher dividend payments as well as some capital gains, it’s usually better to diversify using REITs in tax-favored accounts like retirement.
Industry / Sector Funds: Some funds specialize in a certain industry or sector such as materials, utilities, financial services, healthcare or tech. These types of funds can be used if you are already exposed to a certain industry by virtue of your job or other investments and need to diversify. However, if you are already buying broad based indexes you will be exposed to all major industries anyway.
International Stocks: Stocks funds can be global, focus specifically on the U.S. or internationally. Companies selected for international stock funds can come from developed markets or emerging markets. Investing in global stocks ensures that you are exposed to the global capital markets and have the opportunity to invest in countries where growth may be much greater than in the U.S.
Developed Markets: Companies based in industrialized countries with established and more stable economic systems. Examples of some developed markets include Europe, US, and some parts of Asia.
Emerging Markets: Companies based in developing markets which may experience much higher GDP growth rates. However, oftentimes these countries experience regular political or economic turmoil. Examples include countries in South America, Africa, SE Asia or the Middle East.
Fixed Income Markets
Bonds: Bonds are a way for companies and governments to raise money. An investor provides funds up front, and the bond issuer will pay coupon payments (interest) to the investor for a period of time until the bond matures, at which time the issuer will repay the original capital. When you buy a bond, the coupon rate (interest rate) is locked in and you’ll be guaranteed your original investment if you hold it to maturity. Given the definitive time period associated with this investment, bonds are helpful because you can match your investment to your time horizon with short-term, mid-term, and long-term investments. If you sell the bond before maturity, you could lose or gain part of your original investment depending on current interest rates. When interest rates increase, bond prices decrease and vice versa. Pricing changes happen with regularity depending on the economy, and a real benefit to investing in bonds is that the price tends to change to a very different degree than stocks.
Corporate Bonds: Debt issued by corporations. The potential returns are based on the credit rating of the firm (i.e. the likelihood they will repay). Oftentimes a corporate bond fund may look attractive because it pays a higher interest rate payment than other types of bonds. But note that the higher the interest rate paid out, the lower the credit quality of the bond.
Government Bonds: Bonds issued by the federal government also known as US Treasuries. They are viewed as safe investments, but don’t often out-earn inflation. These can be short-term (bills), mid-term (notes), long-term (bonds), zero coupon and inflation adjusted (TIPS). Government bond interest is taxable at the federal level, but not at the state level.
Municipal Bonds: These bonds are issued by state and local governments to make infrastructure improvements. These types of bonds enjoy special tax treatment. Interest rates paid to shareholders are exempt from federal tax. If you purchase a bond in the state you live in, it’s likely exempt from state tax too. This investment is suited for taxable brokerage accounts to provide a tax free income source, and it’s especially helpful for higher earners.
Short -Term Bonds: Bonds that mature in a few years or less. These bonds offer a lower interest rate but their price will be less impacted by short-term interest rate adjustments by the Federal Reserve.
Mid -Term (or Intermediate) Bonds: Bonds that mature in less than 10 years. These bonds offer a higher interest rate than short-term bonds.
Long-Term Bonds: Bonds that mature in more than 10 years. The highest interest rates are offered for long-term bonds. However, by owning them, you also have to endure many years of price changes due to economic and interest rate changes.
Cash reserves/cash equivalents: Funds that are safe from market fluctuations but will not usually out-earn inflation. These include money market funds, savings accounts, and certificates of deposit.
Types of Investing Risk
Market risk: Risk that security prices fall as a result of an overall downturn. In general, the price of individual investments will be affected by the volatility of the financial markets. Volatility can occur during economic fluctuations related to growth, employment or global events.
Interest rate risk: Inverse relationship between investment prices and interest rates. When interest rates rise, bond values fall, and, when interest rates fall, bond prices rise. Interest rate risk works in your favor if interest rates fall, but to your disadvantage if rates rise, if you have to sell a fixed-income investment before its maturity date. Stocks are often also affected negatively by rising interest rates.
Inflation risk: Loss of buying power due to inflation, i.e. the price of goods increases faster than your investments.
Business risk: Risk that one company or industry will experience a decline in the stock market. This can happen if a company doesn’t do as well as expected or has a major PR blunder, or if a major regulation impacts an entire industry.
Reinvestment risk: Being forced to invest at lower rates. For instance when bond interest rates decline, prices go up. If you’re current investment matured and you’re looking to reinvest the capital, you’ll be able to buy fewer bonds at a lower interest rate than you earned before.
Volatility: Erratic ups and down in security prices across all industries/sectors. High volatility means significant price changes, low volatility means there is more muted price changes. Some types of investments like stocks have more volatility than other types of investments, such as bonds.
