Assets are investments—things that have economic value and can act as a store of wealth. Assets that can quickly be bought or sold at a fair price are said to be liquid assets. Tesla stock, a mutual fund, and cash in your bank account are liquid assets. Your home, a rental property, or family business are assets, but not very liquid.
Asset classes are groups of similar assets that share similar risks. They include things like stocks, bonds, cash, and real estate. Many of these can be more granularly classified into sub groups that have similar characteristics such as industry or size.
Diversification is spreading your investment over many different asset classes, business sectors, industries, companies, and even countries. Investing has many risks, but most risks do not impact all asset classes in the same way. Diversifying your assets is generally less risky than concentrating your money in one asset or asset class.
Asset allocation uses statistical analysis to manage diversification. Modern Portfolio Theory attempts to construct a portfolio that maximizes the potential for return at each given level of risk. It does this by analyzing each asset class’s historical return, the variability of that return (variance), and the degree to which asset classes go up and down in price at the same time (covariance).
Stocks represent ownership in a corporation. Each share of stock represents a small but equal share in the company. The stocks you can buy are in public companies, who have registered their stock with the SEC. Privately held corporations also have stock, but it may not be sold to the public.
Bonds are loans that can be bought or sold. Each bond represents a promise by the issuer to pay a certain amount of interest and repay the full amount of the loan on a specific date in the future. The issuer (borrower) might be the US government, a state or local government, or a corporation. Interest from municipal bonds, those issued by state and local governments, is exempt from federal income tax and usually tax of the issuing state. US Treasury bonds, bills, and notes are exempt from state income taxes. Interest from corporate bonds is fully taxable.
Most stocks and some bonds are traded on stock exchanges. These are centralized, computerized markets in which orders to buy are matched with orders to sell, a price is agreed, and a trade executed. Most US stocks trade either on the New York Stock Exchange or the Nasdaq exchange.
Investors must go through a brokerage firm to buy or sell on an exchange. This ensures both parties to the trade that the other party actually has money to buy or stock to sell. Investors open an account at a brokerage firm that holds the securities they own. The broker settles any trades they do by delivering securities they sell or payment for shares they buy to the other party. They also do all the bookkeeping and send their clients statements and tax documents.
Corporations may choose to distribute part of their profits, or earnings, to their shareholders. These payments are called dividends. Investors are taxed at a lower rate on corporate dividends than on other income because the corporation has already paid tax on their profits and dividends are a distribution of those profits to the owners. Dividends are not guaranteed and companies can change the amount or stop paying them at any time.
When a security pays out cash to its owners, as dividends on a stock or interest on a bond, the annual amount of those payments can be expressed as a percentage of the value of the security—an interest rate equivalent. For example, a stock with a $50 value and a $1 annual dividend yields 2% (1/50). A bond with a $1000 value that pays $50 interest yields 5% (50/1000). Yields will change as the value of the security changes or if a dividend amount changes.
Borrowers with good credit pay less interest on their loans than those with not such good credit. Since bonds are loans to a company or government, the bonds of issuers who are believed to be safe pay lower interest than those of less credit-worthy firms and governments. For this reason, the more risk you are willing to take that the bond issuer won’t repay your principal (default), the higher the interest you’ll get from a bond. High Yield Bonds are those with lower credit ratings that pay higher interest. They are sometimes called Junk Bonds.
A mutual fund or ETF incurs expenses such as management fees, custodial fees, and marketing costs. The expense ratio is the annual expenses divided by the fund’s value expressed as a percentage. It is the amount by which your annual return is reduced to the pay fund’s expenses.
This is short for Market Capitalization. It is the total value of a corporation, the price per share of stock times the number of shares outstanding. Large cap stocks are the biggest companies—generally with market cap of over $10 billion. Mid cap stocks have values between $2 and $10 billion. Small Caps are generally those companies worth less than $2 billion.
These are companies whose revenue (sales) and earnings (profits) have grown regularly year over year. They can be of any size, but will have a history of growth that stock analysts expect to continue. People buy them hoping the price will go up as they continue to grow. Growth stocks usually don’t pay a dividend because they are reinvesting their profits to make the company grow faster. Think Facebook and Alphabet.
These are companies with stable earnings (profits) that have gone down in price. People buy them believing that the market has undervalued them and they will go up when the market sees it’s mistake. Value stocks often have high dividends compared to their stock price (yields). Think Apple.
An index represents all the securities in some large segment of “The Market”. This could be the entire US stock market (Russell 3000 index), the 500 largest US stocks (S&P 500 index), the stocks of 23 developed countries (MSCI World index), or the US bond market (US Aggregate Bond index). Indexes are used as comparison points, or benchmarks, against which investment managers measure their performance.
Investments go up and down in value. Some, like stocks of small, speculative companies, go up and down a lot. Others, like high grade corporate bonds, tend not to move much. Volatility is a measure of how much the price of an investment is likely to move in a given time period. The more volatility the asset has, the riskier it is thought to be. Generally, the more assets in a portfolio, the less the volatility of any one asset impacts the risk of the portfolio.
Investors usually focus on the risk of the value of an asset going down. There is not much we can do about things like wars and natural disasters. However, things like bad management of a company, new competition, and new government regulation can be mitigated by diversifying your portfolio so things that hurt a particular company, industry, or country don’t wreck your whole financial plan.
If you sell an investment for a profit, you have a capital gain. If you sell for less than you paid (accountants call what you paid your Cost Basis), you have taken a capital loss. The US taxes gains on assets you’ve held longer than 1 year at a lower rate than those held for less time. These are called long-term gains and short-term gains respectively. Capital losses are generally deducted from capital gains before any tax is calculated. Currently, up to $3000 of capital losses can be deducted against other income each year.
Mutual funds are collections of investments that trade as a single security. Think of them as a suitcase full of securities: stocks, bonds, gold, or almost any other legal investment. They can be actively managed or passively invested. The main benefit of a mutual fund is diversification. You can buy shares of one fund and own a tiny amount of many, many individual stocks or bonds.