The continuum goes something like this: You make money. Some of it is used to pay bills and buy groceries. Some you spend for entertainment and some is saved to be invested. The whole point of investing is to use invested money to earn more money for some future purchase or (more likely) to live on in retirement.
You get to decide how much you will save and invest. You also get to decide how you will invest. Most investments boil down to one of two types of vehicles – equities (i.e., stocks) and fixed income (typically bonds, savings accounts or CDs).
Fixed Income Investing
Fixed income investments like bonds, savings accounts or CDs are designed to be safe, low-risk investments. Because of that, the return (interest earned) is lower than with other riskier types of investments.
Fixed income investments can generate a return so low it doesn’t keep up with inflation. When that happens, you not only don’t earn much, you may even lose some of the value of your investment.
Equity investments, typically stocks, offer a potential large return, especially when compared to fixed income. From a safety standpoint, equity investments are often quite risky or at least much riskier than fixed income investments. With equity you can gain a lot or lose a lot – even all your investment.
The amount of risk you take depends on the risk associated with the company behind the stock. For example, a small, young company that produces a new product that has not been on the market long, could represent a very risky investment. If the product takes off, the company grows and many investors want in, your stock in that company could go up – way up. If the product loses appeal and the company goes out of business, you could lose everything you have invested.
Mitigations For Both Types
There are ways to mitigate or allow for both the risk of equity investments and the low return on fixed income investments. For example, by investing in so-called “blue chip” stocks – large companies with a long history of making a profit – your return will generally be less risky than investing in a startup with an unproven track record.
On the fixed income side of the ledger, you can increase return by buying bond or CD products with a longer-term to them. (The longer the term, the higher the rate of return.) You can mitigate risk by buying what are known as “investment grade” bonds. These are considered the safest in the marketplace. Bonds rated below investment grade offer higher returns – and more risk.
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Most investors choose a mix of fixed income and equity investments because that offers the best mitigation of all. This allows you to take more risk (with potentially more reward) on the equity side and balance that with reliable, but somewhat boring, fixed income on that side of your portfolio.
The mix (of stocks and bonds or similar assets) you have in your portfolio is up to you but one rule of thumb is known as the 100 rule. Subtract your age from the number 100, and that's the percentage of assets you should hold in equities (stocks). If you are currently 30 years old, you could have 70% of your holdings in stocks. If you are 60, the percent of stocks should be no more than 40%.