When you hear about investing, a saying is to invest in stocks and bonds. What are they though? How much of each should you invest in? Which one? Let’s break it down.
What is a stock?
A stock is a security representing a fraction of ownership in a company, a share. You’re a shareholder because you receive a share of the company profits.
What is a bond?
A bond is a loan to a company or government. They use the money to fund their operations. The investor who loaned the money receives interest on the investment.
There are a few different types of bonds
- Treasury bonds: backed by the federal government and considered one of the safest types of investments.
- Municipal bonds: issued by states, cities, counties and other non federal government entities. They fund state or city projects.
- Corporate bonds: Corporations issue bonds when they need to raise money for something. Unlike a stock, corporate bonds do not give you ownership in a company.
Generally, stocks are more risky but offer higher returns. Bonds are generally safer but offer lower returns. The long term average returns of stocks is around 10%. The long term average return of government bonds is around 5%.
If you’re young, financial advisors generally recommend an investment portfolio that is mostly stocks with some bonds. As you get older, you can slowly shift your investment mix to more bonds and some stocks.
Many target date index funds (which you will learn about later) put an investor under age 40 in a mix of assets that is 90% stocks and 10% bonds. The target date index fund will gradually add a higher % of bonds in the investment portfolio as the investor gets older.
The different asset classes
- U.S. or international stocks
- Bonds
- Cash
- Commodities (ex: oil, gold)
- Alternatives (Crypto such as Bitcoin and Ethereum)
- Real estate
Stocks and bonds are the two types of common assets in investment portfolios. To invest, people usually go with mutual funds such as index funds or ETFs.
A mutual fund is an investment fund that a bunch of people mutually contribute to in order to buy securities such as stocks and bonds.
An index fund is a type of mutual fund that aims to track the returns of a market index.
An ETF (Exchange Traded Fund) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange.
Now that you know what stocks, bonds, mutual funds, index funds, and ETFs are, how do you actually choose them for your investment portfolio? Many people do one of two things:
- Three-fund portfolio (U.S. stock, International stock, and U.S. bond)
- Target date index fund (the easy button of investing. You pick a target date index fund for year around when you turn 65 and invest your money. It automatically rebalances and manages your investment mix).
Target date index fund
A target date index fund can be a great way to be an investor building wealth in a passive, hands-off way. Just do consistent, regular contributions into the target date index fund and a person is good to go!
A person invests in a target date index fund that matches around when they turn 65 years old. Some examples of target date index funds, using the popular brokerage firm, Fidelity, are below:
Fidelity Freedom Index 2055 Fund (Ticker Symbol: FDEFX)
Fidelity Freedom Index 2060 Fund (Ticker Symbol: FDKLX)
Fidelity Freedom Index 2065 Fund (Ticker Symbol: FFIJX)
After opening your investment account , you would set up auto-monthly contributions and select where you want your money invested. You input the ‘ticker symbol’ in the search bar, find your fund, then click the ‘buy’ button.
Pros:
- Auto rebalancing
- Low cost
- Well diversified
Cons:
- Might not be available 🙁
- May be too conservative (too much bonds)
Example
A person decides they want to start investing. Except, they don’t have much of a clue about what to actually invest in. They find out target date index funds are good all in one funds that have a mix of stocks, bonds, and they automatically rebalance a person’s portfolio for them.
They open their Roth IRA at Fidelity, then try to find out which target date index fund to pick. They were born in year 1996, so they will reach traditional retirement age around year 2060. So they set up consistent auto contributions to their fidelity account and pick their investment: Fidelity Freedom Index 2060 fund (ticker symbol: FDKLX).
In the next lesson, you will learn about what type of investment account people usually open. In the final lesson, there will be a link to a video walkthrough showing how to open an account and actually invest your money.
Three-fund portfolio
Sometimes, target date index funds are not offered in a brokerage. Some workplace 401k plans don’t have access to them. In that case, people usually opt for doing a three-fund portfolio. It’s a little more work than a target date index fund since you have to handle the rebalancing yourself but still relatively simple.
Sometimes people don’t have access to a target date index fund at their brokerage or in their 401k plan. Or maybe they just don’t want to use a target date index fund. Whatever the reason, a three-fund portfolio is another common method for picking investments inside your 401k or IRA.
A three-fund portfolio typically uses a U.S. total market index fund, international total market index fund, and a bond index fund.
A three-fund portfolio at Fidelity could look like this:
- Fidelity ZERO Total Market Index Fund (FZROX)
- Fidelity ZERO International Index Fund (FXNAX)
- Fidelity U.S. Bond Index Fund (FXNAX)
Recap
When people invest, their investment portfolio is usually a mix of stocks and bonds. There are two common approaches to investing in stocks and bonds.
Target date index fund or doing a three-fund portfolio (U.S. stock, International stock, U.S. bond)