Stocks and bonds come in many flavors
You see each of the different types of stocks and bonds; and how they differ from each other.
STOCKSBONDSLarge-Cap – Large companies with a market capitalization (“market capitalization” defined as outstanding shares multiplied by share price) greater than $10 billion. Government – An ultra safe investment backed by the government. In exchange for their low risk, government bonds tend to yield less than stocks. Mid-Cap – Medium-sized companies with a market capitalization between $1 billion and $5 billion Corporate – A bond issued by a company. These are typically riskier than government bonds but safer than stocks. Small-Cap – Smaller companies with a market capitalization of less than $1 billion. Short Term – Bonds with maturities typically less than three years. International Investing – Stocks of companies in other countries, including emerging markets (like China and India) and developed markets (like the UK and Germany). Americans can sometimes buy these outright, but may have to buy them through funds. long term
These bonds typically mature in ten years or more and, as a result, offer higher yields than shorter-dated bonds. Growth – Stocks that can outperform other stocks or even the market as a whole. These are bonds issued by local governments Value – stocks that appear cheap (ie cheaper than they should be) Inflation Protected – Inflation Linked Government Bonds or TIPS are ultra safe investments that protect against inflation.
Note that REITs, “real estate investment trusts” — which are vehicles that allow you to invest in real estate through a single ticker symbol, just like a stock — don’t fall into either of these categories because of their complicated structure.
The importance of diversification
Now that we know the basics of the asset classes (stocks, bonds, and cash) at the bottom of the pyramid, let’s explore the different opportunities within each asset class. Basically, there are many types of stocks, and we need to own a little of each. The same applies to bonds. This is called “diversification,” and it essentially means learning about each asset class — stocks and bonds — and investing in all of its sub-categories.
As the table above shows, the broad category of “stocks” actually encompasses many different types of stocks, including large-cap stocks, mid-cap stocks, small-cap stocks, and international stocks. To add another wrinkle, none of them perform consistently. In the same year, small-cap stocks could gain huge percentages, but international stocks could plummet — and that performance can vary from year to year. Likewise, different types of bonds offer different benefits, including different yields and tax benefits. In his 2012 book Skating Where the Puck Was, William Bernstein says that you “should come to terms with the fact that diversification between risky assets plays a big part[s] little protection against bad days or bad years, but that it helps protect against bad decades and generations that can make prosperity far more destructive.”
Diversification is about long-term security.
key to take away
The fact that performance varies so much in each asset class means two things: First, when you’re trying to make money quickly investing, you’re usually losing money because you have no idea what’s going to happen in the near future. Anyone who tells you this is a fool or a commission based seller. Second, you should own different categories of stocks (and maybe bonds) to balance your portfolio. For example, you don’t want to own only US small-cap stocks or funds that only own small-cap stocks. If they didn’t perform well for ten years, that would really suck. However, if you own small-cap stocks plus large-cap stocks plus international stocks and more, you’re effectively insured against an area that’s dragging you down. So if you were to invest in stocks, you should diversify and buy all different types of stocks or stock funds to have a balanced portfolio.
To learn more about diversification, you can refer to Diversified Investment Portfolios: How to Build a Portfolio (+ Examples).
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