Understanding investment terms and concepts

Below are summaries of some basic principles you should understand when evaluating an investment opportunity or making an investment decision. Rest assured, this is not rocket science. In fact, you'll see that the most important principle on which to base your investment education is simply good common sense. You've decided to start investing. If you've had little or no experience, you're probably apprehensive about how to begin. It's always wise to understand what you're investing in. The better you understand the information you receive, the more comfortable you will be with the course you've chosen.

DON'T BE INTIMIDATED BY JARGON

Don't worry if you can't understand the experts in the financial media right away. Much of what they say is jargon that is actually less complicated than it sounds. Don't hesitate to ask questions; when it comes to your money, the only dumb question is the one you don't ask. Don't wait to invest until you feel you know everything.

UNDERSTAND STOCKS AND BONDS

Almost every portfolio contains one or both of these kinds of assets.

If you buy stock in a company, you are literally buying a share of the company's earnings. You become an owner, or shareholder, of the company. As such, you take a stake in the company's future; you are said to have equity in the company. If the company prospers, there's no limit to how much your share can increase in value. If the company fails, you can lose every dollar of your investment.

If you buy bonds, you're lending money to the company (or governmental body) that issued the bonds. You become a creditor, not an owner, of the bond issuer. The bond is in effect the issuer's IOU. You can lose the amount of the loan (your investment) if the company or governmental body fails, but the risk of loss to creditors (bondholders) is generally less than the risk for owners (shareholders). This is because, to stay in business and continue to finance its growth, a company must maintain as good a credit rating as possible, so creditors will usually pay on time if there is any way at all to do so. In addition, the law favors a company's bondholders over its shareholders if it goes bankrupt.

Stocks are often referred to as equity investments, while bonds are considered debt instruments or income investments. A mutual fund may invest in stocks, bonds, or a combination.

Don't confuse investments such as mutual funds with savings vehicles such as a 401(k) or other retirement savings plans. A 401(k) isn't an investment itself but simply a container that holds investments and has special tax advantages; the same is true of an individual retirement account (IRA).

Note: Before investing in a mutual fund, carefully consider its investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing.

DON'T PUT ALL YOUR EGGS IN ONE BASKET

This is one of the most important of all investment principles, as well as the most familiar and sensible.

Consider including several different types of investments in your portfolio. Examples of investment types (sometimes called asset classes) include stocks, bonds, commodities such as oil, and precious metals. Cash also is considered an asset class, and includes not only currency but cash alternatives such as money market instruments (for example, very short-term loans). Individual asset classes are often further broken down according to more precise investment characteristics (e.g., stocks of small companies, stocks of large companies, bonds issued by corporations, or bonds issued by the U.S. Treasury).

Investment classes often rise and fall at different rates and times. Ideally, in a diversified portfolio of investments, if some are losing value during a particular period, others will be gaining value at the same time. The gainers may help offset the losers, which can help minimize the impact of loss from a single type of investment. The goal is to find the right balance of different assets for your portfolio given your investing goals, risk tolerance and time horizon. This process is called asset allocation.

Within each class you choose, consider diversifying further among several individual investment options within that class. For example, if you've decided to invest in the drug industry, investing in several companies rather than just one can reduce the impact your portfolio might suffer from problems with any single company. A mutual fund offers automatic diversification among many individual investments, and sometimes even among multiple asset classes. Diversification alone can't guarantee a profit or ensure against the possibility of loss, but it can help you manage the types and level of risk you take.

RECOGNIZE THE TRADEOFF BETWEEN AN INVESTMENT'S RISK AND RETURN

For present purposes, we define risk as the possibility that you might lose money, or that your investments will produce lower returns than expected. Return, of course, is your reward for making the investment. Return can be measured by an increase in the value of your initial investment principal, by cash payments directly to you during the life of the investment, or by a combination of the two.

There is a direct relationship between investment risk and return. The lowest-risk investments --for example, U.S. Treasury bills--typically offer the lowest return at any given time The highest-risk investments will generally offer the chance for the highest returns (e.g., stock in an Internet start-up company that may go from $12 per share to $150, then down to $3). A higher return is your potential reward for taking greater risk.

UNDERSTAND THE DIFFERENCE BETWEEN INVESTING FOR GROWTH AND INVESTING FOR INCOME

As you seek to increase your net worth, you face an immediate choice: Do you want growth in the value of your original investment over time, or is your goal to produce predictable, spendable current income--or a little of both?

Consistent with this investor choice, investments are frequently classified or marketed as either growth or income oriented. Bonds, for example, generally provide regular interest payments, but the value of your original investment will typically change less than an investment in, for example, a new software company, which will typically produce no immediate income. New companies generally reinvest any income in the business to make it grow. However, if a company is successful, the value of your stake in the company should likewise grow over time; this is known as capital appreciation.

There is no right or wrong answer to the "growth or income" question. Your decision should depend on your individual circumstances and needs (for example, your need, if any, for income today, or your need to accumulate retirement savings that you don't plan to tap for 15 years). Also, each type may have its own role to play in your portfolio, for different reasons.

UNDERSTAND THE POWER OF COMPOUNDING ON YOUR INVESTMENT RETURNS

Compounding occurs when you "let your money ride." When you reinvest your investment returns, you begin to earn a "return on the returns."

A simple example of compounding occurs when interest earned in one period becomes part of the investment itself during the next period, and earns interest in subsequent periods. In the early years of an investment, the benefit of compounding on overall return is not exciting. As the years go by, however, a "rolling snowball" effect kicks in, and compounding's long-term boost to the value of your investment becomes dramatic.

Saving for retirement and a child's education at the same time

You want to retire comfortably when the time comes. You also want to help your child go to college. So how do you juggle the two? The truth is, saving for your retirement and your child's education at the same time can be a challenge. But take heart--you may be able to reach both goals if you make some smart choices now.

KNOW WHAT YOUR FINANCIAL NEEDS ARE

The first step is to determine what your financial needs are for each goal. Answering the following questions can help you get started:

For retirement:

• How many years until you retire?
• Does your company offer an employer-sponsored retirement plan or a pension plan? Do you participate? If so, what's your balance? Can you estimate what your balance will be when you retire?
• How much do you expect to receive in Social Security benefits? (You can estimate this amount by using your Personal Earnings and Benefit Statement, now mailed every year by the Social Security Administration.)
• What standard of living do you hope to have in retirement? For example, do you want to travel extensively, or will you be happy to stay in one place and live more simply?
• Do you or your spouse expect to work part-time in retirement?

For college:

• How many years until your child start college?
• Will your child attend a public or private college? What's the expected cost?
• Do you have more than one child whom you'll be saving for?
• Does your child have any special academic, athletic, or artistic skills that could lead to a scholarship?
• Do you expect your child to qualify for financial aid?

Many on-line calculators are available to help you predict your retirement income needs and your child's college funding needs.

FIGURE OUT WHAT YOU CAN AFFORD TO PUT ASIDE EACH MONTH

After you know what your financial needs are, the next step is to determine what you can afford to put aside each month. To do so, you'll need to prepare a detailed family budget that lists all of your income and expenses. Keep in mind, though, that the amount you can afford may change from time to time as your circumstances change. Once you've come up with a dollar amount, you'll need to decide how to divvy up your funds.

RETIREMENT TAKES PRIORITY

Though college is certainly an important goal, you should probably focus on your retirement if you have limited funds. With generous corporate pensions mostly a thing of the past, the burden is primarily on you to fund your retirement. But if you wait until your child is in college to start saving, you'll miss out on years of tax-deferred growth and compounding of your money. Remember, your child can always attend college by taking out loans (or maybe even with scholarships), but there's no such thing as a retirement loan!

IF POSSIBLE, SAVE FOR YOUR RETIREMENT AND YOUR CHILD'S COLLEGE AT THE SAME TIME

Ideally, you'll want to try to pursue both goals at the same time. The more money you can squirrel away for college bills now, the less money you or your child will need to borrow later. Even if you can allocate only a small amount to your child's college fund, say $50 or $100 a month, you might be surprised at how much you can accumulate over many years. For example, if you saved $100 every month and earned 8 percent, you'd have $18,415 in your child's college fund after 10 years. (This example is for illustrative purposes only and does not represent a specific investment.)

If you're unsure how to allocate your funds between retirement and college, a professional financial planner may be able to help you. This person can also help you select the best investments for each goal. Remember, just because you're pursuing both goals at the same time doesn't necessarily mean that the same investments will be appropriate. Each goal should be treated independently.

HELP! I CAN'T MEET BOTH GOALS

If the numbers say that you can't afford to educate your child or retire with the lifestyle you expected, you'll have to make some sacrifices. Here are some things you can do:

• Defer retirement: The longer you work the more money you'll earn and the later you'll need to dip into your retirement savings.
• Work part-time during retirement.
• Reduce your standard of living now or in retirement: You might be able to adjust your spending habits now in order to have money later. Or, you may want to consider cutting back in retirement.
• Increase your earnings now: You might consider increasing your hours at your current job, finding another job with better pay, taking a second job, or having a previously stay-at-home spouse return to the workforce.
• Invest more aggressively: If you have several years until retirement or college, you might be able to earn more money by investing more aggressively (but remember that aggressive investments mean a greater risk of loss).
• Expect your child to contribute more money to college: Despite your best efforts, your child may need to take out student loans or work part-time to earn money for college.
• Send your child to a less expensive school: You may have dreamed your child would follow in your footsteps and attend an Ivy League school. However, unless your child is awarded a scholarship, you may need to lower your expectations. Don't feel guilty--a lesser-known liberal arts college or a state university may provide your child with a similar quality education at a far lower cost.
• Think of other creative ways to reduce education costs: Your child could attend a local college and live at home to save on room and board, enroll in an accelerated program to graduate in three years instead for four, take advantage of a cooperative education where paid internships alternate with course work, or defer college for a year or two and work to earn money for college.

CAN RETIREMENT ACCOUNTS BE USED TO SAVE FOR COLLEGE?

Yes. Should they be? Probably not, most financial planners discourage paying for college with funds from a retirement account; they also discourage using retirement funds for a child's college education if doing so will leave you with no funds in your retirement years. However, you can certainly tap your retirement accounts to help pay the college bills if you need to. With IRAs, you can withdraw money penalty free for college expenses, even if you're under age 59½ (though there may be income tax consequences for the money you withdraw). But with an employer-sponsored retirement plan like a 401(k) or 403(b), you'll generally pay a 10 percent penalty on any withdrawals made before you reach age 59½ (age 55 in some cases), even if the money is used for college expenses. You may also be subject to a six month suspension if you make a hardship withdrawal. There may be income tax consequences, as well. (Check with your plan administrator to see what withdrawal options are available to you in your employer-sponsored retirement plan.)

Some investors purchase silver or gold as a hedge against inflation or currency fluctuations.

In general, as inflation rises, the value of the dollar normally goes down. Historically, when a significant drop in the dollar occurred, gold and silver (and platinum to a lesser extent) went up in value. Precious metals such as gold had a tendency to retain their purchasing power no matter how badly the currency declined. Precious metals have intrinsic value, while currency can literally become worth less than the paper it is printed on, as was the case with the German mark after World War I. Keep in mind, though, that past performance is no guarantee of future results, and there can be no assurance that an investment will ever be profitable.

As with any other investment, risks are involved when investing in gold. These include certain risks uncommon to other types of investments, such as monetary policy changes and currency devaluations. Investors should discuss the risks of investing in gold with their financial professional.

Some options for investing in precious metals include actually purchasing the asset (i.e., gold bullion or coins), buying shares of mining companies, investing in a fund that concentrates its portfolio in the securities of issuers principally engaged in gold-related activities, buying futures or options contracts (see below) or investing in an exchange-traded fund that holds bullion.


OPTIONS

Options give the owner the right, but not the obligation, to buy or sell an underlying asset at a set price (strike price) before a certain date (expiration date). The underlying asset can be (to name some of the more popular ones) currency, a stock, an index, a bond, or a Treasury bill. A call option is the right to buy the underlying asset, and a put option is the right to sell the underlying asset. The price paid for the option is called the premium.

An investor purchases an option to control a specific number of shares for a limited period of time. An investor might purchase a call option because he or she believes that the price of the stock will go up during that period. Similarly, an investor might purchase a put option because he or she believes that the price will go down during that period. If the investor has guessed wrong, the option expires worthless and he or she could lose the total premium paid for the option.

An investor may sell an option for income on an underlying security that he or she owns. The income is the premium that an option buyer pays to purchase the option. If the underlying security moves in favor of the option buyer, the buyer may exercise the option, and the option seller may be required to sell the underlying security. If the underlying security moves in favor of the seller, the buyer normally will not exercise the option, and the seller keeps both the premium and the underlying asset.

These are just two strategies in which an investor uses options. Although there are many benefits in using them, options are risky and not suitable for all investors. For example, selling an option is done in a margin account, subjecting the seller to interest costs and margin calls. Before attempting to buy or sell options, it is important to discuss the role they can play in your portfolio with a financial professional.


FUTURES

A futures contract is a promise to buy or sell a commodity for a certain price on a future date. Commodities include oil, natural gas, lumber, and base metals, as well as many agricultural products such as farm grains, beef, pork. coffee, and cocoa. In addition to commodities, investors can trade futures on foreign currencies, interest rate products such as Treasury bills, precious metals, and market indexes such as the S&P 500.

Investors purchase futures contracts either as a hedge against price fluctuations or for speculation purposes. Hedging is the primary purpose of futures contracts. The purchaser of the futures contract establishes a price now for a purchase or sale that will take place in the future. Speculators buy and sell futures contracts based on whether they expect prices to move up or down; they hope to profit from the price changes that hedgers try to avoid, and rarely take delivery of the underlying commodity itself.

Futures contracts are extremely high-risk investments. They should be considered only by experienced investors and professionals.


REAL ESTATE INVESTMENT TRUSTS

A real estate investment trust (REIT) is a corporation (or business trust) that invests in real estate or provides financing for real estate. REITs own and, in most instances, manage income-producing real estate such as offices, shopping centers, apartments, and warehouses. REITs derive their income from rents and capital gains realized on the sale of real estate. Some REITs invest in mortgages secured by real estate and get their income from the collection of interest. A REIT may specialize in one type of real estate--for example, office buildings--or have holdings in a variety of types.

REITs offer a convenient way for an investor to participate in commercial real estate. First, an investor's capital commitment is lower, since the investor buys shares of a REIT rather than the actual property. Second, owning a REIT generally offers greater liquidity than owning the property itself. Most REITs trade on the major stock exchanges and can be purchased or sold through stockbrokers. Finally, you get professional property management, which means you don't have to chase after the rents or respond to late-night phone calls about maintenance problems.

REITs offer long-term growth potential and income. Also, investing in REITs helps diversify a portfolio, though diversification alone can't guarantee a profit or protect against potential loss. However, risks are associated with real estate investing. The value of real estate is affected by interest rate changes, economic conditions (both national and local), property tax rates, and other factors. It is important to discuss with a financial professional the role REITs can play in your portfolio.