Why Invest Now?

The terms saving and investing are often used interchangeably, but they are quite different.

Saving is storing money safely—such as in a bank or money market account—for short-term needs such as upcoming expenses or emergencies. Typically, you earn a low, fixed rate of return and can withdraw your money easily.

Investing is taking a risk with a portion of your savings—such as by buying stocks or bonds—in hopes of realizing higher long-term returns. Unlike bank savings, stocks and bonds over the long term have returned enough to outpace inflation, but they also decline in value from time to time.

How Saving and Investing Differ:

Inflation

Inflation—the rise in the price of goods and services—can steadily erode the purchasing power of your income. That's why it's important to invest a portion of your savings.

No one can predict the direction of inflation rates, which could decline or return to the double-digit rates of the late 1970s and early 1980s. Even if inflation holds steady at 3.5 percent per year for 20 years, consumer prices will nearly double.
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Your Investment Options

If you're like most investors, your portfolio includes the three primary asset classes: cash investments, bonds and stocks.

Cash Investments

•  What They Are
These are short-term debt instruments, or IOUs, that you can convert into cash easily, with little or no cost or penalty. Examples are money market mutual funds, bank checking accounts, certificates of deposit (CDs), and Treasury bills (T-bills).

•  How They Work
They generally remain stable in price and return a modest amount of interest. (Bank checking accounts, CDs and T-bills are government-insured. Money market funds are neither insured nor guaranteed; while they seek to maintain a $1 per share price, there's no assurance that they will do so.)

•  What to Consider
Because cash investments are viewed as safe, the interest rates they pay are low, and over time their returns have only slightly exceeded the rate of inflation. Therefore, if you have a long-term time horizon, these investments should not be your primary choice.

Bonds

•  What They Are
Bonds are debt securities, or IOUs, issued by corporations or governments in exchange for money you lend them.

•  How They Work
In most instances, bond issuers agree to repay their loans by a specific date (the "maturity") and make regular interest payments (the "coupon") until that date. That's why bonds are often referred to as "fixed-income" investments.

•  What to Consider
The longer a bond's maturity, the more its price will be affected by changes in interest rates. Because of these price fluctuations, bonds are considered more risky than cash investments; over time, however, bonds have provided slightly higher returns—and a slightly better hedge against inflation—than cash investments.

Stocks

•  What They Are
Stocks represent part ownership, or equity, in a public corporation.

•  How They Work
If the company prospers, you as a stockholder share in its profits (usually in the form of dividends) and benefit from any rise in the market value of its stock. Conversely, if the company runs into problems, the value of your investment could decline.

•  What to Consider
Because their prices tend to fluctuate suddenly and sometimes sharply, stocks are considered more risky than bonds or cash investments. Over time, however, stocks have offered the highest returns of the three asset classes—as well as the best hedge against inflation.
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The Risks of Investing

For most investors, the concept of "risk" can be summed up in one question: "What's the chance that I'll lose money?" The key element in any investment strategy is the trade-off between risk and reward.

Simply put, to seek greater rewards—such as a higher investment return—you must be willing to accept greater risk. If you wish to minimize risk, you must be willing to accept lower returns. You can't eliminate all types of risk.

Of the three primary asset classes, a cash investment (e.g., money market accounts, certificates of deposit) typically pose the least risk, bonds a medium risk, and stocks the greatest risk. But cash investments offer the least rewards, and stocks have the potential for the greatest return. That's why it's so important to diversify your investments.

Your first impulse may be to protect the value of your savings by picking a relatively conservative investment, something that maintains a stable value and thus poses little short-term risk to your money. If you're investing for the long term, however, you should take more short-term risk of price fluctuations to reduce the long-term risk that inflation will erode the value of your savings.

This means that if you're investing for the long term, stocks—which historically have fared better than bonds or cash investments—should play a major role in your investment mix.

Following is a glossary of investment risks you will encounter:

•  Call risk - The possibility that falling interest rates will cause a bond issuer to redeem—or call—its high-yielding bond before the bond's maturity date.

•  Country risk - The possibility that political events (a war, national elections), financial problems (rising inflation, government default), or natural disasters (an earthquake, a poor harvest) will weaken a country's economy and cause investments in that country to decline.

•  Credit risk - The possibility that a bond issuer will fail to repay interest and principal in a timely manner. Also called default risk.

•  Currency risk - The possibility that returns could be reduced for Americans investing in foreign securities because of a rise in the value of the U.S. dollar against foreign currencies. Also called exchange-rate risk.

•  Income risk - The possibility that the dividends paid by a fixed-income investment, such as a bond, will decline as a result of falling overall interest rates.

•  Industry risk - The possibility that a group of stocks in a single industry will decline in price due to developments in that industry.

•  Inflation risk - The possibility that increases in the cost of living will reduce or eliminate an investment's real (inflation-adjusted) returns.

•  Interest-rate risk - The possibility that a bond investment will decline in value because of an increase in interest rates.

•  Manager risk - The possibility that an actively managed stock or bond fund's investment adviser will fail to execute the fund's investment strategy effectively and, as a result, the fund will fail to achieve its stated objective.

•  Market risk - The possibility that stock or bond prices overall will decline over short or even extended periods. Stock and bond markets tend to move in cycles, with periods when prices rise and other periods when prices fall.

•  Principal risk - The possibility that an investment will go down in value, or "lose money."

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Reducing Your Investment Risk

Whether you're new to investing or a sophisticated investor, you may want to use dollar-cost averaging, a basic strategy favored by many financial experts and the method most commonly used to contribute to retirement plans.

The approach takes advantage of Wall Street's only certainty: Bond and stock prices fluctuate. With dollar-cost averaging, you make the market's natural volatility work for you by lowering the average price you paid for your shares. All you do is invest equal amounts in a security at regular intervals.

Because the amount you invest remains constant, you are able to buy more shares when the price is low and fewer shares at a higher price. As a result, the average cost per share—and the amount you paid for the shares—will always be lower than the average market price of the shares. There's no magic to it—just simple arithmetic.

Dollar-cost averaging can help you:

•  Reduce your investment risk - The strategy prevents you from committing substantial assets at the wrong time. Suppose you have $10,000 to invest in the stock market. If you invest the entire amount at once, you risk a large loss. For example, if you had invested $10,000 at the start of 1973, it would have dwindled to $6,270 by year-end 1974—a 37 percent decline. You would then have waited two years for your investment to recover its original value.

•  Invest regularly - Many mutual fund companies offer an automatic program to investors at no charge. Often it's as easy as setting up regular transfers from your bank account or money market fund account. In addition to providing your investment program a measure of discipline, you'll protect yourself from your emotions—and the natural tendency to cease investing—in a weak market.

Dollar-cost averaging is especially appropriate for individual retirement accounts or other long-term investments—because the longer you maintain a regular investment program, the more likely you will be to buy shares at a wide variety of prices.

Keep in mind that dollar-cost averaging does not ensure you a profit or protect you against a loss in declining markets. You should also consider your ability to invest continuously through periods when the market is down.

Another way to minimize your risk is through diversification. Diversification spreads your risk across numerous financial investments, reducing the impact that poor returns from any one investment will have on your overall portfolio.

Diversification follows a simple logic:

•  The prices of stocks, bonds, real estate, precious metals and other investments often do not rise and fall in tandem. When one type of investment is declining, another may be on the rise.

•  By investing in two or more types of securities you increase the possibility that when something you own is doing poorly, something else you own will be doing well. Your winner's good performance can offset your loser's disappointing returns.

•  The end result: Your portfolio's overall performance is likely to be less volatile—that is, undergo less price fluctuation—than a portfolio invested in just one security or one type of security. Put another way, your well-diversified portfolio will minimize your risk while achieving a good rate of return.

You can spread your risk by investing in:

•  All three primary asset classes: cash investments, bonds and stocks. Some investors further diversify by holding real estate or precious metals.

•  Various types of investments within the primary asset classes, which perform well under differing economic conditions. (Examples are short-term bonds and intermediate-term bonds, or growth stocks and value stocks).

•  Both U.S. and foreign securities.

•  Mutual funds, rather than individual securities. Funds pool your money with that of many other investors to buy an array of securities within a single asset class or even across more than one asset class.

Keep in mind that diversification can't eliminate market risk (the possibility that stock or bond prices overall will decline over short or even extended periods). Remember, too, that when you diversify your portfolio it may decline less in down markets—but it will also rise less when markets are strong.
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Realistic Expectations for Investment Returns

Why Time Matters More Than Timing

While average annual returns indicate long-term performance, they mask the year-to-year price fluctuations (or volatility) of securities investments.

Volatility is the chief risk of investing in stocks. From 1926 through 1998, the stock market provided annual returns ranging from a low of –43.3 percent in 1931 to a high of 53.9 percent in 1933. (Bond prices generally fluctuate less than stock prices, and their volatility is offset by the income they provide. Cash investments seek stability of principal so their prices fluctuate little.)

Time greatly reduces—but certainly does not eliminate—the volatility in returns from stocks. Historically, as the holding period increases, the gap between the best and worst returns tends to narrow. In other words, the longer you hold an investment, the less impact unusually high and low returns will have on your total return.

When it comes time to invest your money, you may hesitate out of fear that your investment will lose value. You may wonder: Are stocks at an all-time high? Are bonds too expensive relative to other investment alternatives?

You may think that the way to avoid market losses and maximize gains is to use "market timing"—a strategy in which you try to buy before the market goes up and sell before it declines. Here's how market timers operate:

•  They wait until stock or bond prices seem to be at an appropriate level relative to various historical measures—or until an expert declares stocks or bonds to be a "good deal." Then they rush to make substantial investments all at once.

•  When prices reach high valuation levels, as measured by historical benchmarks or expert opinion, market timers rush to sell all at once.

Unfortunately, few investors can predict with any degree of accuracy when, and how much, the securities markets will rise and fall. (Even economists and other financial experts cannot accurately forecast market movements consistently.) As a result, many investors jump into the market after a sustained rally, or they panic and sell at a loss when prices fall.

What makes market timing even more difficult is that stock and bond market rallies tend to occur in spurts. Market timers are at high risk of missing those rallies. For example, according to a study conducted at the University of Michigan , 95 percent of the market gains between 1963 and 1993 stemmed from the best 1.2 percent of trading days. The implication is clear: Over time, being out of the market even briefly can significantly diminish an investor's returns.

You may not be able to predict how your investments will perform, but you can gauge how much of a bite costs will take out of your bottom-line returns. When you invest in a mutual fund, high sales commissions, excessive operating expenses and other fees can significantly erode your investment assets.
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