1. What’s the difference between stocks and bonds?
Stocks give you a share of a public company’s assets and earnings. The value of your shares goes up and down with the company’s financial well-being—and with shareholders’ perception of that company’s well-being. Read: They’re risky, but potentially rewarding.
Bonds are like loans given to an institution. When you buy bonds from a corporation, government or other entity, you’re lending money to be paid back with interest at a specified time. Read: They’re relatively safe as long as the entity stays in business. You can look at how a bond is rated before you buy one to see how risky it is. (“AAA” and “AA” indicate a high credit-quality investment grade.)
2. What are dividends?
Dividends are periodic payouts of earnings that companies may give to certain shareholders. Typically, they’re paid in cash or additional stock. For investors, they’re a good way to collect some income while still investing for higher returns. Note that dividends may be subject to taxes.
3. What’s the difference between passive and active funds?
Calling an investment fund “passive” or “active” refers to how it’s managed. Passive funds are run with a hands-off approach, and therefore generally come with low fees.
Index funds, for example, are set up to move in tandem with associated indices (like the S&P 500, which tracks 500 of the most widely held stocks on the Nasdaq and New York Stock Exchange) and mirror their returns. Actively-managed funds attempt to beat that benchmark by making a wider variety of investments.
4. What’s the difference between mutual funds and exchange-traded funds?
Because many ETFs track indices, and are therefore more passively run, they tend to charge lower fees. They’re also traded like common stocks at varying prices throughout the day. Conversely, shares of mutual funds are priced based on their net asset value (NAV) once at the end of the trading day.
5. What’s an expense ratio, and what’s a good one?
An expense ratio is how much it costs to run a fund, including fees paid for management, recordkeeping, custodial services and taxes. It’s calculated annually by dividing operating expenses by the average dollar value of the fund’s assets—lowering returns for investors, which is why it’s important to know.
“High fees will erode your profits and significantly impact your portfolio,” says Oklahoma-based Certified Financial Planner Shanda Sullivan. “Especially when you’re saving for retirement, you’re talking about 30 years to 50 years—that’s going to add up. And remember it’s not only the money you’re losing, but it’s also the potential earnings that money could be producing.”
She suggests sticking with funds that have expense ratios below 1 percent, and preferably below 0.5 percent, as well as steering clear of so-called “load” funds, which charge extra at the point of sale.
6. What’s diversification?
Diversification means spreading your investments across a variety of assets, including stocks and bonds, CDs and cash. For example, for your stock allocation, you want to invest in the U.S. and abroad; in large, medium and small companies; and in fast-growing businesses and more-established firms. Ideally, a well-diversified portfolio includes assets that will go up if others are down.
7. How does compounding work?
Put simply: Compound interest is when your interest earns interest—which helps your money grow at a faster rate than when “simple interest” (interest added only to the principal) is applied. Money invested in the stock market benefits from compounding, which is why it pays to start investing as early as possible.
This post was updated in July 2018.
March 9, 2016
March 9, 2016