Personal Finance is not normally taught in high school and college so you can understand why so many people struggle with this subject. I have 2 college aged sons that will be graduating soon so I am creating a number of posts that will prepare them for the real world. If you ever wondered how stocks and bonds work, read on.
Normally you will see stocks classified by market capitalization and industry.
Market capitalization (commonly referred to as “market cap”) is how much a company is worth. In other words, it is the number of shares of stock outstanding multiplied by the current stock price for a specific company. When looking for stocks, you will see 3 types of market capitalizations:
- Small cap — Companies worth less than $2 billion
- Mid cap — Companies worth between $2 billion and $10 billion
- Large cap — Companies worth more than $10 billion
Industry categorization refers to what type of industry the company is in. For example, companies may be in utilities, healthcare, energy, telecom, technology, etc.
Finally, stocks may be domestic or international. Sometimes, domestic stocks do better than international funds (think about the financial issues in Greece), but sometimes international funds fare better than domestic ones.
Normally you will see bonds classified by bond type and credit rating.
Bond types refer to different segments of bonds. For example, companies issue corporate bonds while governments issue treasury and municipal bonds. Additionally, you will see agency bonds, high yield bonds, and foreign bonds.
Credit rating reflects how credit worthy the issuer of the bond is. It is similar to grades we received in school (A, B, C, and D), with A being the best (meaning the least risky). Within each grade (A for example), you can have varying levels of credit worthiness (A-, A, A+, AA-, AA, AA+, AAA), with AAA being the most credit worthy available. When looking at bonds, here is a general guideline of riskiness:
- A- through AAA — Not very risky.
- B- through BBB — Medium risk.
- C- through CCC — High risk.
- D through DDD — Very high risk.
When investing, it’s a good idea to diversify your portfolio. In other words, if you put all your money in a single stock like Exxon, what happens if the company has a major oil spill and the company goes belly up. You guessed it, you would lose all your money.
In that example, let’s say you diversified but within the same industry (let’s say you put money in Exxon, Texaco, and Chevron). If an oil crisis happens, you will probably lose money in all 3 of these stocks because they are in the same industry.
Similarly, when investing in bonds, you may not want to buy only government bonds because there may be times when the government defaults on bonds or money for them dries up. So like stocks, it is a good idea to diversify your holdings among different classifications.
Now that you have a good understanding of classifications, you probably figured out that it’s a good idea to diversify your stocks and bonds in different categories so that you spread out your risk. If that’s what you’re thinking, you’re right!
However, figuring all of this out and buying enough different stocks and bonds can be a maintenance headache. Luckily, there’s a solution. It’s called mutual funds and bond funds.
A mutual fund is comprised of lots of different stocks and they may be in different industries and market capitalization. So rather than buy a lot of different stocks, you can simply purchase two or three mutual funds and be fully diversified. You can even purchase stocks that are comprised of the S&P 500 (giving you a really well-diversified investment).
Similarly, you can purchase bond funds that invest in different types of bonds with different credit ratings and this provides the diversification you seek.
Now that you have an understanding of stock and bond classifications, let’s get to the bottom line. Once you start your career, set aside money for savings and have that money automatically deducted from your paycheck. Start with 15% of your paycheck, more if you can swing it.
Open up a Fidelity account and begin contributing money to a few mutual funds. If you want to really diversify, I suggest these 4 funds to invest equal amounts in:
- FUSVX — A mutual fund that invests in S&P 500 stocks
- FSEVX — A mutual fund that invests in small and mid cap stocks
- FSITX — A bond fund that invests in credit worthy bonds (note: if you are young and have 30 or more years before you retire, you may consider delaying the purchase of bonds for a while since you will not care as much about market fluctuations).
- FSIVX — A mutual fund that invests in international stocks (like those in Europe).
Finally, track your budget and investments with an online tool. Personal Capital is an excellent tool for this and best of all, it’s free**. This is a great start to financial independence!
** Note: I have no affiliation with Fidelity nor do I get any compensation, I am just more familiar with their services than other investment companies so that is why I recommend them in this article. I am an affiliate for Personal Capital, it is a totally free and superior way to keep watch over your investments. I would never recommend anything that I don’t personally use and completely believe in, so give it a try.
Steve and his wife built a software company, sold it and retired early. Steve enjoys blogging about lifestyle freedom, financial independence, and technology. If you like this blog, subscribe here to get an email each time he posts.
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