The first steps of becoming a competent investor involve a lot of learning. Beginners should spend time on reading theory and of course it is best to begin with the basics. This introductory section will explain the basics of securities and investing. More detailed and in-depth sections that are meant for both beginning as well as experienced investors will follow.

1.0 Introduction: Investing

When people earn money, they can either spend it right away or save it for later.
Saving is basically storing money safely, for example in a bank, for future expenses or emergencies. Typically, you earn a low, fixed rate of return and can withdraw your money easily. Investing, on the other hand, is taking a risk with a portion of your savings, such as by buying stocks or bonds, in the hope of realising higher long-term returns. Unlike bank savings, stocks and bonds have returned enough to outpace inflation over the long term, but there is the risk that they decline in value from time to time.

How Saving and Investing Differ

1.1 Investment types

If you're like most investors, your portfolio includes the three primary asset classes: cash investments, bonds, and stocks. Certain investors also have part of their investment capital invested in real estate and/or other specific items such as stamps, antiques or paintings. Where one invests into generally depends on personal preferences as well as market influences.

Cash Investments
These are short-term debt instruments that one can convert into cash easily, with little or no cost or penalty. Examples are, bank checking accounts, certificates of deposit (CDs), and Treasury bills (T-bills). They generally remain stable in price and return a modest amount of interest. Because cash investments are viewed as safe, the interest rates they pay are low. Research shows that 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
Bonds are debt securities issued by corporations or governments in exchange for money they borrow. 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. Bonds are often referred to as "fixed-income" investments. 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 than cash investments.

Shares
Shares represent part ownership, or equity, in a public corporation. If the company does well, you as a shareholder share in its profits (usually in the form of dividends) and benefit from any rise in the market value of its share. However, if a company runs into problems, the value of the investment could decline. Because prices sometimes fluctuate suddenly and sharply, shares are considered more risky than bonds or cash investments. Over time, however, shares have offered the highest returns of the three asset classes.

1.2 Risks of Investments

As you develop your investment strategy, it's important to consider the risks and rewards associated with different types of investments. The key element in any investment strategy is the trade-off between risk and reward: what is there to lose? Simply put, to seek higher investment return, you must be willing to accept greater risk. If you wish to minimise risk, you must be willing to accept lower returns.

Of the three primary asset classes, cash investments typically pose the least risk, followed by bonds with a slightly higher risk; stocks pose the greatest risk. But cash investments on the other hand offer the least rewards, and stocks have the potential for the greatest return. This is the most important reason 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 ought to 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 portfolio. As an investor you run amongst others the following risks:

Principal Risk.
The possibility that an investment will go down in value.

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

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 returns. If one’s stock value goes for example up with 5% one should take into account the inflation percentage as well.

Country Risk.
The possibility that political events (e.g. national elections), financial problems (e.g. rising inflation), or disasters (such as an earthquake) will weaken a country's economy and cause investments in that country to decline.

Interest Risk.
The possibility that a bond investment will decline in value because of an increase in interest rates, which are directly linked.

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.

Currency Risk.
The possibility that returns could be reduced for investing in foreign securities because of a decline in the value of foreign currency (exchange-rate risk); fortunately, because of the Euro this is no longer a risk in most European countries.

1.3 Diversification

You can spread your risk across numerous financial investments, i.e. creating a portfolio and diversifying your investments. In case you have a poor return from any investment the impact will be much less if you have a portfolio of ten instead of two investments.

Diversification works as follows:

The prices of stocks, bonds, and other investments usually do not rise and fall all at once. When one type of investment is rising, another may be declining.
By investing in two or more types of securities, therefore, you increase the possibility that when something you own is doing poorly, something else you own will be doing relatively well.
Therefore, your portfolio's overall performance is likely to be less volatile (less price fluctuation) than a portfolio invested in just one security or one type of security.

Forms of Diversification

You can spread your risk by investing in:

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

Various types of investments within the primary asset classes, which perform well under differing economic conditions. For example IT companies may follow a different pattern than financial institutions.

Worldwide securities, i.e. mitigating the country risk.

Mutual funds, rather than individual securities. Funds pool your money with that of many other investors to buy many securities.

Please note that diversification won't eliminate market risk—the possibility that stock or bond prices overall will decline over short or longer periods.

Asset Allocation

Investing also means gathering some information about yourself. What kind of investor would you be; what would be your goals? How do you feel about risk and the possibility of losing your investment? You have to be very honest to yourself, because there are substantial risks involved with many types of investment.

Your asset allocation is first of all based on your risk attitude. One’s risk attitude depends mainly on four factors, which are discussed below:
Investment goal;
Time horizon;
Financial resources;
Risk tolerance.

Investment Goal

The first step in diversifying is in figuring your asset allocation by determining your investment goal. Certain common investment goals could be:

To increase your money reserves in case of upcoming expenses or emergencies;
To build up the capital requirement for a comfortable retirement;
To buy goods.

If you have more than one goal in mind, you might even want to allocate assets to a separate portfolio for each. Goals help you focus on why you're investing, help keep you on the right track when market volatility tempts you to change your investment strategy.

Time Horizon

Your time horizon is the number of years you have available to invest. It includes the time until you reach your goal, as well as the period, when you make withdrawals from your investment.

It is important to note that:

The longer the time your time horizon, the more aggressively you can consider investing, because over time you have the possibility to undo market down trends, if any.
As you approach your goal, your portfolio has less time to recover from market down trends. Therefore, it may be wise to gradually shift to a more conservative asset allocation.

Financial Resources

Your financial resources strongly influence your asset allocation decision. If you are not in good financial position, you might be unable to take much risk with your investments. On the other hand, if your personal finances are in a good shape, you might be able to tolerate the price fluctuations that will occur in a higher-risk portfolio.

When figuring your asset allocation, therefore, carefully consider the following:

How stable is your job?
Is your current income adequate to pay your bills?
Do you have savings set aside for emergencies or unexpected expenses?
Do you anticipate any large cash expenditures in the near future, such as for a wedding or for your kids?

Risk Tolerance

Your risk tolerance is your willingness to endure declines in the value of your investments while you wait for them to return a profit. Some investors find it easy to ignore market fluctuations and to focus on their long-term investing goals. Others become rather anxious when their portfolio declines in value by even a small percentage.

1.4 Gathering Information

All investing should start with gathering information, and in many respects information is the most important factor in the whole process. There are so many different types of investment possibilities out there: some might be just right for you, where others could be completely unsuitable.
Before buying any shares, it is crucial that the investor learns about the factors that will influence the performance of these shares. Good information can be found from many sources and from many different media such as financial newspapers, television, the internet, etc.
You have to research the companies that you are interested in: what do they do, how do they do it, are they any good, are they making money, will they make money in the future?

1.5 Some Useful Tips

Before continuing with the more in depth theory, here are some useful practical tips to keep in mind when making your investments.

Get informed.
Make sure you know the background of any investment opportunity you are considering.

Stay informed.
Once you have put money in a particular investment, make sure you stay on top of any developments.

Be wary of tips.
Different people have different goals, and different insights into the market. You will have to trust your own research and analysis in a company before even considering putting your hard earned money on a tip.

Get rid of losers and keep the winners.
All to often investors take profits by selling their investments that are appreciating but hold onto stocks that are declining, hoping for a rebound. Why would you sell a good investment and keep a bad one?

This article may not be reproduced, in whole or in part by any means without express permission,
© 1999-2001 www.thesharetrader.co.uk
© 1999-2001 www.sharegames.co.uk