Investing Basics
I am going to take a number of pages to talk about investing. This would be no substitute
for the thousands of pages to be found in the many good books on the subject.  All I can
do on these pages is to give you a limited overview of some of the key principles.  For me
to cover everything, I would need to write several books. I recommend that you increase
your knowledge by consulting some of the many good books written on the subject.
Streams Of Income
The best kind of income is the kind that doesn't require a lot of effort to maintain. Even a
brain surgeon is a working stiff because no matter how much he is making, he has to go to
work and operate every day to make money. Owning your own business doing something
you love is a great way to earn a living, but the amount of time and effort that you have to
put in is often way more than working for some one else. Financial freedom means you
don't have to work unless you want to and if you do work it's at something you love. What
are these types of income that you don't have to work for. One is residual income from
something you have created. You put in the effort at one time but now it generates income
with no further effort. The other is passive income from investments. This is when you put
money to work for you. This is the kind of income we will be looking at on this page.
Residual and Passive Income
Let's look at some examples of residual income. You invent something, write a song, write a
book, or perform in a TV show or commercial. You get royalties or in the case of the
commercials or TV reruns they are actually called residuals. If it's a successful effort, you
receive income long after you've done the work. Unfortunately, while many dream and spend
a lifetime trying to get that type of income, few succeed. That doesn't mean you
shouldn't try if it's something you love to do. But you better have a backup plan. Passive
income would be the type of income that you get from putting money to work for you. It's
called investing. Not everyone can be successful at creating something that will be
popular enough to generate a reliable stream of residual income. Anyone can succeed at
generating streams of passive income, once they know how. You just have to learn the
principles that apply and have the discipline to follow through.
Stocks And Bonds
I want to talk mostly about stocks on this page but bonds are important to a balanced
investment portfolio.  We discussed US government bonds on the previous page. Public
companies get money to expand in two ways. One they issue marketable bonds, which can
be bought and sold by anyone in the bond market. When you buy a corporate bond, you
are lending the company money. Two they issue stock, which can bought and sold in the
various stock markets. When you buy stock in a company, you actually become a part
owner of that company. Many other entities issue marketable bonds. States,cities, towns,
and other groups issue bonds to pay for particular projects. They don't issue stock. You
can lend them money but you can't own them. Bonds are rated by three different rating
companies. They can't be as safe as US government issued bonds but top rated bonds
are considered safe. They are generally considered safer than stocks but they do not
have the backing of the Us government like Federally insured savings or US government
bonds. I may discuss bonds further on future pages but for now I want to focus on stocks.
Market Risk
When you buy shares of stock in a company you are counting on that company to be
successful. Then the value of the company will grow and the price of your shares will
increase, so then when you sell them they will make money. Of course sometimes the
company doesn't do well and the price of your shares go down, so you lose money when
you sell. Sometime the company really does bad, even fails and you shares become
worthless. Even once good companies can make mistakes and lose value. Sometimes the
whole economy hits a bump and everything even the good stuff goes down. It sounds
pretty risky so why invest. Because with all the ups an downs in the stock market over the
years, the trend has always been up. Until the US Treasury issued Inflation adjusted
bonds, it was the only way to beat inflation. Read what I have written on the first money
page
"Financial Independence" how you might get 12% or better. The market has done
that over the long term historically but
honest financial people have to tell you that
past performance is no guarantee of future performance. In other words, history
may not repeat itself.
But the stock market for the US grows with the US economy. If you
believe in our country and it's future, you have to believe in the market.
Managing Risk
There are ways to manage risk. Should we always go for the lowest risk. No because high
risk gives the potential for high gain. Many start up companies fail but Microsoft was once a
start up company. What if you had gotten in on the ground floor Microsoft. You would be
very well off today. How do you know which start up companies will succeed? You don't but
if you bought shares a lot of different ones you would have a better chance of having some
winners. The profit from the winners could more than make up for the losers. It's called
diversification and is one way to manage risk. Stocks come in many flavors, small cap,
large cap, growth and growth and income to name a few. You can even invest in the
markets of other countries. Some market segments are less risky than others. A balanced
portfolio of many different stocks and different kinds of stocks along with some bonds can
manage risk. Most people don't have the money to buy all these different stocks and get
good diversification. The answer is mutual funds. We will discuss those on the next page.
Along with that we will also discuss another long term investing strategy, dollar cost
averaging.  
Controlling Expenses
You usually have to buy and sell shares of stock through a broker. For their services they
charge a commission both when you buy and when you sell. At one time, you had mostly
full service brokers with fairly high commissions. There is a temptation for a broker to get
you to trade excessively to generate higher commissions for themselves. It's called
churning. Most brokers are honest but beware of excessive trading. Now the
knowledgeable can trade on line with low commissions. We are going to be focusing on
long term investing, so we can hold trading to a minimum. We will be talking about
expenses associated with various mutual funds on the next page. There is a type of fund
called an index fund that has very low expenses. Expenses lower your return. If you invest
a $100 and ten goes for expenses, you've already lost 10% as you are only getting $90
worth of shares. Investment expenses cannot be eliminated entirely but you need to keep
them as low as possible to maximize your investment gain.
Minimizing Taxes
Another big drag on your investment return is taxes. The government wants to encourage
people to save for retirement, education and home ownership so they give tax breaks. For
home mortgages, your interest and real estate taxes are deductible. For education there
are various tax breaks. For example, you don't have to pay taxes on the interest from
savings bonds if they are used for education. For retirement you have the 401K to save
tax free at work, other programs for the self employed and individual retirement accounts,
the IRA for most everyone. The IRA now comes in two types, the regular and the Roth.  
Tax rules are complex and always changing. That is why you can't use last years tax form
to do this Years taxes. I will talk some more on this topic later and also recommend that you
seek out the many good books available for further study.
Market Terms
The stock market may seem very complicated. There are so many different terms used for
different types of stock. That is because companies  differ in so many ways. The different
terms group them according to shared characteristics. Let's look at some of these. Three
numbers that you hear every day on TV in relation to the market are the Dow, S&P and the
NASDAQ. These are three numbers that help you keep score. They tell you how the
market is doing. There are many others but these are the three most used in a brief
snapshot of market performance.
Market Indexes
Different types of investments have different risk levels. Fixed investments like high quality
bonds are considered safer than stocks. The stocks  of large well established companies
called large cap stocks are considered less risky than small cap growth stocks. These
different types of stocks are grouped to make it easier to track different parts of the
market. These groups are called indexes. The Standard & Poor' rating services publish a
number of indexes tracking different sectors of the market.
DOW
The word Dow stands for the Dow Jones Industrial Average. This is the oldest score
keeping number for the market. It follows the performance of thirty large-cap stocks.
Large-cap means large capital. These are companies that have assets worth a lot of
money or capital. They are often called blue-chip. They are the biggest most solid
companies and deserve should be part of any investment portfolio. Of course sometimes
once great large-cap companies falter. The DOW is not static. A company that ceases to
measure up to the DOW standard will be replaced by one that does.
S&P 500
S&P 500 stands for Standard & Poor's 500 stock index. An index is a grouping of stocks
with common characteristics. The S&P is a grouping of 500 large-cap companies. It is a
good market score card as it contains 500 of the largest most successful companies in the
US. These companies should be part of any good investment portfolio. This is the least
risky sector of the market to invest in. If a company  doesn't continue to measure up it will
be replaced on the S&P 500. The one drawback is that they generally lack the potential for
growth that newer smaller companies offer.
Stock Markets
Stock markets are places where stocks and bonds are traded. The biggest is the New York
stock exchange located on Wall Street in New York City. A lot smaller is the American stock
exchange, also in New York. There are also regional exchanges located in major US cities
as well as foreign exchanges around the world. These major markets have a specific
location and a trading floor. Finally there is the over the counter market of new and
growing companies listed on the NASDAQ. This is an automated system. These companies
have higher risk but if you pick the winners a higher potential for growth. The NASDAQ
index is the other most cited index to represent that sector of the market.
Stock Markets
On this page I've tried to give you a little overview of the stock market. It's the minimum of
what you need to know for the next money lesson on long term investing. You can never
learn too much and I have recommended some resources to help you do that. These
pages are only meant to give you an overview and hit some high points on the things you
need to know. The authors I suggest are far more expert than I and you should learn what
they have to teach you. I doubt that there will be much disagreement on the basic
principles but they will cover the subjects in much greater depth.
© 2005
Investing