Bonds. At their most basic, bonds are loans. When you buy a bond, you become a lender to an institution, and that institution pays you interest. As long as the institution does not go bankrupt, it will also pay back the principal on the bond, but no more than the principal.
There are two basic types of bonds: government bonds and corporate bonds. U.S. government bonds (otherwise known as T-bills or Treasurys) are issued and guaranteed by Uncle Sam. They typically offer a modest return with low risk. Corporate bonds are issued by companies and carry a higher degree of risk (should the company default) as well as return.
Bond investors must also consider interest rate risk. When prevailing interest rates rise, the market value of existing bonds tends to fall. (The opposite is also true.) The only way to alleviate interest rate risk is by holding the bond to maturity. Investing in corporate bonds also tends to require just as much homework as stock investing, yet bonds generally have lower returns.
Given their lower risk, there is certainly a place for bonds or bond mutual funds in most portfolios, but their relative safety comes with the price of lower expected returns compared with stocks over the long term.
Real estate. Most people's homes are indeed their largest investments. We all have to live somewhere, and a happy side effect is that real estate tends to appreciate in value over time. But if you are going to use real estate as a true investment vehicle by buying a second home, a piece of land or a rental property, it's important to keep the following in mind.
First, real estate can and does sometimes decline in value. Second, real-estate taxes will constantly eat into returns. Third, real-estate owners must worry about physically maintaining their properties or must pay someone else to do it. Likewise, they often must deal with tenants and collect rents. Finally, real estate is rather illiquid and takes time to sell -- a potential problem if you need your money back quickly.
Some people do nothing but invest their savings in real estate and do quite well. But just as stock investing requires effort, so does real-estate investing.
Bank savings accounts. The problem with bank savings accounts and certificates of deposit is that they offer very low returns. The upside is that there is essentially zero risk in these investment vehicles, and your principal is protected. These types of accounts are fine as rainy-day funds -- a place to park money for short-term spending needs or for an emergency. But they really should not be viewed as long-term investment vehicles.
The low returns of these investments are a problem because of inflation. For instance, if you get a 3% return on a savings account, but inflation is also dropping the buying power of your dollar by 3% a year, you really aren't making any money. Your real return (return adjusted for inflation) is zero, meaning that your money is not really working for you.
The bottom line
Though investing in stocks may indeed require more work and carry a higher degree of risk compared with other investment opportunities, you cannot ignore the higher potential return that stocks provide. And as we will show in the next lesson, given enough time, a slightly higher return on your investments can lead to dramatically larger dollar sums for whatever your financial goals in life may be.
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