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Investing Basics

Resources: Investing Basics: Types of Investments

Investments are vehicles that can help you reach your financial goals. Each one is different, reacts to the markets in different ways and has its own special characteristics. Our approach to investing is not to own just one type of investment. Indeed, we believe prudent investors should not limit themselves to just one category of investments (stocks, for example), but rather should hold a diversified portfolio comprised of different types of investments. That diversification, combined with the inherent price relationships between the various investments, can help reduce risk and provide a better chance of portfolio growth over time.

What are stocks?

Stocks represent ownership in a company. If you own one or more shares of a company's stock, you own part of the company. (This is also referred to as equity; thus stocks are also referred to as equities.) The number of shares you own, in proportion to the total number that have been issued, determines the percentage of the company you own. By owning stock, you can potentially earn:

  • Dividends (distributions of the company's earnings), if they are issued;
  • Capital appreciation, if the price of your shares is higher at the time you sell them than when you bought them.

Owning common stock also gives you the right to vote as a partial owner of a company.

Stocks are broken into three basic categories of market capitalization, which is basically the market's estimate of the company's value. The three most commonly used ways to describe a stock's capitalization—or size—classification are:

  • Large-cap stocks. Typically represent companies with over $5 billion in outstanding market value. This classification often includes large, well-established companies.
  • Mid-cap stocks. Represent companies with $1 billion to $5 billion in market capitalization.
  • Small-cap stocks. Represent companies with less than $1 billion in market capitalization. Often these are less well-established than their larger counterparts, but may be faster-growing companies.

Value and growth stocks are determined by a company's financial situation, price performance and future prospects.

  • Growth stocks have faster-than-average earnings gains that are expected to continue for the near-term. They are generally considered to have more risk than value stocks since they tend to have higher price-earnings ratios. They often reinvest profits and pay little or no dividends.
  • Value stocks represent companies with lower price-to-earnings ratios and relatively high dividend yields. They may be low-growth, out-of-favor companies in cyclical or mature industries or blue chip companies with long records of stable earnings and dividends.

Historically, stocks have offered the best opportunity for long-term price growth compared to the returns of bonds and cash. Stocks generally also fluctuate in price more than bonds. All stocks may be subject to risk, including price volatility.

If you hesitate to invest in individual stocks, a good alternative may be investing in equity mutual funds.

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What are bonds?

Bonds are interest-bearing obligations through which the issuer agrees to pay the bondholder interest at fixed periods, and repay the amount borrowed (principal) at the end of the loan period (maturity). Bonds have been a favorite investment for people who want a regular income, since many bonds pay a fixed interest rate on a specified time schedule.

Corporations, governments (federal, state, municipal) and their agencies issue bonds to raise money. When you purchase a bond, you're lending money to the bond issuer.

Bonds' interest rates vary, depending on the reliability of the bond issuer and how risky the investment is considered to be. For example, U.S. government bonds offer generally lower interest rates, since they carry less risk. Bonds issued by corporations are considered riskier, and so typically offer higher interest rates. The highest risk bonds and those paying the highest interest rates are commonly referred to as "junk bonds" or "below investment grade" bonds.

Interest rates and bond prices have an "inverse relationship." When interest rates increase, for instance, bond prices typically decline. Investing in bonds involves certain types of risk. (You can learn more about them—as well as how to minimize them —in the article Types of Risk.)

If you're interested in bonds, but don't know how to do the research to select an appropriate bond to buy, a good choice could be investing in fixed income mutual funds (you'll learn more about these below, in the sections What are mutual funds? and What types of mutual funds exist?).

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What are cash equivalents?

Cash equivalents are short-term investments that typically offer a high degree of liquidity. These include U.S. Treasury bills (T-bills) and money market funds.

A T-bill is a short-term, discounted security issued by the U.S. government. The U.S. government guarantees to pay you a specific interest rate if you hold the T-bill to maturity. This is a specified future date, in this case one year or less, although securities considered cash equivalents most often mature in three months or less.

The drawback of short-term investments is that they often carry a low interest rate. While they're relatively safe places for cash—that is, they help preserve principal—they aren't likely to help you grow your money significantly over time compared to the potential growth of stocks and bonds.

A money market fund is a low-risk mutual fund that invests in short-term securities, such as T-bills. Money market funds allow you to withdraw money when you see fit, and many offer check-writing privileges. Money market funds are also subject to price fluctuations. An investment in a money market fund is neither insured nor guaranteed by the U.S. government, and there can be no assurance that a money market fund will be able to maintain a stable net asset value of $1.00 per share.

You'll learn more about money market funds and other mutual funds below.

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What are mutual funds?

A mutual fund is a collection of stocks, bonds or other securities. It is owned by a group of investors (shareholders) and managed by a professional money management team.

These funds are operated as an investment company, which raises money from its shareholders and then can invest in stocks, bonds, options, futures, and money market securities. This type of structure lets investors get the benefits of buying into a diversified portfolio managed by a professional investment team. This team conducts investment research and analysis, trades the securities, maintains records, completes necessary compliance functions and issues regular shareholder statements. To enable delivery of these services, a management fee and other administrative costs are charged to shareholders.

Funds come in a wide variety and can be classified according to their investment goal, management structure, types of investments held in the portfolio, or investment strategy followed. In addition, funds offer different types of share classes to various types of shareholders based on such variables as account size, time horizon, and whether they are institutions or individuals.

When you buy shares of a mutual fund, your money is pooled with that of other shareholders. Your pooled dollars are invested and managed by the fund manager.

Different mutual funds have different goals with varying degrees of risk and return. There are thousands of mutual funds, designed to help investors meet a wide range of personal investment goals.

Mutual funds have been popular investments for a variety of reasons, including:

  • The power of pooling
    Since a mutual fund pools money from a large number of investors, it has greater buying power than an individual investor. This allows the fund to invest in a wider range of securities more effectively than you might be able to afford on your own.
  • Diversification has benefits
    A typical mutual fund has a diverse portfolio of holdings in many different companies, market capitalizations and investment styles so it spreads your risk over many investments and investment classifications. Diversification helps to reduce the impact if one of the fund's investments performs poorly.

    Asset allocation/diversification does not guarantee a profit or protect against a loss.

  • Professional management
    Once you find a mutual fund that matches your goals, the professional fund management team does the daily and longer-term work of maintaining the strategy, executing trades, and filing the needed paperwork and recordkeeping. Professional fund managers monitor the fund's holdings and performance, using in-depth research and analysis to investigate new opportunities while pursuing the fund's goals.

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What types of mutual funds exist?

Mutual funds come in a wide variety of types, which generally include:

  • Equity funds
    Equity funds are pooled amounts of money invested primarily in stocks. They are often good choices for investors with a long-term investment horizon (those who plan to invest for five years or more) who are looking for capital growth. Equity funds vary in investment style and company size. For example, depending on your goals, you might invest in an aggressive small-cap growth fund or a conservative large-cap income fund.
  • Fixed-income funds
    Fixed-income funds are pooled amounts of money invested primarily in bonds. They are often good choices for people who want an income stream with lower risk (although risk levels and income distributions can vary greatly). Some funds invest in a variety of fixed-income investments; others specialize in areas such as conservative, investment-grade corporate bonds or high-risk junk bonds.

    Fixed-income investments are subject to interest rate risk, and their value will decline as interest rates rise.

  • Municipal funds
    Municipal funds are pooled amounts of money that invest primarily in obligations such as municipal bonds, which are issued by a state, city or local government to finance operations or special projects. While interest rates on municipal bonds are often lower than other types of bonds, investors may receive tax advantages for this type of holding.
  • Money market funds
    Money market funds are pooled amounts of money that invest in high-quality, short-term money market securities, such as T-bills and commercial paper.

    These funds seek to preserve the value of your investment at one dollar per share (with fluctuating interest rates), though it is possible to lose money by investing in them. But because they make short-term investments in large, creditworthy banks and corporations, they are considered the lowest-risk type of mutual funds; however, they also tend to have the lowest returns.

    An investment in a money market fund is neither insured nor guaranteed by the U.S. government, and there can be no assurance that a money market fund will be able to maintain a stable net asset value of $1.00 per share.

  • Balanced funds
    This type of fund seeks a growth-oriented, low-risk strategy by investing a near-equal percentage of the portfolio in stocks and bonds. Balanced funds historically have not fallen in value as steeply during declining (bear) markets, nor risen as far in advancing (bull) markets as equity or bond funds alone.
  • Asset allocation funds
    Since not all assets perform the same during particular market conditions, this strategy deploys assets into what the manager believes will be the best performing assets classes (stocks, bonds, cash equivalents) during the market cycle.
  • Sector funds
    Specialization has its role, and sector funds target a specific market segment (such as energy, technology, health care, precious metals) and devotes its research efforts to finding the best companies to invest in. Since not all sectors do well at any one time, this focused type of investment typically will have more up-and-down movement than more broad-based funds as markets advance over longer periods (5 years or more).

    Note: Funds investing in specific sectors may be subject to higher risks and price volatility.

  • Fund of funds
    A fund of funds is a type of fund management structure in which a manager invests in shares of other mutual funds to obtain a combination of an optimal mix of assets and better performing managers. The goal is to provide investors with the best opportunity for capital appreciation and diversification. Funds of funds are operationally distinct from a single fund that often invests in only a single asset class.
  • International and global funds
    International funds invest in non-U.S. stock and bonds markets. These types of funds have access to a wide range of companies and can offer broader portfolio diversification by investing in markets that behave differently from U.S. markets. These types of funds involve more risk, as they fluctuate in share price and returns in response to currency fluctuations and changing economic, social and political events that occur in the countries where investments are made. Global funds differ from international or foreign funds in that a certain percentage of their assets may be invested inside the U.S.

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How can I invest?

Mutual funds may be purchased directly from the fund company itself (if available), or through a licensed investment professional such as a broker (full service or discount), investment advisor, financial planner, or bank representative. Not all funds, however, are available through all these types of financial professionals.

Opening an account to purchase a fund is easy. A financial professional will provide you with the needed paperwork and will ask questions that will help determine investments that might be suitable for you, such as your investment experience, financial goals, beneficiaries and other information. Funds have a minimum investment amount, usually ranging from $1,000 to $5,000.

To learn more about our investments, visit our Fund Information section.

 

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To obtain a prospectus, download online or call Customer Service at 1.800.222.5852

While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that The Principal® is not rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements. For more information about our funds, including their full names, please see the Principal Funds, Inc. prospectus or call Customer Service at 1.800.222.5852.

A mutual fund's share price and investment return will vary with market conditions, and the principal value of an investment when you sell your shares may be more or less than the original cost.

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