From my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see the index page to my full summary.
“While ignorance may be bliss, as the English poet Thomas Gray once wrote, it is not profitable.”
Basic Point Two – Focus on Four Investment Categories
In this section of his book, Malkiel overview the four types of investments to consider (he does not include insurance, which he says should only be used for protection, or collectables included gold):
- Cash – this includes checking accounts and other short term securities that can be turned into cash on short notice and with no risk of loss on principle. This includes short term Treasury bills, short term CDs that can be made to cash without penalty, money market mutual funds. “Every investor needs a cash reserve to meet the various emergencies of life…” More in Rule 3 on how to build this cash reserve.
- Bonds – A long-term IOU from government, industry. Owning bonds make you a creditor of the company. They yield a specific rate of interest. If interest rates rise, bond prices fall. Some bonds are sold at discount and yield their face value at maturity (called zero coupon bonds). Bonds are fixed income investments. High quality bonds are good for retirees. Types of bonds:
- U.S. Treasury
- Ginny Mae (Gov’t National Mortgage Association)
- Sally Mae (Student Loan Marking Association)
- Municipal (including state and local gov’t)
- Corporate. Varying quality. Riskier than other bonds so they offer a greater return to attract buyers. Junk bonds are high yielding but the riskiest.
- Common stocks – Owning stock makes you part owner of a company.
- You can make greater yields if the company does well; but greater risk if not. There is no specific promise of return as in bonds.
- However, over the long haul, stocks have done well. (average yield is 8-9%/year vs 5-6%/year for high quality bonds).
- “Bull” (gaining) markets dominate the long history of the stock market. But “bear (loosing) markets can go on for years. So your money in stocks needs to be for long-term objectives (e.g. retirement).
- He says the stock market is pretty efficient about pricing stocks over the long term. But once in a while the stock market goes “loony”. There can be a “herd mentality” where something starts doing well and then everyone wants a piece of the gain so that a particular stock or segment gets overvalued. Eventually, it will come back to reasonable values and those who bought at the end will lose much (e.g. internet, “dot.com” craze).
- He recommends a simple, low-risk, diversified strategy that will make money and keep us from making mistakes of following the herd. But it will take discipline when others boast of their short-term gains.
- Real estate – besides owning your own home, it can be profitable to invest in commercial real estate.
- Values of real estate typically rise (and thus the value of this investment) and you also get share in the income of the property.
- Like stock mutual funds, real estate investment trusts (REITs) allow you to share ownership in real estate with many others. There are differing REITs depending on the segment of property you are interested in. While they have only been around for 20 years, they look like a place to have some of your investment portfolio.
Next time: Understanding the Risk/Return Relationship
For more, see the index page to my full summary.