Every builder starts with a foundation. If you are new to investing, you are building an investment portfolio, and you need to start with an investment foundation. That foundation consists of the basic investment principles.
Boiled down to its bare basics, investing concerns returns and risks.
An investor's return consists of current income, plus capital gains due to growth, minus any losses from the investment.
Return = current income + capital gains due to growth - any losses
Sounds simple, and it is, except that most investors would prefer to know the return before making the investment.
Absent a crystal ball, investors can only make an educated guess as to what kind of return to expect. If an investor's actual return turns out to be different than the return he expected, he could suffer an unexpected loss.
Of course, an investor's expected return must be reasonable. Expecting a return of 25% just because your stockbroker says that's what you'll earn is not reasonable. Most expectations are based on what happened in the past, and unfortunately history doesn't always repeat itself. On the other hand, there is little else to go on, and reasonable conclusions about future returns can be reached by looking at the past, tempered with the understanding that these returns aren't guaranteed.
Even if your expectations are reasonable, however, there is the possibility that your investment's actual return will be different than expected. This is the risk you must take on as an investor, and it includes the possibility of losing some or all of your original investment. Risk is greater when the possibility is greater that the actual return will differ from the expected return.
Put another way, the greater the uncertainty, the greater the risk.
What is uncertainty? The future is uncertain, and the longer you must wait for your return—or, the longer the time period over which you must make your educated guess as to return—the greater the uncertainty. In addition, the quality and stability of the investment is uncertain.
Investors can usually be more certain of their predictions on future returns for investments that have a greater income component because they will receive more of their return sooner rather than later. For instance, bonds that pay a fixed interest rate have more predictable returns than stocks, whose returns come primarily from capital gains.
However, this may be offset by uncertainty over the quality of the income payments—whether they will continue to be paid and how certain it is that they will continue at the expected level. A bond backed by the full faith of the U.S. government is more certain to meet its interest payments and pay back principal than a bond backed by a corporation that may or may not suffer financial difficulties.
Continue to Step 2 »
