Ask Carrie by Carrie Schwab Pomerantz

For me, September always evokes the pleasures (and some pains) of going back to school. I thought I'd start this academic year by doing a little educating of my own: investing fundamentals.

Part I will cover the basics of why we invest and what we invest in. Part II will discuss the "how": the basics of portfolio management, including asset allocation and diversification, along with measuring your progress, making adjustments, and dealing with volatility — the need to keep emotions out of investing is harder than it sounds.

If you're just starting to invest, this should give you a foundation for future learning and the confidence to begin. If you're an old hand, I hope this material will inspire you to spend some time with your financial plan and portfolio. And, of course, the fact that we're in the midst of a particularly turbulent market makes sticking to the fundamentals even more important for every investor.

WHY DO WE INVEST?

We invest to build wealth for our future. Note the essential difference between investing and saving. Saving is what we do by making sure we're spending less than we earn; it's what powers our ability to invest.

Two other points before I delve into the basics of investing: First, understand that investing goes hand in hand with risk. In order to tap the potential of a meaningful return, you must put your money at risk to some degree (different people will take different chances). Second, when you invest money for long-term goals, you're going to give up some access to your money. With liquid investments like stocks and funds, you can always sell your stake if you need cash; however, if you need cash when the markets are down, you may have to sell at a loss — not good!

You should consider establishing an emergency fund, several months' worth of living expenses, before you start pouring a large amount of money into an investment program. Note: As I've written before, if you can participate in a 401(k) with a match offered by your employer, always do that first; it's too valuable an opportunity to pass up. Then build your emergency fund, followed by investing.

WHAT DO WE INVEST IN?

People invest in all kinds of items, such as businesses and real estate, but for most people, investing means buying financial instruments with the potential to generate income and/or grow. That typically means fixed income securities like bonds and equity securities like stocks. Bonds are debt instruments issued by companies and government entities both in the United States and overseas. They generally pay a fixed rate of income called the "coupon" rate; however, because they are actively traded, the prices of the bonds themselves vary according to market conditions. Equity refers to actual ownership: A share of stock represents a tiny sliver of the company itself. Typically, people purchase bonds to generate income and stocks for their growth potential (though that is by no means the only reason).

However, many investors don't buy bonds or stocks individually.

Instead, they buy mutual funds, which pool investor money in order to create a portfolio. Mutual funds come in many varieties — index funds that cover a particular market like the S&P 500 Index, or a market sector that focuses funds on specific segments of the markets, the economy or regions of the world. Index funds are said to be "unmanaged," which means the goal is to replicate the performance of a market or sector, not try to pick the best securities within that market segment. For that approach, investors often turn to actively managed funds that strive to outperform a particular market or sector by picking winners.

Both index and actively managed funds can pursue a number of objectives such as capital appreciation, dividend income and growth. Some investors prefer using exchange-traded funds (ETFs) to build their portfolio; ETFs function similar to mutual funds. They invest in the securities of a particular index or sector, but trade like stocks. There are literally thousands of fund investment possibilities.

There are two big advantages to beginning with funds instead of individual stocks or bonds:

First, many funds are highly diversified, and variation is critical to the construction of your portfolio. What's diversification? You know that old adage: "Don't keep all your eggs in one basket." Well, mutual funds represent many eggs and lots of baskets. If you own a few highly diversified mutual funds, you'll be exposed to probably hundreds of different securities. That's generally considered good because it means that one bad stock, or even one poor sector, won't necessarily drag your portfolio down.

Second, mutual funds are usually an inexpensive way to get started. Many mutual funds are "no load," meaning they impose no sales charge or commission; instead, they make money by charging a management fee. A fixed income or index fund might charge a fraction of a percent, while an actively managed fund focused on emerging markets might cost up to 2 percent (reflecting the higher costs associated with running such a fund). These are reasonable costs, but remember that you're paying these fees — if you can save on them, do so. Say, for example, you locate two growth funds that appeal to you. You might use management fees to determine which fund to buy. Saving 0.75 percent per year can add up to a lot of wealth over a lifetime.

If I sound like a cheerleader for mutual funds, that's OK with me. The fact is that mutual funds offer an easy, cost-effective way to gain exposure to the financial markets. Individual stocks may be more interesting to talk about with your friends, or you could ultimately decide to invest in stocks as your portfolio develops and you become more comfortable in the financial markets; however, it takes a lot of capital to achieve the right level of diversification as well as more effort to keep up-to-date with your portfolio. If you're a beginner, consider sticking with funds —you have a world of opportunity in which to choose.

Still that leaves the big question: If there are thousands of funds to pick from, which ones do you buy? To answer that question requires some different knowledge, and I'll address that in part II.

Carrie Schwab Pomerantz is Chief Strategist, Consumer Education, Charles Schwab & Co., Inc., Member SIPC. You can e-mail Carrie at askcarrie@schwab.com. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.

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