Fundamental Concepts

These fundamental concepts will provide a foundation for understanding investments, markets, and investment strategies.

Supply and Demand

The value of an item depends not on what you paid for it, but on what someone else would be willing to pay for it today. What someone is willing to pay is related to supply and demand. For example, if there is a fixed supply of something, and the demand for it increases, then the price will increase. If demand for something remains constant, and there is an increase in supply, the price will decrease.

Yield, Total Return, and Compounding

For any asset, yield is the income earned (interest or dividends) divided by the price of the asset, such as a bond or a share of stock. Price and yield move in opposite directions.

• If a $100 bond earns 5 percent interest, it earns $5 on a $100 asset, or $5 divided by $100, which is a 5 percent yield. If the price of the bond increases to $105, the yield declines to $5 on a $105 asset, or 4.8 percent.

• If a share of stock is worth $50 and pays a $1 dividend per share, the yield is $1 divided by $50, or 2 percent. If a company increases its dividend, then the yield will also change. Raising the dividend to $1.10 results in a 2.2 percent yield.

Total return is the combination of yield and the change in valuation. Total return takes into account the income earned on an investment, such as interest or dividends, and any appreciation or depreciation in the value of the asset. If a stock earns a 2 percent dividend yield and appreciates 5 percent in a year, the total return is 7 percent.

Compounding means that there is growth on the growth. For example, an investment of $100 with appreciation of 7 percent will be worth $107 at the end of the first year. If the investment appreciates 7 percent again in the second year, the return would be 7 percent on $107, or $7.49.

Risk

In investing, risk is the variability, or volatility, of investment returns. Volatility is measured by the dispersion, or the standard deviation, of outcomes or returns. The standard deviation is how far an actual return might be from the average, or expected, return for a particular investment. Expected return is the average of past returns. With investments, the greater the standard deviation, the greater the risk.

The Sharpe Ratio is a measure of the relative riskiness of an investment portfolio, or fund. Developed by Nobel laureate William F. Sharpe, the ratio computes risk-adjusted returns. The higher the Sharpe Ratio, the better the risk-adjusted return for a portfolio.

Liquidity

Liquidity reflects how easily an asset can be sold, or converted to cash. For example, shares of a mutual fund are liquid, whereas an ownership stake in a small business is not.

Concentration and Diversification

The saying “Don’t put all your eggs in one basket” applies to investments, because concentration increases risk. Whether you invest your money yourself or work with a professional, never put all your assets in the same basket—or the same kind of stock, bond, or other investment.

In addition to avoiding concentration, diversification is key for improving investment results. Various asset classes, or types of investments, tend to perform differently under certain market conditions—some perform better and some perform worse depending on what is going on with the economy and financial markets.

Correlation

Correlation measures how things, such as investment returns, move in relation to each other. Some asset class returns are more correlated than others:

• If two investments have a correlation of 1.0, they are perfectly correlated. In this case, if one investment increases by 10 percent, then the other will also increase by 10 percent.
• If a correlation is negative 1.0, the investments move in the exact opposite directions. If one investment increases by 10 percent, then the other will decrease by 10 percent.

A low or negative correlation across investment holdings can reduce downside risk. In this case, the poor performance of one asset class is offset, to some degree, by the good performance of another asset class.

Fees

In the investment arena, fees are usually charged as a percentage of assets. They are often quoted in terms of basis points. A basis point is one-one-hundredth of 1 percent, or 0.01 percent. In other words, 100 basis points equals 1 percent, or 1.0 percent, and 50 basis points equals one-half of 1 percent, or 0.50 percent.

With a commission, the brokerage firm charges a fee for each transaction. A sales load is a one-time front-end or back-end fee that goes to the brokerage firm that is selling you a mutual fund. A front-end load is a reduction to the initial investment. Not all mutual funds have sales loads. Discount or online brokerage firms offer no-load funds. Fee-based advisers are paid an annual fee based on a percentage of assets under management.

Taxes and Tax Efficiency

As an investor, you need to consider the impact of taxes. For tax-deferred accounts, such as 401(k)s and 403(b)s, you do not pay taxes on the income or capital gains generated each year. Instead, you pay taxes when you withdraw money from the account. A college savings plan is an example of a tax-advantaged account. You fund it with after-tax dollars, but the income, appreciation, and withdrawals are tax free. For taxable accounts, you owe taxes each year on income and capital gains. Tax efficiency means that you are managing a taxable account in a way that minimizes the taxes owed each year.

A capital gain or capital loss is the difference between the cost basis of an investment and what is received when the investment is sold. The cost basis is the original amount paid for an investment plus or minus any adjustments to the original cost that occur while you hold the investment.

Short-term capital gains occur when an appreciated investment is held for one year or less. Long-term gains occur when an appreciated investment is held for at least one year plus one day. Tax rates for short-term gains are much higher than they are for long-term gains. Short-term gains are taxed as ordinary income at a rate that can be as high as 39.6 percent, depending on your tax bracket. Ordinary income is the tax rate that you pay on your wages or salary and on interest and other sources of income. Depending on where you live, state taxes may also apply.

You cannot realize a capital loss in the event of a wash sale, which occurs when an investor sells an investment to realize a loss and buys it back within 30 days.

For taxable accounts, the treatment of dividends depends on if they are qualified or nonqualified. Most US company dividends are qualified and are taxed at the same rate as long-term capital gains. Depending on your income, these rates can be as high as 23.8 percent. Dividends from foreign companies and REITs are nonqualified. Investment income from nonqualified sources is taxed at the ordinary income rate, which can be as high as 43.4 percent, or 39.6 percent plus 3.8 percent.