The Basics of Investing

When you invest in a company, you become a partial owner of that company. You now have a vested interest in the company's performance. Whether you're managing money for a household or for a multinational corporation, you want the money you invest to give you the best possible return-whether for the short, the intermediate, or the long term. This article will discuss a variety of ways that go beyond just CDs-and things to think about when planning portfolios and making specific investment decisions.

Short-Term Investments
You may find yourself with substantial cash reserves that you don't need to invest or spend immediately. At the same time, you want this cash to be earning as much interest as possible until the investment decision is made-without giving up safety and liquidity. Three of the most popular solutions to this problem are money-market funds, brokered certificates of deposit, and Treasury bills. We'll discuss each in turn.

• Money-market funds. This is a popular way of investing cash reserves. Investment firms offer a variety of money-market portfolios investing in high-quality, short-term debt instruments. Money-market funds let you invest in a professionally managed, diversified portfolio of short-term investments. During periods of economic fluctuation, money-market funds may provide temporary shelter-a vantage point from which to watch the direction of the market and interest rates. These funds can be quick to respond to fluctuations in interest rates, offering competitive and variable yields.
  
  

  Money market funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information, can be obtained by calling your financial advisor. Read it carefully before you invest.

  An investment in a money-market fund is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund.

• Certificates of deposit (CDs). Brokered CDs, available from most full-service investment firms, may offer an alternative to traditional bank products. Available for $1,000 each, your CDs can be sold before maturity through any broker that maintains a secondary market (buying large blocks of federally insured CDs for resale to investors). Maturities typically range from three months to ten years. However, keep in mind that if you sell your brokered CD before maturity, you may receive more or less than your initial investment, depending on current interest rates and any applicable early-withdrawal penalties. Before investing, understand how interest is compounded and the actual effective yield. By staggering the maturities of your CDs between three, six, and twelve months, you may be able to increase your liquidity while receiving competitive yields.
  
  

  CDs are FDIC-insured up to $100,000 per institution and offer a fixed rate of return. Brokered CDs may be longer-term investments, and their yield and value will fluctuate.

  Generally, CDs may not be withdrawn prior to maturity, but when permitted would incur an interest penalty.

  CDs may be issued by out-of-state institutions. If your CD is purchased at a premium in the secondary market, the premium over the face value is not covered by FDIC insurance.

• Treasury bills (T-bills). T-bills are guaranteed by the full faith and credit of the U.S. government for the timely payment of interest and principal if held to maturity and are available with 13-, 26-, and 52-week maturities. They are sold at a discount; at maturity, you receive the full face value. The minimum denomination is $1,000, but the actual cost of a T-bill varies according to its maturity and interest rate. T-bills are fully negotiable, and T-bills purchased from an investment firm can be sold before maturity in the secondary market without a penalty. Keep in mind, however, that selling a T-bill before maturity may result in a profit or loss, depending on interest rates.
  
  

  Although treasuries are considered free from credit risk, they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate, and deflation risk, which may cause the principal to decline and the securities to under perform traditional treasury securities. There is no guarantee as to the market value of these securities if they are sold prior to maturity or redemption.

Intermediate- and Long-Term Considerations: Risk and Reward
Investing for the intermediate term (one to 10 years) and the long term (10 to 30 years) makes it important to consider the risk/reward characteristics of any prospective investment. Before committing funds to any investment, consider these questions:

• What is the investment goal? What do I want this money to do?
• How much time do I have? When do I plan to sell the investment I buy today?
• What annual rate of return on investment (ROI) must this investment achieve to meet the investment goal?
• How important is it to preserve this capital? How much risk can I afford to take in search of the desired ROI?

Generally, the greater the risk you're willing to take, the greater the reward you may receive if the investment turns out well. Of course, greater risk can lead to greater losses if the investment turns out poorly. This is true for all the major types of investments: stocks, bonds, and mutual funds that invest in stocks and bonds.

Risk and Reward: Common Stocks
Common stocks are equity securities. They represent partial ownership in the issuing corporation. As the assets and liabilities of the corporation fluctuate, the stockholders' equity fluctuates, and so does the book value (balance-sheet value-assets minus liabilities) of your shares. Stock prices also fluctuate with investors' changing perceptions of the prospects for the company.

Of the company's earnings (profits), the board of directors determines what portion will be distributed to stockholders as dividends¹ and what portion will be retained to enhance book value or reinvest in the business. Thus stocks offer two components of return: dividends (which can usually be automatically reinvested if you wish) and a gain or a loss (changes in the stock's price).

Neither the stock's future price nor the payment (or amount) of future dividends is guaranteed. If the company fails, its creditors (bondholders) have the first or senior claim on its assets-holders of common stock, as the owners of the company are paid last.

However, in return for assuming greater risk, the stockholder also has the opportunity for potentially greater reward. If the company is successful in generating profits over the years, the stockholder is the one who may benefit. As a group, historically, stocks have consistently outperformed bonds over longer periods of time. In exchange for less risk, the bondholder has given up the opportunity for greater rewards. Keep in mind, however, that past performance is no guarantee of future results.

In considering a stock investment, think about questions like these:

• How is the company that issued the stock doing?
• Does it have a record of long-term earnings growth?
• Are the senior managers responsible for its success still in place?
• Does it have a strong position in its industry?
• Is it threatened by strong competition or a tough regulatory environment?
• How will the company's products and services probably fare over the term of this investment?

Risk and Reward: Bonds
Bonds are debt securities-the bondholder is a creditor of the issuing entity. The bond acknowledges that you have made a loan of the face value to the issuer. It represents the issuer's agreement to pay you a specified rate of interest over a specified period (hence the term "fixed-income investment"), after which the face value will be repaid to you.

Whereas stocks are ordinarily chosen for their growth potential, bonds are ordinarily chosen for the potential fixed income and capital preservation they may offer. However, this doesn't mean that bonds are without risk. When considering bond investments, think about each of the following types of risk:

• Credit risk/quality. If the issuer is unable to pay interest and principal when due, the bond is in default. The smaller the chance that the issuer will go into default, the higher the bond's quality rating. Thus a bond rated AAA offers more safety but may also yield lower interest than a bond rated A.
• Maturity risk. Some bonds have call provisions. This means the issuer can call (repurchase) the bond from you at face value after a specified time. If the issuer chooses to call the bonds, it's usually because prevailing interest rates have fallen since the bond was issued. The call provision means the issuer can pay you off and re-borrow the face value at a lower interest rate-leaving you with an unhappy choice between re-lending it at the lower rate or trying to find a better rate elsewhere. To compensate investors for this risk, bonds with call provisions ordinarily offer higher interest rates than bonds without them.
• Liquidity risk. This is the risk that, should you want to sell your bonds before maturity, you won't be able to find a buyer. For example, a bond of a fairly obscure issuer will not be as liquid-as easy to sell-as a U.S. Treasury bond; a bond with complex features will not be as liquid as a simpler bond. Other things being equal, less liquid bonds generally offer potentially higher yields to compensate the investor for the added risk.
• Interest-rate risk. If you invest long-term and interest rates rise, you may have missed the chance to invest the money at the new higher rates-and if you try to sell your bond before maturity in order to reposition the money, you may find that the bond's principal value has fallen (to bring its effective return in line with current bond issues). Similarly, if you invest short-term and interest rates fall, you've missed the chance to invest the money long-term at the old higher rates. Since the long-term investor bears interest-rate risk over a longer period, long-term bonds ordinarily yield more than short-term bonds.
• Reinvestment risk. The yield-to-maturity calculation assumes reinvestment of semi-annual income at the stated or coupon rate. A zero-coupon bond is exempt from reinvestment risk, because it is structured to compound at the stated rate of return. (More on zero-coupon bonds below.) On the other hand, a conventional bond with a high rate involves greater reinvestment risk-where can you invest the (relatively small) interest payments at that same high rate of return?

For ordinary accounts, municipal bonds issued by government entities offer interest generally free of federal income tax (and often free of income tax in the state where they are issued²). However, these yields are correspondingly lower. For tax-advantaged accounts such as pension funds and IRAs, corporate bonds (interest on which is taxable in ordinary accounts) pay significantly higher yields with no commensurate loss of safety.

In dealing with bonds, keep three axioms clearly in mind:

• As yields rise, dollar prices (market values of bonds sold before maturity) decline; as yields fall, dollar prices rise.
• For equal changes in yields, prices on longer-term bonds change more than prices on shorter-term bonds.
• For equal changes in yields, discounted bonds (bonds purchased at less than face value) undergo a larger percentage change in dollar price than par bonds (bonds bought at face value) or premium bonds (bonds bought at more than face value).

Zero-coupon bonds or "zeros" represent US Treasury obligations. They work much like U.S. Savings Bonds: they are sold at a deep discount and compound at a stated rate until they mature at full face value. Since they do not pay current income, their market value fluctuates with interest rates even more widely than the market value of conventional (coupon) bonds. Thus a drop in interest rates may produce a quick rise in the market value of a long-term zero, offering the potential of a capital gain. (However, every upside has a downside: if you take the quick gain, the interest rates at which you can reinvest are lower.) It's also important to note that the growth of zeros is taxable each year, even though you don't receive it until maturity. Hence zeros are especially useful in tax-advantaged accounts.  (Investors should consult with their tax advisors as to the special tax consequences of zero coupon bonds.) As with nearly all fixed-income investments, if you sell a zero before maturity, it may be worth more or less than your initial cost.

The market value of zero coupon bonds fluctuates more with changes in market conditions than regular coupon bonds and, therefore, may  not be suitable for all investors.

Risk and Reward: Mutual Funds
Mutual funds pool the money of many investors and invest in diversified portfolios of stocks and/or bonds, to help reduce the risks inherent in single investments. They provide professional investment management, research, and record-keeping. If you are considering a mutual fund, request the fund's prospectus and its Statement of Additional Information, and read these materials carefully before making a decision. Study the fund's performance record over the last ten years, and compare it with the performance of other funds of the same type. Keep in mind, however, that past performance is no guarantee of future results. If the fund has been successful, see whether the senior managers responsible for its success are still there. Make sure the fund's investment objectives and philosophy are compatible with your own.

Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information, can be obtained by calling a Wachovia Securities Financial Advisor. Read it carefully before you invest.

Making Interest-Rate Fluctuations Work for You
Changes in inflation and interest rates have major effects on both stock and bond prices, and predictions about their movements are not reliable. However, you may be able to help make changes in interest rates and prices work for you through time diversification.   

For stocks, time diversification takes the form of dollar-cost averaging. This simply means investing the same number of dollars in the chosen security at regular intervals, without regard to current prices. The result is that you buy more shares when prices are low, fewer shares when prices are high. Over time, the average purchase price of your shares is lower than if you had bought the same number of shares at each interval. You're protected against the risk of buying the entire investment at the top of the stock's price range. Of course, you also give up the chance of buying the entire investment at the bottom of the price range.

Dollar-cost averaging does not guarantee a profit and does not protect against a loss in declining markets.

As long as you're ultimately able to sell the investment at more than your average purchase price, dollar-cost averaging means volatility works for you: the more volatile the stock, the farther below the stock's average price (for the period) your average purchase price will be. But, whether volatile or not, the stock or fund chosen should be one that you expect to rise strongly over the period of your investment.

For bonds, time diversification usually takes the form of a bond ladder. If new money becomes available each year, this works much like dollar-cost averaging in stocks, as you can invest roughly the same number of dollars in new bonds at current interest rates.

But even without new money, you can diversify over time by staggering the maturities of your bonds. As a portion of your portfolio matures each year, the face value is reinvested in new bonds at current interest rates.

In a five-year ladder, for example, the portfolio is divided evenly among bonds maturing in each of the next five years. As each year's bonds mature, the proceeds are invested in new five-year bonds. Moreover, if the bonds are conventional coupon bonds and the interest payments received each year are not needed for current expenses, these payments too can be invested in new five-year bonds, for a potential compounding effect.

All these forms of time diversification can help you smooth out the effects that interest-rate and market fluctuations have on your portfolio.

For more information, or for assistance in managing your money, talk with a Wachovia Securities Financial Advisor.

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