LESSON 2: Getting a Good Start With Sound Strategy

The Big Picture: How Investments Dovetail With Assets

A balance sheet is a cumulative record of finances recorded at a single point in time. It

is a three-part compilation of everything you own, everything you owe and everything
you have left over. The difference between what you own and what you owe -- known
as assets and liabilities, respectively -- is your balance sheet equity, also known as net
worth.

A balance sheet provides a bird's-eye view of finances in a way that lets you see how
all of the pieces make up the whole and whether any adjustments need to be made.
Balance sheet equity offers an objective measure of financial freedom. Each addition
to assets, without an offsetting addition to liabilities, directly increases net worth. And
here lies the ultimate goal of investing: increasing your net worth.

The first step toward financial freedom demands sufficient liquid assets to fund short-
term liabilities and foreseeable obligations, such as home repair or a car replacement
fund. Your balance sheet should include categories devoted to specific future
obligations. Once these categories have been funded, you can then devote your
attention to increasing your net worth through investments.

Asset Allocation

Asset allocation is a process of continually dividing your assets into categories to

maximize returns and control the risk of lost principal. As we move through this
course, you'll see how the concept behind asset allocation can also be applied to
investments. Effective asset allocation includes liquid asset categories to fund
contingencies such as unexpected car repairs. You should also have funds devoted to
foreseeable obligations such as insurance co-pays and deductibles. However, you may
not want to allocate all the funds up front for long-term obligations. It's a better idea to
pay for these in smaller installments.

Your personal judgment is also central to how these funds are actually invested.
Liquid investments can be converted to cash at any time without losing any of the
money you initially invested. Contingency funds should be in cash or highly liquid
investments, such as money in a savings account. If you put contingency funds in
stocks, an illiquid form of investment, there's no telling what the fund will be worth if
you eventually decide that you need the cash to pay your bills. Likewise, funds
devoted to short-term foreseeable obligations should be liquid, though with these
funds you have a little more latitude in your decision-making process. If you know
beforehand when you will need the money, you can invest in higher-earning
certificates of deposit or short-term bonds whose maturities match the timing of your
obligations.
Diversification: Capitalizing on Diversity

The markets offer many kinds of investments that differ in their risk and return
characteristics. Before thinking about your many choices, it is important to have a
clear idea of the advantages of diversification. By sampling many different types of
investments and including a proper mix in your portfolio, you ensure stability and a
well-rounded portfolio.

Diversification allocates investment assets into categories that respond differently to

economic events. This helps preserve your portfolio's value, mainly because some
investments rise while others fall. Investors also practice diversification to capitalize
on unforeseeable growth and increase their net worth. For example, only a few
investors anticipated in 1998 that oil service stocks would triple over the next two
years. But, if you had a balanced and diversified portfolio that included many different
types of investments, there's a good chance that you too might have capitalized on the
growth of oil service stocks.

Diversification not only provides protection, but it also offers an opportunity for
profit. To learn more about how to make diversification work for you, read Chapter 4
of Investing 101.

Fixed Income vs. Equity Investments

All investments can be categorized as either fixed income or equity. When discussing
investments, equity is not quite the same as balance sheet equity. Equity, as it relates
to investments, is something you own, such as stock or rental property. Fixed income
is a loan you make to somebody who promises to repay principal and interest. Bonds,
the most common form of fixed income investment, promise a specified amount of
interest and specified maturity date when the loan is to be repaid.

Fixed income and equity respond somewhat differently to economic events. Changes
in the interest rate directly influence the value of fixed income investments. While
rising interest rates reduce their value, falling interest rates will increase their value.
Although interest rate increases do tend to suppress stock values, equities are far more
sensitive to anticipated future corporate earnings than anything else. This distinction is
important because stock prices change even when interest rates are stable, and the
value of fixed income can change even when corporate profits are stable.

Within the two general investment categories of fixed income and equity, there are
many possibilities for diversification, all of which possess different properties. For
example, bonds with long maturities (e.g., 10 to 20 years) are more sensitive to
interest rate changes than shorter-term bonds. You may want to select several different
types of investment to protect yourself from any unforeseeable benefits or problems.
Among equities, stocks issued by utility companies, for example, are less sensitive to
economic changes than stocks issued by retail companies.

An Overview of Asset Categories

Successful diversification depends on your knowledge of your own asset categories

and how each category responds to economic events. A useful approach
conceptualizes investments along two dimensions: equity and fixed income
investments, and international and domestic investments.

Your personal preferences and goals drive asset allocation and diversification. If your
overall financial plan requires income from your investments, your portfolio should
have only a few investments that risk principal and more with fixed income
investments. If your plan seeks portfolio growth and you have a long time horizon, use
fewer fixed income investments and more equities and international investments.

Here is a list of the chief investment categories with a brief summary of their
properties:

Equity

 Real estate -- Yields rent payments and capital gains, which are the profits you earn
when you sell equity at a price higher than the price you paid for it. Prices vary with
changes in rental demand and business outlook.

 Stocks -- Issued by corporations, confer corporate ownership.

 Income stocks -- Pay high dividends, which are the payments many corporations
pay to owners of stock. These stocks commonly have low price volatility, which
means that the market value does not change much from day to day, compared with
that of most stocks.

 Growth stocks -- Pay low, if any, dividends. Prices rise faster than for other stocks,
but fall faster on bad news. Examples: technology stocks, small company stocks.

 Value stocks -- Have prices low in relation to "true" value that are often suppressed
because of market attention to other sectors or temporary corporate/industry problems.
Examples: Oil service stocks in 1998, some technology stocks.

Fixed Income

All of these prices vary with changes in the prevailing interest rates.
 Corporate debt -- Generated when companies sell debt to investors. They are
essentially IOUs; they carry stated interest rates and maturity dates. Notes are another
form of corporate debt. The difference? Notes are short-term, and bonds are long-
term. Values vary with ratings based on a company's ability to repay.

 Junk bonds -- Usually corporate stock issues that pay high interest rates because of
market concern over the company's ability to repay.

 Government debt -- Issued by federal, state and local governments, usually at

lower interest rates and with tax benefits. Examples: Treasury issues, municipal
bonds.

 Money market debt -- Usually issued by corporations. Debt with maturity less than
one year, low interest, high safety.

 Domestic -- Any investment issued by U.S. companies. These prices are influenced
by economic growth, the prevailing interest rates and by corporate, industry and
regional business prospects.

 International -- Issued by non-U.S. companies. Prices are influenced by currency

valuation, political stability, local and regional economics.