When you buy shares of stock, choose a mutual fund, or inherit things of value that either provide income or can be sold for a profit, you're an investor. If you continue to invest—either by buying more shares of the stock and funds you already own or by selecting new stocks and funds—you're on the road to building an investment portfolio.

If you reinvest any earnings from your existing investments, you can take advantage of the power of compounding to increase the size and value of your investment base.

You don't need a lot of money to start investing. Many mutual funds let you open an account with as little as $1,000. Once an investment account is open, you can add money on a regular schedule, such as 10% of your paycheck each pay period or $100 a month. It's also a good idea to seek the advice of a financial advisor, who can help you build a portfolio that is aligned with your financial goals.

There are three basic asset classes, or investment categories, that should be the core of any portfolio: stocks, bonds, and cash or cash-equivalents. You can invest directly in any or all of them, or indirectly by buying mutual funds that pool your assets with those from other investors.

Stocks
Stocks are ownership shares in a corporation. If the company does well, you may receive part of its profits as dividends and see the price of your shares increase. But if the stock price falls, the value of your investment can drop.

A stock has no absolute value. At any given time, its value depends on whether its shareholders want to hold it or sell it, and on what other investors are willing to pay for it. If the stock is "hot," and lots of people want shares, the price will likely go up. If a company is losing money or a particular industry is doing poorly, stocks in that company or industry will probably lose value.  

Bonds
Bonds are loans that investors make to corporations or governments. Unlike buying stocks or equity securities, which makes you a part owner in a company, buying bonds or debt securities makes you a creditor.

Bonds are also called fixed-income securities because they usually pay a specified amount of interest on a regular basis. However, one of their limitations for individual investors is their cost. Few sell for less than $1,000, and it's often hard to buy just one.

Cash and Cash-equivalents
Cash and cash-equivalent investments include money market funds, money in bank accounts, certificates of deposit (CDs), and U.S. Treasury bills.

If you wanted to invest in these three asset classes using mutual funds, you might consider creating a portfolio comprising stock funds, bond funds, and money market funds. Your financial advisor can help you make informed decisions about what investments are right for you.

Asset allocation means dividing your portfolio among different investment asset classes, according to a particular formula. One sample allocation model, would be to put 60% of your investment capital in stocks, 30% in bonds, and the remaining 10% in cash.

No single asset allocation model, however, is ideal for everyone. While a stock-heavy portfolio may tend to grow faster over time, its value may also fluctuate more, producing potential losses in some years.

You don't have to stick to the same model throughout your investing life. In fact, you should work with a professional financial advisor to evaluate your asset allocation and realign the investment mix from time to time. For example, if your stock holdings increase in value, they will make up a larger percentage of your portfolio. To maintain your asset allocation, you and your financial advisor may want to decrease your stock holdings and increase your bond or cash holdings.

Your age and your risk tolerance will guide the asset allocation you choose. Younger investors might put 80% or more of their investments in stock mutual funds, while investors nearing retirement might want more of their assets in income-producing investments, such as municipal bond or corporate bond funds.

One way to help protect your investment portfolio against risk is diversification—spreading your money among different investments instead of investing in only one or two. For example, if you own just one stock, and the price of that stock drops in value, the value of your portfolio will shrink. Similarly, if the industry the stock is part of goes out of favor with investors—as most industries do from time to time—the value of your whole portfolio will suffer as a result.

But if you own several stocks in different industries or in companies operating in different countries, it's not likely that they will all drop in value at the same rate and at the same time.

Well-diversified portfolios—containing various mixes of stocks, bonds, and cash-equivalents through mutual funds or direct investments—can help smooth out a lot of the ups and downs in investing. And studies have shown that, over lengthy periods, investors didn't have to sacrifice much in the way of returns to reduce volatility. Finding the right portfolio mix depends on your type of assets, your age, and how much investment risk you are willing to take. However, diversification does not guarantee a profit or protect against loss in declining markets.

There's no escaping risk. But there are ways to invest so that you can potentially offset one type of risk with another. And there are ways to capitalize on the flip side of risk, which is potentially higher returns.

Investments with the highest potential return are often the most volatile. Volatility is the extent to which the value of an investment tends to fluctuate over periods of time. For example, a stock that drops $15 in price, say from $50 to $35 a share, is more volatile than a stock that drops $1.50, from $50 to $48.50. But the first stock may have the potential to increase more dramatically in price than the second—to $65 or higher rather than something closer to $51.50 in a similar time frame.

Using time to your advantage can potentially help you reduce risk while reaping the return that certain volatile investments may provide. For example, when you consider a stock mutual fund, ask yourself whether you plan to keep it in your portfolio for an extended period, barring any unforeseen developments, such as a management change or an acquisition. The longer you hold a volatile investment, the better the chance it will be worth more than you paid for it.

Remember, though, that some volatile investments may not become less risky over time. For example, high-yield bonds are likely to remain as risky throughout their term as when you first bought them.

Since investment performance can vary over time and your needs will change at different life stages, you should meet with your financial advisor regularly to evaluate your asset allocation and realign, or rebalance, your investment mix. For example, if stock holdings as a group increase in value, they will make up a larger percentage of your portfolio. To maintain your asset allocation, you may want to decrease your stock holdings and increase your bond or cash holdings. It is important, however that asset allocation does not guarantee a profit or protect against loss in declining markets. Rebalancing a portfolio may have tax consequences.

Traditionally, the rule of thumb has been that you should invest between 5% and 10% of your gross income regularly—preferably each time you get paid. If you reinvest your dividends, interest, and other investment income instead of spending it, you can build your net worth more quickly than if you spent that money. Please remember that this is not intended to be investment advice and you should contact your financial advisor who can help you determine what savings goals are most appropriate for your situation.

You buy a growth investment if you anticipate that it will increase in value over time, though there's no way to predict the rate of growth or the change in value. Shares in a stock mutual fund, a direct stock investment, and real estate (i.e., land and the buildings on it) are all typical growth investments.

An investment grows in value when its price increases, and you can sell it for more than you paid for it. For example, if you buy 100 shares of stock at $8 a share, and its price goes up to $18 a share, you could profit from the growth in value. So the longer your time frame, the more sense growth may make, since you can ride out cyclical downturns in the value of your investment.

Typically, investments in equity products like stock mutual funds and individual stocks have the most potential to grow in value over the long term. You should also know that there are many different kinds of growth stocks; by investing in a range of industries, sectors, or geographic regions, you can take advantage of the benefits of diversification.

But, as with any investment, you have to be prepared for the fact that you could lose rather than make money, especially in the short term. Speak with your financial advisor about what growth investments may be most appropriate for you.

If you're counting on cash from your investments to pay part of your living expenses or to meet short-term goals, you may be more likely to make income investments.

Bond and bond mutual funds may produce income on a monthly, quarterly, or annual basis. Other investments, such as annuities, can be converted to an income stream; still others can be sold and the proceeds used to buy income-producing investments, such as bonds or an immediate annuity.

Stocks in large companies with long histories, known formally as large capitalization companies and informally as "blue chips," often pay dividends. And certificates of deposit (CDs) pay regular interest.

Many financial advisors suggest buying bond funds rather than individual bonds. One reason is that you usually need less money to invest in a fund than you do to make a bond purchase. And since funds own many bonds, you get more diversification in your portfolio.

As an investor, you don't actually own the bonds, but rather shares in the bond fund. The fund pays you distributions, or your share of the fund's earnings, based on the interest it receives on its bond holdings and any capital gains it makes for selling the bonds for a profit.

Unlike an individual bond, with a bond fund, there is no promise that you'll get your investment back at a particular point in time. Nor is there a fixed rate of interest, because the fund buys and sells bonds regularly, rather than holding them to maturity. As a result, the fund doesn't earn interest at a single, set rate, but collects from many bonds paying at different rates.

Most experts suggest that when you are planning for retirement income, it's smart to diversify your income sources, just as you did when you were accumulating assets. One traditional mix of professionally managed retirement accounts is 60% of total assets in equities and 40% in fixed-income accounts. Or you might choose to keep 10% in cash and reduce one or both of the other allocations. This is not intended to be investment advice and you should consult your financial advisor to help you determine the right asset allocation for your goals and risk tolerance.

The whole point of investing is making money. That may happen if an investment grows in value or pays you income. But, while growth and income may seem like equally appealing ideas, they aren't interchangeable goals.

You may emphasize growth when you are investing to meet long-term goals. That way you'll have time to weather a downturn in the markets and not have to change your plans. On the other hand, if you're counting on cash from your investments to pay part of your living expenses or to meet short-term goals, you may be more likely to make income investments.

Another approach is to choose investments that provide a strong total return. That's the combination of growth and income.

1. Economic downturn: A downturn in the economy could cause the value of your equity investments to drop and reduce dividends. If those losses were significant, you could be facing substantially reduced income after you retire, despite your planning. A situation like that may mean you may want—or need—to delay retirement.

2. Trading risk: If interest rates go up, you may have a capital loss if you sell older bonds that are paying a lower rate of interest. In this instance, potential buyers will typically pay less for the bonds than you paid to buy them because they'll be earning less than the current rate.

3. Rising inflation: Since the dollar amount you earn on a bond investment doesn't change, the value of that money can be eroded by inflation. For example, if you held 30-year bonds paying $5,000 annual interest, the income would buy less at the end of the term than at the beginning.

When investing in an income-producing vehicle like bonds, it's important to remember that both principal and interest are vulnerable to inflation. For example, if a $1,000 bond pays 5% interest each year for 10 years, the $50 will buy less the tenth year than it did the first. If that's the money you're using to buy groceries, for instance, you might find yourself short at the checkout counter.

One way to minimize the inflation threat is to buy short-term bonds with a portion of the principal you've allocated to fixed income. Because short-term bonds mature within a year or less, the buying power of the interest they pay isn't eroded. A diversified portfolio that includes both income and growth investments can also help you outpace inflation. Please remember that this is not intended to be investment advice and you should consult with your financial advisor to determine an asset allocation that aligns with your goals.

One way to pay less in income taxes is to invest in tax-free municipal bonds, or munis. These bonds are issued by state or local governments, usually to raise money for building or improvement projects or to pay for day-to-day operating expenses.

Munis usually pay less interest than comparable taxable corporate or Treasury bonds, but you usually don't owe federal tax on your earnings. Your earnings are also exempt from state tax if the bonds are issued in the state where you live.

For long-term tax-exempt income, you might also consider investing through a Roth IRA or a Roth 401(k) or 403(b), if your employer offers that option. While you contribute aftertax income, withdrawals are tax-free, provided that you're at least 59½ when you take the money out and that your account has been open at least five years. And if you're investing to pay education expenses, you might consider a tax-free Coverdell education savings account (ESA) or a 529 college savings plan. There are rules about how the money can be spent to qualify for tax-free treatment, but the restrictions are clearly spelled out in the plan descriptions. Your tax advisor can also explain how to take advantage of tax exemptions.

Over time, tax laws are modified to reflect changes in the economy, shifts in political thinking, and evolving attitudes toward investing. However, there's no way to predict the rate at which you may have to pay taxes on your future earnings, or whether the rules governing tax-deferred withdrawals or those that set estate taxes will become more or less restrictive. So it's important to take advantage of the existing opportunities to build your retirement assets.

If you donate appreciated property, such as stock or a house that you've held for over a year, you may be able to deduct the market value and avoid capital gains tax on the appreciation. If a stock's value has dropped, you can sell it, take the capital loss, and donate the proceeds of the sale.

If you have a child who is older than 18, you can often save on taxes by giving the child stock that has appreciated in value while you owned it. The child can then sell the shares and pay capital gains tax at a lower rate than yours.

You'll want to take taxes into account when you're deciding which assets to use for income in retirement, assuming you have a variety from which to choose. That's because what your heirs will owe varies with different types of inherited investments.

Stocks left to your beneficiaries, for example, become their property at current market value. That's known as a step-up in basis. No tax is ever due on the gains that occurred prior to your death. Dividends from qualifying domestic stocks and some international stocks, and any long-term capital gains on most securities, are taxed at a lower rate than regular income.

Withdrawals from traditional IRAs, annuities, and other tax-deferred investments are taxed at the same rate that applies to your heirs' regular income. The timing of those withdrawals depends on the way your particular plan is set up. If you're married, your spouse can spread them over his or her lifetime, and the same may be true for other beneficiaries as well. It's important to check that provision as you choose among tax-deferred investment providers.

If your fund portfolio is concentrated in U.S. stocks, international funds are one way to diversify. These funds, also known as overseas funds, buy stocks in companies headquartered outside of the United States.

Many international funds invest widely, buying stocks in both mature markets and faster-growing emerging markets. Broad-based funds may include both large and mid cap companies in their portfolios to seek a combination of stability and growth. Or, if you prefer, you may decide to invest in international funds that focus on more volatile small cap companies.

When you invest in international markets, whether through a mutual fund or on your own, your return is affected not only by how well the investments perform but also by the changing values of the currencies in your home country and in the countries where you're invested.

So, if your country's currency gains in value against the currency of the country where you're invested, any earnings on your investment will be worth less than they would have been if you had invested using the currency in which the investment was sold, though you may have capital gains.

For example, if you use U.S. dollars to buy a stock sold in euros, and the dollar gains in value against the euro, any dividends the stock pays will be worth less to you than to someone buying with euros. That's because as the dollar increases in value, you will need more euros to equal a fixed number of dollars when your earnings in euros are converted to, or exchanged for, dollars.

The good news is that if your country's currency loses value, the value of your overseas investments can increase.

When you put money into a mutual fund, it's pooled with money from other investors to create much greater buying power than you would have investing on your own.

Since a fund can own hundreds of different securities (e.g., stocks and bonds), its success doesn't depend on the performance of just one or two holdings. And the fund's professional managers keep constant tabs on the markets, working to adjust the portfolio for the strongest possible performance.

1. A large number of people with money to invest buy shares in a mutual fund.
2. Their pooled money has buying power. 
3. The fund manager invests the money in a collection of stocks, bonds, or securities.
4. Successful investment adds value to the fund.
5. Investors receive distributions.

Typically, every mutual fund is established with a specific investment objective that focuses on one of three basic goals:

• Future growth
• Current income
• Both income and growth

To achieve its objective, a fund invests in securities it believes will produce the results it wants. To identify those securities, the professionals who manage the fund often do a vast amount of research, which involves analyzing individual companies, among other metrics. 

A mutual fund makes money in two ways: 1) by earning dividends or interest on its investments and 2) by selling investments that have increased in price. The fund distributes, or pays out, its profits (minus fees and expenses) to its investors.

Income distributions are derived from the money the fund earns on its investments. Capital gain distributions are the profits from selling investments. Different funds pay their distributions on different schedules—from once a day to once a year. Many funds offer investors the option of reinvesting all or part of their distributions to buy more shares in the fund.

Mutual funds are created by investment companies (called mutual fund companies), brokerage houses, and banks. The number of funds an investment company offers varies widely, from as few as two or three to more than 150.

Each fund has a professional manager or team of managers, an investment objective, and a plan, or investment program, which the manager follows in building the fund portfolio.

Variable annuities provide tax-deferred earnings and the opportunity to make a potentially unlimited contribution if the annuity is nonqualified (i.e., you've purchased it individually rather than selected it as one of the options in a qualified employer plan or individual retirement arrangement). Variable annuities also offer the potential for larger returns and the opportunity to purchase optional benefits that guarantee lifetime income.

In addition, when you buy a variable annuity, you can allocate your money among a number of investment portfolios, which resemble mutual funds in a number of ways. Variable annuities are either designed specifically for the annuity company or are versions of existing funds designated for exclusive annuity use. However, although the names of the portfolios may be the same or similar to those of retail mutual funds, they are not the same funds.

The first time you buy shares in a mutual fund, you typically must invest a minimum amount, often $1,000. However, once your account is open, you can make additional investments of amounts as little as $100, or sometimes less if you enroll in a direct investment program where the amount is deposited on a regular schedule from another account. Each fund sets its own minimums.

Most mutual funds are open-end funds. That means the fund sells as many shares as investors want to buy. As money comes in, the fund grows. If investors sell, the fund buys back their shares. Sometimes open-end funds are closed to new investors when they grow too large to be managed effectively—though current shareholders can continue to invest money. When a fund is closed, the investment company often creates a similar fund to capitalize on investor interest.

Closed-end funds more closely resemble stocks in the way they are traded. While these funds invest in a variety of securities, they raise money only once, offer only a fixed number of shares, and are traded on an exchange or over the counter (OTC). The market price of a closed-end fund fluctuates in response to investor demand, as well as to changes in the value of its holdings.

Exchange-traded funds (ETFs) resemble open-end mutual funds, but are listed on a stock exchange and trade like stock through a brokerage account. You buy shares of the fund, which in turn owns a portfolio of stocks, bonds, commodities, or other investment products. You can use traditional stock trading techniques, such as buying long, selling short, and using stop orders, limit orders, and margin purchases.

The ETF doesn't redeem shares you wish to sell, as a mutual fund does. Rather, you sell in the secondary market at a price set by supply and demand. ETF prices change throughout the trading day rather than being set at the end of the trading day, as open-end mutual fund prices are. Like a mutual fund, each ETF has a net asset value (NAV), which is determined by the total market capitalization of the securities or other products in the portfolio, plus dividends but minus expenses, divided by the number of outstanding shares issued by the fund. For ETFs, the market price and the NAV are rarely the same, but the differences are typically small for the most widely traded conventional ETFs.

Most mutual funds are actively managed, wherein fund managers buy and sell investments to achieve a particular goal, such as providing a certain level of return or outperforming a relevant benchmark. Most ETFs are linked to a market index, which determines the fund's portfolio. While the majority of the indexes are traditional, some are described as fundamental. In those indexes, components of the index are identified on the basis of selective criteria, such as their performance, rather than their market capitalization or some other objective standard.

When you buy mutual funds through a financial advisor, you generally pay a sales charge or commission, usually figured as a percentage of the amount of the transaction. That commission is called a “load,” and funds on which you pay a commission are called “load funds.”

A no-load fund, in contrast, doesn't charge a sales commission and is generally available directly from the fund company rather than through a financial advisor. However, you may pay a commission on some no-load funds if you buy them through an intermediary rather than directly from the fund itself.  

Since both load and no-load funds can provide strong returns, either type may be a good investment.

The most accurate measure of a mutual fund’s performance is its total return, that is, the change in value plus reinvested distributions. Total return is reported for several time periods, typically for as long as the fund has operated. When the figure is for periods longer than a year, the number is annualized, or converted to an annual figure. It is calculated as a geometric mean, which is more accurate for numbers multiplied in a sequence than a simple average return is.

Annualized figures reflect the impact of gains and losses over the period that is being tracked. But they don’t report whether the return represents a fairly consistent performance from year to year or a seesaw of ups and downs.

Among the key factors that influence total return are the direction of the overall market in which the fund invests, the performance of the fund’s portfolio, and the fund’s fees and expenses.  

In addition, by comparing total percent return to a benchmark, such as a stock, bond, or mutual fund index, you can examine a fund’s performance in relation to the performance of a comparable segment of the investment market or to similar funds. Each fund indicates in its prospectus the indexes it has identified as appropriate benchmarks for the fund.

For example, a large company stock fund may be compared to the performance of the S&P 500^® Index¹ for the same period. A small cap fund may use the Russell 2000^® Index² as a benchmark.

For specialized funds, the fund will identify a more narrowly focused benchmark. You're in a better position to evaluate the performance of a sector fund if you compare it to an index for that sector rather than to the broader S&P 500. In addition, Lipper and Morningstar Inc.—companies that evaluate mutual funds—provide a range of indexes that track specific categories of funds.

Mutual fund companies provide information on the funds they offer on their Websites and in quarterly and annual reports to shareholders. The financial press tracks individual funds daily in an abbreviated format, as well as monthly, quarterly, and annually in more comprehensive detail.

In addition, all mutual funds publish a prospectus that you should read and consider carefully before investing, which explains a fund's objectives, management, fees, risk level, and past performance, and provides details of operation.

Mutual funds have different investment objectives, which impact the types of investments they make, and different risk profiles, which communicate the types of risk they take. So the first step in choosing a new fund for your portfolio is to identify the category of fund you want to add. Working with a financial advisor, you can then compare a number of funds in that category in relation to each other to identify the one that you think is the best choice for you based on your individual goals and risk tolerance.

Evaluating funds in relation to each other generally includes looking at the following criteria:

1. What’s the fund sponsor’s reputation for leadership, clarity of communication, transparency, and business continuity?
2. What is the tenure and experience of the fund managers?
3. What’s the fund’s style?
4. What’s the fund’s expense ratio?
5. Has the fund provided consistently strong returns relative to its peers?

Mutual funds offer investors the benefits of economy, diversification, and the expertise of a professional manager. In addition, you have the convenience of daily liquidity, an automatic reinvestment option, distribution options, and the availability of telephone redemption and transfer.

You take certain risks when you put your money into mutual funds, as you do with any investment. The return may be less than you had expected, and the value of your account could decline.

You pay taxes on the distributions you receive from the mutual fund unless you hold the funds in a tax-deferred (e.g., 401(k) account) or tax-free account. The taxes are due whether the money is reinvested or paid out in cash. But if a fund loses more than it makes in any year, it can use the loss to offset future gains. Until profits equal the accumulated losses, distributions aren't taxable, although the share price may increase to reflect the profits.