We all have our reasons for investing and they are all legitimate. Whether it’s saving up for retirement, putting some capital aside while the going is good, or finding ways to improve our current financial standing, a basic understanding of the types of investments is a necessity before you make the first few steps.
If you look at the big picture, the cornerstones of investing are quite simple. Investors aim to:
- accumulate funds for future use—retirement accounts are a typical example;
- buy someone else’s debt so the debtor can repay it with interest—bonds represent this approach;
- profit from the success of a company—trading stocks and collecting dividends embody this concept;
- get a tangible asset in the real world in return for money—gold and real estate are examples of this;
- prognosticate an increase in significance and value —cryptocurrencies are a good example of this.
This is what investing is all about; the rest is technicalities. But it’s precisely those technicalities that we will examine in greater detail below.
We will review twelve different types of investment, including stocks and bonds, financial instruments, different funds, retirement plans, lending investments in insurance, and even cryptocurrencies. How does each of these investment types work? And even more importantly, what benefits can they offer you?
For all that and more, let’s dive in.
Buying stocks makes you a shareholder in a company. This means that you, as an investor, own a small part (an X amount of shares) of the total worth of a venture. Companies offer stock because they need your money to break even or (most often) to expand their operation.
Let’s take a look at the different types of stocks available to you.
There is actually more than one way to collect returns on your investment in stocks. The first one is to receive a dividend when the company is performing well. This happens when profits are distributed among shareholders, usually annually. Keep in mind that not all companies offer dividend stocks (that’s what they are called) because firms that are still in the growth phase prefer to reinvest the profit in expanding the business (IT startups, for example).
The other and probably more iconic way to benefit from investing in stocks is to trade them. You get stocks when they are cheap and you sell them when they are expensive. Although it sounds simple, it most certainly isn’t. The value of stocks fluctuates, both daily and in the long run. There is a possibility that the stock you just got will lose its value down the line. This is a risk every investor in stocks has to face.
Experienced investors do their best to mitigate such risks by closely following relevant data. Sell or buy decisions can be guided by expectations that certain events will have a critical influence over the market. For example, a new robust piece of legislature or outcome of elections are examples of such events. Of course, the investment strategies can get far more technical and elaborate.
Investors can easily sell their stocks if they want to cash in on an investment. There is always someone that will buy your shares at the stock exchange.
Lending money: that’s the simplest way to think of bonds. The only major difference is the fact that governments and corporations ask to borrow some money from individual investors, as opposed to what we are generally used to (i.e. banks lending to clients). These types of big loans are always needed to complete municipal or corporate projects. It’s one of the safest investment options out there because bondholders are almost always guaranteed to get their investment back.
Factoring in maturity on bonds
As with any other loan, there is a principal (borrowed sum), an interest rate, and a repayment date (a.k.a. a bond maturity date). Investors get their interest on a regular basis (annually or semi-annually). However, the principal is due once the bond matures—this usually takes years. If you as an investor ask for your money before the bond matures, you will have to forfeit a percentage of its total worth.
A return on investment with bonds is almost guaranteed because even governments (as bond issuers) can default on their debts. Also, bonds, as lending investments, are up against the rate of inflation in the long run and this alone can make the returns conservative.
Selling a bond on short notice can cause a significant reduction in its value, though this is not always the case.
When it comes to retirement plans, although many of us say, “I’m saving for retirement”, this is practically an investment. The money can be easily withdrawn from a regular savings account if need be, while the money accumulated in a retirement fund is not accessible until we actually retire. Taking the investment out of a retirement account attracts heavy penalties, not to mention that you are losing your retirement nest egg.
Also, some retirement accounts allow specific provisions. For example, the 401(k) plan provides an opportunity for employers to match your contributions in the retirement fund. If there was another investment where a partner was willing and able to match the investor’s portion of each installment, a lot of people would’ve been happy to hand over their earnings.
On the other hand, individual retirement accounts (IRA) like Roth are tax-free, which means you get the total income on your investment when you retire.
Retirement accounts are not a liquid asset and pulling this money out before you retire (if at all possible) should be your last resort.
Certificates of deposit (CD)
When investors give a loan to the bank, that’s called a Certificate of Deposit. It usually goes like this: clients set cash aside to sit in a bank account for a certain amount of time. It’s a bank product because the investor receives interest on the money, while the bank uses the cash to service its clients.
This is yet another low-risk investment that provides guaranteed but low returns. Insured deposits are safe even if the bank is sold (and your loan with it) or if the bank defaults. Investors in cash assets like CDs are mostly up against the inflation rates over the long run. However, favorable interest rates can leave them afloat.
Early withdrawals of money from Certificates of Deposit incur heavy penalties and are not recommended.
Another popular type of investment are investment funds. Many investors pool their resources together to benefit from joint handling of large sums of money while still maintaining some control over their individual share in the venture. That’s how an investment in funds is put together, although the respective arrangements on using the money in a fund may differ.
Some funds require active management from a professional portfolio manager, while others can passively track a relevant benchmark. It all boils down to limiting costs, eliminating commission fees, and increasing returns, and the short review of specific types of investment funds that follows will better illustrate this point.
Mutual funds make diversification and professional management more accessible to individual investors. Diversification simply means that the money can be used for different types of investments: bonds, stocks, commodities, and other assets. Professional management means that you get full-time professional help in decision making and active fund management that’s affordable. Investing is delegated to the fund manager who follows a set strategy, while individual investors can exit at any given time since they only own shares in the fund.
Though the cost is shared, the fees for investing in a mutual fund can be high, and the fund manager has to be paid for their services.
Some consider index funds as a subset of mutual funds. Index funds are a textbook example of passively managed mutual funds and usually track an important stock market index. Investors typically shadow the Dow Jones Industrial Average or the S&P 500. The reason is quite simple—an increase in value (and the general success of the American economy) will bring returns if investors choose to sell their shares in the fund for profit.
Also, the costs associated with passively managed funds are considerably lower than those for mutual funds.
Exchange-traded funds (ETFs)
The bulk of ETFs are passively managed investment vehicles and they track broad indices, but a small percentage of them are actively managed. Their distinctive feature is the fact they can be traded during the day, which allows greater control over the price. Because of this and the fairly diverse assets incorporated in the funds (stocks and bonds, financial instruments, and shares in real estate trusts), they are very popular with new investors.
At the same time, the degree of diversification enables a varied income stream (and does not depend solely on trading), but may also pay out dividends and interest to investors.
There are two ways to get an income stream from real estate investment: it can be a one-off opportunity to resale a property if its value has increased or it can be recurring payments (via renting or a lease) provided that investors find tenants.
Buying a commercial or residential property is a great inflation hedge because buildings are tangible assets. Unfortunately, not everyone can afford to set aside money for a hefty down payment in order to acquire property. And even if that is an option, the maintenance costs and taxes stay in the way of return on investment.
For those who can’t afford to or choose not to buy property on their own, there are alternatives such as REIT.
Real estate investment trusts (REITs) operate in a very similar way to mutual funds and are a great crowdfunded option to invest in property. Shares in the trust are bought and sold on an ongoing basis and the accumulated fund is usually used on income-generating real estate like warehouses, malls, and other larger buildings.
Although investors share the returns, joining also allows sharing of maintenance costs. The main perk of REITs is in their liquidity. Since individual investors own shares, they can be easily traded as opposed to selling an actual building if you are in imminent and dire financial straits.
Some would jump to exclude annuities from the category of investments. However, they are definitely more than saving accounts—they are lending investments. Investors can secure annuities if they lend a lump sum of money to an insurance company and get regular periodic payments from them in return.
We say “regular,” but this is to be taken with a grain of salt since the terms of a contract on annuities may vary. They may be tied to the stock market or they may ensure that investors get one upfront payment, and that’s it. Careful study of the terms is very important for this type of investment.
There are virtually no risks involved with annuities, but investors can’t expect large returns on these contracts. Usually, they run on par with retirement accounts to provide a steady source of income.
You’ve probably heard some of this financial lingo in passing, but haven’t quite put your finger on its exact relevance to investing. Don’t sweat it since none of these types of investment will seem as intimidating once you get familiar with the underlying concepts.
Investing in “options” is practically buying a contract to potentially buy or sell stock up to a set date in the future. The contract provides investors with an option to go on and complete the transaction or to disregard it.
Call options allow an investor to hold a position on buying stocks. If the value of a stock goes up and you exercise the call option, your return is secured. The main benefit is in the fact that investors can control an X amount of shares with significantly less money tied up in the transaction. If the value of a stock goes down, and you bought it at its original value (the traditional way), your loss is substantial. If your call option expires (you cancel the transaction), then the loss is reduced in a major way.
You can probably see why options are part of risk aversion in investing strategies.
Put options work the same way but in the opposite direction. Investing in put options gives the stockholder the right to sell stocks at an agreed-upon price if they choose to. When the price of a stock goes down and the investors exercise a put option on it, the loss is limited to the agreed price.
Obviously, these types of investments are for seasoned investors.
In order to offset the risks involved in dealing with financial markets, speculative investors turn to assets in the real world. Speculative investors and those that have a stake in the traded commodities descend to the futures market.
These commodities are usually precious metals, crude oil and gas, or agricultural products. Investing in futures contracts on a commodity means that the investor agrees to buy or sell a certain amount of the asset at a fixed price and at a preset time in the future. The value of commodities is in great fluctuation. For example, the price of gold for almost a century was fixed each day, twice a day, in a meeting of market makers in London (London Gold Market Fixing Limited). Hence, this is a fast way to both earn and lose money.
Newcomers are usually advised to stay away from futures and commodities unless they are traded as a way to diversify assets in an ETF.
Digital currencies attract a lot of buzz these days. They were introduced as an alternative to the traditional brick-and-mortar banks in a bid to escape government regulation in the financial sector. The technology behind the most popular cryptocurrencies like Bitcoin allows users to leave their signatures in a decentralized manner.
Crypto is a fairly new type of investment. However, some businesses already accept payment with more than one digital currency instead of fiat money. The value of crypto coins is in flux and therefore returns are uncertain. Investors in cryptocurrencies are enthusiastic about the wide acceptance of the model and its subsequent increase in value in the future, but no one can really guarantee this.
Among the uncertainties, there are a number of users (up to 20% of the total users) who are allegedly locked out of their accounts because they forgot their passwords. Can you begin to imagine what would happen to the market once any of them finds their forgotten password in the back end of a tool-shed drawer? Stay away if you are serious about your investment.
The need for money changes throughout life, so it might be prudent to set specific goals before you start your investment journey. Also, the age of the investor (or their stage in life) limits the risk they are able to handle. Saving up for retirement requires a conservative approach (low risk and low but guaranteed returns), while investors who are after big returns adopt a more aggressive style and engage with volatile, high-risk types of investments.
Whatever the case with you, in essence, there are two ways to start: on your own or through financial advisors. You need a brokerage account in either case and you can easily set one up.
The types of investments that include joining forces with other investors are great for dipping your feet in the water if you are new. Mutual funds, exchange-traded funds, and index funds can allow you to have an investment portfolio with a minimal amount of money. They also serve to showcase the importance of mixing different types of investments (or diversification as it is known) early on, while also limiting risks.
Taking different types of investments (or asset classes) into consideration is very important before you choose one and invest. If you know the characteristics of other investment products and markets, you can more easily offset risks, transfer to a liquid asset, or increase profit on your initial investment.