With so many types of investment, it is not always easy to get your bearings. Should you choose stocks, put your money into bonds or entrust your portfolio to professional fund managers? What are asset classes, and why should you care? For most investors, merely understanding the terms seems like a large undertaking.
Fortunately, these concepts are not quite as elusive as they appear. While there is no overnight path to investment success, these basic pointers will help you raise your confidence about your fiscal future in no time.
What are the different types of investment?
Most people understand the general concept behind investing: The core idea is to put money into financial opportunities that generate some kind of profit. The problem with that idea is that it is as far as the general public’s knowledge goes. Even though the U.S. ranks 14th when it comes to global financial literacy or money-management skills, this really is not something to brag about. A 2016 survey showed that almost two-thirds of Americans failed a basic financial literacy test.
How do the most popular types of investment work?
What are Americans missing out on concerning investment knowledge? Most people get stuck on the fundamentals. Even though the vast majority seems to lump stocks, bonds and other investment options into one vague group, there are a few important distinctions to understand regarding common types of investments:
- Securities are any financial asset that can be traded.
- A stock is a security that represents ownership in a company sold by the firm to an investor or shareholder. The business then uses the money to fund operations, and the investor receives dividends, or fiscal rewards, based on the company’s performance and earnings.
- A bond is a type of debt security where an investor, or creditor, funds someone else’s loan in return for interest or other payments. Unlike a stock, a bond doesn’t represent a stake in a company.
- Mutual funds are a type of investment fund or pooled investment vehicle. Third-party financial managers use money from multiple investors to purchase a range of different security types where they usually charge fees for their work. These securities include stock, hybrid, money market and fixed-income funds.
- Index funds are mutual funds that adhere to predetermined rules, which makes it easier to track specific classes of investments.
- An exchange traded fund, or ETF, is an index fund that gets traded like stocks on exchanges. Theses funds can contain a range of securities and assets.
- Options are instruments based on prospective transactions. These contracts let investors reserve the right to trade in assets at a later date and a given price.
- Retirement accounts, such as IRAs and 401ks, are tax-advantaged plans designed to help people prepare for their future and retirement. The account can be tied to a variety of investment vehicles that heighten their value.
- Real estate investments are purchases of tangible land or property, such as personal homes or commercial lots.
- Alternative investment is a general term for investment options that are not in the stock, bond or cash category. An example would be investing in a startup as a venture capitalist or getting involved with hedge funds.
- A portfolio is a collection of investment assets. Most people try to structure their portfolios by carefully choosing types of investments that maximize their gains while reducing their risk of losses.
What are assets?
An asset is any valuable good classified as durable or useful over time. This means that it can be used to store value. For example, you are presented with the option of purchasing either a luxury car or a shipping container’s worth of exotic produce for about the same price. In the case of an asset, you should choose the vehicle because only the vehicle yields lasting benefits.
Assets can be real, such as a car, or strictly financial, like contractual claims. Asset classes refer to instruments that have similar enough characteristics and market behaviors to be grouped together for purposes including investment, trading and economic analysis.
Which types of investments are right for me?
The main reason there are so many types of investments is that no single option is right for everyone. Even though most experts advise investing in fewer risky financial vehicles the older you get, they all have their own takes on the ideal portfolio breakdowns.
In traditional investment models, investors required the aid of intermediaries to manage their money. Now, technology is making it easier than ever to save time without sacrificing controlof how your portfolio works.
A deep dive into popular types of investment
Before you can become a portfolio whiz, you’ll need to know more about the pros and cons of different types of investment options:
1. Stocks made simple
A stock represents ownership in a company. Buying stock gives an investor multiple chances to make money. In addition to being paid annual dividends, you can sell your shares on the stock market. If the value of the stock has increased since you originally purchased it, then you can turn a profit.
It’s important to consider, however, that great returns aren’t always guaranteed for these investment options. With thousands of publicly traded companies selling stock, they are not all going to be success stories.
The performance of a single stock is contingent on the performance of the company and will rise or fall with its success or failure respectively. A single stock is one of the most risk-filled investment choice and people need high expected returns to compensate them for this risk. Stocks are investments for people with a long time horizon and high risk tolerance. Owning multiple stocks diversifies the risk away from any one particular company, but does not guarantee a profit.
2. Breaking into bond investing
Bond investing lets you act as the creditor to companies, governments and municipalities. As such, some are riskier than others. For instance, bonds issued by the federal government come with more guarantees, while those from cities and states have less promises. Bonds issued by corporations are typically seen as riskier than those issued by the government, which do not have the same level of creditworthiness as the U.S. Treasury.
One nice thing about these investment options is that they grant you a stable income. This income is derived over a fixed term set at the time of issuance. The term usually corresponds to the loan’s repayment period, however you can bail out at any time. Selling early may mean that you do not recoup your initial principal investment, but since bond profits are related to loan interest rates, it may be the right move if you can find a bond issued at higher rates.
3. Demystifying mutual funds
Mutual funds are ideal for those who want to make money without getting caught up in the details. Instead of having to worry about whether you are picking the right securities, you can choose a fund that groups them together on your behalf.
Since third parties manage most mutual funds, trust is a major issue. Although it is usually easy to find a money manager, choosing one with a track record of generating profitable returns can be trickier. If you have a portfolio full of unique or unconventional assets, then you should consider devising your own custom management strategy.
4. Index fund investment options
Index funds offer another way to get around the typical intermediary costs. Instead of depending on third-party managers to research and select securities, investors rely on the fact that each index fund follows a particular market index.
As a form of passive investing, indexing reduces the expense associated with maintaining portfolio assets. These funds also tend to outperform many mutual fund investments over the long term because there are fewer expenses in researching and trading investments. Warren Buffett recommended index funds as one of the better types of retirement investments options.
5. Exploring ETFs
An ETF is a specific kind of security that tries to match the performance of a predetermined indicator, like an index fund. The key distinction is that they offer more flexibility because these exchange-traded funds get bought and sold on the stock exchange.
With a mutual fund, transactions are pegged to daily end-of-trading prices. With exchange-traded funds, you can capitalize on the fluctuations depending on when you sell. Thanks to automated advisers, these types of investments are more accessible and reliable than they once were.
6. What are stock options?
When you purchase a stock option, you are really only buying a contract. This contract gives you the right to subsequently trade a certain number of stock shares, usually 100, at a specified date and time. This type of investment also lets you choose the price for the transaction, as long as your trading partner agrees to it.
What is the point of such complexity? The goal of stock options is to outguess the market or hedge price movements. You either want to buy a stock for less than its’ worth or sell it for more. If things do not look like they are going to work out, you are not obligated to complete the deal, although you will lose what you spent on the options contract.
7. Types of investments for retirement: IRAs and 401ks
Investing for old age is different than other kinds of investment. Long-term portfolio stability is the name of the game here, and you can take advantage of some unique financial vehicles to achieve it:
- An IRA, or individual retirement account, is a good way to plan for the future and capitalize on various benefits. Traditional IRAs let you deduct the contributions from your taxes, and Roth IRAs let you make transactions without incurring tax penalties. To maintain your eligibility for such advantages, you’ll need to stick to a variety of rules for withdrawals and contributions, however.
- A 401k is a form of IRS-recognized pension account where your employer provides or matches your contributions. Since the contributions come from your paycheck before you receive it, you do not pay taxes until you withdraw the money. As with most retirement accounts, you can only withdraw under certain conditions. There are a host of labyrinthine laws to adhere to, but you might be able to reduce your tax burden by waiting to pay until you are in a lower tax bracket.
8. Putting down roots: Real estate investment and home ownership
Real estate investment options let you put money into stable assets in the hopes that they will appreciate over time. For instance, you might invest in a home that you plan on occupying until you sell it for a higher price. Or, you might invest in a business property and become a residential or commercial landlord.
As with other types of investments, real estate investment options hold unique risks. Events like housing crises and economic downturns can take large amounts out of your cash flow, and if you are running a business, then you also have to consider your operating costs.
Doing something different: Alternative investments
Alternative investments can be difficult to value, and they typically come with low liquidity because they are harder to sell. Since most traders and investors are relatively unfamiliar with alternative investments, it is critical to understand the nuances going in.
1. Real estate investment trusts
A real estate investment trust, or REIT, is a public or private company that owns real property that creates income. This type of property is usually commercial, and the REIT typically assumes the responsibility for operating it. REITs may specialize in equity ownership or mortgaging, and they can be traded on exchanges.
A commodity is a service or good whose units are fungible, or interchangeable. In terms of futures contracts, which function similarly to stock options, commodities are typically classified as:
- Soft, or products of agricultural origin, such as grain,
- Hard, or goods that come from mineral exploitation, such as iron ore,
- Energy, which includes electricity and fuel sources.
3. Precious metals
Precious metals, such as gold and silver, are a type of hard commodity. Due to their rarity and stringent trading regulations, these alternative investments carry minimal risks. Of course, holding a lot of coins or gold certificates may not be very convenient, but they can balance out portfolios that contain other types of investments for sustained wealth building.
4. Hedge funds and private equity
A hedge fund is a managed fund that derives capital from institutional investors and so-called sophisticated investors, or those who have a high enough net worth to receive special regulatory designations. Private equity investment funds are limited partnerships that specialize in purchasing and restructuring nonpublic enterprises. These types of investments are typically for venture capitalists or the independently wealthy.
How to get your portfolio on point
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