Main Types of Investment Assets
One of the biggest reasons people don’t invest the money they have is the sheer number of different investment vehicles available and the complexities of each. It can be quite overwhelming, but the truth is most investors only need to know about a few of them. Let’s go over some of the most popular and easy to trade investments out there.
Stocks are the first thing that come to mind for most people when talking about investing. A stock is nothing more than a share of ownership of a company, hence the term ‘share‘ being synonymous with ‘stock’. A person that holds 1% of the shares of a company effectively owns 1% of that company and is entitled to 1% of that company’s profits, which is paid to shareholders in the form of dividends, usually on some regular schedule for consistently profitable companies. The real underlying value of ownership is that a shareholder has a claim to all future profits. It sounds obvious, but that’s a point many amateur investors overlook, so I’ll say it again, slightly differently. The underlying value of a stock is the present value of all future dividend payments. It’s easy to get caught up in a rising stock and to value it based only on the hunch that down the line someone will want to pay even more than you did to buy that stock from you, but don’t fall into that trap. Eventually markets will become rational and the market price of a stock will tend toward what analysts believe is the value of the company’s profit stream.
Bonds are nothing more than loans. When you buy a bond, you are making a loan to the writer of that bond. You are offered some predetermined interest rate for a specific amount of time on that loan, after which the loan must be repaid. While bonds are generally considered safer investments than stocks, they do carry a risk: there’s nothing stopping the company writing the bond from declaring bankruptcy and going out of business before it can pay the bondholders.
In fact, if you’ve ever heard the term ‘junk bond’, that’s exactly the case. Junk bonds are bonds issued by companies in very poor financial positions. They generally have to offer very high interest rates to get anyone to buy the bonds. If the company does end up succeeding, the bondholder gets a nice return on his or her investment from the high interest rate, but if the company fails it will likely never be able to repay the original value of the bond.
One last common type of corporate bond is a convertible bond. A convertible bond can be converted into common stock, generally at the bondholder’s discretion. This allows the issuing company to sell bonds with a lower interest rate by offering bondholders upside potential if the stock takes off and surpasses the face value of the bond.
It is worth noting that bondholders have a higher claim to the assets of a company than do regular shareholders. In the event a company is liquidated, all bondholders will be paid before any shareholders.
Municipal bonds can be issued by private or public sector organizations to raise funds for public projects. The primary advantage of municipal bonds is that many are federal and state income tax exempt. This is of particular value to high earning investors (i.e. investors in high tax brackets) and investors in states with high income tax rates. Investors in more tax-friendly states or in lower brackets may prefer to seek out higher interest rates from bonds that don’t get preferential tax treatment.
Treasury bonds are a lot like corporate bonds, except they’re issued by the United States Department of Treasury. Many consider this the closest thing to a risk-free asset. Even if the United States government finds itself in a dire financial situation, the treasury department has the ability to print money as a last resort to make good on its obligations. Because of this, don’t expect this financial instrument to do much more than help you keep pace with inflation.
Mutual Funds and Exchange Traded Funds (which are essentially the same things, except rather than giving your money directly to the fund, you buy shares of the fund on an exchange) are incredibly popular investment vehicles. They allow ordinary investors that don’t have millions of dollars to still have a well diversified portfolio by indirectly owning tiny fractions of hundreds or thousands of underlying securities. A simplistic view of how they work is a fund manager picks a bunch of securities, buys them, pools them together, and then sells claims to fractions of that entire basket of securities. If a few individual securities in that basket do poorly, they’re still only a fraction of the entire basket. Likewise, if a few securities really take off, they can only pull on the entire basket by so much. Overall, the basket, or fund, should be much more stable and predictable than individual securities within the basket. That’s known in mathematics as the law of large numbers. This allows investors to get the higher expected return of risky assets, while mitigating risk through diversification.
There are two important classes of these funds: actively managed and passively managed. Actively managed funds have (usually highly paid) managers that closely study the securities within the fund and make changes as they deem appropriate and generally charge a higher fee. Passively managed funds (index funds), on the other hand, just blindly buy across a large group of stocks, for example the entire S&P 500, a bunch of stocks with high earnings relative to the price of the stock (value stocks), etc. While the former may sound smarter, consider the theory behind passively managed funds. The stock market is an efficient market and the price of a stock reflects its true value as determined by all participants in the market. If a fund manager says a particular stock is undervalued and should be bought, he’s basically making the claim that he’s smarter or knows more than everyone else on Wall Street. After all, if others agreed with that manager, they would also buy that stock, thereby driving the price up, until it was no longer undervalued. The argument for passively managed funds is that the market has done the research for you, for free. Why pay analysts big bucks to do unnecessary research?
There are certainly complexities to modern financial markets, but you don’t have to have a degree in Finance to understand enough to start investing. Most people don’t need anything more complicated than mutual funds or bond funds in their portfolio. One of the most overlooked risks to investing is letting your risk aversion allow you to forego growth opportunities. Taken to an extreme, i.e. holding all your savings in cash, will just allow inflation to eat away most of what you have if given enough time.