Types of Investments
Throughout the series this far we have mentioned different types of investments - stocks, bonds, real estate, index link funds etc. but let’s break each one of these down as part of laying our investment foundation.
Stocks
Stocks represent ownership in a company. When you buy a share of stock, you become a part-owner of that company. Stocks are also known as equities because, as a part owner of the company, you have a right to the company's profits and assets after liabilities have been paid. Equity is calculated as Assets (what the company owns) minus Liabilities (what the company owes)
Stocks are traded—bought and sold—on stock exchanges. Most companies are listed on only one stock exchange, but some large multinational companies might be listed on more than one.
When a company first offers shares in the company to be bought and sold by the general public on a stock exchange, it's called an Initial Public Offering (IPO). You may also hear this referred to as “going public.”
Types of Stocks
- Common Stock: Provides shareholders with voting rights and dividends. The value of common stock can fluctuate significantly.
- Preferred Stock: Offers fixed dividends and has priority over common stock in the event of a company's liquidation. Preferred shareholders typically do not have voting rights.
Most of the time when you are buying stock you are likely buying common shares.
Advantages of Stocks
- High Return Potential: Stocks have historically provided higher returns compared to other asset classes.
- Liquidity: Stocks are easily bought and sold on stock exchanges.
- Ownership: Owning stocks means you have a stake in the company and may receive dividends (see above on different types of returns).
Disadvantages of Stocks
- Volatility: Stock prices can be highly volatile, leading to potential losses.
- Market Risk: Stocks are subject to market risk (see above on types of risk) and can be affected by economic conditions and company performance.
Bonds
Bonds are debt securities issued by corporations, municipalities, and governments to raise capital (money). This means they are basically an IOU from a company or government to you. You won’t own a part of the company like you would with shares in the company, so you will be paid interest on the loan and not a dividend.
When you buy a bond, you are lending money to the issuer in exchange for periodic interest payments and the return of the bond's face value at maturity. Maturity means the length of the bond. For example, some bonds are three years, others are five and still others are 10-year bonds. The interest rate that a bond pays is referred to as the coupon rate.
Types of Bonds
1. Corporate Bonds: Issued by companies to raise capital (money).When you buy bonds, unless you are an incredibly savvy, high-net-worth individual - read Warren Buffet, you are buying bonds from a publicly traded company. So, it is possible to own shares in and bonds from the same company.
Convertible bonds are bonds that give the bondholder the option to convert the bond into shares in the company. The convertible bond will have a conversion ratio and from that investors can calculate a conversion price.
Conversion Ratio: The number of shares that each bond can be converted into. For example, if a bond has a conversion ratio of 20, the bondholder can convert each bond into 20 shares of the company's stock.
Conversion Price: The price at which the bond can be converted into stock is determined by dividing the bond's face value by the conversion ratio. For instance, if the bond's face value is $1,000 and the conversion ratio is 20, the conversion price is $50 per share.
2. Government Bonds: Issued by governments to raise money and are separated by the level of government.- Municipal Bonds: Issued by state and local governments. Interest earned is often exempt from federal taxes.
- Treasury Bonds: Issued by the federal government and considered low-risk.
Advantages of Bonds
- Fixed Income: Bonds provide regular interest payments, making them a stable source of income. Remember our example of the $10,000 invested in a 10-year bond with a coupon rate of $300? This means that you will be paid $300 each until the bond matures, and when the bond matures, you will get your original $10,000 investment back regardless of what market conditions or volatility is happening in the stock market.
- Lower Risk: Because of this, bonds are generally less risky than stocks, especially government bonds.
- Diversification: Adding bonds to your portfolio can help diversify and reduce overall risk. Remember our conversation on market cycles? Stock prices often decline during a recession and during a recession, central banks often lower interest rates to stimulate the economy. And, when interest rates fall, the prices of existing bonds usually rise. This is because new bonds are issued at lower rates, making existing bonds with higher rates more attractive.
While it's not strictly true to say that the relationship between stocks and bonds is inverse, they can move in opposite directions during periods of economic uncertainty or changes in interest rates; there are also times when they move in the same direction.
Disadvantages of Bonds
- Lower Returns: Bonds typically offer lower returns compared to stocks.
- Interest Rate Risk: The value of bonds can decline if interest rates rise. (see discussion above on types of risk)
- Credit Risk: There is a risk that the bond issuer may default on payments. (see discussion above on types of risk)
Real Estate
Real estate investing involves purchasing property to generate income or appreciation. Return is measured both by capital gains and by any monthly rental income.
Types of Real Estate Investments
- Residential Real Estate: Includes single-family homes, multi-family homes, and apartments.
- Commercial Real Estate: Includes office buildings, retail spaces, and industrial properties.
- REITs: Companies that own, operate, or finance income-producing real estate. They offer a way to invest in real estate without directly owning property or taking on the day to management and responsibilities of being a landlord.
Advantages of Real Estate
- Income Generation: Real estate can provide rental income.
- Appreciation: Property values can increase over time.
- Diversification: Real estate adds another asset class to your portfolio. Think again about our discussion on interest rates and market cycles.
Disadvantages of Real Estate
- Illiquidity: Real estate is not easily sold compared to stocks and bonds.
- Management: Owning property requires management and maintenance.
- Market Risk: Real estate values can fluctuate based on economic conditions and market demand.
Mutual Funds and ETFs
Now, you could build a portfolio of investments made up of the different types of investment vehicles that we have talked about so far - stocks, bonds and real estate. Or you could invest in a mutual fund, which is essentially buying a piece of a portfolio that another investor - or portfolio manager - has built and manages. This is called a mutual fund. Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other securities.
Types of Mutual Funds
Equity Funds (Remember equity means stock):
- Growth Funds: These funds primarily invest in stocks of companies that are expected to grow at an above-average rate compared to other companies. They focus on capital appreciation and typically reinvest earnings rather than paying dividends.
- Value Funds: These funds invest in stocks that are considered undervalued in price based on fundamental analysis. They look for stocks that are trading for less than their intrinsic values and often pay dividends.
- Income Funds: These funds invest in stocks that pay regular dividends, providing investors with a steady income stream. They often include shares of established, financially stable companies.
- Sector Funds: These funds focus on a specific sector of the economy, such as technology, healthcare, or energy. They provide targeted exposure to a particular industry but come with higher risk due to lack of diversification.
- Index Funds: You have heard mention of these funds so far in this book. These funds aim to replicate the performance of a specific index, such as the S&P 500. They are passively managed, with lower fees, and provide broad market exposure.
Bond Funds. In the same way that a number of different stocks are held in an equity fund, a number of different bonds can be held together in a bond fund):
- Government Bond Funds: These funds invest in government securities, such as Treasury bonds, which are considered low-risk. They offer steady income with minimal risk.
- Corporate Bond Funds: These funds invest in bonds issued by corporations. They offer higher yields than government bonds but come with higher risk.
- Municipal Bond Funds: These funds invest in bonds issued by state and local governments. The interest earned is often exempt from federal taxes and sometimes state and local taxes, making them attractive to investors in higher tax brackets.
- High-Yield Bond Funds: Also known as junk bond funds, these invest in lower-rated bonds with higher yields. They come with higher risk due to the increased possibility of default.
Balanced Funds:
- These funds aim to provide a balanced mix of stocks and bonds to achieve a blend of growth and income. They are designed to reduce risk through diversification across asset classes and are suitable for investors looking for a moderate risk-return profile.
Money Market Funds:
- These funds invest in short-term, high-quality instruments like Treasury bills, certificates of deposit (CDs), and commercial paper (short-term, unsecured debt issued by corporations to raise money for short-term needs). They offer high liquidity and are considered very low risk, making them suitable for short-term investment goals and as a place to park cash.
International and Global Funds:
- International Funds: These funds invest in securities from countries outside of the investor's home country. They offer exposure to global markets and can help diversify a portfolio.
- Global Funds: These funds invest in securities from around the world, including the investor's home country. They provide broad international exposure.
Specialty Funds:
- These funds focus on specific investment strategies or market sectors. Examples include the REITs we have discussed above, and socially responsible funds, which invest in companies that meet certain ethical, environmental, and social criteria.
Exchange-Traded Funds (ETFs):
These are similar to mutual funds but trade on stock exchanges like individual stocks. ETFs offer the diversification of mutual funds with the flexibility of stock trading.
Advantages of Mutual Funds and ETFs
- Diversification: Both mutual funds and ETFs provide instant diversification.
- Professional Management: Mutual funds are managed by professionals who make investment decisions on behalf of investors. Do you feel all your worries about mismanaging your investment melt away?
- Accessibility: Both mutual funds and ETFs are accessible to individual investors with relatively low minimum investment requirements. I.e. You don’t need an investment advisor to buy your mutual funds for you.
Disadvantages of Mutual Funds and ETFs
- Fees: Mutual funds can have higher fees, such as management fees and expense ratios.
- Performance: Actively managed mutual funds may underperform their benchmarks.
- Market Risk: ETFs and mutual funds are subject to market risk and can fluctuate in value.
Commodities
Commodities are raw materials or primary agricultural products that can be bought and sold, such as gold, oil, natural gas, and agricultural products like wheat and corn. Including commodities in your investment portfolio can be another way to diversify and protect against inflation.
Commodities often have a low correlation with traditional asset classes like stocks and bonds. Including them can reduce the overall risk of your portfolio by spreading risk across different asset types. Additionally, commodities tend to perform well during periods of high inflation. As the prices of goods and services rise, the prices of commodities often increase as well, providing a hedge against inflation.
Advantages of Commodities
- Diversification: Commodities provide diversification as their prices often move independently of stocks and bonds.
- Inflation Hedge: Commodities can act as a hedge against inflation since their prices tend to rise with inflation.
Disadvantages of Commodities
- Volatility: Commodity prices can be highly volatile due to supply and demand factors.
- No Income: Commodities do not generate income like dividends or interest payments.
Empower Your Wealth: Become Your Own Financial Investment Manager is a 20 part series that teaches readers how to self-manage their investments. It covers basics to advanced strategies, emphasizing the importance of financial independence, diversification, risk management, and technology.