An Overview Of The Different Types of Investments
There are many different types of investments to choose from. The choices available make it difficult for the average investor to understand what is appropriate for them, or what they even are. If you are a beginner, or only invest in employer-provided 401k style plans at this time, then your focus should be on mutual funds. Mutual funds are the most likely types of investments offered to you through your sponsored plan. However, you should still be familiar with the other classes of investments mentioned here, because all mutual funds are based upon them. Additionally, it is a great idea to learn more about your investment options because your needs may change and you might want to diversify your portfolio with other types of investments when opening other investment accounts.
Stocks, also called equity or shares, represent a claim or part ownership of a company. Ownership of stock in a company means you own a portion of everything the company owns (assets) and everything it makes (earnings). Most companies have sold millions of shares, so your ownership in the company will probably be very small.
The two primary means of profiting by owning stock are through price appreciation and dividends. Price appreciation is achieved when investors feel that the company is worth more based on its earnings, value, and even speculation. Dividends are set payments that an investor receives based on a portion of the earnings the company makes. Some companies pay dividends on a quarterly basis, some pay occasionally, and some never pay dividends.
Fixed income investments include corporate bonds, treasuries (government issued bonds, notes, and bills), and municipal bonds. Bonds are basically loans that you provide to these entities for a set period of time. In return for your loan, they pay you a set interest rate (typically paid every six months) and then re-pay the initial loan (bonds are typically sold in increments of $1,000) at the end of the term. Terms vary from as little as a few years to as long as 50 years!
Interest rates vary on fixed income investments based on risk. Usually, government bonds are considered risk free and municipal bonds are considered low risk. Risk free is kind of a misnomer because all debt carries risk of default, even for government entities. However, based on guarantees the U.S. Government provides, treasuries are considered the standard in risk free fixed income investments. Corporate bonds interest rates will vary more widely than government bonds because their risk profile is quite different. A corporation’s risk of default can run the entire spectrum of high quality to currently in default. It depends on the financial stability of the company that issues the bond.
Mutual funds are extremely popular investment vehicles because they make investing easier. Mutual funds are provided by investment companies who create these funds by collecting money from a large group of investors in order to maximize the theory of “economies of scale.” By acting on a collective basis, investors capitalize on professional experience to invest for them and enables participation in the market on a larger scale through diversification and buying power. Simply, when you purchase a share of a mutual fund, you are giving money to a professional investment manager who purchases a “basket” of investments on your behalf. Your share of the mutual fund represents fractional ownership of many different assets.
There are many different types of mutual funds. They range from investments in U.S. stocks and bonds, international stocks and bonds, real estate, etc. They can represent very broad parts of the market or very specific niches. Dividends and capital gains (profit when you sell stocks) are passed through to the investor based on how many shares of the mutual fund you own. Mutual funds are traded only once a day, at the end of the day. You pay a management fee (known as expense ratios) to the investment company for being part of the mutual fund. The fee is often quoted as a percent and is automatically taken from the fund’s return.
Exchange Traded Funds
Exchange Traded Funds (ETF) are put together much like mutual funds. ETF’s are built to be extremely tax efficient, so they are made up of indexes (indexes are investments or assets that are grouped together as a means to compare investment performance.) and attempt to negate dividends and capital gains. The difference between ETF’s and mutual funds are mainly seen in the fee’s and through trading. ETF’s trade like stocks throughout the day and usually have lower expenses than mutual funds because they do not require active management by the sponsoring investment company. ETF’s can be used to develop an entire investment portfolio, or they can be used to diversify existing portfolios by creating instant access to specific types of investments in different countries or industries.
Stocks, bonds, mutual funds, and ETF’s are the primary types of investments the common investor should be involved with. Those are the ones you should really get to know and make part of your investment portfolio. They will be important tools for wealth building and retirement saving. That said, there are many other types of investments you can get involved with. These alternative investments should only be utilized by advanced traders. Most people should not get involved in alternative investments because they are not well suited for the majority of Americans. They either require a very large sum of money to get started, or they can really damage your net worth if you do not know what you are doing. You should only invest in things you have an understanding of.
Alternative investments include: real estate, derivatives, options, futures, commodities, currency (forex), and many more. Later, I will cover some basic alternative investments that are encompassed within mutual funds. However, this is probably as far as the typical investor should go. Alternative investments make the headlines a lot. This is because some people make great sums of money on “bets” that cover these types of investments. Many people also lose a lot of money because of them. Again, I want to emphasis that you are investing your savings…not betting. Investing is not, and should not be gambling.
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