(Understanding)
Here are the major asset classes, in order of ascending risk, on the investment risk ladder:
Cash: A bank deposit is the safest and simplest investment asset to understand. It’s usually the first one we encounter. It provides investors with a clear account of the interest they will earn and ensures they will get their capital back. However, the interest from cash in a savings account rarely keeps up with inflation.
Certificates of deposit (CDs) are less liquid and typically offer higher interest rates than savings accounts. Your money is locked in a CD for several months to years, and there is usually a penalty for early withdrawal.
Bonds: A bond is a loan that an investor makes to the issuer, typically a corporation or government. The borrower issues a fixed interest rate to the bond buyer in exchange for using their capital. U.S. Treasuries are the most popular bonds in the world.
Bond rates are largely influenced by central bank interest rates. Therefore, these bonds are actively traded when the U.S. Federal Reserve or other central banks increase rates.
(Understanding) Mutual Funds
A mutual fund is a large investment pool where many people combine their money and give it to a professional money manager. This manager buys stocks, bonds, or other investments on their behalf. In return, you receive shares based on how much you invest in the large pool of assets.
These funds allow investors to start with as little as $500, and many have no minimum. Even with a small investment, you can own pieces of hundreds of different companies. For example, if you invest $1,000 in a mutual fund with 100 different stocks, it’s like buying small portions of all those companies at once.
Some mutual funds track popular indexes like the S&P 500, similar to what the first mutual funds in the 1970s did. These are known as “passive” funds because the managers aim to match a specific index, which requires much less effort than trying to beat the market.
Other mutual funds are actively managed. In these cases, investment professionals attempt to outperform the market by constantly adjusting their investments, much like a chef trying out different ingredients. These funds usually charge higher fees, which can reduce your returns over time.
Unlike stocks, which you can buy and sell throughout the day, mutual fund transactions only occur once a day after the market closes. The price you pay or receive is based on the net asset value (NAV), which is the total value of the investment pool calculated at the end of each trading day.
(Understanding) Exchange-Traded Funds (ETFs)
Exchange-traded funds (ETFs) became very popular after their launch in the early 1990s. ETFs function like mutual funds but trade throughout the day on an exchange. You can trade them just like shares of Apple (AAPL) or any other publicly traded company. Their value fluctuates during the trading day.
ETFs can mirror an underlying index, such as the Dow Jones Industrial Average (DJIA), or other collections of stocks selected by an ETF manager. The index might cover various sectors, like emerging markets, commodities, biotechnology, or agriculture. However, the most popular ones, especially among large institutional investors and regular contributors, remain those that track indexes.
Stocks
When you buy a stock, you are purchasing a small ownership stake in a company. If you own Apple stock, for instance, you are a part-owner of the business, even if it’s only a small amount.
There are two primary ways to profit from stocks:
- The share price increases after your purchase. When other investors find the company attractive and the stock price appealing, they will buy the stock. If enough people do this, the share price will rise. When it does, you can sell your shares for a capital gain, which is the amount above what you paid.
- Dividends are regular payments that companies share with their stockholders. Companies that have paid dividends for 25 consecutive years are referred to as dividend aristocrats.
However, stocks carry real risks. Companies can lose money, stock prices can drop below your purchase price, and in the worst-case scenario—if a company goes bankrupt—stockholders are last in line to receive any money back. For this reason, financial advisors often recommend not investing money in stocks that you may need within the next five years.
You can reduce your risk by selecting certain types of stocks. Large, established companies like Coca-Cola (KO) or Johnson & Johnson (JNJ) generally provide more stable but slower growth. Midsized companies fall in between, while small companies, known as small-caps, can grow rapidly but are also more likely to face difficulties.
The most speculative stocks usually come from young companies in emerging sectors or those experiencing financial trouble. Known as “penny stocks,” they trade for less than $5 per share.
(Understanding) Alternative Investments
There is a wide range of alternative investments that do not fit into the categories of stocks, bonds, or funds:
Real Estate: You can invest in real estate in two ways. The direct method involves buying property, which requires significant time and capital. Alternatively, you can purchase shares of real estate investment trusts (REITs). REITs are companies that own and manage properties and trade like stocks. They must pay out 90% of their profits each year to investors, leading to higher dividends.
Hedge Funds and Private Equity: These investment vehicles are exclusive and only accessible to accredited investors. Hedge funds use complex strategies to seek profits regardless of market direction. Private equity firms purchase entire companies, restructure them, and sell them for a profit. Both often require investors to lock in their money for several years.
Commodities: These tangible goods include gold, crude oil, or agricultural products. You can invest in commodities through specialized funds that track their prices. Many investors use commodities as a hedge against inflation, as their prices often increase when living costs rise.
(Understanding).