Investing 101: A Beginner’s Guide to Types of Investments
What is a stock?
- When you purchase individual stocks, or “equities,” you become a shareholder or part owner of the business. This entitles you to vote at the shareholders’ meeting and allows you to receive any profits that the company allocates to its owners. These profits paid to shareholders are referred to as dividends. Ownership is determined by the number of shares a person owns relative to the total number of outstanding shares.
- Individual stocks are the most risky to invest in because they have high volatility, but some are more risky than others. The stock market has 11 sectors (or categories): Financial, Utilities, Consumer Discretionary (luxury products), Consumer Staples (everyday products), Energy, Health Care, Industrials, Information Technology, Telecommunications, Real Estate, and Materials.
- Sectors like Utilities and Consumer Staples tend to be more defensive than sectors like Consumer Discretionary and Information Technology. It’s typically better to invest in defensive sectors when the market is bearish (not doing well), so you don’t lose a lot of money, and better to invest in riskier sectors when the market is bullish (doing well), in hopes of high returns. Remember, you have to be willing to lose money in order to make money.
- Information Technology is a popular sector right now due to competitive, high innovation among companies in a bullish market. The most watched tech stocks are commonly referred to in the media as “FAANG” (Facebook, Amazon, Apple, Netflix, and Google).
- The issue with investing in stocks is it can result in many different outcomes. For example, if you had bought $1,000 worth of shares of Apple (AAPL) in August 2002 at its low, you would now have approximately $150,000. Alternatively, if you had bought $1,000 worth of shares of BlackBerry (BBRY) in July 2007 at its high, you would now only have about $50. Most likely you will end up somewhere in between. This shows the importance of constantly monitoring the companies whose stocks you want to buy, so you can try to estimate the best time to buy and sell.
What is a bond?
- Grouped under the general category called fixed-income securities, the term bond is commonly used to refer to any securities that are founded on debt. When you purchase a bond, you are lending out your money to a company, municipality or government. In return, they agree to give you interest on your money and eventually pay you back the amount you lent out.
- Each bond has a stated date of maturity and a rate of interest payments (coupons). The value of a bond can fluctuate during its holding period; however, if held to maturity, it will be redeemed at par, or 100 ($1,000). Bonds may also be bought or sold during the holding period for current market value, which would either be at a “premium” or “discount” to par.
- Bonds are very stable investments, especially those with high credit ratings, and are often used in retirement accounts because you’re less likely to lose money. However, little risk also means less potential return.
What is a mutual fund?
- A mutual fund is a collection (or basket) of stocks and bonds. When you buy a mutual fund, you are pooling your money with a number of other investors, which enables you (as part of a group) to pay a professional fund manager to select specific securities for you.
- Mutual funds are set up with a specific strategy in mind, and their distinct focus can be nearly anything.
- A mutual fund can only be traded (bought or sold) at the end of a trading day at its final net asset value (NAV) price. The “NAV” or closing price each day represents the current market value of all underlying holdings and since both stocks and bonds fluctuate in price every day, a mutual fund may rise or fall in value on any given day and/or over time.
- There are different categories of mutual funds with various levels of volatility to choose from. Some are more heavily weighted toward equities (stocks), and some are more weighted toward bonds.
- Equity funds are broadly categorized into large cap, mid cap, and small cap according to the size of the companies in their holdings. For example, Apple (AAPL) is a large cap company due to its high market value.
- There are funds categorized as international. International, emerging market funds can be risky due to factors such as unstable governments or exchange rates. But they can also have a high return due to large economic growth potential.
- Bond funds are categorized by the time periods the bonds will take to mature.
- The two possible investment strategies are passive vs. active management. Passively managed funds usually own an index, have a low fee, and have little tracking error. Actively managed funds have a manager who chooses investments, a higher fee, higher tracking error, and can either out perform or under perform an index.
What is an ETF?
- An exchange-traded fund (ETF) is a security that tracks an index, a commodity or a basket of assets similar to a mutual fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.
- ETFs are fairly new and are quickly gaining popularity due to low average expense ratios compared to mutual funds.
- An advantage to mutual funds and ETFs is the diversification benefits. You can own a portfolio of multiple stocks without having to buy the more expensive individual shares.
What is an index?
- An index is an imaginary portfolio of securities representing a particular market or a portion of it. Each index has its own calculation methodology and is usually expressed in terms of a change from a base value. Thus, the percentage change is more important than the actual numeric value. Because, technically, you can’t actually invest in an index, index mutual funds and exchange-traded funds (based on indexes) allow investors to invest in securities representing broad market segments and/or the total market.
- The most popular in the U.S. are the Dow Jones Industrial Average (DJIA), the Standard & Poor’s 500 (SPX), and the Nasdaq Composite (COMP), which is heavily weighted towards the Information Technology sector. They are often used as a way to benchmark and monitor the overall market.
Hopefully you now have a better understanding of the different investment vehicles available. If you are ready for the 200 or 300 level courses on investing, Investopedia has some great resources.
If you’re ready to take the plunge and start investing your money, make sure to always consider the amount of risk you’re both willing and able to take. You can easily pinpoint you risk tolerance with this short questionnaire.