6 Different Types of Investments
As an investor, you have a lot of options for where to put your money. It’s important to weigh types of investments carefully.
Investments are generally bucketed into three major categories:
- Cash equivalents
There are many different types of investments within each category.
Here are six types of investments you might consider for long-term growth, and what you should know about each.
A stock is an investment in a specific company. When you purchase a stock, you’re buying a share, or a small piece, of that company’s earnings and assets. Companies sell shares of stock in their businesses to raise cash. Investors can then buy and sell those shares among themselves.
Stocks sometimes earn high returns but also come with more risk than other investments. Companies can lose value or go out of business.
How investors make money: Stock investors make money when the value of the stock they own goes up and they’re able to sell that stock for a profit. Some stocks also pay dividends, which are regular distributions of a company’s earnings to investors.
A bond is a loan you make to a company or government. When you purchase a bond, you’re allowing the bond issuer to borrow your money and pay you back with interest.
Bonds are generally considered less risky than stocks, but they also may offer lower returns. The primary risk, as with any loan, is that the issuer could default.
U.S. government bonds are backed by the “full faith and credit” of the United States, which effectively eliminates that risk. State and city government bonds are generally considered the next-less-risky option, followed by corporate bonds. Generally, the less risky the bond, the lower the interest rate.
How investors make money: Bonds are a fixed-income investment, because investors expect regular income payments. Interest is generally paid to investors in regular installments, typically once or twice a year, and the total principal is paid off at the bond’s maturity date.
3. Mutual funds
If the idea of picking and choosing individual bonds and stocks doesn't appeal to you, you’re not alone. In fact, there’s an investment designed just for people like you: the mutual fund.
Mutual funds allow you to purchase a large number of investments in a single transaction. These funds pool money from many investors, then employ a professional manager to invest that money in stocks, bonds, or other assets.
Mutual funds follow a set strategy. A fund might invest in a specific type of stocks or bonds, like international stocks or government bonds. Some funds invest in both stocks and bonds. How risky the mutual fund is will depend on the investments within the fund.
How investors make money: When a mutual fund earns money, through stock dividends or bond interest, for example, it distributes a proportion of that to investors. When investments in the fund go up in value, the value of the fund increases as well, which means you could sell it for a profit. Note that you’ll pay an annual fee, called an expense ratio, to invest in a mutual fund.
4. Index funds
An index fund is a type of mutual fund that passively tracks an index, rather than paying a manager to pick and choose investments. For example, an S&P 500 index fund will aim to mirror the performance of the S&P 500 by holding stock of the companies within that index.
The benefit of index funds is that they tend to cost less because they don’t have that active manager on the payroll. The risk associated with an index fund will depend on the investments within the fund.
How investors make money: Index funds may earn dividends or interest, which is distributed to investors. These funds may also go up in value when the benchmark indexes they track go up in value. Investors can then sell their share in the fund for a profit. Index funds also charge expense ratios, but as noted above, these costs tend to be lower than mutual fund fees.
5. Exchange-traded funds
ETFs are a type of index fund: they track a benchmark index and aim to mirror that index’s performance. Like index funds, they tend to be cheaper than mutual funds because they are not actively managed.
The major difference between index funds and ETFs is how they are purchased. ETFs trade on an exchange like a stock, which means you can buy and sell ETFs throughout the day and an ETF’s price will fluctuate throughout the day.
Mutual funds and index funds, on the other hand, are priced once at the end of each trading day. That price will be the same no matter what time you buy or sell.
Bottom line: this difference doesn’t matter to many investors, but if you want more control over the price of the fund, you might prefer an ETF.
How investors make money: As with a mutual fund and an index fund, your hope as an investor is that the fund will increase in value and you’ll be able to sell it for a profit. ETFs may also pay out dividends and interest to investors.
An option is a contract to buy or sell a stock at a set price, by a set date. Options offer flexibility, as the contract doesn’t actually obligate you to buy or sell the stock. As the name implies, doing so is an option. Most options contracts are for 100 shares of a stock.
When you buy an option, you’re buying the contract, not the stock itself. You can then either buy or sell the stock at the agreed-upon price within the agreed-upon time, sell the options contract to another investor, or let the contract expire.
How investors make money: Options can be quite complex, but at a basic level, you are locking in the price of a stock you expect to increase in value. If your crystal ball is right, you benefit by purchasing the stock for less than the going rate. If it is wrong, you can forgo the purchase and you’re only out the cost of the contract itself.
Before you start investing
Be sure to educate yourself about different types of investments, how they work, and the risks associated with each before you start investing. An ill-informed investment strategy could cause you to lose a lot of money.