Introduction to Investing
The investment landscape can be extremely dynamic and ever-evolving. But those who take the time to understand the basic principles and the different asset classes can see their investments grow over time.
The first step is learning to distinguish different types of investments and what rung each occupies on the "risk ladder."
Understanding the investment risk ladder
Here are the major asset classes, in ascending order of risk, on the investment risk ladder.
A cash bank deposit is the simplest, most easily understandable investment asset—and the safest. Not only does it give you precise knowledge of the interest you'll earn, but it also guarantees you'll get your money back.
On the downside, the interest earned from cash in a savings account rarely beats inflation. Term Certificates are very similar to cash deposits and typically provide higher interest rates savings accounts. However, money is locked up for a period of time and there can be early withdrawal penalties involved.
A bond is a debt instrument representing a loan made by an investor to a borrower. A typical bond will involve either a corporation or a government agency, where the borrower will issue a fixed interest rate to the lender in exchange for using their capital. Bonds are commonplace in organizations that use them in order to finance operations, purchases, or other projects.
Bond rates are essentially determined by the interest rates. Due to this, they are heavily traded during periods of quantitative easing or when the Federal Reserve—or other central banks—raise interest rates.
A mutual fund is a type of investment where more than one investor pools their money together in order to purchase securities.
Mutual funds are not necessarily passive, as they are managed by portfolio managers who allocate and distribute the pooled investment into stocks, bonds, and other securities.
Individuals may invest in mutual funds for as little as $1,000 per share, letting them diversify into as many as 100 different stocks contained within a given portfolio.
Mutual funds are valued at the end of the trading day, and all buy and sell transactions are likewise executed after the market closes.
Exchange-traded funds (ETFs)
Exchange-traded funds (ETFs) have become quite popular since their introduction back in the mid-1990s. ETFs are similar to mutual funds, but they trade throughout the day, on a stock exchange.
In this way, they mirror the buy-and-sell behavior of stocks. This also means their value can change drastically during the course of a trading day.
Shares of stock let investors participate in the company’s success via increases in the stock’s price and through dividends. Shareholders have a claim on the company’s assets in the event of liquidation (that is, the company going bankrupt) but do not own the assets.
Holders of common stock enjoy voting rights at shareholders’ meetings. Holders of preferred stock don’t have voting rights but do receive preference over common shareholders in terms of the dividend payments.
There is a vast universe of alternative investments, including the following sectors:
- Real estate: Investors can acquire real estate by directly buying commercial or residential properties. Alternatively, they can purchase shares in real estate investment trusts (REITs). REITs act like mutual funds: a group of investors pool their money together to purchase properties. They trade like stocks on the same exchange.
- Hedge funds and private equity funds: Hedge funds, which may invest in a spectrum of assets designed to deliver beyond market returns, called "alpha." However, performance is not guaranteed, and hedge funds can see incredible shifts in returns, sometimes underperforming the market by a significant margin. Typically only available to accredited investors, these vehicles often require high initial investments of $1 million or more. They also tend to impose net worth requirements. Both investment types may tie up an investor's money for substantial time periods.
- Commodities: Commodities refer to tangible resources such as gold, silver, crude oil, as well as agricultural products.
The bottom line
Investment education is essential, as is avoiding investments you don't fully understand. Rely on sound recommendations from experienced investors, while dismissing "hot tips" from untrustworthy sources.
When consulting professionals, look to independent financial advisors who get paid only for their time, instead of those who collect commissions. And above all, diversify your holdings across a wide swath of assets.