Investing for the first time can be intimidating, which is why we are writing this series for beginning investors. The first article in the series covered why we should invest. In it we discussed the importance of investing and how it’s not as difficult as many people believe. In this article, we discuss ways to invest and different types of investments.
Are you familiar with different types of investments? If you think that bonds are British secret agents and stocks are what thieves were shackled into in Colonial America, you’re not alone. Just like any subject, investing has its own vocabulary and it can feel a little intimidating to ask basic questions of an expert. So here is a breakdown of different ways to invest your money, and what they all will mean for your bottom line:
Investment Basics – Types of Investments
Certificates of Deposit
A Certificate of Deposit (CD) is a short-term, debt-based investment offered by a bank. In short, you give your money to the bank who lends it out to someone in the form of a loan. You receive your money back plus interest anywhere from three months to six years later. CDs are very low risk investments, but they also offer a relatively low return on investment. Because these deposits are based on a set time limit, there may also a penalty if you need to withdraw your money prior to the maturity date. Read more about using CDs as short term investments in our article about how to build a CD ladder.
A treasury bill (T-bill) is a short-term investment offered by the government. The term is usually less than one year and typically three months. T-bills generally don’t pay interest, but you can buy them at a discount, meaning you yield the difference between the purchase price and the redemption value. This means you actually buy the bond at less than face value and redeem it for face value upon the maturity date. T-bills are backed by the government and offer the closest thing to a risk-free investment available to any investor. However, their very low yield is a major drawback. US Savings bonds can be similar low risk, low return investments.
A bond is similar to a CD in that it is debt-based. Essentially, a bond is an IOU issued by a company. When you purchase a bond, you loan a specified amount of money for a specified number of years in return for interest on the investment. Bonds generally offer much higher interest rates than CDs or T-bills and offer relatively low risk. However, they are long-term investments, which means that your money is tied up for anywhere from 10 to 30 years. If you need to sell your bond before it reaches maturity, the sale may result in a loss. Also, though bonds are relatively low risk, it is always possible that the bond issuer may declare bankruptcy or otherwise default, meaning it is possible to lose money.
A stock is different from the debt-based investments. When you purchase stock, you have in effect become a partial owner of a company—and you get a piece of any profits (known as dividends) that the company allots to share holders. Dividend investing is a popular and proven way to invest in stocks, but if your stocks do not pay dividends (not all do), then you only make money if your stock increases in value. Unlike a bond, your return on investment is not guaranteed with a stock. Stock values fluctuate from day to day, which means that your risk is greater—as are your potential returns.
Mutual funds were created in order to allow investors to pool their money in order to buy a variety of investments—and let a professional money manager determine the best use of the investors’ money. Mutual funds are an easy way to diversify your investments (more on that next week). However, many mutual funds charge management fees of around 2% (the professional money manager needs to take a cut) and their performance depends on how good your fund manager is.
Index funds are similar to mutual funds—they allow investors to pool their money to purchase stocks in a large number of companies, giving them the opportunity to invest in a variety of companies without buying hundreds of individual stocks. The main difference between index funds and mutual funds is active management vs. passive management. Mutual funds are managed actively, meaning the portfolio manager actively chooses which stocks to purchase based on the mutual fund goal, and index funds are passively managed, meaning the stocks in the index fund are based on a preset list of stocks. Most index funds track a market index such as the S&P 500, NASDAQ, Wilshire 5000, indexes which track foreign markets, and similar stock market indexes. The goal of an index fund is to simply match the market as closely as possible, while not charging investors as much money in fees as some actively managed funds charge. Learn more about why index funds are attractive investments.
Gold, Silver, Precious Metals, and Commodities
Many people feel the stock market is too risky and prefer to invest in a physical asset such as gold, silver, precious metals, or even commodities. These investments can be a good way to diversify your investments. However, like most investments, it may not be a good idea to maintain a portfolio which 100% invested in precious metals. Learn more about investing in precious metals.
Which type of investment is best?
Each of these investments has its own set of pros and cons, and they can all be appropriate for investors based on their individual investment needs. In most cases it is a good idea to use a variety of different investment types in one portfolio. Next week, we’ll take a look at why diversity is important in your investments.