Investing 101: Types Of Investments
There are many types of investments and investing styles to choose from. Mutual funds, ETFs, individual stocks and bonds, closed-end mutual funds, real estate, various alternative investments and owning all or part of a business are just a few examples.
Buying shares of stock gives the buyer the opportunity to participate in the company’s success via increases in the stock’s price and dividends that the company might declare. Shareholders have a claim on the company’s assets in the event of liquidation, but do not own the assets.
Holders of common stock have voting rights at shareholders’ meetings and the right to receive dividends if they are declared. Holders of preferred stock don’t have voting rights, but do receive preference in terms of the payment of any dividends over common shareholders. They also have a higher claim on company assets than holders of common stock.
Bonds are debt instruments whereby an investor effectively is loaning money to a company or agency (the issuer) in exchange for periodic interest payments plus the return of the bond’s face amount when the bond matures. Bonds are issued by corporations, the federal government plus many states, municipalities and governmental agencies.
A typical corporate bond might have a face value of $1,000 and pay interest semi-annually. Interest on these bonds are fully taxable, but interest on municipal bonds is exempt from federal taxes and may be exempt from state taxes for residents of the issuing state. Interest on Treasuries are taxed at the federal level only.
Bonds can be purchased as new offerings or on the secondary market, just like stocks. A bond’s value can rise and fall based on a number of factors, the most important being the direction of interest rates. Bond prices move inversely with the direction of interest rates.
A mutual fund is a pooled investment vehicle managed by an investment manager that allows investors to have their money invested in stocks, bonds or other investment vehicles as stated in the fund’s prospectus.
Mutual funds are valued at the end of trading day and any transactions to buy or sell shares are executed after the market close as well.
Mutual funds can passively track stock or bond market indexes such as the S&P 500, the Barclay’s Aggregate Bond Index and many others. Other mutual funds are actively managed where the manager actively selects the stocks, bonds or other investments held by the fund. Actively managed mutual funds are generally more costly to own. A fund’s underlying expenses serve to reduce the net investment returns to the mutual fund shareholders.
Mutual funds can make distributions in the form of dividends, interest and capital gains. These distributions will be taxable if held in a non-retirement account. Selling a mutual fund can result in a gain or loss on the investment, just as with individual stocks or bonds.
Mutual funds allow small investors to instantly buy diversified exposure to a number of investment holdings within the fund’s investment objective. For instance, a foreign stock mutual might hold 50 or 100 or more different foreign stocks in the portfolio. An initial investment as low as $1,000 (or less in some cases) might allow an investor to own all the underlying holdings of the fund. Mutual funds are a great way for investors large and small to achieve a level of instant diversification.
ETFs or exchange-traded funds are like mutual funds in many respects, but are traded on the stock exchange during the trading day just like shares of stock. Unlike mutual funds which are valued at the end of each trading day, ETFs are valued constantly while the markets are open.
Many ETFs track passive market indexes like the S&P 500, the Barclay’s Aggregate Bond Index, and the Russell 2000 index of small cap stocks and many others.
In recent years, actively managed ETFs have come into being, as have so-called smart beta ETFs which create indexes based on “factors” such as quality, low volatility and momentum.
Beyond stocks, bonds, mutual funds and ETFs, there are many other ways to invest. We will discuss a few of these here.
Real estate investments can be made by buying a commercial or residential property directly. Real estate investment trusts (REITs) pool investor’s money and purchase properties. REITS are traded like stocks. There are mutual funds and ETFs that invest in REITs as well.
Hedge funds and private equity also fall into the category of alternative investments, although they are only open to those who meet the income and net worth requirements of being an accredited investor. Hedge funds may invest almost anywhere and may hold up better than conventional investment vehicles in turbulent markets.
Private equity allows companies to raise capital without going public. There are also private real estate funds that offer shares to investors in a pool of properties. Often alternatives have restrictions in terms of how often investors can have access to their money.
In recent years, alternative strategies have been introduced in mutual fund and ETF formats, allowing for lower minimum investments and great liquidity for investors. These vehicles are known as liquid alternatives.