There is plenty of articles and books out there that will explain the breakdown of investment types, but the vernacular and word choice reminds me something closer to a Shakespearean play than actual layman’s terms of what different investment classes mean.
Keep in mind this is an extremely basic overview to get your feet wet into what different investment classes indicate in a general sense. There will definitely be room for future posts and articles to dive strictly into each investment class, but a basic overview will suffice for a general dive into the waters.
You’ve heard it plenty of times already. If you want to be smart and financially successful, then you should invest your money. But, what does investing your money actually entail and mean in practice?
Money In A Savings Account Weakens Overtime
While it’s essential to save consistently overtime to insure yourself against future emergencies, you don’t want to keep more than 3-6 months of emergency spending in your banks’ savings account. You may be the most frugal person on the planet or pull in a 6-figure income in your early 20’s, but no one escapes the unrelenting power of inflation.
The average rate of inflation on a year basis is 3-4%. Say you kept your entire net worth of 20k in your bank account and you left it alone for 5 years. After that time period, that same 20,000 dollars will not have the same buying power due to the average cost of goods and services ever increasing annually.
Protect yourself against inflation and improve your buying power against degradation of value by investing intelligently over a long time period. Everyone’s investment philosophy is different, but to develop your own, you should spend time to building your foundation of understanding.
Before we start, remember, no one can consistently time the market. Again, no one in the world can time the market. If Warren Buffet can’t do it, don’t think you will be the first to do so. A lucky bet here and there is not an indication of consistent success.
Stocks are riskier if you are investing for the short term. In return, the gains made on stock funds will typically be greater than other investment classes on average.
What is a stock? A stock is a representation of a piece of a company. The amount that one pays for a single share of a company is the stock price. Stock prices rise and fall in accordance to the value of the company, the industry, supply and demand, what have you. Stock prices rise and fall for any number of reasons, some that may not have to do with a particular company or industry at all.
As such risk is intrinsic with stock funds, these funds will perform better on average in due accordance with the risk.
You can make money on stocks in a couple of ways.
A capital gain is the difference between the higher price you sell your shares for as opposed to the initial price you bought in at.
A dividend are consistent payouts from a company to shareholders.
Both are ways in which people seek to benefit from holding stock funds.
A bond can be characterized as being owed money by a particular organization, government, or such. Purchasing a bond is similar to offering a loan that will be paid back with interest.
Some bonds will be paid based on either a monthly or quarterly basis. Some other bonds won’t be paid out until the bond has completely and fully matured on its term.
The risk with bonds is called default risk and an interest rate risk.
A default risk is when the issuer of the bond can’t pay back the money and you won’t get repaid.
An interest rate risk is if the market level interest increases while you own a bond, so the rate at which you bought the bond originally won’t be as strong as the current-day market’s. This is an extremely simple way of stating that, but again, it is best to start off building the foundation with a basic understanding.
These are a safe alternative for those who prefer to not keep money in a bank account, but don’t necessarily want to invest in a bond or stock fund. Some people actually keep their emergency money in a mutual fund as opposed to a savings account, as there is a somewhat higher interest return on the money held here as opposed to savings accounts.
It’s also easier to access the money in a mutual fund compared to getting your money out of stocks or bonds. The return on mutual funds can come in the form of capital gains, dividends, or interest. Mutual funds are a great way to diversify your income, as they can track a number of different stock or bond market indexes.
ETFs are short for electronically traded funds. While mutual funds are valued at the end of a trading day, ETFs are valued as long as the market is open. ETFs can also track market indexes, such as the S&P 500.
Many ETFs track commodities, assets, indexes, or particular groupings. Advantages of ETFs can include lower expense ratio compared to mutual funds and diversification of an index fund.
What is your risk tolerance?
Again, this is an absurdly simple definition of four main investment types. Diving into each particular investment class could (and have) taken up entire books.
However, I argue that it is in your best interest to build foundational knowledge before developing your investment philosophy as it dependent on your risk tolerance, time frame, and so forth.