20 Tools For Building Up Your Portfolio
The concept of a portfolio and the birth of individual investing have opened up possibilities for everyone. The only real difference between you and Warren Buffett is a few well-chosen stocks - the billion-dollar fortune is the result. Stocks, while important, aren't all there is to investing. Keeping your portfolio divided between the different investment vehicles reduces your overall risk while still generating returns. Here are 20 investment tools you can use to increase your portfolio's diversity.
Go Global With ADRs
American Depository Receipts (ADRs) were introduced to streamline the purchase of foreign assets. ADRs are created when banks buy bundles of foreign shares and repackage them to sell on U.S. stock exchanges. Instead of having investors switch dollars for another currency to buy foreign shares and switch back to dollars when selling, banks eliminate the currency transaction. ADRs face exchange rate risks and political risks as well as the regular risks for stocks, but they offer global diversity in a convenient package. For more, see ADRs: Invest Offshore Without Leaving Home.
Add Annuities To Your Retirement Portfolio
Annuities are investments that provide annual payments and are usually sold by insurance companies. Although generally used as retirement vehicles, annuities come in several flavors. Deferred annuities and immediate annuities differ in when the payments begin, and fixed annuities and variable annuities have different payment structures. Disadvantages include penalties for withdrawing the principal and the ever-present drain of inflation on future returns. Despite this, annuities can be a great way for investors nearing or in retirement to enjoy the benefits of compounding because they are low risk and gains are tax deferred. (For more on this, see Personal Pensions: Repackaging The Annuity.)
Get In On Closed-End Investment Funds
A closed-end investment fund is similar to a mutual fund, the difference being that the price of shares in the fund are decided by demand on the open market rather than by net asset value. Basically, you are buying shares of a fund that buys shares in the market, so your fund's share price is only as good as the management's performance. Generally, these funds specialize according to purpose (capital appreciation, dividend income, etc.) and market (energy, technology, pharmaceuticals, etc.), so it is important to read the prospectus and check the performance history before buying in. See Open Your Eyes To Closed-End Funds.
When footage of Marilyn Monroe sells for over $14,000 and a Honus Wagner card for over $1 million, it's hard not to see an upside to collectibles. Before you make them the base of your portfolio, however, it's important to look at the downside. Similar to precious metals, owning collectibles produces no income and gains are only realized through appreciation. Unlike precious metals, physical damage can erase all the value of a collectible, meaning that you need to factor maintenance costs against future returns. There is no doubt collectibles can produce big returns, but they're more of a purchase than an investment and are usually best left to those with a genuine passion. For more on this, see Contemplating Collectible Investments.
Common Stock, Uncommon Returns
Stocks have history running in their favor, averaging 11-12% a year, and they outperform just about every type of investment. The trade-off is that stocks come with greater risk. Average market returns are no comfort if you buy at the market peak and sell during the graveyard. Still investing in stocks is no longer as mysterious or as elite an activity as it used to be. Armed with the desire to learn, you can make stocks a powerful source of returns in your portfolio. To learn more about stocks, see our Stock Basics Tutorial.
The Magic Of Convertible Securities
Convertible securities are the alchemists of the financial world. They can change bonds representing a company's debt into stocks representing ownership of the company. Convertible bonds allow a company to get financing at a low interest rate without having to explicitly issue more stock - something that existing shareholders frown upon. For investors, convertible bonds offer protection in that they function as bonds if the company does poorly, but can be turned into stock if a company does well. Depending on the company, convertible bonds offer risks and rewards somewhere between true stocks and true corporate bonds, and carry an extra caveat in that they are callable. See Convertible Bonds: An Introduction for more.
Enter The World Of Corporate Finance
Corporate bonds are basically loans made from an investor to the corporation issuing the bond. Whereas normal people go to a bank and have to get approved, corporations set their own terms and then find investors. Bonds are evaluated by the default risk of the borrower, the interest rate offered,and the maturity date. Corporate bonds carry a higher yield - that is, they pay more to investors - than government bonds. Corporations with a high default risk have to pay even more to woo investors - these are called junk bonds. To learn more about bonds, see our Bond Basics Tutorial.
Buy Into The Future
At its core, a futures contract is simply a way to move the risk of price volatility off producers and onto investors, who are prepared to take on the risk in order to profit. If an egg producer needs $2/dozen to stay in business, but the market price fluctuates between $1 and $3 throughout the year, the producer can enter a futures contract at $2 to lock-in the price. The investor now holds the risk of the price of eggs plummeting and the profit if the price goes up - though in the latter case, the investor may be left with only the fee the producer paid to enter the contract rather than the profits. For more on trading in futures, see the Futures Fundamentals Tutorial.
Play The Game Of Life
Taking out life insurance is essentially playing the odds on your mortality. When you're young the issuer is willing to give it to you cheap because the odds are against you dying suddenly and making them pay out your plan. As you age, however, the ante keeps going up. Life insurance is invaluable for the peace of mind it provides and can even be used as a hedge against wasting illnesses that you may not have coverage for under your health plan (dread disease rider). Although your goal should be to get into a financial situation where your assets will more than cover your obligations when you die, life insurance is an excellent stop-gap until that day. For more, see How Much Life Insurance Should You Carry?
Take Idle Funds To The Money Market
The money market is a basket of short-term, fixed-income securities that are meant to provide a return on idle funds without sacrificing liquidity. For example, many full service brokerages keep investors' cash balances in money market accounts while the investor considers his or her investment options. If you need to house money for a short time and don't have the thousands it takes to buy directly into the money market, it can be accessed through money market funds. These are basically mutual funds dealing exclusively in the money market. If you are working with a longer time horizon, however, then bonds or equities are a better bet. To learn more, see our Money Market Tutorial.
Give Mortgage-Backed Securities A Second Chance
The world revolves on credit. Freddie, Fannie and Ginnie are responsible for repackaging mortgages into investments so that banks can move loans off their balance sheets and offer more credit to consumers. There was a time when mortgage-backed securities (MBS) were as good as gold. That is to say that they carried little risk of default, offered both liquidity and capital appreciation, and offered better returns than bonds - all in all, an excellent investment. Unfortunately, the MBS industry took a hit in the mortgage meltdown of 2007-08 as loans were being given to less credit-worthy individuals - the MBS then became toxic. MBS will recover to provide excellent investment opportunities in the future as they have become as essential as stocks for making the market work, but they must now be approached with healthy skepticism. See Profit From Mortgage Debt With MBS for more.
Invest In Infrastructure
Municipal bonds are debt instruments issued by local governments to cover capital expenditures like road maintenance and other infrastructure projects. Munis carry very good tax breaks because the governments, federal and state, want to encourage private investment in infrastructure as it lessens the strain on their budgets. The interest on munis tends to be much lower than corporate bonds because of the advantageous tax breaks. You can get exposure to a pool of munis through municipal bond funds to lessen the risk of default in any one county. Although default is very rare, it has happened. See The Basics Of Municipal Bonds for more.
Follow The Leader
Mutual funds are the casual investors solution to research. In theory, you pay a management fee to a professional who does the due diligence for you and comes up with a portfolio that should provide above-average returns. By pooling your money with other investors, your fund manager can buy into investments that require larger amounts of capital. Sadly, funds vary widely according to the quality of the fund manager, so you will still have to do research to find a fund that fits your investment goals, and has a manager who can deliver choice returns. The upside is that a good mutual fund gives you diversity through a single investment. For more, see our Mutual Fund Basics Tutorial.
Take Stock Of Your Options
If you are comfortable trading stocks, there is a way to increase your gains by leveraging your bets on a stock. Options allow investors to speculate on the movement of a stock or to hedge an existing investment by using a call or a put. If you think a stock will shoot up in value, you can purchase a call option at the current price and, if it goes up, you can exercise the option and profit from the difference in prices. The price of purchasing an option is much cheaper than actually purchasing and holding the stock, but using this financial shortcut requires a high risk tolerance. It's not unusual for the value of an option to whipsaw 30-40% within a single trading day. See our Options Basics Tutorial for more.
Get Preferential Treatment
Similar to convertible bonds, preferred stock takes up a middle ground between the risk and rewards of common stock and those of corporate bonds. Preferred stock holders get regular dividend payouts unlike the unpredictable dividends for holders of common stock and, in the case of a bankruptcy, rank just behind corporate bondholders on the payback list. Unfortunately the higher dividend is taxable, so the choice between common and preferred is as much a tax issue as an investment one. The purpose of preferred shares is to produce more income than bonds while only slightly increasing the risks. See A Primer On Preferred Stocks.
Become The Landlord
People who balk at the idea of going through a financial statement and shudder at the thoughts of scouring footnotes often make a more difficult investment without a second thought. Buying a house makes you every bit as sophisticated as a qualified investor, especially if you're the type to check the fixtures and go to the town council for zoning laws. Real estate investing seems more comprehensible to people because buying a house is something everyone has to do at some point in his or her life. With the power of leverage, real estate investing can be an excellent source of income - providing people choose their investment as wisely as they do their own house. See Investing In Real Estate for more.
Team Up With The Landlord
If you want to invest in real estate but you don't want tenants calling you at 3am with a flooding toilet, than REITs might be for you. REITs allow investors to enjoy some of the benefits of investing in real estate - income from rent paid as dividends and some tax benefits - without giving up liquidity or having to learn plumbing in your spare time. REITs come in different types: equity REITs pool investor money and buy properties to rent, mortgage REITs issue mortgages and invest in mortgage backed securities, and hybrid REITs do a bit of both. Depending on what you're looking for, REITs offer an easy way to diversify into real estate without wielding a pipe wrench. For more, see What Are REITs?
Uncle Sam's IOU
Treasuries are essentially the same as munis, but issued by the federal government. The government securities are broken up into three categories: long-term treasury bonds, short-term treasury bills, and medium-term treasury notes. They may vary in the term of investment, but all of them are exempt from state and municipal taxes. Because the U.S. government specifically endorses these investments, they often become the life raft for investors when the market begins to tank. Although the rate of return won't wow your friends, the low risk of default on treasuries makes them a safe haven in a choppy market. See Asset Allocation Within Fixed Income for more.
Who Needs Fund Managers?
A unit investment trust (UIT) is like a mutual fund without a fund manager. The portfolio, be it bonds or stocks, is selected by professionals and then the UIT undergoes a process similar to an IPO where investors buy into the trust. The trust buys-and-holds the securities after the IPO - the portfolio is not actively managed. Shares of the trust can be traded in secondary markets or sold back to the issuer to be resold, but the total of shares issued doesn't change. Usually a UIT remains in operation only for the life of the investments. If there is any uncertainty, as with a stock unit trust, a termination date is set beforehand. In short, UITs provide the diversity of mutual funds without the management risks.
Bonds Gone Wild
Zero-coupon bonds are bonds that have been stripped of their coupons. In layman's terms, this means a brokerage has taken a bond and split it into two parts. One part is the interest payments, or coupons, and the other part is the face value of the bond (the size of the loan it represents). On a $1,000 bond, the face value is simply $1,000. You can buy that bond for less than $1,000, however, because it no longer pays interest. This means you might pay $800 for a bond worth $1,000, but you have to wait until the bond matures to see your $200 profit. Basically, stripping bonds is a way for banks and brokerages to free up credit faster, but investors also benefit from the returns that come from buying theses bonds at a deep discount. To learn more about this, see What is the difference between a zero-coupon bond and a regular bond?
Conclusion: Divide and Conquer
While putting all the eggs in one basket has worked for exceptional stock pickers, real estate investors and other specialists, most people benefit from diversifying their portfolios away from a single type of investment. It is extremely unlikely that you'll own all of these investments at the same time, but a well-diversified portfolio doesn't need to have everything, but rather a mix that suits your investing needs. As your needs change, so will your tools. You may find that stocks are for your salad days while treasury bonds and annuities keep you warm in old age. That's why it's important to be aware of what's out there already and what new financial tools are being created - even if they're not the proper investment for you right now, they may be in the future.