The investment landscape can be extremely dynamic and ever evolving. But those who take the time to understand the basic principles stand to richly gain over the long haul.
- Investing can be a daunting idea for beginners with an enormous variety of possible assets to add to a portfolio.
- The investment 'risk ladder' identifies asset classes based on their relative riskiness, with cash the most stable and alternative investments often the most volatile.
- A well-diversified portfolio with the proper allocation weights to each asset class is often the best advice for a new investor.
Understanding the Investment 'Risk Ladder'
A cash bank deposit is widely considered to be the most easily understandable investment asset. Not only does it give investors precise knowledge of the interest they'll earn, but it also guarantees they'll get their capital back. On the downside, the interest earned from cash socked away in a savings account seldom beats inflation. On the other hand, Certificates of Deposit (CDs) are cash-like instruments that typically provide higher-than-average interest rates, however money is locked up for longer periods of time and there are potential early withdrawal penalties involved.
Slightly higher on the risk ladder, bonds are debt instruments where investors effectively loan money to a company or agency (the issuer), in exchange for periodic interest payments, plus the return of the bond’s face amount, once the bond matures. Bonds are issued by corporations, the federal government, as well as many states, municipalities and governmental agencies.
A typical corporate bond might have a face value of $1,000 and pay semi-annual taxable interest. However, interest on municipal bonds is exempt from federal taxes and may be exempt from state taxes, for residents who live in the issuing state. Interest on Treasuries are taxed at the federal level only.
Similar to stocks, bonds can be purchased as new offerings, or they may be procured through the secondary market. A bond’s value can fluctuate based on a multitude of factors, however it's chiefly influenced by the inverse direction it moves with interest rates.
Buying shares of stock lets 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, but do not own the assets. Holders of common stock enjoy voting rights at shareholders’ meetings and they're entitled to dividends, if they are declared. Holders of preferred stock don’t have voting rights, but do receive preference over common shareholders, in terms of the divided payments.
A mutual fund is a pooled investment vehicle managed by an investment manager, exposing investors to a basket of stocks, bonds or other investment vehicles, as described in a fund’s prospectus. Individuals may invest in mutual funds for as little as $1,000/share, letting them diversify into as many as 100 different stocks contained within a given portfolio. Mutual funds can passively track stock or bond market indexes like the S&P 500 or the Barclay’s Aggregate Bond Index. Other mutual funds are actively managed by managers who hand pick the underlying investments. However these funds generally have greater costs, which can cut into an investor's returns.
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. Like individual stocks or bonds, selling a mutual fund can result in a gain or loss on the investment.
Mutual funds are valued at the end of trading day, and all buy and sell transactions are likewise executed after market close
Exchange Traded Funds (ETFs)
Exchange-traded funds (ETFs) have become quite popular since their introduction, some 20 years ago. ETFs are similar to mutual funds, but they trade throughout the day, on a stock exchange, just like shares of stock. Unlike mutual funds, which are valued at the end of each trading day, ETF values fluctuate intra-day.
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. In recent years, actively managed ETFs have emerged, as have so-called smart beta ETFs, which create indexes based on factors such as quality, low volatility and momentum.
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), which pool the money of several investors, to purchase properties. REITS trade like stocks, but there are mutual funds and ETFs that invest in REITs.
- Hedge funds and private equity funds. Hedge funds, which may invest in a spectrum of assets, tend to outperform conventional investment vehicles in turbulent markets. Private equity allows companies to raise capital without going public. 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 resources such as gold, silver, crude oil, as well as agricultural products.
How to Invest Sensibly, Suitably and Simply
Many veteran investors rely on a simple diversified portfolio, to achieve success. Spending hours performing regression analysis is not an option for many part-time investors. Kiplinger's Steven Goldberg has stated that most people are too busy to worry about monitoring their portfolios on a daily basis. Therefore, sticking with index funds that mirror the market is a viable solution. Goldberg further argues that one only needs three index funds: one covering the U.S. equity market, another with international equities and the third tracking a bond index.
A good piece of advice to investors is to start with simple investments, then incrementally expand their portfolios. Specifically, mutual funds or ETF's exchange-traded funds are a good first step, before moving on to individual stocks, real estate and eventually: hedge funds.
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.