The investment landscape can be extremely dynamic and ever-evolving. But those who take the time to understand the basic principles and the different asset classes stand to gain significantly over the long haul. The first step: learning to distinguish different types of investments and what rung each occupies on the "risk ladder."

Key Takeaways

  • Investing can be a daunting prospect 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 being the most stable and alternative investments often being the most volatile.
  • Sticking with index funds or exchange-traded funds that mirror the market is often the best path for a new investor.

Understanding the Investment 'Risk Ladder'

Here are the major asset classes, in ascending order of risk, on the investment risk ladder.

Cash

A cash bank deposit is the simplest, most easily understandable investment asset—and the safest. 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. Certificates of Deposit (CDs) are highly liquid instruments, very similar to cash that are instruments that typically provide higher interest rates than those in savings accounts. However, money is locked up for a period of time and there are potential early withdrawal penalties involved.

Bonds

Slightly higher on the risk ladder, bonds are debt instruments in which 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, and many states, municipalities, and governmental agencies.

A typical corporate bond might have a face value of $1,000 and pay semi-annual taxable interest. 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 U.S. Treasury bonds and bills are taxed at the federal level only.

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, but it's chiefly influenced by prevailing interest rates.

Stocks

Shares of stock let 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 (that is, the company going bankrupt) but do not own the assets. Holders of common stock enjoy voting rights at shareholders’ meetings. Holders of preferred stock don’t have voting rights but do receive preference over common shareholders in terms of the dividend payments.

Mutual Funds

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. Some 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: They are run by portfolio managers who handpick 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 the trading day, and all buy and sell transactions are likewise executed after the market closes.

Exchange Traded Funds (ETFs)

Exchange-traded funds (ETFs) have become quite popular since their introduction back in the mid-1990s. 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.

Alternative Investments

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 tangible resources such as gold, silver, crude oil, as well as agricultural products.

How to Invest Sensibly, Suitably and Simply

Many veteran investors diversify their portfolios using the asset classes listed above, with the mix reflecting their tolerance for risk. 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 other alternative investments.

However, 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. Steven Goldberg, a principal at the firm Tweddell Goldberg Investment Management and longtime mutual funds columnist at Kiplinger.com further argues that most individuals only need three index funds: one covering the U.S. equity market, another with international equities and the third tracking a bond index.

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.