The investing landscape can be extremely dynamic and change year after year, but there is a lot to be said for investing in what you really know and understand. Considering the enormous number of products on offer, as well as the nature of the industry, it is not that simple to be simple, but it can certainly be done.

Key Takeaways

  • 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'

Cash

One could argue that the only asset that is fully understandable is cash in the bank or some form of fixed deposit. Here, you know exactly how much you will earn and that you will get your capital back. The problem is that you will be lucky to beat inflation, and simply leaving your money in cash is not the answer; it is just not a productive investment. Certificates of Deposit (CDs) are cash-like instruments where money is locked up for a period of time.with potential early withdraw penalties, but provide higher than average interest rates.

Bonds

Moving a bit up the risk ladder, we get to bonds. 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.

Given the variety of bonds and bond funds, understanding what you get is also not necessarily that simple. Government bonds are fairly straightforward, but, again, they don't pay much. Municipal bonds pay a little more and are usually tax-exempt, but are not going to satisfy the average investor's retirement needs. So to really earn anything, you need a variety of bonds, both corporate ones and, arguably, foreign. Yet, these start to become complex and riskier, depending on various factors relating to the issuing company or country. Likewise, bond funds may depend on a number of managerial and financial issues.

Stocks

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.

Mutual Funds

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.

Exchange Traded Funds (ETFs)

ETFs have been getting more popular since they were introduced 20 years ago. 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.

Alternative Investments

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.

Commodities are also often used to diversify portoflios, with holdings in gold, silver, crude oil, and agritcultural products increasingly common in portfolios.

How to Invest Sensibly, Suitably and Simply

In general, we really know very little about a lot of asset classes and investments. Nonetheless, there are many ways of ensuring that you are investing in what you know. You can really invest in a straightforward manner, and understand what you're doing.

Many veteran investors have simple diversified portfolios and look more at asset allocation. Spending hours performing regression analysis is not an option for many part-time investors. For example, Steven Goldberg of Kiplinger has said in his "Value Added Web Column" that, "Most people wish they didn't have to be investors," and that they "lead busy enough lives without having to worry about stocks, bonds, and mutual funds." Goldberg, therefore, recommends sticking with index funds that simply mirror the market and only attempt to be average. He even 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.

Trackers are sometimes better than actively managed funds. Lower fees, low turnover and a combination of available investor education make index investing extremely attractive. So, a really straightforward mix of these funds is transparent, cheap and does as good (or better) a job as more complex and expensive vehicles. Despite the above, to be fair, there are a lot of well-managed funds out there. With a bit of effort, you can find reliable and understandable equity and bond funds with which you can relax.

A good piece of advice is to start with simple investments and then expand and extend as you learn more. Specifically, mutual funds or exchange-traded funds are a good way to get going, and one can then move on to individual stocks, real estate and further down the line, even a sensible amount into resources or hedge funds.

It is interesting to note the book, How Buffett Does It: 24 Simple Investing Strategies from the World's Greatest Value Investor (James Pardoe, McGraw-Hill, 2005), about the world's greatest pro. Buffett himself says that Wall Street dislikes too much simplicity. The reason is that brokers make money out of complexity. But you do not have to fall for this.

The Bottom Line

The more you learn, the better. But above and beyond this, you can (and probably should) avoid investments that you do not understand in principle. A small number of index funds seems a very good solution.

Also, go on sound recommendations. If your parents-in-law have been investing for 20 years in a mixed fund, which has served them well, you may choose to take their advice and feel fairly good about it (although nothing is guaranteed). On the other hand, if you get a call from someone you met in a pub last week who wants to give you a hot tip as a "big favor," you should be more skeptical.

Likewise, there are many independent financial advisors around who get paid only for their time and not on commission. Their job is to understand what they recommend, without the pressure of having to sell to earn a commission. And make sure you diversify, not only into asset classes but possibly into different banks and fund providers. Then, if something goes wrong that neither you nor anyone else seemed to understand, the losses are not so disastrous.

Always bear in mind, though, that too many bits and pieces also creates complexity that can lead to errors.