Mar 31, 2022
What are the different types of investments?
By Stash Team
We explain the basics to help you start investing.
You have many options when it comes to choosing forms of investment, but people often start with the most common types of securities:
Stocks and bonds frequently form the building blocks of portfolio and investment strategy. Because they tend to perform differently under different market conditions, investors can use this variance to help meet their investment goals.
Forms of investment
Here’s an overview of these different types of investments, where and how to invest in them, and the part they can play in your portfolio.
Purchasing a stock means buying a small piece of ownership, or a share, in a company. Stocks are bought and sold on stock exchanges. Generally speaking, stock prices rise and fall based on investor demand. Most of the time, the more people want to purchase a particular stock, the higher the price is likely to be. When fewer people want that stock, the price may drop.
You can potentially make money on stocks by selling your shares at a higher price than you paid for them. But stock prices can be volatile, meaning they may rise and fall quickly. Investor demand and stock prices fluctuate for any number of reasons. For example, good news, such as strong sales numbers or the unveiling of a popular new product, could cause stock prices to rise. Bad news, like product safety issues or poor revenue numbers, could cause stock prices to fall. After prices fall, it can take a while for them to recover. That’s one of the reasons stocks are often held as a long-term form of investment.
Not all successful investment strategies involve holding stocks for long periods, however. More sophisticated investors, such as hedge funds, might use different types of investment strategies designed to generate returns over the short term, such as shorting a stock. Investors using this strategy start by borrowing stocks, then selling them quickly in the hope they can buy them back later at a lower price. If they can, they return the stocks to their original owner and keep the difference in price as profit.
Other sophisticated strategies include using stock options, which are contracts that allow investors to buy or sell a given stock at a set price and time. Options allow investors to bet markets will rise and offer some downside protection. For example, if you buy an option for $20 a share and prices go up to $30, you can use your option to buy shares at the lower price before selling at the higher price. If you buy the same option for $20 per share and stock prices fall, you’re under no obligation to use the option to buy.
You may also get a return on your investment through dividends, which are a share of the company’s profits. Companies typically face a choice between spending their earnings to research and develop new products or distributing them to shareholders as dividends. Many established companies with predictable revenues and expenses choose to divide a portion of their earnings among investors as a regular cash dividend during the year.
Dividends can also make stocks more attractive to investors, as consistent dividend payments are a sign of consistent profits. Since share prices generally rise when stocks become more attractive, dividends can amplify returns in two ways: by paying investors in cash and by increasing stock prices and returns over time.
Bonds are interest-bearing securities issued by companies or governments. Investors can purchase them for a set amount of time, known as a bond term. Bonds are a form of debt that the issuer takes out, similar to a loan; in this case, you are “loaning” the issuer money when you purchase the bond. In exchange for this loan, the company or government promises to pay you interest and repay the original amount of the loan when the term is up. Generally speaking, interest is paid regularly in the form of a “coupon.”
Bonds have three basic components:
- The price at which you buy them
- The interest rate that’s used to calculate your coupon
- The yield, or return an investor receives between the time they purchase the bond and the end of the loan term
The interest rate stays the same throughout the life of the bond, while the bond’s price will usually change based on the movement of interest rates in the economy.
Those price changes happen because bonds become more or less attractive to other investors based on a combination of current interest rates and the return another investor could get buying a new bond. When interest rates go down, older bonds that pay higher coupons may become more appealing, which can drive their price up.
The opposite happens when interest rates go up: The price of older bonds that pay lower coupons generally goes down. It’s important to remember that in either case, the interest rate you get paid for holding the bond remains the same.
Stocks vs. bonds: risks and returns
Over the long term, stocks may offer higher returns than bonds. Since 1926, stocks from large companies have returned an average of 10% per year. For 2020 and going forward, however, the projected compound return for large U.S stocks is forecast to be about 4%. But because stock prices can be volatile, they are usually considered a more risky form of investment than bonds. Unless the bond issuer defaults, you’ll receive a fixed return over the life of the bond, in addition to having your principal repaid. That’s one reason bonds are also called fixed-income investments.
The lower risk associated with bonds often translates into lower long-term returns compared to stocks. Government bonds, which are backed by the United States Treasury, have returned between 5% and 6% since 1926. Bonds issued by private companies, or corporate bonds, range in quality based on the likelihood that their issuer will be able to make timely payments. In most cases, the highest-quality corporate bonds pay more interest than government bonds, even though large, established blue-chip companies are unlikely to default on their payments.
On the other end of the spectrum, companies with a shakier track record and a higher risk of default tend to issue bonds with much higher interest rates. While these so-called junk or high-yield bonds offer investors a better return, the chances that investors actually receive all their payments are substantially lower.
Building a portfolio of stocks and bonds
While you can buy a single stock or bond, many investors choose different types of investment vehicles that help them build a more varied portfolio. This strategy is called diversification: a form of investment that helps investors spread the risk of poor performance among multiple securities. That way, if a particular business or industry runs into trouble, other more successful businesses or industries can help balance out your returns. Investment products such as mutual funds, exchange-traded funds (ETFs), and index funds offer investors opportunities to buy a range of stocks, bonds, or a mix of both.
Different types of investment vehicles
A mutual fund consists of a basket of investments chosen by fund managers. When you buy a share in a mutual fund, you buy a share of the portfolio. Buying a share of the portfolio means you’re buying a fraction of a share from each of the stocks and/or bonds the fund holds.
Mutual fund prices are determined at the end of the trading day and depend on the total price of all the assets in the fund’s portfolio. At the end of each day, mutual funds calculate their per-share price, or net asset value. The total value of the portfolio is divided by the number of outstanding shares held by investors. That calculation provides the price at which shareholders can buy or sell.
Exchange-traded funds (ETFs)
ETFs are a form of investment similar to mutual funds. Both hold a basket of investments, and owning a share equates to owning a fraction of a share of each of the stocks and/or bonds the fund holds. However, shares of ETFs trade on exchanges all day long, just like individual stocks. As a result, the price of a share in an ETF can fluctuate throughout the day based on stock market demand.
The investment professionals who build mutual funds and ETFs usually have a strategy in mind. Often, that means investing in a variety of stocks or bonds with similar traits, such as large companies, small companies, or companies from a certain industry or a particular part of the world. Index funds are a type of mutual fund or ETF that matches the companies making up a major stock or bond index, such as the S&P 500, the Dow Jones Industrial Average, or the Bloomberg Barclays Aggregate Bond Index. These funds aren’t actively managed by investment professionals. Consequently, buying shares of these funds tends to have lower costs than actively managed mutual funds or ETFs.
How to get started with different types of investments
Whether you’re looking to invest in stocks, bonds, or funds, you generally need to open a brokerage account or another specialized account like a 401(k) or an IRA. You can also purchase government bonds online directly from the U.S. Treasury.
Your goals will help you determine the different types of investment options you choose. Brokerage accounts can be good for short-term investment goals, since they provide relatively easy access to your money. Retirement accounts may be advantageous for long-term goals, since they don’t allow easy withdrawals.
Stash has boiled down its investing philosophy into the Stash Way, which includes leveraging various forms of investment for a diverse portfolio, investing regularly, and investing for the long term.
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