Types of investments: Breaking down the basics
Jan. 3, 2022 • 7 min read
What we'll cover
Five main investment types
Stocks, bonds, mutual funds, index funds and exchange-traded funds (ETFs)
How to invest in each and choose the right type of investments for you
Even if you know you should invest, choosing the right types of investments and learning all the ways to invest can seem like a real head-scratcher.
One of the most important lessons to learn might sound really obvious: Investing is different from saving. Saving involves putting your money in a savings account, in a money market fund or even under your mattress, but it doesn't give your cash a lot of room to grow. Investing gives you the opportunity to take a few more risks with your money because it has more earning potential and is one of the best ways to beat inflation and take advantage of compounding. (Compound interest occurs when your interest makes money off of interest.)
So, where do you start with investing, and which types of investments make the most sense for your portfolio? In this article, we'll go over five popular investment choices and walk through how you can purchase these types of investments.
Five investment types
Let's walk through five investment types you may want to consider. We'll take a look at characteristics of each type of investment and help you decide whether this investment type will fit your portfolio.
A stock represents a small portion of ownership in a company. When you purchase a stock, you buy a tiny slice of that company's earnings and assets. Companies sell shares of stock to raise cash. Stocks sometimes earn high returns, but they can also invite more risk than other investments.
Why is that?
When you invest in the stock of one company, you invest solely in that single company rather than in multiple companies, as you would with mutual funds.
Some stocks also pay dividends, which are regular distributions of a company’s earnings to investors. That's one way you can make money on stocks. Otherwise, you can make money based on the regular increase of stock price.
Think you might want to invest in stocks? Learn how the pros and cons stack up:
Stocks typically have more potential for higher returns compared with other types of investments, especially looking over a long term.
Some stocks pay dividends, which can help against a drop in stock price (interchangeably called share price) and provide you with extra income. You can also use dividends to buy more shares.
Stock prices can rise and fall dramatically
You can’t guarantee you’ll see a return on your investment
Anyone can invest in stocks — they can be particularly attractive to long-term investors who are willing to take on a certain amount of risk. Certain stocks are riskier than others, so it's important to review the underlying factors of each company you invest in, such as company size, leadership, the company's balance sheet, volatility and dividend history.
Think of a bond as an IOU to a government, municipality or corporation. The government, municipality or corporation will then use your money and pay you back your initial investment, with interest. Let's take a look at a few common types of bonds:
Corporate bonds: Private and public corporations issue corporate bonds.
Municipal bonds: Also called “munis,” municipal bonds are debt securities issued by states, cities, counties and other government entities. These can include general obligation bonds, revenue bonds and conduit bonds.
S. Treasuries: The Department of the Treasury issues Treasury bonds on behalf of the federal government. They are considered safe because they carry the full faith and credit of the U.S. government.
Are there more types of bonds? Of course! Do your research to choose which one works best for you.
Bonds may not fluctuate as much as stocks, often making them a more stable investment
They can add stability to a largely all-stock portfolio
Historically, bonds have provided lower long-term returns than stocks.
Bond prices fall when interest rates go up. Long-term bonds often suffer from price fluctuations as interest rates rise and fall.
Since bonds offer lower risk, you want to assess your comfort level with bonds. If you have a longer time horizon, you might find a stock-heavy portfolio to be more friendly rather than a bond-heavy portfolio because you have time on your side. Investing in a less risk-averse portfolio may not allow you to benefit from compound interest quite as rapidly. On the other hand, if you’re getting closer to retirement age, you may want to pepper your portfolio with bonds because you may need to create lasting funds in retirement.
Mutual funds, which are professionally managed investment funds, pool money from many investors. Investors can purchase a wide variety of bonds, stocks and other types of securities. Bond mutual funds, for example, only invest in bonds. Due to compound interest, your mutual fund will rise in value over time, particularly if you have a long investment time horizon.
Mutual funds are some of the most popular types of investment accounts, though they do come with their own set of pros and cons. Take a look:
Mutual funds offer advanced portfolio management, which can be great for new investors.
Mutual funds provide automatic diversification because you don’t invest in a single company — you own stock in multiple companies.
You can invest in almost any type of mutual fund. Whether you identify ESG (Environmental, Social and Governance) mutual funds you want to invest in, specific industries or sectors, the choices for mutual funds are practically limitless.
You have less control over your portfolio because an investment manager makes the decisions about what goes into your portfolio.
Since mutual funds are professionally managed, this means that they often cost more than certain types of investments, such as index funds. The extra costs come from paying a fund manager to manage your investments.
New investors, who may not want to worry about putting together a diversified investment plan, might find mutual funds to be a good way to dip their toes into investing.
How do you know whether a mutual fund is a good choice for you? If you want an opportunity to invest but feel more comfortable with a professional choosing the contents of your portfolio, you may want to consider a mutual fund. Mutual funds can also be a great alternative for those who plan to invest for a number of years, including for retirement purposes.
Index funds are a type of mutual fund or exchange-traded fund (ETF) that match or track a market index. For example, an index fund may follow a benchmark index, such as the S&P 500 or the Nasdaq 100.
They are a popular type of investment because you can tap into a diversified bundle of stock or mutual fund choices without having to pay the extra costs associated with a mutual fund, and you can make money from an index fund by earning returns. They’re designed to track an underlying stock market index, which can help you avoid losses.
Index funds offer instant diversification
Index funds usually cost less than certain other types of securities, particularly mutual funds
They track an index, which means that you’ll likely see similar returns of some of the most successful companies in the U.S.
You don’t get a choice in index composition because they comprise set portfolios. If you buy an index fund, you’re tied to whichever stocks or mutual funds make up that particular index fund — you cannot pick and choose.
Index funds can’t beat the market, so if you’re interested in making large gains from short selling or another method, you may not want to buy index funds.
Index funds pose risk just like any other type of investment, but because they offer diversification, your risk may be a little more tempered. Anyone can invest in index funds, but those who have a little time on their side might find them to be a better fit.
Exchange-traded funds (ETFs)
An exchange-traded fund (ETF) tracks an index, sector, commodity or other asset, but you can purchase or sell it on a stock exchange just like a regular stock. The benefit to this is that you can execute your trade at any time of the day, which means you can buy and sell at that exact time — not at the end of the day like a mutual fund.
You can choose from lots of different types of ETFs, including index ETFs, actively managed ETFs, bond ETFs, commodity ETFs, sector ETFs, foreign market ETFs and more.
Let’s walk through some of the pros and cons of an ETF:
You get automatic diversification with ETFs
They trade like stocks
ETFs cost less than mutual funds and other types of securities
Management fees, execution prices, and other expenses are all different with ETFs
Some tracking discrepancies can occur. Some ETFs fall far from the benchmark index of which they are supposed to track.
You might consider ETFs if you’re a beginner investor, an investor who wants to track an index or an investor who want to actively trade ETFs. ETFs invite risk but examining the underlying factors for all ETFs you’re considering can give you a great basis for a wise purchase.
How to purchase different types of investments
How do you purchase different types of investments?
Great question. You may not have a lot of time on your hands, so your first question when you’re learning about investing might be about whether you can set up a brokerage account quickly? The answer is yes. In most cases, you can set up an online brokerage account in a matter of minutes, although it depends on the brokerage.
Once you enter your basic information, such as your name and email address, and create a username and password, you’ll need to link your bank account to your new brokerage account, which means you’ll have to initiate a deposit or funds transfer. A brokerage will typically deposit a couple of pennies into your account, and you’ll have to confirm how much the broker deposited.
Once you’re linked, you can start investing! Most brokerages have made it simple to get started, with explainers, glossaries and easy-to-access help on each website.
Choosing the right types of investments for you
When you want to get started investing, pat yourself on the back. There’s no better feeling than taking control of your finances and putting yourself on a great path toward financial security. If you’re still not sure about the right type of investments for you, you could try a diverse combination of investment types, like the ones we’ve mentioned above.
It’s worth noting that there are lots of other ways you can invest your money, including stock options, forex and futures. However, some of these riskier (and more advanced) types of investments might better serve you once you get comfortable with the basics of long-term investing. Many experts recommend learning about trading options for beginners once you’re settled in your investing journey.
Choosing your investments and determining the types of investing that fit you is a very personal decision — that’s why it’s called personal finance!
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