If you’re new to investing, you’ve probably heard a lot of jargon thrown around. But even if you’ve been trading on the markets for a while now, it can be difficult to keep track of the investment landscape.
There are many types of investments out there. While some investors focus on a couple kinds of securities, the best, most-diversified investment portfolios usually encompass different types of securities.
Types of investments include:
- Mutual funds.
- Index funds.
- Exchange-traded funds.
- Certificates of deposit.
In this article, we’ll describe each of these types of investments. Read on to learn about the securities you should be thinking about to build a diversified investment portfolio today.
What Are the Different Types of Investment?
Stocks, or shares, are an investment in a company. In other words, when you buy shares of a company, or equity shares, you’re buying a small piece of the company itself. Companies sell shares to raise cash to invest in capital or grow their business. Investors can buy and sell stocks among themselves.
Investors in stock make money when the value of the stock they hold goes up and they sell it to other investors for a profit. Stocks are riskier than other kinds of securities, such as bonds or certificates of deposit, but they have the potential for higher yields.
There are two basic types of stocks. Common stock is the type all publicly traded companies issue. Owners of common stock share in the company’s successes, because the value of the stock goes up (or down) depending on how the company is faring. The company might pay dividends — a portion of profits that it distributes to its investors on a regular basis — but is not required to do so.
The second basic kind of stock is preferred stocks. Preferred stocks usually come with guaranteed, fixed dividend payments. Preferred stock dividends are paid out before common stockholders receive dividends. For this reason, preferred stock tends to be less risky than common stock, but the potential for returns is lower. While preferred stocks don’t lose as much value as common stocks during market downturns, they don’t gain as much during periods of market growth, either.
Within these two broad categories are a number of other stocks. You might also hear about penny stocks. Penny stocks, according to the U.S. Securities and Exchange Commission (SEC), are stocks issued by small companies that trade at under $5 per share. Investors like penny stocks because you can pick them up cheap, without investing a lot of capital. So if a small company takes off, you’re positioned to make a lot of cash. Penny stocks are also much riskier for this reason.
You must purchase stock through a broker. You can work with a broker in person or through an online brokerage firm to buy and sell stock.
A bond is different than a stock. A bond is basically a loan you, as an investor, make to a company or another entity, such as a local or federal government. When you purchase a bond, you do not get an ownership share in the entity; rather, you are giving the bond issuer cash to use for their own purposes. In exchange, they pay back the underlying investment with interest.
Like any other type of security, investing in bonds has its tradeoffs. Traders usually consider bonds less risky investments than stocks, but they also tend to offer lower returns. As with any kind of loan, the issuer could default, meaning the investor is out of luck. Bonds issued by the U.S. government are the safest options, followed by those issued by city and state governments. Bonds issued by corporations are slightly riskier.
The rule of thumb is the riskier a bond, the higher the interest rate an investor will receive. The higher interest rate is designed to compensate the investor for making a riskier bet.
Bonds are fixed-income investments. That means bondholders receive regular interest payments, often once or twice per year. Additionally, the total principal is paid off after the bond’s maturity date.
Options are slightly more complicated. They are a contract that gives the holder the option to either buy or sell a stock at a set price, known as a strike price, by a certain date. Options offer more flexibility than other kinds of investments since, as the name implies, they give the holder the option to execute a purchase or sale. Buying an option means buying a contract, not the underlying stock.
Options can be more or less complex, depending on the type. At a basic level, however, buying an option means locking in the price of a stock in the future. For example, if you expect the price of a stock to go up, you can buy an option and eventually benefit from purchasing the stock at a lower price than the going rate. If your bet is wrong, you’re still only out the price of the option, since you haven’t purchased or sold the underlying stock.
There are two basic kinds of options: put options and call options. A put option gives the holder the right to sell the stock, while a call option gives him or her the right to buy a stock. When you purchase call options, you are taking a long position on the market. The investor selling that option, called a writer, is taking a short position.
Plenty of investors love the thrill of picking stock, doing their research, and scoring big. But other investors just want a low-risk stream of income to save over the long-term, often for retirement. Mutual funds are great options for this type of investor.
Mutual funds let investors buy a large number of investments in one transaction. Mutual funds pool money from many investors. A professional manager then decides how to invest that money in stocks, bonds, and other assets to yield a reasonable return for the investors.
Each mutual fund tends to follow a set strategy. Some funds invest in both stocks and bonds, for example, while others might focus on a particular type of each investment, such as international stocks or government-issued bonds. The investments the manager makes determine that mutual fund’s risk level.
When the mutual fund earns money, that profit gets distributed proportionally to its investors. Investors pay an annual fee, called an expense ratio, to invest in a mutual fund. Mutual funds carry similar risks to investing in stocks, but because most mutual funds consist of a diversified portfolio, they are typically less risky than trading individual stocks.
Index funds are types of mutual funds. Rather than paying a manager to choose investments, index funds passively track a particular index. For example, an S&P 500 index fund would track the performance of the S&P 500 itself by holding stock of the companies that fall under that index.
Because index funds don’t require a manager to track investments and make trades, they are usually cheaper to invest in. The risk associated with the investment depends on the investments the index fund holds.
The interest and dividends earned by index funds are distributed to investors. The value of the fund itself can also go up and down, and investors can sell their shares in a fund. Like other mutual funds, index funds charge an expense ratio, but it’s lower than an actively managed mutual fund.
Exchange-traded funds, or ETFs, are specific types of index fund. Like index funds, ETFs track a particular index and tend to be less expensive than mutual funds because they do not require active management.
However, unlike index funds, ETFs get traded on an exchange like a stock, which means you can trade ETFs throughout the day, much like stocks. Mutual funds and index funds, on the other hand, are only priced at the end of each trading day, so it makes less sense to buy and sell them throughout the day.
New traders often start with ETFs because they tend to be more diversified than individual stocks. Like with mutual and index funds, investors make money from ETFs when their value goes up and you can sell them for a profit. ETFs also sometimes pay out dividends and interest to investors.
Certificates of Deposit
Certificates of deposit, or CDs, are very low-risk, easy investments. They’re basically one step up from a typical savings account you might open at a bank. When you invest in a CD, you give the bank a certain amount of money and promise to leave it there for a set period. In exchange, at the end of the loan period, the bank promises to pay you the principal plus a predetermined amount of interest.
CDs are FDIC-insured up to $250,000, so they are relatively risk-free. However, you will pay a large penalty if you withdraw your money before the end of the CD’s term.
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