"The Many Different Types of Investments, and How They Work" by @lifehacker
Most people have heard of stocks and bonds, but there are a ton of different ways to invest your money—mutual funds, CDs, real estate...the list is seemingly endless. Here's our reference guide to all the different types of investments and what they mean.
You'll probably come across a handful of terms associated with your investments. We've listed a few of them below. These terms generally refer to the actual stuff you're invested in, but, of course, they have specific definitions, too. They include:
- Assets: An owned resource expected to increase in value.
- Holdings: The specific assets in your investment portfolio.
- Portfolio: Your "portfolio" refers to all of your investments, as a group. Diversifying your portfolio means investing in a variety of assets.
- Asset classes: A group of assets with similar characteristics. Generally, stocks, bonds and cash.
Investopedia breaks up all the different types of investments into these basic categories: investments you own, lending investments, and cash equivalents. Here's how different investments compare in each of these three categories.
Ownership Investments
When you buy an ownership investment, you own that asset—something that's expected to increase in value. Ownership investments include:
- Stocks: Also known as an equity or a share, a stock gives you a stake in a company and its profits. Basically, you get partial ownership of a public company. A large percentage of your portfolio should probably be made up of stocks.
- Real Estate: According to Investopedia, any real estate you buy and then rent out or resell is an ownership investment (though it can sometimes be classified as an alternative investment). By their terms, the home you own fulfills a basic need, so it doesn't fall under this category.
- Precious objects: Precious metals, art, collectables, etc. can be considered an ownership-type of investment if the intention is to resell them for a profit. They also fall under a separate category, "alternatives." More on that later.
- Business: Putting money or time toward starting your own business—a product or service meant to earn a profit— is another type of ownership investment.
Lending Investments
With lending investments, you buy a debt that's expected to be repaid. You're sort of like a bank. Generally, these are low-risk, low-reward investments. This means they're thought to be a safer investment, but their return is usually low.
- Bonds: "Bond" is a more umbrella term for any type of debt investment. When you buy a bond, you loan money to an entity (a corporation or the government, for example) and they pay you back over a set period of time with a fixed interest rate. Another big chunk of your portfolio will probably be made up of bonds.
- CDs: A CD, or certificate of deposit, is a promissory note issued by a bank in exchange for your money. You've probably seen your bank offer these. They're a type of savings account, but they're a little different. Instead of taking your money out at any time, you commit to leaving it in the account for a set period. In return, they'll offer a higher interest rate based on how long you invest in them. Savings accounts can also be considered lending investments, if you think about it. You're giving your money to a bank that loans it out. But your return is usually pretty low (lower than the inflation rate), so most people don't consider it a true investment.
- TIPS: TIPS are treasury-inflation protected securities. These are bonds backed by the US Treasury, specifically designed to protect against inflation. When your TIPS investment matures over time, you'll get your principal and interest back, both indexed for inflation. Bogleheads explains how they work in a bit more detail.
Even if you're up for risk, you should have some lending investments in your portfolio to balance things out. The SEC has a helpful beginner's guide to balancing your portfolio.
Cash Equivalents
Generally, a smaller percentage of your portfolio with be made up of cash. Cash equivalents are investments that are "as good as cash," as Investopedia puts it. This might be a simple savings account. It might be a money market fund. A money market fund is really a type of lending investment, but the return is so low, it's considered to be a cash-equivalent investment.
We'll talk about funds more in a bit, but first, let's check out another way to categorize investments—alternatives.
Alternatives
So we've covered how different investments can generally be categorized as ownership, lending and cash. Those categories are broad descriptors, but they're helpful in explaining how different types of investments work.
But investing companies break things down a little differently. They go by asset class: stocks, bonds, cash and alternatives. We already know about stocks, bonds and cash—the most traditional ways to invest. In terms of asset class, alternatives are everything else. Consequently, much less of your portfolio should be invested in them.
Also, it's easy to categorize some investments alternatives, because they could actually be considered ownership or lending investments, depending on how they're bought. But let's take a look at some examples.
REITs: Real Estate Investment Trusts, or REITS, are another way to invest in real estate. Instead of buying your own property, you work with a company that earns profit from their own real estate investments.
Really, an REIT can be an ownership investment or a lending investment, depending on what type you buy. You can buy an REIT that gives you a share in the real estate itself. This would count as an ownership investment. Investopedia explains:
"When you buy a share of a REIT, you are essentially buying a physical asset with a long expected life span and potential for income through rent and property appreciation.
But you could also invest in the mortgage of the real estate, which would make it a lending investment."
Venture Capital: This is money you give to a startup or small business, with the expectation that it will grow, and you'll get a return on that money. A lot of times, venture capitalists become partners in the company, owning part of a its equity and getting a say in business decisions. In this way, they can be thought of us ownership investments.
Commodities: Investing in a commodity is investing in some sort of resource that affects the economy. Oil, beef and coffee beans are all different types of commodities. The contracts you use to buy these goods are called Futures Contracts, and you have to fill them out through a National Futures Association broker, MarketWatch explains.
Precious Metals: Like we mentioned earlier, metals and collectables are, technically, ownership investments. You own the gold you're buying, for example. But it's not a stock or a bond, so most people refer to it as an alternative.
Funds
Funds can fall under any of the main categories of investments. They're not specific investments, but a general term for a group of investments. The Guardian defines investment funds as:
"...a pool of money which is professionally managed to achieve the best possible return for investors. When money is paid in the manager uses it to buy assets, typically stocks and shares."
Basically, an investment company picks a collection of similar assets for you. It can be a group of stocks or a group of bonds. Or, the fund can be even more specific—there are funds made up of all international stocks, for example. In return for their curating your investments, you'll pay a fee, or an "expense ratio." But they aim to be a more convenient investment, with picks that provide a better return than anything you would probably pick on your own.
Let's check out the different terms associated with funds.
Mutual Funds: A mutual fund is, basically, another term for investment fund. To provide a more formal definition, here's how Investopedia explains it:
"An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus."
Index Funds: A type of mutual fund meant to mirror the return of a specific market, like the S&P 500. Get Rich Slowly offers a thorough piece on index funds, and they explain them as:
"Index funds are mutual funds, but instead of owning maybe twenty or fifty stocks, they own the entire market. (Or, if it's an index fund that tracks a specific portion of the market, they own that portion of the market.) For example, an index fund like Vanguard's VFINX, which attempts to track the S&P 500 stock-market index, tries to own the stocks in its target index (the S&P 500, in this case) in the same proportions as they exist in the market."
Because they're meant to mirror the market, index funds are "passively managed", which means there isn't a team of investors constantly analyzing, forecasting and adjusting the assets in the fund (known as active management). As a result, they tend to have lower expense ratios, which means you keep more of your money.
Exchange Traded Funds (ETFs): These are very similar to index funds in that they're meant to track an index, or a measure of a specific market. The biggest difference is the way they're traded. ETFs can be traded like stocks, and their prices adjust like stocks throughout the day. Mutual and index funds don't work this way. ETF Database further explains:
"The biggest difference between these two products is the frequency with which they are priced and traded. Index mutual funds are, after all, mutual funds, and as such they are priced once a day after markets close. ETFs–including both active and passive ETFs–are priced throughout the day, and can be bought or sold whenever the markets are open."
Hedge Fund: Hedge funds are like mutual funds, with a few very important differences. First, they're not regulated by the U.S. Security and Exchange Commission (SEC). They're also considered riskier than regular mutual funds, because their assets can include a broader range of investments. Also, they often use borrowed money to invest, as BarclayHedge explains. To learn more about hedge funds, check out Investopedia's full explanation of them.
Keep in mind, this list is meant to be a reference, rather than a guide to getting started. Depending on where you're at with investing, many of these may or may not be on your radar. Most beginning investors will likely find CDs and mutual funds to be most useful. As you learn more about investing and how to diversify your portfolio, you might consider REITs or TIPs.
With so many terms associated with investing, knowing what exactly to invest in can seem complicated. But once you organize these terms into categories, it's actually pretty easy to understand how they work.
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