As we’re working through this series on what it takes to create an investment portfolio, we are ready to tackle the question most people have. What on earth am I buying?! Well we’re going to go over that now.
We’re going to keep this straightforward and avoid getting in the details of individual companies and their stocks. We’re not here to recommend any product; we are here to share knowledge that has helped others build wealth. We’ll cover different types of assets, their strengths and weaknesses and allow you to decide what fits your long term goals best.
Securities (also assets which means the same thing) are a general term used to describe any product you can buy as an investment. Securities roughly fall into two categories: equities and fixed-income. Equities give you part ownership in a company and access to its success via stock gains, dividends, etc. Fixed-income assets are typically bonds that are debts you buy that pay you interest offering more stability and less risk. Knowing what your goals are will help you decide what type of securities are right for you!
The answer to this question is complicated but it all comes down to your time horizon and risk tolerance. If you have more time, you are probably going to accept more risk in the short term for larger returns in the long term. If you have less time, you are more likely to accept lower returns for more stability. Either way it’s important to be clear on what your timeline is, and how much risk you want to take on. Each asset carries its own type of risk and reward. We’re going to dive into a few different types of assets so you can decide for yourself what is best for your goals.
Stocks are a type of security that represents ownership in a company. They're traded on exchanges and the bigger exchanges are the New York Stock Exchange and the NASDAQ. The idea behind buying a stock is that you can benefit from the success of a company, sometimes in a scheduled cash payment call a dividend, or through increased share prices. (I.E. buying a share for $5 and selling it for $10). The price of stocks is determined by multiple factors and this is why we say investing is risky and volatile. In a perfect world, a stock price is measured by supply and demand (people buying or selling), a company’s financial performance, and how it performs next to competitors. However that is not always the case. A good example of volatility is the “Meme stock” rally of 2021 when public opinion and constant buying heavily out weighed all other measures for stocks. No matter how much we try, no one can guarantee what a stock will do. In fact, this WSJ article covered how blind folded monkeys can outperform professionals and that’s not to say professionals aren’t competent but that there is an element of luck and randomness with individual stocks.
Bonds are fixed-income securities issued by corporations, governments, and municipalities. They differ from stocks in that they pay investors a rate of interest and are paid back in full. The interest is called a coupon and bonds normally have a set time limit where they pay interest out. For example, you can buy a 3-year bond that pays 4% interest. Different bonds can pay interest in different ways - some compound every month, quarters, six months etc. Once you buy a bond, you don't get paid interest until the end of that time limit, this is called maturing. When a bond matures, the issuer repays you all your principal plus accrued interest. A popular bond option is something called an I-Bond, which has a set interest rate for six months and allows you to keep your bond between 1 - 30 years.
Bonds a considered “safer” than individual stocks because they are debts that must be paid back. If an organization doesn’t pay back its debt, there are consequences for that failed agreement. If a company has its stock price fall, you will lose money and there are no consequences on the company.
Mutuals fund belong to a broader category called Index funds. The definition of an index fund is an investment product that is built to track a specific index, and example could be that S&P 500 index which is made up of the 500 biggest companies in the US.
Mutual funds are managed by professional investment managers who decide what to invest in and how much to invest. Think of a mutual fund as bucket and the bucket is made of stocks, bonds, or other assets. The idea behind mutual funds, and all other index funds, is that you can easily diversify your portfolio by buying a single product. One share gives you access to hundreds of different companies.
What makes mutual funds unique from other index funds is they are not a security you can buy and sell as quickly as individual stocks. Most mutual funds have their price set at the end of the trading day, when the individual shares that make up the mutual fund have their prices set. Other index funds do not operate in this manner. Another thing to consider is that mutual funds are often thought to be expensive with higher than normal expense ratios. We’ll dive into expense ratios and fund costs later on, but it’s important to know that although mutual funds have a reputation of being expensive, any index fund could cost you more money than expected. The type of index fund that aims to solve that is the Exchange Traded Fund, and we’ll get into that next.
All index funds, including mutual funds having something called a prospectus, which is a large document that contains all of the fund information. This is where you can find what fees you pay, what companies make up the fund, and other very important pieces of information.
ETFs, or exchange-traded funds, are a type of index fund that trade on a stock exchange like individual stocks. They’re similar in that they track an index and provide diversification to your portfolio; but unlike mutual funds, ETFs can be bought and sold throughout the day on an exchange. This makes them more liquid than mutual funds—you can buy or sell an ETF at any time during normal trading hours as opposed to waiting for an end-of-day settlement.
We mentioned that there are fees related to all index funds and that mutual funds typically have the reputation of being very expensive. There is some truth to mutual funds being more expensive because they charge fees to buy and sell loads, and sometimes 12b-1 fees that are used to market the fund. On top of those fees, there are two styles of fund management know as actively managed and passively managed. Active managed meaning the fund manager buys and sells the individual shares on the backend of the fund; you will never see this on your side. Passive managed meaning the fund manager does very little buying and selling and only focuses on tracking its target index.
These costs aren’t exclusive to mutual funds, but most of the time ETFs have lower costs than most other investments since there are no fees associated with buying or selling shares and they often utilize a passive management style. A powerful example of this is how Vanguard, a top investment provider in the United States, made low cost ETFs incredibly popular. Without getting too lost in the details, they keep their expenses down on each fund, avoid unnecessary management and track indexes as closely as possible. No fees for buying and selling and using passive management on their funds means you, the investor, pay less in fees, expense ratios, and overall invest more money.
Real estate investment trusts (REITs) are a type of company that owns, operates, and finances income-producing real estate. They pool capital from investors to buy and manage properties on their behalf. REITs can manage office buildings, medical spaces, warehouses, or any other type of real estate. They offer a way for investors to add real estate to their portfolios without having to own the entire property.
REITs are an interesting security to own because they are regulated differently from mutual funds and ETFs. Publicly traded REITs are required to pay a higher than normal dividend to their shareholders, around 90% of their taxable income in a year. Dividends are a nice way to keep your investments liquid and not have to sell any assets to get cash out and REITs have a fairly unique benefit if you value getting frequent dividends.
There are a variety of different types of assets to invest in. Real Estate Investment Trusts (REITs) offer a way to invest in real estate without necessarily having to buy property yourself. Exchange Traded Funds (ETFs) give investors exposure to the entire market without taking on much risk. Mutual Funds allow you to invest in stocks or bonds with one purchase while taking advantage of professional management and diversification. Finally, individual stocks can be bought and sold easily through any online brokerage account while providing high returns over time with low capital requirements. As we’ve said in our previous Portfolio Foundations posts, knowing what your goals are is incredibly important to establish first. Once you understand what you value and what your goals are, you’ll be more confident in selecting what types of assets are best for you and your investment portfolio. Good luck, and go earn!
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