Welcome back for part 2 of the Investing for Beginners Series at Break Your Budget! If you haven’t checked out PART 1 yet, make sure you head over to that post where we broke down stock market basics, investing strategies, risk tolerance, and how to figure out your investing budget.
In Part 2, we’re doing to learn about different types of investments, also called investment vehicles.Investing can feel intimidating, especially because there are so many options available and it is difficult to understand which are right for you. Knowing the different types of investments available to you, and how they work, will aid in making the best long-term decisions for your own personal situation.
The Most Common Types of Investments
Stocks are the most well-known type of investment; most people think of simply buying stocks when they think of investing. Stock translates into ownership of a publicly traded company, so if you purchase stock you become a partial owner of the company whose stock you purchased.
When you buy stock, the hope is that the value of the stock will increase and you will make money. However, there is always a risk that the value of the stock will go down and you could lose money. You can mitigate this risk by researching the company you are purchasing stock from and looking at their long-term growth potential, industry trends, and financial health to better predict how the stock may perform.
A bond is a fancy word for a loan; but in this case, you as an investor are the lender. When you purchase a bond, you are basically lending money to an entity (typically they are government or corporate entities), with the expectation of earning back the money and a predetermined interest rate.
For example, say you purchase a $100 bond from the government with a 3% interest rate. Not only would you receive that $100 back when the bond expires, you’d also receive 3% in interest. Bonds are typically less risky than investing in stocks, but they also typically have lower interest rates. However, keep in mind that all investments include risk, and while bonds are low risk they are not no risk.
Think of mutual funds as a pooled money. To start, there are 2 types of mutual funds: active and passive. An active mutual fund is managed by a fund manager, who makes the decisions on which investments the money will actually go to. A passive mutual fund is an index fund, which I will explain next.
When you invest in an active mutual fund, you are in essence pooling your money with other people to be invested by a fund manager. Mutual funds will have different defined strategies, which will help guide the fund manager in choosing what to invest in. These strategies can be based on investment type, geography, industry, etc. For example, you can invest in a mutual fund that only buys stocks from technology companies, or that only invests in US-based fitness companies. Ultimately, the goal is to achieve the highest possible return and outpace the return on the overall market.
Mutual funds are considered to be risky in many of the same ways as both stocks and bonds. However, because mutual funds are invested in more than just a single stock or a single bond, their risk is considered to be diversified. This means that the risk is spread out amongst the variety of investments, so poor performance of one company will not dictate the return of the fund if other companies are performing well.
Index Funds are a passive version of a mutual fund. Passive investing means that there is no fund manager in charge of making investment decisions; all of the investments are predetermined based on a specific index that the fund tracks. An index is a way of measuring performance; think of it as a basket of different stocks that are used to gauge the overall performance of different markets.
An index fund is simply a fund that contains all of the same investments as a specific index. For example, an S&P500 index fund is invested in all 500 companies on that specific index. As a result, when you invest in an index fund you get a slice of a variety of different companies, just like if you were to invest in an active mutual fund. The difference is that the companies in the fund only change if the index changes, and the performance return mimics the performance of the index.
Index funds are considered to be a great core, long-term investment. They operate on the theory that over a long period of time, an index will outperform any individual stock.
There are many types of investments available to choose from, and within each type there are thousands of choices. When you choose to invest, it is critical to understand what you are investing in and why you’ve chosen that particular investment. Each investment requires taking on a degree of risk, although some investments are riskier than others. Be sure to align the types of investments you choose with your desk tolerance and your goals, which were discussed in part 1. Please keep in mind, no part of this article should be interpreted as financial advice. Any investment action taken is at your own risk.