The Basics of Investing
The Ins and Outs of Different Types of Investments
Learning the basics of investing is like learning a new language. It is easy to get lost or feel overwhelmed. The good news is that once you have mastered certain investing basics, you'll better understand how your money is being invested for your future plans.
To assist you on that journey, here is a look at the handful of the most common types of investments you will encounter in your lifetime: stocks and bonds, mutual funds, and real estate.
Finding the Right Mix for You
The world of investing offers a seemingly endless number of assets and opportunities. There are financial securities, which include stocks and bonds. You also have real assets, which are physical assets you can see and touch; real estate is an example. Then you have assets that are bundled together into what's called a fund. We'll walk through stocks, bonds, real estate, mutual funds, and other investing structures and entities.
The assets that are right for you will depend on many things such as your investment time frame, appetite for risk, and financial goals. Situations and preferences change with time, so it's good to reevaluate your strategy when your circumstances change. With an overview of your options, you can have a better idea of finding what's right for you.
Without a doubt, owning stocks has been the best way, historically, to build wealth. Stocks are shares of ownership in a specific company. When you own a share of Apple, for example, you own a tiny piece of that company. Stock prices fluctuate with a company's fortunes, and also with the economy at large. Public companies list and share their shares on exchanges. Some companies issue shares but are private—meaning they do not trade on an exchange.
These investments come in different quality depending on the underlying company's financial stability. Some stocks pay a regular return of company profits in the form of dividends, and others do not. Investors can realize capital gains if the shares appreciate in value above what they paid for them.
If you sell an investment for more than you paid for it, you'll be required to pay capital gains tax on the profits.
Best For: Stocks are a great choice for investors who are aiming for higher returns, have a higher risk tolerance, and have faith in the success of companies.
When you buy a bond, meanwhile, you are lending money to the company or institution that issued it. Bonds are debt securities and can be in the form of Treasuries, municipal bonds, corporate bonds, and other types of debt. You are lending money that the borrower will pay back by a stated date. Until they pay you back, the borrower will pay you interest on a regular basis. Buying a bond issued by a company means you're lending money to that company, which it can use to grow the business.
Like with stocks, bonds come in different quality with the best being AAA. Rating agencies like Moody's set the rating on a bond. Some bonds are called junk bonds due to the instability of the underlying company and are riskier to own. Bonds have to be held for a period before they mature. However, you can resell them on the secondary market through your broker.
Best For: Bonds are best for investors who have a lower tolerance for risk and seek out less volatility in their investments. With the consistent payments from bonds, they are also great for investors that want predictability in their income. These traits make bonds ideal investments for those nearing or in retirement.
Put Money in Mutual Funds
One of the most popular ways to own stocks and bonds is through mutual funds. In fact, most people are statistically less likely to own individual investments than they are shares of companies through mutual funds held in their 401(k) or Roth IRA.
Mutual funds offer many benefits to investors, particularly to beginners who are just mastering investing basics. They're pretty easy to understand and allow you to diversify your investments over more companies. However, mutual funds also have a few serious drawbacks: they charge fees, which can eat into your profits, and with some funds, they may boost your tax bill, even in a year when you don't sell shares.
Mutual funds are pooled money investments that will have a primary focus. As an example, you may see a mutual fund that follows a particular index, invests primarily in a specific region of the world, or focuses its holdings on companies of a specific size. You and hundreds of other people give a fund manager money which they invest in various holdings.
In most cases, there is a broker fee to buy or sell these holdings.
Best For: For investors who want a diverse portfolio without the hassle of managing their investments, a mutual fund is a fitting choice. For a small fee, a fund manager and their team will choose a pool of securities that align with the stated goal of the fund.
Invest in Real Estate
The world is full of people who are convinced that real estate is the only investment that makes sense. Whether you subscribe to that philosophy or not, there are more ways than ever to add real estate to your portfolio.
Yes, you can buy a home for yourself, or properties to rent. But you also can purchase securities such as a real estate investment trust (REIT). REITs have a structure much like a mutual fund where a professional manager handles the individual assets held within the trust's portfolio. However, in this case, all the investments are only in real estate.
Best For: Real estate is best for those investors who are interested in real assets and have the experience to make the right picks. Investing in real estate without knowledge of the asset, location, and regulations could lead to headaches and a poor-performing asset.
Other Investing Structures and Entities
When you move beyond stocks, bonds, mutual funds, and real estate, you encounter different types of investment entities. For example, millions of people will never own a share of stock or a bond. Instead, they invest their money in a family business, such as a restaurant, retail shop, or rental property. Yes, these are businesses, but you also should consider them as investments, and treat them accordingly.
More experienced investors tend to invest in hedge funds or private equity funds or trade in futures and options contracts. Others will buy shares of publicly traded limited partnerships through their broker. These special legal structures can have big tax implications for you, and it is important you understand how investing through them can both benefit, and potentially harm, your pocketbook.
Investing Through Ups and Downs
It's the nature of the world that sometimes bad things happen. When they happen to your investments or savings, you don't need to panic. Sometimes, you need to take a hit before you can make some money again, and holding on until the recession ends is often the best plan.
Even though there are thousands of investments available to any individual, some strategies have stood the test of time and can offer investors a guide to follow in order to persevere. Some basics include buying and holding long-term, diversifying, dollar-cost averaging, and choosing quality funds with the lowest fees.
Besides reading and learning as much as you can, one of the best things you can do is talk to a financial planner or accountant who can help you better understand the world of investing.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.