It's easy to get intimidated by all of the possibilities and challenges when you decide to start investing as an absolute beginner. But learning how to make investments isn't anywhere near as difficult as it might seem at first.
At its core, investing is about laying out money today with the expectation of getting more money back in the future.
Most of the time, it's best to invest in productive assets, which generate money from some sort of activity. For example, if you buy a painting, you haven't acquired a productive asset. Forty years from now, you'll still own only the painting, which may or may not be worth more money. On the other hand, if you buy an apartment building, you'll not only have the building in 40 years, you'll also have generated 40 years of rental income from it.
Each type of productive asset has its own pros and cons, unique quirks, tax rules, and other relevant details. Here's a look at three of the most common productive assets you can invest in: stocks, bonds, and real estate.
Investing in Stocks
When people talk about investing in stocks, they usually mean common stocks of publicly traded companies. But they could also be buying partial ownership of a private company, which can also issue shares to its owners—just not ones that trade hands on an exchange.
Investing in Privately Held Businesses: When you have equity—an ownership stake—in a business, you are entitled to a share of the profit or losses generated by that company's operating activity. When they're started from scratch, businesses can be a high-risk proposition. But if you manage to financially back the right person with the right idea, you can be rewarded by making substantial gains on your investment.
Investing in Publicly Traded Businesses: Private businesses sometimes sell part of themselves to outside investors, in a process known as an initial public offering, or IPO. Once a business has gone public and its shares are listed on an exchange, anyone can buy the stock and become a partial owner.
The types of stocks you buy may differ based on the kind of person you are. For instance, if you are the type of person who craves stability, you might want to invest in blue-chip stocks that have a long track record of steady earnings and dividend payments to shareholders. These shares might be the best examples of productive assets among the investing categories of stocks.
If you are someone who is OK with risk (and maybe even excited by it) if it offers the possibility of greater rewards, you might lean toward growth stocks, which are characterized by volatile stock prices with bigger gains in bull (upward-trending) markets and greater drops in bear (downward-trending) markets. On the other hand, if you're a skilled shopper who's always looking for bargains, you might gravitate toward value stocks and aim to buy shares in companies that are undervalued by the market.
Investing in Bonds
When you buy a bond, you are really lending money to the bond issuer in exchange for interest income and the eventual repayment of your principal—the initial amount you invested. That income makes bonds productive assets.
You can trade bonds like you would stocks; you don't have to hold on to them until they mature—the point when you stop receiving interest payments and are repaid your principal.
Within the world of bonds, you have several choices:
- U.S. Treasury bonds are considered to be safe from credit or default risk, because investors assume the federal government will not fail to meet its obligation to pay you back.
- You might also consider investing in tax-free municipal bonds, which are issued by city and town, county, and state governments. These bonds are exempt from federal income tax and may also be exempt from state and local taxes.
- Finally, you can invest in corporate bonds, whose credit risk depends on the perceived creditworthiness of the company that issued them. Corporate bonds that are considered to be especially vulnerable to credit or default risk are called high-yield or junk bonds.
In addition to credit or default risk, the other major type of risk bonds are subject to is interest rate risk. A bond's yield is its return based on the interest or coupon rate it pays to holders and its price in the market. In the bond market, yield and price move in opposite directions: When yields go up, prices goes down—and so does the bond market. And when prices and the market go up, yields go down.
That's because when prevailing interest rates go up—not specifically the rate for the particular bond you're holding—newly issued bonds will generally offer a higher coupon rate to keep up with the overall trend in rates. The bond you're holding will be less valuable in the market because there are now other bonds offering higher rates—and so its price will go down as yields go up.
Interest rate risk is the risk bond investors face in the event prevailing interest rates rise, lowering the prices of their bond holdings.
Investing in Real Estate
Most investors in real estate make money by purchasing properties and renting them out. They can also make money by eventually selling the properties for more than they spent to buy them.
Some people also try to make money by buying homes for a low price, quickly making improvements to them, and selling them for more than they paid plus the cost of the improvements. It's a practice known as house flipping.
A less hands-on way to invest in real estate is through the purchase of stock in companies known as real estate investment trusts, or REITs. These companies own real estate of one type or another—perhaps hotels, office buildings, or even storage units—and in return for favorable tax treatment, they are required to distribute 90% of their taxable income to shareholders in the form of dividends.
Type of Ownership
Once you've settled on the asset classes you want to own, your next step is to decide how you are going to own them. For example, if you decide to invest in stocks, you can own the shares outright or through a pooled structure. You can either buy shares of individual companies or of funds—mutual funds or exchange-traded funds (ETFs)—that directly own the stocks.
If you buy individual stocks, perhaps through an online broker, you control where all of your money is invested. When you buy mutual funds, you're leaving the investment decisions up to fund managers. And when you buy ETFs, you're most often investing in all of the stocks in a particular index, such as the Standard & Poor's 500.
Place of Ownership
After you've decided the way you want to acquire your investment assets, your next decision regards where those investments will be held. You can open a taxable brokerage account that isn't connected to a retirement account. You can invest through your employer's 401(k) plan if it offers one. And you can also invest in one of a number of types of individual retirement accounts (IRAs): a traditional IRA, Roth IRA, SIMPLE IRA, or SEP-IRA.
The type of IRA you choose depends on your employment situation (the SIMPLE and SEP IRAs are for employees or owners of small companies) and whether you want to:
- Invest tax-free dollars and pay taxes on the gains from your investments once you start taking out money (a traditional IRA)
- Invest after-tax dollars and pay no taxes on the gains from your investments (a Roth IRA).
A 401(k) plan generally offers only a few investment choices, typically a handful of stock or bond mutual funds. The main upside of a 401(k) plan is that many employers match a certain percentage of the money you put into the plan.
You might choose to keep your real estate holdings in a limited liability company (LLC) or some other type of corporate structure, such as a limited liability partnership (LLP). If you're unsure which is the best option for you, consider seeking the help of a legal or accounting professional—or both.
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.