Table of Contents

 

Introduction

When people save their money, they often put the majority of their savings into bank savings deposits. These accounts currently earn well less than 1% interest annually, a small amount that does not keep up with inflation. To earn a greater return, many people allot some of their savings toward investments. There are a number of different types of investments:

  • Individual stocks and stock mutual funds
  • Individual bonds and bond mutual funds
  • Real estate and Real Estate Investment Trusts or REIT’s
  • Commodities, such as gold and silver (precious metals), energy and agriculture
  • Mutual funds are baskets of stocks and/or bonds and baskets of real estate holdings are REIT’s

There are many thousands of stocks, bonds and mutual funds, both in the United States and in foreign countries. Unlike Federally insured bank accounts, investments carry more risk. Many people don’t understand how to assess investments or where to begin the process. When this happens it is easy to become overwhelmed and give up, leaving your money in bank savings accounts, CD’s or money markets. These accounts currently earn less than the rate of inflation, which reduces the purchasing power of your savings.

Why should you invest?

The only way to assure that your savings retain their purchasing power over time is to make a return on your investment that exceeds the rate of inflation. The more your rate of return exceeds the rate of inflation, the greater the purchasing power of the money you invested. For example, say inflation is running at 2.5% per year, and the money in your bank account is earning 0.01% per year in interest. At the end of one year every $1 of savings has a purchasing power of 97.5 cents ($1 + essentially no interest minus 2.5 cents reduced purchasing power from inflation = 97.5 cents).

Now suppose you invested in a stock mutual fund that earned 8% in one year and inflation was 2.5%. At the end of one year, every $1 you invested has a purchasing power of $1.055 ($1 + 8 cents minus 2.5 cents loss of purchasing power from inflation = $1.055). One important reason to invest is to maintain the purchasing power of your investments.

A second reason to invest is to grow wealth. The money you invest is called your principal and the amount by which that investment grows is your profit. If you reinvest your invested profits, then you are earning interest on your interest,which is called compounded interest and that, according to Albert Einstein, is a most powerful force. Let’s look at some examples:

  • Say you make a principal investment of $20,000 and let it sit for 20 years
  • Your investment earns an average return of 10% per year
  • After 20 years of compounded growth, your investment would be worth $134,550

To take another example:

  • If you invested $100 per month and continued investing for 25 years
  • Assume your investment in say a stock mutual fund earned 10% per year
  • At the end of 25 years, your investment would be worth $133,789

The less we know about investing the scarier it is to do it. The first step in overcoming the fear of investing is to learn some basic information about the world of investing and the different types of investing opportunities. So let’s begin.

How Do Markets Work?

Before we talk about the different kinds of investments people can make, it is important to discuss what markets are and how they work. The workings of the markets will be invisible to the individual investor, but this section is included to help you understand what is going on behind the scenes when you place a trade.

Many of the investments we discuss in the next section – like stocks, bonds, mutual funds, and some alternative investments – are traded on public markets or exchanges. These are central locations where stocks, bonds, and other investments – collectively called securities – are traded amongst investors.

There are many securities exchanges around the world. Securities from different companies are traded on different markets, so most investors end up doing their buying and selling across multiple markets. The two major stock markets in the U.S are:

  •  New York Stock Exchange (NYSE): The “Big Board” is one of the most well-known and longest-running stock exchanges in the world. The NYSE is an “auction exchange,” so there are people physically at the market trading stocks on the behalf of buyers and sellers.
  • NASDAQ: The National Association of Securities Dealers (NASDAQ) is a virtual stock exchange. Unlike the NYSE and other markets, there is no physical market – all transactions are done electronically. Many large tech companies trade on the NASDAQ.

Investors use licensed brokers to buy and sell securities at these markets. The brokers charge a small commission, or fee for their services.

Indexes

There are thousands of stocks traded around the world, so as a result indexes have been set up to track how certain segments of the market, or the whole market, is doing.

When someone is talking about the market being up or down, they’re usually talking about an index that follows the market or a segment of it. Some of the more important stock indexes are:

  • The Dow Jones Industrial Average: The Dow, as it’s known to many investors, tracks the stocks of 30 large companies in the United States that have the most influence on the market as a whole. As a result, it is one of the most watched indexes in the world by analysts, journalists, and regular investors.
  • The S & P 500: Standard & Poor’s 500 Stock Index consists of 500 of the most widely traded stocks in the United States, representing 70% of the U.S. market’s total value.
  • The Wilshire 5000: When people talk of the “total market index,” they mean the Wilshire 5000, which tracks nearly all publicly traded U.S. companies.
  •  The Russell 2000: While the Dow Jones tracks the largest companies on the market, the Russell 2000 tracks the smallest 2000 companies on the Russell 3000 index of the 3,000 smallest publicly traded companies.

Types of Investments

Beginning investors may be overwhelmed by the variety of investment options available to them. However, the savvy investor sees the multitude of options as a benefit because they can diversify their investments, or have eggs in many baskets so that when one kind of investment is down (losing money), another may be up (earning money). We’ll discuss how to create a diverse portfolio later, but for now, understand what different kinds of investments exist, and the benefits and risks associated with each.

Stocks

What are they?

Stocks are one of the more common investments that people make. At its most basic, stock is a stake in a company. Whether you say “stock,” “share,” or “equity,” it all means the same thing: a small piece of a company. When an investor buys equity in a company, or becomes a shareholder, they are now one of many, many minority owners of that company.

Companies issue stock to help expand their business. When investors buy stock after events called Initial Public Offers (IPOs), where companies first list their stock for sale on public markets, this brings in money to the company to allow it to expand into new markets, open new stores, or buy more equipment.

When a company sells stock traded on public markets like the NYSE or NASDAQ, to name two, the company is a public company. As a result, the company has to publicly disclose more of their business and finances as dictated by the law than privately held companies that do not sell stock on public markets.

Resources:

– Learn more about what public companies have to disclose, and what sets public companies apart from private companies, here.

Investors buy stock because they hope that the value of their shares will increase based on the value of the company as a whole. The value of one stock, or a share, fluctuates depending on what the market’s perceived worth of the company is, which determines what a tiny piece of that company is worth. After the IPO, shares of a company are traded and sold on markets.

What exactly determines a stock’s value is complicated and doesn’t always seem rational, but at its most basic, stock prices rise or fall based on:

  • Supply and demand – if more people want to buy stock in a company then those who want to sell, the price goes up. Conversely, if more people are selling their stock than buying it, the price drops
  • Investors’ views of a company – this is hard for some people to wrap their heads around, but the value of a share is not necessarily a direct reflection of a company’s earnings or profit margin. The value is also determined by what investors perceive a stock to be worth, and so is influenced by their attitudes and expectations of a company, and their view of its future earnings potential. Investors’ perceptions often drive supply and demand. For those long-term buy and hold investors who participate in dividend reinvestment, roughly 40% of their profits will be a result of reinvesting their dividends.

Stock ownership also gives shareholders a claim on a portion of the company’s profits. Companies sometimes pay out their profits to shareholders in the form of dividends, or regular payments to shareholders paid on a dollar amount per share basis (so the more stock you have, the more dividends you receive). Not all companies pay out dividends on their stock. Investors can either take dividends as cash payments or reinvest their dividends into more shares in the company.

How do I invest in them?

People typically buy stock through brokers, or a middle party that executes buy and sell orders from an investor in exchange for a commission. Investors open accounts with brokerages by depositing cash, often in a money market that is attached to their brokerage account. From these accounts the investor can buy and sell stocks and mutual funds. There are many brokerage firms and they generally fall into two categories. Full service brokerage services provide investment advice and generally charge higher fees, while discount brokerages usually don’t provide advice and charge much lower fees for trades. For more information on working with brokers and financial advisors, as well as how to invest on your own, see our section on Getting Started.

It used to be that when people bought stock, they received a stock certificate, or a piece of paper proving ownership in a company. Now, with all transactions being carried out online, investors need only log in to their brokerage accounts to check their portfolio, as well as buy and sell stock any time, anywhere in the world.

Are there different kinds of stock?

There are two kinds of stock:

Common stock: Generally when investors buy and sell stock, they are trading common stock. When we described what stock is in the previous section, we were discussing common stock: a tiny stake in a company.

–  Preferred stock: Preferred stock is not as widely traded or available as common stock, and most investors never own preferred stock. What you need to know is that:

  • Preferred stock usually has a guaranteed, fixed dividend, unlike common stock whose dividends can change
  • If a company goes bankrupt and liquidates (or sells off its assets to pay off creditors), after debts are paid, preferred shareholders see money before common shareholders.
  • Preferred stock may be callable, which means that the company can choose to buy back shares from shareholders at any time

Stock may also come in different classes, so a company may offer a Class A share of its stock and a Class B. What differentiates these classes is usually voting rights, so Class A shareholders would have more votes than Class B. Of course, there is a higher cost of investment for higher classes of stock.

What are the benefits of owning stock?

  • Stockholders own a piece of a company – so when companies do well, shareholders do well
  • Shareholders are not responsible for the running of business – instead, management is hired to run businesses, with their job being to increase the value of the company for shareholders. If management is doing their job well, stockholders earn money without having had to do anything but buy in
  • Some stocks pay dividends, so shareholders receive a portion of the profits
  • Stocks can grow at high rates of return with interest compounding
  • The growth from stocks can be used to save long-term for retirement, education, purchase of a home, or any number of life needs

What are the risks of owning stock?

Basically:

–       The risk of owning stock is that stock values can depreciate, or go down

  • Investors can lose some of the principal they invested, or
  • Investors can lose the total value of the principal they invested

However, this risk – that investors can lose some or all of the value they initially invested – is actually one of the benefits of owning stock: all shareholders have to risk is the value of their investment. If a company goes bankrupt, gets in legal trouble, or owes money, investors are not personally responsible. If a company goes bankrupt, investors won’t have to sell their houses, cars, or other assets to pay off the company’s creditors – but they will feel the effects from the stock price dropping.

Bonds

What are they?

Bonds are essentially loans investors make to companies or governments for projects, growth, or other initiatives. Whereas when shareholders become owners in companies when they buy stock, investors become creditors when they purchase bonds.

When investors purchase bonds, they receive interest on a periodic basis (usually biannually or annually) based on the value of a bond until the bond is paid off, or matures.

Say you buy a bond worth $1,000 with a 10-year maturity.

  • This means that over the next 10 years, the issuer of the bond (the company or government offering the bond) will pay interest on the bond until the bond matures in 10 years. At maturity the issuer will pay the bond-holder the full $1,000 they invested up-front.
  •  If that bond has an interest rate, or coupon, of 5%, this means that the issuer will pay the investor $50 annually until the bond matures.
  • Over the 10 years of holding the bond, the bond-holder would receive a total of $500 of interest $50 per year for 10 years = $500).

How do I invest in them?

Some bonds can be bought directly from the issuer. Bonds issued in the U.S. by the federal government can be bought directly from the government through TreasuryDirect. Most bonds, like stocks, are completed through a broker or other third party.

Bonds are bought and sold on securities exchanges. If the bond is held until maturity, changes in interest rates do not affect the bond-holder. However if the bond-holder decides or needs to sell the bond early, then it is critical to understand how changes in interest rates affect the price of the bond. If interest rates increase above the rate of interest at which the bond was purchased, the price of the bond will fall. If interest rates decrease below the rate at which the bond was purchased, the price of the bond will increase: For example:

  • A 10 year bond was purchased at an interest rate of 5%
  • If the next year interest rates dropped to 4% and the bond was sold, the price of the bond would increase and bond-holder would make a profit. (that 5% bond is more valuable because it earns more interest than a new bond issue)
  • However, if the interest rate grows the next year to 6%, that 5% bond is worth less than a new bond issue and the value to other investors decreases. If the bond were sold, it would be sold at a loss.

Are there different kinds of bonds?

There are three types of bonds:

  • Corporate bonds issued by companies
  • Municipal bonds issued by states, cities, counties, and their agencies
  • U.S. Treasury bonds, issued by the federal government, which are simply known as “Treasuries”

The duration of a bond varies. Some Treasury bills mature in as little as 90 days, while other bonds can take 30 years.

What are the benefits of owning bonds?

High-grade bonds are one of the safer investments an investor can make, but as a result, have lower returns. Still, they are an important piece of any investment portfolio.

  • Bonds are what is called a fixed-income security, meaning the value of a matured bond and the interest rate determined when issued does not change
  • As a result, bonds are good investments for people who cannot afford to lose the principal invested, such as retirees on a fixed income
  • As a creditor, bondholders are paid before shareholders in case of bankruptcy

What are the risks of owning bonds?

High-yield or junk bonds are issued by companies or municipalities that have excessive debt and to compensate the bond-holder for the greater risk of default, these bonds usually pay a higher rate of interest. It is critical to understand that if you purchase a high-yield bond that you are assuming more risk, which could result in a reduction or loss of interest payments, or the issuer may default and the bond-holder lose the money they invested. Although this may occur with a higher rated bond, the higher the bond is rated the less the risk of this happening.

Not so much a risk, but something to note is that if an investor decides to withdraw (cash out) a bond early, he or she will lose the interest and may have to pay a penalty.

For investors looking to trade their bonds at a profit, there is more risk as interest rates fluctuate, and the value of the bond to other investors fluctuates with it.

Mutual Funds

What are they?

There are thousands of stocks and bonds traded on the exchanges, and with many shares costing a pretty penny, it can be difficult for the average investor to create a diverse, balanced portfolio, let alone have the knowledge to invest in the right ones.

That’s why mutual funds are a popular investment for millions of investors today. A mutual fund is a collection of stocks and/or bonds put together and managed by a professional manager. Mutual funds allow investors to essentially own a variety of different stocks and/or bonds but at a much lower total cost than buying individual shares or bonds.

Investors buy into funds much like they would buy a share of a company or a bond, and make money in much the same way. Investors can earn returns on their investments in mutual funds when:

  • The fund’s holdings, or the stocks and bonds held by the fund, increase in price. This pushes the value of the mutual fund shares up, which investors can then sell for a profit. This is what most investors hope for when they buy mutual funds.
  • The stocks held by the fund earn dividends and the bonds held by the fund earn interest. These earnings are then paid out to the fund holders in cash or reinvested into more shares of the fund, per the wishes of each individual fund holder.
  •  The fund’s manager sells stocks or bonds that have increased in value for a profit. These earnings are paid out to fund holders like dividends or interest.

One difference between mutual funds and individual stocks or bonds is that mutual funds are traded only once a day, when the market has closed and the prices of the fund’s holdings have been determined. Stocks and bonds are traded throughout the day and as a result prices can rise and fall throughout the day.

It’s important to note that mutual funds do charge fees and expenses to fund holders, and typically the more a fund is managed (the more the fund manager buys and sells the holdings) the more charges are passed on to the holders.

We’ll go into more detail on the costs of holding mutual funds when the risks of mutual funds are discussed.

How do I invest in them?

Mutual funds are traded through brokers, just like stocks or bonds, or can be bought directly from the fund companies.

Are there different kinds of mutual funds?

There are four major kinds of mutual funds:

– Stock Funds: the name says it all – funds that hold a variety of stocks – but many stock funds are targeted toward specific types of stocks with specific goals in mind. Some examples include:

  • Sectors: sector funds invest in stocks issued by companies involved in certain industries, such as healthcare, utilities, technology, real estate, or food.
  • Income: income funds invest in stocks that pay dividends.
  • Index: index funds mirror the major stock indexes, like the S & P 500, and indexes tracking entire markets such as the NASDAQ Composite Index. Index funds are passively managed – unlike mutual funds that have a fund manager – and so have smaller fees and expenses than actively managed funds. For many beginning investors, index funds are an easy and inexpensive option.

– Bond Funds: much like stock funds, bond funds hold varieties of bonds based on designations including:

  • Issuer: government, municipal, or corporate
  • Index: funds can track the total bond market, all 10-year bonds, or other indexes
  • Grade: bonds are rated by grades that indicate their risk of default

–  Money Market Funds: somewhat like bonds, money market funds are low-risk funds that invest in short-term investments issued by companies, municipalities, the federal government, and their agencies.

–  Life-cycle or Target Date Funds: also known as lifecycle funds, these funds are a popular choice for investors planning for retirement.

  • These funds hold a mix of stock and bond funds and adjusts the percentages of each for the persons age and expected time to retirement (the ‘target date’)
  • For example, say a 20 year old opens a Life-Cycle fund with a planned retirement target date at age 65.
  • Initially the fund would be invested almost entirely in stock mutual funds. As the person ages, the fund would automatically but gradually shift into less stock mutual funds and a higher percentage of bond funds.
  • These funds are am excellent choice for someone who has neither the time nor the interest in doing their own investment research. You can purchase them and forget about your investments. And if your Life-Cycle fund is a well-diversified index fund, then you can be certain to as well as the index.

What are the benefits of owning mutual funds?

– You don’t have to manage them. A professional fund manager handles all buying and selling within a fund, and selects which stocks, bonds, and other investments a fund holds. For investors who don’t have the time to research stocks and manage their portfolio’s holdings, buying into mutual funds is an easy and relatively inexpensive way to begin investing and get a professional’s help.

– Mutual funds help diversify your portfolio. Smart investors spread out their risk by investing in different kinds of assets across different industries. This way, when stocks are down and bonds are up, or one industry is doing well while another isn’t, all your eggs aren’t in one basket.

  • Mutual funds make it financially possible for the average investor to own a diverse portfolio with many, many securities across a variety of industries. Mutual funds may hold hundreds of assets. The average investor simply does not have the resources to buy that variety of stocks or bonds due to the cost of the assets, and the brokerage fees typically associated with those transactions.

– There are many different kinds of mutual funds. Any investor with any goal – such as to retire in 30 years, or to invest in emerging markets, or to track the entire market – can find a mutual fund that helps meet those goals.

What are the risks of owning mutual funds?

The risk of owning a mutual fund is the same of any investment – no investment is guaranteed. Mutual funds may lose money because the markets are unpredictable, and even professional managers may make bad investments.

While not a “risk,” something to be aware of with mutual funds is the fees and expenses charged to investors. Mutual funds are expensive to create and manage, and are moneymaking ventures for the fund creators and managers. Typically, mutual funds charge higher fees for:

  •  Management: the fund manager receives a fee for their work.
  • High trading volumes: when securities are bought and sold, transaction fees are part of a fund’s expenses. Generally, the more actively managed a fund is – that is, the more securities are bought and sold within the fund – the more is charged back to the investor.
  • Sales charge: some mutual funds charge a fee just for buying the fund. These are called load funds; mutual funds that do not charge a sales fee are called no-load.

It is crucial for investors to understand a mutual fund’s expense ratio (the percent of a fund’s assets charged back to investors) and whether that makes a mutual fund a good investment for them or not. The higher the expense ratio, the more a fund’s fees will eat into your investment savings.

Typically, the lower the expense ratio, the better. Though an expense ratio may only be a percent or two, that can add up over time.

For example, an index fund:

  • Has a 0.18% expense ratio.
  • With a $10,000 principal,
  • The investor pays $230 in fees over 10 years.

But looking at an actively managed that:

  • Has a 1.75% expense ratio.
  • With a $10,000 principal,
  • The investor pays $1,856 in fees over 10 years.

Mutual fund fees can add up for investors, eating into hard-earned savings that would otherwise go to retirement or an education, but instead find themselves in a fund manager’s pocket. A number of studies have been done looking at the cost and outcomes of investing in actively managed funds versus passively managed index funds. It can be argued that when the extra management fees and expenses as well as the tax effects of active trading are taken into account, investors can make out better with passively managed funds. That being said there remains a strong market for actively managed funds, so when researching mutual funds, be sure to investigate sales loads and expense ratios before investing.

Resources:

Exchange-Traded Funds (ETFs)

What are they?

An Exchange-Traded Fund, or ETF is like a mutual fund that trades like a stock. ETFs may track an index, a commodity, or a variety of holdings, but unlike mutual funds which trade once a day, can be traded throughout the day while the market is open.

How do I invest in them?

Investors can buy and sell ETFs just as they would stocks or bonds – by trading through brokers.

Are there different kinds of ETFs?

Like mutual funds, there are many different ETFs that follow different segments of the market, indexes, or industries.

What are the benefits of owning ETFs?

ETFs have many of the same benefits of mutual funds, including:

  • They help diversify your portfolio
  • They make it possible for investors to own many different kinds of securities
  • You don’t have to manage them
  • There many different ETFs with holdings in many different kinds of securities and industries

What sets ETFs apart from mutual funds, and may make them more attractive to some investors, is:

  • ETFs can be traded throughout the day, like stocks and bonds. For some investors, this is a big selling point. If an ETF tracks an index that is doing very well during the day, an investor can buy that ETF and sell it only a few hours later for a profit.
  • ETFs have very low expense ratios, generally much lower than even mutual funds with the lowest expense ratios.

What are the risks of owning ETFs?

The risks of ETFs are also the same as any kind of investment: no investment is a sure thing. ETFs may track indexes that fall or track securities that lose value.

One note about ETFs, but not necessarily a risk: while ETFs have low expense ratios, they make incur commission costs when bought through a brokerage firm. Research these fees to make sure they do not negate the benefits of having a lower expense ratio.

Certificates of Deposit

Certificates of deposit (CDs) are low-risk but low-return investments. To learn more about CDs, see our section in the Comprehensive Guide to Budgeting and Savings.

Annuities

What are they?

Annuities are an investment tool often used by people planning for retirement because they pay out a steady income in the future, sometimes for a few years, sometimes for the rest of someone’s life.

Investors pay either a lump sum or a series of payments to an insurer, and then the insurer invests that money. Investors are paid on a regular basis based on the terms of the annuity. Annuities can be paid either almost immediately after money is invested or payments can be deferred to a later date.

The goal behind investing in annuities is to increase savings while generating a later stream of income. However it is important to understand that while annuities can be a valuable investment, there are some significant risks and expenses that go along with annuities. It is critical that you understand these before you decide to invest in them.

How do I invest in them?

Investors buy annuities through banks or other financial institutions.

Are there different kinds of annuities?

There are three different kinds of annuities:

Fixed annuities guarantee the investor a certain rate of interest during the time the account is growing. They also guarantee that the future payments from the insurer will be for a specified amount based on how much money was invested in the annuity.

Indexed annuities track a stock index, like the Dow Jones Industrial Average or S & P 500. Some indexed annuity contracts may include a minimum that will be paid out to the investor, even if the index being tracked doesn’t do that well.

Variable annuities are riskier than fixed and indexed annuities but have a chance at greater returns. Variable annuities can be invested in mutual funds, and so offer the investor more flexibility in how their annuity is invested, but the payments from the annuity will depend on the return of the holdings tied to the annuity.

What are the benefits of owning annuities?

– Other retirement accounts have a limit to the amount of money investors can put in annually. Not so with annuities, which may make them an enticing option for people who are playing catch up on their retirement saving.

–  Annuities also have tax benefits. Annuities are said to have tax-deferred growth, which means that while invested money is growing inside an annuity, you don’t pay taxes on it. Taxes will have to be paid when annuity payments are made to the investor.

What are the risks of owning annuities?

The risk associated with annuities depend on the kind of annuity purchased:

  • Fixed annuities are low-risk as they have a set interest rate and guarantee the amount of future payments.
  • Indexed annuities are somewhat riskier as they track a specified index, but some may guarantee a minimum payment.
  • Variable annuities are the riskiest as they are tied to specific holdings which have the potential to lose some or all of their value.

Another note about annuities: while not a risk, one potential drawback to keep in mind is that annuities may charge high fees. Annuities are typically thought of as an expensive investment product.

  • Brokers or financial professionals who sell annuities typically receive a commission.
  • Variable annuities may have high annual expenses because they track actively managed mutual funds which also have expense ratios.
  • Investors will be hit with hefty fees (called surrender charges) for withdrawing money early from an annuity.

Resources:

–       To learn more about variable annuities, see this SEC guide to what you should know.

Investing in foreign countries

For those who fell comfortable investing in stocks, it is worth considering allocating 5-8% of your investments in foreign stocks. Some of the fastest growing economies are in the ‘emerging markets’ in countries such as Brazil, India, China, Russia, Vietnam and others. The safest and easiest way to make these investments is in broadly diversified index funds, such the many Emerging Market Index Funds that are offered by large mutual fund companies. There are also funds that index Europe and other parts of the world. Vanguard even offers a Total World Stock Market Index Fund that provides broad exposure to international markets.

You can research these and most other mutual funds through Morningstar. For those investors who invest primarily or entirely through mutual funds, a subscription to Morningstar would be something to consider. For those who have a small percent of their portfolio in mutual funds, they may be able to access these services through their library.

Alternative Investments

Of course, your investment options are not just limited to stocks, bonds, mutual funds, and annuities. There is a multitude of ways to invest money. Here are a few more that are a bit more complex and much riskier. However these may be considered as part of a well-diversified portfolio where the investor wants some exposure to such things as gold, silver, etc.

Options

An option is a contract that gives an investor the right to buy or sell a stock, bond, or other asset at a specific price during a specific timeframe. The buyer does not have to buy the asset in the end, but either way, has to pay for the option. Options can be traded on listed option exchanges.

Learn more:

Futures

Options give investors the right to buy or sell an asset; a futures contract obligates an investor to fulfill the terms of the contract. Investors trade these contracts because they lock in prices for certain assets at a later date. When the date to fulfill the contract arrives, the price for the asset may be less than the current market price, and so that contract can be sold for a profit.

The assets in question are called commodities. One of the more time-honored, far-reaching, impactful, and complicated types of investing is commodities futures trading. Some examples of widely traded futures commodities are:

  • Precious metals (like gold and silver)
  • Currencies
  • Energy (crude oil)
  •  Tangible goods (such as petroleum, aluminum, copper, and other staple items)
  • Agriculture and livestock

Learn more:

  • Get familiar with the basics of the futures market.
  • Visit the U.S. Commodity Futures Trading Commission’s Education Center for resources to help understand the risks of trading, how to read futures price tables, and how to protect yourself as a consumer.

Real Estate

A common form of investing around the world is to invest in real estate. The buying, selling, and renting of real estate (properties, houses, apartments, and more) traditionally outperforms the stock market, but is a complicated and risky industry with many rules and regulations governing it. Investors should do their due diligence before testing the real estate waters.

Learn more:

  •  Not everyone has the time or desire to manage their own properties, but that doesn’t need to stop investors from being involved in the real estate market. Learn more about Real Estate Investment Trusts (REITs), the mutual funds of real estate investing.
  • Check out more resources and tips applicable to real estate investing in our Guide to Home Ownership.

Risks of alternative investments

Options and futures are complex and extremely risky. Before you even consider these investments you should spend time and effort to thoroughly understand how they work and the risks they entail.

Purchasing real estate (aside from owning your home) requires that you understand the markets you are in. Your chances of making money are improved if you can do your own repairs on your properties. Real Estate Investment Trusts (REITs) are baskets of properties that allow you to participate in a diversified basket of properties. They have the added benefit that you do not need to do your own repairs when things break down.

Building a Portfolio

You’re familiar with the different kinds of investments you can make, and the benefits and risks associated with each. The next step is to begin building your investment portfolio, or your collection of stocks, bonds, mutual funds, and other investments.

Finding Your Risk Tolerance

The first step in building a portfolio is not rushing headlong into buying stocks or bonds. Before that, a smart investor will determine their risk tolerance to help guide how they build their portfolio from here on out. These four factors should go into determining how much risk you want to take on in your portfolio.

  1.  Determine Your Investment Objectives

Why are you investing? Is it for retirement in a few decades, or for a house you hope to buy in the near future? By evaluating your objectives and making sure they are realistic and achievable, you can determine your investment strategy.

2.  What is Your Investment Timetable?

This goes hand-in-hand with the previous step. If you’re planning for retirement, how long do you have? 30 years, or were you looking to retire much sooner? Are you saving for a house 10 years from now, or hoping to buy within 2? The answer affects what mix of high-risk, high-return investments and low-risk, low-return investments you include in your portfolio

3.  What Does the Money You Are Investing Mean to You?

Or in other words, can you afford to lose money on your investment? Say you are looking to invest $10,000. If your net worth is $50,000 and you need to use all that money to buy a house in 2 years, you cannot afford to lose it on a high-risk investment. However, if you have a net worth of $75,000 you can more easily assume the risk. Understand what the money you want to invest means to you based on your investment goals and your financial situation

4.   What is Your Personality – Risk Averse or Risk Loving?

 

You know yourself better than anyone else – let your portfolio be a reflection of you. Don’t choose a level of risk you are uncomfortable with, or one that is too conservative (not risky enough) for you. Above all, be comfortable with the amount of risk in your portfolio.

Resources:

Following the Risk Pyramid

Now that you know risk tolerance in accordance with your investment objectives and goals, you can begin to build your portfolio.

It is important to create a diverse portfolio with investments containing different levels of risk. You don’t want to invest entirely in high-risk, high-reward assets; at the same time, investing only in low-risk bonds and CDs limits your portfolio’s potential for growth.

Smart investors create portfolios with a balance of risks. Many investors use an investment tool called a risk pyramid to help plan out their portfolios.

Risk Pyramid
[Source]

Base

At the base of the risk pyramid are low- or no-risk investments and assets including:

  • Cash
  • CDs
  •  Money Market Accounts
  • Savings Accounts
  • Government bonds and debt

It is important to build a strong base of these conservative, or low-risk investments to help during times when the market is down or higher-risk investments are struggling.

Middle

At the middle of the pyramid are investments with moderate risk, but a greater chance of higher returns. These investments include:

  • Stocks
  • Bonds and debt with higher returns, such as some corporate bonds
  • Mutual funds
  • ETFs
  • International index funds from areas of the world in which you want to have exposure. Alternatively you can consider a very broadly diversified portfolio, such as Vanguard’s Total World Stock Index Fund

Some people feel that you should decide before you invest what level of allocation you feel most comfortable with. For example, if you knew that you had less tolerance for fluctuations in the market, you may decide that you feel comfortable with an allocation of 40% stocks and 60% bonds. Others may feel comfortable enough with market fluctuations that they want 60-80% of their portfolios in stocks and the rest in bonds. Whatever your tolerance, if you decide to allocate by percentages, then once a year you should rebalance if your percent allocations are too far off the mark.

Summit

At the top of the pyramid are the riskiest investments, such as options and futures.  The summit is the smallest part of the risk pyramid because investors generally want to keep the smallest portion of their portfolio in the highest-risk investments. You may not want to invest in these. However some people want to pursue these options, such as putting some money into gold and silver as a hedge against inflation or to invest in real estate or REITs or other alternative investments.

How an investor proportions their pyramid – how much of their pyramid is in the base (conservative investments) and how much is in the summit (the high-risk investments) depends on each individual investor’s goals and risk tolerance. In the next section, we’ll take a look at some different investment portfolios for different levels of risk tolerance.

Example Portfolios

The following are examples of portfolios with different risks, and who might invest using those portfolio allocations. As you may notice, the amount of risk in a portfolio can change at different stages of life.

Therefore, it is important for investors to rebalance their portfolios, or change the allocations in their portfolios, from time to time. A person who begins investing in their 20s may start with a risky portfolio, but may rebalance to a conservative portfolio over time.

Conservative

A conservative portfolio is one that takes a careful approach to investing. This is a portfolio with a low tolerance for risk.

– Goals:

  • To maintain value
  • To protect against inflation
  • To offer a small return
  • Not to lose value

– Allocations:

  • 70-75% fixed income securities (bonds, CDs, money market accounts)
  • 15-20% equities (stocks and mutual funds)
  • 5-15% cash savings

– Who Might Invest This Way:

  • People who want to avoid fluctuations in the market, such as:
    • People nearing retirement
    • Retirees
    • People needing to pay for life needs like college or a house in the near future

Moderate

An investor with an average risk tolerance and a longer timeframe for their investments may choose to create a moderately risky portfolio. A moderately risky portfolio is heavier on equities than a conservative portfolio, and so has a greater chance to grow, but also has some fixed income securities and cash to offset any market down swings or potential losses.

– Goals:

  • To grow long-term
  • To gain compound interest
  • To balance risk and reward

– Allocations:

  • 50-55% equities
  • 35-40% fixed income securities
  • 5-10% cash savings

– Who Might Invest This Way:

  • People looking to invest long-term and who can psychologically withstand market fluctuations that inevitably occur and at times can be significant:
    • Parents saving for a college education and will not require that money for at least five years
    • Workers saving long-term for retirement, a house, or other long-term life needs

Risky

A risky portfolio has the potential for the greatest returns, but also the greatest potential for losses, and is the most susceptible to the ups and downs of the market. Some long-term investors may devote portions of their portfolio to this kind of allocation.

– Goal:

  • High returns

– Allocations:

  • 70-75% equities
  • 15-25% fixed income securities
  • 0-15% cash savings

– Who Might Invest This Way:

  • People saving long-term who can withstand strong market swings, such as:
    • Young investors
    • 20-somethings
  • Investors with an expendable portion of their income

Guiding Principles

  •  Invest for the long-term. People looking to get rich quick trade too often and chase the latest invest fads. They usually do poorly compared to smart, long-term buy and hold investors.
  • Compound interest adds up (see examples in the beginning of this section). Stick with your investments long-term to maximize your gains in compound interest and if possible, strongly consider dividend reinvestment of your stock and stock mutual fund holdings as a way to increase your profits.
  • Don’t pull out of the market when it’s down. Markets fluctuate; that’s just in their nature. In fact, market downturns may be the perfect time to invest in undervalued securities. Had you invested in the market in 2008-2009, you would have participated in one of the best bull markets this country has seen.
  • Keep a diversified portfolio. By keeping your eggs in many baskets, your portfolio can stay strong while one market is up and another is down, and it reduces your risk.
  • Rebalance your portfolio from time to time to make sure you are sticking to your goals and meeting your financial needs.
  • Stay true to your risk tolerance. Make investments you are comfortable with, and adjust your investments as your risk tolerance changes over time.
  • Always do your research and read the fine print. Understand how fees and expenses will impact your returns, and compare investment options accordingly.
  • Don’t be afraid to get help! See our Getting Started section for advice on working with brokers and financial advisors.

Getting Started

Researching Investments

  • This Beginners’ Guide to Financial Statements shows how to decipher company’s balance sheets, income statements, cash flow, and other numbers to help you make an informed decision before you invest.
  •  Use the federal EDGAR database to find crucial information investors need: whether a company is making and if so (or if not), why that is. The database allows access to required SEC filings (like periodic reports) from public companies
  • Once you’ve found all those numbers, what do you do with them? Follow this NASDAQ guide to analyzing a stock in 12 easy steps.

Working with Brokers and Financial Advisors

Investing on Your Own

For investors that don’t need professional financial advice or want to save from paying broker fees and other expenses, there are many discount brokerage options available. These discount brokers carry out buy and sell orders just like a full-service broker, but at a reduced commission. Discount brokers also do not provide any financial advice.

Some popular discount broker options include:

Factors to consider when choosing a discount broker:

– Do they charge a commission for trades?

  • Is it per trade, or does it vary depending on level of trading (how many shares are being bought or sold)?

– Is there a minimum for opening an account?

– Do they offer trading on foreign exchanges?

– Do they offer their own mutual or index funds? Oftentimes discount brokers offer no-load fund options with some of the lowest expense ratios on the market.