Let’s bring it down to the basics.
In the investment world, there are 3 main asset classes: equities (stocks), fixed income (bonds), and cash equivalents (money market). To further explain asset classes, think of it as a type of investment you can purchase that have very similar characteristics and they operate under the same set of rules and regulations. There are alternative asset classes, such as real estate and commodities but I am going to focus on a high level explanation of fixed income and equities because it will help explain what the differences are between stocks, ETFs, mutual funds, and bonds.
Fixed Income, or Bonds
Bonds are sold by government entities (federal, state and local) and corporations. When you purchase a bond, you are loaning this money to the entity you are investing in. Since the government or corporation is borrowing this money from you, they promise to pay a set interest rate for a predetermined amount of time. When the bond matures (terms expire), the borrower returns the principal amount to you.
What’s great about these types of investments is you’ll generate regular income and have a reduced risk in your investment portfolio compared to stocks. Some examples of bonds are CDs issues by banks, municipal bonds and U.S. treasury bills. The downside of this type of security/investment are the low returns and your cash will be tied up according to the terms of the bonds you purchased.
Here is an example: U.S. Treasury bonds can have 10 to 30 year terms or maturity. Meaning, once the terms of the bonds are up, the U.S. Treasury will pay you back the principal you invested. If you bought $5,000 in bonds, they will give you that money back when the bonds mature. In addition, if the bonds has a interest rate of 2% (as an example) they will pay you interest semi-annually based on the face value that you own. Therefore, in the example of $5,000 in bonds, you will receive $200 in one full year of interest.
Equities, or Stocks
The equities asset class is comprised of stocks from corporations that are raising capital. As an investor, you can purchase stocks for the market value and have a piece of ownership in a company. There’s a lot of debate about the statement “you own a piece of a company” and it’s with good reason. I won’t go down that path in this post but it’s not meant to be taken literally. There are different levels of stock ownership rights and each company should be able to provide those terms to you.
The great thing about stocks is that the potential for gains are very strong, but the risk level is much higher than bonds. When you invest in stocks, you’ve got to have the mindset knowing that you can loose it all or gain a crap load if the market is in your favor! Stocks have proven to outperform other forms of investments in the long run so stay in the game for the long term.
When it comes down to the actual price of the stock, it will lead into the discussion of basics in supply and demand. There is a limited number of stocks for one company and if the demand for the stock increases it will raise the price to entice the stockholders to sell their stocks. There is a whole lot that can drive a stock up or down and some can be company performance, interest rates, the economy, public policy, international affairs, inflation, deflation, etc.
Mutual Funds and ETFs
Mutual Funds are professionally managed and it’s a financial company that pools together money raised from investors. Mutual funds have different strategies, levels of diversification and vary in how they invest in different asset classes.
Mutual funds can focus on 1 asset class, such as money markets, bonds, and stocks or they can be a hybrid (combination of the asset classes) which gives more diversification in the investment. As you search for a mutual fund, take a thorough look into their strategies and the securities they invest in. You want to make sure the mutual fund is a match with your own investment strategy.
ETFs stand for exchange-traded funds. ETFs trade just like stocks and it’s a type of fund that owns the asset classes it invests in and it divides the ownership of those assets into shares. So, when you buy into an ETF you do not directly own the stocks and investments in the fund. The great thing about ETFs is the great diversification strategy they have and the ability to start small with micro-investing. ETFs are pretty straightforward.
What do you do from here? As you enter the investment world, consider the asset classes, the level of diversification you want in your portfolio, and whether you want to take an aggressive/moderate/conservative stance with your money. Remember, some asset classes are riskier than others,so be sure to keep that in mind.
If you’re looking for more personalized and detailed advice on investment strategies, I’m not your guy. You will need to consult with an investment advisor to talk about an investment strategy that is best for you. But, if you want to keep things simple and invest in ETFs, check out how I’m investing my Stash and consider micro-investing to start.