Investing for the Absolute Beginner, Part 2: Types of Investments
In part one of my series "Investing for the Absolute Beginner" I discussed the reasons one should invest money rather than merely save money. The primary reason is the potential for greater returns on an investment than what is possible with ordinary savings accounts and strategies. In this part two below I will discuss some of the many general types of investments while highlighting their various pros and cons and offering my thoughts on what types of investments are appropriate for long-term investors in various situations.
Individual Stocks
What are they?
The idea behind a "stock" is quite simple. A share of a stock is literally a small percentage of a company. By purchasing shares of stock in the company of your choice, you are entitled to share in the proceeds of the company's profits (or losses!) in the form of dividends or an increase in value of your shares.
Pros:
We have all heard of the individual stock success stories such as Alphabet, Inc. (Google) (NASDAQ: GOOG) or Microsoft (NASDAQ: MSFT). If you are fortunate enough to pick the right stock, then your investment can be multiplied many times over. Of course, the majority of companies out there are not as quite as successful as Google or Microsoft, but a healthy company can show a healthy profit that can generate returns far greater than nearly any other investment medium.
Cons:
The cons of individual stocks are their volatility and their unpredictability. Stock prices have a tendency to fluctuate with wide ups and downs due to a plethora of factors. If you are fortunate enough to buy a stock while it is on the downswing, then you can make a lot of money, but the reality is that you are just as likely to pick a stock that will lose you money in the long run.
The sheer number and types of factors that influence stock prices make it nearly impossible to predict the future price of a stock on any time frame. This makes individual stocks the riskiest of the investment types I will discuss here, although if you are willing to hold on to those stocks for a while, it is possible to ride the ups and downs of the market and enjoy the benefits of long-term growth.
Mutual Funds:
What are they?
Mutual funds are collections of individual investments that are bought and sold as a whole rather than individually. When you buy a unit of a mutual fund you are buying tiny fractions of tens hundreds or thousands of individual investments. Mutual funds can be actively managed (fund holdings adjusted actively according to market trends) or passively managed (fund holdings determined by any of various market indexes).
Pros:
Mutual funds allow an investor to enjoy the great potential for gains that the stock market possesses while also alleviating some of the risk inherent to investing in individual stocks. Since each individual holding inside a mutual fund comprises a very small fraction of the fund as a whole, if an individual company begins to lose its value, the fund price remains relatively stable due to the small relative weight of that stock inside the entire fund. In addition, a fund that is actively managed can be upheld by rotating out the failing stocks on a regular basis and replacing them with stocks that have brighter prospects. In short, mutual funds offer the benefits of the stock market without the risk of individual stocks.
Cons:
Do not get me wrong, the benefits of mutual funds far outweigh the drawbacks for long-term investing. But there are a few drawbacks to mutual funds that one must be aware of. First, actively managed funds are unlikely to outperform passive funds that mirror the major stock indexes. Since someone, or a group of someones, must choose which stocks will be included into a mutual fund, the same difficulty in picking individual stocks is inherent in deciding which stocks to include in a mutual fund.
Fund managers are often paid a great deal of money to squeeze every last cent (or percent) of returns from their funds, but the luck factor makes fund managers unlikely to outperform the market indexes as a whole, which have a steady and relatively predictable uptrend. The solution to this difficulty is to stick with those funds that are passively managed, although it is true that actively managed funds sometimes do succeed in generating greater returns than passive funds.
The second drawback to mutual funds versus other forms of investments is the presence of annual management fees. Fees are charged to the owners of the mutual fund units in order to cover the costs of maintaining the mutual fund. Actively managed funds carry higher maintenance fees than passive funds, so this difficulty can again be alleviated by sticking to passive mutual funds. The fees are usually a couple of percentage points at most, but over the course of thirty or forty years, those small percentages can make a serious dent in your overall net worth at retirement. So although mutual funds are safer than individual stocks, they do have serious drawbacks that must be factored into your decision to include them in your long-term retirement portfolio.
Exchange Traded Funds (ETFs)
What are they?
An Exchange Traded Fund (ETF for short) is similar to a mutual fund insofar as an ETF consists of a bundle of individual holdings that are bought and sold collectively. Unlike mutual funds, however, ETFs are divided up into individual shares that are bought and sold as shares on the various stock markets.
Pros:
ETFs enjoy the risk-alleviating benefits of mutual funds while carrying additional benefits. ETFs are much more liquid than mutual funds and can be bought or sold regularly like any other item on the stock market. While this liquidity is not so important for long-term investing, if you want your investments to be easily redeemable (or if you want to be able to invest on a whim at the drop of a hat) then ETFs have a distinct advantage over mutual funds.
Another advantage of Exchange Traded Funds over mutual funds is that most ETFs are passively managed funds. Since the stock market indexes as a whole have a steady uptrend, despite the fluctuations of the market in the short-term, ETFs allow the investor to enjoy predictable returns in a long-term portfolio without the high management fees of actively managed mutual funds. And the liquidity of ETFs means that you can invest in a fund anytime the stock market is open for trading. This makes ETFs perfect for the "impulse investor" (like me) who likes to invest for the fun of it and not just for the benefits of sound personal finance.
ETFs are my favorite investment type in this list due to the ease of setting up an adequate long-term investment portfolio using just a few ETFs. If you would like to see a sample of how ETFs are used in my own Roth IRA portfolio, you can click here to take a look at my portfolio's ETF holdings. In short, ETFs combine the best elements of individual stocks and mutual funds: they are liquid like individual stocks but they are less risky like mutual funds.
Cons:
ETFs have one main disadvantage: trading costs. Since the buying or selling of ETFs must be done via a broker (whether a person, a brokerage company, or an online discount broker), there are usually trading fees associated with the buying or selling of ETFs on the stock exchange. Each trade will usually cost a certain dollar amount in addition to the cost of the securities one is investing in. These trading fees can do a good job of wiping out a good percentage of the gains in a portfolio, so when investing in ETFs care must be taken to minimize trading costs.
One way to minimize trading costs is to use an online or discount brokerage. Since ETFs are often used to invest in passive index funds, there is little or no need to pay someone to invest for you. By cutting out the middleman and investing through an online broker, you are significantly reducing the cost of buying ETF shares. There are several good online brokerages to choose from, but I will be covering those later in this series when I discuss how to choose a brokerage and open an account. There are naysayers who will hold that the trading fees basically eliminate the benefits of ETFs over mutual funds, but if one is careful to minimize those trading fees then ETFs are perfect for the beginning investor.
Bonds:
What are they?
Bonds are basically loans that the investor makes to the government or to a financial institution that will be repaid with a fixed percentage increase after a designated time frame. This of course describes bonds in the most general of terms, but the above description is adequate for the purposes of this post. By investing in a bond (or a bond fund, which is similar to a mutual fund but with bonds instead of stocks), you are guaranteeing a fixed return on your investment after a fixed term.
Pros:
The pros of bonds are obvious: they guarantee a fixed return on your investment that is not subject to the unpredictability and volatility of the stock market. This makes bonds perfect for those investors who are looking to invest for the short-term (and hence who cannot afford to ride out a short-term drop in their investment), and also for those investors who are seeking a predictable and stable return (such as during retirement when a stable income is needed for living expenses). As one gets closer to retirement, bonds should occupy a larger percentage of your portfolio to enable you to keep the returns that your lifetime of investing has generated.
Cons:
The stability of bonds is actually a disadvantage when it comes to maximizing one's investment for the long-term. Although stocks are more volatile than bonds, stocks have been shown to yield reliably greater returns in the long-run than bonds. This means that that value of your investments may not fluctuate as much if you invest in bonds, but you may be cheating yourself out of hundreds of thousands of dollars worth of returns over thirty or forty years of compounded investing.
This makes bonds wildly inappropriate for those investors who are just getting started investing and with decades to go until retirement. As such I consider bonds to be only tangentially related to long-term investing, although some folks advocate having always even a small percentage of your portfolio in bonds to help smooth over the downturns in the stock market and keep your portfolio a tad more stable. If you are in your twenties or thirties, however, those weekly or monthly fluctuations matter little for the long-term; as such I advocate having all of your portfolio in stocks if you have anything over ten years to go until retirement. Falling stock prices mean that you should buy more stock so that you will own even more when the market returns to normalcy, not that you should run for the safety of bonds!
Conclusion:
That about wraps up my account of the various investment avenues. There are, of course, more specialized investments and sectors inside each of these major categories, but that is a topic for another post. Next time I will cover the basics of how to choose an online broker and the various types of investment accounts available to you as a long-term retirement investor. As always, feel free to contact me with any questions, and be sure to follow this entire series if you are new to the world of investing.
Here are the entries in this series: -Part 1- -Part2- -Part 3-
