There are a number of different types of investments you can use to grow your money. Some of them are useful for general goals, while others serve very specific purposes. As you work towards your goals, it’s helpful to know what the different types of investments are, and when each one might be useful. Let’s go through your options (more or less) in order of riskiness and complexity.
Note: this article ended up being quite long. However, it’s still just an overview of different investment types. My temptation is to include every detail with the pros and cons, but you’d probably fall asleep if I did that. So use this as a starting point for further research.
Cash
There are more than 31 flavors of investments.
This is the most basic type of investment, and generally the safest. Keeping your money in cash (or investments that are very similar to cash, such as money market funds) is fairly simple. You’re probably familiar with savings accounts and certificates of deposit (CDs), and those are cash investments. The safest way to keep cash is in a government guaranteed bank account.
Advantages: cash is generally safe. You don’t have to take on the risks that come with most other types of investments. If the stock markets go up and down, your cash is generally safe (assuming you have it in a government guaranteed bank account). It is also easy to get to quickly, so if you need to spend or invest at a moment’s notice, having cash on hand is helpful.
Disadvantages: because of their safety, cash investments generally don’t earn much. That’s not necessarily a bad thing – there’s certainly a time and a place for keeping money safe – but it’s something you should be aware of. Over long periods of time (many years, or decades, let’s say) investments in cash can lose purchasing power. In other words, you probably won’t be able to buy as much with your cash 20 years from now as you could today due to the effects of inflation.
Best uses: cash is best for money that you intend to spend in the relatively near future. It is also good for money that you are not willing or able to lose. If the return of your principal is more important than the return on your principal, consider cash as an option.
Stocks
Stocks are on the opposite end of the risk and reward spectrum from cash. They are risky investments, meaning that their value can change dramatically over short periods of time. They can go up quickly, and they can go down quickly. Stocks represent ownership in a company, but most people simply buy them hoping that they will be able to sell for more later (it’s not like you have any say in how the company is run, unless you own a substantial amount of a company’s stock).
Advantages: because of their high level of risk, stocks have the potential provide high returns. Over long periods of time, stocks have tended to deliver returns higher than most other types of investments.
Disadvantages: stocks are risky. It is very possible to lose money investing in stocks, and it’s almost certain that you’ll see losses for at least short periods of time. If you’ll need your money back while you’re stocks are down, you’ve got problems. Investing in individual stocks can also be complicated and time-consuming because there’s a lot you need to do (and you need to continually monitor things). Plenty of people have had bad experiences investing in stocks – the potential for high returns is attractive, but the fact is that stocks don’t always go up.
Best uses: stocks are best for long-term investors who are willing and able to take the risk. People who need and want growth might invest in a diversified mix of stocks in hopes of achieving their goals. This only ever works if you’re willing and able to ride out the ups and downs (and if there happen to be more ups than downs by the time you need your money).
Bonds
Bonds are somewhere in between stocks and cash when it comes to risk. They are similar to loans: you give somebody your money, they pay you interest, and at some point you get all of your money back (your principal might be returned at the end of your loan term, or possibly along the way). These types of investments are issued by companies, governments, and other organizations.
Advantages: bonds can provide income, and they can also gain (or lose) value. They are considered “safer” investments than stocks, depending on who issued the bond. Bonds from the United States government, for example, are generally considered quite safe because it’s a fairly safe bet that the government will stay in business and pay you back. On the other hand, “junk bonds” issued by financially shaky companies are riskier – so they generally have to pay higher interest rates to compensate you for taking that risk. Some bonds can provide tax-free income, which is helpful to high income earners.
Disadvantages: depending on the type of bond you use, you might find several disadvantages. “Safe” bonds might be less likely to lose money, but they have a harder time keeping up with inflation. If you want to maximize your opportunity for growth over the long term, you probably don’t want all of your money in these types of investments. There’s also the chance that your bond issuer will default: you won’t get your interest payments, nor will you have your principal returned. Finally, even “safe” bonds can lose money as interest rates change – and this is an unpleasant surprise to conservative investors. When interest rates rise, bond prices fall. That might not matter to you if you intend to hold a bond forever (of course, then you’re stuck with an investment that pays less interest than you could get elsewhere), but you would lose money if you had to sell before the bond matures.
Best uses: bonds are most often used to provide income, and to reduce risk and a portfolio. No matter how much risk you want to take, there’s probably a place for some amount of bonds, whether they’re risky bonds or safer bonds.
Mutual Funds and ETFs
Mutual funds and exchange traded funds (ETFs) are pooled investments. Instead of buying a bunch of individual stocks and bonds, you can put your money into a “pool” with other investors and have it done for you. For example, you might just want exposure to stocks, so you could find a mutual fund that invests in the US stock market. Funds can invest in any other type of investment (stocks, bonds, alternatives) or a combination of different types. These funds may be passive (low cost options that track market indices) or active (using a money manager decides what to buy and sell based on opinions of what’s best).
Advantages: a main benefit of using mutual funds and ETFs is that you can easily diversify (or spread your money out over many different investments) using one fund. You don’t have to do it all yourself, which saves a lot of time and money on transaction costs. Target date funds, while not perfect, make it easy to diversify with one fund.
Disadvantages: these types of funds do not have many disadvantages. Most problems are a result of the type of fund you might use or the individual fund you choose. Funds can be expensive and/or poorly run, so it’s important to know what you’re buying. Some of them are extremely risky, while others take less risk. Occasionally, mutual funds can create tax “surprises,” but those events are not likely for somebody who’s starting out with nothing and investing a few hundred dollars per month.
Best uses: mutual funds are good long term investments. They allow you to choose a type of investment, and let somebody else take care of the details. They are often used for retirement planning and other long term goals.
Alternatives
The world of alternatives is growing every day and becoming increasingly complex. The basic idea of alternatives is to invest in something that behaves differently from stocks and bonds, or that helps you achieve some specific goal. When stocks and bonds zig, hopefully your alternatives will zag. That’s not always the case (in the market crash of 2008, pretty much everything went straight down at the same time), but you can always hope. “Alternatives” might include the following types of investments:
- Real estate
- Precious metals
- Commodities
- Foreign currencies
- Different types of strategies (long/short, momentum, etc.)
- And endless other types of investments
Advantages: alternatives allow you to have an extra arrow in your quiver. In an ideal world, they’ll make money while your stocks are losing money, or possibly generate returns regardless of what the markets are doing. Again, that’s not something you should count on, but alternatives certainly help to diversify a portfolio. They offer a greater number of ways to balance your risk, grow your money, and create income. In some cases they can protect against certain risks (inflation or a weak dollar) in ways that stocks and bonds can’t.
Disadvantages: alternatives can be complicated. Because they’re hard to understand, they might surprise investors by moving more quickly than you’d expect. These types of investments trade in markets that can be extremely volatile. Depending on which alternatives you use, and how you get exposure to them, alternatives can also be expensive.
Best uses: alternatives can be used to diversify and round out a portfolio. It’s probably not a good idea to load up too much on any particular alternative investment, but having modest amounts of exposure might be helpful for long-term investors.
Annuities
Annuities are contracts with an insurance company. They might invest in stocks, bonds, and alternatives, or they might just invest in conservative investments and pay you a fixed interest rate. You can put money into annuities over time or in a lump sum. You can also take money out in a lump sum, or set up a series of payments that will last for the rest of your life. It’s important to know that annuities are contracts with an insurance company, and insurance companies can fail (and take your money with them).
Advantages: different types of annuities offer different advantages to different types of investors. Conservative investors might enjoy fixed annuities, which pay a fixed rate of interest on any money you have in the contract. More aggressive investors, using variable annuities, might enjoy certain guarantees that the insurance company offers (at a price, of course) while going for growth. Annuities can be set up to pay retirement income to you for as long as you live, and they also provide some tax benefits (but you give up the opportunity to enjoy different tax benefits).
Disadvantages: again, depending on the type of annuity you use, you have to be aware of the disadvantages. With most annuities you have to keep your money with the insurance company for several years (or more) or you’ll have to pay stiff “surrender charges.” Fixed annuities are generally considered safe, but they are unlikely to keep up with inflation. Variable annuities are expensive, so it’s important that you understand the costs, and whether or not you really need to pay them. Finally, annuities are extremely complicated – you might think they can address all of your hopes and fears, but there’s always a trade-off.
Best uses: annuities can provide tax benefits to high income earners who are willing to (someday) pay taxes at ordinary income rates. They can also provide guarantees for long term investors planning for retirement, and they might even provide lifetime income similar to a pension. They work only when you understand all the pros and cons.
Other Types of Investments
The investment options above are some of the most basic types of investments. However, there are numerous other options out there. Those other types are beyond the scope of this article. If you’ll allow a generalization, the more esoteric investments out there probably (but not always) put you farther out on the risk/reward spectrum: they may have the potential for high returns, but they’re complicated and full of landmines.
Some of these investments might include: buying into a business, peer to peer loans, viaticals, leveraged real estate, and a million other things I’ve never heard of.
Photo credit: dennis