Investing your hard earned savings can be daunting. There are so many options it can be hard to figure out what to do. You likely have several investment options in your 401(k). And what about all the other options? Are IRAs or ETFs right for you?
You can untangle the mess of terminology and options if you understand that at the root of things, there are only three types of investments. Everything else is simply a container to hold those investments. The three categories are:
- Stocks: Also known as equities. When you invest in stock you own a small piece of a company. As an owner you share in the company’s earnings with other owners. Your earnings may be sent to you in the form of a dividend, or the company might reinvest them in the business. Growth in earnings and dividends drives the long-term value of the shares you own, though many things influence the daily prices of stock in a publicly traded company. Because the future earnings are uncertain, stocks are risky investments.
- Bonds: Also known as fixed income. When you invest in a bond, you own a piece of a loan made to a company or government entity. There are even bonds that bundle together mortgage loans to individuals known as mortgage backed securities. As the owner of a bond you are entitled to interest and the return of principal (your piece of the amount loaned). The daily value of a bond is driven by changes in interest rates and the time remaining until the loan must be paid back, but if you hold the bond to maturity you will simply get the interest and principal. Because the interest and principal payments are contractual obligations, bonds are less risky than stocks.
- Hard Assets: Hard assets are things you can touch, like precious metals, agricultural products, oil and gas or real estate. The value of most hard assets is driven by supply and demand. Real estate is the exception. Real estate can also generate income through rent. Supply and demand is unpredictable, so hard assets are also risky investments.
Within each of these broad categories is a host of sub-categories. They include US and international stocks in large, mid or small sizes, US and international corporate and government bonds and many more. There are thousands of companies and bond issues, and you can hold any of them directly. All other investments are indirect ways, or containers, for holding one or more of these three investment categories. Here are a few of the common forms of holding investments indirectly.
- Mutual Funds: Mutual funds can hold any or all of the three investment categories. There are single category mutual funds that invest in only one of the three, and there are multi-category funds that invest in two or more categories.
- Exchange Traded Funds (ETFs): ETFs are a special type of mutual fund. Mutual funds are valued at the end of each day and sold through the fund company that manages them. ETFs are sold on the stock market like a company stock. The value fluctuates throughout the day. Because the ETF must have a value at any given moment, most invest to mimic an index, which is a fixed group of investments, like the S&P 500.
- Target Date Mutual Funds: Target date funds are also a special form of mutual fund. They were designed for retirement savings investments and invest in at least stocks and bonds, if not hard assets too. They usually have a year in their name, like 2035 or 2050. When the target date is far in the future, these funds invest most of their holdings in stocks, and as the target date approaches their holding of bonds become larger.
There are many other vehicles that allow you to indirectly invest in the three main categories. Whether you are investing directly or indirectly to get a truly diversified portfolio, you should spread your investment money among different categories. Diversification reduces the risk of your holdings, because their values aren’t influenced by the same drivers, and therefore they will perform differently in any given circumstance. The biggest reduction in risk comes from adding investments in the lower risk bond category to your other holdings. Different investments in the same category offer some diversification, but not as much as investments across categories.
The next container up is the account. The different forms of accounts are merely ways of titling your holdings, similar to the way you would title an account in both you and your spouse’s name or the name of a business. The different titles designate how the account is to be used. Theoretically an account can hold any kind of investment, but the institution or the provider may limit what they offer you.
- 401(k): You may have a 401(k) or its cousin the 403(b) account through work. Your employer has picked a list of several mutual funds for you to choose from and will include some in both the stock and bond categories as well as at least one or two investing in multiple categories.
- IRA: IRA accounts are available through most financial institutions. Common places to open an IRA are through a full service brokerage firm, like Merrill Lynch, through a discount brokerage firm, like Charles Schwab or directly through a mutual fund company, like Vanguard. There are many more investment options available in an IRA. You can hold stocks, bonds and hard assets¹ directly, or you can hold any of hundreds of mutual funds and ETFs.
- 529 Plan: 529 plans are college savings plans offered through your state of residence. The state will offer a limited line-up of investment options that will usually include a fund paying guaranteed interest, funds investing in single categories and age based funds, that like target date funds are designed to become less risky as the date of college attendance approaches.
- Taxable Account: Taxable accounts are simply titled in your name or jointly in you and your spouses name or the name of a business. They don’t have any tax advantages, and the title simply designates who has the authority to use the account. You can use the money in the account for any purpose including retirement and college. Like with IRAs, the investments you can hold in a taxable account are wide open.
401(k)s, IRAs and 529 plans have tax advantages. If you use them as intended your investments can grow tax free. It is still your money, and you can use it however you like. But the government will want the taxes that you didn’t pay along the way if the money isn’t used as intended, and in some cases there may be a penalty in the form of additional taxes.
Investing is a process of matching the account type with the intention you have for the money, deciding whether to invest indirectly through mutual funds, ETFs, and other vehicles or directly depending on what is available to you and how much work you want to put into managing your money, and diversifying your investments among the different categories according to the amount of risk you are willing to take. What the money is for may be the only straight forward decision here, but understanding this framework will help you know what questions to ask.
Hard assets are held through futures and forward contracts to buy or sell the product, or in the case of real estate, through real estate investment trusts. There are a few specialty institutions that can hold title to real property.
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