For those of us that don’t (yet) have financial security, the only way to attain financial independence is by saving and investing for the long run. The goal is to put your money to work for you through investment vehicles.
To form a plan you should know at least the basics so you can enjoy the benefits of managing your own money.
What kinds of investment options we have? Here you can read a list of them:
- Certificates of Deposit (CDs)
- Exchange-Traded Funds (ETFs)
- Mutual Funds
- Real Estate Investment Trusts (REITs)
Certificates of Deposit
A certificate of deposit is a savings account that holds a fixed amount of money for a fixed period of time. In the end of that period of time, you receive the money invested plus interest. So if you invest in a CD $10,000 for 1 year with a 3% interest, you will make a profit of $300 (3% x $10,000).
Important: In the United States, if you invest in a CD through a federally insured bank, your investment is insured up to $250,000. In Portugal, for example, is €100,000 ($120,000). More information here.
Usually this investment is the most relevant in terms of safety.
Stocks are a way of investing in a company. It’s a security that gives the investor a share of ownership in that company in return for their money. They are also referred as “equities”.
In terms of investment you can have a return through: dividends or capital appreciation.
Additionally you can have two main types of stocks:
- Common: Where you receive dividends and vote on shareholder meetings;
- Preferred: Usually receive dividends before common stocks. Also they have priority over common stock if a company goes bankrupt.
When a company, government or municipality wants to raise money from investors, one way is to issue bonds (debt security) where they promise to pay a specified rate of interest throughout the life of the bond and in the end repay the principal (the money that I’ve invested).
Bonds usually can help offset the exposure that an investor has to volatile securities such as stocks. This is particularly evident for Investment-grade bonds (Higher credit rating. Thus more likely to repay) and/or Treasuries (bonds issued on behalf of the federal government of the U.S.).
There are other types of bonds such as:
- Corporate (Private or Public corporations)
- High-Yield (Lower credit rating -> more risk – Governments and Corporations)
- Municipal (Bonds from states, counties and cities)
Exchange Traded Funds (ETFs)
This type of investment represents a way for investors to invest in a fund that makes investments in stocks, bonds or other assets. Another key feature of ETFs is that you can trade its shares on a national stock exchange. (Mutual funds don’t have this option)
Another thing worth mentioning is that the value in the stock exchange, could differ from the net asset value (NAV) of the ETF. NAV is the value of the assets minus its liabilities, divided by the number of shares outstanding.
There are essentially two types of ETFs:
- Index-based: Where the fund seeks to track a number of securities from an index such as S&P500. In essence it tries to buy stocks from the 500 companies that comprise the S&P500.
- Actively Managed: This type of ETF is more like mutual funds. Therefore an adviser could actively buy or sell securities regardless of the index.
A mutual fund is a company that attracts money from investors and then invest in securities such as stocks, bonds or commodities. As investor buys shares in the mutual fund, which represents the investor part ownership in the fund.
The big difference in comparison with ETFs (index-based) is that you have a “Professional Management Team”. These fund managers do the research and select the securities where they will invest your money in return for a yearly fee. Generally the fee of a mutual fund is far superior when compared with the fee of an ETF.
There’s a growing “war” between people that defend ETFs VS people that defend mutual funds. Some argue that mutual funds usually fail the return of a simple index. Therefore they defend this choice (ETFs) specially for the “average joe”.
An annuity is a financial product that consists in a contract between financial institutions like an insurance company, and the investor. As an investor I can buy an annuity by making either a single payment or a series of payments.
On the same token, you can receive your money as a one lump-sum payment or as a steady cash flow during your retirement years.
One way of investing in commodities is to invest in futures contracts where you agree to buy (or sell) a specific quantity of a commodity at a specified price on a particular date in the future.
Oil, gold, grains, sugar, and so on, are examples of commodities that can be traded.
Real Estate Investment Trusts (REITs)
Similar to a mutual fund, a REIT is a company that invests in income-producing real estate, such as shopping malls, hotels, office buildings, warehouses and so on.
With a REIT an investor doesn’t have to buy properties directly. But it can earn a share of the income produced through commercial real estate ownership.
These are the main types of investment vehicles. A portfolio, as I wrote before, should be always diversified. Mainly because when you mix the right asset classes, you could reduce the overall volatility of your portfolio. And still have a decent return.
Additionally making concentrated bets on a single investment can be rewarding if you get it right, but it can also have negative effects if you’re wrong.
Make a plan, and keep it simple. Here are some tips:
- Choose the investment(s) vehicle(s) that makes you feel more comfortable
- Allocate a % of your investment money to each asset according to your risk tolerance
- The benefit of keeping those % balanced is that it will make you sell high and buy low
- Make sure you control/minimize your costs (managing costs, buying/selling, and so on)
- Don’t invest too much in an asset that is too risky/volatile unless you can tolerate wild fluctuations of the price
- Remember that in 2008 the SPY (ETF that tracks the S&P500) was losing half of its value in a couple of months. It ended the year with a negative return of -36%
- Invest for the long run
- Read carefully the documentation associated with your investment vehicles
- Make sure you have an emergency fund that can you can use so you don’t need to sell investments
- Diversification is protection against ignorance