Ready to dip your toes in the investing waters, but not sure where to start? Understanding the different purposes, processes and types of investments can be intimidating at first, especially if you’ve previously focused on saving opportunities. While building a strong savings foundation — like your emergency fund — is important, balancing the risks and rewards of investing can help your money grow over time.
Bonds, stocks, mutual funds and exchange-traded funds (ETFs) are four basic types of investment options. They have the potential to earn a higher return, but they also carry a greater potential for loss if sold when the market is lower.
As you explore the world of investing, it’s essential to understand the various types of investments and how each one fits within your investment profile. Each investment vehicle has unique characteristics that may or may not be appropriate when applied to your situation. However, when combined with other types of investments, they can provide diversification, reducing your risk while improving your long-term investment performance.
Bonds — An IOU to you
Governments, municipalities and companies issue bonds to raise money. The bond is essentially an IOU from the issuer that promises to pay an investor interest over the life of the bond, plus repay the amount invested — the principal — at a certain due date, known as maturity. This is a way to invest, while still minimizing risk. It can also be a way of ensuring an income stream since bonds often pay interest twice a year. Some bonds (e.g., many municipality bonds) also carry tax advantages.
There are still risks involved, however. While U.S. savings bonds are considered one of the safest investments, bonds issued by individual companies or municipalities may be risky if the issuer runs into financial difficulties. The issuer can also buy back the bond, which effectively pays the remaining principal balance in full and cancels the bond.
Stocks — A piece of a company
Stocks are a type of security that allow an investor to own a share, or a piece, of a company. When a company wants to raise money, it will sell shares of its stock. If the company performs well, it may pay its shareholders part of its earnings, called a dividend. Stock owners sometimes also get voting rights at shareholder meetings.
Stocks have a great potential for growth over time. However, they can also carry a great deal of risk, as the stock market can fluctuate greatly. If you purchase a share of stock and the price goes down, when you sell it, you will lose money.
Mutual Funds — A more diversified option
It would be difficult for an individual investor to own many shares of a variety of stocks. It might also be hard to pick which stocks to own. One way to get past this is for an investor to buy a share in a mutual fund, which is a pool of money from many investors. Mutual funds may invest in stocks, bonds or other securities, a combination of these, depending on the portfolio, or a selection of funds. The investments of a mutual fund are outlined in the fund’s prospectus.
In an actively managed fund, an investment adviser picks the stocks, bonds and other securities in which the fund invests. Their goal is to outperform a stock market index, such as the S&P 500, by performing investment research and analysis. However, the majority of managed mutual funds underperform the corresponding market index. An unmanaged fund, or an index fund, seeks to track the performance of a stock market index.
Another type of fund is a target date fund. This fund is managed with a specific time horizon in mind. Typically, the time frame relates to retirement dates — the further away you are from retirement, the more aggressive the fund choices. When retirement is closer, the fund will transition to less risky investments.
Mutual funds tend to be less risky than individual stocks because they are more diversified — meaning they contain a mix of investments. However, they do still carry risk, because the shares can lose value if the underlying companies, or the market, face financial difficulties.
Mutual funds also have expenses and fees that can eat into returns, sometimes costing investors thousands of dollars over a period of ownership. Actively managed funds are more likely to have higher expenses than index funds because of the additional investment research, and because they often experience more trades. Before you choose a mutual fund, analyze the mutual fund’s expenses by using the Financial Industry Regulatory Authority’s Fund Analyzer Tool and by reading the fund’s prospectus.
ETFs — Another way to diversify
Similar to mutual funds, ETFs allow investors to pool their money when investing in stocks, bonds or other assets. However, ETFs differ from mutual funds in that they are traded on the national stock exchange at market prices.
As with all types of investments, make sure you understand the objectives, risks, costs and potential performance of ETFs before investing. You can learn all of that information and more by reading the prospectus, which you can locate through the Security and Exchange Commission’s EDGAR system.
Protecting yourself when you invest
While all investments carry a certain amount of risk, savvy investors can protect themselves by following a few good practices:
Know the signs of fraud before investing. The old adage remains true: If something sounds too good to be true, it generally is.
To learn more about investment options at Alpine Bank, visit our Wealth Management webpage.
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