You’ve probably already heard that investing is a critical part of building wealth, especially when it comes to meeting long-term financial goals like retirement. But what may be less clear is what you should actually invest in. After all, there’s no shortage of investment options to choose from. And when you’re just getting started, how do you know which is right for you?
To help clear up some of that confusion, we’re breaking down some of the most common investment options, how they work, and when they might be a good addition to your portfolio.
Key Investment Options
There are many different investment options to choose from, but let’s start by discussing the three primary asset classes: cash, stocks, and bonds.
When you think of cash, you might be thinking of the bills and coins you carry around in your wallet or purse. But cash (and cash equivalents) is actually an asset class that expands far beyond your traditional idea of cash.
In general, cash and cash equivalents consist of the money in certain banking products. Those investments include:
Savings account: A bank product where you can store your money and, in return, your bank offers a low rate of interest. While rates on these accounts have historically been low, many online banks now offer high-yield savings accounts.
Certificates of deposit: A bank product where you can store your money and, as long as you leave it in the account for a certain period of time, you can earn a certain amount of interest. CD terms range from as short as three months to as long as several years. If you withdraw your money early, you may be subject to certain financial penalties.
Money market account: A bank product that combines the benefits of both a checking and savings account. Like a checking account, you may have a debit card and check-writing privileges. And, like a savings account, you can earn interest on your savings.
These investments are considered risk-free in that most are protected by FDIC insurance. And unlike other types of investments, your cash investments generally can’t lose money if the market is down.
That being said, there are still certain risks you’re subject to with cash investments. The rate of return on these accounts is often lower than the rate of inflation. As a result, if all of your money is housed in these accounts, then your buying power is being eroded over time. Instead, you may want cash and cash equivalents to make up just a small portion of your portfolio, which can be used as an emergency fund or for any financial goals coming up in the next few years.
Stocks are another important component of your investment portfolio, and what many people think of what they picture investing. A stock is technically a share of ownership in the company. When you buy a company’s stock, you’ll become a shareholder and benefit from the company’s success.
Stock investments generally make money in two different ways. First, you can make money through capital gains, meaning you’re able to sell your stock for more than you bought it, therefore earning a profit. The other way to make money from stocks is from dividends, which are distributions a company makes to its shareholders as a way of passing along some of its profits. Remember though, not all stocks pay out dividends.
There are two primary types of stocks:
Common stock: As an investor, you’re most likely to buy common stock. This type of stock gives shareholders the right to vote at shareholder meetings, as well as the potential for dividends. And of course, common stockholders benefit from a rise in a company’s share price.
Preferred stock: With this type of stock, you receive dividends before common stockholders do. You also have a priority over common stockholders if the company goes out of business and must liquidate its assets. However, preferred stockholders usually don’t have the right to vote at shareholder meetings.
A bond is a type of debt security, meaning when you buy it, you’re essentially loaning money to the issuing entity. Both companies and government entities issue bonds to raise capital, either for operating expenses or specific projects.
When you purchase a bond, the issuer sets a specific interest rate, and you’ll often receive fixed interest payments every six months. Bonds have terms ranging from less than one year to 30 years. Once the bond reaches maturity, you’ll receive your principal — meaning the face value of the bond — back from the bond issuer.
Bonds are considered lower-risk than stocks and, therefore, help to create diversification and reduce the overall risk of your portfolio. However, there are several types of bonds that each have their own unique features and risks. Here are the most common:
S. Treasury securities: These bonds are issued by the U.S. Treasury Department and are considered risk-free since they’re backed by the U.S. government. There are several types of securities — bills, notes, and bonds — which have different possible terms. There are also U.S. Treasury securities that are indexed for inflation, meaning the interest rates can increase over time.
Municipal bonds: These bonds are issued by government entities other than the U.S. Treasury Department, including states, counties, and cities. Municipal bonds are generally low-risk but could have a higher risk than Treasury securities, especially if they’re intended to be repaid from a specific project.
Corporate bonds: These bonds are issued by corporations. The amount of risk depends on the company issuing them. Investment-grade bonds are very low-risk since they come from companies with good credit histories. On the other hand, high-yield or junk bonds are generally issued by less creditworthy companies. They have more risk, but also a potentially higher return.
Additional Investment Options
Cash, stocks, and bonds are the primary asset classes, but they are far from your only options when you’re building your investment portfolio. Below we’ll talk about additional investments to consider based on your financial situation and goals.
A mutual fund is a type of investment vehicle that allows many investors to pool their money together to buy many underlying investments. Each individual investor buys shares in the fund, and then the fund invests in assets that fit its objective. And each investor owns the underlying assets proportional to their ownership in the fund.
Mutual funds can hold a variety of assets, including stocks, bonds, and a combination of the two. Each fund has a professional fund manager, but they can be either actively or passively managed. Mutual funds also charge fees to investors, which can range from practically 0% for passive funds to about 1% for some active funds.
An exchange-traded fund (ETF) is nearly identical to a mutual fund in many ways. Both allow investors to gain exposure to a large number of underlying assets with a single investment vehicle. The primary difference between the two is how they trade.
Mutual funds are offered by mutual fund companies, and you generally buy shares directly from that company. No matter when during the day you place your buy order, all transactions close at the end of the trading day. ETFs, on the other hand, trade throughout the day on exchanges, just like stocks.
An index fund is actually a type of mutual fund or ETF, but it has one unique characteristic. These funds track the performance of a specific underlying stock index or faction of the market, such as a particular sector. The fund manager builds a portfolio that matches the underlying index but doesn’t generally actively buy and sell investments.
Unlike actively managed funds, the goal of an index fund is to match the stock market rather than beat it. And because these funds have a passive management style, they also generally have lower expense ratios for investors.
Index funds have become one of the most popular ways for investors — especially long-term investors — to build wealth. An investor can build their entire portfolio with just a few investments that give them exposure to hundreds, if not thousands, of investments. They can buy shares and allow their investment to grow for many years.
Real estate is a very different asset class from stocks and bonds because it consists of physical property. However, it remains one of the most popular investments available, providing both a recurring income from property rents, as well as long-term investment growth.
One way that investors can gain exposure to real estate is by purchasing a rental property, which they can then rent out to tenants. Some people choose to rent their property to long-term tenants who stay for a year or more, while others use sites like Airbnb to rent to short-term tenants.
Real estate investing comes with some risks, including the lack of liquidity and the risk of having a tenant who doesn’t pay rent (or not being able to find a tenant at all). One way to avoid some of these risks is by investing in a real estate investment trust (REIT), which is a real estate company that sells shares.
When you buy REITs, you become a partial owner of the company’s real estate holdings and can receive both recurring income and long-term gains. However, you pass along some of the direct risks to the real estate company and can enjoy the liquidity of having an asset you can easily sell if and when you want to.
A hedge fund is a type of pooled investment targeted at more experienced investors. With a hedge fund, investors contribute to the fund, which then seeks out investments with a high potential reward.
Hedge funds generally employ a high-risk-high-reward investment strategy. Additionally, they also tend to charge higher fees than mutual funds and ETFs, meaning more of your returns are eaten up. As a result, they are limited to accredited investors, meaning those with either a high income or a high net worth.
Commodities are another asset class that, like real estate, is made up of actual physical assets. They are the raw materials that consumers use and include products like oil, metals like gold, agricultural products like wheat, and much more.
When individual investors add commodities to their portfolios, they generally aren’t directly purchasing those products. Instead, it’s common to invest in an index fund that tracks those underlying commodities.
One of the benefits of investing in commodities is that they simply behave differently from other assets. As a result, they might help you hedge your risk during times of market volatility and can also provide a hedge against inflation since their prices rise with the price of goods and services.
Private Equity Funds
Private equity is a way for individuals to invest in companies that aren’t listed on public exchanges. Individual investors can invest in a private equity fund, which then invests in private companies on behalf of its participants. Private equity funds often have high minimum investments, which can range from hundreds of thousands to upwards of $1 million.
One of the benefits of investing in private equity is you can get in on the ground floor of newer companies that have more room to grow. As a result, these investments can experience massive growth. However, there is also the risk that the companies you invest in will fail. Because of the increased risk, private equity funds, like hedge funds, are usually only open to high-income and high-net-worth investors.
A brokerage isn’t technically a type of investment. Instead, it’s an account in which you can buy and sell various investments. There are many brokers that allow investors to open investment accounts, but some of the most popular include major discount brokers like Vanguard, Schwab, and Fidelity which allow you to buy stocks and bonds, and which also offer their own funds.
The assets in your brokerage account are subject to various types of taxes. Any interest, dividends, or capital gains you earn may be subject to either income or capital gains taxes. Ordinary income taxes apply to your interest income, as well as certain dividends and short-term capital gains. Other dividends, as well as long-term capital gains, are eligible for a more favorable long-term capital gains tax rate.
Like a brokerage account, retirement isn’t a specific investment. Instead, it’s a type of investment account where you can buy, sell, and hold various assets.
The key difference between a retirement account and other brokerage accounts is their tax treatment. The funds in your retirement account are eligible for certain tax advantages. First, you won’t pay taxes on your investment growth as long as the funds remain in the account.
Some retirement accounts offer a tax deduction on your contributions, and then require that you pay income taxes on your withdrawals. Others require that you make after-tax contributions, but then you can withdraw funds tax-free during retirement. Contributions subject to this after-tax treatment are known as Roth contributions.
Depending on the type of retirement account, you may have slightly limited investment options. With an individual retirement account (IRA) that you open with a broker, you’ll generally have access to all of the investments the broker offers. But with a 401(k) plan, you’ll only have access to the limited menu of investments that your employer offers.
When you first start investing, it’s easy to become overwhelmed with all of the options available to you. Most investors start building their portfolios with a collection of stocks, bonds, and cash. But depending on your investment goals and financial acumen, you may also decide to add alternative investments like real estate to your portfolio.
Remember that you also don’t have to build your portfolio alone. If you sign up, and are eligible, for Personal Capital’s wealth management services you can work with one of your fee-only fiduciary advisors to build a portfolio that meets your needs.