While you might have hundreds of thousands, or even millions, of dollars in your investments, you might not know exactly what you’re invested in, and how those investments are working for you. After all, many people aren’t formally educated in investing or know the ins and outs of how exactly it works. In addition, many financial advisors can make investing seem more complicated than it really is.
We, on the other hand, want to simplify investing and how it works. Why? Because we believe that if you know about your money, you’ll feel better about it and will make better decisions around it.
From the different types of investments to how these investments could work for you as part of your investment strategy, we’re breaking down the essential terms of investing for you in this blog post. Read on to learn more!
When you buy a stock, you’re essentially buying a piece of a company. And as the value of the company goes up and down, so does the value of the stock.
There are three main ways you can own stocks: by investing in individual stocks, mutual funds, or ETFs.
Another way to invest in stocks is to invest in mutual funds. With this type of investing, you’re trusting somebody else to go and buy a collection of stocks. In mutual funds, there are thousands of people who are part of the fund. Each of you invest some money into the fund, and then the fund manager goes out and buys stocks. Because of this, it’s possible to own a greater number of stocks for less money since you’re pooling your money together.
However, one thing to note about mutual funds is that they only trade once per day after the market closes. While you can send your money to the company managing your fund at any time, they’re not going out and trading that money right away. Instead, they wait until the end of the day, which is when the value of the underlying assets is calculated.
Exchange-Traded Funds (ETFs)
Exchange-Traded Funds (ETFs) are a newer way to invest in stocks. This type of investing is similar to mutual funds in that it’s a collection of stocks, but it’s also similar to owning individual stocks in that you can trade these stocks, or exchange traded funds, throughout the day. Because of this, ETFs have different prices throughout the day, starting from when the stock market opens to when it closes.
Another way to invest in stocks is to invest in index funds. This is a type of mutual fund or exchange traded fund that is made to try and match the market, like the S&P 500, or the Dow Jones. These funds are a way to invest passively, which means you’re not necessarily trying to beat the market, which you might be trying to do when buying individual stocks or mutual funds, but instead are just trying to match it.
A lot of people believe that index funds and exchange traded funds are the same but that’s not necessarily true. The ETF is just a way to buy investments – it is not necessarily an index fund. You can have an index fund in an ETF, or through a mutual fund.
Making Money From Stocks
There are two ways to make money from your stocks, whether it’s individual stocks or stocks in a mutual fund or ETF — dividends and gains.
If you own a piece of the company and they are making money and sending out some of their profit to investors, that’s a dividend.
On the other hand, gains can be either positive or negative. If the market is down, your gains could be negative. Therefore, dividends are a bit more consistent, whereas gains fluctuate up and down every single day.
Value Stocks and Growth Stocks
These are also two types of stocks you can own: value stocks and growth stocks.
A value stock is one that might trade at a lower price relative to its actual value, which would make it more appealing to investors. When the market is down, there might be a lot of value companies that are on sale because those are stocks that are usually not as high price as they could be. The reason why people buy value stocks is because if the price is low now, it could come back up later — and that’s where you make your money. Now keep in mind the stock price might be low for a good reason – it might not be ‘on sale,’ but may be low because the company isn’t doing well.
With growth stocks, which are now usually technology firm-type stocks, these stocks are growing no matter what the market is doing. This is more so because the company is on a big trajectory and not because it’s making money just because it’s on sale. Now keep in mind, just because a company has grown so far doesn’t mean it will continue to grow. You might be paying a high price for future growth that doesn’t end up happening.
Diversifying Your Stocks
Like with all areas of your portfolio, you generally want to be well-diversified with your stocks — meaning that you’re spreading things out to keep your portfolio safe from market drops.
One way to do this is by buying mutual funds or ETFs. If, for example, you only had $1,000 and the stock that you want to buy is worth $100, you can get 10 shares of that stock but will then have no money left to go and buy other stocks. But if you took that $1,000 and bought a mutual fund, you might be able to get 50 or 100 stocks since you are buying portions of each of those stocks when you buy them as a part of these funds. With a mutual fund or ETF, you’re able to diversify your investments into various companies at once.
Some other areas to diversify include:
- Company size:
- Small company stocks
- Mid-Size company stocks
- Large company stocks
- Domestic and International:
- Domestic, or U.S., company stocks
- International stocks
- Stock Types
- Growth stocks
- Value stocks
You never know what will happen in the market, and not everything can be a winner all the time. By spreading things out in each of these categories, you’re ensuring that you’re on whichever side that is going to be growing in the future and protecting yourself if one of your areas isn’t performing as well as you’d hoped.
While you own your stocks, bonds are more of a loan. With a bond, you give a loan to a company, and they usually have an end date when it comes due for the company to repay you the principal they owe.
When you own a bond, you earn interest over time. Then, at the end of the bond period, you get your principal paid back.
One common belief with individual stocks is that they don’t fluctuate, and because of this, you can’t lose money. But this isn’t necessarily true. Bonds will fluctuate each and every day just like when you have a mutual fund of bonds or a group of funds. The difference is you’re probably not checking the individual bonds as often and just don’t notice their value going up and down because you are focusing on getting your principal back in the end.
There are also times when your bonds will default. Just like people don’t always pay their mortgages, sometimes, bonds don’t pay back their loans. That is one of the reasons why we feel it is advantageous to have a bond mutual fund or bond exchange traded fund. With these, you might own 50 or a hundred or 500 different bonds, but if any one of those default, you probably don’t even notice — whereas if you have individual bonds, you’re more likely to feel the pain.
Short- Medium- and Long-Term Bonds
Just like there are different types of stocks, there are also different types of bonds.
Short-term bonds are bonds that come due in a shorter amount of time, like two to three years. These are generally safer investments because it’s more likely for a company to still be around for two or three years to pay back your principal.
On the other hand, medium-term bonds might have three to seven years before they’re due. However, this type of bond is more risky than short-term bonds because the company you’ve invested in might have trouble five, six, or seven years down the road. This means that there is a higher chance that they don’t pay back your principal and default.
Long-term bonds usually last seven years or beyond. If you buy a 30-year bond, that means you’re essentially trusting that company to be around for 30 years. Typically, short-term bonds are safer, but they don’t pay out as much as medium term-bonds or long-term bonds. With more risk, bonds need to pay out a little bit more to get people to invest.
As with stocks, it is generally recommended to also diversify the types of bonds you’re purchasing. When you’re looking at bonds that are short-, medium-, and long-term, you’ll most likely get you a good diversification balance around when things are coming due and also in the amount that each bond might pay out depending on their varied risk levels.
Another category to think to include in your diversification is the credit-worthiness of bonds. Typically, the U.S. government is more credit-worthy than a normal company since they are the most likely to pay everybody back.
Companies you can trust typically can also be referred to as investment-grade bonds. A top-of-the-line U.S. company that you’ve heard of is typically an investment-grade company, whereas other companies that are less well-known have more risk and are therefore instead called high-yield bonds, which are higher risk so they need to provide higher payouts in return for that added risk.
Owning Real Estate
A lot of times, when people think about investing in real estate, they’re thinking about owning some real estate properties.
With this type of investing, there are a few things we recommend keeping in mind to ensure this is the right type of investment for you, including:
- Do you actually want to manage the property and be the one who is collecting rent and fixing up things that break?
- Are you comfortable with the risk of owning property as an investment? Remember, just because you own something you can see, doesn’t mean it is safe, that the value won’t go down, or that someone will always be using the space, or paying the rent on time!
Tax Advantages of Owning Real Estate
If this type of investing is ideal for you, there are also three main tax advantages to owning real estate.
- Having a Mortgage
If you wanted to buy a $400,000 duplex but don’t have that money in cash, you can go get a mortgage to help you pay for it. That makes it much easier to buy a property, since it then might only take $50,000 or $100,000 of cash to go out and buy it. In addition there are some tax rules that can help you deduct the interest you pay on the mortgage.
- Step-Up in Cost Basis
This tax rules means that if you bought a rental for $400,000, for example, and you later die and pass on the property over to your family when it is worth $500,000, they get a step-up where they don’t have to pay the taxes on what you gained with the property.
Finally, there’s another big tax advantage called depreciation. If you made $5,000 last year from your rental, then just the fact that you bought real estate means that the government will allow you to take off a little bit of money from your earnings on your taxes and let you write off more for free. It’s this thing called depreciation. With this, you don’t have to pay taxes on what you made, but when you sell the property, you have to add back in all those write-offs that you put in for depreciation. This tax advantage allows you to take advantage of deferring your taxes until later on.
Please remember: these 3 advantages are NOT available within your Traditional IRA!
Retirement Estate Investment Trusts (REITs)
If you want to own real estate inside your IRA then you may want to own something called a REIT — real estate investment trust.
Owning a REIT is typically just like owning a mutual fund. You own companies that go out and manage and own real estate. It could also be just like owning a mutual fund of bonds, where you’re lending money to other companies who go out and buy that real estate.
REITs are a common way to invest in real estate, whether it’s inside of an IRA or not, because you don’t have to manage the property and you can get a lot more diversified for a lower investment commitment than buying properties on your own.
The final type of investment is cash. We all love cash. And as an investment, cash may seem easy and hands-off, but there are still some things you need to consider.
When you’re talking about cash and investments, you’ll typically see talk about money markets. When you have a broker like Schwab, Fidelity, or TD Ameritrade, these big brokers, a lot of the time, get to set what the money market rate is.
But sometimes, you get a choice. So if you have a decent amount in your investment account that’s in cash, go take a look at the interest rate. You might be getting 0.01 or 0.03% and if you do a bit of research, you might be able to get that money market rate above 1%. So go out and maximize your cash and get a higher interest rate.
That’s it for now! If you have any questions about investments and how they work as a part of your overall plan and portfolio, or are retiring soon, please do not hesitate to contact us. We’re always more than happy to help!
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