Finance: Understanding Investment Options

Maybe your accountant told you to put money into an IRA this year to shield some earnings from taxes, and now you don’t know what to do with it. Or maybe you’ve been hearing about “investing” and just aren’t sure how to get started. You hop online only to find a confusing world of acronyms, shorthand, and convoluted words that seem designed to intimidate would-be investors.

Fear not! The basics of investing aren’t as scary as the lingo surrounding it. To give you the push you might need to get going, we put together this handy guide to clear up confusion and put your savings to work.

Risk. It’s what's for dinner.

It’s helpful to understand the underlying principal that drives investment decisions: risk. How likely is it that this investment will decline in value, and by how much? Low risk investments are ones that you can be fairly certain you’ll get your money back on, and even make a bit of money. High risk investments carry a high degree of uncertainty about their return.

The important thing to know about risk is that the riskier the investment, the higher the potential return should be. So if an investment is low risk—say, a U.S. treasury bond—you would expect the return to be low. And if you put your money into a brand-new startup, your potential to make a lot of money should be large since it’s high risk. That’s not to say that things can’t go wrong—that’s where the risk comes in. But it is far less likely that the U.S. Treasury will go bankrupt than, say, the latest hot gaming company.

In general, investments fall into two categories: lending money and ownership. When you lend money, you expect to receive that money back with interest. When you own something, you receive your proportional amount of any proceeds or leftover value. In investment terms, lending money is known as fixed income, and ownership is equity.

Loans are less risky than ownership, as they have claim over money coming in first before any ownership gets paid out. So fixed income investments are, in general, expected to be lower return than equity investments.

Let’s take a look at these two in more detail.

Fixed Income

If you put your money under your mattress, the same amount will be there tomorrow. Most of us know to at least put our money in a savings account, where you will earn some small amount of interest. You essentially give the bank a loan with your deposit, which it uses for its lending operations like home mortgages and credit cards. In exchange, the bank pays you interest on your deposit.

A savings account is only one way to make an investment where you earn interest. The most common fixed income investments are certificates of deposit, treasuries, and bonds. In each of these investments, the issuer (the one you’re lending money to) pays the investor (you) a specified amount of money at intervals (your interest payments, also known as coupons), and then repays the loan at the end of a set term.

The interest you earn is based on the amount of perceived risk of the investment. So the interest rate on your savings account is low because there is little chance that you will lose your money. But lending to a small business with an uncertain future should have a high interest rate to make up for the risk that they might go out of business and not be able to pay you back.

Here are a few of the more common fixed income investments you can make:

Certificates of deposit (aka CDs)

CDs are like giving your bank a short-term loan, which they agree to repay at a specific time (called its maturity) with interest. The interest rate is fixed when you buy it and is higher the longer maturity you buy. This is unlike most savings accounts, whose interest rates fluctuate based on market conditions. The FDIC protects CDs up to $250,000 of investments (just like your checking account).

Treasuries

Treasuries are loans given to the U.S. government. There is little risk that they won’t be repaid with their promised interest, and thus the interest rates are usually quite low.

Bonds

Bonds are a catch-all term for loan investments that you can buy and sell in the market. The issuers can be either government entities, known as municipal bonds, or companies.

Since there is a wide variation in the risk level of different companies, many bond issuers get their bonds evaluated for their risk level by ratings agencies. Firms like Moody’s or Standard & Poor's look at the financial health of a company and give a grade. AAA for S&P and Aaa for Moody’s are the best scores, working down alphabetically. So an AAA rating means that it is less likely that a company will not be able to pay bondholders than a BBB rating. That also means that the lower the rating, the higher the interest rate that will be charged.

Equity

Equity investments are what most people think of when they think of investing in “the market.” And for good reason: It’s called the stock market, and stocks are equity!

OK, but what is equity? Equity is the ownership of a company. It gives you claim over whatever assets or value is available after the company pays off its debts. For companies traded on public exchanges like the New York Stock Exchange, that equity is divided up into shares of stock.

Unlike bonds, owning stock does not entitle you to any guaranteed cash flow. The latest price at which someone agreed to sell and someone else agreed to buy determines the price of a stock. If the price that people are agreeing to pay in the future is more than what you bought it for then the value of your investment has gone up and vice versa.

The risk that the value will go down might seem a foolhardy way to invest your hard-earned cash. But the potential upside can also be much greater, to compensate you for that risk.

Investment Structures

Most other investments are either bundles of basic stocks and bonds or spinoffs of them. Mutual funds and exchange traded funds (ETFs) group together stocks or bonds. This makes it easier to own large sets of investments and reduce the risk of picking an individually bad investment.

Do you watch Downton Abbeyas much as the Verily team? If so, you'll learn that Lord Grantham puts the majority of their fortune into an investment in a single railroad company. Well, then the company goes belly-up. Luckily for investors in 2014, we can buy hundreds of stocks or bonds by buying a single investment fund. If Lord Grantham could have bought a fund focused on several railroad companies, he'd own stakes in many of them and would benefit as railroads in general succeed.

There are any number of investment foci you can buy in funds. You want to own something that mimics the S&P 500? You can get that. Interested in mid-tier tech firms? Sure. Something focused on China? You got it.

If you want to buy a fund, there are two main types: ETFs and Mutual Funds:

Exchange Traded Funds (ETFs)

ETFs are pools of investments that attempt to replicate the performance of a related index, like the S&P 500. Buying an ETF is like buying a part of a basket of investments that holds the same investments as that underlying index. Because there is no active manager, and due to the technical structure of ETFs, management fees are low.

Mutual Funds

Mutual funds are professionally managed pools of investments that have a particular aim to their investing. Mutual funds, like ETFs, can be found across the fixed income and equity spectrum, from low-risk, bond-only funds to specialized stock strategies. Some mutual funds invest in both stocks and bonds to achieve a certain goal. Some of the names and strategies can get pretty complicated, but the most common mutual funds are bond funds, stock funds, and asset allocation funds.

Bond funds and stock funds have objectives that usually fall along two lines: investment type and investment style. For bonds, the type will be the kind of security it holds, like treasuries or bonds. Style usually indicates either the riskiness of the bonds or the length of time until the bonds mature. Stock funds typically indicate the size of the companies they target and whether they employ a growth or value investment strategy (or a blend of the two). Asset allocation funds invest in a mix of stocks and bonds to achieve their stated goal. An example would be providing steady income in retirement or maintaining a set mix between stocks and bonds. The holdings within a mutual fund change based on the fund manager’s decisions to meet the fund's goal. Management fees are taken out of the fund balance periodically, along with some charge purchasing fees (known as load).

Understanding the lingo isn’t an investment strategy. But now you’ll understand your financial advisor when he starts talking about ETFs and how much you want to allocate to bonds versus stocks. Now go out there and put your money to work!

Photo by Belathee Photography