Introduction to Investing

The main categories of investments - also called asset classes- equities (AKA stock), fixed income or debt and cash. Though there are many subcategories and variations on these categories.

Equities or Stocks

Equity or common stock represent ownership in a company. There are many different ways to classify shares but some of the most important factors to look at are risk and return. This can lead to stocks being categorized as a defensive stock, growth stock or speculative stock. Defensive stocks, also known as income stocks, have lower volatility in their prices so are often considered safer. They usually pay out dividends regularly. Growth stocks are stocks that are expected to grow at a rate above the average market growth. Speculative stocks are stocks with large risks attached to them but in turn have the highest potential for returns. Speculative stocks are less likely to pay dividends and returns are earned primarily in the form of price appreciation (AKA capital gains)

Another important factor to look at in stocks are if they are dividend or non-dividend stocks. Many companies often share their profit with you quarterly in the form of a dividend. However, not all stocks pay dividends. Non-dividend stocks can generate greater capital gains if the price of the stock increases.

Another factor to look at before buying stocks is also where the company is headquartered. The biggest thing to look at is if the company is headquartered in a developed or emerging country. Ownership in large companies located in developed countries around the world such as Volkswagen in Germany or Toyota in Japan, typically carry similar risk as a US Fortune 500 company.

Companies headquartered in emerging economies typically carry a higher level of risk. These are shares in companies in developing nations such as Brazil, Nigeria and Turkey. Developed markets are more mature economies and are generally more stable with less volatility in the economy and currency. Developed nations include the UK (though not for long), USA, Germany and Japan.

Debt or Fixed Income

Next up is debt or fixed income. Debt can come in many forms. Fixed Income is an investment that provides a regular annual return (based on interest or coupon payments) and returns your principal investment at a date certain in the future (so called maturity date). You can buy debt instruments directly as govt bonds, corporate bonds (Apple or Microsoft for example) or you can buy bank Certificates of Deposit (CDs). CDs are usually  insured up to a maximum amount (insured CDs are guaranteed by the US Government) and can be purchased directly from your bank or from a brokerage. 

The three most important things to consider in a bond investment are: 1) the maturity (AKA duration): when you get your investment back, 2) credit risk: the risk the investment defaults or fails to pay back the investment and 3) the interest rate: this represents your annual return. Interest Rate is also often called the coupon on the bond. 

Bond maturity or duration can range from as little as overnight to 30 years. The longer the duration or maturity of the bond, the riskier it is. Due to this added risk long duration bonds usually have a higher interest rate (though not always).

Credit risk in bonds is how likely the bond issuer is to default on their payments of principal and interest. The more likely they are to default on these payments, the higher the interest rate or coupon. Usually the credit risk of a bond is encapsulated in what is called a credit rating. Credit ratings range from very strong - AAA to very weak Single B and below. When you are investing in bonds or bond funds it's important to know the credit risk you are exposed to. Investments referred to as "investment grade" are higher rated and investments referred to as speculative grade have junk ratings. Many seemingly safe funds are called bank loan funds. Sure harmless enough name. In reality they are backed by very high risk junk loans (rated BB and below). Beware a misleading label.

Though bonds can be risky, in general bonds are less risky than stocks. This is because if a company goes bankrupt it needs to pay its bond investors in full before shareholders will get anything.

Cash

Cash is the least risky of the three. But just because there is low risk this doesn't mean there is zero risk. If you hold too much cash you are at risk of inflation reducing the purchasing power of your money. Inflation is a risk that can sneak up on you over time. When prices go up your purchasing power is lower. So, if your salary and investments don’t keep pace with inflation you will be poorer over time. That’s why keeping everything in cash isn’t necessarily the best thing. Cash can include anything from a checking account at your bank to a money market fund at your brokerage. Cash should have both very low maturity and credit risk. 

How do you invest in stocks, bonds or cash?

One option is to invest directly in individual bonds or stocks. For example you can buy Apple stock or you can by a US government treasury bond or even an Apple Corporate Bond. You can purchase Treasuries directly from the US Government at their Treasury Direct site. Alternatively you can buy treasuries, corporates and CDs at most brokerage companies like Fidelity and Charles Schwab.

Another way is to invest in a fund. In the US the most common type of funds are mutual funds and Exchange Trade Funds (ETFs).

With a fund, unlike buying individual stocks, a professional manager manages the investments and the manager will invest in a diversified portfolio of investments. The value will rise or fall depending on the value of the underlying investments owned by the fund. Say you want to invest $10,000 in a fund; if each fund unit costs $10, you can buy 1000 units. Nine months later, if each unit is worth $13, your investment is worth $13,000. Mutual funds and ETFs are typically safer than investing in individual shares because a fund is more diversified. Building your own diversified portfolio is not impossible but requires research and on-going management of the portfolio as well as a higher minimum amount of investible assets in order to achieve the ideal diversity in your portfolio.

That shouldn’t stop you from taking a flier on a stock you know and love  but you should understand the risks and not invest all your savings in your favorites.

Need help with investments? Check out the below TPE investment tools.

Portfolio Valuation Tool

Investment Allocation Tool​

​Mutual Fund and ETF Analysis

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