Investing - What Works and What Fails
- November 8, 2022
- by Angela
One way to lose a bunch of money is to invest in just one thing, hoping to make a big profit in a short amount of time. The secret to investing is to spread it around (known as diversification) in order to reduce risk and lock in a good long term return. To do that it is necessary to know what your options are when investing. There are advantages and disadvantages with each option. In this text, you will find out everything you need to become a savvy investor.
1) Cash Savings, CDs, and Bonds
Cash, CDs, and Bonds are considered low-risk types of investments. If you are new to investing or are very uncomfortable with any risk, one of these options could be a good place to start. Keep in mind that low-risk investments also tend to have low returns. Retirees also tend to keep a larger percentage of their money in this asset class as they are depending on the money to be there for them. However overusing this asset class can lead to disastrous results and we can see in our retirement withdrawal calculator when 100% is directed to cash.
Savings accounts and CDs
For new investors this is a good place to start watching your money grow and to build up your emergency fund.
Your bank or credit union will make it easy to open a savings account or money market account. Money market accounts are similar to savings accounts, but with slightly higher interest rates in exchange for higher balance requirements.
A CD or certificate of deposit is another type of banking product, similar to a money market account except your balance is “locked” for a period of time. A CD works as follows: if you agree to lend a certain amount of money to the bank for a certain period, you get a fixed amount of interest that is generally higher than a regular savings account. If you need the money early you can break the CD for a small penalty. CDs are a low-risk investment, but with low risk comes low profit. A large number of banks offer CDs with a yield of less than 2%, and this amount is not even enough to keep up with inflation.
Bonds - US Treasuries, Municipals, and Corporate Bonds
Bonds are the next step up in terms of low-risk investment. Returns may be a little better than CDs, but the risk / complexity is a bit higher. Bonds can be purchased from the US government, state and city governments (municipalities), or corporations using your online brokerage account. Bonds work similar to CDs in that you are lending out your money in exchange for a fixed rate of return.
US government bonds are savings bonds and they are virtually risk-free. You wonder why the government issues bonds. The main reason is to raise money for projects, and the same applies to bonds issued by corporations.
Corporate bonds are riskier than government bonds because there is a greater risk that the corporation will default on its loan. Just like individuals, corporations have credit ratings that influence what interest rate they offer on their bonds. Many people confuse corporate bonds and stocks, and the main difference is that by buying shares in a corporation you become a part owner of that corporation, while by buying bonds you have no ownership in a particular company.
Another thing to keep in mind with bonds is tax treatment. US Treasuries are exempt from state and local tax. Munis are exempt from federal tax, and also state tax if you happen to reside in that state.
2) Investment Funds
Investment funds make it easy for ordinary people to have access to a collection of different stocks, bonds, and other assets. Generally speaking money invested in a fund could lose value but also isn’t needed right away. When held for a long time, the fund is expected to grow in value both from appreciation and from reinvesting dividends. Some funds have clocked steady 7-10% returns on average which makes for a bright future if done steadily.
There are all kinds of recommendations for the “optimal allocation”. Some say put in 60% stocks and 40% bonds. Others say to put age in bonds and the rest in stocks. Others can’t decide and are 50/50. You can check out our Portfolio Allocation Calculator to get a sense of how different mixes did in the past.
Mutual funds are a pool of securities (stocks, bonds, etc) managed by professionals. Through your brokerage account or company retirement plan you can buy into a slice of these funds. They are diversified across many holdings according to the prospectus. Different mutual funds have different focuses (US stocks, international stocks, US bonds, growth funds, value funds, etc). The number of funds can be overwhelming but generally speaking the simple ones like “total market”, “us market”, “balanced fund” are common choices for beginners because they make it so simple.
Many retire rich with mutual funds after holding them for decades. The secret to success here is to pick funds that have low expenses, dollar cost average your contributions, and pick a risk profile that lets you sleep through the night including wild market swings.
Exchange-traded funds, or ETFs as they are commonly called, are similar to mutual funds, except they trade like a stock (as opposed to mutual funds which settle in value after the market closes each business day).
Each ETF has its own ticker symbol, but instead of it being a single company, when you buy an ETF you are buying into a pool of securities the ETF owns. Again, ETFs have expense ratios just like mutual funds, so it pays to shop around. The ETF world is huge with all kinds of boutique things to invest in. This is both good and bad, as investors have more choices, but the more custom a fund is the higher the fees are.
Index Funds - Active vs Passive Management
Index funds are a special type of Mutual Fund / ETF where the fund manager is required to allocate the monies in the fund according to a formula provided by an index (such as the S&P 500). This is called passive management because the fund manager is just following along with the overall market. This can be good for investors because it generally means lower fees, and better returns.
Historically most funds have been under “active” management where the fund manager has wider latitude in terms of what the fund bets on. This can lead to better returns, but more commonly lower returns because the fund manager is churning holdings more often which leads to higher fees (and sometimes taxes) for the people who own the fund.
3) Advanced / Speculative Investments
These categories are here for discussion and would generally represent a small percentage of an overall portfolio if it has a place at all.
Buying shares of a company can lead to big wins or big losses. When you buy shares of a certain company your fortune is tied to how well that company does. It could be a big hit, or it could flop. Stock picking requires a lot of research and some luck to do well. Before you delve into this, consider if you can afford to lose any money you put into individual stocks and how much pain you are willing to endure if it does go down.
Stock options allow an investor to benefit from price movements in a stock without actually owning shares. There are also strategies such as covered calls where you buy the stock and simultaneously sell an out of the money call. Anything having to do with options is considered high-risk. Therefore it is not advisable to trade options unless you really know what you are getting into.
Put options - When you buy a PUT, it means that you have the right to sell the stock to someone at that price. So if the stock drops, the PUT goes up in value. PUTs are kind of like an insurance policy, or also a bet the stock will drop.
Call options - When you buy a CALL you have the right to buy the stock at a certain price. If the stock goes up in value so does the CALL. If you think a stock will go up quickly in the near future CALL options can be very profitable, but because they are leveraged if you are wrong you will lose 100% of the money you bet. Key word here is “bet”, options are more like gambling than investing for most people.
Gold and Silver
Gold and silver are one of the oldest stores of value. Although it can be said that this investment does not bring great wealth. The price of gold and silver depends on certain factors, such as scarcity and fear, but also the overall supply and demand. When there is scarcity and fear, the price of gold skyrockets, and when gold is widely available, the price of gold falls.
If you believe that there will be a great scarcity in the future, then this is the right opportunity to invest in gold. Holding a small percentage of gold (or other precious metals) can be a counter balance to other assets like stocks and bonds. Several ETFs allow you to invest in gold and silver using your brokerage account. Alternatively mining stocks give you exposure to the price of precious metals. Or you can collect coins / bars yourself which can be fun.
Cryptocurrencies are one of the newer types of investment, but seem similar to the great tulip bubble of 1637. These are digital currencies that can be traded on cryptocurrency sites or even as ETFs in your retirement account.
The most famous cryptocurrencies are Bitcoin, Ethereum and Dogecoin. After all, in recent years they have been extremely popular on social media which goes hand in hand with rapid (insane) price increases. Regardless of their growth, they are still a very risky investment. Cryptocurrencies have no intrinsic value and could disappear as quickly as they were created.
Annuities are contracts between an investor and an insurance company, which works by the investor paying a lump sum, and in return receiving periodic payments made by the insurer. Annuities are typically used to supplement income and lock in a steady monthly payment during retirement. These can be good for people who are unable to manage their own money and need a fixed income stream that is guaranteed. Annuities are risk-free, but there are no refunds either. They serve to set aside income for retirement, but not for its growth.
4) Real Estate
There are various ways to invest in real estate by buying houses, apartments and commercial premises, but the main problem is that it takes a lot of money to get started and it can become a full time job managing it all. We discussed this at length in our post - Real Estate Investing What You Should Know.
5) What Are the Worst Types of Investments?
Many people make the mistake of investing in material things that lose value over time, such as a car or a boat, or any other thing that is expendable. Another common way to lose money is to chase a fad or a get rich quick scheme.
6) What Are the Best Types of Investments?
The common advice given out there is to:
- Build up an emergency fund.
- Pay off high interest debt.
- Start saving in a tax deferred account such as your company 401k, personal IRA, or personal Roth IRA.
- Pick investments with low fees according to your risk profile.
- Talk to a fee only financial advisor to get a professional opinion about your situation
This is just a suggestion, and it is up to you to decide how to manage your money and what your budget looks like.
Honestly the best advice we can give is to invest in yourself by reading up on personal finance so you are comfortable with all these topics and have a solid plan to meet your goals.
Conclusion: in this article, we have outlined low-risk and high-risk investments. It is up to you to choose where to invest and how to get started. For more ideas see our post on asset allocation.