As a financial advisor, guiding clients through the complexities of various investment options is a key part of my role. Understanding the different types of common investments—stocks, bonds, mutual funds, and ETFs—is crucial for building a well-rounded portfolio. This blog post will provide a comprehensive breakdown of these investment types by exploring what they are, how they work, and the risk versus reward tradeoff associated with each.
Stocks
Stocks represent ownership in a company. Companies issue stock to raise capital for growth and operations. When you purchase a stock, you buy a share of the company’s assets and earnings. Investors buy stocks through stock exchanges, with the anticipation that the value of the stocks will increase over time.
Stockholders may earn returns through capital appreciation, or the increase in the price of each share of the stock. We all know the common adage, ‘buy low and sell high’. Whether we succeed with that strategy or not is another story. Another way that stockholders earn returns is through dividends, which are a share of the company’s profits. Dividends are traditionally paid on a regular schedule, typically once per quarter.
Stocks can be highly volatile, with prices fluctuating based on company performance, market conditions, economic factors, and geopolitical events. Despite this volatility, stocks have historically provided higher returns compared to other asset classes over long term periods (10 to 20 years or more), making them attractive for growth-oriented investors.
Bonds
Bonds are debt securities issued by corporations, municipalities, or governments. This is a professional I.O.U. When you purchase a bond, you are effectively lending money to the issuer in exchange for periodic interest payments and the return of the bond’s face value at maturity. Bonds pay interest, known as the coupon, at fixed intervals. The bondholder receives the principal amount back at the end of the bond’s term, or maturity. Bonds can also be bought and sold in the secondary market before they mature.
Bonds are generally less volatile than stocks, but they do carry certain risks such as credit risk, interest rate risk, and inflation risk.
If the issuer of the bond defaults on payment or goes bankrupt and is unable to pay back the obligation, the owner of the bond may lose some or all the income they were entitled to, including some or all the original amount that was invested. All bonds carry some degree of credit risk.
Interest rate risk is one of the primary drivers of a bond’s price on the secondary market. The best way to describe interest rate risk is by thinking about a seesaw with interest rates on one side and price on the other. When interest rates go up, the price of the bond goes down. Think about it, if you were holding a bond that had a 5% coupon and there are other bonds out there with a 6% coupon, who would want to purchase your bond? The only way to make that instrument appealing would be to sell it at a lower price.
Inflation risk can undermine the return of your bond through a decline in purchasing power. To grow our wealth, we need to be able to purchase more tomorrow than we are able to today. If the rate of inflation is greater than the coupon rate of the bond that you own, you are technically losing purchasing power to inflation. This is a similar concept to keeping money under your mattress. It may be a safe bet, but the money is not growing or going to work for you.
Nevertheless, bonds typically offer more stable returns and regular income, making them suitable for conservative investors and those seeking steady income streams.
Mutual Funds
Mutual funds pool money from many investors to purchase a diversified portfolio of stocks, bonds, or other securities. These funds can follow a specific index or be managed by professional fund managers who make investment decisions on behalf of the investors. By buying shares of a mutual fund, investors own a fraction of the fund’s holdings. Mutual funds will have stated objectives for the invested capital, such as growth, income, or a balance of both.
Mutual funds can be considered active or passive depending upon the underlying investment strategy. Active management is a hands-on approach to investing with portfolio managers making investment decisions for the mutual fund. Decisions can range from attempting to purchase securities that are mispriced to relying on forecasts of economic industries prospects for growth to try to increase fund performance relative to the overall market. Passive management attempts to follow certain indexes and mirror its performance. In this instance, the fund managers are not making specific decisions to add or drop certain investments. Rather, they follow what the index will do. Actively managed mutual funds often cost more to invest in than passively managed mutual funds because the active style of management requires ongoing analysis and portfolio upkeep. Historically, passively managed mutual funds have performed better than actively managed funds over time periods of 10 years and longer. Certain actively managed mutual funds may be able to beat the market in the shorter terms, up to a few years, but it is nearly impossible to do this year in and year out for a period of 20 years or more.
The risk level of mutual funds depends on the underlying assets. They carry market risk similar to stocks or bonds, as well as management risk, which is dependent on the performance of the fund manager. Additionally, mutual funds can be subject to fees and expenses that impact overall returns. Despite these risks, mutual funds provide diversification, which can reduce risk compared to holding individual securities. They offer the potential for capital appreciation and income, depending on the fund’s strategy.
Another interesting fact about mutual funds is how they are priced and traded. Mutual funds trade at their net asset value (NAV). The net asset value is the net value of a mutual fund’s assets minus liabilities divided by the number of outstanding shares at market close. This process is done daily after the market has closed to establish the price of each mutual fund share. NAV is calculated and published daily around 6pm Eastern Time. Because of this additional calculation that needs to be done, mutual funds only trade once per day. Orders to buy or sell mutual funds will be submitted during the trading day but are only executed after the markets have closed.
Exchange-Traded Funds (ETFs)
ETFs are similar to mutual funds in that they hold a basket of securities. However, unlike mutual funds, ETFs are traded on stock exchanges just like individual stocks. ETFs can track an index, sector, commodity, or other assets. Unlike mutual funds that are only priced once per day at the time of close, investors can buy and sell ETF shares throughout the trading day at market prices. ETFs still have a NAV, but depending upon the buy/sell demand for the ETF, the price can deviate from the NAV.
ETFs are subject to market risk and the specific risks associated with the assets they track. Some ETFs, particularly those that use leverage or invest in exotic assets, can be riskier.
The Importance of Diversification
Diversification involves spreading investments across different asset classes, such as stocks, bonds, mutual funds, and ETFs, as well as across various sectors. The idea is to avoid concentrating all your dollars with one particular investment type or company. By diversifying, you can mitigate the impact of poor performance in a single investment or sector, as gains in other areas can help balance out losses.
Diversification helps protect your portfolio from significant losses. If one investment underperforms, others can compensate, smoothing overall returns. Diversified portfolios tend to experience less volatility and more stable returns over time. Furthermore, a diversified portfolio can tap into various growth opportunities across different markets and sectors that may have been missed if the investor was concentrated in only a few different positions. This can enhance potential returns of the portfolio.
In conclusion, understanding the different types of investments—stocks, bonds, mutual funds, and ETFs—is essential for constructing a robust investment strategy. Each type has its unique characteristics, risk profiles, and potential rewards. By diversifying your portfolio, you can manage risk more effectively and position yourself for long-term financial success. As always, consult with a financial advisor to tailor an investment strategy that aligns with your goals and risk tolerance.
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Brent Schafer, CFP®, Financial Advisor
