Published September 27, 2011
Investing sounds intimidating to the uninitiated, but a little knowledge can go a long way. If you're building a portfolio for the first time, set up a strong foundation with some of these common types of investments. Find them in a variety of places, including discount brokerage firms, mutual fund firms, banks and even the Treasury.
One share of stock represents a slice of ownership in a business. Companies generally sell pieces of the business to the public in order to raise money. In return, stockholders may receive a share of company earnings through dividends. Investors who sell their stock after it has increased in value also benefit from capital appreciation.
After an initial public offering, stocks are sold on the secondary market -- where most of the daily trading takes place.
Most financial planners recommend that individual investors put their money into stocks through mutual funds.
Mutual funds buy a bunch of different securities. Investors, in turn, buy shares of the funds. There are thousands of funds that buy lots of different things, but most of them simply own stocks or bonds or a combination of the two. Others focus on specific sectors such as commodities, REITs, technology companies or even currencies.
One particular type of mutual fund has soared in popularity in recent years: the index fund. An index is a benchmark for the market as a whole. For instance, the Standard & Poor's 500, made up of 500 large-cap stocks, can be mimicked by index funds that hold roughly the same positions in the same proportions. "The larger the company, the more they're represented in the index," says Flower.
Actively managed funds are run by a manager or a team of people who follow a particular investment strategy. They pit their investing skills against a benchmark.
"Index funds outperform some 80 percent of the actively managed funds," says Brosious. "Over the long term they will outperform."
Whereas equities represent ownership in corporations; bonds represent loans made by investors to the issuer. Corporations, municipalities and the government issue bonds to raise money.
"You're loaning money to an entity; it could be the government or a corporation. And they agree to pay you interest and then pay you back your principal at the end of the term," says Kinder.
The issuer repays the original investment after a stated amount of time, known as the term to maturity. Bonds mature at varying times; between five years and 30 years are the most common. Longer term bonds produce higher yields. "The longer the maturity, the more that investors demand in return," says Kinder.
While maturities influence the yield or the interest rate that investors receive on bonds, quality also matters. The highest rated bonds are from the Treasury because they are virtually risk-free. "The higher the quality, the lower the interest they're going to pay you, because of the higher guarantee you'll get your money back," says Kinder.
For those who like to live dangerously, junk bonds (also called high-yield bonds) generally offer the highest yields -- as well as a higher probability that the company will default on its loans. However, most advisers recommend bonds as a conservative anchor in an investment strategy and some like to just stick to the basics.
"In the bond market, it's not like you can make a huge return, so why not go with some type of Treasury where you have a guarantee of the full faith and credit of the U.S. government behind the bond and receive income that has historically been between 4 (percent) and 6 percent and be very safe," says Flower. "It really acts as stability for an overall portfolio."
The value of the bond can also fluctuate throughout the term, but that only affects bondholders if they sell their bonds prematurely. "If interest rates increase, the bond that you hold is probably going to be worth less because people know that they can go out and get a bond that pays a better interest rate -- and if rates go down, your bond now has a higher interest rate than other ones out there and it becomes a bigger value," says Flower. "But you're always receiving that income from the interest rate attached to that bond."
Issued by the government, Treasury Inflation-Protected Securities adjust with inflation as measured by the consumer price index. "Part of the return on a TIP government bond is the interest that they earn. But they will also increase the underlying value of the bond when inflation increases so you get not only the interest income, but also the value of the bond increasing periodically when inflation increases," says William M. Howell, CFP, CPA of Howell Financial Advisors Inc., in Noblesville, Ind.
TIPS pay a fixed interest rate, though the principal adjusts every six months with inflation. Although the value of the investment can go down, at maturity investors are paid either the greater of the adjusted principle or the original investment amount.
Available to individual investors directly, TIPS can be purchased through TreasuryDirect.gov, banks or brokers. They can also be bought through mutual funds.
"There are certain mutual funds, no-load, that concentrate solely on the TIPS market," says Howell. "You can go out and buy individual TIPS if you like, but I prefer to use a mutual fund manager to do that for me. They have more of an idea with their analysts and their background and specialty for that particular slice of the fixed-income market."
The National Association of Real Estate Investment Trusts defines REITs as companies which own or operate income-generating commercial real estate. The structure of the company allows investors to buy into real estate the same way they could purchase a mutual fund. In order to qualify as a REIT, the company must derive a certain portion of its income from real estate and provide 90 percent of its earnings to shareholders every year.
REITs hold all kinds of real estate-related holdings. "Sometimes people get confused and think they are all the same," says Kinder. Some hold mortgage loans or they can be apartment buildings, shopping malls, warehouses or even timberlands, he says.
Exchange-traded funds, or ETFs, have been gaining in popularity in recent years, though they have been around for a while, says Brosious. Good for tax-conscious investors looking to pay less in expenses, ETFs work essentially like a mutual fund with some characteristics of stocks. "These actually trade like an individual security but they are a basket of individual securities, just like a mutual fund," Brosious says.
ETFs follow market indexes in their investing strategy. Because of this, their operating expenses are less costly than those of the average mutual fund, says Flower.
Certificates of deposit provide a fixed interest rate for a stated amount of time. Most CDs have a minimum purchase amount and charge a penalty for withdrawing the principal early. Because of their modest guaranteed return and low risk, they add stability to an investment portfolio.
In general, longer-term CDs pay a higher return than their short-term counterparts. Correlated with the interest rate moves by the Fed, CD yields vary over time. Laddering CDs can guard against the fluctuations of interest rates over time. Rates, investing time frame and the direction of the economic tides could determine the length of a CD ladder.
"If I'm doing a 24-month ladder, I may end up buying three or four different CDs with varying maturities, six months, 12 months, 18 months and 24 months," says Howell. "That way I have a CD coming due every six months and as that CD comes due, I check the interest rates and see what kind of yields are available. And if at that point we're still keeping a 24-month ladder, I'll roll it into another 24-month CD."
Like rebalancing your portfolio at the end of every year, reinvesting in the longest term in your ladder smoothes out returns and removes the guesswork of market timing.