When you are just learning how to start to invest, all the options and choices can feel completely overwhelming. Once you've chosen the best investment account for you, you may be staring at a list of funds, with all different types of investments, and thinking... "Okay, now what?" The reality is all those different funds and choices can be grouped into a few basic categories. Understanding the differences between them, as well as their historical return and risk profile, will help you begin to determine which investments are the right ones for you!
The 3 Core Types of Investments
The basic building blocks of investing are:
- Cash and cash equivalents
There are other asset classes as well - real estate, commodities, currencies, - which I will discuss at the end of this post. But for purposes of investing from your investment accounts, be it a retirement, college savings, or health savings account, I'm going to focus on these 3 core different types of investments, or asset classes, first.
What is an Asset Class?
Asset class is the official finance term for describing different types of investments. These investments get grouped together because they tend to behave similarly in the market: they have a similar risk and return profile, and from a legal perspective, are structured similarly, regulated the same, and trade on the same exchanges. As I break down each of these different types of investments, or asset classes, below, I will highlight the variations in each of these areas:
- Structure and behavior
- Risk and return profile
- Regulatory oversight
By understanding these concepts for each asset class, you will have a better understanding of how each investment works, the risks associated with them and how to use them as part of your overall invesment portfolio.
What are Cash & Cash Equivalents?
I think it's safe to say most people know what cash is... this is money in the bank or literally in your hands that can be used in the everyday purchasing of goods and services or to pay your bills.
Cash equivalents may be a less familiar concept. These are investments, that can earn a very low return, are very low risk, that are also highly liquid and easily converted back into cash. Liquid means an investment has a high volume of market activity: lots of people are trading it every day, which makes it very easy for you to sell and convert your investment back into cash.
An example of a cash equivalent would be government Treasury bills. These are government bonds (more on bonds below). They are issued by and backed by the credit of US government, which makes them very low-risk. They typically mature in less than a year. The low-risk, short-term, and highly liquid nature of Treasury bills is what makes them a cash equivalent.
Money market funds are a kind of mutual fund that invests in cash equivalents. When you first open your investment account, you may elect to allocate your money to money market funds so that it earns some small return instead of earning nothing just sitting as cash until you start allocating it to higher returning investments.
What are Stocks?
This is what comes to mind first for most people when you talk about different types of investments - stocks. But what actually is a stock?
Stock is an ownership, or equity, share of an individual company. If you invest in a stock, you are known as a company shareholder. This entitles you to a share of the company's future earnings stream, gives you a vote at shareholder meetings, and if the company issues one, entitles you to dividends issued by the company as well.
How Do Stocks Work
If you started a company tomorrow, it would be privately owned by you and any partners you involve, and whatever money is invested by you and your partners represents the initial equity in the company. As the founder(s), you would hold 100% ownership, divided based on the money you each contributed. All the stock is held by you and your fellow founders or partners.
As your company grows, you may attract or look for outside investors to help it grow faster. Venture Capital and Private Equity firms may invest privately in companies at this stage. You give up a piece of your ownership to these investors in exchange for the capital they give you to help you grow.
Eventually, as a company gets more mature and established, it may look to access the public equity markets through an initial public offering (IPO). In an IPO, all existing ownership gets broken down into equally valued, individual shares, or stock. Additional new shares may be issued in an IPO to raise new capital for the business, reducing existing shareholders' ownership, and/or existing shareholders, the original founders, and private investors may sell part of their existing shares as well. An IPO converts all of a company's existing equity into publicly-traded stock, available for anyone to buy or sell in the stock market.
How are Stocks Regulated
As part of the IPO process, all the stock of a company becomes equity securities registered with an exchange and the US Securities and Exchange Commission (SEC). This now requires the company to abide and follow all the rules of the SEC and the exchange(s) they are registered on. These regulations are all intended to protect you as an investor. It lets you know that a company is following a certain set of rules, requires them to disclose financial information on a consistent basis and format, and in a fair manner. It is also what makes stocks easily comparable from one company to another. The SEC also sets out the rules that you as an investor must follow as well.
The image below is the cover of the latest quarterly filing for the Class A Common Stock for GameStop (Ticker: GME). This is the equity security you buy when you buy GameStop stock in your brokerage account. Quarterly (10-Q) and annual (10-K) filings are an SEC requirement to remain a listed security in the public market. You can also see at the very bottom exactly how many shares there are in total outstanding.
How Do Stocks Behave
Stocks, as a piece of the ownership in a company, are attractive to investors for the upside potential they offer. Any increase in earnings for the company increases the equity of the company and the potential value of your stock.
However, the potential for higher returns doesn't come without added risk. If the business does poorly, and a company has to file for bankruptcy, equity holders are the last ones paid in a liquidation.
This risk profile causes the price of stocks to move more over time than other, lower risk, securities. We call this movement in price, volatility, and it can be measured and calculated, mathematically. Volatility can also vary between different stocks. It can vary for any range of reasons - be it higher earnings growth, having less liquidity or less shares publicly traded, overall size, acquisition or news activity.
For serious math nerds interested in formulas, this is how volatility is calculated:
As an example, let's compare WD-40 Company and Procter and Gamble over the last 5 years. Both are consumer staples companies - they produce consumer goods, that are largely considered essential, things like cleaning supplies and personal care products.
P&G is a far larger company - with more revenue, far more shares outstanding and a market cap nearly 80x that of WD-40 Company. WD-40's smaller size overall, makes it easier for them to grow faster - but they also have less cash flow and a smaller dividend. WD-40 did generate a higher return over the last 5 years, but they also had higher risk - as measured by their higher volatility, which you can visibly observe in the greater magnitude of movement in the price over time.
Different Types of Stock Investments
The different causes for risk and volatility causes stocks that behave similarly to often be further broken down into different groups.
Stocks are often classified by size, usually measured by their market capitalization. You will hear them referred to as Large Cap or Small Cap. In the example above, P&G is a large cap company, while WD-40 is a medium to small cap company.
Indexes are typically market-cap-weighted, and often broken down by size. The Dow Jones Industrial Average is made up of 30 large-cap companies. The S&P 500 represents the 500 largest stocks and is a large-cap index. The larger the company's market cap, the more weight they carry in the index. Similarly, the Russell 1000 represents the largest 1,000 stocks in the US, and is still a large-cap index, though with more names. The Russell 2000 represents the 2,000 smallest stocks in the Russell 3000, and is a small-cap index.
Typically, smaller cap stocks are higher growth and higher volatility than large cap stocks.
Sometimes stocks are classified by investment style: Value vs. Growth. Value stocks tend to be slower, but steady in their growth, more established businesses in traditional industries, and generate more cash flow. They tend to trade at a lower valuation, given their lower growth, but also have lower volatility.
Growth stocks tend to be faster growing, in more rapidly evolving industries, like technology, trading at higher valuations with higher volatility. They have more upside potential, but come with higher risk.
Stocks are also classified by sector. Stocks are not only impacted by actions within a company, but also by the economy as a whole. Often times, stocks in the same sector behave similarly under different economic conditions. As an example, if oil prices fall, it negatively impacts most companies in the Energy Sector. They also tend to have similar business models and may be valued similarly by the market.
There are 11 major sectors, and you can often find ETF index funds by these sectors. Below are the major S&P sectors, and examples of the companies you will find in each one.
Here is a snapshot of how different sectors have performed over the last 5 years relative to the overall market as well.
What are Bonds?
So far we've talked about cash and stocks. The last major investment type is bonds. Bonds represent pieces of a loan, or debt, split up into $1,000 increments. Like stocks, they can be registered and publicly traded. If you hold a bond, you are a lender to the bond issuer. Bond issuers can be public or private companies, as well as local, state or national governments. And just like debt you may hold, like your mortgage or student loans, the issuer pays interest on the bond periodically, and at some point in the future, repays the bond in its entirety as well.
How Do Bonds Work
If you want to borrow money, you go to your local bank, they check your credit, and based on your credit and income, they approve a loan amount at a certain interest rate, which will be higher the lower your income and overall credit is, to compensate the bank for taking more risk.
When a company or government wants to raise hundreds of millions or even billions in debt, they issue bonds in the bond market. Intead of a single bank making them a loan, their loan is extended through thousands of individual bond holders.
In order for bonds to be easily tradeable and comparable, they all share some common features:
- $1,000 Face Value: all bonds have a $1,000 face value. This is the amount the company will repay you at maturity.
- Coupon Rate: this is the interest rate the bond issuer will pay you on the face value of the bond. A bond with a 3% coupon rate will pay you $30 (3% x $1,000 face value), annually. Coupons are typically paid semi-annually, so in the example above, you would receive $15 every 6 months.
- Maturity Date: this is the date the bond issuer must repay the face value of the bond. If I issue a bond today in 2021 with a 5-year maturity, its maturity date is in 2026.
All of the facts above get factored into a bond math formula to determine the current price of a bond. At issuance, bonds are typically issued with coupon rates at prevailing market rates so that bonds are issued at par, or 100. Investors demand to be compensated for the risk they are taking by extending a loan. That risk is typically dependent on two key factors: time to maturity and the overall credit of the issuer.
Risk Factor - Time
As a baseline, consider the current yield curve for US Treasuries, which backed by the US government, are widely viewed as close to risk-free. The interest rate increases with time to maturity.
If we view the rate paid by the US government as the baseline, all other issuers then pay an additional rate - or spread - over that baseline based on their individual credit risk.
Risk Factor - Creditworthiness
Every bond issuer gets an overall credit rating, and every individual bond issued also gets a rating based on where it falls in priority for payback in the event of a default.
As a comparison, as individuals, we each have a credit score that represents our overall creditworthiness. If we take out a mortgage, part of what determines the interest rate is our credit score. And if we take out a second mortgage, it comes with a higher interest rate, because if we default and the home is sold, it only gets repaid after the first mortgage.
Issuers receive their credit rating(s) from one of 3 major credit rating agencies: Moody's, Standard & Poors, and/or Fitch. Most issuers get ratings from at least 2 agencies, and they do pay a fee to be rated. They also have to pay a fee to have each bond issuance issued.
Credit ratings are determined very much like our individual credit scores - how much income and cash flow does a company generate. What is its ability to repay its existing debts. How will this new debt issuance change that? The higher a company's credit rating, the more financially stable and able a company is to repay its debts, and also the lower coupon rate It will have to pay on its debts as well.
Why Do Bond Prices Go Down, When Bond Yields Go Up
Bond math is based on the time value of money: that a dollar today is always worth more than a dollar in the future - and we discount dollars in the future to present value based on a discount rate appropriate to the risk associated with repayment.
At issuance, a bond's coupon rate is set based on current market risks and outlooks, as well as a company's current credit risk. But all of this is constantly changing... see how much the US Treasury yield curve has moved just over the last year?
Bond prices move up and down to reflect those broader market and issuer-specific changes. If at issuance, a coupon rate is set at 4%, but then market interest rates fall, the 4% bond still has to pay 4%, and will now trade at a premium, or a price above par because it is paying above-market rates. You might have to pay a price of 101, or $1,010 because the bond now pays a rate above market. The new yield to maturity, or the 4% relative to the new higher price, will give a yield to maturity below 4% and in-line with the new, lower market rate.
For serious math nerds interested in formulas, this is how bond prices are calculated:
If market interest rates rise, the 4% bond still only has to pay 4%, but will now trade at a discount, or below par because it is paying a rate below market. You may be able to pay 99, or $990 because the bond now pays a rate below market. The new yield to maturity, or the 4% relative to the new price, will give a yield to maturity above 4% and in-line with the new, higher market rate.
The bond price moves relative to the coupon rate to reflect a yield to maturity in line with current market rates for the given risk and time to maturity associated with the bond.
Different Types of Bond Investments
As with stocks, bonds are also grouped into different categories that behave similarly with similar risk and volatility profiles. In general, bonds have lower volatility than stocks for two key reasons: coupon payments and seniority in the capital structure. Both these features of bonds narrow the range of return outcomes - there's not huge upside opportunity, but there is also less downside risk unless a company defaults entirely - and even then, bonds get repaid before shareholders. This creates reduced volatility.
By Issuer Type, Geography or Currency
Bonds can be issued by corporations, like Coca-Cola. They can also be issued by governments, like US Treasury Bonds, and at every level of government. States can issue bonds, as can municipalities - these bonds are known as "munis." Foreign governments can issue bonds just like the US does too. And bonds can be issued and denominated in different currencies as well.
By Credit Rating
After separating bonds by issuer, the next most common driver of volatility difference between bonds is overall credit quality. Bonds are often grouped in two buckets - Investment Grade and High Yield, also known as Junk Bonds.
Investment grade bonds are those rated Baa3/BBB- or higher. High yield bonds are rated below that - and as the name implies, carry a higher yield, or coupon rate, to compensate you for the higher credit risk.
Bonds can also be categorized by the other major risk factor - time to maturity. This is especially true for Treasury bonds or large corporate issuers who have large issuances across a range of maturity dates.
These will be characterized as short-term (inside of a year to maturity, medium term (5-10 years to maturity), and long-term (20+ years to maturity).
The longer-dated a bond's maturity, the more time risk is associated with the bond - there more opportunity for market rates to change between now and when the bond matures. This requires these bonds to pay a higher coupon rate to compensate you for that risk, and also creates more volatility in their price over time.
Different Types of Investments - Big Picture
If you take a step back, what is the risk vs reward trade off between the 3 core investment types?
Hopefully, this gives a very clear visual of what more risk, more volatility and the payoff - higher returns, looks like for each of cash, stocks and bonds over the last 5 years. A similar relationship holds over the last 10 years too.
Other Speculative Types of Investments
The 3 core different types of investments - cash, stocks, bonds - all have something in common. They are all underpinned by an actual income generating asset or generate an income stream themselves. Real Estate is often characterized as the 4th core investment type, and similarly, has a value that is underpinned by an income generating asset, as it can produce rental income.
The other two asset classes I'm most frequently asked about - commodities and currencies, or FX, are more speculative. Unless you are going to fill your safe with Euros, or keep barrels of oil and gold bars in your basement, most people invest in these via futures contracts (or ETFs which hold futures contracts). And whether you hold them in your basement or via futures or ETFs, you are essentially just speculating on which direction the price will go, as opposed to investing in an asset that pays a yield or generates an earnings stream over time.
And at least over the last 10 years, for commodities it hasn't paid off. While it can be a source of further diversification, given the volatility and speculative nature, these aren't core holdings in most retail investor portfolios. You can also get both FX and commodity exposure through investment in stocks and bonds: in companies with overseas operations, in energy and mining companies, or through bonds denominated in other currencies, if you'd like.
What different types of investments do you currently hold in your investment portfolio? Do you have a clearer understanding of how the 3 core types of investments - cash, stocks and bonds - work, and why they have different levels of risk and returns? What other questions do you have about different types of investments?
Coming up next in the Investing for Beginner Series... Diversification. What does it mean? And I'll also show you how diversifying your investment portfolio helps reduce risk overall. Be sure to follow the complete series: How to Start to Invest here.