08 Apr The Many Types of Investing Methods – a Breakdown
Stocks, Index Funds, CDs, 401ks, and IRAs are just the beginning of what it means to be an investor. Let's be honest, if you are new to the financial world (or have even been at it a couple of years), that can sound like a whole lot of gibberish. What are all of these things, what do they do, and, frankly, why would someone want to invest their hard-earned money in them? Today, we are going to break these investment methods down so you have an idea of what options are available and will be best for your investing needs.
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If you have all of your money hidden under the bed, it is time to advance into the 21st century! A simple savings account is where most people start. Put your cash into a savings account until you figure out what you want to do with it. Your investment will only be making pennies from interest, but it is an excellent place to start if you are building from zero or if you are looking for a safe location to store your emergency fund. Not all savings accounts are created equal, with some banks offering better deals than others. Take a look around and aim for a 1.7% or higher rate return on your money.
It is highly likely that you have heard of stocks and the stock market. By investing in stocks, you are buying a teeny tiny portion of a company, which is called a share. You can purchase just one share of a company, or you can buy thousands. When you are buying stocks, it is because you (or your financial advisor) believe that the value of the company will rise, which means so will the worth of the share. Thus, you make money from the rise in value while still enabling quick access to your funds if you were to need it.
However, having all of your stocks invested in just one company can be risky because any one company’s future can be uncertain. By contrast, history shows us that over the long run, markets as a whole always grow. Accordingly, it’s a good idea to own stocks from a wide variety of companies across a diverse range of industries and geographic locations in order to reduce your overall risk while also growing at a strong pace.
When you invest in bonds, you are essentially buying a loan or an IOU from the government or a corporation. Say what? It's confusing; let us explain. The government, and some corporations, use bonds as a way to borrow money. Perhaps the government needs money for roads or a war, but the government can't get a loan from a bank as we can. Instead, they are borrowing money from you.
So, why would we invest by giving out a loan? Because that bond comes with interest. The government or corporation who issued the bond will pay you back the cost of the “loan” with interest at a flat rate. Bonds are considered a relatively safe and stable form of investment because they have specific contractual dates and payments. You know precisely what you are going to get and when! The amount of money you can make from owning bonds is generally lower than most other investments but making money on bonds is basically guaranteed. Less risk, less reward… but a nearly guaranteed reward. For assured stability, bonds should be a portion of every balanced portfolio.
Certificates of Deposit
A certificate of deposit, more commonly known as a CD in this crazy finance world, is a product offered by banks. They’re fairly similar to government bonds. When you invest in a CD, you essentially agree to leave a certain amount of money, untouched in a special account where you can't access it, in the bank for a certain amount of time. For example, a CD you could buy would be $5000 with the promise of leaving it alone for a year.
What you get for investing in a CD is interest. Each bank offers a different interest rate, so it is vital to do your research before picking one. The interest that you make from a CD is usually more than you could in a Savings Account, but less of a return than what you would get with stocks. It is a safe middle ground for when you want to put some money off to the side, have no need to access it, and still want to earn a little extra cash.
You may be thinking, “Hey, wait a minute! That sounds just like a bond!” You are correct! Bonds and CDs are very similar; the main difference between the two is that a bond can be sold before it matures, and a CD cannot.
Mutual funds are like a big mixing pot of investments. Within a mutual fund, there will be stocks, bonds, and other investment options. When you invest in a mutual fund, you are primarily investing in a little piece of everything in that fund. The fund itself is operated by a professional money manager who does their best to increase the value of the fund. Therefore, when the investments within your fund increase in value, so does your overall fund.
What’s the difference between a mutual fund and a stock? Great question! A stock is with ONE company, so when you invest in a single stock, you are putting all of your eggs in one basket. If that stock fails, goodbye money. 😭 With mutual funds, you are investing in a little bit of MANY different companies, therefore spreading out your eggs into a bunch of different baskets. This means that if one company fails, it won’t affect you that much because it will get balanced out with the other companies in the fund that are probably growing overall. Now, let's go a bit further by adding in Index Funds.
An index fund is a type of mutual fund, but it acts more like a mirror. No, not the kind of mirror where you check your hair, but like a copycat. Index funds are made up of lots of little company pieces, like a mutual fund. However, instead of a money manager actively managing the fund in an effort to increase its value, an index fund is a mostly unchanging group of investments grouped together to copy a financial market index. Wait up, did that make sense? Let's rephrase.
Let's pretend for a moment that we have the Thrive Oak Index Fund (which isn't real, btw). The index fund is designed to mirror (copycat) the S&P 500 by holding a similar mix of companies in similar quantities. When the S&P 500 goes up by a certain amount, so does our index; when the S&P 500 goes down, the index funds value drops by a similar margin. Make sense now? Good!
Many investors, including the famous Warren Buffet, love Index Funds because they provide extensive access to a wide range of investment options, have low operating expenses (because they don’t require professionals to actively manage them), and generally deliver long-term success. That is why retirement accounts have Index Funds as their core feature. Don't worry; we will get to retirement funds in a minute!
Are you still with us? Keep going; you got this! An exchange-traded fund is a combination of a stock and a mutual fund. Huh? I know, bear with me here! An ETF is like a mutual fund in the sense that it’s a combination of a bunch of different investments except that there isn’t a manager constantly fiddling with it to try to maximize returns. Also similar to index funds, ETFs are largely “set it and forget it” by their creators and are updated infrequently. As a result, they can have lower fees while still providing solid diversification and returns. Studies show the mutual funds, while actively managed, oftentimes perform worse than ETFs and index funds.
401(k)s & 403(b)s
A 401(k) is a retirement account offered by many employers to their employees. If you choose to invest in your company’s 401(k) program, which you definitely should, a certain amount of your earnings will be automatically pulled from your paycheck each month and deposited into this account. Generally, those funds are then invested in mutual or index funds to gain more money over the years. The main benefit of 401(k)s is that the employer will match your contribution (free money!) Let’s math this out for a second.
For example, let’s say that you signed up to put $500 per paycheck into your 401(k). Your employer would also $500 into your account. This means that you save $1000 into your 401(k) each paycheck. That is essentially a bonus of $500! Plus, you don’t get taxed on this money until you take it back out! Assuming that you do this for your entire career, you would have hundreds of thousands of dollars (or even millions, depending on how early you start investing), waiting for you once you retire. There are two different types of 401(k)s, which you can read more about HERE.
What if your job doesn’t offer a 401(k), but instead you are getting a 403(b). What is the difference? A 403(b) is almost the same thing as a 401(k) except that it is used for employees of non-profits, schools, religious groups, and government organizations.
Individual Retirement Accounts (IRAs) are similar to 401(k)s except that they are designed for personal investment, hence the “individual” in the title. Instead of investing it through your work, with your employer matching you, you do it on your own through a different tax-advantaged account. Whereas 401(k)s have limits to how much you can contribute in a single year, IRAs don’t have caps. So, if the amount that you save and invest each year exceeds your 401(k) limits, then it’s generally a good idea to invest the rest in an IRA. There are also two different types of IRAs as well, which you can learn more about HERE.
At the end of the day 401(k)s, 403(b)s, and IRAs are accounts that people use to invest in stocks, ETFs, and other investment options with special rules and benefits outside of your normal investment routine. For a more in-depth look at 401(k)s and IRAs (and which one is the better option for you), check out this post!
Private Equity is made up of investors and funds that directly invest in specific companies privately. Whereas stocks are publicly traded and available to anyone, investment companies can provide cash to private companies (meaning they aren’t publicly traded on the stock markets) in order to foster their growth in exchange for a share in the company’s profits. Does the name make sense now?
Essentially, instead of buying a stock on the stock market, you are purchasing a part of the company. Generally, private equity investors consist of Limited Partners, i.e., those who have limited responsibility but own 99% of the company. On the flip side, the other 1% is owned by General Partners, who actually have a say in the direction of the company and its money.
Private Equity investing is for those who have a large (and by large, we mean a freaking LOT) amount of money in the bank and the ability to invest that money for long periods of time. Again, private equity investing is not for those just starting, but something that you can think about doing later on down the road. While historically not available to people like you and me, private equity has become more available to the average investor through companies like Funder's Club, Spring Capital, MicroVentures, and many more. Most of these services are brand new compared to bonds and index funds, so it’s tough to know how they will perform long term. We advise that our investor community only invest in these services with caution.
Investing in real estate is a league all its own, which would take another whole website to explain. To give you just a sneak peek, real estate investing can include rental properties, wholesaling, vacation rentals, raw land, commercial real estate, and so much more. When done correctly, real estate investors can make huge returns, but it takes extreme amounts of knowledge and time. If you are interested in taking a deep dive into real estate investing, we recommend visiting the Bigger Pockets website for more information.
Grandma and grandpa may have told you that gold and silver were the way to go when it came to investment. When you invest in something like gold or silver, those are considered to be commodities. Commodities are just material things that you invest in. It could be agricultural products, energy products, precious metals, or something else entirely.
The plus side of investing in commodities is that it is a tangible thing, something that can be seen and touched. The negative side is that commodities also have external pressures such as politics and weather that can decrease their value quickly.
Have you heard of Bitcoin? We thought so. Bitcoin is a type of Cryptocurrency; Cryptocurrency is a digital currency without any government backing. Cryptocurrencies can be bought and sold on cryptocurrency exchanges, used as payment among individuals, and even used in some stores as a form of money. While cryptocurrency is a secure form of transacting money, it has not yet been proven to be successful in the long run. With time, there will be more information on its success rate which can be used to determine if it is a worthwhile investment or not.
Investing at the End of the Day!
You made it all the way to the end! Way to go! You have just begun your journey to financial independence and a lifetime of wise financial choices. Let’s keep this going with the next articles on how to avoid common investing mistakes for beginners or investment lessons learned from successful investors.