WTF Are Investments? Part 6: Know The (Investment) Types: Stocks, Bonds, Mutual Funds + Alternatives

September 13, 2016 Paco de Leon

Ok, remember way back in the second post of this series when I told you all about investment products and I compared them to frozen treats? Logistically what happens when you invest your money is you open up a certain type of investment account (more on that later) and you put money in it either from your checking or savings or maybe even another investment account. Putting money into your investment account is called “funding your account”. Then once the money is in the account, you can buy investments - like stocks and bonds and mutual funds.

There different investment products and what makes them different are their characteristics. I’m going to tell you about them now.

Bonds (AKA debt securities)

The Short Story

Bonds are considered safe because there is low risk and you nearly always get your money back. You are lending money when you buy a bond.

The Long Story

When you buy a bond, you are lending money to a company or sometimes a government or government agency. Sounds weird, but it’s like when you get a loan from the bank. You are borrowing money from the bank that you will eventually pay back and what it costs you to borrow that money is what you pay in interest. The bond is like that. Hence the alternative moniker, debt securities. You are lending money that you will eventually get paid back and you get paid an interest rate as compensation for you lending out your money.

Bonds are attractive because they are relatively safe investments. It’s generally believed (and it’s generally been true) that when you buy bonds from a stable government, your investment is virtually guaranteed, or risk-free.

But the cost of low risk means there is little return. Risk = return, remember? As a result, the rate of return on bonds is generally lower than another type of investment.

Stocks (AKA equities AKA shares)

The Short Story

They’re considered riskier than bonds because you can lose all your money, but your potential to gain is unknown - meaning, you can gain a lot! You get ownership in a company when you buy stock.

The Long Story

When you buy a stock, you are now part owner of the company. How weird is that? Pretty weird, but that’s exactly what happens. Stocks are ownership shares in a company. So when you buy stock, you become a shareholder.

Characteristics: Voting Rights

Being a shareholder comes with some privileges. These privileges are some of the reasons why people buy stock. One entitlement shareholders have is the right to vote at the shareholders' meeting. Most people don’t exercise this right IRL, but some do, especially if they have a lot shares.

Characteristics: Dividends

Sometimes companies pay out profits (AKA earnings) to it’s owners. These owners include shareholders. The earnings are called dividends. Remember when we told you about compounding - dividends are the reason compounding works.

Characteristics: Volatility

A defining characteristic about stocks is what the industry calls volatility. That means the price of the stock (the value) fluctuates every day. When you buy a stock, you aren't guaranteed anything; you can lose all your money. Many stocks don’t pay dividends, so the only way to get your money back is to sell the stock.

But the upside is there isn’t really a limit to what you can gain when you sell the stock. Meaning, the stock price that you ultimately sell the stock at can be much higher than when you bought it.

Stocks are riskier than bonds, but you the potential return is high. In other words, the price you pay for potential returns is the risk of losing your money.

Mutual Funds

It’s a Basket of Stuff

A mutual fund is when people pool their money together to create a fund. A fund is a collection of investments, usually stocks and bonds. Think of a mutual fund as a basket and inside of the basket are various different stocks and bonds.

It’s People Pooling Their Money Together

It’s beneficial for people to put their money into a mutual funds because when everyone pools their money together, they can buy more securities. Here’s an example to illustrate how this works.

Let’s say you need to prepare dinner, you only have $1 and you can only get your dinner from a store that sells ingredients at $1 each. So you can buy a head of lettuce for $1, dressing costs $1, croutons costs $1, rice is $1, chicken costs $1, etc. (not realistic, but stay with me).

If you only have $1, you are stuck only buying one thing for dinner. Now let’s say in this world, everyone else has very limited resources, meaning other people are going to the store and they only have one or two dollars as well. What if you called up all your friends who also only have a dollar or two to spend to prepare dinner and you asked them all to pool your dollars together so you have twenty dollars, enough to buy a lot of ingredients to make a proper meal. Then all of you get the amount of food equal to the amount you put it - a dollar’s worth of food, but you get a fraction of everything. A little bit of salad with a little bit of dressing and little bit of croutons and a little bit of rice with a little bit of chicken, etc. Without pooling your money, you can only buy one thing. With pooling your money, you get diversity.

I guess what I’m saying is the beauty of a mutual fund is it’s like a potluck. You walk in with a gallon of potato salad, but you get a gallon of everything everyone else brought to the potluck.

It Has People In Charge

There are people who get paid to be in charge of the mutual fund. They’re called fund managers. They execute the strategy. They get paid for managing the fund, usually with part of the money each person is investing into the fund and/or when they do a good job and make the fund more money.

It Has Advantages and Disadvantages

The main advantage of participating in a mutual fund is that you can invest your money without the time or the experience that are often needed to choose a good investments, because of the fund managers. The other advantage is the diversity that comes with pooling your money.

However, in reality, there are lots of different aspects about mutual funds that you should be aware of before choosing them, but we won't discuss them here.

Alternative Investments: Options, Futures, FOREX, Gold, Real Estate, Etc.

So the two basic securities are stocks (equity) and bonds (debt). Lots of investments will fall into either the stock or bond category, but there are numerous other investments types that are called alternatives. These types of investments are usually the most complicated types of securities and usually associated with complicated investment strategies.

If you’re just getting your whistle wet in the world of investing, you probably don’t need to worry about alternative investments at the moment. But now you know they exist. Voila.

In general, investments are riskier. And what did we learn about riskier investments, kids? Yup, that’s right. The potential for higher reward. Hence why anyone would bother taking on risk in the first place. You need specialized knowledge and/or the guidance of a professional so you don’t blow your financial feet off.

Like pretty much everything else in all of life, ever: focus on the fundamentals first and build a solid financial foundation before your blast off into atmospheres you are not equipped to navigate.