Investment Basics - A Guide for New Investors
Stocks, or equities, are likely one of the first things that come to mind when you think about investing. But the financial markets include a wide variety of investment types—each with its own potential advantages and disadvantages. How do you know which are right for you? It will depend, in part, on your goals and your tolerance for risk.Let’s take a quick look at each, and what you should know about them.
A stock represents part ownership in a company—which is why you buy “shares.” and are . With stocks, you earn a return when the price increases. And if the stock pays a dividend, you earn a portion of the profits as well.
There are two types of stocks:
- Common stock entitles you to vote on company matters at annual shareholder meetings and receive dividends (if they are offered) as a stockholder of that company.
- Preferred stock has features of both stocks and bonds. Holders forego voting rights in exchange a preferred status. Should something go wrong with the company, preferred stockholders are paid before common stockholders.
- Stock prices can fluctuate depending on many factors, so while history has shown you will likely make money over the long term, it is possible to lose money as well
Bonds are, in essence, a loan that you provide to a company or government. Bonds provide a way to earn regular income through interest payments. And, if you hold the bond until maturity, you will also receive the par, or face, value of the bond, which may be more than you paid for it.
Bonds are typically issued when a company or government is looking to fund a particular project or initiative:
- Municipal and federal governments issue bonds when they need to fund things like building roads and hospitals. Typically, these bonds are backed by the government, so there is little risk and often lower interest rates.
- Corporations may issue bonds for operational capital or to expand or for many other initiatives. Corporate bonds are not guaranteed and include credit risk, so it’s important to understand the company’s credit rating, as there is the chance they could default on the bond. Of course, corporate bonds tend to offer higher interest rates to compensate for the higher risks.
- Agency bonds are issued by government-affiliated organizations, such as The Federal Bridge Corporation. These agencies are typically backed by the government, but the bonds are not guaranteed.
Options are like contracts that allow an investor the opportunity to buy or sell a financial product, like 100 shares of stock, at an agreed upon price (the strike) at a specific time in the future (the expiration date). The buyer pays a “premium” for the option, but is under no obligation to actually buy the underlying assets and has no ownership claims until and unless the option is exercised.
If the option is “in the money,” the option price is below the current selling price (for a call option) and will likely be exercised so the option owner can buy the shares low, sell them at the higher current price and profit from the difference. Put options work in the opposite way.
Of course, risk exists on both sides of an options trade—if the market price falls, the call option may expire worthless, causing the buyer to lose their premium payment. Conversely, if the market price rises, the put option seller may be required to buy the stock at a higher market value in order to fulfill the contract, thereby losing money on the price difference.
Mutual funds represent pools of investments. They can be portfolios of stocks, bonds, alternatives, or any mix of these underlying holdings.
Mutual funds can be designed to provide growth, income, or many other types of goals. They may be broadly diversified portfolios with hundreds of securities, or they may be focused portfolios with only 20-50 holdings.
While mutual funds can be bought at any time, but can only be redeemed, or sold, at the end of the trading day. So if something is going wrong, or right, in the market, you may be either miss out on the growth or may be more hurt by a price decline.
It’s worth noting that mutual funds often have to buy or sell securities in order to meet purchases and redemptions. This can cause them to overpay for securities and/or to have tax consequences for investors. Mutual funds may have sales loads and are not guaranteed and can lose value.
EXCHANGE TRADED FUNDS (ETFs)
ETFs are somewhat similar to mutual funds, in that they can invest in stocks, bonds or alternatives in nearly any sector. ETFs can also have any number of objectives and can be focused, broadly diversified and even leveraged. Unlike mutual funds, however, they are listed on stock exchanges, and their shares can be bought and sold throughout the day, just like stocks. That means the price will fluctuate during the day as an ETF is bought and sold.
In general, ETFs enjoy lower expense ratios and fewer broker commissions than stocks or mutual funds, though actively managed ETFs have somewhat higher fees than passive ones. Because ETFs can be traded to other investors, they are typically far more tax efficient than mutual funds. Naturally, focused and leveraged ETFs may carry higher risks than other, more diversified or long-only ETFs.
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