Types of Investments: Stocks and Bonds and Funds, Oh My!
The investment world has a way of taking things that are understandable at their most basic element and complicating them to the point that the common person no longer recognizes them. In an effort to help individuals understand investments, I like to simplify them down into two primary categories, loans and ownership. Most people can understand the concepts of loaning money or owning something because it’s familiar to them. So, let’s start with those basic concepts and build from there to the point of helping you understand the investments in your retirement plan at work.
Loans
A loan is created when money is passed from one party to another in exchange for a promise to repay the original principal amount along with interest to compensate for the use of that money. As we consider loans as investments, we have to put ourselves on the lending side instead of the borrowing side of the equation.
While we don’t often discuss it in these terms, a bank CD is actually a form of loan. When you take out a CD, you are essentially loaning money to the bank with a specified maturity date and interest rate. When the loan (CD) matures, the bank will return the original loan amount plus interest.
Bonds are a type of investment that represents a loan made to a company or government. Bonds are simply another way for businesses and governments to borrow money. As we could expect, the less credit-worthy the borrower, the higher the interest rate will need to be to entice an investor to loan the money. It’s the same as when you borrow money. If you have a low credit score, you’re considered a higher risk and will be charged a higher interest rate to compensate the lender for taking additional risk. After all, a guarantee is only as good as the person guaranteeing it.
The primary profit motive of investing in loans is to earn interest while allowing others to use your money. The biggest risk associated with loans is that the borrower may not have the ability to repay you in the end.
Ownership
A person can purchase ownership rights to all or a portion of an asset. Assets that have inherent physical value are typically referred to as real assets. These could be things like real estate, precious metals, oil or agricultural grain. Business interests are another form of ownership that can be purchased and are typically represented in the form of stock.
When you own a stock, you own part of the business that it represents. Ownership gives you a right to the assets and the earnings of that business. Your amount of ownership is determined by the number of shares of the company you have divided by the total number of shares in existence. For example, if a company has 100 total shares and you own 1 of them, you are a 1% owner of the company. Keep in mind that some of the larger corporations may have over 1 billion shares of stock, so the ownership represented by one share could be very small.
The value of your ownership interest (stock) in the company will change depending on the success of the underlying business. If the business does well, the value of your ownership in the company should increase. However, if the business struggles, the value of your portion will likely decrease. As with any assets though, the real value is only what someone else is willing to pay for it and that can vary depending on the buyer and the time when you want to sell.
The profit motives of investing in ownership interests is for the value of your asset to increase or for it to produce income for the owners.
Risk Comparison
Bonds are traditionally seen as more conservative investments than stocks. The reason is found in the structure of the two investments. Since bonds are loans, the owner of the bonds are creditors of the borrower and stand first in line for repayment. Owners (stockholders) have to wait for creditors to be paid back before receiving any value from the assets of the company.
The easiest way to demonstrate this relationship is to consider the example of a homeowner that borrowed money to purchase a home. In this scenario, the bank is like the bondholder in that they have loaned money in exchange for a promise to be repaid, with interest. You are the owner of the house and any increase or decrease in the value of the home will go to you. If you sell the house before the loan is paid off, the bank will be first in line to receive any proceeds. If there’s not enough money to pay the bank back in full, there will be nothing left for you. On the other hand, if the value of the home has increased, the bank will be paid off and any extra proceeds will be yours to keep as the owner.
If we look at an isolated situation, it would be true that lenders to that company (bond investors) are taking less risk than the owners (stock investors). However, we can’t just assume that all bonds have less risks than stocks because other variables can come into play. For example, the stock of a very stable company may actually have less risk than a loan made to a struggling company.
Mutual Funds
Mutual funds are a type of investment that most people will encounter as part of their workplace retirement plan. Because of the popularity of mutual funds, I feel it is important for everyone with a retirement plan at work to understand the basics.
Mutual funds are investment structures that allow multiple investors to pool their money together for a common purpose and those funds are then used to buy a variety of stocks, bonds, or other investments, which will be referred to as the portfolio. It basically works like a business and just as a company’s ownership is represented by shares of stock, the ownership of these funds is represented by shares as well. The value of the fund is determined by the underlying value of the investments it holds.
If you’ve ever attempted to research a mutual fund, you’ve probably come across a lot of investment terminology. In an effort to make sense of that information, I’ve put together a list of terms you will likely encounter and an explanation for each. These will also help you understand how a mutual fund works.
Investment Objective – Each mutual fund will have an investment objective that states the ultimate investment goal for that fund. Examples of investment objectives are Capital Preservation, Income, Capital Appreciation, etc. They will also state what type of assets the fund will buy. Some will invest everything in a single type of investment while others will invest in a mixture. As an investor you will look for a fund that invests in a manner that best fits your personal goals.
Fund Management – Each fund has a designated professional manager who oversees the decisions of the fund. Actively managed funds will have managers and a staff of analysts that are making the investment decisions. Since active fund managers are the brains behind the operation, they are an important piece to consider. Passive funds, such as index funds, may have limited staff and make their investment decisions based on a pre-designed mixtures of investments, such as the S&P 500 index of stocks.
Diversification – It’s not uncommon for a single mutual fund to own more than 100 different investments. If you have several mutual funds in your retirement account, the number of actual holdings will be much higher. Diversification is a big reasons for the popularity of mutual funds since small accounts can also be well diversified.
Fund Expenses – Mutual funds will incur expenses in the process of doing business. These costs can include things like management fees, trading costs, and other operating costs. These expenses are shared by all fund investors and are taken directly out of the fund assets, so you don’t actually see them coming out of your account. Mutual Fund expenses must be disclosed to investors and can range anywhere from a fraction of a percent to a couple of percent per year. The size of the expense ratio will depend on several factors including the amount of staff required to run the fund, the amount of trading being performed and the type of investments being purchased. For example, buying and selling stocks in a small, foreign marketplace will be more expensive than buying and selling stocks in the US. As a rule of thumb, it’s better to be on the lower end of the expense spectrum, but it ultimately comes down to whether the manager is worth more than they cost.
Sales Charges – Some mutual funds are sold by investment professionals and charge an additional fee (commonly called a commission) to compensate this sales force. It can be in the form of a percentage charged to you when you initially make the investment or an additional fund expense paid for the first several years that you are invested in the fund. Other funds are known as “no-load funds” and they do not have a sales charge because they don’t compensate a sales force.
Past Performance – Most people will go straight to past performance numbers to make their investment decisions and this is a common mistake. Past performance illustrates returns that you didn’t and won’t ever earn, unless you owned that fund during that time period. Past returns can help you understand what to expect from a risk perspective, but should never be used as the sole reason to invest in a specific fund. Research shows that investors making decisions based on past returns earn much lower returns than those who don’t.
In a classic example of investors chasing returns, there was a mutual fund that in the 10 years between 2000 and 2009, earned an average annual return of 17.9% in what was a horrible 10 year period for stocks. The most interesting statistic is that the average investor in that fund during those same 10 years had an average return of -10.8% (almost 30% less per year than the fund itself). The reason was that the fund was very volatile during that period of time and investors would buy when it was doing well and then get scared and sell when it was doing poorly. In the end, that emotional buying and selling cost investors a lot of money.
Conclusion
There’s nothing inherently scary about the terms used in the investment world. It often comes down to breaking things apart until you get to the pieces you understand and then building it back up from there. I often hear people say they are scared of investing without a reasonable understanding of what it is they’re even afraid of. In our modern society, we’re going to be confronted with the basic concepts contained in this article, so we might as well try to understand them so we can make informed decisions. It all goes back to stewardship and managing God’s resources. If we’re going to be wise managers, we have to be able to understand our options.
Brad Graber, CFP® has been working with clients on personal financial planning and investment issues since 1996. He invests his time mentoring and educating individuals on ways to be better stewards of the resources God has entrusted to them.
***Disclaimer: The information contained in this article is general in nature, is provided for informational purposes only, and should not be construed as investment advice. I cannot guarantee that all information is accurate, complete, or timely. The information in this article should not be construed as investment advice or a recommendation of any particular investment. Please seek out professional investment advice before investing.