Understanding The Different Types Of Investments
This chapter focuses on the different types of investments. Understanding your investments is vital to achieving a successful outcome. As such, you’ll be introduced to the different types of investments and products that are out there.
There are a few basic investment choices you’ll want to know about:
- Alternative investments
Now we are going to look at the basic types of investments and how they work.
3.1 Cash Investments
There’s no doubt about it: it’s wonderful to have cash. Although on its own, cash won’t increase in value. On the contrary, as time passes it will actually decrease in value. Think about it. A few decades ago, you could purchase a huge house for $100,000. But you won’t find one that cheap nowadays. Depending on where you live, you’ll be lucky to even find an apartment for that price. The process by which your cash loses its value—and everything seems to cost more—is called inflation.
Inflation, fees, commissions, costs and fun
If you have cash, you have to protect it from inflation. How do you do this? By investing it. You’ll have to make sure that the rate of return you receive on your cash is greater than the inflation rate.
Just keep in mind that you’ll probably have to pay fees, commissions, various costs to invest in almost any circumstances. They will vary from investment to investment and country to country. There will most likely be income tax charged on any interest you earn as well. However, if your tax rate is low and the inflation rate is low, you’ll quite possibly still come out ahead. Isn’t it fun?
The interest rates offered by banks are low. But look carefully and you’ll most likely find building societies, online accounts or postal accounts that offer slightly better rates. The rates offered and the types of opportunities will vary from area to area. However, you’ll probably find that a lot of these accounts offer fixed-rate options assuring you a zero-risk interest rate if you promise to leave your money with them for a certain number of years. This is perfect if you’re approaching retirement age and want to know that the nest egg you’ve already built up will be secure.
If you can’t find any accounts that offer suitable returns? There’s no need to panic. There are plenty of other types of investments.
They used to say that the value of property never goes down. A few people stopped saying this around the time of the 2008 financial crisis. The reality is that property rarely loses value over long periods. It usually increases in value at a rate faster than the inflation rate. And this, of course, is exactly what you want.
There are a few different ways to make an investment in the real estate market. As such, we’ve split real estate into two distinct sections. This makes it easier to understand how each one works and how they benefit you as an investor.
Real estate – Direct investments
Direct investments in real estate are actual properties that you purchase. They may be homes or commercial properties that you rent out. In any case, there are other benefits involved. Why? Because at the end of the day, you don’t need to own stock, bonds or have a hedge fund. You do need a roof over your head. And you’ll have this if you own your own home.
What if you own a property that you rent to someone else? You’ll find yourself in the wonderful position where you use the rent they pay to pay off your property. Not only is your money working for you, your tenant is working for you too! Of course, there are downsides. You’ll have to find the time, motivation and cash required to look after the property and keep it up to the standards it’s legally required to meet to qualify as a rental property. And you’ll have to make sure you have a tenant. Otherwise, you might find you’re paying off the mortgage yourself.
Real Estate Investment Trusts – REITs
With Real Estate Investment Trusts, you don’t invest in a property of your own. Instead, the REIT uses your investment capital to purchase commercial properties. Anything from offices and apartment buildings to hospitals and hotels. In fact, it’s virtually anything that allows them to take tenants in and charge rent. The rent itself usually increases every five years when the rates are renegotiated.
Based on your investment, the REIT will pay you a dividend. This is a percentage of the profit being released to investors. The exact dividend you receive will depend on what percentage of the total investment was made in your name.
You need to look at two different factors in determining the value of a REIT:
1. The values of the different properties it owns.
2. The expected funds it earns from operations. The number here includes everything from rent to real estate depreciation.
REITs vs direct real estate investments
One of the benefits of a REIT over privately purchasing property is that you don’t necessarily have to put down as much capital to buy an interest. This will depend on which REIT you invest in. Another difference? You’re investing your spare cash rather than taking out a mortgage to invest. Nice!
With a REIT, you’re not really involved in the day-to-day management of the properties, you don’t need to spend much time in ensuring it meets required standards. The bad news is that you have to pay fees to the trust to do this. Nonetheless, if you play your cards right, your investment in a REIT will net you a healthy return.
3.3 Bonds. Investment Bonds.
When you invest in a bond, you effectively loan money to someone who promises to pay it back at a certain date in the future. Whoever issues the bond usually agrees to pay a certain amount of interest on this amount, every so often, until the date of maturity.
Bond terms and what they mean
The money you initially invest in the bond is called the principal. It’s also referred to as the face value. You are paid back the principal of a bond on the date of maturity.
The issuer of the bond is the person, organisation or company that sells the bond.
You become the bond holder when you purchase a bond.
Date of maturity
This is one to put down in your agenda: on the date of maturity, you’re paid back the principal (the amount of money you initially invested in the bond). The date of maturity is also called the redemption date.
When you purchase a bond, you receive interest on it. This interest payment is called a coupon. You’ll typically receive coupon payments once or twice a year, but it will depend on the specifications of the bond. The amount you receive depends on the yield.
This is the interest that you receive on the bond that is paid out in the coupon. The yield is also known as the coupon rate.
You are the bond holder of a bond with a principal of $1,000 and a 5% yield. The date of maturity is three years from the date you purchased the bond. Every year, you receive a coupon of $50. On the date of maturity the bond matures, so as well as the third $50 coupon, the bond issuer also pays you the $1,000 >principal you originally invested.
There are different types of bonds. Most are issued by government agencies or large companies. And those folks are typically pretty reliable about paying back the money they owe. As such, bonds are usually considered to have very little risk associated with them.
The government issues a bond with a 7% interest rate. (We really wanted to write 007% interest rate, but we had already done that joke.) The interest is paid every year for five years, at which point the bond matures and your contract concludes. You pay £1000 for the bond.
After one year, you can collect your 7% interest: £70. You do the same for the next three years as well. At the end of the fifth year—the date of maturity—you collect your final £70 in interest and your original £1000 investment.
All in all? You’ve earned £350 by basically doing nothing!
Bonds and fees
Does this sound simple? Great! But don’t rush off to purchase bonds just yet. There are fees involved with bonds. There may even be hidden fees. You’ll also want to take a close look at the interest rates being offered. Are they fixed? Or are they likely to fluctuate? What about inflation? When everything is factored in, will you still come out ahead?
A fixed-rate bond pays interest at the same rate for the entire term of the bond. The advantage? As the bond holder, you’ll know exactly how much money you’ll have coming in.
A floating-rate note, floating-rate bond or quite unfortunately, a floater usually has its interest rate tied to a benchmark like the federal fund rate, a money market reference rate or, in this super-simplified example, the LIBOR: the London Interbank Offer Rate.
The LIBOR is calculated based on the interest rate London Banks offer on deposits made by other banks in the Eurodollars market … It goes up and down and is fairly random. Now, let’s say the LIBOR rate is at 5%. You think it will increase to 6%. The fixed rate for a bond is 5%. You’re better investing in a floating rate bond, but only if the LIBOR rate manages to reach the 6% mark. If it drops to 4%, you’ll miss out.
You might find a bond with relatively high-interest rates. But this probably means that the company or government issuing it has a higher likelihood of defaulting. In the event of a default, you’re probably not going to be paid back the money you invested.
Buying, trading and selling bonds
You’re able to buy bonds when they’re issued. You’re also able to trade bonds. They might trade at prices above or below the price you initially paid for them. This means you could potentially profit in the short term.
There’s another potential benefit here too. You might decide that you need the capital you originally invested in the bond. By trading or selling the bond, you’re able to reacquire this initial capital.
Of course, if the bond issuer is rumoured to be having difficulties, you may have trouble selling your bond. That doesn’t sound so bad in theory. But suppose you had 100 bonds, each worth £1,000. It would sound pretty bad then.
When you buy shares in a company, you’re actually buying a part of that company. You become a shareholder. As a shareholder, you’re likely to have a right to decide on the direction the company is to take in the future. In most cases, this means you’re eligible to attend the General Meeting for the company where you’ll be allowed to vote in certain elections.
What’s the difference between shares and stock? There’s a slight linguistic difference. You’ll typically say you own stock or shares in a specific company. But you wouldn’t talk about owning shares in general. You would talk about owning stock in general.
How do shares and returns work?
There’s a simple reason why so many investors invest in stock and shares: the expected returns. Exactly how do these returns work?
Basically, a company makes its shares available for purchase. Investors buy these shares. The company then uses the money it receives from these investors to expand or pursue certain projects that, it hopes, will bring in greater profits. If it does make a profit? There are two ways that investors benefit. One is in the dividends that are paid out. The other is by selling their shares at higher share prices.
Meet Bob. Bob is an investor in Lazy Name Co. Bob bought 1,000 shares for £1.00 per share. This means Bob is a shareholder.
It’s a good year for Lazy Name Co. They make a huge profit. They decide to pay this profit out as dividends. Each share will earn a dividend of £0.50. Bob has 1,000 shares. This means Bob receives £500 in dividends.
Because Lazy Name Co. has performed so exceptionally well, Bob’s friend Rob wants to buy shares. After all, he expects to make a handsome return on the shares. Bob decides to sell 500 shares. Rob buys them. But instead of paying £1.00 per share, he pays £2.00 per share. This means Bob receives an extra £500 in profits on his shares.
As such, you gain a profit from the dividends paid out to you and you gain a profit from the higher share price. The returns you receive are higher than you would receive from cash, property or bonds. But the risk is higher too. This means there’s a good chance that something will go wrong …
A year later, the huge success of Lazy Name Co. has resulted in the establishment of plenty of similar businesses. Lazy Name Co. doesn’t realise a profit this year. In fact, they suffer a huge loss. They do not pay out any dividends.
Bob decides to sell his shares. But they are no longer selling at £2.00 per share. The shares sell for just £0.50 each.
Rob originally invested £1,000. After he has sold his shares, he has just £250. In other words? Rob suffered a loss of £750.
Bob originally invested £1,000. This turned a dividend profit of £10,000 after the first year. The sale of half his stock retuned £500 of his original investment, plus £500 in profits from the higher share price. Now Bob has £11,000 in his pocket, plus 500 shares in Lazy Name Co.
Why invest in a fund?
Would it be wise to invest in just one company? What would happen if the value of the shares in that company dropped? Your capital would plummet at the same speed.
Let’s say your capital is divided between ten investments. One of these crashes and burns. You lose what you had in that investment. But you don’t lose everything. You still have the capital from the nine other investments. And you still benefit from any returns these remaining investments make. Better yet? Spread your investment across more than ten different investment companies. It reduces the risk of default even further.
Of course, it’s going to take plenty of time for you to research and decide on which companies you would like to invest in. And even more time to ensure there are no big threats to these companies on the horizon. This is why you might like to invest in a fund. A fund takes investment capital from you and any number of other investors and uses it to purchase shares in a variety of companies. Perfect! But which type of fund is the best type to invest in?
You’ll find banks promote mutual funds quite a lot. They will tell you that a mutual fund will try to beat the returns offered by a specific market. What does this mean?
There are different markets. A market could relate to a specific product or industry. It could relate to a specific country or region. And the failures and successes of this industry are measured with what is known as an index. When a mutual fund tries to beat a market, it’s trying to achieve returns that are better than those recorded in the index.
There are a few indexes you’ll want to know about. They include:
- The S&P500: The 500 largest companies in the US.
- Dow Jones: The 30 largest companies in the US.
- Nasdaq Composite: 4,000+ companies from the US. Most of them are in technology.
- DAX: The 30 largest companies in Germany.
- FTSE 100: The 100 largest companies in the UK.
- Euro Stoxx 50: The 50 largest companies in the Eurozone.
- CAC 40: The 40 largest companies in France.
- Nikkei 225: The 225 largest companies in Japan.
- Hang Seng: The 40 largest companies in Hong Kong.
- Shanghai SE Composite: All the companies traded on the Shanghai Stock Exchange.
- BEL 20: The 20 largest companies in Belgium.
- SMI 20: The 20 largest companies in Switzerland.
The person responsible for achieving these market-beating returns in the asset manager. It’s the asset manager’s responsibility to keep an eye on everything the fund is investing in as well as any other potentially interesting investments. It means you’re not really involved. But this isn’t a problem unless you wanted to have a personal say in what happens to the money you’re investing.
The asset manager spends a lot of time researching different possibilities and moving investments around in an attempt to achieve the best returns possible. This theoretically makes your money grow more quickly. You move away from any investment before it heads into a downward slump. Instead, you jump aboard those other investments that are doing especially well and realising huge gains. It sounds pretty good. But unfortunately, these human-directed mutual funds tend not to beat the market. And when they do, there are massive costs involved; every market exchange has fees attached, you also need to pay commissions and other costs that are minimised with other investments.
Exchange Traded Funds
You’ve probably realised it costs a lot to have an asset manager assessing, re-assessing and buying in and out of the different assets in a mutual fund every day. You might even wonder whether it’s necessary. Or whether there’s an alternative approach. Like the one taken by ETFs: Exchange Traded Funds.
ETFs don’t try to beat the market. Instead, they use computers and algorithms to replicate the index. This might sound like ETFs replace human asset managers with computers. And that’s certainly part of the story. But there’s another difference in how the search is performed.
An asset manager looks for investments that will result in better returns than the market index. This doesn’t just mean looking for rises in value, but also selling stock to avoid short-term downturns.
If asset managers want to beat the market, they need to know how well the market is performing. This is shown by indexes.
First of all, it’s important to know what a market is. It can be the particular companies and/or financial institutions for a country, an industry, a specific group of commodities or anything in between.
If one company in a market is performing well, it doesn’t mean the entire market is. This is why a more representative sample needs to be used to calculate the performance of the market. As such, a sample may include companies that are performing particularly well, as well as those that aren’t recording the best figures, as well as any number of other companies from the same market. From their performance, the general performance of the market is calculated.
This is called an index.
There is more to indexes than this. But try to take this on board for now. We will take another look in more detail in Chapter 6 about choosing your investment style.
An ETF doesn’t do this. It analyses actual market performance based on long-term results—or indexes—and makes its investments from these results. The long-term approach means the downturns are taken in stride, with confidence that the market will bounce back.
Here’s the cool thing: the ETF still earns about 60-80% of what an actively managed fund earns … It isn’t as much. But it turns out to be more when you bring costs into the equation. Asset managers charge sky-high fees to outsmart the market. With an ETF, you pay considerably less. In the long-term, you’ll almost always come out ahead with an ETF.
Exactly how much are these ETF fees? There’s a wide variety depending on the ETF itself; there are ETFs for almost every region, country, industry and class of asset. In fact, if there’s a specific market you would like to invest in, you’ll find an ETF for it. But the more specific your ETF comes, the higher the prices climb.
An index fund is a mutual fund that tries to track the performance of an index such as the S&P500. It’s not actively managed and has very low operating costs. When you invest in an index fund, you don’t have to spend endless hours researching and analysing stocks. In these respects, an index fund is exactly like an ETF. The difference is that an ETF is traded on the stock exchange and an index fund isn’t.
3.6 Alternative Investments
There are plenty of alternative investments. Here is a quick run-down of a few of them:
You could look at derivatives as being a type of contract. They derive their value from the value of underlying entities. These underlying entities could be stocks, indexes or even interest rates. The derivative is a kind of contract that pays based on the way the underlying entity behaves. The behaviour could relate to the way the value of a derivative changes, the speed at which it changes, the value it reaches or any of a million other factors.
This is probably a touch vague and complicated at the moment. Which is why it’s best to think about sport. The people who play it are actively involved. There are also bookies, advertisers, coaches, team doctors, merchandisers, etc. They don’t play the sport, but the results of a single match, the performance of a specific team or the success of a single player will have a major influence on their livelihoods. In other words? Their livelihoods are derived from the sport.
You have a similar situation with financial derivatives. The derivatives are a step removed from an underlying asset. What happens to the underlying asset influences the derivative.
Bob invests £1,000 to buy 1,000 shares in Lazy Name Co. The shares cost £1.00 each.
Bob is worried the market will crash next year and decides to limit his risk with an option. He pays the bank £0.03 per share to have the option of selling the shares at £0.90 each at any time within the next year.
It turns out Bob was pretty clever. The market does crash. And the value of Lazy Name Co. shared plummets to just £0.65 per share. Bob calls the bank and makes the most of his right to sell at shares at £0.90.
Bob still makes a loss. But if he hadn’t taken out the option? The loss would have been much worse.
The exact way in which the derivative will work depends on the stipulations within the contract. You might have a stipulation that if the share price for a specific asset reaches a certain price, you’ll be allowed to purchase a specific number of shares at that price. If the price isn’t reached, you’ll lose the money you paid for the derivative.
They are more popular in different countries around the world. There is often a stigma attached to them; because of the potential for loss, it’s usually only the more established investors who invest in them. However, the risk attached to a derivative depends on the way in which it’s used.
There are three main types of derivatives:
Options allow you to buy or sell an asset at a pre-determined price. You have to do this within a specific time frame. This means that if your asset doesn’t reach the pre-determined price within the specific time frame, your option is worthless and you’ll lose whatever you paid for the option. (You won’t lose your investment in the actual asset if you had one.)
The benefit of options is in knowing that you’ll be able to buy an option at a pre-determined price, or that you will always receive a certain pre-determined price if you sell. This is what Bob did. And by doing this, Bob was able to reduce loss.
There are plenty of different types of futures. But in general, futures work much the same way as options. However, with an option, you have the choice of making the buy or sell detailed in the contract at the pre-determined price. You don’t have a choice with a future. At the date of expiration of a future, you’re obliged to make the purchase or sale.
Swaps are traded on the stock exchange. They’re more like customised contracts that are traded over the counter between two parties. This means there’s a high risk of the person you’re swapping with defaulting. When you make a swap, you make a deal with another party. In this deal, you agree to pay the other party a predetermined, fixed rate of interest on a set notional principal on specific dates and for a specific amount of time. At the same time, the other party agrees to pay you payments on the same notional principal. As the actual principal never changes hands, it’s called a notional principal.
Company ABC and Company XYZ enter into a five-year swap on 31 December 2012.
- Company ABC pays 7% interest every year on a notional principal of £500,000.
- Company XYZ pays Company A an amount equal to one-year LIBOR + 1% per year on a notional principal of £500,000.
LIBOR is the London Interbank Offer Rate, or in other words, an interest rate offered by London Banks. It goes up and down all the time.
On 31 December 2013, ABC pays XYZ:
- 7% of £500,000 = £35,000
and XYZ pays ABC:
- 5% (the LIBOR rate) of £500,000 = £25,000
- 1% of £500,000 = £5,000.
The total XYZ pays ABC is £30,000. As ABC owes B £35,000, both companies will most likely take the sensible, easy path. ABC will simply pay XYZ the balance of £5,000.
The two companies keep doing this every year for five years, although the 5% LIBOR could climb or drop, affecting the annual payments.
A venture is basically a start-up company. It’s not possible for you to invest in a venture capital as a regular individual investor. You need to do this through a venture capital fund or through a crowdfunding platform. Before you decide to invest, do your homework and make sure your investment will go to a company with great potential. After all, you’re basically purchasing a stake in the ownership of the company. If the company succeeds and starts recording profits, you’ll share in any dividends that are paid out. If the start-up fails? Your investment will disappear with it. There’s usually a very high level of risk associated with venture capital investments.
Although a hedge fund is a type of fund, we decided to include it as an alternative investment rather than as a fund. Why? Because hedge funds have a terrible reputation. People blame hedge funds for everything. If a currency collapses? It’s the fault of a hedge fund. Bank goes bankrupt? A hedge fund is behind it. Late to work on Monday morning? You might be able to blame this on a hedge fund too.
Realistically, hedge funds are not likely to be responsible for all these issues. Why do people see fit to blame them? It’s because hedge funds are often unregulated. They don’t have to follow the rules that apply to other funds. And this is made worse with so many hedge funds being based offshore, allowing them to be secretive about what they’re doing.
When you invest in a hedge fund, you provide capital to a hedge fund manager. The hedge fund manager has a lot of freedom in the ways this capital is invested. They aren’t limited to investing in equities and bonds. They are allowed to put capital into derivatives, currencies and shorts (investments where they basically bet on a certain kind of investment failing, with big payouts if it meets certain parameters when it fails). They have a high level of risk and a very high rate of failure. But when they do pay off? They pay off with impressively high returns.
There are times when companies or organisations want investment money, but don’t want to sell shares in the company. In these instances, they may privately offer the purchase of debt placements. Basically, these are very similar to bonds. Your investment capital is paid back in full, on the date of maturity and with the relative interest attached. The interest rate is most likely higher than with a bond. But there’s perhaps a touch more risk. Because there’s a higher chance that the company with which you place a private-debt placement will default or go bankrupt. The good news? Your debt placement is paid out before shareholders receive anything. This means that you have more risk than with a bond, but less risk than with shares. Of course, if the company stock increases exponentially, as a debt-placement holder, you’ll still only receive back your initial investment and the interest originally agreed upon.
The next step
Each of these different types of investments has a level of risk associated with it. In the next chapter about choosing your investment style, we look at how the risks, returns and time work together to help you decide the type of investment that will best put you on the path to achieving your investment objectives.
3.7 Additional Reading
This guide is for educational purposes only, and should not be seen as financial advice.
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