Investing evokes a wide array of mental images. To some it is a complete black box where pretentious people bandy terms like “arbitrage” use words in ways you are pretty sure don’t mean what they think they mean. 1 turns out that “butterfly” option strategy didn’t have anything to do with ornithology. . Whether you have a cursory understanding of how the stock market works or feel like “investing” is code for gambling, my goal here is to provide a quick summary of what it’s about and a few things to watch for.
First of all, investing is essentially spending our money to buy a part of something we hope or expect to be generate value over time. This is a really broad concept and there are many things we can do with our money (some admittedly wiser than others) so let’s start with a quick summary of the key investment types or “asset classes” that are out their vying for your hard earned dollar.
Cash
The first asset class is cash. Whether it is in your wallet, bank account, or mattress 2 This can get lumpy, I don’t recommend it. cash is the easiest to get understand of the asset classes.
Characteristics
- Extremely liquid. Cash can be used directly to pay for just about anything.
- Cash is extremely “safe” in that it’s value is set by the issuing country so typically your cash will still be accepted unless that entire country becomes unable to pay its bills 3 This is actually more common than you’d think in some parts of the world.
- The buying power of cash decreases over time. This is increasingly impactful in times of high inflation where we rapidly find that our cash just doesn’t buy what it used to!
When and Where to Invest in Cash
- Cash does have a place in your portfolio as all of us need some money that we can easily access to pay our bills and handle emergency expenses. I recommend at least $1,000 in an emergency fund kept immediately accessible (expanding to 3-6 months of expenses over time).
- Since cash decreases in buying power over time, look for places to invest where your cash can accrue interest. For this reason, it will typically make sense to limit your cash savings to what you need to pay the bills plus a buffer for emergency expenses.
Fixed Income
With Fixed income investments you are investing your money in exchange for its repayment at a fixed interest rate. The most common type of fixed income investment is bonds. Companies and even countries issue bonds (debt) to pay for their operations with the promise to pay you back with interest. In general, the bigger the risk of them not repaying their debt, the bigger the interest rate they have to pay. Short term, very low risk fixed income investments are available from your bank in the form of certificate of deposits (CDs) and money market accounts.
Characteristics
- Bonds are generally lower risk than stocks. This is because companies are legally responsible to pay their debt before they pay their owners (equity).
- With relatively lower risk comes…lower expected returns. Bonds may be safer, but they have limited upside 4 if the company does really well, they aren’t going to generously pay extra to the people who lent them money!
- The risk of a bond has to do with how likely it is that the issuer won’t be able to pay you. There are companies called “ratings agencies” whose business is evaluating this risk (notable examples include Standard & Poors and Moodys) and reporting it in something called a “credit rating”. Typically a “safe” company (or country) would have an “investment grade” credit rating.
When and where to invest in bonds
- Certificates of deposit, and money market accounts offer liquidity (ability to quickly access your money when needed). These investments are “FDIC Insured” so you still have the comfort that the US government guarantees that you can get your cash out when needed. These can be good options for emergency funds.
- On specific investment that has received recent press is the IBond issued by the US government. This bond is unique in that it guarantees to cover inflation plus a fixed return on top of that (although this is often 0%). There are downsides, however, That in that you won’t be able to get your money out for at least 6 months, can only invest up to $10,000/person/year and will lose the last 3 months of interest when you do take it out if you do so before the first 5 years. If you can manage those restrictions this can be a good place to store your emergency funds and avoid losing your value to inflation.
- Sovereign debt is debt issued by a government. The risk here is whether the country will fail to pay its debt. Typically US debt is considered “risk free” as given the size of the country and the implications of failing to pay it is considered unlikely that you’ll fail to see your money.
- Domestic bonds offer a way to lend to companies in your country while international bonds are issued by companies outside yours. Generally domestic bonds are lower risk as not every other country is as concerned about you getting repaid.
Equities
Equities are owning a piece of a company. When you buy equity you own a piece of the company (or group of companies) with all the rights that come with that ownership (rights to share in distributions of cash and have some voting interest in the board of directors for the company).
Characteristics
- Equity holders are paid after the company pays its debt. This means that equity is a higher risk to you than bonds, but it also means you can expect a higher return. This expectation comes with risk, however. If things go poorly, the value of your ownership interest can deteriorate quickly (dissipating altogether if the company goes bankrupt).
- Equities can take some of the cash generated by their company and issue them to their owners in the form of dividends.
- Other stocks (often called “growth” stocks) take all that money and reinvest it in the company 5 You know…to grow For these growth stocks it is common to pay a price much larger than the current year’s earnings in expectation of future growth.
When and where to Invest in public Equities
- When to invest in equities will depend very much on your individual tolerance for risk. If your time horizon (length of time you plan to invest) is long, equities typically comprise a larger part of your portfolio, as historical market returns have exceeded inflation by about 5% over the long term. For this reason, long term equity investments are one of the most effective ways to build wealth.
- Stocks are perhaps the most well known type of equity. When you buy a stock you own a “share” or small percentage of the company that issued that stock. You can buy stocks through many online brokers.
- Mutual funds are groups of stocks managed by a portfolio manager. They will generally follow a theme (value, growth, industry, company size, etc) allowing you to invest without specifically knowing the companies you are owning.
- Index funds are financial instruments 6An interesting term for it as I think about it as the mental image of an accountant with an oboe really couldn’t be further from the truth. 7Because anecdotal evidence supports my premise that most accountants prefer the keyboard…
Real Assets
Real assets are investments in things you can touch / feel. While this could be anything from real estate to comic books, the most common real asset is a primary residence.
Characteristics
- Real assets are typically less liquid (not as easily traded for cash). It requires more work/expense/expertise to sell a house than to trade a stock.
- Real assets typically recover inflation in the very long term, but individual assets can vary widely. The more obscure the asset, the greater the risk. 8My son’s Pokémon cards may pay for his his retirement, but it could also drop to zero!
- In recent years, it has been increasingly common to find funds that allow you to invest in a portfolio of assets in a class rather than actually buy the asset yourself. For example, you can invest in Fundrise to own a piece of real estate across many investments rather than buying an investment property yourself.
Other asset classes
There are plenty of other asset classes that can be invested in. Typically these are less accessible to casual investors.
- Private equity is the practice of taking an ownership interest in companies that are not publicly traded. An entire industry exists in the business of buying up positions in companies, building them up, and flipping them at a (hopefully) higher price. Not every investment pays off so this industry often counts on a few big winners to cover losses elsewhere. Private equity is relatively illiquid as you can’t easily sell your stake without the entire business being sold. This is harder to invest in as an individual investor.
- Hedge funds seek to generate a disproportional return by exploiting a market inefficiency. Typically a hedge fund will have a premise (eg large banks are undervalued) and come up with creative ways to monetize that. They are also pretty costly to get into, as they require significant expertise to operate. Again, probably not something the typical invidious investor has as a part of their portfolio.
- Cryptocurrency is another recently popular asset class. On its surface, without a government backing it to provide a “guaranteed” value, there is no intrinsic value in crypto, making it especially risky. Crypto’s value is entirely driven by the value attributed to it by its investors, making this a wild ride indeed for the average individual investor. It could well be the next big thing, but you could just as easily lose your shirt. If you choose to invest here in search of the impressive upsides, just be sure you can afford to lose your investment if things go otherwise.
Hopefully this was a helpful introduction into what I’d out there for your consideration.