As an intelligent investor, it’s important to command a working knowledge of investment vehicles as the foundation of decision making. Various investments have their pros and cons, and gaining a familiarity with the resulting situational advantages will help you navigate your investments with confidence.
What is an Investment Vehicle?
An investment vehicle is simply a way for an individual to invest their money. It’s essential to have an understanding of these vehicles for those looking to allocate their own finances. Each option varies in risk, and many different types are included in a diversified portfolio.
A general trend that overarches all investment vehicles is the correlated relationship of risk and return. Simply put, the higher the risk, the higher the returns. However, this is not true across the board. For instance, some lower-risk investments have historically carried higher returns, while many high-risk investments never provide returns at all due to default.
Logically, adhering to this principle makes sense. As an investor, you want to balance your returns with your risk – many times, it’s unwise to invest in a vehicle that yields lower profits when another available investment with higher returns carried the same risk.
Investment vehicles exist even outside the finance industry. In short, anything you can purchase and sell for a profit presents an opportunity for financial gain. Some types of investments stray far from the conversations of stocks and bonds. For example, real estate, rare cars, and fine art can all be considered “investment vehicles” in their own rights.
However, for the purposes of this article, we will focus on providing an overview of the investment vehicles that pertain directly to the world of finance.
Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. This article is not investment advice. Always consider your personal situation – and the help of a licensed financial professional – when making any investment decisions.
Money Market Securities
Money market securities are investments that provide investors with higher levels of yield (interest) than a checking or savings account while still offering the same level of principal protection as outright cash.
Most money market investments are actually short-term fixed income (bond) investments. Typically, investments that fall under the money market umbrella have a term of one year or less.
Like other types of debt securities, the term of the loan influences the yield on money market investments. In other words, the longer the term, the higher the yield. Furthermore, money market yields are highly sensitive to short-term interest rates.
Classic examples of money market securities include:
- Treasury Bills
- Certificates of Deposit (CDs)
- Commercial Papers
- Bankers Acceptances
- Repurchase Agreements
The point of cash in a portfolio is not to provide investors with high returns. Instead, you should view cash as a tool to acquire investment assets or provide you with liquidity.
Money market investments can serve as a handy tool for individual investors looking to squeeze out a little bit of extra yield from their cash positions while protecting their principal from the volatility of the capital markets.
Bonds are IOU investments between the issuer and the bondholder. The bondholder, or investor, agrees to lend money to the issuer which is typically a government body or corporation. The money on loan goes toward operating and funding various projects. In return, the issuer agrees to pay back the bondholder on a specified date (with interest).
Due to the underlying guarantees, investing in bonds is generally viewed as less risky than investing in equities (stocks). Another crucial difference is that stocks do not agree to any financial reimbursement. As a result, bonds tend to provide lower rates of return.
While fixed income does not yield the highest returns compared to its sexier, more volatile counterpart (equities), the asset class still has potential to add considerable value to a portfolio.
Bonds are issued by federal, state and local governments, agencies of the government, and corporations. There are three basic types of bonds: U.S. Treasury securities, municipal bonds, and corporate bonds.
Treasury Securities (“Treasuries”)
Bonds issued by the government are typically called “treasuries” and are the highest-quality securities available. These securities are issued through the U.S. Department of the Treasury through the Bureau of Public Debt.
One advantage to treasuries is that interest payments are exempt from state and local taxes. Furthermore, because the U.S. government backs treasures, there is a lower risk of default.
Treasury bonds, bills, and notes are differentiated by their respected terms to maturity. Bills mature in less than a year, notes from 1-10 years, and bonds from 10-30 years.
Municipal Bonds (“Munis”)
Municipal bonds are issued by state and local governments with the purpose of funding public projects such as schools and roads.
Munis may offer more competitive rates than treasuries because local governments can default by going bankrupt. An advantage to this type of bond is that they tend to be exempt from federal income tax.
In addition to government bodies, corporations can also issue bonds of their own. These corporate bonds are often used to fund large capital investments.
Corporate bonds tend to carry higher levels of risk than the previously mentioned investments. This elevated risk is associated with higher rates of return – but in investing, there are no guarantee. Simply stated, the risk of an individual corporation defaulting due to bankruptcy is higher than that of the federal government.
The risk and value associated with corporate bonds depend on the reputation and financial outlook of the company issuing the bond. For example, bonds issued by companies with low credit rating are often called “junk bonds.” These bonds may yield higher interest rates because of their higher levels of risk.
When it comes to funds, there are two primary investment vehicles that are the most common among investors: ETFs and mutual funds.
A mutual fund is an investment that pools together the money of thousands of investors, thereby lowering the risk for each individual. That money is managed by a fund manager according to a set, specific strategy.
As an investor in the mutual fund, you own shares of the fund, just like you would own shares of stock in a publicly traded company. The value of the shares tends to fluctuate with the performance of the underlying investments owned by the mutual fund. If the fund manager selects investments that perform well, the value of your shares will increase, and vice-versa. Other factors like supply and demand may play a role as well.
Mutual funds have historically provided investors with several benefits such as:
- Professional management
- Strategic Investing (i.e income, capital appreciation, etc.)
However, many investors are wary of primarily relying on mutual funds due to the fact that they are not in control of the way the fund’s assets are managed. Depending on the manager’s history, this can raise or lower the investment risk. Also, mutual funds have been known to carry higher fees compared to ETFs and owning individual stocks.
Exchange Traded Funds (ETFs)
The meaning of an ETF is simply found by understanding the acronym. An Exchange Traded Fund (ETF) is a fund that you can purchase on an exchange which tends to mirror the performance of a particular sector, asset class, country, etc.
These funds trade similar to stocks. Like other types of funds, ETFs pool together money from different investors to form a group of investments.
How Do ETFs Work?
- An ETF provider creates a grouping of assets with a unique ticker (could be any combination of stocks, bonds, commodities or currencies).
- Investors are able to purchase shares of that group of assets (just like buying stocks)
- Buyers and sellers trade the ETF just like a stock
Some common types of ETF’s include:
- Stock ETFs
- Commodity ETFs
- Bond ETFs
- Sector ETFs
- International ETFs
By spreading the fund’s money into different securities, ETFs can generally provide investors with diversification to help balance risk. They provide the ease of stock trading combined with the diversification benefits of mutual funds.
Simply put, a stock is a financial security that represents ownership in a corporation. Stocks are measured in units called shares. Owning these shares is what entitles the shareholder to a proportional allotment of the company’s profits.
Stocks primarily trade on exchanges, but there are other ways to buy and sell these securities, as well. For instance, some corporations sell stocks in private transactions. Others may offer stock to its employees in a compensation or benefits package.
Common Stock vs. Preferred Stock
Common stock is typically what comes to mind when an average person thinks of stocks. Owning common stock means that you own a share in the company’s profits and have voting rights. Common stock owners may earn dividends; however, dividends are not guaranteed.
Preferred stocks are more similar to bonds. This is because the issuing companies guarantee shareholders fixed dividends. Preferred stock prices are less volatile than common stock prices meaning that they are less sensitive to rises and drops in value. Preferred stock is advantageous to an investor looking for stable income over long-term growth.
Stocks are an essential piece in every investor’s portfolio, but how you invest in them depends on your age, your current situation, and your financial plan. Having a basic understanding of what a stock is, is the best place to start.
A Final Word on Investment Vehicles
There are several types of investment vehicles out there, each with its own pros and cons. Understanding how each acts on its own and in relation to the others is the key to building a diversified portfolio tailored to your specific needs.