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. Furthermore, by learning more about the types of investments available to you, you increase your financial IQ – which means bettering your prospects and your future in one fell swoop.
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 a diversified portfolio typically consists of many different types.
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. On the other hand, 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.
Certificates of Deposit (CD’s)
A certificate of deposit, or CD, is a bank-offered product where the investor/lender deposits money into an account with a fixed date of withdrawal and a fixed interest rate. CD’s generally pay higher interest rates than regular savings accounts because lenders can’t remove their money until the maturity date. (Without a penalty, anyway).
A certificate of deposit may be a good investment for those who want the safety of a savings account and won’t need access to the invested funds for a set amount of time. Compared to bonds and stocks, CD’s are a more conservative investment because they offer a lower opportunity for growth but have a guaranteed, federally-insured rate of return.
A no-penalty CD is a certificate of deposit that comes with more freedom. As the name indicates, no-penalty CD’s don’t have early withdrawal penalties. These act similar to savings accounts with one notable difference: no-penalty CD’s carry fixed interest rates. However, the interest rates of savings accounts can fluctuate with federal interest rates.
The longer the term length of the CD, the higher the interest rate you will earn. Many CD’s with terms over 12 months have higher rates of return than the best savings accounts.
All CD’s come with a fixed term and rate of return, but there are still a variety of options to choose from depending on the issuing institution. It’s worth shopping around for the best deals from various types of banks. Generally, online banks and credit unions generally offer better rates than traditional brick and mortar institutions.
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.
Federal, state, and local governments, agencies of the government, and corporations all issue bonds for various purposes. There are three basic types of bonds: U.S. Treasury securities, municipal bonds, and corporate bonds.
Treasury Securities (“Treasuries”)
Government-issued bonds are typically called “treasuries” and are the highest-quality securities available. The U.S. Department of the Treasury through the Bureau of Public Debt issues these securities to the public.
One advantage of 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”)
State and local governments issue municipal bonds 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. The money from these corporate bonds often 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 guarantees. 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 asset management within the fund. Depending on the manager’s history, this can raise or lower the investment risk. Also, mutual funds may carry higher fees compared to ETFs and individual stocks.
A hedge fund is an investment only available to accredited investors. These individuals or entities are high net-worth individuals or organizations who are presumed to understand the unique risks associated with a less-regulated investment style.
Hedge funds operate by pooling money from a limited number of partners (investors). A professional fund manager then handles the funds and determines investment strategies.
Investors refer to these as “hedge funds” because originally they held both long and short stocks to ensure returns even during periods of market fluctuation. Nowadays, hedge funds invest via many varying strategies, and the name just stuck.
Both mutual funds and hedge funds are professionally managed portfolios, which means an individual or firm takes care of actually moving and investing the money. These pooled funds both achieve returns through diversification. However, hedge funds typically assume higher-risk positions, with the managers adopting more aggressive strategies than in mutual funds.
Additionally, where mutual funds basically stick to stocks and bonds, a hedge fund can invest in almost any security. Hedge funds are really only bound to keeping true to their underlying mandate – the strategy and risk parameters the fund informs investors it will follow.
Furthermore, mutual funds are subject to stringent regulation because they manage a large amount of the public’s money. As a rule, mutual funds are held more accountable for their risks. Because hedge funds are not regulated as heavily as mutual funds or traditional financial advisors, however, they are only offered to those officially recognized as intelligent investors.
Modern Hedge Fund Strategies
There are several different ways a hedge fund manager may invest the funds under their care. Each of these is designed to generate returns from different sources or through varying techniques. Some of these strategies include:
- Long/Short Equity: Investment research leads to decisions of expected winning and losing companies. These hedge funds then take long and short positions on these companies. The combined portfolio reduces market risk by having short positions offset the long.
- Global Macro: These funds analyze how macroeconomic trends will affect interest rates, commodities, equities, and/or currencies around the world and take positions on asset classes they believe will be most sensitive.
- Quantitative: These funds use technology to make trading decisions based on understanding patterns using mathematical modeling, statistical modeling, and machine learning techniques.
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.
Real Estate Investment Trusts (REIT’s)
A real estate investment trust is a company that owns and operates income-producing real estate and properties. In most cases, you can own shares of an REIT, just like you can own shares of a publicly traded company. Because the majority of REITs are publicly traded on exchanges, they are much more liquid than traditional real estate, which can take longer to sell.
There are different classifications of REITs from which you can choose as an investor. Some REITs specialize in specific types of properties, such as:
- Commercial properties
- Industrial complexes
- Healthcare facilities
As a shareholder of an REIT, you can participate in the appreciation of value of the property owned by the trust. Just as shares of stock become more valuable as a company increases in value, so, too, do shares of REITs. The fundamental difference between the two is that REIT investors hold shares in a trust that owns and manages real estate properties. Stock investors, on the other hand, own shares of ownership in a public company.
Growth in REIT earnings typically depends on higher revenues, lower costs, and new business opportunities. The most immediate sources of revenue growth for real estate are higher rates of building occupancy and increased rents.
While REITs are more liquid as a rule, publicly-traded REITs don’t offer some of the benefits of traditional real estate. Chief among these are the tax benefits that follow property depreciation and the ability to leverage your property against purchasing more property. On the other hand, investors don’t need to deal with tenants or the many major operational decisions involved with traditional real estate.
In the world of investing, a derivative is a security that derives its value based on another investment’s price movements (hence the name). The derivatives world is large and complex, which makes research incredibly important.
Options contracts are an example of such investments. Most likely, you’ve heard the term (even if you don’t know what it means) in the form of “stock options.”
In essence, an option is a financial contract that gives the owner the right, but not the obligation, to buy or sell X investment at Y price. The sale price is known as the strike price.
There are two basic types of options contract:
- Call options give the owner the right to buy at the strike price.
- Put options give the owner the right to sell at the strike price.
Each contract that an investor purchases grants them the right to trade 100 shares at the strike price. For example, if you purchase 2 stock option contracts, you can trade 200 shares of the equity at the strike price.
There are options contracts for almost every type of security, including:
Depending on your financial goals, you can use an option to hedge against loss, guarantee a gain, or create income. Some investors use them to speculate on investment prices. Whatever you do, be sure to do plenty of research before you invest so you understand what you’re getting into before you throw real money into your investments.
Futures, or future contracts, are another type of financial derivate. These function similarly to an options contract in that a buyer or seller enters an agreement to trade a specific security at a set price. However, futures have a couple of important distinctions from options.
With a future, the investor agrees to buy or sell the asset at a set price and by a set time, known as the expiration date. This date is agreed upon when the investor enters the contract. After the agreement is settled, investors often identify their futures by the month of expiration – an October stock future expires in October, and so on.
Furthermore, when the expiration date comes, the buyer or seller must trade their future according to the terms of the contract. This is the main disinction between a future and an option, as the contract details obligation over possibility.
Eligible futures investments include:
- Commodities such as gas, oil, and even farm produce
- Stock index futures
- Treasury bonds
All of these futures trade on a designated futures exchange. Investors look to these investments when they want to trade speculation or hedge against potential losses.
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.