There are five main investment categories. As a starting investor it’s useful to have at least some degree of knowledge with all five categories. That will make it easier to make sound investments in the future as well as give options to diversify your investment portfolio as much as possible. In a future article I will explain why diversifying investments is a good idea.
In this article I will try to answer three questions for each category:
- What is it?
- What are the risks?
- What is its liquidity? (How quickly can the investments be turned into cash, with little to no loss in value?)
A summary at the end will give a quick overview of all categories and their characteristics.
Cash is any amount of money that is directly usable in hand or on a bank. Money from a savings account might not be directly usable, but is also a form of cash. Cash on bank and savings accounts can give earnings in the form of yearly interest. The risks of keeping cash are low, but so is the rate of return compared to the other investment categories. In some cases the return is so low that it doesn’t even counter yearly inflation. Because cash can normally be used instantly, its liquidity is the best of all investment categories.
With bonds an investor loans money to the bond issuer which can be a corporation or a government. The issuer borrows the invested funds for a certain period of time and the investors receive a yearly interest rate (fixed or variable) over the invested funds. Normally the received interest rate depends on two factors: the duration of the bond and the credit quality of the issuer. The higher the interest received, the higher the risks for the investor. If the financial situation of the bond issuer is bad, than it’s possible the investor will not receive interest or even his invested funds back.
The liquidity of bonds is a little worse than cash. Bonds can be sold during market trading hours. That means invested funds can be converted to cash every weekday.
Stocks (or shares)
With stocks an investor is part-owner of a corporation. Stocks give investors certain rights with the issuing corporation. For instance, if the corporation does well and makes a profit, that profit is usually partly payed to all investors in the form of dividend. Dividend is not a certainty, even if a corporation makes a profit. Its management might decide it’s better to reinvest all earnings, which could be better for shareholders in the long run. Shareholders also get to decide on important topics during shareholder meetings of the corporation.
The risks of stocks are higher than bonds from quality issuers. Unlike bonds there is no direct correlation between risk and reward. A very decent company might go bankrupt and a small company might become the next Apple. Generally, stocks do give a higher rate of return on the long term. Stocks are essential for any active investor.
The liquidity of stocks is the same as bonds, meaning that invested funds can be converted to cash every weekday.
If you are a home owner than you have already invested in real estate. The return on investment can be high given the right times when the property is bought and sold. Renovation can also help to make the initial investment become worth more. The risks are high, also because most people will need a loan to actually be able to buy the property. The loan will account for extra monthly expenses, limiting the amount that can be invested in the other categories. Because it can take years to sell real estate, the liquidity is terrible. Of course it’s also possible to indirectly invest in this category by investing in real estate funds, which do have good liquidity.
This category encompasses every other investment that doesn’t fit in the above four. Alternative investments can be anything from wine, cars, art, stamps, oil, gold and hedge funds. Risks and rewards can be al over the place and are usually dependent on the expertise of the investor with the specific investment. Generally, the liquidity of these investments is bad simply because it’s difficult to find serious buyers for the investment. Just as with real estate though, it’s possible to invest in many alternative investments without headaches by investing in related mutual funds.
|Category||What is it?||Risk/Reward||Liquidity|
|Bonds||Loan to the bond issuer||Low to High||Good|
|Stocks/Shares||Ownership stake in a company||High||Good|
|Real estate||Buildings||Very high||Terrible|
|Alternative investments||Everything else||All over the place||Usually bad|