4 types of Investments

Definition of an investment

There are many definitions of an investment but the majority fixate on investing money to make money, whether that be in the form of capital appreciation or through generating income. The end goal is to create more money than began with. To understand these types of investments we first have to understand what an investment is.

For example, we can take definitions from Investopedia, Cambridge, Oxford and Merriam-Webster dictionaries as follows.

Investopedia:

An investment is an asset or item acquired to generate income or appreciation. Appreciation refers to an increase in the value of an asset over time. When an individual purchase a good as an investment, the intent is not to consume the good but rather to use it in the future to create wealth. An investment always concerns the outlay of some asset today—time, money, or effort—in hopes of a greater payoff in the future than what was originally put in.

Cambridge:

the act of putting money, effort, time, etc. into something to make a profit or get an advantage, or the money, effort, time, etc.

-Advertisement-

Oxford:

The act of investing money in something.

Merriam Webster:

The outlay of money is usually for income or profit: capital outlay also: the sum invested or the property purchased.

When we talk about a portfolio the term refers to your particular asset collection. This collection which we call a portfolio can include the following types of securities:

  • Stocks
  • Bonds
  • Exchange Traded Funds – ETFs
  • Funds
  • REITs

Individual stocks

Stocks are securities that represent an ownership share in a company.

For companies, issuing stock is a way to raise money to grow and invest in their business. For investors, stocks are a way to grow their money and outpace inflation over time.

When you own stock in a company, you become a shareholder and you share in the company’s profits.

A public company sells their stock through the stock market exchange, for example, the LSE or the Nasdaq. In these markets, investors can buy and sell the shares among themselves through a broker. Trading these stocks through an exchange can track the supply and demand of each company’s stock, this will have a direct effect on the stock’s share price.

Stock prices fluctuate throughout the day, but investors who own stock hope that over time, the stock will increase in value. 

This comes with risk as not every company or stock does increase in value and some can lose value or go out of business completely, this is described as market risk, one of the many types of risks of investing.

Types of investments building a portfolio

-Advertisement-

There are 7 variations of stocks with each having different characteristics.

  • Blue chip

Blue chip stocks are shares in large, stable companies that are continually profitable. They normally have slow growth but their earnings are extremely dependable. The characteristics of these stocks are they are normally expensive but provide relatively low risk and have an established track record of earnings.

  • Speculative

Speculative stocks are normally startup companies with little financial history. These companies often develop new and untested products or explore untapped markets. These types of stocks carry high risk as many companies don’t succeed but there is the potential for a large gain.

  • Growth

Growth stocks are issued by companies which are expected to have high earnings. Though these earnings are reinvested back into the company for future development. You will find these stocks normally pay little to no dividend.

  • Value

Value stocks are viewed by an investor to be undervalued in the current market, but investors see potential. This is normally where the assets which the company holds are worth more than the stock price. This is where investors believe the company’s share price is at bargain levels and will become more valuable in the future.

  • Income

Income stocks are often blue chip stocks which are well-established companies. These stocks normally pay a high dividend, this may include the majority of their earnings at times. These are normally the least volatile class of stocks and provide investors with consistently growing income. The typical industries are energy, finance, utilities and natural resources.

  • Penny

Penny stocks are low prices with high risk. In the American market, they trade for no more than $5 a share. This type of stock is normally issued by small startups that need money. If the company does well, the stock price can increase dramatically. But most of these types of stocks fail to thrive.

  • Cyclical 

Cyclical stocks are dependent on the health of the economy. During strong economic times, these stocks flourish. During tough economic times, they lose a substantial amount of value. The typical industries are an airline, electronics and car manufacturing. 

Bonds

A bond is a fixed income instrument, this could be viewed as an I.O.U between the lender and borrower.

Bonds are usually used by companies, municipalities and governments to finance projects and operations.

Unlike stocks, bonds don’t represent ownership of a company, but they are a loan from the buyer to the issuer of the debt.

Bond details include an end date when the principal of the loan is due to be paid to the bond owner. The band usually includes terms of a variable or fixed interest payments made by the borrower.

The characteristics of bonds

  • Face value

Face value is the money amount the bond will be worth at maturity. 

  • Coupon rate

A coupon rate is the rate of interest the bond issuer will pay on the face value of the bond. This is expressed as a percentage. For example, a 5% coupon rate means that the bondholder will receive 5% X £1000 face value = £50 a year.

  • Coupon dates

A coupon date is a date at which the bond issuer will make interest payments. These can be made at any interval but the standard is semi-annual.

  • Maturity date

The maturity date is the date on which the bond will mature and the bond issuer will pay the bond holder the face value of the bond.

  • Issue price

The issue price is the price which the bond issuer originally sold the bond for.

Corporate bonds

These corporate bonds are issued by companies. Companies can issue bonds rather than seek bank loans for financing their debts. The reasons could be the bond market offers more favourable terms and lower interest rates than banks. You will find these can offer a higher coupon rate than government bonds. The higher the coupon rate find normally riskier the company is.

Government bonds

You can find most governments offer bonds to service the country’s debts. These types of bonds are viewed normally safer than corporate bonds but will vary from country to country. The United States issue U.S. Treasury bonds, otherly known as T-bills. The UK government issues bonds called Gilts.

Bonds can have a varying maturity dates depending on the issuer and can vary from 1 year to no maturity period. There are 4 categories of bond maturities:

Short-term (Bills): maturities between zero and one year.

Medium-term (Notes): maturities between one and ten years.

Long-term (Bonds): maturities between ten and thirty years.

Perpetual: no maturity period.

Bond contract

ETFs & mutual funds

An ETF is short for Exchange Traded Fund, you can find these alongside stocks in the stock market and is traded just like a stock. The price of an ETF’s share will change throughout the trading day as the shares are sold and bought on the market. This is much different from mutual funds which are not traded on an exchange and trades only happen once per day after market close. ETFs tend to be more cost-effective and more liquid when compared to mutual funds.

ETFS

An ETF is a type of fund that holds multiple underlying assets, rather than only one like a stock. Because an ETF has multiple assets within it, they’ve become a popular choice for simple diversification.

An ETF can own hundreds or thousands of stocks across various or a particular industry/sector or geographic area. For example, we have the FTSE 100 which is the top 100 UK stocks, S&P 500 which is the top 500 US companies, All-world ETF or more specific such as a renewables ETF.

There are various types of ETFs available to an investor. These can be used for income generation, speculation, price increases or to hedge and uncorrelated their portfolio.

Some examples:

  • Bond ETFs – This could include government or corporate bonds.
  • Industry ETFs – Track a particular industry such as renewables, mining, technology, etc.
  • Commodity ETFs – To invest in commodities such as gold or oil.
  • Currency ETFs – To invest in foreign currencies rather than home currency such as USD or EUR.
  • Inverse ETFs – An attempt to gain from a declining market.

Some real-world examples of the top 3:

For bonds, we could look at ETFs like VGOV (UK Gilts), VUTY (US Treasurys) or VAGP (Aggregate bonds).

Industry-focused ETFs we can look into ETFs like INRG (Clean Energy), RBOD (Automation/robots) or ESPO (Gaming/Esports).

Commodity-focused ETFs we have SGLN (Physical gold), DH2O (Global water) or OD7F (Crude oil).

*These are only examples and not suggestions of ETF investments.

The advantages & disadvantages of ETFs

Pros:

  1. Access to many stocks across various industries
  2. Low expense ratios and fewer broker commissions
  3. Risk management through diversification
  4. ETFs exist that focus on targeted industries

Cons:

  1. Actively managed ETFs have higher fees
  2. Single industry-focused ETFs limit diversification
  3. Lack of liquidity hinders transactions.

With ETFs, the price can sometimes be different from the ETF’s underlying value. This can lead to situations in which an investor might pay a premium above the value of the underlying stocks or commodities within the ETF. This typically corrects over time but it’s important to remember this risk. This can be calculated by the Net Asset Value (NAV) compared against the ETF price. Doing so allows you to see whether you are buying that specific ETF as a discount or premium.

If you are interested in ETF check out why choose ETFs in my portfolio article.

Why Choose ETFs in my Portfolio?

Mutual funds

Both Mutual funds and ETFs offer investors pooled investment product options but compared to ETFs, mutual funds have a more complex structuring with varying share classes and fees.

Where ETFs are traded when the market is open, mutual funds trade at the end of the market once they know what the Net Asset Value (NAV) of the fund is. This means, compared to ETFs, the funds are sold at NAV and cannot be bought at a discount or premium.

Typically we find funds are actively managed, the opposite of ETFs which are normally passively managed.

Though you can find passively managed mutual funds, many investors look towards such investments as they can add value through actively managed strategies of the fund manager. Where an ETF simply tracks an index such as the S&P 500, mutual funds which are actively managed can build an optimal portfolio rather than following an index.

Where the fund manager can try and optimize their portfolio, this can bring the risk of underperforming the markets, compared to simply tracking the index.

Because these mutual funds are actively managed, we find the fees are higher and typically include a management fee.

Mutual funds can offer multiple share classes and each has its fee structuring.

Some of the fees you could be charged are Initial charges, performance fees & Ongoing charges. You can be charged for buying or selling the fund if they perform well and an ongoing charge to cover the cost of running the funds. These all vary between funds and it’s down to the investor to choose whether or not they are happy to invest.

Funds (Open/closed)

When looking at funds you may notice they may say open-end fund or closed-end fund.

An open-end fund is the most common type of mutual fund available. Open-end funds though generally actively managed can find some which are passively managed.

Open-end funds do not limit the number of shares they can offer and are bought and sold on demand. When an investor purchases these shares the fund issues new shares and when someone sells their shares, they are bought back by the fund. When shares are sold the fund pays using cash on hand or from selling some of its investments.

A closed-end fund is traded among investors on the exchange and has a fixed number of shares. When a closed-end fund launches they do so as an initial public offering (IPO) to raise money before it can trade on the open market. Although their value is based on the NAV of the fund, the actual price of the fund is determined by the supply and demand of the market. This results in the possibility of buying such a fund at a premium or discount compared to the value of its holdings.

Type of fundPricingManagement style
Open-endEnd of dayActive or passive
Closed-endIntradayGenerally active
ETFIntradayGenerally passive

Pooling investors funds

REITs

A Real Estate Trust (REIT) is a company that owns, operates or finances income-generating real estate. REITs are modelled after mutual funds as they pool investors’ capital together. This enables individual investors to earn dividends from real estate investments without the hassle of traditional real estate.

The way REITs are set up they normally generate a steady income for investors but don’t offer much in the way of capital appreciation.

REITs are traded publicly just like a stock which makes them highly liquid to buy and sell, unlike physical real estate. REITs invest in most real estate property types which include apartment buildings, cell towers, data centres, hotels, medical facilities, offices, retail centres and warehouses.

To be classed as a REIT a company must comply with certain rules. These rules are made by the IRC and the requirements include owning real estate for the long term and to distribute income to shareholders. The company must meet the following requirements to qualify as a REIT:

  1. Invest at least 75% of the total assets in real estate, cash or U.S. treasuries
  2. Derive a least 75% of gross income from rents, interest on mortgages or real estate sales
  3. Pay a minimum of 90% of taxable income in form of dividends each year
  4. Be an entity that’s taxable as a corporation
  5. Be managed by a board of directors or trustees
  6. Have at least 100 shareholders after its first year of existence
  7. Have no more than 50% of shares held by five or fewer individuals.

There are three types of REITs with each having its characteristics.

  • Equity REITs

The majority of REITs are equity REITs. This means these companies own and manage income-producing real estate. The revenue is generally generated primarily through rents and not by selling properties.

  • Mortgage REITs

Mortgage REITs make their money through lending to real estate owners and operate through mortgages or loans. Their earnings are mostly generated through interest margin which is the difference between the interest rate on the mortgage or loans and the cost to fund such loans.

  • Hybrid REITs

Hybrid REITs use a mix of both Mortgages/loans and owning the real estate.

As well as the three types there are also three classifications of REITs. These are publicly traded REITs which are listed on exchanges. These can be bought and sold by individual investors. 

Public Non-traded REITs are less liquid as they are not traded on an exchange. These tend to be more stable as they aren’t directly affected by market fluctuations. 

Lastly, we have private REITs, these aren’t registered with the SEC and are not traded on an exchange. Generally, these can only be bought and sold by institutional investors.

When looking into the investment world of REITs we come across a term called Net Lease. This can be single (N), double (NN) or triple (NNN) net lease REITs. Each has its different characteristics. 

Single Net Lease (N) the tenant pays a lower base rent in addition to the property taxes.

Double Net Lease (NN) includes property taxes and insurance premiums in addition to the base rent.

Triple Net Lease (NNN) includes property tax, insurances and maintenance costs in addition to the base rent.

REITs buying property

Now we know REITs are not all made the same we can look at some examples:

CompanyProperty typeType of REITN, NN or NNN 
Realty IncomeRetailEquityNNN
STAG IndustrialIndustrialEquityNNN
Medical Property TrustHealthcareEquityNNN
Two Harbors InvestmentReal estateMortgage
Starwood Property TrustReal estateMortgage

*These are only examples and not suggestions of REIT investments.

Summary

There are many types of investments an investor can utilize in their portfolio. Each type has a different risk tolerance associated with it. Its generally thought that bonds offer a low risk compared to other types of assets, as a result, this may mean you have lower rewards. ETFs such as index funds can offer a good medium ground for investors, where you won’t beat the market but certainly won’t lose more than the market.

On the higher end of the risk tolerance scale, we have equities such as stocks and REITs. These rely on the performance of one company, compared to an ETF which is a handful of stocks from the market.

Each of these types of investments can be broken down further and you will find that some investments may be riskier than others.

A good balance of these investments can offer diversity across asset classes and geographies to further reduce risk and reliance on one asset allocation.

-Advertisement-

You might also like
dijital pazarlama