Investing: The word can present an endless amount of options, possibilities, and stress. You’ve probably thought about investing—maybe you’ve contributed to your employer-sponsored 401k, or dabbled with a few stock trades. You might trust your financial advisor, use an investment app, or scour #FinTwit or FinkTok for stock tips—but do you really know how the stock market works based on your unique needs?
Before you invest a time, you have to understand the different asset classes so you know where to invest over your lifetime, based on your goals and situation. Each asset class incurs greater risk, and potentially greater reward, as you move along. Work these terms into your lexicon as you strive for financial independence and more.
Cash and Cash Alternatives
Cash is the first of four asset classes. Let’s say a portion of your funds need to be saved for a home or vacation property purchase, maybe a car or a new roof. You would want to be sure that portion is in a low-risk investment that is liquid, or accessible to you, quickly, when it is needed. You could choose to park your dollars in a Money Market Account, a U.S. T-Bill or possibly even a CD.
A CD is a Certificate of Deposit and is similar to a savings account but holds your money for a specific period of time—six months, one year, two years, five years or and longer. The bank that issues you the CD will pay you interest during the selected length of time (classified as income), and at the end of the set period you will receive your principal back—that is when the CD matures.
A U.S. T-Bill is backed by the U.S Treasury Department and allows the investor to make a small return (interest) on their funds over the course of one year or less. T-Bills are affordable for many, starting at $1,000 each, and are considered low-risk investments. Like with many investments, the longer the time between purchase and maturity, the greater the return.
Money Market Account
A Money Market Account can be an account at a bank or a mutual fund. Money Market Accounts are safe and accessible when needed. You will receive a small return for allowing the institution to borrow your funds to use in their overnight lending to other institutions and even companies.
This is a large category, so I want to focus on a few of the most popular options within fixed income. Fixed income works exactly like it sounds—a fixed amount of interest (income received) on a fixed schedule. Interest is usually paid semi-annually.
Municipal Bonds are debt securities that can be issued by state and local governments which the investor will purchase in exchange for interest payments and return of principal, principal is the initial dollar amount used at the time of purchase. Municipal bonds are issued (sold) to raise funds for projects like parks and bridges.
“A municipal bond may sound like a lot of jargon but all it is is an organization–be it a company or the government–borrowing money for a period of time and agreeing to pay it back with interest,” says Alexa von Tobel. (opens in new tab) Municipal bonds backed by the U.S. government are intended to be low risk because we trust the government to be there to pay it back.
Interest paid on municipal bonds can be tax-free, making them appealing to investors in higher tax brackets.
Corporate Bonds are another debt security, but issued by a company to acquire the capital it needs for expansions, improvements and possibly even acquisitions. The minimum investment is usually $1,000 just like with T-Bills and can be issued with maturities between 1 and 30 years. The longer the duration, the more sensitive the bond can be to interest rate changes. Many investors like corporate bonds because they can invest in a company they like.
Fixed income does have a certain degree of risk, but typically lower than stocks, and can offer a slightly greater return than with cash and cash equivalents.
Now, let’s move on to the most popular of the four asset classes: equity securities.
When you purchase a stock, you are actually buying a share: partial ownership of a company. You are in turn called a “shareholder.” The more shares you buy, the greater your ownership in the company. Being a shareholder allows you to have a voice in the company by attending shareholder meetings. Individual investors purchase certain stocks for a variety of reasons, maybe they shop their regularly, have a family member that works there, or just like the way they do business. Whatever the reason, stocks are the most widely traded and can be the most mis-understood asset class.
Some investors want to generate income with potentially less volatility from their stock portfolio, and in that case they would choose dividend paying stocks. By owning a dividend paying stock you can actually “get paid” for owning shares of that company. Not every company pays a dividend, so you would need to work with a financial professional if an income producing portfolio is your goal. An example: If you own 100 shares of a company that pays a $1.50 annual cash dividend, your portfolio would generate $150 each year for owning shares of the company stock. Dividends can vary and they often do.
If you like to purchase stocks that may have fallen out of favor due to certain events or shifts in the economic cycle, then you are a Value investor. Value investors like to buy when many others aren’t and generally will pay less per share than if they had purchased when the company is in favor. Warren Buffet is one of the most widely known supporters of value stocks. Word of caution: Investing in value stocks requires patience and works best with long-term investment horizons.
Investing in companies that are at the forefront of innovation and product development can be exciting. If you have a higher risk tolerance, then Growth stocks may be for you. Growth stocks are selected by most investors for their potential capital gains and not because they pay dividends because they usually don’t.
Alternative investments are the last asset class, and potentially the least liquid. Some examples include REITs (Real Estate Income Trusts), Venture Capital, Private Equity, Hedge Funds, and Cryptocurrency. Let’s discuss one of the most widely known alternative investments is Hedge Funds. A hedge fund allows a group of qualified, usually high net worth and ultra-high net worth, investors to combine their assets and employ a long-short investment strategy. If the fund manager anticipates the market will rise over time they would implement a long strategy and alternatively, if they anticipate the market will decline over time they would short stocks. The idea is that these methods have the potential for above-average returns. Keep in mind that hedge funds can be risky investments and typically require a minimum liquid net worth of $1 million and/or an annual salary of 200k.
An understanding of the asset classes and how an investment portfolio is built, based on risk tolerance and financial objectives, is of utmost importance. Once you are ready to take the plunge into fixed income, equities, and/or alternative investments I would meet with a financial advisor – working with a professional can save you time and money in the long term and many advisors will take the extra time to ensure you have a basic understanding of your portfolio and the holdings. You don’t have to know everything but having an understanding of the basic fundamentals will help build a solid foundation.