While there is ample financial literature out there on asset allocation, risk, investment income and more, some never step back to provide an overview of different types of investments and their common attributes. Having a knowledge of traditional investments may help you start answering some of the more complex questions when investing. In this article, we'll identify and discuss some of the more traditional assets you may come across, such as stocks, bonds, mutual funds, exchange traded funds and cash.
Stocks are one of the most common types of investments. A stock is an investment that represents partial ownership of a company. By holding a company's stock, you take part in a company's ongoing earnings and revenues through direct payments like dividends and indirectly through changes in the stock price. A dividend is a payment a company may (or may not) pay to all shareholders on a regular or irregular basis. While some investors build whole portfolios based on earning dividends, we believe investing for total return (dividends plus changes to the stock price) is what matters most.
Many investors worry about the risk, or short-term volatility, inherent in investing in stocks. Stock prices tend to fluctuate more than some other investments might, but this volatility may not be all bad. Despite short-term volatility in stock prices, their long-term returns tend to be stronger than those of other, less volatile assets. The long-term annualized return of stocks is about 10%, which can be extremely helpful for investors needing long-term growth.[i] However, many investors struggle to achieve these market returns because they react to the short-term volatility and deviate from their long-term investment strategy.
Bonds (also called fixed income products) are another common type of investment. Bonds are loans between investors and institutions—often governments or corporations. When an investor purchases a bond, the issuer of the bond generally pays interest on an ongoing basis for a specified time period. By the end of that time period, the issuer of the bond will generally pay back the original investment amount, this is often called reaching maturity.
Many corporate and government bonds are traded on secondary, over-the-counter (OTC) markets, while others may be purchased directly from the issuer. Organizations will often issue bonds to raise money when they are looking to fund new projects or refinance existing debt obligations. The initial price of the bond is usually set at par or face value. The price of each bond generally fluctuates based on the maturity date, credit quality of the issuer and the interest rate (often called the coupon rate) compared to the lending environment at the time the bond is purchased.
While stocks may have higher short-term volatility than bonds, bonds have their own set of risks. For example, default risk is the risk that bond issuer is unable to pay back their debt obligation. The less creditworthy the issuer, the higher their bond yields could be. Similarly, interest rate risk arises from interest rates' and bond prices' negative correlation, which means selling a bond before it matures in a rising interest rate environment could cause a loss.
Funds is a broad term but generally entails investing in pooled asset products, which then invest in underlying securities for those who own shares of the fund. These can be especially beneficial for investors with insufficient funds to create a diversified portfolio of individual stocks or bonds. Funds can be focused on stocks, bonds or other securities and may be focused on specific areas within those asset classes.
Two common types of funds are mutual funds and exchange-traded funds. While similar, these two securities have their differences. Mutual funds generally trade at the end of each trading day after the value of all the fund's underlying securities is calculated and the price of one share of the fund, based on the value of the holdings, is reported. Many mutual funds are open-ended, meaning an unlimited number of shares can be issued on an ongoing basis. Mutual funds can also be close-ended, meaning only a specified number of shares are issued when the fund is first offered for sale to the public.
Exchange-traded funds (ETFs) are another financial instrument very similar to mutual funds. They pool investor assets and invest in underlying securities, but they trade throughout the trading day like stocks. Many tout ETFs' cheaper costs compared to mutual funds, but some mutual funds' costs have dropped to compete in recent years.
Lastly, cash is a very common asset and most of us have some of this for its liquidity. Cash can be traded easily in exchange for goods and services, but it often doesn't hold much long-term investment return as such. If you have some near-term expenses you've been saving up for or know you'll need to spend money in the short-term, having some cash on hand or in your portfolio can make sure you have the funds necessary to meet your needs. However, holding too much cash in your investment account can mean low returns, which may not help you reach your long-term goals.
To find this balance of how much cash or investment income you should have, Fisher Investments Canada may be able to help.
[i] Source: FactSet, Global Financial Data, as of 14/02/2019. S&P 500 Index total returns in Canadian dollars, 31/01/1931 – 31/12/2018.