Different Types of Investments and How They Work
Most people have heard of stocks and bonds, but there are tons of other ways to invest your money: mutual funds, CDs, real estate … the list seems endless. Here’s our reference guide to the different types of investments and how they work.
You’ve probably come across several terms related to your investments, but let’s look at a few key ones here:
- Asset : A resource that you own and that is expected to increase in value.
- Holdings: specific assets in your investment portfolio.
- Portfolio : all your investments as a group. Diversifying your portfolio means investing in different assets.
- Asset classes : A group of assets with similar characteristics. Stocks, bonds, and cash are all asset classes.
Investopedia breaks down all the different types of investments into the following main categories : investments you own, loan investments and their equivalents. Here’s how different investments compare in each of these three categories.
When you buy an investment in a property, you own that asset.
Property investments include:
- Stocks : A stock, also known as a stock or share, gives you a stake in a company and its earnings. Basically, you get partial ownership of a public company.
- Real Estate: Any real estate that you buy and then rent out or resell is an investment in property.
- Precious items. Precious metals, art, collectibles, etc. can be considered a form of investment ownership if it is intended to be resold for a profit. They also fall under a separate category of “alternatives”. More on this later.
- Business : Investing money or time in starting your own business – a product or service designed to make a profit – is another type of property investment.
Loan investments are debts that you buy while waiting to be paid back. You are kind of like a bank. As a rule, these are investments with a low level of risk and low return. This means they are considered a safer investment and you are not making a lot of money from them.
- Bonds: “Bonds” is a general term for any type of debt investment. When you buy a bond, you lend money to a legal entity (such as a corporation or government) and they return the money to you over a period of time at a fixed interest rate.
- CDs: A CD or certificate of deposit is a promissory note issued by a bank in exchange for your money. You’ve probably seen that your bank offered them. This is a type of savings account, but it is slightly different. Instead of withdrawing money at any time, you agree to leave it in the account for a certain period. In return, the bank will offer a higher interest rate depending on how long you leave your money alone.
- Savings Accounts: This general type of bank account can also be thought of as a loaned investment when you think about it: you give your money to a bank that lends it out. But your rate of return is usually quite low (below inflation), which is why most people don’t consider this a real investment.
- ADVICE. TIPS are inflation-protected Treasury securities. These are US Treasury-backed bonds specifically designed to guard against inflation. When your TIPS investment expires over time, you will receive your principal and interest back, indexed to reflect the rate of inflation. Bogleheads explains how they work in more detail.
Even if you accept the risk, there should be some credit in your portfolio to balance your property investment.
Typically, a smaller portion of your portfolio is cash. Cash equivalents are investments that, according to Investopedia, are “no worse than money.” This could be a simple savings account. This could be a money market fund. (The money market fund is actually a type of credit investment, but the return is so low that it is considered a cash equivalent investment.)
We’ll talk about funds a little later, but first let’s look at another way to categorize investments – alternatives.
We looked at how the various investments can be categorized into ownership, lending, and cash. These categories are general descriptions, but they help explain how different types of investments work.
But investing companies do things a little differently. They are broken down by asset class: stocks, bonds, cash, and alternatives. We already know about stocks, bonds and cash – the most traditional ways of investing. As for the asset class, everything else is alternatives. Therefore, you should invest in them much less than your portfolio.
Some investments are easy to categorize as alternative investments because they can actually be considered a property investment or a loan, depending on how they were purchased. But let’s take a look at a few examples.
REIT : Real estate investment funds or REITS are another way to invest in real estate. Instead of buying your own property , you work with a company that profits from its own real estate investment.
Indeed, a REIT can be a property investment or a loan investment, depending on which type you buy. You can buy a REIT that gives you a stake in the property itself; it will be considered an investment in property. But you can also invest in a real estate mortgage, which makes it an investment in a loan.
Venture capital: This is money that you give to a startup or small business in the hope that it will grow and that you will profit from that money. Venture capitalists often partner with a company, own a portion of its capital, and have a say in business decisions. Thus, they can be viewed as an investment in property.
Commodities: An investment in a commodity is an investment in a resource that affects the economy. Butter, beef and coffee beans are all commodities.
Precious Metals : As we mentioned earlier, metals and collectibles are technically an investment in property – for example, you own the gold you buy. But these are not stocks or bonds, which is why most people see them as an alternative.
Funds can fall under any of the main investment categories. This is not a specific investment, but a term for a group of investments.
Basically, an investment company selects a set of similar assets for you. It can be a group of stocks or a group of bonds. Or the fund could be even more specific – for example, there are funds made up of all international stocks. In exchange for them returning your investment, you will pay a commission or a certain rate of expenditure .
Funds aim to be a more convenient investment, with a choice that will provide better returns than anything you would probably choose for yourself.
Let’s take a look at the various terms associated with funds.
Mutual funds: A mutual fund is essentially another term for an investment fund. To give a more formal definition, here’s how Investopedia explains it:
A mutual fund is a type of financial instrument made up of a pool of money collected from many investors to invest in securities such as stocks, bonds, money market instruments, and other assets. Mutual funds are managed by professional money managers who allocate fund assets and try to provide capital gains or income for fund investors. The mutual fund portfolio is structured and maintained in accordance with the investment objectives specified in its prospectus.
Index Funds: This is a type of mutual fund designed to reflect the performance of a specific market, such as the S&P 500. Get Rich Slowly offers a detailed article on index funds and explains them as follows:
Index funds are mutual funds, but instead of owning twenty or fifty shares, they own the entire market. (Or, if it’s an index fund that tracks a specific portion of the market, it owns that portion of the market.) For example, an index fund like the Vanguard VFINX , which tries to track the S&P 500 stock market index , tries to do so. own shares of your target index (in this case the S&P 500) in the same proportions as in the market.
Because they are designed to reflect the market, index funds are “passively managed,” which means there is no team of investors constantly analyzing, predicting, and adjusting the assets in the fund (known as active management). As a result, they tend to have lower spending ratios, which means you save more of your money.
Exchange Traded Funds (ETFs): They are similar to index funds in the sense that they are designed to track an index or measure of a specific market. The biggest difference is how they are traded: ETFs can be traded like stocks and their prices move like stocks throughout the day. Index funds don’t work like that – they only change prices once a day.
Hedge Fund: Hedge funds are similar to mutual funds with some very important differences. First, they are not regulated by the US Securities and Exchange Commission (SEC). They are also considered to be more risky than conventional mutual funds because their assets can include a wider range of investments. In addition, they often use borrowed money for investing. To learn more about hedge funds, check out their full explanation from Investopedia.
Please be aware that this listing is for reference and not a guide to getting started investing . Depending on where you are in your financial journey, many of these types of investments may or may not be on your radar.
With so many investment terms, knowing what to invest in can seem daunting. But if you categorize the terms, it’s much easier to understand how they work.
This post was originally published in 2015 and was updated by Lisa Rowan on 5/19/2020. Updates include the following: replaced the feature image and removed additional images, checked links for accuracy, consolidated some of the information and edited it to reflect the current site style, and added additional links to related content.