A lot of people seems to have an opinion about how to make money from investing, or what is the next hottest stock to buy into. Some people would tell you to buy mutual funds for retirement, or buy this and that stock. For the individual who have never been exposed to investing or stocks, this can be quite daunting.
The purpose of this article is to provide a simple introduction to what investing is and what investment products are out there. Investing isn't rocket science and once people can wrap their heads around the concepts, everything becomes much clearer.
Stocks are units or slices of a company. Each unit allows you to own a share of the company (hence that is why people use shares and stocks interchangably). There are two ways for investors to earn money through stock ownership. The first way is through capital appreciation. The second way is through earning dividends.
With capital appreciation, when the price of your stock becomes higher than the price you purchased at, you can sell it for a profit. Let's say you purchased a share at $10, by next week the shares have gone up in price to $14. When you sell it the following week, the profit earned is $4.
What moves the price of shares from day to day? The stock market (also called the secondary market). The stock market is where buyers and sellers of stocks or shares get together and exchange share for money.
The second way of earning an income are through dividends. Dividends are when companies decide to allow investors share in the company's annual profits. For example, companies such as Apple issues dividends quarterly (every 3 months). To put it simply, let's say Apple earned $10 in 2016 and decides to issue $2 dividends to its investors. The company now is handing out a portion of its profits to its shareholders.
Not all companies issue dividends because based on each company's business, it may need to keep some of the profits for reinvestment in the future.
These type of securities operate from people pooling their funds together, and with the money, invests in various stocks, bonds, and other products. An investment manager runs the fund and decides what to buy and sell and must follow the investment objective of the mutual fund.
There are benefits from investing in a mutual fund such as an investment professional is investing on your behalf. Also, there is diversification from investing in different stocks and bonds. When an investor owns 10 different securities in bonds and stocks, risk is lowered because not every stock will move in the same way. So when one stock goes down, the other may retain its value.
The downside of mutual funds are its expensive fees. There has been a trend in the last couple years of investors pulling away from mutual funds because the fees are to high. In general most fees are now 2.5 percent and this makes a difference overtime especially when a fee is still charged when the mutual fund is not making money. Several years ago, hedge funds was gaining traction as a viable investment product.
Another down side to holding mutual funds is its illiquidity. Investors cannot trade them as freely as they do with stocks.
Much similar to mutual funds, hedge funds also pools capital from different investors and invests it. The only difference here is that hedge fund managers generally invest with little to no restrictions because the thinking is that these people should be able to invest where they can maximize fund's returns. For their expertise they charge a high fee to the funds. This hurted the hedge fund industry when the returns promised never materialized.
Exchange Traded Funds (ETFs):
ETFs is a security that tracks an index, bonds, or basket of assets. It is very similar to mutual funds but the difference is that ETFs are traded on the stock exchange. That's why ETFs have higher liquidity than mutual funds. These type of securities also comes with lower fees, making it very attractive to individual investors.
Much similar stocks and mutual funds, Exchange Traded Funds can earn dividends and capital gains.
ETFs are also safer than stocks because it has diversification from investing in a basket of assets. Each ETF have different types of investment strategies so there is a risk between various exchange traded funds.
Bonds is a debt instrument whereas mutual funds, bonds, ETF are equity investments. Equity investors generally own the asset or company they purchase. Bonds involves lending money to another company. So when an investor purchases government or corporate bonds, essentially the investor is lending money. Bonds are heavily impacted by rising and falling interest rates. The price of bonds move accordingly to what the interest rates are.
Bond investors or bond holders earns their returns from interest and selling the bonds above what they paid for. As an investor, bonds are useful because they tend to be safer than most stocks. While stocks can move up and down according to the markets, bonds have less fluctuations than stocks and is considered safer. Another benefit to buying bonds is that if a company ever goes bankrupt, it would be the bondholders that get their money back first before the stockholders do.
Summing it up:
This is just only a brief summary of the different investment securities out there. Each type of security whether it is mutual funds, bonds, stocks, ETFs have even more strategies and products. The type of security to invest in depends on what your goals are and how involved you want to be in your investments. An investor who only wants to spend a minimal amount of time can consider investing in mutual funds or exchange traded funds. These investments have an investment manager that will invest on your behalf. Stocks generally involves more time commitment because people should read up on the news of what the company is doing and look through its financial statements.
Investing isn't hard and it is not rocket science. What is important is that people at least have an idea of what investment securities are out there so they can make an informed decision in what they want to invest in.