If you’re new to investing, you might feel overwhelmed by the number of options at your disposal and all the financial jargon used to describe them. It seems like there are endless types of investments to choose from, and you’re struggling to identify which investments are the right fit for you and your financial goals.
Feeling confused? Take a deep breath and relax. You’ve come to the right place. Below, we’ll explore the different types of investments out there and offer specific advice for how to find the right investments for you.
Start With Your Goals
Before getting started, it’s important to know:
- Why you’re investing
- When you need the money
- How much risk you’re willing to take
- How hands-on or hands-off you want to be
- Whether you want to be a passive or active investor
If you don’t know the answer to some or all of these questions, don’t worry. Take a look at this beginner’s guide to investing to figure out your preferences.
The Importance of Diversification
Once you’ve identified your investing preferences, you can begin selecting your specific investments. The most important thing you should do is diversify. When you’re selecting investments, choose a handful of different investment types, and within those types choose various industries and economic sectors. There’s no such thing as a low-risk, high-return investment, so it’s important to balance things out.
You might be wondering why diversification is so important. Statistically speaking, it’s because the risk of a total portfolio is less than the risk of its individual investments. Research shows that 90% of a portfolio’s volatility (which are its ups and downs compared to its average returns) is determined by asset allocation, or having a mix of different investments.
Think of it this way: If you put all of your money in a single security and it ends up being a poor investment, you’ve just lost a decent amount of money. If you diversify your portfolio, meaning you select 10 or 20 different types of investments across various industries and economic sectors, even if a single investment plummets, you’ll still have other investments which may be doing well.
(Keep in mind that the only type of investment you don’t need to diversify are bank-type investments, so long as the total balance is less than the FDIC-insured amount of $250,000.)
The Easiest Ways to Diversify
If you’re interested in diversifying your investments, there are two easy, low-cost ways to do so, which we’ve explored in detail below.
A mutual fund involves an investment manager pooling funds from a group of shareholders and investing that money in a diversified portfolio that includes various securities, such as stocks, bonds, and money market investments. Many mutual fund investments can be purchased with a small amount of money to start, such as $25. All mutual fund share purchases and sales are executed at the end of the trading day.
You can also invest in a diversified portfolio of mutual funds themselves to cover more areas of the financial markets. This can typically be done using a Target Date Fund (a diversified fund that seeks to grow assets over a specific time frame for a targeted goal, such as retirement) or an Asset Allocation Fund (a fund with a diversified portfolio of different types of assets in fixed proportions).
If you’re looking to invest in a mutual fund, make sure you select one that has low fees and doesn’t have “loads,” which are sales charges.
If you’re looking for a simple, easy, and diversified investment, another option would be an exchange-traded fund (ETF). This type of fund tracks a group, or index, of securities. An exchange-traded fund trades like a stock and can be bought and sold during market hours.
If you want a more hands-on approach to investing than ETFs or mutual funds can offer, keep reading. Below, we’ll explore various other types of investments to consider.
How to Determine the Right Investments for You
When it comes to selecting the types of investments that are right for you, there are two primary things to consider: 1. When you’ll need the money by and 2. Your risk tolerance, or how much you can afford to lose if the investment doesn’t pan out.
Below, you’ll find a guide to what types of investments you should consider depending on your timeline and risk tolerance.
Timeline: 0-5 Years
If your investing timeline is between zero and five years, consider cash-equivalent investments, which are low risk. With a short timeline, the most important factor is generally protecting what you’ve already saved. Here’s how to determine which short-term investments are right for you.
Take this example for perspective: Let’s say you’re saving money for a down payment on a condominium that you hope to purchase in three years. You’ve saved $20,000 so far, but you’d like a total of $30,000 for your down payment. You’ll want to keep your $20,000 nest egg in a low-risk, short-term, cash-equivalent investment, such as a high-yield bank savings account, certificate of deposit (CD), or money market fund.
There are pros and cons to cash-equivalent investments. The upside is that they’re very low risk, and your money is extremely likely to be there when you need it. However, they also come with low returns (typically less than 3% annually) and they might not keep pace with inflation or grow your principal significantly. Because of this, they’re ideal for short-term investments like buying a home, not long-term investments like retirement.
If you opt for a CD, you’ll want to match the CD maturity date to one or two months before you’ll need the money. If you choose a money market fund, you’ll want to search for a fund that invests in short-term, high-quality, and low-risk bank, corporate, and government securities.
Perhaps you’re interested in a short-term investment with a little more risk. For example, let’s say you’ve saved $10,000 for your three-month sabbatical to Thailand, but you realize it’s only going to cost you $8,000. You can keep at least $8,000 in short-term, low-risk investments and then take a little more risk with the remaining $2,000 by investing in something like a no-load mutual fund or a conservative brokerage portfolio.
Timeline: 5-10 Years
If your investing timeline is somewhere between five and 10 years, you’ll generally want to stick primarily with bonds and cash-equivalent investments. Investors with a very aggressive risk tolerance may add a small percentage of some high-quality stocks.
Bonds are a type of investment that offer investors fixed income over a fixed period of time. When you purchase a bond, you’re effectively making a loan to the bond issuer, who is paying you back in interest and the principal at maturity. Imagine you lent your friend $10 for a period of 10 years. Every six months, she paid you 30 cents for that loan, which is a 6% annual interest rate. After 10 years, she gives you your $10 back. That’s basically how a bond works.
After bonds are issued, most are traded in an electronic market composed of financial institutions. It’s not possible to buy individual bonds if you’re a small investor since most trade in large denominations. You can, however, invest in diversified bond portfolios easily with small amounts of money through bond mutual funds or bond ETFs.
There are different types of bonds, including:
- Government bonds (treasury bonds, TIPS, and Fannie Mae and Freddie Mac securities)
- Corporate bonds (bonds issued by large corporations)
- High-yield bonds (keep in mind that these are also higher risk, as it means the bond issuer has a lower credit quality)
- Convertible bonds (bonds that can convert to stocks if their target price is reached)
- International bonds
- Municipal bonds (bonds issued by state and local governments)
There are pros and cons to investing in bonds. Here are some of the advantages:
- You can target the bond maturity date to when you’ll need the money.
- There is a low risk of default.
- They’re predictable — you’ll receive fixed income on a fixed schedule.
- There is only moderate risk.
Some of the disadvantages of bonds include:
- Bond prices will fall when interest rates fall.
- There is a risk of loss if you have to sell your bonds before their maturity date, or if the issuer defaults (which is rare for high credit quality bonds).
- The returns are modest.
Have you heard of peer-to-peer lending? This is a new type of lending, enabled by technology, between individuals. If you lend through a peer-to-peer platform, you may receive a higher interest rate than buying a bond, but the risk of default, or not getting paid back, is higher. Unlike a bond, you generally won’t be able to sell your peer-to-peer loan in the secondary market.
Timeline: 11+ Years
If you have a longer timeline for investing, you’ll likely want to invest primarily in stocks (or ETFs comprised of stocks).
Stocks are ownership securities in a publicly traded company. When you own a company’s stock, you own a very small portion of that business. As part owner in that business, you make or lose money depending on whether or not the company is profitable. Stocks are traded on exchanges, like the New York Stock Exchange and the NASDAQ, and via electronic networks.
Historically speaking, stock returns are the highest of all investment types over longer periods of time. For early or mid-career investors with a moderate to aggressive risk tolerance, stocks would typically make up the majority of your retirement portfolio, based on your age and time until retirement.
Stocks come with their upsides and downsides. Some advantages of stocks include:
- There is a chance you’ll be able to grow your money substantially over time.
- You’ll likely be able to beat inflation.
- Diversified stock portfolios are easy to invest in.
Disadvantages of stocks include:
- They are higher risk than other investments.
- The fluctuation in stock value means they aren’t ideal for short-term investment goals.
- It’s expensive to trade individual stocks.
If you’re a more hands-off investor who prefers to leave the work to someone else, you can invest your money in a stock fund, which are typically categorized by company size (large-cap, mid-cap, and small-cap), the style of investing (growth or value) and their risk profile (aggressive or conservative). For example, a stock fund described as “aggressive mid-cap growth” would be a fund that specializes in medium-sized, growing companies and takes aggressive trading positions.
If you have long-term investing goals, would you put 100% of your investments into stocks? For diversification purposes, that may not be wise. Modern portfolio theory showed that the difference in projected results between a 100% stock portfolio and a portfolio that’s 80% stocks/20% bonds is negligible, and the 80/20 portfolio had lower variation.
For example, someone investing in their 401(k) for retirement in 2040 who has a moderate risk tolerance might put 75% to 80% of their money in stocks and 20% to 25% in bonds. If they are more hands-off, they could opt for a single Target Date Fund with a date that corresponds with when they’d like to retire.
Additional Investment Options for Long-Term Investors
The whole idea behind diversification is that risk of loss can be reduced by incorporating different investment types into your portfolio that don’t respond in similar ways to economic conditions. This is fairly easy for consumers to do through things like stock and bond mutual funds and ETFs. However, there are additional investment options for long-term investors who want to diversify their portfolio:
A new investor can consider including real estate in their portfolio by investing in real estate mutual funds or real estate ETFs. Typically, funds that focus on real estate invest in Real Estate Investment Trusts (REITs), which are publicly-traded portfolios of commercial and rental real estate. Many 401(k) plans include access to a real estate mutual fund, and many Target Date Funds include real estate in the total portfolio.
There are advantages and disadvantages to investing in real estate funds.
Pros of investing in real estate funds:
- They allow for more portfolio diversification.
- You can own real estate without buying individual properties.
- There are steady dividends in the form of income that is passed through to the various shareholders.
Cons of investing in real estate funds:
- Overall stock market changes can have a bigger impact on real estate funds than owning an individual property.
- They’re not a core holding, but rather are complementary to stocks and bonds.
Commodities and Futures
One other investment type long-term investors can consider are mutual funds or ETFs which invest in commodities and futures. Keep in mind that these investments are typically for sophisticated investors and could carry a significant amount of underlying risk. Like salt in cooking, you don’t want too much.
Commodities are raw materials (like oil, gold, or corn) that can be bought and sold, while futures are contracts to buy or sell a commodity at a pre-set price on a set date. Like real estate funds, commodities and futures funds come with their advantages and disadvantages.
Pros of investing in commodities and futures:
- You’re diversifying or hedging risk in your portfolio.
- You keep pace with inflation.
- It’s a way to participate in the sector without trading individual contracts.
Cons of investing in commodities and futures:
- They’re higher risk.
- They’re volatile, meaning they’re susceptible to quick price changes.
- They’re not a core holding — they’re complementary to stocks, bonds, and real estate.
The Final Say
When you’re looking at types of investments to consider, the most important thing is to know your investment objectives from the start. How risk-prone or risk-averse are you? What’s your timeline? Do you anticipate being hands-on or hands-off?
Once you have your objectives down, it’s important to be educated on the various investment options out there so you can align them with your goals.
Now that you’ve learned about various types of investments, it’s time to begin investing. Get started by reading this guide for how to start investing. Good luck!