Investing in Different Assets: What are Your Possible Choices?
You want to begin investing, but have no idea where to start. Here is your guide to investing in different assets, jargon-free.
Stocks, bonds, and cash are the most common components of a portfolio that investors should know about.
Bonds are typically less risky than stocks, but stocks have had higher returns over time.
Determining the risk level and diversification of your portfolio are important factors to consider when creating your financial plan.
It’s easy to get overwhelmed by the number of new and foreign terms we encounter while investing. In this article, we will provide a basic overview of different types of investments and how you should think about using them.
Before we get started, the first jargony term that you may encounter is “asset class.” Though it sounds fancy, it simply describes a broad group of fundamentally similar investments.
You can think of different asset classes as different species of investments — investments in each asset class share common traits. Stocks, bonds and cash are three of the most common asset classes in the investing world.
There are others, like commodities (raw materials or agricultural products) and real estate, but they fall outside the scope of this article and are less common for investors to consider.
One final note—here at Betterment, we invest your funds in stock and bond ETFs that we’ve researched and selected for you. You can read more about our investments and portfolio strategies here. The information in this article is intended to be educational so that you can be an informed investor no matter where you choose to invest.
Investing In Stocks
First, let’s understand exactly what we are getting when we buy a stock.
When you buy a stock you are getting partial ownership of the company, and with that comes all the benefits (and risks) of being an owner.
You get a vote in how the company is run — which often takes the form of proxy votes. You participate in the value creation when the company does well — generally in the form of an increase in the value of the stock or dividends. You also experience the downside when the company performs poorly — generally in the form of lower share prices or reduced dividends.
As a stockholder you have a claim on a company’s earnings after debts are paid. This is a fundamental feature of stocks and differentiates them from bonds and cash. The most meaningful difference here is that potential future value of a stock is not limited.
So, if a company does very well, you participate in all the positive performance after debts are covered. The flip side of this is that if the company does poorly, stockholders are the first to absorb losses, before lenders are impacted.
Overall, this means stocks are more risky than bonds but also have the potential to generate higher returns. Historically, stocks have outperformed bonds. The chart below shows the historical growth of a broad stock investment compared to bonds and cash, after adjusting for inflation.
As you can see, stocks are more volatile, but also generated the most growth.
Data source: Stocks For The Long Run. Page 10. 1998.
Bonds are essentially IOU’s from companies or governments. A bondholder essentially owns a loan that must be repaid in the future. Bondholders earn income from interest payments and return of the initial loaned amount, called principal, at the bond’s maturity.
Unlike stocks, the return on a bond is capped. The payments to the bondholder are predetermined at the time the bond is issued. This means that even if a company does extremely well, the bondholder will only get what was agreed upon in the terms of the bond.
This is why bonds are often called “fixed income” investments — because the amount of income generated by a bond is fixed at the time of purchase.
If a company does poorly, however, bondholders have priority when it comes to getting paid. This makes bonds less risky than stocks. In general, bonds are a safer asset class than stocks.
Holding Cash And Equivalents
Cash is the asset class you might be most familiar with. There are a wide range of places you can park your cash and earn interest in the process. Cash and cash equivalent assets are very low risk, highly liquid (easily convertible to cash), short term investments. These include money markets, treasury bills, certificates of deposit (CDs), and short-term corporate debt.
Because cash and cash equivalents tend to be very safe, the biggest risk is inflation eroding the buying power of your dollars. In fact, historically holding cash can lose an investor money after accounting for inflation. Below is a chart of interest rates on a savings account after accounting for inflation.
As you can see, after accounting for inflation, the “safe” investment in cash can actually lose value.
Now that we understand the different kinds of assets in which we can invest, it’s worth considering one additional concept — investment funds.
Mutual Funds vs. ETFs
Investment funds will select a group of stocks or bonds and manage those assets for the benefit of fund shareholders. The two most common type of funds are mutual funds and exchange traded funds (ETFs).
The advantage of an investment fund is that you immediately benefit from diversification since a fund holds many individual assets. Diversification is the process of investing in different assets to reduce exposure to risk.
In fact, investment funds allow you to invest in broad swaths of asset classes in one fell swoop. For example, Vanguard’s Total Stock Market ETF (VTI) invests in the entire U.S. stock market. The fund owns over 3,000 individual US stocks.
There are some subtle, but meaningful distinctions between mutual funds and ETFs. Perhaps the most obvious is that ETFs, as the name suggests, are traded directly on the stock exchange. This means that you can buy or sell shares of an ETF throughout the trading day. Mutual funds transactions, on the other hand, occur once at the end of each day at the funds closing Net Asset Value (NAV).
ETFs are also more tax efficient than mutual funds. Without getting into too much detail, ETFs are able to swap out investments with large taxables gains with new shares of the same investment. This means that ETFs are substantially less likely to generate capital gains inside the fund.
Ultimately, there are many advantages to using ETFs that could better serve your financial plan.
How To Invest
We know that stocks are generally more risky than bonds and that we can use investment funds to get broad exposure to these asset classes.
The next logical question is: What exactly should I buy and how much of each?
To answer this, we want to focus on two things: risk level and diversification.
First, we want to make sure that we are building a portfolio of stocks and bonds that takes an appropriate amount of risk for your investment goal and time horizon. In general, shorter term goals should take less risk, which means holding more bonds and fewer stocks.
As your investment horizon (or the length of time you are aiming to invest your portfolio) lengthens, you should consider investing a larger part of your portfolio in stocks. More time allows for more opportunities to participate in the upside potential that stocks provide. However, you should think broadly about all the factors influencing your financial life and set customizable goals to further your financial plan.
You also want to make sure that you are selecting stocks and bonds in our portfolio that maximize the level of diversification in your portfolio. Simply put, you want to add investments that you believe will grow in value but also don’t go up or down in value in exactly the same way at exactly the same time.
In the illustrative example below, you can see that by combining U.S. and international stocks, the overall portfolio is less volatile.
A portfolio with good diversification overall will typically grow while the value of the overall portfolio remains more stable compared to individual investments.
Let Us Take The Wheel
Here at Betterment, we’ll take care of it all for you. We’ll invest your funds in a mix of globally diversified stock and bond ETFs, chosen to help you earn better returns at various levels of risk. Speaking of risk, we’ll recommend how much to take on based on when you’ll need your money. Get started with us and put your investment choices on auto-pilot today.
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