For many people, the world of investing still remains a mystery, filled with unfamiliar terms and concepts.
The good news is that successful investing doesn’t require advanced math skills or complex strategies. Instead, it starts with the basics of investment types (known as asset classes) and understanding how they work together. From the relative safety of a savings account to the growth potential of stocks—each type offers varying levels of risk and reward.
Understanding the Risk Ladder of Investments
Below are the primary asset classes arranged in increasing order of investment risk.
Cash
A bank deposit is considered the safest and most straightforward form of investment—usually the first one people encounter. It not only provides investors with a clear report on the interest they will earn but also guarantees the return of their principal. The downside is that the interest earned on cash in a savings account often fails to outpace inflation.
Certificates of deposit (CDs) are less liquid, but they typically offer higher interest rates than savings accounts. However, the funds deposited in a CD are locked for a specific period (ranging from months to years), and early withdrawal usually results in penalties.
Tip
Financial advisors often begin by advising clients to plan for the long term. “For many people, a long-term, ‘buy and hold’, diversified, low-cost investment strategy is probably more suitable than active trading in most situations,” said David Tenerelli, a certified financial planner from Plano, Texas. “This helps investors ignore the 'noise' and stay focused on a disciplined approach.”
Bonds
A bond is a debt instrument reflecting the investor’s loan to a borrower. Typically, a bond will be issued by a corporation or government, where the borrower will pay a fixed interest rate to the bondholder in exchange for using their capital. U.S. Treasury bonds are the most popular bonds worldwide.
Bond rates are mainly influenced by central bank interest rates. For this reason, bonds are actively traded when the U.S. Federal Reserve or other central banks raise interest rates.
Comparing Annual Returns of Stocks and Bonds
Stocks generally offer higher annual returns than bonds, but they also come with greater risk. Historically, the average annual return of stocks is about 7-10%, while bonds typically yield around 2-5%. Bonds are more stable and provide steady interest, while stocks can be volatile but tend to deliver higher long-term gains.
Mutual Funds
A mutual fund is a large investment pool where many people combine their money and entrust it to a professional fund manager, who invests it in stocks, bonds, or other securities on their behalf. In return, you receive shares proportional to the amount you contributed to the fund.
These funds typically start with an investment of just $500, though many have no minimum investment requirement. Even with small investments, you can own shares in hundreds of different companies. For example, investing $1,000 in a mutual fund holding 100 different stocks is like purchasing small portions of all those companies at once.
Some mutual funds are designed to replicate popular indexes, such as the S&P 500—this is what the first mutual funds in the 1980s aimed to do. These are called “passive” funds, as their managers simply try to match a specific index, which requires much less effort than trying to beat the market.
Other mutual funds are actively managed, meaning that investment professionals attempt to outperform the market by constantly adjusting their holdings (much like a chef experimenting with ingredients). However, these actively managed funds often charge higher fees, which can erode your returns over time.
Actively Managed vs. Passive Index Funds
| Feature | Actively Managed Funds | Passive Index Funds |
|---|---|---|
| Investment Goal | Aims to outperform the market or benchmark | Aims to match the performance of a specific index |
| Expense Ratio | Typically higher (average 0.66% for stock funds in 2023) | Typically lower (average 0.06% for stock funds in 2023) |
| Risk | Can be higher or lower than the market, depending on strategy | Matches market risk based on the tracked index |
| Transparency | Investments may not always be disclosed frequently | Investments are typically known and track the index |
| Minimum Investment | Often higher | Often lower, making it more accessible |
Unlike stocks, which you can buy and sell throughout the day, mutual fund transactions occur only once per day, after the market closes. The price you pay or receive is based on the fund’s net asset value (NAV)—essentially the total value of the fund’s assets, which is calculated at the end of each trading day.
Tip
The toughest time for any investor is when the market enters a period of turbulence. "I suggest discussing past market experiences and potential volatility," said Alyson Basso, Head of Hayden Wealth Management in Middleton, Massachusetts, to Investopedia. This way, clients are mentally prepared. However, investors can help themselves by preparing in advance. "I also remind them that diversified investing helps spread risk, so they don't put all their eggs in one basket."
Exchange-Traded Funds (ETFs)
The popularity of exchange-traded funds (ETFs) has surged since their introduction in the early 1990s. ETFs are like mutual funds but are traded throughout the day on the stock exchange. This means you can trade them just like Apple Inc. (AAPL) stock. It also means their value fluctuates throughout the trading day.
ETFs can track a specific index, such as the Dow Jones Industrial Average, or any other group of stocks chosen by the ETF manager. The index can include anything, from emerging markets to commodities, or even specific business sectors like biotechnology or agriculture. However, the most popular ETFs for both institutional investors and those investing a portion of their paycheck remain those that track indices.
Key Types of ETFs for Beginners
| Type | What it does | Risk Level | What You Should Know |
|---|---|---|---|
| Index ETFs | Tracks a market benchmark like the S&P 500; invests in multiple companies | Moderate | Usually chosen by beginner investors; a good portfolio starting point |
| Bond ETFs | Invests in a range of government or corporate bonds | Low to Moderate | Generally more stable than stock ETFs; good for steady income |
| Sector ETFs | Focuses on one sector, such as technology or healthcare | High | Riskier as investments are concentrated in one sector; use cautiously |
| Money Market ETFs | Invests in very short-term, high-quality securities | Low | A newer type of ETF; similar to savings accounts but offers better interest rates |
Stocks
When you buy stocks, you are purchasing a small ownership share of a company. For example, if you own Apple stock, you are technically a partial owner of the company, even if it’s only a small amount.
There are two main ways to make money from stocks:
Stock price increases after you buy them: First, when other investors like what they see in the company and are happy with the price offered for the stock, they will buy shares. If enough people do this, the stock price rises. When this happens, you can sell your shares—the difference between what you paid and what you sold them for is called capital gains.
Dividends: Second, some companies share their profits directly with shareholders by paying dividends regularly.
Companies that have paid dividends for 25 consecutive years are known as dividend aristocrats. Below is a list of such companies from the S&P 500 index.
Alternative Investments
There are many so-called alternative investments that aren’t stocks, bonds, or mutual funds, which include the following:
- Real Estate: You can invest in real estate in two ways. The direct approach involves purchasing actual buildings or land—if you’ve bought a house, you know what kind of effort is involved. A simpler method is to buy shares in real estate investment trusts (REITs)—companies that own and manage real estate. REITs trade like stocks but are required to pay out 90% of their profits to investors annually, often resulting in higher dividends.
- Hedge Funds and Private Equity: These investment vehicles are like exclusive clubs—they are usually only open to those who already have wealth (known as “accredited investors”). Hedge funds attempt to make money using complex strategies, whether the markets are going up or down. Private equity firms buy entire companies, restructure them, and sell them for a profit. Both typically require investors to lock up their funds for a year.
- Commodities: These are physical goods like gold, crude oil, or agricultural products. While you probably don’t want a herd of cattle in your backyard, you can invest in commodities through specialized funds that track their prices. Many investors use commodities as a hedge or protection against inflation, as their prices often rise when living costs increase. Goldman Sachs. “Which commodities are the best inflation hedges?” Some specialized ETFs are also aimed at commodity-focused investments.
How to Invest Smartly, Properly, and Simply
Starting your investing journey doesn’t have to be complicated. Here’s a simple approach:
- Start with the basics: Begin with mutual funds or ETFs that track broad market indices. This is better than trying to pick individual winners from the start.
- Keep costs low: Every dollar you pay in fees is a dollar that doesn’t grow in your account. Index funds typically have lower fees than actively managed investments.
- Diversify gradually: As you get more comfortable checking your portfolio – you’ll start to get nervous about every mark, but this fades (usually) – you can start adding different types of investments. But don’t feel pressured to have everything. Many successful investors stick with a simple mix of stock and bond index funds throughout their lives.
Remember Warren Buffett’s advice: The world’s most famous investor says most people would do well with just two funds—one that tracks the S&P 500 (U.S. stocks) and another for U.S. bonds.
Tip
For most people, the best portfolio is not the most complicated one, but the one they can stick with through the market's ups and downs.