Understanding Types of Investments
Contributing to an employer-sponsored retirement plan or individual retirement account is the first step to a sound retirement savings plan. The second is to decide how to invest your money.
An important concept when talking about investment vehicles is weighing risk versus reward. In general, investments with higher potential for growth (reward) pose a greater risk of losing money. Low-risk investments pose less risk of losing money, but they tend to provide lower rates of growth. Let's take a look.
Certificates, sometimes called share certificates or certificates of deposit, are short-term investments that are fairly liquid (easy to access). They’re popular among conservative investors who aren’t willing to risk their money on higher-risk investments, especially those nearing retirement or who are already retired. Since certificates are widely regarded as a safe investment, they provide a great low-risk way to grow retirement savings. Many people purchase them because, like other investments, they pay interest, but unlike higher-risk investments like stocks and bonds, there’s no danger of losing principal (the original amount of money invested).
Stocks and Bonds
Stock is an equity investment, which means when investors purchase a share of stock, they become partial owners of that company, otherwise known as stockholders or shareholders. Since shareholders share in the company’s profits and growth, retirement investors purchase stocks and bonds because they offer a potential to increase in value and stay ahead of inflation.
Moreover, some stocks pay dividends and can therefore provide regular income to help fund retirement, or you can reinvest the dividend back into your portfolio.
Bonds are a debt security, much like an I.O.U. Essentially, the investor is lending money to a bond issuer, such as a corporation, government or municipality. Investors purchase bonds for income, safety and diversification. Retirement investors purchase them because, while they aren’t risk-free, they tend to have less dramatic price swings than stocks and can help stabilize portfolio values when the stock market struggles. In addition, investors are paid regular interest payments, usually based on a fixed annual rate, until a stated maturity date is reached.
If you’re investing in an employer-sponsored retirement plan, you’ll probably be given a selection of mutual funds—rather than individual stocks and bonds—from which to choose. Mutual funds pool money from many different investors to purchase investments, which allows retirement investors to invest in a portfolio of securities, often at a lower cost than they could achieve on their own.
The most common types of mutual funds include the following:
- Stock Funds are investments in common stocks.
- Index Fund. One type of stock fund is an index fund. An index fund provides a low-cost way to gain a diversified exposure to stocks.
- Bond Funds are investments in corporate, government and municipal bonds and provide investors with interest income in the form of regularly scheduled dividends.
- Money Market Funds are investments that only purchase certain high-quality, short-term investments. The overall objectives of these funds are protecting your investment and keeping it liquid. (Note: Money market mutual funds are not the same as money market deposit accounts, which are hybrids of checking and savings accounts.)
- Balanced Funds are invested primarily in a combination of stocks and bonds, and strive to provide both growth and income.
Exchange-traded funds (ETFs) are similar to mutual funds in that they pool money from investors in order to buy shares in individual stocks and/or bonds. You can buy and sell shares in an ETF during the trading day, and your price will be based on the price at the time of the transaction. (With mutual funds, the price is determined at the end of the trading day.) Two of the primary reasons retirement investors are interested in ETFs is because fees are generally inexpensive and they can be more tax-efficient than other investments.
Choosing a Fund
Choosing a mutual fund requires thinking about numerous factors, particularly your investment objectives, risk tolerance and time horizon. The mutual fund’s prospectus is a document that describes the fund’s past performance, objective(s) and primary investments. It’s important to read it before deciding on a mutual fund to help ensure its objectives match your own.
Section Complete! Here's how you did: