Different Types of Investments
FINANCIAL SERVICES DEPT.
The Three Different Kinds of Basic Investments Include Stocks, Bonds and Cash.
There are also three types of investors: conservative, moderate and aggressive.
Overall, there are three basic kinds of investments. These include stocks, bonds, and cash (cash = money market or certificates of deposit). Sounds simple, right? Well, unfortunately, it gets very complicated from there. You see, each type of investment has numerous types of investment vehicles that fall under it.
There is quite a bit to learn about each different investment type. The stock market can be a big scary place for those who know little or nothing about investing. Fortunately, the amount of information that you need to learn has a direct relation to the type of investor that you are.
There are also three types of investors: conservative, moderate, and aggressive.The different types of investments also cater to the two levels of risk tolerance: high risk and low risk.
Conservative investors often invest in cash.This means that they put their money in interest bearing savings accounts, money market accounts, mutual funds, US Treasury bills, and Certificates of Deposit. These are very safe investments that grow over a long period of time. These are also low risk investments.
Moderate investors often invest in cash and bonds, and may dabble in the stock market.Find a variety of information and resources on investment bonds here. Moderate investing may be low or moderate risks. Moderate investors often also invest in real estate, providing that it is low risk real estate.
Aggressive investors commonly do most of their investing in the stock market, which is higher risk.They also tend to invest in business ventures as well as higher risk real estate. For instance, if an aggressive investor puts his or her money into an older apartment building, then invests more money renovating the property, they are running a risk. They expect to be able to rent the apartments out for more money than the apartments are currently worth - or to sell the entire property for a profit on their initial investments. In some cases, this works out just fine, and in other cases, it doesn't. It's a risk.
Before you start investing, it is very important that you learn about the different types of investments, and what those investments can do for you. Understand the risks involved, and pay attention to past trends as well. History does indeed repeat itself, and investors know this first hand!
The different types of stock are what confuse most first time investors. That confusion causes people to turn away from the stock market altogether, or to make unwise investments. If you are going to play the stock market, you must know what types of stock are available and what it all means!
Common StockCommon Stock is a term that you will hear quite often. Anyone can purchase common stock, regardless of age, income, age, or financial standing. Common stock is essentially part ownership in the business you are investing in. As the company grows and earns money, the value of your stock rises. On the other hand, if the company does poorly or goes bankrupt, the value of your stock falls. Common stock holders do not participate in the day to day operations of a business, but they do have the power to elect the board of directors.
Class A or B StockAlong with common stock, there are also different classes of stock. The different classes of stock in one company are often called Class A and Class B. The first class, class A, essentially gives the stock owner more votes per share of stock than the owners of class B stock.
The ability to create different classes of stock in a corporation has existed since 1987. Many investors avoid stock that has more than one class, and stocks that have more than one class are not called common stock.
Preferred StockThe most upscale type of stock is of course Preferred Stock. Preferred stock isn't exactly a stock. It is a mix of a stock and a bond. The owner's of preferred stock can lay claim to the assets of the company in the case of bankruptcy, and preferred stock holders get the proceeds of the profits from a company before the common stock owners.
If you think that you may prefer this preferred stock, be aware that the company typically has the right to buy the stock back from the stock owner and stop paying dividends.
Investing in bonds is very safe, and the returns are usually very good. There are four basic types of bonds available and they are sold through the Government, through corporations, state and local governments, and foreign governments.
The greatest thing about bonds is that you will get your initial investment back. This makes bonds the perfect investment vehicle for those who are new to investing, or for those who have a low risk tolerance.
The United States Government sells Treasury Bonds through the Treasury Department. You can purchase Treasury Bonds with maturity dates ranging from three months to thirty years.
Treasury bonds include Treasury Notes (T-Notes), Treasury Bills (T-Bills), and Treasury Bonds. All Treasury bonds are backed by the United States Government, and tax is only charged on the interest that the bonds earn.
Corporate bonds are sold through public securities markets. A corporate bond is essentially a company selling its debt. Corporate bonds usually have high interest rates, but they are a bit risky. If the company goes belly-up, the bond is worthless.
State and local Governments also sell bonds. Unlike bonds issued by the federal government, these bonds usually have higher interest rates. This is because State and Local Governments can indeed go bankrupt, unlike the federal government.
State and Local Government bonds are free from income taxes � even on the interest. State and local taxes may also be waived. Tax-free Municipal Bonds are common State and Local Government Bonds.
Purchasing foreign bonds is actually very difficult, and is often done as part of a mutual fund. It is often very risky to invest in foreign countries. The safest type of bond to buy is one that is issued by the US Government.
The interest may be a bit lower, but again, there is little or no risk involved. For best results, when a bond reaches maturity, reinvest it into another bond.
The American Recovery and Reinvestment Act of 2009 creates the new Build America Bond program, which authorizes state and local governments to issue Build America Bonds as taxable bonds in 2009 and 2010 to finance any capital expenditures for which they otherwise could issue tax-exempt governmental bonds. State and local governments receive a direct federal subsidy payment for a portion of their borrowing costs on Build America Bonds equal to 35 percent of the total coupon interest paid to investors.
There are certain things you must understand about bonds before you start investing in them. Not understanding these things may cause you to purchase the wrong bonds, at the wrong maturity date.
The three most important things that must be considered when purchasing a bond include the par value, the maturity date, and the coupon rate.
The par value of a bond refers to the amount of money you will receive when the bond reaches its maturity date. In other words, you will receive your initial investment back when the bond reaches maturity.
The maturity date is of course the date that the bond
will reach its full value. On this date, you will receive
your initial investment, plus the interest that your money has earned.
Corporate and State and Local Government bonds can
be "called" before they reach their maturity, at which time the corporation or issuing Government will return your initial investment, along with the interest that it has
earned thus far. Federal bonds cannot be "called."
The coupon rate is the interest that you will receive
when the bond reaches maturity. This number is written as a percentage, and you must use other information to find out what the interest will be. A bond that has a par value of $2000, with a coupon rate of 5% would earn
$100 per year until it reaches maturity.
Because bonds are not issued by banks, many people don't understand how to go about buying one. There
are two ways this can be done.
You can use a broker or brokerage firm to make the purchase for you or you can go directly to the Government. If you use a brokerage, you will more than likely be charged a commission fee. If you want to use
a broker, shop around for the lowest commissions!
Purchasing directly through the Government isn't nearly as hard as it once was. There is a program called Treasury Direct which will allow you to purchase bonds and all of your bonds will be held in one account, that
you will have easy access to. This will allow you to
avoid using a broker or brokerage firm.
Mutual funds and other investment companies are often labeled by the objectives they hope to accomplish, such as current income or growth.
Mutual fund families may have a number of different funds available to meet various objectives. Note, however, that there is no guarantee that any mutual fund will actually attain the desired objective.
Mutual Funds can be
loosely classified as one of these:
(1) diversified common stock
(2) balanced fund,
(3) bond and preferred stock fund,
(4) municipal bond fund, and
(5) money-market fund.
In comparing one mutual fund to another, it is important that both funds have a similar investment objective. For example, it wouldn't be fair to compare the expenses of an intensely managed aggressive growth fund to those of an index fund.
Each type of fund has a different investment objective that requires it to take a different investment approach, and those differing approaches are going to affect each fund's expenses.
However, it would be fair to compare the expenses of one aggressive growth fund to another aggressive growth fund, or the expenses of one index fund to another index fund. To begin with, then, the investor has to determine which investment objective he or she wants to achieve, and then compare the funds that have that investment objective.
Once an investor has determined his or her investment objective, there are three major factors by which mutual funds can be compared.
PerformanceA record of successful growth or appreciation in the fund's capital value in the past is a positive sign, but it is no indication that the growth will continue in the future. The larger and more successful a fund becomes, the more difficult it is to maintain that growth. Performance rankings of the top funds change considerably over a period of time.
RiskEvery investment involves risk. Investors hope that, if they are willing to take a greater risk, they will be rewarded with a greater return. Analysts use "risk-adjusted performance" to rank funds of a given type on their rate of return adjusted for risk, measuring a fund's performance in both up and down markets. A volatile fund may produce above-average gains when the market is up. But it may also lose value much faster than average in a falling market. Funds that have performed well in both good periods and bad may be ranked higher than more volatile funds with a greater return.
CostA final element for comparison between funds is cost. The expense ratio gives you the fund's operating expenses for the year expressed as a percentage of the fund's average net assets. In general, the lower the expenses, the greater the return to the investor.
The management advisory fee, somewhere around 0.5% of net assets, is usually the largest single component of operating expenses. Most funds will try to keep their operating expenses around 1% of the fund's assets. But currently funds range from a low expense ratio of .29% to as high as 9% of assets. The average stock fund in the early 1990s had an expense ratio of 1.6%. Expenses higher than average will reduce the investor's return.
Investors will find many features that cannot be
compared statistically from fund to fund. Nevertheless,
the special features may weigh heavily with specific investors. The presence or absence of features like telephone transfers, exchange privileges, front-end or back-end loads, or minimum purchase amounts may override differences in performance with these investors.
Most mutual funds offer a variety of ways for an investor to purchase shares. One of these is an open or regular account. Under this arrangement, an investor estab-
lishes the account by making a substantial lump-sum investment with no commitment to make regular purchases. However, because the account is "open,"
the investor may make additional investments as
desired and as money is available.
Because there is usually a sales charge assessed on each individual purchase, investors should be aware
that they may benefit from accumulating small dollar amounts into larger amounts before each investment.
In addition, there are generally specified dollar amounts, like $5,000, at which the sales charge is reduced.
Dollar cost averaging can reduce an individual's concern about making an investment at the "wrong" time. Investors sometimes delay investing when the market has been rising rapidly because they feel that it may be due for a correction. Meanwhile, the market continues to rise and they lose what would have been a good opportunity to invest. Or they may delay investing when the market has been falling because they fear it may be in a long-term downward trend. They wait until
the market shows some strong upward movement, and then they find themselves on the other side of the vi-
cious circle continuing to delay while they wait for a correction.
How Safe is Your Dividend Income?
As an investor, you buy stock for two basic reasons. You hope to benefit from any gains in the capital value of the stock. Or, you want the steady stream of income that stock dividends can provide. The best of both worlds, of course, is a stock that does both: rises in value and pays a dividend consistently.
Investors, particularly those on fixed incomes for whom safety is of principal importantance, are more likely to buy common stocks that pay dividends. The potential for regular increases in dividends is attractive when compared to the fixed-income payments bonds and preferred stocks provide.
If you invest in dividend-paying common stocks, you should exercise caution when choosing a stock on the basis of an attractively high dividend. Some companies whose dividends are enticingly high today may not be able to boost those dividends for a long time. They may even have to cut their dividend if earnings are off.
What, then, are the criteria you should use in measuring a particular dividend-paying stock? You want, above all else, to ensure the consistency of your dividend payments. You also want your dividends to increase on a regular basis. Moreover, you would like to see that the company you invest in has reasonable prospects for earnings growth.
There are yardsticks that you can use to give you a better idea of a company's financial health and its continued ability to pay dividends. While not foolproof, they will give you a clearer understanding of what to look for in picking an income stock. When you examine an income stock, you should check if the company has a record of uninterrupted earnings and dividend growth over the years. You should examine the company's prospects for future dividends growth. Be wary where a company pays out as dividends more than it earns.
And look also at the stock's price/earnings (P/E) ratio. The P/E ratio is essentially a measure of investor confidence in a particular stock. Ask yourself where the company stands in terms of current earnings and future prospects. How high or low is the P/E ratio when compared to other stocks in the same industry?
Certain companies have historically performed well on a consistent basis no matter whether the economy is in a boom or a bust cycle. Utilities have been a good example. Gas, electric, telephone, and water companies on the whole have tended to exhibit steady, dependable growth and consistent increases in dividends. You can measure the credit quality of utility and telephone companies by checking how they are rated by ratings services such as Moody's and Standard & Poors.
Many stocks in groups other than utilities pay dividends that increase regularly. Many Fortune 500 firms show steady, reliable earnings growth and provide consistent dividends. Industries that provide basic commodities, products, and services tend to hold their own even during downturns in the economy. However, even Fortune 500 firms are subject to the swings of a volatile stock market.
Inflation and high interest rates are other concerns for investors in dividend-paying stocks. You should know that the prices of income stocks tend to fall in times of high inflation and high interest rates. However, their dividends tend to move up in tandem with the level of inflation. In all, successful investing for income requires time, patience, and good advice.
Dividends are distributions of property (which can include money, stock of another corporation or other property) a corporation pays you because you own stock in that corporation. You also may receive dividends through a partnership, an estate, a trust, a subchapter S corporation or from an association that is taxable as a corporation.
Most dividends are paid in cash. A shareholder of a corporation may be deemed to receive a dividend if the corporation pays the debt of its shareholder, the shareholder receives services from the corporation, or the shareholder is allowed the use of the corporation's property. A shareholder may also receive distributions such as additional stock or stock rights in the distributing corporation; such distributions may or may not qualify as dividends.
You should receive a Form 1099-DIV, Dividends and Distributions, from each payer for distributions of $10.00 or more. Also, if you receive dividends through a partnership, an estate, a trust, or a subchapter S corporation, you should receive a Schedule K-1 from that entity indicating the amount of dividends taxable to you. You must report all taxable dividends even if you do not receive a Form 1099-DIV or Schedule K-1.
Ordinary dividends are the most common type of distribution from a corporation. They are paid out of the earnings and profits of the corporation. Ordinary dividends are taxable as ordinary income unless they are qualified dividends. Qualified dividends are ordinary dividends that meet the requirements to be taxed as net capital gains.
Distributions that qualify as a return of capital are not dividends. A return of capital is a return of some or all of your investment in the stock of the company. A return of capital reduces the basis of your stock. For information on Basis of Assets, refer to Topic 703. A distribution generally qualifies as a return of capital if the corporation making the distribution does not have any accumulated or current year earnings and profits. Once the basis of your stock has been reduced to zero, any further non-dividend distribution is capital gain.
Capital gain distributions may be paid by regulated investment companies (mutual funds) and real estate investment trusts (REITs). Capital gain distributions are always reported as long-term capital gains. You must also report any undistributed capital gain that mutual funds or REITs have designated to you in a written notice. Those undistributed capital gains are reported to you on Form 2439 (PDF). Please refer to the Form 1040 Instructions or Form 1040A Instructions for information on how to report qualifying dividends and capital gain distributions.
Form 1099-DIV should break down the distribution into the various categories. If it does not, contact the payer.
You must give your correct social security number to the payer of your dividend income. If you do not, you may be subject to a penalty and/or back-up withholding. Refer to Topic 307 for more information on back-up withholding.
If you receive dividends in significant amounts, you may have to pay estimated tax.
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