6 types of investment (and how they work)

6 types of investment (and how they work)

Stocks or bonds? Gold or cash? Funds or ETFs?

Susi Weaser

May 27, 2020

·

10

min read

When you start researching types of investment, it’s easy to quickly be put off by the complexities of the financial world, packed with jargon, acronyms and assumed prior knowledge.

But you’re not alone. We're here to demystify all of your options, so you can start making the kind of financial decisions that can have a massive impact on your life.

So, where exactly is your money best invested?

The Speed Read

1. Stocks provide the biggest financial reward, but are the most risky.

2. Cash and gold are mainly used to keep a proportion of your money safe.

3. A mix of investments is ideal, and you can invest in mutual funds or ETFs to do this for you.

Types of investment: Direct investments

Stocks and shares

Let’s start with an easy one: what’s the difference between stocks and shares?

The answer? Nothing. In English, both words are used interchangeably.

So now on to a more complex question:

How do stocks and shares work?

When a company ‘goes public’, it goes through an Initial Public Offering (IPO), which is when the shares first become available to buy and the company becomes listed on a stock exchange. It’s at this point that a company goes from private, owned by individuals, to public, where it’s owned by members of the public, like you and me.

For the founders and earlier investors, that means a nice payout for their idea or support, and for the company, it’s a chance to raise money for future plans.

When a company goes through an IPO, it gets divided like a pie, so the public can buy pieces of that pie. And like any good pie, it can be cut into any number of slices - or shares. The share price is based on good old fashioned supply and demand, so the more people want one, the higher the price will go.

And when you land yourself a share you become a part of that company. That gives you the right to ask questions and vote on big decisions, which is normally done at the company’s Annual General Meeting (check out Bill Murray's recent cameo appearance asking a question at an investor meeting he attended).

How do you make money through stocks and shares?

When you buy a share, you do so in the hope that it increases in value. This will allow you to sell it for a profit.

Take Google: if you’d bought one share at its IPO in 2004, you would have paid $85 (€85). If you were to sell that share today, you would get approximately $1,410 (€1,285)- an impressive increase of 1,558% on your initial investment.

Google's share price chart
SOURCE: YAHOO FINANCE

But there’s also a second way of making money with shares: dividends.

These are regular payments made to shareholders based on company profits. They can be in cold hard cash, or in the form of additional stock. They’re only issued when a company is profitable though, so during financial downturns dividend payments are often put on hold.

In fact, recent analysis has suggested that companies are likely to make fewer dividend payments in the future, as they choose to shore up their finances against future recessions rather than spend it rewarding shareholders.

A simple explanation as to how stocks work. Read more on the Cooler Future blog

Pros:

- Rewards from directly investing in stocks can be significant.

- It’s an exciting form of investing - there’s a reason Hollywood hasn’t made a film about Leonardo DiCaprio putting money in a savings account ;)

Cons:

- High rewards are because the risk of your money decreasing in value is significant (although this risk decreases the longer you keep hold of your shares).

- Picking the right stocks means doing your homework before buying, and closely monitoring the market so you sell at the right time.

Bonds

Bonds are a loan of money that you give to a company, municipality or government, so they can finance a new project or investment.  

For the government, that might be something like the nationwide installation of electric vehicle charging points. For a company, you could be loaning money for them to invest in the manufacturing of electric vehicle charging stations. (These are both examples of green bonds, a particularly hot topic at the moment as businesses and governments focus on cutting carbon emissions across the globe.)

Bonds cut out the middleman - in this case, banks - so are cheaper for the borrower of the loan, as well as offering you, the lender, a higher return on your investment than a savings account. This return is called the coupon rate.

How do you make money from bonds?

Bonds pay you an agreed interest rate on an annual basis, and must be repaid to you by a specific date, called the maturity date.

The interest rate is based on the risk that the borrower won’t be able to return the loan - the higher the risk, the higher the interest rate. This is calculated by credit agencies, who look at a number of factors to determine the financial stability of an organisation.

Selling the bond before its maturity date can also mean making a profit. If the coupon rate of a similar bond has fallen e.g. buyers are now only getting 5% interest whereas your bond offers 7%, you’ll be able to sell yours for more money.

A simple explanation as to how bonds work. Read more on the Cooler Future blog

Pros:

- Less risky than stocks, because they’re not subject to the same market fluctuations.

- The money you’ve loaned should get returned to you.

Cons:

- As with normal loans, there’s always a chance that the institution or government will default on payment and your money won’t get returned.

- Selling your bond before maturity comes with a risk you’ll lose money, if similar bonds now offer a higher coupon rate.

Gold

Investing in gold is just as you imagine. People really do invest in gold bars, and banks around the world really are full of vaults packed with them.

Bars of gold are officially called gold bullion, but gold can also take the form of coins, jewellery, or anything else made out of this precious metal (silver and platinum are also common investments).

Gold is seen as a crucial part of any investment portfolio, because it mitigates the risk that the rest of your investments will be subject to. If you’ve got 75% of your wealth invested in things that may not pay off, it’s reassuring (and wise!) to know that 25% is likely to retain its value.

Investment portfolio
Investment portfolio is the name for all of your investments or assets, whether they are shares, gold, cash or something else, such as property. It’s like your overall financial wallet.

How do you make money from gold?

Gold is typically seen as a safe investment, because it holds its value and isn’t supposed to be subject to market fluctuations in the same way stocks are. Therefore it’s less a way of making money, and more a case of protecting your money against a financial hit.

But that doesn’t always hold true. From a 2011 high of €1,751 per ounce, the price of gold dipped to €970 in 2015, before reaching a recent high of €1595. Buying gold in 2015 would mean you’d make a 64% profit if you were to sell today.

So while there are fluctuations, its main characteristic is that it often doesn’t reflect what’s going on in the stock market.

For instance, while both the S&P and the Dow Jones have seen losses of 10-15% this year, gold has increased in value by 15%.  That’s because demand is up, as investors move their money away from the stock market towards gold.

Liquidity
Assets, such as cash or possessions, that can be converted into spending money quickly, without losing a substantial amount of value.

Pros:

- Protects your finances against stock market fluctuations.

- Lower commission rates than stock trading, because of lower administrative costs compared to monitoring the stock market and making numerous trades.

Cons:

- Large amounts of gold has low liquidity, which can make it difficult to trade (if you buy a 1kg bar of gold for €50,000, you can’t chip off a corner to sell every time you want €1,000 cash).

Cash

In the world of investing, cash doesn’t mean the money in your pocket, but simply leaving your money in its original form, rather than using it to buy something else.

For most of us, the most common form of cash investment is a bank savings account.

Like gold, cash is seen as an important part of an investment portfolio, offering you some protection for your money, rather than focusing on growing it.

How do you make money from cash investments?

Interest payments in any form of cash investment are low. In fact, bank interest rates have hit record lows with no sign of increasing, which means you’ll be lucky to get more than 2% interest on your basic bank savings at the moment.

If you’re happy to have your money locked away for a specific amount of time, you can get a better rate by buying a Certificate of Deposit. Banks offer these, charging you a penalty if you withdraw your money early.

Pros:

- The safest form of investment: in the EU, money in bank accounts is guaranteed as safe up to €100,000.

- Easy to withdraw and spend your money.

Cons:

- Low return on investment.

- You have no control over where the bank loans out your money.

Making direct investments as an individual is a risky business. A recent studyfound that the average investor grew their investment by 5.19% a year, while the S&P 500 Index (a collection of 500 of the biggest US companies) grew 9.85%. That means those investors that blanket invested in all S&P companies saw 4.66% more money than those who personally selected their investments.

So if you’re beginning to feel like these investments involve too many decisions - when to buy, what to buy, when to sell, what to sell - there’s good news.

Indirect investments allow you to pass some of that responsibility to an expert. The types of investments are the same - you still invest in the stock market, bonds, gold and cash - but the way you invest is different.

Types of investment: Indirect investments

Mutual Funds

A mutual fund (often just called a fund) is a pool of investors’ money, used to buy assets, such as stocks, bonds, gold and sometimes cash.  

Investing in a mutual fund allows you to invest in a range of assets, by adding your financial contribution to others’, creating a large pool of investment money. It’s not a private arrangement - you won’t know the other people investing - and the fund will be a financial product that you buy through your bank, broker or online.

How do you make money through a mutual fund?

You make money through a fund in the same way you do if you were directly investing in financial assets. When it comes to shares, you’ll rely on dividend payments and hope for an increase in value before you sell. With bonds, there’s the coupon (interest) rate, and a possible slight increase in value before you sell. Gold and cash can also be part of a fund portfolio, providing a certain amount of safety for your investment.

There are two types of funds: active and passive.

An actively managed fund will be run by a fund manager, who will decide what to invest in, selling those assets that aren’t performing and investing in those that are on a daily basis. They will take a percentage of your investment as a fee for this management.

A passive fund follows a particular index, simply mirroring what the index is doing. So if your passive fund tracks the FTSE100, an index of the UK’s 100 biggest companies, you will own shares in all 100 companies, in the same proportions as their market value. Your investment will then go up and down in line with the FTSE100 going up and down.

How do mutual funds work?

Pros:

- Gives you a diverse portfolio without spending a lot of money, because your money is pooled with other investors.

- Bulk purchasing of assets by a fund manager means less fees.

- Easier to invest, since you don’t have to research the companies you’re investing in - your fund manager (active) or index (passive) will make the decisions for you.

- Can invest in a fund that matches your needs e.g. finance-based, such as a regular income, or values-based, such as a fund that doesn’t invest in fossil fuel companies.

Cons:

- No control over decisions regarding what to invest in - you can’t exclude certain stocks (such as fossil fuel companies) or add any additional stocks.

Exchange Traded Funds (ETFs)

ETFs are very much like mutual funds. They also allow you to invest in a collection of assets, pooling your money with other investors.

The difference is that ETFs are listed themselves on exchanges, and traded over the course of the day. They have their own symbol, just like stocks. For instance, the SPDR S&P 500 ETF is listed on the NYSE with the symbol SPY, and tracks the S&P 500 Index, a collection of 500 of the largest US companies.

Stock symbol
Sometimes called the ticker symbol, it's a unique shorthand for the company you’ve invested in, making it easily identifiable on stock market exchanges. Some are abbreviations (AAPL for Apple) while some are more creative (HOG for Harley Davidson).

An ETF can contain all types of investments, including stocks, bonds and gold. It can be restricted to one industry, such as technology; one country, such as the UK; or spread across many company types and geographic locations.

You can invest in an ETF through a broker, and much like mutual funds, they can then be actively managed for a fee, or passively track an index.

How do you make money from ETFs?

Because ETFs are traded on the stock exchange, their price fluctuates over the course of the day, just like a traditional stock. That means you’re able to trade them in the same way, hopefully buying low and selling high, ultimately making a profit.

And just like directly buying stock, you’ll get dividends. That’s because stocks make up at least part of your ETF portfolio, so when companies awarded dividends to shareholders, you’re part of that group.

How do ETFs work?

Pros:

- Lower commission fees than buying stock individually.

- An easy way to diversify your portfolio, so there’s less risk to your money even if one asset significantly decreases in value.

- Allows investment in small amounts of something, such as gold, allowing you to trade smaller amounts of this typically low liquidity asset.

Cons:

- If the ETF specialises in investing in an industry that suffers a setback - such as the airline industry during coronavirus travel bans -  that diversity isn’t enough to protect you.


Conclusion

We’ve talked a lot about the importance of diversifying your financial portfolio, and that’s for one very good reason: every type of investment has advantages and disadvantages.

By choosing to invest in different types of assets, you can balance the pros and the cons. For instance, you can take advantage of things like the higher rewards of the stock market, while also ensuring that a proportion of your money is safe by investing in something like gold or cash.

The true decision is not so much which type of investment you choose, but what proportion of your money you will allocate to each type.

Financial advisors consider your “investment horizon”, which is how long you intend to hold on to your investments before wanting a return, and your “tolerance to risk”, essentially how much of a disaster it would be if you lost money. The interplay of these two factors determines your investment strategy.  

The ideal mix of investments will be different for everyone. But whatever you choose, the most important thing is to understand your investments. It’s this knowledge that means you can make the right decision for you and your financial goals.

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