When it comes to investing, the options can seem overwhelming. However, there are basically three different types of investment options that people can access. Most investments are a derivative of these three major options.
Simply stated, a share of stock represents a small sliver of ownership in a company. Shareholders have a claim to any profits that a company might earn, and these profits will usually pay off through a higher market price or a dividend payment for each share. It’s possible to purchase stocks through mutual funds and exchange-traded funds. These funds are basically baskets of stocks that allow investors to diversify their holdings with a single purchase. Over time, the stock market as a whole has a better rate of return than the other two options.
Bonds do not provide any benefits of ownership in a company. They are simply debt instruments. Companies and governments frequently need cash to finance improvements. Companies might want to build a new plant; governments might want to build a new road. To access cash quickly, they might issue bonds. Investors in bonds are promised periodic interest payments for the use of their money. Once the bond matures, the investor will theoretically get their principal investment back. The more risky the market perceives a company or government to be, the higher the interest rate they’ll have to pay. Defaults do happen, but bonds are usually viewed as less risky than stocks. Like stocks, it’s possible to buy funds that include bonds for instant diversification.
People who want to avoid the risk of volatility might want to keep some of their money in investments that are cash equivalents. This option includes bank savings accounts, certificates of deposit, and money market accounts. Cash equivalents pay interest, but it’s usually much lower than the interest rate an investor can expect to earn with a bond or bond fund. There is little volatility with cash equivalents, and the likelihood of losing capital is very low. However, there is a major risk that comes with cash equivalents. That risk is inflation. If the interest rate paid does not keep up with inflation, an investor will lose purchasing power over time because a dollar will likely be worthless in 10 years than it is today.