And no, I’m not referring to stock options, those financial instruments that let you buy or sell shares of a stock at a specified price for a specified period of time. I have no experience as an options trader.
Nor am I referring to employee stock options that offer the employee the right to purchase a set number of shares at a specified price for a fixed period of time, like those lucky people who worked at Google in the early years and became millionaires.
But I will be describing the most common types of investments that you will probably want to include in your portfolio.
If you missed my prior two posts, you may want to go back and check them out, as they provide very helpful background information about investment accounts—in addition to setting up a killer metaphor that I will continue to explore.
If you have read my latest posts, you know all about the “grocery baskets” (AKA, types of retirement investment accounts). When it’s time to go shopping, what can you put in your baskets?
The “groceries,” of course (AKA investment options)!!!
In this post, I will provide definitions for different types of investments and try to steer you towards those that are most “consumer-friendly.” By this, I’m assuming you are not a day-trader, investment guru, or otherwise have the means and interest to invest outside of the mainstream. I won’t be talking about commodities, cryptocurrencies, precious metals, collectibles, and other like investments. Annuities (pension-like products that individuals can purchase) and real estate are also two investment types that, alas, will not be covered here. But never fear, they shall be the subjects of future posts and I will provide further details about them down the road.
Most radiologists have a limited amount of time they’re willing to devote to the management of their investments. That’s why many will pay an advisor to do it for them (more in an upcoming post on what I think constitutes “good financial advice at a fair price”). Even so, in order to know if your financial advisor is acting in your best interests, you should at least understand what your options are.
|In general, the greater the expected return on an investment, the greater the risk.|
The investment products described below each serve a different purpose, depending on how long the money will be invested and how much risk the investor can/is willing to take. Money can be invested for short-term goals (e.g., saving for a vacation) and long-term goals (e.g., retirement 30 years in the future). If you are very averse to risk or don’t need to take any risks with your investments (did you receive a big windfall of cash from an inheritance or win the lottery, or have you already saved up more than you’ll need for the rest of your life?), you may choose not to invest in stocks or stock funds. A radiologist who is just starting out in her career and has a 30-40 year time horizon for saving may want to put a lot of money in stocks because she isn’t concerned about the short-term swings in the stock market.
In general, the greater the expected return on an investment, the greater the risk. Helping you choose the right investments is a topic I’ve saved for a later post about asset allocation, (i.e., dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash).
Right now, I want to explain what they are. I’ve listed them in order of lowest risk/lowest return to greatest risk/highest expected return (super helpful of me, right?). Note: Highest “expected” return, not guaranteed return.
Since 1926, large stocks have returned an average of 10% per year, long-term government bonds have returned between 5% and 6%, and cash equivalents close to the inflation rate, averaging about 3%per year over the past 80 years. This doesn’t mean you should expect these returns in the future, but it’s reasonable to expect that there will continue to be a differential in the rate of return between the three.
So, buckle up, because it’s going to be a fast and furious ride through the investment product landscape:
Investment type: cash equivalents
Most practicing radiologists will not have a lot of their retirement money in cash equivalents, because, although they are a very safe way to invest, they have the lowest return and don’t allow your money to grow enough for your retirement needs. But such accounts have an important role as a vehicle for stashing money for short-term investments (e.g., saving for a car or a house down payment). Some retired radiologists, who have as much money as they’ll ever need, feel more comfortable keeping more of their wealth in cash. Someone once said that “once you’ve won the game, you can stop playing”.
Cash equivalents are any investment that you can quickly convert to cash without cost to you. An example is a checking account that allows you to write a check, withdraw cash by visiting a teller at a bank or an ATM, or transfer money from the account electronically from your desktop computer/tablet/phone. These accounts generally don’t pay much interest so you don’t want to keep more money in this account than you need to.
Savings accounts pay more interest than checking accounts do, at a rate dependent on the amount of money in the account. Savings accounts have changed dramatically in the recent past. More people are ditching bricks and mortar banks in favor of online banks that offer much higher interest rates and convenient online transactions.
Money market mutual funds are another type of cash equivalent that invests in very safe securities such as short-term bank certificates of deposit, U.S. government-issued Treasury bills, and short-term bonds. Investors, both large and small, invest hundreds of billions of dollars in money market mutual funds because the best money market funds historically have produced higher yields than bank savings accounts.
Certificates of deposit (CDs) are products offered by banks and credit unions that offer a fixed, guaranteed interest rate for the duration term of the CD (e.g., 3 months, 6 months, 1 year, 3 years, or 5 years). This is in contrast to a money market or savings account, where the interest rate can change at any time. The added “risk” you accept for this higher return is that the CD cannot be liquidated (i.e., cashed in) prior to maturity (i.e., the length of the term) without paying a penalty. Almost all banks, credit unions, and brokerage firms offer a menu of CD options, with varying durations, rates, and penalties.
Shopping around is crucial to finding the best CD rates because different financial institutions offer a surprisingly wide range. Your brick-and-mortar bank might pay a pittance on even long-term CDs, for example, while an online bank or local credit union might pay three to five times the national average. As of January 20, 2020, the best one-year CD rate being offered was 2.15% (with a $500 minimum deposit).
Note: The National Credit Union Administration (NCUA) and the Federal Deposit Insurance Corporation (FDIC) are both independent federal agencies that regulate and insure the deposits of credit unions and banks, respectively. Both insure the following types of individual accounts up to $250,000: checking accounts, savings accounts, money market accounts, CDs, cashier’s checks, and money orders. Neither insures money invested in stocks, bonds, mutual funds, life insurance policies, annuities or municipal securities, even if these investments are purchased at an insured bank or credit union.
Investment type: bonds
Bonds are a form of debt. They are loans, or IOUs, and you are the bank. You loan your money to a company, a city, the government – and they promise to pay you back in full, with regular interest payments. A city may sell bonds to raise money to build a bridge, a hospital may sell bonds to build a new facility, while the federal government issues bonds to finance its spiraling debts.
Most investors have some of their savings in bonds because over time they pay more than cash equivalents and are less volatile than stocks. As people near retirement, they tend to have more invested in bonds and less invested in stocks.
That doesn’t mean that all bonds are risk-free – far from it. As with all investments, you’re paid more for buying a riskier security. In the bond world, that risk comes in a few different forms.
The first is the likelihood the bond issuer will make good on its payments. Less credit-worthy issuers will pay a higher yield, or interest rate. That’s why the riskiest issuers offer what’s called high-yield or “junk” bonds. Those at the opposite end of the spectrum, or those with the best histories, are deemed investment-grade bonds.
The safest bonds, issued by the U.S. government, are known as Treasurys. They’re backed by the “full faith and credit” of the U.S. and are deemed virtually risk-free. If you can’t rely on the federal government, what can you rely on?
How long you hold the bond (or how long you lend your money to the bond issuer) also influences risk. Bonds with longer durations – say a 10-year bond versus a one-year bond – pay higher yields. That’s because you’re being paid for keeping your money tied up for a longer period of time.
Interest rates, however, probably have the single largest impact on bond prices. As interest rates rise, bond prices fall. That’s because when rates climb, new bonds are issued at the higher rate, making existing bonds with lower rates less valuable.
In addition to buying individual bonds, you can also purchase mutual funds (see below) that invest in bonds. Bond funds do not have a maturity date (although the individual bonds held by the fund do), so the amount you invest will fluctuate as will the interest it generates.
Why bother with a bond fund? It’s work to build and manage your own diversified portfolio of bonds. Buying a fund that holds bonds is easier.
There are many types of bonds:
Treasurys are issued by the U.S. government and are considered the safest bonds on the market. As such, you won’t collect as much in interest as you might elsewhere, but you don’t have to worry about defaults. They can be purchased directly through TreasuryDirect.gov (with no fees) or through a bank or broker.
You may hear about three types of treasuries: bills, notes, and bonds. They differ by their length to maturity. Treasury bills (aka T-bills) are issued for terms less than a year. Treasury notes are issued for terms of two, three, five, seven, and 10 years. Treasury bonds are issued for terms of greater than 10 years.
Treasury Inflation-Protected Securities (TIPS) are a flavor of Treasury that protects against inflation. They usually pay a lower interest rate than other Treasurys, but their principal and interest payments adjust with inflation as measured by the Consumer Price Index. If you’ve been around a while you may remember that the federal interest rate in 1980 was 20%. That may seem great to you if you’re the “loaner” and collecting 20% interest on bonds. But if you’re the “borrower” you might not like paying such an astronomical interest rate on a mortgage or car loan. In December 2008, the interest rate was at a low of 0.25%.
There are also two types of savings bonds offered by the U.S. treasury: EE Savings Bonds and I Savings Bonds (similar to EE savings bonds, except that they’re indexed for inflation).
Agency bonds are issued by government-sponsored enterprises (e.g., Small Business Administration, the Federal Housing Administration and the Government National Mortgage Association (Ginnie Mae) and are perceived to be safer than corporate bonds. They are not, however, backed by the “full faith and credit” of the U.S. government like Treasurys, which would make them virtually risk-free.
Municipal bonds, or Munis, as they’re commonly known, are issued by states, cities and local governments to fund various projects. Municipals aren’t subject to federal taxes, and if you live where the bonds are issued, they may also be exempt from state taxes. Because of this tax break, expect the interest rate to be lower than non-munis (you can’t have your cake and eat it too).
Corporate bonds are bonds issued by companies. Corporate debt can range from extremely safe to super risky.
Investment type: stocks
Stocks may be the most well-known and simple type of investment. When you buy an individual stock, you’re buying an ownership share in a publicly traded company. Many of the biggest companies in the country — think Microsoft, Amazon, Apple and Facebook — are publicly traded, meaning you can buy stock in them. If Apple (Apple, Inc., AAPL) sells a lot of iPhones, the value of the company increases, and it may (or may not) pay out more money in dividends to its owners. When you buy one or more shares of Apple stock, you become an “owner.” If however, you were to buy bonds issued by Apple, you would be a “loaner.” You can potentially make a lot more money as an owner than a loaner, but that greater expected return comes with greater risk.
When you buy a stock, you’re hoping that the price will go up so you can then sell it for a profit. The risk, of course, is that the price of the stock could go down, in which case you’d lose money. No one can predict which stocks will perform well over the long run.
Investment type: mutual funds
A mutual fund is a pool of many investors’ money that is invested broadly in a number of stocks, bonds, or properties (referred to as “securities”). The number of securities held within a particular fund can vary from dozens to thousands. Some mutual funds invest only in stocks, others only in bonds and some in a mixture of the two. Investors buy “shares” of a mutual fund.
Mutual funds carry many of the same risks as stocks and bonds, depending on what they are invested in. The risk is lesser, though, because the investments are inherently diversified. Diversification is an investment strategy that aims to reduce risk while maximizing return. It does this by spreading exposure to several different asset classes and within each asset class. The thinking is that if one sector or one holding goes down, the whole portfolio won’t sink and may even experience gains elsewhere.
Mutual funds can be actively managed or passively managed. An actively managed fund has a fund manager who picks companies and other instruments in which to put investors’ money. Fund managers try to beat the market by choosing investments that they predict will increase in value.
A passively managed fund simply tracks a major stock market index like the Dow Jones Industrial Average or the S&P 500 (a market index tracking the 500 largest publicly-traded companies on the market). Passively managed funds simply try to capture the return of the market by buying all the securities in a particular index instead of trying to predict the “winners.” It will hold all the winners and the losers, but at such a low cost that they outperform the average actively managed fund, especially over a long period of time.
The issue of passive versus active funds has been hotly debated since before passive index funds became an investment option for the individual investor. If you search “active versus passive investing” on Google you will find proponents of both. An academic at heart, I like to make important decisions, like how to invest my money, based on the best scientific evidence that comes from unbiased sources. On page 178 of his book “A Random Walk Down Wall Street” (W. W. Norton & Company, New York, NY, 2012), Burton G. Malkiel (who holds the Chemical Bank Chairman’s Professorship at Princeton University) says:
“The evidence from several studies is remarkably uniform. Investors have done no better with the average mutual fund than they could have done by purchasing and holding an unmanaged broad stock index. In other words, over long periods of time, mutual-fund portfolios have not outperformed randomly selected groups of stocks. Although funds may have very good records for certain short time periods, superior performance is not consistent, and there is no way to predict how funds will perform in any given future period.”
In other words, actively managed funds have not outperformed passive index funds over the long run. And because managed funds cost more in fees (a topic for a later post), passive funds outperform managed funds over time.
Investment type: exchange-traded funds
An ETF is called an exchange-traded fund because it’s traded on an exchange just like stocks. The price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market. This is different from mutual funds, which are not traded on an exchange, and trade only once per day after the markets close. Like mutual funds, they are a collection of investments, and most track a broadly diversified market index and can be passively or actively managed.
Whew—that was a whirlwind tour of the more common types of investments!!! Unless you are a finance geek (that’s me!) and it really tickles your fancy, however, you don’t really need to know more than the basics.
But if you have someone helping you with your investments, now you’ll be able to impress her with your financial acumen.
And maybe you’re just one step closer to not needing that financial advisor!