Understanding Investment Types
Understanding different types of investments and their pluses and
minuses provides us with the knowledge and confidence to
invest our money. Such knowledge helps us select the best investments for
our needs.
This is especially true as new types of investments come into
the market all the time, and our own needs also fluctuate during
our lives. Let's first look at the characteristics that apply to all investments,
then look at different types of investments. Afterwards, we'll also examine some
general guidelines for investing.
Characteristics
- Investment Period — How long our money stays in the investment
is called the investment period. This could be months, years, or even decades.
Some investments allow the investment period to be as short
or long as we would like. In some, there could be a minimum length
of time we need to be invested in before we see any gains.
- Principal — This is the amount we put into the investment.
This is what grows as long as it is invested.
- Return — Investments, when they're doing well, return
a profit. This is the reason we invest. The return can be a little or a lot.
Some investments return the same percentage of the principal year after year.
The yearly return percentage (that is, the return amount for a principal of $100)
is called the rate of return or simply, ROR.
Other types of investments have a variable ROR that can go up and down over time.
- Risk — Investments that could potentially lose some money (either
the interest earned, or even the principal) are risky. Several types of
investments fall into this category. Typically — but not always —
the higher an investment's return is, the higher its risk also, and
vice versa.
So, why would anyone invest in a risky investment? The idea is
that, if the investment has a high enough ROR and if the
investment only occasionally drops in value, the high ROR could compensate
for any occasional loss. And, over a long investment period, the
investment will make substantial gain.
- Taxes — Any profit we make in our
investments is taxed by the government. At the
same time, investment companies want to make it attractive for
us to invest. As a result, there are different flavors of taxation, which
give us choices in deciding how and what to invest in.
In any investment, three things typically happen: (1) we deposit some
money into the investment; (2) the money we invested grows over time;
(3) we withdraw money from the investment.
Different investment types treat these three "events" in different ways.
Here is a much simplified look at the taxation of investment profits
based on the above "events":
- Pre-tax versus after-tax deposit —
Some investments allow us to invest pre-tax income money
(money before paying our income taxes, so that the pre-tax invested money is
not accounted for when paying income tax). Of course, when we
later withdraw money from the investment (usually years or even decades
later), we do have to pay taxes!
Other investments allow us to only invest our after-tax money.
- Tax-free versus taxed growth — If the investment grows
without us having to pay a tax every year on the profit made during
that year (if we haven't withdrawn any money from the investment
during that year), it is said to be growing tax-free. We pay taxes only
when we withdraw some or all of the profit.
In contrast, in the case of taxed-growth investments, we pay tax
every year on that year's profit made by our investment, even if we didn't
withdraw any or part of the profit.
The advantage of tax-free growth is that, since nothing is taken
away from the investment (to pay taxes), the entire profit in
a year gets added to the next year's principal.
- Tax-free versus taxed withdrawal —
If the investment allows us to pay no taxes when we encash (withdraw)
a portion or all of it, the withdrawal is said to be tax-free.
On the contrary, an investment is a regular-taxed withdrawal investment
if, when we encash a portion of all of our investment,
we are required to pay taxes.
In this case, depending on whether the investment was made with
after-tax or pre-tax money, we pay taxes only on the profits or on the entire
withdrawal, respectively.
Once again, the above description is a much simplified look at the
taxation characteristics of investments.
Taxation of investments is a vast topic and we just scratched the surface.
There are many other tax-related aspects to consider when investing,
since each of our financial picture is different. Consulting
a good financial advisor or tax expert is important to understand what
will work best for us.
- Liquidity — Liquidity indicates how quickly we can turn
some or all of an investment into cash. For example, a bank account is a highly
liquid investment; we simply withdraw the money. In contrast, a home is a fairly
low-liquidity investment, especially if it is currently occupied — it
may take some time (weeks to months) to sell it and get the money.
- Fees — Some companies require us to pay an annual fee
for the investments to be managed for us. Depending on the type of
investment and the institution that manages it, the fee could be a
flat amount or a percentage of the investment amount. Even within
an investment type, the fee could vary significantly between
different institutions. Examples: different banks can charge very
different annual fees for checking accounts; some banks could
waive the annual fee if a minimum deposit amount is maintained, or
if we have multiple accounts in the same bank, or if we use other
services of the bank (such as credit cards, home loans, etc.);
some other banks don't waive the annual fees; some mutual funds
charge a flat fee to manage our investment, while others offer
similar services for free. With such variations in fees, it is a good
idea to check this before investing, as the fees could reduce our
effective gain.
Investment Types
Let's now look at a few investment types to see how the above characteristics apply to them. (Once again, this is a very simplified view — if any of the investments looks relevant or
interesting, do more research to learn it in depth.)
We do not include fees in this comparison, since, as we said earlier,
the fee structure is decided more by the institution and less by the
investment type.
Investment Type | Description | Term | Return | Risk | Liquidity | Taxation (deposit, growth, withdrawal) |
Cash | Deposit money in a checking/savings account in a bank. | Any | Low | Low (NOTE) | High | Post-tax, taxed, tax-free |
Government Bonds | Buy a government bond, and encash it when its term is up. | Short, Medium | Low (NOTE) | Low | Low (NOTE) | Post-tax, tax-free, varies (NOTE) |
Commercial Bonds | Buy a corporate bond and get paid interest periodically. | Short, Medium | Low, medium | Varies (NOTE) | Medium (NOTE) | Post-tax, taxed, tax-free |
CDs (Certificate of Deposit) | Buy a CD and either get paid interest periodically or encash when its term is up. | Medium (generally 5-10 years) | Low | Low | Medium (NOTE) | Post-tax, taxed, tax-free |
Government Bond Mutual Funds | Mutual funds that invest in government bonds. | Medium, Long | Low (NOTE) | Low | High | Post-tax, taxed (NOTE), tax-free |
Corporate Bond Mutual Funds | Mutual funds that invest in corporate bonds. | Short, Medium | Low to Medium, depending on the company. (NOTE) | Low | High | Post-tax, taxed (NOTE), tax-free |
Stock Mutual Funds | Mutual funds that invest in stocks. | Medium, Long | Low to High, depending on the stocks (NOTE) | Medium, High | High | Post-tax, taxed (NOTE), tax-free |
Stocks | Directly invest in stocks. | Short to Long | Low to High, depending on the stock | High | High | Post-tax, taxed/tax-free (NOTE), taxed |
Qualified Pre-tax Retirement Accounts | Invest money into these (taken from salary, or on our own, etc.). | Long | Low to High (NOTE) | Low to High (NOTE) | Low (NOTE) | Pre-tax, tax-free, taxed. |
Qualified Post-tax Retirement Accounts | Invest money into these (taken from salary, or on our own, etc.). | Long | Low to High (NOTE) | Low to High (NOTE) | Low (NOTE) | Post-tax, tax-free, tax-free. |
Real Estate | Buy a home, and sell it when its value has increased. (NOTE) | Short, Medium | Low to High (NOTE) | Low to Medium (NOTE) | Low | Post-tax, tax-free, taxed. |
Rental Property | Buy one or more homes and rent them out. (NOTE) | Medium, Long | Low to High (NOTE) | Low to Medium (NOTE) | Low | Post-tax, taxed (NOTE), taxed (NOTE). |
Low risk because bank deposits are typically insured by government, up to a limit.
Low risk if the government issuing the bond is stable. Government bonds are typically backed by the financial stability of the government.
Some bonds (typically state or local bonds) are tax-free.
The risk is proportional to the financial stability of the company.
These have a term. Withdrawing before the term could be not possible or could result in some loss.
The return may be reduced by any fee paid to manage the fund.
Mutual funds may buy and sell stocks throughout the year to balance and maximize profit. Any profits from these sales are taxed in the year the sales are made.
Retirement accounts allow the money to be invested in a combination of bonds, mutual funds, and cash. Thus, the return and risk are dictated by those of the chosen investment types.
Withdrawing before the government-stipulated retirement age usually results in significant penalty.
This is a high-overhead strategy. If the home is also our primary residence, it additionally requires packing and moving every few years.
The gain/loss depends on the ups and downs of the real-estate market.
The homeowner is also responsible for any maintenance and property taxes for the home(s).
The gain/loss depends on the ups and downs of the rental market.
The annual rent is taxable.
If and when the home is sold, the profit could be taxable.
Some companies pay annual dividends for shareholders. These dividends could be taxable in the year they are paid.
The list above covers only the most common and typical investment types. There are several more. Consult
with your financial advisor to understand about those and decide on their suitability.
Tips for Investing
Irrespective of the investment types we select, the basic goals and
principles of investing are similar. We'll look at some of them now.
Note that none of the principles are cast in stone — there's
always a give and take amongst the principles; it is the net profit
(including any tax considerations) that we need to focus on
maximizing.
- Minimize loss — some investments are inherently high reward, high risk.
We need to understand our tolerance to risks. It is important to
try to picture the loss in terms of actual dollars, and not just
as a percentage number. For example, a risk tolerance of 5% might
sound reasonable, but if the investment is a million dollars, a
drop of 5% means a loss of $50,000. Picturing this happening to us
(even within a single day) and seeing if we'll still be okay
with this is a good exercise. Once we know our risk tolerance,
we can decide how to divide our money into different investments.
There are a few ways to minimize losses:
- Restrict risky investments to a separate bucket so that any loss in
them doesn't affect the other (low risk) investments.
- Restrict the amount of money invested in high-risk high-return
investments. Even though this puts a cap of how much we can profit (the less
the principal, the less the profit), it also
puts a cap on any potential loss. Over time, we can dial this up
and down based on our confidence level and market conditions.
- Reduce taxes — Learn the taxation characteristics of different
investment types to see which ones save us the most tax.
- Consult a competent financial advisor or a tax consultant. Their job is to keep up to date with both the latest investment opportunities and with the latest tax laws,
so they're the best to advise us on our unique financial situations.
Summary
We took a brief look at the characteristics of investments and which ones
apply to which investment types. We learnt of a few things to keep in
mind when investing, so that the details and complexity of investing do not
side-track or overwhelm us from forgetting our objectives.