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.

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.