Chapter 18 – Investment Products

There are many different assets you may choose to hold the money you save. These investments are diverse and serve very different roles in a portfolio. In this chapter, we will be discussing various types of investment vehicles, and their role in a portfolio.

The Investment Pyramid

The graphic below shows the investment pyramid. The investment pyramid orders investments by their investment and inflation risk (for a review of these risks, please see chapter 17). Investments at the top of the pyramid have very high investment risk, and very low inflation risk. Investments at the top of the pyramid have very low investment risk and very high inflation risk.

The Investment Pyramid

Let's discuss each of the investments listed here, starting at the bottom of the investment pyramid.

Liquid Assets

The bottom of the pyramid contains liquid assets. These are assets that are very easy to convert into cash. They also have almost no investment risk at all. This means that money in a liquid asset can earn only very very low rates of return. There are three general types of liquid assets:

1. Checking and savings accounts are the most common types of transaction accounts. These accounts are generally offered by banks and are usually insured by the Federal Deposit Insurance Corporation (FDIC). This is a government program that guarantees that the funds held by an FDIC insured bank will always be available to the depositor even if the bank goes out of business. This protects your from losing your savings if your bank closes.

2. A certificate of deposit (called a “CD” for short) are highly liquid, short-term investments which you can purchase from a bank. Each CD has a specific term that is generally between one month and 10 years. During this term, the investor is not allowed to withdraw the money they put into the CD. In exchange, the bank pays the investor the agreed upon interest rate. The inability to withdraw money from a CD whenever you want allows CDs to pay a bit more interest than a checking or savings account.

3. Money market funds and high yield savings accounts are similar to checking accounts, but with additional restrictions on when and how you can withdraw money. The withdrawal restrictions on money market funds and high-yield savings accounts allows these investments to provide slightly higher rates of return than checking and savings accounts. They are good for saving up for goals that you plan to meet in less than 5 years. They can also make a good accounts to use as your emergency fund.

Investment assets

Investment assets are the most commonly used assets for long-term investing and saving up for retirement. The basic investment assets are bonds, stocks, mutual funds, and real estate.

1. Bonds are a form of investing where the investor lends money to a company or government agency. When an investor purchases a bond, they are lending money to a corporation or government entity. That company then has an obligation to pay the investor interest on the loan, just like people pay interest on loans that they get from banks. Government bonds are unique among investment vehicles in that they are inherently tax-free investments. However, because they are less risky than corporate bonds, they typically pay a lower interest rate than corporate bonds.

2. Stocks are simply a fractional ownership of a company. If you own a share of Disney stock, for example, then you own a tiny part of the Disney company. This entitles you to a portion of its profits, but it also makes you responsible for a portion of its debts. The more profitable the company is, the more money you, as an owner of the company, will earn. Stocks are riskier than bonds. The prices of stocks and the payments (called dividends) made to shareholders are much more uncertain for stocks than for bonds but they also have much higher potential to give the investor a large profit. Stocks are best used to save for goals that are more than 5-years away. They are the primary source of interest that investors can earn.

3. A mutual fund is simply a collection of investments. Mutual funds can contain all stocks, all bonds, or some mixture of the two. The exact combination of investments held by the mutual fund is determined by the mutual fund manager. Mutual funds charge fees for their management. They can be a great way to diversify your portfolio with relatively little work on your part. But be careful - an expensive mutual fund can take more in fees than they earn! look for a mutual fund with a very low expense ratio.

4. An exchange traded fund is a fund that is not actively managed. Rather, it is a fund that simply tried to mimic the movements of the overall market with as little cost as possible. ETF’s have good tax efficiencies, similar returns to mutual funds, and often have much lower fees than mutual funds.

5. Target date funds are a type of mutual fund. Each target date fund has a date built into it's name. You use these best by selecting the fund whose date most closely aligns with the year that you expect to retire. For example, you might find the "Vanguard 2050 Target Date Fund" - this fund would have a target for the year 2050. Target date funds are designed to automatically change their collection of investments as you grow closer to the target date. This can significantly improve your chances of being ready to retire at the date specified.

6. Real estate refers to land and buildings. You will notice that real estate is at the top of the investment assets category in the investment pyramid. This means that real estate has higher risk than stocks, bonds, and mutual funds. Real estate feels like a much safer investment than stocks and bonds to many people. In reality, research has shown that it is quite risky to buy land and hope its value goes up, or to buy property and try to find tenants, than it is to simply buy stocks or bonds. Real estate investment trusts (REIT) are like mutual funds, except of instead of purchasing stocks and bonds, they purchase real estate. They are a quick and efficient way to invest in the real estate market without having to buy physical property.

All of these types of investments can be purchased through mutual fund companies such as Fidelity, T Rowe Price, and Vanguard. As a rule of thumb, when selecting between otherwise similar investments funds, select the one with the lowest expense ratio.

Speculative Investments

The last category of investments is called speculative investments. These investments include options, futures, collectibles, and some types of real estate. These investments are called speculative because they are extremely high risk, but the potential rewards are also great. These types of investments are not for everyone. You must be very risk tolerant to handle owning these types of investments. They do not necessarily have to be included in a portfolio in order for the portfolio to have a healthy degree of diversification. It is generally not recommended for anyone who is not a sophisticated and highly educated investor to buy any of these types of investments.

Definitions:

Lender: a person (or entity) providing money to other entities which use the money and returns interest

Stocks: fractions of ownership of a company

Transaction accounts: very highly liquid, very low return accounts that are generally held by banks and are FDIC insured

Intermediate accounts: accounts that are similar to transaction accounts, but are slightly less liquid

CD’s: notes which you can purchase from a bank

Money market funds: similar to checking accounts, but with additional restrictions on their withdrawal terms

Investment vehicles: types of investments that are most commonly used to invest with

Bonds: a form of investing where the lender is a borrower

Government loans: tax free investments that pay a lower interest rate than corporate bonds

Mutual fund: a collection of bond and stock investments

Speculative investment: are extremely high-risk investments with potentially great rewards

Exchange traded fund: a fund that tries to mimic the movements of the overall market with as little cost as possible and is not actively managed

Real estate investment trusts: a collection of purchase real estate investments

Target date funds: a mutual fund that shifts its asset allocation as you get closer to the target date