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Course Section 2 - Lesson 2
We don't often think too hard about the mode of transportation that we choose to take us where we need to go. Traveling down the street to get a bite to eat: we take a bike. Traveling to see family 20 miles away: we take a car. Going on a vacation across the country: we take a plane. Because we travel so frequently, assessing the pros and cons of each mode of transportation is second nature, and we can instantly identify the correct type of vehicle to get us where we need to go.
Investing isn't naturally ingrained in us the way that travel is. Often we know where we want to go: Save for retirement, save for a new home, save for a rainy day. But because these decisions are made infrequently, we are not as conditioned to know what investment vehicle we should choose for a given destination.
In this lesson, I want to review the types of investment vehicles available to us as investors. Of course, as this is a course on investing in stocks, this will be one of the few times that we mention most of these. However, I am sure that knowledge of what options are available will serve as valuable context as you orient yourself around the many investment options you see available in your brokerage account.
Securities that Companies Issue
We are, of course, aware that public companies issue shares of stock, but that's not the only option companies have to raise capital. In fact, issuing stock is generally considered expensive capital.
To reduce the implied cost that a company pays to fund itself, a company will issue a mix of 3 types of securities: Equity, Debt, Preferred Shares. If a company healthy, it will usually issue debt as it is the least expensive funding method.
Corporate Debt: Corporate bonds are fixed-income instruments that companies issue as a way to raise capital. When issued, a bond will have a defined term and an interest rate that it will pay over the life of the bond. An example might be a 3% interest rate paid over 20 years. If an investor were to purchase $100 of this bond, they would expect to receive $3 each year for 20 years. In the final year, they would receive their principal, $100, back as well.
In the event that a company goes bankrupt, its bondholders are paid before its preferred stockholders and common stockholders, making it the safest of the three types of investments.
Preferred Stock: Preferred stock is a hybrid security that sits between debt and equity. The payments that preferred shareholders receive are fixed. However, the company can abstain from making payments to preferred shareholders during periods of distress without penalty. The catch is that preferred shareholders must be paid before common shareholders can receive dividends.
In the event that a company goes bankrupt, bondholders still get paid first, but preferred stockholders get paid next.
Common Stock: Stockholders are the true owners of the company. They take the most risk but also have the highest upside if the company succeeds. This course focuses on these securities.
Fund Products - Mutual Funds and ETFs
I will refer to mutual funds and ETFs in aggregate as pooled investment vehicles. The two types of investments are very similar but different in important ways. Both investments aggregate funds from many investors into a single investment pool which then buys the securities on the investors' behalf. For this service, they both charge a fee.
Mutual Funds: Mutual funds are typically actively managed investment strategies, although many passive options exist. These funds will invest in a range of securities, including stocks, bonds, and preferred stock as well as more arcane investment options like mortgages, options, futures, and commodities, which we won't be discussing in this course.
When you invest in a mutual fund, the first decision that you have to make is the type of investment exposure you want. There are ~8,000 mutual funds currently operating. Nearly all of them will focus on a specific investment style, for instance, large-cap growth stocks, international stocks, investment-grade corporate bonds, and many others.
Once you decide on a strategy, you then attempt to select a fund company that you believe will deliver that strategy most effectively. Once a fund is selected and your investment made, you don't have to take any additional action. The fund company will monitor the securities in the portfolio and make trades as necessary. For this service, a mutual fund will charge a management fee.
One of the big differences between Mutual Funds and ETFs is that most mutual funds tend to be actively managed, which means that mutual funds are devoting resources to identifying attractive securities. This active investment process is expensive, and mutual funds charge higher fees as a result, usually around 1% of the total investment each year.
ETFs (Exchange Traded Funds): The most significant difference between Mutual Funds and ETFs is that ETFs usually focus on passive investment strategies (although this is not a hard and fast rule). Instead of researching to identify attractive investments, passive strategies buy every security in a market or index. This approach of buying everything requires much less labor to execute and allows ETFs to charge lower fees than mutual funds as a result.
Commodities / Futures / Options
As you continue to explore investing, you will likely come across commodities, futures, and options contracts. These are all advanced securities that we will not cover in this course. In the right hands, these securities can be used to reduce risk and allow both investors and companies to fine-tune their investments to specific risk-return characteristics. In the wrong hands, they are used as purely speculative instruments that are much more akin to gambling than investing.
Most brokerages will allow you to trade these types of securities very easily. I'd suggest that you stay far away from them until you are much more comfortable with investing basics.