I know you have no doubt been eagerly awaiting Part II of this post since Part I came out. Well, you can stop refreshing your browser every three minutes and breathe a sigh of relief; Part II is here!
Without further ado, a glossary of investment options:
CD (Certificate of Deposit): CDs are typically very straight-forward. The bank sets a rate (floating, meaning it varies with interest rate changes, or fixed) and a maturity (1 year, 5 years, etc). You agree to lock in your moolah. The advantage is ease of use, steady returns, and no broker fees; the disadvantage is your money is very illiquid (you’ll pay penalties to get it out before maturity), and interest payments may stink (like they do right now). Verdict: low risk, low return.
Bonds: When you give someone money for a bond, you are essentially giving a loan to a certain counterparty (or basket of counterparties). The counterparty then pays you interest, and returns your money in full at maturity. This is all hunky-dory, except for Default Risk (i.e. the chance that your counterparty doesn’t pay you back and you’re screwed). Because of this risk, bonds are sold based on credit ratings from AAA (the best) to D (in default). Anything below BBB- is considered a ‘junk’ bond. These low-rated bonds are also called ‘high yield’ bonds because the interest rates are so high. But don’t be fooled by the name; interest rates are high because there’s a good chance the counterparty will never pay the money back. Verdict: Ranges from low risk to very risky depending on the credit rating.
Derivatives: I almost didn’t include this one, since it’s too risky/complex for the average investor, but for the sake of information (and because most people look at my husband blankly when he says he works with derivatives), I’ll discuss them briefly. A derivative is something that behaves according to something else (think back to Calculus here). So a derivative on corn will give you exposure to market gains/losses on corn without having to actually own bushels of corn. You can basically buy a derivative on anything… and despite the bad press, derivatives can help business lower their risk. Let’s say Firm A has a $1M services contract with Firm B. Firm A then buys a $1M derivative that moves opposite to Firm B’s performance. If Firm B goes out of business, Firm A loses its $1M contract, but has protected itself (i.e. “hedged”) and earns $1M from the derivative, essentially breaking even. This can easily go amuck when companies use derivatives for gambling purposes rather than risk hedging. If you don’t believe me, check out Jérôme Kerviel who single-handedly lost $7B in risky derivative bets within Societe General. Verdict: Useful for mitigating risk, but can also be exceptionally risky if used speculatively… leading to big returns or disastrous losses.
ETF (Exchange Traded Funds): These have gotten a lot of buzz in the past couple years. An ETF essentially just tracks a specific fund, like the Spider (ticker: SPY) which tracks the S&P 500. A plus to ETFs is that fees run lower than mutual funds, but they also tend to be riskier since they are more likely to have a narrower focus than a mutual fund. There also isn’t an active manager (which a mutual fund has) to rearrange assets. So if you’re in an energy ETF, you are locked into following that index, whereas an energy-focused mutual fund would have a (theoretically) nimble money manager who could sell oil and buy solar energy if he thought the oil market was tanking. Verdict: Higher risk than a balanced mutual fund, but lower fees and easier direct access (if you want it) to a specific product/market.
IRA (Individual Retirement Account) / 401 (k)/ 403(b): I won’t go into another saving for retirement rant as this was covered in Part I. But strictly in terms of definitions, a 401(k) and IRA are identical concepts (lock away money for retirement), with the only difference being that a 401(k) is run by your employer and often includes employer matching. A 403(b) is the 401(k) equivalent for non-profits. Both 401(k)s and IRAs can either be tax deferred (contributions aren’t taxed now, but contributions + earnings are taxed when withdrawn at retirement) or Roth (contributions are taxed now but contributions + earnings are tax free when withdrawn). Generally the Roth comes out to be a better deal, unless you are in a very high tax bracket now (:: cough:: NYC residents :: cough:: ) or expect to be in a very low tax bracket in retirement. Verdict: A no-brainer if you don’t want to be eating Ramen Noodles six days a week when you’re 80.
Lifetime (or ‘Target Date’) Funds: These handy funds are based on a target date for your retirement (say 2050). Investments are automatically re-allocated based on your time horizon. So young investors’ target date funds are in higher risk investments (stocks), then are re-balanced to less risky ones (bonds, treasuries) as you near retirement. Verdict: Compare fees, but overall it’s a great low-maintenance option for retirement plans.
Money Markets: Highly liquid (though not as liquid as a true cash savings account) short term investments, with interest rates slightly above pure cash. If you think you might need access to the cash soon, go with this option over a CD or mutual fund. Verdict: Low risk (though a bit higher than a CD if counterparties default), moderately low return.
Mutual Funds: Mutual funds are essentially baskets of investments. An easy example is a Blue Chip Mutual Fund, which means you (and say 99 other investors) would put in $100 each and the fund would use the total $100,000 to buy a variety of stocks like Microsoft, GE, etc. Mutual Funds don’t have to be just stocks – they can also include bonds, commodities, and other investments depending on which ones you have signed up for. Many also have specific geographical focuses, so you can choose to invest specifically in domestic/European/emerging markets, etc. Watch out for the fees on these funds as they can vary widely! Verdict: A balanced risk approach to investing, but mind the fees.
Treasuries: Traditionally these were as low-risk as it comes – US Treasuries pay a certain interest rate over a set maturity (a very similar set-up to CDs). The US has never defaulted on debt, so treasuries are considered ‘risk-free.’ Of course, given our current fiscal crisis and ballooning debt, who knows. I can’t imagine the US defaulting on their debt… but then again, if a company ran its finances the way our country runs its budget, it would have gone bankrupt long ago. Verdict: Historically risk-free, low return
There are many more investment types out there, but for the sake of space and boredom levels I’ve just hit the highlights. If you have specific questions on these or other types of investments, leave a comment and I’ll do my best to answer!
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