There are several different types of investments to consider when planning personal investments. The most appropriate investment depends on the investor’s objective.
Money that is needed to make purchases or pay bills in the near future, called transactions money, needs to be kept in a safe place with virtually no risk. The most common place to invest transactions money is in bank accounts.
Bank accounts are deposits in commercial banks or similar institutions, such as credit unions. A commercial bank is a financial institution that attempts to make a profit by paying depositors little or no interest and lending a portion of the deposits to borrowers at moderate to high rates of interest. A credit union is an institution that provides financial services similar to those offered by commercial banks, such as accepting deposits and making loans, but does not attempt to earn a profit. Credit unions were created to provide inexpensive financial services to their members. Thus credit unions may offer higher rates of return to depositors, lower interest rates to borrowers, and lower fees than commercial banks. Depositors use bank accounts to facilitate transactions. Money used to pay the rent or buy groceries and other living expenses can be held safely in checking or savings accounts at banks or credit unions.
Money that is being saved for a purchase in the next few years can potentially earn a higher rate of return than bank account deposits. When people save money for a down payment on a house or a car, for example, many financial advisors suggest investment in certificates of deposit or money market mutual funds.
Certificates of deposit (CDs) are financial instruments that promise to pay the purchaser a specified fixed rate of interest over a designated period of time if the purchaser promises not to withdraw the funds. CDs typically offer a higher rate of return than regular savings accounts because the purchaser is sacrificing liquidity. Any investment with a fixed rate of return, such as a CD or a bond, is subject to interest rate risk, however. Interest rate risk is the loss of a higher potential rate of return or the loss of the value of the financial asset if interest rates increase in the future.
When investors save money for the distant future, such as for retirement, they can consider a wider range of investments, such as bonds, stocks, mutual funds, and real estate.
A bond is a financial instrument that represents a loan from the purchaser of the bond to the issuer of the bond. For example, government bonds are a way for the government to borrow money. Municipal bonds are issued by state and local governments and frequently provide investors with tax breaks. Purchasers of municipal bonds are usually not required to pay taxes on the interest income earned from the bonds. Corporate bonds are issued by corporations that desire to borrow money directly from investors rather than through commercial banks. Junk bonds are corporate bonds issued by companies with high bankruptcy risk.
Stocks are shares of ownership in a corporation. By owning stock, the shareholder owns part of the corporation. Corporations typically pay quarterly dividends, which are the portion of profits paid to stockholders. The primary reason investors purchase stocks, however, is for capital gains. Capital gains are the increase in the value of the stock over time. Capital gains occur when the price of a stock rises as potential investors seek to buy ownership in the company.
Blue chip stocks are shares of ownership in large well-established corporations. Blue chip stocks are considered by most financial advisors to be less risky than shares of stock issued by relatively small, less-established corporations.
Aggressive growth stocks are shares of ownership in relatively small, less-established corporations. Because of their higher risk, they are considered by most financial advisors to have a higher potential return than blue-chip stocks.
Mutual funds are financial assets in which investors pool their investment funds and have them invested under the direction of a manager or management team. The primary benefit of mutual funds is diversification. Diversification means investors own small pieces of many different financial instruments rather than have all of their investment in one or a few such instruments. Diversification reduces bankruptcy risk. The investment options considered by the managers of a mutual fund are specified in a prospectus. A prospectus is a legal document that provides information to potential investors as required by law. Mutual funds may invest in stocks, bonds, real estate or other assets.
Money market funds are mutual funds that invest in short-term loans or other financial instruments that are similar to certificates of deposit.
Real estate refers to land, houses, and other buildings. An old adage suggests that the three most important attributes of real estate are location, location and location. The rates of return on real estate can be wildly unpredictable, ranging from extremely high gains to significant losses.
