According to the 2019 Schwab Modern Wealth Survey, Americans believe someone to be “wealthy” if they have at least $2.3 million in net worth.
Arguably, the best approach to building wealth is to invest and watch your money multiply.
Before you start investing, though, you must understand the different types of investment vehicles, and how they work to appreciate your money.
What Is an Investment Vehicle?
In order to put your money towards an investment, you will need a “vehicle,” or a means of getting it there. Investment vehicles are just that—they give investors the ability to invest and watch their money grow.
There are several different investment vehicles individuals can choose from, including:
- Stocks (equities)
- Bonds (debt)
- Mutual Funds
- Exchange-Traded Funds (ETFs)
- Real Estate
Each of these vehicles varies in terms of the amount of risk associated with it. Typically, the higher the risk, the higher the potential return can be.
Now, let’s take a look at how each one works.
What Are Stocks?
The first investment vehicle, stocks, is a form of equity. Stocks represent ownership of a particular company. Investors can buy and sell shares of stock on an exchange such as the New York Stock Exchange (NYSE) or Nasdaq.
Stocks are among the most common types of investments because of the liquidity and historic returns the stock market has produced. Companies will issue stock when raising funds for the company to continue operations, fund projects, or if they are in need.
Individuals who own stock are referred to as shareholders. Shareholders are given the ability to vote in shareholder meetings and receive dividends. Dividends are a share of the company’s earnings that are paid out to shareholders, typically on either an annual or quarterly basis.
Collecting dividends and reinvesting has been one of the most effective approaches to building wealth. In fact, according to a study from Hartford Funds, it accounts for 78 percent of the total returns from the S&P 500.
Reinvesting dividends gives investors an ability to begin collecting compound interest (the amount of money you earn from interest on top of your initial investment).
Risk Level: Stocks come with a varying amount of risk, depending on which companies you are investing in, as well as the state of the economy, politics, etc. Generally I would say they are medium to high risk.
What Are Bonds?
Stocks and bonds often get talked about together, but are really two completely different investment vehicles.
Companies will issue bonds when they are raising money to fund projects and other operations. Bonds are a form of debt, where you invest your money into the company, city or country.
In return, investors receive a fixed payment of interest on their loan, and eventually get their principle back as well.
The borrower will select the terms (or length of the loan) for the bond, which will dictate the interest payments that will be made, and the date the principal is due.
Bonds are also bought and sold in what’s called the “secondary market.” In that market, interest rates heavily influence the price you can get for a bond you hold.
If interest rates are high, bond prices will decline, and the opposite is true as well. So if rates go down, you can sell your existing bonds at a much higher profit.
Risk Level: Bonds are often seen as less risky than stocks because stocks must gain value over time, where bonds pay a fixed amount (if you hold them to maturity). The risk will vary depending on whether you buy government bonds or corporate bonds.
What Are Commodities?
Commodities are assets or goods that can be bought and sold. Investors will commonly purchase commodities to either hedge their positions or as speculation.
Commodities are commonly divided into four categories:
- Precious Metals
Precious metals, including gold, and silver, are frequently bought by investors when they are worried stock prices may decline, as they usually experience an inverse relationship. When it comes to energy, investors will speculate on the prices of things like natural gas and oil.
Risk Level: Commodities can be risky to invest in, as they are subject to price changes based on factors that require a great deal of attention.
>>Related: 5 Ways to Spot Investment Scams
What Are Mutual Funds?
Mutual funds allow investors to pool their money together, and then it is managed by a professional money manager. This gives them the ability to invest in stocks, bonds, and commodities that they might not have been able to otherwise.
Unlike stocks, when you own a share in a mutual fund, you are invested in many stocks (or securities), not just one. The value of a mutual fund is determined by the performance of the investments held in that fund.
Mutual funds charge annual fees, and sometimes commissions, which can affect their overall returns significantly.
Risk Level: Mutual funds generally have more moderate risk, due to the diversification. But the level of risk will be determined by the asset allocation of the portfolio.
What Are ETFs?
Exchange-traded funds (ETFs) are similar to mutual funds, in that they are a pool of funds from many investors. However, unlike mutual funds, ETF shares trade on the open market and can be bought and sold during market hours.
ETFs often “track indexes” as opposed to being actively managed like mutual funds. So an S&P 500 ETF like SPY, consist of all stocks that make up the S&P 500 Index.
And because the ETF is not actively managed, usually the fees you pay to be in the pool are much less than mutual funds. Often the high fees of mutual funds erode the performance so much, you do better being in an ETF.
ETFs are an excellent choice for those looking to passively invest, or who don’t have the time to invest in single stocks.
Risk Level: These types of funds are carry lower to medium risk because of the diversification and the fact that they invest very broadly into many stocks.
What Is Cash?
Cash and cash equivalents can also be considered an investment because of the interest accrued. Cash equivalents can include savings accounts and other bank accounts.
Risk Level: Cash is theoretically the least risky of all investments because it can’t lose its value, as it’s not “invested.” However, because inflation makes our money worth less every year, your cash loses value that way. So if you made .5% interest in a year, but inflation was 2%, your money lost 1.5%.
Plus, investors won’t have the potential of earning more considerable returns just sitting on cash. Usually, investors will take a cash position when other financial markets look unstable, to protect their earnings.
What Is Real Estate?
Some people might categorize real estate as an asset class, not an investment vehicle, but I consider it one. It is a way to directly invest and grow your money.
Real estate consistently increases in value overtime, and outperforms other investments. Although not all real estate investments are good ones.
Risk Level: The risk is lower to medium, depending on what type of investment you make, and how well you’ve vetted the real estate. It could be a higher risk for newbie investors with little knowledge.
If you are new to real estate investing, study up! Make sure you read Real Estate Strategy 101: Learn the Basics, the Lingo, and the Opportunities.
Which Investment Type Typically Carries The Least Risk?
When it comes to investment vehicles, generally, it’s assumed that the lower the risk, the lower the potential return. So cash and cash equivalents will be the least risky of the investments, but will also often produce the least amount of returns.
Next up are bonds. US treasuries would be considered the least risky bond, while a cooperate bond would be considered higher on the bond risk scale.
I would put real estate next. Real estate experiences far less volatility, while producing very consistent returns with cash flow, amortization and appreciation.
Plus, when you add the leverage of the mortgage into the equation, it often far outperforms stocks for significantly less volatility. But it’s not as easy to get in and out of.
Mutual funds and ETFs come next in terms of risk. They are a great option for diversifying your portfolio and give you the ability to invest in several different assets. The diversification reduces the risk as well.
Very commonly, a management firm will invest your money in a combination of stock ETFs along with bond ETFs. They will often make the bond ETF a percentage of the portfolio equal to your age.
Lastly, when it comes to individual stocks, the specific company you invest in will determine the amount of risk you take on. Also keep in mind that the financial markets themselves add another layer of risk, and that can be hard to account for.