Investing can be overwhelming for beginners, especially when it comes to deciding what type of investments will work best for you. You’ve likely heard terms like mutual funds, stocks, bonds, and maybe even ETF’s, but do you know what each one is and the differences between them? Before buying anything with your hard earned dollars, you need to understand it and how it can benefit you.
If you are just starting to save money the first thing you want to do is save up an emergency fund. That will cover you if any unexpected expenses come up and will prevent you from having to dip into your long-term savings. You want to keep your emergency fund safe and easily accessible, so I recommend putting it in a high-interest savings account. You won’t earn much return on it, but you’ll never lose money, and you can get at it right away. For longer-term savings (we’re talking 5+ years out), it makes sense to start investing that money to get it to grow. Remember, anytime you have money in the market it can be volatile, so you need to have an idea of how much risk you are willing to handle. Higher risk can often mean higher returns, but it also means increased volatility and more potential for loss.
I’m going to talk about a few of the most common investment options to help you determine which ones are the best fit for you. And remember, you’re not tied to any one type…you can always mix and match to get a well-balanced portfolio.
GICs (Guaranteed Income Certificates)
GICs are the ultimate in safety when it comes to investments because, just as the name suggests, they guarantee your return. Now that sounds great, right? Sure, but the downside is that you’re not going to earn much growth on them. That is especially true in today’s low-interest environment…think 1.50% on a 5-year GIC. The concern with such a low return is that your money may not even beat inflation, which means you’re actually losing money in the long term. You know how a dollar doesn’t buy you as much today as it would have done 50 years ago? That’s inflation. The Bank of Canada tries to keep inflation between 1% and 3% every year, so if you’re only earning 1.5%, then your money might not be keeping up. The other concern with GIC’s is that most are locked in for the entire term, so you can’t get access to your money if you need it before the maturity date.
Now onto more complicated matters…bonds. There are many types of bonds, but they are all basically debt investments. You loan the issuer money, and in return, they pay you back your principal investment with added interest. Bonds are usually a low-risk investment, but it really depends on the type of bond you buy and the trustworthiness of the issuer. You can get government bonds (think Canada Savings Bonds) or corporate bonds that could be backed by very solid companies, but there are also less established bond issuers who have a higher chance of going under. With that said, even if a company goes under, bondholders get paid out before stockholders which make them inherently less risky.
Bonds are also a lot more challenging to buy as they aren’t traded in the same manner as stocks. For most retail investors, the easiest way to hold a bond component in your portfolio is through a mutual fund that invests in bonds.
If you’re familiar with any type of investment, it is likely stocks. Like bonds, stocks are issued by companies looking to raise capital. The difference is that instead of loaning a company money like you do with bonds, stocks allow you to actually buy a share in the company. Stocks are a riskier option, but they are also where you can earn the highest returns. High risk, high reward right? Stocks don’t always have to be high risk, it really depends on what company you are investing in and how well situated they are. Even big companies you might think of as super successful (think Twitter), can have disappointing results in the stock market.
Making money in stocks is simple in theory, but actually choosing companies with enough upside and not too much downside is really hard. Even the experts often get it wrong. What you want is to buy shares in a company, hold them for a bit, then sell them at a higher price. It doesn’t always work out that way, but that’s the goal. That difference in purchase price and sell price is called a capital gain (or loss). You can also earn money from a stock through dividends. Many companies (but not all) will pay you to hold their stock so monthly, quarterly, or annually they will pay you what is called a dividend just for maintaining your stock position. A lot of people out there (dividend investors) seek out stocks that pay high dividends instead of focusing solely on growth.
Mutual funds are basically just a collection of stocks that are chosen by the fund manager, packaged together, and then sold to the investor. You can buy a mutual fund that covers just about any part of the market, whether it be targeted to a specific risk level, geographical region or corporate sector. Because you are buying a whole bunch of stocks instead of just one or two, mutual funds are more diversified and often less volatile than individual stocks. You do, however, have to pay for the expertise that the fund manager brings they come with higher fees than other types of investments. The guys and gals that run mutual funds are good at their jobs and have all possible research, analytics and models available to them to help them succeed. Stock picking can be fun, but you just aren’t going to have the time or resources to do the job they do. Many people are against mutual funds because of the high fees, but I’m OK paying them so I can be less involved. If you are a new investor with limited assets, funds can also be a way to get into a few sectors of the market with smaller amounts of money.
Index Funds and Exchange Traded Funds (ETFs)
Index funds and ETFs are created to mirror an index (such as the S & P 500) which basically means they hold the stock positions used in that specific index. Like mutual funds, they are a good way to diversify your account, but they won’t cost you as much because they simply buy what’s in the index and aren’t actively managed. Just remember that while you won’t do any worse than the index, this doesn’t mean you are always going to have positive returns. The markets aren’t always up and can sometimes be down…by a lot.
Hopefully, this helps you understand some of the different components you can use in building an investment portfolio. It can feel really complicated and overwhelming when you’re a newbie investor, but if you keep things simple by investing in balanced funds or ETF’s or a few large-cap companies you have confidence in, then you can learn the ropes without taking a ton of risk.