Chapter 2: Understanding Investment Vehicles

Before you embark on your investing journey, it's important to know the different paths you can take. Investment vehicles are like the tools in your toolbox—they help you build your financial future. In this chapter, we'll explore the various types of investments available, such as stocks, bonds, mutual funds, and more. By understanding how each one works, you'll be better equipped to choose the options that align with your goals and comfort level with risk. Let's go.

Stocks and Bonds

What Are Stocks?

Stocks, also known as shares, represent ownership in a business. When you buy a stock, you're buying a small piece of that business. This means you become a shareholder, and you have a claim on part of the business assets and earnings.

Stocks can make you money in two main ways:

• Price Increase (Capital Gains): If the company's value goes up, the price of its stock usually goes up too. For example, if you buy a stock for $10 and later sell it for $15, you've made a $5 profit.
• Dividends: Some companies share part of their profits with shareholders by paying dividends. If you own stock in such a company, you'll receive regular payments, based on the company dividend policy.

Before you say, "Stocks are too risky", here is one quick fact, the S&P 500 index (which is a basket of top 500 listed companies in the US) gave annualized average returns of 10.26% since its 1957 inception through the end of 2023. Do note that this is after accounting for the 2000 internet bubble, the 2008 financial crisis, the 2020 COVID pandemic etc.,

"In the short run, the market is a voting machine but in the long run it is a weighing machine"
-Benjamin Graham

What Are Bonds?

Bonds are like loans you give to governments or companies. When you buy a bond, you're lending money to the issuer (the government or company). In return, they promise to pay you back the full amount (the principal) on a specific date in the future (the maturity date) and make regular interest payments (coupon payments) to you along the way. Please note throughout the book, the terms "bonds" and "Debt" were used interchangeably because both construe the same meaning.

Bonds make you money primarily through interest payments:

• Interest Payments (Coupon Payments): Bonds pay a fixed interest rate, known as the coupon rate. For example, if you buy a bond worth $1,000 with a 5% annual interest rate, you'll receive $50 each year until the bond matures.
• Price Changes: If you sell the bond before it matures, you might sell it for more or less than you paid, depending on interest rates and the issuer's creditworthiness.

Comparing Stocks and Bonds

Understanding the differences between stocks and bonds can help you decide which is better for your investment goals.

Ownership vs Lending

• Stocks: When you buy stocks, you own a part of the company.
• Bonds: When you buy bonds, you're lending money to the company or government.

Returns

• Stocks: Potential for higher returns through price increases and dividends, but also higher risk. Stock prices can go up or down significantly.
• Bonds: Generally offer steady, fixed-interest payments with lower risk. However, returns are usually lower than stocks over the long term.

Risk

• Stocks: Higher risk. If the company does poorly, stock prices can drop, and dividends may be cut.
• Bonds: Lower risk, especially with government bonds. But there's still a risk if the issuer can't pay back the loan or make interest payments.

Priority in Bankruptcy

• Stocks: Shareholders are last in line to be paid if a company goes bankrupt. They may lose their entire investment.
• Bonds: Bondholders are paid before shareholders. They may recover some or all of their investment.

Liquidity

• Stocks: Often easier to buy and sell quickly on stock exchanges.
• Bonds: Some bonds may not be as easy to sell before they mature, especially if they're from smaller issuers.

Which One Should You Choose?

Stocks: Good if you're willing to take on more risk for the chance of higher returns. Suitable for long-term goals.

Bonds: Better if you prefer a steady income and lower risk. Useful for preserving capital and generating income.

Combining Stocks and Bonds

Many investors choose to have both stocks and bonds in their investment portfolios. This mix can help balance risk and return. Stocks can provide growth, while bonds can offer stability.

Also, one quick rule to calculate stock allocation is the age rule. Suppose your age is 25 years, you can invest (100- age) i.e. 75% in stocks as per this rule. This makes sense because, when you are young, you have more time and risk tolerance. Of course, you need to consider other factors as well like your time horizon, financial position, goals etc.,

Simple Portfolio Example

• 60% Stocks: For growth potential.
• 40% Bonds: For income and reduced risk.

Adjusting the Mix

Younger Investors: Might choose more stocks because they have more time to ride out market ups and downs.

Older Investors: Might prefer more bonds to protect their savings and generate income.

Final thoughts

Understanding stocks and bonds is a key step in learning how to invest. Knowing how they work and how they differ helps you make informed decisions that fit your financial goals and comfort with risk.

Mutual Funds and ETFs

What Are Mutual Funds?

A mutual fund is like a big pot where many people put their money together. This pooled money is then used to buy a variety of investments like stocks, bonds, or other assets. By investing in a mutual fund, you're essentially buying a small piece of a large, diversified portfolio.

How Do Mutual Funds Work?

• Professional Management: A mutual fund has a manager or a team of experts who decide where to invest the money. They research and select investments they believe will help the fund grow.
• Diversification: Because the fund invests in many different things, your risk is spread out. If one investment doesn't do well, others might do better, balancing things out.

Types of Mutual Funds:

• Equity mutual Funds: Invest mainly in stocks.
• Debt mutual funds: Invest mainly in bonds.
• Balanced Funds: Invest in a mix of stocks and bonds.
• Money Market Funds: Invest in very short-term, low-risk securities.

For example, imagine you have $100 to invest, but that's not enough to buy shares in big companies like Apple or Google. By investing in a mutual fund, your $100 is combined with money from many other investors. Together, you can invest in a wide range of companies and assets that you couldn't afford on your own.

Understanding Exchange-Traded Funds (ETFs)

An Exchange-Traded Fund, or ETF, is also a collection of investments like stocks or bonds. Like mutual funds, ETFs allow you to invest in a variety of assets at once. However, ETFs have some key differences.

How Do ETFs Work?

• Traded Like Stocks: ETFs are bought and sold on stock exchanges throughout the day, just like individual stocks. This means you can trade them whenever the market is open.
• Often Track an Index: Many ETFs are designed to mimic the performance of a specific market index, like the S&P 500, Nifty 50 etc.,. This means they aim to match the market, not beat it.
• Lower Costs: Since many ETFs simply track an index and don't require active management, they often have lower fees compared to mutual funds.

For example, suppose you want to invest in the top 500 companies in the U.S., but buying shares in each company would be impossible for most people. An ETF that tracks the S&P 500 lets you invest in all those companies with just one purchase.

Comparing Mutual Funds and ETFs

Understanding the differences between mutual funds and ETFs can help you decide which is better for you.

Trading and Pricing

• Mutual Funds: Priced once a day after the market closes. You buy or sell at this end-of-day price.
• ETFs: Priced and traded throughout the day. The price can change from minute to minute, just like stocks.

Management Style

• Mutual Funds: Often actively managed, meaning managers try to outperform the market by picking investments they think will do better.
• ETFs: Usually passively managed, aiming to match the performance of a specific index. Some ETFs are actively managed, but they're less common.

Costs and Fees

• Mutual Funds: These may have higher fees due to active management. Some also have sales charges called "loads" when you buy or sell.
• ETFs: Generally have lower fees because they are often passively managed. You do pay a commission when you buy or sell, like with stocks, but many brokers offer commission-free ETFs.

Minimum Investment

• Mutual Funds: This may require a minimum investment amount, like $1,000 or more.
• ETFs: You can buy as little as one share, which might cost anywhere from a few dollars to several hundred dollars, depending on the ETF.

Final Thoughts

Both mutual funds and ETFs offer easy ways to invest in a diversified portfolio without needing a lot of money or expertise. Your choice depends on your investment goals, preferences, and how involved you want to be in trading.

• If you prefer simplicity and are investing for the long term, mutual funds might be a good fit.
• If you want lower costs and the ability to trade anytime during market hours, ETFs could be the better option.

Remember, it's important to read the fund's prospectus or the ETF's information before investing. This will help you understand the objectives, risks, fees, and other important details.

Alternative Investments

Imagine your investment portfolio as a colorful garden. While stocks and bonds are like sturdy trees and shrubs, alternative investments add unique flowers and exotic plants that make the garden more vibrant. Let's explore three interesting additions: real estate, commodities, and cryptocurrencies.

Real Estate

Real estate investing involves buying property to earn money. This could be a house, an apartment building, an office space, or land. When you invest in real estate, you can make money in a couple of ways. One way is through rental income—you rent out your property to tenants who pay you money each month. Another way is through the property increasing in value over time. If you buy a house for $200,000 and sell it years later for $250,000, you've made a profit of $50,000.

However, real estate often requires a lot of money upfront. You'll need to cover costs like a down payment, closing fees, and ongoing expenses for maintenance and repairs. Also, selling property can take time, so your money isn't as easy to access quickly if you need it.

If that sounds daunting, there is a simpler approach. Enter Real Estate Investment Trusts or REITs. A REIT is a corporation that owns or finances income-producing real estate, such as apartments, shopping centers, or office buildings. When you invest in a REIT, you're buying shares of this company, which can be traded like stocks. This means you can invest in real estate with less money and without the hassles of managing property yourself.

REITs often pay dividends to their shareholders because they are required by law to distribute most of their taxable income. This can provide a steady stream of income. For example, if you invest $1,000 in a REIT that pays a 5% annual dividend, you'd receive $50 each year as long as the dividend remains the same.

Investing in REITs allows you to benefit from real estate investments without the large upfront costs and responsibilities of property ownership. However, like all investments, REITs come with risks. The value of REIT shares can go up or down based on the real estate market and other economic factors.

Commodities

Commodities are basic goods used in everyday life, such as metals like gold and silver, energy sources like oil and natural gas, and agricultural products like wheat and corn. Investing in commodities allows you to own or have a stake in these physical goods.

You can invest in commodities in several ways. One method is to buy the physical commodity itself, like purchasing gold coins. Another way is through financial instruments like futures contracts, which are agreements to buy or sell a commodity at a set price on a future date. Many people also invest in commodities through mutual funds or exchange-traded funds (ETFs) that track the prices of these goods.

Commodities can help protect against inflation because their prices often rise when the cost of living increases. However, the prices of commodities can change quickly due to factors like weather events, political changes, or shifts in supply and demand, making them a riskier investment.

Cryptocurrencies

Cryptocurrencies are digital or virtual currencies that use special coding techniques to secure transactions. Bitcoin is the most well-known, but there are many others like Ethereum and Lite coin. These currencies operate on a technology called blockchain, which is a shared ledger that records all transactions across a network of computers.

To invest in cryptocurrencies, you can buy them directly through online platforms called exchanges and store them in digital wallets. Some investors choose to invest in funds that hold various cryptocurrencies or in companies that are involved in cryptocurrency technology.

Cryptocurrencies have the potential for high returns because their values can increase rapidly. For example, someone who bought Bitcoin when it was $1,000 and sold it when it reached $10,000 would have made a significant profit. However, cryptocurrencies are also highly risky. Their prices can drop just as quickly as they rise, and they are not backed or regulated by governments or banks. There are also security concerns, as digital wallets can be hacked if not properly protected.

Final Thoughts

Exploring alternative investments like real estate, commodities, and cryptocurrencies can offer new opportunities to grow your money. They can help diversify your investment portfolio. However, these alternatives also come with their challenges and risks. It's important to understand how each one works and consider your own financial goals and how much risk you're comfortable taking.