It is useful to have an understanding of the different types of investments available when building an investment portfolio. Four of the main types of investments are cash, bonds, funds and shares. Each have different return and risk characteristics.
Cash - safety first
Cash deposits at a bank or in a money market fund represent a relatively safe option for investors. Cash can be held either as a deposit that can be accessed quickly or for a fixed period, such as six months or a year. Fixed-term deposits tend to offer higher interest than regular savings accounts. But if you need the money before the term is up, you may have to pay a penalty. In investing, low risk is often equated to low return. As such, earnings on cash tend to be modest.
Bonds are a "half way house" between risk and return
On the risk and return scale, bonds sit between the safety of cash and the volatility of shares. The eZonomics video How bonds work details how bonds are like a loan to a company or government for a time period that is typically between 1 and 30 years. Corporate bonds are considered more risky than government bonds (primarily because it is more likely that a company could fail and, therefore, not pay interest and initial loans back to investors).
Credit rating agencies - such as Moody's or Standard & Poor's - analyse issuers' financial conditions and come up with a rating that they believe reflects the ability of the issuer to pay investors back. It is generally agreed the higher the rating, the safer the bond. Some bonds are rated as "junk" - so be careful.
Funds aim to spread the risk
Funds are usually run by investment institutions and pool money collected from individual investors. The beauty of a fund is that it is made of a variety of investments - aiming to diversify and cut risk while earning a reasonable return. The wide range of funds include some that invest only in cash, bonds or shares, and others that focus on a specific sector (such as biotechnology) or a certain part of the world (such as Asia). Some mix cash, bonds, shares and possibly property in what is called a "balanced fund".
When it comes to funds that invest in shares or bonds, the two basic types are index tracker and managed funds.
Index trackers - or passive funds, as they are sometimes known - aim to mimic leading market indexes, such as the S&P 500 in the United States or the German DAX. The idea is if the general market goes up, investors benefit too but falls in the market mean investors lose money. Tracker funds tend to have low management fees.
With a managed - or active investment - fund, a fund manager decides which shares and bonds to buy and sell. The goal is often to outperform a certain leading market benchmark such as the S&P 500 or the German DAX. Managed funds tend to charge higher fees. Debate around whether index trackers or managed funds are better continues.
A study by Burton G Malkiel, a Princeton University economics professor and author of influential book A Random Walk Down Wall Street, found broad stock market index funds tend to outperform actively managed mutual funds.
Shares - more return but more risk
The highest risk of the main types of investment are shares - also known as stocks or equities. Buying a share is buying a small piece of a company. As the company prospers, so should you, with dividends and the ability to sell shares at a higher price among the potential pay offs. But there's no guarantee companies will do well and as an eZonomics video on the topic shows, a lot of factors that affect share price can't be predicted.
Investing in individual shares is complicated and requires a lot of research - so newcomers to investing might be better off trying cash, bonds or funds first.