Mutual Funds, Index Funds, and More: the Four Flavors of Investing
Ice cream comes in a myriad of flavors. According to The NPD Group, the top four are vanilla, chocolate, butter pecan, and strawberry. Investments also come in a wide range of varieties. The “basic flavors” of investments are stocks, bonds, real estate, and cash. The right mix of these four basic investments will depend on your age, your risk tolerance, your employment status, and your life goals. Here’s the scoop on each…
The Flavor: Stocks
The Perk: Growth
Key Phrase: Over Time
Stocks (otherwise known as “equities”) are pieces of ownership in businesses. If you purchase shares of an underlying business at a reasonable price, the price of those shares should go up in time, along with the wellbeing of that underlying business. The key phrase to keep in mind with stocks is: over time. If you look at charts showing the correlations between the earnings of a company in any given year and the movement of that company’s stock price, they will often look as wild as your hair when you first get out of bed. However, if you extend a typical stock chart out five years (ten is even better) you’ll start to notice a much tighter relationship between how the company performs operationally and the movement of its stock price. The primary role that stocks play in your portfolio is to provide growth.
The Flavor: Bonds
The Perk: Protection
Key Phrase: Limited Time
Bonds (also known as “fixed income”) are loans, made either to governments or corporations. In exchange for loaning money for a specified period of time, you receive periodic interest payments. When the pre-agreed upon loan period is up you will get back your original investment (aka the “principal”) so long as the underlying entity has not gone bankrupt. If you have to sell the bond before the specified loan period is up, the price you get back will depend upon how the interest rate that bond is paying compares to prevailing market interest rates. Because you will receive your original investment back if you wait for the full term of the loan and the underlying government or corporation remains solvent, the primary role of bonds in your portfolio is for protection.
The Flavor: Real Estate
The Perk: Enjoyment
Key Phrase: Profit Not Guaranteed
Unless you have a deep desire to become a landlord, for the vast majority of people, ownership of a primary home is enough exposure to this third flavor of investments. In years past, real estate was a big source of wealth creation due to a perfect storm of conditions that are unlikely to repeat going forward (namely, our parents bought homes with 20% down, 30-year fixed rate mortgages, lived in them for decades, and received meaty cost of living increases in their salaries due to inflation. This enabled them to pay off fixed monthly mortgages with ever-increasing paychecks). Today, home ownership is still a wonderful thing—but it’s not a guaranteed homerun in our more mobile society. This investment should be made with a primary focus on affordable enjoyment. If you make a profit when you sell, it’s the cherry on top.
The Flavor: Cash
The Perk: A Temporary Parking Place
Key Phrase: Garnish, Not Ingredient
Cash (sometimes called “cash equivalents”) includes savings accounts, money market funds and accounts, and certificates of deposit or CDs. The role of cash in your portfolio is to earn enough interest to offset inflation. You can think of it as the whipped cream on top of your investment sundae—a garnish, not a main ingredient.