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6. Investing 101: Types of Investments

With $70 trillion in stock markets globally ($70,000,000,000,000) and growing, there is seemingly a financial product or investment vehicle available for every taste. Baskin Robbins ain’t got nothin’ on all the different flavours available to investors, but…just like the ice cream, there are only a couple flavours that are any good.

Bonds

Bonds are debt.

Bonds are cash you are lending to a government or company, for a certain time period, and each bond carries what’s called a “coupon” which is the interest rate you’ll be paid each year for lending the money.

The “coupon” for the most popular bonds, which are called US treasuries, are typically between 2-4% interest for 10-30 year time periods. The interest rates are low because these bonds issued by the US government, are seen as “risk-free”.

Basically, you are now the bank lending the money.

Ok next, type of asset…

just kidding, although to be honest, this would basically be how much time I would want to give bonds.

I’m not a fan of bonds for a few different reasons. They’re for people who already have truckloads of money or for people who don’t know what they’re doing. If you’re reading this you probably don’t fall into either category.

A typical bond (chunk of debt you’re lending out) will get you somewhere in the neighborhood of 2-4% from the government or company you’re lending to.

When you factor in inflation (think of it like gravity for money, it’s always working against you…more on this later) if inflation is at say 3%, this bond (debt) ends up being a 1% return. After 20 years, you basically end up with what you started with in buying power. Who in their right mind would invest in something as awful as a bond? Good question.

One reason is fear. People who don’t what they’re doing may invest part of their portfolio in bonds so it doesn’t fluctuate as much. This is a very expensive anchor. The opportunity costs here are massive, meaning what you could otherwise be doing with that chunk of change.

Another reason is they are already extremely wealthy and just want to park their millions somewhere. Makes sense.

If for some reason you wanted to purchase one you could do it through a primary or secondary offering on the bond market, just like a stock. Although to buy a bond it takes a minimum $1000.

For investors like us who follow the principles of Ben Graham and Warren Buffett, bonds are essentially useless and you don’t really need to pay attention to them until you’re extremely wealthy. And even then, they are a miniscule part of Warren Buffett’s 100 billion + portfolio.

Mutual funds

A mutual fund is a pool of money gathered from a bunch of people, usually actively managed, meaning a person in an office somewhere is picking and choosing where to put the money, but usually with many restrictions.

Mutual funds were thought to provide a really fast and cheap way of diversifying across a whole bunch of stocks and industries for the small investor.

Mutual funds operate on something called a fee based structure. Meaning mutual fund companies are compensated on the Assets Under Management (AUM).

Why is this a big deal?

What if you went to your dentist, and you had to pay whether they worked on your teeth or not? Sound crazy? It is.

Mutual funds are compensated a percentage of the AUM, regardless of performance. If you know of a better compensation structure, I’d love to hear about it.

Warren Buffett was quoted saying “…people get nothing for their money from professional money managers.”

Here’s where it gets even better and is representative of the fee structure, and so much more that is wrong with the financial industry: 96% of all money managers since 1985 have underperformed the S&P 500. Meaning 4% of money managers actually did what you paid them to do.

Let that sink in.

With some mutual funds charging 2% on total amount you invest, regardless of performance, over 40 years that equals roughly 50-70% of profits you would have otherwise received. They are paid this even when they lose you money.

“Hey I’ve got a deal for you, you put up all the money, you take all the risk, but I get 65% of profits.” This is a mutual fund.

ETFs

ETFs or exchange-traded funds are like mutual funds in many respects, but are traded on the stock exchange day just like shares of stock.

Many ETFs track market indexes like the S&P 500, Dow Jones, and the Russell 2000 index of small cap stocks and many others.

The only ETF I recommend checking out is the Vanguard ES&P 500 that tracks the S&P 500.

ETFs have fees, but they’re much more subtle than mutual funds. ETFs have something called “Look through expenses” which can add up. Mutual funds have them too, but ETFs are advertised as very low fee, well when you add up share dilution, market making, brokerage, and other fees, they add up to much more than advertised.

Alternative investments

For the beginner investor, there is very little worth exploring here, beyond stocks, bonds, ETFs, and mutual funds, there are many ways to invest, a lot of them extremely dangerous.

So to the beginner investor, I highly recommend you stay away.

With that said, when you’re ready, there are things possibly worth looking at.

Real estate investment trusts (REITs) pool investor’s money and purchase properties. REITS are traded like stocks. Some mutual funds and ETFs invest in REITs as well.

Hedge funds and private equity are also classified as alternative investments, although they are usually restricted to those who meet certian income and net worth requirements. Also called being an “accredited investor”.

Derivitives, options, swaps etc. This is what I call the no go zone. Highly leveraged, thinly traded, the odds of success are highly stacked against you.

Stocks

This is our lane, this is where we can succeed and do extremely well.

Buying shares of stock gives us the ability to become minority owners in a real living-and-breathing business.

As shareholders, we are entitled to the profits of the business, based on the number of shares we own.

So if the company earns $1 per share and we own 100 shares, our equity, or the money that’s ours, inside the company, grew by $100!

Stocks are incredible investment vehicles as they have theoretically unlimited potential. No investment vehicle has come close to matching stocks over time in terms of performance.

Because stocks are a real ownership stake in a tangible business, and because businesses have unlimited growth potential, the is no limit to the returns that can be achieved with stocks!