The following is a guest post from Ron at The Wisdom Journal:
So you’re ready to begin investing. You’ve paid off all your high-interest debt, have 3 to 6 months of living expenses socked away in a liquid account, and you’ve developed a working budget that leaves cash each month for investing in the stock market. Not so fast. There are a lot of options to consider before investment of your hard-earned money into the stock market just because you read a blog post about Scottrade. What options? What are the pros and cons of each?
- Certificates of Deposit (CDs)
- Index Funds
- Exchange Traded Funds
- Mutual Funds
- Individual Stocks
Certificates of Deposit (CDs)
A CD is a type of deposit account with a bank or brokerage house that usually offers a higher rate of interest than a regular savings account. Unlike other investments, CDs offer federal deposit insurance up to $250,000.
When you purchase a CD, you invest a fixed sum for fixed period of time( 30 days to 5 years or more) and the issuing bank pays you interest at regular intervals. When you cash in your CD, you receive the money you originally invested plus accrued interest. If you redeem your CD before it matures, you may have to pay an “early withdrawal” penalty or forfeit a portion of the interest you earned.
Pros of CDs: Safety and security, guaranteed interest, ease of understanding.
Cons of CDs: Low interest rates, funds aren’t very liquid without withdrawal penalties.
A bond a debt instrument where you loan money to a corporation or a municipality. Corporations use the money to grow their business while municipalities use it to pay for schools, roads, and infrastructure. Corporations repay this debt with future earnings and municipalities repay it with future tax revenue. Bonds are relatively safe, depending on the solvency of the borrowing entity, so check out who you’re lending money to!
Many municipal bonds offer income exempt from both federal and state taxes. There is an entirely separate market of municipal bond issues that are taxable at the federal level, but still offer a state – and often local – tax exemptions on interest paid to residents of the state of issuance.
Pros of bonds: Generally safe as an investment, low volatility, potentially tax-exempt.
Cons of bonds: Usually offer a lower rate of return than other investments, the volatility bonds DO experience is directly tied to going interest rates.
My personal favorite! Index funds are large groupings of individual stocks, some with 500 stocks, some with 3,000, some with even more. What you get with index funds is wide exposure to the market and lower risk as a result.
These index funds can hold “baskets” of stocks, bonds, or other investments and debt instruments.
Pros of index funds: wide exposure to the entire market, low fees because they don’t require much maintenance, you match the market rather than try to beat it, there is little investment turnover, resulting in lower capital gains distributions.
Cons of index funds: not as flashy or exciting as individual investments, you can’t select which investments are in the basket, the portfolio remains invested in down markets.
Exchange-traded funds (ETFs) are funds that target a specific investment group. They may track Brazilian stocks, or health-care stocks in the USA, or the stocks of emerging markets. They may also track bonds or specific industries within a certain niche. Because they trade with a regular ticker symbol, you can buy and sell ETFs just like stocks.
If the ETF is large enough, you could get similar diversification of an index fund in addition to the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund.
Pros of ETFs: Lower average costs of maintenance, usually a lower turnover ratio resulting in a smaller capital gains tax, with many ETFs, any earned dividends are automatically reinvested.
Cons of ETFs: Since they are traded just like stocks, you’ll have to pay a commission, there can be a difference between an ETF’s price and the net asset value (NAV) of its portfolio, especially for ETFs that aren’t traded regularly.
Mutual funds are investment vehicles created by a pool of funds gathered from investors to invest stocks, bonds, money markets, real estate or other financial instruments and assets. The funds are operated by managers who invest the fund’s cash in an attempt to produce gains and income for investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.
Unfortunately, the vast majority of fund managers regularly fail to match the market’s performance as a whole. Yet they still manage to generate a healthy fee for this “management.”
Pros of mutual funds: Gives the small investor an opportunity to invest in professionally managed portfolios of stocks, bonds and other securities, which would be quite difficult (if not impossible) to create with a small amount of cash.
Cons of mutual funds: Higher fees than index funds or ETFs, generally lower performance than the market as a whole, portfolios are actively managed (many trades) resulting in higher taxes.
A stock is simply part ownership in a business. The more “shares” you own, the greater your stake. The more control you can personally exercise over how the business is run. With common stocks, you have the right to vote on who sits on the company’s board of directors. This means you have a say in how the company is run to a small extent.
Investing in individual stocks isn’t for the faint of heart. Stocks can be adversely affected by emotion, taking precipitous drops in price followed by huge upward swings for seemingly no reason. Investing in individual stocks should only be done after careful research and lots of it. If you’re really interested in single stocks, consider using a direct stock purchase plan (DSPP) from the company itself or a dividend reinvestment plan (DRIP).
Pros of individual stock investing: Opportunity to realize large capital gains, opportunity to earn dividends and reinvest them.
Cons of individual stock investing: Potential for large volatility, poor management decisions can run the company into the ground and negatively affect the stock price, picking winners means doing much more than just adequate research – it means doing some intensive research.
For New Investors
If you’re new to investing, I would recommend AGAINST:
- Real estate
- Foreign exchange (foreign currencies market)
- Precious metals
- Anything that sounds too good to be true – it probably is.
These investments are high risk and require quite a bit of research and education before you invest your hard-earned dollars.
Are you currently investing? Do you have anything to add to this list?
This is a guest post from Ron Haynes, the blogger, and writer behind The Wisdom Journal, where he writes about making wise choices, improving your finances, and living a better life. Check out one of his recent posts: How to Really Screw Up Your Life (Insurance).