Invest! Invest! Invest! It is what we are told to do with our savings (disposable income), with the expectation it would increase in value and not be eroded by inflation over time. The concept of investing to grow your money has been around for a very long time.  There is even a parable in the Bible referring to persons who were rewarded for exercising good stewardship over money given to them by investing it.

Traditionally, the most common form of investments for the “ordinary” person were buying properties and having a savings bank account.  There are now many types of investment vehicles available to choose from, each with a different risk profile and focus.  In recent years it has become easier for individuals to manage their own investments with the emergence of online brokerages.  The fees and commissions charged by online brokerages tend to be lower than the traditional ones.  With all the choices available, it is advisable to become acquainted with some of the more widely used types of investments. Below is a very high-level overview of bonds, stocks, mutual funds, and exchange-traded funds also known as ETFs.

 

Bonds

Simply stated, a bond is a loan by an investor to an issuer of the bond for a fixed period.  The issuer or borrower can be the government, federal agency, corporation, or any other organisation.  In most instances, the loan is repayable in full at the end of the fixed period with interest or interest can be paid at different times during the period.  The money the bondholder will receive when the bond matures it is known as the face value and that specific date of payment is the maturity date.

Other important terms or characteristics of bonds are coupon rate, coupon date and issue price.  The coupon rate is the rate of interest to be paid on the face value of the bond and the coupon date is the date interest will be paid out.  A bond may have several coupon dates, but the standard is twice per year.  The issue price is the original price at which the bond issuer sells the bond.

There are a variety of bonds, each having their own attributes. 

Zero-coupon bond as its name suggests, has no coupon payment.  It is issued at a discount to its par value and the bondholder obtains a return when it is redeemed at its full-face value.

Convertible bond allows the bondholder the option to convert the debt into a predetermined number of common stocks of the issuing company, at certain times during the life of the bond. This type of bond has both debt and equity like features.

Callable bond is one which can be redeemed before the date of maturity at the issuer’s discretion.  This is benefitable to the issuer as it allows the company to repay its debt earlier and to take advantage of any drop of interest rate. To compensate the bond holder, the interest rates on callable bonds are higher than on similar non-callable bonds.

Puttable bond is almost the opposite of a callable bond.  This type of bond provides the bondholder with the option to sell (put) the bond back to the issuer before the maturity date.

 

Stocks/Shares

A company or any entity looking to fund its business ventures can do so by borrowing or selling a stake in their entity.  As we have seen, bonds are issued when an entity wishes to raise capital by borrowing. On the other hand, when an entity issue shares, it is selling you, ownership of the entity. In the world of finance, a company’s capital stock consists of all the shares into which its ownership is divided.             

When you purchase shares in a company, you become a shareholder of the company and in effect, you own part of the company.  Your percentage of ownership is the proportion of the number of shares you own to the total number of shares of the company.  Depending on the type of shares you purchase, it will determine your voting and dividend pay-out entitlements.

There are two main types of shares: common shares, and preferred shares.  With common shares you have the right to vote at shareholder meetings and receive dividends if they are declared.  Dividends are not guaranteed, and the amount paid varies.  Preferred shareholders have limited or no voting rights but tend to receive higher payouts of dividends ahead of any dividends being issued to common shareholders.  Further, in the unfortunate circumstance that a company faces liquidation, preferred shareholders have precedent over common shareholders to claims of the assets of the company.

Most people who invest in stocks own common shares and would have acquired them from a stock exchange, such as the Nasdaq, TSX (Toronto Stock Exchange) or FTSE (London Stock Exchange), etc. Stock exchanges are where stocks can be traded, i.e. bought and sold.  Investors in stocks make money when the price of the stocks increase and when dividends are paid out. 

There is no guarantee that the price of a stock will increase; it may fall.  This makes investing in stocks riskier than bonds, but they can also yield a higher return. Stock prices are driven by several factors.  One of them being the financial performance of the company. Other factors are the economic outlook, investor sentiments and even geopolitics.

 

Mutual Funds

Mutual funds are professionally managed investment vehicles; pooling money from many investors and investing in a portfolio of securities, such as stocks, bonds, or other assets. Each mutual fund has its investments objectives set out in a prospectus and tailors its portfolio to match these objectives.

The portfolios of most mutual funds are made up of hundreds of different securities, offering an investor of a fund the opportunity to diversify his/her risks. This is especially true for small investors, who may not have the money to directly invest in different stocks, to be able to reduce their risk by diversification. In return for having a managed, diversified portfolio of security, the investor pays a fee and sometimes a commission to the mutual fund company.  The average fee ranges from 1 – 3% of funds being managed.

An investor in a mutual fund, is really buying ownership of the assets of the mutual fund company.  The investor does not directly own securities which the mutual fund company has acquired.

There are three ways an investor earns income from a mutual fund:

1. The mutual fund earns dividends from the securities it holds.  These dividends are then paid out to the investors of the fund by way of a distribution. An investor can choose to take the distribution as a pay out or reinvest it into the fund.
2. If the securities held by a fund increases in price and is sold, the fund would have a capital gain, which it also pays out to the investor as a distribution.
3. The fund’s share price increases if the securities it holds increases in price.  The investor can sell their shares of the mutual fund on the market for a profit.

A difference between mutual funds and stocks is that the share price of a mutual fund does not fluctuate during market hours as stock prices.  Purchases of mutual fund shares are redeemed or settled at the end of the trading day at the current share price.  After all the day’s purchases have been settled, then the share price of the fund is updated at the close of the trading day. Mutual funds are priced at their net asset value.

 

Exchange-Traded Funds

Exchange-traded funds  (ETFs), are very similar to mutual funds as they are also a type of pooled investment security.  Some common securities held by ETFs are stocks, bonds, and commodities, but they can also track a market index. One can benefit from the increase in performance of a stock market, without buying every stock of that market, by buying an ETF that tracks that stock market.

Like stocks, ETFs are traded on exchanges.  This is one of the significant differences between ETFs and mutual funds, ETFs can be bought and sold through the trading day whereas mutual funds can only be traded once per day after the close of the market.  This makes ETFs a more liquid asset than mutual funds.

There are passive and active ETFs. Passive ETFs set out to replicate a broader index such as the NASDAQ or S&P 500.  There are also actively managed ETFs which engage portfolio managers to decide which securities should be sold or added to the funds.

 

Conclusion

Broadly speaking, bonds are relatively low risk investments with generally lower returns than other forms of investments.  Stocks are risker with potentially higher returns than bonds.  Mutual funds and ETFs offer the opportunity of diversifying your investments at a reasonable cost. However, ETFs are more liquid than mutual funds.

With these different array of investment vehicles easily available, and there are others, such as Forex, and newcomers like crypto currencies, investors can tailor their investments to suit their long-and short-term goals.  Each has risks and tax implications; it is very important before deciding which one(s) to invest in, that you understand how the investment vehicle works. You must then determine what your risk tolerance is.  Most people focus on the rate of return they would like to achieve, but it may be also worth considering how much loss you are prepared to tolerate. Finally, do not forget to factor in the management fees and brokers commissions as these will affect your investment’s final rate of return.

 

 

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