Comparing the Risks of Different Investment Types

Comparing the Risks of Different Investment Types

The investment landscape is constantly changing and evolving. However, those who take the time to understand the fundamental principles and the various asset classes stand to gain significantly in the long term.

The first step is learning to distinguish between different types of investments and the level of risk associated with each. There are different asset classes on the investment risk ladder, ranked by risk level, like:

Cash

Cash is the safest and simplest investment asset. It provides precise knowledge of the interest earned and guarantees the return of the capital. However, the interest earned from cash in a savings account usually does not beat inflation.

Certificates of deposit (CDs) offer higher interest rates but are less liquid and there are potentially early withdrawal penalties involved.

Bonds

A bond is a debt instrument representing a loan made by an investor to a borrower. A typical bond will involve either a corporation or a government agency, where the borrower will issue a fixed interest rate to the lender in exchange for using their capital. Bonds are commonplace in organizations that use them to finance operations, purchases, or other projects.

Bond rates are essentially determined by interest rates. Due to this, they are heavily traded during periods of quantitative easing or when the Federal Reserve—or other central banks—raise interest rates.

Mutual Funds

A mutual fund is a type of investment where multiple investors combine their money to purchase securities. Mutual funds are actively managed by portfolio managers who allocate the pooled investment into stocks, bonds, and other securities.

Most mutual funds have a minimum investment of between $500 and $5,000, and some have no minimum requirement at all. Even a relatively small investment provides exposure to as many as 100 different stocks within a given fund's portfolio.

Mutual funds can either track specific indexes like the S&P 500 or the Dow Jones Industrial Average, or they can be actively managed by portfolio managers who adjust the allocations within the fund. However, actively managed funds generally have higher costs, such as yearly management fees and front-end charges, that can cut into an investor’s returns.

Additionally, mutual funds are valued at the end of the trading day, and all buy and sell transactions are executed after the market closes.

Exchange-Traded Funds (ETFs)

Exchange-traded funds (ETFs) have become the most popular investment instrument since their introduction back in the mid-1990s. ETFs are similar to mutual funds, but they trade throughout the day on a stock exchange. This means they mirror the buy-and-sell behavior of stocks. This also means that their value can change drastically during a trading day.

ETFs can track an underlying index such as the S&P 500 or any other basket of stocks with which the ETF issuer wants to underline a specific ETF. This covers everything from emerging markets to commodities, individual business sectors such as biotechnology or agriculture, and more. ETFs are extremely easy to trade and offer broad coverage, making them extremely popular with investors.

Stocks

Shares of stock let investors participate in a company’s success via increases in the stock’s price and through dividends. Shareholders have a claim on the company’s assets in the event of liquidation (that is, the company going bankrupt) but do not own the assets.

Holders of common stock have voting rights at shareholders’ meetings, while holders of preferred stock do not have voting rights but receive preference over common shareholders in terms of dividend payments. There is a wide range of alternative investments, including the following sectors:

Real estate

Investors have the option to acquire real estate by directly purchasing commercial or residential properties. Alternatively, they can buy shares in real estate investment trusts (REITs). REITs are similar to mutual funds, where investors pool their money to purchase properties. They trade like stocks on the same exchange.

Hedge funds

Hedge funds may invest in a variety of assets aiming to achieve returns higher than the market, known as "alpha." However, there is no guarantee of performance, and hedge funds can experience significant fluctuations in returns, sometimes performing worse than the market.

Typically, these investment opportunities are only available to accredited investors and often require initial investments of $1 million or more, along with certain net worth requirements. Investing in hedge funds may also tie up an investor's funds for extended periods.

Private equity fund

Private equity funds are similar to mutual and hedge funds. A private equity firm, known as the "adviser," pools money from multiple investors and then makes investments on behalf of the fund. These funds often take a controlling interest in a company and engage in active management to increase its value.

Other strategies include targeting fast-growing companies or startups. Private equity firms usually focus on long-term investment opportunities of 10 years or more, similar to hedge funds.

Commodities

Commodities are tangible resources such as gold, silver, crude oil, and agricultural products. There are various ways to invest in commodities.

One way is through a commodity pool or "managed futures fund," which is a private investment vehicle that combines contributions from multiple investors to trade in the futures and commodities markets.

One advantage of commodity pools is that an individual investor's risk is limited to their financial contribution to the fund. Additionally, there are specialized ETFs designed to focus on commodities.

An important question that may arise is: How can one invest sensibly, suitably, and simply?

Many experienced investors diversify their portfolios using the asset classes listed above, with the mix reflecting their risk tolerance. A valuable piece of advice for investors is to begin with simple investments and then gradually expand their portfolios. Specifically, mutual funds or ETFs are a good first step, before moving on to individual stocks, real estate, and other alternative investments.

Most people are too busy to monitor their portfolios daily. Therefore, it is a good idea to stick with index funds that mirror the market. For most individuals, three index funds are sufficient: one covering the U.S. equity market, another focused on international equities, and the third tracking a broad bond index.

However, Investors who prefer a more hands-on approach may wish to select their combination of assets when building a diversified portfolio that aligns with their risk tolerance, investment timeframe, and financial objectives. This allows them to potentially achieve higher returns by adjusting their portfolio allocation to emphasize specific asset classes based on the prevailing economic conditions.

This article is contributed by - Farzad Vajihi

(Analyst of stock market and cryptocurrency, Ph.D. in economics.)