Who: This is the 4th post in a series of investment basics. If you want to learn the basics of investments and how to get started, I suggest reading Investing 101, Investing 102, and Investing 103. You will find this post helpful if you want some information regarding different types of investments.
What: This post seeks to isolate some common types of investments and describes what they are, the fees associated with the investments and possible strategies to maximize the benefit one can receive from these investments.

Equities - An equity is just another name for a stock. When you purchase equities, you are investing in a company. Each share represents a percentage (albeit a small one) of ownership in the company. Equities are traditionally considered among the most volatile of investments because of their lack of diversification. This is because the value of the equity is directly tied to the perception and value of just a single company.

  • Upfront cost: Equities trades have been getting cheaper and cheaper. Some brokerages allow you free equity trades with a large enough balance. For the most part, the average cost of a purchase of shares ranges from $5 - $12 per purchase. On a $1,000 trade this is equivalent to 0.5 - 1.2%.
  • Ongoing cost: Equities do not have ongoing costs associated with them. Once you purchase shares, there are no upkeep fees for those shares.
  • Appreciation: You gain value from equities when the stock price rises. In other words, as the value of the company rises, so does the stock price (for the most part). In the same way, if the value of a company decreases, you can expect the stock price to decrease as well. Many companies also offer dividends to stockholders. Dividends are paid out to holders of the stock periodically (quarterly, semi-annually, etc). Dividends are often expressed in an amount per share (often a few cents per share) or a percent of the share price that a dividend constitutes. Dividends can be paid in cash or reinvested in more stocks, depending on the company, your broker, and your preferences.

Mutual Funds - Mutual funds are much more complicated than people make them out to be. And the reason for this is simple. Unlike many other things, the simple explanations of a mutual fund give you all the information you need to know without getting into nitty-gritty, technical specifics. So, *basically* a mutual fund is a collection of stocks. When you purchase “shares” of a mutual fund, you are purchasing a share of the underlying securities. The benefit of a mutual fund is that you can quickly diversify your holdings by purchasing a fund, rather than buying dozens of individual securities. But with great power, comes great responsibility.

  • Upfront cost: This varies from mutual fund to mutual fund. First, we’ll talk about load mutual funds. Load mutual funds charge a load when you buy (frontload) or sell shares (backload). These are commissions that you pay (just like commissions on equity trades) which can vary but are usually in the vicinity of 2-6% of the investment and are usually tiered such that larger investments pay a smaller percentage. I have a somewhat controversial opinion on load mutual funds. Personally, I think that there are very few that are worth any thought at all. There are excellent mutual funds available without a load. However, I DO think that there are some load funds that are worth the load because of excellent fund management. Next, there are no load funds. As you may have guessed, no load funds do not have any commissions on purchase (except for those fees that may be charged by your broker). Many brokerage houses have a list of funds that they offer for free and a list of funds that they charge a standard mutual fund purchase fee for. There is no reason to buy a no load fund from a broker that charges a fee to purchase that fund
  • Ongoing cost: This is where things get a little bit tricky for mutual funds. Almost every mutual fund has ongoing fees. The fees include management fees, 12b-1 fees (administrative stuffs), and other miscellaneous fund maintenance fees. Overall, the fees are represented by a number that is called an expense ratio. For most actively managed funds, expense ratios vary from 0.50 - 1.25%. A 1% expense ratio means that if the underlying assets of a fund returned 8.3% for the year, your actual return would be 8.3 - 1.0 = 7.3%. 1% may not seem like much, but on a $10000 investment that would have grown 8% per year (without fees) over 20 years, the fees total over $7900!!!
  • Appreciation: The value of your holdings in a mutual fund is determined by the Net Asset Value. The Net Asset Value of the fund increases and decreases based on the appreciation and depreciation of the underlying equities which the fund is composed of. Mutual funds also pay dividends like equities. These dividends are the sum of all the dividends paid out by the companies which the mutual fund has in it’s holdings. Over the course of the year the mutual fund will have gains and losses based on the trades it makes. By law, a mutual fund is required to pass these on to their investors. These are distributed in much the same way dividends are.

Exchange Traded Funds - ETF’s are funds that can be traded just like stocks on an exchange. Most ETF’s track indices (S&P 500, Specific industries, etc) and usually include a bundle of securities who’s performance is meant to mimic the performance of the index that the ETF is meant to track.

  • Upfront cost: Since ETF’s are traded just like equities, their upfront costs are pretty much the exact same as the equities. You will pay a commission on a per trade basis (depending on your brokerage account). Additionally, an important thing to keep in mind that many people do not know about is a built in spread that exists on ETF’s. When you purchase an ETF, you will often purchase it at a price slightly above it’s market value. This is a market spread and should also be seen as a fee associated with purchasing ETF’s. A spread is just a generic term for the difference between the price people are selling the security for and the price that people are willing to pay for the security.
  • Ongoing cost: Since ETF’s are managed funds that are periodically changed so as to better track the underlying index, managers are paid fees to run the fund. However, unlike mutual funds, most of these funds are “passively” managed as opposed to “actively” managed. Turnover is usually much less on ETF’s and accordingly, management fees are significantly lower, ranging from 0.10 - 0.20% on average.
  • Appreciation: ETF’s appreciate in much the same way that mutual funds do. When the underlying assets of an ETF increase in value, so does the ETF. ETF’s also pay dividends in much the same way that mutual funds do.

Bonds - There are a huge variety of bonds out there and there is no time to discuss them all. This will serve as a general overview of bonds. Basically, when you purchase a bond, you are lending money to the issuer of the bond (the U.S government, a local government, commercial entity, etc). In a very basic, “vanilla” bond, you will receive periodic interest payments (coupon payments) and at the end of a certain period of time, you will receive your initial lump sum payment back.

  • Upfront cost: The costs of purchasing bonds varies widely from brokerage to brokerage. There are many places to purchase treasury bonds for a very low price, or even free. Purchasing commercial bonds is more expensive and the prices vary widely for purchasing the bonds.
  • Ongoing cost: Bonds are called fixed income vehicles because you know beforehand exactly how much you will receive, and when, from your bond. The price of the bond will fluctuate based on the prevailing interest rate, but if you hold on to your bond until maturity, you will not really be affected by the change in the interest rates. An ongoing cost may include increase possibility of default. If the issuer of your bonds gets into trouble, they may default on their bond (rare, or not so rare, depending on the type of bond and issuer) and you may not receive your bond payments.
  • Appreciation: As stated in the ongoing cost section, if you hold your bond until maturity, there is no real appreciation of value, just coupon payments that you periodically receive. However, if you buy and sell bonds before maturity, if interest rates go up, then your bond’s coupon rate becomes less competitive and this the value of the bond decreases. Conversely, if interest rates plummet, the coupon rate on your bond becomes more attractive to investors and you can sell it for a higher price if you choose to do so. It is important to note that 2 major types of bonds are fixed rate bonds and floating rate bonds. As you may have figured out, fixed rate bonds have a coupon rate that is fixed for the term of the bond, while floating rate bonds have a rate that is tied to some benchmark and adjusts periodically.

Bond Funds - This one should be easy if you have read the mutual fund post. A bond fund is a collection of bonds. The bond fund allows you to diversify your bond holdings by just making a single purchase.

  • Upfront cost: The cost of purchasing bond funds is often the same as the cost of purchasing mutual funds. These costs vary from brokerage to brokerage and from fund to fund. Refer to the mutual fund upfront cost section for an explanation of how this works.
  • Ongoing cost: Surprise! This works in much the same way mutual funds do. Bond Fund managers charge a fee (usually lower than mutual fund fees) for their management of the fund’s assets. Refer to the mutual fund ongoing cost section for an explanation of how this works.
  • Appreciation: If you notice a theme here, that’s because there is one. A bond fund’s value is based on the appreciation and depreciation in it’s underlying assets, just like a mutual fund. Its underlying assets are bonds, so their behavior is also described above in the bonds section. Voila! Simple.

There you have it. A quick and dirty run down of a few different investment vehicles and how they work. If you’re more interested in finding out about each of the different types of funds click their names in the above sections. This post was meant to give you a general overview of the investment vehicles and their fee structures. It should be obvious that many other investment vehicles have been left off this list. That was not because I got lazy, but instead because this is a PRIMER on investing and we’re looking to get across the most important points. Remember, always do your own research and do it more in depth (this is just a guide!).

In the next installment, Investing 105, I will discuss some simple and intuitive investment strategies that allow you to determine which investment vehicles you should use. Then, tune in for Investing 106, where I discuss different brokerage accounts and how to select the right one for you.

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