The analogs of umbrellas and sunglasses in the investment world are the different asset classes. Broadly speaking, these are the kinds of “things” that you can put your savings into. They include stocks (which can be further divided into U.S. stocks, international stocks, and emerging markets stocks), bonds, inflation-protected bonds, commodities, and real estate.
Stocks are financial assets that represent fractional ownership in actual companies. Stocks have real value because as companies make money they usually return a portion of the profits to shareholders in the form of cash dividends that are paid every year. In the absence of any kind of stock market, the value of any stock would simply be the expected value of its future stream of dividends, discounted to today’s dollars to account for inflation. In the real world where stocks constantly trade hands on an exchange, prices fluctuate wildly because nobody really knows for certain what the value of that dividend stream will be.
Investors in stocks expect to make a return on their investment in two different ways:
- Dividends. The annual or semi-annual payments to shareholders that represent earnings returned to owners.
- Capital gains. The result from selling the stock to someone else for a price higher than the purchase price.
Stocks can be split further into different asset classes based on the country where the underlying company resides. The logic of this divide is that the economic cycles of different regions of the world will not always exactly coincide. For instance, Chinese stocks may do well at a time when Italian stocks do not.
Domestic stocks are investments in U.S. companies that are usually listed on the New York Stock Exchange or the NASDAQ market. U.S. stocks are the safest investments for U.S. citizens to hold for two reasons:
- The firmly established legal system in the United States ensures that there is a high probability that the rights of investors will be protected. This is extremely important since any investment involves giving a certain amount of money away today for an uncertain return in the future. With a less established legal system companies might be tempted to take the money and not give anything back.
- Since the investments are in companies whose earnings are mostly in dollars, there is less currency risk compared to investing in companies overseas.
International developed-markets stocks are companies domiciled in places like Europe, Australia, and Japan. These are also countries that have long and established histories of capitalism and the rule of law, though the risks for U.S. citizens in investing in other countries may be somewhat greater than in purchasing U.S. assets. The returns to these investments are usually in a different currency like the Euro or Yen. This creates the risk that U.S. investors will lose money if that currency loses value relative to the dollar. However, some of these economies may experience higher growth rates than the United States in the coming years.
Emerging-markets stocks from countries like China, India, and Brazil are thought by many to have the highest potential returns as well as the highest potential risks of any stocks. These rapidly developing countries do not always have established histories of capitalism or legal systems, and there is always a small chance that a home government will seize the shares of foreigners during the time of a crisis. At the same time, the economies of many emerging-market countries have grown much faster than the U.S. economy in the past decade. It is likely that countries like China and India will, on average, continue to grow faster in the future, because they currently have vastly lower living standards. This does not guarantee that their stock market will outperform the US market, however, since it is possible that the price of their shares already accounts for the expectation of high growth in the future.
As discussed previously, bonds are like IOUs to a company or government. Bondholders lend out their money, for a fixed period of time. In return, they are compensated by interest payments at a set period – often every six months. Bonds are considered a safer investment than stocks for a couple reasons:
- With a bond, the borrower makes a promise to pay back the full amount of the loan at the end of the term. With stock investments, there is no such promise.
- In the event that the company is unable to pay back its loans and goes bankrupt (as was the case with Enron and Lehman Brothers), bondholders have the first claim on the company’s assets, so they will get paid back in full before stockholders receive anything.
The bond market can be broken into multiple different segments based on the type of entity that is issuing the bond – i.e. the borrower. The major segments include Treasury bonds, corporate bonds, mortgage-backed securities, and municipal bonds.
Investments in federal government bonds (called Treasury bonds because they are issued by the U.S. Treasury Department) are the safest kind of bond investments because they come with the full backing of the U.S. government, which has the authority to tax citizens of the largest economy in the world, as well as to print money.
There is also a large market for corporate bonds, which are just bonds issued by corporations in order to fund their capital needs. Because there is always a chance that a company might go bankrupt and not be able to pay back its obligations to bond-holders, these are considered riskier than Treasury bonds, and therefore make higher interest payments to their holders.
Mortgage-backed bonds are, as the name would suggest, bonds that are used to fund mortgages for home purchases. These are often guaranteed by one of the now-famous quasi-governmental agencies, Fannie Mae or Freddie Mac. Because they are implicitly backed by the Federal government, they tend to have interest payments that are lower than corporate bonds. However purchases of mortgage-backed securities are subject to another kind of risk called prepayment risk. In short, since homeowners have the option to refinance or pay their mortgage back early, MBS holders are never quite sure when they will receive their money back (which is not an attractive feature if you are trying to plan for retirement).
Municipal bonds are bonds that are issued by cities and states in order to fund short-term spending needs. “Muni Bonds,” as they are known, are primarily interesting because they are tax-free bonds – the federal government does assess normal income taxes on interest payments. This makes them attractive to investors in a high tax bracket who are using a taxable account. However, because of this, muni bonds may sell at a premium to other kinds of bonds, so for investors with a tax-free account or who are in a lower tax bracket, there may be better options.
Inflation Protected Bonds
Although ordinary Treasury bonds guarantee return of the full amount of the loan, there is no guarantee as to what that money will be able to purchase when it is returned. For instance, imagine “Average Joe” purchases a 30-year Treasury bond with a 5% interest rate for $1,000. Joe will receive $50 every year as well as the return of his original $1,000 after 30 years. However, in those 30 years, the annual rate of inflation (the gradual increase in the price of goods over time) may have also been 5%. Using the “rule of 72” from the first chapter, this means that the price of goods would double about every 15 years (72 / 5 is about 15) and quadruple in 30 years. So although Joe did receive his original $1,000 back as planned, it will only purchase him 1/4 of the things that it would have 30 years ago.
Treasury inflation-protected securities (TIPS) were designed to solve this problem for investors. The interest payment that bondholders receive every six months is called a coupon. TIPS pay a smaller semiannual coupon than normal Treasury bonds, but in return they protect investors from increasing inflation by automatically adjusting both coupon payments and the value of the loan for the effects of inflation. So in the above example, Joe would have actually received $4,000 back after 30 years, despite only investing $1,000. And he would be able to buy just as many things with his investment as he could have 30 years ago when he made it. In addition, he received his annual interest payments, though they are generally smaller for TIPS than for a regular Treasury bond.
Real Estate (REITs)
Real estate might be the asset class that is the most familiar to the average investor. But many do not realize that in addition to purchasing a personal residence, they can also buy shares in apartments, houses, and commercial holdings like shopping malls. Individuals can invest in real estate through a financial instrument called a Real Estate Investment Trust, but more commonly known by its acronym: REIT. REITs are legal entities that own properties like apartment buildings, malls, and office buildings. REITs make money by charging the occupants of their buildings rent every month. They are legally obligated to pass through most of the profits that they make every year directly to shareholders in the REIT in the form of dividends. Because a REIT is a special entity that is required by law to distribute most of its profits every year, it does not have to pay corporate income taxes, which is a key advantage to the structure. REITs are an important asset class to the individual investor, since they often perform well in periods when the stock market is down or when there is high inflation.
Commodities are actual, physical resources like oil, gold, and copper. Purchasing commodities outright is distinct from buying the stocks of companies that extract commodities, such as Exxon-Mobil. Investors can own pieces of funds that invest in actual commodities through an innovative new set of ETFs. These funds mimic the process of actually buying and holding physical commodities through the use of what are called futures contracts. It is not absolutely necessary to understand how this works in order to plan for your retirement, but check the further reading section for more details if you are interested.
Alternative assets like venture capital, hedge funds, and private equity are other options for high wealth and sophisticated investors, but they will not be covered here.