Investing Your Money Wisely (Part 1/2)

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Understanding Asset Categories

My friends and I always ask ourselves how we can invest our money. Like many people, we are always looking for simple and comprehensible ways to earn interest on relatively small amounts (less than $10,000) without taking too much risk. Turns out if you even have as much as $500, there are several options for you to make money on that principal. Once you have determined how much you will invest, for how long and the level of risk you are willing to take, you can set up a portfolio with the help of a financial advisor or a broker. Let me first explain in simple terms what kind of financial instruments that may end up in your portfolio.

  • Equity: Equity is a portion of the ownership of a company that is sold through an instrument called a stock. Some stocks pay dividends on a periodic basis, which represent a part of earnings that the company chooses to redistribute to the shareholders. We distinguish public equity from private equity. The first is exchanged on a stock market whereas the latter is traded within private funds. In addition to dividends, you can also make money on equity by reselling your stock at a higher price than the one you bought. This is called a capital gain.

Tip: Once issued by the company, a public stock has a life of its own; meaning it no longer reflects the value of the company, but instead the value other investors think the company is (or will be) worth at a particular point in time. This may result in a higher return on your investment, or a higher loss (market risk).

  • Fixed-Income: You can lend money to an institution for a predetermined period of time and at a certain rate of interest by buying bonds. Bonds pay you interest (coupons) on a periodic basis until maturity, at which point your initial principal is reimbursed. You make money through the coupons you receive.

Tip: Unlike dividends, coupon payments are mandatory for the bond issuer. This makes fixed-income investments typically safer than equity; nevertheless bond buyers are still exposed to risk. The bond issuer may default on payments, the coupons may not keep up with inflation and the bond may be hard to resell.

  • Commodities: Raw materials (gold, iron, silver), agricultural products (wheat, cotton, coffee) and natural resources (oil, gas, coal) are examples of commodities you can buy. You would not physically own these; instead you would make money by trading futures. These are contracts that allow you to buy or sell the commodity at a predetermined price.

Tip: Commodities are a good way to diversify a portfolio because they are always in demand; however they react very quickly to global external factors, which makes them riskier for individuals.

  • Currencies: You can buy dollars, yen or euros in exchange for say pounds. Similar to commodities, you would not physically own the currencies; instead you trade pairs of currencies based on your expectations of their exchange rates. Currencies are liquid but very sensitive to economic and political factors thus they require constant tracking.
  • Real Estate: You can invest in real estate without owning a property by buying REITs (Real Estate Investment Trusts). A REIT is created when a corporation (or trust) uses investors’ money to purchase and operate income properties. REITs are bought and sold on the major exchanges, just like stocks. REITs do not appreciate much in value (lower capital gains than the stock market) but they have historically paid high and steady dividends (better performance than the bond market). It also is an excellent way to diversify your portfolio.

Tip: The ideal time to buy REITs is during periods of low interest rates and a down stock market. Conversely, when the stock market is booming, returns from REITs are not as attractive as average annual returns from stocks. They are also less attractive during periods of high interest rates, when government bonds and some corporate bonds are similarly if not more rewarding.

This summarizes the types of assets you can invest. In my next article, I will explain the basic steps to set up your portfolio with popular financial products.

Read Part 2: Setting up your portfolio

 

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