After starting to Pay Yourself First, cash starts to accumulate. That is when we Put Our Money to Work (our rule for early retirement #2), but to do so, we must pick both an investment and an account type.
However, trying to cover both in one blog takes too long, so for today, we’ll focus first on investment options at a high level. This will finish with a brief outline of what I recommend as an investment progression using our own progression as an example.
Investment Types
We categorize investments generally as liquid or illiquid depending upon how easily a seller can find and contract with a buyer. Additionally, a spectrum of complexity also exists within these categories from beginner to advanced.
Liquid Investments
Liquid investments sell easily and convert to cash. Beginner accounts provide roughly the same security as cash and rarely offer either big risks or rewards. More advanced investments offer better returns, but they can also lose money (add risk).
Beginner Investments
Investors usually start with basic cash and cash equivalent accounts. In fact, most readers already own one of these. The typical options pay a small amount of interest (a monthly payment based off of a percentage of the account balance) but carry low to no investment risk:
- Checking accounts are low-interest paying accounts that offer easy access to the money. Everyone benefits from these accounts to pay bills and to keep cash safe.
- Savings accounts offer increased interest payments in exchange for restrictions on the number and frequency of withdrawals.
- Money Market funds provide an investment (often purchased in a stock brokerage account) designed to produce steady, but small positive returns with minimal risk; these attempt to be equivalent to a checking or savings account.
- Certificate of deposit (CD) accounts consist of a contract between the buyer and the issuer for a fixed interest rate of return over a fixed time period. CDs pay higher rates in exchange for strict restrictions on access.
- US Savings Bonds are a mini-loan to the US Government usually purchased directly from the US Treasury. They pay a fixed rate (EE Bonds) or a variable rate designed to match inflation (I Bond).
Historically, checking accounts, savings accounts, and CDs do not decrease in value unless the issuer itself fails (now protected against by insurance, see below). Money market funds also historically have positive values, but a few poorly constructed money market funds ‘broke the buck’ or lost money during the 2008 financial crisis causing regulatory changes to prevent such losses in the future.
Basic options make good accounts for beginners because they don’t lose money. However, sooner or later, most people want more returns from their savings and they graduate to other investments.
Intermediate Investments
Intermediate investments introduce risk, but also offer the opportunity for higher rewards. These investments fluctuate in value and the current retail price of the investment can go up or down. The more ‘volatile’ the investment, the greater the potential price movement over a short period of time.
Unlike basic investments, these investments no longer represent a contract for a cash deposit. Instead, you now purchase a portion of a loan, a slice of a company, or a percentage of a basket of investments.
United States Treasury Bonds
Each US Treasury Bond corresponds to a $1,000 loan to the United States government for a fixed interest rate and for a fixed period of time. Upon the end of the end of the fixed period of time (AKA: maturity date), the bond redeems and the owner of the bond receives the ‘face value’ of the loan ($1,000).
The value of US treasuries and higher-yield bonds (coming up next), can increase or decrease. For example, when the government raises interest rates, the value of older issues of bonds with lower interest rates decreases in value. Therefore, it can be possible to purchase a $1,000 bond at a premium (Ex: $1,125) or a discount (Ex: $850) depending upon the bond’s current value.
Economists and investors consider US Treasuries the absolutely safest investment in the market and their return is essentially guaranteed so long as the USA maintains financial strength. More experienced bond investors can generate returns larger than the interest rate by strategies to buy under-valued treasury bonds and anticipating changes in the interest rates.
Higher-Yield Bonds
Riskier bonds offer higher rates than US treasuries and are issued by states, cities, corporations, and agencies (government related entities such as airports, water boards, etc.). These bonds offer a spectrum of risk from the very safe to the very risky based upon the market’s evaluation of the entity’s ability to pay off the loan at maturity.
The higher the risk, the higher the interest payment. However, the higher the interest payment, the more likely the issuer will go bankrupt or stop making payments (aka: default on the loan). Companies that go bankrupt don’t pay back the full value of the loan, but bond holders traditionally become first in line to receive the remaining funds.
All of these bonds fluctuate in value partially based on the current movements of the US treasury rates, but also based upon changing opinions about the entity’s ability to pay. Buying the riskiest bonds requires expert understanding to achieve success.
Equities, Also Known As Stocks
Shares of equities, aka: stocks, provide ownership of a portion of the company. This slice can be very, very small since many public companies release millions of shares. Stocks can be risky because if the company fails, the stock becomes worthless and you can lose all of your invested money.
However, as I illustrated in my last blog, the value of stocks can increase significantly and provide good investment returns. Many stocks also pay dividends which allows the shareholder, or owner, to receive income for owning the stock.
As an intermediate investor, the reasonable types of equity investments include:
- Exchange traded funds (ETFs) offer professionally managed portfolios of investments (bonds, stocks, etc.) that can be bought or sold on the stock market and through brokerage accounts. Common options include an index fund based on top stocks in an index such as the NASDAQ 500 or S&P 500.
- Specific company stocks offer slices of specific companies for purchase. The common stock offers both investment as well as voting rights on the company’s direction.
- Preferred stock offers high dividend stock with preferential payment in exchange for reduced voting rights and less stock price increase during the good times. Often these stocks can be ‘called’ or bought back by the company without the prior permission of the current preferred stock owner.
- Mutual funds offer professionally managed portfolios of investments (bonds, stocks, etc.) purchased for exact dollar amounts (say $1,576.58) instead of at share prices (ex: $100 / share).
- Real Estate Income Trusts (REIT) are a special type of legal corporation that focuses specifically on a portfolio of real estate. By law, these companies must pay out 90% of their taxable income to their shareholders every year. In practice, these entities offer high dividend payouts compared to most common stocks.
- Business development corporations (BDCs), like RIETs, must payout 90% of their taxable income to shareholders, but instead of real estate, they fund smaller companies with loans or equity investments.
Other types of equity investments exist such as penny stocks (value < $1), warrants, and mortgage backed securities. However, these uncommon and risky options are beyond the scope of this blog. Even within the categories above, a wide range of risk exists so investors should master the investments covered above before they pursue more exotic options.
Advanced Investments
In addition to the riskier versions of the intermediate investments above, specific categories of investments can require advanced or even expert understanding to achieve success. The increased risk comes from aspects such as less transparency in the market, higher risk for loss, possible losses in excess of the amount of money invested, more complexity in trading, and more vulnerability to market manipulation.
Typical advanced investments include:
- Margin investing allows an investor to borrow money from a stock brokerage to buy more stock than they currently have available cash in their account. The brokerage company charges interest on the loan and, if the stock drops too much, the brokerage can sell the stock to pay off the loan without the account holder’s permission.
- Short selling makes a bet that the investment will decline in value. Essentially, the investor borrows the investment from the brokerage, sells it, and waits for the investment to drop in value so the investment may be repurchased and returned to the brokerage.
- Currency investments involve buying other currencies (British Pound, European Union Euro, Japanese Yen, etc.) and hoping to sell it for a profit later. Currencies can also be shorted with an accompanying increase in risk.
- Crypto or cryptocurrency essentially performs exactly the same as a currency, however, instead of being backed by the power of the country behind the currency (USA, EU, etc.), crypto is backed by the strength of the algorithm and the security of its blockchain record. Despite its popularity, buyers should possess significant mathematics and computer skills to avoid the steepest risks.
- Commodity investments buy and sell things many people and companies need such as oil, corn, tin, gold, and soy beans. Companies and countries buy these commodities to use them, investors buy and sell them hoping to make a profit over time. Commodities will typically be bought and sold virtually, but the final owner must take physical delivery of the oil or corn and possess a secure place to store the no-longer liquid investment.
- Derivatives or Options (aka: futures) make a bet on the future value of a stock, commodity, currency, etc. Options are contracts to buy or sell larger amounts of the investment in the future, so investors very easily get into big financial trouble very quickly without experience and deep understanding.
These advanced investments may also be combined such as shorting an option to buy cryptocurrency, or buying an option for oil using margin. The combination of these advanced investments exponentially increases the risk and the amount of possible loss.
As an investor with over 30 years of experience, I don’t mess with advanced investments. While I studied options off and on for the same amount of time, I still get confused so I just stay away and focus on what I understand much better.
Illiquid Investments
Illiquid investments require time and effort to find buyers. These investments will often be physical, do not require accounts, and may require the owner to protect and secure the investment.
Illiquid investments carry higher risk and are more difficult to understand as an investment. However, some people simply buy them for their related value and not as an investment. Key examples include:
- Real Estate investments buy the land and/or buildings on the land and attempt to generate income from the land or hold it for future resale. The most common personal real estate investment is a house to live in and some people buy it as a way to control their rent. Other examples include apartment buildings, warehouses, vacant lots, etc.
- Collectibles (cars, cards, artwork, jewelry, porcelain cats, etc.) can easily go up or down in value along with the interest in the collectible so they are very risky. Beanie Babies were all the rage until, suddenly, they were worthless. However, if you really like that necklace, go ahead and buy it for its emotional value to you, and any additional value as an investment is a bonus.
- Entrepreneurial investments include anything related to starting a small or large business such as buying a fast food franchise, starting a drone photography company, or trying to become a social media influencer. The risk is proportional to the required investment of time and money offset only by the revenue and profit that the company makes. This category requires a lot of work and therefore comes with a big chance that the investment will be lost without luck, hard work, and know-how.
Illiquid investments tend to require a lot of time so people who pursue these categories often make jobs out of trying to become successful with these investments. I recommend illiquid investments only once you establish a solid foundation of liquid investments.
A home can make a good investment, but like all illiquid investments, don’t overlook the additional associated costs such as maintenance and taxes. All illiquid investments should be considered intermediate or advanced-level investments due to their complexity and risk.
Recommended Progression
It may already be obvious, but investors should start with beginning investments and then eventually graduate to intermediate investments. Advanced investments should be reserved for after you prove yourself successful with the more simple investments.
Our Progression
For my wife and I, we started initially with a checking account. Checking accounts pay very little interest, so to increase our performance, we obtained a linked savings account that paid a higher interest rate. Linking the accounts allowed us to use the savings account as the ‘minimum balance’ so we could maintain less money in our checking account that paid less interest.
Today, I would recommend looking at high-interest checking accounts or linked checking and savings accounts as the first investments. When we started out we enjoyed a 1% to 3% interest rate for our checking and better for our savings account, but high interest rates also meant we suffered with a 10.5% home loan! Today, look for at least a 2% to 3% savings account rate and just accept that checking accounts pay very little.
Next we began investing in mutual funds that matched our investing interests. Initially, we focused on:
- Growth and Income Stocks: a compromise strategy combining the stability of income stocks with the potential gains of growth-oriented stocks.
- Income Stocks: a focused strategy for regular returns based on income paying stocks such as banks, consumer goods, and retail stores.
- Aggressive Growth: a focused strategy that seeks growth from tech stocks and other high-growth sectors.
- US Short Term to Medium Term Bonds: a stability oriented option that seeks higher returns than a savings account without the risk of a company stock oriented fund.
Most mutual funds include investing terms in their names to help investors understand the goals of the mutual fund portfolio. We initially invested equally into these funds, but after a few years, our basic checking/savings accounts and the stable bond fund became big enough to make us feel like we had a secure emergency fund.
After that, we felt more comfortable adding only to our growth oriented funds as well as dabbling in specific equity investments. Our first equity investments were well-known stocks (such as General Electric, and Disney) and ETFs for the S&P 500.
Mutual funds and their equivalent ETFs provide an excellent starting point for most investors seeking to develop their understanding of intermediate investing options. I really want to go into more detail on mutual funds and exchange traded funds, but to do so, I still need to cover a few more basics so that we can share a common understanding.
For now, just understand that ETFs now outnumber individual stocks! I would recommend starting with basic stock index-oriented ETFs before exploring exotic covered call or artificial intelligence stock ETFs.
Final Thoughts on Beginning Investing
As long as you start the critical step of starting to save money, you start the journey to a more secure future. Investing more aggressively moves that retirement date closer to today, but it needs to be done at a reasonable pace.
Start with savings that acts as an emergency fund (a future topic to explore) to cover at least three months of expenses before tying up money into mutual funds, ETFs, or CDs. Only then can you allocate additional funds to intermediate investing options that fit your comfort levels.
If you can’t stand the idea of losing money, stick to CDs, savings accounts, and bonds (individual bonds can be tricky to buy, so start with bond funds or ETFs). If the idea of missing out on the stock market growth bothers you more than losing money, look at stock or REIT focused mutual funds or ETFs.
A balance works best. Think of it like building a pyramid. If you want the pyramid (your retirement) to last, you need a stable foundation of conservative investments. More aggressive investments can allow your pyramid to soar, but only if the bottom is solid.