What does investing actually mean?
What does investing actually mean? When you hand money over to a broker, bank, or advisor, and they say we want to "diversify your portfolio" what actually happens to your hard earned capital?
Well first we would need to break down each asset class. There's stocks, which is equity in a company, or ownership. Each share represents a small part of a company's assets and earnings potential. Then there are bonds. Bond's represent loan obligations to companies, and for the most part, the higher the rate of interest, the more riskier the borrower is. When you hear bonds, think debt. Then there are variation's of each. Convertible bonds are bond's that pay you less interest that can later be converted to shares at a certain point. There's callable preferred stock. There's non callable convertible bonds. Well, you get the point. There are many different ways to invest in a company.
There are tons of ways you can invest as well into these instruments. You can buy stocks and bonds directly, you can buy ETF's on exchanges, or even mutual funds. With buying stocks and directly, you have the ability to partake in the company’s growth via the share price and you have the ability to share in profits through dividends that the company might declare. With Bonds, you own the actual debt obligation directly, which basically means you're loaning money to a company or agency in exchange for periodic interest payments plus the return of the bond’s face value when the bond matures. Bonds are issued by many different entities, such as corporations, the federal government, states,
municipalities and even governmental agencies.
A mutual fund is a pooled investment vehicle that allows you to invest in many bonds and stocks at once. What the mutual fund invests in is stated in the funds prospectus. Mutual funds are valued at the end of trading day and any transactions to buy or sell shares are executed after the market close. Mutual funds can make distributions in the form of dividends, interest and capital gains. These distributions will be taxable if held in a non-retirement account. Selling a mutual fund can result in a gain or loss on the investment, just as with individual stocks or bonds. Mutual funds can be passive, where they follow a bench mark, or active, where an actual manager is buying and selling the investments on your behalf. This manager could buy 50 to 100 stocks/bonds on your behalf, all the while keeping costs lower than if you did it yourself. There are a few different types of shares of a mutual fund you can buy. The A share carries a upfront fee and typically lower ongoing fees, a C share does not cost anything up front, but carries larger ongoing fees, as well as a penalty if you sell within a given amount of time, and then there is the I share, these carry no up front fees, and a lower ongoing fee. Most fee based accounts use I shares.
ETF's are like mutual funds but they trade like stocks. They usually are passive, meaning they follow a benchmark, and their fees usually come in lower, because there is no manager actually trying to beat the benchmark. Also they are most likely more tax efficient as well, as they trade like a stock, and are not forced to kick out capital gains and losses every year because of the way they buy and sell securities. As you can see there are many ways to invest, and with so many options to choose from, it's very hard for the average person to know what to do.
That's where most people either go to a financial advisor, broker, bank, roboadvisor, or discount online brokerage to get help. With so many different terms its hard to keep up, so lets break down each. Typically a financial advisor may help you in many area's of your life, insurance, investments, as well the one who will build a financial plan for you. They typically have a license that allows them to charge a fee on assets under management. That fee can be between 0.50% all the way up to 2.50% depending on what they are doing for you, how much assets you have with that advisor, as well as what relationship you have with them. This does not include the actual cost of investments in the portfolios. Fee based advisors more than likely have to adhere to a fiduciary standard, where they are acting in your best interest. A broker typically is someone that buy's and sells stocks in a portfolio for you. They charge a commission. This is a dollar figure or a mark up/mark down based on how much is invested in the given investment. An example of this is, if you buy a stock with 10,000 dollars, and a 2% mark up, you will pay a 200 dollar commission. When you sell that stock, a 2% mark down would be another 200 dollar commission.
A discount online brokerage is one that charges you a flat commission for trades. Companies such as Scottrade, Etrade, and TD Ameritrade will let you buy and sell stocks on their platform for as little as under 10 dollars a trade, while offering basic advice. A roboadvisor is a hybrid between a financial advisor, and a discount online brokerage firm. You don't get as much hands on support, but you get a professionally managed portfolio based on your risk tolerance and time horizon. So the questions is what type of help do you want. If you are more of a do it yourself investor, you could stick with roboadvisors and discount broker firms, if you have more complex situations, or want more help, you can go with a financial advisor.
This is a small breakdown of what it means to invest. If you are fearful of investing, or have many questions, your best bet would be to go with a financial advisor.