Once you have enough money saved in your emergency fund, totaling about six months of expenses, you should start putting money into the market. A confusing part of beginning this process is knowing what products to put money into. Let’s dive in!
Bonds
The simplest investment vehicle to park money into are federal bonds. The Federal Reserve sets fixed interest for different periods, such as 1-year, 2-year, 10-year or 30-year. Treasury Direct is the most straightforward way to purchase bonds, though many brokerages also offer that ability. Bonds have been at historically low interest rates, and a young investor can find much better returns elsewhere. They are considered a fixed-income asset because the interest rate is known and fixed after purchase. This can be useful as an individual grows older and begins thinking about retirement. Many companies also offer fixed bond rates, but they come at a higher risk than federally issued bonds; buying a company’s stock is usually a better return than a company’s bond.
Equities
Equities often make up a vast majority of retirement and personal investment accounts. An equity is a share in any publicly traded company, such as Apple or Google. Young investors should put most, if not all, excess cash in equities. Stock selection is extremely difficult, and in fact, most hedge fund managers perform worse than the aggregate market. Investing in mutual funds or exchange-traded-funds (ETFs) removes the complication of picking single companies while providing broad market exposure. The S&P 500, which tracks 500 of the largest companies in the United States, has provided a 10.5% annual return on investment since its inception in the mid-twentieth century. If you were to invest $100 a month starting at the age of 25, you would have nearly $650K by age 65.
The downside to equities is their volatility; any investment in a public company can in theory go to $0. One can point to the 2008 financial crisis or the bursting of the 2000 tech bubble as times when people lost a large portion of their investments. As you get older, wealth protection becomes more important than wealth growth. Holding too many equities can become a liability in case of a market downturn; however, younger investors should be willing to take more equity risk as their investment horizon is much longer.
Options
Options are an investment class that have exploded in popularity with apps such as Robinhood. They are a type of derivative, which means they derive their value from another investment product—most often an equity. An option is a contract between two individuals to buy or sell a certain equity at a specific price, called the strike price. For example, if Apple is trading at $120, someone could purchase a call option at a strike price of $125. This contract gives them the option to buy a share of Apple at $125. If the stock price increases to $130, they would be able to make a $5 profit on the difference. This price change must occur by the expiration date, which is when the contract ends. The counter to a call is a put option, which would allow an individual to sell a stock at a certain price. In short, one would purchase a call if they believed the price would increase and purchase a put if they thought the price would decrease.
Futures
Futures are the second most common derivative product after options. Like options, futures are also a bet on a certain price by a specific date, though the only transactional cost is a commission. Let’s take a look at current crude oil futures, specifically for June 2022.
The June 2022 futures contract’s price is $102.96. The contract’s purchaser would be entitled to 1,000 barrels of oil at that price during June, while the seller is obligated to procure 1,000 barrels of oil. The contract is considered physically delivered since there are goods exchanged. Futures contracts in investment portfolios are strictly financial, where two individuals are betting on the price of the contract over time. It is important to fully understand the risk cases and have a fundamental thesis for trading a futures contract.
Takeaway
Investment classes can be confusing to understand, and there are pros and cons to each one. As a beginner, stick to investing in equity-based ETFs, such as the S&P 500. Bonds yields are so low that they do not even keep up with the rate of inflation. On the other hand, high percent returns from options or futures can be enticing, but there is often immense risk. As you continue along your financial trek, you can consider expanding into more niche products, but equities should remain the priority. If you’re looking for more information on what accounts you should be opening, check out our previous article here.
