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Investment Types and Risk of Each Investment Strategy

Posted on May 1, 2011 by Thomas DeGrace

Learn what are Investment Types and Risk of Each Investment Strategy.  Investment types are investments such as cash, stocks, commodities, collectibles, real estate and business. In choosing which Investment type fits into your own personal investment goals can have a major impact on your retirement plan. Each investment type comes with its own risks and rewards. Here we try and talk about the major types of investments that each has a global market value of over 1 trillion dollars.

Investment Type Cash

Cash investments generally refer to investments where cash is invested usually for a fixed interest rate return. The advantage of cash investments is that there is relativity low risk compared to investing in assets. The differences in which type of cash investments includes the rate of return received the liquidity of the investment.

Cash investment types include CD’s, bonds and money markets. Government bonds, CD’s and money markets carry the lowest risk and pay usually a fixed amount over a period of time. Mortgage-backed securities and corporate bonds have a higher risk of default in which you could lose a substantial amount if the secured asset loses value.

Risks
A risk of cash investments is inflation in which case your cash loses its buying power as inflation rises. There is also a small risk that a currency could collapse and lose a huge amount of value over a short period of time.

Investment Type Stocks

Stock investing can include investing in things such as stocks & options. You will need an online brokerage account in order to buy & sell stocks on the stock market. As a shareholder of a company, you in effect own a piece of that company and benefit from the company increases in value. The value of the company goes up as the company grows both sales and earnings. Generally, as the economy grows, company earnings increase and the stock market goes up. As the economy falls and enters a recession, the stock market goes down.

When determining the value of one stock over another, most look at the P/E ratio (price to earnings), growth and its tangible book value. A common belief is that a stock trading at a fair market value is trading at P/E ratio that is even or less than its growth rate. Example if Microsoft was growing at 15% per year, then a P/E of 15 or less is warranted. The exception to this rule is that stocks with even no growth usually trade at least 6-10 times earnings. This is because the average inflation rate is 4% and stocks usually trade at least 2x the inflation rate. Other things you might want to consider in choosing stocks are growth potential, market leadership, earnings to debt ratio, competition and stability of earnings. You can pick your own individual stocks and or buy a basket of stocks in an ETF or mutual fund. Some investors also may buy a fund that tracks a popular index such as the DJIA, NASDAQ or the S&P 500.

Risks
A big risk to stock investing is that if a company goes bankrupt, the stock value will go to zero and you the investor will end up with nothing and the remaining company assets are sold with the proceeds going to bondholders. If the company emerges from bankruptcy, the bondholders then become the new owners of the stock. Diversification can help shield investors from losses if one company’s stock goes bankrupt. No Company in history has ever gone bankrupt that has had no debt so buying companies with low or no debt is a good idea. In a single year, an overall stock index such as the Dow or S&P 500 can lose over 50% of its value.

Though the benefit to owning stocks is that since 1900 the stock market has produced an average return of 10% per year. Also by owning stocks, you are hedging against inflation which can erode the value of money over time.

Investment Type Commodities

Commodities is a physical substance that can include energy, food and metals. Commodities tend to go up in times of high inflation and when the economy is growing rapidly. Commodities can also go up or down inversely to supply and demand when investors speculate to future trends or as different commodities go in and out of favor. Since commodities can move up rapidly sometimes over 50% in a single year for some, timing can be essential for capturing short-term gains. Gold is a very popular commodity that people invest in. Gold, however, isn’t used much in manufacturing and only a limited amount of the gold produced is used in jewelry.

Risks
A large part of price movements of gold is driven solely by the demand of investors. You can invest in commodities yourself by buying an ETF, hedge or mutual fund. You can also buy futures to speculate on the future price movements of commodities.

Investment Type Collectibles

Collectibles can include almost anything of value from baseball cards to antiques to paintings. A collectible is a tangible asset which value varies due to the demand by collectors. The less supply of the individual collectible, the more value it has. So to protect from oversupply, one would need to make sure the creator of the asset whether an artist or manufacturer is no longer producing copies or variants of the collectible.

Risks
Some risks while owning a collectible are that it could become damaged over the course of time which could lower the value. Also, there is a risk of the item being stolen so you would need to keep it in a safe place or have insurance to cover the item. When selling a collectible, it may not be easy to find a buyer for niche collectibles and auction houses can charge fees as high as 20% to sell the item for you. Investing in collectibles can help hedge you against inflation.

Investment Type Real Estate

Real estate investing is investing in things such as land, residential and commercial property. Land investing is based on the fundamental that there is only so much land available and demand will continue to increase over time. However, while holding land there isn’t any cash being generated and you will still have to pay the taxes every year.

A common real estate investment is rental properties. The investment strategy here is to rent the property to a tenant for a fixed price hopefully covering the cost to hold the property. The major benefit to investing real estate is that you can earn fixed rate return often exceeding the return rate of bonds while at the same time protecting yourself from inflation.

Risks
The risk with real estate investing is that the value of real estate could fall or there could be some event that would happen that would cause you to invest money into the property to keep it functional such as the foundation cracking or a roof leaking. Also owning real estate may require some of your personal time that could be spent doing other things. By using leverage, you can increase your returns however if you can’t afford to make your mortgage payments, then you would lose all your equity if the bank were to foreclose on the property.

There is an option to own a REIT (Real Estate Investment Trust) which by law pays out 90% of it’s earnings to investors in the form of dividends. A REIT is as easy to buy as a stock though as with stocks, the value can move up and down with investor demand.

Investment Type Business

Rather you are stating your own business or investing in someone else’s business, this type of investment has its own risks and rewards. The different ways to invest in a business may include starting your own business, buying a piece of some else’s business or owning a fund that specializes in investing in new businesses such as venture capital funds. When starting your own business, there likely needs to be both time and money invested up front before you are ready to sell a product or service to customers.

Risks
You may lose 100% of the money invested if you can’t make a profit above what your fixed labor, marketing and operating costs are. When owning a piece of someone else’s business, you may not see a return on your investment unless there is either an agreement to provide dividends or if the company goes public.

The major benefit of owning a business is that the returns can be almost unlimited. There are many cases of a $10,000 investment turning into over 1 million dollars in less than 10yr time. A business is also a hedge against inflation.

Summary

As we see, there are a large variety of investment types to choose from that has its risks and rewards. The greater the return, the greater the risk. You need to decide what your long-term goals are in order to which investment type you want.