Employee Education: Class 203 – “Investment Categorization”

Summary:

Here we will discuss in more specific detail the broad investment categories prevalent in 401(k)s.

Agenda:

  1. Introduction
  2. Investment Categories
    1. Cash
    2. Bonds
    3. Stocks
    4. Alternative Investments
  3. Application
  4. Recap

 

1. Introduction

To help you as an investor, we have taken a top-down approach in our education process. We began with the end in mind by discussing the goal of retirement in Class 201 – “The Private Pension”, went deeper to discuss investment strategies to help actualize your goal in Class 202 – “401(k) Investing Strategies”, and now we will discuss investments at a broad level to break them into categories by their risk and potential reward characteristics. The purpose of this is to help you understand how these categories of investments work with the strategies we discussed previously so that you can build your own investment lineup.

2. Investment Categories

Mentioned in Class 202 – “401(k) Investing Strategies” were four broad categories of investments. Here, we are going to discuss those further to help build an understanding of the significance, risks, and potential rewards of each:

A. Cash

Cash investments, or cash equivalents, are very short-term debt instruments that typically have a maturity of less than six months. They generally offer lower returns than other types of investments. Cash investments include U.S. Treasury bills, certificates of deposit (CDs), and money market accounts. There are also different kinds of bank accounts and investment companies that invest in cash securities. In 401(k)s, the de facto cash investment will usually be a Money Market fund.

Due to the low risk (and low return) nature of cash investments, they are appropriate when preservation of principal is an important concern. They are often used to balance higher-risk stock and bond investments in a portfolio, as well as for short-term investment goals.

As such, cash investing is utilized in asset allocations to provide a stable slice of pie. Due to its low potential returns, cash investing is not for young investors who have many years yet to realize their goal of retirement, but when you are nearing your goal, you will be confident in knowing a portion of your investment portfolio is tucked away in cash investments.

For practical application when reviewing investment options, note that cash investments are usually referred to as Cash or Money Market investments.

B. Bonds

“Loan” is probably the word that best describes a bond because a bond is basically an I.O.U. The borrower, or bond issuer, promises to make regular interest payments to the lender, or investor. That promise of steady income, in the form of interest payments, is why bond investments are often called fixed-income investments.

Bonds are often the choice of people seeking a steady stream of income, such as retirees. Since some bonds may be less risky than stocks, investors may also use them to help protect their principal.

Like any investment, bonds do entail certain risks — for example, there’s no guarantee that the borrower will be able to meet its interest payments or repay your principal when the bond matures.

Inflation is another risk affecting bond investments. If the rate of inflation rises higher than the bond’s interest payments, the bond investor could experience a negative net return.

Overall, bond investing is utilized in almost all asset allocations. Only the most risky asset allocations would forego a slice of bond investing. While not as stable an investment as cash, bond investing is remarkably stable and income oriented. As such, it is an increasingly important component of asset allocation as you get nearer to your goal of retirement.

For practical application when reviewing investment options, note that bond investments are usually referred to as Bonds or Fixed Income investments. It is important to note bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

C. Stocks

Stock investing represents ownership in a company. If you owned half of all the stock issued by a company, you would be a 50% owner of that company. If a company does well, or is expected to do well, other investors may be willing to pay more for its stock than you did. Of course, if the company experiences hard times, you may not be able to recover your initial investment when you want to sell the stock. Stocks can also be subject to wide variations in value, since most trade on highly liquid markets, and are subject to different market forces.

As a result, stocks have high potential returns (that is, you could sell stock investments for more than you paid) and high potential risk (you could lose money when you decide to sell). This is often called the risk/return tradeoff — a phrase that you may have already heard and one you will want to keep in mind whenever you consider specific investments.

Despite the risks, it’s worth remembering that stock investments have historically produced greater returns than bond and cash investments over the long run. Of course, past performance is no guarantee of future results.

As such, stock investing is utilized in all asset allocations. The potential return of stock investing is a significant source of growth and hedge against inflation for an asset allocation. Stocks provide the horsepower to help get you to your goal. That said, stocks also have significant risks with them, and they aren’t always a source of joy.

For practical application when reviewing investment options, note that stock investments are referred to as Stock or Equity investments.

D. Alternative Investments

Whereas stock investing represents ownership in a company, alternative investing often represents ownership of raw, physical goods. Gold, livestock, oil, soybeans, and real estate are representatives of alternative investments. The category of alternative investments is a very broad category, so further research is often necessary to better understand what underlies any specific investment within it. Typically, alternative investments have commodities or real estate at their core, though some focus on specific investment strategies or monetary currencies.

Alternative investments tend to behave differently from both stocks and bonds in their returns. Often, they are seen as a hedge against inflation. As compared to bonds, alternative investments will tend to have higher potential risks and rewards. Compared to stocks, alternative investments have similar potential risks and rewards, but fluctuate for different reasons at different times. As such, all asset allocations should use alternative investments. The potential return of alternative investing is a significant source of growth and hedge against inflation for an asset allocation. Alternative investments will help provide growth to help get you to your goal, but bear in mind alternative investments, like stocks, also come with significant risks.

For practical application when reviewing investment options, examples of Alternative Investments include Commodities, Real Estate, and investments labeled as Alternative Investments or Multialternatives.[a]

3. Application

Now that you have this information and the overarching strategies from Class 202 – “401(k) Investing Strategies”, you can get started in selecting your own investments! Start from the top with an appropriate asset allocation for your age, then select diversified investments within each broad investment category using your plan’s investment menu, and finally, use the strategies discussed previously to keep things on track. If you need a sounding board or advice, contact your plan adviser for assistance! If you are looking for even more detailed information, carry on to the “Advanced” classes.

Remember though, if you feel like this is more effort than you are comfortable committing to, head back to the ideas discussed in Class 102 – “Investments”, and ask your 401(k) plan’s adviser about the “Do It For Me” options in your plan. Always remember though, no matter how much effort you put into the investment aspect of your retirement goal, if you aren’t contributing enough to the 401(k), you aren’t going to be successful in addessing your goal.

4. Recap

There are several different investments in the world of 401(k). Here then are the broadest categories in which investments tend to lie:

A. Cash – very short-term debt instruments that typically have a maturity of less than six months. Cash has very low risk and very low potential return.
B. Bonds – a bond is basically an I.O.U with the promise of steady income. Accordingly, bonds have low potential risk and low potential return.
C. Stocks – stock investing represents ownership in a company. As such, stocks have high potential risk and high potential return.
D. Alternative Investments – alternative investing often represents ownership of raw, physical goods. Gold, livestock, oil, soybeans, and real estate are representatives of alternative investments. As such, alternative investments have high potential risk and high potential return.

Understanding these categories and the strategies discussed in Class 202 – “401(k) Investing Strategies” will allow you to begin building an investment lineup for your own personal goal of retirement!

Disclosures:

[a] Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.

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