Overview of Investment Options
This is fairly brief and focused - may want to integrate it into a more extensive treatment on investment.
Following are a list of some of the options for investment. As a note, so some items are included (bank accounts, annuities, etc.) that would not be categorized as "investments" by the industry- but from the perspective of the customer, they are options for managing their funds.
Deposit accounts (savings accounts) with a bank provide a low level of return, virtually no risk (provided the account is insured by FSDIC), and high liquidity. See the research on "banking" for additional details.
Due to the low level of return, deposit accounts are not generally considered to be an "investment," merely a place to warehouse money where the trickle of interest it receives is generally just enough to keep up with inflation.
CERTIFICATES OF DEPOSIT
CDs are another banking product that offer a slightly higher level of return and the same low level of risk (again, providing it is FSDIC insured), but somewhat less liquidity (the buyer must lock in their funds for a period of time, generally not less than three months, and pays significant penalties for early withdrawal). See the research on "banking" for additional details.
CDs are considered "investments," but are generally short-term investments user to earn a small amount of profit on funds that are not needed immediately, but which may be needed in the near future. The focus tends to be on staying ahead of inflation rather than achieving growth.
The U.S. Department of the Treasury offers a number of securities that offer low-risk, low-return investment opportunities that, like CDs, are more geared toward keeping pace with inflation (to prevent money from losing value) than achieving growth.
- Savings Bonds - Issued in small denominations (some under $100), bonds come in two basic forms: one that is purchased at a discount and redeemed at face value at a future date, and another that is purchased at face value and pays interest when redeemed.
- Treasury Bills - Issued in $1,000 denominations for short periods of time (as little as four weeks), bills are purchased at a discount of their face value and redeemed at a future date.
- Treasure Notes - Issued in $1,000 increments, these investments have maturity dates of two to ten years and pay interest twice a year.
- Treasure Bonds - Issued in $1,000 increments, these bonds have maturity rates of 10 to 30 years and pay interest twice a year.
Most treasury securities are generally purchased by institutions rather than (most) individuals, though it is possible for an individual to obtain them, either through an intermediately (a bank) or directly from the treasury department.
From what I've read, it's hard to see why treasury securities would be appealing to the individual investor. CDs pay a higher interest rate than long-term treasury instruments and savings accounts pay a higher rate than the short-term ones, and both are equally secure (insured by the FSDLIC).
MONEY MARKET ACCOUNT
Investment companies offer money market accounts that seem to be similar to checking or savings accounts offered by banks (depending on check-writing privileges). These accounts generally pay higher interest than bank accounts, but they are not insured by the FSDIC.
Technically speaking, a money market account is actually a mutual fund that invests in sort-term, low-risk investments (T-bills) and who attempt to fix their share price at one dollar, so earnings are in the form of additional shares rather than an increase in the value of each share (a one-share/one-dollar ratio makes redemption efficient).
These accounts vary greatly in their exact features and policies - some work almost exactly like a checking account (no limits on balances or frequency of deposits and withdrawals), others have minimum balance requirements and restricted withdrawal privileges.
Mutual funds are a way for investors to pool their money into a professionally-managed portfolio of securities. Generally, there is a minimum initial investment, and the returns of various mutual funds can vary depending on the type of securities they invest in, from low-risk/low-return to high-risk/high-return.
Mutual funds are the most common form of investment for most individuals, even those with moderate resources (most retirement plans are invested in them). Additional details are provided elsewhere.
An annuity is a contract arrangement with a company (typically a life insurance firm) the provides the purchaser with a stream of payments in exchange for a lump-sum investment (or a stream of payments into the annuity to fund it).
Bonds are loans to government and corporate entities that pay regular interest payments for a period of time, then mature and return their face value to investors. The face value, interest rate, and payment frequency vary widely.
Due to the high cost of bonds (typically, a single bond costs $10,000), and the limited liquidity, investors are generally steered toward mutual funds that invest in a pool of bonds.
Stocks are individual ownership shares in corporations that are sold through a number of different exchanges. Investors who purchase stock earn long-term profits through capital appreciation (the price of a stock rises as the company becomes more valuable) and short-term income through dividends (though some companies pay no dividends at all).
Due to the high degree of fluctuation in stock prices and the expertise needed to evaluate the finances of a corporation and predict its future performance, most investors are dissuaded from getting involved in stocks, and are steered instead toward mutual funds.
An investor can purchase shares of stock outright, or they can purchase on the margin (borrowing money to buy more shares than they can afford). The loan is secured, at least partially, by the portion of the security the person owns outright, and if the security falls below a certain price (value), the investor must either cough up some dough or liquidate his holdings to pay the loan. Trading on margins is highly speculative, and highly inadvisable.
Options are highly speculative investments, in which an investor buys the right to purchase a specific security at a specific price (that may be higher or lower than its current value) until a specific date (at which point, the option expires and becomes worthless).
The legitimate use of options is to hedge against fluctuations in an investment - obtaining guarantees that a stock can be bought or sold at a certain price in the future can help offset unexpected changes in price that would be detrimental to the value of a portfolio.
Speculators will dabble in the options market, attracted by the opportunity to make a large profit at a very low price (for a little bit of money, you can get an option to buy a large amount of stock). This is speculation rather than investment.
Futures are contracts to purchase a specific commodity good (oil, orange sugar, pork bellies) at a specific price. It is also possible (and more common) to purchase an option on futures contracts, which works similar to a stock option (exercisable at the buyer's discretion, until it expires)
The legitimate use of futures markets is by corporations that need certain goods for their own manufacturing operations and wish to lock in a purchase price or purchase options to hedge against future market fluctuations.
Speculators often dabble in futures markets on the belief that they can make a profit on the future fluctuations in prices. This is speculation rather than investment.
The FOREX (foreign exchange) market buys and sells currencies from various countries. The legitimate use of foreign currency exchange is for businesses to be able to obtain foreign currency today to pay future obligations, thereby insulating themselves against the risk of exchange-rate fluctuations.
Speculators often dabble in foreign currency on the belief that they can make a profit on the future fluctuations in currency values. This is speculation rather than investment.