Choosing investments can be overwhelming for new investors. When you ask yourself, "What should I invest in?" you need to be asking yourself what role each investment has in your portfolio.
It is important to find a good balance of diversification and simplicity so your plan doesn't become too complex and overwhelming. You can read more about the importance of using low-cost index funds and exchange-traded funds (ETFs) when building a portfolio in our free investment course, which includes a page on building a portfolio.
In this post, I want to provide a guide as to why you might include certain types of investments in your portfolio. This list is not exhaustive, but it (hopefully) will help you feel like you have a grasp of the basics.
Before we get started, an important disclaimer: This post is not investment advice as I do not know your personal goals or finances, and I am not a financial advisor. It is an educational post about different types of investments. Consult with a financial professional to see if these investments or strategies might be a good fit for your personal situation.
Total Stock Market Funds
Generally, when people have a total stock market fund, they are trying to keep their equity investments simple but diverse. These funds tend to be weighted more towards US large-cap companies, with over 70% of the fund being in large-cap companies. However, the funds tend to provide slightly more exposure to mid and small-cap companies than an S&P 500 fund. Very little maintenance is required for a portfolio consisting of this fund alone or this fund paired with a total bond fund.
It is worth noting that a total stock market fund may or may not have exposure to the total international stock market. Some may only have exposure to US companies, while others may include international markets.
Cap Weighted Funds
Investors may opt to instead invest in separate cap-weighted funds to have more control of their exposure to different-sized companies than if they only invested in a total stock market fund.
Large Cap/S&P 500
Large-cap funds or S&P 500 funds are made up of large, stable companies with market capitalizations of $10 billion or more. They are reliable and may provide some dividends and some growth. Generally, large-cap companies can weather bad economies due to their large financial reserves.
Mid Cap
Mid-cap funds tend to provide a balance of growth and stability. They include companies with market capitalizations of $2 billion to $10 billion. They are less volatile than small-cap funds but have more growth opportunities than large-cap funds.
Small Cap
Small-cap funds are much less stable, but provide more opportunities for growth than large and mid-cap funds. They include companies with market capitalizations of $250 million to $2 billion.
International
The United States makes up less than 30% of the world market. While it is an important part of the world economy, there are opportunities to diversify by investing in markets outside of your home economy. Some additional risks may be associated with international markets such as currency conversion and political unrest. Some people argue that the world has become so globalized that you do not need to invest directly in international funds to gain exposure to an international market.
Emerging Markets
Emerging markets are a subset of international investments that focus on markets that are experiencing growth and expansion and may not have the same level of stability as more established markets. There is more volatility and risk with the opportunity for more growth.
Real Estate
Real estate investments can offer another way to diversify your investments and provide potential dividend income. Some people may opt to invest directly in real estate through rental properties, but there is also the option to invest in real estate investment trusts (REITs) within your portfolio.
REITs allow you to own income-producing real estate, often across residential, office, retail, and storage facilities. They must return 90% of their income to the shareholders in the form of dividends, so this is often an investment best held in a tax-advantaged account.
Investment Strategies
Sometimes you will see funds that are "tilted" towards a certain investing strategy for equity investments. You will sometimes see these tilts combined with cap-weight: small-cap value, large-cap blend, or mid-cap growth, for example.
Dividend Investments
These investments tend to provide a steady, reliable dividend that may be reinvested (if you choose) or provide regular income. The downside is that they are often not investing profits in company growth and innovation, so capital appreciation (the increased price of the fund) may be limited. Furthermore, dividends are not guaranteed, so it is important to find a fund containing companies with a long history of steady or increasing dividends. Dividend-focused investments are often avoided in taxable accounts as they create a taxable event, even if reinvested.
Growth Investments
Growth investing focuses on investing in companies that show good growth potential. These companies are often reinvesting their profits into the company's growth, so they are rarely paying dividends. The focus of growth investments is on capital appreciation. Growth stocks often perform well in low-interest and low-inflation environments.
Value Investments
Value investing focuses on buying and holding undervalued stocks compared to their intrinsic value. This strategy is championed by Warren Buffett, an extremely successful investor. Value investing tends to do well in high-interest and high-inflation environments. Value investing focuses on the current value of the company rather than expected growth.
Blend Investments
Blend funds have a mix of growth and value stocks. Since both strategies perform better in different economic cycles, this is a way to diversify and appreciate the benefits of both investing styles. This is not to be confused with a "balanced" fund which is a mix of stocks and bonds.
Investment Style Box
There is a quick way to analyze a fund using a box designed by Morningstar (an investment research company). This box is present on most fund summaries and can help you quickly determine the composition and investment style of a fund. Note that this is a very basic, but useful, analysis tool.
The box consists of nine squares. The vertical axis indicates cap weight and is labeled small, mid, and large. The horizontal axis indicates investment style and is labeled value, blend, and growth. One of the boxes is generally filled in or marked, indicating which style and cap weight is predominant in the fund. Some versions of the box have a specific point indicating the primary style in one box with a shaded area around it indicating where most of the additional holdings in the fund fall.
You can use this box to make sure you don't have too much overlap between funds. If all of your index funds and ETFs are centered around the same box, then you are likely not as diversified as you think. This lack of diversification opens you up to more risk in the event of a market crash. On the other hand, you don't need to have every single box represented in your portfolio. The style box is just a quick reference when you are considering a fund and analyzing your portfolio.
Bonds
Bonds often make up the fixed-income portion of a portfolio and are often added as investors near retirement. They differ from stocks in that you are not buying a portion of the company when you own the bond. A bond is a loan to a company or government in exchange for interest and the return of the original loan amount after a specified period of time.
In addition to the interest generated by the bond, you can consider the price or value of the bond. If you hold an individual bond until maturity, you will not lose money. However, if you decide to sell the bond before maturity, you may see fluctuation in the bond value.
The value of a bond changes based on fluctuating interest rates. When interest rates fall, the value of a bond rises because it is now offering a better interest rate than new bonds. When interest rates rise, the value of the bond decreases because the bond is providing a lower interest rate than new bonds.
You can buy individual bonds, but many people prefer to invest in bonds using a bond mutual fund or ETF. Bonds are more complicated than stocks, but there are a few features of bonds that can help you understand the different types of bonds that may be included in a fund.
Bond Maturity
The time until maturity can impact the value and interest rate.
Long-Term Bonds
Long-term bonds have a maturity date of 10 years or more. Funds made up of long-term bonds tend to be more volatile in value because they are more sensitive to interest rate changes. The longer commitment and risk mean that these bonds usually offer higher interest rates than short-term bonds.
Intermediate-Term Bonds
Intermediate-term bonds have a maturity date between 5 and 10 years. Funds made up of intermediate-term bonds tend to have a balance between volatility, risk, and interest rates.
Short-Term Bonds
Short-term bonds have a maturity date of less than 5 years. Funds made up of short-term bonds tend to be more stable in value because they are less likely to be affected by a significant change in interest rates. The lower commitment/risk means these bonds usually offer lower interest rates.
Credit Rating
The credit rating of a company or government can impact the interest rate that is being offered. The higher the risk of defaulting by the company, the lower the credit rating.
There are several different credit rating systems. Generally, the highest rating includes the letter A, followed by B, C, and D, and something with three letters is better than a single letter. So an AAA rating is better than an A which is better than a BB. You will often see credit ratings divided into two broad categories.
Junk (High-Yield) Bonds
High yield may sound like a good thing, but in the bond world, it is a code word for risky. These higher yields come with a trade-off: a higher risk of defaulting and a lower credit rating, which may make them more volatile. They are highly correlated with the stock market.
Investment Grade Bonds
These bonds have a higher rating credit rating and lower volatility. Because there is less risk, the interest rates tend to be lower.
Bond Types
The entity that is offering the bonds can also impact the value of the bond.
Corporate Bonds
Corporate bonds are bonds issued by companies. They tend to be subject to the same influences as the stock market, so you may see a high correlation with the stock market. Credit rating is essential to consider with corporate bonds.
Treasury Securities
These bonds are issued by the United States government and are generally considered one of the safest investments because there is very little risk of the US government defaulting on the loan. Treasuries tend to move in opposition to the stock market, with less volatility than the stock market.
Municipal Bonds
Municipal bonds are issued by states, counties, or cities. These are beneficial to some investors because they often include tax benefits. Credit rating is important because there have been defaults on bonds by some cities in the past.
Mortgage-Backed Securities
These are bonds that have groups of mortgages as collateral. This type of bond can be issued by government agencies or private institutions. These investments tend to offer variable monthly income.
Bond Funds
A bond fund will allow you to diversify your exposure to different types of bonds. Similar to equities, you can simplify by buying a total bond market fund or your can target your bond choices by choosing a more specific bonds fund such as long-term treasuries or short-term investment grade corporate bonds. Bond fund prices will fluctuate as the prices of the underlying bonds fluctuate due to interest rate changes.
Bond funds are often used as a less volatile fixed-income investment that is not always correlated with stock fluctuations, with a small steady amount of income. The idea is that when the stock market crashes, bonds will not experience the same level of volatility. This allows you to avoid selling stocks during a crash by selling bonds instead. Bonds may also provide an opportunity to rebalance and purchase stocks at a discount while stock prices are low.
What Should I Invest In?
With so many options, building a portfolio can be overwhelming. If you are new to investing, you will need to first choose a brokerage and decide what investment account is best for your goal. Then you will need to invest the money in your account by purchasing an index fund or ETF.
Helpful Tip: The linked post about brokerages above includes a table of index funds and ETFs at each brokerage. Some brokerages charge a separate transaction fee for buying a competitor's mutual fund, so investors often choose a fund offered by their brokerage. ETFs are not usually subject to the same fees.
If simplicity is your goal, consider a target date fund or total stock market fund for your initial investment. If you think you might add small or mid-cap funds later, consider starting with a large-cap or S&P 500 fund instead.
Don't stress too much about which fund is the best. There is so much overlap between total stock market, large-cap, and S&P 500 funds that you likely won't notice a difference in the performance. The important thing is to avoid analysis paralysis and start investing as soon as possible to take advantage of compounding growth.
*Reminder: I am not a financial advisor - talk to a financial professional before making any decisions.*
Once you are comfortable with the process of buying investments, you can consider adding additional investments. Take some time to determine what percentage you want each fund to comprise of your overall portfolio. This will be important when you manage your portfolio and rebalance annually. The asset allocation you choose should take your risk tolerance and timeline into account so you don't panic sell during a market decline.
Buy-and-hold index investing emphasizes diversification to reduce overall risk to your portfolio while still maximizing returns. You can read more about Modern Portfolio Theory to find out how to analyze your investments and see if they approach the Efficient Frontier.
Bestie, you can do this. Choose diversified investments and keep your fees low. Just start investing. Your future self will thank you. You've got this!
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