The five building blocks of the stock market

- One of the hardest things about investing is getting started. And one of the things that stops people getting started is understanding what all the words mean. In this video I'm going to cover the five basic building blocks of investing. I'll start with simple, low risk products and move up the scale to more complex, higher risk products. So let's start with something simple, cash. Cash is the easiest thing to understand, because we use it every day. You can invest in cash equivalents, also known as money market accounts or certificates of deposits, also known as CDs, or T-bills. These pay slightly higher interest rates than your trusty savings account, but you can't move money in and out of them easily like a bank account. For something that has better returns, but more risk, let's look at bonds. Most people are probably familiar with savings bonds. Bonds are also called fixed income instruments. They're essentially a loan you make to a third party for which you get paid interest. There's a vast range of bonds available. They range from essentially risk-free bonds issued by governments, all the way to super risky junk bonds issued by companies. The rule of thumb with bonds is that the higher the risk on the bond, the higher the interest rate you'll be paid. One of the nicest things about bonds is that they're all rated by bond rating services, so you can very easily look up how risky that bond is. The fees on bonds are also generally super low, usually a transaction fee to buy and sell them. The next investment category you can put your money into is stocks. Also known as equities or shares, a stock is literally ownership of a piece of a company. So if you own a common stock of Apple you are an owner of Apple. And as an owner you're eligible to share in the company's profits through dividend payments. You also have shareholder voting rights. And because stocks are traded in public markets, the value of the stock changes. So if you invest in a good company and the value of the stock goes up, you'll be able to sell your shares for more money than you bought them for, giving you a gain on your investment. The cost of holding stocks is just the cost of buying and selling them, usually just a few dollars. Finally, it's important to know that historically US stocks have averaged a real 5% annual rate of return in the 20th century. The next investment category are funds. There are funds that you buy and sell just like a stock on an exchange called ETFs. These are exchange-traded funds. Some are built to match a specific index, like the S&P 500, for example. In fact, for every share of an ETF there exists a basket of stocks of that targeted index. The beauty of an ETF is that they can reflect a specific index. So if you want to match the overall return of the market an ETF's perfect. You won't beat the market, but you certainly won't underperform either. And they are, for the most part, low cost. You have to pay a fee to buy and sell ETFs, just like stocks, but on top of that, you have to pay a fee as a percentage of what you own. For large funds, this can be low, sometimes less than a 10th of a percent, but for smaller, more exotic funds fees can hit 2% or more. But overall ETFs can be a powerfully low cost, low effort way of getting into investing. Mutual funds have traditionally been a very popular way to invest. They operate differently than stocks and ETFs. They're not treated on an exchange, so you have to go directly to mutual fund companies to buy and sell them. The big point of difference to ETFs is that mutual funds are usually actively managed, so they have experts who buy and sell holdings to take advantages of changes in real time. But one of the big problems with mutual funds is they charge a lot of fees, because there's people managing these funds who need to be paid. After their fees have been taken out of your investment it can be quite difficult for you to beat the market. You may also have to pay a sales fee or load. The final area I need to mention is the world of alternative investments. These are annuities, whole life insurance products, private placements, and hedge funds. For people getting started I recommend they stay away from these investments. Most of them have heavy fees or are offered by non-fiduciary standard providers. And many of these products are not liquid, meaning they're difficult to sell. They're difficult investments to understand and manage and often do not provide enough return to cover the cost. For people getting started with investing on their own I recommend getting familiar with stocks, bonds, and ETFs as step one. And for investors working with an advisor, I'd recommend steering away from complicated products, as they usually come with complicated fees, and to make sure your advisor is very clear how much the different investments are costing you.