Investing

This is the other big section. I can't possible cover all the types of investments there are, or the details of them. And know this. While most financial advisors feel great if they beat the S&P or Dow–Jones Industrial average for the year, the big players in investing often won't look at investments that don't have the possibility of making at least 20–50% return/year. And when your advisor calls (if you're lucky) when stock prices drop, the great majority will blame the market, not themselves.

Diversity: Advisors recommend diversity, but this doesn't mean just a variety of stocks or mutual funds, which, by their nature, were originally designed to be diverse. Most advisors think of diversity only in terms of stock sectors, possibly extending into REITs (Real Estate Investment Trust). But the original paper on diversity, which won the Nobel Prize for Economics, spoke of diversity in terms of having a portion of your money in commodity traded accounts (they did the numbers and found that ~20% created the maximum advantage with the least risk involved). Most advisors recoil in horror if I mention commodity traded accounts. "Way too risky" they all claim. "Just throwing money away." However, historically, when stock prices are going down (and they are right now), commodities tend to do well, though one really has to do their homework and find good managers. It is true – commodities are more risky. Why? Leverage. Remember the 1929 stock crash? It wasn't just the prices falling. It was the margin calls. Back then, you could put 10% down and pay the rest when the price went up and you sold. Oops. They changed the rules and now, margin is generally, as best, 50%, and most brokerages don't allow that until you have done a bunch of trades with them and have a strong positive track record. Commodities are highly leveraged. You can command a huge amount for a relatively little amount of money – usually 5–25% of the real cost. So you can lose up to 4–20 times the amount that you put in. Ouch. Real estate is another way to diversify. Since most of us don't want to go out and buy actual property, REIT's were created. It isn't the most effective way to make money in Real Estate, but it is a way to diversify without getting your hands dirty!

Risk: Risk is an interesting concept. And people have very interesting preconceived notions about it. For most advisors and people, risk means that you are willing to trade an increase in possible profitability for a lower percentage loss. Traders and other major investors think that keeping money safe (in CD's or savings or money market accounts) that gets less than or equal to inflation is guaranteed risk. It's like the story in the bible. The three sons get some money. The first buries it, the second puts it in the equivalent of a savings account, and the third invests. Who gets the rest? The third son. Why? He was willing to risk to get something back. Now it is true that you can lose while leaning to invest (I've made a boatload of mistakes and paid for them.). But you make nothing while doing nothing or doing the "safe" thing. If you only keep up with inflation, the money you are socking away will only be worth what it is now – a one for one. So even if you put half your salary away every year, you would only have a half of your salary to live on if you live the number of years you worked (work 40 years, retire at age 60 and live to 100). Since the numbers stay the same and inflation marches on, you, are, effectively, screwed. Risk is an interesting concept and the rich and middle class generally have different concepts about it.

This is a brief overview of types of investments, in order of increased risk and reward (the two generally go hand in hand):

Annuities: Sold by insurance companies mainly, annuities are investments where you put money in, a manager invests it, and you get a set amount back later. You get some known rate of return, anywhere from typical money market rates to rates following the S&P capped out at about 12%/year and if the S&P is less than 0% that year, some know rate around 2–5%. You get to take money out at some point in the future. Very low risk unless the company goes under.

Savings and Money Markets: You put the money in a bank, they use it for loans and other investments, and they pay you some rate of return less than what they make. When the market it good, you might get 3–8%, when the market is bad, it can be as low at 0.5%. It is almost always less than the rate of inflation.

Bonds: Your money is used for the government or municipalities or companies to use as they see fit and you will get money back at some set rate of return. Safe ones pay a low percent back, ones that are more likely to default pay a higher rate of interest. Supposedly good when the market is bad, but they actually follow the S&P returns with a high degree of correlation, as opposed to commodities, which tend to go in the opposite direction. Rates of return are from 3–10%, depending on the "risk." Governmental bonds are guaranteed, municipal bonds are slightly more risky, and low–rated company bonds are even more risky, also known as "junk" bonds, which were traded so heavily in the 80's and had such a downfall after Drexel Burnham's bankruptcy created in part by Michael Milken, who's name is so tightly associated with them. Rarely does the bond market surpass inflation, which makes a portfolio heavily weighted towards bonds less "risky" by its nature, but more risky by the fact that one is never quite getting ahead.

Stocks, Mutual Funds and Index Funds: Companies borrow money from people and give them a share of the company in return. The people that buy that share of stock can sell their shares to others, called the secondary market. That's generally where regular investors come in. Stocks make money for you in two ways. If you buy a stock at a low price and can sell it for a higher price, you make the difference. Often companies also pay a "dividend," some amount of money, from pennies to dollars per share, either quarterly or yearly, based on their profit for that time period. Companies that are in a high growth period, when they are just starting out, typically don't pay a dividend, whereas older, stronger companies do. It was a big deal when Microsoft began paying dividends, for example, rather than pour all it's profit back into the company. The rate of return depends on the type of stock and on the vagaries of the stock market and general economics. Young, new companies may make you a very high rate of return, or nothing, or you could lose some or all of your money if you don't sell fast enough when the stock is going down, or you can't get rid of it. Older, more stable companies rates of return tend to be less, sometimes simply because their stock price is so high (it's a lot easier to get a 50% return on a $1.00 stock than on a $100 stock), but they make up for some of this in dividends. Also, companies that have been around for a long time are less likely to go out of business, so losses tend to be less from the company side. Sometimes, the market moves in the down direction, and everything goes with it. Big stocks will go down then too. When the economy is tanking, most everything goes with it.

Mutual funds work much the same way as stocks in terms of making money from prices going up or down. Mutual funds are groups of stocks that a manager is buying and selling for you. They started back in the 1930's because regular people could not buy shares of stock. They were too out of range for the average investor. So companies bought groups of stock, broke them up into affordable shares of a fund, and sold shares of the fund. You own the mutual fund, not pieces of the individual companies as you do with stock. If you ever want to take advantage of using your stock ownership, that issue becomes important. The mutual fund's price is based on the fund's stocks prices and how they go up and down. You make money if the stocks the fund owns goes up and lose if they go down. There are every conceivable groupings of funds now – sector funds, funds for metals, oil companies, every foreign market, as well as ones that are diversified for every type of lifestyle and life stage. You can easily have 4–7 mutual funds and be completely diversified in stocks (though not completely diversified). The advantages are the diversification; the lesser likelihood of losing money because you have a wider base; someone else is managing your portfolio and hopefully, the manager is a good one; and ease of tracking. Disadvantages are the manager gets a fee, sometimes a hefty one; one can only buy and sell at the end of the day (important during stock crashes); and you don't get dividends (they are supposed to get folded into the fund price). There are now more mutual funds than the underlying stocks, and figuring out for yourself which are good ones can be daunting. Rarely do more than 20% of funds beat the market as a whole.

Index funds are funds that follow some index as nearly identically as possible. Though new, there are now many index funds that follow many indexes and it is possible to be fully diversified in stocks using 4–7 index funds. They follow the underlying stock prices completely and you own bits of the actual stock, not the fund as with mutual funds. So you get the dividends when they are paid. You also get the benefits of owning the stock (going to meetings associated with vacations and taking part off your taxes, for instance). Also, management fees are minimal because a computer is the only manager, re–balancing the stock ratios at regular intervals. A disadvantage is that you can never have a better rate of return than the index the fund is based on. Understand that 85% of managers do not do better than the S&P for longer than three years. The market has given an average of around 12% (depending on what dates you start and end with) yearly for the past 100+ years if you stay in the market for over 20 years. Less than that and you are subject to economic conditions of the time. There are a few managers (Warren Buffet comes to mind) and traders who have consistently beaten the market and have their ways to pick companies. The rest of us can generally count on 12%.

Real Estate: REIT's can produce returns that approximate stocks and Mutual Funds. They are real estate investment trusts, where a group of people are investing in a group of real estate deals and profiting from them. They are sold just like stocks are. One can also get into real estate directly, buying and selling houses, apartments, or commercial properties, buying and holding rental properties, lend money to developers (hard money lending), fix properties for re–sale, and any number of other deals. Real estate can produce returns up to 60%/year depending on the deals, in large part because of the leveraging involved. If you can put 5–20% down and make 5%/year, you can double your money in two years. While "0% down" isn't as easy as it used to be, and real estate is taking a hit right now, there is still money to be made here. And, you can lose your shirt if the deal you make is a bad one. Real estate can be very risky if you don't know what you are doing, and very dirty if you chose to do the work yourself.

Futures: The commodities markets started ages ago, in the east with rice and in the west with salt and ice. Producers of the commodity wanted to make sure that they would be guaranteed a fair price for their product, and end buyers wanted to make sure they paid a fair price. Originally, farmers and producers struck deals person to person with buyers and that was that. But then they centralized things, here in America, in Chicago for grains and animals for example, and the farmers and end buyers would meet at a known place (now the Chicago Board of Trade) to state their respective bids and offers. Middlemen came into play and would meet in "pits" for their respective products and make offers or bids. Like stocks, other people (speculators) would buy and sell these contracts because they thought they would go up or down. Futures are interesting because one can make money in either direction, and the speculators tend to be either bullish or bearish, to use stock terminology, and will buy or sell contracts based on their distinct way of thinking. The subject of commodities is too complex to explain in one short paragraph. Suffice to say, one can make a boatload of money on futures and in a hurry, because of the leverage involved. One can pay a couple of hundred dollars and control thousands of dollars worth of grain or pork bellies or orange juice. And make or lose hundreds for every tenth of a cent up or down. In futures, you can make a great deal, and lose it all in one deal. It is not for the feint of heart. Nor should one put money into futures that one cannot afford to lose. But when you have a portfolio of several hundred thousand dollars, putting 20% in a commodity traded account, or learning to do it yourself can greatly increase your rate of return on your money. The Nobel Prize paper on diversity showed that 20% in commodities would nearly double your rate of return.