How to Own Investments
To become a better investor, you must understand the basics of investments. If you are a beginner investor, it may be confusing on how to get started with investing. There are three primary decisions to make when investing:
- What investments should you own?
- How should you go about buying them?
- What accounts should the investment be held?
This article covers the first two questions, and a later article will cover the third.
What is an Investment
An investment is an asset whose purpose is to generate income or appreciation. Income could be in the form of dividends, interest, rent payments received, or business distributions. Appreciation is the increase in the value of the asset as realized by being able to sell it to a willing buyer.
Here are the five main categories of investments:
Cash
According to our definition, cash at the bank is an investment because cash earns interest even if that interest is not very much. When is cash no longer an investment per our definition? When it no longer earns interest (ie - physical cash).
Equity (Own)
Equity is another word for ownership in a business venture. The business venture could be as simple as your own business that you run to owning shares (stock) in a large, multinational corporation like Microsoft or Apple.
Investment returns for equity can be through dividends, appreciation (capital gains), or distributions (income).
Debt (Loan)
Debt refers to the money that you loan to others. If you own a loan to someone else, they have a contractual obligation to pay you interest on the loan amount over a set period of time (7 days, 1 year, 10 years, 30 years, etc) with a defined interest rate (1%, 5%, 24.75%) and at a certain payment frequency (daily, monthly, quarterly, balloon). At the end of the period, they are also contractually obligated to pay you back the original amount you loaned them.
The primary source of investment return for debt is through interest but there are times when you may receive appreciation as well.
Derivatives
Derivatives are investments whose value is based on the value of something else. For example, a stock option for Apple stock is not ownership of Apple itself but the value of the stock option is based on the value of Apple stock. Common Derivatives are stock options, futures contracts, collateralized debt obligations, swaps, warrants, and more.
Derivatives are complex investments, and the investment return can be dependent on any number of events happening.
Physical Assets
Physical Assets encompass a wide variety of investments. The most common examples are real estate and commodities like gold and silver. With some physical assets like gold and silver, the primary return for investors is from price appreciation. With others like real estate, the return can range from primarily appreciation as is house flipping or value-add properties or from income as in a rental.
What is not an investment?
People often confuse investments for accounts. Think of an account like a bucket in which you put investments in. You can put an investment in multiple different buckets. The underlying investment is the same across all of the buckets. What is different are the rules that apply to the results of the investment. Examples of accounts are Brokerage Accounts, 401k’s, Traditional IRA’s, or Roth IRA’s.
Life insurance and annuities are a little more complex. On one hand, the base features of life insurance, death benefit and tax-deferred growth on cash value, and the base features of annuities, tax-deferred growth on investments and income guarantees, are not themselves investments. They are built into IRS code and are a contractual agreement with the insurance company. On the other hand, underlying elements of life insurance and annuities can be investments such as sub-account investments, guaranteed returns like MYGA’s, or buffered strategies which are based on derivatives.
How to Purchase Investments
Direct Ownership
The first way to own an investment is through direct ownership. That is, you are listed as the owner on that particular investment. For example, you can purchase 1 share of Apple stock and you can also be the owner of a real estate property.
With direct ownership, the risk and reward of the investment lies in the success of that investment. Direct ownership can be a very cost effective way to own an investment as you do not pay an investment manager.
For investments like stocks, bonds, CDs, and derivatives, the most common option today to purchase these investments is through investment custodians such as Charles Schwab, Fidelity, or Vanguard to facilitate the buying process. This route offers the advantage of owning multiple investments in a single place, streamlining their management.
Stocks can also be purchased directly at a place called the Transfer Agent. The transfer agent is a company that keeps track of who owns the stock or bonds of other companies. Examples of Transfer Agents are Computershare and American Stock Transfer & Trust. A disadvantage to this approach is that the different stocks you might own will be separate by Transfer Agent and not consolidated.
Pooled Vehicles
Pooled vehicles were developed as a way to achieve greater diversification and allow for smaller investors to gain access to more investments. For example, not many people can afford to purchase 1 share of Berkshire Hathaway A Share (BRK.A) valued at $528,460 per share as of July 21, 2023. But if 1,000 people pooled together a much more manageable $528.46 each, they could purchase the share of BRK.A and then each own 0.1% of the stock.
In reality, pooled vehicles aren’t generally designed for one position. Instead, they are designed to own many investments within the vehicle. For example, a mutual fund could own hundreds or thousands of stocks (equity).
The most common pooled vehicles are mutual funds, exchange traded funds (ETF’s), unit investment trusts, pension funds, Real Estate Investment Trusts (REIT), sub-accounts, and hedge funds. This article does not cover the differences between these vehicles.
Pooled investment vehicles can be actively managed, meaning an investment manager or team decides what investments to buy, or passively managed, meaning the fund follows an index to determine investment selection. Pooled investment vehicles have investment fees ranging anywhere from 0% to 3%+ depending on the fund management and focus.
Check out my article on the differences between mutual funds and ETFs: Mutual Funds vs. ETFs: A Comprehensive Comparison – Gilbert Wealth