This article is designed to equip you with very basic knowledge. Before we jump in, please allow me to give you a few do's and do not's to live by when pursuing your financial education:
- Do not beat yourself up for not already knowing this stuff. We were all without this knowledge at one time.
- Do not allow anyone (including yourself) to tell you that you are "not good with money."
- Do keep in mind that investing isn't rocket science - these are concepts you can absolutely learn and understand.
In this article, I'll outline the most common types of assets someone might own as an investment. Those include individual stocks, individual bonds, mutual funds, and exchange traded funds. I'll also outline the different types of accounts where a person might hold these investments.
Assets You Might Own
The dictionary definition of an asset is "a useful or valuable thing." For our purposes, think of an asset as a thing that has value and has the potential to increase in value over time. In my world, those things are typically stocks, bonds, cash, real estate, mutual funds, and exchange traded funds (ETFs).
Stocks
A share of stock can be thought of as a teeny tiny slice of a company. When you own a share of stock, you own part of the company. I'll pick on Proctor & Gamble (PG) to draw an example. Proctor & Gamble has 2.6 billion shares of stock outstanding - that's 2.6 billion slices of PG available to be bought and sold by investors. Shares of stock are bought and sold (traded) on stock exchanges.
Just like you go to the grocery store to buy a gallon of milk, you go to a stock exchange to buy shares of stock.
When you buy a gallon of milk, you know what you'll pay because the store has put a price tag on it. Stocks work a bit differently because the price of a share of stock isn't static. That price will typically move up or down all day while the stock exchange is open. When you buy a share of stock, you can do so "at the market," meaning you will pay the price per share being asked by a willing seller.[1]
Stocks are risky. So risky, in fact, that it is possible to lose your entire investment. But they are also so risky that investors who own them for long periods of time can earn an average annual return of 8%. The potential for a stock to go to zero is one reason that it's best to own a wide variety of different stocks - to keep your eggs in a variety of baskets.
Bonds
Bonds are the most common counterpart to stocks in an investment portfolio. A stock represents ownership, while a bond represents a loan. When a company (or government) needs money for a purchase or project, they may borrow it. When a company (or government) borrows money, they do so by issuing bonds. When you buy a bond, you are buying a debt obligation. In exchange for borrowing money using a bond issue, the company will pay interest to the owner of the bond - just like when you finance a home or car.
Just as with your home or car note, there is a term over which the debt is to be paid. The term may be short (one to five years), long (10 to 30 years), or somewhere in between. While the loan is outstanding, the owner of the bond receives interest payments. When the loan matures (the term ends), the owner of the bond receives the original loan amount back. Just like shares of stock, bonds can be bought and sold among investors. Similar to stocks, bonds may rise and fall in price over time.[2]
Bonds are less risky than stocks. While it's not impossible, it's unlikely a bond investor will lose his or her investment. However, this lower level of risk comes with a tradeoff. A bond investor can expect to earn an average annual return of 4.6% over a long period of time.
Cash
Yes, technically cash is an investment asset. While it is considered a risk-free asset, the long-term return potential is quite low. Most investment portfolios keep a nominal amount of cash on hand (about 2% of the total portfolio at any given time).
Real Estate
Some investors like to include real estate in their investment portfolio. An investor can do this by buying residential real estate (rental homes or rental condos), purchasing commercial real estate (office buildings or warehouses), or utilizing a Real Estate Investment Trust (REIT).
While real estate can serve to diversify a portfolio, it is not always included in every investor's asset mix.
Mutual Funds
Mutual funds are an indirect way to own stocks, bonds, and other assets. When you own shares of a mutual fund, you own a slice of a portfolio. A mutual fund is actively managed - meaning that a manager or team of managers works to meet a specific objective by buying, holding, and selling specific investments.
For example, the management team of a stock mutual fund that seeks capital appreciation will buy stocks that they believe will appreciate in value over time. Meanwhile, the management team of a stock mutual fund that seeks to provide current income and an opportunity for capital appreciation will buy stocks that they believe will appreciate in value over time and which also pay a dividend.
Because they are actively managed, mutual funds have internal expenses that can range from as low as 0.5% to as high as 3%. Mutual fund shares are purchased directly from the mutual fund company and sold back to (redeemed by) that same mutual fund company when you no longer wish to own any shares you've purchased.
Mutual funds can be a good way to diversify smaller amounts of money.
They can also be a good way for individual investors to access an expert portfolio manager. The value of the mutual funds that an investor owns is driven by the value of the investments that the fund owns.
Exchange Traded Funds
Exchange Traded Funds (ETFs), are also an indirect way to own stocks, bonds, and other assets. As with mutual funds, when you own shares of an ETF, you own a slice of a portfolio. The assets that make up an ETF will depend on which index it mirrors. ETFs can track stock indexes, bond indexes, a precious metal index, and so forth.
Most ETFs are passively managed, meaning that a manager works to mirror the performance of an index. For example, an ETF might seek to mirror the S&P 500. The management team only wants to get the same performance as the S&P 500 and thus spends less time, money, and effort picking investments. They simply buy the components of the index.
Because they are passively managed, ETFs typically have lower internal expenses that can range from 0.1% to 1%. ETFs are traded on an exchange, similar to the way stocks are bought and sold. Once an ETF share is created, that share is traded amongst investors on the open market. The value of the ETF shares that an investor owns is driven by the value of the investments that underpin the fund.
Accounts Where You Might Hold Your Assets
So far we've talked about the basic types of investments. But those investments need to live somewhere. While there are more than three places to own an investment, these are the most common.
Investing Account
This is nothing more than an account that an investor would open at a brokerage firm like Baird, E*Trade, Fidelity, or any number of other providers. To get started, an investor need only open the account, put cash in it, and then use that cash to purchase the investments they wish to own.
The big things to know about these accounts in the context of divorce are that they are generally liquid (meaning you can access the investments and turn them into cash reasonably easily), and they often come with some tax consequences attached. If you sell an investment for more than it cost to purchase, you will realize a capital gain, which will then be taxable.
401(k)
This is the most common type of employer retirement plan, and it's likely a part of your case. Most 401(k) accounts allow you to own a limited set of mutual funds. The available funds will vary by plan. To learn what you can own in a 401(k) you've been awarded, you'll need to visit the plan's website.
In the context of a divorce, the important thing to know is that these types of accounts are tax advantaged and have some strings attached. As long as the assets in the 401(k) remain in the account, they are not subject to taxation. Once you withdraw money (make a distribution), that money then becomes taxable as Ordinary Income.[3] If you withdraw money before you attain age 59 ½, you'll also be subject to an additional 10% penalty.
IRA
An IRA is a cousin to the 401(k). It is a retirement account that is held at a brokerage firm (like Baird, E*Trade, Fidelity, etc.) and is not associated with an employer. Like an investing account, you are generally free to buy most any stock, bond, mutual fund, ETF, or REIT that you wish.[4]
While assets remain in the IRA, they are non-taxable. As with a 401(k), once you withdraw money (make a distribution), that money then becomes taxable as Ordinary Income.[5] If you withdraw money before you attain age 59 ½, you'll also be subject to an additional 10% penalty.
Continuing Your Education
I do not expect you to read this article and suddenly become an investing enthusiast. I also do not expect you to run out and buy books on investing or take classes on portfolio management. (If you are interested in further reading, you can find my Recommended Reading List here.) Most people have other things they would rather do with their limited time.
As an individual investor, one of the best things you can to educate yourself is hire a Financial Advisor who is willing and able to teach you what you need to know about investing. The best among us do our jobs with the heart of a teacher, and we enjoy educating clients and helping them cultivate a solid understanding of their investments.
Investors should consider the investment objectives, risks, charges and expenses of any mutual fund or ETF carefully before investing. This and other information about the fund can be found in the prospectus or summary prospectus. A prospectus or summary prospectus may be obtained from your financial advisor or the fund website and should be read carefully before investing.
All investments carry some level of risk, including loss of principal. An investment cannot be made directly in an index.
Struggling to figure out your investments post-divorce?
Call me at 713-973-3814 or email me at scuddy@rwbaird.com to find out how I can help.
[1] How does a seller of stock know at what price he or she needs to sell the stock (or on the other side, buy)? In general, stock prices are driven by what investors believe the company will earn. A stock price will rise if investors believe the company will earn more in the future, and it will fall if investors believe a company will earn less in the future. Note that this is a highly simplified explanation; there are many other factors that drive stock prices, but this is generally how it works.
[2] Unlike stocks, bond values are largely driven by the creditworthiness of the issuer and the rate of interest the bond pays.
[3] If you have a Roth 401(k) (uncommon), distributions made after you attain age 59 ½ are non-taxable.
[4] In some cases, some investments may not be available at some firms if they do not meet basic standards. For example, some firms will not allow investors to own "penny stocks" in their account.
[5] If you have a Roth IRA, distributions made after you attain age 59 ½ are non-taxable.