Investments 101: Types of Investments

  • An introduction to various investment instruments and how to invest in these instruments
  • Stocks: it’s all about earnings and earnings growth, but there are other “external” factors
  • Mutual funds: a pooling of stocks
  • Exchange Traded Funds (ETFs)
  • Types of Accounts
    • brokerage account
    • retirement accounts
      • 401(k) Plan
      • Roth IRA
      • Traditional IRA
  • What we recommend: contribute to your 401(k) plan first, then open a brokerage account for after-tax investments, then augment retirement savings with either Roth IRA or Traditional IRA account

This article is an introduction to investments. We will cover equities such as stocks, mutual funds, and exchange traded funds (ETFs). Then we will discuss the types of account where you can buy and sell these types of equities to include a brokerage account, and various retirement accounts such as the 401(k) Plan, the Roth IRA (Individual Retirement Account), and the Traditional IRA.

As the title implies, this article is only the first of a series on Investments. Other articles that may be of interest to you include:

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Stocks is one of the fundamental elements of capitalism. You buy shares of a company’s stock in the hopes of increased shareholder value over time in the form of price appreciation and/or dividend payouts.

So What Drives the Price of a Stock Higher?

Ah, isn’t that a million dollar question? There are lots of factors. The same factors can work against the stock price and drive it down. Here are a few:

Supply and Demand. Sounds obvious, right? As with most things, supply and demand drives the price. When there is more supply (shares of stock being sold) than demand (shares of stock being bought), the price goes down. Conversely, when there is more demand than supply, the price tends to go up.

MTN, a bull thesis proved right
MTN, a bull thesis proved right

So what drives supply and demand? There is supply from shareholders wanting to sell to lock in their profits, “profit taking” as it is called. Shareholders could also be selling because they are disappointed with the company’s earnings, reacting to some bad news, and/or exiting their positions due to devaluation of shareholder value. There is demand from buyers when they want to buy the stock when there are great earnings reports, promise of increased revenues, of increased profit margins, or of increased profit. Sometime these actions are based on facts, other times they are based on rumors. Whether the motivation is true or false, it’s all about the collective market perception of the company and the desirability of its stock.

Company Financial Performance. As companies perform well financially, the market will reward it with a fair price. It’s about earnings. A common measure is Price-to-Earnings ratio. Also called “P/E ratio” or “PE ratio” for short, it is the ratio of the stock price to its earnings per share. Let’s say a stock is currently trading for $16.00/share. And its earnings over the past four rolling quarters is $1.00/share. Then its current P/E ratio is $16.00 / $1.00 = 16:1 = 16.

Promise of Future Revenues and/or Profit. Investors usually pay a premium for the credible potential of future revenues and/or profit. It’s also about revenue and/or earnings growth. Depending on the risks of achieving such growth, investors will pay a premium six months, a year, some times even several years before the promise of such revenue or profit performance can be realized. This is called “discounting the future”. For a growth stock that is currently growing its earnings by significant percentage per year, the Price-To-Earnings to Growth ratio (or PEG ratio) is usually a metric of interest. For example, let’s suppose a company is growing at a 50% per year clip, and it has a P/E ratio of 75 (its stock price 75x higher than its earnings per share), then its PEG is 75/50 = 1.5. This is premium that investors are willing to pay for the stock.

But there are other “external” factors that drive the supply and demand of a stock. By external we mean factors that the company do not directly control. Factors such as the economy and the prevailing interest rate, and market forces such as the buying and selling of stock by mutual fund companies and large investment organizations.

Economic Cycles and Interest Rates. The economy historically has gone up and down in cycles. In response to these cycles, the Federal Reserve sets the short-term interest rates that banks charge for overnight loans in order to throttle the economic growth. This interest rate impacts the cost of borrowing for businesses. When interest rates go up, businesses have to pay more for capital investments and operational costs, reducing their ability to generate a profit in the end. Having said that, the Federal Reserve raises interest rates in order to slow down economic growth, to prevent the economy for overheating and to avoid out-of-control inflation. When the economy slows too much, the Federal Reserve can lower interest rates, making it easier for businesses to invest and grow. So where we are in the economic cycle and the Federal Reserve’s stance on tightening or loosening interest rates can indirectly impact the ability for companies to generate earnings and earnings growth.

Large Investors. When mutual fund companies and large investment organizations, with their billions and billions of dollars in stock holdings, buy and sell stocks, they can influence the stock price because they’re selling millions and millions shares of stock, sometimes in a short period of time. When mutual funds rotate out of technology stocks to financial stocks, as in a “market sector rotation”. The former stocks take a beating in their share prices due to increased supply, while the latter stocks benefit from price appreciation due to increased demand.

Where can you find the best stocks?

This topic will be covered in depth in our Investment 102: Finding the Right Stock Investment article. Follow us on facebook to be notified when this article is posted. For now, here are some sources for ideas in stock investments:

  • “Invest in what you know”, says Peter Lynch, one of the greatest mutual fund managers ever. Do you use Facebook or Instagram? Own an Apple iPhone? Use Netflix streaming service? Use Google search engine? Why not look into their stocks (FB, AAPL, NFLX, and GOOG/GOOGL) as potential investments?
  • Jim Cramer’s CNBC show “Mad Money” is a great source of private investor education, investment ideas, and advice
  • Seeking Alpha: is a good source of market news, stock blogs from bulls and bears. Do read these bulls/bear theses with guarded skepticism and a boatload of salt.
  • Motley Fool: similar to Seeking Alpha
  • Fortune magazine: for ideas.
Mutual Funds

Think of Mutual Funds as an office PowerBall lottery pool, but for stocks. In an office Lotto pool, you contribute your money into a pool from which Lotto tickets will be bought. At Pragnotion Enterprises, Inc. we do not condone in office Lotto pool, but thought it to be an example most can identify with. If you chip in $10 into the pool, and the total pot comes out to $200, then you’re entitled to 5% of any winnings. If they buy some Match 5 tickets and it wins $1000. Then you get $50 of the winnings. If they also bought some PowerBall Lotto tickets and it wins the $20M jackpot, then you get a cool $1M, before taxes. Don’t forget the tax man.

Similarly, mutual funds works the same way. You contribute to the pool.  Mutual Funds are run by companies such as Vanguard, INVESCO, Vanguard. They mutual fund manager researches companies, picks the potentially winning ones, allocates a portion of the total portfolio for the stock. This is very much like the way the office lottery pool manager allocates from the various lottery products.

Actively Managed Funds. Are managed by portfolio managers based on their investment objectives. An aggressive growth fund would invest in stocks such as Facebook, Amazon, Netflix, Alphabet (Google). They will make portfolio allocation and buy/sell decisions. In return for their services, companies would charge a fee, unlike the office Lotto pool manager who does it for just the love.

Mutual Fund companies do it for a living, and their fees are called:

  • Load: refers to the commission charged by mutual fund companies for buying or selling mutual fund shares. Front-end load (or purchase fee) is the commission upon the purchase, usually to pay for the broker’s or intermediary expenses, and advertising. A back-end load (or redemption fee) is the commission charged upon the redemption/sell of the mutual fund shares. These load are specified in terms of a percent of the dollar value of the buy or sell, ranging typically from 0.25% to as much as 6%. Mutual funds that don’t have such loads are called “no-load” mutual funds.
  • Management fees: All mutual funds charge a management fee, called the 12b-1 fee, each year to manage the assets of the funds. Some charge more than others depending on how actively they manage the funds, their operating expenses, and the profit they give themselves. These fees are implicitly charged by reducing the net asset value (NAV) of the mutual fund, that is the price of each mutual fund share.
Types of Mutual Funds

Index funds: are designed to mirror certain stock market indices, such as S&P 500 index. These are not actively managed, per se, as they are comprised of the same stocks that make up the index that they “mirror”. When new money flows into the fund, the companies’ computer programs buy proportions of stock shares based on the index, be it the S&P 500, NASDAQ, Dow Jones. Because of this, the fees are low compared to actively managed funds.

Large Capitalization Growth funds: buy shares of stock of large companies that are still growing like Amazon (AMZN), Google (GOOGL), Apple (AAPL), Facebook (FB), and Netflix (NFLX). What companies they buy and how much of each company’s stock they buy are at the discretion of the fund manager and her team. These are actively managed funds. Their annual management fees tend to be much higher than those of Index Funds.

Small Capitalization funds: buy shares of stock in small companies. These are actively managed funds, as the management team scour the market for worthwhile, promising small companies.

International Growth funds: invest in foreign companies with promise of growth. The management team actively seeks out opportunities worldwide for growth. In the case of Vanguard International Growth Fund Admiral Shares (ticket symbol: VWILX) fund, it invests in Chinese companies like Tencent Holdings Ltd (TCEHY), Alibaba (BABA), Baidu Inc (BIDU), and NetEase (NTES) and even U.S. companies such as Amazon (AMZN).

Example: Vanguard VWILX International fund
Example: Vanguard International Growth Fund Admiral Shares (ticket symbol: VWILX) disclosure showing its top ten stocks holdings as highlighted in red (from
Where can you find the best mutual funds?
Exchange Traded Funds (ETFs)

Exchange Traded Funds (ETFs) are very much like mutual funds. The difference is that they are bought and sold on exchanges instead of going through the mutual fund company or affiliated brokerages to buy them. They trade like stocks and their prices fluctuate during the trading day, whereas mutual funds only have the closing price at the end of each trading day.

Where can you find the best ETFs?

You can find ratings for ETFs much like you can find rankings for the best mutual funds:

Types of Accounts

Most investors have one or more of the following types of accounts.

Brokerage Account

A brokerage account allows you to buy stocks, mutual funds, ETFs, bonds, certificate of deposits (CDs) using your after-tax dollars. You can hold the account as an individual or as a joint owner (if you’re married). Just like a checking account or savings account, a brokerage account is essential to your managing your savings and investments, and achieving your financial goals.

So what should you consider in selecting a brokerage account?

Go with a discount broker vs. full-service broker. Unless you’re rich, go with a discount broker and do-it-yourself (DIY) investing rather than to pay exorbitant commissions and fees for “professional” brokers and investment advisers to give you investment advice and hand hold you through every step of the process. These fees will quickly consume your limited investment dollars, instead of putting them to work for you. Discount brokers will buy and sell stocks, mutual funds, ETFs, bonds, CDs for you quickly and efficiently.

Wealth of Investment Information. All discount brokerage firms like Schwab, TD Ameritrade, Fidelity, E*Trade provide ample amounts of free information to their account holders, not to mention the tremendous amount of financial and investment information freely available on the internet.

Investment Choices and “Products”. All discount brokers offer the full range of investment choices and products. Some will pass along savings and not add additional fees when you buy mutual funds and ETFs, aside from their standard commission fee.

Trade Execution. I have bought and sold stocks using Schwab, TD Ameritrade, Fidelity, and E*Trade. I have not ever notice any differences in trade execution speed, accuracy, or price. Go with the reputable brokers as listed here and you can’t go wrong.

Fees. All discount brokers offer very competitive fees. For example, many charge $6.95 per stock trade commission. Schwab charges even lower, at only $4.95.

Account Minimum Balance. Some do not have minimums, others require a minimum balance of $1000 to $2500. You can have cash and/or a combination of investments to meet the minimum balance. It just has to be held by the brokerage firm.

Hand Holding. When you’re new, some extra hand holding is always good, as you submit your first buy and sell orders. Schwab goes the extra distance by providing useful “Order Messages” specific to your stock buy or sell order, so you know what to expect ahead of time. See the two sample screen shots below.

Example 1: Sample buy stock scree
Example 1: Buy order screen showing useful prompts, as highlighted inside red box (from
Example 2: Sample sell order screen
Example 2: Sell order screen showing useful prompts, as highlighted inside red box (from

What Brokerage Do We Recommend?

We recommend the Schwab One brokerage account for the beginning investor, in case that wasn’t obvious already. As a discount broker, Schwab offers stock trades for only $4.95 and offers some extra hand holding through your first buy and sell orders. Open a Schwab One brokerage account together with a Schwab Bank checking account. Get a $100 bonus for opening a both accounts by funding the brokerage account with at least $1000.

For advanced investors, we recommend TD Ameritrade due to the extra service, a great smartphone/mobile app, and advanced, powerful investment tools such as Trade Architect and Think or Swim.

TDAmeritrade's mobile apps and platform
TDAmeritrade’s mobile apps and platform (photo credit: TDAmeritrade)
401(k) Account

The 401(k) account is usually offered by employers for employees to save for retirement with their pre-tax income. Employees can choose to contribute up to a certain percentage of their pre-tax annual income into this account.

Employer Matching. Many employers provide some level of matching of the employee’s contribution to the 401(k). For example, suppose your employer matches dollar-for-dollar the first 5% of your annual salary, and let’s say your annual salary is $50,000. Then if you elect to contribute 5% of your annual salary, or $2,500, then your company would also contribute $2,500 to your account. That effectively doubles your investment! For this reason, we strongly advise that you contribute at least the amount necessary to realize your employer’s contribution. It’s taking advantage of “free money”. Well, it is actually part of your total compensation package, but sometimes you have to know to help yourself.

Vesting of Employer’s Contribution. The above sounds good, but there is one big caveat: your employer may require that their contribution vests over a number of years. Let’s say the employer contribution vests over a three-year period. So after one year, 1/3 of the employer’s $2500 contribution or $833.33 vests. Vesting means it belongs to you legally, even if you quit your job. But you would forfeit the other portion that is still not vested. If you stay after the second year, the second $833.33 portion vests, for a total of $1666.66. After three years, the full $2500 amount is vested. Some employer allows vesting to be 100% immediately after your third year of employment. So everything is 100% starting with your fourth year of employment. Other employers might do a rolling three-year vesting plan. Either way, it’s your employer’s way of rewarding you for your years of loyalty and service. The rolling vesting serves as “glue”, helping them keep you long-term.

Plan Administration. These plans are administered by investment companies such as Vanguard, Fidelity, and Transamerica. Your employer chose the investment company on behalf of all employees. When you start with your employer and opt in to 401(k) plan, your employer directs the plan administrator company to create an account just for you. You are the owner of the account. With your statement information (such as account number), you can then register to get online access to your account. Your employer maintains a link to your account to fund it with your pre-tax contributions that they withhold from each paycheck based on the contribution level that you select. You choose the  contribution level as a percentage (for example 16%) of your annual salary upon the start of your employment, and annually during Benefits Open Enrollment each year. Some plan administrators, depending on the plan established with your employer, allow you to change your contribution level at any time during the year, through their web site. Based on your contribution level, your employer would also incrementally contribute the vested portion of their contribution to your account. The total of these amounts are available for investments.

Investment Options. Employees can choose to invest from a number of mutual funds that the administering company offers. There are usually a handful of mutual funds similar to those we described above for Mutual Funds. Additionally, there are target retirement year funds where the asset allocation (mix of stocks to bond) is automatically adjusted based on your investment horizon or target retirement year. As you get closer to your retirement, the fund will automatically rotate a portion of your money out of stock-based investments in favor of fixed-income bond investments. The latter is considered a more conservative investment, with lower yields but also lower risk in order to protect your principal. When you are close to retirement, you don’t want to risk losing your principal in an unexpected stock market correction.

Vanguard target retirement funds
Example: Vanguard target retirement year funds (from

Opt In Your 401(k) Plan Today. The most important action with regards to the 401(k) Plan is to opt-in and specify your contribution, as a minimum, a level that takes full advantage of your employer’s matching. Start early and let the power of compounding of the years work for you.

Roth IRA

The Roth IRA (Individual Retirement Account) is a self-directed retirement account. You open the account on your own, unlike the 401(k) Plan which is sponsored by your employer. You make all investment decisions on your own, unless you use a full-service broker (as we discussed above). The Roth IRA is a retirement account funded with your after-tax dollars. That means you already paid income tax on these dollars. You can contribute up to $5,500 a year to your Roth IRA account. If you’re 50 years old or older, you may contribute another $1000 as “catch up” contributions for a total of $6,500/year.

Some caveats on the contribution amount: If you are single, you can contribute as long as your Modified Adjusted Gross Income (MAGI) is less than $118,000 (for 2017). The amount of your contribution is reduced if your MAGI is between $118,000 and $133,000. Above $133,000, you cannot contribute to your Roth IRA. For married coupled, you can each contribute the full amount to your individual accounts as long as your MAGI is less than $186,000. If your MAGI is between $186,000 and $196,000, the amount of your contributions are reduced. Above $196,000, you. Fortunately, most of us do not have these contribution limitations.

These contribution amounts must be from your earned income (i.e., your job). Gains grow tax-free. Starting at age 59 1/2,  you can start withdrawing the funds tax free! If you expect your tax bracket to be higher in retirement, the Roth IRA account is advantageous because you are contributing when your tax bracket is lower.

You can open a Roth IRA account with any discount broker like Schwab, TD Ameritrade, Fidelity and E*Trade. Roth IRA accounts are individually owned (that’s the “I” in “IRA”). There is no such thing as a joint account, even for married couples. Each spouse opens their own individual Roth IRA account. Each can contribute up to $5,500 per year. In fact, this is true for all retirement account types.

Traditional IRA

Before the Roth IRA, there was the Traditional IRA, where you contributed your pre-tax dollars. But instead of taking it out of your gross paycheck like the 401(k) Plan, you contribute your money each year using your after-tax dollars. When you file your income tax return for that year, you can take a deduction for the same amount as your contribution, which basically removes the income tax that you would have paid for that contribution.

Just like the Roth IRA, the Traditional IRA is a self-directed retirement account. You can contribute up to $5,500 a year to your Traditional IRA account. If you’re 50 years old or older, you may contribute another $1000 as “catch up” contributions for a total of $6,500/year. These contribution amounts must be from your earned income (i.e., your job).

Proceeds in the account would grow tax-free. When you reach age 59 1/2, you can start withdrawing the funds, and they are taxed as regular income the year funds are withdrawn. If you expect your tax bracket to be lower in retirement, the Traditional IRA account is advantageous because you are contributing with your pre-tax dollars when your tax bracket is higher.

Like the Roth IRA, you can open a Roth IRA account with any discount broker like Schwab, TD Ameritrade, Fidelity and E*Trade. There is no such thing as a joint account, even for married couples. Each spouse opens their own individual Traditional IRA account. Each can contribute up to $5,500 per year.

Additional information on Traditional and Roth IRAs:

What We Recommend

Before you invest, make sure to have your financial house in order. Here’s what we recommend, in this order:

  1. Create a monthly budget, and live by it. It will take some discipline.
  2. Pay off your debts: credit card debts, student loans, in the order of highest interest rates first.
  3. Put aside some savings for a “rainy day”, also known as your emergency fund. Where? We recommend the Discover Bank Online Savings account, as it pays generous interest/APR (1.15% APR as of October 2017).

Once you have your financial house in order, we recommend that you consider the following approach to investing, in this order:

  1. Contribute to your 401(k) plan, as much as you can for your retirement assuming you are employed. At the minimum, contribute the percentage of salary that will get all of your employer’s matching dollars. For example, if your employer matches your contributions for the first 5% of your annual salary, then contribute at least that 5%. It is very important to maximize your retirement contribution, and to let it grow through the power compounding over decades of your working life. If you’re young and have at least a decade before retirement, consider investing in the stock/equity-based mutual funds, like the S&P 500 Index fund. Or go with you retirement year fund. That is, if you are retiring in 2055, then choose the Retirement Year 2055 fund.
  2. Open a brokerage account, like our recommended Schwab One brokerage account, to invest your after-tax dollars. If you’re stock savvy, try a portion of your brokerage dollars on buying individual stocks. Otherwise, invest in mutual funds. The S&P 500 Index fund is a good place to start. You’ll be getting good returns, while minimizing mutual fund loads and
  3. Open either a Roth IRA or a Traditional IRA to save even more for your retirement. Consider your present tax bracket vs. that at retirement when trying to figure which IRA type to open.

The fact that you’re reading this article is a good sign that you’re taking your long-term financial well-being seriously. Go the distance by formulating a plan, tending to the plan and follow through, and you will maximize your returns by leveraging the power of compounding. Leverage time, and leverage your investment dollars to work for you, so that eventually, you can have the financial freedom to do whatever you want. We wish you the best in achieving your financial goals.

Other Investment Articles of Interest

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