Stocks represent ownership in a company. As a result, their value is mainly derived from how well the company is doing today or how successful people believe it will be in the future.
Stocks are considered one of the riskier asset classes — their value can rise and fall quite suddenly and, if a company goes bust, it’s highly likely that shareholders will lose all of their money.
But, as they’re riskier, the returns that investors can expect are also typically higher, which compensates investors for that extra risk.
Exchange-traded funds (ETFs) are investments that give investors exposure to the returns of a diversified portfolio of underlying assets.
The most popular ETFs use a portfolio of stocks as the underlying assets to generate the returns of a major stock market index, like the S&P 500 or the FTSE 100.
ETFs have risen in popularity in recent years because of their low costs and liquidity — shares are traded on public stock exchanges allowing investors to buy and sell their stake whenever an exchange is open.
While ETFs mirroring major indices have produced fairly stellar returns over the last decade, it’s important to remember that they mirror the returns of an index whether those are positive or negative. As with any product traded on a stock exchange their value can rise and fall.
Guide: Guide to investing in ETFs
Exchange-traded commodities (ETCs) are very similar to ETFs. The difference is that ETCs invest in commodities, like gold, silver or oil.
Some ETCs will hold the underlying asset. This is more common for precious metals like gold.
Others, including oil ETFs, are more likely to hold derivatives contracts that give exposure to the underlying asset.
The benefit of ETCs is that they let you invest in commodities without having to buy the physical underlying asset, something that can be tricky, expensive or impractical to do.
As an example of this, just imagine buying a barrel of oil. Unless you happen to own an oil tanker and have some pipelines attached to your house, the chances are that this is going to be deeply impractical for you to do. Buying an ETC makes things much easier.
One thing to bear in mind if you do buy an ETC is that they can be volatile and higher risk than index-tracking ETFs.
Guide: Investing in commodities
For something less risky, that returns a more modest but steady stream of income, look towards bonds or bond funds.
If a company or a government wants to borrow money, they issue bonds to investors who purchase these and expect to be paid at regular intervals , based on the cost that the company/government agreed to pay when borrowing the money.
Whereas corporate bonds tend to carry less risk than equity investments, government or sovereign bonds are typically (though not always!) even less risky than corporate bonds.
These risks reflect the likelihood that the entity that’s borrowed the money ends up in a position where they are unable to repay the principal and interest owed.
In most cases, investors in bonds are able to take a borrower to court if the borrower fails to pay, which provides an added layer of security.
A popular type of asset that you’ll find in the UK are investment trusts.
These are a form of investment fund that issues a fixed number of shares at its launch.
The shares are traded on stock exchanges, however, they do not always reflect the underlying value of the fund’s portfolio.
If the shares are trading below the value of the portfolio (or its Net Asset Value, NAV for short) the trust is said to be trading at a discount. If shares are trading above the value of its NAV, they are trading at a premium.
If you buy shares in an investment trust, you can benefit from the expertise of the trust’s fund manager and you are likely to be getting exposure to a diverse range of assets.
This can also be a negative as you don’t have control over what the fund is buying.
Moreover, investment trusts will sometimes borrow money to invest in the expectation that it will provide higher returns. This is known as ‘gearing’ and it can lead to higher losses if the investment fails to pay off.
One of the cool things about stock exchanges today is that they allow you to access a range of assets — you aren’t just limited to buying shares in individual companies.
This is good because it gives you more choice and the opportunity to build a diverse portfolio.
When you own a range of assets — stocks in companies, bond ETFs, investment trusts — you are said to be “diversified”.
This means the risks you are taking are not all on the success or failure of a single company, but they are spread across a number of different assets that will ideally rise and fall in value in ways that are unrelated to each other.
Different assets carry with them different levels of risk. So understanding these different assets is useful because you can match your risk appetite to the level of risk that they carry with them.
Guide: Investment trusts explained