Securities are one of the most important assets to understand when you’re starting to invest. Almost every investment you can make involves securities, so knowing about the different types of securities and how they fit in your portfolio can help you design a portfolio that fits with your investing goals.
What Is a Security?
A security is a financial instrument investors can easily buy and sell. The precise definition varies with where you live, but in the United States, it refers to any kind of tradable financial asset.
Securities may be represented by a physical item, such as a certificate. Securities can also be purely electronic, with no physical representation of their ownership. The owner of a security, whether it is physical or digital, receives certain rights based on that ownership.
For example, the owner of a bond is entitled to receive interest payments from the issuer of that bond.
Types of Securities
There are many different types of securities, each with unique characteristics and a different role to play in your portfolio.
A stock is a security that represents ownership of a company.
When a business wants to raise money — for example, to invest in expanding the business — it can issue stock to investors. Investors give the business money and receive an ownership interest in the company in exchange.
The number of shares that exist in a company determine how much ownership each individual share confers. For example, someone who owns one share in a company with 100 shares outstanding owns 1% of the company. If that business instead had 100,000 shares outstanding, a single share would represent ownership of just 0.001% of the business.
Investors can easily buy and sell shares in publicly traded companies through the stock market. Shares regularly change in value, letting investors buy them and sell them for either a loss or a profit. Owning stock also entitles the shareholder to a share of the company’s earnings in the form of dividends if the company chooses to pay them, and the right to vote in certain decisions the company must make.
A bond is a type of debt security that represents an investor’s loan to a company, organization, or government.
When a business or other group wants to raise money but doesn’t want to give away ownership, it can instead borrow money. Individuals typically borrow money from a bank, but companies and larger organizations often borrow money by issuing bonds.
When an organization needs to borrow money, it chooses an interest rate and the amount that it wants to borrow. It then offers to sell bonds to investors until it sells enough bonds to get the amount of money it wishes to borrow.
For example, a company may decide to issue $10 million worth of bonds at an interest rate of 5%. It will sell bonds in varying amounts, usually with a minimum purchase requirement, until it raises $10 million. Then, the company stops selling the bonds.
With most bonds, the issuing organization will make regular interest payments to the person who owns the bond. The payments are based on the interest rate and the value of the bond purchased. For a $1,000 bond at an interest rate of 5%, the issuer might make two annual payments of $25.
The bonds also come with a maturity date. Once the maturity date arrives, the bond issuer returns the money it raised to the bondholders and stops making interest payments. For example, when it matures, the holder of the $1,000 bond might receive a final interest payment of $25 plus the $1,000 they initially paid to buy the bond.
Interest payments and returned principal go to the person who holds a bond on the payment date, not necessarily the original purchaser. This means that people who own bonds can sell them to other investors who want to receive interest payments. The value of a bond will depend on how much time is left until it matures, the bond’s interest rate, the current interest rate market, and the bond’s principal value.
Money Market Securities
Money market securities are incredibly short-term debt securities. These types of securities are similar to bonds, but their maturities are generally measured in weeks instead of years.
Because of their short maturities and their safety, investors often see money market securities and investments in money market funds as equivalent to cash.
Mutual Funds and ETFs
Mutual funds and exchange-traded funds (ETFs) are both securities that purchase and hold other securities. They make it easier for investors to diversify their portfolios and offer hands-off management for investors.
For example, a mutual fund may purchase shares in many different companies. Investors can purchase shares in that mutual fund, which gives them an ownership stake in the different shares that the fund holds. By buying shares in one security — the mutual fund — the investor gets exposure to many securities at once.
The primary difference between mutual funds and ETFs is how investors buy and sell them. With mutual funds, investors place orders that settle at the end of the trading day. That makes mutual funds best for long-term, passive investment. ETFs are traded on the open market, so investors can buy them from or sell them to other investors whenever the market is open. This means ETFs can be used as part of an active trading strategy.
There are many different types of mutual funds and ETFs, each with its own investing strategy. Some mutual funds aim to track a specific index of stocks. Others actively trade securities to try to beat the market. Some funds hold a mix of stocks and bonds.
Mutual funds and ETFs are not free to invest in. Most charge fees, called expense ratios, that investors pay each year. For example, a fund with an expense ratio of 0.25% charges 0.25% of the investor’s assets each year. Fees vary depending on the fund provider and the fund strategy.
Preferred shares or preferred stock are a special kind of shares in a company, which have different characteristics than shares of common stock.
Compared to common stock, preferred shares typically:
- Have priority for dividends over common stock
- Receive compensation before common shares if a company is liquidated
- Can be converted to common stock
- Do not have voting rights
Derivatives are securities that derive their value from other securities rather than any value inherent to themselves.
One of the most common types of derivatives is an option, which gives the holder the right — but not the requirement — to buy or sell shares in a specific company at a set price. Derivatives are more complex financial instruments than generally aren’t suitable for beginners because they can be confusing and come with elevated risk.
How Securities Fit in Your Portfolio
Most investors use securities to build the majority of their investment portfolios. While some people may choose to invest solely in assets like real estate rather than securities like stocks and bonds, securities are highly popular because they make it easy for people to build diversified portfolios.
The mix of investments you choose is called asset allocation. Each type of security fits into an investment portfolio in different ways.
The Role of Stocks
For example, stocks generally offer high volatility and some risk, but higher rewards than fixed-income securities like bonds. People with long-term investing plans and the risk tolerance to weather some volatility may want to invest in stocks.
Within stocks, investors often hold a mixture of large-cap (large, well-known companies) and small-caps (smaller, newer businesses). Typically, larger companies are more stable but offer lower returns. Small-caps can be risky but offer greater rewards.
Large-caps often pay dividends, which are regular payments to shareholders. This makes them popular for people who want to produce an income from their portfolio but who don’t want to shift too heavily into safer, but less lucrative investments like bonds.
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The Role of Bonds
By contrast, bonds are good for people who want to reduce volatility in their portfolios. A retiree or someone who wants to preserve their portfolio’s value instead of growing it might use bonds.
Bonds experience much less volatility than stocks, with their values changing primarily with changes in interest rates. If rates rise, bond values fall. If rates fall, bond values rise.
If you hold individual bonds and don’t sell them, you can only lose value from the bonds if the issuer defaults and stops making payments. That means that bonds can provide a predictable return, assuming you can hold them to maturity.
Bonds also make regular interest payments, often twice annually, making them very popular for income-focused investors.
The Role of Mutual Funds
A huge number of everyday investors opt to invest in mutual funds and ETFs instead of buying individual stocks and bonds. These funds hold dozens or hundreds of different stocks and bonds, making it easy for investors to diversify their portfolios. There are also many different funds that follow different investing strategies, meaning that almost everyone can find a mutual fund that meets their needs.
One of the most popular types of mutual funds is the target-date fund. These funds reduce their stock holdings and increase their bond holdings as time passes and gets closer to the target date. This makes them an easy way for investors to reduce risk and volatility in their portfolio as they get closer to needing the money,
For example, someone who wants to retire in 2062 might invest their money in a target date 2060 or 2065 fund. In 2020, the fund might hold a 90/10 or 80/20 split of stocks and bonds. By 2060, the fund will have reduced its stock holdings and increased its bond holdings so that its portfolio is a 40/60 split between stocks and bonds.
The Role of Derivatives
Derivatives are designed for advanced investors who want to use more complex strategies, such as using options to hedge their portfolio’s risk or to leverage their capital to produce greater gains.
For example, a trader could use options to short a stock. Shorting a stock is like betting against it, meaning the trader earns a profit if the share price falls. On the other hand, if the share price increases, the trader will lose money.
These are best used by advanced investors who know what they’re doing. Derivatives can be more volatile than even the riskiest stocks and can make it easy to lose a lot of money. However, if they’re used properly, they can be a safe way to produce income from a portfolio or a hedge to reduce risk.
A security is the basic building block of an investment portfolio. Most assets that people invest in — like stocks, bonds, and mutual funds — are securities. Each type of security has different features and plays a different role in an investor’s portfolio.
Many investors succeed by investing in mutual funds or ETFs, which give them exposure to a variety of securities at once. If you want an even more hands-off investing experience, working with a robo-advisor or financial advisor can help you choose the best securities to invest in.