In this article, I present more than a dozen of the most popular financial products, and rank them from safest to riskiest.
1 – Fixed income assets
A) Certificates of Deposit (COD)
A Certificate of Deposit is a short-term financial product offered by banks. You receive a higher-than average interest rate in exchange for agreeing to deposit a sum of money on an account you can’t access for the entire duration of the certificate.
In the USA, you can purchase a COD with as little as $1000. Since this is a short term instrument, saving periods go from 1 day to 2 years. In France, COD are reserved for financial institutions and high net-worth individuals.
Why buy a COD? For the following reasons:
- To hedge against market volatility: If the market is having a bad year, you may want to invest part of your money in a COD while you wait for market conditions to improve
- To generate returns on savings: If you have an important purchase coming up, placing your money in a COD allows you to generate interest risk-free while you wait.
Bonds are a mechanism used by governments and corporations to raise funds.
The issuer is the borrower and the buyer is the lender: When you buy a bonde, you are lending money to the person selling it to you.
If you buy a 10-year bond with a 3% interest, you will be paid 3% interest yearly (this is the coupon) and your principal will be paid back at the end of the 10th year (maturity date).
Always remember that a bond’s interest rate is proportional to the risk of not getting your interest and principal paid back. Thus, very trustworthy governments and companies have low interest rates and more untrustworthy ones have higher interest rates.
The most popular bond is undoubtedly the US government Treasury bond. It’s the most popular because the US is the world’s most powerful economy and the dollar is the world reserve currency. China and Japan each own more than $1 trillion worth of US bonds.
Who buys bonds?
- Retirees who want a risk-free, guaranteed source of income
- Financial institutions who buy them to diversify their portfolios
- Investors who want to hedge against market volatility
2 – Low-risk assets
A) Index Funds
Index Funds are possibly the single best investment beginners can make. For example, over a 30 year period, the S&P 500 Index Fund generates average annual returns of 7-10% yearly. This is enough to beat the returns of most professional hedge fund mangers and virtually all retail investors.
To find out more about index funds, read this article.
B) Dividend Aristocrats and Dividend Kings
A lot of companies pay dividends. However, not all companies pay them consistently year in year out. Some companies regularly reduce or eliminate their dividends because they are unable to generate consistent cash flows.
Dividend Aristocrats are companies who have increased their dividend payment at least once a year for the past 25 consecutive years. Famous Dividend Aristocrats include Walmart, Caterpillar, McDonald’s and Pepsico.
Dividend Kings are companies who have increased their dividend payment at least once a year for the past 50 consecutive years. Notable Dividend Kings include Coca-Cola, American States Water, Johnson and Johnson and 3M.
Dividend Aristocrats and Dividend Kings are solid companies who have proven track records of delivering value for shareholders, even in times of crisis.
One thing to keep in mind is that these stocks offer relatively low dividend yields: On average, you will get a yield of 2-3%. This is low but it’s the price to pay for the safety they provide.
C) Blue Chip Stocks
Blue Chip stocks are very mature companies who are often leaders in their respective fields. These companies have very solid business models, numerous competitive advantages and consistently generate massive profits. However, they are not Dividend Aristocrats because some of them have only started paying dividends recently and others don’t pay any dividends at all.
Companies such as Apple, Microsoft, IBM, Amazon, Visa, Mastercard, Facebook and Berkshire Hathaway are examples of Blue Chip stocks.
3 – Risky Assets
Stocks are by far the best performing asset class. Over a 30 year period, no other asset comes close to providing similar returns.
A stock represents an ownership stake in a company. As a shareholder, you have a vested interest in the success of that company and the right to vote in general assemblies. Owning a stock can make you money in one of two ways: a) the stock price goes up and you sell at a profit and/or b) you receive dividend payments if the company pays a dividend.
However, stocks carry a very high level of risk because no company can guarantee success. If it fails to deliver, investors will rush to sell their shares and the stock price will plummet, which means you’ll lose a substantial part of your investment; also, if the company’s results are disappointing, it can cut or eliminate its dividend, which deprives you of that income source. This is especially damaging for retirees who rely on dividends to finance their lifestyle.
The best way to minimize your risk is to conduct fundamental analysis before you purchase a stock. Fundamental analysis consists of analyzing the company’s business model, the growth prospects of the industry it operates in, its competitive advantages, its margins and profitability, its management team, its debt structure, and various other parameters that provide you insight as to whether it’s a sound investment.
But be warned: No amount of fundamental analysis can protect you from losses. Companies who look good on paper can still flatter to deceive and lose you money. It’s very important you conduct due diligence before you purchase a stock.
Real Estate Investment Trusts (REIT) are companies specialized in purchasing and renting real estate to corporations and people.
These companies are obligated by law to distribute 90% of their taxable income as dividends to avoid paying taxes so they generally offer higher dividend yields than Dividend Aristocrats/Kings. REITs are very popular investments among income investors.
The risk of investing in REITs is that their ability to pay dividends is often correlated with the health of the economy. Since they pay 90% of their taxable income as dividends, they need to borrow lots of money to invest in new properties. When the economy is doing well, tenants pay their rent, REITs pay off their loans and distribute dividends. But when the economy is in crisis, tenants can’t pay rent, REITs can’t pay back their loans and you don’t get dividends.
During the 2007-08 crisis, many REITs cut their dividends. This year, the coronavirus crisis is forcing many REITs to cut or eliminate their dividends. Dividends will probably be reinstated when the situation clears, but there is no timeline for that and in the meantime income investors have to do without their regular dividend payments.
By cryptocurrencies, I’m mainly speaking of Bitcoin and Ethereum. I discourage beginners from investing in altcoins (all coins that are not Bitcoin and Ethereum) because they are essentially pure speculative plays.
Bitcoin and Ethereum are decentralized digital currencies built on the BBlockchain. I’ve published several articles on this blog explaining what cryptocurrencies are and I’m sure you have at least a vague idea of what they are.
I believe cryptocurrencies have a very bright future ahead of them and that every investor should hold at least 1% of his portfolio in either Bitcoin and/or Ethereum.
Here are several reasons why I’m bullish on Bitcoin:
- Your keys, your coins: Nobody can confiscate your assets
- Decentralized: The coins are not controlled by a central authority
- Nodes: Authentification of transactions is completely decentralized
- Digital: You can carry all of your bitcoin in a usb drive
- Low fees: You can transfer Bitcoin to anyone, anywhere, for pennies
- Max supply: The total Bitcoin supply is capped at 21 million coins
- Privacy: Various privacy features for those who want discretion
However, cryptocurrencies are still very volatile assets and not everyone can stomach seeing their investments fluctuate from one day to the next. I suggest you allocate a small part of your portfolio to these two coins and take the time to learn what they are and why they are interesting investments.
4 – Sophisticated Assets
A) Short selling
Short selling is betting that a stock price will fall. Here’s a quick example to help you understand.
I believe stock A’s price will fall from $100 to $50 so I decide to borrow 100 shares of stock A from my friend Max who is long this stock.
Once I have possession of the 100 shares, I immediately sell them for the market price of $100 and pocket $10K. I still owe my friend 100 shares and my plan is to buy them for cheaper than what I just sold them for and keep the difference as profit.
Then, I wait for the price to fall. Two things can happen:
- If the stock price falls to $50 as planned, I buy the 100 shares I owe my friend for $5K, give him his shares back and keep the extra $5K as profit
- If the stock price rises to $150, I still have to buy 100 shares because I have to return them to my friend. Thus, I have to spend $15K to buy them and I lose $5K.
As you can see, short selling is profitable if you get it right but it’s costly if you get it wrong. Keep in mind that your total profit will never exceed 100%, because a stock price can only go to zero, but your potential losses are infinite because a stock price can go up to infinity.
For example, people who have shorted Tesla have collectively lost $18 billion of dollars this year alone.
Options are contracts which give the buyer the right, but not the obligation to buy or sell an underlying asset at a predetermined price on or before a specific date. The underlying asset can be a stock, a commodity or a currency.
The buyer or seller makes money when the price of the underlying assets goes beyond the predetermined price on or before the specific date. If it doesn’t, then the contract expires worthless.
The person who writes (sells) the contract is paid a premium to sell it and keeps the premium if the contract expires worthless.
These days, options are readily available for trading on most brokerage platforms but this doesn’t mean they provide easy returns. Options are very lucrative when the stock price moves in your favor but they can also result in you losing 100% of the capital spent on buying the options contract.
Warrants are very similar to options. They give the buyer the right, but not the obligation, to buy a stock at a predetermined price on or before a specific date. Unlike options, warrants are issued by companies. When a warrant is exercised, the company issues new shares. Unlike options, warrants are more difficult to purchase because they’re often traded on secondary markets.
The Forex is the Foreign Exchange market where you can buy and sell foreign currencies.
Forex is mainly used by traders who buy and sell currencies on a daily basis. This is a sophisticated endeavor which requires knowledge of technical analysis and staying informed of economic and financial news.
Beginners should stay away from Forex markets. If you are interested in trading Forex, you should start out by paper trading, which is trading with fake money, until you develop strategies that consistently make you money. Otherwise, you will lose money and leave the markets disgusted.
Every financial product has a reason for being and a role to play in the markets.
Your job is figuring out which ones fit your investor profile and help you achieve your financial objectives.
As with most things in life, it’s better to start out safe while you learn. Once you’re comfortable navigating the markets, you can start investing in riskier assets. Just never forget that risk comes at a price and you won’t always be on the winning side.
Thank you for reading.
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DISCLAIMER: This article is the fruit of my personal research and should not be viewed as financial advice. I enjoy analyzing stocks and providing investment ideas but I encourage you to do your own research before investing. NEVER invest without having done proper due diligence. NEVER invest out of the Fear Of Missing Out (FOMO). Also, NEVER invest because some internet message boards are hyping up a high-flying stock: the number of rockets included in a tweet are inversely proportional to the quality of the advice given.