What are my investment options?

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Do you know the difference between a mutual fund and an index fund? A certificate of deposit and a corporate bond? If you open a retirement account or a brokerage account, you will be faced with many different investment options. They will generally be distinguished by their riskiness and potential for high returns, two features that come hand in hand. This pyramid will introduce you to the risk (and potential reward) spectrum of investments vehicles:

Here is a more detailed list of the common investment option and their most important features. 

Money Market Accounts

Money market accounts offer slightly higher interest rates than savings account and all the liquidity of a savings account, but a fee will be assessed if a money market account does not carry at least the minimum balance.  Like savings accounts, money market accounts are insured by the Federal Deposit Insurance Corporation (FDIC).

Certificates of Deposit (CDs)

CDs offer higher interest rates than savings or money market accounts, but lock up your money for an agreed upon time.  It's like giving the bank a loan that will be paid off with interest in one future payment.  If you cash in your CD early, you will have to pay a fee. CDs are insured by the Federal Deposit Insurance Corporation (FDIC).

U.S. Treasury Bills, Notes, and Bonds

  •  U.S. treasury bills are issued by the federal government.  The purchaser pays a discounted rate that reflects interest (say, $995), and collects the full value of the bill (say, $1000) upon its "maturity date" (the date upon which the government has agreed to repay the purchaser).  "T-Bills" mature in one year or less and are sold in denominations of $1000.
  • "T-Notes" are like T-Bills, except that they mature in 1-10 years and pay out interest every six months instead of being sold at a discount.
  • "T-Bonds" are like T-Notes, except that they mature in 10-30 years.
  • T-Bills, T-Notes, and T-Bonds are all ultra-low risk investments with low rates of return and high liquidity.  The value of the instrument on the secondary market will be subject to change depending on various market conditions.
  • These treasury instruments are subject only to federal tax.

Annuities

Annuities are contracts with insurance companies.  The insured makes one or more payments into the account, and the insurer agrees to distribute that money plus earnings on it back to the insured during some period in the future.  Distributions will continue until the insured dies or until the contract's specified end date, whichever comes first. 

Mutual Funds

Mutual funds pool money from various investors in order to take advantage of the efficiency of putting many people's money under one person's full-time management.  Mutual funds come in many flavors, such as small-company growth funds, emerging markets funds, low-risk funds, or real estate, health, banking, or energy funds.  You can choose what type of fund to invest in based on your risk tolerance and your predictions as to what types of industry will be performing well over the next few years.  The manager will buy and sell individual assets for the fund as he sees fit.  Mutual funds are highly diversified across the industry they focus on, which means that, in contrast to investing in individual stocks, there won't be major swings in your investment's value based on the fortune of any single company.  Mutual funds charge an annual management fee, which is typically a reasonable price to pay for not having to micromanage your investments.  It is generally quick and easy to invest in or withdraw money from a mutual fund, especially if you go through an online brokerage firm account.

You can compare fees using the Financial Industry Regulatory Authority's (FINRA) mutual fund fee calculator.

Index Funds

Index funds are like mutual funds, in that they are diversified and highly liquid.  However, instead of being made up of a shifting array of assets that are bought and sold at the discretion of a mutual fund manager, index funds are made up of shares of all the companies on a particular index, such as the Dow Jones Industrial Average or the S&P 500.  Thus, an index fund aims to track the movements of the associated index.  If the S&P 500 goes up 2%, an S&P 500 index fund should go up by about 2%.  Index funds have lower fees than mutual funds due to the lack of active management.  Some index funds are also "exchange traded funds," which means that you can buy and sell them without any special process, just as if they were a stock for an individual company.

Bonds

Bonds are issued by governments and corporations.  When you buy a bond, you are effectively giving the bond issuer a loan, which they promise to repay with interest.  Different bonds have different risk ratings, and the higher the perceived risk, the greater the bond's yield (i.e., interest rate).  There is risk involved because issuers sometimes default on their debt obligations, which means that the bondholders will lose all of their investment except for the interest that has already been paid out.  Even sovereign debt is not risk-free: for instance, in early 2012, Greece was in danger of defaulting on billions of dollars of bonds, unless the bondholders would agree to accept lesser repayments and international organizations would provide another bailout.  Municipalities have been known to default on their bonds, and any company that goes bankrupt will do the same.  But there are plenty of low-risk bonds available.  Research the issuer and the bond rating before making a purchase. Municipal bonds are exempt from most taxes.


Stocks

Stocks are shares of the "equity" of a company.  They represent claims on the corporation's assets and future earnings.   As a company's actual earnings and anticipated future growth and earnings increase, the value of each share of stock increases, and vice versa.  When companies make a profit, they will either reinvest that money (theoretically increasing the value of the company and thus every share of stock) or disburse the money to shareholders in the form of dividends.  Stock prices tend to rise and fall much more rapidly than prices of other assets, such as bonds and fund shares.


Creating your own mock account can be a fun tool to use when learning about the stock market and how it works: