Investment Basics

Unit 3: Types of Investments


Stock represents a share of equity ownership in a corporation.  The owner of a share of stock owns part of the company that issued the stock.  For example, if a company is worth $1 million and has issued 100,000 shares of stock, each share is worth $10.  As an owner, the stockholder shares in the profits or losses of the company. 

There are two main kinds of stocks: common stock and preferred stock.

  • Common stock entitles owners to vote at shareholder meetings and receive dividends.
  • Preferred stockholders usually don’t have voting rights but they receive dividend payments before common stockholders do, and have priority over common stockholders if the company goes bankrupt and its assets are liquidated.

Common and preferred stocks may fall into one or more of the following categories:

  • Growth stocks have earnings growing at a faster rate than the market average. They rarely pay dividends and investors buy them in the hope of capital appreciation. A start-up technology company is likely to be a growth stock.
  • Income stocks pay dividends consistently. Investors buy them for the income they generate. An established utility company is likely to be an income stock.
  • Value stocks have a low price-to-earnings (PE) ratio, meaning they are cheaper to buy than stocks with a higher PE. Value stocks may be growth or income stocks, and their low PE ratio may reflect the fact that they have fallen out of favor with investors for some reason. People buy value stocks in the hope that the market has overreacted and that the stock’s price will rebound.
  • Blue-chip stocks are shares in large, well-known companies with a solid history of growth.

Dividends are the only cash payments regularly made by corporations to their stockholders. They are decided upon the declared by the board of directors and can range from zero to virtually any amount the corporation can afford to pay (typically, up to 100 percent of present and past net earnings).

Common stocks involve substantial risk because the dividend is at the company’s discretion and stock prices typically fluctuate sharply, which means that the value of investor’s claims may rise and fall rapidly over relatively short periods of time.
The following two dividend terms are important:

  • The dividend yield is the income component of a stock’s return stated on a percentage basis. It is one of the two components of total return. Dividend yield typically is calculated as the most recent 12-month dividend divided by the current market price.
  • The payout ratio is the ratio of dividends to earnings. It indicates the percentage of a firm’s earnings paid out in cash to its stockholders.

Dividends are declared and paid quarterly. To receive a declared divided, an investor must be a holder of record on the specified date that a company closes its stock transfer books and compiles the list of stockholders to be paid.


Stocks are sometimes categorized by their size. Market capitalization refers to a company’s size and is derived by multiplying the number of shares outstanding by the current market price of the shares. Generally, stocks are considered to fall into one of the following three categories:

  • Small Cap. Stocks with a market capitalization of less than $750 million. Historically, these have been among the best and worst performers within the stock market because they are usually younger, less established companies and therefore carry more investment risk.
  • Mid Cap. Stocks with market capitalization of from $750 million to $3 or $4 billion. While the risk is higher for these stocks than the large caps, it is considerably less than small caps. Over one thousand companies fit this category and some are household names.
  • Large Cap. Stocks with market capitalization over $4 billion. Many of these companies are among the largest in their respective field and are household names. This category of stocks tends to be the most widely covered by research analysts and institutions.  

Mutual Funds

A mutual fund is nothing more than a collection of stocks or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares that represent a portion of the holdings of the fund. 

Mutual funds are corporations typically formed by an investment advisory firm that selects the board of trustees for the company. The trustees, in turn, hire a separate management company, normally the investment advisory firm, to manage the fund. The management company is contracted by the investment company to perform necessary research and to manage the portfolio, as well as to handle the administrative chores for which it receives a fee.

Mutual funds typically are purchased directly or indirectly:

  1. Directly, from a fund company, using mail, telephone, or at office locations.
  2. Indirectly, from a sales agent, including securities firms, banks, life insurance companies, and financial planners.

Mutual funds may be affiliated with an "underwriter," which usually has an exclusive right to distribute shares to investors. Most underwriters distribute shares through broker or dealer firms.

Mutual funds are the most popular form of investment for the typical investor. One reason is that the minimum investment requirements for most funds are small. Two-thirds of all funds require $1000 or less to get started, and 85 percent require $5,000 or less.

There are two major types of mutual funds:

  1. Money market mutual funds (short-term funds)
  2. Equity and bond & income funds (long-term funds)

Money market funds concentrate on short-term investing by holding portfolios of money market assets, whereas equity and bond & income funds concentrate on longer term investing by holding mostly capital market assets, such as stocks and bonds.

Money market funds can be divided into taxable funds and tax-exempt funds.

  • Taxable money market funds hold assets such as Treasury bills, negotiable CDs, and prime commercial paper. Some funds hold only bills, whereas others hold various mixtures. Commercial paper typically accounts for 40 to 50 percent of the total assets held by these funds, with Treasury bills, government agency securities, domestic and foreign bank obligations, and repurchase agreements rounding out the portfolios. The average maturity of money market portfolios ranges from approximately one month to two months. SEC regulations limit the maximum average maturity of money funds to 90 days.
  • Tax-exempt money market funds consist of national funds which invest in short-term municipal securities of various issuers and state tax-exempt money market funds, which invest only in the issues of a single state, thereby providing additional tax benefits.

Here are the major types of mutual funds:

  • Aggressive Growth Funds seek maximum capital appreciation (a rise in share price); current income is not a significant factor. Some funds in this category may invest in out-of-the-mainstream stocks, such as those of fledgling or struggling companies, or those in new or temporarily out-of-favor industries. Some of these funds may also use specialized investment techniques such as option writing or short-term trading.  For these reasons, these funds usually entail greater risk than the overall mutual fund universe.
  • Balanced Funds generally try to balance three different objectives: moderate long-term growth of capital, moderate income, and moderate stability in an investor's principal. To reach these goals, balanced funds invest in a mixture of stocks and bonds.
  • Corporate Bond Funds seek a high level of income by purchasing primarily bonds of U.S.-based corporations; they may also invest in other fixed-income securities such as U.S. Treasury bonds.
  • Flexible Portfolio Funds may invest in any one investment class (stocks, bonds, or money market instruments) or any combination thereof, depending on the conditions in each market. Because they do not limit a fund manager's exposure to any one market, these funds provide the greatest flexibility in anticipating or responding to economic changes.


Bonds are debt obligations of a publicly owned company or government agency.  Bonds do not represent ownership but are obligations to repay a loan over some time period with a set interest payment.  Bonds are sold with a face value and a specific rate of return. 

When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it "matures," or comes due after a set period of time.

Investors buy bonds because:

  • They provide a predictable income stream. Typically, bonds pay interest twice a year.
  • If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing.
  • Bonds can help offset exposure to more volatile stock holdings.

Companies, governments, and municipalities issue bonds to get money for various things, which may include:

  • Providing operating cash flow
  • Financing debt
  • Funding capital investments in schools, highways, hospitals, and other projects

There are several types of bonds:

  • Corporate bonds are debt securities issued by private and public corporations.
  • Municipal bonds are debt securities issued by states, cities, counties and other government entities.
  • General obligation bonds. These bonds are not secured by any assets; instead, they are backed by the “full faith and credit” of the issuer, which has the power to tax residents to pay bondholders.
  • Revenue bonds. Instead of taxes, these bonds are backed by revenues from a specific project or source, such as highway tolls or lease fees.
  • U.S. Treasuries are issued by the U.S. Department of Treasury on behalf of the federal government. They carry the full faith and credit of the U.S. government, making them a safe and popular investment.

Various types of U.S. Treasuries include:

  • Treasury Bills. Short-term securities maturing in a few days to 52 weeks.
  • Notes. Longer-term securities maturing within ten years.
  • Bonds. Long-term securities that typically mature in 30 years and pay interest every six months.
  • TIPS. Treasury Inflation-Protected Securities are notes and bonds whose principal is adjusted based on changes in the Consumer Price Index. TIPS pay interest every six months and are issued with maturities of five, ten, and 30 years.

Bonds provide a means of preserving capital and earning a predictable return. Bond investments provide steady streams of income from interest payments prior to maturity. Interest from municipal bonds generally is exempt from federal income tax and also may be exempt from state and local taxes for residents in the states where the bond is issued.

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