How to Invest in Stocks - Top 10 Alternatives
KEY POINTS
There are many ways to invest in stocks and each one has its own risk profile.
Exchange traded funds, mutual funds, and index funds provide a high degree of diversification.
Derivatives (e.g., options and futures) can provide leverage and have an inherently higher risk profile than investing directly in equities, exchange traded funds, mutual funds, and index funds.
In this post we will highlight how to gain exposure to stocks through different types of securities. We will focus on investing in public equities as opposed to private equities.
How to Invest in Stocks Top 10 List
Individual Stocks - Long
Companies can issue two primary types of stock: common stock and preferred stock. Common stock represents a pure equity investment with voting rights whereas preferred stocks have limited voting rights and share attributes of both common stocks and bonds.
Both types of stocks will trade on a public stock exchange (e.g., NYSE, NASDAQ, Toronto Stock Exchange) and purchases / sales can be made through a brokerage account.
Your bank or brokerage firm may charge you substantial foreign currency exchange fees, often exceeding 4%, when purchasing stocks denominated in foreign currencies. Company’s like Wise can substantially reduce these costs.
2. Individual Stocks - Short Selling
Short selling a publicly traded stock allows investors to earn positive returns when the stock price decreases. The process involves several steps.
First, the investor borrows a stock they do not own. Next, they sell the stock on the open market with the hopes of buying it back at a lower price. Finally, the investor repays the lending institution the original amount borrowed plus interest.
This strategy is notably different than a long only trading strategy.
It requires a margin trading account to facilitate the trades. Margin calls can be triggered by adverse movements in the stock price. Margin calls must be met the next business day by transferring sufficient cash or other securities to the margin account.
As the investor has borrowed the stock, interest accrues based on the initial value of the stock borrowed and is payable to the lender upon settlement. Not all stocks attract the same interest rate. Supply and demand of a particular stock is a key determinant of the interest rate charged.
3. Exchange Traded Funds
Exchange Traded Funds (“ETFs”) trade on a stock exchange and provide exposure to a basket of securities. Such basket may track a specific index (e.g., S&P 500), sector (e.g., U.S. banks), or an investment theme (e.g., artificial intelligence).
A single ETF provides exposure to multiple equities. The degree of diversification will vary across ETFs.
ETFs trade like stocks and can be purchased / sold through a brokerage account.
4. Index Funds
Index funds aim to replicate the performance of a specific stock market index. Such provides a high degree of diversification compared to an investment in the shares of an individual company.
A key difference between Index Funds and ETFs is the way they trade. ETFs trade throughout the day whereas index funds trade after the market closes based upon the end of day closing price.
5. Mutual Funds
Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks. Like ETFs, they can provide broad diversification benefits while providing exposure to an index, industry, or theme.
6. Closed-Ended Funds
A closed-end fund operates like a publicly traded investment company. It may share several traits with a mutual fund (e.g., diversification, various strategies, actively managed). However, there are several important differentiating factors.
Closed-end funds issue a fixed number of shares through an Initial Public Offering and those shares trade on a stock exchange. Whereas an open-end mutual fund will continuously issue and redeem shares based on the net asset value on the respective dealing day.
Closed-end funds are typically less liquid than open-end mutual funds and can also trade at a discount or premium to their net asset value.
7. Real Estate Investment Trust
A real estate investment trust (“REIT”) provides investors a way to invest in a diversified group of real estate assets without purchasing such properties directly. Such may include properties classified as commercial, residential, industrial, or infrastructure assets.
REITs trade on public stock exchanges or they can be privately held. Publicly traded REITs are more liquid than privately held REITs.
8. Stock Options
Stock option contracts trade on a regulated exchange. Such contracts are classified as derivatives as the contract price is derived from the price of the underlying stock and other variables (e.g., time to expiry, volatility, exercise price).
A call option gives the holder the right to buy a specific stock at a predetermined price within a specified period. Conversely, a put option gives the holder the right to sell a specific stock at a predetermined price within a specified period.
9. Futures Contracts
An equity futures contract involves two parties that agree to buy / sell shares of a specific company at a predetermined price within a specified period.
Equity futures contracts trade on a regulated exchange. Like the stock options above, futures contracts are classified as derivative contracts. However, unlike stock options, futures contracts trade on margin and are subject to daily margin calls.
10. Hedge Funds
Hedge funds are subject to less regulation than mutual funds and are typically only available to financial institutions and accredited investors. The U.S. Securities and Exchange Commission defines the criteria utilized to determine who qualifies as an accredited investor.
An accredited investor is primarily subject to two qualifying tests: net income, and net worth.
The income test requires an individual to have an annual minimum income of $200,000 for each of the past two years (or $300,000 combined income with spouse), with the expectation of maintaining a minimum income of $200,000 in the current year.
The net worth test requires a minimum net worth of $1,000,000 (individual or combined with spouse). Such excludes the value of the primary residence.
BOTTOM LINE
This post was created to explain how to invest in stocks. It covered the 10 most common types of securities retail investors utilize to gain exposure to equities. There are many types excluded from this post (e.g., warrants, swaps, contract for differences, etc.).
Each type of security described has its own unique attributes and investment risk profile. Such includes, but is not limited to, market risk, liquidity risk, counterparty risk, interest rate risk, currency risk, and more.
We encourage you to engage your financial advisor to ensure your allocation to equities fits your risk profile while achieving your short-term and long-term goals.
Happy investing !!!
