The following was taken from an assignment submitted during a recent Fundamentals of Investments upper-division financial course:
According to our textbook on pages 7 and 8, short-term investments are investment vehicles that generally last for one year or less. Many investors purchase these investments because they have idle funds and want to earn, at least, a small return on these low-risk investments until they decide which long-term investments to pursue. Additionally, these types of investments are extremely liquid and can be converted into cash rather quickly without any significant loss in value (J. et al., 2016).
As an example of a short-term investment, according to Investopedia, a Money Market Mutual Fund is an investment that is a type of mutual fund that invests in short-term debt instruments, cash, and cash equivalents. A Certificate of Deposit (CD) is an excellent example of a debt-based mechanism that a Money Market Mutual Fund may invest (SEGAL, 2020). Another example of a short-term investment is a United States Treasury Bills (T-Bills), short-term debt obligations backed by the U.S. Treasury with maturities of one year. Like short-term investments in general, these T-Bills are also low-risk and secure investments (CHEN, 2020).
As briefly discussed on pages 8 and 9 of our textbook, another type of investment is stock. Common stock, specifically, is an equity investment that represents ownership in a company. The returns for a stock investment comes from either dividends or capital gains. Dividends are when a company pays its shareholders, usually when the company earns a profit for a specific period. On the other hand, capital gains occur when the stock price rises above what the investor initially paid for (J. et al., 2016). Much of the risk associated with stocks depends on the companies; thus, research into their company financials and management is useful for determining how risky a company is for a stock investment.
Furthermore, regarding common stock and preferred stock, the former generally entitles the owner to vote at shareholders' meetings and receive dividends paid out by the company. The latter usually do not have voting rights but receive a higher claim on assets and earnings. For example, preferred stockholders would receive higher priority on assets than common stockholders if a company went bankrupt (HAYES, 2020)
As described on page 9 of our textbook, fixed income securities are investments that offer a periodic cash payment that may be fixed in dollar terms or may vary depending on a predetermined formula. Fixed income securities can be more secure when investors can "lock-in" specific interest rates, assuming the borrower can pay back the loaned funds. An example of fixed income security is a bond, a long-term debt instrument issued by corporations and governments. Generally, the U.S. government issued bonds are incredibly less risky because the United States Government backs them. Unfortunately, corporate bonds are usually riskier than government bonds but often offer higher returns than their government counterparts (J. et al., 2016).
Regarding the final types of investments from this assignment's list, mutual funds are portfolios of stocks, bonds, and other assets purchased by a pool of funds from investors and managed by an investment company on behalf of its clients. Mutual funds are generally less risker than purchasing any single stock because mutual funds allow diversification among various securities. As our textbook describes, it is much easier, diversified, and cheaper to buy shares of a mutual fund that owns 500 stocks than to buy shares individually from 500 different companies (J. et al., 2016).
As for exchange-traded funds (ETFs), they are highly like mutual funds in that they are portfolios of different securities and offer investors high amounts of diversification. However, they differ in that ETFs are traded on exchanges where investors can buy and sell at the current market price, whereas mutual funds must be traded after the market closes. Another difference is that ETF shares represent a fixed number of claims on a fixed portfolio of securities. You are acquiring shares from investors who want to sell their ownership of the ETF. On the other hand, when investors buy more shares of a mutual fund, they give the investment company more resources, which they usually use to buy more shares. This process can be problematic when multiple investors want to sell their shares of a mutual fund simultaneously. When this simultaneous selling happens, the investment company may need to sell their stock shares at lower prices quickly to create cash for the selling investors (J. et al., 2016).
CHEN, J. (2020). Treasury Bills (T-Bills) Definition. https://www.investopedia.com/terms/t/treasurybill.asp
HAYES, A. (2020). Stock Definition. https://www.investopedia.com/terms/s/stock.asp#common-vs-preferred-stock
J., L., B., S., & D., M. (2016). Fundamentals of Investing, Global Edition.
SEGAL, T. (2020). Money Market Fund Definition. https://www.investopedia.com/terms/m/money-marketfund.asp