Accumulating wealth for long-term financial goals such as funding your retirement or your children’s college education is generally a long-term proposition that requires a commitment to saving and investing over time. To decide what kind of long-term investments make sense for you, consider six of the best long-term investment vehicles and the advantages and disadvantages of each, and factor in your time horizon, tolerance for risk, and goals.
Many financial experts suggest that before you even decide how to invest money long-term, you start with building a sufficient emergency fund invested in cash or low-risk, short-term investment vehicles. This emergency fund can be used for short-term cash needs such as an unexpected home repair or to fill in for lost income due to losing your job. After that, however, it’s time to invest for your longer-term financial and life goals.
Stocks represent ownership in a company, and shareholders invest with the expectation that the company will continue to grow, causing the share price to increase.
Although the stock market has been pretty dismal so far in 2016, over the longer term investing in stocks has been a great way to accumulate wealth. For example, a hypothetical $100 invested in the S&P 500 Index on Jan. 1, 1928 would have been worth $294,061 by the end of 2015. That’s not to say that stocks go up all the time — quite the contrary: The S&P 500 Index lost 37 percent in 2008, the peak year of the financial crisis.
Individual stocks can be a great source of wealth, but knowing how to invest in stocks — which stock to purchase, when to buy it, and most importantly, when to sell — is a difficult field to master. Because stock market health factors can be unpredictable, some investors never master this type of investment. Even with strong companies selling popular products, the stock market can be unpredictable.
For example, on Dec. 31, 2002 one share of Apple (AAPL) stock sold for $1.02 on a split-adjusted basis. Apple closed on Feb. 19, 2016 at $96.04 per share — quite a gain in spite of some recent weakness in the stock at the time.
Not all stocks do as well, despite the company’s popularity or good reputation. The chart below compares the gains on Apple to those for another tech giant, Microsoft (MSFT), from Dec. 31, 1999 through Feb. 19, 2016. As you can see Apple’s gain is over 2,500 percent while Microsoft’s is about 12.5 percent — quite a difference.
Picking the right individual stocks can be rewarding, but an individual stock also carries the full business risk associated with that company. Enron was a high-flying stock until fraud and corruption were exposed, driving the company out of business and leaving stockholders holding the bag. Many of these shareholders were employees who lost not only their jobs but, in many cases, a majority of their retirement savings.
Pros of investing in stocks: Over time, can be a great source of wealth despite stock market’s overall health.
Cons of investing in stocks: Mastering the knowledge to buy and sell profitably is difficult in this unpredictable field. Individual stocks carry the full business risk associated with the company.
Unlike stocks, which represent ownership in the underlying company, bondholders are creditors of the issuer — meaning that those holding the bonds are debtholders as they are lending money to the legal entity that develops and sells securities to finance its own operations. Bonds are purchased with the expectation that bond holders will receive regular interest payments, usually semi-annually, and then will receive the face value of the bond — usually $1,000 — when the bond is redeemed.
Generally, bonds can be bought or sold on the secondary market, though the price might be higher or lower than the price that you originally paid for the bond. The price of a bond moves inversely with interest rates. In other words, when interest rates increase, the price of a given bond will decrease.
This is a potential issue since the Federal Reserve has started on what could be a series of interest-rate hikes at the end of 2015. For investors who plan to hold onto their bonds until maturity, this will not have too much of an impact.
Other factors to consider when looking at individual bonds include the credit quality of the company or the municipality issuing the bond and whether they have the financial wherewithal to make the interest payments and pay off the bond at maturity. The time until the bond matures is another factor to weigh: The longer a bond has until it matures, the greater the impact of a change in the prevailing level of interest rates will have on its price. Bonds are generally less volatile than stocks and have a low correlation to stocks, so they can be a good diversifier in an investment portfolio.
Pros of investing in bonds: Good diversification from stocks and regular income.
Cons of investing in bonds: Price can drop in periods of rising interest rates.
Related: 17 Smart Investments
3. Mutual Funds
Mutual funds invest in stocks, bonds or other types of investments. This type of long-term investment offers a diversified portfolio that is either actively managed — the manager makes decisions on the stocks or bonds to buy and sell — or is a passively managed index fund where the fund attempts to replicate the performance of an index such as the S&P 500.
A mutual fund like the Vanguard Total Stock Market Index (VTSMX) tracks an index that replicates the majority of the U.S. stock market. There are index funds that track the total bond market, some that track the total non-U.S. stock market, and others that track indexes representing various segments of the stock and bond markets.
The advantage of mutual funds is that even a small investor can purchase a fund made up of a number of different stocks or bonds and have a degree of instant diversification. Index funds provide a low-cost way to invest compared to most actively managed funds — especially considering that many active managers consistently underperform their benchmarks over time, despite the skill and expertise these fund managers are supposed to have to select better stocks and bonds than an index like the Dow or S&P 500.
Factors to consider for all mutual funds include costs. Be wary of mutual funds that assess a sales charge or front-end load. For actively managed funds it is important to understand who is managing the fund and what their track record is.
Pros of investing in mutual funds: Easy way for small investors to invest in a portfolio of stocks or bonds with a relatively small investment.
Cons of investing in mutual funds: Actively managed funds often have high expense ratios and deliver mediocre performance.
Exchange-traded funds or ETFs are like mutual funds in many respects. The major difference is that they trade all day during the trading day on the stock exchange just like stocks. ETFs can trade at the net asset value of the underlying holdings, or above or below that level.
ETFs like the Vanguard Total Stock Market Index ETF (VTI) and the Standard and Poor’s Depository Receipts (SPDR) S&P 500 ETF (SPY) track popular segments of the stock market and mainstream market benchmarks. These and other popular index ETFs offer low-cost exposure to a portion of the stock market. Other popular index ETFs track indexes for various parts of the U.S. and foreign stock markets and the domestic and foreign bond markets, as well.
Most brokerage firms charge a commission to trade ETFs, though a number of brokers — including Charles Schwab, Fidelity and TD Ameritrade — offer a menu of no-transaction-fee ETFs. Vanguard account holders can trade Vanguard’s ETFs with no transaction fees.
It’s important to note that not all ETFs are created equal. Over the past few years, there have been many new ETFs that are based on benchmarks that were invented in the lab, so to speak. These indexes have little or no actual market history; their performance has only been back-tested on the computer, a form of simulation. ETFs can be a great low-cost way to invest, but as with any investment, you need to understand what you are buying and why you are investing there.
Pros of investing in ETFs: Low-cost, transparent investment vehicle. Many are quite tax-efficient.
Cons of investing in ETFs: Many new ETFs are based on questionable benchmarks with unproven market performance.
5. Retirement Accounts
Retirement accounts are not a type of investment like the others listed here but rather a type of account via which you can invest in a wide range of investment vehicles such as stocks, bonds, mutual funds, ETFs and others. Retirement accounts are included on this list is to emphasize the importance of investing for retirement specifically during your working years.
IRAs can be traditional or Roth. The former can offer the opportunity to contribute on a pre-tax basis if you meet certain income requirements. Roth accounts are funded with after-tax dollars, but as long as the requirements have been met the money can be withdrawn tax-free. There are maximum levels of income where those earning above these levels are not eligible to contribute to a Roth IRA. Money invested within a traditional IRA grows tax-free, but is taxed when withdrawn, except for the value of any after-tax contributions.
Workplace retirement plans such as a 401k, a 403(b), a 457 or the government’s Thrift Savings Plan are called defined-contribution plans and workers contribute a percentage of their salary. The investments are often a menu of mutual funds and in some cases there is an employer match. Some plans offer a Roth option as well.
The value of investing here is that these accounts are the main vehicle for many workers to fund their retirement. You should consider funding an IRA or workplace retirement plan if you have access to one.
Pros of investing in retirement accounts: Great way to save for retirement on a tax-deferred basis.
Cons of investing in retirement accounts: Too many 401k plans offer sub-par investment menus with high fee structures.
6. Alternative Investments
Alternative investments are investments that fall outside the realm of traditional long-only stocks, bonds and cash. Traditionally these have only been available to accredited investors who meet certain income and net-worth requirements and institutions such as foundations, endowments and pension funds. Hedge funds and private equity are some examples. In recent years many alternative strategies have become more widely available as mutual funds and ETFs with fewer purchase restrictions.
Alternative investments in more liquid formats — called liquid alts — such as mutual funds or ETFs have become quite common over the last decade. In fact, financial advisors are inundated with pitches to use these products by the mutual-fund and ETF distributors.
“Modern Portfolio Theory suggests that you can reduce your portfolio risk by diversifying into different types of investments,” financial advisor Kirk Chisholm said. “Alternative investments are a great way to diversify a portfolio. The term ‘alternative investment’ has traditionally been used to describe a hedge fund. However, since the 2008 financial crisis, investors have been looking for more liquid alternatives like ETFs, closed-end funds (CEFs), or mutual funds that use an alternative investment strategy.”
Alternative investments can add diversification to a portfolio and they can also dampen portfolio volatility. Whether you’re investing liquid alts in a mutual fund or ETF wrapper or more traditional alternative investments like hedge funds, as an investor you need to understand the factors: what you’re investing in, the fees and expenses involved, and any restrictions or lock-ups associated with traditional alternative products.
Pros of investing in alternative investments: They can add another level of diversification to an investment portfolio.
Cons of investing in alternative investments: They are hard for many individual investors to understand and often have high fees and expenses.