We’ll try to list the main investment types out there, how they function, i.e. how do you make money from them and we’ll try to classify how passive they are and the usual expected volatility.
What Are The Main Investment Types?
1. Real Estate
There are several ways to invest in real estate, from land acquisition, land development, single family rentals, multi family rentals, office rentals, industrial rentals. While there are a lot more hybrid investment types from house hacking to vacation rentals, we’ll only go through the main investment types in this introductory post.
1.1 Single Family Rentals
This is probably the most straightforward investment type in the real estate space: acquiring single family homes and rent them out. The business is simple: rent the home and maintain it in habitable condition for the customer.
The owner of the rental also may also profit down the road by selling the property for a profit if it appreciates.
1.2 Multi Family Rentals
Similar to single family rentals, but the asset is in general an apartment building. Duplexes and triplexes, smaller buildings, also qualify as multi family.
1.3 Land Acquisition
This is usually an appreciation play, where one would simply acquire land hoping to sell later in time, for a profit, if the land appreciates in value over time.
There’s one main exception regarding agricultural lending, where one can lend its land to a farmer to exploit the land. The owner of the land receives a rent and in exchange the farmer can exploit the land growing crops or farming livestock.
1.4 Land Development
Land development consist in acquiring raw land and developing it, usually bringing electricity, water and sewer to sell it to a real estate builder to then build and sell buildings, often multi family or single family homes.
1.5 Office Rentals
This is similar to multi family rentals, in the sense that this involves usually bigger buildings, however they’re usually leased to companies or specialized professionals.
1.6 Industrial Rentals
This is similar to office rentals, but concerns industrial buildings usually leased to companies. In this categories we usually have warehouses or industrial buildings able to house machinery.
Stocks are usually fractions of a company traded on an exchange. By buying the stock, you buy a fraction of said company.
2.1 Regular Stocks
By buying the stock, you expect the company to do well and have its share price increase to later sell it for a profit.
ETFs or Exchange Traded Fund are usually funds that invest in several companies/stocks or track some indexes. It allows you to own a pool of investments without the hassle of having to buy every single one of them individually.
Similar to stocks, you’d buy the ETF expecting it to go up in value to sell for a profit.
2.3 Dividend Stocks
Dividend stocks are stocks that pay a dividend, sometimes monthly, but usually quarterly, as long as you’re holding the stocks. These stocks are usually from more established companies, with proven business models, where the growth of the stock usually lower but compensate for it with its dividend.
Dividend are taxed differently than capital gains from selling stocks for a profit and can be interesting in that regards.
Also several dividend companies tend to increase their dividend over time. Dividend aristocrats are dividend companies that have increased their dividend for at least 25 years.
REITs or Real Estate Investment Trust are companies that invest primarily in you guessed it, real estate. To qualify as a REIT must have at least 75% of its income derived from real estate and it must distribute at least 90% of its taxable income as dividend to its shareholders.
REITs income is usually taxed as income, unlike dividends and based on your tax bracket, it may be advantageous to hold them in tax preferred accounts such as a 401k or an IRA.
Bonds are loan to a government (government bonds) or to a company (corporate bonds) for a certain period of time (maturity)and you receive interest (the coupon) , until the loans matures at which point you receive the principal payment.
4. Leveraged Financial Instruments
Options, commonly on stocks, but can also apply against other financial instruments, are just that: option (not obligation) to buy (call option) or sell (put option) at a given price (strike price) until a certain time, the expiration date.
These investments are usually more volatile and riskier, because of the leverage builtin into the contract.
This is the currency market, where ones can profit from the gain of a currency against another. While usually reserved for more advanced investors, the concept is often eye opening that whatever you own that changes in value is a paired trade. When the USD/JPY forex pair trade goes up it means the US dollar goes up against the Japanese yen. When your home goes up in value, it means your home value goes up against the dollar. At which point you want to ask, is the house gaining in value or is the dollar losing in value?
Forex symbols are usually traded with leverage which can increase the risk if not managed carefully.
Futures are contract, usually on commodities but also on stock indexes and currencies. The contract establishes the price of an amount of a commodity at a certain date, e.g. The June 2020 Gold contract, at $1583, establishes the price of an ounce of gold by June 2020.
The market allows producers of such commodities to lock in a price for their production, while speculators, often blamed for commodities volatility allow the market to exist in the first place.
While not perfect, it should be noted that the existence of the market allow producers to hedge their production and many producers would not be in business without the existence of the futures market.
Futures , like the Forex, are usually traded with leverage which can increase the risk if not managed carefully.
5. Alternative Investments
This involves structured financial products in various area, such as art, real estate, marine, legal… It often involve lending money to a third party using various assets from the third party as collateral.
It’s usually reserved to accredited investors, i.e. investors earning more than $200,000 annually if single ($300,000 if married) or have more than $1,000,000 in assets excluding the primary residence. Or institutional investors like investment banks, pension funds and so on.
6. Private Equity
Private equity is generally speaking part of the alternative investments class, but probably deserves a note of its own. Like for alternative investments, these investments come mainly from accredited investors or institutional investors. There are 2 main segments in private equity: one for early stage companies or startups, one for later stage companies and distressed companies.
6.1 Early stage companies or startups
That’s usually where venture capital and angel investors come in. They will pool money or invest their own money to help develop early stage companies, usually in the hope the resell it at a higher price to a bigger company or take it to the public market, where they can exit their position.
The game in startups investing is that most of your investments will go to zero, but the few who survive will make a disproportionate amount of money.
If you want to put some rough numbers, successful startups investors, often see 90% of their investments go to zero. 9% percent of their investments get a 10-50x returns. And 1% turn into a 100-2000x returns and sometimes more.
The downside is that there’s usually no liquidity, so it’s very hard to liquidate your holdings and it’s usually a long game. It will take usually more than 5 and often around 10 years for those early companies to mature to the point where you can expect those enormous gains.
6.2 Distressed companies
Another side of private equity is to invest in failing or distressed companies. Investors usually buy the debt of a company at a steep discount and will try to turn the management around and eventually turn it into a profitable company again, so they can eventually collect the debt repayment.
If that ideal scenario fails and the company is forced into bankruptcy, investors will try to recoup some money during the bankruptcy process.
7. Institutional Investments
This are types of investments reserved for institutions (e.g. CDS), usually due to the amount required to participate in such investments which can range from several hundreds millions of dollar or billions of dollars and sometimes require special licenses to be allowed to participate into such investments. We won’t discuss much about these but it’s good to know that they exist because they can have some influence into other types of investments accessible to the general public.
We’ve presented most of the common investment classes. As far as building a passive income portfolio, we’ll talk more about rental real estate and stocks. We’ll also touch upon alternative investments and also discuss some opportunities with leveraged financial instruments when they arise.