Woman considering different types of investments

Investing, simply, is putting your money to work for you now so that you have more of it in the future. Some people feel their money is safer in cash—either in a bank or under the bed. It’s true that we need cash for emergency reserves and daily expenses, but if we hold on to too much cash for too many years, it loses purchasing power over time as prices rise.

The daunting part is that there are a myriad of choices for when, where, and how to invest, and different types of investments come with their own sets of pros and cons. Also intimidating is the might-as-well-be foreign language the financial advisors speak in. I remember the first conversation I had with a financial advisor. After hello, I didn’t have a clue what he was saying.

But it doesn’t have to be that hard. All investments are a compromise between risk and reward.

risk/returns graph

There are thousands of variations of investments, but let’s focus on three.

3 Different Types of Investments You Should Be Aware Of

1. Bonds

Also called fixed income, bonds are an investment in which you loan money to either government entities or corporations for a defined period of time at either a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities—such as anything from – to -. The issuer (entity that wants to borrow the money) states contractually the interest rate (called coupon) that will be paid and the time at which the amount borrowed must be paid back (maturity date). Bonds are usually issued in $1,000 units, called par. The higher the credit quality of the issuer, usually, the lower the interest rate they can expect to receive. A couple of risks associated with bonds is that your money might grow too slowly to accomplish your goals or the institution to which you loaned your money can go under and not be able to pay you back.

2. Stocks

Also called equities, stocks are ownership investments in companies that can generate revenue and profits. They used to come in the physical form of stock certificates, which represented a share of ownership in a company. Now, of course, everything is electronic. The diapers or toothpaste you buy is likely produced by the company Johnson & Johnson. If you have an iPhone, it is manufactured by a company called Apple. You can go online and buy shares in companies like these that you are familiar with. If you buy a certain number of shares, you generally continue to have that number of shares even though the price might fluctuate up and down

3. Exchange-Traded Funds (ETFs)

ETFs are like the grocery cart of companies. The fund manager chooses which individual stocks or bonds to include in the fund, ideally with a high level of diversity. ETFs are traded electronically on an exchange, and prices change throughout the day. There two primary exchanges through which ETFs circulate are the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASDAQ).

Risk Tolerance

So, how much should you be investing in each of these areas? That depends on your level of risk tolerance. When you first meet with your financial advisor, you will be asked to complete a risk tolerance questionnaire. Practically everything in life comes with risk. Just being born is a risk. If you try to avoid all risks in investing, you probably won’t be happy with the outcome. But just how much risk can you tolerate and still be able to sleep at night? Staying the course is critical, so you need to get on the right one to begin with. That starts with accurately and fairly assessing your risk tolerance before looking into different types of investments.

Risk Capacity

While risk tolerance addresses how much risk you can handle, risk capacity is how much risk your financial plan can stand. What impact will inflation have on your purchasing power? Will social security be there when you need it? The longer your time horizon and flexibility in timing, the greater your risk capacity. Multiple sources of stable income could also increase risk capacity and take the pressure off an investment portfolio. A young woman contributing to a 401(k) has more capacity for risk since the funds won’t be accessed for a long time. But someone five years from retiring doesn’t have as much capacity to take risks, since they need that money much sooner.