Types of Investment Securities

Why This Matters

When you're tested on investment securities, you're really being tested on your understanding of risk-return tradeoffs, ownership versus lending, and how different instruments serve different investor needs. Every security exists because it solves a specific problem—whether that's raising capital for a company, providing steady income for retirees, or letting sophisticated investors hedge against market swings. The exam will push you to understand why an investor would choose one security over another and how each fits into a broader portfolio strategy.

Don't just memorize definitions—know what category each security belongs to and what tradeoffs it represents. Can you explain why bonds move inversely to interest rates? Why ETFs often beat mutual funds on fees? Why derivatives can both reduce and amplify risk? These conceptual connections are what separate strong exam answers from mediocre ones.

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Ownership Securities: Claiming a Piece of the Pie

When you buy ownership securities, you're becoming a partial owner of an asset or company. Your returns depend on how well that underlying asset performs—which means higher potential rewards but also higher risk.

Stocks (Equities)

• Represent ownership in a company—shareholders have claims on profits and voting rights in corporate decisions
• Two return sources: capital appreciation (price increases) and dividends (profit distributions to shareholders)
• Highest volatility among traditional securities—prices fluctuate with company performance, market sentiment, and economic conditions

Real Estate Investment Trusts (REITs)

• Companies that own income-producing real estate—gives investors exposure to property markets without buying buildings directly
• Required to distribute 90% of taxable income as dividends, making them attractive for income-seeking investors
• Liquidity varies significantly—publicly traded REITs sell like stocks; private REITs lock up capital for years

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Debt Securities: Lending Your Money for Fixed Returns

Debt securities make you a creditor, not an owner. You're lending money in exchange for promised interest payments and return of principal. Lower risk than ownership securities, but returns are capped.

Bonds

• Debt instruments issued by corporations or governments—the issuer promises to repay principal plus interest over time
• Inverse relationship with interest rates—when rates rise, existing bond prices fall (and vice versa)
• Risk varies by issuer—government bonds are safer; corporate bonds offer higher yields but greater default risk

Treasury Securities

• U.S. government debt instruments—includes T-bills (under 1 year), T-notes (1-10 years), and T-bonds (10-30 years)
• Considered virtually risk-free—backed by the full faith and credit of the U.S. government
• Benchmark for all other interest rates—the "risk-free rate" used in financial calculations like $CAPM$ and $NPV$

Certificates of Deposit (CDs)

• Time deposits with fixed rates and maturity dates—you agree to lock up funds for a specific period
• FDIC-insured up to $250,000—virtually eliminates default risk for amounts under the limit
• Early withdrawal penalties apply—sacrifices liquidity for higher yields than regular savings accounts

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Pooled Investment Vehicles: Diversification Made Easy

These securities let investors pool money together to access diversified portfolios they couldn't build alone. Professional management and instant diversification reduce individual security risk.

Mutual Funds

• Professionally managed portfolios where investors buy shares representing a slice of the total holdings
• Priced once daily at net asset value (NAV)—you can't trade them throughout the day
• Fee structures vary widely—expense ratios, load fees, and management costs can significantly erode returns

Exchange-Traded Funds (ETFs)

• Trade on exchanges like stocks—allows real-time buying and selling at market prices throughout the day
• Typically lower expense ratios than comparable mutual funds due to passive management and tax efficiency
• Track indices, sectors, or commodities—offers targeted exposure (e.g., S&P 500 ETF, gold ETF, tech sector ETF)

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Money Market Securities: Safety and Liquidity First

Money market instruments prioritize capital preservation and liquidity over returns. Short maturities (typically under one year) mean minimal interest rate risk and quick access to cash.

Money Market Instruments

• Short-term debt securities including Treasury bills, commercial paper, and repurchase agreements
• Maturities of one year or less—minimizes exposure to interest rate fluctuations
• Lower returns than long-term investments—the tradeoff for safety and immediate liquidity

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Derivatives: Contracts Based on Underlying Assets

Derivatives don't represent direct ownership or lending—they're contracts whose value derives from another asset. Used for hedging risk or speculation, but complexity and leverage make them dangerous for inexperienced investors.

Options

• Right, but not obligation to buy (call) or sell (put) an asset at a predetermined strike price before expiration
• Three primary uses: hedging existing positions, speculating on price movements, and generating income through premiums
• Time decay affects value—options lose value as expiration approaches, requiring precise timing

Futures

• Binding contracts obligating parties to buy or sell an asset at a set price on a future date
• Commonly used for hedging—farmers lock in crop prices; airlines hedge fuel costs
• Significant leverage amplifies outcomes—small price movements create large percentage gains or losses

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Quick Reference Table

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Self-Check Questions

1. Which two securities both provide diversification but differ in how they're traded and priced—and which typically has lower fees?

2. Explain the key difference between options and futures in terms of obligation. Why does this affect their risk profiles?

3. If interest rates rise significantly, which securities would likely decrease in value? Which would be relatively unaffected?

4. Compare stocks and bonds as ways to invest in a corporation. What does each represent, and how do their risk-return profiles differ?

5. A conservative investor needs to park cash for six months with minimal risk. Compare and contrast three securities that might meet this need, explaining the tradeoffs between them.