Types of Securities

Once you have settled on a broad asset allocation foundation, it's time to choose among the thousands of investment vehicles that will represent each of your asset classes. That may sound like a daunting task, but you only have to do it once... right now. After that it will become a matter of making minor adjustments from time to time.

Individual stocks

For your equity allocation, picking stocks can be challenging, exciting, and even fun if you're into it. But this method comes with a cost - volatility of returns. If you can tolerate lots of price volatility, this could be the way to go.

The big questions to consider are these. If you're going to pick stocks, what's your edge? How good is your information? Do you know something that the big money players haven't figured out yet? Are you more skilled at analyzing a company than someone who does this for a living? Check your ego because you may be suffering from hubris bias.

Mutual Funds

Another way to go is to leave the stock picking to the pros who do it full time. They have better information, better technology, and better access to company insiders than you do. There are drawbacks to this approach, like the fact that mutual fund managers don't like to take much risk and so their returns won't much different from their benchmark index. 

You, on the other hand, can go anywhere and make decisions quickly, since you don't have get approval from an investment committee. This freedom can make you or break you, mostly due to how lucky you are.

ETFs

Now we get to the type of security that is the undisputed champ among all others. ETFs are leaner, faster, and more liquid than their mutual fund predecessors. And their expense ratios are low - sometimes as low as 5 basis points per year. 

However, ETFs are not a panacea as a type of security. ETFs have flaws just like mutual funds and individual stocks do. For one, most ETFs must track an index and there is no room for deviation (creativity). They are managed by algorithms, and when the algo says to buy a stock, it doesn't matter how overpriced it is, or how much bad news there is about the company. They are compelled to buy anyway.

As a result, ETFs can be loaded with toxic stocks that you would never buy for yourself. Keep this in mind when using ETFs to populate your portfolio.

Closed-End Funds

Closed end funds, or CEFs, are a bit of an odd duck as far as securities are concerned. They're a little like a mutual fund, but not really. They're a little like an ETF, but not really. And like all other securities, you can make or lose a lot of money with CEFs. 

The risk is in the structure. They use leverage (they borrow money to goose performance) and they can trade at big discounts or premiums to their net asset value (NAV). 

So, you could buy the most attractive, solid, steady CEF and still take a beating if the price swings from a premium to a discount relative to what their holdings are worth.

Furthermore, the money they borrowed is subject to recall by the lenders. When that happens, the CEF will often reduce their payout ratio and the price will drop sharply.

Private Equity

You have to have lots of capital to get into a private equity fund. And you must agree to lock your money up for a few years before you see any profits, if there are any. Why would anyone do this?

Because the top managers in private equity are highly skilled at the game and the rewards can be outstanding.

Hedge Funds

You need even more capital to get into a top-tier hedge fund. And you have to show that you're making lots of money at your job or business. The fly in the ointment here is the outrageous cost.

You will pay an annual fee of 1.5% of your account balance whether the fund is up or down, and if it's up, you have to give the manager 20% of any profits you make. A great deal for the fund, but not so much for you.

Managed Futures

The futures market is arguably the most risky market out there. These funds take money from investors and gamble with it. They make bets on the future prices of things like soybeans, cattle, currencies and interest rates. It's a wild game and you can make a killing or get killed, depending on the skill of the manager.

Leveraged Loans

These funds invest in senior debt obligations that banks make to their clients. When the economy is growing, these funds pay healthy dividends to their investors. But when the worm turns, look out below because defaults won't be far behind.