Learn about the strengths and weaknesses of different investment accounts.
You may never have had more choice when it comes to which type of investment account to open - but having a lot of options won't necessarily make your decision any easier.
In fact, it could make it all the more confusing.
If you're thinking about opening an investment account, it helps to understand not only the purpose of each account but also its strengths and weaknesses.
But it doesn't end there.
It's also important to know which accounts let you pick investments on your own and which manage that process for you.
To help you navigate the choices, MoneyRates sorted its list of seven investment account types on the basis of how investment decisions are made.
Investment Accounts Sorted by Management Approach
Even within the seven categories of investment accounts below, there are often a number of choices to make. As you progress through the list, you'll find the accounts are designed to take on more of the decisions around investments and require less of your personal involvement to manage your assets.
So, from most to least control over how investment decisions are made, here are the seven types of investment accounts you should know:
1. Demand deposits
Demand deposits are bank or credit union accounts like savings accounts, money market accounts and checking accounts. By definition, they are accounts from which you can withdraw money with less than seven days' notice without penalty.
Why include these in an investment article?
It's because they may be used to house funds as you execute your investment strategy.
Demand deposits at banks and credit unions are covered by federally backed insurance for up to $250,000 per depositor per institution. Their principal values are guaranteed.
Savings and money market accounts generally earn interest, and many checking accounts do as well. However, most checking accounts charge a monthly maintenance fee which can often exceed the amount of interest earned. Savings and money market accounts may also charge monthly fees, though these are not as common as with checking accounts.
Demand deposits offer a high degree of safety along with nearly immediate access to your money.
Interest rates on these accounts are generally quite low. Many checking accounts offer no interest at all.
Interest rates and fees on these accounts can vary widely, so consumers have to shop carefully to get a good deal. Also, interest rates on these accounts can change at any time, so the rate you signed up for may not be the rate you get in the future.
2. Time deposits
Time deposit accounts are meant to house funds for a defined period of time, not to facilitate transactions and withdrawals.
Essentially, balances in a time deposit are locked and only become available to the customer again at a specified future date, known as the maturity date. In the meantime, the principal is covered by federally backed insurance and typically earns a higher rate of interest than a demand deposit would get.
Certificates of deposit (CDs) are the most common form of time deposit. Time periods range from a month to five years; but the longer the term of the CD (meaning the further away the maturity date is) the higher the interest rate is.
In exchange for offering higher interest rates, CDs almost always impose an early withdrawal penalty if you want to take money out before the maturity date. Usually, the longer the term of the CD, the greater the early withdrawal penalty will be.
Besides offering safety and stability, time deposits let you lock in a particular interest rate for a set period of time. That way you know what the account will earn for a period of months or even years - and that is often a higher rate than on a demand deposit.
Time deposits may make it costly to access your money before the maturity date if an unexpected need arises.
Locking in a rate can also have disadvantages: If rates rise, you could find that you're stuck with a lower rate for months or years to come.
3. Self-directed brokerage accounts
These accounts are designed to trade stocks, bonds and other securities. "Self-directed" means that you are making the investment decisions yourself, though a broker may provide information, tools or recommendations to assist with your decisions.
Generally speaking, the securities you can invest in with these types of accounts are things like stocks and bonds that can help you save for retirement or reach other long-term goals. They have the potential to offer higher returns than bank deposits do, but those returns are not guaranteed and these investments can lose money.
Brokerage accounts usually charge a commission when trades are made. Some may charge a monthly maintenance fee or an inactivity fee if you go an extended period of time without trading.
Self-directed investment accounts allow you to tailor your portfolio to your own needs, risk tolerances and investment perspectives. If your decisions are successful, you can earn a strong rate of return over the long term.
Long-term investments like stocks carry the risk of steep and possibly permanent losses. In addition, managing an investment account can be very challenging, requiring experience, skill and frequent attention.
Finally, fees and commissions may vary, so it's important to choose a broker whose charges will be cost-effective given your investment approach.
4. Actively managed investment accounts
These are accounts that can use a range of investments like stocks and bonds that are managed by an investment professional. Actively managed portfolios may be available within mutual funds for investors with relatively small portfolios (under $100,000) or within separate accounts for investors with more money.
Using a professional manager is often seen as a way of trying to beat the market, but it has other purposes as well. It can be used to try to maintain a portfolio within a certain risk tolerance. It can also simply be a way of relieving the account's owner of the responsibility to manage it.
Managers of active accounts can generally point to some academic and professional credentials that demonstrate their qualifications, and to a track record to show how well their investments have done in the past. These accounts usually charge a fee that is calculated as a percentage of the amount of money under management.
For people who don't have the time, qualifications or resources to manage a portfolio themselves, an actively managed account can put professional expertise to work for them. Often investment managers employ teams of professionals who can research and monitor investments more thoroughly than any one person could.
Professional expertise does not guarantee that a manager's decisions will be successful. Also, management teams can change over time. The track records of professional managers vary widely and, in many cases, may under-perform the market and/or lose money. In particular, it is difficult for an active manager to add enough value for a client to make up for the fee.
5. Index funds
Index funds are for people who want to participate in long-term investments without the risk of making active decisions. Index funds are designed to imitate a particular segment of the market. For example, an S&P 500 index fund is likely to have the same holdings that are in the S&P 500 and in the same proportions as in the index.
Index funds aim to keep their holdings as close as possible to the make-up of the index they are designed to imitate. Since the purpose of these funds is not to beat that index but to mimic it, a key characteristic of index funds is called tracking error. This is the amount by which the performance of the account differs from the performance of the target index.
Note that since the indexes themselves can lose value, simply eliminating active investment decisions does not mean that you will not lose money.
Since beating the market can be difficult, index funds offer the opportunity to make sure that you stick fairly closely to the market's performance. They generally offer broad diversification and, because they are not actively managed, their fees are usually well below those of actively managed accounts.
Since index funds are not actively managed, they leave one key choice up to the client: Which index or indexes do you want to imitate? There are a great many different indexes from which to choose, representing different asset classes and market segments. If you choose to follow an index that performs poorly, there is nothing to prevent your account from performing poorly as well.
6. Balanced funds
Long-term investors generally own a mix of stocks and bonds. You could make each type of investment separately by investing in different stock and bond funds or portfolios, or you could seek an approach that combines both stocks and bonds in what is known as a balanced portfolio.
The name "balanced" may seem to imply a 50/50 mix of both stocks and bonds, but that is not always the case. The term "balanced" is often used to describe any mix of different asset classes.
This means balanced funds come in a variety of different asset mixes. That allows you to choose one with a risk profile that makes you comfortable. 401(k) plans often employ target date funds in which the asset mix is geared toward a planned retirement date.
Balanced funds can provide the opportunity to take a "one-stop shopping" approach to investing by getting stocks and bonds all in one fund or investment portfolio. Since asset allocation is one of the most important investment decisions you can make, one of the advantages of balanced funds is the fact that the allocation is professionally coordinated.
Investment managers often specialize in a particular asset class, so any one fund or portfolio manager may not necessarily be equally good at managing both stocks and bonds.
7. Robo advisors
Rather than relying on your own abilities or that of an investment professional to manage your money, a robo advisor gives you the option to take the human element out of the process.
Robo advisors manage your investments according to complex formulas. They are also able to efficiently maintain your portfolio as market conditions change.
Because this is an automated approach to investing, robo advisors can also help reduce the cost of investment management.
Robo advisors can represent a lower-cost alternative to traditional investment management. They can also eliminate some of the potential mistakes that can result in poor investment performance.
An automated approach is only as good as the formulas on which it is based, so even robo advisors rely somewhat on human decision-making.
Also, robo advisors typically center around owning a broadly representative group of stocks or other securities. Like any indexed approach, it does not even try to do better even when financial markets are performing poorly.
Some or all of the above investment approaches are likely to be available both for your personal investments and on a 401(k) plan menu. Knowing the strengths and weaknesses of these approaches can help you make better investment decisions.