There are thousands of investment products in the market today. They range from the ultra safe to the very risky, and are designed to meet the needs of different types of investors. Most people understand the different risk profiles of each type of investment, but there are a few types of investments which are often misunderstood. Investors tend to think that these investments are rock-solid safe, when in fact they are not. Here are the 3 most misunderstood investment instruments:

1. Structured Notes. These are usually issued (created) by investment banks and sold to individual investors. They are sometimes marketed as an investment similar to a bond, but with a higher yield. For example, they may promise a coupon payment every 6 months, and the return of your principal capital after a few years. This makes them very similar to bonds and many investors tend to think that they are both the same thing. The advertisements for these structured notes sometimes focus on the high yields that they provide, and this makes some investors think that they are like savings deposits or term-deposits, and hence just as safe.

This is a misconception. Structured notes are actually a bet on an underlying stock index or some other set of events. For example, a structured noted may be designed to return you the high yields advertised, but only if the S&P index and the Dow Jones Industrial Averages do not drop by more than 30% over the next 3 years. If the indexes do drop by more than 30% over the time period, then you may lose all of your money. The sales people selling these structured notes may play-down these clauses, or may suggest that these events are unlikely to happen. Be careful when this happens. You need to understand the structure of the note thoroughly; remember you are making a bet, and you want to be sure to understand what it is you are betting on. The details will be in the prospectus that accompanies the note. They tend to be hundreds of pages long, and very tedious to read. But I recommend taking the time to understand it if you are planning to invest your hard earned savings in it.

2. Money market fund. These are very commonly marketed by banks and brokerages. If you have a brokerage account, chances are any money in the account is being automaticaly put into a money market fund for you.

Many people have the impression that money market funds are like savings accounts. Unfortunately this is not true. Money market funds are actually mutual funds that invest in bonds that are about to mature. So technically they can lose value if the company debt that they invested in defaults.

The interesting thing about Money Market funds is that financial companies use a very unique marketing strategy to sell them to investors. Each Money Market fund unit is often priced at $1, and most financial companies will do everything possible (including making good on losses that the fund has incurred using their own money) to make sure that the money market fund unit never drops below $1. This is what gives most investors the impression that money market funds are capital protected, and as safe as government insured savings accounts. But don't count on this $1 price being maintained if the fund made some bad investments and the financial company/bank/brokerage managing the fund is facing bankruptcy. The company simply won't have money to compensate investors for any losses made due to bad investing decisions.

Note that money market accounts (also known as money market deposit accounts) are a different thing entirely. Money market accounts are actually savings accounts, and are guaranteed by the government up to the usual government limits.

3. Bonds. Company bonds (also known as corporate bonds) are often seen as safe investments because they "guarantee" regular coupon payments, and the return of all you capital when the bond matures. What most people forget is that these payments are only guaranteed if the company doesn't get into financial trouble. So when you invest in a company bond, you are making a bet that the company will continue to be well managed and that the company's business will do well. What most people don't realize is that by investing in a company's bond, you are lending the company money. The repayment structure of the bond (e.g. coupon payments) are simply the agreement of how the company is going to pay you back your money over time.

Certain bonds are safer than others. For example, municipal bonds and government bonds tend to be safer because cities and countries usually don't go broke. A city can always raise its taxes and municipal fees to cover its bond payments. Likewise, government can raise taxes to cover their debt payments. There are always exceptions to the rule; for example the government of Argentina defaulted (i.e. stopped paying back the bond owners) on over 93 billion dollars worth of its bonds in 2001/2002.

Company bonds are generally given a credit rating that denotes how likely it is that the company will default on its payment (i.e. not pay its bond holders). These credit ratings have indicators like AAA/Aaa or BBB/Baa1 (these ratings are given by professional ratings agencies, and each agency uses a different rating scale). It is a misconception that investing in AAA rated bonds means that your savings are completely safe. What an AAA rating simply means is that the ratings agency thinks that the probability of default is low. For example, out of 1000 bonds that the agency gives an AAA rating, statistically speaking, only 1 will default in any year. While this is like a low probability, imagine if you had all your life savings in the 1 AAA rated bond that defaulted. In this case, you would have lost your life savings.

The only truly safe investment: The only investment that is really safe is a government insured savings account. It's not very exciting, and financial advisers don't make any money by recommending it. But it is the only really safe investment, as long as the government doesn't become communist or decide to freeze everyone's bank accounts. But you should be aware that governments usually only guarantee a certain amount of money in each bank account. For example, a government may only guarantee the first $100,000 in savings for a depositor in a particular bank. So if you had $200,000 to save, you might consider opening accounts with two banks and putting $100,000 into each (be sure its two different banks, not just two different branches of the same bank)

Article Copyright © 2008: Wei L. Wang