Understanding Investment Choices

When learning a new skill, like riding a bicycle or playing golf, it always helps to understand the “tools” and “terms” involved. With a few basics under your belt, you’ll become comfortable enough to essentially teach yourself, making the pursuit both challenging and rewarding.

That is the ultimate aim of this course, to help you help yourself. Understandably, investing and finance have a reputation for being complex and confusing. Take our word for it, much of this reputation simply comes from the thick layer of industry lingo (or some say jargon) that actually is easy to define and understand.

This lesson covers the primary “tools” with which you will employ to reach your goal of sound investing. Once you become comfortable with these “tools” and understand what each can accomplish – and what they cannot – you will begin an exciting journey toward financial security.

As with most journeys, you will encounter some twists, turns, and detours. With your newfound knowledge, however, you should navigate successfully during both sunny and pleasant periods and during stormy conditions. Enjoy your trip!

Bank and Credit Union Products

Most everyone has opened a savings account at the bank. If that includes you, congratulations, you are an investor! You probably already know the drill: the bank provides a safe place to store your money, and for the privilege of housing your hard-earned money, the bank awards you a small interest rate.

In addition to savings accounts, banks typically offer two other products Certificates of Deposit (CDs) and Money Market Accounts (MMAs). Here is a breakdown of all three:

Savings Accounts: These accounts come in a variety of options. Your typical options will allow you to choose:

Interest rate
Frequency of interest (earnings) posting periods
Different minimum balance accounts that pay higher interest rates if you maintain the minimum amount on deposit
Certificates of Deposit (CDs): You agree to deposit a specific amount of money for a fixed period of time. In return, your financial institution agrees to pay you interest (usually higher than regular savings accounts) over this period. You will have limited opportunities to access these funds so use this investment to earn more interest on money you don’t anticipate needing until after your CD matures.

Should you need some or all of your money in CDs, you can withdraw it. But, you will pay a substantial penalty, often forfeiting all the interest you have earned since you purchased the CD.

Money Market Accounts (MMAs): These accounts are basically a combination of a classic savings account and a CD. Some typical features include:

Higher interest rate than classic savings accounts
No maturity date as with a CD
A minimum balance that must be maintained (e.g., $2,500)
Limited withdrawals each month (typically up to six transactions per month)
MMAs can be confusing because some investment firms also offer MMAs. Though, there is a real difference between the two. Essentially, banks are very safe places to put your money. Savings accounts, CDs, and bank MMAs all have federal insurance protections, currently up to $250,000 per depositor. Investment firm MMAs do not have that protection. In fact, investment firm MMAs are typically short-term investments in one or more mutual funds that may or may not generate positive earnings (mutual funds are covered later in the lesson).

The bottom line here is that when you have one of these savings accounts, you are really “loaning” your financial institution your money. In return, the bank or credit union pays you interest for making these loans. Unlike most loans, however, you are usually guaranteed repayment; even if your institution fails. In case of the bank’s failure, the free federal insurance covers the loss.

The relative low risk involved in these investments means the interest rates (or your “return”) are low. This is an important principal in investing: the lower the risk, the lower the potential reward, and vice versa.

Stocks

Though most think of New York’s famed Wall Street as the stock center, stocks are bought and sold constantly around the globe. Stocks are “equity investments.” Having even one share of a company’s stock means you are an owner. For example, if you own one share of stock in a company that has 1,000,000 shares that are “issued and outstanding,” you own a piece (albeit a small sliver) of that company.

As you are probably aware, the prices and values of stocks are volatile. This is where the risk comes in. Some stocks can change in value dramatically, for either better or for worse. In addition, there is no federal insurance protecting your investments.

That said, people do make a living buying and selling stocks (sometimes, a great living), while others care to just dabble and tinker. The difference between the pros and Joes really comes down to time spent researching companies and trends and amount of money invested. Otherwise, all investors are essentially in the same boat, buying and selling the same stocks in the same markets.

Simple stocks are not all. There are a few other choices out there for the investor:

Mutual Funds: This is an open-ended fund assembled by an investment firm that contains a group of stocks (or other assets). The firm uses shareholder monies to purchase assets for the fund. Gains, losses, and earnings are mutually shared with investors in proportion to the size of their investment.

Since one of the primary rules of investment is to diversify portfolios, a mutual fund can be a simple and successful way to accomplish this goal. With one investment, you might own slivers of stock of many corporations.

ETFs (Exchange-Traded Funds): At first glance, ETFs appear very similar to Mutual Funds, in that one investment purchases a group of stocks. However, there are differences of which you should be aware. Unlike Mutual Funds, ETF shares can be traded any time the host stock market is open for transactions. This ability to react quickly comes at a price. Making these trades usually incurs a broker fee. Therefore, larger trades are more cost efficient.

ETFs are also often tied to an index, which make them exchange-traded index funds. These ETFs are a bit less diversified as they concentrate their stocks on a particular asset type, region, or other recognizable index. For example, many ETFs try to mirror the composition of the Standard & Poor (S&P) 500 or 600, using their performance as an index.

Stocks can be risky business. As an investor, there is no sure-fire way to eliminate that risk. Though, you can put yourself in the best position possible to succeed by researching the market, indexes, and companies carefully before you invest, and also diversifying your portfolio. The old adage holds true, don’t put all your eggs in one basket.

Bonds

There are three common types of bond available for general sale. They offer different levels of security and projected earnings.

Corporate Bonds: Unlike stocks, which are equity instruments, bonds are debt instruments. Think of it like this, by buying a corporate bond, you are loaning your money to a company (kind of like a bank savings account). Bonds have a stated earnings rate and will provide a regular cash flow, in the form of coupon payments, to bondholders. This cash flow contributes to the value and price of the bond and affects the true yield (earnings rate) bondholders receive. There are no such promises associated with common stock ownership.

These bonds can be quite secure or sometimes risky. Their inherent value is greatly determined by the credit worthiness of the corporation offering the bonds. Of course, corporate stability can change over time. For example, until 2009, most bonds offered by U.S. automakers implied good levels of security. However, the bankruptcies of GM and Chrysler, combined with serious financial problems at Ford, generated much higher risk factors for their corporate bonds. Typically, however, corporate bonds are more secure than corporate stocks.

Understand the difference between your coupon payments and the true yield of a bond. For example, assume you purchase a corporate bond at a price higher than face value. Coupon payments are fixed and related only to a bond’s face value. Therefore, your yield will be lower than if you purchased it at face value. Conversely, should you purchase a bond at less than face value, your yield increases.

Treasuries: U.S. Treasuries carry the full faith and credit of the federal government. Once again, you are loaning your money to the government. Because the government is relatively stable, purchasing Treasuries eliminates much of the risk associated with most investments. As you can imagine, in return for this minimized risk, your earnings rate will also be less than with most of the more “exotic” investment choices.

Treasuries, particularly the 3-month Treasury bill, are sometimes quoted as the “risk-free rate of return,” the minimum rate of return an informed investor will accept for enjoying the minimum risk. In the real world, there is no true risk-free investment, although Treasuries do come close.

You should also understand the meaning of a “yield curve.” Usually displayed graphically, a yield curve is the relationship between the interest rate offered and the time to maturity of an investment. While all investments have a yield curve, many traders and economists closely follow the yield curve of Treasuries of different maturities to help make other financial decisions and projections.

Municipal Bonds: States, cities, or other local governments often issue bonds to raise money to fund services or infrastructure projects (road and bridge repair, sewers, purchasing open land, etc.). The primary advantages to investors are security and tax benefits. For example, most municipal bonds offer interest earnings that are exempt from federal taxes. In addition, if you are a resident of the state in which you own one or more municipal bonds issued by local governments, your earnings may also be exempt from state or local taxes.

Sounds like a great investment, right? But do be careful. Some local governments may be in dire financial condition and your risk factor may outweigh any tax benefits you enjoy.

Gold and Other Precious Metals

Just as during the San Francisco gold rush, precious metals, particularly gold and sometimes silver, are attractive investments to many people. Though, instead of mining and sifting river beds, successfully investing in gold and other precious metals necessitates much research. Precious metals can fluctuate in value as rapidly as common stocks. From a real world prospective, investing in gold or other precious metals has some unique advantages. Here’s the rundown:

Coins and bars: If you enjoy a high degree of “tangibility,” accumulating coins or gold bars should satisfy that craving.
Certificates: If you’d rather not have your spare bedroom filled with gold bars, choose certificates that indicate your ownership in specified amounts of precious metals.
Precious metal mutual funds: If you’d like to spread your risk over several precious metals, you might like this option.
Stocks directly in mining corporations: Get right to the source of your favorite precious metals if you wish.
Precious metal futures: This is often the most “exciting” (and risky) option as you would gamble a bit on what gold or other precious metals will be valued in the future.
Investing in precious metals may or may not result in high returns. You may think that gold is always valuable; at least the jewelry isn’t getting any cheaper. However, the question an investor faces is whether it is currently more or less valuable than what the investor paid for it.

FX, Currency Speculation, and Hedging

FX (foreign exchange), currency speculation, and hedging are variations of the same basic investment strategy. Not for the faint-hearted, these investments involve more due diligence and savvy than many other options.

For example, should you decide to become a foreign exchange investor, you are really making two investments at the same time. You will buy one or more foreign stocks, which are basically the same as domestic stocks, and you are also investing in a foreign currency, which you hope will be profitable when compared to the U.S. or Canadian dollar during your period of ownership.

Currency speculation and hedging (usually through hedge funds) are similar. You invest in foreign currency believing (sometimes just hoping) that the exchange rate against the dollar becomes more favorable – and profitable over time.

For a very simplified example, let’s say 1 US Dollar is currently equal to 1 Euro. You think the Euro will be stronger in the future, so you convert your 1 US Dollar into 1 Euro. A few months down the line, you are right, the Euro strengthens, and 1 Euro is now equal to 1.5 US Dollars. By converting your Euro back into Dollars, you effectively turned 1 US Dollar into 1.5 US Dollars.

Most advisors would agree that this area is consistently one of the most “exciting” options for investors… and by “exciting,” they mean risky!

Real Estate

Buying and selling real estate as an investment strategy is quite different from simply buying a home or commercial building. Just as important in determining FMV (fair market value) as comparable properties are when buying a home, the income stream generated by a property is a primary component for an investor. You typically have three options if you want to invest in real estate:

Buy specific pieces of residential and commercial property
Invest in mutual funds focused on real estate investments or an REIT (real estate investment trust)
Invest in MBS (mortgage-backed securities) or MBO (mortgage-backed obligations)
In normal or expanding economies, real estate investing can be quite lucrative and relatively safe. In down markets, both the potential rewards decline and the possible risks escalate quickly.

Understand Risk and Investing

As stated above, investing involves risk. The only thing a wise investor can do is prepare himself or herself properly to deal with the risk. This means utilizing all the solid expert data you can find. For example, if gold values typically increase when the real estate market spirals downward, figure this into your investment strategy.

For those just beginning, a good point of reference is the recent performance of the common investments described above. How have they done over the last five years? These charts illustrate their performance over the same time period. When looking at the charts, keep in mind what you read earlier in the lesson and what you’ve heard about the economy in the news.

For example, regarding real estate, you’ll see the price of homes has fallen from 2006 to 2009, in part owing to a bad economy. As we stated: In normal or expanding economies, real estate investing can be quite lucrative and relatively safe. In down markets, both the potential rewards decline and the possible risks escalate quickly.

(see charts in WSSLesson1Addendum.doc)

Remember, there is no risk-free rate of return on investment. The key is to establish the risk, evaluate the potential return in light of this risk, and decide if you are comfortable with it.

Your journey into the investment world has now begun. Enjoy the ride!