Investing 101

Updated: May 19

Where you can invest your money – and why stocks are the best!

For those of you who are wondering where to invest, in this article Stock Wealth Safely provides an overview of the types of investments that are available to an individual investor and the relative risks and benefits of each. A person could potentially invest their money in any of the following broad investment categories: stocks, bonds, cash instruments, commodities, real estate or a small business. We will focus on stocks, as this is the area that we believe will provide the most attractive investment opportunity, but it is good to understand the general principles of the other classes of investments.

Cash instruments include savings accounts, certificates of deposit, or money market accounts. These allow you to put your money securely in one of these instruments with a high degree of certainty that it can be withdrawn at any time with no risk of loss. The major drawback is usually the very low interest rate that is offered for your money. Typically, the longer that you promised to leave your money in a particular area, the higher the interest that you will receive and you will be penalized in the form of receiving last interest if you withdraw your money before that period of time, for example 90 days.

Real estate is another investment option and potentially offers a very high return if the property appreciates in a short time. The risk, of course, is that if the property depreciates there can be considerable losses. Other major drawbacks are that typically a relatively large amount of money is required to invest in real estate and that it is considered to be an illiquid investment in the sense that it can be hard to sell at a reasonable price quickly, if you should need your money for some other reason.

Investing in a small private business, such as a franchise, offers the potential of making a large amount of money if it is successful. However, it is also true that the past majority of new small businesses fail and therefore there is a chance of losing all of your investment. Additionally, will generally take several years for a new business to start making a profit, even if it does turn out to be successful in the long term.

Commodities, such as precious metals (gold and silver), agricultural products or foreign currencies, tend to have prices that fluctuate widely over a relatively short period of time. For this reason, the potential for both a large profit or a large loss is quite high and these investments are considered to be very risky. Most individuals who trade in these areas tend to have extensive knowledge of the specific commodity in which they trade.

Bonds are the category of investment that is most often compared with stocks, and many individuals will have both bonds and stocks in their portfolio. When you purchase a bond, you are making a loan to the company or government that issues that bond. The bond issuer borrows your money for a set period of time (maturity) and pays you back at a specific interest rate. For this reason, bonds are called a fixed income investment as you know exactly how much you will be paid for the loan. The main risk to a bond is the same as that with any loan, which is that the issuer defaults. The risk of default is estimated by a rating agency which will give a particular bond a specific rating. The higher the rating, the lower the risk of default, but also the lower interest rate that will be paid on that bond. The safest bonds are those issued by the federal government and these are termed Treasury bonds (or bills or notes). Treasury bills are offered at different times of maturity such as 90 day, 10 year or 30 year. Municipal bonds are issued by other levels of government. A company can issue a corporate bond when it needs to raise money to expand its business. Corporate bonds have a range of ratings, from the high investment grade which pays a low rate of interest, to the more risky (sometimes called junk bonds) which have a higher rate of default but also pay a higher interest.

Stocks represent a share in the ownership or equity in a public company. Buying a stock, therefore, provides the investor with a “piece” of the company, which is why stocks can be referred to as an equity investment. Companies issue stocks in order to raise money to allow the business to grow. This is called a primary offering. However, most trading of stocks is done by investors trading among themselves in stock exchanges.

Investors can make money from stocks in two ways. The first is when the price of a stock increases. The stock price increases when the earnings of the company increase and therefore the company becomes more valuable. Academic theory states that the value of a stock should represent the discounted value of future cash flows. In practice, this does not occur consistently, and the resulting fluctuation in prices creates an opportunity for both profit and loss. However, it is generally true that over time a company that increases its earnings will see an increase in its stock price. The second way of profiting from stock ownership is when a company pays a dividend to its shareholders. This occurs when the company decides to pay some of its earnings to its shareholders, in appreciation of them having purchased stock in the company. Dividends can be thought of as being somewhat similar to the interest paid from a bond. One important difference, however, is that the bond interest rate is fixed whereas the company can vary the amount of dividend that it pays at any time. It should also be noted that not all companies pay dividends.

Long term studies have shown that stocks yield approximately twice as much on an annual basis as do high quality bonds. Traditionally, this is attributed to the fact that the stock of a price can fluctuate as the earnings of the company go up and down, and therefore stocks are considered to be a riskier investment than bonds. Therefore, the increased yield from stocks is considered to be a risk premium.

There are several ways by which an individual can invest in the stock market, with the most common being shares of individual companies, mutual funds, index funds and exchange traded funds.

Investors who buy individual stocks believe that they can successfully identify companies whose share price will rise in value before the rest of the market, and therefore buy them before the stock value climbs. This approach is potentially the most profitable but requires that the investor can consistently identify the correct stocks to purchase

Mutual funds are a choice for investors who believe that they do not have the time or skill to successfully pick winning stocks. A mutual fund pools money from investors and then invests this in stocks identified by their own money managers. Advantages are the skill of the funds money managers and the ability to partially own a larger number of stocks than an individual could do on their own. A disadvantage is that by definition not all stocks will grow to the same degree and the profits from the winners are diluted by owning those that do not do as well. Mutual funds can be costly as investors pay an annual fee called an expense ratio, regardless of how well the mutual fund performs.

Index funds are a type of mutual fund that passively tracks an index such as the SP 500. Since there no money managers trying to identify the best stocks, index funds cost investors less than actively managed funds.

Exchange traded funds (ETF) are a type of index fund that track a particular indices. ETF’s however, are traded on public exchanges. ETF’s can be quite narrow in scope, tracking stocks in a specific industry or some other characteristic (eg small cap stocks, value stocks etc).

To choose among the above, we will start with the requirement that you are an investor wants an annual return of at least 10% in an investment that is fairly liquid, allowing the easy withdrawal of cash if necessary. These criteria exclude cash instruments and bonds from consideration because of their low yields. Real estate or small business are also not suitable as they are considered to be illiquid investments that will typically tie up relatively large amounts of cash for several years or more.

This leaves commodities and stocks as investments that are both liquid and can provide a rate of return of 10% or more annually.

To choose between them we turn to the matter of risk. While no investment is risk free, different types of investments carry different degrees of risk. One way of assessing risk is the degree of volatility of an asset. Commodity prices are known to fluctuate widely, as the underlying conditions that determine their value vary in an unpredictable manner. Depending on the commodity, these can include weather (for agricultural products), the political conditions in a country (currencies) or the world economy (metals, energy, precious metals) to name a few. No study has ever found that it is possible to predict these macro events with any degree of reliability and therefore rationally predict the future direction of a commodity price. Any individual can get lucky with their choice of a particular commodity but they are as unlikely to repeat this success as they would be to have a prolonged winning streak in Las Vegas. Putting money into commodities, therefore, should be considered more as speculation than as rational investing.

This analysis, therefore, has demonstrated that among competing investment products, stocks clearly provide the best combination of a liquid investment that offers a good annual return and has an acceptable risk profile ie Stock Wealth Safely.

The next step is to determine how to choose the best stocks to purchase. Future articles will discuss in more detail the pro and con aspects of individual stocks, mutual funds, index funds and exchange traded funds and how to determine which might be the most appropriate for you to choose.

The Stock Wealth Safely approach is a good method of creating investor wealth.

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