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We all prefer more money to less. It affords opportunities and alternatives, which will improve our quality of life. This is why we invest.
Investing is deferring current spending and putting those funds to work in order to earn a return over time to meet an objective. Essentially, investing is the use of money in hopes of making more money, which you will then use at a later date.
Investment objectives could be: funding an education, starting a business, purchasing a residence, retirement from work, or just additional financial security. However, there are always some risks associated with investing. There are no guarantees that your investment goals will be achieved or even that your initial investment will not lose money.
The key to investing is reconciling your objectives and/or return expectations with the risks associated with current opportunities. Remember that you have committed your money to something with the expectation that it will grow in the future. However, the future is always uncertain and your investment may provide results that are much different that anticipated. They could be much better or far worse.
Therefore it is critically important that you have some understanding of your objectives as an investor as well as the current risks and return opportunities. Training is key for the new investor. Novice investors often have difficulties getting started due to limited resources and/or lack of expertise. However, its possible to start an investment program with modest amounts of money and self-study on some basic concepts. The discipline to set aside some investment funds is the first step for the novice investor.
Training is key for the new investor as well. An understanding of investment planning and the inherent risk / return relationship in markets will be of life long value. The payoff from investment education can yield several thousands of dollars over the years, yet it costs relatively little in today's information age. Remember that no one will look after your financial interests with as much devotion as you will. Also, all investing involves committing funds for a future return and involves risks. Therefore, training efforts should include a strong focus on understanding the various risks associated with investing.
Growing your investment and/or meeting objectives requires achieving a return on your funds over time. A return is the amount of growth or income achieved over a specific time period. Time is a key variable for the investor. The longer that investment funds are committed, the greater the uncertainty or risk exposure. However, greater risk is typically associated with greater return because the investor must be compensated for bearing this uncertainty. Compounding is a key concept that allows investments to grow over time. It is simply earning returns on the returns earned in prior time periods. This is how your money works for you. Returns earned in prior periods are added to your initial investment such that you have more funds earning going forward. A simple example illustrates this point.
Joe invests $100 for a 10-year period that will pay him 10% per year. He does not withdraw any funds and allows his returns to compound. Simple arithmetic return calculations would only allow him to earn $10 per year (10%) or $100 for the 10-year period. This would leave him with $200 for the entire period-- his initial $100 investment plus $100 in investment earnings. However, since Joe let his investment compound over time he now has $59 more or $259. Compounding is what enables this greater return. The 10% annual rate is applied to a continually growing capital base. There are more dollars each earning 10 cents each. Compounding is a powerful concept which increases is strength the longer and more frequently it is applied.
Simple interest differs from compounding in that it does not allow for interest earned to be added to the original investment. There is no opportunity to earn interest on interest from prior periods. The simple interest rate is always applied to the same principal. Compounding offers the investor a large advantage in that returns earned are continually applied to the principal. This allows earning interest on interest.
A key aspect of compounding is how frequently it is applied. The more often a return is compounded the better it is for the investor. This allows the compounding advantage to be applied more often. For example an investment that pays 4% compounded quarterly has an annual percentage rate (APR) of 17% or 1% more than the 16% simple interest derived from 4 quarterly 4% payment.
Investors derive returns over time from two primary sources, capital gains and income.
Capital gains result when an asset is sold at a higher value than purchase. The gains component provides the investor with a few advantages such as more control and greater return opportunities. The investor controls when returns are realized through a sale and therefore the timing and treatment of any tax liability. (Capital gains on investments currently enjoy preferential tax treatment.) Investments that are more oriented toward capital gains and longer-term growth are typically associated with higher expected returns. However, these assets, such as stocks, also have greater risks.
Income oriented investments pay investors periodically over time. These payments usually occur at specific pre-determined intervals. The investor does not control this return component but does enjoy the stability of regular payments. (Income payments are taxed in the year they are received.) Income oriented investments, such as bonds, tend to be associated with lower risks and returns.
Many investments have both capital gains and income components. However, their orientation can vary greatly. Appropriateness and suitability of any investment is largely dependent on the risk tolerance and the specific circumstances of the investor. Investors should also realize that investment earnings, both capital gains and income, have tax consequences. However, there are currently preferential tax treatments on long-term capital gains and qualifying dividend income. The current tax code allows these investment earnings to be taxed at lower rates, which enhances the total net return realized. Capital gains earned over more than one year qualify for long-term treatment of only a 15% maximum tax rate.
Qualified dividends are those paid by US corporations or those traded on a US stock exchange. Certain foreign companies in US territories or those eligible for US tax treaty benefits also qualify. Additionally, investors must also own the dividend paying security for more than 60 of the 120 days surrounding the company's declaration date.
Investing is a very large and complex discipline if you let it be. This prompts many new investors to miss excellent opportunities out of fear. However, investing is ultimately quite logical and those who spend the time to understand some basic concepts are rewarded. Any fears can be overcome through education, planning and diligent research. While all investing does involve some risk, if properly assessed and understood, these risks can become opportunities for a patient investor.
One of the first key concepts for new investors to understand is the risk and return relationship.
There are several types of risks that affect investment results.
Systematic or market risk is that which is associated with the entire market or asset class. All marketable securities (e.g. stocks, bonds, funds, etc.) are subject to market risk. It's driven by large macro variables such as the broad economy or political climate and therefore cannot be eliminated. However, investors can mitigate market risk somewhat by investing in different classes of securities because of the differing impacts of the various systemic factors. For example, inflation is a system wide variable, which affects both stocks and bonds. However, the impact on the bond market is typically greater due to the fixed payment nature of bonds.
Unsystematic risk only applies to a specific security or groups of securities. Every company is subject to risks that are fairly unique to: its own business, its industry, and its economic sector.
This risk can be reduced and managed through diversification. Diversification is allocating funds across different investments that are not subject to the same risk factors. For example, the factors which affect the risk / return characteristics of a software stock are often much different than those affecting a bank. These differing risk exposures drive divergent return patterns. Divergent return patterns are said to have lower correlations.
The greater the difference between these assets, or the lower the correlation, the greater the diversification benefit when combined. A broadly diversified portfolio with several securities has far less unsystematic risk. Company, industry, and sector allocations are spread across several securities. The diversification benefits diminish as more and more securities are added. Taken to the extreme, the investor would have a market portfolio with only systematic risk.
Investors are faced with countless individual investment opportunities. However, each investment can be broadly grouped into a few categories called asset classes. Each asset class is comprised of investments with similar structural and risk/return characteristics.
The most common asset classes are equity (stocks), fixed income (bonds) and cash. These securities are generally the most liquid in that they can be sold and converted to spending currency quickly and efficiently. Less liquid investments such as real estate and hedge funds are typically grouped into an asset class called alternatives.
Equity investments such as stocks represent fractional ownership in a company. As owners, investors participate in the profits and losses of the company and can affect major decisions regarding its management and strategic direction. Equity ownership of successful companies is highly valued in the marketplace over time. However, it also has higher levels of risk. On a longer-term basis, returns on equities have historically been much higher but more variable than other asset classes.
Fixed income investments such as bonds represent a lender / borrower or creditor relationship. Investors lend money in order to receive periodic interest payments over time and their original investment at a specific maturity date. Fixed income investments are typically contractually binding arrangements whereby the borrower must meet its obligations to pay investors for the use of their funds. The fixed payment nature of the structure typically results in lower returns and lower variability. While there are no guarantees that the borrower (bond issuer) will meet its obligations, bond defaults are fairly rare historically. Most bonds are issued by established corporations or government entities such as the US Treasury.
Cash investments are considered the safest asset class. They have a similar structure to bonds but are very short-term. The highly short-term nature of these instruments increases liquidity and lowers risk and return variability considerably. Given this low risk profile, returns on cash equivalent investments have lagged other asset classes over time.
US Treasury bills are considered a good proxy for this asset class. Other investments would include bank CDs and other short-term loan arrangements. Many investors participate in this asset class through a money market fund, which is a portfolio of similar instruments.
Some investors consider international investments to be an additional asset class. These investments are subject to different systematic risks because they reside in outside economic and political systems. Although the correlation between global markets has increased in recent years, foreign investments can still provide diversification benefits. Additionally, international investing affords opportunities for direct participation in the world's fastest growing economies. This rapid economic growth has provided some excellent returns in recent years. However, they can introduce the additional risks of participating in more volatile governments, economies and currencies. Allocation among these major asset classes is among the most important decisions that investors face. The extent to which stocks, bonds, and cash are represented has tremendous implications on the overall risk/return for the portfolio. A basic understanding of the asset classes helps the investor construct an appropriate and suitable portfolio that has a good chance of achieving investment objectives.
Beginning investors should also strongly consider developing a formal investment plan. The plan seeks to define objectives and constraints and to reconcile them with personal risk tolerance. Devising an appropriate investment policy and asset allocation involves profiling your current financial situation and risk aversion. A careful review of factors such as time horizon, tax situation, liquidity needs and growth objective is required.
There are several questionnaires, such as the one attached, which can be quite helpful to investors considering asset allocation decisions.
Well above average (points 25 - 29? 100% Equity?) - Responses to the risk tolerance questionnaire indicated a well above average risk tolerance. Your current circumstances suggest a several-year investment horizon, which allows your investment portfolio to ride out market fluctuations and fully capitalize on compounding over time. Additionally, current disposable income and overall wealth affords significant flexibility in your financial situation. Long-term investors with a good resource base and a constructive attitude toward risk should strongly consider equities. A diversified equity portfolio, including international exposure, would be appropriate. A combination of investment vehicles such as individual stocks, ETFs and mutual funds has historically provided good long-term returns at reasonable levels of risk.
Above average (points 20 - 24? -75% Equity 25% Fixed Income?) - Responses to the risk tolerance questionnaire indicated an above average risk tolerance. Your current circumstances suggest a multi-year investment horizon such that your investment portfolio can weather most market corrections fairly well. You likely have enough income and other wealth to keep portfolio withdrawals low and capitalize on compounding. Investors in this group also typically view risk fairly constructively. An investment portfolio that combines a strong equity bias with a small fixed income allocation is appropriate. The equities would provide good long-term return potential while the fixed instruments provide some shield to volatility and diversification benefits.
Moderate (points 15-19? - 50% Equity 50% Fixed Income?) - Responses to the risk tolerance questionnaire indicated a moderate risk tolerance. Your current circumstances and/or views toward market risks suggest a balanced approach would be most appropriate. Historically, an even mix of diversified equity and fixed income investments has provided competitive absolute returns over the long pull while mitigating losses from difficult markets. Inasmuch as income, financial flexibility and time horizon may be somewhat limiting, it’s important that downside risks be managed.
Below Average (points 10 -14? - 25% Equity 75% Fixed Income?) - Responses to the risk tolerance questionnaire indicated a below average risk tolerance. It's likely that these investors have a shorter time horizon, which diminishes the compounding effect and the likelihood of a healthy recovery from declining markets. Financial wealth and near term income prospects may be limiting factors too. Additionally, investment risks are probably viewed with caution. Higher quality fixed income investments would be a most appropriate choice for the majority of the portfolio. Although longer-term potential is relatively lower, the safety and income characteristics of bonds need to drive the allocation in this instance. However, equities do provide an important supporting role in terms of diversification benefits and inflation protection.
Well Below Average (points 10 or less? - 100% Fixed Income?) - Responses to the risk tolerance questionnaire indicated a well below average risk tolerance. Typically these investors have a very short time horizon and an extremely guarded attitude. Additionally, income factors and limited financial flexibility could make portfolio market losses devastating. A high quality and diversified portfolio of bond funds and / or fixed income vehicles is suitable. Investors should also consider the maturity of these investments in order to manage risks associated with changing interest rates.
Channel Overview - There are several ways that an investor can implement their asset allocation strategy and put their investment plan into action. Each approach has its advantages and disadvantages. These largely relate to the tradeoff between fees and investor service. Investors should carefully consider their ability and willingness to be involved in the construction and ongoing management of their portfolio. On Your Own.
DIY approach - This is a very good approach for investors who are just starting out and those that want to keep expenses low. Many are already participating in the markets through their self-directed fund selections within their 401(k) plan. Adding additional (post tax) investments to form a total portfolio is a natural progression. However, investors should remember to consider diversification of asset classes, funds and tax treatment in considering their total portfolio.Investors can work independently by contacting mutual fund companies directly. There are many fund companies that offer several choices within all asset classes. It is very easy to purchase, sell or switch between offerings. While this approach can be very cost efficient, investors should realize that service and reporting would be less. Equity investors can also work directly with specific companies that offer dividend reinvestment plans. This allows investors to own shares in a specific company (e.g. AT&T, IBM, DuPont, etc.) without having to utilize a broker. Purchases and sales are done directly through the company, making it quite cost effective.
Independent Advisor - Many investors favor working with advisory firms because they offer customized service and unbiased advise. Advisors often partner with discount brokerage firms and offer access to a wide range of potential investments and good liquidity. These firms are independent practitioners who tend to charge higher fees in exchange for their advice and council. This is a good option for those investors seeking a higher level of service in implementing their investment strategy and the objectivity of an independent firm.
Discount Brokerage Firms - Investors gain several advantages from discount brokerage firms. They offer competitive fees while allowing access to countless alternatives within each asset class. Trades enjoy excellent liquidity in terms of price and execution. These firms also have substantial technology infrastructure that help contain their costs. On line investors have several tools at their disposal in order to monitor their holdings, research investment ideas and follow the markets. This is a “hands on” approach whereby investors largely control not only the formulation of their investment plan, but also its execution and ongoing monitoring. However, discount brokers do have some resources dedicated to client service and guidance.
Full Service - The key distinctions between a full service firm versus a discount are services and fees. Full service firms typically offer a dedicated representative (broker) to investors. The broker works closely with the client investor in formulating and executing a tailored investment strategy. The rep can help interpret performance in the correct context, access considerable resources and provide guidance on related matters like taxes. Additionally, they can avail additional investments that may broaden opportunities such as new companies or specific funds. Full service firms offer all this in addition to broad investment access, liquidity and on line technology. However, the higher level of service does result in higher fees to the investor. Working with a full service firm can be a good approach for those who lack the time, confidence or expertise to invest on their own.