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Understanding Investments

Updated on September 8, 2009

Investment is the process of converting accumulated savings into productive use. Wise investment of personal savings necessitates a clear understanding of objectives, because choices that fulfill some needs may fail completely to satisfy others. Every investment outlet can be viewed as a package offering a unique combination, over a period of time, of: (1) principal value, (2) expected income, (3) ease of converting principal into cash, and (4) tax consequences. Each outlet has a greater or lesser degree of uncertainty associated with each factor. After weighing his willingness to assume the associated risks, a conscientious investor will select the outlet or combination of outlets that best satisfy his needs.

Investment Objectives

A major concern of all individuals, at least for a portion of their funds, is safety of principal plus assurance of liquidity (conversion into cash quickly and easily) at no loss in value. Savings in this category are usually kept for emergencies. Such savings could be held in small bills hidden under the mattress or in a bank checking account, but most individuals choose a savings account for a modest return at no significant loss of safety or liquidity.

Many persons, including widows and the retired, will want their invested funds to provide high and stable current income, either to live on or to augment other income. High-grade bonds with fairly long maturities offer stable and relatively high current income plus reasonable assurance of ultimate principal recovery.

Individuals for whom neither liquidity nor current income is important frequently seek long-run appreciation (increase in market value), either by reinvesting income each year or by acquiring ownership in a. prospering business venture. The latter position, usually achieved through purchase of common stock, involves a degree of risk normally greater than that incurred on investments promising return of fixed principal at maturity.

Investors with long-term goals will also be concerned with preserving the purchasing power of their funds. The sum of $100 placed under the mattress in 1945 for anticipated retirement would have lost, by 1970, half of its original purchasing power. To protect against such erosion of value, investors must select outlets expected to grow in monetary terms as the value of the dollar diminishes. Common stocks and real estate are the most frequently cited examples.

Direct Investments

An individual may invest directly, or he may give his money to a financial institution to invest in his behalf. Direct investment outlets available to most individuals consist of stock shares, bonds, and real estate. Other direct alternatives include personal loans to acquaintances (or relatives) and investing in one's own business.

Common Stock

A holder of common stock owns a fractional equity in a corporation. If he holds 100 shares of a firm having 25 million shares outstanding, he owns 1/250,000th of the firm. As a stockholder he receives a certificate and his pro-rata share of any dividends declared by the directors. He may vote for directors. He cannot recover his principal from the corporation (except that, in the rare case that the corporation is liquidated, he will receive his pro-rata share of any liquidation proceeds remaining after all debts and other prior claims have been paid in full). But he may transfer his shares to any other investor at a mutually agreeable price. The stock market provides the mechanism for buying and selling shares of stock.

Because earnings and dividends to shareholders may grow or diminish (or disappear), depending on the economic fortunes of the firm, the market value of common stock depends on expectations for the future of the company as well as on investor attitudes toward the stock market in general.

Corporate Bonds

Corporate bondholders own a promise (in certificate form) by a corporation to return the bondholders' principal (usually $1,000 per bond) at a specific maturity date; and, in addition, to pay (usually every 6 months) a specific amount of interest. Failure to make these payments will lead to bankruptcy, so the probability is strong that the corporation will make all payments as long as it is able.

A bond investor wishing to liquidate his investment before maturity must sell in the open market. Promise of ultimate repayment adds an element of stability to bond market values; however, if interest rates paid on new bond offerings rise, market prices of already outstanding bonds will drop. Falling interest rates will force market prices on outstanding bonds to rise. Fluctuations in market price will be greater for bonds having longer remaining lifetimes, so investors concerned with possible early liquidation usually select short, maturities.

Preferred Stock

Preferred stock represents legal ownership but has investment characteristics similar to debt securities. A preferred stockholder accepts a fixed and limited dividend rate in return for a guarantee that he will receive his dividends (including unpaid dividends from previous years) before common stockholders can receive any dividends. Preferred stock has no maturity, so holdings must be liquidated by sale on the open market.

Government Bonds

The U.S. government, the states, and municipalities issue bonds. Federal bonds are generally considered as having the least risk of default of any security. They are available (1) in a marketable form that may be sold at any time to another investor and (2) as savings bonds that can be liquidated prior to maturity only by redemption at predetermined prices that reduce the yield.

Bonds issued by states and municipalities are of three types: General obligation bonds are secured by the full, faith and credit pledge of a governmental unit that may levy taxes to pay for the bonds. Revenue bonds are paid with proceeds from specific revenue-producing projects, such as toll roads. 'Assessment bonds' are payable from assessments levied against property owners who benefited from the issue.

Interest on state and municipal bonds is exempt from federal income taxes; federal bonds are fully taxable.

Real Estate

The most common single investment of families is in ownership of a home, which combines investment with fulfillment of personal needs. Individuals also invest in rental property, farmland, vacant land for speculative appreciation, and mortgages. Direct ownership of property is similar to ownership of common stocks, for the investor has an equity that will produce more or less income or appreciation depending upon economic conditions. Real estate investments are generally less liquid than common stocks, and conversion of even an excellent piece of property into cash may take months. On the other hand, well-chosen real estate is highly regarded as a hedge against inflation.

Institutional Investment

Because direct investment requires analytical ability and time, many investors turn the selection process over to a financial institution. Institutional investment in common stocks can be obtained by purchasing shares of an investment company. Many pension funds own common stocks, as do some life insurance companies offering variable annuities.

'Investment clubs' are non-professional investment intermediaries, formed by perhaps a dozen individuals who pool their savings to invest together and gain, at the same time, knowledge and experience in investment decision making. Individual members study and report on specific securities, and the membership votes on stocks to be purchased. Each member owns a share of the club's portfolio.

'Savings institutions' provide fixed-income, guaranteed principal outlets for savings. A savings deposit at a commercial bank guarantees return of principal at any time and pays a stated rate of interest. Savings accounts may also be opened at savings and loan associations, which make long-term loans to home buyers; at mutual savings banks, which invest in mortgages, corporate bonds, and government bonds; and in credit unions, which are cooperatives providing personal loans to members. Certain life insurance policies have a built-in savings reserve against which policyholders may borrow. Sums of money may also be invested through personal trust departments of commercial banks, either by creating a new trust or through participating in a common trust fund.

Investment Principles

Through 'diversification', an investor applies the adage "Don't put all your eggs in one basket." Analysis of individual corporate securities is uncertain to a degree, so a diversified portfolio lessens the chance of major loss through a single adverse selection. Individuals who invest through financial institutions share in a diversified portfolio; those who invest directly should combine securities of varying characteristics so that a single economic event is not likely to affect the entire portfolio adversely.

Long-term common stock investors also practice dollar cost averaging, the placing of a fixed dollar sum in a specific stock at regular intervals, regardless of fluctuations in the price of that security. More shares are purchased at low prices than at high, so the resulting average cost per share is less than the average price of the security.

Some investors rely on "fundamentals" in analyzing a security. They make selections after analysis of business and economic conditions affecting the future of the company. Other investors use a "technical approach," relying on trends in stock prices, trading volume, or various other indicators of market behavior. Technicians frequently use charts to identify what they believe to be underlying forces in the market.

Careful anticipation of tax impact is important for many investors. In the United States interest and cash dividends are taxable at regular personal tax rates, but gains from long-term appreciation are taxable only at the time of sale and at the lower capital-gains rate. Persons in high tax brackets often find it more advantageous to select securities for long-run appreciation than to purchase income securities and reinvest the after-tax income. Many individuals in high tax brackets invest in municipal bonds, interest on which is free from federal income tax.

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