Module 6
Investments
a. Preparing for an Investment Program
The old saying goes “I’ve been rich and I’ve been poor, and believe me, rich is
better.” While being rich doesn’t guarantee happiness, the creation of wealth does
provide financial security. In addition, the creation of wealth can provide a safety net for
unexpected emergencies. Also, the act of saving and investing money will allow you to
retire on your terms when and where you choose. Regardless of the reason, the creation
of wealth is a worthy goal. And yet, just dreaming of being rich doesn’t make it happen.
By studying the basic investment principles presented in this, along with the information
on stocks, bonds, mutual funds, real estate, and other alternatives in the remaining
investment, you can create an investment plan that is custom-made for you.
For most people, the first step is to establish investment goals. To be useful,
investment goals must be written, specific, and measurable. They must also be tailored to
your particular financial needs. The following questions will help you establish valid
investment goals. Your investment goals are always oriented toward the future. These
same classifications are also useful in planning your investment program. For example,
you may establish a short-term goal of accumulating $2,500 in a savings account over the
next 12 months. You may then use the $2,500 to purchase stocks or mutual funds to help
you obtain your intermediate or long-term investment goals.
From both legal and ethical standpoints, you have an obligation to pay for credit
purchases. Moreover, business firms that extend credit expect you to pay for a product or
service purchased using credit. Serious repercussions occur if you don’t pay for products
or services purchased on credit.
Many individuals regularly spend more than they make. They purchase items on
credit or use the cash advance provision on their credit cards. Then they must make
monthly installment payments and pay finance charges, often over 20 percent. With this
situation, it makes no sense to start an investment program until credit and installment
purchases, along with the accompanying finance charges, are reduced or eliminated. A
good rule of thumb is to limit consumer credit payments to no more than 20 percent of
your net (after tax) income. Eventually, the amount of cash remaining after the bills are
paid will increase and can be used to start a savings program or finance investments.
Before starting an investment program you should begin with the accumulation of
an emergency fund. An emergency fund is an amount of money you can obtain quickly in
case of immediate need. The amount of money to be put away in the emergency fund
varies from person to person. However, most financial planners agree that an amount
equal to three to six months’ living expenses is reasonable. For example, Debbie Martin’s
monthly expenses total $1,600. Before Debbie can begin investing, she must save at least
$4,800 ($1,600 × 3 months = $4,800) in a savings account or other near-cash investments
to meet emergencies. There are times when you may want to increase the amount. If you
think you are about to lose your job, an emergency fund equal to three months’ living
expenses may not be enough to tide you over until you find new employment.
You may also want to establish a line of credit at a bank, savings and loan
association, or credit union. A line of credit is a short-term loan that is approved before
you actually need the money. Because the paperwork has already been completed and the
loan has been preapproved, you can later obtain the money as soon as you need it. The
cash advance provision offered by major credit card companies can also be used in an
emergency. However, both lines of credit and credit cards have a ceiling, or maximum
dollar amount, that limits the amount of available credit. If you have already exhausted
both of these sources of credit on everyday expenses, they will not be available in an
emergency.
While the typical personal finance course is not an economics course, it does help
to have a basic understanding of how the nation’s economy affects your personal
financial situation. Let’s begin with a basic definition for economics. Economics is the
study of how wealth is created and distributed. Experts often use economics to explain
the choices the government, businesses, and individuals make and what is important to
each group. For example, assume you want to save money to pay off your credit card
debt, and you also want to take a weekend trip to New York City. Because you can’t
afford to do both, you must decide which is the most important.
Major factors that can affect the economy, your personal financial plan, and the
value of your investments include actions the federal government may take to maintain a
healthy economy. For example, to offset the effects of a recession, the government may
use fiscal policy to alter the tax structure and levels of government spending—specific
actions designed to influence the amount that citizens and businesses save, invest, and
spend. In addition to fiscal policy, the Federal Reserve may use monetary policy to
determine the size of the supply of money in the nation and the level of interest rates that
both consumers and businesses pay to borrow money. Both fiscal policy and monetary
policy are used on a regular basis to stabilize the economy and encourage economic
growth.
A nation’s business cycle also affects your personal finances. Many economists
define a business cycle as the increase and decrease in a nation’s economic activity.
While all industrialized nations seek sustained economic growth, full employment, and
price stability, the fact is that a nation’s economy fluctuates from year to year. If you
were to graph the economic growth rate for a country like the United States, it would
resemble a roller-coaster ride with peaks (strong economy) and low points (weak
economy). For example, the U.S. economy experienced a recession in 2008. What
happened? This economic crisis—which was worse than most recessions—had many
causes, including problems in the banking and financial industry, a downturn in home
sales, lower consumer spending, and high unemployment rates. At the time of
publication, the economy has improved. Still, it could happen again.
How badly do you want to achieve your investment goals? Are you willing to
sacrifice some purchases to provide financing for your investments? The answers to both
questions are extremely important. Take Rita Johnson, a 35-year-old nurse in a large St.
Louis hospital. As part of a divorce settlement in 2010, she received a cash payment of
almost $65,000. At first, she was tempted to spend this money on a trip to Europe, a new
BMW, and new furniture. But after some careful planning, she decided to save $45,000
in a certificate of deposit and invest the remainder in a conservative mutual fund. On May
31, 2018, these investments were valued at $84,000.
What is important to you? What do you value? Each of these questions affects
your investment goals. At one extreme are people who save or invest as much of each
paycheck as they can. At the other extreme are people who spend everything they make
and run out of money before their next paycheck. Most people find either extreme
unacceptable and take a more middle-of-the-road approach. These people often spend
money on the items that make their lives more enjoyable and still save enough to fund an
investment program.
For many people, the easiest way to begin an investment program is to participate
in an employer-sponsored retirement account—often referred to as a 401(k) or a 403(b)
account. Many employers will match part or all of your contributions to a retirement
account. For example, an employer may contribute $0.50 for every $1.00 the employee
contributes. And while the amount of the “match” varies, some employers still match
$1.00 for every $1.00 employees contribute up to a certain percentage of their annual
salary. Be warned: Many employers have reduced or eliminated the matching provisions
in their employee’s retirement plans in order to reduce the cost of their salary and benefit
programs. Some additional suggestions to help you obtain the money you need to
establish an investment program are described in the nearby How To . . . Obtain the
Money Needed to Establish an Investment Program feature.
Many people never start an investment program, because they have only small
sums of money. But even small sums grow over a long period of time. For example, if
you invest $2,000 each year for 40 years at a 2 percent annual rate of return, your
investment will grow to $120,804. Notice that the value of your investments increases
each year because of two factors. First, it is assumed you will invest another $2,000 at the
end of each year. At the end of 40 years, you will have invested a total of $80,000
($2,000 × 40 years = $80,000). Second, all investment earnings are allowed to
accumulate and are added to your yearly deposits. In the above example, you earned
$40,804 ($120,804 total return − $80,000 yearly contributions = $40,804 accumulated
earnings).
Also, the rate of return makes a difference. As noted above, a $2,000 annual
investment that earns 2 percent is worth $120,804 at the end of 40 years. But if the same
$2,000 annual investment earns 10 percent each year, your investment is worth $885,180
at the end of the same 40-year period. The search for higher returns is one reason many
investors choose stocks and mutual funds, which offer higher potential returns compared
to certificates of deposit or savings accounts. Be warned: Investments with higher returns
are not guaranteed. In order to obtain higher returns, you must be willing to accept more
risk and sacrifice some safety.
b. Factors Affecting the Choice of Investments
Millions of Americans buy stocks, bonds, or mutual funds, purchase real estate, or
make similar investments. And they all have reasons for investing their money. Some
people want to supplement their retirement income when they reach age 65, while others
want to become millionaires before age 40. Although each investor may have specific,
individual goals for investing, all investors must consider a number of factors before
choosing an investment alternative.
For most people, the perfect investment is one with no risk and above average
returns. Unfortunately, the perfect investment does not exist, because of the relationship
between safety and risk. The safety and risk factors are two sides of the same coin. Safety
in an investment means minimal risk of loss. On the other hand, risk in an investment
means a measure of uncertainty about the outcome.
Investments range from very safe to very risky. At one end of the investment
spectrum are very safe investments that attract conservative investors. Investments in this
category include government bonds, certificates of deposit, and certain stocks, mutual
funds, and corporate bonds. Real estate may also sometimes be a very safe investment. At
the other end of the investment spectrum are speculative investments. A speculative
investment is a high-risk investment made in the hope of earning a relatively large profit
in a short time. Such investments offer the possibility of larger dollar returns, but if they
are unsuccessful, you may lose most or all of your initial investment. Speculative stocks,
certain bonds, some mutual funds, some real estate, commodities, options, and
collectibles are high-risk investments.
First, investors often choose some investments because they provide a predictable
source of income. For example, you may choose to purchase a corporate bond because
the bond pays a specific amount of interest every six months. If the corporation
experiences financial difficulties, it may default on interest payments. In other words,
there is a risk that you will not receive future income payments.
A second type of risk associated with many investments is that an investment will
decrease in value. For example, the value of Johnson & Johnson decreased during the
first part of 2018 when investors became concerned about the pharmaceutical company’s
current earnings and revenue projections for the future. As a result, the stock decreased
8.5 percent in just one month.
When investing, not everyone has the same tolerance for risk. Some people will
seek investments that offer the least risk. For example, Ana Luna was injured in a work-
related accident three years ago. After a lengthy lawsuit, she received a legal settlement
totaling $420,000. When she thought about the future, she knew she needed to get a job,
but realized she would be forced to acquire new employment skills. She also realized she
had received a great deal of money that could be invested to provide a steady source of
income, not only for the next two years while she obtained job training but also for the
remainder of her life. Having never invested before, she quickly realized her tolerance for
risk was minimal.
When people choose investments that have a higher degree of risk, they expect
larger returns. Simply put, one basic rule sums up the relationship between the factors of
safety and risk: The potential return on any investment should be directly related to the
risk the investor assumes. To help you determine how much risk you are willing to
assume, take the test for risk tolerance presented in the nearby Financial Literacy for My
Life feature, “A Quick Test to Measure Investment Risk Tolerance.”
When you invest, you expect a return on your investment. For example, if you
purchase a one-year certificate of deposit (CD) guaranteed by the FDIC (Federal Deposit
Insurance Corporation), your CD may earn 2 percent a year. At the end of one year, you
receive your initial investment plus 2 percent interest. Another investment alternative,
such as a mutual fund, may earn 7 percent a year. In this case, you receive an additional 5
percent return when compared to the CD because you chose to invest in a mutual fund
that increased in value. While most investors don’t like to think about it, an investor must
assume more risk because the mutual fund could decrease in value for a number of
reasons and your original investment or any possible returns are not guaranteed.
There is a risk that the financial return on an investment will not keep pace with
the inflation rate. To see how inflation reduces your buying power, let’s assume you have
deposited $10,000 in the bank at 2 percent interest. At the end of one year, your money
will have earned $200 in interest ($10,000 × 2% = $200). Assuming an inflation rate of 3
percent, it will cost you an additional $300 ($10,000 × 3% = $300), or a total of $10,300,
to purchase the same amount of goods you could have purchased for $10,000 a year
earlier. Thus, even though you earned $200, you lost $100 in purchasing power. And
after paying taxes on the $200 interest, your loss of purchasing power is even greater.
The interest rate risk associated with government or corporate bonds is the result
of changes in the interest rates in the economy. Assume you purchase a John Deere
corporate bond that pays 3.9 percent interest and hold it for three years before deciding to
sell your bond. The value of your bond will decrease if interest rates for new comparable
bonds increase during the three-year period. On the other hand, the value of your John
Deere bond will increase if interest rates for new comparable bonds decrease during the
three-year period. When interest rates in the economy change, you can calculate the
approximate value of a bond. The first step is to calculate the dollar amount of annual
interest for a bond.
If bond interest rates for new, comparable bonds increase to 4.5 percent, the
market value of your 3.9 percent bond will decrease since a comparable bond that pays
4.5 percent can be purchased for $1,000. As a result, you will have to sell your bond for
less than $1,000 or hold it until maturity. The second step to determine the approximate
market value is to divide the bond’s annual interest amount by the comparable interest
rate.
The price calculated in the above example would provide the purchaser with a 4.5
percent return. If you sold your bond at the current price of $867, you would lose $133
($1,000 − $867 = $133) because you owned a bond with a fixed interest rate during a
period when overall interest rates in the economy increased. On the other hand, if overall
interest rates declined, your bond would increase in value.
The risk of business failure is associated with investments in stock, corporate
bonds, and mutual funds that invest in stocks or bonds. With each of these investments,
you face the possibility that bad management, unsuccessful products, competition, the
economy, or a host of other factors will cause a business to be less profitable than
originally anticipated. Lower profits usually mean lower dividends or no dividends at all.
If the business continues to operate at a loss, even interest payments and repayment of
bonds may be questionable. The business may even fail and be forced to file for
bankruptcy, in which case your investment may become totally worthless. Before
ignoring the possibility of business failure, consider the plight of employees and investors
who owned stock in Toys R Us. Because of a decline in sales and massive debt, the
company filed for bankruptcy in 2018. At the time of publication, the company known
for its wide selection of children’s toys was closing all of its U.S. stores and liquidating
its remaining assets. Ultimately, Toys R Us stockholders will lose the money they
invested in this once-promising investment.
Of course, the best way to protect yourself against such losses is to carefully
evaluate (and continue to evaluate) the companies that issue the stocks and bonds you
purchase. It also helps to purchase different types of investments. Business failure risk
can also affect the value of mutual funds that invest in stocks and corporate bonds or
municipal bonds issued by local and state governments.
Two different types of risk—systematic and unsystematic— can affect the market
value of stocks, bonds, mutual funds, real estate, and other investments. Systematic risk
occurs because of overall risks in the market and the economy. Factors such as an
economic crisis, increasing interest rates, changes in consumer purchasing power,
political activity, and wars all represent sources of systematic risk. Because this type of
risk affects the entire market, it is not possible to eliminate the risk through
diversification. On the other hand, unsystematic risk affects a specific company or a
specific industry. Because this type of risk affects one company or one industry,
unsystematic risk can be reduced by diversifying an investment portfolio. For example,
an investor who owns 30 different stocks in different industries can reduce unsystematic
risk because she or he is well diversified. Anything that happens to one company in the
investor’s portfolio is not likely to wipe out the value of the entire portfolio.
The prices of stocks, bonds, mutual funds, and other investments may also
fluctuate because of the behavior of investors in the marketplace. Fluctuations of this type
may have nothing to do with the fundamental changes in the financial health of
corporations or the corporations that issue the stocks contained in a mutual fund.
Today more investors are investing in stocks and bonds issued by foreign firms
and in global mutual funds because investing in global securities can diversify your
portfolio. For example, when the U.S. markets are in decline, other markets around the
globe may be increasing. An investor can purchase stocks or bonds issued by individual
foreign firms or purchase shares in a global mutual fund. For the small investor who has
less than $200,000 to invest and doesn’t have the expertise required to evaluate foreign
firms or is unaccustomed to the risks in foreign investments, global or international
mutual funds offer more safety.
Investors sometimes purchase certain investments because they want a predictable
source of income. The safest investments—passbook savings accounts, certificates of
deposit, and securities issued by the U.S. government—are also the most predictable
sources of income. With these investments, you know exactly how much income will be
paid on a specific date.
If investment income is a primary objective, you can also choose municipal
bonds, corporate bonds, preferred stocks, or selected common stock issues. When
purchasing these investments, most investors are concerned about the issuer’s ability to
continue making periodic interest or dividend payments. For example, some corporations,
such as Coca-Cola and Colgate Palmolive, are very proud of their long record of
consecutive dividend payments. Each company has paid dividends for over 50 years and
will continue to pay dividends if at all possible.
Other investments that may provide income potential are mutual funds and real
estate rental property. Although the income from mutual funds is not guaranteed, you can
choose funds whose primary objective is income. Income from rental property is not
guaranteed, because the possibility of either vacancies or unexpected repair bills always
exists.
c. Asset Allocation and Investment Alternatives
Based on the above facts, it would seem that everyone should invest in stocks
because they offer the largest returns. And yet, as indicated by the last bulleted item,
stocks can lose money or decline in value. For more proof that stocks can decrease in
value, ask an investor what happened to the value of their stock investments on February
5, 2018. That’s the day when the Dow Jones Industrial Average declined over 1,100
points—the worst one-day point decline in history. 9 In reality, stocks may have a place
in every investment portfolio, but there is more to establishing a long-term, investment
program than just picking a bunch of stocks. Before making the decision to purchase
stocks, consider the factors of asset allocation, the time period that your investments will
work for you, and your age.
How difficult is it to find the right mix of asset classes? Surprisingly easy!
According to noted financial expert and author William Bernstein, if you had invested in
the stocks and bonds that make up the widely quoted averages for large-cap U.S. stocks,
small-cap U.S. stocks, foreign stocks, and high-quality U.S. bonds (25 percent in each of
these asset classes), you would have beaten over 90 percent of all professional money
managers and with considerably less risk over a 10- or 20-year period. 2 And Bernstein is
not alone. Today, most financial experts recommend asset allocation as a valued tool that
can reduce the risk associated with long-term investment programs.
To help you decide how much risk is appropriate for your investment program,
many financial planners suggest that you think of your investment program as a pyramid
consisting of four levels, the cash, CDs, and other conservative investments provide the
foundation for your financial security. After the foundation is established in level 1, most
investors choose from the investments in levels 2 and 3. Be warned: Many investors may
decide the investments in level 4 are too speculative for their investment program. While
the investments at this level may provide high dollar returns, they also have an
unacceptable level of risk for many investors.
The amount of time that your investments have to work for you is another
important factor when managing your investment portfolio. Review the investment
returns presented earlier in this section. Since World War II, stocks have returned on
average almost 10 percent a year and returned more than other investment alternatives.
And yet, during the same period, there were years when stocks decreased in value. 11
The point is that if you invested at the wrong time and then couldn’t wait for the
investment to recover, you would lose money.
The amount of time you have before you need to withdraw money from your
investments is crucial. If you can leave your investments alone and let them work for 5 to
10 years or more, then you can invest in stocks and mutual funds. On the other hand, if
you need your investment money in 2 years, you should probably invest in short-term
government bonds, highly rated corporate bonds, or certificates of deposit. By taking a
more conservative approach for short-term investments, you reduce the possibility of
having to sell your investments at a loss because of depressed market value or a
staggering economy.
A final factor to consider when choosing an investment is your age. Younger
investors tend to invest a large percentage of their nest egg in growth-oriented
investments. If their investments take a nosedive, they have time to recover. On the other
hand, older investors tend to be more conservative and invest in government bonds, high-
quality corporate bonds, and very safe corporate stocks or mutual funds. As a result, a
smaller percentage of their nest egg is placed in growth-oriented investments.
How much of your portfolio should be in growth-oriented investments? Many
financial planners suggest that you subtract your age from 100, and the difference is the
percentage of your assets that should be invested in growth investments. For example, if
you are 40 years old, subtract 40 from 100, which gives you 60. Therefore, 60 percent of
your assets should be invested in growth-oriented investments, while the remaining 40
percent should be kept in safer, more conservative investments.
Once you have considered the risks involved when investing, asset allocation, the
length of time your investments can work for you, and your age, it’s time to consider
which investment alternative is right for you. The remainder of this section provides a
brief overview of different investment alternatives. The remaining investment provide
more detailed information on stocks, bonds, mutual funds, real estate, and other
investment alternatives.
Equity capital is money that a business obtains from its owners. If a business is a
sole proprietorship or a partnership, it acquires equity capital when the owners invest
their own money in the business. For a corporation, equity capital is provided by
stockholders, who buy shares of its stock. Since all stockholders are owners, they share in
the success of the corporation. This can make buying stock an attractive investment
opportunity.
However, you should consider at least two factors before investing in stock. First,
a corporation is not required to repay the money obtained from the sale of stock or to
repurchase the stock at a later date. Assume you purchased 100 shares of Southwest
Airlines stock. Later you decide to sell your Southwest stock. Your stock is sold to
another investor, not back to the company. In many cases, a stockholder sells a stock
because he or she thinks its price is going to decrease in value. Another stockholder, on
the other hand, buys that stock because he or she thinks its price is going to increase. This
creates a situation in which either the seller or the buyer earns a profit while the other
party to the transaction experiences a loss.
Second, a corporation is under no legal obligation to pay dividends to
stockholders. A dividend is a distribution of money, stock, or other property that a
corporation pays to stockholders. Dividends are paid out of earnings, but if a corporation
that usually pays dividends has a bad year, its board of directors can vote to reduce or
even omit dividend payments to help pay necessary business expenses. Corporations may
also retain earnings to make additional financing available for expansion, research and
product development, or other business activities.
There are two basic types of stock: common stock and preferred stock. A share of
common stock represents the most basic form of corporate ownership. People often
purchase common stock because this type of investment can provide (1) a source of
income if the company pays dividends and (2) growth potential if the dollar value of the
stock increases. The most important priority an investor in preferred stock enjoys is
receiving cash dividends before common stockholders are paid any cash dividends. This
factor is especially important when a corporation is experiencing financial problems and
cannot pay cash dividends to both preferred and common stockholders. Other factors you
should consider before purchasing either common or preferred stock.
There are two types of bonds an investor should consider. A corporate bond is a
corporation’s written pledge to repay a specified amount of money, along with interest. A
government bond is the written pledge of a government or a municipality to repay a
specified sum of money, along with interest. Thus, when you buy a bond, you are loaning
a corporation or government entity money for a period of time. Regardless of who issues
the bond, you need to consider two questions before investing in bonds.
First, will the bond be repaid at maturity? The maturity date is the date on which a
corporation, government, or municipality will repay the borrowed money. For example,
assume you purchase a $1,000 Ford Motor Credit Company corporate bond that pays
4.40 percent interest. The maturity date is June 20, 2025 —the date the corporation will
repay your investment. The maturity dates for most bonds range between 1 and 30 years.
An investor who purchases a bond has two options: Keep the bond until maturity and
then redeem it, or sell the bond to another investor before maturity. In either case, the
value of the bond is closely tied to the ability of the corporation or government entity to
repay the bond at maturity. Also, keep in mind that the value of a bond may increase or
decrease in value before it reaches maturity because of changes in interest rates in the
economy. To review how interest rates affect the value of a bond, review the material on
interest rate risk discussed in the previous section, “Factors Affecting the Choice of
Investments.”
Second, will the corporation or government entity be able to maintain interest
payments to bondholders until maturity? Bondholders normally receive interest payments
every six months. For example, investors who purchase the Ford Motor Credit Company
bond in the previous example earn 4.40 percent or $44 each year until maturity ($1,000
× .0440 = $44.00). Because interest payments on bonds are paid every six months,
investors would receive a check for $22 every six months for each bond they own.
Receiving periodic interest payments until maturity is one method of making money on a
bond investment. Investors also use two other methods that can provide more liberal
returns on bond investments.
A mutual fund pools the money from many investors—its shareholders—to invest
in a variety of securities. When choosing a mutual fund, professional management is an
especially important factor for investors with little or no previous investment experience.
Another reason investors choose mutual funds is diversification. Since mutual funds
invest in a number of different securities, an occasional loss in one security is often offset
by gains in other securities. As a result, the diversification provided by a mutual fund
reduces risk.
The goals of one investor often differ from those of another. The managers of
mutual funds realize this and tailor their funds to meet their clients’ needs and objectives.
As a result of all the different investment alternatives, mutual funds range from very
conservative to extremely speculative investments. Many investors choose mutual funds
for their retirement accounts, including traditional individual retirement accounts, Roth
IRAs, and retirement plans sponsored by your employer. As mentioned earlier in this,
many employees contribute a portion of their salary to a retirement account. And in many
cases, the employer matches the employee’s contribution. Although investing money in a
mutual fund provides professional management, even the best managers can make errors
in judgment. The responsibility for choosing the right mutual fund is still based on your
evaluation of a mutual fund investment.
One of the major concerns for investors who choose mutual funds is fees. Mutual
fund fees may include sales charges, redemption fees, management fees, and other fees.
Knowing these fees is important because they reduce your investment return. Together,
all the different management fees and fund operating costs are often referred to as an
expense ratio. Many financial planners recommend that you choose a mutual fund with
an expense ratio of 1 percent or less. This is an important factor to consider when
evaluating a mutual fund.
As a rule, real estate increases in value and eventually sells at a profit, but there
are no guarantees. Although many beginning investors believe real estate values increase
by 10 or 15 percent a year, in reality the nationwide average annual increase is about 3 to
5 percent over a long period of time. This growth rate makes real estate a long-term
investment and not a get-rich-quick scheme. Success often depends on if you invest in
residential property, commercial property, the economy, interest rates, and many other
factors. It also helps to remember that real estate values can decrease because of an
economic crisis or recession.
As defined earlier in this, a speculative investment is a high-risk investment made
in the hope of earning a relatively large profit in a short time. By its very nature, any
investment may be speculative; that is, it may be quite risky. However, a true speculative
investment is speculative because of the methods investors use to earn a quick profit.
Without exception, investments of this kind are normally referred to as speculative for
one reason or another. For example, the gold market has many unscrupulous dealers who
sell worthless gold-plated lead coins to unsuspecting, uninformed investors. With any
speculative investment, it is extremely important to deal with reputable dealers and
recognized investment firms. It pays to be careful.
Earlier in this, we examined how safety, risk, income, growth, and liquidity affect
your investment choices. In the preceding section, we looked at investment alternatives.
Now let’s compare the factors that affect the choice of investments with each alternative.
With this type of information, it is now possible to begin building a personal plan for
investing. Most people use a series of steps like those listed. And while each step is
important, establishing investment goals (step 1), evaluating risk and potential return for
each investment alternative (step 5), and continued evaluation (step 8) may be the most
important.
d. Factors That Reduce Investment Risk
Let’s assume you have $25,000 to invest. Also assume your investment will earn
a 10 percent return the first year. At the end of one year, you will have earned $2,500 and
your investment will be worth $27,500. Now ask yourself: How long would it take to
earn $2,500 if I had to work for this amount of money at a job? For some people it might
take a month; for others, it might take longer. The point is that if you want this type of
return, you should be willing to work for it. When choosing an investment, the work is
the time needed to research different investments so that you can make an informed
decision. In fact, much of the information in the remaining investment will help you learn
how to evaluate different investment opportunities.
Would you believe that some people invest their money, but don’t track the value
of their investments? They don’t know if their investments have increased or decreased in
value. They don’t know if they should sell their investments or continue to hold them. A
much better approach is to monitor the value of your investments. Regardless of which
type of investment you choose, monitoring your investment will help you determine if it
increases or decreases in value. The Financial Literacy Calculations feature, “Monitoring
the Value of Your Investment,” presents further information on monitoring the value of
your investments.
Accurate record keeping can help you spot opportunities to maximize profits or
reduce dollar losses when you sell your investments. Accurate record keeping can also
help you decide whether you want to invest additional funds in a particular investment.
At the very least, you should keep purchase records for each of your investments that
include the actual dollar cost of the investment, plus any commissions or fees you paid,
along with records of income (dividends, interest payments, rental income, etc.) you
receive from your investment holdings. It is also useful to keep a list of the sources of
information (internet addresses, business periodicals, research publications, etc.), along
with copies of the material you used to evaluate each investment. Then, when it is time to
reevaluate an existing investment, you will know where to begin your search for current
information. Accurate record keeping is also necessary for tax purposes.
To achieve their financial goals, many people seek professional help. In many
cases, they turn to stockbrokers, lawyers, accountants, bankers, or insurance agents.
However, these professionals are specialists in one specific field and may not be qualified
to provide the type of advice required to develop a thorough financial plan. Be warned:
Some of the above professionals earn commissions on the investments they recommend.
The fact they are receiving commissions may influence which investments they
recommend for their clients.
e. Common and Preferred Stocks
Today, investors—especially beginning investors—face two concerns when they
begin an investment program. First, they don’t know where to get the information they
need to evaluate potential investments. In reality, more information is available for most
corporate stock issues than most investors can read. Second, beginning investors
sometimes worry that they won’t know what the information means when they do find it.
Yet common sense goes a long way when evaluating potential investments.
Corporations prefer selling stock because the money doesn’t have to be repaid,
and the company doesn’t have to buy back shares from stockholders. Stock is equity
financing. Equity financing is money received from the sale of shares of ownership in a
business. Important point: A stockholder who buys common stock may sell his or her
stock to another individual. The selling price is determined by how much a buyer is
willing to pay for the stock. The price for a share of stock changes when information
about the firm or its future prospects is released to the general public. For example,
information about future sales revenues, earnings, expansion or mergers, or other
important developments within the firm can increase or decrease the price for a share of
the company’s stock.
Important point: Dividends are paid out of profits, and dividend payments must be
approved by the corporation’s board of directors. A dividend is a distribution of money,
stock, or other property that a corporation pays to stockholders. Dividend policies vary
among corporations, but most firms distribute between 30 and 70 percent of their
earnings to stockholders. However, some corporations follow a policy of smaller or no
dividend distributions to stockholders. In general, these are rapidly growing firms, like
eBay (online auctions), Amazon (online retail), and Alphabet (the parent company of
internet search engine Google) that retain a large share of their earnings and profits for
research and development, expansion, or acquisitions. On the other hand, utility
companies, such as Duke Energy and American Electric Power (AEP), and other
financially secure corporations, may distribute up to 70 to 90 percent of their earnings.
Always remember that the board of directors may vote to reduce or omit dividend
payments because the corporation had a bad year or for any other reason.
In return for the financing provided by selling common stock, management must
make concessions to stockholders that may restrict corporate policies. For example, the
common stockholders elect the board of directors and must approve major changes in
corporate policies. Stockholders may vote in person at the corporation’s annual meeting
or by proxy. A proxy is a legal form that lists the issues to be decided at a stockholders’
meeting and requests that stockholders transfer their voting rights to some individual or
individuals.
In the search for investments that offered larger returns, Patricia Nelson invested
$10,000 in McDonald’s Corporation on May 22, 2008. Ten years later, Nelson’s
investment had increased to $27,242. 1 During the 10-year period, she earned an average
of just over 10 percent a year. What happened? Well, three factors account for her
investment’s increase in value. First, Nelson made the decision to look at McDonald’s
stock as an investment alternative when she noticed that the local McDonald’s where she
often had breakfast was always busy. Second, she spent more than 20 hours evaluating
the firm and its financial performance. She also looked at what stock advisory services
said about the company and learned all she could about McDonald’s before investing her
$10,000. Finally, McDonald’s Corporation did its part. The fast-food chain continued to
sell food items in record numbers while managing to improve its operating and marketing
activities. Will Nelson’s investment continue to increase in value? Will McDonald’s
stock continue to increase in value? Both good questions, but that’s why successful
investors like Nelson continue to evaluate their stock investments—even if they are
enjoying above-average returns.
While the first two items are pretty impressive, investors sometimes forget that
stocks can decrease in value. Before you invest in stock, consider the last item one more
time: Since 1926, stocks lost money in 25 years. For more proof that stocks can decrease
in value, just ask a stock investor what happened to the value of their investments on
February 5, 2018. That’s the day when the Dow Jones Industrial Average declined over
1,100 points—the worst one-day decline in history. 5 The fact is that stocks and the stock
market are volatile, and investors often experience wide price swings from one day to the
next. The market’s volatility underscores the importance of a long-term investment
program that will allow you to weather the ups and downs in the market. In fact, the key
to success with any investment program is often the opportunity to allow your
investments to work for you over a long period of time. The sooner you start investing,
the more time your investments have to work for you.
Another reason why financial experts recommend a long-term investment
program is lower taxation. Short-term investments—stocks held for one year or less—are
taxed as ordinary income. Generally, tax rates for short-term investments range from 10
to 37 percent, depending on your total taxable income. On the other hand, long-term
investments—stocks held for more than one year—are taxed at a lower rate. Under the
Tax Cuts and Jobs Act that was signed into law in 2017, long-term investments are taxed
at 0, 15, or 20 percent, depending on your total taxable income from all sources. While
paying lower taxes on long-term investments doesn’t seem like a big deal, those tax
savings can be used to buy new long-term stock investments that can provide additional
dividend income and appreciate in value.
f. Evaluating a Stock Issue
Many investors are unwilling to spend the time required to become a good
investor. They wouldn’t buy a car without a test drive, but for some unknown reason they
invest without doing their homework. The truth is that there is no substitute for a few
hours of detective work when choosing an investment. A logical place to start the
evaluation process for stock is with the classification of different types of stock
investments.
In this section, we examine some websites that are logical starting points when
evaluating a stock investment, but there are many more than those described. Let’s begin
with information about corporations that is available on the internet. Today most
corporations have a website, and the information these sites provide is often useful
because it is easily accessible. All you have to do is type in the corporation’s URL
address or use a search engine to locate the corporation’s home page. Second, the
information on the corporate website may be more up to date and thorough than printed
material obtained from the corporation or outside sources. By clicking on a button, such
as the Investor Relations button, you can access information on the firm’s earnings and
other financial factors that could affect the value of the company’s stock.
g. Numerical Measures That Influence Investment Decisions
Many analysts believe that a corporation’s ability to generate earnings in the
future is one of the most significant factors that account for an increase or decrease in the
price of a stock. Simply put, higher earnings generally equate to higher stock prices. The
reverse is also true. If a corporation’s earnings decline, generally the stock’s price will
also decline. It also helps to remember that the price for a share of stock is determined by
what another investor is willing to pay for it. In fact, there are times when investors may
pay a high, inflated price for a share of stock. For example, the term stock market bubble
is used to describe a situation when stocks are trading at prices above their actual worth.
The bubble for a specific stock can burst when a company reduces or omits dividend
payments to stockholders or lowers earnings expectations, or when stockholders begin to
sell the stock for any other reason, including an economic slowdown, high unemployment
rates, higher interest rates, and other factors that affect the economy.
P-E ratios need to be interpreted carefully. Generally, the average P-E ratio for the
stock market is between 15 and 25 for any specific year. Stocks with high price-earnings
ratios are often issued by young, fast-growing corporations. For these stocks, a high
price-earnings ratio above the average P-E ratio for the market often indicates investor
optimism because of the expectation of higher earnings in the future. If earnings do
increase, the stock usually becomes more valuable. On the other hand, a stock with a low
price-earnings ratio below the average P-E ratio for the market indicates investors have
lower earnings expectations for a company’s stock. If future earnings don’t maintain the
same level of growth or decrease, the stock will become less valuable. Stocks with low P-
E ratios tend to be issued by large, established, corporations or corporations in mature
industries. When researching a stock, comparing the P-E ratios of one company to other
companies in the same industry is usually the most helpful. It is also possible to compare
a company’s P-E ratio against the company’s own historical P-E ratios or to the market in
general.
Today, many investors purchase stocks for dividend income. Because dividends
are a distribution of a corporation’s earnings, these same investors must be concerned
about the firm’s future earnings and the dividend payout. The dividend payout is the
percentage of a firm’s earnings paid to stockholders in cash. This ratio is calculated by
dividing the annual dividend amount by the earnings per share.
For 3M, the dividend payout ratio indicates the company is paying 81 percent of
earnings to its stockholders. The 3M Company should be able to continue to pay
dividends even if the company experiences a small decline in earnings. One of the most
common calculations investors use to monitor the value of their investments is the
dividend yield. The dividend yield is the annual dividend amount divided by the
investment’s current price per share.
Dividends total $1,075 ($10.75 per-share dividend × 100 shares = $1,075). The
capital gain of $3,000 results from the increase in the stock price from $169 a share to
$199 a share ($30 per share increase × 100 shares = $3,000). In this example, the
investment increased in value and you received dividends. And while it may be obvious,
we should point out that the larger the dollar amount of total return, the better. The
annualized holding period yield calculation takes into account the total return, the
original investment, and the time the investment is held.
The beta is a measure reported in many financial publications that compares the
volatility associated with a specific stock issue with the volatility of the overall stock
market or an index like the Standard & Poor’s 500 Stock Index. The beta for the S&P 500
is defined as 1.0. The majority of stocks have betas between 0.5 and 2.0. Generally,
conservative stocks have low betas, while more speculative stocks have betas greater than
1.
Because individual stocks generally move in the same direction as the stock
market, most betas are positive, but it is possible for a stock to have a negative beta. A
negative beta occurs when a corporation’s stock moves in the opposite direction
compared to the stock market in general. Although little correlation may exist between
the market value of a stock and its book value, book value is widely reported in financial
publications. Therefore, it deserves mention. The book value for a share of stock is
determined by deducting all liabilities from the corporation’s assets and dividing the
remainder by the number of outstanding shares of common stock.
While the average market-to-book ratio varies from one industry to another, a
statistic often quoted for this ratio is 3 to 1. A low market-to-book ratio (less than the
average) could mean that the stock is undervalued, and a high market-to-book (greater
than the average) ratio could mean that a stock is overvalued. Some investors believe
they have found a bargain when a stock’s market value is about the same as or lower than
its book value. Be warned: Book value and market-to-book ratio calculations may be
misleading, because the dollar amount of assets used in the above formula for book value
may be understated or overstated on the firm’s financial statements.
Investors sometimes use three different investment theories to determine a stock’s
value. Fundamental analysis is based on the assumption that a stock’s intrinsic or real
value is determined by the company’s future earnings. If a corporation’s expected
earnings are higher than its present earnings, the corporation’s stock should increase in
value. If its expected earnings are lower than its present earnings, the stock should
decrease in value. In addition to expected earnings, fundamentalists consider (1) the
financial strength of the company, (2) the type of industry the company is in, (3) new
product development, and (4) the economic growth of the overall economy. The goal of
fundamental analysis is to find a stock’s intrinsic value, which is a fancy way of trying to
determine what you think a stock is really worth instead of what the stock is actually
trading for in the marketplace. If you find a stock with an intrinsic value that is more than
the current market price, it makes sense to buy the stock. One of the most famous and
successful users of fundamental analysis is Warren Buffett, the chairman and CEO of
Berkshire Hathaway. Mr. Buffett is well known for successfully employing fundamental
analysis to identify both stocks and corporations that are undervalued. His ability to use
fundamental analysis has turned him into a billionaire.
Technical analysis is based on the assumption that a stock’s market value is
determined by the forces of supply and demand in the stock market, not on the expected
earnings or the intrinsic value of an individual corporation’s stock. Technical analysis is
also based on the assumption that past market trends can predict the future direction for
the market as a whole. Typical technical factors are price movements, the total number of
shares traded, the number of buy orders, and the number of sell orders over a period of
time. Technical analysts, sometimes called chartists, construct charts or use computer
programs to plot past price movements and other market averages. These charts allow
them to observe trends and patterns for the market that enable them to predict the effect
that changes in supply and demand will have on different securities.
The efficient market hypothesis (EMH) is based on the assumption that stock
price movements are purely random. Advocates of the efficient market hypothesis
assume the stock market is completely efficient and buyers and sellers have considered
all of the available information about an individual stock. According to this theory, it is
impossible for an investor to outperform the average for the stock market as a whole over
a long period of time. Advocates of the efficient market hypothesis believe it is useless to
identify undervalued or overvalued stocks and the only way to achieve superior results is
to pick riskier investments. Most investors reject the efficient market hypothesis on the
assumption that, by means of the fundamental theory, technical analysis, or a
combination of the two theories, they can improve their performance (and ultimately their
financial returns) in the stock market.
h. Buying and Selling Stocks
To purchase common or preferred stock, you generally have to work through a
brokerage firm. In turn, your brokerage firm must buy the stock in either the primary or
secondary market. In the primary market, you purchase financial securities, via an
investment bank or other representative, from the issuer of those securities. An
investment bank is a financial firm that assists corporations in raising funds, usually by
helping to sell new security issues.
New security issues sold through an investment bank can be issued by
corporations that have sold stocks and bonds before and need to sell new issues to raise
additional financing. The new securities can also be initial public offerings. An initial
public offering (IPO) occurs when a corporation sells stock to the general public for the
first time. For example, Snap, Inc., the parent company of Snapchat, used an IPO to raise
over $3.4 billion in 2017. Snapchat provides social media users with a camera application
that helps people to communicate through short videos and images. The promise of quick
profits often lures investors to purchase IPOs. Investors who purchased shares in Snap’s
IPO initially saw shares increase in value, but quickly share prices returned to about the
same price they paid. A year after its IPO, Snap was trading for one dollar higher than its
price on the day of the IPO. 9 Be warned: An IPO is generally classified as a high-risk
investment—one made in the hope of earning a relatively large profit in a short time.
Depending on the corporation selling the new security, IPOs may be too speculative for
many people.
After a stock has been sold through the primary market, it is traded through the
secondary market. The secondary market is a market for existing financial securities that
are currently traded among investors. Once stocks are sold in the primary market, they
can be sold time and again in the secondary market. Although a corporation does not
receive money each time its stock is bought or sold in the secondary market, the ability to
obtain cash by selling stock investments is one reason why investors purchase corporate
stock. Without the secondary market, investors would not purchase stock in the primary
market, because there would be no way to sell shares to other investors.
A securities exchange is a marketplace where member brokers who represent
investors meet to buy and sell securities. The securities sold at a particular exchange must
first be listed, or accepted for trading, at that exchange. Generally, the securities issued by
nationwide corporations are traded at either the New York Stock Exchange or regional
exchanges. The securities of very large corporations may be traded at more than one
exchange. American firms may also be listed on foreign securities exchanges—in Tokyo,
London, or Shanghai, for example.
The New York Stock Exchange is one of the largest securities exchanges in the
world. Most NYSE members represent brokerage firms that charge commissions on
security trades made by their representatives for their customers. Other members are
called specialists or specialist firms. A specialist buys or sells a particular stock in an
effort to maintain an orderly market. The stock of corporations that cannot meet the
NYSE requirements, find it too expensive to be listed on the NYSE, or choose not to be
listed on the NYSE is often traded on one of the regional exchanges or through the over-
the-counter market.
Not all securities are traded on organized exchanges. Stocks issued by several
thousand companies are traded in the over-the-counter market. The over-the-counter
(OTC) market is a network of dealers who buy and sell the stocks of corporations that are
not listed on a securities exchange. Today these stocks are not really traded over the
counter. The term was coined more than 100 years ago when securities were sold “over
the counter” in stores and banks.
Many stocks are traded through Nasdaq (pronounced “nazzdack”). Nasdaq is an
electronic marketplace for buying and selling global stocks and securities. In addition to
providing price information, this computerized system allows investors to buy and sell
shares of companies listed on Nasdaq. When you want to buy or sell shares of a company
that trades on Nasdaq—say, Microsoft—your account executive sends your order into the
Nasdaq computer system, where it shows up on the screen with all the other orders from
people who want to buy or sell Microsoft. Then a Nasdaq dealer (sometimes referred to
as a market maker) matches buy and sell orders for Microsoft. Once a match is found,
your order is completed.
An account executive, or stockbroker, is a licensed individual who buys or sells
securities for his or her clients. Even though an account executive can buy and sell
securities for you and should help you develop your investment program, you should be
actively involved in your investment program. Avoid allowing your account executive to
use his or her discretion without your approval when making investment decisions for
you. Finally, keep in mind that account executives generally are not liable for client
losses that result from their recommendations. In fact, most brokerage firms require new
clients to sign a statement in which they promise to submit any complaints to an
arbitration board. This arbitration clause generally prevents a client from suing an
account executive or a brokerage firm.
Although the distinctions between full-service, discount, and online brokerage
firms have blurred in recent years, there is healthy competition between different types of
brokerage firms. Many investors begin the search for a brokerage firm by looking at the
commissions they charge to buy or sell stock for you. Another factor to consider is how
much research information is available and how much it costs. Also, consider how much
help you need when making an investment decision. Although there are many exceptions,
the information below may help you decide whether to use a full-service, discount, or
online brokerage firm.
Once you and your account executive have decided on a particular stock
investment, it is time to execute an order to buy or sell. Today most investors buy or sell
stocks online. It is also possible to trade stocks by using a brokerage firm’s automated
telephone system. Finally, you can contact your broker and execute a broker-assisted
trade. Let’s begin by examining three types of orders used to trade stocks.
A market order is a request to buy or sell a stock at the current market value.
Since the stock exchange is an auction market, the account executive’s representative will
try to get the best price available, and the transaction will be completed as soon as
possible. According to new rules issued by the Securities and Exchange Commission,
payment for stocks is generally required within two business days after the transaction.
For example, if you buy or sell stock on Monday, the transaction will settle on
Wednesday—two business days after the transaction. Today it is common practice for
investors to leave stock certificates with a brokerage firm. Because the stock certificates
are in the broker’s care, transfers when the stock is sold are much easier. The phrase “left
in the street name” is used to describe investor-owned securities held by a brokerage
firm.
A limit order is a request to buy or sell a stock at a specified price or better. When
you purchase stock, a limit order ensures that you will buy at the best possible price but
not above a specified dollar amount. When you sell stock, a limit order ensures that you
will sell at the best possible price, but not below a specified dollar amount. For example,
if you place a limit order to buy Macy’s common stock for $28 a share, the stock will not
be purchased until the price drops to $28 a share or lower. Likewise, if your limit order is
to sell Macy’s for $28 a share, the stock will not be sold until the price rises to $28 a
share or higher. Be warned: Limit orders are executed if and when the specified price or
better is reached and all other previously received orders have been fulfilled.
Many stockholders are certain they want to sell their stock if it reaches a specified
price. A limit order does not guarantee this will be done. With a limit order, as mentioned
above, orders by other investors may be placed ahead of your order. If you want to
guarantee that your order will be executed, you place a special type of order known as a
stop-loss order. A stop-loss order (sometimes referred to as a stop order) is an order to
sell a particular stock at the next available opportunity after its market price reaches a
specified amount. This type of order is used to protect an investor against a sharp drop in
price and thus stop the dollar loss on a stock investment. For example, assume you
purchased Ford common stock at $12 a share. Two months after making your investment,
Ford is facing multiple product liability lawsuits. Fearing that the market value of your
stock will decrease, you enter a stop-loss order to sell your Ford stock at $9. This means
that if the price of the stock decreases to $9 or lower, the account executive will sell it.
While a stop order does not guarantee that your stock will be sold at the price you
specified, it does guarantee that it will be sold at the next available opportunity. Both
limit and stop-loss orders may be good for one day, one week, one month, good until
canceled (GTC), or a specified date.
