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Semi-Retirement.com
Part 4:
Investments
Purposes and Goals
of Investing
(Adapted from Investopedia; link to
original article)
 © Investopedia Inc. 2005
Investment Capital
As an investor you are providing capital to businesses
and/or public entities for various purposes. Capital is the most
important commodity; it can be used to purchase goods and services,
finance business operations, and fund public projects.
The Three Characteristics of Capital
- Mobile
Sensitive
Scarce
Sources and Users of Capital
In general, savings and investments are the
main sources of capital. Capital is transferred from its sources to
users through these elements:
- Financial instruments such as stocks and bonds.
- Financial markets such as stock exchanges.
- Financial intermediaries such as investment firms and banks.
Investment Objectives
Investors have varying objectives and
a number of different investment methods from which to choose. Often,
the tradeoff between risk and return is a key factor in determining the
nature and composition of their investments. In general, the riskier the
investment, the greater return we can expect to receive.
- Primary Investment Objectives
Safety
Clients with this objective want to maintain their capital
position. As a result they are:
- Willing to accept a lower rate of return in exchange for
reduced risk
- Willing to give up opportunities for capital growth
Appropriate investments are low risk securities such as federal
and municipal bonds, high grade corporate bonds, and Treasury bills.
Income
Clients with this objective are willing to forego some safety in
order to maximize income return. Investments that provide income
include corporate bonds and/or preferred stocks that pay regular
dividends.
Growth
Clients in higher tax brackets often seek capital gains rather
than income because of favored tax treatment of these gains.
Companies with growth stock tend to be expanding companies
and innovative industries. These companies tend to reinvest retained
earnings to fuel growth rather than pay a dividend.
- Secondary Investment Objectives
Liquidity
What is the likelihood that a client will need to withdraw a
portion or all of their investment on short notice? If there is a
high likelihood of this occurrence, investments with a high degree
of liquidity are required.
Tax Minimization
After-tax return is the return that matters. Consider your tax rate and any special tax circumstances that
might apply; it may be advantageous to look at tax-exempt or tax-sheltered securities as a part of
your portfolio.
More on the risk-reward tradeoff
(Adapted from Investopedia; link to
original article)
Risk-Reward Concept
The risk-reward concept states that the higher the
risk of a
particular investment, the higher the possible return.
Anytime you invest money into something there is a risk,
whether large or small, that you might not get your money back. In turn,
you expect a return, which compensates you for bearing this risk. In
theory the higher the risk, the more you should receive for holding the
investment, and the lower the risk, the less you should receive.
For investment
securities,
we can create a chart with the different types of securities and their
associated
risk/reward profile.
At the right end of the arrow are choices that offer investors a higher
potential for
above-average returns, but this potential comes with a higher risk
of below-average
returns. On
the left are much safer investments, but these investments have a lower
potential for high returns.
Determining Your Risk Preference
With so many different types of investments to choose from, how does an
investor determine how much risk he or she can handle? Every individual
is different, and it's hard to create a steadfast model applicable to
everyone, but here are two important things you should consider when
deciding how much risk to take:
- Time Horizon
Before you make any investment, you should always determine the
amount of time you have to keep your money invested. If you have
$20,000 to invest today but need it in one year for a down payment
on a new house, investing the money in higher-risk stocks is not the
best strategy. The riskier an investment is, the greater its
volatility or price fluctuations, so if your time horizon is
relatively short, you may be forced to sell your securities at a
significant a loss.
With a longer time horizon, investors have more time to recoup any
possible losses and are therefore theoretically more tolerant of
higher risks. For example, if that $20,000 is meant for a lakeside
cottage that you are planning to buy in ten years, you can invest
the money into higher-risk stocks because there is be more time
available to recover any losses and less likelihood of being forced
to sell out of the position too early.
- Bankroll
Determining the amount of money you can stand to lose is another
important factor of figuring out your
risk
tolerance. This might not be the most optimistic method of
investing; however, it is the most realistic. By investing only
money that you can afford to lose or afford to have tied up for some
period of time, you won't be pressured to sell off any investments
because of panic or liquidity issues.
The more money you have, the more risk you are able to take and vice
versa. Compare, for instance, a person who has a net worth of
$50,000 to another person who has a net worth of $5,000,000. If both
invest $25,000 of their net worth into securities, the person with
the lower net worth will be more affected by a decline than the
person with the higher net worth. Furthermore, if the investors face
a
liquidity issue and require cash immediately, the first investor
will have to sell off the investment while the second investor can
use his or her other funds.
Investment Risk Pyramid
After deciding on how much risk is acceptable in your
portfolio by acknowledging your time horizon and bankroll, you can use
the
risk pyramid approach for balancing your
assets.
This pyramid can be thought of as an asset allocation
tool that investors can use to diversify their portfolio investments
according to the risk profile of each security. The pyramid,
representing the investor's portfolio, has three distinct tiers:
- Base of the Pyramid– The foundation of the pyramid
represents the strongest portion, which supports everything above
it. This area should be comprised of investments that are low in
risk and have foreseeable returns. It is the largest area and
composes the bulk of your assets.
- Middle Portion– This area should be made up of
medium-risk investments that offer a stable return while still
allowing for capital appreciation. Although more risky than the
assets creating the base, these investments should still be
relatively safe.
- Summit– Reserved specifically for high-risk
investments, this is the smallest area of the pyramid (portfolio)
and should be made up of money you can lose without any serious
repercussions. Furthermore, money in the summit should be fairly
disposable so that you don't have to sell prematurely in instances
where there are
capital losses.
Personalizing the Pyramid
Not all investors are created equally. While others
prefer less risk, some investors prefer even more risk than others who
have a larger net worth.
Those who want more risk in their portfolios can
increase the size of the summit by decreasing the other two sections,
and those wanting less risk can increase the size of the base. The
pyramid representing your portfolio should be customized to your risk
preference.
It is important for investors to understand the idea of risk and how it
applies to them. Making informed investment decisions entails not only
researching individual securities but also understanding your own
finances and risk profile. To get an estimate of the securities suitable
for certain levels of risk tolerance and to maximize returns, investors
should have an idea of how much time and money they have to invest and
the returns for which they are looking.
The Basics of Investing in Securities
(Adapted from Investopedia; link to
original article)
Investopedia has very useful tutorial series on the
three major types of investment securities:
-
Stocks Basics: Tutorial
-
Bond Basics: Introduction
-
Mutual Fund Basics: Tutorial
Coming Soon: Part 5
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