Choosing the Right Investments
Where to begin?
In recent articles I have addressed the need to build a solid financial foundation by first instituting a systematic approach to saving. Once you have accumulated some savings you then select investment alternatives which will best meet your financial goals. There are many investment alternatives: stocks, municipal bonds, corporate bonds, US treasury bonds, and certificates of deposit to name a few. The most important step in choosing from these or other investments is to fully understand each of these products before investing. While it is prudent to use the help of professional investment advisors such as BCU Investment Advisory Services, the burden is on each investor to do some homework beforehand to acquire at least a basic knowledge concerning the various investment products available.
There are many sources of information through which to accomplish the task: literature from financial services firms, seminars offered by various investment advisory groups, US Treasury department publications, and of course the Internet. My favorite web site regarding investor education is www.investopedia.com. Investopedia offers a wealth of information on virtually every type of investment. The pages are not difficult to navigate, although you will encounter the usual barrage of advertisements which accompany such free sites. If you select the tutorials tab on the top of the home page, it reveals a pull down box which allows you to select your level of expertise from beginner to experienced trader. Although I am an experienced trader I have drawn a wealth of knowledge from the beginners tab. You can spend hours absorbing the information, or narrow down your focus to one or two specific areas; either approach will be both informative and potentially rewarding.
What are some alternatives?
The most common investments made by individual investors include common stocks, savings bonds, and certificates of deposit (CDs). However, more and more, individual investors are broadening their perspectives and moving into real estate, treasury securities, and corporate bonds.
Common stocks, or equities, are ownership shares in corporations traded in a regulated marketplace, which generally price the value of a company in terms of its potential for profitability. Many factors enter into the value of a companys stock, but most importantly it is the earnings of the company (or the losses incurred) which most impact the price of their shares. In selecting common stocks for your portfolio it is important to realize that the value of the shares will reflect the future prospects for the company. Price is not impacted based upon how the company has performed in the past; past performance was reflected in yesterdays price. The potential for success in common stock investing lies in the ability to forecast the demand for the companys goods or services going forward, as well as in the ability to evaluate the competition and the companys potential for innovation.
Well established companies generally pay a dividend to holders of their shares, this helps to enhance the total return on the investment. A dividend paying stock is generally referred to as a blue chip stock because of its ability to share profits with shareholders in the form of dividends. Selecting good quality common stocks takes a great deal of research and investigation, much of which can be provided by your investment advisor or broker. Common stocks are very liquid investments, which means they are easily bought and sold, a feature which becomes very important when you need access to your investment funds.
Mutual funds are a very common choice of investors looking to invest in common stocks, as mutual funds diversify by pooling investors money and buying a number of different stocks. They are also professionally managed, yet you should examine the performance history of a particular fund before selecting it as part of your portfolio. While the history is not a guarantee of future results, it does offer some insights into the abilities of the fund managers.
Savings bonds have been an important part of personal portfolios for many years. While the return on savings bonds currently is very low (about 3% generally), the safety of your invested dollar and your periodic interest earnings are guaranteed by the US government. Additionally, interest earned on savings bonds is not taxable at the state or local level, and under certain circumstances may be tax exempt at the federal level when used to pay educational expenses. The tax exemption should be considered to evaluate the true return on your investment. For example, if you are earning 3% on a tax exempt investment, you would need to earn approximately 4 ½ to 5 % on a taxable investment to achieve the same results. Savings bonds are available in denominations as small as $25, which facilitates building a portfolio even for those just starting to invest.
Certificates of deposit (CDs) are also a good way to build a portfolio over time, as most credit unions and other savings institutions will establish a CD for as little as $500. CDs are also insured by the federal government (up to certain maximums) when purchased at an insured credit union such as BCU or a bank which has FDIC insurance. CDs are purchased for set periods of time, generally from 90 days to 5 years, with greater rates of return for longer terms. With this product you are able to determine its future value at maturity at the time you purchase the CD, a feature which adds stability to a portfolio and allows for future financial planning with some certainty. CDs are not as liquid as some other investments, as you may incur an interest penalty if you liquidate the CD before its maturity date.
Real estate has gained popularity as an investment vehicle in recent years. Im not referring to a personal residence, as I dont consider a personal residence as an investment in the sense that it would be a part of a portfolio. However, rental property or investments in real estate investment trusts (REITs) could be part of a diversified portfolio. A REIT is an investment vehicle which pools the money of many investors and buys apartment buildings or shopping centers for example, attempting to earn profits from rental income as well as from price appreciation of the property over time. The collapse in real estate prices over the last year has dampened the enthusiasm for this type of investment; nonetheless it has played a significant role in personal portfolios in the past, and eventually could be considered as another alternative. REITs are liquid as they can be easily sold in the open market; specific properties are very illiquid as it may take many months to sell a given property.
Treasury securities other than savings bonds include treasury bills, treasury notes, and treasury bonds. The differentiation among these products is based upon their time to maturity from the date of issuance. A treasury bill has a maturity of one year or less, while a note matures between 2 and 10 years, and a bond generally has a maturity of 15 to 30 years. Again, these securities are backed by the full faith and credit of the US government so they are considered risk free investments. Furthermore they are very liquid as the treasury market trades billions of dollars worth of government securities each day. Also, for investors with large portfolios, there is no limit to the amount of insured value of treasury securities, as the US government stands behind all treasury securities issued regardless of the dollar value held by any one investor.
Corporate bonds are yet another type of investment to consider. Here I am referring to high grade corporate bonds as determined by the professional rating services (e.g., Standard & Poors, Moodys Investor Services). Bonds are rated as to their quality based on the underlying financial condition of the company selling the bonds; the better their financial health, the higher the rating. Most companies need to borrow money to grow and to innovate in order to continue to provide a return for their shareholders. Corporate bonds are issued for varying lengths of time (maturities) ranging from 3 years on up. These bonds pay competitive rates of interest, and sometimes have other benefits such as the ability to convert the bonds to shares in the company when it is beneficial for the bondholder to do so. Recently because of the credit crunch and the fact that many banks reduced or eliminated their lending for a period of time, corporate bonds have been issued with some very attractive rates of interest. The companies needed the funds to continue to operate and therefore had to pay higher rates of interest to attract sufficient capital for their needs. This provided opportunity for those who understood both the product and the circumstances.
A word about diversification
We have all heard the expression dont put all of your eggs in one basket. This expression is particularly applicable to investments. Often when we hear of a diversified portfolio, it is in reference to the fact that the portfolio has many different common stocks representing different industries or services or product lines. However, if the entire portfolio is invested in common stocks it is not well diversified. As evidenced by the most recent market collapse, there are times when all investments in one particular class will suffer the same fate. Therefore, the true meaning of diversification as it applies to investments is that we eventually own different types of investments in our personal portfolios. Those who owned some treasury securities, some CDs, some real estate and some common stocks over the last year withstood the difficult times better than those who only owned common stocks, and/or real estate. Part of their portfolio included investments (CDs and treasury securities) that performed well during the financial crisis.
There are many additional types of investments which can be considered depending on the amount of capital available to invest and the objectives of the investor. Whatever investments you choose, the key is to understand how they work and how they will help to achieve your particular financial goals.
©Patrick J. Catania 2009
The views and opinions expressed herein are solely those of the author and do not necessarily reflect those of Baxter Credit Union, its Board of Directors, or its employees. The author is responsible for the content. Readers should consult with, and seek professional advice from their own attorneys, accountants, and financial advisors with respect to their individual financial needs and circumstances.
We welcome your feedback and ideas regarding this service. To submit a comment or idea for a future article, please email us at firstname.lastname@example.org