Investment is the placement of present capital into a productive enterprise with the aim of receiving future income and/or appreciation of capital. Investments may look to the short or long term and seeks to maximize current income or long-term growth, or some balance of the two.
Classification of Investments
Investments may be classified into these general types:
Low-risk savings include interest-bearing checking and savings accounts, certificates of deposit, money-market accounts, U.S. savings bonds, and certain life insurance and annuity contracts.
Domestic securities include common and preferred stocks, corporate bonds, mutual funds, federal, state and municipal bonds, variable annuities, commodity futures contracts, and stock options.
International securities are the securities of corporations domiciled or headquartered in other nations.
Real estate includes real property held for rental income or appreciation and may be residential or non-residential (commercial), and mortgage loans on real property held for the interest return on the money loaned.
In many instances, investment returns are directly proportional to investment risks; as risk increases, so does potential reward–and potential loss. Investors must consider these various risks in relation to their risk tolerance, financial situation and personal objectives as they develop an investment plan which meets their needs. Investment risks may be classified as follows:
Inflation risk, also known as purchasing power risk, recognizes the effects of general price movements on real investment return. If the yield on an investment is less than the inflation rate–the rate at which prices are increasing–then the purchasing power of the client’s investment will decline over time. Corporate bonds, fixed annuities and preferred stock, for example, are prone to inflation risk.
Capital risk is the risk of loss of principal under circumstances not related to the financial strength of the issuer. If an option expires out-of-the-money, for example, the investor loses his or her principal even though the security on which the option was issued remains solvent.
Selection risk is the risk of loss of principal because the investor selected a poorly performing investment. An example would be stock purchased in a company that eventually goes bankrupt.
Timing risk is the risk that the client will buy or sell a security at an inopportune time. Typically this means buying a stock at its high or selling it at its low, or buying a bond just before interest rates rise or selling a bond just before interest rates fall.
Bond investors, who generally seek a stable income, risk being unable to reinvest their interest earnings, and their principal at maturity, at the same rate in a time when the prevailing rates are falling. Zero-coupon bonds reinvest interest automatically at the same rate until maturity, and thus are not prone to this reinvestment risk until that time.
Market risk is the risk of reduction in capital because of price fluctuations in the market for the investment. For example, the relationship between bond prices and bond yields is inverse. As bond yields rise, bond prices drop (and vice versa). Thus, the market price of old bonds drops when new bonds are issued that pay higher coupon rates.
Credit risk, also known as financial risk or default risk, is the risk that an investor will lose principal due to the business failure of the issuer. Bonds issued by the federal government are said to have minimal credit risk, while non-investment grade (“junk”) bonds generally have high credit risk.
Also known as marketability risk, liquidity risk is the risk of not being able to dispose of an investment readily, or to convert it into cash, when desired. For example, securities traded on national and regional exchanges are liquid, but precious jewels, metals and collectibles are less so.
Legislative risk is the risk that tax and other laws may change in a way adverse to investment holdings. This happened to some investors in direct participation programs (tax shelters) in the 1980s when certain tax loopholes were narrowed or closed altogether.
Investment Goals and Objectives
Investment goals and objectives differ widely from person to person, and they change over time. They typically fall into categories which can be identified and briefly described as follows:
It is frequently thought prudent to keep approximately four to six months income available in liquid and low-risk investments to provide for unexpected needs or to safeguard against loss of income.
Life insurance and disability income insurance can protect against the risks that premature death or disability will undermine personal and family financial security.
Investors may seek to augment their earned income with investment income in order to enjoy a higher standard of living than they could otherwise afford. Bonds, preferred stock, and mutual funds in which the objective is to seek income can be used for this purpose.
Savings may be accumulated to purchase a principal residence, a second home, a boat or an airplane, or some other desired property. Investments chosen to help meet such objectives are typically shorter term in nature.
College or Child-Related Funds
A program of regular accumulation to help meet eventual college tuition needs, or to provide for a disabled child’s special needs, is a frequent incentive to invest. Investment goals should be calculated and funding vehicles selected with such needs in mind.
Individual investors increasingly tend to assume more responsibility for their own financial well-being during retirement, and to place less reliance on Social Security and on company defined benefit pension plans. Accumulation of assets which will produce income during retirement is a long-term process which tends to be more growth-oriented and risk-tolerant at the beginning, and more income-oriented and risk-averse toward the end.
Many investors seek to leave something behind them after they have departed, either for family members or friends, or for favored charities. Investments made with this end in mind tend to be chosen for long-term value and propensity for capital appreciation.
Type of Mutual Funds
As is the case with most corporations, a board of directors oversees the operation of a mutual fund. These directors are typically elected by shareholders at the fund’s annual meeting. Directors are of two types: outside and inside. “Inside directors” have some sort of direct tie to the mutual fund or to an affiliated company; “outside directors” do not.
U.S. Equity stock funds
This type of fund invest in the stocks of domestic corporations. Objectives vary from income, to growth, to aggressive growth. Sector stock funds specialize in the securities of one particular market or industry segments such as health care, or technology, or utilities income. Index funds attempt to match or exceed the performance of some market index and include S & P 500 index funds, small cap. Stock index funds, and total market index funds. It is important to remember that indexes are unmanaged; therefore, index funds do not necessarily invest in all of the stocks included on the index or in the same proportions as on the index. As a result of these differences, and the expenses of the fund that will decrease the performance of the fund, the fund’s performance generally does not quite match the index’s performance. The prospectus should be carefully reviewed.
Global stock funds
This type of fund invest in the stock of corporations around the world, including the U.S. This sort of diversification is designed to reduce the risk of a downturn in any one country’s economy. The downside is that investments abroad may be vulnerable to risks posed by accounting, political, regulatory, currency exchange-rate fluctuations, or other factors which are normally not problematic for domestic investments. The prospectus should be carefully reviewed.
International stock funds
This type of fund invest in the stocks of corporations around the world, excluding the U.S. Risks and benefits are similar to those discussed under “Global Stock Funds” above, with the difference that U.S. stocks are not carried in the portfolio. Again, the prospectus should be carefully reviewed.
European stock funds
This type of fund invest in the stocks of European-domiciled corporations. These offer an opportunity to invest outside the U.S., but limit themselves to investing in corporations of countries generally thought to be more stable and safe. Risks are nonetheless similar to those discussed under “Global Stock Funds” above. The prospectus should be carefully reviewed.
Pacific stock funds
This type of fund invest in stocks associated with “Pacific Rim” countries, such as Japan, South Korea, Taiwan and Singapore. While they offer an opportunity to diversify outside the U.S. economy, such funds may be sensitive to economic changes or political problems in another country. Ancillary risks should be carefully assessed, the prospectus should be carefully reviewed.
This type of fund invest in the shares of gold or precious metals mining firms located primarily outside the U.S. Such shares are thought by some to offer a hedge against inflation, and to serve as a store of value in unstable economic times. Risks should be carefully assessed. We have only covered a few of the leading alternatives for equity fund investing, and this list is hardly exhaustive. For example, there are funds that concentrate on regions other than Europe and the Pacific Rim, funds that focus on commodities other than gold, and funds that specialize in options and futures. the prospectus should be carefully reviewed.
Balanced funds combine bonds and stocks to achieve growth and income in varying proportions. Because balanced funds maintain some level of investment in both stocks and bonds, values tend to be less volatile than in straight growth funds. Bonds, theoretically, should go up when stocks go down, providing a counterbalance to value that is lost when the stock market declines. Variations on straightforward balanced funds include. The prospectus should be carefully reviewed.
Municipal Bonds and Muni-Bond Mutual Funds
Municipal bonds is the common name for debt obligations issued not only by cities, but also by states, public school districts, and other governmental entities. The interest received on them is exempt from federal income taxation, and is attractive to high-bracket investors, although gain on their sale is taxable. Some states exempt interest received on bonds issued by political entities within the state from state and local income taxes. The prospectus should be carefully reviewed.
This website does not provide investment advice or recommendations. Nothing in this website shall be considered a solicitation to buy or an offer to sell a security, to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the laws of such jurisdiction.