Purposes and Goals of Investing
Adapted from: © Investopedia Inc.
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
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:
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.
Clients with this objective want to maintain their capital position. As a result they are:
Appropriate investments are low risk securities such as federal and municipal bonds, high grade corporate bonds, and Treasury bills.
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.
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.
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.
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)
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.
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:
Before you make any investment, you should always determine the amount of time you have to keep your money invested. If you have $60,000 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 $60,000 is meant for the 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.
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
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:
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: