Investing

One of the purposes of this resource is to assist you in making investment decisions that will help you towards your goals. Regardless of the investment vehicles that you ultimately decide upon you will need to read this chapter first in order to understand some of the basic concepts about investing.

Before you begin an investment program there are several things that you need to understand and have in place. First, you need to understand what investing is and, by implication, what it is not. Second, there are four things that you need to have in place before you begin to invest large sums of money for future use.

Sometimes people use the language of investing when they really are talking about something else. For example, someone may look upon new clothes as an “investment” in their career. Buying new clothes for employment may indeed be a wise thing to do but it is not investing. Investing is putting some of your money at risk in such a way that you hope to have it returned to you with interest; or that the underlying asset will increase in value. When buying new clothes, very few of us have the expectation that the clothes will increase in value. No one is going to send us a dividend check simply because we have nice shoes. Having nice clothes can be a very wise decision and it can lead to further opportunities but it is not investing. Neither is a new car or a vacation or any number of things that people choose to spend their money on. Don’t use the language of investing when you are really talking about spending, even if it is wise spending.

Before you really start to invest, you need to have four basic things in place. They have all been covered in previous chapters. You need to have your emergency fund in place. You should have all of the appropriate insurance products in place that were covered earlier. You need to have your consumer debt eliminated or well on the way to being eliminated. And, you need to have made a decision about housing. All of these issues revolve around a central theme. Without these elements of your financial life in place, you may be forced to sell investments for cash at a time when the financial markets are not favorable for sellers. With each of these four elements in place, you should be able to withstand temporary reversals and hold on through to the time when your investments will pay off.

Types of Risk

There is no such thing as a risk-free investment that pays guaranteed interest or dividends and is going to grow in value year after year. Every investment carries with it some sort of risk. Investing is not about avoiding risk altogether. It is about selecting investments that will help you reach your financial goals but carry with them the amount of risk that you are comfortable with. As time goes by and you gain experience with investments of various kinds, you will learn about what kinds of investments are within your comfort range and which ones are outside your comfort range. This will change as you get closer to the point in time where you will need to tap into your investments to meet your goals. When your goals are far in the future, you may find that you can tolerate more risk than when they are relatively close in time.

Purchasing Power Risk

There is always a chance that even though your money grows through investment return that it will actually have less buying power in the future than you did when you first invested. For example, if you earn a 5% return but the cost of the living goes up 6%, you actually end up with less than you had at the beginning. You have more money but less purchasing power.

Interest rate risk

The values of some investments tend to move in the opposite direction to interest rates. When rates are going up, the underlying investment goes down in value. When rates are going down, the underlying investment goes up in value.

Financial risk

This is where you really need to be aware of the financial strength of a company. If they are carrying a lot of debt, there is always the chance that they will be unable to service their debt and sometimes companies in that situation go out of business. If they have no debt, there is no financial risk.

Business risk

Here you actually focus in on the nature of the business. What good is produced? What service is provided? Is it done well and at a competitive price? Will the market for that product or service continue into the future and will this company be able to remain competitive? This is where you will need to take a look at demographic trends, business plans, competing companies, management, etc, etc., etc.

Market risk

Sometimes, regardless of how good a company is and how strong their balance sheet is, a broad decline in the financial markets will adversely affect them even when they are much stronger than other companies that are declining in value. If you have observed the financial markets over a couple of years you will know that sometimes a market correction can be brutal and when the tide goes out, all the stocks (good and bad) are affected.

Investment considerations

What are you investing for?

This is the first and most important question that you need to ask about your investments. In recent years, changes in the tax code has made it possible for individuals to prepare for future financial challenges (retirement, college, etc.) in some very advantageous ways. Money needs to be earmarked so that you take advantage of the investment opportunities that are out there.

Start Early

The sooner you start investing, the easier it will be to reach your financial goals. It also allows you to invest for the long term and take more risk and generally that means a higher rate of return over time.

Time Horizon

Even when you invest for the long term, there comes a point where the need for the money is too close to allow investing for the long term. You always need to be aware of your time frame so that you do not find yourself suffering through a short-term decline in the value of your investment at the time when you start to need them.

Liquidity

In order to realize the gain in your investment and convert it to dollars where it can be used for something else, you need to be aware of how quickly something can be converted to cash. In some instances, the liquidity is immediate. In others, it may take some time to convert to cash.

Marketability

To what extent does a market exist for the investments that you have chosen? It can be either a formal or informal market but it needs to be there or else you need to rethink you decision to invest. Even where markets exist, conditions may mean that an asset is not immediately marketable.

Tax consequences

Different investments have different tax consequences and you need to be aware of this before you invest. At this point in time, if you are investing for retirement or the education of your children, there are some excellent ways to do that and avoid taxes at the same time.

Inflation protection

Finally, you need to give consideration to how you will protect yourself from inflation. Some investments have historically performed better than inflation and offer a hedge against rising prices. Other investments tend to under-perform when compared to the rate of inflation and should be considered for short-term investment vehicles. Knowing which investment is appropriate for you as you consider the impact of inflation is important to your future.

A few other points to ponder…

The value of an investment is based on its ability to produce income. Income may be in the form of dividends or interest or it may come to you as a capital gain. Be very wary of investments that have no earnings or that pay no dividends or interest. If all that an investment offers is capital gains then at the time you wish to realize the gain, you will need to find someone who is willing to invest in something that pays no dividends or interest. This can be difficult and limits the pool of possible buyers.

In spite of that, focus on assets, not income. You will need to look at the underlying asset very closely and make sure that you understand what it is that you are buying and how it can be maximized over time. This is especially true of real estate. In the chapter on real estate investment, some techniques will be presented that will allow some rather impressive results over time if you focus on assets first and income second.

Let it grow. The temptation for some is to venture into an investment, make a few dollars and then run to the sidelines. Select investments that are good for the long run and move between investments only when it is wise to do that. Jumping in and out will dominate your time and attention and probably reduce your return over time.

Pay attention (lots of attention) to taxes. The difference can be dramatic. Have a strategy in place at the time that you invest that will minimize the tax that you pay at the time that you sell. Do not expect that the individual who prepares your taxes will know how to minimize your taxes. Learn that for yourself and then follow it when it makes sense to do that.

Get good financial advice. Spend a little time each week reading articles that relate to your investments or searching on line for information that is helpful. If you decide to go with a financial advisor, select one who has the experience and training necessary for the role that they will play.

Don’t get bad financial advice. As your investment grows, you will come across a lot of “opportunities”; a lot of people who know what the “next great investment“ is… Listen, but don’t chase after every idea that comes down the road. Don’t get caught up in schemes that you do not understand or that promise results beyond what can reasonably be expected. There is enough risk associated with good investments and you don’t need to add to that the risks associated with bad investments.

Invest for your own retirement. While the nature of retirement continues to evolve as each generation approaches it, you need to put aside money early for this purpose. This should start with the first job of your career and continue throughout your working life. There a number of great ways to do this that are covered in the chapter that deals with retirement.

Invest for the education of your children. While your contribution is only part of the picture here, it is an important part of what you should be doing to get your children off to a good start in life. There will be other sources of income to assist them when the time comes (including their own earnings and savings) but your contribution is important. Once again, there are some excellent ways to save for this purpose that will be presented in the chapter that deals with this subject.
 

WEB SITES:

http://www.asec.org/ 
http://www.usaaedfoundation.org/financial/bi10.asp