Financial Planning 101: Part 8
Understanding Investments
by Gerald Townsend, Financial Editor
August 2009
In this month’s installment of the Financial Planning 101 Series, we focus on understanding investments, while next month’s article will address how to actually construct a portfolio.
We work to earn the money needed to pay our bills and support our lifestyle. We save and invest so that in the future our money can work for us instead of us working for our money. An "investment" is an asset or financial product we place our money in with the hope that it will generate future income, increase in value, or both.
We work to earn the money needed to pay our bills and support our lifestyle. We save and invest so that in the future our money can work for us instead of us working for our money. An “investment” is an asset or financial product we place our money in with the hope that it will generate future income, increase in value, or both.
Given the headlines of corporate scandals, “get-rich-quick” schemes and Bernie Madoff frauds, it is easy to think that investing is the same as gambling—but it is not. Gambling is a risky, short-term, zero-sum game played with a “winner-take-all” attitude. Investing involves the long-term creation of wealth. Some individual gamblers in Las Vegas win, but the casino itself always wins. When you invest, you actually own the casino. There is risk in investing, but it is a measured risk.
Investing utilizes what Albert Einstein called the “ninth wonder of the world”—compound interest—where your profit (interest, dividends, capital gains) are added back to your original principal and this new sum continues growing (compounding) exponentially.
Savings accounts, real estate, mutual funds, stocks, bonds, antiques or your own business are all examples of investments; however, they differ from each other in several important areas.
If you need to get your money out of your investment, can you do so quickly and without any loss to your principal? This is known as “liquidity” and your savings account is considered to be a liquid investment, but very few other ones meet this definition.
Because a public market exists where stocks, bonds and mutual funds can quickly be converted to cash, they are considered to be “marketable” securities, but since principal is not guaranteed, they are not liquid assets. While you may be able to sell your real estate or your own business, they normally cannot be sold quickly, so they are considered to be “non-marketable” assets.
You invest with the hope of a future return and this return comes from several sources. Money in a savings account or a bond is effectively loaned to someone else and your return comes from interest. With stocks, your own business or real estate you are the owner and your return comes from dividends (rent, if real estate) and potential appreciation in value of the investment. Thus, the first big distinction in investing comes from either being a “loaner” or an “owner.” As a general rule, “loaner” investments tend to be safer, but with a smaller expected return, than “owner” investments. The most significant investment decision you will ever make is the allocation of your assets between loaner and owner investments.
All investments have risk, but what do we actually mean by that four-letter word? Is risk the possibility of actually losing some or all of what you have invested or is it just the daily up-and-down volatility of the investment markets? Both of those are forms of risk, but they are not the only ones. What about the risks of inflation, taxes, interest-rate changes, or regulatory impacts? Every investment is subject to some type of risk.
Therefore, the challenging task for investors is balancing the desire for keeping their money safe and secure with the practical need for their funds to grow and provide future retirement income—or their goal of achieving high returns with their fear of losing their original investment.
How do you go about constructing a portfolio to balance these competing desires? That will be the subject of next month’s installment of Financial Planning 101.
Gerald A. Townsend, CPA/PFS, CFP®, CFA® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com