3.1 Investment Basics
[1]Before looking at investment planning and strategy, it is important to take a closer look at the galaxy of investments and markets where investing takes place. Understanding how markets work, how different investments work, and how different investors can use investments is critical to understanding how to begin to plan your investment goals and strategies.
You have looked at using the money markets to save surplus cash for the short term. Investing is primarily about using the capital markets to invest surplus cash for the longer term. As in the money markets, when you invest in the capital markets, you are selling liquidity.
The capital markets developed as a way for buyers to buy liquidity. In Western Europe, where many of our ideas of modern finance began, those early buyers were usually monarchs or members of the nobility, raising capital to finance armies and navies to conquer or defend territories or resources. Many devices and markets were used to raise capital,For a thorough history of the evolution of finance and financial instruments, see Charles P. Kindleberger, A Financial History of Western Europe (London: George Allen & Unwin, Ltd., 1984). but the two primary methods that have evolved into modern times are the bond and stock markets. We will discuss each on their own later in this module, but a brief introduction is provided below.
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Bonds and Bond Markets
Bonds are debt. The bond issuer borrows by selling a bond, promising the buyer regular interest payments and then repayment of the principal at maturity. If a company wants to borrow, it could just go to one lender and borrow. But if the company wants to borrow a lot, it may be difficult to find any one investor with the capital and the inclination to make large a loan, taking a large risk on only one borrower. In this case the company may need to find a lot of lenders who will each lend a little money, and this is done through selling bonds.
A bond is a formal contract to repay borrowed money with interest (often referred to as the coupon) at fixed intervals. Corporations and governments (e.g., federal, state, municipal, and foreign) borrow by issuing bonds. The interest rate on the bond may be a fixed interest rate or a floating interest rate that changes as underlying interest rates—rates on debt of comparable companies—change. (Underlying interest rates include the prime rate that banks charge their most trustworthy borrowers and the target rates set by the Federal Reserve Bank.)
There are many features of bonds other than the principal and interest, such as the issue price (the price you pay to buy the bond when it is first issued) and the maturity date (when the issuer of the bond has to repay you). Bonds may also be “callable”: redeemable before maturity (paid off early). Bonds may also be issued with various covenants or conditions that the borrower must meet to protect the bondholders, the lenders. For example, the borrower, the bond issuer, may be required to keep a certain level of cash on hand, relative to its short-term debts, or may not be allowed to issue more debt until this bond is paid off.
Because of the diversity and flexibility of bond features, the bond markets are not as transparent as the stock markets; that is, the relationship between the bond and its price is harder to determine. The U.S. bond market is now more than twice the size (in dollars of capitalization) of all the U.S. stock exchanges combined, with debt of more than $27 trillion by the end of 2007.[2]
U.S. Treasury bonds are auctioned regularly to banks and large institutional investors by the Treasury Department, but individuals can buy U.S. Treasury bonds directly from the U.S. government. To trade any other kind of bond, you have to go through a broker. The brokerage firm acts as a principal or dealer, buying from or selling to investors, or as an agent for another buyer or seller.
Stocks and Stock Markets
Stocks or equity securities are shares of ownership. When you buy a share of stock, you buy a share of the corporation. The size of your share of the corporation is proportional to the size of your stock holding. Since corporations exist to create profit for the owners, when you buy a share of the corporation, you buy a share of its future profits. You are literally sharing in the fortunes of the company.
Unlike bonds, however, shares do not promise you any returns at all. If the company does create a profit, some of that profit may be paid out to owners as a dividend, usually in cash but sometimes in additional shares of stock. The company may pay no dividend at all, however, in which case the value of your shares should rise as the company’s profits rise. But even if the company is profitable, the value of its shares may not rise, for a variety of reasons having to do more with the markets or the larger economy than with the company itself. Likewise, when you invest in stocks, you share the company’s losses, which may decrease the value of your shares.
Corporations issue shares to raise capital. When shares are issued and traded in a public market such as a stock exchange, the corporation is “publicly traded.” There are many stock exchanges in the United States and around the world. The two best known in the United States are the New York Stock Exchange (now NYSE Euronext), founded in 1792, and the NASDAQ, a computerized trading system managed by the National Association of Securities Dealers (the “AQ” stands for “Automated Quotations”).
Only members of an exchange may trade on the exchange, so to buy or sell stocks you must go through a broker who is a member of the exchange. Brokers also manage your account and offer varying levels of advice and access to research. Most brokers have Web-based trading systems. Some discount brokers offer minimal advice and research along with minimal trading commissions and fees.
Commodities and Derivatives
Commodities are resources or raw materials, including the following:
- Agricultural products (food and fibers), such as soybeans, pork bellies, and cotton
- Energy resources such as oil, coal, and natural gas
- Precious metals such as gold, silver, and copper
- Currencies, such as the dollar, yen, and euro
Commodity trading was formalized because of the risks inherent in producing commodities—raising and harvesting agricultural products or natural resources—and the resulting volatility of commodity prices. As farming and food production became mechanized and required a larger investment of capital, commodity producers and users wanted a way to reduce volatility by locking in prices over the longer term.
The answer was futures and forward contracts. Futures and forward contracts or forwards are a form of derivatives, the term for any financial instrument whose value is derived from the value of another security. For example, suppose it is now July 2010. If you know that you will want to have wheat in May of 2011, you could wait until May 2011 and buy the wheat at the market price, which is unknown in July 2010. Or you could buy it now, paying today’s price, and store the wheat until May 2011. Doing so would remove your future price uncertainty, but you would incur the cost of storing the wheat.
Alternatively, you could buy a futures contract for May 2011 wheat in July 2010. You would be buying May 2011 wheat at a price that is now known to you (as stated in the futures contract), but you will not take delivery of the wheat until May 2011. The value of the futures contract to you is that you are removing the future price uncertainty without incurring any storage costs. In July 2010 the value of a contract to buy May 2011 wheat depends on what the price of wheat actually turns out to be in May 2011.
Forward contracts are traded privately, as a direct deal made between the seller and the buyer, while futures contracts are traded publicly on an exchange such as the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX).
When you buy a forward contract for wheat, for example, you are literally buying future wheat, wheat that doesn’t yet exist. Buying it now, you avoid any uncertainty about the price, which may change. Likewise, by writing a contract to sell future wheat, you lock in a price for your crop or a return for your investment in seed and fertilizer.
Futures and forward contracts proved so successful in shielding against some risk that they are now written for many more types of “commodities,” such as interest rates and stock market indices. More kinds of derivatives have been created as well, such as options. Options are the right but not the obligation to buy or sell at a specific price at a specific time in the future. Options are commonly written on shares of stock as well as on stock indices, interest rates, and commodities.
Derivatives such as forwards, futures, and options are used to hedge or protect against an existing risk or to speculate on a future price. For a number of reasons, commodities and derivatives are more risky than investing in stocks and bonds and are not the best choice for most individual investors.
Mutual Funds, Index Funds, and Exchange-Traded Funds
A mutual fund is an investment portfolio consisting of securities that an individual investor can invest in all at once without having to buy each investment individually. The fund thus allows you to own the performance of many investments while actually buying—and paying the transaction cost for buying—only one investment.
Mutual funds have become popular because they can provide diverse investments with a minimum of transaction costs. In theory, they also provide good returns through the performance of professional portfolio managers.
An index fund is a mutual fund designed to mimic the performance of an index, a particular collection of stocks or bonds whose performance is tracked as an indicator of the performance of an entire class or type of security. For example, the Standard & Poor’s (S&P) 500 is an index of the five hundred largest publicly traded corporations, and the famous Dow Jones Industrial Average is an index of thirty stocks of major industrial corporations. An index fund is a mutual fund invested in the same securities as the index and so requires minimal management and should have minimal management fees or costs.
Mutual funds are created and managed by mutual fund companies or by brokerages or even banks. To trade shares of a mutual fund you must have an account with the company, brokerage, or bank. Mutual funds are a large component of individual retirement accounts and of defined contribution plans.
Mutual fund shares are valued at the close of trading each day and orders placed the next day are executed at that price until it closes. An exchange-traded fund (ETF) is a mutual fund that trades like a share of stock in that it is valued continuously throughout the day, and trades are executed at the market price.
The ways that capital can be bought and sold is limited only by the imagination. When corporations or governments need financing, they invent ways to entice investors and promise them a return. The last thirty years has seen an explosion in financial engineering, the innovation of new financial instruments through mathematical pricing models. This explosion has coincided with the ever-expanding powers of the computer, allowing professional investors to run the millions of calculations involved in sophisticated pricing models. The Internet also gives amateurs instantaneous access to information and accounts.
Much of the modern portfolio theory that spawned these innovations (i.e., the idea of using the predictability of returns to manage portfolios of investments) is based on an infinite time horizon, looking at performance over very long periods of time. This has been very valuable for institutional investors (e.g., pension funds, insurance companies, endowments, foundations, and trusts) as it gives them the chance to magnify returns over their infinite horizons.
For most individual investors, however, most portfolio theory may present too much risk or just be impractical. Individual investors don’t have an infinite time horizon. You have only a comparatively small amount of time to create wealth and to enjoy it. For individual investors, investing is a process of balancing the demands and desires of returns with the costs of risk, before time runs out.
Return
Returns are always calculated as annual rates of return, or the percentage of return created for each unit (dollar) of original value. If an investment earns 5 percent, for example, that means that for every $100 invested, you would earn $5 per year (because $5 = 5% of $100).
Returns are created in two ways: the investment creates income or the investment gains (or loses) value. To calculate the annual rate of return for an investment, you need to know the income created, the gain (loss) in value, and the original value at the beginning of the year. The percentage return is calculated as:
Return = 100 x (Income + Current Value – Original Value)/Original Value.
Note that if the ending value is greater than the original value, then Ending value − Original value > 0 (is greater than zero), and you have a gain that adds to your return. If the ending value is less, then Ending value − Original value < 0 (is less than zero), and you have a loss that detracts from your return. If there is no gain or loss, if Ending value − Original value = 0 (is the same), then your return is simply the income that the investment created.
For example, if you buy a share of stock for $100, and it pays no dividend, and a year later the market price is $105, then your return = 100 x [0 + (105 − 100)] ÷ 100 = 100 x 5 ÷ 100 = 5%. If the same stock paid a dividend of $2, then your return = 100 x [2 + (105 − 100)] ÷ 100 = 100 x 7 ÷ 100 = 7%.
The above calculation only works for one year changes. Due to the impact of compounding growth, we cannot use the simple percent change to determine annual growth over several years. Instead, we return to our compounding growth formula to determine the annual growth rate. The benefit is that because we are just looking for annual growth rates, we do not need to worry about compounding periods. Therefore, we can use the equation
FV=PV(1+r)t.
We need to solve for r which means that we will need to use fractional roots like we did in module 1.
Let’s try one together…
On January 2, 2020, the Amazon stock (NYSE: X) had a price of 1,898.01. On December 31, 2020 it had a price of 3256.93. They did not pay any dividend (nor have they ever paid a dividend.) Calculate the annual return for 2020.
Answer: 71.6%
Let’s try one together…
Answer: 55.4%
Let’s try one together…
At the beginning of 2016, the PPG stock (NYSE: PPG) had a price of $94.49. At the end of 2020 it had a price of $144.22. Calculate the average annual return over this five-year period. (Ignore any potential dividend payment.)
Answer: 8.8%
Let’s try one together…
At the beginning of 2016, the Dick’s Sporting Goods stock (NYSE: DKS) had a price of $34.49. At the end of 2020 it had a price of $56.21. Calculate the average annual return over this five-year period. (Ignore any potential dividend payment.)
Answer: 10.3%
While information about current and past returns is useful, investment professionals are more concerned with the expected return for the investment, that is, how much it may be expected to earn in the future. Estimating the expected return is complicated because many factors (i.e., current economic conditions, industry conditions, and market conditions) may affect that estimate.
For investments with a long history, a strong indicator of future performance may be past performance. Economic cycles fluctuate, and industry and firm conditions vary, but over the long run, an investment that has survived has weathered all those storms. So you could look at the average of the returns for each year. There are several ways to do the math, but if you look at the average return for different investments of the same asset class or type (e.g., stocks of large companies) you could compare what they have returned, on average, over time.
If the time period you are looking at is long enough, you can reasonably assume that an investment’s average return over time is the return you can expect in the next year. For example, if a company’s stock has returned, on average, 9 percent per year over the last twenty years, then if next year is an average year, that investment should return 9 percent again. Over the eighteen-year span from 1990 to 2008, for example, the average return for the S&P 500 was 9.16 percent. Unless you have some reason to believe that next year will not be an average year, the average return can be your expected return. The longer the time period you consider, the less volatility there will be in the returns, and the more accurate your prediction of expected returns will be.
Returns are the value created by an investment, through either income or gains. Returns are also your compensation for investing, for taking on some or all of the risk of the investment, whether it is a corporation, government, parcel of real estate, or work of art. Even if there is no risk, you must be paid for the use of liquidity that you give up to the investment (by investing).
Returns are the benefits from investing, but they must be larger than its costs. There are at least two costs to investing: the opportunity cost of giving up cash and giving up all your other uses of that cash until you get it back in the future and the cost of the risk you take—the risk that you won’t get it all back.
Risk
Investment risk is the idea that an investment will not perform as expected, that its actual return will deviate from the expected return. Risk is measured by the amount of volatility, that is, the difference between actual returns and average (expected) returns. This difference is referred to as the standard deviation. Returns with a large standard deviation (showing the greatest variance from the average) have higher volatility and are the riskier investments.
What risks are there? What would cause an investment to unexpectedly over- or underperform? Starting from the top (the big picture) and working down, there are
- economic risks,
- industry risks,
- company risks,
- asset class risks,
- market risks.
Economic risks are risks that something will upset the economy as a whole. The economic cycle may swing from expansion to recession, for example; inflation or deflation may increase, unemployment may increase, or interest rates may fluctuate. These macroeconomic factors affect everyone doing business in the economy. Most businesses are cyclical, growing when the economy grows and contracting when the economy contracts.
Consumers tend to spend more disposable income when they are more confident about economic growth and the stability of their jobs and incomes. They tend to be more willing and able to finance purchases with debt or with credit, expanding their ability to purchase durable goods. So, demand for most goods and services increases as an economy expands, and businesses expand too. An exception is businesses that are countercyclical. Their growth accelerates when the economy is in a downturn and slows when the economy expands. For example, low-priced fast food chains typically have increased sales in an economic downturn because people substitute fast food for more expensive restaurant meals as they worry more about losing their jobs and incomes.
Industry risks usually involve economic factors that affect an entire industry or developments in technology that affect an industry’s markets. An example is the effect of a sudden increase in the price of oil (a macroeconomic event) on the airline industry. Every airline is affected by such an event, as an increase in the price of airplane fuel increases airline costs and reduces profits. An industry such as real estate is vulnerable to changes in interest rates. A rise in interest rates, for example, makes it harder for people to borrow money to finance purchases, which depresses the value of real estate.
Company risk refers to the characteristics of specific businesses or firms that affect their performance, making them more or less vulnerable to economic and industry risks. These characteristics include how much debt financing the company uses, how well it creates economies of scale, how efficient its inventory management is, how flexible its labor relationships are, and so on.
The asset class that an investment belongs to can also bear on its performance and risk. Investments (assets) are categorized in terms of the markets they trade in. Broadly defined, asset classes include
- corporate stock or equities (shares in public corporations, domestic, or foreign);
- bonds or the public debts of corporation or governments;
- commodities or resources (e.g., oil, coffee, or gold);
- derivatives or contracts based on the performance of other underlying assets;
- real estate (both residential and commercial);
- fine art and collectibles (e.g., stamps, coins, baseball cards, or vintage cars).
Within those broad categories, there are finer distinctions. For example, corporate stock is classified as large cap, mid cap, or small cap, depending on the size of the corporation as measured by its market capitalization (the aggregate value of its stock). Bonds are distinguished as corporate or government and as short-term, intermediate-term, or long-term, depending on the maturity date.
Risks can affect entire asset classes. Changes in the inflation rate can make corporate bonds more or less valuable, for example, or more or less able to create valuable returns. In addition, changes in a market can affect an investment’s value. When the stock market fell unexpectedly and significantly, as it did in October of 1929, 1987, and 2008, all stocks were affected, regardless of relative exposure to other kinds of risk. After such an event, the market is usually less efficient or less liquid; that is, there is less trading and less efficient pricing of assets (stocks) because there is less information flowing between buyers and sellers. The loss in market efficiency further affects the value of assets traded.
As you can see, the link between risk and return is reciprocal. The question for investors and their advisors is: How can you get higher returns with less risk?
Diversification
Every investor wants to maximize return, the earnings or gains from giving up surplus cash. And every investor wants to minimize risk, because it is costly. To invest is to assume risk, and you assume risk expecting to be compensated through return. The more risk assumed, the more the promised return. So, to increase return you must increase risk. To lessen risk, you must expect less return, but another way to lessen risk is to diversify—to spread out your investments among a number of different asset classes. Investing in different asset classes reduces your exposure to economic, asset class, and market risks.
Concentrating investment concentrates risk. Diversifying investments spreads risk by having more than one kind of investment and thus more than one kind of risk. To truly diversify, you need to invest in assets that are not vulnerable to one or more kinds of risk. For example, you may want to diversify
- between cyclical and countercyclical investments, reducing economic risk;
- among different sectors of the economy, reducing industry risks;
- among different kinds of investments, reducing asset class risk;
- among different kinds of firms, reducing company risks.
To diversify well, you have to look at your collection of investments as a whole—as a portfolio—rather than as a gathering of separate investments. If you choose the investments well, if they are truly different from each other, the whole can actually be more valuable than the sum of its parts.
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Steps to Diversification
In traditional portfolio theory, there are three levels or steps to diversifying: capital allocation, asset allocation, and security selection.
Capital allocation is diversifying your capital between risky and riskless investments. A “riskless” asset is the short-term (less than ninety-day) U.S. Treasury bill. Because it has such a short time to maturity, it won’t be much affected by interest rate changes, and it is probably impossible for the U.S. government to become insolvent—go bankrupt—and have to default on its debt within such a short time.
The capital allocation decision is the first diversification decision. It determines the portfolio’s overall exposure to risk, or the proportion of the portfolio that is invested in risky assets. That, in turn, will determine the portfolio’s level of return.
The second diversification decision is asset allocation, deciding which asset classes, and therefore which risks and which markets, to invest in. Asset allocations are specified in terms of the percentage of the portfolio’s total value that will be invested in each asset class. To maintain the desired allocation, the percentages are adjusted periodically as asset values change.
Asset allocation is based on the expected returns and relative risk of each asset class and how it will contribute to the return and risk of the portfolio as a whole. If the asset classes you choose are truly diverse, then the portfolio’s risk can be lower than the sum of the assets’ risks.
One example of an asset allocation strategy is life cycle investing—changing your asset allocation as you age. When you retire, for example, and forgo income from working, you become dependent on income from your investments. As you approach retirement age, therefore, you typically shift your asset allocation to less risky asset classes to protect the value of your investments.
Security selection is the third step in diversification, choosing individual investments within each asset class. Here is the chance to achieve industry or sector and company diversification. For example, if you decided to include corporate stock in your portfolio (asset allocation), you decide which corporation’s stock to invest in. Choosing corporations in different industries, or companies of different sizes or ages, will diversify your stock holdings. You will have less risk than if you invested in just one corporation’s stock. Diversification is not defined by the number of investments but by their different characteristics and performance.
- Adapted from 12.1 Investments and Markets: A Brief Overview in Personal Finance by Lumen Learning shared under a CC BY-NC-SA license. ↵
- Financial Industry Regulatory Authority (FINRA), http://apps.finra.org/ (accessed May 20, 2009). ↵
Publicly issued and traded long-term debt used by corporations and governments.
A bond interest rate that does not change over time, from issuance to maturity.
A bond interest rate that changes over time, usually related to a benchmark rate such as the U.S. discount rate or prime rate.
The original market price of a bond at issuance.
Date at which a bond matures, or the end of the bond’s term, when the bond must be redeemed.
A bond that is eligible for redemption.
The date on which payment of a financial obligation is due, such as bond redemption date.
A condition placed on bond issuers (borrowers) to protect bondholders (lenders).
Shares issued to account for ownership, as defined by owners’ contributions to a corporation.
A share of corporate profit distributed to shareholders, usually as cash or corporate stock.
An organized market for the trading of corporate shares conducted by members of the exchange.
Raw materials—natural resources or agricultural products—used as inputs in processing goods and services.
A publicly traded contract to buy or sell an asset at a specified time and price in the future.
A private contract to buy or sell an asset at a specified time and price in the future.
Financial instruments such as options, futures, forwards, securitized assets, and so on whose value is derived from the value of another asset.
The right but not the obligation to buy or sell at a specific price at a specific time in the future; commonly written on shares of stock as well as on stock indices, interest rates, and commodities.
A portfolio of investments created by an investment company such as a brokerage or bank. It is financed as the investment company sells shares of the fund to investors. For investors, a mutual fund provides a way to achieve maximum diversification with minimal transaction costs through economies of scale.
A mutual fund designed to track the performance of an index for investors who seek diversification without having to select securities.
A fund that tracks an index or a commodity or a basket of assets but is traded like stocks on a stock exchange.
The use of mathematical modeling to create and value new financial instruments and markets.
The return expected for an investment based on its average historical performance. Statistically, it is the mean or average of the investment’s past performance.
In finance, the statistical measure that calculates the frequency and amount by which actual returns differ from the average or expected returns.
A kind of investment distinguished by its uses and market (e.g., stock, bonds, fine art, real estate, currency).
A strategy of diversifying a portfolio between risky and riskless assets.
The strategy of achieving portfolio diversification by investing in different asset classes.
An investment strategy in which asset allocation is based on the investor’s age or stage of life.
The process of choosing individual securities to be included in the portfolio.
