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When you invest in a company, you become a partial owner of that company. You now have a vested interest in the company’s performance. Whether you're managing money for a household or for a multinational corporation, you want the money you invest to give you the best possible return—whether for the short, the intermediate, or the long term. This article will discuss a variety of ways that go beyond just CDs—and things to think about when planning portfolios and making specific investment decisions.
Short-Term Investments
You may find yourself with substantial cash reserves that you don't need to invest or spend immediately. At the same time, you want this cash to be earning as much interest as possible until the investment decision is made—without giving up safety and liquidity. Three of the most popular solutions to this problem—available from full-service investment firms—are money-market funds, brokered certificates of deposit, and Treasury bills. We'll discuss each in turn.
Intermediate- and Long-Term Considerations: Risk and Reward
Investing for the intermediate term (1 to 10 years) and the long term (10 to 30 years) makes it important to consider the risk/reward characteristics of any prospective investment. Before committing funds to any investment, you must consider these questions:
Generally, the greater the risk you're willing to take, the greater the reward you may receive if the investment turns out well. Of course, greater risk can lead to greater losses if the investment turns out poorly. This is true for all the major types of investments: stocks, bonds, and mutual funds that invest in stocks and bonds.
Risk and Reward: Common Stocks
Common stocks are equity securities. They represent partial ownership in the issuing corporation. As the assets and liabilities of the corporation fluctuate, the stockholders' equity fluctuates, and so does the book value (balance-sheet value—assets minus liabilities) of your shares. Stock prices can also fluctuate with investors' changing perceptions of the prospects for the company.
Of the company's earnings (profits), the board of directors determines what portion will be distributed to stockholders as dividends and what portion will be retained to enhance book value or reinvest in the business. Thus stocks offer two components of return: dividends (which can usually be automatically reinvested if you wish) and a gain or a loss (changes in the stock's price).
Neither the stock's future price nor the payment (or amount) of future dividends is guaranteed. If the company fails, its creditors (bondholders) have the first or senior claim on its assets—holders of common stock, as the owners of the company are paid last.
However, in return for assuming greater risk, the stockholder also has the opportunity for potentially greater reward. If the company is successful in generating profits over the years, the stockholder is the one who may benefit. As a group, historically, stocks have consistently outperformed bonds over longer periods of time. In exchange for less risk, the bondholder has given up the opportunity for greater rewards.
In considering a stock investment, think about the following questions:
Risk and Reward: Bonds
Bonds are debt securities—the bondholder is a creditor of the issuing entity. The bond acknowledges that you have made a loan of the face value to the issuer, and represents the issuer's agreement to pay you a specified rate of interest over a specified period (hence the term "fixed-income investment"), after which the face value will be repaid to you.
Whereas stocks are ordinarily chosen for their growth potential, bonds are ordinarily chosen for the potential fixed income and capital preservation they may offer. However, this doesn't mean that bonds are without risk. When considering bond investments, think about each of the following types of risk:
For ordinary accounts, municipal bonds issued by government entities offer interest free of federal income tax (and often free of income tax in the state where they are issued). However, these yields are correspondingly lower. For tax-advantaged accounts such as pension funds and IRAs, corporate bonds (interest on which is taxable in ordinary accounts) pay significantly higher yields with no commensurate loss of safety.
In dealing with bonds, keep three axioms clearly in mind:
Zero-coupon bonds or "zeros" represent US Treasury obligations. They work much like US Savings Bonds: they are sold at a deep discount and compound at a stated rate until they mature at full face value. Since they do not pay current income, their market value fluctuates with interest rates even more widely than the market value of conventional (coupon) bonds. Thus a drop in interest rates may produce a quick rise in the market value of a long-term zero, offering the potential of a capital gain. (However, every upside has a downside: if you take the quick gain, the interest rates at which you can reinvest are lower.) It's also important to note that the growth of zeros is taxable each year, even though you don't receive it until maturity. Hence zeros are especially useful in tax-advantaged accounts. Like nearly all fixed income investments, if you sell the zero prior to maturity, it may be worth more or less than your initial cost.
Risk and Reward: Mutual Funds
Mutual funds pool the money of many investors and invest in diversified portfolios of stocks and/or bonds, to help reduce the risks inherent in single investments. They provide professional investment management, research, and record-keeping. If you are considering a mutual fund, request the fund's prospectus and its Statement of Additional Information, and read these materials carefully before making a decision. Study the fund's performance record over the last ten years, and compare it with the performance of other funds of the same type. If the fund has been successful, see whether the senior managers responsible for its success are still there. Make sure the fund's investment objectives and philosophy are compatible with your own.
Mutual Funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information, can be obtained by calling your Financial Advisor. Read it carefully before you invest.
Making Interest-Rate Fluctuations Work for You
Changes in inflation and interest rates have major effects on both stock and bond prices, and predictions about their movements are not reliable. However, you can make changes in interest rates and prices work for you through time diversification.
For stocks, time diversification takes the form of dollar-cost averaging. This simply means investing the same number of dollars in the chosen security at regular intervals, without regard to current prices. The result is that you buy more shares when prices are low, fewer shares when prices are high. Over time, the average purchase price of your shares is lower than if you had bought the same number of shares at each interval. You're protected against the risk of buying the entire investment at the top of the stock's price range. Of course, you also give up the chance of buying the entire investment at the bottom of the price range. Of course, dollar-cost averaging does not guarantee a profit and does not protect against a loss in declining markets.
As long as you're ultimately able to sell the investment at more than your average purchase price, dollar-cost averaging means volatility works for you: the more volatile the stock, the farther below the stock's average price (for the period) your average purchase price will be. But, whether volatile or not, the stock chosen should be one that you expect to rise strongly over the period of your investment.
For bonds, time diversification usually takes the form of a bond ladder. If new money becomes available each year, this works much like dollar-cost averaging in stocks, as you can invest roughly the same number of dollars in new bonds at current interest rates.
But even without new money, you can diversify over time by staggering the maturities of your bonds. As a portion of your portfolio matures each year, the face value is reinvested in new bonds at current interest rates.
In a five-year ladder, for example, the portfolio is divided evenly among bonds maturing in each of the next five years. As each year's bonds mature, the proceeds are invested in new five-year bonds. Moreover, if the bonds are conventional coupon bonds and the interest payments received each year are not needed for current expenses, these payments too can be invested in new five-year bonds, for a potential compounding effect.
All these forms of time diversification can help you smooth out the effects that interest-rate and market fluctuations have on your portfolio.
For more information, or for assistance in managing your money, talk with your financial advisor.
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