Investing: Knowing the Products

My last article dealt with the issue of understanding risk as and how it relates to helping a new investor identify what kind of risk taker they might be. The next step is knowing what investment products are available and how they relate to or fit in with an individual’s risk profile. There are many investment products available in the market but I will discuss the characteristics of some of the more common ones.

Bonds – Bonds are grouped under the general category of fixed-income securities. The term bond is commonly used to refer to any security that is founded on debt. When you purchase a bond, you are lending out your money to a company or government. In return, they agree to give you interest on your money and eventually pay you back the amount you lent out.

The main attraction of bonds is their relative safety. If you are buying bonds from a government, your investment is virtually guaranteed, or risk free. The safety and stability, however, come at a cost. Because there is little risk, the rate of return on bonds is generally lower than other higher-risk securities.

For example, if you buy a bond with a face value of $1,000, a coupon of 5.75%, and a maturity of 10 years, you will receive a total of $57.50 ($1,000 x 5.75%) of interest per year for the next 10 years. Because most bonds pay interest semi-annually, you'll receive two payments of $28.75 a year for 10 years. When the bond matures at the 10 year mark, you'll get your $1,000 back.

Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market. There is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.

The issuer of a bond is a crucial factor to consider, as the issuer's stability is your main assurance of getting paid back. For example, the Bahamas government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small. The reason behind this is that a government will always be able to bring in future revenue through taxation. A company, on the other hand, must continue to make profits, which is far from guaranteed. This added risk means corporate bonds must offer a higher yield in order to entice investors. Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives.

Stocks

Stocks (also known as "shares" or "equity") are a type of security that signify ownership in a corporation and represent a claim on part of the corporation's assets and earnings.

There are two main types of stock: common and preferred. Common stock usually entitles the owner to vote at shareholders' meetings and to receive dividends. Preferred stock generally does not have voting rights, but has a higher claim on assets and earnings than the common shares. For example, owners of preferred stock receive dividends before common shareholders and have priority in the event that a company goes bankrupt and is liquidated.

A holder of stock (a shareholder) has a claim to a part of the corporation's assets and earnings. In other words, a shareholder is an owner of a company. Ownership is determined by the number of shares a person owns relative to the number of outstanding shares. For example, if a company has 1,000 shares of stock outstanding and one person owns 100 shares, that person would own and have claim to 10% of the company's assets.

When you purchase stocks, you become a part owner of the business. This entitles you to vote at the shareholders' meeting and allows you to receive any profits that the company allocates to its owners. These profits are referred to as dividends.

A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.

While bonds provide a steady stream of income, stocks are volatile. That is, they fluctuate in value on a daily basis. When you buy a stock, you aren't guaranteed anything. Many stocks don't even pay dividends, in which case, the only way that you can make money is if the stock increases in value - which might not happen.

Compared to bonds, stocks provide relatively high potential returns. Of course, there is a price for this potential: you must assume the risk of losing some or all of your investment.

Mutual Funds

A mutual fund is a collection of stocks and bonds. When you buy a mutual fund, you are pooling your money with a number of other investors, which enables you (as part of a group) to pay an investment manager to select specific securities for you. Mutual funds are all set up with a specific strategy in mind, and their distinct focus can be nearly anything, stocks, bonds, stocks and bonds, or even real estate/rental property etc.

The primary advantage of a mutual fund is that you can invest your money without the time or the experience that are often needed to choose a sound investment.

Money Market Funds

Money market funds consist of short-term debt instruments. This is a safe place to invest your money. You won't get great returns, but you won't have to worry about losing your principal. A typical return is twice the amount you would earn in a regular checking/savings account and a little less than the average certificate of deposit (fixed account).

Bond Funds

Bond funds are named appropriately: their purpose is to provide current income on a steady basis. Bond funds invest primarily in government and corporate debt. Investors who take advantage of these funds consist of conservative individuals and retirees.

Bond funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds aren't without risk.

Balanced Funds

The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities.

Equity Funds

Generally, the investment objective of this class of funds is long-term capital growth with some income. The strategy of the equity funds is to invest primarily in stocks, which historically has produced much higher returns over the long term than the other classes of mutual funds. However, equity funds far more risky than the other mutual funds previously mentioned because of their high exposure to stocks.

Understanding risk and knowing which products are available in the marketplace helps you as a potential investor better understand the investment process, and can allow you to develop an appropriate investment strategy, and subsequently, to implement and monitor that strategy over time.

Knowing the Product (At-A-Glance)

RISK:VEHICLE

Low: Individual Bond, Money Market Fund, Bond Fund

Medium: Balanced Fund

High: Stocks, Equity Fund