Investing is often poorly understood because individuals sometimes have exaggerated ideas of how well they or some advisor can do when investing money. Individuals sometimes feel that there is a trick or there is some brilliant strategist who can make or earn exceeding good returns on investments. Unscrupulous people prey on such individuals and the result is usually not exceeding good returns but exceeding large losses.
One of the basic, athough not fully agreed upon, rules in investing is that there is an inverse relation between risk and return . The higher the return desired the greater the risk of losing all or much of your investment. If a safe investment yields 5% and you want 15%, then you must move to a more speculate investment but risk losing a good part of the your investment. For instance, a safe government bond may only yield 5% while a bond from a new company may promise 15% but that company may fold and you may lose everything. In this environment of risk and return, speculative opportunities need to hold out the promise of a high return to attract money. However, since they are speculative, with perhaps no history or a shaky history, they can go under more easily than a less speculative venture.
An other important investing concept is the efficient market hypothesis. It means that information about securities (investments) travels very fast, and, as a result, it is difficult to beat or do better than the average performance of the market. If there is a good report that a stock selling for $50 is really worth $60, then the people holding the stock will get the information as fast as the people who want to buy it. As a result they will hold out for $60. The people looking to buy at $50 and resell at $60 will be disappointed.
A third, and usually surprising piece of information, is that random (the proverbial dart thrower) selection of securities often produces results as good as people trained and certified in financial planning. This means that simply buying an indexed fund that is based on all the stocks is as good as paying someone to analyze and purchase securities for you.
What follows is a simple primer on various types of securities and some comments on their risk.
Investment is usually defined in very simple terms -- not spending all your income, but rather saving some. Of course, a person or government could spent all its income and still invest by investing borrowed dollars. Thus, investing involves not spending some money, even if it is borrowed.
Broadly there are two kinds of investments:
Real assets and
Financial assets
Real assets include gold, property, and other physical assets such as silver, paintings, baseball cards, etc. Financial assets are instruments or agreements to pay and (hope) to be paid back. In all cases the investors hope to get back a larger return than the amount given. Investors would especially like to receive a large return with the smallest risk.
Some investors "go for broke", hoping for that one big strike; others, always take the conservative route. One is called the risk taker; the other, risk adverse. The prudent investor, supposedly, diversifies -- some risky investments; some not so risky investments. From these definitions, three possible investment strategies can be seen:
Governments are usually required to be prudent if not very prudent in their investment strategies. Thus, their portfolio or collection of investments would lean toward the conservative or less risky side (risk adverse).
The remainder of the discussion is limited to investing in fixed income securities and stock or equity securities. In general both fixed income and stocks are financial assets and are generically referred to as securities.
Fixed income securities can carry a small or a great deal of risk. The fixed designation usually means that the security can be held to a maturity date and, if fortunate, one can collect all that was promised. Fixed income securities include:
All categories can be quiet safe. A U.S. treasury bill can fluctuate in value, but if held to maturity (often a year, but it could be shorter), the federal government will pay back the principal invested.
Corporate bonds (sometimes called debt securities) can entail considerable risk. New companies or companies struggling may offer very high interest rates, but whether the interest or principal will be paid is open to question. Of course, corporate bonds can also be very safe if the firm has a strong operating history and sound financial base.
Investors often look carefully at the financial statements of these entities to get an idea of how safe or risky the investment is. Investors frequently do the same for government securities. The section, Using the Financial Statement, in chapter 3 provides information on assessing the financial strengths and weaknesses of governments.
Stocks (sometimes referred to as equity security) are often considered risky but do not have to be. Many stocks are quite safe.
There are very technical model for picking stocks and bonds or portfolios. Portfolios are collections of stocks, bonds, and perhaps other types of investments. These portfolios are designed to balance risk. The idea is to get the best return for a given level of risk. However, since the future is very difficult to predict, these models are better at balancing risk than getting the best return for a given level of risk. In other words, balanced portfolios are considered to do well even when they perform only as well as the markets where these securities or other investments are traded (bought and sold). In fact, portfolios can be built to reflect the market -- just buy an sample or index of the market. If the markets advance 9% in one year, a portfolio can be consider successful if it matched the growth in the market.
P-E or price earnings ratio is commonly used to judge individual stocks. Technically, the P-E is calculated as the:
market price per share/earnings per shareFor example, if the price of the stock on the last day of the reporting period were $20 and the earning per share for the period were 5, the P-E would be 4. The calculation is more complicated than it appears since the bottom number (the denominator) must itself be calculated. Earnings per share (EPS) is:
net income - preferred dividends/average shares of common stock outstanding.
Even this a simplified version since the EPS calculation can itself be quite complex. Fortunately, EPS information is often given on the face (front page) of the income statement.
One way to look at the results of a P-E, in this case a P-E of 4, is that it would take four years of earning to equal the stock price. In general low P-Es are assumed to be less speculative and high P-Es more speculative. The higher the P-E the more money the company has to make in order pay back the price paid for its stock. In the U.S. P-Es typically range from 5 to 20 although when the stock is a high point the P-Es are higher than when the stock market is a low points.
As a P-E gets higher this means that investors are expecting the firm to do better in the future, meaning the expectation for better dividends and stock prices.
What constitutes a high P-E depends on the time and the industry. In a fast growing industry in a rapidly increasing market, a P-E of 20 may not be considered high.
By way of illustration, consider these three stocks in the same industry. All have the same EPS of $5 but one is priced at $20, one at $40, and one at $100. These figures would yields P-Es of 4 (20/5), 8 (40/5), and 20 (100/5). The last one, with a P-E of 20 would be considered the most speculative and the first with a P-E of 4, the least.
Although P-E is viewed as an indicator of how speculative a stock is, a more direct indicator of riskiness is a measure called the beta. The beta is considered a more direct measure of risk since it compares the price variance of a given stock with the variation of all other stocks in that market. The beta then captures the riskiness of a single stock relative the market as a whole. Normal variations range from .5 to 2.5. Three points or ranges are given to suggestion riskiness.
<1 less risky
1 as risky as the market as a whole
>1 more risky
An investor who was not risk adverse (thus willing to take on high risk) would not be unwilling to pick stocks with beta above 1. If history were an indicator these stocks might outperform the market but then they might do much worse than the market.
The last indicator covered here is for bonds, and it is the bond rating. More technically, it is viewed as the credit risk, or the risk that the issuer of the bond will not be able to payback the principal or interest. Private agencies do the bond rating for issuers. Two of the biggest rating agencies are:
Moody's Investment Service
Standard and Poor's Corporation
Ratings are for each bond issue. One bond from the same issuer may have a different rating than another. Moreover, the rating on an issue can change as the risk on that bond changes. The highest rating for an issue is a triple A (AAA or Aaa). The ratings move down from there, although even a triple B (BBB or Baa) can be consider adequate. Below BBB, bonds are considered speculative.
While all these indicators are used to pick or select individual stocks and bonds, they are also used to build portfolios . As noted, portfolios are frequently used to diversify or to include securities of different levels of risk and return. Profession financial analysts try to find portfolios with the highest return for a given risk or conversely, the lowest risk for a given return. But the idea is the same -- diversification.
One other consideration in risk analysis is whether the investment is for the short of long term. In government, prudence is usually the guide but it is especially the case for short term investing. If money will be needed three months from now to meet payrolls, any investment should be almost certain if not certain. These will not have a very high return, but risk is essentially canceled.
In longer term investments situations, such as pension funds, more risk can be taken since one bad year might be outweighed my several good years. Nonetheless, state law often requires those investing government money to avoid high risk investments.
State law or not, some governments have, either through circumvention or ignorance, invested in highly speculative securities and have lost large amounts of money. The derivative market is one such market.
Derivatives are instruments that derive their value from some other security. One type of derivative may gets is value from how well bonds perform and the bonds in turn may get their value from whether interest rates go up or not. The complexity and danger should be apparent from the bond example. Bonds are generally considered safe, especially if they have a high rating. But in the short run and in situation where derivatives are sold for the bonds, risk can be significant.
Take the example of a large investment firm that buys U.S. treasury bonds with the intention of creating derivatives and selling these to governments that typically invest in U.S. bonds, ostensibly as a way of staying on the safe side.
The risk with bonds often comes from buying bonds with a long maturity, say 10 years. If the bond yields 6% but in the next two years interest rates go up then new entrants into the market can buy the same bond and get a higher interest rate. If the holder of the original bond wants to sell, the sale must be for a discount of a price lower than the price paid to make up for the fact that similar bonds are now yielding more. Large investment firms often create derivatives to push this risk off on to smaller investors. If these smaller investors are unaware of the risk or willing to take it, they may suffer huge losses.
What can happen is that the original purchaser writes the derivative contract so that the buyer of the derivative get some of the benefits but most of the risk. In the case of bonds, if interest rates stay the same or fall, the buyer gets some of the rewards, but if interest goes higher, especially much higher in a short time, the buyer of the derivative contract can shoulder most of the risk.
There are many products on the market that are structure to offer some reward but at the sake of large risk. Willing or naive investors can fall for the small reward but end up taking the large loss.
Ordinarily, stocks are considered to experience gains and losses, but not bonds. However, both can experience significant gains or losses. Actually, the calculations on gains and losses are more difficult for bonds.
If a stock is purchased for $10,000 and sold for $12,000 the calculation for gain is simple and can be done in absolute dollars, percentage, or annualized percentage.
original price 10,000 selling price 12,000 duration in years 2.5 absolute gain 2,000 percent gain 20.00% annualized % gain 8.00%
The absolute gain is nothing more than the selling price minus the purchase price, in this case, 12,000 - 10,000.
The percentage gain is the calculated via the formula:
(selling price - purchase price)/purchase price.The annualized % gain is the total percentage gain divided by the number of years or fraction of years.
A stock purchased for 5,000 and sold for 4,500 would show a loss. All calculations include any commission paid.
Gains and loses for the sale of bonds can be considerably more complex if the bond is sold before it matures. If it is bought at par, held to maturity and the seller is able to collect all the principal and interest, then there is neither a gain nor loss, only interest revenue. However, if it is sold before maturity then there will likely be either a gain or loss and that calculation requires use of time value of money, including present value of $1 and the present value of an annuity. An example follows.
principal 1,000,000
contact rate 0.05
market rate 0.08
periods 10
pv
table
principal 1,000,000 0.46319 463,190
interest received 50,000 6.7101 335,505
798,695
The discount amount, in this case $798,695, is calculated by taking the present value of $1 for the $1,000,000 and the present value of an annuity for the interest. The present value of $1 is used for the $1,000,000 since it is received only once and the present value of an annuity is used for the interest since it is received periodically. The exact present values used is for 10 periods and the market rate of 8%. Market rate is used since the value must be determined at the going interest rate.
In the second case, the facts are reversed. How much would the investor get now?
principal 1,000,000
contact rate 0.08
market rate 0.05
periods 10
pv
table
principal 1,000,000 0.61391 613,910
interest received 80,000 7.7217 617,736
1,231,646
The calculations are essentially the same here, except now the market rate is 5% and thus 5% is used in the present values.
Notice in the second case, a premium is obtained since the seller has a bond that yields more than the market rate.
Investing and investing in stocks and bonds is a pervasive and critical part of dealing with the long term operations of government. This lesson examined some of the strategies for avoiding poor investments.