A Guide to Investing for North Carolinians
Table of Contents
Almost all people invest money during their lifetimes, yet most consumers
remain confused about investing and investments. This publication presents a simple,
straightforward guide to investing. It should be helpful to beginners and more experienced
investors alike.
Why
Invest?
Since most investments involve risk, why should you invest your money at all? Why not keep the
money you save in a mattress, safe, or safety deposit box?
Some people invest because they believe they can make a lot of money very
quickly - that is, make a "big killing" with their investment. This may occur for a lucky few, but it
should not be your main goal in investing. Rather, the main reason for investing should be to
transfer your purchasing power to some future date.
To see what this means, let us consider an example. Suppose that you are
putting money aside for your newborn child's college education and that you will save $1,000 this
year to be used in 20 years when your child is in college. If prices increase at a rate of only 3
percent a year for each of the next 20 years, then the $1,000 you have saved this year will have
the purchasing power of only $544 when your child is in college. Therefore, even a modest
inflation rate of 3 percent a year will destroy almost one-half the value of your savings over a
20-year period.
The major reason for investing, then, is to prevent inflation from destroying
the value of the money saved for some future use. The interest rate, or rate of return, that
you earn on the investment will counteract the effects of inflation and protect the
value, or purchasing power, of the money you save.
Of course, the higher the interest rate you earn on your investment, the
greater the chance that you will actually "beat" inflation and increase the purchasing power of
your money over time. In fact, most people who invest will be able to achieve at least a modest
increase in their purchasing power (wealth) over time. However, as will be discussed later, to
earn very high interest rates and make a "big killing," you must usually accept high risk.
Basic Kinds of
Investments
An investment can earn money for you in three basic ways. First, an investment can earn
current income. Current income is simply money that you receive periodically -- for
example, every month or every 6 months from the investment. A certificate of deposit (CD)
provides current income because interest is paid to your account periodically.
A second way that an investment can earn money is through capital
growth. Here, the amount of money you have invested grows in value over time but does not
provide income along the way. You get your money back - plus any increase in value - when you
sell the investment. Examples of capital growth investments include those stocks that do not pay
dividends and other things that you may own, such as your home, gold, and collectibles like
stamps and rugs.
Finally, a third way that an investment can earn Income is through a
combination of current income and capital growth. Examples include rental property and stocks
that pay dividends.
The type of investment that will be best for you depends on your age and
income. Younger investors who are working and earning income from their jobs may not need to
earn current income from their investments. They may be more interested in capital growth. In
contrast, investors who are retired and living on limited Social Security and pension funds are
more likely to be interested in earning current income from their investments.
Elements of
Investments
Most investors compare investments by the interest rate earned. The interest rate is of course
very important, but other elements of investments are also important. Before placing your money
in any investment, you should examine and understand the five elements discussed in the
following sections.
Required Minimum Deposit
For most investments there is a minimum amount required in order to open the investment. This
minimum can range from $1 to $10,000 or more. The lower the required minimum deposit, the
greater the number of investors who can take advantage of the investment.
Liquidity
Liquidity simply means the ease with which the investor can convert some or all of his investment
to cash with relatively little cost or risk. For example, since an investor can withdraw funds at any
time from a passbook savings account or money market fund without penalty, these investments
would be considered highly liquid. in contrast, if you withdraw funds early from a CD,
you will often pay a penalty. Or if you want to sell your rental property to obtain cash, you will
have to pay the selling costs. Therefore, a CD and rental property would be considered to be
relatively illiquid investments. Liquid investments usually pay a lower interest rate than
illiquid investments.
How important liquidity is for a particular investment depends on how
much income and savings you have. Investors with limited income and limited savings probably
want to keep their savings in liquid investments so that the funds will be readily available in case
of an emergency. On the other hand, investors with higher income and more savings can keep part
of their money in liquid investments and part in illiquid investments.
Interest Rate
In general, investors prefer higher interest rates to lower ones. But before going after an
investment with a high rate of return, you should consider some characteristics of interest
rates:
"Real" Interest Rate. What matters in investing is the spread" or
difference between the interest rate earned and the inflation rate. This spread is called the "real"
interest rate because it is what the investor really gains the interest earned less the loss of
purchasing power to inflation. Earning a high interest rate is not always better. For example, if
the interest rate earned is 13 percent and the inflation rate is 12 percent, the real return on the
money is only 1 percent. In contrast, if the interest rate earned is 6 percent and the inflation rate
is 2 percent, the real interest rate is 4 percent and the investor is better off.
Floating Versus Fixed Interest Rates. One important
characteristic of an interest rate is whether it is fixed (remains constant) over the term of
the investment or floats (can change). An investment with a fixed interest rate will turn
out to be a good choice if, over the term of the investment, interest rates on new investments fall.
In this case, the person with the fixed interest rate "wins" because the fixed rate yields more than
could be earned on any new investment. In contrast, a fixed-interest-rate investment will be a bad
choice if interest rates on new investments rise. When that happens, the investor with the fixed
interest rate "loses" because the fixed rate yields less than could be earned on a new
investment.
The opposite happens with a floating interest rate, one that changes with
market conditions. A floating interest rate will be a good choice if future interest rates on new
investments rise. In this case the floating interest rate will rise, whereas a fixed interest rate would
not change. On the other hand, a floating interest rate will be a bad choice if future interest rates
fall. In this case, the floating interest rate will fall while the fixed interest rate remains the
same.
Of course, if you knew what direction future interest rates would take, you
would know exactly which type of interest rate to choose, fixed or floating. The problem is that
no one can accurately predict future interest rates. Probably the best general guideline is that
when the amounts of money, credit, and spending in the economy are growing very rapidly for a
significant period of time (say 12 to 18 months), future interest rates can be expected to rise
eventually.
Short-Term Versus Long-Term Interest Rates. Another
characteristic of interest rates is their term or duration. A short-term interest rate is one paid on
an investment that will end in a short time-for example, in one year or less. This means that the
investment will mature or come due, and the money originally invested will be paid back to the
investor within that period. A long-term interest rate is one paid on an investment that will
continue for a long time - for example, 5, 10, or 30 years.
Long-term interest rates are generally higher than short-term rates for two
reasons. First, because a long-term investment will tie up a person's money for a longer time than
a short-term investment, he or she will be compensated for not having access to the money for a
long time by receiving a higher interest rate. Second, there is a longer time for things to go wrong
with a long-term investment, which means that there is more risk for the investor. The higher
interest rate also compensates for the increased risk.
Interest Rates and Risk. There is a strong relationship between
interest rates and risk. Investments that involve more risk will attract investors only if they pay
higher interest rates. Safer investments will be able to attract investors even though they pay
lower rates. The difference in interest rates between a risky investment and a safe investment is
not established by law, nor is there any formula you can use to determine it. Instead, these
differences, called "risk premiums," are determined in the marketplace by the interaction of
thousands or millions of investors. The risk premiums can also change over time. Each investor
must decide whether the higher interest rate associated with a less secure investment is worth the
risk.
Risk
In addition to influencing interest rates, risk is a fourth element of investments that a
person should consider. it is important to recognize that there is more than one type of risk.
Credit risk is probably the type thought of most commonly. It is the risk of losing the
money originally invested (the principal). Deposits at federally insured banks and savings
and loan associations involve little credit risk because the Federal Depository Insurance Corp.
(FDIC) and the Federal Savings and Loan Insurance Corp. (FSLIC) insure the deposits. If the
institution should fail, these federal agencies will repay the investors. Other investments (like
stocks) may carry no insurance, and the investor can lose the principal if the investment fails. The
credit risk is directly related to the possibility that the creditor (the person or firm with whom the
funds are invested) will fail. Some investments, such as bonds, are given a rating (AAA, AA, or
A, for example) to indicate the degree of credit risk.
Rate risk occurs with capital growth investments, such as housing
and stock. The rate of interest that will be paid is not known in advance. Therefore, there is a
risk that you will not earn the rate of interest you expect.
The last type of risk is called market risk. It is the risk that the
interest rate earned on your investment will not be as good as the interest rate you could earn on a
new investment. Market risk pertains mainly to investments with a fixed interest rate. Here the
concern is that interest rates on new investments will rise, leaving the owner with a "low" interest
rate.
Tax Status
The last investment element to consider is tax status. What is important to the investor, of
course, is how much money the investment will ultimately put into his or her pocket. Since
different investments are treated differently by the tax laws, it is important to consider the effect
of taxes on investments.
Your choice of investments can affect your taxes in three ways. First, the
interest earned on some investments, such as municipal bonds, is not subject to federal income
taxes. Second, some investments can provide a "tax write-off." A common tax write-off is
depreciation, which can be taken on rental property, equipment, and other "physical" investments.
A tax write-off is like a tax deduction because it allows the investor to reduce his or her taxable
income and therefore reduce taxes. Last, an investment can allow a person to delay the payment
of taxes. Money invested in an individual retirement account (IRA), Keogh Plan, or deferred
compensation plan will not be taxed until a later time, typically when the investor retires. If the
person's tax rate is lower at that time, a savings will result.
The importance of an investment's tax status depends heavily on the
investor's tax bracket, the amount of tax charged on each additional dollar of income.
The higher your tax bracket, the more important are investments that will reduce taxes.
Types of
Investments
Our nation's financial system offers hundreds of different kinds of investment opportunities. This
section will describe the kinds most commonly used by the individual investor.
Passbook Savings Accounts
Conventional savings accounts have been the mainstay of investments for the average individual.
They offer low minimum deposits, perfect liquidity, and the protection of either federal or state
insurance. Until 1986, the major disadvantage of passbook savings accounts was their low,
regulated interest rate. In 1986, however, the regulations were removed, and banks and savings
and loan associations can now pay whatever interest rates they like on passbook savings accounts.
Because of their safety and liquidity, it is likely that these accounts will continue to pay a
relatively low interest rate.
Certificates of Deposit
Certificates of deposit (CDs) are offered by banks and by savings and loans associations in various
amounts (for example, $1,000, $10,000, or $100,000), with differing terms (for example, six
months, one year, or two years), and with various interest rates. Usually, the longer the term, the
higher the interest rate. CDS are not perfectly liquid because early withdrawal of funds from a
CD will usually result in a penalty. Except for very large amounts, CDS are included in the total
insurance coverage by the bank or savings and loan insurance program.
NOW Accounts
Negotiable orders of withdrawal (NOW) accounts are checking accounts that pay interest. In
order to receive the interest, however, you must keep a minimum balance in the account.
Individuals with a large amount of money to invest can sometimes do better by using a regular
checking account and investing other funds in a CD paying a higher interest rate.
U.S. Treasury Securities
The federal government issues securities that are similar to bank and savings and loan certificates
in that they are virtually risk-free investments. (in fact, treasury securities are safer than bank and
savings and loan deposits because the federal government can always print enough money to pay
its debts.) These securities primarily produce current income rather than capital growth (although
they can provide capital growth if bought at a discount). The federal government issues treasury
securities in order to borrow money - for example, when tax revenues fall short of expenditures.
Because they are virtually risk-free, the interest rate paid on these securities is somewhat less than
that paid on comparable securities issued by commercial firms (for example, corporate bonds).
An important feature of treasury securities is that the interest earned from them is exempt from
state and local taxes.
The three types of treasury securities are bonds (which have a long term),
notes (intermediate term), and bills (short term). A notable feature of treasury bills is that they are
sold at "discount," meaning that the investor in effect receives the interest at the time of
purchase.
Bonds
Issued by corporations and governments to raise funds, bonds are long-term debt instruments.
Treasury bonds, discussed earlier, are an example. The majority of bonds are issued at fixed
interest rates for terms as long as 30 years. Bonds bought at the time of issue and held to
maturity provide current income through periodic payments of interest to the investor. For
example, if an investor buys a $1,000 bond with a 10 percent interest rate and a term of 30 years,
the investor will receive $100 in interest ($1,000 x 0.10) annually for 30 years and $1,000 at the
end of 30 years.
The major risk associated with bonds is market risk. Since the interest rate
is fixed and since the term is usually considerable, there is a good chance that interest rates will
rise above the bond's fixed interest rate. Therefore, when you purchase a bond you are betting
that the average market interest rate during the bond's term will not exceed the bond's interest
rate.
Bonds also entail credit risk. The issuer of the bond could default and the
investor would lose both the principal and future claims to interest payments. To help investors
gauge the credit risk of bonds, rating services (such as Moody's and Standard and Poor's) rate
bonds at their time of issue. Moody's system progresses from the highest rating, Aaa to the lower
ratings: Aa, A, Baa, Ba, Bb, and so on. Standard and Poor's system starts with a highest ratting
of AAA and progresses to lower ratings of AA, A, BBB, BB, B, and so on. "Junk" bonds are
bonds carrying a low rating - that is, a high risk.
If you want to convert a bond to cash before the end of the bond's term,
you can sell it. The price you will receive depends on the bond's interest rate and current market
interest rates. If the two rates are the same, you will be able to sell the bond for its face value. If
market rates are lower than the bond's interest rate, you will be able to sell the bond for more than
its face value, but if market rates are higher, you will receive less than face value.
For example, consider a $1,000 bond having an interest rate of 10 percent
(yielding a yearly interest payment of $1 00). If market interest rates rise to 12 percent, the price
of the bond could drop to a low of $833.33, so that the interest payment divided by the price
($100/$833.33) equals the market rate of 12 percent. Thus investors buying the bond at the
reduced price would receive the market interest rate on their investment.
Municipal Bonds
Bonds are often issued by state or local governments or other local public agencies (for example,
hospital authorities) when they need to borrow money over a long term. They are much like other
types of bonds, with one exception. The returns from municipal bonds are not taxed by the
federal government and in some cases are not taxed by the state. This makes the bonds very
attractive for investors in high tax brackets.
Zero-Coupon Bonds
This type of bond is a relatively new development. A zero coupon bond can be thought of as a
capital growth bond. With a conventional bond the investor receives periodic interest payments
and receives the original face value of the bond at the end of a specified period. With a
zero-coupon bond, the investor receives no periodic interest payments but instead receives a much
larger sum than the original face value at the end of the bond's term. For example, an investor
might purchase a zero-coupon bond for $2,000 today and in 30 years get $27,000 back. This
increase would correspond to a compound interest rate of approximately 9 percent. In essence,
interest payments that the bond owner would have received with a conventional bond are
continually reinvested. This means that interest is in effect paid on both the original investment
and the interest earnings at the bond's implied interest rate.
Although periodic interest payments are not received, current federal tax
regulations treat the proceeds as if they were - that is, the holder of a zero-coupon bond is taxed
on the interest payment that would have been earned each year! However, there are ways to
avoid this taxation. One way is to purchase zero-coupon bonds through an individual retirement
account (IRA). Another way is to buy a municipal zero-coupon bond, which is exempt
from federal tax.
Government National Mortgage Association Investments
Sometimes called "Ginnie Mae's," these investments are somewhat out of the ordinary but have
some interesting features. In essence, when you put money into a Ginnie Mae fund, you are
lending money to home buyers. Each month the Ginnie Mae investor receives a payment, part of
which is a return of the original investment (the principal) and part of which is interest. Ginnie
Mae's are attractive for two reasons: first, the quoted interest rate is usually higher than that for
CDs, and second, the federal government guarantees that the principal and interest payment will
be made. However, the federal government does not guarantee the interest rate. Ginnie Mae's
can be bought in units as small as $1,000 from stockbrokers.
Ginnie Mae's have some distinct disadvantages for the average investor.
For one, they are very sensitive to market interest rates. This means that you can lose money if
you want to cash in your Ginnie Mae. For example, if market interest rates have risen since you
invested in a Ginnie Mae, you may get back less than you invested. On the other hand, if interest
rates fall, your return may also fall because home buyers will be prepaying their mortgages and
taking out new mortgages at lower interest rates. Another problem with Ginnie Mae's is that you
can never be sure how large a payment you will receive each month nor how long the payments
will last. When a substantial number of home buyers prepay their mortgages, you will get a large
check that month (because part of the principal is returned to you) but smaller checks
thereafter.
In summary, Ginnie Mae's are much more complicated than CDs. if you buy
a Ginnie Mae, consider holding it for the full term (usually 7 to 12 years). That way your
investment will be unaffected by any fluctuations in its value.
Mutual Funds
In a mutual fund a number of investors in effect pool their money to buy specific investments.
There are many types of mutual funds. Some invest in stocks, some in bonds some in the money
market, and some in real estate, to name but a few. Furthermore, within a "family" of stock
mutual funds, the investor can choose between individual funds offering different combinations of
risk and return. Some mutual funds are based on particular industries or particular geographic
areas, such as those that invest in the "high-tech" industry or in Mexican companies.
The mutual fund investor does not directly own the stocks, bond, money
market securities, or property purchased by the fund. Instead, the investor owns shares of the
fund. The value of the fund's shares is based on the values of the underlying investments.
The buying and selling of investments by the fund is handled by a paid
manager. Working within guidelines set forth in the fund's charter, the manager decides what
investments should be bought and sold by the fund. Mutual funds thus offer the advantage of
professional management but at the expense of less direct control by the investor. The funds also
permit a person to invest in a wider range of investments than would be possible for an individual
investor. Such diversification is usually considered an advantage.
Shares in mutual funds can be bought in load or no-load form. Load funds
charge a commission and are sold by stockbrokers. No-load funds charge no commissions and
are sold directly to investors by the organization that operates the fund.
Unit Investment Trusts
Investment trusts are offered by brokerage houses as a way to avoid the relatively high minimum
deposits required for many investments (for example, treasury securities and Ginnie Mae's).
Essentially, the brokerage house "breaks" such investments into smaller units by combining funds
from many investors. The trust units are then offered at affordable prices - for example, $1,000
per unit. The unit carries the investment characteristics of the "parent" security.
Stocks
When a person thinks of investments, he or she usually thinks of stocks and the stock market.
Stocks are perhaps the premier type of investment.
Technically, ownership of a stock represents ownership of a claim
on the net earnings of a company, after the claims of creditors are satisfied. Therefore,
earnings from ownership of stock depends on the fortunes of the company. Earnings from a stock
can be in three forms: dividends, appreciation, or a combination of the two. Dividends are
periodic payments to the stockholder, much like interest payments on a bond. However, unlike
bond interest, dividend payments are based on the company's earnings. They are generally not
predetermined but are established each year after the company's financial position has been
reviewed.
Some stocks never pay dividends. Instead, earnings are reinvested in the
company to promote further growth. These are called growth stocks. The investor benefits from
the increase in the value of the stock, which is called appreciation.
Stocks can be bought for almost any amount of money; single shares of
some stock may cost as little as a couple of dollars. Stocks can be readily converted to cash by
selling them on the market. However, the price of stocks fluctuates daily, and there is no
guarantee that the price the seller will receive is comparable to the purchase price. At the time the
owner wishes to sell, the value of the stock may be low. Stocks should therefore be viewed as
relatively illiquid assets.
Both credit risk and rate risk occur with stocks. Credit risk occurs because
there is some possibility that the company will fail and the investor will lose the purchase price of
the stock. Obviously, the risk varies widely among companies. Rate risk occurs because the
effective interest rate earned on the stock is not known in advance. Risk in stock
purchases can be reduced by buying a number of stocks from different industries. This process is
called diversification.
The questions "How should an investor pick stocks?" or "Is now the right
time to invest in the stock market?" are always being asked by individuals. Obviously, these
questions have no simple answer. The performance of a stock depends on the future fortunes of
the company, which in turn depend on the production, management, and marketing decisions of
the company and its competitors; on changes in the market; and on the policies and conditions of
the countries in which the company buys, produces, and sells.
In general, the stock market performs best when inflation is low, there is
moderate economic growth, and there is a high degree of certainty about the future course of the
economy.
There are four techniques commonly used in selecting stocks. Those who
believe in fundamental analysis assume that the basic value of each stock can be
determined by analysis of current conditions and, more important, by the company's prospects.
The basic value of a stock is based on the present value of the future net earnings of the company.
Followers of fundamental analysis therefore try to project future net earnings of the company and
determine the corresponding basic value of the stock. If the basic value is found to be greater
than the stock's price, the stock is considered a good buy. A short-cut method is to look at the
ratio of the stock's price to the company's net earnings, termed the price-to-earnings ratio, or
P-E ratio. A low P-E ratio is taken to mean that the company's stock price should increase
and that the stock is therefore a "good" buy, although this belief is very
controversial.
Employing fundamental analysis seems straightforward, but it has problems. Obviously,
projecting the net earnings of a company is no easy task; at a minimum it requires a projection of
the economic and market conditions in which the company operates. And with respect to P-E
ratios, how low is low?
Technical analysis relies on the construction and interpretation of
stock charts or technical indicators. "Technicians" believe that stock prices move in repeated
trends; therefore they study past movements of stock prices and trading volume for clues to
establishing where stock prices in general and the price of particular stocks fall on the
trend lines. The position of a stock on the trend line will determine the technician's
recommendation to buy, hold, or sell.
A third analytical technique may be called the psychological method.
Followers of this school maintain that what really matters is the psychology of the investors.
A stock that is selling far above its basic value is still a good buy if traders in the market are
continuing to buy it. The task of the investor is to understand the psychology of the stock traders
and buy what they like, with the expectation that a future trade will bring an even higher price. Of
course, a trader who follows this approach runs the risk of being the last to buy before the stock
falls into disfavor and the price tumbles.
A cousin of the psychological approach, called contrarian investing,
is a matter of buying and selling in opposition to market trends. For example, if stock prices
are down and everyone is selling, a contrarian investor buys instead. The idea is that the market
always overacts and prices eventually reverse.
Are these techniques useful in finding good buys in stocks? Subscribers to
the fourth school of thought, the efficient market approach, say no. They believe that the
current price of a stock already reflects everything that is known and expected about the
company. For example, if the company is expected to grow, promoters of this school say that this
fact is already known on the market and incorporated into the stock's price. (In this case,
prospects of future growth would increase the stock's price.) Similarly, a stockbroker's analysis of
a stock is also common knowledge (in fact, the broker may merely be repeating common
knowledge) and is already reflected in the price of the stock. In short, followers of this school of
thought say that the stock market is an efficient processor of information. Therefore, on the
average and over the long run, it does not matter what stocks you pick; in fact, your best bet is to
pick a wide selection of stocks and hold them for a long time. If you take a "random walk down
Wall Street" and pick stocks, your stocks will perform just as well as a set of stocks (a portfolio)
chosen by any other means that has the same amount of risk. Some mutual stock funds now
choose stocks on this basis.
Real Estate and Rental Property
Property has been a popular investment in the past because of its rapid increase in value and its
tax benefits. As an investment, real estate and rental property can produce returns in two ways:
current income and net appreciation (capital gains). Current income is derived if the property is
currently used; for example, if crops are grown on the land or the property is rented to tenants.
Net appreciation occurs if the property increases in value during the holding period. Usually the
net appreciation cannot be converted to cash until the property is sold. Current income is related
to how the property is currently used; net appreciation is related not only to the current use of the
property, but also to the potential use of the property. Farmland, for example, can increase in
value because the net earnings from the crop it produces have increased or because the farmland
could be used for a more profitable shopping center or residential development.
Another reason for the popularity of real estate is the tax advantages. For
example, an investor in rental property can use the depreciation of the property to reduce his
taxable income. Depreciation is a percentage of the rental property's value that the tax laws allow
the investor to deduct each year.
A major disadvantage of real estate and rental property is that they are
illiquid assets - that is, it takes time and resources to convert them to cash. It may take many
months to sell a piece of property, months which an investor may not have when emergency cash
is needed. Real estate and rental property are subject to credit risk (your original investment in
real estate is not guaranteed) and rate risk (you are not certain what your earnings will be). It is
also important to realize the strong influence of neighborhood factors on property values. For
example, construction of a noisy highway or waste facility nearby will decrease residential
property values, whereas new parks and open spaces will have a positive effect. The investor in
real estate should be very familiar with current neighborhood factors and their potential for
change.
Gold
This precious metal is considered an exotic and somewhat mysterious investment. The glitter of
gold has been somewhat tarnished in recent years after its dramatic rise in price during the 1970s
and its equally dramatic price decline in the early 1980s. What has happened to gold?
As with any product, the price of gold is determined by the relationship
between its supply and demand. However, there are some unique features to the supply and
demand of gold. The production of gold is relatively small and constant; gold in large quantities is
mined in few parts of the world. (South Africa and the USSR are the largest producers.) This
means that the supply of gold responds very slowly to changes in price. With respect to demand,
gold has very few "productive" uses; its major use is as a speculative investment. Owning gold is
currently viewed as a major alternative to holding currencies (paper money). When the inflation
rate is high and the major currencies (for example, the U.S. dollar) are depreciating rapidly,
demand for gold rises and so does its price. Conversely, when inflation is cooling, the demand for
gold falls and its price drops. Hence, any world event that investors believes could affect the
stability of the major world currencies has an impact on the demand for gold. The fall in the price
of gold in the early 1980s was directly related to the drop in the U.S. inflation rate and the
increase in the foreign exchange value of the U.S. dollar.
For the investor, the moral of the story is that credit risk and rate risk with
gold are substantial. Gold prices are subject to rapid and wide swings. Gold prices rise, in
particular, when the U.S. inflation rate rises and the foreign exchange value of the U.S. dollar
falls. In contrast, gold prices fall when the inflation rate drops and the foreign exchange value of
the U.S. dollar increases. Gold can be obtained in three ways: by purchasing shares of mining
companies, buying gold coins, and investing in bullion accounts.
Investment
Strategies
Now that you know about the common investment options, you will need to consider your
investment strategy. Although your overriding objective will no doubt be to earn the highest
return on your money (after taxes), you should also consider the amount of risk you are willing to
accept and the amount of liquidity you want. These factors are directly related to your personal
characteristics and the state of the economy.
First, consider your age. Younger investors often have many expenses to
meet in beginning a family and building a household, but they do not yet have the experience to
earn top incomes. Therefore, they usually have only a small amount to invest. They will find it
best to invest conservatively, taking little risk, and obtain liquid investments that will provide
current income while keeping funds readily accessible to meet emergency needs. Middle-aged
investors usually have the greatest amount of discretionary income to invest. Their children have
been raised and are gone, and their other expenses are usually low. They can afford to increase
their risk, decrease their liquidity, and increase the percentage of capital growth in their
investments, as long as a reserve of liquid funds is maintained for emergencies.
Finally, retired investors should return to a more conservative approach.
Their primary concern is to obtain enough income to live on. They often lack the option of
earning funds to replace any investment losses. They will therefore want liquid investments that
pay current income and carry little risk.
You should always maintain a safe, liquid fund for emergencies. If only
enough savings are available for an emergency fund, riskier investments should not be
considered.
In choosing your investments, consider the state of the economy. When
interest rates are rising, it is a good time to move more of your money into short-term investments
such as money market funds, treasury bills, and short-term CDS. When the economy is in the
beginning stages of a downturn (a recession), interest rates will be at their peak, so long-term
investments such as bonds will be a better choice. Finally, when the economy is initially
recovering from a recession and beginning a growth phase, stock prices will usually be low but
will eventually head upward. That is a good time to channel more of your investment funds into
the stock market.
For Additional
Information
- Andrew, John. Buying Municipal Bonds. Free Press, 1987.
-
Burton, Malkiel. A Random Walk Down Wall Street.
Norton, 1985.
- Dorf, Richard. The New Mutual Fund Investment Advisor.
Probus, 1987.
-
Graham, Benjamin. The Intelligent Investor. Harper and Row,
1973.
[ Economics ]
[ Educational Resources ]
AG-390
Prepared by:
Michael Walden, Extension Specialist