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In unit 1, you learned about financial building blocks such as cash management. Now it’s time to examine basic investing principles. Wise investing requires knowledge of key financial concepts and an understanding of your personal investment profile and how these work together to impact investing decisions. This unit will: |
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Even though the words "saving" and "investing" are often used interchangeably, there are differences between the two.
Saving provides funds for emergencies and for making specific purchases in the relatively near future (usually three years or less). Safety of the principal and liquidity of the funds (ease of converting to cash) are important aspects of savings dollars. Because of these characteristics, savings dollars generally yield a low rate of return and do not maintain purchasing power.
Investing, on the other hand, focuses on increasing net worth and achieving long-term financial goals. Investing involves risk (of loss of principal) and is to be considered only after you have adequate savings.
| Savings vs. Investment Dollars | |||||||||||||||||
Savings $$
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Investment $$
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Total return is the profit (or loss) on an investment. It is a combination of current income (cash received from interest, dividends, etc.) and capital gains or losses (the change in value of the investment between the time you bought and sold it). The published rate of return for a selected investment is usually expressed as a percentage of the current price on an annual basis. However, the real rate of return is the rate of return earned after inflation, which is further reduced by income taxes and transaction costs.
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Illustration of "Total Return" and "Rate of Return" |
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Historically, stocks have had the highest average annual investment return of all types of investments, especially over long time periods of 10 years or more. The average annual rates of return for major investment asset classes from 1925-2004, according to the Chicago investment research firm, Ibbotson Associates, were: 10.4% large company stocks; 12.7% small company stocks, 5.4% government bonds, 3.7% Treasury Bills, and 3.0% inflation.
ALL investments involve some risk because the future value of an investment is never certain. Risk, simply stated, is the possibility that the ACTUAL return on an investment will vary from the EXPECTED return or that the initial principal will decline in value. Risk implies the possibility of loss on your investment.
Factors which affect the risk level of an investment include:
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Inflation |
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Business failure |
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Changes in the economy |
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Interest rate changes. |
Generally speaking, risk and rate of return are directly related. As the risk level of an investment increases, the potential return usually increases as well. The pyramid of investment risk (Figure 2) illustrates the risk and return associated with various types of investment options. As investors move up the pyramid, they incur a greater risk of loss of principal along with the potential for higher returns.
Figure 2. Pyramid of Investment Risk
Source: National Institute for Consumer Education, 1998
You can do several things to offset the impact of some types of risk. Diversifying your investment portfolio by selecting a variety of securities is one frequently used strategy. Done properly, diversification can reduce about 70% of the total risk of investing. Think about it. If you put all of your money in one place, your return will depend solely on the performance of that one investment. Alternatively, if you invest in several assets, your return will depend on an average of your various investment returns. Here are three basic ways to diversify your investments:
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By choosing securities from a variety of asset classes, e.g. a mix of stock, bonds, cash and real estate |
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By choosing a variety of securities or funds within one asset class, e.g. stocks from large, medium, small and international companies in different industries |
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By choosing a variety of maturity dates for fixed-income (bond) investments. |
By diversifying, you won’t lose as much as if you invested in just one security right before its market value goes down. However, if the market goes straight up from the time you started, you won’t make as much in a diversified portfolio either. However, historically, most people are concerned about protection from dramatic losses.
Another technique to help soften the impact of fluctuations in the investment market is dollar-cost averaging. You invest a set amount of money on a regular basis over a long period of time—regardless of the price per share of the investment. In doing so, you purchase more shares when the price per share is down and fewer shares when the market is high. As a result, you will acquire most of the shares at a below-average cost per share.
Look at the dollar-cost averaging illustration below. One hundred dollars is invested each month. Due to fluctuations in the market, the number of shares purchased with the $100 each month varies, because the shares vary in price from $5 to $10. You can see that, when the share price is down, you acquire more shares as in months 2, 3, and 4. You benefit when/if the price per share goes up.
Dollar-Cost Averaging Illustration |
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Regular Investment |
Share Price |
Shares Acquired |
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Month 1 |
$100 |
$10.00 |
10.0 |
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Month 2 |
100 |
7.50 |
13.3 |
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Month 3 |
100 |
5.00 |
20.0 |
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Month 4 |
100 |
7.50 |
13.3 |
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Month 5 |
100 |
10.00 |
10.0 |
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TOTAL |
$500 |
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66.6 |
Your Average Share Cost: $500 ¸ 66.6 = $7.50 |
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As most investors know, market timing . . . always buying low and selling high . . . is very hard to accomplish. Dollar-cost averaging takes much of the emotion and guesswork out of investing. Profits will accelerate when investment market prices rise. At the same time, losses will be limited during times of declining prices. For most people, dollar-cost averaging is not so much a way of making extra money as a way to limit risk.
Now that you understand the concepts of risk and return, let’s turn to an element that is at the heart and soul of building wealth and financial security...TIME.
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Here is how time can work for you: |
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Compounding works like this . . . |
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The interest earned on your investments is reinvested or left on deposit. At the next calculation, interest is earned on the original principal PLUS the reinvested interest. Earning interest on accumulated interest over time generates more and more money. |
Compounding also applies to dividends and capital gains on investments when they are reinvested. The following illustration and questions give you a first-hand opportunity to calculate the impact of time on the value of your investment accumulation. Please complete the exercise below before moving ahead to the next section.
How Time Affects The Value Of Money
Investor A invests $2,000 a year for 10 years, beginning at age 25. Investor B waits 10 years, then invests $2,000 a year for 31 years. Compare the total contributions and the total value at retirement of the two investments. This example assumes a 9 percent fixed rate of return, compounded monthly. All interest is left in the account to allow interest to be earned on interest.
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Age |
Years |
Investor A |
Investor B |
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Contributions |
Year End Value |
Contributions |
Year End Value |
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25 |
1 |
$ 2,000 |
$2,188 |
$ 0 |
$ 0 |
26 |
2 |
2,000 |
4,580 |
0 |
0 |
27 |
3 |
2,000 |
7,198 |
0 |
0 |
28 |
4 |
2,000 |
10,061 |
0 |
0 |
29 |
5 |
2,000 |
13,192 |
0 |
0 |
30 |
6 |
2,000 |
16,617 |
0 |
0 |
31 |
7 |
2,000 |
20,363 |
0 |
0 |
32 |
8 |
2,000 |
24,461 |
0 |
0 |
33 |
9 |
2,000 |
28,944 |
0 |
0 |
34 |
10 |
2,000 |
33,846 |
0 |
0 |
35 |
11 |
0 |
37,021 |
2,000 |
2,188 |
36 |
12 |
0 |
40,494 |
2,000 |
4,580 |
37 |
13 |
0 |
44,293 |
2,000 |
7,198 |
38 |
14 |
0 |
48,448 |
2,000 |
10,061 |
39 |
15 |
0 |
52,992 |
2,000 |
13,192 |
40 |
16 |
0 |
57,963 |
2,000 |
16,617 |
41 |
17 |
0 |
63,401 |
2,000 |
20,363 |
42 |
18 |
0 |
69,348 |
2,000 |
24,461 |
43 |
19 |
0 |
75,854 |
2,000 |
28,944 |
44 |
20 |
0 |
82,969 |
2,000 |
33,846 |
45 |
21 |
0 |
90,752 |
2,000 |
39,209 |
46 |
22 |
0 |
99,265 |
2,000 |
45,075 |
47 |
23 |
0 |
108,577 |
2,000 |
51,490 |
48 |
24 |
0 |
118,763 |
2,000 |
58,508 |
49 |
25 |
0 |
129,903 |
2,000 |
66,184 |
50 |
26 |
0 |
142,089 |
2,000 |
74,580 |
51 |
27 |
0 |
155,418 |
2,000 |
83,764 |
52 |
28 |
0 |
169,997 |
2,000 |
93,809 |
53 |
29 |
0 |
185,944 |
2,000 |
104,797 |
54 |
30 |
0 |
203,387 |
2,000 |
116,815 |
55 |
31 |
0 |
222,466 |
2,000 |
129,961 |
56 |
32 |
0 |
243,335 |
2,000 |
144,340 |
57 |
33 |
0 |
266,162 |
2,000 |
160,068 |
58 |
34 |
0 |
291,129 |
2,000 |
177,271 |
59 |
35 |
0 |
318,439 |
2,000 |
196,088 |
60 |
36 |
0 |
348,311 |
2,000 |
216,670 |
61 |
37 |
0 |
380,985 |
2,000 |
239,182 |
62 |
38 |
0 |
416,724 |
2,000 |
263,807 |
63 |
39 |
0 |
455,816 |
2,000 |
290,741 |
64 |
40 |
0 |
498,574 |
2,000 |
320,202 |
65 |
41 |
0 |
545,344 |
2,000 |
352,427 |
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Value at Retirement |
$545,344 |
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$352,427 |
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Less Total Contributions |
($20,000) |
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($62,000) |
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Net Earnings |
$525,344 |
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$290,427 |
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Using the data for investors A & B, answer the following questions.
At $2,000 a year, how much did Investor A invest in the ten years between the ages of 25 and 35?
What is the value of Investor A’s investment when the Investor is 35?
At $2,000 a year, how much did Investor B invest over the 31 years, from age 35 through 65?
What is the value at retirement of Investor A’s investment?
What is the value at retirement of Investor B’s investment?
What are Investor A’s net earnings?
What are Investor B’s net earnings?
What advice would you give to your children about investing for their retirement?
The answers to questions 1 - 7 can be found at the end of this unit.
Note that Investor A, who invested much less than Investor B, has a much higher nest egg at retirement age, because of a 10-year head start. As you can see from this example, compound interest is especially magical when money is steadily invested and left to grow over a long period.
In the final analysis, your overall investment return will be closely associated with the asset categories and allocations that you select. An investor’s group of investments, frequently called an investment portfolio, can be divided in numerous ways among stocks, bonds and cash management options. You might choose a 20/40/40 portfolio . . .20% stocks, 40% bonds and 40% cash options. Or . . . a 75/20/5 ratio . . . 75% stocks, 20% bonds, and 5% cash.
Figure 4. Asset Asset Allocation Options |
 S = Stocks B = Bonds C = Cash |
Several factors will impact the exact rate of return that you receive on your investment portfolio. Studies show that the most important one, asset allocation, will account for about 90% of your return. The selection of individual securities and market timing will account for the remaining 10% or so.
The critical question, of course, is: "What is the ideal asset allocation for you?"
Here are several factors to consider as you make this decision.
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Your Ideal Asset Allocation will be Influenced by Your . . . |
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Goals are specific things (e.g., buy a car) that people want to do with their money. As discussed in Unit 1, as people move through various life stages, their needs and financial goals change. Your selection of investments should relate closely to your financial goals; each goal will define the amount and liquidity of the money needed as well as the number of years available for the investment to grow.
Risk tolerance is a person’s emotional and financial capacity to ride out the ups and downs of the investment market without panicking when the value of investments goes down. Risk tolerances vary widely. Some are associated with personality factors, while others are based on changing needs dictated by your stage in the life cycle. If you won’t sleep well at night when the principal value of your investment goes down, you should select saving and investment options with lower risk. On the other hand, it’s important to realize that investments which guarantee the safety of principal will not grow your money quickly and may not maintain purchasing power in times of inflation or over a long time span. In reality it’s necessary to take some risk just to maintain purchasing power. The question is: "What kind of risks are you willing to take?"
As discussed earlier, time is a very important resource to investors. For example, young investors with a long time horizon may choose investments that exhibit wide price swings, knowing that time is available for fluctuations to average out. Families investing for a specific mid-life goal (e.g., funding a child’s education or purchasing a home) may choose a more moderate course which has opportunity for growth, but provides more safety for the principal. Individuals nearing retirement and those with the need to depend on investment income to cover daily expenses, may wish to select investments that lock in gains and provide a guaranteed income stream.
The return on any investment is influenced by your federal, state, and local tax situation. Investment earnings may be:
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Before selecting an investment, learn its tax consequences for you. Remember, what counts is not what you make on an investment, but what you get to keep both now and in the long run.
Some investments require little or no time commitment or special knowledge. Others, such as rental property, or a portfolio of high-risk individual stocks may require constant monitoring and management. How much time are you willing and able to spend?
In a nutshell, the asset allocation which you select must be customized to your situation, needs and temperament. Spend a few minutes completing the "What are Your Investment Preferences" exercise to help you further clarify and summarize your investing preferences.
Consider each pair of words below as a continuum. Place an "x" on each line of the continuum to indicate how important each of these features is to you. Marking the middle of a line would therefore mean that the features were of equal importance.
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Low risk (Safety) |
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High-risk |
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Low rate of return |
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High rate of return |
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Low capital growth |
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High capital growth |
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High capital preservation |
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Low capital preservation |
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Not very liquid |
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Highly liquid |
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Short-term maturity |
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Long-term maturity |
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Taxable |
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Tax-exempt |
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No minimum investment |
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High minimum investment |
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Low costs and fees |
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High costs and fees |
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Little or no management required |
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Much management required |
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Present income |
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Capital growth |
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Conservative |
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Aggressive |
Figure 5. What are Your Investment Preferences?
Adapted from: Hogarth, Jeanne and Swanson, Josephine (1987). TOPICs,
Investment basics, Cornell University, 1987.
If others are sharing investment responsibility with you, ask them to complete it as well.
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In this unit we have discussed basic financial concepts that you need to understand before becoming involved in an investing program. You’ve learned about the difference between saving and investing, the predictable trade-off between risk and return, the importance of time to an investment program and about asset allocation. In addition, you looked at various aspects of your personal situation and their possible impact on your asset allocation decisions.
The steps below suggest important actions for you to take to establish a solid foundation for future investing activity. Once completed, you will be ready to begin developing a personal investment plan. A necessary part of the plan is locating dollars to invest. The next unit will help you meet that challenge.
Action Steps - Check each action step as it is completed
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Review your current financial
holdings and determine if they are in saving or investment vehicles. |
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Determine the rate of return
for your current financial holdings. |
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Establish short-, medium-, and
long-term financial goals for you and your family. Estimate the length of time between now
and when you want to achieve each goal. |
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Complete the
"What are Your Investment Preferences?" exercise to identify your characteristics and
needs as an investor. |
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Set aside time each week to
read one of the family financial magazines recommended in Unit 9. |
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Assess your interest, skill, and time to make decisions about your investment plan and portfolio. Proceed on your own or seek assistance. |
References
Garman, E.T. & Forgue, R.E. (2006). Personal finance.8th Edition. Boston: Houghton Mifflin Company.
Quinn, J. B. (1997). Making the most of your money. New York: Simon & Schuster.
2005 Yearbook (2004). Chicago: Ibbotson & Associates.
Consumer approach to investing (1998). National Institute for Consumer Education. Ypsilanti, MI.
Joan Witter worked on the Cooperative Extension staff at Michigan State University for over 20 years. She received both B.S. and M.A. degrees from Michigan State University and is currently Program Leader Emeritus, Extension Family Resource Management Programs.
Answers to questions 1-7 of section - How Time Affects Money:
1. 20,000; 2. 37,021; 3. 62,000; 4. 545,344; 5. 352,427; 6.
525,344; 7. 290,427
Last updated: March 12, 2007, webmaster@rce.rutgers.edu
