Investing For Your Future

Unit 4: Ownership Investments

Irene Leech, Ph.D., CFCS, Virginia Tech

Now that you know some basics about investing and ways to find money to invest, it’s time to learn about the types of investments that are available. There are two basic categories of investments: ownership and loanership. Equity or ownership investing means becoming a partial owner of a company or piece of property through the purchase of investments such as stock, growth mutual funds, and real estate. With ownership investments, you have influence on some decisions made about the investment. For example, if you own stock, you may vote for members of the board of directors that makes decisions about the company or make proposals concerning its operations. If you own an apartment which you rent, you make decisions such as repainting and setting the rent price. When the value of an investment goes up, you share that increase with other owners; when it goes down, you share the loss.

When there are earnings, you share them. There are no guarantees about what the price of the investment will be should you want to sell it in the future. The price may be higher than it was when you bought the investment but it could be lower. Likewise, there are no guarantees that there will be earnings (such as dividends) or of how much they will be. Price and earnings may be affected by the management of a company or by outside factors such as political changes, weather, and the national or world economy.

The focus of this unit is ownership investments. These investments, equities, can either be owned outright or purchased on credit. Examples of equities include stock, growth mutual fund shares, real estate, collectibles, commodities, and businesses. This unit will provide you with an overview of investment products available for purchase. If you are interested in investing in any of these products, you should learn more about their characteristics, as well as about the particular company or product, before investing.

Most ownership investments are found fairly high in the Pyramid of Investment Risk pyramid (Figure 1). In other words, with the increasing potential for a high rate of return comes a high potential for loss of principal. The specific investments you make can influence how high that risk is. For example, owning a speculative stock has more risk than owning a home in an established neighborhood.

Figure 1. Pyramid of Investment Risk
Source: National Institute for Consumer Education, 1998

Common Stocks

When a company wants to raise money, it offers investors a share of ownership in the company in the form of stock in exchange for that money. As a partial owner of the company, each investor shares in the success or failure of the business. There is no guarantee of return on the investment. Investors become part owners of a business and have no guarantee that they will receive any income for the use of their money or that they will get back any or all of their money in the future.

If the company makes money in a given time period, its board of directors may decide to reward its owners by distributing dividends or may choose to reinvest the money in the company. If you own a stock that pays dividends, you may have the option of reinvesting them in more stock instead of receiving a cash dividend. The dividends are still taxable but dividend reinvestment plans (also known as DRIPs) are an easy way to increase your investment holdings.

As owners of the business, stockholders elect directors who select the people who manage the company on a day-to-day basis. Depending upon the business and the way in which it is set up to operate, stockholders may have the opportunity to influence other decisions as well. Typically, this happens at an annual business meeting and stockholders can cast proxy votes if they are unable to attend the meeting in person.

There are many companies that offer stock investments. If you are interested in purchasing stock you should learn about the industry and the particular business in which you are considering investing. There are many ways to learn. Magazines such as Kiplinger’s and Money are one. Newspapers, especially those that focus on economic topics, like the Wall Street Journal, and those in large cities, such as the New York Times are good sources. Companies such as Value Line produce materials to specifically rate stocks. These are typically carried in the reference section of larger libraries.

The Internet is full of Web sites that offer information. Scrutinize each site to determine the source and note whether written material is produced by a person or business that may gain profit from the information provided. One place to look for such Web sites is in the money section of the site at http://www.consumerworld.org/. There, you will find a link to the American Association of Independent Investors at http://www.aaii.org/, as well as a link to a stock market simulation for learning about how the market works.

By law, a company must provide a prospectus, which describes information such as its management and financial situation when it first issues stock. If you are interested in purchasing new stock in a company, you can request a prospectus. You may also find prospectuses on line at the Securities and Exchange Commission Web site (http://www.sec.gov). Some annual reports are available online from the Public Registers Annual Report Service at http://www.prars.com.

Investors use indexes to assess the general activity of the stock market. They are widely reported in newspapers, on television and radio, and via the Internet. The Dow Jones Industrial Average is the most widely followed gauge of daily market activity. It includes 30 stocks in well-established companies. Other indexes include the Standard & Poor’s 500 (which includes 400 industrial companies, 40 financial institutions, 40 public utilities, and 20 transportation firms), the New York Stock Exchange Composite (all stocks traded on the New York Stock Exchange), the American Stock Exchange Composite (stocks traded on the American Stock Exchange), and the NASDAQ Composite (newer stocks traded over-the-counter in the quotations system of the National Association of Securities Dealers).

Indexes also help show trends in market behavior. Investors use Beta as a measure of a stock’s price volatility–how much it changes. The average Beta for all stocks is +1. However, the Beta for an individual stock can be either positive or negative. The larger the Beta figure (e.g. +2 versus .50), the more speculative–and thus risky–a stock.

A "must read" for all equity investors is a company’s annual report. Along with other investor resources, such as Value Line and professional advisors, annual reports provide important clues to company performance. To obtain a company’s annual report, call its "shareholder relations" department or request a copy online from the company Web site.

The first part of a company’s annual report is the letter to shareholders. Here, company management explains significant changes in company operations (e.g., new products, decreased earnings) and in the report’s financial statements (balance sheet and income statement).

Like a personal net worth statement, the balance sheet in an annual report lists a company’s assets and liabilities (debts) at a particular time (usually the end of a company’s fiscal year). Assets are things owned by a company, such as product inventory and accounts receivable (money owed by customers). Liabilities are company obligations to pay for goods and services or to repay borrowed funds (e.g., interest and principal on company bonds). The name balance sheet reflects the fact that figures must "balance;" the value of a company’s assets must equal the sum of its liabilities and shareholder equity (the total value of all shareholders’ investments in a company).

Various financial ratios can be used to determine the financial health of a company. A common one is the current ratio, which is current (less than a year) assets divided by current liabilities. A 2:1 ratio ($2 of assets for every $1 of debt) is considered adequate. Another helpful ratio is the debt-to-equity ratio, a company’s total liabilities divided by shareholder equity. It should be less than 1:1.

Income statements in an annual report describe a company’s net income (or loss) per share. A common ratio used to analyze income statements is earnings per share: net income divided by the number of outstanding shares. Another is the price/earnings (P/E) ratio, which is calculated by dividing the share price by earnings per share (e.g., $24 per share and $2 earnings per share = P/E of 12).

Stocks can be bought and sold on one of the nine major exchanges. Newspapers typically report on the New York Stock Exchange and the American Stock Exchange. Newer or less frequently traded stocks are sold by telephone or computer hookup rather than at an exchange and are called Over the Counter.

Current information about stock prices and sales is available in most newspapers. An example of a newspaper report of the New York Stock Exchange is shown in Figure 2.

Figure 2 -  NYSE

Terms used in Figure 2:
52-week High-Low–These numbers tell the highest and lowest prices at which the stock has sold in the last year. Prices are in dollars and decimals of dollars. For example, highest price the AT&T stock sold for in the last year was $96.13 and the lowest price was $48.38.
Abbreviation–Standard abbreviation of the stock’s name. For example, AT&T.
Sales (000s)–The number of shares traded yesterday. It is multiplied by 1,000. Thus, AT&T sold 12,728,000 shares the previous selling day.
Last–Price at closing yesterday. For AT&T it was $85.56 per share.
Chg–The difference in the closing price yesterday and the day before. The price today was $2.44 lower than yesterday’s.

Note: The nation's stock exchanges converted stock prices from fractions to decimals in 2001. 

When stock is purchased or sold, a fee is generally charged. The cost will vary, depending on where the stock is purchased (e.g. discount broker, direct purchase, online). Comparison shop to determine available costs and services and to get the best deal.

Many investors use a specific strategy, dollar cost averaging, to invest in stocks. They regularly invest the same amount (e.g. $50) at regular intervals (e.g. monthly)–regardless of the price of the stock.

When investors use the buy and hold strategy, they purchase stocks and keep them for a number of years, not worrying about the changes in the market. Investors refer to times when prices are very low as a bear market and times when they are high as a bull market. The goal of successful equity investing is to buy when prices are low and sell when prices are high. You can learn more about these strategies in Unit 2, Investment Basics.

This very popular investment alternative includes land, the permanent structures on land and accompanying rights and privileges, such as crops and mineral rights. A home is generally the single largest asset that most people have. They often think of it as just shelter, not realizing that it is also a major investment. Other ways to invest in real estate include owning rental houses and land for potential housing or commercial development. You can also invest in real estate indirectly by purchasing units in a real estate limited partnership or shares in a real estate investment trust (REIT). Since direct ownership of real estate is so common, we will begin by discussing it.

When you purchase real estate, the costs of purchase include:

You can also purchase real estate indirectly through

Thoroughly investigate these investments before purchasing them.

Investors in real estate limited partnerships buy shares for unit costs of $500 or $1,000. The partnership invests in land or commercial real estate such as shopping malls and apartment complexes. A pro-rated share of rental income is passed on to investors as taxable income. When a partnership is liquidated or sold, any profits are distributed as capital gains.

When you buy shares in a real estate investment trust (REIT), the company manages various real estate investments. It may own real estate (e.g. apartment complexes and offices) and make money by renting the property or by making loans to others who own and manage property. Like a mutual fund, REITs provide diversification and professional management. They are required to distribute almost all of their annual income as dividends to investors. If the REIT portfolio is not properly managed or there are changes in the market, the principal investment may lose value.

You can select from over 300 REITs for investors. REIT shares, typically costing up to $40 each, are purchased from brokers and traded like stock on major exchanges. Additional information about REITs can be obtained from brokerage firms or the National Association of Real Estate Investment Trusts Web site: <http://www.nareit.com/>.

Equity Unit Investment Trusts

Unit investment trusts (UITs) are an unmanaged portfolio of professionally selected securities that are held for a specified period of time. They were first issued in the 1960s as a way to "package" and sell portfolios of professionally selected bonds, especially tax-exempt municipal bonds. The cost of a unit is generally $1,000. During the 1990s, the UIT concept was extended to stocks.

Unlike mutual funds, that are professionally managed, equity UITs are a "buy-and-hold" investment. Securities in the portfolio are held for a pre-determined time to generate dividends and capital gains for investors. At maturity, investors can take their cash and invest elsewhere or can "roll over" their balance into a new UIT.

Like their bond counterparts, equity UITs are an unmanaged portfolio of stocks that usually remains unchanged throughout the life of the trust. Some equity UITs follow a specific investment strategy such as investing in the five or ten highest yielding stocks among the 30 stocks included in the Dow Jones Industrial Average or only in stocks listed on foreign stock exchanges. Like mutual funds, an increasing number of equity UITs also select stocks from a particular industry sector (e.g., technology) or companies located in a particular state or region of the country.

Like individual stocks, UIT dividends and capital gains are taxable, whether earnings are distributed in cash or reinvested in additional UIT units. If the value of a UIT portfolio increases, that capital gain is taxed. Most equity UITs have maturities of six years or less. Shares can be sold prior to the trust’s maturity at a price determined by market conditions. Two advantages of equity UITs are not having to worry about changes in portfolio holdings or management and tax efficiency (low taxes because stocks in a UIT portfolio are rarely traded). A major disadvantage is their up-front cost. Equity UITs typically charge a front-end load (commission) of 3% to 5% of the amount invested.

Collectibles

People collect just about anything-stamps, coins, art, cars, autographs. To be financially successful with collectibles as an investment, however, a high level of knowledge is required. Some people collect as a hobby and enjoy spending their time this way.

To make money with this type of investment, you need a collection of items in top condition. You probably cannot regularly use or touch the collectible and will need to safely store them in a protective environment. Keep documented evidence of the value of your collection, (e.g. an appraisal of antiques). Regular maintenance and insurance may be necessary, too and there could be storage costs. The specific needs and the type of collectible will determine costs.

Generally, collectibles do not provide a regular or periodic income. When you sell an item, you see the gain in value. When you want to sell, you may take a while to find the buyer willing to pay what you think your collectible is worth. A professional appraiser or auction house may also be required to sell items to other investors. As you make investment decisions about collectibles, it is important to be sure that you are truly focusing on the value of the investment and that you are not unduly influenced by the psychological pleasure you receive from owning it.

Business

Ownership of a business is another investment option. There are many different kinds of businesses and many ways to be involved. You may own and operate a business yourself or hire someone to operate it. You can start your own business or purchase a franchise of a larger business. While businesses certainly offer opportunity for income, they also have many risks. Careful attention must be given to the financing, cash flow needs, and reserves. It is important to separate businesses from the family budget. You want to avoid putting your shelter, for example, at risk because your business has difficult financial times.

In many states Cooperative Extension offers education on micro- and home-based businesses. The Small Business Administration offers assistance. Other organizations in communities and in state government have valuable resources. If you are considering such an investment, search widely for information. The failure rate of small businesses is very high. Planning, especially development of a business plan, is critical.

Commodities

At the very top of the investment risk pyramid are commodities. These include pork, grain, coffee, sugar, etc. Financial expert Andrew Tobias says that since 90% of the people who speculate in commodities lose (and 98% may be a more accurate figure), the key is how to be among the 10% or (2%) who win. He simply compares investing in commodities to gambling. At the top of the investment risk pyramid, you have high potential for return, but also high risk. To invest there, you need to be able to afford to lose your entire investment.

Costs include brokerage fees. You also need considerable knowledge of the commodity in question and the markets in which it is created and sold as well as the changing situations of the buyers.

Buying and Selling Equity Investments

There are many ways to purchase equity investments. The specific type of investment you select will affect your choices. For example, you may trade collectibles and real estate directly with other buyers and sellers. When you purchase stock or REITs, you may work with a broker. Full-service brokers generally provide more assistance with research and advice and charge higher commissions than discount brokers. Use the "Rule of Three"-compare the costs of buying and selling with at least three firms.  Other ways to make investment purchases include:

The process for executing an online trade is as follows.

1. First, you need a computer with a modem and an Internet service provider.

2. Once connected, log onto the Web site of online brokerage firms such as Accutrade, Bull & Bear, Datek, E*Trade, Fidelity, Schwab, and Web Street.

3. Complete an online application.

4. Mail additional forms and a check to open an online trading account. The minimum amount required by most online brokerage firms to establish an account is between $2,000 and $15,000.

5. You will be notified by e-mail when your application is received and you are approved to make online transactions. Stock trades are generally executed within seconds of placing an order.

Regardless of the method you use to buy and sell equities, be sure that you fully understand the types of orders used to buy and sell. Be sure that when you make an offer to buy or sell you know when it will be placed and what costs are involved. Know what will happen if your offer is not processed immediately or if the market changes significantly before your offer reaches it.

Diversification

Whatever investments you make, remember to diversify. You can either select investments, such as mutual funds, that invest in a variety of securities, or you can purchase a variety of securities yourself. If you do it yourself, be sure to invest in different sectors of the market (e.g. energy, financial services, technology) as well as in different specific investments.

Summary

Equity investing means becoming a partial owner of a company or piece of property through the purchase of investments such as stock, equity mutual funds, and real estate. Capital appreciation over time is the primary objective, although some equity investments, such as REITs and equity-income mutual funds, also provide dependable dividend income. This unit has reviewed general characteristics of equity investments and "nitty gritty" details such as how to purchase them. Diversification and asset allocation, as they relate to equity investing, were also discussed. The unit concluded with a discussion of specific equity investments. Now you need to consider appropriate equity investments that will mesh with your personal financial goals.

Use these action steps and the Equity Investment Comparison Worksheet below to make investment decisions.

Equity Investment Comparison Worksheet

References

Brennan, P.Q. (1997). Buying stocks without a broker. Rutgers Cooperative Extension curriculum.

Case, S. (1994). The first book of investing. Rocklin (CA):Prima Publishing.

Gruber, B. (1996). The investing kit. Chicago: Dearborn Financial Publishing.

Keown, A.J. (1998). Personal finance: Turning money into wealth. Upper Saddle River: NJ Prentice Hall.

Korn, D. (1999, March). Going from the dogs. Financial Planning, 73-76.

O’Neill, B. (1999). Investing on a shoestring. Chicago: Dearborn Financial Publishing.

Rankin, D. (1994). Investing on your own. Yonkers (NY): Consumer Reports Books.

Reinhardt, C., Werba, A., & Bowen, J. (1996). The prudent investor’s guide to beating the market. Chicago: Irwin Professional Publishing.

Rosefsky, R. S. (1999). Personal finance. 7^th Edition. New York: John Wiley & Sons.

Tobias, A. (1998). The only investment guide you’ll ever need. San Diego: Harcourt Brace.

Wall, G. (1995). The way to invest. New York: Owl Books.

Wessel, D. (1999, March 15). U.S. stock holdings rose 20% in 1998, highest percent of assets in postwar era. The Wall Street Journal, A6.

Author Profile

Irene Leech, Ph.D., CFCS, is an associate professor of Consumer Affairs at Virginia Tech and former consumer education specialist for Virginia Cooperative Extension. She teaches in the undergraduate and graduate resource management program at Virginia Tech. Her professional memberships include the Association for Financial Counseling and Planning Education and the American Council on Consumer Interests.