The Main Types of Investment Products - Research Paper Example

Topic:' A report explaining the main types of Investment products available to individuals and companies, advantages and disadvantages of different forms of investment and the Tax implications of different types of investment products. Table of Contents: Introduction: 2 Comparative Study Of Different Investment Products: Advantages, Disadvantages And Tax Implications 3 Stock 3 Bonds/fixed income 5 Cash instruments 6 Property: 7 Conclusion: 8 References: 9 Introduction: There are indeed a lot of investment products available for retail as well as institutional investors. While there are a few investment products are open only to High Networth Individuals (HNIs) and Institutional investors, there are still more investment products that are principally open only to retail investors and not for HNIs and Institutional investors. (Glossary of terms, n.d.) Broadly, all investment products can be categorized under four groups: 1. Equity/Shares/Stock 2. Debt/Fixed income/Bond 3. Cash instruments 4. Property All these four asset classes have their own combination of growth and risk associated with it. The asset allocation strategy of an investor among the various asset classes is influenced by a multitude of factors and is as much art as it is science. While investors with more risk appetite will opt for equity based investment products, an investor who prefers stability or in other words is a risk averse will prefer Debt/Fixed income investment tools more. However, financial companies have designed investment products that are not pure play Equity/Fixed income/Cash instruments, but are hybrid in nature and have varied components of equity, debt and cash instruments. Pooled investments are managed by professional fund managers and are considered to be safer for individual investors. These pooled investments have exposure to almost all asset classes to spread risk, maintain growth rate and liquidity. Comparative Study Of Different Investment Products: Advantages, Disadvantages And Tax Implications Stock Stock represents a part of ownership in a firm. Buying stock of a given company is equivalent to being a part owner of the company, and the investor, in essence, becomes part owner of all future earning of the company. The value of an investment in stock is dependent on the performance of the company. If the company performs well, the value of the investment goes, and vice versa. Investment in stock entails higher risk as compared to other investment products like fixed income/debt/bonds and cash instruments. Additionally, money invested in stock has lower liquidity as compared to other products. However, the possible upside of investment in stock is much higher as compared to other investment products. Investment in stock should be done only after a proper research on the company, its future prospects, the market it is operating in and other factors influencing the company. It is very strongly recommended to invest in a group of companies (portfolio) rather than investing in a single company. By investing in companies from different domains and with varied market capitalization, the inherent risk can be substantially managed. However, developing and managing a well spread out portfolio requires a good amount of research, insight and constant tracking that may be difficult for an individual investor. One of the best ways of avoiding this effort is by investing in Mutual Funds. A Mutual fund is an investment company or a trust in which investors pool their funds and invest them in a wide variety of securities. (District Human Resources, n.d.) Mutual funds are managed by professional fund managers backed by team of analysts that are perfectly capable of analyzing and identifying best performing and under-valued stocks. Mutual funds, in turn, follow their stated policy of investment. While some Mutual funds aggressively invest in high risk, high growth sectors, there are other mutual funds that strike a balance between higher stability and modest growth. Depending on the risk appetite of the investor, s/he can choose the right mutual fund. Advantages: Stocks represent one of the most attractive asset classes. In invested judiciously, stocks can offer substantially higher than market return rates. Additionally, a stock investor can get profits through dividends, capital gains as well as rights/bonus issues. Disadvantages: As mentioned earlier, investing in stocks and maintaining a portfolio involves a high amount of research and tracking. Individual investors often find it difficult to properly track and research the companies they invest in. While investment in stocks can offer higher than normal appreciation in wealth, a misguided and misinformed investment can also be hit by capital erosion. Any business enterprise, inherently, is subjected to risk. Hence, buying stock in a sinking company can wipe out the entire investment of an investor. Tax Implications: Investment in stocks offers two kinds of returns- dividend and capital gains. In most economies, including UK, dividend is taxed. Dividend is generally added to the annual income of the investor and then tax is levied on the total annual income of the investor. The profit gained due to appreciation in process of the stock is called capital gains. Capital gains are generally taxed in almost all economies. However, governments tend to offer incentives in the form of tax breaks to encourage various sectors. (Venture Capital trusts, March 2008) For example, UK investors get tax breaks in income gained from investing in 'green companies' and start-ups. (Grifitths S., February 2008) Bonds/fixed income Bonds are fixed term investment option offered by a government or semi-government organisation with an undertaking made to repay the funds loaned by investors at a specific rate by a specific date. (Glossary, n.d.) By definition, bonds are insured by the issuing agency, and hence they carry minimal (in case of corporate bonds) or no risk (in case of government issued bonds or gilts). Conversely, the rates of return offered by most bonds are very conservative. Bonds are one of the preferred financial tools used by Government bodies and corporate bodies to raise fund. There are many variants of bonds, and bonds can be categorized under different heads like type of issuer (government or corporate) and maturity period. Unlike shares, bonds have a shelf life and are redeemed at the end of the maturity period at face value. Government bonds, by virtue of its high security quotient, generally offer a lesser rate of return. However, returns on government bonds are generally tax exempted. Corporate bonds have a higher rate of return. These bonds are rated for security by various independent rating agencies, and the rate of return offered generally varies inversely with the perceived security of the issuer. Bonds are traded in bond markets and hence are semi-liquid in nature. Advantages: One of the primary advantages of bonds is the relatively higher degree of security associated with bonds with respect to shares. Bonds offer steady rate of return, and in some cases, they offer capital appreciation too. However, this capital appreciation happens only in the secondary market, and is always redeemed at face value. Additionally, bonds are liquid and are traded daily. Government bonds, also known as gilts, generally offer tax exemption. Disadvantages: If the bond issuing company becomes bankrupt, the investor may lose the entire investment. Long-term bonds may lose their attractiveness if inflation goes up, thereby diminishing the effective rate of return. Additionally, bonds offer little capital growth opportunities. (Bonds, n.d.) Tax advantages: Income from government bonds is exempt in many economies, including UK. Cash instruments As the name suggests, this asset class involves keeping money in bank accounts and in building-society accounts. This asset class is virtually risk free. The only risk in cash deposits is in the scenario when the bank or the building society goes bankrupt. However, these cases are extremely rare. These asset classes have the highest liquidity, and the amount can be used anytime. Hence, these asset classes are maintained mainly in anticipation for emergency situations. However, the rate of return on these investment products is very low and these investment products offer no capital growth. Return from Cash deposits are not taxed in UK. However, due to the tax breaks, there is a limit to which any investor can put in his savings account. Property: Investment in real estate and property is the fourth asset class, and is characterized by moderate to high rate of return. Property investments attract two kinds of returns- regular return in the form of rentals and also capital appreciation. Property investments can be either for residential purposes, where the property is rented out for residential purposes, and also for commercial purposes where the property is rented out for commercial activities. Capital appreciations as well as increase in rentals depend on the location, age, and the tenant of the property. Advantages: Historically, investment in property has offered higher rate of returns than bonds but lower than stocks. The rate of return in commercial properties tends to be higher than residential properties. (Tisha K., May 2008) Additionally, investment in property carries relatively lower risk than shares. Disadvantages: One of the most critical disadvantages of investing in property is its illiquidity. Any investment in property may take as much as half a year to be liquidated. However, this time period comes down drastically if the investment is done through pooled investments. (Tisha K., May 2008) Other risk scenarios include situations where the tenant defaults in paying rent, or there is damage to the property, thereby requiring more investment from the investor to restore the property. If the investor has partly financed the investment through loans, then higher interest rates may result in higher repayment rates, thereby negating the return on investment. Tax implications: In UK, renting out a property is almost equivalent to running a business. While rentals are considered as revenue, expenditure incurred in maintaining the property is considered as expenditure. Income in the form of rental from property minus the expenditure is treated as profit from business, and hence is taxed accordingly. However, in some special scenarios where the investor is renting out a part of a property, or is getting less than a specified amount as yearly rental, then this income attracts some exemption from tax. The final rate of tax also depends on the total income of the investor. (Tax on Rental Income: An Overview, n.d.) All profit derived from selling a property is taxable, and the investor has to pay the appropriate Capital Gains Tax. Conclusion: Investment thus is once again established as more of an art than a science. To make a judicious investment decision one needs to have the right insight into prevailing market sentiment and also the potential market performance. In the recent times the emerging economies of Asia are stealing the focus of domestic investors of bigger economies like UK and US. Due to the sub-prime crisis in the UK economy, business investment (the largest component total fixed investment) growth has slackened by a considerable rate. (Future Prospects, n.d.) To make sure that there is the right trade off between risk and gain, one needs to ideally invest in all asset classes instead of investing in one particular tool. 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