Basics of Finance and Investment - Essay Example

BASIC INVESTING An Investment Primer for Claire Patterson Introduction From the time of the Great Depression (and maybe because of it), the words “investing” and “stock market” have been associated by many of us with the words “risk” and “gambling,” with good reason. The most spectacular news regarding the stock market is that a crash has wiped out people’s life savings, or that a Nick Leeson has brought down 233-year-old Barings bank (the personal bank of Her Majesty the Queen, no less), or that a Bernard Madoff had completely fooled hundreds of investment-savvy, big-name individuals. And how much more risky are investments, then, to a 32-year-old child psychologist who has lived her whole life in Alnwick, Northumberland! The Benefits of Investing Bad news is always remembered more because it is human nature that people’s miseries create a stronger impact in our minds. But it should also be remembered that if there is a Leeson, there is also a Warren Buffet. Money was lost on internet stocks, but just before that, money was also made on the same internet stocks. And Bernard Madoff was one of a kind, who took advantage of people’s confidence to him as a SEC consultant. There was nobody before or after him who operated at the level he did, because the there is usually in place an effective regulation of the market and most such operators are caught early on (Arnold, 2004). If there are no extreme developments such as market crashes and financial crises, investing for value long-term has always been sound strategy for enhancing wealth. There are several vehicles for investment: the savings account, the money market, certificates of deposit and common stocks are some of them. Each of these instruments is associated with a particular level of rate of return. The rate of return is the percentage gain an investment makes – in short, how much yearly earnings are expected as a proportion of the capital invested. The rates of return fluctuate, but they maintain a more or less consistent relationship with those of the others. For instance, the savings account in a bank would normally have the lowest rate of return which is denoted by its interest rate. The money market placement has a slightly higher interest rate, followed by certificates of deposit, and then the stock investment. The average rates of return for each of these instruments is shown in the second row of Table 1 (source: UK National Statistics Online). The rate of return plays an important part in the concept of compounding. In compounding, the returns that have been accumulated for one year becomes part of the capital and earns further returns in the coming year. It is denoted by the compound equation: Fn = P0 ( 1 + k ) n where: Fn = future value of the investment after n compounding periods (years) P0 = initial investment at the beginning of the first year k = rate of return of the investment n = number of compounding periods (years) (Reilly & Brown, 2006) Now, supposing Claire Patterson, a fixed wage earner, is capable of saving up £1,000 a year. Presently she puts it in a savings account the average rate of return of which is 0.50%, according to the UK Office for National Statistics. By the time she is 75 years old (43 years from now), she would have approximately £47,840 in her account. This is, however, the nominal return of the account. If one were to include the effect of inflation, which is an average of 2.75% over the last decade or so, one would have a lower real return than that shown by the average nominal rate. A look at Table 1 shows two return schedules for each of the four investments shown, the first schedule showing the nominal returns, and the second showing the real, inflation-adjusted return, for the same investment of £1,000 annually (Litterman, 2003). For the savings account of Claire Patterson, she may expect her £43,000 to accumulate to £47,840, but since the inflation rate is 2.75% which overtakes the 0.50% annual savings account interest rate, the purchasing power of her money would be equivalent to £27,740 in today’s terms, or a real loss of -35.49%. For money market investments, the average rate of return is 2%, but with inflation at 2.75% this puts the real (adjusted) rate of return at -0.75%. Thus, the nominal value of Claire’s investments at age 75 would be £67,159, but with a buying power of only £36,873, compared to the £43,000 she put into it. For certificates of deposit, the average nominal rate of return is 5%, yielding a value of £142,993 in 43 years. Adjusted for inflation, the real value of the investment would be £71,257, which has a real positive return of 65.71%, a worthwhile consideration. Finally investment in stocks, which has for four decades averaged with the highest comparative returns at 8%, will be expected to provide a nominal value of £329,583, but adjusted for inflation the real return would be £163,576, for a real overall return of 280.41%, a truly worthy investment for Claire’s old age. One might wonder why different types of investments yield different rates of return. This is because each type of investment poses a different risk to the investor (Gitman et al., 2008). The Vehicle for Investments Bonds. The first investment vehicle we shall consider are bonds. These are fixed-income securities that are founded on debt. By purchasing a bond, one lends out his money to the issuer which is either a company or government. In return, the bondholder is entitled to a payment of interest on the principal, and at the end of the life of the debt, which is one year or more, the bondholder is entitled to the return of his principal. If the bond issuer is the government, then the return is practically guaranteed against default, and therefore has a very low risk, or none at all. This is called the risk-free rate, or at least a reasonable approximation of it. Bonds are the safest of the long-term investments, because of the promise of a fixed income and the return of principal at the maturity of the investment, which is also at a fixed point in time. But because there is little risk, the return is lower than that for other securities (Gitman, et al., 2008; Reilly et al., 2006). Stocks. The second investment vehicle under consideration is stock investment, where the investor purchases securities that are termed common stocks or common equities. Common stocks are shares of ownership of a company, thus stocks are issued by listed corporations established for business, never by governments. The stockholder is entitled to the rights and privileges of ownership. If the company has done well, stockholders receive dividends, either in the form of cash or additional shares of stocks. Stockholders are also entitled to exercise their voting rights, that is, to select the board of directors of the company. In this manner may they exert their control over the policies and governance of the corporation (Gitman, et al., 2008; Arnold, 2004). Stocks are different from bonds because unlike the latter, they do not provide a fixed stream of income, there is no fixed period after which the principal shall be returned, and there is even doubt whether the original capital invested will be returned. That is because stock prices are volatile; depending on whether the company attracts many investors who buy the stock and drive the market price up, or if the company is seen as a poor investment thus causing investors to sell the stock in the market and drive the price down. Thus there are no guarantees in stock investing, either of dividends or of return of capital. Because investors in stocks risk much more than investors in bonds, stockholders demand a higher rate of return on their investment than lower-risk instruments. This is the basic relationship governing risk and return: the higher the risk (of losing your investment), the higher the possible return (that you would require in order to invest) (Gitman et al., 2008). Mutual Funds. Investing in stocks and bonds could be complicated to the individual investor. This is because determining the quality of the instruments or the issuers of the instruments can require specialised information and knowledge, which can be beyond the reach of the single investor. Mutual funds, on the other hand, are professionally managed funds. They are a pool of resources by several people that are invested in a group of bonds and stocks. The idea behind a mutual fund is that people who feel ill-prepared to make investment decisions, especially in combining investment instruments in their portfolio, feel more confident with a professional managing their investments. Thus they buy shares in mutual funds, which is seen as a more profitable alternative than a savings account, but with the risk managed by a professional, and with the advantages of diversification (combining instruments to minimise risk while enhancing returns), economies of scale (making sizeable investments to lower the transaction cost), liquidity (ability to convert the investment to cash in a short span of time), and simplicity and ease of transaction. However, disadvantages also exist in the form of costs of administration, professional fee for the manager, dilution in the case of too much diversification, and failure by fund managers to consider the investor’s personal tax situation (in the case of capital tax when a security is sold) (Kane, 2004). Money Market Funds. Unlike mutual funds, bonds and stocks, all of which comprise the capital markets and are essentially long-term, the money market consists of short-term debt instruments. Treasury bills for the most part comprise the money market, with maturities of less than one year. The money market does not promise high returns, but there is certainty of a return of principal and interest thereon (Reilly, et al, 2006). Conclusion: The Importance of Value Investing This brief discussion touches only the surface of investing. For sure, successful investing is not a matter of relying on rumors or “hot tips”. There is such a thing as speculating, when one buys or sells securities, currencies or commodities based on their study of price charts and their reliance on momentum swings of demand and supply. This is called technical analysis, and the action in the market is in the nature of “playing the market” in the short term, buying when the price dips and selling when it rises, rather than investing. Value investing involves indepth research and careful analysis of the fundamental worth of the security. It requires patience, deliberation, and a clear definition of one’s investing goals and risk tolerance. Investing for value means that great effort is placed in determining the intrinsic value of a firm that is thought to be underpriced in the market, and finding a company that is worthy, putting money into it to enable it to grow. When the firm grows, the stock price is expected to follow as more and more investors buy into the stock. Most of all, value investing is long term, because the economic value of the firm takes time to develop. Claire Patterson, as well as all new first-time investors, should invest for value. It is certain that the returns they reap well into the future will be more substantial for their needs in old age, than relying in a low-return savings account. References Arnold, G 2004 The Financial Times Guide to Investing, The Definitive Companion to Investment and the Financial Markets. FT Prentice Hall. Gitman, L J & Joehnk, M D 2008 Fundamentals of Investing, 10th Edition. Pearson Education Inc. Kane, S 2004 Scientific methods in finance. International Review of Financial Analysis, vol. 13, pp. 105-118. Litterman, B 2003 Quantitative Resources. Modern Investment Management: An Equilibrium. Wiley Finance. Reilly, F K & Brown, K C 2006 Investment Analysis and Portfolio Management. Thomson South-Western U.K. Office for National Statistics 2009 Accessed 1 January 2010 from http://www.statistics.gov.uk/instantfigures.asp Read More