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Lesson 5a: Investing Basics

Objective: Learn the basics of returns on investments

Investing may sound like a daunting task.  First, most Americans live day-to-day and do not have extra money to invest.  Second, there are so many options it can be difficult to choose.  In recent years the ability to invest in mutual funds and exchange traded funds (ETFs) has made investing a lot easier.  This section will focus on how investing works, not where to invest.

As we learned in the retirement section, everyone will need to save for their retirement.  So it is important to learn the basics of investing.  The basics of investing center around:

1) Risk vs. reward

  • Risk is a measure of the volatility of an investment, the fluctuations in price and rate of return.
  • For example, stocks are more volatile than bonds and thus have a higher risk.
  • The more risk you take on your investment, the higher the potential rewards should be.
  • Investments with guaranteed high returns at low or minimal risk should be reviewed carefully, because they are probably too good to be true.

    An investment that is too good to be true is not as good as it sounds.  A return is calculated based on (1) the price you buy-in at, (2) the future price you sell at, and (3) the investment returns you receive in the mean time.  In an efficient market where all known information is reflected in the price of the investment, an investment that appears to have a better than expected return (compared to risk) will draw many investors and thus the buy-in price will increase.  The increased buy-in price will lower the future return, because the anticipated future sale price does not change.  Thus, in an efficient market, the risk vs. return should correlate and not leave an opportunity for a big return with little risk.

    In an inefficient market, there may be an investment that provides a larger return for a smaller risk.  However, these markets are few and far with investors quickly finding investments that are too good to be true and running up the price until expected future returns return back to normal.  Note, for an inefficient market to exist, there needs to be some element that hinders the buy-sell process, such as:

      • Entry barrier where only select few can join either due to price or needing to be voted in like the NBA, NFL or MLB
      • Few buyers or sellers (e.g., someone sells out of desperation for a buyer)
      • High transaction costs which deter people from buying the investment

2) Investment horizon

  • The longer your investment horizon is, the larger the returns should be.
  • For bonds and CDs, longer duration bonds typically have higher returns (with some exceptions in times of high inflation).
  • For money market funds and checking/savings accounts, the returns are typically less than inflation since you can pull the money out at any time (i.e., little to no investment horizon).

3) Building blocks of investment return

  • Based on the time and risk premiums above, the expected rate of return on an investment is

    expected return = expected inflation + time horizon premium + risk premium

  • The longer the investment duration and the higher the risk, the higher the expected return should be.

4) Diversify

  • You can reduce risk by investing in several different assets.
  • If invested in equities, you will want to invest in 12 or more stocks or in a broad based mutual fund or ETF. However, be careful of investing in just one specific sector because similar stocks like energy stocks tend to move in the same direction and thus have less diversification of risk compared to a similar number of unrelated stocks.
  • You should have different types of investments (bonds, stocks - foreign and domestic, real estate, etc.)
  • Be cautious if your only investment is your house.

    In today's society we have been bidding up the price of houses because of our desire to have the newest, biggest, and best house on the block.  Advisors have suggested that buying a house is a great investment.  Some people invest all they have in their house and plan on this investment for their retirement.  Because this is only one investment, it has a big risk that can be overlooked.  One such risk is if there is damage due to an earthquake, mudslide, flood, or termite damage, most basic insurance policies would not cover the loss.  What happens to your investment then?

Is an investment too good to be true?

In the 1990's, the investment was internet stocks.  Today, the investment is real estate.  I get worried when I hear that real estate will provide larger returns at lower risk than the stock market.  If this is true, why don't we hear stories about Warren Buffet or Bill Gates investing in real estate?  This is what the savvy investor would do; invest in products with high returns with low risk.  Do I hope real estate prices keep on going up?  Yes, but I am also cautious because there are risks that individual speculators are not considering, such as:

Reasons why real estate is a good investment
Reasons why real estate is a questionable investment
Tangible good that people need Can be destroyed by earthquakes, termites or decay which are not covered by insurance
Limited land supply around cities With telecommuting, people can live further away from cities where land is cheaper
Recent history of high returns Same phrase was used by stock brokers in the 1990's about internet stocks
Good to diversify between stock, bonds and real estate Not good if real estate makes up a majority of net worth and prices fall
Can invest only 10% to 20% of the home price to leverage your return (a 20% increase on $100,000 home with $20,000 down payment results in 100% return) You can do the same thing with stock, but most advisors will suggest against taking such a risk, because a 20% decline in stock or home value will wipe out your investment.
Can flip property for profit with a small amount of fixing up You will need to pay high financing fees (closing costs) and real estate commissions that will limit the return unless you have friends in the business who can give you a deal.

Real estate may be a good investment, as a part of a much larger investment plan.  However, to believe that we will see double digit growth in real estate prices with no risk of a market correction may be too good to be true. If it were true, then in an efficient market, the prices would sky rocket to a point where future growth in home prices would be at a more reasonable rate.  The question today is, has the price increased to a point which reflects a reasonable price, an over-inflated price, or are prices still a bargain?  If you are looking at real estate as an investment, you will not want to buy in if market prices are over-inflated.

Personal Topic : Delayed Gratification
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