Financial & Investment Terms
Investing can be overwhelming at times, so here are some fundamental investment terms to help you understand the financial industry better.
Your investment objectives should be clearly identified. Objectives often include:
Safety of Principal
This is important when a specific future commitment exists, such as college education, old age, sickness, and death. Investments must not diminish if the economy should falter and price levels should fall. Unfortunately, there is an inverse relationship between safety of principal and profit potential and income. Profits and income can be obtained only by incurring risk; generally, the safer the investment, the lower the yield. It is impossible to find an investment that will maximize safety, profit potential, and income simultaneously.
Retirees and those nearing retirement are concerned with investment yields, since they must live on the yield once earned income stops. Generally, investments with the highest current income have a corresponding reduction in safety of principal, as the high return reflects the extra cost to attract investors. However, there is a hidden cost in very safe, low income investments. Although the yield may be stable, the purchasing power declines due to inflation.
Growth of Capital
This objective places income from investments as secondary. The investor must be willing to accept reasonable risks in order to obtain growth of capital. An investment must have the potential for growth in order to realize an increase in purchasing power over time.
An investment is liquid if it is easily and quickly converted to cash without a substantial price concession. Every investor needs some liquid assets for emergencies. Liquid assets generally do not have much growth potential.
Taxation and Deferral
Money has a time value. If two investments are equal in all other respects and one provides for the deferral of income tax through current deductions while the other does not, the investment generating current tax deductions yields the greater return. The use of tax-deferred accounts is fundamental to a successful investment program.
You should understand the risks inherent in investments.
The price of a security, bond, or mutual fund may drop rapidly and stay low for a long period. Market risk is caused by investor reaction to tangible and intangible events. Market risk is often caused by factors independent of a particular security. For example, political, economic and social events sometimes trigger market events. The imminent war in Iraq depressed the market, which quickly recovered when the U.S. started achieving military success.
While high quality, low-yield investments protect against market risk, they are highly susceptible to inflation. Proper timing and consistent investments over a prolonged period of time also protect against market risk.
Rising interest rates may cause investments to drop in price. For example, higher interest rates make yields on existing bonds less attractive, causing their market values to decline. Conversely, when interest rates fall, the market prices of previously issued bonds rise.
Purchasing Power Risk (Inflation Risk)
A dollar will not buy as much next year, because purchasing power is eroding at the rate of inflation. Inflation averaged 6% over the last twenty years. Inflation was 3% in 1991 and is expected to remain low for a while.
Equity based, variable income investments provide some protection to the investor against purchasing power risk.
Business and Financial Risk (Specific Risk)
These risks are associated with a particular industry or a particular company within an industry. For example, a business borrower who issues a bond may not pay back the loan. One insurance company may default on an annuity causing share prices of other insurance companies in the industry to deteriorate as well.
Careful selections and timing offer some protection against business risk. A debt based, fixed income investment offers greater protection against business risk than an equity based, variable income investment.
Slow economic growth will cause investments to fall in price. Shares of emerging growth companies may shrink. Cyclical companies cannot easily cut costs during a recession. Economic downturns can undercut high yield bonds issued by financially weak firms.
Liquidity is the ability to readily convert an investment into cash at any time without losing any of the original principle invested. If there is no buyer immediately available for your security when you want to sell it, the security is illiquid. Real estate is relatively illiquid. Blue-chip stocks are traded on major stock exchanges and are very liquid. Mutual funds are similarly liquid.
Overseas investments are subject to fluctuations in the value of the dollar against the currency of the investment in a particular country. This is also referred to as exchange rate risk.
Risk Drives Returns
Risk is the ally of the investor. The greater the risk, the greater the return in general. All investment decisions involve calculated risks. The challenge is to maximize the return while minimizing the risk.
While the future is uncertain, one lesson from the past is clear. People who invested solely in debt based, fixed income investments lost purchasing power.
Investing in equities will expose you to greater volatility, and perhaps even loss of capital if you withdraw from the market too soon or at a bad time. Nevertheless, you should be willing to tolerate equity swings of up to 20%. The solid mutual fund families experience market volatility like the rest, but they have always come back in better markets. You will be well served with one or more good mutual fund families.
After investment objectives have been defined and the different risks weighed, it is important to understand certain basic investment principles.
Worthwhile financial achievements are accomplished only by making determined progress toward stated goals. A firm strategy should be established to accomplish the goals, but flexible enough to adjust to economic changes. Attaining a stated goal requires a measure of discipline.
Acquiring and managing investments takes not only money, but time and professional skill. It means knowing what to buy, when to buy, how to buy, and when and how to sell. This applies to every type of investment. Unless you intend to devote a substantial amount of time and undertake a great degree of responsibility, you should make use of professional advice. Being an investment specialist is a full time occupation.
By spreading capital over many types of investments, risks will be reduced. In general, no asset, regardless of how secure it might presently seem, should be depended upon so heavily that a change in economic conditions might endanger a significant portion of your financial program. Thus, investments should be apportioned over several different investments.
A sound investment program should be balanced between fixed and variable investments. The proportions depend on the investment objectives and investor temperament.
In addition to establishing a set plan, which includes professional management, diversification and balance, adequate liquid sources of funds must be maintained. There is need for liquid funds not only for protection of your "living estate," but your "estate at death" as well. Your estate will incur expenses such as estate taxes and administrative costs. Your assets must be positioned to cover such needs. But rather than tying up a significant portion of your "living estate," prudent economic ways should be used to provide for liquidity needs.
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