Investment Basics

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Investment Basics

Different Investments

There are three basic types of investments, also known as asset classes, all of which we are going to discuss. These investments are stocks, bonds and cash.

You can buy stocks and bonds as individual investments, or you can invest in them by buying mutual funds or exchange traded funds (ETFs) that own stocks, bonds or a combination of the two. If you invest in cash, you can put money into bank accounts and money market mutual funds or you can buy what are known as cash equivalents: US Treasury bills, Certificates of Deposit and similar investments.

While you may not think of bank accounts as investments because they currently pay such a low rate of interest, technically any time you use money to make more money, you are investing. On the other hand, stock-based vehicles have been the more profitable investment over time.

Stock Overview

Buying stock makes you a part owner of the corporation that issued the stock. In the past, stocks have offered one of the greatest long term investment returns, in large part because of the strength of the US economy which has been reflected in the growth of US corporations and the price appreciation of corporate stocks.

When a company prospers, investors who own its stock can make money in two ways:

Current income, if the company pays part of its earnings to shareholders as dividends;

Capital appreciation, if the price of its shares increases.

Since there is no limit as to how much a company can earn or how high its stock price can go, there is no limit as to how much return a stock investment can provide. Similarly, there is no limit as to how long you can own a stock and continue to benefit from its increasing value either through dividend income or price appreciation. You might also think about stocks as a way to build your estate by leaving them to your heirs in your will or through a trust.

Stocks, also known as equity investments because they give you ownership, can pose risk as well as the opportunity for profit. That's because their price fluctuates in response to what is happening in the company that issued the stock, in the industry of which the company is a part, and in the economy as a whole.

If you sell a stock at a time when the stock market or an individual stock price is down, you might have little or no profit, and you could even lose some, most, or all of your principal.

Stock Prices

There are two reasons why a stock's price goes up or down.

The first is the future financial outlook of the company issuing the stock. If it seems likely that a company's earnings will grow at a healthy rate, investors will probably be willing to pay higher prices to own its stock. On the other hand, if it seems that the company is struggling to grow its sales and earnings, investors will be less interested in owning the stock and its price may drop or, at best, remain relatively stable.

The second reason a stock's price goes up or down is related to the general state of the stock market. If the market is booming, stock prices typically go up. But if the market is falling, many stocks often drop in price, regardless of the future financial prospects of individual companies.

While it is very difficult to anticipate the general movement of the stock market accurately, investors can study the market by reading about it in the Selection and Opinion section of The Value Line Investment Survey. You can study individual stocks using the information provided on the Value Line page. We know of no source that gives more concise and detailed information.

Expectations

Professional analysts and individual investors tend to change their expectations about individual corporate earnings in response to new information about the health of the economy in general.

If investors expect boom times, they are often willing to pay increasingly higher prices across the board for stocks. But if they expect a recession to occur, they will assume that many businesses will suffer slowdowns and earn less money. Stock valuations are likely to drop.

For example, if the economy is weak and people are being laid off, or are afraid of being laid off, they are less likely to be buying new cars. So investors will lower their expectations for automakers' earnings. Similarly, if fewer cars are being manufactured, automakers will buy less steel. That means steel companies can be expected to earn less.

How does that translate into investment decisions?

In this scenario, the stock prices of automobile and steel manufacturing companies are likely to decline as investors shy away from them.

In a serious recession, prices of stocks in vulnerable sectors will continue to drop and drag the entire stock market down. But in a more typical situation, when the price drops to a certain level, investors once again see the stock as a promising opportunity to make money and begin to buy again. A parallel situation typically develops with the automobiles themselves: Since they are not selling, the company lowers the prices. In all but the worst economic conditions, that encourages people to buy. An upward swing of the economy begins and investors who have bought stock in the automobile company when its price was depressed see the price begin to climb.

Investors also know that every business is not affected equally by a recession. Even in a recession, people still brush their teeth. So the earnings of companies that manufacture toothpaste probably won't suffer as much during a recession as those companies in the automobile and steel sectors. That means that their stock prices aren't likely to drop as far and may even remain strong since they represent one place to make money unless the economy as a whole slips into a deep recession or a depression.

On the other hand, when times get better, people don't brush their teeth any more than they did when times were bad. So unless the toothpaste company can introduce new products or increase the price of the toothpaste significantly, its earnings are not likely to increase in a boom period as rapidly as earnings in more cyclical industries.

Interest Rates

Fluctuations in interest rates usually affect the stock market. That's partly because the level of interest rates affects the appeal of stocks versus bonds. When interest rates are high, bonds are more attractive relative to stocks: when interest rates are low, bonds become less attractive relative to stocks. But it's also because a change in the level of interest rates can affect corporate profits.

Higher interest rates often mean lower profits. If interest rates rise, companies have to pay more to borrow the money they need to grow. Eventually that translates into higher prices for their goods and services and, often, slower sales, especially if customers are buying on credit and have to pay higher interest rates themselves to borrow. Potential customers may decide they can't afford to buy.

The eventual decline in corporate sales and earnings is something investors anticipate as soon as interest rates go up. The result is that stock prices may go down even before the effects of the increased interest rates are actually felt on the company's bottom line.

The reverse happens when interest rates fall. Company borrowing costs are lower, so their profits on the same level of sales will be higher. And customers who buy on credit are more comfortable buying if they are paying lower rates, so they buy more. That increases sales and ultimately means higher corporate profits. Higher profits typically result in higher stock prices.

In this situation as well, investors are typically ready to pay higher prices for stocks as soon as interest rates drop in anticipation of the cycle of increased profits.

Bond Overview

Bonds are financial obligations of corporations, governments, or government agencies. The issuer usually pays periodic interest to the bondholder and is obligated to repay the value of the bond at a specified time (known as the maturity date).

Short-term bonds normally have maturities of less than one year. Intermediate-term bonds normally mature in two to ten years. Long-term bonds normally run more than 10 years.

Bonds are generally described as less risky investments than stocks, since, if you buy a bond when it is issued and hold it until it matures, you normally get regular income and your investment capital back. The risk you take—in addition to the possibility that rising inflation will undercut the buying power of the interest income you earn—is that the issuer may not be able to meet its obligation to pay the interest and repay the loan. This is known as credit risk.

However, since bonds are rated by independent rating companies, you can buy highly rated bonds that pose virtually no danger of default.

But bonds constantly fluctuate in value, so that if you need to liquidate your bond investment during its term, you might have to sell for less than you paid. That is known as market risk.

Bonds are generally considered a smart way to diversify an investment portfolio, since in most years they perform differently from stocks and in some periods when stocks are depressed, bonds can provide a positive return.

Bond Prices

There are two primary reasons why bond prices fluctuate, and why you might not get back the full amount of the principal you paid to buy a bond if you have to sell before the bond matures.

The first reason is that people change their expectations about the ability of the bond's issuer—the company, government or agency that borrowed the money—to meet its obligations to pay interest and/or repay the principal. The more worried they are, the less willing they will be to pay for the bond. The increased risk investors take when they buy low-rated bonds also explains why these bonds typically pay a higher rate of interest than bonds that are highly rated.

The second reason is changing interest rates. If interest rates go up, the price of existing bonds, including the ones you hold, goes down. But if interest rates go down, the price of existing bonds will go up.

Some examples of bond fluctuations:

Suppose you spent $1,000 for a bond paying 5.75% interest, or $57.50 a year. That interest is fixed for the term of the loan.

If the interest rates go up to 6%, investors won't be interested in bonds on which they'll earn less than 6%. But they will be willing to pay less than the face value, or the $1,000 you spent for the bond you own. Specifically, they'll pay enough less—in this case $958.33—so that the $57.50 they receive as interest equals the going rate of 6%.

To find the current price of a bond with a fixed interest payment, use the following formula:

Bond Price X Fixed Interest Rate = Annual Interest

In our example: $1,000 X 5.75% = $57.50

Now, if interest rates rise to 6%, the value of the bond which pays annual interest of $57.50 is:

Bond Price X 6.00% = $57.50

Bond Price = $57.50/0.06 = $958.33

If on the other hand, rates fall, let's say, to 5%, the following will happen

Bond Price X 5.00% = $57.50

Bond Price = $57.50/0.05 = $1,150.00

Yield

Whatever price investors pay for a bond—its face value at the time it is issued, a discounted price when interest rates on new bond increase, or a premium price when interest rates drop—the amount that's repaid at maturity is the face value, typically $1,000.

For example, whether you pay $958, $1,000 or $1,150 in the bond market, you will get back $1,000 if you own the bond when it comes due. You have to take that situation into account if you are considering buying bonds after they are issued. Specifically what you want to know is the bond's "Yield to Maturity," which factors in the amount of time left in the bond's term as a way to evaluate what you will earn on your investment.

"Yield to Maturity" measures the annual rate of return an investor will receive from both the interest to be paid and any appreciation or depreciation expected when the bond matures (is paid off).

Those figures are available from your investment advisor and, for certain bonds, available from financial news sources.