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Recognizing the three types of investment

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The word “investment” has become muddled with overuse these days. Referring to a stock or a bond as an investment is still in regular use, but now we hear people make “investments” in almost everything. For instance, we hear young professionals “invest” in a good car, homemakers “invest” in high-end appliances and even students “invest” in top-of-the-line laptops and gadgets.

In order to address the challenges of recognizing what an investment is, we will look at the three basic types of investment as well as some of the things that are definitely not investments – no matter how the commercial puts it.

Investment, as the dictionary defines it, is something that is purchased with money that is expected to produce income or profit overtime. As such, investments can be broken into three basic groups: ownership, lending and cash equivalents.

 

Ownership Investments

Ownership investments are what comes to mind for most people when the word “investment” is batted around. They are the most volatile and profitable class of investment. The following are examples of ownership investments:

Stocks: A stock is literally a certificate that says you own a portion of a company. More broadly speaking, all traded securities, from futures to currency swaps, are ownership investments, even though all you may own is a contract. When you buy one of these investments, you have a right to a portion of a company’s value or a right to carry out a certain action (as in a futures contract).

Your expectation of profit is realized (or not) by how the market values the asset you own the rights to. If you own shares in Apple (AAPL) and the company posts a record profit, other investors are going to want Apple shares too. Their demand for shares drives up the price, increasing your profit if you choose to sell the shares.

Business: The money put into starting and running a business is an investment. Entrepreneurship is one of the hardest investments to make because it requires more than just money. Consequently, it is also an ownership investment with extremely large potential returns. By creating a product or service and selling it to people who want it, entrepreneurs can make huge personal fortunes. Bill Gates, founder of Microsoft and one of the world’s richest men, is a prime example.

Real Estate: Houses, apartments or other dwellings that you buy to rent out or repair and resell are investments. However, the house you live in is a different matter because it is filling a basic need. It fills a need for shelter and, although it may appreciate over time, shouldn’t be purchased with an expectation of profit. The mortgage meltdown of 2008 and the underwater mortgages it produced are a good illustration of the dangers in considering your primary residence an investment.

Precious objects and collectibles: Gold, Da Vinci paintings and a signed LeBron James jersey can all be considered an ownership investment – provided that these are objects that are bought with the intention of reselling them for a profit. Precious metals and collectibles are not necessarily a good investment for a number of reasons, but they can be classified as an investment nonetheless. Like a house, they have a risk of physical depreciation (damage) and require upkeep and storage costs that cut into eventual profits.

 

Lending Investments

Lending investments allow you to be the bank. They tend to be lower risk than ownership investments and return less as a result. A bond issued by a company will pay a set amount over a certain period, while during the same period the stock of a company can double or triple in value, paying far more than a bond – or it can lose heavily and go bankrupt, in which case bondholders usually still get their money and the stockholder often gets nothing.

Your savings account: Even if you have nothing but a regular savings account, you can call yourself an investor. You are essentially lending money to the bank, which it will dole out in the form of loans. The return is currently quite low, but the risk is also next to nil because of the Federal Deposit Insurance Corporation (FDIC).

Bonds: Bond is a catch-all category for a wide variety of investments from Treasuries and international debt issues to corporate junk bonds and credit default swaps (CDS). The risks and returns vary widely between the different types of bonds, but overall, lending investments pose a lower risk and provide a lower return than ownership investments.

 

Cash Equivalents

These are investments that are “as good as cash,” which means they’re easy to convert back into cash.

Money market funds: With money market funds, the return is very small, 1% to 2%, and the risks are also small. Although money market funds have “broken the buck” in recent memory, it is rare enough to be considered a black swan event. Money market funds are also more liquid than other investments, meaning you can write checks out of money market accounts just as you would with a checking account.

 

What About Investing in Education?

Education: Your education is often called an investment and many times it does help you earn a higher income. A case could be made for you “selling” your education like a small business service in return for income like an ownership investment.

The reason it’s not technically an investment is a practical one. For the sake of clarity, we need to avoid the absurdity of having everything be classified as an investment. We’d be “investing” every time we bought an item that could potentially make us more productive, such as investing in a stress ball to squeeze or a cup of coffee to wake you up. It is the attempt to stretch the meaning of investment to purchases, rather than education, which has obscured the meaning.

 

But there are many items that are Not Investments!

Consumer Purchases: Beds, cars, mobile phones, TVs – and anything that naturally depreciates with use and time – are not investments. As an example, you don’t invest in a good night’s sleep by buying a foam pillow. Unless you’re very famous, and even then, it’s a stretch, since you can’t reasonably expect someone to pay more for your pillow than the initial purchase cost. Don’t take it personally, but there’s very little demand in the second-hand pillow market.

 

Therefore, there is no fourth category of consumer purchases. Admittedly, it’s a clever piece of advertising that removes some of the guilt from impulse purchasing; you’re not spending money frivolously – you’re investing! The decisive test is whether there is a potential to turn a profit. The important word is “potential” because not every legitimate investment makes money.

Making money through investing requires researching and evaluating different investments, not simply knowing what is and is not an investment. That said, being able to see the difference between an investment and a purchase is an essential first step.

 

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Wealth Advisor

The big question: Invest or pay down dept?

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Many investors face the dilemma of whether to pay down debt with excess cash or to invest that money in an attempt to turn it into even greater amounts of wealth. If you pay off too much debt and reduce your leverage, you may not garner enough assets to retire.

Conversely, if you’re too aggressive, you may end up losing everything. In order to decide whether to pay down debt or invest, you must consider your best investment options, risk tolerance, and cash flow situation.

 

Pay Down Debt or Invest?

All debt is not equal. The type of debt you have can play a role in the decision as to whether to pay it off as soon as possible or put your money toward investments.

From a numbers perspective, your decision should be based on your after-tax cost of borrowing versus your after-tax return on investing. Suppose, for instance, that you are a wage earner in the 35% tax bracket and have a conventional 30-year mortgage with a 6% interest rate. Because you can deduct mortgage interest (within limits) from your federal taxes, your true after-tax cost of debt may be closer to 4%.

Student loans are a tax-deductible debt that can actually save you money. The IRS allows you to deduct the lesser of GHc 2,500 or the amount you paid in interest on qualified student loans that were used for higher education expenses, although it phases out at higher income levels.

If you hold a diversified portfolio of investments that includes both equities and fixed income, you may find that your after-tax return on money invested is higher than your after-tax cost of debt. For example, if your mortgage is at a lower interest rate and you are invested in riskier securities, such as small-cap value stocks, investing would be the better option. If you’re an entrepreneur, you also might invest in your business rather than reduce debt. On the other hand, if you are nearing retirement and your investment profile is more conservative, the reverse may be true.

 

What Is Your Risk Tolerance?

Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand.

When determining risk, the following must be considered:

  • Your age
  • Income
  • Earning power
  • Time horizon
  • Tax situation
  • Any other criteria that are unique to you

For example, if you’re young and able to make back any money you might lose and have a high disposable income in relation to your lifestyle, you may have a higher risk tolerance and be able to afford to invest more aggressively versus paying down debt. If you have pressing concerns, such as high health care costs, you may also opt not to pay down debt.

Rather than investing excess cash in equities or other higher-risk assets, however, you may choose to keep greater allocations in cash and fixed-income investments. The longer the time horizon you have until you stop working, the greater potential payoff you could enjoy by investing rather than reducing debt, because equities historically return 10% or more, pretax, over time.

A second component of risk tolerance is your willingness to assume risk. Where you fall on this spectrum will help determine what you should do. If you are an aggressive investor, you will probably want to invest your excess cash rather than pay down debt. If you are fairly risk-averse in the sense that you cannot stand the thought of potentially losing money through investing and abhor any kind of debt, you may be better off using excess cash flow to pay down your debts.

However, this strategy can backfire. For instance, while most investors think paying down debt is the most conservative option to take, paying down – but not eliminating – debt can actually produce results that are the opposite of what was intended.

For example, an investor who aggressively pays down his mortgage and winds up with meager cash reserves may regret his decision should he lose his job and still need to make regular mortgage payments.

 

Building a Cash Cushion and Managing Debt 

Financial advisors suggest that working individuals have at least six months’ worth of monthly expenses in cash and a monthly debt-to-income ratio of no more than 25% to 33% of pretax income. Before you begin investing or reducing debt, you may want to build this cash cushion first, so that you can weather any rough events that occur in your life.

Next, pay off any credit card debt you may have accumulated. This debt usually carries an interest rate that is higher than what most investments will earn before taxes. Paying down your debt saves you on the amount that you pay in interest. Therefore, if your debt-to-income ratio is too high, focus on paying down debt before you invest. If you have built a cash cushion and have a reasonable debt-to-income ratio, you can comfortably invest.

Keep in mind that some debt, such as your mortgage, is not bad. If you have a good credit score, your after-tax return on investments will probably be higher than your after-tax cost of debt on your mortgage. Also, because of the tax advantages to retirement investing, and given the fact that many employers partially match employee contributions to qualified retirement plans, it makes sense to invest versus paying down other types of debt, such as car loans.

If you are self-employed, having cash on hand may mean the difference between keeping the doors open and having to go back to work for someone else. For example, suppose that an entrepreneur with a fairly tight cash flow gets an unexpected windfall of GHc 10, 000 and he or she has GHc 10, 000 in debt. One obligation carries a balance of GHc 3, 000 at a 7% rate, and the other is GHc 7,000 at an 8% rate.

While both debts could be paid off, he or she has decided to pay off only one, in order to conserve cash. The GHc 3, 000 note has a GHc 99 monthly payment, while the GHc 7, 000 note has a GHc 67 monthly payment. Conventional wisdom would say he or she should pay off the GHc 7, 000 note first because of the higher interest rate.

In this case, however, it may make sense to pay off the one that provides the greatest cash flow yield. In other words, paying the GHc 3, 000 note off instantly adds nearly GHc 100 a month to his or her cash flow, or almost 40% cash flow yield (GHc 99.00 x 12 / GHc 3, 000). The remaining GHc 7, 000 can be used to grow the business or as a cushion for business emergencies.

 

Balanced Budgeting Methods

There are a number of different budgeting methods that account for both debt repayment and investments. For instance, the 50/30/20 budget sets aside 20% of your income for savings and any debt payments above the minimum. This plan also allocates 50% to essential costs (housing, food, utilities), and the other 30% for personal expenses.

Oprah’s Debt Diet allots 15% of income to debt repayment and 10% of income to savings.

One Financial expert offers a back-and-forth approach to tackling debt and investments. He suggests saving GHc 1,000 in an emergency fund before working to get out of debt, excluding your home mortgage, as quickly as possible. Once all debt is eliminated, he advises going back to building an emergency fund that contains enough funds to cover at least three to six months of expenses. Next, his plan calls for investing 15% of all household income into investments and pre-tax retirement plans while also saving for your child’s college education, if applicable.

 

In all, knowing whether to pay down debt or invest depends not only on your economic environment but also on your financial situation. The trick is to set reasonable financial goals, keep your perspective, and evaluate your investment options, risk tolerance, and cash flow.

Take a look at your personal finances to determine where your money will make the most impact. If the hard math doesn’t help you to decide between one and the other, try tackling both at the same time, or else put your focus on the financial goal that will give you the most peace of mind.

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