Investments: An overview

Key topic

In this lesson we give students an overview of investments.  Students will get information on basic concepts and definitions, as well as the different types of investments that exist. Moreover, we will examine risk, what it means and how it affects investment decisions and choices.

Learning objectives

• Appreciate the motives behind investing
• Understand the basics of investments
• Understand the different types of investments
• Discover the risks associated with investments

Why people invest

All of us need to be educated on the basics of investing. Such knowledge will help us create successful investment strategies and plans, through which we may generate enough income to support the lifestyle we envision and attain financial freedom. Knowledge forms the foundation of any successful investment strategy. Knowledge can give people the tools to invest wisely and make their money work for them!

The reason many people invest is to achieve financial freedom. The term “financial freedom” means something different to each person. Many define it as being able to have the lifestyle they want and knowing they can afford it financially without worrying about paying bills and making ends meet. Financial freedom means you’ll be able to retire comfortably and spend time doing things you want to do. To move towards attaining this goal it’s important to start getting your money grow instead of having to work for every penny.

In addition to having your money work for you, there is more to be gained through investing:

• You can protect your money against the possibility of negative interest rates which can decrease instead of increase the balance of your precious saving accounts. If you save a lot of money in the bank and interest rates are close to zero or negative, then you’ll essentially be losing money instead of gaining, especially in the face of a high inflation rate. Investing successfully on the other hand, will gain you more money.
• Investing helps you keep pace with inflation, by growing your money fast enough to at least keep up with rising prices caused by inflation.
• If you decide to invest money in a new or current business, you support the creation of new jobs and new products. Except from enjoying the process of creating and establishing a new business, you can get a strong return on your investment.
• Investing may help you reduce your taxable income. There are certain investments such as retirement funds which are exempt from taxation.

Whatever goals you may have set in your financial freedom plan, whether travelling the world or retiring on a yacht in the Greek Islands, investing is the key to getting you where you want to be.

Basic investment definitions and concepts

Investing is buying assets that you believe will go up in value and/or produce income. Assets do not always increase in value, so every time you invest, you risk losing some or all of your money. Before stepping into the world of investments there are some basic definitions that will help you better understand how investments work.

Risk capital refers to money that you can afford to lose without putting you in dangerous financial circumstances. It is strongly advised that you only invest money you can afford to lose.

There are three types of income. Active income is earned through work, while Passive income is earned without your work effort, like income from renting out properties or from interest on your savings. Portfolio income represents the returns from investing in the financial market.

Prices change according to the law of Supply and Demand. Demand reflects how much quantity of a product or service is desired by buyers at a certain price. Supply is how much quantity of a certain good producers are willing to supply at a certain price. The more people demand a product, the more the supply price of that product goes up. When fewer people demand that product, prices go down.

Return on investment (ROI) is a performance measure that helps investors compare the return offered by one investment to returns on other investments and is expressed as a percentage or ratio.  It measures the gain or loss generated on an investment, relative to the amount of money invested. The basic formula is: Return of Investment= Return/ Investment. For example if you have invested $10,000 on a stock and you have received $300 in dividends during the year, then your return on investment is 3% ($300/$10,000).

Interest rate is the amount charged by a lender to a borrower for the use of assets, expressed as a percentage on the principal. Interest rates are typically charged/credited on an annual basis, known as the annual percentage rate (APR). Anyone can lend money and charge interest, but it’s usually banks that do that. They use the deposits from savings or checking accounts to fund loans and they pay interest rates to encourage people to make deposits.

Banks charge borrowers a little higher interest rate than they pay depositors so they can profit. At the same time, banks compete with each other for both depositors and borrowers. The resulting competition keeps interest rates from all banks within a narrow range of each other.

Compounding interest is the process by which the value of an investment increases exponentially because it earns interest both on the principal and on the prior interest payments. The beauty of compounding interest is that you make money both on the money you deposit and on the interest your investments pay you. Using this principle if you invested just $100 a month when you were 18 years old you could become a millionaire by retirement age.

The Rule of 72 says that if you divide 72 by the non-decimal interest rate (10, not 0.1) you are receiving from an investment, the answer tells you how many years it will take for that money to double. This principle helps illustrate that the earlier you start saving for retirement, the better the chances that your money will double. If for example you have $10,000 in savings which are earning a 10% interest rate, your money will double in 7.2 years. (72 /10 = 7.2)

Risk

Risk is the chance that an investment you make will lose money. There are ways you can manage risk, but a certain amount of risk will remain present in every financial decision you make.  There are different kinds of investment risks. Common investment risks include:

Inflation risk – The value of an asset or income may decrease due to the reduced value of the currency. A rise in inflation translates into increasing prices. The purchasing power of the investment return declines.

Liquidity risk – This risk is commonly associated with real estate and refers to the inability to convert an asset to cash. With stocks that have a high trading volume, typically your liquidity risk is low except for when there is a significant market correction. For example, an Apple stock is much more liquid than a piece of land because you can turn it into cash much faster.

Interest rate risk – When interest rates rise, the value of a fixed-rate investment will decline in value.

Business risk – The potential for a company in which you have invested (in a stock or bond) to go out of business, become bankrupt, or be unable to pay back their bond obligations.

Opportunity risk (cost) – When you are presented with a better investment option than the one to which you have committed your money, it is called opportunity risk. Because your money is already tied up in a project, you cannot act on the new opportunity and you potentially lose profits.

Credit risk – Credit risk is a specific risk for bondholders where the bond issuer cannot make interest or principal payments.

Market risk or Systematic Risk – The uncertainty and movement of financial markets is called market risk. This type of risk affects all securities in the same asset class in a similar manner. Changes in interest rates, tax base, and other factors all affect your potential return on investment. Some events that can increase your market risk include: natural disasters like the recent COVID-19 pandemic, major policy changes, and events that can impact the overall market.

Idiosyncratic risk – The risk that an individual investment holds by itself (e.g. the risk of holding a single stock of a company). This type of risk can be eliminated by diversifying your investments. The more diversified your investments are, the closer the idiosyncratic risk goes to zero.

Reinvestment risk – This risk mainly applies to those bondholders whose bonds are coming due and who are seeking a bond investment with equal or greater interest and with the same amount of risk. If they are unsuccessful, their income can be reduced or they may have to invest in riskier bonds.

Political risk – Government action that might change the value of the investment is a risk that must be considered. For example, certain countries in the world have unstable regimes that change constantly through violence and coups. The political risk there is much higher than it is in stable regimes such as the US and the UK. For example, if you have invested in real estate in a politically unstable country, you run the risk to lose on your investment.

Before you start investing it is critical to understand the relationship between risk and return. There are different types of investments, each associated with a level of risk and return. Risk is the chance that the return from an investment will be different than the one expected. Low risk is usually associated with low potential returns while high risk is associated with high potential returns. You can choose the level of risk you feel comfortable taking in exchange for a chance at higher returns.

Risk and return have a correlative relationship, or at least they should if you are getting a good deal. If you are investing in something that carries a low level of risk, then you probably cannot expect to earn very high returns.  The opposite is true of high-risk ventures. In that case you would expect higher returns in exchange for risking your money.

For instance, if you invest your money in a brand-new company that has no proven track record, that investment is high-risk. The company could easily go out of business, and you would lose everything. On the other hand, it could be highly successful, in which case you would make a lot of money.

There are a lot of different investments out there, so when presented with different investment opportunities you should make a list of possibilities and evaluate the advantages and disadvantages of each one. Weed out any investments with overwhelming “cons,” and zero in on the best investments for your budget and goals.

Types of investments

When you start investing as part of your financial freedom plan, you may need to educate yourself on the different investment options available. To be able to choose amongst different investments you need to have some knowledge about the different investment categories and their characteristics. The most common types of investments are grouped into several general categories: ownership, lending and cash equivalents and we set below some basic information on all three groups of investments.

Ownership Investments: Ownership investments are considered the most volatile and profitable class of investment. When you purchase an ownership investment or equity as it is alternatively called, you own an asset or part of it. You expect the value of this asset to increase, thus giving you a return on your investment. The value of the asset is determined by fluctuations of its relevant market. Some examples of ownership investments are:

Stocks: When you own stock in a company, you partially own the company and have a right to a portion of the company’s value and profits. For example, if you own 10,000 shares of a company that has 1,000,000 outstanding shares, you would own 1% of that company.  You can profit by how the market values the asset you own. If the company has a big profit, investors will want to own its shares, driving up demand for them and thus increasing their price. You can profit by selling your shares at a higher price than the price you bought them or by receiving dividends on the shares included in your investment portfolio. Dividends are income distributions by a company to its stockholders.

Business: Putting money in a new or running business, is an ownership investment with high potential returns. People such as Bill Gates of Microsoft and Elon Musk of Tesla have made huge personal fortunes by creating products and services and selling them to the market through their own businesses.

Real Estate: Buildings that you buy to rent out or repair and resell are considered ownership investments.  The financial crisis following the housing market crash is a good illustration of the risks associated with investing in real estate. The house you purchase to live in, is not considered an investment, as it is not purchased with an expectation of profit.

Precious objects and collectibles: Precious metals and stones, art and collectibles, if bought with the intention to resell for profit, can all be considered ownership investments. There are risks associated with owing these investments since if you don’t take good care of them, they might be damaged and depreciate in value.

Funds: Mutual funds, index funds, and ETFs can help investors diversify their portfolios.

• Mutual funds are funds operated and actively managed by an investment company. The money is pooled together from various shareholders and then invested in different stocks, bonds, options, commodities, or money market securities. Mutual fund managers buy and sell stock on a regular basis and try to deliver returns that beat the overall market performance.
• An index fund is a type of mutual fund whose portfolio is designed to track the components of a market index and can give investors increased diversification, broad market exposure, and low operating expense. Examples of indeces that index funds mimic are: the S&P 500, the NASDAQ 100, the Wilshire 5000, and the Dow Jones. Index funds are not actively managed; they just mimic a particular market index.
• An ETF (exchange traded fund) is a security that tracks a basket of assets like a commodity, sector, index, or other area. It acts similarly to an index fund, but trades like a stock. Examples include S&P 500 ETFs — called “spiders” — and Wilshire 5000 ETFs — called “vipers”.

Lending Investments: Lending investments usually bear a lower risk than ownership investments and have lower returns as a result. If you choose to invest in a bond issued by a company, you will receive a set amount over a certain period, while if you choose to invest  in a stock of the same company, you might get double or triple the money or lose all of it if it goes bankrupt. In case of bankruptcy, bondholders usually still get their money and the stockholder often gets nothing.

Your savings account: The money you deposit in your savings accounts are essentially being lent to the bank, which loans it out to other people. The low return you get is associated with the minimum risk you have since deposits are protected up to a certain amount by authorities such as the FDIC in the USA.

Bonds: Bonds are basically debt obligations, a form of borrowing money. The issuer of the bonds receives money which has to repay over time, including periodic interest that has to be paid to the lender. The risks and returns will depend on the financial status of the issuer of the bond and type of bond, but overall, lending investments are considered lower risk and have a lower return than ownership investments.

Cash Equivalents: Cash equivalents are investments that can be readily converted into cash and are characterized as low-risk, low-return investments. There are different types of cash equivalents: Treasury bills, commercial paper, marketable securities, money market funds and short-term government bonds.

The Stock Market: The stock market is a market for trading the stock of companies and other financial securities and offers investors the opportunity to reap rewards, but there is also a risk. Although any investment carries risks, education, experience, and a trusted team can help you achieve successful returns on your investments.

The stocks of public companies are listed and traded on stock exchanges. The stocks of companies in the United States are listed on several different exchanges; for example, the New York Stock Exchange (NYSE), NASDAQ, AMEX, etc.

Let’s watch a 3-minute video which features four different types of investing markets.

Four types of investing markets

Action steps – Exercise 1 (12 minutes)

Let’s see what you took away from today’s class. Please respond to the following statements with a True or False (T/F):

1. By investing, you can protect your money against the possibility of high interest rates ___
2. It is advised that you only invest money that you can afford to lose ___
3. Prices are determined according to the law of supply and demand  ___
4. Compounding interest is the process by which the value of an investment increases exponentially because it earns interest both on the principal and on the prior interest payments ___
5. Liquidity risk depends upon the stability and actions of a country’s government ___
6. An example of a high-risk investment is investing your money in Google ___
7. An example of high-risk investment is investing in your money in a startup with no proven track record ___
8. Rises in inflation levels are not so good when you have a lot of savings in the bank ___
9. You should always invest in the stock market ___
10. Funds (such as mutual funds, index funds, and EFTs) can help investors diversify their portfolios ___

Answer sheet

Lesson wrap-up

Today we discussed investments. Investing is all about making your money work for you. We explained why people invest and the basic investment definitions and concepts surrounding investments. Moreover, we discussed the role of risk and how you should incorporate risk into the decision-making process. Finally, we looked at different types of investments out there, such as real estate, stocks, and bonds.

At this point we will wrap up today’s lesson. First, we will go over the learning objectives of this lesson and we want your feedback as to whether they have been achieved and then we will address any questions you may have. Please feel free to ask anything you’d like in relation to today’s lesson and we would love to hear how the concepts we discussed today relate to you and your life!

LESSON DETAILS

Lesson Duration: 45 minutes

Lesson Breakdown
Lecture: 25 minutes (Word count –3.100)
Activities: 12 minutes
Videos: 3 minutes
Wrap-up: 5 minutes