Investing Basics Review Questions
1.Why is it unwise to use savings vehicles for investment goals or investment vehicles for savings dollars?
Savings vehicles offer the benefits of safety of principal and liquidity, which are offset by generally low yields that are significantly reduced by inflation. In other words, dollars in savings vehicles tend to lose their purchasing power, and therefore the use of the funds is generally limited to a time frame of three years or less. Although safety of principal is an important consideration for investment dollars, or dollars “saved” for long-term goals, the other characteristics of savings vehicles are not important. Liquidity is generally not an important concern, given the longer time horizon, and lower rates of return that are significantly affected by inflation would not enable you to reach your investment goals.
In contrast, investment vehicles are characterized by greater risk of principal, but risk that should be offset by higher yields from income, appreciation, or both. Remember: the higher the risk, the higher the return, and the longer the time horizon, the greater the risk exposure you can afford. Risk is often equated with volatility, or unstable account values, another characteristic of some investment vehicles. Because of these characteristics, investment vehicles are not a good choice for savings dollars, or dollars that will be needed in a 3 to 5 year time frame.
2.Why is it important to consider both current income and total return when choosing an investment to match a financial goal?
Total return includes both current income and capital gains or losses (reflective of changes in price between purchase and sale). Note that these factors may also be associated with risk. For example, an aggressive growth stock or mutual fund would be expected to experience price appreciation, but return little or no current income.
The tax consequences of current income and capital gains (or losses) must also be considered, unless the investment earnings are tax deferred. For a taxable investment, annual current income earnings are fully taxable, whereas price appreciation in an investment has no tax consequence until the year the investment is sold. In other words, payment of any taxes due on the gain could be postponed for many years until the investment is sold. In the year of the sale, the capital gain is taxable. The marginal tax rate applied to current income and capital gains earnings may also be different contingent on the length of ownership of the investment. (For more information on this concept see Unit 7.) Consequently, both current income and total return must be considered when matching an investment choice with a particular goal such as retirement (tax deferred) or a down payment on a second home (taxable).
Aside from the tax consequences, it is also important to consider how the characteristics of the investment match the goal. If the goal is to supplement living expenses, an elderly investor might choose investments that are less risky and provide a steady income stream of dividends or interest. For the young adult saving for retirement, the risk of more aggressive investments that fluctuate in value may offer the greater return and better match the long-term need for accumulating a nest egg.
3.Why is it important to consider rate of return and real rate of return when choosing an investment to match a financial goal?
Real rate of return is the inflation-adjusted rate of return for an investment. In reality, this rate is further reduced by transaction costs and income taxes, if applicable. Treasury bills, for example, have an historical real rate of return of slightly over 2%. This could be a good intermediate investment vehicle for holding anticipated annual retirement expenses needed five years in the future. Transaction costs are minimal, and there is safety and stability of principal, important considerations for funded needed in the near future. To the contrary, Treasury bills would not be recommended as a primary retirement vehicle for younger individuals. A real rate of return of slightly over 2% is significantly less than the historical real rate of return of slightly over 9% for small company stocks. It is important to consider the anticipated rate of return and real rate of return, as well as other associated characteristics of an investment, when choosing different investment vehicles to best meet your goals.
4.Why is it important to consider the risk/rate-of-return relationship when choosing an investment to match a financial goal?
As shown in Figure 2, risk increases as you move up the investment pyramid. Because risk and return are typically correlated, you should be rewarded with more compensation for taking on more risk. However, you cannot ignore the fact that, with greater risk, (read: a higher return) comes a greater chance of loss, perhaps because the initial principal declined in value. Increasing risk also increases the possibility that the actual return will be less than the expected return.
Risk and return also have to be considered closely with an investor’s time horizon. In other words, the longer the time horizon or time until the funds are needed, the more risk you can take and the more time you have to recoup losses associated with market downturns. Conversely, the shorter the time horizon, the less risk exposure you can afford. You also have a shorter window of time to recuperate from market downturns, or in the worst case, you may need the money during the market downturn, and be forced to sell at a loss. All of these issues should be considered when matching investment vehicles to different investment goals. Although related to the issue of diversification, it also becomes apparent that one investment truly does not fit all goals.
5.Well-planned diversification of an investment portfolio can reduce much of the total risk associated with investing. Name three approaches to diversification.
The term diversification is most often used in the context of choosing securities from a variety of asset classes, such as stocks, bonds, cash and real estate. However, it is also important to diversify within the class of assets on the basis of company size, geographic region, or sector of the economy, for example when considering common stocks or stock mutual funds. When investing in fixed income investments, or bonds, it is also important to consider characteristics of the issuing company as well as buying bonds with a range of maturity dates.
6.Why does diversification have the potential to both increase and decrease returns?
By spreading investment dollars over a number of different investments, your return represents an average of the entire group. Mathematically, this average will be lower than the rate of return on the best performer and higher than the rate of return on the worst performer. Had you invested all of your money in the best investment paying the highest return, you would have earned more. But consistently picking the investment with the best performance is a difficult, if not impossible, task. The investment yielding the highest return this year could yield the lowest return another year. By diversifying investment dollars you reduce risk by owning a broader spectrum of the investment market.
7.How do you implement a dollar-cost averaging investment strategy? What are the benefits of such an approach?
Dollar-cost averaging requires you to invest the same amount of money at regular time intervals (bi-weekly, monthly, quarterly, etc.) regardless of the price of the securities purchased. The strategy reduces the average share cost, as more shares are acquired when prices are down and fewer shares are acquired when prices are higher. Benefits of dollar-cost averaging include:
8.Based on the principles of time-value of money, what advice would you give a young person who asserts s/he cannot afford to invest today, but prefers to wait until later when earnings increase?
Young people need to clearly understand the message, “Time is on your side; you can’t afford NOT to invest.” By starting early, and using the benefits of compounding, a young person has a much longer time for his/her money “to grow more money.” This means he or she can save smaller amounts and easily reach the investment goal. In contrast, reducing the time period to save for a goal, even with the effects of compounding, means that larger amounts must be saved. To make your investment goals more manageable, and to maximize the benefits of the time value of money, it pays to start early, as demonstrated in Figure 4.
9.Relate the asset allocation models shown in Figure 4 to the Compound Annual Rate of Return and the Pyramid of Investment Risk, shown in Figures 1 and 2, respectively. Assuming any truth to the proposition, “the higher the risk, the higher the return,” which asset allocation model would be expected to have the highest return?
The aggressive asset allocation model would be expected to have the highest rate of return, given the historical averages shown in Figure 1. Approximately 75% of the assets are allocated to stocks, with the remaining 25% divided between bonds and cash. Historically, stocks have returned 10% or more and represent the range of medium risk investments, as shown in Figure 2. Government bonds and money market mutual funds, likely vehicles for the bonds and cash, fall in the low risk range and would likely earn around 5%. Earnings, and risk, are higher should corporate bonds be used in place of, or in addition to, government bonds.
10.When considering the four factors that influence your choice of asset allocation, why might it be unwise to use a money market mutual fund as the primary investment vehicle for accumulating retirement funds?
First, it is important to note that using any single investment vehicle is not asset allocation. By definition, asset allocation refers to the diversification of investment capital among different types of assets, or investment vehicles. That fact acknowledged, the question is still worthy of consideration.
For an investment goal of retirement, you know the approximate number of years until the funds are needed and you can estimate the amount needed. (For help with this step, complete the Ballpark E$timate at www.asec.org/.) Because of the long-term nature, or time horizon of the goal, liquidity is not a concern. Assuming that tax-deferred vehicles are used for accumulating retirement funds, there will be no income taxes due on these investments for the current income tax year. In fact, investing for retirement in tax-deferred vehicles can improve your tax situation for the current year. (For an explanation of this concept, see Unit 7.) The fourth consideration when choosing an asset allocation model is risk tolerance. An individual might initially choose a money market mutual fund as a retirement investment vehicle because of the recognized safety and stability of principal, and the relatively consistent rate of return.
However, you cannot ignore the fact that taking on too little risk can also be problematic. Historically, returns on money market mutual funds have been significantly reduced by inflation. In other words, dollars invested in this vehicle tend to more quickly lose their purchasing power,than, say, dollars invested in stocks that have a much higher real rate of return. This question illustrates the need to balance all four factors when choosing an asset allocation model, and to strive for an average rate of return that will allow you to accomplish your investment goal. Choose an asset allocation model that matches your risk tolerance.
11.Investment earnings may be taxable, tax-deferred, or tax exempt. How does this status affect the choice of investment strategies and the applicable financial goal(s)?
Tax exempt and tax-deferred investments offer the best deal because they avoid income taxation, but cannot be used to fund all investment goals. Aside from municipal bonds, which are tax exempt at the federal and perhaps state level, tax exempt or tax-deferred status is typically limited to investments for funding retirement or education. Restrictions on the amounts also may apply. Under certain circumstances these funds can be used for other purposes, but are then likely to incur taxes. The exception would be the Roth IRA, which will be discussed more in Unit 7. Other investment goals are limited to taxable accounts, but remember that earnings and capital gains (or losses) are taxed differently. In summary, remember these two rules of thumb:
12.It is important to understand your own investment preferences. However, it is also important that the preferences shown in Figure 5 are considered when matching investment products with financial goals. Use the principles introduced in this unit to explain this relationship.
Adequately diversifying your investments in line with your asset allocation model may require you to trade-off some preferences for realistic alternatives. For example, choosing to use only low risk, conservative stock, bond and cash investments may mean that (1) you will never be able to realistically earn enough to meet your goal and thus must scale it back or (2) you must invest significantly more because of the lower return associated with these investment choices. Conversely, a preference for aggressive investments with capital growth that allow you to avoid income taxes may be equally unrealistic as an avenue for meeting a moderate-term investment goal. In other words, the returns may not outweigh the failure to start investing early.