5a: Investing Basics
the basics of returns on investments
Investing may sound like a daunting task. First,
most Americans live day-to-day and do not have extra money to invest. Second,
there are so many options it can be difficult to choose. In
recent years the ability to invest in mutual funds and exchange traded
(ETFs) has made investing a lot easier. This section will focus
on how investing works, not where to invest.
As we learned in the retirement section, everyone will
need to save for their retirement. So it is important to learn
the basics of investing. The basics of investing center
1) Risk vs. reward
- Risk is a measure of the volatility of an investment, the fluctuations
in price and rate of return.
- For example, stocks are more volatile than bonds and thus have a
- The more risk you take on your investment, the higher the potential
rewards should be.
- Investments with guaranteed high returns at low or minimal risk
should be reviewed carefully, because they are probably too good
to be true.
An investment that is too good to be true is not
as good as it sounds. A
return is calculated based on (1) the price you buy-in at,
(2) the future price you sell at, and (3) the investment returns
you receive in the mean time. In
an efficient market where all known information is reflected
in the price of the investment, an investment that
to have a better than expected return (compared to risk)
will draw many investors and thus the buy-in price will increase. The
increased buy-in price will lower the future return, because
the anticipated future
sale price does not change. Thus, in an efficient market,
the risk vs. return should correlate and not leave an
opportunity for a big return with little risk.
In an inefficient market, there may be an investment that provides
a larger return for a smaller risk. However, these markets
are few and far with
investors quickly finding investments that are too good to be true
and running up the price until expected future returns return back
to normal. Note, for an inefficient market to exist, there
needs to be some element that hinders the buy-sell process, such
- Entry barrier where only select few can join either due
to price or needing to be voted in like the NBA, NFL or MLB
buyers or sellers (e.g., someone sells out of desperation
for a buyer)
- High transaction costs which deter people from buying the
2) Investment horizon
- The longer your investment horizon is, the larger the returns
- For bonds and CDs, longer duration bonds typically have higher returns
(with some exceptions in times of high inflation).
- For money market funds and checking/savings accounts, the returns
are typically less than inflation since you can pull the money out
little to no investment horizon).
3) Building blocks of investment return
- Based on the time and risk premiums above, the expected rate of return
on an investment is
expected return = expected inflation + time horizon premium +
- The longer the investment duration and the higher the risk, the higher
the expected return should be.
- You can reduce risk by investing in several different assets.
- If invested in equities, you will want to invest in 12 or more stocks
a broad based mutual fund or ETF. However, be careful of investing
just one specific
similar stocks like energy stocks tend to move in the same
direction and thus have less diversification of risk compared to a
similar number of unrelated stocks.
- You should have different types of investments (bonds,
stocks - foreign and domestic, real estate, etc.)
- Be cautious if your only investment
is your house.
In today's society we have been bidding up the price of houses
because of our desire to have the newest, biggest, and
best house on the block. Advisors
have suggested that buying a house is a great investment. Some
people invest all they have in their house and plan on this
this is only one investment, it has a big risk that can be
such risk is if there is damage due to an earthquake, mudslide,
flood, or termite damage, most basic insurance
policies would not
cover the loss. What happens to your investment then?
Is an investment too good to be true?
In the 1990's, the investment was internet stocks. Today,
the investment is real estate. I get worried when I hear that real
estate will provide larger returns at lower risk than the stock market. If
this is true, why don't we hear stories about Warren Buffet or Bill Gates
investing in real estate? This is what the savvy investor would do;
invest in products with high returns with low risk. Do I hope real
estate prices keep on going up? Yes, but I am also cautious because
there are risks that individual speculators are not considering, such as:
Reasons why real estate is a good investment
Reasons why real estate is a questionable investment
|Tangible good that people need
||Can be destroyed by earthquakes, termites or decay which are
not covered by insurance
|Limited land supply around cities
||With telecommuting, people can live further away from cities where
land is cheaper
|Recent history of high returns
||Same phrase was used by stock brokers in the 1990's about internet
|Good to diversify between stock, bonds and real estate
||Not good if real estate makes up a majority of net worth and prices
|Can invest only 10% to 20% of the home price to leverage your return
(a 20% increase on $100,000 home with $20,000 down payment results
||You can do the same thing with stock, but most advisors will suggest
against taking such a risk, because a 20% decline in stock or home
value will wipe out your investment.
|Can flip property for profit with a small amount of fixing up
||You will need to pay high financing fees (closing costs) and real
estate commissions that will limit the return unless you have friends
in the business who can give you a deal.
Real estate may be a good investment, as a part of a much larger investment
plan. However, to believe that we will see double digit growth in real
estate prices with no risk of a market correction may be too good to be
true. If it were true, then in an efficient market, the prices would sky
to a point where
future growth in home prices would be at a more reasonable
question today is, has the price increased to a point which reflects a reasonable
price, an over-inflated price, or are prices still a bargain? If
you are looking at real estate as an investment, you will not want to buy
in if market prices are over-inflated.