Saving and Investing - Personal Investing
Where’s the best place to put my hard-earned savings?
This is a question a lot of people ask themselves – and it’s a good one. We should be careful about where we save and invest our money. Savings is about holding on to a portion of our income so that we can have it for use later on. So we don’t want to expose it to unnecessary risk and possibly lose it. In fact, we would like it to grow over time so that we have even more money for our future needs.
Investing is all about risk and reward – the higher the risk you take, typically the higher the reward (rate of return). So, where is a safe place to invest - to earn a nice rate of return, without risk of losing your initial investment? Many financial advisors will tell you there are 3-4 main categories of investments – cash, bonds, stocks (or equities), and real estate. I will explain each of these, but also add a fifth category – debt reduction. Before we get into the details, let’s make sure we have a high-level understanding of these asset categories.
Personal Investment Categories
CDs or Certificates of Deposit (Cash):
- Commercial Banks and Savings & Loan banks offer investments known as certificates of deposit. They work just like bonds except they don’t have interest rate risks like bonds because you can’t buy or sell them before maturity. In fact, if you want your money back before maturity, you will pay an interest rate penalty. On line banks like Synchrony Bank, Discover Bank, Ally Bank, offer significantly higher interest rates than regular banks (as they have lower costs than banks with physical customer facing buildings).
High Yield Money Markets (Cash):
- Banks also offer what are called high yield money markets. These are like CDs except there is no penalty for early withdrawal. They typically require a substantial initial investment $$2,500-$10,000) and have limited number of transactions per month. In other words, you can’t use them like a regular checking account with numerous checks of debit charges each month. High Yield Money market funds are a good place to store emergency funds or other amounts that you might need in the next few months. Their interest rate varies from day to day as general interest rates rise or fall, but it is usually a lot better than a regular savings or checking account interest rate.
Stocks (also known as equities):
If you own “common” stock, you are literally an owner of the underlying company that issued the stock. You participate in the earnings of the company (EPS or earnings per share). . If the company makes a lot of money, the value of your stock will go up. If the company pays annual dividends, you typically receive dividend payments. You can sell the shares of stock at current market value at any time. You can buy or sell stock certificates through an investment stock broker. Know that there are also some types of stock called preferred stock, that offer higher dividend rates or other preferences such as voting or liquidation rights. More common strategy o buy stocks is to buy them through stock funds – portfolio of stocks with a given purpose such as technology, health care, international stock funds. Almost all investment broker firms offer the ability to buy stock funds that track the S&P 500 (top 500 largest US stocks) index fund. This is a good way to reduce the risk of total loss from buying a single stock of company that then goes bankrupt.
Corporate Bonds:
- Bonds are loans to corporations that issue the bonds. You are not an owner of the company but they owe you money (the price of the bond) and they will pay a stated interest either periodically across the life of the bond (semi-annually, annually) or at the final maturity (end date) of the bond. If the company becomes insolvent and has to file for bankruptcy, you may not get back the full amount of your investment (principal). Bond rating companies specialize in letting you know how stable the underlying company is by issuing a bond rating such as A+, B, etc. In general, Bond prices tend to vary much less than stock prices because unless the company goes bankrupt, they have to pay bond investors the stated interest rate and the original investment (called principal) at the time of maturity. Almost all investment broker firms offer the ability to buy Bond funds that track underlying companies’ bonds. The funds ae typically organized by short term, intermediate term and longer term bond funds, which are based on the maturity dates of the bonds. You should know that the longer the duration of the fund, the more the bond fund is subject to what is known as interest rate risk. Interest rate risk is the risk that the value of the bond (or fund) will go up or down as general interest rates go up or down. For example, if you buy a 10-year maturity $1,000 bond with a 5% stated interest rate (or $50 interest per year), and general interest rates drop to 4%, your bond will go up to $1,250 in value to yield 4% (.04 x $1,250 = $50). Likewise, if interest rates go up, your bond will go down in value – i.e. interest rate risk. In general, the value of the bonds go up or down to yield the current general interest rates. However, if the bond is closer to maturity date such as short term (or even intermediate term) bonds, the value of the bond won’t change as much because the underlying company that issued the bond has to pay you the full original purchase price (principal) at the time of maturity (soon).
US Treasury Bonds:
- Treasury bonds are bonds issued by the US government. They work just like corporate bonds, except that the underlying issuer is the US Government. Treasury bonds are considered to the least risky investment you can make because of the power and size of the US government. So for example, if the current Treasury bonds rate of return is 5%, it would make no sense to buy a corporate bond (that has more risk of failure) at a 4% interest rate when you can buy a lower risk US Treasury at 5%.
Real Estate:
- Real estate is physical property such as a house, townhome, or condo. You can buy a home (see below) or invest in Reals Estate funds through an investment broker. The funds perform much like individual properties except that the risk is spread across multiple properties and geographic areas in an effort to reduce overall risk.
Debt Reduction:
- Ok, let’s talk first about debt reduction as an investment class. Many of us carry credit card balances from month to month. We also may have student loan debt, auto loan payments or even a mortgage on our home. Debt is a convenient way to spread out the payment of high-cost items over a longer period of time so that we don’t have to come up with all the money at once. The thing about most debt, however, is that it comes with a very high price tag – interest payments! Normally, you end up paying a higher interest rate than you could ever earn if you put the same amount of money into an investment on your own. So if you have debt, it usually makes more sense to pay off the debt before investing any available extra cash in other assets. Let’s say for example, you take a $1,000 cash advance on your credit card at 18% interest. At the end of one year, you would owe $180 in interest payments. If you put the money in a Bank High yield money market account, you might earn anywhere from .5 to 4%. Let’s say you got the higher rate of return – 4 %. Now your money in the bank is worth $1,040 after one year (1.04% x 1,000)., but you owe $1,180. So, in fact you lost $140. For the most part it is typically the case that individual investors cannot earn a higher rate of return on an investment than they would be paying on debt interest (unless they invest in a high-risk asset where they may lose all or a significant portion of the initial investment). So, my first piece of advice to any potential investor, is if you have some extra money (above and beyond your emergency fund), pay down debt first – especially high interest date – before investing in CDs, money markets, stocks or any other assets. The other thing about paying down debt is that it is a “risk free” investment. If you buy a stock, bond or property, the price may go up or down afterwards. It has risk. However, when you pay off debt, you know exactly how much the debt will be reduced. There is no price risk as with other assets.
After paying down debt, how should you allocate any remaining money you have? The first thing to think about is how soon you will need the money. The sooner you will need the money, the less risk you will want to assume. So, if you are saving for a down payment on your first home and you would like to purchase a home in the next 5 years, you will want a low risk investment, like CDs, short term bonds or short term US Treasury Notes. On the other hand, if you are saving for retirement 30 years from now, you can invest in asset classes with higher risk (and long term higher return), like stocks and longer term bonds. The higher risk asset classes, such as stocks, may go up or down in any given year, but over the long term will typically earn a higher return than lower risk assets like CDs.
OK, so once you decide when you’ll need the money, how should you invest it. If it’s not needed for a long time, should you invest it all in high risk / high reward investments like stocks? Not necessarily. Most investment professionals will tell it’s a bit safer to invest in a mix of asset classes to counter balance each other when one type of asset declines in value. For example, bonds or real estate may go up in value as stock come down, but not always. In general, it is desirable to diversify your investments across multiple asset classes to reduce risk. For example, allocate your savings to some bonds, some stocks, some real estate. Ok, but how much and which ones to select? Let’s start with some typical scenarios and investment strategies on the following pages:
Written by Francis Daly. Fran is a Life Science Business Technology Executive. He earned a Bachelor of Science degree in Business and Spanish from the State University of New York - Oneonta, and a Master’s of Business Administration in Finance from Fairleigh-Dickinson University. Fran is a Certified Public Accountant and has extensive experience working in the pharmaceutical and life sciences industry over the last 40 years, working for Schering-Plough Pharmaceuticals, Revlon, and Apps Associates.