Investment and Savings 101
Historically there have been certain time-honoured principles that can be applied to investing and saving. If you intend to be involved in this arena, it is essential to understand these basics, which are the foundation of all investing and saving.
Concept of Investing
In simple terms, investing occurs when money is used for the goal of making more money. A business invests money in new equipment, for instance, that will assist the business to produce more products faster and/or cheaper. By doing this type of investing, the business profits from its investment. The goal of individual investors is to invest a sum, called “principal” or “capital,” in an investment that will be repaid to the investor plus a profit. That profit is called the “return.”
It is important to understand that there are many investment options available for individual investors. Some investments actually guarantee that the full amount invested will be repaid plus a profit. These investments include Guaranteed Investment Certificates (GICs), and some bonds. Other investments do not guarantee that the amount invested will be repaid. These non-guaranteed investments include stocks, mutual funds, and real estate.
Investment Basics
Let us explore the basics of investment, so that you have a good understanding of how investing works, how returns are generated for investors, and how investors manage risk.
Compounding (Compound Interest)
Compounding is a concept that is basic to investing. It is a very powerful investing tool.
Compounding occurs when investment returns are earned on reinvested investment returns through compound interest. Compounding achieves a multiplier effect.
In order for compounding to work to its maximum potential, all investment returns must be reinvested. It’s important to know that any withdrawals diminish compounding.
Compounding is especially effective when it is applied over a long period of time. For this reason, younger investors have a greater opportunity to benefit from compounding than those who are older.
Unfortunately, compounding also has a negative side since costs can also compound. Debt, in which an outstanding unpaid balance is charged interest, also compounds.
The diagram below shows that over time, the compounding effect accelerates. Time is money’s best friend. That is why as a Financial Security Advisor, I recommend that individuals start saving as early in life as possible so that the benefits of compounding can be realized to their full potential.
Investment Returns
All investments have one of three types of return. Returns can be positive and reflect a profit earned from the investment. Returns can be neutral, in which the investor receives the sum initially invested. Returns can also be negative. In this case, the investor will not receive back all the money invested. This is the risk of investing.
The return is often expressed as a percentage of the amount invested. In those cases, it is called “rate of return.” It can be a positive number, such as 10%, or a negative number, such as -10%.
In some cases, investors may be informed of the expected rate of return on an investment before they invest.
There is also a scale of risk for investments which tells the investor how likely it is that he will receive all his money back. The scale of risk plots the amount of risk an investor takes on in a range between the bottom of the scale, very low risk, and the top of the scale, speculative risk.
An investor with a very low risk investment can be very confident that he will receive back all his invested money.
Speculative investments are the most risky. An investor with a speculative investment is very uncertain of receiving back any of the invested money. There is a very high degree of risk that he will experience a negative return and lose money. However, there is also a possibility of very high returns.
Moderate or balanced risk is in between the two ends of the risk spectrum.
Why would an investor consider risky investments? Risky investments provide the opportunity for far greater positive returns than those with lower risk. This concept is what underlies investment risk/return theory. It is based on rewarding those who are prepared to risk their money with a better return. Investors who are not willing to risk the loss of their money receive a lower rate of return.
Returns are classified as nominal returns or real returns. A nominal return is the stated or advertised rate. For example, a savings account is advertised with a 2% return. That is its nominal return.
Real return is calculated as the nominal return on an investment minus the rate of inflation.
Asset Classes
Asset classes are categories assigned to investments that have similar characteristics and are governed by similar laws and regulations.
The three main asset classes are stocks (also called “equities”), bonds (also called “fixed income” or “debt”), and cash (also called “money market instruments”). Two other classes are often added. They are real estate and commodities.
Each type of asset class has its own risk and return features. Asset classes are fundamental to the investment concept of diversification.
Diversification
Diversification manages risk. It is based on the idea that, by combining asset classes and investments within those classes, investing risk will be lower and overall returns will be higher, as compared to investing all in one security.
Another form of diversification uses foreign investments to take advantage of different economic conditions in other countries.
Segregated funds are a good example of a diversified investment. Each type of segregated fund is invested in a wide range of investments specific to the type of segregated fund. For instance, a bond fund is diversified across a broad spectrum of bonds in its portfolio that mature at different times, have varying degrees of risk, and make payments at different interest rates.
Other investments that offer similar diversification include mutual funds and Exchange-Traded Funds (ETFs).
It is very difficult for an individual investor to achieve meaningful diversification unless he invests in a fund-type investment. Most investors simply do not have enough investment capital to be able to achieve diversification on their own.
Liquidity
Liquidity describes how easily an investment can be converted into cash. It is also used to describe how easily and quickly an asset or investment can be sold without affecting its value.
An investment that has characteristics of liquidity is called a “liquid investment.” Blue-chip stocks are one good example of a liquid investment since they are stocks of large, well-established, and financially sound companies. They can be sold quickly without a decrease in value.
An investment that does not have characteristics of liquidity is called “illiquid.” Real estate is often cited as an example of an illiquid investment since a quick sale often translates into a sale at a lower market price than could otherwise be obtained.
Liquidity is essential when a part or all of an investment will be used to provide an emergency fund to an investor. An emergency fund is a portion of earnings set aside for emergency purposes, such as when there is a sudden need to create an income due to unexpected job loss. When such a need arises, the investor must be able to sell his investment and obtain its highest market value.
Time Value of Money
The present value of money is one aspect of the principle known as the time value of money. The future value of money is the other. It is very important to understand the differences between the two.
Both principles are based on the potential for invested money to increase in value over time. Therefore, the time value of money shows that $25,000, in five years’ time, is not worth $25,000 today.
Present Value
Present value works backwards from a future date. It tells us that $25,000 at a future date is not worth $25,000 today because if $25,000 was invested today it would grow over time to a sum greater than $25,000. A dollar today has a lesser value than it will tomorrow or a year from now.
The value of the future sum today is its present value, or PV. The present value calculation is performed when the future sum is known; the future date is known when the sum is needed, and when the rate of return between today and the future date can be specified.
Present value is generally calculated using a financial calculator, through an online resource, or with software provided by insurers. It applies to both a sum of money and cash flows. The formula for the calculation is:
FV is the known future value and n is the number of periods for the calculation.
Being able to calculate present value is essential to many financial planning activities. For instance, a person retiring in 25 years who wants a nest egg of a specified amount wants to know how much that amount is in today’s dollars. A parent who must meet post-secondary education costs for a child wants to know how much must be saved from now to pay the expense later.
Future Value
The future value of money, or FV, is the value of today’s sum of money at a future date, based on a specified rate of return. It looks ahead to show what today’s money is worth in the future.
Therefore, the calculation is performed when today’s amount of investment is known, the future date is known, and the rate of return between today and the future date can be specified.
Like present value, future value is best determined using a financial calculator, through an online resource, or software provided by insurers.
The formula for the calculation is:
PV is the known present value and n is the number of periods for the calculation.
The future value calculation informs investors of the value of their current investments at a future date, given the rate of return they are earning. Therefore, if a future retiree has a certain amount saved for retirement purposes, he can determine how much that amount will be worth at retirement.
I hope this article helped you understand the world of investment and savings a bit better.
Respectfully,
Kevin D. McNabb
Financial Security Advisor
Freedom 55 Financial