The Pros and Cons of the Five Basic Investments

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The Pros and Cons of the Five Basic Investments -Learn to Earn_ A Beginner’s Guide to the Basics of Investing and Business.

There are five basic ways to invest money: putting it in a saving account or something similar; buying collectibles; buying an apartment or a house; buying bonds; and buying stocks. Let’s examine these one at a time.

  1. Savings Accounts, Money-Market Funds, Treasury Bills, and Certificates of Deposit (CDs)

All of the above are known as short-term investments. They have some advantages. They pay you interest. You get your money back in a relatively short time. In savings accounts, Treasury bills, and CDs, your money is insured against losses, so you’re guaranteed to get it back. (Money markets lack the guarantee, but the chances of losing money in a money market are remote.) Short-term investments have one big disadvantage. They pay you a low rate of interest. Sometimes, the interest rate you get in a money-market account or a savings account can’t even keep up with inflation. Looking at it that way, a savings account may be a losing proposition.

Inflation is a fancy way of saying that prices of things are going up. When gas goes from $1.10 a gallon to $1.40, or a movie ticket from $4.00 to $5.00, that’s inflation. Another way to look at inflation is that the buying power of the dollar is going down.

In recent times, inflation has been running just below 3 percent, which means for every dollar you own, you’re losing three cents every year. This adds up very quickly, and in ten years, at the present rate of inflation, all your dollars will have had thirty cents taken out of them.

The first goal of saving and investing is to keep ahead of inflation. Your money’s on a treadmill that’s constantly going backward. In recent years, you had to make 3 percent on your investments just to stay even.

As the chart on page 101 clearly indicates, money markets and savings accounts often don’t pay enough interest to make up for the losses from inflation. And when you subtract the taxes you have to pay on the interest, money markets and savings accounts have been losers in at least ten years out of the twenty shown on the chart.

Sources: IBC’s Money Fund Report, a service of IBC/Donoghue, Inc. U.S. Bureau of Labor Statistics; Federal Reserve.

That’s the problem with leaving money in a bank or a savings and loan. The money is safe in the short run, because it’s insured against loss, but in the long run, it’s likely to lose ground against taxes and inflation. Here’s a tip—when the inflation rate is higher than the interest rate you’re getting from a CD, Treasury bill, money-market account, or savings account, you’re investing in a lost cause.

Savings accounts are great places to park money so you can get at it quickly, whenever you need to pay bills. They are great places to store cash until you’ve got a big enough pile to invest elsewhere. But over long periods of time, they won’t do you much good.

  1. Collectibles

Collectibles can be anything from antique cars to stamps, old coins, baseball cards, or Barbie dolls. When you invest your money in such things, you are hoping to sell them at a profit in the future. There are two reasons this might happen: The things become more desirable as they get older, and people are willing to pay higher prices for them; and inflation robs cash of its buying power, which raises prices across the board.

The trouble with investing in things is they can get lost, stolen, warped, stained, ripped, or damaged by fire, water, wind, or in the case of antique furniture, termites. There is insurance for some of this, but insurance is expensive. Things in general lose value with wear and tear, although they also increase in value as they get older. That’s the constant hope of collectors, that the age of the thing will raise its price more than the condition of the thing will lower it.

Collecting is a very specialized business, and successful collectors are experts not only in the items they collect, but also in the market and the prices. There’s a lot to learn. Some of it you can pick up from books, and the rest you get the hard way, by experience.

Lesson one for all potential collectors, particularly young collectors, is that buying a new car is not an investment. The word “investment” showed up in a recent TV ad for a car, but if you see this ad, don’t be swayed by it. Antique cars are investments, if they are kept in a garage and rarely driven, but new cars subjected to everyday use lose their value faster, even, than money does. Nothing will eat up your bankroll faster than a car will—unless it’s a boat. Don’t make the mistake that Bigbelly did.

  1. Houses or Apartments

Buying a house or an apartment is the most profitable purchase most people ever make. A house has two big advantages over other types of investments. You can live in it while you wait for the price to go up, and you buy it on borrowed money. Let’s review the math.

Houses have a habit of increasing in value at the same rate as inflation. On that score, you’re breaking even. But you don’t pay for the house all at once. Typically, you pay 20 percent up front (the down payment), and a bank lends you the other 80 percent (the mortgage). You pay interest on this mortgage for as long as it takes you to pay back the loan. That could be as long as fifteen or thirty years, depending on the deal you make with the bank.

Meanwhile, you’re living in the house, and you won’t get scared out of it by a bad housing market, the way you might get scared out of stocks when the stock market has a crash or a correction. As long as you stay there, the house increases in value, but you aren’t paying any taxes on the gains. And once in your lifetime, the government gives you a tax break when you do sell the house.

If you buy a $100,000 house that increases in value by 3 percent a year, after the first year it will be worth $3,000 more than what you paid for it. At first glance, you’d say that’s a 3 percent return, the same as you might get from a savings account. But here’s the secret that makes a house such a great investment. Of the $100,000 it takes to buy the house, only $20,000 comes out of your pocket. So, at the end of year one, you’ve got a $3,000 profit on an investment of $20,000. Instead of a 3 percent return, the house is giving you a 15 percent return.

Along the way, of course, you have to pay the interest on the mortgage, but you get a tax break for that (unless the government decides to take away the tax break), and as you pay off the mortgage, you’re increasing your investment in the house. This is a form of savings that people often don’t think about.

Fifteen years up the road, if you’ve got a fifteen-year mortgage and you stay in the house that long, the mortgage is paid off, and the house you bought for $100,000 is worth $155,797, thanks to the annual 3 percent increase in the price.

Let’s pick up where we left off with Joe Bigbelly and Sally Cartwheel. They’ve both moved up to assistant manager at WalMart, making identical salaries. Cartwheel is living in her own house, while Bigbelly’s parents have kicked him out of theirs. He would have preferred to buy a house or an apartment on his own, but since he lacked a down payment, he had no choice but to rent an apartment.

Bigbelly’s monthly rent is somewhat lower than Cartwheel’s monthly mortgage payment, plus she has to buy home insurance, pay the lawn service, and make the occasional repair. So Bigbelly has more cash in his pocket at the outset. In theory, he could take this extra cash and invest it in the stock market and build up his assets for the future, but he doesn’t. He spends it on stereo equipment, scuba gear, golf lessons, and so on.

A person who won’t save money to buy an apartment or a house isn’t likely to save money to invest in stocks. It’s routine for families to make sacrifices so they can afford to own a house eventually, but when have you ever heard of a family making sacrifices so it could buy its first mutual fund?

By owning a house, Cartwheel already has gotten into the habit of saving and investing. As long as she’s paying the mortgage, she’s forced to invest in the house, and since she already invested in mutual funds to secure the down payment, there’s a good chance she’ll invest in mutual funds in the future, whenever she has money to spare.

In fifteen years, when her mortgage is paid off, Cartwheel will be living in a valuable asset, and her biggest monthly bill will have disappeared. Bigbelly will have nothing to show for all his rent payments, which will be much higher than they were when he first moved into the apartment. They will also be much higher than the final payment Sally Cartwheel had to make.

  1. Bonds

You’ve probably heard newscasters talk about “the bond market,” “the rally in bonds,” or “the decline in bond prices across the board.” Maybe you know people who own bonds. Maybe you’ve wondered, “What is a bond?”

A bond is a glorified IOU. It’s printed on fancy paper with doodles around the border and artwork at the top, but its purpose is no different from the purpose of the IOU that’s scrawled on a napkin. It’s a record of the fact that you’ve loaned your money to somebody else. It shows the amount of the loan and the deadline for paying it back. It gives the interest rate that the borrower has to pay.

Even though it’s called “buying a bond,” when you purchase one, you aren’t really buying anything. You’re simply making a loan. The seller of the bond, also called the issuer, is borrowing your money, and the bond itself is proof that the deal happened.

The biggest seller of bonds in the world is Uncle Sam. Whenever the U.S. government needs extra cash (which these days is all the time), it prints up a new batch. That’s what the $5 trillion national debt is all about—it’s owed to all the people who’ve bought the government’s bonds. Individuals and companies here and abroad, even foreign governments, have loaned the $5 trillion to Uncle Sam. They’ve got the IOUs in their safety deposit boxes to prove it.

Eventually, these people have to be paid back—that’s what the deficit crisis is all about. In the meantime, the government has to pay the interest on the $5 trillion worth of loans—Uncle Sam is going broke trying to keep up with these payments. This is the mess we’ve gotten ourselves into. The government owes so much to so many that more than 15 percent of all the federal taxes goes to paying the interest.

The type of bond that young people are most likely to get involved in is the U.S. Savings Bond. Grandparents are famous for giving savings bonds as gifts to their grandchildren. It’s a round-about way of putting money in their grandchildren’s pockets. Instead of handing them the money directly, the grandparents lend it to the government, by purchasing the bond. Over the years, the government pays back the money, plus interest—not to the grandparents, but to the grandchildren.

The U.S. government is not the only seller of bonds, in spite of its constant need for money. State and local governments also sell bonds to raise cash. So do hospitals and airports, school districts and sports stadiums, public agencies of all kinds, and thousands of companies. Bonds are in abundant supply. They’re for sale in any stockbroker’s office. You can buy them as easily as you can open a savings account or buy a share of stock.

Basically, a bond is quite similar to the CDs and the Treasury bills we’ve already talked about. You buy them for the interest you’ll get, and you know in advance how much interest you’ll be paid and how often, and when you’ll get your original investment back. The main difference between bonds and CDs or Treasury bills is that with CDs and Treasuries, you get paid back sooner (the period varies from a few months to a couple of years), and with bonds you get paid back later (you might have to wait five years, ten years, or as long as thirty years).

The longer it takes for bonds to pay off, the greater the risk that inflation will eat up the value of your money before you get it back. That’s why bonds pay a higher rate of interest than the short-term alternatives, such as CDs, savings accounts, or the money market. Investors demand to be rewarded for taking the greater risk.

All else being equal, a thirty-year bond pays more interest than a ten-year bond, which in turn pays more interest than a five-year bond, and so on. The buyers of bonds have to decide how far out they want to go, and whether the extra money they make in interest on, say, a thirty-year bond is worth the risk of having their money tied up for that long. These are difficult decisions.

At current count, more than $8 trillion worth of bonds of all varieties are owned by investors in the United States, making bonds a more popular investment than stocks. Meanwhile, investors also own more than $7 trillion worth of stocks traded on the major exchanges (and that doesn’t count the ones traded in regional or pink-sheets exchanges), and there’s a continuing debate over the merits of one versus the other. Both have their good points and their bad points. Stocks are riskier than bonds, and potentially far more rewarding. To understand why this is true, let’s look at two choices: one where you buy McDonald’s stock, and the other where you buy a McDonald’s bond.

When you buy the stock, you’re an owner of the company with all rights and privileges. McDonald’s makes a bit of a fuss over you. They send you their reports, and they invite you to the annual meetings. They also pay you a bonus, in the form of a dividend. If they have a really good year at their sixteen thousand hamburger stands, they might raise the dividend, so you get an even bigger bonus. But even without the dividend, if McDonald’s sells another zillion Big Macs and all goes well, the stock price will rise. You can sell your stock for more than you paid for it and make money that way.

Nevertheless, there are no guarantees that McDonald’s will prosper, that you’ll get a bonus, or that the stock price will rise. If it falls to less than what you paid for it, McDonald’s won’t reimburse you. They haven’t promised anything, and they aren’t obliged to pay you back. As an owner of the stock, you don’t have a safety net. You must proceed at your own risk.

When you buy a McDonald’s bond, or any bond, for that matter, it’s a much different story. In that case, you’re not an owner. You’re a lender, giving McDonald’s the use of your money for a fixed period of time.

McDonald’s can have the greatest year in hamburger history, and if you’re a bondholder, they won’t even think about sending you a bonus. Companies are constantly raising the dividend on their stock to reward the stockholders, but you’ll never hear of a company raising the interest rates on its bonds to reward the bondholders.

The worst part about being a bondholder is watching the stock go through the roof and knowing that you won’t see a penny of the gain. McDonald’s is a perfect example. Since the 1960s, the stock (adjusted for splits) has soared from $22.50 to $13,570 and investors have made 603 times their money, turning $100 into $60,300 or $1,000 into $603,000. The people who bought McDonald’s bonds were hardly as fortunate. They collected interest payments along the way, but aside from that, they broke even.

If you buy a $10,000 ten-year bond and hold it for ten years, you get your money back plus interest, and nothing more. Actually, you get back much less because of inflation. Let’s say the bond is paying 8 percent a year, and the inflation rate over that ten-year period is 4 percent. Even though you’ve collected $8,000 in interest payments, you’ve lost almost $1,300 to inflation. Your original $10,000 investment is now worth $6,648 after ten years of 4 percent annual inflation. So the whole ten-year investment has left you with less than a 3 percent annual return, and that’s before taxes. If you figure in the taxes, your return approaches zero.

The good thing about a bond is that even though you miss the gain when the stock goes up, you also miss the loss when the stock goes down. If McDonald’s stock had gone from $13,570 to $22.50 instead of the other way around, stockholders would be crying and bondholders would be laughing, because McDonald’s bonds aren’t affected by the stock price. No matter what happens in the stock market, the company must repay its debts to the bondholders on the date when the loans terminate and the bonds “come due.”

That’s why a bond is less risky than a stock. There’s a guarantee attached to it. When you buy a bond, you know in advance exactly how much you’ll be getting in interest payments, and you won’t lie awake nights worrying where the stock price is headed. Your investment is protected, at least more protected than when you buy a stock.

Still, there are three ways you can get hurt by a bond. The first danger occurs if you sell the bond before the due date, when the issuer of the bond must repay you in full. By selling early, you take your chances in the bond market, where the prices of bonds go up and down daily, the same as stocks. So, if you get out of a bond prematurely, you might get less than you paid for it.

The second danger occurs when the issuer of the bond goes bankrupt and can’t pay you back. The chances of this happening depend on who is doing the issuing. The U.S. government, for example, will never go bankrupt—it can print more money whenever it wants. Therefore, the buyers of U.S. government bonds are repaid in full. It’s an ironclad guarantee.

Other issuers of bonds, from hospitals to airports to corporations, can’t always offer such a guarantee. If they go bankrupt, the owners of the bonds can lose a lot of money. Usually, they get something back, but not their entire investment. And sometimes, they lose the whole amount.

When an issuer of a bond fails to make the required payments, it’s called a default. To avoid getting caught in one, smart bond buyers review the financial condition of the issuer of a bond before they consider buying it. Some bonds are insured, which is another way the payments can be guaranteed. Also, there are agencies that give safety ratings to bonds, so potential buyers know in advance which ones are risky and which aren’t. A strong company such as McDonald’s gets a high safety rating—the chances of McDonald’s defaulting on a bond are close to zero. A weaker company that has trouble paying its bills will get a low rating. You’ve heard of junk bonds? These are the bonds that get the lowest ratings of all.

When you buy a junk bond, you’re taking a bigger risk that you won’t get your money back. That’s why junk bonds pay a higher rate of interest than other bonds—the investors are rewarded for taking the extra risk.

Except with the junkiest of junk bonds, defaults are few and far between.

The biggest risk in owning a bond is risk number three: inflation. We’ve already seen how inflation can wreck an investment. With stocks, over the very long term, you can keep up with inflation and make a decent profit to boot. With bonds, you can’t.

  1. Stocks

Stocks are likely to be the best investment you’ll ever make, outside of a house. You don’t have to feed a stock, the way you do if you invest in horses or prize cats. It doesn’t break down the way a car does, nor does it leak the way a house can. You don’t have to keep it mowed, the way you do with real estate. You can lose a baseball card collection to fire, theft, or flood, but you can’t lose a stock. The certificate that proves you own a stock might be stolen or burned up, but if that happens, the company will send you another one.

When you buy a bond, you’re only making a loan, but when you invest in a stock, you’re buying a piece of a company. If the company prospers, you share in the prosperity. If it pays a dividend, you’ll receive it, and if it raises the dividend, you’ll reap the benefit. Hundreds of successful companies have a habit of raising their dividends year after year. This is a bonus for owning stocks that makes them all the more valuable. They never raise the interest rate on a bond!

You can see from the chart below that stocks have outdone other investments going back as far as anybody can remember. Maybe they won’t prove themselves in a week or a year, but they’ve always come through for the people who own them.

* The Standard & Poor’s 500 is a well-known index of 500 stocks that is often used as a barometer of the stock market in general.

Sources: Haver, Ibbotson Annual Yearbook, Datastream, The Economist Created by: Equity Research Infocenter—JL

More than 50 million Americans have discovered the fun and profit in owning stocks. That’s one out of five. These aren’t all whizbangs who drive RollsRoyces like the people you see on Lifestyles of the Rich and Famous. Most of these shareholders are regular folks with regular jobs: teachers, bus drivers, doctors, carpenters, students, your friends and relatives, the neighbors in the next apartment or down the block.

More than 50 million Americans have discovered the fun and profit in owning stocks. That’s one out of five. These aren’t all whizbangs who drive RollsRoyces like the people you see on Lifestyles of the Rich and Famous. Most of these shareholders are regular folks with regular jobs: teachers, bus drivers, doctors, carpenters, students, your friends and relatives, the neighbors in the next apartment or down the block.

People who train to be pilots are put into flight simulators, where they can learn from their mistakes without crashing a real plane. You can create your own investment simulator and learn from your mistakes without losing real money. A lot of investors who might have benefited from this sort of training had to learn the hard way, instead.

Friends or relatives may have warned you to stay away from stocks. They may have told you that if you buy a stock you’re throwing your money away, because the stock market is no more reliable than a casino. They may even have the losses to prove it. The chart on page 110 refutes their argument. If stocks are such a gamble, why have they paid off so handsomely over so many decades?

When people consistently lose money in stocks, it’s not the fault of the stocks. Stocks in general go up in value over time. In ninety-nine cases out of one hundred where investors are chronic losers, it’s because they don’t have a plan. They buy at a high price, then they get impatient or they panic, and they sell at a lower price during one of those inevitable periods when stocks are taking a dive. Their motto is “Buy high and sell low,” but you don’t have to follow it. Instead, you need a plan.

The rest of this book is devoted to understanding stocks and the companies that issue them. This is introductory material, which we hope will lay the groundwork for a lifetime of investing.

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