CHAPTER 13

Factors Affecting the Choice of Investments.

Millions of Americans buy stocks, bonds, or mutual funds, purchase real estate, or make
similar investments. And they all have reasons for investing their money. Some people
want to supplement their retirement income when they reach age 65, while others want
to become millionaires before age 40. Although each investor may have specific,
individual
goals for investing, all investors must consider a number of factors before choosing
an investment alternative.

SAFETY AND RISK
How do you define a perfect investment? For most people, the perfect investment is one
with no risk and above average returns. Unfortunately, the perfect investment does not
exist, because of the relationship between safety and risk. The safety and risk factors
are two sides of the same coin. Safety in an investment means minimal risk of loss. On
the other hand, risk in an investment means a measure of uncertainty about the
outcome.
Investments range from very safe to very risky. At one end of the investment spectrum
are very safe investments that attract conservative investors. Investments in this
category include government bonds, certificates of deposit, and certain stocks, mutual
funds, and corporate bonds. Real estate may also sometimes be a very safe
investment.
At the other end of the investment spectrum are speculative investments. A speculative
investment is a high-risk investment made in the hope of earning a relatively large
profit in a short time. Such investments offer the possibility of larger dollar returns, but
if they are unsuccessful, you may lose most or all of your initial investment. Speculative
stocks, certain bonds, some mutual funds, some real estate, commodities, options,
precious
metals, precious stones, and collectibles are high-risk investments.
THE RISKRETURN TRADE-OFF
You invest your money and your investments earn money. Thats the way investing is
supposed to work, but there is some risk associated with all investments. In fact, you
may experience two types of risks with many investments.
First, investors often choose some investments because they provide a predictable
source of income. For example, you may choose to purchase a corporate bond
because the bond pays a predictable amount of interest every six months. If the
corporation experiences financial difficulties, it may default on interest payments.
In other words, there is a risk that you will not receive periodic income payments.
A second type of risk associated with many investments is that an investment will
decrease in value. For example, the value of Goldman Sachs stock decreased on
April 16, 2010, when this large financial corporation that provides various banking
and lending services to customers in the United States and internationally was
accused of investment fraud and sued by the Securities and Exchange Commission
(SEC). As a result, the stock decreased 13 percent in just one day. 5 In fact,
many investments decreased in value during the recent economic crisis.
Exhibit 13-2 lists a number of factors related to safety and risk that can affect an
investors choice of investments.
EVALUATING YOUR TOLERANCE FOR RISK
When investing, not everyone has the same tolerance for risk. In fact, some people will
seek investments that offer the least risk. For example, Ana Luna was injured in a work-
related accident three
years ago. After a lengthy lawsuit, she received a legal settlement totaling $420,000.
When she thought about the future, she knew she needed to get a job, but realized she
would be forced to acquire new employment skills. She also realized she had received
a great deal of money that could be invested to provide a steady source of income not
only for the next two years while she obtained job training but also for the remainder of
her life. Having never invested before, she quickly realized her tolerance for risk was
minimal. When people choose investments that have a higher degree of risk, they
expect
larger returns. Simply put, one basic rule sums up the relationship between the factors
of safety and risk: The potential return on any investment should be directly related to
the risk the investor assumes. To help you determine how much risk you are willing to
assume, take the test for risk tolerance presented in the Financial Planning for Lifes
Situations feature on page 434.
CALCULATING RETURN ON AN INVESTMENT
When you invest you expect a return on your investment. For example, if you purchase
a one-year certificate of deposit (CD) guaranteed by the FDIC (Federal Deposit
Insurance Corporation),
your CD may earn 2 percent a year. At the end of one year, you receive your initial
investment plus 2 percent interest. Another investment alternative like a mutual fund
may earn 7 percent a year. In this case, you receive an additional 5 percent return when
compared to the CD because you chose to invest in a mutual fund that increased in
value. While most investors dont like to think about it, the mutual fund could decrease
in value for a number of reasons and your original investment or any possible returns
are not guaranteed.
To determine how much you actually earn on an investment over a specific period of
time, you can calculate your rate of return. To calculate rate of return, the total income
you receive on an investment over a specific period of time is divided by the original
amount invested.
EXAMPLE : Rate of Return
Assume that you invest $3,000 in a mutual fund. Also assume the mutual fund
pays you $50 in dividends this year and that the mutual fund is worth $3,275 at
the end of one year. Your rate of return is 10.8 percent, as illustrated below.
Step 1 Subtract the investments initial value from the investments value at the
end of the year.
$3,275 $3,000 = $275 Annual increase in value
Step 2 Add the annual income to the amount calculated in Step 1.
$50 + $275 = $325
Step 3 Divide the total dollar amount of return calculated in Step 2 by the
original investment.
$325 $3,000 = 0.108 = 10.8 percent
Note: If an investment decreases in value, the steps used to calculate the rate of
return are the same, but the answer is a negative number.
With these same steps, it is possible to compare the projected rate of return for different
investment alternatives that offer more or less risk. If based on projections, the
rate of return you calculate is only as good as the projections used in the calculations.
Often, beginning investors are afraid of the risk associated with many investments.
But it helps to remember that without risk, it is impossible to obtain larger returns that
really make an investment program grow. The key is to determine how much risk you
are willing to assume, and then choose quality investments that offer higher returns
without an unacceptably high risk.