Risk based investments

Low-risk investments

Cash and cash equivalents are favorite investments for safety and liquidity—lower return and short term. We all know cash, but what about cash equivalents? In accounting balance-sheet terms, they are bank accounts, marketable securities, and treasury bills. Basically, they are the securities that let people keep their money close and safe. These securities are usually lent for a very short period, from one day to less than one year. They also only lent to reputable investors. They are called cash equivalents because they are designed to be almost as reliable as cash.

Many individuals and companies use cash equivalents as good short-term parking places for cash and hope to beat inflation while still having the flexibility to have their money any time they need it. If you plan to buy a car or house, it might take a few months before you find the right one. You want to save enough money for a down payment but don’t want to leave the money idle without earning anything. Where should you go?

Go to a local bank and

  • open a money-market fund. This is a pool of money to invest in short-term debt securities, such as US Treasury bills from the US government and commercial papers by business. A commercial paper is kind of short-term debt issued by a corporation, typically for their short-term financing needs. It is usually offered at a discount.
  • open a savings account. This is basically a loan to the bank with no time limit. It is insured by the US government.
  • buy a CD. This is a loan to the bank with a predetermined time limit. It is also insured by the US government.

Go online to treasurydirect.gov and buy

  • US Treasury bills. These are loans to the federal government for ninety days or less. These bills are backed by the US government. The auction schedule is on the website too.

Find a brokerage or asset-investment company

Either go online or visit a local branch and buy the following:

  • Municipal money-market funds. These usually invest in local-government projects. The good thing is that the interest earned through the funds can be state tax-exempt.
  • Banker’s acceptance. This is a short-term debt instrument issued by a firm that is guaranteed by a commercial bank in international trade to facilitate imports/export activates.
  • There is no connection to the Euro currency or Eurozone. This is a deposit in a foreign bank that is denominated in US dollars.

Medium-risk investment

Usually, medium-risk investments have characteristics of less liquidity and less safety with low risk of losing the principal completely. One may consider extending the investment time frame. If you put down $100,000, the value of the investment may go down to $80,000 a year later. If you take the money out, you will lose $20,000. Sometimes you may wait for another year or so, hoping it rises again so you can get the principal or principal-plus-return back.

Bonds and bond mutual funds

A debt investment is one in which an investor loans money to an entity (corporate or governmental) for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states, and US and foreign governments to finance a variety of projects and activities. A bond mutual fund is a pool of money from a large number of investors, and the collected money is then used to purchase various bond products. Based on the type of the bond products that the fund purchases, we can classify bond funds as corporate bond funds, municipal bond funds, and others.

Real-estate investment

One can acquire ownership of or rent a house, an apartment, or any real property for personal usage or for rental. The owner can get rental income as a return and still keep the house as the principal. Or the owner can live in the house and sell the house when the price of the house has gone up.

Investment-insurance products

These products usually have short-term liquidity issues but are relatively safe in getting a return. They are insured by licensed and regulated insurance companies, similar to how your home, auto, or health is insured. And just like your home, auto, and health insurance, they are backed by the insurance company up to stated policy limits. State insurance guarantees vary from state to state.

  • Annuities: This is similar to a long-term CD in terms of safety but with restrictions on when to cash out. Annuities are insurance products that protect against the risk of outliving your income.
  • Cash-value life insurance: These are life-insurance products with both protection and potential tax-free cash accumulation. The guaranteed feature will provide safety to the investment.

High-risk investment

It is important to remember the following:

  • High return must involve high risk.
  • High risk, however, may not provide high return.

As risk runs higher, government regulations get tighter as well. What are the high-risk investments out there?

Mutual funds

A mutual fund pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments. The combined holdings the mutual fund owns are known as its portfolio. Each share represents an investor’s proportionate ownership of the fund’s holdings and the income those holdings generate.

Over the past decade, American investors increasingly have turned to mutual funds to save for retirement and other financial goals. Mutual funds can offer the advantages of making your investments more balanced and professionally management. But as with other investment choices, investing in mutual funds involves risk, and fees and taxes will diminish a fund’s returns. It pays to understand both the upsides and the downsides of mutual-fund investing and how to choose products that match your goals and tolerance for risk.

Most employees invest their retirement money accounts (401(k), 403(b), 457, etc.) in mutual funds, since most employers offer only mutual funds as an option. Based on the risk and investment goal, employees can choose the following:

  • Bond funds have two types of high-return funds:
    • High-yield funds invest in high-risk and lower-graded bonds to pursue higher interest.
    • Total-return funds look for bonds with good interest income and appreciation potential.
  • Stock funds typically come in four types:
    • Growth funds focus on stocks that may not pay a regular dividend but have the potential for large capital gains.
    • Income funds invest in stocks that pay regular dividends.
    • Index funds aim to achieve the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, by investing in all or perhaps a representative sample of the companies included in an index.
    • Sector funds may specialize in a particular industry segment, such as technology, health care, or consumer products stocks.

Exchange-traded funds (ETFs)

ETFs are investment companies that aim to achieve the same return as a particular market index. They can be either open-end companies or unit-investment trusts (UITs). But ETFs are not considered to be and are not permitted to call themselves mutual funds.

Hedge funds

A hedge fund is a general, nonlegal term used to describe private, unregistered investment pools that traditionally have been limited to sophisticated, wealthy investors. Hedge funds are not mutual funds. They are not subject to the numerous regulations that apply to mutual funds for the protection of investors, including

  • regulations requiring a certain degree of liquidity;
  • regulations requiring that mutual-fund shares be redeemable at any time;
  • regulations protecting against conflicts of interest;
  • regulations to assure fairness in the pricing of fund shares and disclosures; and
  • regulations limiting the use of leverage.

Stocks

A stock certificate provides proof of ownership in a corporation. The person who buys stock gives money to the company issuing the certificate in exchange for ownership and a share of future profit. The certificate is also called a share. A stockholder often receives dividends for profit sharing.

Investors usually buy the certificate at a market value based on supply and demand. There are many ways to determine the fair value of a stock. There are small-cap stocks, medium-cap stocks, and large-cap stocks from which to choose. The small-company stocks are usually considered riskier.

Options

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.

Foreign currencies

Currency markets provide investors with the opportunity to generate excess returns from the movement in exchange rates. They also enable investors to control some of the risks inherent in cross-border investments and liabilities.

Futures

As the name implies, futures are contracts on commodities, currencies, and stock-market indexes that attempt to predict the value of these securities at some date in the future.

Derivatives

A derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate. It can be used for a number of purposes, including ensuring against price movements or hedging, increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.

Ventures

Venture-capital investment is financial capital provided to early-stage, high-potential-growth start-up companies. The venture-capital fund earns money by owning equity in the companies it invests in, which usually has a new technology or business model in high-technology industries, such as biotechnology and computer software.

Exercises
  1. Give real-life examples representing the logic of investing.
  2. If you need to put aside money to take care of unexpected expenses, in which of the following forms would it be least beneficial to you if you need the money right away?
  • Checking account
  • Savings account
  • Investing in a down payment on a car
  • Stocks
  1. What are your expected returns on different types of investment choices? First discuss your goal for investment before doing the allocation.

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Asset classes          Risk type (Short, Med., Long)        Dollar amount       Percentage

Money market

Savings

CD

US Treasury Bill

Bond

Stocks

Real estate

Total                                                    100%

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