If you’ve been following this series, then you’ve learned how to design an efficient budget and you’ve also been given the tools to decide the amount of risk that is appropriate for you and your investments. Now, the next step is to identify the sort of investments that will help you achieve your goals.
In these next two episodes, I will give you an overview of the most common investments available in the financial markets. As you’ll notice, I’ve decided to arrange the investments based on where they fall on the Investment Risk Ladder. In this episode, we will start with the lowest risk securities, and we’ll move on to risker assets next month. I’ve also dedicated a substantial portion of this series to providing you with some important information, tips, and things to consider before making any investment decisions.
Where Do I Purchase Securities?
Most investors will use the services of a brokerage firm (referred to as a broker-dealer/BD) to purchase investments.
Firms like Fidelity and Vanguard (“full-service firms”) are good choices for investors that want to do more than just buy and sell securities – these firms offer retirement accounts, mutual funds, and an array of other services and products. Alternatively, firms like Robinhood (“discount firms”) may be more suitable for investors only interested in trading. You may also open a brokerage account through your bank since most large banks will offer brokerage services through a partner brokerage firm.
Before opening any account, be sure to shop around and compare various brokerage firms. These days, there is immense competition amongst brokerage firms to get customers, so most are being pushed to offer more services at lower costs. As always, pay attention to fees. In particular, ask about commission fees (how much they charge to execute an order) and inactivity fees (fees charged on accounts that don’t have much activity) – note that most firms have moved to a “zero-commission” fee model.
1. Cash & Cash Equivalents:
We begin our analysis of the investment risk ladder with cash and cash equivalents which are considered risk averse due to their high liquidity and general safety.
This asset class includes checking and savings accounts, certificates of deposits (CDs), and Money Market Funds. Another feature of this class of investments is that they are easy to understand – you place your money in a deposit account, and you earn interest on the funds.
Before opening an account, make sure that you pay attention to 1) minimum investment amounts, 2) whether the interest rate is fixed or variable, and 3) whether the account provides Federal Deposit Insurance Corporation ("FDIC") insurance. The FDIC is a US agency that provides insurance of up to $250,000 for eligible deposit accounts in the event that the bank fails. (You can search for FDIC insured banks here.)
Investors who wish to deposit more than $250,000 can still be insured under FDIC. The coverage limit only applies to each eligible account and is not capped on a per person basis. In other words, you can open multiple accounts that each have up to $250,000 in coverage. For example, if you wanted to have $500,000 covered by FDIC, then you could split the total in half and: 1) invest in two different banks, 2) invest in two different account types at the same bank (like a CD and savings account), or 3) invest in the same type of account (like a CD) but open one as a personal account and the second as a joint account with a spouse or family member. For more information on FDIC insurance, see here.
The greatest drawback of cash accounts is the low interest rate. In most cases, the interest that is earned seldom beats inflation. So, if you invest $10,000 a year in a cash account with a 1% interest rate, and inflation is around 2%, then you actually lose 1% of your investment each year. This drawback is particularly important today, as we are in a record low interest rate environment. Due to their safety and easy access, cash accounts are appropriate for emergency funds, everyday spending, and savings. They can also be used to park proceeds from other investments if you are not sure about the condition of the market.
2. Bonds:
A bond (or “fixed income”) is a debt security that represents a loan made by a lender (i.e., you) to a corporation or government.
In a typical bond arrangement, the issuer will promise to pay back the lender’s initial investment (“principal”) and promises to make scheduled interest (“coupon”) payments. Each bond has its own “maturity” date, which is the date the investor receives her principal back (terms vary but most are between 5–30 years).
A bond can also come with special features. For example, a “convertible” bond means that under certain circumstances, the investor can convert the bond into another security (usually common stock of the issuing company). Bond ownership does not give an investor any voting rights or ownership in a company. Also, while most bonds pay interest, some do not – and these are referred to as zero-coupon bonds. An example of a zero-coupon bond is a U.S. Treasury bill (“T-bills”), which is a short term (less than a year) debt obligation of the U.S. Government.
Why Are Bonds Considered to Be Relatively Safe Investments?
Bonds are generally considered to be safe investments because the issuer makes a promise to repay the lender – in other words, an investor is given a guarantee that they will be paid back. However, a bond is only as safe as the borrower. For this reason, credit rating agencies like Moody’s will provide credit ratings for bond issuers. For a complete list of the various credit ratings, see here.
Bonds that are rated “Investment Grade” offer the most security but lower coupon payments. Anything below Investment Grade is called a “High-Yield” or “Junk” bond. These lower rated bonds must compensate investors for the additional risk by offering higher coupon payments.
Bond Prices and Interest Rates
When a bond is first issued, it is given an artificial value of $1,000 (or sometimes $100) which is known as “face” or “par” value.
Bond prices have an inverse relationship to interest rates, so as interest rates increase, bond prices fall and vice versa.
Who Should Invest in Bonds?
Bonds are appropriate for investors seeking both income and growth opportunities and can be utilized by investors with varying levels of risk tolerance.
The Importance of Calculating a Bond’s Yield
For income investors, determining the total return (“yield”) of your investment in a bond is a critical calculation.
The current yield calculation is just one of many calculations available to determine the yield of a bond. Another important calculation is known as Yield to Maturity, which represents the overall return on investment if an investor plans to keep the bond until it matures. If you are interested in learning more about calculating bond yields, this supplemental article is a good start.
Conclusion
Bonds and cash and cash equivalents play an integral role in an investor’s portfolio. Since bonds tend to move in the opposite direction of stocks and riskier assets, they provide important diversification.
You can use sites like Bankrate or Nerdwallet to keep up with cash and cash equivalent accounts.
For bonds, you should keep up to date with prevailing interest rates such as the Fed Funds Rate and treasury security rates. You can also follow bond rating agencies such as Moody’s and Standard and Poor’s.
Tune in next month where I will discuss the remaining asset classes in the investment risk ladder.
PracticePro and the writer of this article do not provide tax, investment, or financial services and advice. Always consult with a financial professional or an accountant for the most up-to-date information and tax implications. This article is not investment advice.