Unit 2: Fundamental Investment Concepts

Risk

All investments involve some risk because the future value of an investment is never certain. Risk is the possibility that the actual return on an investment will vary from the expected return. Risk implies the possibility of loss on your investment.

Factors which affect the risk level of an investment include:

• Inflation
• Business failure
• Changes in the economy
• Interest rate changes
  

Investment Return

Investment return is the profit or loss on an investment.  It is a combination of current income (cash received from interest, dividends) and capital gains or losses (the change in value of the investment between the time you bought and sold it). However, the real rate of return is the rate of return earned after inflation, which is further reduced by income taxes and transaction costs.

The Risk / Rate-Of-Return Relationship

Generally, risk and rate of return are directly related. As the risk level of an investment increases, the potential return usually increases as well. As an investor takes on more risk, they incur a greater risk of loss along with the potential for higher returns.

Diversification

Investors offset the impact of risk through diversification. Done properly, diversification can reduce about 70% of the total risk of investing.  Here’s how it works: If you put all of your money in one place, your return will depend solely on the performance of that one investment. Conversely, if you invest in several assets, your return will depend on an average of your various investment returns.

Here are three basic ways to diversify your investments:

• By choosing securities from a variety of assets such as a mix of stock, bonds, cash and real estate
• By choosing a variety of securities or funds within one asset class: stocks from large, medium, small and international companies in different industries
• By choosing a variety of maturity dates for bond investments

By diversifying you won’t lose as much as if you invested in just one security before its market value goes down. However, if the market goes straight up from the time you started, you won’t make as much in a diversified portfolio either. Diversification is intended to protect your investments from dramatic losses.

Dollar-Cost Averaging

Another technique to help offset risk is dollar-cost averaging. You invest a set amount of money on a regular basis over a long period of time, regardless of the price per share of the investment. In doing so, you purchase more shares when the price per share is down and fewer shares when the market is high. As a result, you will acquire most of the shares at a below-average cost per share.  Profits will accelerate when investment market prices rise and losses will be limited during times of declining prices.

The Time-Value of Money

Now that you understand the concepts of risk and return, let’s turn to an element that is essential to wealth and financial security—time.As discussed earlier, time is a very important resource to investors. For example, young investors with a long time horizon may choose investments that exhibit wide price swings.  Families investing for a specific mid-life goal such as funding a child’s education or purchasing a home may choose a more moderate course which has opportunity for growth. Individuals nearing retirement may wish to select investments that lock in gains and provide a guaranteed income such as annuities.

Asset Allocation

In the final analysis, your overall investment return will be closely associated with the asset categories and allocations that you select.  An investor’s group of investments, frequently called an investment portfolio, can be divided in numerous ways among stocks, bonds and cash management options.

Several factors will impact the exact rate of return that you receive on your investment portfolio. Studies show that asset allocation will account for about 90% of your return. The selection of individual securities and market timing will account for the remaining 10% or so.

The critical question, of course, is: "What is the ideal asset allocation for you?"

Here are several factors to consider as you make this decision.

• Your Investment Goals:  Goals are specific things that people want to do with their money. As people move through various life stages, their needs and financial goals change. Your selection of investments should relate closely to your financial goals.  Each goal will define the amount of money needed as well as the number of years available for the investment to grow.
• Your Risk Tolerance:  Risk tolerance is a person’s emotional and financial capacity to ride out the ups and downs of the investment market without panicking when the value of investments goes down. Risk tolerances vary widely. Some are associated with personality factors, while others are based on changing needs dictated by your stage in the life cycle. If you won’t sleep well at night when the principal value of your investment goes down, you should select saving and investment options with lower risk.
• Your Tax Situation:  The return on any investment is influenced by your federal, state, and local tax situation. Before selecting an investment, learn its tax consequences.

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