- Describe common types of investments
- Demonstrate an understanding of the time value of money
Generally speaking, to invest in stocks, bonds, and mutual funds, you need an investment account with a broker. You’ll want to evaluate brokers based on factors like costs (trading commissions, account fees), investment selection, and investor research and tools.
Before selecting an investment broker, it is best to understand what types of investments are traditionally offered. We’ll take a look at the most commonly used types of investments:
- Mutual Funds
- Rental Real Estate
A stock is a share of ownership in a single company. Stocks are also known as equities. Stocks are purchased for a share price, which can range from the single digits to a couple of thousand dollars, depending on the company. Starbucks stock was trading at $60 per share in 2016, 2017, and 2018, showing very little growth, but in 2019 it increased to almost $100 per share. If you’d put $6,000 into your brokerage account in 2018 and bought only Starbucks stock, you’d have 100 shares. By August of 2019, you could have sold those shares for $9,500, making a $3,500 profit in just one year.
In July of 2015, a single share of Amazon stock was trading at $500. By the end of 2018, the stock was up to almost $2,000 per share, but it dropped back down to about $1,500 in 2019. However, during the coronavirus pandemic of 2020, the stock was trading at close to $2,500. A $5,000 investment in 2015 would only buy you 10 shares of stock, but by 2020, just five years later, your stock would have been worth $25,000.
On the other hand, during that same time period, Ford Motor Company, a stock that had once traded at almost $40 per share in 1999, dropped from $15 per share to $5.
Picking winners in the stock market has been debated for as long as there have been publicly traded stocks, with as many different opinions and systems as there are stocks to pick from, which is literally thousands. Most astute investors diversify, which is to say they buy a wide range of stocks in different industries in order to balance their portfolios.
The Need for Diversifying
One of the worst examples of investing in a single stock is Enron. When Enron bought Portland General Electric, all the employees who had stock in PGE suddenly found themselves owning stock in Enron instead, and shortly after that, Enron went bankrupt and the stock went from $90 a share to $0 in the span of a few months. PGE employees lost their entire retirement savings.
A bond is essentially a loan to a company or government entity that agrees to pay you back in a certain number of years. In the meantime, you get interest payments. Bonds are generally less risky than stocks. The trade-off is that the market value of bonds doesn’t fluctuate, so while they are safer, they offer less opportunity for growth.
Mutual funds are a mix of investments packaged together. Mutual funds are managed by professional investment firms, so they allow investors to skip the work of picking individual stocks and bonds and instead purchase a diverse collection in one transaction. The inherent diversification of mutual funds makes them generally less risky than individual stocks.
Rental Real Estate
Another type of investments is purchasing rental real estate such as single-family homes, apartment complexes, condominiums, or even raw land to rent out to tenants—or lease properties to businesses for use. Rental real estate is considered “passive” income, but buying and selling real estate can be complex, and a very specialized area of expertise is needed in order to minimize the investment risks. You may, however, find you have an affinity for it and gain the experience and expertise to invest wisely and get great returns over the years.
Other Investment Options
There are other options, as well—such as cryptocurrency, puts and calls, precious metals, and a host of other less common alternatives that require a deeper understanding of investing and of each specific type of investment. Although you may one day want to pursue some of these other investment options, it’s best to stick with a few solid stocks and mutual funds when you’re just getting started.
Your Investment Strategy
Your investment strategy depends on your saving goals, how much money you need to reach them, and your time horizon. If your savings goal is more than 20 years away (like retirement), almost all of your money can be in equities because higher-risk equities can recover from market drops over the longer period of time until your retirement. If, however, you’re saving for a short-term goal like emergency funds, you’re better off keeping your money in a savings account or another low-risk, easily accessible fund.
Later in this course, the accounting behind some of these investments will be covered more in detail. It is important for you to invest time to better understand your investment strategy and the vehicles that move you in the direction of your financial goals.
PRactice Question: Investing
Present Value vs. Future Value
The present value of an amount of money depends on several factors, but in its simplest form, it represents what a future amount of money is worth today. For example, you promise to give your daughter $10,000 for college once she enrolls five years from now. If your investment account grows at about 8% every year, you would need to put $6,806 in your account today.
Let’s dive into how that growth works:
- Year 1: You put the $6,806 in your account, and it earns 8% during that first year. You now have the original $6,806 plus $544.48 (6,806 × .08) in earnings. These earnings are often called interest, but they could also be growth, dividends, or rents. At the end of that first year, you have $7,350.48.
- Year 2: Your investment earns another 8%, but this time it’s on the balance of $7,350.48. This is compounding—where you earn a return on your original investment plus the growth. During the second year, your $7,350.48 grows to $7,938.52, as you’ve earned $588.04 in interest.
- Note: Compounding interest works for you when you are saving and investing, but conversely, it works against you when you are borrowing.
- Year 3: Your account grows to $8,573.60, given the same conditions as the previous year.
- Year 4: You have $9,259.49, given the same conditions as the previous year.
- Year 5: You have $10,000.25 to give to your daughter for her college tuition.
|Year||Account balance, beginning of the year||Earnings/growth at 8%||Account balance, end of year|
In other words, if someone offered you $7,000 today, or $10,000 five years from now, you’d be smart to take the $7,000 if you think you can sustain a return on your investments of 8% because the future value of the $7,000 is more than $10,000 (it is, in fact, $10,285 and some change.)
- The present value of $10,000 five years from now, discounted at 8%, with interest compounded annually, is $6,806.
- The future value of $6,806 at 8% compounded annually is $10,000.
You can calculate these amounts using a spreadsheet, a financial calculator, web-based calculators, commonly found tables, or even by hand if you are a math whiz. The trick to know is whether you are looking for the present value of a future amount (often called discounting) or the future value of a present amount. In addition, if the compounding period is more often than yearly, depending on what calculator you are using, you may have to do some quick math. For instance, if you are looking at tables for 8% compounded quarterly for 5 years, the number of periods (n) will be 20 (5 years times 4 quarters per year) and the interest rate (r) will be 2% (8% per year divided by 4 quarters). In calculations, remember that 8% is actually 0.08 as a number.
Compound Interest Calculator
The mathematical formula for Future Value (FV) is:
- C = initial investment (present value)
- r = rate of return
- n = number of periods
Try it out: In our first example, the present value was 6,806, n = 5, and r = .08
[latex]6806\times\left(1+.08\right)5 = 10000.25[/latex]
Future Value Tables
Because these calculations need to be done frequently, brokers and accountants create future value tables, which help people calculate future values without a financial calculator.
If you were using a future value table for this example, you would find the column for 8% and the row for n = 5, and you’d find a factor of 1.4693. That’s the future value of $1. So you would then multiply the factor by your initial investment of $6,806, and you get $10,000.06 (the factor is rounded to the nearest ten-thousandth, making it slightly less accurate than using the actual mathematical formula).
An annuity is a steady stream of monthly or annual income. There are tables and calculations for the future and present values of annuities as well. The calculations are more complex than those for a single (lump) sum, but spreadsheets, calculators, and tables make the analysis possible. When it comes to periodic payments that are not all the same, or that have odd timing, a spreadsheet is going to be your best bet.
Suppose for college, your sponsor, Yoshi Nakamura, offers you $6,806 today, or $2,000 for each of the next five years (a total of $10,000). The present value of an ordinary annuity (payments at the end of each period) of $2,000 assuming an 8% investment rate for five years is $7,985.4 (2000 × 3.9927 factor from the present value of an annuity table). Based on this calculation, the $2,000 annuity is worth more than just $6,806, because you get some of the money each year, which you can then invest. In fact, using a future value analysis, by getting the $10,000 in installments and investing it at 8%, you’ll end up with $11,733.20.
SAvings Goals Calculator
The important thing to know about the time value of money is that value is not fixed; it’s relative, which is another way of saying, “it depends.” It depends as well on factors other than just the rate of return you think you could get from investing. It depends on how badly you need the money right now, and inflation, and taxes, and a host of other factors. Still, in essence, the thing to remember is that a $1 bill right now is more valuable to you than that same $1 bill many years from now.
PRactice Question: Present Value vs. Future Value