6. Making Your Investment Decisions

Florida State College at Jacksonville; Zhijing Teng

6. Making Your Investment Decisions

Learning Objectives

Apply basic terminology/concepts in investing.
Identify various investment options such as stocks, bonds, and other alternatives.

Introduction

Have you ever gambled? Maybe you have engaged in casino games, sports betting, the lottery, or online gambling. Some people think that gambling and investing are the same thing. Do you agree?

Gambling and investing do have some similarities. Both involve risk and choice. However, there are also some key differences. Gambling is typically a short-lived activity, where you risk money on an event with an uncertain outcome. On the other hand, investing can last a lifetime and provides ample ways to mitigate potential losses.

In this chapter, you will learn some basic ideas about investing. You will learn about different types of investments, how to diversify your portfolio, and how to manage risk. By the end of this chapter, you will be able to make informed decisions about how to invest your money.

Why Do People Invest?

When income is larger than expenses, there is a budget surplus. The budget surplus provides liquidity, and that liquidity has value. You can choose to do several things with a budget surplus.

A budget surplus can be used immediately to enjoy goods and services, or that liquidity can be sold by lending the extra money to someone who wants it more than you do now and is willing to pay for its use.

So What Is the Difference Between the Money Market and Capital Market?

In general, if you need to access your money in the short term, you should store it in the money market. The money market is a safe place to store your money, and you are unlikely to lose much even if the market goes down. However, it offers low returns.

If you do not need to access your money in the short term, you can invest it in the capital market. The capital market offers the potential for higher returns but carries a higher risk of losing money. If you are willing to take on some risk, you can invest your money in stocks, bonds, or other capital market investments.

Remember: Saving Money Alone Is Not Enough

Remember, saving money alone is not enough to achieve long-term financial success. One reason is that the low returns offered in money markets are usually similar to or lower than the inflation rate. This means that your interest earnings are eaten up by inflation and your money actually loses value over time. To achieve long-term financial success, you need at least part of your extra money earning a return higher than the inflation rate. This can be done by investing in capital market investments, such as stocks, bonds, or real estate.

How to Become an Investor

When you invest, you lend money (transfer capital) to someone who needs it. You are trusting that they will be able to pay you back with interest later. Investing happens over your lifetime, and the type of investments you make will change as you get older. In your early adult years, you typically have little surplus to invest. Your first investment may be your home, or you may start saving for your children’s education or retirement. As you get older, you will have more money to invest, and you can begin to take on more risks. You may invest in stocks, bonds, or other capital market investments.

As your career progresses, your income increases. This means that you will have more money to save and invest. It is important to start thinking about your long-term financial goals, such as retirement or your children’s education, and to start investing early. Investing for your future is about more than just your immediate financial needs. It is about securing your financial future and achieving your long-term goals.

Before you invest, ask yourself:

Do I pay my bills on time?
Do I pay my credit card balance in full every month?
Is my budget balanced (i.e., income = spending)?
Are my basic needs met?
Do I have an adequate emergency fund?
Do I regularly contribute to my retirement plan?

If you answered “yes” to all these questions, you are ready to start investing!

What Are Some Sources of Investment Capital?

Save a small amount every payday by signing up to automatically transfer some income to a savings or investment account.
Save your net raise after income taxes to use for investments.
Invest any found money (e.g., tax refunds, bonuses, gifts, and inheritances)
Take overtime or get a second job.
Sacrifice some consumption to finance your investment.

How to Get Started on Your Investment Journey

Investing can be a great way to grow your money over time and reach your financial goals. However, it can be daunting to know where to start. Here are a few tips to help you get started on your investment journey:

What Type of Investor Are You?

Risk tolerance is how much risk an investor is willing to take. It is an important factor in investing, as it determines the type and amount of investments an individual chooses. Investors with a high risk tolerance are willing to take on more risk in exchange for the potential for higher returns. Investors with a low risk tolerance are more conservative and prefer to invest in safer assets with lower returns.

To learn more, check out the following resources:

Active vs. Passive Investing

There are two main approaches to investing: active and passive. Which approach should you take? Active investors must work hard at investing almost every day. Passive investors are in for the long term and do not actively buy and sell investments.

There is no one-size-fits-all answer to whether to be an active or passive investor. The best approach for you will depend on your individual circumstances, risk tolerance, and investment goals.

Risks of Investing

It is essential to remember that investments are not guaranteed to perform as expected. When you invest, you are taking on risk. Risk is measured by the amount of volatility, which is the difference between actual returns and average (or expected) returns. Riskier investments have higher volatility.

For example, a stock with high volatility might have returns that fluctuate wildly from month to month. It might go up 20% in one month, and in the next month, it might go down 10%. A stock with low volatility, on the other hand, might have more consistent returns. It might go up 5% in one month and up 5% in the next month.

Returns on Investment

Expected Return

Expected return is the amount of profit an investor can anticipate receiving on an investment. It is calculated by multiplying potential outcomes by the odds of them occurring and then taking the average of these results. The expected return figure can be considered a long-term weighted average of historical returns. However, expected returns cannot be guaranteed.

Relationship Between Risk and Return

Risk and return are like two sides of a coin. The more risk you take, the more potential return you can make. But the higher the risk, the more potential losses you may incur. For example, a T-bill is a very low-risk investment because the U.S. government backs them. However, the rate of return on a T-bill is also very low.

On the other hand, stocks are a higher-risk investment. The risk of losing money on stocks is higher because there is no guarantee that they will increase in value. However, the rate of return on stocks can also be much higher than the rate of return on T-bills.

It is important to remember that there is no risk-free investment. Every investment carries some risk, even T-bills. The key is to find an investment with a risk level that you are comfortable with, offering a potential return that you are happy with.

Types of Investments

Money Markets

Money markets are a good option for saving surplus cash for the short term. They offer a higher interest rate than savings accounts, but they are still relatively safe. Money markets were discussed in more detail in Making Your Savings Decisions.

Here is a ranking of money markets based on return, from low to high:

Money market accounts or savings account
Certificates of Deposit (CDs)
Money market mutual funds (MMMFs)

To learn more, visit, The best places to save your money: Money market accounts, savings accounts and CDs.

Capital Markets

Capital markets are a good option for investing surplus cash for the longer term. They offer the potential for higher returns than money markets, but they also carry more risk.

Here are some investment options available in the capital markets:

bonds
stocks
mutual funds
futures
options
real estate

Bonds

A bond is an investor’s loan to a company or government. Bonds are considered a relatively safe investment, as the borrower is legally obligated to repay the loan’s principal (the amount borrowed) and interest.

Here are the key details about bonds:

Term: The term of a bond is the length of time that the loan will last. Bonds typically have terms of 10–30 years, but shorter-term and longer-term bonds are also available.
Coupon: The coupon is the interest rate the borrower pays the investor each year. Coupons are typically fixed, but there are also floating-rate bonds, which have coupons that fluctuate with market interest rates.
Principal: The principal is the amount of money the borrower borrows from the investor. The principal is repaid to the investor at the end of the bond term.
Maturity date: The maturity date is the date on which the principal of the bond is repaid to the investor.

Bonds can be a good investment for investors looking for a relatively safe investment with a steady income stream. However, it is essential to remember that bonds are not without risk. The value of a bond can go down if interest rates rise, and the borrower may default on the loan.

Bonds and the Secondary Market

Bonds are like IOUs that companies and governments can give to people to borrow money. Investors can purchase bonds in the primary market when the company or government first issues the bonds. They can also purchase bonds in the secondary market when investors buy and sell bonds from each other.

The price of a bond can go up or down in the secondary market depending on a few things.

First, if interest rates go up, the price of a bond will go down. This is because investors can get a higher interest rate on a new bond, so they won’t be willing to pay as much for an old bond with a lower interest rate.

Second, if the creditworthiness of the company or government that issued the bond goes down, the bond price will also decrease. This is because investors will be more likely to lose money if the company or government defaults on the bond, so they will not be willing to pay as much for it.

It is important to understand the factors that can affect the price of a bond before investing in one. Investors should also diversify their portfolios by investing in various bonds. This will help to reduce their risk and improve their chances of meeting their investment goals.

Review this video for more information:

Return on Investment

Types of Bonds

The bond issuer type will determine the investment’s risk and return. The most common types of bonds are U.S. Treasury, Municipal, Federal Agency, and Corporate Bonds.

Treasury bond (also called T-bond): The U.S. Treasury issues T-bonds. Because it is backed by the federal government, it is considered the safest investment. Interest is subject to federal income tax but exempt from state and local taxes.
Municipal bonds: Municipal bonds are issued by state and local governments. Like treasury bonds, they offer a low-interest rate, but interest is exempt from federal income tax.
Federal agency bonds: Federal agency bonds are issued by government-sponsored enterprises (GSEs), which are not technically part of the government. However, they are considered very safe investments and offer a higher interest rate than Treasury bonds. The interest is taxable.
Corporate bonds: Corporate bonds are issued by companies. They are considered the riskiest type of bond, but they also offer the potential for higher returns. Large, well-known firms have lower default risk and lower returns. However, smaller, less stable corporations have higher default risk and higher returns. The interest is taxable.

FYI: U.S. Treasuries

Issued by the U.S. Department of the Treasury on behalf of the federal government. U.S. treasuries include:

Treasury Bills: Short-term securities maturing in a few days to 52 weeks
Notes: Longer-term securities maturing within 10 years
Bonds: Long-term securities that typically mature in 30 years
TIPS: Treasury Inflation-Protected Securities are notes and bonds whose principal is adjusted based on changes in the Consumer Price Index. TIPS pay interest every 6 months and are issued with maturities of five, 10, and 30 years.

Stocks

A stock (also called equity) is a share of ownership in a corporation.

Why Do Companies Issue Stock?

Companies issue stock to raise money for various reasons, which may include:

Reason 1: Paying off debt

Companies may issue stock to pay off debt. This can help to improve the company’s financial health and make it more attractive to investors.

Reason 2: Launching new products

Companies may issue stock to raise money to launch new products. This can be costly, and issuing stock can help finance the development and marketing of new products.

Reason 3: Expanding into new markets or regions

Companies may issue stock to raise money to expand into new markets or regions. This can be a great way to grow the company but it can also be expensive. Issuing stock can help to finance the expansion.

Reason 4: Enlarging facilities or building new ones

Companies may issue stock to raise money to enlarge facilities or build new ones. This can be necessary to meet increasing demand or to improve efficiency. Issuing stock can help to finance the expansion.

What Does It Mean When You Buy Stock?

When you buy a stock, you buy a small part of a company. This means you own a little bit of the company and get to share in its profits. If the company does well, the value of your stock will go up, and you can make money by selling it. But if the company does poorly, the value of your stock will go down, and you could lose money.

Some companies pay their shareholders money called dividends. The company’s board of directors decides the amount of the dividend. Dividends can be paid every quarter, every 6 months, or every year.

Not all companies pay dividends. But even if a company does not pay dividends, you can still make money if the stock price increases. This is called capital appreciation.

Types of Stock and Types of Stock Markets

There are two main types of stock: common and preferred

Common Stock

Preferred Stock

A type of equity security representing company ownership. Common stockholders are entitled to vote at shareholder meetings and to receive dividends, if any. However, common stockholders have the lowest priority regarding receiving payments from the company in the event of liquidation.

A type of equity security representing company ownership. Preferred stockholders are entitled to receive dividends before common stockholders, and they have priority over common stockholders in the event of liquidation. However, preferred stockholders do not have voting rights.

There are two types of stock markets: primary and secondary.

How to Trade Stocks

After a company goes public through an initial public offering (IPO), its stock becomes available for investors to trade on a stock exchange. Investors typically use a brokerage account to sell stock on the exchange, which lists the purchasing price (the bid) or the selling price (the offer). The stock price is influenced by supply and demand factors in the market, among other variables. Every stock transaction charges a brokerage commission.

What Is the Difference Between Stocks and Bonds?

Stocks and bonds are two different types of investments. Stocks represent ownership in a company, while bonds represent a loan to a company.

Stockholders are owners of a company and are entitled to a share of the company’s profits, if any. They are also entitled to vote on important corporate matters, such as the election of directors and the approval of major corporate actions. However, stockholders do not have a guarantee of return on their investment. The value of their stock can go up or down, and they may even lose all of their investment if the company goes bankrupt.
Bondholders are creditors of a company and are entitled to interest payments and repayment of the principal invested. They have a priority over stockholders in the event of bankruptcy. Bondholders will be paid first if the company’s assets are liquidated. However, bondholders do not have any ownership in the company.

In general, stocks are considered to be riskier investments than bonds. This is because the value of stocks can go up or down and there is no guarantee of a return on investment. Bonds are considered to be safer investments, but they offer lower returns.

Watch this video for more information.

Investments: Mutual Funds

A mutual fund is an investment portfolio comprising stocks, bonds, or other assets. Mutual funds are created and managed by mutual fund companies, brokerages, or banks.

Advantages of Investing in Mutual Funds

Diversification: Mutual funds allow small or individual investors to access a diversified portfolio of assets, which can help reduce risk.
Professional management: Mutual funds are managed by professional investment managers with the expertise to select and manage a diversified portfolio.
Low transaction costs: Mutual funds typically have lower transaction costs than individual stocks or bonds.
Index funds: Index funds are mutual funds that track a specific market index, such as the S&P 500 and the Dow Jones Industrial Average. Index funds are a good option for investors who want to follow the market and minimize transaction costs.
Retirement savings: Mutual funds are a popular way to save for retirement. Many employer-sponsored retirement plans, such as 401(k)s and IRAs, offer mutual funds as investment options.

Return From Investing in Mutual Funds

Mutual funds can generate returns through two main channels:

Dividend distribution: Mutual funds may distribute dividends to shareholders. Dividends are a company’s payments to its shareholders out of its profits.
Capital appreciation: The value of a mutual fund’s shares may increase over time. This is known as capital appreciation.

Diversification Among Mutual Funds to Lower Risk

Diversifying investments among different types of mutual funds is important to reduce risk. For example, you could invest in a mix of stock funds, bond funds, and money market funds. You could also diversify your investments among mutual funds from different countries.

Watch this video for more information:

Investments: Futures

Futures are a type of derivative contract that allows you to buy or sell an asset at a predetermined future date for a set price.

Example:

You could buy a futures contract for May 2024 wheat in July 2023. This means you would agree to buy wheat at a set price in May 2024, even though the wheat does not exist yet.

Details on Futures to Keep in Mind

Types of Futures

Futures contracts can be traded on a variety of assets, including:

Commodities: Commodities are raw materials, such as crude oil, natural gas, coffee, wheat, and sugar.
Precious metals: Precious metals are metals that are valued for their beauty and rarity, such as gold and silver.
Stock market indices: Stock market indices are baskets of stocks that track the performance of a particular market or sector. For example, the S&P 500 is a stock market index that tracks the performance of the 500 largest companies in the United States.
Currencies: Currencies are the units of exchange used by countries. For example, the euro is the currency used by the European Union, and the U.S. dollar is the currency used by the United States.
Interest rates: Interest rates are the prices paid for borrowing money. For example, the federal funds rate is the interest rate banks charge each other for overnight loans.

To learn more about futures, please read What are futures and how do they work?

Investments: Options

Futures and options are often placed in the same bucket because they are both about what-if prices.

Futures and options are both financial instruments that let you bet on what a future price will be.

Futures are contracts that you buy or sell now, but they do not actually happen until the future. For example, you could buy a futures contract for a barrel of oil that will be delivered in 6 months.
Options are a bit different. They give you the right, but not the obligation, to buy or sell something in the future. For example, you could buy an option to buy a share of stock for $50 in 3 months. If the stock price goes up to $60 in 3 months, you can exercise your option and buy the stock for $50, even though it is worth $60.

Futures and options are complex financial instruments and they are not for everyone.

To learn more, check out the following resources:

Investments: Real Estate

Real estate is land and anything permanently attached to it, like buildings. You can buy real estate to rent it out to people. This is called being a landlord.

Returns From Rental Properties

There are two main ways to make money from rental properties:

Rental income: Renters pay you money to live in your property. This is called rental income. Rental income can provide you with positive cash flow, which means you have more money coming in than going out.
Appreciation: The value of your property may increase over time. This is called appreciation. You will make a profit if you sell your property for more than you paid for it (i.e., capital gain).

Risks From Rental Properties

There are also some risks associated with owning rental properties:

Renters could default: Renters may not be able to pay their rent. This could mean that you have to evict them and find new renters.
The property value could decline: The value of your property may decrease over time. This could happen if the economy is bad or if the neighborhood changes.

There are many other ways to invest in real estate besides buying rental properties. Here are a few examples:

Real Estate Investment Groups (REIGs): REIGs are groups of investors who pool their money together to buy and manage rental properties. This is a good option for people who want to own rental real estate but do not want to deal with the day-to-day management of the properties.
House flipping: House flipping is the practice of buying undervalued properties, fixing them up, and selling them for a profit. This can be a risky investment, but it can also be very profitable if you do your research and find good deals.
Real Estate Investment Trusts (REITs): REITs are companies that own and manage income-producing real estate. REITs are traded on stock exchanges, so you can buy shares of REITs just like you would buy shares of stock. This is a good option for investors who want portfolio exposure to real estate without a traditional real estate transaction.
Real estate investing platforms: Real estate investing platforms allow you to invest in real estate projects without buying a property yourself. This is a good option for investors who want to invest in real estate but do not have the money or experience to buy their own properties.

To learn more, check out the following resources:

Investments: The Government Role—The SEC

The Securities and Exchange Commission (SEC) is a government agency that helps protect investors by ensuring the stock market is fair and honest.

The SEC:

Requires companies to disclose information about their finances and operations to investors.
Prohibits fraud and manipulation in the stock market.
Enforces the laws that govern the stock market.

The SEC is vital because it helps to keep the stock market honest and fair. This helps to protect investors from losing money. The SEC also helps to ensure that the stock market is a fair place for companies to raise money.

Please read Securities and Exchange Commission (SEC) Defined, How It Works to learn more.

Investments: Long-Term Strategies

Here are some investment strategies that can help you grow your money:

Strategy 1

Portfolio diversification

This means investing in various assets, such as stocks, bonds, and real estate. This helps to reduce your risk because if one asset goes down in value, the others may not. This is like putting your eggs in different baskets. If one basket breaks, you will not lose all of your eggs (eggs being your hard-earned dollars). To learn more, please read Portfolio Diversification.

Strategy 2

Buy to Hold

This passive investment strategy means buying a diversified portfolio and holding on to it long-term. This strategy can help you ride out the market’s ups and downs and achieve your investment goals. This is like planting a tree. It takes time for a tree to grow, but it will eventually grow into a strong and healthy tree.

Strategy 3

Dollar-Cost Averaging

This investment strategy involves investing a fixed amount of money into a particular asset regularly, such as every month. This can help you average the cost of your investment and reduce your risk. This is like filling your water bottle with a small amount of water daily. Eventually, your water bottle will be full. Please read to learn more, Dollar-Cost Averaging: Definition and Examples

Strategy 4

Asset Allocation

This is the process of deciding how much of your money to invest in different asset classes, such as stocks, bonds, and real estate. Asset allocation can help you achieve your investment goals and reduce risk. You need to make sure that you are spending your money in a way that meets your needs and goals. This is like deciding how many eggs go into each basket. (The type of investment you choose, such as stocks or bonds, is called asset allocation.) To learn more, please read What Is Asset Allocation and Why Is It Important? With Example

Fit Investing Into Your Financial Plan

Questions to ask yourself:

What are your investment goals?
Given your existing budget, should you make investments now?
Based on your risk tolerance, how should you invest funds?

“The best place to invest your savings…depends on your timeline and your risk tolerance.”^[1] Your investment decisions will also vary with your situation. Let’s say you have $1000 and you’re not sure what to do with it. First, look at paying down high-interest debt. If you’re paying 25% interest on credit card balances, that’s probably higher than any interest you would earn from investments. If you have a time-sensitive situation that requires you to have easily accessible cash–like a tuition bill due at the end of the month–then you wouldn’t want to invest your money in a place that ties it up or that could take a loss.

Please read How to Invest Your Savings for Short-Term or Long-Term Goals to learn more about investment options by time horizon (short-, mid- and long-term financial goals). The article has at-a-glance charts that show quick facts and potential returns on each investment; and provides an explanation of each strategy.

Key Takeaways

Investment risk is the possibility that an investment’s actual return will not be its expected return.
Savvy investors consider both risk and return and try to find a balance.
Risk tolerance often determines the type and amount of investments an individual chooses.
Rebalance your portfolio at least once a year.
Borrowing to invest to recover losses rarely works.
Long-term investors don’t practice market timing and know that the long-term trend is always up.
Stocks perform better when interest rates are low.

Attributions

This chapter contains content from the following sources in the text and learning activities:

(1) “Personal Finance: Chapter 7.2” was adapted by Saylor Academy under a CC BY-NC-SA 3.0 without attribution as requested by the work’s original creator or licensor.

(2) “Personal Finance: Chapter 12.1” was adapted by Saylor Academy under a CC BY-NC-SA 3.0 without attribution as requested by the work’s original creator or licensor.

(3) “Investor.gov: What are stocks?” by U.S. Securities and Exchange Committee is in the Public Domain

Introduction

Why Do People Invest?

So What Is the Difference Between the Money Market and Capital Market?

How to Become an Investor

What Are Some Sources of Investment Capital?

How to Get Started on Your Investment Journey

What Type of Investor Are You?

Active vs. Passive Investing

Risks of Investing

Returns on Investment

Expected Return

Relationship Between Risk and Return

Types of Investments

Money Markets

Capital Markets

Bonds

Bonds and the Secondary Market

Review this video for more information:

Return on Investment

Types of Bonds

FYI: U.S. Treasuries

Stocks

Why Do Companies Issue Stock?

Reason 1: Paying off debt

Reason 2: Launching new products

Reason 3: Expanding into new markets or regions

Reason 4: Enlarging facilities or building new ones

What Does It Mean When You Buy Stock?

Types of Stock and Types of Stock Markets

Common Stock

Preferred Stock

How to Trade Stocks

What Is the Difference Between Stocks and Bonds?

Investments: Mutual Funds

Advantages of Investing in Mutual Funds

Return From Investing in Mutual Funds

Diversification Among Mutual Funds to Lower Risk

Investments: Futures

Types of Futures

Investments: Options

Investments: Real Estate

Returns From Rental Properties

Risks From Rental Properties

Investments: The Government Role—The SEC

Investments: Long-Term Strategies

Strategy 1

Strategy 2

Strategy 3

Strategy 4

Fit Investing Into Your Financial Plan

Attributions

Further Readings & References

License

Share This Book