2022 AFBA Financial Planning Guide

publicly traded stocks through various information sources including Value Line and Standard & Poor’s. The chart below portrays the relative risk relationship between various investment vehicles.

10–3. RISK AND RETURN. The following discussion examines a few fundamental investment concepts. Return/Yield. The purpose of investing is to make money and the money you make is called the investment’s return or yield. The return is normally expressed in a percentage form and represents the relationship between the money made and the money invested. For example, if you earn $100 on a $1,000 investment, your return is 10%. Return quotes are normally provided on an annual basis. Consequently, if you had earned the $100 over a six month period your annual yield would be 20%. There are two types of return — income return and capital return. Income return refers to the monies received periodically from the investment, i.e., dividends from stock investments, interest from bond investments, or rental income from real estate investments. This income return goes by various names — for stocks it is called dividend yield and for bonds it is called current yield. Capital return refers to the increase (or decrease) in the value of the investment (change in selling price) that occurs over the period of time that you hold the item. Some investments may only provide a capital return, i.e., an investment in undeveloped land; other investments may only provide an income return, i.e., an investment in municipal bonds that were purchased and redeemed at par; while still other investments have the potential of providing both an income and capital return, i.e., common stock. Risk. Risk is the chance that an investment’s actual return may not equal its expected return. In short, the probability of not making what you thought you would make on a given investment. Generally, there is a direct relationship between risk and return — the greater the risk, the higher the potential return; the lower the risk, the lower the anticipated return. Relatively safe investments like U.S. Government securities generally provide a much lower return while relatively risky investments, like common stock, provide the opportunity (but not the guarantee) of earning a much higher return. A common measure of stock risk is beta — a statistically developed value which measures relative market risk. The beta approach to risk assessment assigns a beta of “one” to the stock market. The betas of stocks traded in the market place are then calculated based upon their individual reaction to changes in the overall market. Stocks with a beta below one are considered less risky than the general market while stocks with betas above one are considered more risky than the general market. Beta values are available for most

Real estate and other tangible investments

Futures

Mutual funds

Deposit accounts and certificates of deposit

Preferred stock

Options

Common stock

Convertible securities

Bonds

Risk-free rate, R F

U.S. government securities

0

Risk

Diversification. Diversification is the process of selecting a number of different investment vehicles for inclusion in an investment portfolio. Portfolios can be developed to maximize potential return, minimize potential risk, or maximize the trade off between potential return and related risk. Diversification is financial jargon for the old adage “don’t put all your eggs in one basket.” Investors with limited resources can achieve diversification by investing in various mutual funds with different investment objectives. Liquidity. Liquidity is a term which stands for cash convertibility, meaning the ability to quickly sell or “liquidate” an investment with little or no loss in value. Certain investments are considered to be relatively liquid (e.g., Treasury Bills and money market mutual funds). These vehicles are either traded in a highly active market which allows the investor to quickly buy and sell or they provide a contractual assurance that allows the investor to quickly receive their money. 10–4. TYPES OF INVESTMENTS. Investments can be classified in a number of different ways depending upon the definitional criteria being used. Common investment categories include: Time. In this category there are two types of investments — short-term and long-term. Short-term investments are those that mature within one year. Stated another way, you get your money back and earn your return within one year. Long-term investments have longer maturities (e.g., bonds) or no established maturity date (e.g., stocks). Although you may earn an income return while you hold the investment,

CHAPTER 10: SAVINGS & INVESTMENTS

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