2022 AFBA Financial Planning Guide

a capital return can only be received when you sell the investment. Risk. Earlier we said that risk is the possibility of not achieving the anticipated return. While risk can be viewed as a continuum (as shown in the previous chart), we will confine our analysis to two categories — low risk and high risk. Low risk vehicles are investments which are considered safe. For these, we can be relatively certain that the anticipated return will be realized. On the other hand, high risk investments present a high degree of uncertainty regarding the anticipated return. They are often referred to as speculative investments. Tangibility. Tangibility refers to physical substance. Based upon this criteria we have two investment categories — tangible and intangible. Tangible investments are often called property investments. Real property is land and buildings while personal property includes gold, artwork, etc. Intangible investments are called securities. Securities are financial instruments which provide the owner with a specific set of rights. There are generally three categories of securities — debt, equity, and derivative. With debt securities the investor lends money in exchange for the promised repayment of both the money lent and interest. Bonds are an example of a debt security. Stock investments are equity instruments which means they represent ownership. When you buy the stock of a company, you are not lending the company money, rather you are actually participating in the company as an owner. Derivative investments are neither debt or equity instruments. Instead they derive their value based upon the price of an underlying security or tangible asset. Location. This refers to whether the investment is domestic or foreign. Many investors trade in the stocks and bonds of both domestic and foreign based firms. 10–5. SHORT-TERM INVESTMENTS. Short-term investment vehicles are debt instruments that mature within one year. They offer a high degree of liquidity with minimal risk and a relatively low potential income return. They provide liquidity for investors who need a near cash reserve and can also serve as a “warehouse” for funds that will ultimately be used for longer term investments. Commercial banks and credit unions offer various types of interest bearing accounts that can serve short-term investment needs. They also sell Certificates of Deposits that mature in one year or less. One advantage of bank type investments is that the FDIC insurance covers most bank deposits. Other popular short- term investment instruments include Treasury Bills sold by the federal government and Money Market Mutual Funds

which invest in both Treasury Bills and high dollar short- term instruments including Commercial Paper and Banker’s Acceptances. Treasury Bills. Treasury Bills (T-Bills) are issued with maturities of 4, 8, 13, 26 and 52 weeks. Since they are backed by the government, they are considered to be one of the safest investments available. The minimum amount an individual can invest in a U.S. Treasury Bill is $100. Additional amounts are in $100 increments. Treasury Bills are purchased at a price discounted from their face value; however, when they mature, the face value or principal is paid to the investor. They can be purchased either directly from the Treasury at www.treasurydirect.gov or through a bank or broker. All bills are issued in electronic form. Discount rates on T-Bills are established by auctions held by the U.S. Treasury on a regular schedule. 10–6. COMMON STOCK. Common stock is an equity investment with each share representing a fractional ownership interest. For example, if a company has 10,000 shares outstanding and you own 100 shares, then you own 1% of the company. Common stock provides the potential to earn both an income return (dividends) and a capital return. Although some stocks have an excellent dividend record, the major source of return in the stock market has historically been on the capital side. Consequently, the volatility in stock prices makes these instruments a relatively risky investment. Additionally, while many stocks can be easily bought and sold, the variability of stock prices does not make these vehicles a good choice for meeting cash reserve objectives. Common stocks may be categorized based upon their past and anticipated future performance. Blue Chip stocks are those that offer the best potential in terms of both an income and capital return. Cyclical stocks are normally companies whose business fortunes tend to follow the general state of the economy. When the economy is up they do well but when the economy is down their investment performance is usually poor. Defensive stocks represent companies that tend to hold their own or even go up in value when economic times are tough. 10–7. FIXED INCOME SECURITIES. These are investment instruments which promise a fixed income return and have the potential for providing a capital gain. They are long-term investments and are generally not suitable for satisfying liquidity objectives. The principle types of fixed income securities are bonds, preferred stock, and convertible securities.


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