HE-625, Reprinted Sept 1998. Fred Waddell, Extension Family Resource Management Specialist, Associate Professor, Human Development and Family Studies, Auburn University. Originally prepared by Josephine Turner, Certified Financial Planner, Extension Program Specialist, Professor, Human Development and Family Studies at Auburn University

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Savings and Investments

This publication is the second in a series on investments offered by the Alabama Cooperative Extension System. In this publication, we will get an overview of some investment choices for the beginning investor. We will look at the difference between saving and investing and examine some types of accounts for savings.

Then we will discuss two important characteristics of investments, risk and return, and the trade-off between them. We will take a quick look at investment options and how they might meet your investment objectives. In-depth discussion of most of these investments, however, is reserved for other articles in this series. And finally, we will discuss how to choose an investment advisor.

Savings

The Difference Between Savings and Investments

Before you can consider investing, you need enough cash to meet living expenses, handle emergencies, and make special purchases. The foundation of your investment portfolio is your savings, and you must manage savings as carefully as your investments.

The difference between savings and investments is that savings are usually safer and more liquid than investments. Safety means that the funds are insured or guaranteed by the federal government. Liquidity means that the savings are easily changed to cash on short notice. That way, you can withdraw your money quickly without losing your original deposit and the interest. Investments often offer a potential for making money faster, but they are usually less liquid and more risky. Investing should be considered only after you have adequate savings.

Interest: The Magic of Compounding

Savings usually involves cash that is deposited into some type of account that earns interest. The original amount deposited is called the principal. Interest is the price a bank or a borrower pays for the use of someone's money.

Interest is usually stated as a percentage of the principal per year, even if the money is deposited for only a few months. For example, if you earned $10 interest in one year on a principal amount of $100, the interest rate would be described as 10 percent. The percentage rate per year is indicated as annual interest rate. When shopping for the best type of account in which to place your cash, one factor to consider is which account offers the highest annual interest rate. You should realize that there are different methods for calculating interest.

Simple interest is calculated by multiplying the principal times the rate of interest times the amount of time in years that you will leave the money in the account. For example, if you put $1,000 principal in a savings account in a bank that pays 12 percent simple annual interest, the interest you will receive in one year can be calculated like this:

Interest = Principal x Rate x Time

Interest = $1,000 x 0.12 x 1 = $120

If you left the principal in the account for 2 years, you would receive $240 in interest (2 x $120).

Notice that the financial institution pays interest only on the principal, and not on any accumulated interest. This is the major characteristic of simple interest.

Compound interest, on the other hand, is interest that is calculated on the principal plus the accumulated interest. Compounding interest means that you earn "interest on interest" during the year. In other words, interest earned after a given period is added to the principal and included in the interest calculation for the next period.

Look at this example. Suppose you place $1,000 in savings and will receive 12 percent per year compounded annually.

Interest (first year) = P x R x T = $1,000 x 0.12 x 1 = $120

To calculate the second year's interest, add the first year's interest to the first year's principal. That will give you the second year's principal.

Second year's principal = $1,000 + $120 = $1,120.00

Second year's interest = $1,120 x 0.12 x 1 = $134.40

To figure the total interest the bank owes you for keeping your money and compounding it annually for 2 years, add the first year's interest to the second year's interest.

Total amount of interest = $120 + $134.40 = $254.40

Compare the results with the $120 amount ($240 for 2 years) you calculated for a deposit in an account with simple interest.You receive $14.40 more with annual compounding because you have received interest on interest. That is what compounding is all about. The more frequently the interest is compounded, the higher the effective interest rate is.

To see whether interest on your savings is simple or compounded, check with your financial institution. For more information about interest rates, write the Federal Reserve Bank of New York, Public Information Department, Federal Reserve P.O. Station, New York, New York 10045 and ask for a pamphlet called "The Arithmetic of Interest Rates."

Types of Deposit Accounts in Financial Institutions

To save wisely, you should shop around for the highest possible interest rate on some type of deposit account. Once you find a type of account that meets your needs, some experts advise sticking with it. Usually, spreading different accounts over several institutions or changing your account whenever another account offers slightly higher interest is not worth the trouble for the average investor.

There are several types of deposit accounts that offer safety and liquidity for your savings. Banks, savings and loans, and credit unions may have different names for them, but deposit accounts usually fit into one of the following categories.

Savings Accounts. Some people place their savings in a regular savings account that pays a fairly low interest rate (5 to 5.5 percent). The effective yield on the account will differ, depending on how the interest is compounded. These accounts require only a small minimum balance, but no check-writing privileges are available.

Money Market Checking Accounts. Most financial institutions offer a money market checking account with levels of interest rates based on the balance of your account. The lower rate offered on smaller accounts is much like the traditional rates on savings accounts. Higher interest rates on accounts with larger balances are tied to an index such as the prime rate or the rate on Treasury bills. Sometimes the rate may be set by the bank's management. Fees on these types of accounts vary depending on the balance in the account.

Money Market Investment Accounts. These types of accounts operate much like the money market checking accounts but offer higher rates. They also allow only limited transactions, so you will be restricted in the number of withdrawals you can make or checks you can write. Fees are again based on size of the balance in the account.

"Premium" money market investment accounts offer even higher rates, but they are limited to accounts with very high balances ($l0,000 and above).

The money market investment accounts are comparable to money market mutual funds offered by brokerage firms, but are usually somewhat lower in yield. Like all of the deposit accounts discussed above, however, money market accounts are federally insured if the bank or financial institution qualifies for federal insurance. This means that if your insured bank or other financial institution fails, a government agency will insure your deposit up to a certain amount. Money market funds with brokers are not insured, although they are considered "safe" investments.

Certificates of Deposit. Certificates of deposit are time deposits. This means that they have a stated date of maturity. If you withdraw the money before the stated maturity date, you will be charged a penalty.

The rates on certificates of deposit (or CDs) may be based on the amount of the deposit. The rates also may vary depending on the maturity date: for example, 6-month CDs will typically pay a lower rate than 1-year CDs. Certificate of deposit rates usually follow the rates of other short-term investments in the market such as Treasury bills.

Other Options for Your Savings

A money market mutual fund offered by a brokerage firm is another option that investors use to store their cash for savings. This kind of fund pools the money of many investors and invests in short-term, relatively safe instruments such as Treasury bills, commercial paper, and bank certificates of deposit. Although a money market fund is not federally insured, it is considered by investment experts to be a safe place to store your cash. See the discussion of money market funds in "Stocks and Mutual Funds," Extension publication HE-627.

Another savings option is the United States savings bond. Series EE bonds can be purchased for small amounts of money, and they pay a variable rate of interest. For more information about savings bonds, see "Basics of Bonds," Extension publication HE-626.

In deciding which option is best for your savings, look at several factors. Compare interest rates. You should also compare the compounding interval. The more often interest is added to your principal, the greater the amount on which the interest is computed. More frequent compounding is more desirable.

While you are thinking about interest, check to see when interest begins to be earned and when it ends. For example, an account may earn interest from the first day of the month if you deposit by the tenth, or it may earn interest only from the date of deposit.

Another factor to consider is the minimum balance. What happens if your account balance falls below the minimum? Also, what types of service fees does the financial institution charge? What are the limitations on check-writing privileges?

Safety, of course, is extremely important. Some accounts are federally insured. Others are not insured but may be considered "safe."

In summary, you cannot begin an investment program until you have adequate savings. You should set aside in savings at least 2 to 6 months' income. Invest your savings only in very safe and liquid investments so they will always be available if and when you need them. Consider carefully your savings options and weigh factors such as safety, interest rates, and restrictions. Once you have set aside enough for savings, you are ready to begin investing.

Investments

In the first publication in this series, "Planning for Financial Security," Extension publication HE-624, we discussed how to set your financial goals. Your choice of investment options will depend in large part upon your financial goals. Your financial goals are often, though not always, related to your age or stage of life. Investments can have one or more of three main objectives:

• Safety of principal
• Current income
• Capital growth

Unfortunately, no investment can give you maximum safety, maximum current income, and maximum capital growth. You must make trade-offs. However, most investments will emphasize one or two of these objectives and de-emphasize the third.

Understanding Risk and Return

To decide what types of investments to select, you will want to know about the value of the investment. The important characteristics for evaluating investments are risk and return. Let's look first at the concept of return.

Return is the gain or profit you receive from investing. The size of the return becomes a critical factor in choosing an investment. Return on an investment may be derived from either the receipt of income or appreciation in value of the investment (being able to sell the investment for more than it cost you).

These two sources of return are called current income and capital gains. The combination of current income and capital gain is the total return from the investment. Current income is measured by the amount of cash you receive from the investment--for example, dividends, rent, or interest. Capital gains are calculated by determining whether you sold your investment for more than you paid for it.

Measuring Returns As Yields. Most investors measure return on a yield basis--that is, as a percentage of the amount invested, rather than in dollars. That way you can compare the yields on different investments and find out how much you earned per dollar invested. Again, the two components of total return (current income and capital gains) are taken into account.

Yield is the return received expressed as a percentage of your original investment on an annual basis.Yield can be calculated with a simple formula. Do not be put off by the numbers--this formula is easy!

Yield (Income + Capital Gains) x 100 divided by Original Price x Years Invested

If your investment is in stock, the income figure is the amount of dividends received. If your investment is in a deposit account or bond, it is the amount of interest received. If your investment is in real estate, the income is the amount of rent you received.

The capital gains figure is the amount you sell the investment for minus the amount you paid for it (original price). You multiply by 100 to get the percentage.

For example, suppose you had a share of stock that paid $3.80 per year in dividends. You bought the stock at $100 per share, and you sold the stock in one year for $110 per share. The yield (the return that you received on that share of stock for the year you held it) could be calculated this way:

Yield = [$3.80 + ($110 - $100)] x 100 divided by $100 x 1

= ($3.80 + $10) x 100 divided by $100

= 13.8 percent

Therefore, the stock had a yield of 13.8 percent. Notice that the current income yield is the percentage of the original price that was paid by the dividends. Income yield in this case was 3.8 percent. Capital gains yield is the percentage of the original price that is accounted for by the price changing from $100 to $110, the price at which you sold the stock. The capital gains yield in this example is 10 percent.

You can now compare this yield to yields from other investments. Realize, too, that it is possible for the capital gain, and therefore the yield, to be negative.

Risk. The other characteristic you will want to consider in selecting your investment is risk. Risk is the possibility that your actual return may be worse than you expected.

Money placed in some investment instruments is at little or no risk. When you purchase a certificate of deposit, for instance, you know exactly how much you will receive at the end of the holding period. Except for inflation or the chance that the bank may fail, there is no uncertainty connected with investing in a certificate of deposit.

Most investments, however, involve much more risk because you cannot be certain of the future value of the investment. Of course, if two investments offer the same return, you will select the investment with the greater certainty of return, or lower risk. That is why it is useful to understand the basics of risk.

The risk you take on when you select an investment can arise from a number of sources. The major sources of risk are:

• Business risk: the uncertainty associated with a company's profitability and its ability to pay its investors. Business risk is determined by management competence, changing costs, type of business, general economic conditions, and demographic shifts, to name a few factors.
• Interest rate risk: the uncertainty of return associated with the rising and falling of interest rates. Fixed-income investments are most affected by this type of risk, although all investments are somewhat affected.
• Inflation risk: the uncertainty of how the purchasing power of income will be reduced over a given period. This is usually measured by the Consumer Price Index, an index that measures the cost of goods and services for an average American family.
• Default risk: the possibility that the return received will be less than promised because the debt issuer cannot pay its financial obligations.
• Market risk: the uncertainty associated with changes in investor attitudes toward investing. For example, even if the financial condition of a firm was unchanged, unfavorable political or economic news could cause its price to fall rapidly because of investors' reactions.

There are sophisticated ways to measure the risk of an investment. Good sources of information concerning the risk of an investment you are considering are brokers and investment advisory services. Two well-known services are Value Line Investment Survey and Dailygraphs (William O'Neil & Co., Inc.). Of course, if you have a broker, you will want to check with him or her also.

The Trade-Off Between Risk and Return. The risk of an investment is directly related to its expected return. In general, if you want higher returns, you must be willing to accept greater risk.

This relationship may not hold exactly true over short periods of time, but over a long investment period, increased return means increased risk. Some types of risk can be offset by diversifying your portfolio--that is, by investing in different types of securities. You could own securities of companies in different industries, such as utilities, food processing companies, and health care companies.

Another way to diversify is to own different types of investments, such as stocks, bonds, and real estate. This strategy can reduce some risk because the higher returns of some of the investments make up for the lower returns of other investments.

However, you should realize that some risk cannot be avoided. Some types of risk result from forces that affect all investments, not just certain ones. For example, inflation, war, and international events are risks that cannot be avoided by diversification because they influence all types of investments.

Other Investment Considerations

As we have seen, risk-return trade-off and the benefits of diversification are critical considerations in putting together your investment plan. You should also think about four other factors affecting your investment:

• Liquidity
• Marketability
• Investment effort and expertise
• Taxes

Liquid assets are those that are easily turned into cash with little or no risk of principal loss. For example, checking accounts or money market mutual funds are liquid assets. Real estate or long-term bonds are not liquid because of the danger of taking a loss if you have to sell them to obtain quick cash.

Marketability means the ease or difficulty of selling an asset at its market value. Market value is the price a willing buyer would pay a willing seller if neither were under pressure to trade quickly. Stock in large, well-known corporations is marketable. Stock in a small family business is not usually marketable.

Investment effort and expertise is a factor that cannot be overlooked. Certain types of investments require little or no time commitment or special knowledge. Others, such as rental property, may require constant management. Consider care fully how much time you are willing and able to spend managing your investment. Take an honest look at your knowledge of investments. Then choose your investments accordingly.

Tax implications are another important consideration, especially if you are in a high tax bracket. To understand how the investment will be taxed, consult an accountant, tax attorney, or other tax professional before you invest.

Choosing an Investment Advisor

An investment advisor can play a large role in helping you design an investment program. Whether you should use an advisor depends on the size of your investment portfolio, whether you feel you can rely on your own research, and the amount of time you can devote to your investments. Realize, too, that there are several types of "advisors." You may wish to consult an investment broker if you have a large portfolio. On the other hand, investment newsletter advisors may suit your needs if your portfolio is smaller.

Investment brokers are salespeople who usually work within a brokerage firm. A full-service broker is a broker who provides investment advice, research reports, and investment ideas. A full-service broker may also make suggestions on how to arrange your portfolio to reach your goals.

Full-service brokers are paid by receiving a commission on the trades they make. More often than not, the larger, more active accounts receive the most attention from a full-service broker. However, good brokers will want to develop future business, so you may get more service if you intend to build a steady investment program.

A discount broker, unlike a full-service broker, does not offer investment advice. Instead, discount brokers earn a straight salary by placing your order. This saves you from having to pay a commission.

If you buy only a few shares or deal only in low-priced stocks, however, you probably will not save anything because of the minimum fees discount brokers charge.

If you are an inexperienced investor and feel you need advice, you may wish to stick with a full-service broker. Another alternative is to subscribe to an investment advisory newsletter for your investment ideas and then place your order with a discount broker.

Whether you select a full-service or discount broker, choose an advisor who shares your investment philosophy in terms of goals and risk tolerance. Compare fees. Consider the type of clientele the broker has. Does the broker deal mostly with clients who are similar to you in terms of age, income, and objectives? If you are nearing retirement, for example, you probably should think twice about an advisor who deals mainly with young, aggressive investors. Finally, consider whether your broker has considerable investing experience.

Bankers sometimes provide investment advice. Trust officers may provide advice to their customers, or a bank may have a special investment subsidiary that provides investment advice. This option may be more available if you have a large account.

Personal financial planners are another possible source of investment advice. Sometimes financial planners work for a bank, brokerage firm, or other financial services firm. Sometimes they may be independent consultants. Financial planners may work for a flat fee, or they may work on commission. Those who work on commission make most of their income by taking a commission from the sale of investments. "Fee-only" planners may be more expensive, but they have less to gain by selling you certain products.

Financial planners can assess your financial situation, help you set financial goals, and make broad investment recommendations. More specifically, a financial planner can provide you with your personal balance sheet, a projection of income taxes, a projection of cash flow, a life and health insurance analysis, and estate and tax planning.

Keep in mind, however, that while a financial planner can be of assistance, no one can be an expert in all aspects of such complex subjects as tax, insurance, and investments. Search for a Certified Financial Planner (CFP). That may not be a guarantee of good advice, but Certified Financial Planners must demonstrate a certain level of competence in financial planning in order to earn and maintain their certification. One way to obtain a referral to Certified Financial Planners in your area is to write to one of the professional organizations listed below.

Sources of Information on Investment Advisors

You may write to one of the following organizations:

Institute of Certified Financial Planners
3801 E. Florida Ave.
Denver, CO 80210-2571
(303) 759-4900

 

International Association for Financial Planning
5775 Glenridge Dr. NE
Atlanta, GA 30328
(404) 845-0011

Investment advisory newsletters are another source of investment advice. There are hundreds of investment newsletters on the market dealing with selection and timing of stock market investments. There are also newsletter rating services that help you decide which newsletter is best for you. One such rating service is the Hulbert Financial Digest. Go to your local library or the business library of a nearby college to get a listing of other investor newsletters and rating services.

Of course, a less expensive way to learn basic investing advice is through popular magazines such as Fortune, Business Weekly, Money, and Changing Times. This is a good place for a beginning investor to learn fundamental money-managing techniques.

Review

In summary, most experts advise that you have the cash equivalent of 2 to 6 months' salary in savings before you begin an investment program. There are several options for "storing" your cash, from deposit accounts in financial institutions to certain mutual funds to savings bonds. Once you begin investing, consider different types of investments to meet your objectives. Consider factors such as the return and the risk of each investment possibility. Realize, of course, that there is a trade-off between risk and return. Finally, consider choosing an investment advisor who best suits your needs.

This publication has given an overview of some basic points about savings and investments, but it is not a "how-to" manual. Your savings and investments are too important to take chances with. Seek professional assistance in planning and managing your savings and investments.

References

Currier, Chet. The Investor's Encyclopedia. New York: Franklin Watts, Inc., 1987.

Garman, E. Thomas and Raymond E. Forgue. Personal Finance. Third Ed. Boston: Houghton Mifflin Company, 1991.

Senchack, Andrew J. Smart Investing. Dallas: Taylor Publishing Company, 1987.

Stokes, Barrie Balzli, J. D. Personal consultation.

Trainer, Richard D., The Arithmetic of Interest Rates. New York: Federal Reserve Bank of New York, 1984.

What Every Investor Should Know. Washington, D.C.: Office of Public Affairs, U.S. Securities and Exchange Commission, 1986.

For more information, contact your county Extension office. Look in your telephone directory under your county's name to find the number.