Investment Options

Let’s say that you have $1,000 in your hands right now, and that you would like to invest it so that it will earn a reasonable rate of return and grow over the next 10 years. Perhaps this $1,000 is a gift you received from your parents that is intended to help your 8 year old son go to college when he is 18. Here is a list of possible investing options — certainly not an exhaustively complete list, but a list of the most common options:

• Your checking account
• A normal passbook savings account at a bank
• A money market account
• A CD
• A U.S. savings bond
• A corporate or municipal bond
• A bond mutual fund
• Stock in some company, like IBM or GM
• A stock mutual fund

That is a lot of options. If you are just starting out, it is a bewildering array of options. The following sections describe, in English, the attributes, advantages and disadvantages of each of these investments. As I write this, today is June 30, 1996. All of the numbers I quote are based on the rates available today.

Your checking account

Even if none of the other options feel comfortable to you right now, you should have a reasonable understanding of how your checking account works. And you know that you could deposit the $1,000 into your checking account and leave it there for 10 years. You also know the advantages and disadvantages of doing this. The advantage is that the money is incredibly easy to access. It is, in other words, liquid. You can instantly withdraw the money by writing a check, or by visiting an ATM. In many cases the extreme liquidity of a checking account is important. For example, when you pay a bill you want extreme liquidity. However, the disadvantage of this sort of liquidity is that, on most checking accounts, you earn nothing in return. In fact, you may actually lose money over time because of fees. Therefore, a checking account is probably not an appropriate place to place junior’s college fund.

A normal passbook savings account at a bank

A normal bank savings account is almost as good as a checking account in terms of liquidity (for example, you can normally withdraw the money at an ATM), but almost as bad as a checking account in terms of return. Today bank savings accounts average a 2.7% return. Therefore, your $1,000 will earn $27 in a year. Unfortunately inflation is running at perhaps 3.3% right now, so you are actually losing money (a year from now it will cost $1,033 to buy what it costs $1,000 to buy today if the rate of inflation is 3.3% — knowing that, you can see why having only $1,027 in your savings account a year from now is actually losing money). In addition, you have to pay income taxes on the $27 earned, so it is really worth only $20 or so (depending on your tax bracket).

A savings account might be a good place to park money that you wish to accumulate over a very short period of time. For example, you might accumulate cash to cover your hidden expenses in a savings account simply because it is easy to transfer money between a savings and checking account (and because some interest income is better than none). However, it is not a good place to put money that you are planning to hold for 10 years.

A money market account

A money market account at most banks works approximately like a savings account, but it gets a better rate of return. In addition there might be a few restrictions on a money market account, like a minimum balance or a maximum number of withdrawals per year. A money market account has the same advantages and disadvantages of a savings account. Current money market rates average 4%. For money that you plan to hold for a short period of time (three months to a year) and that needs to be liquid, a money market account is probably your best bet.

A CD

A CD, or Certificate of Deposit, is a bank account that earns a better rate in return for a fixed time commitment on your part. You deposit money into the account and receive a certificate that allows you to withdraw the money at some later date. You can get six month CDs, one year CDs, five year CDs and so on. The rate normally rises with the length of the time commitment. If for some reason you need to withdraw the money early, the bank officer will look at you sternly and generally penalize you by withhold all or part of the interest you would have earned.

Certificates of deposit have several advantages. First and foremost, they are absolutely secure if they are held by an FDIC-insured bank and the account balance falls within the $100,000 limit. It is impossible to lose the money. They also pay a fairly reasonable rate of return that exceeds the inflation rate. Typical rates today for a one year CD are 5%. However, there are two disadvantages. First, they are not very liquid, so they are not good for money that you may need to use on a moment’s notice. Also, they represent only a holding action — you generally do not make any money off a CD. Here’s why: the current rate of return is 5%, and the inflation rate is 3.3%. Therefore, the real return rate is 1.7%. However, you must pay taxes on the money that the CD earns each year. The taxes essentially nullify the 1.7%. Therefore, the real rate of return from a CD is zero, and this is true almost always. If you are absolutely certain that you cannot afford to lose the money, then a CD may be the best place to put it. However, the money will not grow.

A U.S. savings bond

A U.S. savings has many of the same attributes as a CD. You deposit the money for a fixed period of time and earn a rate of return that is on the order of 4.5%. The most typical bond — a series EE bond — must be held for at least five years to earn this rate, but you can hold it for any length of time beyond five years and continue to earn that rate.

A savings bond has one advantage over a five year CD: You do not have to pay state income taxes on the interest. Also, if used to pay college tuition, you may not have to pay any federal taxes on the interest either (see your bank for details or call 1-800-USBONDS). Therefore, you can actually earn money with a savings bond. Savings bonds are also absolutely secure, like a CD. They share the same disadvantages as a CD as well: low liquidity, penalties for early withdrawal, and a relatively low rate of return.

A corporate or municipal bond

A corporate or municipal bond represents a loan. The corporation or municipality needs money for some project — a new factory, a new school, whatever — and issues bonds to raise the money. The corporation or municipality then pays interest on the money over time at some rate. The rate of interest depends on the prevailing interest rates at the time of issue, as well as the stability of the entity issuing the bond. A bond issued by IBM, for example, will have a lower interest rate than a bond issued by a two year old small company. You may have heard the term junk bond — it refers to bonds issued by riskier corporations.

Municipal bonds generally have some sort of tax advantage. For example, you may not have to pay state or federal taxes on municipal bond interest. Therefore, municipal bond rates are generally slightly lower to reflect this advantage.

You could use your $1,000 to purchase a 10 year corporate or municipal bond. The advantage (and the only reason you would buy this sort of bond as opposed to a U.S. savings bond, given a choice) would be a higher rate of return. However, be sure that you take the tax consequences into account when calculating the return on a bond. If you are spending the $1,000 on college tuition, then a U.S. savings bond may have a better rate of return. Ask your bank (or call 1-800-USBONDS) for details. The disadvantages of corporate and municipal bonds make them less suitable for small investors. The disadvantages include:

• Risk — If the corporation or municipality has problems, then the bond may become worthless. Most municipal bonds are considered to be safe, but then Orange County, CA had its problems and put at risk thousands of bond holders. Corporations can also have problems, as IBM did several years ago.
• Lack of liquidity — A bond has a fixed time period attached to it. If you want your money prior to the end of that time period, your only choice is to sell the bond to someone else on the bond market. You will have to pay a broker a commission to do this. Also, your bond will return more or less than it is worth depending on the change in interest rates. If interest rates have gone down since you purchased your bond, you will make money. If rates have gone up you will lose money. Here is an example to help you understand why. Let’s say that you buy a bond for $1,000 from your county, and the bond is written such that it promises to pay you $2000 at the end of 10 years in one lump sum. At the time you purchase the bond CD interest rates are at 8%. After 5 years, CD interest rates have fallen to 6% and you try to sell your bond. Someone might be willing to pay you $1,600 for the bond (which is more than you would expect). The person knows that in five more years the bond will pay out $2,000 and if the $1,600 were invested in a CD today it would only return 6% (as opposed to the 8% rate that was in effect when the bond was written). A bond therefore acts like a time machine, in a way, allowing investors to move back in time to a different interest rate.

A 10 year bond issued by a stable company or municipality might not be a bad way to invest $1,000, but the liquidity problem can make things difficult. Also, if you expect interest rates to rise over time a bond might not be the best place to put the money.

A bond mutual fund

A bond mutual fund is simply a collection of bonds (generally of a certain type, like low-risk corporate bonds, or NY municipal bonds) owned by a pool of people. The fund lowers risk by holding a collection of bonds. If one company goes bad, it will have a low effect on the overall pool of bonds held by the fund. A bond fund will generally pay interest every month. Also, the value of fund shares will rise and fall each day depending on the rise and fall of interest rates.

Bond funds have the advantage of liquidity. You can sell your shares any time and get out. However, your share value will change every day — share value goes up when interest rates fall, and down when rates rise. Therefore, if you think interest rates are going to rise over 10 years you may want to take that fact into account before purchasing a bond fund.

Stock in some company, like IBM or GM

Stock represents ownership of a company, and that is all that it is. It is easiest to understand how stock works, and what it means, by looking at a simple example.

Let’s say that you decide you want to start a business, and therefore you decide to open a restaurant. You go out and buy a building, buy all the kitchen equipment, tables and chairs that you need, buy your supplies and hire a cook, waitresses, bus boys, etc. You advertise and open your doors. Let’s say that you spend $300,000 on the building and the equipment, and that every year you spend $100,000 on supplies and pay roll. At the end of your first year you have paid out the $100,000 for expenses but actually earned $125,000. Your net profit is $25,000. However, at the end of the second year you bring in $140,000, for a net profit of $40,000. At this point you decide that you want to sell the business. What is it worth?

One way to look at it is to say that the business is worth $300,000. You could sell the building, the equipment, etc. and get $300,000. This is a simplification, of course — the building probably went up in value, and the equipment went down because it is now used. Say things balance out to $300,000. This is the asset value of the business — the value of all of the business assets if you sold them outright today.

However, this business is a going concern. That is, if you keep it going it will probably make at least $40,000 this year. Therefore you can think of the restaurant as an investment that will pay out $40,000 in interest every year. Looking at it that way, I might be willing to pay $400,000 for it. A $40,000 return per year on a $400,000 investment represents a 10% rate of return. I might be even be willing to pay $500,000, which represents an 8% rate of return, or even more, if I thought that the restaurant’s client base will grow and increase earnings over time at a rate faster than the rate of inflation.

If I am the restaurant’s owner, I therefore will set my price accordingly. What if 10 people come to me and say, wow, I would like to buy your restaurant but I don’t have $500,000. Then I might sell shares in the restaurant. That is, I might divide ownership of the restaurant up into 10 pieces, or shares, and sell one share to each person for $50,000. Then each person would receive one tenth of the profits at the end of the year, and have one out of 10 votes in any business decisions. Or I might divide ownership up into 1,000 shares, and sell each one for $500. Or I might divide ownership up into 2,000 shares, keep 1,000 for myself, and sell the remaining shares for $250 each. That way I retain a majority of the shares and retain control of the restaurant, while sharing the profit with other people. In the meantime, I get to put $250,000 in the bank when I sell the 1,000 shares to other people.

That is all stock is. It represents ownership of a company’s assets and profits. A dividend on a share of stock represents that share’s portion of the company’s profits, generally dispersed yearly. A large company like IBM has millions of shares of stock outstanding (540 million, to be exact). One measure of the value of the company, at least to investors, is the product of the number of outstanding shares multiplied by the share price.

Stocks are bought and sold at a stock market like the New York Stock Exchange. The NYSE can be thought of as a big room where everyone who wants to buy and sell shares of stocks can go to do their buying and selling. The exchange makes buying and selling easy. If the exchange did not exist, you would have to place a classified ad in the paper, wait for a call, haggle on a price, etc. whenever you wanted to sell stock. With an exchange in place you can buy and sell shares instantly.

The exchange has an interesting side effect. It allows the price of a stock to be fixed every second of the day. Therefore, the price fluctuates based on news from the company, media reports, national economic news, etc. Buyers and sellers take all of these factors into account each day. So, for example, when the FAA shut down ValuJet for a month in June 1996, the value of the stock plummeted. Investors could not be sure that the airline represented a going concern and began selling, driving the price down. The asset value of the company acted as a floor on the share price. The price of the stock also reflects the dividend that the stock pays, the projected earnings of the company in the future, the price of tea in china (especially Lipton stock), and so on.

Should you invest your $1,000 in an individual stock? Perhaps not, for two reasons:

• You have to pay a commission when you buy and sell a stock on the exchange. The commission might be $50 at both ends. That $100 represents 10% of the $1,000, and therefore is probably too high. However, if you know a stock will go up 200% over 10 years you might be willing to take the 10% hit.
• Stocks carry risk. If the company has problems then you can lose part or all of the money you invest. You can eliminate some of the risk by investing in blue chip companies like IBM, GM, Disney, etc. — companies with long successful track records. However, IBM is a good example of what can go wrong. Several years ago it’s share price fell by more than half when the company had problems. Later it came back. But if you had purchased IBM stock when it was high and needed to sell it when it was low you would have lost a lot of money.

Stocks have several advantages over other investments, especially if you buy stock in more than one company (a collection of stocks purchased from several companies is called a portfolio ). Portfolios lower the risk by spreading your money over a number of companies. Also, you pay taxes on stocks only when you sell them. Therefore, if you buy a stock, hold it 10 years, and it goes up 100% in that time, you will pay tax on that capital gain only once. The capital gain represents the money you made on the difference in the buy and sell price. You do not have to pay taxes on that capital gain each year, but instead only in the year that you sell the stock. This is different from a savings account or a CD. In these accounts, you pay taxes every year on the interest you earn. So imagine a savings account earns, say, $27 in a year. You then pay the tax and net only $20. Next year, you earn interest on $1,020 instead of $1,027. That sounds like small potatoes, but if you multiply the numbers by 10 or 100 and then do it for 10 or 20 years, the difference that tax-deferred compounding can make is startling. Capital gains on stocks represent a form of tax-deferred compounding.

You can use the Taxed and Non-taxed Compounding Calculator to help you calculate how much an initial investment of $1,000 (or any other amount) will grow in both taxed and tax-free accounts. It will also help you learn about the effects of inflation. (To run this calculator you will need a web browser that understands JavaScript. The later versions of NetScape, the MS Internet Explorer, etc. all do)

A stock mutual fund

If you are just getting into investing and have a small amount of money to invest (like $1,000), then stock mutual funds represent a possible place to put money being invested for more than 5 years. A stock mutual fund is simply a pool of stocks owned by a group of investors. A big mutual fund might have 100,000 investors and might own stock in 100 different companies. The risk is lower because of the large portfolio of stocks, and the transaction fees are no longer a concern of the individual investors.

Stock mutual funds have the same disadvantages as stocks. If the economy has a problem, then you can lose money. However, if the economy does well the returns can be relatively high. Many studies have shown that, on average, the stock market returns an average of 10% or so per year if you leave money in it for long periods of time. That 10% return includes market crashes. Even when the market crashes, if you can leave the money alone it will, over time, earn roughly 10%. The problem is that you may have to leave the money alone for many years, say five or 10, to get the 10% return.

This is why stocks are said to be less liquid than other investments. If the stock market is rising, then money in the stock market is very liquid. You can sell your stocks at any time and make a profit. But when the market falls you want to leave your money in the market so it can recover. This makes your money unliquid. Since you cannot predict the rising and falling of the market, you cannot count on the liquidity of your investment. You can sell your shares at any time on the exchange, but you will lose money if you are forced to sell when the market is low.

Thus stocks and stock mutual funds are thought by many experts to represent a great place to put retirement money, because this money is being invested for long periods of time. A book like The Wealthy Barber spends a great deal of time talking about the advantages of mutual fund investing. Stocks are probably a bad place to put money that you need a year from now, because you simply do not know what the market will do over that short a time frame.

Stock mutual funds come in two forms: load and no load. Load funds charge a fee when you purchase shares of the fund. No loads do not. For a beginning investor you will probably want to choose no load funds.

Stock mutual funds also invest their money differently depending on their charter. You can discover the exact investment mix by looking at the prospectus of the fund. The prospectus will tell you what types of companies the fund invests in, what its rate of return has been through the years, and exactly what stocks it holds at the moment. There are several general categories of stock mutual funds:

• Income funds — These funds invest generally in larger, safer companies that pay dividends regularly. Therefore you can rely on the dividend income each year.
• Growth funds — These funds invest in companies that the fund manager expects will grow, in terms of share price, over the years.
• Aggressive Growth funds — These funds invest in smaller companies. When a small company succeeds its share price has the potential of growing rapidly. However, small companies have a higher potential for failure. Therefore, aggressive growth funds tend to be more volatile (their share prices rise and fall more frequently and drastically than other funds). However, the returns over the long haul should be greater if the economy in general is doing well.
• Index funds — These funds invest in some fixed set of stocks and do not play the market. For example, a fund might be tied to the stocks represented by the S&P 500. A common question here would be what is the S&P 500? or what is the Dow Jones Industrial Average? These are indexes. The DJIA is made up of 30 large companies. Each day the share prices of these 30 stocks are averaged to produce a single number, and as that number rises and falls each day it tells you something about the market in general. The S&P 500 is made up of 500 large companies, which are also averaged to produce a single number. Click here to see a list of many of the different indexes that are available. An index fund invests in the stocks of a particular index, so that the fund value rises and falls is exact correspondence with the index. Usually index funds have lower fees, and you know exactly where they stand each day because indexes are widely publicized on the radio and TV.
• Foreign funds — These funds invest in stocks in foreign stock markets.

Funds are broken up into fund families. For example, Vanguard is a large fund family with many different mutual funds that it manages. Each fund in the family has a different personality because it invests in different types of companies. Vanguard funds are generally no load. Fidelity is a large load fund family.

Making investment decisions

So, let’s return to the original question: Where should you invest $1,000 that is needed 10 years from now for college tuition expenses? The answer to this question will depend on your risk tolerance. If you absolutely want a guaranteed rate of return, and if you will lose sleep at night if, 10 years from now, you lost all or part of the $1,000 your parents gave you, then a good place to put the money is in a CD or a U.S. Savings bond. Choose whichever one will have a better rate of return after taking the tax consequences into account.

If you are willing to take a risk that you might lose money, in return for the possibility of a much better rate of return, then you can consider putting the money into a no-load stock mutual fund. The next article in this series discusses exactly how you would go about doing this.

• Go to the next article in the series
• Go to the series Introduction

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