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Investing and Mutual FundsResearch Paper

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Investing in the Future

The Importance of Investing

The financial planning process basically takes into account the different financial needs that a person expects to have in their life, and ensure that they are able to meet those needs. Sam is forty years old with two children aged 3 and 8. He wants to put them through college. He also wants to retire in 20 years at the age of 60. He claims to be putting $150/mo into a savings account, at 1% interest, but there is no record of how much money he actually has saved to this point. There is no information about whether he has equity in a home, what his income level is, what his risk preferences are, what happened to the mother of his children, what his parental situation is, or anything else. So in essence, we are flying almost completely blind with Sam, and do not actually know enough to make a recommendation for him.

What can be said is that investing is an important part of financial planning. The reason is simple -- most savings accounts pay less than the going rate of inflation. What that means is that the real return on a savings account is often negative. The current Fed funds rate range is between 0.25-0.50%, which means that Sam is earning a positive real return, but barely. The rate is expected to increase later this year, so that the real return might be negative by the end of the year (Dunsmuir & Saphir, 2016). Investing allows the investor to take on additional risk on the assumption that there will be additional return, above and beyond the risk free rate (Investopedia, 2016).

The superior returns that one expects from investing form an important part of the financial plan. They are essentially putting your own money to work for you, where you gain net worth on the basis not of your own labor but on the basis of what the companies in which you invest do. Investing allows the investor to not only build wealth, but to control the risk level of the portfolio, to control the timing of cash flows, and in many instances to reduce taxes as well. Thus, there are many benefits that come from investing.

There are many different products in which a person can invest. There are stocks, bonds, mutual funds, derivatives, and government securities. Each of these has its own unique risk profile, and therefore adds different value to the portfolio. A portfolio is just a collection of investments, and each investor has one. How the portfolio is structured depends on a variety of factors, but these should take into account the full range of circumstances that the investor has.

Buying and Selling Securities

The process of buying and selling securities is fairly straightforward, and it has actually become easier in recent years. Individuals are not allowed to buy directly in the market, and therefore must go through an intermediary. There are two options with this. The first option is to do-it-yourself, through a discount brokerage. The brokerage access the market on behalf of its clients, taking a small fee. For most investors, and by the sounds of it for Sam in particular, this is not the best approach. Typically, a financial planner or investment advisor will handle the trading for the client, because that is the person who also makes the recommendations with respect to what goes in the portfolio. The client talks the options over with the advisor, and then the advisor places the trade, again going through the financial services company that is the intermediary.

There will always be a transaction fee. Discount brokerages often charge minimal fees because their clients do all the work. An investment advisor or financial planner takes a much bigger fee on any given trade, to compensate for the advisory work that they do. But from the client's perspective, the fee is just the cost of doing business. Typically, the client's responsibilities will end there -- the order is placed and filled. The market works electronically, with bids and offers lined up via the market software. Trades at the market are usually filled instantly. Trades can also be done as limit orders, where the client sets the price at which they are willing to buy or sell, and the trade only is filled when the security hits that price.

Trades typically settle in three days, though this can vary depending on the type of security. The funds to cover the trade must be in the account at settlement, or the trade will be reversed. Somebody like Sam will likely not worry too much about that, as Sam probably will not be an active trader.

Stocks

Equities are generally considered to be risky investments. An equity is an investment in a company's future earnings. The value of the stock is theoretically related to the expectation that the market has with respect to those future earnings. Stock value can also reflected expected future dividends. Equity shareholders are typically paid out only after the creditors of a company, which means that equity has more risk than debt. As such, the principle is that equity should have a higher return, on average, than debt. It is important to remember when investing in equities, however, that higher risk does not mean higher return. What it means is higher volatility of returns. A risky stock moves up and down more strongly than the general market, and the investor needs to account for that when thinking about what companies to buy into.

The investor needs to consider several factors when thinking about what stocks to buy. We know almost nothing about Sam. What we do know is that he might not have much money in the bank, and that he cannot afford to put much money aside either. He is presently only putting aside $1,800 per year. This will never get him to pay for his children's education, and will not do a whole lot for his retirement. But as his first child is ten years away from college, we at least know that his time frame is a minimum of ten years out. At any rate, we don't know nearly enough about Sam to actually pick stocks for him. The reality is this. We don't know much money Sam has set aside. An investor in Sam's position should have a diversified portfolio. If he doesn't have much money set aside -- and it doesn't sound like he does -- then he will not be able to achieve an acceptable amount of diversification without incurring steep transaction costs. Only if he does it himself with a discount brokerage would he be able to keep transaction costs low enough to invest in a handful of stocks. But then, if that's his choice, I will not help him pick the stocks for free. Working with an investment advisor, Sam will pay the appropriate fees, and to get a diversified portfolio will require a mutual fund.

The first thing to consider for Sam with respect to equity is the risk of the security. This is the beta. The beta reflects the volatility of the stock price, versus the overall market. In theory, over time a company with a higher beta should have a higher return, but Sam has to be willing to accept the risk associated with that. His risk tolerance and time horizon, as well as his present financial condition, will tell a lot about how much risk he is willing to take on.

The second thing to consider is the dividends. Some stocks are useful because they pay back dividends. Most companies prefer to avoid cutting dividends as that is a bad look, so only the most stable companies pay them out. But they are good for an investor, because they can be relied upon as part of the income stream for a client. Dividends also matter because they are taxed differently than capital gains, and because Sam needs some of this money before retirement he has to consider the potential tax implications of his transactions.

The third thing to consider is the leverage that the company has. Sam should not be focused on companies with a high degree of leverage because those companies are riskier. If the economy tanks in the next ten years, Sam will be unable to send his oldest to school. He needs stocks that project as being reliable, and in part that means companies that do not have too much leverage, but rather that have room to increase their leverage if need be.

Advantages and Disadvantages

Stocks are among the riskiest of investments. A key advantage is that they can have the biggest upside potential, but that is countered by the reality that they have the biggest downside potential as well. Further, stocks are expensive to trade, which is a disadvantage if Sam intends to trade frequently. They are not diversified by themselves, either. Another advantage of stocks is that the… [END OF PREVIEW]

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