What Investments Can I Buy?
Where shall we start? Let’s make certain we understand the basics of risk vs. reward, stocks and bonds, and certainly profits and losses.
The most sensible investments include savings accounts, bonds, stocks, mutual funds, and ETFs. There are certainly many more ways that some invest, including buying gold, silver, and other precious metals or commodities like corn or uranium. Other people buy rare dolls, toys, art, rare automobiles, baseball memorabilia or something else that they think will go up in value. We will focus on the sensible investments, not the ones with a lot of risk.
What is Volatility? Is it Risk?
Many different types of investments can behave differently during short periods of time. Most of the time, the present Covid-19 pandemic hysteria excluded, some investments are less likely to go up in value quickly or go down quickly. If a stock with little volatility is trading for $10 per share, you shouldn’t expect it to race up-and-down in price. One measurement for volatility is called beta. Beta is calculated using “regression analysis.” We don’t have to understand those fancy words or calculations to understand the value of beta. Some days my investments grow by $25,000 and other days they drop in value by more than $50,000 in total. It is interesting to watch, but the wise investor doesn’t make decisions based on today’s price increases or decreases.
What is Beta and why is it valuable?
The measurement called “beta” helps us know how volatile a stock’s price is in comparison to stocks in general. If a stock’s beta is greater than 1, it indicates a stock’s price swings more wildly than most stocks. If the beta is less than 1 the stock’s price is usually steadier than most stocks. If the beta is 1, it means the stock’s price moves much like the overall market. Some low-beta stocks are utilities and some high-beta stocks are technology companies. For example, SEDG currently has a beta of 1.32, TSLA beta is 1.20, NEE is 0.93 and TGT is 0.75. The solar company (SEDG) and the electric car company (TSLA) have more volatility in stock price. The utility (NEE) and Target have lower price fluctuations. If I buy shares of SEDG I shouldn’t be surprised by rapid up-and-down movement in the stock price for SEDG. That is beta.
We should be mindful of volatility, but not overly fearful about it. It means we might change how we buy or sell an investment. For example, if the stock price bounces around it is probably a good idea to buy shares using a buy limit order. You should set the price you are willing to pay. You don’t enter the order and hope to get a good price.
What about Risk?
The Bible shares wisdom about risks. Just about anything we do or don’t do has some risk. Riding a bike involves risk. Swimming in the ocean has risks. Climbing a ladder can be risky.
Risk is a different concern for investors. We know it is risky to walk across a freeway at night wearing black clothing. It is risky to text and drive a car. We should know it is risky and we could get hurt. Some investments are also very risky. If a company isn’t making a profit, but some investors think it might, the share prices could go up quickly. But the prices could also go down quickly, even all the way to $0 and bankruptcy. The long-term investor should focus on buying quality investments with reasonable risk. Then, in times of panic and great volatility, the wise investor just sits still and ignores the crazy price changes. It is, however, helpful to understand where we can see risk. Usually, large cap stocks like Disney should be less risky than a small company’s stock.
What are the Risks?
Types of investment risk include…
Market risk. The risk of investments declining in value because of economic developments or other events that affect the entire market.
Size risk. Generally, the smaller the company, the bigger the risk.
Asset class risk. Different investments have different risks. Most investors don’t just buy stocks. They also have bonds and some cash. Stocks, bonds, and cash are different asset classes. If you only buy bonds, you have risks unique to bonds.
Event risk. You can’t always know when this might happen. Examples include the coronavirus pandemic and the crash of more than one Boeing 737 passenger jet.
Political risk. If a law is passed that is harmful to an investment, the price of that investment could drop dramatically. For example, if a law is passed making it illegal to buy or own guns, the gun manufacturers would suffer. Also, different countries have different rules, so the risk can vary by country.
Liquidity risk. An investment is highly liquid if it is easy to sell it because there are a lot of buyers. If an investment is not in high demand, you face the risk of being unable to sell your investment at a fair price when you want to. To sell the investment, you might have to accept a much lower price.
Concentration risk. This risk is easy to avoid. You shouldn’t just buy companies located in the path of hurricanes. You don’t just buy stocks of cruise lines or donut makers. Wise investors spread the risk over different types of investments, industries and geographic locations.
Credit risk. This is being wise about buying investments in companies with too much debt. If a company cannot pay back the money they borrowed in good times when times get tough, they can go bankrupt.
Inflation risk. As mentioned in a previous lesson, it is good to have an emergency savings account. However, a savings account has a lot of inflation risk. The $100 you save today will probably be worth about $75 in several years. The spending power goes down. The candy bar I bought when I was ten years old for ten cents was much bigger than the $1.00 candy bar today.
Longevity risk. You might live longer than your investments last. However, if you are a wise steward and wise investor, you can minimize this risk.
Some links for more reading:
THINKADVISOR: Types of Investment Risk
GETSMARTERABOUTMONEY: Understanding Risk
Stocks and Bonds
Stocks give you ownership in a company. If you buy 100 shares of McDonald’s stock, you are an owner of a tiny piece of McDonald’s. You should see profit from French fries, burgers, soda and shakes. If you buy a bond, you aren’t an owner. You are a lender. A bond is a way to loan money to a company, like a bank or to a city like Detroit.
Many different types of companies offer bonds to investors. The value of the bond may go up and down, but you are generally going to receive a regular payment or income from the bond you buy. For example, I own a bond that is called “WISCONSIN ST HEALTH &EDL FACS AUTH REV.” The bond pays 3.25% until 12/01/2030 for BELLIN MEMORIAL HOSPITAL. Bellin Health is a health care service headquartered in Green Bay, Wisconsin. Bellin Health serves northeastern Wisconsin and the Upper Peninsula of Michigan. I hold the bond in my brokerage account because the income is not taxed by the IRS. The bond can be “called” which means the hospital could choose to pay back my $5,000 investment and stop paying me the 3.25% I currently receive.
Profits and Losses
Every investment should generate income and a profit. You can get income while you own an investment. This can be income from interest or dividends. The profit can come if you buy an investment for $100 and sell it for $500. If that happens, you make a profit of $400. If you buy an investment for $100 and sell it for $1, you have a loss of $99.
For investments like stocks, you can get income from dividends, but you can also gain income if you sell “covered calls” on stocks you own. If you sell a covered call, you get to keep the money from the sale, and you might get to keep your investment too. That type of trading will have to be covered in a future lesson. Like all investing, even trading options like covered calls has risk.
You should now understand the difference between volatility and risk. You should also realize that there are different types of investments you can buy from the same company: stocks and bonds.