Joan Koonce, Ph.D., AFC® Extension Financial Planning Specialist

Joan Koonce, Ph.D., AFC® Extension Financial Planning Specialist
Investments Joan Koonce, Ph.D., AFC® Extension Financial Planning Specialist

Investment Terminology and Concepts
What is Investing? Investing is putting your money into an asset that generates a rate of return. Some examples of investments are stocks, bonds, mutual funds, and real estate.

Investment Income Income that you receive from the investment while you have it from bonds you receive interest from stocks you receive dividends from real estate you receive rent

Capital Gain or Loss Profit or loss received when you sell an investment that has increased or decreased in value

Rate of Return Total return (investment income and capital gains) generated from an investment stated in percentage terms Investment Risk Uncertainty that an investment will not perform as expected There are several different types of risk. Some of which we will explore on the next slide. Every investment carries some type of risk. Some risk can be reduced or eliminated through diversification, but others can’t. Those risks that can’t be diversified away are the risks we are rewarded for accepting.

Types of Risk Interest rate risk Inflation (purchasing power) risk Financial (default) risk Liquidity risk Business risk Market risk Interest rate risk is the risk the investment’s value will fluctuate in response to changes in interest rates. For example, when interest rates increase, bond prices decrease and when interest rates decrease, bond prices, increase. Inflation risk is the risk that the return earned on an investment does not keep up with the rate of inflation. Financial (default) risk is the risk that the company that issued you a bond may not be able to pay the annual interest or repay the principal you loaned to them at the maturity date. Liquidity risk is the risk that you are unable to convert your asset to cash quickly without a capital loss. Business risk is the risk associated with poor company management or product acceptance in the marketplace. Market risk is the risk associated with the swings in the overall market for similar types of investments. Market risk is usually caused by economic, social, political and market conditions. Financial risk, liquidity risk and business risk can be diversified away, but the others can’t. For example, to reduce financial risk, you can reduce the number of lending investments in your investment portfolio and invest in fewer companies that finance their operations with the use of debt. To reduce liquidity risk, you can invest in assets that have greater liquidity.

Risk Capacity The amount of risk you can afford to accept Risk Tolerance The amount of risk you feel comfortable accepting Risk capacity and risk tolerance don’t always go hand in hand. You may be very risk tolerant, but have a low risk capacity or your level of risk tolerance may be low, while your risk capacity is high. That is why both of these should be taken into consideration when determining the amount of risk you can and want to accept.

What is your “risk” personality?

Diversification Investing in several different types of securities in an effort to reduce overall risk in your investment portfolio Dollar-Cost Averaging Investing an equal amount of money regularly regardless of the investment’s price Diversification reduces risk, but it also reduces return. Dollar-cost averaging allows you to purchase more shares when the price per share is low than when the price per share is high. Thus, it reduces the average cost per share over a period of time.

Asset Allocation Allocating proportions of your investment portfolio to different categories of assets Leverage Using borrowed money to make an investment Time Horizon The period of time before you will need the money you invested Asset allocation is a way of diversifying your portfolio. However, the proportions are usually maintained over a period of time. For example, your investment portfolio may consist of 70% stock or stock mutual funds, 25% bonds or bond mutual funds and 5% percent cash. The proportions in each investment class could be further broken down. For example, the 70% stock proportion could be broken down into 40% aggressive growth stock, 20% income stock and 10% international stock. Most people borrow money to invest in real estate outright because the price is so high. Some people also borrow money to invest in stocks. This is called buying margin buying. Time horizon can be short or long depending on your goals. Your time horizon is important because it helps to determine the types of assets you should have in your investment portfolio. Your investments should be matched with your time frame for achieving your goals. For example, if you will need your money in a couple of years, you should not invest in growth stock. Growth investments are designed to be held over a long period of time (greater than 5 years) in an effort to produce substantial capital gains.

Types of Investments Ownership investments (Equity) Stock Real estate Lending investments (Debt) Bonds When you purchase shares of stock and real estate, you own the investment or a portion of the investment. Ownership investments are also referred to as equity investments. When you invest in bonds, you are a creditor of the company. You have made a loan to the company, but you have no ownership rights. Lending investments are also referred to as debt investments.

What are Stocks? Stocks are shares of ownership in a company. Stock represents a claim on the company's assets and earnings.

What Does Stock Ownership Mean?
Voting Rights Owning shares in Home Depot does not mean you can go help yourself to free home improvement or other building materials! Ownership gives you voting rights. You have a say in how the company is run only through these voting rights. You get one vote per share to elect the Board of Directors to represent you at meetings and for any other issues shareholders are allowed to vote on.

Buying Stocks Brokers DRIPs & DSPPs or DIPs
Dividend Reinvestment Plans (DRIPs) and Direct Stock Purchase Plans (DSPPs) or Direct Investment Plans (DIPs) are plans with which individual companies for a minimal cost, allow shareholders to purchase stock directly from the company. There are two different types of brokers. Discount brokers primarily buy and sell securities for their clients. In addition to buying and selling securities for their clients, full service brokers provide a range of services for their clients including personal investment advice. Today, instead of using discount brokers, many people are using the internet to invest. There are many online brokerage firms such as E-Trade where people can buy and sell securities for a small fee. In addition, people who already own stock in a company are using dividend reinvestment plans (DRIPs) and direct stock purchase plans (DSPPs) or direct investment plans (DIPs) to purchase additional shares of stock in the company. Not all companies offer DRIPs and DSPPs or DIPs. One advantage of these plans is the automatic investing of dividends. One disadvantage of these plans is lack of diversification. The money is being invested in the stock of the same company. Having plans with several companies can increase diversification.

Why Consider Stocks? Stocks can provide investors with dividends and capital gains. Over time, common stocks outperform all other investments. Stocks are somewhat liquid. Growth of your investment is determined by more than just interest rates.

General Classifications of Stock
Blue-Chip Stocks Growth Stocks Income Stocks Speculative Stocks Cyclical Stocks Defensive Stocks Large-Cap, Mid-Cap, Small-Cap and Micro-Cap Stocks Blue-Chip Stocks Stock issued by large well-known companies Normally have sound financial histories Normally have solid dividend and growth records Examples: General Electric, Texaco and Proctor & Gamble Growth Stocks Stock issued by companies whose sales and earnings growth have outpaced the market Often are newly formed, smaller companies Example: Microsoft Income Stocks Stock issued by mature firms that normally pay high dividends Usually have low growth rates Examples: Utility companies Speculative Stocks Stock issued by higher risk companies Some are associated with huge capital gains and losses Examples: Companies with new innovations or technology stocks Cyclical Stocks Stock issued by companies whose earnings tend to follow the economy Examples: Ford and General Motors Defensive Stocks Issued by companies whose earnings tend to move inversely to the larger economy and may actually increase during economic downturns Examples: Manufacturers or sellers of repair parts Large-Cap, Mid-Cap and Small-Cap Stocks Classification of stock based on the size of the company Large-Cap: $5 billion or more in assets Mid-Cap: $1-$5 billion in assets Small-Cap: $100 million-$1 billion in assets Micro-Cap: $100 million or less

What are Bonds? Similar to an I.O.U. When you purchase a bond, you are making a loan to a corporation, local, state or federal government, federal government agency or other entity known as the issuer. The issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal when it “matures,” or comes due.

Bonds produce steady current income.
Why Consider Bonds? Bonds produce steady current income. Bonds can be a safe investment if held to maturity. When you invest in bonds, you receive interest either annually or semi-annually throughout the life of the bond. When the bond matures, you receive the money you loaned to the entity back.

Basic Bond Terminology and Features
Face Value: the amount you loan (principal) and is returned to you at maturity Coupon Rate: the annual interest rate that is paid over the life of the bond Maturity date: the date the investor receives the principal back Bonds are usually purchased in denominations of $1,000. Meaning the amount you loan or the face value of the bond is $1,000. The coupon rate (interest rate) remains the same throughout the period you hold the bond. Assuming you purchased one 30-year bond with a $1,000 face value and a coupon rate (interest rate) of 10%, you would receive $100 per year for 30 years. If the interest is received semi-annually, you will receive $50 semi-annually. At the end of the 30 year period (maturity date), you will receive your $1,000 back.

Types of Bonds Corporate Bonds Municipal Bonds
Treasury Bills, Notes, Bonds and Treasury Inflation-Protected Securities (TIPS) Corporate bonds are issued by companies and have the highest default risk. Municipal bonds are issued by the local and state government. The interest earned on municipal bonds is exempt from federal income taxes. If the bonds are purchased in the state in which you reside, they are also exempt from state and local income taxes. Municipal bonds have higher default risk than treasury securities. Treasury bills, notes, bonds and TIPS are offered by the federal government and have the lowest default risk. The interest earned on treasury securities is exempt from state income taxes. Treasury bills are short-term securities with maturities ranging from a few days to 26 weeks. Bills are sold at a discount from their face value. Treasury notes are securities that are issued with maturities of 2, 5 and 10 years and pay interest semi-annually. Treasury bonds are issued with maturities of 30 years and pay interest semi-annually. Treasury Inflation-Protected Securities (TIPS) are marketable securities whose principal is adjusted by changes in the Consumer Price Index. Interest is paid semi-annually on the adjusted principal.

Bond Ratings Generally ratings run from AAA or aaa for the safest to D for the extremely risky. Ratings categorize bonds by default risk. Rating Companies Standard & Poor’s Moody’s Fitch Corporate bonds and municipal bonds are rated for default risk. U.S. government (Treasury) securities are considered default risk free. Bonds with lower ratings pay higher interest because the investor is accepting a higher degree of default risk.

What are Mutual Funds? An investment company that pools money from investors to buy stocks, bonds, and other investments. Investors own shares of the fund proportionate to the amount of their investment.

Why Invest in Mutual Funds?
Benefits the Small Investor Mutual funds allow people with a limited amount of money the opportunity to invest and purchase enough investments to have a fully diversified investment portfolio.

Advantages of Mutual Fund Investing
Diversification Professional Management Minimal Transaction Costs Liquidity Flexibility Service Mutual funds provide investors with diversification. Fund assets are invested in a variety of different companies. It is important to examine the assets held by the fund to make sure that diversification does exists. Mutual funds have a person who professionally manages the assets in the fund. It is important to examine the track record of this person when deciding whether or not to invest in a particular fund. Some mutual funds have sales charges when you buy and/or sell shares in a mutual fund. These funds are called load funds. According to the Security and Exchange Commission (SEC), these loads can’t be greater than 8.5%, but most funds have a sales charge lower than the 8.5%. Normally, if you have the interest, dividends and capital gains that you earn in your funds automatically reinvested, you are not charged to reinvest this money. In addition, some funds do not have loads. These are called no-load funds. Mutual funds are fairly liquid as you can redeem your shares fairly easily. Depending on the fund, a request can be made via the internet, phone, mail, fax, etc. Once the request is made to the fund, they have 7 business days to liquidate the shares and give you the money. Most funds will not take that long. The number of shares redeemed will be based on the amount of money you are requesting and the share price at the time of the request. Mutual funds provide their investors with flexibility and many services. It is easy to buy and sell shares. You can automatically invest money regularly and reinvest earnings. You normally have switching privileges within a mutual fund family. For example, if you own shares in JCK Growth Fund, you can switch some or all of these shares for shares in JCK Income Fund at no cost. Mutual funds also have withdrawal plans that allow investors to systematically withdraw money.

Disadvantages of Mutual Fund Investing
Lower Than Market Performance Costs Loads Management fees 12b-1 fees Capital Gains Distributions Based on statistics mutual funds typically have lower performance than the S&P 500 stock index. Although there are some funds with no-loads, some mutual funds have front-end or back-end loads. Mutual funds with front-end loads charge a sales commission to the investor when purchasing fund shares. Mutual funds with back-end loads charge a sales commission to the investor when selling the shares; may be a sliding scale that decreases over time. No-load mutual funds charge no sales commission at all. Because these funds are professionally managed, investors are also charged a management fee. The 12b-1 fees paid by investors cover the marketing and distribution expenses. Because mutual fund managers buy and sell shares in the funds, investors can have capital gains distributions even when they do not sell their shares. These capital gains distributions are taxable income to the investor even though they did not receive them.

Types and Objectives of Mutual Funds
Money Market Mutual Funds Stock Mutual Funds Aggressive growth funds Small company growth funds Growth funds Growth and income funds Sector funds Index funds International funds Money market mutual funds Invest in short-term securities with maturities of less than 30 days. These include Treasury bills, short-term CDs, etc. Work much like an interest-bearing checking account with some limitations There are some tax exempt money market mutual funds. These funds invest in short term municipal debt. Returns are exempt from federal taxes. Stock mutual funds Aggressive growth funds tend to go for stocks whose prices rise dramatically with small dividends. Small company growth funds limit investment to small companies. Growth funds pay attention to strong firms that may not pay large dividends. Growth and income funds provide a steady stream of income in addition to the increase in value of the stock. Sector funds invest in securities from a specific industry. Index funds are tied to an index (invest in companies that are represented in a particular index), such as S and P 500. International funds have a certain percent of their assets in companies outside the U.S.

Types and Objectives of Mutual Funds
Balanced Mutual Funds Asset Allocation Funds Life-Cycle Funds Bond Funds Balanced mutual funds Try to balance objectives of long-term growth, income, and preservation of the money invested Invest in common stock, preferred stock, and bonds Less volatile than stock funds Asset allocation mutual funds Are similar to balanced mutual funds in the mix of securities Assets are rebalanced to maintain a certain proportion of assets in each category High turnover rate and associated transaction costs Life-cycle mutual funds Similar to asset allocation funds Tailor holdings to best meet the needs of investors in a certain stage of the life cycle, such as age or risk tolerance Bond mutual funds Allows small investors to buy shares in a diversified bond portfolio More liquid than individual bonds Provide regular income

Investing for Emergencies
Savings Accounts Money Market Accounts Money Market Mutual Funds Short-term Certificates of Deposit Money set aside for emergencies should be put into accounts that are relatively safe from loss of the money invested and fairly liquid. It is important that you be able to have ready access to your money in the event of an emergency. These type of accounts do not earn a huge rate of return and have a high degree of inflation (purchasing power) risk.

Investing for Education
Qualified Tuition Plans (QTPs or 529 Plans) Prepaid Tuition Plans Savings Plans Coverdell Education Savings Account (ESA) Series EE Savings Bonds Traditional IRA Roth IRA Qualified tuition plans (QTPs or 529 plans) There are many ways you can invest for your children’s education. The benefits of qualified tuition plans (also called 529 plans) are tax-deferred growth, withdrawals to pay for qualified educational expenses are excludible from gross income, the assets are removed from the estate of the owner, low costs (management fees and commissions), state tax deductions for contributions in some states and control of the account by the owner. The owner can change the beneficiary and controls the withdrawals from the plan. If the money is not used to pay for qualified educational expenses, the owner pays federal income taxes and a 10 percent tax penalty on the earnings that are withdrawn. Qualified tuition plans (QTPs) allow you to participate in prepaid tuition plans or savings plans. With prepaid tuition plans, you prepay for college tuition at current prices for your children in the future. A savings plan is similar to a Coverdell ESA. The owner of the savings plan contributes cash to the account that has tax-deferred earnings. Unlike a Coverdell ESA, however, the owner of a QTP does not choose the investments. Coverdell education savings account (ESA) The Coverdell ESA (formerly known as Education IRAs) offers the same tax benefits as QTPs. Coverdell ESAs allow you to contribute cash to an investment account that has tax-deferred earnings. Withdrawals from the account to pay for qualified educational expenses are federal income tax and penalty free. If withdrawals are not used for qualified expenses, there are federal income tax consequences and a 10 percent tax penalty. Owners of these accounts control the withdrawals from the account and the beneficiary can be changed. Unlike, QTPs, owners of Coverdell ESAs do choose the investments. Series EE savings bonds Series EE U.S. Savings Bonds are another way to pay for your children’s education. These bonds are purchased for half their face value, and as interest accrues throughout the life of the bond, reach face value at maturity. If these bonds are used to pay for qualified higher educational expenses, no federal income tax has to be paid on the accrued interest. In order to receive this tax advantage, your adjusted gross income must be below a certain amount. Series I U.S. Savings Bonds also have tax benefits when you pay qualified higher educational expenses. Traditional and Roth IRA The traditional IRA and the Roth IRA were not designed to pay for the college education of children; they were designed as a way for individuals to prepare financially for their retirement. However, the government does allow individuals to use the funds in their traditional and Roth IRAs to pay for their children’s college education without a tax penalty. Normally, if you withdraw money from your IRA before age 59 1/2 (and/or certain other conditions), you have to pay a 10 percent tax penalty on the part of the money that was not previously taxed. This is not true if the money is used to pay for qualified higher educational expenses. Unlike the QTPs and Coverdell ESAs, federal income tax is owed on the money withdrawn. There are other ways of savings for your children’s college education, but the ones listed above are the most advantageous.

Investing for Retirement
Employer-Sponsored Plans Defined-Contribution Plans Defined-Benefit Plans Personal Savings Plans Traditional IRAs Roth IRAs Defined-benefit plans With these plans, you have a predetermined pension payment on the basis of a formula. It is often based on average salary for certain years, years of service, and a set percentage (For example: Monthly benefit = Average salary for last 5 years x years of service x %). Some examples include Teachers’ Retirement System of Georgia (TRSGA) and the State Employees Retirement System of Georgia (ERSGA). Defined-contribution plans With these plans, you and your employer or the employer alone contribute to retirement account. The amount you receive at retirement is based on the amount invested and investment performance. Some examples include profit-sharing plans (based on company’s performance), money-purchase plans (employer contributes a set percentage to your account), thrift and savings plans (employer matches your contribution), employee stock ownership plan (ESOP) (retirement funds invested directly into company stock), 401(k) plans (tax-deferred retirement plan where employees contribute a portion of their wages up to a max amount. Employers may contribute a full or partially matching amount. It is similar to thrift and savings plan), 403(b)plans (a plan similar to 401(k) plans for employees of schools, hospitals, religious organizations and other non-profit institutions) and 457 plans (a similar plan for state and local government employees and other non-profit organizations). Traditional IRAs For some people, all or a part of the contributions are tax deductible. Earnings grow tax-deferred until withdrawn. You pay taxes on the earnings and contributions that were not previously taxed when you withdraw the money from the account. Nonworking spouses can make contributions to a spousal IRA. The money in these accounts cannot be invested in life insurance or collectibles, except gold or silver U.S. coins. Distributions from these accounts prior to age 59½ are subject to a 10 percent tax penalty, with few exceptions (purchasing your first home purchase -- up to $10,000, paying college expenses, becoming disabled, needing to pay for medical expenses or medical insurance premiums, with restrictions). Roth IRAs Contributions are not tax deductible for anyone, but earnings grow tax-free. Withdrawals from the Roth IRA are tax-free if the withdrawal is a return of your contributions. Withdrawals of earnings are tax-free if the Roth IRA is held for 5 years and one of the following occur: death, disability, become age 59 ½ and first-time home purchase (up to a $10,000 limit). If the withdrawal does not meet the qualifications above, the money withdrawn is subject to federal income tax. There is also a 10 percent tax penalty unless the money is used to pay for qualified higher educational expenses.

Investing for Retirement
Self-Employed Plans Keogh plan Simplified Employee Pension Plan (SEP) Keogh plan This plan is similar to corporate pensions or profit sharing plans for small business owners and those who are self-employed. The contributions are tax-deductible and earnings are tax-deferred. SEP This plan is similar to a Keogh plan, but easier to establish. It is used by small business owners with no or few employees. The contributions are tax-deductible and earnings are tax-deferred. Small business owners and other self-employed people should contact a CPA or financial planner that specializes in setting up self-employed retirement plans.

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Joan Koonce, Ph.D., AFC® Extension Financial Planning Specialist

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