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1.2: Investment Characteristics and Attributes

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    79463
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    Video - Audio - YouTube - Presentation File (Material for this section begins on slide 5.)

    As you work through the material in this introductory chapter, remember that this is an Introduction to Investments class. Don’t worry about all the jargon and buzzwords and proclamations and sexy graphics and silly antics that you may have heard or seen from the talking heads on the financial media outlets. Please forget anything and everything your brother-in-law, the self-appointed Expert-On-All-Things-Including-How-To-Invest, told you at the Thanksgiving dinner table. What follows is a list of general characteristics and attributes about investments. Study these terms, write them down, print the chapter 1 Study Guide, and watch and listen to the first lecture presentation for chapter 1 on the class website. This is all you need to learn and know for now.

    Securities, Property, and Personal Investments

    There are three broad categories of investments: securities, property, and personal. According to Wikipedia, a “security is a tradable financial asset.” Investopedia goes into more detail and defines a “security as a fungible, negotiable financial instrument that holds some type of monetary value.” The fancy words fungible and negotiable mean that the security can be traded and its value can be negotiated. Another popular definition of security is “an investment that represents debt or ownership or the legal right to acquire or sell an ownership interest.” This last definition introduces the three main categories of securities that we will detail later. The word security is an unfortunate term. Many people don’t have a clear picture of what is meant by the word security. Our class used to be titled, “Investments and Securities.” Students would say, “I’m not an Administration of Justice major. I don’t need to take this class.” No, not that type of security! For now, please understand that a security is a financial asset that can be traded and whose value changes over time.

    Property investments are sometimes referred to as hard assets or tangible assets. They include gold and other precious metals, art and other collectibles such as cars, commodities such as basic foodstuffs and materials, and real estate. We will discuss property investments toward the end of our journey together. They are important options but for the vast majority of us, securities are the best choice for prudent, long-term investments. This class concentrates on securities.

    Finally, personal investments are endeavors we undertake to better ourselves. Examples include education, training, and travel. Many say that their personal investments such as college or traveling the world were often the best investments they ever made. I agree. We will do our best to make our time together one of the best, if not the best, personal investments you will ever make. None other than Benjamin Franklin said, "An investment in education pays the best interest."

    Primary Assets versus Derivative Assets

    Investments fall into either primary or derivative assets. For the vast majority of our time together, we will be covering primary assets. Primary assets fall into two categories: debt and equity. Debt investments are investments where investors lend their money to someone else. Examples of these include bonds and savings accounts. Equity investments are investments where the investor has full or partial ownership of the entity. Examples include stocks, real estate, and partnerships. Debt investors are loaners. Equity investors are owners.

    On the other hand, derivatives are securities that derive their value from other assets. Examples of derivatives are options and futures. With derivatives, you can make a whole lot of money quickly and then lose a whole lot of money quickly. In fact, you can lose the whole value of your derivative investment overnight. Many in the industry do not categorize derivatives as investing. According to Mr. Graham’s definition above, derivatives would certainly be regarded as speculative. As we will see, in the investment world, “speculative” is a euphemism for the word “gambling.” We will discuss options and futures in detail at the very end of our journey together. Before we impress upon you just how dangerous these speculations are, if anyone tries to entice you with riches beyond your wildest dreams trading in options or futures, please tell them you are waiting until the end of the Introduction to Investments class before you make a decision one way or the other. (Spoiler alert: Unless you enjoy losing money quickly, stay away from derivatives of all forms! They are hazardous to your financial well-being.)

    Direct Investments versus Indirect Investments

    Direct investments are investments for which you have control of the underlying investment assets. Your name is on the title or the account. You are in control of the asset. Examples of these types of investments include stocks, bonds, real estate, and hard assets. With an indirect investment, someone else is making the decision about what underlying investment will be chosen. You may have some input into the decision but more often than not, you have no control of what assets will be chosen. Examples of these investments are mutual funds, limited partnerships, and Real Estate Investment Trusts (REITs). With indirect investments, you choose the mutual fund or limited partnership or REIT, and the manager or general partner chooses the underlying investments in stocks or bonds or real estate.

    Investment Domesticity

    Domesticity describes the location of an investment. There are three categories: domestic, global, and international. The first category is easy; a domestic investment is domiciled inside the United States. There is a subtle but important distinction with regard to the second two categories. A global investment means that it could be based anywhere in the world, including the United States. An international investment is based outside the United States. Please pay attention to this important difference. International investments are also often called foreign investment or overseas investments.

    Until the 1970’s, the differences between these categories were important. However, as globalization has evolved since the 1980’s, the differences have become much less pronounced. Greg Ireland, a successful mutual fund manager with over 35 years of experience once said, “The world is a very small place economically.” The influential magazine Forbes reported that, “Sixty-five percent (by value) of the parts in the Ford Mustang come from the U.S. and Canada. Ninety percent of the parts in the Toyota Sienna – which is built in Indiana – come from the U.S. and Canada.” Which is the more American car, a Ford Mustang or a Toyota Sienna?

    In the presentation, we list seventeen well-known companies and ask, “Which are domestic and which are foreign?” (Spoiler alert: They are all foreign.) In the United States, the issue of globalization has spilled into the political arena and elicited much controversy. At times, this controversy has taken the form of anger, fear, and loathing. This is unfortunate from our viewpoint as investors. Nothing is perfect and that includes our efforts to globalize the economy. However, on balance, globalization has been a tremendous positive for investors around the world and has helped bring hundreds of millions of people out of poverty and into the global middle class. The tricky part is ensuring that all enjoy the benefits of the expansion of the global economy.

    Next in the presentation, we list the top 18 countries according to per capita gross domestic product. We then ask a simple question: Which country had the best average annual return between 1970 and 2021? (No spoiler here! Please watch or listen to the presentations on the class website.) The world is indeed a very small place economically these days.

    Time Horizon

    One of the most important, if not the most important, characteristic that we must decide upon before we make an investment decision is our time horizon, also known as our time frame. When will we need to use the funds from our investment? Here are some popular guidelines:

    Time Horizons
    Time Frame Financial Industry Life Insurance Industry
    Short-Term Up to a year or so 1 to 3 years
    Intermediate-Term 2 to 5 years 3 to 5, 6, or even 7 years
    Long-Term More than 5 years More than 7 years

    Before you make an investment, we must know our time frame. As we will learn, our time frame will dictate what types of investment we can and cannot use.

    Liquidity

    No, not how much beer we need for the weekend! Liquidity refers to how easily your investment can be turned into cash. Liquid investments are easily and quickly converted into cash. There is a ready market to purchase the investment and change of ownership happens quickly. Examples include stocks and mutual funds. Go online or call your broker and you will have your money very quickly, usually within a day or two. Illiquid investments are the exact opposite. The market for the investment is small or the change of ownership happens slowly, or both. It usually takes some time ‒ sometimes much time ‒ to convert your investment into cash. The poster child for illiquid investments is real estate. Real estate usually takes at least two or three or more months to sell. Other examples of illiquid investments include limited partnerships, fine art, and collectibles.

    Risk versus Return

    Do you want to eat well or do you want to sleep well? In the investment world, risk is the chance that your actual investment returns will differ from your expected return. Wait a minute! That is not the typical definition of risk. When most people think of risk, they think of the possibility of suffering harm or loss. They think of danger. When they think of risk with regard to investing, they think of losing their investment. They think of losing all their money. Instead, in the investment world, when we endeavor to measure risk, we calculate the probability that what we receive from our investment will not match what we expect from our investment. It is an imperfect measurement but it can help us to keep a long-term perspective and can even help us to take advantage of the risks inherent in an investment.

    In general, the higher the expectation of investment returns, the higher the risk level we will have to accept. There is no way to negate this relationship. If we want high returns, we are going to have to accept high risk. Here is the risk versus return spectrum that we will use:

    Risk versus Return Attributes of Investments
    Risk Level Return Expected
    Low Risk 2% to 4%
    Moderate Risk 4% to 8%
    High Risk 8% to 12%
    Speculative Risk Greater than 12%

    Unless they are being dishonest, others will use different but ultimately similar spectrums. Please remember that speculation is not considered investing by many in the industry, Your Humble Author included. As mentioned, we are going to do our best to help you learn how to handle the ups and downs of moderate to high-risk investments and at the same time, generate reasonably moderate to high returns over the long term. We want you to eat reasonably well and sleep reasonably well!

    It’s time for some checking for comprehension. At the end of the presentation, we list six examples of investments. We want you to ascribe the various characteristics and attributes we covered to the six investments. Again, only concern yourself with what we have covered so far. Relax and have fun. Give my regards to Uncle Harry!


    This page titled 1.2: Investment Characteristics and Attributes is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Frank Paiano.