Canto 2

Three Kinds of Investments

These notes are going to focus on three main kinds of investments: cash, income and equity. There are other kinds of investments, which I'll briefly list at the bottom, but other than in this note I'm going to ignore them.

Cash

This category of investments has very low risk of dropping in value, but doesn't rise much either. Because of the low risk, investments in this category don't pay much in the way of interest or dividends. In fact, sometimes a good savings account at an on-line bank will pay a higher rate of interest, so there is kind of a fuzzy line between this category of investment and your savings. People who are saving for something they'll need the money for in less than five years should include a lot of cash type investments in the mix. More information on cash type investments.

Income

This category of investments has a higher risk of changes in value than the cash category, but also tends to have higher dividend payments. Income securities are usually called bonds. They can be issued by governments at all levels, or by companies. Here are a few of their key features:

• If you buy a bond when it is originally issued, you are lending your money (the face value of the bond) to the government or company that issued it. They agree to pay you interest on a regular basis. At the end of the term of the bond, the holder of the bond can redeem it for the face value.
• If there is a higher risk that the issuer might run into financial trouble and be unable to pay either the interest or the face value at the end, they end up having to pay a higher rate of interest to persuade investors to buy.
• Usually once a bond has been issued, it can be resold on the bond market. Sometimes it can be sold for more than the face value and sometimes for less. How much more or less depends on things like whether the interest rate still looks attractive compared to newer bonds, and whether the issuer is still in the same financial shape as before.
• You can buy bonds directly through a broker, but most people buy bonds through a bond fund that owns lots of different bonds.

People who are saving for a long term objective should probably include some income investments in the mix. More information on income type investments.

Equity

This category of investment has the highest risk of changes in value among these three types, but also has the highest potential for profits. Equity securities are usually called stocks, or shares in a company. They are issued by companies. Some stocks pay dividends to the shareholders and some don't. People who buy the stocks that don't pay dividends are expecting to make a profit when the shares go up in value. Here are some of their key features:

• If you buy a stock you are buying a piece of the company that issued it. That's why it's called a share. You become a part owner of the company.
• Most shares give you voting rights in how the company is run, though if you don't own very many shares you don't have very many votes.
• Companies that make a profit can pay some of it to the shareholders in the form of dividends, can use some of it to buy back shares (and thereby push up their price somewhat), or can put the profits back into the business to develop new products and so on. Some well-established, stable companies, like electric utilities or banks, pay dividends reliably year after year. Some new companies in industries like high-tech, are very busy growing and don't pay dividends at all.
• Shares generally never mature. If you want your money back out of them, you have to sell them through some kind of stockmarket, usually through a broker. That means someone has to want to buy them from you. If you are fortunate, the buyer will want to pay you more than you bought them for and you will make a profit. If the buyers only want to pay less than you paid for them and you're determined to sell them anyway, you will lose some money.
• If a company gets into financial trouble, the shareholders can actually lose all their money. Companies that go bankrupt are obliged to pay their loans (including bonds you might own) before they pay anything to the shareholders. Sometimes there is nothing left for the shareholders. On average, though, this doesn't happen to most stocks.
• Over the long term, stocks tend to offer more profit than either of the other two kinds of investments. That's why people buy them.
• You can buy stocks directly through a broker, but most people buy stocks through a stock fund that owns lots of different stocks.

People who are saving for a long term objective should probably include some equity investments in the mix. More information on equity type investments.

Have I Oversimplified?

Yes, in several ways. Here are some:

• I haven't talked about investing in securities from different countries. I'll talk about that in another canto.
• I haven't talked about how these categories kind of shade into each other. The divisions between them are not as sharp as I've described.

What Kinds of Investments Have I Left Out?

I've left out lots of things, such as:

• Direct investment in companies - like if you start a company of your own or become a partner in one. I don't have any direct experience, so I'm not going to go there.
• Direct investment in land or buildings, for renting them out and so on. I'll cover investing in companies that own land and buildings, and investing in funds that own shares in those companies, but not buying the buildings themselves. We own a house, but it's a place where we live, not an investment.
• Buying stuff, like rare stamps or coins, antique cars, wine, works of art, and that kind of thing. I have no experience in that, so I'm not going there either.
• Commodities. There are ways of investing in things like gold bricks, soybeans, or crude oil. Man, if you start investing in pork bellies, you're on your own.
• Futures and options. I kind of understand these things. You're buying a kind of contract that either allows or requires you to buy or sell something on a future date at a particular price. It's sort of a bet that the underlying thing that would be bought and sold is going to go up or down in price by then. They're useful for someone who understands them. If you don't understand them, you can get in real trouble.

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