Over the years we’ve heard many clients indicate a strong preference for certain kinds of investments. We have had clients who were convinced that it only made sense to invest in large, “blue chip” American companies. Some have told us that they felt their small business, whatever it was, was the best investment they could ever make. Still others have told us that they would only invest in real estate.
These conversations are challenging for us, because while we attempt to remain objective, our clients approach the topic with an almost religious zeal. But, investing is not religion. In fact, modern, evidenced-based investing is grounded in science. At Springwater, we’re students of the science of investing, and our advisors have taught the subject at the university level.
We would suggest that all investments be considered objectively, based on their unique characteristics. As an investor, you should decide whether to invest in something based on an objective assessment of its characteristics and how the investment meets your personal needs. So, let’s consider the five key characteristics of investments.
Return
You invest in something with the expectation that you’ll earn a return. More explicitly, for you to be willing to part with your money today, you must have a reasonable expectation that you’ll be compensated at some point in the future for that loss of the use of your money.
How do we calculate your return? There are several ways. But let’s keep this simple. The return on investment (or “ROI”) is calculated as: (1) the current value of the investment, (2) less the original cost of the investment, (3) divided by original cost of the investment. Let’s consider a basic example. You invest $100 today. In one year, your investment is worth $115. Your return is ($115 – $100)/$100 = 0.15, or 15%.
Risk
The risk of an investment is the probability that you could lose some (or all) of your investment. This risk of loss is a big deal for investors. No one wants to lose money on an investment. In fact, the only reason why you would make any investment is that you expect to earn the return we just discussed. If you knew for certain that you were going to lose some (or all) of your investment, you wouldn’t make the investment.
Investors are willing to accept risk, because they believe they’ll be compensated for accepting it. That compensation comes in the form of the return. Indeed, there’s a direct relationship between risk and reward. The greater the risk, the greater the expected return. The opposite is also true.
How do we measure risk? This is more challenging. If we know the history of the value of an investment, we can measure its risk. A good example involves looking at the price of a publicly traded stock, such as IBM. We have price history for IBM stock since it started trading publicly in 1911. We can measure the risk of IBM stock by calculating the degree to which the stock price varies from its mean (i.e. average) over time. Investors use “standard deviation” to measure this price dispersion. For our purposes, the formula is not important. But the concept is. The more the price of a stock varies from its mean, the riskier it is. The riskier it is, the more expected return investors will want.
What do we do if we don’t know the risk of an investment? This is a problem. If we don’t know how risky an investment is, we can’t easily determine its expected return. Unfortunately, it’s difficult, if not impossible, to calculate the risk of many investments.
Marketability
People generally prefer to buy and sell investments in a market. A market is simply an environment in which buyers and sellers gather to trade. The more the buyers and sellers, the more robust the market. Also, the broader the market, the easier it is to determine the proper price of an investment. The New York Stock Exchange (NYSE) is an example of a market. The NYSE trades stocks for 2,800 companies, including IBM.
Marketability refers to the ease with which an investment can be traded (i.e., bought or sold). Investments for which there is no market are difficult to trade. This lack of marketability makes an investment less valuable. Publicly-traded stocks of American companies are highly marketable. Your coin collection is less marketable. There is virtually no market today for the East German marks sitting in my nightstand.
Liquidity
If you bought IBM stock, then decided to sell it, you would have no problem doing so. The stock trades on the NYSE, there are lots of investors who are interested in buying and selling IBM, and the costs of doing so are minimal. If you had a brokerage account at, say, Fidelity or Schwab, you could sell your IBM stock and pay no commission. Yes, the price you’d receive (the “bid”) for selling IBM is a bit less than the price someone would pay (the “ask”) to buy it. But that price “spread” is minimal. So, IBM’s stock is “liquid.”
Liquidity is the degree to which an investment can quickly and easily be bought or sold at a price that accurately reflects its value. Quickness is important, because investors prefer to convert their investments as fast as possible to maximize returns and/or minimize risk. Ease is important, because investors prefer to convert their investments with minimal effort and disruption.
The most liquid investment is cash, because you use cash to buy other investments (or things) instantly. Sellers prefer cash. Every other investment you might consider will be at least slightly less liquid than cash.
Taxation
You should always consider the tax characteristics of an investment before committing yourself to making it. There are very few (if any) investments which aren’t subject to taxation. Taxes erode the value of your investments. So, look for investments that are subject to low tax rates.
Taxes come in many forms. Investments that produce interest, dividends, and capital gains are all subject to taxation if held in a taxable account. Taxes can be levied by the federal government, your state, and even your local county or city. The rates of taxation vary and are beyond the scope of this article.
Final Thought
We’ve reviewed the five key characteristics of any investment: return, risk, marketability, liquidity, and taxation. You should evaluate these characteristics whenever you’re considering an investment.
If you need help putting together your investment plan, consider working with a Certified Financial Planner™ (CFP®), Chartered Financial Consultant® (ChFC®) or Chartered Financial Analyst (CFA). Advisors who hold these designations had to meet rigorous educational, experience and ethics requirements.
