Understanding Investment Characteristics: A Comprehensive Guide

There are many different types of investments, each with its own unique characteristics and risk factors. The three basic categories of investment are ownership, lending, and cash equivalents. Ownership investments include stocks, real estate, and precious metals, while lending investments include bonds and savings accounts. Cash equivalents, such as money market accounts, are easy to liquidate and offer a modest return.

When making investment decisions, it is important to consider factors such as budget, emergency funds, and credit card debt. The level of risk associated with an investment is also a crucial factor, as higher-risk investments tend to offer higher potential returns but also carry a greater chance of loss.

Different types of investors may prefer certain types of investments over others. For example, younger investors tend to favour growth-oriented portfolios, while older investors approaching retirement age often opt for more conservative investments.

Stocks

There are two main types of stock: common and preferred. Common stock usually entitles the owner to voting rights at shareholder meetings and to receive any dividends paid out by the corporation. Preferred stockholders generally do not have voting rights, though they have a higher claim on assets and earnings than common stockholders. For example, owners of preferred stock receive dividends before common shareholders and have priority in the event of a company going bankrupt and being liquidated.

The holder of stock, a shareholder, may have a claim to part of the company's assets and earnings. A shareholder is considered an owner of the issuing company, determined by the number of shares an investor owns relative to the number of outstanding shares. If a company has 1,000 shares of stock outstanding and one person owns 100 shares, that person would own and have a claim to 10% of the company's assets and earnings.

Stockholders do not own a corporation, but corporations are a special type of organisation because the law treats them as legal persons. Corporate property is legally separated from the property of shareholders, which limits the liability of both the corporation and the shareholder. If a corporation goes bankrupt, a judge may order all of its assets sold, but a shareholder's assets are not at risk.

There are two ways to earn money by owning shares of stock: through dividends and capital appreciation. Dividends are cash distributions of company profits. If a company has 1,000 shares outstanding and declares a $5,000 dividend, stockholders will get $5 for each share they own. Capital appreciation is the increase in the share price itself. If you sell a share to someone for $10, and the stock is later worth $11, the shareholder has made $1.

Historically, stocks have outperformed most other investments over the long run. However, all investments carry a degree of risk and stocks are no exception. Stocks, like any other investment, can lose value if market conditions decline.

Bonds

When an investor buys a bond, they are lending money to the issuer, which may be a government entity, municipality, or corporation. In return, the issuer promises to pay the investor interest at predetermined intervals (usually annually or semi-annually) and to repay the principal on a specified maturity date, ending the loan.

There are several types of bonds, including:

• Corporate bonds: These are issued by companies rather than banks for debt financing because bond markets offer more favourable terms and lower interest rates. The risk and return of corporate bonds vary widely, usually reflecting the issuing company's creditworthiness.
• Municipal bonds: These are issued by states, cities, counties, or other government entities. Municipal bonds typically offer tax advantages since the interest earned is often exempt from federal, state, and local taxes.
• Government bonds: These are issued by national governments to defray their expenses. They are also known as sovereign bonds or sovereign debt. Because the issuing governments are unlikely to default, these bonds have a high credit rating and a low yield. In the US, government bonds are called Treasuries, while in the UK, they are called gilts.
• Agency bonds: These are issued by government-affiliated organisations, such as Fannie Mae or Freddie Mac in the US. Although not directly backed by the government, they have a high degree of safety due to their government affiliation.
• Zero-coupon bonds: These do not pay coupon payments and are instead issued at a discount to their par value. The return is generated once the bondholder is paid the full face value when the bond matures.
• Convertible bonds: These are debt instruments with an embedded option that allows bondholders to convert their debt into stock (equity) at some point, depending on certain conditions like the share price.
• Callable bonds: These have an embedded option that allows the company to "call" or repay the bond before it matures.
• Puttable bonds: These allow bondholders to put or sell the bond back to the company before it matures. This is valuable for investors who are worried that a bond may fall in value or if they anticipate rising interest rates.

When investing in bonds, it is crucial to consider credit ratings, interest rates, and maturity dates. The market value of a bond changes over time as it becomes more or less attractive to potential buyers. Bonds that are higher-quality (more likely to be paid on time) generally offer lower interest rates, and those with shorter maturities tend to have lower interest rates as well.

Real estate

Physical Real Estate Investments

Physical real estate investments include land, residential and commercial properties.

Residential Real Estate

Residential real estate is anywhere that people live, such as single-family homes, condos, and vacation homes. Residential real estate investors make money by collecting rent from property tenants and/or through appreciated property value when they sell.

Residential real estate investments can be active or passive. Active investing involves directly managing properties or being involved in real estate development projects, which requires more hands-on involvement and cash flow but tends to be more lucrative. Passive investing, on the other hand, doesn't require owning or managing a property and includes investing in real estate investment trusts (REITs), real estate funds, and crowdfunding.

Commercial Real Estate

Commercial real estate is a space rented or leased by a business, such as an office building, gas station, or retail store. Commercial properties tend to have longer leases and can command more rent than residential properties, resulting in greater and steadier long-term income. However, they may also require higher down payments and property management expenses.

Land

Investors often buy land for commercial or residential development. However, buying land to develop requires market research and a deep understanding of building codes, zoning regulations, and local rental markets.

Indirect Real Estate Investments

Indirect real estate investments allow individuals to invest in the real estate sector without managing physical properties. Examples include REITs, real estate company stocks, real estate mutual funds and exchange-traded funds (ETFs), and mortgage-backed securities (MBS).

Factors to Consider When Investing in Real Estate

When investing in real estate, it's important to consider factors such as property location, valuation, investment purpose and horizon, expected cash flows and profit opportunities, leverage, new construction vs. existing property, and your credit score.

Additionally, real estate markets fluctuate, so it's crucial to stay up-to-date with trends and statistics. Real estate can help diversify your portfolio, and it's generally considered a sound investment with competitive risk-adjusted returns and a low correlation with other major asset classes.

Private equity

Some key features of private equity investment include:

• An investment manager raises money from institutional investors (e.g. hedge funds, pension funds, university endowments, and ultra-high-net-worth individuals) to pursue a particular investment strategy.
• The fundraised proceeds are placed into an investment fund, in which the investment manager acts as a General Partner (GP) and the institutional investors act as Limited Partners (LPs).
• The investment manager then purchases equity ownership stakes in companies using a combination of equity and debt financing, with the goal of generating returns on the equity invested over a target horizon (typically 4-7 years).
• The use of debt financing in acquiring companies increases an investment's return on equity by reducing the amount of initial equity required to purchase the target.
• The interest payments on the debt financing are tax-deductible, so they reduce corporate taxes and increase total after-tax cash flows generated by the business.

Over time, "private equity" has come to refer to many different investment strategies, including leveraged buyouts, distressed securities, venture capital, growth capital, and mezzanine capital.

Collectables

There are several risks associated with investing in collectables. They do not generate passive income and can incur maintenance and insurance costs. They are also subject to counterfeiting and destruction. Additionally, the capital gains tax on the sale of a collectable is 28% if it appreciates in value.

Despite the risks, collectables can be a rewarding investment, helping to maximise returns and hedge against inflation. They can also bring personal interest and joy to the collector.

Frequently asked questions