INVESTMENT

ROLCAM · Posted: Wed Jun 06, 2007 1:00 pm Post subject: INVESTMENT

Investment is the use of money to earn income or profit. The term also refers to the expenditure of funds for capital goods--such items as factories, farm equipment, livestock, and machinery. Capital goods are used to produce other goods or services.

Most people invest part of their income for future financial gain. Others make investments to protect the purchasing power of their savings against rising prices. Some invest because they want to buy their own business, such as a store or gas station.

Investment promotes economic growth and contributes to a nation's wealth. When people deposit money in a savings account in a bank, for example, the bank may invest by loaning the funds to various business companies. These firms, in turn, may invest the money in new plants and equipment to increase their production. In addition to borrowing from banks, most corporations issue stocks and bonds that they sell to investors to raise capital needed for business expansion. Governments also issue bonds to obtain funds to invest in such projects as the construction of dams, roads, and schools. All such investments by individuals, businesses, and governments involve a present sacrifice of income to get an expected future benefit. As a result, investments raise a nation's standard of living.

Kinds of investments

Before making any kind of investment, a person should learn as much as possible about how the money will be used. The person also should find out what he or she can gain from an investment. Every investment involves some risk--that is, a chance for loss. An individual should carefully examine the expected income from an investment in relation to the degree of risk involved. Some kinds of investments yield a large profit but offer little safety. Other investments earn a much smaller profit but provide almost complete safety. A person also should know whether he or she can easily turn an investment into cash that may be needed to take care of unexpected expenses.

There are seven major kinds of investments. The types are (1) savings accounts, (2) life insurance, (3) business investments, (4) real estate, (5) bonds, (6) stocks, and (7) mutual funds.

Savings accounts, also called time deposits, are a common kind of investment. Money placed in a savings account at a bank, credit union, or savings and loan association earns interest at a certain annual rate.

Many banks offer such special savings instruments as money market accounts and certificates of deposit (CD's). A money market account earns interest based on conditions in the money market, which deals in corporate and government short-term securities. Funds placed in a CD cannot be removed until the end of a certain period, such as one or two years. Money market accounts and CD's pay a higher rate of interest than do regular savings accounts.

Most commercial banks that offer both checking and savings accounts are privately owned. Credit unions, savings banks, and many savings and loan associations are cooperative organizations operated for the benefit of the members. A person invests in the organization by making a deposit or buying shares in the association. The organization then loans the funds to borrowers or makes other investments. Earnings from the interest it receives, less operating expenses, are returned to the members as interest and dividends.

Savings accounts and certificates yield small profits compared with some other kinds of investments. They also may provide little protection against rapid inflation--that is, a sharp, general rise in prices. People who leave money in a savings account for years may find that it has less purchasing power than when they deposited it.

In spite of its disadvantages, a savings account is suitable for investors of moderate means because it involves little risk that the money will be lost. Deposits or shares in most savings institutions in the United States are insured up to $100,000 by one of three agencies of the federal government: (1) The Federal Deposit Insurance Corporation (FDIC), through its Bank Insurance Fund, protects deposits in insured banks. (2) The Savings Association Insurance Fund, administered by the FDIC, insures deposits or shares in savings and loan associations. (3) The National Credit Union Administration insures deposits or shares in credit unions.

In Canada, most savings accounts are in large branch banks chartered by the national government. The government does not insure deposits, but it requires banks to maintain a certain reserve to protect depositors.

Life insurance serves as a form of investment for many people. A person may buy life insurance to provide financial protection for family members in case the person dies or is disabled. In addition to furnishing this protection, many types of life insurance include some kind of savings provision. The insurance company sets aside part of each premium paid after a policy has been in force for a certain period of time. This sum, called the cash value of the policy, accumulates and earns a specified rate of interest, as does a savings deposit.

The cash value of a policy may be useful in an emergency if extra funds are needed. Policyholders can exchange their life insurance for the cash value or keep the policy and borrow against its cash value.

Business investments. The purchase of a small business may be the most demanding kind of investment. Investors may find that they must work full time to make a profit. They should be sure the business will provide both a satisfactory income and a reasonable return on their investment.

Before buying a business, people should study the industry as a whole. They should become particularly familiar with the demand for the specific product or service that they plan to offer. They also must consider their operating costs, including the interest they pay to borrow money to start the business. In addition, people should determine realistically whether they have the ability to properly operate the business.

Real estate. People invest in real estate when they buy a home, land, or rental property. Real estate may have considerable resale value. It also may produce income--directly, in the form of rent; or indirectly, in the form of crops, mineral resources, or timber.

Real estate can often bring a higher return than many other forms of investments. It is considered an especially good investment during a period of inflation, when the value of property tends to rise. On the other hand, real estate values can fall sharply during a recession or a depression.

Investment in real estate has some major drawbacks. For example, it requires large sums of money. In most cases, the cost of a home or land is several times the buyer's yearly income. A majority of buyers borrow part of the cost of a home from a savings institution. Most purchases of commercial property are financed by commercial banks, finance companies, pension funds, or insurance companies.

Another problem with real estate investments is that reselling the property may take a considerable amount of time. Thus, real estate rates low in liquidity, the ease with which an investment can be turned into cash without loss.

Bonds include government securities and corporate bonds.

Government securities are issued by the federal government or by a state or local government. These investments pay interest at a specified rate after a certain period of time.

The savings bonds issued by the United States government are widely popular among small investors because of their low purchase price and great safety. A $50 savings bond, the lowest denomination issued, costs $25. A buyer can cash it for at least twice the purchase price after 17 years, when the bond matures (comes due). The interest rates on most savings bonds are based on the interest rates earned on certain other federal securities. Most savings bonds can be cashed after six months.

People who wish to invest at least $1,000 can buy other types of United States government bonds, such as Treasury bonds. These bonds are tradeable on stock exchanges. Most Treasury bonds pay a higher rate of interest than do savings bonds because their price may change considerably from time to time. Such price fluctuations reflect the changes in current interest rates. For example, Treasury bonds issued during an inflationary period may pay 8 percent interest. Bonds issued earlier at 5 percent would then become less desirable to own. Their market price would fall until their current yield was also 8 percent. A bond's current yield is the amount of money the bond earns annually, expressed as a percentage of the bond's current market value.

The federal government also sells securities called Treasury bills. They yield high interest during periods of inflation and low interest during recessions. The bills are issued only in large denominations starting at $10,000. Treasury bills mature after three, six, or nine months--much sooner than bonds do.

State and local governments issue securities called municipal bonds. The interest earned by some municipal bonds is not subject to federal income tax. For this reason, such bonds appeal to many people on an upper income level, who must pay a high tax rate. Municipal bonds that are not subject to federal income tax pay lower interest than do most federal bonds. In 1986, the U.S. Congress passed legislation that made the interest on many kinds of municipal bonds subject to federal income tax.

Corporate bonds are loans made by investors to business firms. A corporation pays each bondholder interest every year until the bond matures. At that time, the corporation must redeem the bond by paying its face value. In most cases, this sum is $1,000. If the company defaults (fails to meet its obligations), the bondholders have the legal right to take over the business and sell assets pledged as security on the bonds.

The prices of bonds issued by corporations or by governments may change due to variations in market interest rates. As a result, investors may fail to get back the purchase price of their bonds if they sell the bonds before the maturity date. In addition, investors may lose money if the government or corporation defaults.

Stock includes two types of corporate security, common stock and preferred stock.

Common stock represents shares of ownership in a company. The stockholders of a firm share in the profits and losses of the company. If the company has a year of high earnings, the stockholders receive cash dividends. The exact rate of return for any common stock depends on its dividend and price on the stock market. If the company suffers losses during the year, it may not have any profits to pass on to its stockholders.

A company may decide to use its profits to expand the business, rather than pay dividends. But some stockholders do not care much about annual dividends as long as the price of the stock rises. The increase of the value of a stock permits a capital gain, the profit received from the sale of stock.

Preferred stock is a form of corporate security that has features of both bonds and common stocks. Like a corporate bond, preferred stock has a fixed rate of return. This return must be paid before any common-stock dividends can be distributed. Thus, preferred-stock holders can expect a more assured income than common-stock holders. Unlike bond owners, however, preferred-stock holders do not have the legal right to make a corporation pay them annual returns if the firm has not earned enough to do so.

Mutual funds are companies that invest in a variety of securities and sell shares of their own stock. They offer several advantages to small investors. For example, mutual funds employ specialists who select stocks or bonds that they consider most likely to yield profits. These investment companies also enable investors to own securities of many corporations in different industries. Such ownership reduces the risk of loss because price increases for certain securities may offset a drop in the value of others.

Mutual funds pay cash dividends to their shareholders. The shareholders of many of these companies may automatically reinvest the dividends in additional shares of the mutual funds.

Mutual funds are open-end funds. In an open-end fund, shareholders can sell their shares back to the fund whenever they wish. The fund must buy back the shares for their approximate net asset value. This amount is based on the current value of the securities that are involved. In a closed-end fund, shares are traded on the stock exchanges, usually at a price that is below the net asset value.

Mutual funds called money market funds invest only in government and corporate short-term securities. These funds provide an alternative to the savings accounts offered by banks. Money market funds usually pay higher rates of interest than do bank savings accounts. In addition, most money market funds allow investors to write checks against their investment in the fund. Because money market funds make short-term investments, there is little variation in the purchasing power of a given amount of principal (money drawing interest) in the fund. However, the principal is not government-insured.

Investing in the stock market

People should consider investing in the stock market only if they are willing to risk losing money. They probably should have enough savings set aside to protect themselves against a temporary loss of income resulting from illness or unemployment.

Most people who buy stock place their order with a brokerage company. A broker may fill the order by purchasing the desired shares from dealers or investment banks that sell newly issued securities. The broker also may relay the purchase order to a representative at a security market where stocks and bonds are traded. The representative then carries out the necessary transaction. The investor pays the purchase price of the shares, plus a commission for the broker's services. Brokers also sell stocks for investors.

Common stocks and preferred stocks both can earn larger profits than bonds can. In fact, over long periods of time, the return on stocks has consistently been much higher than the return on bonds or on other kinds of investments. However, stocks also involve a greater risk of losing money. Stock values change continually, and often by large amounts. As a result, investors have no assurance that they will get back the full purchase price of their shares. A business recession or poor company management may reduce a firm's earning power and lower the price that people are willing to pay for the firm's stock. Stockholders might then lose money if they sold their shares. In many cases, stocks also provide poor protection against inflation.
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Roland Camilleri

Moderator

Sydney , Australia.