Do you often feel like you are missing out? Do you ever wonder, am I doing the right thing? Do you find yourself irritable, frustrated or stressed out? Prozentivus can help.... I am not advocating that you take prescription drugs if you feel this way... about investing. Funny joke. Instead, I'd like to review 5 basic investment choices out there AND dabble in what the outcome might look like if you put your financial fate in any of them.
Savings or Money Market Accounts: A safe place to park your money. FDIC insured up to $250,000 if the bank goes under. Pays interest but it varies depending on the current interest rate environment. Might not be a great place for long term growth or for keeping up with inflation. Can be a good place for emergency savings and money you will need in the short term.
Certificates of Deposit (CD account): You give up access to your money for a period of time to lock in an interest rate. These periods of time can be as short as 1 month and as long as 10 years. If you access your money early, you pay a penalty. CDs are typically not great long term solutions. They can be a good solution if you know you won't need your money for a period of time and are looking for some guaranteed interest.
Bonds: Bonds are loans to the federal government, a municipality or a corporation. You buy a bond (give them your money), they typically guarantee to pay you a fixed interest rate for the term or length of the loan. The term of the loan, aka, maturity date of the bond, can vary. On the maturity date, you receive your money back. The longer the length generally means the higher the interest they will pay.
Treasury Bonds or Treasuries are loans to the federal government. Treasury Bills are less than 1 year. Treasury Notes are 2 to 10 years. Treasury Bonds are 10+ years. Bills, Notes, Bonds... just call them all Treasuries. These are the most secure types of bonds because they are backed by the US Government.
Municipal Bonds are Loans to states, cities or counties and other local government entities. If you want to sound cool, you call them "munis". Certain people like "munis" because the interest earned is generally tax free on the federal level and can be tax free on the state level as well. Munis tend to pay less because of the tax free interest offered. If you are in a high tax bracket, these might be a good option. Notice how I said "munis" two more times after saying it was cool... it's because I am... so cool.
Corporate Bonds are loans to corporations. Maturities can be short term (less than three years), medium term (four to 10 years), or long term (more than 10 years). Credit rating agencies assign credit ratings based on their evaluation of the risk any company might have to default on its bonds. Lower credit rating means higher risk of default which typically means higher interest will be paid. The opposite goes for higher credit rated, lower risk, corporate bonds.
Bonds trade on a public market. What in the world does that mean? Unlike a CD where your money is locked up for a period of time to avoid penalty, with a bond you can gain access to your money at any time, without penalty, by selling your bond on the market. Yes, I promise, no penalties... BUT... the value of your bond can go up or down depending on the current interest rate environment, among other factors.
How interest rates impact bond values. Let's assume you bought a bond for $10,000 that will pay an annual 3% on that money for 10 years. At the end of the 10 years, you will get your $10,000 back. Two years into owning this bond, you have a need for this money. You go to sell your bond on the public market but it's only worth $9,000 now. Why!? What happened!? Over that two years the federal reserve decided to raise the federal funds rate. I don't have time to explain why they would do this or what the federal funds rate even is but I did include a few links in the description below if you are a financial nerd and would like to learn more. For purposes of right now, all you need to know is when the federal reserve raises the federal funds rate, it tends to raise rates everywhere. Mortgages, car loans, rates paid in a money market, on a CD, and the rates paid out on bonds. If NEW 10yr bonds are now paying 5%, why would anyone want to buy your bond paying at 3%? They wouldn't, unless you sell it to them at a discount. The same can happen in the other direction if rates drop, your bond would then become more valuable.
Stocks: When you buy a stock, you are buying equity or ownership in that company. When you buy a corporate bond, you do not own equity in that company. You receive only the interest and principal on the bond, no matter how profitable that company becomes or how high its stock price climbs. Bonds are limited but more secure. Stocks are not quite limitless but have a much higher likelihood of growth potential, and carry more risk. You are a lender when you buy a bond. You are an owner when you buy a stock.
Their are many ways to buy stocks. You can buys individual stocks. You can buy funds that own many stocks. You can borrow money to purchase stocks (often referred to as "buying on margin" or using leverage). You can even buy option contracts on underlying stocks. These options are "bets" you are making on the direction you think the share price of a stock will go. Option contracts can be utilized for many different purposes. A common one is to protect your down side.
Create a game plan for investing in stocks. Some people trade stocks daily, others monthly, while still others buy and hold for longer periods of time. The share price of a stock, or a stock itself, might be great for someone and not for someone else... it all depends on your circumstance and the approach you are taking. It is important you put together a game plan and do your best to take the emotion out of your investment experience with stocks. A large degree of your success will rest on your ability to remain unemotional and disciplined.
Real Estate: Real Estate is defined as property consisting of land and buildings, and the legal and economic interests associated with it. Said like a normal person, it can be a building you own where people live, or work, or store things, or shop, or make things. It can also be land.
The value of your real estate can increase over time. You can also charge people to use it. Win - Win. What if the value goes down, like house values in 2008? What if people stop using your office building because employees start working from home? What if a renter decides not to pay you? These are some of the risks associated with real estate.
Many love real estate because of leverage. You take $20,000 and invest it into something that earns 10% over a year. You now have $22,000, very neat. What if you took that $20,000 and used it as a downpayment on a condo that was worth $200,000. The other $180,000 you borrowed through a mortgage. You intend to cover the mortgage payment with the rent income you will receive by renting the condo out. Let's say that townhome increases 10% in value over the year. You now have an asset worth $220,000... this is wonderful. With leverage, you doubled your $20,000 investment. Leverage can be powerful, just be careful of overextending yourself. What if the value of your townhome drops 20% over that year, to $160,000. You now owe $180,000 on a condo that is worth $160,000... it's not always sunshine and daisies. But still... if you leverage responsibly, you can hopefully manage any future risk.
Many also love real estate because of the potential tax savings. When you buy a physical item like a car or hiking boots or a building... they wear down over time. Said in a more sophisticated manner, they DEPRECIATE. With real estate, you are allowed to recognize this depreciation and take it as a tax deduction against any income said real estate produces for you. Tax free income is what that sounds like... but know... this depreciation decreases the cost basis in your property. If you bought a condo for $200,000 and sold it for $400,000, depreciating it down to $0 along the way for the tax deductions... you would recognize $400,000 of income, despite buying it for $200,000.
Which should you choose?
See video above for return comparison over different time frames.
*Spoiler*
It can be a mixed bag in any given year at which does the best.
Over the long term and despite some volatile times, Stocks and Real Estate have historically generated the highest returns.
If you have more time, stocks and/or real estate might be a better option for you. If you have less time, cash and bonds might make more sense. These are GENERAL rules. I work with a number of retirees who still maintain a large portion of their portfolio in stocks or real estate. Their can be a whole host of reasons why this might be, one big reason, their financial plan. We know how how much they plan to spend and when they plan do it, allocating the appropriate amounts in each type of investment based on their situation
Bond values have dropped off quite dramatically over the past two years. Why? One big reason, the federal reserve has raised the federal funds rate quite aggressively to fight inflation.
If you exclude the last two years then the annualized return in bonds increases by roughly 1% to 4.43% from 2002 to the end of 2021.
Also, remember what bond values typically do when interest rates go down... (they go up).
I think it wise to diversify your wealth. Don't concentrate too heavily in any one of these investments out of fear (cash or CDs) or out of greed (stocks or real estate). You can lose in either scenario.
Sources & Disclosures found in the video link on Youtube