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Investing 101: Own/Loan

Why did those guys with black hats and masks rob stagecoaches in the Old West?

When you have money to invest, there are basically two things you can do with it:

• Loan it to someone or
• Own something 

Loan to someone:

Investments that promise to pay interest and return your original investment, or principal, are essentially loans. A bond is a loan packaged as a tradable security. Two key factors help determine what to expect from a loan investment, or bond:

• Quality – How likely are they to pay you interest and give you your money back?
• Time – How long will they have your money?

 Both factors affect how much return you can expect to make on the loan.

• Bank Deposits
  • Cash deposited at a bank is actually a loan to the bank. They promise to give you your money back in the future – usually within a few days, and the quality is high due to bank account being FDIC insured. Because of these two factors, the interest paid is very low.
• Certificates of Deposit
  • Same FDIC insurance, but by adding time of a year or more, you’d expect to get a higher return, otherwise you’d stick with cash or money market.
• Bonds
  • Government bonds – high quality due to a promise to pay by the US Government or government agencies, but more time has been added, so a higher yield (return) is expected
• Municipal and Corporate Bonds
  • Have credit ratings indicating the default rates of similar companies
  • May or may not have insurance backing the payments
  • and usually are for short (1-3 years), intermediate (3-7 years) and long-term (7, 10 and even 30 year) timeframes.
  • Due to adding more risk by lowering quality, and possibly a longer time to maturity, you would expect more return (after taxes in the case of municipal bonds). Otherwise, you’d use a CD or money market, etc.

Many of the bonds in the Old West were called “bearer bonds.” Whoever held the bond could take it to the bank and clip off a coupon from it for the interest payment that was due. Once all the coupons were gone, the bond would be returned for the return of the principal.   So, if the black hat, mask-wearing guys could grab some bonds, they could become the ‘bearers’ for the future payments.

Own something:

Ownership investments often include dividend, or value, stocks; growth stocks; real estate; and commodities. These can generally be grouped into two categories: Growth with Income and Growth.

Growth with Income:

Companies are divided into shares (also called stocks) that are traded on stock exchanges. Some companies take some of their earnings and pay them out to shareholders each year.  That’s called a dividend. Companies paying out a dividend higher than the market average are usually categorized as dividend stocks.  Common dividend stocks are those from utility companies, food and beverage companies, banks, healthcare and some industrial companies.  A simple way to think of dividend stocks is to equate them with a farm that is rented out.  You expect the land to grow in value over the years, and while you wait, you collect rent from the crops each year. Real estate companies are often organized as Real Estate Investment Trusts (REITs) and are in this category, too.

 Growth:

Companies that reinvest the majority their capital back into themselves rather than paying a dividend out to shareholders are growth companies.  Decades ago when Starbucks was spending everything, they made building up to 100 stores a month, they were a high growth company.  They were hoping to add value to their shares by adding more stores.  A simple way to think about growth stocks is to think about a piece of land you own that doesn’t produce any income.  You buy it today and hope to sell it in the future for more than you paid for it.  Commodities like gold and silver fit in this category, because they don’t pay anything while you hold them.  You just hold them and hope to sell them in the future for more than you paid.

 The guys with the black hats could also find some stock certificates along with the bonds. 

 Most investors prosper by understanding the risks and rewards of these different ways to place their money into “loans” and “ownership” investments in a balance to match their goals.  

Thankfully, it’s a lot harder to have your securities taken from you today than it was in the Old West.