Introduction
Normally any person who earns some income out of any occupation has the following uses for his income:
- to meet the current living expenses;
- to provide for the personal requirements and other future expenses and,
- some part of the income to be saved (Narach Investment).
The saving is meant to meet any emergent expenditure or to revitalize the income by employing some financial returns in the future which amount to invest. Thus, ‘investment’ may be defined as the action to keep aside and employing the money in different financial and other instruments. Such deployment of funds will be done in the present with the objective of obtaining a positive return in the future. To describe briefly investment is a sacrifice being made in the present with the anticipation of a possible future gain. There are a number of possible combinations in which the investments can be planned and each one of them will represent a portfolio. It is possible to combine the investment opportunities of a particular investor into a number of portfolios, depending on his choice of risk-taking levels. The investments may be made in deposits, stocks and debt instruments, mutual funds, or real estate. Normally the expected return from any portfolio forms the basis of arriving at the possible portfolios for investment. There are various risks attached to each kind of investment and different advantages and disadvantages attached to each class of investments. This paper details the risks and pros of various investments.
Investment Portfolio
An investment portfolio can be defined as a group of investments that an individual may hold. A portfolio is thus the different investments in sectors like real estate, stocks, bonds, and commodities, and so on, which together create a portfolio. The portfolio of investments normally reflects the risk-taking capacity and character of the investing individual (VideoJug).
Different Kinds of Investments
There are various kinds of investments with each one described as a ‘sector’. The sectors may be stock, bonds, mutual funds, etc. The stocks represent the ownership rights in a company. The stocks also provide some voting rights to the individual who owns the stocks which help to control the affairs of the company to which the shares belong. A bond in contrast to the stock is a debt instrument, where the investor lends money to the company or the government based on a bond. Normally the company or the government pays interest to the investor for using his/her money. A mutual fund on the other hand represents a pool of investments where different individuals combine their resources under professional management. The investment managers of the mutual fund using the pooled resources make investments in different kinds of securities like bonds or stocks whichever has the ability to meet the objectives of the mutual fund. Then there are the investments in real estate where the investments are made in landed properties and buildings. A ‘treasury note’ is issued by the US government against investments as loans to the government. There are three different types of notes that are dealt with in the market. They are:
- T-Notes referring to Treasury note having a maturity period ranging from one to ten year
- T-Bonds covering treasury notes having long-term maturity of more than 10 years and
- T-Bills which have a maturity of less than a year
Thus a bond calls for a stated amount of money to be paid to the investor on agreed maturity dates either singly or in staggered maturities including the final maturity (James C. Van Horne).
Asset Class and Asset Allocation
The terms ‘asset class’ and ‘asset allocation’ are the two important terms associated with the investment field. An ‘asset class’ represents a group of securities having price movements that are more or less similar to each other. The individual securities may be represented by stocks, bonds, or real estate but such individual securities to be denoted, as an asset class should possess the character of exhibiting similar reactions to the changing market conditions with respect to their prices. Since the prices of securities in a specified asset class will move up or down together all these securities can be grouped together since they can be expected to possess the same risk and reward characteristics among them. Examples of asset classes include cash, stocks, and bonds. There are certain advanced classifications of the asset class in ‘Large-cap Growth Stock’ or ‘High-risk bond’. However, these classifications are a more specific form of the asset class.
‘Asset allocation describes the process of management of the individual risks associated with an asset class. The objective or purpose of asset allocation – to the extent that there are similar price movements in a particular class of assets – is to pick up different asset classes having dissimilar price movements. The idea is that if there is a downward trend in the prices of one class of assets it can be offset by another class of assets where the prices are showing an increasing trend. This enables an investment manager to reduce the risk associated with an individual asset class.
Investment and Risk
There are really types of risks associated with various investments. When the risks are discussed by the people, they invariably think about particular risks associated with specific kinds of investments. For instance, the risks associated with investments in stock are very high due to the volatility attached to the prices of the shares. The term volatility implies the range between which the prices go up and down. Depending on the level of changes in the prices the risks associated with this kind of investment are determined. The risk on the investment in the bonds of companies is that the company may make default in the repayment of the money due to its inability to muster necessary cash flows.
The other risks associated with the investment in the bonds are that the growth in the bond value or the interest rates might not have kept up to the level of inflation. When it comes to the question of risks associated with the investments, it should not be assumed that one should invest to eliminate the risks totally. It is not at all possible as without an element of risk adding some return to the investments is not achievable. It is only through undertaking risk people add returns to their investments in various classes of assets. Risk-taking is the process of investing. It is concerned with the elimination of the risk to the extent possible and in addition understanding and managing the risks that guarantee an expectation in the growth of the investment portfolio over a defined future period of time.
Meaning of Risk Tolerance
There are two basic components that can be identified with the risks on investments; one is the personal risk implied by the psychological aspect of risk and the other is economic risk implying the mathematical aspect. The personal or psychological risk is one that a person willingly undertakes to handle with the intention of investing in a portfolio that will make him/her reach the goal of an investment. An example in this connection is the case of a stock market crash or downturn in the stock market which is risk is personally undertaken by the investors. The economic aspect of the risk is to allow the investment in the portfolio in which it was invested till the time the investment brings back the goals established in respect of the planned investments.
The expected return on any investment is a function of a security’s risk and would be based on several established models of risk that have been developed over a period. (Ross, Westerfield, and Jaffe).
Diversification
In order to mitigate the risks in the investments is ‘diversification’. Diversification is the process involved in the elimination of risks by investing the available resources in multiple securities or classes of investments. For instance, the risk associated with owning a single stock instead of three of four different stocks will enable the investor to spread the risks within the same investment. Similarly, the investment may be spread in different sectors like real estate bank deposits, etc instead of only in securities or bonds. By investing in a multiplicity of sectors the risks associated with investments in one sector can be spread over.
Risk Premium
A risk premium is the expected return in addition to the normal risk-free return that an investor would like to receive on his/her investments for the additional risk he/she proposes to take in any investment which
Diversifiable and Non-diversifiable Risk
There are two basic kinds of risks. They are diversifiable risks and non-diversifiable risks. Diversifiable risk is the traditional form of risk that can be mitigated by investing in different kinds of securities. A non-diversifiable risk is one that is undertaken by the investor due to the reason that such risks are unavoidable. The non-diversifiable risks are those which provide the investor the number of expected returns and which are willingly undertaken by them.
Risk Profile
The risk profile is mostly individual-based. The risk profile is based on the risk tolerances that an individual can take. The determination of the risk profile of an individual is often complex and a tough task. This is because the point of risk profile changes in the real situation that what was perceived as an individual’s risk profile earlier. Traditionally risk profiles helped to identify the level of risk an investor can take. But in the present circumstances, practices have made the concept of risk profile having lesser use, since the investors think and act in circumstances different from the ones with which they are concerned. However, the risk profile is an important phenomenon, since investing is a long-term project it involves looking closely at the risk profile of the investor. But in reality, most of the risks taken by the investors are of a short-term nature only. For instance, the stock market crash is a short-term risk that an investor is expected to handle. Unless the short-term risks are handled efficiently it would become difficult for the investor to achieve his long-term goals of investments. Here the risk profile comes in handy. It tells the level of short-term losses that an investor can handle to remain strongly motivated to stock to their long-term strategy and achieve his/her long-term investment goals.
Safest Types of Investments
Investing in the stock market may prove to be riskier than investing in other kinds of securities like bonds. This implies that the chances of the value of investments going down in stocks are more. If an investor wants his money out of his investments in stock he is sure to make a loss in realizing his investment and that is the risk associated with the investments in the stock market. However, if the returns from the stocks are considered over a longer period, the investments in stocks may prove worthier than those on the bonds as stocks, in the long run, would outperform the bonds. Traditionally the investments in fixed income securities like bonds are considered the safest. One of the safest investments may be found in the certificate of deposit. This investment is considered safest because of two reasons; one is that there is a fixed return on the investment and the amount invested is guaranteed by the backing of the federal government. Because of these qualities, the US government bonds are considered the safest, since there is no chance that the government would fail on its repayment of the bonds.
The next set of securities is the corporate bonds. Depending on the size and quality of the company the credit quality of the company can be determined. Based on this aspect, a large and well-established company is quite unlikely that it will make a default on the payment of interest or repayment of its bonds as compared to the chances with a start-up company, which should be considered riskier.
Pros and Cons of Investing
There are distinct pros and cons attached to investments in different kinds of securities. For example, the investments in real estate would provide a long-term return to the investor by way of appreciation in the capital value in addition to providing a regular flow of periodical rental income if the property is a commercial or residential one. The next advantage with investing in real estate is that the investor would get a lot of leverage in acquiring the real estate property like ‘seller financing’. Seller financing is the process in which the investor pays the down payment over time and the rest is arranged through bank loans. However, investing in real estate has its own problems. When one invests in real estate and is unable to make the installment payment the investor may lose his property, and that will be damaging the credibility of the borrower. Another disadvantage with investment in real estate is that there is the risk of the tenants not paying the rent or too quick changes in the tenants may eat up the profits or returns from the investment. There is an enormous cost involved in maintaining the real estate properties which is another disadvantage associated with the real estate investment (Kevin Cox)
Investing in mutual funds has the advantages of efficient diversification in the investments and there is a professional environment for investing which enhances the efficiency of the investments. There is clear liquidity associated with the investment in mutual funds as shares or units in the fund can be purchased or sold easily. The biggest disadvantage with mutual funds is that the returns from the fund and the capital appreciation depend largely on the skill and judgment of the professional manager. The fees and charges on the administration are likely to reduce the quantum of returns. Redemption of the mutual fund in short term might affect the return due to sales commission (Money Instructor)
Investing in stocks gives the investor the potential of getting larger returns on the stocks. Another advantage is that if there is a loss in the investment, it is limited to the extent of the investment made and most stocks are liquid in that they can be sold and purchased quickly and easily. Although historical information does not provide a guarantee for the future, stocks traditionally have proved to provide greater returns than other investment avenues. The biggest disadvantage with the stocks is that since the stockholders represent the owners of the company in the event of the winding-up of the company they are the last people to receive any money against their investments. Sometimes due to inadequate information about the working and true financial status of the company the investors may take wrong decisions in connection with their investments in stocks (Financial Web).
Conclusion
This paper described the salient features of investment and different kinds of investments available as possible avenues open for the investors to make decent returns on their investments. The paper also discussed various issues concerning the risks associated with investment The possible advantages and disadvantages of each kind of investment were also discussed. The main theme of investment that has been observed is that the return and risks are closely associated with each other and the risks largely influence the rewards that can be expected of the investments.
Reference
Financial Web ‘Common Stock: Advantages and Disadvantages’. Web.
James C. Van Horne (2002) ‘Financial Management Policy’ Edition XII Prentice Hall of India Private Limited India. Web.
Kevin Cox ‘The Advantages and Disadvantages of Investing in Real Estate’ Ezine Article. Web.
Money Instructor.com ‘Advantages and Disadvantages of Investing in Mutual Funds’. Web.
Narach Investment ‘Introduction to Investment Management’. Web.
Ross A Stephen, Westefield W Randolph & Jaffe Jaffrey ( 2004) ‘Corporate Finance’ Edition VII Tata McGraw Hill Publications New Delhi India.