Explain the investments listed on the Financial Pyramid. Discuss their level of risk versus their rates of return.
Very High Risk: Precious Metals, Collectibles, Options, Commodities, Penny Stocks
• Options: an investment security that gives the holder the right, but not the obligation, to buy or sell something at a fixed price within a specified period of time
• Commodities: products (corn, wheat, gold, etc.) that are traded on a futures exchange
• Penny Stocks: a stock selling for a very low price, sometimes less than $1 per share
These investments are volatile and have significant risk. In the case of futures, options, and commodities, investors are frequently “leveraged.” This means that investors control a large amount of an asset with only a small “down payment.” This is very risky, and one's entire initial investment — and maybe more — can be lost quickly. Of course, there is the possibility for great gain, too!
High Risk: Real Estate, Growth Stocks, Aggressive Growth Mutual Funds
• Real Estate: land, including the buildings and natural resources found on it
• Growth Stock: a stock whose earnings and price are expected to show significant increases in the future
• Aggressive Growth Mutual Funds: mutual funds whose primary assets consist of growth stocks
Sometimes people consider real estate investments to be a “sure thing.” This is not always true since real estate values can fall as well as rise. Furthermore, when one makes a down payment and secures a mortgage, one is actually “leveraged.” If the market value of the house falls, one can lose most, and sometimes all, of the down payment/equity.
Moderate Risk: Municipal Bonds, Blue Chip Stocks, Income Mutual Funds, High-grade Corporate Bonds
• Municipal Bonds: issued by a municipality or state government and backed by the taxing authority of that governmental authority. The federal government does not tax the interest earned from municipal bonds. States levy no state income taxes on their own bonds, but sometimes tax interest on municipal bonds from other states.
• Blue Chip Stocks: the stock of a mature company with a history of good earnings and relative price stability
• Income Mutual Funds: a mutual fund whose primary assets are bonds and securities that give relatively high rates of interest or dividends
• High-grade Corporate Bonds: a bond issued by a business with the two highest ratings — AAA or AA
Although bonds are considered a relatively “safe” investment, they are quite volatile in times of fluctuating interest rates. Any fixed-interest security, like a bond, will lose value if interest rates in the economy rise. (Conversely, bond values will rise if interest rates fall.) This often happens in times of unexpected inflation.
Low Risk: Fixed Annuities, U.S. Government Bonds, Traditional (whole life) Insurance, Savings Accounts, Certificates of Deposit, Money Market Accounts
The key characteristic of these investments is that there is little market risk. (See definition below.) For some, the amount invested is even “guaranteed,” such as accounts backed by the FDIC (currently up to $250,000 per account) and bonds issued by the U.S. government. The trade-off is that the return on these investments is quite low.
Discuss these five basic types of Investment Risk.
• Financial Risk: the risk that the business or government will not be able to return the money you invested, to say nothing of giving a positive return on the investment! For example, businesses and even governments sometimes go bankrupt, rendering investments worthless.
• Market Risk: the risk that your investment is subject to changes in the market (volatility).
• Inflation Risk: the risk that your investment will lose value because of inflation. If the inflation rate is 3%, a nominal return of 8% on a certain investment is really only a 5% real return. Bonds are very susceptible to inflation risk because inflation typically causes interest rates to rise, which causes bond prices to fall.
• Liquidity Risk: the risk that your investment cannot be converted to cash quickly.
• Fraud Risk: the risk that your investment is misrepresented.
