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Thursday, January 3, 2013

Investing 102: From Safe to Risky

By V. Raymond Ferrara, CFP®, CSA®

“Investing 101: Even the Mattress Has Risks,” featured in the November isuue of Senior Spirit, talked about the necessity of finding a competent and ethical financial planner, the importance of developing a financial and investment plan and then having the discipline to follow the plan in good times and bad. Now, let’s talk about how different investments might be used. Space does not permit us to talk about all alternatives, nor can we determine which investments are most suitable to you.

Perhaps the most basic investments are also the safest as long as they are Federal Deposit Insurance Corporation (FDIC) insured. These generally include checking accounts, savings accounts and certificates of deposit (CDs). Visit with your banker to understand your personal coverage, especially if you have multiple accounts at the same bank. Multiple accounts do not necessarily provide multiple layers of insurance. Interest rates today are extremely low, but perhaps, like Will Rogers in the 1930s, you are more concerned about the return of your money than in the return on your money.

Another popular conservative vehicle is the use of a fixed annuity with an insurance company. Annuities issued today will generally have an underlying guaranteed return of 2 percent, although the actual percentage paid could be higher because the rate is reset each year. The money grows on a tax-deferred basis. When you withdraw the money from the annuity, the earnings are taxed as ordinary income, and should you withdraw money prior to age 59½, there is a 10 percent penalty. Annuities almost always have a surrender penalty if they are cashed in prematurely. You should generally avoid purchasing any annuity with a surrender period that exceeds seven years. A longer period may cause a liquidity issue, which is especially important for those in retirement.

Government Bonds

Let’s now discuss bonds, which many people consider a “safe” investment. Most bonds are safer than stocks, but not all bonds are created equal. The safest bond is a U.S. government bond, which is backed by the full faith and credit of the U.S. government. As long as the government has paper, ink and a printing press, you will always get your money back. But there is risk involved, as was seen in August 2011 when Standard & Poor downgraded U.S. government bonds from AAA to AA. The longer the term to maturity on a bond, the higher the interest rate paid and the greater the volatility of the bond’s price. When interest rates go down (like they are today), the price of bonds goes up. Conversely, when interest rates go up (as they are likely to do in the future), the price of bonds goes down. Thus, while you own a bond you will see its value increase and decrease over time, but if you hold the bond to maturity, the U.S. government will pay you the face value of the bond. State and local governments offer municipal bonds that are attractive because the interest is tax free.

Other countries also issue government bonds, but those come with their own set of risks. The last several years have been filled with financial difficulties in Greece, Spain, Italy and other countries, so it is important to understand the fiscal condition of any country prior to investing. When you invest in foreign bonds, you must also be concerned with currency risk.

Corporate Bonds

Corporate bonds generally have greater risk than government bonds and come in investment-grade (trust quality) and high-yield options. Large stable corporations are often considered less risky and generally pay lower interest rates. Small corporations or corporations that are in trouble financially offer bonds that are called “high-yield.” Because you are taking a greater risk than with government bonds, corporations must entice you with a higher interest rate. Unlike government bonds, corporate bonds are only guaranteed by the corporation that issues the bond. As seen during the financial crisis, even large firms can be at risk. The most convenient and often safest way for most investors to purchase bonds is to purchase mutual funds and/or exchange traded funds (ETFs).

The difference between stocks and bonds is that bonds are investments in which you loan money to a government or corporation that pays interest on the “loan,” while stocks actually provide ownership in a company. There are no underlying guarantees as to the financial success of the companies in which you have ownership. In particular, most investors should avoid investing in “penny” stocks, which are generally company shares that sell for less than $5 per share. A lot of promoters sell these very inexpensive stocks by promising huge gains. For the most part, the smaller the company, the greater the risk.

Small Versus Large Companies

Most stock investments are categorized by small, medium and large companies, which are determined by the market capitalization of a company (total value of all shares). In most equity portfolios, an investor wants to have a few small stocks, some medium and mostly larger company shares. Although it is commonly assumed that the larger the company, the lower the risk, we have all come to learn that even big companies can have big difficulties.

Most large corporations based in America have a significant amount of revenue coming from overseas, thus helping investors diversify their portfolio through international investing. But, investors will often purchase stocks from foreign companies in an effort to further diversify the portfolio. Foreign investments are divided into mature countries (Germany, England, France, etc.) and emerging countries (China, Russia, South America, etc.). Greater risk exists in the emerging countries. In addition to all of the regular risk associated with owning stocks, there are also foreign currency risks and accounting risks because many countries don’t have the same high accounting standards as the U.S.

Stocks that pay dividends (a share of the profits) are considered more stable and less risky than stocks that don’t pay dividends. When a company makes money, it must use that money to either grow the business by purchasing more equipment, reinvest that money by buying other companies or share some of the profits with investors. Again, the best way for most investors to buy stocks is through mutual funds, which spread the risk of any one stock.

In addition to these common investments, you may mix in other investments like variable annuities, real estate investment trusts (REITs), commodity funds and perhaps some precious metal funds. It depends upon your risk level. No two investors are alike, and you must be careful that you don’t get “cookie cutter” advice.

Visiting with a financial planner, you can determine your investment goals, risk tolerance and asset allocation program. Avoid putting all your eggs in one basket. A diversified portfolio that provides both income and opportunity for growth works best for most people.

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V. Raymond Ferrara, CFP®, CSA, is president and CEO of ProVise Management Group, LLC in Clearwater, Florida (727-441-9022). © November 2012