Investment vehicle options and risk | Investments for beginners
Every investment is risky, even cash. You must be thinking of. Avanti has gone nuts. How is cash risky? Well, I'm not crazy. And I'm going to prove it in this video. It really depends on how you define risk and you need to determine what kind of risk is acceptable to you as an investor. To do this? You must look at your investment plan. Create one. If you haven't already. In the description, I share my personal investment template and this video right here guides you on how to use that investment template. Hi, there I'm Avanti. I'm a mom and investment. Okay. And a CFA charter
holder and I've helped dozens of women take control of their financial future. Subscribe to my YouTube channel and follow my Facebook page to learn how you can build your own wealth through investing. In this video. I'll then talk about the different types of investments available to you, how to make money from those investments and the types of risks associated with each investment. We're going to map all available investment options on this risk return grid. On the X axis we measure risk. So as we move from left
to right, the expected risk goes up. And as we move from bottom to top, the expected return goes up. So investments that are on the bottom left corner have lower expected return and risk and investments that are in the top right have higher expected return and risk. I'm using historical average returns to measure expected future returns. Note that these are not guaranteed future returns . And I'm using standard deviations as a measure of risk.
And the reason we're using standard deviation to measure risk is because it gives us an idea of how much the returns drift about are below the mean. If the historical standard deviation is high, the investment has had a wide range of returns and is deemed more risky. Typically higher investment returns come with a higher risk. The idea here is that if an investor is willing to take additional
risk, he or she needs to be compensated with a higher return for taking on that additional risk. There are many different ways you can measure risk, but on this risk return grid, we are only mapping risk that is associated with volatility or standard deviation. So let's start. Investment vehicle number one, let's talk about cash. So cash includes the cash that's in your wallets or purses or the cash in your checking account or the cash under your mattress. If you are that person . The return on cash is zero, which means you don't earn any interest on that cash that you hold.
You might think that the risk in cash is zero as well. And that's true. If you measure risk just on this risk return grid, in terms of volatility, cash has zero risk. So if you stash a hundred dollars under your mattress today after 20 years, you will still have a hundred dollars.
But in 20 years, that hundred dollars will be worth less because of something called inflation. Every year, prices of goods and services tend to creep up. There may be some years where prices have fallen, but in general prices tend to inflate or go up. In fact, in the post pandemic world,
you may have already noticed large price increases in everyday purchases. Hundred dollars in 1980 could buy you 47 gallons of milk. If instead of investing or spending that a hundred dollars, had you stashed it under your mattress, that same hundred dollars today will buy you only 27 gallons of milk. So do you see how inflation that is increase in the price of milk has reduced your purchasing power because milk costs a lot more today than it did back in 1980.
Instead of stashing that hundred dollars under your mattress, had you invested it in the S&P 500 index today, those hundred dollars would have grown enough to be able to buy you 2,110 gallons of milk. I'm not a psychopath. I promise I don't have thousands of gallons of milk in my refrigerator. I'm just trying to explain you how cash is the worst investment vehicle. If you factor in inflation, of course you need cash for your day-to-day purchases, but don't use cash as an investment. I'm going to share a fun fact. Eight November, 2016, my Indian friends will never forget this date 8:15 PM. PM. The government of India announced that two denominations. So the Indian currency is the rupee
thousand rupees and 500 rupee bills will be voided; no longer considered legal tender. And those of you who don't know, India is a big cash economy. So even substantially large transactions take place using cash. Imagine holding a huge stock pile of cash. And in a minute, the government just announced that it's no longer going to be considered legal tender. That's a tough situation to be in and not, not such a fun fact for people who went through that demonetization, which was done to combat tax evasion, unlikely to happen again but something to consider. So don't hold a lot of cash. Investment vehicle, number two savings account. Savings
accounts , give you a little bit of interest and keep your money safe. The interest rate, which is also known as the annual percentage yield or APY is typically very small. And the interest that you earn is taxable. Once you keep your money in a savings account, the interest rate is not fixed. It changes as the central bank or the Fed hikes or cuts interest rates. So for example,
in 2019, Goldman Marcus offered 2.25% on their online savings account. And as of the day of this recording, the rate stands at 0.5%. A savings account is a perfect place to stash your emergency fund. The upside is not very high. That is your capital will not appreciate by significant amount,
but you will be able to preserve your capital for emergencies. Look for banks that are insured by the FDIC or Federal Deposit Insurance Corporation, or if you plan to use credit union to open a savings account, make sure that the credit union is insured by the NCUA or the National Credit Union Administration, or you can choose an online money market account or a high yield savings accounts such as Goldman Marcus or Ally Bank. Just make sure that these banks are insured by the FDIC or NCUA. to make sure that the money you're stashing is perfectly safe. Some of these online banks limit the number of transactions that you can make the withdrawals to about six a month, investment vehicle, number three, CDs or certificates of deposit. These are very similar to your savings account with some differences While a savings accounts offer the flexibility of making withdrawals CDs don't. CDs offer a slightly higher rate than savings accounts, but this comes at the cost of access to your money. In the US interest rates on CDs are awfully low,
but there was a time during the 1980s, when you could earn double digit interest rates on CDs. CDs are offered for a term, and your money is locked for the term of the CD. Terms can be short suggest three months or long, like one year, two years, five years. , and in some cases, even 10 years, your money stays locked with the bank for the entire term of the CD. If you need to withdraw your money before the CD matures, you will pay an early withdrawal penalty. Now, quick quiz for you - can a bank change the interest rate on your CD? Can they say tomorrow that we are not profitable anymore and we just don't feel like it. So instead of the 4% that we promised you at the beginning
of the term, uh, we are going to pay you just 0.5%. Can they say that? The answer is no. Once you open a CD, your interest rate stays the same through the entire term of the CD. However, once you open an account and tomorrow, you bring your sister to the same bank, she can get a different interest rate based on what rates they're offering on that date . And that rate will remain constant throughout the term of her CD. Another pop quiz. What do you think is the risk in opening this type of investment vehicle. If interest rates rise during the term of your CD, you cannot withdraw from your current CD without incurring a penalty. So say for example, today you open a new CD for a term of three years and tomorrow banks start offering a higher interest rate, the penalty that you will incur by withdrawing from this original CD, maybe higher than the potential return that you may get from switching. And by the time your CD
matures, the interest rates may be lower than when you started. If you're still with me, don't forget to hit the like button. And if you haven't already please subscribe to my channel. So you get access to all my latest videos. And if you're watching me on Facebook, don't forget to follow my page. I keep adding new videos on building wealth through investing and to help you better allocate your income. I have linked my personal budgeting worksheet in the description. So don't forget to grab that.
Moving on to vehicle number four T-bills. T stands for treasury. T-bills are short term debt securities issued by the US government. In simple terms when you buy a T-bill, but you are giving the government your money to use for ongoing expenses, in exchange, you receive a promise from the government that you will get your money back with interest. T-bills are short-term debt securities, which means they
have maturities ranging from a few days to a year. The amount that the government pays you back at maturity is called the par value and T-bills are sold at a discount to this par value. The amount of the discount is determined at the auction. Getting a discount on this par value is like earning interest. And this interest is exempt from state and local taxes.
You do have to pay federal taxes on the interest. You can buy T-bills directly from the government or on secondary markets. To buy directly. You have to go to treasury direct.gov. It's linked in the description. As an individual investor or a retail investor, you would bet non competitively
at the auction, basically just bid the amount of T-bills that you're willing to buy at a discount rate that is going to be set at the competitive auction, which you don't have to worry about. The discount rate gets determined through the competitive bidding process by institutional investors. So this is the announcement page of treasury direct.gov, where you will see auction dates for treasury securities. On auction date, you are able to place your non-competitive bid until 11:00 AM eastern standard time. Competitive bidding closes at 1130 Eastern standard time, which is when the discount rate is determined. This page here shows one announcement from march
of 2022. These announcements are made several days before the auction. It tells you the term of the security. In this case, it is 91 days or three months, the auction amount, the auction date. And so on. At the end of the competitive auction, you will be able to see the yield that you will receive. In this auction on March 14, the yield was 0.45%. Using a simple calculation, 0.45 times the term of the T-Bill, which is 91 days divided by 360 gives you the discount on a par value of 100. So essentially you would be able to buy a hundred
dollar T-bill for the discount of 11 cents or a price of 99.88625, which is this price right here. If you are buying thousand dollars worth of T-bills, you could buy them for $998.8625. At maturity that is on June 16th, you will receive your par value back. The interest rate you earn on T-bills are super low and you could earn a higher yield through online savings account. However, it's good to be aware of different investment options because
interest rates are always changing. T-bills are one of the safest investments you can ever make because they are backed by the full faith and credit of the United States government. But also note that the return on T-bills is super low. There's always interest rate risk in that existing T-bill holders will lose out on a higher interest rate if interest rates are rising. But again, these are short-term securities with maturities,
less than a year. There are many different types of risks associated with bonds. But before I go into the risks, I want to tell you about the different types of bonds you can invest in. Vehicle number five, treasury notes and bonds. Treasury notes have maturities between one and 10 years and Treasury bonds have maturities of 20 or 30 years. These are issued by the United States government. Both treasury notes and treasury bonds pay semi-annual interest. And these interest payments are called coupons.
Similar to treasury bills or T-bills treasury notes and bonds are backed by the full faith and credit of the United States government. By purchasing these treasury notes or bonds, you're giving the United States government your money to spend on projects, such as highways and bridges, et cetera. And in the dome, the government promises to pay you back at maturity. In addition to that, the government also sends you semi-annual interest payments, which are known as coupons. Back in the day when you bought a treasury note or a treasury bond, you would actually get a physical piece of paper with detachable coupons. So for example, if you bought a 10-year note, you got a paper with 20 detachable coupons, which you could cash in for semi-annual interest. These interest payments are exempt from state and local taxes.
You still have to pay federal taxes on You can buy these bonds and notes directly from the government through treasury, direct.gov, or you can also buy them through your brokerage account information about upcoming auctions can be found on this website. . It's also linked in the description. At the end of the competitive auction, you should be able to see the results that will give you some very valuable information. Here are the results from the auction of February 9th, 2022. It tells you the term of this note which is 10 years.
The interest rate is one and seven, eight of a percent, which is 1.875%. So if you buy a note with a par value or face value of hundred dollars at the end of the 10 year term, you will get a hundred dollars back. And every six months you will receive 1.875 divided by two, which is 0.9375 or 93.75 cents. Because remember this is a semi-annual coupon. So we have to divide by 2. How much do you have to pay for this note today? For that we need a third piece of information, which is the high yield of 1.904%. I use a simple
present value calculation to get the value you pay for the a hundred dollars part value note. And it comes out to $99 and 73.707 cents. Because this value is below the par value of hundred dollars. This note is set to be trading at a discount. Bonds can also trade about par value , and you can get compensated through a higher coupon rate. Let me know if you're interested in learning how I calculated these numbers, and I'm happy to do a video on bond math. There are other treasury instruments, such as I bonds are tips for treasury inflation, protected securities.
I bonds that especially attractive now because the inflation rate is very high. So I hope that gave you an overview of treasury related debt instruments. Now let's talk about municipal bonds on munies, which are issued by local municipalities. So by buying a municipal bond, you are giving
a local government, your money for projects, such as building schools or hospitals or parks. And the way municipalities make money is through taxes. Munies are tax exempt, but even though they are issued by local governments, these are not risk-free. Many munis have defaulted on debt.
The most famous being jefferson county, Alabama, that defaulted on billions of dollars of debt. As always I'm not scaring you from investing, you need to be aware of all the risks before you make any investment decisions. Don't put all your eggs in one basket. Creating a well-diversified portfolio is key to minimizing risk and generating strong returns that will meet your investment goals., Investment number seven, corporate bonds,
similar to governments issuing bonds for ongoing expenses. Companies can issue corporate bonds for making a new acquisition to pay existing debt for R and D. And so on the type of interest you get on a corporate bond is typically higher than what you can collect from a government bond. Why? Because these are not risk-free. Remember investors, will demand to be compensated for taking additional risk. So if a company is deemed to be more risky, the demand for that bond will be lower and investors will demand a higher interest rate before they touch that investment.
Corporate bonds pay interest. Semi-annually we go. Number eight, mortgage backed securities or MBS. Mortgage backed securities are similar to bonds, but instead of a government or a company or a local municipality issuing these bonds these bonds are backed by mortgages. So when you buy a house more often than not, you will get a mortgage from a bank. A bank issues
like hundreds or thousands of different mortgages and they can combine these different mortgages into a security and then sell these securities to investors. In exchange, the bank gets money from the investor. And each month, when you, as a homeowner makes those mortgage payments, the bank, takes the mortgage payments from the homeowner and it passes them to the MBS owner or the investor. So each month, uh, MBS holder will get an agreed upon payment from the bank. So bonds are known as fixed income securities. You may have heard of this term fixed income.
Typically when you hold a bond to maturity, you know, what kind of payments to expect at each period. So if it's a government bond who know what kind of coupons to expect every six months, So you get a fixed income and you know what to expect at maturity, hence the term fixed income security. However, just because they're called fixed income, they are not risk-free. I mean, treasury bonds are different types of bonds have different types of risks associated with them. Not all bonds are created equal. Before I talk about risks of bond investing, a quick reminder for you to show me some love by hitting the like button and subscribing to my channel if you haven't already.
As is true with any kind of investment bonds come with some risks. , I would highlight some of the more understandable risks associated with bond investing. First is interest rate risk. The price of a bond moves in the opposite direction as the interest rate. So let's say you bought a 20 year bond from Verizon that pays 5% coupon and you bought it at part of value of a hundred dollars. So it's a corporate bond. So par value is what you will receive at maturity. And there is no discount because you bought it at par value, you bought it. A hundred dollars. So the yield for this bond or the interest rate for this bond
is 5%. So let's say tomorrow interest rates rise. And Verizon starts issuing new bonds that yield 6%. Now you want to sell your bond? Can you sell it at par value? Can you sell it at a hundred dollars that you bought the bond for? No, because market interest rates have risen and an investor will demand a higher coupon rate of 6% because Verizon is currently issuing bonds at 6%. Can you force Verizon to change the coupon rate of your existing bond from 5% to 6%? Again, the answer is no, you cannot. So instead to compensate the next buyer for that additional interest rate, you will have to sell your bond at a discount.
In this case, it comes out to 94 point 45. So $94 and 45. Because the market interest rate rose, you now have to sell the bond at a discount of $5 and 55 cents. So if you hold a bond, the value of your bond holdings will rise. If the interest rates go down and the value of your bond holdings will fall if the interest rate rises. So that's interest rate risk in an nutshell, The second risk is prepayment risk. So if you've got a loan from a lender,
have you asked this question? If there are pre payment penalties, it's an important question. If you're getting a loan, always be sure to ask your lender if there is a prepayment penalty. What's a prepayment. Sometimes if the interest rate on your loan is very high. Or if you have extra cash on hand and you're trying to pay off your debt faster, you will make extra payments towards that loan. So any extra payment then goes towards the principal of the loan is called pre payment.
And most of the times you will do it in order to reduce your interest burden over the term of the loan. Another time prepayment can happen is when you refinance a loan, see you got a mortgage, a 30 year mortgage at 4% interest rate, and then fed starts lowering interest rates, and that affects your mortgage rate in the market. And then you're able to find another lender who was able to refinance your loan at 2%. What happens then is this new lender pays off the entire amount of the loan balance to the current lender. And you as a homeowner starts making your new mortgage payments to this new lender.
Now let's see what happens on the lenders side. So remember I just talked about mortgage backed securities. What happens is a lender will combine multiple mortgages into a security and sell it to investors. And as the lender receives
mortgage payments from homeowners, the bank passes those payments onto investors. Now in a falling interest rate environment, many home owners will refinance their mortgage . So this lender would receive cash payments in a lump sum, which it will then pass on to the mortgage back security investors. So these. Investors will now receive lump sum cash payment, which then they have to invest at a lower investment rate. So this gives rise to a third type of risk known as reinvestment risk, because remember the overall market interest rates have dropped. So you will have fewer opportunities of bond investing this lump sum amount at a higher rate. The fourth risk is credit risk.
A bond issuer can default on principal or interest payments in some cases, because they don't have the money to pay investors. If they're going bankrupt or something. In some cases like Russia, it's because of sanctions. So let me tell you what happened in Russia. Russia has billions of dollars of debt in dollars and Euro. Russia has an outstanding debt of 40 billion. Us dollars interest payments of $117 million were due in March of 2022. And these were dollar denominated debt. Dollar denominated means
the payments have to be made in dollars. Not euros, not rubles , just us dollars. Now Russia has $600 billion of foreign currency reserves. But because of the needless and senseless war they started in Ukraine the US froze, some of their assets.
There a few days when markets were worried, that Russia was going to default on interest payments. due in March. Which they were able to make. Eventually there are more payments coming up , so we'll see what, what happens then. There's also downgrade risk Bond issuers can be downgraded by rating agencies, such as Moody's Fitch or Standard & Poor. When a downgrade happens, investors demand a higher interest rate to buy that bond. So if you're an existing bond holder, The value of your holding will go down when there is a downgrade.
This point here on the chart shows the risk and return of an index of investment grade bonds that include treasuries, corporate bonds, mortgage backed securities, and so on. Investing in a diversified pool of bonds will reduce your overall risk. There are seven other kinds of risks, suggest sovereign risk, volatility risk yield curve risk and so on. But I hope I was able to give you a general overview of the different types of risks associated with bond investing. I'm giving you a little bit of homework here, log into your 401k account or any retirement account you may have and check the types of bond funds that you're invested in. Bond funds are suitable for tax advantage
portfolios, such as retirement accounts and not your regular taxable brokerage accounts. Why? Because bonds give interest income and interest income is taxed at your regular income taxe rate. Which is higher than the rates your qualified dividends get taxed at. So your homework is to go and check the composition of bond funds in your portfolio. Let me know in the comments, what do you find out. Being aware of where your money is invested and how you're diversified is really important. So
I hope this section gave you an overview of bond investing. Because I told you I would give you an overview of all available investments. I want to talk about four more investments. The first one is alternatives. This is private equity, venture capital and hedge funds. Many retail investors don't have access to these types of investments. They're not publicly traded and most retail investors don't have access to these types of investments because of regulation. These investments Do require, investors do have
a certain level of income or assets. So I will leave this asset class for a future session. The next one is real estate. I've included residential properties, office space, storage space, hotel properties, et cetera in this dot. Some people like the consistency of regular rental income that comes with owning a property, but don't ignore the risk. Awareness is key. Like when the pandemic began, if you were a landlord that owned a lot of office space, which short term leasees .
You may have lost money because a lot of companies decided to. To remote work and office space was empty. So imagine being a landlord with a big portfolio of office rental space, not a pretty situation to be in. REITs another option that will give you exposure to real estate without the hassle of owning property. But the income that comes from owning REITs is not qualified, which means it gets taxed at a higher rate, which is your income tax rate, rather than the rate that qualified dividends get taxed at, which is the capital gains tax. The next week is commodities. It includes three main categories, agriculture, which includes commodity,
such as corn, soybean, wheat, sugar, coffee, capital, pork, et cetera, energy commodities, which includes oil and natural gas and metals, which includes gold platinum, copper. Buying and selling actual commodities, actual physical commodities is tedious and time consuming, especially if you're not in the commodity business. So an easier way to get exposure to commodities is either through ETFs or companies that have exposure to commodities, such as a mining company, , are through, , futures contracts, which comes under a special class of investments, known as derivatives. I will cover the derivatives in a future. And finally, I want to touch upon cryptocurrencies. I could not place cryptocurrencies on this chart because the risk and return both are off the charts. I will share, my feelings about crypto in a later video, but here's what I think about crypto in brief crypto is super speculative.
It is not backed by anything and could disappear in no time. Having said that if you have , the risk appetite for crypto, do your research and invest, but only invest your fun money in it don't let crypto be more than 5% of your total portfolio. I want to use a diet analogy in this case. To stay fit. You need a balanced diet, a combination of carbs, protein, fat water, fiber, and so on. Similarly, you need a good balance of all the
assets I went over in a healthy combination, too much of anything is going to be harmful, consume a lot of carbs and you will gain weight, consume a lot of protein and you know, what's coming next constipation. Crypto is like dessert on your portfolio plate. Having a little bit of it. It's not going to hurt you. In fact, it'll make you feel really good, but making a whole meal out of it will hurt your big time. Going back to the risk return grid you may have noticed, I did not talk about any of the stock investments that's because in my next video, I'm going to talk about the stock market. That video is going to be the first video in a series on the basics of stock market.
If you are new to investing, it will be a great video for you to attend because I'm going to explain concepts in a way that even my five-year-old can understand. And if you are a veteran investor, it will be a refresher video for you. So make sure to subscribe to my channel and hit the bell icon. So you don't miss it. That's it from. Or this week as always, don't forget to be happy to be kind and to be your best self by. And here are some more videos I think you will enjoy. I would really appreciate your hitting the like button and sharing this video with your friends and family. It will help me reach more people.
2022-04-11 22:41
