About Investments

If you would know the value of money, try to borrow some.     —poor richard's almanac

INTRODUCTION

Investment is the placing of funds for the pur- pose of getting some income return and/or an increase in the invested principal. Return in the form of interest constitutes a rental for the use of the money and as such has been socially acceptable for thousands of years; indeed, tablets and inscriptions from ancient Egyptian and at a specified rate was a common business transaction even in those days. The modern world contains many investment media; among them are real estate, life insurance, commodities, bonds, stocks, and savings accounts.

All forms of investment have in common the following characteristics : (a) the amount in-vested, called the principal; (b) the rate of re- turn, usually stated as an annual rate in per cent; (c) the degree of risk; (d) the liquidity, or how quickly the investment may be converted into cash; (e) the capital gain, or increase in the value of the principal, sometimes termed the grown factor. Assuming a certain principal amount, the other four factors vary widely with the nature of the investment. These variations may be seen in  the following table:

CHARACTERISTICS OF VARIOUS TYPES OF INVESTMENTS
Safety         Return       Liquidity   Growth
Cash................................................. high       none           high        none
Savings account................................ high       3-3 ¾%      good      none
Savings and loan assn. (insured)......... high       3-4 ½         high        low
Life insurance.................................... high       2                high        low
Credit union funds............................. high       3-4             good      low
U. S. savings bonds........................... high       3¾             high        low
Corporate bonds (high grade)............ good      4½-5          good      low
Preferred stocks (high grade)............ good      4½-5          fair         low
Common stocks (investment)............ low        3½-4          low        low
Common stocks (growth).................. low        0-2 ½         low        high
Investment companies....................... fair         3-4             fair         low
Real estate (unimproved)................... fair         none           poor       fair

In order to achieve high safety and high liquidity, growth and rate of return must be sacrificed. On the other hand should high return or growth be desired, it is equally apparent that some degree of safety and liquidity must be sacrificed. No investment will combine high safety with a high rate of return;  these are always in inverse relationship, and it must be borne in mind that this is a basic fact of both savings and investment in general.

To be an investor you must first accumulate funds for investment, and safety in your savings plan is the first consideration. This will im-mediately limit the number of media into which such funds may be placed (see the above table). After you have accumulated a sufficient amount, then will be the time to consider whether higher risks are justified.

How much should be the goal before further investment, with attendant higher risks, is at­tempted? The answer cannot be given in the form of an exact amount, because your total in­come and expenditures will have a bearing upon it; but most authorities agree that a "nest egg" or "rainy day fund" must first be obtained which is the equivalent of at least three months' salary. After that, further savings may be made for in­vestment at a somewhat higher risk. Thus, if you guard against unforeseen emergencies, a program of investment with some degree of se­curity and peace of mind may be undertaken. We must emphasize that no short cut should be resorted to here.

In other words, investment for the person of modest means is a series of steps: the gradual accumulation of surplus cash as a "rainy day" or emergency fund; the accumulation of an ad­ditional fund for investment; and the placing of this fund in investments which may entail somewhat higher risks.

The sections that follow discuss some of the types of investments in which immediately nec­essary funds may be placed with reasonable safety; later chapters discuss investments that carry somewhat higher risks or call for some­what larger amounts of investment funds.

MUTUAL SAVINGS BANKS

These banks are quite different from com­mercial banks, inasmuch as there are no stock­holders and the depositors themselves receive, as dividends upon their deposits, all funds in excess of the costs of doing business and the amounts transferred to surplus. There are more than five hundred mutual savings banks in the United States, and these are limited to seventeen states. They were originally founded to encour­age thrift by persons who would risk their own funds in order to guarantee the success of the undertaking. They are closely supervised by state regulations and the states themselves set the maximum interest rates which may be charged upon funds left on deposit. The amount and time of withdrawal is very rarely restricted, although the bank may legally do so in a crisis, provided written notice is given; in other words, when this provision is enforced, the depositor must give written notice of his intention to with­draw funds and must then wait 30 or 60 days before being permitted to make the withdrawal. This form of savings bank has several advan­tages, among which the following are worthy of mention:

1. It is a safe place for the deposit of sur­ plus funds.
2. It issues various combinations of life in-­ surance at very low rates.
3. The Federal Deposit Insurance Corporation membership offers $10,000 maximum insurance (as it does for other types of banks) on each deposit account for some of these banks; in   three   states    (Massachusetts,   Connecticut, New Hampshire) the banks contribute to a cen­tral fund which provides similar protection.

Since these banks are state regulated, they will be subjected to frequent examination, which, in turn, protects the depositors.

Since the depositor is essentially a stock­holder, even though he does not own any stock, he is likely to feel a closer personal identifica­tion with this kind of banking institution than he would with some of the larger commercial banks. Bringing his funds into a bank where he may find the profits translated into interest gains for himself will probably give him a feeling of closer relationship to the banking institution.

COMMERCIAL BANKS

The modern commercial bank, with its vari­ous departments and services, may be considered as applying modern merchandising methods to the banking business. Fifty years ago the small depositor was of little importance; indeed, some banks refused to accept deposits which they felt were undesirable from their point of view. We have witnessed a remarkable change in recent years. Now the depositor is king. He finds nu­merous services at his command (checking, savings, personal loans, home improvement fi­nancing, appliance and auto loans, foreign ex­change, traveler's checks, bank money orders, etc.), and although he is asked to pay fees for these services, he finds it a distinct advantage to be able to do all his banking at one place. His bank has indeed become the department store of banking.

For our present needs we may restrict our dis­cussion to two of the functions of the commercial bank. The first of these is the checking account, which has three advantages for the householder. First, a checking account is a safe place for funds which, if left in a household, might be lost, misplaced, or even stolen; second, a can­celed check is considered as a valid receipt for an obligation which it has paid; third, the check­book is a useful record of transactions. The costs for a checking account are not high and are figured, in most cases, by reference to the aver­age balance of the account and/or the number of transactions (checks drawn and deposits made). Some banks have instituted a special form of checking account, wherein the depositor purchases the checks, usually at a nominal charge, and is then permitted to write as many checks as he pleases, without regard to a mini­mum balance.

Another important feature of the commercial checking account is the fact that a check is a "demand" on funds, and the deposits are termed "demand deposits," since they are payable on demand. This differs from savings funds, which are termed "time deposits," since, legally, their withdrawal may be restricted.

If all funds are placed on deposit and subject to checking, it is often a temptation to mingle the savings amounts with the everyday living ex­penses. For this reason, and also to encourage the habit of thrift, it is wise to establish a sep­arate savings account.

The savings or thrift account, as operated by most banks, is an excellent depository for sur­plus funds. The interest rate varies with general business and money conditions, but is about 3 per cent at present, usually credited semiannually, and compounded if not withdrawn. The account is insured up to $10,000 by any bank which is a member of the Federal Deposit In­surance Corporation. Over 90 per cent of present day commercial banks are members of the or­ganization.

A savings account will permit the withdrawal of funds without delay under normal conditions, but all banks reserve the right to restrict that privilege when they deem it necessary. This is to protect themselves from heavy withdrawals in time of severe financial crisis. Under ordinary conditions this right is not invoked, but upon giving notice the bank may require all deposi­tors to file a notification of withdrawal of funds and then to wait the legal period of from 30 to 60 days, after which the funds are payable.

Banks use many methods to compute interest on their savings accounts, but almost all of them use the semiannual interest period beginning January 10th and July 10th, and closing June 30th and December 31st respectively. Overactive accounts are usually penalized, since the bank cannot operate as profitably if the funds avail­able to it for investment are constantly fluctuat­ing. In reality, the true saver benefits most by leaving funds undisturbed.

Many people complain that the rate of inter­est of about 3 per cent is too low. They forget that a high degree of safety will always be cou­pled with a low rate of return and that this is a fundamental principle of all investment.

SAVINGS AND LOAN ASSOCIATIONS

Building and Loan Associations
These are locally owned, privately managed thrift and finance corporations. The savers really become stockholders, since they purchase shares in the company with their deposits. Some of these associations even offer installment ac­counts, whereby the depositor may buy shares on the installment plan. Their savings accounts are similar to those of banks, but they often pay a higher rate (32 to 42 per cent), because a larger percentage of their loans are invested in long-term home mortgages which carry a higher interest rate. Most of them are state chartered, but some are federal chartered and will carry the word "Federal" in their titles. Those which are federal are members of the Federal Savings and Loan Insurance Corporation, which pro­vides an insurance of $10,000 maximum per ac­count per person, similar to that in savings banks. Some state charters require membership in the Federal Home Loan Banking System as well. The depositor should find out in all cases; the information is readily available.

As in the case of savings banks, these insti­tutions are not required to pay out money on de­mand, but usually do so.

UNITED STATES SAVINGS BONDS

These bonds were first offered in March, 1935, and later were designed as an investment for excess savings during World War II, They are not really bonds, in a technical sense, since they are not a lien upon the properties of the government; more properly they should be classed as debentures, since their security de­pends entirely upon the credit and stability of the government of the United States. However, they are usually termed bonds, and they bear such a designation upon their face.

Savings bonds such as these offer the investor certain very valuable features. Their safety is unquestioned; they are registered, with the re­sult that if they are lost, stolen, or even de­stroyed the owner suffers no loss; they are bought without any fees or commissions; there is no problem of marketing or pricing, since bonds may be redeemed for cash at any time ac­cording to a given schedule of redemption values; interest accrues with the progress of time, so that the bonds become increasingly more valuable at the end of each half-year period, which is the equivalent of compound interest. Perhaps their main shortcoming is the fact that they are not designed to benefit the short-term saver, since they must be held for a considerable period of time in order to obtain the maximum return. The short-term saver or investor, who may need a sum of money within a relatively short period of time, had better make use of some other medium of saving; but for those who are willing to be patient, the bonds offer a combination of unquestioned high security coupled with a good rate of return for this class of investment. The interest is exempt from all state and local forms of taxation, al­though it is taxable as ordinary income by the federal government.

Perhaps the strongest criticism of U. S. Sav­ings Bonds has been directed against them be­cause of the impact of inflation. If bonds were bought during the war years (the forties) and cashed in at maturity during the postwar years (the fifties), the buyer was penalized for saving, because the dollars he actually received would buy considerably less in goods and services. The answer to this criticism is that inflation affects all forms of investment that are repaid in a fixed number of dollars—the proceeds of life insurance, savings accounts, corporate bonds, etc. Perhaps the only investments that are con­stantly revalued from day to day are real estate, commodities (grain, vegetable oils, coffee, tea, etc.), and common stocks. Since these suffer serious valuation losses at times, it may be pru­dent to hold at least some investments in those forms which are payable in a fixed number of dollars. Besides, who has the necessary knowl­edge to be sure that all his investments in com­modities, stocks, and real estate such will be pre­served without loss? As we shall make clear, the stock market is often considered a strong hedge against inflation, but it is not a one-way street; it can decline as well as rise. Can the losses that are incidental to a sudden drop be absorbed? For the average investor the answer is usually in the negative.

EFFECTS OF COMPOUND INTEREST

Many people do not know, or at least do not understand, the way in which compound inter­est operates. Since the principle of compound interest has an important place in all invest­ment, a few simple examples may serve to ex­plain its working.

Suppose an investor places $100 in an account paying 2 per cent compounded annually. At the end of the first year the interest, which amounts to $2, will be added to the principal amount, making it $102. At the end of the second year the interest will be $2.04 which, when added again, gives $104.04. If this is continued through a period of ten years, the final accumulated amount will be $121.90. If the lending institu­tion gave 3 per cent compounded semiannually, as is the case with most banks, the final amount would be $134.69. In other words, interest is computed not only on the original deposit, but upon the interest itself as it is added to the original amount. This is the basis of the values of the Series E Bonds, bought at $18.75, $37.50, $75.00, etc., and amounting at maturity to $25, $50, $100, etc. It is easy to see that placing funds at compound interest for a lengthy period of time has its rewards. If a parent were to place $100, in a savings account at the birth of a child, and if the savings institution were to pay an average annual rate of 22 per cent compounded semiannually (interest rates paid on funds on deposit vary with business conditions), then the child at age twenty-one would have $168.50. A high degree of safety would have been provided at the same time.

Should $100 be placed at interest, com­pounded semiannually for ten years, it would amount to the following: at 2 per cent, $122.02; at 22 per cent, $128.20; at 3 per cent, $134.69; at 32 per cent, $141.48. These figures are based on the assumption that the stated rate re­mains unchanged. For savings placed in either a savings bank or a building and loan associa­tion, the rate paid depends largely upon general business conditions and the prevailing "money rate."

FINANCIAL SECURITY

The word "security" has a comfortable con­notation, but a large majority of families would be placed in an awkward position if they were asked to define their own relative security. They might feel that a home, food and clothing, and some of the so-called "luxuries" of life constitute security, and that if they had all of these now, they would be quite secure. They overlook the fact that the basic idea behind security in a fast-moving and rapidly changing world has become not merely the few necessities and the few luxuries that life may offer, but something even beyond these—complete financial security.

We must emphasize that "financial security" does not mean simply the ability to buy enough meat and bread, enough clothes and shelter, a car and a television set. Quite the contrary, be­cause for many these are usually unplanned and part of vague so-called "needs." Because of a lack of knowledge of the underlying principles of financial security, many people are lulled into a false security and feel that they are secure when they really are not. Others have an attitude of resignation, feeling that such security is something they cannot attain. Still others are completely indifferent. Many of these people are buying a home and life insurance, both of which are good first steps toward ultimate finan­cial security; but they fail to realize that to be able to combat unexpected reverses is a diffi­cult and worrisome matter and that they have not come face to face with this problem.

Is it possible to attain a fair measure of fi­nancial independence? The answer is definitely "yes," as is amply shown by the thousands who have realized that they were getting nowhere fast and have succeeded in doing something about it. Let us make clear, however, that those persons who merely have good intentions—those who talk about saving but never save—will not achieve real security.

How may financial security be obtained? All authorities agree that careful planning is neces­sary for financial success; all agree that financial success is necessary for financial peace of mind. This means that if you wish to get "off the treadmill" and partake of a richer life, you must be willing to undertake such a plan whole­heartedly.

OBJECTIVES

Before you draw up your plan for investment, it will be necessary to consider carefully the objectives you want to achieve. Let us suppose that conservation of principal is a "must"; then what else may be expected? Much will depend upon   a   proper   choice   among   these   three:
(a) regular income; (b) income plus capital appreciation; (c) capital appreciation alone. Let us see how the selection of one of these will depend upon the personal needs of the investor. John Doe is fifty-three years of age. He has worked hard all his life, and it is only after reaching middle age, with his children married and "on their own," that he has managed to ac­cumulate extra funds for investment purposes. His health is good, but he plans to retire at the age of sixty, and for this reason alone he is interested in security of principal coupled with a steady income upon which he can depend. Are bonds for him?

Richard Roe is a much younger person (thirty-three) and has a wife and two small children. He carries adequate life insurance and is buying a home. Both he and his wife take the "long view" of their future and wish to invest in something that may show a considerable in­crease in invested principal over the years, in­come being secondary. Are common stocks for them?

For a long-term investment there are bonds and preferred and common stocks. Each has its advantages and disadvantages, some of which are tabulated below:

ADVANTAGES AND DISADVANTAGES OF BONDS           AND COMMON STOCKS
Advantages                                                                      Disadvantages
Bonds (high grade): Capital safety                          Fixed dollar return
Steady income                                                       Fixed dollar redemption
Narrow price changes

Bonds (medium grade):
Common Stocks (high grade):
Common Stocks (medium grade):                                                     Fair income security
 Wider price changes                                                Capital appreciation if bought at a discount
Hedge against inflation                                                          Some appreciation possible
Hedge against inflation                                                          Greater appreciation possible
Fixed dollar return                                                                Fixed dollar redemption
Lack fixed income                            Fair risk factor Considerable price changes
Lack fixed income                            Higher risk factor                      Wide price changes

Preferred stocks are not considered in this table; they will be discussed later.

Although this summary is not complete, it furnishes food for reflection. It should be obvious that a choice between bonds (including U. S. Savings Bonds) and common stocks demands careful appraisal of the degree of risk assumed. In addition, the proportion of bonds and stocks in any total proposed investment must be decided. In order to do this we must de­vise an investment plan that will meet our in­dividual requirements.

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