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Let’s use an example to demonstrate the types of investments. For instance, pretend you are going to start a lemonade stand. You need some money to get your stand started. You ask your grandmother to lend you $100 and write this down on a piece of paper: "I owe you (IOU) $100, and I will pay you back in a year plus 5% interest." Your grandmother just bought a bond (IOU) by lending money to your "company" named Lemo. To get more money, you sell half of your company for $50 to your brother Tom. You put this transaction in writing: "Lemo will issue 100 shares of stock. Tom will buy 50 shares for $50." Tom has just bought 50% of the shares of stock from Lemo.
You sell $500 worth of lemonade. Business is good. Your costs for setting up the stand are $150, plus you pay yourself $100 for the hours you work. The company makes profits of $250.
After one year, from the $250 profits, you pay back your grandmother $100 plus $5 interest. You pay $20 to Tom and yourself, shareholders (a fancy name for owner). In business, the $20 paid to the owners is called a dividend. You decide to put the dividend money in the bank. Banking the money is a short-term investment.
This example covers three types of investments: short-term investments, bonds, and stocks. Besides these three, there are real estate (buying a house), commodities (gold and silver), collectibles (such as baseball cards), and mutual funds. Let’s examine these seven, one at a time.
Bank savings accounts, money-market funds, Certificates of Deposit (CD’s), and Treasury Bills (T-bills) are known as short-term investments. There are pros and cons to short-term investments.
Even though your money earns interest in a bank account, inflation can take away its real value. Money in a bank’s passbook savings account and in money market funds often can’t make enough interest to offset the losses from inflation. That’s why it is important to understand the other ways to invest.
In the lemonade example, the grandmother bought a bond when she lent $100 and contracted to get it back with 5% interest in a year. When you invest in bonds, the bond you buy will show the amount of money being borrowed (face value), the interest rate (coupon rate or yield) that the borrower has to pay, the interest payments (coupon payments), and the deadline for paying the money back (maturity dates).
One way to invest is to lend your money to others. In this case, it is called "buying a bond." If you buy a bond with a $10,000 face value and a 15-year maturity, and you hold it for fifteen years, you will get $10,000 back plus interest payments, normally every three or six months.
The main difference between bonds and CDs or T-bills is that, with bonds, you get paid a higher interest rate (about 2% more), but you wait longer to get your money back (ten to thirty years). With CDs and T-bills, you get your money back in three months to two years.
There are pros and cons to bond investments.
Advantages
Disadvantages
One of the risks of investing in bonds is a default, which occurs when the issuer of the bond fails to make payments. To keep investors informed about the chance that a bond will default, companies such as Standard & Poors (S & P) and Moody’s give ratings to bonds. The higher the rating, the lower the chance that a bond will default. S & P grades bonds from AAA, AA, A ... to D. Moody’s rates bonds from Aaa ... to C. A strong company such as Disney gets AAA or Aaa. AAA or Aaa means the chance of Disney defaulting on a bond is very small.
The low rated bonds, such as bonds issued by USAir, are called junk bonds. A junk bond is issued by a weak company that may have trouble paying its bills. To compensate the risk an investor takes in purchasing a junk bond, it pays high interest rates (10 to 15 percent).
There are three types of bonds: Treasury bonds (T-bonds), municipal bonds (munis), and corporate bonds.
The U.S. government is the biggest seller (issuer) of bonds in the world. Although our government runs up $5 trillion of debts, (money that is borrowed to run its budget), and spends more than 15% of its tax income to pay the interest on the debt, Uncle Sam’s bonds are safe. Of course, the interest rate on T-bonds is lower than those of corporate bonds. Generally speaking, the safer your money is, the less interest you will get paid.
The kinds of bonds that kids are likely to buy are called U.S. Savings Bonds. These can be bought with as little as $25. Grandparents are known for giving savings bonds as gifts to their grandchildren. For more information about Treasury Bonds call 1-800-USBONDS or click here.
Muni bonds are bonds sold by municipalities to raise money to build public facilities such as schools, roads, water supplies, and stadiums.
The advantages in buying munis is that the interest payments are free from federal and state income taxes. However, the downside is that, unlike Uncle Sam, local governments can have money problems, and sometimes may not be able to make interest payments. For example, when Orange County in California filed bankruptcy in 1994, some of the bonds the county issued were in default. Check the bond rating before you invest.
Corporate bonds are bonds that are issued by corporations such as Disney, IBM, and General Electric. These bonds work the same as munis except that their interest payments are taxable. Corporate bonds also receive bond ratings from S & P and Moody’s.
When you keep a bond until its maturity, you get paid the bond’s face value, the same price you paid for the bond, plus the yearly coupon payments, which is a fixed amount based on the interest rate.
Bond originally issued:
Face Value : $1,000
Current Interest Rate: 10%
The bond’s yield reflects interest rate: 10%
Yearly bond payment (coupon payment): 1,000 × 10% = $100 (fixed)
If you sell the bond prematurely, the bond's price can change, depending on the current interest rate and the fixed coupon payment. For example:
Case #1 (Premium)
Current Interest rate: 8%
Yield : 10% - 2% = 8%
Yearly bond payment : 1,250 × 8% = $100 (fixed)
Bond price = $1250 (You make $250)
If the current interest rate goes down to 8%, the bond's yield also reflects the 8%. Moreover, when the interest rate goes down, the bond's price must go up in order to keep the coupon payment fixed at the original issue amount. In this case, since the coupon payment must stay at $100, the bond's price goes up to $1250. It is sold at a premium (more than the face value) when interest rates go down. Depending on the interest rate at the time, the bond has to sell at a premium or discount to compensate for the change of interest rate.
Conversely, the bond price will come down if current interest rates go up. Then, you will sell the bond at a discount (less than the face value).
Case #2 (Discount)
Current Interest rate: 13%
Yield : 10% + 3% = 13%
Yearly bond payment : 769 × 13% = $100 (fixed)
Bond price : $769 (You lose $231)
Bond prices and current interest rates are published daily in the financial sections of major newspapers. You can also find bond quotes on the Internet.
Stocks are shares in a company. When you invest in a company's stock or buy its shares, you own part of a company as demonstrated when Lemo sold half of its ownership or stocks to Tom. If the company makes money, your stock will increase in value. But, just as in short-term investment and bonds, there are pros and cons to stock investments.
In the long run, stocks have beaten alternative investments such as bank accounts, bonds, real estate, and commodities. A Chicago consulting firm, Ibbotson Associates, has compiled data to show that stocks are the way to go. Stocks, represented by the Standard & Poors 500, doubled the compound annual return of T-bonds issued in 1926.
If you buy a share or shares of stock in a public company, you become a part owner of that company. As a shareholder of one share of Microsoft, you enjoy the same basic privileges and rights as Bill Gates who owns millions of shares.
As a shareholder, you have the privilege to receive quarterly reports and an annual report informing you of the financial health of the company. These reports are just like report cards you receive from school. The quarterly reports tell how much money the company has made or lost and business activities during the reporting period. The annual report is a combination of all quarterly reports and is often printed with fancy charts and photographs. It gives detailed business and financial information about the company. As a shareholder, every year you’ll be invited to attend the annual shareholders’ meeting, where you can ask Mr. Gates questions about Microsoft.
In addition, you will have the right to vote for Microsoft’s board of directors, the shareholders’ representatives who keep track of the important issues of the company. They will, in turn, hire officers such as Chairman Gates to run the company.
Most companies use a one-vote-one-share system. Even though your one share of Microsoft does not count much against Mr. Gates’s millions of votes, the company takes each vote seriously. If you cannot go to the annual shareholder’s meeting, they will send you an absentee ballot.
This investment could be buying a house, an apartment, or just plain land. Buying real estate is a bit expensive for a kid. If you are interested in real estate investments, you might consider real estate investment trusts (REIT), a public company that owns and manages a lot of real estate such as apartments, shopping malls, and office buildings. You can buy shares of REIT stock and not worry about managing these buildings.
A commodity is anything from gold, silver, or oil, to farm products, such as cotton, soybeans, or meat. It can also be foreign currencies, such as yen, pounds, and lira.
The prices of commodities are driven mostly by supply and demand. For example, oil prices will go higher if there is a shortage. Investments in commodities are very speculative because their future demand is difficult to predict. These investments are best left to professionals, not kids. More information about commodities trading is available at the Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT) Web sites.
A collectible is anything from baseball cards, coins, stamps, or dolls to antiques. When you buy these collectibles, you hope to resell them for a profit some day. The downside of collectibles is that they can get stolen or damaged, resulting in losses. Also, they may not increase in value as they get older; some things actually lose value due to wear and tear. For youngsters, collecting baseball cards is fun, but not a sure way to make money. Click here for an example of a collectable Web site.
A mutual fund is a pool of lots of investors’ money to purchase a variety of investments such as all six types we have previously covered. There are many different types of mutual funds.
Mutual funds are diversified investments that help put your eggs into many baskets. To invest, you can buy as little as one share (a unit) of a mutual fund.
According to Lipper Analytical, in the last 35 years, only 33% of the mutual funds beat the S & P 500 index. In the last ten years, only 21% the of mutual funds beat the S & P 500 index. Nonetheless, a good fund manager such as Peter Lynch can beat the market most of the time.
There are thousands of mutual funds to suit each individual’s investment objectives. Mutual fund prices are listed in the financial section of major newspapers, and on the Internet. Click here for more information on mutual funds.
Now that we have looked at the different types of investments, we can see that stocks look the most promising for kids because they have the highest rate of return over time. They may go down for the short-term, but over time, stocks in solid companies will rise. Click here to learn more about stocks.