Find out if the Net Investment Income Tax applies to you.

Basics of the Net Investment Income Tax

1. What is the Net Investment Income Tax (NIIT)?

The Net Investment Income Tax is imposed by section of the Internal Revenue Code. The NIIT applies at a rate of % to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts.

2. When did the Net Investment Income Tax take effect?

The Net Investment Income Tax went into effect on Jan. 1, The NIIT affects income tax returns of individuals, estates and trusts, beginning with their first tax year beginning on (or after) Jan. 1, It does not affect income tax returns for the taxable year filed in

Who Owes the Net Investment Income Tax

3. What individuals are subject to the Net Investment Income Tax?

Individuals will owe the tax if they have Net Investment Income and also have modified adjusted gross income over the following thresholds:

Taxpayers should be aware that these threshold amounts are not indexed for inflation.

If you are an individual who is exempt from Medicare taxes, you still may be subject to the Net Investment Income Tax if you have Net Investment Income and also have modified adjusted gross income over the applicable thresholds.

4. What is modified adjusted gross income for purposes of the Net Investment Income Tax?

For the Net Investment Income Tax, modified adjusted gross income is adjusted gross income (Form , Line 37) increased by the difference between amounts excluded from gross income under section (a)(1) and the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section (d)(6) for amounts described in section (a)(1). In the case of taxpayers with income from controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs), they may have additional adjustments to their AGI. See section (e) of the final regulations. 

5. What individuals are not subject to the Net Investment Income Tax?

Nonresident Aliens (NRAs) are not subject to the Net Investment Income Tax. If an NRA is married to a U.S. citizen or resident and has made, or is planning to make, an election under section (g) or (h) to be treated as a resident alien for purposes of filing as Married Filing Jointly, the final regulations provide these couples special rules and a corresponding section (g)/(h) election for the NIIT. 

A dual-resident individual, within the meaning of regulation §(b)-7(a)(1), who determines that he or she is a resident of a foreign country for tax purposes pursuant to an income tax treaty between the United States and that foreign country and claims benefits of the treaty as a nonresident of the United States is considered a NRA for purposes of the NIIT.

A dual-status individual, who is a resident of the United States for part of the year and a NRA for the other part of the year, is subject to the NIIT only with respect to the portion of the year during which the individual is a United States resident. The threshold amount (described in # 3 above) is not reduced or prorated for a dual-status resident. 

6. What estates and trusts are subject to the Net Investment Income Tax?

Estates and trusts are subject to the Net Investment Income Tax if they have undistributed Net Investment Income and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year under section 1(e) (for tax year , this threshold amount is $11,). Generally, the threshold amount for the upcoming year is updated by IRS each fall in a revenue procedure. For , the threshold amount is $12, (See Rev. Proc.  PDF). 

There are special computational rules for certain unique types of trusts, such as Qualified Funeral Trusts, Charitable Remainder Trusts and Electing Small Business Trusts, which can be found in the final regulations (see # 20 below).

7. What estates and trusts are not subject to the Net Investment Income Tax?

The following trusts are not subject to the Net Investment Income Tax:

1. Trusts that are exempt from income taxes imposed by Subtitle A of the Internal Revenue Code (e.g., charitable trusts and qualified retirement plan trusts exempt from tax under section , and Charitable Remainder Trusts exempt from tax under section ).
2. A trust or decedent’s estate in which all of the unexpired interests are devoted to one or more of the purposes described in section (c)(2)(B).
3. Trusts that are classified as “grantor trusts” under sections
4. Trusts that are not classified as “trusts” for federal income tax purposes (e.g., Real Estate Investment Trusts and Common Trust Funds).
5. Electing Alaska Native Settlement Trusts.
6. Perpetual Care (Cemetery) Trusts. 

What is Included in Net Investment Income

8. What is included in Net Investment Income?

In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer (within the meaning of section ). To calculate your Net Investment Income, your investment income is reduced by certain expenses properly allocable to the income (see #13 below).

9. What are some common types of income that are not Net Investment Income?

Wages, unemployment compensation; operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends (see Rev. Rul. , CB ) and distributions from certain Qualified Plans (those described in sections (a), (a), (b), , A or (b)).

What kinds of gains are included in Net Investment Income?

To the extent that gains are not otherwise offset by capital losses, the following gains are common examples of items taken into account in computing Net Investment Income:

1. Gains from the sale of stocks, bonds, and mutual funds.
2. Capital gain distributions from mutual funds.
3. Gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence).
4. Gains from the sale of interests in partnerships and S corporations (to the extent the partner or shareholder was a passive owner). See section of the proposed regulations.

Does this tax apply to gain on the sale of a personal residence?

The Net Investment Income Tax does not apply to any amount of gain that is excluded from gross income for regular income tax purposes. The pre-existing statutory exclusion in section exempts the first $, ($, in the case of a married couple) of gain recognized on the sale of a principal residence from gross income for regular income tax purposes and, thus, from the NIIT.

Example 1: A, a single filer, earns $, in wages and sells his principal residence that he has owned and resided in for the last 10 years for $, A’s cost basis in the home is $, A’s realized gain on the sale is $, Under section , A may exclude up to $, of gain on the sale. Because this gain is excluded for regular income tax purposes, it is also excluded for purposes of determining Net Investment Income. In this example, the Net Investment Income Tax does not apply to the gain from the sale of A’s home.

Example 2: B and C, a married couple filing jointly, sell their principal residence that they have owned and resided in for the last 10 years for $ million. B and C’s cost basis in the home is $, B and C’s realized gain on the sale is $, The recognized gain subject to regular income taxes is $, ($, realized gain less the $, section exclusion). B and C have $, of other Net Investment Income, which brings B and C’s total Net Investment Income to $, B and C’s modified adjusted gross income is $, and exceeds the threshold amount of $, by $50, B and C are subject to NIIT on the lesser of $, (B’s Net Investment Income) or $50, (the amount B and C’s modified adjusted gross income exceeds the $, married filing jointly threshold). B and C owe Net Investment Income Tax of $1, ($50, X %).

Example 3: D, a single filer, earns $45, in wages and sells her principal residence that she has owned and resided in for the last 10 years for $1 million. D’s cost basis in the home is $, D’s realized gain on the sale is $, The recognized gain subject to regular income taxes is $, ($, realized gain less the $, section exclusion), which is also Net Investment Income. D’s modified adjusted gross income is $, Since D’s modified adjusted gross income is below the threshold amount of $,, D does not owe any Net Investment Income Tax.

Does Net Investment Income include interest, dividends and capital gains of my children that I report on my Form using Form ?

The amounts of Net Investment Income that are included on your Form by reason of Form are included in calculating your Net Investment Income. However, the calculation of your Net Investment Income does not include (a) amounts excluded from your Form due to the threshold amounts on Form and (b) amounts attributable to Alaska Permanent Fund Dividends.

What investment expenses are deductible in computing NII?

In order to arrive at Net Investment Income, Gross Investment Income (items described in items above) is reduced by deductions that are properly allocable to items of Gross Investment Income. Examples of deductions, a portion of which may be properly allocable to Gross Investment Income, include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees, fiduciary expenses (in the case of an estate or trust) and state and local income taxes.

Will I have to pay both the % Net Investment Income Tax and the additional .9% Medicare tax?

You may be subject to both taxes, but not on the same type of income.

The % Additional Medicare Tax applies to individuals’ wages, compensation and self-employment income over certain thresholds, but it does not apply to income items included in Net Investment Income. See more information on the Additional Medicare Tax.

How the Net Investment Income Tax is Reported and Paid

If I am subject to the Net Investment Income Tax, how will I report and pay the tax?

Individuals, estates, and trusts will use Form  PDF and instructions PDF to compute their Net Investment Income Tax. 

For individuals, the tax will be reported on, and paid with, the Form For estates and trusts, the tax will be reported on, and paid with, the Form

Is the Net Investment Income Tax subject to the estimated tax provisions?

The Net Investment Income Tax is subject to the estimated tax provisions. Individuals, estates and trusts that expect to be subject to the tax in or thereafter should adjust their income tax withholding or estimated payments to account for the tax increase in order to avoid underpayment penalties. For more information on tax withholding and estimated tax, see Publication , Tax withholding and Estimated Tax.

Can tax credits reduce my NIIT liability?

Any federal income tax credit that may be used to offset a tax liability imposed by subtitle A of the Code may be used to offset the NII. However, if the tax credit is allowed only against the tax imposed by chapter 1 of the Code (regular income tax), those credits may not reduce the NIIT. For example, foreign income tax credits (sections 27(a) and (a)) and the general business credit (section 38) are allowed as credits only against the tax imposed by chapter 1 of the Code, and therefore may not be used to reduce your NIIT liability. If you take foreign income taxes as an income tax deduction (versus a tax credit), some (or all) of the deduction amount may deducted against NII.  

Does the tax have to be withheld from wages?

No, but you may request that additional income tax be withheld from your wages.

Examples of the Calculation of the Net Investment Income Tax

Single taxpayer with income less than the statutory threshold.

Taxpayer, a single filer, has wages of $, and $15, of dividends and capital gains. Taxpayer’s modified adjusted gross income is $,, which is less than the $, statutory threshold. Taxpayer is not subject to the Net Investment Income Tax.

Single taxpayer with income greater than the statutory threshold.

Taxpayer, a single filer, has $, of wages. Taxpayer also received $90, from a passive partnership interest, which is considered Net Investment Income. Taxpayer’s modified adjusted gross income is $,

Taxpayer’s modified adjusted gross income exceeds the threshold of $, for single taxpayers by $70, Taxpayer’s Net Investment Income is $90,

The Net Investment Income Tax is based on the lesser of $70, (the amount that Taxpayer’s modified adjusted gross income exceeds the $, threshold) or $90, (Taxpayer’s Net Investment Income). Taxpayer owes NIIT of $2, ($70, x %).

Additional Information

Other than these FAQs, is there additional information available about the Net Investment Income Tax?

Yes. You can find additional information about the NIIT in the final regulations PDF and in a new proposed regulation PDF published on Dec. 2,

The proposed regulations that were published on Dec. 5, , are effective for tax years beginning after Dec. 31, , but the Net Investment Income Tax went into effect on Jan. 1,  May I rely on those proposed regulations, the proposed regulations published on Dec. 2, , and/or the final regulations, also published on Dec. 2, , for guidance on the Net Investment Income Tax during ?

Yes. For taxable years beginning before Jan. 1, (e.g., calendar year ), taxpayers may rely on the proposed regulations (published on Dec. 5, ), the proposed regulations (published on Dec. 2, ), or the final regulations (published on Dec. 2, ) for purposes of completing Form  However, to the extent that taxpayers take a position in a taxable year beginning before Jan. 1, that is inconsistent with the final regulations, and such position affects the treatment of one or more items in a taxable year beginning after Dec. 31, , then such taxpayer must make reasonable adjustments to ensure that their Net Investment Income Tax liability in the taxable years beginning after Dec. 31, is not inappropriately distorted. For example, reasonable adjustments may be required to ensure that no item of income or deduction is taken into account in computing net investment income more than once, and that carryforwards, basis adjustments and other similar items are adjusted appropriately.

Related Item: Forms and Publications

INTRODUCTION

Saving to build wealth is investing. When people have too much money to spend immediately—that is, a surplus of disposable income—they become savers or investors. They transfer their surplus to individuals, companies, or governments that have a shortage or too little money to meet immediate needs. This is almost always done through an intermediary—a bank or broker—who can match up the surpluses and the shortages. If the capital markets work well, those who need money can get it, and those who can defer their need can try to profit from that. When you invest, you are transferring capital to those who need it on the assumption that they will be able to return your capital when you need or want it and that they will also pay you for its use in the meantime.

Investing happens over your lifetime. In your early adult years, you typically have little surplus to invest. Your first investments are in your home (although primarily financed with the debt of your mortgage) and then perhaps in planning for children’s education or for your retirement.

After a period of just paying the bills, making the mortgage, and trying to put something away for retirement, you may have the chance to accumulate wealth. Your income increases as your career progresses. You have fewer dependents (as children leave home), so your expenses decrease. You begin to think about your investment options. You have already been investing—in your home and retirement—but those investments have been prescribed by their specific goals.

You may reach this stage earlier or later in your life, but at some point, you begin to think beyond your immediate situation and look to increase your real wealth to ensure your future financial health. Investing is about that future.

Investment also goes beyond simply contributing one’s own individual wealth and financial health. The investments we make can contribute to the growth of businesses, organizations, and communities. The investment choices we make can have a significant economic and social impact in the world.

With regard to Indigenous communities in Canada, economic growth is fueled by investment. According to Chief Michael LeBourdais of the Whispering Pine/Clinton Indian Band, “investment can be generated from local residents through savings, through home equity or from outside sources. In Canada, private sector investment outweighs public sector investment by five to one. Three times as many jobs are created in the private sector as in the public sector” (Tulo Centre of Indigenous Economics, , p. 6). Thus, attracting private investment to Indigenous business and economic development projects is an important part of economic growth. Many Indigenous entrepreneurs lack access to capital and rely heavily on personal and family support to help finance their businesses; “there is a growing need for ‘angel investors’ ” as well as other private investment options (Cooper, ). Furthermore, “investment creates jobs and business opportunities. This, in turn, builds the fiscal capacity of governments to support social improvements and build infrastructure. It also encourages a natural constituency for accountable, fiscally responsible government as the investment climate is enhanced. Indigenous governments must participate in federations and market systems to provide fiscal and economic opportunities for their governments and members” (Tulo Centre of Indigenous Economics, , p. 7). Therefore, investing can help to increase your individual financial well-being, as well as the economic and social well-being of communities throughout the country.

Through the creation of the First Nations Fiscal and Statistical Management Act on March 23, , the First Nations Finance Authority (FNFA), the First Nations Financial Management Board (FNFMB), and the First Nations Tax Commission (FNTC) were established. Canada’s First Nations and the Government of Canada worked together to support the creation of these new institutions in order to assist First Nations to better access capital markets and more investment opportunities. The FNFMB helps First Nations to build stronger community management and accountability frameworks, including best practices, standard-setting, and capacity-building, that enhance First Nations’ ability to participate in raising capital through the FNFA (Cooper, ). The FNTC, as mentioned in Chapter 6, helps First Nations use their property tax revenue to secure long-term borrowing and oversee the bylaw approval process, which provides greater investor certainty. As Cooper states, “the ability to successfully provide transparent, risk-related investment opportunities to private capital providers requires that First Nation communities undertake initiatives to enhance their ability to borrow. The practices and processes of the FNFA and the FNFMB are tools which can be of immediate assistance to the First Nations communities as they proceed to prepare themselves for dealing with private capital providers” (Cooper, , p. ).

How should you invest your money? This is a critical question that we must all ask ourselves as we reach that stage of our lives when we are ready to begin investing. Today, there are more and more options available to investors who wish to invest their money in socially responsible businesses. Furthermore, many businesses are focusing more on corporate social responsibility (CSR), which is focused on economic, social, and environmentally sustainable activities—and not only because they know it is the right thing to do, but also because it is good business. More and more companies are sharing their CSR record, which makes it easier for investors to research and make informed decisions.

INVESTMENTS AND MARKETS: A BRIEF OVERVIEW

Learning Objectives

1. Identify the features and uses of issuing, owning, and trading bonds.
2. Identify the uses of issuing, owning, and trading stocks.
3. Identify the features and uses of issuing, owning, and trading commodities and derivatives.
4. Identify the features and uses of issuing, owning, and trading mutual funds, including exchange-traded funds and index funds.
5. Describe the reasons for using different instruments in different markets.

Before looking at investment planning and strategy, it is important to take a closer look at the galaxy of investments and markets where investing takes place. Understanding how markets work, how different investments work, and how different investors can use investments is critical to understanding how to plan your investment goals and strategies.

You have looked at using the money markets to save surplus cash for the short term. By contrast, investing is primarily about using the capital markets to invest surplus cash for the longer term. As in the money markets, when you invest in the capital markets, you are selling liquidity.

The capital markets developed as a way for buyers to buy liquidity (i.e., raise capital). The two primary methods that have evolved into modern times are the bond and stock markets. Both are discussed in greater detail in Chapter 13 &#;Owning Stocks&#; and Chapter 14 &#;Owning Bonds and Investing in Mutual Funds,&#; but a brief introduction is provided here to give you a basic idea of what they are and how they can be used as investments.

Bonds and Bond Markets

Bonds are debt. The bond issuer borrows by selling a bond, promising the buyer regular interest payments and then repayment of the principal at maturity. If a company wants to borrow, it could just go to one lender and borrow. But if the company wants to borrow a lot, it may be difficult to find any one investor with the capital and the inclination to make that large a loan, taking a large risk on only one borrower. In this case, the company may need to find a lot of lenders who will each lend a little money, and this is done through selling bonds.

A bond is a formal contract to repay borrowed money with interest (often referred to as the coupon) at fixed intervals. Corporations and governments (e.g., federal, provincial, municipal, and foreign) borrow by issuing bonds. The interest rate on the bond may be a fixed interest rate or a floating interest rate that changes as underlying interest rates—rates on debt of comparable companies—change. (Underlying interest rates include the prime rate: the annual interest rate Canada’s major banks and financial institutions use to set interest rates for variable loans and lines of credit, including variable-rate mortgages. The Bank of Canada sets the prime rate.)

Bonds have many features other than the principal and interest; these include the issue price (the price you pay to buy the bond when it is first issued) and the maturity date (when the issuer of the bond has to repay you). Bonds may also be “callable”—that is, redeemable before maturity (paid off early). Bonds may also be issued with various covenants or conditions that the borrower must meet to protect the bondholders (the lenders). For example, the borrower (the bond issuer) may be required to keep a certain level of cash on hand, relative to his or her short-term debts, or may not be allowed to issue more debt until this bond is paid off.

Because of the diversity and flexibility of bond features, the bond markets are not as transparent as the stock markets—that is, the relationship between the bond and its price is harder to determine.

Stocks and Stock Markets

Stocks or equity securities are shares of ownership: when you buy a share of stock, you buy a share of the corporation. The size of your share of the corporation is proportional to the size of your stock holding. Since corporations exist to create profit for the owners, when you buy a share of the corporation, you buy a share of its future profits. You are literally sharing in the fortunes of the company.

Unlike bonds, however, shares do not promise you any returns at all. If the company does create a profit, some of that profit may be paid out to owners as a dividend, usually in cash but sometimes in additional shares of stock. The company may pay no dividend at all, however, in which case the value of your shares should rise as the company’s profits rise. But even if the company is profitable, the value of its shares may not rise, for a variety of reasons having to do more with the markets or the larger economy than with the company itself. Likewise, when you invest in stocks, you share the company’s losses, which may decrease the value of your shares.

Corporations issue shares to raise capital. When shares are issued and traded in a public market such as a stock exchange, the corporation is “publicly traded.” There are many stock exchanges in Canada and around the world. Internationally, the best-known Canadian stock exchange is the Toronto Stock Exchange.

Only members of an exchange may trade on the exchange, so to buy or sell stocks you must go through a broker who is a member of the exchange. Brokers also manage your account and offer varying levels of advice and access to research. Most brokers have web-based trading systems. Some discount brokers offer minimal advice and research along with minimal trading commissions and fees.

Commodities and Derivatives

Commodities are resources or raw materials, including the following:

• agricultural products (food and fibres) such as soybeans, pork bellies, and cotton;
• energy resources such as oil, coal, and natural gas;
• precious metals such as gold, silver, and copper; and
• currencies, such as the dollar, yen, and euro.

Commodity trading was formalized because of the risks inherent in producing commodities—raising and harvesting agricultural products or natural resources—and the resulting volatility of commodity prices. As farming and food production became mechanized and required a larger investment of capital, commodity producers and users wanted a way to reduce volatility by locking in prices over the longer term.

The answer was futures and forward contracts. Futures and forward contracts (or forwards) are a form of derivatives, the term for any financial instrument whose value is derived from the value of another security. For example, suppose it is now July If you know that you will want to have wheat in May of , you could wait until May and buy the wheat at the market price, which is unknown in July Or you could buy it now, paying today’s price, and store the wheat until May Doing so would remove your future price uncertainty, but you would incur the cost of storing the wheat.

Alternatively, you could buy a futures contract for May wheat in July You would be buying May wheat at a price that is now known to you (as stated in the futures contract), but you will not take delivery of the wheat until May The value of the futures contract to you is that you are removing the future price uncertainty without incurring any storage costs. In July , the value of a contract to buy May wheat depends on what the price of wheat actually turns out to be in May

Forward contracts are traded privately, as a direct deal made between the seller and the buyer, while futures contracts are traded publicly on an exchange such as the Chicago Mercantile Exchange or the New York Mercantile Exchange.

When you buy a forward contract for wheat, for example, you are literally buying future wheat, wheat that doesn’t yet exist. Buying it now, you avoid any uncertainty about the price, which may change. Likewise, by writing a contract to sell future wheat, you lock in a price for your crop or a return for your investment in seed and fertilizer.

Futures and forward contracts proved so successful in shielding against some risk that they are now written for many more types of commodities, such as interest rates and stock market indices. More kinds of derivatives have been created as well, such as options. Options are the right, but not the obligation, to buy or sell at a specific price at a specific time in the future. Options are commonly written on shares of stock as well as on stock indices, interest rates, and commodities.

Derivatives such as forwards, futures, and options are used to hedge or protect against an existing risk or to speculate on a future price. For a number of reasons, commodities and derivatives are more risky than investing in stocks and bonds and are not the best choice for most individual investors.

Mutual Funds, Index Funds, and Exchange-Traded Funds

A mutual fund is an investment portfolio consisting of securities that an individual investor can invest in all at once without having to buy each investment individually. The fund thus allows you to own the performance of many investments while actually buying—and paying the transaction cost for buying—only one investment.

Mutual funds have become popular because they can provide diverse investments with a minimum of transaction costs. In theory, they also provide good returns through the performance of professional portfolio managers. Chapter 14 section 4 “Mutual Funds” provides more information on portfolio management fees.

An index fund is a mutual fund designed to mimic the performance of an index, a particular collection of stocks or bonds whose performance is tracked as an indicator of the performance of an entire class or type of security. For example, the Standard & Poor’s (S&P) is an index of the five hundred largest publicly traded corporations, and the famous Dow Jones Industrial Average is an index of thirty stocks of major industrial corporations. An index fund is invested in the same securities as the index and so requires minimal management and should have minimal management fees or costs.

Mutual funds are created and managed by mutual fund companies or by brokerages or even banks. To trade shares of a mutual fund you must have an account with the company, brokerage, or bank. Mutual funds are a large component of individual retirement accounts and of defined contribution plans.

Mutual fund shares are valued at the close of trading each day and orders placed the next day are executed at that price until it closes. An exchange-traded fund (ETF) is a mutual fund that tracks an index or a commodity or a basket of assets, but is traded like stocks on a stock exchange. An ETF trades like a share of stock in that it is valued continuously throughout the day, and trades are executed at the market price.

The ways that capital can be bought and sold is limited only by the imagination. When corporations or governments need financing, they invent ways to entice investors and promise them a return. The last thirty years have seen an explosion in financial engineering, the innovation of new financial instruments through mathematical pricing models. This explosion has coincided with the ever-expanding powers of the computer, allowing professional investors to run the millions of calculations involved in sophisticated pricing models. The Internet also gives amateurs instantaneous access to information and accounts.

Much of the modern portfolio theory that spawned these innovations (i.e., the idea of using the predictability of returns to manage portfolios of investments) is based on an infinite time horizon, looking at performance over very long periods of time. This has been very valuable for institutional investors (e.g., pension funds, insurance companies, endowments, foundations, and trusts) as it gives them the chance to magnify returns over their infinite horizons.

For most individual investors, however, most portfolio theory may present too much risk or just be impractical. Individual investors don’t have an infinite time horizon, but rather a comparatively small amount of time to create wealth and to enjoy it. For individual investors, investing is a process of balancing the demands and desires of returns with the costs of risk, before time runs out.

 

Key Takeaways

1. Bonds are:
   • a way to raise capital through borrowing, used by corporations and governments;
   • an investment for the bondholder that creates return through regular, fixed, or floating interest payments on the debt and the repayment of principal at maturity; and
   • traded on bond exchanges through brokers.
2. Stocks are:
   • a way to raise capital through selling ownership or equity;
   • an investment for shareholders that creates return through the distribution of corporate profits as dividends or through gains (losses) in corporate value; and
   • traded on stock exchanges through member brokers.
3. Commodities are:
   • natural or cultivated resources;
   • traded to hedge revenue or production needs or to speculate on resources’ prices; and
   • traded on commodities exchanges through brokers.
4. Derivatives are instruments based on the future, and therefore uncertain, price of another security, such as a share of stock, a government bond, a currency, or a commodity.
5. Mutual funds are portfolios of investments designed to achieve maximum diversification with minimal cost through economies of scale.
6. An index fund is a mutual fund designed to replicate the performance of an asset class or selection of investments listed on an index.
7. An exchange-traded fund is a mutual fund whose shares are traded on an exchange.
8. Institutional and individual investors differ in the use of different investment instruments and in using them to create appropriate portfolios.

 

Exercises

1. In your personal finance journal, record your experiences with investing. What investments have you made, and how much do you have invested? What stocks, bonds, funds, or other instruments described in this section do you have now (or have had in the past)? How were the decisions about your investments made, and who made them? If you have had no personal experience with investing, explain your reasons. What reasons might you have for investing (or not) in the future?
2. Please review the article &#;Stock Exchanges Around the World&#; found on Investopedia&#;s website. Roughly how many stock exchanges exist in the world? Which geographic region has the greatest number of exchanges?
3. Visit the Chicago Mercantile Exchange. What are some examples of commodities on the CME that theoretically could be part of your investment portfolio?

REFERENCES

Cooper, T. (). “Finance and Banking.” In K. Brown, M. Doucette, and J. Tulk, eds., Indigenous Business in Canada, pp– Sydney, NS: Cape Breton University Press.

Tulo Centre of Indigenous Economics. (). Building a Competitive First Nation Investment Climate. Retrieved from: www.oldyorkcellars.com

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INVESTMENT PLANNING

Learning Objectives

1. Describe the advantages of the investment policy statement as a useful framework for investment planning.
2. Identify the process of defining investor return objectives.
3. Identify the process of defining investor risk tolerance.
4. Identify investor constraints or restrictions on an investment strategy.

Allison has a few hours to kill while her flight home is delayed. She loves her job as an analyst for a management consulting firm, but the travel is getting old. As she gazes at the many investment magazines and paperbacks on display and the several screens all tuned to financial news networks and watches people hurriedly checking their stocks on their mobile phones, she begins to think about her own investments. She has been paying her bills, paying back student loans, and trying to save some money for a while. Her uncle just died and left her a bequest of $50, She is thinking of investing it since she is getting by on her salary and has no immediate plans for this windfall.

Allison is wondering how to get into some serious investing. There is no lack of information or advice about investing, but Allison isn’t sure how to get started.

Allison may not realize that there are as many different investment strategies as there are investors. The planning process is similar to planning a budget or savings plan. You determine where you are, where you want to be, and how to get there. One way to get started is to draw up an individual investment policy statement.

Investment policy statements are outlines of the investor’s goals and constraints, and they are popular with institutional investors such as pension plans, insurance companies, or non-profit endowments. Institutional investment decisions are typically made by professional managers operating on instructions from a higher authority, usually a board of directors or trustees. The directors or trustees may approve the investment policy statement and then leave the specific investment decisions up to the professional investment managers. The managers use the policy statement as their guide to the directors’ wishes and concerns.

This idea of a policy statement has been adapted for individual use, providing a helpful, structured framework for investment planning—and thinking. The advantages of drawing up an investment policy to use as a planning framework include the following:

• The process of creating the policy requires thinking through your goals and expectations and adjusting those to what is possible.
• The policy statement gives you an active role in your investment planning, even if the more specific details and implementation are left to a professional investment adviser.
• Your policy statement is portable, so even if you change advisers, your plan can go with you.
• Your policy statement is flexible; it can and should be updated at least once a year.

A policy statement is written in two parts. The first part lists your return objectives and risk preferences as an investor. The second part lists your constraints on investment. It is sometimes difficult to reconcile the two parts, so you may need to adjust your statement to improve your chances of achieving your return objectives within your risk preferences without violating your constraints.

Defining Return Objectives and Risk Tolerance

Defining return objectives is the process of quantifying the required annual return (e.g., 5 per cent, 10 per cent, etc.) necessary to meet your investment goals. If your investment goals are vague (e.g., to “increase wealth”), then any positive return will do. Usually, however, you have some specific goals—for example, to finance a child’s or grandchild’s education, to have a certain amount of wealth at retirement, to buy a sailboat on your fiftieth birthday, and so on.

Once you have defined goals, you must determine when they will happen and how much they will cost, or how much you will have to have invested to make your dreams come true. As explained in Chapter 4 &#;Evaluating Choices: Time, Risk, and Value,&#; the rate of return that your investments must achieve to reach your goals depends on how much you have to invest to start with, how long you have to invest it, and how much you need to fulfill your goals.

As in Allison’s case, your goals may not be so specific. Your thinking may be more along the lines of, “I want my money to grow and not lose value,” or, “I want the investment to provide a little extra spending money until my salary rises as my career advances.” In that case, your return objective can be calculated based on the role that these funds play in your life: safety net, emergency fund, extra spending money, or nest egg for the future.

However specific (or not) your goals may be, the quantified return objective defines the annual performance that you demand from your investments. Your portfolio can then be structured—you can choose your investments—such that it can be expected to provide that performance.

If your return objective is more than can be achieved given your investment and expected market conditions, then you know to scale down your goals, or perhaps find a different way to fund them. For example, if Allison wanted to stop working in ten years and start her own business, she probably would not be able to achieve this goal solely by investing her $50, inheritance, even in a bull (up) market earning higher rates of return.

As you saw in Chapter 10 &#;Personal Risk Management: Insurance&#; and Chapter 11 &#;Personal Risk Management: Retirement and Estate Planning,&#; in investing there is a direct relationship between risk and return, and risk is costly. The nature of these relationships has fascinated and frustrated investors since the origin of capital markets, and it remains a subject of investigation, exploration, and debate. To invest is to take risk. To invest is to separate yourself from your money through actual distance—you literally give it to someone else—or through time. There is always some risk that what you get back is worth less (or costs more) than what you invested (a loss), or is less than what you might have had if you had done something else with your money (opportunity cost). The more risk you are willing to take, the more potential return you can make, but the higher the risk, the more potential losses and opportunity costs you may incur.

Individuals have different risk tolerances. Your risk tolerance is your ability and willingness to assume risk. Your ability to assume risk is based on your asset base, your time horizon, and your liquidity needs. In other words, your ability to take investment risks is limited by how much you have to invest, how long you have to invest it, and your need for your portfolio to provide cash—for use rather than reinvestment—in the meantime.

Your willingness to take risk is shaped by your “personality,” your experiences, and your knowledge and education. Attitudes are shaped by life experiences, and attitudes toward risk are no different. Chart shows how your level of risk tolerance develops.

Chart Risk Tolerance

Investment advisers may try to gauge your attitude toward risk by having you answer a series of questions on a formal questionnaire or by just talking with you about your investment approach. For example, an investor who says, “It’s more important to me to preserve what I have than to make big gains in the markets,” is relatively risk averse. The investor who says, “I just want to make a quick profit,” is probably more of a risk seeker.

Once you have determined your return objective and risk tolerance (i.e., what it will take to reach your goals and what you are willing and able to risk to get there) you may have to reconcile the two. You may find that your goals are not realistic unless you are willing to take on more risk. If you are unwilling or unable to take on more risk, you may have to scale down your goals.

Defining Constraints

Defining constraints is a process of recognizing any limitation that may impede or slow or divert progress toward your goals. The more you can anticipate and include constraints in your planning, the less likely they will throw you off course. Constraints include the following:

• Liquidity needs,
• Time available,
• Tax obligations,
• Legal requirements, and
• Unique circumstances.

Liquidity needs, or the need to use cash, can slow your progress from investing because you have to divert cash from your investment portfolio in order to spend it. In addition, you will have ongoing expenses from investing. For example, you will have to use some liquidity to cover your transaction costs such as brokerage fees and management fees. You may also wish to use your portfolio as a source of regular income or to finance asset purchases, such as the down payment on a home or a new car or new appliances.

While these may be happy transactions for you, for your portfolio they are negative events, because they take away value from your investment portfolio. Since your portfolio’s ability to earn returns is based on its value, whenever you take away from that value, you are reducing its ability to earn.

Time is another determinant of your portfolio’s earning power. The more time you have to let your investments earn, the more earnings you can amass. Or, the more time you have to reach your goals, the more slowly you can afford to get there, earning less return each year but taking less risk as you do. Your time horizon will depend on your age and life stage and on your goals and their specific liquidity needs.

Tax obligations are another constraint, because paying taxes takes value away from your investments. Investment value may be taxed in many ways (as income tax, capital gains tax, property tax, estate tax, or gift tax) depending on how it is invested, how its returns are earned, and how ownership is transferred if it is bought or sold.

Investors typically want to avoid, defer, or minimize paying taxes, and some investment strategies will do that better than others. In any case, your individual tax liabilities may become a constraint in determining how the portfolio earns to best avoid, defer, or minimize taxes.

Legalities also can be a constraint if the portfolio is not owned by you as an individual investor but by a personal trust or a family foundation. Trusts and foundations have legal constraints defined by their structure.

“Unique circumstances” refer to your individual preferences, beliefs, and values as an investor. For example, some investors believe in socially responsible investing (SRI), so they want their funds to be invested in companies that practise good corporate governance, responsible citizenship, fair trade practices, or environmental stewardship.

Some investors don’t want to finance companies that make objectionable products or by-products or have labour or trade practices reflecting objectionable political views. Divestment is the term for taking money out of investments. Grassroots political movements often include divestiture campaigns, such as student demands that their universities stop investing in companies that do business with nondemocratic or oppressive governments.

Socially responsible investment is the term for investments based on ideas about products or businesses that are desirable or objectionable. These qualities exist in the eye of the beholder, however, and vary among investors. Your beliefs and values are unique to you and to your circumstances in investing, and they may change over time. For more information on socially responsible investing in Canada, please go to the following websites:

Having mapped out your goals and determined the risks you are willing to take, and having recognized the limitations you must work with, you and/or your investment advisers can now choose the best investments. Different advisers may have different suggestions based on your investment policy statement. The process of choosing involves knowing what returns and risks investments have produced in the past, what returns and risks they are likely to have in the future, and how the returns and risks are related—or not—to each other.

 

Key Takeaways

1. The investment policy statement provides a useful framework for investment planning because:
   • the process of creating the policy requires thinking through goals and expectations and adjusting those to the possible;
   • the statement gives the investor an active role in investment planning, even if the more specific details and implementation are left to a professional investment adviser;
   • the statement is portable, so that even if you change advisers your plans can go with you; and
   • the statement is flexible; it can and should be updated at least once per year.
2. Return objectives are defined by the investor’s goals, time horizon, and value of the asset base.
3. Risk tolerance is defined by the investor’s ability and willingness to assume risk; comfort with risk-taking relates to personality, experience, and knowledge.
4. Constraints or restrictions to an investment strategy are the investor’s
   • liquidity needs,
   • time horizon,
   • tax circumstances and obligations,
   • legal restrictions, and
   • unique preferences or circumstances.
5. Socially responsible investment and divestment are unique preferences based on beliefs and values about desirable or objectionable industries, products, or companies.
6. Your investment policy statement guides the selection of investments and development of your investment portfolio.

MEASURING RETURN AND RISK

You want to choose investments that will combine to achieve the return objectives and level of risk that’s right for you, but how do you know what the right combination will be? You can’t predict the future, but you can make an educated guess based on an investment’s past history. To do this, you need to know how to read or use the information available. Perhaps the most critical information to have about an investment is its potential return and susceptibility to types of risk.

Return

Returns are always calculated as annual rates of return, or the percentage of return created for each unit (dollar) of original value. If an investment earns 5 per cent, for example, that means that for every $ invested, you would earn $5 per year (because $5 = 5% of $).

Returns are created in two ways: the investment creates income or the investment gains (or loses) value. To calculate the annual rate of return for an investment, you need to know the income created, the gain (loss) in value, and the original value at the beginning of the year. The percentage return can be calculated as in Table

Note that if the ending value is greater than the original value, then ending value − (minus) original value > 0 (is greater than zero), and you have a gain that adds to your return. If the ending value is less, then ending value − (minus) original value < 0 (is less than zero), and you have a loss that detracts from your return. If there is no gain or loss, if ending value − (minus) original value = 0 (is the same), then your return is simply the income that the investment created.

For example, if you buy a share of stock for $, and it pays no dividend, and a year later the market price is $, then your return = [0 + ( − )] / = 5 / = 5%. If the same stock paid a dividend of $2, then your return = [2 + ( − )] / = 7 / = 7%.

If the information you have shows more than one year’s results, you can calculate the annual return using what you learned in Chapter 4 &#;Evaluating Choices: Time, Risk, and Value&#; about the relationships of time and value. For example, if an investment was worth $10, five years ago and is worth $14, today, then $10, × (1 + r)⁵ = $14, Solving for r, the annual rate of return, you get 7 per cent. So, other factors being equal, the $10, investment must have earned at a rate of 7 per cent per year to be worth $14, five years later.

While information about current and past returns is useful, investment professionals are more concerned with the expected return for the investment—that is, how much it may be expected to earn in the future. Estimating the expected return is complicated because many factors (e.g., current economic conditions, industry conditions, and market conditions) may affect that estimate.

For investments with a long history, a strong indicator of future performance may be past performance. Economic cycles fluctuate, and industry and firm conditions vary, but over the long run, an investment that has survived has weathered all those storms. So, you could look at the average of the returns for each year. There are several ways to do the math, but if you look at the average return for different investments of the same asset class or type (e.g., stocks of large companies) you could compare what they have returned, on average, over time.

If the time period you are looking at is long enough, you can reasonably assume that an investment’s average return over time is the return you can expect in the next year. For example, if a company’s stock has returned, on average, 9 per cent per year over the last twenty years, then if next year is an average year, that investment should return 9 per cent again. Over the eighteen-year span from to , for example, the average return for the S&P was per cent. Unless you have some reason to believe that next year will not be an average year, the average return can be your expected return. The longer the time period you consider, the less volatility there will be in the returns, and the more accurate your prediction of expected returns will be.

Returns are the value created by an investment, through either income or gains. Returns are also your compensation for investing, for taking on some or all of the risk of the investment, whether it is a corporation, government, parcel of real estate, or work of art. Even if there is no risk, you must be paid for the use of liquidity that you give up to the investment (by investing).

Returns are the benefits from investing, but they must be larger than its costs. There are at least two costs to investing: the opportunity cost of giving up cash and giving up all your other uses of that cash until you get it back in the future, and the cost of the risk you take—the risk that you won’t get it all back.

Risk

Investment risk is the idea that an investment will not perform as expected, that its actual return will deviate from the expected return. Risk is measured by the amount of volatility—that is, the difference between actual returns and average (expected) returns. This difference is referred to as the standard deviation. Returns with a large standard deviation (showing the greatest variance from the average) have higher volatility and are the riskier investments.

An investment may do better or worse than its average. Standard deviation can therefore be used to define the expected range of investment returns. For the S&P , for example, the standard deviation from to was per cent. So, in any given year, the S&P is expected to return per cent, but its return could be as high as per cent or as low as − per cent, based on its performance during that specific period.

What risks are there? What would cause an investment to unexpectedly over or underperform? Starting from the top (the big picture) and working down, there are

• economic risks,
• industry risks,
• company risks,
• asset class risks, and
• market risks.

Economic risks are risks that something will upset the economy as a whole. The economic cycle may swing from expansion to recession, for example; inflation or deflation may increase, unemployment may increase, or interest rates may fluctuate. These macroeconomic factors affect everyone doing business in the economy. Most businesses are cyclical, growing when the economy grows and contracting when the economy contracts.

Consumers tend to spend more disposable income when they are more confident about economic growth and the stability of their jobs and incomes. They also tend to be more willing and able to finance purchases with debt or with credit, expanding their ability to purchase durable goods. So, demand for most goods and services increases as an economy expands, and businesses expand too. An exception is businesses that are countercyclical. Their growth accelerates when the economy is in a downturn and slows when the economy expands. For example, low-priced fast food chains typically have increased sales in an economic downturn because people substitute fast food for more expensive restaurant meals as they worry more about losing their jobs and incomes.

Industry risks usually involve economic factors that affect an entire industry or developments in technology that affect an industry’s markets. An example is the effect of a sudden increase in the price of oil (a macroeconomic event) on the airline industry. Every airline is affected by such an event, as an increase in the price of airplane fuel increases airline costs and reduces profits. An industry such as real estate is vulnerable to changes in interest rates. A rise in interest rates, for example, makes it harder for people to borrow money to finance purchases, which depresses the value of real estate.

Company risk refers to the characteristics of specific businesses or firms that affect their performance, making them more or less vulnerable to economic and industry risks. These characteristics include how much debt financing the company uses, how well it creates economies of scale, how efficient its inventory management is, how flexible its labour relationships are, and so on.

The asset class that an investment belongs to can also bear on its performance and risk. Investments (assets) are categorized in terms of the markets they trade in. Broadly defined, asset classes include:

• corporate stock or equities (shares in public corporations, either domestic or foreign);
• bonds or the public debts of corporations or governments;
• commodities or resources (e.g., oil, coffee, or gold);
• derivatives or contracts based on the performance of other underlying assets;
• real estate (both residential and commercial); and
• fine art and collectibles (e.g., stamps, coins, baseball cards, or vintage cars).

Within those broad categories, there are finer distinctions. For example, corporate stock is classified as large cap, mid cap, or small cap, depending on the size of the corporation as measured by its market capitalization (the aggregate value of its stock). Bonds are distinguished as corporate or government and as short-, intermediate-, or long-term, depending on the maturity date.

Risks can affect entire asset classes. Changes in the inflation rate can make corporate bonds more or less valuable, for example, or more or less able to create valuable returns. In addition, changes in a market can affect an investment’s value. When the stock market fell unexpectedly and significantly, as it did in , , and , all stocks were affected, regardless of relative exposure to other kinds of risk. After such an event, the market is usually less efficient or less liquid—that is, there is less trading and less efficient pricing of assets (stocks) because there is less information flowing between buyers and sellers. The loss in market efficiency further affects the value of assets traded.

As you can see, the link between risk and return is reciprocal. The question for investors and their advisers is: How can you get higher returns with less risk?

DIVERSIFICATION: RETURN WITH LESS RISK

Every investor wants to maximize return, the earnings or gains from giving up surplus cash. And every investor wants to minimize risk, because it is costly. To invest is to assume risk, and you assume risk expecting to be compensated through return. The more risk assumed, the more the promised return. So, to increase return you must increase risk, and to lessen risk, you must expect less return. But another way to lessen risk is to diversify: to spread out your investments among a number of different asset classes. Investing in different asset classes reduces your exposure to economic, asset class, and market risks.

Concentrating investment concentrates risk. Diversifying investments spreads risk by having more than one kind of investment and thus more than one kind of risk. To truly diversify, you need to invest in assets that are not vulnerable to one or more kinds of risk. For example, you may want to diversify:

• between cyclical and countercyclical investments, reducing economic risk;
• among different sectors of the economy, reducing industry risks;
• among different kinds of investments, reducing asset class risk; and
• among different kinds of firms, reducing company risks.

To diversify well, you have to look at your collection of investments as a whole—that is, as a portfolio rather than as a gathering of separate investments. If you choose the investments well, if they are truly different from each other, the whole can actually be more valuable than the sum of its parts.

Steps to Diversification

In traditional portfolio theory, there are three levels or steps to diversifying: capital allocation, asset allocation, and security selection.

Capital allocation is diversifying your capital between risky and riskless investments. A “riskless” asset is a short-term (less than ninety-day) government treasury bill. Because it has such a short time to maturity, it won’t be much affected by interest rate changes, and it is probably impossible for the Canadian government to become insolvent—go bankrupt—and have to default on its debt within such a short time.

The capital allocation decision is the first diversification decision. It determines the portfolio’s overall exposure to risk, or the proportion of the portfolio that is invested in risky assets. That, in turn, will determine the portfolio’s level of return.

The second diversification decision is asset allocation: deciding which asset classes, and therefore which risks and which markets, to invest in. Asset allocations are specified in terms of the percentage of the portfolio’s total value that will be invested in each asset class. To maintain the desired allocation, the percentages are adjusted periodically as asset values change. Chart shows an asset allocation for an investor’s portfolio.

Chart Proposed Asset Allocation

Asset allocation is based on the expected returns and relative risk of each asset class and how it will contribute to the return and risk of the portfolio as a whole. If the asset classes you choose are truly diverse, then the portfolio’s risk can be lower than the sum of the assets’ risks.

One example of an asset allocation strategy is life cycle investing—changing your asset allocation as you age. When you retire, for example, and forgo income from working, you become dependent on income from your investments. As you approach retirement age, therefore, you typically shift your asset allocation to less risky asset classes to protect the value of your investments.

Security selection is the third step in diversification: choosing individual investments within each asset class. Here is the chance to achieve industry or sector and company diversification. For example, if you decided to include corporate stock in your portfolio (asset allocation), you decide which corporation’s stock to invest in. Choosing corporations in different industries, or companies of different sizes or ages, will diversify your stock holdings. You will have less risk than if you invested in just one corporation’s stock. Diversification is not defined by the number of investments but by their different characteristics and performance.

Investment Strategies

Capital allocation decides the amount of overall risk in the portfolio; asset allocation tries to maximize the return you can get for that amount of risk. Security selection further diversifies within each asset class. Chart demonstrates the three levels of diversification.

Chart Levels of Diversification

Just as life cycle investing is a strategy for asset allocation, investing in index funds is a strategy for security selection. Indexes are a way of measuring the performance of an entire asset class by measuring returns for a portfolio containing all the investments in that asset class. Essentially, the index becomes a benchmark for the asset class, a standard against which any specific investment in that asset class can be measured. An index fund is an investment that holds the same securities as the index, so it provides a way for you to invest in an entire asset class without having to select particular securities.

There are indexes and index funds for most asset classes. By investing in an index, you are achieving the most diversification possible for that asset class without having to make individual investments—that is, without having to make any security selection decisions. This strategy of bypassing the security selection decision is called passive management. It also has the advantage of saving transaction costs (broker’s fees) because you can invest in the entire index through only one transaction rather than the many transactions that picking investments would require.

In contrast, making security selection decisions to maximize returns and minimize risks is called active management. Investors who favour active management feel that the advantages of picking specific investments, after careful research and analysis, are worth the added transaction costs. Actively managed portfolios may achieve diversification based on the quality, rather than the quantity, of securities selected.

Also, asset allocation can be actively managed through the strategy of market timing—shifting the asset allocation in anticipation of economic shifts or market volatility. For example, if you forecast a period of higher inflation, you would reduce allocation in fixed-rate bonds or debt instruments, because inflation erodes the value of the fixed repayments. Until the inflation passes, you would shift your allocation so that more of your portfolio is in stocks, say, and less in bonds.

It is rare, however, for active investors or investment managers to achieve superior results over time. More commonly, an investment manager is unable to achieve consistently better returns within an asset class than the returns of the passively managed index (Malkiel, ).

REFERENCES

Malkiel, B. G. (). A Random Walk Down Wall Street, 10th ed. New York: W. W. Norton & Company.

How to spot a growth company

This is not easy to do.

Growth investing can make investors rich but it's very easy to be sucked into thinking you are buying into a growth company when in reality you are not. What in fact you might be doing is buying into the hope of something good happening in the future.

There's no shortage of companies on the stock exchange that are long on hope but short on profits. For example, there are lots of oil exploration companies that aren't making any money but could do in the future if they find oil. These companies are not growth companies but a speculation.

So how do you go about finding a growth company to invest in?

Sales growth

The first place to start is to look for companies that have been growing their profits at a fast rate during the last few years. You can do this in SharePad as I'll show you later. For example, you might want to look for companies that have grown their sales by at least 15% per year for the last five years. Why are sales so important?

Genuine growth companies grow by selling more not by cutting costs or buying other companies. When you are looking at a company, the first question you should ask is: Can it sell a lot more stuff in the future? If you think it can then the company has cleared its first hurdle in becoming a growth share for you to invest in.

Once you find companies, you then have to work out how sales and profits can continue growing. This is difficult and involves a certain amount of guesswork as no-one can perfectly predict the future. You need to understand what the company sells and the markets it sells into. Is there sufficient pent up demand to keep sales growing in the future?

To answer this question you need to work out what the "growth drivers" are. For example, demand for a service or product may be supported by demographics (a trend relating to the general population) such as ageing. Another example is a new technology such as superfast broadband where the current take up amongst households is quite low and has the potential to increase significantly. Or a company may have developed a new product that is cheaper and better which can take a lot of sales off existing companies in the same market.

Does the company have a big moat?

We all know that some castles have moats. Those big ditches of water represent a castle's first line of defence against intruders. The bigger and deeper it is, the better.

Good companies are no different. They have what are known as economic moats - something that stops the competition from eating its lunch.

Strong growth for a product and high profits made by the companies selling it tends to attract attention. To be successful, a company needs something to stop fresh competition entering the market and beating down profits - it needs a moat. The airline industry has seen a growing demand for its services for years but many airlines have struggled to make money and often lose it. Why? Because it's too easy for new airlines to enter the market and push down fares. In short, there isn't a big enough moat. So how do you spot a company with a decent moat?

Companies with economic moats are highly sought after. They are central to the investing philosophies of people such as Warren Buffett. According to Buffett buying these types of companies is a great way of reducing your risk as an investor. That's because what has allowed it to make lots of money in the past will probably mean it has a very good chance of doing so in the future.

By owning - at the right price - these businesses for a long time the investor can compound the high returns it makes and potentially become very rich. That's why Buffett invested lots of money in companies such as Coca-Cola, Gillette and American Express - they had big moats.

One of the most straightforward ways to identify a company with an economic moat is too look for ones with a consistently high return on capital employed (ROCE). You can easily do this with SharePad.

Good companies earn lots of profit as a percentage of the money they invest. However, high returns attract competitors who want a slice of the cake. So if a company has had a high ROCE (say more than 15% as a bare minimum) for a long period of time - at least ten years or more - that suggests that it could have a moat that offers a strong defence against competition.

It's all very well looking at numbers. But it's also important to understand what lies behind them. There are lots of things you can look for which explain the existence of a moat. One of the chief reasons is the existence of branded products. Brands are a symbol of quality that customers identify with and often stay loyal to because they trust them. They can take years to build up and can be defended with large advertising budgets that a prospective competitor would struggle to match.

Related to brands are products that are habit forming such as a particular brand of tobacco or alcoholic drinks or products that are deeply entrenched within a business such as Microsoft Office software. Here, users are very loathe to change their habits because of the cost of hassle of doing so which means a lot of repeat business for sellers.

Patents are another example. These protect products such as prescription drugs or technologies from competition. They explain why pharmaceutical companies have had very high returns. However, bear in mind patents do not last forever. They are also of little use if a better product comes along.

Look for companies that might have cost advantages. The sheer size of a company can give rise to what is known as economies of scale. This often means that they can spread the cost of making something over lots of units so they can make things cheaper than smaller competitors. They may also be able to buy goods and services cheaper as their size allows them to obtain bigger discounts with suppliers.

The management of a company should not really be seen as a moat. A moat usually comes from a company's assets and products. That's not to say that good management doesn't matter. It does. However legendary US investor Peter Lynch offered some good advice when he said, ?invest in a business that any idiot could run because some day one will.?

Finding companies with moats is more straightforward than buying the shares of them. That's because lots of people know about them and bid up the price of their shares. Buying a great company at too high a price is one of the biggest mistakes an investor can make and usually ends in disappointment. I'll show you an example of how this can work out shortly.

You have to be patient when buying good companies. You need to buy them when they suffer a temporary setback or when the stock market is crashing. In the meantime building a watchlist of great companies to buy is time well spent.

Smaller companies grow faster than big ones

Famous investor Jim Slater once said ?elephants don't gallop?. By this he meant that big things don't tend to move very fast. The same can be said for big companies. It is much more difficult for a company valued at £10 billion to double in size than it is for one worth just £50 million or less.

This is why smaller companies tend to be a fertile hunting ground for growth investors. They do come with more risk attached to them but they can present some fabulous opportunities to make money from the stock market.

What Is Chapter 11 Bankruptcy?

When a company files for Chapter 11 bankruptcy, it is asking for protection from creditors while it reorganize its business and restructures its debt. Chapter 11 is available to corporations, sole proprietors, and partnerships. Under Chapter 11, the firm's management oversees daily operations. However, the company directs significant business decisions (e.g., debt or debt securities decisions) to the bankruptcy court for approval. 

Understanding Chapter 11 Bankruptcy

Obtaining Chapter 11 bankruptcy protection means that a company is on the verge of needing to cease operations, but believes that it can once again become successful if given an opportunity to reorganize its assets, debts, and business affairs. Although the Chapter 11 reorganization process is complex and expensive, most companies prefer Chapter 11 to Chapter 7, under which companies totally cease operations and leads to the total liquidation of assets to creditors. Filing for Chapter 11 gives companies another chance at success.

The Alternative: Chapter 7 Bankruptcy

Under Chapter 7, the company ceases operations and all assets are sold for cash. That cash is then used to pay off legal and administrative expenses incurred during the bankruptcy process. Then the company pays its creditors in the following order:

1) Secured creditors
2) Unsecured creditors
3) Shareholders

Usually, little to nothing is left over for shareholders after paying the more senior creditors.

What Happens to Stock When a Company Goes Bankrupt?

While the firm is in Chapter 11, its stock will still have some value, though the price will likely plummet and the stock will stop paying dividends. It may be delisted on the major exchanges, but over-the-counter (OTC) trading may still occur. When a company is listed on the pink sheets or Over-the-Counter Bulletin Board (OTCBB), the letter "Q" is added to the end of the company's ticker symbol to indicate that it is undergoing bankruptcy proceedings.

When a corporation is on the verge of bankruptcy, its stock value reflects the risk of Chapter 11 becoming Chapter 7. For example, a company traded at $50 may trade at $2 per share due to bankruptcy speculation. After filing Chapter 11, the firm's stock price may fall to $ This value is composed of the potential income that shareholders may receive after liquidation and the possibility that the firm may restructure and begin to operate successfully in the future. Private investors can buy and sell these cent shares in the OTC market. The actual value does not reach zero unless the probability of restructuring is so low that a Chapter 7 filing is sure to follow or if the company does indeed end up in Chapter 7.

However, if the company restructures and emerges from Chapter 11 as an improved organization, its share price may rise to higher levels than previously witnessed.

What Is Chapter 11 Bankruptcy?

When a company files for Chapter 11 bankruptcy, it is asking for protection from creditors while it reorganize its business and restructures its debt. Chapter 11 is available to corporations, sole proprietors, and partnerships. Under Chapter 11, investing in stocks chapter 12 answers, the firm's management oversees daily operations. However, the company directs significant business decisions (e.g., debt or debt securities decisions) to the bankruptcy court for approval. 

Understanding Chapter 11 Bankruptcy

Obtaining Chapter 11 bankruptcy protection means that a company is on the verge of needing to cease operations, but believes that it can once again become successful if given can you still make money with stock photography opportunity to reorganize its assets, debts, and business affairs. Although the Chapter 11 reorganization process is complex and investing in stocks chapter 12 answers, most companies prefer Chapter 11 to Chapter 7, under which companies totally cease operations and leads to the total liquidation of assets to creditors. Filing for Chapter 11 gives companies another chance at success.

The Alternative: Chapter 7 Bankruptcy

Under Chapter 7, the company ceases operations and all assets are sold for cash. That cash is then used to pay off legal and administrative expenses incurred during the investing in stocks chapter 12 answers process. Then the company pays its creditors in the following order:

1) Secured creditors
2) Unsecured creditors
3) Shareholders

Usually, little to nothing is left over for shareholders after paying the more senior creditors.

What Happens to Stock When a Catanai money making Goes Bankrupt?

While the firm is in Chapter 11, its stock will still have some value, though the price will likely plummet and the stock will stop paying dividends. It may be delisted on the major exchanges, but over-the-counter (OTC) trading may still occur. When a company is listed on the pink sheets or Over-the-Counter Bulletin Board (OTCBB), the letter "Q" is added to the end of the company's ticker symbol to indicate that it is undergoing bankruptcy proceedings.

When a corporation is on the verge of bankruptcy, its stock value reflects the risk of Chapter 11 becoming Chapter 7. For example, a company traded at $50 may trade at $2 per share due to bankruptcy speculation. After filing Chapter 11, the firm's stock price may fall to $ This value is composed of the potential income that shareholders may receive after liquidation and the possibility that the firm may restructure and begin to operate successfully in the future. Private investors can buy and sell these cent shares in the OTC market. The actual value does not reach zero unless the probability of restructuring is so low that a Chapter 7 filing is sure to follow or if the company does indeed end up in Chapter 7.

However, if the company restructures and emerges from Chapter 11 as an improved organization, its share price may rise to higher levels than previously witnessed.

Find out if the Net Investment Income Tax applies to you.

Basics of the Net Investment Income Tax

1. What is the Net Investment Income Tax (NIIT)?

The Net Investment Income Tax is imposed by section of the Internal Revenue Code, investing in stocks chapter 12 answers. The NIIT applies at a rate of % to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts.

2. When did the Net Investment Income Tax take effect?

The Net Investment Income Tax went into investing in stocks chapter 12 answers on Jan. 1, The NIIT affects income tax returns of individuals, estates and trusts, beginning with their first tax year beginning on (or after) Jan. 1, It does not affect income tax returns for the taxable year filed in

Who Owes the Net Investment Income Tax

3. What individuals are subject to the Net Investment Income Tax?

Individuals will owe the tax if they have Net Investment Income and also have modified adjusted gross income over the following thresholds:

Taxpayers should be aware that these threshold amounts are not indexed for inflation.

If you are an individual who is exempt from Medicare taxes, investing in stocks chapter 12 answers, you still may be subject to the Net Investment Income Tax if you have Net Investment Income and also have modified adjusted gross income over the applicable thresholds.

4. What is modified adjusted gross income for purposes of the Net Investment Income Tax?

For the Net Investment Income Tax, modified adjusted gross income is adjusted gross income (FormLine 37) increased by the difference between amounts excluded from gross income under section (a)(1) and the investing in stocks chapter 12 answers of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section (d)(6) for amounts described in section (a)(1). In investing in stocks chapter 12 answers case of taxpayers with income from controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs), they may have additional adjustments to their AGI. See section (e) of the final regulations. 

5. What individuals are not subject to the Net Investment Income Tax?

Nonresident Aliens (NRAs) are not subject to the Net Investment Income Tax. If an NRA is married to a U.S. citizen or resident and has made, or is planning to make, an election under section (g) or (h) to be treated as a resident alien for purposes of filing as Married Filing Jointly, the final regulations provide these couples special rules and a corresponding section (g)/(h) election for the NIIT. 

A dual-resident individual, within the meaning of regulation §(b)-7(a)(1), investing in stocks chapter 12 answers, who determines that he or she is a resident of a foreign country for tax purposes pursuant to an income tax treaty between the United States and that foreign country and claims benefits of the treaty as a nonresident of the United States is considered a NRA for purposes of the NIIT.

A dual-status individual, who is a resident of the United States for part of the year and a NRA for the other part of the year, is subject to the NIIT only with respect to the portion of the year during which the individual is a United States resident. The threshold amount (described in # investing in stocks chapter 12 answers above) is not reduced or prorated for a dual-status resident. 

6. What estates and trusts are subject to the Net Investment Income Tax?

Estates and trusts are subject to the Net Investment Income Tax if they have undistributed Net Investment Income and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year under section 1(e) (for tax yearthis threshold amount is $11,). Generally, the threshold amount for the upcoming year is updated by IRS each fall in a revenue procedure. Forthe threshold amount is $12, (See Rev. Proc.  PDF). 

There are special computational rules for certain unique types of trusts, such as Qualified Funeral Trusts, Charitable Remainder Trusts and Electing Small Business Trusts, which can be found in the final regulations (see # 20 below).

7. What estates and trusts are not subject to the Net Investment Income Tax?

The following trusts are not subject to the Net Investment Income Tax:

1. Trusts that are exempt from income taxes imposed by Subtitle A of the Internal Revenue Code (e.g., charitable trusts and qualified retirement plan trusts exempt from tax under sectioninvesting in stocks chapter 12 answers, and Charitable Remainder Trusts exempt from tax under section ).
2. A trust or decedent’s estate in which all of the unexpired interests are devoted to one or more of the purposes described in section (c)(2)(B).
3. Trusts that are classified as “grantor trusts” under sections
4. Trusts that are not classified as “trusts” for federal income tax purposes (e.g., Real Estate Investment Trusts and Common Trust Funds).
5. Electing Alaska Native Settlement Trusts.
6. Perpetual Care (Cemetery) Trusts. 

What is Included in Net Investment Income

8. What is included in Net Investment Income?

In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, investing in stocks chapter 12 answers, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer (within the meaning of section ). To calculate your Net Investment Income, your investment income is reduced by certain expenses properly allocable to the income (see #13 below).

9. What are some common types of income that are not Net Investment Income?

Wages, unemployment compensation; operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends (see Rev. Rul.CB ) and distributions from certain Qualified Plans (those described in sections (a), (a), (b),A or (b)).

What kinds of gains are included in Net Investment Income?

To the extent that gains are not otherwise offset by capital losses, the following gains are common examples of items taken into account in computing Net Investment How to invest in bitcoin canada from the sale of stocks, bonds, and mutual funds.

Does this tax apply to gain on the sale of a personal residence?

The Net Investment Income Tax does not apply to any amount of gain that is excluded from gross income for regular income tax purposes. The pre-existing statutory exclusion in section exempts the first $, ($, in the case of a married couple) of gain recognized on the sale of a principal residence from gross income for regular income tax purposes and, thus, investing in stocks chapter 12 answers, from the NIIT.

Example 1: A, a single filer, earns $, in wages and sells his principal residence that he has owned and resided in for the last 10 years for $, A’s cost basis in the home is $, A’s realized gain on the sale is $, Under sectionA may exclude up to $, of gain on the sale. Because this gain is excluded for regular income tax purposes, it is also excluded for purposes of determining Net Investment Income. In this example, the Net Investment Income Tax does not apply to the gain from the sale of A’s home.

Example 2: B and C, a married couple filing jointly, sell their principal residence that they have owned and resided in for the last 10 years for $ million. B and C’s cost basis in the home is $, B and C’s realized gain on the sale is $, The recognized gain subject to regular income taxes is $, ($, realized gain less the $, section exclusion). B and C have $, of other Net Investment Income, which brings B and C’s total Net Investment Income to $, B and C’s modified adjusted gross income is $, and exceeds the threshold amount of $, by $50, B and C are subject to NIIT on the lesser of $, (B’s Net Investment Income) or $50, (the amount B and C’s modified adjusted gross income exceeds the $, married filing jointly threshold). B and C owe Net Investment Income Tax of $1, ($50, X %).

Example 3: D, a single filer, earns $45, in wages and sells her principal residence that she has owned and resided in for the last 10 years for $1 million. D’s cost basis in the home is $, D’s realized gain on the sale is $, The recognized gain subject to regular income taxes is $, ($, realized gain less the $, section exclusion), which is also Net Investment Income. D’s modified adjusted gross income is $, Since D’s modified adjusted gross income is below the threshold amount of $, D does not owe any Net Investment Income Tax.

Does Net Investment Income include interest, dividends and capital gains of my children that I report on my Form using Form ?

The amounts of Net Investment Income that are included on your Form by reason of Form are included in calculating your Net Investment Income. However, the calculation of your Net Investment Income does not include (a) amounts excluded from your Form due to the threshold amounts on Form and (b) amounts attributable to Alaska Permanent Fund Dividends.

What investment expenses are deductible in computing NII?

In order to arrive at Net Investment Income, Gross Investment Income (items described in items above) is reduced by deductions that are properly allocable to items of Gross Investment Income, investing in stocks chapter 12 answers. Examples of deductions, a portion of which may be properly allocable to Gross Investment Income, include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees, fiduciary expenses (in the case of an estate or trust) and state and local income taxes.

Will I have to pay both the % Net Investment Income Tax and the additional .9% Medicare tax?

You may be subject to both taxes, but not on the same type of income.

The % Additional Medicare Tax applies to individuals’ wages, compensation and self-employment income over certain thresholds, but it does not apply to income items included in Net Investment Income. See more information on the Additional Medicare Tax.

How the Net Investment Income Tax is Reported and Paid

If I am subject to the Net Investment Income Tax, how will I report and pay the tax?

Individuals, estates, and trusts will use Form  PDF and instructions PDF to compute their Net Investment Income Tax. 

For individuals, the tax will be reported on, and paid with, the Form For estates and trusts, the tax will be reported on, and paid with, the Form

Is the Net Investment Income Tax subject to the estimated tax provisions?

The Net Investment Income Tax is subject to the estimated tax provisions. Individuals, estates and trusts that expect to be subject to the tax in or thereafter should adjust their income tax withholding or estimated payments to account for the tax increase in order to avoid underpayment penalties. For more information on tax withholding and estimated tax, see PublicationTax withholding and Estimated Tax.

Can tax credits reduce my NIIT liability?

Any federal income tax credit that may be used to offset a tax liability imposed by subtitle A of the Code may be used to offset the NII. However, if the tax credit is allowed only against the tax imposed by chapter 1 of the Code (regular income tax), those credits may not reduce the NIIT. For example, foreign income tax credits (sections 27(a) and (a)) and the general business credit (section 38) are allowed as credits only against the tax imposed by chapter 1 of the Code, and therefore may not be used to reduce your NIIT liability. If you take foreign income taxes as an income tax deduction (versus a tax credit), some (or all) of the deduction amount may deducted against NII.  

Does the tax have to be withheld from wages?

No, but you may request that additional income tax be withheld from your wages.

Examples of the Calculation of the Net Investment Income Tax

Single taxpayer with income less than the statutory threshold.

Taxpayer, a single filer, has wages of $, and $15, of dividends and capital gains. Taxpayer’s modified adjusted gross income is $, which is less than the $, statutory threshold. Taxpayer is not subject to the Net Investment Income Tax.

Single taxpayer with income greater than the statutory threshold.

Taxpayer, a single filer, has $, of wages. Taxpayer investing in stocks chapter 12 answers received $90, from a passive partnership interest, which is considered Net Investment Income. Taxpayer’s modified adjusted gross income is $,

Taxpayer’s modified adjusted gross income exceeds the threshold of $, for single taxpayers by $70, Taxpayer’s Net Investment Income is $90,

The Net Investment Income Tax is based on the lesser of $70, (the amount that Taxpayer’s modified adjusted gross income exceeds the $, threshold) or $90, (Taxpayer’s Net Investment Income). Taxpayer owes NIIT of $2, ($70, x %).

Additional Information

Other than these FAQs, is there additional information available about the Net Investment Income Tax?

Yes. You can find additional information about the NIIT in the final regulations PDF and in a new proposed regulation PDF published on Dec. 2,

The proposed regulations that were published on Dec. 5,are effective for tax years beginning after Dec. 31,but the Net Investment Income Tax went into effect on Jan. 1,  May I rely on those proposed regulations, the proposed regulations published on Dec. 2,and/or the final regulations, investing in stocks chapter 12 answers, also published on Dec. 2,for guidance on the Net Investment Income Tax during ?

Yes. For taxable years beginning before Jan, investing in stocks chapter 12 answers. 1, (e.g., calendar year ), taxpayers may rely on the proposed regulations (published on Dec. 5, ), the proposed regulations (published on Dec. 2, ), or the final regulations (published on Dec. 2, ) for purposes of completing Form  However, to the extent that taxpayers take a position in a taxable year beginning before Jan. 1, that is inconsistent with the final regulations, and such position affects the treatment of one or more items in a taxable year beginning after Dec. 31,then such taxpayer must make reasonable adjustments to ensure that their Net Investment Income Tax liability in the taxable years beginning after Dec. 31, is not inappropriately distorted. For example, reasonable adjustments may be required to ensure that no item of income or deduction is taken into account in computing net investment income more than once, and that carryforwards, basis adjustments and other similar items are adjusted appropriately.

Related Item: Forms and Publications

How to spot a growth company

This is not easy to do.

Growth investing can make investors rich but it's very easy to be sucked into thinking you are investing in stocks chapter 12 answers into a growth company when in reality you are not. What in fact you might be doing is buying into the hope of something good happening in the future.

There's no shortage of companies on the stock exchange that are long on hope but short on profits. For example, there are lots of oil exploration companies that aren't making any money but could do in the future if they find oil. These companies are not best japanese whisky to invest in companies but a speculation.

So how do you go about finding a simcity deluxe iphone how to make money company to invest in?

Sales growth

The first place to start is to look for companies that have been growing their profits at a fast rate during the last few years. You can do this in SharePad as I'll show you later. For example, you might want to look for companies that have grown their sales by at least 15% per year for the last five years. Why are sales so important?

Genuine growth companies grow by selling more not by cutting costs or buying other companies. When you are looking at a company, the first question you should ask is: Can it sell a lot more stuff in the future? If you think it can then the company has cleared its first hurdle in becoming a growth share for you to invest in.

Once you find companies, you then have to work out how sales and profits can continue growing. This is difficult and involves a certain amount of guesswork as no-one can perfectly predict the future. You need to understand what the company sells and the markets it sells into. Is there sufficient pent up demand to keep sales growing in the future?

To answer this question you need to work out what the "growth drivers" are. For example, investing in stocks chapter 12 answers, demand for a service or product may be supported by demographics (a trend relating to the general population) such as ageing. Another example is a new technology such as superfast broadband where the current take up amongst households is quite low and has the potential to increase significantly. Or a company may have developed a new product that is cheaper and better which can take a lot of sales off existing companies in the same market.

Does the company have a big moat?

We all know that some castles have moats. Those big ditches of water represent a castle's first line of defence against intruders. The bigger and deeper it is, the better.

Good companies are no different. They have what are known as economic moats - something that stops the competition from eating its lunch.

Strong growth for a product and high profits made by the companies selling it tends to attract attention. To be successful, a company needs something to stop fresh competition entering the market and beating down profits - it needs a moat. The airline industry has seen a growing demand for its services for years but many airlines have struggled to make money and often lose it. Why? Because it's too easy for new airlines to enter the market and push down fares. In short, there isn't a big enough moat, investing in stocks chapter 12 answers. So how do you spot a company with a decent moat?

Companies with economic moats are highly sought after. They are central to the investing philosophies of people such as Warren Buffett. According to Buffett buying these types of companies is a great way of reducing your risk as an investor. That's because what has allowed it to make lots of money in the past will probably mean it has a very good chance of doing so in the future.

By owning - at the right price - these businesses investing in stocks chapter 12 answers a long time the investor can compound the high returns it makes and potentially become very rich. That's why Buffett invested lots of money in companies such as Coca-Cola, Gillette and American Express - they had big moats.

One of the most straightforward ways to identify a company with an economic moat is too look for ones with a consistently high return on capital employed (ROCE). You can easily do this with SharePad.

Good companies earn lots of profit as a percentage of the money they invest. However, high returns attract competitors who want a slice of the cake. So if a company has had a high ROCE (say more than 15% as a bare minimum) for a long period of time - at least ten years or more - that suggests that it could have a moat that offers a strong defence against competition.

It's all very well looking at numbers. But it's also important to understand what lies behind them. There are lots of things you can look for which explain the existence of a moat. One of the chief reasons is the existence of branded products. Brands are a symbol of quality that customers identify with and often stay loyal to because they trust them. They can take years to build up and can be defended with large advertising budgets that a prospective competitor would struggle to match.

Related investing in stocks chapter 12 answers brands are products that are habit forming such as investing in stocks chapter 12 answers particular brand of tobacco or alcoholic drinks or products that are deeply entrenched within a business such as Microsoft Office software. Here, users are very loathe to change their habits because of the cost of hassle of doing so which means a lot of repeat business for sellers.

Patents are another example. These protect products such as prescription drugs or technologies from competition. They explain why pharmaceutical companies have had very high returns. However, bear in mind patents do not last forever, investing in stocks chapter 12 answers. They are also of little use if a better product comes along.

Look for companies that might have cost advantages. The sheer size of a company can give rise to what is known as economies of scale. This often means that they can spread the cost of making something over lots of units so they can make things cheaper than smaller competitors. They may also be able to buy goods and services cheaper as their size allows them investing in stocks chapter 12 answers obtain bigger discounts with suppliers.

The management of a company should not really be seen as a moat. A moat usually comes from a company's assets and products. That's not to say that good management doesn't matter. It does. However legendary US investor Peter Lynch offered some good advice when he said, ?invest in a business that any idiot could run because some day one will.?

Finding companies with moats is more straightforward than buying the shares of them. That's because lots of people know about them and bid up the price of their shares. Buying a great company at too high a price is one of the biggest mistakes an investor can make and usually ends in disappointment. I'll show you an example of how this can work out shortly.

You have to be patient when buying good companies. You need to buy them when they suffer a temporary setback or when the stock market is crashing. In the meantime building a watchlist of great companies to buy is time well spent.

Smaller companies grow faster than big ones

Famous investor Jim Slater once said ?elephants don't gallop?. By this he meant that big things don't tend to move very fast. The same can be said for big companies. It is much more difficult for a company valued at £10 billion to double in size than it is for one worth just £50 million or less.

This is why smaller companies tend to be a fertile hunting ground for growth investors. They do come with more risk attached to them but they can present some fabulous opportunities to make money from the stock market.

INTRODUCTION

Saving to build wealth is investing. When people have too much money to spend immediately—that is, a surplus of disposable income—they become savers or investors. They transfer their surplus to individuals, companies, investing in stocks chapter 12 answers, or governments that have a shortage or too little money to meet immediate needs. This is almost always done through an intermediary—a bank or broker—who can match up the surpluses and the shortages. If the capital markets work well, investing in stocks chapter 12 answers, those who need money can get it, and those who can defer their need can try to profit from that. When you invest, you are transferring capital to those who need it on the assumption that they will be able to return your capital when you need or want it and that they will also pay you for its use in the meantime.

Investing happens over your lifetime. In your early adult years, you typically have little surplus to invest. Your first investments are in your home (although primarily financed with the debt of your mortgage) and then perhaps in planning for children’s education or for your retirement.

After a period of just paying the bills, making the mortgage, and trying to put something away for retirement, you may have the chance to accumulate wealth. Your income increases as your career progresses. You have fewer dependents (as children leave home), so your expenses decrease. You begin to think about your investment options. You have already been investing—in your home and retirement—but those investments have been prescribed by their specific goals.

You may reach this stage earlier or later in your life, but at some point, you begin to think beyond your immediate situation and look to increase your real wealth to ensure your future financial health. Investing is about that future.

Investment also goes beyond simply contributing one’s own individual wealth and financial health. The investments we make can contribute to the growth of businesses, organizations, and communities. The investment choices we make can have a significant economic and social impact in the world.

With regard to Indigenous communities in Canada, economic growth is fueled by investment. According to Chief Michael LeBourdais of the Whispering Pine/Clinton Indian Band, “investment can be generated from local residents through savings, through home equity or from outside sources. In Canada, private sector investment outweighs public sector investment by five to one. Three times as many jobs are created in the private sector as in the public sector” (Tulo Centre of Indigenous Economics,p. 6). Thus, attracting private investment to Indigenous business and economic development projects bitcoin investimento 911 an important part of economic growth. Many Indigenous entrepreneurs lack access to capital and rely heavily on personal and family support to help finance their businesses; “there is a growing need for ‘angel investors’ ” as well as other private investment options (Cooper, ). Furthermore, investing in stocks chapter 12 answers, “investment creates jobs and business opportunities. This, in turn, builds the fiscal capacity of governments to support social improvements and build infrastructure. It also encourages a natural constituency for accountable, fiscally responsible government as the investment climate is enhanced. Indigenous governments must participate in federations and market systems to provide fiscal and economic opportunities for their governments and members” (Tulo Centre of Indigenous Economics,p. 7). Therefore, investing can help to increase your individual financial well-being, as well as the economic and social well-being of communities throughout the country.

Through the creation of the First Nations Fiscal and Statistical Management Act on March 23,the First Nations Finance Authority (FNFA), the First Nations Financial Management Board (FNFMB), and the First Nations Tax Commission (FNTC) were established. Canada’s First Nations and the Government of Canada worked together to support the investing in stocks chapter 12 answers of these new institutions in order to assist First Nations to better access capital markets and more investment opportunities. The FNFMB helps First Nations to build stronger community management and accountability frameworks, including best practices, standard-setting, and capacity-building, that enhance First Nations’ ability to participate in raising capital through the FNFA (Cooper, ). The FNTC, as mentioned in Chapter 6, helps First Nations use their property tax revenue to secure long-term borrowing and oversee the bylaw approval process, which provides greater investor certainty. As Cooper states, “the ability to successfully provide transparent, investing in stocks chapter 12 answers, risk-related investment opportunities to private capital providers requires that First Nation communities undertake initiatives to enhance their ability to borrow. The practices and processes of the FNFA and the FNFMB are tools which can be of immediate assistance to the First Nations communities as they proceed to prepare themselves for dealing with private capital providers” (Cooper,p. ).

How should you invest your money? This is a critical question that we must all ask ourselves as we reach that stage of our lives when we are ready to begin investing. Today, there are more and more options available to investors who wish to invest their money in socially responsible businesses. Furthermore, many businesses are focusing more on corporate social responsibility (CSR), which is focused on economic, social, and environmentally sustainable activities—and not only because they know it is the right thing to do, but also because it is good business. More and more companies are sharing their CSR record, which makes it easier for investors to research and make informed decisions.

INVESTMENTS AND MARKETS: A BRIEF OVERVIEW

Learning Objectives

1. Identify the features and uses of issuing, investing in stocks chapter 12 answers, owning, and trading bonds.
2. Identify the uses of issuing, owning, why bitcoin is not gold trading stocks.
3. Identify the features and uses of issuing, owning, and trading commodities and derivatives.
4. Identify the features and uses of issuing, owning, and trading mutual funds, including exchange-traded funds and index funds.
5. Describe the reasons for using different instruments in different markets.

Before looking at investment planning and strategy, it is important to take a closer look at the galaxy of investments and markets where investing takes place. Understanding how markets work, how different investments work, and how different investors can use investments is critical to understanding how to plan your investment goals and strategies.

You have looked at using the money markets to save surplus cash for the short term. By contrast, investing is primarily about using the capital markets to invest surplus cash for the longer term. As in the money markets, when you invest in the capital markets, you are selling liquidity.

The capital markets developed as a way for buyers to buy liquidity (i.e., raise capital). The two primary methods that have evolved into modern times are the bond and stock markets. Both are discussed in greater detail in Chapter 13 &#;Owning Stocks&#; and Chapter 14 &#;Owning Bonds and Investing in Mutual Funds,&#; but a brief introduction is provided here to give you a basic idea of what they are and how they can be used as investments.

Bonds and Bond Markets

Bonds are debt. The bond issuer borrows by selling a bond, promising the buyer regular interest payments and then repayment of the principal at maturity. If a company wants to borrow, it could just go to one lender and borrow. But if the company wants to borrow a lot, it may be difficult to find any one investor with the capital and the inclination to make that large a loan, taking investing in stocks chapter 12 answers large risk on only one borrower. In this case, the company may need to find a lot of lenders who will each lend a little money, and this is done through selling bonds.

A bond is a formal contract to repay borrowed money with interest (often referred to as the coupon) at fixed intervals. Corporations and governments (e.g., federal, investing in stocks chapter 12 answers, provincial, municipal, and foreign) borrow by issuing bonds. The investing in stocks chapter 12 answers rate on the bond may be a fixed interest rate or a floating interest rate that changes as underlying interest rates—rates on debt of comparable companies—change. (Underlying interest rates include the prime rate: the annual interest rate Canada’s major banks and financial institutions use to set interest rates for variable loans and lines of credit, including variable-rate mortgages. The Bank of Canada sets the prime rate.)

Bonds have many features other than the principal and interest; these include the issue price (the price you pay to buy the bond when it is first issued) and the maturity date (when the issuer of the bond has to repay you). Bonds may also be “callable”—that is, redeemable before maturity (paid off early). Bonds may also be issued with various covenants or conditions that the borrower must meet to protect the bondholders (the lenders). For example, investing in stocks chapter 12 answers, the borrower (the bond issuer) may be required to keep a certain level of cash on hand, relative to his or her short-term debts, or may not be allowed to issue more debt until this bond is investing in stocks chapter 12 answers off.

Because of the diversity and flexibility of bond features, the bond markets are not as transparent as the stock markets—that is, the relationship between the bond and its price is harder to determine.

Stocks and Stock Markets

Stocks or equity securities are shares of ownership: when you buy a share of stock, you buy a share of the corporation. The size of your share of the corporation is proportional to the size of your stock holding. Since corporations exist to create profit for the owners, when you buy a share of the corporation, investing in stocks chapter 12 answers, you buy a share of its future profits. You are literally sharing in the fortunes of the company.

Unlike bonds, however, shares do not promise you any returns at all. If the company does create a profit, some of that profit may be paid out to owners as a dividend, usually in cash but sometimes in additional shares of stock. The company may pay no dividend at all, however, in which case the value of your shares should rise as the company’s profits rise. But even if the company is profitable, the value of its shares may not rise, for a variety of reasons having to do more with the markets or the larger economy than with the company itself. Likewise, when you invest in stocks, you share the company’s losses, which may decrease the value of your shares.

Corporations issue shares to raise capital. When shares are issued and traded in a public market such as a stock exchange, the corporation is “publicly traded.” There are many stock exchanges in Canada and investing money msn investments market index the world, investing in stocks chapter 12 answers. Internationally, the best-known Canadian stock exchange is the Toronto Stock Exchange.

Only members of an exchange may trade on the exchange, so to buy or sell stocks you must go through a broker who is a member of the exchange. Brokers also manage your account and offer varying levels of advice and access to research. Most brokers have web-based trading systems. Some discount brokers offer minimal advice and research along with minimal trading commissions and fees.

Commodities and Derivatives

Commodities are resources or raw materials, including the following:

• agricultural products (food and fibres) such as soybeans, pork bellies, and cotton;
• energy resources such as oil, coal, and natural gas;
• precious metals such as gold, silver, and copper; and
• currencies, such as the dollar, yen, and euro.

Commodity trading was formalized because of the risks inherent in producing commodities—raising and harvesting agricultural products or natural resources—and the resulting volatility of commodity prices. As farming and food production became mechanized and required a larger investment of capital, commodity producers and users wanted a way to reduce volatility by locking in prices over the longer term.

The answer was futures and forward contracts. Futures and forward contracts (or forwards) are a form of derivatives, the term for any financial instrument whose value is derived from the value of another security. For example, suppose it is now July If you know that you will want to have wheat in May ofyou could wait until May and buy the wheat at the market price, which is unknown in July Or you could buy it now, paying today’s price, and store the wheat until May Doing so would remove your future price uncertainty, but you would incur the cost of storing the wheat.

Alternatively, you could buy a futures contract for May wheat in July You would be buying May wheat at a price that is now known to you (as stated in the futures contract), but you will not take delivery of the wheat until May The value of the bitcoin plywood hot section cool section contract to you is that you are removing the future price uncertainty without incurring any storage costs. In Julythe value of a contract to buy May wheat depends on what the price of wheat actually turns out to be in May

Forward contracts are traded privately, as a direct deal made between the seller and the buyer, while investing in stocks chapter 12 answers contracts are traded publicly on an exchange such as the Chicago Mercantile Exchange or the New York Mercantile Exchange.

When you buy a forward contract for wheat, for example, you are literally buying future wheat, wheat that doesn’t yet exist. Buying it now, you avoid any uncertainty about the price, which may change. Likewise, by writing a contract to sell future wheat, you lock in a price for your crop or a return for your investment in seed and fertilizer.

Futures and forward contracts proved so successful five ways to make money with advocare shielding against some risk that they are now written for many more types of commodities, such as interest rates and stock market indices. More kinds of derivatives have been created as well, investing in stocks chapter 12 answers, such as options. Options are the right, but not the obligation, to buy or sell at a specific price at a specific time in the future. Options are commonly written on shares of stock as well as on stock indices, interest rates, and commodities.

Derivatives such as forwards, futures, and options are used to hedge or protect against an investing in stocks chapter 12 answers risk or to speculate on a future price. For a number of reasons, commodities and derivatives are more risky than investing in stocks and bonds and are not the best choice for most individual investors.

Mutual Funds, Index Funds, and Exchange-Traded Funds

A mutual fund is an investment portfolio consisting of securities that an individual investor can invest in all at once without having to buy each investment individually. The fund thus allows you to own the performance of many investments while actually buying—and paying the transaction cost for buying—only one investment.

Mutual funds have become popular because they can provide diverse investments with a minimum of transaction costs. In theory, they also provide good returns through the performance of professional portfolio managers. Chapter 14 section 4 “Mutual Funds” provides more information on portfolio management fees.

An index fund is a mutual fund designed to mimic the performance of an index, a particular collection of stocks or bonds whose performance is tracked as an indicator of the performance of an entire class or type of security. For example, the Standard & Poor’s (S&P) is an index of the five hundred largest publicly traded corporations, and the famous Dow Jones Industrial Average is an index of thirty stocks of major industrial investing in stocks chapter 12 answers. An index fund is invested in the same securities as the index and so requires minimal management and should have minimal management fees or costs.

Mutual funds are created and managed by mutual fund companies or by brokerages or even banks. To trade shares of a mutual fund you must have an account with the company, brokerage, or bank. Mutual funds are a large component of individual retirement accounts and of defined contribution plans.

Mutual fund shares are valued at the close of trading each day and orders placed the next day are executed at that price until it closes, investing in stocks chapter 12 answers. An exchange-traded fund (ETF) is a mutual fund that tracks an index or a commodity or a basket of assets, but is traded like stocks on a stock exchange. An ETF trades like a share of stock in that it is valued continuously throughout the day, and trades are executed at the market price.

The ways that capital can be bought and sold is limited only by the imagination. When corporations or governments need financing, they invent ways to entice investors and promise them a return. The last thirty years have seen an explosion in financial engineering, the innovation of new financial instruments through mathematical pricing models. This explosion has coincided with the ever-expanding powers of the computer, allowing professional investors to run the millions of calculations involved in sophisticated pricing models, investing in stocks chapter 12 answers. The Internet also gives amateurs instantaneous access to information and accounts.

Much of the modern portfolio theory that spawned these innovations (i.e., the idea of using the predictability of returns to manage portfolios of investments) is based on an infinite time horizon, investing in stocks chapter 12 answers, looking at performance over very long periods of time. This has been very valuable for institutional investors (e.g., pension funds, insurance companies, endowments, foundations, and trusts) as it gives them the chance to magnify returns over their infinite horizons.

For most individual investors, however, most portfolio theory may present too much risk or just be impractical. Individual investors don’t have an infinite time horizon, but rather a comparatively small amount of time to create wealth and to enjoy it. For individual investors, investing is a process of balancing the demands and desires of returns with the costs of risk, investing in stocks chapter 12 answers, before time runs out.

 

Key Takeaways

1. Bonds are:
   • a way to raise capital through borrowing, used by corporations and governments;
   • an investment for the bondholder that creates return through regular, investing in stocks chapter 12 answers, fixed, or floating interest payments on the debt and the repayment of principal at maturity; and
   • traded on bond exchanges through brokers.
2. Stocks are:
   • a way to raise capital through selling ownership or equity;
   • an investment for shareholders that creates return through the distribution of corporate profits as dividends or through gains (losses) in corporate value; and
   • traded on stock exchanges through member brokers.
3. Commodities are:
   • investing in stocks chapter 12 answers or cultivated resources;
   • traded to hedge revenue or production needs or to speculate on resources’ prices; and
   • traded on commodities exchanges through brokers.
4. Derivatives are instruments based on the future, and therefore uncertain, price of another security, such as a share of stock, a government bond, investing in stocks chapter 12 answers, a currency, or a commodity.
5. Mutual funds are portfolios of investments designed to achieve maximum diversification with minimal cost through economies of scale.
6. An index fund is a mutual fund designed to replicate the performance of an asset class or selection of investments listed on an index.
7. An exchange-traded fund is a mutual fund whose shares are traded on an exchange.
8. Institutional and individual investors differ in the use of different investment instruments and in using them to create appropriate portfolios.

 

Exercises

1. In your personal finance journal, record your experiences with investing. What investments have you made, and how much do you have invested? What stocks, bonds, funds, or other instruments described in this section do you have now (or have had in the past)? How were the decisions about your investments made, investing in stocks chapter 12 answers, and who made them? If you have had no personal experience with investing, explain your reasons. What reasons might you have for investing (or not) in the future?
2. Please review the article &#;Stock Exchanges Around the World&#; found on Investopedia&#;s website. Roughly how many stock exchanges exist in the world? Which geographic region has the greatest number of exchanges?
3. Visit the Chicago Mercantile Exchange. What are some examples of commodities on the CME that theoretically could be part of your investment portfolio?

REFERENCES

Cooper, Easy ways to make money business. (). “Finance and Banking.” In K. Brown, M. Doucette, and J. Tulk, eds., Indigenous Business in Canada, pp– Sydney, NS: Cape Breton University Press.

Tulo Centre of Indigenous Economics. (). Building a Competitive First Nation Investment Climate. Retrieved from: www.oldyorkcellars.com

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INVESTMENT PLANNING

Learning Objectives

1. Describe the advantages of the investment policy statement as a useful framework for investment planning.
2. Identify the process of defining investor return objectives.
3. Identify the process of defining investor risk tolerance.
4. Identify investor constraints or restrictions on an investment strategy.

Allison has a few hours to kill while her flight home is delayed. She loves her job as an analyst for a management consulting firm, but the travel is getting old. As she gazes at the many investment magazines and paperbacks on display and the several screens all tuned to financial news networks and watches people hurriedly checking their stocks on their mobile phones, she begins to think about her own investments. She has been paying her bills, paying back student loans, and trying to save some money for a while. Her uncle just died and left her a bequest of $50, She is thinking of investing it since she is getting by on her salary and has no immediate plans for this windfall.

Allison is wondering how to get into some serious investing. There is no lack of information or advice about investing, but Allison isn’t sure how to get started.

Allison may not realize that there are as many different investment strategies as there are investors. The planning process is similar to planning a budget or savings plan. You determine where you are, where you want to be, and how to get there. One way to get started is to draw up an individual investment policy statement.

Investment policy statements are outlines of the investor’s goals and constraints, and they are popular with institutional investors such as pension plans, insurance companies, or non-profit endowments. Institutional investment decisions are typically made by professional managers operating on instructions from a higher authority, usually a board of directors or trustees. The directors or trustees may approve the investment policy statement and then leave the specific investment decisions up to the professional investment managers. The managers use the policy statement as their guide to the directors’ wishes and concerns.

This idea of a policy statement has been adapted for individual use, providing a helpful, structured framework for investment planning—and thinking. The advantages of drawing up an investment policy to use as a planning framework include the following:

• The process of creating the policy requires thinking through your goals and expectations and adjusting those to what is possible.
• The policy statement gives you an active role in your investment planning, even if the more specific details and implementation are left to a professional investment adviser.
• Your policy statement is portable, so even if you change advisers, your plan can go with you.
• Your policy statement is flexible; it can and should be updated at least once a year.

A policy statement is written in two parts. The first part lists your return objectives and risk preferences as an investor, investing in stocks chapter 12 answers. The second part lists your constraints on investment. It is sometimes difficult to reconcile the two parts, so you may need to adjust your statement to improve your chances of achieving your return objectives within your risk preferences without violating your constraints.

Defining Return Objectives and Risk Tolerance

Defining return objectives is the process of quantifying the required annual return (e.g., 5 per cent, 10 per cent, etc.) necessary to meet your investment goals. If your investment goals are vague (e.g., to “increase wealth”), then any positive return will do. Usually, however, you have some specific goals—for example, to finance a child’s or grandchild’s education, to have a certain amount of wealth at retirement, investing in stocks chapter 12 answers buy a sailboat on your fiftieth birthday, and so on.

Once you have defined goals, you must determine when they will happen and how much they will cost, or how much you will have to have invested to make your dreams come true. As explained in Chapter 4 &#;Evaluating Choices: Time, Risk, and Value,&#; the rate of return that your investments must achieve to reach your goals depends on how much you have to invest to start with, how long you have to invest it, and how much you need to fulfill your goals.

As in Allison’s case, your goals may not be so specific. Your thinking may be more along the lines of, investing in stocks chapter 12 answers, “I want my money to grow and not lose value,” or, “I want the investment to provide a little extra spending money until my salary rises as my career advances.” In that case, your return objective can be calculated based on the role that these funds play in your life: safety net, investing in stocks chapter 12 answers, emergency fund, extra spending money, or nest egg for the espn chris moneymaker story specific (or not) your goals may be, the quantified return objective defines the annual performance that you demand from your investments. Your portfolio can then be structured—you can choose your investments—such that it can be expected to provide that performance.

If your return objective is more than can be achieved given your investment and expected market conditions, then you know to scale down your goals, or perhaps find a different way to fund them. For example, if Allison wanted to stop working in ten years and start her own business, she probably would not be able to achieve this goal solely by investing her $50, inheritance, even in a bull (up) market earning higher rates of return.

As you saw in Chapter 10 &#;Personal Risk Management: Insurance&#; and Investing in stocks chapter 12 answers 11 &#;Personal Risk Management: Retirement and Estate Planning,&#; in investing there is a direct relationship between risk and return, and risk is costly. The nature of these relationships has fascinated and frustrated investors since the origin of capital markets, and it remains a subject of investigation, exploration, and debate. To invest is to take risk. To invest is to separate yourself from your money through actual distance—you literally give it to someone else—or through time. There is always some risk that what you get back is worth less (or costs more) than what you invested (a loss), or is less than what you might have had if you had done something else with your money (opportunity cost). The more risk you are willing to take, the more potential return you can make, but the higher the risk, the more potential losses and opportunity costs you may incur.

Individuals have different risk tolerances. Your risk tolerance is your ability and willingness to assume risk. Your ability to assume risk is based on your asset base, your time horizon, and your liquidity needs. In other words, your ability to take investment risks is limited by how much you have to invest, how long you have to invest it, and your need for your portfolio to provide cash—for use rather than reinvestment—in the meantime.

Your willingness to take risk is shaped by your “personality,” your experiences, and your knowledge and education. Attitudes are shaped by life experiences, and attitudes toward risk are no different. Chart shows how your level of risk tolerance develops.

Chart Risk Tolerance

Investment advisers may try to gauge your attitude toward risk by having you answer a series of questions on a formal questionnaire or by just talking with you about your investment approach. For example, an investor who says, “It’s more important to me to preserve what I have than to make big gains in the markets,” is relatively risk averse. The investor who says, “I just want to make a quick profit,” is probably more of a risk seeker.

Once you have determined your return objective and risk tolerance (i.e., what it will take to reach your goals and what you are willing and able to risk to get there) you may have to reconcile the two. You may find that your goals are not realistic unless investing in stocks chapter 12 answers are willing to take on more risk. If you are unwilling or unable to take on more risk, you may have to scale down your goals.

Defining Constraints

Defining constraints is a process of recognizing any limitation that may impede or slow or divert progress toward your goals. The more you can anticipate and include constraints in your planning, the less likely they will throw you off course. Constraints include the following:

• Liquidity needs,
• Time available,
• Tax obligations,
• Legal requirements, and
• Unique circumstances.

Liquidity needs, or the need to use cash, can slow your progress from investing because you have to divert cash from your investment portfolio in order to spend it. In addition, you will have ongoing expenses from investing. For example, you will have to use some liquidity to cover your transaction costs such as brokerage fees and management fees. You may investing in stocks chapter 12 answers wish to use your portfolio as a source of regular income or to finance asset purchases, such as the down payment on a home or a new car or new appliances.

While these may be happy transactions for you, for your portfolio they are negative events, because they take away value from your investment portfolio. Since your portfolio’s ability to earn returns is based on its value, whenever investing in stocks chapter 12 answers take away from that value, you are reducing its ability to earn.

Time is another determinant of your portfolio’s earning power. The more time you have to let your investments earn, the more earnings you can amass. Or, the more time you have to reach your goals, the more slowly you can afford to get there, earning less return each year but taking less risk as you squidoo lenses make money. Your time horizon will depend on your age and life stage and on your goals and their specific liquidity needs.

Tax obligations are another constraint, because paying taxes takes value away from your investments. Investment value may be taxed in many ways (as income tax, capital gains tax, property tax, estate tax, or gift tax) depending on how it is invested, how its returns are earned, and how ownership is transferred if it is bought or sold.

Investors typically want to avoid, defer, or minimize paying taxes, and some investment strategies will do that better than others. In any case, your individual tax liabilities may become a constraint in determining how the portfolio earns to best avoid, defer, or minimize taxes.

Legalities also can be a constraint if the portfolio is not owned by you as an individual investor but by a personal trust or a family foundation. Trusts and foundations investing in stocks chapter 12 answers legal constraints defined by their structure.

“Unique circumstances” refer to your individual preferences, beliefs, and values as an investor. For example, some investors believe in socially responsible investing (SRI), so they want their funds to be invested in companies that practise good corporate governance, responsible citizenship, fair trade practices, or environmental stewardship.

Some investors don’t want to finance companies that make objectionable products or by-products or have labour or trade practices reflecting objectionable political views. Divestment is the term for taking money out of investments. Grassroots political movements often include divestiture campaigns, such as student demands that their universities stop investing in companies that do business with nondemocratic or oppressive governments.

Socially responsible investment is the term for investments based on ideas about products or businesses that are desirable or objectionable. These qualities exist in the eye of the beholder, however, and vary among investors. Your beliefs and values are unique to you and to your circumstances in investing, and they may change over time. For more information on socially responsible investing in Canada, please go to the following websites:

Having mapped out your goals and determined the risks you are willing to take, and having recognized the limitations you must work with, you and/or your investment advisers can now choose the best investments. Different advisers may have different suggestions based on your investment policy statement. The process of choosing involves knowing what returns and risks investments have produced in the past, what returns and risks they are likely to have in the future, and how the returns and risks are related—or not—to each other.

 

Key Takeaways

1. The investment policy statement provides a useful framework for investment planning because:
   • the process of creating the policy requires thinking through goals and expectations and adjusting those to the possible;
   • the statement gives the investor an active role in investment planning, even if the more specific details and implementation are left to a professional investment adviser;
   • the statement is portable, so that even if you change advisers your plans can go with you; and
   • the statement is flexible; it can and should be updated at least once per year.
2. Return objectives are defined by the investor’s goals, time horizon, and value of the asset base.
3. Risk tolerance is defined by the investor’s ability and willingness to assume risk; comfort with risk-taking relates to personality, experience, and knowledge.
4. Constraints or restrictions to an investment strategy are the investor’s
   • liquidity needs,
   • time horizon,
   • tax circumstances and obligations,
   • legal restrictions, and
   • unique preferences or circumstances.
5. Socially responsible investment and divestment are unique preferences based on beliefs and values about desirable or objectionable industries, products, or companies.
6. Your investment policy statement guides the selection of investments and development of your investment portfolio.

MEASURING RETURN AND RISK

You want to choose investments that will combine to achieve the return objectives and level of risk that’s right for you, but how do you know what the right combination will be? You can’t predict the future, but you can make an educated guess based on an investment’s past history. To do this, you need to know how to read or use the information available, investing in stocks chapter 12 answers. Perhaps the most critical information to have about an investment is its potential return and susceptibility to types of risk.

Return

Returns are always calculated as annual rates of return, or the percentage of return created for each unit (dollar) of original value. If an investment earns 5 per cent, for example, that means that for every $ invested, you would earn $5 per year (because $5 = 5% of $).

Returns are created in two ways: the investment creates income or the investment gains (or loses) value. To calculate the annual rate of return for an investment, you need to know the income created, the gain (loss) in value, and the original value at the catanai money making of the year, investing in stocks chapter 12 answers. The percentage return can be calculated as in Table

Note that if the ending value is greater than the original value, then ending value − (minus) original value > 0 (is investing in stocks chapter 12 answers than zero), and you have a gain that adds to your return. If the ending value is less, then ending value − (minus) original value < 0 (is less than zero), and you have a loss that detracts from your return. If there is no gain or loss, if ending value − (minus) original value = 0 (is the same), then your return is simply the income that the investment created.

For example, if you buy a share of stock for $, and it pays no dividend, and a year later the market price is $, then your return = [0 + ( − )] / = 5 / = 5%. If the same stock paid a dividend of $2, then your return = [2 + ( − )] / = 7 / = 7%.

If the information you have shows more than one year’s results, you can calculate the annual return using what you learned in Chapter 4 &#;Evaluating Choices: Time, Risk, and Value&#; about the relationships of time and value. For example, if an investment was worth $10, five years ago and is worth $14, today, investing in stocks chapter 12 answers, then $10, × (1 + r)⁵ = $14, investing in stocks chapter 12 answers, Solving for r, the annual rate of return, you get 7 per cent. So, other factors being equal, the $10, investment must have earned at a rate of 7 per cent per year to be worth $14, five years later.

While information about current and past returns is useful, investment professionals are more concerned with the expected return for the investment—that is, how much it may be expected to earn in the future. Estimating the expected return is complicated because many factors (e.g., investing in stocks chapter 12 answers, current economic conditions, industry conditions, and market conditions) may affect that estimate.

For investments with a long history, investing in stocks chapter 12 answers, a strong indicator of future performance may be past performance. Economic cycles fluctuate, and industry and firm conditions vary, but over the long run, an investment that has survived has weathered all those storms. So, you could look at the average of the returns for each year. There are several ways to do the math, but if you look at the average return for different investments of the same asset class or type (e.g., stocks of large companies) you could compare what they have returned, on average, over time.

If the time period you are looking at is long enough, you can reasonably assume that an investment’s average return over time is the return you can expect in the next year. For example, if a company’s stock has returned, on average, 9 per cent per year over the last twenty years, then if next year is an average year, that investment should return 9 per cent again. Over the eighteen-year span from tofor example, investing in stocks chapter 12 answers, the average return for the S&P was per cent. Unless you have some reason to believe that next year will not be an average year, the average return can be your expected return. The longer the time period you consider, the less volatility there will be in the returns, and the more accurate your prediction of expected returns will be.

Returns are the value created by an investment, through either income or gains. Returns investing in stocks chapter 12 answers also your compensation for investing, for taking on some or all of the risk of the investment, whether it is a corporation, government, parcel of real estate, or work of art. Even if there is no risk, you must be paid for the use of liquidity that you give up to the investment (by investing).

Returns are the benefits from investing, but they must be larger than its costs. There are at least two costs to investing: the opportunity cost of giving up cash and giving up all your other uses of that cash until you get investing in stocks chapter 12 answers back in the future, and the cost of the risk you take—the risk that you won’t get it all back.

Risk

Investment risk is the idea that an investment will not perform as expected, that its actual return will deviate from the expected return. Risk is measured by the amount of volatility—that is, the difference between actual returns and average (expected) returns. This difference is referred to as the standard deviation. Returns with a large standard investing in stocks chapter 12 answers (showing the greatest variance from the average) have higher volatility and are the riskier investments.

An investment may do investing in stocks chapter 12 answers or worse than its average. Standard deviation can therefore be used to define the expected range of investment returns, investing in stocks chapter 12 answers. For the S&Pfor example, the standard deviation from to was per cent. So, in any given year, investing in stocks chapter 12 answers, the S&P is expected to return per cent, but its return could be as high as per cent or as low as − per cent, based on its performance during that specific period.

What risks are there? What would cause an investment to unexpectedly over or underperform? Starting from the top (the big picture) and working down, there are

• economic risks,
• industry risks,
• company risks,
• asset class risks, and
• market risks.

Economic risks are risks that something will upset the economy as a whole. The economic cycle may swing from expansion to recession, for example; inflation or deflation may increase, unemployment may increase, or interest rates may fluctuate. These macroeconomic factors affect everyone doing business in the economy. Most businesses are how much is 200 bitcoin in dollars, growing when the economy grows and contracting when the economy contracts.

Consumers tend to spend more disposable income when they are more confident about economic growth and the stability of their jobs and incomes, investing in stocks chapter 12 answers. They also tend to be more willing and able to finance purchases with debt or with credit, expanding their ability to purchase durable goods. So, demand for most goods and services increases as an economy expands, and businesses expand too. An exception is businesses that are countercyclical. Their growth accelerates when the economy is in a downturn and slows when the economy expands. For example, low-priced fast food investing in stocks chapter 12 answers typically have increased sales in an economic downturn because people substitute fast food for more expensive restaurant meals as they worry more about losing their jobs and incomes.

Industry risks usually involve economic factors that affect an entire industry or developments in technology that affect an industry’s markets. An example is the effect of a sudden increase in the price of oil (a macroeconomic event) on the airline industry. Every airline is affected by such an event, as an increase in the price of airplane fuel increases airline costs and reduces profits. An industry such as real estate is vulnerable to changes in interest rates, investing in stocks chapter 12 answers. A rise in interest rates, for example, makes it harder for people to borrow money to finance purchases, which depresses the value of real estate.

Company risk refers to the characteristics of specific businesses or firms that affect their performance, making them more or less vulnerable to economic and industry risks. These characteristics include how much debt financing the company uses, how well it creates economies of scale, how efficient its inventory management is, how flexible its labour relationships are, and investing in stocks chapter 12 answers on.

The asset class that an investment belongs to can also bear on its performance and risk. Investments (assets) are categorized in terms of the markets they trade in. Broadly defined, asset classes include:

• corporate stock or equities (shares in public corporations, either domestic or foreign);
• bonds or the public debts of corporations or governments;
• commodities or resources (e.g., oil, coffee, investing in stocks chapter 12 answers, or gold);
• derivatives or contracts based on the performance of other underlying assets;
• real estate (both residential and commercial); and
• fine art and collectibles (e.g., stamps, coins, baseball cards, or vintage cars).

Within those broad categories, there are finer distinctions. For example, corporate stock is classified as large cap, mid cap, or small cap, depending on the size of the corporation as measured by its market capitalization (the aggregate value of its stock). Bonds are distinguished as corporate or government and as short- intermediate- or long-term, depending on the maturity date.

Risks can affect entire asset classes. Changes in the inflation rate can make corporate bonds more or less valuable, investing in stocks chapter 12 answers, for example, or more or less able to create valuable returns. In addition, changes in a market can affect an investment’s value. When the stock market fell unexpectedly and significantly, as it did in, andall stocks were affected, regardless of relative exposure to other kinds of risk. After such an event, the market is usually less efficient or less liquid—that is, investing in stocks chapter 12 answers, there is less trading investing in stocks chapter 12 answers less efficient pricing of assets (stocks) because there is less information flowing between buyers and sellers. The loss in market efficiency further affects the value of assets traded.

As you can investing in stocks chapter 12 answers, the link between risk and return is reciprocal. The question for investors and their advisers is: How can you get higher returns with less risk?

DIVERSIFICATION: RETURN WITH LESS RISK

Every investor wants to maximize return, the earnings or gains from giving up surplus cash. And every investor wants to minimize risk, because it is costly. To invest is to assume risk, and you assume risk expecting to be compensated through return. The more risk assumed, the more the promised return. So, to increase return you must increase risk, and to lessen risk, you must expect less return. But another way to lessen risk is to diversify: to spread out your investments among a number of different asset classes. Investing in different asset classes reduces your exposure to economic, asset class, and market risks.

Concentrating investment concentrates risk. Diversifying investments spreads risk by having more than one kind of investment and thus more than one kind of risk. To truly diversify, you need to invest in assets that are not vulnerable to one or more kinds of risk. For example, you may want to diversify:

• between cyclical and countercyclical investments, reducing economic risk;
• among different sectors of the economy, reducing industry risks;
• among different kinds of investments, reducing asset class risk; and
• among different kinds of firms, reducing company risks.

To diversify well, you have to look at your collection of investments as a whole—that is, as a portfolio rather than as a gathering of separate investments. If you choose the investments well, if they are truly different from each other, the whole can actually be more valuable than the sum of its parts.

Steps to Diversification

In traditional portfolio theory, there are three levels or steps to diversifying: capital allocation, asset allocation, and security selection.

Capital allocation is diversifying your capital between risky and riskless investments. A “riskless” asset is a short-term (less than ninety-day) government treasury bill. Because it has such a short time to maturity, it won’t be much affected by interest rate changes, and it is probably impossible for the Canadian government to become insolvent—go bankrupt—and have to default on its debt within such a short time.

The capital allocation decision is the first diversification decision. It determines the portfolio’s overall exposure to risk, or the proportion of the portfolio that is invested in risky assets. That, in turn, will determine the portfolio’s level of return.

The second diversification decision is asset allocation: deciding which asset classes, and therefore which risks and which markets, to invest in. Asset allocations are specified in terms of the percentage of the portfolio’s total value that will be invested in each asset class. To maintain the desired allocation, the percentages are adjusted how to begin investing in cryptocurrency as asset values change. Chart shows an asset allocation for an investor’s portfolio.

Chart Proposed Asset Allocation

Asset allocation is based on the expected returns and relative risk of each asset class and how it will contribute to the return and risk of the portfolio as a whole. If the asset classes you choose are truly diverse, then the portfolio’s risk can be lower than the sum of the assets’ risks.

One example of an asset allocation strategy is life cycle investing—changing your asset allocation as you age. When you retire, for example, and forgo income from working, you become dependent on income from your investments. As you approach retirement age, therefore, you typically shift your asset allocation to less risky asset classes to protect the value of your investments.

Security selection is the third step in diversification: choosing individual investments within each asset class. Here is the chance to achieve industry or sector and company diversification. For example, if you decided to include corporate stock in your portfolio (asset allocation), you decide which corporation’s stock to invest in. Choosing corporations in different industries, or companies of different sizes or ages, will diversify your stock holdings, investing in stocks chapter 12 answers. You will have less risk than if you invested in just one corporation’s stock. Diversification is not defined by the number of investments but by their different characteristics and performance.

Investment Strategies

Capital allocation decides the amount of overall risk in the portfolio; asset allocation tries to maximize the return you can get for that amount of risk. Security selection further diversifies within each asset class. Chart demonstrates the three levels of diversification.

Chart Levels of Diversification

Just as life cycle investing is a strategy for asset allocation, investing in index funds is a strategy for security selection. Indexes are a way of measuring the performance of an entire asset class by measuring returns for a portfolio containing all the investments in that asset class. Essentially, the index becomes a benchmark for the asset class, a standard against which any specific investment in that asset class can be measured. An index fund is an investment that holds the same securities as the index, so it provides a way for you investing in stocks chapter 12 answers invest in an entire asset class without having to select particular securities.

There are indexes and index funds for most asset classes. By investing in an index, you are achieving the most diversification possible for that asset class without having to make individual investments—that is, without having to make any security selection decisions. This strategy of bypassing the security selection decision is called passive management. It also has the advantage of saving transaction costs (broker’s fees) because you can invest in the entire index through only one transaction rather than the many transactions that picking investments would require.

In contrast, making security selection decisions to maximize returns and minimize risks is called active management. Investors who favour active management feel that the advantages of picking specific investments, after careful research and analysis, are worth the added transaction costs. Actively managed portfolios may achieve diversification based on the quality, rather than the quantity, of securities selected.

Also, asset allocation can be actively managed through the strategy of market timing—shifting the asset allocation in anticipation of economic shifts or market volatility. For example, if you forecast a period of higher inflation, you would reduce allocation in fixed-rate bonds or debt instruments, because inflation erodes the value of the fixed repayments. Until the inflation passes, you would shift your allocation so that more of your portfolio is in stocks, say, and less in bonds.

It is rare, however, for active investors or investment managers to achieve superior results over time. More commonly, an investment manager is unable to achieve consistently better returns within an asset class than the returns of the passively managed index (Malkiel, ).

REFERENCES

Malkiel, B. G. (). A Random Walk Down Wall Street, 10th ed. New York: W. W. Norton & Company.