Many people choose their investments based almost solely on interest rate or yield. There are other factors which should be considered, however. In fact, many investment professionals recommend that you answer three questions before you even consider interest rate or yield. These questions are:
- What are my investment goals?
- What level of risk am I willing to accept?
- What degree of liquidity do I need?
INVESTMENT GOALS
There are four major investment goals:
- Preservation - the assurance that the initial investment does not decline in value
- Appreciation - the growth of funds
- Income - the additional cash flow realized from the investment itself
- Liquidity - availability of funds
An investment cannot satisfy all four goals. You must therefore decide which goals are most important to you. Your cash flow is critical to your business, so preservation and liquidity will probably be important to you. The best way to judge whether an investment will preserve its value is to evaluate its risk.
RISK
All investments include some risk, and some carry more than others. The five main types of investment risk are:
- Market Risk: the risk that the investment may sell for less than originally paid. Stocks are one example of market risk.
- Interest Rate Risk: the risk of uncertainty about changes in interest rates. A deposit account with a variable-rate of interest (vulnerable to dropping interest rates) is a good example of the risk.
- Purchasing Power Risk: the risk that the investment will not keep pace with inflation. Savings certificates with a fixed-rate purchased before a period of increasing inflation and interest rates are examples.
- Tax Risk: the risk that tax laws may unfavorable affect an existing investment. An investment that is partially or fully tax-exempt but which may lose its exemption is an example.
- Financial (Business) Risk: the risk that the business may not succeed, or may be less successful than anticipated. The stock of a new company is one investment susceptible to this risk.
Evaluating risk can be challenging, but it is a necessary task when choosing the best investment for you. You must decide which types and what degree of risk you can accept.
LIQUIDITY
Liquidity is simply the ease with which your investment can be converted to cash. Liquidating an investment can consist of a withdrawal from a deposit account, the sale of stock, or the redemption of a bond.
MAKING THE CHOICE
Once you know your choices, how do you decide what's best for you? You need to consider your average daily cash needs, and the amounts and due dates of your payables. As a rule, you should always maintain enough funds in your checking account and liquid investments (such as a daily savings account) to cover your daily expenses. Additional amounts may be placed in investments that are less liquid.
The individual handling your investment should explain to you:
- Term (or length) or your deposit/investment
- Method of converting the investment to cash (redemption, sale, etc.)
- Restrictions on converting it to cash
- Penalties for early redemption or sale (if any)
- Fees (if any)
FEES AND CHARGES
Certain types of investments, such as stocks, incur fees when they are purchased or redeemed (sold). Others, such as mutual funds, may also assess ongoing charges or management fees. These fees may reduce the yield you receive on your investment, so be sure to ask questions. Whether a fee is charged is not as important as how much your investment appreciates overall.
TYPES OF INVESTMENTS
You should realize that not all investments available to you as an individual are available to you as a business (especially if you are a corporation). Federal regulations limit the types of investments businesses may use. Your CPA, banker, and other experts can explain the many types of investments available to you.
A LAST WORD
Sound complicated? It isn't really. Just follow these simple steps when choosing an investment:
- Decide how much you can invest and for how long
- Evaluate the risk associated with the investments available
- Determine how liquid various investments are
- Seek the best value of the investments that are appropriate for you, including yield, length of investment, etc.
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