Investing for Your Future

Investing is a fundamental concept in the world of business and finance. It involves the allocation of resources, often in the form of money, with the expectation of generating a profit or a material result. For business students, understanding investing principles is not just important for personal finance management, but it’s also crucial in various business contexts, from starting and running a business to making strategic business decisions.

In the most common sense, investing typically refers to the purchase of assets or securities such as stocks, bonds, or real estate. The goal is to buy these assets and hopefully sell them at a higher price in the future, or earn income from them over time, generating a positive return on investment. However, investing is not limited to purchasing financial assets. It can also involve investing time, effort, and resources into starting a business, pursuing education or training, or any other initiatives that can potentially lead to long-term benefits.

Investing always involves some degree of risk. While the potential for higher returns often comes with higher risk, understanding how to manage and mitigate these risks is a key part of successful investing. This is where concepts like diversification (spreading investments across a variety of assets to reduce risk), asset allocation (choosing the right mix of assets based on your risk tolerance and investment horizon), and due diligence (thoroughly researching and understanding an investment before investing) come into play.

In the business world, investment decisions are at the core of many strategic and operational choices. Businesses invest in new products, technologies, and markets with the expectation of increasing profits. Therefore, understanding investing principles can help business students not only manage their finances effectively but also make smarter, data-driven decisions in their professional lives. Regardless of their future roles, a solid understanding of investing principles will provide business students with valuable skills and insights for their careers.

Understanding Risk

Financial investing involves taking on certain levels of risk in the hopes of achieving a return on the invested capital. Risk refers to the potential for losing some or all of an investment or facing financial instability due to various factors. It’s essentially the possibility that the actual financial outcomes will differ from the expected outcomes, and it can impact an individual’s ability to meet their financial goals. Understanding and managing risk is crucial in personal financial planning. The nature and degree of this risk can vary significantly based on the type of investment.

Here are a few types of investment risks:

1. Market Risk – This is the risk that the overall market will decline, negatively impacting the majority of stocks and bonds, regardless of their performances.
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2. Interest Rate Risk – This is the risk that changes in interest rates will negatively impact the value of an investment. For instance, when interest rates rise, bond prices typically fall.
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3. Inflation Risk – This is the risk that the rate of inflation will exceed the rate of return on investment, reducing purchasing power.
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4. Liquidity Risk – This is the risk that an investor may not be able to buy or sell an investment quickly without impacting its price.
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5. Credit Risk – This is the risk that a bond issuer will default and fail to pay the interest or principal on time.

Risk tolerance refers to an individual’s capacity and willingness to endure swings in the values of their investments in the pursuit of higher returns. It is typically determined by factors such as financial goals, time horizon (how long they plan to invest), income level, financial obligations, and personal temperament.

Investors with high-risk tolerance may be more comfortable investing in higher-risk options, like stocks, which have higher volatility but the potential for significant long-term returns. Those with low-risk tolerance might prefer more conservative investments, like bonds or money market funds, which have lower potential returns but offer more stability.

In essence, understanding the risks associated with financial investing and one’s personal risk tolerance is crucial in creating an investment strategy that aligns with one’s financial goals, time horizon, and comfort level with risk. A well-diversified portfolio, which includes a mix of different types of investments, is typically recommended to mitigate risk while still aiming for a reasonable return.

Financial Tip

Investments and Markets

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.

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.

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.

Mutual Funds, Index Funds, and Exchange-Traded Funds (EFTs)

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) 500 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.

Financial Tip

What Is A Mutual Fund? ^[1]

Owning Stocks

Resources have costs, so a company needs money, or capital, which is also a resource. To get that start-up capital, the company could borrow or it could offer a share of ownership, or equity, to those who chip in capital.

If the costs of debt (interest payments) are affordable, the company may choose to borrow, which limits the company’s commitment to its capital contributor. When the loan matures and is paid off, the relationship is over.

If the costs of debt are too high, however, or the company is unable to borrow, it seeks equity investors willing to contribute capital in exchange for an unspecified share of the company’s profits at some time in the future. In exchange for taking the risk of no exact return on their investment, equity investors get a say in how the company is run.

Stock represents those shares in the company’s future and the right to a say in how the company is run. The original owners—the inventor(s) and entrepreneur(s)—choose equity investors who share their ideals and vision for the company. Usually, the first equity investors are friends, family, or colleagues; this allows the original owners freedom of management. At that point, the corporation is privately held, and the company’s stock may be traded privately between owners. There may be restrictions on selling the stock, as is often the case for a family business so that control stays within the family.

If successful, however, eventually the company needs more capital to grow and remain competitive. If the debt is not desirable, then the company issues more equity, or stock, to raise capital. The company may seek out an angel investor, venture capital firm, or private equity firm. Such investors finance companies in the early stages in exchange for a large ownership and management stake in the company. Their strategy is to buy a significant stake when the company is still “private” and then realize a large gain, typically when the company goes public. The company may also seek a buyer, perhaps a competitive or complementary business.

Alternatively, the company may choose to go public, selling shares of ownership to investors in the public markets. Theoretically, this means sharing control with random strangers because anyone can purchase shares traded in the stock market. It may even mean losing control of the company.

What Exactly Are Stocks? ^[2]

Primary and Secondary Markets

The private corporation’s board of directors—shareholders elected by the shareholders—must authorize the number of shares that can be issued. Since issuing shares means opening the company up to more owners, or sharing it among more people, only the existing owners have the authority to do so.

Those authorized shares are then issued through an initial public offering (IPO). At that point, the company goes public. The IPO is a primary market transaction, which occurs when the stock is initially sold and the proceeds go to the company issuing the stock. After that, the company is publicly traded; its stock is outstanding, or publicly available. Then, whenever the stock changes hands, it is a secondary market transaction. The owner of the stock may sell shares and realize the proceeds. When most people think of “the stock market,” they are thinking of the secondary markets.

The existence of secondary markets makes the stock a liquid or tradable asset, which reduces its risk for both the issuing company and the investor buying it. The investor is giving up capital in exchange for a share of the company’s profit, with the risk that there will be no profit or not enough to compensate for the opportunity cost of sacrificing the capital. The secondary markets reduce that risk to the shareholder because the stock can be resold, allowing the shareholder to recover at least some of the invested capital and make new choices with it.

Common and Preferred Stocks

A company may issue common stock or preferred stock. Common stock is more prevalent. All companies issue common stock, whereas not all issue preferred stock. The differences between common and preferred have to do with the investor’s voting rights, risk, and dividends.

Common stock allows each shareholder voting rights—one vote for each share owned. The more shares you own, the more you can influence the company’s management. Shareholders vote for the company’s directors, who provide policy guidance for and hire the management team that directly operates the corporation. After several corporate scandals in the early twenty-first century, some shareholders have assumed a more active voting role.

Common stockholders assume the most risk of any corporate investor. If the company encounters financial distress, its first responsibility is to satisfy creditors, then the preferred shareholders, and then the common shareholders. Thus, common stocks provide only residual claims on the value of the company. In the event of bankruptcy, in other words, common shareholders get only the residue—whatever is left after all other claimants have been compensated.

Common shareholders share the company’s profit after interest has been paid to creditors and a specified share of the profit has been paid to preferred shareholders. Common shareholders may receive all or part of the profit in cash—the dividend. The company is under no obligation to pay common stock dividends, however. The management may decide that the profit is better used to expand the company, invest in new products or technologies, or grow by acquiring a competitor. As a result, the company may pay a cash dividend only in certain years or not at all.

Shareholders investing in preferred stock, on the other hand, give up voting rights but get less risk and more dividends. Preferred stock typically does not convey voting rights to the shareholder. As noted above, preferred shareholders have a superior claim on the company’s assets in the event of bankruptcy. They get their original investment back before common shareholders but after creditors. ^[3]

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Tax-Sheltered Savings Plans

Canada has several savings plans that are registered with the Canada Revenue Agency (CRA). The money you save in these plans may be exempted from income taxes or taxed at a lower rate, depending on the type of plan and your financial situation.

Tax-Free Savings Accounts (TFSAs)

TFSAs earn income from investments without paying taxes on the income, even when it is withdrawn. Contributions to a TFSA are not deductible for income tax purposes as you are investing post-tax dollars.

Money contributed to a TFSA can remain cash, or can be invested in mutual funds, stocks, GICs, or bonds.

Starting in 2009, TRSA contribution room accumulates every year, with any unused TFSA contribution room from the previous year carrying forward.

To find your TFSA limit, create and login into your CRA account.

Registered Retirement Savings Plans (RRSPs)

Similar to TFSAs, money contributed to a RRSP can remain cash, or can be invested in mutual funds, stocks, GICs, or bonds.

Contributions and earnings from a RRSP are generally free from income tax until withdrawn. The tax rate will depend on your income level.

Yearly contribution allowance for RRSPs are calculated by the Canadian Revenue Agency (CRA) up to a maximum amount (about $26,000).

To find your RRSP limit, create and login into your CRA account.

You can withdraw certain amounts tax-free for certain purposes, such as a house down payment or an education plan, but you have to return it within a certain time period or pay penalties.

Definition

These plans are not only useful for savings – they can help you minimize taxes on income earned from the plans. These plans are not investments themselves. Think of them as filing cabinets. They’re secure receptacles where you store different kinds of investments. They help you minimize the taxes you pay. You pay tax on the earnings only when you pull an investment out of a drawer (except for TFSAs). The rules for putting money into these plans and taking it out can be complicated, so you may want to check with your financial institution before making contributions and withdrawals. Get expert advice on the best plan for you and how to manage the funds you save there.