An investor’s return from lending investments is typically limited to the original investment plus interest payments. If you lend your money to Netflix through one of its bonds that matures in, say, ten years, and Netflix triples in size over the next decade, you won’t share in its growth. Netflix’s stockholders and employees reap the rewards of the company’s success, but as a bondholder, you don’t; you simply get interest and the face value of the bond back at maturity.
THE DOUBLE WHAMMY OF INFLATION AND TAXES
Bank accounts and bonds that pay a decent return are reassuring to many investors. Earning a small amount of interest sure beats losing some or all of your money in a risky investment.
The problem is that money in a savings account, for example, that pays 1.5 percent isn’t actually yielding you 1.5 percent. It’s not that the bank is lying; it’s just that your investment bucket contains some not-so-obvious holes.
The first hole is taxes. When you earn interest, you must pay taxes on it (unless you invest the money in municipal bonds that are federal and state tax-free or in a retirement account, in which case you generally pay the taxes later when you withdraw the money). If you’re a moderate-income earner, you may end up losing about a third of your interest to taxes. Your 1.5 percent return is now down to 1 percent.
But the second hole in your investment bucket can be even bigger than taxes: inflation. Although a few products become cheaper over time (computers, for example), most goods and services increase in price. Inflation in the United States has been running about 2 percent per year over recent years (3 percent over the much longer term. Inflation depresses the purchasing power of your investments’ returns. If you subtract the 2 percent “cost” of inflation from the remaining 1 percent after payment of taxes, I’m sorry to say that you’ve lost 1 percent on your investment.
To recap: For every dollar you invested in the bank a year ago, despite the fact that the bank paid you your 1.5 pennies of interest, you’re left with only 99 cents in real purchasing power for every dollar you had a year ago. In other words, thanks to the inflation and tax holes in your investment bucket, you can buy less with your money now than you could have a year ago, even though you’ve invested your money for a year.
Considering Cash Equivalents
Cash equivalents are any investments that you can quickly convert to cash without cost to you. With most bank checking accounts, for example, you can conduct online transactions to pay bills or do the old-fashioned writing of a check or withdraw cash through an ATM machine or from retailers like a grocery store that enable you to get cash back when making a purchase.
Money market mutual funds are another type of cash equivalent. Investors, both large and small, invest hundreds of billions of dollars in money market mutual funds because the best money market funds historically have produced higher yields than bank savings accounts. (Some online banks offer higher yields, but you must be careful to understand ancillary service fees that can wipe away any yield advantage — see Chapter 7 for information.) The yield advantage of a money market fund over a savings account almost always widens when interest rates increase because banks move to raise savings account rates about as fast as molasses on a cold winter day.
Why shouldn’t you take advantage of a higher yield? Many bank savers sacrifice this yield because they think that money market funds are risky — but they’re not. Money market mutual funds generally invest in safe things such as short-term bank certificates of deposit, U.S. government-issued Treasury bills, and commercial paper (short-term bonds) that the most creditworthy corporations issue.
Another reason people keep too much money in traditional bank accounts is that the local bank branch office or online bank makes the cash seem more accessible. Money market mutual funds, however, offer many quick ways to get your cash. Most money market mutual funds can be accessed online, just like most bank accounts. You can also write a check (most funds stipulate the check must be for at least $250), or you can call the fund and request that it mail or electronically transfer your money.
Steering Clear of Futures and Options
Suppose you think that IBM’s stock is a good investment. The direction that the management team is taking impresses you, and you like the products and services that the company offers. Profits seem to be on a positive trend. Things are looking up.
You can go out and buy the stock. Suppose that it’s currently trading at around $100 per share. If the price rises to $150 in the next six months, you’ve made yourself a 50 percent profit ($150 – $100 = $50) on your original $100 investment. (Of course, you will incur some brokerage fees to buy and then sell the stock.)
But instead of buying the stock outright, you can buy what are known as call options on IBM. A call option gives you the right to buy shares of IBM under specified terms from the person who sells you the call option. You may be able to purchase a call option that allows you to exercise your right to buy IBM stock at, say, $120 per share in the next six months. For this privilege, you may pay $6 per share to the seller of that option (and you’ll also pay trading commissions).
If IBM’s stock price skyrockets to, say, $150 in the next few months, the value of your options that allow you to buy the stock at $120 will be worth a lot — at least $30. You can then simply sell your options, which you bought for $6 in the example, at a huge profit — you’ve multiplied your money five-fold!
You could easily lose your entire investment. If a company’s stock price goes nowhere or rises only a little during the six-month period when you hold the call option, the option expires as worthless, and you lose all — that is, 100 percent — of your investment. In fact, in my example, if IBM’s stock trades at $120 or less at the time the option expires, the option is worthless.
A call option represents a short-term gamble on a company’s stock price, not an investment in the company itself. In my example, IBM could expand its business and profits greatly in the years and decades ahead, but the value of the call option hinges on the ups and downs of IBM’s stock price over a relatively short period of time (the next six months). If the stock market happens to dip in the next six months, IBM may get pulled down as well, despite the company’s improving financial health.