Today we will take up a few ‘passive’ investment options.
Passive Investments: We define passive investments as those investments we make that require ‘comparatively’ less on-hand supervision than active investments. The operating word here is ‘comparatively’ as all investments require diligence and management if we are to stand any good chance of succeeding at them. What might, acceptably, be the difference is just the amount of time and effort that may be required in managing them. I mean, setting up and running a poultry farm (an active investment) will likely require more of your time and effort than investing in T-Bills (a passive investment).
There is a wide range of passive investments that individuals could make. They include:
Stocks: When we talk of ‘stock’ in investment we are referring to ownership of a piece of company (private or public), and not the accounting term that refers to raw materials, work-in-progress, and finished goods. If you are involved, hands-on, in running the affairs of a company you invested in, then your investment is active and falls under what we discussed last week. However, if you will not be involved in actively running the company, then you are making a passive investment.
There are generally two ways people make money in stocks. One is to buy the stock at ‘good value’ and then sell it within a ‘short’ period if the price increases. Another is holding the stock long, earning dividends, share bonuses and ultimately capital appreciation.
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Interest rates and other socio-economic realities do affect all investible products. Hence, it is important to study and understand relevant variables and their dynamics as regards each stock. Specifically, the risks of investing in stock can be significantly higher than with other options such as bonds and annuities discussed below.
Many members of my generation and those older lost money heavily in shares during the global crises of 2008 which hit our local markets heavily. Arising from the experiences, many are now averse to anything ‘shares’! I think that is quite unlearning. I can tell you that I made good money in shares at that time even as I took margin loans for the investments. How? I purchased shares of companies with excellent fundamentals and value at IPOs and sold them the moment I was happy with the price gain regardless of the sentiment of the investing public about ‘further price increase’. I ran away with my profits and was happy irrespective of what eventually happened thereafter. The only time I lost money on two stocks was when I didn’t act fast enough after ‘succumbing’ to the sentiments of the investing public instead of sticking with my philosophy and approach.
Bonds: Bonds are loans an investor (creditor?) makes to a bond issuer, usually corporations and government entities. Investors receive a fixed and recurring coupon payment, say twice a year, over the life of the bond and upon maturity receive back the principal invested. You can opt to hold on to your investment to maturity or sell it before the maturity.
The market value of a bond may differ from its face value depending on economic realities and options as well as the remaining period to maturity. Mostly, bonds offer lower returns than stocks but are also less risky. Government bonds are usually considered less risky than corporate bonds. In other climes, investments can be leveraged for higher returns through so-called derivative products. They are, however, higher risks with possibilities of higher losses as well. They should be appealing only to those who understand them.
Bonds offer a steady stream of income, liquidity and an option to diversify your portfolio. However, they can become unattractive depending on interest rate regimes and inflationary pressures.
Mutual Funds and Index Funds: Generally speaking, ‘Funds’ are pools of aggregated stocks, bonds, commodities, etc., designed to craft a desired vehicle in line with some investment philosophy or aimed at achieving some investment objective(s). An investor can buy shares of a mutual fund that holds ownership of particular types of stocks rather than having to go through the process of investing in individual companies. Mutual Funds are actively managed by investment managers and can earn money through dividends from shares or interest from bonds. A proportion of the earnings are distributed to the investors. Furthermore, the value of the fund could increase and an investor could sell at a profit.
Index Funds are a type of mutual fund that tracks an index. They are managed passively as they simply imitate a benchmark, thereby tending to cost less. The way they make money is not dissimilar to a straight mutual fund.
Annuities: Annuity refers to recurring payments of similar amounts over a period that is agreed by one party (the issuer) to another (the purchaser/annuitant) upon receipt of investments made by the purchaser. The payment by the purchaser may be made one-off or in instalments over an ‘accumulation’ period. Operationally, an annuity is a contract agreed to by financial institutions, often Insurance Companies, to make payments to a beneficiary who purchases (directly or indirectly) the annuity. The issuer agrees to make fixed or variable streams of payment after an ‘annuitisation period’ periodically (usually monthly but could also be annually) to the beneficiary either for a term of say, twenty years, or until death. When payment is for a fixed term, it would continue to a nominated person in the event of the death of the beneficiary before the payment term expires.
Depending on the issuer you are dealing with, annuities are generally both low risk and low yield. However, the predictable payments should be comforting as long as the competence and integrity of the issuer are without doubt. Annuities may also be appropriate towards enhancing guaranteed cash inflows and reducing overall portfolio risks.
Next week we will take up ‘Managing Your Investments’.
