Investments in Financial Planning

Investments is one of the core subjects in the financial world. Without investments, many financial service companies would not exist. This section will cover investments and how investing is used with financial planning.

Investing and Financial Planning

Financial planners work with clients to create a investment plan that can be followed to achieve the client's financial goals. An element that financial planning brings to investing is highlighting the importance of risk tolerance and having an investment time horizon.

A financial planner should determine the right basket of investments for a client according to how aggressive the client wants to be versus how much risk the client wants to tolerate. Too much investment risk will lead to high volatility which can end up disastrous, if the client is looking to retire or cash in those investments in less than a year. On the other hand, too conservative investment risk could lead to a return that does not make enough money for retirement or for a certain financial goal (i.e. Paying for a child's college tuition).

Clearly, the importance of a planner having the understanding of a client's risk tolerance and investment time horizon should reflect what investments are recommended.

I. Introduction to Investments

Investing is a key factor to one creating wealth for an individual. In order for one to invest, he must choose an investment to put his cash into. Hypothetically, almost anywhere one's money goes can be called an investment. A person can spend money on a gym membership to invest in a healthier lifestyle or a person could spend his money on an expensive meal to invest in an amazing taste experience.

The concept is all the same. Where one puts his money is to expect a greater position in life than before and the action of putting money into that expectation is called an investment. This topic could lead into many different roads, but for the sake of this introduction, lets focus on security investments with a few sprinkles of other types of investments like real estate, collectible, and precious metal investments.

Interest (Rate of Return)

When an investment is made, an expectation of some type of return is involved. This rate of return monetarily would be considered "interest". Interest can be synonymous to three different terms: a rate of return, a discount rate, or opportunity cost.

Interest rates are typically quoted on an annual basis. However, the compounding period may be less than a year despite an annual basis quote.

Types of Interest

Simple Interest

Definition: An amount, A, invested for n periods at a simple interest rate of r per period is worth: $A (1 + r)^n$ at maturity.

Compound Interest

Definition: An amount, A, invested for n periods at a compound interest rate of r per period is worth $A (1+r)^n$ at maturity.

Rate of Return

Discount Rate

Opportunity Cost

What Are Securities?

Investments in financial planning will mostly involve security investments. Most of the chapters go in depth into describing the different types of securities. Before going in depth however, we must first define what securities are. The Uniform Securities Act defines a security as but not limited to:

  • Stocks
  • Bonds
  • Notes
  • Rights
  • Warrants
  • Collateral trust certificates
  • Voting trust certificates
  • Pre-organization certificates or subscriptions
  • Certificates of interest or participation in a profit sharing agreement
  • Certificates of interest in an oil, gas, or mining title or lease
  • Transferable shares
  • Certificates of deposit for a security
  • Investment contracts
  • Options
  • Variable annuities
  • Interest in a REIT (real estate investment trust)

The following investments are not securities:

  • Fixed Annuities
  • Whole Life / Term Life Insurance Policies
  • Bank CDs up to $100,000 (fully insured)
  • Commodities / Future Contracts
  • Collectibles (like antiques)
  • Precious metals
  • Real estate

A general rule of thumb is: If something is not secure, it can be called a security

II. Common Stock

The definition of common stock is an equity position in an company where an investor is a shareholder, or part-owner, of the company who issued the common stock to the investor. Equity means ownership.

Different Types of Common Stock

Authorized Stock — Max shares allowed to be sold (issued)
Issued Stock — Shares sold to the public in a Primary Distribution. Shares are taken from authorized stockpile.
Treasury Stock — Also known as Repurchased Stock, this stock is created when a company does a stock repurchase.

A stock repurchase is an indicator that the company is trying to increase their Earnings Per Share (EPS), finances future acquisitions, provide stock for employee stock option plans, or fight a takeover attempt.

Benefits of Holding Common Stock

Hedge Against Inflation — Historically proven, common stock typically performs higher than inflation during inflationary periods.
Growth Potential — Common stocks have shown a greater potential for returns than other types of securities

III. Bonds

Bond Risks

  • Purchasing Power Risk
  • Reinvestment Risk
  • Interest Rate Risk
  • Exchange Rate Risk
  • Default Risk
  • Call Risk
  • Liquidity Risk

Recall your risk definitions? Click here

Zero-coupon bonds are not subject to reinvestment rate risk during the term of the bond because no payments are made until maturity.

Liquidity vs Marketability
Liquidity = Ability to sell an investment with little price concession and little chance of loss
Marketability = Ability to find a ready market where investment may be sold quickly

III. Yield Curve Theories

Term Structure of Interest Rates

Expectations Theory - Current long-term rates reflect market expectations about future short-term rates.
- Same return regardless of long term bonds or series of short-term rates

Segmentation Theory - Yields for given maturities reflect demand and supply conditions for bonds at those maturities.

Liquidity Preference Theory - Combination of expectations and segmentation theories.

Covariance - Statistical measure of how returns of one investment move or vary with the returns of another investment.

IV. Introduction to Options

Now right from the start, I am going to warn you that options can be a very thick concept to comprehend, and there is no better way to start learning option concepts than starting with the basics. An option is often defined as the right to choose or right to buy something.

Here is my example that hopefully can teach you the concept of options through soda:
If I gave you the chance to buy 100 bottles of your favorite soda in the 1950's at 5 cents each (when that was the common price for a soda bottle), would you say, "Sure"? Despite that being a large amount of sodas, you agree and I write you a contract saying you can buy 100 bottles of that soda from me at five cents each until the year 2020, signed and guaranteed by me.

I finish up the contract and offer you the contract, and just when you reach for it, I say "Hold up chief, you need to pay me for this contract." You balk at the idea of paying me for a piece of paper to buy 100 sodas. However, there are a few things you can notice from this contract. The price of the soda is in the 1950s price and the cost of soda may go up with inflation and all.

V. US Government Securities


The US Government has three basic securities: Treasury Bills (T-Bills), Treasury Notes (T-Notes), and Treasury Bonds (T-Bonds)

The risks associated with US Treasury securities are subject to inflationary (purchasing power) risk, interest rate risk, and market risk.

In addition to US Treasury securities, certain US Government Agencies can issue debt to provide capital for their operations.

Treasury Bills (T-Bills)

In the US, T-Bills are pure discount instruments issued by the federal government. T-Bills are sold at a discount with no coupon obligations which means no interest is given to investors. This leaves the yield on T-Bills being only the discount.

The face value of a T-Bill is the amount the US government promises to pay back to a T-Bill investor. So when an investor purchases a T-Bill, the investor pays the face amount less the discount, and recieve the face amount at maturity.

Three and six-month T-Bills are sold at weekly auctions, while one-year T-Bills are sold at monthly auctions held by Federal Reserve Banks.

Issues of Federal Agencies

Some government agencies able to issue debt include:

  • Fannie Mae (Federal National Mortgage Association)
    • A publicly owned government sponsored company that buys mortgages from lenders and is the largest source of home mortgage funds for low, moderate, and middle income home buyers in the United States
  • Ginnie Mae (Government National Mortgage Association)
  • Freddie Mac (Federal Home Loan Mortgage Corporation)
  • Sallie Mae (Student Loan Marketing Association)

VI. Mutual Funds, CEFs, Hedge Funds, and ETFs

VII. Technical Terminology

Investment Examinations

Series 7 Exam
Series 24 Exam
Series 63 Exam
Series 65 Exam
* Note that the Series 66 is a combination of the Series 63 and Series 66.

Formulas To Remember

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