Michael L. Walden, Reynolds Distinguished Professor
North Carolina State University
Congratulations on receiving money from the tobacco buyout program. Now you must decide what to do with the money. Here are answers to eleven important investment questions that will help guide your decision.
1. How much risk are you willing to take?
Many of you will answer, "none", but at the same time you'll say you want to earn a high return on your money. Unfortunately, this attitude ignores the iron rule of investing, which simply says that making more money on an investment generally required taking more risk. So first you need to decide how much risk to take.
Your acceptable level of risk will be determined by a number of factors, including your age, your need to have ready access to your money, and the amount of money you have to invest. In general, the older you are, the more you need access to your money, and the smaller the amount you have to invest, the less risk you'll want to take.
Figure 1 ranks common investments by their level of risk.
Two recommended ways of managing risk and increasing your investment earnings are diversification and buy and hold. Diversification means to invest in several investments with different risk levels. Buy and hold means keeping investments for a long time period, expecting that any losses will eventually be recovered over several years.
Figure 1. Investments Ranked from Low Risk to High Risk
U.S Government Securities
Insured Accounts
State and Local Government Securities
High Grade Corporate Bonds
Real Estate
Stocks
Low Grade Corporate Bonds
2. Do you have expensive debt?
If the answer to this question is yes, then an excellent way to effectively earn a high return on your money is to pay down on this debt. When you reduce debt by a dollar, you are saving, and thus essentially earning, the interest rate charged on that debt. For example, paying off a $1000 credit card debt on which you are charged 18% is like earning 18% on that money. On the other hand, if you have a mortgage loan charging 4%, paying down on that debt only earns 4% on your money.
So you want to compare the interest rate charged on your debts to the interest rate you could earn on investments and put your money where the interest rate is highest.
3. Are fees charged on the investment?
Fees can be charged on investments in many ways - when you initially invest money, while your money is invested, and when you withdraw your money from the investment. These fees certainly reduce your investment earnings.
Investment fees vary between investments and investment companies. Always ask what you're earning after subtracting the fees.
4. What kind of investment returns do you want?
Investments can earn money in three different ways: by paying a regular amount of income like interest or dividends, by having the investment increase in value over time, or by a combination of the two.
Which payment type is best depends on your particular circumstances. If you need regular income from your investments for living expenses, then investments paying regular income or dividends may be best. Alternatively, if regular income isn't important, then investments which grow in value and only pay when they're sold may be a better choice. There are also tax advantages to these kinds of investments. The third investment type, which blends the two forms of payments, is a compromise.
5. Are fixed interest rates or variable interest rates better?
Many investments, such as certificates of deposit and bonds, pay a stated interest rate. However, with these interest rates, there is the choice between locking in the rate for a long period of time, or allowing the rate to float, or vary, over time. Which is better?
Unfortunately, there is no set answer. If you knew with certainty that future interest rates earned by investors were going to drop, then you would want to lock-in today's relatively high rate. On the other hand, if you were sure interest rates would rise in the future, then a floating interest rate would be preferred. The problem is, no one can perfectly predict future interest rates.
One option is to invest in a mix of fixed and floating interest rates. Also, pay attention to what experts are saying about the direction of interest rates.
6. Are stocks too risky?
The stock market continually rises and falls, and trends are very difficult to predict. This is even truer for individual stocks. Yet over long periods of time, the stock market does rise.
One way to deal with the risk of buying individual stocks is to buy indexed stock funds instead. These funds purchase a varied collection of stocks that represent the entire stock market. With stock index funds, you still have the risk of the whole stock market, but you avoid much of the risk tied to individual stocks.
7. Should you invest in mutual funds?
Mutual funds are a very popular way of investing. They are a way of investing, not a type of investment. Mutual funds collect money from many investors, they hire a professional manager, and then the manager makes the specific investment decisions. With most mutual funds, you can withdraw money anytime you want.
One critical question to ask about any mutual fund is, what specific investments will the manager buy? The fund's prospectus will answer this. Knowing what the mutual fund invests in will give you information about the fund's risk and earnings potential. Also, don't assume a mutual fund's past investment performance is a perfect predictor of how it will do in the future.
8. Should you look for tax-favored investments?
If some of your tobacco buyout money is classified as earnings (for example, producer payments are earned income while quota owner payments are capital gains income in most cases), you may want to consider some of the tax favored investments geared to saving for retirement. The major ones are the regular IRA, the Roth IRA and the SEP account (see IRS publications 560 and 590 for eligibility and investment rules).
However, keep in mind two important issues regarding these investments. First, in most cases your money will be "tied up" in the investments until you reach age 59 ½. There are substantial penalties for withdrawing money before then. Second, these investments are still only a tax-treatment. You still must decide where specifically to put the money, like stocks, bonds, certificates of deposit, etc.
There are other tax-favored investments outside of retirement programs that pay periodic income that is federally tax-free. Municipal bonds are an example. However, the interest rate these investments earn is also lower than for comparable taxable investments. Generally, the higher your income, the more likely these investments will be a good idea for you.
9. Can certain kinds of spending be investing?
In considering where to invest your buyout money, don't forget that some kinds of spending are really investments. Spending that allows you or your business to be more productive is really an investment. Examples include education, training, and purchases of technology and equipment. Work with an accountant or business manager to estimate the investment return on such expenditures.
10. Should you pay attention to investment predictions?
It's easy to make predictions about investments, but it's much harder to be correct about them. The performance of investments is tied to the economy, and the economy is very unpredictable, even for professional economists and financial experts. So just use a healthy dose of skepticism when considering investment forecasts, especially very optimistic ones.
11. Should you use an investment professional?
There are many types of investment professionals available for you to hire, and you may want to use one for advice with your buyout funds.
Before engaging an investment professional, carefully consider several questions. What is the advisor's education and training? Does the advisor provide information on all kinds of investments or only for certain types? How is the advisor compensated? The options are a flat fee versus a percentage of the investment returns. Last, talk to current and former clients of the advisor for their views on the value of the advisor's services.
Investing your buyout funds is a very important decision. Consider your options carefully and don't be afraid to ask questions. It's your money!
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