How to invest your money most profitably

Understanding your objectives and your own nature is a large part of successful investing. These are two anchors in a sea of financial variables.

Before investing your first dollar, it helps to know what your time frame is. Are you investing for short-term, medium-term or long-term objectives? If you have previously invested, a glance at your transactions will reveal your tactics, though perhaps not your intentions.

Short-term speculations have a way of becoming long-term investments when the market moves the wrong way.

By definition, successful investing is a long-range endeavor. If you expect immediate results and instant gratification, you are by temperament unsuited to long-term investments.

The financial markets are but a reflection of the business world and its activities. Change in business conditions, product line and profit margins can be slow. It takes time to turn around an ailing company or to enhance the prospects of a successful one.

The perception of change can, sometimes, be agonizingly slow. Therefore, investing is a waiting game, one in which you will need more patience than money if you are to be successful.

Long-term investing can mean different things to different people, but in the financial world, long term commitments are those that made for at least five years. Middle-range investments are those between one and five years, while short-term commitments start tomorrow and last for a matter of months, a year or two years.

Many investors have great difficulty matching their investments with their objectives. There are two general goals for the investor to pursue: income and growth. These goals are conditioned by such factors as safety, diversification and speculation.

While investors' objectives fall into these two categories, not only are there dozens of investment vehicles -- common stock, preferred stock, bonds, debentures, pass-through certificates, warrants, futures, and so forth -- but thousands of companies, municipalities, governments and alternative issuers of negotiable and tradable securities. In brief, investment objectives are few, but the investment world is enormous.

How does one match the investment with one's objective? For the moment, it is important to understand what is meant by income and growth. Then it is appropriate to review how the characteristics of safety, diversification and speculation affect the selection of where to invest.

Investing for Income

Income is the yield (or return) from invested funds. In the case of common or preferred stock, income is derived from the dividend.

Dividends are that portion of net earnings a company passes on to its shareholders. Corporations usually pay dividends quarterly (four times a year) to stockholders of record as of a specific date.

Income from bonds is called interest, a kind of rent payment for the use of the money you lend. If bonds are registered, payment will come in the mail to the person whose name appears on the corporation's books. If the instruments are bearer bonds, a coupon must be presented to a bank or brokerage house in order to receive payment.

To make meaningful comparisons, you need to know the current yield rather than just the fixed interest rate. The other type of yield that concerns investors is yield to maturity.

Thus the yield to maturity will include the additional $50 that was the difference between the purchase price ($950) and the redeeming or par value ($1,000). The yield to maturity in this case is 8.6 per cent if the 8 per cent bond had 15 years to maturity.

An investor should ask either the bank or the brokerage house to supply the yield to maturity, or he or she should consult a table of bond values. Since bonds are constantly selling at premiums or discounts, it is imperative to know the yield to maturity in order to evaluate true income.

Bond interest remains fixed throughout the life of a bond, but dividend income from stocks can go up or down. Should a company decide to increase a dividend, that action will certainly increase your income.

Indeed, many companies, especially utilities, attempt to do just that. Bond income is more stable and predictable than stock dividend income. Nevertheless, some companies pride themselves on unbroken strings of dividend income. Investors traditionally buy the common stock of utilities and telephone companies when they want interest income.

Investing for Growth

The other reason for investing -- and some would say the chief reason -- is appreciation of capital, that is, seeing your money grow. Money in the bank does not appreciate: the bank only promises to pay you (in most types of accounts) what you originally deposited plus the accumulated interest.

Fixed-income investments promise essentially the same thing: to pay back your principal upon the maturity of the debt. Whether monthly or semi-annually, the debtor periodically pays interest on the borrowed sum.

Rarely does the debtor pay back more than what was originally promised. It is possible to buy bonds at a discount from par (less than face value) and to sell them at a premium (more than face value).

The ability to do this rests largely on timing and interest rate fluctuations. Most individual bond investors do not, however, trade bonds for capital appreciation; they buy them and hold them to maturity.

Therefore, common stock tends to be the main financial asset available for capital appreciation. Stocks bought specifically for appreciation are called growth stocks.

Growth stock investors are not interested in high dividend payouts.

For the investor desiring growth, the smaller the dividend payout, the greater the amount of earnings to be reinvested in the business.

This not only causes a stockholder's equity to increase in value but also enables the company to maximize its ability to grow. For example, it can then spend more on research and development or increase its sales force.

Regular growth stocks are riskier than blue chip securities, but they are not as risky as high-growth stocks. In the US over time blue chips have had a total return -- dividends plus capital appreciation -- of 7.5 per cent a year.

In comparison, the total return for regular growth stocks has been 9 to 9.5 per cent. High growth stocks, on average, returned something on the order of 11 per cent -- virtually all of it from capital appreciation.

High growth companies tend to be in start-up ventures and new technology; and even if they have earnings, they rarely use them for dividends. A sound growth investment is one in which earnings increase in an appreciable and constant fashion. The profits of such an investment increase in all types of economic weather and into the foreseeable future.

Some economists define a growth company as one that grows by at least 10 per cent a year, while others think the figure should be closer to 20 per cent. In brief, earnings growth is a dynamic process that can be expected to translate into an increase in a stock's market value. By intelligent research, you can find growth stocks in several industries.

Excerpt from: The Basics of Investing by Gerald Krefetz

Price: Rs 190

Gerald Krefetz is a principal of Krefetz Management and Research, he runs a private money management service for individuals in Manhattan, USA and has written more than twelve books.