How to Invest Money by George Garr Henry (best novels for teenagers .txt) 📕

have a general impression that a high rate of income is apt to indicate less assurance of safety, but he rarely applies the same reasoning to other qualities. When he buys securities, he is quite likely to pay for qualities which he does not need. It is very common, for example, when he wishes to make a permanent investment and has no thought of reselling, to find him purchasing securities which possess in a high degree the quality of convertibility. From his point of view, this is pure waste. A high degree of convertibility is only obtained at the sacrifice of some other quality—usually rate of income. If he were to use more care in his selections, he could probably find some other security possessing equal safety, equal stability, and equal promise of appreciation in value, which would yield considerably greater revenue, lacking only ready convertibility. Thus he would satisfy his real requirements and obtain a greater income, at the expense only of a quality which he does not need.

The quality of convertibility divides investors into classes more sharply than any other quality. For some investors convertibility is a matter of small importance; for others it is the paramount consideration. Generally speaking, the private investor does not need to place much emphasis upon the quality of convertibility, at least for the larger part of his estate. On the other hand, for a business surplus, ready convertibility is an absolute necessity, and in order to secure it, something in the way of income must usually be sacrificed.

Again, some investors are so situated that they can insist strongly upon promise of appreciation in value, while others can not afford to do so. Rich men whose income is in excess of their wants, can afford to forego something in the way of yearly return for the sake of a strong prospect of appreciation in value. Such men naturally buy bank and trust-company stocks, whose general characteristic is a small return upon the money invested, but a strong likelihood of appreciation in value. This is owing to the general practise of well-regulated banks to distribute only about half their earnings in dividends and to credit the rest to surplus, thus insuring a steady rise in the book value of the stock. Rich men, again, can afford to take chances with the quality of safety, for the sake of greater income, in a way which poor men should never do. In practise, however, if the writer's observation can be depended upon, it is usually the poor men who take the chances—and lose their money.

In the quality of safety, there is a marked difference between safety of principal and safety of interest. With some investments the principal is much safer than the interest, and vice versa. This can best be illustrated by examples. The bonds of terminal companies, which are guaranteed as to interest, under the terms of a lease, by the railroads which use the terminal, are usually far safer as to interest than as to principal. While the lease lasts, the interest is probably perfectly secure, but when the lease expires and the bonds mature, the railroads may see fit to abandon the terminal and build one elsewhere, if the city has grown in another direction, and the terminal may cease to have any value except as real estate. On the other hand, a new railroad, built in a thinly settled but rapidly growing part of the country, may have difficulty in bad years in meeting its interest charges, and may even go into temporary default, but if the bonds are issued at a low rate per mile and the management of the road is honest and capable, the safety of the principal can scarcely be questioned.

Stability of market price is frequently a consideration of great importance. This quality should never be confused with the quality of safety. Safety means the assurance that the maker of the obligation will pay principal and interest when due; stability of market price means that the investment shall not shrink in quoted value. These are very different things, tho frequently identified in people's minds. An investment may possess assured safety of principal and interest and yet suffer a violent decline in quoted price, owing to a change in general business and financial conditions. In times of continued business prosperity very high rates are demanded for the use of money, because the liquid capital of the country, to a large extent, has been converted into fixt forms, in the development of new mines, the building of new factories and railroads, and in the improvement and extension of existing properties. These high rates have the effect of reducing the price level of investment securities because people having such securities are apt to sell them in order to lend the money so released, thus maintaining the parity between the yields upon free and invested capital.

As an illustration of this tendency, within the last few years New York City 3½-per-cent bonds have declined from 110 to 90, without the slightest suspicion of their safety. Their inherent qualities have changed in no respect except that their prospect of appreciation in quoted price has become decidedly brighter. Their fall in price has been due to two factors, one general and the other special—first, the absorption of liquid capital and consequent rise in interest rates, occasioned by the unprecedented business activity of the country, and, second, to the unfavorable technical position of the bonds, due to an increased supply in the face of a decreased demand.

It will be seen that the question of maintaining the integrity of the money invested is a matter of great importance and deserves to rank as a fifth factor in determining the selection of investments, altho it is not an inherent quality of each investment, but is dependent for its effect upon general conditions. If it is essential to the investor that his security should not shrink in quoted price, his best investment is a real-estate mortgage, which is not quoted and consequently does not fluctate. For the investment of a business surplus, however, where a high degree of convertibility is required, real-estate mortgages will not answer, and the best way to guard against shrinkage is to purchase a short-term security, whose approach to maturity will maintain the price close to par.

The foregoing comments, in a brief and imperfect way, serve to indicate the main points which should be considered in the selection of securities for investment. The considerations advanced will be amplified as occasion demands in the following pages. For the present, the main lesson which it is sought to draw is the necessity that a man should have a thorough understanding of his real requirements before he attempts to make investments. For a private investor to go to a banker and ask him to suggest a security to him without telling him the exact nature of his wants is about as foolish as it would be for a patient to go to a physician and ask him to give him some medicine without telling him the symptoms of the trouble which he wished cured. In neither case can the adviser act intelligently unless he knows what end he is seeking to accomplish.

It is plainly impossible within the limits of a small volume to consider the needs of all classes of investors. Special attention will be paid to the requirements of a business surplus and of the private investor. In the field of private investment two distinct classes can be recognized—those who are dependent upon income from investments and those who are not. Both classes will be considered. For the investment of a business surplus, safety, convertibility, and stability of price are the qualities to be emphasized; for investors dependent upon income, safety and a high return; and for those not dependent upon income, a high return and prospect of appreciation in value. In the following chapters railroad bonds, real-estate mortgages, industrial, public-utility, and municipal bonds and stocks will be considered in turn; their advantages and disadvantages will be analyzed in accordance with the determining qualities above enumerated, and their adaptability to the requirements of a business surplus and of private investment will be discust.

II RAILROAD MORTGAGE BONDS

A railroad bond is an obligation of a railroad company (usually secured by mortgage upon railroad property) which runs for a certain length of time at a certain rate of interest. It is apparent, from this definition, that the price of a railroad bond, as distinct from its value, is affected by two accidental conditions quite apart from the five determining qualities described in the preceding chapter.

These accidental conditions are the length of time that the bond has to run and the rate of interest that it bears. To understand clearly the influence of these accidental conditions is a matter of the utmost importance. It is evident, for instance, that a 5-per-cent fifty-year bond, based on a given security, will sell at a widely different price from a 3½-per-cent twenty-year bond, based on the same security; yet the only difference is in the accidental conditions which are under the control of the board of directors.

In order to eliminate these accidental features from the situation, it is customary for bond-dealers to classify bonds purely on the basis of their yield, or net income return. As a thorough understanding of this point is essential to an accurate judgment of bond values, whether railroad bonds or otherwise, it must be developed in detail, even at the risk of carrying the reader over familiar ground.

If a bond sells above par, it does not yield its purchaser a net return as great as the rate of interest which the bond bears, for two reasons: first, because the loss in principal, represented by the premium which the purchaser pays, must be distributed over the number of years which the bond has to run, and operates to reduce the rate of interest which the holder receives; and, secondly, because the rate is paid only on the par value of the bond instead of on the actual money invested. Thus, if a 6-percent bond with eight years to run sells at 110¾, it will yield only 4.40 per cent, which means that if the holder spends more than $48.73 (4.40 per cent of $1,107.50) out of the $60 which he receives annually, he is spending the excess out of principal, and not out of income. Conversely, if a bond sells below par, it yields more than the rate of interest which the bond bears.

These yields have been calculated with the utmost exactness for all bonds paying from 2 per cent to 7 per cent and running from six months to one hundred years, so that it is only necessary to turn to the tables to discover what will be the net return upon a given bond at a given price. This net return is generally known as the "basis," and bonds are spoken of as selling upon a 3.80 per cent basis or a 4.65 per cent basis or whatever the figure may be, with no reference whatever to the price or to the rate of interest which the bond bears. Indeed, so exclusively is the basis considered by bond-dealers that very often bonds are bought and sold upon a basis price, and the actual figures at which the bonds change hands are not determined until after the transaction is concluded.

It is not expected, of course, that the average business man will purchase bonds in quite as scientific a way as this, but it is essential that he should understand that while the intrinsic value of a bond is determined only by the five general factors described, its money value, or price, is affected also by these two accidental conditions. Exprest in other words,