Hello, dear reader! This new episode of the series is focused on investing instruments. A few keywords are popping up in the finance world, for example, bank account, deposit account, currencies and crypto-currencies, bonds, etc.
In this episode, I aim to understand what they are and how efficient they are in terms of investments and returns and try to categorize them to have a more precise overview.
To better understand the topic, I will primarily work on this Excel file, but I will try to report the key aspects here.
Low-Risk Investments
Here, we will talk about low-risk investments. These are those instruments that guarantee fixed but low returns. These are bank accounts, deposit accounts, currencies (and cryptocurrencies), and bonds.
For each of them, I will quickly summarize here what they are, what is the expected return, what is the volatility — i.e., the standard deviation of the expected return —, how fast I can liquidate, what are the risks, how long I have to wait to have my returns and how Italian taxes affect those instruments.
Bank Accounts
It’s a financial arrangement provided by a bank that allows individuals to deposit, withdraw, and manage their money with added services like debit cards or checks.
Here, the return is — most of the time — a bit negative. This is because banks usually make you pay some management fees to keep your account alive.
There is no volatility, as the fees will mostly remain the same.
If the bank is opened, the liquidity is immediate.
In Italy, there are no risks. This is because usually, the only risk is the bank bankruptcy, for which there exist warranty funds that typically cover up to 100k. So, if you are below this number, you can consider yourself safe. Also, in Italy, no bank ever went utterly bankrupt. This is because, most of the time, they have been saved with taxpayers’ money from the state and everyone got refunded — I’m not completely sure about this statement, I should investigate more —.
Time is not relevant in this case.
Italian taxes here are really strange:
26\% \text{ on interests (if positive) } + 35€ \text{ if account } > 5kTo conclude, it’s not the best as you basically gain nothing, but they keep your money. Actually since you deposit something they’re not your anymore, but you got the point.
Deposit Account
It’s a type of bank account where money is deposited for safekeeping, often offering interest on the deposited funds. It’s not that different from a bank account, but the returns exist.
Generally speaking, the returns are between 0.5% and 1% (gross).
There is no volatility except for changing rates, which depend on the signed contract.
As for bank accounts, liquidity is immediate if the bank is open.
In Italy, there are no risks. This is because usually, the only risk is the bank bankruptcy, for which there exist warranty funds that typically cover up to 100k. So, if you are below this number, you can consider yourself safe. Also, in Italy, no bank ever went utterly bankrupt. This is because, most of the time, they have been saved with taxpayers’ money from the state and everyone got refunded — I’m not completely sure about this statement, I should investigate more —.
Usally time doesn’t matter, unless it’s bounded, then it’s usually one year.
Here Italian taxes are as follow:
26\% \text{ on interests } + 0.2\% \text{ of what was deposited at the time of the account statement}This means that this 0.2% is taken on the last bank statement before tax gathering and not on the average statement. In fact, many people withdraw everything the day before so they don’t have to pay any tax.
This is now the most profitable and stable: low but stable returns and shallow risk.
Currency (and Crypto-Currency)
I wanted to include these two in the same category as they technically are the same. Here we will focus on the most famous ones, i.e., globally recognized forms of money used in international trade and finance, such as the US dollar (USD), Euro (EUR), Japanese yen (JPY), British pound (GBP), and Chinese yuan (CNY).
The return on currency investments is between -5% and +5%, average of 0%. It’s way more random for cryptocurrencies: between -100% and +5000%.
The volatility is low for traditional currencies and high for crypto.
Liquidity is, in both cases, one market day.
There are no risks for classical ones, while the blockchain may stop working for crypto or get deleted.
The time for the return is usually one year for classical currencies, while it can be years to days for crypto ones.
Taxes are a complete mess here and won’t be covered. If you want to open Pandora’s box, let me know what you get.
I’m not sure I got the point of investing in currencies, but it is good to know you can do that.
Bonds
Ouch. It’s the most complex thing by far. As far as I understood, they are debt securities issued by governments (in this case, called treasury bonds) or corporations to raise capital, representing a loan to the issuer with a promise to repay the principal and interest over a specified period.
Bond returns are usually between -0.5 and 1%. But let’s dive a bit in here.
Standard Bonds
You pay 100. Each period, you get a coupon (just the interest, say 2%). At the expiration, you get 100 + the interest for that year. Let’s see an example:
| 01/01/2023 | – 100€ |
| 01/01/2024 | + 2€ |
| 01/01/2025 | + 2€ |
| 01/01/2026 | + 2€ |
| 01/01/2027 | + 102€ |
In the case of an unstable company, nobody would buy at full price. So you usually will find lower buying prices:
| 01/01/2023 | – 70€ |
| 01/01/2024 | + 2€ |
| 01/01/2025 | + 2€ |
| 01/01/2026 | + 2€ |
| 01/01/2027 | + 102€ |
On the other hand, if the company is solid, the buying price will be higher:
| 01/01/2023 | – 105€ |
| 01/01/2024 | + 2€ |
| 01/01/2025 | + 2€ |
| 01/01/2026 | + 2€ |
| 01/01/2027 | + 102€ |
Step-up Bond
The strategy here is to give increasing or decreasing (step-down) coupons. It’s not that interesting as they usually depend on statistics that cannot be predicted, so it’s not that different from gambling. Here is an example:
| 01/01/2023 | – 100€ |
| 01/01/2024 | + 0.5€ |
| 01/01/2025 | + 1€ |
| 01/01/2026 | + 1.5€ |
| 01/01/2027 | + 102€ |
Varying Rate Bond
The most exciting thing is that when interest rates rise, the interest payments on variable-rate bonds also increase, reflecting the higher prevailing rates. This adjustment feature protects investors from losing potential income in a rising rate environment. So basically, they’re not affected by market rate change. On the other hand, they’re still dependent on the company’s stability.
Zero-Coupon Bond
Here, the coupon is 0. You get 100 at the end. It’s like a loan to a friend. Of course, the buying price must be lower than 100.
The bond volatility is zero but highly depends on the interest rate and the issuer’s stability. The equitability is one market day. You can indeed sell the bond whenever you want. You will also get the next coupon payment from the buyer. This doesn’t happen in stocks.
The only risk is the bankruptcy of the issuer.
You get coupons in a period that varies a lot—for example, six months to 10 years.
The taxes are computed as follows:
26\% \text{ of returns } + 26\% \text{ on the difference between reimbursement and buying price}To conclude, back in the day, this was the best. Unfortunately, return rates are low nowadays, so it’s not worth it.
High-Risk Investments
Now, let’s talk a bit about high-risk investments. I know currencies and crypto are not so low-risk and should belong to this category, but it’s how Prof. Coletti is showing them; maybe I will rearrange them.
This section will discuss stocks, features, warrants, ETFs, funds, and levers.
Stocks
Stocks are ownership shares in a company representing a claim on its assets and earnings. Investors buy stocks to gain ownership and participate in potential profits through capital appreciation and dividends.
The return is historically around 7%. For very stable companies is lower, for unstable ones is higher. Generally, they range between 4% and 15%.
Volatility, on the other hand, is really high. This means that during a year, a single stock may lose from -50% and gain 50%.
Sock’s liquidity is pretty fast, generally one market day. But this is true only with widespread adopted stocks, where it’s easier to find buyers.
Stocks suffer the same bond risk: bankruptcy and permanent lowering of prices.
The time span to get the best out of a stock (typically +7%) is ten years. Anyway, it differs a lot from stock to stock and market to market.
What about taxes? In Italy, it’s 26% on dividends, and if sold, it’s 26% of the difference between the buying and selling prices.
A side note about correcting prices in Stocks
As we said before, when talking about bonds, when we buy a bond, we have to remember to pay the maturated coupon to the previous holder. This is something we can’t do in stocks. We can’t know a-priori how much the dividends will be or if there will be any. For this reason, it’s really hard to separate the price of the stock from the return. This is the typical trend for a stock price:
Where the red line (the price drop) is equal to the dividend payment amount. So, while for bonds, the price is kind of steady, when detaching dividends in stocks, the price drops. To keep track of this drop, we must correct the price such that th/e day before the dividend payment is the same as the day after. There are a few methods:
- \overset{-}{P_i} = P_i\, -\, d \;\; \forall i < 0
This is the simplest one. It has two main problems- Mathematical Problem: if in the past, for whatever reason, the price P_i was lower than d, we will find negative prices in the time series.
- Formally, d shouldn’t be subtracted for every point in the past but should be beveled over time.
- \overset{-}{P_i} = P_i\, +\, d \;\; \forall i \geq 0
Here I’m just adjusting the price after the dividend payment. This correction can be considered fair. There are two problems:- d here is not considered to be reinvested and causes problems with the computation of the compound interest
- Most people don’t know about this correction and might not get why the final price differs from the real one.
- C_0 = N * P_0 + N * d = N * (P_0 + d) = \overset{-}{N} * P_0
Here, I am including in the correction the ability to reinvest dividends. To do so, I’m correcting the number of stocks. So basically this mean solving this equation:
\overset{-}{N} = N * (1 + \frac{d}{P_0})
Now, to convert this correction to a price correction:
\overset{-}{P}_i = P_i * (1+ \frac{d}{P_0}) \;\;\forall i \geq 0 - This last method is used by Yahoo Finance and corrects past values:
\overset{-}{P}_i = P_i * (1 - \frac{d}{P_0}) \;\; \forall i < 0
Other corrections might be needed when companies decide to fraction stocks (to make them easier to buy) and so the price drops or when they group them (so the price increases). Of course, this will end up with spikes in the graph, which we must correct. Usually, we correct in the past:
\overset{-}{P}_i = P_i * k \;\; \forall i < 0where k is called the adjustment factor.
Future
Futures are contracts obligating the buyer to purchase or the seller to sell an asset (like commodities, currencies, or financial instruments) at a predetermined price on a specified future date. These are often used for hedging or speculating on price movements without owning the underlying asset. They’re not really used nowadays. For example, buying wheat 🌾 futures locks in a price for purchasing wheat at a future date. For instance, if the market price rises after six months, buying at the agreed-upon lower price through the futures contract saves money.
The return are potentially really high and goes from -\inf to +\inf.
The cost of the future is basically 0, therefore the volatility depends on the market and can be very high.
The liquidity is just hard in the last few days before expiration —I didn’t really understand why—.
Risks are non-existent.
Usually, the time for this asset is one year.
In Italy, taxes are, as always, 26% on the difference between the buying and selling price.
Warrants
Warrants are similar to futures. The only difference is that you’re not forced to buy after the expiration. So either you lose your money, or you get as a return the difference between buying and selling price. It’s really like gambling.
Warrants’ returns can vary from -100% to +\inf.
As for futures, volatility can be really high.
As for futures, liquidity can be difficult in the last days before the expiration.
Here we have a small risk. If returns are really high, the issuer of the warrant may go bankrupt if the warrant is covered.
Exchange Traded Funds (ETF) – Stocks
This set includes also ETC (for currencies) and ETN (for commodities), which are basically the same thing. ETFs are investment funds traded on stock exchanges, mirroring the performance of an index, commodity, bonds, or a mix of assets. ETFs offer diversification, trade like stocks, and provide exposure to various markets or sectors. They’re better than buying single stocks, because you are relying on a bigger set of stocks.
The return is the stock average of 7%.
Volatility is low because of the diversification.
Liquidity is within one market day.
Basically, there are no risks. This is because, having a really high number of stocks, if one company fails, it doesn’t affect the whole ETF too much.
The best time interval for ETFS is around ten years.
Taxes here are entirely random. Here, there is 26% on the dividends (if any) and 26% on the difference between the selling and buying price, but you cannot use capital losses to compensate the difference (ITA: non compensabile con minusvalenze, così, debbotto, senza senso).
Exchange Traded Funds (ETF) – Bonds
I won’t go that deep here because it’s basically the same concept for Stocks ETF. The difference here is on the returns: -0.5% to 1% and the volatility highly dependent on interest rates (as for single bonds). The best time interval here is around 3 to 5 years.
Funds
These are like ETFS but actively managed. The goal for funds is to beat indices. Spoiler: usually, they can’t.
Financial Leverage
It is basically using borrowed funds or debt to increase the potential return on an investment. It involves magnifying both gains and losses by using borrowed capital, thereby amplifying the investment’s impact on returns. Extreme volatility and if in one day the lever drops to -100/lever%, you end the day with -100%. This mean you lost everything.
Conclusions
This article was the best so far for me to write. I’ve learned a lot and now I have a clearer idea about what I will end up probably doing in the next years. Two main instruments are relevant:
- Deposit Account: no risk, low return.
- ETF: higher risk (still almost none) but higher returns.
This article will likely be rewritten or adjusted as I gain more knowledge, so feel free to comment below!
See you around!