In
today's economic climate, many consumers are questioning the wisdom
of conventional savings and investment strategies. The fallout from
the subprime lending crisis and subsequent liquidity crunch have
hit financial and non-financial stocks hard, with the major stock
indexes experiencing notable declines in recent weeks. The Federal
Reserve has been lowering short-term interest rates in an effort
to restore liquidity and confidence to financial markets, and reduce
the odds of a recession. But economy-boosting rates in the current
mixed economic environment have caused many investors to worry about
inflation. While the typical investor has not abandoned traditional
investment vehicles, many are seeking alternatives to add additional
inflation protection to their portfolios.
The
Federal Reserve reduced both the federal
funds target rate and the discount rate by half a point at the
September 18, 2007 Federal Open Market Committee (FOMC)
monetary policy meeting, and lowered the benchmark fed funds target
rate again in October. These actions have added to investors' concerns
about price stability; inflation concerns are validated by the rising
cost of numerous bellwether commodities, like crude oil and gold.
While
core inflation rates remain relatively low, headline inflation has
been rising at a disquieting rate. Core inflation doesn't factor
in prices for food and energy, which are economic staples, and therefore
fails to reflect the real price increases that are pinching the
average American consumer. Petroleum-based energy prices alone have
increased substantially in 2007. From January to September, 2007,
grocery store prices have risen by an annual rate of 6.7 percent,
while dairy products jumped 17.7 percent. Meanwhile, the Federal
Reserve may cut interest rates again on December 11, 2007, which
would place additional inflationary pressure on the U.S. economy.
While
finding smart investments that outpace real inflation is certainly
more challenging in the current economic climate, there are many
profitable opportunities available in both traditional and non-traditional
financial markets. Of course, the best investment strategy depends
heavily upon the individual circumstances of each investor; factors
such as age, income, goals, and risk tolerance play key roles.
Though
the stock market hasn't been performing well in recent weeks, most
financial advisers agree that one of the best ways to keep money
growing faster than inflation is by investing in equities. Despite
recent volatility in the stock market, overall returns have remained
strong over the past 22 months. From December 30, 2005 to November
9, 2007, the Dow Jones Industrial Average (DJIA)
gained an impressive 21.7 percent, the S&P 500 advanced by 16.46
percent, while the NASDAQ
Composite Index added 19.16 percent. Both the DJIA and the S&P
500 closed with record highs on October 9, 2007.
While
stock market investments involve risk, a conservative, long-term
approach to investing can reduce the chances of capital loss significantly.
Mutual funds are very popular because they consistently grow at
a respectable rate, and they generally aren't as risky as investing
in individual stocks. There are many different mutual funds available
on the market, and each fund has it's own unique risk potential:
some offer better returns with the downside of being riskier, while
others offer moderate returns, with the upside of being relatively
safe.
Bonds
are investments that can offer a bit more security to the investor
who is leery of stock market risk. Bonds generally have an inverse
relationship with interest rates: as the cost of a bond rises, the
yield that the bond offers falls. In most cases, a fixed interest
rate is paid to the investor throughout the life of the bond in
exchange for the use of the principal by the corporation, municipality
or government agency that issued the bond. Risk levels vary with
bonds, and can be determined by ratings, which range from AAA bonds,
the most secure, down to junk bonds, which are quite risky, but
offer very attractive returns. An investor can balance out risk
by investing in a bond fund.
For
federally-insured security in investment, CD's, or Certificates
of Deposit, and Money Market accounts are available. These investments
are particularly good for those who have a low tolerance for risk,
like investors nearing retirement age or those on a fixed income.
Low risk is the key for these investors, as they lack the time to
recover from potential losses that can occur with higher-risk investment
vehicles. While returns on these investments are lower than the
average investment in stocks or bonds, they invariably offer better
rates than simple savings accounts, and are usually the safest investment
vehicles that also tend to stay ahead of inflation.
An
innovative area that has been attracting more interest from both
modest and deep-pocket investors is peer-to-peer lending. While
these types of arrangements have been in place in small communities
for many years, the Internet has taken the idea of person-to-person
lending to an entirely new level. Prosper.com, based in San Francisco,
and Zopa.com of London are among the most popular peer-to-peer lending
communities, offering cheaper credit to borrowers, and handsome
returns for lenders, as much as 12 to 13 percent in some cases.
Peer
to peer lending is done without the involvement of traditional financial
institutions. Borrowers post a request for a loan amount and a maximum
interest rate they are willing to pay for that loan. These loans
are then funded by bidders, in most cases with a number of lenders
contributing small portions of the total loan amount. This method
of funding loans spreads the risk among a number of investors, minimizing
the loss to each should the borrower default (although rates of
default are quite low according to numbers provided by Zopa: 0.05
percent.) Lenders can further minimize risk by distributing their
investment capital in small increments among many borrowers, contributing
as little as $50 to each borrower's total loan amount, and setting
interest rates that are commensurate to the level of risk.
Each
investor, whether following the traditional paths of investment
or eschewing convention in favor of innovative investment vehicles,
must be sure to set investment goals according to a solid assessment
of present and future financial needs. Balancing risk potential
against the rate of return is crucial when planning an effective
defense against inflation, helping to ensure the safety of your
hard-earned capital. With some disciplined research into the many
options available in today's financial markets, one can find a variety
of smart investments to outpace inflation, thus keeping this insidious
and unavoidable evil from eroding the purchasing power of one's
nest egg.
by Steve "AmCy" Brown, FedPrimeRate.comSM
November 11, 2007
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