module 3 - investments - uaw-gm center for human resources
TRANSCRIPT
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CONTENTS
INTRODUCTION .............................................................................6Investment Planning: Setting Your Goals And Objectives ....9
RISK AND RETURN......................................................................12Inflation Risk .......................................................................13Interest Rate Risk ...............................................................13Market Risk.........................................................................15Speculative Risk .................................................................16Leverage Risk .....................................................................17Risk Pyramid ......................................................................17
INVESTMENT PLANNING SUMMARY .........................................18
TYPES OF INVESTMENTS ..........................................................20Money Market Investments.................................................21Fixed Income Investments ..................................................23Equity Investments .............................................................25Asset Allocation and Diversification .....................................27Customizing Your Asset Allocation to Your InvestmentGoals ..................................................................................31Empirical Evidence for the Effectiveness of AssetAllocation ............................................................................34
MANAGER INVESTMENT STYLES .............................................43Equity Investment Styles ....................................................43Fixed Income Investment Styles .........................................44
INTRODUCTION TO MUTUAL FUNDS ........................................46Types of Money Market Mutual Funds ..................................48Municipal Bond Money Market Funds ..................................49Single-State Municipal Bond Money Market Funds ..............49Using Money Investments ....................................................49Fixed Income Mutual Funds .................................................50
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TYPES OF FIXED INCOME MUTUAL FUNDS...............................51Corporate Bond Funds ........................................................51Call Provisions ....................................................................52Municipal Bond Funds .........................................................52Government Bond Funds .....................................................53Convertible Bond Funds ......................................................54International Bond Funds .....................................................54Municipal Bond Fund Tax-Exempt Yield ComparisonWork Sheet .........................................................................55
EQUITY MUTUAL FUNDS ............................................................58Equity Mutual Fund Styles ..................................................58Investment Style (Equity): Additional Comments ................59Mutual Fund Types .............................................................64
MUTUAL FUND QUOTATION AND TERMINOLOGY.......................68
MUTUAL FUND EVALUATION...................................................... 72
MUTUAL FUND CHARGES ..........................................................75Mutual Fund Charges (As a Percentage) .............................76
SOURCES OF INFORMATION TO SELECT A MUTUAL FUND...77
MUTUAL FUND EXPENSES: PROSPECTUS .............................. 79Summary of Fund Expenses ..............................................79
ANALYZING MUTUAL FUNDS .....................................................80
MIXED PORTFOLIO/ASSET ALLOCATION ................................. 83
DOLLAR COST AVERAGING ....................................................... 84
UNIT WITHDRAWAL .................................................................... 86
DEDICATION OF ASSETS - MATCHING......................................88
INVESTMENT SELECTION ..........................................................89
CAPITAL GAINS & LOSSES ON MUTUAL FUNDS......................91Computing Basis ................................................................91
COMMON STOCKS ......................................................................94Common Stock Basics........................................................ 95
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LIMITED PARTNERSHIPS .............................................................97Cash Flow vs. Profit And Loss .............................................98Types of DPP Programs...................................................... 99Is a Limited Partnership Right For Me? ..............................100
REAL ESTATE INVESTMENT TRUSTS (REITS) ....................... 101Mortgage REIT ................................................................. 101Equity REIT ...................................................................... 101Hybrid REIT ...................................................................... 102
OTHER REAL ESTATE RELATED INVESTMENTS ................... 103Land Contracts ................................................................. 103Discount Mortgages .......................................................... 103
CERTIFICATES OF DEPOSIT AND ANNUITIES ........................ 104CD Rates and Yields .........................................................105Compound Interest for Time (CD) Deposits .......................106Compounding More Often Than Annually ...........................107
TYPES OF ANNUITIES............................................................... 109Immediate Annuity ............................................................ 109Deferred Annuity ............................................................... 110Fixed vs. Variable Annuity .................................................. 111Split Funded Annuity .......................................................... 111
OTHER INVESTMENTS ............................................................. 114Options ............................................................................. 114Option Terminology ........................................................... 115Option Positions ............................................................... 116Buying Calls ...................................................................... 116Writing Calls ..................................................................... 117Buying Puts ...................................................................... 119Writing Puts ...................................................................... 121Other Option Strategies – Straddles And Spreads............ 122
COLLECTIBLES.......................................................................... 125Where to Purchase Collectibles .........................................126Buying At Auctions .............................................................126Precious Metals - Gold And Silver......................................127
INTRODUCTION TO DEBT MANAGEMENT .............................. 129Open End Credit Plans ..................................................... 130
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GETTING CREDIT .......................................................................134Getting Credit for the First Time .........................................134Shopping for Credit Cards ................................................135Grace Periods ...................................................................136Fees and Charges ............................................................137
HOW CREDITORS GRANT CREDIT.......................................... 138Rating Systems ................................................................138
KEEPING CREDIT ......................................................................140Staying Current .................................................................140Repayment Priorities ........................................................141Hidden Fees .....................................................................141High Interest Rates ...........................................................141
CREDIT FRAUD ..........................................................................143
NORMAL CREDIT LIMITS ..........................................................146
CONCLUSION ............................................................................148
Disclaimer
This publication is designed to provide accurate and authoritative information inregard to the subject matter covered. It is provided with the understanding thatthe author is not engaged in rendering legal, accounting, investment or otherprofessional advice. If legal or other expert assistance is required, the servicesof a competent professional person should be sought.
No part of this publication may be reproduced, stored in a retrieval system, ortransmitted, in any form or by any means, electronic, mechanical, photocopying,recording, or otherwise, without the prior written consent of the copyright holder.Limited license for reproduction for personal use is granted.
All rights reserved, © LJPR, 2009.
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INTRODUCTION
The world of investing presents us with a puzzling array ofalternatives and decisions. Now, more than ever, awareness and abasic understanding of how investments work are essential toinvestment success.
We assume that you have completed your preliminary financialplanning tasks. These tasks included gathering information onyour:
• Insurance Coverage• Current Assets and Liabilities• Cash Flow• Expenses and Budgeting
Gathering this information is an important step in setting up acomplete financial plan, including your investment needs.
Once you’ve gathered your financial planning information, the firststep in investing is to determine your goals and objectives. Eachindividual has a unique combination of financial goals.
• Perhaps one of your goals is short term, such as purchasing
a car or a home, or taking a vacation in the near future.
• Other goals may be intermediate, such as funding a 13 year
old child’s education or paying off a $6,000 credit cardbalance.
• Still other goals may be long term– perhaps achievingfinancial independence before retirement or financing a
newborn’s college education.
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Most of us have a combination of short-term, intermediate-term, andlong-term financial goals. We need to identify our goals and thenmatch our investments to these goals.
Another basic investment concept is: Never invest in anything that youdo not understand. So, we need to discuss the different types ofinvestments, their characteristics and the benefits they offer.
Investments may provide five basic benefits to investors:
• Safety• Appreciation• Income• Tax Benefit• Liquidity
However, not all investments provide the same benefits, and noinvestment provides all five. Therefore, matching the rightinvestment to each of your goals is important. Moreover, your age,time horizon, situation and tolerance for risk will also play a role indetermining the right investment.
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For example:
• If a 30-year old man’s goal is maintaining his standard of living
in retirement, his current objective would be capital
appreciation.
• A 50-year old married couple, each earning $75,000 a year
with no dependents or mortgage, would most likely seek aninvestment offering tax benefits.
• An 80-year old retiree seeking to supplement a pension andSocial Security probably wants current income and safety of
principal.
Notice that the investment benefits people seek change with theirstage of life and their risk tolerance.
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Investment Planning:Setting Your Goals and Objectives
Whenever you create or review your investment portfolio, you needto see how all of the pieces of your financial puzzle fit together.Two large pieces of your financial puzzle are your Pension and your401(k) or 403(b). It’s clear that your Pension Plan represents the solidfoundation for your retirement and investment planning. Becauseof the security it offers, it allows you to tilt your 401(k) or 403(b) moretoward equity investments than would otherwise be prudent. In thiscase, one piece of the puzzle allows another to focus more on growthand inflation protection. You’ll learn more about your Pension and401(k) or 403(b) in the Retirement Module.
Of course, you must also take into account your goals, objectives,time horizon and tolerance for risk. Let’s review these investment-planning terms:
• Goal
A general statement of a desired outcome. “I want a comfortableretirement.”
• Objective
A specific, measurable indication of a desired outcome. “I want tohave 80% of my pre-retirement income in retirement.”
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• Time Horizon
The length of time that funds will be invested before they will beneeded for a specific purpose. For example, if you have ten yearsremaining until retirement, do not be misled into thinking that yourtime horizon is only ten years. Your actual time horizon is muchlonger. In fact, your time horizon for the investment of assets togenerate retirement income should extend from the presentthrough your life expectancy. That is, you will need to have assetsinvested for retirement income throughout your retirement, not justuntil you retire.
• Risk Tolerance
The ability to withstand fluctuations in the value of an investment.
Multiple Objectives
Ultimately, you can receive income from your investments,preserve the principal value, protect against inflation and allow forlong term appreciation, all with the same block of capital.
Prior to retirement, your 401(k) or 403(b) is the ideal vehicle foraccomplishing your objectives. After retirement, you may wish totransfer your 401(k) or 403(b) to an IRA Rollover Account for continuedtax deferral as well as investment and cash flow flexibility.
You also need to factor inflation into your mix, both before and afterretirement, regardless of the tool you use to calculate your incomeneeds.
For example, once you elect to receive monthly income from yourPension Plan, you should consider it part of your fixed incomeallocation. As a result, you can invest your 401(k), 403(b) or IRARollover more heavily in equities. Because your Pension Plan doesnot guarantee adjustment for the cost of living, you must take inflationinto account in selecting your 401(k) or 403(b) investments duringretirement.
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• Historical Investment Returns
At this point, we remind our readers to base their projections onreasonable expectations of investment return. According tostatistics published annually by Thompson Reuters, we know that the10 year total returns of various asset classes are approximately asshown:
Large Capitalization Stocks 6.20%Small Capitalization Stocks 7.08%Bonds 6.95%Cash Equivalents 3.47%
One widely used index of common stocks, the Standard & Poor’s500, exceeded a 20% total return in each of the five years from 1995through 1999. Some investors began to expect such lofty investmentreturns as if they were normal. The average annual return for the S&P500 was approximately 6% for the last ten years ending in 2007. Wecaution all investors to take a long perspective when dealing inaverage returns, and consider the volatility associated with bothstocks and bonds. We strongly recommend that you base yourplanning on conservative estimates of return for each asset class. Inthe event that your returns exceed your projections, you can retireearly, increase your spending, enhance your charitable giving or findother uses for your abundance.
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RISK AND RETURN
For many investors, an investment’s potential return is the mostimportant aspect of their evaluation. However, the amount of riskthat will be necessary in obtaining that return is just as important.What is risk? It can be defined as “uncertainty.” That is, risk is theuncertainty that an investment’s actual return will be different fromits expected return. Risk is measured in a variety of ways. Themost common measures of risk are Beta and standard deviation(defined later). Both of these measurements of risk show howmuch variation exists in an investment’s return.
An investment’s return should compensate the investor for its levelof risk. On average over a long time horizon, riskier investmentscan be expected to have higher returns and less risky investmentsto have lower returns.
In some cases, riskier investments do not generate higher returns.These types of investments are referred to as inefficientinvestments. Similarly, lower risk investments rarely ever producehigher returns. You should view claims of low risk investments thatproduce high returns with caution, unless they are made by atrusted advisor who can provide you with a full explanation.
Every investor must answer the question: “How much risk am Iwilling to assume?” This is an essential step in the investmentplanning process. To answer this question, we must understandthe different types of investment risk we face:
• Inflation Risk• Interest Rate Risk• Market Risk• Speculative Risk• Leverage Risk
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Inflation Risk
Inflation Risk, also called Purchasing Power Risk, is the risk that aninvestment’s return will not offset inflation, resulting in a loss ofpurchasing power.
For example, Treasury Bills are one of the safest investmentsavailable. What if you were to purchase a one-year T-Bill yieldingthree percent? Seems safe, doesn’t it? If you loan your money tothe federal government for one year, they will pay you three percenton your money and return your principal in one year. However,what if the rate of inflation is five percent? The purchasing powerof the T-bill investment has declined by two percent! This isinflation risk. Inflation reduced the amount of goods and servicesyou can purchase by two percent. To make matters worse, theactual rate of return is lower because you must also pay federalincome tax on the interest.
Interest Rate Risk
Interest Rate Risk is the change in investment value caused by achange in current interest rates. It is a major risk affecting all fixedincome investors. When interest rates rise, the prices or values offixed income investments fall and vice versa. To illustrate howinterest rate changes affect the value of fixed-income securities,consider newly-issued federal government bonds yielding 8%.
• The federal government will issue these new bonds today by
contracting to pay the purchasers 8% (of $1,000) annual
interest and guaranteeing to redeem the bonds in 20 years.
• Investor buying these bonds today will pay $1,000 and
receive $80 in interest each year for 20 years.
• In 20 years the federal government will return the $1,000,
unless they default — a highly unlikely event.
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• As long as the investor holds the bonds for the entire 20 years,
the investor takes no further principal risk.
• However, if the bonds must be sold before maturity, the
investor will receive either more or less than the $1,000
originally paid, depending on current interest rates.
Now, assume that an investor who bought the $1,000 bondsyielding 8% needs to sell them two years later, after interest rateshave risen. Now, newly issued bonds are yielding 10%. In order tosell his 8% bonds, he must be willing to do so at a discount. Thatis, he must sell them for less than $1,000. Why? Becauseinvestors will not pay $1,000 for a bond paying 8%, when they canbuy new federal government bonds yielding 10%. Becauseinvestors now expect a 10% yield, rising interest rates have forcedthe price of the 8% bonds down to a price of about $800, on whicha new investor will receive a 10% yield on the $80 fixed cash flow($80/$800 = 10%).
The opposite happens if interest rates decline. Falling interestrates will drive up the price of existing bonds. As interest rates falland new bonds are issued at 6%, our 8% bonds will become moreattractive to investors. Preferring the higher 8% yield, investors willbid the 8% bonds up to a price where the yield, based on the $80cash flow, is equal to the 6% yield on new bonds. That is, they willbid the price of the 8% bonds up to about $1,333. The fixed $80cash flow priced at $1,333 yields the same 6% as new bonds (80/$1,333 = 6%).
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Market Risk
Market Risk is the risk of the general aggregate stock marketdeclining. Although all securities are exposed to market risk, itprimarily affects common stocks. Let’s consider a typical scenarioleading to a general stock market decline. First, suppose investorsare concerned about inflation. Because of this concern, investorswill demand higher interest rates on their fixed-income securities.They demand higher rates because they don’t want their bondinvestments to lose purchasing power due to inflation. As interestrates rise, what typically happens to the stock market? It usuallyfalls. Why? As interest rates rise, investors perceive thatcompanies will be required to pay higher rates to borrow money. Asa result of higher borrowing costs, companies will raise their priceson goods and services. Now, at higher prices, consumers willpurchase fewer goods and services. In addition to higher prices,consumers will also spend less because of the higher cost to borrowfunds to pay for the goods and services. As individuals buy fewergoods and services, corporate profits will decline. Finally, decliningcorporate profits normally result in lower stock prices.
We’ve just explained why rising interest rates cause investors toanticipate declining corporate profits and stock prices. Equallyimportant is the effect of rising interest rates on investor preferencefor bonds over stocks. As interest rates rise, investors are attractedto the higher bond yields, fixed cash flows and the comparativesafety of bonds over stocks. Investors begin to sell stocks and buybonds. As investors sell stocks, they drive down stock prices. Byincreasing the supply and lowering the demand for stocks, investorpreference for bonds over stocks contributes to market risk.
Other factors contribute to market risk as well, such as politicalinstability, disruptions in the supply of materials, adverse changesin tax laws, and other conditions that affect the level of corporateprofitability.
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Speculative Risk
Speculative Risk takes many forms. It can include:
• The risk of an individual firm or individual industry and their
ability to make money and pay their debts.
• Companies making products currently in the early growth or
declining stages of the product life cycle are sometimesreferred to as speculative.
• Speculative risk involves the probability of a companysuffering losses, or profits less than expected, for a given
period because of adverse circumstances in that particular
company’s industry.
• In fixed income investments speculative risk is the greater
risk of investing in lower quality, high-yielding bonds. Thesebonds, often called junk bonds, have a higher risk of default.
Default risk is the risk that a bond issuer will not be able to
make timely payment of interest and principal to bondholders.
• Risk can also be caused by factors such as worldwiderecession, inflation, poor management planning, trade
restrictions, or possibly hostile relationships with a foreign
country where a majority of the company’s goods aremarketed.
Another example of speculative risk is the possibility that all firms ina particular industry are adversely affected by a common factor; agood example would be a troubled domestic auto industry.
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Leverage Risk
What’s worse than losing all your original investment? Losing morethan all your investment. When you borrow money to make aninvestment, it is generally called “buying on margin”.
High Risk
Speculation
Income andLong-Term
Growth
Liquidityand Safety
OptionsMargin Transactions
Futures
Aggressive Mutual FundsHigher Risk Stocks
Junk Bonds
Blue Chip StocksGrowth Stocks
Growth & Income Funds
Money MarketsBank Accounts
Certificates of Deposit
Risk Pyramid
The Risk Pyramid is a graphical representation of an investor’sportfolio containing investments with different amounts of risk.
Note that as we move up the pyramid, fewer assets are allocated toinvestments with successively greater amounts of risk.
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INVESTMENT PLANNINGSUMMARY
In setting your personal investment strategies, be sure to considereach of the planning factors we discussed. Below, you will find thesefactors in a convenient checklist format designed to facilitate yourinvestment planning efforts:
• Time• How long before you need the money?
• Will you need to get it out immediately?
• What are the odds of your goals changing?• What will your income be during this time?
• Risk• How much can you “afford” to lose?
• Can you make up the difference if you lose money?• Will other sources of income tide you over?
• How much do you know about investing?
• What Are Your Expectations About• Inflation?• Tax rates?
• Interest rates?
• The stock market?
• Return• How important is the rate of return?
• Can you tolerate a zero return in one year and a 25% return
the next?• Would you tolerate negative return?
• Do you need current income?
• Do you have a fixed need for income?
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• Taxes• Is this qualified plan money?
• Can the tax liability be shifted to a lower tax bracket?
• Do you need the current income?• Will your tax rate change in future periods?
The Bottom Line: Match your investment needs with yourinvestment choices.
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TYPES OF INVESTMENTS
We have discussed that before you invest, you must identify yourinvestment goals. Your next step is selecting the type or types ofinvestments that will best achieve each of those goals. Consider atoolbox. We normally expect toolboxes to hold several differenttools, each designed for a specific purpose. We know that atoolbox containing only hammers would not be very useful,because we would be very limited in the types of jobs we couldperform effectively.
A portfolio is similar to a toolbox, because it also contains tools. Inthis case, however, the tools are different types of investmentsdesigned to achieve the financial goals of growth, income, liquidity,tax-advantage and safety. Like that toolbox with only hammers, theusefulness of a portfolio containing a single type of investmentwould be very limited. For example, a portfolio containing onlyinvestments designed to achieve safety would do a poor job ofachieving long-term retirement goals. Safe investments, such as asavings account, are not designed to generate the growth ofprincipal needed to fund future retirement income. Like a toolbox,your portfolio should contain a variety of investments havingdifferent uses. Our job as investors is to select and use the righttool for the right job.
If you are like most people, you probably have goals that requirevarious types of investments. For example, if you want to acquire asafety net or emergency fund, you would probably want somethingsafe, liquid and easily accessible. A Money Market fund may be thebest choice. If you have a long-term goal, such as retirement, youmight choose a mix of stocks, bond funds, and equity mutual funds;since these types of investments tend to do well over the long run. Ifyou are striving for income after you retire, you might choose a bondmutual fund along with some stocks for inflation protection.
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Almost all investments will fall into one of three categories. Eachinvestment will be a money market investment, an incomeinvestment, or an equity investment.
Money Market Investments
A money market investment is a short-term debt instrument. Thismeans the investor is loaning money to earn interest.
• Money market investments are short-term loans to entities
such as governments, financial institutions, or corporations.
• The terms of these loans range from one day to one year,
and are often less than 90 days.
• Typically, these transactions are very large. While some
individuals can invest directly in these securities, most investindirectly through money market accounts and money
market mutual funds.
• Investors expect to receive interest for the use of their
money in addition to the return of their principal at maturity.
• Since these types of loans are short-term, there is very little
risk. Therefore, money market investments usually pay less
interest than longer-term debt instruments.
• Money market investments have little or no potential for
appreciation of principal, but offer investors income, liquidityand a low probability of default.
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Some examples of money market type investments are:
• U. S. Treasury Bills (T-Bills)• Commercial Paper• Short-Term Municipal Paper• Short-Term Bank CDs• Money Market Funds• Money Market Accounts
Money market types of investments are designed for your short-term goals, where you seek a reasonable return with safety ofprincipal and liquidity. Remember that liquidity is the ability toconvert an asset into cash quickly, with no risk of principal loss.Money market investments assure you that all of the principal youinvest will be available when you need it. Safety, liquidity andreasonable returns are the reasons most investors use moneymarket investments for their liquid cash reserves. Money marketinvestments can be used for planned and unplanned expenses,such as emergencies, and as a parking place betweeninvestments.
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Fixed Income Investments
Fixed-income investments are also debt instruments. Again, theinvestor is loaning money to receive interest. Fixed-income differsfrom money market investments in the length of the loan. Fixed-income investments involve loaning money for longer than oneyear. Here are some key points about fixed-income investments:
• The issuer is the entity that borrows the money. The debt
security issued, often called a bond, is the contractual
promise to repay the principal at a specified maturity date, aswell as interest at specified intervals until maturity.
• Fixed-income investors face default risk, that is, the risk theissuer may not be able to make timely payments of interest or
principal.
• Fixed-income investors are also subject to interest rate risk.
As discussed previously, interest rate risk is the risk that
interest rates will rise after purchasing a bond. When thishappens, the bond’s price will fall. In the short run, bond values
will fluctuate with interest rates, but as they near maturity, bonds
will return to their original, or face value.
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Fixed Income investments include:
• Individual Bonds- Corporate Bonds
- Government and Agency Bonds- Municipal Bonds
• Bond Mutual Funds• Bond Investment Trusts• Government National Mortgage Association (GNMA)
Funds and Pools• Preferred Stocks (Actually, a Hybrid of Fixed Income and
Equity Securities)• Long-Term Brokered Certificates of Deposit
Income investments are best suited for investors needing currentincome. Bonds also allow investors to match maturity dates tospecific financial goals. This ensures funds, the bond’s principal,will be available when needed. For example, investors often usebonds for college funding. Using bonds, investors can plan to haveprincipal come due before the beginning of each school year.Bonds also play an important role in asset allocation. Assetallocation involves spreading portfolio assets among and within thethree types of investments (money market, fixed-income and equityinvestments) to reduce risk exposure.
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Equity Investments
Equity investments, unlike money market or fixed-incomeinvestments, represent ownership.
• In contrast to fixed-income investments, equity securities
have neither a guaranteed return, nor a maturity date.
• The common stock of corporations is an important type of
equity investment. The common stockholders of a
corporation are its owners.
• As owners, stockholders have a residual claim on corporate
earnings and assets. Therefore, stockholders take more riskthan bondholders who lend money to the corporation.
Because they have a residual claim, stockholders are last to
be paid. After all creditors (including the IRS, suppliers,employees, bondholders, and preferred stock holders) are
finally paid, equity holders may receive what is left, the
residual.
• If a corporation has earnings after all creditors have been
paid, those earnings may be either paid to the commonstockholders as dividends or reinvested in the corporation.
If the board of directors decides to reinvest some portion of
earnings back into the corporation, stockholders generallyexpect a future increase in their dividends and stock price.
• Equity investors expect two forms of return: appreciation andincome. Together these are called total return. However,
remember that neither type of return is guaranteed. In fact,
equity investors may lose some or (in rare instances) evenall their principal.
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Equity Investments Include:
• Individual Common Stock- Stock Mutual Funds
- Stock Investment Trusts• Real Estate
- Real Estate Mutual Funds
- Real Estate Investment Trusts (REITs)• Tangible Investments, such as:
- Commodities
- Precious Metals- Natural Resources
Equity investments are best suited for your long-term financialgoals, such as retirement, involving capital appreciation. Althoughequity returns are unpredictable over short periods, they typicallyoffer superior returns over long time horizons. In a properlyallocated portfolio, the equity portion protects investors againstinflation by transferring purchasing power into the future.
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Asset Allocation & Diversification
From our discussion of money market, fixed-income and equityinvestments, we see that each type produces different investmentresults in terms of safety, income and principal appreciation. Theconcept of asset allocation is based on these very differences. Assetallocation is the practice of allocating assets among different assetclasses and diversifying our investments within each investmentclass to reduce risk exposure for a given level of return. Assetallocation allows investors to benefit from the strong points whileminimizing the weak points of each investment type. Investors useasset allocation to reduce the risk exposure of their investmentportfolios.
The strengths and weaknesses of each investment type aresummarized in the chart below.
Successful asset allocation and portfolio development require notonly an understanding of each investment type’s strengths andweaknesses, but also how the strength of one type minimizes theweakness of another.
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For example:
• Money Market Investments
• StrengthsMoney market investments are excellent for safety and
liquidity. These benefits make them appropriate liquid cashreserves for unplanned expenses such as emergencies.
• WeaknessesHowever, money market investments are only average in
producing income and provide no principal appreciation. To
offset these weaknesses, investors requiring current incomemay need to add bonds to their portfolios, which are
excellent in producing income. Investors saving for
retirement will need to add equities for the principalappreciation needed to fund future retirement income.
• Fixed-Income Investments
• StrengthsFixed-Income investments are above average to excellent in
providing current income to investors. Attractive, fixed cash
flows make bonds appropriate for retired investors needingto replace income from their paychecks to pay bills and other
expenses.
• WeaknessesDespite their ability to provide high, fixed current income,
bond principal tends to lose purchasing power over time.For example, assume an investor lends $10,000 to a
corporation for ten years by purchasing its newly issued
bonds. During the 10 years, the investor uses the fixed cashflow to pay bills and other expenses. At the end of 10 years,
the investor’s $10,000 principal is returned. Will this
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$10,000 now purchase the same amount of goods and
services as it would have 10 years earlier? Most likely it will
not, because inflation has eroded its purchasing power. Thisexample demonstrates two different concepts of safety. One
is the return of one’s principal. The other is the return of
one’s purchasing power. To offset this weakness, investorsusing bonds for current income also need to invest in
equities. Successful, long-term equity positions will replace
the purchasing power loss of bond principal.
• Equities
• StrengthsSuccessful long-term investments in equities excel in
providing appreciation of principal, or growth. Equities, suchas common stock, may also provide quarterly dividends,
which are normally lower than the interest received from
bonds. The total return from equities, which includes bothcapital appreciation and dividends, typically out-performs
other types of investments over the long run.
• WeaknessesDespite impressive long-term returns on equities, those
investing only in equities face significant risk. The short-termvolatility of equities makes them inappropriate for funding
short-term goals, including liquid cash reserves or other
financial goals that require funds within a five-year timehorizon. Can you imagine explaining to your son or daughter
that there will be no Christmas gifts this year, because the
market took a dip in November?
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A similar problem exists when using only equities for current income.In addition to paying only poor to average dividends, investors sellingstock on a regular basis to create income would suffer from the sameshort-term volatility of equities. A strategy requiring the sale ofequities for current income, particularly when prices may be down,would certainly reduce portfolio value over time. Because of the short-term volatility of equities, investors need money market investmentsfor their liquid reserves. Similarly, those requiring current incomeneed fixed-income investments.
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Customizing Your Asset Allocation toYour Investment Goals
Since each investment type has strong points and weak points,professionals usually mix the various types to meet specific clientobjectives. Professional money managers typically keep a portionof their portfolio in the money market for safety and liquidity. Theykeep another portion in income investments to generate additionalcash flow to reinvest. Money managers place the last portion inequities to provide potential long-term gains and an inflation hedge.
The following charts illustrate examples of asset allocationsdesigned to meet specific investor goals:
• A Safety Asset Mix
MoneyMarket
Income
Growth
Safety: HighReturn: AverageAppreciation: Low
Equity
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• Equal Asset Allocation
MoneyMarket
Income
Growth
Safety: AverageReturn: AverageAppreciation: Higher
• A Liquidity Asset Mix
MoneyMarket Income
Safety: HigherReturn: LowerAppreciation: Lower
Equity
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• A Growth Asset Mix
MoneyMarket
Income
Growth
Safety: LowerReturn: HigherAppreciation: Higher
With each of the allocations displayed on the previous pages, theinvestor is trying to find an optimal mix of asset types to fit hispersonal risk/return profile. A 65 year-old retiree who wants verylittle investment risk might select the “Liquidity Asset Mix”, sincethat portfolio has no equity risks, and reduced risks from incomeinvestments. A 38 year-old with a 20-year retirement horizon mightadopt the “Growth Asset Mix” for the superior returns the equitiesmay provide.
Equity
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Empirical Evidence for theEffectiveness of Asset Allocation
Asset Allocation, according to a nationally recognized study,accounts for over 90% of return variation. In fact, the study foundthat the mix of assets in a portfolio was far more important thanindividual stock selection or market timing.
Total Return Variation
Asset Allocation(91.5%)
Stock Selection(4.6%)
Market Timing(1.7%)
Source: Financial Analysts Journal, G.P. Brinson, B.D. Singer and G.L. Beebower,
Other(2.1%)
The findings of this and similar studies have led to the importanceplaced upon asset allocation by academicians, professionalportfolio managers and individual investors.
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• Markowitz’s Efficient Frontier Theory
Harry Markowitz won the Nobel Prize in Economic Sciences byshowing that investors can get better risk-adjusted return by mixingdifferent investment types through Asset Allocation.
Markowitz’s Efficient Frontier Theory
Expected Return
Risk
PortfolioA
PortfolioB
PortfolioC
PortfolioD
Portfolio A = 100% Money MarketPortfolio B = 20% Equity, 50% Income, 30% Money MarketPortfolio C = 60% Equity, 20% Income, 20% Money MarketPortfolio D = 95% Equity, 5% Money Market
Observing a variety of portfolios will provide a look at risk andreturn.
For example:
An agressive equity portfolio (portfolio D) gives a 11.2% expectedrate of return. In the worst case (once in 20 years), we could expect a23.8% loss. The investor looking for the most return would probablypick portfolio D. On the other hand, an investor seeking a ‘no loss’(worst case scenario of no negative return) portfolio may pickportfolio B of 20% equities, 50% bonds and 30% cash.
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evisserggA 91.11 98.53 )89.02(
• Additional Aspects of AssetAllocation & Diversification
Before considering some additional aspects of asset allocation,let’s revisit our working definition. Remember that asset allocationis the practice of allocating assets among different asset classesand diversifying our investments within each investment class toreduce risk exposure for a given level of return.
On the following pages, we will summarize the benefits of:
1. Allocating Assets Among Money Market, Fixed Income and
Equity
2. Allocating Assets Among Investment Sub-Types3. Diversifying Assets Among Individual Securities
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1. Allocating Assets Among Money Market, FixedIncome and Equity
• Asset allocation allows investors to benefit from the strong
points while minimizing the weak points of each investment
type. Investors use asset allocation to reduce the riskexposure of their investment portfolios.
• Asset allocation reduces the risk in a portfolio when, inresponse to the same change in the economic environment,
the value of fixed-income and equity investments move in
opposite directions. This differential response to economicchanges helps to reduce temporary losses in portfolio value.
For example, consider a portfolio with money market, fixed-
income and equities. Assume that a number ofdisappointing earnings reports cause common stocks to fall
in value. This is an example of market risk. As investors
perceive stocks to be too risky, they shift to high-qualitybonds. They are attracted to the relatively high guaranteed
returns that bonds now offer at relatively less risk. As
investors sell stock to buy bonds, the prices of bonds rise.Through asset allocation, this increase in bond values helps
to offset the decline in the stock portion of the portfolio
caused by market risk.
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• Investors benefit from asset allocation even when both fixed-
income and equities respond negatively to the same
change in the economic environment. For example, one ofthe most troublesome changes in the economic environment
is an unanticipated rise in interest rates. Again, consider a
properly allocated portfolio with money market, fixed-incomeand equities. Assume the financial press reports significant
interest rate increases with additional increases expected.
We know from our discussion of interest rate risk that risingrates will temporarily drive down the value of bonds. We
also understand that rising interest rates often result in
market risk, which drives down the value of stocks. The onlygood news under a rising interest rate scenario is that funds
allocated to money market investments will now earnhigher rates to modestly offset losses in the bond and stockportions of the portfolio. However, because of proper asset
allocation the news is really somewhat better:
- First, although bond values are temporarily down,rising interest rates have not adversely affected theguaranteed fixed-income cash flow of the bondinvestments. This guaranteed cash flow will helpsustain investors until interest rates and securityvalues readjust.
- Second, any dividends earned on the stock portionof the portfolio will continue to provide investors withadditional cash flow, while waiting for stock andbond prices to recover.
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- Finally, as previously mentioned, the money marketinvestments in the portfolio will produce more currentincome in response to rising interest rates. This willonly minimally offset the temporary losses in the bondand stock portions of the portfolio. But again, theadditional cash flow will help sustain investors duringdifficult times. However, the most important aspect ofmoney market investments is that they do not loseprincipal value during times of rising interest rates.Therefore, investors have a stable source ofprincipal in liquid cash reserves they may use foradditional cash flow or emergency needs. In addition,the money market investment portion of the portfoliocreates an important buffer between investors and thevolatility of the market. Investors can use these liquidcash reserves to meet current financial needs, insteadof being forced to sell fixed-income or equitysecurities at a loss.
• Note: Before age 59 ½, investors usually keep a large
portion of their liquid cash reserves in non-tax deferred
accounts. This avoids any penalty for early withdrawal fromtax-deferred accounts.
These examples show how proper asset allocation among the threebasic investment types allow investors to survive the worst of financialtimes and to benefit from the good times that may be just around thecorner.
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2. Allocating Assets Among InvestmentSub-Types
• Allocating assets among investment sub-types provides
additional opportunities for investors to increase portfolio
returns and reduce risk.
• Fixed-income and equity investments consist of individual
securities belonging to different sub-groups. These sub-groups have different risk and return characteristics. They
may also respond differently to economic changes.
Investors exploit these differences to obtain better risk-adjusted returns on their portfolios. Achieving better risk-
adjusted returns means either taking less risk for the same
return or receiving a higher return for the same amount ofrisk.
• Allocation of portfolio assets across various industries andforeign countries provides similar benefits.
• Allocating assets among investment sub-types will bediscussed completely in the section entitled “Manager
Investment Styles”.
3. Diversifying Assets Among Individual Securities
• Diversification, as we all know, means not placing all youreggs in one basket. Where asset allocation spreads risk
among different asset classes, diversification does so
among individual securities. “Asset allocation” and“diversification” are often used interchangeably. This causes
considerable confusion and disagreement over the proper
use of the terms.
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• The following example of asset allocation and diversification
may clarify the allocation process and use of the terms:
- First, investors determine what percentage of their
portfolios will be allocated to money market, fixed
income and equity investments. For example, assumean investor with a $100,000 portfolio decides to
allocate $60,000 to equities.
- Next, investors allocate the funds in each investment
type into sub-classes. In our example, the investor
now selects appropriate sub-classes for the $60,000earmarked for equities, and then decides what portion
will go into each equity sub-class. Suppose our
investor determines that $15,000 will go into each oflarge cap value, large cap growth, small cap value
and mid-cap growth. (We will describe each of these
asset sub-classes in the section entitled “ManagerInvestment Styles”.)
- Finally, the investor will diversify by purchasingindividual equity securities or a mutual fund within
each equity sub-class.
• Diversification is important because of default risk, the risk that
a company may not be able to make timely payments of
interest or principal, or that the company may go bankrupt. Ifone company in a portfolio has problems, the positive
returns of others will reduce the negative effects. This is
called the “portfolio effect.”
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• Diversification is particularly important in the equity portion of a
portfolio. Remember, as common stockholders, equity
investors are residual claimants on the corporation’searnings and assets. This increases the downside risk of
equity investments.
• Investors often select individual securities or mutual funds
that tend not to move exactly the same in the market. This
practice lowers portfolio risk, because one security may beup in value when another is down.
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MANAGER INVESTMENT STYLES
In the discussion on the previous pages we saw how investors useasset allocation to reduce their risk exposure for a given level ofreturn. First, they allocate portfolio assets among the basic moneymarket, fixed-income and equity investment types. Then, theyallocate the funds in each of these investment types into asset sub-classes and diversify their investments within each sub-class tofurther reduce risk for a given return. This section identifies thevarious asset sub-classes available to investors for assetallocation. They will be discussed further in the Mutual FundEvaluation section. These asset sub-classes are often referred toas manager investment styles, because they include both themanager’s particular investment methodology as well as the size ofthe companies in which they invest.
Equity Investment Styles
Morningstar’s® Style box shows that nine possible combinations, orsub-classes, exist, ranging from large capitalization/value for thesafest funds, to small capitalization/growth for the riskiest.
Value Blend Growth
Large
Mid
Small
Morningstar® categorizes an equity fund’s portfolio as beinggrowth-oriented, (G), value-oriented, (V), or a blend of the two, (B).Generally speaking, a fund with a growth-oriented manager willhave a concentration of stocks that he or she believes have thepotential to grow faster than the rest of the market. A valueorientation, on the other hand, involves focusing on stocks that the
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manager believes are undervalued in price and will eventually berecognized by the market. A blend fund will mix the two philosophies:the portfolio may contain growth stocks and value stocks, or it maycontain stocks that exhibit both characteristics.
Generally, all funds with an average investment in companies with amarket size of less than $1 billion were grouped in the small-company,or Small-Cap, (S) category. Those that range from $1 billion to $5billion were labeled as Medium-Cap (M) Securities and funds withmedian market capitalization exceeding $5 billion qualified for Large-Cap (L) designation. Recent changes in size categories will bediscussed in the Mutual Funds Evaluation section.
Fixed Income Investment Styles
Morningstar® Fixed Income Style Box categorizes fixed incomefunds into nine sub-classes, ranging from short maturity/high qualityfor the safest funds to long maturity/low quality for the riskiest.
Short Int Long
High
Medium
Low
Morningstar® splits fixed-income funds into three maturity groups,(short, intermediate and long), and three credit-quality groups, (high,medium and low). These groupings display a portfolio’s effectivematurity and credit quality to provide an overall representation of thefund’s risk, given the length and quality of bonds in its portfolio. Again,you’ll learn more about Morningstar’s® Fixed Income Style Box in theMutual funds Evaluation section.
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Investments
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2002 90.22- 84.02- 49.51- 38.41 86.1 83.2
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18 9.4- 0.2 0.1- 60. 7.51 9.8
08 4.23 6.83 4.42 7.2- 1.21 4.21
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INTRODUCTION TOMUTUAL FUNDS
A mutual fund is a corporation or trust, in which individual investorspool their funds and invest in a variety of commonly linked securitiesaccording to the type of the fund. Mutual funds are advantageous inthe way that they are managed – the client doesn’t have to managethe portfolio.
There are several reasons why mutual funds are popular withindividuals:
• Reduced Risk• Diversification• Convenience• Professional Management• Liquidity
Mutual Funds are a pooling of professionally managed investments,shares of which are sold to the general public through variouschannels. In a mutual fund, the investor owns shares, just like in aregular corporation. The fund then buys a number of otherinvestments, like stocks, bonds or money market instruments. Theinvestor owns a little piece of each investment in a convenient format.In other words, investors diversify away some risk by buying andholding more than one investment.
Mutual funds provide diversification by investing in many securities,sometimes hundreds or even thousands of different investments. Bypurchasing many different securities, mutual funds reduce the risks ofindividual securities. If one security declines in value, the total fund isonly slightly affected.
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Another advantage of mutual funds is professional management.Most individual investors lack the resources and expertise necessaryto select and maintain a portfolio of stocks. Mutual funds havemanagers whose job it is to invest and manage the fund. Managers,of course, vary in their skill and style, which makes it important for aninvestor to look not only at the fund, but more particularly at themanager of the fund. Funds charge a fee ranging from under 0.2% toover 3% annually.
EQUITY MUTUAL FUNDS
DIVERSIFICATION
STOCK 1 STOCK 2 STOCK 3
STOCK 4 STOCK 5 STOCK 6
Mutual funds also offer a much higher degree of liquidity. Aninvestor in most funds can sell shares back to the funds on a veryrapid basis. Sale denominations can even be in the form of acheckbook, which some funds provide. Most mutual funds haverelatively low deposits required to become an investor. Some fundswill allow you to get in for as little as $25 to $50 a month or bymaking an initial investment of $250 to $1,000.
Note: A strict definition of liquidity means an ability to exchange anasset for cash without risk of loss of principal. Here, liquidity meansthat you can obtain cash from the mutual fund very quickly, but withthe possibility of a gain or loss.
Because of these features, we would say that mutual funds providean investor: Diversification, Professional Management,Liquidity and Convenience. Mutual funds are very useful vehiclesfor investing.
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• Investment risk is reduced through sharing in the portfolio with
others. Managers watch the funds and buy and sell securities
that are suitable for the type of fund described in theprospectus.
• Many people cannot afford to diversify widely by usingseparate stocks, nor have the time and expertise to monitor
their investments. Mutual funds offer diversity and professional
management at an affordable price.
• Mutual fund shares include automatic reinvestment at full or
fractional shares, exchange privileges within a family offunds, simplification of tax liabilities, and automatic purchase
or withdrawal plans.
As with common stock, mutual fund shareholders may have certainrights such as the right to approve changes in investmentobjectives and advisory agreements, voting rights and receipt ofannual reports.
Types of Money Market Mutual Funds
These are funds that invest in a variety of short term paper likeCDs, treasury bills, commercial paper, banker’s acceptances andrepurchase agreements. The funds usually offer a check writingprivilege that allows you to write checks for a minimum of $250 or$500. You may need anywhere from $1,000 to $5,000 to open oneof these funds. Money market mutual funds are very liquid and safe,but are not insured. A major objective of money market mutual fundsis to maintain a constant unit value of $1.00, so there is minimal risk ofloss of principal. Nonetheless, it is possible that the $1.00 unit valuemight not be maintained if the fund experiences highly unusual losses.
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Municipal Bond Money Market Funds
Municipal bond money market funds purchase short-term municipalbonds and other tax-exempt securities. The funds will usually offer acheck-writing privilege. Interest is exempt from federal income tax.
Single-State Municipal Bond MoneyMarket Funds
Single-state municipal bond money market funds purchase short-termmunicipal bonds issued by a single state and are exempt from federalincome taxes and state income taxes in that state. So, for a Michiganresident, a Michigan Municipal Money Market fund would providemoney market interest that is tax-exempt from federal and Michiganincome taxes. However, the interest may be included in thealternative minimum tax calculation to the extent that Private PurposeBonds are included in the fund.
Using Money Investments
Money investments have three primary functions: to provide a safeparking place for money between investments; to provide a basesafety net for emergencies; and to provide liquidity for purchases.A common use of the money market account or fund is as a cashmanagement account.
Cash management accounts direct paychecks, interest checks,retirement checks, etc., into the money market to earn interestimmediately. Disbursements are also made from the cashmanagement account.
Money investments are excellent places to keep temporary fundsfor emergencies, upcoming events such as taxes due ormiscellaneous payable items.
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Fixed Income Mutual Funds
Fixed income mutual funds invest in debt securities of corporations,governments and municipalities. A debt security is where investorsloan a company, government or municipality a sum of money inreturn for income.
A bond is an example of a debt security.
There are several features of bonds we should be familiar with:
• Principal or Face Amount
• Maturity Date
• Interest or Coupon Rate
For example:
ABC Corporation, $1,000, 10%, 1/1/2020
This means that this is a $1,000 bond, maturing on January 1, 2020and the investor will receive 10%, or $100 per year in income untilmaturity. At maturity, the $1,000 you have loaned ABC Corporationwill be returned to you in cash.
If you were to sell this bond before the maturity date, the price ofthe bond may sell above or below the face amount, dependingupon interest rates. An easy reminder when referring to bonds:
• When interest rates go up, bond prices (and fixed income
mutual funds) go down.
• When interest rates go down, bond prices (and fixed
income mutual funds) go up.
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TYPES OF FIXED INCOMEMUTUAL FUNDS
Corporate Bond Funds
Corporate bond funds invest in bonds that are issued bycompanies.
• Interest is Taxable
• Rated for RiskRatings range from top ratings of AAA (or Aaa) to D for
bonds in default. (Bonds rated BB or Ba or worse are
frequently called “junk bonds”). The better the rating, theless a bond generally yields; the lower the rating, the higher
the yield. This is because investors demand more return
from riskier investments. The two main rating services areMoody’s and Standard & Poor’s. Bonds rated BBB, (or Baa),
and above are considered “investment grade”.
• May be Short-term (4 years or less), Intermediate-term (4-10
years) or long term (over 10 years). Short-term bond funds
have the lowest interest rate risk. Intermediate term fundshave higher risks, and long-term funds have the highest risk.
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Call Provisions
Corporate bonds frequently have a call option, which allows theissuing corporation to “call” the bond back in by paying theprincipal. These provisions are usually exercised when interestrates are low, so the issuing corporation can reissue its debt at alower rate. Some investors have been surprised as their 14%bonds get called in when the market rates are at 9%. Some bondsoffer a call premium if redeemed early, or offer a call protectionfeature for some time frame.
Municipal Bond Funds
These funds invest in bonds issued by state and localgovernments.
• Interest is usually federally tax-exempt.
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• Interest may be state or local tax exempt as well.
• Municipal bonds are rated for risk like corporate bonds.
• Funds may be insured (the word “insured” is used in the title of
the bond). Insured bonds have a AAA rating and bear a loweryield.
• May be short-term (5 years or less), intermediate-term (5-12years) or long-term (over 12 years).
• Short-term bond funds have the lowest interest rate risk.
• Intermediate term funds have higher risks, and long-term
funds have the highest risk.
Municipal bond interest is tax-exempt if the projects funded bybonds are necessary (public purpose). Otherwise, the interest maybe taxable if the investor is subject to the alternative minimum tax.
Government Bond Funds
These funds buy bonds that are issued by the federal government andmay be exempt from state and local taxes. Government bonds areconsidered to be very safe since they are backed by the federalgovernment.
• Interest is federally taxable (but exempt from state tax and local
tax).
• Top quality (Government bonds are considered above AAA)
• May be short-term (4 years or less), intermediate-term (4 - 10years) or long-term (over 10 years)
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• Short-term bond funds have the lowest interest rate risk.
Intermediate-term funds have higher risks, and long-term funds
have the highest risk.
• Some bonds are agency bonds which provide income plus
return of principal monthly. These funds usually buy mortgagesfrom the Government National Mortgage Association (GNMA).
• May have adjustable rates that go up or down.
Convertible Bond Funds
These funds buy bonds that can be converted or traded forcommon stock of the issuing company. Convertible bonds have alower yield than equivalent rated bonds because of the conversionfeature. Convertible funds have the feature of unlimited upsidepotential:
• Interest is taxable• Bonds are rated for safety• The price of a bond can move with the common stock• Conversion allows unlimited upside
International Bond Funds
These funds buy bonds around the globe. Interest rates varyinternationally, with some countries having a much higher rate ofinterest than the US.
• Interest is taxable (and may be subject to foreign tax)• Currency risk (e.g. Euro/Dollar exchange rate)• No international rating system exists• Higher yields than domestic funds
International Funds carry added risk of currency exchangefluctuations.
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Municipal Bond Fund Tax-Exempt YieldComparison Work Sheet
This form summarizes the data relevant to choosing between a tax-exempt and a taxable fixed income investment. By referring to thetable showing equivalent taxable yields, an assessment can bemade of the comparative after-tax yields of taxable versus tax-exempt investments.
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01 87.2 33.3 98.3 44.4 65.5 76.6 87.7
51 49.2 35.3 21.4 17.4 88.5 60.7 42.8
52 33.3 00.4 76.4 33.5 76.6 00.8 33.9
82 74.3 71.4 68.4 65.5 49.6 33.8 27.9
33 37.3 84.4 22.5 79.5 64.7 69.8 54.01
53 58.3 26.4 83.5 51.6 96.7 32.9 77.01
Note: This table shows the taxable yield to equal the yield on a tax-exempt investment, assuming the individual investor is not subject toAlternative Minimum Tax.
If the charts above cannot be used, use the following formula:
Taxable Equivalent Yield =
Tax-Exempt Rate = 3.5% = 3.5% = 4.86%1 – Tax Bracket 1 - 0.28 0.72
Another Example: 7.25% tax free, federal tax rate of 28%
TEY = 7.25% = 7.25 = 10.07% 1.00 - 0.28 0.72
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To take into account your state tax rate, follow the formulabelow:
Taxable Equivalent Yield for Combined State and Federal Tax Rate
Taxable Tax-Exempt RateEquivalent Yield = (1 - State Tax Rate) x (1-Federal Tax Rate)
= 6.25(1 - 0.04) x (1 - 0.28)
= 6.25(0.96) x (0.72)
= 6.250.6912
= 9.04%
Taking into account both State and Federal tax rates, the taxableequivalent yield is 9.04%.
Under the Jobs and Growth Tax Relief Reconciliation Act of 2003(JAGTRRA), Federal tax brackets have been lowered. As a result,when Taxable Equivalent Yield calculations are made, it is helpful touse the formula shown above. As the income tax brackets becomelower, the tax-exempt nature of the Municipal Bond interestbecomes somewhat less attractive.
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EQUITY MUTUAL FUNDS
Stocks are equity investments. Stocks represents ownership in acorporation. This type of ownership provides an investor with thepossibility of dividends, plus prospective growth of share price.
When mutual funds invest in stocks, another characteristic toexamine is their style.
Equity Mutual Fund Styles
Equity Mutual Funds can be analyzed by the style of the manager,along with capitalization (size) of the underlying stocks. Style isbroken into three general categories:
• Value
A value-oriented manager generally purchases securities with a lowprice to book value (P/B) ratio. [Book value is defined as thehistorical cost of assets, less depreciation, less debt per share]. Lowmeans low relative to the average. Value managers also generallypurchase stocks with a low price to earnings (P/E) ratio. Other ratiosconsidered are price/sales, price/cash flow and dividend yield. Thebasic theme of the value style is to buy stocks that are on sale.Historically, this style has had a higher long-term rate of return than thegrowth style, although this is not true of every time period.
• Growth
A growth-oriented manager buys stocks with high P/B and high P/E.Growth managers look for stocks with earnings momentum andhigher than average earnings growth. Additional factors ofimportance are sales growth, cash flow growth and book valuegrowth. Growth styles will generally out-perform value styles in a
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rising market and lose more in a falling market. Growth and Valuestyles tend to alternate in terms of superior investment performance.
• Blend
A blend manager does not favor either growth or value. The stocksselected may have relative ratios between the extremes, or may haveratios outside the extremes such that the average results in a blendfund style.
Investment Style (Equity):Additional Comments
Referring to the Morningstar® matrix, note that the style data displayboth the fund’s particular investment methodology and the size of thecompanies in which it invests. Combining these two variables offersa broad view of a fund’s holdings and risk. For style data, ninepossible combinations exist, ranging from large capitalization/valuefor the safest funds, to small capitalization/growth for the riskiest.
Equity style data rely on a mathematical representation of aparticular fund’s investment style. Morningstar® categorizes afund’s portfolio as being growth-oriented (G), value-oriented (V), ora blend of the two (B). Generally speaking, a fund with a growth-oriented manager will have a concentration of stocks that he or shebelieves have the potential to grow faster than the rest of themarket. A value orientation, on the other hand, involves focusingon stocks that the manager believes are undervalued in price andwill eventually be recognized by the market. A blend fund will mixthe two philosophies: the portfolio may contain growth stocks andvalue stocks, or it may contain stocks that exhibit bothcharacteristics.
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It is important to note that equity style data are for evaluating only thestock portions of a fund’s portfolio. Thus, funds with a significant mixof stocks, bonds, and cash may have a substantial portion of theirportfolios left out of the equity style data. Consequently, they will begiven both equity and fixed income style data.
• Capitalization
Managers also typically have a preference for the size of thecompanies they buy: Large, Mid and Small capitalization.Morningstar® changed the way it classified stock funds according tosize. Until mid-2002, the 5,000 largest stocks in the Morningstar®database were categorized as follows:
Top 5% 250 Stocks Large CapitalizationNext 15% 750 Stocks Mid CapBottom 80% 4,000 Stocks Small Cap
(The former system indicated that Large Cap Stocks have over $5billion in market capitalization, Mid Cap between $1 billion and $5billion, and Small Cap less than $1 billion).
Morningstar® now classifies funds according to marketcapitalization. Large cap stocks are those that account for the top70% of the capitalization in the Morningstar® database. Mid-capstocks represent the next 20%, and small-cap stocks represent thebalance.
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Morningstar ® characterizes fund styles as follows:
Equity Style Box
Value Blend Growth
Large
Mid
Small
Historically, the small/value and mid/value boxes have had the bestlong-term rate of return. In general, growth is riskier than value,and small is riskier than large.
• Investment Style (Fixed Income)Both domestic and international fixed-income funds, with the
exception of convertible bond funds, feature their own fixed-income style data, which focus on two pillars of fixed-income
performance - interest rate sensitivity and credit quality.
Morningstar® splits fixed-income funds into three maturitygroups - short, intermediate and long - and three credit-
quality groups - high, medium and low. These groupings
display a portfolio’s effective maturity and credit quality toprovide an overall representation of the fund’s risk, given the
length and quality of bonds in its portfolio. As with equity
funds, nine possible combinations exist, ranging from shortmaturity/high quality for the safest funds to long maturity/low
quality for the riskiest.
The average term length of a fund’s bond portfolio is based
on average effective maturity (a weighted average of the
maturities of the bonds in each fund’s portfolio). Thisstatistic is calculated by weighting each bond’s maturity date
by its relative size within the portfolio. Average effective
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maturity provides a more accurate description of a bond fund’s
true life than does a maturity date; the former takes into
consideration all mortgage prepayments, puts (rights that allowa bond holder to redeem the issue before maturity), and
adjustable coupons. Funds with an average effective maturity
of less than four years qualify as short-term bond funds (S).Funds whose bonds have an average effective maturity from
four to ten years are categorized as intermediate (I), and those
with an average that exceeds ten years are long-term (L).Some financial analysts will refer to duration when evaluating a
bond portfolio’s weighted maturity. Although duration (which
takes into account the coupons of the securities and the ratesof cash flow) is considered a more sophisticated measure of
interest-rate sensitivity than is average effective maturity,
duration is also a complicated figure that is not alwaysavailable from the fund companies, nor is it calculated
uniformly among funds. For these reasons, Morningstar® uses
average effective maturity as well as duration.
The average quality rating of a bond portfolio is the other
style factor considered for fixed-income funds. Those thathave an average credit rating of AAA and AA are categorized
as high quality (H). Bond portfolios with average ratings less
than AA, but greater than or equal to BBB are medium quality(M), and those rated below BBB are categorized as low
quality (L). For the purposes of Morningstar’s® calculations,
U.S. government securities are considered AAA bonds, non-rated municipal bonds are classified as BB, and all other
non-rated bonds are labeled B.
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Equity funds usually run the scope of possible style
combinations, with funds from each objective and vary greatly.
Fixed-income funds, on the other hand, favor certaincombinations over others.
For example, there are far more long - and intermediate - maturityfunds than short-maturity funds, and far more funds boast high ormedium credit quality than low quality.
Fixed Income Style Box
Short Int Long
High
Medium
Low
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Mutual Fund Types
The Investment Company Institute classifies mutual funds into 25broad categories according to their basic investment objectives.Here is a brief description of each.
Maximum Capital Appreciation or Aggressive Growth Fundsseek maximum capital gains as their investment objective. Currentincome is not a significant factor. Some may invest in stocks ofbusinesses that are somewhat out of the mainstream, such asfledgling companies, new industries, companies fallen on hard timesor industries temporarily out of favor. Some may also use specializedinvestment techniques such as option-writing or short-term trading.
Balanced Funds generally have a three-part investment objective:l) to conserve the investors’ initial principal, 2) to pay currentincome, and 3) to promote long-term growth of both principal andincome. Balanced funds have a portfolio mix of bonds, preferredstocks and common stocks.
Corporate Bond Funds, seek a high level of income. They do soby buying bonds of corporations for the majority of the fund’sportfolio. The rest of the portfolio may be in U.S. Treasury bonds orbonds issued by a federal agency.
Flexible Portfolio Funds may be 100 percent invested in stocksOR bonds OR money market instruments, depending on marketconditions. These funds give the money managers the greatestflexibility in anticipating and responding to economic changes.
GNMA or Ginnie Mae Funds invest in mortgage securities backedby the Government National Mortgage Association (GNMA). Toqualify for this category, the majority of the portfolio must always beinvested in mortgage-backed securities.
Global Bond Funds invest in the debt securities of companies andcountries worldwide, including the U.S.
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Global Equity Funds invest in securities traded worldwide, includingthe U.S. Compared to direct investments, global funds offer investorsan easier avenue to investing abroad. The funds’ professional moneymanagers handle the trading and record keeping details and dealwith differences in currencies, languages, time zones, laws andregulations, and business customs and practices. In addition toanother layer of diversification, global funds add another layer ofrisk— exchange-rate risk.
Growth Funds invest in the common stock of well-establishedcompanies. Their primary aim is to produce an increase in thevalue of their investments (capital gains) rather than a flow ofdividends. Investors who buy a growth fund are more interested inseeing the fund’s share price rise than in receiving income fromdividends.
Growth and Income Funds invest mainly in the common stock ofcompanies that have had increasing share value but also a solidrecord of paying dividends. This type of fund attempts to combinelong-term capital growth with a steady stream of income.
High-Yield Bond Funds maintain at least two thirds of theirportfolios in lower-rated corporate bonds (Baa or lower by Moody’srating service and BBB or lower by Standard and Poor’s ratingservice). In return for a generally higher yield, investors must beara greater degree of risk than for higher-rated bonds.
Income-Bond Funds seek a high level of current income for theirshareholders by investing at all times in a mix of corporate andgovernment bonds.
Income-Equity Funds seek a high level of current income for theirshareholders by investing primarily in equity securities ofcompanies with good dividend-paying records.
Income-Mixed Funds seek a high level of current income for theirshareholders by investing in income-producing securities, includingboth equities and debt instruments.
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International Funds invest in equity securities of companies locatedoutside the U.S. Typically, at least 90% of their portfolios must beinternationally invested at all times to be categorized here.
Long-term Municipal Bond Funds invest in bonds issued bystates and municipalities to finance schools, highways, hospitals,airports, bridges, water and sewer works, and other public projects.In most cases, income earned on these securities is not taxed bythe federal government, but may be taxed under state and local laws.For some taxpayers, portions of income earned on these securitiesmay be subject to the federal alternative minimum tax.
Money Market Mutual Funds invest in the short-term securitiessold in the money market. These are generally the safest, moststable securities available, including Treasury bills, certificates ofdeposit of large banks, and commercial paper (the short-term lOUsof large U.S. corporations).
Option/Income Funds seek a higher current return by investingprimarily in dividend-paying common stocks on which call optionsare traded on national securities exchanges. Current returngenerally consists of dividends, premiums from writing options, netshort-term gains from sales of portfolio securities on exercises ofoptions or otherwise, and any profits from closing purchasetransactions.
Sector Funds are funds that invest in a specific or single area suchas health, technology, leisure, finance, precious metals etc.
Sector funds have higher risks due to their lack of diversification.
Precious Metals/Gold Funds maintain two thirds of their portfoliosinvested in securities associated with gold, silver and other preciousmetals.
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Short-Term Municipal Bond Funds invest in municipal securitieswith relatively short maturities. These are also known as tax-exemptmoney market funds. For some taxpayers, portions of income fromthese securities may be subject to the Federal Alternative MinimumTax.
State Municipal Bond Funds—Long-Term work just like otherlong-term municipal bond funds except their portfolios contain theissues of only one state. A resident of that state has the advantage ofreceiving income free of both federal, state and local tax. For sometaxpayers, portions of income from these securities may be subject tothe Federal Alternative Minimum Tax.
State Municipal Bond Funds—Short-Term work just like othershort-term municipal bond funds except their portfolios contain theissues of only one state. A resident of that state has the advantage ofreceiving income free of both federal, state and local tax. For sometaxpayers, portions of income from these securities may be subject tothe Federal Alternative Minimum Tax.
U.S. Government Income Funds invest in a variety of governmentsecurities. These include U.S. Treasury bonds, federallyguaranteed mortgage-backed securities, and other governmentnotes.
Socially Conscious Funds invest in companies that adhere to aspecific social idea or priority such as avoiding companies that dealin defense, alcohol or tobacco products. These funds may alsoemphasize investing in solid corporate citizens that maintainexcellent environmental and hiring practices.
Index Funds are designed to mirror an established market indexsuch as the S&P 500 or Wilshire 5,000. These are not managed inthe same way as other funds. Securities are not bought and sold inorder to enhance total return. The stocks in the fund merely attempt toreplicate what is contained in the index, allowing the investor a chanceto participate in a market segment, large or small, at lower cost.
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MUTUAL FUNDS QUOTATION ANDTERMINOLOGY
Family of Funds: A mutual fund management company may haveseveral different funds under their control. For example, VanguardFunds offer long-term fixed income funds, short-term bond funds,index funds and actively managed equity funds. An investor caninvest in any number of these funds. Mutual fund families mayhave special provisions that allow you to switch funds from time totime. There is sometimes a charge for switching funds.
• Net Asset Value (N.A.V.): Also called the sell price, is the
fair market value per share of a mutual fund.
• Public Offering Price (P.O.P.): Also called the buy price,P.O.P is the price at which the shares are offered for sale to
the public.
• No-load: When there is no charge to buy into a fund or
particular investment. All the money invested goes into thefund for investment. In this case, the NAV and the POP are
equal.
• Load: Is the charge to buy into a mutual fund. (Different
types of loads will be discussed in detail later).
The load for buying into a mutual fund can generally be determinedby looking at a mutual fund quote in the newspaper.
All mutual funds have management fees that typically range from 0.3%to 2% of total asset value.
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Example:
In the following chart, the CapV Fund has a N.A.V. of 13.22 and aP.O.P. of 13.84. The difference between the P.O.P. and the N.A.V.is 0.62 (this is also called the spread). The load for the CapV Fundcan be found by dividing the difference (0.62) by the P.O.P. (13.84). Inthe case of the CapV Fund the load (or charge to buy into the fund) is4.5%. Note that CapV also has a “p” footnote. This tells us that thefund, in addition to charging a front-end load, also assesses adistribution charge.
Loads are commissions and must be considered when determiningnet profits or losses.
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Fund Group N.A.V. P.O.P. ChangeExample: (Sell) (Buy)
A Bond 13.95 NL . . . . .CalTx 14.68 NL - 0.02CapV p 13.22 13.84 - 0.04CvSec 9.71 NL + 0.02Dreyf 11.76 NL - 0.05GthOp 11.14 NL - 0.01InsTx p 17.66 NL - 0.03Interm 13.53 NL - 0.02Levge 15.14 15.85 - 0.01Mas Tx 15.74 NL - 0.02NJ Tx p 12.42 NL - 0.02NwLd p 27.63 NL + 0.06NY Tax 15.03 NL - 0.02NYTE 16.64 NL - 0.03NYIn p 10.86 NL - 0.03ShinT 12.53 NL . . . . .ShlGv 11.15 NL - 0.01StrAg p 27.70 28.56 + 0.08Stinc p 13.20 13.82 - 0.01Stinv p 17.53 18.36 + 0.04StrW p 21.23 21.89 + 0.11Tax Ex 12.54 NL - 0.03Thrd C 6.39 NL + 0.02USG In 12.48 NL - 0.01
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There are two types of mutual funds with regard to the manner inwhich they are sold and the cost to purchase them:
• Closed-End: A closed-end mutual fund has a fixed
allocation of issued shares and is traded as a primary
offering or in the secondary markets on the exchanges.Investors pay a commission since it is traded similar to a
common stock.
• Open-End: Open-end companies have an unlimited amount
of capitalization and investors can buy both full and fractional
shares. Buying and selling is done directly through the fundthus it is always a primary offering. Shares are not traded
between shareholders.
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MUTUMUTUMUTUMUTUMUTUAL FUND EVAL FUND EVAL FUND EVAL FUND EVAL FUND EVALALALALALUUUUUAAAAATIONTIONTIONTIONTION
In evaluating mutual funds, a variety of methods are used. Usually, thefollowing items can be found in Value Line ® or Morningstar ®. Bothof these proprietary investment services offer independent researchon mutual funds. Among the factors normally considered relevant byanalysts:
1. Fund Type: Is the fund type appropriate to the investor’s
allocation? Does the investor need growth? Income?
Growth and income? Asset allocation is responsible for over90% of return (as opposed to timing or investment
selection).
2. Manager Style: What is the manager’s style? If this is an
equity fund, is this a large cap growth? Small cap value?
Blend? If this is a bond fund, is it short-term, high quality?Long-term, low quality?
3. Manager Tenure: How long has the manager been with thefund? How much return is attributable to the manager?
Some large fund families shift managers between funds,
thus making it difficult to measure a manager’s performance.
4. Performance: How has the fund performed relative to the
appropriate index? For stock funds, the fund is usuallycompared (plus or minus) to the Standard & Poor’s 500
index. There are also bond indexes and international
indexes.
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5. Risk: How risky is the fund? Fund risk can be measured by
the two standards:
A) Beta: Beta measures the volatility of the fund’s returnrelative to an index. Beta is expressed as a factor inrelation to the overall market risk having a measurementof 1.00. This means that funds with less volatility have aBeta less than one, and more volatile funds have a Betaabove one. Beta roughly equates to percentage; thus wemight say a fund with a beta of 0.59 is about 59% asvolatile as the market. A fund with a Beta of 1.15 is 15%riskier than the market index.
B) Standard Deviation: Standard deviation is astatistical measure of the variation of return. Standarddeviation is a percent; it says that, roughly two-thirds ofthe time, a fund’s return will fall within a certain range.Example: Fund Y has a return of 12%, and a standarddeviation of 4%. This means that two-thirds of the time,the return will be 12 ± 4%. Two standard deviations (8%in the above example) account for 95% of occurrences ina ‘normal’ situation.
While beta is a measurement of comparative risk,Standard Deviation is a measurement of absolute risk.Both statistics are highly useful in analyzing the riskinessof equity investments.
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6. Risk/Return: How much risk in relation to return? Generally,
two Modern Portfolio Theory (MPT) statistics are useful:
A) Alpha: Alpha generally measures the risk-adjustedadded value of the fund. The higher the Alpha, the moreelevated the fund’s ‘starting’ return. Alpha must also beconsidered with another statistic, R2. R-squared issometimes called the reliability statistic, because itmeasures how reliable alpha (and beta) are.
Example:Alpha Beta R2
Fund X 5.7 0.60 0.16Fund Y 4.3 0.63 0.79
We might say that “Fund X has a superior return of 5.7%with about 60% of the risk of the market, and thesestatistics are 16% reliable”. Fund Y has a superior returnof 4.3% with about 63% of the risk of the market, andthese statistics are 79% reliable. An analyst looking atthese statistics may well conclude that Y is the betterfund.
B) Sharpe: An increasingly commonly reported statisticis the Sharpe Ratio, which defines how much excessreturn is derived by each unit of risk. (Restated, a fund witha Sharpe of 0.89 would translate to: We get 0.89% morereturn when we take 1% more risk.) Generally, the higherthe Sharpe, the better.
7. Fees: Regardless of conflicting claims in the industry, asimple truth is: fees reduce performance. Fees break down
into a few categories:
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MUTUAL FUND CHARGES
Front-End Load: is an initial sales expense (up to 8.5%) that ischarged as your shares are purchased. Some of this money goesto managing the fund, but most of it goes to pay salescommissions.
Back-End Load: is a deduction taken from the proceeds of thesale of your shares. The percentage charged usually decreasesthe longer you hold the shares. This is also referred to as adeferred sales charge or a contingent deferred sales charge.
Re-Load: is a charge to re-invest your gains and/or cash dividends,and is typically the same charge as the front-end load. Re-loadsare now rare.
Exit Fee: is a charge to cash in any shares of your fund. It’susually a flat dollar rate or a percentage, typically 1% to 2% of theproceeds. The fee is intended to discourage short-term trading ofmutual fund shares.
Management Fee: is used to cover costs like salaries, operatingexpenses, etc. All mutual funds have management fees.
12b-1 Fee: is used to cover advertising, commissions and othercosts of managing the fund. The maximum 12b-1 fee is limited bylaw to no more than 1% per year. To see what the actual expense ofthe fund is, add this expense to the management fee .
Transfer Fee: is a charge to switch from one fund in the companyto another. It’s usually a fixed dollar amount, like $5 or $10.
Rule of Thumb: For a fee-heavy fund to out-perform a low-fee fund itmust consistently produce a higher return.
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Mutual Fund Charges (As A Percentage)
Front-End Load _____ + __________________
Back-End Load _____ + __________________
Exit Fee _____ + __________________
Management Fee _____ + __________________
12b-1 Fee _____ + __________________
Transfer Fee _____ + __________________
Total Expenses _____ + __________________
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SOURCES OF INFORMATION TOSELECT A MUTUAL FUND
The prospectus is the best tool in the selection of a mutual fund.The prospectus can provide you with all information pertaining to aparticular fund including the fund’s portfolio, investment objectives,manager, loads, expenses, history of past performance, number ofshares issued, yields and more. Other helpful resources includeMONEY Magazine’s issue which rates all mutual funds (usually April),Kiplinger’s Personal Finance, Barron’s, The Wall Street Journal andForbes’ Mutual Fund Issue.
When you request a prospectus, you should also ask for aStatement of Additional Information and a most recent annual orquarterly report. These statements will show the make-up of theportfolio and the accounting information. The following are someimportant questions to ask yourself when looking to invest in a mutualfund.
• What type of fund is it? (Money Market, Fixed Income, Equity,
other?)
• What is the objective of the fund? (Capital Appreciation,
Income?)
• What are the loads and breakpoints? A breakpoint cuts the
load at higher levels of investment. Also ask about using
letters of intent and combination privileges to reducecommissions.
• Are there telephone exchange privileges? Are you able topurchase and trade fund shares over the Internet?
Prospectus
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• Is there free reinvestment? (Do your dividends get reinvested
without charge?)
• Is this fund in a family of funds?
• What is the minimum initial investment? ($500, $1,000?)
• What is the fund’s past performance? Look at 1 year, 3 year, 5
year and 10 year returns.
• How long do I want to stay in the fund? (What are my
goals? My time horizon?)
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MUTUAL FUND EXPENSES:PROSPECTUS
Summary of Fund Expenses
A. Shareholder Transaction ExpensesMaximum Sales Load Imposed on Purchase NoneMaximum Sales Load Imposed on Reinvested Dividends NoneDeferred Sales Load Imposed on Redemptions NoneExchange Fee None
B. Annual Fund Operating Expenses(as a percentage of average net assets)Management Fee 0.54%12b-1 Fee NoneOther Expenses 0.98%Total Fund Operating Expenses 1.52%
C. Example:
YEARS 1 3 5 10You would pay the following expenseson a $1,000 investment in the Fund,assuming (1) a 5% annual return and(2) full redemption at the end of each $15 $48 $83 $181time period.
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ANALYZING MUTUAL FUNDS
The following information is from Morningstar® Mutual Funds.Morningstar®, available at many public libraries, is an independentinvestment research company providing reports on mutual funds.Morningstar® can be very valuable in picking a fund. Fundinformation from Morningstar® is also available on the Internet.
• Objective: Defines the fund’s purpose. For example, “This
is a growth fund.”
• Load%: Tells the front-end load, if any.
• Yield: Shows the current income from the fund’s investment.
• Return/Risk Rating: This indicates the fund’s return in
relation to the average fund of this type, the risk in relationto this type of fund and the rating. Morningstar® gives a one
through five star rating (five star is the highest).
The Morningstar® Star Rating System shows the risk-adjusted returnranking of each fund for its category, as follows:
Star Rating PercentileFive Stars Top 10%Four Stars Next 22.5%Three Stars Middle 35%Two Stars Next 22.5%One Star Bottom 10%
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Style: The style boxes show what management style is used. Stockfunds have a size (large, middle and small cap) and style (value,blend, growth) grid.
Analysis: This is what the Morningstar® editors think about the fund.
Portfolio: This shows the thirty largest holdings of the fund.
Performance/Risk: This shows the most recent performancefigures for the fund, as well as longer-term performance. The lowerpart of the section shows the risk-adjusted rating on a star basis,with five-star being the best. Also listed in this section are somestatistical measures:
• Alpha: An alpha above zero shows that a fund has a statistical
advantage. The fund has out-performed a relevant index over
a reasonable period of time such as three years. A positivenumber for Alpha is evidence of a manager’s added value.
• Beta: This measures the risk of the fund in relation to thewhole market. A Beta of 1.00 means the fund has the same
volatility as the Standard and Poor’s 500 (or other relevant
index). A Beta of less than one means the fund is less volatilethan the relative index.
For Example, if the market goes up 10%, a balanced fund with aBeta of 0.75 would be expected to move 75 percent of what themarket moved, or 7.5 percent (0.75 times 10%). An aggressivegrowth fund with a beta of 1.50 will be expected to move 150 percentof what the market moved, or 15 percent (1.5 times 10%). Individualswho can tolerate more risk would consider funds with betas greaterthan 1, and those who wanted less risk would consider funds withbetas less than 1.
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Credit Analysis: For bond funds, this shows how much of the fund isin different rated securities and the overall quality and financialcapability of the companies in the fund.
Operations: This gives the particulars of how to contact the fund,etc.
Bottom Line: One popular and useful tool for analyzing mutualfunds is Morningstar®. It provides an independent analysis ofthousands of mutual funds, as well as individual common stocks.
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MIXED PORTFOLIO/ASSETALLOCATION
In a mixed portfolio strategy, the investor buys a variety of types offunds in each of the three investment areas.
MoneyMarket Income
Growth
This strategy minimizes the investor’s loss exposure: If interestrates go up, the fixed income funds may go down, but the moneymarket funds will have increased returns. If money market rates aredown, it is likely that the stock market will be up, so the equity portionwill probably increase in value. Thus, asset allocation helps reduceloss exposure.
Equity
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DOLLAR COST AVERAGING
Dollar cost averaging is a systematic method to invest in a mutualfund or stock. Shareholders invest equal sums of money at regularintervals such as monthly, semiannually, or annually.
The system levels off the “peaks” and “valleys” of the share pricesand works best if practiced over the full business cycle, at least fiveyears. Regular savings lets the investor make money even whenthe market is down.
The following illustrates an example of dollar cost averaging andshows how this strategy works.
Which example would you prefer?
$9 8 7 6 5 4 3 2 1 0
1 2 3 4 5 6
$ 9
$ 4
EXAMPLE 1
EXAMPLE 2
SharePrice
Month
$50/Month for 6 Months
Rising Market
Fluctuating Market
Most people choose Example One (rising). However, ExampleTwo’s (fluctuating) results were better. This following chart shows theadvantages of “Dollar Cost Averaging” in fluctuating markets.
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Example 1Rising Market
Invest. Price/ # of SharesShare
50 4 12.5050 5 10.0050 6 8.3350 7 7.1450 8 6.2550 9 5.56
Example 2Fluctuating Market
Invest. Price/ # of SharesShare
50 4.0 12.5050 2.5 20.0050 1.5 33.3350 1.0 50.0050 2.0 25.0050 4.0 12.50
Example 1 Example 2
Total # of Shares 49.78 153.33Final Price x 9.00 x 4.00
Value $448.02 $613.32
Even when investing larger lump sums, dollar cost averaging isrecommended. In such a plan, the investor is not concerned if themarket is up or down. When investments are made on a regularbasis with consistent amounts, you automatically take advantage ofdollar cost averaging. The same amount of money investedmonthly or at any regular interval allows you to buy more shareswhen prices are lower. This reduces your cost per share withouthaving to know the “right” time to buy. While dollar cost averaginghas definite advantages, it cannot assure a profit or protect againstloss in declining markets. The investor should consider his abilityto continue to invest in periods of low price levels.
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UNIT WITHDRAWALUNIT WITHDRAWALUNIT WITHDRAWALUNIT WITHDRAWALUNIT WITHDRAWAL
Unit Withdrawal works like Dollar Cost Averaging, only in reverse.You withdraw a systematic amount, like $200 per month. In goodmarkets, you are keeping more of your investment at work, and inbad markets, you are taking out a bigger portion. Let’s say aperson had a $36,000 investment. She could withdraw about $250per month and, depending on the rate of return, possibly not touchthe principal. If the investment did well, (say it earned 12%), then$250 would only be part of the income, and the investor would havemore than $36,000 at the end of a year ($37,320), because ofreinvested excess income. Thus, the next year, the investor couldeither keep the larger amount working (and earn even moreincome), or take a larger withdrawal (like $300 a month).
For example:
Using the chart on the following page, an investment of $50,000 atan 8% rate of return will yield an annual withdrawal of $4,715.40(94.308 x 50) or $392.95 per month, for 20 years. (Assumeswithdrawal at the beginning of each year).
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SRALLOD000,1REPTNEMYAPraeYfogninnigeBtastnemyaP
sraeY %5 %6 %7 %8 %9 %01 %11 %215 679.912 959.322 539.722 409.132 568.532 618.932 757.342 786.742
6 636.781 258.191 170.691 292.002 415.402 437.802 259.212 661.712
7 095.461 599.861 414.371 548.771 582.281 237.681 581.191 146.591
8 453.741 129.151 215.651 521.161 657.561 404.071 460.571 537.971
9 199.331 007.831 544.341 222.841 620.351 558.751 407.261 075.761
01 833.321 771.821 360.331 099.731 459.241 059.741 479.251 220.851
11 656.411 616.911 336.421 007.921 318.431 669.931 451.541 173.051
21 354.701 525.211 566.711 668.221 021.821 124.331 367.831 041.441
31 683.101 665.601 328.111 051.711 835.221 089.721 964.331 779.831
41 312.69 594.101 468.601 213.211 928.711 604.321 430.921 607.431
51 557.19 531.79 216.201 671.801 518.311 225.911 482.521 390.131
61 678.78 153.39 239.89 806.401 763.011 791.611 780.221 720.821
71 574.48 240.09 427.59 905.101 283.701 133.311 443.911 804.521
81 374.18 921.78 909.29 897.89 287.401 648.011 679.611 851.321
91 508.87 845.48 324.09 414.69 505.201 976.801 129.411 712.121
02 224.67 052.28 812.88 803.49 105.001 187.601 131.311 535.911
12 282.47 391.08 152.68 734.29 137.89 311.501 665.111 270.811
22 353.27 543.87 194.48 077.09 161.79 146.301 291.011 597.611
32 606.07 876.67 019.28 082.98 367.59 833.201 389.801 976.511
42 020.96 961.57 584.18 349.78 615.49 281.101 619.701 007.411
52 475.76 997.37 791.08 047.68 004.39 351.001 379.601 938.311
62 252.66 155.27 920.97 556.58 993.29 532.99 731.601 280.311
72 040.56 214.17 869.77 476.48 005.19 614.89 693.501 414.211
82 629.36 073.07 200.77 687.38 096.09 386.79 637.401 528.111
92 009.26 514.96 021.67 089.28 959.98 620.79 941.401 403.111
03 459.16 735.86 413.57 842.28 992.98 634.69 626.301 348.011
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DEDICATION OF ASSETS -MATCHING
An important factor in individual investing is to MATCH theinvestment types with the personal risk and return targets of theperson investing. This match is accomplished by looking at WHATTHE INVESTMENT IS SUPPOSED TO DO.
Let’s look at some examples:
Frank, 54, and Sue, 48, have $20,000 to invest. They want to retire infive years and use the $20,000 as a down payment on a cabin inNorth Carolina.
Under the concept of Matching, they would buy a short-term orintermediate term bond fund to accomplish their goal. If they werein the 28 or 31% tax bracket, they would probably consider amunicipal fund. An investment advisor would probably suggest50% in short-term bonds and 50% in intermediate-term bonds tolower risk and increase return.
• Time: They dedicated the portfolio to exactly when they
needed the money.
• Risk: They selected short- and intermediate-term bonds,which are low risk.
• Return: The investment return is related to the risk.
• Taxes: They considered municipal bonds to save taxes.
The same process can be repeated for any financial goal.
Some bond funds, specifically short and intermediate term funds,allow the investor to write checks from the bond fund. However,the number of checks and the amount of each check is restricted.
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INVESTMENT SELECTION
To set your own personal mutual fund investment strategies,remember to use the following factors from the InvestmentPlanning Section:
• Time• How long before you need the money?
• Will you need to get it out immediately?
• What are the odds of your goals changing?• What will your income be during this time?
• Risk• How much can you “afford” to lose?
• Can you make up the difference if you lose money?• Will other sources of income tide you over?
• How much do you know about investing?
• What Are Your Expectations About• Inflation?• Tax rates?
• Interest rates?
• The stock market?
• Return• How important is the rate of return?
• Can you tolerate a zero return in one year and a 25% return
the next?• Would you tolerate a negative return?
• Do you need current income?
• Do you have a fixed need for income?
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• Taxes• Is this qualified plan money?
• Can the tax liability be shifted to a lower tax bracket?
• Do you need the current income?• Will your tax rate change in future periods?
The Bottom Line: Match your investment needs with yourinvestment choices.
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CAPITAL GAINS & LOSSES ONMUTUAL FUNDS
If you sell, transfer or exchange mutual funds, you may have acapital gain or loss for the year of the transaction. Capital gainsand losses are determined under the following formula:
Selling Price - Basis = Gain or Loss
Basis is essentially what you paid for the asset, including anycommission. For both tax and investment reasons, it is veryimportant to keep accurate track of your mutual fund purchasesand sales. You need a record of:
• Dates of purchase and sale• Per-share price• Number of shares involved
Mutual fund companies report sales of mutual fund shares on aform 1099-B. This information is reported to the IRS and shouldmatch the Schedule D on your tax return.
Computing Basis
The IRS allows four methods for mutual fund investors to computetheir basis. It’s important to remember that you must make a basiscalculation to compute your gain or loss.
Four Methods:
• First-In, First Out (FIFO)• Specific Identification• Average Cost - Single Category• Average Cost - Double Category
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FIFO and Specific Identification can be used by anyone. The averagecost methods require a special election notification to the IRS beforeyou can use them. Each method can significantly change the amountof tax owed.
• FIFO
FIFO makes a simple assumption, that the first shares you sell arethe first shares you bought. FIFO is the most common method offiguring basis and has no special requirement imposed by the IRS.
• Specific ID
The Specific Identification Method can be very beneficial inplanning your taxes. It allows you to select the shares you sell atany given time. For example, it may be advantageous to sellshares purchased at a higher price to get a deductible loss.Current law allows you to deduct up to $3,000 per year in lossesagainst ordinary income. Selling shares purchased at a higherprice may also reduce the amount of your gain and the taxes youowe.
If you use specific ID, you must notify the mutual fund company eachtime you sell or exchange shares. The IRS requires that notificationbe made to the mutual fund company at the time of sale.
• Average Cost
There are two average cost methods– the single category and thedouble category. The single category method averages the price ofall of your shares, while the double category method averageslong-term (holding period of over one year) and short term (oneyear or less) shares separately. If you use an average costmethod:
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• You must state which method is being used on your tax return.
• Once you choose a method, you must use that same methodfor all accounts in the same name in that mutual fund. You can’t
change methods without permission from the IRS.
You may use different methods for different mutual funds, so youcould use the average cost method (remembering to state so onyour income tax return) for one fund and specific ID for anotherfund. The key rule here is good record keeping!
FIFOPurchase
1/1100 sh.
3/1100 sh.
5/1100 sh.
7/1100 sh.
Sale
9/1100 sh.
SPECIFIC IDPurchase
1/1100 sh.
3/1100 sh.
5/1100 sh.
7/1100 sh.
Sale
9/1100 sh.
AVERAGINGPurchase
1/1100 sh.
3/1100 sh.
5/1100 sh.
7/1100 sh.
Sale
9/1100 sh.
AVERAGE
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COMMON STOCKS
In recent years, many investors have been attracted to individualstocks instead of equity mutual funds. Both mutual funds andindividual issues have their advantages and disadvantages.
Common stocks are, of course, the ingredients within equity mutualfunds. Investors in mutual funds have delegated the selection (andthe de-selection) of securities to the fund managers. Fundinvestors have no influence over what is contained in the fund.Moreover, fund participants have no control over the timing of theincome tax results. The mutual fund manager decides what to buyand sell, and when. Any gains or losses are simply distributed tothe fund shareholders on a pro rata basis.
Many people also feel that individual stocks are more exciting. Forsome, it’s interesting and rewarding to do research, comparison,analysis, investigation and selection. In 2000 and 2001, for example,many learned that their individual stock portfolios were not asdiversified as equity mutual funds, and carried much more risk.Technology stocks were a prime example.
In any case, each investor should determine whether individualcommon stocks, mutual funds, or a combination of the two is themost suitable approach.
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Common Stock Basics
Investors in individual common stocks expect a higher return thanmost other forms of investment, because they assume more risk. Thereturns to be derived from common stock are twofold:
• Capital Gains• Dividend Income
Common stocks will, hopefully, appreciate over time, but there is noguarantee. Even if the stock is held in a personal, taxable account,there is no current income tax on the growth of the stock until thestock is sold. At that time, the capital gain is taxed. If the holdingperiod is one year or less, the gain is taxed as ordinary income, justlike salary and interest. If the holding period exceeds one year, thegain is taxed as a long-term capital gain, at a rate not to exceed15%. For taxpayers in the 10% or 15% brackets, the tax rate onlong term capital gains is 5%.
Dividends, on the other hand, represent a payment to the shareholderof a portion of the earnings (profits) of a company. In a taxableaccount, the dividends are now taxed at the same rate as long termcapital gains. If the company does well financially, the board ofdirectors may increase the dividend periodically. The increasingdividend is an appealing feature of many stocks, especially as a wayto offset the effects of inflation.
Investors use a number of different analytical techniques to studythe merits of common stocks. Most institutional and individualinvestors favor Fundamental Analysis, in which the financialaspects of a company are scrutinized. The assets, liabilities, cashflows and other aspects of a corporation are analyzed to determinethe company’s fair value and whether the current price is attractive.
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Other investors use Technical Analysis, which involves a number oftechniques to examine trends in stock prices, volume of trades andvarious relationships with other indicators. In essence, much oftechnical analysis is intended to provide an answer to the question:“When should I buy (or sell) the stock?” In other words, it’s amatter of market timing. Whether you decide to use individualissues of common stock or mutual funds, or a combination, youshould probably emphasize equities in your portfolio of investmentsfor long-term goals and objectives. Long-term here means typicallyfive years or more. If your investment time horizon is less than fiveyears, most advisors would suggest using fixed income or moneymarket investments instead of equities, due to the risks involved.
One final note relating to investing in equities: remember that youhave two basic ways to invest from a tax standpoint. The personaltaxable account mentioned above is one way. The other is within atax-favored retirement plan like a 401(k) or 403(b) plan or IRA. In tax-favored plans, the capital gains and dividends are tax-deferred untildistribution at a later date, often in retirement. At that time, many ofus will be in a lower income tax bracket. Your best investmentopportunity, then, is probably equities within a qualified retirementplan or IRA. Once you have maximized the limits of those plans,then you may consider additional investments in other forms suchas regular taxable personal accounts.
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LIMITED PARTNERSHIPS
Limited Partnerships, also known as DirectParticipation Programs (DPPs) are available toinvestors when they do not have the time, capital, orknowledge to open their own business, but they wish tobe involved in a business venture. With “DPPs,” theinvestors share in the income, losses, tax deductions andcredits.
Investors also have limited liability. If the partnership should default onits loans, investors can lose their entire investment, but they are notpersonally liable for other partnership debts.
Individual investors who participate in these DP programs are calledlimited partners (LPs). The LPs are considered to be passiveinvestors because they are not actively managing the investmentand are not allowed to participate in the management of thepartnership.
General Partners (GPs) on the other hand are responsible for allmanagement aspects of the partnership. They monitor theinvestors’ capital, choose the investments, and manage thepartnership or business assets that have been acquired. The GPsalso assume full personal responsibility for all aspects of thepartnership’s debts.
Limited Partnerships pass through to investors the tax andeconomic consequences of the partnership. Investors will receivecash distributions based on the partnership profits and will also paytaxes on the partnership income.
One important note to keep in mind since the Tax Reform Act (TRA)of 1986 is that individual investors may deduct passive losses onlyagainst passive income. Any unused passive losses arerecognized upon the subsequent sale of the investment.
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Cash Flow Vs. Profit and Loss
One interesting point with Limited Partnerships is that the limitedpartner may receive a cash distribution, even after the partnershipshows a loss. Let’s look at the example below.
Profit & Loss Cash FlowStatement Statement
Rent $200,000 $200,000Less Rent Expense (50,000) (50,000)Gross Profit 150,000 150,000
Less Interest Expense (60,000) (60,000)Less Depreciation Expense (90,000) 0Profit 0Cash Flow Before Taxes 90,000
Less Taxes (0) (0)Profit After Taxes 0After-Tax Cash Flow 90,000
Less Principal on Loan 40,000Net Cash Flow 50,000
The point at which the depreciation and other deductions no longerexceed the cash flow or income of the partnership is known as thecrossover point (or shelter burnout). In most cases the investorwill have to purchase another partnership at this point to offset theincome from the partnership.
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Types of DPP Programs
There are many different types of Limited Partnership Programsthat are available for investment consideration.
Real Estate and Oil and Gas Limited Partnerships are two of themore common types of partnerships available.
If an investor is interested in participating in a Real Estate LimitedPartnership there are many choices, with each option havingdifferent objectives and characteristics. Listed below are some ofthe options:
• Existing Properties• New Construction• Government Assisted Housing• Raw Land
If the investor is interested in Oil and Gas Programs, there are alsomany choices:
• Income Programs• Exploratory• Developmental• Combinations of the above
Even though real estate and gas and oil are probably the mostcommon forms of limited partnerships, there are other types ofpartnerships available:
• Equipment Leasing• Cattle Breeding• Research and Development• Cable TV• Other
Each partnership should be analyzed carefully to see if it meets theinvestor’s objectives.
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Is a Limited Partnership Right for Me?
Individuals considering investing in a limited partnership shouldcarefully and cautiously review the prospectus and offering document,and also the sponsor’s track record.
One of the first rules is to avoid basing your decision on thebeautiful glossy pictures you will see in some of the marketingmaterial.
Cash flow is probably the most important variable to consider whenevaluating the project. A program cannot support its operations ifthere are insufficient cash flows.
When these programs are established, each partnership will have adifferent objective. Some promoters are extremely aggressive (forexample, using high amounts of debt) and this could be detrimentalto the investors. The IRS may determine that the program isabusive, and may disallow some or all of the deduction, assessback penalties and fines, and criminally charge the GP with intentto defraud.
Lastly, DPPs are extremely illiquid, so the investor must be ableto commit money for a long period of time and be able to meet thesuitability requirements of the sponsor, namely minimum net worthand earning requirements.
All of the above factors should be considered in determining ifDPPs are right for the investor, and if so, which DPP is suitable forthe investor.
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REAL ESTATE INVESTMENTTRUSTS (REITS)
Real Estate Investment Trusts (REITs) are investmentorganizations that buy mortgage pools and/or realproperty. The REIT is run by directors who in turn hiremanagers to operate the property owned by the REIT.After expenses and fees are deducted from gross income,the net is distributed to all investors. There are generallythree categories of REITs.
1. Mortgage REITs2. Equity REITs3. Hybrid REITs
Mortgage REIT
This type of REIT does not own real property (real estate). Itinvests in mortgages by lending money, secured by the properties,to property owners. Payments are made to the REIT as repaymentof the loan.
Equity REIT
Equity REITS invest in real property. They may specialize in aparticular type of property or a specific geographic area.
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Hybrid REIT
These are a combination of mortgage and real property REITs.They invest in mortgages and buy actual real estate.
REITs work like mutual funds, that is, indirect ownership of theassets. Unlike limited partnerships, REITs have marketabilityprovided by an organized secondary market. REIT shares are tradedon the stock exchanges.
Income in the form of interest payments received by mortgage andhybrid REITs is fully taxable. Rental and lease payments receivedby equity REITs may be partially tax-sheltered. Any tax onappreciation in share price is deferred until shares are sold or theREIT terminates.
REITs provide the investor with the means to come as close to realproperty ownership as possible without actually owning theproperty.
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OTHER REAL ESTATE RELATEDINVESTMENTS
Land Contracts
Land Contracts (LCs) are installment sales for real property. The titleusually remains with the seller until all installments are made. LCs canbe purchased from the holder and used as an investment.
Discount Mortgages
Mortgages are negotiable items that can be bought and sold.Usually the seller offers the buyer a discount on the remainingprincipal value of the mortgage for a cash payment.
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CERTIFICATES OF DEPOSIT ANDANNUITIES
This section covers:
• Certificates of Deposit• Types of Annuities• Annuity Payouts• Fixed vs. Variable• Split Funded Annuity Certificates of Deposit (CDS)
A certificate of deposit (CD) is obtained by depositing money into abanking institution. Your money is locked up for a specified time(from 3 months up to 10 years) and your money earns adesignated interest rate. CDs are offered by commercial banks,savings and loan institutions and savings banks. When the bankobtains your deposit it invests in debt instruments such as U.S.Government Notes and Treasury Bills.
CDs are insured by the Federal Government against default up to$100,000. The Federal Deposit Insurance Corporation (FDIC)administers the insurance program. FDIC charges each memberbank a fee that equals a percentage of the total deposits.
One of the more notable opportunities for small investors is theavailability of “Brokered CDs”. These are CDs that can be boughtand sold in the secondary market. Large denomination CDs arealways negotiable, but not for the small investor. A brokerage houseserves as an intermediary for a FDIC insured bank in the selling of thebank’s CDs. The brokerage house can offer a wide variety ofmaturities and interest rates through numerous FDIC-insuredinstitutions. The brokerage house will buy back your CDs through thesecondary market. The amount you receive will depend on marketconditions and interest rates. CD values are affected by changinginterest rates just as bonds and other fixed income instruments.
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There are several advantages in purchasing brokered CDs.
• Wide choice of issues and maturities• May avoid penalty for early sale• Possibly higher rate• Convenience• Added safety by brokerage analysis
Any interest penalty imposed for breaking the CD early is anadjustment (subtraction) from gross income on tax form 1040.
CD Rates and Yields
The Interest Rate (coupon rate) on a CD is usually quoted on a360-day basis. This type of quote gives a daily interest rate.
Daily Interest Rate on CD=
Coupon Rate x Principal Amount360
For example:
Coupon Rate is 5% 0.05 x 5,000 = $0.69Principal is $5,000 360
CDs are quoted on “CD Basis” when a 360-day period is used. Thesimple annual interest rate will be higher than the coupon rate. Thefollowing formula shows how to compute the simple annual interestrate once the quoted rate on the CD is known.
Simple Annual Interest Rate =
Quoted rate on CD x 365360
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For example:
Quoted Rate 5%Simple Annual Interest Rate =
0.05 x 365 = 0.0507360
Not all CDs are quoted on “CD Basis.” Some are quoted on a “bondequivalent basis.” The simple annual interest rate for a CD quoted ona bond equivalent basis is the same as the coupon rate.
Compound Interest for Time (CD)Deposits
Compounding or Compound interest results when interest is left toaccumulate with the principal so that the investor is receivinginterest on interest.
Interest Compounded Annually
Interest = Principal x Rate x Time
Note: The first year of a Multi-year time deposit will be the sameas with simple interest.
Example: Annually Compounding
Principal $1,000Time 3 yearsInterest Rate 5%
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Year 1 Interest = Principal x Rate x Time= 1,000 x 0.05 x 1 = $50
Year 2 Interest = Principal x Rate x Time= 1,050 x 0.05 x 1 = $52.50
Year 3 Interest = Principal x Rate x Time= 1,102.50 x 0.05 x 1 = $55.12
When this 3-year time deposit matures, the total compoundedinterest is $157.62.
Compounding More Often Than Annually
Compounding can occur as often as daily. However, quarterly orsemi-annually are the most popular.
Interest = Principal x Rate x Compounding Period (Time)
Example: Quarterly Compounding
Principal 1,000Rate 5%Compound Quarterly
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1st Quarter Interest
= 1,000 x 0.05 x 312
= 50 x 0.25 = $12.50
2nd Quarter Interest
= 1,012.50 x 0.05 x 312
= 50 .63 x 0.25 = $12.66
3rd Quarter Interest
= 1,025.16 x 0.05 x 312
= 51.25 x 0.25 = $12.81
4th Quarter Interest
= 1,037.97 x 0.05 x 312
= 51.90 x 0.25 = $12.97
Total Quarterly Compound interest for one year = $50.94 vs.$50.00 with simple interest or compound interest annually for thefirst year.
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TYPES OF ANNUITIES
An annuity is a series of payments, made annually or more frequently.Annuities are classified into two groups. Classification depends uponwhen the annuity payments begin. The two types of annuities are:
• Immediate Annuities• Deferred Annuities
Immediate Annuity
As its name implies, an immediate annuity is one in which anindividual makes a lump sum deposit and receives paymentsimmediately after the contract is purchased. This type of arrangementis known as a single-premium annuity. However, it should be notedthat not all single-premium annuity contracts are immediate.
The proceeds from an immediate annuity may be distributed inthree different ways, and this decision is made at the time thecontract is purchased.
• Straight Life AnnuityThe annuitant may take the distribution for as long as the
annuitant lives, and then the annuity ceases.
• Joint and Survivor AnnuityWith this alternative the annuitant will receive a percentage
of the straight life amount, and once the annuitant isdeceased, a percentage of the benefit will continue to be
paid to a surviving spouse (or other joint annuitant).
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• Ten Year (or other time period) Fixed PeriodThis alternative will pay benefits to the annuitant and abeneficiary for a period not to exceed ten years. After this ten
year period, benefits will no longer be payable.
Note: Other variations and combinations are also available,especially Life Income with a minimum guarantee period such as tenyears. If death occurs during the guarantee period, the survivingbeneficiary receives the income for the balance of the guaranteeperiod. Otherwise, the income continues for the lifetime of theoriginal annuitant.
Deferred Annuity
The deferred annuity works differently from the immediate annuity.With the deferred annuity an individual will make payments or alump sum deposit to an insurance company with the expectation ofsome future benefit. The deferred annuity’s major benefit is the taxdeferral of interest earned during the deferral period.
The payments to the annuitant do not begin until some future pointin time. A single premium may be paid as in the case with theimmediate annuity, or an investor may make installment paymentsinto the contract until the annuity payments are to begin. All of theannuity payout options are then available.
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Fixed Vs. Variable Annuity
When an individual invests in a fixed annuity, this means that theinterest rate is fixed for a specific period of time. Because theinterest rate remains fixed it may not provide a hedge againstinflation. An individual may purchase an annuity and be satisfied withthe return at the present time, but because of the increase in the costof living, the investor may find that the income is inadequate.
The variable annuity offers the investor the chance of keeping upwith inflation. The variable annuity is purchased just as the fixedannuity but a value is assigned to each accumulation unit within thevariable annuity, based on the type of underlying investment suchas equity or bond funds.
With the variable annuity, the value will change as the value of theinvestment portfolio fluctuates.
This means that due to the fluctuations in the portfolio, the paymentto the annuitant may fluctuate, period to period. Nevertheless,variable annuities can offer the investor numerous equity or fixedincome options for tax-deferred growth.
Split Funded Annuity
Annuities are popular with investors seeking income and taxdeferral. The split-funded annuity provides both. This vehicle isused mostly by retirees and/or individuals needing income with littlerisk to principal.
A lump sum investment is divided into two parts. One partpurchases an immediate annuity and the other part purchases asingle premium deferred annuity (SPDA).
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• Income Account: Current income is paid from the income
account for a set number of years.
• Accumulation Account: Investment grows tax-deferred in
the SPDA. Interest is credited based on a current rate, with
a minimum rate guaranteed.
The following example illustrates the concept of a split-funded annuity.
Split Funded Annuity10-Year Term Certain Immediate Annuity
Single Premium Deferred Annuity(SPDA)
For: Tom Masters Male Age 55
Original Investment$100,000.00
Initial premium divided to purchase immediate
annuity and SPDA.Premium
$55,839.47
Compounded at 6.00% for 10 years
will grow to:
$100,000.00
SPDA funds targeted to match your original
premium when monthly payments
end.
Funds grow on tax-sheltered basis.
Total income from monthly payments
Monthly tax-advantaged
income
$454.41 per month approximately 80% of which is tax free.Guaranteed payable
for 10 years.
Total guaranteed 10-year income
$54,529.20
Premium$44,160.52
For Tax-Favored Income:
Immediate Annuity
For Tax-Deferred
Growth:Deferred Annuity
Assumes a constant 6.00%
interest rate
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3 17.505,66 03.710,16
4 50.694,07 28.748,26
5 28.527,47 62.337,46
6 73.902,97 62.576,66
7 39.169,38 15.576,86
8 46.999,88 87.537,07
9 26.933,49 58.758,27
01 00.000,001 95.340,57
11 00.000,601 09.492,77
21 00.063,211 47.316,97
31 06.101,911 61.200,28
41 07.742,621 22.264,48
51 65.228,331 79.506,68
61 19.158,141 79.506,98
71 30.363,051 51.492,29
81 18.483,951 79.260,59
91 09.749,861 68.419,79
02 77.480,971 13.758,001
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OTHER INVESTMENTS
This section covers:
• Options• Collectibles• Precious Metals - Gold & Silver
Options
In recent years there has been an increased usage of options. Ineveryday language an option is simply a choice - the right to dosomething or not to do something. In a more technical aspect, anoption is:
A contract that gives an individual the right to buy or sell a specificsecurity, at a specific price, within a specific time period.
Options come in two basic forms: calls and puts.
A call option is a contract allowing its owner the choice, for alimited time, of purchasing or not purchasing a specific security at adesignated price.
A put option is the opposite; it allows the owner to sell a specificsecurity at a designated price within a specific time period.
A contract is an agreement between two individuals or parties.With option contracts, there is a buyer (owner) of the contract onone side, and the seller (writer) of the contract on the other side.The owner of the option has the right to buy or sell the securitynamed in the contract, and the seller of the option has theobligation to take the other side of the agreement if the buyerchooses to exercise the contract.
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Think of options this way:
• Call Option is the right to call securities away from theoption writer.
• Put Option is the right to put securities to the optionwriter.
Put and call options are currently available covering four types ofunderlying interests:
• Common Stocks• Stock Indexes• Government Debt Securities• Foreign Currencies
The most familiar types of options are those on common stocks.
Option Terminology
There are numerous terms and phrases used in the options arenathat may be new to those not acquainted with the options market.The following items are commonly used option terms.
Strike or Exercise Price refers to the per share price of the stockto be bought or sold during the transaction of the option.
In the Money is used to denote a situation in which the generalmarket price of the stock exceeds the strike price in the optionscontract. The option now has intrinsic value.
Out of the Money refers to a situation when the stock’s currentmarket price is less than the strike price.
At the Money refers to a situation when the stock’s current marketprice is equal to the strike price.
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The Premium is the price per share (100 shares in a contract) thebuyer pays for the option. For example, if a premium is $4, thatindicates $400 ($4 x 100 shares of stock).
Naked Option is a situation where a seller enters into an optionsagreement and does not own the optioned stock.
Covered Option is one in which the writer (seller) of the optionalready owns the stock being optioned.
Option Positions
Now that we are familiar with some of the option terminology, it isimportant to determine if you want to take a bullish or bearishposition in the market. The matrix below will help you determineyour market position:
Bullish Buy Calls Write PutsBearish Buy Puts Write Calls
Buying Calls
Since call buyers are bullish, the individual investor expects theprice of the underlying security to increase in value within thecontractual time period. Let’s look at an example in which TomMasters purchases an option contract.
Tom buys 1 Ford November 50 call at 3.
Option Position: BullishNumber of Contracts: 1 (100 shares)Underlying Security: Ford Motor CompanyMonth of Expiration: NovemberExercise Price: $ 50 (Strike price)Premium Paid $ 300Current Stock Price: $ 52
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Tom holds one option on Ford stock. This option gives him the right tobuy 100 shares (each contract usually gives the investor the right to100 shares) of Ford at the strike or exercise price of $50 before thecontract expires in November.
If Tom does not choose to exercise his contract to purchase theunderlying stock at $50 per share, all he would lose is the $ 300premium he paid for the option.
Tom anticipates the price of the Ford stock will go up in valuebetween now and November. If Tom is correct and the price of theFord stock is trading at $56 for example, before the expiration ofthe contract, he can sell the option at a profit of approximately $6per share. ($56 -$50. Don’t forget that Tom paid $300 for thisprivilege, so he would make a profit of $300.)
What if Tom is wrong and the stock is trading below $50? Tom willnot exercise the option because this would mean buying stockabove the current market price. Instead he would let the optionexpire worthless and lose the initial $300 he had invested.
Writing Calls
We mentioned earlier that an option contract involves two parties;each option contract must have a buyer and a seller. For Tom tobuy 1 Ford November 50 call at 3, there had to be a seller willing tosell 1 Ford November 50 call at 3.
Let’s say that Ann wrote (writing is the same as selling) the above-mentioned option; she may be called upon anytime beforeNovember to deliver 100 shares of Ford stock if Tom (the callbuyer) exercises his option.
If Tom does not exercise his option, Ann will keep the $300premium that Tom paid her for entering into the agreement. (Notethat Ann received $300 up front to enter into the agreement.)
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Because Ann wrote the options contract, she is taking a bearishposition, hoping the price of the security declines and the optiongoes unexercised; this way the $300 she received up front fromTom becomes her profit.
On the other hand, Ann is taking one of the riskiest optionpositions. Her loss is essentially unlimited. How high is up? If thesecurity went up to $1000 per share, she would lose $950 pershare or $95,000 on her contract!
Investors who write calls are speculating that a stock will notgo up.
Let’s look at another example:
Ann sells 1 Ford November 50 call at 3.
Option Position: BearishNumber of Contracts: 1Underlying Security: Ford MotorMonth of Expiration: NovemberExercise Price: $50Premium Received: $300Current Stock Price: $52
As the writer of the option, Ann has agreed to sell 100 shares ofFord Motor for $50 a share, sometime on or before the expirationdate in November. Since the price for the option here is $3, Annwill receive $300 up-front when the contract is made.
If the price of Ford goes down to $45 by the expiration date, theoption will not be exercised, because the buyer could purchase theshares in the market for less than $50. In this case, Ann keeps thepremium she received. If the price goes up to $55, Tom willexercise the option. Tom would be able to purchase 100 shares ofFord at $50, while others would have to pay $55. Here Ann willlose $5 per share because she will have to go into the market andbuy 100 shares of Ford for $55, and turn around and sell them to
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Tom for $50. (Remember Ann received $3 a share for the optioncontract, so she netted a $2/share loss or $200.)
Buying Puts
When an individual purchases a put contract, the investor is takinga bearish position in the market.
Believing that the price of a security is going to decline, Bill mayenter into an options arrangement and purchase a put contract.Let’s say Bill engages in the following transaction:
Buys 1 QRS October 30 put at 4 ½.
Option Position: BearishNumber of Contracts: 1Underlying Security: QRS CorporationMonth of Expiration: OctoberExercise Price: $30Premium Paid: $450Current Stock Price: $28
Bill has acquired the right to sell 100 shares of QRS stock at astrike price of $30 per share anytime between now and theexpiration date in October. For this privilege, Bill paid a premium of$450 to the writer of the put.
Bill thinks that the QRS stock will sell below $30 per share betweennow and October. If this bearish outlook is correct, Bill can sell theQRS option at a profit because the current market price of thesecurity is less than the strike price of the contract.
Investors usually purchase put options because they expectthe underlying security to decline in value. If the decline doesoccur, they can profit in one of two ways. The investor can exercisethe option to sell the stock, or sell the options contract itself,because the decline in the price of the stock causes the value ofthe options contract to increase.
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A put contract is valuable to own in a declining market when theexercise price is higher than the underlying security. This potentialreward keeps increasing as the value of the stock decreases.
If the stock becomes worthless, the investor’s reward will be equalto the strike price less any premium paid to enter into theagreement.
Let’s say that, in the above example, Bill exercised the option whenthe price of the underlying security was at $20. How much wouldBill profit or lose? Bill would profit somewhere near $550. (Thecurrent value of the option would be near $10: 100 times $10 is$1,000, less the $450 Bill paid to enter into the agreement equals$550.)
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Writing Puts
When an investor writes or sells put option contracts, the investor istaking a bullish position in the market, and is hoping that there willbe an increase in the value of the underlying security.
Shanda writes the following options contract:
Writes 1 QRS October 30 put at 4 ½.
Option Position: BullishNumber of Contracts: 1Underlying Security: QRS CorporationMonth of Expiration: OctoberExercise Price: 30Premium Received: $450Current Stock Price: $28
Shanda must buy 100 shares of QRS stock at $30 per share upondemand from Bill (the put buyer). Thus if Bill decides to exercisethe option, Shanda must pay $3,000 for the stock. Shanda’sobligation lasts only until the option expires in October.
For assuming this risk and entering into the contract, Shandareceives $450 in premium from Bill.
When Shanda writes an option and receives the premium of $450,she expects the stock to go up in value. If this bullish outlook iscorrect, and the stock price rises above $30 before the optionexpires, Shanda’s profit is $450.
If the price of QRS goes down to $24, however, Bill will want toexercise his option. Remember he purchased the right to sell QRSat $30. In this example, Shanda would have to buy 100 sharesfrom Bill (who bought them in the market place at $24) for $30 ashare, sell them for $24, and lose $6 a share. However, shereceived $450 for the contract, so she would lose $150.
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Other Option Strategies – Straddles andSpreads
A Straddle is the purchase of a combination of a call and a put onthe same stock with the same strike price and the same exercisedate. The buyer of a straddle believes the underlying stock’s priceis highly volatile, capable of going up or down. Each part of thestraddle can be exercised separately. The price of the stock mustrise and fall enough to equal both the put and call premiums.
A Spread is the buying and selling of an equivalent option differingin one aspect such as maturity. Spreads are used to reduce risk.
There are two basic types of spreads.
1. Money Spread2. Time Spread
A Money Spread is made up of the purchase of a call option at onestrike price and the sale of the same option at a different strikeprice.
Example: Buy 1 Ford January 50 calland
Sell 1 Ford January 60 call
A Time Spread is the purchase and sale of identical contractsexcept for the expiration dates, which are different.
Example: Buy 1 Ford January 60 calland
Sell 1 Ford April 60 call
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If the priceof the
stock:
Price goes up,
Exercise the option or -
you can sell a closing call
making a profit.
Price stays the same,
Option not exercised -
you lose the premium paid for
the option.
Price goes down,
Option not exercised -
you lose the premium paid for
the option.
Price goes up,
Option not exercised -
the price received for the put
is your profit.
Price stays the same,
If option not exercised -
the premium received for the
put option is your profit.
Price goes down,
Option exercised -
you can purchase a closing
put, or you must purchase the
stock at the strike price.
If the priceof the
stock:
RESULTS
BUY A CALL SELL A PUT
If you believe the stock's price will go up
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If the priceof the
stock:
Price goes up,
Option not exercised -
you lose the money paid for
the option.
Price stays the same,
Option not exercised -
you lose the price of the option.
Price goes down,
Option exercised -
you can sell a closing put at a
profit or sell the stock.
Price goes up,
Option exercised -
you can buy a closing call or
you must deliver the stock and
sell it at the exercise price.
Price stays the same,
Option not exercised -
the premium received for the
call is your profit.
Price goes down,
Option not exercised -
the premium received for the
call is your profit.
If the priceof the
stock:
RESULTS
BUY A PUT SELL A CALL
If you believe the stock's price will go down
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COLLECTIBLESCOLLECTIBLESCOLLECTIBLESCOLLECTIBLESCOLLECTIBLES
As with any investments, collectibles should be given carefulconsideration.
• Does the item meet your objectives?• Why do you want to purchase it?• How much do you know about the subject?• Is there a resale market?
Collectibles cover a broad range of items.
• Paintings and other art forms• Various antiques• Coins• Model Trains• Firearms• Baseball cards• Stamps
In general anything that is of interest and is in limited supplycan be a collectible.
Collectibles should be purchased because you enjoy owning theitems for your own satisfaction. The market for these items isusually very limited.
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Where to Purchase Collectibles
Regardless of whatever items you decide to collect, you mustnarrow your scope and become familiar with available sources.Your obvious sources include:
• E Bay/Internet• Dealers• Auction Houses• Art Galleries• Wholesale/Retail Stores• Other Collectors
If you are a novice and need a place to start, try the public library andthe internet. Get as much background information as possible toimprove your overall knowledge about the subject matter.
Buying at Auctions
Auction houses provide a source for a wide variety of collectibles.Most have in-house experts that may be able to answer questions.
The auction catalog will provide useful information on the historyand current conditions of the items for sale. The conditions of thesale will also be listed in the catalog.
The following are things to do or be aware of at an auction:
• Obtain an auction catalog• Study the terminology• Attend any pre-auction exhibitions• Ask for cost estimates• Arrive early for a good location• Watch your competition• Do not exceed your pre-set limit
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Precious Metals - Gold and Silver
Of the precious metals used as investments, gold and silver are themost well known. These investments are high risk by their very nature.Nevertheless, gold and silver are glamour investments that enticecountless novice and seasoned investors to invest too high apercentage of their total assets.
Current wisdom suggests limiting one’s investments to five to tenpercent of one’s total portfolio. Your age and current financialposition, as with any investment, play a major role in allocatingmoney for investments.
Investments such as stocks and bonds potentially yield some type ofreturn simply by holding them over time. Holding gold and silver,however, can actually cost the investor in terms of storage andinsurance costs.
It is possible to lower the risks associated with investing in preciousmetals by diversifying within that category. Instead of just buyinggold, maybe include silver and platinum in the metals portion ofyour portfolio. Buying shares of stock in mining companies canalso add another dimension to diversification.
Marketability is a consideration in any investment, includingprecious metals. Metals such as gold and silver are marketabledue to their trading activity. However, platinum and palladium, forexample, are not as marketable due to much lower trading activity.
Investing in precious metals requires some decision-makingregarding what form your investment will take. Listed on thefollowing page are several forms that your investment in preciousmetals can take.
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Bullion Bars - These are usually rectangular, brick-shaped pieces ofgold, silver, platinum or palladium. Their sizes and weights vary fromlight weight (a few grams) to heavy pieces.
Bullion Coins - These are represented mostly by gold coins,although silver and platinum coins exist. Popular coins such as theCanadian Maple Leaf and U.S. Gold Eagle are examples of thiscategory.
Bagged Coins - This category is popular for silver. Pre-1965dimes, quarters and half-dollars, used in everyday U.S. currency,were 90% silver. These coins are bagged with $1,000 worth ofcoins, (dimes, quarters, half-dollars) weighing 723 ounces. Thevalue is tied to the market price of silver, not the face value of thecoins. This type of silver is referred to as “junk silver.”
Numismatic Coins - These are rare coins that are normallypreferred by coin collectors for the coin’s rarity rather than its metalvalue.
Metal Certificates - This is a document that states your ownershipof a specific amount of a particular metal. The certificates claim togive the investor the benefits of owning the metal without theheadaches of insurance, storage, etc.
Mining Stock Shares - These are shares of common stock incompanies that mine and process precious metals. This is anindirect participation in the precious metals market.
The allure of precious metals is usually enhanced during times ofhyper-inflation (over 7% per year). In normal times, the investorshould carefully examine the risks and potential rewards ofprecious metals compared to other available opportunities.
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INTRINTRINTRINTRINTRODUCTION ODUCTION ODUCTION ODUCTION ODUCTION TTTTTO DEBTO DEBTO DEBTO DEBTO DEBTMANMANMANMANMANAAAAAGEMENTGEMENTGEMENTGEMENTGEMENT
As investors, we have almost limitless opportunities. We can investin stocks, bonds and money markets, either directly or through mutualfunds. We can buy real estate, options and collectibles. Investmentscan be purchased with or without borrowing. We mentioned marginloans earlier, and indicated the risks and rewards available throughleverage.
Incurring debt to finance investments is, of course, not the only useof debt. An important part of comprehensive financial planning isthe prudent use of credit and debt in all respects. Unwise debtmanagement practices inhibit the ability to accumulate wealththrough investments. Proper use of credit can enhance investmentsuccess.
In this section, we discuss some basic concepts related to debt andcredit management. Keep in mind that one of your bestinvestments is the avoidance of high cost debt.
Credit is a means of buying a service or merchandise NOW andpaying LATER. It allows us to enjoy our purchases immediatelyand pay for them while we enjoy them. It enables millions ofAmericans to achieve their goals such as buying a new home, acar, getting married, putting a child through college, or makinghome improvements.
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Credit comes in a variety of forms. Some of the credit tools availableinclude:
• personal loans• lines of credit• mortgages• store charge accounts• credit cards
All forms of credit fall into one of two categories: Open End CreditPlans or Closed End Credit Plans.
Open End Credit Plans
Open end credit plans are also known as charge or revolving-creditaccounts. They allow repeated debits on an account up to thecredit limit. Payments may be minimum installments generallybased on a percentage of the credit balance or paid in full. There isusually a finance (interest) charge on the balance. Credit cards,retail store charge cards and lines of credit are all examples of Open-End Credit Plans.
There are three different types of credit cards available today—bank cards, retail cards and travel and entertainment cards.
• Bank Cards
Bank cards are credit cards offered by financial institutions such asa bank or savings and loan. Bank cards include VISA, MasterCard,and Discover. Bank cards grant credit to individuals, allowing themto purchase services or goods from third parties. Banks generallyallow us to pay a minimum balance, larger installments, or thebalance in full. Usually there is a charge such as an annual fee forthis service.
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Bank cards are usually governed by the laws of the state in which thebank card company’s operations are located; (e.g., your residence isin Maine and your bank card company is in Colorado). Your creditcard agreement is governed under the laws of Colorado. Coloradolaws may allow the credit card issuer to charge higher interest ratesthan the law allows in Maine.
• Retail Cards
Retail cards are credit cards issued by department stores andgasoline companies. Credit is extended to the customer directlyfrom the merchant authorizing the credit. There are usually noannual fees associated with this type of card.
Retail charge agreements are governed by the laws of the state inwhich you live and not by the state where the retail store’s homeoffice operation is located.
• Travel and Entertainment Cards
Travel and Entertainment Cards include American Express, CarteBlanche and Diners Club. They are credit granted by third parties,which require balances to be paid in full. There is also an annualfee associated with the use of these types of credit cards. Thestate in which the customer resides governs the amount of interestthat may be charged, the opposite of bank cards.
• Closed-End Credit Plans
Closed-End Credit Plans, also known as installment plans, arecharacterized by vehicles such as personal loans, mortgages,home equity loans and car loans. Principal and interest payments areusually amortized over the life of the loan, are a predeterminednumber of equal payments, and are based on a fixed interest rateof the outstanding balance. Usually the item being purchasedserves as collateral for the loan.
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Mortgages are an example of a closed-end credit plan where the realproperty is used as collateral for the loan. Loan interest deductible onloans secured by a residence has been limited to $1,000,000 of suchdebt.
Home Equity Loans are especially popular since the interest onloans up to $100,000 is entirely deductible while other types ofconsumer interest are generally no longer deductible. Home equityloans allow you to borrow money based on the equity you have inyour home. In most cases, financial institutions allow you to borrowup to 70 to 80 percent of the current value of your home minus anycurrent indebtedness, use the money for anything you like, andhave all interest entirely deducted. Any interest charged onamounts over $100,000 and not used to improve the home will betreated as non-deductible consumer interest.
Example:
Purchased price $70,000Current market value $100,000Current indebtedness $50,000
80% of $100,000 (current market value) = $80,000Minus $50,000 (current indebtedness) = – $50,000Permitted home equity loan = $30,000
• Secured Loans
Secured loans are loans that require property to be used ascollateral to support the loans. The asset pledged will be forfeitedin the event of a default by the borrower.
• Unsecured Loans
Unsecured loans are loans that require no security to be used ascollateral. Loans are based on the applicant’s income and ability torepay the loan. These are frequently referred to as “Signature Loans.”
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• Debit and Secured Cards
These types of cards strongly resemble the regular bank cards. Themain difference is that you are not borrowing money from the bankinginstitution. Instead you make deposits into an account with a creditorand borrow money against the funds you deposited.
With debit cards you are actually debiting money you havedeposited with the financial institution in a money market or savingsaccount. Since you are using your own money there are no interestcharges with these types of accounts; however, there may betransaction fees imposed.
Just as the name implies, secured credit cards are secured by adeposit you make with the financial institution issuing the card. Forexample, the creditor will allow you to charge up to $1,000, but youmust also maintain an account balance of $1,000 with the creditorthat issued the card. In the event you default, the creditor usesyour $1,000 deposit as collateral. These cards are generally usedby individuals with adverse credit ratings, and are thereforeexpensive in transaction fees and application fees.
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GETTING CREDIT
It’s easy to get credit! As long as there are no adverse reports inyour name, credit companies make getting credit extremely easy, aswell as making it equally easy to stay in debt. Creditors like to grantcredit; that’s how they make money.
Getting Credit for the First Time
Getting credit can be difficult for individuals who have neverestablished credit before. So how does the first-time applicant getcredit?
• Open a checking or savings account at a local bank.
• After you have established an account at a bankinginstitution, request a small loan - one that you can afford to
make the payments. Your loan and payments will be reported
to a credit bureau, thus establishing credit.
• If you are a college student, get a student charge card. Many
times, creditors offer special applications for students whohave never established credit before.
• If you belong to a particular organization that offers a creditcard, apply for it. Because you belong to an organization that
is sponsoring a credit card, it may be somewhat easier to get
credit.
• Request a car loan. Most institutions will grant car loans
because they can repossess it if you fail to meet thepayments. It is customary with most institutions to finance
80% of the purchase price, with a 20% down payment. If this
is your first loan, you may have to put more than 20% down.
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• Get a Cosigner. Often, lending institutions will require a
cosigner on a loan for a first-time borrower. The amount of
the loan will be based on your ability to pay, but the cosignerbecomes responsible for payments if you should miss a
payment.
Shopping for Credit Cards
Most people spend more time shopping for their peanut butter thanthey do for credit. Making the correct credit purchase decision isextremely essential to our financial well-being. The cost of using acredit card could significantly increase our cost of a purchase, if allfactors involved in purchasing credit are not evaluated. Forexample, some credit cards charge higher interest rates, in somecases as high as a 21% annual percentage rate, while others haveannual percentage rates as low as 12.5%. Some have “teaser” ratesas low as 4.9% (or lower) that can be raised under certain conditions,like late payments or a six-month introductory period.
Since lending institutions are highly competitive and new productsare constantly being offered, it is well worth your time and effort toperiodically shop your credit products. Not only does the interestrate vary from company to company, but also fees and graceperiods, which could have a significant effect on your actual cost toborrow. You should ask yourself the following important questions,when shopping for credit:
• What is your grace period, if any?
• What is your annual percentage rate?
• What annual or monthly fees/charges, if any, are associated
with this card?
• What balance computation method is the company using?
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• What is the line-of-credit amount?
• Are there personal check cashing privileges?
• How widely accepted is the card?
• Is there insurance protection?
• Does the card have access to money machine networks?
Grace Periods
If you’re an individual who pays the balance in full every month, youshould be more interested in a card that has a grace period than acard with a low interest rate. If you have a card without a graceperiod, you will be charged interest from either the date of purchaseor the actual date the transaction is posted.
Some companies have a grace period for as many as 45 days. Forexample, you might have charged an item on June 1, received yourbill on June 30, and have until July 14 before the billing due date.
It is also important, if you’re someone who pays your balance in full,that you are sure to pay the entire balance. If you’re as much as adollar short on paying the entire balance, you may be charged theinterest on the entire balance.
On the other hand, if you’re someone who does not pay your bill infull every month, and you pay only minimum payments orinstallments, you should be more concerned with shopping for acard with a low interest rate. Similarly, if you use your card for alarge purchase, in other words, as a substitute for a personal loan,you might want to consider shopping for a personal loan with alower rate than a credit card. This would ultimately reduce yourtotal interest charges.
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Fees and Charges
Be conscious of the fees and charges credit companies impose onyour credit cards. Some of these charges include monthly fees,whether you use the card or not, late payment fees, over-the-limitpenalties and transaction fees.
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HOW CREDITORS GRANT CREDIT
Rating Systems
A lot of people think of banks as service organizations. If youremember that banks are in the business to make a profit and theydetermine their loan policies and decisions on the risks they face,you will be better prepared for the process of submitting a creditapplication. Once a creditor receives your credit application it isscored to determine whether you will be a good credit risk.
In the past creditors have relied on the “three C’s”:
• Character
Character indicates your willingness to pay, your credit history,stability, and reliability. For example, you are scored based on howlong you’ve been at your current residence, whether you rent orown a home, current and prior employment history, current liabilityamounts, and whether you pay your bills on time.
• Capacity
Capacity indicates whether or not you can afford these additionalloan payments. Your monthly expenditures, income and employmenthistory are measured. For example, what is your job description, yourcurrent monthly income and expenses, and total number ofdependents.
• Collateral
Collateral indicates your available property, which may be used tosupport the debt, should you fail to repay. It could include itemssuch as savings accounts, a home, investments or other property.
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Many creditors have instituted an elaborate computer rating systemwhere an applicant receives different values/grades for variouspersonal criteria. Creditors will rate you based on as few as six or asmany as 20 different components. You receive a grade for the variouscomponents and then your score is totaled. If your total exceeds theirpassing score, then you will more than likely be extended the credit.On the other hand, if it falls short, you will be denied the credit.
All creditors use different credit-scoring systems. It is possible tobe granted credit from one creditor and denied credit from anotherbased on identical information. Creditors are not required to revealyour scores and they may use whatever scoring system theychoose so long as they don’t discriminate.
Some lenders will assume more risk than others. That is, youmight find one creditor that extended you credit and another thatwouldn’t. The one that granted the easy credit is taking more riskand therefore, you’ll pay a higher rate of interest in most cases.
Remember, lenders make money by granting loans. They likeloans on their books. Why? It’s simple. Lenders make money byoffering you 5 percent on a savings account and loaning you themoney out at 10, 11, or 12 percent. This difference is what is calledthe “spread”. The spread must be large enough to pay the lender’soperating expenses, absorb occasional credit defaults, and yield anet profit. A creditor does not want to lend money to someone whowon’t repay it.
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KEEPING CREDIT
Staying Current
To assure favorable reporting of your account, you should alwaysmake your payments on time. Mail your payment a couple of daysbefore the due date or, if possible, personally deliver the paymentto the creditor by the due date to assure your payment is receivedon time. Some credit companies will charge a late payment fee forpayments not received by the due date. If you notice you’re beingcharged late payment fees, call your creditor to determine whenthese fees are being assessed. Most creditors will allow a five toten day grace period beyond the payment due date before chargingthe fee, while others charge the fee on the payment due date.
Always follow the creditor’s instructions when paying the bill. Makesure you are mailing your payment to the address indicated forreceipt of payments. Always write your account number on yourcheck and return any detachable portions of your statement withyour payment. If your creditor does not supply you with returnpayment stubs, jot a note to the creditor stating your name,address, account number and amount of your remittance and mailwith your payment.
If you are going to be late on a payment, try to make at least apartial payment by the due date. Always make a phone call to giveyour reasons for your tardiness.
Finally, when you receive a statement, always make sure yourpayment has been credited to your account.
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Repayment Priorities
All debts should be paid according to the terms of your agreements.Note that the less you pay and the longer you delay your payments,the more it costs you to borrow. However, be aware of some of thecosts that could be incurred when using credit.
Hidden Fees
Always look out for hidden fees including late-payment penalties,which were discussed previously, and over-the-limit charges. If youare being charged an over-the-limit fee, you should make everyeffort to reduce your balance below your approved credit limit. Beaware that some creditors charge an over-the-limit fee if you go asmuch as a penny over your credit limit. Others charge the fee ifyour balance exceeds 15 percent of your credit limit.
If you are having difficulty reducing your indebtedness, contact yourcreditor and request that your credit limit be increased. This shouldavoid any additional over-the-limit fees. Be careful in taking thisstep though; this can be just the ticket for getting deeper into debt.
High Interest Rates
Interest rates have fallen dramatically over the last few years, butborrowers still continue to pay as much as 21 percent on creditcards. If you loan money to an entity such as the government or acorporation, let’s say, for example, in the form of a bond, yourobjective is to loan the money for the longest period of time for thehighest rate possible. When a creditors loan you money, theirobjective is the same. If you begin to get in the habit of thinkingthat paying off a debt is the same as earning money, you’re on theright track. If you pay off an 18 percent credit card, it’s the same asa guaranteed 18 percent earned.
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The first step to earning a “guaranteed” interest rate is to list all yourobligations from the highest interest rate to the lowest. Then, repaythe highest rate of interest debts first. You might even want toconsider taking out a lower rate personal loan or shopping for a lowerinterest rate credit card. Remember, these high interest rates arecosting you money.
Another important consideration when setting debt repaymentpriorities is to remember that consumer interest is no longer taxdeductible. Prior to Tax Reform Act of 1986, if you itemizeddeductions on your federal income tax return, the interest you paidin any year was 100% deductible. This was a definite tax benefit, ifyou happened to have a large amount of consumer debt. But thisdeduction is no longer available, so one of your primary goals inrepaying debt should be to pay off all consumer debt as soon aspossible.
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CREDIT FRAUD
Are you able to list every piece of valuable information in yourwallet or purse? Have you ever had your wallet or purse stolen ordestroyed? Have you ever been in a situation where you’ve had tolist all your credit cards and found it difficult? If this has everhappened to you, you’ve probably learned that keeping a separatelist of these important credit card account numbers, names and phonenumbers in a safe place is essential.
If your credit cards are lost or stolen, your first action should be tocall the creditor and report the lost or stolen cards. In most cases,credit cards have the credit issuer toll free phone numbers listedright on the back of the credit card. Unfortunately, if the card ismissing, how are you going to have immediate access to the phonenumber with no card or separate list?
You should always follow-up your phone call with a letter in writingindicating your name, credit card account number, the exact timeand date the card was discovered missing and the time and dateyou telephoned the creditor reporting the lost or stolen card.
According to the federal Truth-In-Lending Act, you cannot be heldliable for any charges to your account after you have reported themlost or stolen. Even though your maximum liability is only $50 percredit card, the sooner you act, the sooner you stop theunauthorized user of your credit card and reduce your total liability.Some casualty insurance companies have liability coverage forcredit card thefts. Check your policies to see if you can bereimbursed for your out-of-pocket expenses.
As always, be sure to open your billing statements immediately, andcarefully go over each item charged line by line. If you recognizeany unauthorized charges on your statements, call your credit cardcompany.
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The following precautions should be taken to guard againstcredit fraud:
• Keep a separate list of credit card account numbers,
expiration dates and issuer phone numbers and addresses in
a safe place for immediate access.
• When not using your credit cards, keep your cards in a safe
place and don’t routinely carry all your credit cards in yourwallet.
• When you give a sales clerk your credit card for a purchase,watch the card closely to be sure it is only being used for
your purchase and the card you’re given back is yours.
• Carefully review the charge slip receipts and always
compare them with your monthly bill. Are the amounts,
account number and totals listed correct?
• When possible, avoid signing a blank, imprinted credit card
slip.
• If an error is made and a new credit card slip has to be
redone, always make sure the sales clerk destroys theincorrect sales slip in your presence.
• Make sure the carbons from the sales slip are destroyed inyour presence. Never just toss sales slips in the trash
without first tearing them up.
• Never leave your copies of the credit card sales slip lying
around at home or your place of employment.
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• Never give out your account number over the phone for a
purchase unless you initiated the call.
• Never lend your account number or credit cards to other
people to use.
• Make sure your account number is not visible when mailing
your payment.
• Cancel charge card accounts that you don’t use or rarely
use.
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NORMAL CREDIT LIMITS
There are warning signals which tell you how much debt is toomuch, and when you are exceeding your limits. You should beaware of what is referred to as the debt-to-income ratio.
As a guideline, your installment debts such as auto loans, storecharge accounts and bankcards should not exceed 18 to 22% of yourannual/monthly take-home pay. Installment debt does not includerent or mortgage payments, medical bills, food, clothing, etc.
For example, if your total monthly take-home pay is $2,500, yourinstallment debts probably should not exceed $450- $550 permonth.
Note: Average standards for debt to income ratios, includingmortgage or rent payments are 36% to 42%.
One of the most important warning signals is when your total debt-to-income exceeds tolerable limits.
Listed on the following page is a chart, which indicates tolerablelimits on credit obligations. Find your income level to determinewhat total indebtedness is comfortable for you.
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• Suggested Debt to Income Ratios
Income Income DebtPer month Per Year Comfortable Maximum
$ 250 $ 3,000 $ 450 $ 660$ 500 $ 6,000 $ 900 $1,320$ 750 $ 9,000 $1,350 $1,980$1,000 $12,000 $1,800 $2,640$1,250 $15,000 $2,250 $3,300$1,500 $18,000 $2,700 $3,960$1,750 $21,000 $3,150 $4,620$2,000 $24,000 $3,600 $5,280$2,250 $27,000 $4,050 $5,940$2,500 $30,000 $4,500 $6,600$2,750 $33,000 $4,950 $7,260$3,000 $36,000 $5,400 $7,920$3,250 $39,000 $5,850 $8,580$3,500 $42,000 $6,300 $9,240$3,750 $45,000 $6,750 $9,900
After you’ve determined where your debt should be relative to yourtotal income, compare it to what your actual percentage is.
If you’re over the 22% level, you should make every effort to reduceyour debt below the maximum tolerable amount.
If you’re between 18% and 22%, try not to assume additional creditobligations.
If you’re under 15%, you are not overextended. However, you shouldbe familiar with the tolerable limits and be wary not to overextendyourself.
These limits are flexible and are to be used only as guidelines.
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CONCLUSION
By now, you should have a solid understanding of many of the mostimportant investment and debt management concepts. It’s time toput those ideas into practice, as you implement the strategies andtactics most suitable for your individual circumstances. Either onyour own or with the help of advisors, we encourage you to makeuse of what you’ve learned.
· Set Goals and Objectives· Determine Risk Tolerance· Select Investment Tools· Diversify· Establish Asset Allocation Percentages· Employ Suitable Investment Techniques· Monitor Your Progress· Adjust as Necessary
Best of success in your investmentplanning!