Investment Tools

Most people will tell you they have a financial plan. What they really mean is they have a “retirement package” with a pension fund, life and health insurance policies, mutual funds, and the like.

The typical plan is nothing more than a collection of financial products purchased without a clear idea of the total picture.

But investing requires a true plan. Where are you and where do you want to go? Do you just want to be secure? Comfortable? Or rich? Are you set up to retire early, or are you living like a financial yo-yo? These are the sorts of questions you need to answer in order to choose your investments wisely.

Think about it this way: It’s difficult to build a jigsaw puzzle without seeing the cover of the box. Likewise, it’s difficult to invest wisely without a fiscal picture in mind. The most successful investors are the ones who can envision a picture—and who build rather than buy the pieces.

So, how do you build your own jigsaw? First, you choose an image by envisioning your future. Will you retire at age 45 or remain self-employed until 80? Live in a mansion on the coast or in a small condo in the city? Spend your twilight years in a long-term care facility or tended to by a private nurse? Do you want to have too little money or too much money?

Once the image is clear, you’ll have to achieve financial literacy to create it. If you do not know how to make money, what type of income is tax favored or tax penalized, when to sell or when to sit tight, your plan is sure to fall apart. With the proper education and experience, however, you can break your plan down into investment vehicles, such as income-producing property, business franchises, and stock portfolios that will optimize your chances of financial well-being.

Of course, no two financial plans will be alike since dreams and comfort levels are different. But one thing is certain: It will take knowledge to turn your financial dreams into financial reality. So, in this chapter, we’re going to start by covering some fundamental information about investment vehicles. Then, we will move on to a more detailed discussion about investing in the stock and options market and developing an investing process and plan.

EXPAND YOUR HORIZONS

An investment is a financial transaction designed to generate passive or portfolio  income. Some investments, like blue-chip mutual funds or Treasury bonds, offer modest gains with little or no risk of principal, although a major downturn in the market can severely affect the principal value of blue-chip stocks. Other investments, such as commodities or stock in emerging companies, are speculative, with the potential for enormous gains or total loss of capital. Thus, investments can be assets or liabilities.

One thing investments are not: savings. When you save a dollar, you keep it safe and liquid; when you invest a dollar, you assume a certain degree of risk in expectation that the money will grow. Whether you access savings by cracking open a piggy bank or making a withdrawal at an ATM machine, you have immediate access to cash. But remember, once it’s spent, it’s gone. Certainly, everyone needs a rainy-day reserve. The rule of thumb is to have enough to cover three to six months of living expenses in case of emergency. However, keep more than that liquid, and your cash could run through your fingers. That’s because savings accounts return such low interest that taxes and inflation erode the money’s purchasing power.

Instead, expand your notion of investments and your range of investment opportunities. A true investor does not become attached to any one investment option. He or she uses different investment vehicles, such as bonds, stocks, mutual funds, and retirement accounts, to assemble a financial plan, preserve earnings, and accumulate assets.

The following are some of the investment vehicles available to you from the financial markets.

BONDS

When a government agency or private corporation needs to raise money, it offers or issues a bond. An investment banker determines how much money the agency or corpora- tion needs, what the interest rate on the loan will be, and when the loan will be repaid. A bond pays interest over a fixed period. An investor who buys a bond intending to hold it to maturity need not worry about fluctuations in the interest rate. However, for those who want to sell before maturity, current interest rates are crucial. In the bond market, lower interest rates in the marketplace raise bond prices, and higher rates lower them. Thus as interest rates go up and down, a fixed-rate bond becomes either more or less valuable.

Unlike stocks, which are traded through organized stock exchanges, bonds are traded in the over-the-counter (OTC) market. The OTC is not a place; it is a market of dealers who do business over the phone or by computer. All U.S. government, municipal, and most corporate bonds are traded over the counter. In addition, U.S. government securities may be purchased by investors directly from the U.S. Treasury through Federal Reserve banks located throughout the country.

Types of Bonds

There are many kinds of bonds, including the following:

•   U.S. Treasuries—By purchasing a treasury, an investor lends money to the U.S. government for a specified amount of time in exchange for interest payments. Treasury securities are backed by the full faith and credit of the U.S. Government. Treasury bills, or T-bills, are short-term government securities with maturity dates ranging from a few days to 26 weeks. Treasury bills are sold at a discount from their face value. For example, you might pay $970 for a $1,000 bill. When the bill matures, you receive $1,000. The difference between the purchase price and the face value is interest. In this example, it was $30, or 3%. Treasury Notes are issued with maturities of two, five, and ten years and pay a fixed rate of interest every six months. Treasury notes mature longer than T-bills and shorter than Treasury bonds. In February 2006, the Treasury resumed selling 30-year bonds. These bonds pay a fixed rate of interest every six months. They are auctioned only four times per year, in February, May, August, and November.

•   Savings bonds—These U.S. government bonds are issued in denominations ranging from $50 to $10,000. Sold at a discount price, they are redeemed at face value at maturity.

•   Municipal bonds—These bonds are issued by state and local governments as a way to raise money for covering revenue shortages or to fund projects such as building bridges, improving roads, or improving infrastructure. You pay no federal income tax on the interest earned, and no state or local income tax if the bond is issued by the state in which you live. Municipal bonds tend to pay less interest than taxable bonds. While the interest payment may remain steady, the price of the bond may rise and fall with changes in the markets.

•   Corporate bonds—These are issued by companies that need to borrow money. The minimum investment in corporate bonds is $1,000. The interest is taxable, so to induce investors, rates are typically higher than for municipal bonds. Here, too, the interest rate may remain steady, but the price of the bond may rise and fall with changes in the markets. Corporate bonds may be riskier than government bonds because businesses can go bankrupt.

•   High-yield (junk) bonds—These are issued by corporations without solid sales and earnings records or with a dubious credit rating. The chance that the investor will not be repaid is higher with a junk bond because of the issuer’s instability. To attract investors, the issuer offers a relatively high interest rate. The price of a junk bond is more likely to fluctuate than that of any other type of bond.

STOCKS

A stock is a share of ownership in a company. When a private business needs money to operate, develop new products, or expand, its management may decide to issue stock for individual public investors to buy. This could be called a private placement or going public.

A company goes public in an initial public offering (IPO). How many shares a company issues depends on the amount of capital needed; what shares should sell for, given current market prices; and the cost of paying experts to prepare, or under- write, the offering. As part of an IPO, a prospectus or financial profile of the company is published to promote interest.

Once stock has been sold, the price of each share will rise or fall depending on the performance of the company, supply and demand, general market fluctuations, and broad economic trends. When this happens, the company does not directly gain or lose money, but the trend of a stock’s price will affect investor interest in future offerings. If the value rises to $100 or more per share, a stock may split, for example. The number of shares could double while the price of each is halved. This makes the stock more affordable to new inves- tors and allows room for additional growth.

How Stocks Are Traded

Trading in the stock market occurs in stock exchanges, where registered brokers publicly buy and sell individual stocks and bonds. Among the exchanges operating in the United States are the American Stock Exchange (AMEX), the New York Stock Exchange (NYSE), the NASDAQ (National Association of Securities Dealers Automated Quotation System), and various regional exchanges. Except for the NASDAQ, which is a telecommunications system, all are actual marketplaces where trading occurs, and all are regulated by the Secu- rities & Exchange Commission (SEC). There are also exchanges in major cities throughout the world, such as London and Tokyo.

Types of Stock

All stock can be categorized as common or preferred.

Preferred stock is given preference over common stock if a company liquidates its assets. Income to shareholders is based on fixed dividends and redemption dates rather than corporate earnings. Convertible preferred stock gives the owner the option to convert preferred into common stock.

Common stock is the choice of most investors. Owners are entitled to vote on the selec- tion of directors and other important corporate concerns. If a company is forced to liqui- date, owners also have a right to a share in the assets after all debts and prior claims have been satisfied.

Here are just a few of the categories of stock:

•  Blue chip—Stocks of large companies with established records of profitability and dividend payment. Blue chips tend to be more expensive than other stocks, but their value is also considered more stable.

•  Small cap—Stocks of smaller companies. “Cap” refers to capitalization, which is the price of a share multiplied by the total number of shares on the market. While these stocks may fluctuate significantly in the short term, over the long term small caps as a whole have performed well.

•  Growth—Stocks of companies with earnings that have risen faster than average. These companies tend to reinvest profits in the business to maintain a competi- tive edge. Investors hope that, over the long term, prices will rise as the company grows. In the short term, though, price swings can be more dramatic than with stocks that pay dividends.

•  Income—Stocks that pay fairly reliable quarterly dividends. Utilities, such as power companies, are the most commonly held income stocks. Income stocks tend to be relatively stable because of the high level of income they produce, yet a more competitive climate or overall market decline can cause drops in prices.

•  Speculative—Stocks in companies that have no proven track record or dividend history. Often called penny stocks, they sell for $5 or less and come with a high risk.

•  Foreign—The price of foreign stock, which is affected by all the market concerns that drive the prices of domestic stock, is also vulnerable to currency exchange rates, political turmoil, different laws and regulatory oversights, and any number of other issues arising in individual countries.

MUTUAL  FUNDS

A mutual fund is a portfolio  of securities purchased by a professional manager with the pooled resources of many private investors. Each mutual fund share represents a partial share of every stock or bond in the portfolio.  By joining financial forces, investors with limited funds are able to benefit from the knowledge of experts, diversify their holdings, and gain from lower prices and fees that come from buying in quantity. Certain funds are required to buy back shares whenever owners want to sell. As with stocks, the redemption price depends on the value of the securities in the portfolio  at any given point in time.

In addition to the cost of mutual fund shares, investors also have to pay fees. Load funds are sold mostly through brokers, who charge a commission when the fund is either bought (front-end load) or sold (back-end load). No-load funds are sold directly to the public at no additional charge. Both load and no-load funds charge management fees of anywhere from one to five percent, and some include marketing fees. All together, fees can add up to a significant reduction in capital gains.

Types of Mutual Funds

Two fundamental types of mutual funds are closed-end and open-end. Closed-end funds issue a fixed number of shares, which trade on exchanges like stocks. The price of shares depends not only on the value of the assets held, but also on the demand for the shares themselves. Shares in open-end funds are bought directly from the fund and trade according to customer demand.

Here are some of the most common types of funds:

•  Balanced funds—These are a conglomeration of stocks and bonds, usually in a set proportion. They are generally suitable for investors who are willing to accept modest growth in exchange for stability.

•  Equity income funds—These invest in the stocks (equities) of well-established companies that pay dividends. They are an alternative to bond funds for those who want steady income.

•  Income funds—These have the same goal as equity income funds, but they rely on more than just stock dividends to attain it. For example, they may deliver interest on bonds and treasuries.

•  Growth funds—These invest in fairly established companies whose stocks offer long- term growth of equity rather than income, for all dividends are reinvested. There can be a fine line between “growth” and “aggressive growth” funds, the latter of which seek maximum capital gains by investing in new but promising companies or down- on-their-luck firms that may rebound.

•  Index funds—Index funds invest in the same securities tracked by stock indexes such as Dow Jones and Standard & Poor’s, the logic being that few managers can beat their performance. These funds usually have lower management fees.

•  International equity funds—These invest primarily in foreign securities.

•  Bond funds—These are primarily for generating income and offer little or no long- term growth. They are relatively stable, with price fluctuations based mainly on changes in interest rates, and may include corporate bonds, U.S. government and municipal bonds, and mortgage-backed bonds issued by the Government National Mortgage Association (Ginnie Mae).

•  Sector funds—Also called single-industry funds, these invest in specific market sectors such as health care, energy, or telecommunications. They tend to be riskier than average because there is nothing to buffer them from a downward trend in their particular sector.

Like stocks and bonds, funds can experience dramatic drops in value, particularly during a general market decline. In a good market, the very buffers that protect against loss can also limit gains.

In a down market, investors can actually find themselves with taxable capital gains even though the value of their holding has dropped dramatically. This occurs when the fund is forced to sell its holdings (with built-in capital gains) to meet the demands of selling shareholders. Furthermore, loads, management fees, and marketing fees can be sizeable.

RETIREMENT PLANS AND ACCOUNTS

Retirement plans are built by regular contributions paid by a company, an employee, or both. The contributions are deposited in a company-sponsored plan or individual account, which accumulates earnings through investments.

When the employee reaches retirement age, benefits are paid in regular installments or a lump-sum distribution.

All retirement funds offer the advantage of tax-deferred earnings; some even shelter earnings or income. They differ, though, as to the limit of contributions, who can contribute, the age when benefits begin, the number of years it takes to be vested, the fees charged, and portability.

Types of Retirement Plans and Accounts

Traditionally, employers rewarded years of loyal service by providing employees with a guaranteed pension for life. So-called defined-benefit plans were fully funded by the company, with the level of benefit determined by the employee’s salary and years of service at the time of retirement. Defined-benefit contributions were free money that the employer planted and grew for employees.

Not surprisingly, defined-benefit plans are rapidly disappearing in favor of various types of employee-contribution plans, including the following:

•  Defined-contribution plans—These define the amount of contribution an employee can make to a retirement fund, usually as a percentage of salary. Although the plans are company sponsored, employers do not have to contribute. Benefits depend on how much has been deposited and how well the investments have done. Earnings are not taxed until withdrawn. A 401(k) is an example of a defined-contribution plan.

•  Individual retirement accounts (IRAs)—An IRA allows the investor who either has no retirement plan at work or falls below a certain salary level to make annual contributions to a tax-favored account. Money cannot be withdrawn until age 59-1⁄ 2, but there are exceptions to the rule. IRA funds can be invested in any number of vehi- cles, including money-market accounts, certificates of deposit, individual stocks and bonds, mutual funds, and government-issued coins. Self-directed IRAs may allow for additional investment opportunities  such as real estate and gold. In addition to traditional IRAs, there are ROTH IRAs (unlike the former, not tax-deductible) and for the self-employed, SEP and SIMPLE IRAs.

•  Keogh plans—Keoghs cover small business owners and the self-employed. They are similar to IRAs but allow more pre-tax earnings to be invested in a tax- deferred account.

What’s Right for You?

Determining which plans are best for you is a personal decision. Much depends on whether you are an employee, self-employed, or living off passive income; whether you are just beginning your career or nearing retirement; whether your income is high or low; and whether you want to retire early or work forever.

An employer-sponsored retirement plan is one of the few tax-savings opportunities  avail- able to employees. The greatest advantage of retirement plans is this: The more you contribute to yourself, the less you contribute to the government in the form of taxes. Furthermore, if you have an employer who matches your investment, every dollar you contribute automatically earns a 100 percent return. But you have to weigh these advan- tages against a plan’s predefined retirement age of 55, 59, or 70, which dictates when you can withdraw your funds.

STOCK OPTIONS

Stock options allow investors to make commitments to buy or sell a specified number of shares of a stock at a specified price at some point in the future. You will learn more about stock options in another chapter.

COMMODITY FUTURES

When you trade in commodity futures, you are speculating on the future price of a commodity, such as corn, coffee, soybeans, rice, wheat, pork bellies, etc.

Unlike when you purchase stocks or bonds, you don’t really buy or own anything when trading commodity futures. You are basically making an assumption about which way you think the future price of a contract for a commodity is going to head and hoping that you are correct about your assumption.

For example, if you thought the price of a commodity was going to go up in the future, you would buy a futures contract. If you thought the price was going to go down, you would sell a futures contract.

Most of the people who invest in commodity futures are the commercial and institutional users of the commodities they trade. For example, a farmer with an orange crop has a financial interest in the direction the price of oranges will head in the future. Likewise, a company that bottles and sells orange juice has an interest in how much orange crop prices will rise or fall.

Let’s say the farmer with the orange crop can’t pick the fruit and deliver an order for some time. If he believes the price of oranges will go down in the future, he could sell a futures contract equivalent to the size of his crop at today’s price. He is hedging his risk from a future price drop. When his crop is ready, he fulfills his contractual obligation to deliver the crop and is given the price that was arranged at the time of the futures contract.

On the flip side of this example, let’s say the company that bottles and sells orange juice, and therefore needs orange crops, believes the price for oranges will rise in the future. They might buy a futures contract for oranges at the current price. That way, no matter what happens with the price of oranges between now and the time the contract is fulfilled, the company is guaranteed it has to pay no more than the current price (the price current at the time they bought the futures contract) for those oranges.

Individuals with absolutely no ties to the commodity itself can also buy and sell commodity futures. They don’t have to own the commodity or be involved with it in any way. They are, however, required to deposit a portion of the contract with a brokerage firm to ensure they will be able to pay the losses if the trade they are making loses money. The deposit amount, as well as any fees charged, may vary substantially between brokerage firms.

Trading commodity futures isn’t for everyone. Speculating about futures pricing is risky, with many factors being able to affect commodity futures trading. These include factors such as weather conditions (e.g., imagine the impact an active hurricane season can have on the orange crops of Florida), government policies, consumer attitudes, and any other factors that can influence the supply and demand for a particular commodity. Educating yourself further about commodity futures trading can help you better understand the potential risks and potential returns involved.

HOLDING COMPANIES DEPOSITARY RECEIPTS (HOLDRS)

HOLDRS make it possible to have ownership in a diversified group of stocks with just one investment. The securities in HOLDRS represent ownership in the American Depositary Receipts or common stock of several companies that belong to a particular sector, industry, or industry group.

EXCHANGE TRADED FUNDS (ETFs)

Think of ETFs like a basket of securities that track an entire index (such as the broad stock or bond market, an industry sector, or international investments), but trade like a single stock. ETFs offer the opportunity to invest in a single fund that combines both stocks and mutual funds.

SINGLE-STOCK FUTURES (SSFs)

With SSFs, two parties enter into an agreement that commits one party to purchase stock at a given price on a specified date and the other party to sell that stock under the terms of the agreement.

The significant difference between SSFs and the purchase of an actual stock is there is no ownership or voting rights with SSFs. They are similar to futures contracts for bonds, gold, crude oil, and stock indexes.

Your market predictions determine what you do with an SSF trade. For example, if investors think the stock price is going to go up, they’ll buy or “go long”  an SSF contract. But if they think the price of the stock is going to go down, they’ll sell or “go short.”