This is the reference that I use to help me understand finance and investing. I expanding some items when I found I almost understood them, and writing them down allowed me to more completely understand an issue. I am probably wrong on many of these things. Because finance and investing has frustrated me for so long -- I have read many books, and still not understood what is actually happening because they do not explain the inter-relationships between things. Or little details that actually make a world of difference. So, I've taking the time to try to explain some things here, and maybe allow someone else to learn faster than I did. I am no kind of financial advisor, and I often do not mention all, or even more than one technique -- because what I've written about is all that I understand!
In other words, I hope this information helps you, but make sure that you develop your own internal picture or model of finance and investing. That being said, the best way to actually have an investment is to start doing it sooner rather than later; it helps tremendously.
This is a place holder for additional content until i fix the web automation to do something different.
XXX Make notes here on various issues about portfolio design. Work-In-Progress. Maybe pull some sections from other parts of here. Maybe make another page. Tax issues Retirement Diversification Asset Allocation
There are many things to look at when making an investment portfolio. Since I've already started explaining the different types of holdings you could have in a portfolio, start with the following introductions I have about the them. I have some details in there, which you can ignore at first, but look at the big picture of what the holding does, which I've tried to include so that I understand it myself!
Also see Publications & Periodicals for info; the difference is thin.
I like Yahoo a for their charts, and The Street their pocket summary of their position. Many of the Electronic Traders (ScotTrade, E-Trade, and Ameritrade) have great tools for customers to examine stocks and analyze the data. However, too bad they don't let you do it with the ease which Yahoo does.
Some firms have some great portfolio analysis tools to let you look at your portfolio as a whole. Then it breaks your portfolio down along many axises, such as: Asset Allocation, Diversification, Market, ... Morningstar has their Portfolio X-Ray, Cake Finacial has their Investor Quick Check, and I'm still looking for more.
Transfer Agencies are financial institutions which represent a company to record and manage their stock shares. For investors, this is commonly seen in a DRIP, where the transfer agency holds your reinvested stock shares.
A stock is a fractional ownership in a firm or some other enterprise. You own shares of the company, can vote to make decisions in its operation. The value of your fractional ownership varies as the company's fortune varies. Others word used to describe a stock is a security, or an equity.
So what do you get out of owning a company? Well, returns come in three forms:
This section on bonds is quite a bit longer than anything else here. That is because for quite some time I didn't understand bonds very well. Finally, between talking with some of my investment guys on a couple of issues, I found that I had all the pieces of knowledge about bonds, but discovered that I needed just a very few critical interconnects to put it all together.
A bond is essentially a type of loan which you make to someone. In return for using your money, they pay interest to you. Other words for bonds in finance are debt; an emerging market debt fund is a fund which deals with bonds in emerging (new) markets. Yet another name for a bond is income; for example the Emerging Market Income fund is really a bond fund in the same class as the earlier named fund. When a issuer desires to do something, they need money to do so. A Bond is essentially a loan of funds to the issuer in exchange for the bond certificate. In return for the loan of the money, the issuer pays interest on the bond until it is redeemed. A bond is a privileged instrument; if the issuer folds, the holders of the bond have first priority to any assets of the issuer. Second priority would be to loans, and Third priority is to he holders of stock.
Comparing a bond to a loan, the bond actually earns more interest, since the interest is always being developed from the full principal. At the same time, with the bond, the principal is not being returned to you during the loan period, which reduces the income of the bond quite a bit compared to the loan. However, compared to a savings account there is no compound interest. Assuming a $1000 amount, at 5.5% interest, period of a year, with some averaging on the interest returned by the loan:
Bonds are not identified by tickers as stocks and funds are. Instead, they use something called an CUSIP as an identifier.
Low yield bonds have very good ratings. Higher yield bonds have lower ratings, but they get good returns. They are riskier because of that, so they have higher rate of returns to interest people in purchasing them. Very high yield bonds are called Junk Bonds because there is a much higher risk involved in them -- you may never get your money back or the remaining interest payments.
In a strange way, it turns out that long duration bonds are riskier than short term bonds. It has nothing to do with the issuer, but rather market volatility. If interest rates keep increasing, your money in the bond will be under-performing compares to market interest rates. Also, since your bond's rate will be lower than market, its market value compared to its redemption value will be low -- so if you want to sell it, you won't get your principal returned. Conversely, if market interest rate drops, your bond's market value will rise, perhaps even beyond its redemption value, because the interest rate will be something people want to own.
It is suggested that bonds be a portion of a portfolio because they add stability to it. For example, when the stock market drops and/or stock dividends reduce for whatever reason ... the bond will still be producing interest at its guaranteed rate. True, the price of the bond may drop in a downfall due to overall market conditions ... but it also could rise, because suddenly that bond may be of interest because of its returns. The downside of a bond is that there is no capital appreciation involved with it. Because of inflation, when the funds are returned to you by the bond holder, there is no increase in their value. So, you need to watch out -- if the bond interest rate is lower than inflation, you are really loosing money. That is true of most any investment, but due to the long-term nature of bonds can be significant.
The liquidity of bond holdings varies. Why? Well, while bonds are traded, they are not as actively traded as stocks. The trading volume is quite a bit lower. Indeed, some bonds may not be traded for months at a time. Also, if no one is interested in the particular named bond that you hold, you can't sell it! Or, you can't buy it because no one wants to let it go. It may be a really great bond, but if it is unwanted, it isn't going anywhere. If you are quite desperate you can offer, your bond at a value below its face value, to make it more attractive to others. Of course, that means you are cheating yourself of income ... but if you need the liquidity of cash, perhaps some cash is better than no cash. Vice-Versa, if you really want a bond badly, you could offer a premium for it, offer more than trading value for it. Again, that higher price will reduce the overall bond yield, but it may get someone to let go of one of theirs. If you look at the bond market reports in the WSJ (XXX or what others?) you will see a much larger split in the offer / trade prices for bonds than you do for stocks.
Bonds are great income producers, versus stocks which typically generate capital appreciation. To mitigate market issues with bonds redemptions, you can ladder them, as you can CDs (and other fixed duration instruments). To see an example of how to ladder, take a look at the laddering example in the Cash & Cash Equivalent section. I mention Callable bonds below; if you plan the potential of a bond being called into your laddering system, it could possibly turn out to be a benefit instead of an un-planned hindrance.
Cash or Cash Equivalents are just that; money which you have. The big thing about cash investment wise is that it doesn't change value as the market and economy goes up and down. Also, the cash you have is a realized earning; once you convert a holding to cash it will remain that value forever, and not swing up or down with the market. You won't get a gain from it ... but you won't get a loss either.
Some of it may be in the form of actual possessed monies (which you usually find in horror films), but that doesn't gain any interest. So, if you keep money like that it is actually loosing value due to inflation.
The more usual cash are things like savings accounts, CDs, money market funds, and T-Bills. These things are cash or can be converted to cash in short-order. Cash, by definition, has the highest liquidity of any holding. Cash Equivalents have varying degrees of liquidity; for example you may have a to wait some years for a CD to expire. However, if you really needed the funds, you could always take a penalty and get the funds right away.
It is recommended that you keep part of your investment portfolio in cash. Personally I believe that this investment cash should be separate from the standby cash that is required for more short term and urgent needs ... such as unexpected expenses, loss of income or job, etc. By the way, the generic recommendation for that cash reserve is usually 3 months of your normal income. I recommend that split because it will keep you from destroying your investment portfolio when something upsets your life in the short term. If you did not have any cash reserves, you would need to convert your other investments to cash immediately, forcing looses, penalties, and perhaps a tax-disadvantaged situation on yourself.
So, now you have this portion of your investment portfolio in cash. What the heck do you do with it? Well, start by finding a good money market checking account, put the cash in there. However, do not stop there. When the market is great, those accounts often get interest rates as good as a long-term CD. However when the market is bad, you may earn so little interest that you are actually losing money due to inflation. What you should do is place the bulk of your funds in fixed-rate guaranteed return holdings. In other words CDs or certificates of deposit or t-bills or treasury bills. I would not suggest variable rate CDs; they don't protect your money against market down-turns.
So, OK, you have your money in a money-market account. There are these fixed-term fixed-rate instruments you can use. How the heck do you use them???? Well, you use a strategy called laddering. The goal of this strategy is to maximize the liquidity of your cash portfolio while also maximizing yields and protecting yourself against market downturns. One warnings -- this strategy may not get you the ultimate return; however what it does do is give you excellent returns on a regular basis. Instead of trying to explain a ladder, let me show you a ladder that is already running in full swing with $5000 in CDs at 5% Interest.
Now, having shown how a ladder works once it is started, here is how to start a ladder, and also some of the notes on the principles of how the ladder works. The ladder uses fixed rate instruments to guarantee you a rate of return over a long period. For example, say you had $5000 in a money market account. It gets good interest (5%) for 1.5 years, but then the economy goes poorly for 2.5 years (1%) (4) and then recovers and does well for another year (5) at 5% again. Well, you only received the good interest rate of 5% which you wanted for 2.5 of those 5 years, and a crappy interest rate of 1% for 2.5 years. Your overall return would be $5807.60, or an overall return of 3.23% per year. That compared to the $6416.79 or 5.67% rate of return on the CD for the same time period. The ladder, or even a single CD will result in a higher rate of return. The long duration CDs typical have the best interest rates available, to get you the most return.
To start a ladder you need a couple of years of patience, at perhaps some slightly lower interest rates (shorter duration CD == lower rate CD) Don't let it worry you -- at the same time you are already doing the best you can to keep your funds available and earning and protected. Don't open 1 giant 5 year CD, or 5 small 5 year CDs; you don't have access to your funds. Instead, open 5 CDs:
Another thing to consider is the availability of your funds; With the money market they are available at any time. With the 5 year CD you can not access your funds for 5 years. With the ladder you have access to $1000 every 12 months. If you aren't concerned with availability (aka you just want to make a lump CD), you may be concerned with return issues that the ladder can help with. One disadvantage of the one giant CD is that you are the victim of whatever low interest rates might exist when the CD matures. When that happens, all of your $5000 will be stuck at low interest rates for the slump period. With the ladder, some of your CDs will sail through the slump period with the existing high (5% example) rate of return. The ones that mature during the slump may only have a 3% rate of return. However, averaging them out (say 50% of your funds mature and are re-laddered during a slump), that is still an overall 4% rate of return. If the slump is shorter duration, say 25% funds affected, your overall rate of return will be 4.5%. That is not bad at all!
If you have more cash funds to invest, say $10000 instead of $5000; you may want to open extra CDs -- say with maturations twice as often (every 6 months), instead of yearly. That way you get access to funds twice as often.
Laddering may be used on smaller time-scale to give you better returns with ready access to your funds. For example, when the market is down, 90 day (3 month) CDs often earn twice the interest rates that money market checking accounts do. 180 and 270 day CDs also have some options wrt higher rates. I mention this to let you maximize your cash income. Short term T-Bills or notes are also good for this, they often have quite short terms, and are completely risk free. However, let me remind you that you always need a readily available cash source to make investments (of any kind) as the opportunity arises. If you are not careful, you can hamstring yourself into not having the resources available to make longer-term investments which you really should make.
One advantage of that cash reserve is that you can take advantage of special offerings. With CDs this is often a considerably higher rate CD with a non-standard term. Say you have a 5 year CD coming due in 3-4 months, but that CD rates have been miserable and look to stay that way for a while. But, a bank offers a special at a really good (5%) interest rate this week for a 55 month period. if you have a cash reserve, use it to grab the good deal while it exists. Then, when the other CD comes due, cash it out to resupply the cash reserves. Without the reserve, you wouldn't be able to take advantage of the special, and perhaps be stuck with that 3% CD I mentioned earlier in the example. Don't despair though; as you see earlier, even those 50% down-turns don't affect your earnings as much as they could.
I mention market downturns and low interest rates a couple of times here. I have also shown that these downturns, with laddering, do not affect your rate of return as much as you think they would. And, if the market continues going down, this strategy will actually give you higher returns as it continues to decline. However, what if the market is in the up-swing, or you believe that the downturn is short-lived and there will be a market upswing? If rates are holding miserably low, or on the increase, you may want to place the funds from long-term investments into much shorter term (< 1 yr, even a few months) CDs. This way, as in the bond issue mentioned above, you are reducing the risk of the investment by using a shorter term. This may (most likely will) upset your investment schedule, but is worth the return if you are not satisfied with lower rates. And if the market really doesn't improve, it doesn't set you behind.
A mutual fund is a group of investors together mutually holding other financial instruments. It is called mutual because the ownership is shared mutually by all the members of the group. Income, dividends, losses, and gains are shared equally by all members.
In many ways the ownership procedures of a mutual fund
are similar to a stock.
An ownership interest in a mutual fund is represented by
The share of a mutual fund always has a current value, which
is simply the current value of all the investments
which the fund holds (also called
NAV, Net Asset Value)
divided by the number of outstanding shares in the fund.
Conceptually, when a single share of a mutual fund is redeemed, the fund needs to sell underlying financial instruments to generate the cash for that share. Vice-versa when a single share is purchased; it will be used to purchase additional underlying holdings. As a practical matter, one share will come out of or go into cash holdings which the fund holds. However, a few shares times thousands of investors making buy/sell transaction day may be a larger deal; the fund will need to purchase or redeem underlying instruments to develop or use that cash. This purchase or redemption "must" occur, regardless of its financial good or badness for the fund and the remaining investors. Typically the fund will have a portfolio strategy, and will try to keep itself balanced with respect to its goals.
One different feature is of a mutual fund results from owning other financial instruments. That is in the handling of taxation of dividends, and capital gains or losses of the underlying items in the mutual fund. When a dividend is received by the fund it is distributed, by percentage ownership of the fund, directly to the owners of the fund. The owners are then responsible for paying the taxes on the dividend amount they receive; just as if they owned the instrument themselves.
Capital gains and losses are more complex. When a fund sells shares of its investments, it will receive either a capital gain or loss on that investment, depending on the buy and sell prices. Inside the fund, the gains and losses will cancel out to a certain extent. At the end of the year, any capital gains which are not counter-balanced by capital losses are then forwarded to the holders of the fund, to have the appropriate capital gains tax applied to them. This can lead to the unfortunate situation where it is possible for the fund's share value to decline -- causing the owners a loss in value -- while at the same time they may have to pay a hefty sum of capital gains taxes! Another downside is that capital losses are not forwarded to the holders to be used for their tax benefit. The fund may lose value tremendously, yet the owners can not offset the income by the losses in capital gains in the fund.
A similar problem occurs when an investor in the fund wants to sell their funds in the share -- if the fund value has decreased, they can not take a capital loss on that decrease in the value. Yet, if the fund increases in value, they are forced to pay capital gains taxes on that amount.
Another oddity about mutual fund ownership comes from another interaction with govt regulation and tax code. To recap, a mutual fund's share value is the sum of its holdings, whether stock, bond, cash, or debt. Every year a mutual fund is forced to distribute 98% of its income (whether from income or capital gains) to its owners. So, the fund may be building holding of cash through the year, waiting to invest it in something else. If that opportunity doesn't become available, then the fund will have to disburse the funds to its owners. Until the day (Ex-Dividend day) the cash is disbursed, it is part of the holding of the fund, and the share price will reflect those accumulated monies. The day after the cash is disbursed, the mutual fund will have less holdings, and its share value will drop quite a bit. But ... there are side-effects of this. If you buy shares in the fund right before the disbursement date, you pay a higher price, and you will now receive a year's worth of accumulated capital gains and income. So, just after buying the fund, you may receive a bunch of money. Yay! However as I mention earlier, now you will also need to pay taxes on that amount ... which can be substantial if the fund was holding on to a lot of resources! If you wait for the day after, you will receive a lower price, or get more shares for a fixed price, and not receive the distribution. Whether this is good or bad is up to you and your tax situation. It is something to be aware of.
My viewpoint and notes on tax handling of mutual funds... There is an unfortunate discrimination against the investors in funds by the US government. The holders of a funds take the same risks as other investors, and help prop up the country and its economy with their investments. However, they are forced to take gains even when they suffer losses, and they have no possibility of taking advantage of the losses they they suffer if they want to sell their shares of a fund at a loss. I think mutual funds should be taxed more advantageously for the holders. After all, they are often held by the people who least understand all of this, and don't have the financial acumen and tools to offset the disadvantages. To summarize:
Mutual funds are managed by a mutual fund company, such as Vanguard, or Fidelity, just to name two. See the list below! Must funds are in fund families, (such as Vanguard) which absorb the overhead and provide the resources of all the operations common to a mutual fund -- cash handling, share buy/sell, paperwork generation, etc.
The management of the individual fund manages the money, securities and other investments of the fund. These are the people who make the decisions about what stocks (bonds, etc) to buy and sell. They often receive a big paycheck -- because they are managing a big risk. They don't invest $1000 on a analysis -- they invest $1,000,000 or more. To back up their decision making they need a lot of analysts and research teams to procure information about the market, technology, a company, patents, trademarks, trends, fund position, and even more things I couldn't imagine. This active management of the fund can be quite expensive overhead-cost wise. The trick about it is -- good managers may may be able to generate higher returns on the fund, sometimes for a moderate period of a couple of years. However, in the long run even the best management has troubles beating the market. A poorly managed fund can easily under-perform the market.
The overhead costs of operating a mutual fund reduce the returns that the fund makes. This can be a substantial amount across the life of an investment in a fund. To compare the operating costs of two mutual funds, you can look at the Total Expense Ratio. The one with higher operating costs will take more for itself than a similar fund with a lower expense ratio. There is a range of management styles of mutual funds, ranging from actively managed funds to the low-cost index funds. As mentioned earlier, an actively managed fund will have higher operating costs due to all the research and analysts needed to manage the fund. A hidden-downside of an active fund is the increase in trading costs needed to operate the fund -- which reduces return. Active trading will typically cause more of a tax liability for investors because of the capital gain situation.
Conversely an index fund is a fund that has some of the lowest operating costs in the business. Why? Well an index fund follows an index, such as the (XXX get rule) Standard & Poors 500 and just changes the stocks held by the fund to match the mix in the index. Management costs are low, because a huge staff isn't required. Transaction costs are low, because funds aren't actively traded; just adjustments to holdings based upon the index. Index funds also turn out to have quite decent returns. They may not have the highest return of funds, but across a many year period it is quite difficult for any fund, even ones with extreme management, to beat the yield of the index.
What is the load of a mutual fund? A load is a commission or a sales charge -- the extra cost that you pay to the fund or fund family to buy into it. The best funds (IMO) are No-Load Funds, which do not have a sales charge and are distributed directly by fund companies. The best-known no-load company is Vanguard; indeed they started the whole no-load concept. The loads on funds are quite horrible -- many funds only make a few % a year, and they are often taking a guaranteed 4-5% up-front from you Once the load is included many funds which appear to actually be making money often turn into negative-yield funds. Ouch -- you are paying to have other people hold your declining value of money. Typically funds sold be investment agencies (third party) are loaded funds. Common examples of funds in this category are too numerous to mention. If you can't buy it yourself there is probably a load.
For example, say there is a fund with a 5% load. If you invest $100 into that fund, first they syphon off 5% ($5) of your money, then they invest the remaining ($95) into the fund. This is typically done by a higher sales price (sales price above market) on the fund. With loaded funds there are typically three share classes, A, B, and C. Really, it is just a different way of paying the loads.
Class A: Front-End Load
Class B: Also called a Back-End Load
Class C: Level-Load Fund
NTF or No Transaction Fee funds are a different issue, separate from the load issues. A NTF fund doesn't charge a transaction fee for buying and selling of a fund. This typically occurs within a fund family and it allows investors to switch their investments easily between different funds, without paying costs. However the flip-side is that there may be a load (or thing like a load) to get into a NTF family of funds. However, once in the family there is no fee to buy/sell different funds. This can be important in retirement holding, since it doesn't reduce your retirement holdings to rebalance your portfolio. However, it is equally important for non-retirement as well; reducing costs lets your money perform better for you. I think NTF funds were created by fund families to keep people's money within a firm. For example, say your have some money in a Stock Fund with Fidelity, and want to balance your portfolio by buying shares in a Bond Fund. If Fidelity has TFs, there is no incentive for you to keep your money at Fidelity, and you will shop around to other fund companies for bond funds. But, say Fidelity has NTFS ... that encourages you to keep your money there and use one of their bond funds ... because you won't pay a fee for moving your money.
I don't mean to place a dim view on mutual funds by by notes about ownership and taxation of funds. The deal is that Mutual funds can be a powerful part of an investment portfolio -- for any level of investor. by
WORK-IN-PROGRESS No-Load funds Tax status VS holdings. Index funds managed funds balanced funds vs money managers
Financial instruments can belong to different markets. Here in the US all are stocks and bonds are in US based companies. However, you can also invest internationally to mitigate the effects of the US economy.
Looking at the side-effects of the US Sub-prime mortgage mess, the market isn't as isolated as some people said -- when US market fell, pretty much everything fell. However, that doesn't mean one should not diversify their assets internationally. Different regions have different growth potential and upswings and downswings. By investing in a wider array, you may be able to take advantage of the growth in different markets which you would otherwise miss.
To help me keep track of the names of the different areas, here they are:
WSJ runs about $79/year. Maybe $39 w/out electronic?
Copyright © 2007-2009 by Bolo -- Josef T. Burger