The Amateur Financier

(Hello again, my dear readers.  It’s time once again to head back to class, in order to learn some interesting and helpful facts about the investing world.  After all, if we’re hoping to be educated investors and stewards of our money, we first have to be educated.  Today, we’re going to start veering a bit away from the different types of investments available, and towards some of the finer points of business and the economy.  To start with, it’s one of the defining features of the modern business world: corporations.)

Q: So, what exactly is a corporation?

A: A corporation is legal entity that is distinct from the shareholders, workers, or anyone else involved in its function.  It’s considered for purposes of law to be a separate individual from the shareholders or other owners, and can be involved in legal proceedings as either a plaintiff or a defendant.  One of the major features of corporations is the concept of limited liability.

Q: Alright, what’s this limited liability all about?

A: Let’s go through a little thought experiment.  You own a small business and run into a small snafu legally.  Perhaps a worker ran over a poodle or something similar.  (No offense intended to any poodle lovers, of course.)  If you owned the company outright, as a sole proprietorship in your own name, the poodle owner could sue you and take not only the assets associated with the company, but any personal assets you happen to own, as well (car, house, pets, etc).  If the company is arranged as a corporation with limited liability, though, then the only money you can lose is the money that was already put into the corporation.  You can lose the money you put into your business, as well as the value of any corporate stock you own (assuming you’ve gone public with the company), but beyond that, all your other assets are safe.

Q: Reasonable enough; but doesn’t that make corporations just a way for the wealthy to dodge responsibility?

A: Well, that’s one criticism that’s leveled at them, sure.  Limited liability is one of the biggest (if not THE biggest) selling point of corporations, but it benefits everyone involved; owners and shareholders (which include most of us, at least for larger companies) can invest without fearing that a mistake made by the corporation will cost them everything.  By limiting the potential to the invested amount (and ONLY the invested amount), investing becomes safer and companies can draw in more investment dollars.  If you own any stock, you’re benefiting from the corporate structure.

Q: I guess I’ll accept that; what are some of the other benefits of a corporation?

A: Besides a possible sense of pride in being able to call your business a ‘corporation’, there are several more tangible benefits, as noted on Find Law.  Many of them have to do with issuing stock; once your company is a corporation, you’ll be able to sell of tiny portions of it as stock, either to raise money or to give to employees.  The corporate structure also sets up a number of positions: the directors, who provide direction to the company; the officers, such as CEOs and COOs, who oversee the business’s daily activities; and shareholders, who hold stock, have an ownership interest in the company, and elect the directors.

Q: I’ve done this enough to know what comes now: what are the downsides of corporations?

A: Yup, corporations aren’t all peaches and cream; they do have a few negatives, as noted in the above Find Law article.  It mentions both the costs of setting up a corporation (which can be substantial) in terms of time and effort, as well as the rules that corporations have to follow in order to preserve its existence as an independent entity (and keep that limited liability in place).  One of the most griped about problems, though, is the possible ‘double-taxation’ within the corporate structure, where profits are taxed first when they accrue to the corporation, and second, when they are distributed to the shareholders as dividends.  (The logic behind this is that, as corporations are separate persons, the money they make should be taxed as their income, and then also taxed when the money is transferred to other people (the investors).  It’s similar to you paying your mechanic out of your own paycheck; the money is taxed when each one of you receives it as income.  The only trick is here is that one person in our corporate example is not actually a person, but a legally created entity.)  There are ways around this double taxation, mainly by choosing a different type of corporation.

Q: Wait, there’s more than one type of corporation?

A: Yes, indeed.  In fact, if we go to Wikipedia’s Companies Law page and look at the index over on the right, we can see that there are a great number of different types of corporations, all with different governing rules and regulations.  Depending on your needs, any number might meet your purposes, although you’d have to do careful research and consideration in order to be sure.  I’ll try to cover some of the types more in depth during the coming weeks.

That’s all for now; hopefully, you’re a little better informed on just what a corporation is, and how it can affect you.

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(It’s Tuesday, and you know what that means: Investing 101 day!  Today we look at compound interest, one of the most basic concepts in investing, and indebtness, for that matter.  So, for a closer view of the concept that Albert Einstein is said to have called ‘the most powerful force in the universe’, let’s journey together, shall we?)

Q: What is compound interest?

A: In a nutshell, compound interest is interest that is earned on interest.  For example, let’s say you have $100 in a bank account that earns 5% interest.  After one year, you will have earned a total of $5 in interest.  If you add no more money to the account, after the second year, you will have earned $5.25, five percent of your new total of $105.

Q: An extra $0.25; how’s that supposed to impress me?

A: It’s not where you start but where you end up that matters.  After five years, you’ll have over $120 in your account and be earning over $6 a year in interest (an increase of twenty percent).  After ten years, you’ll have $155 in the bank and earn nearly $8.  If you keep the money in there for thirty years, you’ll have $411 in the bank (more than four times the money you started with) and will be earning over $20 each year.  All of that is possible with a tiny starting balance and only a moderate level of return; if you start with $10,000 and get a 10% return (a frequently cited average for the return from the stock market), you will have nest egg worth $158,000 in thirty years, and will receive over $15,000 each year in returns, without investing another dollar.  Not a bad start to funding your retirement.

Q: Okay, that’s more exciting; are there any disadvantages to compound interest?

A: Well, yes.  While compound interest is your best friend when you have money in the bank, if you are in debt, compound interest can be a killer.  A debt of $5000 can grow to more than $10,000 in five years if you are being charged 20% interest on your debt (a rather low rate, among credit card interest rates).  If you’re paying only the minimum charges (usually only two to three percent of your outstanding total), there’s no way to ever get ahead on your debt.

Q: Alright, fair enough; how can I take advantage of compound interest, without letting it take advantage of me?

A: There are some pretty simple rules when it comes to your investments and debts so that compound interest works for you.  First, starting saving early, and consider putting aside a little more than you initially planned.  The three factors that determine how much you will gain in compound interest are the starting amount, the interest or return rate, and the time you allow the investment to grow.  How much you invest and how long you allow the money to grow are within your control.

Second, try not too be too cautious in your investments, especially when you are young.  It’s tempting, especially when the investment world seems to be falling apart (as it did at times last year), to flee to the safest investments you can find.  But, money market funds, Treasuries and even bond funds will all yield less over the long run than stocks or real estate.  Attempt to avoid the risk of falling account values, and you can find yourself facing the risk of not having enough to retire or meet your other needs.

Finally, if you owe money, do your best to pay off the debt by paying more money than you owe.  If you are paying only or predominantly interest, your debt will just continue to grow and grow.  Paying down some of the principle of your debts, be they your mortgage or credit card loans, will only save you money in the long run.

That’s all there really is to it; pay down debts (particularly the principle), give your money time to grow, and take some smart risks with your money as long as you have time to recover.  Do that, and compound interest will be your best friend (and will all but pay for your retirement).

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(Welcome once again to my ongoing feature, Investing 101.  This week, we’re looking at indexes, those things whose prices you hear quoted at the end of most business news reports.  But what are they, how do they work, and why does everyone seem so concerned about this ‘Dow Jones’ guy?  Read on for the exciting answers to these and other questions of vital importance!)

Q: So what is an index, anyway?

A: An index is simply a collection of stocks, bonds, or other individual investments.  Depending on the particular index, it can represent the entire market or some smaller portion, divided up according to index creator’s criteria.  You can think of them as imaginary portfolios holding the particular investments that it tracks.

Q: Alright, why should I care about indexes?

A: Well, if you are investing in index funds, where the mutual fund company attempts to own all of the stocks in the index (or a representative portion, in some cases), then indexes should be quite familiar to you.  They serve as the basis of your funds’ holdings.  You can thus use the performance of the index (which are frequently reported in newspapers) as a proxy for your investment performance.  (Although, it’s worth mentioning that your index fund will (almost) always lag the performance of your index; real mutual funds have expenses while indexes themselves do not.  Still, your fund should perform roughly the same as the underlying index, making the index a useful tool.)

Q: That’s fine for index investors, but I buy actively managed funds and individual stocks.  How do indexes help me?

A: Well, indexes serve as a benchmark for your actively selected investments.  If you own an actively managed fund (or attempt to manage your own money), you should compare your returns to an appropriate index.  If your fund is not outperforming the index (or an index fund, to take into account the aforementioned mutual fund fees) that holds the same type of investments, you should consider switching to an index fund and being done with it.  You’re paying higher fees (or trading commissions) to achieve worse results than you could get with an index fund.  (Now, of course, be reasonable with your comparisons; dropping a fund for one year of under-performance is not usually justified.  But do be sure to watch how your active investments perform compared to an appropriate index.)

Q: Alright, what sort of indexes are out there?

A: There are literally hundreds of indexes, run by numerous different companies.  There are indexes created by Standard & Poor’s, Morgan Stanley, and the Russell Investment Group, amongst others.  Three of the most commonly encountered indexes are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite Index:

• The Dow Jones Industrial Average, commonly called the Dow, is composed of 30 different stocks that are among some of the largest companies traded in America.  These companies are considered some of the leaders in their fields, and the index, although limited, is considered a good representative of how American industry is doing.  It’s also the most commonly and prominently mentioned index on financial and other news programs, and thus one that’s easy to track.  For a more complete picture of how American business is doing, we can look at:
• The Standard and Poor’s (S&P) 500 Index, which measures the performance of 500 of the largest companies in the United States.  It includes all the Dow stocks and an additional 470 stocks of large companies, making it a more complete and accurate picture of American industrial performance.  It does not include mid- and small-cap stocks, though,
• The NASDAQ Composite Index measures the performance of the more than 4,000 stocks that trade on the NASDAQ exchange.  It tends to be weighted towards technology and other ‘hipper’ stocks (one reason why it suffered a tremendous fall at the end of the tech boom).

Q: That’s quite a list; you say there are other indexes?

A: Oh yes, indeed.  There’s the DJ Wilshire 5000, which includes all the stocks in America, making it even more representative of the American economy than the S&P 500, the MSCI EAFE, which invests in European, Asian, and Far Eastern stocks, and the Russell 2000, which invests in small- and mid-cap stocks (a total of 2000 of them, to be exact).  Which index funds (and related indexes) you should invest in and how much money you put into each one will depend on your goals, financial situation, and personality.

Good luck in the wonderful, funderful world of indexes, and see you for the next edition of Investing 101!

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(Once again, when it’s Tuesday, that means it is Investing 101 day!  We’re running out of individual investment vehicles to cover, so we’re going to start covering some broader investment concepts.  Today, that means asset allocation, a concept that comes up repeatedly in discussions of investing and personal finance.)

Q: What is Asset Allocation?

A: In general, asset allocation refers to how you have your money distributed among different investments.  The point of asset allocation is to view your portfolio holistically, ensuring that you aren’t taking more risk than you want, or less risk than you need, with the money and resources you have available.

Q: What’s the perfect asset allocation, then?

A: There’s no way I can answer that; no one single perfect asset allocation exists.  It’s a bit like individual investment choices; some people prefer investing in stocks, others in real estate, still others in mutual funds.  Each option could be equally effective at building wealth, it’s simply a matter of personal preference and individual needs with the investment that will dictate the best one for each person.  Similarly, the best asset allocation for you will depend on a number of personal factors.

Q: Alright, how do I determine the best asset allocation for me?

A: There are a few important factors to consider to determine how to build your asset allocation.  The first step is to consider what goal(s) you’re investing to meet.  The big one for most people is retirement, of course; besides being one of the most expensive events in your life, it’s also one of the few you can’t take out a loan to finance.  You might also find yourself investing for college (for yourself or your children) or investing in order to buy a house.  For the purpose of keeping track of your progress, it might be best to think of each of these goals as a separate portfolio, even if in practice they are co-mingled.

Second, know how long you have until you need the money.  The less time you have available to make up any shortfalls, the more conservative you’ll have to be with your investments.  In general, the advice is that any money you’ll need within five to ten years (depending on the source of the advice) should not be invested in the stock market or similar risky ventures.  (As an aside: for goals where you’ll need the money all at once, this means you should be completely invested in bonds, bond funds or cash equivalents five to ten years before the event.  For goals that occur over the space of years or decades, like retirement, you can (and should) remain invested in stocks or other growth investments at the start of your retirement, to maximize the growth of your money and help make sure it lasts through your whole retirement.)

The third consideration is how much growth you need.  If you can save enough money to meet the goal through your own efforts, you can focus on keeping that money safe rather than growing it, by putting it aside in a savings account or other secure cash equivalent.  You won’t see much return, but the money you save will be safe and secure for when you need it.  If you need a great deal of growth (for a huge event such as retirement), you’ll have to put your money into riskier but higher average growth investments like stocks.  (Of course, you still need to balance your need for growth of your money with your time frame; if you try to make up for a short time frame by investing in highly risky ventures, you put yourself at risk of losing even more money and falling even further behind in meeting your goal.  If you have limited time, you should try to boost your savings to make up the difference, not upping your investment risk.)

A fourth consideration is your own tolerance for risk.  Depending on how well you can stomach the ups and downs of the market, you can tweak your portfolio to be slightly less risky or slightly more risky (with a higher average return).  Note that I say tweak; you shouldn’t take a huge amount of risk if you only have a few years left to make up your losses, regardless of how ‘risk-tolerant’ you are, nor should you hide from any risk if you have a long investment horizon and a large amount of money that you need to gain through investing.  While much is made about risk tolerance, ultimately it has to take a back seat to more practical concerns of time and needed growth.  At most, you could shift ten to twenty percent of your portfolio to a more or less risky investment according to your tolerance; that should moderate your returns while still allowing a reasonable level of growth.

Q: Whoa, that’s a lot to think about; care to run through an example asset allocation?

A: Sure, here’s an example of an investment portfolio for retirement, showing how to start, how to shift the investment over time, and where to end up:

1. Start with stock mutual funds, approximately one-third in a total foreign fund and the rest in a total US stock fund.  (Consider adding more funds to cover other investment classes, like REITs or commodities, but don’t worry about getting too complex.)  Rebalance whenever the ratio gets too far from your desired allocation.  (A five percent threshold before selling off part of the portfolio will keep you from constantly buying and selling within your portfolio.)
2. About twenty-five years before your intended retirement, switch ten percent of your portfolio over to a bond mutual fund, either a total bond market or total short term bond fund.  Keep the same proportion of US and foreign funds in your stock allocation.  (Ideally, make the switch within a retirement account to avoid paying any capital gains taxes on the growth of your stock funds.)  Rebalance between the three funds as needed, ideally by directing new investment money towards the laggards in your portfolio.
3. Every five years, continue to build up the bond portion of your portfolio, ten percent each time.  In this way, you’ll slowly scale back on the risk that a bad stock market will deplete your retirement reserves.  Continue to rebalance if your actual allocation gets too far out of proportion.
4. At ten years to go, start putting the new bond money into a TIPS fund, to provide you with an inflation hedge.  With ten years until retirement, you should have 40% in US stocks, 20% in foreign stocks, 30% in bonds and 10% in TIPS.  Have I mentioned that you should rebalance your portfolio if it gets too far from this allocation?
5. With five years to go before retirement, ensure that your cash reserves equal three to four years worth of expenses, to give you a buffer if your investments decrease in value.  Add more TIPS to your portfolio, giving you a final portfolio allocation of 33% US stocks, 17% foreign stocks, 30% bonds, and 20% TIPS.  Rebalance when needed.
6. At retirement, start to live off your cash reserves (as well as any pensions, Social Security payments, or annuities you happen to have).  Put the dividends from your investments into your cash accounts, and when selling your investments (if the dividend income is not enough to meet your needs), try to maintain the same asset allocation you had before you retired (in that way, you’ll automatically be rebalancing your portfolio as you progress).  With a large enough investment portfolio, this method should enable you to live quite well in retirement.

Q: Wow, that’s kind of complicated.  Is this the only asset allocation I should use?

A: Far from it.  This is just a simple, off the cuff allocation progression.  With some effort and a little research, you can probably come up with an even better investment plan of your own, or at least tweak this one enough to meet your personal needs.  It does illustrate some key points about your own asset allocation plan, though.  First, when you have plenty of time to invest, you should invest agressively, using a lot of stocks and other growth investments.  Second, when you are approaching your goal, you should scale down your risk, starting to focus more on preserving what you’ve gained rather than gaining still more.  Lastly, there should be a ‘flight path’, a slow, gradual progression from agressive to safe investments, which you follow over the course of your investment career.

There you have it, some basics on creating an asset allocation and altering it over the course of a lifetime.  Hopefully, these tips will help you as you begin your own investing career.  Good luck, and happy investing!

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(Welcome to a somewhat unusual edition of Investing 101 (not that too many of these columns are ‘usual’).  We’re going to cover an aspect of investing that many passive, value-oriented investors such as myself don’t usually consider, technical analysis.  Of course, just because it’s not my favorite subject, doesn’t mean it isn’t important to know.  So, as we often do, it’s time again to get some of our questions answered.)

Q: What is Technical Analysis?

A: Technical Analysis is a method of investing (actually, speculation) that maintains that the current and past prices of a security tell you everything you need to know about the security.   The goal of a technical investor is to use the patterns of past prices to determine how the price of the stock will shift in the future.  The technical investor does not concern himself or herself with the fundamental value of the underlying stocks, per se, instead studying the momentum and current prices of the stock based on trading patterns.

Q: Sounds pretty neat; how do they track these trends?

A: The most common tool used by the technical trader is a chart of past stock prices.  An example is shown below, showing the S&P 500 Index from 1996 to 2006 (taken from markettechnician.com):

The idea is, by studying the patterns of charts like this (usually covering shorter time frames, days, weeks, or months) and applying a range of tools in order to determine where the stock prices will go, it becomes possible to determine how the stock prices will change in the future, and profit by either buying the stocks or shorting them.

Q: Whoa, cool!  How do you read these charts?

A: Hold on there, that’s a rather complex question.  Technical analysts claim that there are dozens of indicators to determine where stock prices are headed, and plenty of patterns that appear in the charts to guide their trades.  Even a basic overview could fill a week’s worth of posts, and frankly, I’m not a bit enough fan of technicians to devote that level of time and effort to examining the process.

Q: Sounds like you don’t enjoy technical analysis; what’s that about?

A: I’m a bit leery of any investment or speculation strategy that focuses on stocks in isolation from the underlying companies.  While it is true that stocks will often increase or decrease in value for reasons that have little to do with the underlying fundamentals of the company, the idea that such increases or decreases can be predicted purely from previous stock prices strikes me as unlikely.  In general, I tend to lean more toward value investing (at least, in theory; in practice, so far I’ve only invested passively without much consideration of either valuation or technical indicators).

Q: Then, why bother to write about technical analysis?

A: A few reasons.  It is a major factor in many traders’ investment choices; even if you don’t apply technical analysis (or even know what it means), the concepts and ideas of technical traders can influence the value of your investments.  Furthermore, I by no means feel that my way is the only way to invest; if you have the right mindset, you might find technical analysis more useful than I’ve portrayed it.  Even if you don’t become a day trader, jumping in and out of investments according to technical signals, it can be helpful to have at least a basic understanding of technical analysis.  With many of your fellow investors following technical signals, knowing whether they are planning to buy or sell will help you to know what will happen to the prices in the short term, and thus whether your stocks are about to become cheaper or more expensive.

This concludes our introduction to technical analysis; it’s not quite my cup of tea, but if you are interested, there are plenty of resources out there to continue your research.  Enjoy living the life of a technician!

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(Tuesday is one of my favorite days of the week, or at least it has become so, because each Tuesday I get to write another Investing 101 post.  As we cover more and more possible investments, I’m starting to get a bit more esoteric with the chosen investment options.  Here, we’re going to look at municipal bonds, commonly known as munis.)

Q: What are munis?

A: Munis, or municipal bonds, are bonds issued by cities or states.  As with any bond, it’s a promise that the invested money will be returned along with an agreed upon interest payment.  Like Treasuries issued by the federal government, munis are a way for cities, counties and states to fund current expenditures by taking on debt and paying it back in the future.

Q: Why invest in munis as opposed to Treasuries, then?

A: Munis have one feature that makes them very attractive, particularly to high income investors: many are federal tax free.  In order to encourage investors to buy munis and help fund state and local projects and programs, the federal government has exempted some munis from federal taxation; all the profit you make from muni interest payments can not be touched by the IRS.  Furthermore, many states exempt munis issued within the state from the state income taxes as well, meaning that the interest from your muni could be free from state taxes as well.

Q: Wow, that’s great; but what’s the catch?

A: The ‘catch’ is that munis have lower yields than corresponding corporate bonds.  Thus, you might be better off financially by taking a higher yield corporate bond and using the profits to pay the needed taxes rather than going with the muni.  In general, if you are in a high tax bracket, muni bonds will be the best option for you; if you are in a low tax bracket, then taxable bonds will be better.

Q: That’s sort of vague; are there any firmer rules I could follow?

A: There’s a simple calculation you can use to make a decision between munis and taxable bonds into an apples-to-apples comparison.  If you take the yield of a municipal bond and divide by 1 minus your tax bracket (in decimal form), you’ll come up with number that you can compare directly to a taxable bond yield in order to choose the best investment for you.  For example, if you are in the 25% tax bracket and can invest in a municipal bond that yields 4%, the calculation would look like this:

(Muni Yield)/(1-Tax Bracket) = 4%/(1-0.25) = 4%/0.75 = 5.33%

Assuming you can find a corporate bond with a yield at or above 5.33%, that would be the smarter investment (assuming both the corporate bond and muni have the same rating and default risk, of course).  If not, the tax exempt nature of the muni will more than compensate for the lower yield, allowing you to come out ahead financially.  (All this assumes that you are investing in a taxable account; if you are investing in a tax-deferred or after tax account (such as a retirement or educational savings account), then the tax advantage of munis disappears and you can just compare the offered interest rates.  Of course, for straight interest rates, corporate bonds usually come out ahead.)

Q: Is there an easier way to invest in munis?

A: Just like with any type of bond, there are mutual funds that invest in purely in municipal bonds.  If you want the tax advantages offered by munis without the hassle of purchasing individual bonds (as well as diversification without having to buy dozens of different bonds), a muni bond fund could be the answer.  Of course, the unlike individual bonds, the yields on muni funds aren’t fixed, which could make it harder to determine whether the muni fund is a better value for your investment dollar.

If you do opt for a muni fund, you can find both general muni funds as well as state specific muni funds.  If you are looking at a mutual fund company such as Vanguard, you can find these funds by looking for the ‘tax-exempt’ title in the fund name or category.  You can find their long-term muni fund or if you are a fellow Pennsylvania resident, you could opt for the Pennsylvania muni fund and save even more in taxes, for example.

Q: Finally, how should I invest in munis or muni funds?

A: Basically, if you are looking to add some bond exposure to your taxable holdings, you can consider using munis for your bond allocation (assuming your tax bracket is high enough to make the lower but tax free return for munis to be worthwhile).  This is one way to manage your taxes and limit how much you will owe.  (Again, if you are investing in a tax advantaged account, munis will do you no good; a tax-free investment in a tax free account serves no purpose).  As with any bond investments, you want to increase your exposure as you get older, stabilizing your portfolio.  How much to hold at each age will depend on your risk tolerance as well as your plans for the future.

That’s about it for municipal bond investments; hopefully, you now have a better idea of just how ‘munis’ can fit into your investment goals and future plans.

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(*Hums the Jaws theme.* Da-dum… Da-dum… Da-dum, da-dum, da-dum, da-dum, da-dum, DA!  Welcome my friends, to yet another installment of Investing 101.  We’re going to get a little bit off the beaten path with this post, looking into investments in gold.  There are times, particularly when the future seems to be rather uncertain, that investments in gold start to become popular; if that doesn’t describe our current situation, I don’t know what would.)

Q: What is gold?

A: You’re kidding me, right?

Q: No, you want to write about gold, you have to expect questions like this.  So, what is gold?

A: (Sighs)  Alright; gold is a chemical element, the 79th on the period table.  The abbreviation is Au, short for aurum, the Latin word for gold.  Pure gold tends to be soft, allowing it to be easily shaped or molded.  Furthermore, it is also very nonreactive; gold is one of the few (metallic) elements that is found naturally in its elemental form.  It is also a unique metal in having a yellow, rather than a silver, color in its elemental form.  Commercially, gold can be used for electronics, in jewelry, or in dentistry.  Most important to our purposes, gold has a history of being used as money, and more recently, as a hedge against paper currencies.  (All this information, as well as more about the chemistry of gold than you ever need to know, can be found on the WebElements page for gold.)

Q: Alright, why is gold so valuable?

A: Gold has a fairly unique combination of nonreactivity, beauty, ease of shaping, and perhaps most importantly, rarity.  Being almost completely nonreactive means that it is fairly easy to find gold in its elemental form, the beauty of which has appealed to humankind throughout recorded history.  Because gold is malleable and easily shaped, it makes a good base for currencies, especially in older periods when metal shaping tools were less advanced.

Its rarity is the real key to gold’s value, however.  Because it has been rare in most of the world for so much of history, it makes a good store of wealth.  If you were deciding on what to use as currency, you’d want something that was unlikely to vary in quantity from year to year (like most crops) or have a sudden discovery drastically shift the relative value of your currency (as with more common metals like iron).  Gold meets these criteria, as well as the previously mentioned traits, and so makes a good potential currency.

Q: How should I invest in gold?  Should I just buy up a bunch of gold and put it into my safe deposit box?

A: Well, buying and holding physical gold is one investment option; unlike other commodities like oil or corn, it’s possible to get an amount of gold with a high value in a small enough space to keep in your home (or a safe deposit box).  That said, I’d advise against holding sizable (investment) amounts of gold yourself; as with any physical object, there are some issues to consider.  You need a place to put your gold (which could take up a large amount of space, if you buy gold bars or something similar), you need to protect your gold against theft or being lost, and you need some way of determining whether the gold you are purchasing is the same quality as you have been led to believe.  For all these reasons, it’s worth considering some alternative methods of investing in gold.

Q: Oh?  What sort of alternatives?

A: That depends on how directly you want to invest; some possibilities include:

• Gold Certificates: Purchased from a company that holds gold in its own vaults, these certificates provide you a way to ‘hold’ gold in your portfolio without having to physically take possession of the gold.  As long as the company is reputable (the Perth Mint in Australia comes highly recommended), it can be good way to own gold and not store it (although, you do have the option to take delivery of the gold at any time).
• Gold ETFs: There are some ETFs in existence that own a sizable amount of gold rather than stocks, bonds, or other financial instruments.  By buying shares of such an ETF (which are usually designed to match the current price of gold), you can own gold directly without needing to physical hold it, just as with gold certificates.
• Gold Futures: As with most other commodities, you can invest in gold through the futures market.  You can buy a contract to purchase an amount of gold for a certain price at some point in the future, and either take delivery or sell the contract, hopefully for a profit.  The same warnings and cavaets apply to gold futures as would with any futures investment; be careful, or you could end up being forced to buy gold you had no intention of purchasing at unfavorable prices.
• Gold Company Stock: A somewhat indirect method of investing in gold, you can hold stock in companies that make a profit by mining gold.  If the price of gold goes up, they make more money and you can benefit from their rising value.  As with all stocks, though, you have to worry that the price will decrease on bad news, or that the company could even go bankrupt.

Q: Wow, sounds like a lot of options!  How much of my money should I invest in gold?

A: As a general rule, not too much.  If you are just looking to diverse your portfolio a bit beyond the typical stock and bond mutual funds and possibly hedge a bit against a down turn, holding about 5-10% of your money in these various gold investments can help to diversify you.  Beyond that, you could end up putting too much of your money into gold, and if gold prices start to drop, your portfolio would drop with it.  Remember to keep your portfolio diversified to be in a good position to benefit no matter which asset classes do the best; in this case, that means having only a small dollop of gold-centered investments in your portfolio.

That’s all for investing in gold; join us next week for another exciting edition of Investing 101!

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(It’s that time again; time to be subjected to get to enjoy another rousing episode of Investing 101!  In this edition, we’re going to look at one of the most commonly touted investments: real estate!  There’s a good chance that might already have dipped your foot into real estate investing, by buying your own house in which to live.  If not, or if you want to expand your horizons and become a real estate mogul, then the first step is start thinking of real estate as an investment.)

Q: Alright, what is real estate?

A: Real estate refers to land and the buildings that sit upon that land; they are real, physical property.  In this way, it is distinguished from financial or paper assets like stocks and bonds.  Real estate tends to be further divided into residential properties (where people live) and commercial properties (where stores or factories are located).

Q: Why should I invest in real estate?

A: There are several reasons why people choose to invest in real estate.  Two of the biggest are for income and for capital appreciation.  If you are investing for income, you would rent out the property for an amount higher than your monthly expenses, and pocket the difference.  If you invest for capital appreciation, you would buy the property, hold it for a period of time, and then sell it for more than you initially paid.  These two methods are not mutually exclusive; you can buy a property, rent it out for months, years, or even decades, and then sell it after it has appreciated in value.

In addition, there are some tax advantages to investing in real estate that are unavailable with other investments.  The interest on a primary mortgage is tax deductible and when you sell your primary residence (one you have lived in for two of the past five years), you can pay no taxes on the first $250,000 for singles and first $500,000 for couples, subject to a few restrictions.  Furthermore, if you sell a property and buy a similar property, you might be able to avoid paying capital gains taxes using a 1031 exchange.

Q: Sounds pretty good; but if I know you, there’s a catch hiding somewhere.  What is it?

A: Well, there are some drawbacks to investing in real estate.  First, because it is a ‘real’ investment, real estate requires care and maintenance; you need to either put your own efforts into caring for and improving your  real estate investments or pay someone else to do it for you.  Second, if you are renting out your propery for income, you will have to interact with your tenants on a regular basis and meet their needs and requirements (or again, pay part of the rental income to somone to take care of such issues).  Finally, real estate tends to be both illiquid and local; if your town or region undergoes a downturn, it could prove hard to sell your real estate for a profit.

Q: What about leverage?  Isn’t that an advantage of real estate investments?

A: Well, it’s certainly cited by many people, particularly real estate gurus, as a major advantage of investing in real estate.  They claim (not without cause) that the leverage opportunities of real estate allow you to amplify your investments,  But it isn’t that cut and dried; leverage could boost or hinder your returns, depending on how the investment fares.

If you put a smaller portion of your own money into the down payment, your returns will be amplified if the real estate appreciates in value.  For example, having only $10,000 in a property that increases in value from $100,000 to $120,000 will give you a net profit of $20,000 a 200% return on your money (not including the transaction costs of buying and selling the property, of course).  However, should the investment value drop, you could find yourself owing more in borrowed money than the house is worth (you would be underwater in your mortgage).  So, if the property you had invested in decreased its value to $80,000, you would owe $10,000 more than you could get from selling the property.

Q: Alright, what advice do you have if I want to invest in real estate?

A: Firstly, befitting our last subject, try to limit the leverage you utilize with real estate investing.  Typically, when you buy residential property, you only need to put down twenty percent of the purchase price; this is 5 to 1 leverage already, and anything more puts you at added risk if the market turns sour.  Second, be willing and able to keep your property for a fairly long period of time (preferably a decade or more).  That way, short term downturns won’t cause you to sell for a loss; over time, real estate values tend to keep even with inflation, slowly rising over time.  Finally, considering using REITs to get your real estate allocation; they allow you to invest in real estate indirectly, benefiting from real estate investments without most of the hassle and trouble.

That concludes this edition of Investing 101.  Turn in next time for more basic investment advice and helpful hints!

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• Getting Started in Commercial Real Estate on Your Own and Without the Sales Pitch
• The Number One Mistake that Would-be Real Estate Investors Make
• Real Estate Secrets - Making Money With Multi-Family Homes
• The Mortgage Crisis and Investments in Real Estate

(Ah, Tuesday, that most impressive day of the week.  Known for coming after Monday, being the day before trash day in my neighborhood, and of course, a new Investing 101 column here on the Amateur Financier!  At times I wonder just how many Investing 101 columns I can keep producing until I exhaust all the investment opportunities available to the average investor, but I then I look at the sheer number of possible investment avenues, and I have to conclude that this column (or something similar) could be sustained almost indefinitely.  With all of that said, it’s time to learn more about commodities!)

Q: I know I always start out by asking this, but what are commodities?

A: Commodities, in brief, are the raw materials that businesses and people use in the course of producing goods for sales.  Pretty much any physical object can be considered a commodity.  In practice, the most commonly traded commodities fall into a few main categories: energy sources (like oil, natural gas, and coal), metals (from industrially important metals like aluminum and copper to precious metals like gold, silver, and platinum) and agricultural products (corn, wheat, and cattle, among others).

Q: Alright, why should I invest in commodities?

A: There are a few reasons to invest in commodities.  First, since they are used in a variety of industrial and other business processes, they have an underlying worth, which keeps them from falling in value to nothing, unlike stocks or bonds.  Second, commodities, unlike many types of investments, tend to hold up well under inflationary conditions, which many people fear will soon be upon us when the economy picks up.  And finally, they can provide diversification to a portfolio, as commodity investments tend to move out of tandem with many other investment classes.

Q: Sounds good!  So, should I just go out and buy up a bunch of commodities, then?

A: It’s not quite that simple.  While it’s possible to purchase and hold some commodities in your house or a safe deposit box (for example, gold or silver bars), for others, buying and holding the commodities directly isn’t always possible for the average investor.  Unless you happen to live on a farm (or have a very understanding spouse), you are unlikely to be able to keep a few hundred head of cattle on your property.

Q: Um, okay then; how could I invest in commodities?

A: There are at least three ways to break into commodities:

-Futures: One of the major ways to invest in commodities is through futures contracts.  If you want to invest directly in commodities without buying and physically holding them, futures are the easiest method.  However, futures can be risky, and if you aren’t absolutely sure about what you are doing, you can lose a great deal of money, potentially even more than you initially invested.  (One way around this risk is to invest in a commodity pool, sort of a mutual fund for futures, where individual allow the pool operator to put their money together and buy futures for the pool.  This arrangement allows easier diversification, and frequently limits the potential loss to just the invested money.)

-Stocks: A more indirect method of investing in commodities is to hold stock in companies that produce the commodities.  If you wanted to benefit from rising oil prices, for example, you could buy Exxon stock.  The correlation between the stock price and the commodity might not be perfect, however, and there are other concerns about the underlying company that you need to understand, as with any direct stock investment.  Proceed with all due caution.

-Mutual Funds/ETFs: These could be invested either in futures or in the stocks of commodity linked companies (typically in sector specific funds).  While they might be a little bit harder to find than typical funds, they do provide one of the easiest and least worrisome ways of expanding your commodity exposure as well as ensuring diversification.

That’s it for this addition of Investing 101; I hope you know have a little better idea of what exactly people are talking about when they discuss commodities and commodity investing.  It’s an interesting area, one that will affect you regardless of your job or investment choices (as anyone who lived through four dollar a gallon gas last year could tell you), and it’s good to understand how the market for them works.

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(As always, when it’s Tuesday, that means it’s time for another thrilling edition of Investing 101.  This week, we’re going to look at something a little bit different, in this case, value investing.  Rather than a single investment or set of investments, as with most of our Investing 101 columns, we’re going look at an entire investing philosophy.  Given the sheer amount of depth in this subject, there’s no way I can cover everything about value investing in one post, or for that matter, even in a week.  Although, this week will cover quite a bit of value investing basics; yesterday’s post on present and future value covered some of the calculations frequently used by value investors.  And now, more of the basics of value investing.)

Q: What is value investing?

A: That’s a rather broad question, and one that’s difficult to answer.  Value investing means different things to different people, and the variety of opinions sometimes leads to misunderstandings.  In a nutshell, value investing requires looking at the intrinsic value of a company, and buy stock in the company as if you were buying the company itself.

Q: As if I were buying the company?  What’s that supposed to mean?

A: Well, unlike technical investors or others who focus on stocks as entities separate from the underlying business, value investors evaluate the shares of stock they consider purchasing as, well, ’shares’ of the company they are considering.  As a result, they look closely at the issuing company, evaluating its present state and future prospects, trying to determine how much the company is worth.

Q: How do you do that?

A: The most basic idea behind value investing is to calculate the intrinsic value of the company.  By making some smart assumptions about how the earnings of the company will grow in the future, it’s possible to determine a reasonable estimate for how much the stock is worth in terms of future growth.  It requires you to make assumptions (based on carefully considered research) on the future growth and run several calculations based on those numbers.

Q: That sounds kind of complex; are there any easier ways to run these calculations?

A: There are numerous online calculators that can be used to run intrinsic value calculations.  One I particularly like comes from MoneyChimp.  Or, if you prefer a more home made touch, I produced my own intrinsic value spreadsheet, based on the calculations listed in Value Investing For Dummies.

Q: Wow, so all I do is plug numbers into these calculators, and they’ll tell whether I should buy these stocks or not?

A: In theory, yes.  In practice, all intrinsic value calculations require you to make assumptions about how much the company value will grow in the future.  As a result, the values you get are only as good as your assumptions.  If you do plenty of research and come up with good values, you’ll likely have results that come close to reality.  How you do that is the basis of value investing.

Hope that gives you a better understanding of value investing, as well as some tools to help you calculate the value of the stocks you in which you seek to invest.

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