(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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(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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(It’s another Tuesday here at the Amateur Financier, and that means one thing: Yep, it’s another thrilling round of Investing 101.  Today, following our recent trend into considering more complex investments, we’re going to look at the futures market, and determine how these futures could help your financial future.)

Q: So what are futures, anyway?

A: When talking about futures, you’re really discussing futures contracts, agreements where you set the price for a commodity or financial products (stocks, bonds, Treasuries, or any number of other investments) at some point in the future.  Let’s say you’re an oil producer, and are afraid that continuing financial shakiness world-wide might lead to falling oil prices.  You can sell a futures contract locking in the current price of oil for the shipment you will produce for September delivery.  This way, you can be certain of the price that will get for your product when it becomes available.  The buyer of the contract also gets the certainty of knowing exactly much the oil will cost.

Q: Sounds pretty good; but why is there such a large market for futures?

A: Well, let’s take a closer look at some possibilities for what can happen between now (June) and September for our example.  If prices fall, as you (the oil producer) expect, then you win; having sold the contract, you locked in your profits, and ensured you will get the desired amount of profit for your oil.  The holder of your contract, on the other hand, loses; he or she has an obligation to purchase your oil at the higher price.  If the holder tries to sell the contract, he or she would have to sell for less than the face value of the contract, to make it attractive to the purchaser.

But, that doesn’t have to be the case.  If oil prices rises, then you, as the contract writer, would have to deliver the oil at lower prices than the current market value.  In this case, the contract holder would win, and could profit in one of two ways: first, he or she could take delivery of your oil at less than market value, pocketing the difference between the amount he or she actually paid and the current cost of that oil.  Or, second, the contract could sell on the futures exchanges for more than the initial cost.

Because of the possibility that the contracts become more valuable, an extensive secondary market in futures has arisen, allowing you to buy or sell contracts, even if you have no intention of taking delivery of the underlying product.  Most people investing in future contracts, especially for raw materials, do so with the intention of making a profit by reselling the contract later, rather than getting the underlying product.

Q: So, why would I want to invest in future contracts?

A: There are several reasons to consider investing in futures.  First, if by chance you are a manufacturer or user of various industrial or agricultural raw materials, it can make sense to lock in your prices to guarantee your future profits or expenses.  This way, you can ensure your future profits and more easily plan out your financial future.

Or you could use futures as a means of speculation, similar to options.  In this way, you can benefit from the increased leverage offered by futures, allowing you to make bigger profits than by holding the underlying assets.  It’s another way to take advantage of leverage, if you so desire.

Q: Sounds good!  Any last comments?

A: As with any form of speculation, you need to be extraordinarily careful about how much you invest in the futures market.  Make sure you know exactly what you are doing before you invest any real money, and only make futures contracts a small part of your portfolio.  Unless you have need for a particular commodity for your business and are using the futures contracts to lock in the future costs, chances are that you don’t REALLY need to invest in futures, and should treat your future contracts very carefully.

That’s all for this week; hopefully, you’ve appreciated this introduction to futures contracts, and have an easier time understanding what futures investing is all about.

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(It’s Tuesday again, and you know what that means!  Yes, yes, only three more weekdays until it’s time to party, but in addition to that, it’s time for another edition of Investing 101!  We’re getting a bit more exotic in our chosen investments, in this case, covering forex, which is really more speculation than investment…)

Q: What is forex?

A: Forex is short for foreign exchange, that is, the relative values of different currencies around the world.  When speculating in forex, you buy or sell pairs of currencies, attempting to determine how the exchange rate between the two will change.  For example, the US Dollar and the Euro are bought and sold in the currency pair EUR/USD.

If you think that the US dollar will fall compared to the Euro (so the EUR/USD ratio will rise), you can buy this pair and benefit from the dollar’s fall.  If you feel that the dollar will rise (decreasing the EUR/USD ratio) you can sell this pair instead, and make a profit when the ratio decreases.  There are ratios corresponding to numerous currency pairings, including all the major and many of the minor currencies around the planet.

Q: How did forex come into existence?

A: Forex was originally created for use by hedge funds and large corporations that do business in multiple currencies, allowing them to hedge against the possibility that the currency fluctuations will decrease the value of their foreign holdings.  If you are an American company and are afraid that rising exchange rates with the Euro will decrease your profits from your French sites, you can sell the EUR/USD currency pair to decrease the risk of losing money from such a fall.

Q: How can I fit forex into my portfolio?

A: Well, as mentioned before, forex trading is speculation, rather than an investment.  Don’t put your money into forex expecting to hold the currency pairs for a long period of time; if you aren’t planning to day trade, you probably should just avoid forex.  Plus, because the lot sizes for forex trading are so large (typically about $100,000), you usually need to take on a great deal of leverage, usually in range of 100 times as much as your own investment.  This means you will be potentially amplifying your gains, but also have the potential to lose more (much more) than you initially deposited.

Q: What else should I know about forex?

A: There are a few things you should consider doing in order to get yourself ready for forex trading.  (That is, assuming you still want to go into forex; as mentioned previously, there’s no pressing need.)  In order to get ready:

- Take some time to practice forex trading: Most forex trading companies will allow you to set up a practice account to test their platform.  Doing so, and taking many weeks, if not months, to practice will make you much more capable of doing well when you decide to speculate for real.

- Know how much you could conceivably lose: Given the high leverage levels, you can stand to lose a great deal of money.  While you are practicing, make sure to note how much money you lose when your trades go wrong.  Make sure you have enough money ready in your account to cover any loses above and beyond your initial investments.

- Keep the money you put into forex to a minimum: Be sure that when you put money into forex that it makes up only a small portion of the money you invest.  Because of the potential losses you can suffer, you need to be sure that you have only a small amount of your investment money put into forex trading.  I’d say no more than 10% of your portfolio should be used for speculating in forex (and probably much, much less, until you know exactly what you are doing).

That’s the short and quick version about forex trading; hopefully, this will help you to decide if this form of speculation is right for you.

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(It’s time again for that classic of investment information, Investing 101!  This time, we’re going to take little look at annuities, a type of investment (if you can even call it that) which you normally acquire from insurance companies.  They tend to be rather complex, so we are going to just skim the surface of annuities, rather than try to dig deep into them, which could easily take a week’s worth of posts or more.)

Q: What exactly are annuities?

A: Annuities are contracts with an insurance company, in which you pay money to them in exchange for a guarantee.  Depending on the type of annuity (and there are quite a few of them), this guarantee might be for protection of the money you put into the annuity, a set rate of growth, financial protction for your family, or lifetime income.  With all these possible objectives, there are any number of possible reasons why an annuity would make sense for a particular investor.

Q: Alright, that’s interesting.  How do they work?

A: In nutshell, it goes like this: you give money to the insurance company, either in one lump sum (in what’s known as an immediate annuity) or over the space of several years (a deferred annuity).  In return, the insurance company with hold and invest your funds, and allow you the option of getting regular payments for the rest of your life.  (This is called annuitization.)  These payments tend to be higher than you could safely pull from your investment amount without using the annuity.

Q: Okay, how would I use an annuity?

A: The primary use of an annuity is to provide income during retirement.  With an immediate annuity, you can turn a single lump sum into a flow of cash for the rest of your life.  This is one way to access the money in your nest egg, and as mentioned, it will allow you to take out more than you could if you tried to manage your savings on your own.

A deferred annuity has a bit of savings plan built into it; because you deposit money regularly, it’s bit more like an IRA than an immediate annuity.  (In fact, similar to an IRA, the taxes on the growth of the money in the annuity are deferred, allowing you to delay paying taxes until you start receiving money from the insurance company; then it will be taxed at your ordinary tax level, though.)  Deferred annuities are sometimes promoted as a means of tax-deferred saving, especially when you’ve maxed out your 401(k) and IRA accounts.

Q: Any other annuity distinctions that I should know?

A: Well, in addition to be divided into immediate and deferred, most annuities also fall into one of two classes: fixed or variable.  Fixed annuities provide an amount of income that is, well, fixed.  The amount you receive each month is determined by how much you put into the investment, and then typically does not change during the entire time you are receiving payments from the annuity company.  The advantage of fixed annuities is that the payout is fixed; the disadvantage is that inflation will gradually decrease the value of your fixed payout.   (Although, some companies offer annuities whose payment will be stepped up each year, either by a fixed percentage or according to inflation; you will pay for this advantage, though, with lower initial returns on your money.)

Variable annuities are a much different beast; you invest in buckets of stocks and bonds, similar to mutual funds.  However, rather than directly own these securities, you attempt to determine whether the accumulation unit value (AUV) of the annuity will increase.  Your payout will increase or decrease based on the performance of the assets to which the annuity is tied.  If the investment rises, so does the amount you receive each month; if it falls, so does the payout.  As a result, over time the pay out on variable annuities should increase along with the performance of the stocks or bonds in which it invests.  The disadvantage, of course, is that your payout in retirement could end up going down.

Q: This is getting complex; what should I do if I want to invest in annuities?

A: If you think this is complex, you should know that in reality, annuity contracts have significantly more details and ‘moving parts than we’ve talked about here.  This is just an overview.  If you want to invest in annuities, it’s important to read carefully, consider all your options, and study, study, study the annuity contract!  If you are confused on anything, make sure it’s made clear to you; given how much annuities cost, as well as how hard they are to leave (significant penalties are usually attached), you don’t want to make a bad investment.

That’s pretty much it for annuities; they are rather complex, but can have benefits if you know what you’re doing when you invest.  Hopefully, you’ve learned a bit more about these arrangements and how they can benefit you.  See you next time!

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(Welcome back my friends, to the column that never ends, we’re so glad you could attend, come inside, come inside!  Indeed, it’s that time of the week again, to cover some basic investments that you might be considering.  Today, we’re going to go a little outside our typical range of covered investments, and talk about Hedge Funds!)

Q: So, what are hedge funds?

A: In a nutshell, hedge funds are specialized investment arrangements, which tend to be rather aggressive, taking on an array of investments in order to maximize return and minimize risk.  The managers attempt to achieve alpha, return above the return that could achieved without the manager’s skill.

Q: So, how do hedge fund managers achieve alpha?

A: They can use a variety of methods; hedge funds are lightly regulated by the Securities and Exchange Commission (SEC), meaning they can do things that other mutual funds or investments can’t do in order to achieve their goals of maximizing their return.  They can employ leverage (borrowing money to purchase investments) and shorting (selling shares of stocks they don’t own, and then buying them back at lower prices) as well as unconventional investments in order to achieve their returns.

If they are successful, the managers usually get compensated by the 2 and 20 formula; an annual fee of 2 percent of the assets under management and 20 percent of the profits that result.  A high price to pay, but it could be worthwhile if the manager exceeds the profits possible with other investments.  On the other hand, hedge funds that lose money tend to close down, skewing the performance of the remaining ones to look higher.

Q: Even so, I’m still intrigued.  How can I get in on this?

A: Chances are, you can’t.  Remember that ‘lightly regulated by the SEC’ part?  That refers to the actions taken by the hedge fund itself.  Because the hedge fund could be quite risky, potentially losing much of an investor’s money, the SEC tries to ensure that only well-off investors take part in hedge funds.  This means that if you want to invest, you need to meet one of the following conditions:

-Have a net worth of $1 million or more
-Have earned $200,000 or more in each of the past two years ($300,000 if combined with a spouse)
-Have a reasonable expectation of making the same amount in the future.

Q: Well, piff.  Why cover hedge funds if most of the investing public (especially us whippersnappers getting investment ideas online) can’t even invest in them?

A: A few reasons, actually.  First, hedge funds are one of those terms that gets tossed around in discussions of finance, and having a better idea of what they are is helpful to your financial education.  Next time you hear a financial commentator talk about what hedge funds are doing, you’ll have a better idea of what they mean.

Also, you might at some point in the future, find yourself in one of the categories listed above someday, or the SEC could relax their regulations; either way might mean that you have the needed resources to consider hedge funds as part of your portfolio.

Q: Alright, any last advice on investing in hedge funds?

A: Don’t put all of your eggs in one basket, especially if the basket tends to be secretive and not very closely monitored (as is the case with hedge funds).    A good rule of thumb is the same as with individual stocks; don’t invest any money you can’t afford to lose and don’t invest more than 10% of your total holdings in any one hedge fund.  That way, if it does go under (or you find out your fund manager was doing a Bernie Madoff impression), you would still have most of your money in other places, safe from that investment loss.

That’s it from the wonderful world of Investing 101; hopefully, you have a better idea of what these ‘Hedge Fund’ thingies are all about, and know whether they’d be right for you.

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Today, in a very special Investing 101 column, we’re going to consider ways to help inflation-proof your portfolio.

Q: What is inflation?

A: That’s something of a complicated question.  The basic definition is that inflation is an economy-wide increase in the price of goods and services.  Remember all those stories your grandfather would tell about how milk used to cost a dime and a loaf of bread used to be a nickel?  The higher prices of those items (as well as everything else, from candy to condos) is evidence of inflation.

Q: What causes inflation, anyway?

A: In the simplest form, inflation is caused by a rising supply of money in the economy.  Think of money as a good that you can trade for other goods and services; how much money you need to trade depends on how rare it is.  If the supply of money increases relative to other goods, you will have to trade more money to obtain a particular item.  For a rather extreme example, imagine that in one year, the amount of money in the economy increases by ten percent while the supply of bread remains the same.  If the price of bread started at $1.00, then after inflation, it would cost $1.10.  This example shows an annual interest increase of 10%.

If we’re looking at the broader economy, inflation rates are usually determined by measuring the growth of a broad price index.  In the United States, the Consumer Price Index (CPI), a basket of consumer good prices, is mostly commonly used.  The average rate of increase is about 3-4% per year, which means that prices should double in about twenty years (although, a few years of higher than normal inflation could easily speed that up).

Q: What can we do about inflation?

A: On the national level, there are several possible techniques that can be used to control inflation.  Adjusting the money supply, increasing the prime rate (making it more expensive to borrow money) and, in the most extreme cases, instituting wage and price controls all have the potential to fight inflation, at least when used properly.  On the individual level, the best way to limit the troubles caused by inflation is by holding some investments that do well in inflationary conditions.

Q: Alright, what are some good investments to combat inflation?

A: The best way to deal with normal levels of inflation (the 3-4% average annual inflation rate) is to hold a diverse portfolio with a sizable portion of money in stocks or other investments that provide decent growth.  To deal with higher inflationary rates, or simply to to provide a more explicit hedge against inflation, you could consider either I-Bonds or TIPS from the US Treasury; both provide a greater investment boost when inflation runs high.

I-Bonds are similar to regular Treasuries, but the interest they pay is a combination of a fixed interest rate for the life of the bond and an adjustment for inflation that is set twice a year.  This inflation adjustment means that if inflation starts to increase greatly, so will the returns on your I-Bonds.  (As an added bonus, if you choose to hold the physical bonds, they have pictures of famous Americans such as Helen Keller and Albert Einstein (presumably, after he immigrated) on them.)

TIPS, or Treasury Inflation Protected Securities, also provide inflation protection, but do so in a different way.  They have a set interest rate, but the amount of principle in the bond fluctuates, depending on the current rate of inflation.  As a result, the amount of interest you receive during the life of the bond, as well as the amount of principle you receive at maturity, will increase along with the rate of inflation.

It’s worth noting that although both of these types of Treasuries can protect you against inflation, they are treated much differently for tax purposes.  The interest payments (and thus, tax liability) for I-Bonds can be deferred until maturity, while TIPS are taxed yearly on both the interest they yield and the ‘phantom income’ of the principle adjustments.  Because of this, it is frequently a good idea to put TIPS bonds into a tax-deferred account like an IRA, or better yet, a tax-free Roth account, to avoid such taxation.

Q: What about commodities and real estate; aren’t they good inflation hedges?

A: Somewhat.  Commodities and real estate are often considered inflation hedges because, as real, tangible items, they have intrinsic value, unconnected to their role as investments.  Assuming no change in the demand, inflation will simply mean that more money will needed to be paid for them, increasing their value along with the rising supply of money.  However, since there is no explicit connection between the returns on these investments and the rate of inflation, it’s possible that high inflation rates could cause the demand for real estate or commodities to drop, decreasing their value.  This is not to say that you shouldn’t own these investments; but think of them more as diversifying your portfolio, rather than serving as inflation hedges.

That’s it for our discussion of how to fight inflation; hopefully, you’re all a little more prepared to combat its effects on your portfolio.

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Welcome once again to the ongoing feature where we take a closer look at various types of investments.  This week, we take a closer look at one of the most popular investment choices in recent months, Treasury bonds, notes, and bills.

Q: Alright, so what are Treasuries?

A: Treasuries are bonds issued by the United States government.  Basically, similar to any other bond, you give the government money up front and receive the promise of the money being returned in the future, with interest being paid on the investment along the way.  The national debt is composed in large part of the future obligations to repay these Treasuries; therefore, owning Treasuries means you are one of the US government’s creditors.

Treasuries come in several varieties, depending on the duration.  Treasury bills mature in less than a year, and they are sold at a discount to the face value, with the interest being paid by the bill’s worth increasing to the face value.  Treasury notes have maturity dates of 2 to 10 years, while Treasury bonds have 30 year maturities, and both of these types of Treasuries pay interest every six months.

Q: Um, cool.  But why invest in Treasuries?

A: Besides the ability to call yourself Uncle Sam’s loan shark, the biggest benefit to Treasuries is that they are very safe.  As long as the United States government doesn’t declare bankruptcy (which is quite unlikely) you are certain to get the promised interest and to receive your invested money back.  Because of this, Treasuries are considered incredibly safe investments, to the point that they are essentially ‘risk-free’.

Q: Sounds like the investment for me!  But why did you put ‘risk-free’ in quotation marks?

A: Here’s the downside: because Treasuries are so low risk, they can pay much lower interest than other investments.  (The greater the chance that you will lose money with an investment, the more interest you need to receive to make the investment worth the risk.)  As a result, if you invest in Treasuries, you will have to worry that inflation will erode the purchasing power of your investment; this is called ‘interest-rate risk’, and it’s unavoidable, even with an otherwise ultra-safe investment.

Because of the incredibly safe nature of Treasury investments, they do make a good standard of comparison for other investments.  If you are taking more risk than Treasury investments (essentially, any sort of investment risk at all) without getting a greater return, you should rethink your investments and either reduce your risks or seek higher yields.

Q: That sounds reasonable.  How should I use Treasuries in my portfolio?

A: Because of their level of safety, you can use Treasuries in your portfolio in much the same way as many of the other cash-equivalents we’ve already discussed.  They can also fill a portion of your bond allocation, particularly if you are looking for more stability and trying to prevent the loss of any of your principle.

Q: Sounds good.  Any last advice on Treasuries?

A: While you can find plenty of mutual funds that invest in Treasuries, it might be better for you to simply cut out the middle man (and the associated expenses) by buying Treasuries directly from the government.  Treasuries tend to be rather inexpensive to purchase, especially in comparison to other bonds, making it easy to get a diversified portfolio.  The Treasury Direct website allows you to learn more about Treasuries as well as purchase all the varieties of Treasuries you could want.

Finally, there are other variations on regular Treasuries, such as I-Bonds and Treasury Inflation Protected Securities (TIPS) that can serve as ways to hedge against inflation.  These Treasuries increase in value according to the rate of inflation, allowing you to protect your money against rising inflation rates.  We’ll look into these investments more in the near future.

That concludes our look into Treasury notes, bills, and bonds.  All of these investments provide a very low risk place to put your money, locking in interest rates and protecting yourself from investment losses, if not rising interest rates.

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This week we’re going to do something a bit different with the Investing 101 post.  We’re not going use a question and answer format this week (Q and A, together: Awwww…).  Instead, keeping with my lists of five theme, we’re going to look at five different investments that can fill the cash portion of your investment portfolio. We’ve covered stocks and bonds, now it’s time to complete the trifecta of basis investment categories.

All of these methods are relatively low risk, and have correspondingly low returns.  They are used for stability in your portfolio, for specific saving goals and for emergency funds.  They make a good anchor for your financial life, rather than an engine for growth.

There are numerous different types of low risk accounts, each with different roles in your financial life.  Five popular ones include:

1) Checking Accounts – A basic type of account offered by banks and credit unions, which allow you easily transfer money into and out of the account.  Frequently accompanied by a check book, allowing you to write paper checks against the balance.

Pro: It’s quick and easy to transfer money into and out of these accounts, whether by cash (as in, currency) deposits, printed checks, or automated fund transfers.  Checking accounts are also federally insured up to $250,000, at least for the foreseeable future, so unless you are holding a large amount of money in your account, you don’t need to worry about bank failures.

Con: Checking accounts offer very low interest rates, if any.  Money held in these accounts will generally not grow at all.

Best Used For: The ease of money transfer makes these funds ideal for paying bills or depositing checks; just don’t keep more money than you need to cover your outstanding bills in these accounts, as you’re giving up interest.

2) Savings Accounts – These accounts are used for, yes, savings.  They offer the same protections as checking accounts, generally with higher interest rates.  (Online-only banks will offer higher interest rates than those available from brick and mortar banks.)

Pro: These accounts offer the same protections as mentioned for checking accounts (up to $250,000 in protection for the amount in your account) and higher interest rates than checking accounts.  Again, this holds especially true for online accounts.

Con: These accounts are less flexible than checking accounts, typically limiting how easy it is to withdraw funds from the account.  They also have lower interest rates than CDs.

Best Used For: Savings accounts are great for general savings and building up an emergency fund.

3) Certificates of Deposit (CDs) – CDs are financial vehicles that lock up your money for set period of time, and give you a set rate of interest.  In essence, they allow you to fix the interest rates that you earn on your money.  CDs come in a variety of durations, with longer duration CDs offering greater interest rates.

They can be laddered, when a group of CDs is purchased with different maturation dates, allowing the invested money to be continually rolled over.  If you have CDs that mature one, two and three months from now, you can wait one month, take the CD that will mature then, buy another three month CD, and again have CDs that expire one, two, and three months from now.

Pro: CDs usually (but, not always) offer higher interest rates than regular savings accounts.  Also, they allow you to secure a set interest rate for the lifetime of the CD.

Con: CDs typically have some rather steep penalties (three to six months worth of interest) if you try to withdraw the money before the CD matures.  Furthermore, because the interest rate for the CD is fixed, it’s possible that the interest rates for other accounts could rise, making the CD’s fixed rate less attractive.  And, as with checking and savings accounts, the FDIC guarantees these accounts.

Best Used For: CDs are great vehicles when saving for a specific goal with a defined date, as they allow you to increase the interest you can get for your savings.  A CD ladder also makes a decent way to build an emergency fund.

4) Money Market Funds – Money market funds are mutual funds that invest in ultrashort investments, such as commercial paper.   These funds tend to be very safe and secure; only twice in history have any money market fund lost money.

Pro: Money Market Funds typically (but not always) offer higher interest rates than regular savings accounts.  Since they are offered by mutual fund companies, it’s also easy to use money market funds as sources of funds to make automatic purchases of other mutual funds.

Con: Money Market Funds aren’t FDIC guaranteed, so there is the potential for money loss.  (Although, as mentioned, this is very rare.)  The interest rates on these funds also change much more frequently that the previously mentioned accounts, making it harder to determine exactly how much interest you will earn.

Best Used For: Money Market funds are great for holding money you’re going to invest in other mutual funds.  If the interest rates are higher than what you can get from a high yield savings account, you can use them for emergency funds, as well.

5) Stable Value Funds - Stable value funds are basically funds that hold short or intermediate term bonds with insurance if the returns dip below a preset level.  As a result, these funds can offer returns at or above those of money market mutual funds with virtually no risk.

Pro: Stable value funds can provide quite good returns.  The insurance backing also makes their returns quite safe and secure.

Con: As with money market funds, stable value funds aren’t backed by the FDIC.  Furthermore, it’s hard to invest in stable value funds outside of a company retirement plan, which makes them rather inconvenient for things like emergency funds.

Best Used For: If you want to add some cash to your retirement portfolio, investing in a stable value fund in your 401(k) is one good method.

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(Welcome as always to another installment of Investing 101, where we take a look at some of the many, many different types of investments in the financial world.  This week’s subject is target date funds, a popular choice for retirement savings, especially in 401(k) plans.  Understanding what they are and how they work is important if you are deciding if they are appropriate for your investment goals.)

Q: What are target date funds?

A: The term target date funds refer to several different products offered by financial companies.  They all share several characteristics, though.  First, they are ‘funds of funds’, consisting of several different mutual funds from the sponsoring family.  Second, all the funds have a target date, when the investor is planning to stop depositing money into the fund and start withdrawing it.  Finally, all the funds of this type gradually become more conservative in their investment holdings as the target date approaches (the fund mixture shifts from mostly stocks towards a higher portion of bonds and cash).

Two major uses for target date funds are to save for retirement and to save for college.  Both of these goals are similar in that you have many years (if not decades) before you need the money.  The target date funds can be more aggressive at the start of the investment period and have lots of time to shift the investment mix every few years and become more conservative.

Q: Why use a target date fund, then?  Why can’t you simply shift your investments over the years by yourself?

A: The short answer is, you certainly can manage your investments on your own.  Target date funds are just more convenient for many people.  They allow you to invest in a single fund and have an investment mixture that is appropriate for your age and the length of time you have before you need the money.  If you want to set up your investment plan and then not think about it again, a target date fund will serve you well.  (Plus, when investing in 529 plans, your ability to shift your investments around is rather limited; using a target date fund will make it easier for your plan to stay on track to meet your college savings goal.)

Q: Sounds intriguing.  What’s the catch?

A: One of the most significant problems is that different fund families follow different investment schedules.  (Although, if Congress has its way, soon this may no longer be the case.)  As a result, a Retirement 2010 fund from Vanguard might have 50% Stocks/50% Bonds, while the 2010 Fund from T. Rowe Price has a 60% Stocks/40% Bonds mix.  If you don’t know what mixture your fund offers, and how it will change over time, you could find yourself holding investments that are inappropriate for your goals and risk tolerance when it comes time to withdraw your funds.

Along the same lines, you might not be able to find a target date fund whose investment progression matches how you want your portfolio to change over time.  If you think that a 50/50 mix of stocks and bonds a year before retirement is too risky, neither of the above funds will meet your needs; the same holds true if you want more stock exposure as you begin retirement.  And of course, the schedule for shifting the asset allocation might not meet your needs, either.

Q: What can I do to get around these problems?

A: Well, there are several possibilities.  If you’ve researched the major fund families, and haven’t found an appropriate fund for when you plan to retire from any of them, you can consider purchasing a plan with a different retirement date.  Funds with later dates will be more aggressive in their composition, while funds with earlier dates will become conservative more quickly.  If shifting dates does not solve your fund composition problems, you could try buying another fund or two to compliment the target date fund.  That way, you could boost your stock or bond holdings while continuing to keep the automatic investment shifting of the target date fund.

If neither of these options goes far enough in fixing the problems you have with the funds’ holdings, you could always forgo using a target date fund at all, and create your own personal mix from the available mutual funds at your preferred fund company.  You’d be giving up the automation of the target date fund for the increased control and effort of a do-it-yourself approach; whether that’s a good trade depends a lot on you and your personality.

I hope you’ve enjoyed this discussion of target date funds, and now have a better appreciation for how they could be used in your portfolio.

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(It’s that time once again, for the fabulous feature known as Investing 101.  For those of you who are new, this is where I attempt to answer some questions about common investments that are posted by…well, me again.  It’s not a perfect system, but it helps to convey the information.  Now, onto the questions!)

Q: What exactly is a REIT?

A: REIT is short for Real Estate Investment Trust.  They are essentially specialized stocks, of companies that invest in real estate ranging from residential homes to office buildings to industrial sites, depending on the particular REIT.  There are two basic types of REITs: equity REITs, which own and operate buildings directly, and mortgage REITs, which lend money to property owners or buy up mortgage-backed securities.

Q: Why invest in REITs, then?  Why not just invest in regular stocks?

A: Investing part of your money in REITs will help to diversify your holdings.  Because REITs are based on real estate, they gain and lose value differently than other stocks.  When most other stocks are up, REITs might be down; and when other stocks are down, REITs can be up (such was the case at the turn of the 21st century).

Furthermore, a particularly noteworthy feature of REITs is that they are required to pay out 95% of their income to their investors.  By doing so, they can avoid paying corporate income tax, and therefore aren’t subject to the double taxation that affects most corporate dividends.  They tend to pay out more than most other stocks for this reason, and are especially useful for investors who are seeking income and want investments beyond bonds and other lending investments.

Q: Sounds good, but why shouldn’t I just buy property and invest in real estate directly?

A: Well, that’s certainly one possibility.  But, contrary to what you see on late night infomercials, buying real estate directly isn’t that easy or inexpensive.  You need to search out a suitable property, get financing, and have the highest bid on the property just to secure it.  Then, if you aren’t planning to do all the maintenance and upkeep work yourself, you will need to hire a property management company to take care of the day to day issues for you.  You’ll still have to supervise the work, though, and frequently inspect the property to insure all your wishes are being met.

And all those issues are before you get into things like insurance, taxes, federal, state, and local regulations…

Q: Alright, alright, I get your point.  How should I go about buying REITs?

A: Like any other stock, you can buy and sell REITs via a stockbroker (either online or off).  Now, as with any stock, you need to be willing and able to do lots of research before settling on which REIT(s) to buy for your portfolio.  Individual REITs can also be volatile and subject to rapid changes in value, or even bankruptcy.

Luckily, just as with stocks, there are mutual funds that invest in REITs.  By holding them in aggregate, you can help to smooth out the bumps in the investment road and eliminate the possibility that choosing the wrong REIT will drop the value of your investment to zero.  Most mutual fund companies should offer a REIT fund; being partial to Vanguard, I like their REIT index fund.

Q: That’s a pretty good plan.  Any final thoughts?

A: Just a word of caution: REIT dividend income is generally fully taxable, like bond dividend income, rather than being taxed at the lower capital gains rates (as is the case with qualified stock dividends).  It’s the downside of the rules that allow them to avoid corporate income taxes; the IRS giveth, and the IRS taketh away.  As a result, REITs and REIT mutual funds should be kept in retirement accounts whenever possible, so as to minimize your possible tax bill.

That concludes our short look into REITs (and REIT mutual funds) as a possible investment choice.  Hopefully, you’re all feeling a bit more informed and enlightened about this particular method of investing in real estate.

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(Welcome once again, dear readers, to the feature I like to call…Investing 101!  This time, we’re again going off the beaten path a bit, and looking at a product that is sometimes promoted as an investment, but also has insurance functions, as well.  That’s right, this week we’re looking at Life Insurance!)

Q: Wait, wait, wait.  How is life insurance a type of investment?

A: Well, amongst the other distinguishing features, life insurance comes in two distinct varieties.  The first type, term life insurance, is pretty straightforward: you pay a monthly premium determined by factors like your age, gender, and family history, and if you die before the term expires, your heirs will receive the amount stipulated in the term agreement.  You can choose from policies that renew every year, where the premium will likely increase over time as your likelihood of dying rises, or a level term policy, where you have coverage for a period of five, ten, twenty, thirty or more years, and the monthly premium stays the same for the whole term.  The initial premiums will be higher, but you’ll be locking in the rate for years, decades even.

The other type of life insurance is known as ‘cash value’ or permanent life insurance, because it lasts as long as you pay the premiums (regardless of your age or health) and builds up value over time.  It’s this increase in value (and the various methods that allow such insurance policies to increase in value) that make them a form of investing, on top of being insurance.

Q: Okay, so permanent life insurance is a type of investment.  What exactly is it?

A: When you pay a premium in a permanent life insurance policy, part of the money is used to increase the cash value of that policy.  There are three different methods through which the increase might occur, corresponding to the three types of permanent life insurance that are offered:

-Whole Life: These are the most straightforward.  Part of the premium will add to the cash value of the policy, increasing the value over time.  The longer premiums are paid into the policy, the greater the value of the policy becomes.  Some policies also produce dividends, which can be used to help pay the premiums, buy more insurance, or be paid out as cash.

-Universal Life: With these policies, premiums are added to a pot with the other policy holders.  Money is taken from the pot to pay administrators and to cover death benefits when any of the policy holders die, and the remainder of the money is invested.  This invested amount is divided proportionally according to how much each person paid into the policy.  The advantage of an universal life policy is the flexibility in payments; you can add more money to increase your stake of the investment proceeds, or add less (or none) and have your premiums deducted from the investment proceeds.

-Variable Universal Life: With these policies, the extra money in your premiums is again invested, but this time according to your directives.  The money can be invested in stock, bond, or even real estate mutual funds, increasing or decreasing in value according to the investment performance.

Q: Wow, that’s a lot of choices.  What’s the best one?

A: Almost without question, you will do better with a term policy than a permanent policy.  Unless you cannot save money except when you are forced to do so, you should simply buy enough term life insurance to cover your needs.  Term policies have several advantages:

1) They Are Cheaper.  Since term life insurance policies don’t build monetary value or allow you to invest any of the premiums, the costs tend to be much lower than permanent life insurance policies.  The money you save can then be invested elsewhere.

2) They Are Simpler.  Because they don’t have any investment or saving components, term policies are much simpler to compare and buy.  Not only does this make shopping for a good policy easier, but it means you can buy term life insurance online, without having to involve an insurance broker to sell you the policy.

3) Your Insurance Needs Change Over Time.  When you’re young and have no dependents, you don’t need much, if any, insurance.  Similarly, when you are older, getting near retirement, and your children (if you had any) have started families of their own, you don’t need much insurance (as you hopefully have enough retirement money to keep your significant other healthy and happy should anything happen to you).  It’s only in the middle part of your life, when you have children and possibly a spouse who depend on your income, but not enough in your investments to care for them should something happen to you, that you really need to worry about life insurance.

As a result, you probably don’t need permanent life insurance.  Rather, if you get a thirty year term policy in your mid to late twenties (when you are likely starting to settle down and raise a family), you will provide adequate coverage to your dependents until you reach your mid to late fifties, at which point you should have sizable non-life insurance funds for your spouse, in case anything should happen to you.

Q: That sounds…reasonable.  How much insurance should I get?

A: That’s a good question, one for which it’s hard to give a short and easy answer.  Most advisers suggest the equivalent of five to ten years of salary, which will be enough to provide for loved ones for quite a while, if you should die.  (Sorry to be morbid, but we are talking about life insurance.)  Running the numbers, with the most conservative predictions possible, will give you a clearer picture of how much to insurance to buy.

If you want to be conservative, you can simply take your income and multiply by twenty, and get enough life insurance to cover that amount.  This plan, as recommended by Suze Orman, has the advantage of allowing your survivors to invest the life insurance money relatively conservatively (with a 5% yield) and pay all their expenses out of the interest the investments generate.  If you’re fairly young and don’t have much in the way of investments or alternate income sources for your family, this makes a pretty good plan.

Q: That’s all well and good for life insurance, but what about all the other types of insurance I need?

A: We’ll have to cover the rest of the insurance products out there at some point in the near future, although probably not in an Investing 101 column, as they don’t really have any investment properties.

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(Welcome to another informative and exciting edition of Investing 101!  We’re going to go a bit beyond the basic investment classes like stocks and bonds, and into some of the more exotic investment and speculation opportunities.  Our subject for this article is options.)

Q: I keep hearing about options in the media, but what are they, anyway?

A: In a nutshell, options are financial instruments that allow the holder to buy or sell an underlying asset (usually, stocks) at a price other than the current going rate. Because they depend on other asset classes, options are considered derivatives.  The price changes in the underlying assets affect the value of the options.

There are two different styles of options, which influence when they can be exercised (that is, when the option-holder is allowed to buy or sell the underlying asset).  American-style options can be exercised at any time the holder desires, while European-style options can only be exercised on the date of expiration.  (All options have an expiration date, but American-style options can be exercised before that date if the option holder chooses.)  American-style options provide the holder with more flexibility, while European options allow the seller to be certain of when the options will be executed.

Q: Okay, I follow so far.  What types of options are there?

A: Options come in two basic flavors, depending on what they allow you to do with the underlying assets.  Call options enable the option holder to buy the asset from the seller at the strike price, the agreed price set out in the option.  The call option seller agrees to provide asset at the strike price. If the strike price is below the current market value, the option is considered to be in the money, and the option holder can exercise the option and purchase the asset at a discount to its current market value.  If the strike price is above the current market value, the option is out of the money, and it will expire without being activated.

Put options are just the inverse; the option buyer has the right to sell the underlying asset to the option seller at the strike price, regardless of the current price of the asset.  If the market value of the asset falls, the option buyer comes out ahead, selling the asset to the option seller for more than it is current worth.  Conversely, if asset value rises, the option will expire without being acted upon.

Q: That’s all a bit complex.  Can you help me to sort all this out?

Of course.  Here’s a chart that should clear some things up:

Option Table

If we look at this table, we can see that an call option seller, for example, wants the asset price to fall below the strike price; in that situation, the option would expire out of the money, and the seller would be able to keep the option price without having to sell the underlying asset.

Q: What are the risks with options?

The risks vary, depending on whether you are the buyer or the seller.  If you are buying options, your only real risk is that the option will expire out of the money.  In that situation, you will lose the money you put up to buy the option, but that’s it; your liability is limited to the option cost.

For the seller, however, it’s a different story; if the option expires in the money, you could be forced to sell your assets at prices below market value (for calls) or to buy assets at an inflated price (for puts).  As a result, the risk level for option sellers is much larger than buyers.

Q: How should I use options?

A: Sparingly, at least until you have a better handle on the risks of various option strategies.  If you decide to invest in options, keep them to a small portion of your overall portfolio.  Be aware that the amount you can lose from option investing can go beyond the amount of money you initially put up, particularly when selling options, and make sure that a bad options bet won’t damage the rest of your portfolio.

This article has just scratched the surface of options and option trading strategies.  There’s a vigorous market in options, just as in stocks or bonds, and the price of a particular option contact will be affected by the value of the underlying asset, the time until it expires, and the volatility of the market, among other factors.  And there are numerous strategies, like ‘straddles’ and ‘strangles’ that I haven’t mentioned.  But for now, I hope this helps you to have a bit better understanding of options.

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(Hey kids!  And teenagers, adults, cats who fell asleep on top of the keyboard and anyone else who might be out there reading this; guess what time it is!  That’s right, it’s Investing 101 Time!  This week, we’ll cover the wonderful, wacky world of ETFs!)

Q: Alright, so what is an ETF?

A: Exchange Traded Funds, more commonly known as ETFs, are similar to mutual funds in that they are investments that hold stake in numerous other investments.  ETFs are created by buying a large amount of stocks (or bonds, real estate, commodities, or other investments), usually following the allocation of a particular market index, and putting them into a trust.  Shares of the trust are created, typically in lots of 50,000 (called creation units) and each share represents a stake in ownership of the trust (similar to the way that shares of stock represent ownership of a company).

Q: Why buy an ETF, then?  Why not just buy the underlying securities?

A: Because there can be hundreds, if not thousands, of securities in a particular index.  To buy all the stocks represented in the S&P 500, you’re have to purchase 500 stocks, each of which will generate a commission at your brokerage.  Buying an ETF enables you diversify your holdings instantly, owning numerous securities with one fell swoop, cutting down your costs.

Q: Wait, I thought that mutual funds diversified your holdings.  Which is it, mutual funds or ETFs?

A: Both, actually.  ETFs are closely related to mutual funds, especially index funds, which follow the same allocation as popular indexes.  Both investment choices allow you to diversify your holdings with a single investment.  Most ETFs invest in the same indexes as index funds, allowing you to choose which type of investment is more appropriate for you.  The prime difference is how they are acquired (ETF shares are purchased through a brokerage, while mutual fund shares are bought from mutual fund companies) and how they are priced (ETFs are priced based on the last traded value, while mutual funds are priced based on the value of the underlying funds).

Q: Are there any particular advantages to using ETFs rather than mutual funds?

A: First, ETFs tend to have a very low expense ratio, even lower than the comparable index mutual funds.  Second, ETFs trade throughout the day, allowing you to purchase or sell them instantly (which might be a disadvantage in some people’s eyes). Third, it’s possible to use ETFs to invest in certain sectors of the broader economy, since you can buy an ETF that is invested in, say, financial stocks when you think they’re about to increase in value, and then sell it easily when you think that sector has peaked.

Furthermore, you can do some more complex investing maneveurs with ETFs that are impossible with index funds, like shorting them (that is, borrowing shares from other investors, selling them, and then buying them back at lower prices, hopefully) or using options (specialized investment derivatives, allowing you to set particular prices at which you can sell your holdings or buy other assets). If you’re an active investor, having these possibilities make ETFs a great trading vehicle.

Q: I’ve done enough of these to know what’s next; what are the downsides to ETF investing?

A: I’m glad you asked.  One big downside is that since you purchase them through brokerages, you need to pay commissions whenever you buy or sell your ETFs shares.  This will cut into your profits, especially if you trade ETF shares regularly.  Further, there is a spread between the bid (the amount a buyer pays) and the ask (the amount a seller receives), which means even if you find a broker that offers you commission-free trades, there’s a hidden cost to your purchases and sales.  For these reasons, if you buy and sell ETF shares throughout the day, you can end up losing more money than simply putting your money into a mutual fund, where the ability to trade shares is much lower (and the temptation is that much less).

Q: Which should I choose, mutual funds or ETFs?

A: It depends on your goals, investment style, and schedule.  If you are investing frequently, especially in small amounts, mutual funds are probably better for your needs.  The lower expense ratios of ETFs will make little difference if you’re paying 5% of your investment money towards commisions to buy the ETF shares.

On the other hand, if your investments tend to be seldom, in large amounts, ETFs are likely to be better.  If you’re investing $10,000 once a year, the expense ratio is going to take a bigger chunk of your money than a small commission fee when you buy the ETF.

Q: Is there any way to actually figure that out?

A: There is.  Just consider this equation:

Real Return = (Money Invested – Commission) * (Rate of Return – Expense Ratio)

The term in the first set of parantheses tells us the amount of money we actually have working for us in our investments.  The second term shows the real rate of return, taking into account the expenses for the fund when calculating the rate of return.  You can use this equation to figure out what will be the less expensive investment, or to work out which type of investment will lead to a greater value years from now (which I would hope is more important to you).

If you don’t feel like setting up a spreadsheet, (and if you’re not a geek like me, you might not want to do so), there are tools out there that allow you to figure out the better investment online.  I like Vanguard’s cost comparison tool, both because I like Vanguard in general, and because it’s an interesting tool.  Seeing how your investment patterns and expenses can influence the better investment choice can be informative, and sometimes surprising.

That’s all the time we have for this edition of Investing 101; hopefully ETFs are now more than a random set of letters to you now, and you feel better about how to go about investing in them.

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• Should You Invest In Vanguard Mutual Funds Or ETFs?

(Welcome back!  I hope you are ready for some learning, as we are going to cover the wonderful world of mutual funds.  Hold onto your hats, it’s going to be a wacky ride.)

Q: What are mutual funds?

A: Mutual funds are companies that buy a variety of other investments, such as stocks, bonds, and REITs.  Shares of the mutual funds are then sold to investors, who then can participate in the gains or losses of the investments.  The mutual funds charge some expenses to the investors, covering the costs of maintaining the funds and employing the fund managers.

Q: Alright, sounds reasonable.  Why should I invest in mutual funds, though?

A: The primary reason to invest in mutual funds is for diversification.  Each mutual fund holds dozens, hundreds, or even thousands of individual investments.  Buying shares of a mutual fund allows the investor to own a tiny amount of each of those investments, limiting the damage that a single bad investment choice can cause.

Another advantage of mutual funds is that fund companies will allow you to regularly invest new money into the mutual fund without paying commissions.  This includes reinvesting dividends or capital gains distributions automatically, if you choose to do so.  By investing in mutual funds, you could save the money that would be spent reinvesting these funds in stocks or bonds.

Q: I’m sold.  What types of mutual funds are there?

A: There are thousands of mutual funds, covering just about every investment type in existence.  Just within the stock funds, for example, you have foreign and domestic funds.  The domestic funds are further divided up into growth (companies that are expected to grow faster than most companies), value (stocks that sell for  less than their intrinsic worth), and blend (a mixture of these styles) funds.  And these funds are divided even futher, into large, mid, and small sized company funds, dependent on the overall net worth of the company.  These divisions are expressly shown in a style box, such as the one below, where each small square represents a different type of fund (with some even covering more than one box):

An example style box

And there are still other distinctions; some funds invest in particular sectors in the broader market (such as technology or utility stocks), others invest for dividend yield, and still others invest according to principles of social responsibility.  And that’s just domestic stock funds; there are other distinctions for foreign funds and bonds…

Q: Alright, alright, I get it; there are lots of different funds.  Are there any important distinctions?

A: All the distinctions are important.

Q: *Threatening Stare*

A: Alright, one particularly important distinction is the difference between index funds and actively managed funds.  Index funds follow various indexes (like the S&P 500, the Russell 2000, the Wilshire 5000), holding all the stocks in the index (or sometimes a smaller, representative sample).  Actively managed funds have managers running things, choosing which investments to buy and sell.

Q: Ooo, that sounds good.  What could go wrong with having professionals choose my investments?

A: Oh, yes, that… Well, while active management can beat the indexes (in theory), in practice, most actively managed funds keep pace with their respective indexes, at best.  When you take into account the higher expenses charged by active funds (typically above 1% of the assets being managed compared to 0.2-0.4% for index funds), they usually end up lagging behind the comparative index.  A good primer on the difference can be heard on the Vanguard website.

Q: That’s no good.  So, it’s better to stick with index funds?

A: Generally, yes.  While there can be actively managed funds that outperform the appropriate index over a long period of time, it will take time and research to find them.  Furthermore, there will be changes, whether in the management or in the broader economy; active managers that do well in good economic situations may crash during bad times, or vice versa.

For the most part, having most (or all) of your mutual fund money in index funds will serve you well.  Adding actively managed funds only after much research, a thorough understanding of how the fund manager will use your money, and a reasonable expectation of how much more money you will earn from taking an active approach is a smart approach.

Q: I get you.  How should I invest my money in mutual funds, then?

A: That’s the $64,000 question; there are almost as many different ideas of how to invest in funds as there are commentators making the recommendations.  In short, a lot of different ideas are being bounced around.  There are a few generally agreed upon principles:

1) When you are young, you should own mostly stock funds, gradually adding bond funds and even cash to the portfolio as you get older.

2) You should have exposure to foreign markets as well as domestic stocks, to help diversify your holdings even further.

3) Narrower types of funds, such as sector-specific funds, should be used sparingly in your portfolio.  Most of your holding should be broad, total-market  funds, whether in domestic stocks, foreign stocks, or bonds.

I go more in depth about one method of creating a portfolio from stock and bond index funds in my second investment pyramid post.

Q: Any shortcuts to all that investment work?

A: Most fund companies now offer target-date funds.  These are funds of funds, mutual funds that invest in a variety of other mutual funds.  They are designed to start out fairly agressive (mostly stocks) and gradually shift into more bonds and cash as the funds get closer to the target date.  By picking a fund with a target date near the time you intend to retire, you can have an investment that does all the rebalancing and reinvestment work for you over the course of your life.

Target date funds aren’t perfect, though.  They charge additional fees on top of the fees for the underlying mutual funds, increasing the expenses.  They also take a ‘one size fits all’ approach, without regards to individual differences in goals or investment needs.  If you do decide to take this route, do some research, and make sure your chosen target date fund will meet your needs, now and in the future.

That wraps our look at mutual funds in all their glory and splendor.  I hope it helped you to get a feel for this investment and how to take advantage of it.

• Mutual Funds Introduction
• Why Index Funds are Bad Investments
• Index Funds 101
• Mutual Fund Investing For Dummies
• I Bought a Mutual Fund...

(This is the second in a regular series where I attempt to explain some common investments and other financial terms. Enjoy the knowledge and sharing.)

Q: So, what exactly are bonds?

A: Simply put, bonds are IOUs. When companies, governments, or even individuals (remember Bowie bonds?) need money, they can sell bonds, allowing them to raise capital and pay it back later.

Q: Why would I want to lend money to people I don’t even know?

A: Well, unlike loans you make to family members or friends, when you purchase a bond, you’ll gain additional money. If you hold onto your bond, you’ll receive regular payments (called dividends), usually twice each year. When the bond matures (that is, when the duration of the loan is over), you’ll receive your money back.

Q: Sounds pretty good to me! How can I lose?

A: There are a few drawbacks to bond investing, unfortunately. They tend to yield less than investments in stocks; if we look at the returns between 1926 and 2007, we see an average return on bond investments of 5.5% compared to 10.4% for stock investments. And unlike certain qualified stock dividends, bond dividends are taxed at your normal income rate.

Plus, there is always the risk that the company or other bond issuing agency could default.

Q: Wait, what? What’s this about default?

A: Well, yeah. If your bond issuers go bankrupt, they may not be able to repay their creditors (which, if you own bonds, will include you). You will be somewhat better off than stock holders (as they are considered part owners, when the company goes under, they lose all their investment), but you might only get a small portion of your investment back, if any. You can avoid this situation, or at least minimize the possibility, if you stick to highly rated, ‘investment grade’ bonds.

Q: Bond ratings, you say?

A: Yes, there are agencies that review the companies, governments, and agencies that issue bonds, including Moody’s, Standard & Poor’s, and Fitch. They classify bonds according to the risk of default, from AAA (or Aaa), the rock-solid, safe as can be issuers, all the way down to D, already in default. Sticking with the bonds rated at least BBB (the fourth highest rank, the lowest investment grade ranking) will all but eliminate the chance of default.

(A caveat, though: many of the mortgage backed securities and their derivatives were ranked AAA by the rating agencies. A high ranking shouldn’t be the end of your research into the bond issuers in which you intend to invest.)

Q: So, if I stick with high rated bonds, there’s no worries?

A: No, sorry, you’re not out of the woods yet. Bond yields are determined by the prevailing interest rates. When rates are high, bond issuers have to pay more to get investors (since the investors have many other options that will give them good return on their money). When rates are low (as they are now), you won’t get a high return from bonds. If you buy bonds when interest rates are low and then the rates rise, the amount the bonds can be sold for will decrease.

Even if you manage to buy the bonds when they’re yielding a high return, there’s the possibility that the bond will be called. In these cases, the bond issuer will pay back your principal early, essentially ending your dividend payments and forcing you to find somewhere else to invest.

Q: Arrgh, with all these drawbacks, why would anyone invest in bonds?

A: There are several reasons to invest in bonds. First, bonds are still very safe investments. The risk of default on investment grade bonds is under 2% (and AAA ranked bonds default about 0.1%), meaning that over 98% of investment grade bonds make it to maturity (or are called ahead of time) without incident.

Bonds also tend to be much more stable investments than stocks. Look back at the comparison of stock and bond portfolios; the worst loss an all-bond portfolio suffered was a loss of 8% in one year, compared to a worst-case result of losing 43% in all stocks. Adding bonds to your portfolio will diversify your holdings, help to smooth out your investment returns and make your portfolio more stable.

If you’re looking for current income, bonds are one of the best sources. The dividend rate you get from bonds usually exceeds what you can get from stocks. In addition, it’s difficult for companies to cut bond dividends without recalling the bonds, so your income stream is safer when investing in bonds than when investing in stocks.

Q: Alright, I’m sold. How do I buy bonds?

A: Well, you can buy bonds directly, from a site like PIMCO or FINRA. (Or US Government Treasuries at the Treasury website) Bonds do tend to be rather pricey, however, frequently selling for $1,000 (or more) each. This makes it tough to build a diverse portfolio as a relatively small investor; most investment advisors recommend between $25,000 and $50,000 to get started in bond investing.

For most investors, getting a diverse portfolio of bonds, enough to ensure that a possible default or two won’t upset your investment plans, the best bet is a bond mutual fund. There are a variety of bond mutual funds available, from companies like Vanguard, Fidelity, and T. Rowe Price. These fund give you exposure to bonds, but are much more diverse.

For a more complete comparison of bonds and bond funds, you’ll just have to wait until tomorrow…

Q: Awww, do I have to?

Yes, yes you do. But have a good time until then!

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(This is the first entry in a regular series, covering some basic information about a variety of investment options in a question and answer format. It’ll be witty, informative, and entertaining, just like high school! Or at least, as what we all wished high school was like.)

Q: What are stocks?

A: In a nutshell, stocks are small ownership portions of a company. If you have Microsoft stock, for example, you are a part owner of the Microsoft corporation.

Q: Sounds good! So, when can I start bossing Bill Gates around?

A: Well, two problems with that: first, Bill is essentially retired, and is putting more time into charity work than Microsoft these days. Second, it’s unlikely you own enough stock to have a controlling stake in a company as large as Microsoft.

Q: Well, shoot, that’s no fun. What determines how much of the company each share of stock represents?

A: It depends on how much of the company’s equity is represented by the stock. If, when initially selling the stock, a company decides to sell 40% of its equity (the value of the company and its assets) in the form of stock, and issues 40,000 shares, then each share will represent 0.001% of the total company. If you bought 1000 shares, for instance,you would own 1% of the total company. Most companies put out millions of stock shares, making it all but impossible for regular investors to gain a controlling (that is, more than 50%) share.

Q: That’s interesting. But why should I own stocks?

A: Stocks are good investments as they have high rates of return. They tend to outperform many other investment categories, such as bonds and money market funds, over the long run. They are useful for saving and growing money for people who have time and patience.

Q: That all sounds good, but how exactly can stocks make me money?

A: Stocks have two different ways to return your investment: (a) capital growth: when stock prices rise, you can sell your shares for more money than you used to purchase them, and pocket the profits, and (b) dividends: some (but not all) stocks pay out a portion of the company’s profits to shareholders once a quarter, essentially rewarding you for holding onto your shares.

Q: Which of those two methods is best? And how should I invest to achieve that goal?

A: Two questions, hunh? Alright, to answer the first one, it depends on your goals; if you are seeking to grow your money, investing for capital growth should be your aim. If you want to gain spendable money (if you’re retired and want a steady source of income), investing for dividends might be better.

You can shift your investments to meet your particular goals. If you want dividends, invest in large, well-established companies (known as blue-chips), which tend to pay out more of their income as dividends. Or invest in REITs, specialized stocks that invest in real estate and are required by law to pay out a large amount of their income. For capital growth, consider investing in smaller companies; they have more room to grow and expand.

Q: That’s great! How can I lose?

A: Well, there are risks to owning stocks. Stock prices rise and fall, sometimes dramatically and quickly, so if you can’t count on regular capital gains. If the stock prices go low enough, you might even find that the stocks are worth less than the money you paid for them. Dividends can be reduced or even cut entirely, sometimes with little warning. And if a company goes bankrupt, as companies sometimes do, the stock holders are unlikely to get any of their money back; they are behind bond holders and other debtors in claiming corporate assets.

Q: This is getting dicey. How can you find good stocks?

A: That’s the $64,000 question; there aren’t too many ways to ensure your stocks will do well. The single best method is to do careful, thorough, complete research, completely vetting the companies you want to invest in, and continue to follow the stocks regularly, being sure to know when things change with the company you now (partially) own.

Q: That sounds pretty hard. Is there any way to get the benefits of stocks without all this work?

A: The easiest way is to buy mutual funds. This allows you to own dozens, hundreds, or even thousands of stocks with a single investment. As a result, you’ll get the dividends and growth potential of stocks with much less risk, and much less work, than hunting down and studying individual stocks. You will give up the potential of finding a superstar stock that drastically increases in value, but you will avoid the possibility of having a large amount of your money tied up in another Bear Stearns.

That wraps up this week’s Investing 101 segment; come back next week, when we’ll delve into the wonderful world of bonds.

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• Becareful When Picking Mutual Fund Based on its Name
• Trading the World Wide Forex Market
• October 2011 Dividend Investment Portfolio Update