The Amateur Financier

(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!

(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.

(*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 investing 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!

(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!