Research bond information within the University Library or the Internet.
Describe in 90- to 175-words what you found. How can you use this information within your personal or professional life?
Differentiate what the following bond ratings mean for investors in 30 to 90 words each:
o AAA
o B
BB
o B
o CC
15 Investing through Mutual Funds
YOU MUST BE KIDDING, RIGHT?
Twins Huan-yue and and Hao Wang invest in mutual funds. Huan-yue majored in English in college. For more than 20 years, she invested in managed funds, counting on professional financial advisers to select the winning companies more often than not. Hao majored in Finance; he invested in unmanaged index mutual funds that achieve the same return as a particular market index by buying and holding all or a representative selection of securities in the index. After 20 years of investing, what are the odds that Huan-yue’s investment portfolio balance will be better than Hao’s?
A. zero
B. 10%
C. 20%
D. 30%
The answer is A. Managed mutual funds generally do not earn returns for investors that exceed the overall market indexes. The fact is the average mutual fund manager earns a lower return at least 90 percent of the time over 5-year time periods. Finding a mutual fund investment manager who can consistently beat the market is very challenging!
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
Describe the features, advantages, and unique services of investing through mutual funds.
Differentiate mutual funds by investment objectives.
Summarize the fees and charges involved in buying and selling mutual funds.
Establish strategies to evaluate and select mutual funds that meet your investment goals.
WHAT DO YOU RECOMMEND?
Tyler and Samantha Gent, a couple in their early 30s, have a 2-year-old child and enjoy living in a moderately priced downtown apartment. Tyler, a library director, earns $60,000 annually. Samantha earns $69,000 as a merchandise buyer for a specialty store. They are big savers: together they have been putting $1000 to $2000 per month into CDs, and the couple now has a portfolio worth $120,000 paying about 2 percent annually. The Gents are conservative investors and want to retire in about 20 years.
What do you recommend to Tyler and Samantha on the subject of investing through mutual funds regarding:
1. Redeeming their CDs and investing their retirement money in mutual funds?
2. Investing in growth and income mutual funds instead of income funds?
3. Buying no-load rather than load funds?
4. Buying mutual funds through their employers’ 401(k) retirement accounts rather than saving through a taxable account as they have been doing?
YOUR NEXT FIVE YEARS
In the next five years, you can start achieving financial success by doing the following related to investing through mutual funds:
1. Match your investment philosophy and financial goals to a mutual fund’s objectives.
2. Save regularly, pick an asset mix of mutual funds that matches your goals, and keep investment costs low by avoiding 12b-1 fees and high management fees.
3. Use your criteria to screen mutual fund investments using free online software.
4. Invest regularly in mutual funds through your employer’s retirement plan.
5. Sign up for automatic reinvestment of your mutual fund dividends.
Most investors prefer to avoid buying individual stocks and bonds because of the high financial risk associated with owning too few investments like two or three stocks or bonds. The average investor usually cannot accumulate a portfolio diversified enough to minimize the risk linked to the failure of a one or two holdings. They often also lack both the ability and the time required to research individual securities and manage such a portfolio. In an effort to avoid these problems, many people invest in the stock and bond markets through mutual funds, which typically buy hundreds of different stocks and bonds. Mutual funds make it easy and convenient for investors to open an account and continue investing throughout their lives. Half of all households invest through mutual funds.
15.1 WHY SHOULD YOU INVEST IN MUTUAL FUNDS?
A
mutual fund
is an investment company that pools funds obtained by selling shares to investors and makes investments to achieve the financial goal of income or growth, or both. Mutual funds invest in a diversified portfolio of stocks, bonds, short-term money market instruments, and other securities or assets.
mutual fund
Investment company that pools funds by selling shares to investors and makes diversified investments to achieve financial goals of income or growth, or both.
The fund might own common stock and bonds in such companies as AT&T, IBM, Google, or Running Paws Cat Food Company (our fictional example from
Chapter 14
). The combined holdings are known as a portfolio, as we noted in
Chapter 13
and as shown graphically in
Figure 15-1
. The mutual fund company owns the investments it makes and the mutual fund investors own the mutual fund company. Unlike corporate shareholders, holders of mutual funds have no say in running the company, although they have equity interest in the pool of assets and a residual claim on the profits.
LEARNING OBJECTIVE 1
Describe the features, advantages, and unique services of investing through mutual funds.
15.1a The Net Asset Value Is the Price You Pay for a Mutual Fund Share
One measure of the investor’s claim on assets is the net asset value. The
net asset value (NAV)
is the price one pays (excluding any transaction costs) to buy a share of a mutual fund. It is the per-share net worth of the mutual fund. It is calculated by summing the values of all the securities in the fund’s portfolio, subtracting liabilities, and then dividing by the total number of shares outstanding.
net asset value (NAV)
Per-share value of a mutual fund.
Figure 15-1
How a Mutual Fund Works
For example, a mutual fund has 10 million shares outstanding and a portfolio worth $100 million, and its liabilities are $5 million. The net asset value of a single share is
The NAV rises or falls to reflect changes in the market value of the investments held by the mutual fund company. This value is calculated daily after the U.S. stock exchanges close, and a new NAV is posted in the financial media. If the stocks and bonds held in a mutual fund increase in value, the NAV will rise. For example, if a mutual fund owns IBM and General Electric common stocks and the prices of those stocks increase, the increased value of the underlying securities is reflected in the NAV of fund shares. This is price appreciation. Some time later when investors sell shares at a net asset value higher than that paid when they purchased the shares (after transaction costs), they will have a capital gain.
The type of mutual fund that is the focus in this chapter is an
open-end mutual fund
. Accounting for more than 90 percent of all funds, open-end mutual funds issue redeemable shares that investors purchase directly from the fund (or through a broker for the fund). They are always ready to sell new shares of ownership and to buy back previously sold shares at the fund’s current NAV. Open-end mutual funds, numbering more than 13,000, total more than the stocks listed on the New York Stock Exchange (approximately 2800).
Table 15-1
lists advantages of investing through mutual funds.
open-end mutual fund
Investment that issues redeemable shares that investors purchase directly from the fund (or through a broker for the fund).
15.1b Dividend Income and Capital Gains Distributions Result from the Mutual Fund’s Earnings
A
mutual fund dividend
is income paid to investors out of profits that the mutual fund has earned from its investments. The dividend represents both ordinary income dividend distributions and capital gains distributions.
Ordinary income dividend distributions
occur when the fund pays out dividends from the stock and interest from the bonds it hold in its portfolio. These are passed onto the investor quarterly.
Capital gains distributions
represent the net gains (capital gains minus capital losses) that a fund realizes when it sells securities that were held in the fund’s portfolio. Mutual funds distribute capital gains once a year, even though the gains occur throughout the year whenever securities are sold at a profit. When a fund pays out these distributions, the NAV drops by the amount paid.
mutual fund dividend
Income paid to investors out of profits earned by the mutual fund from its investments.
ordinary income dividend distributions
Distributions that occur when the fund pays out dividends from the stock and interest from the bonds it hold in its portfolio; these are passed onto the investor quarterly.
capital gains distributions
Distributions representing the net gains (capital gains minus capital losses) that a fund realizes when it sells securities that were held in the fund’s portfolio.
DO IT IN CLASS
Table 15-1 Advantages of Investing Through Mutual Funds
Diversification
Many investors find it easier to achieve diversification through ownership of mutual funds that own hundreds of stocks and bonds rather than picking and then owning individual stocks and bonds.
Affordability
Individuals can invest in mutual funds with relatively low dollar amounts for initial purchases, such as $250 or $1000. Subsequent purchases can be as little as $50.
Professional Management
The fund’s investment advisers have access to excellent research, and they select, buy, sell, and monitor the performance of the securities purchased; they oversee the portfolio.
Liquidity
You can very easily convert mutual fund shares into cash without loss of value because the investor sells (or
redeems
) the shares back to the investment company by using a telephone, wire, fax, mail, or online.
Low Transaction costs
Because mutual funds trade in large quantities of shares, they pay far less in brokerage commissions than stock investors. Shares bought and sold are at the NAV plus any fees and charges that the fund imposes, and these are often quite low.
Uncomplicated Investment choices
Selecting a mutual fund is easier than selecting specific stocks or bonds because mutual funds state their investment objectives, allowing investors to select funds that almost perfectly match their own objectives.
redeems
When an investor sells mutual fund shares.
15.1c Capital Gains Can Result When You Sell Mutual Fund Shares
When you sell your shares in the mutual fund, you receive the NAV of the share at its current market price. If the price is higher than the price you originally paid, you have a capital gain due to the increase in the NAV although your gain is reduced by transaction costs.
Reinvesting income greatly compounds share ownership.
Figure 15-2
illustrates the positive results obtained by reinvesting dividends.
15.1d Unique Mutual Fund Services
A
mutual fund family
is an investment management company that offers a large number of different mutual funds to the investing public, each with its own investment objectives. There are more than 400 mutual fund families (see biz.yahoo.com/p/fam/a-b.xhtml).
mutual fund family
Investment management company that offers a number of different funds to the investing public, each with its own investment objectives or philosophies of investing.
Mutual funds, as shown in
Table 15-2
, offer a number of valuable services that are unique to this type of investment and that are helpful and appealing to investors. More than 40 percent of the total return of the S&P 500 over the past 80 years has come from reinvested dividends. Enrolling in an automatic reinvestment program is a smart and easy way of accumulating wealth over time.
Figure 15-2
The Wisdom of Automatic Dividend Reinvestment
The initial $10,000 investment in S&P 500 Index Fund grew to $58,000 over 20 years, instead of $40,000, because of the reinvestment of dividends.
DO IT IN CLASS
Table 15-2 Unique Mutual Fund Services
Convenience
Funds make it easy to open an account and invest in and sell shares. Fund prices are widely quoted. Services include toll-free telephone numbers, detailed records of transactions, checking and savings alternatives, and the paperwork and record keeping, including accounting for fractional shares.
Ease of Buying and Selling Shares
Opening an account with a mutual fund company is as simple as opening a checking account. After making your initial investment, you can easily buy more shares. Shares can be bought or sold at any time. Each is redeemed at the closing price—the NAV—at the end of the trading day.
Check Writing and Electronic Transfers
Mutual funds often offer interest-earning, check-writing money market mutual funds in which investors can accumulate cash, accept dividends, or hold their money. Investors can electronically transfer funds to and from mutual funds and banks.
Automatic Reinvestment of Income and Capital Gains
Mutual funds allow investors to choose to receive current income payments or have them automatically reinvested to purchase additional fund shares (often without paying any commissions). This is
automatic reinvestment
, as illustrated in Figure 15-2.
Exchange Privileges
An
exchange privilege
permits mutual fund shareholders to easily swap shares on a dollar-for-dollar basis for shares in another mutual fund managed by the same mutual fund family, usually at no cost.
Automatic Investment Program (AIP)
Funds often allow investors to make periodic monthly or quarterly payments using money automatically transferred from their bank accounts or paychecks to the mutual fund company. You can invest as little as $25 monthly or quarterly.
Effortless Establishment of Retirement Plans
An employee can fill out a one-page form that directs his or her employer to transfer a specified dollar amount from every paycheck to a mutual fund to buy shares for a 401(k) plan. Similarly, individuals can fill out a one-page form to buy shares for their individual retirement accounts.
Beneficiary Designation
A
beneficiary designation
enables the shareholder to name one or more beneficiaries so that the proceeds go to them without going through probate.
Withdrawal Options
Mutual funds offer
withdrawal options
(also called
systematic withdrawal plans
) to shareholders who want to receive income on a regular basis from their mutual fund investments. The minimum withdrawal amount is $50 at regular intervals. You may make regular withdrawals by (1) taking a set dollar amount each month, (2) cashing in a set number of shares each month, (3) taking the current income as cash, or (4) taking a portion of the asset growth.
automatic reinvestment
Investor’s option to choose to automatically reinvest any interest, dividends, and capital gains payments to purchase additional fund shares.
exchange privilege
Allowance for mutual fund shareholders to easily swap shares on a dollar-for-dollar basis for shares in another mutual fund within a mutual fund family. Also called switching, conversion, or transfer privilege.
beneficiary designation
Allowance of fund holder to name one or more beneficiaries so that the proceeds bypass probate proceedings if the original shareholder dies.
withdrawal options (systematic withdrawal plans)
Arrangements with a mutual fund company for shareholders who want to receive income on a regular basis from their mutual fund investments.
DID YOU KNOW
Types of Investment Companies
The federal Investment Company Act distinguishes among investment companies. Open-end mutual funds are by far the most widely owned investment companies. Four other types exist:
1.
Closed-end mutual funds. Closed-end mutual funds
issue a limited and fixed number of shares at inception and do not buy them back. These companies operate with a fixed amount of capital. Closed-end shares are bought and sold on a stock exchange or in the over-the-counter market. After the original issue is sold, the price of a share depends primarily on the supply and demand in the market rather than the performance of the investment company assets. Closed-end shares of about 600 companies are actively traded like common stocks and bonds, primarily on the New York Stock Exchange.
2.
Real estate investment trusts. A special kind of closed-end investment company is a
real estate investment trust (REIT)
. REITs invest in a portfolio of assets as defined in the trust agreement, such as properties, like office buildings and shopping centers (called an equity REIT), or mortgages (a mortgage REIT). Hybrid REITs invest in both. REITs have no predetermined life span. There are about 160 REITs traded on the New York Stock Exchange.
3.
Unit investment trusts. A
unit investment trust (UIT)
is a closed-end investment company that makes a one-time public offering of only a specific, fixed number of units. A UIT buys and holds an unmanaged fixed portfolio of fixed-maturity securities, such as municipal bonds, for a period of time. This could be a few months or perhaps 50 years. Each unit represents a proportionate ownership interest in the specific portfolio of perhaps 10 to 50 securities. Sold by brokers for perhaps $250 to $1000 a unit, there is no trading of these securities, although brokers may repurchase and resell them. There are about 5800 UITs.
4.
Exchange-traded funds. An
exchange-traded fund (ETF)
is a basket of passively managed securities structured like an index fund as it owns all or a representative set of securities that duplicate the performance of a market segment or index. In effect, ETFs ditch the fund manager and pass the savings on to the investor. There are ETFs for the S&P 500, called Spiders; the Dow Jones Industrial Average, called Diamonds; and Qubes based on the NASDAQ 100. There are about 1200 ETFs, and their prices are set by market forces since they are listed on securities markets (primarily on the American Stock Exchange) and traded throughout the day. ETFs give investors an easy way to track an index without buying an index fund. ETFs are available for nearly every index, from large U.S. companies to health care and foreign bonds.
CONCEPT CHECK 15.1
1. Explain how net asset value is calculated and how it is used by mutual funds.
2. List five advantages of investing in mutual funds.
3. Name five services that are unique to mutual funds.
LEARNING OBJECTIVE 2
Differentiate mutual funds by investment objectives.
15.2 MUTUAL FUND OBJECTIVES
Most mutual funds are managed funds, meaning that professional managers are constantly evaluating and choosing securities using a specific investment approach. On a daily basis, active managers select the stocks and bonds in which to invest and sell them when they deem appropriate. The managers earn a fee often up to 2 percent, for their services, and ultimately their choices are responsible for the performance of the fund.
These also are index mutual funds (or index funds) whose investment objective is to achieve the same return as a particular market index by buying and holding all or a representative selection of securities in it. Index funds are called unmanaged funds because their managers do not evaluate or select individual securities. An S&P 500 index fund would effectively mirror the companies in the index, which are primarily large-cap U.S. stocks. Annual management fees are extremely low, perhaps only 0.07 to 0.30 percent.
index mutual funds (or index funds)
are those funds whose investment objective is to achieve the same return as a particular market index by buying and holding all or a representative selection of securities in it.
DID YOU KNOW
Money Websites on Mutual Funds
Informative websites for investing through mutual funds, including online screens to compare funds are:
Business Week Online on funds (
www.businessweek.com/markets-and-finance/mutual-funds-and-etfs
)
CNNMoney.com on funds (
money.cnn.com/pf/funds/index.xhtml
)
Kiplinger’s Personal Finance (
www.kiplinger.com/fronts/special-report/mutual-funds/index.xhtml
)
Kiplinger’s model portfolio (
www.kiplinger.com/article/investing/T033-C009-S001-kiplinger-25-model-portfolios.xhtml
)
MarketWatch (
www.marketwatch.com/investing/mutual-funds?link=MW_Nav_INV
)
Motley Fool (
www.foolfunds.com
)
Vanguard (
www.vanguard.com
)
Wikipedia (
en.wikipedia.org/wiki/Mutual_fund
)
Yahoo! Finance (
finance.yahoo.com/funds
)
Yahoo! Finance’s fund screener (
screener.finance.yahoo.com/funds.xhtml
)
Before investing in any specific mutual fund, you need to decide whether the fund’s investment objectives are a good fit for your own investment philosophy and financial goals. The SEC requires funds to disclose their investment objective. Mutual funds may be classified in one of three categories: (1) income, (2) growth, and (3) growth and income. Each type has different features, risks, and reward characteristics, and the name of a fund gives a clue to its objectives.
15.2a Income Objective
A mutual fund with an income objective, such as money market and bond funds, invests in securities that pay regular income in dividends or interest.
Money Market Funds Mutual fund companies and brokerage firms offer
money market funds (MMFs)
. They invest in highly liquid, relatively safe securities with very short maturities (always less than one year), such as CDs, Treasury bills, and commercial paper (i.e., short-term obligations issued by corporations). To enhance liquidity, regulations require that MMFs keep 10 percent of their assets in cash or investments that can be converted easily to cash within one day. You can write checks or use an ATM card to access a money market fund account. Issuers keep the NAV (the price of each share of the fund) at $1.
money market funds
are those that invest in highly liquid, relatively safe securities with very short securities, always less than one year.
Money market funds (and there are about 580 of them) pay a higher rate of return than accounts offered through banks and credit unions. They are considered extremely safe.
Tax-exempt money market funds
limit their investments to tax-exempt municipal securities with maturities of less than 60 days, and their earnings are tax free to investors. Government securities money market funds appeal to investors’ concerns about safety by investing solely in Treasury bills and other short-term securities backed by the U.S. government.
tax-exempt money market funds
Funds that limit their investments to tax-exempt municipal securities with maturities of 60 days or less.
Bond Funds
Bond funds
(also called fixed-income funds) aim to not incur undue risk while earning current income higher than a money market fund by investing in a portfolio of bonds and other investments, such as preferred stocks and common stocks that pay high dividends. They also earn some capital gains because bond fund prices fluctuate with changing interest rates. Today’s nearly 2000 bond funds are categorized by what they own and the maturities of their portfolio holdings.
bond funds (fixed-income funds)
Fixed-income funds that aim to earn current income higher than a money market fund without incurring undue risk by investing in a portfolio of bonds and other low-risk investments that pay high dividends and offer capital appreciation.
• Short-term corporate bond funds invest in securities maturing in one to five years.
• Short-term U.S. government bond funds invest in Treasury issues maturing in one to five years.
• Intermediate corporate bond funds invest in investment-grade corporate securities with five- to ten-year maturities.
• Intermediate government bond funds invest in Treasuries with five- to ten-year maturities.
• Long-term corporate bond funds specialize in investment-grade securities maturing in 10 to 30 years.
• Long-term U.S. government bond funds invest in Treasury and zero-coupon bonds with maturities of ten years or longer.
• Mortgage-backed funds invest in mortgage-backed securities issued by agencies of the U.S. government, such as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation).
• Junk bond funds invest in high-yield, high-risk corporate bonds.
• Municipal bond (tax-exempt) funds invest in municipal bonds that provide taxfree income. Both investment-grade and high-yield municipal bond funds exist.
• Single-state municipal bond funds invest in debt issues of only one state.
• World bond funds invest in debt securities offered by foreign corporations and governments.
15.2b Growth Objective
A mutual fund that has a growth objective seeks capital appreciation. It invests in the common stock of companies that have above average growth potential, firms that may not pay a regular dividend but have the potential for large capital gains. Growth funds carry a fair amount of risk exposure, and this is reflected in substantial price volatility. Growth funds are categorized by what they own and their investment goals.
Aggressive growth funds
(also known as maximum capital gains funds) seek the greatest long-term capital appreciation. Also known as capital appreciation funds, they make investments in speculative stocks with volatile price swings. They may employ high-risk investment techniques, such as borrowing money for leverage, short selling, hedging, and options. Lots of buying and selling occurs to enhance returns.
aggressive growth funds (maximum capital gains funds)
Funds that invest in speculative stocks with volatile price swings, seeking the greatest long-term capital appreciation possible. Also known as maximum capital gains funds and capital appreciation funds.
Growth funds
seek long-term capital appreciation by investing in the common stocks of companies with higher-than-average revenue and earnings growth, often the larger and well-established firms. Such companies (like Walmart, Microsoft, and Coca-Cola) tend to reinvest most of their earnings to facilitate future growth.
growth funds
Funds that seek long-term capital appreciation by investing in common stocks of companies with higher-than-average revenue and earnings growth, often the larger and well-established firms.
Growth and income funds
invest in companies that have a high likelihood of both dividend income and price appreciation.
growth and income funds
Funds that invest in companies that have a high likelihood of both dividend income and price appreciation; less risk-oriented than aggressive growth funds or growth funds.
Value funds
specialize in stocks that are fundamentally sound and whose prices appear to be low (low P/E ratios), based on the logic that such stocks are currently out of favor and undervalued by the market.
value funds
Funds specializing in stocks that are fundamentally sound whose prices appear to be low (low P/E ratios) based on the logic that such stocks are currently out of favor and undervalued by the market.
DID YOU KNOW
Bond Funds Drop in Value When Interest Rates Rise
Extremely low interest rates—like those during and following an economic recession—are eventually replaced by rising interest rates because subsequent economic growth eventually results in inflation. When inflation goes up, the value of a bond mutual fund decreases. For every 1 percentage point change in interest rates, the value of the bond fund changes by the amount of the duration of maturity. For example, if a bond fund has an average duration of seven years and interest rates rise 1 percentage point, the value of the bond fund will drop by 7 percent. Should today’s interest rates rise 3 percent over the next few years, the net asset value of a bond mutual fund is likely to decline in value by 21 percent.
Large-cap funds invest in the stocks of companies with a market capitalization of more than $10 billion.
Midcap funds invest in the stocks of midsize companies with a market capitalization of $2 to $10 billion in size that are expected to grow rapidly.
Small-cap funds (or small company growth funds) invest in lesser-known companies with a market capitalization of $300 million to $2 billion in size that offer strong potential for growth.
Microcap funds invest in high-risk companies with a market capitalization of $50 to $300 million.
Sector funds concentrate their investment holdings in one or more industries that make up a targeted part of the economy that is expected to grow, perhaps very rapidly, such as energy, biotechnology, health care, and financial services.
Regional funds invest in securities listed on stock exchanges in a specific region of the world, such as the Pacific Rim, Australia, or Europe.
Precious metals and gold funds invest in securities associated with gold, silver, and other precious metals.
Global funds invest in growth stocks of companies listed on foreign exchanges as well as in the United States, usually multinational firms.
International funds invest only in foreign stocks throughout the world.
Emerging market funds seek out stocks in countries whose economies are small but growing. Fund prices are volatile because these countries tend to be less stable politically.
15.2c Growth and Income Objective
A mutual fund that has a combined growth and income objective seeks a balanced return made up of current income and capital gains. Such funds primarily invest in common stocks. They seek a return not as low as offered by funds with an income objective but not as high as that offered by funds with a growth objective. They invite less risk than growth funds. There are a variety of growth and income funds.
Growth and income funds invest in companies expected to show average or better growth and pay steady or rising dividends.
ADVICE FROM A PROFESSIONAL
Invest Only “Fun Money” Aggressively
Once the investor has his or her financial plan in place, taking on more risk is acceptable—but only within the limits of the individual’s “fun money.” Fun money is a sum of investment money that you can afford to lose without doing serious damage to your total portfolio. You might, for example, resolve to trade with a specific sum, such as $5000, or perhaps no more than 2 or 3 percent of your portfolio. Keep such fun money in a separate account from your long-term investments. Decide mentally that if and when the money is gone, it has been spent on an activity that you enjoyed trying, but accept that the money lost is lost forever. Avoid the temptation to “throw good money after bad” by investing more money in an effort to try to recover your losses.
Speculative investing is not much different from gambling. The biggest danger of fun-money investing is that you might be successful. Success can give you the confidence— albeit probably false confidence—that you are a great investor. While you might be the next billionaire investor like Warren Buffett, such success is likely to tempt you to aggressively invest even more of the assets in your total portfolio. That approach can result in disaster. As financial columnist Jane Bryant Quinn observes, “The money you really need for life is better off in broadly diversified mutual funds, where a mistake is not forever.”
Robert O. Weagley
University of Missouri–Columbia
Figure 15-3
Balancing Risk and Returns on Mutual Funds
ADVICE FROM A PROFESSIONAL
Stable-Value Funds Are Available Only through Employers
Stable-value funds
are only available through employer-sponsored retirement plans.
They offer attractive returns and liquidity without market risk to defined contribution plan participants (and some 529 tuition savings plans) because they have contracts with banks and insurance companies designed to permit redemption of shares at book value regardless of market prices. Over the past ten years, stable-value funds returned 3.0 to 5.0 percent annually. GIC funds increased in value during the worst of the Great Recession while virtually all others declined. Stable-value funds invest in high-quality, intermediate-term bond funds, including guaranteed investment contracts (GICs) offered by insurance companies. A GIC guarantees the owner a fixed or floating interest rate for a predetermined period of time, and the return of principal is guaranteed.
Dana Wolff
Southeast Technical Institute, Sioux Falls, SD
Stable-value fund
Mutual fund that offers attractive returns and liquidity without market risk to defined contribution plan participants (and some 529 tuition savings plans) because they have contracts with banks and insurance companies designed to permit redemption of shares at book value regardless of market prices.
Equity-income funds invest in well-known companies with a long history of paying high dividends as they emphasize income and capital preservation.
Socially responsible funds invest in companies that meet some predefined standard of moral and ethical behavior. Criteria could be progressive employee relations, strong records of community involvement, an excellent record on environmental issues, respect for human rights, and safe products, as well as no “sinful” products such as tobacco, guns, alcohol, and gambling. See examples at The Forum for Sustainable and Responsible Investment (
www.ussif.org/
).
DID YOU KNOW
Bias toward Inertia in Investment Decisions
People engaged in investing through mutual funds have a bias toward certain behaviors that can be harmful, such as a tendency toward inertia or the tendency to not change. Once an employee selects a 401(k) plan contribution rate many never increase it, and only 20 percent of employees ever rebalance their investments. What to do? One day there will be a lot of money for you to manage in your 401(k) retirement account so regularly ratchet up your savings contribution, perhaps when you get a raise each year, and rebalance at least annually.
Balanced funds
(or hybrid funds) keep a set mix of stocks and bonds, often 60 percent stocks and 40 percent bonds, in order to earn a well-balanced return of income and long-term capital gains.
balanced funds
Funds that keep a set mix of stocks and bonds, often 60 percent stocks and 40 percent bonds, in order to earn a well-balanced return of income and long-term capital gains.
Blend funds invest in a combination of stocks and money market securities, but no fixed-income securities, such as bonds.
Asset allocation funds
invest in a mix of assets (usually stocks, bonds, and cash equivalents and sometimes international assets, gold, and real estate), and they buy and sell regularly to reduce risk while trying to outperform the market. The asset mix may be based on risk tolerance (aggressive, moderate, and conservative).
asset allocation funds
Investments in a mix of assets (usually stocks, bonds, and cash equivalents and sometimes international assets, gold, and real estate); they buy and sell regularly to reduce risk while trying to outperform the market.
Target-date retirement funds (life-cycle funds)
are asset allocation funds that offer investors premixed portfolios of stocks, bonds, and cash that investors of a certain age and risk tolerance might prefer. They are often named for the year one plans to retire, for example, the “Fidelity Freedom Fund 2030.” These are targeted to people in their 30s, 40s, and 50s. Target-date funds shift assets from aggressive to moderate to a more conservative mix of securities as the retirement target date approaches. They seek to first grow and then preserve the portfolio assets. This is a no-hassle, “set-it-and-forget-it” approach to investing for retirement. Regulations require target-date funds to provide investors with information that shows the projected allocations over the life of the fund.
target-date retirement funds (life-cycle funds)
Asset allocation funds that offer investors premixed portfolios of stocks, bonds, and cash that investors of a certain age and risk tolerance might prefer, and they are often named for the year one plans to retire.
Mutual fund funds earn a return by investing in other mutual funds. This provides extensive diversification, but expenses and fees are higher than average.
DID YOU KNOW
For the Lowest Fees Invest in ETFs and Index Mutual Funds
Instead of looking for a needle in a haystack when investing—finding the best mutual fund—why not buy the whole haystack? The lowest costs in investing can be found among the nation’s 373 index funds and 1200 exchange traded funds (ETFs). These are unmanaged baskets of passively managed securities that own a representative set of securities that duplicate the performance of an index or market segment. ETFs trade throughout the day and index funds close after the end of the business day.
One in four investors has ETFs in their portfolios partly because of the extremely low costs (0.36% annual management fee on average), which are lower than similar index mutual funds (0.76% on average). The lowest annual fee of all ETFs is Vanguard Total Stock Market ETF (VTSAX), only 0.07 percent, which tracks 3000 stocks, while Schwab’s U.S. Broad Market ETF (SCHB) tracks 2500 stocks with an annual fee of 0.08 percent.
The average annual gain of 9.6 percent on stock investments over the long-term is measured by the MSCI USA equity index from 1970 forward. It consists of 3.37 percent from dividends and 6.23 percent in capital gains. Stock pickers who are employed by managed funds have to actively trade and as a result they must obtain a return of 11 percent on average to achieve the same result as unmanaged index investment, because their fees and expenses often add up to 2 percent.
There is absolutely no scientific evidence that active fund management outperforms index funds and ETFs. Beating an unmanaged index investment may be remotely possible, but in reality it is highly unlikely.
CONCEPT CHECK 15.2
1. What are the three basic types of mutual fund objectives?
2. Distinguish among mutual funds with an income objective, growth objective, and growth and income objective.
3. Explain why investors like index mutual funds and exchange traded funds.
LEARNING OBJECTIVE 3
Summarize the fees and charges involved in buying and selling mutual funds.
15.3 MUTUAL FUND INVESTING FEES AND CHARGES
Individuals who invest through mutual funds pay transaction costs that often are less than those associated with buying individual stocks, bonds, and cash equivalent securities. However, the fees and charges associated with investing in mutual funds are many, and they can be confusing.
15.3a Load Versus No-Load Funds
All mutual funds are classified as either load or no-load funds. This refers to whether or not they assess a sales charge, or load, when shares are purchased. There are also other fees assessed on load and no-load funds that can be avoided through careful research.
Load Funds Are “Sold” and Always Charge Transaction Fees Funds that levy a sales charge for purchases are called
load funds
. Load funds are generally “sold” by stock brokerage firms, banks, and financial planners rather than marketed directly to investors by a mutual fund company. The load is the commission used to compensate sellers for their time and expertise in recommending appropriate funds for clients.
load funds
Mutual funds that always charge a “load” or sales charge upon purchase; the load is the commission used to compensate brokers.
This commission, often called a
front-end load
, typically amounts to a level sales charge of 3 to 8.5 percent of the amount invested. This reduces the amount available to purchase fund shares. For example, assume that you and your stockbroker have discussed the investment potential of the Conglomerate Cat and Dog Food Mutual Fund and you decide to invest $10,000. Because this load fund charges a commission of 8.5 percent (the maximum permitted by the SEC), the stockbroker receives $850 ($10,000 × 0.085). As a result, only $9150 of your money is actually available to purchase shares.
front-end load
A sales charge paid when an individual buys an investment, reducing the amount available to purchase fund shares.
The sales charge may be shown either as the stated commission or as a percentage of the amount invested. The
stated commission
(8.5 percent in our example) is always somewhat misleading. The “percentage of the amount invested” is a more accurate figure because it is based on the actual money invested and working. A stated commission of 8.5 percent actually amounts to 9.3 percent of the amount invested: $10,000 − $9150 = $850; $850 ÷ $9150 = 9.3%. If you want to invest a full $10,000 in this load fund, you will need to pay out $10,930 [$10,930 − ($10,930 × 8.5%) = of $10,000]. Investments of $10,000 or more often receive a discount on the load.
stated commission
The sales charge as a percentage of the amount invested.
So-called
low-load funds
may carry a sales charge of perhaps 1 to 3 percent. These funds may also be sold by brokers and are sometimes sold via mail and through mutual fund retailers located in shopping centers.
low-load funds
Funds carrying sales charges of perhaps 1 to 3 percent; sold by brokers, via mail, and sometimes through mutual fund retailers located in shopping centers.
Many No-Load Funds Also Assess Back-end Loads and Redemption Fees A
back-end load
(or contingent deferred sales charge) is a sales commission that is imposed only when shares are sold. Deferred loads are often on a sliding scale. The fee may decline 1 percentage point for each year the investor owns the fund. For example, a fund might charge a 6 percent fee if an investor redeems the shares within one year of purchase, and then the fee declines on an annual basis, until it reaches zero after six more years.
back-end load (contingent deferred sales charge)
A sales commission that is imposed only when shares are sold; often charges are on a sliding scale, with the fee dropping 1 percentage point per year that the investor stays in the fund.
A
redemption charge
(or
exit fee
) is lower and is usually 1 percent of the value of the shares redeemed. A fund assesses such a charge to reduce excessive trading of fund shares. The fee disappears after the investment has been held for six months or a year. Long-term investors for retirement do not need to be concerned about paying about back-end loads and exit fees, as these largely disappear over time.
redemption charge (exit fee)
Similar to a deferred load but often much lower; used to reduce excessive trading of fund shares.
All No-Load Funds Assess Fees A
no-load fund
sells shares at the net asset value without the addition of sales charges. These mutual fund companies let people purchase shares directly from the mutual fund company without the services of a broker, banker, or financial planner. Interested investors simply seek out advertisements for these funds in financial newspapers, magazines, and the Internet and make contact through toll-free telephone numbers, online, or mail. However, the SEC does allow funds to be called “no-load” even though they assess a service fee of 0.25 percent or less when shares are purchased. No-load funds are usually the best mutual funds in which to invest.
no-load funds
Funds that allow investors to purchase shares directly at the net asset value (NAV) without the addition of sales charges.
About One-half of No-Load Funds Also Assess Expensive 12b-1 Fees A
12b-1 fee
(named for the SEC rule that permits the charge) is an annual charge deducted by the fund company from a fund’s assets to compensate underwriters and brokers for fund sales as well as to pay for advertising, marketing, distribution, and promotional costs. A 12b-1 fee is also known as a
distribution fee
. This fee also pays for
trailing commissions
, which is compensation paid to salespeople for months or years in the future.
12b-1 fees (distribution fees)
Annual fees that some “no-load” fund companies deduct from a fund’s assets to compensate salespeople and pay other expenses.
trailing commission
Compensation paid to salespeople for months or years in the future.
Although the funds do not call 12b-1 fees “loads” because they are not charged up front, they have the same effect as loads—that is, they reduce the investor’s return, often quite dramatically. Over 60 percent of funds assess 12b-1 fees, including many no-load funds.
These fees are hidden and they decrease a shareholder’s earning power each year without being described as a sales commission. A 12b-1 fee is actually a “perpetual sales load” because it is assessed on the initial investment as well as on reinvested dividends, every year, forever. The SEC caps 12b-1 fees at 0.75 percent, although recall that the SEC also permits a 0.25 percent service fee, which brings the total to 1 percent. Some funds stop assessing 12b-1 fees after four to eight years. The 12b-1 fee is supposed to be replaced in 2017 with a 12b-2 fee to pay for “distribution activities, again capped at 0.25 percent annually.
DID YOU KNOW
Bias toward Worrying about the Wrong Things
People engaged in investing through mutual funds have a bias toward certain behaviors that can be harmful, such as a tendency toward worrying about the wrong things. Many investors focus on returns and passively ignore high investment fees associated with active account management, especially when they are automatically deducted from an account. What to do? Realize that high fees—which can be totally avoided— will reduce the growth of your assets 30 percent or more over many years, so steer clear of them!
FINANCIAL POWER POINT
Avoid Managed Funds because Low Fees and Expenses Mean Higher Returns
The investment balances 20 years later if an investment earns a 7 percent annual return on a $10,000 investment are as follows:
• Actively managed mutual fund (1.9 percent; $29,190)
• Index mutual fund (0.70 percent; $33,936)
• Index ETF (0.07 percent; $38,193)
Over 20 years that is $9,003 or a 31 percent higher return ($38,193 − $29,190 = $9,003/$29,190) for investing in an Index ETF compared to an actively managed mutual fund. Smart investors avoid managed funds!
15.3b Mutual Fund Share Classes—Designed to Confuse—Are Sold to You
A single mutual fund may be available to investors in more than one class of shares: Class A, B, or C, and they all are falsely sold as “no load” funds. They all invest in the same portfolio of securities and have the same investment objectives but have different fee and expense patterns. Class A shares normally have a front-end sales charges paid at the time of the initial purchase. Class B shares have back-end sales charges paid when selling the shares within a specified number of years, and they might (if held long enough) allow automatic conversion to share with a lower 12b-1 fee. Class C shares might have a 12b-1 fee and a redemption charge.
Moreover, the performance results for each class will differ depending on how long you hold the shares. These shares are sold by brokers and financial planners and can be avoided by investors who choose to invest in no-load funds.
15.3c Use FINRA’s Website to Compare Mutual Fund Fees
To compare the costs of various funds and share classes for your expected holding period and estimated returns, see the Financial Industry Regulatory Authority’s Mutual Fund Expense Analyzer (
www.apps.finra.org/fundanalyzer/1/fa.aspx
). This tool estimates the value of the funds and impact of fees and expenses on your investment and also allows you to look up applicable fees and available discounts for thousands of funds.
The SEC requires that mutual funds provide investors with a summary prospectus— in plain English—of information needed to help make investment decisions, and it appears at the front of a fund’s full prospectus. It must include a
standardized expense table
that describes and illustrates in an identical manner the effects of all of its fees and other expenses. Look for the fund’s
expense ratio
, the expense per dollar of assets under management. Expense ratios average 1.26 percent for managed diversified stock funds (which is way too expensive) and easily as low as 0.25 percent for index funds (much lower costs).
standardized expense table
SEC-required information that describes and illustrates mutual fund charges in an identical manner so that investors can accurately compare the effects of all of a fund’s fees and other expenses relative to other funds.
expense ratio
Expense per dollar of assets under management.
FINANCIAL POWER POINT
High Fees Will Cost You a Fortune
Mutual funds found in 401(k) plans can vary greatly in expense ratio fees. Here is how much the fees will be on $50,000 invested in certain lifecycle funds often found in 401(k) plans, as stated in Consumer Reports: Vanguard Target Retirement 2030 Investor, $3,531; TIAA-CREF Lifecycle 2030 Institutional, $9,416; Fidelity Freedom K 2030, $12,199; Blackrock LifePath 2030 Portfolio Class K, $13,104; T. Rowe Price Retirement 2030 Class R, $14,529. Be certain to find out how much the fees are before investing!
15.3d What’s Best: Load or No Load? Low Fee or High Fee?
The best choice is to invest in no-load mutual funds or ETFs with low fees. Investors can almost guarantee a poorer return than others if they put their money into a load fund with high management fees. Experts agree that “If you pick your own funds, sales charges and high management fees are a total waste of money.” The SEC says that for a long-term investor a 1 percent fee that increases at 4 percent a year will devour one-third of your total return! And 1 percent is much less than the average set of fees.
Sales Commissions Reduce Returns The sales commissions charged by load funds indisputably reduce total returns. When investment results are adjusted to account for the effects of sales charges, no-load mutual funds always have an initial advantage because the investor has more money at work. Many are perplexed at the stubbornness of actively managed funds that have not reduced their fees in years, even though countless investors have moved to low- or no-load funds.
12b-1 Fees Kill Long-Term Returns Annual 12b-1 charges are very costly over the long run. If you pay 1 percent per year in 12b-1 fees for a mutual fund in which you invest for ten years, you will be giving up nearly 10 percent of your investment amount in trailing commissions. Yikes!
DID YOU KNOW
Learn More about Mutual Funds
Information on mutual fund investing is vast, especially on the Internet, and excellent information about mutual funds is available from numerous sources.
Personal Finance Magazines
Kiplinger’s Personal Finance, Money, Business Week, Consumer Reports, Forbes, Fortune, and Worth. comprehensive examinations of the performance of numerous mutual funds are featured every year in the late August issue of Forbes, the October issue of Money, a late February issue of Business Week, and the September issue of Kiplinger’s Personal Finance.
Financial Press
The Wall Street Journal Barron’s, Investor’s Business Daily, and the business sections of newspapers such as The New York Times and USA Today.
Online News and Quote Services
CompuServe, Dow Jones News/Retrieval-Private Investor Edition, Farcast, Personal Journal,
Quote.com
, and Reuters Money Network.
Mutual Fund Investment Publications and Websites
Morningstar Mutual Funds, Morningstar No-Load Funds, Mutual Funds Update, Investment Companies Yearbook, IBC/IDonoghue’s Mutual Funds Almanac, Standard & Poor’s, Lipper Mutual Fund Profiles, Moody’s, and The Value Line Mutual Fund Survey. Dozens of newsletters that specialize in mutual funds are available, too. Morningstar (
www.morningstar.com
) and the Investment Company Institute (
www.ici.org
) provide information on thousands of funds. Some charge fees, and others are free.
Avoiding High Fees Is Critical to Investment Success Research has found that over five-year periods, lower-cost funds always deliver returns better than those offered by higher-cost funds. It’s even harder if you’re paying 1.9 percentage points a year for active management. That’s like carrying a couple of heavy barbells during a marathon. The equally fast runner without the barbells is going to win over the long run.
CONCEPT CHECK 15.3
1. Give three examples of fees or charges associated with load funds.
2. Which is better for most investors, load or no-load funds? Why?
3. Summarize the effects of loads and fees on investment returns.
15.4 HOW TO SELECT THE FUNDS IN WHICH YOU SHOULD INVEST
Selecting mutual funds in which to invest is a do-it-yourself effort for no-load investors and it is easy to do. Brokers are not needed because a tremendous amount of objective information is available to help investors evaluate and select funds. To explain the process of selecting funds, let’s follow Catalina Garcia’s decision making. She is in her late twenties, lives in San Jose, California, and earns $51,000 annually in her sales management job.
Figure 15-4
illustrates the process of selecting mutual fund investments, and
Table 15-3
contains performance data for a number of large-cap mutual funds from Kiplinger’s Personal Finance.
LEARNING OBJECTIVE 4
Establish strategies to evaluate and select mutual funds that meet your investment goals.
Figure 15-4
The Process of Selecting Mutual Funds
DO IT IN CLASS
Table 15-3 Mutual Fund Performance
15.4a Review Your Investment Philosophy and Investment Goals
Catalina began by reviewing her investment philosophy and financial goals. These topics were examined in Chapter 13. Catalina has a moderate investment philosophy, and she has a written investment plan (
Figure 13-7
on page 405). The investment goal she is interested in investing for now is retirement, and her investment time horizon is the next 30 years or longer. She anticipates an annual return of at least 4 to 5 percent. She does not care about income taxes because these investments will be made within Catalina’s tax-deferred 401(k) retirement plan at work, where her earnings will grow tax-free.
Catalina does not have any lump sums available in a savings or money market account to use for investing. To help fund her retirement plan, she decided to have $200 a month withheld from her paycheck to invest in a mutual fund with a growth investment objective. Catalina’s employer’s 401(k) plan offers about 20 funds as well as company stock.
DID YOU KNOW
Your Worst Financial Blunders in Investing Through Mutual Funds
Based on others’ financial woes, you will make mistakes in personal finance when you:
1. Buy funds with high fees and expenses.
2. Withdraw cash dividends rather than reinvesting.
3. Chase short-term performance by investing in “hot” funds.
15.4b Eliminate Funds Inappropriate for Your Investment Goals
Catalina began by reviewing all fund classifications (pages 459–463) and balancing the risks and returns of various funds as illustrated in Figure 15-3 on page 464. She aims to eliminate mutual funds inappropriate for her retirement investment goal.
DID YOU KNOW
Turn Bad Habits into Good Ones
Do You Do This?
Have only a few investments like stocks and bonds
Find it difficult to reinvest dividends and interest
Buy load funds or those with 12b-1 fees
Seem confused about the right funds in which to invest
Find it difficult to monitor your investments
Do This Instead!
Diversify by investing in mutual funds
Invest in funds that reinvest automatically
Invest in no-load funds or ETFs
Use a free online fund-screening tool
Manage your fund portfolio free online
Catalina recognizes that increasing the potential for higher returns also increases the risk to the investor’s capital. Therefore, she eliminated the following types of funds: sector funds, emerging markets funds, and aggressive growth funds, as well as stock in the company where she works. She also realizes that investing too conservatively invites the risk of failure to achieve her goal of a financially successful retirement. Therefore, Catalina eliminated money market funds.
15.4c Create a Portfolio of Funds in Which to Invest
Instead of simply investing in “this and that” funds, Catalina smartly decided to create a portfolio of mutual funds tailored to her needs. At www.kiplinger.com/article/investing/T033-C009-S001-kiplinger-25-model-portfolios.xhtml she found 25 portfolios recommended by Kiplinger’s Personal Finance editors and writers. They are customized for different situations and stages of life. On that website, she can get updated returns and track the performance of her investments with the benchmark portfolios.
15.4d Choose No-Load Funds with Low Fees
The sales commissions charged by load funds indisputably reduce total returns. Catalina reasoned that since no-load mutual funds have an initial advantage—the investor has more money at work—she preferred no-load funds. Because her $200 a month was going into investment for retirement, she also thought that 12b-1 fees would be very costly over the long term. For the same reason, she wanted to avoid high management fees. She did not care about back-end loads and exit fees, as these largely disappear over time. Catalina decided to invest in one or more no-load mutual funds with no 12b-1 fees and very low management expense ratios. Catalina will have to look up some of this information on the Internet since data in Table 15-3 is quite limited.
15.4e Obtain Investment Information and Advice
Because Catalina is going to invest in no-load funds, she figured she did not need the services of a broker or financial planner. Instead, she plans to use the tremendous resources that are available via the Vanguard website (www.vanguard.com)—information, education, and professional advice. Vanguard is the largest mutual fund family in the country. Catalina’s employer offers investing and retirement planning seminars and workshops provided by Ernst & Young, Vanguard, T. Rowe Price, and other companies. Significant others are welcome to attend. Employer-sponsored financial advice may cover an employee’s entire financial situation, including debt reduction, college planning, spousal assets, real estate, and other investments. Once Catalina’s retirement assets build up to a substantial amount, perhaps $50,000 or more, she would be wise to seek professional financial advice.
Catalina’s employer offers retirement plan participants access to services that automatically rebalance their retirement assets known as a
limited management account
, first discussed in chapter 13. For an annual fee of perhaps as little as $20 annually, the firm sells and buys her mutual fund assets on a quarterly basis to rebalance her portfolio back to her specific standards.
limited management account
An account at an investment firm whereby, for a fee, they sell and buy your mutual fund assets, usually quarterly, on your behalf to automatically rebalance your portfolio back to your specific standards.
DID YOU KNOW
How to Ease into Investing Cautiously
Investors who are fearful of investing in the stock market can try these techniques: (1) Start by buying shares of a diversified stock mutual fund using monthly purchases for 12 months or (2) Purchase a life cycle or target date mutual fund that contains a premixed allocation of stocks and bonds.
15.4f Screen and Compare Funds That Meet Your Criteria
When comparing the track records of mutual funds, there are a number of criteria to consider. These may include expenses; net asset value; minimum initial purchase; size of fund; ratings; past performance (perhaps one, three, five, and ten years); best and worst performance in up and down markets (volatility); fund manager tenure; and services. Catalina is interested in stock funds, international funds and global funds, low management fees, and no 12b-1 fees.
DID YOU KNOW
Sean’s Success Story
Sean’s superb financial life continues. He increased his 401(k) contributions from 6 to 8 percent so the $90,000 in mutual funds in the account will total over $100,000 by December. That figure will be a milestone for Sean’s retirement planning. While the return on his mutual fund portfolio was only 2 percent between 2007 and 2009, it did not decline; it more than doubled since then. Sean figures that the stock market is bound to go up even more as the economy grows and unemployment declines. Therefore, he has decided to move his investments completely into stock mutual funds.
Since today’s share prices go up and down quite considerably during any one year, Catalina checked the volatility ratings of funds. Volatility characterizes a mutual fund’s (or any security’s) tendency to rise or fall in price over a period of time. A measure of volatility is the standard deviation, which gauges the degree to which a security’s historical return rises above or falls below its own long-term average return— and therefore may be likely to do so again in the future. A standard deviation is a probability indicator, not an economic forecast. The bigger an investment’s standard deviation, the more volatile its price may be in the future. High volatility suggests greater long-term rewards but a greater-than-normal risk of short-term losses during economic downturns. Other common measures of risk are beta, the Sharpe Ratio, and R-squared. Publications like Kiplinger’s Personal Finance and Money provide volatility ratings for mutual funds.
Catalina started searching for mutual fund investments at Vanguard (
www.personal.vanguard.com/us/FundsMFSIntro?%20FROM=VAN
), which is considered one of the best mutual fund screening websites, and she began by typing in the fund symbols in “search.” A
fund screener
or
fund-screening tool
permits an individual to screen all of the mutual funds in the market. Other mutual fund screening tools are available at the following websites:
fund screener (fund-screening tool)
Permits investors to screen all of the mutual funds in the market to gauge performance.
• Yahoo! Finance (
www.screener.finance.yahoo.com/funds.xhtml
)
• Kiplinger.com (
www.kiplinger.com/tool/investing/T052-S001-search-and-com-pare-stocks-equities/index.php
)
• Fidelity (
www.fidelity.com/fund-screener/evaluator.shtml#!&ntf=Y
)
• Vanguard (
www.personal.vanguard.com/us/FundsMFSBasicSearch?FROM=VAN
)
Catalina focused on large-cap funds, including those shown in Table 15-3. She researched funds using the Vanguard fund screener. She obtained online a profile prospectus from Vanguard on each of the funds she liked. A
profile prospectus
(or
fund profile
) describes the mutual fund, its investment objectives, and how it tries to achieve its objectives. Written in lay language, it offers a two- to four-page summary presentation of information contained in an SEC-required legal prospectus that answers 11 key investor questions, including risks, fees, and details about the fund’s ten-year performance record.
profile prospectus (fund profile)
Publication that describes the mutual fund, its investment objectives, and how it tries to achieve its objectives in lay terms rather than the legal language used in a regular prospectus.
After reading fund details, looking at the numbers, and comparing performance, Catalina decided to split her monthly $200 investment between Vanguard Total Stock Market Index (VTSMX) and Vanguard Emerging Markets Stock Index (VEIEX), partly because of their low to nil expense ratios. (In addition, any minimum initial investment fees are waived for investments via her employer’s retirement plan.) Catalina thinks the fund managers will beat the average market returns, such as a S&P 500 index like Vanguard’s 500 Index (VFINX). Catalina might be right, or she might be wrong, but she is probably correct.
DID YOU KNOW
The Tax Consequences of Mutual Fund Investing
Ordinary income dividend distributions, capital gains distributions, and realized gains from the sale of mutual funds are generally subject to taxation.
1. In regular investment accounts:
• When you buy and hold mutual fund shares, you owe income taxes on any ordinary income dividends and on the fund’s capital gains in the year you receive or reinvest them.
• When you sell shares, you owe taxes on the capital gains earned on the difference between what you paid for the shares and the selling price (less transaction costs).
• Before purchasing a mutual fund toward the end of the year, like in December, determine whether the fund has already made its end-of-year capital gains distribution. If you buy the fund before the record date (the date established by an issuer to determine who is eligible to receive a dividend or distribution), you will receive the income but you also will owe capital gains taxes for the whole year. Buying after the record date avoids that tax because you will not have received the distribution.
2. Interest from a tax-exempt municipal bond fund is exempt from federal income taxes.
3. In retirement accounts (such as a 401[k] or traditional IRA account), all taxes are deferred until funds are withdrawn from the account.
The next step is for Catalina to contact the human resources department at her employer and sign the documents to withhold $200 a month from her paycheck and invest $100 into each of the two funds. Catalina also knows that for every dollar invested, she gets an immediate 50 percent return because her employer’s policy is to match 401(k) contributions 50 cents on the dollar for the first 6 percent of earnings. Catalina’s 401(k) balance in 12 months, therefore, will show $2400 in contributions and $1200 in employer matching contributions (that’s an immediate 50 percent return on her $2400!), plus whatever gain occurs (hopefully not a loss) in NAV. Catalina’s 401(k) balance this time next year is likely to be more than $3600.
It is easy to research mutual funds on the Internet.
15.4g Monitor Your Portfolio of Mutual Fund Investments
Tracking your portfolio is imperative because investors do not want to keep any underperforming mutual funds in their portfolio for very long. If Catalina wants to invest outside of her 401(k) plan in the same or other no-load funds, she can purchase funds directly from mutual fund investment companies, such as family fund companies like Fidelity, T. Rowe Price, or any other mutual fund, like Gabelli, Neuberger, or Calvert.
Use Portfolio Monitoring on the Internet Monitoring a mutual fund portfolio is easy using any of the top-rated mutual fund websites cited earlier. Some services charge nominal fees.
Check Fund Quotations in Newspapers You can check closing prices online any time on the financial websites cited earlier or read quotes in newspapers. See
Figure 15-5
for an illustration. Newspapers’ quotations for no-load mutual funds list the name of the fund followed by columns for its net asset value, net change from the previous day, and year-to-date percentage return.
Figure 15-5
How Mutual Funds Are Quoted
For example, within the group listing for Fidelity Investments mutual funds, the Balanced Fund (abbreviated as Balanc) has a net asset value (NAV) of $15.14, a change in the net asset value (NET CHG) of —$0.20 from the closing price of the previous trading day, and a year-to-date percentage return (YTD %RET) of 1.1 percent.
DO IT NOW!
You know more about personal finance after reading this chapter, so get started right now by:
1. Identifying five unique services provided by mutual funds (see page 459) that appeal to you.
2. Identifying two of your long-term financial goals and determining whether you would seek a fund with a growth objective or growth and income objective for each goal.
3. Selecting one mutual fund from those listed in
Table 15-3
on page 470 to follow for two or three months, then reassessing your selection if warranted.
Mutual Fund Bid Price
In mutual funds, the NAV is also known as the
mutual fund bid price
. Shareholders receive this amount per share when they redeem their shares—that is, the company is willing to pay this amount to buy the shares back. Also, the NAV is the amount per share an investor will pay to purchase a fund, assuming it is a no-load fund. A no-load fund is indicated as such by the alphabetic letter n at the end of the fund’s name.
mutual fund bid price
Shareholders receive this amount per share when they redeem their shares, which is the same dollar amount as the NAV.
Mutual Fund Ask Price
The
mutual fund ask price
(or
offer price
) is the price at which a mutual fund’s share can be purchased by investors. It equals the current NAV per share plus sales charges, if any. If you wanted to buy or sell shares of Fidelity Balanced Fund, a no-load (note the superscript n in Figure 15-5) mutual fund, the price would be $15.14 per share. The funds listed without an n are load funds. The SEC requires that appropriate footnotes appear in newspaper listings of mutual funds to indicate other expenses and charges.
mutual fund ask (or offer) price
Price at which an investor can purchase a mutual fund’s shares; current NAV per share plus sales charges.
CONCEPT CHECK 15.4
1. Explain why it is important to review your investment philosophy and goals when selecting mutual fund investments.
2. Explain how you would eliminate funds inappropriate for your investment goals.
3. How might you go about monitoring your mutual fund investments?
WHAT DO YOU RECOMMEND NOW?
Now that you have read the chapter on mutual funds, what do you recommend to Tyler and Samantha Gent in the case at the beginning of the chapter regarding:
1. Redeeming their CDs and investing their retirement money in mutual funds?
2. Investing in growth and income mutual funds instead of income funds?
3. Buying no-load rather than load funds?
4. Buying mutual funds through their employers’ 401(k) retirement accounts, rather than saving through a taxable account as they have been doing?
BIG PICTURE SUMMARY OF LEARNING OBJECTIVES
LO1 Describe the features, advantages, and unique services of investing through mutual funds.
A mutual fund is an investment company that pools funds obtained by selling shares to investors and makes investments to achieve the financial goal of income or growth, or both. The net asset value (NAV) is the per-share value of the fund. Advantages of mutual funds include diversification, affordability, and professional management. Unique services include ease of buying and selling, check writing, and easy establishment of retirement plans.
LO2 Differentiate mutual funds by investment objectives.
A mutual fund with an income objective invests in securities that pay regular income in dividends or interest. A fund that has a growth objective seeks capital appreciation. A fund that has a combined growth and income objective seeks a somewhat balanced return made up of current income and capital gains. The name of a fund, such as aggressive growth fund, typically gives a clue to its objectives.
Index funds and ETFs are popular because they earn almost exactly the same return as a particular market index.
LO3 Summarize the fees and charges involved in buying and selling mutual funds.
Individuals who invest through mutual funds pay annual fund operating expenses—management fees—that are deducted from fund assets before earnings are distributed to shareholders. Investors must make decisions on load and no-load funds, 12b-1 fees, deferred load, and redemption fees.
LO4 Establish strategies to evaluate and select mutual funds that meet your investment goals.
The process of selecting no-load mutual funds in which to invest is a do-it-yourself effort. The steps are (1) review investment philosophy and investment goals, (2) eliminate funds inappropriate for your investment goals, (3) create a portfolio of funds in which to invest, (4) choose no-load funds with low fees, (5) obtain investment information and advice, (6) screen and compare funds that meet your investment criteria, and (7) monitor your mutual fund investments.
LET’s TALK ABOUT IT
1. Investing in Tough Economic Times. Comment on this statement: “A great time to invest is during times of economic turmoil when assets are undervalued.”
2. One Fund of Interest. Review the three objectives of mutual funds. Based on your investment philosophy, which one type of fund would be of most interest to you if you were saving to buy a home several years from now? Give reasons why.
3. Two Funds. Assume you graduated from college a few years ago, have a job paying $75,000 annually, and want to invest $300 per month in mutual funds for retirement. Which combination of two or more mutual funds (see pages 468–469) would you think appropriate? Give reasons for each of your selections.
4. Spread Your Money into Funds. Assume that your uncle gave you $50,000 to invest solely in mutual funds. Based on your point in the life cycle and your investment philosophy, identify your investment goals and explain how you would spread your money among different funds. (See pages 469–469.)
5. Good Choices. Identify the types of mutual funds that would be good choices to meet the following four investment objectives: emergency fund, house down payment, college fund for 2-year-old child, and retirement fund for a 25-year-old. (See pages 469–469.) Give two reasons why each one of your recommendations would be appropriate.
6. Load or No-Load. Which is a better choice for you, load or no-load mutual funds? Give some reasons.
7. Review Table 15-1 on the “Advantages of Investing in Mutual Funds” on page 457, and select two that would be important to you as an investor. Explain why.
DO THE MATH
1. Profits and Taxes. A year ago, George Jetson, from Orbit City, Texas, invested $1000 by buying 100 shares of the Can’t Lose Mutual Fund, an aggressive growth no-load mutual fund. George reinvested his dividends, so he now has 112 shares. So far, the NAV for George’s investment has risen from $10 per share to $13.25.
(a) What is the percentage increase in the NAV of George’s mutual fund?
(b) If George redeemed the first 100 shares of his mutual fund investment for $13.25 per share, what would be his capital gain over the amount invested?
(c) Assuming George pays income taxes at the 25 percent rate, how much income tax will he have to pay if he sells those first 100 shares?
2. Mutual Fund Sales. Two years ago, Izabella Martinez, from Denver, Colorado, invested $1000 by buying 125 shares ($8 per share NAV) in the Can’t Lose Mutual Fund, an aggressive growth no-load mutual fund. Last year, she made two additional investments of $500 each (50 shares at $10 and 40 shares at $12.50). Izabella reinvested all of her dividends. So far, the NAV for her investment has risen from $8 per share to $13.25. Late in the year, she sold 60 shares at $13.25.
(a) What were the proceeds from Izabella’s sale of the 60 shares?
(b) To use the Internal Revenue Service’s “average-cost basis method” of determining the average price paid for one share, begin by calculating the average price paid for the shares. In this instance, the $2000 is divided by 215 shares (125 shares 1 50 shares + 40 shares). What was the average price paid by Izabella?
(c) To finally determine the average-cost basis of shares sold, you multiply the average price per share times the number of shares sold—in this case, 60. What is the total cost basis for Izabella’s 60 shares?
(d) Assuming that Izabella has to pay income taxes on the difference between the sales price for the 60 shares and their cost, how much is this difference?
FINANCIAL PLANNING CASES
CASE 1
The Johnsons Decide to Invest Through Mutual Funds
After learning about mutual funds, the Johnsons are confident that they are a great way to invest, especially because of the diversification and professional management that funds offer. The couple has a financial nest egg of $9500 to invest through mutual funds. They also want to invest another $300 per month on a regular basis.
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PAGE 469–471
Although not yet completely firm, Harry and Belinda’s goals at this point are as follows:
• They want to continue to build their retirement income to retire in about 36 years.
• They will need about $10,000 in six to eight years to use as supplemental income if Belinda has a baby and does not work for six months.
• They might buy a luxury automobile requiring a $10,000 down payment if they decide not to have a child.
Knowing that the Johnsons have a moderate investment philosophy, that they live on a reasonable budget, and that they have a well-established cash-management plan, advise them on their mutual fund investments by responding to the following questions:
(a) Some comparable mutual fund performance data on stock funds are shown in Table 15-3. Using only that information and assuming that you are recommending some funds for the Johnsons’ retirement needs, which two funds would you recommend? Why?
(b) How would you divide the $9500 between the two stock funds? Why?
(c) How much of the $300 monthly investment amount would you allocate to each of the stock funds? Why?
(d) Assume that both funds increase in value over the next ten years. Another bear market then occurs, causing the NAVs to drop 25 percent from the previous year. Would you recommend that the Johnsons sell their accumulated shares in the funds? Why or why not?
(e) Determine the value of the shares purchased with their $9500 original investment in ten years, assuming that the two funds’ NAVs increase 6 percent annually for the ten years. (Hint: Use Appendix A.1 or the Garman/Forgue companion website.)
CASE 2
Victor and Maria Invest for Retirement
Victor and Maria Hernandez plan to retire in less than 15 years. Their current investment portfolio is distributed as follows: 40 percent in growth mutual funds, 40 percent in corporate bonds and bond mutual funds, and 20 percent in cash equivalents. They have decided to increase the amount of risk in their portfolio by taking 10 percent from their cash equivalent investments and investing in some mutual funds with strong growth possibilities.
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PAGE 469–471
(a) Of the stock mutual funds listed in Table 15-3, which two would you recommend to meet the Hernandezes’ goals? Why?
(b) Would you recommend that the Hernandezes remain invested in those two funds during their retirement years? Why or why not?
CASE 3
Julia Price Is Going to Invest Big in Mutual Funds
It has been over 25 years since Julia graduated with a major in aeronautical engineering, and she has been quite successful in her career as well as in managing her personal finances. She has moved up the career ladder, earns a high salary, has $50,000 in equity in her condo, and has an investment portfolio valued at $300,000 that includes $200,000 in retirement assets through her employer’s 401(k) plan. She wants to liquidate her $300,000 investment portfolio now invested in stocks, bonds, and gold and put everything into mutual funds. Julia is optimistic about the future of investing. After serious research, Julia has decided to invest $300,000 into ETFs and index mutual funds rather than actively managed funds. Offer your opinions about her thinking.
CASE 4
Matching Mutual Fund Investments to Economic Projections
Joshua Wickler, an automobile salesperson for the past ten years in Albuquerque, New Mexico is divorced and contributes to the support of his two children. He is interested in investing in mutual funds. Joshua wants to put $20,000 of accumulated savings into a stock index mutual fund and then continue to invest $200 monthly for the foreseeable future, perhaps using the money for retirement starting in about 25 years. Joshua has limited his choices solely to the index mutual funds listed in Table 15-3.
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PAGE 469–471
(a) In Table 15-3, note that there are two index funds based on the S&P 500 Index. Suggest a reason why Joshua should invest in one or the other, noting that the returns for the Vanguard 500 Index Fund slightly lagged the Fidelity Spartan Index Fund.
(b) Given that Joshua plans to invest $2400 annually for the next 25 years, which of the other two index funds (Vanguard Total Stock Market Index Fund or Vanguard Emerging Markets Stock Fund) would you recommend, and why?
CASE 5
Selection of a Mutual Fund as Part of a Retirement Plan
Lola Garcia, a single mother of a 6-year-old child, works for a utility company in Chestertown, Maryland, and is willing to invest $3000 per year in a mutual fund. She wants the investment income to supplement her retirement pension starting in approximately 30 years, and she has a moderate investment philosophy. Lola is concerned about not investing too conservatively because she expects to live a long life, given that her eldest relatives lived well into their 80s and early 90s. Advise Lola by responding to the following questions:
(a) If Lola invests $3000 annually into two growth mutual funds, which two types would you recommend and why? See the list on pages 460–461.
(b) Alternatively, if Lola invests $3000 annually into two growth and income funds, which two would you recommend and why? See the list on pages 461–463.
(c) Summarize why these four types of mutual funds might be suitable for Lola.
BE YOUR OWN PERSONAL FINANCIAL MANAGER
1. Your Mutual Fund Preferences. Review the section “Mutual Fund Objectives” and then complete Worksheet 61: My Mutual Fund Preferences from “My Personal Financial Planner.” For each of the types of mutual funds listed, identify which are of interest to you and one characteristic you like about them, and note those in which you might invest during your own investing life.
2. Comparing Mutual Fund Investments. Learn about three stock mutual funds that might be of interest to you, such as Vanguard Target Retirement 2055 Fund (VFFVX), Vanguard Target Retirement 2050 Fund (VFIFX), and Spartan 500 Index – Investor Class (FUSEX), by going online. Then complete Worksheet 62: Comparing Mutual Funds as Investments from “My Personal Financial Planner” by recording the facts requested.
3. Calculating Mutual Fund Returns. Use the information for the exercises immediately above and complete Worksheet 63: Calculating the Return on Mutual Fund Investments from “My Personal Financial Planner,” which will help you deter mine the return from income and capital gains after you make some assumptions, such as a 5-year holding period and the like.
4. Evaluating My Investment Returns. Complete Work sheet 64: Evaluating the Performance (Gain or Loss) of My Investments from “My Personal Financial Planner” using one example for which you make the assumptions. Perhaps you can use the Spartan 500 Index – Investor Class (FUSEX) in which you invested $3000 two years ago for $66.50 and its present price of $7.90.
ON THE NET
Go to the Web pages indicated to complete these exercises.
1. Low Cost Mutual Funds. Visit the Kiplingers website for low-cost mutual funds (
www.kiplinger.com/tool/investing/T041-S000-kiplingers-25-favorite-fund/index.php
). Summarize why they think these are good investments.
2. Which ETFs for You? Visit the website for Vanguard Investments and read its section on exchange-traded funds (ETFs) (
www.personal.vanguard.com/us/funds/etf
). Summarize why you think ETFs might or might not be a good investment for you.
3. Mutual Fund Information. Visit the website for CNNMoney. Go to the page titled “What Is a Mutual Fund” at
www.money.cnn.com/retirement/guide/investing_mutualfunds.moneymag/index.htm
. Review the dozen or so short articles and compare what you read there with what you read in this chapter. List two things that are new to your understanding.
4. FINRA on Mutual Funds. Visit the website for the Financial Industry Regulatory Authority (FINRA) at
www.finra.org/Investors/SmartInvesting/ChoosingInvestments/MutualFunds/
, where you will find a section titled “Mutual Funds.” Review the several paragraphs there and compare what you read with what you read in this chapter. List two things that are new to your understanding.
ACTION INVOLVEMENT PROJECTS
1. Review Some Mutual Fund Portfolios. Go to Kiplinger’s article on model portfolios at
www.kiplinger.com/article/investing/T033-C009-S001-kiplinger-25-model-portfolios.xhtml?si=1
and review the three illustrative portfolios that might fit your needs. Summarize your findings.
2. Using a Fund Screener. Go to the fund screener of Yahoo! Finance (finance.yahoo.com/funds) and look up three funds of interest to you, perhaps using some of the names of funds you found in the exercise immediately above. Summarize your findings.
3. Reviewing ETFs. Go to Fidelity’s ETF fund screener website (
www.research2.fidelity.com/fidelity/screeners/etf/landing.asp?
) and click on the “Learn More” section of “ETF Portfolio Builder.” Compare what you learn there with what is in this book.
4. Unique Mutual Fund Services. Review Table 15-2 on “Unique Mutual Fund Services” on page 459 and select 2 that would be important to you as a mutual fund investor. Explain why.
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PAGE 459
Visit the Garman/Forgue companion website at
www.cengagebrain.com
.
14 Investing in Stocks and Bonds
YOU MUST BE KIDDING, RIGHT?
Brothers Michael and Christopher Morton differ in investment philosophies—Michael is a conservative investor and Christopher holds a moderate investing outlook. Their father left each of them $100,000 when he died ten years ago, and Christopher invested in common stocks while Michael invested in corporate bonds. After ten years, how much more money is Christopher likely to have in his account than Michael?
A. $12,000
B. $21,000
C. $148,000
D. $179,000
The answer is B, $21,000. One could expect in today’s times to obtain a long-term average annual return of perhaps 6 percent on U.S. common stocks compared with about 4 percent on corporate bonds. A $100,000 common stock portfolio that returned 6 percent annually would accumulate to $179,000 in ten years while a bond portfolio earning 4 percent annually over the same time period would grow to $148,000. Christopher’s willingness to accept more risk by investing in common stocks may provide him with a balance bigger than his brother’s by a whopping $31,000 or 21 percent ($31,000/$148,000)!
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
Explain how stocks and bonds are used as investments.
Describe ways to evaluate stock prices, and calculate a stock’s potential rate of return.
Use the Internet to evaluate common stocks in which to invest.
Summarize how to buy and sell stocks, as well as the techniques of margin buying and selling short.
Describe how to invest in bonds.
WHAT DO YOU RECOMMEND?
Ashley Diaz, age 42, is a senior Web designer for a communications company in Lansing, Michigan. She earns $92,000 annually. From her salary, Ashley contributes $200 per month to her 401(k) retirement account, matched by her employer, through which she invests in the company’s stock. Ashley is divorced and has custody of her three children, 10-year-old twins and a 6-year-old. Her ex-husband pays $1500 per month in child support. Ashley and her former spouse contribute $3000 each annually to a college fund for their children. Over the past 15 years, Ashley has built a $300,000 portfolio of investments after starting by investing the proceeds of a $50,000 life insurance policy following the death of her first husband. Currently, her portfolio is allocated 40 percent into preferred stocks (paying 4.5 percent); 30 percent into cyclical, blue-chip common stocks (P/E ratio of 14); 10 percent into Treasury bonds (paying 2.2 percent); 10 percent into municipal bonds (paying 1.7 percent); and 10 percent into AAA corporate bonds (paying 4.6 percent). Ashley’s total return in recent years has been about 6 percent annually. Her investment goals are to have sufficient cash to pay for her children’s education and to retire in about 18 years.
What do you recommend to Ashley on the subject of stocks and bonds regarding:
1. Investing for retirement in 18 years?
2. Owning blue-chip common stocks and preferred stocks rather than other common stocks given Ashley’s investment time horizon?
3. The wisdom of owning municipal bonds rather than corporate bonds?
4. The likely selling price of her corporate bonds, if sold today?
5. Investments that might be appropriate to fund her children’s education?
YOUR NEXT FIVE YEARS
In the next five years, you can start achieving financial success by doing the following related to investing in stocks and bonds:
1. Don’t be afraid of investing in the stock market so include stocks and bonds or stock mutual funds in your investment portfolio.
2. Use fundamental analysis to determine a company’s basic value before investing in any stock, bond, or stock mutual fund.
3. Resist putting money into so-called hot stocks.
4. Invest part of the conservative portion of your portfolio in TIPS (Treasury Inflation-Protected Securities) to beat inflation.
5. When you have children, use zero-coupon bonds to help save for their education.
LEARNING OBJECTIVE 1
Explain how stocks and bonds are used as investments.
To earn a larger return than offered by conservative investments, you must accept more risk. Historically, common stocks, for example, have earned substantially more than bonds, often twice as much. When you invest in stocks, you can increase returns significantly while increasing risk only slightly. These investments belong in everyone’s investment portfolio because they provide opportunities for moderate and aggressive investors alike. Your task when selecting stocks is to find the right balance between safety and risk.
The principles of long-term investing remain valid because over time turbulent stock and bond markets calm down and provide investors fairly predictable returns. In fact, a good time to invest is when the share prices of high-quality firms have been beaten down to affordable levels. When the stock markets are down that means that stocks are “on sale,” as prices are lower than usual.
You should welcome the fact that economic slumps always spark a powerful market recovery. The typical post-recession rally in prices on the stock market is a 50 percent increase over the following 18 months. In fact, the Great Recession stock market that started in October 2007 saw stock prices decline 55 percent by March 2009, and the subsequent bull market more than doubled prices in less than four years. Investing is an act of faith and confidence in the future of the U.S. and global economies. History argues that by the time students in college are ready to retire, stock market prices will have tripled or quadrupled.
14.1 THE ROLE OF STOCKS AND BONDS IN INVESTMENTS
Individual investors provide the money corporations use to create sales and earn profits. The investor shares in those profits. A corporation is a state-chartered legal entity that can conduct business operations in its own name. A public corporation is one that issues stock purchased by the general public and traded on stock markets such as the New York Stock Exchange. In contrast, the stock of a privately held corporation is held by a relatively small number of people and is not traded on a public stock exchange. The ability to sell shares of ownership to investors offers a corporation the opportunity to develop into a firm of considerable size. It can continue to exist even as ownership of its shares changes hands. For example, the owners of AT&T are the holders of its more than 5.38 million shares of stock.
A corporation’s financial needs will vary over time. To begin its operations, a new corporation needs start-up capital (funds initially invested in a business enterprise). During its life, a corporation may need additional money to grow. To raise capital and finance its goals, it may issue three types of
securities
(negotiable instruments of ownership or debt): common stock, preferred stock, and bonds.
securities
Negotiable instruments of ownership or debt, including common stock, preferred stock, and bonds.
14.1a Common Stock
Stocks
are shares of ownership in the assets and earnings of a business corporation. Each stock investor is a part owner in a corporation.
Common stock
is the most basic form of ownership of a corporation. For the investor, stocks represent potential income because the investor owns a piece of the future profits of the company. Investors usually have two expectations: (1) the corporation will be profitable enough that income will exceed expenses, thereby allowing the firm to pay
cash dividends
(a share of profits distributed in cash); and (2) the
market price
of a share of stock, which is the current price that a buyer is willing to pay a willing seller, will increase over time.
stocks
Shares of ownership in a business corporation’s assets and earnings.
common stock
Most basic form of ownership of a corporation.
cash dividends
Cash profits that a firm distributes to stockholders.
market price
The current price of a share of stock that a buyer is willing to pay a willing seller.
Stocks usually require a low minimum investment. Investors expect to earn annual returns of 6 percent or higher on average over time from the combination of dividends and capital gains.
Each person who owns a share of stock—called a
shareholder
or
stockholder
—has a proportionate interest in the ownership (usually a very small slice) and, therefore, in the assets and income of the corporation. This
residual claim
means that common stockholders have a right to share in the income and assets of a corporation only after higher-priority claims are satisfied. These higher-priority claims include interest payments to those who own company bonds and preferred stocks.
shareholder (stockholder)
Each person who owns a share of a company’s stock holds a proportionate interest in firm ownership and, therefore, in the assets and income of the corporation.
residual claim
Common stockholders have a right to share in the income and assets of a corporation after higher-priority claims are satisfied.
Stockholders have a limited liability, as their responsibility for business losses is limited to the amount invested in the shares of stock owned. These amounts may be small or large, but the most the shareholder can lose is the original amount invested. If the corporation becomes bankrupt, the common stockholder’s ownership value consists of the amount left per share after the claims of all creditors are satisfied first. Each common stockholder has
voting rights
: the proportionate authority to express an opinion or choice in matters affecting the company. Stockholders vote to elect the company’s board of directors. This group of individuals sets policy and names the principal officers of the company—management—who run the firm’s day-to-day operations. The number of votes cast by each shareholder depends on the number of shares he or she owns. Stockholders attend an annual meeting or vote by proxy—shareholders’ written authorization to someone else to represent them and to vote their shares at a stockholder’s meeting.
voting rights
Proportionate authority to express an opinion or choice in matters affecting the company.
14.1b Preferred Stock
Preferred stock
is a type of fixed-income ownership security in a corporation. Owners of a preferred stock receive a fixed dividend per share that corporations are required to distribute before any dividends are paid out to common stockholders. They receive no extra income from the stock other than their fixed dividend, even when the firm is highly profitable. The regular dividend payments appeal to those who desire a reliable stream of income, such as retired investors. While the income stream may be consistent, the market price of preferred stock is sensitive to changes in interest rates. Preferred stockholders rarely have voting privileges.
preferred stock
Type of fixed-income ownership security in a corporation that pays fixed dividends.
DO IT IN CLASS
Sometimes a corporation decides not to pay dividends to preferred stockholders because it lacks profits or simply because it wants to retain and reinvest all of its earnings. When the board of directors votes to skip (pass) making a cash dividend to preferred stockholders, holders of
cumulative preferred stock
must be paid that dividend before any future dividends are distributed to the common stockholders. For example, assume that a company passes on the first two quarterly dividends of $2.25 each to preferred stockholders, who expect to receive $9 each year ($2.25 × 4 quarters).
cumulative preferred stock
Preferred stock for which dividends must be paid, including any skipped dividends, before dividends go to common stockholders.
If the company prospers and wants to give a cash dividend to its common stockholders in the third quarter, it must first pay the passed $4.50 to the cumulative preferred stockholders. Furthermore, the usual third-quarter cash dividend of $2.25 has to be made to the preferred stockholders before the common stockholders can receive any dividends. In the case of noncumulative preferred stock, the preferred stockholders would have no claim to previously skipped dividends.
Convertible preferred stock
, a unique security occasionally sold by companies, can be exchanged at the option of the stockholder for a specified number of shares of common stock.
convertible preferred stock
Can be exchanged at the option of the stockholder for a specified number of shares of common stock.
14.1c Bonds
Individuals who want to invest by loaning their money can do so by buying bonds and becoming a creditor of the business (again a very small one). A bond is an interest-bearing negotiable certificate of long-term debt issued by a corporation, the U.S. government, or a municipality (such as a city or state). Bonds are basically IOUs. Corporations and governments often use the proceeds from bonds to finance expensive construction projects and to purchase costly equipment.
With bonds, investors lend the issuer a certain amount of money—the
principal
—with two expectations: (1) they will receive regular interest payments at a fixed rate of return for many years, and (2) they will get their principal returned at some point in the future, called the
maturity date
. The regular pattern of interest appeals to those who desire a reliable stream of income, again retired investors. The market price of bonds is sensitive to changes in interest rates.
principal
Face amount of a bond.
maturity date
Date upon which the principal is returned to the bondholder.
DID YOU KNOW
Don’t Get Scared Out of Buying Stocks and Stock Mutual Funds
Investment expert Peter Lynch says, “The real key to making money in stocks and stock mutual funds is not to get scared out of them.” Investing based on the recent past is like driving a car while focused on the rear view mirror: it is stupid and dangerous. Therefore, remain optimistic about stocks and look for gains of 4 to 6 percent annually for the next 10 or 20 years.
14.1d An Illustration of Stocks and Bonds: Running Paws Cat Food Company
To better understand how a corporation finances its goals by issuing common and preferred stock while also paying returns for stockholders, consider the example of Running Paws Cat Food Company. When reading through the example, imagine that the numbers have many more zeros to better visualize a company the size of Google or Microsoft.
Running Paws Is Born Running Paws began as a small family business in Lincoln, Nebraska, started by Linda Webtek. She developed a wonderful recipe for cat food that contained no corn, corn meal, or corn gluten meal and sold the product through a local grocery store. As sales increased, Linda decided to incorporate the business, expand its operations and share ownership of the company with the public by asking people to invest in the company’s future. Running Paws issued 10,000 shares of common stock at $10 per share. Three friends each bought 2500 shares, and Linda signed over the cat food recipe and equipment to the corporation itself in exchange for the remaining 2500 shares. At that point, Running Paws had $75,000 in working capital (7500 shares sold at $10 each), equipment, a great recipe, and a four-person board of directors. Each of the directors worked for the firm, although they paid themselves very low salaries.
Running Paws Begins to Grow The sales revenues of a corporation like Running Paws are used to pay (1) expenses, (2) interest to bondholders, (3) taxes, (4) cash dividends to preferred stockholders, and (5) cash dividends to common stockholders, in that order. If money is left over after items 1 and 2 are paid, the corporation has earned a
profit
. If funds are available after item 3 is paid, the company has an
after-tax profit
. The average corporation pays out 40 to 60 percent of its after-tax profit in cash dividends to stockholders. The remainder, called
retained earnings
, is left to accumulate and finance the company’s goals—often expansion and growth. In its early years, Running Paws retained all of its profits and distributed no dividends.
profit
Money left over after a firm pays all expenses and interest to bondholders.
after-tax profit
Money left over after a firm has paid expenses, bondholder interest, and taxes.
retained earnings
Money left over after a firm has paid expenses, bondholder interest, taxes, preferred stockholder dividends, and common stockholder dividends.
Common stockholders, such as the stockholders of Running Paws Cat Food Company, are not guaranteed dividends. However, most profitable companies do pay common stockholders a small dividend on a quarterly basis until increased earnings justify paying out a higher amount.
FINANCIAL POWER POINT
Assume Your Investment Portfolio Will Earn 5 Percent to 6 Percent
When planning for long-term financial goals, assume your investments will conservatively earn 3 percent after inflation or at least 5 percent to 6 percent a year. Your investment returns could be higher.
Given that Running Paws retained all its earnings, you might wonder why people would invest in such a company. Two reasons explain the attraction. First, as a company becomes more efficient and profitable, cash dividends to common stockholders may not only begin but also become significant. Second, the market price of the stock may increase sharply as more investors become interested in the future profitability of a growing company. Common stock constitutes a share of ownership; thus as the company grows, the price of its common stock follows suit.
Increasing sales meant more production for Running Paws. Soon more orders were coming in from Chicago than the firm could handle. After three years, the owners of Running Paws decided to expand once again. They wanted to borrow an additional $100,000, but their business was so new and its future so uncertain that lenders demanded an extremely high interest rate. To raise the needed funds, the owners decided to issue 5000 shares of preferred stock at $20 per share, promising to pay a cash dividend of $1.80 per share annually, providing a 9 percent yield to investors. The preferred stock was sold to outside investors, but the original investors retained control of the company through their common stock.
Running Paws Becomes a National Company Following its pattern of expanding into new markets, Running Paws soon developed additional lines of cat food that sold well. With the proceeds from the sale of preferred stock, and after a new plant in Brooklyn, New York, opened, the income of the four-year-old business finally exceeded expenses, and it had a profit of $13,000. The board of directors declared the promised preferred stock dividend of $9000 (5000 preferred shares × $1.80) but no dividend for common stockholders. In the following year, net profits after taxes amounted to $28,000. Once again the board paid the $9000 dividend to preferred stockholders but retained the remainder of the profits to finance continued expansion and improved efficiency.
Then one of the original partners wanted to exit the business and needed to sell her 2500 shares of stock, for which she had originally paid $25,000. Because Running Paws was beginning to show some profits, two other private investors recommended by a local stockbroker made offers to purchase her shares. The shares were sold at $16 per share, with 1500 shares going to one investor and 1000 shares to another investor. Thus, this original investor gained $15,000 in price appreciation ($16 × 2500 = $40,000; $40,000 − $25,000 = $15,000) when she sold out. (Running Paws did not profit from this transaction.) Now five owners of the common stock, including the two new ones, voted for the board of directors, with each share representing one vote.
During the sixth year, the company’s sales again increased and its earnings totaled $39,000. This time the board voted $9000 for the preferred stockholders and $5000 ($0.50 per share) for the common stockholders but retained the remaining $25,000. With the $5000 distribution, the common stockholders finally began to receive cash dividends.
Even with its success, Running Paws faced another decision. To distribute its products nationally would require another $400,000 to $500,000 for expansion costs. After much discussion, the board voted to sell additional shares of stock and issue some bonds. The company planned to sell 10,000 shares of common stock at $25 per share. This would dilute the owners’ proportion of ownership by half. Common stockholders, however, have a
pre-emptive right
to purchase additional shares before new shares are offered to the public. Thus, each current stockholder retained the legal right to maintain proportionate ownership by being allowed to purchase more shares.
pre-emptive right
Right of common stockholders to purchase additional shares before a firm offers new shares to the public.
Bonds were sold, too.
*
Running Paws issued two hundred $1000 bonds with a coupon rate of 8 percent. After several months, all of the new stock and bond shares were sold. After brokerage expenses, the company netted more than $190,000 from the bonds to help finance the expansion. On the stock sales, various local stockbrokers took selling commissions totaling $16,000, leaving $234,000 available for the company to use for expansion. These and other investors will follow the progress of Running Paws and buy and sell shares accordingly. The company will not benefit from this trading. Running Paws and its shareholders will benefit from a rising stock price because ownership in a growing company becomes increasingly valuable. If Running Paws continues to prosper, its board of directors might work toward having its stock listed on a regional stock exchange (discussed later in this chapter) to facilitate trading of shares and to further enhance the company’s image.
DID YOU KNOW
Money Websites Investing in Stocks
Informative websites for investing in stocks and bonds, including online screens to compare stocks are:
AOL Money Basics (
www.dailyfinance.com/?icid=navbar_Finance
)
BloombergBusinessWeek (
www.businessweek.com/markets-and-finance
)
CNN Money (
www.money.cnn.com/magazines/moneymag/money101/
)
Kiplinger’s Personal Finance (
www.kiplinger.com/fronts/channels/investing/
)
Market
Watch (
www.marketwatch.com/personal-finance?showsmscrim=true
)
Morningstar (
www.morningstar.com
)
Motley Fool (
www.fool.com
)
NASDAQ (
www.nasdaq.com
)
Yahoo! Finance on stocks (
www.finance.yahoo.com/marketupdate?u
)
Zacks Investment Research (
www.zacks.com
)
CONCEPT CHECK 14.1
1. Distinguish between common stocks and bonds.
2. How do public corporations use stocks and bonds?
3. Why do individuals invest in stocks?
LEARNING OBJECTIVE 2
Describe ways to evaluate stock prices, and calculate a stock’s potential rate of return.
14.2 HOW TO EVALUATE COMMON STOCKS
When thinking about investing in a stock it is helpful to begin by reviewing
Table 14-1
, which shows the types of stocks and their characteristics.
14.2a Use Beta to Compare a Stock to Similar Investments
Beta is a number widely used by investors to predict future stock prices. The
beta value
) (or beta coefficient) is a measure of an investment’s volatility compared with a broad market index for similar investments over time. For large-company stocks, the S&P 500 Stock Index often serves as a benchmark. The average for all stocks in the market is a beta of 11.0, thus a stock with a beta of + 1.0 typically moves in lockstep with the S&P and a beta greater than 1.0 indicates higher-than-market volatility. Recall from
Chapter 13
that market risk is assumed to be 8 percent; thus when the overall stock market increases 8 percent a stock with a 1.0 beta is likely to increase the same amount. A stock with a beta of 1.2 will move 20 percent high and lower than the index.
beta value (beta coefficient)
A measure of stock volatility; that is, how much the stock price varies relative to the rest of the market.
Most stocks have positive betas between 0.5 and 2.0. A beta of less than 1.0 (0.0 to 0.9) indicates that the stock price is less sensitive to the market. This is because the price moves in the same direction as the general market, but not to the same degree. A beta of more than +1.0 to +2.0 (or higher) indicates that the price of the security is more sensitive to the market because its price moves in the same direction as the market but by a greater percentage. Higher betas mean greater risk relative to the market. A beta of zero suggests that the price of the stock is independent of the market, much like that of a risk-free U.S. Treasury security. You may look up betas for stocks (just input the stock’s symbol) at Calculator Edge (
www.calculatoredge.com/finance/betas.htm
) or Yahoo! Finance (
screener.finance.yahoo.com/stocks.xhtml
). Stocks with a negative beta move in the opposite direction of the market.
DID YOU KNOW
Reasons to Invest in Dividend-Paying Stocks
When you invest in companies that pay dividends, odds are that they will continue to pay the dividend even when the company is not doing well financially. Dividend-paying companies typically outperform other firms and provide a greater total return than the return on the S&P 500 index. Firms that pay dividends typically boost them about 3.2 percent annually. When inflation is low a dividend of 2 to 4 percent is an excellent return. Finally, dividend-paying companies are less volatile than other stocks often with a beta of 1.0 or less.
14.2b Most Use Fundamental Analysis to Evaluate Stocks
The theory underlying
fundamental analysis
is that each stock has an intrinsic (or true) value based on its expected stream of future earnings. Most professional stock analysts and investors take this approach to investing as they research corporate and industry financial reports. Fundamental analysis suggests that you can identify some stocks that will outperform others given the state of the economy. The fundamental approach presumes that a stock’s basic value is largely determined by its current and future earnings trends, assets and debts, products, competition, and management’s expertise to assess its growth potential. The aim is to seek out sound stocks—perhaps even unfashionable ones—that are priced below what they ought to be.
fundamental analysis
School of thought in market analysis that assumes each stock has an intrinsic (or true) value based on its expected stream of future earnings.
Fundamental analysis suggests that you should consider investing only in companies that will likely be industry leaders—not necessarily the largest firms and fastest-growing industries, but the pacesetters in terms of profitability. You should invest in a stock because you have good reasons related to earnings and profitability, such as a new division in a firm that soon is expected to be quite profitable, a firm is starting to outsell its competitors, product research looks promising, or the firm is a leader in an industry that will be a future driver of profits in the economy. Several numerical measures are used to evaluate stock performance, and these are readily available to investors on the Internet to help you assess future stock prices.
Table 14-1 Characteristics of Stocks
Type of Stock
Characteristics
Income Stock
Company that pays a cash dividend higher than that offered by most companies. Stocks issued by telephone, electric, and gas utility companies; beta often less than 1.0.
Growth Stock
Corporations that are leaders in their fields, that dominate their markets, and that have several consecutive years of above-industry-average earnings are considered; pays some dividends. Investor awareness of such corporations is widespread, and expectations for continued growth are high. The P/E ratio is high; betas of 1.5 or more.
Blue-Chip Stock
A company that has been around for a long time, has a well-regarded reputation, dominates its industry (often with annual revenues of $1 billion or more), and is known for being a solid, relatively safe investment; betas are usually around 1.0.
Countercyclical Stock
A company whose profits are greatly influenced by changes in the economic business cycle in consumer-dependent industries, like automobiles, housing, airlines, retailing, and heavy machinery; betas of about 1.0. A stock with a beta that is less than 1.0 is called a countercyclical (or defensive) because it exhibits price changes contrary to movements in the business cycle, thus prices remain steady during economic downturns. Examples are cigarette manufacturers, movies, soft drinks, cat and dog food, electric utilities, and groceries.
Value Stock
A company that grows with the economy and tends to trade at a low price relative to its company fundamentals (dividends, earnings, sales, and so on) and thus is considered under-priced by a value investor; beta 1.0 to 2.0.
Large-Cap, Small-Cap, and Mid-Cap stocks
A company’s size classification in the stock market is based on market capitalization. Large caps are those firms valued at or more than $10 billion. Mid-caps are $2 billion to $10 billion. Small caps is $300 million to $2 billion.
Tech Stock
A company in the technology sector that offer technology-based products and services, biotechnology, Internet services, network services, wireless communications, and more.
Speculative Stock
A company that has a potential for substantial earnings at some time in the future but those earnings may never be realized; betas above 2.0. Examples: computer graphics firms, Internet applications firms, small oil exploration businesses, genetic engineering firms, and some pharmaceutical manufacturers.
income stock
A stock that may not grow too quickly, but year after year pays a cash dividend higher than that offered by most companies.
growth stock
The stock of a company that offers the promise of much higher profits tomorrow and has a consistent record of relatively rapid growth in earnings in all economic conditions.
blue-chip stocks
Stocks that have been around for a long time, have a well-regarded reputation, dominate its industry, and are known for being solid, relatively safe investments.
Countercyclical Stock
The stock of a company whose profits are greatly influenced by changes in the economic business cycle.
value stock
A stock that tends to trade at a low price relative to its company fundamentals (dividends, earnings, sales, and so on) and thus is considered undervalued by a value investor.
DO IT IN CLASS
14.2c Some Investors Use Technical Analysis to Evaluate Stocks
An opposing and minority theory on valuing common stocks is advocated by proponents of
technical analysis
, often investment newsletter authors. This method of evaluating securities analyzes statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value but instead use charts, graphs, mathematics, and software programs to identify and predict future price movements. Technical analysis has proved to be of little value, although some investors find technical analysts’ logic appealing.
technical analysis
Method of evaluating securities that uses statistics generated by market activity, such as past prices and volume, over time to determine when to buy or sell a stock.
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14.2d You Should Use Corporate Earnings and Other Measures
Those who use fundamental analysis use several numerical measures to evaluate stock performance. These numbers are readily available to investors on the Internet that will help you assess future stock prices.
Corporate Earnings
Corporate earnings
are the profits a company makes during a specific time period. If a company cannot generate earnings now or in the future, stock market analysts and investors are not going to be impressed. As people reach this conclusion, there quickly will be more sellers than buyers of the company’s common stock, and that will depress the stock’s market price. Corporate earnings are at the core of fundamental analysis.
corporate earnings
The profits a company makes during a specific time period that indicate to many analysts whether to buy or sell a stock.
Earnings Per Share A company’s
earnings per share (EPS)
is annual profit divided by the number of outstanding shares. It indicates the income that a company has available, on a per-share basis, to pay dividends and reinvest as retained earnings. The EPS is a measure of the firm’s profitability on a common-stock-per-share basis, and it is helpful because investors can use it to compare financial conditions of many companies. The EPS is reported in the business section of many newspapers as well as online.
earnings per share (EPS)
A firm’s profit divided by the number of outstanding shares.
In our example, assume that next year, after payment of $9000 in dividends to preferred stockholders, Running Paws had a net profit of $32,000. With 20,000 shares of stock, the company’s EPS would be $1.60 ($32,000 ÷ 20,000).
Price/Earnings Ratio The
price/earnings ratio (P/E ratio)
(or
multiple
) is the current market price of a stock divided by earnings per share (EPS) over the past four quarters. This ratio is the primary means of valuing a stock. It demonstrates how expensive the stock is versus the company’s recently reported earnings, by revealing how much you are paying for each $1 of earnings. For example, if the market price of a share of Running Paws stock is currently $25 and the company’s EPS is $1.60, the P/E ratio will be 16 ($25 ÷ $1.60 = 15.6, which rounds to 16). This value can also be called a 16-to-1 ratio or multiple, or a P/E ratio of 16. The P/E ratios of many corporations are widely reported on the Internet and in the financial section of newspapers. Stocks with low P/E ratios tend to have higher dividend yields, less risk, lower prices, and slower earnings growth.
price/earnings (P/E ratio) (or multiple)
The current market price of a stock divided by earnings per share (EPS) over the past four quarters; used as the primary means of valuing a stock.
To assess a company’s financial status, you could compare that firm’s P/E ratio with the P/E ratios for other similar stocks. The P/E ratios for corporations typically range from 5 to 25.
The historical average P/E ratio for stocks is 15, although it varies for different industries. Financially successful companies that have been paying good dividends through the years might have a P/E ratio ranging from 7 to 10. Rapidly growing companies would likely have a much higher P/E ratio—13 to 20. Speculative companies might have P/E ratios of 25 or 50 or even higher because they have low earnings now but anticipate much higher earnings in the future. Firms that are expected to have strong earnings growth generally have a high stock price and a correspondingly high P/E ratio.
Inverting a P/E ratio of 12 reveals that stocks have an
earnings yield
of 8.5 percent. In other words, each $100 of stocks is backed by $8.50 in expected earnings. During times of low interest rates, an 8.5 percent yield on stocks looks terrific.
earnings yield
The earnings per share of a stock divided by its price; an inversion of the price/earnings ratio; helps investors more clearly see investment expectations.
Trailing and Projected Price/Earnings Ratios The standard P/E ratio is, in fact, called a
trailing P/E ratio
measure because it is calculated using recently reported earnings, usually from the previous four quarters.
trailing P/E ratio
Calculated using recently reported earnings, usually from the previous four quarters.
Investors need to focus on future prospects when analyzing the value of a stock. A
projected P/E
or
forward price/earnings ratio
divides price by projected earnings over the coming four quarters, an estimate available via online stock quote providers. The earnings yield, which is the inverse of the P/E ratio (Running Paws’ earnings yield is 6.4 percent [$1.60 ÷ $25]), helps investors think more clearly about expectations for investments.
projected P/E ratio (forward price/earnings ratio)
Because investors need to look to the future rather than the past, this measure divides price by projected earnings over the coming four quarters. Also known as forward price/earnings ratio.
Being invested in the stock market is an excellent way to create wealth.
PEG Ratio Critics of the price-earnings ratio argue that because of fundamentals sometimes they should pay more for a stock. Those firms with high levels of growth should not be penalized for having high P/E ratios.
PEG ratio
, or price-earnings growth, is a way to adjust for this. Divide the P/E ratio by the company’s projected growth rate. Going back to Running Paws, divide the firm’s P/E ratio of 16 by its projected growth rate of 15 percent (16/15 = 1.07). Investors think a PEG ratio of 1 is fairly priced while a value of 2 or more is too high.
PEG ratio (price-earnings growth)
A way to rationalize buying a stock that has high growth is to calculate by dividing the P/E ratio by the company’s projected growth rate.
Price/Sales Ratio The
price/sales ratio (P/S ratio)
indicates the number of dollars it takes to buy a dollar’s worth of a company’s annual revenues. The P/S is obtained by dividing a company’s total market capitalization by its sales for the past four quarters. For example, if Running Paws Cat Food Company’s common stock currently sells for $25 per share and 20,000 shares of the company’s stock are outstanding, its total capitalization is $500,000. If company revenues (sales of dog and cat food) were $750,000 over the past year, the stock’s P/S would be 0.67 ($500,000 ÷ $750,000). Stock analysts suggest investors avoid companies with a P/S greater than 1.5 and favor those having a P/S of less than 0.75. Many investors ignore the P/S, but it works better than the highly acclaimed P/E ratio in predicting which companies provide the best return, as explained in James P. O’shaughnessy’s What Works on Wall Street.
price/sales ratio (P/S ratio)
Tells the number of dollars it takes to buy a dollar’s worth of a company’s annual revenues; calculated by dividing company’s total market capitalization by its sales for the past four quarters.
Cash Dividends Stocks usually pay dividends. Cash dividends are distributions made in cash to holders of stock. They are the current income that you receive while you own shares in the company. The firm’s board of directors usually declares a dividend on a quarterly basis (four times per corporate year), typically at the end of March, June, September, and December. Dividends are ordinarily paid out of current earnings, but in the event of unprofitable times (low earnings or none), the money might come from cash reserves held by the company. Occasionally, a company will borrow to pay the dividend so as to maintain its reputation of consistently paying dividends. Later profits can be used to repay any funds borrowed for this purpose.
Dividends per Share The
dividends per share
measure translates the total cash dividends paid out by a company to common stockholders into a per-share figure. For example, Running Paws might elect to declare a total cash dividend of $8000 for the year to common stockholders. In that case, cash dividends per share would amount to $0.40 ($8000 ÷ 20,000 shares).
dividends per share
Translates the total cash dividends paid out by a company to common stockholders into a per-share figure.
Dividend Payout Ratio The
dividend payout ratio
is the dividends per share divided by EPS. It helps you judge the likelihood of future dividends. For example, imagine that Running Paws Cat Food Company earned $32,000 (after paying preferred stockholders), paid out a cash dividend of $8000 to company stockholders, and retained the remaining $24,000 to facilitate growth of the company. In this case, the dividend payout ratio equals 0.25 ($8000 ÷ $32,000). For that year, Running Paws paid a dividend equal to 25 percent of earnings.
dividend payout ratio
Dividends per share divided by earnings per share (EPS); helps judge the likelihood of future dividends.
Newer companies usually retain most, if not all, of their profits to facilitate growth. An investor interested in growth would, therefore, seek a company with a low payout ratio. The lower the payout ratio the greater the likelihood that the company will grow, which results in later capital gains for investors. Examples of companies that historically have a high payout ratio are AT&T (T), Chevron (CVX), Exelon (EXC), Home Depot (HD), Intel (INTC), Merck (MRK), Pfizer (PFE), and Verizon (VZ).
Dividend Yield The
dividend yield
is the cash dividend paid to an investor expressed as a percentage of the current market price of a security. For example, the $0.40 cash dividend of Running Paws divided by the current $25 market price for its stock reveals a dividend yield of 1.6 percent ($0.40 ÷ $25). Growth and speculative companies typically pay little or no cash dividends, so they have limited dividend yields. Such companies are attractive to investors who are interested in capital gains.
dividend yield
Cash dividend to an investor expressed as a percentage of the current market price of a security.
Book Value
Book value
(also known as shareholder’s equity) is the net worth of a company, which is determined by subtracting the company’s total liabilities from its assets. It theoretically indicates a company’s worth if its assets were sold, its debts were paid off, and the net proceeds were distributed to the investors who own the outstanding shares of common stock.
book value (shareholder’s equity)
Net worth of a company, determined by subtracting total liabilities from assets.
Book Value per Share The
book value per share
reflects the book value of a company divided by the number of shares of common stock outstanding. Running Paws has a net worth of $230,000, which, when divided by 20,000 shares, gives a book value per share of $11.50.
book value per share
Reflects the book value of a company divided by the number of shares of common stock outstanding.
Often little relationship exists between the book value of a company and its earnings or the market price of its stock. A stock’s price usually exceeds its book value per share. The reason is that stockholders bid up the stock price because they anticipate earnings and dividends in the future and expect the market price to rise even more. When the book value per share exceeds the price per share, the stock may truly be underpriced.
Price-to-Book Ratio The
price-to-book ratio (P/B ratio)
, also called the
market-to-book ratio
, identifies firms that are asset rich, such as many banks, brokerage firms, and insurance companies. The P/B ratio is the current stock price divided by the per-share net value of the company’s plant, equipment, and other assets (book value). It tells you the premium that you are paying for the net assets of the company.
price-to-book ratio (P/B ratio)
Current stock price divided by the per-share net value of a firm’s plant, equipment, and other assets (book value).
In the Running Paws example, the book value per share of $11.50 would be divided into the recent price at which the stock was sold ($25 in this case); thus, the P/B ratio for Running Paws is 2.17. The current P/B ratio for most stocks lies between 2.1 and 1.0. The lower the ratio, the less highly a company’s assets have been valued, indicating that the stock may be currently under-priced. If the ratio is less than 1, the assets may be utilized ineffectively. In such cases, an under-performing and undervalued company may become a target of a corporate takeover;
where
the company may be broken up and sold.
DID YOU KNOW
Bias toward Following the Bandwagon
People engaged in investing in stocks and bonds have a bias toward certain behaviors that can be harmful, such as a tendency toward getting on the “bandwagon” when investments are headed down. What to do? Remember that markets that go down will definitely come up again, so stay in the market and continue to invest or you will miss the big upswing that sure will follow.
14.2e Calculating a Stock’s Potential Rate of Return Takes Five Steps
There is but a single reason to make an investment: to obtain a positive return. Although you cannot know the exact performance of any investment in advance, you certainly will want to pay no more than the “right price” for the investment given its potential rate of return. Calculating returns on a potential investment involves five steps. Armed with these data, you will be better positioned to make informed decisions:
1. Use beta to estimate the level of risk of the investment.
2. Estimate the market risk.
3. Calculate the required rate of return.
4. Calculate the potential rate of return on the investment.
5. Compare the required rate of return with the potential rate of return on the investment.
1. Use Beta to Estimate the Risk of the Investment
Beta is a useful piece of information when you want to estimate the rate of return you require on an investment in a stock, bond, or mutual fund before putting your money at risk. Betas for individual stocks, mutual funds, and other investments are available online from brokerage firms, advisory services, and investment magazines.
The following example illustrates how to use beta to estimate the amount of risk in an investment portfolio. Assume you are willing to accept more risk than the general investor and that you buy a stock with a beta of 1.5. If the average price of all stocks rises by 20 percent over time, the price of the stock you chose might rise by 30 percent, which is the beta of 1.5 multiplied by the increase in the market (1.5 × 20%). If the average price of all stocks drops in value by 10 percent, the price of the stock you chose might drop by 15 percent (1.5 × 10%).
2. Estimate the Market Risk
To estimate the required rate of return on an investment, you need to quantify the market risk. market risk, also known as systematic risk, which we discussed in
Chapter 13
, is the risk associated with the effects of the overall economy on securities markets. It often causes the market price of a particular stock or bond to change, even though nothing has changed in the fundamental values underlying that security. Historical records indicate that 8 percent represents a realistic estimate of market risk for U.S. stocks. Market risk is high during turbulent times in stock markets, and in the near term, it remains elevated.
DID YOU KNOW
About Employee Stock Options
Many employers give stock options to attract and retain senior employees. An employee stock option (ESO) is a gift, like a bonus, from an employer to a senior employee that allows them to benefit from the appreciation of their employer’s stock with or without putting any money down. The company gives them the right and opportunity to “exercise” the option by buying the stock sometime in the future at an “exercise” or “striking” price established when the option was given. If the company prospers, when the employee eventually decides to exercise the options, the current share price may be much higher than the exercise price, thus allowing the employee to buy the shares at a considerable discount.
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DID YOU KNOW
How to Use Online Stock Calculators
You can perform almost any kind of mathematical calculation necessary in investing by using one of the online investment websites. For example, by using
DailyFinance.com
(
www.dailyfinance.com/calculators/stocks/
), you can get answers to these questions:
• What is the return on my stock if I sell now?
• Should I wait a year to sell my stock?
• Should I sell my stock now and invest the money elsewhere?
• What stock price achieves my target rate of return?
• What is my current yield from dividends?
• How much do fees affect my stock’s rate of return?
• Which is better: income or growth stock?
• How do exchange rates affect my foreign stock?
• When will I recover my stock costs?
3. Calculate Your Required Rate of Return
The return on short-term U.S. Treasury bills has historically exceeded the rate of inflation by a slight degree (but not always as sometimes it is lower). Thus, when T-bills pay 2 percent interest, the inflation rate might hover around 1.7 percent. (The various interest rates in this chapter are chosen to be instructive. Note that the government’s real T-bill rate is currently much lower than 1 percent.) This circumstance provides almost no gain for the investor because the combination of inflation and income taxes reduce the return to about zero. For this reason, investors often use the yield on Treasury bills as a base number that provides a zero real rate of return—that is, a zero return on investment after inflation and income taxes.
To calculate your required rate of return on an investment, multiply the beta value of an investment by the estimated market risk and then add the risk-free T-bill rate, as shown in
Equation (14.1)
. For recent T-bill rates, see
www.treasurydirect.gov/indiv/research/indepth/tbills/res_tbill_rates.htm
. Use
Equation (14.1)
to determine an
estimate of the required rate of return on an investment
.
estimate of the required rate of return on an investment
A calculation that multiplies the beta value of an investment by the estimated market risk and adds the risk-free T-bill rate that suggests to investors the return required to put their money at risk.
For example, assume you are considering investing in Running Paws Cat Food Company, which has a beta of 1.5. If you assume a market risk of 8 percent and the current T-bill rate is 2.0 percent, the total rate of return you will require on this investment is 14.0 percent [2.0 1 (1.5 × 8.0)]. Investors need the promise of a return higher than 14 percent to put their money at risk in this investment.
4. Calculate the Stock’s Potential Return
The
potential return
for any investment over a period of years can be determined by adding anticipated income (from dividends, interest, rents, or other sources) to the future value of the investment and then subtracting the investment’s original cost. The investor using fundamental analysis can obtain the figures needed to construct the expected stream of future earnings for a company from a variety of sources. For example, you can use estimates for earnings and dividends gathered from large investment data firms such as Value Line, Standard & Poor’s, MarketWatch, or Reuters, and then obtain an individual stock analyst’s projections or you can create your own numbers.
potential return
Determined by adding anticipated income (from dividends, interest, rents, or other sources) to the future value of investment and then subtracting the investment’s original cost.
Add Up Projected Income and Price Appreciation
Table 14-2
illustrates how to sum up the projected income (dividend income) and price appreciation (earnings). You can convert these figures into a potential rate of return by calculating the approximate compound yield, as shown in
Equation (14.2)
. This figure can then be compared with returns on other investments.
Table 14-2 One Investor’s Projections of the Earnings and Dividends for Running Paws Cat Food Company
End of Year |
Earnings |
Dividend Income |
1 |
$2.76 |
$0.76 |
2 |
3.17 |
0.87 |
3 |
3.65 |
1.00 |
4 |
4.20 |
1.15 |
5 |
4.83 |
1.33 |
Total dividends |
$5.11 |
|
Average annual dividend ($5.11 ÷ 5) |
$1.02 |
DID YOU KNOW
Get Dividends if You Want Investment Income
If you want regular investment income, put some of your money into dividend-paying stocks and mutual funds. Everything is liquid and priced daily, and most pay quarterly. Including price appreciation you might earn 4 or 5 percentage points more than from Treasuries. If instead of cashing the checks, you may reinvest the income distributions so your returns will compound over time. Some high-dividend paying stocks include American Electric Power (AEP) and AT&T (T). Some appropriate mutual funds include Artio Global High Income (BJBHX) and DoubleLine Total Return Bond N (DLTNX).
Example: Running Paws Cat Food Company Based on a recommendation from his stockbroker, Izzle Stevens, who lives in Seattle, is considering Running Paws Cat Food Company as a potential investment. Izzle figures that the company’s stock might provide a better return than inflation and income taxes for about five years. He has determined the following information about this stock investment: It is currently priced at $30 per share, its most recent 12-month earnings amounted to $2.40 per share, and the cash dividend for the same period was $0.66 per share.
Izzle began the task of projecting the future value of one share of the stock by using the EPS information. He first calculated the P/E ratio to be 12.5 ($30 ÷ $2.40). Next, as illustrated in
Table 14-2
, Izzle applied a 15 percent rate of growth estimate (the same rate that occurred in previous years, according to Running Paws’ annual report) for the EPS for each year ($2.40 × 1.15 = $2.76; $2.76 × 1.15 = $3.17; and so forth). Using a P/E ratio of 12.5 (the same as the current ratio), Izzle estimated the market price at the end of the fifth year to be $60.38 (12.5 × $4.83). This calculation gives a projected net appreciation in stock price over five years of $30.38 ($60.38 minus the current price of $30).
To project the future income of the investment in Running Paws—the anticipated cash dividends—
Table 14-2
shows that Izzle estimated a 15 percent growth rate in the cash dividend ($0.66 × 1.15 = $0.76; $0.76 × 1.15 = $0.87; and so forth). Adding the projected cash dividends over five years gives a total of $5.11. Izzle obtained the potential return for one share of Running Paws over five years by adding anticipated dividend income ($5.11) to the future value of the investment ($60.38) less its original cost (
$30.00
), for a result of $35.49 ($5.11 + $30.38). Thus, Izzle has projected that $30 invested in one share of Running Paws will earn a potential total return of $35.49 in five years.
What is the ACY? The question now becomes, what is the percentage yield for this dollar return? The
approximate compound yield (ACY)
provides a measure of the annualized compound growth of any long-term investment. You can determine this value by using
Equation (14.2)
. The calculation requires use of an annual average dividend rather than the specific projected dividends. In this example, the annual average dividend of $1.02 is computed by dividing the $5.11 in dividend income by five years. Substituting the data from
Table 14-2
into
Equation (14.2)
and using the average annual dividend figure results in an approximate compound yield of 15.7 percent on the potential investment in one share of Running Paws stock for five years. (This formula can be found on the Garman/Forgue companion website.)
approximate compound yield (ACY)
A measure of the annualized compound growth of any long-term investment stated as a percentage.
5. Compare the Required Rate of Return with the Potential Rate of Return on the Investment
Now the moment of decision making is at hand. You compare the estimated required rate of return on an investment (given its risk) with the investment’s potential projected rate of return. In our example involving Running Paws Cat Food Company, the risk suggested a required rate of return of 14.0 percent. The investment’s potential rate of return was projected to be 15.7 percent, which suggests that Running Paws is a good buy for Izzle at the current selling price of $30—that is, the stock is under priced. Once armed with projected rate of return information for an investment, you can compare it with other investments.
DID YOU KNOW
Seven Questions Every Investor Needs to Answer
Before investing, investors ought to have written down responses to the following questions:
1. My investment experience?
2. My investment philosophy (conservative, moderate, or aggressive)?
3. My investment goals?
4. My age and family responsibilities?
5. My net worth?
6. My income?
7. My investment time horizon?
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CONCEPT CHECK 14.2
1. Distinguish between the terms income stocks and growth stocks.
2. Explain how a stock with a beta of 1.0 differs from ones with a beta of 1.2 and 2.5
3. What is the focus of fundamental analysis?
4. Summarize the meanings of the terms trailing and projected price/earnings ratio.
5. List the five steps to calculate a stock’s potential rate of return.
LEARNING OBJECTIVE 3
Use the Internet to evaluate common stocks in which to invest.
14.3 USE THE INTERNET TO EVALUATE AND SELECT STOCKS
An overwhelming amount of information is available on stock investments. With about 5000 U.S. public companies to choose from and another 33,000 stocks in other countries, stock selection takes time. Hundreds of investment resources exist, including television and radio shows, books, websites, blogs, and newsletters. What approach should you take? Use the Internet because everything you need is online.
14.3a Begin by Setting Criteria for Your Stock Investments
The process of setting criteria for a stock investment starts with a review of your investment plan, as discussed in
Chapter 13
and illustrated in
Figure 13-7
on page 405. To make informed selections of the stock investments that match your investment goals, philosophy, and time horizon, begin by making decisions on criteria for your stock investments:
• What classifications of stocks are best suited for your goals?
• What market capitalization size company meets your desires?
• What specific numeric measures do you require on beta, sales, profitability, P/E ratio, dividends, payout ratio, and market price?
• What projected EPS growth do you require?
• Do you want to invest in an industry leader?
FINANCIAL POWER POINT
Phone Apps for Investing
Vanguard’s Phone app users can access their stock brokerage accounts and mutual fund accounts, read market news, listen to podcasts, and watch videos. Scores of apps for investing are available including those from Bloomberg, Chase, CNBC Real-Time, EFFdb, Mint, Morningstar, Fidelity, Forbes, Charles Schwab, StockTwits, Wikinvest Portfolio Manager, and Yahoo! Finance.
14.3b Investor Education Is Widely Available Online
Comprehensive investment websites provide updated news headlines; market overviews; market statistics; industry statistics; industry trends; corporate stock symbols; current stock market prices; specific company profiles, history, financials, prices, and outlook for the future; tips on how to build a portfolio; and stock-screening tools with search capabilities. Following are some popular websites on investor education:
• The Investor’s Clearinghouse (
investoreducation.org/release032013.cfm
)
• FINRA Investor Education Clearinghouse (
www.finrafoundation.org/resources/education/modules/
)
• US Securities and Exchange Commission (
investor.gov/
)
• The Motley Fool (
www.fool.com/how-to-invest/index.aspx?source=ifltnvpnv0000001
)
14.3c Set Up Your Portfolio Online
You can set up a portfolio through an online brokerage account or by using any of several websites. For example, see WikiHow at
www.wikihow.com/Build-a-Stock-Portfolio
and JP Morgan at
www.jpmorganfunds.com/cm/Satellite?pagename=jpmfVanityWrapper&UserFriendlyURL=buildyourportfolio
. Both let you insert the number of shares you own and at what price. The sites then track stock quotes to update the value of your holdings.
14.3d Use Stock Screening Tools
You can research stocks, bonds, and mutual funds by using
stock-screening tools
available on the Internet. Screening enables you to quickly sift through vast databases of numerous companies to find those that best suit your investment objectives. For example, you can use the Kiplinger screening tool to filter thousands of stocks using 27 search criteria, and you can use Kiplinger’s or another company’s tools to identify dividend-paying stocks, small companies, and growth companies. You simply set the standard for screening, such as high P/E ratios, and the program sorts out the investment choices, including five-year EPS growth projections by professional stock analysts. You may be surprised to find how easy it is to screen stocks. The following websites offer stock-screening tools:
stock-screening tools
Enable you to quickly sift through vast databases of hundreds of companies to find those that best suit your investment objectives.
• Kiplinger (
www.kiplinger.com/tools/stockscreener/index.xhtml
)
• MSN Money (
investing.money.msn.com/investments/stockscouter-top-rated-stocks?sco=10
)
• MarketWatch (
www.marketwatch.com/tools/stockresearch/screener//
)
14.3e Get a Sense of the History of a Stock
You can study the price of stock movements over different time frames, including bull and bear markets, as well as make comparisons to various benchmarks such as the S&P 500 Index. See Market Watch (
bigcharts.marketwatch.com/historical//
).
14.3f Go to the Source for Company Information
Corporate filings required by the Securities and Exchange Commission are available on the Internet from the Electronic Data Gathering and Retrieval (EDGAR) project (
www.sec.gov/edgar/searchedgar/webusers.htm#.U2p5IaJn34g
). Top online sources for stock, bond, and mutual fund information include Morningstar (
www.morningstar.com
) and Bloomberg (
www.bloomberg.com
). Each public company has its own website that offers insights from management about the future of the firm, and it is easy to request a company’s annual report.
Every company registered with the Securities and Exchange Commission (SEC) is required to file once each year to ensure public availability of accurate current information about the firm. The company summarizes its financial activities for the year. The
10-Q report
includes the financial results for the quarter, a discussion from management, a list of material events and other risk factors that have occurred (such as legal problems and loss of a large customer), a forecast of the company’s future, and any significant changes or events in the quarter. A similar 10-K report is filed annually. You can obtain both 10-Q and 10-K reports from the SEC online (
www.sec.gov
). You can find executive compensation details on Form DEF 14A.
10-Q report
A report required by the SEC prepared by the company showing its financial results for the quarter, a discussion from management, a list of material events and other risk factors that have occurred, forecasts of the company’s future, and notes of any significant changes or events in the quarter.
There are numerous websites that offer fundamental and technical analysis of stocks. The Motley Fool does so with humor.
The company’s
annual report
is mostly a numbers-free publication that looks like a slick marketing magazine. While annual reports do contain some summarized financial information, they serve more as promotional corporate brochures.
annual report
Legally required yearly report about financial performance, activities, and prospects sent to major stockholders and made available to the general public.
When a company issues any new security, it files a
prospectus
with the SEC. This disclosure describes the experience of the corporation’s management, the company’s financial status, any anticipated legal matters that could affect the company, and potential risks of investing in the firm. The language is legalistic and full of technical jargon, but the interested investor may find it useful to sift through the details.
prospectus
Highly legalistic information presented by a firm to the SEC and to the public with any new issue of stock.
14.3g Use Stock Analysts’ Research Reports
Stock analysts working for independent stock advisory firms or stock brokerages write research reports on companies and industries, as illustrated in
Figure 14-1
with a report from Standard & Poor’s. Reports based on fundamental analysis are quite informative. The quality of advice is uneven, ranging from brilliant to pedestrian as analysts have a tendency to run with the herd and make similar recommendations. They often recommend buying certain stocks and rarely suggest selling. The prudent investor interprets “hold” recommendations as a signal to sell.
14.3h Read Research Newsletters
The most popular firms that offer stock advisory research services on a subscription basis to individual investors are Morningstar (
www.morningstar.com
), Value Line (
www.valueline.com
), MarketWatch (
www.marketwatch.com
), and Reuters (
reuters.com/finance/markets
). The cost for some of these services is in the hundreds of dollars per year. A Google search for “stock advisory newsletters” will reveal several dozen firms that offer guidance on stock selections, market updates, and investment advice. You may wish to avoid those that offer suggestions based on a “technical” or “chartist” approach to analyzing stocks; instead select one that uses a mainstream approach emphasizing fundamental research.
Figure 14-1
Illustrative Stock Analyst’s Report
FINANCIAL POWER POINT
Investment Blogs
There is a vast array of investment blogs. Many are rubbish; some seem useful. Some favorites include those from Listly’s Lists (list.ly/list/1 HO-top-100-investment -blogs) and Swing-Trade-Stocks.com(
www.swing-trade-stocks.com/recommended-blogs.xhtml
)
14.3i Be Aware of Economic Trends
You need to know the stage of the business cycle (recession or prosperity) and the current interest and inflation rates. You also need to understand how economic conditions are likely to change over the next 12 to 18 months. (These topics were examined in
Chapter 1
.) Economic information is available through almost all media:
• Search engines: Yahoo!, Google, and Momma
• Big newspapers: USA Today, Los Angeles Times, The Wall Street Journal
• Business news: Business Week Fortune, Forbes Financial World
• Personal finance: Money magazine and Kiplinger’s Personal Finance
• Investment sources: The Wall Street Journal, Barron’s, Investor’s Business Daily, Market Watch, Reuter’s
• News magazines: U.S. News & World Report, Time
14.3j Pay Attention to Securities Market Indexes
Reports on securities market indexes are provided around the clock in almost every media. “The Dow went up 80 points today.” “The S&P 500 rose 68 points.” When it is reported that “the Dow rose 80 points today in heavy trading,” realize that these “points” are changes in the index, not actual dollar changes in the value of the stocks. A
securities market index
is an indicator of market performance. It measures the average value of a number of securities chosen as a sample to reflect the behavior of a more general market. Popular indexes include the following.
securities market index
Measures the average value of a number of securities chosen as a sample to reflect the behavior of a more general market.
Dow Jones Industrial Averages The
Dow Jones Industrial Average (DJIA)
is the most widely reported of all indexes. The most popular DJIA industrial average, also called the “Dow,” follows prices of only 30 actively traded blue-chip stocks, including well-known companies such as American Express, AT&T, Caterpillar, Coca-Cola, Nike, Visa, Walmart, and Walt Disney. The average is calculated by adding the closing prices of the 30 stocks and dividing by a number adjusted for splits, spin-offs, and dividends.
*
The DJIA also produces a transportation average based on 20 stocks, a utility average based on 15 stocks, and a composite average based on all 65 industrial, transportation, and utility stocks.
Dow Jones Industrial Average (DJIA)
The most widely reported of all stock market indexes that tracks prices of only 30 actively traded blue-chip stocks, including well-known companies such as American Express and AT&T.
Standard & Poor’s 500 Index The popular Standard & Poor’s (S&P) 500 Index reports price movements of 500 stocks of large, established, publicly traded firms. It includes stocks of 400 industrial firms, 40 financial institutions, 40 public utilities, and 20 transportation companies. Companies with the highest market values influence the index the greatest.
NASDAQ Composite Index The NASDAQ Composite Index takes into account virtually all U.S. stocks (about 3700) traded in the over-the-counter market in the automated quotations system operated by the National Association of Securities Dealers. It provides a measure of companies not as popular or as large as those traded on the popular exchanges, including price behavior of many smaller, more speculative companies, although some big companies (such as Cisco Systems, Intel, Microsoft, and Staples) are listed as well. It is often used as a benchmark for the performance of high-tech stocks.
Dow Jones Wilshire 5000 Index The Dow Jones Wilshire 5000 Index represents the total market value of all the publically traded stocks in the United States, about 3776. One point in the index is worth $1 billion; thus when the index is 20,200, that translates into a U.S. stock market valued at over $20 trillion.
Russell 2000 Index The Russell 2000 Index is a small-cap stock market index of relatively small capitalized companies and is the most widely quoted measure of the overall performance of the small-cap to midcap company shares.
Foreign Stock Exchanges Stock exchanges are located in major cities throughout the world, including London, Sydney, Tokyo, Toronto, Frankfort, Mumbai, Hong Kong, Shenzhen, Shanghai, and Kuala Lumpur. U.S. investors often check the stock exchanges throughout the night to gain a hint of what might happen that day in the U.S. stock market.
14.3k Securities Exchanges (Stock Markets)
A
securities exchange
(also called a
stock market
) is a market where agents of buyers and sellers can find each other easily by providing an orderly, open plan to trade securities. Each exchange has its own rules, is subject to government regulation, and provides constant supervision and self-regulation.
securities exchange (stock market)
Market where agents of buyers and sellers can find each other easily by providing an orderly, open plan to trade securities.
The transactions were historically performed in an organized physical location, such as the New York Stock Exchange (known officially as NYSE Euronext and listed as NYX), and also known as the “Big Board”) as well as the American Stock Exchange (known officially as NYSE MKT LLC and also owned by NYSE Euronext) Both are in New York City. You may visualize a bustling exchange that ends the trading day with a bell. However, today most stock trading occurs in a fragmented collection of 50 trading platforms, and almost all transactions are performed electronically. The market capitalization of the NYSE Euronext’s over 8000 listed companies is over $16 trillion. As many as 100 billion shares trade daily on the New York Stock Exchange.
Regional stock exchanges are places where equity in publicly-held companies (often regionally located firms) is traded, and these firms do not meet the strict listing requirements of national stock exchanges. Examples are located in Boston, Chicago, Philadelphia, and San Francisco. Newer exchanges also exist like Direct Edge, in New Jersey, and BATS Exchange in Kansas; each handles about 10 percent of trades in the U.S.
OTC or Over-the-Counter Trading
Over-the-counter (OTC)
or
off-exchange trading
is done directly between two parties, without any supervision of an exchange. The electronic telecommunications network facilitates the buying and selling of securities that usually are not listed on the major exchanges through market makers.
Over-the-counter (OTC) (off-exchange trading)
trading is done directly between two parties, without any supervision of an exchange.
FINANCIAL POWER POINT
Amateurs Have an Advantage over Big Stock Research Firms
Three to five years before analysts really start to follow such developments, local investors can be among the first to see the company in which they work start to really succeed. They also may see nearby new retailers in shopping malls with bright futures.
14.3l Looking Up a Stock Price
What affects the price of a stock the most is supply and demand. When more people want to buy, the price goes up. When more people want to sell, the price goes down. If you know the company’s stock symbol (search Google for “stock symbols”), the current price of any stock may be obtained by inputting the company symbol into Google or any of the other popular investment websites, such as Yahoo! Finance, MSN Money, Reuter’s, and MarketWatch.
DID YOU KNOW
Crowd Funding for Startup Companies
Congress passed a law approving crowd funding as a way for companies to raise capital. Startup companies now may use web portals overseen by federal regulators to solicit up to $1 million annually in small amounts from lots of people, rather than solicit from a few large investors as securities laws have required. Those with an annual income of less than $100,000 will only be allowed to invest $2000 or 5 percent of their assets, whichever is greater.
Kickstarter.com
is the most well known. This opens up a badly needed source of funds. However, crowd funding could turn into “crowd fleecing” if investors cannot tell the difference between a legitimate opportunity and a scam.
The millions of daily buying and selling transactions involving stocks, bonds, and mutual funds are summarized in The Wall Street Journal, the most widely read financial newspaper in the United States. Many daily newspapers publish abbreviated information, and security prices are quoted and traded to two decimal points. Stock quotations that might appear in The Wall Street Journal for Walmart, a retailer, are illustrated in
Figure 14-2
.
Column 1: YTD % Change. The numbers in this column report the “year to date (YTD) as a percentage” change in the price (18.6%) of Walmart stock since January 1 of the current calendar year.
Columns 2 and 3: 52 Weeks, High and Low. This column shows that Walmart stock traded at a high price of $63.08 and a low price of $41.50 during the previous 52 weeks, not including the previous trading day.
Figure 14.2
How Stocks Are Quoted
Column 4: Stock and Sym. This column gives the name of the stock (Walmart in this example) and its abbreviated trading symbol (WMT).
Column 5: Div. The dividend amount is based on the last quarterly declaration by the company. For example, Walmart last paid a quarterly dividend that, when converted to an annual basis, amounts to an estimated $0.28 annual dividend.
Column 6: Yld %. The figure in this column represents the yield as a percentage of dividend income, calculated by dividing the current price of the stock into the recent estimated dividend. The yield of the Walmart stock is 0.4 percent.
Column 7: PE. This figure provides the P/E ratio based on the current price. The earnings figure used to calculate the price is not published in the newspaper but is the latest available. When Walmart’s “last” or closing price of $62.52 is divided by earnings, it gives a P/E ratio of 42.
Column 8: vol 100s. This figure indicates the total volume of trading activity for the stock measured in hundreds of shares. Thus, 10,457,200 shares of Walmart were traded on that day.
Column 9: Last. The price of the last trade of the day before the market closed for Wal-Mart was $62.52.
Column 10: Net Cng. The net change, +0.82%, represents the difference between the closing price (last) on this day and the closing price of the previous trading day. Today’s Walmart closing (last) price of $62.52 was up $0.82 from the previous closing price, which must have been $61.70.
DID YOU KNOW
Bias toward Short-term Emotions
People engaged in investing through mutual funds have a bias toward certain behaviors that can be harmful, such as a tendency toward paying too much attention to our short-term emotions when making long-term decisions. When markets are calm, investors think they will stand pat; when they start declining they bail out, often at the worst possible moment. What to do? Set short-term goals to accomplish long-term goals you are comfortable with and stay the course, or hire an investment professional to do it for you.
14.3m Using Portfolio Tracking to Watch Your Investments
Watching your investments requires record keeping, particularly for income tax purposes, although when you sell any securities your brokerage firm will provide you with sufficient details. Recordkeeping tasks can be performed easily using the Internet.
Portfolio tracking
automatically updates the value of your portfolio after you enter the symbols of the stocks you own and the number of shares held. Online portfolio tracking services also alert you to events that may affect your stocks. Tracking helps you stay on top of your holdings so you know which stocks are performing well, which are underperforming, and which might need to be sold. For programs type in “portfolio tracker” on Google.
portfolio tracking
Automatically updates the value of your portfolio after you enter the symbols of the stocks you own and the number of shares held.
CONCEPT CHECK 14.3
1. Give three examples of the types of website resources available to investors on the Internet.
2. List five places where you can obtain investment information on a specific stock.
3. Distinguish between the Dow Jones Industrial Average and the S&P 500.
4. Where can you go to look up stock symbols and prices?
LEARNING OBJECTIVE 4
Summarize how to buy and sell stocks, as well as the techniques of margin buying and selling short.
14.4 BUYING AND SELLING STOCKS
Securities transactions require the use of a licensed broker serving as a middleman between the seller and the buyer and collecting a fee on each purchase or sale of securities. A
stockbroker
(also known as an account executive) is licensed to buy and sell securities on behalf of the brokerage firm’s clients. You can buy or sell securities through an online or human stockbroker who works for a brokerage firm that has access to the securities markets. Brokerage firms often provide investors with investment advice.
stockbroker (account executive)
Professional who is licensed to buy and sell securities on behalf of the brokerage firm’s clients.
As a matter of convenience and to facilitate resale, investors prefer to leave securities certificates in the name of their brokerage firm rather than take physical possession themselves. Securities certificates kept in the brokerage firm’s name instead of the name of the individual investor are known as the
security’s street name
. Brokers have a duty to assess each client’s suitability for particular investments.
Table 14-3
shows the different types of stock brokerage firms.
security’s street name
Securities certificates kept in the brokerage firm’s name instead of the name of the individual investor.
14.4a Opening a Brokerage Account
To trade securities, you will need a brokerage firm to act as your agent. You can open an account at a full-service general brokerage firm or a discount brokerage firm. The firm charges a commission for any trading it conducts on your behalf. You should make clear to the brokerage firm, in writing, your investment objectives and your desired level of risk. A
cash account
is a brokerage account that requires an initial deposit (perhaps as little as $1000) and specifies that full settlement is due to the brokerage firm within three business days after a buy or sell order has been given. After each transaction, your account is debited or credited, and written confirmation is immediately forwarded.
cash account
A brokerage account that requires an initial deposit (perhaps as little as $1000) and specifies that full settlement is due to the brokerage firm within three business days after a buy or sell order has been given.
14.4b Broker Commissions and Fees
Brokerage firms receive a commission on each securities transaction to cover the direct expenses of executing the transaction and other overhead expenses. They have established fee schedules that they use when dealing with any except the largest investors. The fees reflect a commission rate that declines as the total value of the transaction increases. For example, in lieu of a minimum commission charge of $25, a brokerage firm might charge 2.8 percent on a transaction amounting to less than $800, 1.8 percent on transactions between $800 and $2500, 1.6 percent on amounts between $2500 and $5000, and 1.2 percent on amounts exceeding $5000.
Table 14-3 Types of Brokerage Firms
General (Full-Service) Brokerage Firm
Offers a full range of services, including investment information and advice; research reports on companies, industries, general economic trends, and world events; an investment newsletter; recommendations to buy, sell, or hold stocks; execution of securities transactions by live brokers and online; and margin loans. Commissions and fees are higher than other firms. See Edward Jones, Raymond James, UBS, Morgan Stanley Smith Barney, and Wells Fargo Advisors.
Discount Brokerage
They charge commissions to execute trades that are often 30 to 80 percent less than the fees charged by full-service brokers. Most offer excellent research and investment tools. See Fidelity, TD Ameritrade, Charles Schwab, USAA Brokerage Services, and Vanguard.
Online Discount Brokerage
Online discount brokers (also called Internet or electronic discount brokers) have reduced the cost of executing a trade to perhaps $20 or even $10 because their primary business is online trading. All the discount brokers noted are also online brokers. Additional highly rated online brokers are TD Ameritrade, E*Trade, Fidelity, Scott Trade, and Vanguard.
general (full-service) brokerage firms
Offer a full range of services to customers, including investment advice and research.
discount brokers
Charge commissions to execute trades that are often 30 to 80 percent less than the fees charged by full-service brokers, but also offer fewer services.
online discount brokers
Such brokers, also called Internet or electronic discount brokers, have reduced the cost of executing a trade to perhaps $20 or even $10 because their primary business is online trading.
DID YOU KNOW
About Online Day Trading
Online
day trading
occurs when an investor buys and sells stocks quickly throughout the day with the hope that the price will move enough to cover transaction costs and earn some profits. Day traders rarely own stocks overnight. Transactions are executed online because they can be done quickly with low commissions. Day trading is a risky practice. One of billionaire Warren Buffett’s commandments for getting ahead in personal finance states, “You will lose money if you trade stocks actively.”
day trading
Occurs when an investor buys and sells stocks quickly throughout a day with the hope that prices will move enough to cover transaction costs and earn some profits.
DID YOU KNOW
How to Check the Background of Your Stockbroker or Investment Advisor
You can check the background of a stockbroker (440,000) or a brokerage firm (45,000) via the Financial Industry Regulatory Authority (FINRA) (
www.finra.org/investors/toolscalculators/brokercheck/
). Also check the disciplinary record of most any financial adviser who manages more than $110 million in assets at the Securities and Exchange Commission at
www.adviserinfo.sec.gov
. Too often the investor receives poor advice. Don’t let it happen to you!
Transaction costs are based on sales of round lots, which are standard units of trading of 100 shares of stock and $1000 or $5000 par value for bonds. An odd lot is an amount of a security that is less than the normal unit of trading for that particular security; for stocks, any transaction less than 100 shares is usually considered to be an odd lot. When brokerage firms buy or sell shares in odd lots, they may charge a fee of 12.5 cents (called an eighth) per share on the odd-lot portion of the transaction, which is called the differential.
The payment of commissions can quickly reduce the return on any investment. A purchase commission of 2 percent is added to a sales commission of another 2 percent, for example, means that the investor has to earn a 4 percent return just to pay the transaction costs. Brokerage commissions typically range from $25 to 3 percent of the value of the transaction. The easiest way to hold down investing costs is to find a brokerage firm that charges low commissions, and that usually means using a discount or online broker.
14.4c How to Order Stock Transactions
Hundreds of millions of shares of securities are traded daily on the stock markets in the United States. Every trade brings together a buyer and a seller to complete the transaction at a given price.
Types of Stock Orders Basically, there are only two types of orders—buy and sell. The stockbroker will buy or sell securities according to prescribed instructions in a process called executing an order. Those instructions can place constraints on the prices at which those orders are carried out.
Table 14-4
shows the instructions that accompany stock orders.
DID YOU KNOW
Regulations Help Protect against Investment Fraud
Public trust is vital to the success of the securities industry; without it, consumers will not invest. Regulation of securities markets aims to provide investors with accurate and reliable information about securities, maintain ethical standards, and prevent fraud against investors. This regulation occurs at five levels:
1.
Securities and Exchange Commission (SEC)
. The SEC is a federal government agency that focuses on ensuring disclosure of information about securities to the investing public and on approving the rules and regulations employed by the organized securities exchanges. The SEC requires registration of listed securities with appropriate and updated information. It also prohibits manipulative practices, such as using insider information for illegal personal gain or causing the price of a security to rise or fall for false reasons. All states require registration of securities sold within their states, and they, too, regulate the securities industry.
2.
Self-Regulatory Agencies
. The Financial Industry Regulatory Authority (FINRA) and other self-regulatory organizations, such as the New York Stock Exchange, enforce standards of conduct for their members and their member organizations. They dictate rules for listing and for trading securities.
3.
Brokerage Firms
. Individual brokerage firms have established standards of conduct for brokers that govern how they deal with investors.
4.
Security Investors Protection Corporation (SIPC)
. The SIPC is a limited insurance program to protect the investing public when an SEC-registered brokerage firm fails. Although investment losses due to fraud, misrepresentation or bad investment decisions are not covered, the SIPC protects each of an investor’s accounts at a brokerage firm against financial loss as a result of unreturned securities and cash up to a total of $500,000, but no more than $100,000 in cash.
5.
Financial Services Oversight Council (FSOC).
The mission of the FSOC is to identify and monitor excessive risks to the U.S. financial system arising from the distress or failure of large, interconnected bank holding companies or non-bank financial companies and from risks that could arise outside the financial system. The idea is to eliminate expectations that any American financial firm is “too big to fail” and to respond to emerging threats to U.S. financial stability.
Table 14-4 Instructions Accompanying Stock Transaction
Instruction |
Process |
Market |
Buy or sell at current prevailing price |
Fill-or-Kill |
Immediately buy or sell at current market price or cancel |
Matched |
Held for minutes, hours or days until executed or cancelled |
Negotiated |
Buyer “bids” for best price and negotiates until accepted or cancelled |
Good-til-Cancelled |
Remains valid until executed or cancelled by the investor |
Limit |
Buy at best possible price “but not above” a specified limit or to sell at a certain price “but not below” a specified price |
Stop (or Stop-Loss) |
Sell at the market price if it goes below a specified price |
DID YOU KNOW
The Tax Consequences of Investing in Stocks and Bonds
The government encourages investing through tax policies that favor investors.
Dividends and Interest
Taxes are low on dividend income. Funds put into regular investment accounts represent after-tax money (you earn an income on which you pay taxes, and then you invest some of the remaining money). Taxes are due on any interest, dividends, and capital gains in the year in which the income is received. The IRS considers as interest income any increase in the par value on bonds, including TIPS bonds. Interest is taxable at the investor’s marginal tax rate. Dividend income is taxed at a maximum rate of 15 percent for most people; a zero percent rate applies to lower-income taxpayers.
Capital Gains and Losses
Capital gains taxes are low. No tax liability is incurred for any capital gains until the stock, bond, mutual fund, real estate, or other investment is sold. When you sell an investment, such as a stock, the gain or loss is calculated by analyzing what you paid for the investment plus broker commissions and loads minus the selling price minus commissions or redemption fees. Short-term gains (for investments held one year or less) are taxed at the same rates as ordinary income. Long-term gains (for investments held at least a year and a day) are taxed at special rates: The long-term capital gains rate for taxpayers below the 25 percent bracket is zero percent, the rate is 15 percent for those in the 25 percent bracket and above, and it is 20 percent for those subject to the 39.6 tax rate. Long-term capital gain rates for collectibles such as stamps and coins are 28 percent. Capital losses can be used to offset capital gains or even your regular income. See
Chapter 4
.
14.4d Margin Buying and Selling Short Are Risky Trading Techniques
For investors interested in taking on additional risk, there are two advanced trading techniques, and both involve using credit: (1) buying stocks on margin and (2) selling short.
Margin Trading Is Buying Stocks on Credit Some investors open a margin account with a brokerage firm in addition to their cash account so they can buy securities using credit. Opening a
margin account
requires making a substantial deposit of cash or securities ($2000 or more) and permits the purchase of other securities using credit granted by the brokerage firm. Both brokerage firms and the Federal Reserve Board regulate the use of
margin buying
, which is using a margin account to buy securities. It allows the investor to apply leverage that magnifies returns or losses.
margin account
Account at a brokerage firm that requires a substantial deposit of cash or securities and permits the purchase of other securities using credit granted by the brokerage firm.
margin buying
Using a margin account to buy securities; allows the investor to apply leverage that magnifies returns—or losses.
The
margin rate
is the percentage of the value (or equity) in an investment that is not borrowed. The current requirement is 50 percent for common stock. Thus at least 50 percent of each dollar invested must be the investor’s. The remainder may be borrowed from the broker. The securities purchased, as well as other assets in the margin account, are used as collateral.
margin rate
Set by the Fed, percentage of the value (or equity) in an investment that is not borrowed—recently 25 to 50 percent.
Buying on margin also can increase returns. Those with an aggressive investment philosophy might buy on margin because it gives them the opportunity to obtain a higher rate of return. Let’s say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you’ll earn a 50 percent return on your investment ($75 − $50 = $25/50). But if you bought the stock on margin—paying $25 in cash and borrowing $25 from your broker—you’ll earn a 100 percent return on the money you invested ($25/$25). Of course, you have to repay your broker $25 plus interest.
The downside to using margin is that if the stock price decreases, substantial losses can occur. Let’s say the stock you bought for $50 falls to $25. If you fully paid for the stock, you’ll lose 50 percent of your money. But if you bought on margin, you’ll lose 100 percent, and you still must come up with the interest you owe on the loan.
DID YOU KNOW
The Investment That Is Best for You May Not Be Best for Your Financial Advisor
Ninety percent of financial advisors sell you what is best for them and is “suitable for you”. Here is how the Securities and Exchange Commission defines the suitability standard. When your broker recommends that you buy or sell a particular security or she must have a reasonable basis for believing that recommendation is suitable for you. In making this assessment, your broker must consider your income and net worth, investment objectives, risk tolerance, and other security holdings.
In other words, a bond portfolio might be suitable for an older investor seeking income; a portfolio of penny stocks would not. The same bond portfolio would be unsuitable, however, for a young investor seeking growth. The suitability standard also does not preclude conflicts of interest. What is best for you may not be best for the financial advisor. There could be two investments that could qualify as suitable for you, but one would pay your advisor a 1 percent commission and the other 6 percent. Which do you think he or she might recommend?
A fiduciary standard means that the broker must always act in the best interest of the client regardless of how it might affect the advisor. Only an investment advisor who is a registered investment advisor (RIA) is legally required to act as a fiduciary. Be sure to ask.
The Department of Labor is drafting a rule requiring that all financial advisors abide by fiduciary standards. The industry is fighting against the proposal.
DID YOU KNOW
Your Worst Financial Blunders in Investing in Stocks and Bonds
Based on others’ financial woes, you will make mistakes in personal finance when you:
1. Invest in stocks that do not match your investment philosophy.
2. Fail to use fundamental analysis when making stock investments.
3. Buy stocks on margin or sell stocks short.
Here a representative of the firm will tell the investor to immediately either put up more collateral (money or other stocks) or face having the investment sold. This procedure is known as a margin call. If the investor fails to put up the additional cash or securities to maintain a required level of equity in the margin account, the broker will sell the securities at the market price, resulting in an even sharper financial loss to the investor. The investor is required to repay the broker for any losses.
Selling Short Is Selling Stocks Borrowed from Your Broker Buying a security with the hope that it will go up in value—the goal of most investors—is called
buying long
. You might suspect, however, that the price of a security will drop. You can earn profits when the price of a security declines by
selling short
. In this trading technique, investors sell securities they do not own (borrowing them from a broker) and after so many days or weeks plan to buy the same number of shares of the security at a lower price (returning them to the broker). Thus, the investor earns a profit on the transaction.
buying long
Buying a security (especially on margin) with the hope that the stock price will rise.
selling short
Investors selling securities they do not own (borrowing them from a broker) and later buying the same number of shares of the security at a lower price (returning them to the broker).
Brokerage firms require an investor to maintain a margin account when selling short because it provides some assurance that the investor can repay the firm for the borrowed stock, if necessary. As a result, some or all of an investor’s funds deposited in a margin account are effectively tied up during a short sale. Many brokers hold the proceeds of a short sale, without paying interest, until the customer covers the position by buying it back for delivery to the broker.
Only a small proportion of investors sell stocks short because this approach is so risky. Selling short and buying on margin are techniques to be used only by sophisticated investors.
CONCEPT CHECK 14.4
1. Summarize the differences among discount, online, and full-service brokers.
2. Summarize the differences among types of stock orders: market, limit, and stop order.
3. Explain what selling short is and how it can go wrong for an investor.
LEARNING OBJECTIVE 5
Describe how to invest in bonds.
14.5 INVESTING IN BONDS
You should consider investing in bonds if you wish to receive periodic income from a portion of your investments. While bonds usually offer a lower return to investors than stocks, there are good reasons to include bonds in one’s portfolio. The primary one is to reduce market risk. Others include obtaining a regular source of predictable although low income, likelihood of profiting from possible future increases in the value of bonds, and matching some of one’s assets to one’s investment time horizon.
A variety of bonds are available to the investor. High quality bonds are called
investment-grade bonds
and they offer investors a reasonable certainty of regularly receiving the periodic income (interest) and retrieving the amount originally invested (principal). Only about 8 percent of the 23,000 largest U.S. companies that issue bonds meet the highest investment-grade rating standards. Bonds are usually issued at a par value (also known as face value) of $1000.
investment-grade bonds
Offer investors a reasonable certainty of regularly receiving periodic income (interest) and retrieving the amount originally invested (principal).
An investor typically earns a low to moderate return on bond investments, an appropriate yield when compared with the higher total returns earned on riskier stocks and stock mutual funds. Owning some bonds (or bond mutual funds) along with stocks and cash diversifies an investment portfolio.
Speculative-grade bonds
pay a high interest rate. These are often derisively called junk bonds, and they are long-term, high-risk, high-interest-rate corporate (or municipal) IOUs issued by companies (or municipalities) with poor or no credit ratings. The interest rates paid investors on junk bonds are 3.5 to 8 percentage points more than those of Treasury bonds.
speculative-grade bonds
Long-term, high-risk, high-interest-rate corporate (or municipal) lOUs issued by companies (or municipalities) with poor or no credit ratings. Also called junk bonds or high-yield bonds.
Also more elegantly called high-yield bonds, they carry investment ratings that are below traditional investment grade and carry a higher risk of default (not repaying the bond investors). Keep in mind that higher returns require greater risk. The default rate on investment grade AAA-rated bonds is ½ of 1 percent. It is 1.5% on AA bonds; 3% on A bonds; and 10% on BBB bonds. The rate is over 4% for munis. For more information, see Bond Pickers (
www.bondpickers.com
) or
www.defaultrisk.com
or search Google using “high-yield bonds.”
Individual investors usually avoid buying individual junk bonds because of the substantial financial risk involved with owning too few investments. Instead, they reduce risk by diversifying their investments through a “high-yield income” bond mutual fund (see
Chapter 15
) that has junk bonds in its portfolio.
14.5a Corporate, U.S. Government, and Municipal Bonds
Three types of bonds are available: corporate bonds, U.S. government securities, and municipal government bonds.
Corporate Bonds Pay Reasonable Returns
Corporate bonds
are interest-bearing certificates of long-term debt issued by a corporation. They represent a needed source of funds for corporations. The dollar value of newly issued bonds is three times the dollar value of newly issued stocks. Because of tax regulations, corporations often finance major projects by issuing long-term bonds instead of selling stocks. One reason they do so is that payments of dividends to common and preferred stockholders are not tax deductible for corporations, unlike interest paid to bondholders. State laws require corporations to make bond interest payments on time. Therefore, companies in financial difficulty are required to pay bondholders before paying any short-term creditors.
corporate bonds
lnterest-bearing certificates of long-term debt issued by a corporation.
DID YOU KNOW
Money Websites for Investing in Bonds
Informative websites for investing in bonds, including the latest bond prices are:
Financial Industry Regulatory Authority (
www.finra.org/
)
JW Korth Shop-4-Bonds (
www.shop4bonds.com
)
Municipal Securities Rulemaking Board (
emma.msrb.org/home
)
Securities Industry and Financial Markets Association (
www.investinginbonds.com
)
Yahoo! Finance on bonds (
finance.yahoo.com/bonds
)
Wikipedia (
en.wikipedia.org/wiki/Bond_(finance)
)
Figure 14-3
Higher Returns on Bonds Requires Greater Risk
The default risk varies with the issuer. To help you in appraising the risks and potential rewards of bond investments, independent advisory services, such as Moody’s Investors Service, Standard & Poor’s, and Fitch, grade bonds for credit risk. These firms publish what they describe as unbiased ratings of the financial conditions of corporations and municipalities that issue bonds.
A
bond rating
represents the opinion of an outsider on the quality—or creditworthiness—of the issuing organization. It reflects the likelihood that the issuing organization will be able to repay its debt. Ratings for each bond issue are continually re-evaluated, and they often change after the original security has been sold to the public. Investors have access to measures of the default risk (or credit risk), which is the uncertainty associated with not receiving the promised periodic interest payments as well as the principal amount when it becomes due at maturity.
bond rating
An impartial outsider’s opinion of the quality—or creditworthiness—of the issuing organization.
default risk (credit risk)
Uncertainty associated with not receiving the promised periodic interest payments and the principal amount when it becomes due at maturity.
Table 14-5
shows the bond ratings used by Moody’s, Standard & Poor’s and Fitch, all well known rating services. The higher the rating, the greater the probable safety of the bond and the lower the default risk. The lower the rating of the bond the higher the stated, or effective interest rate. When bonds are reduced in price from their face amount, more risk is involved. Higher ratings denote confidence that the issuer will not default and, if necessary, that the bond can readily be sold before its maturity date. Investment-grade corporate bonds may provide returns as much as 2.5 percentage points higher than the returns available on comparable U.S. Treasury securities.
U.S. Government Securities Represent Quality and Safety U.S. Treasury securities are the world’s safest investment because the government has never intentionally defaulted on its debt. U.S. Treasury securities are backed by the “full faith, credit, and taxing power of the U.S. government,” and this all but guarantees the timely payment of principal and interest. The debt is held by a variety of investors, including the governments of Japan and China, the largest U.S. creditors. U.S. debt is denominated in dollars and is the cornerstone of the global financial system.
U.S. government securities are classified into two groups: (1) Treasury bills, notes, and bonds and (2) federal agency issue notes, bonds, and certificates. Treasury bills, notes, and bonds are collectively known as
Treasury securities
, or Treasuries. The federal government uses these debt instruments to finance the public national debt.
Treasury securities (Treasuries)
Known as Treasuries, securities issued by the U.S. government, including bills, notes, and bonds.
Treasury securities have excellent liquidity and are simple to acquire and sell. Previously issued marketable Treasury securities are bought and sold in securities markets through brokers. New issues can be purchased online using the Treasury Direct Plan (
www.publicdebt.treas.gov
), where they are stored electronically. Individuals may buy Treasury securities in amounts as small as $100.
Table 14-5 Summary of Bond Ratings
The interest rates on federal government securities are lower than those on corporate bonds because they are virtually risk free. The possibility of default is near zero. Individuals with a conservative investment philosophy and overseas investors and governments are often attracted to the certainty offered by U.S. government securities. Investors can purchase these directly from the Treasury. Although interest income is subject to federal income taxes, interest earned on Treasury securities is exempt from state and local income taxes.
Treasury Bills, Notes, and Bonds
Treasury bills
, or T-bills, are short-term government securities with maturities ranging from a few days to just less than one year. Bills are sold at a discount from their face value (par). The difference between the original purchase price and what the Treasury pays you at maturity, the gain or par, is interest. This interest is exempt from state and local income taxes but is reported as interest income on your federal tax return in the year the Treasury bill matures.
Treasury bills
Known as T-bills, U.S. government securities with maturities of less than one year.
Stated as an interest rate, the return on such investments is called a
discount yield
. For example, if you buy a $10,000 26-week Treasury bill for $9925 and hold it until maturity, your interest will be $75 for an annual return of approximately 1.5 percent. An investor can hold a bill until maturity or sell it before it is due. When a bill matures, the proceeds can be reinvested into another bill or redeemed and the principal will be deposited into the investor’s checking or savings account. The minimum purchase of T-bills is $100.
discount yield
Difference between the original purchase price of a T-bill and what the Treasury pays you at maturity.
A
Treasury note
or
bond
is a fixed-principal, fixed-interest-rate government security issued for an intermediate or long term. Notes are issued for two, three, five, or ten years, and pay interest every six months. Treasury bonds have a maturity of 10 to 30 years. Notes and bonds exist only as electronic entries in accounts. The interest rate on notes and bonds is typically higher than the rates for T-bills because the lending period is longer. Interest payments are to be reported as interest income on one’s federal tax return in the year received. When the security matures, the investor is repaid the principal. Investors can hold a note or bond until maturity or sell it.
Treasury note (bond)
Fixed-principal, fixed-interest-rate government security issued for an intermediate term or long term. Notes mature in ten years or less; bonds mature in more than ten years.
Floating-rate notes are the Treasury’s newest security. Their interest rates change weekly over the two-year time period, paying investors more when market rates rise and less when they fall, and they make quarterly interest payments. Interest rates are pegged to the yield on 3-month Treasury bills. Floating-rate notes may be purchased at auction or via Treasury Direct with a $100 minimum investment.
I bonds
are nonmarketable savings bonds backed by the U.S. government that pay an earnings rate that is a combination of two rates: (1) a fixed interest rate that is set when the investor buys the bond and (2) a semiannual variable interest rate tied to inflation that protects the investor’s purchasing power. They are sold at face value, such as $25 for a $25 bond. Interest stops accruing 30 years after issue, and I bonds pay off only when redeemed. If you redeem a I bond within the first five years, you will forfeit the three most recent months’ interest; after five years, you will not be penalized. All earnings on savings bonds are exempt from both state and local income taxes, while federal taxes can be deferred until the bonds are either redeemed or reach final maturity. I bonds cashed in to pay education expenses are exempt from federal income taxes.
I bonds
Nonmarketable savings bonds backed by the U.S. government that pay an earnings rate that combines two rates: a fixed interest rate set when the investor buys the bond and a semiannual variable interest rate tied to inflation that protects the investor’s purchasing power.
Treasury Inflation-Protected Securities (TIPS)
are marketable Treasury securities whose principal increases with changes in the Consumer Price Index (CPI). These inflation-indexed bonds are the only investment that guarantees that the investor’s return will outpace inflation. TIPS bonds are sold in terms of 5, 10, and 30 years, and interest is paid to TIPS owners every six months until they mature. The interest rate is set when the security is purchased, and the rate never changes. The principal is adjusted every six months according to the rise and fall of the CPI; if inflation occurs and the CPI rises, the principal increases. The government sends the interest payment on the new principal to the investor’s account. The fixed interest rate on TIPS is applied to the inflation-adjusted principal; so if inflation occurs throughout the life of a TIPS security, every interest payment will be greater than the one before it. The amount of each interest payment is determined by multiplying the inflation-adjusted principal by one-half the interest rate.
Treasury Inflation-Protected Securities (TIPS)
Marketable Treasury bonds whose value increases with inflation. These inflation-indexed $1000 bonds are the only investment that guarantees that the investor’s return will outpace inflation.
The inflation-adjusted amount added to the principal on a TIPS bond every six months is taxable, even though the investor does not receive the money until the bond matures. Thus, TIPS bonds pay “phantom taxable interest income,” like
zero-coupon bonds (zeros or deep discount bonds)
(described in the Advice From a Professional box, so the investor pays federal income taxes on the interest earned each year. The investor must use other funds to pay the taxes on that income. If the TIPS are owned in a retirement account, the returns are not taxable until withdrawn.
zero-coupon bonds (zeros or deep discount bonds)
Municipal, corporate, and Treasury bonds that are issued at a sharp discount from face value and pay no annual interest but are redeemed at full face value upon maturity.
ADVICE FROM A PROFESSIONAL
Zero-Coupon Bonds Pay Phantom Interest
Zero-coupon bonds (also called zeros or deep discount bonds) are municipal, corporate, and Treasury bonds that pay no annual interest. They are sold to investors at sharp discounts from their face value and may be redeemed at full value upon maturity. For example, a 4 percent, $1000 zero-coupon bond to be redeemed in the year 2024 might sell today for $457. Zeros pay no current income to investors, so investors do not have to be concerned about where to reinvest interest payments. The semiannual interest accumulates within the bond itself, and the return to the investor comes from redeeming the bond at its stated face value at the maturity date. In this manner, zeros operate much like Series EE savings bonds and T-bills. The maturity date for a zero could range from a few months to as long as 30 years.
Parents often invest in zero-coupon bonds to help pay for their children’s college education, and they wisely establish ownership of the zeros in the child’s name. The phantom income “paid” to the child is generally so small that little, if any, income taxes are due.
People planning for retirement often buy zeros because they know exactly how much will be received at maturity. Even though the investor receives no interest money until maturity, the investor still pays income taxes every year on the interest that accumulates within the bond. Investors can avoid income taxes altogether by buying zeros in a qualified tax-sheltered retirement plan account.
Anne Ranczuch
Monroe Community College, Rochester, New York
When TIPS mature, the federal government pays the inflation-adjusted principal (or the original principal if it is greater). Investors can hold a TIPS bond until it matures or sell it before it matures. The interest on TIPS bonds can be excluded from federal income tax when the bond owner pays tuition and fees for higher education in the year the bonds are redeemed.
U.S. government savings bonds
are nonmarketable, interest-bearing bonds issued by the federal government and sold at face value. They are considered a low-risk savings product that earns interest while protecting one from inflation and market risk calamities.
U.S. government savings bonds
Nonmarketable, interest-bearing bonds issued by the U.S. Treasury.
Series EE/E savings bonds
are a secure savings product issued by the federal government that pays a fixed rate of interest for up to 30 years. The maximum amount of savings bonds you can buy in a single year is $10,000. Electronic EE savings bonds are sold at face value in TreasuryDirect. Paper bonds are no longer available. EE savings bonds are sold at one-half of the face value and pay no annual interest, and they may be redeemed at full value upon maturity. For example, a $100 EE savings bond might be purchased for half of its face amount, $50. The interest, compounded semi-annually, accumulates within the bond itself, and the return to the investor comes from redeeming the bond at its stated face value at the maturity date. Interest on Series EE bonds is exempt from state and local taxes. There is no federal income tax liability on the interest at redemption if the proceeds are used to fund the child’s college education. (Series HH savings bonds [no longer sold] were originally issued at par and acquired only by exchanging Series EE bonds. Interest on Series HH bonds is exempt from state and local taxes.)
Series EE/E savings bonds
Nonmarketable, interest-bearing bonds issued by the federal government that are issued at a sharp discount from face value and pay no annual interest, and that may be redeemed at full value upon maturity.
Agency Bonds Pay Slightly Better Returns than Treasuries
More than 100 different bonds, notes, and certificates of debt are issued by various federal agencies that are government-sponsored enterprises but stockholder owned; these are
agency bonds
. Well-known examples of these agencies are Fannie Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Corporation), and Sallie Mae (Student Loan Marketing Association). Together these make up about 40 percent of the outstanding investment-grade bonds. The first two are the government-chartered agencies responsible in part for the housing and credit debacle that went bankrupt and today are substantially owned by the federal government. Fannie and Freddie service continue to sell bonds, buy mortgages, and package home loans into securities.
agency bonds
Bonds, notes, and certificates of debt issued by various federal agencies that are government-sponsored enterprises but stockholder owned, such as the Federal National Mortgage Association.
Other government-chartered agencies that issue bonds include the Tennessee Valley Authority, Federal Farm Credit Banks, Federal Home Loan Banks, and Government National Mortgage Association (Ginnie Mae). Each security represents interest in a pool of loans that are sold to institutions and investors in units of $25,000, although they can also be purchased in smaller units through a mutual fund.
The assets and resources of the issuing agency back these bonds. Although the federal government does not guarantee the debt issued by such agencies, it did provide billions of dollars when Fannie Mae and Freddie Mac faced default. Agency bonds are not as widely publicized as Treasury securities, yet they pay a yield two-tenths to one full percentage point higher than the yield for comparable-term Treasury securities.
Municipal Government Bonds
Municipal government bonds
(also called
munis
) are long-term debts issued by local governments (cities, states, and various districts and political subdivisions) and their agencies. Their proceeds are used to finance public improvement projects, such as roads, bridges, and parks, or to pay ongoing expenses. Moody’s Bond Record rates some 20,000 munis, and twice as many unrated securities exist. Bonds range in quality from AAA-rated state highway bonds to unrated securities issued by local governmental parking authorities.
municipal government bonds (munis)
Long-term debts (bonds) issued by local governments (cities, states, and various districts and political subdivisions) and their agencies.
The investor’s interest income on municipal bonds is not subject to federal income taxes. This is because the U.S. Constitution requires that municipal bond interest be exempt from federal income tax. Because the interest income is tax free, municipal bonds are also known as tax-free bonds or tax-exempt bonds. Interest income on munis also is exempt from state and local income taxes when the investor lives in the state that issued the bond.
FINANCIAL POWER POINT
Check Bond Performance Online
The bond section of the FINRA website highlights all the key questions one might have about investing in bonds (
www.finra.org/Investors/InvestmentChoices/Bonds/SmartBondInvesting/Introduction/
). Municipal bond prices and information is available at the Municipal Securities Rulemaking Board (
emma.msrb.org/home
).
DID YOU KNOW
Sean’s Success Story
Sean’s success in investing through the years pushed the value of his portfolio to $140,000. His old portfolio matched his aggressive investment philosophy: cash (10%), bonds (10%), and equities (80%). However, his investments took a terrible hit during the bear market crash of 2007–2009. Because of defaults, his bond values dropped from $14,000 to $11,000. The equity portion of his portfolio, which was mostly hightech, small-cap and microcap stocks and stock mutual funds, dropped 50 percent from $112,000 to $56,000.
The first thing Sean did to try and keep his net worth figure from dropping even further was to spend less money on eating out, music, and electronics. He was scared but resisted the urge to sell low and get out of the market completely; therefore, he stayed invested throughout those two long years, which was depressing for almost all investors. Within 4 years the equities in his portfolio rose well over 60 percent to $130,000. Even though these were still shaky economic times, Sean stayed in the market, and he will continue to invest regularly as the stock markets recovers in the coming years with the slowly growing world economies. Thus by remaining invested as the market recovered, Sean recovered all of his losses, and his portfolio is up from its old high.
Municipal bonds offer a lower stated return than other bonds. However, if your marginal tax rate is higher than 25 percent, it generally makes economic sense to invest in municipal bonds because the after-tax return on a muni might be higher than that of a corporate bond. To compare the after-tax returns of investments, see page 129.
Capital gains on the sale of munis are taxable. Such gains may be realized when bonds are bought at a discount and then sold at a higher price or redeemed for full value at maturity. Bonds bought at a premium also may appreciate to produce a gain.
14.5b Evaluating Bond Prices and Returns
Investors can utilize the standard factors to evaluate bond prices and potential returns: interest rates, premiums and discounts, current yield, and yield to maturity.
Interest Rate Risk Results in Variable Value A bond’s price, or its value on any given day, is affected by a host of factors. These include its type, coupon rate, and availability in the marketplace; demand for the bond; prices for similar bonds; the underlying credit quality of the issuer; and the number of years before it matures.
Most important, the price also varies because of fluctuations in current
market interest rates
in the general economy. The state of the economy and the supply and demand for credit affect market interest rates. These are the current long- and short-term interest rates paid on various types of corporate and government debts that carry similar levels of risk.
market interest rates
Current long- and short-term interest rates paid on various types of corporate and government debts that carry similar levels of risk.
Long-Term Interest Rates Set by Investors Plus Occasional Fed Interventions Long-term rates are largely set by bond investors’ buying and selling decisions, primarily based on their expectations of future inflation. Short-term interest rates are manipulated by the Federal Reserve Board, which is popularly known as the “Fed.” When inflation rises, the Fed often raises interest rates to discourage borrowing, which reduces consumer and business spending. When the economy slows, the Fed often lowers the interest rates on short-term Treasury issues in an attempt to stimulate economic activity by making it cheaper for companies to borrow and expand. On occasion, the Fed buys long-term mortgage securities and Treasury bonds and notes and related debt for autos and credit cards, again to stimulate the economy.
DO IT IN CLASS
Table 14-6 Unique Characteristics of Bonds
Coupon Rate
The bond’s coupon rate (also known as the coupon, coupon yield, or stated interest rate) is the interest rate printed on the certificate when the bond is issued. It reflects the total annual fixed rate of interest that will be paid.
Serial or Sinking Fund
Occasionally bonds are retired serially. That is, each bond is numbered consecutively and matures according to a prenumbered schedule at stated intervals. These investments are known as serial bonds. Many bonds include a
sinking fund
through which money is set aside with a trustee each year for repayment of the principal portion of the debt.
Secured or Unsecured
A corporation issuing a
secured bond
pledges specific assets as collateral in the indenture (written legal agreement between debtor and lenders) the principal and interest guaranteed by another corporation or a government agency. An unsecured bond (or debenture) does not name collateral as security for the debt and is backed only by the good faith and reputation of the issuing agency.
Registered and Issued
By law, all bonds issued now are
registered bonds
. This provides for the recording of the bondholder’s name so that checks or electronic funds transfers for payment of interest and principal can be safely forwarded when due.
Book Entry
All bonds today are issued in book-entry form, which means that certificates are not issued. Instead, an account is set up in the name of the issuing organization or the brokerage firm that sold the bond, and interest is paid into this account when due.
Callable
An issuer might desire to exercise a
call option
when interest rates drop substantially. For example, assume a company issues bonds paying a $60 annual dividend (6 percent coupon rate). When interest rates drop perhaps to 4 percent, the 6 percent bonds may represent too high a cost for borrowing to the corporation. If the bonds have a callable feature, the issuer can redeem the bonds before the maturity date. The issuer repurchases the bond at par value or by paying a premium, often a partial year’s worth of interest. Approximately 80 percent of long-term bonds are classified as callable.
sinking fund
Bond feature through which money is set aside with a trustee each year for repayment of the principal portion of the debt at maturity.
secured bond
Pledges specific assets as collateral in indenture or has the principal and interest guaranteed by another corporation or government agency.
indenture
Written, legal agreement between bondholders and debtor that describes terms of the debt by setting forth the maturity date, interest rate, and other details.
registered bond
Bondholder’s name is recorded so that checks or electronic funds transfers for payment of interest and principal can be safely forwarded when due.
call option
Stipulation in some indentures that allows issuer to repurchase the bond at par value or by paying a premium, often one year’s worth of interest.
14.5c Pricing a Bond in Today’s Market
As we noted in
Chapter 13
,
interest rate risk
is the risk that interest rates will increase and bond prices will fall, thereby lowering the prices on older bond issues. This decline in value ensures that an older bond and a newly issued bond will offer potential investors approximately the same yield. Bonds generally have a fixed yield (the interest income payment remains the same) but a variable value.
interest rate risk
Risk that interest rates will rise and bond prices will fall, thereby lowering the prices on older bond issues.
For example, assume you own a 30-year bond with a face value of $1000 paying a semiannual coupon interest rate of 6 percent that has 20 years remaining until maturity. If interest rates in the general economy jump to 8 percent after one year, no one will want to buy your 6 percent bond for $1000 because it pays only $60 per year. If you want to sell it, the price of the bond will have to be lowered, perhaps to $802.80.
The value of bond (or bond selling price) formula,
Equation (14.3)
, shows the calculation involved. If rates on similar bonds are now at 8 percent, then the discount rate is 8 percent (or 4 percent twice a year for 40 payments). The task is to calculate the present value of the interest payments and the repayment lump sum. To do so, use Appendix A.2 and Appendix A.4 and look across the interest rows to 4% and down to 40 “n” periods.
where
Conversely, if interest rates on newly issued bonds slip to 4 percent, the price of your 6 percent bond will increase sharply, perhaps to $1273.55. Thus, investors might be willing to pay a
bond premium
of $273.55 ($1273.55 − $1000), which is a sum of money paid in excess of the bond’s face amount, to buy your $1000 bond paying 6 percent when other rates are only 4 percent. Remember that bond yields and prices move in opposite directions— as one goes up, the other goes down.
bond premium
A sum of money paid in addition to a regular price.
DO IT IN CLASS
Premiums and Discounts When a bond is first issued, it is sold in one of three ways: (1) at its face value (the value of the bond stated on the certificate and the amount the investor will receive when the bond matures), (2) at a discount below its face value, or (3) at a premium above its face value. After a bond is issued its market price changes in order to provide a competitive effective rate of return for anyone interested in purchasing it from the original bondholder.
As an example, assume that Running Paws Cat Food Company decided to issue 20-year bonds at 8.8 percent. While the bonds were being printed and prepared for sale, the market interest rate on comparable high-risk bonds rose to 9 percent. In this instance, Running Paws would sell the bonds at a slight discount to provide a competitive return. Discounts and premiums on bonds reflect changing interest rates in the economy and the number of years to maturity.
Current Yield The
current yield
equals the bond’s fixed annual interest payment divided by its bond price. It is a measure of the current annual income (the total of both semiannual interest payments in dollars) expressed as a percentage when divided by the bond’s current market price. When you buy a bond at par, its current yield equals its coupon yield. For example, a bond with a 5.5 percent coupon yield purchased at par for $1000 has a current yield of 5.5 percent. As bond prices fluctuate because of interest rate changes and other factors, the current yield also changes. For example, if Sarah Jones of Denver, Colorado paid $940 for a $1000 bond paying $55 per year, the bond’s current yield is 5.85 percent, as shown by the current yield formula,
Equation (14.4)
.
current yield
Equals the bond’s fixed annual interest payment divided by its bond price.
The current yields for many bonds based on that day’s market prices are available online and are published in the financial section of many newspapers.
The total return on a bond investment consists of the same components as the return on any investment: current income and capital gains. In Sarah’s case, she will receive $1000 at the maturity date (20 years from now), even though she paid only $940 for the bond; therefore, her anticipated total return (or effective yield) will be higher than the 5.85 percent current yield. How much higher is accurately revealed by the yield to maturity formula (discussed next).
Yield to Maturity
Yield to maturity (YTM)
is the total annual effective rate of return earned by a bondholder on a bond if the security is held to maturity. The YTM is the internal rate of return on cash flows of a fixed-income security. The YTM reflects both the current income and any difference if the bond was purchased at a price other than its face value spread over the life of the bond. The market price of a bond equals the present value of its future interest payments and the present value of its face value when the bond matures.
yield to maturity (YTM)
Total annual effective rate of return earned by a bondholder on a bond if the security is held to maturity—takes into consideration both the price at which the bond sold and the coupon interest rate to arrive at effective rate of return.
Three generalizations can be made about the yield to maturity:
1. If a bond is purchased for exactly its face value, the YTM is the same as the coupon rate printed on the certificate.
2. If a bond is purchased at a premium, the YTM will be lower than the coupon rate.
3. If a bond is purchased at a discount, the YTM will be higher than the coupon rate.
For example, because Sarah bought her 20-year bond with a coupon rate of 5.5 percent at a discount for $940, her yield to maturity must be greater than the coupon rate because she will receive $60 more than she paid for the bond when she receives the $1000 at maturity. Exactly how much greater can be determined by calculating an approximate yield to maturity when contemplating a bond purchase because bonds that seem comparable may have different YTMs.
The yield to maturity (YTM) formula,
Equation (14.5)
, which is duplicated on the Garman/Forgue companion website, factors in the approximate appreciation when a bond is bought at a discount or at a premium:
where
I
= Interest paid annually in dollars
FV
= Face value
CV
= Current value (price)
N
= Number of years until maturity
If Sarah paid $940 for a 20-year bond with a 5.5 percent coupon rate, the YTM is calculated as follows:
If you plan to buy and hold a bond until its maturity, you should compare YTMs instead of current yields when considering a purchase because YTMs fairly represent all factors. The current yield on a bond is not an effective measure of the total annual return to the investor; in fact, the fewer years until maturity, the worse an indicator it becomes. As just calculated, Sarah’s 20-year bond with a coupon rate of 5.5 percent and a current yield of 5.85 percent has a YTM of 5.98 percent. If the same bond had been purchased with only ten years until maturity, the YTM would be 6.29 percent; with five years until maturity, the YTM would be 6.90 percent; and with two years until maturity, the YTM would be 8.76 percent. Exact YTMs are online and listed in detailed bond tables available at large libraries and at brokers’ offices.
DID YOU KNOW
Turn Bad Habits into Good Ones
Do You Do This?
Invest only in certificates of deposit
Listen to tips and invest in hot stocks
Invest in speculative stocks
Invest in fewer than five stocks
Ignore big changes in interest rates
Accept broker’s advice on stock choices
Utilize full-service brokers exclusively
Buy on margin and sell short
Avoid bonds as investments
Do This Instead!
Invest in common stocks, bonds and mutual funds
Invest only in stocks with good fundamentals
Utilize no more than 5 to 10 percent for speculative stocks
Invest in more than five, or buy stock mutual funds
Invest in bonds on interest rate shifts (but not when rates are rising)
Use the Internet to research stocks and bonds
Buy and sell online to save on commissions
Never buy on margin and sell short, as it is too risky
Buy some TIPS bonds
DO IT NOW!
You know more about personal finance after reading this chapter, so get started right now by:
1. Identifying three types of stocks (See
Table 14-1
on page 417) that are appropriate for your investment goals and selecting an example of each.
2. Following the price fluctuations of those stocks for two months online or via newspapers.
3. Considering a bond investment of a corporate bond by selecting one, and researching its price, and bond rating.
Six Decisions for Bond Investors Individuals interested in investing in bonds can review resources on the website of the Securities Industry and Financial Markets Association (
www.investinginbonds.com
). It offers a free, searchable database of the latest corporate, government, municipal, and mortgage-backed bond issues and prices. Bond investors must make six decisions:
1. Decide on credit quality. Consider Treasury/agency, investment-grade corporate and municipal, and below investment-grade corporate and municipal.
2. Decide on maturity. Consider the time schedule of your financial needs: short, medium, or long term. Bonds with a short maturity have the lowest current yield but excellent price stability. Medium maturity bonds pay close to the higher rates earned on long-term bonds and enjoy much greater price stability.
3. Determine the after-tax return. Assuming equivalent risk, choose the bond that provides the better after-tax return because tax-exempt securities may offer a higher after-tax return than taxable alternatives. To compare the after-tax return of investments, see page 129 in
chapter 4
.
4. Select the highest yield to maturity. Given similar bond securities with comparable risk, maturity, and tax equivalency, investors are wise to choose the one that offers the highest yield to maturity, as calculated by
Equation (14.5)
.
5. Instead, think about investing in bond mutual funds. Consider whether it is smarter to invest in bond mutual funds rather than individual bonds. This topic is examined in
Chapter 15
.
6. Consider selling bonds or bond mutual funds. Consider selling when interest rates have dropped or are expected to rise substantially in the near future, the bond rating has seriously declined, and because you can profit when rate declines push up the value of your bond.
CONCEPT CHECK 14.5
1. Distinguish between investment- and speculative-grade bonds.
2. Give some reasons why individuals often invest in corporate bonds rather than Treasuries.
3. Summarize the differences among Treasury bonds, I bonds, and TIPS bonds.
4. Give a math example of how to calculate a bond’s yield to maturity that is different than the one in the book.
WHAT DO YOU RECOMMEND NOW?
Now that you have read the chapter on stocks and bonds, what do you recommend to Ashley Diaz in the case at the beginning of the chapter regarding:
1. Investing for retirement in 18 years?
2. Owning blue-chip common stocks and preferred stocks rather than other common stocks given Ashley’s investment time horizon?
3. The wisdom of owning municipal bonds rather than corporate bonds?
4. The likely selling price of her corporate bonds, if sold today?
5. Investments that might be appropriate to fund her children’s education?
BIG PICTURE SUMMARY OF LEARNING OBJECTIYES
LO1 Explain how stocks and bonds are used as investments.
Individual investors provide the money corporations use to create sales and earn profits. The investor shares in those profits by investing in corporations’ common stock, preferred stock, and bonds.
LO2 Describe ways to evaluate stock prices and calculate a stock’s potential rate of return.
Common stocks may be broadly classified as either income or growth stocks. The investor studies certain fundamental factors, such as the company’s sales, assets, earnings, products or services, markets, and management, to determine a company’s basic value. To do so, investors examine several revealing ratios such as price/earnings (P/E), price/sales (P/S), and dividend payout, as well as revealing numbers such as book value per share. Individuals also estimate the value of a company by using beta to compare its history and expected future profitability with those of competing stocks.
LO3 Use the Internet to evaluate common stocks in which to invest.
Individuals begin evaluating stocks by setting criteria for a stock investment. This may involve using stock-screening software; obtaining security analysts’ research reports, annual reports, 10-Q and 10-K reports, and prospectuses; acquiring economic and stock market data; and using portfolio-tracking services.
LO4 Summarize how to buy and sell stocks, as well as the techniques of margin buying and selling short.
Securities transactions require the use of a licensed broker serving as a middleman between the seller and the buyer. You can buy or sell securities online or through a live stockbroker who works for a brokerage firm that has access to the securities markets. Many individuals use discount and online brokers rather than full-service brokers. Types of stock orders include market, limit, and stop orders. Buying on margin and selling short are risky trading techniques.
LO5 Describe how to invest in bonds.
Investment-grade bonds offer a reasonable certainty of regularly receiving the periodic income (interest) and retrieving the amount originally invested (principal). Junk bonds are available, too. Corporate bonds usually pay higher returns than government bonds. Interest rate risk results in variable value on bond investments.
LET’s TALK ABOUT IT
1. Investing Today. What counsel can you offer long-term investors who are hesitant to invest in stocks and bonds in today’s economy?
2. Common or Preferred Stock. Make a list of the plusses and minuses of investing in either common stock or preferred stock, and give your conclusion as to which is better for you.
3. Three Good Companies. Make a list of three products and services that you buy on a weekly or monthly basis and the companies that sell them. Offer your initial views on whether each company would be a good place to invest money.
4. Two Useful Measures. The text introduced a variety of ways to measure stock performance. Name two of those measures that you might use in your own decision making. Offer reasons for selecting those measures.
5. Would You Buy? You have just heard that Microsoft’s stock price dropped $5. If you had the money, would you buy 100 shares? Give three reasons why or why not.
6. Interesting Stock. Review the classifications of common stock. Based on your personal comfort level for risk, which one type of stock would be of interest to you? Give three reasons why.
7. Sources of Information. If you had an investment portfolio of stocks worth $20,000, identify three sources for information that you would likely use to keep abreast of current information affecting your investments.
8. Potential Rate of Return. Do you think anyone really calculates the potential rate of return on a particular investment? Should they? If so, offer a reason why.
9. Invest Using Credit. Buying on margin and selling short both involve using credit. Would you invest this way? Give two reasons why or why not.
10. Interest in Bonds. Do bonds interest you as an investment? Why or why not?
DO THE MATH
DO IT IN CLASS
PAGE 418
1. Numerical Measures. A stock sells at $15 per share.
(a) What is the EPS for the company if it has a P/E ratio of 20?
(b) If the company’s dividend yield is 3 percent, what is its dividend per share?
(c) What is the book value of the company if the price-to-book ratio is 1.5 and it has 100,000 shares of stock outstanding?
2. Bond Selling Price. What is the market price of a $1000, 8 percent bond if comparable market interest rates drop to 6 percent and the bond matures in 15 years?
3. Market Price. What is the market price of a $1000, 8 percent bond if comparable market interest rates rise to 10 percent and the bond matures in 14 years?
DO IT IN CLASS
PAGE 131
4. Equivalent Taxable Yield. For a municipal bond paying 3.4 percent for a taxpayer in the 25 percent tax bracket, what is the equivalent taxable yield? (Hint: See page 129.)
5. Equivalent Taxable Yield. For a municipal bond paying 3.7 percent for a taxpayer in the 33 percent tax bracket, what is the equivalent taxable yield? (Hint: See page 129.)
6. Yield, Price, and YTM. A corporate bond maturing in 15 years with a coupon rate of 9.9 percent was purchased for $980.
(a) What is its current yield?
(b) What will be its selling price in two years if comparable market interest rates drop 1.9 percentage points?
(c) Calculate the bond’s YTM using Equation (14.6) or the Garman/Forgue companion website.
7. Yield, Price, and YTM. A corporate bond maturing in 20 years with a coupon rate of 8.2 percent was purchased for $1100.
DO IT IN CLASS
PAGE 441
(a) What is its current yield?
(b) What will the bond’s selling price be if comparable market interest rates rise 1.8 percentage points in two years?
(c) Calculate the bond’s YTM using Equation (14.6) or the Garman/Forgue companion website.
8. Beta Calculations. Michael Margolis is a single parent and motivational training consultant from Reno, Arizona. He is wondering about potential returns on investments given certain amounts of risk. Michael invested a total of $6000 in three stocks ($2000 in each) with different betas: stock A with a beta of 0.8, stock B with a beta of 1.7, and stock C with a beta of 2.5.
DO IT IN CLASS
PAGE 442
(a) If the stock market rises 7 percent over the next year, what will be the likely value of each investment?
(b) If the stock market declines 8 percent over the next year, what will be the likely value of each of Michael’s investments?
9. Investment Calculations. Xiao and Shiao Jing-jian, newly weds from Rockville, Maryland, have decided to begin investing for the future. Xiao is a 7-Eleven store manager, and Shiao is a high-school math teacher. The couple intends to take $3000 out of their savings for investment purposes and then continue to invest an additional $200 to $400 per month. Both have a moderate investment philosophy and seek some cash dividends as well as price appreciation.
Calculate the five-year return on the investment choices in the table below. Put your calculations in tabular form like that shown in
Table 14-2
. (Hint: When making your calculations you should assume at the end of the first year. At the end of the first year the EPS for Running Paws will be $2.40 with a dividend of $0.66, and the EPS for Eagle Packaging will be $2.76 with a projected dividend of $0.86.)
(a) Using the appropriate P/E ratios, what are the estimated market prices of the Running Paws and Eagle Packaging stocks after five years?
(b) Show your calculations in determining the projected price appreciations for the two stocks over the five years.
(c) Add the projected price appreciation of each stock to its projected cash dividends, and show the total five-year percentage returns for the two stocks.
(d) Determine the average annual dividend for each stock, and use these figures in calculating the approximate compound yields for each.
(e) Assume that the beta is 2.5 for Running Paws and 2.8 for Eagle Packaging. If the market went up 20 percent during the year, what would be the likely stock prices for Running Paws and Eagle Packaging?
(f) Assume that inflation is approximately 4 percent and the return on high-quality, long-term corporate bonds is 8 percent. Given the Jing-jians’ investment philosophy, explain why you would recommend (1) Running Paws, (2) Eagle Packaging, or (3) a high-quality, long-term corporate bond as a growth investment. Support your answer by calculating the potential rate of return using the information on pages 421–424 to; or by using the Garman/Forgue website. The Jing-jians are in the 25 percent marginal tax bracket.
Running Paws |
Eagle Packaging |
|
Current price |
$30.00 |
$48.00 |
Current earnings per share (EPS) |
$ 2.00 |
$ 2.30 |
Current quarterly cash dividend |
$ 0.15 |
$ 0.18 |
Current P/E ratio |
15 |
21 |
Projected earnings annual growth rate |
20% |
|
Projected cash dividend growth rate |
10% |
FINANCIAL PLANNING CASES
CASE 1
The Johnsons Want Greater Yields on Investments
The investments of Harry and Belinda have done well through the years. While the cash portion of their portfolio has risen to $16,000, it is earning a minuscule 1 percent in a money market account; thus they are seeking greater yields with bond investments. Examine the following table, which identifies eight investment alternatives, and then respond to the questions that follow. The coupon rates vary because the issue dates range widely, and market prices are above par because older bonds paid higher interest than today’s issues.
(a) What is the current yield of each investment alternative? Use
Equation (14.5)
or visit the Garman/Forgue companion website. (Write your responses in the proper column in the table.)
(b) What is the yield to maturity for each investment alternative? (Write your responses in the proper column in the table.) You may calculate the YTMs by using Equation (14.6) or by visiting the Garman/Forgue companion website.
(c) Knowing that the Johnsons follow a moderate investment philosophy, which one of the six corporate bonds would you recommend? Why?
(d) Given that the Johnsons are in the 25 percent federal marginal tax rate, what is the equivalent taxable yield for the municipal bond choice? Should they invest in your recommendation in part (c) or in the municipal bond? Why? You may calculate the equivalent taxable yield using the information on page 129.
(e) Which three of the eight alternatives would you recommend as a group so that the Johnsons would have some diversification protection for their $16,000? Why do you suggest that combination?
CASE 2
DO IT IN CLASS
PAGE 413
AND 416
Victor and Maria Hernandez Wonder About Investing
Victor and Maria have decided to increase their contribution to their investment portfolio since Victor is now age 59 and thinking about retiring in five years. For years, they have followed a moderate-risk investment philosophy and put their money in suitable stocks, bonds, and mutual funds. The value of their portfolio is now $320,000, and this is in addition to their paid-for rental property, which is worth $200,000. They plan to invest about $9000 every year for the next five years.
(a) Why should Victor and Maria consider buying common stock as an investment with the additional money?
(b) If Victor and Maria bought a stock with a market price of $50 and a beta value of 1.8, what would be the likely price of an $8000 investment after one year if the general market for stocks rose 6 percent?
(c) What would the same investment be worth if the general market for stocks dropped 8 percent?
(d) Review the types of stocks in
Table 14-1
on page 417 and select 2 that you think Victor and Maria might prefer as investments. Explain why.
(e) Discuss the positives and negatives of preferred stock for Victor or Maria.
CASE 3
Julia Price Seeks Rewards in the Bond Market
Julia’s investments survived the Great Recession-related bear stock market declines because she was well diversified and was investing more heavily in bonds in the years preceding the decline. When it seemed like the coming recession was starting to look like a reality, Julia cashed out of some equities and moved most of that money into corporate bonds and Treasuries. As a result, over the past four years, the bond portion of her portfolio rose over 20 percent due to low inflation and declining interest rates, which pushed up the value of her bonds. Now she thinks inflation and bond prices will rise so she is selling all her bonds and investing the proceeds into equities. But the stock market prices seem too high already, so she is hesitating. Offer your opinions about her thinking.
CASE 4
An Aggressive Investor Seeks Rewards in the Bond Market
Jessica Varcoe works as a drug manufacturer’s representative based in Murfreesboro, Tennessee. She has an aggressive investment philosophy and believes that interest rates will drop over the next year or two because of an expected economic slowdown. Jessica, who is in the 25 percent marginal tax rate, wants to profit in the bond market by buying and selling during the next several months. She has asked your advice on how to invest her $15,000.
(a) If Jessica buys corporate or municipal bonds, what rating should her selections have? Why?
(b) Jessica has a choice between two $1000 bonds: a corporate bond with a coupon rate of 5.1 percent and a municipal bond with a coupon rate of 3.2 percent. Which bond provides the better after-tax return? (Hint: See Equation [4.1] on page 129.)
(c) If Jessica buys fifteen, 30-year, $1000 corporate bonds with a 5.1 percent coupon rate for $960 each, what is her current yield? (Hint: Use Equation [4.1].)
(d) If market interest rates for comparable corporate bonds drop 1 percent over the next 12 months (from 5.1 percent to 4.1 percent), what will be the approximate selling price of Jessica’s corporate bonds in (c)? (Hint: Use the Garman/Forgue companion website.)
(e) Assuming market interest rates drop 1 percent in 12 months, how much is Jessica’s capital gain on the $15,000 investment if she sells? How much was her current return for the two semiannual interest payments? How much was her total return, both in dollars and as an annual yield? (Ignore transaction costs.)
(f) If Jessica is wrong in her projections and interest rates go up 1 percent over the year, what would be the probable selling price of her corporate bonds? (Hint: Use the Garman/Forgue companion website.) Explain why you would advise her to sell or not to sell.
CASE 5
Two Brothers’ Attitudes Toward Investments
Kyle Broflovski, a guidance counselor in South Park, Colorado, has purchased several corporate and government bonds over the years, and his total bond investment now exceeds $40,000. He prefers investments with some inflation protection. His kid brother Ike, a highly paid physician, has more than $150,000 invested in various blue-chip income stocks in a variety of industries.
(a) Justify Kyle’s attitude toward bond investments.
(b) Justify Ike’s attitude toward stock investments.
Explain why both brothers might be happy investing some of their money in TIPS bonds.
CASE 6
A College Student Ponders Investing in the Stock Market
Ji Wu of Jefferson City, Tennessee, has $5000 that he wants to invest in the stock market. Ji is in college on a scholarship and does not plan to use the $5000 or any dividend income for another five years, when he plans to buy a home. He is currently considering a small company stock selling for $25 per share with an EPS of $1.25. Last year, the company earned $900,000, of which $250,000 was paid out in dividends.
(a) What classification of common stock would you recommend to Ji? Why?
(b) Calculate the P/E ratio and the dividend payout ratio for this stock. Given this information and your recommendation, would this stock be an appropriate purchase for Ji? Why or why not?
(c) Identify the components of the total return Ji might expect, and estimate how much he might expect annually from each component.
(d) Review the section titled “You Should Use Corporate Earnings and Other Measures” on pages 418–420 and select two that you think Ji would utilize to evaluate when investing in stocks. Explain why.
BE YOUR OWN PERSONAL FINANCIAL MANAGER
1. Your Stock Preferences. Complete Worksheet 54: My Preferences Among Stocks from “My Personal Financial Planner” by identifying, for each of the seven types of stock, those that are of interest to you, what you do or do not like about them, and those in which you might invest during your own investing life.
2. Compare Different Stocks as Investments. Learn about the stocks of three publically traded companies of interest to you, perhaps General Motors, Ford Motor Company, and Google, by visiting the website for Kiplinger at
www.kiplinger.com
. Then complete Worksheet 55: Comparing Stocks as Investments from “My Personal Financial Planner” by recording for each company each of the several performance variables.
3. Preference Among Types of Bond. Complete Worksheet 56: My Preference Among Bonds from “My Personal Financial Planner” by marking for each of the nine types one characteristic you do or do not like about each and which might be of interest to you as an investor.
4. Taxable Versus Tax-Free Income. Complete Worksheet 57: Comparing Taxable and Tax-Free Income from “My Personal Financial Planner” by inserting a realistic rate of investment return and tax rate and then performing the appropriate calculations.
5. Current Yield on a Bond. Complete Worksheet 58: The Current Yield on My Bond Investment from “My Personal Financial Planner” by inserting realistic different current market prices on two existing bonds (perhaps $980 and $910) and different annual interest payments (perhaps $70 and $80) for two bonds and calculating the current yields.
6. Current Value of a Bond. Complete Worksheet 59: The Current Value on My Bond Investment from “My Personal Financial Planner” by going online to find the current market prices of two existing bonds, perhaps individual issues of General Motors and Ford Motor Company, and then inserting the following information in the places provided: annual interest payment and years to maturity. Look online elsewhere for a current market interest rate on comparable securities, or perhaps use 7%, and complete the calculations required.
7. Yield to Maturity on a Bond. Complete Worksheet 60: The Yield to Maturity on My Bond from “My Personal Financial Planner” by going online to find the following information about two bonds: current market price, face value, number of years until maturity, and annual interest in dollars.
ON THE NET
Go to the Web pages indicated to complete these exercises.
1. Latest Financial Information. Go to Kiplinger.com and determine the top three news items that you think are related to personal investing. Note how you can use that information in making a good investment decision.
2. Stock Quotes. Visit the website for Kiplinger at
www.kiplinger.com
, where you can find stock quotes for most publicly traded companies. Type in the symbols for the following companies: Coca-Cola (KO), Google (GOOG), Microsoft (MSFT), and Disney (DIS). Evaluate these four firms on the basis of EPS, dividend yield, and P/E ratio. What do these data suggest to you about the relative attractiveness of these companies for investors?
3. Stock Screener. Visit the website for Yahoo! Finance, where you can find a stock-screener utility at
www.screener.finance.yahoo.com/stocks.xhtml
. Search among the S&P 500 stocks for companies with a $50 minimum share price. How many companies meet this criterion? Select again using a P/E ratio from 0 to 20. How many companies meet this new criterion? Why is this list longer? Do you recognize any of the companies on either list?
4. Recent Treasury Prices. Visit the website for the U.S. Treasury Department at
www.treasurydirect.gov
and enter its Institutional section, where you will find the results of recent auctions for Treasury notes and bonds. What do the results of the auctions over the past year tell you about market expectations for movement of interest rates in the future? (Hint: Compare auction rates for bonds and notes with similar maturity periods.)
5. Find Bond Ratings. Visit the Standard and Poor’s website at
www.standardandpoors.com
and look up the current bond ratings for General Motors and Ford Motor Company. Summarize your findings.
6. Bond Calculator. Go to Investopedia’s Bond Calculator to input illustrative pricing data on bonds (
www.investopedia.com/calculator/BondPrice.aspx
). Write what you think of this tool.
7. Beta Values. Go to Calculator Edge (
www.calculatoredge.com/finance/betas.htm
) and input basic information on any stock to calculate its beta. Use 2 percent or a lower figure as the risk-free interest rate.
ACTION INVOLVEMENT PROJECTS
DO IT IN CLASS
PAGE 424
1. Answer Seven Questions. Review the box “Did You Know? Seven Questions Every Investor Needs to Answer” on page 424 and write down your responses to each question.
2. Latest Stock Market Values. Using a resource like The Wall Street Journal or the Internet in general, find the latest values for the following market indexes and indicate how each has performed over the past 12 months: DJIA, S&P 500, NASDAQ Composite, and Dow Jones Wilshire 5000 Index.
3. Prices of Popular Stocks. Find the latest values for the following stocks and indicate how each has performed over the past 12 months: American Express, AT&T, Caterpillar, Coca-Cola, Dell, Merck, Walmart, and Walt Disney.
4. Characteristics of Bonds. Review the section “Unique Characteristics of Bonds” on pages 443, select 2 that would be critically important to you as a bond investor. Explain why.
Visit the Garman/Forgue companion website at
www.cengagebrain.com
.
*
Companies that need capital to begin or expand their operations sell new issues of stocks, bonds, or both to the investing public. New issues of stock are referred to as initial public offerings (IPOs). Investment banking firms serve as intermediaries between companies issuing new stocks and bonds and the investing public.
*
A stock split occurs when the shares of a stock owned by existing shareholders are divided into a larger number of shares. This may be an indicator that management expects better profits in the years ahead. Many companies provide a cash dividend to stockholders, and sometimes companies declare a noncash dividend in the form of a stock dividend. Here the shareholder receives additional shares of the company’s stock.
16 Real Estate and High-Risk Investments
YOU MUST BE KIDDING, RIGHT?
Friends Nicholas Belisle and Joseph Sanders both have aggressive investment philosophies. Nicholas invests primarily in residential real estate, and Joseph invests in commodities futures contracts. As longtime investors, they consider themselves experts, but occasionally, each has experienced financial losses. What are the odds that the typical investor will make money investing in commodities futures contracts?
A. 50%
B. 30%
C. 20%
D. 10%
The answer is D. Ninety percent of individual investors in futures contracts lose money. Funds used for these investments should be only those that one can afford to lose!
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
Demonstrate how you can make money investing in real estate.
Recognize how to take advantage of beneficial tax treatments in real estate investing.
Calculate the right price to pay for real estate and how to finance your purchase.
Assess the disadvantages of investing in real estate.
Summarize the risks and challenges of investing in the alternative investments of collectibles, precious metals, and gems.
Explain why options and futures are risky investments.
WHAT DO YOU RECOMMEND?
Britanny Day, a 37-year-old marketing manager for a large corporation in Long Beach, California, earns $110,000 per year. She saves an additional about $800 each month beyond her contributions to her employer’s 401(k) retirement plan. Her total 401(k) holdings are worth $260,000.
Ever since her grandfather gave her some stocks as a child, Britanny has loved investing—and she has enjoyed a good track record with her efforts. Britanny is an active trader, often trading every three or four weeks, primarily in the oil, technology, and pharmaceutical prescription drug industries. Every year, she has some losses as well as gains. Her private portfolio is currently worth $160,000. Britanny has never bought or sold options or futures contracts, but her stockbroker suggested that she consider them. Britanny also has a friend who owns several residential rental properties that she bought when prices were low who has asked her to consider investing as her partner in her next real estate venture.
What do you recommend to Britanny on the subject of real estate and alternative investments regarding:
1. Investing in real estate?
2. Putting some of her money in an alternative investment, like a collectible or gold?
3. Investing in options and futures contracts?
YOUR NEXT FIVE YEARS
In the next five years, you can start achieving financial success by doing the following related to real estate and high-risk investments:
1. Before deciding to invest in real estate, carefully consider the disadvantages of such investments.
2. Invest only in real estate properties that have a positive cash flow.
3. Finance real estate investments with conventional mortgages, not mortgages with adjustable interest terms.
4. Use the price-to-rent ratio and discounted cash-flow methods to help determine the right price to pay for a real estate investment.
5. Do not put any of your long-term investment money into real estate or high-risk investments are they are not suitable.
A home tends to accomplish more than just putting a roof over your head. It is also an investment, because historically housing values have increased about 3 percent annually over the long term. A
real estate (or housing) bubble
for residential markets occurred in the United States in the middle of the last decade. The bubble saw rapid increases in home valuations (10 or 20 percent, or more, a year) until they were unsustainable.
real estate (or housing) bubble
Rapid and unsustainable increases in home prices followed by sharp declines in values.
Then the real estate market crashed as home values plummeted 40 or 50 percent or even more in some communities. The “for sale” signs on millions of foreclosed homes also pulled down the values of nearby homes. Today over 10 percent of all mortgage holders owe more on their homes than they are worth (they are “under water”), making it extremely difficult for them to sell. Unemployment and underemployment also makes it difficult for many others to buy homes. Fortunately, the real estate market has started to recover, thus there are some reasonable investment choices available.
Investors with an aggressive investment philosophy who seek high returns and are willing to accept greater risks might consider owning alternative assets such as collectibles, precious metals, gems, options, and futures contracts. All these are referred to as
high-risk
(or
alternative
)
investments
because they have the potential for significant fluctuations in return, sometimes over short time periods.
high-risk (or alternative) investments
Present potential for significant fluctuations in return, sometimes over short time periods.
Many investment advisors today recommend that people put 10 percent of their money into alternative investments as a way to diversity their money, recommending for example that someone in their twenties have a portfolio of 65% stocks, 15% bonds, 10% alternatives, and 10% cash. They are wrong. Real estate and alternative investments are not suitable investments for long-term investing program, such as for your retirement, because they are too risky for you too diversify appropriately Think about it? How many real estate investments can you make? How many precious metals can you own? How many options and future contacts can you buy?
16.1 HOW TO MAKE MONEY INVESTING IN REAL ESTATE
Real estate investing is not the same as buying a home in which to live, which was the subject of
Chapter 9
. Investing in real estate might provide you with extra income now and give a boost to your future retirement plans. But you have to do a lot of things right.
LEARNING OBJECTIVE 1
Demonstrate how you can make money investing in real estate.
Real estate investing is complicated given today’s market conditions, thus you must become smart about taxes, financing, insurance, and community economics. Real estate investments are complex, and they are much riskier than investing in mutual funds and stocks. People often do not possess the mental toughness that it takes because investing in real estate is a job. Most people are not cut out to be a do-it-yourself landlord. Dealing with tenants requires a business attitude, not a willingness to view tenants as friends.
Real estate
is property consisting of land, all structures permanently attached to that land, and accompanying rights and privileges, such as crops and mineral rights. For example, you can invest directly as an individual or jointly with other investors to buy properties designed for residential living, such as houses, duplexes, apartments, mobile homes, and condominiums. You also could invest in commercial properties designed for business uses, such as office buildings, medical centers, gas stations, and motels. You might buy raw land or residential lots, although they are extremely risky and often lose money for the investor. For someone considering an investment in real estate, there are two key questions that you must answer.
real estate
Property consisting of land, all structures permanently attached to that land, and accompanying rights and privileges, such as crops and mineral rights.
16.1a Question 1: Can You Make Current Income While You Own?
The most important consideration for real estate investors in today’s real estate market is not whether the price will rise enough in a few years to make a profit. The boom days of the rapidly rising prices of the housing bubble are probably gone in most markets. The focus for real estate investors now is whether the rental income will be sufficient to make ends meet while waiting for the property to increase in value.
If you invest in a property and you are paying out more than the rental income coming in, the negative cash flow exposes you to two risks: (1) whether you can afford to continue paying out that money month after month and year after year, and (2) whether you can make up for these cash flow losses when the property sells, which you hope will be for more than you paid for it. Get either of these wrong, and you lose your invested money and maybe more.
Know the Price-to-Rent Ratio To measure the current income in a real estate market, investors can begin by using the
price-to-rent ratio
, which is the ratio of median residential real estate prices to the median annual rents that can be earned from the real estate. The lower the ratio, the smaller the gap between annualized rental and purchase costs and the more attractive the decision to buy a home versus renting a similar one. If the price-to-rent ratio is too high, the prices for homes are likely to be too high.
price-to-rent ratio
The ratio of median residential real estate prices to the median annual rents that can be earned from the real estate.
Nationally the price-to-rent ratio was 15 at the peak of the housing bubble. Now it is 11, which is back to 2004 levels. For recent information on price-rent ratios see Trulia (
trends.truliablog.com/category/rent-vs-buy-index/
) and Altos Research (
blog.altosresearch.com/single-family-home-rental/
). The ratio might range from perhaps 4 in Detroit to 35 in Honolulu, or more, depending on local market conditions— meaning how low or high housing prices are.
For investors, the lower the price-to-rent ratio is in a given community and a particular property, the easier it should be to earn back your investment. For example, in San Jose, California, a condominium renting for $2600 a month might sell for the high price of
$890,000
for a price-to-rent ratio of 28.5(12 × $2600 = $
31,200
; $890,000/$31,200).
DO IT IN CLASS
Alternatively, a home in Pittsburgh, Pennsylvania, might cost
$165,000
and rent for $1200 a month, thus providing a price-to-rent ratio of 11.5($165,000/$
14,400
[$1200 × 12]). Investing in rental property with a high ratio will provide a profit only with a future increase in its resale value, which may be difficult to achieve in the near term.
Current Income Results from Positive Cash Flow For an income-producing real estate investment, you pay operating expenses out of rental income. The amount of rental income you have left after paying all operating expenses is called
cash flow
. The amount of cash flow is obtained by subtracting all cash outlays from the cash income. If the property has a mortgage (a common occurrence), payments toward the mortgage principal and interest also must be made out of rental income. Operating expenses such as mortgage payments, real estate property taxes, repairs, and vacancies may eat up half or more of the rental income.
cash flow
Amount of rental income you have left after paying all operating expenses.
Calculate the Rental Yield Investors also calculate the
rental yield
on properties, as shown in Equation (16.2). This is a computation of how much income the investor might pocket from rent each year before mortgage payments as a percentage of the purchase price. Most properties yield about 4 percent of income annually, although the rental yield may be as little as 1 or 2 percent and as high as 8 or 9 percent.
rental yield
A computation of how much income the investor might pocket from rent each year (before mortgage payments) as a percentage of the purchase price; divide the annual rent by 2 and then divide by the purchase price.
DID YOU KNOW
Invest in Foreclosed Property Using a Short Sale
Foreclosure is the legal and professional procedure in which a mortgagee, or other lienholder, usually a lender, repossesses a home and sells it because the borrower has fallen behind in making payments on the loan. Prior to foreclosure, the homeowner has three options: (1) depart the property and try, for moral reasons, to repay the lender the deficiency, (2) declare bankruptcy, or (3) try to arrange a short sale. Oftentimes the remaining balance owed on the home is more than the property is worth. Unless the lender is willing to modify the terms of the loan, the lender then pursues the homeowner for the deficiency.
In a short sale the lender accepts less than the full mortgage amount and often forgives whatever debt is left unpaid. The deficiency amount is the difference between the amount owed and what the bank collects at the short sale. When a bank agrees to a short sale, the homeowner hires an agent to find a buyer. New rules require lenders to provide preapproved terms for short sales; thus, an investor’s bid is more likely to be accepted. Lenders agree to absorb the loss, although they might demand the homeowner make some kind of payment or share the loss. A debt that is forgiven may be subject to income taxes. A short sale may be a buying opportunity for investors, although negotiating with banks is sometimes a cumbersome and lengthy process.
Less expensive properties often offer higher yields. The formula assumes half of rental income goes for expenses other than debt repayment.
San Jose |
Pittsburgh |
|
Purchase price |
$890,000 | $165,000 |
Annual rent |
31,200 | 14,400 |
Annual rent/2 |
15,600 |
7,200 |
Yield (annual rent/2/purchase price) |
1.75% |
4.36% |
A slowly growing economy can lead to unfinished units and losses for real estate investors.
16.1b Question 2: Can You Profit When You Sell the Property?
The capital gain earned in a real estate investment comes from price appreciation. It is the amount above ownership costs for which an investment is sold. In real estate, ownership costs include the original purchase price as well as expenditures for any capital improvements made to a property prior to sale.
Capital improvements
are costs incurred in making changes in real property—beyond maintenance and repairs—that add to its value. Installing a pool and adding a room represent capital improvements.
capital improvements
Costs incurred in making value-enhancing changes (beyond maintenance and repair) in real property.
Repairs
are expenses (usually tax deductible against an investor’s annual cash-flow income) necessary to maintain the value of the property. Repainting, mending roof leaks, and fixing plumbing are examples of repairs, but in the eyes of the IRS they are not capital improvements.
repairs
Usually tax-deductible expenses necessary to maintain property value.
DID YOU KNOW
Money Websites in Real Estate
Informative websites for investing in real estate, including price-to-rent ratios in your community are:
Altos Research (
blog.altosresearch.com/single-family-home-rental/
)
LasVegas4Us.com
discounted cash flow calculator
www.lasvegas4us.com/JwwDCF/discounted_cash_flow_calculator.htm
Realtor.com (
www.realtor.com/
)
Trulia (
trends.truliablog.com/category/rent-vs-buy-index/
)
Yahoo real estate (
homes.yahoo.com/
)
Zillo (
www.zillow.com/
)
In markets in which real estate is difficult to sell (too many properties on the market and too few buyers), perhaps because of continuing job losses in a sluggish regional economy, residential housing prices might decline 2 or 3 percent annually for a long time. That means continuing deflation in home prices in some markets year after year.
CONCEPT CHECK 16.1
1. What are the two key questions to consider before investing in real estate?
2. Distinguish between the price-to-rent ratio and the rental yield as measures of current income.
16.2 TAKE ADVANTAGE OF BENEFICIAL TAX TREATMENTS
The U.
S.
Congress, through provisions in the Internal Revenue Code, encourages real estate investments by giving investors five special tax treatments.
LEARNING OBJECTIVE 2
Recognize how to take advantage of beneficial tax treatments in real estate investing.
16.2a 1. Depreciation Is a Tax Deduction
Investors in real estate become successful by understanding the “numbers” of real estate investing. For example, assume that Jisue Han, a lawyer from Columbus, Ohio, invested
$200,000
in a residential building ($170,000) and land ($30,000). She rents the property to a tenant for
$24,000
per year. You might initially think that Jisue has to pay income taxes on the entire $24,000 in rental income. Wrong. IRS regulations allow taxpayers to deduct depreciation from rental income.
Depreciation
represents the decline in value of an asset over time due to normal wear and tear and obsolescence. A proportionate amount of a capital asset representing depreciation may be deducted against income each year over the asset’s estimated life. Land cannot be depreciated.
depreciation
Decline in value of an asset over time due to normal wear and tear and obsolescence.
Jisue can deduct an equal part of the building’s cost over the estimated life of the property. IRS guidelines provide that residential properties may be depreciated over 27.5 years, while nonresidential properties are allowed 39 years. Jisue calculates (from
Table 16-1
) the amount she can annually deduct from income to be $6182 ($170,000 ÷ 27.5).
Table 16-1
shows the effects of depreciation on her income taxes, assuming Jisue pays income taxes at a combined federal and state rate of 36 percent. In this example, the depreciation deduction lowers taxable income on the property from $24,000 to
$17,818
($24,000 − $6182) and increases the return on the investment to 9.29 percent.
DID YOU KNOW
What to Do before Investing in Real Estate
1. Set up a limited liability corporation to own your real estate investments because it protects your personal assets in case someone is injured on your rental property and sues you.
2. Consider investing in properties only in locales where there are thriving businesses located near good schools, supermarkets, and public transportation.
3. Hire an accountant experienced in real estate investing.
4. Line up financing options before searching for properties.
5. Hire an inspector to inspect the physical condition of the property.
6. Hire a licensed contractor for plumbing, electrical, and expensive repair jobs rather than doing them yourself.
7. Consider hiring a management company to tend to your property; the cost is 5 to 10 percent of rental income.
8. Set aside $5000 as a contingency fund for unanticipated problems with real estate investment property.
16.2b 2. Interest Is a Tax Deduction
Real estate investors incur many business expenses in attempting to earn a profit: interest on a mortgage, real estate property taxes, insurance, utilities, management bills, homeowner’s association fees, capital improvements, repairs, and accounting and legal costs. The largest of these costs often is the interest expense, as properties are often purchased with a mortgage loan.
Table 16-2
illustrates the effect of interest expenses on income taxes. To purchase her $200,000 investment property, assume Jisue borrowed $175,000 for 15 years at 5 percent with a monthly payment of $1383 (from
Table 9-4
on page 273). After deducting annual depreciation of $6182 and interest expenses of $7900 her taxable income is reduced to $9918. Because her income tax liability is only $3570, Jisue’s after tax return of $12,530 yields 50.12 percent on her leveraged investment.
Table 16-1 Depreciation Reduces Income Taxes Which Increases Investor’s Return
Table 16-2 Additional Effect of Interest Paid on Income Taxes on Return
Gross rental income |
$24,000 | |
Less annual depreciation deduction |
−6,182 |
|
Subtotal |
$17,818 | |
Less interest expense for the year (5 percent, $175,000 mortgage) |
−7,900 |
|
Taxable income |
$ 9,918 |
|
cash flow after paying interest ($24,000 − $7900) |
16,100 |
|
Less income tax liability (0.36 × $9918) |
−3,570 |
|
After-tax return ($16,100 − $3570) |
$ 12,530 |
|
After-tax yield [$12,530 ÷ ($200,000 − $175,000)] |
50.12% |
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Tax laws permit investors to deduct interest expenses. The interest deduction gives Jisue a cash flow after paying mortgage interest of $16,100 ($24,000 − $7900). In essence, the $7900 in interest is paid with $2844 ($7900 × 36 percent combined federal and state income tax rate) of the money that was not sent to the federal and state governments and $5056 ($7900 − $2844) of Jisue’s money.
The
loan-to-value ratio
measures the amount of leverage in a real estate investment project. It is calculated by dividing the amount of debt by the value of the total original investment. On this property Jisue’s loan-to-value ratio was 87.5 percent ($175,000/$200,000) because she made a down payment of $25,000.
loan-to-value ratio
Measures the amount of leverage in a real estate investment project by dividing the total amount of debt by the market price of the investment.
16.2c 3. Capital Gains Are Taxed at Very Low Rates
Capital gains on real estate are realized through price appreciation. For most taxpayers, long-term capital gains are taxed at a rate of 15 percent.
16.2d 4. Exchange of Properties Can Be Tax Free
Another special tax treatment results when a real estate investor trades equity in one property for equity in a similar property. If none of the people involved in the trade receives any other form of property or money, the transaction is considered a
tax-free exchange
(or a
1031 exchange
).
tax-free exchange (or 1031 exchange)
Arises when a real estate investor trades equity in one property for equity in a similar property and no other forms of property or money change hands.
If one person receives some money or other property, only that person has to report the extra proceeds as a taxable gain. For example, assume you bought a residential rental property five years ago for $220,000 and today it is worth much more. You trade it with your friend by giving $10,000 in cash for your friend’s $280,000 single-family rental home. Your friend needs to report only the $10,000 as income this year. In contrast, you do not need to report your long-term gain, $50,000 ($280,000 − $10,000 − $220,000), until you actually sell the new property.
16.2e 5. Taxes Can Be Lower on Vacation Home Rental Income
If you rent out your vacation property for 14 or fewer days during the year, you can pocket the income tax free because the IRS does not want to hear about this gain. The home is considered a personal residence, so you can deduct mortgage interest and property taxes just as you would for your principal residence. That same tax break is available for those who rent their primary home for 14 days or less, for example, to people attending a major sporting event in your city.
If you rent your property for 15 days or more, you are a landlord and you have turned the endeavor into a business. You may deduct expenses attributable to the rental business, such as mortgage interest, real estate property taxes, depreciation, utilities, repairs, insurance, advertising, homeowner’s association fees, and property management fees, as well as auto and other travel expenses.
If you actively participate in the management of the property (defined as approving new tenants, deciding on rental terms, or approving repairs and capital improvements), you can deduct rental expenses up to the level of rental income you report prorated for the number of days it was rented out. When your adjusted gross income (AGI) is less than $100,000, a maximum of $25,000 of rental-related losses may be deducted each year to offset income from any source, including your salary. The $25,000 limit is gradually phased out as your AGI moves between $100,000 and $150,000. This ability to shelter income from taxes represents a terrific benefit for people who invest in real estate on a small scale.
CONCEPT CHECK 16.2
1. Summarize how depreciation is used to reduce the income from a real estate investment.
2. Briefly explain how the interest paid on the mortgage of a real estate investment reduces one’s income taxes.
3. Summarize the special income tax regulations on renting out vacation homes.
16.3 PRICING AND FINANCING REAL ESTATE INVESTMENTS
LEARNING OBJECTIVE 3
Calculate the right price to pay for real estate and how to finance your purchase.
Sure ways to go wrong in a real estate investment are to pay too much for the property and finance it incorrectly.
16.3a Pay the Right Price
The
discounted cash-flow method
is an effective way to estimate the present value or appropriate price of a real estate investment. It emphasizes after-tax cash flow and the return on the invested dollars discounted over time to reflect a discounted yield. Software programs are available online to calculate the discounted cash flows. (For example, see
www.lasvegas4us.com/JwwDCF/discounted_cash_flow_calculator.htm
.) You also can use Appendix A-2, as illustrated in
Table 16-3
.
discounted cash-flow method
Effective way to estimate the value or asking price of a real estate investment based on after-tax cashflow and the return on the invested dollars discounted over time to reflect a discounted yield.
To see how this method works, assume that you require an after-tax rate of return of 10 percent on a condominium advertised for sale at $210,000. You estimate that rents can be increased about 2 percent each year for five years. After all expenses are paid, you expect to have after-tax cash flows of $4000, $4100, $4200, $4300, and $4400 for the five years. Assuming some price appreciation, you anticipate selling the property for $230,000 after all expenses are incurred. That’s a conservative increase in the value of the property of less than 10 percent over 5 years. How much should you pay now to buy the property?
Table 16-3
explains how to answer this question. Multiply the estimated after-tax cash flows and the expected proceeds of $230,000 to be realized on the sale of the property by the present value of a dollar at 10 percent (your required rate of return). Add the present values together to obtain the total present value of the property—in this case, $198,343. The asking price of $210,000 is too high for you to earn an aftertax return of 10 percent.
Table 16-3 Discounted Cash Flow to Estimate Price
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Your choices are to negotiate the price down, accept a return of less than 10 percent, increase rents, hope that the sale price of the property will be higher than $230,000 five years from now, or consider another investment. The discounted cash-flow method provides an effective way to estimate real estate values because it takes into account the selling price of the property, the effect of income taxes, and the time value of money.
ADVICE FROM A PROFESSIONAL
Timesharing Is a Financial Disaster as an Investment
Timesharing is the joint ownership or lease of vacation property through which the principals occupy the property individually for set periods of time. Timesharing is not an investment, although it is promoted as a way to simultaneously invest and obtain vacation housing. For $5000 to $30,000, buyers can purchase one or more weeks’ use of luxury vacation housing furnished right down to the salt-and-pepper shakers. Timeshare owners pay an annual maintenance fee that averages $822 for each week of ownership. Maintenance fees increase every year, and occasionally there are special assessment fees.
With deeded timesharing, the buyer obtains a legal title or deed to limited time periods of use of real estate. Purchasers become secured creditors who are guaranteed continued use of the property throughout any bankruptcy proceedings. They really own their week (or two) of the property.
Nondeeded timesharing is a legal right-to-use purchase of a limited, preplanned timesharing period of use of a property. It is a long-term lease, license, or club membership permitting use of a hotel suite, condominium, or other accommodation, and the right to use usually expires in 20 to 25 years. If the true owner of the property—the developer—goes bankrupt, creditors can lock out the timeshare purchasers (technically they are tenants) from the premises. And it happens.
It is extremely hard to sell a timeshare, and sales commissions of legitimate resellers are 30 percent of the price. The Resort Property Owners Association says that the average timeshare unit languishes on the market for 4.4 years before being sold. At any point in time, 60 percent of all timeshares are up for sale. Timeshare sellers rarely sell for 30 percent of their original investment. As one observer said, “If someone tries to sell you a timeshare, run!”
In good economic times or bad, you can find rental lodgings in the same area at a lower price than owning. The good thing about owning a timeshare is that it forces you to take a yearly vacation, and the vacation will be at the same time and place regardless of where you live in the future. If you want variety in vacation time or place, some timeshare plans allow owners to swap their property for others in distant locations through membership in a worldwide vacation exchange such as My Resort Newwork (www.myresortnetwork.com /timeshare-exchange/) or
www.RC
I.
com
.
Philip C. Bryant
Ivy Tech Community College, Bloomington, Indiana
DID YOU KNOW
Sean’s Success Story
Sean got greedy and then got smart. He greedily invested too heavily in aggressive stock mutual funds and then, because of the gyrations in the stock market, got scared and pulled out by the end of the year with his portfolio down about 10 percent. He got smarter when he decided to no longer jump in and out of the market trying to make quick profits. Thus he has decided to invest his 401(k) funds in ETF mutual funds that pretty much track the broader indexes. In addition, Sean and his brother calculated the numbers on a real estate investment with a projected 7 percent annual return, so they made a down payment on a duplex that is close to an A-rated high school. The old renters have signed new leases, and the investment produces a positive cash flow.
FINANCIAL POWER POINT
Find Out Home Prices in Seconds
To find prices on a home anywhere in the country, check out Zillo (
www.zillow.com/
), AO
L.
com (
realestate.aol.com/blog/home-values/
), and Trulia (
www.trulia.com/home_prices/
). Simply type in an address to obtain an estimate of its price. Be advised, however, that there have been complaints about accurate prices so perhaps check more than one site.
16.3b Financing a Real Estate Investment
Borrowing to finance a real estate investment is more expensive than borrowing to buy one’s own home, often 0.5 to 1.5 percentage points above the rate for customary homebuyers. There is more risk because the investor does not live at the property. The minimum down payment for investors is often 20 or 25 percent. To make a smaller down payment and perhaps get a lower mortgage rate, some real estate investors buy a home, live in it for a year, and then rent it out as an investment.
A popular way to finance a real estate investment is through
seller financing
(or
owner financing
). This occurs when a seller is willing to self-finance a loan by accepting a promissory note from the buyer who makes monthly mortgage payments. No lending agency is involved. Investing buyers pay higher interest rates for seller financing. The seller may accept little or no down payment in exchange for an even higher interest rate, perhaps 1½ to 2½ percent above conventional mortgage rates. Owner-financed deals can be transacted very quickly for investors.
seller financing (or owner financing)
When a seller self-finances a buyer’s loan by accepting a promissory note from a buyer, who makes monthly mortgage payments.
Another way to start in real estate investing is to purchase
sweat equity property
. With this approach, you seek a property that needs repairs but has good underlying value. You buy this fixer-upper at a favorable price and “sweat” by spending many hours cleaning, painting, and repairing it to rent or sell at a profit.
sweat equity property
Property that needs repairs but that has good underlying value; an investor buys the property at a favorable price and fixes it up to rent or sell at a profit.
CONCEPT CHECK 16.3
1. Summarize how the discounted cash-flow method helps determine the right price to pay for a real estate investment.
2. Comment on the wisdom of buying a timeshare as an investment.
3. List three ways to finance a real estate investment.
16.4 DISADVANTAGES OF REAL ESTATE INVESTING
LEARNING OBJECTIVE 4
Assess the disadvantages of investing in real estate.
Real estate investing can be profitable. But it does have some significant disadvantages.
• Business risk. It is quite possible to lose money in real estate investments, as lots of investors found out in recent years. A local recession, perhaps because a large employer closed, can depress housing prices. Zoning changes can slash housing values. Rents cannot keep up with costs in communities in which industries and jobs are moving elsewhere or in deteriorating neighborhoods.
• Foreclosures. In communities where there are many foreclosures, other sellers have to lower their home prices to compete. This depresses the values of all comparable housing—no matter how wonderful the location or condition—thus making it more difficult for anyone to sell at a reasonable price.
• Illiquidity. Besides being expensive, the market for investment property is much smaller than the securities market. As a result, it is common to experience trouble in selling. It may take months or even a year or more to find a buyer, arrange the financing, and close the sale of a real estate investment.
• Complex Assumptions. Real estate investments require much more investigation than do most other investments. Numerous assumptions about financial details such as projected rents and the cost of repairs in the future also must be made.
• Large initial investment. Direct investment in real estate generally requires many thousands of dollars, often with an initial outlay of $15,000, $30,000, $50,000, or more.
• Lack of diversification. So much capital is required in real estate investing that spreading risk is almost impossible.
• Dealing with tenants. Picking the wrong tenants can quickly turn a real estate property into a big financial loss. Someone has to screen rental applicants for their credit histories, criminal records, work references, and experience with previous landlords. Lexisnexis.mysmartmove.com runs credit and criminal background checks. State laws may make it impossible to evict a deadbeat tenant for several months or a year or more.
• Time-consuming management demands. Managing a real estate investment requires time for conducting regular inspections of the property, dealing with insurance companies, making repairs, and collecting overdue rents. It’s a job.
• Low current income. Expenses may reduce the cash-flow return to less than 2 percent or even generate a net loss in a given year.
• Unpredictable costs. Estimating costs is problematic. Investors cannot control increasing real estate tax assessments or accurately predict when a central air-conditioning unit might break down.
• Interest rate risk. When interest rates rise or unemployment grows, fewer people can afford to buy homes, and this puts downward pressure on prices and rents.
• Legal fees. The services of a real estate attorney will be needed to help handle the real estate purchase, sale, building inspections, zoning issues, tenant problems, insurance disputes, accounting, and any liability issues. Title insurance is a critically important expense to investors, particularly when allegations suggest that lenders may or may not have properly inspected the seller’s legal documents.
• High transfer costs. Substantial transfer costs, often representing 6 to 7 percent of the property’s sale price, plus money for fix-up costs, may be incurred when real estate is bought or sold.
DID YOU KNOW
The Tax Consequences of an Income-Producing Real Estate Investment
When you are considering a real estate investment, you use the investment amount (purchase price or down payment) to begin the process of estimating the likely rate of return. This calculation result may then be compared with other investment alternatives. Because some of the many assumptions in real estate calculations could be incorrect, caution is warranted in real estate analyses.
The following table shows five-year estimates for a hypothetical residential property in Denver, Colorado located close to a well-respected high school with a purchase price of $200,000. The building will be purchased with a $150,000 mortgage loan, so the buyer has to make a $50,000 down payment plus pay $8000 in closing costs. The gross rental income of $18,000 annually is projected to rise at an annual rate of 5 percent, vacancies and unpaid rent at 10 percent, real estate taxes at 7 percent, insurance at 8 percent, and maintenance at 10 percent. Virtually the entire payment for the 30-year, $150,000, 6½ percent, fixed-rate mortgage loan is assumed to be interest during these early years. For income tax purposes, the land is valued at $20,000, and the building is depreciated over 27.5 years. The amount of annual straight-line depreciation is calculated to be $6546 ($200,000 − $20,000 = $180,000;$180,000 ÷ 27.5 = $6546).
Note (in line D) how challenging it is to earn current income from rental properties. During the first two years, the total cash flow (line D) is projected to be positive ($976 and $652), but for the following three years, the cash flow is expected to be negative (−330, −$10, and −$305). However, because the income tax laws permit depreciation (line E, $6546) to be recorded each year as a real estate investment expense, even though it is not an out-of-pocket cost, the investor calculates a total taxable loss (line F) for each of the five years of expected ownership (− $5570 the first year).
These losses can be deducted on the investor’s income tax returns. Because the investor pays a 30 percent combined federal and state income tax rate, the loss results in a first-year annual tax savings of $1671 (line G). Therefore, instead of sending the $1671 to the government in taxes, the investor can use that amount to help pay the operating expenses of the investment. Consequently, the net cashflow income (line D) of $976 is enhanced by tax savings (line G) of $1671 to result in a net cash-flow gain after taxes of $2647($1671 1 $976).
Estimates for a Successful Real Estate Investment
Assume that the property appreciates in value at an annual rate of 4 percent and will be worth
$243,330
(line K) in five years ($200,000 × 1.04 × 1.04 × 1.04 × 1.04 × 1.04).
If it is sold at this price, a 6 percent real estate sales commission of $14,599 ($243,330 × 0.06) would reduce the net proceeds to
$228,731
($243,330 − $14,599).
Now we can calculate the crude annual rate of return on the property, as shown in the second table. A crude annual rate of return is a rough measure of the yield on amounts invested that assumes that equal portions of the gain are earned each year. The total return in this example was substantial. The investor made out-of-pocket cash investments of $50,000 for the down payment and $8000 in closing costs, and we subtract the accumulated net cash flow (line N) of $10,505 (adding all the numbers across line H because the investor already has received that money) for a total investment (line O) of $47,495. The investor has a capital gain (line M) of $53,461. After dividing to determine the before-tax total return (line R) to obtain 112 percent, the crude annual rate of return (line S) is 22.4 percent annually over the five years (112 percent ÷ 5 years).
Crude Rate of Return on a Successful Real Estate Investment
Taxable cost |
||||
I. |
Purchase price ($50,000 down payment; $150,000 loan) |
$200,000 | ||
Closing costs |
8,000 |
|||
208,000 |
||||
J. |
Less accumulated depreciation |
32,730 |
||
Taxable cost (adjusted basis) |
$175,270 |
|||
Proceeds (after paying off mortgage) |
||||
K. |
Sale price |
$243,330 | ||
Less sales commission |
14,599 |
|||
Net proceeds |
$228,731 | |||
L. |
Less taxable cost (J) |
175,270 |
||
M. |
Taxable proceeds (capital gain) |
$ 53,461 |
||
Amount invested |
||||
Down payment |
$ 50,000 |
|||
8,000 | ||||
N. |
Less accumulated net cash-flow gains |
(10,505) |
||
O. |
Total invested |
$ 47,495 |
||
Crude annual rate of return |
||||
P. |
||||
Q. |
Taxable proceeds (capital gain from M) |
|||
R. |
Before-tax total return ($53,461/$47,495) |
112% |
||
S. |
Crude before-tax annual rate of return (112 percent ÷ 5 years) |
22.4% |
CONCEPT CHECK 16.4
1. Summarize why foreclosures and illiquidity are disadvantages in real estate investing.
2. Comment on why real estate investors often have time-consuming management demands.
16.5 INVESTING IN COLLECTIBLES, PRECIOUS METALS, AND GEMS
LEARNING OBJECTIVE 5
Summarize the risks and challenges of investing in the alternative investments of collectibles, precious metals, and gems.
Investors often think of assets as something they would like to own for the long term. When investing in collectibles, precious metals, and gems, the investor owns illiquid real assets, not intangible items represented by pieces of paper. While an asset may be bought for its long-term investment potential, profits might be earned in the short term.
A
speculator
buys in the hope that someone else will pay more for an asset in the not-too-distant future. Speculators often buy or sell in expectation of profiting from market fluctuations. If you put money into these illiquid assets, limit your speculative investing to no more than 5 to 10 percent of your total investment portfolio, and buy only what you truly adore. Don’t consider collectibles, precious metals, and gems as part of your savings plan for retirement. When investing for retirement you should only use long-term strategies as outlined in
Chapter 13
.
speculator
An investor who buys in the hope that someone else will pay more for an asset in the not-too-distant future.
16.5a Collectibles
Collectibles
are cultural artifacts that have value because of their beauty, age, scarcity, or popularity. They include baseball cards, posters, sports memorabilia, guns, photographs, paintings, prints, ceramics, comic books, watches, lunchboxes, matchbooks, glassware, spoons, stamps, rare coins, art, rugs, fine wine, cars, and antiques. The collectible markets are fueled by nostalgia, limited availability, and “what is hot to own today.” Prices for collectibles often lag other investments and continue to lag. Collectibles won’t beat the return of stocks over the long term, but they are lots of fun to own.
collectibles
Cultural artifacts that have value because of their beauty, age, scarcity, or popularity, such as antiques, stamps, rare coins, art, baseball cards, and so on.
DID YOU KNOW
Bias toward Being Reluctant to Invest Again after a Loss
People engaged in real estate and high-risk investments have a bias toward certain behaviors that can be harmful, such as a tendency toward the pain of losing money. People often avoid strong growth investment opportunities because they have lost in investments in the past. Research shows that an investment loss packs twice the emotional blow of a gain and among retirees the impact is tenfold. What to do? Set your focus on how much of a gain or loss you are willing to accept on a future investment and then accept reality by selling when those gains or losses actually occur.
FINANCIAL POWER POINT
Search for Collectibles Prices at Christie’s and Sotheby’s Online
The giant auction houses of Christie’s (
www.christies.com
) and Sotheby’s (www .sothebys.com) offer big selections of prints, photographs, watches, wines, furniture, diamond jewelry, and other collectibles. Check out their catalogs and videos on their websites, and consider signing up for text messages and the ability to bid by phone or online.
Making a Profit on Collectibles Is Not Easy One key to success in collectibles is to invest in quality—the higher the better. Think about the highest value collectibles as being equivalent to blue-chip stocks. Although buying collectibles can be easy, turning a profit may not. The only return on collectibles occurs through price appreciation, and you must sell to realize a profit. That could be hard for you to do if the collectibles give you pleasure. If you sell, the IRS requires that you pay a 28 percent income tax rate (or your tax bracket, whichever is lower) on collectibles rather than a 15 percent tax on capital gains.
Items that are almost certain to lose value include those that are mass produced and marketed as collectibles or limited editions. You often see these kinds of collectibles advertised on television and in newspapers and magazines. Another risk is the wholesale-to-retail price spread, which could be 50 or 100 percent. If you buy from a dealer, you’ll probably pay a markup of about 40 to 50 percent. Investors generally get more for their money buying at an auction, but realize that professional dealers are always bidding there too.
DID YOU KNOW
Scams Abound in Collectibles, Precious Metals, and Gems
The average investor can’t tell a diamond from a cubic zirconium or a Monet from a Manet. The values of collectibles, gold, other precious metals, and precious gems rely in part upon the authority of “experts” who purport to determine their worth. Such blind trust invites risk for potential investors. When an asset does not generate a readily quantifiable return (such as rent, interest, or dividends) its value is determined by supply and demand— as well as lies and rumors. Scams, forgeries and frauds abound with these investments, as promoters and telemarketers tell tales about skyrocketing prices and high profit potentials to encourage their purchase. Collectibles, precious metals, and gems are not wise choices for the casual investor.
Prices on collectibles vary greatly from item to item and year to year. Markets are fickle. If the investor needs to convert the asset to cash, a sale may take days, weeks, or months, and the seller may be forced to accept a lower price.
Buying and Selling Collectibles on the Internet You can buy collectibles on the Internet, using eBay for example, purchasing in minutes what you might never have found even after searching for years in magazines, junk shops, flea markets, and auctions. Buying collectibles on the Internet is efficient and convenient, and it is easy to compare products and prices. It is hard to inspect the collectible before purchase, however. Search Google for “collectibles,” but realize that this is a risky way to invest particularly with lots of fakes in existence.
16.5b Gold and Other Precious Metals
There is an allure to owning gold. You can own and hold it with pride, and it is beautiful to look at. Gold is a uniquely private, personal, and portable way to hold some genuine wealth. For purposes of investing, however, the reasons for owning it often do not add up. For example, gold does not generate current income while you own it. Its value is determined solely by supply and demand at the time of sale. Thus, investing in gold is speculating. Some other metals beside gold have a similar appeal to investors.
Fear Pushes Up Gold Prices Fear is what pushes up the price of gold. Some of the world’s worried investors purchase gold reasoning that if their national economies crash they will be able to trade gold even if their country’s paper currency is devalued. Others who buy gold are concerned about such things as high inflation, rising interest rates, countries seen as printing too much money, economic collapse, possible wars, excessive government borrowing, collapse of the credit system, and international trade wars.
The fear that gripped investors around the globe during the Great Recession has moved “gold fever” from the fringes of the investing world to the mainstream. Prices soared, and gold hoarders, who are often criticized as crackpots, for a while appeared to be smart speculators. They thought that a wave of inflation would overcome the nation due to the growing national debt and the Federal Reserve’s actions to stimulate the economy.
Gold Prices Were Stagnant and Then Soared and Crashed Again Back in 1976 when there were serious concerns about extremely high inflation in the United States, gold prices jumped in 4 years from $100 an ounce to more than $800 in 1980. Then the price dropped to $400 before sliding even lower to $280 by 2001.
This roller coaster price ride for gold has happened again. After many years of little change, gold prices began to rise slowly until they hit $1000 in March of 2008 during the worst of the Great Recession and then sharply dropped to $700 a few months later. As the U.S. and world’s economies continued to struggle, gold prices climbed to $1895 in 2011. Then gold prices dropped 9.4 percent in one day. Prices have since slipped to below $1200 an ounce. That’s about a 37 percent loss in just a few months for those who got in late and bought near the high of $1895.
While the increase over the past ten years in gold prices may make gold sound like an appealing speculative investment, consider further that if you bought $10,000 in gold in 1980, it would have been worth $10,600 in 2013. If you invested the same $10,000 in 1980 in a mutual fund that tracks the S&P 500, you would have over $200,000 by 2013. These are not the kind of data that a gold promoter earning sales commissions wants investors to see.
Can the fear and greed of doomsayers, conspiracy theorists, and gold promoters keep gold prices rising, or is this the same kind of price bubble that happened before? Like any alternative investment, gold is subject to a meltdown. The smart investor proceeds with caution even when speculating.
DID YOU KNOW
Bias toward Chasing Hot Investments
People engaged in real estate and high-risk investments have a bias toward certain behaviors that can be harmful, such as a tendency toward recent performance. People often see investments as good or bad based on recent performance and chase hot investments expecting to cash in as they continue to rise even higher only to see them drop in price. What to do? Avoid speculation and in the future invest only on fundamentally sound information, not what is hot.
DID YOU KNOW
Speculate by Trading in Currencies
Investors deeply worried about the economic future of their country or world may find it desirable to put some of their assets in the cash of the world’s presumed two safest currencies, the U.S. dollar and the Euro. Individuals may speculate on the changing daily values of the dollar, Euro, Yen, Pound, Swiss Franc, and other currencies in the forex (foreign exchange trading). A “mini” account can be opened for only $300 at Forex Capital Markets (
www.FXCM.com
) where you try out a practice account and then trade up to 200 times that amount by using margin. Currency trading uses a lot of margin and is risky!
16.5c You Can Invest in Gold in Several Ways
An initial investment in gold need not be expensive, although buying gold directly can be. There are many ways to invest in gold or other precious metals.
Gold Bullion
Gold bullion
is often thought of as the large gold “bricks” that weigh about 28 pounds that people imagine are stored in Fort Knox. Each brick is worth more than $100,000 at today’s prices. All the gold in the world would create a heavy cube only 67 feet square.
gold bullion
A refined and stamped weight of precious metal.
The term bullion simply means a refined and stamped weight of precious metal. Gold bullion is traditionally purchased and traded in 1- and 10-ounce gold bars. Gold as bullion is expensive to own. There are fees for refining, fabricating, and shipping bullion. A sales charge of 5 to 8 percent is common. There are storage costs. When gold is sold, the bank or dealer buying it from an investor may insist on reassaying its quality, yet another cost for the investor. The investor should purchase insurance against fire, theft, and fraud because such transactions are not government regulated.
Gold Bullion Coins Some costs of investing in gold can be avoided by those wanting to take physical possession of gold bullion itself by owning modern
gold bullion coins
, each containing 1 troy ounce (31.15 grams) of pure gold issued by the various world mints. The most popular coins are the South African Krugerrand, Canadian Maple Leaf, and the U.S. Gold Eagle. Other gold bullion coins are available, including the Great Britain Sovereign, Australian Kangaroo Nugget, and Chinese Panda. Minimum orders are ten coins, and commissions are 5 to 6 percent when buying and 1 to 2 percent when selling. These gold bullion coins do not need to be tested for purity, are portable, and have worldwide liquidity. Investors need to store and insure their coins. Visit
www.usmint.gov
for a list of U.S. Gold Eagle dealers.
gold bullion coins
Various world mints issue these coins, which contain 1 troy ounce (31.15 grams) of pure gold.
Collectible Gold Coins People who buy collectible gold coins buy them in part because of their intrinsic beauty and scarcity. They face high markups, difficulty in grading coins (or must pay to hire a grading service), and costs for storage and insurance. Major coin graders include American Numismatic Association Certification Service (
www.anacs.com
), Numismatic Guaranty Corporation (
www.ngccoin.com
), and Professional Coin Grading Service (
www.pcgs.com
). The World Gold Council (
www.gold.org/
) maintains a list of firms that buy and sell gold. Note that the long-term capital gains tax on collectibles, like gold, is 28 percent (or your tax bracket, whichever is lower).
Gold and other precious metals are highly volatile investments.
DID YOU KNOW
Bitcoin Is a “Fad” Virtual Currency
Bitcoin
is a peer-to-peer experimental decentralized digital cash currency based on an open source cryptographic protocol. You can buy them at an exchange and you store them in a “wallet” on your computer. Bitcoins can be transferred through a computer or smartphone without an intermediate financial institution. The purchasing power is zero thus Bitcoin has no intrinsic value. It is not protected by a central bank and governments will never confer the status of legal currency on a private currency.
Bitcoin
A peer-to-peer experimental digital cash currency based on an open source cryptographic protocol that can be bought at an exchange and transferred through a computer or smart phone without an intermediate financial institution.
Bitcoin is accepted in trade by some merchants and individuals in parts of the world. A large share of its commercial use is believed to be for illicit goods, including marijuana, cocaine, prescription painkillers, and gambling transactions. Promoters say Bitcoin helps users avoid taxes, regulations and government seizures of assets. The lack of regulations allows everything to happen, including fraud.
Many have criticized Bitcoin’s highly volatile market value as prices jumped in 3 months from $17 to $230. Then in 2 days it plunged to $68 before returning to a price of $77 a week later. Subsequently it went over $1200, and then dropped to $380 in one day. Critics argue that Bitcoin is volatile, inflexible, and minimally used in commerce. The largest Bitcoin exhange in Tokyo went bankrupt after several hundred million dollars of Bitcoins disappeared. The Internal Revenue Service does not treat Bilcoin as a currency rather it is classified as “property,” hence buying and selling transactions are capital gains.
Gold Mining Stocks, Mutual Funds, and ETFs Investors wanting to capitalize on world crises, economic fears, and rising gold prices by investing in smaller amounts may choose to put speculative cash in the stocks of gold mining companies, in mutual funds that own gold companies, and in specialized exchange-traded funds (ETFs). For example, you may have heard of the now defunct Homestake Gold Mine, one of the early enterprises associated with the Gold Rush of 1876 in the northern Black Hills of what was then Dakota Territory. Today, there are a handful of gold mining companies in the United States and dozens around the world.
Popular gold mutual funds include Van Eck International Investors (INIVX), USAA Precious Metals and Minerals (USAGX), Oppenheimer Gold & Special Metals A (OPGSX), and Vanguard Precious Metals and Mining (VGPM). Gold stock prices are much more volatile than the price of gold itself as they can readily swing up or down 50 percent in a matter of months. During 2013 the average gold stock price dropped 50 percent. The largest gold exchange-traded fund (ETF) is SPDR Gold Shares (GLD). Other popular gold ETFs are iShares COMEX Gold Trust (IAU) and Market Vectors Gold Miners ETF (GDX).
16.5d Investing in Other Metals—Silver, Platinum, Palladium, and Rhodium
Some other metals also appeal to certain investors. Silver, platinum, palladium, and rhodium are metals used industrially and occasionally in jewelry. The values of these metals rise and fall with changes in demand. An investor might reason that since palladium is used in auto production that when demand in China and India for vehicles increases substantially, the price of the metal will soar. Prices can drop, too. When gold prices dropped recently silver declined 25 percent in just 4 days. Illustrative specialized ETFs in these precious metals include iShares Silver Trust (SLV), ETFS Physical Platinum (PPLT), and ETFS Physical Palladium Shares (PALL).
DID YOU KNOW
Money Websites in Gold
American Numismatic Association
Certification Service (
www.anacs.com
)
Kitco gold prices (
www.kitco.com/
)
Numismatic Guaranty Corporation (
www.ngccoin.com
)
Professional Coin Grading Service (
www.pcgs.com
)
World Gold Council (
www.gold.org/
)
USA Gold (
www.usagold.com/
)
U.S. Mint (
www.usmint.gov
)
16.5e Precious Stones and Gems
Precious stones and gems, such as diamonds, sapphires, rubies, and emeralds, are also examples of alternative investments. Investors purchase investment-grade gems as “loose gems” rather than as pieces of jewelry. Wholesale firms, not jewelers, sell the best-quality precious gems. The gem certification process may be touted as a science, but it is not; rather it is educated guesswork. Obtaining two assessments of a stone’s quality, particularly on stones of less than 1 carat, is likely to result in a variation of 10 to 20 percent.
Sales commissions on precious stones are high, and reselling is very difficult. Novice investors often buy at retail and then wind up trying to sell at retail, and then selling at or near wholesale. This approach is the opposite of smart investing—that is, buying low and selling high. Losing 20 to 50 percent of one’s investment in precious stones upon selling them is not uncommon.
CONCEPT CHECK 16.5
1. Identify one collectible that might be an interesting investment, and explain why it might be difficult to make a profit.
2. Explain why some investors buy gold and other precious metals, and tell why choosing one type of investment might be appealing or unappealing to you.
3. Identify some risks of investing in precious stones and gems.
LEARNING OBJECTIVE 6
Explain why options and futures are risky investments.
16.6 INVESTING IN OPTIONS AND COMMODITY FUTURES CONTRACTS
A derivative (or derivative security) is an instrument used by people to trade or manage more easily the asset upon which these instruments are based. Derivative securities are available for commodities, equities, bonds, interest rates, exchange rates, and indexes (such as a stock market index, consumer price index, and weather conditions). Investors choose derivatives to either reduce risk by hedging against losses or taking on additional risk by speculating. The investor’s returns are derived solely from changes in the underlying asset’s price behavior. Two of the most common derivative instruments are options and futures contracts.
DID YOU KNOW
Your Worst Financial Blunders in Real Estate and High-Risk Investments
Based on others’ financial woes, you will make mistakes in personal finance when you:
1. Assume that real estate prices will go up and interest rates will not increase.
2. Do not set enough money aside for maintenance, repairs, unanticipated capital improvements, and rising real estate taxes on rental property.
3. Invest some retirement money in these risky investments: margin trading, short selling, options, commodity futures, gold, precious metals, and gems, currencies, and timeshares.
16.6a Options Allow You to Buy or Sell an Asset at a Predetermined Price
An option is a contract to buy or sell an asset at some point in the future at a specified price. The most common type of option is a stock option. This derivative gives the holder (purchaser) the right, but not the obligation, to buy or sell a specific number of shares (normally 100) of a certain stock at a specified price (the striking price) before a specified date (the expiration date, typically three, six, or nine months).
Two types of option contracts exist: calls and puts. A call option gives the option holder (buyer) the right, but not the obligation, to buy the optioned asset from the option writer at the striking price. A put option gives the option holder (buyer) the right, but not the obligation, to sell the optioned asset to the option writer at the striking price.
DID YOU KNOW
How to Make Sense of Option Contracts
The two principal players in the options game are the option writer and the option holder.
Most option contracts expire without being exercised, and the option seller is the only person to earn a profit. The profit results from the option premium charged when the option was originally sold. Buying and selling options are techniques used by all types of investors.
Conservative Investors Make Money on Options Selling a call option can be a fairly safe way to generate income by conservative option writers who own the underlying asset (the stock). When they sell a call, it is described as a
covered option
because the writer owns the underlying stock. If the writer does not own the asset, it is a naked option, a speculative position. When used effectively by conservative option writers, calls can potentially pick up an extra return of perhaps 1 to 2 percent every three months and minimize risk at the same time. In effect, this conservative investor protects himself financially by hedging his investment against loss due to price fluctuation. You also can conservatively profit by selling a call on stock already owned, giving the buyer the right to purchase your shares at a certain price any time during a relatively short period at a fixed strike price, which is higher than the current price.
covered option
Occurs when an option writer who owns the covered option sells the call.
Aggressive Investors Profit with Options Aggressive investors in the options market attempt to profit in two ways. First, the investor can hope for an increase in the value of the option. For example, if the price of a stock is rising, the holder of a call option might sell it to another investor for a higher price than that originally paid. Second, the investor can exercise the option at the striking price, take ownership of the underlying securities, and sell them at a profit.
16.6b Buying and Selling Commodities Futures Contracts
A
futures contract
is the obligation to make or take delivery of a certain amount of a commodity by a set date. A futures derivative contract requires the holder to buy the asset on the date specified. If the holder does not want to buy the asset, he or she must sell the contract to some other investor or to someone who wants to actually use the asset.
futures contract
The obligation to make or take delivery of a certain amount of a commodity by a set date.
DID YOU KNOW
Money Websites in Options
Informative websites for investing in options, including suggestions from professionals are:
Options Industry Council
(
www.optionscentral.com
)
Chicago Board Options Exchange
(
www.cboe.com
)
OptionsXpress (
www.optionsxpress.com
)
TradeKing (
www.tradeking.com
)
DID YOU KNOW
About Hedge Funds
Hedge funds
are freewheeling risky investment pools for the extremely wealthy that use unconventional investment strategies. They are global companies, beyond most of the regulations of the U.S. government. Hedge funds trade options and commodities sell short, use leverage, risk arbitrage, buy and sell currencies, and invest in undervalued mature companies, often those in or nearing bankruptcy. Hedge funds can profit in times of market volatility as well as in a falling market. The investors are partners.
hedge funds
Freewheeling risky investment pools for the extremely wealthy that use unconventional investment strategies such as trading options and commodities, selling short, using leverage and arbitrage, buying and selling currencies, and investing in undervalued mature companies.
Fees charged by the hedge fund manager typically are 2 percent of assets under management and 20 percent of the upside (the “performance fee”) of the fund. Most managers assess no full fees until the profits are above 8 percent. None of the 8000 hedge funds can be offered or advertised to the general investing public in the United States. They are limited to “accredited investors and purchasers” who have incomes over $200,000 and a net worth over $1 million and who own more than $5 million in investments. The small investor can buy shares in publicly traded firms, like Blackstone (BX) or Kohlberg Kravis Roberts (KKR), which are parent companies of hedge funds. A number of hedge funds have had catastrophic losses and have gone bankrupt.
Conservative Economic Needs Creates Futures Markets Farmer Geraldo Esperanza who planted a 10,000-bushel soybean crop in Chana, Illinois, might want to sell part of it now to ensure the receipt of a certain price when the crop is actually harvested. Similarly, a food-processing company might want to purchase soybeans now to protect against sharp price increases in the future. And an orange juice manufacturer might want to lock in a supply of oranges at a definite price now rather than run the risk that a winter freeze would push up prices. These economic needs create futures markets. You can trade futures on an organized market for lots of commodities, such as coffee, sugar, corn, pigs, plywood, metals, energy, foreign currencies, gold, and other precious metals.
DID YOU KNOW
Turn Bad Habits into Good Ones
Do You Do This?
Avoid investing in real estate
Buy collectibles, precious metals, and gems
Invest in options and commodity futures for quick profits
Do This Instead!
Do the math to see if it might be profitable
Never put long-term investment money into these assets
Be prepared to lose money
Speculators Trade in Futures Markets The speculative investor who buys or sells a commodity contract is hoping that the market price of the commodity will rise (or fall) before the contract matures, usually 3 to 18 months after it is written. These derivatives offer the potential for extremely high profits because such contracts often are highly leveraged. Depending on the commodity, the volatility of the market, and the brokerage house requirements, an investor can put up as little as 5 to 15 percent of the total value of the contract. Some contracts require a deposit of only $300. Commissions average about $20 for each purchase and sale.
Futures Are a Zero-Sum Game In each futures transaction a winner and a loser will emerge. A buyer of a futures contract benefits if the price of the commodity increases, but the seller suffers. When prices decline, the reverse is true. An estimated 90 percent of investors in the futures market lose money. Five percent (mostly the professionals) make profits from the losers and the remaining 5 percent break even.
Trading in futures is a zero-sum game in which the wealth of all investors remains the same. The trading simply redistributes the wealth among those traders. Each profit must be offset by an equivalent loss; therefore, the average rate of return for all investors in futures is zero. The return actually becomes negative if transaction costs are included. Most investors do not belong in commodities.
DO IT NOW!
You know more about personal finance after reading this chapter, so get started right now by:
1. Imagining what you would do if you came into $50,000 that you could invest without any concern about losing the money. Would you invest all or some of it in alternative investments? Explain why or why not.
2. Searching your local newspaper for opportunities to buy a house as rental property, assuming that real estate is an option for your investment. Find out the price-to-rent ratio for an average home in your community and then estimate the asking price for a particular property, the rate of interest you could expect for a mortgage, the likely rent you could charge, and other factors.
3. Then calculating the net present value of the property to determine the price you might offer for the property.
CONCEPT CHECK 16.6
1. Distinguish between a call and a put for the options investor.
2. Summarize one way a person with a conservative investment philosophy can profit in options.
3. Explain how a speculative options investor can make a lot of money.
4. Offer reasons why futures contracts are not appropriate for the average long-term investor.
WHAT DO YOU RECOMMEND NOW?
Now that you have read the chapter on real estate and high-risk investments, what do you recommend to Britanny on:
1. Investing in real estate?
2. Putting some of her money in an alternative investment, like a collectible or gold?
3. Investing in options and futures contracts?
BIG PICTURE SUMMARY OF LEARNING OBJECTIYES
LO1 Demonstrate how you can make money investing in real estate.
The key questions for real estate investors are: “Can you make current income while you own?” and “Can you profit when you sell the property?” To help find answers, investors calculate the price-to-rent ratio and rental yield.
LO2 Recognize how to take advantage of beneficial tax treatments in real estate investing.
The Internal Revenue Service offers the investor five beneficial tax treatments, including depreciation, interest that is deductible, low tax rates on capital gains, tax-free exchanges of real estate, and special tax breaks on renting and vacation homes.
LO3 Calculate the right price to pay for real estate and how to finance your purchase.
The discounted cash-flow method is an effective way to estimate the value or asking price of a real estate investment. It takes into account the selling price of the property, the effect of income taxes, and the time value of money. There are various ways to finance a real estate investment.
LO4 Assess the disadvantages of investing in real estate.
There are many disadvantages in real estate investing, such as large initial investment, lack of diversification, dealing with tenants, low current income, unpredictable costs, illiquidity, and high transfer costs.
LO5 Summarize the risks and challenges of investing in the alternative investments of collectibles, precious metals, and gems.
When investing in collectibles, precious metals, and gems, the investor owns illiquid real assets, not intangible items represented by pieces of paper. The investor’s only return comes from price appreciation, as they do not pay interest or dividends. While prices are set by supply and demand, promoters hype these alternative investments. Changing investor tastes and rumors also influence prices.
LO6 Explain why options and futures are risky investments.
Derivatives, such as options and commodity futures, are instruments used by market participants to trade or manage more easily the asset upon which these instruments are based. While all types of investors can profit in options, only speculators with an aggressive investment philosophy should consider trading in futures. Most investors in derivatives lose money, and losses can accumulate quickly.
LET’s TALK ABOUT IT
1. Invest in Real Estate. Describe what would encourage you to invest in real estate given that in recent years many communities prices have declined severely.
2. Two Questions. Which of the two questions in real estate investing is more important? Explain why.
3. Beneficial Tax Treatments. Review the five beneficial tax treatments of real estate and explain which one seems most important to you as a real estate investor.
4. Reasons to Invest. Assume you have $30,000 in cash. Give reasons why you might want to invest that money in a real estate investment. Offer two reasons why others might not be willing to invest in real estate.
5. Manage Tenants. Do you think you could successfully deal with tenants and the management demands required in real estate investing? Why or why not?
6. Disadvantages of Real Estate. Review the list of “Disadvantages of Real Estate Investing,” and identify one that you think is most important. Explain why.
7. Timeshares as an Investment. Explain why timeshares should not be considered an investment. Why do some people buy timeshares?
8. Put Some Money into Alternative Investments.What percentage of your portfolio, if any, do you think should be invested in alternative investments? Explain.
9. Invest in Gold? Would you invest in gold today? Explain why or why not.
10. Options and Futures. Both options and futures are risky investments. Identify one that seems like an unwise idea, and explain why it is unappealing.
DO THE MATH
1. Price-to-Rent Ratios. Calculate the price-to-rent ratios for the following properties arranged by price of home followed by likely annual rental income: (a) $400,000/$40,000;
(b) $300,000/$36,000;
(c) $200,000/30,000.
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PAGE 483
2. Real Estate Investment Returns. Austin Sandler, an electrician and his teacher spouse Emily from Laramie, Wyoming, are interested in the numbers of real estate investments. They have reviewed the figures in
Table 16-2
and are impressed with the potential 50.12 percent return after taxes. Austin and Emily are in the 25 percent marginal tax bracket. Answer the following questions to help guide their investment decisions:
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PAGE 487
(a) Substitute the Sandler’s 25 percent marginal tax bracket (his state has no state income tax) in
Table 16-2
, and calculate the taxable income and return after taxes.
(b) Why does real estate appear to be a favorable investment for Austin and Emily?
(c) What one factor might be changed in
Table 16-2
to increase their return?
(d) Calculate the after-tax return for Austin and Emily, assuming that they bought the property and financed it with a 7 percent, $175,000 30-year mortgage with annual interest costs of $11,971.
3. Review the math in
Table 16-3
, on page 489, Discounted Cash Flow to Estimate Price, and give your opinion on which part of the assumptions (price increases or sales price) is more subject to poor thinking.
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PAGE 489
FINANCIAL PLANNING CASES
CASE 1
The Johnsons Consider a Real Estate Investment
Harry and Belinda Johnson are considering purchasing a residential income property as an investment. The Johnsons want to achieve an after-tax total return of 7 percent. They are considering a property with an asking price of $190,000 that should produce $27,000 in gross rental income and $15,000 in net operating income.
(a) Calculate the price-to-rent ratio on the property.
(b) Calculate the present value of after-tax cash flow for the property, assuming that the after-tax cash-flow numbers are $8000 for the first year, $8400 for the second year, $8800 for the third year, $9200 for the fourth year, and $9600 for the fifth year, and that the selling price of the property will be $210,000 in five years. Prepare your information in a format similar to
Table 16-3
, using Appendix A-2 or the Garman/Forgue companion website to discount the future after-tax cash flows to their present values.
(c) Give the Johnsons your advice on whether they should invest in the property at its current price of $190,000.
CASE 2
Victor and Maria Consider Selling Maria’s Mother’s Home
Victor and Maria Hernandez are thinking about selling her mother’s home, which she recently inherited, and use the proceeds to enhance their investments for retirement. It’s price declined about $30,000 in recent years to today’s value of $170,000. The home is fully paid for.
(a) If the rent is $1000 a month, what is the rental yield?
(b) If they sold the home, should they invest the proceeds into any alternative investments, such as gold?
CASE 3
Julia Price Wants to Try Alternative Investments
Julia continues to be a hard worker and, at age 50, has saved and invested wisely for her planned financially successful retirement. She has an extra $15,000 in a cash management account beyond what she needs for emergency savings. She rejected options and commodity futures as too risky but is considering gold. Julia wonders if the price volatility of gold over the past few years will continue, and she has always thought about investing in antique furniture. Offer your opinions about her thinking.
CASE 4
Real Estate or Stocks?
Junhee Chang, a senior research analyst in St. Clairsville, Ohio, has bought and sold high-technology stocks profitably for years. Lately some of her stock investments have done quite poorly, including one company that went bankrupt. Emily, a longtime friend at work, has suggested that the two of them invest in real estate together because property values in some neighborhoods have been rising in anticipation of a large manufacturing company’s plans to substantially increase its workforce. Emily has looked at three small office buildings and some residential duplexes as possible investments.
(a) Contrast the wisdom of investing in commercial office buildings versus the attraction of investing in residential properties.
(b) List three of the advantages associated with real estate investments.
(c) List three things that can go wrong for real estate investors.
CASE 5
From Real Estate to Options and Futures
Jonathan Williams and Cody Richardson, longtime partners in Lawton, Oklahoma, have bought and sold real estate properties for ten years. They have profited on many transactions, although they did have some substantial losses during the Great Recession. Their portfolio of real estate is worth about $4.7 million, on which they owe $2.9 million. Jonathan has read about investing in options and futures contracts, and last week, he talked with a stockbroker about the possibilities.
(a) Offer some reasons why Jonathan want to invest $100,000 or more in options and futures contracts.
(b) List some of the risks of options trading for Jonathan and Cody.
(c) From an investor’s point of view, contrast trading in futures contracts with buying highly leveraged real estate.
BE YOUR OWN PERSONAL FINANCIAL MANAGER
1. Foreclosure and Short Sales. Given that there are so many foreclosed homes on the market, tell why you might or might not be interested in buying one as an investment. Write a summary of your conclusions.
2. Before Investing in Real Estate. Review the information in the Did You Know? Box titled “What to do Before Investing in Real Estate” and identify two suggestions that you definitely would follow if you invested in real estate. Write a summary of your conclusions.
3. Disadvantages of Real Estate Investing. Review the list in the “Disadvantages of Real Estate Investing” section and identify two disadvantages that you think might keep you from personally investing in real estate. Write a summary of your conclusions.
4. Real Estate ETFs. Go to the “Real Estate ETF” page for
StockEncyclopedia.com
(
etf.stock-encyclopedia.com/category/real-estate.xhtml
) and select three illustrative companies, such as ProShares UltraShort Real Estate Fund. Write a brief report comparing those three ETFs.
ON THE NET
1. Research Home Prices. To find prices on homes in your community, go to Zillo (
www.zillow.com/
). Input addresses of homes on five nearby streets and summarize your price information findings.
2. Research Mortgage Rates. Find out current mortgage rates for 15- , 20- , and 30-year loans for both residential and investment loans. See
LendingTree.com
,
Quickenloans.com
,
BankRate.com
, and
Loan.com
. Write a brief report on your findings.
3. Current Prices of Metals. Find out the current prices of five popular metals, such as gold, silver, nickel, aluminum, cobalt, copper, lead, palladium, platinum, and silver, at websites like Kitco (
www.kitco.com/
) and USA Gold (www .usagold.com/). Write a brief report on your findings.
4. Gold ETFs. Go online and search “gold prices per ounce” on Google or Bing. Click on five websites, including Wikipedia’s “Gold ETFs,” and review what is written, especially about predictions of future prices. Prepare a report summarizing your findings.
5. Collectibles Websites. Search the Internet for two websites featuring one type of collectible that interests you (such as coins, toys, watches, or sports memorabilia). Write a brief report comparing the types of information and features available for buyers of these collectibles.
6. Research Hedge Funds. Go online and research two large hedge funds (such as JP Morgan Chase, Bridge-water Associates, Paulson & Co., Brevan Howard, and Soros Fund Management) by inserting “hedge fund” after the company name. Write a report comparing what services the two funds perform, participation requirements, and investment returns.
ACTION INVOLVEMENT PROJECTS
1. Community Real Estate Prices. Telephone two real estate brokers to determine if the prices of single-family dwellings in your community have been decreasing or increasing over the past four or five years, and ask why. Inquire about homes located near your college as well as those farther away from campus. Prepare a brief report of your findings including reasons for the change in prices.
2. Invest in Commercial Real Estate. Research current commercial properties for sale in your college community by reviewing the real estate section of newspapers. How many listings do you find? How many duplexes? How many small apartment buildings? Select one and prepare a report analyzing the property using the price-to-rent ratio and rental yield.
3. Tax Consequences of Real Estate Investment. Select a possible commercial real estate investment in your community and make a “first attempt” to prepare an analysis similar in format to that in the Did You Know? box titled “The Tax Consequences of an Income-Producing Real Estate Investment.” Make any reasonable assumptions you desire and calculate the numbers. Prepare the table and a brief report of your findings.
Bond Ratings [due Mon]
Top of Form
Bottom of Form
Assignment Content
1.
Top of Form
Research bond information within the University Library or the Internet.
Describe in 90- to 175-words what you found. How can you use this information within your personal or professional life?
Differentiate what the following bond ratings mean for investors in 30 to 90 words each:
· AAA
· B
BB
· B
· CC
Bottom of Form
13 Investment Fundamentals
YOU MUST BE KIDDING, RIGHT?
Twins Tiffany and Taylor Jackson have worked for the same employer for many years. Tiffany started early to save and invest for retirement by putting $5000 away each year for 15 years starting at age 25 and never added any more money to the account. Taylor waited until age 40 to begin saving for retirement and he invested $5000 per year for 25 years until retirement at age 65. Assuming that they both earn a 6 percent annual return, how much more money will Tiffany have accumulated for retirement than Taylor by the time they reach age 65?
A. $ 98,919
B. $174,231
C. $274,323
D. $373,242
The answer is A, $98,919. Tiffany’s account balance at age 65 is projected at $373,242 and Taylor’s is $274,323. Even though Tiffany saved for only 15 years compared with Taylor’s 25 years of saving, Tiffany’s long-term investment approach had her starting to save early in her working career for retirement. Thus, she accumulated 36 percent more money than her brother ($373,242 – $274,323 = $98,919/$274,323). Starting early on long-term investment goals is a money-winning idea!
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
Explain how to get started as an investor.
Identify your investment philosophy and invest accordingly.
Describe the major risk factors that affect the rate of return on investments.
Decide which of the four long-term investment strategies you will utilize.
Create your own investment plan.
Use Monte Carlo Advice when investing for retirement.
WHAT DO YOU RECOMMEND?
Shavenellyee and Sarena are sisters, both in their 20s. Shavenellyee drives a leased BMW convertible, and she makes about $42,000, including tips, as a part-time bartender at two different restaurants. Although she has no employee benefits, she enjoys having flexible work hours so that she can go to the beach and the local nightspots. Currently, Shavenellyee has $10,000 in credit card debt. She has $1500 in a bank savings account, and two years ago she opened an individual retirement account (IRA) with a $1000 investment in a mutual fund. Her sister Sarena drives a paid-for Honda CR-V, pays her credit card purchases in full each month, and sacrifices some of her salary by putting $100 per month into her employer’s company stock through her 401(k) retirement account. Over the past seven years, the stock price, which was once about $40, has risen to almost $70, and Sarena’s 401(k) plan is now worth about $16,000. Sarena also has invested about $14,000 in a Roth IRA mutual fund account that is currently invested in an aggressive growth mutual fund, and she plans to use that money for a down payment on a home purchase. She earns $58,000 as a manager of a restaurant, plus she receives an annual bonus ranging from $2000 to $4000 every January that she uses for a spring vacation in Mexico. Sarena’s employer provides many employee benefits.
What do you recommend to Shavenellyee and Sarena on the subject of investment fundamentals regarding:
1. Portfolio diversification for Sarena?
2. Dollar-cost averaging for Shavenellyee ?
3. Investment alternatives for Sarena?
YOUR NEXT FIVE YEARS
In the next five years, you can start achieving financial success by doing the following related to investment fundamentals:
1. Start investing early in life by sacrificing some income and putting some cash into a diversified investment portfolio for the future.
2. Avoid thinking about short-term results and accept substantial risk when investing for the long term.
3. Invest regularly through your employer’s retirement plan.
4. Invest no more than 5 or 10 percent of your portfolio in any single company stock, including that of your employer.
5. Rebalance your portfolio at least once a year based on your chosen asset allocation strategy.
At many points in this book, we have encouraged you to set aside funds for the future, especially by accumulating funds through regular savings. Financial writer Andrew Tobias argues that saving more is the smartest, safest investment move you will ever make. Save every nickel you can. Then you will have funds for investing.
Investments can be tricky, of course. When the stock market crashed in 2008, millions of American investors lost 40 to 50 percent of their investment assets and some lost even more. The biggest declines occurred in portfolios that were poorly diversified, as their money was not spread among various types of investments. Those who had a well-diversified portfolio lost only about 20 percent. People who remained invested (instead of selling while the market was declining week after week) were happy when the market started its rebound only 2 years later. Within another year the market doubled and those who remained in the market recovered all their losses. Since then they made even more gains, plus an additional 29 percent return last year. Patience is critically important when investing.
Despite the ups and downs of the world’s stock markets, one of the best ways to make money over the long term—especially for retirement—is to invest in stocks, bonds, and mutual funds. This remains the best advice! The earning power of the U.S. and world economies, even with occasional serious fluctuations, endures. This chapter explains both why this is true and how to succeed during an economic recession; in an economy growing at a slow pace; or in the course of a rapidly growing economy.
13.1 STARTING YOUR INVESTMENT PROGRAM
To help secure a desirable future lifestyle, you cannot spend every dollar that you earn today. Instead, you must sacrifice by setting aside some of your current income and invest it. You postpone the pleasure of using money for here-and-now consumption so you can have more in the future. To be inancially successful, you are wise to start investing early in life, invest regularly, and stay invested. Why? Because, for every five years you delay investing, you will have to double your monthly investment amount to achieve the same goals. Remember: You—and no one else—are responsible for your own financial success.
13.1a Investing Is More than Saving
Savings is the accumulation of excess funds by intentionally spending less than you earn. Investing is more.
Investing
is taking some of the money you are saving and putting it to work so that it makes you even more money. Your goals and the time it will take to reach those goals dictate the investment strategies you follow and the investment alternatives you choose.
investing
Putting saved money to work so that it makes you even more money.
The most common ways that people invest are by putting money into assets called
securities
, such as stocks, bonds, and mutual funds (often purchased through their employer-sponsored retirement accounts), and by buying real estate.
Stocks
are shares of ownership in a corporation, and
bonds
represent loans to companies and governments. Essentially, they are IOUs that are bought and sold among investors. All of your investment assets make up your
portfolio
, which is the collection of multiple investments in different assets chosen to meet your investment goals.
securities
Assets suitable for investment, including stocks, bonds, and mutual funds.
stocks
Shares of ownership in a corporation.
bond
A debt instrument issued by an organization that promises repayment at a specific time and the right to receive regular interest payments during the life of the bond.
portfolio
Collection of investments assembled to meet your investment goals.
13.1b What Investment Returns Are Possible?
Figure 13-1
shows the long-term rates of return on some popular investments. While stock market returns have averaged about 9.6 percent over the long term, the returns in the first decade of the millennium were extremely low and then much higher in more recent years.
LEARNING OBJECTIVE 1
Explain how to get started as an investor.
Figure 13-1
Long-Term Rates of Return on Investments (Annualized returns since 1926)
Since 1927, the worst 20-year performance for stocks was a gain of 3 percent annually. Over the past 80 years, the chance of making money during any one year in the stock market has been 66 percent. Over five years, the probability increases to 81 percent; over ten years, it increases to 89 percent.
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13.1c Gains (and Losses) Plus Dividends Equals One’s Total Return
When people invest their money, they take a financial risk (also called business risk)— namely, the possibility that the investment will fail to pay any return to the investor. At the extremes, a company could have a very good year earning a considerable profit, or it could go bankrupt, causing investors to lose all of their money.
Investors hope that their investments will earn them a positive
total return
, which is the income an investment generates from a combination of current income and capital gains.
Current income
is money received while you own an investment. It is usually received on a regular basis as interest, rent, or dividends.
total return
Income an investment generates from current income and capital gains.
current income
Money received while you own an investment; usually received regularly as interest, rent, or dividends.
As we have noted elsewhere in the text,
interest
for an investor is the return earned for lending money. Rent is payment received in return for allowing someone to use your real estate property, such as land or a building. A dividend is a portion of a company’s earnings that the firm pays out to its shareholders. For example, Eliza Rodriguez from Ypsilanti, Michigan, purchased 100 shares of H&M stock at $45 per share ($4500) last year. The company paid dividends of $3 per share during the year, so Eliza received $300 in cash dividends as current income.
interest
Charge for borrowing money; investors in bonds earn interest.
DID YOU KNOW
Bias toward Minimizing Investment Losses
People engaged in the understanding investment fundamentals have a bias toward certain behaviors that can be harmful, such as a tendency toward forgetting about their investment losses. People usually forget about losses and instead remember more clearly their successes, convinced that they are above-average investors. What to do? When one has investment losses, stop and think, and learn from mistakes.
DID YOU KNOW
Money Websites for Investment Fundamentals
Informative websites for investment fundamentals, including tips for young adults are:
Bankrate.com’ risk tolerance quiz (
www.bankrate.com/finance/financial-literacy/quiz-what-is-your-risk-tolerance.aspx
)
Fundamentals of Investing (
www.financialwisdom.com
)
Financial Soundings’ limited management accounts (
www.financialsoundings.com
)
How To Be Set For Life (
www.howtobesetforlife.com/articles/6-investment-fundamentals/
)
Kiplinger.com’s risk tolerance quiz (
www.kiplinger.com/quiz/investing/T031-S001-the-investor-psychology-quiz/
index.xhtml
)
Motley Fool (
www.fool.com/how-to-invest/thirteen-steps/index.aspx
)
Wikipedia on asset allocation (en.wikipedia.org/wiki/Asset_allocation)
A
capital gain
occurs only when you actually sell an investment that has increased in value. It is calculated by subtracting the total amount paid for the investment (including purchase transaction costs) from the higher price at which it is sold (minus any sales transaction costs). For example, if the price of H&M company stock rose to $52 during the year, Eliza could sell it for a capital gain. If Eliza paid a transaction cost of $1 per share at both purchase and time of sale, her capital gain would be $500 [($5200 − $100) – ($4500 + $100)].
capital gain
Increase in the value of an initial investment (less costs) realized upon the sale of the investment.
Capital losses
can occur as well. For most investments, a trade-off arises between capital gains and current income. Investments with potential for high capital gains often pay little current income, and investments that pay substantial current income generally have little or no potential for capital gains. Long-term investors are often willing to forgo current income in favor of possibly earning substantial future capital gains.
capital loss
Decrease in paper value of an initial investment; only realized if sold.
The
rate of return
, or
yield
, is the total return on an investment expressed as a percentage of its price. It is usually stated on an annualized basis, and it includes dividends and capital gains. For example, if Eliza sells the H&M stock for $52 per share after one year, she will have a total return of $800 ($300 in dividends plus $500 in capital gains). Her yield would be 17.78 percent ($800 ÷ $4500).
rate of return/yield
Total return on an investment expressed as a percentage of its price.
FINANCIAL POWER POINT
Out of the Market? You Missed a 45 Percent Gain
If you had been out of stocks during the market’s ten best days in the past decade, according to Charles Schwab, you would have missed out on 45 percent of the gains.
13.1d Your Investing Future Looks Promising
Corporate profits—and investor’s returns—are difficult to earn when the United States and the world’s large economies are struggling. During such challenging economic times, one’s average investment returns from stocks are likely to be about 6 percent. This is likely to come from a 2 percent dividend yield for stocks and an earnings growth rate of around 4 percent. These are still good returns when inflation is low.
CONCEPT CHECK 13.1
1. How does savings differ from investing?
2. Why were returns so poor for the first decade of the millennium?
3. What are the two parts of an investor’s total return?
4. What stock market returns can be anticipated in the near- to mid-term, and why?
13.2 IDENTIFY YOUR INVESTMENT PHILOSOPHY AND INVEST ACCORDINGLY
Achieving financial success requires that you understand your investment philosophy and adhere to it when investing. Thus, you also need to know about investment risk and what to do about it. Keep in mind the advice offered by investment guru Warren Buffett, “The first rule of investing is don’t lose money; the second rule is don’t forget Rule No. 1.”
13.2a You Can Learn to Handle Investment Risk
Pure risk, which exists when there is no potential for gain, only the possibility of loss, was discussed in
Chapter 1
0
. Investments, in contrast, are subject to
speculative risk
, which exists in situations that offer potential for gain as well as for loss.
Investment risk
represents the uncertainty that the yield on an investment will deviate from what is expected. For most investments, the greater the risk is, the higher the potential return. This potential for gain is what motivates people to accept increasingly greater levels of risk, as illustrated in
Figure
13-2
. Nevertheless, many people remain seriously averse to risk.
speculative risk
Involves the potential for either gain or loss; equity investments might do either.
investment risk
The possibility that the yield on an investment will deviate from its expected return.
Figure 13-2
also provides insight about possible investment choices. Don’t be overwhelmed because these investments are explained in the following chapters. You will learn how to make informed investment decisions for yourself.
13.2b Investors Demand a Risk Premium
One popular investment is the short-term Treasury bill, or T-bill, which is a government IOU of less than one year. Because T-bills are risk-free investments, they pay too low a return for most people, perhaps only 0.25 or 0.35 percent. Some people invest in T-bills to safeguard their money until it can be invested at a later time.
LEARNING OBJECTIVE 2
Identify your investment philosophy and invest accordingly.
DO IT IN CLASS
Figure 13-2
Risk Pyramid Reveals the Trade-Offs Between Risk and Return
Investors need the promise of a high return to warrant placing their money at risk in an investment. When making investments, people demand a
risk premium (or equity risk premium)
for their willingness to make investments for which there is no guarantee of future success. This risk premium constitutes the difference between a riskier investment’s expected return and the totally safe return on the T-bill.
risk premium (or equity risk premium)
The difference between a riskier investment’s expected return and the totally safe return on the T-bill.
If the expected return is 8 percent on stocks and 2 percent on ten-year Treasury securities, the risk premium is 6 percent. Industry experts figure that the amount of the risk premium for most investors is 3 to 6 percent, although the long-term average is 8 percent. Higher-risk investments carry higher-risk premiums.
13.2c What Is Your Investment Philosophy?
Investors have to take risks that are appropriate to reach their financial goals. The task is to find the right balance and make choices accordingly. You must weigh the risks of an investment with the likelihood of not reaching your goal.
Your
risk tolerance
is your willingness to weather changes in the values of your investments. This is not the same as your capacity to take risk. To be successful in investing, your risk tolerance must be factored into your investment philosophy. If you lose sleep over your investments, you know it is time to reduce your risk and adjust your investment philosophy.
risk tolerance
An investor’s willingness to weather changes in the value of your investments, that is, to weather investment risk.
An
investment philosophy
is one’s general approach to tolerance for risk in investments, whether it is conservative, moderate, or aggressive, given the financial goals to be achieved. The more risk you take, within reason, the more you can expect to earn and accumulate over the long term. However, just because you are comfortable with a risky portfolio does not mean that you actually need one. By the same token, you still need to be aggressive enough to meet your financial goals. Wise investors follow their investment philosophy without wavering; they do not change course unless their basic objectives change.
investment philosophy
Investor’s general approach to tolerance for risk in investments, whether it is conservative, moderate, or aggressive, given the investor’s financial goals.
Are You a Conservative Investor? If you have a
conservative investment philosophy
, you accept very little risk and are generally rewarded with relatively low rates of return for seeking the twin goals of a moderate amount of current income and preservation of capital. Preservation of capital means that you do not want to lose any of the money you have invested. In short, you could be characterized as an investor who is
risk averse
. This is one who tends to dislike risk and is unable to put money into investments that seem risky.
conservative investment philosophy (risk aversion)
Investors with this philosophy accept very little risk and are generally rewarded with relatively low rates of return for seeking the twin goals of a moderate amount of current income and preservation of capital.
risk averse
In investments, one who tends to dislike risk and is unable to put money into investments that seem risky.
Conservative investors focus on protecting themselves. They do so by carefully avoiding losses and trying to stay with investments that demonstrate gains, often for long time periods (perhaps for five or ten years). Tactically, they rarely sell their investments. Investors who are approaching retirement or who are planning to withdraw money from their investments in the near future often adhere to a conservative investment philosophy.
Conservative investors typically consider investing in obligations issued by the government. Examples include Treasury bills, notes, and bonds, municipal bonds, high-quality (blue-chip) corporate bonds and stocks, balanced mutual funds (which own both stocks and bonds), certificates of deposit, and annuities. A bond is essentially a loan that the investor makes to a government or a corporation. It is a debt of the issuer. Over the course of a year, a conservative investor with $1000 could possibly lose $20 and is likely to gain $20 to $30.
Are You a Moderate Investor? People with a
moderate investment philosophy
seek capital gains through slow and steady growth in the value of their investments along with some current income. They invite only a fair amount of risk of capital loss. Most have no immediate need for the funds but instead focus on laying the investment foundation for later years or building on such a base. Moderate investors are fairly comfortable during rising and falling market conditions. They remain secure in the knowledge that they are investing for the long term. Their tactics might include spreading investment funds among several choices and adjusting their portfolio by trading some assets perhaps once or twice a year.
moderate investment philosophy (risk indifference)
Investors with this philosophy accept some risk as they seek capital gains through slow and steady growth in investment value along with current income.
People seeking moderate returns consider investing in dividend-paying common stocks, growth and income mutual funds, high-quality corporate bonds, government bonds, and real estate. Over the course of a year, a moderate investor with $1000 could possibly lose $150 and is likely to gain $40 to $60.
Are You an Aggressive Investor? If you choose to strive for a very high return by accepting a high level of risk, you have an
aggressive investment philosophy
. As such, you could be characterized as a risk seeker. Aggressive investors primarily seek capital gains. Many such investors take a short-term approach, remaining confident that they can profit substantially during major upswings in market prices.
aggressive investment philosophy (risk seeker)
Investors with this philosophy primarily seek capital gains, often with a short time horizon.
People seeking exceptionally high returns consider investing in common stocks of new or fast-growing companies, high-yielding junk bonds, and aggressive-growth mutual funds. Such investors also may put their money into limited real estate partnerships, undeveloped land, precious metals, gems, commodity futures, stock-index futures, and collectibles. Devotees of this investment philosophy sometimes do not diversify by spreading their funds among many alternatives. Also, they may adopt short-term tactics to increase capital gains. For example, aggressive investors might place most of their investment funds in a single stock in the hope that it will rise 10 percent over 90 days, giving a yield of more than 30 percent annually. Those shares could then be sold and the money invested elsewhere. Investment tactics for aggressive investors are discussed in Chapter 16.
Aggressive investors must be emotionally and financially able to weather substantial short-term losses—such as a downward swing in a stock’s price of 30 or 40 percent—even though they might expect that an upswing in price will occur in the future. Over the course of a year, an aggressive investor with $1000 could possibly lose $300 and could gain $100, $200, $300, or even more.
FINANCIAL POWER POINT
Take a Risk-Tolerance Quiz
Find out how much risk you can comfortably tolerate by taking a risk-tolerance quiz at one of the following websites:
• Bankrate.com:
www.bankrate.com/finance/financial-literacy/use-investments-to-reach-your-goals-2.aspx
.
• Kiplinger: www.kiplinger.com/quiz/investing/T031-S001-the-investor-psychology-quiz/.
13.2d Should You Take an Active or Passive Investing Approach?
Another aspect of your personal investment philosophy is your level of involvement in investing. That is, do you want to be an active or passive investor?
Active Investing An active investor carefully studies the economy, market trends, and investment alternatives; regularly monitors these factors; and makes decisions to buy and sell, perhaps three or four or more times a year, with or without the advice of a professional. In addition, active investors stay alert because the prices of many investments vary with certain news events, world happenings, and economic and political variables. Knowing what is going on in the larger world helps active investors understand when to buy or to sell investments quickly so as to reap profits and/or reduce losses.
Passive Investing Succeeds over the Long Term A passive investor does not actively engage in trading of securities or spend large amounts of time monitoring his or her investments. Such an individual may make regular investments in securities, such as mutual funds (described in
Chapter 15
), and his or her assets are rarely sold for short-term profits. Instead, passive investors simply aim to match the returns of the entire market. They ignore “hot” tips and the investment of the day touted in the financial press. They keep their emotions in check, and they earn higher returns than active investors over the long term. Most long-term investors utilize a passive approach.
An active investor keeps a close watch on the economy and financial markets.
13.2e Identify the Kinds of Investments You Want to Make
The investments you choose should match your interests. Before investing, think about lending versus owning, short term versus long term, and how to select investments that are likely to provide your desired potential total return.
Do You Want Lending Investments or Ownership Investments? You can invest money in two ways, by lending or by owning. When you lend your money, you receive some form of IOU and the promise of repayment plus interest. The interest is a form of current income while you hold the investment.
You can lend by depositing money in banks, credit unions, and savings and loan associations (via savings accounts and certificates of deposit) or by lending money to governments (via Treasury notes and bonds as well as state and local bonds), businesses (corporate bonds), mortgage-backed bonds (such as Ginnie Maes), and life insurance companies (annuities).
These lending investments, or
debts
, generally offer both a fixed maturity and a fixed income. With a
fixed maturity
, the borrower agrees to repay the principal to the investor on a specific date. With a
fixed income
, the borrower agrees to pay the investor a specific rate of return for use of the principal. Such investments allow lenders to be fairly confident that they will receive a certain amount of interest income for a specified period of time and that the borrowed funds will eventually be returned. Thus, the return is somewhat assured.
debts
Lending investments that typically offer both a fixed maturity and a fixed income.
fixed maturity
Specific date on which a borrower agrees to repay the principal to the investor.
fixed income
Specific rate of return that a borrower agrees to pay the investor for use of the principal (initial investment).
No matter how much profit the borrower makes with your funds, the investing lender at best receives only the fixed return promised at the time of the initial investment. Lending investments rarely result in capital gains.
Alternatively, you may invest money through ownership of an asset. Ownership investments are often called
equities
. You can buy common or preferred corporate stock (to obtain part ownership in a corporation) in publicly owned companies, purchase shares in a mutual fund company (which invests your funds in corporate stocks and bonds), put money into your own business, purchase real estate, buy commodity futures (pork bellies or oranges), or buy investment-quality collectibles (such as rare antiques or gold). Ownership investments have the potential for providing current income; however, the emphasis is usually upon achieving substantial capital gains.
equities
Ownership equities such as common or preferred stocks, equity mutual funds, real estate, and so on that focus on capital gains more than on income.
Making Short-, Intermediate-, and Long-Term Investments When investing for a short-term goal, such as less than one year, you would want to be very conservative to ensure that a sudden drop in the market would not jeopardize your reaching the goal before the market has time to recover. You want to be confident that you preserve the value of what you have. After all, you don’t want to lose money in an investment when you need to use that money for a near-term goal, such as college tuition, or be forced to sell an investment because you need cash in a hurry. People with a short or intermediate time horizon require investments that offer some predictability and stability. As a result, these investors are usually more interested in current income than capital gains.
By contrast, if you are investing to achieve long-term goals, you want your money to grow. Long-term investors usually invite more risk by seeking capital gains as well as current income.
When investing for long-term goals, you can afford to be more aggressive. That is one reason why the stock market is a good place to save for retirement. After you retire, you can leave a portion of your portfolio in stocks or stock mutual funds since you likely will still have 20 to 25 years before you need the last dollars in your nest egg.
Long-term investors seek growth in the value of their investments that exceeds the rate of inflation. In other words, they want their investments to provide a positive
real rate of return
. This is the return after subtracting the effects of both inflation and income taxes.
real rate of return
Return on an investment after subtracting the effects of inflation and income taxes.
DID YOU KNOW
Calculate the Real Rate of Return (After Taxes and Inflation) on Investments
1.
Identify the rate of return before income taxes
. Perhaps you think that a stock will offer a return of 10 percent in one year, including current income and capital gains.
2.
Subtract the effects of your marginal tax rate on the rate of return to obtain the after-tax return
. If you are in the 25 percent federal income tax bracket, the calculation is (1 − 0.25) × 0.10 = 0.075 = 7.5 percent.
3.
Subtract the effects of inflation from the after-tax return to obtain the real rate of return on the investment after taxes and inflation
. If you estimate an annual inflation of 4 percent, the calculation gives 3.5 percent (7.5 percent – 4.0 percent). Thus, your before-tax rate of return of 10 percent provides a real rate of return of 3.5 percent after taxes and inflation.
13.2f Choose Investments for Their Components of Total Return
When investing, you want to build a portfolio of investments that will provide the necessary potential total return through current income and capital gains in the proportions that you desire. One stock might provide an anticipated cash dividend of 1.5 percent and an expected annual price appreciation of 6 percent, for a total anticipated return of 7.5 percent. Another choice offering the same projected total return might be a stock with expected annual cash dividends of 2.5 percent and capital gains of 5 percent.
13.2g What Should You Do Next?
Once you have clarified your investment philosophy, whether to lend or own, active or passive, understand the investment timeline of your financial goals, and accept the components of your anticipated total return, you will be able to make investing decisions with confidence and conviction. You will be able to show patience by following your long-term views rather than making emotional and wrong decisions—in other words, mistakes—about your money. The investments you choose and the returns earned will match your investment philosophy.
CONCEPT CHECK 13.2
1. Summarize your investment philosophy and general approach to tolerance for risk.
2. Indicate whether you view yourself as an active or passive investor, and explain why.
3. Summarize your personal views on lending or owning investments.
4. Which type of investment return—current income or capital gains— seems more attractive to you? Why?
13.3 RISKS AND OTHER FACTORS AFFECT THE INVESTOR’s RETURN
To be a successful investor, you must understand the major factors that affect the rate of return on investments. Being informed, you can then take the appropriate risks when making investment decisions.
LEARNING OBJECTIVE 3
Describe the major factors that affect the rate of return on investments.
Random Risk Is Reduced by Diversification, Eventually
Random risk
(also called
unsystematic risk
) is the risk associated with owning only one investment of a particular type (such as stock in one company) that, by chance, may do very poorly in the future because of uncontrollable or random factors, such as labor unrest, lawsuits, and product recalls. If you invest in only one stock, its value might rise or fall. If you invest in two or three stocks, the odds are lessened that all of their prices will fall at the same time. Such
diversification
—the process of reducing risk by spreading investment money among several different investment opportunities—provides one effective method of managing random risk as it reduces the ups and downs of a portfolio.
random/unsystematic risk
Risk associated with owning only one investment of a particular type (such as stock in one company) that, by chance, may do very poorly in the future due to uncontrollable or random factors that do not affect the rest of the market.
diversification
Process of reducing risk by spreading investment money among several different investment opportunities.
The principle holds that when you own different types of investment assets in a portfolio, some assets should be rising when others are falling. It results in a potential rate of return on all of the investments that is lower than the potential return on a single alternative, but the return is more predictable and the risk of loss is lower. Diversification does not mean that you will not lose money. Diversification averages out the high and low returns. While investors might be disappointed with a lower return from a diversified portfolio, they would be even more disappointed by the return in a down market from one that is poorly diversified.
Research suggests that you can cut random risk in half by diversifying into as few as five stocks or bonds; you can eliminate random risk by holding 15 or more stocks or bonds. Rational investors diversify so as to reduce random risk, and over the long term—as little as a decade—it works. You also can diversify by investing in foreign stocks.
13.3a Market Risk and the Great Recession
Diversification among stocks or bonds cannot eliminate all risks. Some risk would exist even if you owned all of the stocks in a market because stock prices in general move up and down over time.
Market risk
(also known as
systematic
or
nondiversifiable risk
) is the possibility for an investor to experience losses due to unknown factors that affect the overall performance of the financial markets.
market risk/systematic risk/undiversifiable risk
The possibility for an investor to experience losses due to unknown factors that affect the overall performance of the financial markets.
In this case, the value of an investment may drop due to influences and events that affect all similar investments. Examples include a change in economic, social, political, or general market conditions; fluctuations in investor preferences; or other broad market-moving factors, such as a recession political turmoil, changes in interest rates, and terrorist attacks. Market risk cannot be eliminated but it can be reduced by dividing your portfolio among several different markets.
The Great Recession Not all markets normally will decline at the same time, but it can happen. The Great Recession of December 2007 through March of 2009 impacted the whole world and it demonstrates the possibility of a mistake in the logic of efficient markets as all types of investments (e.g., credit, investments, and real estate) fell in unison. The systemic collapse proves that once-in-a-lifetime financial disasters not only can occur, but do. The mission of the Financial Stability Oversight Council is to identify financial companies in need of government intervention before they collapse and negatively affect the American economy.
The Congressional Budget Office (CBO) predicts that the U.S. economy will continue to crawl along at a 2.4 percent rate of annual growth through 2022, rather than a more typical growth rate of 3.0 percent or higher.
U.S. and world markets are continuing to recover in today’s challenging economic environment. Over the short term, diversification cannot protect your investments against market declines. Over the long term, and this suggests that if you remain invested in the market during your entire lifespan, you will likely experience a significant down market that will take back a sizable chunk of your wealth. But in time you will get it all back and then some.
Market Risk in an Investor’s Portfolio Market risk remains after an investor’s portfolio has been fully diversified within a particular market. Over the years, market risk for all investments has averaged about 8 percent. As a consequence of this risk, the return on any single securities investment (such as a stock), through no fault of its own, might vary up and down about 8 percent annually. The total risk in an investment consists of the sum of the random risk and the market risk.
13.3b Types of Investment Risks
A number of other investment risks affect investor returns:
DO IT IN CLASS
• Business failure risk. Business failure risk, also called
financial risk
, is the possibility that the investment will fail, perhaps go bankrupt, and result in a massive or total loss of one’s invested funds.
financial risk
Possibility that an investment will fail to pay a return to the investor.
• Inflation risk. Inflation risk may be the most important concern for the long-term investor. Inflation risk, also called purchasing power risk, is the danger that your money will not grow as fast as inflation and therefore not be worth as much in the future as it is today. Over the long term, inflation in the United States has averaged 3.1 percent annually. Historically, common stocks and real estate have reduced inflation risk, as their values tend to rise with inflation over many years. However, all ownership investments are also subject to deflation risk. This is the chance that the value of an investment will decline when overall prices decline. Housing prices declined 30 to 60 percent in many U.S. communities as a result of the Great Recession.
• Time horizon risk. The role of time affects all investments. The sooner your invested money is supposed to be returned to you—the time horizon of an investment—the less the likelihood that something could go wrong. The more time your money is invested, the more it is at risk. For taking longer-term risks, investors expect and normally receive higher returns.
• Business-cycle risk. As we discussed in Chapter 1, economic growth usually does not occur in a smooth and steady manner and this affects profits as well as investment returns. This is known as
business-cycle risk
. Instead, periods of expansion lasting three or four years are often followed by contractions in the economy, called recessions, that may last a year or longer. The profits of most industries follow the business cycle. Some businesses do not experience business-cycle risk because they continue to earn profits during economic downturns. Examples are gasoline retailers, supermarkets, and utility companies.
business-cycle risk
The fact that economic growth usually does not occur in a smooth and steady manner, and this impacts profits as well as investment returns.
• Market-volatility risk. All investments are subject to occasional sharp changes in price as a result of events affecting a particular company or the overall market for similar investments, and this is
market-volatility risk
. For example, the value of a single stock, such as that of a technology company like Apple, might change 10 or even 20 percent in a single day. Also, all technology stocks could decline 2 or perhaps 5 percent if two or three competitors announce poor earnings. In recent years the number of days with a 4 percent swing in the overall stock market prices ranged from 2 to 11.
market-volatility risk
The fact that all investments are subject to occasional sharp changes in price as a result of events affecting a particular company or the overall market for similar investments.
• Liquidity risk.
Liquidity
is the speed and ease with which an asset can be converted to cash. You can sell your stock investments in one day, but rules state that it may take up to four days to have the proceeds available in cash. You will never truly know the value of liquidity until you need it and you do not have it.
Liquidity risk
is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). Real estate is illiquid because it may take weeks, months, or even years to sell.
liquidity
The speed and ease with which an asset can be converted to cash.
liquidity risk
The risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).
• Marketability risk. When you have to sell a certain asset quickly, it may not sell at or near the market price. This possibility is referred to as marketability risk. Selling real estate in a hurry, for example, may require the seller to substantially reduce the price in order to sell to a willing buyer.
• Reinvestment risk. Reinvestment risk is the risk that the return on a future investment will not be the same as the return earned by the original investment.
13.3c Commission Costs Reduce Returns
Buying and selling investments may result in a number of transaction costs. Examples include “fix-up costs” when preparing a home for sale, appraisal fees for collectibles, and storage costs for precious metals.
Commissions
are usually the largest transaction cost in investments. These are fees or percentages of the units or selling price paid to salespeople, agents, and companies for their services—that is, to buy or sell an investment. The commission charged to buy an investment (one commission) and then later sell it (a second commission) is partially based on the value of the transaction.
commissions
Fees or percentages of the selling price paid to salespeople, agents, and companies for their services in buying or selling an investment.
Commission ranges are as follows: stocks, 1.5 to 2.5 percent (although trades can be made on the Internet for less than $10); bonds, 0 to 2.0 percent; mutual funds, 0 to 8.5 percent; real estate, 4.5 to 7.5 percent; options and futures contracts, 4.0 to 6.0 percent; limited partnerships, 10.0 to 15.0 percent; and collectibles, 15.0 to 30.0 percent.
DID YOU KNOW
“Improve Returns by Minimizing Expenses”
Vanguard’s Total Stock Index mutual fund charges a mere 0.17% in management expenses while the typical actively managed mutual fund charges 1.4%. The results after 30 years of investing $4000 annually with both accounts earning 5 percent: Low management fee: $270,594 ; high management fee: $217,479. An extra $53,115 is a big difference!
13.3d Leverage May or May Not Increase Returns
Another factor that can affect return on investment is
leverage
. In the leveraging process, borrowed funds are used to make an investment with the goal of earning a rate of return in excess of the after-tax costs of borrowing. You can become financially overextended by using leverage, a factor you should not ignore. For example, housing investors during the last decade were shocked when home values declined 5, 10, or even 15 percent in a year, thus forcing many real estate investors into bankruptcy. In many U.S. cities housing prices dropped 50 percent or more. Now prices are rising in most markets.
leverage
Using borrowed funds to invest with the goal of earning a rate of return in excess of the after-tax costs of borrowing.
CONCEPT CHECK 13.3
1. Distinguish between random risk and market risk.
2. Summarize three other types of investment risks that may affect returns.
3. Explain how transactions costs and leverage may increase or decrease investment returns.
13.4 ESTABLISHING YOUR LONG-TERM INVESTMENT STRATEGY
Investing is not rocket science! Anyone reading this book and following its recommendations for making long-term investments can become a successful investor.
LEARNING OBJECTIVE 4
Decide which of the four long-term investment strategies you will utilize.
13.4a Long-Term Investors Understand Bull and Bear Markets and Corrections
Long-term investors understand how the
securities markets
(places where stocks and bonds are traded) are performing as a whole. That is, are the markets moving up, moving down, or remaining stagnant?
securities markets
Places where stocks and bonds are traded (or in the case of electronic trading, the way in which securities are traded).
Bull Markets Are Profitable for Investors A
bull market
results when securities prices have risen 20 percent or more over time. Historically, the more than 20 bull markets averaging 55 months in length have seen an average gain of 159 percent.
bull market
Market in which securities prices have risen 20 percent or more over time.
Bear Markets Turn into Bull Markets A securities market in which prices have declined in value by 20 percent or more from previous highs, often over the course of several weeks or months, is called a
bear market
. Four bear markets have occurred since 1980. Bear markets are what clear the decks for a longer-lasting recovery and drives valuations down to truly low levels from which bigger gains can spring.
bear market
Market in which securities prices have declined in value by 20 percent or more from previous highs, often over the course of several weeks or months.
The bear market that started in October 2007 saw stock prices decline 55 percent by March 2009. Then the optimistic bull buyers took over thinking that surely the U.S. economy had already reached rock bottom and that stock prices were certain to rise as the economy recovered. Since March 9, 2009 when stock prices stopped falling the U.S. bull market saw a 100+ percent rally in just a few years, a gigantic move, and tech stocks rose an amazing 200+ percent in 5 years.
A bull in the market is a person who expects securities prices to go up; a bear expects the general market to decline. The origin of these terms is unknown, but some suggest that they refer to the ways that the animals attack: Bears thrust their claws downward, and bulls move their horns upward. Historically, bear markets last, on average, about 9 months; bull markets average 55 months in length.
Market Corrections Also Occur Another type of short-term market trend is called a market correction, which typically occur every 18 months. A
market correction
is a reverse movement of at least 10 percent in a stock, bond, commodity, or index to adjust for recent price rises. They interrupt an uptrend in the market or an asset.
market correction
A short term price decline in the stock markets of at least 10 percent in a stock, bond, commodity or index to adjust for a recent price rises.
13.4b Long-Term Investors Accept Substantial Market Volatility
In an average year, the price of a typical stock fluctuates up and down by about 50 percent; thus, the price of a stock selling for $30 per share in January might range from $15 to $45 before the end of the following December. It is not unusual for overall stock market prices to fall (or rise) 3, 4, or 5 percent in a single day. In a recent year the stock market fluctuated 11 times by more than 4 percent in one day. That tells us that today’s stock markets are riskier than yesterday’s. Terrifying daily swings are likely to remain a constant during these turbulent economic times. Such swings are today’s “new normal.”
Long-term investors who get scared during market downturns and withdraw most or all of their investing dollars miss out on the subsequent increase in prices during the next up market. Long-term investors must learn to accept
market volatility
by ignoring short-term market movements.
market volatility
The likelihood of large price swings in securities due to a company’s success (or lack of it) and various market conditions.
13.4c Long-Term Investors Do Not Practice Market Timing
Investors get into trouble when they start to think too much like traders.
Market timers
attempt to predict the short-term movements of various markets (or market segments) and, based on those predictions, move capital from one segment to another in order to capture market gains and avoid market losses. Essentially, market timers try to outguess the trend of stocks or other prices. For example, an investor worried about the future might sell his or her stock investments and move to cash. Another investor who anticipates increasing future stock prices might get 100 percent invested in stocks.
market timers
Investors who attempt to predict the short-term movements of various markets (or market segments) and, based on those predictions, move capital from one segment to another in order to capture market gains and avoid market losses.
To succeed in timing the market, you need to know just the right time to buy and just the right time to sell, know what signals suggest you take action, and exhibit the discipline to do it. Market timers often sell at the first sign of trouble and then keep their money out of the market until better opportunities are apparent. If you try to time the market, you are just as likely to miss an upswing as you are to avoid a downswing. Note that market timers are competing against graduates from Chicago, Stanford, and Wharton who do the same job full time for big paychecks.
Market Timing Loses Money
Market efficiency
has to do with the speed at which new information is reflected in investment prices. The theory is that security prices are reflective of their true value at all times because publicly available information has driven market prices to the correct level.
market efficiency
The speed at which new information is reflected in investment prices suggesting that security prices are reflective of their true value at all times because publicly available information has driven market prices to the correct level.
When information is reported in the financial press, it is already too late for the typical investor to act and make a profit. And individuals don’t always even know which information is relevant. Therefore, individual investors cannot pursue an active investment strategy that beats the market because they are just as likely to invest in an overpriced security rather than one that is undervalued. Thus, these investors typically earn substantially less than average market returns every year.
Not surprisingly, stock analysts and investment managers believe they can make better choices than the average investor in part because they can act on information more quickly than other investors. The reality, however, is that 70 to 80 percent of investment managers, and oftentimes 90 percent in any given year fail to beat the average returns of the stock market.
DID YOU KNOW
Women Are Better Investors than Men
Research suggests that women are better investors than men. The big reason is that men are overconfident about their financial prowess and as a result they make more mistakes. A woman’s investment portfolio exceeds a man’s by about 1 percentage point every year. Investing $4000 annually for 30 years earning 6 percent shows that a woman’s portfolio will amount to $316,000 and the man’s earning 5 percent will be $266,000, a $50,000 difference, which adds up to 18.8 percent more.
13.4d Long-Term Investors Avoid Trading Mistakes
Long-term investors avoid trading mistakes by not trading too much, buying high and selling low, and by avoiding herd behavior.
Trading Too Much Loses Money One cause of lower returns is trading too much. The more you trade, the more likely you are to make a wealth-destroying mistake. Such investors also often sell winners too soon and keep losers too long. Don’t make the mistake of trading when you should be investing.
Buying High and Selling Low Loses Money Emotion, not logic, often rules investing decisions. Investors often overreact when buying and selling as their thinking goes through alternating times of panic and euphoria. When plunging portfolio values become too much to accept, investors just want the pain to end so they sell, which presumably means big losses. This is “buying high and selling low,” which is the opposite of what investors should do.
Herd Behavior Loses Money At the other extreme, when the market prices are rapidly rising, people are fooled into thinking that it is safe to invest more (“I’ve got to put more money in there”) and lose their sense of caution because it must be safe if everyone else is buying. People follow the crowd and tend to push stock prices too far up or down. They look at behavior and assume it is based on knowledge, but often it’s not. This is an illustration of
herd behavior
, which arises when investors decide to copy the observed decisions of other investors or movements in the markets rather than follow their own beliefs and information.
herd behavior
When emotion, not logic, rules investing decisions and investors decide to copy the observed decisions of other investors or movements in the markets rather than follow their own beliefs and information.
Herd behavior happens in part because people feel compelled to look at prices in the newspaper every day or watch the 24-hour financial news chatter, such as CNBC and CNN, whose TV talking heads spew financial factoids with minute-by-minute updates and sensationalize every blip in the stock markets. Such arcane and sometimes meaningless information creates anxiety or mania that can lead to bad decision making. Acquiring more “facts” is not the same as gaining knowledge or expertise.
The kinds of news and information on cable news and the blogosphere is not designed to appeal to our long-term, rational thought processes. It excites our emotions and fears, and sometimes stokes our prejudices and cynicism. It compels action, not patience. Therefore, ignore that kind of news and information. Stay focused on your long-term investing strategy and make decisions accordingly; otherwise, your returns will be less than the averages, like those of most American investors.
Long-Term Investors Avoid Too Many “Facts.”
13.4e There Are Only Four Strategies for Long-Term Investors
To succeed financially, you must establish your own long-term investment strategies. And follow them! Don’t sabotage your plan by doing stupid thing like those described above. There are only four long-term investment strategies to follow, and they all hang together.
Strategy 1: Buy-and-Hold Anticipates Long-Term Economic Growth The secret to long-term investing success is benign neglect. Long-term investors need to relax with the confidence and knowledge that investing regularly and not trading frequently will create a substantial portfolio over time. Long-term investors do not follow or react emotionally to the day-to-day changes that occur in the market. Ignoring them is the best advice. Because most people are overly sensitive to short-term losses, daily monitoring could motivate one to make shortsighted buying and selling decisions.
Selling high-quality assets in a bear market is a poor strategy because sellers lock in their losses, plus they fail to realize that bear markets are typically short in duration (about 9 months). It is smart to buy more shares when prices are lower during market downturns because rising prices in a bull market always follow a bear market.
Most long-term investors use the investment strategy
buy and hold
(also called
buy to hold
). That is, they buy a widely diversified mix of stocks and/ or mutual funds, reinvest the dividends by buying more stocks and mutual funds, and hold on to those investments almost indefinitely. With this approach, the investor expects that the values of the assets will increase over the long run in tandem with the growth of the U.S. and world economies. The investments may pay some current income as well. The investor’s emphasis is on holding the assets through both good and bad economic times with the confidence that their values will go up over the long term. This is a wise strategy.
buy and hold/buy to hold
Investment strategy in which investors buy a widely diversified mix of stocks and/or mutual funds, reinvest the dividends by buying more stocks and mutual funds, and hold onto those investments almost indefinitely.
Some critics argue that “buy and hold” is a discredited concept. But they are wrong because this remains the best approach for investing over 20 years or longer. Long-term investors must have the patience and fortitude necessary to tolerate bear markets, no matter how severe.
Buy and hold does not mean buy and ignore. Review your whole portfolio once a year to make sure that each remains a good investment. Questions to ask include: “Is the valuation too high?”; “Has the fundamental outlook of the company changed?”; “Does this asset still fit my investment plan?”; “Would I buy it today?” If necessary, sell the asset and keep the remainder of your portfolio.
FINANCIAL POWER POINT
The Stock Market Is for Long-Term Investors
While average return of the stock market has been 9.6 percent annually for almost 100 years, it still does okay even in terrible economic times. If you had invested at the peak of the market’s March 2000 high and then survived the following two horrible bear markets, you still would have earned 3.5 percent annually.
Strategy 2: Dollar-Cost Averaging Buys at “Below-Average” Costs
Dollar-cost averaging
(or
cost averaging
) is a systematic program of investing equal sums of money at regular intervals regardless of the price of the investment. In this approach, the same fixed dollar amount is invested in the same stock or mutual fund at regular intervals over a long time. Since investments generally rise more than they fall, the “averaging” means that you purchase more shares when the price is down and fewer shares when the price is high. Most of the shares are, therefore, purchased at
below-average costs
.
dollar-cost averaging/cost averaging
Systematic program of investing equal sums of money at regular intervals, regardless of the price of the investment.
below-average costs
Average costs of an investment if more shares are purchased when the price is down and fewer shares are purchased when the price is high.
This strategy avoids the risks and responsibilities of investment timing because the stock purchases are made regularly (usually every month) regardless of the price. It also ignores all outside events and short-term gyrations of the market, providing the investor with a disciplined buying strategy.
Table 13-1
shows the results of dollar-cost averaging for a stock under varying market conditions (commissions are excluded). As an example, assume that you invest $300 into a stock every three months. Notice that dollar-cost averaging is successful in all three scenarios illustrated.
Dollar-Cost Averaging in a Fluctuating Market
To illustrate the effects of dollar-cost averaging, assume that you first invested funds during the “fluctuating market” shown in Table 13-1. Because the initial price is $15 per share, you receive 20 shares for your investment of $300. Then the market drops—an extreme but easy-to-follow example—and the price falls to $10 per share. When you buy $300 worth of the stock now, you receive 30 shares. Three months later, the market price rebounds to $15 and you invest another $300, receiving 20 shares. The price then drops and rises again.
DID YOU KNOW
Sean’s Success Story
Sean’s financial life continues successfully. Only six years past college graduation, he has a retirement plan at work now worth over $90,000. He continues to have an aggressive investment philosophy and is invested in six mutual funds through his job. After paying off his car three years ago, Sean continued to make payments to himself, thus building up his savings account as well, which now is over $20,000. He is worried about the economy even though it has been rising recently, so he is keeping those dollars out of the stock market for the time being. Sean’s employer recently announced that employees may now contribute up to 8 percent of their salaries to their retirement plan with a full match, so he is going online this weekend to bump up his contribution from 6 to 8 percent.
Table 13-1 Dollar-Cost Averaging for a Stock or Mutual Fund Investment
You now own 120 shares, thanks to your total investment of $1500. The
average share price
is calculated by averaging the amounts paid for the investment: Simply divide the share price total by the number of investment periods. In this example, the average share price is $13 ($65 ÷ 5). The
average share cost
, a more meaningful amount, is the actual cost basis of the investment used for income tax purposes. It is calculated by dividing the total amount invested by the total shares purchased. In this example, it is $12.50 ($1500 4 120). Based on the recent price of $15 per share, each of your 120 shares is worth on average $2.50 ($15 – $12.50) more than you paid for it. Thus, your gain is $300 (120 × $2.50; or $15 × 120 = $1800, $1800 − $1500 = $300).
average share price
Calculated by dividing the share price total by the number of investment periods.
average share cost
Actual cost basis of the investment used for income tax purposes, calculated by dividing the total amount invested by the total shares purchased.
Dollar-Cost Averaging in a Declining Market
Markets may also decline over a time period. The “declining market” columns in Table 13-1 (representing a prolonged bear market of 15 months) show purchases of 190 shares for increasingly lower prices that eventually reach $5 per share at the bottom of the business cycle. In a declining market, if you keep investing using dollar-cost averaging, you will purchase a large volume of shares. If you sell when the market is down substantially, you will not profit. In this example, you have purchased 190 shares at an average cost of $7.89, and they now have a depressed price of $5. Selling at this point would result in a substantial loss of $550 [$1500 ‒ (190 × $5)]. Investing during a lousy market can be a benefit because shares are accumulated at low prices.
Dollar-Cost Averaging in a Rising Market
During the “rising market” in Table 13-1, you continue to invest but buy fewer shares. The $1500 investment during the bull market bought only 140 shares for an average cost of $10.71. In this rising market, you profit because your 140 shares have a recent market price of $20 per share, for a total value of $2800 (140 × $20).
Almost anyone can profit in a rising market. If you use dollar-cost averaging over the long term, you will continue to buy in rising, falling, and fluctuating markets. The overall result will be that you buy more shares when the cost is down, thereby lowering the average share cost to below-average prices. The totals in Table 13-1, for example, reveal an overall investment of $4500 ($1500 + $1500 + $1500) used to purchase 450 shares (120 + 190 + 140) for an average cost of $10 per share ($4500 × 450). With the recent market price at $20, you will realize a long-term gain of $4500 ($20 current market price × 450 shares = $9000; $9000 − $4500 invested = $4500 gain). Note that the dollar-cost averaging method would remain valid if the time interval for investing were monthly, quarterly, or even semiannually. The benefits of dollar-cost averaging are derived, in part, from the regularity of investing.
ADVICE FROM A PROFESSIONAL
Use a Dividend-Reinvestment Plan to Dollar-Cost Average
Many well-known companies allow investors to purchase shares of stock on a dollar-cost basis directly from them without the assistance of a stockbroker and then to continue to invest on a regular basis with low or no brokerage commissions. Such a program is known as a dividend-reinvestment plan (DRIP). You simply sign up with the company, agreeing to buy a certain number of shares and to reinvest cash dividends into more shares of stock for little or no transaction fees. Investors’ accounts are credited with fractional shares, too.
The Direct Stock Purchase Plan Clearinghouse at
www.dripinvestor.com/clearinghouse/home.asp
manages the DRIP for many companies. Coca Cola (stock symbol KO) is illustrative. It requires a minimum investment of $500 or minimum monthly investments of $50 each for at least 10 months. The enrollment fee is $10. Coca Cola will buy back shares for a transaction fee of only $15. Other companies offering DRIPs include AT&T, ExxonMobil, Home Depot, McDonald’s, Johnson & Johnson, Verizon, and Chevron.
Jon Wentworth
Southern Adventist University, Collegedale, Tennessee
Dollar-Cost Averaging Offers Two Advantages
The first advantage is that it reduces the average cost of shares of stock purchased over a relatively long period. Profits occur when prices for an investment fluctuate and eventually go up. Although this approach does not eliminate the possibility of loss, it does limit losses during times of declining prices. And profits accelerate during rising prices.
The second advantage is that dollar-cost averaging dictates investor discipline. This strategy of investing is not particularly glamorous, but it is the only approach that is almost guaranteed to make a profit for the investor. It takes neither brilliance nor luck, just discipline. People who invest regularly through individual retirement accounts (IRAs), employee stock ownership programs, and 401(k) retirement plans (all discussed in
Chapter 17
) enjoy the benefits of dollar-cost averaging. Dollar-cost averaging is a systematic strategy that will eventually get your portfolio where you want it to be.
Strategy 3: Portfolio Diversification Reduces Portfolio Volatility Owning too much of any one investment creates too great a financial risk. Experts advise that you never keep more than 5 or 10 percent of your assets in one investment, including your employer’s stock. Many workers who invested too much in their employer’s stock have seen their retirement funds disappear or be drastically reduced in value when their employers’ stocks plunged in price.
DID YOU KNOW
The Tax Consequences in Investment Fundamentals
There are some favorable aspects to income taxes to think about when making investments.
1.
Income versus capital gain
. Current investment income, such as dividends and interest, is taxed at one’s marginal tax bracket, likely 25 percent. Capital gains are taxed at special lower rates, likely at 10 or 15 percent.
2.
Tax-deferred investments
. The income and capital gains from investments within employer-sponsored retirement accounts are not subject to income taxes until the funds are withdrawn. Thus such investments rise in value much more quickly than those that are taxed.
3.
After-tax return
. When comparing similar investments, your objective is to earn the best after-tax return. This return is the net amount earned on an investment after payment of income taxes. (See Equation 4.1 on page 129.)
4.
Tax-exempt income
. Income earned from municipal bonds is exempt from federal income taxes.
5.
Tax-exempt investments
. The income and capital gains from investments within Roth IRA accounts are not subject to income taxes, unless the funds are removed from the account within five years of opening it.
Figure 13-3
Diversification via Asset Allocation Averages Out An Investor’s return
This chart represents a hypothetical mix of winning and losing various investments after one year. One investment, for instance, increased in value 13 percent; another declined 6 percent. While some investments lost value, over the year those losses were offset with the gains of others, and the overall portfolio earned a 7.1 percent average return.
Diversification is the single most important rule in investing.
Portfolio diversification
is the practice of selecting a collection of different asset classes of investments (such as stocks, bonds, mutual funds, real estate, and cash) that are chosen not only for their potential returns but also for their dissimilar risk-return characteristics.
portfolio diversification
Practice of selecting a collection of different asset classes of investments (such as stocks, bonds, mutual funds, real estate, and cash) that are chosen not only for their potential returns but also for their dissimilar risk-return characteristics.
The goal of portfolio diversification is to create a collection of investments that will provide an acceptable level of return and an acceptable exposure to risk. This outcome can be achieved because asset classes typically react differently to economic and marketplace changes. The major benefit of having a diversified portfolio is that when one asset class performs poorly, there is a good chance that another will perform well, and vice versa, thus this strategy helps control your exposure to risk.
As shown in Figure 13-3 diversification reduces portfolio volatility while averaging out an investor’s return. If you were totally invested in the investment that rose 13 percent, you would be happy; if you were totally invested in the investment that declined 10 percent, you would be sad. Instead your diversified portfolio over 9 investments averaged 7.1 percent, which is a respectable return. Diversification lowers the odds that you will lose money investing and increases the odds that you will make money.
The lack of diversification can quickly destroy one’s investment portfolio. All stock prices dropped dramatically (actually 55%) during the Great Recession.
Table 13-2
illustrates the point demonstrating that when stocks crash 50 percent, a $200,000 portfolio that is poorly diversified (too heavy on equities in this case) is devastated, in this case down $85,000.
Strategy 4: Asset Allocation Keeps You in the Right Investment Categories for Your Time Horizon
Asset allocation
, a form of diversification, is deciding on the proportions of your investment portfolio that will be devoted to various categories of assets. Asset allocation helps preserve capital by selecting assets so as to protect the entire portfolio from negative events while remaining in a position to gain from positive events. This strategy helps control your exposure to risk.
asset allocation
Form of diversification in which the investor decides on the proportions of an investment portfolio that will be devoted to various categories of assets.
Asset allocation rather than your choice of specific securities is the most important determinant of financial success. Research shows that more than 90 percent of returns earned by long-term investors result from having one’s assets allocated in a diversified portfolio. Thus you must strive to own the right asset categories at the right time.
Your allocation proportions and investment choices need to reflect your age, income, family responsibilities, financial resources, risk tolerance, goals, retirement plans, and investment time horizon. You need not change the proportions of your asset allocation until your broad investment goals change—possibly not for another five or ten years. When your investment objectives change, perhaps because of marriage, birth of a child, child graduating from college, loss of employment, divorce, or death of a spouse, you may need to change your asset allocation as well. Otherwise, stay the course.
Table 13-2 The Great Recession Devastated Portfolios That Were Not Well Diversified
Asset Allocation Requires Only Three Types of Investments
To achieve an appropriate mix of growth, income, and stability in your portfolio, you need a combination of three investments: (1) stocks and/or stock mutual funds (equities), (2) bonds (debt), and (3) cash (or cash equivalents like Treasury securities). You need a little cash or cash equivalents in your portfolio because this allows you to move more money into stocks when appropriate. Asset allocation requires that you keep your equities, debt, and cash at a fixed ratio for long time periods, occasionally rebalancing the allocations, perhaps quarterly or annually, so as to continue to meet your investment objectives.
Asset Allocation Rules of Thumb
Consider these two rules of thumb to guide the stock and bond allocation of your portfolio:
1. The percent to invest in equities is 110 minus your age, multiplied by 1.25. For example, if you are 40 years old, calculate as follows: 110 − 40 = 70; 70 × 1.25 = 87.5. Therefore, a 40-year-old investor is advised to maintain a portfolio where 87.5 percent of the assets are in equities and 12.5 percent are in bonds and cash equivalents.
2. The percent to invest in equities is found by subtracting your age from 120. Put the resulting number in the form of the percentage of your portfolio to invest in stocks. Put the remainder in bonds. So if you are age 30, put 90 percent (120 — 30) in stocks and 10 percent in bonds and cash. Every year, subtract your age from 120 again and rebalance your portfolio as needed.
Know Your Risk Tolerance and How Much Time You Have to Invest
Figure 13-4
illustrates model portfolios that reflect varying degrees of risk tolerance and time horizons. A young, risk-tolerant, long-term investor with an aggressive investment philosophy might have a portfolio that is 100 percent in equities because equities offer the highest return over the long term. Younger investors also have ample time to ride out market fluctuations and make up any major losses. A moderate approach with a time horizon of six to ten years might have an equities-bond-cash portfolio of 60/30/10 percent.
Rebalance Your Investments at Least Once a Year
Portfolio rebalancing is the process of bringing the different asset classes back into proper relationship following a significant change in one or more of them. You must reset your asset allocation to return your portfolio to the proper mix of stocks, bonds, and cash when they no longer conform to your plan. Here is why.
Figure 13-4
Asset Allocation and Time Horizons
Assume you have a moderate investment philosophy and started out with a 50/40/10 bond-equities-cash portfolio, as shown in
Figure 13-5
, and a year later, stock values increased to 49 percent of your portfolio’s value while bonds dropped to 42 percent. The result: Your portfolio is now too heavy in stocks and too light in bonds. It is too risky. As shown in Figure 13-5, this suggests that you sell some of your equities and use the proceeds to buy more bonds, thus rebalancing your portfolio according to your previously determined asset allocations.
When rebalancing, you will be selling high and buying low—the goal of all investors. It is temperamentally difficult for investors to rebalance. They don’t like to sell assets that have increased in value because they hope those values will continue to increase. Rebalancing is an appropriate form of market timing as it provides some of the benefits of market timing without the risk.
Figure 13-5
Rebalance Assets in Your Investment Portfolio Even Though Values Increased
DO IT IN CLASS
ADVICE FROM A PROFESSIONAL
When to Sell an Investment
It is time to consider selling an investment when one of the following conditions has been met:
• Something significant about the company’s business or its earnings has changed dramatically for the worse since you bought the company’s stock.
• The stock is doing so well that it is overvalued, and the share price is much higher than what you believe the company is worth.
• The investment is performing poorly and causing you undue anxiety. The great financier Bernard Baruch advised, “Sell down to the level where you are sleeping well.”
• You need cash for a worthwhile purpose, and this investment appears the most fully priced.
• The investment no longer fits your situation or goals, and you have a more promising place to invest your money.
Diann Moorman
University of Georgia
About half of employees who participate in their employer-sponsored retirement plan have access to paid services that automatically rebalance employees’ retirement assets. A worker can sign up for the services of a
limited managed account
. Once you have signed a contract with a vendor approved by your employer, you decide on your preferred asset allocation. Then under supervision by the limited managed account contract the company sells and buys your mutual fund assets, usually quarterly, on your behalf each time adjusting your portfolio back to your specified asset allocation percentages.
limited managed account
An account at an investment firm whereby, for a fee, they sell and buy your mutual fund assets, usually quarterly, on your behalf to automatically rebalance your portfolio back to your specific standards.
The service may be paid for entirely or just subsidized by the employer. A study by Financial Engines and Aon Hewitt of 425,000 savers over 5 years found that the median annual returns of those workers who got these services was almost 3 percentage points higher than those who invested on their own. Financial Soundings charges $20 annually, and both Betterment and SigFig Wealthfront charge 0.25 percent annually. Similar programs are offered by Morningstar and Financial Engines.
DID YOU KNOW
Bias toward Not Selling
People engaged in the understanding investment fundamentals have a bias toward certain behaviors that can be harmful, such as a tendency toward refusing to sell poorly performing investments that have lost value, clinging to the hope that the assets will eventually regain their old values. What to do? Regularly monitor your portfolio and sell investments that are no longer providing the desired return and then reinvest the money elsewhere.
CONCEPT CHECK 13.4
1. Summarize what the buy-and-hold strategy is all about.
2. Explain the concept of dollar-cost averaging including why one invests at below-average costs.
3. What is the goal of portfolio diversification, and how is this accomplished?
4. What is asset allocation, and why does it work?
5. What happens to a worker’s 401(k) retirement account if he or she signs up for a limited management account service?
13.5 USE MONTE CARLO ADVICE TO HELP YOU INVEST FOR RETIREMENT
Employer-based financial advice must follow the requirements of the Pension Protection Act. The advice must be based on computer simulations of projected investment performance using
Monte Carlo analysis
, an evolution of the long-term strategy of asset allocation. Here, the goal is to identify the investor’s acceptable level of risk tolerance and then find an optimal portfolio of assets that may reduce overall portfolio volatility while providing the highest expected returns for that level of risk. This technique performs a large number of trial runs of a particular portfolio mix of investments, called simulations.
Monte Carlo analysis
Technique that performs a large number of trial runs of a particular portfolio mix of investments, called simulations, to find an optimal allocation for a particular investor’s goals and risk tolerance.
LEARNING OBJECTIVE 5
Use Monte Carlo Advice when investing for retirement.
13.5a Monte Carlo Simulations
Monte Carlo simulations, named for the famous casino site, can be used to model the performance of hundreds or even thousands of individual mutual funds and stocks through thousands of fluctuating securities markets. The simulations allow you to estimate the probability of reaching your financial goals, such as a specific retirement income at a certain point in the future.
The mathematical simulations are based on long-term historical risk and return characteristics for various mixes of stock, bond, and short-term investment asset classes. Each simulation estimates how much you need to save—the accumulation phase—of your investments performed better or worse than expected, and it gives the odds that your assets will last throughout the retirement time period—the distribution phase—after you choose a given set of investments and establish a withdrawal amount. These calculations are probabilities, not certainties.
By using Monte Carlo simulations, investors can get a fairly realistic view of how much their current investments may yield in retirement. Investors often learn that they are playing it too safe by investing too conservatively, and this may prevent them from reaching their goals. By evaluating the trade-offs among various combinations of retirement plan contribution levels, diverse investment mixes, overall portfolio risk, projected retirement age, and retirement income goals, Monte Carlo simulations let you understand how certain changes in these factors will affect the chance that you will have enough money in retirement. Some investors may have to learn to be comfortable with increased risk, while others may have to save more or work longer. See
Figure 13-6
for illustrative Monte Carlo calculations.
13.5b Monte Carlo Software Programs Available
Software programs can be used to assist investors in creating an efficient portfolio using Monte Carlo simulations. Products are available from Financial Engines, Financial Soundings, Morningstar, and Vanguard. Many employers offer employees free or low-cost access to Monte Carlo analysis as an employee benefit for retirement planning, often through an outside firm that offers limited management accounts.
DID YOU KNOW
Your Worst Financial Blunders in Investment Fundamentals
Based on others’ financial woes, you will make mistakes in personal finance when you:
1. Buy and sell more than you should.
2. Diversify less than you should.
3. Hold on to a bad investment long after evidence shows it was a bad decision.
Figure 13-6
Monte Carlo Simulation from Financial Engines
CONCEPT CHECK 13.5
1. Review Figure 13-6, Monte Carlo Simulation from Financial Engines, and give your impressions of the “New Strategy” recommendations.
2. What do you think about paying $20 a year for Monte Carlo simulations through your employer from a limited management company?
LEARNING OBJECTIVE 6
Create your own investment plan.
13.6 CREATING YOUR OWN INVESTMENT PLAN
To create an
investment plan
, which is a reflection of your investment philosophy and your logic on investing to reach specific goals, see the illustrated plan for Christina Garcia in
Figure 13-7
. Christina’s plan includes saving for retirement as well as to buy a vehicle. You can begin creating your own investment plan by identifying your financial goals and explaining your investment philosophy as called for in Steps 1 and 2 in Figure 13-7.
investment plan
An explanation of your investment philosophy and your logic on investing to reach specific goals.
To help in your thinking for Step 3 in Figure 13-7, consider the time horizons of various investments. (Terms new to you are explained in the chapters that follow.) What are the time horizons for your investment goals? Are you building up an amount for a down payment on a home, creating a college fund for a child, or putting away money for retirement? Or are all three time horizons relevant? Keep in mind why you are investing and proceed accordingly. Now calculate the numbers. How much money do you need to achieve each goal, and by when? What is the total of your current investment assets? Do the math.
Step 4 in Figure 13-7 asks about investment alternatives. Review Figure 13-1 on the long-term rates of return on various investments. Then examine Figure 13-2 because it shows the trade-offs between risk and return on investment alternatives. Next take a pencil or pen and delete some investment choices that do not appeal to you or match your investment philosophy. You will be left with alternatives that better fit your investment goals and philosophy.
FINANCIAL POWER POINT
Create Your Financial Plan on the Web
To obtain an overall assessment of your financial progress and advice on how to achieve your goals, you may want to consult an online financial advisor to construct a financial plan. Prices vary from $250 to $500 or more. Check out Fidelity .com, Schwab.com, TRowePrice.com, and Vanguard.com.
DID YOU KNOW
Turn Bad Habits into Good Ones
Do You Do This?
Make small contribution to employer’s retirement plan
Invest conservatively for retirement
Try to time investments to market ups and downs
Ignore transaction costs on investments
Invest mostly in employer’s stock
Do This Instead!
Contribute the maximum
Invest aggressively for long-term goals
Stay invested for the long term
Hold down transaction costs
Reduce holding to 5 or 10 percent
Figure 13-7
Christina Garcia’s Investment Plan
After some thinking and reading, Christina, age 24, jotted down some investment plan notes.
DO IT NOW!
You know more about investment fundamentals after reading this chapter, so get started right now by:
1. Writing down your investment philosophy.
2. Recording the percentages you would allocate to stocks, bonds, and cash equivalents using an asset allocation strategy to save for retirement.
3. Starting to save even a small amount perhaps by signing up to automatically transfer some money every payday to a savings or investment account.
Now you have started to create an investment plan, so record your responses to Steps 5, 6, and 7. Then create an investment portfolio appropriate for your life now using Figure 13-4 as a model. All that remains is to put your plan into action. That means filling out forms to open an investment account, selecting your investments, writing checks for your first investing dollars, and monitoring your investments. These topics are examined in the chapters that follow.
When you take the appropriate retirement planning action steps, including a moderate amount of risk when investing, you will be able to relax with the confidence that you are making wise decisions about your investment assets and the knowledge that your money will grow and will be there to fund your lifestyle during the last quarter of your life.
CONCEPT CHECK 13.6
1. Review
Figures 13-1
and 13-2, and record in writing an investment plan to fund your retirement, presumably one of your own long-term goals.
WHAT DO YOU RECOMMEND NOW?
Now that you have read the chapter on investment fundamentals, what do you recommend to Shavenellyee and Sarena on the subject regarding:
1. Portfolio diversification for Shavenellyee?
2. Dollar-cost averaging for Shavenellyee?
3. Investment alternatives for Shavenellyee?
BIG PICTURE SUMMARY OF LEARNING OBJECTIVES
LO1 Explain how to get started as an investor.
Before investing, think about how investing is more than savings, the investment returns which are possible, and the long-term rates of return on investment choices. Investors hope that their investments will earn them a positive total return, which is the income an investment generates from current income and capital gains.
LO2 Identify your investment philosophy and invest accordingly.
Achieving financial success requires that you understand your investment philosophy and adhere to it when investing. An investment philosophy is one’s general approach to tolerance for risk in investments, whether it is conservative, moderate, or aggressive, given the financial goals to be achieved. You also need to know about investment risk and what to do about it. Before investing your money, you need to think about lending versus owning, short term versus long term, and how to select investments that are likely to provide your desired potential total return.
LO3 Describe the major risk factors that affect the rate of return on investments.
Because of the uncertainty that surrounds investments, people often follow a conservative course in an effort to keep their risk low. Being too conservative when investing means that they risk not reaching their financial goals. To be a successful investor, you must understand the major risk factors that affect the rate of return on investments so you can then take the appropriate risks when making investment decisions. Key concepts include random and market risk.
LO4 Decide which of the four long-term investment strategies you will utilize.
To succeed as an investor, you must establish your own long-term investment strategy. Most investors accept the fact that they cannot time the market with any consistency. Most long-term investors are passive investors. They wisely ignore the ups and downs of the stock market and the business cycle and simply use the four investment strategies of buy and hold, dollar-cost averaging, diversification, and asset allocation. Rebalancing your portfolio at least once a year is critical to success.
LO5 Use Monte Carlo Advice when investing for retirement.
By using Monte Carlo simulations, investors can get a more realistic view of how much their current investments may yield later on during retirement. Investors may learn that they are playing it too safe by investing too conservatively today, and this may prevent them from reaching their long-term goals. Some investors may have to learn to be comfortable with increased risk, while others may have to save more or work longer.
LO6 Create your own investment plan.
An investment plan is an explanation of your investment philosophy and your logic on investing to reach specific goals. Steps include identifying your goals, contemplating which types of investments might best fit your investment goals, clarifying your investment philosophy, learning about investment alternatives, and narrowing down your choices.
LET’s TALK ABOUT IT
1. Why Invest. Why should people invest? Give three reasons each for college students, young college graduates in their 20s, couples with young children, and people in their 50s.
2. Long-Term Rates of Return. Review Figure 13-1, “Long-Term Rates of Return on Investments” on page 383. and offer your views on which two investment types would be most suitable for yourself.
3. Market Risk. What do you think is the likelihood of years of poor stock market returns.
4. What Is Your Tolerance for Risk in Investing? Is it the same as for other members of your class? Why or why not?
5. Risk and Return Trade-Offs. Review Figure 13-2, “The Risk Pyramid Reveals the Trade-Offs Between Risk and Return” on page 385 and give your views on which three investments would be most suitable for you.
6. Your Investment Philosophy. Is your investment philosophy conservative, moderate, or aggressive? Give two reasons to support the adoption of your philosophy. How does your view compare with the philosophies of other members of your class?
7. Review the section on “Types of Investment Risks” on page 391, and note two that might worry you the most in the world of investing.
DO IT IN CLASS
PAGE 391
8. Invest How Much? Assume you have graduated from college and have a good-paying job. If you had to commit to investing regularly right now, how much money would you put away every month? Explain why. How does your view compare with the views of other members of your class?
DO THE MATH
1. Annual Investments. Sheldon Cooper and Amy Farrah live in Pasadena, California, have as a new investment goal to create a college fund for their newborn daughter. They estimate that they will need $200,000 in 18 years. Assuming that the Cooper-Fowler family could obtain a return of 5 percent, how much would they need to invest annually to reach their goal? Use Appendix A-3 or the Garman/Forgue companion website.
2. Number of Years. Mary Cooper, Sheldon’s mother, who lives in Texas, wants to help pay for her grandchild’s education. How long will it take Mary to reach her goal of $200,000 if she invests $10,000 per year, earning 6 percent? Use Appendix A-3 or the Garman/Forgue companion website.
3. Future Cost. If one year of college currently costs $15,000, how much will one year cost Michelle Spindle’s newborn daughter, Melissa, in 18 years, assuming a 5 percent annual rate of inflation? Use Appendix A-1 or the Garman/Forgue companion website.
4. Returns and Actions. Kunal Nayyar from California, had $50,000 in investments at the beginning of the year that consisted of a diversified portfolio of stocks (40 percent), bonds (40 percent), and cash equivalents (20 percent). His returns over the past 12 months were 13 percent on stocks, 6 percent on bonds, and 1 percent on cash equivalents.
DO IT IN CLASS
PAGE 400
(a) What is Kunal’s average return for the year?
(b) If Kunal wanted to rebalance his portfolio to its original position, what specific actions should he take?
5. Early Investor Wins. Jordan and Jeremy, who are twins living in Rexburg, Idaho, took different approaches to investing. Jordan saved $2000 per year for ten years starting at age 23 and never added any more money to the account. Jeremy saved $2000 per year for 20 years starting at age 35. Assuming that the brothers earned a 6 percent return, who had accumulated the most by the time they reached age 63? Use Appendix A-1 and Appendix A-3 or the Garman/Forgue companion website.
FINANCIAL PLANNING CASES
CASE 1
The Johnsons Embark on a Solid Investment Program
After nearly eight years of marriage, Harry and Belinda’s finances have improved, even though they have incurred debts for an automobile loan and a condominium. Because they did not contribute very much to their retirement plans every year, Harry’s account is currently worth only $28,000 and Brenda’s is $31,000, but they do have $12,000 in investments outside their employers’ retirement plans.
DO IT IN CLASS
PAGES 383
AND 385
Therefore, the Johnsons have decided to seriously forgo some current spending for the next three years to concentrate on getting a solid investment program under way while they still have two incomes available and before they start a family. They are willing to accept a moderate amount of risk and expect to invest between $600 and $800 per month over the next three years. Respond to the following questions:
(a) In what types of investments (choose only two) might the Johnsons place the first $2000? (Review Figures 13-1 and 13-2 for ideas and available options, and consider the types of investment risks inherent in each choice.) Give reasons for your selections.
(b) In what types of investments might they place the next $4000? Why?
(c) What types of investments should they choose for the next $10,000? Why?
CASE 2
Victor and Maria Hernandez Try to Catch Up on Their Investments
The expenses associated with sending two children through college prevented Victor and Maria Hernandez from adding substantially to their investment program. Now that their younger son, Joseph, has completed school and is working full time, they would like to build up their investments quickly. Victor is 47 years old and wants to retire early, perhaps by age 60. In addition to the retirement program at his place of employment, Victor believes that their investment portfolio, currently valued at $70,000, will need to triple to $210,000 by retirement time. He and Maria realize that they will have to sacrifice a lot of current spending to save and invest for retirement.
(a) What rate of return is needed on the $70,000 portfolio to reach their goal of $210,000 (assuming no additional contributions)? Use Appendix A-3 or visit the Garman/Forgue companion website.
(b) Victor and Maria think they will need a total of $400,000 for a retirement financial nest egg. Therefore, they will need to create an additional sum of $190,000 through new investments. Assuming an annual return of 8 percent, how much do the Hernandezes need to invest each year to reach their goal of $190,000? Use Appendix A-3 or visit the Garman/Forgue companion website.
(c) If they assume a 6 percent annual return, how much do the Hernandezes need to invest each year to reach their goal of $190,000? Use Appendix A-3 or visit the Garman/Forgue companion website.
CASE 3
Julia Price’s Goal Is to Buy a Luxury Condominium
It has been about 20 years since Julia graduated with a major in aeronautical engineering, and she has been quite successful in her career and her personal finances. Accordingly she wants to sell her home and buy a luxury condominium. She has $40,000 in savings, and she figures that she can continue her savings and investment program for three more years before making a 20 percent down payment on a luxury condominium. The home that she wants to purchase is currently priced at $450,000. Julia thinks she should invest her $40,000 and additional savings during the next three years by using lending investments like certificates of deposit and bonds rather than owning stocks or stock mutual funds. Offer your opinions about her thinking.
CASE 4
A First-Time Investor Gets a Head start
Lucia Gomez, a flight attendant from Indiana, Pennsylvania, is thinking about jump-starting a retirement savings plan by investing the $50,000 gift that her elderly uncle gave her. She also wants to invest $1000 a month for the next 25 years for retirement. Lucia knows little about investments and does not seem to have a big desire to learn.
(a) What can you suggest to Lucia about figuring out her investment philosophy? (Hint: Mention the information in Figure 13-2 in your response.)
(b) Would you recommend active or passive investing for her, and why?
(c) Should Lucia be a lender or owner?
(d) Identify three risks to her retirement investments that Lucia should try to avoid, and explain how she can avoid them.
(e) Select two of the four recommended investment strategies to recommend to Lucia, and explain why she should follow them.
(f) If Lucia’s $50,000 is invested in a standard investment account and her $1000 monthly is invested in a tax-sheltered account, with each account growing at 5 percent annually for 25 percent in 25 years, how much money will she have accumulated in each account? (Hint: Adjust the lump-sum investment for 25 percent taxes.)
BE YOUR OWN PERSONAL FINANCIAL MANAGER
1. Your Personal Risk Pyramid. Review Figure 13-2, “The Risk Pyramid Reveals the Trade-Offs Between Risk and Return,” and record your opinions on which types of risk you are probably willing to take over the next ten years in the world of investing by listing the names of the investments with which you would be comfortable.
2. What Is Your Investment Philosophy? Review the section titled “Identify Your Investment Philosophy and Invest Accordingly” and then complete Worksheet 50: My Investment Philosophy from “My Personal Financial Planner” to record various aspects of your approach to investing.
3. Your Long-Term Investment Strategies. Complete Worksheet 51: My Preferred Long-Term Investment Strategies from “My Personal Financial Planner” by check marking the strategies you like and that you might follow during your investing life.
4. Real Return on Investments. Review the box “Did You Know? Calculate the Real Rate of Return (After Taxes and Inflation) on Investments” and complete Worksheet 53: The Real Return on My Investments from “My Personal Financial Planner” by inserting some realistic numbers next to the examples.
ON THE NET
Go to the Web pages indicated to complete these exercises.
1. Why Invest? Visit the John Hancock website
www.jhinvestments.com/Article.aspx?ArticleID={79432E5F-30DF-4624-94F8-FC319EA99D71}
and read the article titled “Why Invest?” Compare what you read there with what is in this chapter.
2. Investing for Beginners Visit the Investing for Beginners website invest-for-beginners.blogspot.com/ and read the series of short articles on that page. Compare what you read there with what is in this chapter.
3. Herd Behavior Visit the Investopedia website
www.investopedia.com/university/behavioral_finance/behavioral8.asp#axzz1yB21OU00
and read the article on herd behavior on that page. Compare with what you read in this chapter.
4. Asset Allocation Visit the Wikipedia website en.wikipedia .org/wiki/Asset_allocation and read it’s contents. Compare with what you have read in this chapter.
5. Monte Carlo Simulation Visit the Financial Engines website corp.financialengines.com/. Click on “How We Help You” and read the links that are there. Compare with what you have read in this chapter.
ACTION INVOLVEMENT PROJECTS
1. Your Investment Strategy. The text discusses four strategies for long-term investors on pages 394-401. Which one appeals to you most and why?
2. Risk-Tolerance Quiz. Go to two of the risk-tolerance quiz websites listed in “Financial Power Point: Take a Risk-Tolerance Quiz” on page 387 and offer some comments on how they differ.
3. Current Investment Magazine Article. Obtain a current issue of Money or Kiplinger’s Personal Finance and summarize an article that offers suggestions on investing.
Visit the Garman/Forgue companion website at
www.cengagebrain.com
.