Unfortunately with investing, as with just about any other
activity that generates income, gains are taxable. That
downside doesn’t mean that you shouldn’t try to invest successfully.
But you should realize that you do pay taxes on
investment gains. Consider the following:
Savings accounts
The gains on simple savings accounts, CDs, and money market
accounts are taxed as income at the local, state, and
federal level. Banks and financial institutions report these
gains to the IRS and state tax offices, just as all investment
gains are reported.
Mutual funds
With mutual funds, unfortunately, you have to pay tax each
year on the capital gains and dividends that the fund distributes
to each of its shareholders. You also have to pay taxes
on your own gains when you sell shares — another reason
for a long-term buy-and-hold strategy. The exceptions are
funds that invest in U.S. securities. You still have to pay federal
income tax on any gains, but you’re free of state and local
tax in most situations.
Although some people believe that municipal bond funds are
free of federal income tax, that’s only true of municipal bond
investments themselves. You pay taxes on capital gains on any
profits that a municipal fund makes from selling bonds.
Stocks
With stocks, you don’t pay taxes on your gains until you sell
your shares — a
feature which fans of stock investing say is
a clear advantage in the long run. The downside, however, is
that when you do cash in shares down the road, your tax
bracket or the tax rate may have increased.
If you do have a
stock loss (
which means a stock is worth less
than what you bought it for), but the stock is one you want
to own, consider selling the stock and rebuying shares at a
lower price. The IRS allows you to consider this a wash sale,
so you won’t have to pay capital gains tax. Note that you must
wait 31 or more days before you can buy back the stock or
else the IRS doesn’t allow the deduction.
Bonds
Price appreciation (if any) on a bond — whether it is a corporate,
government, or municipal bond — is taxable when
the bond matures. Interest on municipal bonds is exempt
from federal tax, but may be subject to state and local tax
(depending on if you live in the state or locality doing the
issuing). Interest on U.S. government bonds is exempt from
tax at the state level, but taxable at the federal level.
If you buy a
bond from Fannie Mae or Ginnie Mae (
the
quasi-government agencies that guarantee mortgages), then
gains are taxable at the local, state, and federal level.
Tax-deferred investing
Don’t forget to take advantage of any form of tax-deferred
investing available to you. Max out on the retirement plans
offered to you at work (such as your 401(k) plan). Investing
in this way really does boil down to a choice of paying yourself
or paying the IRS.
With retirement plans such as a 401(k), you enjoy the added
bonus of being able to deduct your contributions, up to a
maximum of 15% of what you earn, from your income each
year for tax purposes. Now that’s hard to beat. The maximum
amount that you can deduct depends on the plan. Some
plans allow 8%, some 10%. But no plan is allowed, by law,
more than 15%.
Contributions made to a 401(k) plan are deductible from
gross income for income tax purposes. If you do your taxes
yourself, you deduct your overall annual contribution from
your gross income. If an accountant or attorney does your
taxes, she or he does the deduction for you.
Just as hard to beat is the Roth IRA. If you have adjusted
gross income under $95,000 as an individual, you can tuck
away $2,000 in a Roth IRA each year and begin to take distributions
tax-free when you hit the age of 591⁄2. If you’re married
and you and your spouse have a combined adjusted gross
income of $150,000 or less, you can tuck away $4,000 a year.
Unlike regular IRAs, Roth IRAs allow investments even if
you’re enrolled in an employer-sponsored retirement plan.
The same goes for self-employed folks. With the Roth, you
get tax-free capital gains every year, and you get to take withdrawals
tax-free when you hit retirement age at 591⁄2, provided
you’ve had the account for at least five years.
Saturday, June 30, 2007
Developing a Dollar Cost Averaging Plan
No one can afford to have his or her investing plan be forgotten
or relegated to the back burner. You need to set up a
plan for making set, regular investments. This way, you can
ensure that your money is working for you even if your best
intentions are diverted.
Dollar cost averaging is a way to ensure that you make fixed
investments every month or quarter, regardless of other distractions
in your life. Dollar-cost averaging is a simple concept:
You invest a specified dollar amount each month
without concern about the price per share or cost of the
bond. The market is fluid — the price of your investment
moves up and down — so you end up buying shares when
they’re inexpensive, some when they’re expensive, and some
when they’re somewhere in between. Because of the commission
cost to buy small amounts of stocks or bonds, dollar
cost averaging is better suited for buying mutual funds.
If you have a
401(k) plan at work, you already have experience
with dollar cost averaging. You fill out the forms for the
plan and direct your payroll department to take a certain dollar
amount or percentage of your pay every payday and use
it to buy the mutual funds, stocks, bonds, and/or money
market account you’ve selected. Investing this way is important
for your retirement accounts and your financial plans:
It’s the only way most of us can grow our money in a consistent
manner.
In addition to helping you overcome procrastination about
saving for investments, dollar cost averaging can help you
sidestep some of the anxiety many first-time investors feel
about starting to invest in a market that can seem too overheated
or risky. With set purchases each month or quarter,
you buy shares of your chosen investments regardless of how
the market is doing.
Dollar-cost averaging isn’t statistically the most lucrative way
to invest. Because markets rise more often than they decline,
you’re better off saving up your money and buying stocks,
bonds, or mutual funds when they hit rock bottom. But dollar
cost averaging is the most disciplined and reliable way to
invest. Consider this: If you set up a dollar-cost averaging
plan now, then in 10, 20, or 30 years, you’ll have invested
every month in between and accumulated a pretty penny in
the interim.
Most mutual funds let you start out on a dollar cost averaging
plan (or automatic investing plan, as they’re also called)
for as little as $50 or $100 a month. The only catch is that
you have to sign up to allow the fund to take the money from
your checking account each month. To find out if the funds
you’re interested in offer the service, look for the information
in their prospectuses or call their toll-free shareholder services
phone number.
or relegated to the back burner. You need to set up a
plan for making set, regular investments. This way, you can
ensure that your money is working for you even if your best
intentions are diverted.
Dollar cost averaging is a way to ensure that you make fixed
investments every month or quarter, regardless of other distractions
in your life. Dollar-cost averaging is a simple concept:
You invest a specified dollar amount each month
without concern about the price per share or cost of the
bond. The market is fluid — the price of your investment
moves up and down — so you end up buying shares when
they’re inexpensive, some when they’re expensive, and some
when they’re somewhere in between. Because of the commission
cost to buy small amounts of stocks or bonds, dollar
cost averaging is better suited for buying mutual funds.
If you have a
401(k) plan at work, you already have experience
with dollar cost averaging. You fill out the forms for the
plan and direct your payroll department to take a certain dollar
amount or percentage of your pay every payday and use
it to buy the mutual funds, stocks, bonds, and/or money
market account you’ve selected. Investing this way is important
for your retirement accounts and your financial plans:
It’s the only way most of us can grow our money in a consistent
manner.
In addition to helping you overcome procrastination about
saving for investments, dollar cost averaging can help you
sidestep some of the anxiety many first-time investors feel
about starting to invest in a market that can seem too overheated
or risky. With set purchases each month or quarter,
you buy shares of your chosen investments regardless of how
the market is doing.
Dollar-cost averaging isn’t statistically the most lucrative way
to invest. Because markets rise more often than they decline,
you’re better off saving up your money and buying stocks,
bonds, or mutual funds when they hit rock bottom. But dollar
cost averaging is the most disciplined and reliable way to
invest. Consider this: If you set up a dollar-cost averaging
plan now, then in 10, 20, or 30 years, you’ll have invested
every month in between and accumulated a pretty penny in
the interim.
Most mutual funds let you start out on a dollar cost averaging
plan (or automatic investing plan, as they’re also called)
for as little as $50 or $100 a month. The only catch is that
you have to sign up to allow the fund to take the money from
your checking account each month. To find out if the funds
you’re interested in offer the service, look for the information
in their prospectuses or call their toll-free shareholder services
phone number.
Knowing When to Sell
Of course, maybe one or more of your investments isn’t performing
up to your standards. This kind of letdown happens
to the best of us, and you can count on a disappointment
once or twice in your investment life. When underperformance
hits home with one of your investments, take a deep
breath and try to figure out what’s happening.
Figuring out how long to hold on to an investment that isn’t
producing any growth is a challenge. You have to first determine
what is keeping the investment on the rocks. The following
sections offer a look at why an investment may be
underperforming.
When you sell a stock, bond, or mutual fund, make sure that
you find a
suitable replacement and don’t leave the cash lying
in your checking account, where it may be pilfered away by
life’s daily expenses.
Is the economy the reason for your
investment’s slump?
Is the entire market taking its lumps? If so, your then investment
isn’t immune. If one or more sectors of the stock market
are taking a licking, consider the impact to your stock,
bond, or mutual fund. A sluggish economy, or one that is in
retreat, can play havoc with investments. Investments are
long-term endeavors. Don’t sell just because of an economic
downturn. You’ll take a loss.
An economic downturn can create a buying opportunity if
it sends the price of stocks spiraling downward.
Is your stock falling behind?
If a stock is struggling, look at the company. Forget about
what’s happened to date for a moment. If you discovered the
company again today, would you buy it? Do some future
analysis on the company’s prospects. Don’t let your answer
be clouded by negative feelings about the past few months
or years. If you bought the stock because you believed that
the company was well-positioned for a turnaround due to
new and competitive products or services, sales, profits, or
other facets of its financial position, hang on a bit more. The
last thing you want to do is take a loss on a stock that may
turn around a few days or months after you give it the boot.
At the same time, if you decide you wouldn’t buy the stock
again today, or some of the economic reasons that attracted
you to the stock in the first place haven’t panned out, selling
is okay.
Is your bond slipping behind?
If a bond is doing poorly, maybe because the stock market is
booming (typically, when the stock market is doing well,
bonds are lagging, and vice versa), ask yourself what cost you
can expect from hanging on to the bond until maturity.
Compare that expense with what it will cost you to sell the
bond. If interest rates rise substantially, say to 15%, and
you’re hanging on to a
bond paying 4%, you might well be
better off selling the older issue and buying a new bond.
Is your mutual fund fumbling?
If your mutual fund isn’t performing up to snuff, then look
at the fund manager’s style. If the stock market is growth-oriented
and your manager is a value manager who looks for
bargains, you may be wise to hang on. Value-style investing
comes in and out of favor, and you wouldn’t want to miss the
upside. Of course, if an inept mutual fund manager is the
only reason you can find for the lagging performance, you
can sell. Just try to wait until a fund’s performance has been
impaired for at least two years in order to avoid unnecessary
losses.
up to your standards. This kind of letdown happens
to the best of us, and you can count on a disappointment
once or twice in your investment life. When underperformance
hits home with one of your investments, take a deep
breath and try to figure out what’s happening.
Figuring out how long to hold on to an investment that isn’t
producing any growth is a challenge. You have to first determine
what is keeping the investment on the rocks. The following
sections offer a look at why an investment may be
underperforming.
When you sell a stock, bond, or mutual fund, make sure that
you find a
suitable replacement and don’t leave the cash lying
in your checking account, where it may be pilfered away by
life’s daily expenses.
Is the economy the reason for your
investment’s slump?
Is the entire market taking its lumps? If so, your then investment
isn’t immune. If one or more sectors of the stock market
are taking a licking, consider the impact to your stock,
bond, or mutual fund. A sluggish economy, or one that is in
retreat, can play havoc with investments. Investments are
long-term endeavors. Don’t sell just because of an economic
downturn. You’ll take a loss.
An economic downturn can create a buying opportunity if
it sends the price of stocks spiraling downward.
Is your stock falling behind?
If a stock is struggling, look at the company. Forget about
what’s happened to date for a moment. If you discovered the
company again today, would you buy it? Do some future
analysis on the company’s prospects. Don’t let your answer
be clouded by negative feelings about the past few months
or years. If you bought the stock because you believed that
the company was well-positioned for a turnaround due to
new and competitive products or services, sales, profits, or
other facets of its financial position, hang on a bit more. The
last thing you want to do is take a loss on a stock that may
turn around a few days or months after you give it the boot.
At the same time, if you decide you wouldn’t buy the stock
again today, or some of the economic reasons that attracted
you to the stock in the first place haven’t panned out, selling
is okay.
Is your bond slipping behind?
If a bond is doing poorly, maybe because the stock market is
booming (typically, when the stock market is doing well,
bonds are lagging, and vice versa), ask yourself what cost you
can expect from hanging on to the bond until maturity.
Compare that expense with what it will cost you to sell the
bond. If interest rates rise substantially, say to 15%, and
you’re hanging on to a
bond paying 4%, you might well be
better off selling the older issue and buying a new bond.
Is your mutual fund fumbling?
If your mutual fund isn’t performing up to snuff, then look
at the fund manager’s style. If the stock market is growth-oriented
and your manager is a value manager who looks for
bargains, you may be wise to hang on. Value-style investing
comes in and out of favor, and you wouldn’t want to miss the
upside. Of course, if an inept mutual fund manager is the
only reason you can find for the lagging performance, you
can sell. Just try to wait until a fund’s performance has been
impaired for at least two years in order to avoid unnecessary
losses.
More Investment Index
The Wilshire 5000
Want a good look at how the overall U.S. stock market is
doing? The Wilshire 5000 tracks a huge universe of stocks
— in fact, it lists almost every publicly listed stock, including
those listed on the New York Stock Exchange, the
American Stock Exchange, and the Nasdaq Composite.
That’s a pretty definitive look at the large-, medium-, and
small-company stock markets.
This is not a must-read index, especially on a daily basis, but
it is an index investors want to at least know about and have
the option of viewing once in a while. It’s the largest index
going. It gives an investor a broad sense of how the U.S. stock
market overall is faring and in which direction stocks are
headed. More mutual funds have also started investing in
stocks listed in the Wilshire 5000, which gives investors total
U.S. stock exposure.
S&P Mid Cap 400
The S&P Mid Cap 400 index measures the performance of
400 medium-sized companies. If you’re interested in investing
in mid-size companies, or mutual funds that do — and
there are a number of success stories in the mid-sized
range — this is a good benchmark to use to gauge your own
success.
The Russell 2000
The Russell 2000 is the most widely used benchmark for the
smaller company market. (Other small company performance
indexes include the S&P Small Cap 600, the Wilshire
Small Company Growth Index, and the Wilshire Small Company
Value Index.)
The Morgan Stanley Capital International
Emerging Markets Index
The Morgan Stanley Capital International Emerging Markets
Index looks at smaller companies that are operating in
up-and-coming and also sometimes highly volatile developing
markets around the world.
The Morgan Stanley Capital International
Europe, Australia, Asia, and Far East
(EAFE) Index
The Morgan Stanley Capital International Europe, Australia,
Asia, and Far East (EAFE) Index, considered one of the more
prominent, tracks more than 1,000 foreign stocks in 20
countries. This is the big daddy for international investors
and money managers. It tells you how the international stock
market is faring, and if you own stock or a mutual fund that
invests globally, how you’re doing in comparison.
Lehman Brothers Aggregate Bond Index
As the name suggests, the Lehman Brothers Aggregate Bond
Index represents an aggregate of the performance of a
number
of bonds, including U.S. Treasury bonds and corporate
bonds. For investors in U.S. bonds or bond funds, this is the
benchmark for relative performance and the direction of the
market.
Lehman Brothers Long-Term High-Quality
Government/Corporate Bond Index
As its name suggests, the Lehman Brothers Long-Term High-
Quality Government/Corporate Bond Index looks at the universe
of higher-rated government and corporate bonds. To
make it onto the index, a bond must have a maturity or duration
of 15 years or more and a rating of A or better from
Moody’s.
If you’re interested in making long-term investments in highquality
bonds, this benchmark gives you an idea of the type
of performance you can expect and the way the market is faring
right now.
Want a good look at how the overall U.S. stock market is
doing? The Wilshire 5000 tracks a huge universe of stocks
— in fact, it lists almost every publicly listed stock, including
those listed on the New York Stock Exchange, the
American Stock Exchange, and the Nasdaq Composite.
That’s a pretty definitive look at the large-, medium-, and
small-company stock markets.
This is not a must-read index, especially on a daily basis, but
it is an index investors want to at least know about and have
the option of viewing once in a while. It’s the largest index
going. It gives an investor a broad sense of how the U.S. stock
market overall is faring and in which direction stocks are
headed. More mutual funds have also started investing in
stocks listed in the Wilshire 5000, which gives investors total
U.S. stock exposure.
S&P Mid Cap 400
The S&P Mid Cap 400 index measures the performance of
400 medium-sized companies. If you’re interested in investing
in mid-size companies, or mutual funds that do — and
there are a number of success stories in the mid-sized
range — this is a good benchmark to use to gauge your own
success.
The Russell 2000
The Russell 2000 is the most widely used benchmark for the
smaller company market. (Other small company performance
indexes include the S&P Small Cap 600, the Wilshire
Small Company Growth Index, and the Wilshire Small Company
Value Index.)
The Morgan Stanley Capital International
Emerging Markets Index
The Morgan Stanley Capital International Emerging Markets
Index looks at smaller companies that are operating in
up-and-coming and also sometimes highly volatile developing
markets around the world.
The Morgan Stanley Capital International
Europe, Australia, Asia, and Far East
(EAFE) Index
The Morgan Stanley Capital International Europe, Australia,
Asia, and Far East (EAFE) Index, considered one of the more
prominent, tracks more than 1,000 foreign stocks in 20
countries. This is the big daddy for international investors
and money managers. It tells you how the international stock
market is faring, and if you own stock or a mutual fund that
invests globally, how you’re doing in comparison.
Lehman Brothers Aggregate Bond Index
As the name suggests, the Lehman Brothers Aggregate Bond
Index represents an aggregate of the performance of a
number
of bonds, including U.S. Treasury bonds and corporate
bonds. For investors in U.S. bonds or bond funds, this is the
benchmark for relative performance and the direction of the
market.
Lehman Brothers Long-Term High-Quality
Government/Corporate Bond Index
As its name suggests, the Lehman Brothers Long-Term High-
Quality Government/Corporate Bond Index looks at the universe
of higher-rated government and corporate bonds. To
make it onto the index, a bond must have a maturity or duration
of 15 years or more and a rating of A or better from
Moody’s.
If you’re interested in making long-term investments in highquality
bonds, this benchmark gives you an idea of the type
of performance you can expect and the way the market is faring
right now.
The Nasdaq Composite Index
In some senses, the Nasdaq Composite Index is sometimes
seen as a competitor to the S&P, but the Nasdaq Composite
is actually very different. For starters, Nasdaq measures the
stock performance of 5,500 companies, nearly half of them
in the telecommunications and high-tech arena, and all of
them found in the Nasdaq market.
The index includes companies
such as Apple, Intel, MCI Communications, Cisco,
Oracle, Sun Microsystems, and Netscape.
As a result, the Nasdaq index is a good deal more volatile
than, for example, the Dow Jones Industrial Average and,
perhaps, the stock market at large. It’s also home to some of
the bigger success stories of the 1990s — many of which are
technology firms. The higher the potential for return an
investment has, the more the risk it carries.
Just like the Dow Industrial Average and the S&P
500, the
Nasdaq Composite gives the average performance of the
stocks in the index both as numbers and percentages. If Nasdaq
goes up, your newspaper might report that “Nasdaq was
up 1 point or 3% today.”
Although it will be increasingly important for investors to
watch the Nasdaq Composite in the days ahead and the performance
of some of its key stocks, it’s equally important to
look at Nasdaq in relation to the S&P 500 — and even the
Dow — to get an overall sense of how the stock market is
doing. For example, if you are a short-term trader (day trader)
then the Nasdaq is where you want to be. The Nasdaq stocks
can offer great potential for profit and, unfortunately, for loss,
as well.
seen as a competitor to the S&P, but the Nasdaq Composite
is actually very different. For starters, Nasdaq measures the
stock performance of 5,500 companies, nearly half of them
in the telecommunications and high-tech arena, and all of
them found in the Nasdaq market.
The index includes companies
such as Apple, Intel, MCI Communications, Cisco,
Oracle, Sun Microsystems, and Netscape.
As a result, the Nasdaq index is a good deal more volatile
than, for example, the Dow Jones Industrial Average and,
perhaps, the stock market at large. It’s also home to some of
the bigger success stories of the 1990s — many of which are
technology firms. The higher the potential for return an
investment has, the more the risk it carries.
Just like the Dow Industrial Average and the S&P
500, the
Nasdaq Composite gives the average performance of the
stocks in the index both as numbers and percentages. If Nasdaq
goes up, your newspaper might report that “Nasdaq was
up 1 point or 3% today.”
Although it will be increasingly important for investors to
watch the Nasdaq Composite in the days ahead and the performance
of some of its key stocks, it’s equally important to
look at Nasdaq in relation to the S&P 500 — and even the
Dow — to get an overall sense of how the stock market is
doing. For example, if you are a short-term trader (day trader)
then the Nasdaq is where you want to be. The Nasdaq stocks
can offer great potential for profit and, unfortunately, for loss,
as well.
The Standard & Poors 500
Also called the S&P 500, the Standard & Poors index, which
most professional money managers say that they use as the
benchmark against which they measure their own investing
prowess, is the one that has become the dominant benchmark
in U.S. investing in recent years.
Although the S&P is not really the appropriate measure of
performance for bonds or the stocks of small-sized companies,
nor the apt standard against which to judge international
investments, the index is still used to gauge these
investments’ performances anyway.
0
5%
10%
15%
20%
1 2 3 4 5
Line = index
Bars = specific mutual fund
The S&P 500 tracks the performance of 500 stocks, comprised
of 400 industrial companies, 40 utilities, 20 transportation
companies, and 40 financial firms. A committee at
S&P reviews the companies periodically and may replace up
to 30 for reasons that include, for example, bankruptcy.
The performance of the 500 stocks is run through a computer
software program that calculates a daily measure of the
market’s rise or fall as well as an overall performance figure.
These are the numbers you hear reported on the nightly
news, see in the newspapers, and can view on your computer
screen if you log on to a personal finance Web site.
The S&P tells you the average performance of the stocks in
the index. This performance is reported as both numbers and
percentages. If the S&P goes up, your newspaper might
report that “
the S&P
went up 2
points or 6% today.” When
the stock market is doing well the numbers and percentages
go up. When it’s doing poorly, they go down.
The S&P 500 is home to some of the hottest stocks of the
late 1990s, including AOL and Dell, the latter of which gave
investors an unrivaled 79.7% average annual return, not for
a day, not for a month, but for 10 years. With so much fanfare,
the S&P has become the index to beat for mutual fund
managers. Outperforming it is cause for celebration — only
1 out of 10 mutual fund managers do so in any five-year
period.
most professional money managers say that they use as the
benchmark against which they measure their own investing
prowess, is the one that has become the dominant benchmark
in U.S. investing in recent years.
Although the S&P is not really the appropriate measure of
performance for bonds or the stocks of small-sized companies,
nor the apt standard against which to judge international
investments, the index is still used to gauge these
investments’ performances anyway.
0
5%
10%
15%
20%
1 2 3 4 5
Line = index
Bars = specific mutual fund
The S&P 500 tracks the performance of 500 stocks, comprised
of 400 industrial companies, 40 utilities, 20 transportation
companies, and 40 financial firms. A committee at
S&P reviews the companies periodically and may replace up
to 30 for reasons that include, for example, bankruptcy.
The performance of the 500 stocks is run through a computer
software program that calculates a daily measure of the
market’s rise or fall as well as an overall performance figure.
These are the numbers you hear reported on the nightly
news, see in the newspapers, and can view on your computer
screen if you log on to a personal finance Web site.
The S&P tells you the average performance of the stocks in
the index. This performance is reported as both numbers and
percentages. If the S&P goes up, your newspaper might
report that “
the S&P
went up 2
points or 6% today.” When
the stock market is doing well the numbers and percentages
go up. When it’s doing poorly, they go down.
The S&P 500 is home to some of the hottest stocks of the
late 1990s, including AOL and Dell, the latter of which gave
investors an unrivaled 79.7% average annual return, not for
a day, not for a month, but for 10 years. With so much fanfare,
the S&P has become the index to beat for mutual fund
managers. Outperforming it is cause for celebration — only
1 out of 10 mutual fund managers do so in any five-year
period.
Purchasing Mutual Funds
When you are ready to invest in a mutual fund, you can
either work through a broker or, in many cases, you can buy
directly from the mutual fund company. Many funds offer a
toll-free number for placing orders, and you can buy shares
of their funds.
Unlike stocks, you don’t have to specify the number of shares
you want to buy. You tell the fund company or broker that
you want to invest a
stated amount, and the fund or broker
tells you how many shares you will get.
Unlike stocks, mutual
funds sell partial or fractional shares.
A mutual fund company can’t sell you shares of a fund unless
you have first received the prospectus for that fund. Whether
you call or request the prospectus on the Web, you have to
give your name and address. Fund managers need this data
to prove that they have fulfilled their obligation to supply
you with a
prospectus.
When you begin to look into mutual funds, pay close attention
to those that come in families — preferably big families.
The term family refers to companies that offer several
different kinds of funds. How big is big? Think in terms of
ten or more funds. You can spot these families easily by looking
at the mutual fund reports in the business section of your
daily paper.
You typically see some kind of headline in the
columns followed by a list of funds offered by a particular
firm. It’s easy to spot the big families at a glance; these include
Fidelity, Oppenheimer, T. Rowe Price, and Vanguard.
Families of funds that charge commissions (also called loads
or load charges) provide the opportunity to switch among
their funds without paying additional commissions. You can
save considerable money with this option over the long term.
Make sure to check out this possibility.
A mutual fund has professional management, which comes
at a price. You, the investor, pay for this management, either
through commissions you pay when you buy or when you
sell and other fees that you are billed for periodically. These
fees reduce your return on investment and can run as high
as 7 to 8% a year, but 2% or lower is more common.
No-load funds don’t charge sales loads. No-load funds are
available in every major fund category.
Although not all mutual fund companies charge commission,
you need to know that the term “
load” is often used in two
ways. One is to specify commission charged when you buy
a fund (referred to as front-end load), and the other refers to
commission charged when you sell your shares in a fund
(known as back-end load).
Many investors wonder why they should pay a commission
to buy shares of a mutual fund when they can buy a similar
fund without a commission. The answer is that, in most
cases, there’s no good reason to buy a load fund rather than
a no-load fund. Several studies have indicated that the performance
of the two types of funds doesn’t differ. Unless you
come across that rare case in which the performance of a load
fund is so superior that it compensates for the load, save your
money and buy no-load funds.
Almost all mutual funds charge some kind of annual fee.
Analysts tally all these up into one measure called the expense
ratio, expressed as a
percentage of the invested funds. Expense
ratios range from about 0.75% to 2%, but a few charge as
much as 7%. The fund’s prospectus discloses the current
schedule of fees.
Beware of any load fund with a high expense ratio. Avoid
funds that charge a back-end load. These high fees and loads
are a large drain on an investment’s overall return; few funds
deliver performance consistently high enough to offset high
expenses.
either work through a broker or, in many cases, you can buy
directly from the mutual fund company. Many funds offer a
toll-free number for placing orders, and you can buy shares
of their funds.
Unlike stocks, you don’t have to specify the number of shares
you want to buy. You tell the fund company or broker that
you want to invest a
stated amount, and the fund or broker
tells you how many shares you will get.
Unlike stocks, mutual
funds sell partial or fractional shares.
A mutual fund company can’t sell you shares of a fund unless
you have first received the prospectus for that fund. Whether
you call or request the prospectus on the Web, you have to
give your name and address. Fund managers need this data
to prove that they have fulfilled their obligation to supply
you with a
prospectus.
When you begin to look into mutual funds, pay close attention
to those that come in families — preferably big families.
The term family refers to companies that offer several
different kinds of funds. How big is big? Think in terms of
ten or more funds. You can spot these families easily by looking
at the mutual fund reports in the business section of your
daily paper.
You typically see some kind of headline in the
columns followed by a list of funds offered by a particular
firm. It’s easy to spot the big families at a glance; these include
Fidelity, Oppenheimer, T. Rowe Price, and Vanguard.
Families of funds that charge commissions (also called loads
or load charges) provide the opportunity to switch among
their funds without paying additional commissions. You can
save considerable money with this option over the long term.
Make sure to check out this possibility.
A mutual fund has professional management, which comes
at a price. You, the investor, pay for this management, either
through commissions you pay when you buy or when you
sell and other fees that you are billed for periodically. These
fees reduce your return on investment and can run as high
as 7 to 8% a year, but 2% or lower is more common.
No-load funds don’t charge sales loads. No-load funds are
available in every major fund category.
Although not all mutual fund companies charge commission,
you need to know that the term “
load” is often used in two
ways. One is to specify commission charged when you buy
a fund (referred to as front-end load), and the other refers to
commission charged when you sell your shares in a fund
(known as back-end load).
Many investors wonder why they should pay a commission
to buy shares of a mutual fund when they can buy a similar
fund without a commission. The answer is that, in most
cases, there’s no good reason to buy a load fund rather than
a no-load fund. Several studies have indicated that the performance
of the two types of funds doesn’t differ. Unless you
come across that rare case in which the performance of a load
fund is so superior that it compensates for the load, save your
money and buy no-load funds.
Almost all mutual funds charge some kind of annual fee.
Analysts tally all these up into one measure called the expense
ratio, expressed as a
percentage of the invested funds. Expense
ratios range from about 0.75% to 2%, but a few charge as
much as 7%. The fund’s prospectus discloses the current
schedule of fees.
Beware of any load fund with a high expense ratio. Avoid
funds that charge a back-end load. These high fees and loads
are a large drain on an investment’s overall return; few funds
deliver performance consistently high enough to offset high
expenses.
Purchasing Bonds
Buying bonds is a lot like buying stocks. You just get in touch
with your broker, set up your account, and place your order.
If you already have an account with a
broker, whether landbased
or Internet, you shouldn’t have to fill out any additional
paperwork to buy a bond. The one account should
allow you to purchase stocks, bonds, and mutual funds as
well. Unless you are going to concentrate most of your investment
money in bonds, there’s usually no need to select a broker
who specializes in this kind of security.
You do, of course, have to pay for any bonds that you purchase.
You pay in the same way and timeframe as with stocks
(within three days of placing the buying order). Fortunately,
you don’t get charged much in the way of miscellaneous fees
when you buy bonds. These fees vary with the brokerage, but
in almost all cases they are very small (sometimes less than
$1 per transaction).
Commissions on bonds are about in the same range as those
for stocks — high with full-service brokers and lower with
discount and Internet brokers. Because investors show much
less interest in bonds, competition has not yet brought bond
commissions down to the very low levels that are paid for
stock transactions on the Internet.
The Internet doesn’t have many Web sites devoted to information
about investing in bonds. There is, however, one outstanding
site that more than makes up for the lack of
numbers: the Bond Market Association site at
www.investinginbonds.com. This Web site offers
advice on buying bonds, explains how bonds fit into a balanced
portfolio, and answers just about any question you
might have about bonds.
Bonds trade on a type of OTC market, and most trade without
securities symbols you see on securities that are traded on
an organized stock exchange, like the New York Stock
Exchange. Therefore, the investor has to tell the broker the type
(tax or tax-free), how long (time) the investor will hold the
bond, and state the investor’s risk parameters. Most brokerages
(discount and full-service) maintain a bond-trading department
in order to meet varied customer needs and preferences.
with your broker, set up your account, and place your order.
If you already have an account with a
broker, whether landbased
or Internet, you shouldn’t have to fill out any additional
paperwork to buy a bond. The one account should
allow you to purchase stocks, bonds, and mutual funds as
well. Unless you are going to concentrate most of your investment
money in bonds, there’s usually no need to select a broker
who specializes in this kind of security.
You do, of course, have to pay for any bonds that you purchase.
You pay in the same way and timeframe as with stocks
(within three days of placing the buying order). Fortunately,
you don’t get charged much in the way of miscellaneous fees
when you buy bonds. These fees vary with the brokerage, but
in almost all cases they are very small (sometimes less than
$1 per transaction).
Commissions on bonds are about in the same range as those
for stocks — high with full-service brokers and lower with
discount and Internet brokers. Because investors show much
less interest in bonds, competition has not yet brought bond
commissions down to the very low levels that are paid for
stock transactions on the Internet.
The Internet doesn’t have many Web sites devoted to information
about investing in bonds. There is, however, one outstanding
site that more than makes up for the lack of
numbers: the Bond Market Association site at
www.investinginbonds.com. This Web site offers
advice on buying bonds, explains how bonds fit into a balanced
portfolio, and answers just about any question you
might have about bonds.
Bonds trade on a type of OTC market, and most trade without
securities symbols you see on securities that are traded on
an organized stock exchange, like the New York Stock
Exchange. Therefore, the investor has to tell the broker the type
(tax or tax-free), how long (time) the investor will hold the
bond, and state the investor’s risk parameters. Most brokerages
(discount and full-service) maintain a bond-trading department
in order to meet varied customer needs and preferences.
Signing a customer service agreement and setting up an account
After you figure out which broker you want to use to place
your order, get back in touch with that person.
The broker will ask you to fill out an application, called the
customer agreement. You can’t avoid filling out this application.
No broker can deal with you until you have provided
him or her with information about yourself and your financial
situation and goals.
From the start, the broker will need
accurate information to process stock purchases and, regrettably
but necessarily, to keep the IRS informed about all the
money you make from your investments.
The application requires you to provide some common personal
information such as your name, address, tax identification
number (social security number for most people),
current job (if employed), your bank, and an estimate of your
net worth.
If you are working with a
full-service broker, you need to
answer some broad questions about your investment goals
and the kinds of stocks you are considering for investment.
Some very personal questions about your finances and goals
may puzzle you or even turn you off, but brokers require this
information for good reasons. A full-service broker is required
by regulation to provide stock advice appropriate to the
client’s situation. This is often referred to as the “know your
customer” rule.
There are two other aspects of the customer agreement that
you should be aware of. The first is extensive and detailed
information about how you will pay for your purchases and
what happens if you are late in paying or don’t pay at all. This
part of the application is complex and legalistic.
I don’t want to exaggerate the complexity of the agreement
in general. It is long and detailed, but your broker should be
willing to answer your questions. The securities industry is
closely regulated, and you can be quite sure that the customer
agreement is not intended to deceive you. It just takes
patience to wade through it.
If you can’t figure out what some parts of it mean, be persistent
in asking your broker to explain the difficult parts to
you. This could be a
good test of whether you have picked
the right broker. You will have lots of questions all along the
way. Don’t deal with a broker who doesn’t have the time or
inclination to work with you.
Make sure that you read and understand the customer agreement
before you sign it. Don’t be rushed into signing it.
Almost all of the customer service agreements currently in use
require that you, the client, sign away your right to sue the
broker if you believe you actually have been wronged. You will
almost certainly be informed that if you have a dispute or
problem, you must take it to arbitration for resolution.
Some brokers, especially Internet-based brokers, may require
that when you establish your account with them, you also set
up an account with sufficient funds in it to cover anticipated
purchases. The brokerage then pays you interest on the funds
you deposit with them.
Placing an order
Placing an order for stocks is simple. You need to know just
two things: the name of the stock and the number of shares
you want to buy.
If you are dealing with a
live broker, the usual process is to
place your order by phone. If you are dealing with an
Internet broker, the transaction is made on your computer
screen and you provide the same information that you would
phone in to a broker.
Under federal regulations, the buyer must pay for stock purchases
within three business days. Brokers are very concerned
to see that you pay within this period because they can be
penalized or disciplined if payment deadlines are not
observed.
After transacting your order, your broker tells you what the
total charge is and sends you a written confirmation. (You
can also check the Web site for your filled order, or call your
broker on the phone.) The charge includes the price of the
shares, the broker’s commission, and usually some small fees.
You then have three business days to get your payment to the
broker. Both discount and full-service brokerages require that
money be in the account within three business days.
Many investors find it more convenient to have funds in a
money market fund at the brokerage before a trade is placed
in order to meet the three-day requirement.
Use an overnight delivery service to deliver your payment.
Sometimes full-service brokers provide clients with prepaid
overnight mailers to use in sending payments. These services
almost always deliver checks in a timely way, and they also
have the means to precisely track when and where your payment
was delivered.
your order, get back in touch with that person.
The broker will ask you to fill out an application, called the
customer agreement. You can’t avoid filling out this application.
No broker can deal with you until you have provided
him or her with information about yourself and your financial
situation and goals.
From the start, the broker will need
accurate information to process stock purchases and, regrettably
but necessarily, to keep the IRS informed about all the
money you make from your investments.
The application requires you to provide some common personal
information such as your name, address, tax identification
number (social security number for most people),
current job (if employed), your bank, and an estimate of your
net worth.
If you are working with a
full-service broker, you need to
answer some broad questions about your investment goals
and the kinds of stocks you are considering for investment.
Some very personal questions about your finances and goals
may puzzle you or even turn you off, but brokers require this
information for good reasons. A full-service broker is required
by regulation to provide stock advice appropriate to the
client’s situation. This is often referred to as the “know your
customer” rule.
There are two other aspects of the customer agreement that
you should be aware of. The first is extensive and detailed
information about how you will pay for your purchases and
what happens if you are late in paying or don’t pay at all. This
part of the application is complex and legalistic.
I don’t want to exaggerate the complexity of the agreement
in general. It is long and detailed, but your broker should be
willing to answer your questions. The securities industry is
closely regulated, and you can be quite sure that the customer
agreement is not intended to deceive you. It just takes
patience to wade through it.
If you can’t figure out what some parts of it mean, be persistent
in asking your broker to explain the difficult parts to
you. This could be a
good test of whether you have picked
the right broker. You will have lots of questions all along the
way. Don’t deal with a broker who doesn’t have the time or
inclination to work with you.
Make sure that you read and understand the customer agreement
before you sign it. Don’t be rushed into signing it.
Almost all of the customer service agreements currently in use
require that you, the client, sign away your right to sue the
broker if you believe you actually have been wronged. You will
almost certainly be informed that if you have a dispute or
problem, you must take it to arbitration for resolution.
Some brokers, especially Internet-based brokers, may require
that when you establish your account with them, you also set
up an account with sufficient funds in it to cover anticipated
purchases. The brokerage then pays you interest on the funds
you deposit with them.
Placing an order
Placing an order for stocks is simple. You need to know just
two things: the name of the stock and the number of shares
you want to buy.
If you are dealing with a
live broker, the usual process is to
place your order by phone. If you are dealing with an
Internet broker, the transaction is made on your computer
screen and you provide the same information that you would
phone in to a broker.
Under federal regulations, the buyer must pay for stock purchases
within three business days. Brokers are very concerned
to see that you pay within this period because they can be
penalized or disciplined if payment deadlines are not
observed.
After transacting your order, your broker tells you what the
total charge is and sends you a written confirmation. (You
can also check the Web site for your filled order, or call your
broker on the phone.) The charge includes the price of the
shares, the broker’s commission, and usually some small fees.
You then have three business days to get your payment to the
broker. Both discount and full-service brokerages require that
money be in the account within three business days.
Many investors find it more convenient to have funds in a
money market fund at the brokerage before a trade is placed
in order to meet the three-day requirement.
Use an overnight delivery service to deliver your payment.
Sometimes full-service brokers provide clients with prepaid
overnight mailers to use in sending payments. These services
almost always deliver checks in a timely way, and they also
have the means to precisely track when and where your payment
was delivered.
Buying Stocks
The most common way to buy stock is to deal with a broker,
which can be either land-based (the kind with folks who
work in offices downtown) or in cyberspace (accessed via the
Internet).
Choosing a broker
The first big choice you need to make is deciding which kind
of broker you are going to deal with: full-service or discount.
If you believe that you are going to need a
lot of advice, a
full-service broker will probably better serve you. If you are
making your own decisions about stocks, by all means use a
discount broker. Discount brokers charge much lower commissions
than do full-service brokers.
Many discount brokers have both electronic and “bricks and
mortar” systems of operation. If you discount broker is on
the Web, you can enter your order electronically and receive
confirmation the same way. Some discount brokers have
branch offices where you can sit down with a broker and discuss
your investment objectives and goals.
Either way, you can obtain commission costs and product
information by visiting a discount broker’s Web site, by calling
their phone number (usually toll-free), or by stopping by
the branch office.
In addition to discount commissions, most discount brokers
also offer other products and services, such as mutual funds,
IRAs, research reports, bonds, and others.
Full-service brokers are paid by the commissions they earn
on buying and selling stocks and other products for clients.
This arrangement can lead to a tendency on their part to recommend
frequent trading of stocks rather than pursuing a
“buy and hold” strategy. This advice can put their interests
in conflict with yours. So if you use a full-service broker,
avoid miscommunication by making sure that she or he
knows that you are not interested in frequent trading but in
buying good stocks and holding them for the long term.
You may be better off if you find a good financial advisor to
guide you on stock purchases and perhaps on other aspects
of your financial program. These advisors often work for a
flat fee on an hourly basis.
If you decide to work with a
full-service broker, you have to
choose a broker one way or another. How do you make this
choice? You probably select a broker pretty much the same
way you select a doctor, a lawyer, or other professional.
You ask people for recommendations. You look in the phone
book. You see ads in the paper or on TV. After you acquire a
list of potential brokers, take the process at least one step further.
After you get several names, make some calls.
Call their offices and ask about account minimums and commission
costs. Find out how convenient their services may
be. If you’re put on hold for longer than a few minutes or the
broker asks to call you back but never does, he or she may
not be the broker for you.
Narrow your choices down to two or three brokers and then
interview each of them.
Sooner or later, you will get on a
mailing list that is sold to
brokers. Then you start getting unsolicited calls. All brokers
have a good line and can be very persuasive. My recommendation:
Find a financial planner in your area and deal with
her or him face to face. A good financial planner whom you
trust can be a very helpful to you as you work to achieve your
financial goals.
which can be either land-based (the kind with folks who
work in offices downtown) or in cyberspace (accessed via the
Internet).
Choosing a broker
The first big choice you need to make is deciding which kind
of broker you are going to deal with: full-service or discount.
If you believe that you are going to need a
lot of advice, a
full-service broker will probably better serve you. If you are
making your own decisions about stocks, by all means use a
discount broker. Discount brokers charge much lower commissions
than do full-service brokers.
Many discount brokers have both electronic and “bricks and
mortar” systems of operation. If you discount broker is on
the Web, you can enter your order electronically and receive
confirmation the same way. Some discount brokers have
branch offices where you can sit down with a broker and discuss
your investment objectives and goals.
Either way, you can obtain commission costs and product
information by visiting a discount broker’s Web site, by calling
their phone number (usually toll-free), or by stopping by
the branch office.
In addition to discount commissions, most discount brokers
also offer other products and services, such as mutual funds,
IRAs, research reports, bonds, and others.
Full-service brokers are paid by the commissions they earn
on buying and selling stocks and other products for clients.
This arrangement can lead to a tendency on their part to recommend
frequent trading of stocks rather than pursuing a
“buy and hold” strategy. This advice can put their interests
in conflict with yours. So if you use a full-service broker,
avoid miscommunication by making sure that she or he
knows that you are not interested in frequent trading but in
buying good stocks and holding them for the long term.
You may be better off if you find a good financial advisor to
guide you on stock purchases and perhaps on other aspects
of your financial program. These advisors often work for a
flat fee on an hourly basis.
If you decide to work with a
full-service broker, you have to
choose a broker one way or another. How do you make this
choice? You probably select a broker pretty much the same
way you select a doctor, a lawyer, or other professional.
You ask people for recommendations. You look in the phone
book. You see ads in the paper or on TV. After you acquire a
list of potential brokers, take the process at least one step further.
After you get several names, make some calls.
Call their offices and ask about account minimums and commission
costs. Find out how convenient their services may
be. If you’re put on hold for longer than a few minutes or the
broker asks to call you back but never does, he or she may
not be the broker for you.
Narrow your choices down to two or three brokers and then
interview each of them.
Sooner or later, you will get on a
mailing list that is sold to
brokers. Then you start getting unsolicited calls. All brokers
have a good line and can be very persuasive. My recommendation:
Find a financial planner in your area and deal with
her or him face to face. A good financial planner whom you
trust can be a very helpful to you as you work to achieve your
financial goals.
Comparing CDs
When you shop around for a CD, ask the following questions.
As with the other investments I discuss in this chapter,
talk to at least three different institutions before you take
the plunge.
What’s the minimum deposit to open the account?
Usually this amount is $500.
What’s the interest rate? What is the compounded
annual yield? Interest is the percent that the bank pays
you for your allowing them to keep your money. The
rate of interest is also called yield. Compounded annual
yield comes into play if a bank is paying interest monthly,
for example. Once the first month’s interest is credited
to your account, that interest starts earning interest, too,
meaning that the compounded annual yield is slightly
higher than the interest rate.
How often is the interest compounded? Remember,
the more frequently it’s compounded, the better it is for
you. Continuous compounding is best.
Is the interest rate fixed or variable? Make sure that
the institution offers you a way to get current interest
rates quickly and easily — by phone, for example.
Can you add to your fund at a higher interest rate if
the rate goes up while your money is invested? If the
rate goes up substantially, and you can add to your fund,
then you can significantly increase your yield.
What’s the penalty for early withdrawal? These penalties
can wipe out any interest you earn.
What happens to the deposit when the CD matures?
Does the institution roll a matured CD into a new one
of a similar term? Does it mail a check? Credit your
checking account?
As with the other investments I discuss in this chapter,
talk to at least three different institutions before you take
the plunge.
What’s the minimum deposit to open the account?
Usually this amount is $500.
What’s the interest rate? What is the compounded
annual yield? Interest is the percent that the bank pays
you for your allowing them to keep your money. The
rate of interest is also called yield. Compounded annual
yield comes into play if a bank is paying interest monthly,
for example. Once the first month’s interest is credited
to your account, that interest starts earning interest, too,
meaning that the compounded annual yield is slightly
higher than the interest rate.
How often is the interest compounded? Remember,
the more frequently it’s compounded, the better it is for
you. Continuous compounding is best.
Is the interest rate fixed or variable? Make sure that
the institution offers you a way to get current interest
rates quickly and easily — by phone, for example.
Can you add to your fund at a higher interest rate if
the rate goes up while your money is invested? If the
rate goes up substantially, and you can add to your fund,
then you can significantly increase your yield.
What’s the penalty for early withdrawal? These penalties
can wipe out any interest you earn.
What happens to the deposit when the CD matures?
Does the institution roll a matured CD into a new one
of a similar term? Does it mail a check? Credit your
checking account?
Shopping for Money Market Accounts
When you open a money market account, as the song says,
you’d better shop around. On any given day, certain banks
may try to attract deposits. Those banks often offer money
market accounts that yield over 5%, although the average
yield nationwide is more in the range of 2.5%. In many cases,
the yield also depends on the amount you deposit.
The first step in opening a money market account is to decide
which type best suits your needs. Money market accounts
come in three types:
The basic money market account: These usually
require a
minimum opening deposit of $
100.
The “tiered” money market account: These often
require a
minimum opening deposit in excess of $
100
and pay a higher yield than most basic accounts. For
example, you might earn 2.5% interest with a $500
account balance, but as much as 5% interest or more
with a balance of $50,000.
The package deal: This is a money market account coupled
with a savings account, certificates of deposit, and
other bank investments. Because the package deal utilizes
several products, banks and credit unions may offer
a slightly higher yield than they do for basic or tiered
accounts. What’s more, the minimum deposit may be
waived.
you’d better shop around. On any given day, certain banks
may try to attract deposits. Those banks often offer money
market accounts that yield over 5%, although the average
yield nationwide is more in the range of 2.5%. In many cases,
the yield also depends on the amount you deposit.
The first step in opening a money market account is to decide
which type best suits your needs. Money market accounts
come in three types:
The basic money market account: These usually
require a
minimum opening deposit of $
100.
The “tiered” money market account: These often
require a
minimum opening deposit in excess of $
100
and pay a higher yield than most basic accounts. For
example, you might earn 2.5% interest with a $500
account balance, but as much as 5% interest or more
with a balance of $50,000.
The package deal: This is a money market account coupled
with a savings account, certificates of deposit, and
other bank investments. Because the package deal utilizes
several products, banks and credit unions may offer
a slightly higher yield than they do for basic or tiered
accounts. What’s more, the minimum deposit may be
waived.
Diving into Savings Accounts
Rather than “taking the plunge,” opening a savings account
is more like dipping your toe into the water. But, we’ve all
got to start somewhere, and this is where many people start
out. Opening a savings account can be the first step to a lifetime
of good savings habits.
You’ve probably heard the advice, “Pay yourself first.” That
doesn’t mean give yourself some cash so that you can go shopping.
When you sit down to pay bills, write the first check
to a savings or investment account. It doesn’t matter if you
start with a very small amount, just make savings a habit.
And when you get bonuses and raises, you can increase those
checks you write to yourself.
When you shop for a bank, savings and loan, or credit union
where you can open a savings account, make sure to ask the
following questions:
Is there a required minimum balance for a savings
account? Some institutions charge a fee if your balance
falls below a required minimum.
What are your fees for savings accounts? You can
expect to be charged either a monthly or quarterly maintenance
fee. The institution may also charge you a fee if
you close the account before a
specified period of time.
How much interest will I get on my savings? Expect
around 2% interest.
Is the account federally insured? Ask specifically
whether the institution has Federal Deposit Insurance
Corporation (FDIC) insurance. If it does, then you can
get up to $100,000 of your savings back if the bank fails.
What services do you offer? Many banks now offer
banking by telephone or the Internet.
Does the bank use a tiered account system? A tiered
account system allows you to earn higher interest if your
account balance is consistently over an amount specified
by the bank.
Call around to at least three different institutions (banks, savings
and loans, and/or credit unions) to compare their offerings.
(You can also call brokerage firms, which offer CDs, to
find out what their minimums and fees are.)
If the answers to all of these questions come out about equal,
choose the institution that’s most convenient for you and
offers the best service, convenient hours, friendly tellers —
whatever suits your banking habits best.
is more like dipping your toe into the water. But, we’ve all
got to start somewhere, and this is where many people start
out. Opening a savings account can be the first step to a lifetime
of good savings habits.
You’ve probably heard the advice, “Pay yourself first.” That
doesn’t mean give yourself some cash so that you can go shopping.
When you sit down to pay bills, write the first check
to a savings or investment account. It doesn’t matter if you
start with a very small amount, just make savings a habit.
And when you get bonuses and raises, you can increase those
checks you write to yourself.
When you shop for a bank, savings and loan, or credit union
where you can open a savings account, make sure to ask the
following questions:
Is there a required minimum balance for a savings
account? Some institutions charge a fee if your balance
falls below a required minimum.
What are your fees for savings accounts? You can
expect to be charged either a monthly or quarterly maintenance
fee. The institution may also charge you a fee if
you close the account before a
specified period of time.
How much interest will I get on my savings? Expect
around 2% interest.
Is the account federally insured? Ask specifically
whether the institution has Federal Deposit Insurance
Corporation (FDIC) insurance. If it does, then you can
get up to $100,000 of your savings back if the bank fails.
What services do you offer? Many banks now offer
banking by telephone or the Internet.
Does the bank use a tiered account system? A tiered
account system allows you to earn higher interest if your
account balance is consistently over an amount specified
by the bank.
Call around to at least three different institutions (banks, savings
and loans, and/or credit unions) to compare their offerings.
(You can also call brokerage firms, which offer CDs, to
find out what their minimums and fees are.)
If the answers to all of these questions come out about equal,
choose the institution that’s most convenient for you and
offers the best service, convenient hours, friendly tellers —
whatever suits your banking habits best.
First Steps in Stock Investing
If you’re willing to roll up your sleeves and do the research
necessary to invest in individual companies, a stock may be
a good fit for your new portfolio. The key is to avoid excessive
risk. The best way to minimize risk is to buy a solid
company — one that is essentially a blue chip or a largercompany
growth stock.
Look for a stock with consistent performance
that appears to sustain and even increase over time.
The Dow Jones Industrial Average is the index of blue chips,
listing the likes of IBM, Kodak, McDonald’s, and Sears.
These stocks tend to hedge investors’ first exposure to equity investing by paying
dividends that offset any lackluster performance.
You may also want to seek out a value stock — a stock that
has been underperforming its peers, but that seems poised to
turn things around. An index called “Dogs of the Dow,”
which is compiled by Dow Jones and printed in The Wall
Street Journal, lists specifically those stocks that are on the
outs. Of course, none is guaranteed to become the next best
stock to own. You have to judge for yourself by looking at a
company’s long-term growth and earnings; its price-to-earnings
(P/E) ratio; and any company news that can give you
insight into debt level, acquisitions on the horizon, and competitive
edge of products, services, and management. (The
P/E ratio is derived by dividing a stock’s share price by its
earnings-per-share price. The result shows how much
investors are willing to pay for each $1 of earnings.
Annual reports, which you can request from a company’s own
investor relations department, can give you some of these
details;
These services can show you a stock’s ups and downs over the years
and even over the past month. Analysts’ reports can project
a company’s earnings, dividends, and price growth over the
next few months and years.
Don’t forget to check on competitors, too. Because all performance
data is relative, a company that may seem like a
great catch may actually be inferior to its peers, but you won’t
know that if you don’t check. For example, if you’re thinking
about investing in McDonald’s, make sure that you check
out the stocks for Wendy’s, too
necessary to invest in individual companies, a stock may be
a good fit for your new portfolio. The key is to avoid excessive
risk. The best way to minimize risk is to buy a solid
company — one that is essentially a blue chip or a largercompany
growth stock.
Look for a stock with consistent performance
that appears to sustain and even increase over time.
The Dow Jones Industrial Average is the index of blue chips,
listing the likes of IBM, Kodak, McDonald’s, and Sears.
These stocks tend to hedge investors’ first exposure to equity investing by paying
dividends that offset any lackluster performance.
You may also want to seek out a value stock — a stock that
has been underperforming its peers, but that seems poised to
turn things around. An index called “Dogs of the Dow,”
which is compiled by Dow Jones and printed in The Wall
Street Journal, lists specifically those stocks that are on the
outs. Of course, none is guaranteed to become the next best
stock to own. You have to judge for yourself by looking at a
company’s long-term growth and earnings; its price-to-earnings
(P/E) ratio; and any company news that can give you
insight into debt level, acquisitions on the horizon, and competitive
edge of products, services, and management. (The
P/E ratio is derived by dividing a stock’s share price by its
earnings-per-share price. The result shows how much
investors are willing to pay for each $1 of earnings.
Annual reports, which you can request from a company’s own
investor relations department, can give you some of these
details;
These services can show you a stock’s ups and downs over the years
and even over the past month. Analysts’ reports can project
a company’s earnings, dividends, and price growth over the
next few months and years.
Don’t forget to check on competitors, too. Because all performance
data is relative, a company that may seem like a
great catch may actually be inferior to its peers, but you won’t
know that if you don’t check. For example, if you’re thinking
about investing in McDonald’s, make sure that you check
out the stocks for Wendy’s, too
The minimum fund investment
Do you think that you need a fortune to get started? You’re
wrong. Many fund companies have a $250 minimum investment
requirement. Others with $2,500 or $10,000 minimum
investments waive those requirements if you’re willing to
invest $50 or $100 each month or even each quarter.
Individual Retirement Accounts are another way to steer
around high minimum investment requirements because
many mutual fund companies allow you to start an IRA with
$1,000. (A few companies accept $250 as a minimum, but
that is becoming more rare.) Almost all mutual funds offer
this service to investors in an attempt to capture assets that
the funds hope to hold on to for years — until the investors
retire. Make sure, however, that you really can use an IRA
and aren’t just looking for a way into a fund. You can’t tap
the money until you reach age 59 1⁄2 without paying income
taxes and a 10% penalty. If you’re investing for retirement,
fine. If you’re investing to pay for your child’s college tuition
or a beach house and expect to require the funds well before
age 59 1⁄2, find a fund that fits your needs.
wrong. Many fund companies have a $250 minimum investment
requirement. Others with $2,500 or $10,000 minimum
investments waive those requirements if you’re willing to
invest $50 or $100 each month or even each quarter.
Individual Retirement Accounts are another way to steer
around high minimum investment requirements because
many mutual fund companies allow you to start an IRA with
$1,000. (A few companies accept $250 as a minimum, but
that is becoming more rare.) Almost all mutual funds offer
this service to investors in an attempt to capture assets that
the funds hope to hold on to for years — until the investors
retire. Make sure, however, that you really can use an IRA
and aren’t just looking for a way into a fund. You can’t tap
the money until you reach age 59 1⁄2 without paying income
taxes and a 10% penalty. If you’re investing for retirement,
fine. If you’re investing to pay for your child’s college tuition
or a beach house and expect to require the funds well before
age 59 1⁄2, find a fund that fits your needs.
First Steps in Mutual Fund Investing
Mutual funds can be a great fit for a first-time investor.
Because they’re managed by a professional, you don’t have to
wrack your brain about what individual stock or bond to buy
or when to buy it or sell it. At the same time, you get a fairly
diversified portfolio in one fell swoop, which involves much
less risk than if you invest in only one stock.
If you’re uncomfortable with the kind of risk that stocks present,
find a good mutual fund for your launch into investing.
Starting out with a
mutual fund doesn’t represent the end of
your quest; it’s the beginning. You can always select a
handful
of decent stocks down the road to add to your portfolio.
With more than 8,000 mutual funds to choose from, the
world may be your oyster, but you eventually have to make
selections that suit you best. In the next three sections, I talk
about three types of mutual funds that can be good first
investments.
You want to see consistent returns over time and relatively
low expenses (ideally 1% or less). If you read the
report carefully, you can also get a
sense of how a manager
approaches his or her investments, and whether the style is
more aggressive than you’re comfortable dealing with.
Also review the fund’s prospectus, which outlines the fund’s
investment objectives and policies, expenses, and risks. Some
better mutual fund companies are starting to graphically
depict the worst quarter and year they’ve experienced, along
with the best, so that you can quickly get an idea of how low
and high the fund may go with your money.
Balanced funds
Although managers of balanced funds invest to earn
respectable returns, they manage first and foremost to avoid
sizeable losses. To do this, many invest in bonds. In some
fund portfolios, bonds account for as much as 30% or more
of the balanced fund’s holdings.
Balanced funds seek income and capital preservation as their
goal, so they offer moderate capital appreciation as compared
to growth funds. Balanced funds don’t take as hard a hit as
more aggressive funds when the market dips.
Large U.S. growth funds
Large U.S. growth fund managers look for large and mid-size
U.S. companies that are fairly stable performers, but have the
potential to continue growing. Changes in society, such as
the aging of the Baby Boom generation, may be one reason
that some companies have good growth potential. For example,
some managers like companies in health care, entertainment,
travel, and financial services because they have the
potential to benefit from the dollars of older, richer Boomers.
A large-company growth index fund
A manager of an index fund invests in companies whose
stocks are listed in an index such as the Standard & Poors
500. The fund tracks the performance of the index. The S&P
has been the index with the best performance in the past
decade. (See Chapter 8 for details on the S&P.) If you want
even more diversification, try a fund that invests, for example,
in the Wilshire 5000, which tracks all of the stocks listed
in the American Stock Exchange, the New York Stock
Exchange, and Nasdaq.
Rather than trying to predict the direction of the market, the
index funds are designed to match the performance of the
index. These funds are considered to be unmanaged because
they invest and hold the same stocks as in the index.
Unfortunately, the fact that index funds match the performance
of the index is the worst part, too, because in a bear market
(when stock prices drop significantly), index funds have
no place else to turn for investments but to the index.
Remember, however, that index funds can offer the investor
long-term, steady growth.
You can pick a small-company mutual fund, a medium-company
mutual fund, a bond mutual fund, and an international
mutual fund as you continue building your portfolio, but it’s
a good idea to start with a fund that invests in large company
stocks. Because, since the late 1920s, these types of stock have
historical average annual returns of more than 11%, this type
of fund can anchor the rest of your portfolio.
Because they’re managed by a professional, you don’t have to
wrack your brain about what individual stock or bond to buy
or when to buy it or sell it. At the same time, you get a fairly
diversified portfolio in one fell swoop, which involves much
less risk than if you invest in only one stock.
If you’re uncomfortable with the kind of risk that stocks present,
find a good mutual fund for your launch into investing.
Starting out with a
mutual fund doesn’t represent the end of
your quest; it’s the beginning. You can always select a
handful
of decent stocks down the road to add to your portfolio.
With more than 8,000 mutual funds to choose from, the
world may be your oyster, but you eventually have to make
selections that suit you best. In the next three sections, I talk
about three types of mutual funds that can be good first
investments.
You want to see consistent returns over time and relatively
low expenses (ideally 1% or less). If you read the
report carefully, you can also get a
sense of how a manager
approaches his or her investments, and whether the style is
more aggressive than you’re comfortable dealing with.
Also review the fund’s prospectus, which outlines the fund’s
investment objectives and policies, expenses, and risks. Some
better mutual fund companies are starting to graphically
depict the worst quarter and year they’ve experienced, along
with the best, so that you can quickly get an idea of how low
and high the fund may go with your money.
Balanced funds
Although managers of balanced funds invest to earn
respectable returns, they manage first and foremost to avoid
sizeable losses. To do this, many invest in bonds. In some
fund portfolios, bonds account for as much as 30% or more
of the balanced fund’s holdings.
Balanced funds seek income and capital preservation as their
goal, so they offer moderate capital appreciation as compared
to growth funds. Balanced funds don’t take as hard a hit as
more aggressive funds when the market dips.
Large U.S. growth funds
Large U.S. growth fund managers look for large and mid-size
U.S. companies that are fairly stable performers, but have the
potential to continue growing. Changes in society, such as
the aging of the Baby Boom generation, may be one reason
that some companies have good growth potential. For example,
some managers like companies in health care, entertainment,
travel, and financial services because they have the
potential to benefit from the dollars of older, richer Boomers.
A large-company growth index fund
A manager of an index fund invests in companies whose
stocks are listed in an index such as the Standard & Poors
500. The fund tracks the performance of the index. The S&P
has been the index with the best performance in the past
decade. (See Chapter 8 for details on the S&P.) If you want
even more diversification, try a fund that invests, for example,
in the Wilshire 5000, which tracks all of the stocks listed
in the American Stock Exchange, the New York Stock
Exchange, and Nasdaq.
Rather than trying to predict the direction of the market, the
index funds are designed to match the performance of the
index. These funds are considered to be unmanaged because
they invest and hold the same stocks as in the index.
Unfortunately, the fact that index funds match the performance
of the index is the worst part, too, because in a bear market
(when stock prices drop significantly), index funds have
no place else to turn for investments but to the index.
Remember, however, that index funds can offer the investor
long-term, steady growth.
You can pick a small-company mutual fund, a medium-company
mutual fund, a bond mutual fund, and an international
mutual fund as you continue building your portfolio, but it’s
a good idea to start with a fund that invests in large company
stocks. Because, since the late 1920s, these types of stock have
historical average annual returns of more than 11%, this type
of fund can anchor the rest of your portfolio.
Investing in a real estate investment trust(REIT)
If you don’t want to be a
landlord, you might consider option
number three: investing in real estate through a REIT (real
estate investment trust). REITs are diversified real estate
investment companies that purchase and manage rental real
estate for investors. A typical REIT invests in different types
of property, such as shopping centers, apartments, and other
rental buildings. You can invest in REITs either through purchasing
them directly on the major stock exchanges or
through a real estate mutual fund that invests in numerous
REITs.
landlord, you might consider option
number three: investing in real estate through a REIT (real
estate investment trust). REITs are diversified real estate
investment companies that purchase and manage rental real
estate for investors. A typical REIT invests in different types
of property, such as shopping centers, apartments, and other
rental buildings. You can invest in REITs either through purchasing
them directly on the major stock exchanges or
through a real estate mutual fund that invests in numerous
REITs.
Buying an investment property
A second way to invest in real estate is to buy residential
housing such as single family homes or multi-unit buildings,
and rent them. In many ways, buying real estate in this way
isn’t an investment, it’s a business. Maintaining a property
can easily turn into a part-time job. If you’re a person who
dreams of putting heart and soul into a property, however, it
may be worth investigating. If you do decide to take this
route, first, be sure that you have sufficient time to devote to
the project. Second, be careful not to sacrifice contributions
to tax-deductible retirement accounts such as 401(k)s or IRAs
in order to own investment real estate.
0
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000 Own
Rent
30252015105 1
$538,415.40
$373,348.52
Deciding to become a real estate investor depends mostly on
you and your situation. Is real estate something that you have
an affinity for? Do you know a lot about houses, or have a
knack for spotting up-and-coming areas? Are you cut out to
handle the responsibilities that come with being a landlord?
Do you have the time to manage your property?
Another drawback to real estate investment is that you earn
no tax benefits while you’re accumulating your down payment.
Retirement accounts such as 401(k)s and IRAs may give you
an immediate tax deduction as you
contribute money to them. If you haven’t exhausted your
contributions to these accounts, consider doing so before taking
a look at investment real estate.
housing such as single family homes or multi-unit buildings,
and rent them. In many ways, buying real estate in this way
isn’t an investment, it’s a business. Maintaining a property
can easily turn into a part-time job. If you’re a person who
dreams of putting heart and soul into a property, however, it
may be worth investigating. If you do decide to take this
route, first, be sure that you have sufficient time to devote to
the project. Second, be careful not to sacrifice contributions
to tax-deductible retirement accounts such as 401(k)s or IRAs
in order to own investment real estate.
0
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000 Own
Rent
30252015105 1
$538,415.40
$373,348.52
Deciding to become a real estate investor depends mostly on
you and your situation. Is real estate something that you have
an affinity for? Do you know a lot about houses, or have a
knack for spotting up-and-coming areas? Are you cut out to
handle the responsibilities that come with being a landlord?
Do you have the time to manage your property?
Another drawback to real estate investment is that you earn
no tax benefits while you’re accumulating your down payment.
Retirement accounts such as 401(k)s and IRAs may give you
an immediate tax deduction as you
contribute money to them. If you haven’t exhausted your
contributions to these accounts, consider doing so before taking
a look at investment real estate.
Investing in Real Estate
There are three ways that you can become a real estate
investor: first, by buying your own home; second, by buying
an investment property; and third, by investing in a real estate
investment trust (REIT).
Although it’s true that over time, real estate owners and
investors have enjoyed rates of return comparable to the stock
market, real estate is not a simple way to get wealthy. Nor is
it for the faint of heart or the passive investor. Real estate goes
through good and bad performance periods, and most people
who make money in real estate do so because they invest
over many years.
Buying your own home
Most people invest in real estate by becoming homeowners.
Part of the American dream is that the equity, which is the
difference between the market value of your home and the
loan owed on it, increases over time to produce a significant
part of your net worth.
Unless you have the good fortune to live in a rent-controlled
apartment, owning a home should be less expensive than
renting a
comparable home throughout your adult life. Why?
As a renter, your housing costs will follow the level of inflation,
while as a homeowner, the bulk of your housing costs
are not exposed to inflation if you have a fixed-rate mortgage.
investor: first, by buying your own home; second, by buying
an investment property; and third, by investing in a real estate
investment trust (REIT).
Although it’s true that over time, real estate owners and
investors have enjoyed rates of return comparable to the stock
market, real estate is not a simple way to get wealthy. Nor is
it for the faint of heart or the passive investor. Real estate goes
through good and bad performance periods, and most people
who make money in real estate do so because they invest
over many years.
Buying your own home
Most people invest in real estate by becoming homeowners.
Part of the American dream is that the equity, which is the
difference between the market value of your home and the
loan owed on it, increases over time to produce a significant
part of your net worth.
Unless you have the good fortune to live in a rent-controlled
apartment, owning a home should be less expensive than
renting a
comparable home throughout your adult life. Why?
As a renter, your housing costs will follow the level of inflation,
while as a homeowner, the bulk of your housing costs
are not exposed to inflation if you have a fixed-rate mortgage.
Identifying potential bond investments
Here’s a look at some items you need to evaluate before
investing in a fund:
Issuer stability: This is also known as credit quality,
which assesses an issuer’s ability to pay back its debts,
including the interest and principal it owes its bond
holders, in full and on time. Although many
corporations, the United States government, and a multitude
of municipalities have never defaulted on a bond,
you can expect that some issuers can and will be unable
to repay.
Maturity: A bond’s maturity refers to the specific future
date when you can expect your principal to be repaid.
Bond maturities can range from as short as one day all
the up to 30 years. Make sure that the bond you select
has a maturity date that works with your needs. T-Bills
and zero coupon bonds pay interest at maturity. All other
bonds pay interest every six months. Most investors buy
bonds in order to have a steady flow of income (from
interest).
The longer the maturity in a bond, the more risk associated
with it — that is, the greater the fluctuation in
bond value based upon changes in interest rates.
Interest rate: Bonds pay interest that can be fixed-rate,
floating, or payable at maturity. Most bond rates are fixed
until maturity, and the amount is based on a percentage
of the face or principal amount.
Face value: This is the stated value of a bond. The bond
is selling at a premium when the price is above its face
value; pricing below its face value means that it’s selling
at a discount.
Price: The price you pay for a bond is based on an array
of different factors, including current interest rates, supply
and demand, and maturity.
Current yield: This is the annual percentage rate of
return earned on a
bond. You can find a bond’s current
yield by dividing the bond’s interest payment by its purchase
price. For example, if you bought a bond at $900
and its interest rate is 8% (0.08), the current yield is
8.89% — 8% or 0.08 ÷ $900 = 8.89.
Yield to maturity (YTM): This tells you the total return
you can expect to receive if you hold a
bond until it
matures. Its calculation takes into account the bond’s face
value, its current price, and the years left until the bond
matures. The calculation is an elaborate one, but the broker
you’re buying a bond from should be able to give you
its YTM. The YTM also enables you to compare bonds
with different maturities and yields.
Don’t buy a bond on current yield alone. Ask the bank
or brokerage firm from whom you’re buying the bond to
provide a YTM figure so that you can have a clear idea
about the bond’s real value to your portfolio.
Tax status: The interest you earn on U.S. Treasury bills,
notes, and bonds is exempt from local and state tax.
Interest paid on municipal bonds is usually exempt from
local (if you live in the municipality issuing the bond),
state (if the municipality issuing the bond is in your state
of residence), and federal tax, although you pay capital
gains tax on any increase in the price of the bond. On
corporate bonds, you pay both state and federal taxes,
where applicable, for interest paid and capital gains taxes
on any increase in price.
If you sell a
corporate, treasury, or municipal bond for more
than you paid for it, you’ll pay capital gains tax on the difference.
investing in a fund:
Issuer stability: This is also known as credit quality,
which assesses an issuer’s ability to pay back its debts,
including the interest and principal it owes its bond
holders, in full and on time. Although many
corporations, the United States government, and a multitude
of municipalities have never defaulted on a bond,
you can expect that some issuers can and will be unable
to repay.
Maturity: A bond’s maturity refers to the specific future
date when you can expect your principal to be repaid.
Bond maturities can range from as short as one day all
the up to 30 years. Make sure that the bond you select
has a maturity date that works with your needs. T-Bills
and zero coupon bonds pay interest at maturity. All other
bonds pay interest every six months. Most investors buy
bonds in order to have a steady flow of income (from
interest).
The longer the maturity in a bond, the more risk associated
with it — that is, the greater the fluctuation in
bond value based upon changes in interest rates.
Interest rate: Bonds pay interest that can be fixed-rate,
floating, or payable at maturity. Most bond rates are fixed
until maturity, and the amount is based on a percentage
of the face or principal amount.
Face value: This is the stated value of a bond. The bond
is selling at a premium when the price is above its face
value; pricing below its face value means that it’s selling
at a discount.
Price: The price you pay for a bond is based on an array
of different factors, including current interest rates, supply
and demand, and maturity.
Current yield: This is the annual percentage rate of
return earned on a
bond. You can find a bond’s current
yield by dividing the bond’s interest payment by its purchase
price. For example, if you bought a bond at $900
and its interest rate is 8% (0.08), the current yield is
8.89% — 8% or 0.08 ÷ $900 = 8.89.
Yield to maturity (YTM): This tells you the total return
you can expect to receive if you hold a
bond until it
matures. Its calculation takes into account the bond’s face
value, its current price, and the years left until the bond
matures. The calculation is an elaborate one, but the broker
you’re buying a bond from should be able to give you
its YTM. The YTM also enables you to compare bonds
with different maturities and yields.
Don’t buy a bond on current yield alone. Ask the bank
or brokerage firm from whom you’re buying the bond to
provide a YTM figure so that you can have a clear idea
about the bond’s real value to your portfolio.
Tax status: The interest you earn on U.S. Treasury bills,
notes, and bonds is exempt from local and state tax.
Interest paid on municipal bonds is usually exempt from
local (if you live in the municipality issuing the bond),
state (if the municipality issuing the bond is in your state
of residence), and federal tax, although you pay capital
gains tax on any increase in the price of the bond. On
corporate bonds, you pay both state and federal taxes,
where applicable, for interest paid and capital gains taxes
on any increase in price.
If you sell a
corporate, treasury, or municipal bond for more
than you paid for it, you’ll pay capital gains tax on the difference.
Recognizing different types of bonds
Bonds come in all shapes and sizes, and they enable you to
choose one that meet your needs in terms of your investment
time horizon, risk profile, and income needs. First, here is a
look at the different types of U.S. government securities that
are available:
Treasury bills: T-Bills: T-Bills have a minimum purchase
price of $10,000 and are offered in 3-month, 6-month,
and 12-month maturities. T-Bills do not pay current
interest, but instead are always sold at a discount price,
which is lower than par value. The difference between
the discount price and the par value received is considered
interest. For example, if you pay the discount price
of $9,500 for a $10,000 T-Bill, you pay 5% less than you
actually get back when the bill matures. Par is considered
to be $10,000.
Treasury notes: Treasury notes have maturities of 2 to
10 years. The minimum investment is $1,000, but they
are also issued in $5,000 and $10,000 amounts. Treasury
notes have coupons that pay interest every six
months.
Treasury bonds:With maturities of up to 30 years, these
are the long-term offerings from the Treasury Department;
as such, these bonds typically pay the highest
interest. The minimum investment is $1,000, but they
are also issued in $5,000 and $10,000 amounts. Treasury
bonds have coupons that pay interest every six
months.
Zero-coupon bonds: Zero-coupon bonds do not pay
current interest. You buy the bond at a steep discount,
and interest accrues (builds up) during the life of the
bond. At maturity, the investor receives all the accrued
interest plus his/her original investment. Zero-coupon
bonds are taxed each year on the interest earned (even
though it’s not actually paid out), unless it is a zero-
coupon municipal bond (which would be free of federal
and possibly state taxes.) Zero-coupon bonds are usually
used in IRA accounts.
Savings bonds: These have been the apple pie of American
investing for years. They act like zero coupon bonds,
but you can purchase them in small denominations from
banks or the Treasury Department. For more zest, the
agency began offering inflation-indexed bonds in 1998,
which guarantee that your return will outpace inflation.
The bond’s yield is actually based on the inflation rate
plus a fixed rate of return, such as 3%. Interest on savings
bonds is not taxed until the bond is cashed in.
Financial experts generally see United States government
bonds as the safest investment bet around. But remember
that risk and reward are tradeoffs that you need to
look at in tandem. As with all investments, the safer the
investment, the less you’re likely to earn or lose!
The following are other types of available bonds:
Municipal bonds: These are loans you make to a local
government, whether it’s in your city, town, or state.
Because most are free from local (if you live in the
municipality issuing the bond), state (if the municipality
issuing the bond is in your state of residence), and
federal taxes, they can be valuable to those who seek tax
relief —
often folks in higher income tax brackets. Generally,
these bonds have proven their worth as safe
investments over the years (although there have been a
few instances when municipalities proved unreliable);
they pay a stated interest rate over the life of the bond.
Some municipal bonds are insured, making them safe
from default. Municipal bonds are generally available at
minimums of $5,000.
Corporate bonds: These are issued by companies that
need to raise money, including public utilities and
transportation companies, industrial corporations and
manufacturers, and financial service companies. Minimum
investment in corporate bonds is $1,000.
Corporate bonds can be riskier than either U.S. government
bonds or municipal bonds because companies can
go bankrupt. So a company’s credit risk is an important
tool for evaluating the safety of a corporate bond. Even
if an organization doesn’t throw in the towel, its risk factor
can be enough to cause agency analysts, such as Standard
& Poors or Moody’s, to downgrade the company’s
overall rating. If that happens, you may find it more difficult
to sell the bond early.
Junk bonds: Junk bonds pay high yields because the
issuer may be in financial trouble, have a poor credit rating,
and are likely to have a difficult time finding buyers
for their issues. Although you may decide that junk
bonds or junk bond mutual funds have a place in your
portfolio, make sure that spot is small because these
bonds carry high risk.
Although junk bonds may look particularly attractive at
times, think twice before you buy. They don’t call them junk
for nothing. You could potentially suffer a total loss if the
issuer declares bankruptcy. As one wag suggested, if you really
believe in the company so much, invest in its stock, which
has unlimited upside potential.
choose one that meet your needs in terms of your investment
time horizon, risk profile, and income needs. First, here is a
look at the different types of U.S. government securities that
are available:
Treasury bills: T-Bills: T-Bills have a minimum purchase
price of $10,000 and are offered in 3-month, 6-month,
and 12-month maturities. T-Bills do not pay current
interest, but instead are always sold at a discount price,
which is lower than par value. The difference between
the discount price and the par value received is considered
interest. For example, if you pay the discount price
of $9,500 for a $10,000 T-Bill, you pay 5% less than you
actually get back when the bill matures. Par is considered
to be $10,000.
Treasury notes: Treasury notes have maturities of 2 to
10 years. The minimum investment is $1,000, but they
are also issued in $5,000 and $10,000 amounts. Treasury
notes have coupons that pay interest every six
months.
Treasury bonds:With maturities of up to 30 years, these
are the long-term offerings from the Treasury Department;
as such, these bonds typically pay the highest
interest. The minimum investment is $1,000, but they
are also issued in $5,000 and $10,000 amounts. Treasury
bonds have coupons that pay interest every six
months.
Zero-coupon bonds: Zero-coupon bonds do not pay
current interest. You buy the bond at a steep discount,
and interest accrues (builds up) during the life of the
bond. At maturity, the investor receives all the accrued
interest plus his/her original investment. Zero-coupon
bonds are taxed each year on the interest earned (even
though it’s not actually paid out), unless it is a zero-
coupon municipal bond (which would be free of federal
and possibly state taxes.) Zero-coupon bonds are usually
used in IRA accounts.
Savings bonds: These have been the apple pie of American
investing for years. They act like zero coupon bonds,
but you can purchase them in small denominations from
banks or the Treasury Department. For more zest, the
agency began offering inflation-indexed bonds in 1998,
which guarantee that your return will outpace inflation.
The bond’s yield is actually based on the inflation rate
plus a fixed rate of return, such as 3%. Interest on savings
bonds is not taxed until the bond is cashed in.
Financial experts generally see United States government
bonds as the safest investment bet around. But remember
that risk and reward are tradeoffs that you need to
look at in tandem. As with all investments, the safer the
investment, the less you’re likely to earn or lose!
The following are other types of available bonds:
Municipal bonds: These are loans you make to a local
government, whether it’s in your city, town, or state.
Because most are free from local (if you live in the
municipality issuing the bond), state (if the municipality
issuing the bond is in your state of residence), and
federal taxes, they can be valuable to those who seek tax
relief —
often folks in higher income tax brackets. Generally,
these bonds have proven their worth as safe
investments over the years (although there have been a
few instances when municipalities proved unreliable);
they pay a stated interest rate over the life of the bond.
Some municipal bonds are insured, making them safe
from default. Municipal bonds are generally available at
minimums of $5,000.
Corporate bonds: These are issued by companies that
need to raise money, including public utilities and
transportation companies, industrial corporations and
manufacturers, and financial service companies. Minimum
investment in corporate bonds is $1,000.
Corporate bonds can be riskier than either U.S. government
bonds or municipal bonds because companies can
go bankrupt. So a company’s credit risk is an important
tool for evaluating the safety of a corporate bond. Even
if an organization doesn’t throw in the towel, its risk factor
can be enough to cause agency analysts, such as Standard
& Poors or Moody’s, to downgrade the company’s
overall rating. If that happens, you may find it more difficult
to sell the bond early.
Junk bonds: Junk bonds pay high yields because the
issuer may be in financial trouble, have a poor credit rating,
and are likely to have a difficult time finding buyers
for their issues. Although you may decide that junk
bonds or junk bond mutual funds have a place in your
portfolio, make sure that spot is small because these
bonds carry high risk.
Although junk bonds may look particularly attractive at
times, think twice before you buy. They don’t call them junk
for nothing. You could potentially suffer a total loss if the
issuer declares bankruptcy. As one wag suggested, if you really
believe in the company so much, invest in its stock, which
has unlimited upside potential.
How bonds work
You have a number of important variables to consider when
you invest in bonds, including the stability of the issuer, the
bond’s maturity or due date, interest rate, price, yield, tax status,
and risk. As with any investment, ensuring that all these
variables match up with your own investment goals is key to
making the right choice for your money.
Be sure to buy a bond with a maturity date that tracks with
your financial plans. For instance, if you have a
child’s college education to fund 15 years from now and you want to
invest part of his or her college fund in bonds, you need to
select vehicles that have maturities that match that need. If
you have to sell a bond before its due date, you receive the
prevailing market price, which may be more or less than the
price you paid.
In general, because they often specify the yield you’ll be paid,
bonds can’t make you a millionaire overnight like a stock can.
What can you expect to earn? Long-term corporate bonds,
for example, have paid anywhere from an average of 1% in
the 1950s to 13% in the 1980s, when in general all bonds did
well. What can you expect to lose?
you invest in bonds, including the stability of the issuer, the
bond’s maturity or due date, interest rate, price, yield, tax status,
and risk. As with any investment, ensuring that all these
variables match up with your own investment goals is key to
making the right choice for your money.
Be sure to buy a bond with a maturity date that tracks with
your financial plans. For instance, if you have a
child’s college education to fund 15 years from now and you want to
invest part of his or her college fund in bonds, you need to
select vehicles that have maturities that match that need. If
you have to sell a bond before its due date, you receive the
prevailing market price, which may be more or less than the
price you paid.
In general, because they often specify the yield you’ll be paid,
bonds can’t make you a millionaire overnight like a stock can.
What can you expect to earn? Long-term corporate bonds,
for example, have paid anywhere from an average of 1% in
the 1950s to 13% in the 1980s, when in general all bonds did
well. What can you expect to lose?
What is a Bond ?
A bond is basically an IOU. When you purchase a bond, you
are lending money to a government, municipality, corporation,
federal agency, or other entity. In return for the loan,
the entity promises to pay you a specified rate of interest
during the life of the bond and to repay the face value of the
bond (the principal you invested) when it matures or comes due.
The entity to whom you’re lending money when you buy a
bond is called the issuer.
Bonds aren’t like stocks. You are not buying part ownership
in a company or government when you purchase a bond.
Instead, what you’re actually buying —
or betting on —is
the issuer’s ability to pay you back with interest.
are lending money to a government, municipality, corporation,
federal agency, or other entity. In return for the loan,
the entity promises to pay you a specified rate of interest
during the life of the bond and to repay the face value of the
bond (the principal you invested) when it matures or comes due.
The entity to whom you’re lending money when you buy a
bond is called the issuer.
Bonds aren’t like stocks. You are not buying part ownership
in a company or government when you purchase a bond.
Instead, what you’re actually buying —
or betting on —is
the issuer’s ability to pay you back with interest.
Identifying potential stock investments
What do you need to know to determine which stocks are
potential investments? To get started, stick with stocks relating
to your own interests or knowledge. If you frequent particular
stores or restaurants and you use and like their
products, find out if they are publicly held companies. Start
identifying and watching these stocks. That advice doesn’t
mean that you should buy their stock right away. You still
have some homework to do.
The following list tells you what to look for when investigating
potential stock investments.
Find out if the industry is growing. Some industries
aren’t. News stories on the industry in question can tell
you the state of the industry and so can the company’s
annual report.
Company shareholder departments and the Securities
and Exchange Commission (SEC), the Washington,
D.C.-based regulator that oversees public companies, can
provide you with copies of annual reports and the quarterly
reports (called 10Qs) that companies must file.
Find primary competitors. Don’t look at a stock in isolation.
A company that looks enticing by itself may look
like a 100-pound weakling when you evaluate its
strengths and weaknesses next to the leading competitors
in the industry. Check out at least two competitors
of any stock you’re evaluating.
Check out annual earnings and sales. This is key in
deciphering how quickly a company is growing over oneyear,
three-year, and five-year time periods, and whether
its earnings are keeping pace with sales. Look for growth
rates of at least 10%.
Look at the stock’s price-to-earnings (P/E) ratios. This
is the primary means of evaluating a stock. The P/E ratio
is derived by dividing a stock’s share price by its earningsper-
share. The result tells you how much investors are
willing to pay for each $1 of earnings. Those stocks that
have faster earnings growth rates also tend to carry higher
P/Es, which means that investors are willing to pay
through the nose to own shares. The value of a P/E ratio,
however, can be subjective. One investor may think that
a particular company’s P/E ratio of 20 is high, while
another may consider it low to moderate.
Find out the price-to-book value (P/B) ratio. The P/B
ratio is the stock’s share price divided by book value, or a
firm’s assets minus its liabilities. This ratio is a good comparison
tool and can tell you which companies are assetrich
and which are carrying more debt.
A low P/B ratio can be an indicator that a stock may be
a good value investment.
Check out the stock’s price-to-growth flow ratio. This
ratio is the share price divided by growth flow (annual
earnings plus research-and-development costs) per share.
This is a useful measure for assessing fast-moving companies,
especially in the technology sector, where management
often puts profits back into product
development.
Look at the stock’s PEG ratio. The PEG ratio is a company’s
P/E ratio divided by its expected earnings’ growth
rate and is an indicator of well-priced stock.
In a soaring stock market, like the one that dominated
the 1990s, a PEG ratio below 1.5 suggests that a stock
may be a good value. A PEG ratio above 2 can indicate
that a stock may be overheated.
Look ahead. Projections of five-year annual growth rates
and five-year P/E ratios can tell you whether analysts
believe that the companies you’re evaluating can continue
to grow at their current rate, can beat it, or will start to
fall behind.
Make a list of the stocks you are interested in and watch their
performance over time. Doing so gives you a feel for how the
stocks respond to different types of economic and market
news. You can also see which stocks’ prices move around and
are more volatile.
So does your own analysis indicate that you have a winner
on your hands or a dog? If you’re unsure, sit tight and watch
what happens in the weeks and months ahead. Watching several
stocks over a period of time not only tells you how well
they’re doing, or not doing, it can also show you how well
you’re honing your own stock analysis skills.
potential investments? To get started, stick with stocks relating
to your own interests or knowledge. If you frequent particular
stores or restaurants and you use and like their
products, find out if they are publicly held companies. Start
identifying and watching these stocks. That advice doesn’t
mean that you should buy their stock right away. You still
have some homework to do.
The following list tells you what to look for when investigating
potential stock investments.
Find out if the industry is growing. Some industries
aren’t. News stories on the industry in question can tell
you the state of the industry and so can the company’s
annual report.
Company shareholder departments and the Securities
and Exchange Commission (SEC), the Washington,
D.C.-based regulator that oversees public companies, can
provide you with copies of annual reports and the quarterly
reports (called 10Qs) that companies must file.
Find primary competitors. Don’t look at a stock in isolation.
A company that looks enticing by itself may look
like a 100-pound weakling when you evaluate its
strengths and weaknesses next to the leading competitors
in the industry. Check out at least two competitors
of any stock you’re evaluating.
Check out annual earnings and sales. This is key in
deciphering how quickly a company is growing over oneyear,
three-year, and five-year time periods, and whether
its earnings are keeping pace with sales. Look for growth
rates of at least 10%.
Look at the stock’s price-to-earnings (P/E) ratios. This
is the primary means of evaluating a stock. The P/E ratio
is derived by dividing a stock’s share price by its earningsper-
share. The result tells you how much investors are
willing to pay for each $1 of earnings. Those stocks that
have faster earnings growth rates also tend to carry higher
P/Es, which means that investors are willing to pay
through the nose to own shares. The value of a P/E ratio,
however, can be subjective. One investor may think that
a particular company’s P/E ratio of 20 is high, while
another may consider it low to moderate.
Find out the price-to-book value (P/B) ratio. The P/B
ratio is the stock’s share price divided by book value, or a
firm’s assets minus its liabilities. This ratio is a good comparison
tool and can tell you which companies are assetrich
and which are carrying more debt.
A low P/B ratio can be an indicator that a stock may be
a good value investment.
Check out the stock’s price-to-growth flow ratio. This
ratio is the share price divided by growth flow (annual
earnings plus research-and-development costs) per share.
This is a useful measure for assessing fast-moving companies,
especially in the technology sector, where management
often puts profits back into product
development.
Look at the stock’s PEG ratio. The PEG ratio is a company’s
P/E ratio divided by its expected earnings’ growth
rate and is an indicator of well-priced stock.
In a soaring stock market, like the one that dominated
the 1990s, a PEG ratio below 1.5 suggests that a stock
may be a good value. A PEG ratio above 2 can indicate
that a stock may be overheated.
Look ahead. Projections of five-year annual growth rates
and five-year P/E ratios can tell you whether analysts
believe that the companies you’re evaluating can continue
to grow at their current rate, can beat it, or will start to
fall behind.
Make a list of the stocks you are interested in and watch their
performance over time. Doing so gives you a feel for how the
stocks respond to different types of economic and market
news. You can also see which stocks’ prices move around and
are more volatile.
So does your own analysis indicate that you have a winner
on your hands or a dog? If you’re unsure, sit tight and watch
what happens in the weeks and months ahead. Watching several
stocks over a period of time not only tells you how well
they’re doing, or not doing, it can also show you how well
you’re honing your own stock analysis skills.
Stock Market tips
Over time, you’re likely to buy a mix of both types of stocks
for your portfolio, so knowing the different characteristics of
each is important. Understanding growth and value stocks
can help you evaluate your options more carefully.
Growth companies are typically organizations with a positive
outlook for expansion and, ultimately, stock prices that move
upward. Investors looking for growth companies usually are
willing to pay a higher price for stocks that have consistently
produced higher profits because they’re betting the companies
will continue to perform well in the future.
Because they use their money to invest in future growth,
growth companies are less likely to pay dividends than other,
more conservative companies; when they do pay dividends,
the amounts tend to be lower. An investor who buys a growth
stock believes that, according to analysis of the company’s
history and statistics, the company is likely to continue to
produce strong earnings and is therefore worth its higher
price.
The stock of a growth company is, however, somewhat riskier
because the price tends to react to negative company news
and short-term changes in the market. Also, the company
may not continue to produce earnings that are worth its
higher price.
In contrast, value stocks are out of favor, left on the shelf by
investors who are busy reaching for more expensive and
trendier items. For that reason, you spend fewer dollars to
buy a dollar of their profits than if you invest in a growth
stock. When investors buy value stocks, they’re betting that
they’re actually buying a turn-around-story — with a happy
ending down the road.
Value companies carry risk, too, because they may never
reach what investors believe is their true potential. Optimism
doesn’t always pay off in profits
for your portfolio, so knowing the different characteristics of
each is important. Understanding growth and value stocks
can help you evaluate your options more carefully.
Growth companies are typically organizations with a positive
outlook for expansion and, ultimately, stock prices that move
upward. Investors looking for growth companies usually are
willing to pay a higher price for stocks that have consistently
produced higher profits because they’re betting the companies
will continue to perform well in the future.
Because they use their money to invest in future growth,
growth companies are less likely to pay dividends than other,
more conservative companies; when they do pay dividends,
the amounts tend to be lower. An investor who buys a growth
stock believes that, according to analysis of the company’s
history and statistics, the company is likely to continue to
produce strong earnings and is therefore worth its higher
price.
The stock of a growth company is, however, somewhat riskier
because the price tends to react to negative company news
and short-term changes in the market. Also, the company
may not continue to produce earnings that are worth its
higher price.
In contrast, value stocks are out of favor, left on the shelf by
investors who are busy reaching for more expensive and
trendier items. For that reason, you spend fewer dollars to
buy a dollar of their profits than if you invest in a growth
stock. When investors buy value stocks, they’re betting that
they’re actually buying a turn-around-story — with a happy
ending down the road.
Value companies carry risk, too, because they may never
reach what investors believe is their true potential. Optimism
doesn’t always pay off in profits
Recognizing different types of stock
Companies issue two basic kinds of stock, common and
preferred, and each provides shareholders with different
opportunities and rights:
Common stock: Represents ownership in a company.
Companies can pay what are called dividends to their
shareholders. Dividends are paid out from a company’s
earnings and can fluctuate with the company’s performance.
Note: Not all companies pay dividends.
Common stock offers no performance guarantees, and
although this kind of stock has historically outperformed
other types of investments, you can lose your entire
investment if a company does poorly enough to wipe out
its earnings and reputation into the foreseeable future.
Common stock dividends are paid only after the preferred
stock dividends are paid.
Preferred stock: Constitutes ownership shares as well,
but this stock differs from common stock in ways that
reduce risk to investors, but also limit upside potential,
or upward trends in stock pricing. Dividends on preferred
stock are paid before common stock, so preferred
stock may be a better bet for investors who rely on the
income from these payments. But the dividend, which
is set, is not increased when the company profits, and
the price of preferred stock increases more slowly than
that of common stock. Also, preferred stock investors
stand a better chance of getting their money back if the
company declares bankruptcy
preferred, and each provides shareholders with different
opportunities and rights:
Common stock: Represents ownership in a company.
Companies can pay what are called dividends to their
shareholders. Dividends are paid out from a company’s
earnings and can fluctuate with the company’s performance.
Note: Not all companies pay dividends.
Common stock offers no performance guarantees, and
although this kind of stock has historically outperformed
other types of investments, you can lose your entire
investment if a company does poorly enough to wipe out
its earnings and reputation into the foreseeable future.
Common stock dividends are paid only after the preferred
stock dividends are paid.
Preferred stock: Constitutes ownership shares as well,
but this stock differs from common stock in ways that
reduce risk to investors, but also limit upside potential,
or upward trends in stock pricing. Dividends on preferred
stock are paid before common stock, so preferred
stock may be a better bet for investors who rely on the
income from these payments. But the dividend, which
is set, is not increased when the company profits, and
the price of preferred stock increases more slowly than
that of common stock. Also, preferred stock investors
stand a better chance of getting their money back if the
company declares bankruptcy
Understanding how stocks work
Companies issue stock to raise money to fund a variety of
initiatives, including expansion, the development of new
products, the acquisition of other companies, or to pay off
debt. In an action called an initial public offering (IPO), a
company opens sale of its stock to investors.
An investment banker helps underwrite the public stock
offering. By underwrite, I mean that the investment banker
helps the company determine when to go public and what
price the stock should be at that time.
When the stock begins selling, the price can rise or fall from
its set price depending on whether investors believe that the
stock was fairly and accurately priced. Often, the price of an
IPO soars during the first few days of trading, but then can
later fall back to earth.
After the IPO, stock prices will continue to fluctuate, based
on what investors are willing to accept when they buy or sell
the stock. In simple terms, stock prices are a matter of supply
and demand. If everyone wants a stock, its price rises,
sometimes sharply. If, on the other hand, investors are fearful
that, for example, the company’s management is faltering
and has taken on too much debt to sustain strong growth,
they may begin selling in noticeable volume. Mass sales can
drive the price down. In addition to specific company issues,
the price can drop for other reasons, including bad news for
the entire industry or a general downturn in the overall
economy.
Stocks are bought and sold on stock exchanges, such as the
New York Stock Exchange, Nasdaq, and the American Stock
Exchange. Companies that don’t have the cash reserves necessary
to be listed on one of the exchanges are traded overthe-
counter, which means that they receive less scrutiny from
analysts and large investors such as mutual fund managers.
In addition, professional analysts who are paid to watch companies
and their stocks can give a thumbs-up or a thumbsdown
to a stock, which in turn can send stock prices soaring
or plummeting. These stock analysts sit in brokerage firms
on New York’s fabled Wall Street and various cities’ Main
Streets. The analyst’s job is to watch closely the actions of
public companies and their managers and the results those
actions produce.
By carefully monitoring news about a company’s earnings,
corporate strategies, new products and services, and legal and
regulatory problems and victories, analysts give stocks a
buy,
sell, or hold rating. Such opinions can have a wide-sweeping
impact on the price of a stock, at least in the short-term.
Rumblings, real or imagined, can send the price of a stock,
or the stock market overall, tumbling downward or soaring
skyward.
The price of stock goes up and down — a phenomenon
known as volatility — but if the news creating the stir is shortterm,
panic is an overreaction. You don’t want to sell a stock
when its price is down, only to see it make a miraculous recovery
a few days, weeks, or even months down the road.
Smart investors who have done their research and are invested
for the longer-term won’t be impacted by short-term price
dips or panics. Unless of course, you use the opportunity to
buy a stock you’ve already researched and were going to buy
anyway. The old adage — buy low, sell high — holds as true
today as it did 75 years ago.
How low can stock prices go? In October 1987, stock prices
tumbled by 22.6%. This decline meant that the value of a
$10,000 investment dropped to $7,740. Many stocks recovered,
but some did not.
You can lose all your money with a stock investment, and
that risk is why you need to analyze your choices carefully.
The three most basic types of risks associated with stock
investments are
You may lose money.
Your stocks may not perform as well as other, similar
stocks.
A loss may threaten your financial goals.
Stock investing carries certain risks, but they can be minimized
by careful investment selection and by diversification,
a technique for building a balanced portfolio.
initiatives, including expansion, the development of new
products, the acquisition of other companies, or to pay off
debt. In an action called an initial public offering (IPO), a
company opens sale of its stock to investors.
An investment banker helps underwrite the public stock
offering. By underwrite, I mean that the investment banker
helps the company determine when to go public and what
price the stock should be at that time.
When the stock begins selling, the price can rise or fall from
its set price depending on whether investors believe that the
stock was fairly and accurately priced. Often, the price of an
IPO soars during the first few days of trading, but then can
later fall back to earth.
After the IPO, stock prices will continue to fluctuate, based
on what investors are willing to accept when they buy or sell
the stock. In simple terms, stock prices are a matter of supply
and demand. If everyone wants a stock, its price rises,
sometimes sharply. If, on the other hand, investors are fearful
that, for example, the company’s management is faltering
and has taken on too much debt to sustain strong growth,
they may begin selling in noticeable volume. Mass sales can
drive the price down. In addition to specific company issues,
the price can drop for other reasons, including bad news for
the entire industry or a general downturn in the overall
economy.
Stocks are bought and sold on stock exchanges, such as the
New York Stock Exchange, Nasdaq, and the American Stock
Exchange. Companies that don’t have the cash reserves necessary
to be listed on one of the exchanges are traded overthe-
counter, which means that they receive less scrutiny from
analysts and large investors such as mutual fund managers.
In addition, professional analysts who are paid to watch companies
and their stocks can give a thumbs-up or a thumbsdown
to a stock, which in turn can send stock prices soaring
or plummeting. These stock analysts sit in brokerage firms
on New York’s fabled Wall Street and various cities’ Main
Streets. The analyst’s job is to watch closely the actions of
public companies and their managers and the results those
actions produce.
By carefully monitoring news about a company’s earnings,
corporate strategies, new products and services, and legal and
regulatory problems and victories, analysts give stocks a
buy,
sell, or hold rating. Such opinions can have a wide-sweeping
impact on the price of a stock, at least in the short-term.
Rumblings, real or imagined, can send the price of a stock,
or the stock market overall, tumbling downward or soaring
skyward.
The price of stock goes up and down — a phenomenon
known as volatility — but if the news creating the stir is shortterm,
panic is an overreaction. You don’t want to sell a stock
when its price is down, only to see it make a miraculous recovery
a few days, weeks, or even months down the road.
Smart investors who have done their research and are invested
for the longer-term won’t be impacted by short-term price
dips or panics. Unless of course, you use the opportunity to
buy a stock you’ve already researched and were going to buy
anyway. The old adage — buy low, sell high — holds as true
today as it did 75 years ago.
How low can stock prices go? In October 1987, stock prices
tumbled by 22.6%. This decline meant that the value of a
$10,000 investment dropped to $7,740. Many stocks recovered,
but some did not.
You can lose all your money with a stock investment, and
that risk is why you need to analyze your choices carefully.
The three most basic types of risks associated with stock
investments are
You may lose money.
Your stocks may not perform as well as other, similar
stocks.
A loss may threaten your financial goals.
Stock investing carries certain risks, but they can be minimized
by careful investment selection and by diversification,
a technique for building a balanced portfolio.
What is a Stock
A stock is a piece of paper that signifies that you own part of
a company. The market price of a stock is directly related to
the profits and the losses of the company. In other words,
when the company profits, the worth of your stock increases.
When the company falters and its profits decline, so does the
worth of your stock.
Investors who buy stock own shares of the company. That’s
why they’re called shareholders.
a company. The market price of a stock is directly related to
the profits and the losses of the company. In other words,
when the company profits, the worth of your stock increases.
When the company falters and its profits decline, so does the
worth of your stock.
Investors who buy stock own shares of the company. That’s
why they’re called shareholders.
Analyzing mutual funds
As you begin your search for mutual funds, make sure that
your performance evaluation produces meaningful results.
Performance is important because good, long-term earnings
enable you to maximize your investments and ensure that
your money is working for you. Gauging future performance
is not an exact science.
A fund’s prospectus, which you can
request from a fund’s toll-free phone number, also outlines
the important features and objectives of the fund.
As an additional check on your selection process, compare
all your choice funds before making a final decision; avoid
choosing one fund in isolation. A single fund can look spectacular
until you discover it trails most of its peers by 10%.
Look for the following information when you select mutual
funds:
One-, three-, and five-year returns: These numbers
offer information on the fund’s past performance. A look
at all three can give you a sense of how well a fund fared
over time and in relation to similar funds.
Year-to-date total returns: This is a fund’s report card
for the current year, minus operating and management
expenses. The numbers can give you a sense of whether
earnings are in line with competing funds, out in front,
or trailing.
Maximum initial sales charges, commissions, or
loads: Unlike stocks and bonds, mutual funds have builtin
operating and management expenses. These expenses
are in addition to any commission you may pay to a broker
or financial planner to buy a fund. A sales charge on
a purchase, sometimes called a load, is a charge you pay
when you buy shares. You can determine the sales charge
(load) on purchases by looking at the fee and expense
table in the prospectus. No-load funds don’t charge sales
loads. There are no-load funds in every major fund category.
However, even no-load funds have ongoing operating
and management expenses.
Go for lower-priced funds or no-load mutual funds,
which by definition must have expenses no higher than
0.25%. Load funds can have charges of up to 5.75%.
What that means is that you must deduct that 5.75%
from any annual performance a fund turns in. If it’s
10%, you can expect to earn 4.25% after you pay the
load or commission.
Annual expenses: Also called annual operating expense
ratios (AOERs), these costs can sap your performance.
Before you settle on one fund, review the numbers on at
least a few competitors to determine if the fund’s
expenses are in line with typical industry charges. In general,
the more aggressive a fund, the more expenses it
incurs trading investments. Before you invest in a particular
fund, be cautious if it has an extremely high
AOER compared to that of similar funds.
To develop a sense of how expenses can take a big bite
out of earnings over the years, consider this example: A
$10,000 investment earns 10% over 40 years with a 1%
expense ratio, which yields a return of $302,771. The
same investment with a 1.74% expense ratio returns
$239,177, or $63,594 less.
Manager’s tenure: Consider how long the current fund
manager (or managers) has been managing the fund. If
it’s only been a year or two, take that into consideration
before you invest — the five-year record that caught your
eye may have been created by someone who has already
moved down the road. Fund managers move around a
often. In an ideal world, your funds are handled by managers
with staying power.
Portfolio turnover: This tells you how often a fund
manager sells stocks in a the course of a year. Selling
stocks is expensive, so high turnover over the long run
will probably hurt performance. If two funds appear
equal in all other aspects, but one has high turnover and
the other low turnover, by all means choose the fund
with low turnover.
Underlying fund investments: For your own sake, take
a look at the top five or ten stocks or bonds that a fund
is investing in. For example, a growth fund may be getting
its rapid appreciation from a high concentration in
fairly risky technology stocks, or a global fund may have
more than 50% of its holdings in U.S. stocks. Neither
of these strategies is a mortal sin if you know about and
can live with it. If you can’t, keep looking for a fund that
matches your goals. Looking at underlying investments
not only helps minimize your surprises as markets and
economies shift, but also enables you to create a balanced
portfolio.
your performance evaluation produces meaningful results.
Performance is important because good, long-term earnings
enable you to maximize your investments and ensure that
your money is working for you. Gauging future performance
is not an exact science.
A fund’s prospectus, which you can
request from a fund’s toll-free phone number, also outlines
the important features and objectives of the fund.
As an additional check on your selection process, compare
all your choice funds before making a final decision; avoid
choosing one fund in isolation. A single fund can look spectacular
until you discover it trails most of its peers by 10%.
Look for the following information when you select mutual
funds:
One-, three-, and five-year returns: These numbers
offer information on the fund’s past performance. A look
at all three can give you a sense of how well a fund fared
over time and in relation to similar funds.
Year-to-date total returns: This is a fund’s report card
for the current year, minus operating and management
expenses. The numbers can give you a sense of whether
earnings are in line with competing funds, out in front,
or trailing.
Maximum initial sales charges, commissions, or
loads: Unlike stocks and bonds, mutual funds have builtin
operating and management expenses. These expenses
are in addition to any commission you may pay to a broker
or financial planner to buy a fund. A sales charge on
a purchase, sometimes called a load, is a charge you pay
when you buy shares. You can determine the sales charge
(load) on purchases by looking at the fee and expense
table in the prospectus. No-load funds don’t charge sales
loads. There are no-load funds in every major fund category.
However, even no-load funds have ongoing operating
and management expenses.
Go for lower-priced funds or no-load mutual funds,
which by definition must have expenses no higher than
0.25%. Load funds can have charges of up to 5.75%.
What that means is that you must deduct that 5.75%
from any annual performance a fund turns in. If it’s
10%, you can expect to earn 4.25% after you pay the
load or commission.
Annual expenses: Also called annual operating expense
ratios (AOERs), these costs can sap your performance.
Before you settle on one fund, review the numbers on at
least a few competitors to determine if the fund’s
expenses are in line with typical industry charges. In general,
the more aggressive a fund, the more expenses it
incurs trading investments. Before you invest in a particular
fund, be cautious if it has an extremely high
AOER compared to that of similar funds.
To develop a sense of how expenses can take a big bite
out of earnings over the years, consider this example: A
$10,000 investment earns 10% over 40 years with a 1%
expense ratio, which yields a return of $302,771. The
same investment with a 1.74% expense ratio returns
$239,177, or $63,594 less.
Manager’s tenure: Consider how long the current fund
manager (or managers) has been managing the fund. If
it’s only been a year or two, take that into consideration
before you invest — the five-year record that caught your
eye may have been created by someone who has already
moved down the road. Fund managers move around a
often. In an ideal world, your funds are handled by managers
with staying power.
Portfolio turnover: This tells you how often a fund
manager sells stocks in a the course of a year. Selling
stocks is expensive, so high turnover over the long run
will probably hurt performance. If two funds appear
equal in all other aspects, but one has high turnover and
the other low turnover, by all means choose the fund
with low turnover.
Underlying fund investments: For your own sake, take
a look at the top five or ten stocks or bonds that a fund
is investing in. For example, a growth fund may be getting
its rapid appreciation from a high concentration in
fairly risky technology stocks, or a global fund may have
more than 50% of its holdings in U.S. stocks. Neither
of these strategies is a mortal sin if you know about and
can live with it. If you can’t, keep looking for a fund that
matches your goals. Looking at underlying investments
not only helps minimize your surprises as markets and
economies shift, but also enables you to create a balanced
portfolio.
Bond funds are less risky
Bond funds are less risky than stock funds, but also less
rewarding. You can choose from the following types of bond
funds:
Corporate
Municipal
U.S. Treasury bonds
Chapter 3: Understanding Mutual Funds, 401(k)s, and IRAs 39
International bond funds
Mortgage bond funds
Balanced funds are another investment option. These funds
are a mix of stocks and bonds that are also called blended or
hybrid funds. Generally, managers invest in about 60% stocks
and 40% bonds. Balanced funds are appealing to investors
because even in bear markets, their bond holdings still allow
them to pay dividends. (A bear market is generally defined as
a market in which stock prices drop 20% or more from their
previous high.)
Money market funds are arguably the least volatile type of
mutual fund. Fund managers invest in things such as shortterm
bank CDs, U.S. Treasury bills, and short-term corporate
debt issued by established and stable companies. This
type of mutual fund is ideal for people who may need to use
the money to buy something in the short term like a down
payment on a home. These funds are also a convenient place
to pool money for future investment decisions.
rewarding. You can choose from the following types of bond
funds:
Corporate
Municipal
U.S. Treasury bonds
Chapter 3: Understanding Mutual Funds, 401(k)s, and IRAs 39
International bond funds
Mortgage bond funds
Balanced funds are another investment option. These funds
are a mix of stocks and bonds that are also called blended or
hybrid funds. Generally, managers invest in about 60% stocks
and 40% bonds. Balanced funds are appealing to investors
because even in bear markets, their bond holdings still allow
them to pay dividends. (A bear market is generally defined as
a market in which stock prices drop 20% or more from their
previous high.)
Money market funds are arguably the least volatile type of
mutual fund. Fund managers invest in things such as shortterm
bank CDs, U.S. Treasury bills, and short-term corporate
debt issued by established and stable companies. This
type of mutual fund is ideal for people who may need to use
the money to buy something in the short term like a down
payment on a home. These funds are also a convenient place
to pool money for future investment decisions.
Stock funds features
Aggressive growth funds: Managers of these funds are
forever on the lookout for undiscovered, unheralded
companies, including small and undervalued companies.
The goal is to get in when the stock is cheap and realize
substantial gains as it soars skyward. That dream doesn’t
always come true. But if you’re willing to accept aboveaverage
risk, you may reap above-average gains.
Growth funds: These funds are among the mainstays of
long-term investing. They own stocks in mostly large- or
medium-sized companies whose significant earnings are
expected to increase at a faster rate than that of the rest
of the market. These growth funds do not typically pay
dividends. Several types are available, including large-,
medium-, and small-company growth funds.
Value funds: Managers of these funds seek out stocks
that are underpriced — selling cheaply, relative to the
stock’s true value. The fund’s manager believes that the
market will recognize the stock’s true price in the future.
Stock price appreciation is long term. These funds don’t
typically turn in outstanding performance when the
stock market is zooming along, but tend to hold their
value a
good deal more than growth funds when stock
prices slide. That’s why value funds are generally believed
to be good hedges to more growth-oriented mutual
funds. These funds come in large-, medium-, and smallcompany
versions.
Equity income funds: These funds were developed to
balance investors’ desires for current income with some
potential for capital appreciation. These fund managers
invest mostly in stocks — often blue chip stocks — that
pay dividends. They usually make some investments in
utility companies, which are also likely to pay dividends.
Growth and income funds: These funds seek both capital
appreciation and current income. Growth and
income are considered equal investment objectives.
International and global funds: These two funds may
sound like the same type of mutual fund, but they’re not.
International funds invest in a
portfolio of only non-U.S.
stocks (international securities). Global funds, also called
world funds, can also invest in the U.S. stock markets. In
fact, during the 1990s, many global funds handed in
remarkable performances not because of their international
stock-picking prowess, but because they concentrated
the bulk of their assets in U.S. stocks. This is a
prime example of the importance of understanding how
fund managers are investing your money. I talk more
about how to make this determination in the next section.
Sector funds: The managers of these funds concentrate
their investments in one sector of the economy, such as
financial services, real estate, or technology. Although
these types of funds may be a good choice after you’ve
already built a portfolio that matches your investment
plan, they have greater risk than almost any other type
of fund because these funds concentrate their investments
in one sector or industry.
If you’re uncomfortable with the potential for significant
losses, make sure that a sector fund only accounts for a
small percentage of your portfolio — say, less than 10%.
Remember, however, that if you invest in a balanced
portfolio, your other investments should hold their own
if only one industry is impacted.
Emerging market funds: The managers of these funds
seek out the stocks of underdeveloped countries and
economies in Asia, Eastern Europe, and Latin America.
Finding undiscovered winners can prove advantageous,
but an emerging market fund — also known as an
emerging country fund — isn’t a recommended mainstay
for new investors because of the potential for loss.
When these countries and economies suffer economic
decline, they can create significant investor losses.
Single-country funds: As their name implies, the managers
of these funds look for the stock winners of one
country. Unless you have close relatives running a country
somewhere and have firsthand knowledge about that
land’s economic prospects, you’re wise to steer clear of
these funds. The reason is simple: They have unmitigated
risk from concentration in one area. For example, when
Japan’s economy declined in 1998, it sent mutual funds
that invested exclusively in that country’s companies
tumbling by more than 50%.
Index funds: The managers of these funds invest in
stocks that mirror the investments tracked by an index
such as the Standard & Poors 500. Some of the advantages
of investing in index funds include low operating
expenses, diversification, and potential tax savings. More
than 150 funds, including growth companies, track a
variety of different indexes. Although they don’t necessarily
rely on the performance of any one company or
industry to buoy their performance, they do invest in
equities that represent a market — such as the U.S. stock
market. If and when that market dips, as the U.S. market
did by 20% in 1987, index funds can be hit pretty
hard.
forever on the lookout for undiscovered, unheralded
companies, including small and undervalued companies.
The goal is to get in when the stock is cheap and realize
substantial gains as it soars skyward. That dream doesn’t
always come true. But if you’re willing to accept aboveaverage
risk, you may reap above-average gains.
Growth funds: These funds are among the mainstays of
long-term investing. They own stocks in mostly large- or
medium-sized companies whose significant earnings are
expected to increase at a faster rate than that of the rest
of the market. These growth funds do not typically pay
dividends. Several types are available, including large-,
medium-, and small-company growth funds.
Value funds: Managers of these funds seek out stocks
that are underpriced — selling cheaply, relative to the
stock’s true value. The fund’s manager believes that the
market will recognize the stock’s true price in the future.
Stock price appreciation is long term. These funds don’t
typically turn in outstanding performance when the
stock market is zooming along, but tend to hold their
value a
good deal more than growth funds when stock
prices slide. That’s why value funds are generally believed
to be good hedges to more growth-oriented mutual
funds. These funds come in large-, medium-, and smallcompany
versions.
Equity income funds: These funds were developed to
balance investors’ desires for current income with some
potential for capital appreciation. These fund managers
invest mostly in stocks — often blue chip stocks — that
pay dividends. They usually make some investments in
utility companies, which are also likely to pay dividends.
Growth and income funds: These funds seek both capital
appreciation and current income. Growth and
income are considered equal investment objectives.
International and global funds: These two funds may
sound like the same type of mutual fund, but they’re not.
International funds invest in a
portfolio of only non-U.S.
stocks (international securities). Global funds, also called
world funds, can also invest in the U.S. stock markets. In
fact, during the 1990s, many global funds handed in
remarkable performances not because of their international
stock-picking prowess, but because they concentrated
the bulk of their assets in U.S. stocks. This is a
prime example of the importance of understanding how
fund managers are investing your money. I talk more
about how to make this determination in the next section.
Sector funds: The managers of these funds concentrate
their investments in one sector of the economy, such as
financial services, real estate, or technology. Although
these types of funds may be a good choice after you’ve
already built a portfolio that matches your investment
plan, they have greater risk than almost any other type
of fund because these funds concentrate their investments
in one sector or industry.
If you’re uncomfortable with the potential for significant
losses, make sure that a sector fund only accounts for a
small percentage of your portfolio — say, less than 10%.
Remember, however, that if you invest in a balanced
portfolio, your other investments should hold their own
if only one industry is impacted.
Emerging market funds: The managers of these funds
seek out the stocks of underdeveloped countries and
economies in Asia, Eastern Europe, and Latin America.
Finding undiscovered winners can prove advantageous,
but an emerging market fund — also known as an
emerging country fund — isn’t a recommended mainstay
for new investors because of the potential for loss.
When these countries and economies suffer economic
decline, they can create significant investor losses.
Single-country funds: As their name implies, the managers
of these funds look for the stock winners of one
country. Unless you have close relatives running a country
somewhere and have firsthand knowledge about that
land’s economic prospects, you’re wise to steer clear of
these funds. The reason is simple: They have unmitigated
risk from concentration in one area. For example, when
Japan’s economy declined in 1998, it sent mutual funds
that invested exclusively in that country’s companies
tumbling by more than 50%.
Index funds: The managers of these funds invest in
stocks that mirror the investments tracked by an index
such as the Standard & Poors 500. Some of the advantages
of investing in index funds include low operating
expenses, diversification, and potential tax savings. More
than 150 funds, including growth companies, track a
variety of different indexes. Although they don’t necessarily
rely on the performance of any one company or
industry to buoy their performance, they do invest in
equities that represent a market — such as the U.S. stock
market. If and when that market dips, as the U.S. market
did by 20% in 1987, index funds can be hit pretty
hard.
Defining Mutual Funds
A mutual fund is managed by an investment company that
invests (according to the fund’s objectives) in stocks, bonds,
government securities, short-term money market funds, and
other instruments by pooling investors’ money.
Mutual funds are sold in shares. Each share of a fund represents
an ownership in the fund’s underlying securities (the
portfolio).
By law, mutual funds must calculate the price of their shares
each business day. Investors can sell their shares at any time
and receive the current share price, which may be more or
less than the price they paid.
When a fund earns money from dividends on the securities
it invests in or makes money by selling some of its investments
at a profit, the fund distributes the earnings to shareholders.
If you’re an investor, you may decide to reinvest these distributions
automatically in additional fund shares.
A mutual fund investor makes money from the distribution
of dividends and capital gains on the fund’s investments. A
mutual fund shareholder also can potentially make money as
the fund’s share per share (called net asset value, or NAV)
increases in value.
NAV of a mutual fund = Assets
– Liabilities
÷ Number of shares in the fund
(Assets are the value of all securities in a fund’s portfolio; liabilities
are a fund’s expenses.) The NAV of a mutual fund is
affected by the share price charges of the securities in the
fund’s portfolio and any dividend or capital gains distributions
to its shareholders.
Unless you’re in immediate need of this income, which is taxable,
reinvesting this money into additional shares is an excellent
way to grow your investments.
Shareholders receive a portion of the distribution of dividends
and capital gains, based on the number of shares they own.
As a result, an investor who puts $1,000 in a mutual fund
gets the same investment performance and return per dollar
as someone who invests $100,000.
Mutual funds invest in many (sometimes hundreds of ) securities
at one time, so they are diversified investments. A diversified
portfolio is one that balances risk by investing in a
number of different areas of the stock and/or bond markets.
This type of investing attempts to reduce per-share volatility
and minimize losses over the long term as markets change.
Diversification offsets the risk of putting your eggs in one
basket, such as technology funds.
A stock or bond of any one company represents just a small
percentage of a fund’s overall portfolio. So even if one of a
fund’s investments performs poorly, 20 to 150 more investments
can shore up the fund’s performance. As a result, the
poor performance of any one investment isn’t likely to have
a devastating effect on an entire mutual fund portfolio. That
balance doesn’t mean, however, that funds don’t have inherent
risks: You need to carefully select mutual funds to meet
your investment goals and risk tolerance.
The performance of certain classes of investments — such as
large company growth stocks — can strengthen or weaken a
fund’s overall investment performance if the fund concentrates
its investments within that class. If the overall economy
declines, the stock market takes a dive, or a mutual fund
manager picks investments with little potential to be profitable,
a fund’s performance can suffer.
Unfortunately, unless you have a crystal ball, you have no
way to predict how a fund will perform, except to look at the
security’s underlying risk. If a fund has existed long enough
to build a track record through ups and downs, you can
review its performance during the last stressful market.
Fortunately for all investors, some companies use a statistical
measure called standard deviation, which measures the
volatility in the fund’s performance. The larger the swings in
a fund’s returns, the more likely the fund will slip into negative
numbers.
invests (according to the fund’s objectives) in stocks, bonds,
government securities, short-term money market funds, and
other instruments by pooling investors’ money.
Mutual funds are sold in shares. Each share of a fund represents
an ownership in the fund’s underlying securities (the
portfolio).
By law, mutual funds must calculate the price of their shares
each business day. Investors can sell their shares at any time
and receive the current share price, which may be more or
less than the price they paid.
When a fund earns money from dividends on the securities
it invests in or makes money by selling some of its investments
at a profit, the fund distributes the earnings to shareholders.
If you’re an investor, you may decide to reinvest these distributions
automatically in additional fund shares.
A mutual fund investor makes money from the distribution
of dividends and capital gains on the fund’s investments. A
mutual fund shareholder also can potentially make money as
the fund’s share per share (called net asset value, or NAV)
increases in value.
NAV of a mutual fund = Assets
– Liabilities
÷ Number of shares in the fund
(Assets are the value of all securities in a fund’s portfolio; liabilities
are a fund’s expenses.) The NAV of a mutual fund is
affected by the share price charges of the securities in the
fund’s portfolio and any dividend or capital gains distributions
to its shareholders.
Unless you’re in immediate need of this income, which is taxable,
reinvesting this money into additional shares is an excellent
way to grow your investments.
Shareholders receive a portion of the distribution of dividends
and capital gains, based on the number of shares they own.
As a result, an investor who puts $1,000 in a mutual fund
gets the same investment performance and return per dollar
as someone who invests $100,000.
Mutual funds invest in many (sometimes hundreds of ) securities
at one time, so they are diversified investments. A diversified
portfolio is one that balances risk by investing in a
number of different areas of the stock and/or bond markets.
This type of investing attempts to reduce per-share volatility
and minimize losses over the long term as markets change.
Diversification offsets the risk of putting your eggs in one
basket, such as technology funds.
A stock or bond of any one company represents just a small
percentage of a fund’s overall portfolio. So even if one of a
fund’s investments performs poorly, 20 to 150 more investments
can shore up the fund’s performance. As a result, the
poor performance of any one investment isn’t likely to have
a devastating effect on an entire mutual fund portfolio. That
balance doesn’t mean, however, that funds don’t have inherent
risks: You need to carefully select mutual funds to meet
your investment goals and risk tolerance.
The performance of certain classes of investments — such as
large company growth stocks — can strengthen or weaken a
fund’s overall investment performance if the fund concentrates
its investments within that class. If the overall economy
declines, the stock market takes a dive, or a mutual fund
manager picks investments with little potential to be profitable,
a fund’s performance can suffer.
Unfortunately, unless you have a crystal ball, you have no
way to predict how a fund will perform, except to look at the
security’s underlying risk. If a fund has existed long enough
to build a track record through ups and downs, you can
review its performance during the last stressful market.
Fortunately for all investors, some companies use a statistical
measure called standard deviation, which measures the
volatility in the fund’s performance. The larger the swings in
a fund’s returns, the more likely the fund will slip into negative
numbers.
What’s new about the Roth IRA
If your income is below $110,000 (
single) or $160,000 (married
and filing jointly), you can contribute $2,000 a year to
a Roth IRA — and this contribution is permitted even if you
participate in other pension or profit-sharing plans.
The Roth IRA, introduced in 1998, offers the benefit of taxfree
withdrawals (if you are 591⁄2 and the account has been
held at least five years). If you choose a Roth IRA, your
$2,000 contribution comes out of income you’ve already paid
taxes on (that is, earnings). That’s very different from the traditional
IRA, in which your contribution may come from
pretax earnings.
Like a traditional IRA, the funds contributed to a Roth IRA
accumulate tax-free. The big difference is that if you are 591⁄2
and have held the Roth IRA for five years, you never pay tax
on the money you withdraw. That means that the earnings
on the $2,000 you contribute annually are tax-free.
If your income is more than $
110,000 and you’re single, or
if you’re married and you and your spouse have a combined
income of over $160,000, you’re not eligible for a Roth IRA.
Another advantage of the withdrawal requirements of a Roth
IRA is that you’re not required to take your money out of a
Roth IRA when you reach 701⁄2 as you are with traditional
IRAs. In fact, you can leave the money and all the earnings
to your heirs, if you want to. This allowance enables you to
control the timing and the pace of your withdrawals from
the account, potentially allowing the funds to stay there,
growing tax-free, for more years.
Investors can contribute to both a
traditional IRA and a
Roth
IRA; however, the total contribution to the two accounts can’t
exceed the $2,000 annual limit. Many financial advisors say
that if you are young and in a low tax bracket, you should
probably open a Roth IRA and fund it with the full $2,000
every year. For most people, it’s not worth debating over the
two because only those who have relatively low incomes or
no other active retirement plans can take advantage of the
deductibility of the traditional IRA.
single) or $160,000 (married
and filing jointly), you can contribute $2,000 a year to
a Roth IRA — and this contribution is permitted even if you
participate in other pension or profit-sharing plans.
The Roth IRA, introduced in 1998, offers the benefit of taxfree
withdrawals (if you are 591⁄2 and the account has been
held at least five years). If you choose a Roth IRA, your
$2,000 contribution comes out of income you’ve already paid
taxes on (that is, earnings). That’s very different from the traditional
IRA, in which your contribution may come from
pretax earnings.
Like a traditional IRA, the funds contributed to a Roth IRA
accumulate tax-free. The big difference is that if you are 591⁄2
and have held the Roth IRA for five years, you never pay tax
on the money you withdraw. That means that the earnings
on the $2,000 you contribute annually are tax-free.
If your income is more than $
110,000 and you’re single, or
if you’re married and you and your spouse have a combined
income of over $160,000, you’re not eligible for a Roth IRA.
Another advantage of the withdrawal requirements of a Roth
IRA is that you’re not required to take your money out of a
Roth IRA when you reach 701⁄2 as you are with traditional
IRAs. In fact, you can leave the money and all the earnings
to your heirs, if you want to. This allowance enables you to
control the timing and the pace of your withdrawals from
the account, potentially allowing the funds to stay there,
growing tax-free, for more years.
Investors can contribute to both a
traditional IRA and a
Roth
IRA; however, the total contribution to the two accounts can’t
exceed the $2,000 annual limit. Many financial advisors say
that if you are young and in a low tax bracket, you should
probably open a Roth IRA and fund it with the full $2,000
every year. For most people, it’s not worth debating over the
two because only those who have relatively low incomes or
no other active retirement plans can take advantage of the
deductibility of the traditional IRA.
The key benefits of traditional IRAs
If you choose a traditional IRA, your contributions may be
tax-deductible, while your savings grow and compound taxdeferred
until you withdraw them at retirement.
In certain situations, your entire contribution to a traditional
IRA can be tax deductible, meaning that you get to subtract
Chapter 3: Understanding Mutual Funds, 401(k)s, and IRAs 29
the amount that you contribute from your income, reducing
the amount of taxes you have to pay overall.
The rules for this tax benefit are as follows:
If you’re single and don’t have an employer-sponsored
retirement plan, the full $
2,000 is deductible on your
income tax return.
If you’re single and covered by an employer-sponsored
plan, you can contribute up to $2,000 and deduct the
full amount if your annual adjusted gross income is
$30,000 or less. (Annual adjusted gross income is defined
as your gross income, less certain allowed business-related
deductions.
Deductions include alimony payments, contributions
to a Keogh plan, and in some cases, contributions
to an IRA.) If your income is between $30,000
and $40,000, the deduction is prorated. If you make
more than $40,000, you can contribute, but you get no
deduction. These numbers gradually increase to $50,000
for taking the full deduction and to $60,000 for taking
no deduction, until the year 2005.
If you’re married and file your tax returns jointly, you
have an employer-sponsored plan, and your annual
adjusted gross income is $50,000 or less, you can deduct
the full amount. The figure is prorated from $50,000 to
$60,000. After $60,000, you can’t take any deduction.
By 2007, the income allowances will increase to $80,000
for taking the full deduction and $100,000 for taking no
deduction.
If your spouse doesn’t have a retirement plan at work,
and you file a joint tax return, the spouse can deduct his
or her full $2,000 contribution until your joint income
reaches $
150,000. After that, the deduction is prorated
until your joint income is $160,000, at which time you
can’t deduct the IRA contribution.
Non-income earning spouses can also open IRAs, and
the annual contribution for a married couple filing
jointly is $4,000 or 100% of earned income, whichever
is less, with a $2,000 maximum contribution for each
spouse.
Funds generally can’t be taken from a traditional IRA before
age 591⁄2 without paying a penalty. If you take money out,
taxes and a 10% penalty are imposed on the taxable portion
of the distribution.
You can make some withdrawals without paying a penalty.
Money can be taken penalty-free if you use it for a first-time
home purchase or for higher education fees. You can also
withdraw penalty-free in the event of death or disability, or
if you incur some types of medical expenses.
After you turn age 701⁄2, you are required to take money from
your traditional IRA account, either in the form of a lumpsum
payout or a little at a time; withdrawing a little at a time
allows you to extend the benefit of the tax shelter.
tax-deductible, while your savings grow and compound taxdeferred
until you withdraw them at retirement.
In certain situations, your entire contribution to a traditional
IRA can be tax deductible, meaning that you get to subtract
Chapter 3: Understanding Mutual Funds, 401(k)s, and IRAs 29
the amount that you contribute from your income, reducing
the amount of taxes you have to pay overall.
The rules for this tax benefit are as follows:
If you’re single and don’t have an employer-sponsored
retirement plan, the full $
2,000 is deductible on your
income tax return.
If you’re single and covered by an employer-sponsored
plan, you can contribute up to $2,000 and deduct the
full amount if your annual adjusted gross income is
$30,000 or less. (Annual adjusted gross income is defined
as your gross income, less certain allowed business-related
deductions.
Deductions include alimony payments, contributions
to a Keogh plan, and in some cases, contributions
to an IRA.) If your income is between $30,000
and $40,000, the deduction is prorated. If you make
more than $40,000, you can contribute, but you get no
deduction. These numbers gradually increase to $50,000
for taking the full deduction and to $60,000 for taking
no deduction, until the year 2005.
If you’re married and file your tax returns jointly, you
have an employer-sponsored plan, and your annual
adjusted gross income is $50,000 or less, you can deduct
the full amount. The figure is prorated from $50,000 to
$60,000. After $60,000, you can’t take any deduction.
By 2007, the income allowances will increase to $80,000
for taking the full deduction and $100,000 for taking no
deduction.
If your spouse doesn’t have a retirement plan at work,
and you file a joint tax return, the spouse can deduct his
or her full $2,000 contribution until your joint income
reaches $
150,000. After that, the deduction is prorated
until your joint income is $160,000, at which time you
can’t deduct the IRA contribution.
Non-income earning spouses can also open IRAs, and
the annual contribution for a married couple filing
jointly is $4,000 or 100% of earned income, whichever
is less, with a $2,000 maximum contribution for each
spouse.
Funds generally can’t be taken from a traditional IRA before
age 591⁄2 without paying a penalty. If you take money out,
taxes and a 10% penalty are imposed on the taxable portion
of the distribution.
You can make some withdrawals without paying a penalty.
Money can be taken penalty-free if you use it for a first-time
home purchase or for higher education fees. You can also
withdraw penalty-free in the event of death or disability, or
if you incur some types of medical expenses.
After you turn age 701⁄2, you are required to take money from
your traditional IRA account, either in the form of a lumpsum
payout or a little at a time; withdrawing a little at a time
allows you to extend the benefit of the tax shelter.
Investing in Individual Retirement Accounts
An Individual Retirement Account (IRA) is a tax-saving program
(established under the Employee Retirement Security
Act of 1974) to help Americans invest for retirement. Anyone
who earns money by working can contribute up to
$2,000 a year, or 100% of your income, whichever is less. If
you don’t have access to a
401(k) or other retirement plan,
or if you’ve calculated that your current plan won’t completely
cover your retirement needs, then an IRA can help.
IRAs offer tax-deferred growth — you don’t pay any tax on it
or the money that it earns for you until you withdraw it during
retirement.
You set up your IRA on your own with a bank, mutual fund,
or brokerage firm. Like a 401(k), you can invest your IRA
money in almost anything you can think of, from aggressive
growth stocks to conservative savings accounts.
Some financial planners advise that you use your IRA for
investments that produce the highest income, such as stocks
paying high dividends, because you defer the taxes. Another
tactic is to put the IRA funds into riskier high-growth investments,
such as stocks or certain types of mutual funds,
because you don’t touch the funds until retirement and can
always switch them to safer investments as you get older.
I suggest investing in an IRA for the following reasons:
If your employer doesn’t offer a 401(k) plan
If you’ve calculated that your current retirement plan
won’t completely cover your estimated retirement needs,
consider investing in an IRA — if you qualify
To invest in high-yield investments — such as stocks
paying high dividends — because your investment dollars
are tax-deferred
To invest in higher risk investments, such as stocks and
certain mutual funds, if you don’t plan to retire for years
to come (by doing so you commit to taking the chance
of receiving higher gains for your investment dollar)
You can choose from two types of IRAs: traditional IRA and
Roth IRA
(established under the Employee Retirement Security
Act of 1974) to help Americans invest for retirement. Anyone
who earns money by working can contribute up to
$2,000 a year, or 100% of your income, whichever is less. If
you don’t have access to a
401(k) or other retirement plan,
or if you’ve calculated that your current plan won’t completely
cover your retirement needs, then an IRA can help.
IRAs offer tax-deferred growth — you don’t pay any tax on it
or the money that it earns for you until you withdraw it during
retirement.
You set up your IRA on your own with a bank, mutual fund,
or brokerage firm. Like a 401(k), you can invest your IRA
money in almost anything you can think of, from aggressive
growth stocks to conservative savings accounts.
Some financial planners advise that you use your IRA for
investments that produce the highest income, such as stocks
paying high dividends, because you defer the taxes. Another
tactic is to put the IRA funds into riskier high-growth investments,
such as stocks or certain types of mutual funds,
because you don’t touch the funds until retirement and can
always switch them to safer investments as you get older.
I suggest investing in an IRA for the following reasons:
If your employer doesn’t offer a 401(k) plan
If you’ve calculated that your current retirement plan
won’t completely cover your estimated retirement needs,
consider investing in an IRA — if you qualify
To invest in high-yield investments — such as stocks
paying high dividends — because your investment dollars
are tax-deferred
To invest in higher risk investments, such as stocks and
certain mutual funds, if you don’t plan to retire for years
to come (by doing so you commit to taking the chance
of receiving higher gains for your investment dollar)
You can choose from two types of IRAs: traditional IRA and
Roth IRA
Getting out of a 401(k)
When you retire or leave your company, you can leave your
401(k) invested as it is, roll it over into another retirement
account (such as an IRA, which I talk about in the section
“Investing in Individual Retirement Accounts,” later in this
chapter), or withdraw it. People usually face some penalties
and an income tax liability for withdrawing the money. You
can claim funds from the 401(k) without a penalty after
age 591⁄2.
When you’re in your 20s and 30s, retirement may seem
impossibly far off — so far off, in fact, that it’s hard to imagine
planning for it now. However, start saving for your retirement,
and the sooner the better. In 1998, the Social Security
Administration estimated that Social Security will provide
less than a quarter of the amount you’ll need to pay for housing,
food, and other living expenses in your retirement. If
you want to retire in comfort, you will have to provide for
yourself.
401(k) invested as it is, roll it over into another retirement
account (such as an IRA, which I talk about in the section
“Investing in Individual Retirement Accounts,” later in this
chapter), or withdraw it. People usually face some penalties
and an income tax liability for withdrawing the money. You
can claim funds from the 401(k) without a penalty after
age 591⁄2.
When you’re in your 20s and 30s, retirement may seem
impossibly far off — so far off, in fact, that it’s hard to imagine
planning for it now. However, start saving for your retirement,
and the sooner the better. In 1998, the Social Security
Administration estimated that Social Security will provide
less than a quarter of the amount you’ll need to pay for housing,
food, and other living expenses in your retirement. If
you want to retire in comfort, you will have to provide for
yourself.
Deciding where to put your 401(k) money
Most 401(k) plans offer a variety of investments, including
mutual funds, stock funds, and bond funds. Deciding which
of these investments to put your money in takes research.
You don’t have to put all your 401(k) money into one investment
vehicle. Unless your research tells you otherwise, you
should invest only a certain percentage of your money in a
high-risk investment, such as stocks. Also note that most
401(k) plans offer mutual funds whose “risk” ranges from
conservative to aggressive.
To determine what percentage of your money to invest in
stocks, many financial advisors recommend that you subtract
your age from 100. For example, if you’re 25, you should
have 75% of your 401(k) money in stocks.
mutual funds, stock funds, and bond funds. Deciding which
of these investments to put your money in takes research.
You don’t have to put all your 401(k) money into one investment
vehicle. Unless your research tells you otherwise, you
should invest only a certain percentage of your money in a
high-risk investment, such as stocks. Also note that most
401(k) plans offer mutual funds whose “risk” ranges from
conservative to aggressive.
To determine what percentage of your money to invest in
stocks, many financial advisors recommend that you subtract
your age from 100. For example, if you’re 25, you should
have 75% of your 401(k) money in stocks.
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