Basic Investing

Why Asset Allocation Is So Important

2008-09-22T07:54:00.001-07:00

By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you'll reduce the risk that you'll lose money and your portfolio's overall investment returns will have a smoother ride. If one asset category's investment return falls, you'll be in a position to counteract your losses in that asset category with better investment returns in another asset category.

The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.

In addition, asset allocation is important because it has major impact on whether you will meet your financial goal. If you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement or college, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock or stock mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for a family's summer vacation.

529 College Tuition Plans

2008-08-19T12:41:00.000-07:00

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.

There are two types of 529 plans: pre-paid tuition plans and college savings plans. All fifty states and the District of Columbia sponsor at least one type of 529 plan. In addition, a group of private colleges and universities sponsor a pre-paid tuition plan.

Pre-paid tuition plans generally allow college savers to purchase units or credits at participating colleges and universities for future tuition and, in some cases, room and board. Most prepaid tuition plans are sponsored by state governments and have residency requirements. Many state governments guarantee investments in pre-paid tuition plans that they sponsor.

College savings plans generally permit a college saver (also called the “account holder”) to establish an account for a student (the “beneficiary”) for the purpose of paying the beneficiary’s eligible college expenses. An account holder may typically choose among several investment options for his or her contributions, which the college savings plan invests on behalf of the account holder. Investment options often include stock mutual funds, bond mutual funds, and money market funds, as well as, age-based portfolios that automatically shift toward more conservative investments as the beneficiary gets closer to college age. Withdrawals from college savings plans can generally be used at any college or university. Investments in college savings plans that invest in mutual funds are not guaranteed by state governments and are not federally insured.

Investing in a 529 plan may offer college savers special tax benefits. Earnings in 529 plans are not subject to federal tax, and in most cases, state tax, so long as you use withdrawals for eligible college expenses, such as tuition and room and board.

However, if you withdraw money from a 529 plan and do not use it on an eligible college expense, you generally will be subject to income tax and an additional 10% federal tax penalty on earnings. Many states offer state income tax or other benefits, such as matching grants, for investing in a 529 plan. But you may only be eligible for these benefits if you participate in a 529 plan sponsored by your state of residence. Just a few states allow residents to deduct contributions to any 529 plan from state income tax returns.

Basic Investing: Mutual Funds

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A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, or other securities. Legally known as an "open-end company," a mutual fund is one of three basic types of investment company. The two other basic types are closed-end funds and Unit Investment Trusts (UITs).

Investors purchase mutual fund shares from the fund itself (or through a broker for the fund), but are not able to purchase the shares from other investors on a secondary market, such as the New York Stock Exchange or Nasdaq Stock Market. The price investors pay for mutual fund shares is the fund’s approximate per share net asset value (NAV) plus any shareholder fees that the fund imposes at purchase (such as sales loads).

Mutual fund shares are "redeemable." This means that when mutual fund investors want to sell their fund shares, they sell them back to the fund (or to a broker acting for the fund) at their approximate per share NAV, minus any fees the fund imposes at that time (such as deferred sales loads or redemption fees).

Mutual funds generally sell their shares on a continuous basis, although some funds will stop selling when, for example, they become too large.

Mutual funds come in many varieties. For example, there are index funds, stock funds, bond funds, money market funds, and more. Each of these may have a different investment objective and strategy and a different investment portfolio. Different mutual funds may also be subject to different risks, volatility, and fees and expenses.

All funds charge management fees for operating the fund. Some also charge for their distribution and service costs, commonly referred to as "12b-1" fees. Some funds may also impose sales charges or loads when you purchase or sell fund shares. In this regard, a fund may offer different "classes" of shares in the same portfolio, with certain fees and expenses varying among classes.

Keep in mind that just because a fund had excellent performance last year does not necessarily mean that it will duplicate that performance. For example, market conditions can change and this year’s winning fund might be next year’s loser.

Employee Stock Option Plans (ESOPs)

2008-01-30T13:53:00.000-08:00

Many companies use employee stock options plans to compensate, retain, and attract employees. These plans are contracts between a company and its employees that give employees the right to buy a specific number of the company’s shares at a fixed price within a certain period of time. Employees who are granted stock options hope to profit by exercising their options at a higher price than when they were granted.

Employee Stock Options Plans should not be confused with the term "ESOPs," or Employee Stock Ownership Plans, which are retirement plans.

Here’s an example of a typical employee stock option plan: an employee is granted the option to purchase 1,000 shares of the company’s stock at the current market price of $5 per share (the "grant" price). The employee can exercise the option at $5 per share—typically the exercise price will be equal to the price when the options are granted. Plans allow employees to exercise their options after a certain number of years or when the company’s stock reaches a certain price. If the price of the stock increases to $20 per share, for example, the employee may exercise his or her option to buy 1,000 shares at $5 and then sell the stock at the current market price of $20.

Day Trading

2008-01-30T13:52:00.000-08:00

Day traders rapidly buy and sell stocks throughout the day in the hope that their stocks will continue climbing or falling in value for the seconds to minutes they own the stock, allowing them to lock in quick profits. Day trading is extremely risky and can result in substantial financial losses in a very short period of time.

Under the rules of NYSE and NASD, customers who are deemed "pattern day traders" must have at least $25,000 in their accounts and can only trade in margin accounts.

Certificates of Deposit (CDs)

2008-01-30T13:51:00.001-08:00

Investors searching for relatively low-risk investments that can easily be converted into cash often turn to certificates of deposit (CDs). A CD is a special type of deposit account with a bank or thrift institution that typically offers a higher rate of interest than a regular savings account. Unlike other investments, CDs feature federal deposit insurance up to $100,000.

Here’s how CDs work: When you purchase a CD, you invest a fixed sum of money for fixed period of time – six months, one year, five years, or more – and, in exchange, the issuing bank pays you interest, typically at regular intervals. When you cash in or redeem your CD, you receive the money you originally invested plus any accrued interest. But if you redeem your CD before it matures, you may have to pay an "early withdrawal" penalty or forfeit a portion of the interest you earned.

Although most investors have traditionally purchased CDs through local banks, many brokerage firms and independent salespeople now offer CDs. These individuals and entities – known as "deposit brokers" – can sometimes negotiate a higher rate of interest for a CD by promising to bring a certain amount of deposits to the institution. The deposit broker can then offer these "brokered CDs" to their customers.

At one time, most CDs paid a fixed interest rate until they reached maturity. But, like many other products in today’s markets, CDs have become more complicated. Investors may now choose among variable rate CDs, long-term CDs, and CDs with other special features.

Some long-term, high-yield CDs have "call" features, meaning that the issuing bank may choose to terminate – or call – the CD after only one year or some other fixed period of time. Only the issuing bank may call a CD, not the investor. For example, a bank might decide to call its high-yield CDs if interest rates fall. But if you’ve invested in a long-term CD and interest rates subsequently rise, you’ll be locked in at the lower rate.

CUSIP Number

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CUSIP stands for Committee on Uniform Securities Identification Procedures. A CUSIP number identifies most securities, including: stocks of all registered U.S. and Canadian companies, and U.S. government and municipal bonds. The CUSIP system—owned by the American Bankers Association and operated by Standard & Poor’s—facilitates the clearing and settlement process of securities.

The number consists of nine characters (including letters and numbers) that uniquely identify a company or issuer and the type of security. A similar system is used to identify foreign securities (CUSIP International Numbering System).

Corporate Bonds

2008-01-30T13:48:00.001-08:00

Corporate bonds are debt securities issued by private and public corporations. Companies issue corporate bonds to raise money for a variety of purposes, such as building a new plant, purchasing equipment, or growing the business.

When you buy a corporate bond, you lend money to the "issuer," the company that issued the bond. In exchange, the company promises to return your money, also known as "principal," on a specified maturity date. Until that date, the corporation usually pays you a stated rate of interest, generally semiannually. While a corporate bond gives you an IOU from the company, you do not have an ownership interest in the issuing corporation—unlike when you purchase the company's stock.

Municipal Bonds

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Municipal bonds are debt securities that states, cities, counties, and other governmental entities issue to raise money for public purposes—such as building schools, highways, hospitals, sewer systems, and other special projects. A primary feature of many municipal securities is that the interest you receive is generally exempt from federal income tax. The interest may also be exempt from state and local taxes if you live in the state where the bond is issued.

When you purchase a municipal bond, you lend money to the "issuer," the government entity that issued the bond. In exchange, the government entity promises to pay you a specified amount of interest, usually semiannually, and return your money, also known as "principal," on a specified maturity date.

Annuities

2008-01-30T13:46:00.001-08:00

An annuity is a contract between you and an insurance company, under which you make a lump-sum payment or series of payments. In return, the insurer agrees to make periodic payments to you beginning immediately or at some future date. Annuities typically offer tax-deferred growth of earnings and may include a death benefit that will pay your beneficiary a guaranteed minimum amount, such as your total purchase payments.

There are generally two types of annuities—fixed and variable. In a fixed annuity, the insurance company guarantees that you will earn a minimum rate of interest during the time that your account is growing. The insurance company also guarantees that the periodic payments will be a guaranteed amount per dollar in your account. These periodic payments may last for a definite period, such as 20 years, or an indefinite period, such as your lifetime or the lifetime of you and your spouse.

In a variable annuity, by contrast, you can choose to invest your purchase payments from among a range of different investment options, typically mutual funds. The rate of return on your purchase payments, and the amount of the periodic payments you will eventually receive, will vary depending on the performance of the investment options you have selected.

An equity-indexed annuity is a special type of annuity. During the accumulation period – when you make either a lump sum payment or a series of payments – the insurance company credits you with a return that is based on changes in an equity index, such as the S&P 500 Composite Stock Price Index. The insurance company typically guarantees a minimum return. Guaranteed minimum return rates vary. After the accumulation period, the insurance company will make periodic payments to you under the terms of your contract, unless you choose to receive your contract value in a lump sum.

Initial Public Offerings (IPO)

2008-01-29T08:29:00.000-08:00

IPO stands for initial public offering and occurs when a company first sells its shares to the public.

The IPOs of all but the smallest of companies are usually offered to the public through an "underwriting syndicate," a group of underwriters who agree to purchase the shares from the issuer and then sell the shares to investors. Only a limited number of broker-dealers are invited into the syndicate as underwriters and some of them may not have individual investors as clients. Moreover, syndicate members themselves do not receive equal allocations of securities for sale to their clients.

The underwriters in consultation with the company decide on the basic terms and structure of the offering well before trading starts, including the percentage of shares going to institutions and to individual investors. Most underwriters target institutional or wealthy investors in IPO distributions. Underwriters believe that institutional and wealthy investors are better able to buy large blocks of IPO shares, assume the financial risk, and hold the investment for the long term.

When an IPO is "hot," appealing to many investors, the demand for the securities far exceeds the supply of shares. The excess demand can only be satisfied once trading in the IPO shares begins. It is unclear how "hot" the offering will be until close to the time when the shares start trading. Since "hot" IPOs are in high demand, underwriters usually offer those shares to their most valued clients.

Underwriting firms that have a high percentage of individual investors as clients are more likely to allocate portions of IPO shares to individuals. Several online brokers offer IPOs, but these firms often have only a small allotment of shares to sell to the public. As a result, individual investors' ability to buy these shares may be limited no matter which firm they do business with.

Mutual Fund Classes

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Known as "multi-class funds," some mutual funds offer investors different types of shares, known as "classes." Each class will invest in the same "pool" (or investment portfolio) of securities and will have the same investment objectives and policies. But each class will have different shareholder services and/or distribution arrangements with different fees and expenses and, therefore, different performance results. A multi-class structure offers investors the ability to select a fee and expense structure that is most appropriate for their investment goals (including the time that they expect to remain invested in the fund).

For example, you might find a multi-class fund with three classes of shares that are sold to the general public—Class A, Class B, and Class C—and a class that is sold only to institutional investors—Class I.

* Class A shares might have a front-end sales load (a type of fee that investors pay when they purchase fund shares).

* Class B shares might not have any front-end sales load, but might have a contingent deferred sales load (CDSL) (a type of fee that investors pay only when they redeem fund shares, and that typically decreases to zero if the investors hold their shares long enough) and a 12b-1 fee (an annual fee paid by the fund for distribution and/or shareholder services). Class B shares also might convert automatically to a class of shares with a lower 12b-1 fee if held by investors long enough.

* Class C shares might have a 12b-1 fee and a CDSL or front-end sales load, but the CDSL or sales load would be lower than Class B’s CDSL or Class A’s front-end sales load, and the Class would not convert to another class.

* Class I would be sold only to institutional investors and might have different fees and expenses.

Treasury Securities

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Treasury securities—including Treasury bills, notes, and bonds—are debt obligations issued by the U.S. Department of the Treasury. Treasury securities are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government. The income from Treasury securities is exempt from state and local taxes, but not from federal taxes.

Stop-Limit Order

2008-01-29T08:26:00.001-08:00

A stop-limit order is an order to buy or sell a stock that combines the features of a stop order and a limit order. Once the stop price is reached, the stop-limit order becomes a limit order to buy or to sell at a specified price.

The benefit of a stop-limit order is that the investor can control the price at which the trade will get executed. But, as with all limit orders, a stop-limit order may never get filled if the stock's price never reaches the specified limit price. This may happen especially in fast-moving markets where prices fluctuate wildly.

The use of stop limit orders is much more frequent for stocks that trade on an exchange than in the over-counter (OTC) market. In addition, your broker-dealer may not allow you to place a stop limit order on some securities or accept a stop limit order for OTC stocks. Before you enter into this type of order, you should speak to your broker or financial advisor about how the order works.

Stock Splits

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When a company declares a stock split, the price of the stock will decrease, but the number of shares will increase proportionately. For example, if you own 100 shares of a company that trades at $100 a share and it declares a two for one stock split, you will own a total of 200 shares at $50 a share after the split. A stock split has no effect on the value of what shareholders own. If the company pays a dividend, your dividends paid per share will also fall proportionately.

Companies often split their stock when they believe the price of their stock exceeds the amount smaller individual investors would be willing to pay for the stock. By reducing the price of the stock, companies try to make their stock more affordable to these investors.

Although many stock splits are two for one, companies can split their stock in any number of ways, including three for one, three for two, and so forth. A stock that has split in the last 52 weeks will be identified in newspaper stock columns with an "S" next to the company's name.

Short Sales

2008-01-29T08:25:00.001-08:00

A short sale is generally the sale of a stock you do not own. Investors who sell short believe the price of the stock will fall. If the price drops, you can buy the stock at the lower price and make a profit. If the price of the stock rises and you buy it back later at the higher price, you will incur a loss.

When you sell short, your brokerage firm loans you the stock. The stock you borrow comes from either the firm’s own inventory, the margin account of another of the firm’s clients, or another brokerage firm. As with buying stock on margin, you are subject to the margin rules. Other fees and charges may apply. If the stock you borrow pays a dividend, you must pay the dividend to the person or firm making the loan.

Savings Bonds

2008-01-29T08:24:00.001-08:00

Savings bonds are debt securities issued by the U.S. Department of the Treasury to pay for the U.S. government’s borrowing needs. Saving bonds are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government.

There are several types of U.S. savings bonds:

* Series EE Bonds These savings bonds replaced the Series E bonds. They are purchased at a discount of half their face value. You cannot buy more than $5,000 (face value) during any calendar year. EE bonds increase in value as the interest accrues or accumulates and pay interest for 30 years. When EE bonds “mature,” or come due, you are paid your original investment plus all of the interest.

* Series HH Bonds You can purchase Series HH bonds, but only in exchange for Series EE or E bonds and Savings Notes, or with the proceeds from a matured Series HH bond. Unlike EE bonds, Series HH bonds are purchased at their face amount in $500 to $10,000 denominations, but there is no limit on the amount you can purchase. These bonds don’t increase in value and have a maturity of 20 years.

* Series I Bonds These bonds are sold at face value and grow with inflation-indexed earnings for up to 30 years. You can buy up to $5,000 in any calendar year.

U.S. savings bonds have tax advantages. You can defer federal taxes on the interest until you cash in the bond or stops paying interest at maturity. Savings bonds are also exempt from state and local taxes. Because savings bonds are registered with the U.S. Treasury’s Bureau of the Public Debt, you can get your bonds replaced if your bond is lost, stolen, or destroyed.

For more information about savings bonds, visit the website of U.S. Department of Treasury's Bureau of the Public Debt. At its site, you can use its Savings Bond Calculator to help you make more informed investment decisions about savings bonds. The website also provides a section describing the different types of securities issued by the Treasury.

Mortgage-Backed Securities

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Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.

Most MBSs are issued by the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U.S. government, have special authority to borrow from the U.S. Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as "private-label" mortgage securities.

Mortgage-backed securities exhibit a variety of structures. The most basic types are pass-through participation certificates, which entitle the holder to a pro-rata share of all principal and interest payments made on the pool of loan assets. More complicated MBSs, known as collaterized mortgage obligations or mortgage derivatives, may be designed to protect investors from or expose investors to various types of risk. An important risk with regard to residential mortgages involves prepayments, typically because homeowners refinance when interest rates fall. Absent protection, such prepayments would return principal to investors precisely when their options for reinvesting those funds may be relatively unattractive.

Spiders (SPDRs)

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SPDRs stand for Standard and Poor’s Depositary Receipts. Known as "Spiders," SPDRs are units of an ETF that holds shares of all the companies in the Standard & Poor’s 500 Composite Stock Price Index (S&P 500). SPDRs closely track the price performance and dividend yield of the S&P 500. There are also SPDRs that track the performance of other indexes.

Investors who purchase a SPDR own approximately one tenth of the value of the S&P 500 and receive pro rata quarterly dividends less expenses of the ETF. Unlike an index mutual fund that can only be bought and sold at the end of each trading day, SPDRs trade throughout the trading day.

Index Funds

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An "index fund" describes a type of mutual fund or unit investment trust (UIT) whose investment objective typically is to achieve approximately the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, the Russell 2000 Index or the Wilshire 5000 Total Market Index. An index fund will attempt to achieve its investment objective primarily by investing in the securities (stocks or bonds) of companies that are included in a selected index. Some index funds may also use derivatives (such as options or futures) to help achieve their investment objective. Some index funds invest in all of the companies included in an index; other index funds invest in a representative sample of the companies included in an index.

The management of index funds is more "passive" than the management of non-index funds, because an index fund manager only needs to track a relatively fixed index of securities. This usually translates into less trading of the fund’s portfolio, more favorable income tax consequences (lower realized capital gains), and lower fees and expenses than more actively managed funds.

Because the investment objectives, policies and strategies of an index fund require it to purchase primarily the securities contained in an index, the fund will be subject to the same general risks as the securities that are contained in the index. Those general risks are discussed in the descriptions of stock funds and bond funds. In addition, because an index fund tracks the securities on a particular index, it may have less flexibility than a non-index fund to react to price declines in the securities contained in the index.

Another type of investment company that attempts to track the performance of a market index is an exchange-traded fund (ETF). ETFs are legally classified as either UITs or open-end companies, but they differ from traditional UITs and open-end companies in a number of respects. For example, pursuant to SEC exemptive orders, shares issued by ETFs trade on a secondary market and are only redeemable in very large blocks (blocks of 50,000 shares, for example). ETFs are not considered to be, and may not call themselves, mutual funds.

Exchange-Traded Funds (ETFs)

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Exchange-traded funds, or ETFs, are investment companies that are legally classified as open-end companies or Unit Investment Trusts (UITs), but that differ from traditional open-end companies and UITs in the following respects:

* ETFs do not sell individual shares directly to investors and only issue their shares in large blocks (blocks of 50,000 shares, for example) that are known as "Creation Units."

* Investors generally do not purchase Creation Units with cash. Instead, they buy Creation Units with a basket of securities that generally mirrors the ETF’s portfolio. Those who purchase Creation Units are frequently institutions.

* After purchasing a Creation Unit, an investor often splits it up and sells the individual shares on a secondary market. This permits other investors to purchase individual shares (instead of Creation Units).

* Investors who want to sell their ETF shares have two options: (1) they can sell individual shares to other investors on the secondary market, or (2) they can sell the Creation Units back to the ETF. In addition, ETFs generally redeem Creation Units by giving investors the securities that comprise the portfolio instead of cash. So, for example, an ETF invested in the stocks contained in the Dow Jones Industrial Average (DJIA) would give a redeeming shareholder the actual securities that constitute the DJIA instead of cash. Because of the limited redeemability of ETF shares, ETFs are not considered to be—and may not call themselves—mutual funds.

An ETF, like any other type of investment company, will have a prospectus. All investors that purchase Creation Units receive a prospectus. Some ETFs also deliver a prospectus to secondary market purchasers. ETFs that do not deliver a prospectus are required to give investors a document known as a Product Description, which summarizes key information about the ETF and explains how to obtain a prospectus. All ETFs will deliver a prospectus upon request. Before purchasing ETF shares, you should carefully read all of an ETF’s available information, including its prospectus.

The websites of the New York Stock Exchange, American Stock Exchange and NASDAQ provide more information about different types of ETFs and how they work. An ETF will have annual operating expenses and may also impose certain shareholders fees that are disclosed in the prospectus.

Currently, all ETFs seek to achieve the same return as a particular market indexes. Such an ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. An ETF will invest in either all of the securities or a representative sample of the securities included in the index. For example, one type of ETF, known as Spiders or SPDRs, invests in all of the stocks contained in the S&P 500 Composite Stock Price Index.