All About Trading Informations

A Guide To Risk Warnings And Disclaimers

2012-01-01T07:39:00.000-08:00

Risk is fundamental to the investment process, but remains a concept that is not particularly well understood by most regular investors. For this reason, risk warnings - those vaguely worded, fine print disclaimers at the bottom of any investment documents and websites - are extremely important for both buyers and sellers.
Unfortunately, although there are many warnings out there, they often remain unread or are not sufficiently explicit. An investor needs a fairly substantial level of experience and sophistication to know what is really meant, or an advisor needs to take the time to explain it to the investor carefully in person. Yet, all too often, these conditions do not prevail. Sometimes, sellers obviously prefer to keep people in the dark in order to make a sale. In this article, we will take a look at the nature of risk warnings in order to figure out what gets the message across properly, and what still leaves investors not truly knowing what they could be getting into. (For the basics of investor risk, read Determining Risk And The Risk Pyramid and Risk Tolerance Only Tells Half The Story.)

Where Do These Warnings Appear and Why?
Mainly for legal reasons, firms generally publish some kind of warning in their brochures and on internet sites. The objective is not only to explain to the investor the nature of the risks involved in the particular kind of investment being offered, but also to ensure that there can be no legal comeback. The warnings are either in a separate internet link, or in a brochure. In the latter case, it may vary from a rather small footnote to a pretty explicit and large-print explanation of what can go wrong. The length tends to vary from one sentence to a couple of pages.

Examples of Written Warnings
Let's look at some actual written examples of how investors are warned of what might happen to their money. We will see what the firms say and just how useful it is.

Example - Too vague"An investor may get back less than the amount invested. Information on past performance, where given, is not necessarily a guide to future performance."
Or
"The capital value of units in the fund can fluctuate and the price of units can go down as well as up and is not guaranteed."

Warnings like these are very common, regrettably. The problem with these is that there is no quantification and the warning does not really hit home. Can you lose 5% or 25%? There is a big difference between the two. It is unlikely that this warning alone will ensure that the unwary investor knows what could potentially happen to his or her money.

Example - Not easily understood by non-experts
"The investments and services offered by us may not be suitable for all investors. If you have any doubts as to the merits of an investment, you should seek advice from an independent financial advisor."

This certainly warns people to be careful, but how many investors really understand what is meant by "suitability" or would bother to double-check? And if the investor trusts the seller, he will think he is being careful. The odds of an investor actually going to an advisor are low.

Example - Relativity and context given
"You should be aware that certain types of funds might carry greater investment risk than other investment funds. These include our Smaller Companies, Pacific Growth and Japan funds."

Now we are moving in the right direction. You can see from this that the same company has other, safer investments, which you may prefer. This is no longer a token warning, and points clearly to lower-risk alternatives.

Example - The losses can be BIG

"Investment in the securities of smaller companies can involve greater risk than is generally associated with investment in larger, more established companies that can result in significant capital losses that may have a detrimental effect on the value of the fund."

What is good about this one is that the investor is warned that the losses can be substantial. This is still not quantified, but the point that the investment is not for the faint at heart is clear enough.

Example - Now that's a warning!

"You should not buy a warrant unless you are prepared to sustain a total loss of the money you have invested plus any commission or other transaction charges."

No need for vast experience or a vivid imagination. It is quite clear that you can lose the lot.

Criteria for a Good Risk Warning
There are several criteria that a warning should fulfill if it is to get the right message across:

Quantification:
Although this is not always possible, investors should have some idea as to the proportion of their money that they could lose.

Warnings should be easy to follow:
Any risk warning should be easy to understand. If you don't understand what the risk warning is telling you, don't assume that the investment is right for you just because you trust the seller. An inexperienced investor could easily be advised to buy anything, ranging from a basic stock fund to a highly complex packaged product. (To get your feet wet in complex products, read The Barnyard Basics Of Derivativesand Understanding Structured Products.)

Signing is important for both parties:
If an investor has to sign the warning, this demonstrates its importance to him or her, and provides good protection to the firm. However, never sign anything your don't understand.

Internet warnings:
On the internet, it is all too easy to click away a warning and carry on with the deal. In a perfect world, the link and entry would be very clear and the investor prompted to take the warning seriously. This is not a perfect world, however, and it's up to investors to make sure they read the disclaimer before continuing.

Personal explanations:
These are the only way many investors will really understand the risks of a given investment. If the print warning does not meet your criteria, seek out personal advice. The explanation should be clear and give sufficient detail so you know what you could lose, and how, and what other products might be more or less suitable and appealing. The seller should also make a note of how the warning was presented and, if possible, get the investor to sign this too.

Ask Until You Are Sure
As a private investor, you need to request verbal and/or written information and explanations until you are sure you understand the warnings. Don't stop until you are fully aware, in quantitative terms, of what you stand to gain and lose, and what other potential investments there are with different risk/reward ratios. (For related reading, see Is Your Broker Acting In Your Best Interest? and Understanding Dishonest Broker Tactics.)

Conclusion
It is essential that investment risk warnings be clear and sufficient not only to provide legal protection, but also to ensure that the message truly gets home. Firms and advisors should only sell products with a warning that conveys the real level of risk in no uncertain terms; unfortunately, what should be done and what is common practice are two different things. As an investor it's crucial to know how much of your money you could lose and what circumstances could cause this to occur. If you are uncomfortable with the risks of the investment, remember there are always lower-risk alternatives.

For another angle on fine print, see Footnotes: Start Reading The Fine Print.

Get A Hold On Mishandled Accounts

2012-01-01T07:37:00.000-08:00

Investors often look to professionals to help them navigate the markets and provide a certain level of service, but there are times when they may feel that an account is being mishandled. As tempting as it may be to find someone to blame for monetary losses, they are often the result of market conditions and investors must be prepared for such risks. However, arbitration or other avenues may be warranted if evidence suggests that a broker recommended an unsuitable investment, committed fraud, or charged excessive commissions by "churning" the account. In this article, we'll help you to decide whether your account has been mishandled and if you do need to act on the complaint. (To learn more, see Paying Your Investment Advisor - Fees Or Commissions?)

Your First Steps

If you feel that your broker has not acted in your best interest, try to exhaust all possible remedies with the investment company. After quantifying the loss, schedule a meeting with the primary contact at the investment firm to have an extensive discussion, and listen to the broker's side of the story. If this process does not yield adequate information, escalate the complaint to the next level of management until some type of resolution is reached. This may include various outcomes, including simply waiting for the markets to improve to ending all discussions and proceeding with legal action.

If the dispute is with a broker, you probably already agreed to settle through arbitration when you began working with the firm. In this case, the Financial Industry Regulatory Authority (FINRA), formerly the National Association of Securities Dealers (NASD), would handle the arbitration process from start to finish. The group's dispute resolution forum helps resolve matters between investors and securities firms, as well as industry-related issues between individual registered representatives and their firms. (To learn more, see Broker Gone Bad? What To Do If You Have A Complaint and When A Dispute With Your Broker Calls For Arbitration.)

If You Need Legal Representation

As with any potentially lucrative legal proceeding, many legal advisors offer free consultations. Consulting an attorney opens up an outside perspective and can help confirm the appropriate forum for resolving a dispute. This is a good time to begin building a short list of potential litigators, should the need arise. If an arbitration path is appropriate, the list will shrink, as more attorneys handle court cases than arbitration.

While the entire process is simplified in order for any one who has a grievance to file a claim and proceed, the majority of customers pursue their claims in conjunction with a legal team that includes at least one attorney and an expert witness. It is also a good time to set reasonable expectations with potential outcomes and time frames. Do not count on large settlements that include punitive damages, as such generous judgments are rarely rendered. Be prepared to wait months or even years before the arbitration date is set. Depending on the size of the claim and the legal participants, anticipate that arbitration that is not completed in the originally scheduled time frame may be postponed to accommodate participant and panel members' schedules.
The Arbitration ProcessThe table below presents the number of cases handled by FINRA on an annual basis. Typically, the caseload increases in years following volatile financial markets where investors have suffered losses. Caseloads hit historically high levels in 2003, approximately two years after what the tech bubble burst and the stock market plunged.

Year	Cases
2002	7,704
2003	8,945
2004	8,201
2005	6,074
2006	4,614
2007	3,238

If arbitration appears to be the best course of action, visit the FINRA website and search pending cases with the investment firm or registered representative in question. The listing will provide a summary and itemization of any pending or closed cases against the firm and its representative or advisor. It will not, however, include every issue or any cases that expunged the record as part of the settlement.

If the search is for a registered investment advisor (RIA) rather than someone who works for a brokerage firm, you will be redirected to the Securities And Exchange Commission (SEC) website, or possibly to a state-sponsored site if the advisor is state licensed. If the search is for a registered representative or a brokerage firm, FINRA's BrokerCheck program will search data from the Central Registration Depository (CRD) registration and licensing database, which gathers data reported on industry registration and licensing forms. BrokerCheck reports professional background information on currently registered brokers, registered securities firms and previously registered parties. One section provides vital information regarding events reported at the CRD, which is required by the securities industry registration and licensing process. Any number of financial disclosures can be listed here, including bankruptcies or unpaid liens. The listing might also contain formal investigations, customer disputes, disciplinary actions and criminal charges or convictions.

Filing a Complaint

If you determine that the portfolio was mishandled, the next step is to file a complaint. FINRA suggests doing so as soon as possible to avoid a delay in arbitration or mediation. Mediation, which can serve as a supplement or replacement for arbitration depending on the outcome, is a voluntary process in which both parties can settle their disputes in a non-binding format. For most claims under $25,000, the process is resolved primarily through written statements filed by each party to FINRA. At any point the claimant, respondent, or arbitrator may request a hearing. These smaller cases can be assigned to a single arbitrator and may settle fairly quickly.

Claim amounts greater than $25,000 are usually assigned to a three-person arbitration panel. Because they typically settle in-person and involve more formalities, they tend to take longer. FINRA offers a complete online claim filing process, and this is where most investors get bogged down. While FINRA has streamlined the process for the layman to follow, it is still a legal proceeding with required documents such as the "statement of claim". Many frustrated investors will pursue the services of an attorney at this point.

Evaluate Your Progress

This stage of the process is a good time to step back, evaluate your progress, and set time frames and expectations. Keep in mind, however, that the relationship between you and the representative or advisor has changed. While customers sometimes stay with the company against which they have filed claims, most do not. Depending on the claim or loss, they have probably moved to another firm, liquidated their holdings or made other arrangements. The process from this point on becomes a legal proceeding, although it is slightly less formal than a typical court proceeding; you should view this process as a resolution-in-progress.

Conclusion

FINRA provides a framework for licensing, registration, education, monitoring and policing of the brokerage community to ensure the public receives the best service. While the vast majority of financial service professionals provide excellent service, some accounts are mishandled and FINRA has the process available for anyone to pursue what he or she believes is a valid claim. It is important to remember that all decisions made by either the sole arbitrator or the combined panel are binding and that the judgments are enforceable, as they would be in a court. Finally, consider that while the investor has every right to pursue a claim, doing so carries costs such as filing fees, arbitration and/or mediation fees, and if the panel decides a case is frivolous, legal and other costs will apply.

ADRs: Invest Offshore Without Leaving Home

2012-01-01T07:36:00.000-08:00

It was April 1927. Calvin Coolidge was president, and noteworthy events that die-hard historians or baseball fans may recall include the Italian anarchists Saccho and Vanzetti receiving their death sentences and Babe Ruth hitting the first of his 60 home runs, - a single-season record at the time. For investors, a third event in April 1927 has proved equally important and far more profitable: the debut of American depositary receipts (ADRs). (Read What Are Depositary Receipts? for background reading on this common type of security.)

An ADR represents ownership of shares in a foreign company, but it can be bought and sold just like any U.S. stock, allowing investors to diversify their portfolios with foreign assets, but skip the hassle of a foreign brokerage account. Sound intriguing? Find out how these securities work and what they can add to your portfolio.

History of the ADR and Current Stats
John Piermont Morgan (yes, that J.P. Morgan), launched the first ADR for the U.K.'s Selfridges Provincial Stores Limited, the famous retailer now known as Selfridges Plc. Even the audacious J.P. Morgan probably had no idea of the trend he was touching off. As of mid-2008, there were more than 2,250 depositary programs representing more than 1,800 companies from over 70 countries listed on global stock exchanges. According to the Bank of New York Mellon, in the first half of 2008, 52 billion shares of ADRs changed hands, representing a value of $2.07 trillion.

Benefits of ADR Investing
Some benefits of ADR investing are clear. First, many international markets, especially emerging markets, have higher GDP growth rates than the United States or Europe. While the American stocks in your portfolio may be stagnating, holding a few ADRs has the potential to provide you with solid returns during downturns in domestic markets. Your broker and the financial media are always advocating diversification; ADRs represent a great avenue to diversify your portfolio. (Read Going International to learn about this and other ways to diversify your portfolio with foreign stocks.)

Another benefit investors can realize through ADR investing is favorable currency conversions for dividends and other cash distributions. For example, if you own shares of a European ADR and the euro is strong against the dollar, a dividend increase will be that much more rewarding because the dividend payment has to be converted to dollars. (Read more in The Impact Of Currency Conversions.)

The most obvious benefit of ADRs is that they make international companies that investors would normally have to pay a premium for (or perhaps be unable to buy at all) more accessible. If you want to buy 100 shares of Petrobras, the Brazilian oil giant, all you need to do is call your broker or log onto your online brokerage account. There's no need to find a distant relative living in Brazil to execute the trade for you.

Perils and Pitfalls
As buyers of ADRs, we treat them as we would any other securities purchase: we want to profit. However, there are issues that can arise with ADRs that aren't always germane to domestic stocks. Let's use a 2008 geopolitical conflict to highlight a potential peril. Say you own some shares of a Russian oil ADR, and neighboring country Georgia's military is able to knock out a couple hundred miles of pipeline. As far-flung as it seems, this scenario could come to bear, especially in a developing nation. The same goes for political unrest. It's probably best to identify dictators and not invest in companies based in nations that are ruled by these leaders, as these countries are more prone to political strife. (Due diligence is key to not getting burned by an unfamiliar investment. Read Due Diligence In 10 Easy Steps to learn what to look for.)

Of course your ADR investments are subject to some of the same risks as your domestic investments, including credit, currency and inflation risk. These should be taken into account, regardless of the state of the market. There are some markets, such as Australia and Canada, where the local currencies are tied directly to commodity prices. If gold or oil is going up, this contributes to a rise in those currencies. Of course, when those commodities fall, the currencies fall in tandem. This is just one more factor an investor needs to take into account. (Read Investing Beyond Your Borders for more risks associated with investing overseas.)

There are levels of ADRs on U.S. markets. For example, a Level I ADR trades over the counter and as such, is highly speculative. Those shares probably aren't liquid and, what's worse, information on the company is scant. Keep in mind that many countries don't require their public companies to report results quarterly like the U.S. does. For better or worse, Level I issues are the fastest-growing segment of the ADR market, according to the Bank of New York Mellon.

Thinking of buying that Chinese solar company that trades 20,000 shares a day at $1.50? It's probably best to wait for it to graduate to the Nasdaq or NYSE. Level II and III ADRs are where investors want to be. These are the ADRs that trade on major U.S. exchanges and must uphold the same general reporting rules and SEC regulations as American-based corporations. (IFRS are poised to change some aspects of international reporting. Read International Reporting Standards Gain Global Recognition to learn more.)

Tax Treatment of ADRs
Tax treatment of ADRs by the IRS is generally the same as for domestic investments. Investors are subject to the same capital gains and dividend taxes at the same rates. There is a little twist, however: many countries will withhold taxes on dividends paid. While the American investor must still pay U.S. income tax on the net dividend, the amount of the foreign tax may be claimed by the investor as a deduction against income or claimed against U.S. income tax. Investors are encouraged to consult a professional tax or investment advisor to make sure they are recording (and paying taxes on) their ADR investments properly. (Read more about capital gains and dividend taxation in Dividend Facts You May Not Know.)

Conclusion
Investors should look beyond the confines of the U.S. borders in an effort to diversify and maximize returns. Many investors ignore the foreign-equity asset class entirely, and this is not beneficial to their portfolios. ADRs are one way to diversify your portfolio and help you achieve better returns when the U.S. market is in a slump.

Why Being A Copycat Investor Can Get You Hurt

2012-01-01T07:35:00.000-08:00

While some investors are trailblazers and do their own research, many investors attempt to mimic the portfolios of well-known investors, such as Warren Buffett of Berkshire Hathaway, in the hope of being able to cash in on those investors' world-class returns. But copying another investor's portfolio, particularly an institutional investor's portfolio, can actually be quite dangerous. So, before you jump on the copycat bandwagon, get to know the pitfalls of this approach to investing.

An Inability to Adequately Diversify Holdings
It is not uncommon for a major institutional investor, such as a mutual fund, to own more than 100 stocks in a given portfolio. Even Berkshire Hathaway (Warren Buffett's investment vehicle), which has a tendency to invest in fewer stocks as opposed to more, owns shares in some 38 (as of June 30, 2008) different public companies! (Read Build A Baby Berkshire and Warren Buffett's Best Buys to learn more about investing like Warren Buffett.)

Institutional investors like Warren Buffett are able to spread their risk over a number of companies so that if one particular company, sector, industry, or even country hits a rough patch, there are other investment holdings that may pick up the slack. Unfortunately, most individual investors have neither the funds, nor the financial wherewithal to ever achieve such diversification. (See what can happen when diversification goes too far in The Dangers Of Over-Diversification.)

So what do investors do when they realize that they cannot maintain as many positions as an institutional investor?

Usually, the individual investor will copy or mimic a small portion of the institution's holdings (that is, heavily invest in some holdings and ignore others entirely). Unfortunately, this is where trouble can occur – especially if one or more of those core holdings heads south.

An individual investor's inability to adequately mimic an institution's diversification profile and mitigate risk is a major reason why many individuals fail to outperform major mutual funds - even if they maintain similar holdings. (To find out more about institutional sponsorship as a gauge of stock quality, read Institutional Investors And Fundamentals: What's The Link?)

Different Investment Horizons
Many people like to refer to themselves as longer-term investors, but when it comes down to it, most investors want to see results in the first 12 to 24 months that they own a particular stock.

In fact, according to an often-cited November 2001 study by Gavin Quill (a senior vice president and director of research studies at Financial Research Corporation, a financial services research and consulting firm), mutual fund holding periods in 2000 were only about three years! That is well shy of the more than 30 years that Berkshire Hathaway has owned shares of Washington Post Company. In other words, on average, institutions seem to have much more patience than their individual-investor counterparts do. (Read more about how investing for the long haul can benefit you in Long-Term Investing: Hot Or Not?)

In short, even if individual investors achieve diversification similar to the institutions they are looking to mimic, they might not be able afford or have the patience to sit on a given investment for five or 10 years, as they may need to tap into the funds to buy a home, to pay for school, to have children or to take care of an emergency situation, and doing so may adversely impact their investment performance.

Institutional Knowledge/Research
In spite of regulations meant to level the playing field between individuals and institutions (such as Reg FD, which outlines a company's disclosure responsibilities), institutions often employ teams of seasoned industry analysts. These trained experts typically have many contacts throughout the supply chain and tend to have more frequent contact with a given company's management team than the average individual investor. (Read more about the role of Reg FD in Defining Illegal Insider Trading.)

Not surprisingly, this gives the institutional analysts a far better idea of what is going on at a company or within a given industry. In fact, it is almost impossible for the individual to ever gain the upper hand when it comes to such knowledge. (Learn more about Wall Street analysts in Three Kinds Of Analysts And What You Need To Know About Them.)

This relative lack of knowledge about future earnings potential, opportunities for growth, competitive forces, etc. can adversely impact investment results. In fact, a lack of knowledge is another major reason why many individual investors tend to underperform mutual funds over time. (You can piece together your own analysis if you have the right information. Read Do-It-Yourself Analyst Predictions to find out how.)

This is compounded by the fact that analysts can sit and wait for new information ,while the "average Joe" has to work and attend to other matters. This creates a lag time for individual investors, which can prevent them from getting in or out of investments at the best possible moment.

Keeping Tabs on Institutions Is Tough
Even if an individual has enough money to adequately diversify him- or herself, the willingness to hold positions for an extended period of time and the ability to accurately track and research multiple companies, it is difficult to copy the actions of most institutions.

Why? Because, unlike Berkshire Hathaway, many mutual funds buy and sell stocks with great vigor throughout a given quarter.

In fact, take T. Rowe Price as an example. According to the company's website, its Capital Opportunity Fund (which invests primarily in domestic securities) has a turnover rate of 63.5 as of July 31, 2008. That's big. This makes positions like these are hard to mimic because even if you had access to databases that track institutional holdings the information is usually updated on a quarterly basis.

What happens in between? Frankly, those looking to mimic the institution's portfolio are left guessing, which is an extremely risky strategy, particularly in a volatile market. (Learn some ways you can keep track of institutional investment activities in Keeping An Eye On The Activities Of Insiders And Institutions.)

Trading Costs Can Be Huge, and Treatment May Vary
By definition, institutions such as mutual funds have more money to invest than the average retail investor. Perhaps not surprisingly, the fact that these funds have so much money and conduct so many trades throughout the year causes retail brokers who service these accounts to fawn over them.

Funds often receive favorable treatment. In fact, it's not uncommon for some funds to be charged a penny (or in some cases a fraction of a penny) per share to sell or purchase a large block of stock – whereas individual investors will typically pay 5-10 cents per share.

In addition, even though there are rules to prevent this (and time and sales stamps that prove when certain trade tickets were entered), institutions often see their trades pushed ahead of those of retail investors. This allows them to realize more favorable entry and exit points. (Read Patience Is A Trader's Virtue and A Look At Exit Strategies for a discussion of setting entry and exit points.)

In short, the odds are that the individual, regardless of his or her wealth, will never be able to garner such preferential treatment. Therefore, even if the individual was able to match an institution in terms of holdings and diversification, the institution would probably spend fewer dollars on trades throughout the year, making its investment performance, on a net basis, better overall. (Learn where you may be paying more than you think in The Hidden Costs Of Investing.)

Bottom Line
While it may sound good in theory to attempt to mimic the investment style and profile of a successful institution, it is often much harder (if not impossible) to do so in practice. Institutional investors have resources and opportunities that the individual investor cannot hope to match. Retail investors may benefit more, in the long run, from an investment strategy more suited to their means.

Coping With Inflation Risk

2012-01-01T07:34:00.000-08:00

Inflation, although not as dramatic as a market crash, can be even more devastating in the long run, steadily eroding the value of a portfolio year after year. Moreover, it is prone to flare-ups, which can make its effects especially acute. These effects include:
Reduction of purchasing power
Disruptions to stock and bond markets, which may cause volatility
Devaluation of income on interest-bearing securities
Squeezing of the profit margins of certain types of stocks
From an investment standpoint, this means inflation is a risk to be managed and balanced against more obvious forms of risk, such as volatility and loss of principal. (To read more about inflation basics, see All About Inflation.)

Historical Examples of Inflation
Inflation is the increase in the price of goods, services, commodities and/or wages. A look at past inflation numbers illustrates what inflation is capable of doing.

According to the widely recognized Ibbotson compilation of data, inflation in the United States averaged 3% annually from the beginning of 1926 through the end of 2007. As is often the case though, long-term averages do not reflect the extremes along the way that can also be instructive in understanding inflation.

While inflation averaged 3% during those 82 years, there were 10 years in which inflation was negative, meaning that prices, in aggregate, actually declined. At the other end of the spectrum, there were four years in which inflation increased at a double-digit rate.

These extremes, which tend to come in bunches, often have a cumulative effect. For example, during the 10 years ending in 1935, inflation decreased at a rate of 2.6% per year. As a result, an item that 10 years prior sold for $100 cost $77.10 in 1935 - a substantial decline in price. On the other hand, during the 10 years ending in 1982, inflation averaged 8.7% annually. Consequently, an item that 10 years prior cost $100, more than doubled in price to $229.65 by 1982.

Even with these extremes, the American economy has never experienced the true extent of inflation risk. Hyperinflation, which occurred in Germany during the 1920s and still crops up from time to time in isolated developing economies, can rapidly devalue a currency and cause economic chaos.

Portfolio ImpactsFor investors, the portfolio impacts of inflation can be discussed in terms of the long-term, overall impact, and the short-term disruptions on specific asset classes.

In the long term, inflation erodes a portfolio's purchasing power. At an average inflation rate of 3% per year, the value of a portfolio is cut in half every 23 years or so.

In this respect, the impact of inflation is every bit as severe as that of a market crash - and even more devastating in the long run. Historically, U.S. stock market crashes are always followed by a recovery, even if it is a long and painstaking one. In contrast, because periods of deflation (negative inflation) are rare, the effects of inflation tend to be permanent.

Thus, investors cannot ignore inflation risk, which unlike other forms of risk, cannot be avoided simply by investing conservatively (or not at all). Even cash held in the safest vault in the world is subject to the steady erosion of purchasing power as a result of inflation.

What You Can Do to Protect Your PortfolioTherefore, the first step toward fighting inflation is to be constructively invested. The challenge of this is that in the short term, periods of inflation are disruptive to all sorts of financial assets. During the highest 10-year period for U.S. inflation, from January 1, 1973, through December 31, 1982, the following were the cumulative real returns (overall returns adjusted for inflation) for stocks, bonds and T-bills:

January 1, 1973, through December 31, 1982
Asset Class	Cumulative Real Return
Stocks	-16.85%
Long-Term U.S. Bonds	-23.73%
T-Bills	-1.93%

Looking at longer-term data, however, adds a very different perspective:

January 1, 1926, through December 31, 2007
Asset Class	Cumulative Real Return
Stocks	+882.37%
Long-Term U.S. Bonds	+572.35%
T-Bills	+72.28%

Some critical takeaways from this data include:

When inflation was at its most extreme, none of the major investment asset classes were able to keep up with the rate of inflation

The effects of extreme inflation were felt most severely by bonds

While T-bills came closest to keeping up with inflation at its most extreme, they offered the weakest long-term return (both before and after inflation)

(Keep reading about real returns in What You Should Know About Inflation and Curbing The Effects Of Inflation.)

Commodities and Inflation

Commodities (oil, grains, metals, etc.) are often touted as a portfolio hedge against inflation. There is some logic to this, as commodity prices tend to rise during periods of inflation, and in turn, rising commodity prices can be a key root cause of inflation. (To read more about commodities, see Commodities That Move The Markets and Commodities: The Portfolio Hedge.)

Unfortunately though, there are some risks associated with investing in commodities:

They have no income or earnings stream; as a result, they have no inherent value beyond their market prices, which are totally dependent on the perceptions of other investors.

They are prone to periods of speculation, which causes volatility. This is especially true during inflationary periods, meaning commodities might be at their most risky just when they seem most appealing.

They are not a perfect inflation hedge.

First of all, there are many types of commodities, not all of which will rise equally during inflationary periods. Inflation can be driven by particular commodities (ex. oil), which may actually dampen the price of other commodities.

Second, not all inflation affects commodities. For example, wage inflation can impact the price of finished goods and services without increasing the price of commodities.

Commodities are good hedges for people and businesses subject to very specific risks based on particular commodities, or for sophisticated investors with a detailed perspective on inflation. However, commodities are not good mainstream portfolio investments for the average investor.

Portfolio Construction

Given its profound impact, inflation has to be addressed by any long-term investment portfolio. While there are no perfect hedges against inflation, there are some rational investment responses to inflation concerns:

A long-term perspective is critical. In the short-run, no asset class is a perfect inflation hedge, but because the effects of inflation are most devastating on a cumulative basis, long-term returns matter most.

Stocks play a crucial role. While stocks may be more subject than other asset classes to loss of principal, they can help a portfolio combat the effects of inflation. This is not simply because they offer the highest returns over time. Fundamentally, stocks represent businesses that are actively adjusting to prevailing conditions, so the earnings stream of a well-diversified portfolio can adapt over time to the inflationary environment.

Bonds are most sensitive to high inflation. In some respects, a U.S. government bond may seem like an iron-clad investment, but while its principal and interest are guaranteed, the future purchasing power of that principal and interest can be significantly reduced by inflation.

The above are general observations, but as always, specific market conditions can change the equation. For example, when stocks are highly overvalued, their future returns (and thus their inflation-fighting power) are likely to be diminished. Conversely, because bonds tend to fall in price in response to signs of inflation, their yields may rise to the point at which they represent an attractive premium over inflation. Therefore, investors should target long-term portfolio weightings according to the long-term trends described above, but should also be alert to market extremes which can skew those trends.

To read more about constructing your portfolio, see Portfolios Rise From Oblivion To Omnipresence and A Guide To Portfolio Construction.

Who's Looking Out For Investors?

2012-01-01T07:32:00.000-08:00

In the financial services industry, consumers pay a fee for a service and expect a certain level of security in return. When an investor pays a broker to handle his or her accounts, the broker is obligated to act in that investor's best interests. This obligation is not only moral, but also arises from the rules set forth by the industry's various regulatory agencies. The problem is that if an account is mishandled, most consumers have no idea where to turn until it's too late.

Examples of mishandling range from churning to suitability to fraud. Churning is an unethical practice employed by some brokers to increase their commissions by excessively trading in a client's account. Suitability relates to the types of investments chosen for the account and whether they are appropriate for a particular investor, while fraud can encompass a wide range of behaviors with varying levels of severity.

So who is looking out for the average investor?
Is it the Financial Industry Regulatory Authority (FINRA), the state regulatory agencies, the Securities and Exchange Commission (SEC), the Office of the Comptroller of the Currency (OCC) or the Federal Reserve Board (FRB)? The answer is all of the above, but each in its own way. Read on to learn more.

FINRAFor most consumers, FINRA, the agency that governs business between brokers, dealers and the investing public, is the first line of defense in the event of a problem associated with an investment account.

When an investor opens an account at a U.S.-based brokerage firm, the fine print in the lengthy account-opening document typically stipulates that consumers give up their rights to pursue the brokerage company in a venue outside arbitration. Under FINRA's rules, however, the consumer maintains the right to pursue arbitration. As a result, the lion's share of consumer complaints against brokerages is fielded by FINRA and is usually arbitrations.

Arbitrations are basically court-like settings where judges are replaced by a panel of peers. Cases are presented by claimants (plaintiffs), with or without their attorneys, and are defended by respondents (defendants), who typically have attorneys.

The process begins by filing a claim with FINRA, which then notifies all parties involved that proceedings have begun. Arbitration is designed to be simple in order to accommodate the average consumer lacking legal expertise and allow him or her to file a claim without the need to hire an attorney. The forms are written in plain language so as not to discourage someone from filing.

However, while the initial filing can be processed without an attorney, it is widely suggested that the claimant (plaintiff) hire an attorney as he or she will encounter a barrage of deep-pocketed legal defense maneuvers once the claim is filed. There is no shortage of legal services available for claimants, and many attorneys will take cases on contingency, especially if there is a large potential settlement and what they feel is a good chance of winning.

While the arbitration process is effective and orderly, consumers pursuing a case should be prepared for the same time lags they would experience with a typical state or federal court case. The filing process can take up to one year and proceedings after the initial filing can take years.

Because the process can take a significant amount of time and resources, it is highly recommended that consumers that have been treated unfairly exhaust all measures for handling grievances directly with their broker or investment manager prior to filing a complaint with FINRA. (For further reading, see Investigating The Securities Police.)

State Regulatory AgenciesWhile FINRA fields the majority of complaints from investors, there are other lines of defense with overlapping powers. For instance, each state has its own regulatory agency to police the in-state activities of the securities industry. While a state's regional jurisdiction is defined by its own state lines, its professional jurisdiction varies.

Typically, the state polices a variety of financial services providers ranging from credit unions to broker dealers. State agencies also cover investment advisors that fall below the requirement for filing with the SEC (less than $25 million under management). Here, the coverage that state agencies provide is similar to the SEC's duties of licensing, filing and auditing. Regulatory overlap is usually avoided as registered investment advisors only register under one agency or the other.
The state typically gets involved early in an investigation and then cooperates with the SEC as the investigation deepens. While effective, the state agencies are not usually as well staffed as FINRA or the SEC and have to cover a larger caseload per investigator.

The SECThe glue that holds the investor protection system together is the SEC, which arose from the ashes of the 1929 stock market crash and was crafted around the Securities Act of 1933 and the Securities Exchange Act of 1934. The SEC governs the self-regulatory organizations (SROs) that reach down to the consumer, and its jurisdiction is far reaching, covering four main divisions:

corporate finance
market regulation
investment management
enforcement

The SEC's responsibilities have become ever more challenging with the advent of computer-based crimes and the increasing complexity of financial products and transactions, but its primary purpose is still to protect the individual investor by watching over the investment management industry and ensuring that public companies provide sufficient financial and other information to the public to allow investors to make informed decisions.

With the new challenges in the marketplace, there has been a call to increase the flexibility of the SEC's power. However, despite years of discussions about consolidating regulatory bodies or appointing a finance czar, there are no concrete plans in the pipeline. (Learn more about how this regulatory body protects the rights of investors in Policing The Securities Market: An Overview Of The SEC.)

The OCC and the FedThere are two other regulatory bodies spoken of frequently, the less common Comptroller of the Currency (OCC) and the famous (or infamous) Federal Reserve Board (FRB). While both of these bodies are very active in watching out for investors, their activities are focused on banking and financial services at a higher level, and their involvement in individual cases is rare.

Conclusion
Each of these regulatory bodies looks out for investors in its own way, and each has its specific duties with some overlap. The regulatory organizations have become increasingly sophisticated to accommodate increasingly complex investment transactions and products, but are challenged each year as new issues arise. These organizations are designed to protect consumers, so if you have a problem that you aren't able to resolve directly with your broker, take advantage. Remember, just like your local police, the regulatory agencies won't know about any issues unless you contact them.

Understanding The Time Value Of Money

2012-01-01T07:31:00.000-08:00

Congratulations!!! You have won a cash prize! You have two payment options:

A. Receive $10,000 now

OR

B. Receive $10,000 in three years

Which option would you choose?

What Is Time Value?
If you're like most people, you would choose to receive the $10,000 now. After all, three years is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.

But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it? Actually, although the bill is the same, you can do much more with the money if you have it now because over time you can earn more interest on your money.

Back to our example: by receiving $10,000 today, you are poised to increase the future value of your money by investing and gaining interest over a period of time. For Option B, you don't have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for Option B, on the other hand, would only be $10,000. So how can you calculate exactly how much more Option A is worth, compared to Option B? Let's take a look.

Future Value Basics
If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which of course is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount:

Future value of investment at end of first year:
= ($10,000 x 0.045) + $10,000
= $10,450

You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation:

Original equation: ($10,000 x 0.045) + $10,000 = $10,450
Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450
Final equation: $10,000 x (0.045 + 1) = $10,450
The manipulated equation above is simply a removal of the like-variable $10,000 (the principal amount) by dividing the entire original equation by $10,000.

If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have $10,920:

Future value of investment at end of second year:
= $10,450 x (1+0.045)
= $10,920.25

The above calculation, then, is equivalent to the following equation:

Future Value = $10,000 x (1+0.045) x (1+0.045)

Think back to math class and the rule of exponents, which states that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following:

We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the three-year future value of the investment would look like this:

This calculation shows us that we don't need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:

Present Value Basics

If you received $10,000 today, the present value would of course be $10,000 because present value is what your investment gives you now if you were to spend it today. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future.

To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P variable with present value (PV) and manipulated as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the two-year mark, we would discount the payment back one year. At the two-year mark, the present value of the $10,000 to be received in one year is represented as the following:

Present value of future payment of $10,000 at end of year two:

Note that if today we were at the one-year mark, the above $9,569.38 would be considered the future value of our investment one year from now.

Continuing on, at the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following:

Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today's present value of the $10,000 expected from a three-year investment earning 4.5%:

So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from Option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000) greater than the future value of Option B.

Present Value of a Future Payment
Let's add a little spice to our investment knowledge. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let's find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:

In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an $18,000 payment in four years would be calculated as the following:

Present Value

From the above calculation we now know our choice is between receiving $15,000 or $15,386.48 today. Of course we should choose to postpone payment for four years! (For related reading, see Anything But Ordinary: Calculating The Present And Future Value Of Annuities.)

Conclusion
These calculations demonstrate that time literally is money - the value of the money you have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.

To read more on this subject, see Continuously Compound Interest.

Basic Investment Objectives

2012-01-01T07:29:00.000-08:00

The options for investing our savings are continually increasing, yet every single investment vehicle can be easily categorized according to three fundamental characteristics - safety, income and growth - which also correspond to types of investor objectives. While it is possible for an investor to have more than one of these objectives, the success of one must come at the expense of others. Let's examine these three types of objectives, the investments that are used to achieve them and the ways in which investors can incorporate them in devising a strategy.

Safety
Perhaps there is truth to the axiom that there is no such thing as a completely safe and secure investment. Yet we can get close to ultimate safety for our investment funds through the purchase of government-issued securities in stable economic systems, or through the purchase of the highest quality corporate bonds issued by the economy's top companies. Such securities are arguably the best means of preserving principal while receiving a specified rate of return.

The safest investments are usually found in the money market and include such securities as Treasury bills (T-bills), certificates of deposit (CD), commercial paper or bankers' acceptance slips; or in the fixed income (bond) market in the form of municipal and other government bonds, and in corporate bonds. The securities listed above are ordered according to the typical spectrum of increasing risk and, in turn, increasing potential yield. To compensate for their higher risk, corporate bonds return a greater yield than T-bills. (For more insight on treasuries, read Buy Treasuries Directly From The Fed.)

It is important to realize that there's an enormous range of relative risk within the bond market. At one end are government and high-grade corporate bonds, which are considered some of the safest investments around; at the other end are junk bonds, which have a lower investment grade and may have more risk than some of the more speculative stocks. In other words, it's incorrect to think that corporate bonds are always safe, but most instruments from the money market can be considered very safe.

Income
The safest investments are also the ones that are likely to have the lowest rate of income return, or yield. Investors must inevitably sacrifice a degree of safety if they want to increase their yields. This is the inverse relationship between safety and yield: as yield increases, safety generally goes down, and vice versa.

In order to increase their rate of investment return and take on risk above that of money market instruments or government bonds, investors may choose to purchase corporate bonds or preferred shares with lower investment ratings. Investment grade bonds rated at A or AA are slightly riskier than AAA bonds, but presumably also offer a higher income return than AAA bonds. Similarly, BBB rated bonds can be thought to carry medium risk but offer less potential income than junk bonds, which offer the highest potential bond yields available, but at the highest possible risk. Junk bonds are the most likely to default.

Most investors, even the most conservative-minded ones, want some level of income generation in their portfolios, even if it's just to keep up with the economy's rate of inflation. But maximizing income return can be an overarching principle for a portfolio, especially for individuals who require a fixed sum from their portfolio every month. A retired person who requires a certain amount of money every month is well served by holding reasonably safe assets that provide funds over and above other income-generating assets, such as pension plans, for example.

Growth of Capital
This discussion has thus far been concerned only with safety and yield as investing objectives, and has not considered the potential of other assets to provide a rate of return from an increase in value, often referred to as a capital gain. Capital gains are entirely different from yield in that they are only realized when the security is sold for a price that is higher than the price at which it was originally purchased. Selling at a lower price is referred to as a capital loss. Therefore, investors seeking capital gains are likely not those who need a fixed, ongoing source of investment returns from their portfolio, but rather those who seek the possibility of longer-term growth.

Growth of capital is most closely associated with the purchase of common stock, particularly growth securities, which offer low yields but considerable opportunity for increase in value. For this reason, common stock generally ranks among the most speculative of investments as their return depends on what will happen in an unpredictable future. Blue-chip stocks, by contrast, can potentially offer the best of all worlds by possessing reasonable safety, modest income and potential for growth in capital generated by long-term increases in corporate revenues and earnings as the company matures. Yet rarely is any common stock able to provide the near-absolute safety and income-generation of government bonds.

It is also important to note that capital gains offer potential tax advantages by virtue of their lower tax rate in most jurisdictions. Funds that are garnered through common stock offerings, for example, are often geared toward the growth plans of small companies, a process that is extremely important for the growth of the overall economy. In order to encourage investments in these areas, governments choose to tax capital gains at a lower rate than income. Such systems serve to encourage entrepreneurship and the founding of new businesses that help the economy grow.

Secondary Objectives
Tax Minimization
An investor may pursue certain investments in order to adopt tax minimization as part of his or her investment strategy. A highly-paid executive, for example, may want to seek investments with favorable tax treatment in order to lessen his or her overall income tax burden. Making contributions to an IRA or other tax-sheltered retirement plan, such as a 401(k), can be an effective tax minimization strategy. (For related reading, see Which Retirement Plan Is Best?)

Marketability / Liquidity
Many of the investments we have discussed are reasonably illiquid, which means they cannot be immediately sold and easily converted into cash. Achieving a degree of liquidity, however, requires the sacrifice of a certain level of income or potential for capital gains.

Common stock is often considered the most liquid of investments, since it can usually be sold within a day or two of the decision to sell. Bonds can also be fairly marketable, but some bonds are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money market instruments may only be redeemable at the precise date at which the fixed term ends. If an investor seeks liquidity, money market assets and non-tradable bonds aren't likely to be held in his or her portfolio.

Conclusion
As we have seen from each of the five objectives discussed above, the advantages of one often comes at the expense of the benefits of another. If an investor desires growth, for instance, he or she must often sacrifice some income and safety. Therefore, most portfolios will be guided by one pre-eminent objective, with all other potential objectives occupying less significant weight in the overall scheme.

Choosing a single strategic objective and assigning weightings to all other possible objectives is a process that depends on such factors as the investor's temperament, his or her stage of life, marital status, family situation, and so forth. Out of the multitude of possibilities out there, each investor is sure to find an appropriate mix of investment opportunities. You need only be concerned with spending the appropriate amount of time and effort in finding, studying and deciding on the opportunities that match your objectives.

Getting To Know The Stock Exchanges

2012-01-01T07:27:00.001-08:00

A stock exchange does not own shares. Instead, it acts as a sort of high-tech flea market where buyers connect with sellers. Every public stock trades on one of several possible exchanges such as the New York Stock Exchange (NYSE) or American Stock Exchange (AMEX). Although you will most likely trade stocks through a broker, it is important to understand the relationship between exchanges and companies and the ways in which the requirements of different exchanges provide protection to investors.

How Does It All Start?
The primary function of an exchange is to provide liquidity; in other words, to give sellers a place to "liquidate" their share holdings.

Stocks first become available on an exchange after a company conducts its initial public offering (IPO). In an IPO, a company sells shares to an initial set of public shareholders (the primary market). After the IPO "floats" shares into the hands of public shareholders, these shares can be sold and purchased on an exchange (the secondary market).

The exchange tracks the flow of orders for each stock, and this flow of supply and demand sets the price of the stock. Depending on the type of brokerage account you have, you may be able to view this flow of price action. For example, if you see that the "bid price" on a stock is $40, this means somebody is telling the exchange that he or she is willing to buy the stock for $40. At the same time you might see that the "ask price" is $41, which means somebody else is willing to sell the stock for $41. The difference between the two is the bid-ask spread.

Auction Exchanges - NYSE and Amex
The NYSE and AMEX are both primarily auction-based, which means specialists are physically present on the exchanges’ trading floors. Each specialist "specializes" in a particular stock, buying and selling the stock in a verbal auction. These specialists are under competitive threat by electronic-only exchanges that claim to be more efficient (that is, execute faster trades and exhibit smaller bid-ask spreads) by eliminating human intermediaries.

The NYSE is the largest and most prestigious exchange. Collectively, as of December 31, 2007, its listed companies represent about $30.5 trillion in market capitalization.

Listing on the NYSE affords companies great credibility because they must meet initial listing requirements and also comply annually with maintenance requirements. For example, to remain listed, NYSE companies must keep their price above $1 and their market capitalization (number of shares x price) above $50 million.

Furthermore, investors trading on the NYSE benefit from a set of minimum protections. Among several of the requirements that the NYSE has enacted, the following two are especially significant:

Companies must get shareholder approval for any equity incentive plan (for example, stock option plan or restricted stock plan). In the past, companies were allowed to sidestep shareholder approval if an equity incentive plan met certain criteria; this, however, prevented shareholders from knowing how many stock options were available for future grant.
A majority of the members of the board of directors must be independent. However, each company has some discretion over the definition of "independent", which has caused controversy. Furthermore, the compensation committee must be entirely composed of independent directors, and the audit committee must include at least one person who possesses "accounting or financial expertise".
AMEX is a smaller but quite prestigious exchange. AMEX also has a history of innovating: it pioneered the concept of exchange-traded funds (ETFs) and it has the second largest options trading market.

Nasdaq (an Electronic Exchange)
The Nasdaq, an electronic exchange, is sometimes called "screen-based" because buyers and sellers are connected only by computers over a telecommunications network. Market makers, also known as dealers, carry their own inventory of stock. They stand ready to buy and sell Nasdaq stocks, and they are required to post their bid and ask prices. Among several high-technology sections, Nasdaq lists the most companies. Although the NYSE has a far greater total market capitalization, Nasdaq has surpassed the NYSE in the number of both listed companies and shares traded.

Nasdaq has listing and governance requirements that are similar but slightly less stringent than those of the NYSE. For example, a stock must maintain a price of $1 and the value of the public float (number of traded shares multiplied by stock price) must be at least $1.1 million. If a company does not maintain these requirements, it can be delisted to one of the OTC markets discussed below.

Nasdaq Small Cap
Nasdaq has a separate "tier" for small capitalization companies; the average market cap of the 685 companies listed in this tier at the end of 2003 was about $60. This is an excellent exchange for investors interested in smaller companies because the Nasdaq Small Cap also has listing and governance requirements.

Electronic Communication Networks (ECNs)
ECNs are part of a class of exchange called alternative trading systems (ATS). ECNs trade Nasdaq-listed stocks, but they connect buyers and sellers directly. Because they allow for direct connection, ECNs bypass the market makers. You can think of them as an alternative means to trade stocks listed on the Nasdaq and, increasingly, other exchanges as well (such as the NYSE or foreign exchanges).

There are several innovative and entrepreneurial ECNs, and they are generally good for customers because they pose a competitive threat to traditional exchanges, and therefore push down transaction costs. Currently, ECNs do not really serve individual investors; they are mostly of interest to institutional investors.

There are several ECNs, including INET (the result of an early 2004 consolidation between the Instinet ECN and Island ECN) and Archipelago (one of the four original ECNs that launched in 1997).

Over-the-Counter (OTC)
Over-the-counter (OTC) refers to markets other than the organized exchanges described above. OTC markets generally list small companies, and often (but not always) these companies have "fallen off" to the OTC market because they were de-listed from Nasdaq.

Some individual investors will not even consider buying OTC stocks due to the extra risks involved. On the other hand, some strong companies trade on the OTC. In fact, several strong companies have deliberately switched to OTC markets to avoid the administrative burden and costly fees that accompany regulatory oversight laws such as the Sarbanes-Oxley Act. On balance, you should be careful when investing in the OTC if you do not have experience.

There are two OTC markets:

Over-the-Counter Bulletin Board (OTCBB) is an electronic community of market makers. Companies that fall off the Nasdaq often end up here. On the OTCBB, there are no "quantitative minimums" (no minimum annual sales or assets required to list).
Companies that list on the Pink Sheets (i.e. less than 300 shareholders) are not required to register with the SEC. Liquidity is often minimal. Also, keep in mind that these companies are not required to submit quarterly 10Qs.

Summary
To be traded, every stock must list on an exchange, a central "flea market" where buyers and sellers meet. The two big U.S. exchanges are the esteemed NYSE and the fast-growing Nasdaq; companies listed on either of these exchanges must meet various minimum requirements and baseline rules concerning the "independence" of their boards. But these are by no means the only legitimate exchanges. Electronic communication networks are relatively new, but they are sure to grab a bigger slice of the transaction pie in the future. Finally, the OTC market is a fine place for experienced investors with an itch to speculate and the know-how to conduct a little extra due diligence.

Start Investing With Only $1,000

2012-01-01T07:26:00.000-08:00

So you have a $1,000 set aside, and you're ready to enter the world of investing. But before you jump head first into the world of stocks and bonds, there are a few things you need to consider. One of the biggest considerations for investors with a minimal amount of funds is not only what to invest in but also how to go about investing. Not long into your investment journey you may find yourself bombarded with minimum deposit restrictions, commissions and the need for diversification, among a myriad of other considerations. In this article, we'll walk you through getting started as an investor and show you how to maximize your returns by minimizing your costs.

What Are the Account Minimums?
To the inexperienced investor, investing may seem simple enough - all you need to do is go to a brokerage firm and open up an account, right? What you may not know, however, is that all financial institutions have minimum deposit requirements. In other words, they won't accept your account application unless you deposit a certain amount of money. Some firms won't even allow you to open an account with a sum as small as $1,000. (To learn more about opening an account or starting to invest, see the Investing 101 tutorial and I want to start buying stocks. Where do I start?)

Stocks
Stock brokers come in two flavors: full-service and discount. As the name implies, a full-service broker provides much more in the way of service, but it only deals with higher net worth clients. It's not unusual to see minimum account sizes of $50,000 and up at full-service brokerages.

This leaves the $1,000 investor with the option of a discount broker. Discount brokers have considerably lower fees, but don't expect much in the way of hand-holding. Fees are low because you are in charge of all investment decisions - you can't call and ask for investment advice. With $1,000, you are right on the cusp in terms of the minimum deposit. There will be some discount brokers that will take you and others that won't. You'll have to shop around. (To find out more, see 10 Things To Consider Before Choosing An Online Broker, Picking Your First Broker and Choosing A Compatible Broker.)

You also could purchase shares directly from a company through direct stock purchase plans (DSPPs). Some of these plans have a minimum investment amount restriction, which ranges between $100 and $500.

With the advent of online trading, there are a number of discount brokers with no (or very low) minimum deposit restrictions. One of the most popular online trading sites is ShareBuilder. You will, however, be faced with other restrictions and see higher fees for certain types of trades. This is something an investor with a $1,000 starting balance should take into account if he or she wants to invest in stocks. (To continue learning about stocks, see our Stock Basics tutorial.)

Mutual Funds and Bonds
If mutual funds or bonds are investments you would like to make, it is simpler in terms of minimum deposit amounts. Both of these can be purchased through brokerage firms, where similar deposit rules apply as for stocks. Mutual funds also can be purchased through your local bank, often for less than $1,000 when you have an existing relationship with the bank.

If you want to purchase government bonds, this can be done straight from the government through TreasuryDirect. The only restriction here is the minimum purchase amount of the bond, which can range from $100 to $1,000. (For more insight, see our Bond Basics Tutorial and Mutual Fund Basics.)

Learn the Costs of Investing
Commissions
Before you open an investment account, you must also consider the costs that you will incur from purchasing investments once the account is open. In most cases, every time you purchase an investment, it will cost you money (through commissions). With a limited amount of funds, these transaction fees can really put a dent on your $1,000.

Investing in stocks can be very costly if you trade constantly, especially with a minimum amount of money available to invest. Every time that you trade stock, either buying or selling, you will incur a trading fee. Trading fees range from the low end of $10 per trade, but can be as high as $30 for some discount brokers. Remember, a trade is an order to purchase shares in one company - if you want to purchase five different stocks at the same time, this is seen as five separate trades and you will be charged for each one. (To learn more about fees, see Introduction To Fee-Based Brokerage Accounts, Fee-Based Brokerage: The Latest Target For Regulators and Paying Your Investment Advisor - Fees Or Commissions?)

Now, imagine that you decide to buy the stocks of those five companies with your $1,000. To do this you will incur $50 in trading costs, which is equivalent to 5% of your $1,000. If you were to fully invest the $1,000, your account would be reduced to $950 after trading costs. This represents a 5% loss, before you investments even have a chance to earn a cent!

If you were to sell these five stocks, you would once again incur the costs of the trades, which would be another $50. To make the round trip (buying and selling) on these five stocks it would cost you $100, or 10% of your initial deposit amount of $1,000. If your investments don't earn enough to cover this, you have lost money by just entering and exiting positions.

Mutual Fund Fees
There are many fees an investor will incur when investing in mutual funds. One of the most important fees to focus on is the management expense ratio (MER), which is charged by the management team each year based on the amount of assets in the fund. The higher the MER, the worse it is for the fund's investors. It doesn't end there: you'll also see a number of sales charges called "loads" when you buy mutual funds.

In terms of the beginning investor, the mutual fund fees are actually an advantage relative to the commissions on stocks. The reason for this is that the fees are the same regardless of the amount you invest. So, as long as you have the minimum requirement to open an account, you can invest as little as $50 or $100 per month in a mutual fund. The term for this is called dollar cost averaging (DCA), and it can be a great way to start investing. (To read more, see DCA: It Gets You In At The Bottom and Dollar-Cost Averaging Pays.)

Reduce Risk With Diversification
Diversification is considered to be the only free lunch in investing. (If you are new to this concept, check out Introduction To Diversification, The Importance Of Diversification and A Guide To Portfolio Construction.) In a nutshell, by investing in a range of assets, you reduce the risk of one investment's performance severely hurting the return of your overall investment. You could think of it as financial jargon for "don't put all of your eggs in one basket".

In terms of diversification, the greatest amount of difficulty in doing this will come from investments in stocks. This was illustrated in the commissions section of the article, where we discussed how the costs of investing in a large number of stocks can be detrimental to the portfolio. With a $1,000 deposit, it is nearly impossible to have a well-diversified portfolio, so be aware that you may need to invest in one or two companies (at the most) to begin with. This will increase your risk.

This is where the major benefit of mutual funds comes into focus. Mutual funds tend to have a large number of stocks and other investments within the fund, which makes the fund more diversified than a single stock.

A Small Step Toward a Large Future
It is possible to invest if you are just starting out with a small amount of money. It's more complicated than just selecting the right investment (a feat that is difficult enough in itself) and you have to be aware of the restrictions that you face as a new investor.

You'll have to do your homework to find the minimum deposit requirements and then compare the commissions to other brokers. Chances are you won't be able to cost-effectively buy individual stocks and still be diversified with a small amount of money. Given these restrictions, it's probably worth starting out on your investment journey with mutual funds. However, like all aspects of investing, it's up to you to do the research and figure out the strategy that suits you best.

What You Get When You Pay For Investment Services

2012-01-01T07:24:00.001-08:00

Investment services offered to individual investors come in a myriad of packaging and delivery options. Discount brokerage houses, full-service brokerage houses, load mutual fund firms, no-load mutual fund firms, banks, insurance companies, private money management firms and fee-based advisors all attempt to convince investors that they are the best available alternative. Yet, despite their different packaging they are each providing all or part of the same three primary value components - advice, portfolio management and administration.

Advice is the process of defining and implementing an appropriate investment strategy given an investor's objectives and particular constraints. Portfolio management is the process of building and maintaining an investment portfolio that properly addresses the strategy the advisory component has defined. Administration is all the trading, clearing and reporting functions required to effectively execute the portfolio management process.

This article will take a closer look at the subcomponents within each of the three broad value components and show you how to use them to analyze which parts of the financial management process are worth paying for, and which you may want to take on yourself.

Administration
Of the three components, administration is the one that you will be least able to do on your own. Any registered broker/dealer has access to many equity, fixed-income and commodities markets through which they can buy and sell. For a host of reasons, you are not able to go directly to these markets yourself. As such, this is a subcomponent that you will have to outsource and pay for in the form of some fee or commission. Fortunately, with online discount brokerages, the costs associated with trading are minimal. In addition, these costs cover trade settlement, confirmations, and other client statements, all of which are in compliance with mandated regulations. There are some other administrative services, however, that are not automatically supplied by your brokerage firm.

While year-end reporting for tax purposes is required, not all brokerage firms track cost basis for you. This is something you can do yourself with a spreadsheet or even a notepad, but depending on the number of holdings you have it can be a time-intensive. In choosing a brokerage firm, try to find one that keeps accurate track of your cost basis. It will save you time when you prepare your tax returns each year. (For more insight, read How do I figure out my cost basis on a stock investment?)

Another important administration function you can handle yourself is performance reporting. Truly accurate reporting, however, will be almost impossible without some fairly sophisticated software that keeps track of all cash flows and is able to calculate time-weighted total rate of return. If your brokerage firm can do this for you at no additional charge, you are receiving a material increase in value.

Portfolio Management
Most investors, and sadly most investment advisors, have little training or knowledge regarding security analysis and portfolio management. Typically, investor portfolios are built in a hodge-podge manner over time. Securities are chosen without benefit of in-depth analysis and without proper regard as to how they interrelate with one another. Holdings are often spread over numerous accounts held at various locations so there is little way to determine how the overall investment portfolio is performing.

Proper security analysis is required to identify suitable and attractive investments. The level of expertise needed varies between investment types. Stock analysis can be fairly straightforward, but many fixed-income investments incorporate a variety of factors that must be carefully considered. Derivatives, options, futures and commodities are even more complex. Without extensive training, you may find it extremely difficult to ascertain fair value of the many varied security options available. On top of the security selection requirements, you must understand how these individual securities act in concert to form an efficient and effective portfolio. At a minimum, you will need to understand some of the core principles of modern portfolio theory (MPT).

Unfortunately, most retail investment advisors have little training in security selection and overall portfolio management. Base licensing requirements are far from in-depth. Various "professional" designations abound, but many are rudimentary at best. The preeminent professional designation for portfolio management is the Chartered Financial Analyst (CFA). The CFA is nearly a requirement if one wishes to be a security analyst or portfolio manager on Wall Street. It is an intensive and comprehensive training program that takes a minimum of three years to complete. Few retail investment advisors hold the CFA and individual investors do not even have access to the program. (For more insight, read The Alphabet Soup Of Financial Certifications.)

You can create and manage an effective investment portfolio without a CFA designation of your own or a CFA acting as your advisor, but it may be more challenging than you think. You could find that you gain more than you lose by outsourcing this particular value component. (For more insight, see Manage My Own Investments? Are You Kidding?)

Advice
Serving as your own investment advisor may be the easiest of the three value components to do yourself. Still, a host of constantly changing factors involving not only investments, but also taxes, insurance needs, liquidity needs, and other special needs or constraints must be addressed.

Resources for financial advice are plentiful. A multitude of books, magazines, web sites, blogs, and organizations churn out tons of valuable information covering almost every aspect of financial planning. With time and effort, there is no reason to believe that reasonably intelligent investors can't serve adequately as their own investment advisors. The key consideration should therefore be the desire to do so. Laws and regulations are constantly in flux. Staying abreast of these changes and adjusting your plan accordingly can be time consuming. If you have the time and desire it can be done, but you may find that you would prefer some help. (For more, see Tailoring Your Investment Plan.)

If you do decide you want the assistance of a professional advisor, your key consideration should be value, since pricing for this service is fairly comparable. Once again, base securities license requirements focus on investment alternatives. Comprehensive financial planning is not covered.

Know Your Limitations, Maximize Your Value
When taking on part of the investment process yourself, you must know your limitations. Being a do-it-yourself investor entails much more than picking a stock or selecting a mutual fund. Make an honest assessment of your abilities, available time and level of desire. If you choose to outsource some or all of the components or sub-components, make certain that you maximize your value. Choose advisors who have demonstrated a commitment to learning and excellence. Select portfolio managers with proper training and credentials. Use brokerage firms that provide a full array of comprehensive services. If you follow these basic principles, there is no reason you won't succeed, regardless of whether you do all of it yourself, some of it yourself, or none of it yourself.

Shopping For A Financial Advisor

2012-01-01T07:23:00.000-08:00

Sometimes we need the help of others. This is a fact of life, and one that also applies to our financial decisions. That's why some of us will seek the services of a financial advisor. Whether we lack the time to do a lot of research ourselves or we feel the need for a professional opinion, financial advisors can be convenient and helpful.

But you don't want to rush out and hire just anyone. Choosing a financial advisor is much like buying a car: it's a big decision, so you must consider many factors and know your criteria before making your purchase. Let's take a closer look at how the essential considerations involved in shopping for a financial advisor are like those involved in shopping for a car.

Design
First impressions are important, and the very first thing that gives you an impression of any car is its design. A car is characterized by its form, which reflects how and for what it is built. Financial advisors make their first impression by their designations: their professional status is shaped by the kind of education they have, or the letters behind their names. Of course, the more letters there are, the more there is to indicate that the planner has extensive knowledge and commitment to his or her industry.

But, like some cars that have sleek designs but also a propensity to rust quickly, a financial professional may have letters that look good but are actually quite limited. There are now many different types of certifications, and not all have the same importance or weight, so do make sure you know what the designations mean. For more information, take a look at the article Are All Certifications Created Equal?

Reputation and Performance
Most of us definitely consider brand reputation when we decide to buy a car. Some of us will buy the tried and true makes that our parents bought, while other people will take a risk with a newly-introduced car company. Similarly, you may want to look for a financial advisor who has a longer track record, or you may decide to take a chance with a new graduate who is building the foundations of his or her reputation. Typically, the financial advisors who have been around for a long time with a good track record will cost more than the new graduates with little experience. That's not to say that the new graduates can't make you profits or help you save money, but they do pose more uncertainty.

Experience is always an asset, but a long track record is not worth much if it isn't a good one. Make sure you find out whether your prospective financial advisor has had many complaints, and if so, look into how he or she resolved them. You can look into the advisor's track record simply by asking him or her about it, but you can also find out more by searching through the SEC records by yourself. (Check out Is Your Broker Acting In Your Best Interest?)

Relationship
Buying a car is an important decision, and you want the person or company selling you the car to know this. A good customer service policy, and a willingness to accept your questions and concerns is crucial to your relationship with a car dealership.

The same qualities are important for your relationship with your financial planner, who must exhibit a high willingness to communicate well with you. Ask yourself the following questions when reviewing your broker relationship:

Does he or she plan to meet or speak with your regularly?
Will there be routine checkups or does he or she plan to contact you only when something bad is occurring?
How often is your portfolio going to be revisited?
Does he or she exhibit a strong willingness to understand what goals you have set out, and has he or she thoroughly explain the intended approach to reaching these goals?
The product variable is a little more complicated. Just as a person working for a Ford dealership isn't going to try to sell you a Chevy, a financial planner working for one financial company, probably won't encourage you to look at what another company offers (although some advisors will). However, a financial planner should primarily look out for your interests, and, to do so, he or she needs a certain degree of independence. Make sure you determine whether the advisor is occupied foremost with helping you make financial gains or pre-occupied by the obligation to make profits for a large mutual fund or investment company.

Options
Once you decide on a car, choosing the options it offers depends directly on what you need - you don't want to pay for an expensive option that is useless to you. If you live in Alaska, does the air conditioning package help you, or if you live in Florida, do you really need the block heater?

Your choice of financial planner will serve you best if you have a clear understanding of your needs and goals. While the meat of financial planning is typically the same everywhere, it's the available options and extras that make a difference. For instance, does your planner offer tax advice, and what type of investment strategy do they have? Would they handle all of your investment accounts or only your retirement account? Make a list of exactly what you need from a financial professional and then determine whether he or she offers you the appropriate services for the price you would be paying.

Conclusion
Deciding on the right financial planner, like picking the right car, is an important step that requires you not only to do some research and shopping around, but also to think about what you need and expect. Keep in mind that this article provides only a basic guideline of what you need to consider, so take your time and make sure you've covered your grounds. Just like the regret of buying an unreliable or unsuitable car, a bad decision on a financial planner can be a long-term burden in more ways than one. A poor advisor will not only prove to be a wasted expense but also a cause for lost profits, money saving opportunities, and even sleep!

Asset Allocation: One Decision To Rule Them All

2012-01-01T07:22:00.000-08:00

Imagine for a moment that you have only one investment portfolio: you don't have money in a retirement fund, a college fund, a 401(k), a variable annuity, municipal bonds with one broker and some stocks and mutual funds with another. No, you merely have a single portfolio to meet all your investment needs - simple, concise, efficient.

In reality, of course, you do have one investment portfolio - you just probably have it divided across a number of different structures. In the aggregate, it forms one portfolio with its own particular investment characteristics. Unfortunately, you probably have little awareness of its characteristics. The multitude of separate entities has caused you to lose sight of the forest for the trees.

If you did have just one investment account though, how would you structure it? What are the critical factors that determine how that portfolio should perform? Let's take a look at what you would choose and show you how to transfer those preferences to your overall portfolio.

Asset Allocation Is the Key
You may have heard the mantra that "asset allocation is the key" so often by now that it barely registers with you anymore.

The belief has its origins in a study by Brinson, Hood and Beebower entitled "Determinants of Portfolio Performance" (Financial Analysts Journal, July/August Issue, 1986). The study concluded that 93.6% of the variation of returns in a diversified portfolio is explained by the asset allocation policy. The key term here is "diversified", but we will address that in a moment.

Your asset allocation decision is critical. Get it "right" and you have accomplished nearly 100% of your task in one step. Even if you have a multitude of accounts at the moment, in the aggregate, you have an overall asset allocation and it is controlling most of your investment outcome. (To get started on asset allocation, see Asset Allocation Strategies and Choose Your Own Asset Allocation Adventure.)

There are many asset classes, including cash, bonds, stocks, real estate, commodities, precious metals and foreign stocks. Each class has demonstrated certain return and volatility characteristics over time. You can combine these asset classes in infinite ways to produce infinite risk/return portfolio profiles. Your greatest challenge is to learn why these asset classes tend to behave the way they do and what influences their performance profile. You may know that stocks have shown a tendency to produce greater average annual returns over time than bonds and you may know that stocks tend to be more volatile than bonds, but do you know why that is? If you prefer to save yourself the time of understanding the causes, you can take an "it is what it is" approach and just use past performance tendencies as your guide to structuring your asset allocation policy going forward. (For more, see Five Things To Know About Asset Allocation.)

How to Start Allocating
How do you know which asset classes to use? A general rule is that if you don't understand the asset class, don't use it. Don't worry about finding the perfect asset allocation mix. There is no perfect mix - except in hindsight, and even then it changes with each passing moment. A good, suitable mix is all you need to get the job done.

Setting an asset allocation policy is not limited to how the asset classes tend to behave. It is also based on how you tend to behave. Your own return goals as well as your own ability to tolerate volatility and uncertainty make up the flip side of the asset allocation "coin". You must attempt to construct an allocation that has the best apparent ability to match your investment temperament. Helter-skelter adjustments of your asset allocation mix based on emotion are a sure-fire way to sabotage your long-term investment success. If you are going to make tactical changes in allocation along the way, you had better have some rational method to guide you. (Keep reading about how emotions topple investment policies in When Fear And Greed Take Over and Master Your Trading Mindtraps.)

While every individual theoretically has a particular investment psyche, one idea is universal: if you are a rational investor, you want to maximize return and minimize volatility. There is no reason to take on more risk if you are not going to get paid for it through the opportunity for greater returns; similarly, there is no need to seek greater returns than you "need".

Jackie Stewart, "The Flying Scot", won three world drivers' championships in Formula 1 racing during his eight-year career. He told an interviewer once that his goal in each and every race was to win that race at the slowest possible speed. The interviewer was confused. What did he mean? Stewart explained that it made no sense to him to risk a wreck or mechanical failure by pushing the car any faster than he needed to in order to finish first. Whether he won by a meter or a mile, it did not matter - it was still a win. Jackie Stewart was notorious for his smooth and effective driving style. Now you know the mindset that guided him in taking that smooth approach. You should have a similar mindset in setting your portfolio. Choose the asset allocation that has the greatest chance of allowing you to reach your goal with the least volatility along the way. If you can reach your goal with an 8% average annual return, don't risk "crashing" by attempting to get 10%.

Systematic vs. Unsystematic Risk
The Brinson, Hood and Beebower study dealt with diversified portfolios. If you want to capture the performance characteristics of U.S. domestic stocks, you aren't going to do it by only owning the stock of one company. The reason has to do with systematic and unsystematic risk.

Systematic risk is the risk inherent to the entire asset class. Broad economic and political conditions are going to impact the earning prospects of all companies, which in turn will impact the price of their stock. Different companies, and thus their stocks, will have varying degrees of sensitivity to these broad influences, but all will be impacted and there is little you can do to avoid it.

Unsystematic risk is specific risk that is inherent in each individual holding. If a promising new blockbuster drug being developed by a pharmaceutical company suddenly proves worthless, it will have a materially negative effect on that company's stock value, but little to no effect on other stocks. Studies have demonstrated that unsystematic stock risk can be diversified away by holding only 20-30 stocks that are not highly correlated in terms of specific industries. (In other words, holding 20 utility stocks still exposes an investor to unsystematic risk associated with the utilities industry so your industry exposure must be more diverse.) Proper diversification works because negative events for one holding are typically offset by positive events for another holding. Return is supposed to be the price you are paid to assume risk, so it makes no sense to expect incremental return from the unsystematic component of a stock's risk profile, because that component can be so easily diversified away.

What cannot be diversified away is systematic risk and stocks have a different level of systematic risk than bonds, cash, real estate, etc. Over time, the return prospects of the asset class are therefore a function of its systematic risk profile. (For more, see The Importance Of Diversification.)

To capture the performance of a given asset class you must have a broad, diversified exposure to that asset class. Again, depending on the asset class, this may be effectively accomplished through some number of individual holdings or it can be accomplished by owning an index fund, exchange-traded fund, mutual funds or any other broadly diversified asset class portfolio.

The Rest of the Story
If asset allocation takes care of nearly 94% of your portfolio's investment profile, what influences the rest? The answer is individual security selection and market timing. The things that come to mind for most people when you mention investing are only incremental factors in determining a diversified portfolio's performance over time - but they are focusing on the 6% and missing the 94%!

If you already have multiple investment accounts, think of your portfolio as one investment and analyze the composition of that investment to determine your current asset allocation. Make certain this allocation is appropriate for your goals and investment temperament. Confirm that you are exposed to all areas of the asset class in order to minimize unsystematic risk. If you are creating a new portfolio, start with the asset allocation and structure your investments in a way that gives you broadly diversified exposure to each asset class. After that, relax, because everything else is merely incremental.

Adapt To A Bear Market

2012-01-01T07:21:00.000-08:00

Witnessing a bear market for stocks doesn't have to be about suffering and loss, even though some cash losses may be unavoidable. Instead, investors should always try to see what is presented to them as an opportunity, a chance to learn about how markets respond to the events surrounding a bear market or any other extended period of dull returns. Read on to learn about how to weather a downturn. (To learn more on making it through downturns in the market, read Surviving Bear Country.)

What is a Bear Market?
The boilerplate definition says that any time broad stock market indexes fall more than 20% from a previous high, a bear market is in effect. Most economists will tell you that bear markets simply need to occur from time to time to "keep everyone honest". In other words, they are a natural way to regulate the occasional imbalances that sprout up between corporate earnings, consumer demand and the combination of legislative and regulatory changes in the marketplace. Cyclical patterns of stock returns are just as evident in our past as the cyclical patterns of economic growth and unemployment that have been around for hundreds of years.

Bear markets can take a big bite out of the returns of long-term stockholders. If an investor could, by some miracle, avoid the downturns altogether while participating in all the upswings (bull markets), their returns would be spectacular - even better than Warren Buffet or Peter Lynch. While that kind of perfection is simply beyond reach, savvy investors can see far enough around the corner to make adjustments to their portfolios and spare themselves some losses.

These adjustments are a combination of asset allocation changes (moving out of stocks and into fixed income products) and switches within a stock portfolio itself. (For related reading, see Asset Allocation Strategies and Achieving Optimal Asset Allocation.)

When the Bear Comes Knocking
If it appears that a bear market could be around the corner, get your portfolio in order by identifying the relative risks of each holding, whether it's a single security, a mutual fund, or even hard assets like real estate and gold. In bear markets, the stocks most susceptible to falling are those that are richly valued based on current or future profits. This often translates into growth stocks (stocks with price-earnings ratios(P/E ratios) and earnings growth higher than market averages) falling in price.

Value stocks, meanwhile, may outperform the broad market indexes because of their lower P/E ratios and the perceived stability of earnings. Value stocks also often come with dividends, and this income becomes more precious in a downturn when equity growth disappears. Because value stocks tend to get ignored during bull runs in the market, there is often an influx of investor capital and general interest in these stodgy companies when markets turn sour.

Many young investors tend to focus on companies that have outsized earnings growth (and associated high valuations), operate in high-profile industries, or sell products with which they are personally familiar. There is absolutely nothing wrong with this strategy, but when markets begin to fall broadly, it is an excellent time to explore some lesser-known industries, companies and products. They may be stodgy, but the very traits that make them boring during the good times turn them into gems when the rain comes.

Seek Out Defensive Investments
In working to identify the potential risks in your portfolio, focus on company earnings as a barometer of risk. Companies that have been growing earnings at a fast clip probably have high P/Es to go with it. Also, companies that compete for consumers' discretionary income may have a harder time meeting earnings targets if the economy is turning south. Some industries that commonly fit the bill here include entertainment, travel, retailers and media companies.

You may decide to sell or trim some positions that have performed especially well compared to the market or its competitors in the industry. This would be a good time to do so; even though the company's prospects may remain intact, markets tend to drop regardless of merit. Even that "favorite stock" of yours deserves a strong look from the devil's advocate point of view. (Find out what to do when the sun sets on a burgeoning market, in Recession-Proof Your Portfolio.)

Identify the Root Causes of Weakness
It may take some time for a consensus to form, but eventually there will be evidence of what ended up causing the bear market to occur. Rarely is one specific event to blame, but a core theme should start to appear; identifying that theme can help identify when the bear market might be at an end. Armed with the experience of a bear market, you may find yourself wiser and better-prepared when the next one arrives.

A Case Study: 2000-2002 Bear Market
Consider the bear market that occurred between the spring of 2000 and the fall of 2002, often referred to as the "tech bubble" or dotcom bubble. As the monikers suggest, the problems in this market began with technology stocks, as evidenced by the more than 60% drop in the tech-laden Nasdaq index. But weakness in a few sectors quickly spread, eventually dragging down all corners of the equity map. Even the blue-chip Dow Jones Industrial Average (DJIA) fell over 25% during the period.

Leading up to the year 2000, the explosion of the internet led to dramatic innovations in all areas of technology, including data servers, personal computers, software and broadband transmission systems like fiber optics and cable. By the late 1990s, any company remotely involved in the internet had a sky-high market cap, giving it access to very cheap capital. Stocks with little or no earnings were suddenly worth billions, and used their stock currency to buy other companies, obtain bank credit and expand operations.

Meanwhile, non-tech based companies felt the need to get caught up technologically, and spent billions on equipment as well as activities related to "Y2K" preparation, further inflating demand for tech products, but it was an artificial demand that could not be supported over time.

The Snowball Effect
As always happens near the peak of a bubble or bull market, confidence turned to hubris, and stock valuations got well above historical norms. Some analysts even felt the internet was enough of a paradigm shift that traditional methods of valuing stocks could be thrown out altogether. But this was certainly not the case, and the first evidence came from the companies that had been some of the darlings of the stock race upward – the large suppliers of internet trafficking equipment, such as fiber optic cabling, routers and server hardware. After rising meteorically, sales began to fall sharply by 2000, and this sales drought was then felt by those companies' suppliers, and so on across the supply chain.
Pretty soon the corporate customers realized that they had all the technology equipment they needed, and the big orders stopped coming in. A massive glut of production capacity and inventory had been created, so prices dropped hard and fast. In the end, many companies that were worth billions as little as three years earlier went belly-up, never having earned more than a few million dollars in revenue.

The only thing that allowed the market to recover from bear territory was when all that excess capacity and supply got either written off the books, or eaten up by true demand growth. This finally showed up in the growth of net earnings for the core technology suppliers in late 2002, right around when the broad market indexes finally resumed their historical upward trend.

Start Looking at the Macro Data
Some people follow specific pieces of macroeconomic data, such as gross domestic product (GDP) or the recent unemployment figure, but more important are what the numbers can tell us about the current state of affairs. Bear markets are largely driven by negative expectations, so it stands to reason that it won't turn around until expectations are more positive than negative. For most investors - especially the large institutional ones, which control trillions of investment dollars - positive expectations are most driven by the anticipation of strong GDP growth, low inflation and low unemployment. So if these types of economic indicators have been reporting weak for several quarters, a turnaround or a reversal of the trend could have a big effect on perceptions. A more in-depth study of these economic indicators will teach you which ones affect the markets a lot, or which ones may be smaller in scope but apply more to your own investments. (From unemployment to inflation to government policy, learn what macroeconomics measures and how it affects you in Macroeconomic Analysis.)

Position Yourself For the Future
You may find yourself at your most weary and battle-scarred at the tail end of the bear market, when prices have stabilized to the downside and positive signs of growth or reform can be seen throughout the market.

This is the time to shed your fear and start dipping your toes back into the markets, rotating your way back into sectors or industries that you had shied away from. Before jumping back to your old favorite stocks, look closely to see how well they navigated the downturn; make sure their end markets are still strong and that management is proving responsive to market events.

Parting Thoughts
Bear markets are inevitable, but so are their recoveries. If you have to suffer through the misfortune of investing through one, give yourself the gift of learning everything you can about the markets, as well as your own temperament, biases and strengths. It will pay off down the road, because another bear market is always on the horizon. Don't be afraid to chart your own course, despite what the mass media outlets say. Most of them are in the business of telling you how things are today, but investors have time frames of 5, 15 or even 50 years from now, and how they finish the race is much more important than the day-to-day machinations of the market.

Invest Without Stress

2012-01-01T07:20:00.000-08:00

Many investors get a lot of anxiety chasing mutual fund returns, hoping that history repeats itself while they are in the fund. In fact, a fund which has already yielded large returns has less of a chance to do so again when compared with its peer group. A better idea, rather than stressing out over the vagaries of the financial markets, is to look for wisdom in time-tested, academic methods. Once your high-quality investment plan is set up, relax. Let your investment compound, understanding that the plan is rooted in knowledge, not hype.

Good Soil
As when growing a garden, you want to invest in good soil (strategy). Accordingly, you can expect there to be some rainy days (bear market) with the sunny (bull market). Both are needed for overall growth. Once a garden (money) starts to grow, don't uproot it and replant, lest it wither and die. Set up your investment wisely and then let it grow. (Check out our related article Digging Deeper Into Bull And Bear Markets to learn the characteristics of the two types of market conditions.)

Academic research creates good soil. The body of knowledge about the market goes through a rigorous review process whose primary goal is truth or knowledge rather than profit. Thus, the information is disinterested - something you should always look for in life to make wise decisions.

Greatly distilling this body of knowledge, here are a few key points to remember when it comes to investing in the stock market.

Risk and return
This concept is similar to the saying "there is no free lunch". In money terms, if you want more return, you are going to have to invest in funds that have a greater probability of going south (high risk). Thus, the law of large numbers really comes into play here, since investing in small, unproven companies may yield better potential returns, while larger companies which have already undergone substantial growth may not give you comparable results.

Market efficiency
This concept says that everything you need to know about conventional investments is already priced into them. Market efficiency supports the concept of risk and return; thus, don't waste your time at the library with a "Value Line investment" unless it provides entertainment value. Essentially, when you look at whether or not to invest in a large corporation, it is unlikely that you are going to find any information different from what others have already found. Interestingly, this also gives insight into how you make abnormal returns by investing in unknown companies like "Bob's Tomato Shack" if you really have the time and business acumen to do front-line research. (This is beyond the scope of this article, so if you want to learn more, check out The Changing Role Of Equity Research, What Kind Of Research Do Investors Want? and Finding Undiscovered Stocks.)

Modern portfolio theory (MPT)
Modern portfolio theory (MPT) basically says that you want to diversify your investments as much as possible in order to get rid of company- or stock-cspecific risk, thus incurring only the lowest common denominator - market risk. Essentially, you are using the law of large numbers in order to maximize returns while minimizing risk for a given market exposure. (Be sure to read Modern Portfolio Theory: An Overview for more information.)

Now here is where things get really interesting! We just found the way to optimize your risk-return tradeoff for a given market level of risk by being well diversified in your investments. However, you can further adjust the investment risk downwards by lending money (investing some of it in risk-free assets) or upwards by borrowing it (margin investing).

Best Market Portfolio
Academics have created models of the market portfolio, consisting of a weighted sum of every asset in the market, with weights in the proportions that the assets exist in the market. Many think of this as being like the S&P 500, but that is an index of only the 500 largest companies in the U.S. Instead, think total market and think globally. One limitation is that while you are investing in the world, you are spending your dollars in your own country, so at this point things get a little dicey. (For further reading on weighted indexes and how they are created, see Fundamentally-Weighted Index Investing.)

Roughly, the world market cap is about one-third U.S. and two-thirds international. As mentioned earlier, if you live in the U.S., this is primarily where you spend your dollars, and thus you could either hedge the currency or beef up the U.S. exposure. To keep this simple and comfortable to the investor, a 50% U.S. / 50% international weighting will help you to get started.

Putting This Into Practice
You can achieve this weighting by selecting ETFs to replicate the market portfolio. You can buy an extended U.S. ETF and an international ETF, put them together and you have your duck soup! Now, you need to assess your greed versus fear: e.g., how much of your investment you want to put into the market portfolio versus T-bills. If you are more greedy than fearful, you could even do some margin investing. (Find out all you need to know about ETFs in our Exchange Traded Funds feature.)

A key item you'll want to consider when assessing your greed factor is the return potential. As a general rule, for the market portfolio estimate a 10% return on average with 20% annual swings up or down not uncommon. Compare this to U.S. Treasuries at a 3-4% rate of return with little principal swings if kept in short duration. Does knowing the difference of return vs. risk change your level of fear, greed or risk tolerance? (For more information on this, read When Fear And Greed Take Over and Master Your Trading Mindtraps.)

Risky Business
To uncover your personal risk status, you must assess your financial resilience first. This is how able you are to sustain a financial loss. How much portfolio value can you put at risk? Since the market generally goes up over time, this really becomes an issue of time horizon. If you have Junior's tuition due in a year, your time horizon is short on the section of your portfolio that must cover that expense. Conversely, if you are just starting your career, you can better ride out any storms from a longer time horizon. (To keep reading about risk, see Determining Risk And The Risk Pyramid and Personalizing Risk Tolerance.)

Second, you must assess your psychological resilience. What would keep you up at night? If you are an anxious individual who checks the stock market every day, you probably should keep your market exposure low. However, if you are more comfortable with the market and are too busy to constantly review stock quotes, your psychology is better suited for a higher market portfolio weighting.

Conclusion
One of the best lines from a common cartoon to take with you each day is Lion King's "Hakuna matata," which means "No worries!" If you enjoy stock picking, go nuts, but do so for entertainment. If investing your nest egg is likely to cause you some anxiety, seek the academic, time-tested good soil and then rest well at night knowing you have done the due diligence and nothing more than modest rebalancing as necessary. A healthy harvest should follow as you learn to grow your green investing thumb.

In Praise Of Portfolio Simplicity

2012-01-01T07:18:00.000-08:00

Many investors find themselves with a portfolio that is too complicated to understand, hard to manage and difficult to change. In fact, some investors' portfolios contain so many mutual fund and principal protected notes (PPN) that they match the complexity of billion dollar pension plans, but without the expertise and resources required to manage them properly. Individual investors, especially those who invest in mutual funds, should strive for simplicity in portfolio construction. Koichi Kawana, a designer of botanical gardens, says "Simplicity means the achievement of maximum effect with minimum means." This could also be applied to an investment portfolio.

Factors Adding Complexity
Many things can lead to a complicated and cluttered portfolio, including, a lack of basic understanding of diversification, a tendency to buy individual stocks or mutual funds on their own merits without regard to the impact on the overall portfolio, buying complex investment products, and buying investments without a disciplined investment strategy. Over time, the portfolio becomes unwieldy, it becomes difficult to manage and performance suffers.

Some of the factors contributing to a portfolio's overall complexity include:

Too Many Advisors
It is not unusual for some investors to have two or more investment advisors as well as managing part of the overall portfolio themselves. The belief that two heads are better than one and that each advisor can provide a different perspective with different investing ideas results in multi-advisor accounts. Without an overall investment strategy to provide the necessary discipline, having more than one advisor might just complicate the portfolio without adding to performance or contributing to risk reduction. This is especially the case if the advisors have the same investment mandate. (For related reading, see Choosing An Advisor: Wall Street Vs Main Street and Do You Need A Financial Advisor?)

If you use more than one advisor, clarity can be improved by splitting the responsibilities between them. In other words, each should have specific asset classes for which they are responsible. For example, one advisor might manage U.S. large cap stocks and the other might be responsible for fixed income and global equities. (For more on asset class, see Diversification: It's All About (Asset) Class and Asset Allocation Within Fixed Income.)

Too Many Accounts
Without much difficulty a husband and wife can have several investment accounts. If each spouse has an IRA, a 401(k), a taxable investment account and a joint account between them, there is a minimum of seven investment accounts. If some of them are split between different institutions as well as managed by themselves it is not unusual for the household to end up with more than a dozen different accounts. Every account at a different institution will have a different reporting standard, which adds to the complexity. Monitoring your investments and determining what investments are put in each account only adds to the administrative burden.

Too Many Securities
Each individual security in a portfolio requires some attention.There is a mistaken belief by some investors that if one mutual fund is good then five must be better. The goal should be to attain proper diversification with a minimum number of securities, rather than adding more. (For related reading, see The Dangers Of Over-Diversification.)

Investment Products Are Too Complicated
A simple mutual fund investing in one asset class, such as large cap equity, fixed income, global equities etc. is relatively straightforward. A balanced fund that invests across several asset classes or a fund of funds adds another level of complexity. Many products, such as hedge funds and PPNs with their embedded options, or variable annuities with their embedded insurance contracts are very difficult to understand by themselves. The tools and expertise required to effectively understand and manage the risks associated with many of these products is often beyond the reach of the individual investor.

Complex Portfolio Problems
A good balanced fund, especially one that is balanced internationally, may be a good choice if your portfolio has just one or two funds, but a portfolio containing six to 10 balanced funds seldom makes a for a good investment. This is because these additional funds just add complexity without further reducing risk or enhancing performance.
Diversification to a point is always a desirable attribute, but over-diversification should be avoided. Portfolios that are over-diversified with too many mutual funds will almost always under perform after the fees are deducted.

To be confident you are making a correct investment decision, it is important to consider the characteristics of an individual security, and the potential impact on the overall portfolio. Will the purchase of the security reduce the overall risk by providing additional diversification or will it increase risk by increasing the concentration in one security or one sector of the market? As markets change, many potential opportunities present themselves, but risk and volatility may also increase. Making the proper investment decisions becomes more difficult and confidence is eroded as the complexity of a portfolio rises. (To learn about risk management, read Measuring And Managing Investment Risk.)

Simplify
One of the first steps to simplifying your portfolio is to consolidate as many investment accounts as possible. How the investments are allocated to the different accounts can not only improve the portfolio's simplicity, but can also make it more tax efficient as well. Although it is important to have an overall objective and asset mix for the consolidated portfolio, it is not important that each account have the same objectives or asset mix.

Each account whether, it is a tax-deferred account or a taxable account, can have a very specific objective and type of investment. One account may be mostly fixed income and another might be more trading orientated, while yet another is just for global investing. Consolidating will not only make it easier to understand and monitor these accounts, but it might help make them more tax efficient as well.

An easy way of simplifying a portfolio is to reduce the number of positions, either mutual funds or individual securities. There are often small insignificant holdings that will have very little impact on the overall portfolio if they are sold. Individual stocks that represent less than 2% of the total equity asset allocation can often be eliminated without impacting performance or diversification. Similarly for mutual funds, broad based mutual funds that represent less than 5% of the overall portfolio could be eliminated. Holding a balanced mutual fund in a portfolio that is already balanced makes little sense, it only complicates matters, but holding mutual funds that invest in single asset classes accomplishes makes a portfolio easier to understand at a glance and easier to locate in the account.

With an account that holds many mutual funds, there are likely to be funds that are similar in style and performance. Eliminating some of the funds and putting the proceeds in the best of the existing funds will simplify the portfolio and improve the probability of creating an outperforming portfolio without hurting diversification.

A portfolio containing index funds or some broadly based exchange-traded funds (ETF) is simpler than actively managed mutual funds or an actively managed portfolio of individual securities. An investor does not have to be concerned with the active management of the assets, only with the asset mix. Replacing three or four mutual funds that invest in U.S. stocks with an appropriate ETF will not only simplify the portfolio, but improve its underlying performance as well. (For more insight on management, read Words From The Wise On Active Management.)

Conclusion
In investing, it is often better to keep things simple. Simplifying your portfolio will make it easier to understand, manage and in the long run this should improve its overall performance. After all, with a simpler, less complicated portfolio, the investor will be able to focus his or her efforts on improving its performance, rather than trying to sort out how it works.

A Fresh Look At The Financial Markets

2012-01-01T07:17:00.000-08:00

With the advent of the internet and electronic trading, investors have access to a large number of financial markets and exchanges representing a vast array of financial products. Some of these markets have always been open to private investors; others remained the exclusive domain of major international banks and financial professionals until the very end of the twentieth century. These markets are not all equal; each requires unique skills and knowledge. As such, investors need to identify the market most suitable to their abilities, personality and investment goals, and then gain the specific skills required to profit in that market. Here we'll take a fresh look at the markets available to private investors and let you in on what you need to know to trade them.

Capital Markets
The capital markets generally offer ease of access and encouragement to private investors, limited leverage opportunity and, as a result, limited upside potential. Any government or corporation requires capital (funds) to finance its operations and to engage in its own long-term investments. To do this, a company raises money through the sale of securities - stocks and bonds in the company's name. These are bought and sold in the capital markets.

Private individuals are seizing on the opportunity to invest more than ever before: according to the "Outline of the U.S. Economy" (2001) by Christopher Conte and Albert R. Karr and the U.S. State Department, "the portion of all U.S. households owning stocks, directly or through intermediaries like pension funds, rose from 31% to 41% between 1989 and 1995." Reflecting this increase in private participation, the capital markets are extensively regulated - in the U.S. by the Securities and Exchange Commission (SEC).

The high private investor participation, varied product offerings, limited margin and extensive government regulation all combine to make the capital markets relatively safe for non-professional traders. But with this limited risk comes limited profit potential - this is a classic example of the risk-return tradeoff. This is partly because there is often a physical limitation as to how fast a company or economy can grow and partly because of the reduced leverage available. For example, most private investors are restricted to borrowing no more than 50% of the face value of their stocks in a margin account. (For background reading, see The Stock Market: A Look Back.)

Stocks
Many private investors' first foray into financial trading in the capital markets is via the stock market. It's relatively easy to understand, offers a wide selection, features many recognizable companies and products, is readily accessible, and its high trading volume creates liquidity that allows investors to "get out" with relatively little hassle. Given these factors, it's not surprising that the New York Stock Exchange's annual trading volume rose almost 15-fold between 1980 and 1998 - from 11,400 million shares to 169,000 million shares ("Outline of the U.S. Economy", 2001).

Bond Markets
A bond is a type of debt security that can be bought and sold by investors on credit markets around the world. This market - alternatively referred to as the debt, credit or fixed-income market - traded $45 trillion worldwide and $25.2 trillion in the U.S. in 2006, according to the Bond Market Association. It is much larger in nominal terms that the world's stock markets. This is considered a passive, low-risk, low-volatility investment. This market also has correspondingly low returns compared to the stock markets when examined over long time periods. (For more on getting into bonds, see the Bond Basics Tutorial.)

Mutual Funds
By the close of the 1990s, the portion of American households holding mutual funds had increased astronomically, from a mere 6% in 1979 to 37% in 1997. Why the dramatic upswing? Mutual funds are an appealing method for individual investors to participate in the outcomes of a large basket of stocks. The money pooled by mutual funds is invested by professional money managers across multiple industries or sectors, and their increased size allows mutual funds to often become active participants in the courses of action their investments take. Mutual fund investors, in turn, are somewhat sheltered from the natural chaos of the stock market through diversification. Returns in equity (stock)-based mutual funds have historically been solid, if not spectacular. Investing in mutual funds removes the need for fundamental security analysis, but asset allocation and sector diversification knowledge will aid investors in maximizing returns for a given level of risk. (For more on this topics, read out Special Feature on Mutual Funds.)

Index Investing
Many private investors are unable to beat the "broad market" as defined by indexes like the Standard & Poor's 500 Index, and consequently believe that simply buying the whole index to be a safer and easier route. Their logic is sound, but investors must also bear in mind that indexes by their nature are susceptible to market fluctuations.

Still, a smaller investor with limited time and capital can achieve a higher degree of sector or market diversification by buying indexes than they could possibly achieve by buying individual stocks. Fortunately for private investors wishing to invest in indexes, there are two simple and low-cost choices: index mutual funds and exchange-traded funds. Both offer low expense ratios and have high trading volumes, allowing for maximum liquidity. Index investing requires little analytical skill. (For more insight, see Index Investing.)

Cash or Spot Market
Investing in the cash or, "spot", market is highly sophisticated, with opportunities for both big losses and big gains. In the cash market, goods are sold for cash and are delivered immediately. By the same token, contracts bought and sold on the spot market are immediately effective. Prices are settled in cash "on the spot" at current market prices. This is notably different from other markets, in which trades are determined at forward prices.

The cash market is complex and delicate, and generally not suitable for inexperienced traders. The cash markets tend to be dominated by so-called institutional market players such as hedge funds, limited partnerships and corporate investors. The very nature of the products traded requires access to far-reaching, detailed information and a high level of macroeconomic analysis and trading skills.

Despite this, an increasing number of private investors are drawn to the massive leverage available and the profit potential. Ironically, it is this high leverage and corresponding high risk that wipes out many new entrants. Professional investors generally do not trade fully leveraged; rather, they operate under disciplined money management rules. It is vital that any private investor wishing to trade within these markets take the time to gain experience and understanding of the market before risking his or her capital. A viable alternative for investors wishing to partake in these opportunities is to invest in a managed account run by an experienced professional. (For more insight, see Hedge Fund Failures Illuminate Leverage Pitfalls.)

Derivatives Markets
The derivative is named so for a reason: its value is derived from its underlying asset or assets. A derivative is a contract, but in this case the contract price is determined by the market price of the core asset. If that sounds complicated, it's because it is. The derivatives market adds yet another layer of complexity and is therefore not ideal for inexperienced traders looking to speculate. However, it can be used quite effectively as part of a risk management program. (To get to know derivatives, read The Barnyard Basics Of Derivatives.)

Leverage can be found in these markets as well, so the chance for high reward attracts individual investor interest; however many would do better to invest in professionally managed accounts or funds. Complex derivative investing requires a high degree of analytical and mathematical skill as well as a broad macroeconomic understanding.

Examples of common derivatives are forwards, futures, options, swaps and contracts-for-difference (CFDs). Not only are these instruments complex but so too are the strategies deployed by this market's participants.

There have been some spectacular and highly publicized institutional losses in the derivatives market. American political and regulatory bodies have demonstrated their concern about the exploitation of derivative instruments - and, as a result, the exploitation of investors.

There are also many derivatives, structured products and collateralized obligations available, mainly in the over-the-counter (non-exchange) market, that professional investors, institutions and hedge fund managers utilize to varying degrees but play an insignificant role in private investing.

Conclusion
A private investor's foray into various markets is a delicate process, with multiple options and multiple chances for error. Each available market - even those dominated by individual traders/investors - requires specific information and thorough comprehension of the market's engine. The newfound electronic availability of previously exclusive markets only makes research that much more important; perhaps the single biggest indicator of an investor's potential success is the choice of the most suitable market for his or her skills.

Simplify Your Portfolio

2012-01-01T07:16:00.001-08:00

Years ago, just after the fall of the Iron Curtain, a joke was making the rounds regarding a recent immigrant from a former communist nation who walks into his first American shoe store to buy a pair of shoes. Citizens of communist nations had grown accustomed to a limited supply of all basic goods and services. This new immigrant was no different. He had grown up in a world where you were lucky to even find a pair of shoes in your exact size, much less a selection of them. Now, as he surveyed the vast array of choices available to him, he became increasingly exasperated. Finally, he turned to leave without making a purchase.

"Didn't we have anything you liked?" asked the salesman.

"That's the problem," exclaimed the immigrant, "There are so many choices I'm too confused to make a decision!"

Investors today have vastly more investment choices than ever before. Yet, despite this wealth of available options, investors continue to struggle. Could it be that the flood of products, vendors and account alternatives is actually making the investment decision process more difficult? Are there ways to simplify your approach and still succeed?

Starting With the Proper Perspective
There seems to be a prevailing misconception that one can quickly "invest" his or her way to a fortune. Throughout history, only a rare few individuals have accomplished this feat and even they typically took on vastly more risk than the average investor could tolerate. Finding the next Microsoft (Nasdaq:MSFT) or day trading your way to wealth is not the mindset one should have when approaching the investment landscape.

As a general rule, you will generate substantially more income and wealth-building potential from your job than you ever will from investing. Wealth is created over time by saving part of this generated income. With a generous income and a disciplined saving habit, a material amount of wealth can be accumulated over an extended period, even if that wealth is invested in nothing more than a traditional bank savings account. Enlightened investors, however, recognize that they can expand the growth of net worth by investing accumulated savings in other assets with greater growth potential. (Uncover how much volatility you can really stand, in Personalizing Risk Tolerance.)

Different Packaging, Similar Contents
Tax laws generate a great deal of unnecessary complexity for the average investor. A number of products and account structures are created to take advantage of tax policy, including variable annuities, IRAs and 401(k)s, to name just a few. Keep in mind, however, that the government rarely gives away anything for free. Capital gains in a taxable account are taxed at lower capital gains tax rates when realized. Those same capital gains are taxed at higher income tax rates when realized and withdrawn from a variable annuity or IRA. These accounts may make sense in many instances, but in other instances they may not be the best alternative. (Got questions about your taxes? Check out Common Tax Questions Answered.)

Financial firms, recognizing that they are all fishing from essentially the same asset ponds, seek to attract clients by finding different ways to combine and package investment assets. As a result, thousands of mutual funds exist today that are essentially just different combinations and packaging of the same stocks and/or bonds. The result of all these multiple account structures and packaging options is that investors often accumulate investments in a hodge-podge manner over time.

Owning several different investments can often mean that little thought is given to how these various parts work in concert with one another. In addition, there is typically no way to discern how they are performing in the aggregate. The task of keeping track of the many statements and assorted paperwork becomes a logistical nightmare for investors and their tax advisors. As a result, investors start looking at the individual accounts and investments as separate parts rather than one, concerted investment portfolio. This is known as "mental accounting" in the behavioral finance world, and it can be detrimental to your long-term investment success. It would be far better to employ a more simplified approach. (Discover how human tendencies can play out in the market, in the Behavioral Finance Tutorial.)

The Impact of Asset Class
Despite all of the many different ways they are packaged, investments largely contain one or more of just a few asset classes. These asset classes include stocks, bonds, cash (or cash alternatives), or physical assets like land, real estate, precious metals and commodities. Other, more complex investment alternatives are based on these underlying assets. Derivatives derive their value from some asset. Options give you the option to buy or sell an asset at a particular price and at a particular time. Futures give you the right to deliver or take delivery of some asset at some set price and at some set point in the future.

The more exotic investment alternatives serve their purposes in certain settings, but you do not need to use them. In fact, you can create an effective investment strategy by sticking to the asset classes with which you may be most familiar - stocks, bonds and cash. The world of investing can be immensely complex, but you can build significant wealth over time without ever getting involved in the esoteric areas of investing. (Are Derivatives Safe For Retail Investors explores these riskier asset classes further.)

In the July/August 1986 issue of the Financial Analysts Journal, a study by Brinson, Hood and Beebower entitled "Determinants of Portfolio Performance" concluded that 93.6% of the variation of returns in a diversified portfolio is explained by the asset allocation policy. While this study has since been the subject of some questioning and has no doubt been somewhat distorted by various marketing materials within the financial services industry, the disproportionate impact of asset class exposure on the return and volatility of a properly diversified portfolio appears evident.

Different asset classes have demonstrated certain performance characteristics over time. No one can predict the future, but a basic knowledge of how these asset classes have tended to perform and how they relate with one another will go a long way in helping you establish a long-term investment strategy that stands a chance of meeting your goals and objectives. (For more insight, read Five Things To Know About Asset Allocation and Choose Your Own Asset Allocation Adventure.)

Less Is More
A simple and straightforward approach can be employed by anyone who wants to establish and maintain an effective long-term investment strategy. First, keep the proper perspective. Do not attempt to get rich quick. In other words, keep your day job! Second, keep accounts and product selection to a minimum. Finally, focus on asset class selection and the overall asset allocation of your entire portfolio, making sure that your asset class exposure is fully diversified. As you can see, your approach does not have to be overly complicated, it does not have to be time consuming, and it does not require a vast array of products or accounts. In the end, you may actually find that less is more. (For related reading, see Three Simple Steps To Building Wealth.)

Financial Tips From A Heavyweight Champion

2012-01-01T07:15:00.001-08:00

Evander Holyfield is one of boxing's most distinguished heavyweight champions, and also one of its most financially successful. When he and Mike Tyson met in the ring for the first time during a 1996 bout, Holyfield, knocked out "Iron Mike" and earned an astounding $34 million dollars. That jaw-dropping amount is just one of the multi-million dollar paydays he's had during a career that's lasted nearly a quarter of a century.

But knocking out opponents isn't the only endeavor where the champ has seen terrific success; unlike many other high-earning sports figures and celebrities, Holyfield has been as successful at managing his money as he has been at managing his career.

Five Tips From the Champ
Holyfield credits his financial success to five basic principles, which he shares in his autobiography, Becoming Holyfield. They include:

1. Be careful who you trust
Never put all of your eggs (or trust, in this case) in one basket. It's a tried-and-true principle whether you are building a team to help you train for a championship or you are assembling a team to help you manage your money. Holyfield looks at each of his advisors - whether it's a lawyer, broker, manager, or trainer - the way investors should look at their portfolios. His philosophy is to never invest more in a single strategy than he can afford to lose.

The champ's advice is not only a good idea when choosing professional advisors (which the champ covers in more detail in tip No.4, below), but it's also a good idea in terms of where you put your money. In the realm of investing, diversification is a strategy that has racked up quite an impressive record of its own. Like a good boxer, your portfolio needs different skills in addition to strength. (Read Portfolio Protection In Diversification And Discipline for insight into how a diversified portfolio can help you avoid taking a beating in a tough market.)

2.Your advisors are not incorruptible
History is littered with athletes, rock stars, lottery winners and other celebrities that have been taken advantage of by unscrupulous advisors. The champ reminds us that even advisors that start out looking out for your best interests can fall victim to addictions or personal problems that cause them to behave out of character.

Trust your advisors, but look out for yourself by periodically checking up on the status of your affairs, even when they have been handled successfully for a long period of time. After all, it's your money, so make sure that you know what is happening with it. Don't accept vague advice or assurances, like "Trust me, it's a good idea", and don't invest in things that you don't understand. (Take a look at The Ghouls And Monsters On Wall Street for a reminder about some of the creepiest cases of financial fraud and the characters behind them.)

3.Break rule No.1 when you can
Whether you are working with an advisor or planning your future with a spouse, at some point, you'll have to trust somebody. Cultivate these relationships carefully, keeping rule No.2 in mind, but letting yourself expand where you can. (Since your choice of spouse can have an enormous impact on your finances, Relationship Money Matters and The No.1 Reason Why Couples Fight can help you begin to plan for whatever dreams lie ahead for you and your special someone.)

4.Stick with experts
When you've got money to spend, everyone volunteers to help. Your neighbors, your family, even people you meet on the street will tell you that they can figure out how to help you. Unfortunately, all the good intentions in the world don't make you an expert.

On this point, the champ's recommendation is simple: hire people who are good at what they do. When you need a financial advisor, hire a good one. When you need an attorney, hire a good one. Putting the right expert in charge of the task is half of the battle. (To learn how to weed out advisors that are just out to make a quick buck, read Find The Right Financial Advisor and Choosing An Advisor: Wall Street Vs. Main Street.)

5.Stay alert
Boxers who don't pay attention get knocked out. The same thing happens to investors. Because your financial situation will not remain static over time, and neither will your relationships with your advisors, you need to remain alert.

When your needs change, make an adjustment. If your financial goals have changed, adjust your investment strategy. If you are not comfortable with your portfolio or the advice that you are getting, find a new expert to guide you. Don't feel bad about the need to make changes. While your personal trainer might be the world's best trainer, he's the wrong man to call when you are having a heart attack and need a doctor. Boxers and other athletes change their stable of experts to reflect their current needs; you may need to do the same from time to time.

Plan Like A Champion
You might never step in the ring with a world-class fighter, but that doesn't mean you can't take a champion's advice when managing your money. Whether you have a vast fortune at your disposal or a more modest sum that you hope to build into a nest egg, plan carefully for a total financial knockout.

How To Dispute A Credit Card Charge

2012-01-01T07:14:00.001-08:00

What happens when the brand-new digital camera you brought home turns out to be a bust? Or the DVD player you got for your spouse's birthday gets stuck permanently on rewind? Or, when you've been double-charged for something you're sure you only came home with one of?

If you've made these purchases on a credit card - and these days, that's a near certainty - you're in luck. Thanks to the Fair Credit Billing Act, consumers have a good deal of protection for their credit card purchases. This law allows consumers to withhold payment on poor-quality, damaged merchandise or incorrectly billed items they bought with a credit card until the matter is resolved. Read on as we show you how to dispute a credit card charge and actually come out on the winning side. (To learn why it's important to fix errors on your bill, see How Credit Cards Affect Your Credit Rating.)

Retrace Your Steps
Your first move is always to go back and attempt to resolve the problem with the merchant. If you give them a chance to address your complaint, they very often will; especially if you approach them with politeness and courtesy. Most large retailers have customer service policies in place that err strongly on the side of being generous, at least within a certain period of time, and under "ordinary" circumstances.

Bottom line is, if you act promptly and reasonably, you're likely to get the full benefit of the doubt. If you don't have luck with the first representative you speak with, ask to talk with the manager or supervisor on duty. Be sure to keep records of each interaction, the person you spoke with as well as the date and time, so you can refer back to them if needed. (For tips on how to handle a heated situation, see Deal Effectively With Difficult Clients.)

Put It In Writing
If the merchant won't budge, it's time to put your complaint in writing. Draft a short, detailed letter outlining your particular dispute, and address it to the merchant via certified mail. Before you send it, make a few copies, so you can save one for your records and send another copy to your credit card company, as proof of your efforts to resolve this dispute.

Next you'll draft a letter to your credit card company, to officially alert it of the disputed purchase amount. The Fair Credit Billing Act mandates that you do this in writing, within 60 days after the bill with the disputed charge was sent to you. In your letter, you'll need to include your account number, the closing date of the bill on which the disputed charge appears, a description of the disputed item and the reason you're withholding payment. You should also enclose a copy of your complaint letter to the merchant, along with any other documentation that supports your position. This letter should also be sent via certified mail, return receipt requested; be sure you send it to the 'billing inquiries' address at your credit card company, and not the regular address for payments (since these are often two separate departments).

Keep on Paying
Even though you're disputing an item on your current bill, it's important to maintain your other payments. If you've charged anything else on your card during this cycle, you'll need to send that payment and all financing charges to the regular address, otherwise you'll incur interest and late-payment charges. (To learn more, see Understanding Credit Card Interest.)

At this point, you're just waiting to hear the result of your challenge. Some card companies - especially the bigger firms, such as Capital One - will often give the benefit of the doubt to their consumers, and issue a temporary credit until the dispute is resolved. This isn't required by law, however, so don't assume you will get this consideration. Meanwhile, the card issuer will get in touch with the merchant to find out their side of the story. Basically, if they end up siding with you, you will enjoy a full refund. If not, you'll have to pay for the disputed item, as well as any additional finance charges that may have accrued.

There are a few catches to the Fair Credit Billing Act. Technically, the sale must be for more than $50 and must have taken place in your home state or within 100 miles of your billing address, which means phone or internet orders may be immune. However, few issuers enforce these rules on purchases, because most credit card companies are eager to hold onto your business, given the highly competitive nature of the industry these days. But, there's still always a chance that your claim could be denied on these grounds.

You Have a Better Chance Than You Might Think
If you find yourself in the position of having to dispute a credit card charge, you may have more rights and advantages than you realize. The key is to act quickly and responsibly. Address the matter in a prompt and courteous fashion with the merchant in question, and if necessary, follow up with your credit card issuer. In most cases the whole matter can be resolved within a matter of weeks to your satisfaction.

The Impact Of Currency Conversions

2012-01-01T07:13:00.001-08:00

The currency price of one country advances and retreats daily against another country's currency. But what exactly does that mean for those who don't trade in forex market? Currency exchange rates affect travel, exports/imports and the economy. In this article, we'll discuss the nature of currency exchange and its effect on people and the economy.

Before delving into the topic in more detail, we must first establish a constant; for demonstration purposes we will be talking about the relationship between the euro and the U.S. dollar. More specifically, we will be talking about what happens to the U.S. economy and to the economies of Europe if the euro trades markedly higher against the U.S. dollar. The assumption we will be making is that US$1 will purchase 0.7 euros.

The Impact on Travelers
If US$1 buys 0.7 euros, U.S. citizens will be more reluctant to travel across the pond. That's because everything from food to souvenirs would be more expensive - about 43% more expensive than if the two currencies were trading at parity.

However, under these conditions European travelers would be much more apt to visit the United States for both business and pleasure. American businesses and governments (via taxes) in the areas that European tourists visit will prosper - even if just for a season. (To read more about traveling, see Travel Tips For Keeping You And Your Money Safe.)

The Impact on Corporations and Equities
The impact that this scenario would have on corporations (particularly large multi-nationals) is a little more complex because these businesses often conduct transactions in a number of different currencies and tend to obtain their raw materials from a wide variety of sources. That said, U.S.-based companies that generate the majority of their revenue in the U.S. (but that source their raw materials from Europe) would likely see their margins take a hit on higher costs. (To read more on this subject, see Commodity Prices And Currency Movements and Global Trade And The Currency Market.)

Similar pain would be felt by U.S. companies that must pay their employees in euros. And by definition, these decreased margins would likely have an adverse impact on overall corporate profits, and therefore on equity valuations in the domestic market. In other words, stock prices may drop due to these lower earnings and forecasts for future profit potential.

On the flipside, U.S. companies that have a hefty overseas presence and draw in a significant amount of revenue in euros (as opposed to dollars), but pay their employees and other expenses in U.S. dollars could actually fare quite well.

European companies that generate the lion's share of their revenue in euros but who also source their materials or employees from the United States as part of their business would likely see margin expansion as their costs and currency decrease. By definition, this could lead to higher corporate profits and equity valuations in some overseas stock markets. However, European companies that garner a significant amount of their revenue from the United States and must pay their expenses in euros are likely to suffer.

The Impact on Foreign Investment
Under these assumptions, it is likely that Europeans (both individuals and corporations) would expand their investment in the United States. They would also be better suited to make acquisitions of U.S.-based businesses and/or real estate. In fact, this has happened at several points in the past. For example, when the Japanese yen traded at record highs against the dollar back in the 1980s, Japanese firms made significant purchases of real estate - including the world-renowned Rockefeller Center.

Conversely, U.S. corporations would be less apt to acquire a European company or European real estate under US$1 for 0.70 euros scenario.

How can you protect yourself from currency moves?
When planning a trip, check the most up-to-date currency conversion before they book their vacations so they can plan their choice of locations appropriately. (There are many ways of finding out local currency rates, including looking in the business section of your local newspaper, checking with a travel agency or searching the internet.) Incidentally, one of the best tips for travelers making purchases overseas is to use a credit card. The reason behind that is that credit card companies tend to negotiate the best rates and the most favorable conversions because they do such a high volume of transactions. These companies take out all the guess work for you, paving the way for smoother (and probably less expensive) transactions. (For more information about foreign currencies, check out Get To Know The Major Central Banks.)

For small and large business owners operating in the U.S. that source some of their raw materials from Europe, one of the best moves can be to stock certain supplies if the price of the euro starts to climb rapidly against the dollar. Conversely, if the euro starts falling against the dollar, it may make sense to keep inventory at a minimum in the hope that the euro will decline enough for the company to save on its purchased goods.

Bottom Line
Over time, currency values can vary quite dramatically. However, individuals, investors and business owners can take steps to mitigate risks and take advantage of such currency movements.

Green Investors Get Heard

2012-01-01T07:11:00.000-08:00

Shareholder activism isn't a new concept, but growing awareness and concern among investors about the detrimental impact business activity has on the global environment is drawing attention to a host of environmental issues. And there is a growing movement of shareholders, be it individual or investment funds, who are concerned about the impact of the businesses in which they are invested.

In this article, we will look at the socially responsible investing (SRI) movement, what has been done so far and what can be done in the future. (To learn more about SRI, see Socially Responsible Mutual Funds and Change The World One Investment At A Time.)

Making Their Opinions Known
The socially responsible investing movement has worked hard to change corporate policies on a host of social, moral and religious issues such as business investments in politically sensitive parts of the world, workers' rights (sweatshops), the manufacturing of land mines and participation in so-called "sin" industries. (To read more on the subject, check out A Prelude to Sinful Investing and Investing The Anti-Corporate Way.)

In similar fashion, environmentally aware investors are focused on issues such as global warming, energy efficiency, reduction of carbon footprints, water quality, air quality and a host of similar concerns. As advocates for the environment, they are using their clout as shareholders to put environmental concerns on corporate agendas and hold companies responsible for their actions. In addition, shareholders are showing their concern through shareholder resolutions, allowing shareholders to propose change.

Green Investor Resolutions
The impact of these investor efforts are starting to be felt in corporate boardrooms. From single individual investors, to small mutual funds to massive hedge funds, corporations have faced a barrage of shareholder resolutions. (Keep reading about shareholder resolutions in Knowing Your Rights As A Shareholder and Can Business Evolve In A Green World?)

Firms of every type have been asked to disclose their carbon footprints, mercury emissions, performance on energy efficiency, recycling policies, political contributions to groups that oppose environmental protection, etc. They have also been asked to disclose their stances on issues ranging from global warming to the use of renewable energy.

Major power producers have faced resolutions seeking to set specific target levels for the reduction of greenhouse gas emissions. For example, in 2007, Sister Patricia Daly, a nun with 300 shares in Exxon Mobil (NYSE:XOM) filed a resolution for the company to adopt quantitative goals to reduce its emissions, which received more than 30% backing by other shareholders.

Insurance companies have been asked to reveal their level of exposure to financial risks from climate change. For example, Prudential Financial (NYSE:PRU) faced a resolution requesting more disclosure on this issue. The resolution was removed by the shareholder who proposed it after the company agreed to disclose more information on the risks it faces from climate change.

Automakers have been asked to support clean air standards, including General Motors (NYSE:GM), which faced a shareholder resolution in 2002 requesting that it set goals on emissions from its vehicles as well as its overall operations.

However, while the majority of these "green" proposals have been voted down, they are still encouraging firms to act. In fact, companies often agree to take certain steps if the shareholders agree to withdraw their resolutions. Such compromises have encouraged many firms to disclose the environmental impact of a variety of activities, to institute policy changes, or to refrain from certain environmentally damaging activities.

For example, some oil companies have agreed to support environmentally friendly policies, computer hardware producers have instituted recycling programs, and a number of companies of all types have agreed to report on the scope of their carbon footprints. At the other end of the scale, refusals to act have painted other companies in a negative light and caused unfavorable comparisons with peers that have taken steps toward meeting the requests of these investors.

The Future of Green: What Can You Do
If you are a shareholder and you want to know what your investments are doing to safeguard the world that you live in, there's no time like the present to reach out and ask.

File a Resolution
Many investors may feel they have too small a position to make a change within a company as their holdings are only a fraction of the total. However, simply look at the example of Sister Patricia Daly who, with just 300 shares, gained 31% of the shareholders' vote on a climate initiative at one of the largest companies in the world.

According to the SEC Rules on Shareholder Proposals, to submit a proposal you must continuously hold $2,000 worth of shares or 1% of the outstanding for at least one year, and must be the registered holder of the shares. As well, each shareholder is able to submit one proposal per shareholder meeting.

Even if you don't file a resolution, make sure to read the proxy statement to see if there are any proposals that push green policies and if it makes sense to you voice your opinion with your vote. (Keep reading about this in Pay Attention To The Proxy Statement.)

Vote With Your Dollars
It is important to note that while you have the right to protest actions by the companies you are invested in and vote whatever way you see fit with certain proposals, it is often an uphill battle to enact change with a specific company. One of the easiest ways to voice your opinion is with your investment dollars by simply selling your shares in companies that are harming the environment and buying companies that are promoting green initiatives. (To keep learning about this subject, see For Companies, Green Is The New Black.)

Conclusion
There has been a clear push in our society to do more to protect our environment from the way we live our lives to the way we invest. More and more proposals have been filed by shareholders to enact change and companies are increasingly becoming aware of their environmental impact. While the move toward being green is just beginning, investors' opportunity to participate is increasing.

Pre-Qualified Vs. Pre-Approved - What's The Difference?

2012-01-01T07:10:00.001-08:00

Ralph Waldo Emerson, American essayist and poet, once said that the future belongs to those who prepare for it. This is sage advice for home buyers who need to lay the necessary groundwork to buy the home of their dreams.

Without good preparation, many buyers get lulled into the mistaken notion that if a lender pre-qualifies them for a mortgage this means that they have been pre-approved for a home loan. Unfortunately, there's a world of difference between these two terms. If you've ever been confused by the two, we'll bring you up to speed on how these terms differ - and why a misunderstanding can mean disaster for borrowers.

The Skinny on Pre-Qualified
Getting pre-qualified is the initial step in the mortgage process, and it's generally fairly simple. You supply a bank or lender with your overall financial picture, including your debt, income and assets. After evaluating this information, a lender can give you an idea of the mortgage amount for which you qualify. Pre-qualification can be done over the phone or on the internet, and there is usually no cost involved. Loan pre-qualification does not include an analysis of your credit report or an in-depth look at your ability to purchase a home.

The initial pre-qualification step allows you to discuss any goals or needs you may have regarding your mortgage with your lender. At this point, a lender can explain your various mortgage options and recommend the type that might be best suited to your situation. (For more, see Mortgages: How Much Can You Afford.)

Because it's a quick procedure, and based only on the information you provide to the lender, your pre-qualified amount is not a sure thing; it's just the amount for which you might expect to be approved. For this reason, a pre-qualified buyer doesn't carry the same weight as a pre-approved buyer who has been more thoroughly investigated. (To read more, see Shopping For A Mortgage.)

The Skinny on Pre-Approved
Getting pre-approved is the next step, and it tends to be much more involved. You'll complete an official mortgage application (and usually pay an application fee), and then supply the lender with the necessary documentation to perform an extensive check on your financial background and current credit rating. (Typically at this stage, you will not have found a house yet, so any reference to "property" on the application will be left blank). From this, the lender can tell you the specific mortgage amount for which you are approved. You'll also have a better idea of the interest rate you will be charged on the loan and, in some cases, you might be able to lock-in a specific rate. With pre-approval, you will receive a conditional commitment in writing for an exact loan amount, allowing you to look for a home at or below that price level. Obviously, this puts you at an advantage when dealing with a potential seller, as he or she will know you're one step closer to obtaining an actual mortgage.

The other advantage of completing both of these steps - pre-qualification and pre-approval - before you start to look for a home is that you'll know in advance how much you can afford. This way, you don't waste time with guessing or looking at properties that are beyond your means. Getting pre-approved for a mortgage also enables you to move quickly when you find the perfect place. When you make an offer, it won't be contingent on obtaining financing, which can save you valuable time. In a competitive market, this lets the seller know that your offer is serious - and could prevent you from losing out to another potential buyer who already has financing arranged.

Once you have found the right house for you, you'll fill in the appropriate details and your pre-approval will become a complete application.

Getting Committed
The final step in the process is what's called a "loan commitment", which is only issued by a bank when it has approved you, the borrower, and the house in question. This means the home should be appraised at or above the sales price. The bank may also require more information if the appraiser brings up anything he or she feels should be investigated (i.e. structural problems, accessibility issues, outstanding liens or litigation in progress). Your income and credit profile will be checked once again to ensure nothing has changed since the initial approval. (For more, see Understanding Your Mortgage.)

A loan commitment letter is issued only when the bank is certain it will lend, so the commitment date on your purchase contract should be closer to closing than to the date of your offer. (The seller can ask to see that letter as soon as the date has passed, so beware of anyone who tries to put an early commitment date into your contract).

One Last Word
Be warned. Pre-approved and pre-qualified are not the same thing, so don't assume that the bank will provide your loan until you have the former. The mistake could cost you your new home!

The 3 Most Timeless Investment Principles

2012-01-01T07:07:00.000-08:00

Warren Buffett is widely considered to be one of the greatest investors of all time, but if you were to ask him who he thinks is the greatest investor he would probably mention one man: his teacher, Benjamin Graham. Graham was an investor and investing mentor who is generally considered to be the father of security analysis and value investing.

His ideas and methods on investing are well documented in his books, "Security Analysis" (1934), and "The Intelligent Investor" (1949), which are two of the most famous investing texts. These texts are often considered to be requisite reading material for any investor, but they aren't easy reads. Here, we'll condense Graham's main investing principles and give you a head start on understanding his winning philosophy. (For more insight, read Ten Books Every Investor Should Read and The Intelligent Investor: Benjamin Graham.)

Principle No.1: Always Invest with a Margin of Safety
Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities, but also to minimize the downside risk of an investment. In simple terms, Graham's goal was to buy assets worth $1 for $0.50. He did this very, very well.

To Graham, these business assets may have been valuable because of their stable earning power or simply because of their liquid cash value. It wasn't uncommon, for example, for Graham to invest in stocks where the liquid assets on the balance sheet (net of all debt) were worth more than the total market cap of the company (also known as "net nets" to Graham followers). This means that Graham was effectively buying businesses for nothing. While he had a number of other strategies, this was the typical investment strategy for Graham. (For more on this strategy, read What Is Warren Buffett's Investing Style?)

This concept is very important for investors to note, as value investing can provide substantial profits once the market inevitably re-evaluates the stock and ups its price to fair value. It also provides protection on the downside if things don't work out as planned and the business falters. The safety net of buying an underlying business for much less than it is worth was the central theme of Graham's success. When chosen carefully, Graham found that a further decline in these undervalued stocks occurred infrequently.

While many of Graham's students succeeded using their own strategies, they all shared the main idea of the "margin of safety".

Principle No.2: Expect Volatility and Profit from It
Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. Graham illustrated this with the analogy of "Mr. Market", the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. At other times, he is depressed about the business's prospects and will quote a low price.

Because the stock market has these same emotions, the lesson here is that you shouldn't let Mr. Market's views dictate your own emotions, or worse, lead you in your investment decisions. Instead, you should form your own estimates of the business's value based on a sound and rational examination of the facts. Furthermore, you should only buy when the price offered makes sense and sell when the price becomes too high. Put another way, the market will fluctuate - sometimes wildly - but rather than fearing volatility, use it to your advantage to get bargains in the market or to sell out when your holdings become way overvalued.

Here are two strategies that Graham suggested to help mitigate the negative effects of market volatility:
Dollar-Cost Averaging
Dollar-cost averaging is achieved by buying equal dollar amounts of investments at regular intervals. It takes advantage of dips in the price and means that an investor doesn't have to be concerned about buying his or her entire position at the top of the market. Dollar-cost averaging is ideal for passive investors and alleviates them of the responsibility of choosing when and at what price to buy their positions. (For more, read DCA: It Gets You In At The Bottom and Dollar-Cost Averaging Pays.)

Investing in Stocks and Bonds
Graham recommended distributing one's portfolio evenly between stocks and bonds as a way to preserve capital in market downturns while still achieving growth of capital through bond income. Remember, Graham's philosophy was, first and foremost, to preserve capital, and then to try to make it grow. He suggested having 25-75% of your investments in bonds, and varying this based on market conditions. This strategy had the added advantage of keeping investors from boredom, which leads to the temptation to participate in unprofitable trading (i.e. speculating). (To learn more, read The Importance Of Diversification.)
Principle No.3: Know What Kind of Investor You Are
Graham advised that investors know their investment selves. To illustrate this, he made clear distinctions among various groups operating in the stock market.

Active Vs. Passive
Graham referred to active and passive investors as "enterprising investors" and "defensive investors".

You only have two real choices: The first is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn't your cup of tea, then be content to get a passive, and possibly lower, return but with much less time and work. Graham turned the academic notion of "risk = return" on its head. For him, "Work = Return". The more work you put into your investments, the higher your return should be.

If you have neither the time nor the inclination to do quality research on your investments, then investing in an index is a good alternative. Graham said that the defensive investor could get an average return by simply buying the 30 stocks of the Dow Jones Industrial Average in equal amounts. Both Graham and Buffett said that getting even an average return - for example, equaling the return of the S&P 500 - is more of an accomplishment than it might seem. The fallacy that many people buy into, according to Graham, is that if it's so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.

In modern terms, the defensive investor would be an investor in index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to predict those areas ahead of time. In doing so, an investor is virtually guaranteed the market's return and avoids doing worse than average by just letting the stock market's overall results dictate long-term returns. According to Graham, beating the market is much easier said than done, and many investors still find they don't beat the market. (To learn more, read Index Investing.)

Speculator Vs. Investor
Not all people in the stock market are investors. Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple: an investor looks at a stock as part of a business and the stockholder as the owner of the business, while the speculator views himself as playing with expensive pieces of paper, with no intrinsic value. For the speculator, value is only determined by what someone will pay for the asset. To paraphrase Graham, there is intelligent speculating as well as intelligent investing - just be sure you understand which you are good at.

Commentary
Graham's basic ideas are timeless and essential for long-term success. He bought into the notion of buying stocks based on the underlying value of a business and turned it into a science at a time when almost all investors viewed stocks as speculative. Graham served as the first great teacher of the investment discipline, as evidenced by those in his intellectual bloodline who developed their own. If you want to improve your investing skills, it doesn't hurt to learn from the best; Graham continues to prove his worth in his disciples, such as Warren Buffett, who have made a habit of beating the market.

Subprime Lending: Helping Hand Or Underhanded?

2012-01-01T07:06:00.000-08:00

Subprime is a classification of loans offered at rates greater than the prime rate to individuals who are unable qualify for prime rate loans. This usually occurs when borrowers have poor credit and, as a result, the lender views them as higher risk.

Loan qualification is based on a number of factors including income, assets and credit rating. In most cases, subprime borrowers have questions marks surrounding them in one or more of these areas, such as a poor credit rating or an inability to prove income. For example, someone with a credit rating below 620 or with no assets will likely not qualify for a traditional mortgage and will need to resort to a subprime loan to gain the necessary financing. Read on to learn more about this type of lending and how it got its bad reputation.

Subprime Vs. Prime
In addition to having higher interest rates than prime-rate loans, subprime loans often come with higher fees. And, unlike prime-rate loans, which are quite similar from lender to lender, subprime loans vary greatly. A process known as risk-based pricing is used to calculate mortgage rates and terms - the worse your credit, the more expensive the loan.

Subprime loans are usually used to finance mortgages. They often include prepayment penalties that do not allow borrowers to pay off the loan early, making it difficult and expensive to refinance or retire the loan prior to the end of its term. Some of these loans also come with balloon maturities, which require a large final payment. Still others come with artificially low introductory rates that ratchet upward substantially, increasing the monthly payment by as much as 50%.

Borrowers often do not realize that a loan is subprime because lenders rarely use that terminology. From a marketing perspective, "subprime" is not an attractive term. (To learn more, read Subprime Is Often Subpar.)

History
The Community Reinvestment Act of 1977 and later liberalization of regulations gave lenders strong incentive to loan money to low-income borrowers. The Deregulation and Monetary Control Act of 1980 enabled lenders to charge higher interest rates to borrowers with low credit scores. Then, the Alternative Mortgage Transaction Parity Act, passed in 1982, enabled the use of variable-rate loans and balloon payments. Finally, the Tax Reform Act of 1986 eliminated the interest deduction for consumer loans, but kept the mortgage interest deduction. These acts set the onslaught of subprime lending in motion. (To learn more, read The Mortgage Interest Tax Deduction.)

Over time, businesses adapted to this changing environment, and subprime lending expansion began in earnest. While subprime loans are available for a variety of purchases, mortgages are the big-ticket items for most consumers, so an increase in subprime lending naturally gravitated toward the mortgage market. According to statistics released by the Federal Reserve Board in 2004, from 1994 to 2003, subprime lending increased at a rate of 25% per year, making it the fastest growing segment of the U.S. mortgage industry. Furthermore, the Federal Reserve Board cites the growth as a "nearly ten-fold increase in just nine years."

The Good
Subprime loans have increased the opportunities for homeownership, adding nine million households to the ranks of homeowners in less than a decade and catapulting the United States into the top tier of developed countries on homeownership rates, on par with the United Kingdom and slightly behind Spain, Finland, Ireland and Australia, according to the Federal Reserve. More than half of those added to the ranks of new homeowners are minorities. Because home equity is the primary savings vehicle for a significant percentage of the population, home ownership is a good way to build wealth.

The Bad
Subprime loans are expensive. They have higher interest rates and are often accompanied by prepayment and other penalties. Adjustable-rate loans are of particular concern, as the payments can jump dramatically when interest rates rise. (To learn more about adjustable rates loans, see Mortgages: Fixed-Rate Versus Adjustable-Rate and American Dream Or Mortgage Nightmare?) All too often, subprime loans are made to people who have no other way to access funds and little understanding of the mechanics of the loan.

On the lending side, the rush to bring in new business can lead to sloppy business practices, such as giving out loans without requiring borrowers to provide documented proof of income and without regard to what will happen if interest rates rise.

The Ugly
Because subprime borrowers generally aren't favorable candidates for more traditional loans, subprime loans tend to have significantly higher default rates than prime-rate loans. When interest rates rise rapidly and housing values stagnate or fall, the ripple effects are felt across the entire industry.

The borrowers' inability to meet their payments or to refinance (due to prepayment penalties) causes borrowers to default. As foreclosure rates rise, lenders fail. Ultimately, the investors that purchased mortgage-backed securities based on subprime loans also get hurt when the underlying loans default. (To learn more about how this works, read Behind The Scenes Of Your Mortgage.)

Buyer Beware
When used responsibly by lenders, subprime loans can provide purchasing power to individuals who might not otherwise have access to funds. While negative attention is often focused on the mortgage industry, particularly on subprime lenders, the borrowers themselves share some responsibility for the problems subprimes have caused in the market. In other words, borrowers should never sign papers for a loan they do not understand or have the ability to repay. Despite the fact that a significant segment of subprime borrowers default on their loans, the loans themselves are neither good nor evil. They are simply an economic tool.

For a one-stop shop on subprime mortgages and the subprime meltdown, check out the subprime Mortgages Feature.

The Barnyard Basics Of Derivatives

2012-01-01T07:05:00.000-08:00

When people think of stocks, bonds or Treasury bills, they can usually come up with a clear picture in their minds, and probably some examples as well. When the word is "derivatives", most people are lucky if they can conjure up anything but an indistinct fog.

Derivatives are generally placed in the realm of advanced or technical investing, but there is no reason why they should remain a mystery to common investors. This article will use a simple story of a fictional farm to explore the mechanics of derivatives.

The Definition
Derivatives are financial products with value that stems from an underlying asset or set of assets. These can be stocks, debt issues, or almost anything. A derivative's value is based on an asset, but ownership of a derivative doesn't mean ownership of the asset.

We will look at some examples.

The Future of Healthy Hen Farms
Gail, the owner of Healthy Hen Farms, is worried about the volatility of the chicken market with all the sporadic reports of bird flu coming out of the east. Gail wants a way to protect her business against another spell of bad news. Gail meets with an investor who enters into a futures contract with her.

The investor agrees to pay $30 per bird when the birds are ready for slaughter, say, in six months time, regardless of the market price. If, at that time, the price is above $30, the investor will get the benefit as he or she will be able to buy the birds for less than market cost and sell them onto the market at a higher price for a gain.

If the price goes below $30, then Gail will be receiving the benefit because she will be able to sell her birds for more than the current market price, or what she would have gotten for the birds in the open market.

By entering into a futures contract, Gail is protected from price changes in the market, as she has locked in a price of $30 per bird. She may lose out if the price flies up to $50 per bird on a mad cow scare, but she will be protected if the price falls to $10 on news of a bird flu outbreak.

By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations. (For related reading, see A Beginner's Guide To Hedging.)

Swapping
Gail has decided that it's time to take Healthy Hen Farms to the next level. She has already acquired all the smaller farms near her and is looking at opening her own processing plant. She tries to get more financing, but the lender, Lenny, rejects her.

The reason is that Gail financed her takeovers of the other farms through a massive variable-rate loan and the lender is worried that, if interest rates rise, Gail won't be able to pay her debts. He tells Gail that he will only lend to her if she can convert the loan to a fixed-rate. Unfortunately, her other lenders refuse to change her current loan terms because they are hoping interest rates will increase too.

Gail gets a lucky break when she meets Sam, the owner of a chain of restaurants. Sam has a fixed-rate loan about the same size as Gail's and he wants to convert it to a variable-rate loan because he hopes interest rates will decline in the future.

For similar reasons, Sam's lenders won't change the terms of the loan. Gail and Sam decide to swap loans. They work out a deal by which Gail's payments go toward Sam's loan and his go toward Gail's loan. Although the names on the loans haven't changed, their contract allows them both to get the type of loan they want. (To learn more, read An Introduction To Swaps.)

This is a bit risky for both of them because if one of them defaults or goes bankrupt, the other will be snapped back into his or her old loan, which may require a payment for which either Gail of Sam may be unprepared. But it allows for them to modify their loans to meet their individual needs.

Buying Debt
Lenny, Gail's financier, ponies up the additional capital at a favorable interest rate and Gail goes away happy. Lenny is pleased as well because his money is out there getting a return, but he is also a little worried that Sam or Gail may fail in their business.

To make matters worse, Lenny's friend Dale comes to him asking for money to start his own film company. Lenny knows Dale has a lot of collateral and that the loan would be at a higher interest rate because of the more volatile nature of the movie industry, so he's kicking himself for loaning all his capital to Gail.

Fortunately for Lenny, derivatives offer another solution. Lenny spins Gail's loan into a credit derivative and sells it to a speculator at a discount to the true value. Although Lenny doesn't see the full return on the loan, he gets his capital back and can issue it out again to his friend Dale.

Lenny likes this system so much that he continues to spin out his loans as credit derivatives, taking modest returns in exchange for less risk of default and more liquidity.

Options
Years later, Healthy Hen Farms is a publicly traded corporation (the ticker symbol is (obviously) HEN) and is America's largest poultry producer. Gail and Sam are both looking forward to retirement.

Over the years, Sam bought quite a few shares of HEN. In fact, he has more than $100,000 invested in the company. Sam is getting nervous because he is worried that some shock, another case of bird flu for example, might wipe out a huge chunk of his retirement money. Sam starts looking for someone to take the risk off his shoulders. Lenny, financier extraordinaire and an active writer of options, agrees to give him a hand.

Lenny outlines a deal in which Sam pays Lenny a fee to for the right (but not the obligation) to sell Lenny the HEN shares in a year's time at their current price of $25 per share. If the share prices plummet, Lenny protects Sam from the loss of his retirement savings.

Lenny is OK because he has been collecting the fees and can handle the risk. This is called a put option, but it can be done in reverse by someone agreeing to buy a stock in the future at a fixed price (called a call option). (For more insight, read the Options Basics tutorial.)

The Happy Ending
Healthy Hen Farms remains stable until Sam and Gail have both pulled their money out for retirement. Lenny profits from the fees and his booming trade as a financier.

In this ideal tale, you can see how derivatives can move risk (and the accompanying rewards) from the risk averse to the risk seekers. Although Warren Buffett once called derivatives, "financial weapons of mass destruction", derivatives can be very useful tools, provided they are used properly. Like all other financial instruments, derivatives have their own set of pros and cons, but they also hold unique potential to enhance the functionality of the the overall financial system.

Sneaky Subsidiary Tricks Can Cloud Financials

2012-01-01T07:04:00.000-08:00

In order to get a broad view of a company's financial situation, you must look not only at the company's financials, but also the financials of its subsidiaries. Consolidated financial statements provide a way for investors to get this wholesale view for companies such as FedEx and Berkshire Hathaway.

In this article, we'll look at what sort of company must produce a consolidated financial statement, what information must be excluded from the statement and what special implications these statements present. (To learn the basics of financial statement analysis, see Introduction To Fundamental Analysis.)

Who uses consolidated financial statements?
Companies are required to consolidate their financial statements whenever they own a controlling interest in another company. In other words, if a company is able to assert control of another company through its stake in it - regardless of the percentage of ownership - that company (called the parent company) must consolidate its financial statements with those of the subsidiary. (To learn more about subsidiaries, see What are the differences between affiliate, associate and subsidiary companies?)

Standard Eliminations
These consolidated statements provide a look at the operations of both the parent company and those of its subsidiaries; however, there is more to this than simply adding up the revenues of the parent and its subsidiaries.

Certain transactions - such as intercompany sales and dividends - must be eliminated from the financial statements in order to provide an accurate picture of how the company performed. These eliminations are essential to ensure that companies aren't artificially inflating their financial numbers.

Example - The importance of eliminations

Let's assume Company A is the parent company of Company B. To make itself seem more attractive to investors, Company A could meet its sales goals by having Company B purchase a large chunk of its inventory. Company B then resells this inventory to consumers. This move would inflate the revenues of both companies and make it appear as if both companies sold more than they actually did. Eliminations prevent this sort of financial slight of hand by removing intercompany sales from the financial numbers.

Some of the typical things eliminated from consolidated financial statements include intercompany sales, and purchases, liabilities, assets and dividends attributable to affiliated companies. Also, the parent company's investments and shareholders' equity in subsidiaries are both partially eliminated. This ensures that the financial statements only reflect the independent operations of each company.

How do consolidated financial statements come about?
Companies currently account for consolidations using one of two major accounting methods: the cost method and the equity method (either complete or partial). Regardless of the accounting method chosen, the end result is the same.

From the separate financial information of each company, the eliminations are made, usually through the use of what's called a "consolidated workpaper". Consolidated workpapers show the methodology used by accountants to step from individual statements to the consolidated statements. They provide a framework for eliminating accounting entries (which show up only on the books of the consolidated entity) in a manner that ensures no stone is left unturned.

Who owns the rest of the subsidiary?
It's popular for companies to elect not to purchase a subsidiary in its entirety. One of the leading reasons for this is cost; buying a 51% stake in a company is considerably cheaper than buying the whole thing, even though both claims provide the same amount of control in the subsidiary.

So, what about the other 49%? The remaining ownership in the company is still accounted for in the consolidated financial statements. It is referred to in these documents as "noncontrolling interest". Noncontrolling interest goes on the books as an equity account in much the same way that a sub-class of stock does. It makes sense to think of noncontrolling interest as a class of stock, such as preferred stock. For most intents and purposes, noncontrolling interest shareholders have no sway in the way the subsidiary conducts its business. All of the control rests in the hands of the parent company. (To learn more about shareholder roles, see Knowing Your Rights As A Shareholder.)

Keep in mind that a parent can own less than 51% and still retain the controlling interest in a company. If no larger shareholder exists and the parent company has a significant amount of sway, it can be asserted that this shareholder has a controlling interest.

Using Separate and Consolidated Financial Statements Together
Think of consolidated financial statements as another tool to help you make an informed investment decision. While they do provide an overview of a company's operations, separate financial statements are still an important source of information.

Examining a company's finances along with those of its subsidiaries can offer a new perspective on a possible investment. For many companies, consolidated financials remain summary statements - that is, they are presented in a company's filings in a digest form, leaving out other information that can contribute to your overall view of the company's operations.

While not necessarily the solution for breaking down a company's financials, consolidated financial statements are a great way to make sure that you're getting the full view before you embark on any investment decision.

To learn more about financial statement analysis, check out What You Need To Know About Financial Statements and Advanced Financial Statement Analysis.

Navigating Government And Nonprofit Financial Statements

2012-01-01T07:03:00.000-08:00

While many investors have at least some understanding of typical financial statements like the balance sheet, income statement and cash flow statement, governmental and nonprofit financial statements may be significantly less familiar. But they shouldn't be.

Governments and nonprofits take our tax and contribution money to provide valuable services - shouldn't we be making sure that they're making good use of our money? In this article we'll examine the different financial statements for these non-businesses organizations (NBOs) and teach you how to read them so you'll always be sure where your money is going. (To get started, see Fundamental Analysis Tutorial and Advanced Financial Statement Tutorial.)

What's Fund Accounting?
Government and nonprofit organizations aren't interested in making money, so they use an accounting system called fund accounting. Fund accounting essentially groups financial data together into funds or accounts that share a similar purpose. This way, the organization has a better idea of what resources it has available to complete a specific task. Fund accounting is typically not a topic enjoyed by people who are used to the concepts of for-profit accounting.

Nevertheless, understanding what fund accounting is, and how it works, is the only way to confidently look at the financial publications that governmental and nonprofit organizations publish each year.

Government and Profit
Governments treat our money in an interesting way - they don't want to make a profit! Ideally, a government wants expenditures to be very close to revenue on any given year. Differences between revenues and expenditures are called surpluses (a positive difference) or deficits (a negative difference).

Don't forget, though, that a surplus is not a profit, nor is a deficit a loss - governments aren't in the business of hoarding money (nor are they "in business" at all, as it were).

Unlike a for-profit company, if a government finds itself operating at a large surplus (profit), it will usually take steps to lower the tax burden for its residents.

Government/NBO Funds
Knowing what the various funds represent can be useful in the analysis of governmental financial statements. In the broadest terms, there are three major classifications of funds in a government. These are:

1) Governmental Funds - Used by the government to provide services whose expenditures aren't met by the fees that are charged for those services.
2) Proprietary Funds - Used to account for "business-type" activities, where the services are completely paid for by charges to the customer (i.e. trash collection).
3) Fiduciary Funds - Used to account for funds held in the interest of a third-party. These aren't reported in government-wide financial statements, since they're not government owned assets (i.e. pension funds).

Governmental Reporting
Each year, every governmental organization in the United States and Canada puts out a Comprehensive Annual Financial Report (CAFR). While the formats and contents can vary, these reports present the financial statements of the governmental entity, as well as important analysis tools like the management's discussion and analysis (MD&A) and the notes to the financial statements. CAFRs are done according to GAAP and Governmental Accounting Standards Board (GASB) regulations. (To learn more, read What You Need To Know About Financial Statements and Footnotes: Start Reading The Fine Print.)

CAFRs often present financial information for individual funds (or at least significant funds) as well as government-wide financial statements that show the position of the government as a whole. Governments use modified accrual accounting for their statements, and include reconciliations explaining how they made the switch from cash-basis accounting (typically used throughout the year) to the modified accrual basis they report in.

Governments present their consolidated financial statements in the CAFR. While some have different names, these statements essentially mirror the for-profit statements:

Business Financial Statement	Equivalent Government Statement
Income Statement	Statement of Activities
Balance Sheet	Statement of Net Assets
Cash Flow Statement	Statement of Cash Flows

The MD&A is a very useful portion of the CAFR that gives quite a bit of insight into the decisions made by your government's decision-makers. Typically, the MD&A has quite a bit more content than the managerial discussions found in the annual reports of business organizations. (To learn how to analyze each of these statements, see Understanding The Income Statement, Breaking Down The Balance Sheet and Analyze Cash Flow The Easy Way.)

Nonprofit Reporting

Just like governmental organizations, nonprofits aren't in it for the money. They too use fund accounting and offer up financial statements for public consumption each year.

Nonprofits straddle the fence somewhere between the private sector and government. Because they are not out to make a profit, fund accounting provides the best accounting system for most nonprofit organizations. The same fundamental ideas apply for nonprofit accounting as governmental accounting - the goal is to have annual expenditures end up very close to annual revenues.

Nonprofits don't publish CAFRs - instead, their reports will typically just be called a "Report of Consolidated Financial Statements". Either way, the statements for both governmental and nonprofit organizations are very similar. Nonprofit financial statements often consist of:

Business Financial Statement	Equivalent Nonprofit Statement
Income Statement	Statement of Activities
Balance Sheet	Statement of Financial Position
Cash Flow Statement	Statement of Cash Flows

If you are at all familiar with the analysis of for-profit financial statements, analyzing the financial statements of a non-business organization shouldn't be too much of a stretch, once you understand what each statement is supposed to be. Nonprofit organizations report using accrual basis accounting and Financial Accounting Standards Board (FASB) and GAAP standards.

Financial statements, governmental or nonprofit, can typically be found on the organization's website, or by calling and requesting a copy.

Making your Voice Heard

After you review of a NBO's financial statements, it is essential to determine whether you feel that the organization is treating your money prudently. If you find a nonprofit organization with exorbitant operating expenses, don't give it your money. In the case of government, hold your politicians and governmental employees responsible for their actions.

Spreading awareness is the only way to make an impact in any large measure, so share what you know about these financial statements with others.

Conclusion

With the amount of money we pay in taxes each year, it is madness to not look at a governmental financial statement just as you would for any other substantial investment. Donating money blindly without making sure that it's getting to those who need it is the same thing. On some level you must approach it as an investment decision.

With a little knowledge about how governmental and nonprofit financial statements work, you can make sure that your getting the most for your money - even if you're not expecting anything more than a warm, fuzzy feeling as a return on your investment.

Giving can have other rewards too. To learn more, check out Deducting Your Donations and Gifting Your Retirement Assets To Charity.

The Flow Of Company Information

2012-01-01T07:01:00.000-08:00

A basic principle of solid fundamental analysis is striving to find out everything one can about the stock issuer's business. Good analysts and investors search for all material information about a company before starting to do a company analysis project. Gathering information about a company is like turning over all the pieces of a jigsaw puzzle before starting to search for matching pieces. In this article, we'll show you which pieces to look for and how to put them together to solve the puzzle to learn the most about a company. (To find out more, see Introduction To Fundamental Analysis, What Are Fundamentals? and Advanced Financial Statement Analysis.)

In the United States, investors are fortunate to have a relatively standardized flow of information from equity issuers. The Securities and Exchange Commission (SEC) has a comprehensive set of rules covering everything from financial statement rules to risk factor disclosure. The SEC also says what companies must present to investors and when they have to do it. For the most part, investors know what to expect and when to expect it. (To read out more about the SEC, see Policing The Securities Market: An Overview Of The SEC.)

Earnings Releases
In the equity investment business, the world tends to revolve around quarterly earnings releases. Four times per year, equity investors deal with earnings season - that few busy weeks every quarter when companies release their quarterly earnings reports. The way companies report earnings varies a lot from company to company and industry to industry. Quarterly earnings announcements generally include unaudited financial statements, discussions about business conditions for the quarter and some type of future business outlook. Some earnings reports are a couple of paragraphs and an income statement. Others are full discussions of business conditions and expectations along with a full set of financial statements. (To see more about these reports, read Understanding The Income Statement and Strategies For Quarterly Earnings Season.)

Earnings releases are important disclosures of financial information and business conditions because they are timely, even though they are often incomplete. Investors usually have enough information in an earnings release to see how well a company met earnings expectations and how close management's financial outlook matches their own. That's key when reviewing the status of a stock you already own. Reviewing historical earnings releases is also important in building a thesis on a stock you are considering for purchase because they help give the investor a sense of the progress of management's business plan as well as management's approach to disclosing financial results. (Keep reading about earnings in Earnings Forecasts: A Primer and Surprising Earnings Results.)

Conference Calls
Most companies also hold an investor conference call on the day of their quarterly earnings releases. Companies typically archive recordings of these on their investor relations websites. Conference calls vary considerably from company to company in terms of disclosure. The purpose of conference calls is to add detail to the earnings release and give analysts the opportunity to ask questions of management. Conference calls can be important sources of information about management's outlook for a business. This outlook is commonly known as guidance. (To learn more, see Conference Call Basics, Evaluating A Company's Management and Putting Management Under The Microscope.)

Forward Guidance
Guidance is management's prediction for the business for the next quarter, several quarters, the fiscal year or several fiscal years. Depending on the company, forward guidance can vary from a full range of revenue and earnings growth rates to simple earnings per share predictions. Some companies give no guidance at all, while others just say they are comfortable with Wall Street predictions.

Investors must be aware of management's outlook and must also be aware of how well management has done with its earnings predictions in the past. While definitely not the only source of information for making predictions, guidance is important in building a set of financial expectations for a company. Examining the trend in historical guidance and how well results matched the reported forecasts can provide a sense of management's understanding of where the company is headed. One can also get a feel for management's conservatism in giving guidance – regardless of whether management tends to "low ball" Wall Street in order to generate positive earnings surprises.

SEC Filings
Every U.S. company must generate four standardized financial reports for public dissemination every year: three quarterly 10-Q reports and one annual 10-K filing. Form 10s elaborate on earnings reports, providing more full disclosures like management's discussion and analysis (MD&A) of financial results. MD&A is a more complete disclosure of business performance during the quarter or year than would commonly be found in an earnings press release. Form 10s also always include a full set of financial statements - unaudited statements for the quarterlies and audited for the annual filing. Audited financials are audited for their adherence to generally accepted accounting principles (GAAP). Unlike earnings announcements, Form 10s are not timely; they always come out at least a few days or weeks after an earnings announcement. Historical Form 10s are the primary source for financial and business information when building a thesis on a new stock. (Keep exploring this subject in How does the NASD differ from the SEC?, What happens to the fines collected by the Securities and Exchange Commission? and Where can I find a company's annual report and its SEC filings?)

Press Releases and Investor Presentations
Companies commonly issue non-earnings-related press releases on business developments throughout the year. These cover anything and everything. Companies must report material business developments to the public as events arise. So every new business contract, acquisition or divestiture, change in management or anything else, is disseminated to the public on an ad hoc basis via press release. (To keep reading on this company actions, see The Basics Of Mergers And Acquisitions and What Are Corporate Actions?)

Press releases are also the avenue through which companies disseminate earnings warnings. When management becomes aware that the company's financial performance for a quarter is not tracking Wall Street's expectations or its guidance, they will disseminate a press release stating this. The idea is to get material information that could affect a stock's price in the market out to the public as soon as possible. Bad financial news is often released well ahead of actual earnings releases.

Many companies include special presentations on the investor relations pages of their websites. These are usually intended to help investors understand the business and management's approach to running it. They can be an important place to start looking at the fundamentals of the business as they often explain key business drivers, industry exposures and non-financial fundamental business drivers. Management often delivers these presentations at institutional investor conferences put on by sell-side firms. These conferences are typically held a few times a year in big cities throughout the country. Institutional investors have to be invited to attend these conferences, requiring ample trading business. Conferences are typically not open to the public, even though investors can usually get a copy of the presentation's slides from the investor relations page. (Find out more about drivers in Forces That Move Stock Prices and What Is The Impact Of Research On Stock Prices?)

The Bottom Line
Equity investors must always remember that the management teams of public companies are the most biased market participants out there. In fact, most company CEOs think their stock is a great investment opportunity. The SEC's disclosure rules help provide unbiased information. Any other color provided by management - like in an investor presentation, face-to-face meeting or interview on television - is bound to put the company in the most optimistic light possible.

Before starting to build an investment thesis on a stock, investors should put their printer to work. Most company analysis files will have at least one 10-K report, several 10-Q reports, a big stack of press releases and hard copies of investor presentations. Once an analyst or investor gets a good base of knowledge from doing this reading he or she can then move on to building a financial model and conducting the financial and business analysis necessary to develop a good investment thesis on a stock.

The 10 Commandments Of Investing

2012-01-01T07:00:00.000-08:00

The biblical Ten Commandments were intended to act as a driver's manual for the road of life. "Thou shalt not kill." "Thou shalt not lie." These are life's version of the stop-at-the-red-light-and-advance-when-safe rules of the road. In other words, they are all guidelines to keep people out of trouble. Because life's highways are full of potholes, blind turns and bad drivers, the investing world also suffers from scandals, scams and dishonest companies. Here are 10 commandments for the investing world designed to help keep investors - and their money - safe:

1. Thou shalt set clear goals.
If you don't have a purpose or a set of goals to guide your investment strategy, don't invest. This sounds harsh, but there are so many types, styles and flavors of investing that, without a particular destination, you will be lost at sea.(For more on this, read Investing With A Purpose and Investing 101: A Tutorial For Beginner Investors.)

2. Thou shalt put thy financial house in order.
To become a successful investor, you have to make sure that your personal finances are in order first. Investing without a purpose is bad, but investing when you have high-interest debt is much worse. (This has been explored in greater detail in The Indiana Jones Guide To Getting Ahead and Digging Out Of Personal Debt.) If you are drowning in overdue bills and credit card payments that you can't meet, take care of those more serious problems before getting too deep into investing.

3. Thou shalt question authority.
Investing is more about the art of asking and answering the right questions than it is about deciding when to buy and when to sell. CEOs, CFOs, CPAs, CFAs and all the other acronyms that we use to classify Wall Street's professional caste can't hide the fact that they are human, and that humans sometimes lie. Analysts get kickbacks, CEOs get stock options and recent accounting scandals, such as Arthur Anderson LLP's conduct regarding Enron, show that impartial accounting is not guaranteed.

To question authority, you will need to educate yourself, especially on the subject of financials. Press releases are flakes of snow that rain down on investors and melt away, but financials stick around. Although financials can be tampered with, there is always a trail left behind. (To read more on this subject, see Evaluating Executive Compensation, Lifting The Lid On CEO Compensation and Common Clues Of Financial Statement Manipulation.)

4. Thou shalt not follow sheep.
Herd mentality is leading to more and more destructive rampages down Wall Street. Investing passively by sticking to funds, indexes and other mainstays of the coach potato portfolio is a perfectly acceptable practice. The danger comes when people move from passive investing to an active portfolio, but stick with the behavior of a passive investor. (To keep reading about portfolio management, see How Portfolio Laziness Pays Off, Words From The Wise On Active Management and A Guide To Portfolio Construction.)

There is a lot of available information for such investors - much of which is true - but accepting it with an uncritical eye and neglecting to check it yourself is what leads to herding. This includes getting the latest and greatest stock tip from your Uncle George.

A person can effortlessly become one of the investors that the analysts shepherd into various "must-buy stocks" after they have become overpriced. This is how investors find themselves in the herd when skittish investors flee, causing the stock to plunge farther than it should have (whereupon a more astute investor buys a bargain off your loss).

When people buy cars, they try to find the best value for the lowest price; when people buy stocks, they only see the price and, ironically, gravitate toward rising prices. If you are going to invest, you have to check things for yourself in order to find the true value and get the bargains. This takes more time, and it could even cause you to miss out on early gains, but it will tell you when to stay out or when to sell well before the herd hears the bell. (To read more about investor behavior, see Mad Money ... Mad Market? and The Madness Of Crowds.)

5. Thou shalt be humble.
If you take the first four commandments to heart, there is a good chance that you will perform better than the majority of individual investors and many of the professionals. But sometimes, particularly during a bull market, gains are not dictated by investor actions as much as by having money in the market, so don't allow yourself to become overconfident. Overconfidence often leads to overtrading, taking unnecessary risk and eventual losses when the bull turns bear. Also remember that you incur commissions every time you trade - this expense can often erase profits or increase losses.

6. Thou shalt be patient.
Patience is a virtue for a good reason: It pays for itself. When the market dips, or even when a particular stock dips, there are always investors who panic and sell. Selling should be treated just as seriously as buying. If it is just a bump, ride it out. If it is truly a problem with the stock, take your time as well - you may find a way to use it in a gain-loss transaction that will save you taxes. By the time you hear it, bad news has already settled in - taking your time isn't going to make it much worse. (To find out more about timing, read Buy, Sell Or Hold?)

7. Thou shalt show moderation.
Investing too much is not a problem many people have, but it can happen. It is said that the pain of a loss has twice the emotional strength of the pleasure of a gain. For some people, this results in them pulling out of the market prematurely, as mentioned above.

For others, losing propels them into successively riskier ventures in an all-or-nothing attempt to win those losses back. Losses are hard to take, but look on the bright side: You can sell a loss to offset a gain in another sector or, if it is in a retirement account, you can use it as a tax write-off. Concentrating your money too much in one area, either by sector, risk level, or even keeping it all in the stock market, is a sure way to see more nothing than all in an all-or-nothing game. (Learn how to use your losses to your advantage in The Importance Of A Profit/Loss Plan and Selling Losing Securities For A Tax Advantage.)

8. Thou shalt not ogle thy investment.
There is nothing like a market correction or a general upswing to change perfectly normal investors into fanatics who have market updates text messaged to their cell phones every five minutes. As with fidelity, the axiom, "look, don't touch" is insufficient because the more you look, the more you want to mess around with your investments. It is not clear if it is a symptom or a cause, but this rabid over-monitoring almost always leads to unnecessary churning in sufferers' portfolios

9. Thou shalt not court or spurn risk.
You should never put everything you have into futures, but you also shouldn't hold everything in Treasury bills. There is an appropriate level of risk for investors of every age and creed. (To figure out your level of risk, see Determining Risk And The Risk Pyramid.)

10. Thou shalt not make heros of mere men.
There are no perfect investors. Warren Buffett, George Soros and Peter Lynch have all slipped up from time to time. That doesn't stop them from being great investors who are worth studying and learning from. That said, you should never mimic an investing strategy that you do not fully understand. (To find out more about these investors, see Pick Stocks Like Peter Lynch, Warren Buffett: How He Does It and What Is Warren Buffett's Investing Style?)

There is too much guru-ism going on among investors - so much so that credentials are often lost beneath book titles in which the word "rich" is prominently featured. As with the early caution against trusting authority, you have to question everything. Even if a strategy works for a certain period of time, once it becomes widespread, it skews the system. For example, the publication of Lynch's tenbagger strategy has led to too many people searching for those stocks, leading prices to become inflated to adjust for the non-market driven demand. Skeptics survive on Wall Street much longer than believers. (Find more helpful tips from investors in the know in The Greatest Investors and Financial Wisdom From Three Wise Men.)

Conclusion
Praying or getting behind the wheel expecting everyone else to follow the same rules you do are both acts of faith. Investing, in contrast, requires practice. To be a good investor, you have to make doubt a part of your creed and a make of ritual of double-checking. These guidelines should help you on your way. Happy driving.

Traders And Investors' Roles In The Marketplace

2012-01-01T06:58:00.001-08:00

Many people use the words "trading" and "investing" interchangeably when, in reality, they are two very different activities. While both traders and investors participate in the same marketplace, they perform two very different tasks using very different strategies. Both of these parties are necessary, however, for the market to function smoothly. This article will take a look at both parties and the strategies that they use to make a profit in the marketplace.

What Is an Investor?
An investor is the market participant that the general public most often associates with the stock market. Investors are those who purchase shares of a company for the long term with the belief that the company has strong future prospects. Investors typically concern themselves with two things:
Value - Investors must consider whether a company's shares represent a good value. For example, if two similar companies are trading at different earnings multiples, the lower one might be the better value because it suggests that the investor will need to pay less for $1 of earnings when investing in Company A relative to what would be needed to gain exposure to $1 of earnings in Company B.

Success - Investors must measure the company's future success by looking at their financial strength and evaluating their future cash flows.
Both of these factors can be determined through the analysis of the company's financial statements along with a look at industry trends that may define future growth prospects. At a basic level, investors can measure the current value of a company relative to its future growth possibilities by looking at metrics such as the PEG ratio - that is, their P/E (value) to growth (success) ratio. (For more on this see, How The PEG Ratio Can Help Investors.)

Who Are the Major Investors?
There are many different investors that are active in the marketplace. In fact, the vast majority of the money that is at work in the markets belongs to investors (not to be confused with the amount of dollars traded per day, which is a record held by the traders). Major investors include:
Investment Banks - Investment banks are the organizations that assist companies in going public and raising money. This often involves holding at least a portion of their securities over the long term. (To read more, see IPO Basics.)

Mutual Funds - Many individuals keep their money in mutual funds, which make long-term investments in companies that meet their specific criteria. Mutual funds are required by law to act as investors, not traders.

Institutional Investors - These are large organizations or persons that hold large stakes in companies. Institutional investors often include company insiders, competitors hedging themselves, and special opportunity investors. (For related reading, see Institutional Investors And Fundamentals: What's The Link?)

Retail Investors - Retail investors are individuals that invests in the stock market for their personal accounts. At first, the influence of retail traders may seem small, but as time passes more people are taking control of their portfolios and, as a result, the influence of this group is increasing.
All of these parties are looking to hold their positions for the long term in an effort to stick with the company while they continue to be successful. Warren Buffett's success is a testament to the viability of this strategy.

What Is a Trader?
Traders are market participants who purchase shares in a company with a focus on the market itself rather than the company's fundamentals. Markets that trade commodities lend themselves well to traders. After all, very few people purchase wheat because of its fundamental quality - they do so to take advantage of small price movements that occur as a result of supply and demand. Traders typically concern themselves with:
Price Patterns - Traders will look at past price history in an attempt to predict future price movements, which is known as technical analysis. (To learn more, read The Basics Of Technical Analysis.)

Supply and Demand - Traders keep close watch on their trades intraday to see where money is moving and why.

Market Emotion - Traders play on the fears of investors through techniques like fading, where they will bet against the crowd after a large move takes place.

Client Services - Market makers (one of the largest types of traders) are actually hired by their clients to provide liquidity through rapid trading.
Ultimately, it is traders that provide the liquidity for investors and always take the other end of their trades. Whether it is through market making or fading, traders are a necessary part of the marketplace. (For more insight, check out What Can Traders Learn From Investors? and What Can Investors Learn From Traders?)

Who Are the Major Traders?
When it comes to volume, traders have investors beat by a long shot. There are many different types of traders that can trade as often as every few seconds. Among the most popular types of traders are:
Investment Banks - The shares that are not kept for long-term investment are sold. During the IPO process, investment banks are responsible for selling the company's stock in the open market through trading.

Market Makers - These are groups responsible for providing liquidity in the marketplace. They make their profit through the bid-ask spread along with fees charged to their clients. Ultimately, this group provides liquidity for all the marketplaces.

Arbitrage Funds - Arbitrage funds are the groups that quickly move in on market inefficiencies. For example, shortly after a merger is announced, stocks always quickly move to the new buyout price minus the risk premium. These trades are executed by arbitrage funds. (To learn more, read Trading The Odds With Arbitrage and Trade Takeover Stocks With Merger Arbitrage.)

Proprietary Traders/Firms - Proprietary traders are hired by firms to make money through short-term trading. They use proprietary trading systems and other techniques in an attempt to make more money by compounding the short-term gains than can be made by long-term investing.

Conclusion
Clearly, both traders and investors are necessary in order for a market to function properly. Without traders, investors would have no liquidity through which to buy and sell shares. Without investors, traders would have no basis from which to buy and sell. Combined, the two groups form the financial markets as we know them today.

Discover Master Limited Partnerships

2012-01-01T06:57:00.000-08:00

Master Limited Partnerships (MLPs) are unique investments that combine the tax benefits of a limited partnership (LP) with the liquidity of common stock. An MLP has a partnership structure but issues investment units that trade on an exchange like common stock. The modern form of MLPs was defined by the Tax Reform Act of 1986 and the Revenue Act of 1987, which outline how companies can structure their operations to realize certain tax benefits and define which companies are eligible. In order to qualify, a firm must earn 90% of its income through activities or interest and dividend payments relating to natural resources, commodities or real estate.

In this article we'll show you how owning MLPs can help you save on your tax bill.

Tax? What Tax?

Tax implications for MLPs differ significantly from corporations for both the company and its investors. Like other limited partnerships, there is no tax at the company level. This effectively lowers an MLP's cost of capital, as it does not suffer the problem of double taxation on dividends. Companies that are eligible to become MLPs have a strong incentive to do so because it means a cost advantage over their incorporated peers.

In an MLP, instead of paying a corporate income tax, the tax liability of the entity is passed on to its unitholders. Once a year, each investor receives a K-1 statement (similar to a 1099-DIV form) detailing his or her share of the partnership's net income, which is then taxed at the investor's individual tax rate.

One important distinction must be made here: While the MLP's income is passed through to its investors for tax purposes, the actual cash distributions made to unitholders have little to do with the firm's income. Instead, cash distributions are based on the MLP's distributable cash flow (DCF), similar to free cash flow (FCF). Unlike dividends, these distributions are not taxed when they are received; instead, they are considered reductions in the investment's cost basis and create a tax liability that is deferred until the MLP is sold.

Fortunately for investors, MLPs generally have much higher distributable cash flow than they have taxable income. This is a result of significant depreciation and other tax deductions, and is especially true of natural gas and oil pipeline and storage companies, which are the most common businesses to choose an MLP structure. Investors then receive higher cash payments than the amount upon which they are taxed, creating an efficient means of tax deferral. According to a report by Wachovia Securities, titled "Master Limited Partnerships: A Primer" (2003), the taxable income passed on to investors often is only 10-20% of the cash distribution, while the other 80-90% is deemed a return of capital and subtracted from the original cost basis of the initial investment.

Cash Flows and Taxes

Let's look at an example of the mechanics of cash flows and taxes that occur when holding and selling MLPs. Let's assume an MLP is purchased for $25 per share, held for three years, makes cash distributions of $1.50/unit per year and passes through $0.30 of taxable income to each unit per year.

First, we calculate the change in cost basis caused by the net return of capital - cash distributions minus allocation of taxable income - over the life of the investment. For simplicity, assume taxable income and cash distribution remains constant through the life of the investment, although in reality, these probably would fluctuate each year.

--	Year 1	Year 2	Year 3
Cost Basis at Beginning of Year	$25.00	$23.80	$22.60
Allocation of Taxable Income	$0.30	$0.30	$0.30
Cash Distributions	$1.50	$1.50	$1.50
Net Reduction of Cost Basis	$1.20	$1.20	$1.20
Adjust Cost Basis at End of Year	$23.80	$22.60	$21.40

If the MLP is sold at the end of the third year for $26 per unit, the investor (LP) would show a gain of $4.60. One dollar of this would be a normal capital gain - having bought at $25 and sold at $26 - and would be taxed at the long-term capital gains tax rate. The remaining $3.60 gain results from the $1.20 return of capital each year, and this amount would be taxed at the investor's personal income tax rate. The table below shows cash flows, including those related to taxes, during the life of the investment. We assume a 35% income tax rate and 15% capital gains rate. (To learn more about capital gains, see A Long-Term Mindset Meets Dreaded Capital-Gains Tax and Capital Gains Tax Cuts For Middle Income Investors.)

Cash Flows	Year 1	Year 2	Year 3
Purchase of Security	-25.00	$23.80	$22.60
Income Tax from Allocation of MLP Income ($0.30x35%)	-$0.11	-$0.11	-$0.11
Cash Distributions	$1.50	$1.50	$1.50
Sale of Security	--	--	$26.00
Capital Gains Tax on Difference Between Purchase Prices and Sale Price	--	--	-$0.15
Income Tax on Difference Between Purchase Prise and Adjusted Cost Basis at End of Year 3 ($3.60x35%)	--	--	-$1.26
Total:	-23.61	$1.39	$25.98

An important side note on the concept of reducing cost basis: If and when the investment's cost basis falls to zero, any cash distribution becomes immediately taxable, rather that being deferred until the sale of the security. This is because the investment cannot fall into a negative cost basis. This can occur if an MLP is held for many years.

MLPs can be used to gain current income while deferring taxes, as seen in the above example. This can be taken one step further when an MLP investment is used as a vehicle for estate planning. When an MLP unitholder dies and the investment is transferred to an heir, the cost basis is reset to the market price on the transfer date, eliminating any accrued tax liability caused by return of capital. (For related reading, see Getting Started On Your Estate Plan.)

Partnership Structure

MLPs contain two business entities: the limited partner and the general partner (GP). The limited partner invests capital into the venture and obtains periodic cash distributions, while the general partner oversees the MLP's operations and receives incentive distributions rights (IDRs). IDRs are structured when the partnership is formed, and provide the GP with performance-based pay for successfully managing the MLP, as measured by cash distributions to the limited partner. Generally, the GP receives a minimum of 2% of the LP distribution, but as payment to LP unitholders increases, the percentage take of the GP through IDRs increases too, often to a maximum of 50%. The table below shows a hypothetical IDR structure outlining the payment split between LP and GP at different distribution levels.

--	LP Distribution Per Unit	LP	GP
Tier 1	Below $1.00	98%	2%
Tier 2	Between $1.00 and $2.00	80%	20%
Tier 3	Between $2.00 and $3.00	65%	35%
Tier 4	Above $3.00	50%	50%

For each incremental dollar distributed to LP unitholders, the GP realizes higher marginal IDR payments. For example, assuming 1,000 LP units outstanding, if $1,000 is distributed to LP unitholders ($1.00 per unit), then the GP will receive $20 (2% of $1,000). However, if $5,000 is distributed to LP unitholders ($5.00 per unit), then the GP will receive $2,810, as outlined below.

--	LP Distribution	GP IDR Level	GP Payment Per LP Unit
Tier 1	$1.00	2%	$0.02
Tier 2	$1.00	20%	$0.25
Tier 3	$1.00	35%	$0.54
Tier 4	$2.00	50%	$2.00
Total	$5.00	--	$2.81

Note: The calculation for the GP's payment for each tier is not a straight multiplication of the GP's IDR with the LP's distribution. The calculation goes as follows:

(LP distribution/LP's IDR) x GP IDR

Thus, at the third tier, the GP payment would be ($1/0.65)x0.35 = 0.538 or $0.54

Here we see that the general partner has a significant financial incentive to increase cash distributions to limited partner unitholders; while LP distribution increases 500%, from $1,000 to $5,000, GP distribution increases by more than 14,000%, rising from $20 to $2,810. Note in the calculations in the above table that the IDR payment is not a percentage of the incremental LP distribution amount, but rather a percentage of the total amount distributed at the marginal level. For example, in the third tier, $1.54 is distributed per LP unit; $1.00 (65%) of that amount paid to LP unitholders, $0.54 (35%) paid to the GP.

The corporate structure of MLPs can be more complex than a simple split between the limited and general partnership interests. In some cases, the GP may own LP shares. In other cases, the general partner of an MLP may be publicly traded, and have its own LP/GP split. Or the MLP may have other relationships with additional entities due to financing arrangements. But the most important relationship for the MLP investor to keep in mind is the cash distribution split between LP and GP, and how this will change over time as distributions fluctuate.

Who Should (and Should Not) Own MLPs
MLPs have remained relatively unknown in part because of their low level of institutional ownership and a consequent lack of sell-side attention. Mutual funds were largely restricted from owning them until 2004, but even now, MLPs present a cumbersome investment because funds must send out 1099 forms to their investors detailing income and capital gains in November, but may not receive K-1 statements from MLPs until February. This causes the potential for costly mistakes in estimation.

Tax-exempt institutional investment funds such as pensions, endowments and 401(k) plans are restricted from owning MLPs because the cash distributions received are considered unrelated business taxable income (UBTI) - income that is unrelated to the activity that gives the fund tax-exempt status. This could create a tax liability on any distribution of more than $1,000. This is also true for individuals when holding MLPs in an IRA account; therefore, the best way to hold them is in a regular brokerage account. (To read more about retirement plans and taxes, see IRA Contributions: Deductions and Tax Credits and How IRA Contributions Affect Your Taxes.)

Individual investors are the principal owners of MLPs. Because few individuals know much about their structure and complex tax implications, they are often purchased for individuals by private-client wealth managers, although this need not be the case. As long as the individual - or his or her accountant - understands how to manage the K-1 statement and cash distributions, this investment can be perfect for an investor seeking current income and tax deferral.

Looking Deeper Into Capital Allocation

2012-01-01T06:54:00.000-08:00

Market-leading companies not only achieve success through their business results, but also by properly allocating capital in a way that is most beneficial to shareholders. Often overlooked as a central theme, capital allocation decisions are vital in determining the future of the company and, as such, are some of the most important responsibilities of company management. This article will examine some of the metrics that help us evaluate management's ability to effectively allocate capital in any set of market conditions. Read on to learn how to use these metrics to facilitate stock research and find companies poised to succeed over the long haul.

"Thanks, Keep the Change"
Should the company issue or increase dividends? Should it build that new factory or hire more workers? These are the dilemmas facing managers of today's publicly-traded companies.

In the past, for example, Microsoft came under increasing shareholder scrutiny for holding onto more than $48 billion in cash and equivalents. Investors rightly asked when Microsoft was going to start sending some of the shareholders' money back their way. In March of 2003, Microsoft finally answered that question by issuing a dividend (worth $0.08 per share) for the first time.

Every company follows a life cycle; in the early stages of life, capital allocation decisions are pretty simple - most of the cash flows will be poured back into the growing business, and there probably isn't going to be much money left over. After many years of strong, steady earnings growth, companies find out that there is only so much market out there to be had. In other words, adding the next product to the shelf, or adding the next shelf for that matter, is only half as profitable per unit as the first things that were put on that shelf many years ago. Eventually, the company will reach a point where cash flows are strong, and there is extra cash "lying around". The first discussions then can begin about such things as:
Entering a new line of business - this requires higher initial outlays of cash, but could prove to be the most profitable course in the long run
Increasing capacity of the core business - this can be confidently done until growth rates begin to decline
Issuing or increasing dividends - the tried and true method
Retiring debt - this increases financial efficiency, as equity financing will almost always be cheaper
Investing or acquiring other companies or ventures - this should always be done cautiously, sticking to core competencies
Buying back company stock
Management makes these kinds of decisions by using the same metrics available to investors. These include:

Return on Equity
A stock's return on equity (ROE) reveals the growth rate of the company in "shareholder dollars".

When looking at a company's ROE, there are a few considerations to take into account, such as the age of the company and what type of business it operates. Younger companies will tend to have higher ROEs because cash deployment decisions are easy to make. Older firms, and those operating in capital-intensive businesses (think telecom or integrated oil), will have lower ROEs because it costs more up front to generate the first dollars of revenue. (Find out more in Keep Your Eyes On The ROE.)

Return on equity is very specific to the industry in which the company operates because each has unique capital requirements; therefore, comparisons should only be made to similar companies when reviewing this valuable metric. A return on equity above the industry average is a good sign that management is wringing the most profit possible out of every invested dollar.

Return on Assets
Return on assets (ROA) is similar in theory to ROE, but the denominator of the equation is changed from stockholder equity to total assets. The ROA number tells us what kind of return management is getting on the assets at its disposal. As with ROE, ROA figures will vary greatly within different industries, and should be compared with this in mind. (For more information, see Understanding The Subtleties Of ROA Vs ROE, ROA On The Way and the Ratio Analysis Tutorial.)

Return on assets performance will, over the long run, provide a clearer picture of profitability than ROE will. Why? Because in the ROE calculations, current net income and last year's net income are major variables; they also happen to be much more volatile than long-term growth rates. When ROA is calculated most of the denominator is made up of long-term assets and capital, which smooths out some of the short-term noise that ROE can create. Essentially, ROE can vary widely for a company from year to year, while ROA figures take longer to change significantly. (To read more about net income, see Zooming in on Net Operating Income, Operating Cash Flow: Better Than Net Income? and Spotting Cash Cows.)

Capital Requirements and Cash Management
Let's say that Company X has averaged an 18% return on equity for first 10 years of its existence. This represents a strong record of growth, but it was achieved during a time when there were ample new markets to get into. With a leading market share, Company X can already see that it won't be able to keep up this rate of growth, and must begin looking at other ways to increase shareholder value. The capital requirements to keep up the business are known and set aside, and the free cash flow that is left over can be assessed for its durability and consistency. Once this has been verified, management can sit down and decide the best use of the funds. One or more of the options mentioned above may be used, and once this process begins investors can really start to evaluate the company's effectiveness outside of simply running the core business.

Dividend-paying stocks are attractive to many investors. Dividends are an effective way or returning free cash flow to shareholders, and they encourage long-term investment in a company. By looking at the payout ratio for a stock's dividend, an investor can easily tell what percentage of net income is being used to pay dividends. The smaller the payout ratio, the more room management has to increase this amount in the future. The most mature dividend-paying companies are paying out 80%+ of all their net income to shareholders, which provides for a nice yield, but leaves very little cash behind to generate future earnings growth. These stocks end up resembling real estate investment trusts (a security where at least 90% of net income must be distributed to shareholders annually). As a result, investments in companies with very high dividend payouts will experience little price appreciation. (To read more on dividend payouts, see How and Why Do Companies Pay Dividends?, The Importance Of Dividends and How Dividends Work For Investors.)

Stock buybacks are another common way to allocate excess capital within an organization. When is this in the shareholders' best interests? If the company truly feels that its stock is undervalued, buying back stock could very well be best use of the funds. This will increase the percentage ownership of all the other shareholders, and is generally seen as a positive sign that management believes in the future of the company. (For more insight, see A Breakdown Of Stock Buybacks.)

Conclusion
For the individual investor, part of any effective due diligence should include understanding the history of, and expectations for, the capital allocation abilities of a company. When looked at along with the valuation and growth, management's ability to allocate capital effectively will determine whether it is destined to have a front-running stock, or an "also-ran".

To continue reading on this subject, see Introduction To Fundamental Analysis, Relative Valuation: Don't Get Trapped and The Fed Model And Stock Valuation: What It Does And Does Not Tell Us.

How Budgeting Works For Companies

2012-01-01T06:52:00.000-08:00

Budgets are an integral part of running any business efficiently and effectively. They serve as a plan of action for managers as well as a point of comparison at the period's end. So how do budgets work, and how can they be used to gauge where a business is going? In this article, we'll introduce you to budgeting and show you how businesses use them.

Business Budgeting
When most people think of budgets, they think of a typical household budget - given a certain amount of money, how much should be allocated to various expenses? This system usually works fine for individuals, but in the business world there needs to be a lot more involved. Determining how much to spend on various expenses is only half the battle. The other half is for a company to be able to effectively judge its spending performance. Regardless of the type of business, the ability to gauge performance using budgets is a matter of life and death in the business world. (For more on how gauge household spending, read The Beauty Of Budgeting.)

Who Uses Budgets?
Nearly everyone uses budgets in some form. From the household budget to the multi-billion dollar budgets used in some corporations, budgets are a pretty universal tool.

However, a company's budget is a bit more involved. Most companies will start with a master, or static, budget. A static budget is a budget with numbers based on planned outputs and inputs for each of the firm's divisions. It's the first part of budgeting, which determines how much a company has and how much it will spend. These are projected amounts and the company expects to stay within these limits. To figure out the numbers, mangers make use of economic forecasting methods to determine a realistic static budget.

Changing Budgets
As you may have experienced with your own household budget, expenses that are not part of the budget often pop up. However, the static budget acts as a guideline; it does not constrain the company to staying within those limits. In other words, a budget is merely a tool that is used to help make business decisions. When it comes down to something that wasn't foreseen when the static budget was put together, companies can decide to spend more money or to spend more of it in a different area than originally planned, although the static budget will still act as a guideline. Budgets can always be changed.

Using a Budget to Evaluate Performance
So, what happens when the period's over? At period end, it's time to determine whether we fell in line with our planned expenditures. That's when a flexible budget is used. A flexible budget is a budget with figures that are based on actual output. It's then compared to a company's static budget to get variances (differences) between what level of spending was expected and what actually occurred.

With a flexible budget, budgeted dollar values (i.e. costs or selling prices) are multiplied by actual units to determine what particular number will be given to a level of output or sales. This yields the total variable costs involved in production. The second component of the flexible budget is the fixed cost. Typically, the fixed cost does not differ between the static and flexible budgets.

There are tons of variances that can arise in the static budgeting system. The two most basic variances are the flexible budget variance and sales-volume variance. The flexible budget variance compares the flexible budget to actual results to determine the effects that prices or costs have had on operations. The sales volume variance compares the flexible budget to the static budget to determine the effect that a company's level of activity had on its operations. From these two budgets, a company can develop individual flexible and static budgets for any element of its operations. For example, the static budget variance is the difference between the static budget and the company's actual results. The variances are always classified as either favorable or unfavorable.

If sales volume variance is unfavorable (flexible budget is less than static budget), the company's sales (or production with a production volume variance) will turn out to be less than anticipated. If, however, the flexible budget variance was unfavorable (the variance effects eventual cash flows negatively) this would be a result of price or cost. By knowing where the company is falling short or exceeding the mark, managers can do a better job of evaluating the company's performance and use the information to make changes to further streamline their processes.

Implementing Budgets
If you run your own business (or household), it's not hard to implement a flexible budget based on the business's numbers. You don't need to be an accountant: the math is simple and it's typically worth the effort in the end. After all, it's hard to know how you can make your company better and more cost efficient when you don't even know where you're missing the mark.

Conclusion
Every major company in the world uses flexible budgeting - and you can bet that there's a good reason for that. So the next time you think about budgeting, think beyond the static budget that most people are familiar with. Understanding flexible budgeting can help you gain a wealth of information through the analysis that budget variances afford to those who use them.

For related reading, see Measuring Company Efficiency and Spotting Profitability With ROCE

Evaluating A Company's Capital Structure

2012-01-01T06:50:00.000-08:00

For stock investors that favor companies with good fundamentals, a "strong" balance sheet is an important consideration for investing in a company's stock. The strength of a company' balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capital structure. In this article, we'll look at evaluating balance sheet strength based on the composition of a company's capital structure.

A company's capitalization (not to be confused with market capitalization) describes the composition of a company's permanent or long-term capital, which consists of a combination of debt and equity. A healthy proportion of equity capital, as opposed to debt capital, in a company's capital structure is an indication of financial fitness.

Clarifying Capital Structure Related Terminology
The equity part of the debt-equity relationship is the easiest to define. In a company's capital structure, equity consists of a company's common and preferred stock plus retained earnings, which are summed up in the shareholders' equity account on a balance sheet. This invested capital and debt, generally of the long-term variety, comprises a company's capitalization, i.e. a permanent type of funding to support a company's growth and related assets.

A discussion of debt is less straightforward. Investment literature often equates a company's debt with its liabilities. Investors should understand that there is a difference between operational and debt liabilities - it is the latter that forms the debt component of a company's capitalization - but that's not the end of the debt story.

Among financial analysts and investment research services, there is no universal agreement as to what constitutes a debt liability. For many analysts, the debt component in a company's capitalization is simply a balance sheet's long-term debt. This definition is too simplistic. Investors should stick to a stricter interpretation of debt where the debt component of a company's capitalization should consist of the following: short-term borrowings (notes payable), the current portion of long-term debt, long-term debt, two-thirds (rule of thumb) of the principal amount of operating leases and redeemable preferred stock. Using a comprehensive total debt figure is a prudent analytical tool for stock investors.

It's worth noting here that both international and U.S. financial accounting standards boards are proposing rule changes that would treat operating leases and pension "projected-benefits" as balance sheet liabilities. The new proposed rules certainly alert investors to the true nature of these off-balance sheet obligations that have all the earmarks of debt. (To read more on liabilities, see Off-Balance-Sheet Entities: The Good, The Bad And The Ugly and Uncovering Hidden Debt.)

For a primer on the debt/equity ratio check out this video:

Is there an optimal debt-equity relationship?

In financial terms, debt is a good example of the proverbial two-edged sword. Astute use of leverage (debt) increases the amount of financial resources available to a company for growth and expansion. The assumption is that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However, as successful as this formula may seem, it does require that a company maintain a solid record of complying with its various borrowing commitments. (For more stories on company debt loads, see When Companies Borrow Money, Spotting Disaster and Don't Get Burned by the Burn Rate.)

A company considered too highly leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share.

Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a company's line of business and its stage of development. However, because investors are better off putting their money into companies with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels.

Capital Ratios and Indicators

In general, analysts use three different ratios to assess the financial strength of a company's capitalization structure. The first two, the so-called debt and debt/equity ratios, are popular measurements; however, it's the capitalization ratio that delivers the key insights to evaluating a company's capital position.

The debt ratio compares total liabilities to total assets. Obviously, more of the former means less equity and, therefore, indicates a more leveraged position. The problem with this measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities. The same criticism can be applied to the debt/equity ratio, which compares total liabilities to total shareholders' equity. Current and non-current operational liabilities, particularly the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities.

The capitalization ratio (total debt/total capitalization) compares the debt component of a company's capital structure (the sum of obligations categorized as debt + total shareholders' equity) to the equity component. Expressed as a percentage, a low number is indicative of a healthy equity cushion, which is always more desirable than a high percentage of debt. (To continue reading about ratios, see Debt Reckoning.)

Additional Evaluative Debt-Equity Considerations

Companies in an aggressive acquisition mode can rack up a large amount of purchased goodwill in their balance sheets. Investors need to be alert to the impact of intangibles on the equity component of a company's capitalization. A material amount of intangible assets need to be considered carefully for its potential negative effect as a deduction (or impairment) of equity, which, as a consequence, will adversely affect the capitalization ratio. (For more insight, read Can You Count On Goodwill? and The Hidden Value Of Intangibles.)

Funded debt is the technical term applied to the portion of a company's long-term debt that is made up of bonds and other similar long-term, fixed-maturity types of borrowings. No matter how problematic a company's financial condition may be, the holders of these obligations cannot demand payment as long the company pays the interest on its funded debt. In contrast, bank debt is usually subject to acceleration clauses and/or covenants that allow the lender to call its loan. From the investor's perspective, the greater the percentage of funded debt to total debt disclosed in the debt note in the notes to financial statements, the better. Funded debt gives a company more wiggle room. (To read more on financial statement footnotes, see Footnotes: Start Reading The Fine Print.)

Lastly, credit ratings are formal risk evaluations by credit-rating agencies - Moody's, Standard & Poor's, Duff & Phelps and Fitch – of a company's ability to repay principal and interest on debt obligations, principally bonds and commercial paper. Here again, this information should appear in the footnotes. Obviously, investors should be glad to see high-quality rankings on the debt of companies they are considering as investment opportunities and be wary of the reverse.

Conclusion

A company's reasonable, proportional use of debt and equity to support its assets is a key indicator of balance sheet strength. A healthy capital structure that reflects a low level of debt and a corresponding high level of equity is a very positive sign of investment quality.

To continue learning about financial statements, read What You Need To Know About Financial Statements and Advanced Financial Statement Analysis.

The Merger - What To Do When Companies Converge

2012-01-01T06:48:00.000-08:00

You may hear about it in the financial news - the merger. It's often a situation cloaked in mystery and confusion. Do you know what to do when a company you've invested in plans to merge with another company? In this article, we'll show you how to invest around mergers and the ups and downs involved in the process.

How It Works
A merger occurs when a company finds benefit in combining business operations with another company in a way that will contribute to increased shareholder value. It is similar in many ways to an acquisition, which is why the two actions are so often grouped together as mergers and acquisitions (M&As).

In theory, a merger of equals is where two companies convert their respective stocks to those of the new, combined company. However, in practice, two companies will generally make an agreement for one company to buy the other company's common stock from the shareholders in exchange for its own common stock. In some rarer cases, cash or some other form of payment is used to facilitate the transaction of equity. Usually though, stock-for-stock arrangements are the most common. (For more reading on mergers, see Cashing In On Corporate Restructuring and The Basics Of Mergers And Acquisitions.)

Mergers don't occur on a one-to-one basis - that is, exchanging one share of Company A's stock typically won't get you one share of the merged company's stock. Much like a split, the amount of the new company's shares received in exchange for your stake in Company A is represented by a ratio. The real number might be one for 2.25, where one share of the new company will cost you 2.25 shares of Company A. In the case of fractional shares, they are dealt with one of two ways: the fraction is cashed out automatically and you get a check for the market value of your fraction, or the number of shares is rounded down.

Mergers vs. Acquisitions
While the two processes are similar, don't confuse mergers with acquisitions. While in many cases the distinction between the two may be corporate politics and semantics, there are a lot of blue chips that make quite a few acquisitions while maintaining a relatively low volatility. As a general rule of thumb, if the corporate leadership of the company in which you own a stake doesn't change much, it is probably an acquisition. However, if your company experiences significant restructuring, we're looking more along the lines of a merger.

Understanding the Buyout Circumstances
The circumstances of a buyout can also be very important. The investor to should get to know the nature of the merger, key information concerning the other company involved, the types of benefits that shareholders are receiving, which company is in control of the deal and any other relevant financial and non-financial considerations.

While it may seem counterintuitive, owning the company that's being bought out can be a real windfall for investors. That's because if the company being bought has shown respectable performance and has good prospects for the future, a certain amount of goodwill may be involved.

Goodwill usually accounts for intangible assets, though if those assets weren't factored into the stock price when you purchased your shares of the company being bought, you can end up on top. Goodwill is a source of confusion for a lot of people, but essentially what it amounts to is the amount of money a company pays over the book value of another company to purchase it. And let's not forget that because intangible assets aren't always easily valued, you can expect that a certain phantom percentage of most companies that have goodwill on their balance sheets may be overvalued. While that's not a good deal for the guy who owns a few shares of the purchasing company, if you own the company being bought, this can be another win for you. (For more insight, check out Can You Count On Goodwill?)

If the company you've invested in isn't doing so well, a merger can still be good news. In this case, a merger often can provide a nice out for someone who is strapped with an under-performing stock. Knowing less obvious benefits to shareholders can allow you to make better investing decisions with regard to mergers. (To learn about additional takeovers and takeover strategies, read The Wacky World of M&As and Bloodletting And Knights: A Medieval Guide To Investing.)

Importance and Consideration Regarding Your Vote
Keep in mind that a company's decision to merge with another company is not necessarily set in stone. If you're a shareholder in the company, the decision about whether to merge with another company is partially yours. The typical voting scenario for a publicly-held company will usually end with a shareholder vote on the issue of the merger. If your analysis and consideration tells you that a merger is a step in the wrong direction or if it tells you that it might be a great financial opportunity, voting with your shares is the best way to exercise your power over the decision-making process.

Non-financial considerations can also be important when looking over a merger deal. Remember: it's not necessarily all about money. Maybe the merger will result in too many lost jobs in a depressed area. Maybe the other company is a big polluter or funds political or social campaigns that you don't support. For most investors, the concept of whether or not the newly formed company will be able to make you money is certainly a big deal, but it might be worthwhile to keep the non-financial issues in mind, because they might be important enough to become deal breakers.

Analyze Financial Reports
Even though there aren't a lot of people who enjoy reading financial statements, examining key information for each company involved in the merger is a good idea. Look over and analyze the company if you're not familiar with it, and determine for yourself if it is a good investment decision. If you find that it isn't, chances are that the newly formed company won't be terribly good either. (To learn how to read financial statements, see What You Need To Know About Financial Statements and Breaking Down The Balance Sheet.)

When analyzing financial statements, make sure that you look over the most up-to-date financial statements and annual reports from both companies. A lot can happen since the last time you took a look at your company's financials and new information can be a key to determining what influenced the other company's interest in a merger.

Understanding the Changing Dynamics of the New Company
The new company likely will have a few noticeable changes from the original. One of the most common situations is the change in leadership. Certain concessions usually are made in merger negotiations, and the executives and board members of the new company will change to some degree, or at least have plans to change in the future. When you cast your vote for a proposed merger, remember that you're agreeing to adjoining conditions like leadership changes as well.

Putting Your Information to Work
As mentioned before, when it comes down to it, your vote is your own and it represents your choice for or against a merger. But keep in mind that as a shareholder of an involved company, your decision should reflect a combination of the best interest for yourself, the company and the outside world. With the right information and relevant consideration of the facts, coming out ahead in the face of a merger can be a realistic goal.

Still have some questions about mergers? Check out these frequently asked questions: What is the difference between a merger and a takeover?, How do stock-for-stock mergers affect existing shareholders? and Why do companies merge with or acquire other companies?

Breaking Down The Balance Sheet

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A company's financial statements - balance sheet, income statement and cash flow statement - are a key source of data for analyzing the investment value of its stock. Stock investors, both the do-it-yourselfers and those who follow the guidance of an investment professional, don't need to be analytical experts to perform financial statement analysis. Today, there are numerous sources of independent stock research, online and in print, which can do the "number crunching" for you. However, if you're going to become a serious stock investor, a basic understanding of the fundamentals of financial statement usage is a must. In this article, we help you to become more familiar with the overall structure of the balance sheet.

The Structure of a Balance Sheet

A company's balance sheet is comprised of assets, liabilities and equity. Assets represent things of value that a company owns and has in its possession or something that will be received and can be measured objectively. Liabilities are what a company owes to others - creditors, suppliers, tax authorities, employees etc. They are obligations that must be paid under certain conditions and time frames. A company's equity represents retained earnings and funds contributed by its shareholders, who accept the uncertainty that comes with ownership risk in exchange for what they hope will be a good return on their investment.

The relationship of these items is expressed in the fundamental balance sheet equation:

Assets = Liabilities + Equity

The meaning of this equation is important. Generally sales growth, whether rapid or slow, dictates a larger asset base - higher levels of inventory, receivables and fixed assets (plant, property and equipment). As a company's assets grow, its liabilities and/or equity also tends to grow in order for its financial position to stay in balance.

How assets are supported, or financed, by a corresponding growth in payables, debt liabilities and equity reveals a lot about a company's financial health. For now, suffice it to say that depending on a company's line of business and industry characteristics, possessing a reasonable mix of liabilities and equity is a sign of a financially healthy company. While it may be an overly simplistic view of the fundamental accounting equation, investors should view a much bigger equity value compared to liabilities as a measure of positive investment quality, because possessing high levels of debt can increase the likelihood that a business will face financial troubles.

Balance Sheet Formats
Standard accounting conventions present the balance sheet in one of two formats: the account form (horizontal presentation) and the report form (vertical presentation). Most companies favor the vertical report form, which doesn't conform to the typical explanation in investment literature of the balance sheet as having "two sides" that balance out. (For more information on how to decipher balance sheets, see Reading The Balance Sheet.)

Whether the format is up-down or side-by-side, all balance sheets conform to a presentation that positions the various account entries into five sections:

Assets = Liabilities + Equity
• Current assets (short-term): items that are convertible into cash within one year
• Non-current assets (long-term): items of a more permanent nature

As total assets these =
• Current liabilities (short-term): obligations due within one year
• Non-current liabilities (long-term): obligations due beyond one year

These total liabilities +
• Shareholders' equity (permanent): shareholders' investment and retained earnings

Account Presentation

In the asset sections mentioned above, the accounts are listed in the descending order of their liquidity (how quickly and easily they can be converted to cash). Similarly, liabilities are listed in the order of their priority for payment. In financial reporting, the terms current and non-current are synonymous with the terms short-term and long-term, respectively, and are used interchangeably. (For related reading, see The Working Capital Position.)

It should not be surprising that the diversity of activities included among publicly-traded companies is reflected in balance sheet account presentations. The balance sheets of utilities, banks, insurance companies, brokerage and investment banking firms and other specialized businesses are significantly different in account presentation from those generally discussed in investment literature. In these instances, the investor will have to make allowances and/or defer to the experts.

Lastly, there is little standardization of account nomenclature. For example, even the balance sheet has such alternative names as a "statement of financial position" and "statement of condition". Balance sheet accounts suffer from this same phenomenon. Fortunately, investors have easy access to extensive dictionaries of financial terminology to clarify an unfamiliar account entry. (To search a financial term, see our dictionary.)

The Importance of Dates
A balance sheet represents a company's financial position for one day at its fiscal year end, for example, the last day of its accounting period, which can differ from our more familiar calendar year. Companies typically select an ending period that corresponds to a time when their business activities have reached the lowest point in their annual cycle, which is referred to as their natural business year.

In contrast, the income and cash flow statements reflect a company's operations for its whole fiscal year - 365 days. Given this difference in "time", when using data from the balance sheet (akin to a photographic snapshot) and the income/cash flow statements (akin to a movie) it is more accurate, and is the practice of analysts, to use an average number for the balance sheet amount. This practice is referred to as "averaging", and involves taking the year-end (2004 and 2005) figures - let's say for total assets - and adding them together, and dividing the total by two. This exercise gives us a rough but useful approximation of a balance sheet amount for the whole year 2005, which is what the income statement number, let's say net income, represents. In our example, the number for total assets at year-end 2005 would overstate the amount and distort the return on assets ratio (net income/total assets).

Since a company's financial statements are the basis of analyzing the investment value of a stock, this discussion we have completed should provide investors with the "big picture" for developing an understanding of balance sheet basics.

To learn more about financial statements, read What You Need To Know About Financial Statements, Understanding The Income Statement and The Essentials Of Cash Flow.

The Working Capital Position

2012-01-01T06:43:00.000-08:00

For investors, the strength of a company's balance sheet can be evaluated by examining three broad categories of investment quality:


Watch: Working Capital

working capital adequacy, asset performance and capitalization structure. In this article, we'll start with a comprehensive look at how best to evaluate the investment quality of a company's working capital position. In simple terms, this entails measuring the liquidity and managerial efficiency related to a company's current position. The analytical tool employed to accomplish this task will be a company's cash conversion cycle.

Don’t be Mislead by Faulty Analysis
To start this discussion, let's first correct some commonly held, but erroneous, views on a company's current position, which simply consists of the relationship between its current assets and its current liabilities. Working capital is the difference between these two broad categories of financial figures and is expressed as an absolute dollar amount.

Despite conventional wisdom, as a stand-alone number, a company's current position has little or no relevance to an assessment of its liquidity. Nevertheless, this number is prominently reported in corporate financial communications such as the annual report and also by investment research services. Whatever its size, the amount of working capital sheds very little light on the quality of a company's liquidity position.

Another piece of conventional wisdom that needs correcting is the use of the current ratio and, its close relative, the acid test or quick ratio. Contrary to popular perception, these analytical tools don't convey the evaluative information about a company's liquidity that an investor needs to know. The ubiquitous current ratio, as an indicator of liquidity, is seriously flawed because it's conceptually based on a company's liquidation of all its current assets to meet all of its current liabilities. In reality, this is not likely to occur. Investors have to look at a company as a going concern. It's the time it takes to convert a company's working capital assets into cash to pay its current obligations that is the key to its liquidity. In a word, the current ratio is misleading. (For related reading, see The Dynamic Current Ratio, Working Capital Works and Do Your Investments Have Short-Term Health?)

A simplistic, but accurate, comparison of two companies' current positions will illustrate the weakness in relying on the current ratio and a working capital number as liquidity indicators:

Liquidity Measures Company ABC Company XYZ
Current Assets $600 $300
Current Liabilities $300 $300
Working Capital $300 $0
Current Ratio 2:1 1:1

At first glance, company ABC looks like an easy winner in a liquidity contest. It has an ample margin of current assets over current liabilities, a seemingly good current ratio and a working capital of $300. Company XYZ has no current asset/liability margin of safety, a weak current ratio and no working capital.

However, what if both companies' current liabilities have an average payment period of 30 days; company ABC needs six months (180 days) to collect its account receivables, and its inventory turns over just once a year (365 days). Company XYZ's customers pay in cash, and its inventory turns over 24 times a year (every 15 days). In this contrived example, company ABC is very illiquid and would not be able to operate under the conditions described. Its bills are coming due faster than its generation of cash. You can't pay bills with working capital; you pay bills with cash! Company XYZ’s seemingly tight current position is much more liquid because of its quicker cash conversion.

Measuring a Company’s Liquidity the Right Way
The cash conversion cycle (also referred to as CCC or the operating cycle) is the analytical tool of choice for determining the investment quality of two critical assets - inventory and accounts receivable. The CCC tells us the time (number of days) it takes to convert these two important assets into cash. A fast turnover rate of these assets is what creates real liquidity and is a positive indication of the quality and the efficient management of inventory and receivables. By tracking the historical record (five to 10 years) of a company's CCC and comparing it to competitor companies in the same industry (CCCs will vary according to the type of product and customer base), we are provided with an insightful indicator of a balance sheet's investment quality. (For a more comprehensive discussion of the CCC, see Understanding the Cash Conversion Cycle and Using The Cash Conversion Cycle.)

Briefly stated, the cash conversion cycle is comprised of three standard, so-called activity ratios relating to the turnover of inventory, trade receivables and trade payables. These components of the CCC can be expressed as a number of times per year or as a number of days. Using the latter indicator provides a more literal and coherent time measurement that is easily understood. The cash conversion cycle formula looks like this:

Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO) = CCC

Here's how the components are calculated:
• Dividing average inventories by cost of sales per day (cost of sales/365) = days inventory outstanding (DIO).
• Dividing average accounts receivables by net sales per day (net sales/365) = days sales outstanding (DSO).
• Dividing average accounts payables by cost of sales per day (cost of sales/365) = days payables outstanding (DPO).

Liquidity is King
One collateral observation is worth mentioning here. Investors should be alert to spotting liquidity enhancers in a company's financial information. For example, for a company that has non-current investment securities, there is typically a secondary market for the relatively quick conversion of all or a high portion of these items to cash. Also, unused committed lines of credit - usually mentioned in a note to the financials on debt or in themanagement discussion and analysis (MD&A) section of a company's annual report - can provide quick access to cash.

The old adage that "cash is king" is as important for investors evaluating a company's investment qualities as it is for the managers running the business. A liquidity squeeze is worse than a profit squeeze. A key management function is to make sure that a company's receivable and inventory positions are managed efficiently. This means ensuring an adequate level of product availability and providing appropriate payment terms, while at the same time making sure that working capital assets don't tie up undue amounts of cash. This is a balancing act for managers, but an important one. It is important because with high liquidity, a company can take advantage of price discounts on cash purchases, reduce short-term borrowings, benefit from a top commercial credit rating and take advantage of market opportunities.

The cash conversion cycle and its component parts are useful indicators of a company's true liquidity. In addition, the performance of DIO and DSO is a good indicator of management's ability to handle the important inventory and receivable assets.

The Successful Investment Journey

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The most successful investors were not made in one day. Learning the ins and outs of the financial world - and your personality as an investor - takes time and patience, not to mention trial and error. In this article, we'll lead you through the first seven steps of your expedition into investing and show you what to look out for along the way.

1. Getting Started

Successful investing is a journey - not a one-time event - and you'll need to prepare yourself as if you were going on a long trip. What is your destination? How long will it take you to get there? What resources will you need? Begin by defining your destination, and then plan your investment journey accordingly. For example, are you looking to retire in 20 years at age 55? How much money will you need to do this? These are questions you must first ask yourself; the plan that you come up with will depend on your investment goals. (To learn more, please see Having A Plan: The Basis Of Success.)

2. Know What Works

Read books or take an investment course that deals with modern financial ideas. The people who came up with theories such as portfolio optimization, diversification and market efficiency received their Nobel prizes for good reason. Investing is a combination of science (financial fundamentals) and art (qualitative factors). Science, however, is a solid place to start and should not be ignored. But don't fret if science is not your strong suit: there are many texts, such as "Stocks For The Long Run" (1994) by Jeremy Siegel, that explain high-level finance ideas in a way that is easy to understand. (For further reading, see Ten Books Every Investor Should Read and Is finance an art or a science?)

Once you know what works in the market, you can come up with simple rules that work for you. For example, Warren Buffett is one of the most successful investors ever. His simple investment style is summed up in this well-known quote: "If I cannot understand it, I will not invest in it." It has served him well. While he missed the tech upturn, he avoided the subsequent devastating downturn of the high-tech bubble of 2000. (To read more, see Warren Buffett: How He Does It and What Is Warren Buffett's Investing Style?)

3. Know Yourself

Nobody knows you and your situation better than you do. Therefore, you may be the most qualified person to do your own investing - all you need is a bit of help. Identify the personality traits that can assist you or prevent you from investing successfully and manage them accordingly.

A very useful behavioral model that helps investors to understand themselves was developed by Bailard, Biehl & Kaiser.

The model classifies investors according to two personality characteristics: method of action (careful or impetuous) and level of confidence (confident or anxious). Based on these personality traits, the BB&K model divides investors into five groups:

Individualist - careful and confident, often takes a "do-it-yourself" approach

Adventurer - volatile, entrepreneurial and strong willed

Celebrity - follower of the latest investment fads

Guardian - highly risk averse, wealth preserver

Straight Arrow - shares the characteristics of all of the above equally

Not surprisingly, the best investment results tend to be realized by an individualist, or someone who exhibits analytical behavior and confidence and has a good eye for value. However, if you determine that your personality traits resemble those of an adventurer, you can still achieve investment success if you adjust your strategy accordingly. In other words, regardless of which group you fit into, you should manage your core assets in a systematic and disciplined way.

4. Know Your Friends and Enemies

Your friends may be reliable investment books, reputable media and investment professionals with experience, long-term perspective and integrity. However, beware of false friends who only pretend to be on your side, such as certain unscrupulous investment professionals whose interests may conflict with yours. You must also remember that as an investor, you are competing with large financial institutions that have more resources, including greater and faster access to information. (See Choosing An Advisor: Wall Street Vs Main Street and Shopping For A Financial Advisor.)

Bear in mind that you are potentially your own worst enemy. Depending on your personality, strategy and particular circumstances, you may be sabotaging your own success. If you are a guardian and you see all your friends making a ton of money in the short term on the latest market craze, you would likely be going against your personality if you joined in (see How Investors Often Cause The Market's Problems). Because you are risk averse and a wealth preserver, you would be affected far more by large losses that can result from high-risk, high-return investments. Be honest with yourself - identify and modify factors that are preventing you from investing successfully or are moving you away from your comfort zone.

5. Find the Right Path

Your level of knowledge, personality and resources should determine the path that you choose. Generally, investors adopt one of the following strategies:

Don't put all of your eggs in one basket. In other words, diversify.

Put all of your eggs in one basket, but watch your basket carefully.

Combine both of these strategies by making tactical bets on a core passive portfolio.

Most successful investors start with low-risk diversified portfolios and gradually learn by doing. As investors gain greater knowledge over time, they become better suited to taking a more active stance in their portfolios (i.e. tactical bets).

(For further reading, see Portfolio Protection In Diversification And Discipline and Asset Allocation Strategies.)

6. Be Disciplined

Sticking with the optimal long-term strategy may not be the most exciting investing choice. However, your chances of success increase if you stay the course without letting your emotions, or "false friends", get the upper hand. (To read more, check out Ten Tips For The Successful Long-Term Investor.)

7. Be Willing to Learn

The market is hard to predict but one thing is certain: it will be volatile. Learning to be a successful investor is a gradual process and the investment journey is typically a long one. At times, the market will prove you wrong - acknowledge it and learn from your mistakes. When you succeed, celebrate.

Conclusion

What you achieve as an investor will depend on your goals, but sticking to these seven simple steps will help keep you on the right path. Bon voyage!

The Impact Of An Inverted Yield Curve

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The term yield curve refers to the relationship between the short- and long-term interest rates of fixed-income securities issued by the U.S. Treasury. An inverted yield curve occurs when short-term interest rates exceed long-term rates. From an economic perspective, an inverted yield curve is a noteworthy event. Here we explain this rare phenomenon, discuss its impact on consumers and investors, and tell you how to adjust your portfolio to account for it.

Typically, short-term interest rates are lower than long-term rates, so the yield curve slopes upwards, reflecting higher yields for longer-term investments. This is referred to as a normal yield curve. When the spread between short-term and long-term interest rates narrows, the yield curve begins to flatten. A flat yield curve is often seen during the transition from a normal yield curve to an inverted one.

Figure 1 - A normal yield curve

What Does an Inverted Yield Curve Suggest?

Historically, an inverted yield curve has been viewed as an indicator of a pending economic recession. When short-term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall. More recently, this viewpoint has been called into question as foreign purchases of securities issued by the U.S. Treasury have created a high and sustained level of demand for products backed by U.S. government debt. When investors are aggressively seeking debt instruments, the debtor can offer lower interest rates. When this occurs, many argue that it is the laws of supply and demand, rather than impending economic doom and gloom, that enable lenders to attract buyers without having to pay higher interest rates. (To learn more, see Forces Behind Interest Rates and Trying To Predict Interest Rates.)

Figure 2 - An inverted yield curve: note the inverse relationship between yield and maturity

Impact on Consumers

In addition to its impact on investors, an inverted yield curve also has an impact on consumers. For example, homebuyers financing their properties with adjustable-rate mortgages (ARMs) have interest-rate schedules that are periodically updated based on short-term interest rates. When short-term rates are higher than long-term rates, payments on ARMs tend to rise. When this occurs, fixed-rate loans may be more attractive than adjustable-rate loans.

Lines of credit are affected in a similar manner. In both cases, consumers must dedicate a larger portion of their incomes toward servicing existing debt. This reduces expendable income and has a negative effect on the economy as a whole. (See ARMed And Dangerous, Mortgages: Fixed-Rate Versus Adjustable-Rate and APR vs APY: How The Distinction Affects You.)

Impact on Fixed-Income Investors
A yield curve inversion has the greatest impact on fixed-income investors. In normal circumstances, long-term investments have higher yields; because investors are risking their money for longer periods of time, they are rewarded with higher payouts. An inverted curve eliminates the risk premium for long-term investments, allowing investors to get better returns with short-term investments. When the spread between U.S. Treasuries (a risk-free investment) and higher-risk corporate alternatives is at historical lows, it is often an easy decision to invest in lower-risk vehicles. In such cases, purchasing a Treasury-backed security provides a yield similar to the yield on junk bonds, corporate bonds, real estate investment trusts and other debt instruments, but without the risk inherent in these vehicles. Money market funds and certificates of deposit (CDs) may also be attractive - particularly when a one-year CD is paying yields comparable to those on a 10-year Treasury bond. (For further reading, see Getting To Know The Money Market and Why do interest rates tend to have an inverse relationship with bond prices?)

Impact on Equity Investors
When the yield curve becomes inverted, profit margins fall for companies that borrow cash at short-term rates and lend at long-term rates, such as community banks. Likewise, hedge funds are often forced to take on increased risk in order to achieve their desired level of returns. In fact, a bad bet on Russian interest rates is largely credited for the demise of Long-Term Capital Management, a well-known hedge fund run by bond trader John Meriwether. (For further reading, see Corporate Bonds: An Introduction To Credit Risk.)

Despite their consequences for some parties, yield curve inversions tend to have less impact on consumer staples and healthcare firms, which are not interest-rate dependent. This relationship becomes clear when an inverted yield curve precedes a recession. When this occurs, investors tend to turn to defensive stocks, such as those in the food, oil and tobacco industries, which are often less affected by downturns in the economy. (For further reading, see What are defensive stocks? and Recession: What Does It Mean To Investors?)

Conclusion
While experts question whether or not an inverted yield curve remains a strong indicator of pending economic recession, keep in mind that history is littered with portfolios that were devastated when investors blindly followed predictions about how "it's different this time". Most recently, short-sighted equity investors spouting this mantra participated in the "tech wreck", snapping up shares in tech companies at inflated prices even though these firms had no hope of ever making a profit.

If you want to be a smart investor, ignore the noise. Instead of spending time and effort trying to figure out what the future will bring, construct your portfolio based on long-term thinking and long-term convictions - not short-term market movements. For your short-term income needs, do the obvious: choose the investment with the highest yield, but keep in mind that inversions are an anomaly and they don't last forever. When the inversion ends, adjust your portfolio accordingly.

For further reading, see The Impact of Interest Rates On REITs.

The Stock Market: A Look Back

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History offers fascinating lessons - the twentieth century was no exception. In the book "Triumph Of The Optimists: 101 Years Of Global Investment Returns" (2002), Elroy Dimson, Paul Marsh and Mike Staunton offer the most complete study of historical global market returns. The book documents market returns for 16 countries from 1900 to 2000. From this research, it is evident that three important changes took place in the global stock market in the last century: the U.S. achieved market dominance; the exchanges were consolidated; and secular sector rotation occurred. Unfortunately, understanding the past doesn't necessarily make predicting the markets' future any easier. Read on to learn what happened in the past century and why some experts say history may not be destined to repeat itself.

To the Winner Go the Spoils

Unfortunately, until "Triumph Of The Optimists" was published, most of the available historical stock market data for the years prior to 1970 was only for the U.S. market. This isn't surprising, since the U.S. stock market was the big winner of the twentieth century. Its weighting increased to 47% of the world's total and, in general, it performed more favorably than the rest of the world's markets. This occurred for a number of reasons, but chief among them were larger investments in physical and human capital, greater technological advancement and greater productivity growth. With its huge investment demand and technological superiority, the U.S. investment industry was a worldwide leader. (To learn more, see What Are Economies Of Scale?.)

By contrast, other countries have lesser-known histories. For example, it took the U.K. much longer to recover from the world wars. Its diminished role after the collapse of the British Empire and the complicated bureaucracies of the colonial system slowed the U.K.'s growth immeasurably. According to the authors, problems with defense spending, labor, productivity and investment plagued the British economy and markets until the mid 1970s.

The U.S., on the other hand, suffered relatively little disruption to its stock market during the world wars and didn't have the prolonged declines that many of the European and Asian markets experienced. In fact, the United States' economy largely benefited from the wars - successful companies such as General Motors and IBM thrived as a result. At the same time, many other economies suffered great losses. For example, according to Phillipe Jorion and William N. Goetzmann in their article "Global Stock Markets In The Twentieth Century" (1999), the Japanese stock market saw a 95% decline in real returns between 1944 and 1949! The German market also suffered devastating losses. In this context, the U.S. market's success seems to be an exception, which the previous lack of data for other countries may have obscured.

Past Success and Future Performance

Many valuable lessons can be learned from history, but extrapolating historical returns into the future is difficult and complicated. For instance, few investors in 1900 could have predicted the monumental changes that would take place in the world after 1913. The two world wars, socialist revolutions, the Great Depression and the Bretton Woods Agreement all had a profound impact on the global economy and stock markets until the 1970s. The impact of these events suggests that although we can study the past, the social and economic events that might affect the markets in the future are often unpredictable. (For more insight, see Dollarization Explained and What Is the International Monetary Fund?)

Furthermore, despite the clear success of the U.S. markets since 1900, investors need to remember that this exceptional performance may be just that: the exception, rather than the rule for the twentieth century. "Triumph Of The Optimists" argues that economic and stock market performance in the U.S. has not been typical of other countries and, therefore, should not necessarily be extrapolated into the future.

The graphs below show a breakdown of the world markets in both 1900 and 2000 and the anomalous growth of the U.S. market during this time.

Globalization and Consolidation

The stock markets of 1900 had more regional exchanges than those of today. For example, Dimson, Marsh and Staunton state that the U.S. and U.K. each had 20 to 30 different regional exchanges. Most of these exchanges - such as the Los Angeles Exchange, which dealt with the petroleum industry - focused on the industries prevalent in their areas.

The difference between the number of exchanges in the early-twentieth century and the number that exists today is due mostly to advancements in telecommunications and innovation within financial markets. In "Globalization Myths" (1996), Paul Bairoch and Richard Kozul-Wright describe how, between 1930 and 1990, the cost of a three-minute telephone call from New York to London dropped from $245 to $3. Advancements like these have propelled the globalization of our economy and its financial markets. Today, New York, London and Tokyo are widely regarded as the world's financial centers, and technological advances have allowed them to be interconnected despite the distance between them. As a result, the twenty-first century global economy is defined by financial centers rather than smaller regional exchanges. (To read more, check out Getting To Know Stock Exchanges and The Tale Of Two Exchanges: NYSE And Nasdaq.)

Sector Rotation Like You Have Never Seen Before

Many investors today focus on short-term sector rotation to add value to their portfolios. According to Dimson, Marsh and Staunton's research, this type of rotation pales in comparison to the changes that can take place over the long term. Sector analysis of the U.S. market between 1900 and 2000 shows us an interesting picture.

Just as a country's influence over global economics evolves, so do the sectors of an economy. As these two tables show, the economies of 1900 and 2000 had few similarities. Of particular note are the sectors that were small in 1900 and 2000. For instance, 84% of the sectors today (represented by market capitalization) were of immaterial size or were non-existent at the beginning of the last century. These sweeping changes also make extrapolating future market performance from past events difficult. (Check out Sector Rotation: The Essentials and The Stages Of Industry Growth.)

Clearly, technological advancements have a big impact on the stock market. Just as railroads consumed the investing public in the latter part of the nineteenth century, computers and the internet did the same at the end of the twentieth century. For all we know, the dominant sector at the end of the twenty-first century may not even exist today. Which technologies will have the most profound impact on the world's productivity in the future? In order to successfully invest in these technologies, you will need to predict these changes before they affect the market - a task that is much easier said than done.

Conclusion

Can the U.S. continue its dominance for another century? Change is inevitable, but one thing is certain: the stock markets of 2100 will look very different than those of today. The incredible advancements in telecommunications have left their mark on the world stock markets, and major centers like New York, London and Tokyo now dominate a once fragmented marketplace. It is easy to refer to the past, but when it comes to your own finances, make sure that your portfolio is structured for the future - in light of all the changes that the markets have undergone so far, basing it on what has occurred in the past may not make sense.