1. finance
2. investing
3. stocks

InvestingDaily.com
Understanding the Stock Market:
How to Buy Stocks
Table
of
Contents
Chapter 1
Welcome to Investing...................................1
Defining Your Investment Goals
Chapter 8
Chapter 2
The ABCs of Stocks...................................... 1
Why And How A Company Issues Stock
How Risky Are You?
Types Of Stock
Picking A Stock
Income Or Growth
Major Exchanges
Indexes: Keeping Track Of Investments
Over-The-Counter Stocks
Chapter 9
Chapter 3
Chapter 12
Broker Basics ..............................................4
Full Service vs. Discount
Commissions And Fees
Minimum Initial Deposit
Customer Service
Research
Mutual Funds And Other Choices
Chapter 4
The ABCs Of Bonds . ..................................6
Bond Background
Finding Your Method
Chapter 5
Bond Basics ................................................7
Different Strokes For Different Folks
When Rates Go Up, Bonds Come Down
The Importance Of Credit Ratings
Sources of Information
Convertible Securities:
The Stock and Bond Hybrid......................10
Muni ABCs..................................................11
General Obligation Bonds
Revenue Bonds
Chapter 10
Mutual Fund ABCs ....................................12
What Is A Mutual Fund?
Chapter 11
Funds That Match Your Personal Style ...12
Open-end And Closed-end . .....................15
Comparing Funds
Accounting For Risk
The Benefits Of Mutual Funds
Mutual Fund Drawbacks
Chapter 13
Nuts & Bolts . .............................................17
How Share Prices Are Determined
Prospectus
Fees And Expenses
Redemption Fees
Management, Administrative Fees And
Transaction Costs
Record Keeping
Chapter 14
Bond Mutual Funds . ...................................9
Foreign Bond Funds
Exchange Traded Funds ...........................19
What’s An ETF?
ETFs vs. Mutual Funds
Risks
Chapter 7
Chapter 15
Junk Bonds . ..............................................10
Glossary .....................................................21
Chapter 6
CHAPTER ONE
Welcome to Investing
I
nvesting is an important aspect of anyone’s finan­cial life.
It’s a way to save for retirement, earn extra income if
you’re already retired or to put your child through college
with.
But to many new investors, learning to invest is a daunting task. There are numerous questions that need answering.
This report will delve into the various aspects of investing,
from defining your investment goals and determining your
risk tolerance to detailing the various types of investments in
the markets.
Defining Your Investment Goals
Investors, from the beginner to the seasoned pro,
shouldn’t enter into any investment without a partic­ular
purpose in mind. That purpose could range from planning
for retirement to saving for a child’s education to preserving existing assets and earning extra income. Often, you may
have two or more goals to consider; in that case, you may
choose a dif­ferent investment for each of your goals.
Before you make your choice, ask yourself these two
important questions:
• When do you plan to use the money you’re investing?
• What’s your risk tolerance?
By answering these questions, you can identify the correct
investment to match your needs, time frame and personal
approach to investing. Let’s look more closely at the latter
question.
CHAPTER Two
The ABCs of Stocks
B
efore you begin investing in the stock market, you first
have to understand what a stock is. A stock—or share—
is basically ownership in a com­pany. The more shares you
have, the more owner­ship you have in the company.
As a shareholder of a particular company, you also receive
voting rights. You get one vote per share of stock you own. As
a shareholder, you get to vote on the board of directors as well
as on other important matters the company is deciding on.
Why and How a Company Issues Stock
A company will issue stock in order to generate revenue—
this revenue is then used to pay off debt, expand the company or research and develop new products. In order for a
company to issue stock, it must first go through an initial
public offering (IPO), otherwise known as “going public.”
There are two types of IPOs—startup companies and private companies that wish to go public. The company will
first hire one of Wall Street’s major stock brokerage firms to
underwrite the company. The brokerage’s investment bankers then deter­mine how many shares of stock to issue and at
what price. The brokerage also builds up investor interest in
the company before it goes public. Like­wise, company insiders have the opportunity to pur­chase shares before public
investors.
It’s wise as a new investor to avoid IPOs. Generally you’ll
end up buying when prices are high and you’ll be forced to
sell when they’re low. A great example of this was during the
Internet boom in the late 1990s. Many Internet companies
went public and investors purchased lots of stock, sending
stock prices sky high. However, a few years later, investor
interest and demand collapsed. Many investors were forced
to sell after the stocks had dropped.
How Risky Are You?
It’s important to determine your risk tolerance before you
start investing. For a younger investor, taking larger risks in
the stock market won’t matter as much because he/she has
years before retire­ment. However, for an investor nearing
retirement, high-risk investing may not be the best option.
Understand there will always be risks no matter what type
of investment you make. There are a number of conditions
that will affect a stock’s per­formance from investors’ perceptions of the stock’s value, to various market conditions, to
world events to the company’s performance and management, among other things. Even if you invest your money in
a high-yielding savings or money-market account—extremely low-risk options—you face inflationary risks.
You have the risk of losing everything in the stock market.
Yet if you don’t invest at all, you risk missing out on great
opportunities. There will always be risks. To be a sound
investor, you have to learn to recognize and minimize
your risks.
Investing Daily, a division of Capitol Information Group, Inc., 7600A Leesburg Pike, West Building, Suite 300, Falls Church, VA 22043. Subscription and customer services: P.O. Box 4123, McLean, VA 22103-9819, 800-8322330. It is a violation of the United States copyright laws for any person or entity to reproduce, copy or use this document, in part or in whole, without the express permission of the publisher. All rights are expressly
reserved. ©2011 Investing Daily, a division of Capitol Information Group, Inc. Printed in the United States of America. ID_HowtoBuyStocks0311-SK. The information contained in this report has been carefully compiled
from sources believed
to be reliable, but its accuracy isnot guaranteed. The information contained in this report has been
carefully compiled from the
sourcesStock
believed to
be reliable, but
its accuracy
is not guaranteed.
1
www.InvestingDaily.com
Understanding
Market:
How
to Buy
Stocks
Disclaimer: For the most up-to-date advice and pricing, go to www.InvestingDaily.com.
Diversification is also important to minimizing your
risks—don’t put your eggs all in one basket. As we detail the
basics of stocks, bonds and mutual funds, we’ll look at the
risks associated with each, as well as where conservative and
more risky investors should put their money.
However, if you do decide to invest in a new IPO, make
sure to read the company’s prospectus, a legally binding document it files with the Securities and Exchange
Commission (SEC). The prospectus details the company’s
future plans as well as its cur­rent financial conditions.
Types of Stock
There are two main types of stock a company can offer—
common and preferred. Common stock is the No. 1 security in the stock market. Every company that issues stock first
issues com­mon stock. Also, when the financial media refers
to how stocks fared in the market on any particular day, they
are always referring to common stock.
However, later in a company’s life, management may
decide it needs to raise more capital, such as for expansion
or an acquisition. To do so, it could issue more common
shares. However, doing so would dilute each stockowner’s
share of future earnings. A better option may be for the
company to offer preferred stock.
Preferred stock shareholders receive greater rights than
common stock shareholders. For instance, preferred holders
will always receive their divi­dend before common stockholders. And should the company have financial problems and be
forced to liquidate assets, preferred shareholders receive payment for their shares before common shareholders.
However, preferred shareholders may not receive voting
rights. They also receive a fixed dividend and don’t participate in the growth of the business. But they have greater
safety with their investment and usually earn a higher dividend yield than common stock.
Picking a Stock
So you want to invest in the stock market, but how do
you know which stocks to pick?
Investors focus on a company’s long-term value in relation to its current stock price. Traders, on the other hand,
are more focused on a company’s stock price alone and how
short-term supply and demand pressures are affecting it. As
an investor, you should believe in the company in which
you’re investing. Do you like its products? Are you happy
with the way management is running the company? Does it
have strong financials, low debt and a solid strategy for the
future?
These are questions you should ask when you’re evaluating a potential stock to purchase. Once you have found a
few companies that you believe have a significantly higher
value than the stock price, your best strategy is to buy and
hold. When you buy and hold for the long term, you generally overlook the daily ups and downs in the market and pay
more attention to the company’s long-term performance.
And bar­ring any major catastrophes, you’ll watch the value
of your investment increase during the longer haul.
2
www.InvestingDaily.com Short-term traders look to make quick profits. They buy
stock that they expect to increase in a brief period of time
and then sell out of it before it drops.
For instance, a short-term trader may purchase a stock
that is trading at $14, expecting it to rise to $15 or $16,
generally within a day or two. Should the stock drop in price
quickly, the trader will sell fast and cut losses. Consistently
predicting short-term price movements is very difficult. It
also requires a significant time commitment where you pay
close attention to the stock market generally and the price of
your particular profit exits and stop losses.
Income or Growth
Every company goes through a life cycle. It may start
out as a growth stock but later in its life, change to be an
income stock. Such companies are typically mature and generate more cash than they can use profitably to expand their
business. Consequently, income stocks pay sharehold­ers this
excess cash in the form of dividends. Older, retired individuals will often invest in income-gener­ating stocks to pay for
their monthly living expenses.
Income stocks are great for conservative investors. They
tend to be less volatile in price fluctu­ations, both down
AND up. Likewise, should the stock fall, your dividend will
help reduce your losses.
However, income stocks aren’t without downside and risk.
First, you do have to pay taxes on your divi­dends, which are
considered taxable income. Also, you face inflationary risks if
the company doesn’t increase shareholders’ dividends yearly.
Growth stocks are companies with faster earnings growth,
usually 15 percent-plus a year. Growth stocks gen­erally fall
in more volatile sectors, such as high tech or oil and gas
exploration. The company is focused on growing its earnings, so any money it brings is reinvested back into the business to expand operations. Dividend payouts are unlikely.
Growth stocks tend to ebb and flow more sharply than
income stocks. They’re also usually younger companies.
Although their businesses may not be fully flushed out, their
growth potential can cause their share prices to increase
many times over.
However, as happened during the Internet boom and bust
of 1996-2002, they are volatile. Should investor interest
decrease, growth stocks can drop quickly.
Major Exchanges
Trading has been around for centuries. From the earliest
days, humans have been bartering with each other. As this
became more sophisticated, buyers and sellers found a more
common area to meet at. In 1792, buyers and sellers met
under a buttonwood tree on Wall Street in New York City.
This gathering eventually grew in popular­ity until the group
formed the New York Stock Exchange (NYSE), giving these
buyers and sellers an organized way to trade stock.
Although the NYSE became a formalized trading
exchange, not all companies were large enough to qualify
for listing there. During the 1830s brokers of these smaller
stocks formed their own exchange outside on the curb.
Understanding the Stock Market: How to Buy Stocks
These curbside brokers didn’t move inside until 1921 and
the exchange was officially named the American Stock
Exchange (AMEX) in 1953. In 2008, the AMEX was
acquired by the NYSE and is now called NYSE Amex, but
remains a separate exchange.
In 1971, the first electronic stock exchange was opened—
the National Association of Securities Deal­ers Automated
Quotation System, commonly referred to as the Nasdaq.
Computers created a faster-paced trading system.
Today, these are the three major exchanges in the U.S.
and a total of 14 national stock exchanges. In addition,
foreign countries throughout the world operate their own
exchanges.
Indexes: Keeping Track of Investments
When you’re investing in the stock market, it’s important to keep track of the way the stock mar­ket is moving.
One easy way to do this is by watching the various indexes.
Although there are hundreds of indexes, the four most
popular indexes are the Standard and Poor’s (S&P) 500,
the Dow Jones Industrial Average, the Nasdaq 100 and the
Russell 2000.
The Dow tracks 30 stocks from the most important sectors of the market. The Dow is price weighted. That means
that whichever stocks have the higher prices per share have a
heavier weighting on the Dow average.
The Nasdaq 100 lists the 100 largest non-financial companies in the Nasdaq Composite and is a proxy for technology stocks. The S&P 500 tracks 500 stocks selected by a
committee at S&P to represent the stock market’s industry
groups. The Russell 2000 tracks the 2000 stocks in the
Russell 3000 with the lowest market cap and is a proxy for
small-cap stocks. These last three indexes are market-cap
weighted, mean­ing those stocks that have a larger market
cap (stock price times number of shares outstanding) carry a
heavier weighting. For more on market cap, see the glossary.
Over-The-Counter Stocks
An over-the-counter (OTC) equity security is any equity
that isn’t listed or traded on a national securi­ties exchange.
The OTC market has a reputation as a “Wild West-style,
any­thing goes outpost,” which is well earned. It’s where
scammers, goons and hucksters ply their trades; it’s also
where legitimate foreign operators like Swiss food company
3
www.InvestingDaily.com Nestle (Other OTC: NSRGY.PK) choose to market their
shares. In other words, the OTC market is home to companies high, low and in-between. The highest quality tier is
the OTCQX and it goes down from there.
It’s also the American market of choice for many
Canadian-based companies that don’t want to be subjected
to the regulatory morass and con­siderable expense a Nasdaq
or NYSE listing entails. These guys—real companies with
real revenues run by real people—have fully exposed themselves according to the requirements of the Toronto Stock
Exchange (TSX) and Canadian regulatory bodies.
The two competing venues for OTC stocks are the Pink
Sheets (www.otcmarkets.com), a pri­vately owned information service, and the Nasdaq-run OTC Bulletin Board
(www.otcbb.com).
The origins of the Pink Sheets date back to 1904, when
the National Quotation Bureau began it as a paper-based,
inter-dealer quotation service linking competing market
makers in OTC securities across the country.
The publication was printed on long, narrow sheets of
pink paper; hence, the “Pink Sheets.” Since that time, the
Pink Sheets have been the central resource for trading information on OTC stocks and bonds.
The OTCBB is a relative upstart, beginning operations
only in June 1990, and was intended to bring some transparency to the OTC marketplace. It’s a regulated quotation
service that displays real-time quotes, last-sale prices and volume information in OTC equity securities.
Because the SEC exerts very little power over the OTC
markets, the Pink Sheets and the OTCBB can attract crooks
and quick-buck scammers.
Pink Sheet-listed issuers aren’t required to register securities with the SEC or keep their reporting requirements
current. Nor are issuers required to file financial or other
company information.
In contrast, OTCBB companies are subject to periodic filing requirements with the SEC.
The 2002 Sarbanes-Oxley Act imposed new regu­latory,
auditing and board requirements, adding tens of thousands
of dollars to the cost of being a public company. Plus, CEOs
must personally guar­antee a company’s financial statements.
“Sarbox” has caused many legitimate foreign companies
to delist from the major U.S. exchanges and move to the
OTC marketplace.
Understanding the Stock Market: How to Buy Stocks
CHAPTER Three
Broker Basics
T
he person most people think of as a stockbroker is actually a registered representative or an account executive
working for a broker-dealer of securities. A broker-dealer
and its account executives make money through commissions on securities transac­tions. A fee is charged whenever
you buy or sell. But they don’t set up a long-term financial
plan for you.
This is an important factor to consider: If you’re seeking
advice on balancing your real estate hold­ings, life insurance
coverage, cash and securities, then you need to look for
a registered investment adviser (sometimes called a financial planner), who will charge a fee for drawing up a total
financial plan for you. The financial planner may work with
an account executive to manage your securities holdings in
har­mony with your total financial plan. Make sure that your
investment advisor has a “fiduciary” duty to operate in your
best interests. Many so-called advisors are only required to
offer “suitable” investments, not the best investments. Such
advisors aren’t suitable for anyone.
Full Service v. Discount
The first thing you should consider is whether you want a
full-service broker or a discount broker. If you do all of your
own investment research, then use a discount broker. That
will save you a considerable amount of money over time.
Discount brokers execute trades for about one-twentieth
the amount that full-service brokers often charge. Where discount brokers typically charge less than $10 for an individual
online trade, you’ll probably pay $100 or more for the average trade done through the typical full-service broker.
Full-service firms provide “advice” and often charge annual main­tenance fees through which they grant themselves a
generous slice of your assets, say about $150 a year or more.
Alternatively, full-service brokerages might grant unlimited
free trades in an account, but will charge you a “wrap fee”
equal to a few percentage points of your total assets per
year. In other words, full-service brokerages provide help at
a very high cost.
Do you get twenty times the value by using one of those
expensively dressed souls who work for Merrill Lynch,
Morgan Stanley Smith Barney, UBS and others?
Most brokers who give advice are just glorified salesmen,
shopping around their brokerage house’s stock picks or
pricey mutual funds. Why shouldn’t they? Brokers get paid
a percentage (the commission) for every sale they make. By
receiving commissions on each trade, their com­pensation is
closely tied with how often their clients’ accounts are traded.
In other words, part of the commission you pay to the firm
may wind up directly in your broker’s pocket. It’s a conflict
of interest.
Whether you’re ready to open your first discount brokerage account or simply wondering if you’re getting the best
4
www.InvestingDaily.com service for your money from your current one, here are
some issues to consider.
Commissions and Fees
Cheaper is not always better—the price per trade at a
discount broker may also indicate the level of customer
service that comes with it. If you aren’t trading in and out
of stocks very often and you’re not too concerned about
whether your trade is exe­cuted within 15 seconds or two
minutes, there really isn’t a significant difference among
the discount brokers charging $5 to $10 per online trade.
If you go much cheaper than that, you may have trouble
getting someone on the telephone to answer any questions
you have. And if you’re paying much more than that, you
should expect near-flawless service.
Furthermore, if you aren’t comfortable trading over the
Internet, be prepared to pay much higher commissions.
Some discount brokers charge up to five times as much for a
telephone order.
Beyond the trading commissions, you’ll find that brokerages may charge other fees, including fees for transferring
assets into the account, fees for closing an account, IRA custodian fees, wire trans­fer fees, account inactivity fees, annual
fees and fees for not maintaining a minimum balance. If you
know your needs, you won’t end up paying for serv­ices you
don’t need.
Minimum Initial Deposit
If you’re just starting out, consider what you’ll be able
to comfortably invest initially. Some brokers have account
minimums, so find the one that best fits your budget.
Customer Service
You should put some time into researching a broker’s
service before you sign on the dotted line. In the case of
discount brokers, customer service includes web site performance and interface. Check out each brokerage’s web site.
Is the inter­face intuitive? Can you find what you’re looking
for without having to click 65 links? Is it speedy?
If talking to a live human is important to you, test their
phone service. Does the brokerage answer the phone
promptly? Is there an office nearby, just in case you need to
talk face-to-face? You’ll definitely want to see how the brokerage does at sending you all relevant material you ask for
online.
What if the Internet breaks? Sometimes you may not have
access to a computer. Check out whether the brokerages
you’re considering also have touch-tone phone trading and
how that works. Sometimes you just might want to place an
order through a real, live person, and many discount brokerages offer that option, too.
Understanding the Stock Market: How to Buy Stocks
If you want to consolidate your PINs and pen­nies, think
about looking for a brokerage account that can accommodate your banking needs. Many brokers now offer: money
market sweeps; check writing and bill payment; Visa cards;
direct deposit; and ATM cards. Your cash will typically
attract higher interest rates in a brokerage money market
account versus the typical savings or checking account.
Research
Some brokerages market their research as a real plus.
That’s fine, but you probably don’t want to pay for it.
There’s plenty of research available on the Internet. Some of
the offerings include analyst reports, real-time quotes, and
detailed financial data.
Mutual Funds And Other Choices
No-load mutual funds can be purchased directly from
mutual fund companies, so unless you’re a mutual fund
5
www.InvestingDaily.com trading addict, the availability of thou­sands of mutual funds
in one location probably shouldn’t affect which broker
you choose. While you may purchase some no-load mutual
funds from discount brokers without paying a transaction
fee, some brokers do charge a fee for funds—so be sure to
check on this before making a purchase. And, of course, if
there’s a particular mutual fund family that you’re set on
using, make sure that the brokerage you select offers that
family of funds.
All the brokerages offer stocks traded on the major
exchanges, and most will offer equity mutual funds. But
there are a number of other investment vehicles that you
may wish to use. If you’re somebody interested in risking
your hard-earned money on over-the-counter (OTC) stocks,
you’ll have to see which brokerages offer them. Other
choices such as bonds, futures, and options are not available
through every brokerage. Determine what you expect you’ll
need, and act accordingly.
Understanding the Stock Market: How to Buy Stocks
CHAPTER four
The ABCs of Bonds
Bond Background
Historically, most investors have bought bonds for
income. They pick a solid company’s bonds and hold on for
the long haul, regardless of what happens to their prices.
Then, when the bonds come due or mature, they cash them
in at their “face” values.
This strategy is fine, provided you don’t need the money
anytime soon. As long as the company remains solvent, its
bonds will always be paid off at a set price (their face values), regardless of infla­tion. Meanwhile, your income stream
will remain constant, at the rate at which you bought the
bond.
At their core, bonds are interest rate-sensitive investments.
Most pay a fixed rate of interest over their lifetimes. The
value of this income stream to investors varies with changes
in interest rates and inflation.
Bond prices, therefore, fluctuate with changes in interest
rates and inflation. When interest rates and inflation rise, the
income stream bonds generate is worth less, so bond prices
fall. On the other hand, when interest rates and inflation
fall, bonds’ income streams are worth more, so bond prices
rise. Con­sequently, unless you hold bonds until they mature,
your total returns will depend heavily on what’s going on
with interest rates and inflation.
For example, from October 1993 to the end of 1994,
rising inflation and interest rates slashed bond prices. That
gave investors a great opportu­nity to buy bonds for income
and capital gains in 1995, as slowing inflation and falling
interest rates pushed bond prices up, handing out big profits. Bond returns were generally weaker in 1996, but the
Asian crisis of 1997 and 1998 drove investors out of stocks
and into bonds. Interest rates on long-term bonds dropped
well below 5 percent for the first time ever and bond returns
went through the roof before dropping again throughout
1999 in the face of a growing economic recovery.
Today, bonds are at a crossroads. They’ve rallied sharply
since the financial crisis of 2008-09 as the world economy
experienced the worst economic recession since the 1930s.
As a result, bonds aren’t the bargains they once were, but
they do have merit for portfo­lios if chosen carefully.
Finding Your Method
The most conservative investors will want to focus most
on bond mutual funds, which give you the broadest possible
diversification. That includes closed-end mutual funds, funds
6
www.InvestingDaily.com that trade on major exchanges like shares of stock rather
than minting new shares to the public.
Aim for those selling for less than the value of their assets,
giving you the possibility of a triple play from high income,
capital appreciation of bonds and the narrowing of their discounts.
Like U.S. bonds, foreign bonds are affected by interest rate swings. However, foreign paper has one major risk
that U.S. securities don’t: They’re denominated in foreign
currencies rather than in U.S. dollars. Consequently, they
can be affected by exchange rate swings as well as by interest rate trends. The effect can be especially severe in lessdeveloped areas, for example Asia or Latin Amer­ica. Here,
political and economic events can trigger stampedes out of
currencies that can devastate bondholders, such as what happened during the financial crisis of 1997-98 and 2008-09.
Even foreign bond mutual funds can be hurt by unexpected
events. These should be only a small part of your overall
bond investment, unless you’re a real dice-roller.
Junk bonds are one type of bond with a bad name. But
they’re definitely worth considering dur­ing a strong economy. These are securities issued by less creditworthy compa­
nies. Consequently, their prices are affected by the performance of the underlying firms, more so than interest rates.
We look at convertible securities—bonds that are
exchangeable into a set number of shares of the issuing
company’s stock. As a result, they rise in value when the
issuing com­pany’s stock rises. This gives them the ability
to benefit from faster economic growth, which boosts their
value.
Resource-rich convertibles are potential benefi­ciaries of
both higher commodity prices and faster economic growth.
That’s because they’re convertible into the stock of natural resource-pro­ducing companies. All four of these bond
groups stand to throw off monster gains and high income in
the coming months, with just slightly more risk than higherquality bonds.
We examine municipal bonds, an area that’s rapidly becoming an investment minefield. But the potential rewards are
better than ever. As always, munis are free of federal income
taxes, as well as state and local taxes in the areas where they’re
issued. Munis have suffered from concerns about their credit
quality, as well as from inflation fears. Many munis will be a
trap for investors. How­ever, there are fine alternatives, particularly in the mutual funds area.
Understanding the Stock Market: How to Buy Stocks
CHAPTER five
Bond Basics
B
efore getting into the dynamics of bonds, let’s get to
the basics—namely, what exactly is a bond? A bond is a
way for corporations (or a government institution) to borrow money to finance invest­ments. Rather than borrowing from a bank to raise money, or for that matter issuing
stock, a company borrows directly from investors. A bond
is simply a promise to repay a certain amount of money on
a given date.
When you buy a $1,000 bond with a 20-year matu­rity at
a 6 percent annual interest rate, for example, you’re essentially buying a commitment from that company to repay
you the $1,000 (the principal) at the end of 20 years, plus
$1,200 in interest. Interest payments are normally distributed every six months, in the form of “coupons,” during
the 20-year period. The interest rate on the bond typically
is determined by whatever long-term interest rates are in
the overall bond market when the bond is issued.
Mind you, even though you bought a bond, you don’t
have to hold on to it for the entire 20 years. You’re perfectly free to sell it to another investor. Five years after
buying the bond, for example, you may need some cash in
an emergency and sell it.
People are buying and selling bonds to each other all the
time, and this makes up the bulk of the bond market. You
don’t have to buy a newly issued bond.
There are several ways to invest in bonds. Which you
choose will depend on what risks you’re willing to take,
what tax bracket you’re in and how much you need income.
How much of each group of bonds you buy will depend
on your own situa­tion. Investors in higher tax brackets—
i.e., more than a 30 percent marginal tax rate—will probably want to focus on municipal bonds, which are typically
exempt from federal taxes and state taxes where issued.
same as when you bought the bond. If interest rates have
gone up to, say, 8 percent by the end of that five-year period, the face value of the bond would be worth only $750.
The reason for the price decline is because no one would
pay more than $750 for your bond. If they did so, they’d
be forfeiting profits they could make by buying a $1,000
bond with an 8 percent interest rate.
If someone bought your bond for $750, the yield on
their investment would be 8 percent (because they’re getting a 6 percent yield on a $1,000 bond). Buying a bond
like this—at a price lower than its face value—is buying it
at discount. In this case, it would have a $250 discount.
Of course, the dynamic works both ways. When interest rates go down, your $1,000 bond yielding 6 percent is
worth more. If interest rates are 4 per­cent, you could get
a handsome $1,500 for it. To cal­culate the value of your
bond, divide its annual yield by the prevailing interest rate.
In our example, divide $60 by 0.04. The result is $1,500.
What if interest rates go up and you don’t want to sell
your bond, and instead hang on to it for the full 20 years?
Even though you’d get your $1,000 back plus the 6 percent annual interest, you wouldn’t nec­essarily come out
ahead. That’s because inflation could eat away your profits.
If inflation averages more than 6 percent during those
20 years, you’ve lost money—in the sense that the real
value of your investment has decreased. That $1,000 (plus
interest) would buy less at the end of 20 years than at the
beginning. Conversely, if inflation averages less than 6 percent during those 20 years, the real value of your invest­
ment has gone up. (For simplicity’s sake, we’ve left out the
effect of taxes in these examples.)
Keep in mind that bond issuers frequently include a “call
date” in the bond agreement, allow­ing them to redeem
your bond in a few years in the event that interest rates fall
significantly. This allows them to avoid having to pay much
more than the prevailing interest rate.
When Rates Go Up, Bonds Come Down
The Importance of Credit Ratings
One of the most commonly misunderstood aspects of
bonds is that when interest rates go up, the face value of
bonds comes down. On the surface, it would seem just
the opposite: After all, because you earn money on a bond
from the interest it yields, wouldn’t you earn more if interest rates go up?
The reason this isn’t the case is because the interest
rate on your particular bond is fixed; it doesn’t change as
prevailing interest rates change. If you want a bond with
a higher interest rate, you’d have to buy a newly issued
bond.
Let’s get back to that $1,000 bond you’re selling after
five years of owning it. Assuming interest rates are still at
6 percent, you could fetch $1,000 for it (the “par value”).
But there’s the catch. Interest rates aren’t likely to be the
Like stocks, bonds aren’t 100 percent safe. When you
buy a 20-year bond, you have to be confident that the
company that issued it will stay in business. U.S. Treasury
bonds are the safest kind because, barring societal collapse,
the government will be in business in 20 years. The bonds
of large “blue chip” companies are also good bets for 20
years down the road.
Smaller companies, however, are riskier invest­ments
because they’re more likely to go out of business or
become unable to meet their obliga­tions. To help make
up for this risk, the interest rate on their bonds is higher.
And if something happens to the company that makes it a
riskier investment, that company’s existing bonds are likely
to be sold at a discount—even if interest rates haven’t
changed.
Different Strokes for Different Folks
7
www.InvestingDaily.com Understanding the Stock Market: How to Buy Stocks
Standard & Poor’s and Moody’s rate bonds according to
their safety. For Stan­dard & Poor’s, ratings range from the
safest bonds—AAA—to bonds in default—D. The pecking order is AAA, AA, A, BBB, BB, B, CCC, CC, C and
D. Moody’s ratings are as follows: Aaa, Aa, A, Baa, Ba, B,
Caa, Ca and C. Your broker should be able to tell you the
ratings for a particular bond, or you can get them from the
ratings agencies’ monthly reports, available by calling the
numbers above.
The highest ratings indicate that the issuer’s abil­ity to
meet its principal and interest obligations is extremely
strong. Midway through the pecking order, namely A-rated
bonds, the issuers are still considered strong companies
but are vulnerable to the ups and downs of the economy,
which could make it more difficult to meet obligations.
BBB and Baa bonds are the lowest investment grade and
are issued by companies whose ability to meet obligations
is adequate, but who are much more vulnerable to economic changes than higher grades. Bonds rated lower than
BBB and Baa are considered more specula­tive, normally
referred to as junk bonds.
Note that because rating agencies are paid by the issuers
of the securities being rated, there is an inherent conflict
of interest and the rating agencies often blunder by assigning ratings that are too high. Enron, for example, had an
investment grade credit rating from all three major credit
rating agencies less than a week before it filed for bankruptcy in December 2001.
The most infamous example of rating agency mistakes
occurred most recently during the 2008-09 financial crisis,
when structured pools of sub-prime mortgages to which
8
www.InvestingDaily.com the rating agencies had given the highest triple-A ratings
ended up defaulting as the housing market collapsed. You
can read all about it at www.fcic.gov.
Sources of Information
Most large daily newspapers provide their read­ers with
some coverage of the bond markets. In The New York
Times and The Wall Street Journal, for instance, the coverage is mainly done in columns titled “Credit Markets.”
The Associated Press and other news agencies also have
bond market stories on their wire serv­ices; these are available on Web sites such as Yahoo! Finance, Marketwatch and
Bloomberg, and are often published by daily newspapers.
These columns feature analyses of daily trad­ing activities
as well as discussions about current interest rate scenarios.
The perspective offered in these columns can give most
investors an idea about what the market is thinking, what
its fears are and which securities offerings have done well.
While many investors might not pay close atten­tion to
these columns or even have access to this news coverage,
the information discussed there is extremely important to
most serious and active fixed-income investors.
In addition to reporting, many newspapers include daily
price lists of actively traded U.S. Treasury securi­ties and
corporate bond prices. The net asset value of many mutual
fund shares is also listed.
Besides newspapers, there are a number of mag­azines
that specifically devote themselves to finan­cial news. These
include Barron’s, The Bond Buyer, The Economist, Grant’s
Interest Rate Observer, Institutional Investor and Investment
Dealers’ Digest.
Understanding the Stock Market: How to Buy Stocks
CHAPTER Six
Bond Mutual Funds
F
or small investors, you just can’t beat bond funds for
their ease of investment: low initial mini­mum investments, no bid/ask spreads, instant diversification, professional management, the list goes on and on. Funds are
far easier to buy and sell than individual bonds. Minimum
required invest­ments are also much lower.
One general rule of thumb when picking funds: Never
buy a bond fund with a sales load (fee charged when purchasing or selling a fund). There are always no-load funds
and ETFs that have done just as well, and more of your
money goes to work for you right away. You should also
look for bond funds that charge low expenses.
The only real disadvantage of bond mutual funds compared to individual bonds is that their income yields can
vary. The reason is that fund managers adjust their portfolios in order to maxi­mize total returns, rather than income.
A particu­larly bearish manager, for example, could shift out
of longer-term bonds, which yield more but also are affected
more by interest rates swings, to shorter-term bonds.
Also, an untimely switch by a fund manager from one type
of bonds to another could leave you out of a bull market or
subject you to some severe bear mar­ket pain, even if you’ve
made the right market call.
Consequently, investors who can afford to hold a diversified portfolio of individual bonds (at least eight different
issues)—and who plan to hold their bonds to maturity, have
a priority for income rather than total returns, or who don’t
mind more active trading—may be better off with individual
bonds rather than funds.
9
www.InvestingDaily.com Foreign Bond Funds
International bond funds are an easy way to cash in on
the global bond boom if you lack the time or money to buy
individual bonds. Foreign bond funds give you instant diversification over several coun­tries, maturities and issues.
That’s vital to reducing the political and eco­nomic risks
associated with going global. Funds also provide management expertise and allow you to own issues that may be
impossible or prohibi­tively expensive to buy individually.
And while foreign bond accounts require at least $20,000 to
avoid exorbitant bid/ask spreads, com­missions and fees, funds
can be purchased with as little as $1,000—less for IRAs.
On the negative side, even no-load fund yields are
reduced by management expenses. Many man­agers also run
with the herd, sticking with the same markets even buying
the same bonds as their colleagues. Naturally, that leaves
them vulnerable to the same traps.
The key to maximizing foreign bond funds’ potential and
dodging the occasional perils they send your way is to pick
conservatively. That means buying funds that invest in countries with high real interest rates, flat yield curves, fiscal and
monetary stability, positive investment flows, a positive bal­
ance of trade, low inflation and low event risk.
Funds should also be relatively diversified between world
regions Asia/Pacific, Europe and the Americas just as a balanced global bond port­folio should. Of course, fund investors must ulti­mately rely on the discretion of the managers,
and even the most current portfolio data available is usually
months out of date. The solution is to stick with funds that
have held down losses in bear markets.
Understanding the Stock Market: How to Buy Stocks
CHAPTER Seven
Junk Bonds
H
igh-yield or junk bonds are issued by corpora­tions with
low credit ratings (rated BB or less). The issuing companies may lack a long operating his­tory or their ability to meet
their interest and princi­pal obligations may be somewhat in
doubt. But to attract investors, they’re forced to offer a higher
rate of interest on their bonds than those paid on investmentgrade bonds of comparable maturities.
Junk bonds have a risk profile similar to common stocks and
are at the opposite extreme from Treasuries in terms of safety.
Junk bonds’ high yields make up for their risk. Despite their
unflattering beginning during the 1980s, junk bonds have
outperformed high-grade bonds over time. Their interest rates
were four to five percentage points above those of AAA-rated
bonds. Losses because of default reduced yields on junk bond
portfolios by about 1.6 percentage points in typical years and 4
to 4.5 percentage points during major recessions.
Because of the risk of default, it’s important to have a goodsized portfolio of junk bonds. Owning fewer than 10 junk
bonds is treading in the waters of speculation, not investment.
The biggest risk to junk is a recession, which puts weaker
companies in jeopardy. But well-chosen junk should reward
investors with high income and capital gains, both from falling
interest rates and from improvement in bonds’ credit quality.
Given the relative risk of junk, conservative play­ers will want
to stick with junk bond mutual funds, which give you instant
diversification. More aggres­sive investors can nibble on individual junk bonds, which promise big-time gains as the underlying
companies return to good financial health.
CHAPTER Eight
Convertible Securities: The Stock/Bond Hybrid
C
onvertibles are bonds that you can convert to shares
common stock. The time to do this is when the stock
reaches the “conversion price”— the point at which the
stock is well above (usually 15 to 30 percent) its price when
the bond is offered for sale.
Prices of convertibles move based on both interest rates
and a company’s stock price. They offer the potential for
growth and also a measure of safety. The profit potential on
them is higher than that of conventional bonds and they’re
less risky than stocks.
Investors like convertibles because they pay higher yields
than most stocks, and because a con­vertible’s value doesn’t
drop as much as the corre­sponding stock when the stock
price falls. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stock, companies’ debt vanishes. Also, convertibles carry lower interest
rates than regular bonds.
Convertible securities are a popular low-cost way for small
companies to raise cash to finance business activities. For
investors, convertibles pay bond-like yields while offering
the potential for capital appreciation if a company’s stock
price rises. In a nutshell, convertibles offer the poten­tial for
very high rewards with little risk.
A convertible bond is like owning a bond with an option
to switch into a specified number of shares of the issuing
company’s common stock at a later date. There are also
convertible preferred stocks that are convertible into shares
of the com­mon stock.
Because they pay high yields, convertibles offer downside
protection in a declining stock market. And if interest rates are
10
www.InvestingDaily.com rising, convert­ibles generally don’t fall as much as bonds. But
convertibles are often misunderstood and over­looked by investors. These investments are diffi­cult to understand, and there’s
a decided lack of information available regarding convertibles.
Convertibles are a great investment when the outlook for
the stock market is unclear and returns in the bond market
are small. That’s because if the underlying common stock
appreci­ates down the road, convertible shareholders will
enjoy a large portion of that gain—something you won’t get
holding a bond. In the meantime, you’ll earn a fat yield.
The tradeoff when buying a convertible instead of a bond
is that the convertible security is gener­ally considered a
“subordinated debenture.” In plain English, that means if
the company goes bankrupt, the bondholders would be paid
off before shareholders of the convertible.
Convertible bonds trade at a pre­mium to their value if
they were switched into common stock. Convertibles trading at low premiums to their conversion value occur when
the stock price is above the bond’s conversion price and
conversion is likely. These convertibles tend to behave like
stocks. In contrast, convertibles trading at large premiums
to their conversion value occur when the stock price is
below the bond’s conversion price and conversion is unlikely. These convertibles act more like bonds and are more
interest rate sensitive.
Most convertibles feature “call” provisions. This means
that the issuer can forcibly redeem them at a predeter­mined
price. For these reasons it may be best to leave investing in
convertibles up to the pros and go the mutual fund route.
Understanding the Stock Market: How to Buy Stocks
CHAPTER Nine
Muni ABCs
M
unicipal securities represent loans to a state, a legally
constituted political subdivision of a state or a U.S.
territory. They’re issued to raise capital to finance public
works and construction projects that benefit the general
public.
Examples include construction and mainte­nance of streets
and highways, water distribution and sewage systems, and
public welfare and health services. There are only two major
cate­gories of municipal securities issues: general obligation bonds (secured by local tax dollars, both property and
income) and revenue bonds (secured by revenue other than
tax dollars).
The interest on most municipal securities is exempt from
federal income taxation. The federal government doesn’t tax
the debt obligations of municipalities. In many cases municipal bonds are also exempt from state income tax for investors who live in the state where the bond is issued or who
purchase bonds issued by a US territory.
The tax advantage of municipal bonds allows municipalities to offer the bonds at lower interest rates than the rates
of taxable bonds. The result is municipal bonds are more
attractive to investors in high tax brackets than those in
lower brackets.
The greatest advantage a tax-exempt bond offers an investor is tax-free income. In the wake of changes in federal tax
laws, these bonds provide one of the few remaining tax shelters. In addition, the liquidity of the secondary tax-exempt
market has offered many investors the chance to earn some
large principal gains. Just like the corporate market, taxexempt securities are sold to numerous institutional and
individual investors every day.
General Obligation Bonds
General obligation bonds (GOs) are issued by state and
local governments and are secured by local tax dollars, both
property and income, which can be raised to meet principal and interest payments if nec­essary. This type of security
is the basic tax-exempt bond sold by school districts and
municipalities across the country.
GO holders have a legal claim to the revenues received by
a municipal government for payment of the principal and
11
www.InvestingDaily.com interest due them. GOs are used to raise funds for those
municipal capital improvements that typically don’t produce revenues (remodeling a volunteer fire department, for
example).
Because general obligation bonds are backed by the taxing
powers of the municipal issuer, they must be approved by
taxpayers voting in a referen­dum. Interest earned on GOs
is exempt from fed­eral taxes as well as the taxes of the governments within the state in which the securities are issued.
Interest is normally paid twice a year on the bonds and the
coupon rates typically are lower than rev­enue bonds with
similar investment risk.
Revenue Bonds
Revenue bonds are payable only from the earn­ings of specific revenue-producing enterprises. The quality of revenue
bonds is determined by sources of revenue, feasibility studies, maturity structure, call provisions, application of revenues and other agree­ments. The taxing power of a local or
state govern­ment doesn’t back up the bonds if the revenue
stream doesn’t meet the debt service requirements.
Revenue bonds are sold to finance the con­struction of
public utilities, airports, toll roads, economic development,
housing, state student loan programs, college dorms, stadiums and health care facilities. They’re the more common
form of municipal issue and can be used to finance any
municipal function that generates income. The sources of
revenue for interest and principal payments come from tolls,
concessions, fees for operations and rental payments.
Typically a municipality might create a bond authority,
which is given the responsibility for the issuance of bonds
and the collection of revenues that will be used to pay
bondholders’ principal and interest.
As with all fixed-income securities, the investor is likely to
be concerned about the chances that a revenue stream will
not provide enough cash flow to meet principal and interest
payments. Some rev­enue bonds are considered to be highly
risky investments that are damaged during economic downturns, whereas others are considered safer than GO bonds
because they are backed by very stable and real assets.
Understanding the Stock Market: How to Buy Stocks
CHAPTER Ten
Mutual Fund ABCs
What is a Mutual Fund?
A mutual fund is a pool of money controlled by an investment company that raises money from shareholders and
invests it in stocks, bonds or virtually any other type of legal
investment. You can think of a mutual fund as a group of
people with similar investment goals putting their money
together to increase their profits. They hire a pro­fessional
manager to invest that money. The man­ager must be able to
adapt to sudden changes in the financial climate and adjust
the fund’s hold­ings accordingly.
The ease with which mutual funds allow investors to
access all sorts of asset classes has resulted in tor­rid growth.
In the late 1940s, there were about 100 mutual funds in
existence, with assets totaling about $2 billion. At the end
of 1970 there were 361 funds with assets approaching $50
billion. The industry has exploded since then: Today there
are over 7,000 funds, with assets exceeding $11 trillion.
But it’s up to each investor to personally craft his or her
portfolio to their risk tolerance and objectives. With that
in mind we’ve given a brief synopsis of the different funds
available to investors below.
CHAPTER Eleven
Funds That Match Your Personal Style
S
ince different funds are designed to meet different
objectives, the first step is to identify the correct type of
mutual fund—one that matches your needs and personal
investing approach.
Mutual funds fall into three general categories:
Equity Funds—These invest solely in shares of common
stocks.
Fixed-income Funds—These purchase corpo­rate or government securities offering fixed rates of return.
Balanced Funds—These invest in a combina­tion of stocks
and bonds.
But these categories are only the beginning. Within each
is an entire spectrum of choices. There are a great variety of
equity funds. Here are some of the options:
Aggressive Growth: These funds are invested in stocks
of emerging or turnaround firms that generally don’t pay
cash dividends. The major fund objective is the pursuit of
capital gains. Aggressive growth funds can use options, buy
stocks on margin and carry out other risky activi­ties. Profit
potential is above average but risk exposure is very high.
Aggressive growth funds can be highly volatile. They’re best
suited for investors still building their wealth and with a
long time horizon.
Balanced: Allocates money between stocks and bonds.
The typical balanced allocation is 60% stock and 40% bond.
These funds aim to conserve capital as well as seek income
and growth. Growth potential is moderate to high, and your
risk exposure is average.
12
www.InvestingDaily.com Convertible Securities: Invests in convert­ible bonds and
preferred stocks. A convertible bond can be converted into
shares of common stocks at the option of the holder. One of
the appeals of convertibles is that typically when stock prices
rise, these bonds tend to follow suit. However, when stock
prices fall, bond prices usu­ally remain flat. Generally, investors can expect higher-than-average current yields and less
price volatility than in an equity income fund.
Corporate Bond: If you’re investing any amount less than
$100,000 at a time, you’re better off with a mutual fund
than with individual corpo­rate bonds. These funds allocate
capital among bonds of varying investment grades and
expiration dates, including some government issues. Your
income potential depends on movement of interest rates and
bond quality.
Note that there’s an opposite relationship between the
prices of these funds and interest rates. When interest rates
fall, share prices rise and vice versa.
Asset Allocation Funds: Managers shift from stocks to
bonds to money market instruments, depending on eco­
nomic and market conditions. Your returns depend on
the manager’s ability to time the mar­kets. Heavy trading
“account churners” (man­agers who buy and sell investments
constantly) can lower your returns.
Ginnie Mae or GNMA: Invests in pools of mortgages
backed by the Government National Mortgage Association,
though the funds themselves aren’t government guaranteed.
As with bond funds, share values can rise when interest rates
drop. Problems arise when mortgage holders refinance mortgages at lower rates, reducing your chances for capital gains.
Understanding the Stock Market: How to Buy Stocks
Global Bond: Buys corporate and government bonds from
around the world. Profit potential is high but so is risk
exposure—subject to whims of the world marketplace, currency fluctuations, politi­cal uncertainty and the like.
Growth: Purchases common shares of well-established
firms with above-average growth rates. Fund managers are
more interested in stock price appreciation than dividends.
The idea behind growth funds is that while stock prices
may fluctu­ate over the short run, they have historically pro­
duced the greatest gains over the long term. These funds
move with the stock market. Growth funds are best-suited
to investors who are in for the long haul-planning for retirement over a period of sev­eral years or longer.
Growth And Income: These are more conserva­tive than
the pure growth funds. Managers purchase a combination
of stocks offering long-term growth and a steady stream
of dividend income. The more conservative the growth
and income fund, the more it invests in income-producing
securities, while funds emphasizing more growth are a bit
more aggressive. By investing a portion of assets in bonds
and divi­dend-paying stocks these funds receive income that
moderates the effects of daily price swings in the stock market. Before buying a fund, make sure the mix of growth
potential and income matches what you’re looking for.
High-Yield Bond: Invests in low-rated “junk bonds”
(generally rated BB or lower). Profit potential comes from
dividend income. As the econ­omy expands, demand for junk
bonds will pick up because issuers will be more likely to
meet their obligations. Conversely, when the economy slows
or enters a recession, junk bonds fair poorly. These funds are
for risk lovers only.
Income-Bond: Managers buy certificates of debt issued by
corporations, the U.S. Treasury, federal agencies and state
and local governments. Some bond income funds also invest
in instruments issued by foreign companies and governments. They’re for safety oriented investors seeking income
in the form of dividends.
Income-Equity: Fund managers pursue a high level of current income for shareholders by invest­ing primarily in stocks
with good dividend-paying records. These funds are safe and
conservative.
International Equity: Managers invest at least two-thirds
of their portfolio in stocks outside the U.S. Profit potential
includes income from stock price appreciation, dividends
and currency fluctua­tions. Downside risk includes susceptibility to cur­rency swings and political instability. Yet the
prospect of profits is high because managers can go where
the action is. Risk exposure is consider­ably above average.
Long-Term Municipal Bond: These funds hold bonds
issued by states, cities and towns that are generally exempt
from federal taxes, and in some cases state and local taxes
too. If you fall within the highest income tax bracket, chances are you could benefit from investing in a tax-free fund.
Profit potential depends on interest rates and bond quality.
Money Market: Managers invest in short-term debt from
13
www.InvestingDaily.com the government, major banks and the safest corporations.
Typically, these securities mature in less than 90 days.
Money market funds are very conservative investments, and
are considered to be the equivalent of cash. Money markets
are the most popular type of fund today, or whenever there’s
eco­nomic uncertainty.
Money market funds are designed to offer investors two
major benefits: stability of princi­pal—you won’t lose any
of your principal; and reg­ular income. The risk in money
markets is extremely low. The major drawback is that you
get mediocre returns, only a little above those of a savings
account.
The problem is exacerbated in today’s environ­ment, with
short-term interest rates still relatively low. Even if you’re
a very conservative investor, it’s a good idea to consider
income funds and bond funds rather than just money markets.
Option/Income: Managers purchase securities paying regular dividends, then augment income by writing call options
on the portfolio. Investor profit potential is good, but top
performers will get “called” away if the market skyrockets.
These are risky funds with complex strategies; read the prospectus care­fully before buying.
Precious Metals: These funds typically hold two-thirds
of their portfolios in gold, silver or other precious metals.
Many also invest in the shares of mining companies, which
tend to correlate strongly with the metals market. Some
funds limit their investments to geographic regions, while
others invest globally. Investor returns are at the mercy of
metals prices and can be quite volatile. If you think inflation
is about to accelerate, it’s a good time to consider metals
funds.
Sector: Fund managers buy stocks of a certain industry
such as biotech, utilities, health care, etc. These funds aren’t
diversified among industries so share prices are subject to
the condition of the sector. Pros suggest investors buy four
or five top-quality stocks in a specific sector rather than a
sector fund. Why? In an effort to diversify, fund managers
typically load up on the bad and the ugly along with the
good.
But if you believe a certain industry is about to take off and
you don’t have the time or inclination to research a group of
stocks, sector funds can be useful. Your profit prospects are
good because your eggs are in one basket. That’s the downside, too: Top performers one year can be dogs the next. Just
ask long-term biotech investors, who watched their 1992
holdings fall into an abyss after reaching new highs in 1991.
Ditto for financial sector funds in 2007-2008.
Small-Cap Stock: This type of fund concentrates on companies that are much smaller than the tradi­tional blue chips
such as Johnson & Johnson or ExxonMobil. The fund manager picks stocks he or she considers to be undiscovered
gems and potential superstars, so your risk exposure ranges
from above average to very high. In fact, there’s the danger
that some of the manager’s picks will disappear com­pletely.
These funds are for adventurous investors.
Understanding the Stock Market: How to Buy Stocks
Short-Term Municipal Bond: Known as tax-free moneymarket funds, they invest in securities issued by states and
localities. Interest payments are usually exempt from federal income tax. Investor return is derived from dividend
income, so there is no capital gains potential here.
Single-State Municipal Bond: Portfolio managers hold
bonds of one state so that residents can earn income exempt
from federal, state, even local city taxes in certain cases. Your
profit potential and risk exposure depend on the term of the
bonds and the economy of the particular state.
Stock Index: A basket of stocks that mirror the performance of well-known stock indexes such as the Standard &
Poor’s 500. Your profit potential mirrors that of the market
14
www.InvestingDaily.com as a whole; if you think the stock market is about to drop
sharply, it’s a good time to sell one of these funds short.
Index funds are almost always fully invested, leaving little
cash to sit and earn nothing. They also have minimal turnover of investments, which reduces the taxable capital gains.
Another benefit is that, due to the simplicity of man­aging
these funds, expenses tend to be very low com­pared with
other funds.
U.S. Government Income: Invests in vehicles backed by
the federal government, including agency securities like
Ginnie Maes and Treasury bonds. Profit potential depends
on interest rates; like corpo­rate bonds, share prices rise when
interest rates fall.
Understanding the Stock Market: How to Buy Stocks
CHAPTER Twelve
Open-End and Closed-End
T
here are two kinds of mutual funds: open-end funds,
which have a varying number of shares, and closed-end
funds, which have a fixed number of shares.
Open-end funds constantly issue new shares for new
investors and redeem (buy back) shares from existing investors when they want to leave the fund. Sometimes funds will
“close” to new investors, at which time they stop issuing
new shares. Pur­chases of open-end mutual funds are generally made directly through the fund, without any extra fees
for brokers. When an investor purchases shares, payment
is made to the fund and new shares are issued. This is the
most popular type of fund offered today.
Closed-end funds are publicly traded mutual funds.
During the 1920s, closed-end funds were the dominant type
of pooled investment, becoming less popular with the coming of open-end funds. But in recent years, closed-end funds
have enjoyed renewed popularity.
Here’s how a closed-end fund works: After the ini­
tial public offering, fund shares are traded on one of the
major stock exchanges or in the over-the-counter market
like regular stocks. Ordinarily, publicly traded funds have a
fixed number of shares, mean­ing the price will appreciate as
demand increases for the fund. This can result in a premium
for the fund, above its net asset value (NAV).
Shares of closed-end funds are purchased through a broker, just like a stock. This means you’ll pay a commission
just as you would when buying or selling any other security.
Closed-end funds can be particularly advantageous when
they’re selling at a discount to their NAV.
Comparing Funds
When you decide which category of mutual fund you want
(e.g., small cap, bond fund or sector fund), you’ll want to
compare the fund’s perform­ance with that of its competitors.
There are several factors you should pay spe­cial attention
to, including the fund’s fees, man­agement and performance.
• Fees—Make sure they’re not high compared with those
of competitors. Find funds with low expense ratios. For
domestic stock funds, stay under expense ratios of 1.50
percent, and for bonds stay under 1 percent. There’ll
sometimes be exceptions but these are good guidelines.
Remember, expense ratios come right off your returns, so
keeping them low means better returns.
• Management—Invest in funds that have a con­sistent performance at least through the last three years as well as a
manager that’s been around for that period of time. You can
make exceptions for man­agers that have recently switched
funds but have a substantial number of years managing
money. But investors should be very careful about sticking
with funds where the manager has left the fund.
• Performance—Avoid chasing funds with short-term “hot”
performance. Academic studies have shown that investors
15
www.InvestingDaily.com who put their money into the top-performing fund for a
short period of time like a year are setting themselves up for
a disappoint­ment. Funds that are at the top of the performance list for one year are likely to be ones where a man­
ager took a big chance and got lucky. That typically doesn’t
repeat itself over time. It’s especially impor­tant to look at
fund performance in both bear and bull markets to get an
idea how a fund performs through an entire market cycle.
Good time periods to use for bear market performance
include the second half of 1990, 1994, the third quarter of
1998, 2002, 2008, and the first quarter of 2009.
Accounting For Risk
Last, don’t look at performance in a vacuum. When examining performance, the most important factor to look at is
how much risk the fund took to generate its returns. One
way to determine that is to look at a fund’s Sharpe ratio.
It’s calculated by taking a fund’s total return over a period
of time, subtracting the risk free rate—which is the T-bill
return over the same period of time—and then dividing by a
fund’s standard deviation.
The higher the Sharpe ratio, the better the fund’s return
on a risk-adjusted basis. Once you get the number, see how
it compares with the S&P 500 or other relevant index as
well as to other funds you’re considering buying.
The Benefits Of Mutual Funds
There are many reasons investors own mutual funds. For the
individual investor, mutual funds pro­vide the benefit of having
someone else manage your investments, maintain records for
you and diversify your resources into many different areas that
otherwise may not be available or affordable to you. Reasons
for owning shares of a mutual fund include the following:
• Diversification—The most successful investors are those
who avoid putting all their eggs into one basket. By its very
nature a mutual fund is diversified—assets are invested in
many different securities, as long as they agree with the
stated objectives of the fund. What’s more, there are many
different types of mutual funds, with dif­ferent investment
objectives, levels of growth potential and risk that allow you
to diversify your own portfolio even further.
The beauty of funds is that they allow you access to a
broad spectrum of investments, no matter what the size of
your bankroll. Funds allow investors to create a diversified
investment portfolio without having to own the individual
stocks or bonds them­selves. The fund manager chooses a
mix of many different securities, within the fund’s stated
goals, so that the performance of any one particular secu­rity
shouldn’t have an enormous effect on the fund. This safely
distributes the fund’s risk exposure among many securities.
Compare this situation to buying securities directly:
Suppose you invest a large portion of your portfolio in a sinUnderstanding the Stock Market: How to Buy Stocks
gle stock or bond. The value of your portfolio will depend
heavily on how that security per­forms. If one price falls,
your portfolio could lose a significant portion of its value.
It’s, of course, possible to create a diversified portfolio of
your own. But when you factor in the costs of broker fees
and the time you spend doing research on many different
companies, the fund advantage becomes apparent.
• Professional Management—Mutual funds are run by professional portfolio managers, searching out the best securities
available for the fund. That choice of securities is, of course,
also controlled by the fund’s stated investment objectives.
Professional management is a somewhat over­stated benefit. Why? Management is “professional” only if it produces
a return that outperforms the market. Anyone can fail.
Nevertheless, research indicates that a mutual fund will
often perform poorly if its manager is replaced, which may
be why funds don’t like to reveal management changes. The
Securities and Exchange Commission (SEC) is currently
looking into new disclosure rules to address this problem.
But once a manager has established a solid track record,
investing in his or her no-load fund is a superb way to get
top-quality management at no cost. The key is to keep track
of any changes at the helm.
• Liquidity—Another benefit of mutual funds is the ability to move money into and out of your account with ease.
Unlike CDs, where your money is tied up for a period
of time, mutual funds are designed so that access to your
money is as easy as a phone call. Moving money from one
mutual fund to another, withdrawing funds at a moment’s
notice and writing checks on your account are just some of
the benefits of the liquid­ity of mutual funds.
• Low Trading Costs—Mutual funds buy and sell securities
in large blocks, thus reducing their trading or commission
costs. This benefit passes through to the investor. Imagine
the commissions you’d pay to buy or sell each of the securities held within the portfolio of a diversified mutual fund!
• Retirement Planning—Most funds are available in several
different types of accounts, including retirement plans like
Individual Retirement Accounts (IRAs) and 401Ks.
• Dollar Cost Averaging—Since mutual funds can be purchased in small amounts and at regular intervals, they’re
ideal vehicles for “dollar cost aver­aging”—buying a set dollar amount of shares each month, resulting in more shares
being purchased when their price is down.
• Automatic Reinvestment—This allows your fund to use
all your dividends and capital gains dis­tributions to buy
more shares. Using this method effectively compounds your
investment in much the same way that interest compounds
at your local savings bank. What’s more, most dividend
reinvest­ment plans charge no sales commissions.
• Automatic Withdrawal—If you’re recently retired, you
may find that your pension and Social Security benefits
don’t stretch far enough to main­tain the standard of living
you would like. One solution is to take advantage of the
automatic withdrawal plans offered by many mutual funds.
16
www.InvestingDaily.com If the shares in your fund account exceed the mini­mum set
value (typically $5,000 or $10,000), you can elect to receive
monthly or quarterly pay­ments in a specified amount of $100
or more. Fill­ing out some simple paperwork is all that it takes
to get started. Before you elect to use an auto­matic withdrawal plan, make sure that your princi­pal will outlast both you
and your spouse. If you’re withdrawing more each year than
you’re earning, your assets will eventually be exhausted. It’s
best to play it safe and withdraw only what you need.
• Ease of Investment—Buying a fund is easier than opening
a bank account. Simply call the fund (almost all have 800
numbers), ask if the fund is for sale in your state and request
a new account appli­cation. If you have questions after you
receive the prospectus and application, telephone the fund
once again. Most funds are extremely responsive and want
to help investors open new accounts.
• Special-Purpose Funds—Innovations during the past two
decades have made funds available in almost every type of
security imaginable. Regard­less of the type of investment
you seek, there’s likely to be a mutual fund to serve you.
• Fund Switching—You can buy or sell a fund over the
telephone or Internet. Major fund families may be able
to help you 24 hours a day. Many investment companies
allow you to switch from one load fund to another within
the fund family without paying an additional sales charge;
some even allow you to reallocate invest­ments among
multiple funds without regard to minimum initial investment thresholds. This service allows investors to switch
objec­tives with minimum hassle and usually at no cost.
A popular operation is for investors to switch between
growth funds and conservative money market funds in
an effort to reduce risk in an uncertain market. Keep in
mind, however, that many fund families discourage shortterm trading by charging a redemption fee if you switch
out of a fund too quickly (e.g., prior to the end of a
60-day holding period).
• Less Paperwork—Investment companies do most of the
paperwork for their shareholders, total­ing gains and losses for
each investor at the end of the year for tax purposes. Funds do
all of the day-to-day chores; all you do is give them the money.
Mutual Fund Drawbacks
It’s important to consider the possible down­side of mutual funds as well as their advantages. Aside from loads and
fees, the main drawback to mutual funds is that you have
no influence over the decision-making process. You can’t
telephone your fund manager and suggest she purchase this
stock or that bond. That’s why evaluating the manager’s
track record is so important.
Also, a fund can switch managers and give no warning to
the investors. A brilliant stock picker may be replaced by a
mediocre analyst. In fact, the manager who succeeds a stellar predecessor almost always disappoints, simply because
there’s a limited number of brilliant stock pickers out there.
So you have to keep an eye on your fund and be ready to
shop around for a new one.
Understanding the Stock Market: How to Buy Stocks
CHAPTER Thirteen
Nuts & Bolts
M
utual funds can be purchased directly from investment companies, at banks, insurance compa­nies and
through stockbrokers. Ownership comes in the form of
shares. As a shareholder, you own a certain number of fund
shares, depending entirely on how much money you’ve
invested in the fund.
Closed-end funds are traded in the marketplace just like
stocks. They must be purchased and sold directly through a
broker who’ll charge his standard commission fee.
To buy shares of no-load open-end funds, you can either
deal with the investment company directly or you can purchase shares through “fund supermarkets” offered by several
discount brokerages. The advantage of purchasing funds
through a broker is that all of your funds are reported on the
same statement, which makes it easier to keep track of your
fund asset allocation. A potential disadvantage is that the broker may charge you an extra commis­sion for the service.
A few fund companies require no minimum investment at
all. Still, most funds demand that you put up an initial stake
of at least $1,000. Initial minimums for IRA accounts are
usually much less, allowing investors to throw in as little as
$50 at regular intervals.
How Share Prices Are Determined
Prices are based on the net asset value (NAV) per share—
the value of all investments owned by the fund, divided by
the shares outstanding. With an open-end, fund investors
pay the NAV per share, plus commissions if any. With a
closed-end fund investors may pay more or less than the NAV
depending on the popularity of that fund at any given time.
Prospectus
Many investors approach the prospectus as a dull chore
and only give it a cursory review. That’s a big mistake.
Even if you already own a fund, you should carefully read
the prospectus. The Securi­ties and Exchange Commission
requires funds to give one to each prospective buyer; funds
also make them available upon request.
If the prospectus reveals that your returns haven’t been
commensurate with risks, you should consider moving into
another fund. Indeed, a com­mon cause of dissatisfaction is
when a fund’s invest­ment objective doesn’t match the investor’s needs. That objective—and the risks of achieving it—
are spelled out in the prospectus.
Other essential data to look for include: mini­mum initial
investment and subsequent require­ments; services, such as
the fund’s exchange pol­icy, automatic investment program
or check writing privileges; and fees. Always reported, in
table for­mat, are all expected expenses. Fees are broken
down into two groups: shareholder transaction fees and
annual fund operating expenses.
If a fund calls itself “no-load,” make sure it doesn’t impose
17
www.InvestingDaily.com a contingent deferred sales charge (CDSC) or a higher annual
expense ratio than a share class that does charge a load. If it
does, it’s not a true no-load fund. About 40 fund families
offer two or three classes of shares in the same fund. Class
A shares typically have a front-end sales load, while Class B
shares usually have a CDSC that starts at 5 or 6 percent and
declines over a period of years until it finally disappears and
the Class B shares convert to Class A shares. Class C shares
usually impose only a one-year CDSC, but they don’t convert
to Class A shares and investors must keep paying the higher
annual expense ratios in perpetuity for as long as they own
the fund. B and C shares often look like the better deal, since
all of your money goes to work right from the start. But
don’t be fooled; in exchange for no upfront load, Class B and
C shares charge CDSCs and impose higher expense ratios and
“12b-1” marketing fees.
Even if you hold the fund for more than five years, your
returns may be higher in the Class A shares. Some funds
also charge for switching assets among their funds, typically
within a specified time frame. If you plan to move in and
out of related funds often, check the cost and the permitted number of moves per year in the prospectus. Also, don’t
overlook any loads attached to reinvested dividends, a function most funds provide for free.
The “Total Fund Operating Expenses” line is the sum of
all operating expenses. For stock funds, total expenses average about 1.25 percent; the average bond fund’s expenses
are 0.75 percent. Established, diversified funds that charge
more are limiting your returns. Funds must report in the
prospectus the effect of expenses on a hypo­thetical $1,000
earning 5 percent annually over various time frames. If
expenses are excessive, consider another fund.
The “Investment Objective and Policies” section spells
out the fund’s goal and outlines the types of investments
management can buy. The “Purchases, Redemption and
Exchanges” section explains where to call or write to buy
shares, redeem holdings or switch assets among funds.
Fees And Expenses
Mutual fund fees and expenses can vary enor­mously. The
most outrageous type is called a sales load, where funds
charge a commission each time you buy shares. Loads fluctuate from less than 3 per­cent to a maximum of 8.5 percent;
those charging the most are usually purchased from brokers.
Mutual funds that don’t have any sales charges are called
“no load” funds. These funds, and there are hundreds of
them, typically sell their shares directly to the investor. All
funds charge a management fee to cover the costs of managing the fund. Many investors are unaware of it because
they don’t pay this fee directly. Instead it’s calculated into a
fund’s share price every day (share prices are “net” of fees
and other expenses).
Understanding the Stock Market: How to Buy Stocks
Redemption Fees
Record Keeping
A few mutual funds also assess a redemption fee that you
pay when you redeem—sell—your shares. These charges
range from 1 percent up to more than 5 percent of the
amount of the sale. Some redemption fees are imposed solely to discourage investors from frequent trading, which can
actually be viewed as a good thing for long-term investors
since frequent trading can increase a fund’s expenses.
Certain funds have redemption fees on a declining scale.
They take 5 percent of your money the first year, 4 percent
the second, etc., ending after about five years. The longer
you hold these funds, the lower the deferred sales charges.
Redemption fees are slightly preferable to sales charges
because income can be earned on the extra money until
redemption. Still, it’s worth shopping around to find quality
funds that put all your money to work for you.
A few funds levy a reloading charge on reinvest­ment from
capital gains distributions. The maxi­mum permissible reloading charge is 7.25 percent of the total investment amount.
So after a $100 capi­tal gains distribution, $7.25 would be
retained by the fund as a selling fee.
The charges to promote and advertise the fund to prospective investors are called 12b-1 fees. These typically range
as high as 1.25 percent of the value of your investment
annually and are now levied by more than half of all funds.
Some mutual funds charge fees to compensate brokers
for servicing accounts of investors that bought fund shares
through their firms. These charges are usually about 0.25
percent per year of the value of your investment. Savvy
investors will avoid this fee by purchasing shares from the
mutual fund directly.
As of now, brokers are only required to report the
gross proceeds from sales, which is pretty useless by itself.
Consequently, keeping accurate records of your mutual
fund purchases is a must. Always keep on file the date and
number of all shares purchased, plus the price paid for each
of those shares. Also record the date on which shares were
sold, as well as the number and price of any shares sold.
These records should also be kept for all rein­vested dividends. Most people end up paying more in taxes than is
necessary, simply because they fail to include reinvested
dividends in their cost basis. So they end up paying taxes on
them twice.
Many funds provide this information in their monthly
or quarterly statements, and all funds include this information on the annual IRS 1099-B forms. For more on mutual
funds and taxes, pick up a free copy of IRS Publication 564,
“Mutual Fund Distri­butions.”
Relief from all this red tape is on the way. In October
2008, Congress passed the Emergency Economic Stabilization
Act, which requires brokers to report “adjusted” cost basis
for taxable accounts to the IRS and taxpayers via Form
1099-B starting with tax year 2011. The adjusted cost basis
is the original cost basis and any adjustments due to corporate actions such as stock splits and dividend payments. The
legislation applies to securities acquired on or after the effective dates as follows:
Management, Administrative Fees and
Trans­action Costs
These charges include:
• Transaction costs incurred by the fund in buying and
selling securities.
January 1, 2011, for equities
January 1, 2012, for mutual funds, ETFs and dividend
reinvestment plans (DRIPs)
January 1, 2013, for other securities (including fixed
income and options)
The legislation also requires that the new Form 1099-B
indicate if the gain or loss is short- or long-term, and the
amount of any loss disallowed under the wash sale rules.
• Operating expenses such as rent, phones, employee
expenses, etc.
• Portfolio management fees paid to fund man­agers.
All of these costs vary from fund to fund, but should be no
more than 1 percent to 1.5 percent of total assets per year.
18
www.InvestingDaily.com Understanding the Stock Market: How to Buy Stocks
CHAPTER Fourteen
Exchange Traded Funds
T
he first exchange-traded fund (ETF) made its debut in
1993 on the American Stock Exchange. The first day’s
trading volume: a little more than 1 million shares.
Fast forward 17 years and that same ETF, the S&P 500
Depository Receipt (NYSE: SPY), now trades on the NYSE
and rou­tinely trades more than 200 million shares in a day.
And ETFs have grown in number from just 1 in 1993 to
several hundred today. Many of these ETFs trade in excess
of 50 million shares on a daily basis.
Clearly, ETFs have exploded in popularity. And there’s
good reason for that: these securities offer investors an
opportunity to diversify their holdings among many stocks
in an extremely low-cost man­ner. ETFs have opened up a
number of strategies to the individual investor that were
previously only available to professional money managers
running multi-million dollar accounts.
Before we delve into the myriad advantages of ETFs, let’s
review what they are, how they’re traded and the best strategies for using the funds.
What’s an ETF?
Similar to index mutual funds, ETFs are simply baskets of
stocks that trade as a single security on the major exchanges.
Unlike mutual funds, ETFs trade just like stocks on the
major exchanges; they can be bought and sold at any time
during normal mar­ket hours. They have symbols and are
quoted on all the major financial websites and in most major
busi­ness newspapers. When buying these funds you will pay
the same commission to your broker that you’d pay to buy
any other stock.
But when you buy an ETF you’re actually buying up to
hundreds or thousands of individual stocks. Take the S&P
500 Depository Receipts as an example. This ETF, commonly called “Spiders,” represents own­ership in all 500
companies that make up the S&P 500 index.
Think of how expensive it would be to buy all those
stocks separately. Even if you paid just $10 in commissions
on each stock, you’re looking at $5,000 in commissions
alone to make all those transac­tions—that’s a big hit indeed.
With the Spiders you simply buy all 500 stocks in one simple transaction.
There are now ETFs available covering just about every
imaginable sector, industry, country and index. For example,
you can purchase a bas­ket of 15 major US retailers by purchasing the Retail HOLDRs (AMEX: RTH). And while
it’s tough for investors to buy many major Japanese stocks
directly, you can purchase a diversified basket of stocks
trading in Tokyo by buying the iShares MSCI Japan Index
(NYSE: EWJ).
ETFs are available covering Hong Kong, China,
Singapore, Italy, France, Brazil and many other developed
and developing markets around the globe. Prior to the
19
www.InvestingDaily.com advent of ETFs, individual investors had limited access to
these mar­kets. International diversification can lower the
overall risk of your portfolio; these funds have opened up a
brand new market for retail investors unavailable just a few
years ago.
ETFs even provide investors with access to alternative
investments. For example, the SPDR Gold Trust (NYSE:
GLD) tracks the performance of gold bullion. And, there
are a host of ETFs that offer exposure to both the corpo­rate
and government bond markets.
Most ETFs are also extremely cost effective. An ETF
typically charges an expense ratio of 0.85 percent or less
annually for specialized indexes and 0.35 percent or less for
broad-based indexes. The Vanguard S&P 500 ETF (NYSE:
VOO) features an expense ratio of only 0.06 percent. These
expense ratios are far less than the amount typically charged
by major mutual funds.
ETFs vs. Mutual Funds
ETFs don’t replace actively-managed mutual funds and
such mutual funds will never disappear from the investing
landscape. However, ETFs do hold some major advantages.
Mutual funds can be purchased only once per day. All
investors wishing to purchase a mutual fund on a given day
will receive the same price. They are not traded actively on
an exchange and you cannot see price updates during the
course of a trading day. And some funds will charge a fee for
redeeming (selling) the fund within a certain time frame.
ETFs offer the advantage of what’s known as liquidity.
Liquidity means that you can buy or sell an ETF easily at
any time during the trading day. You’re now forced to wait
to sell—you can buy and sell funds even within a single
trading day.
Furthermore, the minimum purchase amount for most
ETFs is a single share (Merrill Lynch HOLDRs require a
100-share minimum). Many mutual funds require a minimum
invest­ment of $1,000, $2,000 or even $10,000 to get into
the fund. That’s not the case with ETFs—in most cases you
can buy a single ETF share. That means that you can scale
your invest­ment to reflect the overall size of your portfolio.
ETFs are also normally more tax efficient since the fund
can redeem large institutional investors through a tax-free
“in-kind” exchange rather than by selling securities for
cash. In addition, some mutual funds impose sales charges,
redemption fees for selling out of the fund quickly, as well as
12b-1 marketing fees.
Mutual funds do offer a few possible advantages as well.
The vast majority of ETFs aren’t actively managed. In other
words, there’s no manager evaluating the fun­damentals of the
stocks in the ETF and buying or selling accordingly. ETFs
simply track the perform­ance of a sector, industry of broad
basket of stocks from a particular region. Some activelyUnderstanding the Stock Market: How to Buy Stocks
managed mutual funds beat the market, whereas index ETFs
never do. A majority of actively-managed mutual funds
underperform the market, however, so you need to choose
wisely if you plan on playing the market-beating game.
And mutual funds also offer a chance to regu­larly make
low-cost contributions. With most funds, you can add a certain amount of money each month to the fund for no cost
at all. Some funds allow investors to add as little as $50 on
a regular basis for free. With ETFs, however, every time you
add to your position you will incur a commission charge for
buying the ETF. However, some brokers (TD Ameritrade,
Zecco, Fidelity, Schwab, and Vanguard) are now offering
commission-free trading on a limited number of ETFs.
Risks
ETFs vary greatly in terms of risk. Risk reflects the price
volatility of the stocks inside the ETF. For example, the
Consumer Staples SPDRs (NYSE: XLP) represent ownership
is a broad bas­ket of higher-quality food, beverage and everyday household products companies.
These companies tend to move slowly—they neither
rise as fast as the markets during rallies nor fall as quickly
when the market sells off. By contrast, the PowerShares
Nasdaq 100 trust (NasdaqGM: QQQQ) and Semiconductor
20
www.InvestingDaily.com HOLDRs (AMEX: SMH) are well known for extreme volatility—these ETFs represent ownership in a basket of fastmoving tech and semiconductor shares respectively.
If used properly, however, ETFs can reduce the overall
risk of your portfolio through diversifica­tion. For example,
foreign markets don’t always move in the same direction
as the U.S. market. By owning ETFs that hold Japanese or
European shares, you will hedge your U.S. holdings.
And when the market is weak, you can also run into the
consumer staples or bond ETFs—these will help shield your
portfolio from volatility.
What’s more, because all ETFs hold baskets of securities,
company-specific risk is less important. Wal-Mart might miss
its earnings numbers and gap lower; that will hit the Retail
HOLDRs but not as badly as if you simply owned Wal-Mart
stock directly.
When using ETFs as part of your investment strategy, think
diversification; consider buying ETFs from many different
categories. For exam­ple, consider purchasing at least one foreign-stock ETF, a major U.S. stock index ETF, a bond ETF
and a low-correlation hedge such as the SPDR Gold Trust or
a general commodity ETF. This type of allocation will offer
you exposure to sev­eral relatively unrelated markets—the
diversifica­tion will lower the risk of your portfolio.
Understanding the Stock Market: How to Buy Stocks
CHAPTER Fifteen
Glossary
accrued interest
appreciation
The amount of interest that has accumulated from the
date of the last interest payment to the date a bond is sold.
Interest accrues until the day of settlement, not the day that
an investor agrees to purchase a bond. See “settle­ment” for
a further explanation.
The increase in the value of an asset such as a stock, bond,
commodity or real estate as deter­mined by increases in the
public market price of the security.
advance decline line
Profiting from price discrepancies when the same security, currency or commodity is pur­chased in one market and
immediately resold in another. A trader who does this is an
arbitrager.
A ratio of the number of stocks advancing in price versus
the number declining in price over a period of time. It’s an
indicator of general mar­ket direction that’s considered positive if advanc­ing issues outnumber declining issues.
alpha
Measure of an investment’s total return in excess of what
is expected given its price volatility relative to the overall
market (i.e, beta). Positive alpha suggests that the investment manager has stock-picking skill. It’s based on aver­age
annual percentage returns relative to the broad market.
Term is most often used in refer­ence to mutual funds.
American Depository Receipts (ADR)
A receipt for the shares of a foreign corpora­tion held in
the vault of a US bank that entitles the shareholder to all
dividends and capital gains. Instead of purchasing actual
shares of a foreign stock on a foreign market, Americans
can buy shares in the U.S. in the form of an ADR. ADRs
are composed of some multiple or fraction of actual foreign
shares held by U.S. financial institutions called American
Depository Shares (ADS).
annuity
A contract sold by life insurance companies that promises
a fixed or variable payment to the pur­chaser according to
a specified payout plan. Investment gains in deferred annuities accumulate tax free until withdrawal, but withdrawals are
taxed at ordinary income tax rates, and not treated as capital
gains. There is also usually some sort of guaranteed return of
principal in exchange for an annual insurance fee. Like IRAs,
early with­drawals are almost always penalized. A fixed annuity
pays fixed, constant pay­ments for a specified time. The purchaser has no control over the investments used to generate
the guaranteed fixed return. In contrast, a variable annuity’s
payout is not constant, but varies depending upon the investment performance of the securities chosen by the purchaser.
Immediate pay­ment annuities are bought with a single payment and start paying interest and a portion of principal
to the purchaser immediately, with no deferral period.
Payments may be for a specified period (e.g., five years) or
for the life of the purchaser.
21
www.InvestingDaily.com arbitrage
ask price
The price at which a security or commodity is offered for
sale. Also the per-share price at which mutual fund shares
are offered to the pub­lic, usually the net asset value per share
plus any sales charges.
assets
Everything a company or person owns. Capital assets
include long-term assets, those that will last longer than one
year. Fixed assets include buildings, equipment and land,
which are often considered part of capital assets.
Current assets include cash, short-term invest­ments,
accounts receivable, unused raw materi­als and inventories of
finished but unsold prod­ucts. Intangible assets include patents, brand names, and goodwill.
balance sheet
A financial report showing the status of a com­pany’s
assets, liabilities and owners’ equity. A balance sheet is only
a snapshot of a company at one particular time and must be
compared with prior balance sheets.
basis point
The smallest measure used in quoting yields on bonds and
notes. One basis point is 0.01 percent of yield. One hundred basis points equal 1 per­centage point.
bear market
A prolonged period of falling prices. A bear mar­ket in
stocks is usually brought on by the antici­pation of declining economic activity or serious inflation. A bear market in
bonds is usually caused by rising interest rates.
bellwether bond
A bond whose yield is used to gauge price trends in the
overall credit market. Usually the 10-year U.S. Treasury
note.
Understanding the Stock Market: How to Buy Stocks
beta
secured bond: Bond backed by a specific asset or assets.
The measure of the historical volatility of an investment
against an independent index, such as the S&P 500. The
S&P 500 is assigned a beta of 1.00.
Investments with betas above 1.00 are more volatile than
the S&P 500; below 1.00 are less volatile.
zero-coupon bond: Bond that sells at a discount to face value,
pays no current inter­est and matures at face value. Taxes
are usually due on accrued interest even though the owner
doesn’t actually receive any cash until maturity.
bid-ask spread
Difference between what dealers pay for a secu­rity (bid
price) and what they charge investors for the same security
(ask price). Individual investors buy at the ask price and sell
at the bid price.
Big Board
The New York Stock Exchange.
blue chip
A common stock of a nationally known company that
has a long record of profit growth, dividend payment and a
reputation for quality manage­ment, products, and services.
bond
Debt certificate issued by a government or corpo­ration.
Usually states the amount of the loan, inter­est to be paid,
repayment time and collateral pledged if the debt can’t be
repaid. Generally, a debt security issued with more than 10
years to maturity is a bond. Debt certificates with maturities
10 years or shorter are called notes and maturities shorter
than a year are called bills.
long bond: Shorthand for a 30-year U.S. Treasury bond.
general obligation bond (GO): Municipal bond backed by no
specific rev­enue source, but rather by the taxing authority of
the issuing govern­ment itself. See also revenue bond.
junk bond: Bond with a speculative credit rating. They have
a greater risk of default and therefore pay higher yields than
other bonds.
convertible bond: Bond that may be exchanged for a specific
amount of stock in the company that issued it at a specified
strike price.
municipal bond (muni): Bond issued by a state, county, city,
town or territory or an authorized agency for one of these
government units. These bonds are exempt from federal
income tax. They may also be free of state and local taxes if
held by someone living in the issuing area.
revenue bond: Bond backed only by the revenue of an airport, highway, stadium or other facility that was built with
the money raised.
savings bond: U.S. government bond with face value denominations ranging from $50 to $10,000 for Series EE bonds
and $50 to $5,000 for I bonds.
unsecured bond: Guaranteed only by the reputation, good
faith and credit of the issuer. Also known as debentures.
22
www.InvestingDaily.com bond ratings
The two most widely used ratings are done by Moody’s
Investors Services and Standard & Poor’s. Moody’s has nine
ratings ranging from Aaa to C. S&P uses seven ratings from
AAA to D. See also Standard & Poor’s and Moody’s.
book-entry issuance
A centralized record-keeping for the holding and accounting of securities. Rather than receiving a certificate, the
investor receives a state­ment indicating that he owns the
security.
book value
The value of a business’ net assets as shown on its balance
sheet. Also the net worth of a busi­ness (difference between
total assets and total liabilities). Based on purchased prices,
not current market value.
broker
Person who acts as an intermediary between a buyer and
a seller, usually charging a commis­sion. A discount broker
charges lower commis­sions than full-service brokers, who
may also provide research and investment advice.
bull market
A prolonged rise in the prices of stocks, bonds or commodities.
callable bonds
Bonds redeemable by the issuer before maturity at a
set price. Bonds are usually called when inter­est rates fall
enough for the issuer to save money by offering new bonds
at lower rates.
capital gain, capital loss
Profit or loss on an investment when it is sold. Capital
gains on investments held 366 days or longer are taxed at
lower rates.
capital gains distribution
For a mutual fund, payment to shareholders of net capital
gains from the sale of portfolio securi­ties.
capital growth
An increase in the market value of securities.
Understanding the Stock Market: How to Buy Stocks
cash equivalent
Consumer Price Index (CPI)
Short-term investments that can be easily sold for cash.
Includes U.S. government securities, short-term commercial
paper and short-term municipal and corporate notes.
This measures changes in consumer prices, as determined
by a monthly survey of the U.S. Bureau of Labor Statistics.
CPI components include housing costs, food, transportation
and electricity. Also known as the cost of living index.
cash flow
An analysis of all the changes that affect a com­pany’s cash
account during an accounting period. This usually includes all
changes in oper­ations, investments and financing. When more
cash comes in than goes out, it’s known as posi­tive cash flow.
Cash flow directly relates to a company’s ability to pay dividends.
certificate of deposit (CD)
A low-risk debt instrument issued by a bank that has a
conservative yield in exchange for safety. Institutional CDs
are issued in denominations of $100,000 or more, and individual CDs start as low as $100. Maturities range from a few
weeks to several years.
closed-end fund
A type of mutual fund that has a fixed number of shares,
usually on a major stock exchange. Unlike open-end funds,
closed-end funds don’t issue and redeem shares on a continuous basis. Closed-end funds often sell at a discount to
their net asset value because of unrealized tax liabilities, high
expenses, and lack of investor confidence in management.
closed fund
A mutual fund that has become so large that it is no longer willing to sell shares to new investors.
commercial paper
Short-term corporate debt with maturities ranging from
one to 270 days.
commission
Fee charged by a broker or other salesperson when buying
or selling an investment.
commodities
Bulk goods such as grains, metals, oil, gas, and foods.
Traded on futures exchanges or in ETF form.
common or preferred stock
Units of ownership of a public corporation. Common
stockholders have the right to vote at the stock­holders meetings, and may receive dividends. Preferred stockholders usually don’t have voting rights, but receive dividends at a specified rate and have preference over common stockholders in
the payment of dividends and in the event of liquidation.
conglomerate
A corporation composed of a variety of different businesses.
23
www.InvestingDaily.com contrarian
An investor who does the opposite of what most investors
are doing at any particular time.
corporation
A legal entity, normally a business, which is chartered by a
U.S. state or the federal govern­ment and that’s separate and
distinct from those who own it. It’s regarded by the courts
as an “artificial person” and may own property, incur debts
or sue and be sued. It has limited liability and easy transfer
of ownership through sales of stock shares.
correction
A short-term price movement in the opposite direction of
a long-term trend.
coupon
Fixed interest payment on a debt security that the issuer
promises to pay to the holder until matu­rity, expressed as an
annual percentage of face value. With many bonds—particularly older municipal bonds—the investor just clips a coupon
from the bond every time interest is due and mails it to the
bond issuer’s paying agent.
currency futures
Contracts in the futures markets that are for deliv­ery in a
major currency, such as US dollars. Cor­porations that sell
products around the world can hedge their currency risk
with these futures.
cyclical stock
A stock that rises quickly when the economy turns up and
falls quickly when the economy turns down. Examples are
housing, autos and paper. Non-cyclical companies such as food
and drug companies aren’t as affected by economic changes.
debenture
A general debt obligation backed only by the issuer’s
promise to repay the debt.
debt-equity ratio
Total liabilities divided by total common shareholder equity. This shows to what extent the company can pay creditors
claims in the event of liquidation.
default
Failure of a debtor to make timely payments of interest
and principal.
Understanding the Stock Market: How to Buy Stocks
deflation
A decline in the prices of goods and services.
depreciation
A decrease in the value of property through wear, deterioration or obsolescence, which can be written off against
earnings.
discount
The percentage below net asset value at which shares sell.
discount rate
The interest rate that the Federal Reserve charges member
banks for loans, using govern­ment securities as collateral.
This provides a floor on interest rates, since banks set their
loan rates above the discount rate. Less important than the
federal funds rate, which is the overnight lending rate member banks charge each other. Falling interest rates usu­ally
give the stock market a boost. Rising rates usually hurt the
stock market.
dividend
A distribution of earnings to shareholders paid in the form
of money or company stock. Divi­dends are usually paid on a
quarterly basis and are considered taxable income.
dividend reinvestment plan (DRIP)
An automatic reinvestment of shareholder divi­dends into
more shares (including fractions) of a company’s stock.
With most companies these investments are made without
incurring any brokerage or commission fees. Some companies offer reinvestment plans that allow the shareholder to
reinvest at a slight discount to the actual share price. Some
brokers offer pseudo-DRIPs for their customers.
dividend yield
A stock’s annual dividend divided by its share price.
dollar-cost averaging (DCA)
A strategy whereby an investor invests the same dollar
amount on a regular basis regardless of the price. When
share prices are higher, the investor purchases fewer shares
than when share prices are lower. Very common among
employees who invest a portion of their salary every month
in the company 401K plan.
downtick
When a security is sold at a price below that of the preceding sale.
downturn
Shift of an economic or stock market cycle from rising to
falling.
earnings per share (EPS)
A portion of a company’s profit allocated to each outstanding share of common stock.
ex-dividend
The period during which a new stock purchaser is not
entitled to a dividend that the stock is scheduled to pay. To
receive a dividend payment, one must be a shareholder of
record by the dividend’s record date. The last day to qualify
is three trading days prior to the record date. Consequently,
the first day a stock trades ex-dividend is two trading days
prior to the record date. Typically, a stock’s price gradually
rises as the dollar amount of the dividend begins to accrue,
and then falls by the dividend amount on the first day that a
stock trades ex-dividend. Market events can reduce or magnify the price effect of the ex-dividend date.
expense ratio
In mutual funds, annual expenses, including all costs of operation, divided by the fund’s average net assets for the year.
Federal Funds rate
Interest rate charged by banks with excess reserves at a
Federal Reserve district bank to banks needing overnight
loans to meet reserve requirements. The Federal Funds rate
is the most sensitive indicator of the direction of interest
rates, since it is set daily by the market.
floating exchange rate
A foreign currency system in which exchange rates
between two currencies are allowed to fluctuate in response
to changes in the world economy.
free cash flow
Dow Jones Industrial Average (DJIA)
The excess money available to a company after subtracting
its maintenance capital expenditures and corporate acquisitions from its operating cash flow. A company with excess
cash can pay dividends, buy back shares, and grow its business. Free cash flow is a sign of a solid company.
30-stock index of blue-chip industrial stocks. Unlike the
market-cap weighted S&P 500, the DJIA is price-weighted.
free cash flow yield
downside risk
The probability and potential magnitude of an investment
losing value.
24
www.InvestingDaily.com A measure of how high the stock’s dividend yield would
be if the company used all its excess cash to pay dividends.
To determine a company’s free cash flow yield, subtract capital spending and corporate acquisitions from cash flow, then
divide the result by the stock’s current share price.
Understanding the Stock Market: How to Buy Stocks
fundamental analysis
individual retirement account (IRA)
Analysis of a company’s management, competitive position, business risk, balance sheet, income state­ment, and
statement of cash flows in order to determine its intrinsic
value. Investors try to determine whether a stock’s market
price is higher or lower than its intrinsic value. A stock is
undervalued if its market price is below its intrinsic value
and overvalued if its market price is above its intrinsic value.
Also see techni­cal analysis.
A personal retirement account consisting of cash, stocks,
bonds, mutual funds, life insurance policies, etc., that
an employed person in the U.S. can set up with a taxdeductible deposit. The allowable amount that can now be
deducted annually is $5,000 for individuals and $10,000
for couples, provided income is within certain limits. After
2010, these limits will be indexed to inflation.
futures contract
An agreement to buy or sell a specific amount of a commodity or financial instrument at a particu­lar price on a
future date.
goodwill
The value of a business in patronage, reputation, brand
names over and beyond its book value. In a merger between
two corporations, the amount the purchasing firm paid for
the goodwill of the other is subtracted (i.e., amortized) from
the purchasing firm’s earnings over a multiyear period.
greenmail
Practice whereby outsiders buy blocks of a com­pany’s
stock and then entice the company to buy the shares back at
a premium to avoid a takeover.
gross domestic product (GDP)
The total value of a nation’s annual output of goods and
services within the domestic economy. Calculated quarterly
by the Department of Commerce.
gross profit
The difference between the selling price of an item or
service and the expenses directly attrib­uted to it, such as the
costs of labor and raw materials.
hard money investments
Investments in precious metal bullion, bullion certificates
and bullion coins, particularly those of gold and silver.
hedging
Strategy used to offset investment risk. A perfect hedge is
one that eliminates the possibility of a future gain or loss.
illiquid
Not readily convertible into cash.
income statement
Financial statement showing all a company’s sources of
earnings and expenses, both cash and non-cash.
inflation
An increase in the prices of goods and services. Often measured by the Consumer Price Index and the Producer Price Index.
Infrastructure
An economy’s basic facilities, e.g., roads, air­ports, water
supplies, schools and universities, medical services, etc.
initial public offering (IPO)
A corporation’s first offering of stock to the public.
insider
A person with access to information before it’s announced
to the public. Usually the term refers to officers and directors of companies.
insolvent
Unable to pay debts when they are due.
institutional investor
An organization that trades large amounts of securities,
such as mutual fund companies, hedge funds, banks or pen­
sion funds.
interest rates, short term, long term
Long-term rates are considered to be the yields of debt
instrument with maturities of more than one year. The U.S.
Treasury’s 10-year note is the benchmark for long-term
rates. Short-term rates are considered to be the yields on
bills or certifi­cates of deposit (CDs) with maturities of less
than one year. Yields of 90-day Treasury bills are the benchmark for short-term interest rates.
intermediate term
The time between the short and the long term, usually
three to 12 months.
investment grade
Term used to describe bonds suitable for invest­ment by
conservative investors. Minimum credit rating of BBB-.
issuer
A company or government entity that borrows money by
selling a bond or other fixed-income instrument to investors.
25
www.InvestingDaily.com Understanding the Stock Market: How to Buy Stocks
junk bond
long bond
A bond with a credit rating of BB+ or lower. Junk bonds
are also known as high-yield bonds.
A bond that matures in more than 10 years. Since these
bonds commit investors’ money for a long time long bonds
usually pay a high yield and expose them to higher risk. The
most com­monly mentioned is the U.S. Treasury 30- year
bond.
Keogh plan
Tax-deferred retirement plan for self-employed persons.
lagging indicator
A statistic on the economy that rises or falls after economic growth has risen or fallen.
leading indicator
A statistic that anticipates trends in the economy.
lender
A person or company that extends credit to a borrower
with the expectation of being repaid, usually with interest.
Someone who invests in bonds is a lender.
leverage
Use of borrowed funds to enhance the return on an
investment.
liabilities
All claims against a corporation. These include accounts
payable, wages and salaries due but not paid, dividends
declared payable, taxes payable and fixed obligations such as
bonds or loans.
limited partnership
An organization composed of a general partner who manages a project, and limited partners who invest money but
have limited liability and aren’t involved in day-to-day management. Usu­ally established to provide tax benefits. Master
limited partnerships are limited partnerships that trade like
stocks on an exchange.
limit order
Order to buy a security up to a specific price. A broker
will only trade the securities within the price restriction.
liquidity
The ability to sell a publicly-traded security for cash without affecting the market price.
On a company’s balance sheet, debt that a company is not
required to pay back for more than a year.
long-term gain, long-term loss
Profit or loss on securities when the time between buying
and selling is longer than 365 days.
M1
A major component of money supply. M1 includes all
currency in circulation, bank demand deposits, savings
accounts, credit union share drafts, and nonbank travelers
checks.
M2
Includes all of M1 plus overnight repurchase agreements
issued by commercial banks, overnight eurodollars, time deposits under $100,000, and money market mutual fund shares.
M3
Includes all of M1 and M2 plus large deposits, institutional shares in money market mutual funds and term repurchase agreements.
macroeconomics
Analysis of a nation’s economy as a whole.
margin
The amount of cash an investor is required to deposit with
a broker when borrowing to buy securi­ties. Margin requirements are usually 50 percent of the value purchased on stock
transactions, and less for commodity futures or currency
trades.
market capitalization
Total value of outstanding common shares of stock. Price
per share times number of shares outstanding.
market price
load
A sales charge paid by an investor when pur­chasing or selling particular mutual funds or annuities.
Last reported price at which a security was sold on an
exchange.
market timing
long
To go long is to purchase a stock, bond or commodity for
investment or speculation. See also selling short.
26
long-term debt
www.InvestingDaily.com Opposite of “buy and hold” investing. A trading strategy
based on the belief that one can determine beforehand when
the overall market is going to fall. The trader’s investment
Understanding the Stock Market: How to Buy Stocks
account is periodically liquidated to cash in hopes of avoiding market declines. High risk that the trader will get out
at the wrong time and miss market advances and investment
gains.
maturity date
Date on which the principal amount of a note, draft,
acceptance, bond or other debt instrument becomes due
and payable.
microeconomics
Study of behavior of basic economic units such as companies, industries or households.
money market instruments
Negotiable, short-term debt securities that are typically
low risk and highly liquid. Treasury bills are the best known
money market instru­ment. Other such securities include
commer­cial paper and certificates of deposit.
money supply
Total stock of money in the economy. Different measures
include M1, M2, M3 and L, with M1 being the most specific and L the broadest.
mortgage
Debt instrument by which the borrower (mort­gagor)
gives the lender (mortgagee) a lien on property as security
for the repayment of a loan. If the loan defaults, the lender
can take control of the property and sell it to recover the
loan amount. Mortgages normally apply to real estate.
moving average
Average price of a security over a specific number of days,
weeks, or months. The average price is continually updated,
adding the latest price data and eliminating the oldest price
data. The most commonly used moving averages are the
50-day moving average and the 200-day moving average.
Securities trading at prices above these moving averages
are considered to be in an uptrend and are in a downtrend
when trading below them.
mutual fund
A fund operated by an investment company that raises
money from shareholders and invests it in stocks, bonds,
options, commodities or money market securities. Mutual
funds offer the advan­tages of diversification and professional
manage­ment. Most charge a management fee of about 1
percent or less for these services.
balanced funds hold bonds and/or preferred stocks in varying ratios to common stocks to maintain stability of capital
and income. Closed-end funds trade on an exchange and
have a fixed number of outstand­ing shares that trade like
stocks.
27
www.InvestingDaily.com Gold mutual funds invest in gold bullion or shares of gold
mining concerns.
Growth funds invest in growth stocks with the goal of providing capital appreci­ation for the fund’s shareholders over
an extended period. These funds are usually more volatile
than money market or income funds.
Income funds invest for cash returns such as divi­dends and
interest to provide a good cash yield for investors.
Index funds’ portfolios match those of a broad-based index
such as the S&P 500 Index. Performance mirrors the index
as a whole minus expenses.
Money market funds invest in commercial paper, government
securities, CDs and other highly liquid and safe securities.
Municipal bond funds invest in securities that are exempt
from federal taxes.
No-load funds don’t charge a com­mission for buying and
selling its shares.
Open-end funds issue new shares at value of assets whenever
new investment comes in.
Sector funds invest in a specific industry, such as utilities.
Nasdaq
Used to be an acronym for National Association of
Securities Dealers Automated Quotation sys­tem, but now
it’s a word in its own right. Nasdaq is a comput­erized trading network composed of a multitude of dealers offering
bid and ask prices. This is in contrast to the New York Stock
Exchange which uses a centralized specialist system.
national debt
Debt owed by the federal government and com­posed of
Treasury bills, Treasury notes and Treasury bonds.
net asset value (NAV)
The NAV, in the case of no-load mutual funds, is the
market price. This price is determined by taking the closing
market value of all securities plus any cash or other assets
and subtracting all liabilities, then dividing the result by the
total number of shares outstanding.
net income, net profit
A company’s remaining earnings after all taxes and
expenses have been deducted.
net worth
The total value of a company after all long- and shortterm debts are deducted from the company’s assets. For a
corporation, net worth is also called stockhold­ers’ equity or
net assets.
Understanding the Stock Market: How to Buy Stocks
no-load fund
profit-taking
A fund that has no sales or commission charges when purchasing or redeeming shares. See also load.
Action by traders to cash in on gains earned on a market
rise. This pushes prices down, but usually only temporarily.
options
program trading
The right to buy or sell the underlying asset at a specified
price during a specified period. A call option gives the holder
the right, but not an obligation, to buy a security within a
specified time at an agreed-upon price. A put option gives
the holder the right, but not the obligation, to sell a security
within a specified time at an agreed-upon price.
Institutional buying of stocks based on a computer algorithm, not based on a human being’s judgment. Such trading
can sometimes, by its sheer volume and speed, increase market
volatility like it did during the “Flash Crash” of May 2010.
prospectus
Description of a security or a market that’s expe­rienced
an unexpectedly sharp rise or fall in price and is thus vulnerable to a sharp move in the opposite direction of the current
trend (i.e., a cor­rection).
Formal written offer to sell securities that explains a proposed business enterprise or the facts con­cerning an existing
one that an investor needs to make informed decisions. A
prospectus for a mutual fund must describe the history of
the fund, managers’ backgrounds, fund objectives, a finan­
cial statement, fees on a sample investment, etc.
par value
proxy statement
Equal to the face value of a security; the principal amount
that a debt security will pay a lender at maturity.
A document which the SEC requires a company to send
to its shareholders that provides material facts concerning
matters on which the shareholders will vote. Shareholders
can mail back a proxy card, appointing management to
represent them at the meeting and instruct management to
vote their shares in accordance with their wishes. This allows
shareholders to participate in voting at the meeting, whether
or not they decide to attend.
overbought, oversold
penny stock
A stock that typically sells for less than a dollar per share.
These are often failed companies with an erratic his­tory of
revenues and earnings whose stocks are more volatile than
larger, more established firms.
premium
For bonds, the amount by which a bond sells above its
par value.
present value
Value today of a future payment discounted at an appropriate discount rate.
price-to-earnings ratio (P/E)
A measure of a security’s value. The price of a share of
stock divided by earnings per share for a 12-month period.
It tells investors how much they are paying for a company’s
current earn­ings. The higher the P/E, the more investors
expect earnings to grow.
prime rate
The lowest interest rate banks charge their largest corporate customers for loans.
Producer Price Index (PPI)
Measure of change in wholesale prices as released monthly
by the U.S. Bureau of Labor Statistics.
pure play
A company that is devoted to one line of business.
Opposite of a conglomerate.
raider
Individual or corporate investor who intends to take
control of a company by buying a control­ling interest in
its stock and installing new man­agement. Think Carl Icahn
(real) or Gordon Gekko (fictional).
real estate investment trust (REIT)
A company that manages a portfolio of real estate to earn
profits for shareholders. REITs make investments in real
estate properties such as shopping centers, office build­
ings, and apartment complexes. In exchange for paying out
almost all of their earnings as dividends, they are treated as
pass-through entities and are exempted from corporate tax.
real interest rates
Current interest rates minus the inflation rate. This gives
investors in bonds and other fixed-rate investments their
actual return after inflation has been factored in.
recession
At least two consecutive quarters of negative economic
growth as measured by GDP.
28
www.InvestingDaily.com Understanding the Stock Market: How to Buy Stocks
return
settlement
Profit or gain on an investment.
return on equity (ROE)
Earnings divided by shareholders’ equity.
revenue
The amount of money a company takes in, including
interest earned and receipts from sales, services provided,
rents and royalties. Never use earnings as a synonym for revenue; these are completely different. Earnings are revenues
minus expenses.
Standard & Poor’s 500 (S&P)
The market capitalization-weighted index of 500 of the
largest and most liquid stocks in the U.S. Includes stocks
from both the New York Stock Exchange and Nasdaq.
The delivery of stock to the investor and the pay­ment of
cash to the seller. Settle­ment occurs in three trading days.
Short-term debt
Borrowed money that must be repaid in a year or less.
split
An increase in a corporation’s number of outstand­ing
shares of stock without any change in equity or market value
at the time of the split. Example: If a shareholder held 100
shares of a $50 stock and it splits 2-for-1, the shareholder
will now have 200 shares at a price of $25.
spot market
Commodities market in which goods are sold for cash and
delivered immediately. Opposite of futures market.
sales charge
spot price
Fee paid to a brokerage house or mutual fund to buy an
investment.
Current delivery price of a commodity traded in the spot
market.
selling short
spreads
When an investor borrows a stock from a broker in a margin account, then immediately sells the stock. While waiting
for the price to fall, the investor pays the broker interest on
the amount of the stock that was borrowed. The investor
hopes that the borrowed stock will fall in price so that he
will be able to repurchase the stock at a cheaper price than
he sold it for. This is a way to profit in a market where stock
prices are declining.
Simultaneous purchase and sale of different futures or
options contracts. Investors are betting that the price differences will either widen or narrow.
secondary market
common stock entitles the shareholder to vote in elections of
directors and other matters discussed at share­holder meetings. Usually, common stock has more potential for appreciation than preferred stock.
The aftermarket where both buyers and sellers of a security are third parties unrelated to the initial transaction involving the issuer of the security.
secured debt
Debt guaranteed by the pledge of assets or other collateral.
sentiment indicators
Measures of the bullish or bearish mood of investors.
Analysts often look at extreme readings of investor sentiment as con­trary indicators. When investors are extremely
bullish, all motivated buyers have already bought and there
is nobody left to push the market higher, which forces motivated sellers to offer a lower price to entice less motivated
buyers. This results in a market drop. When investors are
extremely bearish, all motivated sellers have already sold and
there is nobody left to push the market lower, which forces
motivated buyers to offer a higher price to entice less motivated sellers. This results in a market rise.
29
www.InvestingDaily.com stock
An ownership interest in a corpora­tion represented by
shares that are a claim on the issuers’ earnings and assets.
There are two kinds: common and preferred.
preferred stock usually doesn’t grant voting rights, but it has
prior claim on earnings and assets. Holders of preferred
stock receive divi­dends before common stockholders.
stop loss
Customer order to a broker to sell an investment if its
price falls below a predetermined level. It’s used to limit
losses from an investment.
street name
Describes securities held in the name of a bro­ker or third
party instead of the customer.
target price
Price a stock is expected to reach within a speci­fied period
of time.
Understanding the Stock Market: How to Buy Stocks
tax shelter
12b-1
Method used by investors to legally avoid or reduce tax
liabilities. Retirement accounts like 401Ks and IRAs are tax
shelters, as are annuities and MLPs.
A charge assessed by mutual funds to pay for promotional
and marketing expenses taken directly from fund assets.
Named after SEC rule 12b-1.
technical analysis
underwriter
Research into the demand and supply of securi­ties based
on past trading activity. Technical analysts project future
stock direction after studying stock charts and volume. See
also fundamental analysis.
A securities dealer who purchases bonds directly from the
issuer for resale to investors.
30-day wash rule
IRS rule stating that losses on a sale of an invest­ment may
not be used as losses for tax purposes if the same investment
is bought within 30 days before or after the date of sale.
tick
The minimum unit for upward or downward movement in
a security’s price.
trader
Anyone who buys or sells goods or services for profit.
Colloquially, this refers to short-term buy­ing and selling.
trading range
A stock’s historical price movement between the highest and lowest prices at which it has traded for a given time
period.
trailing earnings
A company’s most recent actual earnings results, often for
the past 12 months.
Treasury bills (T-bills)
Short term securities with maturities of one year or less
issued at a discount from par value. Many floating rate loans
and variable rate mortgages have interest rates tied to the
yield of these bills. See also interest rates, Treasury bonds.
Treasury bonds (T-bonds)
Long term debt instruments with maturities of more than
10 years. The 30-year U.S. Treasury bond is the most widely followed T-bond. See also interest rates, Treasury bills.
trend
Any direction of price movement that is continu­ous and
consistent.
turnaround
Favorable reversal in the fortunes of a company, market or
economy in general.
30
www.InvestingDaily.com upside potential
Amount of upward price movement an investor or analyst
expects in a particular stock, bond or commodity.
uptick
When a security is sold at a higher price than it was on the
previous trade.
uptrend
Consistent and continuous upward price move­ment for an
investment.
volume
Total amount of an investment traded in a partic­ular
period of time.
warrant
A type of option usually issued with a bond or preferred
stock that entitles the shareholder to buy a certain amount of
common stock at a spec­ified price, within a specific period of
time. The time until expiration for a warrant is usually longer
than the time until expiration for an exchange-traded option.
yield
The annual rate of return on an investment, as paid in dividends or interest. It is obtained by dividing the 12-month
dividend or interest pay­ment by the investment’s price.
yield to maturity
A yield measurement that accounts for the compounded
interest earned on the bond through the maturity date,
as well as any capital gain or loss from the bond returning
its par value at maturity. The yield that will most often be
quoted by the bond salesmen will refer to a worst case situa­
tion. In other words, if a bond can be redeemed (i.e., called)
prior to its stated maturity date, say in 10 years rather than
30 years, the quoted yield will reflect the early redemption
value of the bond in 10 years.
zero-coupon bond
A bond that pays no interest, but is issued at a deep discount price, which will appreciate to par value at maturity.
Tax is usually due on a zero-coupon’s annual appreciation
despite the fact that the zero’s owner does not receive any
cash until maturity.
Understanding the Stock Market: How to Buy Stocks