Introduction to Mutual Funds

Mutual funds have been around for a long time, dating back to the early 19th century. The first modern American mutual fund opened in 1924, yet it was only in the 1990s that mutual funds became mainstream investments, as the number of households owning them nearly tripled during that decade. With recent surveys showing that over 88% of all investors participate in mutual funds, you're probably already familiar with these investments, or perhaps even own some. In any case, it's important that you know exactly how these investments work and how you can use them to your advantage. A mutual fund is a special type of company that pools together money from many investors and invests it on behalf of the group, in accordance with a stated set of objectives. Mutual funds raise the money by selling shares of the fund to the public, much like any other company can sell stock in itself to the public. Funds then take the money they receive from the sale of their shares (along with any money made from previous investments) and use it to purchase various investment vehicles, such as stocks, bonds and money market instruments. In return for the money they give to the fund when purchasing shares, shareholders receive an equity position in the fund and, in effect, in each of its underlying securities. For most mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund will fluctuate daily, depending upon the performance of the securities held by the fund. Advantages It may not be obvious at first why you would want to purchase shares in different securities through a mutual fund "middleman" instead of simply purchasing the securities on your own. There are, however, some very good reasons why millions of Americans opt to invest in mutual funds instead of, or in addition to, buying securities directly. Mutual funds can offer you the following benefits: Diversification can reduce your overall investment risk by spreading your risk across many different assets (see InvestorGuide University: Asset Allocation). With a mutual fund you can diversify your holdings both across companies (e.g. by buying a mutual fund that owns stock in 100 different companies) and across asset classes (e.g. by buying a mutual fund that owns stocks, bonds, and other securities). When some assets are falling in price, others are likely to be rising, so diversification results in less risk than if you purchased just one or two investments. Choice: Mutual funds come in a wide variety of types. Some mutual funds invest exclusively in a particular sector (e.g. energy funds), while others might target growth opportunities in general. There are thousands of funds, and each has its own objectives and focus. The key is for you to find the mutual funds that most closely match your own particular investment objectives. Liquidity is the ease with which you can convert your assets--with relatively low depreciation in value--into cash. In the case of mutual funds, its as easy to sell a share of a mutual fund as it is to sell a share of stock (although some funds charge a fee for redemptions and others you can only redeem at the end of the trading day, after the current value of the fund's holdings has been calculated).

Low Investment Minimums: Most mutual funds will allow you to buy into the fund with as little $1,000 or $2,000, and some funds even allow a "no minimum" initial investment, if you agree to make regular monthly contributions of $50 or $100. Whatever the case may be, you do not need to be exceptionally wealthy in order to invest in a mutual fund. Convenience: When you own a mutual fund, you don't need to worry about tracking the dozens of different securities in which the fund invests; rather, all you need to do is to keep track of the fund's performance. It's also quite easy to make monthly contributions to mutual funds and to buy and sell shares in them. Low Transaction Costs: Mutual funds are able to keep transaction costs -that is, the costs associated with buying and selling securities -- at a minimum because they benefit from reduced brokerage commissions for buying and selling large quantities of investments at a single time. Of course, this benefit is reduced somewhat by the fact that they are buying and selling a large number of different stocks. Annual fees of 1.0% to 1.5% of the investment amount are typical. Regulation: Mutual funds are regulated by the government under the Investment Company Act of 1940. This act requires that mutual funds register their securities with the Securities and Exchange Commission. The act also regulates the way that mutual funds approach new investors and the way that they conduct their internal operations. This provides some level of safety to you, although you should be aware that the investments are not guaranteed by anyone and that they can (and often do) decline in value. Additional Services: Some mutual funds offer additional services to their shareholders, such as tax reports, reinvestment programs, and automatic withdrawal and contribution plans. Professional Management: Mutual funds are managed by a team of professionals, which usually includes one mutual fund manager and several analysts. Presumably, professionals have more experience, knowledge, and information than the average investor when it comes to deciding which securities to buy and sell. They also have the ability to focus on just a single area of expertise. (However, it should be noted that this apparent benefit has not always translated into superior performance, and in fact the majority of all mutual funds don't manage to keep up with the overall performance of the market.)

Disadvantages There are certainly some benefits to mutual fund investing, but you should also be aware of the drawbacks associated with mutual funds. No Insurance: Mutual funds, although regulated by the government, are not insured against losses. The Federal Deposit Insurance Corporation (FDIC) only insures against certain losses at banks, credit unions, and savings and loans, not mutual funds. That means that despite the risk-reducing diversification benefits provided by mutual funds, losses can occur, and it is possible (although extremely unlikely) that you could even lose your entire investment. Dilution: Although diversification reduces the amount of risk involved in investing in mutual funds, it can also be a disadvantage due to dilution. For example, if a single security held by a mutual fund doubles in value, the mutual fund itself would not double in value because that security is only one

small part of the fund's holdings. By holding a large number of different investments, mutual funds tend to do neither exceptionally well nor exceptionally poorly. Fees and Expenses: Most mutual funds charge management and operating fees that pay for the fund's management expenses (usually around 1.0% to 1.5% per year). In addition, some mutual funds charge high sales commissions, 12b-1 fees, and redemption fees. And some funds buy and trade shares so often that the transaction costs add up significantly. Some of these expenses are charged on an ongoing basis, unlike stock investments, for which a commission is paid only when you buy and sell (see InvestorGuide University: Fees and Expenses). Poor Performance: Returns on a mutual fund are by no means guaranteed. In fact, on average, around 75% of all mutual funds fail to beat the major market indexes, like the S&P 500, and a growing number of critics now question whether or not professional money managers have better stockpicking capabilities than the average investor. Loss of Control: The managers of mutual funds make all of the decisions about which securities to buy and sell and when to do so. This can make it difficult for you when trying to manage your portfolio. For example, the tax consequences of a decision by the manager to buy or sell an asset at a certain time might not be optimal for you. You also should remember that you are trusting someone else with your money when you invest in a mutual fund. Trading Limitations: Although mutual funds are highly liquid in general, most mutual funds (called open-ended funds) cannot be bought or sold in the middle of the trading day. You can only buy and sell them at the end of the day, after they've calculated the current value of their holdings. Size: Some mutual funds are too big to find enough good investments. This is especially true of funds that focus on small companies, given that there are strict rules about how much of a single company a fund may own. If a mutual fund has $5 billion to invest and is only able to invest an average of $50 million in each, then it needs to find at least 100 such companies to invest in; as a result, the fund might be forced to lower its standards when selecting companies to invest in. Inefficiency of Cash Reserves: Mutual funds usually maintain large cash reserves as protection against a large number of simultaneous withdrawals. Although this provides investors with liquidity, it means that some of the fund's money is invested in cash instead of assets, which tends to lower the investors potential return. Different Types: The advantages and disadvantages listed above apply to mutual funds in general. However, there are over 10,000 mutual funds in operation, and these funds vary greatly according to investment objective, size, strategy, and style. Mutual funds are available for virtually every investment strategy (e.g. value, growth), every sector (e.g. biotech, internet), and every country or region of the world. So even the process of selecting a fund can be tedious.

Basic Mutual Fund Concepts

There's a lot of terminology associated with mutual funds that you'll need to know before you can start investing in them. These concepts are an important part of mutual fund investing; you should make sure that you understand them in full before you start to invest in mutual funds. Open-end Funds All mutual funds fall into one of two broad categories: open-end funds and closedend funds. Most mutual funds are open-end. The reason why these funds are called "open-end" is because there is no limit to the number of new shares that they can issue. New and existing shareholders may add as much money to the fund as they want and the fund will simply issue new shares to them. Open-end funds also redeem, or buy back, shares from shareholders. In order to determine the value of a share in an open-end fund at any time, a number called the Net Asset Value (described below) is used. You purchase shares in open-end mutual funds from the mutual fund itself or one of its agents; they are not traded on exchanges. Closed-end Funds Closed-end funds behave more like stock than open-end funds; that is to say, closed-end funds issue a fixed number of shares to the public in an initial public offering, after which time shares in the fund are bought and sold on a stock exchange. Unlike open-end funds, closed-end funds are not obligated to issue new shares or redeem outstanding shares. The price of a share in a closed-end fund is determined entirely by market demand, so shares can either trade below their net asset value ("at a discount") or above it ("at a premium"). Since you must take into consideration not only the fund's net asset value but also the discount or premium at which the fund is trading, closed-end funds are considered to be more suitable for experienced investors. You can purchase shares in a closed-end fund through a broker, just as you would purchase a share of stock. Net Asset Value (NAV) Open-end mutual funds price their shares in terms of a Net Asset Value (NAV) (note that you can calculate NAV for a closed-end fund too, but it will not necessarily be the price at which you buy or sell closed-end shares). NAV is calculated by adding up the market value of all the fund's underlying securities, subtracting all of the fund's liabilities, and then dividing by the number of outstanding shares in the fund. The resulting NAV per share is the price at which shares in the fund are bought and sold (plus or minus any sales fees). Mutual funds only calculate their NAVs once per trading day, at the close of the trading session. Public Offering Price (POP) The public offering price (POP) is the price at which shares are sold to the public. For funds that don't charge a sales commission (or "load"), the POP is simply equal to the Net Asset Value (NAV). For a load fund, the POP is equal to the NAV plus the sales charge. As with the NAV, the POP will typically change on a day to day basis. Dividends and Capital Gains Distributions Mutual funds earn money on their investments through one of two ways: dividend income and capital appreciation. In other words, a mutual fund makes money on one

of the fund's assets when that asset pays the mutual fund dividends or interest, or when the mutual fund sells the asset for more than what it initially paid (if it sells the asset for less than what it initially paid, then that is called a capital loss). The federal government mandates that all mutual funds distribute these dividends and capital gains to the fund's shareholders at least once per year. Most mutual funds choose to distribute their investment income on a quarterly, semi-annual or annual basis. In order to determine which shareholders qualify for distribution payments, mutual funds specify a day during each distribution period that is known as the record day. If you own shares in a fund on or before the record day you qualify for a distribution. The day after the record day is known as the ex-dividend date. If you purchase shares on the ex-dividend date then the amount of the distribution is subtracted from the fund's net asset value (NAV) per share. You should be aware that if you receive distributions from a mutual fund then you must pay taxes on them, regardless of how long you have owned shares in the fund and regardless of whether or not you received the distributions in the form of cash or in the form of new shares. In January of every year, mutual funds issue Form 1099DIV to all of their shareholders as well as to the IRS in order to report income on distributions (see InvestorGuide University: Taxes and Your Investments). Mutual Fund Family A mutual fund family is a group of mutual funds that is managed by the same company. It is usually easy to switch money between mutual funds that are part of the same family. Additionally, most fund families make monitoring multiple investments easier, and make tax time easier, by aggregating the information from the various funds for you. Share Classes Mutual funds shares are sometimes broken down into lettered "classes" that have different characteristics. Here's a brief rundown of some commonly used designations: A: Shares that have a front-end load (see InvestorGuide University: Loads). B: Shares that have a back-end load. Y: Shares for institutional investors; no front-end load. Z: Shares for employees of the mutual fund. Dual-Purpose Fund As with some stocks, certain closed-end funds distinguish between common shareholders and preferred shareholders -- these funds are called dual-purpose funds. As the name suggests, common shareholders receive all distributions from capital gains, while preferred shareholders receive all dividend and interest income. These funds have a set expiration date, at which time all preferred shares in the fund are redeemed, giving the common shareholders sole ownership of the fund. Those shareholders then decide whether to liquidate the fund and divide up the proceeds or to convert the fund into an open-end mutual fund.

Fees and Expenses

Mutual funds are in business first and foremost to make money for themselves; their second priority is to make money for their shareholders. For this reason, all mutual funds charge fees, and these fees come in several different varieties. Some of them are common to all mutual funds; others are charged by some but not others. Before you invest in a fund, you should look at the total of the fees and expenses that they charge. Loads Loads are the most talked about fees that mutual funds charge. A "load" on a mutual fund is just another way of saying that the fund charges a sales commission for purchase, sale, or both. There are funds that charge loads and there are funds that do not charge loads (known as "load funds" and "no load funds" respectively). Load funds can charge either a front-end load or a back-end load, that can range between as low as 1% and as high as 8.5%, which is the legal limit. Front-end loads are sales commissions that are paid up front at the time of your purchase. So, if you give a fund a $10,000 investment and it charges a front-end load of 5%, then the fund will take 5% of your investment (that's $500) and pocket it right away. Only what is left over after the load has been deducted will be invested into the fund (in this example, only $9,500 is invested in the fund from your initial $10,000 investment) Back-end loads charge their sales commissions when you sell (or "redeem") your shares. So, when you go to redeem your shares in a fund with a back-end load you will end up receiving whatever money the shares are worth minus the sales commission. Funds that have loads justify it by saying that it discourages frequent trading (which it does), and that it enables the fund managers to invest the money more confidently, without having to keep a large amount of cash reserves ready for redemptions. But do load funds offer superior returns in order to justify the expense of the load? There is no evidence to suggest that this is the case. However, you probably shouldn't just disregard a mutual fund because it has a load. Loads are just one of many expenses that mutual funds charge. You may find that a mutual fund with a large load will often have much lower 12b-1 fees and management expenses than other funds. Also, if you are buying the fund for the long term, you should remember that you only need to pay the load once, upon buying or selling the fund, rather than on an ongoing basis. Management Fees Mutual funds charge management fees in order to pay for the management services used to run the fund. In other words, these fees are used to pay the salaries of the fund's managers and analysts. Management fees usually do not amount to more than one percent of the fund's assets, and they are significantly lower for passivelymanaged funds, such as index funds, than for actively-managed ones (see InvestorGuide University: Index Funds). You should remember that a high management fee in no way guarantees a more skillful

management team. 12b-1 Fees 12b-1 fees, also sometimes called "distribution fees", pay for any marketing and advertising expenses that the fund incurs. They are called 12b-1 fees because that is the number of the SEC rule that allows mutual funds to charge them. No-load mutual funds often have higher 12b-1 fees because they do not charge sales commissions. You should always look at 12b-1 fees in conjunction with sales loads. Other Fees There are many other fees and expenses that a mutual fund might charge to you. There are custodian fees (charges used to pay the custodian that holds the fund's assets), and sometimes there are even account-maintenance fees (charges used to pay for handling your account). Be sure to ask your mutual fund for a complete list of all the fees that it charges before you invest. Expense Ratio Besides comparing loads and 12b-1 fees, you can use a fund's expense ratio to get a sense of the fund's expenses. The expense ratio expresses as a percentage the amount of all operating expenses, including administrative expenses, management expenses, 12b-1 fees, etc, (but not sales loads) versus the fund's total assets. This number should be listed in both the fund's prospectus and its annual report. A higher expense ratio does not necessarily mean that the fund is better managed. Larger funds typically have lower expense ratios than smaller funds because they enjoy lower transaction costs for higher volume trades. Index funds almost always have very low expense ratios since they have low management expenses and since they trade very little. On average, expense ratios are about 1.5%, which means that the average fund uses 1.5% of its assets to operate the fund. Turnover Ratio The turnover ratio for a mutual fund can provide you with useful information about how expensive a fund is and how it is managed. Turnover ratios measure the amount of trading activity in the fund's portfolio. They are calculated by taking all of the fund's sales for a specified period of time (usually one year) and dividing by the fund's total assets. This number tells you how much the fund's portfolio has changed. You probably will want to exercise caution when investing in a fund with a high turnover ratio. High turnover means that the fund's manager is buying and selling very often, and, since every sale and every purchase involves a commission, this means that funds with high turnover ratios often have high expenses. Some experts recommend focusing on funds

whose turnover ratio is less than 50%.

Stock Mutual Funds

Simply put, stock funds (also sometimes called "equity funds") are mutual funds that invest only in stocks. For that reason, they are considered to be more risky than most other types of funds, such as bond funds or money market funds. Along with the greater risk, however, comes the potential for greater returns. Over long periods of time, equities have historically outperformed both bonds and cash investments, and when stocks do well, stock mutual funds naturally follow suit. But not all stock funds are alike -- these funds can vary greatly according to their stated objectives, their style of management, and the types of companies in which they invest. Growth Funds Growth funds are stock funds that invest in stocks with the potential for long-term capital appreciation. They focus on companies that are experiencing significant earnings or revenue growth, rather than companies that pay out dividends. The hope is that these rapidly growing companies will continue to increase in value, thereby allowing the fund to reap the benefits of large capital gains. In general, growth funds are more volatile than other types of funds -- in bull markets they tend to rise more than other funds but in bear markets they can fall much lower (see InvestorGuide University: Growth Funds). Value Funds Value funds invest in companies that are thought to be good bargains -that is to say, they invest in companies that have low P/E ratios (see InvestorGuide University: P/E ratios). These are the stocks that have fallen out of favor with mainstream investors for one reason or another, either due to changing investor preferences, a poor quarterly earnings report or hard times in a particular industry. Value stocks are often the stock of mature companies that have stopped growing and that use their earnings to pay dividends (see InvestorGuide University: Value Stocks). Thus value funds produce current income (from the dividends) as well as long-term growth (from capital appreciation once the stocks become popular again). They tend to have more conservative and less volatile returns than growth funds. Aggressive Growth Funds Aggressive growth funds are similar to regular growth funds, only they are more extreme. Like growth funds, aggressive growth funds target stocks of companies that are experiencing very rapid earnings or revenue growth. But aggressive growth funds tend to trade more frequently and take many more risks than regular growth funds. An aggressive growth fund might, for example, buy initial public offerings (IPOs) of stock from small companies and then resell that stock very

quickly in order to generate big profits (see InvestorGuide University: IPOs). Some aggressive growth funds may even invest in derivatives, such as options, in order to increase their gains (see InvestorGuide University: Options). You should note that these funds can be quite volatile and risky investments. Blend Funds If you want to achieve both growth and value objectives, the mutual fund industry has a ready solution for you: blend funds (or "blended" funds). These funds invest in both value and growth stocks so that you can enjoy current income and long-term capital appreciation within the same fund. Since blend funds tend to vary considerably it is difficult to make generalizations about how risky they are in comparison to other types of mutual funds -- most likely, they are somewhat more risky than value funds and somewhat less risky than growth funds. Sector Funds Sector funds are stock funds that invest in a single sector of the market, such as the energy sector or the biotechnology sector. Sector funds are usually used by investors to achieve growth -- in other words, you would choose sector funds that match the industries that you think are going to do well in the future. But sector funds can also be used for other purposes too -- for example, to act as a hedge against other holdings in a portfolio. Some common sector funds include financial services funds, gold and precious metals funds, health care funds, and real estate funds, but mutual funds exist for just about every sector. To be considered a sector fund, a fund must invest at least 25% of its portfolio in one sector, although many sector funds invest all of their holdings in a single industry. In general, sector funds are more volatile and risky than mutual funds that invest their assets across a wide variety of industries. Large Cap, Mid Cap, Small Cap, and Micro Cap Funds Stock funds may also be classified according to the market capitalization of the companies in which they invest. The market capitalization, or "market cap", of a company is simply the value of the company on the stock market -- in other words, it is the number of outstanding shares of the company times the price of those shares. There are three main types of cap funds: large-cap, mid-cap, and small-cap. Although the dividing line isn't precise, large cap funds tend to invest in companies with market caps above $10 billion, mid cap funds tend to invest in companies with market caps of $1 billion to $10 billion, and small cap funds tend to invest in companies with market caps below $1 billion. Some mutual funds also add a fourth category called micro-cap funds to describe funds that invest in companies worth less than $250 million. In general, the smaller the average market cap of the fund's holdings, the more volatile the return; micro-cap funds can be especially risky. Focused Funds

Focused funds are funds which hold large positions in a small number of stocks. While many mutual funds hold 100 positions or more, focused funds usually have 10 to 40 positions at any given time. They emphasize quality over quantity, and would rather hold just the stocks they have the most confidence in, rather than diversifying across a large number of holdings. In theory this should enable them to more thoroughly research and track their holdings, although they lose the benefits of diversification and tend to be more volatile than other mutual funds. Index Funds An index fund is a "passively" managed mutual fund that tries to mirror the performance of a specific index, such as the S&P 500 or the Dow Jones Industrial Average. Since index funds attempt to mirror a stock index, decisions about which stocks to buy and sell are automatic for the fund and transactions are infrequent. This means that index funds do not require the management of a professional money manager, and so they are said to be "passively managed" (while any fund that requires a manager to select stocks is said to be "actively managed"). Index funds have become increasingly popular with investors over the past few decades for a variety of reasons. First, the funds have much lower operating expenses than actively managed funds. This is because passive funds do not require the services of a professional money manager to select stocks for the fund's portfolio; instead, they simply buy and sell according to the holdings of a particular index. And, since most indexes do not often change their holdings, index funds benefit from lower transaction costs and fewer capital gains taxes in addition to the lower management costs. Many investors also like index funds because they do not have to worry about "beating the market" since they can choose to invest in an index that mirrors the market (either the market as a whole or some specific part of it). But although you'll never significantly underperform the market with an index fund, you'll also never have the opportunity to significantly outperform it. Even so, as more and more studies have shown that most mutual fund managers are unable to beat the market consistently, more and more investors have been starting to take advantage of index funds. For individuals who don't have the time or interest to select and monitor a portfolio of actively managed mutual funds, InvestorGuide recommends seriously considering index funds. Exchange-Traded Funds Exchange-traded funds (ETFs) are similar to index funds, but with one important distinction: they trade on stock exchanges. When you buy a share in an ETF, you are buying a share in a unit investment trust or another type of trust (see InvestorGuide University: Unit Investment Trust). In order to create an ETF, the trust bundles together many different securities into one basket and then sells shares in the trust on a stock exchange. ETFs always bundle together the securities that are in an index; they never track actively managed mutual fund portfolios (because most actively managed funds only disclose their holdings a

few times a year, so the ETF would not know when to adjust its holdings most of the time). Investors can do anything with an ETF that they can do with a normal stock, such as short selling (see InvestorGuide University: Short Selling). Because ETFs are traded on stock exchanges, you can buy and sell them at any time during the day (unlike most mutual funds). Their price will fluctuate from moment to moment, just like any other stock's price, and you'll need a broker in order to purchase them, which means that you'll have to pay a commission. On the plus side, though, ETFs are more taxefficient than normal mutual funds, and since they track indexes they have very low operating and transaction costs associated with them. There are no sales loads or investment minimums required to purchase an ETF. The first ETF created was the Standard and Poor's Deposit Receipt (SPDR, pronounced "spider") in 1993. SPDRs gave investors an easy way to track the S&P 500 without buying an index fund, and they soon become quite popular. Shortly thereafter, a number of other ETFs came onto the market, including "cubes" (which track the Nasdaq 100 under the symbol QQQ) and "diamonds" (which track the Dow under the symbol DIA). Today you can buy ETFs for dozens of different indexes.

Bond Mutual Funds

As the name suggests, bond mutual funds invest in bonds and other debt securities. As such they are conservative investments that aim to protect the invested principal while paying out a regular income, rather than taking on more risk in search of superior returns. If you invest in a bond fund you'll receive monthly dividends from the fund that include interest payments on the fund's underlying securities plus any capital appreciation in the prices of the portfolio's bonds. As with other types of mutual funds, bond funds have a net asset value (NAV) that is the dollar value of one share in the fund; this is the price that investors pay or receive when they buy or sell shares in the fund. Investors typically choose to buy bond funds for two reasons: income and diversification. Bond funds tend to pay higher dividends than money market and savings accounts, and they usually pay out dividends more frequently than individual bonds. Bond funds are also considered to be "low risk" investments that can provide stability to a portfolio that is weighted heavily with stock. You should note, however, that bond funds are not risk-free investments -- they are still subject to the same credit and interest rate risks as regular bonds. But since the fund's investments are spread out among many bonds, the overall risk is usually lower. Bond funds are also more liquid investments than individual bonds; shares can be bought and sold much more easily. Like some types of bonds, certain bond funds may be exempt from federal and/or state taxes (see InvestorGuide University: Municipal Bonds).

Types of Bond Funds There are three basic types of bond funds: U.S. government bond funds, municipal bond funds, and corporate bond funds. The returns of these bond funds differ according to the amount of risk inherent in each fund. US Bond Funds U.S. government bond funds invest in debt securities that are issued by the United States government and its agencies. These funds are regarded as the safest of the bond funds because the underlying securities are backed by the full faith and credit of the United States government (however, the fund itself is not backed by the government). The funds invest in such debt instruments as Treasury bills, Treasury notes, Treasury bonds, and mortgage-backed securities issued by government lending agencies such as Fannie Mae (see InvestorGuide University: Treasury Bills, Treasury Notes, Treasury Bonds, MortgageBacked Securities). Certain U.S. government bond funds, like Treasury funds, are exempt from state and local (but not federal) taxes. The biggest risks involved in investing in these funds are related to fluctuating interest rates and inflation. Municipal Bond Funds Municipal bond funds invest in debt securities issued by state and local governments to pay for local public projects, such as bridges, schools, and highways. These bond funds are popular among investors with high incomes because they are exempt from federal taxes and, in some cases, from state taxes as well. As with U.S. government bond funds, the underlying securities in municipal bond funds are backed by the government and thus are considered to have a high credit rating. However, municipalities have been known to declare bankruptcy on occasion, making these funds more risky than their U.S. government counterparts. Corporate Bond Funds Corporate bond funds are comprised of bonds issued by corporations. Unlike the securities held by U.S. government and municipal bond funds, the bonds in a corporate bond fund are not backed by any government institution. Thus it is more likely that the underlying bonds could default if the companies that issue them run into financial trouble. Along with the greater risk, however, comes a greater reward -- the income paid out by corporate bond funds is typically much greater than that paid by municipal or U.S. government bond funds. Investment-grade corporate bond funds invest only in the most creditworthy of companies; they are considered to be the safest of all corporate bond funds. Other Types of Bond Funds Besides the aforementioned bond funds, there are many other types of bond funds. Zero-coupon bond funds invest in zero coupon bonds (see InvestorGuide University: Zero Coupon Bonds); international bond funds

invest in bonds issued by foreign governments and corporations; convertible securities funds invest in bonds that may be converted into stock (see InvestorGuide University: Convertibility). And finally, if you're looking to diversify your holdings even more, there are multisector bond funds that invest in all different types of bonds: corporate bonds, municipal bonds, international bonds and so on.

Other Types of Mutual Funds

The mutual funds in this section cannot be classified as either stock funds or bond funds. Some, like lifecycle funds and balanced funds, invest in both stocks and bonds, while others, like money market funds, invest in neither. Money Market Funds Money market funds are among the safest and most stable of all the different types of mutual funds. These funds invest in short term (one day to one year) debt obligations such as Treasury bills, certificates of deposit, and commercial paper (see InvestorGuide University: Treasury Bills, Certificates of Deposit, Commercial Paper). The main goal is the preservation of principal, accompanied by modest dividends. These funds are in no way guaranteed or insured by the federal government or any other institution. Although money market mutual funds are among the safest types of mutual funds, it still is possible for money market funds to fail. But given the conservative nature of their investments, such scenarios are highly unlikely. In fact, the biggest risk involved in investing in money market funds is the risk that inflation will outpace the funds' returns, thereby eroding the purchasing power of the investor's money (see InvestorGuide University: Inflation). Income Funds Income funds focus on providing investors with a steady stream of fixed income. In order to achieve this, they might invest in bonds, government securities, or preferred stocks that pay high dividends (see InvestorGuide University: Preferred Stocks). They are considered to be conservative investments, since they stay away from volatile growth stocks. Income funds are popular with retirees and other investors who are looking for a steady cash flow without assuming too much risk. Balanced Funds The purpose of balanced funds (also sometimes referred to as "hybrid funds") is to provide investors with a single mutual fund that combines both growth and income objectives. In order to achieve this goal, balanced funds invest in both stocks (for growth) and bonds (for income). Balanced funds typically invest no more than 50% of their money in stocks, with the rest allocated to debt instruments. Such diversified holdings ensure that these funds will manage downturns in the stock market without too much of a loss; the flip side, of course, is that balanced funds will usually enjoy fewer gains than an all-stock fund during a bull market. Asset Allocation Funds Asset allocation funds are a type of balanced fund that invest in a number of different asset classes, such as stocks, bonds and cash. They are similar to balanced

funds, except they invest in many other types of asset classes in addition to stocks and bonds (e.g. money market accounts). International, Global, Regional, and Emerging Markets Funds If one of the goals in mutual fund investing is diversification, then what better way to achieve that goal than by investing in assets from all over the world? That is the logic underlying global mutual funds (also sometimes called world funds). Such funds invest throughout the world, including in the U.S. Global mutual funds can provide more opportunities for diversification than domestic funds alone. You should take into account, however, that there can be additional risks associated with global funds involving currency fluctuations and political and economic instability abroad. International funds (sometimes referred to as foreign funds) are similar to global funds but with one major exception: they do not invest in any domestic assets. International funds therefore do not offer as great an opportunity for diversification as global funds, but they are useful for investors who want to concentrate their holdings in foreign assets only, or who already have significant domestic investments in their portfolio. As with global funds, international funds can involve risks associated with currency fluctuations and political and economic instability abroad. Regional funds can be thought of as a particular type of international fund that focuses on only one particular region -- for example, Western Europe or Latin America. Even more specific are emerging markets funds that invest only in the capital markets of foreign countries that are undergoing dramatic economic transitions, such as those economies that are transforming from an agricultural economy to an industrialized one (as in the case of many third world countries) or those that are transforming from a state-run economy to a free-market one (as in the case of many former Eastern bloc countries). Emerging markets funds offer potentially higher-than-normal returns due to these economic transitions, but they can also involve a significant amount of risk if the economic transition fails or if there is instability in the country or its currency. Mortgage-Backed Securities Funds Mortgage-backed securities funds invest in home mortgage securities that are offered through several government agencies. These agencies, such as "Ginnie Mae" (the Government National Mortgage Association) and "Freddie Mac" (the Federal National Mortgage Association), purchase and then pool together groups of home mortgage loans, which they then later resell to investors (such as mutual funds) as a single security. Mortgage-backed securities funds receive interest payments on the mortgages, which they pass on to shareholders, as well as principal payments, which they use to reinvest in more securities (see InvestorGuide University: MortgageBacked Securities). These funds are considered to be very safe since mortgagebacked securities from the aforementioned agencies are either backed by the federal government or they have very high credit ratings. However, these funds may suffer from prepayment risks (in which case the mortgagor may pay off the principal earlier than anticipated) and interest rate fluctuations (which could cause the value of the fund to go up and down). Hedge Funds Hedge funds are funds that use a variety of aggressive investing strategies (such as

short selling, investing in derivatives, and leverage) to seek higher returns. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allows them to accomplish aggressive investing goals. They are restricted by law to no more than 100 investors per fund, and as a result most hedge funds set exceptionally high minimum investment amounts, ranging anywhere from $250,000 to over $1 million. As with traditional mutual funds, investors in hedge funds pay a management fee; however, hedge funds also collect a percentage of the profits (usually 20%). Fund Supermarkets Fund supermarkets are analogous to grocery supermarkets: they allow consumers to buy a variety of goods from different producers at one central location. In the case of fund supermarkets, the consumers are investors, the producers are mutual fund families, and the central location is a brokerage firm. The primary benefit of such an arrangement is simplicity: you get to buy funds from different families and receive all their statements in a single report. Fund supermarkets are also supposed to save on costs, since the funds are usually traded with no commissions and no transaction fees. In reality, however, the supermarkets charge the fund families a stiff fee, which is then passed off to investors through the form of expense fees or reduced distributions. Funds of Funds "Funds of funds" (FOFs) are meta-mutual funds; that is, they are mutual funds that invest in other mutual funds. Just as a normal mutual fund invests in a number of different securities, so an FOF buys shares of many different mutual funds. These funds were designed to achieve even greater diversification than normal mutual funds; however, they suffer from several drawbacks. Expense fees on FOFs are typically higher than those on regular funds because they include part of the expense fees charged by the underlying funds. But even FOFs with low fees may suffer from another disadvantage: duplication. Since FOFs buy many different funds which themselves invest in many different stocks, it is possible for the FOF to own the same stock through several different funds. Most experts say that FOFs are not terribly useful, given that one or a few mutual funds can provide adequate diversification without the second level of fees. Lifecycle Funds Starting in the early 1990s, many mutual fund families began offering "lifecycle" funds designed to carry investors from one stage of life to the next. The idea is to offer investors three types of funds -- high growth, average growth, and low growth -- that they can switch between as their risk tolerance changes once they move from youth to middle age to retirement. Although lifecycle funds all share the common goal of first growing and then later preserving principal, they can contain any mix of stocks, bonds, and cash. Institutional Funds Institutional funds are mutual funds that target pension funds, endowments, the wealthy, and other multi-million dollar investors. Their main objective is to reduce risk, so they invest in hundreds of different securities, which makes these funds among the most diversified funds available. They also do not tend to trade securities

very often, so they are able to keep operating costs to a minimum. Although in the past investors typically needed at least $1 million in order to invest in an institutional fund, nowadays some discount brokers offer access to these funds for more modest sums of money, such as $1,000-$5,000. Socially Responsible Funds Perhaps the most subjective of all the types of mutual funds, socially responsible funds aim to invest only in companies that adhere to certain ethical and moral principles. Exactly what this means obviously varies from fund to fund, but some examples include: funds that only invest in environmentally conscious companies ("green funds"), funds that invest in hospitals and health care centers, and funds that avoid investing in alcohol or tobacco companies. Socially responsible funds try to maximize returns while staying within these self-imposed boundaries. Contrarian Funds Contrarian funds seek to make a profit by investing in the opposite direction of the prevailing market sentiment. During the extended bull market of the 1990s this term actually came to be equated with bear market investing, but really it just means investing in the opposing direction (see InvestorGuide University: Bear Market). Contrarian funds will invest in bonds when the stock market is high (in anticipation that it will fall) and stocks when the stock market is low (in anticipation it will rise). GIC Funds GIC funds are mutual funds that invest solely in guaranteed investment contracts (GICs). GICs are fixed income debt instruments sold by insurance companies to pensions and other types of retirement plans. They pay a fixed interest rate over a short period of time, usually about 5 years, and they are guaranteed by the insurance agency that issues them, not by the government. As with other mutual funds that invest in debt instruments, GIC funds are generally considered to be conservative investments. Unit Investment Trusts (UITs) Unit Investment Trusts (UITs) technically are not a type of mutual fund, but they behave similarly to them. Like mutual funds, UITs pool together money from a group of investors and then use that money to purchase a basket of securities (usually bonds but occasionally stocks). Unlike mutual funds, however, UITs do not later buy and sell more securities for their portfolio -- in other words, a UIT's portfolio is frozen after the initial securities are bought. And unlike mutual funds, UITs have expiration dates (usually anywhere from one to five years); after a UIT expires, investors may choose to receive their investment in cash (minus operating costs and sales charges) or they can roll over their investment into a new UIT. Some investors prefer UITs to mutual funds because UITs typically incur lower annual operating expenses (since they are not buying and selling shares); however, UITs often have steep sales charges and entrance/exit fees that could end up costing more than the fees paid to a mutual fund. The other problem with UITs is that they can only be purchased through the investment houses that created the trust and not on the open market. This can make it difficult for investors to find pricing information for the UIT, and so it can be quite difficult for investors to compare prices across UITs before deciding which one to purchase.

Market Neutral Funds Neutral funds attempt to provide a higher return than the risk-free rate (the rate on Treasury bills) while neutralizing their risk to zero. They try to accomplish this by fully hedging their portfolios through a series of long and short positions aimed at balancing off any risks to equal zero. Leveraging is used to earn a higher rate of return than the risk-free rate. Option and Futures Funds Option and futures funds are among the most risky mutual funds available. This is because the fund does not own the securities underlying the options or the futures; it only owns the right or the obligation to buy or sell those securities at a certain date in the future (see InvestorGuide University: Other Investments). The goal of option and futures funds is primarily capital appreciation, although sometimes they are used to hedge against prevailing market conditions. Most option and futures funds have minimum net worth requirements and are not appropriate investments for inexperienced investors (just as options and futures aren't appropriate for beginners).

Prospectuses, Annual Reports, and Other Documents

Every mutual fund is required to publish documents that help you evaluate its suitability as an investment. There are three such documents that are especially important, and which you should read and understand before making the decision to invest in any given mutual fund: the prospectus, the Statement of Additional Information (SAI) and the annual report. Although these documents are usually rife with legal and financial jargon, they also contain important information about the fund and its overall financial health. Each is described below. Prospectus The first place you should look for information when considering investing in a mutual fund is the fund's prospectus. The prospectus is a legal document required by the Securities Act of 1933 that explains the mutual fund offer. It includes information about the terms of the offer, the issuer, and its objectives. Before you invest in a mutual fund, you should always make sure that you understand what it said in the prospectus. Prospectuses can seem daunting at first as they are packed with information and tables, but you should keep in mind that the information presented there is for your benefit. When reading through a prospectus you should look for the following key sections: Investment Objective At the front of the prospectus should be a short statement of the fund's investment objectives. This section contains information about what the fund hopes to accomplish -- for example, some funds might aim to achieve short-term growth while others might focus on long-term stability. You should check to see whether or not the fund's objectives match your own personal investment objectives, since you

probably only want to invest in funds that have similar goals to your own. Be careful when evaluating a fund's investment objective, however, since they are often times vague. It's always a good idea to look through the rest of the prospectus to get a better sense of the fund before making any decisions about whether or not to invest. Investment Strategy While the investment objectives section outlines what goals the fund hopes to accomplish, the investment strategy section describes exactly how the fund plans to accomplish them. For example, a mutual fund whose objective is current income might adopt a strategy involving a mixture of bonds and other fixed income securities. The prospectus does not, however, include a list of specific stocks or bonds in which the fund invests -- it simply describes the types of assets which the fund purchases (e.g. corporate bonds or small cap stocks). But the prospectus usually does detail its asset allocation plan, and some may even specify maximum or minimum percentage limitations for specific asset classes. Fees and Expenses Although mutual funds aim to make money for their investors, their ultimate goal, just like any other business, is to make money for themselves. In order to do so, funds charge their shareholders a variety of fees and expenses, all of which must be documented in the prospectus. A table at the front of every prospectus contains a breakdown of the different fees and expenses, along with a hypothetical projection of how the fees would impact a $10,000 investment over a 10 year period. This should make it easy for you to compare fees and expenses across mutual funds (see InvestorGuide University: Fees and Expenses). Account Information This section contains very basic information about how to buy and sell shares and other account-related information. For most mutual funds the method of buying shares is the same. You can either go the traditional route and send a check to the fund each time you want to deposit more money, or you can set up automatic withdrawals from your bank account. Some mutual funds also allow wire transfers for quick deposits, but often times they charge a small fee for the transfer. In addition to telling you how to get your money into the fund, the prospectus will also tell you how to remove it. Most mutual funds will require that you fill out a redemption form or write a letter to the fund in order to receive your investment. However, some funds will also let you redeem shares over the phone and others will even wire the money straight into your bank account for you (although usually they will charge a fee for this service). The prospectus will inform you which of these redemption methods are available to you. Risks One of the most important sections in the prospectus is the one describing the level of risk that the fund takes with its investments. Although all investments in stocks and bonds (with perhaps the exception of U.S. Treasuries) involve some measure of risk, this section will tell you what risks are associated with the specific investments made by the fund. So, for example, if the fund invests in emerging markets, this

section would include information about the risks particular to investing in such markets (e.g. political, economic and/or social instability). Performance This section is usually entitled "Financial Highlights" or "Per Share Data Table." It includes information about the fund's performance over the last 10 years (or less, if it hasn't been around that long.) When looking at the fund's historical performance, however, it's important for you to remember that past performance is not necessarily an indicator of future results. Still, you can judge how well the fund has traditionally performed compared to an index, such as the S&P 500. You can also get some useful information from this section about the fund's volatility, dividend payments, and turnover (see InvestorGuide University: Dividend Payments, Turnover). Management This is the section where you'll have the opportunity to find out more about the people in charge of your money. The management section should tell you the name of your manager along with some additional information about his or her experience and qualifications (if this information is missing, you should consult the Statement of Additional Information, the annual report, or the company's web site). Once you know your portfolio manager's name, you can try to find out whether or not he or she has managed other funds in the past in order to get a sense of his or her past strategies and results. Statement of Additional Information In 1983, the Securities and Exchange Commission began to require that mutual funds split their prospectuses into two parts -- the "prospectus" (described above) and the Statement of Additional Information (SAI). While the prospectus contains a simple summary of the fund and its objectives, the SAI contains much more detailed information about the fund. It's important for you to understand that the SAI is considered to be part of the prospectus, so for legal purposes it is assumed that you have read it. But whereas mutual funds routinely send out prospectuses and annual reports to potential investors, they don't always send out the SAI unless it is specifically requested. If you don't receive the SAI with the prospectus, you should request one before making an investment decision. The SAI goes into great detail about the fund's board of directors, and you might be interested in knowing just how much you, as a shareholder, are paying them. On a more practical level, though, the SAI can tell you much more about any limitations on the fund's investments (e.g. if it is restricted from purchasing certain assets), and it will break down in detail the fees and expenses that are mentioned in the prospectus. Although the SAI may look like a long and tedious document, it in fact contains a wealth of valuable information. Annual Report Every year (or, in some case, twice a year) your mutual fund will send you a report describing the fund's performance for the previous year. You should use these annual reports to check whether or not your fund is performing according to your expectations. The reports include a list of the fund's financial statements, a list of the fund's securities, and explanations from the fund's management as to why the fund

performed as it did. There is also usually a line graph comparing the fund's performance to a benchmark, such as the S&P 500. When looking a fund's annual report, you should ask yourself the following questions: Is the fund comparing itself to an appropriate benchmark? It would make little sense for a technology fund to compare itself to the Dow, since only a handful of Dow components are in the tech sector. Make sure the report is using a reasonable benchmark to assess its performance. How did the fund perform in its peer group? There are probably dozens of funds that are similar in objective to the one you own. You should check to see whether or not your fund managed to beat its peers (you can find out how other funds performed by requesting copies of their annual reports or by searching on the internet for performance information (see InvestorGuide: General Mutual Fund Resources). What does the manager have to say about the fund's performance? Obviously, the manager is always going to try to put a positive spin on why the fund performed the way it did. You should read his or her statement carefully to determine if the manager really knows what he or she is talking about. What are the fund's fundamentals? You can look through the financial statements to find more information about the fund's Net Asset Value, its turnover ratio, and its expense ratio (see InvestorGuide University: Net Asset Value, Turnover Ratio, Expense Ratio). Make sure these are in line with what you expect from a fund. And finally, what securities does the fund hold? Although one of the big advantages to investing in securities via mutual funds is having a professional manage your investments for you, nevertheless it's a good idea to know what specific securities are being chosen. You may even want to consider doing your own research on the top holdings (see InvestorGuide University: Research).

Mutual Funds and Your Portfolio

Depending on your particular situation and goals, you might benefit by including mutual funds in your portfolio. The first step when constructing any portfolio is to define your objectives (see InvestorGuide University: Building a Portfolio). Most investors use mutual funds in their portfolio in order to achieve diversification but mutual funds can be used for a number of other purposes as well (see InvestorGuide University: Diversification). This section will examine all of the central issues involved when adding mutual funds to a portfolio: the risks, the diversification benefits, and the tax consequences. It will also give you some advice on how to select and purchase mutual funds, and how to maintain your portfolio after it is established. Diversification and Other Benefits Mutual funds are generally lower-risk investments, especially when compared to individual stocks. This is because mutual funds are by definition diversified investments. When you purchase a share in a mutual fund, you are actually purchasing a very small amount of ownership in the many securities that the fund holds. So, if one of the securities in the fund happens to perform poorly, there is always the chance that other securities in the fund's holdings will be able to offset any losses. The opposite, of course, is true as well: when you hold a single security

that realizes a large gain, you receive all of the gain, but when you hold a mutual fund, any large gains in one security might be offset by losses in another. Most investors use mutual funds in order to diversify their holdings and provide some stability to their portfolios. You can also use mutual funds in your portfolio to target a specific asset class in which you want to invest without purchasing individual securities in that class yourself. For example, you might know that you want to invest in bonds because you are looking for fixed income, but you might not know which specific bonds to invest in. Even though bonds are considered low-risk investments, selecting the right individual bonds yourself might be difficult, so instead you could just invest in a bond mutual fund and have the mutual fund manager make the decisions about which bonds to buy for you. Choosing a Mutual Fund Once you've identified your reasons for including mutual funds in your portfolio, the next step is to select the fund or funds that will give you the best performance. Remember, however, that the mutual funds you pick must fit your overall strategy and make sense with the rest of your portfolio. First, you should decide what types of funds you want, and then choose ones in those areas; or if you've already selected (or already own) some good funds, fill in the gaps. You can use a screen to put together a list of candidates (or skip this if you already know which ones you're interested in), and then research them by getting the fund's prospectus (see InvestorGuide University: Prospectus). Most of the information below is provided in the first few pages of the fund's prospectus. You can also find more information from the mutual fund company's website or from its annual report (see InvestorGuide University: Annual Report). Performance Investigate performance, both before and after taxes (see InvestorGuide University: Taxes). Look at the fund's historical performance over a long period of time (3, 5, and 10 years). Why? Because there's a positive correlation between past and future results (although the correlation is far from exact, as some funds do very well one year and very poorly the next). It's dangerous to focus only on recent performance: it could be a fluke, or the manager could be good only in bull markets. Keep the following questions in mind when investigating the performance of a particular mutual fund: Is the performance consistent? How is the performance when compared with peers and indices? If you expect that a fund you're considering won't keep up with the indices, you should just get an index fund instead (see InvestorGuide University: Index Fund). How is the performance after taxes and costs (front and back-end loads and expenses) are factored in? This is what will end up in your pocket. Also investigate the mutual funds investment style. Consider the following: Growth or Income? Large cap or small? U.S. or international? Does the fund's investment style match your goals? Has the style been consistent through time?

What level of risk do they take on? Are you comfortable with this? Does the performance reflect this level of risk? (if the fund takes above average risk, performance should be above average) The strategies that they use: short selling, leverage, derivatives, market timing (see InvestorGuide Unversity: Short Selling, Leverage, Derivatives, Market Timing).

Look beyond the name of the fund to determine the style; names aren't always indicative of the true style. For example, a fund that started out as a small cap may have ballooned in assets to the point where it's forced to buy larger cap stocks, but the name of the fund wouldn't have changed. Specific holdings might give some clues as to investment style. Keep in mind that mutual funds are only required to divulge their holdings twice a year, and few do it more frequently, so by the time you find out what they have, their holdings have probably changed. Also, many funds 'window dress' their portfolios with yesterday's winners to make the reports look good, so these semi-annual reports aren't a perfect indicator of investment style. Manager This is important because the manager makes most of the buy and sell decisions. If the manager has been leading the fund for a long time, you can be confident that the fund's investment style and strategy (discussed above) are the manager's. If not, determine the manager's style based on previous funds that have been managed by him/her. Take a look at what the manager says in the annual report and the prospectus. Find out if the manager has substantial personal assets invested in the fund. If not, find out why. Fund Family Different fund families have different policies, areas of expertise, and services. You should check out several of them to find out their particular policies and services. Services You can get this information directly from the fund. Call them or look in the prospectus (see InvestorGuide: Mutual Fund List). Account information and availability Newsletters Annual reports Checking accounts Phone redemption and switching Phone account info and quotes (24 hrs?) Web account info and quotes (24 hrs?) Hours of live representative Wrap accounts Margin loans Other Considerations Loads and other fees Minimum investment

Here are a few additional tips to consider when choosing mutual funds for your portfolio: You don't need to own a lot of different mutual funds. A handful should be enough to achieve diversification, because each of them in turn invests in dozens of stocks, bonds, etc. Consider dollar cost averaging, the practice of investing the same amount each month (see InvestorGuide Unversity: Dollar Cost Averaging). This is an easy way to ignore the market fluctuations and focus on the long-term picture The above advice should get you started on the right path. You will probably discover other things to consider as you investigate further. To gather more information, check out mutual fund magazines, talk to others about their strategies, and check out some fund ratings. Buying and Redeeming Shares Depending on the mutual fund you decide to purchase, you might be able to buy shares directly from the fund. This would allow you to sidestep any brokerage commissions. For some mutual funds, however, you may need to go through a broker; check with the fund to find out which methods they allow. A third alternative is to go through a mutual fund supermarket where you can easily move your money between funds with a single account (see InvestorGuide University: Mutual Fund Supermarket). Be aware that not all mutual funds participate in supermarkets, although hundreds do. There will probably also come a time when you want to sell, or redeem, your shares. For example, if you find that your fund is not meeting your expectations or if your particular set of investing objectives happens to change, then you might decide to sell shares in one or more of your mutual funds and look into other funds or other investments entirely. Check out your fund's prospectus in order to find out the details of their redemption process. Most funds allow you to redeem by telephone, but some might require that you send in a form. The point of mutual fund investing, however, is not to be actively buying and selling shares all the time. You are, after all, paying someone to manage your investments for you, so you shouldn't be spending too much of your own time actively managing the funds in your portfolio. Nevertheless, it's always a good idea to keep an eye on your investments; after all, it's your money.

Extra material
Building a Portfolio
A portfolio is essentially the sum of all of your different investments. These investments will probably include stocks, which are investments in individual businesses; bonds, which are investments in debt that are designed to earn interest; and mutual funds, which are essentially pools of money from many investors that are invested by professionals or according to indices. Building a winning portfolio is

dependent on a number of factors, but it is important to remember that your portfolio should be designed according to your needs and goals. For that reason, your ideal portfolio may not be the same as another investor's and you must carefully study your finances and your options in order to be successful. Unfortunately, there are few shortcuts in the world of investing. Asset Allocation One of the most important steps to building a successful portfolio is properly dividing assets among different types of investments. The most important asset classes are stocks, bonds, and cash. Because these investments perform differently depending on economic conditions, a good balance can keep a portfolio strong in a wide range of economic situations. In this sense, asset allocation may be the most important form of diversification. Also, asset classes carry varying amounts of risk, meaning that the best allocation will depend on a range of factors related to an individual's investing profile. When putting together an asset allocation plan, it is most important to consider investing goals, risk tolerance, and time horizons. Of course, all three of these factors are closely related. Essentially, they allow you to map out how much money you will need at certain points in your life and how much uncertainty you can tolerate in moving from one life stage to the next. Investing goals are closely tied to age and family situations. Younger people can generally tolerate more risk in their investments because they can afford to wait out bad patches and make up the difference later. Time horizons are simply the lengths of time until the invested money will be needed. Common examples are the time until a child starts college or the time until you retire. Again, long time horizons allow for riskier investments because a temporary downturn will not ruin the long-term plan. Once you have decided your time horizons and the level of risk you're comfortable with, the next step is to determine the investment options that are best for your profile. Higher risk opens the door to greater rewards, but those potential rewards are worthless if they are missing when the money is needed. Stocks offer the best long-term growth prospects to investors. In the long run, they have outperformed nearly all other investments, but they are also quite volatile, making them a riskier investment. Over shorter periods of time, stocks can lose a great deal of value. Also, the impressive performance of stocks is based on looking at stocks as a whole. Individual stocks may not keep up with the market as a whole, or they may become completely worthless (for example, if the company declares bankruptcy). Bonds are a safer investment with less spectacular returns over time. The lower returns are the cost of removing a great deal of volatility from the equation. Cash investments such as money markets are the safest investments, and, as expected, they deliver the lowest returns. Assets should be divided among these major groups and possibly some more specific ones like real estate or international investments in order to create a portfolio that meets your specific needs in terms of risk and reward. In order to get some help with asset allocation without having to hire a financial adviser or become an expert, many investors turn to mutual funds. Asset allocation funds offer different mixes of stocks, bonds and other investments to fit different investing profiles. Alternatively, mutual funds can be used to provide diversification within different asset classes, meaning that you can simply divide your money among stock funds, bond funds and money market funds in the proper ratios.

An advantage to asset allocation funds is that they are constantly rebalanced to reflect the intended allocation among the asset classes. For investors using individual funds or picking their own investments within the classes, it is important to regularly rebalance the portfolio to reflect the ideal allocation that was initially determined. For example, if your stock investments take off, you may find yourself with a greater than desired portion of your assets in stocks. At that point, you are taking on more risk than you would like to because the value of his portfolio has shifted as it has increased. The opposite phenomenon can occur if one portion of a portfolio underperforms. Of course, the tendency would be to abandon the underperforming asset class, but it is important to return it to the desired level of prominence in the portfolio in order to remain true to the initial goals and time horizons. In order to rebalance, funds must be shifted from over-weighted areas of the portfolio to underweighted ones, restoring the original mix of asset classes. Alternatively, new money can be invested in the under-weighted classes or money can be removed from the over-weighted classes, increasing or decreasing the total value of the portfolio respectively. Risk When dealing with investments, risk essentially refers to the chance that investments will decline in value. Obviously, this decline would result in a net loss, so risk can be considered the potential for loss. Risk takes many forms in the investing world. Every investment carries with it some degree of risk. To get an accurate picture of the risk associated with a given investment or portfolio of investments, the various forms of risk should be considered collectively. The result can be viewed with potential return in the context of a given investor's goals to determine if the investment is worthwhile. Risk can also be assessed by tracking the volatility of a given investment. Volatility is simply the tendency of the value of the investment to change. If the price of a stock moves up and down rapidly over short time periods, it is said to be volatile. If the price almost never changes, the stock is not volatile. As you might expect, the volatile stock is a riskier investment because its unpredictability makes it more likely to decline in value. In general, the more volatile the investment, the greater the chance of loss. At the same time, the more volatile investment may also be more likely to produce a large return. For this reason, risk and return must be carefully balanced. The following list includes some of the many risk factors that should be carefully considered before investing. Currency risk: If money must be exchanged to make a certain investment, changes in the value of the currency relative to the American dollar will affect the total loss or gain on the investment when the money is converted back. This risk usually affects businesses, but it can also affect individual investors who make international investments. Inflation risk: Although all investing decisions involve risk, simply not investing is not the answer. Inflation causes money to decrease in value at some rate. So inflation risk occurs whether you invest or not. It is up to you to choose investments that outpace inflation; otherwise, invested money will gradually lose value even if the principal invested is increasing at some rate (see InvestorGuide University: Inflation and Interest Rates).

Interest rate risk: As interest rates change, the value of fixed-income investments such as bonds change. This risk can be reduced by diversifying the durations of the fixed-income investments that are held at a given time. Market risk: The value of investments may decline over a given time period simply because of economic changes or other events that impact large portions of the market. Asset allocation and diversification can protect against market risk because different portions of the market tend to underperform at different times. Industry risk: Changes in the environment of a particular industry may introduce a great deal of risk and cause securities connected to that industry to decline. Diversification can help to counter this risk because industries don't usually all underperform simultaneously. Stock-specific risk: Events that impact a particular company can have a monumental effect on the company's stock. The potential problems that can arise at a given company can infuse a great deal of risk into a particular stock. Again, this type of risk can be combated by diversification because not all companies experience problems at the same time. Liquidity risk: An investment may need to be sold before its maturity in order to extract the invested funds. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from it. There can also be significant fees associated with liquidating some investments before a certain time. By the same token, the need to liquidate will eliminate the possibility of earning returns that would have been expected if the investment were held as long as expected. Principal risk: There is always the possibility that through some set of circumstances, invested money will decrease or completely disappear. In this case, principal is lost in addition to returns and expected returns. If the invested money is essential, it will have to be replaced in some way.

Diversification The goal of diversification is to reduce the risk involved in building a portfolio. Volatility is limited by the fact that not all asset classes or industries or individual companies move up and down in value at the same time or at the same rate. While this limits the rate of growth as well, it reduces the likelihood of substantial losses and allows for more consistent performance under a wide range of economic conditions. Devising an asset allocation plan is the first step toward diversifying a portfolio. Dividing funds between different asset classes provides some protection against loss when one type of investment is underperforming. Because the values of different investments often move in opposite directions, investing in a range of securities reduces the risk that all assets will be decreasing in value at the same time. The process of diversification, however, does not end with asset allocation. Within asset classes, it is important to purchase securities from a variety of industries, so that poor performance in one area will not send an entire portfolio reeling. Certain industries perform better under certain economic conditions, but a diverse portfolio should continue to build overall value under almost any conditions. Diversification should then continue even within industries by purchasing securities from a

mix of companies that serve different roles within the industry. A single stock in a high-flying industry may still fail, but a group of ten diverse stocks within that industry will have lower volatility than just one would. Learning enough about the many industries and companies that make up a diverse portfolio is no easy task. A great deal of research is required to make good decisions. For investors who wish to learn about a few specific areas to pick individual investments, mutual funds can fill in the gaps. Professionals design mutual funds to have a great deal of diversification built in. Even mutual funds that focus on a particular part of a particular industry will usually provide the chance to invest in a broad cross-section of that sector (see InvestorGuide University: Mutual Funds). Index funds provide another option for diversification by giving investors the opportunity to invest in all of the stocks that appear in a certain index. While these funds vary widely in terms of the stocks they cover, they all provide the opportunity to tie the returns on invested funds to the performance of a large number of individual stocks. These funds differ from the actively managed funds discussed above in that the contents of the funds are determined independently by whoever maintains the index instead of relying on a fund manager who has the power to make decisions about where to invest the money.

Taxes and Your Investments

We have enjoyed years of economic growth and positive developments for a number of years, but now that times are difficult, thinking about your investments, savings, and retirement is even more important. Capital Gains Whenever you sell an investment at a profit, you will (in most cases) owe the IRS a tax known as a capital gains tax. This is true for most investments, including mutual funds, bonds, options, collectibles, your home, or business. Capital gains are the amount by which an asset's selling price exceeds its initial purchase price. A realized capital gain is an investment that has actually been sold at a profit. An unrealized capital gain is an investment that hasn't been sold yet but would result in a profit if sold; the gain equals the difference between the purchase price and the selling price. The term capital gain is often used to mean realized capital gain. The opposite of a capital gain is a capital loss, which occurs when the selling price of an investment is less than the purchase price. In relation to your home, you may be able to exclude the gains from the sell of your primary residence (the one you spend most of your time in) if you have lived in it for at least two consecutive years. The limit is $250,000 for single taxpayers and $500,000 for married couples filing jointly. The IRS divides capital gains into two distinct categories, with each having different

tax consequences. Long-term capital gains are gains on investments held for more than a year, while short-term capital gains are gains realized on investments that are held for a year or less. Short-term capital gains are taxed according to your income tax bracket and long-term gains are taxed at 20% if you are in the 28% or higher tax bracket, and only 10% if you are in the 15% bracket. In other words, long-term gains are subject to lower tax rates because the IRS wants to encourage long-term investing. The Tax Relief Act of 1997 created new rules, including low capital gains rates on assets held for more than five years: If you are in the 15% income tax bracket you can take advantage of the fiveyear capital gains tax rates of 8%. This rate applies not only to investors who are single, but also to those married or filing jointly (granted you are still in the 15% tax bracket). If you are in a higher tax bracket and your stocks and capital assets were acquired after December 31, 2000, you can take advantage of the five-year capital gains tax at a rate of 18%. The cost basis of your investment, the amount that was originally paid for the investment, can be determined by several methods: If you purchased the investment, the cost basis is the amount you paid for it. If you inherited the investment, the cost basis is the value of the stock on the date of the original owners death. If you received the investment as a gift, the cost basis is the amount that was originally paid for the investment, unless the market value of the investment on the date the gift was given was lower. To determine the capital gains tax on an investment, subtract the amount paid for the investment, including any broker commissions, from the sales price to arrive at the capital gain or loss. Then take this amount and multiply it by the appropriate tax rate, which will give you the tax owed on the sale of your investment. In the case of a mutual fund investment, you will likely have a capital gains distribution, which is the profit that the mutual fund made by selling securities for more than their purchase price. Federal law requires funds to distribute the realized capital gains and income to investors at least once a year. The tax status (short-term or long-term) of capital gains distributions is determined by the period of time that the mutual fund held the underlying security that was sold, not by how long you were invested in the fund. One effective strategy for reducing capital gains taxes is to sell money-losing investments in the same year that you have offsetting capital gains, thereby reducing your capital gains taxes. In fact, if you still have a net loss position after offsetting all your gains with equivalent-sized losses, the IRS will allow you to apply as much as $3,000 per tax year toward a loss. If the losses are greater than $3,000 you can carry those losses forward to later years indefinitely. For example, some investors try to sell their money-losing investments within the first year, so they can offset their highly-taxed short-term gains, while keeping their winners for more than a year whenever possible. There is one significant restriction on the use of this capital gains offset strategy. You cannot deduct losses from a security if you repurchase the same (or a substantially identical) security with 30 days before or after the sale. This is known as the "Wash Sale Rule", and it prevents investors from

abusing the strategy by selling at a loss for tax purposes and then simply repurchasing. Wash Sale Rules are complex, and we encourage you to read the IRS guidelines about them. Another capital gains reduction strategy is through the use of a tax-deferred account, such as an IRA or 401(k) (see InvestorGuide University: IRAs, 401(k)). Wash Sale Rule The IRS defines a wash sale as the selling of a security at a loss and the immediate repurchase of the identical security within 30 days of the initial sale in order to reduce your taxes. The wash sale rule was created to prevent a person from buying back the same security within a short period of time, to take advantage of rules that allow you to offset your capital gains with capital losses. If you repurchase the security before the end of the 30-day period, the IRS will automatically disallow the loss and adjust the basis of your new purchase to reflect the loss. Lottery Lottery winnings are taxable at the federal level and in some cases at the state level as well. If you win more than $5,000 in the lottery, you must pay federal income taxes. You will get a Form W-2G from the payer (which also goes to the IRS) showing the total amount won and the taxes withheld. These earnings might bump up your tax bracket, in which case the amount withheld might not be enough to cover your tax bill. Investment Interest While the term 'investment interest' might sound like it means the interest you earn on your investments, to the IRS it actually means something different. Investment interest is money that an investor pays on a loan that's used to purchase an investment. The investment can be stocks, bonds, real estate, or another type of asset. However, the definition does not include a primary or secondary home, rental income property, or property that's used for business. The most common type of investment interest is margin interest, which an investor pays to a broker when 'buying on margin' (that is, buying securities with money borrowed from the broker). Investment interest is tax-deductible up to the amount of net income you receive from that investment. This net investment income amount includes interest, dividends, and short-term and long-term capital gains. IRS regulations about taxdeductibility are sometimes complex and do change periodically, so we recommend that you visit the IRS web site for the latest rules. Holding Period Holding period is the length of time that you have held an asset; it determines whether a gain/loss is a short-term or long-term capital gain. The trade date determines the holding period and the year in which the sale must be reported. A long-term holding period is one year and one day. The short-term holding period is less than one year. Stocks

When you sell a stock at a profit you incur capital gains taxes, which are calculated according to the amount of time that the stock is actually held (see InvestorGuide University: Capital Gains). There are other considerations when investing in stocks. Selling short is borrowing a security (or commodity futures contract) from a broker and selling it, with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker. SEC rules allow investors to sell short only on an uptick or a zero-plus tick, to prevent "pool operators" from driving down a stock price through heavy short-selling, then buying the shares for a large profit. Short sells can have unlimited losses; you can only short a stock that has moved by at least 1/16. You must have a margin account to make a short sell so you are subject to margin calls if the stock increases quickly. Your broker can call back the stock at any time. Profits are taxed as short-term capital gains. Some companies choose to distribute dividends, which are taxable payments given by a company to its shareholders out of the company's current or retained earnings. If the dividends paid are in the form of cash, those dividends are taxable. When a company issues a stock dividend, not cash, you do not have any tax consequences until you sell those shares. Stock Splits A Stock Split is the increase in number of outstanding shares of a company without any change in the shareholder's equity or market value. For example, if a company decides to give its current shareholders 2 shares for every 1 share that they currently own, each shareholders proportion of ownership in the company wont change (see InvestorGuide University: Stock Splits). There are no tax consequences when a stock split occurs, but you should be aware of pre-split and post-split prices for tax calculations of determining gains/losses. Employee Stock Options Employee stock options are an increasingly popular compensation perk, allowing employees to purchase shares of their employer's company at a specified price by a specific date. There are two different types: non-qualified stock options (NQSOs) and incentive stock options (ISOs). Taxes depend on the particular type of option, the holding period of the stock, and your marginal tax rate. When you exercise a NQSO, you owe ordinary income taxes on the difference between the market price and the exercise price. If you do not immediately sell the shares and hold them for more than a year, you will be taxed at the lower capital gains rate on any further profits when you sell. ISOs, on the other hand, are taxed as capital gains rather than ordinary income. If you hold the shares for at least 1 year and do not sell the shares until at least two years after your company issues the options to you, the gains are taxed as long-term capital gains. If you hold the shares for under a year, you will incur the higher shortterm capital gains tax rate. Exercising ISOs could also trigger Alternative Minimum Taxes(AMTs) (see InvestorGuide University: AMTs). If the difference between the exercise price and the market price of the stock at the time of exercise is a positive

adjustment to your income, then it is calculated for Alternative Minimum Taxes; if this is larger than your regular tax bill, you have to pay this tax. In the case of ISOs, it is said that the sale of stock is a qualifying disposition if you owned the stock for at least two years after the grant date and at least one year after the exercise date. A portion of the gain is considered ordinary income and will be reported as earned income. Any additional gain is considered a capital gain. A disqualifying disposition happens when you owned the stock for two years or less after the grant date or for one year or less from the exercise date. In this, your employer will report the bargain element (market price at the exercise date minus the actual price paid for the stock, multiplied by the number of shares) as compensation. Any additional gain is considered capital gain. Mutual Funds Shareholders receive all the income or profits realized by a mutual fund (see InvestorGuide University: Mutual Funds). There are two forms of distribution: Income Dividends (interest and dividends generated by a fund's investments). Capital Gains (the fund subtracts its capital losses from its capital gains to determine its net capital gains, which it distributes to shareholders) Both forms of distribution are subject to federal income tax and often state and local taxes, except if the distributions were received in a tax-deferred account, or if the income dividend distributions are from municipal money market funds and municipal bond funds(these are exempt from federal taxes and in some cases state taxes). (see InvestorGuide University: Money Market Funds, Bond Mutual Funds). Mutual funds do not pay taxes on the capital gains from its investments; instead, shareholders pay capital gains taxes, whether or not the gain is distributed for a particular year. Mutual fund distributions are reported to shareholders and to the IRS by the fund on Form 1099-DIV or a substitute statement. Income dividend distributions and short-term capital gains are taxed as ordinary income at your marginal tax rate. Distributions of long-term capital gains are taxed at the minimum rate. Reinvested distributions are taxed in the same way as distributions paid to the shareholder. If dividends are reinvested, the cost basis of the shares is increased, therefore reducing your taxes when you sell the fund. Remember to include dividends in the cost of your investment or you might pay taxes on gains you never realized. There are some things you can do in order to avoid getting hit with a big tax bill: Look for funds with low turnover; sometimes funds buy and sell constantly in an attempt to maximize returns and generate big distributions, but these are subject to taxes, which will cut into your gains. Use tax-deferred accounts for tax-inefficient funds. Buy and hold; the more you sell or exchange shares, the more capital gains you are likely to realize, so seek long-term capital gains. You can invest in other types of funds. Index Funds simply follow a stock index like the S&P 500. Since the turnover is lower than 40%, they have

lower taxable distributions. Tax-Managed or Tax-Efficient Funds focus on after-tax returns; their goal is to keep taxable gains low. Bonds A Bond is a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing (see InvestorGuide University: Bonds). The Federal government, states, cities, corporations, and many other types of institutions sell bonds. A bond is generally a promise to repay the principal along with interest on a specified date. Bonds can be divided into two types, taxable and tax-exempt. As the names suggest, taxable bonds are ones for which interest payments are subject to federal, state, and/or local income tax, while tax-exempt bonds are bonds whose interest payments are not subject to federal income tax. These tax-exempt bonds are typically issued by municipal, county or state governments, whose interest payments are not subject to federal income tax, and sometimes also state or local income tax. Bonds that were not issued by the federal government, your state government, or a local government within your state, have taxable interest on both your federal and state tax returns. Bonds issued by your state or county, city or other municipality within your state, are tax-exempt on your federal and state tax return. If the bond was issued by a governmental authority in a state other than the one where you reside, the interest is taxable on your state income tax return, but not on your federal return. If it is a Government Bond (municipal, Treasury, or U.S. Savings bond), the interest is taxable only on your federal tax return, not on your state tax return. It is important to note that gains from the sale or redemption of municipal bonds and U.S. Treasury Bonds are taxable for both federal and state tax purposes. It is only the interest income that is tax-exempt for the state return. Traders Traders are those investors who hold stocks and securities for a short period of time (less than a few days or even a few hours). The goal is to profit from short-term gains in the market. The stock selection is generally based on things like charting which relate only to the stock price instead of a fundamental evaluation of the company as a business. There are certain benefits of the trader status. Traders can deduct their interest expense without itemizing; seminar costs can be deducted as well as home office expenses in connection with investing. One of the more attractive rules is that if you are a trader and you elect the Mark-to-Market election you could benefit from additional benefits: the wash sale rule does not apply to your trading activity. gains are considered income, so if you have a total annual loss, the loss is not subject to the $3,000 loss limitation (see InvestorGuide University: Capital Gains). In this last case, your trading profits are treated as ordinary income, and not as capital gains. If you make the Mark-to-Market election, you must identify which stocks are to be treated as an investment. At the end of the year, any profits made from your stocks are to be reported as income except for those identified as investments in which case those will be treated as capital gains (realized or

unrealized). This can be an advantage if you have held a stock for more than a year and the gains are substantial. While there are certain advantages to filing as a trader, you also increase your risk for an audit. Although the definition of a trader is not very clear, the IRS can still audit you and determine that you are not a trader in which case you might end up with additional taxes, interest and penalties.

Stock Strategies
There are many different ways to approach investing in the stock market. This section will take you through some of the most common strategies for investing in equities. Buy and Hold The "buy and hold" approach to investing in stocks rests upon the assumption that in the long term (over the course of, say, 10 or more years) stock prices will go up, but the average investor doesn't know what will happen tomorrow. Historical data from the past 50 years supports this claim. The logic behind the idea is that in a capitalist society the economy will keep expanding, so profits will keep growing and both stock prices and stock dividends will increase as a result. There may be short term fluctuations, due to business cycles or rising inflation, but in the long term these will be smoothed out and the market as a whole will rise. Two additional benefits to the buy and hold strategy are that trading commissions can be reduced and taxes can be reduced or deferred by buying and selling less often and holding longer. Some proponents of the buy and hold strategy of investing often believe in the Efficient Market Hypothesis or the Random Walk Theory (see InvestorGuide University: Efficient Market, Random Walk). Market Timing Market timing is essentially the opposite of buying and holding. Market timers believe that it is possible to predict when the market, or certain stocks, will rise and fall. It therefore makes sense to buy when the markets are low and to sell when they are high in order to maximize profits. Market timers can use any number of different methods for timing the market technical analysis, fundamental analysis, or even intuition (see InvestorGuide University: Technical Analysis, Fundamental Analysis). Most experts agree that market timing is incredibly difficult if not downright impossible. They also warn against it because: It's hard to say when the market or a particular stock is "high" or "low"; often a seemingly high stock will go higher, and a seemingly low stock will go lower. Commissions eat away at your profits when you trade frequently, especially on small transactions. The bid/ask spread also eats away at your profits, especially for thinly traded stocks. In the long run, the market goes up. Unless you're a superb timer, you'll do better staying fully invested at all times. For example, in the last 40 years, the market returned about 11.3% annually. If you were fully invested the

whole time, but got out completely for the 40 best months, your annual return would've dropped to 2.7%. If you miss the big moves it hurts, and no one really knows when they're coming. Growth Growth investors focus on one aspect of a company: its potential for earnings growth. They believe that companies with high earnings growth will see their stock price continue to increase, since investors will want to own profitable companies that can pay large dividends in the future. The number that they pay the most attention to is earnings per share, especially how it changes from year to year, although they sometimes look at revenue growth as well (see InvestorGuide University: Earnings per Share). Some investors also compare the price/earnings ratio with the annual earnings growth, to get a feel for how much the market is willing to pay for a given rate of earnings growth. Growth stocks tend to be from young companies, so they are often riskier than the average security. They have the potential for large gains, but they also have the potential for large losses. In the 1990s technology stocks were the most commonly purchased stocks by growth investors, although growth stocks can exist in just about any industry. Value Value investors look for stocks that are selling at an attractive price; in other words, they are bargain hunters. This does not mean that value investors buy stocks because they are "cheap" (such as penny stocks); value investing utilizes several measures of a company's value to identify stocks that can be purchased for less money than they're worth, regardless of whether they're worth $10 or $100. Although it's possible that a growth stock could represent a good value, growth investing and value investing are usually considered opposing strategies. This is because value investors tend to focus on traditional valuation metrics such as the P/E ratio, looking for low ratios which are typically not found in growth stocks (see InvestorGuide University: P/E Ratio). Value stocks often are ones which have fallen out of favor with the investment community for one reason or another, perhaps because they are in a slumping industry or because they reported poor earnings. GARP If you're torn between the growth approach to investing in stocks and the value approach, then you might want to consider trying the GARP approach. GARP stands for "growth at a reasonable price" so, as you might expect, GARP investors look for companies with growth potential whose stock price is undervalued. That can be a difficult task since growth and value stocks tend to have opposing characteristics, but it's not impossible. Most GARP investors look at the price-to-earnings-growth ratio (PEG) ratio in order to find bargain stocks with growth potential that are selling at a reasonable price (see InvestorGuide University: PEG). Warren Buffett and Quality Some investors prefer to consider themselves not 'value' or 'growth' but 'quality'. This is a sort of hybrid approach in which the investor is searching not for questionable companies at bargain prices or exceptional companies at outrageous prices, but good companies at good prices. This strategy relies on a combination of quantitative and qualitative factors.

Warren Buffett is often cited as a classic example of a quality investor. Buffett relies on a fairly simple investment strategy that can benefit any investor interested in identifying good values. He looks for great stocks, then buys them and holds them for several years or more. Buffett is a long term investor who plans to hold onto stocks for many years from the time of purchase. He thinks of his investment as buying a piece of a business, not just shares of its stock. In this sense, the management of the underlying company is an important criterion in the investment decision. Buffett determines the value of a business by totaling the net cash flows he expects to occur over the life of the company and discounting them by the appropriate interest rate. He may add a premium based on the risk involved in the particular investment. He focuses on return on equity, operating margins, debt levels and capital expenditures to identify the best investments. Interestingly, Buffett challenges some of traditional notions regarding diversification. He believes that diversification is less necessary for those able to confidently choose a select number of stocks they are confident will significantly outperform the market. For him, identifying a few good values is far more important than spreading invested money across a typical diverse portfolio. Income Income investors practice a very straightforward strategy: they buy stocks with the highest dividends. Income investors focus primarily on securing a steady income stream, instead of worrying about capital gains (although they obviously hope that the shares will increase in value). The stocks of large, well-established companies usually qualify as income stocks. Income investing is one of the more conservative stock strategies, yet there are still the usual risks involved in investing in equities. In some respects, this strategy is closer to bond investing than stock investing, even when stocks are used. Dollar Cost Averaging Dollar cost averaging is a good strategy for beginners that involves regular contributions of a fixed dollar amount to a portfolio or specific investment. At each interval, the chosen amount is invested, removing any emotional motivation to react to short-term changes in the value of the investment. Of course, dollar cost averaging does not guarantee a profit, but it does encourage consistent investing and prevents short-term movement from leading investors to make emotion-based decisions that could harm their long-term strategy. Because the investment is purchased at a range of prices over time, fluctuations in price are evened out and the initial price has a far smaller impact on the returns at the time the investment is sold. The average price paid trends toward the current price at each interval. As a result, the gap between the value of the money paid in and the current value of the investment decreases. However, the average price does not move fast enough to completely eliminate the possibility of profit or loss. Although dollar cost averaging can prevent a large negative gap from growing between the price paid and the current price, it limits the potential for a positive gap in the same way.

Essentially, dollar cost averaging is ideal for investors who wish to eliminate the risk associated with timing the price of an investment and reacting to short-term results at the expense of limiting themselves to a decidedly conservative strategy. Some investors believe dollar-cost averaging is most effective when a stock is underperforming because more shares can be acquired for the same regular investment amount. However, better performance is not guaranteed and that aspect should not be the primary motivation for adopting this strategy. DRIPs and DSPs Some stock strategies focus on reducing brokerage commissions in order to boost overall returns. Direct Stock Purchase plans (DSPs) let you buy shares of stock directly from the company, without the use of a brokerage (and without the commission they charge). DSPs are a good way to invest since you don't even have to be a current shareholder in order to purchase the shares. The company will not charge you a commission, but they may charge you a small fee in order to set up a stock purchase account. Dividend Reinvestment Plans (DRIPs) are also a good way for you to bypass a broker and save on commissions by investing your money directly with the company; however, with DRIPs you must purchase the first share you buy in the company through a brokerage. After that, though, you're free from the broker. The company will take whatever dividends it would normally send to you as a check and instead it will reinvest them to purchase more shares in the company for you, all without charging a commission. The only drawback is that you have no control over when your money from the dividends is used to purchase new stock in the company, which means you might be buying new shares at sub optimal times. Note that DSPs and DRIPs are only offered by some companies, although there are hundreds of well-established blue chips offering such programs (see InvestorGuide: DRIP's List). Dogs of the Dow This is a very simple strategy in which you find out which ten of the Dow Jones Industrial companies currently have the highest dividend yield and then you purchase those stocks (see InvestorGuide University: Dividend Yield). These stocks are called the dogs of the Dow because they tend to have lower prices than the other Dow components, which means that they could experience substantial price increases in the next year. If you decide to use this strategy, its important for you to remember to reallocate your portfolio every year, since the dogs will change over time. Historically this approach has been successful, but there's no compelling reason to believe it will continue to be. CANSLIM CANSLIM is a strategy for investing that was pioneered by William J. ONeil, who later went on to found Investors Business Daily. The strategy is a mixture of fundamental analysis and technical analysis. Each of the letters in the acronym describes a different metric used to pick a stock: C Current Earnings: current earnings growth for the stock must be at least in the 20%-25% range

A Annual Earnings: average annual earnings growth for the stock over the past five years should be substantial, around 25%. N New Things: the company should be involved in developing new services or products; this can sometimes even refer to new highs for the stock price. S Shares Outstanding: the company should have less than 30 million shares outstanding so that it has the potential for good growth. L Leading Stocks: the company should be a leader in its industry. I Institutional Ownership: the stock should have at least a couple of institutional shareholders (e.g. pension funds, endowments, etc.). M Market Conditions: the market should be moving upward or ready to move upward.

Most of the principals involved in CANSLIM investing make sense to experts. Of course, figuring out whether or not a company meets these seven criteria is a whole other story. Contrarian Contrarian investing is a strategy that relies on behaving in opposition to the prevailing wisdom; for example, buying when others are pessimistic and selling when they're optimistic, or buying out-of-favor stocks and selling them when they're popular again. In an extended bull market, the term contrarian can begin to mean someone who is bearish or prefers value stocks to growth stocks, although this is really just a subset of contrarian investing. Insider Activity Another strategy for investing involves looking out for what insiders at a company are doing with their stock. Keeping an eye on insider trades can be useful because it allows you to see what the people who have a large stake in a company are doing with their stock. These insiders are often the ones who know what is going on at the top levels of their company, and so they may have the best information about whether a company's stock is actually worth more or less than the current price. Insiders can be either individuals or corporations. They are required to report both direct holdings (which are held in the name of the insider) and indirect holdings (which are controlled by the insider but are held by a family member, trust, company plan, or corporation with which the insider is affiliated). Note that we're not talking specifically about illegal insider trading (that is, insiders who are trading based on privileged information), but instead about all types of insider trades, including when no such privileged information exists, but the insiders are just generally confident about the company's outlook. Other Investing Strategies Constant Ratio System: Unlike the constant dollar system, the same percentage of funds is divided between different assets. When the balance is upset, it is periodically restored by moving money from overperforming assets to underperforming ones. This system prevents one asset class from dominating the portfolio. This is one way to maintain a desirable asset allocation. Variable Ratio System: This is a variation on the constant ratio system that relies on market timing to shift the proportions of the various asset classes contained in the

portfolio. Buying low and selling high is built into this strategy, but, like the constant dollar system, prolonged movements in a given direction will harm returns. Bottom-up Analysis: This is a name for an investing strategy that focuses on the fundamentals of individual securities as opposed to the state of the overall economy. Top-down Analysis: In contrast to bottom-up analysis, this investing strategy begins with a look at the overall economic picture and then narrows it down to sectors, industries and companies that are expected to perform well. Analysis of the fundamentals of a given security is the final step.

Fundamental Analysis
Fundamental analysis is a method used to determine the value of a stock by analyzing the financial data that is fundamental to the company. That means that fundamental analysis takes into consideration only those variables that are directly related to the company itself, such as its earnings, its dividends, and its sales. Fundamental analysis does not look at the overall state of the market nor does it include behavioral variables in its methodology. It focuses exclusively on the company's business in order to determine whether or not the stock should be bought or sold. Critics of fundamental analysis often charge that the practice is either irrelevant or that it is inherently flawed. The first group, made up largely of proponents of the efficient market hypothesis, say that fundamental analysis is a useless practice since a stocks price will always already take into account the companys financial data (see InvestorGuide University: Efficient Markets). In other words, they argue that it is impossible to learn anything new about a company by analyzing its fundamentals that the market as a whole does not already know, since everyone has access to the same financial information. The other major argument against fundamental analysis is more practical than theoretical. These critics charge that fundamental analysis is too unscientific a process, and that it's difficult to get a clear picture of a company's value when there are so many qualitative factors such as a company's management and its competitive landscape. However, such critics are in the minority. Most individual investors and investment professionals believe that fundamental analysis is useful, either alone or in combination with other techniques. If you decide that fundamental analysis is the method for you, youll find that a companys financial statements (its income statement, its balance sheet and its cash flow statement) will be indispensable resources for your analysis (see InvestorGuide University: Stock Reports). And even if youre not totally sold on the idea of fundamental analysis, its probably a good idea for you to familiarize yourself with some of the valuation measures it uses since they are often talked about in other types of stock valuation techniques as well. Earnings It is often said that earnings are the bottom line when it comes to valuing a companys stock, and indeed fundamental analysis places much emphasis upon a companys earnings. Simply put, earnings are how much profit (or loss) a company has made after subtracting expenses. During a specific period of time, all public

companies are required to report their earnings on a quarterly basis through a 10-Q Report (see InvestorGuide University: 10-Q Report). Earnings are important to investors because they give an indication of the companys expected dividends and its potential for growth and capital appreciation. That does not necessarily mean, however, that low or negative earnings always indicate a bad stock; for example, many young companies report negative earnings as they attempt to grow quickly enough to capture a new market, at which point they'll be even more profitable than they otherwise might have been. The key is to look at the data underlying a companys earnings on its financial statements and to use the following profitability ratios to determine whether or not the stock is a sound investment (see InvestorGuide University: Income Statements). Earnings Per Share Comparing total net earnings for various companies is usually not a good idea, since net earnings numbers dont take into account how many shares of stock are outstanding (in other words, they dont take into account how many owners you have to divide the earnings among). In order to make earnings comparisons more useful across companies, fundamental analysts instead look at a companys earnings per share (EPS). EPS is calculated by taking a companys net earnings and dividing by the number of outstanding shares of stock the company has. For example, if a company reports $10 million in net earnings for the previous year and has 5 million shares of stock outstanding, then that company has an EPS of $2 per share. EPS can be calculated for the previous year ("trailing EPS"), for the current year ("current EPS"), or for the coming year ("forward EPS"). Note that last year's EPS would be actual, while current year and forward year EPS would be estimates. P/E Ratio EPS is a great way to compare earnings across companies, but it doesnt tell you anything about how the market values the stock. Thats why fundamental analysts use the price-to-earnings ratio, more commonly known as the P/E ratio, to figure out how much the market is willing to pay for a companys earnings. You can calculate a stocks P/E ratio by taking its price per share and dividing by its EPS. For instance, if a stock is priced at $50 per share and it has an EPS of $5 per share, then it has a P/E ratio of 10. (Or equivalently, you could calculate the P/E ratio by dividing the company's total market cap by the company's total earnings; this would result in the same number.) P/E can be calculated for the previous year ("trailing P/E"), for the current year ("current P/E"), or for the coming year ("forward P/E"). The higher the P/E, the more the market is willing to pay for each dollar of annual earnings. Note that last year's P/E would be actual, while current year and forward year P/E would be estimates, but in each case, the "P" in the equation is the current price. Companies that are not currently profitable (that is, ones which have negative earnings) don't have a P/E ratio at all. For those companies you may want to calculate the price-to-sales ratio (PSR) instead (see InvestorGuide University: PSR). PEG So is a stock with a high P/E ratio always overvalued? Not necessarily. The stock could have a high P/E ratio because investors are convinced that it will have strong earnings growth in the future and so they bid up the stocks price now. Fortunately, there is another ratio that you can use that takes into consideration a stocks projected earnings growth: its called the PEG. PEG is calculated by taking a stocks

P/E ratio and dividing by its expected percentage earnings growth for the next year. So, a stock with a P/E ratio of 40 that is expected to grow its earnings by 20% the next year would have a PEG of 2. In general, the lower the PEG, the better the value, because you would be paying less for each unit of earnings growth. Dividend Yield The dividend yield measures what percentage return a company pays out to its shareholders in the form of dividends (see InvestorGuide University: Dividends). It is calculated by taking the amount of dividends paid per share over the course of a year and dividing by the stock's price. For example, if a stock pays out $2 in dividends over the course of a year and trades at $40, then it has a dividend yield of 5%. Mature, well-established companies tend to have higher dividend yields, while young, growth-oriented companies tend to have lower ones, and most small growing companies don't have a dividend yield at all because they don't pay out dividends. Dividend Payout Ratio The dividend payout ratio shows what percentage of a companys earnings it is paying out to investors in the form of dividends. It is calculated by taking the company's annual dividends per share and dividing by its annual earnings per share (EPS). So, if a company pays out $1 per share annually in dividends and it has an EPS of $2 for the year, then that company has a dividend payout ratio of 50%; in other words, the company paid out 50% of its earnings in dividends. Companies that distribute dividends typically use about 25% to 50% of their earnings for dividend payments. The higher the payout ratio, the less confidence the company has that it would've been able to find better uses for the money it earned. This is not necessarily either good or bad; companies that are still growing will tend to have lower dividend payout ratios than very large companies, because they are more likely to have other productive uses for the earnings. Book Value The book value of a company is the company's net worth, as measured by its total assets minus its total liabilities. This is how much the company would have left over in assets if it went out of business immediately. Since companies are usually expected to grow and generate more profits in the future, most companies end up being worth far more in the marketplace than their book value would suggest. For this reason, book value is of more interest to value investors than growth investors. In order to compare book values across companies, you should use book value per share, which is simply the company's last quarterly book value divided by the number of shares of stock it has outstanding. Price / Book A company's price-to-book ratio (P/B ratio) is determined by taking the company's per share stock price and dividing by the company's book value per share. For instance, if a company currently trades at $100 and has a book value per share of $5, then that company has a P/B ratio of 20. The higher the ratio, the higher the premium the market is willing to pay for the company above its hard assets. Priceto-book ratio is of more interest to value investors than growth investors. Price / Sales Ratio

As with earnings and book value, you can find out how much the market is valuing a company by comparing the company's price to its annual sales. This measure is known as the price-to-sales ratio (P/S or PSR). You can calculate the P/S by taking the stock's current price and dividing by the company's total sales per share for the past year (or equivalently, by dividing the entire company's market cap by its total sales). That means that a company whose stock trades at $1 per share and which had $2 per share in sales last year will have a P/S of 0.5. Low P/S ratios (below one) are usually thought to be the better investment since their sales are priced cheaply. However, P/S, like P/E ratios and P/B ratios, are numbers that are subject to much interpretation and debate. Sales obviously don't reveal the whole picture: a company could be selling dollar bills for 90 cents each, and have huge sales but be terribly unprofitable. Because of the limitations, P/S ratios are usually used only for unprofitable companies, since such companies don't have a P/E ratio (see InvestorGuide University: P/E ratio). Return on Equity (ROE) Return on equity (ROE) shows you how much profit a company generates in comparison to its book value (see InvestorGuide University: Book Value). The ratio is calculated by taking a company's after-tax income (after preferred stock dividends but before common stock dividends) and dividing by its book value (which is equal to its assets minus its liabilities). It is used as a general indication of the company's efficiency; in other words, how much profit it is able to generate given the resources provided by its stockholders. Investors usually look for companies with ROEs that are high and growing.

Initial Public Offerings

Initial Public Offerings (IPOs) are the first time a company sells its stock to the public. Sometimes IPOs are associated with huge first-day gains; other times, when the market is cold, they flop. Its often difficult for an individual investor to realize the huge gains, since in most cases only institutional investors have access to the stock at the offering price. By the time the general public can trade the stock, most of its first-day gains have already been made. However, a savvy and informed investor should still watch the IPO market, because this is the first opportunity to buy these stocks. Reasons for an IPO When a privately held corporation needs to raise additional capital, it can either take on debt or sell partial ownership. If the corporation chooses to sell ownership to the public, it engages in an IPO. Corporations choose to go public instead of issuing debt securities for several reasons. The most common reason is that capital raised through an IPO does not have to be repaid, whereas debt securities such as bonds must be repaid with interest. Despite this apparent benefit, there are also many drawbacks to an IPO. A large drawback to going public is that the current owners of the privately held corporation lose a part of their ownership. Corporations weigh the costs and benefits of an IPO carefully before performing an IPO. Going Public

If a corporation decides that it is going to perform an IPO, it will first hire an investment bank to facilitate the sale of its shares to the public. This process is commonly called "underwriting"; the banks role as the underwriter varies according to the method of underwriting agreed upon, but its primary function remains the same. In accordance with the Securities Act of 1933, the corporation will file a registration statement with the Securities and Exchange Commission (SEC). The registration statement must fully disclose all material information to the SEC, including a description of the corporation, detailed financial statements, biographical information on insiders, and the number of shares owned by each insider. After filing, the corporation must wait for the SEC to investigate the registration statement and approve of the full disclosure. During this period while the SEC investigates the corporations filings, the underwriter will try to increase demand for the corporations stock. Many investment banks will print "tombstone" advertisements that offer "bare-bones" information to prospective investors. The underwriter will also issue a preliminary prospectus, or "red herring", to potential investors. These red herrings include much of the information contained in the registration statement, but are incomplete and subject to change. An official summary of the corporation, or prospectus, must be issued either before or along with the actual stock offering. After the SEC approves of the corporations full disclosure, the corporation and the underwriter decide on the price and date of the IPO; the IPO is then conducted on the determined date. IPOs are sometimes postponed or even withdrawn in poor market conditions. Performance The aftermarket performance of an IPO is how the stock price behaves after the day of its offering on the secondary market (such as the NYSE or the Nasdaq). Investors can use this information to judge the likelihood that an IPO in a specific industry or from a specific lead underwriter will perform well in the days (or months) following its offering. The first-day gains of some IPOs have made investors all too aware of the money to be had in IPO investing. Unfortunately, for the small individual investor, realizing those much-publicized gains is nearly impossible. The crux of the problem is that individual investors are just too small to get in on the IPO market before the jump. Those large first-day returns are made over the offering price of the stock, at which only large, institutional investors can buy in. The system is one of reciprocal back-scratching, in which the underwriters offer the shares first to the clients who have brought them the most business recently. By the time the average investor gets his hands on a hot IPO, its on the secondary market, and the stock's price has already shot up. Investor Research Although it is difficult to get in on the ground floor of an IPO, there are still ways individual investors can make money on the IPO market. For one, full-service and online brokerages are increasingly offering IPO shares to their customers. Unfortunately, these shares tend to be reserved for clients with the largest balances (usually $100,000 and up), and are thus out of the reach of many investors. Furthermore, most brokerages will not allow investors to sell IPO shares within a

certain time period (generally 60-90 days), which prevents any short-term gains. The other, more-realistic way to profit from IPOs is to buy into some carefully chosen stocks after they've become available to the broad market. In a suitably-hot IPO, institutional investors will not get as many shares as they want before the stock becomes available on the broad market; thus, an individual investor can buy the stock as soon as its available, and count on the institutional investors to drive the price higher. And, of course, the stock may rise purely because the share price is undervalued. We should point out, though, that historically stocks tend to fall slightly in the first several months of trading, so it's often best to not buy on the first day. As with any investment, proper education and careful research are vital to profiting from IPOs. Research should include a measure of the risks involved with investing in an IPO. Business, financial, and market risk are several of the risks that should be included in the evaluation process. Researching business risk involves examining the business model of the corporation and the management team of the corporation. Researching financial risk involves examining the corporations financial statements, capital structure, and other financial data. Researching market risk involves examining the appeal of the corporation to current and future market conditions (see InvestorGuide University: Choosing a Stock). You should also inquire about the purpose of raising capital through an IPO. If the corporation were issuing an IPO just to get out of financial problems, is investing in this corporation a wise decision? Those previous problems could be indicative of other problems, such as weak management. Similarly, if the company was having an IPO just because the IPO market was hot and investors were currently paying too much for IPO shares, then you would want to think twice before buying. On the other hand, if the company has some smart plans for the money, then the IPO might be justified. The investor must thoroughly investigate all available information to obtain an objective view on an IPO. DPOs A direct public offering (DPO), like the more traditional IPO, is a stock's introduction to the stock market. The stock is offered to the public for the first time. Unlike an IPO, which utilizes an underwriter to sell shares to the public, DPO shares are purchased directly from the issuing company. Individual investors have limited opportunities to participate in IPOs, so DPOs give the average person a chance to invest in a public offering. However, because DPOs are typically low-profile, it can be difficult to research and locate these offerings. These are less common and more difficult to research than IPOs.

Options
Options are a type of derivative, which simply means that their value depends on the value of an underlying investment. In most cases, the underlying investment is a stock, but it can also be an index, a currency, a commodity, or any number of other securities. A stock option is a contract that guarantees the investor who has purchased it the right, but not the obligation, to buy or sell 100 shares of the underlying stock at a

fixed price prior to a certain date. Each option has a buyer, called the holder, and a seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party. In the case of a security that cannot be delivered such as an index, the contract is settled in cash. There are two basic forms of options. A call option provides the holder with the right to buy 100 shares of the underlying stock at the strike price, and a put option provides the holder with the right to sell 100 shares of the underlying stock at the strike price. If the price of a stock is going to rise, a call option allows the holder to buy stock at the price before the increase occurs. Similarly, if the price of a stock is falling, a put option allows the holder to sell at the earlier, higher price. For the holder, the potential loss is limited to the price paid to acquire the option. When an option is not exercised, it expires. No shares change hands and the money spent to purchase the option is lost. The upside, however, is unlimited. Options, like stocks, are therefore said to have an asymmetrical payoff pattern. For the writer, the potential loss is unlimited unless the contract is covered, meaning that the writer already owns the security underlying the option. Options are most frequently used by individual investors as either leverage or insurance. As leverage, options allow the holder to control equity in a limited capacity without paying the full price of buying shares up front. The difference can be invested elsewhere until the option is exercised. As insurance, options can protect against price fluctuations in the near term because they provide the right acquire the underlying stock at a fixed price for a limited time. Stock options also form the basis for more complicated trading strategies that will be discussed only briefly here. It is important to remember that options can be an extremely risky investment, and they are certainly not appropriate for beginning investors. Only the most experienced investors should include options in their investment strategy, and even the most knowledgeable investors should prepare for the possibility of substantial losses. Information about options trading can be acquired from the Chicago Board Options Exchange (1-800-OPTIONS). Advantages and Disadvantages of Options Advantages: An investor can gain leverage in a stock without committing to a trade. Option premiums are significantly cheaper on a per-share basis than the full price of the underlying stock. Risk is limited to the option premium (except when writing options for a security that is not already owned). Options allow investors to protect their positions against price fluctuations. Disadvantages: The costs of trading options (including both commissions and the bid/ask spread) is significantly higher on a percentage basis than trading the underlying stock, and these costs can drastically eat into any profits.

Options are very complex and require a great deal of observation and maintenance. The time-sensitive nature of options leads to the result that most options expire worthless. Making money by trading options is extremely difficult, and the average investor will fail. Some option positions, such as writing uncovered options, are accompanied by unlimited risk.

Option Components An option for a given stock has three main components: an expiration date, a strike price and a premium. The expiration date tells the month in which the option will expire. Options expire one day after the third Friday of the expiration month. The strike price is the price at which the holder is allowed to buy or sell the underlying stock at a later date. The premium is amount that the holder must pay for the right to exercise the option. Because the holder acquires the right to trade 100 shares, the total cost of the option, if exercised, is 100 times the premium. In order to relate them to the price of the underlying stock at any given time, options are classified as in-the-money, out-of-the-money or at-the-money. A call option is in-the-money when the stock price is above the strike price and out-of-themoney when the stock price is below the strike price. For put options, the reverse is true. When the stock price and strike price are equal, both types of options are considered at-the-money. Of course, when calculating profit and loss, the premium, as well as taxes and commissions must be factored in. Therefore, an option must be far enough in-themoney to cover these costs in order to be profitable. Valuing and Pricing Options The price of an option is primarily affected by: The difference between the stock price and the strike price The time remaining for the option to be exercised The volatility of the underlying stock Affecting the premium to a lesser degree are factors such as interest rates, market conditions, and the dividend rate of the underlying stock. Because the value of an option decreases as its expiration date approaches and becomes worthless after that date, options are considered "wasting assets". The total value consists of intrinsic value, which is simply how far in-the-money an option is, and time value, which is the difference between the price paid and the intrinsic value. Understandably, time value approaches zero as the expiration date nears. The Black-Scholes model, based on wave equations from physics, is used to calculate the theoretical value of options. The formula reveals the time value remaining in an option and take into account the pricing factors listed above. Over time, option prices approach their theoretical values. In general, premiums should increase as the volatility of the underlying stock increases because the greater fluctuation makes the right to buy in the future at the current price more valuable. Volatility can be historical or implied. Historical volatility

is based on the past performance of the stock. Implied volatility is a reflection of the way options are being priced in general. Exercising Options Exercising an option consists of buying (in the case of a call option) or selling (in the case of a put option) 100 shares of the underlying stock at the strike price. Options are classified as American or European depending on the way in which the holder may exercise them. The holder may exercise an American style option at any point between the time of purchase and the expiration date. A European style option, on the other hand, cannot be exercised until expiration. Most stock options are American style, but some index options are European style. Advanced Options Covered call: A call option is sold in a stock already owned by the writer. This is an attempt to take advantage of a neutral or declining stock. If the option expires unexercised, the writer keeps the premium. If the holder exercises the option, the stock must be delivered, but, because the writer already owns the stock, risk is limited. This is the opposite of an uncovered call, when the writer sells a call for a stock that he does not already own, a very dangerous strategy with unlimited risk. Married put: A put option is purchased on a stock owned by the writer. The strategy is an insurance policy that protects against a decline in the price of the underlying stock. If the price declines, the stock can be sold at the higher price any time before expiration. Of course, if the stock price remains neutral or increases, the option is worthless and the premium is lost. Synthetic put: A call option is purchased in a stock that the holder is already short on. The holder is able to protect against an increase in the price of the underlying stock. Spreads and Straddles A spread is made up of two or more options in the same stock where either the strike price, the expiration date or both are different. Spreads can limit or alter risk while returning a profit when the gains from one or more option offset the losses from the rest. A straddle provides the opportunity to profit from a prediction about the future volatility of the market. Long straddles are used to profit from high volatility. Such a straddle can be effective when an investor is confident that a stock price will change dramatically, but cannot predict the direction of the move. Short straddles represent the opposite prediction that a stock price will not change. Warrants A warrant is a certificate, usually issued along with a bond or preferred stock, entitling the holder to buy a specific amount of securities at a specific price, usually above the current market price at the time of issuance. Expirations range anywhere from a few years to forever. The warrant may be sold separately from the underlying security. It increases in value as the price of the underlying stock rises.

LEAPs LEAPs is an acronym for Long-term Equity AnticiPation Securities. LEAPs are very similar to standard options except for the fact that they expire much further in the future. They can be safer than traditional options because it is somewhat easier to predict stock movement over longer periods. Like options, they allow an investor to lock in a fixed price for the underlying security. Therefore, like options, they can be effective for both leverage and insurance purposes. Expiration generally occurs 36 months after purchase, and LEAPs are American style, so they can be exercised at any time before expiration. Strike prices usually range around 25% above or below the price of the underlying stock when the LEAP is first offered. Options on Futures Contracts An investor can purchase options contracts for which the underlying security is a futures contract (see InvestorGuide University: Futures). Like any other option, these options guarantee the right, but not the obligation to purchase the underlying security at a given price. They are also priced in the same manner as other options. Futures options can limit the risk of futures trading, but any profits are reduced by the cost of the option premium.

Short Selling
Short selling (or "selling short") is a technique used by people who try to profit from the falling price of a stock. Short selling is a very risky technique as it involves precise timing and goes contrary to the overall direction of the market. Since the stock market has historically tended to rise in value over time, short selling requires precise market timing, which is a very difficult feat. Here's how short selling works. Assume you want to sell short 100 shares of a company because you believe sales are slowing and its earnings will drop. Your broker will borrow the shares from someone who owns them with the promise that you will return them later. You immediately sell the borrowed shares at the current market price. When the price of the shares drops (you hope), you "cover your short position" by buying back the shares, and your broker returns them to the lender. Your profit is the difference between the price at which you sold the stock and your cost to buy it back, minus commissions and expenses for borrowing the stock. But if you're wrong, and the price of the shares increase, your potential losses are unlimited. The companys shares may go up and up, but at some point you have to replace the 100 shares you sold. In that case, your losses can mount without limit until you cover your short position. Here are a few reasons why short selling might make sense: Some investors are better at identifying overpriced, bad companies than underpriced, good companies. Brokers and analysts focus on what to buy, not what to sell, so the good news is more widely known than the bad news. When an analyst issues a sell recommendation on a stock, they find it much harder to get information from the company's investor relations department, and the analyst's firm would never get an opportunity to raise capital or float a bond for the company, so

they focus more on good news than bad. If you discover bad news, it might not yet be totally factored in to the current price of the stock. Many institutions just won't do short selling, leaving unexploited short selling opportunities from which you can benefit. A portfolio which includes both long and short positions in stocks which tend to move together will generally have lower volatility than one which has only long positions.

But short selling is not as easy and profitable as it may sound; there are a lot of caveats: As we mentioned, theres unlimited downside potential (i.e. if the stock price keeps rising, you keep losing). Most short sellers set a limit to how much they're willing to lose, but then they become vulnerable to a short 'squeeze', in which long investors buy shares as the stock rises and demand delivery. As short sellers buy to cover their losses, the price continues to rise, triggering more short sellers to cover their losses, etc. This is a risk especially for small, illiquid companies. The danger is that even if the stock is overpriced, it may become even more overpriced, and you will have to buy it at some point to cover your position. When you sell short, you're not just betting on what the stock is worth, you're betting on what the market will be willing to pay for the stock in the future. You're fighting the trend of the market, which is, in the long run, up. When you buy a stock that you're confident is greatly undervalued, you should feel content to wait as long as it takes for the dividends to start rolling in (provided you have a sufficiently long investment horizon). When you're on the short side, however, you will eventually need to buy the shares back, at whatever the market price happens to be; and while you wait and wait for the speculative bubble to burst, the rest of the market will probably continue on its upward trajectory. SEC rules allow investors to sell short only on an uptick or a zero-plus tick. In other words, you cannot sell a stock short if it is already going down. This rule is in effect to prevent traders known as "pool operators" from driving down a stock price through heavy short selling, then buying the shares for a large profit. Money from a short sale isn't available to the seller, but is escrowed as collateral for the owner of the borrowed shares. You aren't earning interest on the money (although big institutions sometimes do, in the form of rebates). You have to pay any dividends that are earned (since in effect you have a negative number of shares). You pay the (usually higher) short term capital gains tax on your profits, regardless of how long you held the short position. Another company could acquire the company youre shorting, possibly at a significant premium, which would drive up the share price. Sometimes shares aren't available to short. While we dont recommend short selling for the above reasons, you may decide to include it in your overall strategy. If you do, consider mitigating the risk by setting strict quitting prices (say a 20% loss per investment). If it reaches that limit, resist the temptation to hang on, thinking it's even more overpriced now. Successful short selling is all about timing, which makes it more like technical analysis than fundamental analysis.

Some short-sellers target the following types of companies: Small cap companies that have been driven up by momentum investors, especially companies that are difficult to value. Companies whose P/E ratios are much higher than can be justified by their growth rates. Companies with bad or useless products and services. Companies riding the latest fad. Companies that have new competition coming. Companies with weak financials (bad balance sheet, negative cash flows, etc.). Companies that depend too heavily on one product.

Municipal bonds
Municipal bonds are bonds issued by any municipal organization including cities, counties, states, and school districts. The purpose of these bonds is for general expenditures or to fund specific projects such as highways, new schools, or an athletic stadium. These bonds offer the municipality the opportunity to raise funds without directly raising taxes. Of course, the funds needed to repay the bonds will often come from a tax increase. The main appeal of municipal bonds is that the interest payments are usually exempt from federal taxes. Many municipal bonds are also exempt from state and local taxes in the area they are issued. However, capital gains that occur when the bond is sold or at the time of maturity (if the bond was bought at a discount) are not exempt from any taxes. Generally, municipal bonds are considered safer than corporate bonds because a local government is far less likely to go bankrupt than a corporationhowever, it has happened in the past, so be aware of the possibility. Because of this safety and the tax benefits, municipal bonds generally have a lower yield than corporate bonds. In order to evaluate the merits of a tax-free bond, you will need to calculate the taxequivalent yield on the bond. This is the amount of interest a tax-free bond would have to provide to create the same return as a taxable bond. Of course, this calculation will depend on the tax bracket of the individual, but it is an effective way to compare the merits of taxable and tax-free bonds. Investors should also be aware that some municipal bonds are subject to the Alternative Minimum Tax. The bond type which is most often subject to the AMT is one which involves a private and public partnership for something like a sports stadium. Some municipal bonds can also be insured by outside agencies. These companies will promise to pay the interest and principal if the issuer defaults. Interestingly, both issuers and bondholders can carry this insurance, though a bondholder would need to have a large stake to get the coverage. Another concern about municipal bonds is the secondary market. In many cases the secondary market is very small, meaning it may be very difficult to sell your bond if you no longer wish to hold it. For more details about the risks that face all bonds, including municipal bonds, visit the front page of the Bonds section (see InvestorGuide University: Bonds). There are two common types of municipal bonds: general obligation and revenue. General Obligation (GO) Bonds

These bonds are unsecured municipal bonds that are simply backed by the full faith and credit of the municipality. Generally, these bonds have maturities of at least 10 years and are paid off with funds from taxes or other fees. Revenue Bonds These bonds are used to fund projects that will eventually create revenue directly, such as a toll road or lease payments for a new building. The revenues from the projects are used to pay off the bonds. An interesting twist is that in some cases the issuer is not obligated to pay interest unless a certain amount of revenue is generated. If a municipal bond makes sense for you, you will need to work through a broker in order to purchase them. This is another drawback as you will be forced to pay a commission to the broker before you finally get your hands on the bond. When comparing these bonds to others, remember to take this additional cost into account. In addition, municipal bonds usually come in $5,000 par values and usually require a minimum investment of $25,000 in order to get the best price. So, if you don't have this amount of money to invest, you may want to look to municipal bond mutual funds to gain access to municipal bonds (see InvestorGuide University: Bond Mutual Funds).

Treasury bonds
Treasury bonds are issued by the government of the United States in order to pay for government projects. The money paid out for a Treasury bond is essentially a loan to the government. As with any loan, repayment of principal is accompanied by a fixed interest rate. These bonds are guaranteed by the 'full faith and credit' of the U.S. government, meaning that they are extremely low risk (since the government can simply print money to pay back the loan). Additionally, interest earned on Treasury bonds is exempt from state and local taxes. Federal taxes, however, are still due on the earned interest. The government sells Treasury bonds by auction in the primary market, but they can also be purchased through a broker in the secondary market. A broker will charge a fee for such a transaction, but the government charges no fee to participate in auctions. Treasury bonds are marketable securities, meaning that they can be traded after the initial purchase. Additionally, they are highly liquid because there is an active secondary market for them. Prices on the secondary market and at auction are determined by interest rates. Treasury bonds issued today are not callable, so they will continue to accrue interest until the maturity date. One possible downside to Treasury bonds is that if interest rates increase during the term of the bond, the money invested will be earning less interest than it could earn elsewhere. Accordingly, the resale value of the bond will decrease as well. Rising inflation can also eat into the interest earned on Treasury bonds. Because there is almost no risk of default by the government, the return on Treasury bonds is relatively low, and a high inflation rate can erase most of the gains by reducing the value of the principal and interest payments.

Investors who wish to participate in auctions and purchase Treasury securities directly from the Federal Reserve Bank can open a Treasury Direct Account. There are no fees associated with the account unless it contains over $100,000, at which point a very small maintenance fee is incurred. There are three types of securities issued by the U.S. Treasury. These are distinguished by the amount of time from the initial sale of the bond to maturity. Treasury bonds These securities have the longest maturity of any bond issued by the U.S. Treasury, from 10 to 30 years. The 30-year bond is also called the "long bond." Denominations range from $1000 to $1 million. T-bonds pay interest every 6 months at a fixed coupon rate. As mentioned above, these bonds are not callable, but some older Tbonds available on the secondary market are callable within five years of the maturity date. Treasury notes T-notes have maturities between 1 and 10 years. Denominations range from $1000 to $5000 and are determined by the amount of time to maturity. Like T-bonds, these securities pay interest semi-annually at a fixed coupon rate. CPI-indexed Treasury Notes (TIPS) TIPS are inflation-indexed securities issued by the U.S. Treasury in an effort to widen the selection of government securities available to investors. The notes have a 10 year maturity and pay interest at a fixed rate. The principal increases with the inflation rate, which in turn increases future interest payments. One danger associated with investing in TIPS is that taxes are due on the increased principal before maturity when the investor gains access to the principal. In times of high inflation, tax payments could even exceed the interest income earned by the note. Treasury Bills T-bills are available with maturities of 13 weeks, 26 weeks and 52 weeks. They are purchased at a discount to their $10,000 face value, and the full amount is received at maturity (making them zero-coupon). The bills are sold at auction where the price of sale is determined by how much the bill is worth on the date of issue, which depends mainly on interest rates.

Other Types of Bonds

Savings Savings bonds are also issued by the U.S. treasury. They differ from other Treasury securities in several ways. Savings bonds are non-marketable, meaning that they cannot be traded after they are purchased from the government; therefore, there is no secondary market for savings bonds. The tax benefits associated with savings bonds are significant. Like all treasury securities, they are exempt from state and local taxes, but in the specific case of savings bonds, all federal taxes may be deferred until the bond is redeemed. Therefore, even though interest will accrue, no

taxes will be due until that money can be accessed. Additionally, if the money received at redemption is used to pay tuition expenses for the holder, a spouse or a dependent in the same year, the interest earned may be exempt from federal taxes as well. Because savings bonds can be redeemed at any time without penalty once they have been held for six months, they are extremely liquid even without a secondary market. Savings bonds are very easy to purchase with a Treasury Direct account (described earlier). Money can also be regularly deducted from paychecks and placed in savings bonds, or, with the "Easy Saver" program, money can be automatically deducted from a bank account at regular intervals. The bonds can also be purchased at banks or at the website of the Bureau of Public Debt. Interest rates earned on savings bonds are adjusted in relation to the market every six months. There are three important types of savings bonds currently being issued: Series EE bonds: EE bonds are purchased for half of their face value, and they can be redeemed for their face value at maturity, which is determined by the interest rate at the time of purchase. However, they can be redeemed at any point after six months for the current value without incurring a penalty. Interest accrues on the first day of each month, making that the best day to redeem savings bonds. All interest and principal is paid only at redemption. Denominations range from $50 to $10,000. At maturity, the bond will automatically enter extended maturity and earn interest according to rates at the beginning of that period. EE bonds will continue to earn interest for 30 years after they are purchased. Once they have reached maturity, EE bonds may be exchanged for Series HH bonds in order to continue to earn interest and further defer federal taxes. An individual can purchase up to $30,000 face value in savings bonds in one year. Series HH bonds: HH bonds are acquired by exchanging EE bonds for them at maturity. HH bonds are available in denominations ranging from $500 to $10,000 and, unlike EE bonds, are sold at face value. They pay interest every six months and continue to earn interest for 20 years. The interest rate at the time of purchase is locked in for the first 10 years that the bond is held. After ten years, HH bonds enter extended maturity and the new interest rate is determined by the rate assigned to new bonds issued at that time. Series I bonds: I bonds are inflation-indexed savings bonds that pay a fixed interest rate for the life of the bond and a variable rate that tracks inflation as measured by the Consumer Price Index. They are sold at face value and pay interest every 6 months. The inflation-adjusted portion of the return is recalibrated semiannually. Up to $30,000 may be invested in I bonds each year by a single individual. I bonds pay interest for up to 30 years, but there is a penalty equivalent to 3 months of earnings for redeeming the bond before 5 years. Agency Other government agencies and organizations issue securities to fund their own projects. While these bonds often deliver higher returns than Treasury securities because some of them are not explicitly guaranteed by the federal government, they must often be purchased from brokers, incurring a commission. They are considered very safe investments because they would most likely be honored by the government if default occurred. The most common agency bonds are mortgagebacked securities.

Mortgage-backed securities are debt obligations with a pool of mortgages as collateral. They fall into the general category of asset-backed securities, which package a group of securities and offer investors access to the cash flows generated by the underlying securities. An individual investor earns interest in proportion to his stake in the entire pool. Therefore, an investment in a mortgage-backed security is not tied to any one mortgage. The firm that assembles the security takes a small fee and insures the pool against credit risk. One type of mortgage-backed security, the mortgage pass-through security, is identified by the fact that interest and principal payments are passed through to the holder, instead of just interest. Payments to investors are usually made on a monthly basis. Mortgage backed securities are a relatively low-risk investment vehicle. Securities issued by the Government National Mortgage Association (Ginnie Mae) are particularly safe because they are backed by the full faith and credit of the U.S. government. One downside to these investments is the risk of prepayment by borrowers, or paying back part or all of the loan before it becomes due, which can lower returns by reducing the interest paid on a given mortgage. Ginnie Mae, Fannie Mae, Freddie Mac and Sallie Mae The Government National Mortgage Association (Ginnie Mae) is a government-owned agency that buys mortgages from lending institutions, turns them into securities, and then sells those securities to investors. Because the payments to investors are guaranteed by the full faith and credit of the U.S. Government, they return slightly less interest than other mortgage-backed securities. The Federal National Mortgage Association (Fannie Mae) is a congressionally chartered corporation which buys mortgages on the secondary market, pools them and sells them as mortgage-backed securities to investors on the open market. The securities contain both conventional mortgages and mortgages insured by the Federal Housing Administration. Monthly principal and interest payments are guaranteed by Fannie Mae but not by the U.S. Government. The Federal Home Mortgage Corporation (Freddie Mac) is similar to Fannie Mae except that none of the pooled mortgages are FHA insured. The Student Loan Marketing Association (Sallie Mae) creates securities by purchasing student loans instead of mortgages. This is simply another type of asset-backed security. Collateralized Mortgage Obligations Collateralized mortgage obligations (CMOs) are backed by mortgage-backed securities with a fixed maturity. They can eliminate the risks associated with prepayment because each security is divided into maturity classes that are paid off in order. As a result, they yield less than other mortgage-backed securities. The maturity classes are called tranches, and they are differentiated by the type of return. A given tranch may receive interest, principal, or a combination of the two, and may include more complex stipulations. One negative aspect of CMOs is the lower interest rates that compensate for the reduction in prepayment risk and increased predictability of payments. Also, CMOs can be quite illiquid, which can increase the cost of buying and selling them.

Brady Bonds Brady bonds arose from an effort in the 1980s to reduce the debt held by lessdeveloped countries that were frequently defaulting on loans. The bonds are named for Treasury Secretary Nicholas Brady, who helped international monetary organizations institute the program of debt-reduction. Defaulted loans were converted into bonds with U.S. zero-coupon Treasury bonds as collateral. Because the Brady bonds were backed by zero-coupon bonds, repayment of principal was insured. The Brady bonds themselves are coupon-bearing bonds with a variety of rate options (fixed, variable, step, etc.) with maturities of between 10 and 30 years. Issued at par or at a discount, Brady bonds often include warrants for raw materials available in the country of origin or other options.

Advanced Bond Concepts

Bonds often have special characteristics that affect the desirability of the bond and/or its purchase price. This section will review some of the unusual features that bonds may carry. Callability When a bond is issued, it will be either callable or non-callable. A callable bond is one in which the company can require the bondholder to sell the bond back to the company. Buying back outstanding bonds is called "redeeming" or "calling". When issued, the bond will explain when it can be redeemed and what the price will be. In most cases, the price will be slightly above the par value for the bond and will increase the earlier the bond is called. A company will often call a bond if it is paying a higher coupon than the current market interest rates. Basically, the company can reissue the same bonds at a lower interest rate, saving them some amount on all the coupon payments; this process is called "refunding." Unfortunately, these are also the same circumstances in which the bonds have the highest price interest rates have decreased since the bonds were issued, increasing the price. In many cases, the company will have the right to call the bonds at a lower price than the market price. If your bond is called, you will be notified by mail and have no choice in the matter. The bond will stop paying interest shortly after the bond is called, so there is no reason to hold on to it. Companies also typically advertise in major financial publications to notify bondholders. Generally, callable bonds will carry something called call protection. This means that there is some period of time during which the bond cannot be called. Zero Coupon Bonds Some bonds, called zero coupon bonds, don't pay out any interest prior to maturity. These bonds are sold at a deep discount because all of the value from the bond occurs at maturity when the principal is returned to the bondholder along with interest. These bonds are also known as "zeros." One type of zero-coupon bond is a "strip." The interest payments are separated from a bond's principal and multiple zero coupon securities are created, one representing the principal amount and one representing each coupon payment. A problem with zero-coupon bonds is that, even

though you do not receive any interest payments during the time you hold the bond, you are still responsible for paying taxes on the suggested interest you are earning. The taxes are based on the appreciation of the bond's market value, which will increase consistently as it approaches maturity. Zeros are also more volatile than bonds that have regular interest payments. The main benefit of zero coupon bonds is if you are saving for a specific event that will occur at a specific time, such as paying for college. You can purchase the zero coupon bonds to mature just before you will be needing the money. Secured vs. Unsecured Bonds Bonds can either be secured by some sort of collateral or unsecured. Unsecured bonds, called debentures, are considered to be riskier than secured bonds because they are simply backed by the issuer's word that it will repay the bonds. Secured bonds are backed by some goods that can be sold by the issuer to raise money to pay off the debt in the event of default. Corporate and municipal bonds can be secured or unsecured, while bonds issued by the federal government are unsecured (but, of course, the government can simply print money to pay off its debts). The most common form of secured bonds are mortgage bonds. These bonds are backed by real estate or physical equipment that can be liquidated. These are thought to be high-grade, safe investments. Other bonds are secured by the revenues created by projects. If an issuer in default has both secured and unsecured bonds outstanding, secured bondholders are paid off first, then unsecured bondholders. Naturally, because unsecured bonds carry greater risk than secured bonds, they usually pay higher yields. Tax Deferred Bonds Some bonds are free from federal taxes while others allow you to defer those taxes until maturity (see InvestorGuide University: Municipal Bonds). When evaluating the value of a bond, the tax considerations can play a major role in determining whether the investment is appealing or not. Find out your tax options on any bond you are considering. Put Provisions The opposite of a callable bond, a bond with a put provision allows the bondholder to redeem the bond at par value with the issuer at a specified point before maturity. Investors might choose to do this if interest rates increase after the bond was issued. The bond will restrict the dates when this can be done. These bonds are quite rare.

Corporate Bonds
Bonds issued by a corporation are called corporate bonds. When a company needs to raise funds for some type of investment or expenditure, they often turn to the public markets for funding. One way to do this is to issue additional stock in the company, but this has implications on the value of the shares and dilutes ownership. The other major option is to sell bonds to the public and take on debt. Selling bonds is often more attractive to companies than getting a loan from a bank.

Corporate bonds are very common and you can find prices and other information in the financial or business sections of major newspapers. Most corporate bonds have a par value of $1,000 and carry various maturity dates. Generally, these bonds pay higher rates than government or municipal bonds due to the increased risk. Corporate bonds have a wide range of ratings and yields because the financial health of the issuers can vary widely. All companies are different and have a different likelihood of defaulting on their obligations. For example, an old economy blue chip is far less likely to default than a new technology company. The blue chip's bonds might carry an investment-grade rating, such as AA. Meanwhile, the less stable company might issue bonds rated in the junk category. These junk or "high yield" bonds might look like the superior investment on paper because they will command a higher yield for the bondholder. However, taking into account the increased risk of default (which would result in the bondholder going unpaid), these bonds might not be worth the risk. If a company goes bankrupt, both bondholders and stockholders can make a claim on the company's assets. However, one of the benefits of being a bondholder is that your claim takes precedence over that of stockholders in a liquidation situation. Additionally, some corporate bonds are "secured." This means that the debt obligation is backed by some asset that can be liquidated in order to pay off the interest and principal. Corporations will often issue mortgage bonds, which are backed by real estate or physical equipment. These bonds are safer than unsecured bonds, which are backed only by the "full faith and credit" of the company which basically means you are taking their word for it. Most corporate bonds are straightforward with a fixed coupon rate that doesn't change until maturity. There are some variations, however. Some bonds will have a floating rate, which means the interest paid in the coupon will be pegged to some independent index like the money market interest rate or the rate on a short term Treasury Bill. While these bonds insure you against a change in interest rates, they tend to offer lower yields. Another type of bond that might be issued is a zero coupon bond, which has no interest payments at all prior to maturity (see InvestorGuide University: Zero Coupon Bonds). Here is a brief look at what to consider when evaluating corporate bonds (click on each term to learn more): Coupon Yield and its permutations Maturity Duration Rating Callability Convertibility (described below) The way in which these factors interact with your investment goals and risk tolerance should provide the necessary guidance to make the proper investment. Generally, people are interested in corporate bonds if they are investing for a tax-deferred account or are in a low tax bracket. Municipal and government bonds have tax benefits that corporate bonds do not. However, because they offer a higher yield, corporate bonds can sometimes have a higher after-tax yield. Braver souls with a tolerance for risk might be attracted to the lower-grade junk bonds for their high yields. It is rare that a municipal bond sinks to the junk bond status, so corporate

bonds are the only place to go for these higher yields. If you are interested in the risks associated with holding bonds, visit the front page of our bond education section (see InvestorGuide University: Bonds). Convertibility Many corporate bonds are convertible bonds. These bonds can be exchanged for some specified amount of common or preferred stock in the issuing company. At the time of issue, the terms of conversion will be outlined, including the times, prices, and conditions under which it can occur. Most convertible bonds are also callable. This means, in effect, that the company can force bondholders to convert their bonds into stock (called "forced conversion"). Convertibility affects the performance of the bond in certain ways. First and foremost, convertible bonds tend to have lower interest rates than non-convertibles because they also accrue value as the price of the underlying stock rises. Therefore, convertible bonds offer some of the benefits of both stocks and bonds. Convertibles earn interest even when the stock is trading down or sideways, but when the stock prices rises, the value of the convertible increases. Convertibles, therefore, can offer protection against a decline in stock price. Because they are sold at a premium over the price of the stock, convertibles should be expected to earn that premium back in the first three or four years after purchase. In some cases, convertibles may be callable, at which point the yield will cease.

Types of Account
Although banks offer a wide variety of accounts, they can be broadly divided into five types: savings accounts, basic checking accounts, interest-bearing checking accounts, money market deposit accounts, and certificates of deposit. All five are insured by the FDIC (in most cases, up to $100,000 per account). Most banks offer all of these types of accounts, so the bank you choose probably won't restrict this decision, although it does make sense to choose the account type you want first, so you can focus on that type as you shop around to various banks. Here is a brief description of each type of account: Savings Accounts These are intended to provide an incentive for you to save money. You can make deposits and withdrawals, but usually can't write checks. They usually pay an interest rate that's higher than a checking account, but lower than a money market account or CD. Some savings accounts have a passbook, in which transactions are logged in a small booklet that you keep, while others have a monthly or quarterly statement detailing the transactions. Some savings accounts charge a fee if your balance falls below a specified minimum. Basic Checking Accounts Sometimes also called "no frills" accounts, these offer a limited set of services at a low cost. You'll be able to perform basic functions, such as check writing, but they lack some of the bells and whistles of more comprehensive accounts. They usually do not pay interest, and they may restrict or impose additional fees for excessive

activity, such as writing more than a certain number of checks per month. Interest-Bearing Checking Accounts In contrast to "no frills" accounts, these offer a more comprehensive set of services, but usually at a higher cost (see InvestorGuide University: Choosing a Bank). Also, unlike a basic checking account, you are usually able to write an unlimited number of checks. Checking accounts which pay interest are sometimes referred to as negotiable order of withdrawal (NOW) accounts. The interest rate often depends on how large the balance in the account is, and most charge a monthly service fee if your balance falls below a preset level. Money Market Deposit Accounts (MMDAs) These accounts invest your balance in short-term debt such as commercial paper, Treasury Bills, or CDs. The rates they offer tend to be slightly higher than those on interest-bearing checking accounts, but they usually require a higher minimum balance to start earning interest. These accounts provide only limited check writing privileges (three transfers by check, and six total transfers, per month), and often impose a service fee if your balance falls below a certain level. Certificates of Deposit (CDs) These are also known as "time deposits", because the account holder has agreed to keep the money in the account for a specified amount of time, anywhere from three months to six years. Because the money will be inaccessible, the account holder is rewarded with a higher interest rate, with the rate increasing as the duration increases. There is a substantial penalty for early withdrawal, so don't select this option if you think you might need the money before the time period is over (the "maturity date").

Cash Investments
As their name implies, cash investments are easily redeemable with small, if any, penalties for withdrawal. Examples of cash investments include money market funds, bank accounts and certificates of deposit (CDs). Investors benefit from the low-risk yield and high liquidity of cash investments. The downsides to cash investments are the low interest rate and the fact that a favorable interest rate can only be locked in temporarily due to the short periods of time that the interest rate is locked in. Certificates of Deposit Traditional CDs are savings certificates that pay a fixed interest rate until they reach maturity. Most are issued by banks and have a somewhat higher interest rate than savings accounts. CDs are very flexible in that they can be issued in any denomination and have a range of maturities. The most common maturities are three months and six months. When the CD reaches maturity, the holder receives the principal invested plus all interest earned while the CD matured. CDs are very safe investments and are insured by the federal government up to $100,000. One

downside to CDs is that there is a penalty associated with removing funds before the maturity date. Rate and yield are two of the most important concepts associated with CDs and they can be quite confusing. The rate, often expressed as annual percentage rate (APR) is the rate of interest earned by the CD. The yield, or annual percentage yield (APY), describes the total amount that will be earned by the investor in one year. The APY is higher than the APR because interest compounds, meaning that interest earned earlier in the year will earn more interest as the year progresses. The APY is the number to focus on, because it reflects the amount of growth you'll actually receive. In addition to rate and yield, an investor should carefully research the maturity of the CD and any special features associated with it before investing. There are more complicated types of CDs that offer variable rates and other features. For example, some long-term CDs may be "called" by the banks that issue them. After that point, interest is no longer paid on the issue. A bank might choose to do this if interest rates decline and it can sell other CDs at a lower rate of interest. This brings up another negative feature of CDs. There is significant interest rate risk, meaning that if interest rates rise after the CD is purchased, the investor cannot take advantage of the more favorable rate. The Money Market The money market is used to buy and sell fixed income securities. Unlike the bond market, money market investments are short-term. These short-term loans usually have a maturity of less than six months. Money market securities are generally very safe investments which return a reasonable interest rate that is most appropriate for temporary cash storage or short-term time horizons. Bid and ask spreads are relatively small due to the large size of the market. Individual investors often must invest in money market funds to participate in the money market because the securities themselves are usually traded only in amounts totaling $100,000 and higher. Money market funds are a highly liquid way to invest in money market securities without the high-denomination barrier of investing directly. Types of Money Market Instruments U.S. Treasury Bills are an extremely low-risk investment vehicle. T-Bills are auctioned off and guaranteed by the government. They mature in either 3 months, 6 months or 12 months, meaning that they have short enough terms to avoid the risks associated with rising interest rates. The bills are sold at a discount from face value and can be redeemed for their full value at maturity. Purchase amounts range from $10,000 to $1,000,000 and, because of an active secondary market, the bills are highly liquid. Commercial paper is available in a wide range of denominations. These promissory notes are short-term debt instruments issued by companies. They can be of either the discounted or interest-bearing variety. They usually have a limited or nonexistent secondary market. Commercial paper is usually issued by companies with high credit ratings, meaning that the investment is almost always relatively low risk. There are a variety of other notes available that vary in terms of return, risk and

liquidity, but all are relatively safe investments that return a modest interest rate.

Inflation and Interest Rates

The economics you hear and read about in the financial press usually goes beyond the simple concept of supply and demand. It is important to get a grasp of at least some of the economic concepts that affect the markets. Doing so can have a significant positive impact on your financial future. What is Inflation? One of the most important economic concepts is inflation. At its most basic level, inflation is simply a rise in prices. Over time, as the cost of goods and services increase, the value of a dollar is going to go down because you won't be able to purchase as much with that dollar as you could have last month or last year. Of course, it seems like the cost of goods are always going up, at least to an extent, even when inflation is thought to be in check. It is important to note that some amount of inflation is considered normal (actually, as we explain below, because of its relationship with unemployment, some inflation is actually desirable). While the annual rate of inflation has fluctuated greatly over the last half century, ranging from nearly zero inflation to 23% inflation, the Fed actively tries to maintain a specific rate of inflation, which is usually 2-3% but can vary depending on circumstances. Deflation (for example, -1%) occurs when prices actually decrease over a period of time. Please note that deflation is not the same as disinflation, which is when the rate of inflation decreases but stays positive (for example, a change from a 3% rate to a 2% rate). How Inflation is Measured There are two main indices used to measure inflation. The first is the Consumer Price Index, or the CPI (see InvestorGuide University: CPI). The CPI is a measure of the price of a set group of goods and services. The "bundle," as the group is known, contains items such as food, clothing, gasoline, and even computers. The amount of inflation is measured by the change in the cost of the bundle: if it costs 5% more to purchase the bundle than it did one year before, there has been a 5% annual rate of inflation over that period based on the CPI. You will also often hear about the "Core Rate" or the "Core CPI." There are certain items in the bundle used to measure the CPI that are extremely volatile, such as gasoline prices. By eliminating the items that can significantly affect the cost of the bundle (in either direction) on a month-tomonth basis, the Core rate is thought to be a better indicator of real inflation, the slow, but steady increase in the price of goods and services. The second measure of inflation is the Producer Price Index, or the PPI (see InvestorGuide University: PPI). While the CPI indicates the change in the purchasing power of a consumer, the PPI measures the change in the purchasing power of the producers of those goods. The PPI measures how much producers of products are getting on the wholesale level, i.e. the price at which a good is sold to other businesses before the good is sold to a consumer. The PPI actually combines a series of smaller indices that cross many industries and measure the prices for three types of goods: crude, intermediate and finished. Generally, the markets are most concerned with the finished goods because these are a strong indicator of what will

happen with future CPI reports. The CPI is a more popular measure of inflation than the PPI, but investors watch both closely (see InvestorGuide University: Economic Indicators). Inflation and Your Investments Inflation is greatly feared by investors because it grinds away at the value of your investments. Put simply, $100 today is not the same as $100 in 1 or 10 years. It is crucial to include measures of expected inflation when calculating your expected return on investment. As the most basic example, if you invest $1000 in a 1-year CD that will return 5% over that year, you will be giving up $1000 right now for $1050 in 1 year. If over the course of that year there is an inflation rate of 6%, the purchasing power of $1000 has decreased by $60, and you have actually lost ground! (Of course, the capital gains taxes you pay on your "gain" will increase this loss.) If you had spent that $1000 instead of investing it, you would have been able to purchase a larger bundle of goods than was possible with the $1050 you earned a year later. However, this is not a suggestion that you spend your money instead of saving it. First, the reasons to save are too numerous to list, but a home and retirement should be enough to inspire you. Given that savings are important, inflation eats away at your purchasing power more if you just put your savings under your mattress than if you had invested it. Now that this issue has been clarified, it is important to be aware of the effects of inflation on your investments. Whenever you can, try to determine your "real rate of return", which is the return you can expect after factoring in the effects of inflation. If you are working with a financial professional, ask him or her for an estimate of the real rate of return of a given investment or portfolio. As explained, inflation can erode the value of cash investments, such as stocks, bonds, and CDs. However, some people believe that investments in real goods, such as a home, are protected from inflation. This is because the value of a real good is determined to a large extent by its intrinsic nature, as opposed to money, which is valued only for what you can trade it for. If inflation is high, the price of a home or a car may simply increase at a similar rate, insulating it from price erosion. The same cannot be said for a 10-year bond. As a result, some investors seek protection from inflation, and investment options which do just that are becoming available. The most popular example is TIPS Treasury Inflation Protected Securities. These investments are just like bonds except that they are insulated from the effects of inflation (see InvestorGuide University: TIPS). The description above explains why investors follow CPI and PPI reports so closely. In addition to being aware of the current rate of inflation, it is crucial to be aware of what inflation rate the experts are anticipating. Both the value of current investments and the attractiveness of future investments will change depending on the outlook for inflation. Inflation and Unemployment Many modern economists believe that inflation is inversely related to unemployment. This relationship is shown through something called the Phillips Curve. The Phillips Curve shows the relationship between a given level of inflation and the expected level of unemployment that would go along with it. As inflation decreases, unemployment is expected to rise. This relationship is why you hear about the Fed's dual tasks of keeping inflation in check and maintaining full employment. Economists agree that there is a minimum level of unemployment that an economy can handle without causing inflation to accelerate (see InvestorGuide University: Federal

Reserve System). Inflation and Interest Rates Interest rates measure the price of borrowing money. If a business wants to borrow $1 million from a bank, the bank will charge a specific interest rate that will usually be expressed in terms of a percentage over a given period of time. For example, if the bank loaned the money to the company at a 5% annual rate, the company would need to repay $1,050,000 at the end of the year. From the company's perspective, the value of that $1,000,000 right now is greater than the $1,050,000 in a year (presumably because they have plans for the money), which is why they want to borrow it. For the bank, it is earning a 5% return on a one-year investment. Generally, there are two types of interest rates: floating and fixed. A floating rate, also called an adjustable rate, moves in step with a rate that is set outside of the lending institution, such as the prime rate (the rate at which banks lend to their best customers). For example, you might see a rate set at "prime plus 2%". This means that the rate on the loan will always be 2% higher than the prime rate, which changes regularly. The prime rate changes to take into account the changes in inflation. The real" interest rate is the nominal (stated) rate minus the rate of inflation. For example, if a bank were to give you a loan at the nominal rate of 9% and inflation was measured at 3%, the real interest rate that the bank earns would be 6%. Banks change nominal interest rates to stabilize the real interest rates they receive. A fixed rate is an interest rate that does not change for the life of the loan. For an individual taking out a loan when rates are low, the fixed rate loan would allow him or her to "lock in" the low rates and not be concerned with fluctuations. On the other hand, if interest rates were historically high at the time of the loan, he or she would benefit from a floating rate loan, because as the prime rate fell to historically normal levels, the rate on the loan would decrease. Interest Rates and the Fed Interest rates change on a regular basis. The rates that you pay on a mortgage or other type of loan will vary from day-to-day and week-to-week based on many macroeconomic variables, including inflation, unemployment rates, growth rates, tax laws, and the Fed's policies and outlook. The Fed affects interest rates by setting two key rates, the discount rate and the federal funds rate. The discount rate is the rate which the Federal Reserve Bank charges its member banks for overnight loans. The Fed actually controls this rate directly, but it tends to have little impact on the activities of banks because these funds are also available elsewhere. The federal funds rate is the interest rate at which banks loan excess reserves to each other. While the Fed can't directly affect this rate, it effectively controls it in the way it buys and sells Treasuries to banks. This is the rate that reaches individual investors, though the changes usually aren't felt for a period of time (see InvestorGuide University: Fed and Monetary Policy). So, why should the average investor care about interest rates? Of course, interest rates affect things such as loans and mortgages, but they also have an effect on the markets as well. As rates change, the demand for different types of investments will change as well. During periods of low interest rates, stocks are considered more attractive than bonds and other fixed interest investmentsthe price the banks and other institutions are willing to pay to borrow your money has gone down. Similarly, periods of high interest rates are considered bad for stocks because safer investments earn higher returns. Moreover, the interest rate picture is often seen as

an indicator for the economy on a large scale. High interest rates mean it is more expensive for businesses to borrow money to expand and will also likely decrease consumer spending.

Types of stock
Stocks can be classified into many different categories. The two most fundamental categories of stock are common stock and preferred stock, which differ in the rights that they confer upon their owners. But stocks can also be classified according to a number of other criteria, including company size and company sector. This section takes a look at the different types of stocks that are available and the important characteristics of each of them. Common Stock Most shares of stock are called "common shares". If you own a share of common stock, then you are a partial owner of the company. You are also entitled to certain voting rights regarding company matters. Typically, common stock shareholders receive one vote per share to elect the companys board of directors (although the number of votes is not always directly proportional to the number of shares owned, (see InvestorGuide University: Stock Classes)). The board of directors is the group of individuals that represents the owners of the corporation and oversees major decisions for the company. Common stock shareholders also receive voting rights regarding other company matters such as stock splits and company objectives. In addition to voting rights, common shareholders sometimes enjoy what are called "preemptive rights." Preemptive rights allow common shareholders to maintain their proportional ownership in the company in the event that the company issues another offering of stock. This means that common shareholders with preemptive rights have the right but not the obligation to purchase as many new shares of the stock as it would take to maintain their proportional ownership in the company. But although common stock entitles its holders to a number of different rights and privileges, it does have one major drawback: common stock shareholders are the last in line to receive the companys assets. This means that common stock shareholders receive dividend payments only after all preferred shareholders have received their dividend payments (see InvestorGuide University: Dividends). It also means that if the company goes bankrupt, the common stock shareholders receive whatever assets are left over only after all creditors, bondholders, and preferred shareholders have been paid in full. Preferred Stock The other fundamental category of stock is preferred stock. Like common stock, preferred stock represents partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, preferred stock pays a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. The main benefit to owning preferred stock is that you have a greater claim on the companys assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders. In general, there are four different types of preferred stock:

Cumulative: These shares give their owners the right to accumulate dividend payments that were skipped due to financial problems; if the company later resumes paying dividends, cumulative shareholders receive their missed payments first. Non-Cumulative: These shares do not give their owners back payments for skipped dividends. Participating: These shares may receive higher than normal dividend payments if the company turns a larger than expected profit. Convertible: These shares may be converted into a specified number of shares of common stock.

Since preferred shares carry fixed dividend payments, they tend to fluctuate in price far less than common shares. This means that the opportunity for both large capital gains and large capital losses is limited. Because preferred stock, like bonds, has fixed payments and small price fluctuations, it is sometimes referred to as a "hybrid security." Stock Classes Although common stock usually entitles you to one vote for every share that you own, this is not always the case. Some companies have different classes of common stock that vary based on how many votes are attached to them. So, for example, one share of Class A stock in a certain company might give you 10 votes per share, while one share of Class B stock in the same company might only give you one vote per share. And sometimes it is the case that a certain class of common stock will have no voting rights attached to it at all. So why would some companies choose to do this? Because its an easy way for the primary owners of the company (e.g. the founders) to retain a great deal of control over the business. The company will typically issue the class of shares with the fewest number of votes attached to it to the public, while reserving the class with the largest number of votes for the owners. Of course, this isnt always the best arrangement for the common shareholder, so if voting rights are important to you, you should probably think carefully before buying stock that is split into different classes. Large Cap, Mid Cap and Small Cap Stocks can be classified according to the market capitalization of the company. The market capitalization of a company represents the total dollar value of the company's outstanding shares. This is equal to the current market price of its stock multiplied by the number of shares of stock that it has outstanding. That number gives you the market value of the company, which is one measure of the companys size. Roughly speaking, there are three basic categories of market capitalization: large cap, mid cap, and small cap (although some analysts include others such as mega cap at the large end and micro cap at the small end). The definitions for each of these might vary somewhat depending on whom youre talking to, but usually they are as follows: Large cap: market cap valued at more than $10 billion Mid cap: market cap valued between $1 billion and $10 billion Small cap: market cap valued at less than $1 billion

In general, the larger the cap size, the more established the company, and the more stable the price of its stock. Small cap and mid cap companies usually have a higher potential for future growth than large cap companies, but their stock tends to fluctuate more in price. Penny Stocks A penny stock is a stock priced under one dollar per share (or in some cases, under five dollars per share). Most penny stocks have only a few million dollars in net tangible assets and have a short operating history. Penny stocks are almost always small cap stocks, but the reverse isn't necessarily true. The term "penny stock" is sometimes used in a derogatory fashion, since many penny stocks are virtually worthless and should be considered extremely high-risk investments. There are also many cases of fraud involving penny stocks each year (see InvestorGuide University: Fraud). InvestorGuide recommends that beginners steer clear of penny stocks. Sector Stocks Stocks are often grouped into different sectors depending upon the company's business. Standard & Poor's breaks the market into 11 different sectors. Two of these sectors, utilities and consumer staples, are said to be defensive sectors, while the rest tend to be more cyclical in nature (see InvestorGuide University: Defensive Stocks, Cyclical Stocks). The other nine sectors are: transportation, technology, health care, financial, energy, consumer cyclicals, basic materials, capital goods, and communications services. Of course, other groups break up the market into different sector categorizations, and sometimes break them down further into subsectors. Cyclical Stocks Stocks can be classified according to how they react to business cycles. Cyclical stocks are stocks of companies whose profits move up and down according to the business cycle. Cyclical companies tend to make products or provide services that are in lower demand during downturns in the economy and higher demand during upswings. The automobile, steel, and housing industries are all examples of cyclical businesses. Defensive Stocks Defensive stocks are the opposite of cyclical stocks: they tend to do well during poor economic conditions. They are issued by companies whose products and services enjoy a steady demand. Food and utilities stocks are defensive stocks since people typically do not cut back on their food or electricity consumption during a downturn in the economy. But although defensive stocks tend to hold up well during economic downturns, their performance during upswings in the economy tends to be lackluster compared to that of cyclical stocks. Tracking Stock A tracking stock is a type of common stock that is tied to the performance of a specific subsidiary of the company. This means that the dividends and the capital gains for the stock depend upon the subsidiary rather than the company as a whole. Owning a tracking stock does not give the owner voting rights in the corporation, nor do owners of tracking stocks have a legal claim upon the general assets of the

corporation. A company will sometimes issue a tracking stock when it has a very successful division that it feels is under appreciated by the market and not fully reflected in the company's stock price.

The Stock Market

When people refer to "the stock market" or "the market" it can sometimes be confusing to beginning investors as to what those terms actually mean. Are they talking about all the stocks that trade on the NYSE, all the stocks that trade in the U.S., or all the stocks in the world? Typically when people refer to the market they are talking about all the publicly traded stocks in this country (they will usually say the global market if they mean the entire world). Indeed, the concept of the market can be a difficult one at first, especially since beginners tend to think of stocks as individual units. This section explains some different ways that investing experts think about the market as a whole. Efficient Market Proponents of the efficient market theory believe that there is perfect information in the stock market. This means that whatever information is available about a stock to one investor is available to all investors (except, of course, insiders, but insider trading is illegal). Since everyone has the same information about a stock, the price of a stock should reflect the knowledge and expectations of all investors. The bottom line is that you should not be able to beat the market since there is no way for you to know something about a stock that isnt already reflected in the stocks price. Thats not to say that efficient market theory fans claim that all stocks are necessarily priced correctly; instead, they claim that there is no way for you to know whether or not prices are too high or too low. Proponents of this theory spend little time trying to pick stocks that are going to be winners; instead, they simply try to match the markets performance. However, there is ample evidence to dispute the basic claims of this theory, and most investors don't believe it. Random Walk The random walk theory draws conclusions that are similar to the efficient market theory, but it uses a different line of reasoning. The theory takes its name from a well-known book by Burton Malkiel (although others pioneered the idea decades earlier) which says that future stock prices are completely independent of past stock prices. In other words, the path that a stocks price follows is a random walk that cannot be determined from historical price information, especially in the short term. Much like efficient market theory fans, the random walkers believe that it is impossible to pick winning stocks and that your best bet is just to try to match the markets performance, usually by using a long-term buy and hold strategy. Behavioral Finance Behavioral finance theory is very different from the random walk and the efficient market theories. Proponents of behavioral finance believe that there are important psychological and behavioral variables involved in investing in the stock market that provide opportunities for smart investors to profit. For example, when a certain stock or sector becomes hot and prices increase substantially without a change in the

companys fundamentals, behavioral finance theorists would attribute this to mass psychology (also known as the follow the herd instinct). They therefore might short the stock in the long term, knowing that eventually the psychological bubble will burst and they will profit. Bull and Bear Markets In addition to the three market theories mentioned above, there are other ways of thinking about the market as a whole, that are less theoretical and more grounded in what is actually happening to them. One way is to describe the overall trends in the market, such as by defining them as bearish or bullish. A bull market, loosely defined, is a market in which the major stock indexes have risen by over 20% over a substantial period of time, usually measured in months or years. Bull markets can happen as a result of an economic recovery, an economic boom, or simple investor psychology. The longest and most famous of all bull markets is the one that began in the early 1990s in which the U.S. equity markets grew at their fastest pace ever. Bear markets are the exact opposite of bull markets: they are markets in which the major indexes have declined by 20% or more over a period of at least two months (a decline that large for any shorter time period is simply called a correction, especially if it followed a substantial rise). Bear markets usually occur when the economy is in a recession and unemployment is high, or when inflation is rising quickly. The most famous bear market in U.S. history was, of course, the Great Depression of the 1930s. Seasonal and Time-Related Market Factors During certain times of the year or certain times of the month, the markets tend to exhibit certain behaviors more often than would be predicted by chance. For example, the early fall, October in particular, has historically been a time when the markets have slumped, although the effect isn't extremely pronounced and there isn't a logical explanation for it. Strong stock performance in January is another example of a seasonal market trend. The so-called "January Effect" occurs because many investors choose to sell some of their stock right before the end of the year in order to claim a capital loss for tax purposes. Once the tax calendar rolls over to a new year on January 1st these same investors quickly reinvest their money in the market, causing stock prices to rise. But although the January effect has been observed numerous times throughout history, it is difficult for investors to profit from it since the market as a whole expects it to happen and therefore adjusts its prices accordingly. In addition to the January effect and the October slump, there is also something called the triple witching hour that occurs four times per year, during the final hour of trading on the third Friday of March, June, September, and December. This is when the expirations on stock index futures, options on the stock index, and options on stock index futures all expire. When this happens, options and futures begin being bought and sold in vast quantities, which causes large fluctuations in the value of their underlying stocks.

Introduction to Other Investments

Stocks, bonds, mutual funds and cash will be the major components of almost every portfolio, but some investors will also devote a portion of their invested funds to more advanced, and, at times, exotic investments. Some investment strategies require these investment vehicles to be executed properly. Additionally, some of these investment options can reduce the risk associated with more traditional securities or serve as a hedge against a downturn. Of course, these benefits come at a price and introduce a new degree of risk into an investing strategy. Derivatives, such as options and futures, are securities that have a value based on the value of an underlying security. Advanced investors may purchase or sell derivatives for several reasons including to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. These techniques can be quite complicated and quite risky and are therefore not recommended for beginners. The remainder of this section touches on some investment options outside of stocks, bonds, and mutual funds. They include a rundown of some of the ways for the average investor to invest in commodities, precious, metals and real estate. There are many ways to get involved with these types of investments, but they vary widely in degree of risk and return and are certainly not appropriate or necessary for all investors.

Choosing a Stock
Stock Screens There are literally thousands of stocks available for purchase on the stock market. So how do you go about finding the right ones to buy? Often it is helpful to use a stock screen, a set of criteria that you can quickly compare stocks against to see if they meet your requirements. You should first sit down and come up with a list of your investing objectives; once you have that you should be able to come up with a suitable screen (see InvestorGuide University: Investing Basics). Your selection criteria for the initial screening should be a few quantifiable measures that you think are the most important for your investing. Here are a few criteria worth considering (and of course there are many others): Earnings growth (see InvestorGuide University: Earnings) Recent earnings surprises (see InvestorGuide University: Annual Reports) Price/earnings ratio (see InvestorGuide University: P/E Ratio) Dividends (see InvestorGuide University: Dividends) Market cap or size (see InvestorGuide University: Market Capitalization) Industry (see InvestorGuide University: Sectors) Relative strength (see InvestorGuide University: Relative Strength) Stock Research

Once youve narrowed down the list of stocks that you are interested in, the next step is to research the stocks. There are a ton of great resources available out there for researching stocks, and fortunately most of them are free. Online research is becoming more and more popular because of its convenience and ease of use. We recommend that you try researching stocks using our handy Stock Research Tool which can give you all of the different types of information you need with just one click of the mouse (see InvestorGuide: Stock Research Tool). You should also take a look at the company's annual report and its financial statements for the following (see InvestorGuide University: Annual Reports). From the Income Statement: o Earnings growth (earnings acceleration is even better). Does the company have a record of exceeding analysts' expectations? Earnings are considered by many investors to be the most important single number, the assumption being that earnings pave the way for future dividends. o Revenue growth. o Stable or increasing margins (see InvestorGuide University: Margins) o Stable or increasing R&D spending as a percentage of sales (specifically for technology companies). o Tax abnormalities. For example, taxes below 25% usually mean the company is using tax loss carry-forwards against income, which are only a temporary earnings booster. o Number of common shares outstanding. Increases in the number of shares negatively impact earnings per share (issuance of new shares isn't necessarily bad; the important consideration is why they're doing it).

From the Cash Flow Statement: o Cash flow. Ideally, cash flow should be positive, large, and increasing. In any case, understand why the company's cash flow is what it is.

From the Balance Sheet: o Debt. The debt to equity ratio (long term debt divided by stockholder's equity) is the measure typically used (see InvestorGuide University: Debt/Equity Ratio). Lower is better, and zero is ideal. o Cash (relative to annual sales). Cash is always a good thing, but it's especially important to companies that sometimes want or need to temporarily go cash flow negative. Remember that when new shares are issued, proceeds from the sale also appear here. o Return on equity. This is a measure of net income relative to stockholder's equity (see InvestorGuide University: Return on Equity). Higher is better. o Receivables and inventory. They should not be rising much faster than sales are. o Current ratio. This is the ratio of current assets (cash, receivables and inventory) to short-term liabilities (see InvestorGuide University: Current Ratio). The higher the better.

From the Management's Discussion and Analysis: o What is the outlook for the future; are there any potential threats and uncertainties they expect to encounter? o What are the company's products and/or services? Do you see a continuing need for them? Are the products and/or services things that customers buy once or repeatedly? Do you see competitive offerings that are as good or better? o Can the company protect their position? If not, big margins can quickly become small margins. Are there no close substitutes to the products and services they offer? Are there barriers to entry? Do they have copyrights, patents, innovative processes, economies of scale, de facto standards, or anything else that will help them defend their niche? Is the product highly differentiated? How do they compare with their competition? o Are they generating significant earnings and revenues from products introduced within the last few years? o What's the outlook for the future, both for the company and for their industry? Do they have lots of new products/services coming? Do they have favorable long-term prospects? Where will they be in ten years? Consider what the analysts and others expect for the future, but also make your own determination. If possible, work out your own revenue and earnings projections. Another technique is to assume that the analysts' expectations are completely factored into the current price; if you think the outlook is better than they do, the stock could be a bargain. o Current dividends (see InvestorGuide University: Dividends). This is more important for portfolios focusing on income rather than capital appreciation, or for investors fearful of a broad market downturn. Growth stock investors are willing to wait patiently for earnings to turn into dividends. o How's the management (see InvestorGuide University: Management)? What's the corporate culture? Are they able to attract and keep highly skilled personnel? o Insider ownership (more is better, especially by the CEO), and recent insider activity. o Do they have a global presence? U.S. companies that operate around the world have outperformed the S&P 500 handily over the last 5 years, and should continue to do so. o How is their marketing? o Do they have a consistent operating history? Uncertainty is something to be avoided, unless you are adequately compensated for it. Change, difficult situations, product shifts, and big mergers all bring with them uncertainty. If a company doesn't have experience with these things but you see them coming, be careful. o Do they have a history of success? Past performance is no guarantee of future results, to paraphrase the mutual fund mantra; but there's certainly a positive correlation (on Wall Street and in life). o Is the stock expensive or cheap? Compare the P/E ratio (or book value, or price to sales ratio, or price to earnings growth, or whatever measures you use), relative to the company's historical average and

relative to the industry (see InvestorGuide University: Fundamental Analysis). See if discrepancies are justified. Also, do their design, manufacturing and distribution costs increase or decrease each year? EDGAR Perhaps the easiest way to access all of the statements available is through the SECs EDGAR database (EDGAR stands for Electronic Data Gathering, Analysis and Retrieval). The database contains required disclosure documents for public companies and mutual funds, including annual 10K and quarterly 10Q reports, proxy statements for all public companies, and prospectuses and semiannual reports for mutual fund companies. You can access the EDGAR database directly, or there are other sites that re-organize the EDGAR data to make it easier to use. For a listing of EDGAR sites, use the SEC filings page (see InvestorGuide: SEC Filings). Choosing a Stock Once you've gathered the facts, you should then perform the analysis. Different investors use different methods for determining what stocks to buy. Most investors prefer fundamental analysis, although there are also a large number who focus on technical analysis (see InvestorGuide University: Fundamental Analysis, Technical Analysis). Whatever one you decide to use, here are a few final considerations to keep in mind: Focus on the market cap, not the per-share price. The market cap is the pershare price times the number of shares outstanding. In essence, this is how much you would have to pay to buy the whole company. Every company has a different number of shares outstanding, making per-share price comparisons meaningless. For this reason, a stock which is trading at $100 per share might actually be cheaper than a stock trading at $2 per share. This doesn't mean that price per share is completely unimportant; some technical analysts believe it can provide clues to where the stock will go next but for fundamental analysis it's really not important. There is no perfect stock screen, because every investor is looking for something different. Some are looking for growth, others for value, still others for dividend income. The screens you apply should be done with your unique goals in mind.

Annual Reports
How you read an annual report depends upon your purpose. As an investor, your purpose may be to assess profitability, survivability, growth, stability, dividends, potential problems, risks or other factors which may affect your investment in that company. The annual report provides a convenient way to monitor the progress of a company. If you own shares in the company you should receive a copy of their annual report in the mail from your broker; if you don't, you can request one or view it online at edgar.sec.gov. Annual reports are a corporate "work of art" and should not be read like a normal book. There is no need to read the report cover to cover. The first pages are a colorful, non-technical overview of the company's objectives and how well it's meeting them. This should be taken with a grain of salt, because it's marketing

literature from the company, designed to put their best foot forward. The pages in the back are for number-crunching and heavy-duty research. Reading annual reports together year to year creates a kind of timeline for the company. You can learn a lot by reading about how the company changed their business model or carried out their desired plans from one year to the next. There are nine sections in most annual reports. Not all reports will have all the sections or the same type and amount of information. Here are the sections, what you'll find in each, and questions you should ask yourself: Chairman of the Board Letter: Should cover changing conditions, previous objectives met or missed and upcoming objectives, and actions taken or not to be taken. Is it well written? Read between the lines; what is being apologized for? Sales and Marketing: Should cover what the company sells, how, where and when. Is it clear where it's making most of its money presently? Is the scope of lines, divisions and operations clear? 10 Year Summary of Financial Figures: Is this included? Have revenues and profits increased each year? Management Discussion and Analysis: Is it a clear discussion of significant financial trends over the past few years? How candid and accurate is it? CPA Opinion Letter: Written by the CPA firm as an opinion on the company's financials. Is it a well-respected firm? What did they have to say about the company's numbers? Financial Statements: Check sales, profits, R&D spending, inventory and debt levels over time. Read the footnotes to ferret out other information. Subsidiaries, Brands and Addresses: Where is their headquarters? Is it clear what lines, brand names the company has and what their overseas distribution network is? List of Directors and Officers: How many directors are insiders and how many are outsiders (a good mix is ideal)? Are the directors well-known and respected? Are there an unusual number of directors (5 to 12 is typical)? Stock Price History: General trend of price over time. Up or down? On which exchange is the company listed? Do they have a history of paying dividends? Financial Statements: Most of the information youll be concerned with in the annual report is located in the financial statements (the balance sheets, the cash flow statements, and the income statements), which are discussed in detail in the Financial Statements section. Income Statements The income statement (sometimes called the profit-and-loss statement or P&L) is the first financial statement that youll find in the annual report. It shows the revenue, expenses and profit for the company during the past year. You can use the income statement to figure out cash flow, profit margins, and other financial metrics for the business. Most importantly, though, the income statement contains the proverbial bottom line: profits. You should be careful when looking at the income statement since companies can sometimes engage in gymnastics with their accounting methods. The statements are audited by outside firms, however, so there should be footnotes or other markers

whenever anything deviates from standard accounting practices. The following list will teach you how to read an income statement and use the information from them to make some simple calculations regarding the firm's operations. Revenues: The revenue section will tell you how much money the company took in for a specified period of time. Sometimes companies will break down revenues according to business sector or geographic region, but usually there will just be one number. Some companies, especially retailers and manufacturers, use the term sales instead of revenues, but it's the same idea. Expenses: The expense section will show you how the company spent its money. Companies spend their money on a lot of different activities, so this section is usually broken down into specific sub-sections. You might see expenses such as the following: o Cost of Sales: This number includes expenses directly associated with creating revenue, such as labor and materials. o Operating Expenses: This number includes activities such as marketing, research and development, and administration. It usually also includes depreciation expenses and any special non-recurring charges. o Interest Expenses: This figure includes all the interest the company paid out on its bonds (if any) and/or long-term debt. o Taxes: The amount of money paid in taxes by the firm. o Extraordinary Expenses: This figure shows any unusual or one-time charges that the firm must pay (e.g. a lawsuit settlement).

Profit: The profit section of the income report is the part to which investors pay the most attention. It shows whether the company made money or lost money. It usually includes these specific sections: o Net Income: This is the companys bottom-line profit after all expenses and revenues have been accounted for. If this number is positive, then the company turned a profit for the period. If its negative, then the company suffered a loss. Number of Shares: This is the average number of shares outstanding during the specified time period; it is used primarily in order to calculate earnings per share. Two numbers are usually reported here: basic shares and diluted shares. Basic shares include only actual shares of stock outstanding, whereas diluted shares include any securities that could possibly turn into stock (such as convertible bonds or stock options). Earnings Per Share: This number is calculated by taking net income and dividing by the number of shares (both basic and diluted, so there are two earnings per share figures).

Margins: You can find out how much a company is really earning from its revenues on the income sheet by calculating its margins, which are earnings expressed as a percentage of sales. Here are a few margins that you might find useful: o Gross Margins will tell you how much a company earns taking into consideration the costs that it incurs for producing its products and/or services. In other words, gross margin is equal to gross income divided by net sales, and is expressed as a percentage. Gross margin is a good indication of how profitable a company is at the most fundamental level. Companies with high gross margins will have a lot of money left over to spend on other business operations, such as research and development or marketing. Net Margins are similar to gross margins, except they take into account all of the expenses associated with the business, including marketing expenses, administrative expenses, etc. (so it is equal to net income divided by net sales). Net margins provide an overall picture for the company; this is what shareholders and investors usually watch most carefully. Low (or negative) net margins might indicate that the company is struggling or is in a competitive industry in which it doesn't have very much power to dictate its prices.

Balance Sheets The second financial statement that you'll encounter in the annual report is the balance sheet. The basic concept underlying a balance sheet is simple enough: total assets equals total liabilities plus equity. A lot of investors tend to focus on the income statement, but the balance sheet is just as important a source of information. You can use the balance sheet to determine the firm's liquidity, to see how leveraged the company is, or just to see all the specific assets and liabilities of the company. The following list will teach you how to read a balance sheet and use the information from it to find out the company's current financial standing. Current Assets are the first numbers you'll encounter on the balance sheet. Current assets are defined as assets that can or will be converted into cash quickly (generally within one year). Current assets include, of course, cash and cash equivalents (money market accounts, etc.), but it also includes the company's inventories (unsold stock) and its accounts receivable (uncollected bills from its debtors). Current Liabilities are the opposite of current assets. They are the money that the company expects to pay out within the next year. Current liabilities include accounts payables (bills the company must pay), interest on long term debt, taxes, and dividends. Non-Current Assets and Liabilities are assets that cannot be turned into cash quickly or liabilities that are not due for over a year, respectively. This includes assets such as the company's plants, property, and equipment, and liabilities like long-term loans. Ratios and Other Calculations can be calculated to analyze the balance sheet, just like you can calculate several different types of margins to help you analyze a company's income statement.

Debt/Asset Ratio: The debt/asset ratio can show you what percentage of the company's assets are financed through debt. You can calculate it by taking total liabilities and dividing by total assets. If the ratio turns out to be less than one, then that means that most of the company's assets are financed through equity. If the ratio turns out to be greater than one, then the company is financing most of its assets through debt. Companies that have high ratios are said to be "highly leveraged." This means that they are carrying excessive amounts of debt and could be in danger if creditors start to demand repayment. Current Ratio: The current ratio is the opposite of the debt/asset ratio: it takes the total number of current assets owned by the company and divides by its total current liabilities. If this number is greater than one, then the company has enough current assets to cover its short term liabilities. A number that is much higher than one, however, might indicate that the company is hoarding its assets instead of putting them to use. A number less than one indicates that the company may experience problems with liquidity. Acid Test: The acid test ratio is similar to the current ratio except that it subtracts out inventory from current assets. To calculate this ratio, you take current assets minus inventory and then divide by current liabilities. The reason why the acid test disregards inventories is because in many industries inventory is not easily liquidated into cash; thus it can't be used to pay off short term debt. Shareholder Equity: Shareholder equity is equal to total assets minus total liabilities. This number shows you what part of the company is owned by the shareholders after all of its obligations have been met. Working Capital: Working capital is calculated by subtracting the firm's current liabilities from its current assets. This number shows you how much in liquid assets the company has available to build its business. The number can be positive or negative, depending on how much debt the company is carrying. In general, companies that have lots of working capital will be more successful since they can expand and improve upon their operations. Companies with negative working capital may lack the funds necessary for growth. Turnover Ratio: The turnover ratio is used to determine how many times a company "turns over" its inventory in a given year. It is calculated by taking the cost of goods sold and dividing by the average inventory for the period. A high turnover ratio is looked upon favorably because it is a sign that the company is producing and selling its goods or services very quickly. A low turnover ratio indicates that the company has large warehouses of inventory going unsold for long periods of time. Leverage: Financial leverage is a measure of how much debt the company has assumed in order to finance its assets. It is calculated by dividing the amount of long-term debt carried by the company by the company's total equity. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders' return on their investment and often there are tax advantages

associated with borrowing. The important thing is to be able to differentiate between a healthy amount of debt for good purposes and too much debt for questionable purposes. Cash Flow Statements The cash flow statement is the newest of the three financial statements; companies have only been required to furnish investors with it since 1988. The cash flow statement is similar to the income statement, except that it dispenses with some of the abstract items found on the income statement (such as depreciation) and focuses on actual cash. Most of the information found on the cash flow statement is contained in either the income statement or the balance sheet, but here it is organized in such a way that it is difficult for companies to use accounting tricks to obscure the facts. The cash flow statement is broken down into three parts: Cash Flows from Operating Activities: Here you'll find how much money the company received from its actual business operations. This does not include cash received from other sources, such as investments. To calculate the cash flow from operating activities, the company starts with net income (from the income statement), then adds back in any depreciation expenses, deferred taxes, accounts payable and accounts receivables, and one-time charges (see InvestorGuide University: Income Statements). Cash Flows from Investing Activities: This section shows how much money the company has received (or lost) from its investing activities. It includes money that the company has made (or lost) by investing its excess cash in different investments (stocks, bonds, etc), money the company has made (or lost) from buying or selling subsidiaries, and all the money the company has spent on its physical property, such as plants and equipment. Cash Flow from Financing Activities: This is where the company reports the money that it took in and paid out in order to finance its activities. In other words, it calculates how much money the company spent or received from its stocks and bonds. This includes any dividend payments that the company made to its shareholders, any money that it made by selling new shares of stock to the public, any money it spent buying back shares of its stock from the public, any money it borrowed, and any money it used to repay money it had previously borrowed. Free Cash Flow: While free cash flow doesn't receive as much publicity as earnings do, it is considered by some experts to be a better indicator of a company's bottom line. Free cash flow is the amount of cash that a company has left over after it has paid all of its expenses, including investments. Whereas earnings reports are subject to a number of different accounting tricks which can artificially boost the bottom line, free cash flow is not. It is quite possible, for example, for a company to have positive earnings and negative free cash flow. Negative free cash flow is not necessarily an indication of a bad company, however; many young companies tend to put a lot of their cash into investments, which diminishes their free cash flow. But if a company is spending so much cash, you should probably be investigating why it is doing so and what sort of returns it is earning on its investments.

10-K Reports

All publicly traded companies are required to file a 10-K report each year to the SEC. The 10-K report is similar to the annual report, except that it contains more detailed information about the companys business, finances, and management. It also includes the bylaws of the company, other legal documents, and information about any lawsuits in which the company is involved. If you are looking for information that you can't find in the annual report, be sure to check out the 10-K. 10-Q Reports (Quarterly Reports) You can think of quarterly reports (also called 10-Q reports) as abbreviated versions of the annual report that are issued every three months instead of every year. Quarterly reports contain financial statements, a discussion from the management, and a list of "material events" that have occurred with the company (such as a stock split or acquisition). Form 8-K Publicly traded companies must file Form 8-K with the SEC whenever any material event occurs that might affect the companys financial condition. The list of material events that must be reported includes stock splits, mergers, management changes, and secondary stock offerings. This information will appear in the subsequent 10-Q, but the 8-K is a faster way to find out about such events. Proxy Statements Every year, each publicly traded company holds a meeting at which the companys business is discussed and common shareholders cast their votes for the Board of Directors. Shortly before each annual meeting, companies send out a document called a proxy statement to each shareholder. The proxy statement contains a list of the business concerns to be addressed at the meeting and a ballot for voting on company initiatives and electing the new Board. This proxy ballot authorizes someone else at the meeting (usually the management team) to vote on your behalf.