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Elves And Gnomes: Fairy Tale Investment Terms
A whole generation of children is growing up on Harry Potter books, not to mention a fair number of adults! In Harry Potter, fantasy creatures run amok - there are dragons in the world and gnomes in the garden. Sadly, most of us have never encountered a garden gnome that wasnt made out of cheap plastic. Driven by a deep-seated desire to meet a dragon before I die, I searched the world to find out where all the fantastic creatures of my childhood were hiding. I was more than a little surprised to find theyd gone corporate and joined Wall Street .
Today youll be (re)introduced to some of the fairytale terms circulating in the investment world. Come, step through the looking glass with me ...
Mad Hatter
Alice encounters this odd little man during her journeys through Wonderland. The Mad Hatter alternates between buttering his watch and asking riddles with answers he doesnt know. In the investing world, a mad hatter can refer to a CEO or management team whose managerial skills dont exactly inspire confidence in investors.
Elves
The elf is generally believed to be Santas employee of choice for gift assembly. Reindeer lack the necessary opposable thumbs, but they do work for food as payment and therefore help keep payroll costs down. But a general cynicism in children and a string of bad movies with Santa in the title have forced some elves to move to Wall Street. Actually, in the investing world, elves are the human guests of the PBS show Wall Street Week. They are technical analysts who try to give viewers a sense of where the market is going and what the prevailing trends are. Perhaps we call them elves because we hope theyll bring us the gift of good news?
Leprechaun Leader
Leprechauns are a fabled Irish creature, and theyre known for having a nasty temper. Due to some clever press, the leprechaun has turned this into a plus, posing for the logo of the Fighting Irish, Notre Dames famed football team. Leprechauns are also the most frugal of fairy tale creatures (excluding dragons), hoarding large pots of gold at the elusive end of the rainbow or somewhere on the Emerald Isle.
Leprechauns seem to have a better security system than Fort Knox. The only way to get their treasure is to catch a leprechaun and force it to tell you where the treasure is. Exhibiting the same tenacious and elusive behavior, a leprechaun leader loves hiding the gold. This mischievous CEO stores away money thats not really his to hide. Furthermore, when you finally catch him, hes often ferreted away the money in an offshore account. A leprechaun leader wont bite your fingers like a normal leprechaun, but he can sure take a chunk out of your portfolio earnings (think Enron).
Smurf
Once upon a time, smurfs were three apples high, blue from head to toe, and sang smurfy tunes on Saturday morning TV. But somehow, the cuddly creatures have gotten themselves mixed up in a criminal enterprise. In investment lingo, a smurf is someone who launders money - that is, filters it illegal funds through corporate fronts in order to make it appear legitimate. At one time, money laundering literally referred to the practice of running counterfeit cash through the clothes dryer to give it the worn look of bills already in circulation. How the smurfs got tangled up in this mess is beyond me. Breaking the law is not smurferrific.
Gnomes
Gnomes pop up all over the world, and in every country they act a little differently. In Norway, theyre as intelligent as humans and they help simple farmers by scaring away gremlins in exchange for food (left out on miniature plates, if you really want to be on their good side). In Britain, gnomes act a lot like leprechauns, hiding wealth underground and engineering elaborate traps to protect it. In Africa, gnomes are indistinguishable from gremlins. African gnomes pinch you during the night until you leave out nourishment to appease them, and they also torment your livestock.
Gnomes are so widespread and diverse that even the investing world has two kinds. The first type of gnome simply refers to the 15-year pass-through securities offered under Freddie Macs cash program. These may be called gnomes because the name just sounds neat, but it could also be a nod to the fact that Freddie Mac investments are generally quite stable, thus scaring off volatility gremlins.
The second breed of gnomes resides in Zürich, Switzerland. The Gnomes of Zürich was the nickname British labor ministers gave to the Swiss bankers during the 1964 sterling crisis. The foreign exchange speculators in Zürich had become so powerful and secretive that the British were beginning to see resemblances between the Zürich speculators and the clever little creatures beneath the streets of London. Zürich continues to be an important financial market , retaining its place as the primary place for gold and precious metal transactions. The British ministers have quit using the term, possibly because the Swiss kept pinching them at night.
Goldilocks Economy
Goldilocks is one of those lovely fairy tale girls who cant seem to stay out of trouble or even distinguish the difference between humans and wildlife (Little Red Riding Hood also had this problem). But, like many of us, she loves her porridge not too hot, not too cold, but just right.
In the investing world, a Goldilocks economy is an economy served up just how Goldilocks likes her porridge. Neither hot nor cold, but just right describes the U.S. economy during the 1990s, as well as the model economies that folks like former Federal Reserve Chairman Alan Greenspan are trying to create and maintain. Unfortunately, just as the three bears came home to interrupt Goldilocks meal, a bear market often shows up to spoil the party.
Dwarf
Dwarfs are generally portrayed in fantasy tales as little bearded warriors with the constitution of a horse. Dwarfs live hundreds of years - surprising, since they are always the first to charge the salivating dragon and, consequently, usually the first to catch fire. In the investing world, dwarfsare the Fannie Mae pool of mortgage-backed securities with 15-year maturities. The best parallel to draw between the fairy tale and Wall Street versions is that they both take a long time to mature.
Sleeping Beauty
According to the fairy tale, Sleeping Beauty was a stunningly majestic woman doomed to wait for someone to wake her. In the investing universe, a sleeping beauty is a company that is an extremely attractive takeover target, but hasnt been approached. Sleeping beauties are very alluring thanks to their firm assets and enormous potential (get your mind out of the gutter).
The Happily Ever After
It looks like Wall Street may have an imagination after all, having brought the alluring creatures of fairy tale into their lingo. Now if only everything in the business world could end with a happily ever after.
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Investing With A Purpose
Why are you investing ? Its ok if you have many different answers for this question, but there is a big problem if you have no answer at all. Investing is like driving - it is best done with your eyes open!
Having clear reasons or purposes for investing is critical to investing successfully. Like training in a gym, investing can become difficult, tedious and even dangerous if you are not working toward a goal and monitoring your progress. In this article we examine some common reasons for investing and suggest investments that fit those reasons.
Retirement
No one knows whether the pension system will survive the coming decades. It is this uncertainty and the reality of inflation that forces us to plan for our own retirement. You need only open the newspaper to find out about a company that is freezing pensions or a new bill that will cut government payouts. In these uncertain times, investing can be a tool to help you carve out a solid path to retirement. There are three maxims that apply to investing for your post-work years:
1. The more years there are between today and your retirement, the more years your money has to grow. You have to keep in mind that you are fighting inflation when you are planning to retire . In other words, if you dont invest your money to outpace inflation, it wont be worth as much in the future. (See Delay In Savings Raises Payments Later On and Why is retirement easier to afford if you start early?)
2. The older you are when you start, the more risk averse you will have to be. This means that you will likely use guaranteed investments such as debt securities, which have lower returns. By contrast, if you start young, you can take larger risks for (hopefully) larger gains. (For further reading, see Determining Risk And The Risk Pyramid.)
3. The earlier you start learning about investing, the easier it will be to pick it up. Financial professionals are difficult to choose and costly to keep, so it is best to manage your own affairs whenever possible.
Investing for retirement is similar to long-term investing. You want to find quality investment vehicles to buy and hold with the majority of your investment capital. Your retirement portfolio will actually be a mix of stocks, debt securities, index funds and other money market instruments. This mix will change as you do, moving increasingly toward low-risk guaranteed investments as you age. (To learn more, read Determining Your Post-Work Income and Introductory Tour Through Retirement Plans.)
Achieving Financial Goals
You dont always have to think long-term. Investing is as much a tool for shaping your present financial situation as it is for forming your future one. Do you want to buy a BMW next year? Want to go on a cruise from Seattle to Morocco? Wouldnt a vacation that was paid for with dividendsfeel nicer?
Investing can be used as a way to enhance your employment income, helping you to buy the things you want. Because investing changes along with the investors desired goals, this type of investing is not like retirement investing . Investing to achieve financial goals involves a blend of long-term and short-term investments. If you are investing in the hope of buying a house, you will almost certainly be looking at longer-term instruments. If you are investing to buy a new computer in the New Year, you may want short-term investments that pay dividends or some high-yield bonds.
The caveat here is that you need to pinpoint your goals first. If you want to go on a vacation in a year, you have to sit down and figure out the cost of the vacation in total and then come up with an investing strategy to meet that goal. If you dont have a set goal, the money that should be going into that investment will doubtless be used for other purposes that seem more pressing at the time (Christmas presents, a night out, and so on).
Investing to achieve financial goals can be very exciting and challenging. Combining the pressure of time constraints with the fact that youre not usually dealing with large sums of vital money (as in retirement investing), you may be less risk averse and more motivated to learn about higher yield investments (growth stocks, shorting, etc.). Best of all, there is a tangible reward at the end.
Reasons Not to Invest
Just as there are two main reasons to invest , there are two big reasons not to invest: debt or a lack of knowledge.
In the first case, it is a simple matter of math. Imagine that you have a $1,000 loan at 9% interest, and you get a $1,000 dollar bonus. Should you invest it or should you pay down the debt? Short answer: pay down the debt. If you invest it, the money has to make a return of well over 9% (not counting commissions and fees) to make it worthwhile. It can be done, but it is much easier to find good returns on investment without having to fight losses on your debt. (To learn more, see Digging Out Of Personal Debt.)
There are different kinds of debt - credit card, mortgage, student loans, loan sharks - and they carry different degrees of weight when you are considering whether or not to invest in spite of them. (For more on this, read The Indiana Jones Guide To Getting Ahead, Paying Off Your Mortgageand Take Control Of Your Credit Cards.)
When it comes to lack of knowledge , it is a matter of fools rush in where angels fear to tread. Throwing your money haphazardly into investments that you dont understand is a sure way to lose it quickly. Returning to the exercise analogy, you dont walk into a gym and squat 500 pounds your first day (unless having kneecaps bothers you). In other words, your introduction to investing should follow the same incremental process as weight training. (To get started, read Investing 101: A Tutorial For Beginner Investors.)
Conclusion: Allowing for Change
Your reasons for investing are bound to change as you go through the ups and downs of life. This is an important process because the only other option is to invest with no purpose, which will likely result in investing practices that reflect your uncertainty and cause your returns to suffer. Your reasons and goals will have to be reviewed and adjusted as your circumstances change. Even if nothing significant has changed, it is always helpful to reacquaint yourself with your reasons at regular intervals to see how youve progressed. Like running on a treadmill, investing gets easier and easier once you actually start.
Beware Of Company Stock In Qualified Plans
Many firms that seek to increase employee motivation and tenure are able to do so by rewarding their workers with shares of company stock. This method of compensation can benefit both employees and employers in many respects; employees can get an extra measure of compensation that takes them beyond their regular paychecks, while employers can allow the open market to shoulder at least a portion of the cost. Many firms encourage their employees to purchase stock inside their 401(k) or other qualified plans as well. But while this strategy does have a few advantages, it can also pose some substantial risks to employees, and these risks are not always explained adequately.
The ERISA Loophole
The Employee Retirement Income Security Act was created in an effort to create secure retirement for American workers. When Congress introduced this act in the early seventies, most major corporations and employers in America were all for it - on one condition. They told Congress that if they were not allowed to put their own stock in the company plan, then they would not offer any of the qualified plans created by the Act in any capacity! Needless to say, Congress quickly caved to their demands and allowed a loophole that permitted the purchase of qualifying employer securities inside an eligible individual account in qualified plans. This provision allows employers to push (or at least offer) their own stock to their employees while maintaining their fiduciary status that requires them to put their employees financial interests before their own.
The Enron Factor
The Employee Benefit Research Institute (EBRI) published a brief in January of 2002 that showed that the total allocation of 401(k) plan assets in company stock had remained steady at just under 20% for the previous five years. Its March 2008 publication stated, however, that by 2006 this percentage had dropped by almost half to about 11% with another 2010 publication giving a percentage of 9.2. The first drop was due largely to the financial meltdowns of Enron and Worldcom, where billions of dollars of assets in the employee pension plans were lost as a result of the company stock becoming worthless within a matter of weeks. Needless to say, this fiasco quickly led to widespread criticism from both the media and securities regulators about the asset allocation practices that were encouraged by both companies. The Pension Protection Act of 2006 was one of several pieces of legislation designed to prevent this from repeating itself. Among the provisions of this act were stipulations prohibiting employers from restricting employees from selling their shares inside a qualified plan.
The National Center for Employee Ownership published a Statistical Profile of Employee Ownership on its website in February of 2012 showing that there are still about 800 401(k) plans and nearly 11,000 ESOP plans that invest either mostly or exclusively in company stock. Although the economic turbulence of the past several years has curtailed the purchase of company shares inside retirement plans , this practice has clearly continued.
Methods of Stock Purchase
401(k) plans and ESOPs are the two most common types of qualified plans in which company shares can be found. ESOPs are popular with closely-held businesses that use the plan as a means of transferring ownership (for this reason, the use of company stock in an ESOP plan is somewhat more understandable). Some employers strongly encourage their workers to invest all of their contributions into company shares, while others will either refuse to match any contributions that are not used to buy company stock or else match employee contributions directly with company shares.
Advantages of Purchasing Company Stock in Qualified Plans
Employers encourage the purchase of company stock in their retirement plans for several reasons. As mentioned in the introduction, they can benefit from improved employee motivation and longevity by aligning their employees financial interests with the company. They can also shore up their power base among the shareholders at large by placing more shares in the hands of workers who are likely to support at least the majority of the decisions made by the board of directors. Perhaps most importantly, they can also save money by making their matching contributions in the form of company shares instead of cash.
Employees can benefit by making tax-deductible purchases of company stock in their plans without having to enroll in a separate plan of any kind, such as an employee stock purchase plan or stock option plan. But the advantages to doing this for employees are often overshadowed by one of the most fundamental rules of asset allocation.
When You Dont Diversify
Any competent financial planner will tell his or her clients to avoid putting most or all of their eggs into one basket. Employees who funnel most or all of their retirement plan contributions into company stock can end up being seriously overweighted with this holding in their portfolios. The employees at Enron, Worldcom, United Airlines and other firms that went bankrupt learned the consequences of this the hard way. Workers who invest in company stock need to realistically consider the possibility that their employers could go bankrupt at some point, and then assess the impact that this would have on their investment and retirement portfolios. It can certainly be tempting to load up on company shares in many cases, especially if the company is doing well and the stock has outperformed the market over time. But factors such as governmental regulation, market forces and economic conditions can drastically alter the solvency of a company in some cases. An employee who has half of his or her liquid assets tied up in a company that goes bankrupt may have to work another five or 10 years to make up for this loss.
Example
Jody works in sales for XYZ Corporation. She makes $100,000 a year and contributes the maximum amount to her 401(k). ABC Corporation will match up to 50% of her 401(k) plan contributions with company stock. After 20 years at the company, she has accumulated nearly $250,000 worth of shares in the company and is starting to think about retirement. The economy heads into a deep recession, however, and the stock price plummets by 80% in one year. Then ABC is unexpectedly forced to declare bankruptcy due to serious problems with its line of products. Jody will only have the remaining balance in her 401(k) plan plus whatever other savings that she has accumulated to live on during retirement.
The Bottom Line
Although there are some very real reasons why purchasing at least some company stock inside a retirement plan can be a good idea, employees should always start by obtaining some unbiased research on their stock, such as a detailed report from a third-party analyst. A series of meetings with a qualified financial planner can also help an employee to determine his or her risk tolerance and investment objectives and provide insight as to how much company stock he or she should own, if any. Companies that genuinely care about the welfare of their employees will often have resources available on this matter as well. For more information on this topic, consult your HR department or financial advisor.
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3 Ways To Tell If Your Stock Has Bottomed
One of the most difficult and intimidating tasks for any trader or investor is to try and determine when a particular stock has bottomed, or reaches a point where it no longer decreases significantly. Everyone wants to buy low and sell high, but if you consider that a stocks price can be influenced by macroeconomic, political and economic events, stating with any certainty that a given stock has bottomed is a daunting task. Also, your stock is just one of the thousands of stocks that trade daily in markets worldwide. Knowing when a stock has bottomed can unlock huge profits and can also prevent big losses. So, how can one know with some confidence that a stock has reached a low point? No one can call stock bottoms with absolute certainty consistently, but there are some common fundamental and technical trends that appear in stocks that are about to make a bottom.
1. Sector Characteristics
The stocks you own in your portfolios belong to sectors. Sectors are simply groups of public companies and stocks that are in a related industry. Oil and gas, technology , financial and retail are some sectors that may be familiar to investors. Typically, stocks follow in lock step to both the overall stock market and their respective sector. Identifying which sector(s) your stocks belong to is a good first step to help determine if your stock is near a bottom or a point of less intense declines.
Most of us are familiar with the credit market meltdown in 2008, which decimated financial stocks and even drove financial icons out of business. Most financial stocks traded downward together for an extended period of time. Investors who looked to find value in certain financial stocks were crushed, as the entire financial sector experienced a historical decline. The lesson is to identify and understand what sector your stock belongs to and compare its performance against the entire market.
2. Price and Volume
Once you identify your stocks sector, some other clues can give you some confidence that your stock is nearing a point bottom. Many technicians think that stock price and stock volume are the two most important indications of where a stock is going. Stocks tend to bottom when there are few sellers of that particular stock. It sounds ridiculously simple, but if you think about it: if few sellers exist, more buyers remain and buyers are more willing to pay a higher price for the stock; this means a price bottom has formed.
Volume adds credibility to stock prices and price direction to an extent. Remember, stocks trade on supply and demand just like all other goods in a free market. There is just a lot more things that influence stock prices than say a gallon of milk. The higher the relative volume once the stock has finished going down, the more likely that the stock will not see lower prices anytime soon. So, if stock XYZs average daily trading volume was 5 million shares a day as it declined 50%, but during the last three trading days it has averaged over 15 million shares daily AND the price of the stock has appreciated during, it is likely that the stock has reached an inflection point and is finished going down significantly. Remember, fewer sellers exist at lower prices as most people were looking to sell high. If only buyers remain, stock prices will rise. (Learn more about analyzing volume in Volume Oscillator Confirms Price Movements.)
3. Keep Your Ear to the Street
Perhaps an overlooked tell of when a stock is bottoming is its perception on The Street. Unfortunately, many average investors hear sound bytes on the business news and take it as gospel. Ironically, there is an entire school of investment with the main strategy being to go against theconventional wisdom. These investors are aptly called contrarians. Contrarians tend to bet against what the smart money is doing. Many times going against the grain can be highly profitable and can also be helpful in determining if your stock has bottomed.
The oil and gas sector went through a significant bear market in sympathy with the great recession that began in 2007. Oil prices went down over 50% and stocks in the oil and gas groups were hemorrhaging. Business news hyped up the decline and pundits were talking about the demise of oil and the use of natural gas substitutes and solar energy. No one wanted to touch an oil stock with a 10-foot pole. Investors who went against the grain and snapped up blue chip oil stocks saw a handsome profit. It pays to see all sides of a stocks story.
Going against the grain is a strategy that many feel works well particularly at market tops and bottoms. As an investor, it is at least worth your time to listen to what everyone is saying and wonder: can they all really be right? (For more information on contrarian investing, check out Buy When Theres Blood In The Street.)
Conclusion
Ideally, investors want to know when price trends are about to make a major change in either direction, whether theyre reaching tops or bottoms. The bottom line is that no one truly knows with certainty. Clues, such as a big volume spike on price changes and paying attention to your stocks sector, will give you some insight into whether your stock has reached a point where it will no longer decline significantly. Keep in mind that these are just pieces of a puzzle in the world of investments but if you can add this skill set to you investment intelligence, you will likely be more successful investor.
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History of ETFs
ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. This product, however, was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in stopping sales in the United States.[10]
A similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange in 1990. The shares, which tracked the TSE 35 and later the TSE 100 stocks, proved to be popular. The popularity of these products led the American Stock Exchange to try to develop something that would satisfy SEC regulation in the United States.[10]
Nathan Most and Steven Bloom, executives with the exchange, designed and developed Standard & Poors Depositary Receipts (NYSE: SPY), which were introduced in January 1993.[11][12] Known as SPDRs or Spiders, the fund became the largest ETF in the world. In May 1995 they introduced the MidCap SPDRs (NYSE: MDY).
Barclays Global Investors, a subsidiary of Barclays plc, entered the fray in 1996 with World Equity Benchmark Shares, or WEBS, subsequently renamed iShares MSCI Index Fund Shares. WEBS tracked MSCI country indices, originally 17, of the funds index provider, Morgan Stanley. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind.[13][14]
In 1998, State Street Global Advisors introduced the Sector Spiders, which follow the nine sectors of the S&P 500.[15] Also in 1998, the Dow Diamonds (NYSE: DIA) were introduced, tracking the famous Dow Jones Industrial Average. In 1999, the influential cubes (NASDAQ: QQQQ) were launched attempting to replicate the movement of the NASDAQ-100.
In 2000 Barclays Global Investors put a significant effort behind the ETF marketplace, with a strong emphasis on education and distribution to reach long-term investors. The iShares line was launched in early 2000. Within 5 years iShares had surpassed the assets of any other ETF competitor in the U.S. and Europe. Barclays Global Investors was sold to BlackRock in 2009. The Vanguard Group entered the market in 2001.
Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes. As of September 2010, there were 916 ETFs in the U.S., with $882 billion in assets, an increase of $189 billion over the previous twelve months.
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7 Reasons To Pick ETFs Over Stocks
Apparently nothing can ever be simple on Wall Street. Take the case of a simple question like should I invest in ETFs? A beginning investor can spend less than 10 minutes on Google (Nasdaq:GOOG) and learn (if that is the right word to use) that exchange traded funds (ETFs) are the greatest invention since fire, the worst thing since the Yugo, or investing in ETFs involves risks and may or may not be appropriate for your individual situation, please consult an advisor. (For a background, see our Introduction To Exchange-Traded Funds.)
While it is true that everybodys financial situation is different, here are some advantages of ETFs - relative to stocks and mutual funds - for beginners to consider.
Less Due Diligence
The iShares US Medical Devices ETF (NYSE:IHI) contains 40 different stocks. It would take weeks for an individual investor to do proper due diligence on each of those names, and that is one of the advantages of ETF investing. Because the impact and importance of any one stock is relatively small, investors can spend their time thinking about which sectors and markets are poised to perform and make investment choices without being bogged down by an overwhelming amount of initial and ongoing due diligence.
Might Be Cheaper
Whether you compare them to mutual funds or individual stocks, ETFs can be cheaper to own and trade. Many major brokerages now offer a selection of ETFs that investors can trade commission-free, and that gives them a cost advantage relative to individual stocks. Many ETFs, particularly index-type ETFs, have lower annual expenses than comparablemutual funds and can be cheaper to hold.
No Minimums
While it is possible to find quality mutual funds with low minimum initial investment requirements, ETFs have no such requirements at all. If an investor has $100 to invest and has an account with a broker that offers free ETFs, it is possible to put that money to work immediately. Likewise, there are no minimums for subsequent investments and no minimum maintenance amounts.
Instant Diversification
ETFs provide instant diversification relative to individual stocks. It would be challenging to have a properly diversified portfolio with 10 individual stocks, but relatively simple with the same number of ETFs. (To learn more, see 10 Ways ETFs Can Grow Your Portfolio.)
Invest In Hard-to-access Markets
Owning gold is a pain for most individual investors; owning SPDR Gold Shares (NYSE:GLD) (which owns gold bullion) is simple. Not only does this ETF bypass the bid-ask spreads of retail gold and the expense of rolling over futures contracts, but it has no storage or security requirements. Likewise, investors can access commodities like copper, precious metals, timberland and so on through the convenient forms of ETFs. (For more, check out Commodities: The Portfolio Hedge.)
Can Buy Insurance
Because they are for all intents and purposes stocks, ETFs offer more sophisticated options for experienced investors – particularly when it comes to insurance. If you own the S&P 500 SPDR (NYSE:SPY) - an ETF that mimics the S&P 500) - you have broad exposure to the U.S. stock market. If you are worried about a decline in the market, though, you can also buy put option contracts to cover some or all of that exposure. This helps ensure your position against loss, though at a cost - just like insurance. This strategy is not really an option with mutual funds.
Can Pair-trade
Pair-trading is only for sophisticated investors, but it is another strategy that ETFs can enable. Pair trading involves buying one security and shorting a similar security, for instance buying a stock like Merck (NYSE:MRK) and simultaneously shorting Pfizer (NYSE:PFE). The idea is to profit from the relative difference in fortunes between the two companies, but investors can use ETFs to pair-trade by buying or shorting the industry and taking an opposite position in a particular company that the investor believes will do better/worse than the industry. (To learn more, seeGive ETF Pairs Trades A Chance.)
The Bottom Line
There is no such thing as a perfect investment, so investors need to accept that any idea will have its flaws and drawbacks. Still, ETFs do stand apart as an investment category with some real positives for individual investors. As a cost-effective way of achieving a broadly-diversified portfolio including hard-to-own (but worthwhile) assets, ETFs are hard to beat. Accordingly, almost any investor may find that ETFs can play a useful role whether in place of or amidst a portfolio of stocks and bonds.
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Currency ETFs or ETCs
In 2005, Rydex Investments launched the first ever currency ETF called the Euro Currency Trust (NYSE: FXE) in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares. In 2007Deutsche Banks db x-trackers launched EONIA Total Return Index ETF in Frankfurt tracking the euro, and later in 2008 the Sterling Money Market ETF (LSE: XGBP) and US Dollar Money Market ETF (LSE: XUSD) in London. In 2009, ETF Securitieslaunched the worlds largest FX platform tracking the MSFXSM Index covering 18 long or short USD ETC vs. single G10 currencies. The funds are total return products where the investor gets access to the FX spot change, local institutional interest rates and a collateral yield.
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Direxion Daily Financial Bear 3X Shares (NYSE:FAZ)
Not all ETFs are designed to move in the same direction or even in the same amount as the index they are tracking. For example, this triple bear fund attempts to perform 300% in the opposite direction of the Russell 1000 Financial Services Index. This fund became popular in 2008 and 2009 when the financial crisis placed downward pressure on financial stocks.
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Definitions For The Fifth Letter Of Ticker Symbols
Have you ever wondered what that fifth letter at the end of the stock symbol is? It signifies that the issuer may have additional circumstances involved with the stock. Most recognizable is the infamous E.
Complete Letter list enclosed below. You may want to print it out for your own reference.
The Eligibility Rule protects investors by ensuring that they have access to companies current financial information when considering investments in OTCBB-eligible securities.
Nasdaq will continue to monitor the filing status of all OTCBB issuers. In the event of a filing delinquency, Nasdaq will append the trading symbol(s) of the delinquent issuers security with an E. The fifth character E will be removed from the symbol once Nasdaq receives notification that the security meets the requirements of the Eligibility Rule. After 30 days (60 days for non-SEC filers), if Nasdaq has not been notified that the appropriate filing has been made with the issuers regulatory authority, the issuers security will be removed from the OTCBB.
Code: Meaning
A: Class A.
B: Class B.
C: Exempt from Nasdaq listing requirements for a limited period of time.
D: A new issue of an existing stock. (Often the result of a reverse split.)
E: Delinquent in required filings with the SEC as determined by the NASD.
F: Foreign.
G: First Convertible Bond.
H: Second Convertible Bond, same company.
I: Third Convertible Bond, same company.
J: Voting.
K Non-voting.
L: Miscellaneous situations such as foreign preferred, preferred when-issued, a second class of units, a third class of warrants, or a sixth class of preferred stock.
M: Fourth preferred, same company.
N: Third preferred, same company.
O: Second preferred, same company.
P: First preferred.
Q: In bankruptcy proceedings.
R: Rights.
S: Beneficial interest.
T: With warrants or with rights.
U: Units.
V: When-issued and when-distributed.
W: Warrants.
X: Mutual Fund.
Y: ADR (American Depositary Receipts).
Z: Miscellaneous situations such as a second class of warrants, a fifth class of preferred stock, a stub, a foreign preferred when-issued, or any unit, receipt, or certificate representing a limited partnership interest.
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How To Choose The Best Stock Valuation Method
When trying to figure out which valuation method to use to value a stock for the first time, most investors will quickly discover the overwhelming number of valuation techniques available to them today. There are the simple to use ones, such as the comparables method, and there are the more involved methods, such as the discounted cash flow model. Which one should you use? Unfortunately, there is no one method that is best suited for every situation. Each stock is different, and each industry sector has unique properties that may require varying valuation approaches. The good news is that this article will attempt to explain the general cases of when to use most of the valuation methods. (Learn several tools that the pros use to predict where the markets are heading. Check out Detecting Market Strength.)
Two Categories of Valuation Models
Valuation methods typically fall into two main categories: absolute and relative valuation models. Absolute valuation models attempt to find the intrinsic or true value of an investment based only on fundamentals. Looking at fundamentals simply mean you would only focus on such things as dividends, cash flow and growth rate for a single company, and not worry about any other companies. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income models and asset-based models.
In contrast to absolute valuation models, relative valuation models operate by comparing the company in question to other similar companies. These methods generally involve calculating multiples or ratios, such as the price-to-earnings multiple, and comparing them to the multiples of other comparable firms. For instance, if the P/E of the firm you are trying to value is lower than the P/E multiple of a comparable firm, that company may be said to be relatively undervalued. Generally, this type of valuation is a lot easier and quicker to do than the absolute valuation methods, which is why many investors and analysts start their analysis with this method.
Lets take a look at some of the more popular valuation methods available to investors, and see when it is appropriate to use each model.
Dividend Discount Model (DDM)
The dividend discount model (DDM) is one of the most basic of the absolute valuation models. The dividend model calculates the true value of a firm based on the dividends the company pays its shareholders. The justification for using dividends to value a company is that dividends represent the actual cash flows going to the shareholder, thus valuing the present value of these cash flows should give you a value for how much the shares should be worth. So, the first thing you should check if you want to use this method is if the company actually pays a dividend.
Secondly, it is not enough for the company to just a pay dividend; the dividend should also be stable and predictable. The companies that pay stable and predictable dividends are typically mature blue-chip companies in mature and well-developed industries. These type of companies are often best suited for this type of valuation method. For instance, take a look at the dividends and earnings of company XYZ below and see if you think the DDM model would be appropriate for this company:
2005 2006 2007 2008 2009 2010
Dividends Per Share $0.50 $0.53 $0.55 $0.58 $0.61 $0.64
Earnings Per Share $4.00 $4.20 $4.41 $4.63 $4.86 $5.11
In this example, the earnings per share are consistently growing at an average rate of 5%, and the dividends are also growing at the same rate. This means the firms dividend is consistent with its earnings trend which would make it easy to predict for future periods. In addition, you should check the payout ratio to make sure the ratio is consistent. In this case the ratio is 0.125 for all six years which is good, and makes this company an ideal candidate for the dividend model. (For more on the DDM, see Digging Into the Dividend Discount Model.)
Discounted Cash Flow Model (DCF)
What if the company doesnt pay a dividend or its dividend pattern is irregular? In this case, move on to check if the company fits the criteria to use the discounted cash flow model. Instead of looking at dividends, the DCF model uses a firms discounted future cash flows to value the business. The big advantage of this approach is that it can be used with a wide variety of firms that dont pay dividends, and even for companies that do pay dividends, such as company XYZ in the previous example.
The DCF model has several variations, but the most commonly used form is the Two-Stage DCF model. In this variation, the free cash flows are generally forecasted for five to ten years, and then a terminal value is calculated to account for all the cash flows beyond the forecast period. So, the first requirement for using this model is for the company to have predictable free cash flows, and for the free cash flows to be positive. Based on this requirement alone, you will quickly find that many small high-growth firms and non-mature firms will be excluded due to the large capital expenditures these companies generally face.
For example, take a look at the simplified cash flows of the following firm:
2005 2006 2007 2008 2009 2010
Operating Cash Flow 438 789 1462 890 2565 510
Capital Expenditures 785 995 1132 1256 2235 1546
Free Cash Flow -347 -206 330 -366 330 -1036
In this snapshot, the firm has produced increasing positive operating cash flow, which is good. But you can see by the high level of capital expenditures that the company is still investing a lot of its cash back into the business in order to grow. This results in negative free cash flows for four of the six years, and would make it extremely difficult or impossible to predict the cash flows for the next five to ten years. So, in order to use the DCF model most effectively, the target company should generally have stable, positive and predictable free cash flows. Companies that have the ideal cash flows suited for the DCF model are typically the mature firms that are past the growth stages. (To learn more about this method, see Taking Stock of Discounted Cash Flow.)
Comparables Method
The last method well look at is sort of a catch-all method that can be used if you are unable to value the company using any of the other models, or if you simply dont want to spend the time crunching the numbers. The method doesnt attempt to find an intrinsic value for the stock like the previous two valuation methods do; it simply compares the stocks price multiples to a benchmark to determine if the stock is relatively undervalued or overvalued. The rationale for this is based off of the Law of One Price, which states that two similar assets should sell for similar prices. The intuitive nature of this method is one of the reasons it is so popular.
The reason why it can be used in almost all circumstances is due to the vast number of multiples that can be used, such as the price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), price-to-cash flow (P/CF), and many others. Of these ratios though, the P/E ratio is the most commonly used one because it focuses on the earnings of the company, which is one of the primary drivers of an investments value.
When can you use the P/E multiple for a comparison? You can generally use it if the company is publicly traded because you need the price of the stock and you need to know the earnings of the company. Secondly, the company should be generating positive earnings because a comparison using a negative P/E multiple would be meaningless. And lastly, the earnings quality should be strong. That is, earnings should not be too volatile and the accounting practices used by management should not distort the reported earnings drastically. (Companies can manipulate their numbers, so you need to learn how to determine the accuracy of EPS. Read How To Evaluate The Quality Of EPS.)
These are just some of the main criteria investors should look at when choosing which ratio or multiples to use. If the P/E multiple cannot be used, simply look at using a different ratio such as the price-to-sales multiple.
The Bottom Line
No one valuation method is perfect for every situation, but by knowing the characteristics of the company, you can select a valuation method that best suits the situation. In addition, investors are not limited to just using one method. Often, investors will perform several valuations to create a range of possible values or average all of the valuations into one.
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Is There An Investing State Of Mind?
As Hurricane Sandy wreaked havoc along the east coast of America, the U.S. stock market experienced its first weather-related closure in 27 years. The decision, which was made in unison by the New York Stock Exchange (NYSE) and other leading players within the industry, was intended to protect individual investors from the threat of plummeting trading volumes.
In addition to this, an enforced break from the market may also allow traders to gain greater perspective on their individual trading strategies, as they seek wealth and fortune within the most volatile of financial environments. More specifically, it affords them the opportunity to consider the role of psychology in trading success, and ponder whether there is a specific state of mind required for investors.
Forex Broker Guide: Using the right broker is essential when competing in todays forex marketplace.
Investment and Chaos Theory: The Importance of Having a Trading Philosophy
The influence of psychology in financial trading is a much-discussed topic, with Bill Williams unique Chaos Theory one of the first to make a connection between the development of an investment philosophy and market success. He argued that the cultivation of a trading philosophy was far more important than the use of technical indicators and analytical tools, especially when it came to earning long-term returns in an increasingly unpredictable economy.
Chaos Theory suggests that there are two main aspects of any investment philosophy, each of which is crucial to a traders overall performance. The first aspect relates to knowledge of the financial markets, including how they operate. The second aspect refers to an individual traders own level of self-awareness and inner confidence. These two mental factors combine to create a strong investment mindset, as the ability to make bold decisions is largely dependent on a core knowledge base and in-depth understanding of a specific financial structure or environment.
The Link between Chinese Philosophy and Financial Gains
Although the theory is not without its critics, its fundamental principles share a great deal in common with some the worlds most long-standing philosophies. Take the ancient Chinese practice of Zen, for example, which despite having its origins rooted firmly in the seventh century, retains considerable relevance in the modern age. Most importantly, part of its wisdom dictates that inner belief and having the courage of your convictions is crucial to the attainment of goals, and this certainly echoes the sentiment of Bill Williams Chaos Theory.
Separate to the philosophy of Zen is the I Ching (Chinese Book of Changes), which offers far greater insight into individual leadership and the art of decision making. In particular, it discusses the need for conviction in decision-making and how an individuals strength of mindset remains the one constant amid changing external conditions and an evolving environment. This has undeniable relevance within the financial markets, as while particularly volatile platforms, such as the foreign exchange, are subject to constant price movements, successful traders are able to rely on their own knowledge, self-assurance and perception in order to succeed.
The Taoist development is another Chinese philosophy that supports the need for an investment mindset, especially in the second phase of its teachings. Within this literature, it is recognized that, although things in this world are ever changeable and changing, the laws that govern this change are not, and this wisdom reflects one of the defining features of the financial market place.
Although the nature of each economic and financial crisis may change, for example, the subsequent reaction of the market remains largely unaltered, which in turn provides an opportunity for traders who are inwardly confident and knowledgeable to profit from bold investment moves.
SEE: Create Your Own Trading Strategies
The Bottom Line
With concerns growing about the impending fiscal cliff and a worsening eurozone crisis, the current economic climate is certainly posing a potentially debilitating threat to financial traders and investors. While this threat is tangible, however, experienced investors will point to the fact that the financial markets are consistently vulnerable to change and potentially influential global events.
This week provides a case in point for U.S. investors, with the October jobs report and election scheduled within a short space of time. However, the majority of seasoned investors will still often find a way to protect their interests and acquire profit in a volatile market. This is primarily because they have cultivated a well-defined trading philosophy over time; this mindset distinguishes them from investors who are driven by emotion or simply new to the workings of the financial markets.
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Criticism of ETFs
John C. Bogle, founder of the Vanguard Group, a leading issuer of index mutual funds (and, since Bogles retirement, of ETFs), has argued that ETFs represent short-term speculation, that their trading expenses decrease returns to investors, and that most ETFs provide insufficient diversification. He concedes that a broadly diversified ETF that is held over time can be a good investment.
ETFs are dependent on the efficacy of the arbitrage mechanism in order for their share price to track net asset value. While the average deviation between the daily closing price and the daily NAV of ETFs that track domestic indices is generally less than 2%, the deviations may be more significant for ETFs that track certain foreign indices. The Wall Street Journal reported in November 2008, during a period of market turbulence, that some lightly traded ETFs frequently had deviations of 5% or more, exceeding 10% in a handful of cases, although even for these niche ETFs, the average deviation was only a little more than 1%. The trades with the greatest deviations tended to be made immediately after the market opened.
According to a study on ETF returns in 2009 by Morgan Stanley, ETFs missed in 2009 their targets by an average of 1.25 percentage points, a gap more than twice as wide as the 0.52-percentage-point average they posted in 2008. Part of this so-called tracking error is attributed to the proliferation of ETFs targeting exotic investments or areas where trading is less frequent, such as emerging-market stocks, future-contracts based commodity indices and junk bonds.[citation needed]
The tax advantages of ETFs are of no relevance for investors using tax-deferred accounts (or indeed, investors who are tax-exempt in the first place). However, the lower expense ratios are proving difficult for the proponents of traditional mutual funds to overcome.
In a survey of investment professionals, the most frequently cited disadvantage of ETFs was the unknown, untested indices used by many ETFs, followed by the overwhelming number of choices.
Some critics claim that ETFs can be, and have been, used to manipulate market prices, including having been used for short selling that has been asserted by some observers (including Jim Cramer of theStreet.com) to have contributed to the market collapse of 2008
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Teaching Your Child To Be Financially Savvy
When it comes to money, the advice parents usually give their children goes something like this: Money doesnt grow on trees, or Close the door when you leave the house - were not paying to heat the whole neighborhood. Although that parental wisdom has stood the test of time, it takes a bit more effort to teach a child sound financial management principles. (Find out what not to do in 5 Ways To Stunt A Childs Financial Growth.)
Getting Started
The first step in the process is to engage the childs interest. Start with an allowance and have your child dedicate a portion of it to spending and a portion to savings. Be sure to give your child discretion on his/her spending allocation. By giving a child money and the power to make decisions regarding its disposition, you will capture the childs interest and give him/her a sense of responsibility.
Lesson No. 1: Saving
The portion of the childs allowance that is dedicated to savings should be deposited into an interest-bearing savings account. Take your child to the bank when the account is opened and involve him/her in the process. Make sure your child understands the purpose of the account and has a working definition of the term interest.
The childs involvement shouldnt end with that first visit to the bank, however. Its a good idea to set up the account so that statements come in your childs name. When the mail arrives, let your child open the envelope. Review the account balance and help your child understand how and why the balance grows. Give your child a binder or folder and have him/her put each monthly statement in the binder. This teaches your child to be organized and to keep records, and it provides a historical document tracing the growth of the account balance.
Take your child to the bank on the day his/her allowance is paid. Let him/her participate in the process of depositing the money. Remember, the point here isnt to try to turn a $5 deposit into a record-setting investment . The point is to teach your child about money, and lesson one is about saving instead of spending. Your objective is to lay the foundation for a lifetime habit of saving.
Lesson No. 2: Investing
Every child matures at a different rate, but when your child is older, start talking about making money grow more quickly. Most teenagers are able to grasp the basics of stock ownership. Spend some time explaining the concept of risk, highlighting the potential risks and rewards of investing in the stock market. If you can afford it, give your child a few hundred dollars and help him/her research companies that he/she finds interesting, such as toy or gaming companies, skateboard makers, and so on. Walk your child through the process of conducting research using the internet and the resources available at your local library. Most large public libraries in the U.S. subscribe to Value Line, ainvestment research provider, or offer net access to a variety of finance sites. (For a good introduction to the world of stocks, see our Stock Basics Tutorial.)
When the research is complete, help your child buy shares. Remember, the purpose of this exercise isnt to create a portfolio that will sustain your child through the ages, and it isnt to demonstrate your fine stock-picking skills. The objective is to give your child the opportunity to learn about money and risk and reward by making his/her own choices. If you dont have a lot of disposable money to give your child, or if you are concerned about his/her research and stock selection abilities, limit the investment to one or two companies at $100 each. Online brokerages make this an affordable exercise for almost everyone.
Dont forget that the possibility of losing money is part of the process. Any investor who claims never to have lost money during a lifetime of investing isnt telling the truth. Keep in mind that this should be a learning experience. You are not expected to hand a 13-year-old child the sum of his/her lifes savings and suggest that he/she have a go at the markets. The intention is to teach him/her about investing and the consequences of making decisions.
Once again, statements for the brokerage account should be addressed to the child. The statements should go into your childs folder or binder. You can use them to compare the fluctuations in the account balance against the balances from the savings account. Review the returns on the childs portfolio , discuss the results and stick with this process over a period of years.
Look to the Future
As your child matures, he or she can grasp more sophisticated investing concepts, such as the importance of asset allocation and portfolio diversification and the advantages of different types of investment vehicles. You can explain that, as people age or accumulate assets, fixed-income investments may become an appropriate addition to an investors portfolio. When possible, you can use your personal portfolio as a tool to demonstrate how portfolio construction evolves over time based on an investors needs. (See A Guide To Portfolio Construction for a step-by-step look at the process.)
Conclusion
Knowledge is power. While some adults may blanch at the prospect of giving their child the freedom to pick stocks, it is important to remember that you wont always be around to do the job on the childs behalf. Bear in mind the old saying about teaching a man to fish and feeding him for a lifetime versus giving him a fish to feed him for a day. Ideally, these early exercises in money management will teach your child valuable financial lessons to last him or her well into adulthood.
While affluent adults will invest substantial sums on behalf of their children, including setting up college savings and personal trusts, giving a child the knowledge required to handle his/her own financial affairs is an equally important parental responsibility. In the long run, teaching children about money may be more valuable than giving them cash and no direction on how to handle it. So, start early and make the experience fun. Good saving and investing habits become second nature over time, and your child will be able to draw on these skills for a lifetime.
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5 Basic Things To Know About Bonds
Want to improve your portfolios risk/return profile? Adding bonds creates a more balanced portfolio, strengthening diversification and calming volatility. You can get your start in bond investing by learning a few basic bond market terms.
On the surface, the bond market may seem unfamiliar, even to experienced stock investors. Many investors make only passing ventures into bonds because they are confused by the apparent complexity of the market. Bonds are actually very simple debt instruments, if you understand the terminology. Lets take a look at that terminology now.
Tutorial: Bond Basics
1. Basic Bond Characteristics
A bond is simply a type of loan taken out by companies. Investors lend a company money when they buy its bonds. In exchange, the company pays an interest coupon at predetermined intervals (usually annually or semiannually) and returns the principal on the maturity date, ending the loan.
Unlike stocks , bonds can vary significantly based on the terms of the bonds indenture, a legal document outlining the characteristics of the bond. Because each bond issue is different, it is important to understand the precise terms before investing. In particular, there are six important features to look for when considering a bond.
Maturity
The maturity date of a bond is the date when the principal, or par, amount of the bond will be paid to investors, and the companys bond obligation will end.
Secured/Unsecured
A bond can be secured or unsecured. Unsecured bonds are called debentures; their interest payments and return of principal are guaranteed only by the credit of the issuing company. If the company fails, you may get little of your investment back. On the other hand, a secured bond is a bond in which specific assets are pledged to bondholders if the company cannot repay the obligation.
Liquidation Preference
When a firm goes bankrupt, it pays money back to investors in a particular order as it liquidates. After a firm has sold off all of its assets, it begins to pay out to investors. Senior debt is paid first, then junior (subordinated) debt, and stockholders get whatever is left over. (To learn more, read An Overview of Corporate Bankruptcy.)
Coupon
The coupon amount is the amount of interest paid to bondholders, normally on an annual or semiannual basis.
Tax Status
While the majority of corporate bonds are taxable investments , there are some government and municipal bonds that are tax exempt, meaning that income and capital gains realized on the bonds are not subject to the usual state and federal taxation. (To learn more, read The Basics of Municipal Bonds.)
Because investors do not have to pay taxes on returns, tax-exempt bonds will have lower interest than equivalent taxable bonds. An investor must calculate the tax-equivalent yield to compare the return with that of taxable instruments.
Callability
Some bonds can be paid off by an issuer before maturity. If a bond has a call provision, it may be paid off at earlier dates, at the option of the company, usually at a slight premium to par. (To learn more, read Callable Bonds: Leading A Double Life.)
2. Risks of Bonds
Credit/Default Risk
Credit or default risk is the risk that interest and principal payments due on the obligation will not be made as required. (To learn more, read Corporate Bonds: An Introduction To Credit Risk.)
Prepayment Risk
Prepayment risk is the risk that a given bond issue will be paid off earlier than expected, normally through a call provision. This can be bad news for investors, because the company only has an incentive to repay the obligation early when interest rates have declined substantially. Instead of continuing to hold a high interest investment, investors are left to reinvest funds in a lower interest rate environment.
Interest Rate Risk
Interest rate risk is the risk that interest rates will change significantly from what the investor expected. If interest rates significantly decline, the investor faces the possibility of prepayment. If interest rates increase, the investor will be stuck with an instrument yielding below market rates. The greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments farther out into the future. (To learn more, read Managing Interest Rate Risk.)
3. Bond Ratings
Agencies
The most commonly cited bond rating agencies are Standard & Poors, Moodys and Fitch. These agencies rate a companys ability to repay its obligations. Ratings range from AAA to Aaa for high grade issues very likely to be repaid to D for issues that are in currently in default. Bonds rated BBB to Baa or above are called investment grade; this means that they are unlikely to default and tend to remain stable investments. Bonds rated BB to Ba or below are called junk bonds, which means that default is more likely, and they are thus more speculative and subject to price volatility.
Occasionally, firms will not have their bonds rated, in which case it is solely up to the investor to judge a firms repayment ability. Because the ratings systems differ for each agency and change from time to time, it is prudent to research the rating definition for the bond issue you are considering. (To learn more, read The Debt Ratings Debate.)
4. Bond Yields
Bond yields are all measures of return. Yield to maturity is the measurement most often used, but it is important to understand several other yield measurements that are used in certain situations.
Yield to Maturity (YTM)
As said above, yield to maturity (YTM) is the most commonly cited yield measurement. It measures what the return on a bond is if it is held to maturity and all coupons are reinvested at the YTM rate. Because it is unlikely that coupons will be reinvested at the same rate, an investors actual return will differ slightly. Calculating YTM by hand is a lengthy procedure, so it is best to use Excels RATE or YIELDMAT (Excel 2007 only) functions for this computation. A simple function is also available on a financial calculator. (Keep reading on this subject in Microsoft Excel Features For The Financially Literate.)
Current Yield
Current yield can be used to compare the interest income provided by a bond to the dividend income provided by a stock. This is calculated by dividing the bonds annual coupon amount by the bonds current price. Keep in mind that this yield incorporates only the income portion of return, ignoring possible capital gains or losses. As such, this yield is most useful for investors concerned with current income only.
Nominal Yield
The nominal yield on a bond is simply the percentage of interest to be paid on the bond periodically. It is calculated by dividing the annual coupon payment by the par value of the bond. It is important to note that the nominal yield does not estimate return accurately unless the current bond price is the same as its par value. Therefore, nominal yield is used only for calculating other measures of return.
Yield to Call (YTC)
A callable bond always bears some probability of being called before the maturity date. Investors will realize a slightly higher yield if the called bonds are paid off at a premium. An investor in such a bond may wish to know what yield will be realized if the bond is called at a particular call date, to determine whether the prepayment risk is worthwhile. It is easiest to calculate this yield using Excels YIELD or IRR functions, or with a financial calculator. (For more insight, see Callable Bonds: Leading A Double Life.)
Realized Yield
The realized yield of a bond should be calculated if an investor plans to hold a bond only for a certain period of time, rather than to maturity. In this case, the investor will sell the bond, and this projected future bond price must be estimated for the calculation. Because future prices are hard to predict, this yield measurement is only an estimation of return. This yield calculation is best performed using Excels YIELD or IRR functions, or by using a financial calculator.
Conclusion
Although the bond market appears complex, it is really driven by the same risk/return tradeoffs as the stock market. An investor need only master these few basic terms and measurements to unmask the familiar market dynamics and become a competent bond investor . Once youve gotten a hang of the lingo, the rest is easy.
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Looking Deeper Into Capital Allocation
Market-leading companies not only achieve success through their business results, but also by properly allocating capital in a way that is most beneficial to shareholders. Often overlooked as a central theme, capital allocation decisions are vital in determining the future of the company and, as such, are some of the most important responsibilities of company management. This article will examine some of the metrics that help us evaluate managements ability to effectively allocate capital in any set of market conditions. Read on to learn how to use these metrics to facilitate stock research and find companies poised to succeed over the long haul.
SEE: Asset Allocation: One Decision To Rule Them All
Thanks, Keep the Change
Should the company issue or increase dividends? Should it build that new factory or hire more workers? These are the dilemmas facing managers of todays publicly-traded companies.
In the past, for example, Microsoft came under increasing shareholder scrutiny for holding onto more than $48 billion in cash and equivalents. Investors rightly asked when Microsoft was going to start sending some of the shareholders money back their way. In March of 2003, Microsoft finally answered that question by issuing a dividend (worth 8 cents per share) for the first time. Recently in 2012, it issued a 20 cent dividend.
Every company follows a life cycle; in the early stages of life, capital allocation decisions are pretty simple - most of the cash flows will be poured back into the growing business, and there probably isnt going to be much money left over. After many years of strong, steady earnings growth, companies find out that there is only so much market out there to be had. In other words, adding the next product to the shelf, or adding the next shelf for that matter, is only half as profitable per unit as the first things that were put on that shelf many years ago. Eventually, the company will reach a point where cash flows are strong, and there is extra cash lying around. The first discussions then can begin about such things as:
• Entering a new line of business - This requires higher initial outlays of cash, but could prove to be the most profitable course in the long run.
• Increasing capacity of the core business - This can be confidently done until growth rates begin to decline.
• Issuing or increasing dividends - The tried and true method.
• Retiring debt - This increases financial efficiency, as equity financing will almost always be cheaper.
• Investing or acquiring other companies or ventures - This should always be done cautiously, sticking to core competencies.
• Buying back company stock.
Management makes these kinds of decisions by using the same metrics available to investors. These include:
Return on Equity
A stocks return on equity (ROE) reveals the growth rate of the company in shareholder dollars.
When looking at a companys ROE, there are a few considerations to take into account, such as the age of the company and what type of business it operates. Younger companies will tend to have higher ROEs because cash deployment decisions are easy to make. Older firms and those operating in capital-intensive businesses (think telecom or integrated oil), will have lower ROEs because it costs more up front to generate the first dollars of revenue.
ROE is very specific to the industry in which the company operates because each has unique capital requirements; therefore, comparisons should only be made to similar companies when reviewing this valuable metric. A ROE above the industry average is a good sign that management is wringing the most profit possible out of every invested dollar.
SEE: How Return On Equity Can Help You Find Profitable Stocks
Return on Assets
Return on assets (ROA) is similar in theory to ROE, but the denominator of the equation has changed from stockholder equity to total assets. The ROA number tells us what kind of return management is getting on the assets at its disposal. As with ROE, ROA figures will vary greatly within different industries, and should be compared with this in mind.
SEE: Use ROA To Gauge A Companys Profits
ROA performance will, over the long run, provide a clearer picture of profitability than ROE will. Why? Because in the ROE calculations, current net income and last years net income are major variables; they also happen to be much more volatile than long-term growth rates. When ROA is calculated, most of the denominator is made up of long-term assets and capital, which smooth out some of the short-term noise that ROE can create. Essentially, ROE can vary widely for a company from year to year, while ROA figures take longer to change significantly.
SEE: ROA And ROE Give Clear Picture Of Corporate Health
Capital Requirements and Cash Management
Lets say that Company X has averaged an 18% ROE for the first 10 years of its existence. This represents a strong record of growth, but it was achieved during a time when there were ample new markets to get into. With a leading market share, Company X can already see that it wont be able to keep up this rate of growth, and must begin looking at other ways to increase shareholder value. The capital requirements to keep up the business are known and set aside, and the free cash flow that is left over can be assessed for its durability and consistency. Once this has been verified, management can sit down and decide the best use of the funds. One or more of the options mentioned above may be used, and once this process begins investors can really start to evaluate the companys effectiveness outside of simply running the core business.
Dividend-paying stocks are attractive to many investors. Dividends are an effective way of returning free cash flow to shareholders, and encourage long-term investment in a company. By looking at the payout ratio for a stocks dividend, an investor can easily tell what percentage of net income is being used to pay dividends. The smaller the payout ratio, the more room management has to increase this amount in the future. The most mature dividend-paying companies are paying out 80%, or more, of all the net income to shareholders, which provides for a nice yield, but leaves very little cash behind to generate future earnings growth. These stocks end up resembling real estate investment trusts (a security where at least 90% of net income must be distributed to shareholders annually). As a result, investments in companies with very high dividend payouts will experience little price appreciation.
SEE: How And Why Do Companies Pay Dividends?
Stock buybacks are another common way to allocate excess capital within an organization. When is this in the shareholders best interests? If the company truly feels that its stock is undervalued, buying back stock could very well be the best use of the funds. This will increase the percentage ownership of all the other shareholders, and is generally seen as a positive sign that management believes in the future of the company.
The Bottom Line
For the individual investor , part of any effective due diligence should include understanding the history of, and expectations for, the capital allocation abilities of a company. When looked at along with the valuation and growth, managements ability to allocate capital effectively will determine whether it is destined to have a front-running stock, or an also-ran.
A Beginners Guide To Mining Stocks
October 11 2012| Filed Under » Commodities, Investing Basics, Investment
If it isnt grown, it has to be mined. Youve probably heard some variation of this saying. It is used by people concerned about the environmental effects of mineral depletion as well as people bullish on mining stocks . Although these two groups have a very different emphasis when they speak it, they are both right - mining is big business. Almost every commercial product has elements that started off buried beneath the earth. Here are a few things that you should know before adding mining stocks to your portfolio.
Two Stocks, One Sector
Mining stocks are truly two distinct groups: majors and juniors. The majors are well-capitalized companies with decades of history, world-spanning operations and a slow and steady cash flow. Major mining companies are no different from large oil companies, and many of the same metrics apply with a mining twist. Both have proven and probable reserves, except mining companies break down profit and cost on a given deposit by ton, instead of barrel. In short, a mining major is easy to evaluate and easy to invest in.
The junior mining stocks are very nearly the exact opposite of mining majors. They tend to have little capital, short histories and high hopes for huge returns in the future. For the juniors, there are really three fates. The most common is failure, which leaves a hole in everyones pocket, including that of the banks and investors. The second fate occurs when a junior has enough success to justify a major paying a decent premium to gobble it up, leading to decent returns all around. In the third and most rare fate, a junior finds a large deposit of a mineral that the market wants a lot of; it is a magical combination of the right deposit at the right time. When this happens, juniors can return more in a few days than a major will return in years.
Valuing Major and Junior Mining Stocks
Although majors and juniors are very different, they are united by the one fact that makes all mining stocks unique: their business model is based on using up all the assets they have in the ground. The catch is that mining companies dont know exactly how much is in a given deposit until it is all dug up. Therefore, the value of mining stock roughly follows the market value of its reserves, with a premium paid to companies with a long history of successfully bringing those reserves to market.
Reserves are evaluated through feasibility studies. These studies independently verify the worth of a deposit. A feasibility study takes the estimated size and grade of the deposit and balances it against the costs and difficulties of extracting it all. If the deposit will fetch more money on the market than it costs to dig up, then it is feasible.
Different Risks, Different Rewards
If a mining major has hundreds of deposits staked and/or being mined, the contents of any single deposit arent likely to shake the stock value too much. A major is the sum of all the deposits with the aforementioned goodwill tied to history. A change in the market value of a mineral that makes up a larger percentage of the deposits will have a much larger effect than a new deposit or a failed deposit. A junior mining stock lives or dies on the results of its feasibility studies.
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A junior mining stock sees the most action leading up to, and immediately after, a feasibility study. If the study is positive, then the value of the company may shoot up. The opposite, of course, is also true. Often, a junior miner wont mine a feasible deposit to the end. Instead, they sell the deposit (or themselves) to a larger miner and move on to search for another one. In this sense, junior mining stocks form an exploration pipeline that feeds the major miners in the end. In this view, the big risks and rewards mostly reside at the junior mining level.
Choosing Between Majors and Juniors
As an aspiring mining investor, youre probably wondering whether you should invest in junior mining stocks or major mining stocks. The answer depends on what you are looking for. Juniors have the potential to offer a lot of appreciation in the right market. This makes them an ideal destination for risk capital, but hardly the best place to put your social security checks. If you are looking for a lower-risk stock with the potential for dividends and some decent appreciation, then major mining stocks may be for you.
The Bottom Line
This is a primer and as such, suffers from being overly broad and simplistic. Before you invest in the mining sector, you should probably know what greenfields exploration is, how to estimate the impact of pricing risk and be able to hold forth on the dangers of buying on a single positive assay. If you are keen enough on mining to do some research, then there is probably room in your portfolio for both mining majors and juniors.
Dispelling 5 Myths About Financial Planners
Its tough to go it alone. Some people have the time, ability and drive to manage all their finances, others dont. Either way, professional advisors can provide great insight and judgment in countless instances, and not necessarily at exorbitant cost. But common misconceptions aboutfinancial planners prevent many from seeking their counsel. In this article well help you avoid these traps so you get the most value from your advisor. (For related reading, check out Do You Need A Financial Advisor?)
Myth 1 - Having a financial planner means I dont need to learn anything about investing.
This myth sends shivers up our spines! If you take nothing else away from this article, understand that whether or not you have an advisor, the most important thing you can do is educate yourself. Having a solid understanding of investing will ensure you understand what your advisor is doing with your money, and allow you to ask the tough questions.
Think of this scenario: you sit down for a review of your personal finances and your new advisor starts with a lecture about asset allocation and diversification and how they are recommending a certain hot new mutual fund . If you understand the terminology you can ask questions like:
• Why are you recommending a 60/30/10 asset allocation between stocks, bonds and the money market ?
• How am I more diversified when I already own similar mutual funds?
• What is the MER (management expense ratio) of this new mutual fund? What compensation do you receive if you sell me this?
By asking the right questions youll understand your portfolio better and also protect yourself from unscrupulous advisors who try to sell you something you dont need. Its just like taking your car into the repair shop and the young attendant tells you your foo-foo valve is shot. If you are able to explain that there is no such thing as a foo-foo valve and is therefore unlikely in need of replacing, there is no way they can overcharge you for services you dont need. (Find out more in Find The Right Financial Advisor.)
Myth 2 - A planner or advisor only gives me advice on investing.
Picking the right investments is certainly an important aspect of your personal finances, but its not the only part. Financial planning takes into account all the varied financial aspects of a persons life: taxes, insurance, retirement, budgeting, estate planning, liquidity requirements and other life goals. It considers the various and sometimes conflicting financial aspects of our lives and develops strategies and objectives to make everything work together. For example, what good is it to pick all the right investments but then see most of your return swallowed up in taxes? Its a full-time job just to keep up with all the laws relating to investment income and taxation. With the aid of a financial planner who considers your individual situation, youll be able to minimize the amount of taxes you pay (legally of course) and have a stronger bottom line in the end.
Myth 3 - By law all financial planners are required to be registered with a government agency.
Actually, financial planners are not required to be registered, whereas stockbrokers and investment advisors are. Before deciding on an advisor, always look up the persons registration at your local state or provincial Business Services Division. Check to see if there are any complaints or if disciplinary action has been taken against them. You should also find out how long the person has been in the profession. A good rule of thumb is to employ a financial planner with at least three to five years experience.
Myth 4 - Certification letters after the persons name mean nothing.
If you are looking for an advisor, give extra credit to those who have designations such as the Certified Financial Planner (CFP). To become a CFP, an advisor must put in hundreds of hours of studying in order to pass a grueling 10-hour exam. Furthermore, members are required to undergo background checks, agree to a code of ethics and do continuing education to keep the certification. While hiring a CFP is no guarantee of performance, its a good indication that the financial professional is legit. (To learn more about all of the different designations available and what they mean, see Are All Certifications Created Equal? and Shopping for a Financial Advisor. For information about becoming a CFP, see Is A Career In Financial Planning In Your Future.)
Myth 5 - Only wealthy people need a financial planner.
Last but not least, this myth is extraordinarily widespread. Financial planning is about helping people of all income levels achieve short-term and long-term financial goals . Many individuals, often those not considered wealthy, assume you need to be a millionaire to get professional help. The truth is that for as little as a few hundred dollars you can have a portfolio assessment done by a fee-based financial planner. This breed of planner only takes compensation from the client and receives no compensation in the form of commissions from selling certain products. Many charge by the hour, which means you can get unbiased advice on specific issues without worrying about being forced into some investment.
Conclusion
Some people are confident enough to make these vital decisions on their own. Others need a helping hand. If you do choose to deal with a planner, keep on educating yourself, understand there is more to managing your portfolio that just picking hot stocks , do the homework in terms of both background checks and certifications and dont think that you cant afford advice just because your portfolio isnt seven figures. Financial planners arent a guarantee or magic solution but they can be of help in many circumstances.
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SPDRs
Usually referred to as spiders, these investment instruments bundle the benchmark S&P 500 and give you ownership in the index. Imagine the trouble and expenses involved in trying to buy all 500 stocks in the S&P 500! SPDRs allow individual investors to own the indexs stocks in a cost-effective manner.
Another nice feature of SPDRs is that they divide various sectors of the S&P 500 stocks and sell them as separate ETFs, there are literally dozens of these types of ETFs. The technology select sector index, for example, contains over 85 stocks covering products developed by companies such as defense manufacturers, telecommunications equipment, microcomputer components and integrated computer circuits. This ETF trades under the symbol XLK on the AMEX.
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