The Investment FAQ (part 1 of 20)

Archive-name: investment-faq/general/part1
Version: $Id: part01,v 1.62 2005/01/05 12:40:47 lott Exp lott $
Compiler: Christopher Lott

This is the table of contents for the plain-text version of
The Investment FAQ, and is the first part of a 20-part posting.
Please visit The Investment FAQ web site for the latest version:


The Investment FAQ is a collection of articles about investments and
personal finance, including stocks, bonds, mutual funds, options,
discount brokers, information sources, life insurance, etc. Although
the FAQ is more of a reference than a tutorial, if you pick your
articles carefully, the FAQ can serve as a comprehensive, unbiased
introduction to investing.


Terms of Use

The following terms and conditions apply to the plain-text version of
The Investment FAQ that is posted regularly to various newsgroups.
Different terms and conditions apply to documents on The Investment
FAQ web site.

The Investment FAQ is copyright 2005 by Christopher Lott, and is
protected by copyright as a collective work and/or compilation,
pursuant to U.S. copyright laws, international conventions, and other
copyright laws. The contents of The Investment FAQ are intended for
personal use, not for sale or other commercial redistribution.
The plain-text version of The Investment FAQ may be copied, stored,
made available on web sites, or distributed on electronic media
provided the following conditions are met:
+ The URL of The Investment FAQ home page is displayed prominently.
+ No fees or compensation are charged for this information,
excluding charges for the media used to distribute it.
+ No advertisements appear on the same web page as this material.
+ Proper attribution is given to the authors of individual articles.
+ This copyright notice is included intact.


Disclaimers

Neither the compiler of nor contributors to The Investment FAQ make
any express or implied warranties (including, without limitation, any
warranty of merchantability or fitness for a particular purpose or
use) regarding the information supplied. The Investment FAQ is
provided to the user "as is". Neither the compiler nor contributors
warrant that The Investment FAQ will be error free. Neither the
compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it. Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers. Readers outside the USA can reach
US-800 telephone numbers, for a charge, using a service such as MCI's
Call USA. All prices are listed in US dollars unless otherwise
specified.

Availability of the FAQ

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Please send comments and new submissions to the compiler.

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TABLE OF CONTENTS

Advice - Beginning Investors part 2
Advice - Buying a Car at a Reasonable Price part 2
Advice - Errors in Investing part 2
Advice - Using a Full-Service Broker part 2
Advice - Mutual-Fund Expenses part 2
Advice - One-Line Wisdom part 2
Advice - Paying for Investment Advice part 2
Advice - Researching a Company part 2
Advice - Target Stock Prices part 2
Analysis - Amortization Tables part 2
Analysis - Annual Reports part 2
Analysis - Beta and Alpha part 2
Analysis - Book-to-Bill Ratio part 2
Analysis - Book Value part 2
Analysis - Computing Compound Return part 2
Analysis - Future and Present Value of Money part 2
Analysis - Goodwill part 2
Analysis - Internal Rate of Return (IRR) part 3
Analysis - Paying Debts Early versus Making Investments part 3
Analysis - Price-Earnings (P/E) Ratio part 3
Analysis - Percentage Rates part 3
Analysis - Risks of Investments part 3
Analysis - Return on Equity versus Return on Capital part 3
Analysis - Rule of 72 part 3
Analysis - Same-Store Sales part 3
Bonds - Basics part 3
Bonds - Amortizing Premium part 3
Bonds - Duration Measure part 3
Bonds - Moody Bond Ratings part 3
Bonds - Municipal Bond Terminology part 4
Bonds - Relationship of Price and Interest Rate part 4
Bonds - Tranches part 4
Bonds - Treasury Debt Instruments part 4
Bonds - Treasury Direct part 4
Bonds - U.S. Savings Bonds part 4
Bonds - U.S. Savings Bonds for Education part 4
Bonds - Value of U.S. Treasury Bills part 4
Bonds - Zero-Coupon part 4
CDs - Basics part 4
CDs - Market Index Linked part 4
Derivatives - Basics part 4
Derivatives - Black-Scholes Option Pricing Model part 5
Derivatives - Futures part 5
Derivatives - Futures and Fair Value part 5
Derivatives - Stock Option Basics part 5
Derivatives - Stock Option Covered Calls part 5
Derivatives - Stock Option Covered Puts part 5
Derivatives - Stock Option Ordering part 5
Derivatives - Stock Option Splits part 5
Derivatives - Stock Option Symbols part 5
Derivatives - LEAPs part 5
Education Savings Plans - Section 529 Plans part 5
Education Savings Plans - Coverdell part 5
Exchanges - The American Stock Exchange part 5
Exchanges - The Chicago Board Options Exchange part 5
Exchanges - Circuit Breakers, Curbs, and Other Trading part 6
Exchanges - Contact Information part 6
Exchanges - Instinet part 6
Exchanges - Market Makers and Specialists part 6
Exchanges - The NASDAQ part 6
Exchanges - The New York Stock Exchange part 6
Exchanges - Members and Seats on AMEX part 6
Exchanges - Ticker Tape Terminology part 6
Financial Planning - Basics part 6
Financial Planning - Choosing a Financial Planner part 6
Financial Planning - Compensation and Conflicts of Interest part 6
Financial Planning - Estate Planning Checkup part 6
Information Sources - Books part 7
Information Sources - Conference Calls part 7
Information Sources - Free to All Who Ask part 7
Information Sources - Investment Associations part 7
Information Sources - Value Line part 7
Information Sources - Wall $treet Week part 7
Insurance - Annuities part 8
Insurance - Life part 8
Insurance - Viatical Settlements part 8
Insurance - Variable Universal Life (VUL) part 8
Mutual Funds - Basics part 8
Mutual Funds - Average Annual Return part 8
Mutual Funds - Buying from Brokers versus Fund Companies part 8
Mutual Funds - Distributions and Tax Implications part 9
Mutual Funds - Fees and Expenses part 9
Mutual Funds - Index Funds and Beating the Market part 9
Mutual Funds - Money-Market Funds part 9
Mutual Funds - Reading a Prospectus part 9
Mutual Funds - Redemptions part 9
Mutual Funds - Types of Funds part 9
Mutual Funds - Versus Stocks part 9
Real Estate - 12 Steps to Buying a Home part 9
Real Estate - Investment Trusts (REITs) part 9
Real Estate - Renting versus Buying a Home part 10
Regulation - Accredited Investor part 10
Regulation - Full Disclosure part 10
Regulation - Money-Supply Measures M1, M2, and M3 part 10
Regulation - Federal Reserve and Interest Rates part 10
Regulation - Margin Requirements part 10
Regulation - Securities and Exchange Commission (U.S.) part 10
Regulation - SEC Rule 144 part 10
Regulation - SEC Registered Advisory Service part 10
Regulation - SEC/NASDAQ Settlement part 10
Regulation - Series of Examinations/Registrations part 10
Regulation - SIPC, or How to Survive a Bankrupt Broker part 10
Retirement Plans - 401(k) part 11
Retirement Plans - 401(k) for Self-Employed People part 11
Retirement Plans - 403(b) part 11
Retirement Plans - 457(b) part 11
Retirement Plans - Co-mingling funds in IRA accounts part 11
Retirement Plans - Keogh part 11
Retirement Plans - Roth IRA part 11
Retirement Plans - SEP IRA part 11
Retirement Plans - Traditional IRA part 12
Software - Archive of Free Investment-Related Programs part 12
Software - Portfolio Tracking and Technical Analysis part 12
Stocks - Basics part 12
Stocks - American Depositary Receipts (ADRs) part 12
Stocks - Cyclicals part 12
Stocks - Dividends part 12
Stocks - Dramatic Price Changes part 12
Stocks - Holding Company Depositary Recepits (HOLDRs) part 12
Stocks - Income and Royalty Trusts part 12
Stocks - Types of Indexes part 12
Stocks - The Dow Jones Industrial Average part 13
Stocks - Other Indexes part 13
Stocks - Market Volatility Index (VIX) part 13
Stocks - Investor Rights Movement part 13
Stocks - Initial Public Offerings (IPOs) part 13
Stocks - Mergers part 13
Stocks - Market Capitalization part 13
Stocks - Outstanding Shares and Float part 13
Stocks - Preferred Shares part 13
Stocks - Price Basis part 13
Stocks - Price Tables in Newspapers part 13
Stocks - Price Data part 13
Stocks - Replacing Lost Certificates part 13
Stocks - Repurchasing by Companies part 14
Stocks - Researching the Value of Old Certificates part 14
Stocks - Reverse Mergers part 14
Stocks - Shareholder Rights Plan part 14
Stocks - Splits part 14
Stocks - Tracking Stock part 14
Stocks - Exchange-Traded Funds and Unit Investment Trusts part 14
Stocks - Warrants part 14
Strategy - Dogs of the Dow part 14
Strategy - Dollar Cost and Value Averaging part 14
Strategy - Hedging part 14
Strategy - Buying on Margin part 14
Strategy - Writing Put Options To Acquire Stock part 14
Strategy - Socially Responsible Investing part 14
Strategy - When to Buy/Sell Stocks part 14
Strategy - Survey of Stock Investment Strategies part 15
Strategy - Value and Growth part 15
Tax Code - Backup Withholding part 15
Tax Code - Capital Gains Cost Basis part 15
Tax Code - Capital Gains Computation part 15
Tax Code - Capital Gains Tax Rates part 15
Tax Code - Cashless Option Exercise part 15
Tax Code - Deductions for Investors part 15
Tax Code - Estate and Gift Tax part 15
Tax Code - Gifts of Stock part 15
Tax Code - Non-Resident Aliens and US Holdings part 16
Tax Code - Reporting Option Trades part 16
Tax Code - Short Sales Treatment part 16
Tax Code - Tax Swaps part 16
Tax Code - Uniform Gifts to Minors Act (UGMA) part 16
Tax Code - Wash Sale Rule part 16
Technical Analysis - Basics part 16
Technical Analysis - Bollinger Bands part 16
Technical Analysis - Black-Scholes Model part 16
Technical Analysis - Commodity Channel Index part 16
Technical Analysis - Charting Services part 16
Technical Analysis - Data Sources part 16
Technical Analysis - Elliott Wave Theory part 16
Technical Analysis - Information Sources part 17
Technical Analysis - MACD part 17
Technical Analysis - McClellan Oscillator and Summation Index part 17
Technical Analysis - On Balance Volume part 17
Technical Analysis - Relative Strength Indicator part 17
Technical Analysis - Stochastics part 17
Trading - Basics part 17
Trading - After Hours part 17
Trading - Bid, Offer, and Spread part 17
Trading - Brokerage Account Types part 17
Trading - Discount Brokers part 17
Trading - Direct Investing and DRIPs part 18
Trading - Electronically and via the Internet part 18
Trading - Free Ride Rules part 18
Trading - By Insiders part 18
Trading - Introducing Broker part 18
Trading - Jargon and Terminology part 18
Trading - NASD Public Disclosure Hotline part 18
Trading - Buy and Sell Stock Without a Broker part 18
Trading - Non-Resident Aliens and US Exchanges part 18
Trading - Off Exchange part 18
Trading - Opening Prices part 18
Trading - Order Routing and Payment for Order Flow part 19
Trading - Day, GTC, Limit, and Stop-Loss Orders part 19
Trading - Pink Sheet Stocks part 19
Trading - Price Improvement part 19
Trading - Process Date part 19
Trading - Round Lots of Shares part 19
Trading - Security Identification Systems part 19
Trading - Shorting Stocks part 19
Trading - Shorting Against the Box part 19
Trading - Size of the Market part 19
Trading - Tick, Up Tick, and Down Tick part 19
Trading - Transferring an Account part 19
Trading - Can You Trust The Tape? part 20
Trading - Selling Worthless Shares part 20
Trivia - Bull and Bear Lore part 20
Trivia - Presidential Portraits on U.S. Notes part 20
Trivia - Getting Rich Quickly part 20
Trivia - One-Letter Ticker Symbols on NYSE part 20
Trivia - Stock Prices in Sixteenths part 20
Warning - Wade Cook part 20
Warning - Charles Givens part 20
Warning - Dave Rhodes and Other Chain Letters part 20
Warning - Ken Roberts part 20
Warning - Selling Unregistered Securities part 20

--------------------Check for updates------------------

Compiler's Acknowledgements:
My sincere thanks to the many contributors for their efforts.

Compilation Copyright (c) 2005 by Christopher Lott.

The Investment FAQ (part 2 of 20)

Archive-name: investment-faq/general/part2
Version: $Id: part02,v 1.62 2005/01/05 12:40:47 lott Exp lott $
Compiler: Christopher Lott

The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plain-text
version of The Investment FAQ, part 2 of 20. The web site
always has the latest version, including in-line links. Please browse



Terms of Use

The following terms and conditions apply to the plain-text version of
The Investment FAQ that is posted regularly to various newsgroups.
Different terms and conditions apply to documents on The Investment
FAQ web site.

The Investment FAQ is copyright 2005 by Christopher Lott, and is
protected by copyright as a collective work and/or compilation,
pursuant to U.S. copyright laws, international conventions, and other
copyright laws. The contents of The Investment FAQ are intended for
personal use, not for sale or other commercial redistribution.
The plain-text version of The Investment FAQ may be copied, stored,
made available on web sites, or distributed on electronic media
provided the following conditions are met:
+ The URL of The Investment FAQ home page is displayed prominently.
+ No fees or compensation are charged for this information,
excluding charges for the media used to distribute it.
+ No advertisements appear on the same web page as this material.
+ Proper attribution is given to the authors of individual articles.
+ This copyright notice is included intact.


Disclaimers

Neither the compiler of nor contributors to The Investment FAQ make
any express or implied warranties (including, without limitation, any
warranty of merchantability or fitness for a particular purpose or
use) regarding the information supplied. The Investment FAQ is
provided to the user "as is". Neither the compiler nor contributors
warrant that The Investment FAQ will be error free. Neither the
compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it. Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers. Readers outside the USA can reach
US-800 telephone numbers, for a charge, using a service such as MCI's
Call USA. All prices are listed in US dollars unless otherwise
specified.

Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Advice - Beginning Investors

Last-Revised: 1 Aug 1998
Contributed-By: Steven Pearson, E. Green, Chris Lott ( contact me )

Investing is just one aspect of personal finance. People often seem to
have the itch to try their hand at investing before they get the rest of
their act together. This is a big mistake. For this reason, it's a
good idea for "new investors" to hit the library and read maybe three
different overall guides to personal finance - three for different
perspectives, and because common themes will emerge (repetition implies
authority?). Personal finance issues include making a budget, sticking
to a budget, saving money towards major purchases or retirement,
managing debt appropriately, insuring your property, etc. Appropriate
books that focus on personal finance include the following (the links
point to Amazon.com):

* Andrew Tobias
The Only Investment Guide You'll Ever Need
* Eric Tyson
Personal Finance for Dummies (4th edn.)
* Janet Bamford et al.
The Consumer Reports Money Book: How to Get It, Save It, and Spend
It Wisely (3rd edn) (out of print; used copies available)

Another great resource for learning about investing, insurance, stocks,
etc. is the Wall Street Journal's Section C front page. Beginners
should make a special effort to get the Friday edition of the WSJ
because a column named "Getting Going" usually appears on that day and
discusses issues in, well, getting going on investments. If you don't
want to spend the dollar or so for the WSJ, try your local library.

What I am specifically NOT talking about is most anything that appears
on a list of investing/stock market books that are posted in
misc.invest.* from time to time. This includes books like Market Logic,
One Up on Wall Street, Beating the Dow, Winning on Wall Street, The
Intelligent Investor, etc. These are not general enough. They are
investment books, not personal finance books.

Many "beginning investors" have no business investing in stocks. The
books recommended above give good overall money management, budgeting,
purchasing, insurance, taxes, estate issues, and investing backgrounds
from which to build a personal framework. Only after that should one
explore particular investments. If someone needs to unload some cash in
the meantime, they should put it in a money market fund, or yes, even a
bank account, until they complete their basic training.

While I sympathize with those who view this education as a daunting
task, I don't see any better answer. People who know next to nothing
and always depend on "professional advisors" to hand-hold them through
all transactions are simply sheep asking to be fleeced (they may not
actually be fleeced, but most of them will at least get their tails
bobbed). In the long run, an individual is the only person ultimately
responsible for his or her own financial situation.

Beginners may want to look further in The Investment FAQ for the
articles that discuss the basics of mutual funds , basics of stocks ,
and basics of bonds . For more in-depth material, browse the Investment
FAQ bookshelf with its recommended books about personal finance and
investments.


--------------------Check for updates------------------

Subject: Advice - Buying a Car at a Reasonable Price

Last-Revised: 1 Aug 2001
Contributed-By: Kyle Busch (kbusch at velocity.net)

Before making a purchase, especially a large one, most buyers ponder an
equation that goes something like: What is it going to cost me, and will
that equal what I am going to get?

Consider that equation when buying your next vehicle. Naturally, you
want to get the most vehicle for the money you spend. Here are several
tips that will help you to get more for your money.

First, and foremost, consider eliminating some of the steep depreciation
cost incurred during the first three years of vehicle ownership by
purchasing a 2- to 3- year-old used vehicle.

The price can be further reduced by paying cash. However, if you need
to finance your next vehicle purchase, consider doing the following to
keep its cost closer to the "as if you were paying cash" figure.
* Take the time to carefully identify your current and your future
transportation needs, and choose an appropriate
vehicle.Transportation represents different things to different
people. For some drivers, it represents status in society. Other
drivers place greater emphasis on reliably just getting from point
A to points B and C. The more closely that you match your driving
needs with the vehicle you buy, the more driving pleasure you will
experience and the more likely you will want to hold on to the
vehicle.

If you can't fully identify your transportation needs or the
vehicle that can best satisfy them, consult the April issue of
Consumer Reports at a public library. The publication groups
vehicles into categories, provides frequency-of-repair information
for many vehicles, and gives vehicle price information. It is a
good idea to identify 2 or 3 vehicles in a particular category that
meet your transportation needs.This enables some latitude when
shopping for the vehicle. =


* Identify how much you can afford to spend per month on
transportation. A rule of thumb suggests that the cost to rent an
apartment per month should not be greater than 25 percent of your
monthly net pay.The cost of an auto loan should not exceed 10 to 12
percent of your monthly net pay. In some instances, leasing a
vehicle could be a better option than taking out a loan.


* The vehicle down payment should be the largest possible, and the
amount of money borrowed the lowest possible. In addition,
borrowing money for the shortest period of time (i.e., a 24-month
loan rather than a 48-month loan) will reduce the overall cost of
the loan.


* Identify the various loan sources such as banks, savings and loans,
credit unions, and national lenders (i.e., go online to ask
jeeves.com and specify "automobile financing sources"). In regard
to national financing vs. local financing, it can be useful to
determine what the cost of a loan would be from the national
sources, but accept a loan from a local source if the loan cost is
comparable or nearly comparable between the two. Compare the APR
(annual percentage rate) that each of the sources will charge for
the loan. The cost of a loan is negotiable. Therefore, be certain
to inform each source what the others have to offer. In addition
to the loan's APR, remember to also compare the other costs
associated with a loan, such as loan insurance and loan processing
costs.


* Be certain to read and understand any fine print contained in the
loan contract. Insist that the loan contract gives you the option
of making payments early and that the payments will be applied on
the loan principle with no penalty or extra cost if you payoff the
loan early.


* Do not settle for a vehicle that does not entirely meet your
transportation needs because of low dealer or manufacturer
incentive financing.Sometimes dealers or manufactures offer
extremely low APR financing on vehicles that the dealer is having a
hard time selling. That's why it helps to have initially
identified the correct vehicle before encountering the sales
pitches and other influences of buying a vehicle. Kyle Busch is
the author of Drive the Best for the Price: How to Buy a Used
Automobile, Sport-Utility Vehicle, or Minivan and Save Money . To find
out more about the author and this book visit:



--------------------Check for updates------------------

Subject: Advice - Errors in Investing

Last-Revised: 2 Aug 1999
Contributed-By: Chris Lott ( contact me ), Thomas Price (tprice at
engr.msstate.edu)

The Wall Street Journal of June 18, 1991 had an article on pages C1/C10
on Investment Errors and how to avoid them. As summarized from that
article, the errors are:
* Not following an investment objective when you build a portfolio.
* Buying too many mutual funds.
* Not researching a one-product stock before you buy.
* Believing that you can pick market highs and lows (time the
market).
* Taking profits early.
* Not cutting your losses.
* Buying the hottest {stock, mutual fund} from last year.

Here's a recent quote that underscores the last item. When asked
"What's the biggest mistake individual investors make?" on Wall $treet
Week, John Bogle, founder and senior chairman of Vanguard mutual funds,
said "Extrapolating the trend" or buying the hot stock.

On a final note, get this quote on market timing:

In the 1980s if you were out of the market on the ten best
trading days of the decade you missed one-third of the total
return.




--------------------Check for updates------------------

Subject: Advice - Using a Full-Service Broker

Last-Revised: 23 Mar 1998
Contributed-By: Bill Rini (bill at moneypages.com), Chris Lott ( contact
me )

There are several reasons to choose a full-service broker over a
discount or web broker. People use a full-service broker because they
may not want to do their own research, because they are only interested
in long-term investing, because they like to hear the broker's
investment ideas, etc. But another important reason is that not
everybody likes to trade. I may want retirement planning services from
my broker. I may want to buy 3 or 4 mutual funds and have my broker
worry about them. If my broker is a financial planner, perhaps I want
tax or estate advice on certain investment options. Maybe I'm saving
for my newborn child's education but I have no idea or desire to work
out a plan to make sure the money is there when she or he needs it.

A huge reason to stick with a full-service broker is access to initial
public offerings (IPOs). These are generally reserved for the very best
clients, where best is defined as "someone who generates lots of
revenue," so someone who trades just a few times a year doesn't have a
chance. But if you can afford to trade frequently at the full-service
commission rates, you may be favored with access to some great IPOs.

And the real big one for a lot of people is quite simply time . Full
service brokerage clients also tend to be higher net worth individuals
as well. If I'm a doctor or lawyer, I can probably make more money by
focusing on my business than spending it researching stocks. For many
people today, time is a more valuable commodity than money. In fact, it
doesn't even have to do with how wealthy you are. Americans, in
general, work some pretty insane hours. Spending time researching
stocks or staying up on the market is quality time not spent with
family, friends, or doing things that they enjoy. On the other hand
some people enjoy the market and for those people there are discount
brokers.

The one thing that sort of scares me about the difference between full
service and discount brokers is that a pretty good chunk of discount
brokerage firm clients are not that educated about investing. They look
at a $20 commission (discount broker) and a $50 commission (full service
broker) and they decide they can't afford to invest with a full service
broker. Instead they plow their life savings into some wonder stock
they heard about from a friend (hey, it's only a $20 commission, why
not?) and lose a few hundred or thousand bucks when the investment goes
south. Not that a broker is going to pick winners 100% of the time but
at least the broker can guide or mentor a beginning investor until they
learn enough to know what to look for and what not to look for in a
stock. I look at the $30 difference in what the two types of brokerage
firms charge as the rebate for education and doing my own research. If
you're not going to educate yourself or do your own research, you don't
deserve the rebate.


--------------------Check for updates------------------

Subject: Advice - Mutual-Fund Expenses

Last-Revised: 16 Feb 2003
Contributed-By: Austin Lemoine

This article discusses stealth erosion of wealth, more specifically how
mutual-fund expenses erode wealth accumulation.

Mutual fund expense ratios, and similar investment-related fees, can
seriously erode wealth accumulation over time. Those fees and expenses
are stealthy, and they go largely unnoticed by investors while steadily
diminishing the value of their investments in both up and down markets.

What you pay for investing in a mutual fund, exclusive of any sales
charges, is indicated by the "expense ratio" of the fund. The expense
ratio is the percentage of mutual fund assets paid for operating
expenses, management fees, administrative fees, and all other
asset-based costs incurred by the fund, except brokerage costs. Those
expenses are reflected in the fund's net asset value (NAV), and they are
not really visible to the fund investor. The reported net return equals
the fund's gross return minus its costs. (And expense ratios do not
account for every cost mutual fund investors bear: additional costs
include any sales charges, brokerage commissions paid by the fund and
other significant kinds of indirect trading costs.)

Mutual fund expense ratios range from less than 0.20 percent for
low-cost index funds to well over 2 percent for actively managed funds.
The average is 1.40 percent for the more than 14,000 stock and bond
mutual funds currently available, according to Morningstar. In dollar
terms, that's $14 a year in fees for each $1,000 of investment value; or
a net value of $986. That might not seem like a big deal, but over time
fees compound to erode investment value.

Let's say the gross return in real terms (after inflation) of a broadly
diversified stock mutual fund will be 7 percent a year, excluding
expenses. (The 7 percent figure is consistent with returns for the U.S.
stock market from 1802 through 2001, as reported in Jeremy Siegel's
book, Stocks for the Long Run, 3rd edition.) Say the fund has an expense
ratio of 1.25 percent. And say you invest $1,000 in the fund at the
start of every year. (The figure of $1,000 is arbitrary, and investment
values below can be extrapolated to any annual contribution amount.)

Compounding at 7 percent, your gross investment value would be $6,153
after 5 years; $14,783 after 10 years; $43,865 after 20 years; $101,073
after 30 years; and $213,609 after 40 years. But with a 1.25 percent
expense ratio, your investment compounds at 7.0 minus 1.25 or 5.75
percent, not 7 percent. So your investment would actually be worth
$5,931 after 5 years; $13,776 after 10 years; $37,871 after 20 years;
$80,015 after 30 years; and $153,727 after 40 years. Fund expenses
account for the difference in value over time, with greater expenses
(and/or lower returns) having a greater negative impact on net
investment value.

That 1.25 percent expense ratio consumes $222 (or 3.6 percent) of the
$6,153 gross value over 5 years; 6.8 percent of gross value over 10
years; 13.6 percent over 20 years; and 20.8 percent over 30 years. Over
40 years, the $59,882 of fund expenses devour 28.0 percent of the
$213,609 gross value. In other words, only 72.0 percent of gross
investment value is left after 40 years, a withering erosion of wealth.

By contrast, let's say there's a broad-based index fund with 7 percent
real return but a 0.25 percent expense ratio. Putting $1,000 at the
start of each year into that fund, the 0.25 percent expense ratio would
consume just 2.9 percent of gross investment value after 20 years. Over
40 years, index fund expenses would total $13,759, a modest 6.4 percent
of gross value; so that the fund would earn 93.6 percent of gross value.
With expenses included, investment value is 30 percent higher after 40
years with the lower cost fund. (Even lower expense ratios can be found
among lowest-cost index funds and broad-based exchange-traded funds.
And funds with higher expenses do not outperform comparable funds with
lower expenses.)

Over the next ten to twenty years, expense ratios and similar fees could
be a huge millstone on wealth accumulation and wealth preservation. To
see why, let's review what's happened since March 2000.

Like a massive hurricane, the stock market has inflicted damage on
almost every portfolio in its path. From the peak of March 2000 to the
lows of early October 2002, it's estimated that falling stock prices
wiped out over $7 trillion in market value. While the market has moved
off its lows, we hope the worst is over.

How long will the market take to "heal itself?" It could take a long
time. A growing consensus holds that stocks just won't deliver the
returns we grew accustomed to from 1984 to 1999. If history is a guide,
real stock returns could average 2 to 4 percent a year over the 10 to 20
years following March 2000.

If lower expectations for stock returns materialize, mutual fund fees
and expenses will have an even greater adverse impact on wealth
accumulation, and especially on wealth preservation and income security
at retirement.

Let's say you'll want $40,000 income from your 401(k) assets without
drawing down principal. If real investment return is 4 percent you'll
need $40,000 divided by 0.04 or $1 million principal. But if you're
paying 1 percent in fees your real return is 3 percent, so you'll need
$40,000 divided by 0.03 or $1.333 million principal; and if 2 percent,
$2 million. The arithmetic is brutal!

It's clear that mutual fund costs and similar fees can be detrimental to
investment values over time. Fund sales charges exacerbate the problem.
Consider investing in lower-cost funds wherever possible.

For more insights from Austin Lemoine, please visit the web site for
Austin Lemoine Capital Management:



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Subject: Advice - One-Line Wisdom

Last-Revised: 22 Aug 1993
Contributed-By: Maurice Suhre

This is a collection of one-line pieces of investment wisdom, with brief
explanations. Use and apply at your own risk or discretion. They are
not in any particular order.

Hang up on cold calls.
While it is theoretically possible that someone is going to offer
you the opportunity of a lifetime, it is more likely that it is
some sort of scam. Even if it is legitimate, the caller cannot
know your financial position, goals, risk tolerance, or any other
parameters which should be considered when selecting investments.
If you can't bear the thought of hanging up, ask for material to be
sent by mail.
Don't invest in anything you don't understand.
There were horror stories of people who had lost fortunes by being
short puts during the 87 crash. I imagine that they had no idea of
the risks they were taking. Also, all the complaints about penny
stocks, whether fraudulent or not, are partially a result of not
understanding the risks and mechanisms.
If it sounds too good to be true, it probably is [too good to be true].
Also stated as ``There ain't no such thing as a free lunch
(TANSTAAFL).'' Remember, every investment opportunity competes with
every other investment opportunity. If one seems wildly better
than the others, there are probably hidden risks or you don't
understand something.
If your only tool is a hammer, every problem looks like a nail.
Someone (possibly a financial planner) with a very limited
selection of products will naturally try to jam you into those
which s/he sells. These may be less suitable than other products
not carried.
Don't rush into an investment.
If someone tells you that the opportunity is closing, filling up
fast, or in any other way suggests a time pressure, be very leery.
Very low priced stocks require special treatment.
Risks are substantial, bid/asked spreads are large, prices are
volatile, and commissions are relatively high. You need a broker
who knows how to purchase these stocks and dicker for a good price.



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Subject: Advice - Paying for Investment Advice

Last-Revised: 25 Apr 1997
Contributed-By: Chris Lott ( contact me )

I'm no expert, but there's a simple rule that you should use to evaluate
all advice that is offered to you, especially advice for which someone
who doesn't know you is asking significant sums of money. Ask yourself
why the person is selling or giving it to you. If it sounds like a sure
ticket to riches, then why is the person wasting their time on YOU when
they could be out there making piles of dough?

Of course I'm offering advice here in this article, so let's turn the
tables on me right now. What's in it for me? Well, if you're reading
this article from my web site, look up at the top of the page. If you
have images turned on, you'll see a banner ad. I get a tiny payment
each time a person loads one of my pages with an ad. So my motivation
is to provide informative articles in order to lure visitors to the
site. Of course if you're reading this from the plain-text version of
the FAQ, you won't see any ads, but please do stop by the site sometime!
;-)

So if someone promises you advice that will yield 10-20% monthly
returns, perhaps at a price of some $3,000, you should immediately get
suspicious. If this were really true - i.e., if you pay for the advice
you'll immediately start getting these returns - you would be making
over 300% annually (compounded). Hey, that would sure be great, I
wouldn't have a day job anymore. And if it were true, wouldn't you
think that the person trying to sell it to you would forget all about
selling and just watch his or her money triple every year? But they're
not doing that, which should give you a pretty good idea about where the
money's being made, namely from you .

I'm not trying to say that you should never pay for advice, just that
you should not overpay for advice. Some advice, especially the sort
that comes from $15 books on personal finance and investments can easily
be worth ten times that sum. Advice from your CPA or tax advisor will
probably cost you a 3 or even 4-digit figure, but since it's specialized
to your case and comes from a professional, that's probably money well
spent.

It seems appropriate to close this article with a quote that I learned
from Robert Heinlein books, but it's probably older than that:

TANSTAAFL - there ain't no such thing as a free lunch.




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Subject: Advice - Researching a Company

Last-Revised: 3 Jun 1997
Contributed-By: George Regnery (regnery at yahoo.com)

This article gives a basic idea of some steps that you might take to
research a company. Many sites on the web will help you in your quest
for information, and this article gives a few of them. You might look
for the following.
1. What multiple of earnings is the company trading at versus other
companies in the industry? The site does
this comparison reasonably well, and they base it on forward
earnings instead of historical earnings, which is also good.
2. Is the stock near a high or low, and how has it done recently.
This is usually considered technical analysis. More sophisticated
(or at least more complicated) studies can also be performed.
There are several sites that will give you historical graphs; one
is Yahoo.
3. When compared with other companies in the industry, how much times
the book value or times sales is the company trading? For this
information, the site is a good place to
start.
4. Does the company have good products, good management, good future
prospects? Are they being sued? Do they have patents? What's the
competition like? Do they have long term contracts established? Is
their brand name recognized? Depending on the industry, some or all
of these questions may be relevant. There isn't a simple web site
for this information, of course. The Hoover's profiles have some
limited information to at least let you get a feel for the basics
of the company. And the SEC has lots of information in their Edgar
databank.
5. Management. Does the company have competent people running it? The
backgrounds of the directors can be found in proxy statements
(14As) in the Edgar database. Note that proxies are written by the
companies, though. Another thing I would suggest looking at is the
compensation structure of the CEO and other top management. Don't
worry so much about the raw figure of how they are paid -- instead,
look to see how that compensation is structured. If the management
gets a big base but bonuses are a small portion, look carefully at
the company. For some industries, like electric utilities, this is
OK, because the management isn't going to make a huge difference
(utilities are highly regulated, and thus the management is
prevented from making a lot of decisions). However, in a high tech
industry, or many other industries, watch your step if the mgmt.
gets a big base and the bonus is insignificant. This means that
they won't be any better off financially if the company makes a lot
of profits vs. no profits (unless, of course, they own a lot of
stock). This information is all in the proxies at the SEC. Also
check to see if the company has a shareholder rights plan, because
if they do, the management likely doesn't give a damn about
shareholder rights, but rather cares about their own jobs. (These
plans are commonly used to defend against unfriendly takeovers and
therefore provide a safety blanket for management.) These
suggestions should get you started. Also check the article elsewhere in
this FAQ on free information sources for more resources away from the
web.


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Subject: Advice - Target Stock Prices

Last-Revised: 25 Jun 2000
Contributed-By: Uncle Arnie (blash404 at aol.com)

A target price for a stock is a figure published by a securities
industry person, usually an analyst. The idea is that the target price
is a prediction, a guess about where the stock is headed. Target prices
usually are associated with a date by which the stock is expected to hit
the target. With that explanation out of the way..

Why do people suddenly think that the term du jour "target price" has
any meaning?? Consider the sources of these numbers. They're ALWAYS
issued by someone who has a vested interest in the issue: It could be an
analyst whose firm was the underwriter, it could be an analyst whose
firm is brown-nosing the company, it could be a firm with a large
position in the stock, it could be an individual trying to talk the
stock up so he can get out even, or it could be the "pump" segment of a
pump-and-dump operation. There is also a chance that the analyst has no
agenda and honestly thinks the stock price is really going places. But
in all too many cases it's nothing more than wishful guesswork (unless
they have a crystal ball that works), so the advice here: ignore target
prices, especially ones for internet companies.


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Subject: Analysis - Amortization Tables

Last-Revised: 16 Feb 2003
Contributed-By: Hugh Chou

This article presents the formula for computing monthly payments on
loans. A listing of thed full series of payments (principal and
interest) that show how a loan is paid off is known as a loan
amortization table. This article will explain how these tables are
generated for the U.S. system in which interest is compounded monthly.

First you must define some variables to make it easier to set up:

P = principal, the initial amount of the loan
I = the annual interest rate (from 1 to 100 percent)
L = length, the length (in years) of the loan, or at least the length
over which the loan is amortized.

The following assumes a typical conventional loan where the interest is
compounded monthly. First I will define two more variables to make the
calculations easier:

J = monthly interest in decimal form = I / (12 x 100)
N = number of months over which loan is amortized = L x 12


Okay now for the big monthly payment (M) formula, it is:
J
M = P x ------------------------

1 - ( 1 + J ) ^ -N
where 1 is the number one (it does not appear too clearly on some
browsers).

So to calculate it, you would first calculate 1 + J then take that to
the -N (minus N) power, subtract that from the number 1. Now take the
inverse of that (if you have a 1/X button on your calculator push that).
Then multiply the result times J and then times P. Sorry for the long
way of explaining it, but I just wanted to be clear for everybody.

The one-liner for a program would be (adjust for your favorite
language):
M = P * ( J / (1 - (1 + J) ** -N))
So now you should be able to calculate the monthly payment, M. To
calculate the amortization table you need to do some iteration (i.e. a
simple loop). I will tell you the simple steps :

1. Calculate H = P x J, this is your current monthly interest
2. Calculate C = M - H, this is your monthly payment minus your
monthly interest, so it is the amount of principal you pay for that
month
3. Calculate Q = P - C, this is the new balance of your principal of
your loan.
4. Set P equal to Q and go back to Step 1: You thusly loop around
until the value Q (and hence P) goes to zero. Programmers will see
how this makes a trivial little loop to code, but I have found that many
people now surfing on the Internet are NOT programmers and still want to
calculate their mortgages!

Note that just about every PC or Mac has a spreadsheet of some sort on
it, and they are very good tools for doing mortgage analysis. Most of
them have a built-in PMT type function that will calculate your monthly
payment given a loan balance, interest rate, and the number of terms.
Check the help text for your spreadsheet.

Please visit Hugh Chou's web site for a calculator that will generate
amortization tables according to the forumlas discussed here. He also
offers many other calculators:



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Subject: Analysis - Annual Reports

Last-Revised: 31 Oct 1995
Contributed-By: Jerry Bailey, Chris Lott ( contact me )

The June 1994 Issue of "Better Investing" magazine, page 26 has a
three-page article about reading and understanding company annual
reports. I will paraphrase:

1. Start with the notes and read from back to front since the front is
management fluff.
2. Look for litigation that could obliterate equity, a pension plan in
sad shape, or accounting changes that inflated earnings.
3. Use it to evaluate management. I only read the boring things of
the companies I am holding for long term growth. If I am planning
a quick in and out, such as buying depressed stocks like BBA, CML,
CLE, etc.), I don't waste my time.
4. Look for notes to offer relevant details; not "selected" and
"certain" assets. Revenue and operating profits of operating
divisions, geographical divisions, etc.
5. How the company keeps its books, especially as compared to other
companies in its industry.
6. Inventory. Did it go down because of a different accounting
method?
7. What assets does the company own and what assets are leased?

If you do much of this, I really recommend just reading the article.

The following list of resources may also help.
* John A. Tracy has written an an easy-to-read and informative book
named How to Read a Financial Report (4th edn., Wiley, 1993). This
book should give you a good start. You won't become a graduate
student in finance by reading it, but it will certainly help you
grasp the nuts and bolts of annual reports.
* IBM offers a web site with much information about understanding
financial reports:



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Subject: Analysis - Beta and Alpha

Last-Revised: 22 Oct 1997
Contributed-By: Ajay Shah ( www.igidr.ac.in/~ajayshah ), R. Shukla
(rkshukla at som.syr.edu), Bob Pierce (rbp at investor.pgh.pa.us)

Beta is the sensitivity of a stock's returns to the returns on some
market index (e.g., S&P 500). Beta values can be roughly characterized
as follows:

* b less than 0
Negative beta is possible but not likely. People thought gold
stocks should have negative betas but that hasn't been true.
* b equal to 0
Cash under your mattress, assuming no inflation
* beta between 0 and 1
Low-volatility investments (e.g., utility stocks)
* b equal to 1
Matching the index (e.g., for the S&P 500, an index fund)
* b greater than 1
Anything more volatile than the index (e.g., small cap. funds)
* b much greater than 1 (tending toward infinity)
Impossible, because the stock would be expected to go to zero on
any market decline. 2-3 is probably as high as you will get.

More interesting is the idea that securities MAY have different betas in
up and down markets. Forbes used to (and may still) rate mutual funds
for bull and bear market performance.

Alpha is a measure of residual risk (sometimes called "selecting risk")
of an investment relative to some market index. For all the gory
details on Alpha, please see a book on technical analysis.

Here is an example showing the inner details of the beta calculation
process:

Suppose we collected end-of-the-month prices and any dividends for a
stock and the S&P 500 index for 61 months (0..60). We need n + 1 price
observations to calculate n holding period returns, so since we would
like to index the returns as 1..60, the prices are indexed 0..60. Also,
professional beta services use monthly data over a five year period.

Now, calculate monthly holding period returns using the prices and
dividends. For example, the return for month 2 will be calculated as:
r_2 = ( p_2 - p_1 + d_2 ) / p_1
Here r denotes return, p denotes price, and d denotes dividend. The
following table of monthly data may help in visualizing the process.
(Monthly data is preferred in the profession because investors' horizons
are said to be monthly.)

Nr. Date Price Div.(*) Return
0 12/31/86 45.20 0.00 --
1 01/31/87 47.00 0.00 0.0398
2 02/28/87 46.75 0.30 0.0011
.. ... ... ... ...
59 11/30/91 46.75 0.30 0.0011
60 12/31/91 48.00 0.00 0.0267
(*) Dividend refers to the dividend paid during the period. They are
assumed to be paid on the date. For example, the dividend of 0.30 could
have been paid between 02/01/87 and 02/28/87, but is assumed to be paid
on 02/28/87.

So now we'll have a series of 60 returns on the stock and the index
(1...61). Plot the returns on a graph and fit the best-fit line
(visually or using some least squares process):

| * /
stock | * * */ *
returns| * * / *
| * / *
| * /* * *
| / * *
| / *
|
|
+------------------------- index returns

The slope of the line is Beta. Merrill Lynch, Wells Fargo, and others
use a very similar process (they differ in which index they use and in
some econometric nuances).

Now what does Beta mean? A lot of disservice has been done to Beta in
the popular press because of trying to simplify the concept. A beta of
1.5 does not mean that is the market goes up by 10 points, the stock
will go up by 15 points. It doesn't even mean that if the market has a
return (over some period, say a month) of 2%, the stock will have a
return of 3%. To understand Beta, look at the equation of the line we
just fitted:

stock return = alpha + beta * index return

Technically speaking, alpha is the intercept in the estimation model.
It is expected to be equal to risk-free rate times (1 - beta). But it
is best ignored by most people. In another (very similar equation) the
intercept, which is also called alpha, is a measure of superior
performance.

Therefore, by computing the derivative, we can write:
Change in stock return = beta * change in index return

So, truly and technically speaking, if the market return is 2% above its
mean, the stock return would be 3% above its mean, if the stock beta is
1.5.

One shot at interpreting beta is the following. On a day the (S&P-type)
market index goes up by 1%, a stock with beta of 1.5 will go up by 1.5%
+ epsilon. Thus it won't go up by exactly 1.5%, but by something
different.

The good thing is that the epsilon values for different stocks are
guaranteed to be uncorrelated with each other. Hence in a diversified
portfolio, you can expect all the epsilons (of different stocks) to
cancel out. Thus if you hold a diversified portfolio, the beta of a
stock characterizes that stock's response to fluctuations in the market
portfolio.

So in a diversified portfolio, the beta of stock X is a good summary of
its risk properties with respect to the "systematic risk", which is
fluctuations in the market index. A stock with high beta responds
strongly to variations in the market, and a stock with low beta is
relatively insensitive to variations in the market.

E.g. if you had a portfolio of beta 1.2, and decided to add a stock
with beta 1.5, then you know that you are slightly increasing the
riskiness (and average return) of your portfolio. This conclusion is
reached by merely comparing two numbers (1.2 and 1.5). That parsimony
of computation is the major contribution of the notion of "beta".
Conversely if you got cold feet about the variability of your beta = 1.2
portfolio, you could augment it with a few companies with beta less than
1.

If you had wished to figure such conclusions without the notion of beta,
you would have had to deal with large covariance matrices and nontrivial
computations.

Finally, a reference. See Malkiel, A Random Walk Down Wall Street , for
more information on beta as an estimate of risk.


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Subject: Analysis - Book-to-Bill Ratio

Last-Revised: 19 Aug 1993
Contributed-By: Timothy May

The book-to-bill ration is the ratio of business "booked" (orders taken)
to business "billed" (products shipped and bills sent).

A book-to-bill of 1.0 implies incoming business = outgoing product.
Often in downturns, the b-t-b drops to 0.9, sometimes even lower. A
b-t-b of 1.1 or higher is very encouraging.


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Subject: Analysis - Book Value

Last-Revised: 23 Mar 1998
Contributed-By: Art Kamlet (artkamlet at aol.com)

In simplest terms, Book Value is Assets less Liabilities.

The problem is Assets includes, as stated, existing land & buildings,
inventory, cash in the bank, etc. held by the company.

The problem in assuming you can sell off these assets and receive their
listed value is that such values are accounting numbers, but otherwise
pretty unrealistic.

Consider a company owning a 40 year old building in downtown Chicago.
That building might have been depreciated fully and is carried on the
books for $0, while having a resale value of millions. The book value
grossly understates the sell-off value of the company.

On the other hand, consider a fast-changing industry with 4-year-old
computer equipment which has a few more years to go before being fully
depreciated, but that equipment couldn't be sold for even 10 cents on
the dollar. Here the book value overstates the sell-off value.

So consider book value to be assets less liabilities, which are just
numbers, not real items. If you want to know how much a company should
be sold off for, hire a good investment banker, which is often done on
take-over bids.


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Subject: Analysis - Computing Compound Return

Last-Revised: 12 Dec 2004
Contributed-By: Paul Randolph (paulr22 at juno dot com), Chris Lott (
contact me )

This article discusses how to compute the effective annual percentage
rate earned by a single investment after a number of years have passed.
A related concept called "average annual return" is frequently seen when
reading about mutual funds but is computed very differently; it is
discussed briefly at the end of this article. Another related concept
called "internal rate of return" is used to calculate the percentage
rate earned by an investment made as a series of purchases, such as
monthly investments in a mutual fund; also see the article on that topic
elsewhere in this FAQ.

To calculate the compound return on an investment, just figure out the
factor by which the original investment multiplied. For example, if
$1,000 became $3,200 in 10 years, then the multiplying factor is
3,200/1,000 or 3.2. Now take the 10th root of 3.2 (the multiplying
factor) and you get a compound return of 1.1233498, which means
approximately 12.3% per year. To see that this works, note that
1.233498 raised to the 10th power equals 3.2.

Here is another way of saying the same thing. This calculation assumes
that all gains are reinvested, so the following formula applies:

TR = (1 + AR) ** YR

where TR is total return (present value/initial value), AR is the
compound annualized return, and YR is years. The symbol '**' is used to
denote exponentiation (e.g., 2 ** 3 = 8).

To calculate annualized return, the following formula applies:

AR = (TR ** (1/YR)) - 1

Thus a total return of 950% in 20 years would be equivalent to an
annualized return of 11.914454%. Note that the 950% includes your
initial investment of 100% (by definition) plus a gain of 850%.

For those of you using spreadsheets such as Excel, you would use the
following formula to compute AR for the example discussed above (the
common computer symbol used to denote exponentiation is the caret or hat
on top of the 6).

= TR ^ (1 / YR) - 1

where TR = 9.5 and YR = 20. If you want to be creative and have AR
recalculated every time you open your file, you can substitute something
like the following for YR:

( (*cell* - TODAY() ) / 365)

Of course you will have to replace '*cell*' by the appropriate address
of the cell that contains the date on which you bought the security.

Don't confuse a compound return with something called an average annual
return, which is a simple arithmetic mean (also see the FAQ article on
this topic). That method simply adds the annual rates and divides by
the number of years. For example, 5% one year and 10% the next year,
average is 7.5% over those two years.

Let's compare the two methods with a contrived example. You invest
$100. After one year, you have $200, which means in that first year,
the investment returned 100%. At the end of the second year, you have
$100, which means in that second year, the investment lost 50%. (In
short, you're back where you started.) Do the calculations for the
compound return and you'll get 0%. Calculate the average annual return
and you get 25%. So this contrived example yields a big difference.
However, common scenarios yield less striking differences, and the
average annual return is a useful approximation.

Here's the one thing to remember from this article. When you read an
investment company's statements about their "average return", you should
check carefully just exactly what they calculated.


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Subject: Analysis - Future and Present Value of Money

Last-Revised: 28 Jan 1994
Contributed-By: Chris Lott ( contact me )

This note explains briefly two concepts concerning the
time-value-of-money, namely future and present value. Careful
application of these concepts will help you evaluate investment
opportunities such as real estate, life insurance, and many others.



Future Value
Future value is simply the sum to which a dollar amount invested today
will grow given some appreciation rate.

To compute the future value of a sum invested today, the formula for
interest that is compounded monthly is:
fv = principal * [ (1 + rrate/12) ** (12 * termy) ]
where

fv = future value
principal = dollar value you have now
termy = term, in years
rrate = annual rate of return in decimal (i.e., use .05 for
5%)

Note that the symbol '**' is used to denote exponentiation (2 ** 3 = 8).

For interest that is compounded annually, use the formula:
fv = principal * [ (1 + rrate) ** (termy) ]


Example:

I invest 1,000 today at 10% for 10 years compounded monthly.
The future value of this amount is 2707.04.



Note that the formula for future value is the formula from Case 1 of
present value (below), but solved for the future-sum rather than the
present value.



Present Value
Present value is the value in today's dollars assigned to an amount of
money in the future, based on some estimate rate-of-return over the
long-term. In this analysis, rate-of-return is calculated based on
monthly compounding.

Two cases of present value are discussed next. Case 1 involves a single
sum that stays invested over time. Case 2 involves a cash stream that
is paid regularly over time (e.g., rent payments), and requires that you
also calculate the effects of inflation.




Case 1a: Present value of money invested over time.
This tells you what a future sum is worth today, given some rate of
return over the time between now and the future. Another way to
read this is that you must invest the present value today at the
rate-of-return to have some future sum in some years from now (but
this only considers the raw dollars, not the purchasing power).

To compute the present value of an invested sum, the formula for
interest that is compounded monthly is:
future-sum
pv = ------------------------------
(1 + rrate/12) ** (12 * termy)
where

* future-sum = dollar value you want to have in termy
years
* termy = term, in years
* rrate = annual rate of return that you can expect,
in decimal



Example:

I need to have 10,000 in 5 years. The present value of
10,000 assuming an 8% monthly compounded rate-of-return
is 6712.10. I.e., 6712 will grow to 10k in 5 years at
8%.




Case 1b: Effects of inflation
This formulation can also be used to estimate the effects of
inflation; i.e., compute the real purchasing power of present and
future sums. Simply use an estimated rate of inflation instead of
a rate of return for the rrate variable in the equation.

Example:

In 30 years I will receive 1,000,000 (a megabuck). What
is that amount of money worth today (what is the buying
power), assuming a rate of inflation of 4.5%? The answer
is 259,895.65




Case 2: Present value of a cash stream.
This tells you the cost in today's dollars of money that you pay
over time. Usually the payments that you make increase over the
term. Basically, the money you pay in 10 years is worth less than
that which you pay tomorrow, and this equation lets you compute
just how much less.

In this analysis, inflation is compounded yearly. A reasonable
estimate for long-term inflation is 4.5%, but inflation has
historically varied tremendously by country and time period.

To compute the present value of a cash stream, the formula is:
month=12 * termy paymt * (1 + irate) ** int ((month - 1)/
12)
pv = SUM
---------------------------------------------
month=1 (1 + rrate/12) ** (month - 1)
where

* pv = present value
* SUM (a.k.a. sigma) means to sum the terms on the
right-hand side over the range of the variable
'month'; i.e., compute the expression for month=1,
then for month=2, and so on then add them all up
* month = month number
* int() = the integral part of the number; i.e., round
to the closest whole number; this is used to compute
the year number from the month number
* termy = term, in years
* paymt = monthly payment, in dollars
* irate = rate of inflation (increase in
payment/year), in decimal
* rrate = rate of return on money that you can expect,
in decimal



Example:

You pay $500/month in rent over 10 years and estimate
that inflation is 4.5% over the period (your payment
increases with inflation.) Present value is 49,530.57




Stefan Heizmann offers a calculator for NPV on the web.


Two small C programs for computing future and present value on a PC are
also available, which may be convenient if you have a large amount of
data. See the article Software - Archive of Investment-Related Programs
in this FAQ for more information.


--------------------Check for updates------------------

Subject: Analysis - Goodwill

Last-Revised: 18 Jul 1993
Contributed-By: John Keefe

Goodwill is an asset that is created when one company acquires another.
It represents the difference between the price the acquiror pays and the
"fair market value" of the acquired company's assets. For example, if
JerryCo bought Ford Motor for $15 billion, and the accountants
determined that Ford's assets (plant and equipment) were worth $13
billion, $2 billion of the purchase price would be allocated to goodwill
on the balance sheet. In theory the goodwill is the value of the
acquired company over and above the hard assets, and it is usually
thought to represent the value of the acquired company's "franchise,"
that is, the loyalty of its customers, the expertise of its employees;
namely, the intangible factors that make people do business with the
company.

What is the effect on book value? Well, book value usually tries to
measure the liquidation value of a company -- what you could sell it for
in a hurry. The accountants look only at the fair market value of the
hard assets, thus goodwill is usually deducted from total assets when
book value is calculated.

For most companies in most industries, book value is next to
meaningless, because assets like plant and equipment are on the books at
their old historical costs, rather than current values. But since it's
an easy number to calculate, and easy to understand, lots of investors
(both professional and amateur) use it in deciding when to buy and sell
stocks.


--------------------Check for updates------------------

Compilation Copyright (c) 2005 by Christopher Lott.

The Investment FAQ (part 6 of 20)

Archive-name: investment-faq/general/part6
Version: $Id: part06,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plain-text
version of The Investment FAQ, part 6 of 20. The web site
always has the latest version, including in-line links. Please browse



Terms of Use

The following terms and conditions apply to the plain-text version of
The Investment FAQ that is posted regularly to various newsgroups.
Different terms and conditions apply to documents on The Investment
FAQ web site.

The Investment FAQ is copyright 2003 by Christopher Lott, and is
protected by copyright as a collective work and/or compilation,
pursuant to U.S. copyright laws, international conventions, and other
copyright laws. The contents of The Investment FAQ are intended for
personal use, not for sale or other commercial redistribution.
The plain-text version of The Investment FAQ may be copied, stored,
made available on web sites, or distributed on electronic media
provided the following conditions are met:
+ The URL of The Investment FAQ home page is displayed prominently.
+ No fees or compensation are charged for this information,
excluding charges for the media used to distribute it.
+ No advertisements appear on the same web page as this material.
+ Proper attribution is given to the authors of individual articles.
+ This copyright notice is included intact.


Disclaimers

Neither the compiler of nor contributors to The Investment FAQ make
any express or implied warranties (including, without limitation, any
warranty of merchantability or fitness for a particular purpose or
use) regarding the information supplied. The Investment FAQ is
provided to the user "as is". Neither the compiler nor contributors
warrant that The Investment FAQ will be error free. Neither the
compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it. Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers. Readers outside the USA can reach
US-800 telephone numbers, for a charge, using a service such as MCI's
Call USA. All prices are listed in US dollars unless otherwise
specified.

Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Exchanges - Circuit Breakers, Curbs, and Other Trading
Restrictions

Last-Revised: 2 Aug 2002
Contributed-By: Chedley A. Aouriri, Darin Okuyama, Chris Lott ( contact
me ), Charles Eglinton

A variety of mechanisms are in place on the U.S. exchanges to restrict
program trading (i.e., to cut off the big boy's computer connections)
whenever the market moves up or down by more than a large number of
points in a trading day. Most are triggered by moves down, although
some are triggered by moves up as well.

The idea is that these curbs on trading, also known as collars, will
limit the daily damage by restricting activities that might lead towards
greater volatility and large price moves, and encouraging trading
activities that tend to stabilize prices. Although these trading
restrictions are commonly known as circuit breakers, that term actually
refers to just one specific restriction.

These changes were enacted in 1989 because program trading was blamed
for the fast crash of 1987. Note that the NYSE defines a Program Trade
as a basket of 15 or more stocks from the Standard & Poor's 500 Index,
or a basket of stocks from the Standard & Poor's 500 Index valued at $1
million or more.

Trading restrictions affect trading on the New York Stock Exchange
(NYSE) and the Chicago Mercantile Exchange (CME) where S&P 500 futures
contracts are traded. When these restrictions are triggered, you may
hear the phrase "curbs in" if you listen to CNBC.

Here's a table that summarizes the trading restrictions in place on the
NYSE and CME as of this writing. The range is always checked in
reference to the previous close. E.g., a move of up 200 and down 180
points would still be an up of 20 with respect to the previous close, so
the first restriction listed below would not be triggered. Any curb
still in effect at the close of trading is removed after the close;
i.e., every trading day starts without curbs.

Note that the "sidecar" rules were eliminated on Tuesday, February 16,
1999.

Restriction Triggered by
NYSE collar (Rule 80A) DJIA moves 2%
CME restriction 1 S&P500 futures contract moves 2.5%
CME restriction 2 S&P500 futures contract moves 5%
CME restriction 3 S&P500 futures contract moves 10%
NYSE circuit breaker nr. 1 DJIA moves 10%
NYSE circuit breaker nr. 2 DJIA moves 20%
NYSE Circuit breaker nr. 3 DJIA moves 30%


Now some details about each.

NYSE Collar (Rule 80A): Index arbitrage tick test
Rule 80A provides that index arbitrage orders can only be executed
on plus or minus ticks depending on which way the DJIA is. In the
parlance of the NYSE, the orders must be "stabilizing." This rule
only effects S&P 500 stocks, and is also known as the "uptick
downtick rule" because it restricts sells to upticks and buys to
downticks. In other words, when the market is down (last tick was
down), sell orders can't be executed at lower prices. In an up
market (last tick was up), buy orders can't be executed for higher
prices. This collar is removed when the DJIA retraces its gain or
loss to within approximately 1% of the previous close. As of 3Q02,
the collar is imposed at 180 points and removed when the DJIA
retraces its position to within 90 points of the previous day's
close.


CME Restrictions
Trading in the S&P500 futures contract is halted just for a few
minutes if the prices moves 2.5%, 5%, or 10% from the previous
close. Because restrictions on the NYSE effectively shut down
trading in this futures contract, there is little need for
additional restrictions on the CME.


NYSE Circuit Breakers
These restrictions are also known as "Rule 80B." The first version
of this rule, adopted in 1988, set triggers at 250 DJIA points and
400 DJIA points. These restrictions are updated quarterly to
reflect the heights to which the Dow Jones Industrial Average has
climbed.

* 10% decline (950 points for 3Q02)
The first circuit breaker is triggered if the DJIA declines by
approximately 10%. The restrictions that are put into place
-- if any -- depend on the time of day when the circuit
breaker is triggered. If the trigger occurs before 2pm
Eastern time, trading is halted for 1 hour. If the trigger
occurs between 2 and 2:30pm Eastern, trading is halted for 30
minutes. If the trigger occurs after 2:30pm Eastern time, no
restrictions are put into place. (This restriction was first
used during the afternoon of 27 Oct 97.) Note that there is no
similar restriction to the downside; nothing is done if the
Dow rallies 10%.


* 20% decline (1900 DJIA points for 3Q02)
The second circuit breaker is triggered if the DJIA declines
by approximately 20%. The restrictions that are put into
place again depend on the time of day when the circuit breaker
is triggered. If the trigger occurs before 1pm Eastern time,
trading is halted for 2 hours. If the trigger occurs between
1 and 2pm Eastern, trading is halted for 1 hour. If the
trigger occurs after 2pm Eastern time, the NYSE ends trading
for the day. Again there is no similar restriction to the
downside; nothing is done if the Dow rallies 20%.


* 30% decline (2850 DJIA points for 3Q02)
The third circuit breaker is triggered if the DJIA declines by
approximately 30%. The restriction is very simple: the NYSE
closes early that day. And like the other cases, again no
restrictions are imposed if the Dow rallies 30%.


The circuit breakers cut off the automated program trading initiated by
the big brokerage houses. The big boys have their computers directly
connected to the trading floor on the stock exchanges, and hence can
program their computers to place direct huge buy/sell orders that are
executed in a blink. This automated connection allows them to short-cut
the individual investors who must go thru the brokers and the
specialists on the stock exchange.

Statistical evidence suggests that about 2/3 of the Mar-Apr 1994 down
slide was caused by the program traders trying to lock in their profits
before all hell broke loose. The volume of their trades and their very
action may have accelerated the slide. The new game in town is how to
outfox the circuit breakers and buy or sell quickly before the 50-point
move triggers the halting of the automated trading and shuts off the
computer.

Here are sources with more information:
* HL Camp & Company offers a concise summary of program trading
collars including current numbers on their web site.

* The Chicago Mercantile Exchange publishes their equity index price
limits.

* The NYSE publishes press releases every quarter with the numbers
for that quarter's circuit breakers.

* The NYSE's glossary includes definitions of the term "Circuit
Breakers".



--------------------Check for updates------------------

Subject: Exchanges - Contact Information

Last-Revised: 13 Aug 1993
Contributed-By: Chris Lott ( contact me )

Here's how to contact the stock exchanges in North America.
* American Stock Exchange (AMEX), +1 212 306-1000,

* ASE, +1 403 974-7400

* Montreal Stock Exchange (MSE), +1 514 871-2424
* NASDAQ/OTC, +1 202 728-8333/8039,
* New York Stock Exchange (NYSE), +1 212 656-3000,

* The Philadelphia Stock Exchange (PHLX),
* Toronto Stock Exchange (TSE), +1 416 947-4700
* Vancouver Stock Exchange (VSE), +1 604 689-3334/643-6500

If you wish to know the telephone number for a specific company that is
listed on a stock exchange, call the exchange and request to be
connected with their "listings" or "research" department.


--------------------Check for updates------------------

Subject: Exchanges - Instinet

Last-Revised: 11 May 1994
Contributed-By: Jeffrey Benton (jeffwben at aol.com)

Instinet is a professional stock trading system which is owned by
Reuters. Institutions use the system to trade large blocks of shares
with each other without using the exchanges. Commissions are slightly
negotiable but generally $1 per hundred shares. Instinet also runs a
crossing network of the NYSE last sale at 6pm. A "cross" is a trade in
which a buyer and seller interact directly with no assistance of a
market maker or specialist. These buyer-seller pairs are commonly
matched up by a computer system such as Instinet.

Visit their web site:


--------------------Check for updates------------------

Subject: Exchanges - Market Makers and Specialists

Last-Revised: 28 Jan 1994
Contributed-By: Jeffrey Benton (jeffwben at aol.com)

Both Market Makers (MMs) and Specialists (specs) make market in stocks.
MMs are part of the National Association of Securities Dealers market
(NASD), sometimes called Over The Counter (OTC), and specs work on the
New York Stock Exchange (NYSE). These people serve a similar function
but MMs and specs have a number of differences. See the articles in the
FAQ about the NASDAQ and the NYSE for a detailed discussion of these
differences.


--------------------Check for updates------------------

Subject: Exchanges - The NASDAQ

Last-Revised: 6 June 2000
Contributed-By: Bill Rini (bill at moneypages.com), Jeffrey Benton
(jeffwben at aol.com), Chris Lott ( contact me )

NASDAQ is an abbreviation for the National Association of Securities
Dealers Automated Quotation system. It is also commonly, and
confusingly, called the OTC market.

The NASDAQ market is an interdealer market represented by over 600
securities dealers trading more than 15,000 different issues. These
dealers are called market makers (MMs). Unlike the New York Stock
Exchange (NYSE), the NASDAQ market does not operate as an auction market
(see the FAQ article on the NYSE). Instead, market makers are expected
to compete against each other to post the best quotes (best bid/ask
prices).

A NASDAQ level II quote shows all the bid offers, ask offers, size of
each offer (size of the market), and the market makers making the offers
in real time. These quotes are available from the Nasdaq Quotation
Dissemination Service (NQDS). The size of the market is simply the
number of shares the market maker is prepared to fill at that price.
Since about 1985 the average person has had access to level II quotes by
way of the Small Order Execution System (SOES) of the NASDAQ.
Non-professional users can get level II quotes for $50 per month. In
May 2000, the Nasdaq announced a pilot program that would reduce this
fee to just $10 per month.

SOES was implemented by NASDAQ in 1985. Following the 1987 market
crash, all market makers were required to use SOES. This system is
intended to help the small investor (hence the name) have his or her
transactions executed without allowing market makers to take advantage
of said small investor. You may see mention of "SOES Bandits" which is
slang for people who day-trade stocks on the NASDAQ using the SOES. A
SOES bandit tries to scalp profits on the spreads. Visit www.attain.com
for more on that topic.

A firm can become a market maker (MM) on NASDAQ by applying. The
requirements are relatively small, including certain capital
requirements, electronic interfaces, and a willingness to make a
two-sided market. You must be there every day. If you don't post
continuous bids and offers every day you can be penalized and not
allowed to make a market for a month. The best way to become a MM is to
go to work for a firm that is a MM. MMs are regulated by the NASD which
is overseen by the SEC.

The brokerage firm can handle customer orders either as a broker or as a
dealer/principal. When the brokerage acts as a broker, it simply
arranges the trade between buyer and seller, and charges a commission
for its services. When the brokerage acts as a dealer/principal, it's
either buying or selling from its own account (to or from the customer),
or acting as a market maker. The customer is charged either a mark-up
or a mark-down, depending on whether they are buying or selling. The
brokerage can never charge both a mark-up (or mark-down) and a
commission. Whether acting as a broker or as a dealer/principal, the
brokerage is required to disclose its role in the transaction. However
dealers/principals are not necessarily required to disclose the amount
of the mark-up or mark-down, although most do this automatically on the
confirmation as a matter of policy. Despite its role in the
transaction, the firm must be able to display that it made every effort
to obtain the best posted price. Whenever there is a question about the
execution price of a trade, it is usually best to ask the firm to
produce a Time and Sales report, which will allow the customer to
compare all execution prices with their own.

In the OTC public almost always meets dealer which means it is nearly
impossible to buy on the bid or sell on the ask. The dealers can buy on
the bid even though the public is bidding. Despite the requirement of
making a market, in the case of MM's there is no one firm who has to
take the responsibility if trading is not fair or orderly. During the
crash of 1987 the NYSE performed much better than NASDAQ. This was in
spite of the fact that some stocks have 30+ MMs. Many OTC firms simply
stopped making markets or answering phones until the dust settled.

Academic research has shown that an auction market such as the NYSE
results in better trades (in tighter ranges, less volatility, less
difference in price between trades). When you compare the multiple
market makers on the NASDAQ with the few specialists on the NYSE (see
the NYSE article), this is a counterintuitive result. But it is true.

In 1996 the NASDAQ was investigated for various practices. It settled a
suit brought against it by the SEC and agreed to change key aspects of
how it does business. Forbes ran a highly critical article entitled
"Fun and Games" on the NASDAQ. This was once available on the web, but
has vanished.

Related topics include price improvement, bid and ask, order routing,
and the 1996 settlement between the SEC and the NASDAQ. Please see the
articles elsewhere in this FAQ about those topics.

In 1998, a merger between the NASD and the AMEX resulted in the
Nasdaq-Amex Market Group.

For more information, visit their home page:


--------------------Check for updates------------------

Subject: Exchanges - The New York Stock Exchange

Last-Revised: 4 June 1999
Contributed-By: Jeffrey Benton (jeffwben at aol.com), Chris Lott (
contact me )

The New York Stock Exchange (NYSE) is the largest agency auction market
in the United States. Visit their home page:

The NYSE uses an agency auction market system which is designed to allow
the public to meet the public as much as possible. The majority of
volume (approx 88%) occurs with no intervention from the dealer.
Specialists (specs) make markets in stocks and work on the NYSE. The
responsibility of a spec is to make a fair and orderly market in the
issues assigned to them. They must yield to public orders which means
they may not trade for their own account when there are public bids and
offers. The spec has an affirmative obligation to eliminate imbalances
of supply and demand when they occur. The exchange has strict
guidelines for trading depth and continuity that must be observed.
Specs are subject to fines and censures if they fail to perform this
function. NYSE specs have large capital requirements and are overseen
by Market Surveillance at the NYSE. Specs are required to make a
continuous market.

Most academic literature shows NYSE stocks trade better (in tighter
ranges, less volatility, less difference in price between trades) when
compared with the OTC market (NASDAQ). On the NYSE 93% of trades occur
at no change or 1/8 of a point difference. It is counterintuitive that
one spec could make a better market than many market makers (see the
article about the NASDAQ). However, the spec operates under an entirely
different system. The NYSE system requires exposure of public orders to
the auction, the opportunity for price improvement, and to trade ahead
of the dealer. The system on the NYSE is very different than NASDAQ and
has been shown to create a better market for the stocks listed there.
This is why 90% of US stocks that are eligible for NYSE listing have
listed.

A specialist will maintain a narrow spread. Since the NYSE does not
post bid/ask information, you need to check out the 1-minute tick to
figure out the spread. In other words, you'll need access to a
professional's data feed before you can really see the size of the
spread. But the structure of the market strongly encourages narrow
spreads, so investors shouldn't be overly concerned about this.

There are 1366 NYSE members (i.e., seats). Approximately 450 are
specialists working for 38 specialists firms. As of 11/93 there were
2283 common and 597 preferred stocks listed on the NYSE. Each
individual spec handles approximately 6 issues. The very big stocks
will have a spec devoted solely to them.

Every listed stock has one firm assigned to it on the floor. Most
stocks are also listed on regional exchanges in LA, SF, Chi., Phil., and
Bos. All NYSE trading (approx 80% of total volume) will occur at that
post on the floor of the specialist assigned to it. To become a NYSE
spec the normal route is to go to work for a specialist firm as a clerk
and eventually to become a broker.

The New York Stock Exchange imposes fairly stringent restrictions on the
companies that wish to list their shares on the exchange. Some of the
guides used by the NYSE for an original listing of a domestic company
are national interest in the company and a minimum of 1.1 million shares
publicly held among not fewer than 2,000 round-lot stockholders. The
publicly held common shares should have a minimum aggregate market value
of $18 million. The company should have net income in the latest year
of over $2.5 million before federal income tax and $2 million in each of
the preceding two years. The NYSE also requires that domestic listed
companies meet certain criteria with respect to outside directors, audit
committee composition, voting rights and related party transactions. A
company also pays significant initial and annual fees to be listed on
the NYSE. Initial fees are $36,800 plus a charge per million shares
issued. Annual fees are also based on the number of shares issued,
subject to a minimum of $16,170 and a maximum of $500,000. For example,
a company that issues 4 million shares of common stock would pay over
$81,000 to be listed and over $16,000 annually to remain listed. For
all the gory details, visit this NYSE page:



--------------------Check for updates------------------

Subject: Exchanges - Members and Seats on AMEX

Last-Revised: 2 Aug 1999
Contributed-By: Jon Feins (proclm at kear.tdsnet.com), J. Bouvrie (fnux
at thetasys.com)

Most exchanges allow you to buy seats (become a member) without being a
registered securities dealer. You would not, however, be allowed to use
the seat to transact business on that exchange. You would be allowed to
lease out the seat and would thus own the seat as an investment.

Here's the disclaimer right up front: I have been negotiating seat
leases for investors for the last 5 years. My expertise is mainly on
the American Stock Exchange (AMEX) and New York Stock Exchange (NYSE).
I spent 5 years on the floor of the NYSE and NYFE before going to the
AMEX for 3 years as a floor broker/trader.

Anyone can purchase a seat on a major stock exchange as an investment
and lease it to either a floor trader, specialist, or floor broker.
Most people do not realize that they can do this without any background
and without taking a test. You do not even have to be a registered rep.
or registered with the SEC. The return is between 12%-20% of the
current seat prices depending on the supply and demand at the time the
lease is negotiated.

The AMEX currently has a very high demand for leases. The last leases I
negotiated were at a variable rate of 1 5/8%/month (19.5% per year) of
the average seat sales as posted by the exchange in their monthly
bulletin. AMEX seats are currently quoted $565,000/bid -
$690,000/offer. The last contracted sale was for $660,000 on 15 July
1999. You can call the AMEX's 24 hour market line 877-AMEXSEAT to hear
the latest quote. Amex seats can be put in an IRA or a Keogh Plan
making the investment even more appealing.

In late 1996, the AMEX approved a rule allowing individuals to own more
than one seat. Since then seats have been slowly going up. Call the
AMEX market line (212-306-2243) for the current price.

There are only 661 regular seats and 203 Option Principal Memberships
(OPM) on the AMEX. Every Specialist and Floor Broker needs a regular
membership to do business. A Trader can use either an OPM or a regular
seat. If a trader wants to trade listed AMEX stocks (s)he needs to use
a regular seat.

When applying for an AMEX membership you need to fill out an application
which consists of:
1. Information about the person applying for membership.
2. Authorization form for orally bidding for or offering the
membership.
3. Personal financial statement.
4. Completed U-4 for for background check along with a fingerprint
form.
5. Acknowledgement of non-eligibility of gratuity fund form.

After completing the paperwork a non-refundable application fee of $500
must be submitted to the exchange. About a week after processing your
application you will be able to buy/bid for a seat. Other costs
involved with the purchase of a seat on the AMEX include a one time
transfer fee of $2,500 (If/when you sell the seat the buyer of your seat
has to pay this transfer fee). When the seat is leased out a transfer
fee of $1,500 is paid by the lessee. Your total costs are:
1. Purchase price of the seat.
2. $500 application fee.
3. One-time $2,500 transfer fee.
4. $24.50 Finger print processing fee.

When you sell the seat there are no costs, and the exchange will send
you a check for the full selling price which they collect from the buyer
of your seat.

In the deals that I broker, once an investor has purchased the seat I
find a lessee. All my leases require a letter of indemnity from the
clearing house of the lessee. A clearing house (Merrill Lynch, Paine
Webber, Bear Stearns etc...) is used by the lessee to clear the trades
they execute. Whether the lessee is a trader, specialist or a floor
broker they must use a clearing house who charges them commissions for
each of their trades and is liable for their losses. If a person who is
worth $100,000 dollars loses $500,000 dollars the clearing house is
liable for the losses of the other $400,000. The letter of indemnity
from the clearing house states that they do not view the seat as
collateral. In addition to this letter of indemnity, I only lease to
people who are employed by a well-capitalized firm which also signs the
lease as a guarantor. My leases have attorney reviewed modifications
which further protect the interests of the owner of the seat. Just like
a person who rents a house needs to be careful of who they lease to, so
does the lessor of a seat.


--------------------Check for updates------------------

Subject: Exchanges - Ticker Tape Terminology

Last-Revised: 19 Sep 1999
Contributed-By: Keith Brewster, Norbert Schlenker, Richard Sauers
(rsauers at enter.net), Art Kamlet (artkamlet at aol.com)

Every stock traded on the world's stock exchanges is identified by a
short symbol. For example, the symbol for AT&T is just T. These
symbols date from the days when stock trades were reported on a ticker
tape. Ticker symbols are still used today as brief, unambiguous
identifiers for stocks. Similar abbreviations are used for stock
options and many other securities.

Ticker symbols get reused on different exchanges, so you'll sometimes
see a qualification ahead of the ticker symbol. For example, the symbol
"C:A" refers to a company traded on one of the Canadian exchanges
(Toronto, to be exact) with the symbol A. The stock quote services on
the web usually understand this notation. It's probably no surprise
that the North American-centric services pretty much assume that
anything unqualified is traded on a U.S. exchange; I've found that they
do not accept something like "NYSE:T" even though they perhaps should.

A few stock ticker symbols include a suffix, which seems to
differentiate among a company's various classes of common stock. Somem
of the quote services allow you to enter the ticker and suffix all run
together, while others require you to enter a dot between the ticker and
the suffix. For an example, try AKO, classes A and B.

Now that you understand a bit about the ticker symbol, there's some more
explanation required to understand what appears on the "ticker tape"
such as those shown on CNN or CNBC.
Ticker tape says: Translation (but see below):
NIKE68 1/2 100 shares sold at 68 1/2
10sNIKE68 1/2 1000 shares sold at "
10.000sNIKE68 1/2 10000 shares sold at "
The extra zeroes for the big trades are to make them stand out. All
trades on CNN and CNBC are delayed by 15 minutes. CNBC once advertised
a "ticker guide pamphlet, free for the asking", back when they merged
with FNN. It also has explanations for the futures they show. You can
also see an explanation on the web at this URL:


However, the first translation is not necessarily correct. CNBC has a
dynamic maximum size for transactions that are displayed this way.
Depending on how busy things are at any particular time, the maximum
varies from 100 to 5000 shares. You can figure out the current maximum
by watching carefully for about five minutes. If the smallest number of
shares you see in the second format is "10s" for any traded security,
then the first form can mean anything from 100 to 900 shares. If the
smallest you see is "50s" (which is pretty common), the first form means
anything between 100 and 4900 shares.

Note that at busy times, a broker's ticker drops the volume figure and
then everything but the last dollar digit (e.g. on a busy day, a trade
of 25,000 IBM at 68 3/4 shows only as "IBM 8 3/4" on a broker's ticker).
That never happens on CNBC, so I don't know how they can keep up with
all trades without "forgetting" a few.

NASDAQ uses a "fifth letter" identifier in its ticker symbols. Four
letter symbols, and five letter symbols in instances of multiple issues
listed by the same company, are listed in newspapers and carried on the
ticker screen by CNBC and CNN. These symbols are required to retrieve
quotes from quote servers.

Here's the complete list of the NASDAQ fifth-letter identifiers with
brief descriptions:

Symbol Meaning
A Class A
B Class B
C exempt from NASDAQ listing qualifications for limited period
D new issue
E delinquent in required SEC filings
F foreign
G First convertible bond
H Second convertible bond (same company)
I Third convertible bond (same company)
J Voting
K Nonvoting
L misc situations, including second class units, third class warrants,
or sixth class preferred stock
M Fourth class preferred (same company)
N Third class preferred (same company)
O Second class preferred (same company)
P First class preferred (same company)
Q in bankruptcy proceedings
R Rights
S Shares of beneficial interest
T with warrants or rights
U Units
V When issued and when distributed
W Warrants
X mutual fund
Y American Depositary Receipts
Z misc situations, including second class of warrants, fifth class
preferred stock or any unit, receipt or certificate representing a
limited partnership interest.



--------------------Check for updates------------------

Subject: Financial Planning - Basics

Last-Revised: 22 Oct 1997
Contributed-By: James E. Mallett (jmallett at stetson.edu)

One complaint I often hear is that an individual would like to invest
but they do not have any money. Financial planning may help many people
to overcome this lack of ability to save for investment. With proper
planning perhaps you will be able to establish goals and save money to
meet these goals. While you can start this personal financial planning
yourself, you may soon discover that it will pay you to find a Certified
Financial Planner to help in the process.

This article gives a short primer on how to start personal financial
planning for yourself.

To begin the financial planning process, you need specific financial
goals. By specific goals, I mean to establish a date to meet the goal
and a savings plan that meets your goals. At first these goals may seem
unobtainable but continuing the planning process will enable you to
evaluate these goals and modify as necessary.

Next you need to track your expenses and income until you can develop a
yearly statement (cash/flow statement). To see where you are currently,
list the value of all your assets and what you owe. Subtract your debts
from your assets and you have your current net worth (balance sheet).
You should update these statements yearly.

Once you have established your income and expenses you can develop a
budget. Your aim in establishing a budget is to attempt to increase
your income and/or reduce your expenditures so that you have savings to
meet your initial goals. If on the first try you are short of funds, do
not despair.

Try looking at your taxes to see if they can be reduced. Consult a tax
attorney if necessary. Analyze your debt to see if it can be
consolidated into a lower interest rate loan. Perhaps a home equity
loan might fit the bill. Next review your consumption patterns. Are
your financial goals worth driving an older automobile; are you shopping
for the best prices; and what current expenses that you have are
unnecessary?

By getting your finances in order, you will gain funds to save and
invest toward your goals. If you do not have sufficient funds to meet
your goals, modify them. Look for opportunities in the future to
reestablish these goals. Seek the aid of financial professionals,
educate yourself with personal finance books and magazines.

Here are a few resources on financial planning.
* James E. Mallett's site about financial planning:

* The International Association for Financial Planning offers a sales
pitch and some information on their site:



--------------------Check for updates------------------

Subject: Financial Planning - Choosing a Financial Planner

Last-Revised: 20 Apr 1998
Contributed-By: James E. Mallett (jmallett at stetson.edu)

Virtually anyone with moderate wealth or a decent income could benefit
from the services of a financial planner. By a financial planner, I
mean someone with the expertise to produce a comprehensive financial
plan for an individual household. This plan should cover the
household's financial goals, budget, insurance and risk review, asset
allocation, retirement plan, and a review of an estate plan. Such
detailed planning is unlikely to be meet by brokers and agents
interested in commissions on financial products they sell.

A financial planner has a broad knowledge of areas such as tax planning,
investments, and estate law but is unlikely to be the financial
professional you require in these individual areas. Rather the
financial planner can help coordinate your financial planning with your
accountant, insurance agent, investment professional, and estate lawyer.
The broad expertise that a professional financial planner possesses will
help insure that your financial goals are met and that all areas of your
financial life are reviewed.

Hiring a planner will help you avoid expensive financial mistakes that
could seriously damage your financial health. It would not be difficult
for most financial planners to find serious gaps in most household
finances, gaps that are easily worth the cost of the planner's services.
Even individuals with expert knowledge in one finance field such as
investments can overlook areas such as insurance or estate planning.
Few people have the time, desire, or expertise to do a complete
financial plan for themselves.

Saying that most would benefit from using a financial planner is not to
imply that there are not wide differences in abilities and costs among
planners. Few areas will pay richer rewards for the public than gaining
basic knowledge in personal finance. If one is not careful, fees and
commissions could negate much, if not all, of the benefit of using a
financial planner. This article lists a few issues to consider when
choosing a financial planner.

The first step in looking for a financial planner is to limit your
search to someone who is certified in financial planning. Two
certifying associations that I would recommend are the Certified
Financial Planner and the Personal Financial Specialist (given to
qualifying Certified Public Accountants). The second step is to seek
out recommendations from people that you respect for names of financial
planners and interview these planners. Your aim is to find someone who
meets your needs and who will look after your interests. A problem that
exists in selecting financial professionals is that what is in your best
interest may fall a distant second to what is in their interest of
making a profit.

The third question you need to ask is how does the financial planner
receive compensation and what will this compensation cost you annually.
In calculating the costs, one must consider fees, commissions,
transaction costs, and (if any) what are the annual fees of the
financial products that they recommend (such as mutual fund management
fees). It is quite possible that after adding sales loads and
management fees, the after-expense return that you receive from equities
will not justify the risk. Recent high market returns have served to
mask the fleecing of many American investors.

Financial planners fall into two broad types: fee-only financial
planners and commission and/or fee-based financial planners. While some
give the nod automatically to fee-only financial planners, it will
depend on your particular circumstances as to which one will be best for
you.

If you only need a comprehensive financial plan and you are willing to
invest your funds yourself, than a fee-only financial planner who
charges by the hour may be your best choice. If you want the financial
planner to manage your money, than many fee-only financial planners have
moved to an asset-based fee, normally 0.5% to 1.5%, of your assets. Two
factors should be kept in mind. One is that this fee is charged
annually. Second, most financial planners put your funds to work in a
mutual fund and that means you continue to pay the mutual fund another
management fee annually. Since evidence and theory suggest that none of
these efforts will result in outperforming an index mutual fund, one
might wonder why not go directly there and save about 2% in management
fees. Plus, on average, you will have a mutual fund that will
outperform most professionals.

With commission-based financial planners, individuals run the risk that
the commissions charged on the financial products that they recommend
will add greatly to the cost of the financial planning. The risk of
conflict of interest arises when the planner receives greater
compensation based on what financial products that they recommend. It
may be possible, however, for some individuals that the free or
reduced-cost financial plan would not be offset by the higher
commissions. For example, the one-time load on the mutual fund might be
cheaper than paying the annual 1.5% fee to a fee-based financial
planner. You must compare all of these costs when deciding which
financial planner is the best for you.

Given this information on financial planners, it is clear that knowledge
on the consumer's part is very important. While many households will
spend a great deal of time shopping for an automobile, the decision of
whom to trust with their wealth too is often made without much thought.
As a result Americans spend many billions more on financial services
than what is really needed.

For more insights from James E. Mallett about financial planning,
please visit his site:


For a list of 10 questions you should ask before hiring a financial
planner, visit this government site:



--------------------Check for updates------------------

Subject: Financial Planning - Compensation and Conflicts of Interest

Last-Revised: 19 Apr 2000
Contributed-By: Ed Zollars (ezollar at mindspring.com)

This article discusses the primary ways that financial planners are paid
for their services, and illustrates the biases and conflicts of interest
that invariably are present in each compensation scheme.



Hourly rate
When a financial planner is paid an hourly rate, he or she may have
a bias towards selling the client more advice than is needed,
and/or selling additional hourly services to the client. However,
the actual financial product sold to the client, or even if any is
sold at all, is a matter of indifference. A practical problem is
that this advice, if done properly (thorough investigation by
adviser into the entire background of the client) is going to be
very expensive because it needs to be customized to the client.
Thus, we see very little of this type of advice except for
specialized areas (like taxation, business law, etc.).


Flat rate
If a financial planner is paid a flat rate, he or she may have a
bias towards giving the client canned advice in order to gain
efficiencies. That can lead to not tailoring the advice to the
specific situation because that adds (uncompensated) time to the
engagement. Additionally, there's a bias towards selling
additional services not included in the initial package. Again,
generally indifference as to whether a sale is closed on an actual
investment, or which investment actually gets chosen. The
advantage to the client is that he or she knows the cost going in.


Percent of assets under management paid annually
If a financial planner receives each year a percentage of assets
under management, he or she may have a bias towards keeping as much
under management as possible, thus leading to some bias against
using funds for other purposes (including paying down debt). This
structure may also encourage the advising of riskier ventures,
since they present the adviser with the potential for higher
compensation. Obviously, the client does have to put some assets
under management (so there is a bias to do something), but the
particular investments are a matter of indifference.


Commissions on sales
When a planner receives a commission on any product sold to the
client, this can lead to a bias towards closing the sale on a
product that will pay the adviser a commission and discouraging the
acquisition of products that won't pay this adviser a commission.
Since advice is offered as a method to encourage the client to get
moving towards a buy, these advisers tend to be rather thorough in
raising issues that relate to their products (finding needs). Will
tend to have a bias to be less thorough in raising issues for which
the solution doesn't involve their product (so in estate planning
there will be lots of talk about ILITs or CRUTs, but little talk
about FLPs, AB trusts, etc.). A practical advantage is that
because the client can simply walk away, this can be the least
expensive way to get a good quick general education on the subject
at hand. Also, many investments sold by commissioned salespeople
spread the fee over a number of years, so it becomes a payment on
the installment plan that may allow some people to receive advice
they need.


Note that any competent professional will actively control for any bias
introduced by the compensation mechanism. Therefore, none of the issues
raised here represent an insurmountable flaw of a particular method of
compensation. Too often this sort of analysis can degnerate into a
mudslinging contest that suggests there is only one right way to handle
every situation, which is simply not the case.

In the end, a client of a financial planner should ask/recognize the
ways by which the planner gets paid, and use that information to note
any bias that might be present in the advice given.


--------------------Check for updates------------------

Subject: Financial Planning - Estate Planning Checkup

Last-Revised: 20 June 1999
Contributed-By: Nolo Press

This article is copyright © Nolo Press 1999 and was reprinted with
specific permission. For more great, free information about legal
matters, visit their website:


Lots of Americans haven't made even a simple will, to say nothing of a
more comprehensive plan to avoid probate or save on estate taxes. And
even those who have thought about what should happen to their property
when they eventually shuffle off to Nirvana haven't updated their plan
in many years. We're not going to nag, but we are going to chime in
with a few suggestions as to what your estate plan should look like. Oh
yes, in case you're new to this area, estate planning is simply a fancy
term for the process of arranging for what will happen to your property
(estate) if a particularly large and lethal brick falls on your head.

Depending on your age, health, wealth and innate level of cautiousness,
you may not need to do much at all in the way of estate planning. And
even if you do decide you need a will or a trust, you probably won't
need a lawyer. Especially if you aren't dripping with Picassos or fat
investment accounts, it is easy and safe to prepare most basic estate
planning documents yourself. Just learn what you're doing by using a
good self-help book or piece of software.

We've arranged our tips by some broad categories of family situation and
age. As they say, check all that apply. But keep in mind that age is
an imprecise proxy for life expectancy, which is affected by all sorts
of other factors--heavy smoking while participating in extreme sports
and driving a motorcycle, for example. It's up to you to add or
subtract a few years, based on your health and lifestyle.



You're 25 and Single
What are you doing reading about estate planning? You're supposed
to be surfing the Net or dancing until dawn. But you might as well
keep reading; this won't take long.

At your age, there's not much point in putting a lot of energy into
estate planning. Unless your lifestyle is unusually risky or you
have a serious illness, you're very unlikely to die for a long,
long time.

If you're an uncommonly rich 25-year-old, though, write a will.
(Bricks can fall on anyone.) That way you can leave your
possessions to any recipient you choose--your boyfriend, your
favorite cause, the nephew who thinks you're totally cool. If you
don't write a will, whatever wealth you leave behind will probably
go to your parents. Think about it.


You're Paired Up, But Not Married
If you've got a life partner but no marriage certificate, a will is
almost a must-have document. Without a will, state law will
dictate where your property goes after your death, and no state
gives anything to an unmarried partner. Instead, your closest
relatives would inherit everything.

Other options to make sure that your partner isn't left out in the
cold after your death is to own big-ticket items, such as houses
and cars, together in "joint tenancy" with right of survivorship.
Then, when one of you dies, the survivor will automatically own
100% of the property.


You Have Young Children
Having children complicates life--but then, you already know that.
Estate planning is no exception. Here's what to think about.

First, write a will. Nothing fancy--just a document that leaves
your property to whomever you choose and names a guardian for your
children. The guardian will take over if both you and the other
parent are unavailable. That's an unlikely situation, but one
that's worth addressing just in case. If you fail to name a
guardian, a court will appoint someone--possibly one of your
parents.

The other big reason to write a will is that if you don't, some of
your property may go not to your spouse, but directly to your
children. When given a choice, most people prefer that the money
go to their spouse, who will use it for the kids. The problem with
the children inheriting directly is that the surviving parent may
need to get court permission to handle the money--a waste of time
and money in most families.

Second, think about buying life insurance so the other parent will
be able to replace your earnings if that damn brick chooses you.
Term life insurance is relatively cheap, especially if you're young
and don't smoke. You can shop for the best bargain by consulting
free services that compare the rates of lots of companies. Look
for their ads in personal finance magazines.


You're Middle-Aged and Know the Names of at Least Three Mutual Funds
If you've made it to a comfortable time in life--you've accumulated
some material wealth and enough wisdom to let you know that other
things matter, too--you will probably want to take some time to
reflect on what you will eventually leave behind.

But given that you may well live another 30 or 40 years, there is
no need to obsess about it. Chances are your conclusions will be
different in ten or 20 years, and your estate plan will change
accordingly.

To save your family the cost (and hassles) of probate court
proceedings after your death, think about creating a revocable
living trust. It's hardly more trouble than writing a will, and
lets everything go directly to your heirs after your death, without
taking a circuitous and expensive detour through probate court.

While you're alive, the trust has no effect, and you can revoke it
or change its terms at any time. But after your death, the person
you chose to be your "successor trustee" takes control of trust
property and transfers it according to the directions you left in
the trust document. It's quick and simple.

There are other, even easier ways to avoid probate: you can turn
any bank account into a "payable-on-death" account simply by
signing a form (the bank will supply it) and naming someone to
inherit whatever funds are in the account at your death. You can
do the same thing, in 29 states, with securities. (Ask your broker
if your state has adopted a law called the Uniform
Transfer-on-Death Securities Registration Act.)

If you have enough property to worry about federal estate taxes,
think about a tax-avoidance trust as well. Currently, estates
worth more than $650,000 are taxed; that amount will increase to $1
million by 2006. Most estates are never subject to tax, but if
estate tax does take a bite, it can be a big one. Tax rates now
start at 37% and rise to 55% for estates worth more than $3
million.

One way to reduce estate tax is to give away property before your
death. After all, if you don't own it, it can't be taxed. But in
2002, gifts larger than $11,000 per year per recipient are subject
to gift tax, which applies at the same rates as does estate tax.
Still, an annual gifting plan can reduce the size of even a big
estate, especially if you have a covey of kids and grandkids.
Gifts to your spouse (as long as he or she is a U.S. citizen),
gifts that directly pay tuition or medical bills, or gifts to a
tax-exempt organization are exempt from gift tax.

Another way to cut taxes is to create certain kinds of trusts. The
most common, the AB trust, is one that couples use. Each spouse
leaves property to their children--with the crucial condition that
the surviving spouse has the right to use the income that property
produces for as long as he or she lives. In some circumstances,
the surviving spouse may even be able to spend principal. By 2006,
an AB trust will shield up to $2 million from estate tax.

Charitable trusts, which involve making a gift to a charity and
getting some payments back, can also save on both estate and income
tax. There are many other varieties of trusts; learn about them on
your own, and then have an experienced estate planning lawyer draw
up the documents you decide on.


You're Elderly or Ill
Now is the time to take concrete steps to establish an estate plan
pronto. It's also a good idea to think about what could happen
before your death, if you become seriously ill and unable to handle
your own affairs.

First, the basics: Consider a probate-avoidance living trust and,
if you're concerned about estate taxes, a tax-saving trust. (These
devices are discussed just above.) Write a will, or update an old
one.

Then, although no one wants to do it, take a minute to think about
the possibility that at some time, you might become incapacitated
and unable to handle day-to-day financial matters or make
healthcare decisions. If you don't do anything to prepare for this
unpleasant possibility, a judge may have to appoint someone to make
these decisions for you. No one wants a court's intervention in
such personal matters, but someone must have legal authority to act
on your behalf.

You can choose that person yourself, and give him or her legal
authority to act for you, by creating documents called durable
powers of attorney. You'll need one for your financial matters and
one for healthcare. (Some states allow the two to be combined, but
it's usually not a good idea. They're used in completely different
situations.) You choose someone you trust to act for you (called
your attorney-in-fact) and spell out his or her authority. If you
wish, you can even state that the document won't have any effect
unless and until you become incapacitated. Once signed and
notarized, it's legally valid, and your mind can be at ease.



--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 9 of 20)

Archive-name: investment-faq/general/part9
Version: $Id: part09,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plain-text
version of The Investment FAQ, part 9 of 20. The web site
always has the latest version, including in-line links. Please browse



Terms of Use

The following terms and conditions apply to the plain-text version of
The Investment FAQ that is posted regularly to various newsgroups.
Different terms and conditions apply to documents on The Investment
FAQ web site.

The Investment FAQ is copyright 2003 by Christopher Lott, and is
protected by copyright as a collective work and/or compilation,
pursuant to U.S. copyright laws, international conventions, and other
copyright laws. The contents of The Investment FAQ are intended for
personal use, not for sale or other commercial redistribution.
The plain-text version of The Investment FAQ may be copied, stored,
made available on web sites, or distributed on electronic media
provided the following conditions are met:
+ The URL of The Investment FAQ home page is displayed prominently.
+ No fees or compensation are charged for this information,
excluding charges for the media used to distribute it.
+ No advertisements appear on the same web page as this material.
+ Proper attribution is given to the authors of individual articles.
+ This copyright notice is included intact.


Disclaimers

Neither the compiler of nor contributors to The Investment FAQ make
any express or implied warranties (including, without limitation, any
warranty of merchantability or fitness for a particular purpose or
use) regarding the information supplied. The Investment FAQ is
provided to the user "as is". Neither the compiler nor contributors
warrant that The Investment FAQ will be error free. Neither the
compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it. Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers. Readers outside the USA can reach
US-800 telephone numbers, for a charge, using a service such as MCI's
Call USA. All prices are listed in US dollars unless otherwise
specified.

Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Mutual Funds - Distributions and Tax Implications

Last-Revised: 27 Jan 1998
Contributed-By: Chris Lott ( contact me ), S. Jaguiar, Art Kamlet
(artkamlet at aol.com), R. Kalia

This article gives a brief summary of the issues surrounding
distributions made by mutual funds, the tax liability of shareholders
who recieve these distributions, and the consequences of buying or
selling shares of a mutual fund shortly before or after such a
distribution.

Investment management companies (i.e., mutual funds) periodically
distribute money to their shareholders that they made by trading in the
shares they hold. These are called dividends or distributions, and the
shareholder must pay taxes on these payments. Why do they distribute
the gains instead of reinvesting them? Well, a mutual fund, under The
Investment Company Act of 1940, is allowed to make the decision to
distribute substantially all earnings to shareholders at least annually
and thereby avoid paying taxes on those earnings. And, of course, they
do. In general, equity funds distribute dividends quarterly, and
distribute capital gains annually or semi-annually. In general, bond
funds distribute dividends monthly, and distribute capital gains
annually or semi-annually.

When a distribution is made, the net asset value (NAV) goes down by the
same amount. Suppose the NAV is $8 when you bought and has grown to $10
by some date, we'll pick Dec. 21. On paper you have a profit of $2.
Then, a $1 distribution is made on Dec. 21. As a result of this
distribution, the NAV goes down to $9 on Dec. 22 (ignoring any other
market activity that might happen). Since you received a $1 payment and
your shares are still worth $9, you still have the $10. However, you
also have a tax liability for that $1 payment.

Mutual funds commonly make distributions late in the year. Because of
this, many advise mutual fund investors to be wary of buying into a
mutual fund very late in the year (i.e., shortly before a distribution).
Essentially what happens to a person who buys shortly before a
distribution is that a portion of the investment is immediately returned
to the investor along with a tax bill. In the short term it essentially
means a loss for the investor. If the investor had bought in January
(for example), and had seen the NAV rise nicely over the year, then
receiving the distribution and tax bill would not be so bad. But when a
person essentially increases their tax bill with a fund purchase, it is
like seeing the value of the fund drop by the amount owed to the tax
man. This is the main reason for checking with a mutual fund for
planned distributions when making an investment, especially late in the
year.

But let's look at the issue a different way. The decision of buying
shortly before a distribution all comes down to whether or not you feel
that the fund is going to go up more in value than the total taxable
event will be to you. For instance let's say that a fund is going to
distribute 6% in income at the end of December. You will have to pay
tax on that 6% gain, even though your account value won't go up by 6%
(that's the law). Assuming that you are in a 33% tax bracket, a third
of that gain (2% of your account value) will be paid in taxes. So it
comes down to asking yourself the question of whether or not you feel
that the fund will appreciate by 2% or more between now and the time
that the income will be distributed. If the fund went up in value by
10% between the time of purchase and the distribution, then in the above
example you would miss out on a 8% after-tax gain by not investing. If
the fund didn't go up in value by at least 2% then you would take a loss
and would have been better off waiting. So how clear is your crystal
ball?

For someone to make the claim that it is always patently better to wait
until the end of the year to invest so as to avoid capital gains tax is
ridiculous. Sometimes it is and sometimes it isn't. Investing is a
most empirical process and every new situation should be looked at
objectively.

And it's important not to lose sight of the big picture. For a mutual
fund investor who saw the value of their investment appreciate nicely
between the time of purchase and the distribution, a distribution just
means more taxes this year but less tax when the shares are sold. Of
course it is better to postpone paying taxes, but it's not as though the
profits would be tax-free if no distribution were made. For those who
move their investments around every few months or years, the whole issue
is irrelevant. In my view, people spend too much time trying to beat
the tax man instead of trying to make more money. This is made worse by
ratings that measure 'tax efficiency' on the basis of current tax
liability (distributions) while ignoring future tax liability
(unrealized capital gains that may not be paid out each year but they
are still taxed when you sell).

So what are the tax implications based on the timing of any sale?
Actually, for most people there are none. If you sell your shares on
Dec. 21, you have $2 in taxable capital gains ($1 from the distribution
and $1 from the growth from 8 to 9). If you sell on Dec. 22, you have
$1 in taxable capital gains and $1 in taxable distributions. This can
make a small difference in some tax brackets, but no difference at all
in others.


--------------------Check for updates------------------

Subject: Mutual Funds - Fees and Expenses

Last-Revised: 28 Jun 1997
Contributed-By: Chris Lott ( contact me )

Investors who put money into a mutual fund gain the benefits of a
professional investment management company. Like any professional,
using an investment manager results in some costs. These costs are
recovered from a mutual fund's investors either through sales charges or
operation expenses .

Sales charges for an open-end mutual fund include front-end loads and
back-end loads (redemption fees). A front-end load is a fee paid by an
investor when purchasing shares in the mutual fund, and is expressed as
a percentage of the amount to be invested. These loads may be 0% (for a
no-load fund), around 2% (for a so-called low-load fund), or as high as
8% (ouch). A back-end load (or redemption fee) is paid by an investor
when selling shares in the mutual fund. Unlike front-end loads, a
back-end load may be a flat fee, or it may be expressed as a sliding
scale. A sliding-scale means that the redemption fee is high if the
investor sells shares within the first year of buying them, but declines
to little or nothing after 3, 4, or 5 years. A sliding-scale fee is
usually implemented to discourage investors from switching rapidly among
funds. Loads are used to pay the sales force. The only good thing
about sales charges is that investors only pay them once.

A closed-end mutual fund is traded like a common stock, so investors
must pay commissions to purchase shares in the fund. An article
elsewhere in this FAQ about discount brokers offers information about
minimizing commissions.

To keep the dollars rolling in over the years, investment management
companies may impose fees for operating expenses. The total fee load
charged annually is usually reported as the expense ratio . All annual
fees are charged against the net value of an investment. Operating
expenses include the fund manager's salary and bonuses (management
fees), keeping the books and mailing statements every month (accounting
fees), legal fees, etc. The total expense ratio ranges from 0% to as
much as 2% annually. Of course, 0% is a fiction; the investment company
is simply trying to make their returns look especially good by charging
no fees for some period of time. According to SEC rules, operating
expenses may also include marketing expenses. Fees charged to investors
that cover marketing expenses are called "12b-1 Plan fees." Obviously an
investor pays fees to cover operating expenses for as long as he or she
owns shares in the fund. Operating fees are usually calculated and
accrued on a daily basis, and will be deducted from the account on a
regular basis, probably monthly.

Other expenses that may apply to an investment in a mutual fund include
account maintenance fees, exchange (switching) fees, and transaction
fees. An investor who has a small amount in a mutual fund, maybe under
$2500, may be forced to pay an annual account maintenance fee. An
exchange or switching fee refers to any fee paid by an investor when
switching money within one investment management company from one of the
company's mutual funds to another mutual fund with that company.
Finally, a transaction fee is a lot like a sales charge, but it goes to
the fund rather than to the sales force (as if that made paying this fee
any less painful).

The best available way to compare fees for different funds, or different
classes of shares within the same fund, is to look at the prospectus of
a fund. Near the front, there is a chart comparing expenses for each
class assuming a 5% return on a $1,000 investment. The prospectus for
Franklin Mutual Shares, for example, shows that B investors (they call
it "Class II") pay less in expenses with a holding period of less than 5
years, but A investors ("Class I") come out ahead if they hold for
longer than 5 years.

In closing, investors and prospective investors should examine the fee
structure of mutual funds closely. These fees will diminish returns
over time. Also, it's important to note that the traditional
price/quality curve doesn't seem to hold quite as well for mutual funds
as it does for consumer goods. I mean, if you're in the market for a
good suit, you know about what you have to pay to get something that
meets your expectations. But when investing in a mutual fund, you could
pay a huge sales charge and stiff operating expenses, and in return be
rewarded with negative returns. Of course, you could also get lucky and
buy the next hot fund right before it explodes. Caveat emptor.


--------------------Check for updates------------------

Subject: Mutual Funds - Index Funds and Beating the Market

Last-Revised: 26 May 1999
Contributed-By: Chris Lott ( contact me )

This article discusses index funds and modern portfolio theory (MPT) as
espoused by Burton Malkiel, but first makes a digression into the topic
of "beating the market."

Investors and prospective investors regularly encounter the phrase
"beating the market" or sometimes "beating the S&P 500." What does this
mean?

Somehow I'm reminded of the way Garrison Keillor used to start his show
on Minnesota Public Radio, "Greetings from Lake Woebegon, where all the
women are beautiful and all the children are above average" .. but I
digress.

To answer the second question first: The S&P 500 is a broad market
index. Saying that you "beat the S&P" means that for some period of
time, the returns on your investments were greater than the returns on
the S&P index (although you have to ask careful questions about whether
dividends paid out were counted, or only the capital appreciation
measured by the rise in stock prices).

Now, the harder question: Is this always the best indicator? This is
slightly more involved.

Everyone, most especially a mutual fund manager, wants to beat "the
market". The problem lies in deciding how "the market" did. Let's
limit things to the universe of stocks traded on U.S. exchanges.. even
that market is enormous . So how does an aspiring mutual fund manager
measure his or her performance? By comparing the fund's returns to some
measure of the market. And now the $64,000 question: What market is the
most appropriate comparison?

Of course there are many answers. How about the large-cap market, for
which one widely known (but dubious value) index is the DJIA? What about
the market of large and mid-cap shares, for which one widely known index
is the S&P 500? And maybe you should use the small-cap market, for which
Wilshire maintains various indexes? And what about technology stocks,
which the NASDAQ composite index tracks somewhat?

As you can see, choosing the benchmark against which you will compare
yourself is not exactly simple. That said, an awful lot of funds
compare themselves against the S&P. The finance people say that the S&P
has some nice properties in the way it is computed. Most market people
would say that because so much of the market's capitalization is tracked
by the S&P, it's an appropriate benchmark.

You be the judge.

The importance of indexes like the S&P500 is the debate between passive
investing and active investing. There are funds called index funds that
follow a passive investment style. They just hold the stocks in the
index. That way you do as well as the overall market. It's a
no-brainer. The person who runs the index fund doesn't go around buying
and selling based on his or her staff's stock picks. If the overall
market is good, you do well; if it is not so good, you don't do well.
The main benefit is low overhead costs. Although the fund manager must
buy and sell stocks when the index changes or to react to new
investments and redemptions, otherwise the manager has little to do.
And of course there is no need to pay for some hotshot group of stock
pickers.

However, even more important is the "efficient market theory" taught in
academia that says stock prices follow a random walk. Translated into
English, this means that stock prices are essentially random and don't
have trends or patterns in the price movements. This argument pretty
much attacks technical analysis head-on. The theory also says that
prices react almost instantaneously to any information - making
fundamental analysis fairly useless too.

Therefore, a passive investing approach like investing in an index fund
is supposedly the best idea. John Bogle of the Vanguard fund is one of
the main proponents of a low-cost index fund.

The people against the idea of the efficient market (including of course
all the stock brokers who want to make a commission, etc.) subscribe to
one of two camps - outright snake oil (weird stock picking methods,
bogus claims, etc.) or research in some camps that point out that the
market isn't totally efficient. Of course academia is aware of various
anomalies like the January effect, etc. Also "The Economist" magazine
did a cover story on the "new technology" a few years ago - things like
using Chaos Theory, Neural Nets, Genetic Algorithms, etc. etc. - a
resurgence in the idea that the market was beatable using new technology
- and proclaimed that the efficient market theory was on the ropes.

However, many say that's an exaggeration. If you look at the records,
there are very, very few funds and investors who consistently beat the
averages (the market - approximated by the S&P 500 which as I said is a
"no brainer investment approach"). What you see is that the majority of
the funds, etc. don't even match the no-brainer approach to investing.
Of the small amount who do (the winners), they tend to change from one
period to another. One period or a couple of periods they are on top,
then they do much worse than the market. The ones who stay on top for
years and years and years - like a Peter Lynch - are a very rare breed.
That's why efficient market types say it's consistent with the random
nature of the market.

Remember, index funds that track the S&P 500 are just taking advantage
of the concept of diversification. The only risk they are left with
(depending on the fund) is whether the entire market goes up and down.

People who pick and choose individual companies or a sector in the
market are taking on added risk since they are less diversified. This
is completely consistent with the more risk = possibility of more return
and possibility of more loss principle. It's just like taking longer
odds at the race track. So when you choose a non-passive investment
approach you are either doing two things:
1. Just gambling. You realize the odds are against you just like they
are at the tracks where you take longer odds, but you are willing
to take that risk for the slim chance of beating the market.


2. You really believe in your own or a hired gun's stock picking
talent to take on stocks that are classified as a higher risk with
the possibility of greater return because you know something that
nobody else knows that really makes the stock a low risk investment
(secret method, inside information, etc.) Of course everyone thinks
they belong in this camp even though they are really in the former
camp, sometimes they win big, most of times they lose, with a few
out of the zillion investors winning big over a fairly long period.
It's consistent with the notion that it's gambling.

So you get this picture of active fund managers expending a lot of
energy on a tread mill running like crazy and staying in the same spot.
Actually it's not even the same spot since most don't even match the S&P
500 due to the added risk they've taken on in their picks or the
transaction costs of buying and selling. That's why market indexes like
the S&P 500 are the benchmark. When you pick stocks on your own or pay
someone to manage your money in an active investment fund, you are
paying them to do better or hoping you will do better than doing the
no-brainer passive investment index fund approach that is a reasonable
expectation. Just think of paying some guy who does worse than if he
just sat on his butt doing nothing!

The following list of resources will help you learn much, much more
about index mutual funds.
* An accessible book that covers investing approaches and academic
theories on the market, especially modern portfolio theory (MPT)
and the efficient market hypothesis, is this one (the link points
to Amazon):
Burton Malkiel
A Random Walk Down Wall Street This book was written by a
former Princeton Prof. who also invested hands-on in the market.
It's a bestseller, written for the public and available in
paperback.


* IndexFunds.com offers much information about index mutual funds.
The site is edited by Will McClatchy and published by IndexFunds,
Inc., of Austin, Texas.



* The list of frequently asked questions about index mutual funds,
which is maintained by Dale C. Maley.



--------------------Check for updates------------------

Subject: Mutual Funds - Money-Market Funds

Last-Revised: 16 Aug 1998
Contributed-By: Chris Lott ( contact me ), Rich Carreiro (rlcarr at
animato.arlington.ma.us)

A money-market fund (MMF) is a mutual fund, although a very special type
of one. The goal of a money-market fund is to preserve principal while
yielding a modest return. These funds try very, very, very hard to
maintain a net asset value (NAV) of exactly $1.00. Basically, the
companies try to make these feel like a high-yield bank account,
although one should never forget that the money-market fund has no
insurance against loss.

The NAV stays at $1 for (at least) three reasons:
1. The underlying securities in a MMF are very short-term money market
instruments. Usually maturing in 60 days or less, but always less
than 180 days. They suffer very little price fluctuation.
2. To the extent that they do fluctuate, the fund plays some (legal)
accounting games (which are available because the securities are so
close to maturity and because they fluctuate fairly little) with
how the securities are valued, making it easier to maintain the NAV
at $1.
3. MMFs declare dividends daily, though they are only paid out
monthly. If you totally cash in your MMF in the middle of the
month, you'll receive the cumulative declared dividends from the
1st of the month to when you sold out. If you only partially
redeem, the dividends declared on the sold shares will simply be
part of what you see at the end of the month. This is part of why
the fund's interest income doesn't raise the NAV.

MMFs remaining at a $1 NAV is not advantageous in the sense that it
reduces your taxes (in fact, it's the opposite), it's advantageous in
the sense that it saves you from having to track your basis and compute
and report your gain/loss every single time you redeem MMF shares, which
would be a huge pain, since many (most?) people use MMFs as checking
accounts of a sort. The $1 NAV has nothing to do with being able to
redeem shares quickly. The shareholders of an MMF could deposit money
and never touch it again, and it would have no effect on the ability of
the MMF to maintain a $1 NAV.

Like any other mutual fund, a money-market fund has professional
management, has some expenses, etc. The return is usually slightly more
than banks pay on demand deposits, and perhaps a bit less than a bank
will pay on a 6-month CD. Money-market funds invest in short-term
(e.g., 30-day) securities from companies or governments that are highly
liquid and low risk. If you have a cash balance with a brokerage house,
it's most likely stashed in a money-market fund.


--------------------Check for updates------------------

Subject: Mutual Funds - Reading a Prospectus

Last-Revised: 9 Aug 1999
Contributed-By: Chris Stallman (chris at teenanalyst.com)

Ok, so you just went to a mutual fund family's (e.g., Fidelity) web site
and requested your first prospectus. As you anxiously wait for it to
arrive in the mail, you start to wonder what information will be in it
and how you'll manage to understand it. Understanding a prospectus is
crucial to investing in a mutual fund once you know a few key points.

When you request information on a mutual fund, they usually send you a
letter mentioning how great the fund is, the necessary forms you will
have to fill out to invest in the fund, and a prospectus. You can
usually just throw away the letter because it is often more of an
advertisement than anything else. But you should definitely read the
prospectus because it has all the information you need about the mutual
fund.

The prospectus is usually broken up into different sections so we'll go
over what each section's purpose is and what you should look for in it.



Objective Statement


Usually near the front of a prospectus is a small summary or
statement that explains the mutual fund. This short section tells
what the goals of the mutual fund are and how it plans to reach
these goals.

The objective statement is really important in choosing your fund.
When you choose a fund, it is important to choose one based on your
investment objective and risk tolerance. The objective statement
should agree with how you want your money managed because, after
all, it is your money. For example, if you wanted to reduce your
exposure to risk and invest for the long-term, you wouldn't want to
put your money in a fund that invests in technology stocks or other
risky stocks.


Performance


The performance section usually gives you information on how the
mutual fund has performed. There is often a table that gives you
the fund's performance over the last year, three years, five years,
and sometimes ten years.

The fund's performance usually helps you see how the fund might
perform but you should not use this to decide if you are going to
invest in it or not. Funds that do well one year don't always do
well the next.

It's often wise to compare the fund's performance with that of the
index. If a fund consistently under performs the index by 5% or
more, it may not be a fund that you want to invest in for the
long-term because that difference can mean the difference of
retiring with $200,000 and retiring with $1.5 million.

Usually in the performance section, there is a small part where
they show how a $10,000 investment would perform over time. This
helps give you an idea of how your money would do if you invested
in it but this number generally doesn't include taxes and inflation
so your portfolio would probably not return as much as the
prospectus says.


Fees and Expenses


Like most things in life, a mutual fund doesn't operate for free.
It costs a mutual fund family a lot of money to manage everyone's
money so they put in some little fees that the investors pay in
order to make up for the fund's expenses.

One fee that you will come across is a management fee, which all
funds charge. Mutual funds charge this fee so that the fund can be
run. The money collected from the shareholders from this fee is
used to pay for the expenses incurred from buying and selling large
amounts of shares in stocks. This fee usually ranges from about
0.5% up to over 2%.

Another fee that you're likely to encounter is a 12b-1 fee. The
money collected from charging this fee is usually used for
marketing and advertising the fund. This fee usually ranges
between 0.25-0.75%. However, not all funds charge a 12b-1 fee.

One fee that is a little less common but still exists in many funds
is a deferred sales load. Frequent buying and selling of shares in
a mutual fund costs the mutual fund money so they created a
deferred sales charge to discourage this activity. This fee
sometimes disappears after a certain period and can range from 0.5%
up to 5%.

When you are looking through a prospectus, be sure that you look
over these fees because even if a mutual fund performs well, its
growth may be limited by high expenses.


How to Purchase and Redeem Shares

This section provides information on how you can get your money
into the mutual fund and how you can sell shares when you need the
money out of the fund. These methods are usually the same in every
fund.

The most common method to invest in a fund once you are in it is to
simply fill out investment forms and write a check to the mutual
fund family. This is probably the easiest but it often takes a few
days or even a week to have the funds credited to your account.

Another method that is common is automatic withdrawals. These
allow you to have a certain amount which you choose to be deducted
from your bank account each month. These are excellent for getting
into the habit of investing on a regular basis.

Wire transfers are also possible if you want to have your money
invested quickly. However, most funds charge you a small fee for
doing this and some do not allow you to wire any funds if you do
not meet their minimum amount.

The fund will also provide information on how you can redeem your
shares. One common way is to request a redemption by filling out a
form or writing a letter to the mutual fund family. This is the
most common method but it isn't the only one.

You can also request to redeem your shares by calling the mutual
fund itself. This option saves you a few days but you have to make
sure the fund has this option open to the shareholders.

You can also request to have your investment wired into your bank
account. This is a very fast method for redeeming shares but you
usually have to pay a fee for doing this. And like redeeming
shares over the phone, you have to make sure the mutual fund offers
this option.


Now that you understand the basics of a prospectus, you're one step
closer to getting started in mutual funds. So when you finally receive
the information you requested on a mutual fund, look it over carefully
and make an educated decision if it is right for you.

For more insights from Chris Stallman, visit



--------------------Check for updates------------------

Subject: Mutual Funds - Redemptions

Last-Revised: 5 May 1997
Contributed-By: A. Chowdhury

On the stock markets, every time someone sells a share, someone buys it,
or in other words, equal numbers of opposing bets on the future are
placed each day. However, in the case of open-end mutual funds, every
dollar redeemed in a day isn't necessarily replaced by an invested
dollar, and every dollar invested in a day doesn't go to someone
redeeming shares. Still, although mutual fund shares are not sold
directly by one investor to another investor, the underlying situation
is the same as stocks.

If a mutual fund has no cash, any redemption requires the fund manager
to sell an appropriate amount of shares to cover the redemption; i.e.,
someone would have to be found to buy those shares. Similarly, any new
investment would require the manager to find someone to sell shares so
the new investment can be put to work. So the manager acts somewhat
like the fund investor's representative in buying/selling shares.

A typical mutual fund has some cash to use as a buffer, which confuses
the issue but doesn't fundamentally change it. Some money comes in, and
some flows out, much of it cancels each other out. If there is a small
imbalance, it can be covered from the fund's cash position, but not if
there is a big imbalance. If the manager covers your sale from the
fund's cash, he/she is reducing the fund's cash and so increasing the
fund's stock exposure (%), in other words he/she is betting on the
market at the same time as you are betting against it. Of course if
there is a large imbalance between money coming in and out, exceeding
the cash on hand, then the manager has to go to the stock market to
buy/sell. And so forth.


--------------------Check for updates------------------

Subject: Mutual Funds - Types of Funds

Last-Revised: 12 Aug 1999
Contributed-By: Chris Lott ( contact me )

This article lists the most common investment fund types. A type of
fund is typically characterized by its investment strategy (i.e., its
goals). For example, a fund manager might set a goal of generating
income, or growing the capital, or just about anything. (Of course they
don't usually set a goal of losing money, even though that might be one
of the easist goals to achieve :-). If you understand the types of
funds, you will have a decent grasp on how funds invest their money.

When choosing a fund, it's important to make sure that the fund's goals
align well with your own. Your selection will depend on your investment
strategy, tax situation, and many other factors.



Money-market funds
Goal: preserve principal while yielding a modest return. These
funds are a very special sort of mutual fund. They invest in
short-term securities that pay a modest rate of interest and are
very safe. See the article on money-market funds elsewhere in this
FAQ for an explanation of the $1.00 share price, etc.


Balanced Funds
Goal: grow the principal and generate income. These funds buy both
stocks and bonds. Because the investments are highly diversified,
investors reduce their market risk (see the article on risk
elsewhere in this FAQ).


Index funds
Goal: match the performance of the markets. An index fund
essentially sinks its money into the market in a way determined by
some market index and does almost no further trading. This might
be a bond or a stock index. For example, a stock index fund based
on the Dow Jones Industrial Average would buy shares in the 30
stocks that make up the Dow, only buying or selling shares as
needed to invest new money or to cash out investors. The advantage
of an index fund is the very low expenses. After all, it doesn't
cost much to run one. See the article on index funds elsewhere in
this FAQ.


Pure bond funds
Bond funds buy bonds issued by many different types of companies.
A few varieties are listed here, but please note that the
boundaries are rarely as cut-and-dried as I've listed here.



Bond (or "Income") funds
Goal: generate income while preserving principal as much as
possible. These funds invest in medium- to long-term bonds
issued by corporations and governments. Variations on this
type of fund include corporate bond funds and government bond
funds. See the article on bond basics elsewhere in this FAQ.
Holding long-term bonds opens the owner to the risk that
interest rates may increase, dropping the value of the bond.


Tax-free Bond Funds (aka Tax-Free Income or Municipal Bond Funds)
Goal: generate tax-free income while preserving principal as
much as possible. These funds buy bonds issued by
municipalities. Income from these securities are not subject
to US federal income tax.


Junk (or "High-yield") bond funds
Goal: generate as much income as possible. These funds buy
bonds with ratings that are quite a bit lower than
high-quality corporate and government bonds, hence the common
name "junk." Because the risk of default on junk bonds is high
when compared to high-quality bonds, these funds have an added
degree of volatility and risk.



Pure stock funds
Stock funds buy shares in many different types of companies. A few
varieties are listed here, but please note that the boundaries are
rarely as cut-and-dried as I've listed here.



Aggressive growth funds
Goal: capital growth; dividend income is neglected. These
funds buy shares in companies that have the potential for
explosive growth (these companies never pay dividends). Of
course such shares also have the potential to go bankrupt
suddenly, so these funds tend to have high price volatility.
For example, an actively managed aggressive-growth stock fund
might seek to buy the initial offerings of small companies,
possibly selling them again very quickly for big profits.


Growth funds
Goal: capital growth, but consider some dividend income.
These funds buy shares in companies that are growing rapidly
but are probably not going to go out of business too quickly.


Growth and Income funds
Goal: Grow the principal and generate some income. These
funds buy shares in companies that have modest prospect for
growth and pay nice dividend yields. The canonical example of
a company that pays a fat dividend without growing much was a
utility company, but with the onset of deregulation and
competition, I'm not sure of a good example anymore.


Sector funds
Goal: Invest in a specific industry (e.g.,
telecommunications). These funds allow the small investor to
invest in a highly select industry. The funds usually aim for
growth.


Another way of categorizing stock funds is by the size of the
companies they invest in, as measured by the market capitalization,
usually abbreviated as market cap. (Also see the article in the
FAQ about market caps .) The three main categories:



Small cap stock funds
These funds buy shares of small companies. Think new IPOs.
The stock prices for these companies tend to be highly
volatile, and the companies never (ever) pay a dividend. You
may also find funds called micro cap, which invest in the
smallest of publically traded companies.


Mid cap stock funds
These funds buy shares of medium-size companies. The stock
prices for these companies are less volatile than the small
cap companies, but more volatile (and with greater potential
for growth) than the large cap companies.


Large cap stock funds
These funds buy shares of big companies. Think IBM. The
stock prices for these companies tend to be relatively stable,
and the companies may pay a decent dividend.



International Funds
Goal: Invest in stocks or bonds of companies located outside the
investor's home country. There are many variations here. As a
rule of thumb, a fund labeled "international" will buy only foreign
securities. A "global" fund will likely spread its investments
across domestic and foreign securities. A "regional" fund will
concentrate on markets in one part of the world. And you might see
"emerging" funds, which focus on developing countries and the
securities listed on exchanges in those countries.

In the discussion above, we pretty much assumed that the funds
would be investing in securities issued by U.S. companies. Of
course any of the strategies and goals mentioned above might be
pursued in any market. A risk in these funds that's absent from
domestic investments is currency risk. The exchange rate of the
domestic currency to the foreign currency will fluctuate at the
same time as the investment, which can easily increase -- or
reverse -- substantial gains abroad.
Another important distinction for stock and bond funds is the difference
between actively managed funds and index funds. An actively managed
fund is run by an investment manager who seeks to "beat the market" by
making trades during the course of the year. The debate over manged
versus index funds is every bit the equal of the debate over load versus
no-load funds. YOU decide for yourself.


--------------------Check for updates------------------

Subject: Mutual Funds - Versus Stocks

Last-Revised: 10 Aug 1999
Contributed-By: Maurice E. Suhre, Chris Lott ( contact me )

This article discusses the relative advantages of stocks and mutual
funds.

Question: What advantages do mutual funds offer over stocks?

Here are some considerations.
* A mutual fund offers a great deal of diversification starting with
the very first dollar invested, because a mutual fund may own tens
or hundreds of different securities. This diversification helps
reduce the risk of loss because even if any one holding tanks, the
overall value doesn't drop by much. If you're buying individual
stocks, you can't get much diversity unless you have $10K or so.
* Small sums of money get you much further in mutual funds than in
stocks. First, you can set up an automatic investment plan with
many fund companies that lets you put in as little as $50 per
month. Second, the commissions for stock purchases will be higher
than the cost of buying no-load funds :-) (Of course, the fund's
various expenses like commissions are already taken out of the
NAV). Smaller sized purchases of stocks will have relatively high
commissions on a percentage basis, although with the $10 trade
becoming common, this is a bit less of a concern than it once was.
* You can exit a fund without getting caught on the bid/ask spread.
* Funds provide a cheap and easy method for reinvesting dividends.
* Last but most certainly not least, when you buy a fund you're in
essence hiring a professional to manage your money for you. That
professional is (presumably) monitoring the economy and the markets
to adjust the fund's holdings appropriately.

Question: Do stocks have any advantages compared to mutual funds?

Here are some considerations that will help you judge.
* The opposite of the diversification issue: If you own just one
stock and it doubles, you are up 100%. If a mutual fund owns 50
stocks and one doubles, it is up 2%. On the other hand, if you own
just one stock and it drops in half, you are down 50% but the
mutual fund is down 1%. Cuts both ways.
* If you hold your stocks several years, you aren't nicked a 1% or so
management fee every year (although some brokerage firms charge if
there aren't enough trades).
* You can take your profits when you want to and won't inadvertently
buy a tax liability. (This refers to the common practice among
funds of distributing capital gains around November or December of
each year. See the article elsewhere in this FAQ for more
details.)
* You can do a covered write option strategy. (See the article on
options on stocks for more details.)
* You can structure your portfolio differently from any existing
mutual fund portfolio. (Although with the current universe of
funds I'm not certain what could possibly be missing out there!)
* You can buy smaller cap stocks which aren't suitable for mutual
funds to invest in.
* You have a potential profit opportunity by shorting stocks. (You
cannot, in general, short mutual funds.)
* The argument is offered that the funds have a "herd" mentality and
they all end up owning the same stocks. You may be able to pick
stocks better.


--------------------Check for updates------------------

Subject: Real Estate - 12 Steps to Buying a Home

Last-Revised: 19 Sep 1999
Contributed-By: Blanche Evans

Why do you want to make a change? Are you ready to start a family, plant
your own garden? Do you feel you've finally "arrived" at your company?
Maybe a raise, or a bonus, or a baby on the way has made you think about
living in a home of your own.

Whatever the reason you are thinking about a home, there are 12 steps
you will inevitably take. If you do them in the right order, you will
save yourself time, frustration, and money. For example, if you start
shopping for homes on the Internet without knowing how much you can
spend, you will not only waste time looking at the wrong homes, but you
may ultimately be disappointed at what you can actually afford.
1. FIND OUT HOW MUCH YOU CAN SPEND

The first thing you need to do is figure out what kind of home you
want to buy and how much you can afford to pay in monthly
installments.

Keep in mind that the results of your calculations will only be an
estimate. Until you have chosen a home and the type of loan you
want, and communicated with a lender, you can only use the
calculated amount to help you determine a price range of homes you
want to preview.


2. GET PRE-APPROVED FOR A LOAN

Either go to a mortgage broker or a direct lender and find out for
certain the size of mortgage for which you can qualify. The
pre-approval letter the lender issues you will help you be taken
more seriously by agents and sellers because they will recognize
you as someone who is prepared to buy. If you want a larger
mortgage or better rate, investigate the government sites such as
HUD.


3. HIRE AN AGENT, PARTICULARLY A BUYER'S AGENT

Using an agent can help you in numerous ways, especially because
you are already paying for those services in the purchase price of
the home. Both the seller's agent and the buyer's agent are paid
out of the transaction proceeds that are included in the marketing
price of the home. If you don't take advantage of an agent, you
are paying for services you aren't getting. If you are planning to
buy a home available through foreclosure or a for-sale-by-owner
(FSBO), you can still use the services of an agent. Agents will
negotiate with you on their fees and the amount of service you will
receive for those fees, and you can arrange for them to be paid out
of the transaction, not out of your pocket.

Start by narrowing the field. If you are interested in a certain
neighborhood in your town, find out who the experts are in that
area of town. They will be better informed and more attuned to the
"grapevine," and are better positioned to network with other agents
in the same area. Contrary to popular belief only 20 percent of
homes are actually sold through newspaper ads. The other 80
percent are sold through networking among agents. If you are
relocating to a new city, ask agents in your own town to refer you
to agents in your new area. They will be happy to do so, because
if you buy a home from their referral, they will receive a referral
fee, so they are motivated to make certain you find the right agent
to assist you in buying a home.


4. SIGN A BUYER'S AGREEMENT

Again, if you find an agent you like, go all the way and sign a
buyer's representation agreement. This agreement means that you
will have one agent representing you as a buyer. The agreement
empowers the agent to not only search out the latest Multiple
Listing Service list, but to seek alternative means of finding you
a home, including searching foreclosures and homes for sale by
owner. With a signed agreement, the agent becomes a fiduciary and
must act, by law, in your best interests.


5. BE AWARE OF YOUR LIKES AND DISLIKES

As you shop for homes, keep in mind what you like and don't like
and pass along your feelings to the agent. You should feel
comfortable looking at numerous homes, but neither you nor your
agent is interested in wasting time on homes that aren't
appropriate. Like any relationship, your home will not be perfect.
If you are finding that most of your criteria is met, it shouldn't
be long before you find the right home. Think in terms of
possibilities as well as what you see is what you get. Perhaps a
home isn't move-in perfect, but with a little work it could be the
home for you. Don't let cosmetic or minor remodeling problems
discourage you. Many remodeling jobs add tremendous value to a
home. If you remodel a kitchen, for example, you may receive as
much as a 128 percent return on your investment. Talk with your
agent, friends, relatives, and contractors and find out what it
will cost to remodel the home the way you want it.


6. WRITE A CONTRACT

When you find the home you want, you will write a contract, either
through your agent or your attorney, or on your own. Your offer
should spell out what you are willing to pay for and what you are
not, when you want to close, and when you want to take possession
of the home. Your contract should be contingent upon getting an
inspection and evaluating the results. If the inspection reveals a
big problem, you and the seller can renegotiate the purchase price
if you are still interested in buying.


7. GET THE LOAN UNDERWAY

As soon as the seller agrees to the contract, you must start
following through on your loan. Take the contract to the lender
and let it start the loan process in earnest. If you have been
preapproved, much of the legwork has already been done and your
loan will process more quickly.


8. THE HOME WILL BE APPRAISED

The lender will arrange to have the home appraised, which may
affect whether the loan is granted. But the likelihood of a
homeselling for more than a lender is willing to lend is slim. The
real estate industry not only keeps up with how quickly homes sell,
but how much they sell for in an area. Most lenders will have a
ceiling on the amount of square feet per home they will lend in a
certain neighborhood. If a home is overpriced, it will quickly be
obvious. You can then go back to the seller and renegotiate.


9. THE HOME IS INSPECTED

In many markets, you will have the inspection after the contract is
signed, rather than before. This is a better protection for the
buyer. The inspection can reveal some nasty shocks, though. Your
inspector may find a major problem with the furnace or the
foundation. These are problems that must be fixed or the home
cannot be conveyed. The seller then has to arrange to pay for the
repairs, or have the repairs paid for out of the contract proceeds
via a mechanic's lien. Before you can truly set the closing date,
the repairs have to be made and approved by the buyer.


10. NEGOTIATIONS CONTINUE AS YOU GET READY TO MOVE

As you find a mover, pack your things, and arrange days off a work
around the closing date, you will find that things can still
change. It is the most intense, nerve-wracking time of the
transaction -- waiting for the other shoe to drop. You think you
may have addressed all the issues and closing will proceed without
any other hitches, but negotiations still continue as you
reevaluate the inspection report, or find out the chandelier you
thought was included is actually excluded from the contract. As
you revisit the home to show your relatives, your hopes raise, even
through your doubts that the home will ever be yours increase.


11. CLOSING -- BE PREPARED FOR ANYTHING TO HAPPEN

Until closing, and even during closing, anything can happen. You
find out that your closing costs are higher than you thought they
would be because some additional service fees have been added by
the lender. A glitch could come out in your credit report that
delays the sale; a problem the owner was supposed to fix wasn't
repaired in time; the homeowner can decide that she or he doesn't
want to pay for the home warranty after all; the appraisal may come
in the day before closing and be short of the asking price of the
home. If so, the buyer, seller, and their agents have to figure
out how to make up the shortfall. Do they lower the price of the
home? Do the agents pay for the difference out of their
commissions? How will last-minute problems be handled? The
negotiating table is an emotionally explosive place. That is why
closings are generally held in private rooms with the buyers and
sellers separated.


12. YOU GET THE KEYS

It's all over. The home is yours. Congratulations.

This article was excerpted from homesurfing.net: The Insider's Guide to
Buying and Selling Your Home Using the Internet , by Blanche Evans.
Copyright 1999 by Dearborn Financial Publishing. Reprinted by
permission of the publisher Dearborn, A Kaplan Professional Company.


--------------------Check for updates------------------

Subject: Real Estate - Investment Trusts (REITs)

Last-Revised: 8 Dec 1995
Contributed-By: Braden Glett (glett at prodigy.net)

A Real Estate Investment Trust (REIT) is a company that invests its
assets in real estate holdings. You get a share of the earnings,
depreciation, etc. from the portfolio of real estate holdings that the
REIT owns. Thus, you get many of the same benefits of being a landlord
without too many of the hassles. You also have a much more liquid
investment than you do when directly investing in real estate. The
downsides are that you have no control over when the company will sell
its holdings or how it will manage them, like you would have if you
owned an apartment building on your own.

Essentially, REITs are the same as stocks, only the business they are
engaged in is different than what is commonly referred to as "stocks" by
most folks. Common stocks are ownership shares generally in
manufacturing or service businesses. REITs shares on the other hand are
the same, just engaged in the holding of an asset for rental, rather
than producing a manufactured product. In both cases, though, the
shareholder is paid what is left over after business expenses,
interest/principal, and preferred shareholders' dividends are paid.
Common stockholders are always last in line, and their earnings are
highly variable because of this. Also, because their returns are so
unpredictable, common shareholders demand a higher expected rate of
return than lenders (bondholders). This is why equity financing is the
highest-cost form of financing for any corporation, whether the
corporation be a REIT or mfg firm.

An interesting thing about REITs is that they are probably the best
inflation hedge around. Far better than gold stocks, which give almost
no return over long periods of time. Most of them yield 7-10% dividend
yield. However, they almost always lack the potential for tremendous
price appreciation (and depreciation) that you get with most common
stocks. There are exceptions, of course, but they are few and far
between.

If you invest in them, pick several REITs instead of one. They are
subject to ineptitude on the part of management just like any company's
stock, so diversification is important. However, they are a rather
conservative investment, with long-term returns lower than common stocks
of other industries. This is because rental revenues do net usually
vary as much as revenues at a mfg or service firm.

REITNet, a full-service real estate information site, offers a
comprehensive guide to Real Estate Investment Trusts.



--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 10 of 20)

Archive-name: investment-faq/general/part10
Version: $Id: part10,v 1.62 2005/01/05 12:40:47 lott Exp lott $
Compiler: Christopher Lott

The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plain-text
version of The Investment FAQ, part 10 of 20. The web site
always has the latest version, including in-line links. Please browse



Terms of Use

The following terms and conditions apply to the plain-text version of
The Investment FAQ that is posted regularly to various newsgroups.
Different terms and conditions apply to documents on The Investment
FAQ web site.

The Investment FAQ is copyright 2005 by Christopher Lott, and is
protected by copyright as a collective work and/or compilation,
pursuant to U.S. copyright laws, international conventions, and other
copyright laws. The contents of The Investment FAQ are intended for
personal use, not for sale or other commercial redistribution.
The plain-text version of The Investment FAQ may be copied, stored,
made available on web sites, or distributed on electronic media
provided the following conditions are met:
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+ No fees or compensation are charged for this information,
excluding charges for the media used to distribute it.
+ No advertisements appear on the same web page as this material.
+ Proper attribution is given to the authors of individual articles.
+ This copyright notice is included intact.


Disclaimers

Neither the compiler of nor contributors to The Investment FAQ make
any express or implied warranties (including, without limitation, any
warranty of merchantability or fitness for a particular purpose or
use) regarding the information supplied. The Investment FAQ is
provided to the user "as is". Neither the compiler nor contributors
warrant that The Investment FAQ will be error free. Neither the
compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it. Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers. Readers outside the USA can reach
US-800 telephone numbers, for a charge, using a service such as MCI's
Call USA. All prices are listed in US dollars unless otherwise
specified.

Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Real Estate - Renting versus Buying a Home

Last-Revised: 21 Nov 1995
Contributed-By: Jeff Mincy (mincy at rcn.com), Chris Lott ( contact me )

This note will explain one way to compare the monetary costs of renting
vs. buying a home. It is extremely prejudiced towards the US system.
A few small C programs for computing future value, present value, and
loan amortization schedules (used to write this article) are available.
See the article "Software - Investment-Related Programs" elsewhere in
this FAQ for information about obtaining them.

1. Abstract
* If you are guaranteed an appreciation rate that is a few points
above inflation, buy.
* If the monthly costs of buying are basically the same as renting,
buy.
* The shorter the term, the more advantageous it is to rent.
* Tax consequences in the US are fairly minor in the long term.

2. Introduction
The three important factors that affect the analysis the most are the
following:
1. Relative cash flows; e.g., rent compared to monthly ownership
expenses
2. Length of term
3. Rate of appreciation

The approach used here is to determine the present value of the money
you will pay over the term for the home. In the case of buying, the
appreciation rate and thereby the future value of the home is estimated.
For home appreciate rates, find something like the tables published by
Case Schiller that show changes in house prices for your region. The
real estate section in your local newspaper may print it periodically.
This analysis neglects utility costs because they can easily be the same
whether you rent or buy. However, adding them to the analysis is
simple; treat them the same as the costs for insurance in both cases.

Opportunity costs of buying are effectively captured by the present
value. For example, pretend that you are able to buy a house without
having to have a mortgage. Now the question is, is it better to buy the
house with your hoard of cash or is it better to invest the cash and
continue to rent? To answer this question you have to have estimates for
rental costs and house costs (see below), and you have a projected
growth rate for the cash investment and projected growth rate for the
house. If you project a 4% growth rate for the house and a 15% growth
rate for the cash then holding the cash would be a much better
investment.

First the analysis for renting a home is presented, then the analysis
for buying. Examples of analyses over a long term and a short term are
given for both scenarios.

3. Renting a Home.


Step 1: Gather data
You will need:
* monthly rent
* renter's insurance (usually inexpensive)
* term (period of time over which you will rent)
* estimated inflation rate to compute present value
(historically 4.5%)
* estimated annual rate of increase in the rent (can use
inflation rate)


Step 2: Compute present value of payments
You will compute the present value of the cash stream that you will
pay over the term, which is the cost of renting over that term.
This analysis assumes that there are no tax consequences (benefits)
associated with paying rent.


3.1 A long-term example of renting


Rent = 990 / month
Insurance = 10 / month
Term = 30 years
Rent increases = 4.5% annually
Inflation = 4.5% annually
For this cash stream, present value = 348,137.17.






3.2 A short-term example of renting


Same numbers, but just 2 years.
Present value = 23,502.38



4. Buying a Home


Step 1: Gather data.
You need a lot to do a fairly thorough analysis:
* purchase price
* down payment and closing costs
* other regular expenses, such as condominium fees
* amount of mortgage
* mortgage rate
* mortgage term
* mortgage payments (this is tricky for a variable-rate
mortgage)
* property taxes
* homeowner's insurance (Note: this analysis neglects
extraordinary risks such as earthquakes or floods that may
cause the homeowner to incur a large loss due to a high
deductible in your policy. All of you people in California
know what I'm talking about.)
* your marginal tax bracket (at what rate is the last dollar
taxed)
* the current standard deduction which the IRS allows

Other values have to be estimated, and they affect the analysis
critically:

* continuing maintenance costs (I estimate 1/2 of PP over 30
years.)
* estimated inflation rate to compute present value
(historically 4.5%)
* rate of increase of property taxes, maintenance costs, etc.
(infl. rate)
* appreciation rate of the home (THE most important number of
all)


Step 2: Compute the monthly expense
This includes the mortgage payment, fees, property tax, insurance,
and maintenance. The mortgage payment is fixed, but you have to
figure inflation into the rest. Then compute the present value of
the cash stream.


Step 3: Compute your tax savings
This is different in every case, but roughly you multiply your tax
bracket times the amount by which your interest plus other
deductible expenses (e.g., property tax, state income tax) exceeds
your standard deduction. No fair using the whole amount because
everyone, even a renter, gets the standard deduction for free.
Must be summed over the term because the standard deduction will
increase annually, as will your expenses. Note that late in the
mortgage your interest payments will be be well below the standard
deduction. I compute savings of about 5% for the 33% tax bracket.


Step 4: Compute the present value
First you compute the future value of the home based on the
purchase price, the estimated appreciation rate, and the term.
Once you have the future value, compute the present value of that
sum based on the inflation rate you estimated earlier and the term
you used to compute the future value. If appreciation is greater
than inflation, you win. Else you break even or even lose.

Actually, the math of this step can be simplified as follows:


/periods + appr_rate/100\ ^ (periods *
yrs)
prs-value = cur-value * | ----------------------- |
\periods + infl_rate/100/



Step 5: Compute final cost
All numbers must be in present value.
Final-cost = Down-payment + S2 (expenses) - S3 (tax sav) - S4 (prop
value)


4.1 Long-term example Nr. 1 of buying: 6% apprecation


Step 1 - the data
* Purchase price = 145,000
* Down payment etc = 10,000
* Mortgage amount = 140,000
* Mortgage rate = 8.00%
* Mortgage term = 30 years
* Mortgage payment = 1027.27 / mo
* Property taxes = about 1% of valuation; I'll use 1200/yr =
100/mo (Which increases same as inflation, we'll say. This
number is ridiculously low for some areas, but hey, it's just
an example!)
* Homeowner's ins. = 50 / mo
* Condo. fees etc. = 0
* Tax bracket = 33%
* Standard ded. = 5600 (Needs to be updated)

Estimates:
* Maintenance = 1/2 PP is 72,500, or 201/mo; I'll use 200/mo
* Inflation rate = 4.5% annually
* Prop. taxes incr = 4.5% annually
* Home appreciates = 6% annually (the NUMBER ONE critical
factor)


Step 2 - the monthly expense
The monthly expense, both fixed and changing components:
Fixed component is the mortgage at 1027.27 monthly. Present value
= 203,503.48. Changing component is the rest at 350.00 monthly.
Present value = 121,848.01. Total from Step 2: 325,351.49


Step 3 - the tax savings
I use my loan program to compute this. Based on the data given
above, I compute the savings: Present value = 14,686.22. Not much
when compared to the other numbers.


Step 4 - the future and present value of the home
See data above. Future value = 873,273.41 and present value =
226,959.96 (which is larger than 145k since appreciation is larger
than inflation). Before you compute present value, you should
subtract reasonable closing costs for the sale; for example, a real
estate broker's fee.


Step 5 - the final analysis for 6% appreciation
Final = 10,000 + 325,351.49 - 14,686.22 - 226,959.96
= 93,705.31


So over the 30 years, assuming that you sell the house in the 30th year
for the estimated future value, the present value of your total cost is
93k. (You're 93k in the hole after 30 years, which means you only paid
260.23/month.)

4.2 Long-term example Nr. 2 of buying: 7% apprecation
All numbers are the same as in the previous example, however the home
appreciates 7%/year.
Step 4 now comes out FV=1,176,892.13 and PV=305,869.15
Final = 10,000 + 325,351.49 - 14,686.22 - 305,869.15
= 14796.12

So in this example, 7% was an approximate break-even point in the
absolute sense; i.e., you lived for 30 years at near zero cost in
today's dollars.

4.3 Long-term example Nr. 3 of buying: 8% apprecation
All numbers are the same as in the previous example, however the home
appreciates 8%/year.
Step 4 now comes out FV=1,585,680.80 and PV=412,111.55
Final = 10,000 + 325,351.49 - 14,686.22 - 412,111.55
= -91,446.28

The negative number means you lived in the home for 30 years and left it
in the 30th year with a profit; i.e., you were paid to live there.

4.4 Long-term example Nr. 4 of buying: 2% appreciation
All numbers are the same as in the previous example, however the home
appreciates 2%/year.
Step 4 now comes out FV=264,075.30 and PV=68,632.02
Final = 10,000 + 325,351.49 - 14,686.22 - 68,632.02
= 252,033.25

In this case of poor appreciation, home ownership cost 252k in today's
money, or about 700/month. If you could have rented for that, you'd be
even.

4.5 Short-term example Nr. 1 of buying: 6% apprecation
All numbers are the same as long-term example Nr. 1, but you sell the
home after 2 years. Future home value in 2 years is 163,438.17
Cost = down+cc + all-pymts - tax-savgs - pv(fut-home-value - remaining
debt)
= 10,000 + 31,849.52 - 4,156.81 - pv(163,438.17 - 137,563.91)
= 10,000 + 31,849.52 - 4,156.81 - 23,651.27
= 14,041.44

4.6 Short-term example Nr. 2 of buying: 2% apprecation
All numbers are the same as long-term example Nr. 4, but you sell the
home after 2 years. Future home value in 2 years is 150,912.54
Cost = down+cc + all-pymts - tax-savgs - pv(fut-home-value - remaining
debt)
= 10,000 + 31,849.52 - 4,156.81 - pv(150912.54 - 137,563.91)
= 10,000 + 31,849.52 - 4,156.81 - 12,201.78
= 25,490.93

5. A Question


Q: Is it true that you can usually rent for less than buying?

Answer 1: It depends. It isn't a binary state. It is a fairly complex
set of relationships.

In large metropolitan areas, where real estate is generally much more
expensive than elsewhere, then it is usually better to rent, unless you
get a good appreciation rate or if you are going to own for a long
period of time. It depends on what you can rent and what you can buy.
In other areas, where real estate is relatively cheap, I would say it is
probably better to own.

On the other hand, if you are currently at a market peak and the country
is about to go into a recession it is better to rent and let property
values and rent fall. If you are currently at the bottom of the market
and the economy is getting better then it is better to own.

Answer 2: When you rent from somebody, you are paying that person to
assume the risk of homeownership. Landlords are renting out property
with the long term goal of making money. They aren't renting out
property because they want to do their renters any special favors. This
suggests to me that it is generally better to own.

6. Conclusion


Once again, the three important factors that affect the analysis the
most are cash flows, term, and appreciation. If the relative cash flows
are basically the same, then the other two factors affect the analysis
the most.

The longer you hold the house, the less appreciation you need to beat
renting. This relationship always holds, however, the scale changes.
For shorter holding periods you also face a risk of market downturn. If
there is a substantial risk of a market downturn you shouldn't buy a
house unless you are willing to hold the house for a long period.

If you have a nice cheap rent controlled apartment, then you should
probably not buy.

There are other variables that affect the analysis, for example, the
inflation rate. If the inflation rate increases, the rental scenario
tends to get much worse, while the ownership scenario tends to look
better.


--------------------Check for updates------------------

Subject: Regulation - Accredited Investor

Last-revised: 1 May 2000
Contributed-By: Chris Lott ( contact me )

The SEC has established criteria for preventing people who perhaps
should know better from investing in unregistered securities and other
things that are less well known than stocks and bonds. For example, if
you've ever been interested in buying into a privately held company, you
have probably heard all about this. In a nutshell, for an individual to
be considered a qualified investor (also termed an accredited investor),
that person must either have a net worth of about a million bucks, or
have an annual income in excess of 200k. Companies who wish to raise
capital from individuals without issuing registered securities are
forced to limit their search to people who fall on the happy side of
these thresholds.

To read the language straight from the securities lawyers, follow this
link:



--------------------Check for updates------------------

Subject: Regulation - Full Disclosure

Last-revised: 30 Jan 2001
Contributed-By: Chris Lott ( contact me )

The full disclosure rules, also known as regulation FD, were enacted by
the SEC to ensure the flow of information to all investors, just just
well-connected insiders. Basically the rule says that publically held
companies must disclose all material information that might affect
investment decisions to all investors at the same time. The intent was
to level the playing field for all investors. Regulation FD became
effective on 23 October 2000.

What was life like before this rule? Basically there was selective
disclosure. Before regulation FD, companies communicated well with
securities analysts who followed the company (the so-called back
channel), but not necessarily as well with individual investors.
Analysts were said to interpret the information from companies for the
public's benefit. So for example, if a company noticed that sales were
weak and that earnings might be poor, the company might call a group of
analysts and warn them of this fact. The analysts in turn could tell
their big (big) clients this news, and then eventually publish the
information for the general public (i.e., small clients). Put simply,
if you were big, you could get out before a huge price drop, or get in
before a big move up. If you were small, you had no chance.

Now, information is made available without any intermediaries like
analysts to interpret (or spin) it before it reaches the public. There
have been some very noticeable consequences of forcing companies to
grant all investors equal access to a company's material disclosures at
the same time. For example, company conference calls that were once
reserved for analysts only are now accessible to the general public.
Another example is that surprises (e.g., earnings shortfalls) are true
surprises to everyone, which leads to more frequent occurrences of large
changes in a stock's price. Finally, now that analysts no longer have
an easy source of information about the companies that they follow, they
are forced to do research on their companies - much harder work than
before. Some have predicted wide-spread layoffs of analysts because of
the change.

Timely information (i.e., disclosures) are filed with the SEC in 8-K
documents. Note that disclosures can be voluntary (i.e., planned) or
involuntary (i.e., goofs). In either case, the new rule says that the
company has to disclose the information to everyone as quickly as
possible. So an 8-K might get filed unexpectedly because a company exec
accidentally disclosed material information during a private meeting.

Here are some sites with more information.
* FDExpress, a service of Edgar. Subscription required to access
company filings.

* CCBN, a company that provides investor relations services.



--------------------Check for updates------------------

Subject: Regulation - Money-Supply Measures M1, M2, and M3

Last-Revised: 4 Jan 2002
Contributed-By: Ralph Merritt

The US Federal Reserve Board measures the money supply using the
following measures.

M1 Money that can be spent immediately. Includes cash, checking
accounts, and NOW accounts.
M2 M1 + assets invested for the short term. These assets include
money- market accounts and money-market mutual funds.
M3 M2 + big deposits. Big deposits include institutional money-market
funds and agreements among banks.


The pamphlet "Modern Money Mechanics," which explains M1, M2, and M3 in
gory detail, was once available free from the Federal Reserve Bank of
Chicago. That pamphlet is no longer in print, and the Chicago Fed
apparently has no plans to re-issue it. However, electronic copies of
it are out there, and here's one:



--------------------Check for updates------------------

Subject: Regulation - Federal Reserve and Interest Rates

Last-Revised: 25 Apr 1997
Contributed-By: Jeffrey J. Stitt, Himanshu Bhatt, Nikolaos Bernitsas,
Joe Lau

This article discusses the interest rates which are managed or
influenced by the US Federal Reserve Bank, a collective term for the
collection of Federal Reserve Banks across the country.

The Discount Rate is the interest rate charged by the Federal Reserve
when banks borrow "overnight" from the Fed. The discount rate is under
the direct control of the Fed. The discount rate is always lower than
the Federal Funds Rate (see below). Generally only large banks borrow
directly from the Fed, and thus get the benefit of being able to borrow
at the lower discount rate. As of April 1997, the discount rate was
5.00%.

The Federal Funds Rate is the interest rate charged by banks when banks
borrow "overnight" from each other. The funds rate fluctuates according
to supply and demand and is not under the direct control of the Fed, but
is strongly influenced by the Fed's actions. As of April 1997, the
target funds rate is 5.38%; the actual rate varies above and below that
figure.

The Fed adjusts the funds rate via "open market operations". What
actually happens is that the Fed sells US treasury securities to banks.
As a result, the bank reserves at the Fed drop. Given that banks have
to maintain at the Fed a certain level of required reserves based on
their demand deposits (checking accounts), they end up borrowing more
from each other to cover their short position at the Fed. The resulting
pressure on intrabank lending funds drives the funds rate up.

The Fed has no idea of how many billions of US treasuries it needs to
sell in order for the funds rate to reach the Fed's target. It goes by
trial and error. That's why it takes a few days for the funds rate to
adjust to the new target following an announcement.

Adjustments in the discount rate usually lag behind changes in the funds
rate. Once the spread between the two rates gets too large (meaning fat
profits for the big banks which routinely borrow from the Fed at the
discount rate and lend to smaller banks at the funds rate) the Fed moves
to adjust the discount rate accordingly. It usually happens when the
spread reaches about 1%.

Another interest rate of significant interest is the Prime Rate, the
interest that a bank charges its "best" customers. There is no single
prime rate, but the commercial banks generally offer the same prime
rate. The Fed does not adjust a bank's prime rate directly, but
indirectly. The change in discount rates will affect the prime rate.
As of April, 1997 the prime rate is 8.5%.

For an in-depth look at the Federal Reserve, get the book by William
Greider titled Secrets of the temple: How the Federal Reserve runs the
country .


--------------------Check for updates------------------

Subject: Regulation - Margin Requirements

Last-Revised: 26 May 2002
Contributed-By: Chris Lott ( contact me ), John Marucco

This article discusses the rules and regulations that apply to margin
accounts at brokerage houses. The basic rules are set by the Federal
Reserve Board (FRB), the New York Stock Exchange (NYSE), and the
National Asssociation of Securities Dealers (NASD). Every broker must
apply the minimum rules to customers, but a broker is free to apply more
stringent requirements. Also see the article elsewhere in the FAQ for
an explanation of a margin account versus a cash account .

Buying on margin means that your broker loans you money to make a
purchase. But how much can you borrow? As it turns out, the amount of
debt that you can establish and maintain with your broker is closely
regulated. Here is a summary of those regulations.

The Federal Reserve Board's Regulation T states how much money you may
borrow to establish a new position . Briefly, you may borrow 50% of the
cost of the new position. For example, $100,000 of cash can be used to
buy $200,000 worth of stock.

The NYSE's Rule 431 and the NASD's Rule 2520 both state how much money
you can continue to borrow to hold an open position . In brief, you
must maintain 25% equity for long positions and 30% equity for short
positions. Continuing the example in which $100,000 was used to buy
$200,000 of stock, the account holder would have to keep holdings of
$50,000 in the account to maintain the open long position. The best
holding in this case is of course cash; a $200,000 margined position can
be kept open with $50,000 of cash. If the account holder wants to use
fully paid securities to meet the maintenance requirement, then
securities (i.e., stock) with a loan value of $50,000 are required. See
the rule above - you can only borrow up to 50% - so to achieve a loan
value of $50,000, the account holder must have at least $100,000 of
fully paid securities in the account.

If the value of the customer's holdings drops to less than 25% of the
value of open positions (maybe some stocks fell in price dramatically),
than the brokerage house is required to impose a margin call on the
account holder. This means that the person must either sell open
positions, or deposit cash and/or securities, until the account equity
returns to 25%. If the account holder doesn't meet the margin call,
then four times the amount of the call will be liquidated within the
account.

Here are a few examples, showing Long Market, Short Market, Debit
Balance, Credit Balance, and Equity numbers for various situations.
Remember, Equity is the Long Market Value plus the Credit Balance, less
any Short Market Value and Debit Balance. (The Current Market Value of
securities is the Long Market value less the Short Market value.) The
Credit Balance is cash - money that is left over after everything is
paid and all margin requirements are satisfied. This is supposed to
give a feel for how a brokerage statement is marked to market each day.

So in the first example, a customer buys 100,000 worth of some stock on
margin. The 50% margin requirement (Regulation T) can be met with
either stock or cash.

To satisfy the margin requirement with cash , the customer must deposit
50,000 in cash. The account will then appears as follows; the "Equity"
reflects the cash deposit: Long
Market Short
Market Credit
Balance Debit
Balance
Equity
------------------------------------------------------------ -----------
100,000 0 0 50,000 50,000


To satisfy the margin requirement with stock , the customer must deposit
marginable stock with a loan value of 50,000 (two times the amount of
the call). The account will then appears as follows; the 200,000 of
long market consists of 100,000 stock deposited to meet reg. T and
100,000 of the stock purchased on margin: Long
Market Short
Market Credit
Balance Debit
Balance
Equity
------------------------------------------------------------ -----------
200,000 0 0 100,000 100,000


Here's a new example. What if the account looks like this: Long
Market Short
Market Credit
Balance Debit
Balance
Equity
------------------------------------------------------------ -----------
20,000 0 0 17,000 3,000
The maintenance requirement calls for an equity position that is 25% of
20,000 which is 5,000, but equity is only 3,000. Because the equity is
less than 25% of the market value, a maintenance (aka margin) call is
triggered. The call is for the difference between the requirement and
actual equity, which is 5,000 - 3,000 or 2000. To meet the call, either
2,000 of cash or 4,000 of stock must be deposited. Here is what would
happen if the account holder deposits 2,000 in cash; note that the cash
deposit pays down the loan. Long
Market Short
Market Credit
Balance Debit
Balance
Equity
------------------------------------------------------------ -----------
20,000 0 0 15,000 5,000


Here is what would happen if the account holder deposits 4,000 of stock:
Long
Market Short
Market Credit
Balance Debit
Balance
Equity
------------------------------------------------------------ -----------
24,000 0 0 17,000 7,000


Ok, now what happens if the account holder does not meet the call? As
mentioned above, four times the amount of the call will be sold. So
stock in the amount of 8,000 will be sold and the account will look like
this: Long
Market Short
Market Credit
Balance Debit
Balance
Equity
------------------------------------------------------------ -----------
12,000 0 0 9,000 3,000


In the case of short sales, Regulation T imposes an initial margin
requirement of 150%. This sounds extreme, but the first 100% of the
requirement can be satisified by the proceeds of the short sale, leaving
just 50% for the customer to maintain in margin (so it looks much like
the situation for going long). To maintain a short position, rule 2520
requires margin of $5 per share or 30 percent of the current market
value (whichever is greater).

Let's say a person shorts $10,000 worth of stock. They must have
securities with a loan value of at least $5,000 to comply with
regulation T. In this example, to keep things simple, the customer
deposits cash. So the Credit Balance consists of the 10,000 in proceeds
from the short sale plus the 5,000 Regulation T deposit. Remember that
market value is long market value minus short market value, and because
we gave our customer no securities in this example, the "long market"
value is zero, making the market value negative. Long
Market Short
Market Credit
Balance Debit
Balance
Equity
------------------------------------------------------------ -----------
0 10,000 15,000 0 5,000


While we're discussing shorting, what about being short against the box?
(Also see the FAQ article about short-against-the-box positions .) When
an individual is long a stock position and then shorts the same stock, a
separate margin requirement is applicable. When shorting a position
that is long in an account the requirement is 5% of the market value of
the underlying stock. Let's say the original stock holding of $100,000
was purchased on margin (with a corresponding 50% requirement). And the
same holding is sold short against the box, yielding $100,000 of
proceeds that is shown in the Credit Balance column, plus a cash deposit
of $5,000. The account would look like this: Long
Market Short
Market Credit
Balance Debit
Balance
Equity
------------------------------------------------------------ -----------
Initial position 100,000 50,000 50,000
Sell short 0 100,000 105,000 100,000 5,000
Net 100,000 100,000 105,000 150,000 55,000


Customer accounts are suppsed to be checked for compliance with
Regulation T and Rule 2520 at the end of each trading day. A brokerage
house may impose a margin call on an account holder at any time during
the day, though.

Finally, special conditions apply to day-traders. Check with your
broker.

Here are some additional resources:
* The NASD's Investor Education section has information about margin:

* The full text of Regulation T



--------------------Check for updates------------------

Subject: Regulation - Securities and Exchange Commission (U.S.)

Last-revised: 22 Dec 1999
Contributed-By: Dennis Yelle

Just in case you want to ask questions, complain about your broker, or
whatever, here's the vital information:

Securities and Exchange Commission
450 5th Street, N. W.
Washington, DC 20549


Office of Public Affairs: +1 202 272-2650
Office of Consumer Affairs: +1 202 272-7440

SEC policy concerning online enforcement:


A web-enabled complaint submission form:


E-Mail address for complaints:




--------------------Check for updates------------------

Subject: Regulation - SEC Rule 144

Last-Revised: 6 June 2000
Contributed-By: Bill Rini (bill at moneypages.com), Julie O'Neill
(joneill at feinberglawgroup.com)

The Federal Securities Act of 1933 generally requires that stock and
other securities must be registered with the Securities and Exchange
Commission (the "S.E.C.") prior to their offer or sale. Registering
securities with the S.E.C. can be expensive and time-consuming. This
article offers a brief introduction to SEC Rule 144, which allows for
the sale of restricted securities in limited quantities without
requiring the securities to be registered.

First it's probably appropriate to explain the basics of restricted
securities. Restricted securities are generally those which are first
issued in a private placement exempt from registration and which bear a
restrictive legend. The legend commonly states that the securities are
not registered and cannot be offered or sold unless they are registered
with the S.E.C. or exempt from registration. The restrictive legend
serves to ensure that the initial, unregistered sale is not part of a
scheme to avoid registration while achieving some broader distribution
than the initial sale. Normally, if securities are registered when they
are first issued, then they do not bear any restrictive legend and are
not deemed restricted securities.

Rule 144 generally applies to corporate insiders and buyers of private
placement securities that were not sold under SEC registration statement
requirements. Corporate insiders are officers, directors, or anyone
else owning more than 10% of the outstanding company securities. Stock
either acquired through compensation arrangements or open market
purchases is considered restricted for as long as the insider is
affiliated with the company. For example, if a corporate officer
purchases shares in his or her employer on the open market, then the
officer must comply with Rule 144 when those shares are sold, even
though the shares when purchased were not considered restricted. If,
however, the buyer of restricted securities has no management or major
ownership interests in the company, the restricted status of the
securities expires over a period of time.

Under Rule 144, restricted securities may be sold to the public without
full registration (the restriction lapses upon transfer of ownership) if
the following conditions are met.

1. The securities have been owned and fully paid for at least one year
(there are special exceptions that we'll skip here).
2. Current financial information must be made available to the buyer.
Companies that file 10K and 10Q reports with the SEC satisfy this
requirement.
3. The seller must file Form 144, "Notice of Proposed Sale of
Securities," with the SEC no later than the first day of the sale.
The filing is effective for 90 days. If the seller wishes to
extend the selling period or sell additional securities, a new form
144 is required.
4. The sale of the securities may not be advertised and no additional
commissions can be paid.
5. If the securities were owned for between one and two years, the
volume of securities sold is limited to the greater of 1% of all
outstanding shares, or the average weekly trading volume for the
proceeding four weeks. If the shares have been owned for two years
or more, no volume restrictions apply to non-insiders. Insiders
are always subject to volume restrictions.

The most recent rule change of Feb 1997 reduced the holding periods by
one year. For all the details, visit the SEC's page on this rule:


Julie O'Neill offers some insights about the SEC's Rule 144:



--------------------Check for updates------------------

Subject: Regulation - SEC Registered Advisory Service

Last-revised: 9 Jan 1996
Contributed-By: Paul Maffia (paulmaf at eskimo.com)

Some advisers will advertise with the information that they are an
S.E.C. Registered Advisory Service. This does not mean a damn thing
except that they have obeyed the law and registered as the law requires.
All it takes is filling out a long form, $150 and no convictions for
financial fraud.

If they attempt to imply anything in their ads other than the fact they
are registered, they are violating the law. Basically, this means that
they can inform you that they are registered in a none-too-prominent
way. If the information is conveyed in any other way, such as being
very prominent, or using words that convey any meaning other than the
simple fact of registration; or implying any special expertise; or
implying special approval, etc., they are violating the law and can
easily be fined and as well as lose their registration.


--------------------Check for updates------------------

Subject: Regulation - SEC/NASDAQ Settlement

Last-Revised: 26 Feb 1997
Contributed-By: John Schott (jschott at voicenet.com), Chris Lott (
contact me )

The SEC's settlement with NASDAQ in late 1996 will almost certainly
impact trading and price improvement in a favorable way for small
investors. The settlement resulted in rule changes that are intended to
improve greater access to the market for individual investors, and to
improve the display and execution of orders. The changes will be
implemented in several phases, with the first phase beginning on 10 Jan
1997. Initially only 50 stocks will be in the program, but in
subsequent steps in 1997, the number of stocks will be expanded to cover
all NASDAQ stocks.

This action began after many people complained about very high spreads
in some shares traded on the NASDAQ market. In effect,the SEC
contention was that some market makers possible did not publically post
orders inside the spread because it impacted their profit margins.

Here are some of the key changes that resulted from the settlement.
* All NASDAQ market makers must execute or publicly display customer
limit orders that are (a) priced better than their public quote or
(b) limit orders that add to the size of their quote.
* All investors will have access to prices previously available only
to institutions or professional traders. These rules are expected
to produce more trading inside the spread, so wide spreads may become
less common. But remember, a market maker or broker making a market for
a stock has to be compensated for the risk they take. They have to hold
inventory or risk selling you stock they don't have and finding some
quickly. With a stock that moves about or trades seldom, they have to
make money on the spread to cover the "bad moves" that can leave them
holding inventory at a bad price. Reduced spreads may in fact force
less well capitalized or managed market makers to leave the market for
certain stocks, as there may be less chance for profit.

It will definitely be interesting to see how the spreads change over the
next few months as the NASDAQ settlement is phased in on more and more
stocks.


--------------------Check for updates------------------

Subject: Regulation - Series of Examinations/Registrations

Last-revised: 30 Sep 1999
Contributed-By: Charlie H. Luh, Chris Lott ( contact me )

The National Association of Securities Dealers (NASD) administers a
series of licensing examinations that are used to qualify people for
employment in many parts of the finance industry. For example, the
Series 7 is commonly (although somewhat incorrectly) known as the
stockbroker exam. The following examinations are offered:

* Series 3 - Commodity Futures Examination
* Series 4 - Registered Options Principal
* Series 5 - Interest Rate Options Examination
* Series 6 - Investment Company and Variable Contracts Products Rep.
Translation: qualifies sales representatives to sell mutual funds
and variable annuities.
* Series 7 - Full Registration/General Securities Representative
Translation: qualifies sales representatives to sell stocks and
bonds. Variations include:
* Securities Traders (NYSE)
* Trading Supervisor (NYSE)
* Series 8 - General Securities Sales Supervisor
* Branch Office Manager (NYSE)
* Series 11 - Assistant Representative/Order Processing
* Series 15 - Foreign Currency Options
* Series 16 - Supervisory Analyst
* Series 22 - Direct Participation Program Representative
* Series 24 - General Securities Principal
* Series 26 - Investment Company and Variable Contracts Principal
* Series 27 - Financial and Operations Principal
* Series 28 - Introducing B/D/Financial and Operations Principal
* Series 39 - Direct Participation Program Principal
* Series 42 - Options Representative
* Series 52 - Municipal Securities Representative
* Series 53 - Municipal Securities Principal
* Series 62 - Corporate Securities Representative
* Series 63 - Uniform Securities Agent State Law Examination
* Series 65 - Uniform Investment Advisor Law Examination

The following NASD resources should help.
* The procedures for becoming a member of NASD, including details
about registering personnel through the Central Registration
Depository (CRD).

* The NASD's CRD call center: +1 (301) 590-6500
* The NASD home page.



--------------------Check for updates------------------

Subject: Regulation - SIPC, or How to Survive a Bankrupt Broker

Last-Revised: 26 May 1999
Contributed-By: Art Kamlet (artkamlet at aol.com), Dave Barrett

The U.S. Securities Investor Protection Corporation (SIPC) is a
federally chartered private corporation whose job is to insure
shareholders against the situation of a U.S. stock-broker going
bankrupt.

The National Association of Security Dealers requires all of their
member brokers to have SIPC insurance. Many brokers supplement the
limits that SIPC insures ($100,000 cash and $500,000 total, I think-- I
could be wrong here) with additional policies so you are covered up to
$1 million or more.

If you deal with discount houses, all brokerages, their clearing agents,
and any holding companies they have which can be holding your assets in
street-name had better be insured with the S.I.P.C. You're going to pay
a modest SEC tax (less than US$1) on any trade you make anywhere, so
make sure you're getting the benefit. If a broker goes bankrupt it's
the only thing that prevents a total loss. Investigate thoroughly!

The bottom line is that you should not do business with any broker who
is not insured by the SIPC.


--------------------Check for updates------------------

Compilation Copyright (c) 2005 by Christopher Lott.

The Investment FAQ (part 12 of 20)

Archive-name: investment-faq/general/part12
Version: $Id: part12,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plain-text
version of The Investment FAQ, part 12 of 20. The web site
always has the latest version, including in-line links. Please browse



Terms of Use

The following terms and conditions apply to the plain-text version of
The Investment FAQ that is posted regularly to various newsgroups.
Different terms and conditions apply to documents on The Investment
FAQ web site.

The Investment FAQ is copyright 2003 by Christopher Lott, and is
protected by copyright as a collective work and/or compilation,
pursuant to U.S. copyright laws, international conventions, and other
copyright laws. The contents of The Investment FAQ are intended for
personal use, not for sale or other commercial redistribution.
The plain-text version of The Investment FAQ may be copied, stored,
made available on web sites, or distributed on electronic media
provided the following conditions are met:
+ The URL of The Investment FAQ home page is displayed prominently.
+ No fees or compensation are charged for this information,
excluding charges for the media used to distribute it.
+ No advertisements appear on the same web page as this material.
+ Proper attribution is given to the authors of individual articles.
+ This copyright notice is included intact.


Disclaimers

Neither the compiler of nor contributors to The Investment FAQ make
any express or implied warranties (including, without limitation, any
warranty of merchantability or fitness for a particular purpose or
use) regarding the information supplied. The Investment FAQ is
provided to the user "as is". Neither the compiler nor contributors
warrant that The Investment FAQ will be error free. Neither the
compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it. Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers. Readers outside the USA can reach
US-800 telephone numbers, for a charge, using a service such as MCI's
Call USA. All prices are listed in US dollars unless otherwise
specified.

Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Retirement Plans - Traditional IRA

Last-Revised: 24 Jan 2003
Contributed-By: Chris Lott ( contact me ), Dave Dodson, David Hinds
(dhinds at hyper.stanford.edu), Rich Carreiro (rlcarr at
animato.arlington.ma.us), L. Williams (taxhelp at hawaiicpa.com), John
Schussler (jeschuss at erols.com), John Lourenco (decals at
autodecals.com)

This article describes the provisions of the US tax code for traditional
IRAs as of mid 2001, including the changes made by the Economic Recovery
and Tax Relief Reconciliation Act of 2001. Also see the articles
elsewhere in the FAQ for information about Roth IRA and Education IRA
accounts.

An individual retirement arrangement (IRA) allows a person, whether
covered by an employer-sponsored pension plan or not, to save money for
use in retirement while allowing the savings to grow tax-free. Stated
differently, a traditional IRA converts investment earnings (interest,
dividends, and capital gains) into ordinary income.

Funds in an IRA may be invested in a broad variety of vehicles such as
stocks, mutual funds, and bonds. Because an IRA must be administered by
some trustee, most people are limited to the investment choices offered
by that trustee. For example, an IRA at a bank at one time pretty much
was limited to CDs from that bank. Similarly, if you open an IRA
account with a mutual-fund company, that account is probably restricted
to owning funds run by that company. Certain investments are not
allowed in an IRA, however; for example, options trading is restricted
and you cannot go short.

IRA contributions are limited, and the limits are quite low in
comparison to arrangements that permit employee contributions such as a
401(k) (see the article elsewhere in the FAQ for extensive information
about those accounts). For tax year 2002, an individual may contribute
the lesser of US$3,000 or the amount of wage income from US sources to
his or her IRA account(s). In other words, an individual may have both
a traditional and a Roth IRA, but can only contribute $3,000 total to
those accounts, divided up any way he or she pleases.

There is one notable exception that was introduced in 1997, namely a
provision for a spousal IRA. Under this provision, married couples with
only one wage earner may each contribute the full $3,000 to their
respective IRA accounts. Note that total contributions are still
limited to the couple's total gross income, so you cannot contribute $3k
each if together you earned less than $6k.

Annual IRA contributions can be made between January 1 of that year and
April 15 of the following year. Because of the extra three and a half
months, if you send in a contribution to your IRA custodian between
January and April, be sure to indicate the year of the contribution so
the appropriate information gets sent to the IRS.

Many people can deduct their IRA contributions from their gross income.
Eligibility for this deduction is determined by the person's modified
adjusted gross income (MAGI), the person's filing status on their
1040(-A, -EZ) form, and whether the person is eligible to participate in
an employer-sponsored pension plan or contributory plan such as a
401(k). To compute MAGI, you include your federally taxable wages
(i.e., salary after any 401(k) contributions), investment income,
business income, etc., then subtract your adjustments (not to be
confused with deductions) other than the proposed IRA deduction. In
essence, the MAGI is the last line on the front side of a Form 1040 with
no IRA deductions.

Anyhow, if your filing status is single, head of household, or
equivalent, the income test has limits that are lower when compared to
filing status married filing jointly (MFJ). These income tests are
expressed as ranges. Briefly, if your MAGI is below the lower number,
you can deduct everything. If your MAGI falls within the range, you can
deduct some portion of your IRA contribution. And if your MAGI is above
the upper number, you cannot deduct any portion. (No longer does
coverage of one spouse by an employer-maintained retirement plan
influence the other's eligibility.) The income tests for 1998 look like
this:

* Not covered by a pension plan: fully deductible.
* Covered by a pension plan:
* MAGI less than 30k (MFJ 50k): fully deductible
* MAGI in the range 30-40k (MFJ 50-60k): partially deductible
* MAGI greater than 40k (MFJ 60k): not deductible

If your filing status is "Married Filing Separately" (MFS), then the
income restriction is much tighter. If your filing status is MFS and
both spouses have a MAGI of $10,000 or more, then neither spouse can
deduct an IRA contribution.

It's important to understand what it means to be "covered" by a pension
plan. If you are eligible for a defined benefit plan, that's enough;
you are considered covered. If you are eligible to participate in a
defined contribution plan, then either you or your employer must have
contributed some money to the account before you are considered covered.
IRS Notice 87-16 gives all the gory details about who is considered
covered by a pension plan.

Here's an excerpt from Fidelity's IRA disclosure statement concerning
retirement plans.

An "employer-maintained retirement plan" includes any of the
following types of retirement plans:
* a qualified pension, profit-sharing, or stock bonus plan
established in accordance with Section 401(a) or 401(k)
of the Code.
* a Simplified Employee Pension Plan (SEP) (Section 408(k)
of the Code).
* a deferred compensation plan maintained by a governmental
unit or agency.
* tax sheltered annuities and custodial accounts (Section
403(b) and 403(b)(7) of the Code).
* a qualified annuity plan under Section 403(a) of the
Code. You are an active participant in an
employer-maintained retirement plan even if you do not have a
vested right to any benefits under your employer's plan.
Whether you are an "active participant" depends on the type of
plan maintained by your employer. Generally, you are
considered an active participant in a defined contribution
plan if an employer contribution or forfeiture was credited to
your account under the plan during the year. You are
considered an active participant in a defined benefit plan if
you are eligible to participate in the plan, even though you
elect not to participate. You are also treated as an active
participant for a year during which you make a voluntary or
mandatory contribution to any type of plan, even though your
employer makes no contribution to the plan.



If you can't deduct your contribution, think about making a full
contribution to a Roth IRA (see the article elsewhere in this FAQ for
more information). The power of untaxed, compound interest should not
be underestimated. But if you insist on making a non-deductible
contribution into a traditional IRA in any calendar year, you must file
IRS form 8606 with your return for that year.

For tax purposes, each person has exactly one (1) regular IRA. It may
be composed of as many, or as few, separate accounts as you wish. There
are basically only four justifiable reasons for having more than one
regular IRA account:
1. Legitimate investment purposes such as diversification.
2. Estate planning purposes.
3. Preserving roll-over status. If you have rolled a former
employer's 401K money into an IRA and you wish to retain the right
to re-roll that money into a new employer's 401k, plan (if allowed
by that new plan), then you must keep that money in a separate
account.
4. Added flexibility when making penalty-free early withdrawals from
your IRA via the "substantially equal payments" method, since there
are IRS private letter rulings (which, admittedly, are only binding
on the addressees) that strongly hint the IRS takes the position
that for this purpose, you can make the calculation on an
account-by-account basis. See your tax professional if you think
this applies to you. In short, you cannot separate deductible and
nondeductible IRA contributions by keeping separate IRA accounts. There
simply is no way to keep money from deductible and non-deductible
contributions "separate." As far as the IRS is concerned, when you go to
withdraw money from an IRA, all they care about is the total amount of
non-deductible contributions (your "basis") and the total current value
of your IRA's. Any withdrawal you make, regardless of whether it is
from an account that was started with deductible or non-deductible
contributions, will be taxed the same, based on the fraction of the
current value of all your IRA's that was already taxed. Stated more
formally, whether or not you put deductible and non-deductible IRA
contributions into the same account, IRS says that any subsequent
withdrawals are considered to be taken ratably from each, regardless of
which account you withdraw from.

Here's an example. Let's say that you go so far as to have IRA accounts
with 2 different companies and alternate years as follows:
* Odd years: contribute the maximum deductible amount to fund A and
deduct it all.
* Even years: contribute $2000 to fund B and deduct none of it.
(Yes, you are allowed to decline taking an IRA deduction you are
eligible for. You just need to include the actual amount of
contributions you made - the amount you're deducting on Form 8606.)
Given the above scheme, there is no possibility of nondeductible
contributions (NDC) actually being in fund A, all of them went directly
into fund B. If fund A is $12,000 with $0 from nondeductible
contributions, and fund B is $18,000 (you put more in) with $6,000 from
nondeductible contributions, and you roll fund B to a Roth, the Form
8606 calculation goes as follows:

Total IRA = $12,000 + $18,000 = $30,000
Total NDC = $0 + $6,000 = $6,000
Ratio = $6,000 / $30,000 = 1/5
Amount transferred = $18,000
NDC transferred = 1/5 of $18,000 = $3,600.

Unfortunately, you can't just say "All of my nondeductible contributions
are in fund B" (even though it's demonstable that this must be so) and
pay taxes on $18,000 - $6,000 = $12,000. You have to go through the
above math and pay taxes on $18,000 - $3,600 = $14,400.

So, once you make a non-deductible contribution, you're committed to
doing the paperwork when you take any money out of the IRA. On the
upside, the tax "problem" never gets any more complicated. You don't
have to keep track of where different contributions came from: all you
need to do is keep track of your basis, the sum of all your
non-deductible contributions. This number is on the most recent Form
8606 that you've filed (the form serves as a cumulative record, perhaps
once of the more taxpayer-friendly forms from the IRS).

Occasionally the question crops up as to exactly why people cannot go
short (see the article elsewhere in the FAQ explaining short sales) in
an IRA account. The restriction comes from the combination of the
following three facts. First, the law governing IRAs says that if any
part of an IRA is used as collateral, the entire IRA is considered
distributed and thus subject to income tax and penalties. Second, the
rules imposed by the Federal Reserve Board et al. say that short sales
have to take place in a margin account. Third and finally, margin
accounts require that you pledge the account as collateral. So if you
try to turn an IRA into a margin account, you'll void the IRA; but
without a margin account, you can't sell short.

Withdrawals can be made from a traditional IRA account at any time, but
a 10% penalty is imposed by the IRS on withdrawals made before the magic
age of 59 1/2. Note that taxes are always imposed on those portions of
withdrawals that can be attributed to deductible contributions.
Withdrawals from an IRA must begin by age 70 1/2. There are also
various provisions for excess contributions and other problems.

The following exceptions define cases when withdrawals can be made
subject to no penalty:

* The owner of the IRA becomes disabled or dies.
* A withdrawal program is set up as a series of "substantially equal
periodic payments" (known as SEP) that are taken over the owner's
life expectancy. Part of the deal with SEP is that the person also
must continue to take that amount for a period of 5 years before he
or she is allowed to change it.
* The funds are used to pay unreimbursed medical expenses that exceed
7.5% of the owner's adjusted gross income.
* The funds are used to pay medical insurance premiums provided the
owner of the IRA has received unemployment for more than 12 weeks.
* The funds are used to pay for qualified higher-education expenses.
* The funds are used to pay for a first-time home purchase, subject
to a lifetime maximum of 10,000. Note that a husband and wife can
both take distributions from their IRAs for a total of 20k to apply
to a first-time home purchase (lots of strings attached, read IRS
publication 590 carefully).

When an IRA account holder dies, the account becomes the property of the
named beneficiary, and is subject to various minimum distribution rules.

The IRS issued new regulations in April 2002 for minimum distributions
from traditional IRAs. The rules (which are retroactive to 1 April
2001) simplify the old, complex rules and reduce the minimum
distribution amounts for many people. First, IRA trustees are required
to report minimum required distributions to the IRS each year (to make
certain Uncle Sam gets his share). Second, account holders can name
beneficiaries at practically any time -- even after the death of the
account holder. Third, major changes were made to the calculation of
required minimum distributions. According to the 2002 rules, the IRA
owner is required (as before) to begin minimum distributions at age 70
and 1/2, or suffer tax penalties. However, these distributions are
calculated based on one of three new tables:
1. Single Life Table: This (depressingly) is used after the owner
dies.
2. Joint and Last Survivor Table: Used when the named beneficiary is a
spouse younger than the owner by at least 10 years (lucky them).
3. Uniform Lifetime Table: Used in nearly all other cases (i.e., when
the named beneficiary is close in age to the owner).

The traditional IRA permits a distribution to be treated as a rollover.
This means that you can withdraw money from an IRA account with no tax
effect as long as you redeposit it (into any of your IRA accounts, not
necessarily the one you took the money from) within 60 days of the
withdrawal. Any monies not redeposited are considered a distribution,
subject to income tax and the penalty tax if applicable. You are
permitted one rollover every 12 months per IRA account.

The rules changed in mid 2001 in the following ways:
* The contribution limit is $3,000 in 2002; reaches $4,000 in 2005,
and finally hits $5,000 in 2008.
* Investors over 50 can put an extra $500 per year (in 2002) and
eventually an extra 1,000 (in 2006) per year; this is called a
catch-up provision.

Order IRS Publication 590 for complete information. You can also get a
PDF version of Pub 590 from the IRS web site:



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Subject: Software - Archive of Free Investment-Related Programs

Last-Revised: 20 Aug 1996
Contributed-By: Chris Lott ( contact me )

This article lists two archives of investment-related programs. Most of
these programs are distributed in source-code form, but some include
binaries. Anyhow, if all that is available is source, then before you
can run them on your PC at home you will need a C compiler to create
executable versions.

Ed Savage maintains an archive of programs which are available here:


The compiler of this FAQ maintains an archive of programs (both source
code and PC binaries) for a number of investment-related programs. The
programs include:

* 401-calc: compute value of a 401(k) plan over time
* commis: compute commisions for trades at selected discount brokers
* fv: compute future value
* irr: compute rate of return of a portfolio
* loan: calculate loan amortization schedule
* prepay: analyze prepayments of a mortgage loan
* pv: calculate present value
* returns: analyze total return of a mutual fund
* roi: compute return on investment for mutual funds

These programs are available from The Investment FAQ web site at URL
.


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Subject: Software - Portfolio Tracking and Technical Analysis

Last-Revised: 2 Jul 2001
Contributed-By: Chris Lott ( contact me )

Many software packages are available that support basic personal finance
and investment uses, such as managing a checkbook, tracking expenses,
and following the value of a portfolio. Using a package can be handy
for tracking transactions in mutual funds and stocks, especially for
active traders at tax time. Many packages support various forms of
technical analysis by drawing charts using historical data, applying
various T/A decision rules, etc. Those packages usually include a large
amount of historical data, with many provisions for fetching current
data via the 'net.

With the advent of online banking, many banks are offering software at
no charge, so be sure to ask locally.

This page lists a few resources that will help you find a package to
meet your needs.
* A decent collection of links for portfolio software is available on
The Investment FAQ web site:

* A yearly compendium is part of AAII's Computerized Investing
Newsletter.
* Anderson Investor's Software, 130 S. Bemiston. Ste 101, St.
Louis MO 63105, USA; Sales 800-286-4106, Info 314-918-0990, FAX
314-918-0980.

* Nirvana Systems of Austin, TX specializes in investment- and
finance-related software. +1 (512) 345-2545, 800-880-0338.
* Money$earch maintains a collection of links to software packages.
The following URL will run a search on their site so you get the
latest results.

* BobsGuide.com is an online showcase for technologies and services
in the banking and finance industry. The target users are
primarily those in the banking and finance community responsible
for purchasing software and hardware technology.



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Subject: Stocks - Basics

Last-Revised: 26 Aug 1994
Contributed-By: Art Kamlet (artkamlet at aol.com), Edward Lupin

Perhaps we should start by looking at the basics: What is stock? Why
does a company issue stock? Why do investors pay good money for little
pieces of paper called stock certificates? What do investors look for?
What about Value Line ratings and what about dividends?

To start with, if a company wants to raise capital (money), one of its
options is to issue stock. A company has other methods, such as issuing
bonds and getting a loan from the bank. But stock raises capital
without creating debt; i.e., without creating a legal obligation to
repay borrowed funds.

What do the buyers of the stock -- the new owners of the company --
expect for their investment? The popular answer, the answer many people
would give is: they expect to make lots of money, they expect other
people to pay them more than they paid themselves. Well, that doesn't
just happen randomly or by chance (well, maybe sometimes it does, who
knows?).

The less popular, less simple answer is: shareholders -- the company's
owners -- expect their investment to earn more, for the company, than
other forms of investment. If that happens, if the return on investment
is high, the price tends to increase. Why?

Who really knows? But it is true that within an industry the
Price/Earnings (i.e., P/E) ratio tends to stay within a narrow range
over any reasonable period of time -- measured in months or a year or
so.

So if the earnings go up, the price goes up. And investors look for
companies whose earnings are likely to go up. How much?

There's a number -- the accountants call it Shareholder Equity -- that
in some magical sense represents the amount of money the investors have
invested in the company. I say magical because while it translates to
(Assets - Liabilities) there is often a lot of accounting trickery that
goes into determining Assets and Liabilities.

But looking at Shareholder Equity, (and dividing that by the number of
shares held to get the book value per share) if a company is able to
earn, say, $1.50 on a stock whose book value is $10, that's a 15%
return. That's actually a good return these days, much better than you
can get in a bank or C/D or Treasury bond, and so people might be more
encouraged to buy, while sellers are anxious to hold on. So the price
might be bid up to the point where sellers might be persuaded to sell.

A measure that is also sometimes used to assess the price is the
Price/Book (i.e., P/B) ratio. This is just the stock price at a
particular time divided by the book value.

What about dividends? Dividends are certainly more tangible income than
potential earnings increases and stock price increases, so what does it
mean when a dividend is non-existent or very low? And what do people
mean when they talk about a stock's yield?

To begin with the easy question first, the yield is the annual dividend
divided by the stock price. For example, if company XYZ is paying $.25
per quarter ($1.00 per year) and XYZ is trading at $10 per share, the
yield is 10%.

A company paying no or low dividends (zero or low yield) is really
saying to its investors -- its owners, "We believe we can earn more, and
return more value to shareholders by retaining the earnings, by putting
that money to work, than by paying it out and not having it to invest in
new plant or goods or salaries." And having said that, they are expected
to earn a good return on not only their previous equity, but on the
increased equity represented by retained earnings.

So a company whose book value last year was $10 and who retains its
entire $1.50 earnings, increases its book value to 11.50 less certain
expenses. The $1.50 in earnings represents a 15% return. Let's say
that the new book value is 11. To keep up the streak (i.e., to earn a
15% return again), the company must generate earnings of at least $1.65
this year just to keep up with the goal of a 15% return on equity. If
the company earns $1.80, the owners have indeed made a good investment,
and other investors, seeking to get in on a good thing, bid up the
price.

That's the theory anyway. In spite of that, many investors still buy or
sell based on what some commentator says or on announcement of a new
product or on the hiring (or resignation) of a key officer, or on
general sexiness of the company's products. And that will always
happen.

What is the moral of all this: Look at a company's financials, look at
the Value Line and S&P charts and recommendations, and do some homework
before buying.

Do Value Line and S&P take the actual dividend into account when issuing
their "Timeliness" and "Safety" ratings? Not exactly. They report it,
but their ratings are primarily based on earnings potential, performance
in their industry, past history, and a few other factors. (I don't
think anyone knows all the other factors. That's why people pay for the
ratings.)

Can a stock broker be relied on to provide well-analyzed, well thought
out information and recommendations? Yes and no.

On the one hand, a stock broker is in business to sell you stock. Would
you trust a used-car dealer to carefully analyze the available cars and
sell you the best car for the best price? Then why would you trust a
broker to do the same?

On the other hand, there are people who get paid to analyze company
financial positions and make carefully thought out recommendations,
sometimes to buy or to hold or to sell stock. While many of these folks
work in the "research" departments of full-service brokers, some work
for Value Line, S&P etc, and have less of an axe to grind. Brokers who
rely on this information really do have solid grounding behind their
recommendations.

Probably the best people to listen to are those who make investment
decisions for the largest of Mutual Funds, although the investment
decisions are often after the fact, and announced 4 times a year.

An even better source would be those who make investment decisions for
the very large pension funds, which have more money invested than most
mutual funds. Unfortunately that information is often less available.
If you can catch one of these people on CNN for example, that could be
interesting.


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Subject: Stocks - American Depositary Receipts (ADRs)

Last-Revised: 19 Feb 2002
Contributed-By: Art Kamlet (artkamlet at aol.com), George Regnery
(regnery at yahoo.com)

An American Depositary Receipt (ADR) is a share of stock of an
investment in shares of a non-US corporation. The shares of the non-US
corporation trade on a non-US exchange, while the ADRs, perhaps somewhat
obviously, trade on a US exchange. This mechanism makes it
straightforward for a US investor to invest in a foreign issue. ADRs
were first introduced in 1927.

Two banks are generally involved in maintaining an ADR on a US exchange:
an investment bank and a depositary bank. The investment bank purchases
the foreign shares and offers them for sale in the US. The depositary
bank handles the issuance and cancellation of ADRs certificates backed
by ordinary shares based on investor orders, as well as other services
provided to an issuer of ADRS, but is not involved in selling the ADRs.

To establish an ADR, an investment bank arranges to buy the shares on a
foreign market and issue the ADRs on the US markets.

For example, BigCitibank might purchase 25 million shares of a non-US
stock. Call it EuroGlom Corporation (EGC). Perhaps EGC trades on the
Paris exchange, where BigCitibank bought them. BigCitibank would then
register with the SEC and offer for sale shares of EGC ADRs.

EGC ADRs are valued in dollars, and BigCitibank could apply to the NYSE
to list them. In effect, they are repackaged EGC shares, backed by EGC
shares owned by BigCitibank, and they would then trade like any other
stock on the NYSE.

BigCitibank would take a management fee for their efforts, and the
number of EGC shares represented by EGC ADRs would effectively decrease,
so the price would go down a slight amount; or EGC itself might pay
BigCitibank their fee in return for helping to establish a US market for
EGC. Naturally, currency fluctuations will affect the US Dollar price
of the ADR.

BigCitibank would set up an arrangement with another large financial
institution for that institution to act as the depositary bank for the
ADRs. The depositary would handle the day-to-day interaction with
holders of the ADRs.

Dividends paid by EGC are received by BigCitibank and distributed
proportionally to EGC ADR holders. If EGC withholds (foreign) tax on
the dividends before this distribution, then BigCitibank will withhold a
proportional amount before distributing the dividend to ADR holders, and
will report on a Form 1099-Div both the gross dividend and the amount of
foreign tax withheld.

Most of the time the foreign nation permits US holders (BigCitibank in
this case) to vote their shares on all or most issues, and ADR holders
will receive ballots which will be received by BigCitibank and voted in
proportion to ADR Shareholder's vote. I don't know if BigCitibank has
the option of voting shares which ADR holders failed to vote.

The depositary bank sets the ratio of US ADRs per home country share.
This ratio can be anywhere, and can be less than or greater than 1.
Basically, it is an attempt to get the ADR within a price that Americans
are comfortable with, so upon issue, I would assume that most ADRs range
between $15 and $75 per share. If, in the home country, the shares are
worth considerably less, than each ADR would represent several real
shares. If, in the home country, shares were trading for the equivalent
of several hundred dollars, each ADR would be only a fraction of a
normal share.

Now, concerning who sets the price: yes, it floats on supply and demand.
However, if the US price gets too far off from the price in the home
country (Accounting for the currency exchange rate and the ratio of ADRs
to home country shares), then an arbitrage opportunity will exist. So,
yes, it does track the home country shares, but probably not exactly
(for there are transaction costs in this type of arbitrage). However,
if the spread gets too big, arbitragers will step in and then of course,
the arbitrage opportunities will soon cease to exist.

Having said this, however, for the most part ADRs look and feel pretty
much like any other stock.

The following resources offer more information about ADRs.
* Citicorp offers in-depth information about ADRs:

* JP Morgan runs a web site devoted to ADRs (with a truly lovely
legal disclaimer you must accept before visiting the site):

* Site-By-Site offers information about specific ADR issues:

* CoBeCo lists background information and current quotes for ADRs:



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Subject: Stocks - Cyclicals

Last-Revised: 9 Apr 1995
Contributed-By: Bill Sullivan (sully at postoffice.ptd.net)

Cyclical stocks, in brief, are the stocks of those companies whose
earnings are strongly tied to the business cycle. This means that the
prices of the stocks move up sharply when the economy turns up, move
down sharply when the economny turns down.

Examples:

Cyclical companies: Caterpillar (CAT), US Steel (X), General Motors
(GM), International Paper (IP); i.e., makers of products for which the
demand curve is fairly flexible.

Non-Cyclical companies: CocaCola (KO), Proctor & Gamble (PG), and Quaker
Oats (OAT); i.e., makers of products for which the demand curve is
fairly inflexible; after all, everyone has to eat!


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Subject: Stocks - Dividends

Last-Revised: 29 Sep 1997
Contributed-By: Art Kamlet (artkamlet at aol.com), Rich Carreiro (rlcarr
at animato.arlington.ma.us)

A company may periodically declare cash and/or stock dividends. This
article deals with cash dividends on common stock. Two paragraphs also
discuss dividends on Mutual Fund shares. A separate article elsewhere
in this FAQ discusses stock splits and stock dividends.

The Board of Directors of a company decides if it will declare a
dividend, how often it will declare it, and the dates associated with
the dividend. Quarterly payment of dividends is very common, annually
or semiannually is less common, and many companies don't pay dividends
at all. Other companies from time to time will declare an extra or
special dividend. Mutual funds sometimes declare a year-end dividend
and maybe one or more other dividends.

If the Board declares a dividend, it will announce that the dividend (of
a set amount) will be paid to shareholders of record as of the RECORD
DATE and will be paid or distributed on the DISTRIBUTION DATE (sometimes
called the Payable Date).

Before we begin the discussion of dates and date cutoffs, it's important
to note that three-day settlements (T+3) became effective 7 June 1995.
In other words, the SEC's T+3 rule states that all stock trades must be
settled within 3 business days.

In order to be a shareholder of record on the RECORD DATE you must own
the shares on that date (when the books close for that day). Since
virtually all stock trades by brokers on exchanges are settled in 3
(business) days, you must buy the shares at least 3 days before the
RECORD DATE in order to be the shareholder of record on the RECORD DATE.
So the (RECORD DATE - 3 days) is the day that the shareholder of record
needs to own the stock to collect the dividend. He can sell it the very
next day and still get the dividend.

If you bought it at least 3 business days before the RECORD date and
still owned it at the end of the RECORD DATE, you get the dividend.
(Even if you ask your broker to sell it the day after the (RECORD DATE -
3 days), it will not have settled until after the RECORD DATE so you
will own it on the RECORD DATE.)

So someone who buys the stock on the (RECORD DATE - 2 days) does not get
the dividend. A stock paying a 50c quarterly dividend might well be
expected to trade for 50c less on that date, all things being equal. In
other words, it trades for its previous price, EXcept for the DIVidend.
So the (RECORD DATE - 2 days) is often called the EX-DIV date. In the
financial listings, that is indicated by an x.

How can you try to predict what the dividend will be before it is
declared?

Many companies declare regular dividends every quarter, so if you look
at the last dividend paid, you can guess the next dividend will be the
same. Exception: when the Board of IBM, for example, announces it can
no longer guarantee to maintain the dividend, you might well expect the
dividend to drop, drastically, next quarter. The financial listings in
the newspapers show the expected annual dividend, and other listings
show the dividends declared by Boards of directors the previous day,
along with their dates.

Other companies declare less regular dividends, so try to look at how
well the company seems to be doing. Companies whose shares trade as
ADRs (American Depositary Receipts -- see article elsewhere in this FAQ)
are very dependent on currency market fluctuations, so will pay
differing amounts from time to time.

Some companies may be temporarily prohibited from paying dividends on
their common stock, usually because they have missed payments on their
bonds and/or preferred stock.

On the DISTRIBUTION DATE shareholders of record on the RECORD date will
get the dividend. If you own the shares yourself, the company will mail
you a check. If you participate in a DRIP (Dividend ReInvestment Plan,
see article on DRIPs elsewhere in this FAQ) and elect to reinvest the
dividend, you will have the dividend credited to your DRIP account and
purchase shares, and if your stock is held by your broker for you, the
broker will receive the dividend from the company and credit it to your
account.

Dividends on preferred stock work very much like common stock, except
they are much more predictable.

Tax implications:

* Some Mutual Funds may delay paying their year-end dividend until
early January. However, the IRS requires that those dividends be
constructively paid at the end of the previous year. So in these
cases, you might find that a dividend paid in January was included
in the previous year's 1099-DIV.


* Sometime before January 31 of the next year, whoever paid the
dividend will send you and the IRS a Form 1099-DIV to help you
report this dividend income to the IRS.


* Sometimes -- often with Mutual Funds -- a portion of the dividend
might be treated as a non-taxable distribution or as a capital
gains distribution. The 1099-DIV will list the Gross Dividends (in
line 1a) and will also list any non-taxable and capital gains
distributions. Enter the Gross Dividends (line 1a) on Schedule B.


* Subtract the non-taxable distributions as shown on Schedule B and
decrease your cost basis in that stock by the amount of non-taxable
distributions (but not below a cost basis of zero -- you can deduct
non-taxable distributions only while the running cost basis is
positive.) Deduct the capital gains distributions as shown on
Schedule B, and then add them back in on Schedule D if you file
Schedule D, else on the front of Form 1040.

Finally, just a bit of accounting information. Earnings are always
calculated first, and then the directors of a company decide what to do
with those earnings. They can distribute the earnings to the
stockholders in the form of dividends, retain the earnings, or take the
money and head for Brazil (NB: the last option tends to make the
stockholders angry and get the local district attorney on the case :-).
Utilities and seasonal companies often pay out dividends that exceed
earnings - this tends to prop up the stock price nicely - but of course
no company can do that year after year.


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Subject: Stocks - Dramatic Price Changes

Last-Revised: 18 Sep 1994
Contributed-By: Maurice Suhre, Lynn West, Fahad A. Hoymany

One frequently asked question is "Why did my stock in X go down/up by
this large amount in the past short time ?

The purpose of this answer is not to discourage you from asking this
question in misc.invest, although if you ask without having done any
homework, you may receive a gentle barb or two. Rather, one purpose is
to inform you that you may not get an answer because in many cases no
one knows.

Stocks surge for a variety of reasons ranging from good company news,
improving investors' sentiment, to general economic conditions. The
equation which determines the price of a stock is extremely simple, even
trivial. When there are more people interested in buying than there are
people interested in selling, possibly as a result of one or more of the
reasons mentioned above, the price rises. When there are more sellers
than buyers, the price falls. The difficult question to answer is, what
accounts for the variations in demand and supply for a particular stock?
Naturally, if all (or most) people knew why a stock surges, we would
soon have a lot of extremely rich people who simply use that knowledge
to buy and sell different stocks.

However, stocks often lurch upward and downward by sizable amounts with
no apparent reason, sometimes with no fundamental change in the
underlying company. If this happens to your stock and you can find no
reason, you should merely use this event to alert you to watch the stock
more closely for a month or two. The zig (or zag) may have meaning, or
it may have merely been a burp.

A related question is whether stock XYZ, which used to trade at 40 and
just dropped to 25, is good buy. The answer is, possibly. Buying
stocks just because they look "cheap" isn't generally a good idea. All
too often they look cheaper later on. (IBM looked "cheap" at 80 in 1991
after it declined from 140 or so. The stock finally bottomed in the
40's. Amgen slid from 78 to the low 30's in about 6 months, looking
"cheap" along the way.) Technical analysis principles suggest to wait
for XYZ to demonstrate that it has quit going down and is showing some
sign of strength, perhaps purchasing in the 28 range. If you are
expecting a return to 40, you can give up a few points initially. If
your fundamental analysis shows 25 to be an undervalued price, you might
enter in. Rarely do stocks have a big decline and a big move back up in
the space of a few days. You will almost surely have time to wait and
see if the market agrees with your valuation before you purchase.


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Subject: Stocks - Holding Company Depositary Recepits (HOLDRs)

Last-Revised: 16 July 2000
Contributed-By: Chris Lott ( contact me )

A Holding Company Depositary Receipt (HOLDR) is a fixed collection of
stocks, usually 20, that is used to track some industry sector. For
example, HOLDRs exist for biotech, internet, and business-to-business
companies, just to pick some examples. A HOLDR is a way for an investor
to gain exposure to a market sector with at a low cost, primarily the
comission to purchase the HOLDR. All HOLDR securities trade on the
American Stock Exchange; their ticker symbols all end in 'H'.

Although a HOLDR may sound a bit like a mutual fund, it really is quite
different. One important difference is that nothing is done to a HOLDR
after it is created (mutual funds are usually managed actively). So,
for example, if one of the 20 companies in a HOLDR gets bought,
thereafter the HOLDR will have just 19 stocks. This keeps the annual
expenses very low (currently about $0.08 or less per share).

So maybe a HOLDR is much more like a stock? Yes, but also with some
differences. Like stocks, HOLDRs can be bought on margin or shorted.
But unlike stocks, investors can only buy round lots (multiples of 100
shares) of HOLDR securities. So buying into a HOLDR can be fairly
expensive for a small investor.

Interestingly, an owner of a HOLDR is considered to own the stocks in
the HOLDR directly, even though they were purchased via the HOLDR. So
the HOLDR holder (sorry, bad joke) receives quarterly and annual reports
from the companies directly, receives dividends directly, etc. And, if
the investor decides it's a good idea (and is willing to pay the
associated fees), he or she can ask the HOLDR trustee to deliver the
shares represented by the HOLDR; the HOLDR then is gone (cancelled), and
the investor holds the shares as if he or she had purchased them
directly.

Merrill Lynch created the first HOLDR in 1998 to track the Brazilian
phone company when it was broken up. Merrill (or some other big
financial institution) serves as the trustee, the agency that purchases
shares in the companies and issues the HOLDR shares. When a HOLDR is
first issued, the event is considered an IPO.

Here are a few resources with more information.
* The Merrill Lynch site:

* The Street.com printed a comprehensive introduction to HOLDRs in
June 2000:



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Subject: Stocks - Income and Royalty Trusts

Last-Revised: 24 Jul 2001
Contributed-By: John Carswell (webmaster at finpipe.com)

Income and Royalty Trusts are special-purpose financing vehicles that
are created to make investments in operating companies or their cash
flows. Investors supply capital to a trust, a legal entity that exists
to hold assets, by purchasing "trust units". The trust then uses these
funds to purchase an interest in the operating company. The trust then
distributes all its income to holders of the trust units.

Income and Royalty trusts are neither stocks nor bonds, although they
share some of their characteristics. Investment trusts are created to
hold interests in operating assets which produce income and cash flows,
then pass these through to investors. A "trust" is a legal instrument
which exists to hold assets for others. A "trust" investment which uses
a trust (the legal entity) to hold ownership of an asset and pass
through income to investors is called a "securitization" or an
"asset-backed security".

The trust can purchase common shares, preferred shares or debt
securities of an operating company. Royalty trusts purchase the right
to royalties on the production and sales of a natural resource company.
Real estate investment trusts purchase real estate properties and pass
the rental incomes through to investors.

Royalty and Income Trusts are attractive to investors because they
promise high yields compared to traditional stocks and bonds. They are
attractive to companies wishing to sell cash flow producing assets
because they provide a much higher sale price, or proceeds, than would
be possible with conventional financings. The investment
characteristics of both types of trusts flow from their structure. To
understand the risks and returns inherent in these investments we must
go beyond their promised yield and examine their purpose and structure.

Cashflow Royalty Created!

For example, let's say that we own an oil company,CashCow Inc., that has
many mature producing oil wells. The prospect for these wells is fairly
mundane. With well known rates of production and reserves, there is not
much chance to enhance production or lower costs. We know that we will
produce and sell 1,000,000 barrels per year at the prevailing oil price
until it runs out in a forecasted 20 years. At the current price of $25
per barrel, we will make $25,000,000 per year until the wells run dry in
2017.

We're getting a bit tired of the oil business. We want to sell. Our
investment bank, Sharp & Shooter, suggest that we utilize a royalty
trust. They explain the concept to us. CashCow Inc., our company,
sells all the oil wells to a "trust", the CashCow Royalty Fund. The
trust will then pay CashCow Inc a management fee to manage and maintain
the wells. The CashCow Royalty Fund then gets all the earnings from the
wells and distributes these to the trust unit holders. We ask, "Why we
just wouldn't sell shares in our company to the public". Sharp &
Shooter tells us that we will get more money by setting up the trust
since investors are "starved for yield". We agree.

Sharp & Shooter then do the legals and proceed with an issue. They
offer a cash yield of 10%, based on their projections for oil prices,
the cost structure, and management fee to CashCow Inc. This means they
hope to raise $250,000,000. We're rich!!

Yield to the Poor Tired Investment Masses

What about the poor tired investment masses? Starving for yield in the
low interest rate revolution, the CashCow Royalty Fund lets them have
their investment cake and eat it too. Thanks to the royalty courtiers
of Sharp & Shooter, yield starved investors can buy a piece of a "high
yield" investment. Sounds a bit strange, but the royalty trust turns
the steady income that made the operating company CashCow Inc.
financially mundane and boring into a scintillating geyser of high
yield.

Since the operating company, CashCow Inc., no longer has to explore for
oil or develop technologies to increase production, its expenditures
will be much lower under the royalty trust structure. Remember, the
purposes of the trust is to pay out the earnings from the oil sales
until the oil fields are exhausted. No more analysts and shareholders
complaining about "depleting" resources. Paying out the steadily
depleting oil sales are now the idea. This means that none of the
revenues and profits from production have to be expended on securing new
supplies. The continuing operations of CashCow Inc. can be downsized
now that maintenance is the only need. No more exploration department,
huge head office staff, or worldwide travel bills.

The investor, who might shun a low dividend yield of 3% on an oil stock
or worry about the risk of a lower grade corporate bond, sees the bright
lights of high yield beckoning. Our $25,000,000 in revenues is only
reduced by a management contract of $1,000,000 paid to the now shrunken
CashCow Inc. to keep the fields maintained. All the earnings will be
passed through to the CashCow Royalty Trust which will be taxed in the
hands of the investors. We can offer a 10% yield to the trust unit
holders which means that we can raise $250,000,000.

What's Wrong with this Investment Picture?

One of the first questions to ask about an investment is, "What's in it
for them?". Why would the owners of CashCow Inc. part with their
$25,000,000 in income? Not just to provide a higher yield for the yield
starved investment masses. Logically, the owners of an operating
company would only sell their interest if they could use the money to
more effect somewhere else. Think about it for a minute. If the owner
of CashCow Inc. can take $250,000,000 and put it into another
investment with a higher yield, it should be done. The fixed return of
10% on established, tired wells might be a tad low next to the upside on
a new oil field, or a well diversified portfolio of growth stocks.

Another question to ask is,"Why didn't the owner just sell the company
to another oil company?". The simple answer is that they get more money
by selling to the income trust. Which begs the question, "Why is the
price so high?". Other companies realize that the price of oil goes up
and down and that the price of $25 a barrel today is very high compared
to the $10 it was a few years ago. At $10 per barrel, the cash flow
would only be $10,000,000 a year. That is why the prospectus for these
trust deals talks about 'forecasted' revenues and earnings. The other
oil companies also realize that 'proven reserves' has an element of
guesswork, and that there might be less oil in the ground, or it may be
'more difficult to recover' than expected.

All this means that the 10% "yield" is not fixed in stone, as we now
realize. As with all investments, we must take our time and do our
analysis. As Uncle Pipeline says, "It's all in the cash flows!"

For more insights from the Financial Pipeline, visit their site:



--------------------Check for updates------------------

Subject: Stocks - Types of Indexes

Last-Revised: 10 Jul 1998
Contributed-By: Susan Thomas, Chris Lott ( contact me )

There are three major classes of indexes in use today in the US:

Equally weighted price index
An example is the Dow Jones Industrial Average.
Market capitalization weighted index
An example is the S&P500 Industrial Average.
Equally weighted returns index
The only one of its kind is the Value-Line index.


The first two are widely used. All my profs in the business school
claim that the equally weighted return indexs is weird and don't
emphasize it too much.

Now for the details on each type.



Equally Weighted Price Index
As the name suggests, the index is calculated by taking the average
of the prices of a set of companies:
Index = Sum (Prices of N companies) / divisor
In this calculation, two questions crop up:

1. What is "N"? The DJIA takes the 30 large "blue-chip"
companies. Why 30? Well, you want a fairly large number so
the index will (at least to some extent) represent the entire
market's performance. Of course, many would argue (and
rightly so) that 30 is a ridiculously small number in today's
markets, so a case can be made that it's more of a historical
hangover than anything else.

Does the set of N companies change across time? If so, how
often is the list updated (with respect to the companies that
are included)? In the case of the DJIA, yes, the set of
companies is updated periodically. But these decisions are
quite judgemental and hence not readily replicable.

If the DJIA only has 30 companies, how do we select these 30?
Why should they have equal weights? These are real criticisms
of the DJIA-type index.


2. The divisor is not always equal to N for N companies. What
happens to the index when there is a stock split by one of the
companies in the set? Of course the stock price of that
company drops, but the number of shares have increased to
leave the market capitalization of the shares the same. Since
the index does not take the market cap into account, it has to
compensate for the drop in price by tweaking the divisor. For
examples on this, look at pg. 61 of Bodie, Kane, and Marcus,
Investments . The DJIA actually started with a divisor of 30,
but currently uses a number around 0.3 (yes, zero point 3).

Historically, this index format was computationally convenient. It
just doesn't have a very sound economic basis to justify it's
existence today. The DJIA is widely cited on the evening news, but
not used by real finance folks. I have an intuition that the DJIA
type index will actually be BAD if the number of companies is very
large. If it's to make any sense at all, it should be very few
"brilliantly" chosen companies. Because the DJIA is the most
widely reported index about the U.S. equity markets, it's
important to understand it and its flaws.


Market capitalization weighted index
In this index, each of the N companies' price is weighted by the
market capitalization of the company.
Sum (Company market capitalization * Price) over N
companies
Index =
------------------------------------------------------------
Market capitalization for these N companies
Here you do not take into account the dividend data, so effectively
you're tracking the short-run capital gains of the market.

Practical questions regarding this index:

1. What is "N"? I would use the largest N possible to get as
close to the "full" market as possible. By the way, in the
U.S. there are companies that make a living on only
calculating extremely complete value-weighted indexes for the
NYSE and foreign markets. CMIE should sell a very complete
value-weighted index to some such folks.

Why does S&P use 500? Once again, a large number of companies
captures the broad market, but the specific number 500 is
probably due to historical reasons when computating over
20,000 companies every day was difficult. Today, computing
over 20k companies for a Sun workstation is no problem, so the
S&P idea is obsolete.


2. How to deal with companies entering and exiting the index? If
we're doing an index containing "every single company
possible" then the answer to this question is easy -- each
time a company enters or exits we recalculate all weights.
But if we're a value-weighted index like the S&P500 (where
there are only 500 companies) it's a problem. For example,
when Wang went bankrupt, S&P decided to replace them by Sun --
how do you justify such choices?

The value-weighted index is superior to the DJIA type index for
deep reasons. Anyone doing modern finance will not use the DJIA
type index. A glimmer of the reasoning for this is as follows: If
I held a portfolio with equal number of shares of each of the 30
DJIA companies then the DJIA index would accurately reflect my
capital gains. But we know that it is possible to find a portfolio
which has the same returns as the DJIA portfolio but at a smaller
risk. (This is a mathematical fact).

Thus, by definition, nobody is ever going to own a DJIA portfolio.
In contrast, there is an extremely good interpretation for the
value weighted portfolio -- it yields the highest returns you can
get for its level of risk. Thus you would have good reason for
owning a value-weighted market portfolio, thus justifying it's
index.

Yet another intuition about the value-weighted index -- a smart
investor is not going to ever buy equal number of shares of a given
set of companies, which is what the equally weighted price index
tracks. If you take into consideration that the price movements of
companies are correlated with others, you are going to hedge your
returns by buying different proportions of company shares. This is
in effect what the market capitalization weighted index does, and
this is why it is a smart index to follow.

One very neat property of this kind of index is that it is readily
applied to industry indexes. Thus you can simply apply the above
formula to all machine tool companies, and you get a machine tool
index. This industry-index idea is conceptually sound, with
excellent interpretations. Thus on a day when the market index
goes up 6%, if machine tools goes up 10%, you know the market found
some good news on machine tools.


Equally weighted returns index
Here the index is the average of the returns of a certain set of
companies. Value Line publishes two versions of it:

* The arithmetic index:
( VLAI / N ) = Sum (N returns)

* The geometric index:
VLGI = { Product (1 + return) over N } ^ { 1 / n },
which is just the geometric mean of the N returns.


Notice that these indexes imply that the dollar value on each company
has to be the same. Discussed further in Bodie, Kane, and Marcus,
Investments , pg 66.


--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 11 of 20)

Archive-name: investment-faq/general/part11
Version: $Id: part11,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plain-text
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for any inaccuracy, error or omission, regardless of cause, in The
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Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
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Subject: Retirement Plans - 401(k)

Last-Revised: 9 Dec 2001
Contributed-By: Ed Nieters (nieters at crd.ge.com), David W. Olson,
Rich Carreiro (rlcarr at animato.arlington.ma.us), Chris Lott ( contact
me ), Art Kamlet (artkamlet at aol.com), Ed Suranyi, Ed Zollars (ezollar
at mindspring.com)

This article describes the provisions of the US tax code for 401(k)
plans as of mid 2001, including the changes made by the Economic
Recovery and Tax Relief Reconciliation Act of 2001.

A 401(k) plan is a retirement savings plan that is funded by employee
contributions and (often) matching contributions from the employer. The
major attraction of these plans is that the contributions are taken from
pre-tax salary, and the funds grow tax-free until withdrawn. Also, the
plans are (to some extent) self-directed, and they are portable; more
about both topics later. Both for-profit and many types of tax-exempt
organizations can establish these plans for their employees.

A 401(k) plan takes its name from the section of the Internal Revenue
Code of 1978 that created them. To get a bit picky for a moment, a
401(k) plan is a plan qualified under Section 401(a) (or at least we
mean it to be). Section 401(a) is the section that defines qualified
plan trusts in general, including the various rules required for
qualifications. Section 401(k) provides for an optional "cash or
deferred" method of getting contributions from employees. So every
401(k) plan already is a 401(a) plan. The IRS says what can be done,
but the operation of these plans is regulated by the Pension and Welfare
Benefits Administration of the U.S. Department of Labor.

For example, the Widget Company's plan might permit employees to
contribute up to 7% of their gross pay to the fund, and the company then
matches the contributions at 50% (happily, they pay in cash and not in
widgets :-). Total contribution to the Widget plan in this example
would be 10.5% of the employee's salary. My joke about paying in cash
is important, however; some plans contribute stock instead of cash.

There are many advantages to 401(k) plans. First, since the employee is
allowed to contribute to his/her 401(k) with pre-tax money, it reduces
the amount of tax paid out of each pay check. Second, all employer
contributions and any growth in the capital grow tax-free until
withdrawal. The compounding effect of consistent periodic contributions
over the period of 20 or 30 years is quite dramatic. Third, the
employee can decide where to direct future contributions and/or current
savings, giving much control over the investments to the employee.
Fourth, if your company matches your contributions, it's like getting
extra money on top of your salary. Fifth, unlike a pension, all
contributions can be moved from one company's plan to the next company's
plan, or a special IRA, should a participant change jobs. Sixth,
because the program is a personal investment program for your
retirement, it is protected by pension (ERISA) laws, which means that
the benefits may not be used as security for loans outside the program.
This includes the additional protection of the funds from garnishment or
attachment by creditors or assigned to anyone else, except in the case
of domestic relations court cases dealing with divorce decree or child
support orders (QDROs; i.e., qualified domestic relations orders).
Finally, while the 401(k) is similar in nature to an IRA, an IRA won't
enjoy any matching company contributions, and personal IRA contributions
are subject to much lower limits; see the article about IRA's elsewhere
in this FAQ.

There are, of course, a few disadvantages associated with 401(k) plans.
First, it is difficult (or at least expensive) to access your 401(k)
savings before age 59 1/2 (but see below). Second, 401(k) plans don't
have the luxury of being insured by the Pension Benefit Guaranty
Corporation (PBGC). (But then again, some pensions don't enjoy this
luxury either.) Third, employer contributions are usually not vested
(i.e., do not become the property of the employee) until a number of
years have passed. Currently, those contributions can vest all at once
after five years of employment, or can vest gradually from the third
through the seventh year of employment.

Participants in a 401(k) plan generally have a decent number of
different investment options, nearly all cases a menu of mutual funds.
These funds usually include a money market, bond funds of varying
maturities (short, intermediate, long term), company stock, mutual fund,
US Series EE Savings Bonds, and others. The employee chooses how to
invest the savings and is typically allowed to change where current
savings are invested and/or where future contributions will go a
specific number of times a year. This may be quarterly, bi-monthly, or
some similar time period. The employee is also typically allowed to
stop contributions at any time.

With respect to participant's choice of investments, expert (sic)
opinions from financial advisors typically say that the average 401(k)
participant is not aggressive enough with their investment options.
Historically, stocks have outperformed all other forms of investment and
will probably continue to do so. Since the investment period of 401(k)
savings is relatively long - 20 to 40 years - this will minimize the
daily fluctuations of the market and allow a "buy and hold" strategy to
pay off. As you near retirement, you might want to switch your
investments to more conservative funds to preserve their value.

Puzzling out the rules and regulations for 401(k) plans is difficult
simply because every company's plan is different. Each plan has a
minimum and maximum contribution, and these limits are chosen in
consultation with the IRS (I'm told) such that there is no
discrimination between highly paid and less highly paid employees. The
law requires that if low compensated employees do not contribute enough
by the end of the plan year, then the limit is changed for highly
compensated employees. Practically, this means that the employer sets a
maximum percentage of gross salary in order to prevent highly
compensated employees from reaching the limits. In any case, the
employer chooses how much to match, how much employees may contribute,
etc. Of course the IRS has the final say, so there are certain
regulations that apply to all 401(k) plans. We'll try to lay them out
here.

Let's begin with contributions. Employees have the option of making all
or part of their contributions from pre-tax (gross) income. This has
the added benefit of reducing the amount of tax paid by the employee
from each check now and deferring it until the person takes the pre-tax
money out of the plan. Both the employer contribution (if any) and any
growth of the fund compound tax-free. These contributions must be
deposited no more than 15 business days after the end of the month in
which they were made (also see the May 1999 issue of Individual Investor
magazine for a discussion of this).

The interesting rules govern what happens to before-tax and after-tax
contributions. The IRS limits pre-tax deductions to a fixed dollar
figure that changes annually. In other words, an employee in any 401(k)
plan can reduce his or her gross pay by a maximum of some fixed dollar
amount via contributions to a 401(k) plan. An employer's plan may place
restrictions on the employees that are stricter than the IRS limit, or
are much less strict. If the restrictions are less strict, employees
may be able to make after-tax contributions.

After-tax contributions are a whole lot different from pre-tax
contributions. In fact, by definition an employee cannot contribute
after-tax monies to a 401(k)! Monies in excess of the limits on 401(k)
accounts (i.e., after-tax monies) are put into a 401(a) account, which
is defined to be an employee savings plan in which the employee
contributes after-tax monies. (This is one way for an employee to save
aggressively for retirement while still enjoying tax-free growth until
distribution time.) If an employee elects to make after-tax
contributions, the money comes out of net pay (i.e., after taxes have
been deducted). While it doesn't help one's current tax situation,
funds that were contributed on an after-tax basis may be easier to
withdraw since they are not subject to the strict IRS rules which apply
to pre-tax contributions. When distributions are begun (see below), the
employee pays no tax on the portion of the distribution attributed to
after-tax contributions, but does have to pay tax on any gains.

Ok, let's talk about the IRS limits already. First, a person's maximum
before-tax contribution (i.e., 401(k) limit) for 2001 is $10,500 (same
as 2000, but will change in 2002). It's important to understand this
limit. This figure indicates only the maximum amount that the employee
can contribute from his/her pre-tax earnings to all of his/her 401(k)
accounts. It does not include any matching funds that the employer
might graciously throw in. Further, this figure is not reduced by
monies contributed towards many other plans (e.g., an IRA). And, if you
work for two or more employers during the year, then you have the
responsibility to make sure you contribute no more than that year's
limit between the two or more employers' 401k plans. If the employee
"accidentally" contributes more than the pre-tax limit towards his or
her 401(k) account, the employer must move the excess, or the excess
contribution amount due to a smaller limit imposed by an imbalance of
highly compensated employees, into a 401(a) account.

Next there are regulations for highly compensated employees. What are
these? Well, when the 401(k) rules were being formulated, the government
was afraid that executives might make the 401(k) plan at their company
very advantageous to themselves, but without allowing the rank-and-file
employees those same benefits. The only way to make sure that the plan
would be beneficial to ordinary employees as well as those "highly
compensated," the law-writers decided, was to make sure that the
executives had an incentive to make the plan desirable for those
ordinary employees. What this means is that employees who are defined
as "highly compensated" within the company (as guided by the
regulations) may not be allowed to save at the maximum rates. Starting
in 1997, the IRC defined "highly compensated" as income in excess of
$80,000; alternately, the company can make a determination that only the
top 20% of employees are considered highly compensated. Therefore, the
implementation of the "highly compensated employee" regulations varies
with the company, and only your benefits department can tell you if you
are affected.

Finally the last of the IRS regulations. IRS rules won't allow
contributions on pay over a certain amount (the limit was $170,000 in
2001, and will change in 2002). Additionally, the IRS limits the total
amount of deferred income (i.e., money put into IRAs, 401(k) plans,
401(a) plans, or pension plans) each year to the lesser of some amount
($30,000 in 1996, and subject to change of course) or 25% of your annual
compensation. Annual compensation defined as gross compensation for the
purpose of computing the limitation. This changes an earlier law; a
person's annual compensation for the purpose of this computation is no
longer reduced by 401(k) contributions and salaray redirected to
cafeteria benefit plans.

The 401(k) plans are somewhat unique in allowing limited access to
savings before age 59 1/2. One option is taking a loan from yourself!
It is legal to take a loan from your 401(k) before age 59 1/2 for
certain reasons including hardship loans, buying a house, or paying for
education. When a loan is obtained, you must pay the loan back with
regular payments (these can be set up as payroll deductions) but you
are, in effect, paying yourself back both the principal and the
interest, not a bank. If you take a withdrawal from your 401(k) as
money other than a loan, not only must you pay tax on any pre-tax
contributions and on the growth, you must also pay an additional 10%
penalty to the government. There are other special conditions that
permit withdrawals at various ages without penalty; consult an expert
for more details. However, in general it's probably not a good idea to
take a loan from your own 401(k) simply because your money is not
growing for you while it is out of your account. Sure, you're paying
yourself some bit of interest, but you're almost certainly not paying
enough.

Participants who are vested in in 401(k) plans can begin to access their
savings without withdrawal penalties at various ages, depending on the
plan and on their own circumstances. If the participant who separates
from service is age 55 or more during the year of separation, the
participant can draw any amount from his or her 401(k) without any
calculated minimums and without any 5-year rules. Depending on the
plan, a participant may be able to draw funds without penalty at or
after age 59 1/2 regardless of whether he or she has separated from
service (i.e., the participant might still be working; check with the
plan administrator to be sure). The minimum withdrawal rules for a
participant who has separated from service kick in at age 70 1/2. Being
able to draw any amount and for any length of time without penalty
starting at age 55 (provided the person has separated from service) is
one of the least understood differences between 401ks and IRAs. Note
that this paragraph doesn't mention "retire" because the person's status
after leaving service with the company that has the 401(k) doesn't seem
to be relevant.

Anyone who has separated from service from a company with a 401(k), and
is entitled to withdraw funds without penalty, may take a lump sum
withdrawal of the 401(k) into a taxable account, and depending on their
age may use an income averaging method. Currently anyone eligible may
use an averaging method which spreads the lump sum over 5 years, and if
born before 1937, may average over 10 years. Or, if a lump sum is
chosen, it can be immediately rolled into an IRA (but they withhold tax)
-- or transferred from the 401(k) custodian to an IRA custodian, and the
account will continue to grow tax deferred.

Note that 401(k) distributions are separate from pension funds. Like
IRAs, participants in 401(k) plans must begin taking distributions by
age 70 1/2. Also, the IRS imposes a minimum annual distribution on
401(k)s at age 70 1/2, just to guarantee that Uncle Sam gets his share.
However, there's an exception to the minimum and required distribution
rules: if you continue to work at that same company and the 401(k) is
still there, you do not have to start withdrawing the 401(k).

Since a 401(k) is a company-administered plan, and every plan is
different, changing jobs will affect your 401(k) plan significantly.
Different companies handle this situation in different ways (of course).
Some will allow you to keep your savings in the program until age
59 1/2. This is the simplest idea. Other companies will require you to
take the money out. Things get more complicated here, but not
unmanageable. Your new company may allow you to make a "rollover"
contribution to its 401(k) which would let you take all the 401(k)
savings from your old job and put them into your new company's plan. If
this is not a possibility, you may roll over the funds into an IRA.
However, as discussed above, a 401(k) plan has numerous advantages over
an IRA, so if possible, rolling 401(k) money into another 401(k), if at
all possible, is usually the best choice.

Whatever you do regarding rollovers, BE EXTREMELY CAREFUL!! This can not
be emphasized enough. Legislation passed in 1992 by Congress added a
twist to the rollover procedures. It used to be that you could receive
the rollover money in the form of a check made out to you and you had a
60 days to roll this cash into a new retirement account (either 401(k)
or IRA). Now, however, employees taking a withdrawal have the
opportunity to make a "direct rollover" of the taxable amount of a
401(k) to a new plan. This means the check goes directly from your old
company to your new company (or new plan). If this is done (ie. you
never "touch" the money), no tax is withheld or owed on the direct
rollover amount.

If the direct rollover option is not chosen, i.e., a check goes through
your grubby little hands, the withdrawal is immediately subject to a
mandatory tax withholding of 20% of the taxable portion, which the old
company is required to ship off to the IRS. The remaining 80% must be
rolled over within 60 days to a new retirement account or else is is
subject to the 10% tax mentioned above. The 20% mandatory withholding
is supposed to cover possible taxes on your withdrawal, and can be
recovered using a special form filed with your next tax return to the
IRS. If you forget to file that form, however, the 20% is lost.
Naturally, there is a catch. The 20% withheld must also be rolled into
a new retirement account within 60 days, out of your own pocket, or it
will be considered withdrawn and subject to the 10% tax. Check with
your benefits department if you choose to do any type of rollover of
your 401(k) funds.

Here's an example to clarify an indirect rollover. Let us suppose that
you have $10,000 in a 401k, and that you withdraw the money with the
intention of rolling it over - no direct transfer. Under current law
you will receive $8,000 and the IRS will receive $2,000 against possible
taxes on your withdrawal. To maintain tax-exempt status on the money,
$10,000 has to be put into a new retirement plan within 60 days. The
immediate problem is that you only have $8,000 in hand, and can't get
the $2,000 until you file your taxes next year. What you can do is:
1. Find $2,000 from somewhere else. Maybe sell your car.
2. Roll over $8,000. The $2,000 then loses its tax status and you
will owe income tax and the 10% tax on it.

Caveat: If you have been in an employee contributed retirement plan
since before 1986, some of the rules may be different on those funds
invested pre-1986. Consult your benefits department for more details,

The rules changed in mid 2001 in the following ways:
* The 2001 contribution limit of $10,500 per year rises to $11,000 in
2002, then $12,000 in 2003, a lucky $13,000 in 2004, $14,000 in
2005, and finally $15,000 in 2005. Thereafter the limit is indexed
for inflation.
* Vesting periods for employer's matching contributions are shortened
starting in 2002. Monies will vest after 3 years of service
(compare with 5 years now), or can be vested gradually from the
second through the sixth year (compare with 3..7 years now).
* Beginning in 2002, a catch-up provision is available to employees
who are over 50 years old. This provision allows these employees
to contribute extra amounts over and above the limit in effect for
that year. The additional contribution amount is $1,000 in 2002
and increases by $1,000 annually until it reaches $5,000 in 2006;
thereafter, it increases $500 annually.
* Participants are supposed to be able to move between plans (like
when switching employers) more easily than now. I believe it makes
roll-overs from a 401 to a 403 plan possible.
* A new option for 401(k) participants appears in 2002. This option
is being called a Roth-style 401(k); it allows deductions to be
taken after-tax in exchange for the right to withdraw (like a Roth
IRA) both contributions and earnings without tax at some distant
point in the future.

Finally, here are some resources on the web that may help.
* The Pension and Welfare Benefits Administration of the U.S.
Department of Labor offers some (although not much) information.

* A brief note from the IRS

* Fidelity offers an introduction to 401k plans

* 401Kafé is a community resource for 401(k) participants.



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Subject: Retirement Plans - 401(k) for Self-Employed People

Last-Revised: 23 Jan 2003
Contributed-By: Daniel Lamaute, Chris Lott ( contact me ),

This article describes the provisions of the US tax code for the 401(k)
plan for Self-Employed People, also called the Solo 401(k). These plans
were established by the Economic Growth and Tax Relief Reconciliation
Act of 2001.

A Solo 401(k) plan provides a great tax break to the smallest business
owners. In addition to the possibility to shelter from taxes a large
portion of income, some Solo 401(k) plans offer a loan feature for
cash-strapped small business owners.

Eligibility for a Solo 401(k) plan is limited to those with a small
business and no employees, or only a spouse as an employee. This
includes independent contractors with earned income, freelancers, sole
proprietors, partnerships, Limited Liability Companies (LLC) or
corporations.

The key benefits of the Solo 401K plan include:
* High limits on contributions: The limits for elective salary
deferrals and employer contributions enable sole proprietors in tax
year 2003 to contribute up to the lesser of 100% of aggregate
compensation or $40,000 ($42,000 if age 50 or older).
* Contributions are fully-tax deductible and are based on
compensation or earned income.
* Assets can be rolled from other plans or IRA’s to a Solo 401K.
There is no limit on roll-overs.
* The account holder can take a loan that is tax-free and penalty
free from the Solo 401K, if allowed by the plan, up to the lesser
of 50% or $50,000 of the account balance.

The contribution limits depend on how the business is established:
* For businesses that are not incorporated, the employer and salary
deferral contributions are based on the net earned income.
Contributions are not subject to federal income tax, but remain
subject to self-employment taxes (SECA). The owner receives a tax
deduction for both salary deferral and employer contributions on
IRS Form 1040 at filing time. The maximum contribution limit is
calculated based on salary (max deferral of about $12,000) and
profit sharing (to get you up to the current max contribution).
* For corporations, the employer contribution is based on the W-2
income and is contributed by the business. The maximum employer
contribution is 25% of pay. It is not subject to federal income
tax or Social Security (FICA) taxes. The salary deferral
contributions are withheld from your pay and are excluded from
federal income tax but are subject to FICA. The business receives
a tax deduction for both salary deferral and employer
contributions. The maximum elective salary deferral amount for
2003 is 100% of pay up to $12,000 ($14,000 if age 50 or older).

Fees for establishing and maintaining the Solo-401(k) type accounts vary
by plan provider and administrator. The plan providers are mostly
mutual fund companies with loaded funds. The plan fees are also a
function of the features of the Solo-401(k). For example, plans fees
tend to be less expensive if they have no loan feature. Plans that
allow assets other than mutual funds in the plan would also be more
costly to maintain. On average, the cost to set up and maintain a
Solo-401(k) is modest for a 401(k) plan; fees on various plans range
from $35 to $1,200 per year.

A solo 401(k) offers several key advantages when compared to Keogh plans
(see the article elsewhere in the FAQ). The solo 401(k) allows higher
contribution limits for most individuals, allows for catch-up salary
deferral contributions (for those 50+ years), and allows loans to
owners.

Rather than raiding their 401K to finance their business - and paying a
big penalty to the IRS - small business owners can take a tax-free loan
and keep their hard earned money working for them. This plan offers
small business owners all the benefits of a big-company 401K without the
administrative expense and complexity.

Small business owners should ask their accountants about this plan and
how it may benefit them. Each Solo 401K must be set up no later than
December 31 of the calendar year to be eligible for tax deductions in
that tax year.

Please visit Daniel Lamaute's web site for more information. There he
offers a Solo-401(k) plan with no set up fee and an administration fee
of $100 per year. That plan includes the loan feature; plan investments
are restricted to mutual funds by Pioneer Investments.



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Subject: Retirement Plans - 403(b)

Last-Revised: 29 Jan 2003
Contributed-By: Joseph Morlan (jmorlan at slip.net)

A 403(b) plan, like a 401(k) plan, is a retirement savings plan that is
funded by employee contributions and (often) matching contributions from
the employer.

403(b) plans are not "qualified plans" under the tax code, but are
generally higher cost "Tax-Sheltered Annuity Arrangements" which can be
offered only by public school systems and other tax-exempt
organizations. They can only invest in annuities or mutual funds. They
are very similar to qualified plans such as 401(k) but have some
important differences, as follows.

The rules for top-heavy plans do not apply.

Employer contributions are exludable from income only to the extent of
employees "exclusion allowance." Exclusion allowance is the total
excludable employer contribution for any prior year minus 20% of annual
includible compensation multiplied by years of service (prorated for
part-timers). Whew! I have no idea what this means. In my own case
there is no extra employer contribution, but rather a salary reduction
agreement. So the so-called employer contribution is actually my own
contribution. At least I think it is.

Employer contributions must also be the lesser of 25% of compensation or
$30,000 annually. Excess contributions are are includible in gross
income only if employee's right to them is vested. I also don't know
what this means.

Contributions to a custodial account invested in mutual funds are
subject to a special 6% excise tax on the amount by which they exceed
the maximum amount excludable from income. (This sounds scary as the
calculation for excludable income seems quite complex. E.g. I already
have another tax-deferred retirment plan which probably needs to be
calculated into the total allowed in the 403b).

The usual 10% penalty on early withdrawal and the 15% excise tax on
excess distributions still apply as in 401(k) plans.

As of 2002, an individual may participate in a 403(b) plan and a 457(b)
plan at the same time.

NOTE: The above is my paraphrasing of the U.S. Master Tax Guide for
1993. Recent changes in the laws governing 401(k)-type arrangements
have made these available to non-profit institutions as well, and this
has made the old 403(b) plans less attractive to many. The following
sites address the new law and compare 401(k) with 403(b) plans:
*
* The following is a link to the IRS special publication on 403b
plans



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Subject: Retirement Plans - 457(b)

Last-Revised: 29 Jan 2003
Contributed-By: Chris Lott ( contact me )

A 457(b) plan is a non-qualified, tax-deferred compensation plan offered
by many non-profit institutions to their employees. This plan, like a
401(k) or 403(b) plan, allows you to save for retirement.

Contributions are made from pre-tax wages, and the Internal Revenue Code
sets the maximum contribution limits. The limit for 2003 is the lesser
of $12,000 or 100% of an employee's salary. Catch-up provisions apply
to those 50 or older; these people can contribute an extra $2,000.

Because contributions are made before tax, naturally this means that
taxes are due when withdrawals are made. However, these plans do not
impose a penalty on early withdrawals.

Funds in a 457(b) plan can be rolled into another 457(b) plan if you
change employers. Alternately, a 457(b) account can be rolled into a
different type of retirement-savings plan such as an IRA or a 401(k).

As of 2002, an individual may participate in a 457(b) plan and a 403(b)
plan at the same time.


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Subject: Retirement Plans - Co-mingling funds in IRA accounts

Last-Revised: 19 Feb 1998
Contributed-By: Art Kamlet (artkamlet at aol.com), Paul Maffia (paulmaf
at eskimo.com)

The term "co-mingling" refers to mixing monies that were saved under
different plans within a single IRA account. You may co-mingle as much
as you want within your IRAs. Although the bookkeeping is not a
problem, there are disadvantages; one example is discussed below.
Remember that you can have as many IRA accounts as you wish, although
there are strict limits on contributions to IRA accounts; see the FAQ
article on ordinary IRA accounts for more details.

The most common situation where co-mingling becomes an issue is if you
have what is known as a "conduit" IRA. This happens if you change
employers, and in doing so, move monies from the old employer's 401(k)
plan into an IRA account in your name. If the IRA is funded with only
401(k) monies, then it is called a conduit IRA. Further, if a later
employer allows it, the entire chunk can be transferred into a new
401(k).

Of course you can mix (co-mingle) the conduit monies with monies from
other IRA accounts as much as you want. The major disadvantage of
co-mingling is that if your 401(k) monies get co-mingled with non-401(k)
monies, you can never place the original monies from the old 401(k) back
into another 401(k). You may also want to read the article on 401(k)
plans in the FAQ.

Hre's a summary of the issues that might motivate you to maintain
separate IRA accounts:

1. Legitimate investment needs such as diversification.
2. Estate planning purposes
3. With passage of the new tax law, to keep your Roth IRA money
separate from regular IRA money and/or Education IRA money.
4. And of course to keep 401K rollover monies separate if you want to
retain the ability to reroll as noted above.


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Subject: Retirement Plans - Keogh

Last-Revised: 23 Apr 1998
From: A. Nielson, Chris Lott ( contact me ), James Phillips

A Keogh plan is a tax-deferred retirement savings plan for people who
are self-employed, and is much like an IRA. The main difference between
a Keogh and an IRA is the contribution limit. Although exact
contribution limits depend on the type of Keogh plan (see below), in
general a self-employed individual may contribute a maximum of $30,000
to a Keogh plan each year, and deduct that amount from taxable income.
The limits for IRAs are much less, of course.

The following information was derived from material T. Row Price sends
out about their small company plan. There are three types of Keogh
plans. All types limit the maximum contribution to $30K per year, but
additional constraints may be imposed depending on the type of plan.

Profit Sharing Keogh
Annual contributions are limited to 15% of compensation, but can be
changed to as low as 0% for any year.
Money Purchase Keogh
Annual contributions are limited to 25% of compensation but can be
as low as 1%, but once the contribution percentage has been set, it
cannot be changed for the life of the plan.
Paired Keogh
Combines profit sharing and money purchase plans. Annual
contributions limited to 25% but can be as low as 3%. The part
contributed to the money purchase part is fixed for the life of the
plan, but the amount contributed to the profit sharing part (still
subject to the 15% limit) can change every year.


Like an IRA, the Keogh offers the individual a chance for his or her
savings to grow free of taxes. Taxes are not paid until the individual
begins withdrawing funds from the plan. Participants in Keogh plans are
subject to the same restrictions on distribution as IRAs, namely
distributions cannot be made without a penalty before age 59 1/2, and
distributions must begin before age 70 1/2.

Setting up a Keogh plan is significantly more involved then establishing
an IRA or SEP-IRA. Any competent brokerage house should be able to help
you execute the proper paperwork. In exchange for this initial hurdle,
the contribution limits are very favorable when compared to the other
plans, so self-employed individuals should consider a Keogh plan
seriously.


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Subject: Retirement Plans - Roth IRA

Last-Revised: 31 Jan 2003
Contributed-By: Chris Lott ( contact me ), Paul Maffia (paulmaf at
eskimo.com), Rich Carreiro (rlcarr at animato.arlington.ma.us)

This article describes the provisions of the US tax code for Roth IRAs
as of mid 2001, including the changes made by the Economic Recovery and
Tax Relief Reconciliation Act of 2001. Also see the articles elsewhere
in the FAQ for information about the Traditional IRA .

The Taxpayer Relief Act of 1997 established a new type of individual
retirement arrangement (IRA). It is commonly known as the "Roth IRA"
because it was championed in Congress by Senator William Roth of
Delaware. The Roth IRA has been available to investors since 2 Jan
1998; provisions were amended by the IRS Restructuring and Reform Act of
1998, signed into law by the president on 22 July 1998. Plans were
amended again in 2001. This article will give a broad overview of Roth
IRA rules and regulations, as well as summarize the differences between
a Roth IRA and an ordinary IRA.

A Roth individual retirement arrangement (Roth IRA) allows tax payers,
subject to certain income limits, to save money for use in retirement
while allowing the savings to grow tax-free. All of the tax benefits
associated with a Roth IRA happen when withdrawals are made:
withdrawals, subject to certain rules, are not taxed at all. Stated
differently, Roth IRAs convert earnings (dividends, interest, capital
gains) into tax-free income. There are no tax benefits associated with
contributions (no deductions on your federal tax return) because all
contributions to a Roth IRA are made with after-tax monies.

Funds in an IRA may be invested in a broad variety of vehicles (e.g.,
stocks, bonds, etc.) but there are limitations on investments (e.g.,
options trading is restricted, and buying property for your own use is
not permitted).

The contribution amounts are limited to $3,000 annually (as of 2003) and
may be restricted based on an individual's income and filing status. In
2003, an individual may contribute the lesser of US$3,000 or the amount
of wage income from US sources to his or her IRA account(s). A notable
exception was introduced in 1997, namely that married couples with only
one wage earner may each contribute the full $3,000 to their respective
IRA accounts. These limits are quite low in comparison to arrangements
that permit employee contributions such as 401(k) plans (see the article
on 401(k) plans in this FAQ for extensive information about those
accounts).

There are absolutely no limits on the number of IRA accounts that an
individual may have, but the contribution limit applies to all accounts
collectively. In other words, an individual may have 34 ordinary IRA
accounts and 16 Roth IRA accounts, but can only contribute $3,000 total
to those accounts, divided up any way he or she pleases (perhaps $40
each, but that's a lot of little checks).

Taxpayers are permitted to contribute monies to a Roth IRA only if their
income lies below certain thresholds. However, participation in any
other retirement plan has no influence on whether a person may
contribute or not. More specifically, a person's Modified Adjusted
Gross Income (MAGI) must pass an income test for contributions to the
Roth IRA to be permitted. The 2003 income tests for individuals filing
singly, couples with filing status Married Filing Jointly (MFJ), and
couples living together with filing status Married Filing Separately
(MFS) look like this:

* MAGI less than 95k (MFJ 150k, MFS 0k): full contribution allowed
* MAGI in the range 95-110k (MFJ 150-160k), MFS 0-10k: partial
contribution allowed
* MAGI greater than 110k (MFJ 160k, MFS 10k): no contribution
allowed. That's right, the limits on married couples who file
separate tax returns are pretty darned low.

A bit of trivia: the Roth contribution phaseout, like the phaseout for
the deductibility of ordinary IRA contributions, has a kink in it. As
long as the MAGI is within the phaseout range, the allowable
contribution will not be less than $200, even though a strict
application of the phaseout formula would lead to an amount less than
$200. So as your MAGI works its way into the phaseout, your
contribution will drop linearly from $2000 down to $200, then will stay
at $200 until you hit the end of the phaseout, where it then drops to
$0.

Annual IRA contributions can be made between January 1 of that year and
April 15 of the following year. Because of the extra three and a half
months, if you send in a contribution to your IRA custodian between
January and April, be sure to indicate the year of the contribution so
the appropriate information gets sent to the IRS. Remember,
contributions to a Roth IRA are never deductible from a taxpayer's
income (unlike a traditional IRA).

The rules for penalty-free, tax-free distributions from a Roth IRA
account are fairly complex. First, some terminology: a Roth account is
built from contributions (made annually in cash) and conversions (from a
traditinal IRA); earnings are any amounts in the account beyond what was
contributed or converted. The rule are as follows:
* Contributions can be withdrawn tax-free and penalty-free at any
time.
* There is 5-year clock 'A'. Clock 'A' starts on the first day of
the first tax year in which any Roth IRA is opened and funded.
* Earnings can be withdrawn tax-free and penalty-free after Clock 'A'
hits 5 years and a qualifying event (such as turning 59.5,
disability, etc.) occurs.
* Additional 5-year clocks 'B', 'C', etc. start running for each
traditional IRA that is converted to a Roth IRA. Each clock
applies just to that conversion.
* If you are under age 59.5 when a particular conversion is done, and
you withdraw any conversion monies before the clock associated with
that particular conversion hits 5 years, you are hit with a 10%
penalty on the withdrawn conversion monies. If you are over age
59.5 when you did the conversion, no penalty no matter how soon you
withdraw the monies from that conversion.
* The order of withdrawals (distributions) has been established to
help investors. When a withdrawal is made, it is deemed to come
from contributions first . After all contributions have been
withdrawn, subsequent withdrawals are considered to come from
conversions. After all conversions have been withdrawn, then
withdrawals come from earnings. I believe the conversions are
taken in chronological order.
* All Roth IRA accounts are aggregated for the purpose of applying
the ordering rules to a withdrawal.

A huge difference between Roth and ordinary IRA accounts involves the
rules for withdrawals past age 70 1/2. There are no requirements that a
holder of a Roth IRA ever make withdrawals (unlike a traditional IRA for
which required minimum distribution rules apply). This provision makes
it possible to use the Roth IRA as an estate planning tool. You can
pass on significant sums to your heirs if you choose; the account must
be distributed if the holder dies.

What the Roth IRA allows you to do, in essence, is lock in the tax rate
that you are currently paying. If you think rates are going nowhere but
up, even in your retirement, the Roth IRA is a sensible choice. But if
you think your tax rate after retirement will be less, perhaps much
less, than your current tax rate, it might be wiser to stick with a
conventional IRA. (To be picky, you really need to think about the tax
rate when you are eligible to take tax-free, penalty-free distributions,
which is age 59 1/2.)

Should you use a Roth IRA at all? Answering this question is tricky
because it depends on your circumstances. In general, experts agree
that if you have a 401(k) plan available to you through your employer,
you should max out that account before looking elsewhere. Otherwise, if
you are allowed to put money in a Roth IRA at all (i.e., if your income
is below the limits), then making contributions to a Roth IRA is always
preferable over making contributions to a nondeductible IRA. You pay
the same amount of taxes now in both cases, because neither is
deductible, but you don't pay taxes on withdrawal from the Roth (unlike
withdrawals from an ordinary IRA). The only exception here is if you're
going to need to pull the money out before the minimum holding period of
5 years.

Holders of ordinary IRA accounts will be permitted to convert their
accounts to Roth IRA accounts if they meet certain criteria. First,
there is a limit on MAGI of $100K for that individual in the year of the
conversion, single or married. Second, taxpayers whose filing status is
married filing separately may not convert their ordinary IRA accounts to
Roth accounts.

Tax is owed on the amount transferred, less any nondeductible
contributions that were made over the years. In more detail: the
current law allows the income (i.e., withdrawal) resulting from a
conversion in 1998 to be divided by 4 and indicated as income in equal
parts on 1998--2001 tax returns (the technical corrections bill changed
this from mandatory to optional). Conversions made in 1999 and
subsequent years will be fully taxed in the year of the conversion.
Deductible contributions and all earnings are taxed; non-deductible
contributions are considered return of capital and are not taxed.

If you convert only a portion of your IRA holdings to a Roth IRA, the
IRS says that these withdrawals are considered to be taken ratably from
each ordinary IRA account. You compute the rate by finding the ratio of
deductible to non-deductible contributions (also known as computing your
IRA basis). This ignores growth or shrinkage of the account's value.
For example, if you stashed $9,000 in deductible contributions and
$3,000 in non-deductible contributions for a total of $12,000 in
contributions to your ordinary IRA, your basis would be 25% of the total
contributions. When you make a withdrawal, 25% will considered to be
from the non-deductible portion and 75% from the deductible portion (and
hence taxable). Not certain whether the proper way to say this is that
your basis is 25% or 75%, but you get the idea.

The technical corrections bill of 1998 added a provision that investors
could unconvert (and possibly recovert) with no penalty to cover the
case of a person who converted, but then became ineligible due to
unexpected income. This opened a loophole: it put no limit on the
number of switches back and forth. With the decline in the markets of
1998, many people unconverted and reconverted to establish a lower cost
basis in their Roth IRA accounts. The IRS issued new regulations in
late October, 1998 that disallow this strategy effective 1 Nov 98, but
grandfather any reconversions that predate the new regulations. Under
the new regulations, IRA holders are allowed just one reconversion.

If you are eligible to convert your ordinary IRA to a Roth IRA, should
you? Again answering this question is non-trivial because each
investor's circumstances are very different. There are some
generalizations that are fairly safe. Young investors, who have many
years for their investments to grow, could benefit handsomely by being
able to withdraw all earnings free of tax. Older people who don't want
to be forced to withdraw funds from their accounts at age 70 1/2 might
find the Roth IRA helpful (this is the estate planning angle). On the
other hand, for people who have significant IRA balances, the extra
income could push them into a higher tax bracket for several years,
cause them to lose tax breaks for some itemized deductions, or increase
taxes on Social Security benefits.

The following illustrated example may help shed light on the benefits of
a Roth IRA and help you decide whether conversion is the right choice
for you. The numbers in this example were computed by Vanguard for
their pages (see the link below). In many situations the differences
between the two types of accounts is quite small, which is perhaps at
odds with the hype you might have seen recently about Roth IRAs. But
let's let the number speak for themselves.

We're going to compare an ordinary deductible IRA with a Roth IRA. Each
begins with $2,000, and we'll let the accounts grow for 20 years with no
further contributions. We'll assume a constant rate of return of 8%,
compounded annually, just to keep things simple. We'll also assume the
contribution to the ordinary IRA was deductible because otherwise the
Roth is a clear winner. Here's the situation at the start; we assume
the 28% tax bracket so you have to start by earning 2,778 just to keep
2,000.
What Ordinary IRA Roth IRA
Gross wages 2,778 2,778
Contributions 2,000 2,000
Taxable income 778 2,778
28% federal tax 218 778
What's left 560 0
So at this point, the ordinary IRA left some money in your pocket, but
the Feds and the Roth IRA took it all. But we're not going to spend
that money, no sir, we're going to invest it at 8% too, although it's
taxed, so it's really like investing it at 72% of 8%, or about 6%.
After 20 years we withdraw the full amount in each account. What's the
situation?
What Ordinary IRA Roth IRA
Account balance 9,332 9,332
28% federal tax 2,613 0
What's left 6,719 9,332
Outside investment 1,716 0
Net result 8,435 9,332
So this worked out pretty well for the Roth IRA. A key assumption was
that the use of the same tax rate at withdrawal time. If the tax rate
had been significantly less, then the Ordinary IRA would have come out
ahead. And of course you had the discipline to invest the money that
the ordinary IRA left in your hands instead of blowing it in Atlantic
City.

I hope that this example illustrated how you might run the numbers for
yourself. Before you do anything, I recommend you seriously consider
getting advice from a tax professional who can evaluate your
circumstances and make a recommendation that is most appropriate for
you.

If you've decided to convert your ordinary IRA to a Roth IRA, here are
some tips offered by Ellen Schultz of the Wall Street Journal
(paraphrased from her article of 9 Jan 1998).

Pay taxes out of your pocket, not out of your IRA account.
If you use IRA funds to pay the taxes incurred on the conversion
(considered a withdrawal from your ordinary IRA), you've lost much
of the potential tax savings. Worse, those funds will be
considered a premature distribution and you may be hit with a 10%
penalty!
Consider converting only part of your IRA funds.
This decision is up to you. There is no requirement to convert all
of your accounts.
Conversion amounts don't affect your conversion eligibility.
When you convert, the withdrawal amount does not count towards the
100k limit on income.


As a final note, you should be careful about any fees that the trustee
of your Roth IRA account might try to impose. For comparison,
Waterhouse offers a no-fee Roth IRA.

Just for the record, a number of changes were made in 1998 to the
original Roth provisions ("technical corrections"). One problem that
was corrected was that the original law included a tax break for
conversion Roth accounts. Specifically, there was no penalty on early
withdrawals from conversion accounts. This means that any money
converted (and any earnings after conversion) to a Roth from an ordinary
IRA could be withdrawn at any time without penalty, so you could roll to
a Roth IRA and use your ordinary IRA money immediately without penalty.
The technical corrections bill corrected this by requiring that 5 years
elapse after conversion before any sums can be withdrawn. Also, under
the wording of the original law, the minimum 5-year holding period for a
Roth conversion account was based on the date of the last deposit into
that account. One of the consequences of the second problem was that
the IRS was insisting on keeping the conversion accounts separate from
contribution (new money) accounts so as to minimize the potential damage
(tax collection-wise) if the correction was not made (but of course it
was). Another change lowered the already low income test for couples
filing MFS from 15k to 10k.

The rules changed in mid 2001 in the following ways:
* The contribution limit of $2,000 per year maximum rises to $3,000
in 2002; reaches $4,000 in 2005, and finally hits $5,000 in 2008.
* Investors over 50 can contribute an extra $500 per year (in 2002)
and eventually an extra 1,000 (in 2006) per year; this is called a
catch-up provision.

Here's a list of sources for additional information, including on-line
calculators that will help you decide whether you should convert an
ordinary IRA to a Roth IRA.

* Kaye Thomas maintains a site with an enormous wealth of information
about the Roth IRA.

* Brentmark Software offers a Roth IRA site that provides technical
and planning information on Roth IRAs.

* The Roth IRA Advisor provides guidelines for IRA owners and 401(k)
participants to optimize the benefits of their retirement plans.
Written by James Lange, CPA.

* Vanguard offers a considerable amount of information about the new
tax laws and Roth IRA provisions, including detailed analyses of
the two accounts, on their web site:

Also see the Vanguard page that discusses conversions:

* And also try the Vanguard calculator (no, they're not sponsoring me
:-)


* An article about Roth IRAs from SenInvest:

* A collection of links to sites with yet more information about Roth
IRAs, with emphasis on mutual fund holders:

* A conversion calculator from Strong Funds:


For the very last word on the rules and regulations of Roth IRA
accounts, get IRS Publication 553.


--------------------Check for updates------------------

Subject: Retirement Plans - SEP IRA

Last-Revised: 16 Feb 2003
Contributed-By: Edward Lupin, Daniel Lamaute (
)

A simplified employee pension (SEP) IRA is a written plan that allows an
employer to make contributions toward his or her own (if self-employed)
or employees' retirement, without becoming involved in more complex
retirement plans (such as Keoghs). The SEP functions essentially as a
low-cost pension plan for small businesses.

As of this writing, employers can contribute a maximum of 25% of an
employee's eligible compensation or $40,000, whichever is less. Be
careful not to exceed the limits; a non-deductible penalty tax of 6% of
the excess amount contributed will be incurred for each year in which an
excess contribution remains in a SEP-IRA.

Employees are able to exclude from current income the entire SEP
contribution. However, the money contributed to a SEP-IRA belongs to
the employee immediately and always. If the employee leaves the
company, all retirement contributions go with the employee (this is
known as portability).

The IRS regulations state that employers must include all eligible
employees who are at least age 21 and have been with a company for 3
years out of the immediately preceding 5 years. However, employers have
the option to establish less-restrictive participation requirements, if
desired.

An employer is not required to make contributions in any year or to
maintain a certain level of contributions to a SEP-IRA plan. Thus,
small employers have the flexibility to change their annual
contributions based on the performance of the business.

For calendar year corporations with a March 15, 2003 tax filing
deadline, SEP-IRA contributions must be made by the employer by the due
date of the company’s income tax return, including extensions. The
contributions are deductible for tax year 2002 as if the contributions
had actually been contributed within tax year 2002.

Sole proprietors have until April 15, 2003, or to their extension
deadline, to make their SEP-IRA contribution if they want a 2002 tax
deduction.

The SEP-IRA enrollment process is an easy one. It’s generally a two
page application process. The employer completes Form 5305-SEP. The
employee completes the IRA investment application usually supplied by a
mutual fund company or some other financial institution which will hold
the funds. Nothing has to be filed with the IRS to establish the
SEP-IRA or subsequently, unlike many other retirement plans that require
IRS annual returns.


--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 8 of 20)

Archive-name: investment-faq/general/part8
Version: $Id: part08,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plain-text
version of The Investment FAQ, part 8 of 20. The web site
always has the latest version, including in-line links. Please browse



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Neither the compiler of nor contributors to The Investment FAQ make
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for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
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Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Insurance - Annuities

Last-Revised: 20 Jan 2003
Contributed-By: Barry Perlman, Chris Lott ( contact me ), Ed Zollars
(ezollar at mindspring.com)

An annuity is an investment vehicle sold primarily by insurance
companies. Every annuity has two basic properties: whether the payout
is immediate or deferred, and whether the investment type is fixed or
variable. An annuity with immediate payout begins payments to the
investor immediately, whereas the deferred payout means that the
investor will receive payments at a later date. An annuity with a fixed
investment type offer a guaranteed return on investment by investing in
government bonds and other low-risk securities, whereas a variable
investment type means that the return on the annuity investment will
depend on performance of the funds (called sub-accounts) where the money
is invested. Based on these two properties with two possibilities each,
there are four possible combinations, but the ones commonly seen in
practice are an annuity with immediate payout and fixed investments
(often known as a fixed annuity), and an annuity with deferred payout
and variable investments (usually called a variable annuity). This
article discusses fixed annuities briefly and variable annuities at some
length, and includes a list of sources for additional information about
annuities.

Fixed Annuities
The idea of a fixed annuity is that you give a sum of money to an
insurance company, and in exchange they promise to pay you a fixed
monthly amount for a certain period of time, either a fixed period or
for your lifetime (the concept of 'annuitization'). So essentially you
are converting a lump sum into an income stream. Whether you choose
period-certain or annuitization, the payment does not change, even to
account for inflation.

If a fixed-period is chosen (also called a period-certain annuity), the
annuity continues to pay until that period is reached, either to the
original investor or to the investor's estate or heirs. Alternatively,
if the investor chooses to annuitize, then payments continue for a
variable period; namely until the investor's death. For an investor who
annuitized, the insurance company pays nothing further after the
investor's death to the estate or heirs (neither principal nor monthly
payments), no matter how many (or how few) monthly payments you
received.

Fixed annuities allow you some access to your investment; for example,
you can choose to withdraw interest or (depending on the company etc.)
up to 10% of the principal annually. An annuity may also have various
hardship clauses that allow you to withdraw the investment with no
surrender charge in certain situations (read the fine print). When
considering a fixed annuity, compare the annuity with a ladder of
high-grade bonds that allow you to keep your principal with minimal
restrictions on accessing your money.

Annuitization can work well for a long-lived retiree. In fact, a fixed
annuity can be thought of as a kind of reverse life insurance policy.
Of course a life insurance contract offers protection against premature
death, whereas the annuity contract offers protection for someone who
fears out-living a lump sum that they have accumulated. So when
considering annuities, you might want to remember one of the original
needs that annuitities were created to address, namely to offer
protection against longevity.

Another situation in which a fixed annuity might have advantages is if
you wish to generate monthly income and are extremely worried about
someone being able to steal your capital away from you (or steal
someone's capital away from them). If this is the case, for whatever
reason, then giving the capital to an insurance company for management
might be attractive. Of course a decent trust and trustee could
probably do as well.

Variable Annuities
A variable annuity is essentially an insurance contract joined at the
hip with an investment product. Annuities function as tax-deferred
savings vehicles with insurance-like properties; they use an insurance
policy to provide the tax deferral. The insurance contract and
investment product combine to offer the following features:
1. Tax deferral on earnings.
2. Ability to name beneficiaries to receive the balance remaining in
the account on death.
3. "Annuitization"--that is, the ability to receive payments for life
based on your life expectancy.
4. The guarantees provided in the insurance component.

A variable annuity invests in stocks or bonds, has no predetermined rate
of return, and offers a possibly higher rate of return when compared to
a fixed annuity. The remainder of this article focuses on variable
annuites.

A variable annuity is an investment vehicle designed for retirement
savings. You may think of it as a wrapper around an underlying
investment, typically in a very restricted set of mutual funds. The
main selling point of a variable annuity is that the underlying
investments grow tax-deferred, as in an IRA. This means that any gains
(appreciation, interest, etc.) from the annuity are not taxed until
money is withdrawn. The other main selling point is that when you
retire, you can choose to have the annuity pay you an income
("annuitization"), based on how well the underlying investment
performed, for as long as you live. The insurance portion of the
annuity also may provide certain investment guarantees, such as
guaranteeing that the full principal (amount originally contributed to
the account) will be paid out on the death of the account holder, even
if the market value was low at that time.

Unlike a conventional IRA, the money you put into an annuity is not
deductible from your taxes. And also unlike an IRA, you may put as much
money into an annuity as you wish.

A variable annuity is especially attractive to a person who makes lots
of money and is trying, perhaps late in the game, to save aggressively
for retirement. Most experts agree that young people should fully fund
IRA plans and any company 401(k) plans before turning to variable
annuities.

Should you buy an annuity?
The basic question to be answered by someone considering this investment
is whether the cost of the insurance coverage is justified for the
benefits that are paid. In general, the answer to that question is one
that only a specific individual can answer based on his or her specific
circumstances. Either a 'yes' or 'no' answer is possible, and there may
be much support for either position. People who oppose use of annuities
will point out that it is unlikely (less than 50% probability) that the
insurance guarantees will pay off, so that the guarantees are expected
to reduce the overall return. People who favor use of annuities tend to
suggest that not buying the guarantees is always an irresponsible step
because the purchaser increases risk. Both positions can be supported.
But the key issue is whether the purchaser is making an informed
decision on the matter.

Now it's time for some cautionary words about the purchase of annuities.
Many experts feel that annuities are a poor choice for most people when
examined in close detail. The following discussion compares an annuity
to an index fund (see also the article on index funds elsewhere in this
FAQ).

Variable annuities are extremely profitable for the companies that sell
them (which accounts for their popularity among sales people), but are a
terrible choice for most people. Most people are much better off in an
equity index fund. Index funds are extremely tax efficient and provide,
overall, a much more favorable tax situation than an annuity.

The growth of an annuity is fully taxable as income, both to you and
your heirs. The growth of an index fund is taxable as capital gains to
you (which is good because capital gains taxes are always lower than
ordinary income) and subject to zero income tax to your heirs. This
last point is because upon inheritance the asset gets a "stepped up
basis." In plain English, the IRS treats the index fund as though your
heirs just bought it at the value it had when you died. This is a major
tax advantage if you care about leaving your wealth behind. (By
contrast the IRS treats the annuity as though your heirs just earned it;
they must now pay income tax on it!)

If you remove some money from the index fund, the cost basis may be the
cost of your most recent purchase (or if the law is changed as the
administration currently recommends, the average cost of your index
investments). By contrast, any money you remove from an annuity is
taxed at 100% of its value until you bring the annuity's value down to
the size of what you put in. (The law is more favorable for annuities
purchased before 1982, but that's another can of worms.)

Tax considerations aside, the index fund is a better investment. Try to
find some annuities that outperformed the S&P 500 index over the past
ten or twenty years. Now, do you think you can pick which one(s) will
outperform the index over the next twenty years? I don't.

Annuities usually have a sales load, usually have very high expenses,
and always have a charge for mortality insurance. The expenses can run
to 2% or more annually, a much higher load than what an index fund
charges (frequently less than 0.5%). The insurance is virtually
worthless because it only pays if your investment goes down AND you die
before you "annuitize". (More about that further on.) Simple term
insurance is cheaper and better if you need life insurance.

Annuities invest in funds that are difficult to analyze, and for which
independent reports, such as Morningstar, are not always available.

Annuity contracts are very difficult for the average investor to read
and understand. Personally, I don't believe anyone should sign a
contract they don't understand.

Annuities offer the choice of a guaranteed income for life. If you
choose to annuitize your contract (meaning take the guaranteed income
for life), two things happen. One is that you sacrifice your principal.
When you die you leave zero to your heirs. If you want to take cash out
for any reason, you can't. It isn't yours anymore.

In exchange for giving all your money to the insurance company, they
promise to pay you a certain amount (either fixed or tied to investment
performance) for as long as you live. The problem is that the amount
they pay you is small. The very small payoff from annuitizing is the
reason that almost no one actually does it. If you're considering an
annuity, ask the insurance company what percentage of customers ever
annuitize. Ask what the payoff is if you annuitize and you'll see why.
Compare their payoff to keeping your principal and putting it into a
ladder of U.S. Treasuries, or even tax-free munis. Better yet, compare
the payoff to a mortgage for the duration of your expected lifespan. If
you expect to live to 85, compare the payoff at age 70 to a 15-year
mortgage (with you as the lender).

For a fixed payout you would be better off putting your money into US
Treasuries and collecting the interest (and keeping the principal).

Now let's consider a variable payout, determined by the performance of
your chosen investments. The problem here is the Assumed Interest Rate
(AIR), typically three or four percent. In plain English, the insurance
company skims off the first three to four percent of the growth of your
investments. They call that the AIR. Your monthly distribution only
grows to the extent that your investment grows MORE than the AIR. So if
your investment doesn't grow, your monthly payment shrinks (by the AIR).
If your investment grows by the AIR, your monthly payment stays the
same. When the market has a down year, your monthly payment shrinks by
the market loss plus the AIR.

If you do decide to go with an annuity, buy one from a mutual fund
company like T. Rowe Price or Vanguard. They have far superior
products to the annuities offered by insurance companies.

Annuities in IRAs?
Occasionally the question comes up about whether it makes sense to buy a
variable annuity inside a tax-deferred plan like an IRA. Please refer
to the list of four features provided by annuities that appears at the
top of this article.

The first, income deferral, is utterly irrelevant if the annuity is held
in an IRA or retirement account. The IRA and plan already provides for
the deferral and, in fact, distributions are governed by the provisions
of Section 72 applicable to IRA retirement plans, not the general
annuity provisions. I would go so far as to tell anyone who has someone
trying to sell them one of these products in a plan based on the tax
benefits to run as fast as possible away from that adviser. S/he is
either very misinformed or very dishonest.

The second, beneficiary designation, is also a nonissue for annuities in
a retirement account. IRAs and qualified plans already provide for
beneficiary designations outside of probate, for better or worse.

The third, annuitization, is potentially valid, since that is one method
to convert the IRA or plan balance to an income stream. Of course,
nothing prevents you from simply purchasing an annuity at the time you
desire the payout rather than buying a product today that gives you the
option in the future.

I suppose it is possible that the options in the product you buy today
may be superior to those that you expect would be available on the open
market at the time you would decide to "lock it in" or you may at least
feel more comfortable having some of these provisions locked in.

Finally, the fourth feature involves the actual guarantees that are
provided in the annuity contract. To take care of an obvious point
first: the guarantees are provided by the insurance carrier, so clearly
it's not the level of FDIC insurance that is backed by the US
Government. But, then again, only deposits in banks are backed by this
guarantee, and the annuity guarantees have generally been good when
called upon.

Normally, any guarantee comes at some cost (well, at least if the
insurer plans to stay in business [grin]) and the cost should be
expected to rise as the guarantee becomes more likely to be invoked.
Some annuities are structured to be low cost, and tend to provide a bare
minimum of guarantees. These products are set up this way to
essentially, provide the insurance "wrapper" to give the tax deferral.

I would note that if, in fact, the guarantees are highly unlikely to be
triggered and/or would only be triggered in cases where the holder
doesn't care, then any cost is likely "excessive" when the guarantee no
longer buys tax deferral, as would be the case if held in a qualified
plan. Note that the "doesn't care" case may be true if the guarantee
only comes into play at the death of the account holder, but the holder
is primarily interested in the investment to fund consumption during
retirement.

What this means is that you need a) a full and complete understanding of
exactly what promise has been made to you by the guarantees in the
contract and b) a full understanding of the costs and fees involved, so
that you can make a rational decision about whether the guarantees are
worth the amount you are paying for them.

It's theoretically possible to find a guarantee that would fit a
client's circumstance at a cost the client would deem resaonable that
would make the annuity a "good fit" in a retirement plan. Some problems
that arise are when clients are led to believe that somehow the annuity
in the retirement plan gives them a "better" tax deferral or somehow
creates a situation where they "avoid probate" on the plan. A good
agent is going to specifically discuss the annuitization and investment
guarantee features when considering an annuity in a plan or IRA and will
explicitly note that the first two (tax deferral and beneficiary
designation) don't apply because it's in the plan or IRA.

Additional Resources
1. Raymond James offers a free and independent resource with
comprehensive information about annuities.

2. Client Preservation & Marketing, Inc. operates a web site with
in-depth information about fixed annuities.

3. Scott Burns wrote an article "Why variable annuities are no match
for index funds" at MSN Money Central on 15 June 2001.

4. TheStreet.com rated annuity comparison shopping sites on 5 May 00.
Also look for the links to two articles by Vern Hayden with
arguments for and against variable annuities.

5. Cornerstone Financial Products offers a site with complete
information about variable annuities, including quotes,
performance, and policy costs.

6. "Annuities: Just Say No" in the July/August 1996 issue of Worth
magazine.
7. "Five Sad Variable Annuity Facts Your Salesman Won't Tell You" in
the April 5, 1995 Wall Street Journal quarterly review of mutual
funds.
8. WebAnnuities.com helps investors choose annuities with instant
quotes and an annuity shopper's library that has extensive
information about annuities.



--------------------Check for updates------------------

Subject: Insurance - Life

Last-Revised: 30 Mar 1994
Contributed-By: Joe Collins

[ A note from the FAQ compiler: I believe that this article offers sound
advice about life insurance for the average middle-class person.
Individuals with a high net worth may be able to use life insurance to
shelter their assets from estate taxes, but those sorts of strategies
are not useful for people with an estate that falls under the tax-free
amount of about a million dollars. Your mileage may vary. ]

This is my standard reply to life insurance queries. And, I think many
insurance agents will disagree with these comments.

First of all, decide WHY you want insurance. Think of insurance as
income-protection, i.e., if the insured passes away, the beneficiary
receives the proceeds to offset that lost income. With that comment
behind us, I would never buy insurance on kids, after all, they don't
have income and they don't work. An agent might say to buy it on your
kids while its cheap - but run the numbers, the agent is usually wrong,
remember, agents are really salesmen/women and its in their interest to
sell you insurance. Also - I am strongly against insurance on kids on
two counts. One, you are placing a bet that you kid will die and you
are actually paying that bet in premiums. I can't bet my child will
die. Two, it sounds plausible, i.e., your kid will have a nest egg when
they grow up but factor inflation in - it doesn't look so good. A
policy of face amount of $10,000, at 4.5% inflation and 30 years later
is like having $2,670 in today's dollars - it's NOT a lot of money. So
don't plan on it being worth much in the future to your child as an
investment. In summary, skip insurance on your kids.

I also have some doubts about insurance as investments - it might be a
good idea but it certainly muddies the water. Why not just buy your
insurance as one step and your investment as another step? - its a lot
simpler to keep them separate.

So by now you have decided you want insurance, i.e., to protect your
family against you passing away prematurely, i.e., the loss of income
you represent (your salary, commissions, etc.).

Next decide how LONG you want insurance for. If you're around 60 years
old, I doubt you want to get any at all. Your income stream is largely
over and hopefully you have accumulated the assets you need anyway by
now.

If you are married and both work, its not clear you need insurance at
all if you pass on. The spouse just keeps working UNLESS you need both
incomes to support your lifestyle (more common these days). Then you
should have one policy on each of you.

If you are single, its not clear you need life insurance at all. You
are not supporting anyone so no one cares if you pass on, at least
financially.

If you are married and the spouse is not working, then the breadwinner
needs insurance UNLESS you are independently wealthy. Some might argue
you should have insurance on your spouse, i.e., as homemaker, child care
provider and so forth. In my oponion, I would get a SMALL policy on the
spouse, sufficient to cover the costs of burying them and also
sufficient to provide for child care for a few years or so. Each case
is different but I would look for a small TERM policy on the order of
$50,000 or less. Get the cheapest you can find, from anywhere. It
should be quite cheap. Skip any fancy policies - just go for term and
plan on keeping it until your child is own his/her own. Then reduce the
insurance coverage on your spouse so it is sufficient to bury your
spouse.

If you are independently wealthy, you don't need insurance because you
already have the money you need. You might want tax shelters and the
like but that is a very different topic.

Suppose you have a 1 year old child, the wife stays home and the husband
works. In that case, you might want 2 types of insurance: Whole life
for the long haul, i.e., age 65, 70, etc., and Term until your child is
off on his/her own. Once the child has left the stable, your need for
insurance goes down since your responsibilities have diminished, i.e.,
fewer dependents, education finished, wedding expenses done, etc

Mortgage insurance is popular but is it worthwhile? Generally not
because it is far too expensive. Perhaps you want some sort of Term
during the duration of the mortgage - but remember that the mortgage
balance DECLINES over time. But don't buy mortgage insurance itself -
much too expensive. Include it in the overall analysis of what
insurance needs you might have.

What about flight insurance? Ignore it. You are quite safe in airplanes
and flight insurance is incredibly expensive to buy.

Insurance through work? Many larger firms offer life insurance as part
of an overall benefits package. They will typically provide a certain
amount of insurance for free and insurance beyond that minimum amount is
offered for a fee. Although priced competitively, it may not be wise to
get more than the 'free' amount offered - why? Suppose you develop a
nasty health condition and then lose your job (and your benefit-provided
insurance)? Trying to get reinsured elsewhere (with a health condition)
may be very expensive. It is often wiser to have your own insurance in
place through your own efforts - this insurance will stay with you and
not the job.

Now, how much insurance? One rule of thumb is 5x your annual income.
What agents will ask you is 'Will your spouse go back to work if you
pass away?' Many of us will think nobly and say NO. But its actually
likely that your spouse will go back to work and good thing - otherwise
your insurance needs would be much larger. After all, if the spouse
stays home, your insurance must be large enough to be invested wisely to
throw off enough return to live on. Assume you make $50,000 and the
spouse doesn't work. You pass on. The Spouse needs to replace a
portion of your income (not all of it since you won't be around to feed,
wear clothes, drive an insured car, etc.). Lets assume the Spouse needs
$40,000 to live on. Now that is BEFORE taxes. Lets say its $30,000 net
to live on. $30,000 is the annual interest generated on a $600,000
tax-free investment at 5% per year (e.g., munibonds). So this means you
need $600,000 of face value insurance to protect your $50,000 current
income. These numbers will vary, depending on interest rates at the
time you do your analysis and how much money you spouse will need,
factoring in inflation. But the point is that you need at least another
$600,000 of insurance to fund if the survivng spouse doesn't and won't
work. Again, the amount will vary but the concept is the same.

This is only one example of how to do it and income taxes, estate taxes
and inflation can complicate it. But hopefully you get the idea.

Which kind of insurance, in my humble opinion, is a function of how long
you need it for. I once did an analysis of TERM vs WHOLE LIFE and based
on the assumptions at the time, WHOLE LIFE made more sense if I held the
insurance more than about 20-23 years. But TERM was cheaper if I held
it for a shorter period of time. How do you do the analysis and why
does the agent want to meet you? Well, he/she will bring their fancy
charts, tables of numbers and effectively lead you into thinking that
the biggest, most expensive policy is the best for you over the long
term. Translation: lots of commissions to the agent. Whole life is
what agents make their money on due to commissions. The agents
typically gets 1/2 of your first year's commissions as his pay. And he
typically gets 10% of the next year's commissions and likewise through
year 5. Ask him (or her) how they get paid.

If he won't tell you, ask him to leave. In my opinion, its okay that
the agents get commissions but just buy what you need, don't buy some
huge policy. The agent may show you compelling numbers on a $1,000,000
whole life policy but do you really need that much? They will make lots
of money on commissions on such a policy, but they will likely have sold
you the "Mercedes Benz" type of policy when a Ford Taurus or a Saturn
sedan model would also be just fine, at far less money. Buy the life
insurance you need, not what they say.

What I did was to take their numbers, review their assumptions (and
corrected them when they were far-fetched) and did MY analysis. They
hated that but they agreed my approach was correct. They will show you
a 12% rate of return to predict the cash value flow. Ignore that - it
makes them look too good and its not realistic. Ask him/her exactly
what they plan to invest your premium money in to get 12%. How has it
done in the last 5 years? 10? Use a number between 4.5% (for TBILL
investments, quite conservative) and 8-10% (for growth stocks, more
risky), but not definitely not 12%. I would try 8% and insist it be
done that way.

Ask each agent these questions:
1. What is the present value of the payment stream represented by the
premiums, using a discount rate of 4.5% per year (That is the
inflation average since 1940). This is what the policy costs you,
in today's dollars. Its very much like paying that single number
now instead of a series of payments over time. If they disagree
with 4.5%, remind them that since 1926, inflation has averaged 3.5%
(Ibbotson Associates) and then suggest they use 3.5% instead. They
may then agree with the 4.5% (!) The lower the number, the more
expensive the policy is.
2. What is the present value of the the cash value earned (increasing
at no more than 8% a year) and discounting it back to today at the
same 4.5%. This is what you get for that money you just paid, in
cash value, expressed in today's dollars, i.e., as if you got it
today in the mail.
3. What is the present value of the life insurance in force over that
same period, discounted back to today by 4.5%, for inflation. That
is the coverage in effect in today's dollars.
4. Pick an end date for comparing these - I use age 60 and age 65.

With the above in hand from various agents, you can see fairly quickly
which is the better policy, i.e., which gives you the most for your
money.

By the way, inflation is slippery and sneaky. All too often we see
$500,000 of insurance and it sounds great, but at 4.5% inflation and 30
years from now, that $500,000 then is like $133,500 now - truly!

Have the agent do your analysis, BUT you give him the rates to use,
don't use his. Then you pick the policy that is the best value, i.e.,
you get more for your money. Factor in any tax angles as well. If the
agent refuses to do this analysis for you, get rid of him/her.

If the agent gets annoyed but cannot fault your analysis, then you have
cleared the snow away and gotten to the truth. If they smile too much,
you may have missed something. And that will cost you money.

Never agree to any policy unless you understand all the numbers and all
the terms. Never 'upgrade' policies by cashing in a whole life for
another whole life. That just depletes your cash value, real cash
available to you. And the agent gets to pocket that money, literally,
through new commissions. Its no different that just writing a personal
check, payable to the agent.

Check out the insurer by going to the reference section of a big
library. Ask for the AM BEST guide on insurance. Look up where the
issuer stands relative to the competition, on dividends, on cash value,
on cost of insurance per premium dollar.

Agents will usually not mention TERM since they work on commission and
get much more money for Whole Life than they do for term. Remember, The
agents gets about 1/2 of your 1st years premium payments and 10% or so
for all the money you send in over the following 4 years. Ask them to
tell you how they are paid- after all, its your money they are getting.

Now why don't I like UNIVERSAL or VARIABLE? Mainly because with Whole
Life and with TERM, you know exactly what you must pay because the
issuer must manage the investments to generate the appropriate returns
to provide you with the insurance (and with cash value if whole life).
With UNIVERSAL and VARIABLE, it becomes YOU who must decide how and
where to invest your premium income. If you guess badly, you will have
to pay a higher premium to cover those bad decisions. The insurance
companies invented UNIVERSAL and VARIABLE because interest rates went
crazy in the early 80's and they lost money. Rather than taking that
risk again, they offered these new policies to transfer that risk to
you. Of course, UNIVERSAL and VARIABLE will be cheaper in the short
term but BE CAREFUL - they can and often will increase later on.

Okay, so what did I do? I bought both term and whole life. I plan to
keep the term until my son graduates from college and he is on his own.
That is about 10 years from now. I also bought whole life (NorthWestern
Mutual Life, Milwaukee, WI) which I plan to keep forever, so to speak.
NWML is apparently the cheapest and best around according to A.M. BEST.
At this point, after 3 years with NWML, I make more in cash value each
year than I pay into the policy in premiums. Thus, they are paying me
to stay with them.

Where do you buy term? Just buy the cheapest policy since you will tend
to renew the policy once a year and you can change insurers each time.
Check your local savings bank as one source.

Suppose an agent approaches you about a new policy and wishes to update
your old ones and switch you into the new policy or new financial
product they are offering? BE CAREFUL: When you switch policies, you
close out the old one, take out its cash value and buy a new one. But
very often you must start paying those hidden commissions all over
again. You won't see it directly but look carefully at how the cash
value grows in the first few years. It won't grow much because the
'cash' is usually paying the commissions again. Bottom line: You
usually pay commissions twice - once on the old policy and again on the
new policy - for generally the same insurance. Thus you paid twice for
the same product. Again - be careful and make sure it makes sense to
switch policies.

A hard thing to factor in is that one day you may become uninsurable
just when you need it, i.e., heart attack, cancer and the like. I would
look at getting cheap term insurance but add in the options of
'guaranteed convertible' (to whole life) and 'guarranteed renewable'
(they must provide the insurance). It will add somewhat to the cost of
the insurance.

Last thought. I'll bet you didn't you know that you are 3x more likely
to become disabled during your working career than you to die during
your working career. How is your short term disability insurance
looking? Get a policy that has a waiting period before it kicks in.
This will keep it cheaper. Look at the exclusions, if any.

These comments are MY opinion and not my employers. All the usual
disclaimers apply and your mileage may vary depending on individual
circumstances.

Sources for additional information:
* Consumers Reports printed an in-depth, three-part series in their
Jul/Aug/Sep 1993 issues.
* Many sites on the web offer life insurance quotes. Here are a few
that have been rated highly by consumer advocates. Also see the
article in the New York Times of 1 August 2001.
Insweb.com , NetQuote.com , Quicken.com , Quotesmith.com ,
Youdecide.com , Term4sale.com .


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Subject: Insurance - Viatical Settlements

Last-Revised: 19 Aug 1998
Contributed-By: Gloria Wolk ( www.viatical-expert.net ), Chris Lott (
contact me )

A viatical settlement is a lump sump of cash given to terminally ill
people (viators) in exchange for the death benefits of their life
insurance. Along with so much of the English language, the name has its
origins in a Latin word, viaticum , which means provisions for a journey
..

These settlements are attractive to a viator (seller) because the person
gets a significant amount of money that will ease the financial stress
of their final days. Viatical settlements are attractive to investors
for their potentially high -- but not guaranteed -- rates of return.

The way it works in the simplest case is the investor pays some
percentage of the face value of the policy, let's say 50% just to pick a
number, and in return becomes the beneficiary of the policy. The
investor is then responsible for paying the premiums associated with the
life insurance policy. Upon the demise of the viator, the investor
receives the death benefit of the life insurance policy. If the viator
dies shortly after the transaction is completed, the investor makes a
large amount of money. If the viator survives several years past the
predicted life expectancy, the investor will lose money.

Like any other deal, there are risks to both parties. For the viator,
the main risk is settling at too low a price. For the investor, there
are risks of not receiving the full death benefit if the insurance
company goes bankrupt, not receiving any death benefit if the insured
committed fraud on the insurance application, etc.

As of this writing, a few honest and a number of less-than-scrupulous
companies market viatical settlements to viators and investors. Be
careful! This investment is not regulated, so there is little or no
protection for investors.

Here are a few tips for potential viators.

* Are you holding back from medical treatment, thinking this will
give you a larger viatical settlement? Don't. It won't get you
more money. Viatical providers take into account Investigational
New Drugs (INDs) when they price policies. Even if you never took
any and don't plan to, they expect viators will try anything that
gives hope, and they price accordingly.
* Was your policy resold by the viatical company? If so, you have no
obligation to a second buyer -- unless you signed an agreement to
extend obligations to future owners. This is like selling a car:
If you sell the car to B and B resells it to C, you have no
obligation to C.
* Be sure to check with your insurer to find out if your policy
includes Accelerated Death Benefits. If so, and if you qualify,
you will get much more money -- and it will be paid faster. This
applies to some group term life as well as individual policies.
* Are you are a member of a Credit Union? Credit Unions may be a
source of information about and referrals to licensed viatical
providers.
* Don't apply to only one viatical company -- even if the referral
was made by your doctor, lawyer, insurance agent, social worker, or
credit union. If you ignore this advice, you're likely to get
thousands of dollars less. Here are a few tips for potential
investors in viatical settlements.
* Are you thinking of using your IRA for viatical investments? Don't.
No matter what viatical sales promoters tell you, life insurance as
an IRA investment is prohibited by the Internal Revenue Code. And,
if you have a self-directed IRA, you are fully responsible for
investment decisions.
* Are you thinking of buying a policy that is within the
contestability period? Don't. If the viator committed fraud on the
application and the insurer discovers this, you could be left with
nothing more than a return of premiums. Gloria Wolk's site offers
much information about viatical settlements.



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Subject: Insurance - Variable Universal Life (VUL)

Last-Revised: 26 Jun 2000
Contributed-By: Ed Zollars (ezollar at mindspring.com), Chris Lott (
contact me ), Dan Melson (dmelson at home.com)

This article explains variable universal life (VUL) insurance, and
discusses some of the situations where it is appropriate.

Variable universal life is a form of life insurance, specifically it's a
type of cash-value insurance policy. (The other types of cash value
life insurance are whole, universal, and variable life.) Like any life
insurance policy, there is a payout in case of death (also called the
death benefit). Like whole-life insurance, the insurance policy has a
cash value that enjoys tax-deferred growth over time, and allows you to
borrow against it. Unlike either term or traditional whole-life
insurance, VUL policies allow the insured to choose how the premiums are
invested, usually from a universe of 10-25 funds. This means that the
policy's cash value as well as the death benefit can fluctuate with the
performance of the investments that the policy holder chose.

Where does the name come from? To take the second part first, the
"universal" component refers to the fact the premium is not a "set in
stone" amount as would be true with traditional whole life, but rather
can be varied within a range. As for the first part of the name, the
"variable" portion refers to the fact that the policy owner can direct
the investments him/herself from a pool of options given in the policy
and thus the cash value will vary. So, for instance, you can decide the
cash value should be invested in various types of equities (while it can
be invested in nonequities, most interest in VUL policies comes from
those that want to use equities). Obviously, you bear the risk of
performance in the policy, and remember we have to keep enough available
to fund the expenses each year. So bad performance could require
increasing premiums to keep the policy in force. Conversely, you gain
if you can invest and obtain a better return (at least you get more cash
value).

If a VUL policy holder was fortunate enough to choose investments that
yield returns anything like what the NASDAQ saw in 1999, the policy's
cash value could grow quite large indeed. The cash value component of
the policy may be in addition to the death benefit should you die (you
get face insurance value *plus* the benefit) *OR* serve to effectively
reduce the death benefit (you get the face value, which means the cash
value effectively goes to subsidize the death benefit). It all depends
on the policy.

A useful way to think about VUL is to think of buying pure term
insurance and investing money in a mutual fund at the same time. This
is essentially what the insurance company that sells you a VUL is doing
for you. However, unlike your usual mutual fund that may pass on
capital gains and other income-tax obligations annually, the investments
in a VUL grow on a tax-deferred basis. Uncle Sam may get a taste
eventually (if the policy is cashed in or ceases to remain in force),
but not while the funds are growing and the policy is maintained.

We can talk about the insurance component of a VUL and about the
investment component. The insurance component obviously provides the
death benefit in the early years of the policy if needed. The
investment component serves as "bank" of sorts for the amounts left over
after charges are applied against the premium paid, namely charges for
mortality (to fund the payouts for those that die with amounts paid
beyond the cash values), administrative fees (it costs money to run an
insurance company (grin)) and sales compensation (the advisor has to
earn a living). How this amount is invested is the principal difference
between a VUL and other insurance policies.

If you own a VUL policy, you can borrow against the cash value build-up
inside the policy. Because monies borrowed from a VUL policy that is
maintained through the insured's life are technically borrowed against
the death benefit, they work out tax free. This means a VUL owner can
borrow money during retirement against the cash value of the policy and
never pay tax on that money. It sounds almost too good to be true, but
it's true.

A policy holder who choose to borrow against the death benefit must be
extremely careful. A policy collapses when the cash value plus any
continuing payments aren't enough to keep the basic insurance in force,
and that causes the previously tax-free loans to be viewed as taxable
income. Too much borrowing can trigger a collapse. Here's how it can
happen. As the insured ages, Cost of Insurance (COI) per thousand
dollars of insurance rises. With a term policy, it's no big deal - the
owner can just cancel or let it lapse without tax consequences, they
just have no more life insurance policy. But with a cash value policy
such as VUL there is the problem of distributions that the owner may
take. Say on a policy with a cash value of $100,000 I start taking
$10,000 per year withdrawals/loans. Say I keep doing this for 30 years,
and then the variability of the market bites the investment and the cash
value gets exhausted. I may have put say 50,000 into the policy -
that's my cost basis, and I took that much out as withdrawals. But the
other $250,000 is technically a loan against the death benefit, and I
don't have to pay taxes on it - until there's suddenly no death benefit
because there's no policy. So here's $250,000 I suddenly have to pay
taxes on.

Once the policy is no longer in force, all the money borrowed suddenly
counts as taxable income, and the policy holder either has taxable
income with no cash to show for it, or a need to start paying premiums
again. At the point of collapse, the owner could be (reasonably likely)
destitute anyway, so there may be very little in the way of real
consequences, but if there are still assets, like a home, other monies,
etcetera, you see that there could be problems. Which is why cash value
life insurance should be the *last* thing you take distributions from in
most cases (The more tax-favored they are, the longer you put off
distributions.) What all this means is that the cash surrender value of
the VUL really isn't totally available at any point in time, since
accessing it all will result in a tax liability. If you want to
consider the real cash value, you need realistic projections of what can
be safely borrowed from the policy.

This seems like a good time to mention one other aspect of taxes and
life insurance, namely FIFO (first-in first-out) treatment. In other
words, if a policy holder withdraws money from a cash-value life
insurance policy, the withdrawal is assumed to come from contributions
first, not earnings. Withdrawals that come from contributions aren't
taxable (unless it's qualified money, a rare occurence). After the
contributions are exhausted, then withdrawals are assumed to come from
earnings.

Computing the future value of a VUL policy borders on the impossible.
Any single line projection of the VUL is a) virtually certain to be
wrong and b) without question overly simplistic. This is a rather
complex beast that brings with it a wide range of potential outcomes.
Remember that while we cannot predict the future, we know pretty much
for sure that you won't get a nice even rate of return each year (though
that's likely what all VUL examples will assume). The date when returns
are earned can be far more important than the average return earned. To
compare a VUL with other choices, you need to do a lot of "what ifs"
including looking at the impacts of uneven returns, and understand all
the items in the presentation that may vary (including your date of
death (grin)).

While I hate to give "rules of thumb" in these areas, the closest I will
come is to say that VUL normally makes the most sense when you can
heavily fund the policy and are looking at a very long term for the
funds to stay invested. The idea is to limit the "drag" on return from
the insurance component, but get the tax shelter.

Another issue is that if you will have a taxable estate and helping to
fund estate taxes is one of the needs you see for life insurance, the
question of the ownership of the insurance policy will come into play.
Note that this will complicate matters even further (and you probably
already thought it was bad enough (grin)), because what you need to do
to keep it out of your estate may conflict with other uses you had
planned for the policy.

Note that there are "survivor VULs", insuring two lives, which are
almost always sold for either estate planning or retirement plan
purposes (or both). The cost of insurance is typically less than an
annuity's M&E charges until the younger person is in their fifties.

A person who is considering purchasing a VUL policy needs to think
clearly about his or her goals. Those goals will determine both whether
a VUL is right tool and how it should be used. Potential goals include:
* Providing a pool of money that will only be tapped at my death, but
will be used by my spouse.
* Providing a pool of money that will only be used at my death, but
which we want to use to pay estate taxes.
* Providing a pool of money that I plan to borrow from in old age to
live on, and which will, in the interim, provide a death benefit
for my spouse.

Once the goals are clear, and you've then determined that a VUL would be
something that could fulfill your goals, you then have to find the right
VUL.


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Subject: Mutual Funds - Basics

Last-Revised: 11 Aug 1998
Contributed-By: Chris Lott ( contact me )

This article offers a basic introduction to mutual funds. It can help
you decide if a mutual fund might be a good choice for you as an
investment.

If you visit a big fund company's web site (e.g., www.vanguard.com),
they'll tell you that a mutual fund is a pool of money from many
investors that is used to pursue a specific objective. They'll also
hasten to point out that the pool of money is managed by an investment
professional. A prospectus (see below) for any fund should tell you
that a mutual fund is a management investment company. But in a
nutshell, a mutual fund is a way for the little guy to invest in, well,
almost anything. The most common varieties of mutual funds invest in
stocks or bonds of US companies. (Please see articles elsewhere in this
FAQ for basic explanations of stocks and bonds.)

First let's address the important issue: how little is our proverbial
little guy or gal? Well, if you have $20 to save, you would probably be
better advised to speak to your neighborhood bank about a savings
account. Most mutual funds require an initial investment of at least
$1,000. Exceptions to this rule generally require regular, monthly
investments or buying the funds with IRA money.

Next, let's clear up the matter of the prospectus, since that's about
the first thing you'll receive if you call a fund company to request
information. A prospectus is a legal document required by the SEC that
explains to you exactly what you're getting yourself into by sending
money to a management investment company, also known as buying into a
mutual fund. The information most useful to you immediately will be the
list of fees, i.e., exactly what you will be charged for having your
money managed by that mutual fund. The prospectus also discloses things
like the strategy taken by that fund, risks that are associated with
that strategy, etc. etc. Have a look at one, you'll quickly see that
securities lawyers don't write prose that's any more comprehensible than
other lawyers.

The worth of an investment with an open-end mutual fund is quoted in
terms of net asset value. Basically, this is the investment company's
best assessment of the value of a share in their fund, and is what you
see listed in the paper. They use the daily closing price of all
securities held by the fund, subtract some amount for liabilities,
divide the result by the number of outstanding shares and Poof! you have
the NAV. The fund company will sell you shares at that price (don't
forget about any sales charge, see below) or will buy back your shares
at that price (possibly less some fee).

Although boring, you really should understand the basics of fund
structure before you buy into them, mostly because you're going to be
charged various fees depending on that structure. All funds are either
closed-end or open-end funds (explanation to follow). The open-end
funds may be further categorized into load funds and no-load funds.
Confusingly, an open-end fund may be described as "closed" but don't
mistake that for closed-end.

A closed-end fund looks much like a stock of a publically traded
company: it's traded on some stock exchange, you buy or sell shares in
the fund through a broker just like a stock (including paying a
commission), the price fluctuates in response to the fund's performance
and (very important) what people are willing to pay for it. Also like a
publically traded company, only a fixed number of shares are available.

An open-end fund is the most common variety of mutual fund. Both
existing and new investors may add any amount of money they want to the
fund. In other words, there is no limit to the number of shares in the
fund. Investors buy and sell shares usually by dealing directly with
the fund company, not with any exchange. The price fluctuates in
response to the value of the investments made by the fund, but the fund
company values the shares on its own; investor sentiment about the fund
is not considered.

An open-end fund may be a load fund or no-load fund. An open-end fund
that charges a fee to purchase shares in the fund is called a load fund.
The fee is called a sales load, hence the name. The sales load may be
as low as 1% of the amount you're investing, or as high as 9%. An
open-end fund that charges no fee to purchase shares in the fund is
called a no-load fund.

Which is better? The debate of load versus no-load has consumed
ridiculous amounts of paper (not to mention net bandwidth), and I don't
know the answer either. Look, the fund is going to charge you something
to manage your money, so you should consider the sales load in the
context of all fees charged by a fund over the long run, then make up
your own mind. In general you will want to minimize your total
expenses, because expenses will diminish any returns that the fund
achieves.

One wrinkle you may encounter is a "closed" open-end fund. An open-end
fund (may be a load or a no-load fund, doesn't matter) may be referred
to as "closed." This means that the investment company decided at some
point in time to accept no new investors to that fund. However, all
investors who owned shares before that point in time are permitted to
add to their investments. (In a nutshell: if you were in before, you
can get in deeper, but if you missed the cutoff date, it's too late.)

While looking at various funds, you may encounter a statistic labeled
the "turnover ratio." This is quite simply the percentage of the
portfolio that is sold out completely and issues of new securities
bought versus what is still held. In other words, what level of trading
activity is initiated by the manager of the fund. This can affect the
capital gains as well as the actual expenses the fund will incur.

That's the end of this short introduction. You should learn about the
different types of funds , and you might also want to get information
about the various fees that funds can charge , just to mention two big
issues. Check out the articles elsewhere in this FAQ to learn more.

Here are a few resources on the 'net that may also help.
* Brill Editorial Services offers Mutual Funds Interactive, an
independent source of information about mutual funds.

* FundSpot offers mutual fund investors the best information
available for free.

* The Mutual Fund Investor's Center, run by the Mutual Fund Education
Alliance, offers profiles, performance data, links, etc.



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Subject: Mutual Funds - Average Annual Return

Last-Revised: 24 Jun 1997
Contributed-By: Jack Piazza (seninvest at aol.com)

The average annual return for a mutual fund is stated after expenses.
The expenses include fund management fees, 12b-1 fees (if applicable),
etc., all of which are a part of the fund's expense ratio. Average
annual returns are also factored for any reinvested dividend and capital
gain distributions. To compute this number, the annual returns for a
fixed number of years (e.g., 3, 5, life of fund) are added and divided
by the number of years, hence the name "average" annual return. This
specifically means that the average annual return is not a compounded
rate of return.

However, the average annual returns do not include sales commissions,
unless explictly stated. Also, custodial fees which are applied to only
certain accounts (e.g., $10 annual fee for IRA account under a stated
amount, usually $5,000) are not factored in annual returns.


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Subject: Mutual Funds - Buying from Brokers versus Fund Companies

Last-Revised: 28 Dec 1998
Contributed-By: Daniel Pettit (dalacap at dalacap.com), Jim Davidson
(jdavidso at xenon.stanford.edu), Chris Lott ( contact me ), Michael
Aves (michaelaves at hotmail.com)

Many discount brokerage houses now offer their clients the option of
purchasing shares in mutual funds directly from the brokerage house.
Even better, most of these brokers don't charge any load or fees if a
client buys a no-load fund. There are a few advantages and
disadvantages of doing this.

Here are a few of the advantages.
1. One phone call/Internet connection gets you access to hundreds of
funds.
2. One consolidated statement at the end of the month.
3. Instant access to your money for changing funds and or families,
and for getting your money in your hand via checks (2-5 days).
4. You can buy on margin, if you are so inclined.
5. Only one tax statement to (mis)file.
6. The minimum investment is sometimes lower.

And the disadvantages:
1. Many discount brokerage supermarket programs do not even give
access to whole sectors of the market, such as high-yield bond
funds, or multi-sector (aka "Strategic Income") bond funds.
2. Most discount brokers also will not allow clients to do an exchange
between funds of different families during the same day (one trade
must clear fist, and the the trade can be done the next day).
3. Many will not honor requests to exchange out of funds if you call
after 2pm. EST. (which of course is 11am in California). This is
a serious restriction, since most fund families will honor an
exchange or redemption request so long as you have a rep on the
phone by 3:59pm.
4. You pay transaction fees on some no-load funds.
5. The minimum investment is sometimes higher.

Of course the last item in each list contradict each other, and deserve
comment. I've seen a number of descriptions of funds that had high
initial minimums if bought directly (in the $10,000+ range), but were
available through Schwab for something like $2500. I think the same is
true of Fidelity. Your mileage may vary.


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Compilation Copyright (c) 2003 by Christopher Lott.