The Investment FAQ (part 1 of 20)

The Investment FAQ (part 1 of 20)

am 30.05.2005 06:30:03 von noreply

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 3 of 20)

am 30.05.2005 06:30:04 von noreply

Archive-name: investment-faq/general/part3
Version: $Id: part03,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 3 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: Analysis - Internal Rate of Return (IRR)

Last-Revised: 25 June 1999
Contributed-By: Christopher Yost (cpy at world.std.com), Rich Carreiro
(rlcarr at animato.arlington.ma.us)

If you have an investment that requires and produces a number of cash
flows over time, the internal rate of return is defined to be the
discount rate that makes the net present value of those cash flows equal
to zero. This article discusses computing the internal rate of return
on periodic payments, which might be regular payments into a portfolio
or other savings program, or payments against a loan. Both scenarios
are discussed in some detail.

We'll begin with a savings program. Assume that a sum "P" has been
invested into some mutual fund or like account and that additional
deposits "p" are made to the account each month for "n" months. Assume
further that investments are made at the beginning of each month,
implying that interest accrues for a full "n" months on the first
payment and for one month on the last payment. Given all this data, how
can we compute the future value of the account at any month? Or if we
know the value, what was the rate of return?

The relevant formula that will help answer these questions is:
F = -P(1+i)^n - [p(1+i)((1+i)^n - 1)/i]
In this formula, "F" is the future value of your investment (i.e., the
value after "n" months or "n" weeks or "n" years--whatever the period
over which the investments are made), "P" is the present value of your
investment (i.e., the amount of money you have already invested), "p" is
the payment each period, "n" is the number of periods you are interested
in, and "i" is the interest rate per period. Note that the symbol '^'
is used to denote exponentiation (2 ^ 3 = 8).

Very important! The values "P" and "p" should be negative . This
formula and the ones below are devised to accord with the standard
practice of representing cash paid out as negative and cash received (as
in the case of a loan) as positive. This may not be very intuitive, but
it is a convention that seems to be employed by most financial programs
and spreadsheet functions.

The formula used to compute loan payments is very similar, but as is
appropriate for a loan, it assumes that all payments "p" are made at the
end of each period:
F = -P(1+i)^n - [p((1+i)^n - 1)/i]
Note that this formula can also be used for investments if you need to
assume that they are made at the end of each period. With respect to
loans, the formula isn't very useful in this form, but by setting "F" to
zero, the future value (one hopes) of the loan, it can be manipulated to
yield some more useful information.

To find what size payments are needed to pay-off a loan of the amount
"P" in "n" periods, the formula becomes this:
-Pi(1+i)^n
p = ------------
(1+i)^n - 1
If you want to find the number of periods that will be required to
pay-off a loan use this formula:
log(-p) - log(-Pi - p)
n = ----------------------
log(1+i)


Keep in mind that the "i" in all these formula is the interest rate per
period . If you have been given an annual rate to work with, you can
find the monthly rate by adding 1 to annual rate, taking the 12th root
of that number, and then subtracting 1. The formula is:
i = ( r + 1 ) ^ 1/12 - 1
where "r" is the rate.

Conversely, if you are working with a monthly rate--or any periodic
rate--you may need to compound it to obtain a number you can compare
apples-to-apples with other rates. For example, a 1 year CD paying 12%
in simple interest is not as good an investment as an investment paying
1% compounded per month. If you put $1000 into each, you'll have $1120
in the CD at the end of the year but $1000*(1.01)^12 = $1126.82 in the
other investment due to compounding. In this way, interest rates of any
kind can be converted to a "simple 1-year CD equivalent" for the
purposes of comparison. (See the article "Computing Compound Return"
for more information.)

You cannot manipulate these formulas to get a formula for "i," but that
rate can be found using any financial calculator, spreadsheet, or
program capable of calculating Internal Rate of Return or IRR.

Technically, IRR is a discount rate: the rate at which the present value
of a series of investments is equal to the present value of the returns
on those investments. As such, it can be found not only for equal,
periodic investments such as those considered here but for any series of
investments and returns. For example, if you have made a number of
irregular purchases and sales of a particular stock, the IRR on your
transactions will give you a picture of your overall rate of return.
For the matter at hand, however, the important thing to remember is that
since IRR involves calculations of present value (and therefore the
time-value of money), the sequence of investments and returns is
significant.

Here's an example. Let's say you buy some shares of Wild Thing
Conservative Growth Fund, then buy some more shares, sell some, have
some dividends reinvested, even take a cash distribution. Here's how to
compute the IRR.

You first have to define the sign of the cash flows. Pick positive for
flows into the portfolio, and negative for flows out of the portfolio
(you could pick the opposite convention, but in this article we'll use
positive for flows in, and negative for flows out).

Remember that the only thing that counts are flows between your wallet
and the portfolio. For example, dividends do NOT result in cash flow
unless they are withdrawn from the portfolio. If they remain in the
portfolio, be they reinvested or allowed to sit there as free cash, they
do NOT represent a flow.

There are also two special flows to define. The first flow is positive
and is the value of the portfolio at the start of the period over which
IRR is being computed. The last flow is negative and is the value of
the portfolio at the end of the period over which IRR is being computed.

The IRR that you compute is the rate of return per whatever time unit
you are using. If you use years, you get an annualized rate. If you
use (say) months, you get a monthly rate which you'll then have to
annualize in the usual way, and so forth.

On to actually calculating it...

We first have the net present value or NPV:


N
NPV(C, t, d) = Sum C[i]/(1+d)^t[i]
i=0
where:

C[i] is the i-th cash flow (C[0] is the first, C[N] is the
last).
d is the assumed discount rate.
t[i] is the time between the first cash flow and the i-th.
Obviously, t[0]=0 and t[N]=the length of time under
consideration. Pick whatever units of time you like, but
remember that IRR will end up being rate of return per chosen
time unit.

Given that definition, IRR is defined by the equation: NPV(C, t, IRR) =
0.

In other words, the IRR is the discount rate which sets the NPV of the
given cash flows made at the given times to zero.

In general there is no closed-form solution for IRR. One must find it
iteratively. In other words, pick a value for IRR. Plug it into the
NPV calculation. See how close to zero the NPV is. Based on that, pick
a different IRR value and repeat until the NPV is as close to zero as
you care.

Note that in the case of a single initial investment and no further
investments made, the calculation collapses into:

(Initial Value) - (Final Value)/(1+IRR)^T = 0 or
(Initial Value)*(1+IRR)^T - (Final Value) = 0
Initial*(1+IRR)^T = Final
(1+IRR)^T = Final/Initial
And finally the quite familiar:
IRR = (Final/Inital)^(1/T) - 1



A program named 'irr' that calculates IRR is available. See the article
Software - Archive of Investment-Related Programs in this FAQ for more
information.


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

Subject: Analysis - Paying Debts Early versus Making Investments

Last-Revised: 14 July 2000
Contributed-By: Gary Snyder, Thomas Price (tprice at engr.msstate.edu),
Chris Lott ( contact me ), John A. Weeks III (john at johnweeks.com)

This article analyzes the question of whether you should apply any extra
cash you might have lying around to making extra payments on a debt, or
whether you should instead leave the debt on its regular payment
schedule and invest the cash instead. An equivalent question is whether
you should cash out an existing investment to pay down debt, or just let
it ride. We'll focus on the example of a first mortgage on a house, but
the analysis works (with some changes) for a car loan, credit-card debt,
etc.

Before we compare debts with investments, it's important to frame the
debate. A bit of financial planning is appropriate here; there are
several articles in the FAQ about that. To start with, an individual
should have an emergency fund of 3-6 months of living expenses.
Emergency funds need to be readily available (when was the last
emergency that you could plan for), like in a bank, credit union, or
maybe a money market fund. And most people would not consider these
investments. So the first thing to do with cash is arguably to
establish this sort of rainy-day fund. If you have to cash out a stock
to get this fund, that's ok; remember, emergencies rarely happen at
market tops.

Before we run numbers, I'd like to point out two important issues here.
The most important issue to remember is risk. Making early payments to
a loan exposes you to relatively few risks (once the loan is paid, it
stays paid), but two notable risks are liquidity and opportunity. The
liquidity risk is that you might not have cash when you need it (but see
above for the mitigation strategy of a rainy-day fund). The opportunity
risk is the possibility that a better opportunity might present itself
and you would be unable to take advantage of it since you gave the bank
your extra cash. And when you invest money, you generally expose
yourself to market risk (the investment's price might fall) as well as
other risks that might cause you to lose money. Of course the other
important issue (you probably guessed) is taxes. The interest paid on
home mortgages is deductable, so that acts to reduce the cost of the
loan below the official interest rate on the loan. Not true for
credit-card debt, etc. Also, monies earned from an investment are
taxed, so that acts to reduce the return on the investment.

One more caveat. If you simply cannot save; i.e., you would cash out
the investments darned quick, then paying down debt may be a good
choice! And owning a home gives you a place to live, especially if you
plan to live in it on a modest income.

Finally, all you can do in advance is estimate, guess, and hope. No one
will never know the answer to "what is best" until long after it is too
late to take that best course of action. You have to take your shot
today, and see where it lands tomorrow.

Now we'll run some numbers. If you have debt as well as cash that you
will invest, then maintaining the debt (instead of paying it) costs you
whatever the interest rate on the loan is minus whatever you make from
the investment. So to justify your choice of investing the cash,
basically you're trying to determine whether you can achieve a return on
your investment that is better than the interest rate on the debt. For
example, you might have a mortgage that has an after-tax rate of 6%, but
you find a very safe investment with a guaranteed, after-tax return of
9% (I should be so lucky). In this case, you almost certainly should
invest the money. But the analysis is never this easy -- it invariably
depends on knowing what the investments will yield in the future.

But don't give up hope. Although it is impossible to predict with
certainty what an investment will return, you can still estimate two
things, the likely return and the level of risk. Since paying down any
debt entails much lower risk than making an investment, you need to get
a higher level of return to assume the market risk (just to name one) of
an investment. In other words, the investment has to pay you to assume
the risk to justify the investment. It would be foolish to turn down a
risk-free 10% (i.e., to pay off a debt with an after-tax interest rate
of 10%) to try to get an after-tax rate of 10.5% from an investment in
the stock market, but it might make very good sense to turn down a
risk-free 6.5%. It is a matter of personal taste how big the difference
between the return on the investment and the risk-free return has to be
(it's called the risk premium), but thinking like this at least lets you
frame the question.

Next we'll characterize some investments and their associated risks.
Note that characterizing risk is difficult, and we'll only do a
relatively superficial job it. The purpose of this article is to get
you thinking about the options, not to take each to the last decimal
point.

Above we mentioned that paying the debt is a low-risk alternative. When
it comes to selecting investments that potentially will yield more than
paying down the debt, you have many options. The option you choose
should be the one that maximizes your return subject to a given level of
risk (from one point of view). Paying off the loan generates a
rock-solid guaranteed return. The best option you have at approximately
this level of risk is to invest in a short-term, high-grade corporate
bond fund. The key market risk in this investment is that interest
rates will go up by more than 1%; another risk of a bond fund is that
companies like AT&T will start to default on their loans. Not quite
rock-solid guaranteed, but close. Anyway, these funds have yielded
about 6% historically.

Next in the scale of risk is longer-term bonds, or lower rated bonds.
Investing in a high-yield (junk) bond fund is actually quite safe,
although riskier than the short-term, high grade bond fund described
above. This investment should generate 7-8% pre-tax (off the top of my
head), but could also lose a significant amount of money over short
periods. This happened in the junk bond market during the summer of
1998, so it's by no means a remote possibility.

The last investment I'll mention here are US stock investments.
Historically these investments have earned about 10-11%/year over long
periods of time, but losing money is a serious possibility over periods
of time less than three years, and a return of 8%/year for an investment
held 20 years is not unlikely. Conservatively, I'd expect about an 8-9%
return going forward. I'd hope for much more, but that's all I'd count
on. Stated another way, I'd choose a stock investment over a CD paying
6%, but not a CD paying 10%.

Don't overlook the fact that the analysis basically attempted to answer
the question of whether you should put all your extra cash into the
market versus your mortgage. I think the right answer is somewhere in
between. Of course it's nice to be debt free, but paying down your
debts to the point that you have no available cash could really hurt you
if your car suddenly dies, etc. You should have some savings to cushion
you against emergencies. And of course it's nice to have lots of
long-term investments, but don't neglect the guaranteed rate of return
that is assured by paying down debt versus the completely unguaranteed
rate of return to be found in the markets.

The best thing to do is ask yourself what you are the most comfortable
with, and ignore trying to optimize variables that you cannot control.
If debt makes you nervous, then pay off the house. If you don't worry
about debt, then keep the mortgage, and keep your money invested. If
you don't mind the ups and downs of the market, then keep invested in
stocks (they will go up over the long term). If the market has you
nervous, pull out some or all of it, and ladder it into corporate bonds.
In short, each person needs to find the right balance for his or her
situation.


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

Subject: Analysis - Price-Earnings (P/E) Ratio

Last-Revised: 27 Jan 1998
Contributed-By: E. Green, Aaron Schindler, Thomas Busillo, Chris Lott (
contact me )

P/E is shorthand for the ratio of a company's share price to its
per-share earnings. For example, a P/E ratio of 10 means that the
company has $1 of annual, per-share earnings for every $10 in share
price. Earnings by definition are after all taxes etc.

A company's P/E ratio is computed by dividing the current market price
of one share of a company's stock by that company's per-share earnings.
A company's per-share earnings are simply the company's after-tax profit
divided by number of outstanding shares. For example, a company that
earned $5M last year, with a million shares outstanding, had earnings
per share of $5. If that company's stock currently sells for $50/share,
it has a P/E of 10. Stated differently, at this price, investors are
willing to pay $10 for every $1 of last year's earnings.

P/Es are traditionally computed with trailing earnings (earnings from
the past 12 months, called a trailing P/E) but are sometimes computed
with leading earnings (earnings projected for the upcoming 12-month
period, called a leading P/E). Some analysts will exclude one-time
gains or losses from a quarterly earnings report when computing this
figure, others will include it. Adding to the confusion is the
possibility of a late earnings report from a company; computation of a
trailing P/E based on incomplete data is rather tricky. (I'm being
polite; it's misleading, but that doesn't stop the brokerage houses from
reporting something.) Even worse, some methods use so-called negative
earnings (i.e., losses) to compute a negative P/E, while other methods
define the P/E of a loss-making company to be zero. The many ways to
compute a P/E may lead to wide variation in the reporting of a figure
such as the "P/E for the S&P whatever." Worst of all, it's usually next
to impossible to discover the method used to generate a particular P/E
figure, chart, or report.

Like other indicators, P/E is best viewed over time, looking for a
trend. A company with a steadily increasing P/E is being viewed by the
investment community as becoming more and more speculative. And of
course a company's P/E ratio changes every day as the stock price
fluctuates.

The price/earnings ratio is commonly used as a tool for determining the
value the market has placed on a common stock. A lot can be said about
this little number, but in short, companies expected to grow and have
higher earnings in the future should have a higher P/E than companies in
decline. For example, if Amgen has a lot of products in the pipeline, I
wouldn't mind paying a large multiple of its current earnings to buy the
stock. It will have a large P/E. I am expecting it to grow quickly.

PE is a much better comparison of the value of a stock than the price.
A $10 stock with a PE of 40 is much more "expensive" than a $100 stock
with a PE of 6. You are paying more for the $10 stock's future earnings
stream. The $10 stock is probably a small company with an exciting
product with few competitors. The $100 stock is probably pretty staid -
maybe a buggy whip manufacturer.

It's difficult to say whether a particular P/E is high or low, but there
are a number of factors you should consider. First, a common rule of
thumb for evaluating a company's share price is that a company's P/E
ratio should be comparable to that company's growth rate. If the ratio
is much higher, then the stock price is high compared to history; if
much lower, then the stock price is low compared to history. Second,
it's useful to look at the forward and historical earnings growth rate.
For example, if a company has been growing at 10% per year over the past
five years but has a P/E ratio of 75, then conventional wisdom would say
that the shares are expensive. Third, it's important to consider the
P/E ratio for the industry sector. For example, consumer products
companies will probably have very different P/E ratios than internet
service providers. Finally, a stock could have a high trailing-year P/E
ratio, but if the earnings rise, at the end of the year it will have a
low P/E after the new earnings report is released. Thus a stock with a
low P/E ratio can accurately be said to be cheap only if the
future-earnings P/E is low. If the trailing P/E is low, investors may
be running from the stock and driving its price down, which only makes
the stock look cheap.


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Subject: Analysis - Percentage Rates

Last-Revised: 15 Feb 2003
Contributed-By: Chris Lott ( contact me )

This article discusses various percentage rates that you may want to
understand when you are trying to choose a savings account or understand
the amount you are paying on a loan.

Annual percentage rate (APR)
In a savings account or other account that pays you interest, the
annual percentage rate is the nominal rate paid on deposits. This
may also be known as just the rate. Most financial institutions
compute and pay out interest many times during the year, like every
month on a savings account. Because you can earn a tiny bit of
interest late in the year on the money paid out as interest early
in the year, to understand the actual net increase in account
value, you have to use the annual percentage yield (APY), discussed
below.

In a loan or other arrangement where you pay interest to some
financial institution, you will also encounter annual percentage
rates. Every loan has a rate associated with it, for example a 6%
rate paid on a home mortgage. Federal lending laws (Truth in
Lending) require lenders to compute and disclose an annual
percentage rate for a loan as means to report the true cost of the
loan. This just means that the lender is supposed to include all
fees and other charges with the note rate to report a single
number, the APR. This sounds great, but it doesn't actually work
so well in practice because there do not appear to be clear
guidelines for lenders on what fees must be included and which can
be omitted. Some fees that are usually included are points, a loan
processing fee, private mortgage insurance, etc. Fees that are
usually omitted include title insurance, etc. So the APR of a loan
is a useful piece of data but not the only thing you should
consider when shopping for a loan.


Annual percentage yield (APY)
The annual percentage yield of an account that pays interest is the
actual percentage increase in the value of an account after a
1-year period when the interest is compounded at some regular
interval. This is sometimes called the effective annual rate. You
can use APY to compare compound interest rates. The formula is:
APY = (1 + r / n ) ^ n - 1
where 'r' is the interest rate (e.g., r=.05 for a 5% rate) and 'n'
is the number of times that the interest is compounded over the
course of a year (e.g., n=12 for monthly compounding). The symbol
'^' means exponentiation; e.g., 2^3=8.

For example, if an account pays 5% compounded monthly, then the
annual percentage yield will be just a bit greater than 5%:
APY = (1 + .05 / 12 ) ^ 12 - 1
= 1.0042 ^ 12 - 1
= 1.0512 - 1
= .0512 (or 5.12%)


If interest is compounded just once during the year (i.e.,
annually), then the APY is the same as the APR. If interest is
compounded continuously, the formula is
APY = e ^ n - 1
where 'e' is Euler's constant (approximately 2.7183).





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Subject: Analysis - Risks of Investments

Last-Revised: 15 Aug 1999
Contributed-By: Chris Lott ( contact me ), Eugene Kononov (eugenek at
ix.netcom.com)

Risk, in general, is the possibility of sustaining damage, injury, or
loss. This is true in the world of investments also, of course.
Investments that are termed "high risk" have a significant possibility
that their value will drop to zero.

You might say that risk is a measure of whether a surprise will occur.
But in the world of investments, positive as well as negative surprises
happen. Sometimes a company's revenue and profits explode suddenly and
the stock price zooms upward, a very pleasant and positive surprise for
the stockholders. Sometimes a company implodes, and the stock crashes,
a not very pleasant and decidedly negative surprise for the
stockholders.

Because investments can rise or fall unexpectedly, the primary risk
associated with an investment (the market risk) is characterized by the
variability of returns produced by that investment. For example, an
investment with a low variability of return is a savings account with a
bank (low market risk). The bank pays a highly predictable interest
rate. That interest rate also happens to be quite low. An internet
stock is an investment with a high variability of return; it might
quintuple, and it might fall 50% (high market risk).

The standard way to calculate the market risk of investing in a
particular security is to calculate the standard deviation of its past
prices. So, the academic definition is:

market risk = volatility = StdDev(price history)

However, it has long been noticed that the standard deviation may not be
appropriate to use in many instances. Consider a hypothetical asset
that always goes up in price, in very small and very large increments.
The standard deviation of the prices (and returns) for that asset may be
large, but where is the market risk?

For practical purposes (trading and system evaluation), a much better
measure of market risk is the distribution of the drawdowns. Given the
history of the prices, and assuming some investment strategy (be it
buy-and-hold or market timing), what is the maximum loss that would have
been suffered? How frequent are the losses? What is the longest
uninterrupted string of losses? What is the average gain/loss ratio?

Other risks in the investment world are the risk of losing purchasing
power due to inflation (possibly by making only risk-free investments),
and the risk of underperforming the market (of special concern to mutual
fund mangers). Occasionally you may see "liquidity risk" which
basically means that you might need your money at a time when an
investment is not liquid; i.e., not easily convertible to cash. The
best example is a certificate of deposit (CD) which is payable in full
when it matures but if you need the money before then, you will pay a
penalty.

Bond holders face several risks unique to bonds, the most prominent
being interest rate risk. Because the price of bonds drops as the
prevailing interest rates rise, bond holders tend to worry about rising
interest rates. Other risks more-or-less unique to bonds are the risk
of default (i.e., the company that issued the bond decides it cannot pay
the obligation), as well as call (or prepayment) risk. What's that last
one? Well, in a nutshell, a bond issuer can call (prepay) the bond
before the bond matures, depending of course whether the terms and
conditions associated with the bond allow it. A bond that can be repaid
before the maturity date is called "callable" and a bond that cannot is
called "non callable" (see the basics of bonds article elsewhere in this
FAQ for more details). Hmm, you might be saying to yourself, the bond
holder got the money back, where's the risk? Because the investor will
have to reinvest the money at some random time, the risk is that the
investor might not be able to find as good of a deal as the old bond.

Market risk has additional components for investments outside your home
country. To the usual volatility of the markets you have to add the
volatility of the currency markets. You might have great gains, but
lose them when you swap the foreign currency for your own. Other risks
(especially in emerging markets) are problems in the economy or
government (that might lead to severe market declines) and the risk of
illiquidity (no one is buying when you want to sell).

This seems like a good place to discuss the classic risk-reward
tradeoff. If we use volatility as our risk measure, then it's clear an
investor will obtain only modest returns from low-volatility (low-risk)
investments. An investor must put his or her money into volatile (i.e.,
risky) investments if he or she hopes to experience returns on
investment that are greater than the risk-free rate of return.

Different individuals will have very different tolerances for risk, and
their tolerance for risk will change during their lifetimes. In
general, if an investor will need cash within a short period of time
(and will be forced to sell investments to raise that cash), the
investor should not put money into high-volatility (i.e., high-risk)
vehicles. Those investments might not be worth very much when the
investor needs to sell. On the other hand, if an investor has a very
long time horizon, such as a young person investing 401(k) monies, he or
she should seriously consider choosing investments that offer the best
possibility of good returns (i.e., investments with significant
historical volatility). The long period of time before that person
needs the money offers an unparalleled chance to allow the investment to
grow; the occasional downturn will most likely be offset by other gains.
All things being equal, it's reasonable to expect that a young worker
will tolerate more risk than a retired person.

A commonly accepted quantification of market risk is beta, which is
explained in another article in this FAQ.


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Subject: Analysis - Return on Equity versus Return on Capital

Last-Revised: 7 June 1999
Contributed-By: John Price (johnp at sherlockinvesting.com)

This article analyzes the question of whether return on equity (ROI) or
return on capital (ROC) is the better guide to performance of an
investment.

We'll start with an example. Two brothers, Abe and Zac, both inherited
$10,000 and each decided to start a photocopy business. After one year,
Apple, the company started by Abe, had an after-tax profit of $4,000.
The profit from Zebra, Zac's company, was only $3,000. Who was the
better manager? I.e., who provided a better return? For simplicity,
suppose that at the end of the year, the equity in the companies had not
changed. This means that the return on equity for Apple was 40% while
for Zebra it was 30%. Clearly Abe did better? Or did he?

There is a little more to the story. When they started their companies,
Abe took out a long-term loan of $10,000 and Zac took out a similar loan
for $2,000. Since capital is defined as equity plus long-term debt, the
capital for the two companies is calculated as $20,000 and $12,000.
Calculating the return on capital for Apple and Zebra gives 20% (= 4,000
/ 20,000) for the first company and 25% (= 3,000 / 12,000) for the
second company.

So for this measure of management, Zac did better than Abe. Who would
you invest with?

Perhaps neither. But suppose that the same benefactor who left money to
Abe and Zac, also left you $100 with the stipulation that you had to
invest in the company belonging to one or other of the brothers. Who
would it be?

Most analysts, once they have finished talking about earnings per share,
move to return on equity. For public companies, it is usually stated
along the lines that equity is what is left on the balance sheet after
all the liabilities have been taken care of. As a shareholder, equity
represents your money and so it makes good sense to know how well
management is doing with it. To know this, the argument goes, look at
return on equity.

Let's have a look at your $100. If you loan it to Abe, then his capital
is now $20,100. He now has $20,100 to use for his business. Assuming
that he can continue to get the same return, he will make 20% on your
$100. On the other hand, if you loan it to Zac, he will make 25% on
your money. From this perspective, Zac is the better manager since he
can generate 25% on each extra dollar whereas Abe can only generate 20%.

The bottom line is that both ratios are important and tell you slightly
different things. One way to think about them is that return on equity
indicates how well a company is doing with the money it has now, whereas
return on capital indicates how well it will do with further capital.

But, just as you had to choose between investing with Abe or Zac, if I
had to choose between knowing return on equity or return on capital, I
would choose the latter. As I said, it gives you a better idea of what
a company can achieve with its profits and how fast its earnings are
likely to grow. Of course, if long-term debt is small, then there is
little difference between the two ratios.

Warren Buffett (the famous investor) is well known for achieving an
average annual return of almost 30 percent over the past 45 years.
Books and articles about him all say that he places great reliance on
return on equity. In fact, I have never seen anyone even mention that
he uses return on capital. Nevertheless, a scrutiny of a book The
Essays of Warren Buffett and Buffett's Letters to Shareholders in the
annual reports of his company, Berkshire Hathaway, convinces me that he
relies primarily on return on capital. For example, in one annual
report he wrote,"To evaluate [economic performance], we must know how
much total capital—debt and equity—was needed to produce these
earnings." When he mentions return on equity, generally it is with the
proviso that debt is minimal.

If your data source does not give you return on capital for a company,
then it is easy enough to calculate it from return on equity. The two
basic ways that long-term debt is expressed are as long-term debt to
equity DTE and as long-term debt to capital DTC. (DTC is also referred
to as the capitalization ratio.) In the first case, return on capital
ROC is calculated from return on equity ROE by

ROC = ROE / (1 + DTE),

and in the second case by:

ROC = ROE * (1 - DTC)

For example, in the case of Abe, we saw DTE = 10,000 / 10,000 = 1 and
ROE = 40% so that, according to the first formula, ROC = 40% / ( 1 + 1)
= 20%. Similarly, DTC = 10,000 / 20,000 = 0.5 so that by the second
formula, ROC = 40% (1 – 0.5) = 20%. You might like to check your
understanding of this by repeating the calculations with the results for
Zac's company.

If you compare return on equity against return on capital for a company
like General Motors with that of a company like Gillette, you'll see one
of the reasons why Buffett includes the latter company in his portfolio
and not the former.

For more articles, analyses, and insights into today's financial markets
from John Price, visit his web site.



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Subject: Analysis - Rule of 72

Last-Revised: 19 Feb 1998
Contributed-By: Chuck Cilek (ccilek at nyx10.nyx.net), Chris Lott (
contact me ), Richard Alpert

The "Rule of 72" is a rule of thumb that can help you compute when your
money will double at a given interest rate. It's called the rule of 72
because at 10%, money will double every 7.2 years.

To use this simple rule, you just divide the annual interest into 72.
For example, if you get 6% on an investment and that rate stays
constant, your money will double in 72 / 6 = 12 years. Of course you
can also compute an interest rate if you are told that your money will
double in so-and-so many years. For example, if your money has to
double in two years so that you can buy your significant other that
Mazda Miata, you'll need 72 / 2 = 36% rate of return on your stash.

Like any rule of thumb, this rule is only good for approximations. Next
we give a derivation of the exact number for the case of an interest
rate of 10%. We want to know how long it takes a given principal P to
double given either the interest rate r (in percent per year) or the
number of years n. So, we are solving this equation:

P * (1 + r/100) ** n = 2P

Note that the symbol '**' is used to denote exponentiation (2 ** 3 = 8).
Since we said we'll try the case of r = 10%, we're solving this:

P * (1 + 10/100) ** n = 2P

We cancel the P's to get:

(1 + r/100) ** n = 2

Continuing:


(1 + 10/100) ** n = 2
1.1 ** n = 2


From calculus we know that the natural logarithm ("ln") has the
following property:

ln (a ** b) = b * ln ( a )

So we'll use this as follows:

n * ln(1.1) = ln(2)
n * (0.09531) = 0.693147

Finally leaving us with:


n = 7.2725527

Which means that at 10%, your money doubles in about 7.3 years. So the
rule of 72 is pretty darned close.

You can solve the equation for other values of r to see how rough of an
approximation this rule provides. Here's a table that shows the actual
number of years required to double your money based on different
interest rates, along with the number that the rule of 72 gives you.

% Rate Actual Rule 72
1 69.66 72
2 35.00 36
3 23.45 24
4 17.67 18
5 14.21 14.4
6 11.90 12
7 10.24 10.29
8 9.01 9
9 8.04 8
10 7.27 7.2
... .. ..
15 4.96 4.8
20 3.80 3.6
25 3.11 2.88
30 2.64 2.4 (note: 10pct error)
40 2.06 1.8
50 1.71 1.44 (note: 19pct error)
75 1.24 0.96
100 1.00 0.72 (note: 38pct error)



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Subject: Analysis - Same-Store Sales

Last-Revised: 9 Jan 1996
Contributed-By: Steve Mack

When earnings for retail outlets like KMart, Walmart, Best Buy, etc.
are reported, we see two figures, namely total sales and same-store
sales. Same-store comparisons measure the growth in sales, excluding
the impact of newly opened stores. Generally, sales from new stores are
not reflected in same-store comparisons until those stores have been
open for fifty three weeks. With these comparisons, analysts can
measure sales performance against other retailers that may not be as
aggresive in opening new locations during the evaluated period.


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Subject: Bonds - Basics

Last-Revised: 5 Jul 1998
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact
me )

A bond is just an organization's IOU; i.e., a promise to repay a sum of
money at a certain interest rate and over a certain period of time. In
other words, a bond is a debt instrument. Other common terms for these
debt instruments are notes and debentures. Most bonds pay a fixed rate
of interest (variable rate bonds are slowly coming into more use though)
for a fixed period of time.

Why do organizations issue bonds? Let's say a corporation needs to build
a new office building, or needs to purchase manufacturing equipment, or
needs to purchase aircraft. Or maybe a city government needs to
construct a new school, repair streets, or renovate the sewers.
Whatever the need, a large sum of money will be needed to get the job
done.

One way is to arrange for banks or others to lend the money. But a
generally less expensive way is to issue (sell) bonds. The organization
will agree to pay some interest rate on the bonds and further agree to
redeem the bonds (i.e., buy them back) at some time in the future (the
redemption date).

Corporate bonds are issued by companies of all sizes. Bondholders are
not owners of the corporation. But if the company gets in financial
trouble and needs to dissolve, bondholders must be paid off in full
before stockholders get anything. If the corporation defaults on any
bond payment, any bondholder can go into bankruptcy court and request
the corporation be placed in bankruptcy.

Municipal bonds are issued by cities, states, and other local agencies
and may or may not be as safe as corporate bonds. Some municipal bonds
are backed by the taxing authority of the state or town, while others
rely on earning income to pay the bond interest and principal.
Municipal bonds are not taxable by the federal government (some might be
subject to AMT) and so don't have to pay as much interest as equivalent
corporate bonds.

U.S. Bonds are issued by the Treasury Department and other government
agencies and are considered to be safer than corporate bonds, so they
pay less interest than similar term corporate bonds. Treasury bonds are
not taxable by the state and some states do not tax bonds of other
government agencies. Shorter term Treasury bonds are called notes and
much shorter term bonds (a year or less) are called bills, and these
have different minimum purchase amounts (see the article elsewhere in
this FAQ for more details about US Treasury instruments.)

In the U.S., corporate bonds are often issued in units of $1,000. When
municipalities issue bonds, they are usually in units of $5,000.
Interest payments are usually made every 6 months.

A bond with a maturity of less than two years is generally considered a
short-term instrument (also known as a short-term note). A medium-term
note is a bond with a maturity between two and ten years. And of
course, a long-term note would be one with a maturity longer than ten
years.

The price of a bond is a function of prevailing interest rates. As
rates go up, the price of the bond goes down, because that particular
bond becomes less attractive (i.e., pays less interest) when compared to
current offerings. As rates go down, the price of the bond goes up,
because that particular bond becomes more attractive (i.e., pays more
interest) when compared to current offerings. The price also fluctuates
in response to the risk perceived for the debt of the particular
organization. For example, if a company is in bankruptcy, the price of
that company's bonds will be low because there may be considerable doubt
that the company will ever be able to redeem the bonds. When you buy a
bond, you may pay a premium. In other words, you may pay more than the
face value (also called the "par" value). For example, a bond with a
face value of $1,000 might sell for $1050, meaning at a $50 premium.
Or, depending on the markets and such, you might buy a bond for less
than face value, which means you bought it at a discount.

On the redemption date, bonds are usually redeemed at "par", meaning the
company pays back exactly the face value of the bond. Most bonds also
allow the bond issuer to redeem the bonds at any time before the
redemption date, usually at par but sometimes at a higher price. This
is known as "calling" the bonds and frequently happens when interest
rates fall, because the company can sell new bonds at a lower interest
rate (also called the "coupon") and pay off the older, more expensive
bonds with the proceeds of the new sale. By doing so the company may be
able to lower their cost of funds considerably.

A bearer bond is a bond with no owner information upon it; presumably
the bearer is the owner. As you might guess, they're almost as liquid
and transferable as cash. Bearer bonds were made illegal in the U.S.
in 1982, so they are not especially common any more. Bearer bonds
included coupons which were used by the bondholder to receive the
interest due on the bond; this is why you will frequently read about the
"coupon" of a bond (meaning the interest rate paid).

Another type of bond is a convertible bond . This security can be
converted into shares of the company that issues the bond if the
bondholder chooses. Of course, the conversion price is usually chosen
so as to make the conversion interesting only if the stock has a pretty
good rise. In other words, when the bond is issued, the conversion
price is set at about a 15--30% premium to the price of the stock when
the bond was issued. There are many terms that you need to understand
to talk about convertible bonds. The bond value is an estimate of the
price of the bond (i.e., based on the interest rate paid) if there were
no conversion option. The conversion premium is calculated as ((price -
parity) / parity) where parity is just the price of the shares into
which the bond can be converted. Just one more - the conversion ratio
specifies how many shares the bond can be converted into. For example,
a $1,000 bond with a conversion price of $50 would have a conversion
ratio of 20.

Who buys bonds? Many individuals buy bonds. Banks buy bonds. Money
market funds often need short term cash equivalents, so they buy bonds
expiring in a short time. People who are very adverse to risk might buy
US Treasuries, as they are the standard for safeness. Foreign
governments whose own economy is very shaky often buy Treasuries.

In general, bonds pay a bit more interest than federally insured
instruments such as CDs because the bond buyer is taking on more risk as
compared to buying a CD. Many rating services (Moody's is probably the
largest) help bond buyers assess the riskiness of any bond issue by
rating them. See the FAQ article on bond ratings for more information.

Listed below are some additional resources for information about bonds.
* The Bond Market Association runs an information site.



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Subject: Bonds - Amortizing Premium

Last-Revised: 12 Jul 2001
Contributed-By: Chris Lott ( contact me )

The IRS requires investors who purchase certain bonds at a premium
(i.e., above par, which means above face value) to amortize that premium
over the life of the bond. The reason is fairly straightforward. If
you bought a bond at 101 and were redeemed at 100, that sounds like a
capital loss -- but of course it really isn't, since it's a bond (not a
stock). So the IRS prevents you from buying lots and lots of bonds
above par, taking the interest and a phony loss that could offset a bit
of other income.

Here's a bit more discussion, excerpted from a page at the IRS. If you
pay a premium to buy a bond, the premium is part of your cost basis in
the bond. If the bond yields taxable interest, you can choose to
amortize the premium. This generally means that each year, over the
life of the bond, you use a part of the premium that you paid to reduce
the amount of interest that counts as income. If you make this choice,
you must reduce your basis in the bond by the amortization for the year.
If the bond yields tax-exempt interest, you must amortize the premium.
This amortized amount is not deductible in determining taxable income.
However, each year you must reduce your basis in the bond by the
amortization for the year.

To compute one year's worth of amortization for a bond issued after 27
September 1985 (don't you just love the IRS?), you must amortize the
premium using a constant yield method. This takes into account the
basis of the bond's yield to maturity, determined by using the bond's
basis and compounding at the close of each accrual period. Note that
your broker's computer system just might do this for you automatically.


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

Subject: Bonds - Duration Measure

Last-Revised: 19 Feb 1998
Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us)

This article provides a brief introduction to the duration measure for
bonds. The duration measure for bonds is a invention that allows bonds
of different maturities and coupon rates to be compared directly.

Everyone knows that the maturity of a bond is the amount of time left
until it matures. Most people also know that the price of a bond swings
more violently with interest rates the longer the maturity of the bond
is. What many people don't know is that maturity is actually not that
great a measure of the lifetime of a bond. Enter duration.

The reason why maturity isn't that great a measure is that it does not
account for the differences in bond coupons. A 10-year bond with a 5%
coupon will be more sensitive to interest rate changes than a 10-year
bond with an 8% coupon. A 5-year zero-coupon bond may well be more
sensitive than a 7-year 6% bond, and so forth.

Faced with the inadequacy of maturity, the investment gurus came up with
a measure that takes both maturity and coupon rate into account in order
to make apples-to-apples comparisons. The measure is called duration.

There are different ways to compute duration. I will use one of the
common definitions, namely:

Duration is a weighted average of the times that interest
payments and the final return of principal are received. The
weights are the amounts of the payments discounted by the
yield-to-maturity of the bond.

The final sentence may be alternatively stated:

The weights are the present values of the payments, using the
bond's yield-to-maturity as the discount rate.



Duration gives one an immediate rule of thumb -- the percentage change
in the price of a bond is the duration multiplied by the change in
interest rates. So if a bond has a duration of 10 years and
intermediate-term interest rates fall from 8% to 6% (a drop of 2
percentage points), the bond's price will rise by approximately 20%.

In the examples and formulas that follow, I make the simplifying
assumptions that:
1. Interest payments occur annually (they actually occur every 6
months for most bonds).
2. The final interest payment occurs on the date of maturity.
3. It is always one year from now to the first interest payment.

It turns out that (especially for intermediate- and long-term bonds)
these simplifications don't affect the final numbers that much --
duration is well less than a year different from its "true" value, even
for something as short as a duration of 5 years.

Example 1:
Bond has a $10,000 face value and a 7% coupon. The yield-to-maturity
(YTM) is 5% and it matures in 5 years. The bond thus pays $700 a year
from now, $700 in 2 years, $700 in 3 years, $700 in 4 years, $700 in 5
years and the $10,000 return of principal also in 5 years.

As you may recall, to compute the weighted average of a set of numbers,
you multiply the numbers by the weights and add those products up. You
then add all the weights up and divide the former by the latter. In
this case the weights are $700/1.05, $700/1.05^2, $700/1.05^3,
$700/1.05^4, $700/1.05^5, and $10,000/1.05^5, or $666.67, $634.92,
$604.69, $575.89, $548.47, and $7,835.26. The numbers being average are
the times the payments are received, or 1 year, 2 years, 3 years, 4
years, 5 years, and 5 years. So the duration is:
1*$667.67 + 2*$634.92 + 3*$604.69 + 4*$575.89 + 5*$548.47 +
5*$7,835.26
D =
------------------------------------------------------------ -----------
$667.67 + $634.92 + $604.69 + $575.89 + $548.47 + $7,835.26
D = 4.37 years

Example 2:
Bond has a face value of $P, coupon of c, YTM of y, maturity of M years.
1Pc/(1+y) + 2Pc/(1+y)^2 + 3Pc/(1+y)^3 + ... + MPc/(1+y)^M +
MP/(1+y)^M
D =
------------------------------------------------------------ ---------------
Pc/(1+y) + Pc/(1+y)^2 + Pc/(1+y)^3 + ... + Pc/(1+y)^M +
P/(1+y)^M
We can use summations to condense this equation:
M
Pc*Sum i/(1+y)^i + MP/(1+y)^M
i=1
D = ------------------------------
M
Pc*Sum 1/(1+y)^i + P/(1+y)^M
i=1
We can cancel out the face value of P, leaving a function only of
coupon, YTM and time to maturity:
M
c*Sum i/(1+y)^i + M/(1+y)^M
i=1
D = -----------------------------------
M
c*Sum 1/(1+y)^i + 1/(1+y)^M
i=1
It is trivial to write a computer program to carry out the calculation.
And those of you who remember how to find a closed-form expression for
Sum{i=1 to M}(x^i) and Sum{i=1 to M}(ix^i) can grind through the
resulting algebra and get a closed-form expression for duration that
doesn't involve summation loops :-)

Note that any bond with a non-zero coupon will have a duration shorter
than its maturity. For example, a 30 year bond with a 7% coupon and a
6% YTM has a duration of only 14.2 years. However, a zero will have a
duration exactly equal to its maturity. A 30 year zero has a duration
of 30 years. Keeping in mind the rule of thumb that the percentage
price change of a bond roughly equals its duration times the change in
interest rates, one can begin to see how much more volatile a zero can
be than a coupon bond.


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

Subject: Bonds - Moody Bond Ratings

Last-Revised: 12 Nov 2002
Contributed-By: Bill Rini (bill at moneypages.com), Mike Tinnemeier

Moody's Bond Ratings are intended to characterize the risk of holding a
bond. These ratings, or risk assessments, in part determine the
interest that an issuer must pay to attract purchasers to the bonds.
The ratings are expressed as a series of letters and digits. Here's how
to decode those sequences.



Rating "Aaa"
Bonds which are rated Aaa are judged to be of the best quality.
They carry the smallest degree of investment risk and are generally
referred to as "gilt edged." Interest payments are protected by a
large or an exceptionally stable margin and principal is secure.
While the various protective elements are likely to change, such
changes as can be visualized are most unlikely to impair the
fundamentally strong position of such issues.
Rating "Aa"
Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are
generally known as high grade bonds. They are rated lower than the
best bonds because margins of protection may not be as large as in
Aaa securities or fluctuation of protective elements may be of
greater amplitude or there may be other elements present which make
the long-term risk appear somewhat larger than the Aaa securities.
Rating "A"
Bonds which are rated A possess many favorable investment
attributes and are considered as upper-medium-grade obligations.
Factors giving security to principal and interest are considered
adequate, but elements may be present which suggest a
susceptibility to impairment some time in the future.
Rating "Baa"
Bonds which are rated Baa are considered as medium-grade
obligations (i.e., they are neither highly protected not poorly
secured). Interest payments and principal security appear adequate
for the present but certain protective elements may be lacking or
may be characteristically unreliable over any great length of time.
Such bonds lack outstanding investment characteristics and in fact
have speculative characteristics as well.
Rating "Ba"
Bonds which are rated Ba are judged to have speculative elements;
their future cannot be considered as well-assured. Often the
protection of interest and principal payments may be very moderate,
and thereby not well safeguarded during both good and bad times
over the future. Uncertainty of position characterizes bonds in
this class.
Rating "B"
Bonds which are rated B generally lack characteristics of the
desirable investment. Assurance of interest and principal payments
of of maintenance of other terms of the contract over any long
period of time may be small.
Rating "Caa"
Bonds which are rated Caa are of poor standing. Such issues may be
in default or there may be present elements of danger with respect
to principal or interest.
Rating "Ca"
Bonds which are rated Ca represent obligations which are
speculative in a high degree. Such issues are often in default or
have other marked shortcomings.
Rating "C"
Bonds which are rated C are the lowest rated class of bonds, and
issues so rated can be regarded as having extremely poor prospects
of ever attaining any real investment standing.


A Moody rating may have digits following the letters, for example "A2"
or "Aa3". According to Fidelity, the digits in the Moody ratings are in
fact sub-levels within each grade, with "1" being the highest and "3"
the lowest. So here are the ratings from high to low: Aaa, Aa1, Aa2,
Aa3, A1, A2, A3, Baa1, Baa2, Baa3, and so on.

Most of this information was obtained from Moody's Bond Record.
Portions of this article are copyright 1995 by Bill Rini.


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

Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 4 of 20)

am 30.05.2005 06:30:04 von noreply

Archive-name: investment-faq/general/part4
Version: $Id: part04,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 4 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:
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excluding charges for the media used to distribute it.
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+ 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: Bonds - Municipal Bond Terminology

Last-Revised: 7 Nov 1995
Contributed-By: Bill Rini (bill at moneypages.com)

These definitions of municipal bond terminology are at best
simplifications. They should only be used as a stepping stone, leading
to further education about municipal bonds.



Act of 1911 and 1915
Used for developments within a particular district and are secured
by special assessment taxes set at a fixed dollar amount for the
life of the bond. 1911 Act Bonds are secured by individual
parcels, while 1915 Act Bonds are secured by all properties within
the district.
Ad Valorem Tax
A tax based on the value of the property
Advance Refunding
The replacement of debt prior to the original call date via the
issuance of refunding bonds.
Authority (Lease Revenue)
A bond secured by the lease between the authority and another
agency. The lease payments from the "city" to the agency are equal
to the debt service.
Callable Bond
A bond that can be redeemed by the issuer prior to its maturity.
Usually a premium is paid to the bond owner when the bond is
called.
Certificate of Participation (COP)
Financing whereby an investor purchases a share of the lease
revenues of a program rather than the bond being secured by those
revenues. Usually issued by authorities through which capital is
raised and lease payments are made. The authority usually uses the
proceeds to construct a facility that is leased to the
municipality, releasing the municipality from restrictions on the
amount of debt that they can incur.
Crossover Refunded
The revenue stream originally pledged to secure the securities
being refunded continues to be used to pay debt service on the
refunded securities until they mature or are called. At that time,
the pledged revenues pay debt service on the refunding securities.
Discount Bond
A bond that is valued at less than its face amount.
Double Barrelled
Bonds secured by the pledge of two or more sources of repayment.
Face Value
The stated principal amount of a bond.
General Obligations
Voter approved bonds that are backed by the full faith, credit and
unlimited taxing power of the issuer.
Mello Roo's
Bonds used for developments that benefit a particular district
(schools, prisons, etc.) and are secured by special taxes based on
the assessed value of the properties within the district. Tax
assessment is included on the county tax bill.
Par Value
The face value of a bond, generally $1,000.
Premium Bond
A bond that is valued at more than its face amount.
Principal
The amount owed; the face value of a debt.
Redevelopment Agency (Tax Allocation)
Bonds secured by all of the property taxes on the increase in
assessed valuation above the base, on properties in the project.
Revenue Bonds
Bonds secured by the revenues derived from a particular service
provided by the issuer.
Sinking Fund
A bond with special funds set aside to retire the term bonds of a
revenue issue each year according to a set schedule. Usually takes
effect 15 years from date of issuance. Bonds are retired through
either calls, open market purchases, or tenders.
Taxable Equivalent Yield
The taxable equivalent yield is equal to the tax free yield divided
by the sum of 100 minus the current tax bracket. For example the
taxable equivalent yield of a 6.50% tax free bond for someone in
the 32% tax bracket would be:
6.5/(100-32) = 0.0955882 or 9.56%
YieldA measure of the income generated by a bond. The amount of
interest paid on a bond divided by the price.
Yield to Maturity
The rate of return anticipated on a bond if it is held until the
maturity date.


This article is copyright 1995 by Bill Rini. For more insights from
Bill Rini, visit The Syndicate:



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

Subject: Bonds - Relationship of Price and Interest Rate

Last-Revised: 28 Oct 1997
Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us), Chris
Lott ( contact me )

The basic relationship between the price of a bond and prevailing market
interest rates is an inverse relationship. This is actually pretty
straightforward. For example, if you have a 6% bond (this means that it
pays $60 annually per $1000 of face value) and interest rates jump to
8%, wouldn't you agree that your bond should be worth less now if you
were to sell it?

If this isn't clear, think about it this way. If the rate of interest
being paid on newly issued bonds stands at 8%, a bond buyer would get
paid $80 annually for each $1,000 investment in one of those bonds. If
that bond buyer instead bought your old 6% bond for the price you
originally paid, that bond would yield $20 less per year when compared
to bonds on the market. Clearly that's not a very attractive offer for
the buyer (although it would be a great deal for you).

To quantify the inverse relationship between the price and the interest
rate, you really need the concept of the present value of money (also
see the article elsewhere in the FAQ on this topic). Computing present
value figures helps you answer questions like "what's better, $95 today
or $100 one year from now?" The beginnings of it go something like this.

Pretend that you have $100. Also pretend that you can invest it in
something that will pay a 5% annual return. So, one year from now you
have:

$100 * (1 + 0.05) = $105



This can be turned around. Let's say that you want to know how much
money you need to have today in order to have $200 a year from now, if
you can earn 5%:

X * (1 + 0.05) = $200 or X = $200/(1 + 0.05) = $190.48



Therefore, we can say that the present value of $200 one year from now,
assuming a "discount rate" (this is what the assumed interest rate in a
present-value calculation is called) of 5% is $190.48.

But what if you wanted to know how much you needed today to have $200
two years from now, again assuming you could earn 5%? Here's the
computation.

[ X * (1 + 0.05) ] * (1 + 1.05) = $200

X represents the original amount, and the quantity "X * (1 + 0.05)"
represents the amount after 1 year. Solving for X we get:

X = 200/(1 + 1.05)^2 = $181.41



So, the present value of $200 two years hence, at a discount rate of 5%
is $181.41. It should be clear that the present value of $200 N years
from now at a discount rate of 5% is:

PV = 200/(1 + 0.05)^N

And this can be generalized to the present value of an amount C, N years
from now, at a discount rate of r:

PV = C/(1 + r)^N

Now you can combine these. Let's say I promise to pay you $300 a year
from today and $500 two years from today. What could I have paid you
today that would have made you just as happy as what I promised? Assume
you can earn 7% on your money. To solve this, just sum the present
value of each payment. This sum is called the "net present value" (NPV)
of a series of cash flows.

NPV = $300/(1+0.07) + $500/(1+0.07)^2 = $717.09

So, given the 7% discount rate, the payments I scheduled are equivalent
to a payment of $717.09 made today.

Let's get a little fancier. What if I'm willing to promise to pay you
$50 per year for 4 years, starting a year from now, and further promise
to pay you $1000 five years from now. What's the most you'd be willing
to pay me now to make you that promise. Assume a discount rate of 6%.

NPV = $50/(1+0.06) + $50/(1+0.06)^2 + $50/(1+0.06)^3 +
$50/(1+0.06)^4 + $1000/(1+0.06)^5 = $920.51



Let's say you want to wait until tomorrow. You have a dream that night
that makes you believe that you'll now be able to earn 10% on your
money. When I come back to you, you now tell me you'll only pay me

NPV = $50/(1 + 0.10) + $50/1.1^2 + $50/1.1^3 + $50/1.1^4 +
$1000/1.1^5 = $779.41



My promise is now worth quite a bit less. You should be able to see
that if your dream had led you to believe you could earn less on your
money, then my promise would have been worth more to you than it did
yesterday.

At this point, it's probably clear that my "promise" is effectively what
a bond is -- I'm agreeing to pay you a fixed amount each year (actually,
the bond would pay half that fixed amount twice a year) and then the
principal amount at maturity. Given what you think you can earn on your
money, the price you should pay for the bond is well-defined. The
question is what affects what you think you'll be able to earn on your
money? Fed policy might. What you think the chances of inflation are
might. Lots of other things might. This is where the fun starts. :-)

Also note that you can turn the equation around. Let's say that you
have a $1000 bond paying $75 per year. The bond matures in 10 years.
Someone is willing to sell it to you for $850. What will I have earned
on my investment? The net present value equation always holds, so $850
equals the net present value of the yearly payments and principal
payment.

Obviously, since we know everything except the discount rate, this
equation must define the discount rate that makes it true. The problem
is that the rate cannot be simply calculated. You must make a guess,
compute the net present value, see how different it is from $850, use
that to adjust your guess, and try again until the sides of the equation
balance. The discount rate you come up with is called the "internal
rate of return" (IRR) and in the bond world is called the "yield to
maturity" (YTM). In fact, if you know the initial value of some
portfolio, all cash flows into and out of the portfolio, and the final
value of the portfolio, you can compute your IRR, thus answering the
common misc.invest.* question of "I put $N into a fund on date X, but
then added $D on date Y and $F on date W. My account is today worth $B.
What's my return?"

As a final note, here's a bit of a stumper to spring on someone:
Assuming you could earn 5% on your money, would you rather be paid $1000
annually (first payment is today, next is a year from now, etc.) forever
(assume you are immortal :-) or $25000 today? Believe it or not, you
should take the $25000 today. Here's the analysis why.

NPV = $1000 + $1000/1.05 + $1000/1.05^2 ...
or
NPV = $1000*(1 + 1/1.05 + 1/1.05^2 + ...)



A math reference book can tell you (or you might remember or derive it)
that the infinite sum:

1 + x + x^2 + x^3 + ... = 1/(1 - x) if |x| < 1

In this case, x = 1/1.05, so

NPV = $1000*[1/(1 - 1/1.05)] = $21000

So believe it or not, you'd be better off taking $25000 today then
taking $1000 per year forever, given the 5% discount rate assumption.


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

Subject: Bonds - Tranches

Last-Revised: 22 Oct 1997
Contributed-By: (anonymous), Chris Lott ( contact me )

A 'tranche' (derived from the French for 'slice') is used in finance to
define part of an asset that is divided (sliced, hence the term) into
smaller pieces. A common example is a mortgage-backed security. One
bank may only be interested in the payments at the longer end of the
security's maturity, while another investment firm may want only the
cash flows due in the near term. An investment bank can split the
original asset into 'tranches' where each party (the bank and the
investment firm) receive rights to the expected cash payments for
particular periods. The two new assets are repriced, and the investment
bank usually makes a tidy profit. This can be done with many assets,
the goal being better marketablity of typically larger assets. If you
want more information on how this is used in specific, I would think
there would be data on the debt of less developed countries that has
been consolidated, then sold in 'tranches' to investors in the developed
worlds. The London Club is a group of commercial creditors which holds
claim on the debt of Russia, for example.


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

Subject: Bonds - Treasury Debt Instruments

Last-Revised: 1 Jan 2002
Contributed-By: Art Kamlet (artkamlet at aol.com), Dave Barrett, Rich
Carreiro (rlcarr at animato.arlington.ma.us)

The US Treasury Department periodically borrows money and issues IOUs in
the form of bills, notes, or bonds ("Treasuries"). The differences are
in their maturities and denominations:

Bill Note Bond
Maturity up to 1 year 1--10 years 10--30/40 years
Denomination $1,000 $1,000 $1,000
Minimum purchase $1,000 $1,000 $1,000


Treasuries are auctioned. Short term T-bills are auctioned every
Monday. The 4-week bill is auctioned every Tuesday. Longer term bills,
notes, and bonds are auctioned at other intervals.

T-Notes and Bonds pay a stated interest rate semi-annually, and are
redeemed at face value at maturity. Exception: Some 30 year and longer
bonds may be called (redeemed) at 25 years.

T-bills work a bit differently. They are sold on a "discounted basis."
This means you pay, say, $9,700 for a 1-year T-bill. At maturity the
Treasury will pay you (via electronic transfer to your designated bank
checking account) $10,000. The $300 discount is the "interest." In this
example, you receive a return of $300 on a $9,700 investment, which is a
simple rate of slightly more than 3%.

The best way for an individual to buy or sell Treasury instruments is
via the US Treasury's "TreasuryDirect" program, which provides for
no-fee/low-fee transactions. Please see the article elsewhere in this
FAQ for more information about using the TreasuryDirect program. Of
course treasuries can also be bought and sold through a bank or broker,
but you will usually have to pay a fee or commission to do this, not to
mention maintain an account.

Treasuries are negotiable. If you own Treasuries you can sell them at
any time and there is a ready market. The sale price depends on market
interest rates. Since they are fully negotiable, you may also pledge
them as collateral for loans. (Note that if the securities are held by
the Treasury as part of their TreasuryDirect service, then they cannot
be used as collateral.)

Treasury bills, notes, and bonds are the standard for safety. By
definition, everything is relative to Treasuries; there is no safer
investment in the U.S. They are backed by the "Full Faith and Credit"
of the United States.

Interest on Treasuries is taxable by the Federal Government in the year
paid. States and local municipalities do not tax Treasury interest
income. T-bill interest is recognized at maturity, so they offer a way
to move income from one year to the next.

The US Treasury also issues Zero Coupon Bonds. The ``Separate Trading
of Registered Interest and Principal of Securities'' (a.k.a. STRIPS)
program was introduced in February 1986. All new T-Bonds and T-notes
with maturities greater than 10 years are eligible. As of 1987, the
securities clear through the Federal Reserve's books entry system. As
of December 1988, 65% of the ZERO-COUPON Treasury market consisted of
those created under the STRIPS program.

However, the US Treasury did not always issue Zero Coupon Bonds.
Between 1982 and 1986, a number of enterprising companies and funds
purchased Treasuries, stripped off the ``coupon'' (an anachronism from
the days when new bonds had coupons attached to them) and sold the
coupons for income and the non-coupon portion (TIGeRs or Strips) as
zeroes. Merrill Lynch was the first when it introduced TIGR's and
Solomon introduced the CATS. Once the US Treasury started its program,
the origination of trademarks and generics ended. There are still TIGRs
out there, but no new ones are being issued.

Other US Debt obligations that may be worth considering are US Savings
Bonds (Series E/EE and H/HH) and bonds from various US Government
agencies, including the ones that are known by cutesy names like Freddie
Mac, as well as the Mae sisters, Fannie, Ginnie and Sallie.

Historically, Treasuries have paid higher interest rates than EE Savings
Bonds. Savings Bonds held 5 years pay 85% of 5 year Treasuries.
However, in the past few years, the floor on savings bonds (4% under
current law) is higher than short-term Treasuries. So for the short
term, EE Savings Bonds actually pay higher than treasuries, but are
non-negotiable and purchases are limited to $15,000 ($30,000 face) per
year.

US Government Agency Bonds, in general, pay slightly more interest but
are somewhat less predictible than Treasuries. For example,
mortgage-backed-bond returns will vary if mortgages are redeemed early.
Some agency bonds, technically, are not general obligations of the
United States, so may not be purchased by certain institutions and local
governments. The "common sense" of many people, however, is that the
Congress will never allow any of those bonds to default.

In October 2001, the Treasury Department announced that it was
suspending issuance of the 30-year bond and had no plans to issue that
security ever again.


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

Subject: Bonds - Treasury Direct

Last-Revised: 2 Oct 2001
Contributed-By: Art Kamlet (artkamlet at aol.com), Bob Johnson, Rich
Carreiro (rlcarr at animato.arlington.ma.us)

Treasury securities can be purchased directly from the US Treasury using
a service named "TreasuryDirect." The minimum purchase for any Treasury
security that can be obtained via the TreasuryDirect program is $1,000.
There are no fees for accounts below $100,000; accounts in excess of
that sum are charged a $25 annual fee. Interest payments can be made
directly to an individual's TreasuryDirect account. Further, mature
Treasury securities can be used to purchase new ones. Investors can do
business with the TreasuryDirect program via the web, phone, or plain
old mail.

The "Direct To You" services offered by the US Treasury have made
transactions in the TreasuryDirect program very attractive for private
investors. First, the Treasury can debit a bank account for the amount
of the purchase after the instrument's price is set by the auction (the
"Pay Direct" service). This means that an investor pays exactly the
right amount, unlike the old system in which an investor was forced to
send in a check for the full face value and wait for a refund. Second,
investors can sell instruments before their maturity dates using the
"Sell Direct" service. The Treasury charges $34 for brokering the sale
of a Treasury instrument, which reportedly is less than the fee charged
by banks and brokerage houses. The instrument is sold using the Federal
Reserve Bank of Chicago, which is responsible for getting a fair price.
Third, holders of Treasury instruments can reinvest funds from maturing
instruments simply by using the telephone or the web along with the
information that appears on a notice sent to holders of maturing
instruments (the "Reinvest Direct" service).

Investors can get more information about the TreasuryDirect program
either by calling 800-722-2678 or visiting the web site:



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

Subject: Bonds - U.S. Savings Bonds

Last-Revised: 4 Mar 2003
Contributed-By: Art Kamlet (artkamlet at aol.com), Gordon Hamachi, Rich
Carreiro (rlcarr at animato.arlington.ma.us), M. Persina, David
Capshaw, Paul Maffia (paulmaf at eskimo.com), J. Zinchuk (jzinchuk at
draper.com), Chris Lott ( contact me )

This article describes US Savings Bonds issued by the US Treasury, and
discusses how they can be purchased or redeemed. Because the US
Treasury changes the rules for these bonds periodically, this article
also gives some information about determining the yields of bonds issued
over the past 30 years.

US Savings bonds are obligations of the US government. Interest paid on
these bonds is exempt from state and local income taxes. Savings Bonds
are not negotiable instruments, and cannot be transferred to anyone at
will. They can be transferred in limited circumstances, and there could
be tax consequences at the time of transfer.

Two types of US Savings Bonds are offered, namely Series EE Bonds and
I Bonds. The I Bond was introduced in 1998 and is indexed for
inflation. The Treasury plans to sell both types of bonds on an ongoing
basis; there are no plans for one or the other to be phased out.

US Savings bonds can be purchased from commercial banks, through an
employer via payroll deductions, or (naturally) over the internet. Most
commercial banks act as agents for the Treasury; they will let you fill
out the purchase forms and forward them to the Treasury. You will
receive the bonds in the mail a few weeks later. See the foot of this
article for the web site that allows on-line purchases.

Savings bonds can be redeemed (cashed in) at many banks or directly with
a branch of the Federal Reserve Bank. Using your bank, credit union, or
savings and loan is probably the fastest way to cash a bond, but be
certain to call ahead to ask (you might need to bring certain
documentation). In some cases, the bank may send the bonds to the Fed,
which will slow things down. If your bank will not cooperate, contact
the appropriate Fed branch to redeem bonds by mail or via the web (see
links at the end of this article).

Series EE bonds are purchased at half their face value or denomination.
So you would purchase a $100 Series EE Bond for $50. I Bonds are
purchased at face value or denomination. So you would purchase a $100
I Bond for $100.

You can buy up to $15,000 (your cost; actually $30,000 face value) of
Series EE Bonds per year. If you buy bonds with a co-owner, the two of
you can together buy up to twice that limit, but even so, no more than
$30,000 (face amount) in EE bonds purchased in one calendar year may be
attributed to one co-owner (so you cannot evade the limits by using many
different co-owners). You can buy up to $30,000 of I Bonds per year.
The Series EE andI Bond limits are independent of each other, meaning an
individual could give Uncle Sam up to $45,000 annually to buy bonds.

Series EE Bonds earn market-based rates that change every 6 months.
There is no way to predict when a Series EE bond will reach its face
value. For example, a Series EE Bond earning an average of 5% would
reach face value in 14 1/2 years while a bond earning an average of 6%
would reach face value in 12 years.

I Bonds are an accrual-type security. In English, this means that
interest is added to the bond monthly. The interest is paid when the
bond is cashed. An I Bond earns interest for as long as 30 years. The
interest accrues on the first day of the month, and is compounded
semiannually. The earnings rate of an I Bond is determined by a fixed
rate of return plus a semiannual inflation rate. The fixed rate (as the
name might imply) remains the same for the life of an I Bond. The
semiannual inflation rate (the bonus) is announced each May and
November, and is based on the Consumer Price Index (CPI), as calculated
by the wizards at the Bureau of Labor Statistics (ooh!).

Series EE Bonds and I Bonds issued after 1 February 2003 must be held
for at least 12 months before they can be cashed (bonds issued before
then could be cashed anytime after 6 months). If an investor cashes an
I Bond within the first five years, the investor is penalized by losing
three months worth of interest. For example, if you cash an I Bond
after exactly twelve months, you will receive just nine months worth of
interest. This "feature" of the I Bond is supposed to encourage
long-term investment.

Series EE Bonds absolutely should be cashed before their final maturity
dates for the following reasons. Firstly, if you fail to cash the
Series EE bond (or roll it over into an Series HH Bond) before the
critical date, you will be losing money because the bond will no longer
be earning interest. Secondly, under IRS regulations, tax is due on the
interest in the year the bond is cashed or it reaches final maturity.
If you hold the bond beyond 12/31 of the final-maturity year, then when
you finally get around to cashing it, you will not only owe the tax on
the earnings, but interest and penalties besides. Thirdly, once the
bond passes its final maturity date (as for example a year later) you
cannot roll the proceeds into an HH to further postpone tax on the
accumulated interest.

Interest on a Series EE/E Bond or I Bond can be deferred until the bond
is cashed in, or if you prefer, can be declared on your federal tax
return as earned each year. When you cash the bond you will be issued a
Form 1099-INT and would normally declare as interest all funds received
over what you paid for the bond (and have not yet declared). This is
what they mean by deferring taxes.

If you with to defer the tax on the interest paid by a Series EE Bond at
maturity yet further, you can do so by using the proceeds from cashing
in a Series EE Bond to purchase a Series HH Savings bond (prior to 1980,
H Bonds). You can purchase Series HH Bonds in multiples of $500 from
the proceeds of Series EE Bonds. Series HH Bonds pay interest every 6
months and you will receive a check from the Treasury. When the HH bond
matures, you will receive the principal, and a form 1099-INT for that
deferred EE interest.

At the time of purchase, a bond can be registered to a single person
("single ownership"), registered to two people ("co-ownership"), or can
be registered to a primary owner and a beneficiary ("beneficiary"). In
the case of co-ownership, either named individual can do whatever they
like with the bond without consent for the other person; if one dies,
the other becomes the single owner. In the case of beneficiary
registration (bond is marked POD for "payable on death"), the primary
owner controls the bond, and ownership passes to the beneficiary if the
primary owner dies.

Ownership of Series EE bonds (but not I-Bonds) can be transferred, for
example if a grandparent wants to give a grandchild some money. A
transfer in ownership (called a "reissue" by the US Treasury) where a
living person who was an owner relinquishes all ownership of a bond is a
taxable event. This means that the person giving the bonds (the
"principal owner") incurs a tax liability for the accrued interest up to
the date of transfer and must pay Uncle Sam. It's essential to keep
good records until the time when the beneficiary finally cashes the
bonds in. Recall that all interest on the bond is paid when it's cashed
in. Because someone paid some tax on that interest already, the person
cashing the bond should not pay tax on the full amount. Alternatively,
the grandparent could just add the grandchild as a co-owner, which
doesn't result in anyone incurring a tax liability at the transfer.

Interest from Savings Bonds can excluded if used to pay higher education
expenses such as college tuition. Please see the article elsewhere in
the FAQ for more details.

If your Savings Bonds are lost, stolen, mutilated, or destroyed, give
prompt notice of the facts to the Department of the Treasury, Bureau of
the Public Dept, Parkersburg, WV 26106-1328, and a list, if possible, of
the serial numbers (with prefix and suffix letters), the issue dates
(month and year) and the denominations of the bonds. Show all names and
addressed that could have appeared on the bonds, along with the owner's
Social Security number, and whether the bond numbers and issue dates are
known. The more information that you are able to provide, the quicker
the Treasury will be able to replace your bonds.

Before describing the specific conditions that apply to Series EE bonds
issued on various dates, it's important to understand the terminology
that is used in these explanations. The following list should help.
Warning: this gets complicated quickly, thanks to your friends at the US
Treasury.

* Issue date: The first day of the month of purchase. Shown on the
face of the bond. (The bond face may also show the date on which
the Treasury processed an application and printed the bond, but
that's not the issue date.)
* Nominal original maturity (date): The date at which a Series EE
Bond reaches its face value. The applicable rates need only exceed
the guaranteed rate (see below) by a small amount for the actual
original maturity date to occur earlier than the nominal first
date.

For Series EE Bonds issued prior to 1 May 1995, the actual first
maturity date depends on the minimum guaranteed rate of interest
that prevails during its life! This period (date) ranges from 9 yrs
8 months for bonds issued prior to 11/86 to 18 years for those
issued since the guaranteed rate was lowered to 4% in 1994. For
bonds purchased prior to 1 Dec 1985, the nominal original maturity
date will be the stated interest rate on the bond divided into 72.
Over the years that date varied from 9 yrs. 6 months to 12 years.
that means minimum guaranteed rates of 6 to 7.5%, except for the
oldest E bonds whose rates (for those still not having reached
final maturity) can be as low as 4%.
* Final maturity (date): the date following which the bond no longer
earns any interest (see discussion above about cashing bonds before
this date).
* Guaranteed minimum rate during original maturity: the minimum
interest rate that the US treasury will pay you on the bonds, no
matter what the market rate may be. This can either be stated as
an interest rate (from which the nominal original maturity date can
be calculated) or as a nominal original maturity date (from which
the minimum guaranteed rate can be calculated). Note that the
Treasury states this guaranteed minimum rate as the overall yield
from issuance, not as the minimum rate for each six-month period.
For example, if a bond paid 8% for some period of time but the
overall guaranteed yield is 4%, then depending on interest rates
and markets, the bond might pay just 1% for some six-month periods
without violating the minimum-rate guarantee.
* Crediting of interest: Prior to 1 May 1995, interest was credited
monthly, and calculated to the first day of the month you cash it
in (up to 30 months, and to the previous 6 month interval after).
Bonds issued after 1 May 1995 and all earlier bonds entering any
extended maturity period after 1 May 1995 will only earn interest
from that point on every six months. For bonds issued after 1 May
1995 or for earlier bonds entering any extended maturity period
after that date, you cash them as soon as possible after any 6
month anniversary date, because cashing a bond any time between any
two 6th month anniversary dates loses all interest since the last 6
month anniversary date.

The following list attempts to clarify the rules that apply to Series E
or EE Bonds that were issued in various time periods. Note that the
rule changes generally change the game only for bonds that are issued
after the rule change. Outstanding Series E Bonds and Savings Notes as
well as Series EE Bonds issued in general continue to earn interest
unter the terms of their original offerings, even as they enter
extension periods.

* Series E bonds issued before 1980

These bonds are very similar to EE bonds, except they were
purchased at 75% of face value. Everything else stated here about
EE bonds applies also to E bonds.


* Series EE Savings bonds issued 1 November 1982 -- 31 October 1986

These bonds have a minimum rate of 7.5% through their maturity
period of 9 yrs 7 mos. If these bonds entered a period of extended
maturity prior to March 1993, they would earn the prevailing market
based rates, or a minimum of the 6.0% guaranteed rate until the
next extended maturity period begins. If these bonds enter a
period of extended maturity after March 1993, they will earn the
prevailing market based rates, or at least the minimum 4.0%
guaranteed rate for the remainder of their life.


* Series EE Savings bonds issued 1 November 1986 -- 28 February 1993

The bonds are subject to the same rules discussed earlier; i.e.,
they earn the 6% guaranteed rate until they reach face value (which
may be before their 12th anniversary depending on prevailing
rates), after which they will earn the prevailing market based
rates, or at least the minimum 4.0% guaranteed rate for the
remainder of their life.


* Series EE Savings bonds issued 1 March 1993 -- 30 April 1995

If held at least 5 years, these bonds have a minimum rate of 4%,
and this rate is guaranteed through their original maturity of 18
years. These EE bonds will earn a flat 4% through the first 5
years rather than the short-term rate, and the interest will accrue
semiannually. Any bond issued before 1 May 1995 will earn a
minimum of 4% after it enters its next extended maturity period.


* Series EE Savings bonds issued 1 May 1995 -- 30 April 1997

These bonds will earn market-based rates from purchase through
original maturity. They will earn the short-term rate for the
first five years after purchase and will earn the long-term rate
from the fifth through the seventeenth year. The bonds will
continue to earn interest after 17 years for a total of 30 years at
the rates then in effect for extensions. If the market-based rates
are not sufficient for a bond to reach face value in 17 years, the
Treasury will make a one-time adjustment to increase it to face
value at that time. Therefore, you are guaranteed that a bond will
be worth its face value as of 17 years of its purchase date. This
equates to a minimum interest rate of 4.1%. If the market-based
rates are higher than this, the bond will be worth more than its
face value after 17 years.

The short-term rate is 85% of the average of six-month Treasury
security yields. A new rate is announced and becomes effective
each May 1 and November 1. The May 1 rate reflects market yields
during the preceding February, March, and April. The November 1
rate reflects market yields during the preceding August, September,
and October.

The long-term rate is 85% of the average of five-year Treasury
security yields. A new rate is announced and becomes effective
each May 1 and November 1. The May 1 rate reflects market yields
during the preceding November through April and the November 1 rate
reflects market yields during the preceding May through October.

Effective 1 May 1995:
The short-term rate is 5.25%
The long-term rate is 6.31%


Interest will be added to the value of the bonds every six months.
Bonds will increase in value six months after purchase and every
six months thereafter. For example, a bond purchased in June will
increase in value on December 1 and on each following June 1 and
December 1. When investors cash their bonds they will receive the
value of the bond as of the last date interest was added. If an
investor redeems a savings bond between scheduled interest dates
the investor will not receive interest for the partial period.


* Series EE Savings bonds issued 1 May 1997 -- present

The latest Treasury program made three significant changes to the
prior system. First, the market rates on which the savings bond
rate are calculated will be long-term rates, rather than a
combination of short-term and long-term rates. Second, all bonds
will earn 90 percent of the average market rate on 5-year Treasury
notes. (This ends the two-tier system that was in place since
1995, as described above.) Finally, interest on savings bonds will
accrue monthly, instead of every six months. This will eliminate
the problem of an investor losing up to five months interest by
redeeming a savings bond at the wrong time. But of course there's
a catch. To encourage longer term holdings of savings bonds, a
three-month interest penalty is imposed if a savings bond is
redeemed within the first five years.

Finally, we'll try to summarize the preceding discussion in a table.

Nom. orig. Final Guar min rate Interest
Issue date maturity maturity orig. maturity credited
before Nov ? yrs 40 yrs ?.?% monthly
1965
1 Nov 1982 9 yrs 7 mos 30 yrs 7.5% monthly
31 Oct 1986
1 Nov 1986 12 yrs 30 yrs 6.0% monthly
28 Feb 1993
1 Mar 1993 18 yrs 30 yrs 4.0% monthly
30 Apr 1995
1 May 1995 17 yrs 30 yrs 4.1% biannually
30 Apr 1997
1 May 1997 TBD 30 yrs TBD% monthly


For current rates, you may call 1-800-4US-Bonds (1-800-487-2663) within
the US. You can call any Federal Reserve Bank to request redemption
tables for US Savings Bonds. You may also request the tables from The
Bureau of Public Debt, Bonds Div., Parkersburg, WV 26106-1328.

Here a few web resources that may help.

* The official US Savings Bonds web site offers a huge amount of
information, as well as a way to purchase Series EE (denominations
50 to 1000) and I Bonds (denominations 50 to 500) with a visa or
master card. This web site can also help you calculate the Current
Redemption Value (CRV) of any bond.

* The Treasury's Bureau of the Public Debt maintains another
government web site with comprehensive information about savings
bonds (includes information about branches of the Federal Reserve
Bank):
www.publicdebt.treas.gov .
* The Savings bond Wizard help you manage your own Savings Bond
inventory. It's a PC program, available free of charge:

* Another site that offers assistance with savings bond issues:


[ Compiler's note: These disgustingly complex regulations come from many
of the same people who developed the US Tax Code. See any
similarities?? Sheesh! ]


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

Subject: Bonds - U.S. Savings Bonds for Education

Last-Revised: 27 Aug 2001
Contributed-By: Jackie Brahney (info at savingsbonds.com)

You can use your U.S. Savings Bonds towards your child's education and
exclude all the interest earned from your federal income. This is
sometimes known as the Tax Free Interest for Education program. Here
are some basics on how the Education Savings Bond program works.

You can exclude all or a portion of the interest earned from savings
bonds from your federal income tax. Qualified higher education
expenses, incurred by the taxpayer, the taxpayers spouse or the
taxpayer's dependent at a institution or State tuition plans (see below)
have to incur in the same calendar year the bonds are cashed in.

The following qualifications and exclusions apply.

1. Only Series EE or I Bonds issued in 1990 and later apply; "Older"
bonds cannot be exchanged towards newer bonds.
2. When purchasing bonds to be used for education, you do NOT have to
declare that at the time of purchase that will be using them for
education purposes.
3. You can choose NOT to use the bonds for education if you so choose
at a later date.
4. You must be at least 24 years old when you purchase(d) the bonds.
5. When using bonds for a child's education, register the bonds in
your name, NOT the child's name.
6. A child CAN NOT be listed as a CO-OWNER on the bond.
7. The child can be a beneficiary on the bond and the education
exclusion can still apply.
8. If you are married, a joint return MUST be filed to qualify for the
education exclusion.
9. You are required to report both the principal and the interest from
the bonds to pay for qualified expenses
10. Use Form 8815 to exclude interest for college tuition.

Here are a few frequently asked questions.

Does everyone in every income bracket qualify?
No. The interest exclusion at the highest level is available to
married couples (who file jointly) starting at $83,650 with a
modified gross income and is eliminated at $113,650 or more in tax
year 2001. For single filers, the exclusion begins to reduce at
$55,750 and is eliminated at $70,750 or more in tax year 2001.
These income limitations apply to the year you use the bonds, and
NOT when you purchase the bonds.


What Institutions Qualify for the Exclusion?
Post secondary institutions, colleges, universities, and various
vocational schools. The schools qualify must participate in
federally assisted programs (ex. They offer a guaranteed student
loan program). Beauty or secretarial schools and proprietary
institutions usually do not apply.


What are Qualified Expenses?
Tuition and fees, for any course or educational program that
involves sports, games or hobbies, lab fees and other required
course expenses that relate to an educational degree or
certificate-granting program. These expenses must be incurred
during the same tax year in which the bonds are cashed in. Note:
Room/board expenses, books, and expendable materials (pens,
notepads, etc.) do not qualify.


A bit of advice: when purchasing bonds that you think will be used for
educational purposes, purchase them in small denominations. That way
you won't have to cash in more bonds than are necessary to pay the
current college tuition expenses. Remember, any excess monies you
receive from cashing in some savings bonds that EXCEED the tuition bills
may create a taxable event when you file your federal tax return.
(Savings Bonds are always exempt from State and Local/City taxes.)

Here are some resources on the web that can help.
* The Treasury Department's web site:

* The bond experts at SavingsBonds.com:
http:/www.savingsbonds.com


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

Subject: Bonds - Value of U.S. Treasury Bills

Last-Revised: 24 Oct 1994
Contributed-By: Dave Barrett

The current value of a U.S. Treasury Bill can be found using the Wall
Street Journal. Look in the WSJ in the issue dated the next business
day after the valuation date you want, specifically in the "Money and
Investing" section under the headline "Treasury Bonds, Notes, and
Bills". There you need to look for the column titled "TREASURY BILLS".
Scan down the column for the maturity date of your bill. Then examine
the "Bid" and "Days to Mat." values. The necessary formula:

Current value = (1 - ("Bid" / 100 * "Days to Mat." / 360)) * Mature
Value

For example, a 13-week treasury bill purchased at the auction on Monday
June 21 appears in the June 22, 1994 WSJ in boldface as maturing on
September 22, 1994 with an "Asked" of 4.18 and 91 "Days to Mat.". Its
selling price on Wedesday August 31, 1994 appeared in the September 1,
1994 Wall Street Journal as 20 "Days to Mat." with 4.53 "Bid". A
$10,000 bill would sell for:
(1 - 4.53/100 * 20/360) * $10,000 = $ 9,974.83
minus any brokerage fee.

The coupon yield for a U.S. Treasury Bill is listed as "Ask Yld." in
the Wall Street Journal under "Treasury Bonds, Notes and Bills". The
value is computed using the formula:

couponYield = 365 / (360/discount - daysToMaturity/100)

Discount is listed under the "Asked" column, and "couponYield" is shown
under the "Ask Yld." column. For example, the October 21, 1994 WSJ
lists Jan 19, '95 bills as having 87 "Days to Mat.", and an "Asked"
discount as 4.98. This gives:
365 / (360/4.98 - 87/100) = 5.11%
which is shown under the "Ask Yld." column for the same issue.
DaysToMaturity for 13-week, 26-week, and 52-week bills will be 91, 182,
and 364, respectively, on the day the bill is issued.


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

Subject: Bonds - Zero-Coupon

Last-Revised: 28 Feb 1994
Contributed-By: Art Kamlet (artkamlet at aol.com)

Not too many years ago every bond had coupons attached to it. Every so
often, usually every 6 months, bond owners would take a scissors to the
bond, clip out the coupon, and present the coupon to the bond issuer or
to a bank for payment. Those were "bearer bonds" meaning the bearer
(the person who had physical possession of the bond) owned it. Today,
many bonds are issued as "registered" which means even if you don't get
to touch the actual bond at all, it will be registered in your name and
interest will be mailed to you every 6 months. It is not too common to
see such coupons. Registered bonds will not generally have coupons, but
may still pay interest each year. It's sort of like the issuer is
clipping the coupons for you and mailing you a check. But if they pay
interest periodically, they are still called Coupon Bonds, just as if
the coupons were attached.

When the bond matures, the issuer redeems the bond and pays you the face
amount. You may have paid $1000 for the bond 20 years ago and you have
received interest every 6 months for the last 20 years, and you now
redeem the matured bond for $1000.

A Zero-coupon bond has no coupons and there is no interest paid.

But at maturity, the issuer promises to redeem the bond at face value.
Obviously, the original cost of a $1000 bond is much less than $1000.
The actual price depends on: a) the holding period -- the number of
years to maturity, b) the prevailing interest rates, and c) the risk
involved (with the bond issuer).

Taxes: Even though the bond holder does not receive any interest while
holding zeroes, in the US the IRS requires that you "impute" an annual
interest income and report this income each year. Usually, the issuer
will send you a Form 1099-OID (Original Issue Discount) which lists the
imputed interest and which should be reported like any other interest
you receive. There is also an IRS publication covering imputed interest
on Original Issue Discount instruments.

For capital gains purposes, the imputed interest you earned between the
time you acquired and the time you sold or redeemed the bond is added to
your cost basis. If you held the bond continually from the time it was
issued until it matured, you will generally not have any gain or loss.

Zeroes tend to be more susceptible to prevailing interest rates, and
some people buy zeroes hoping to get capital gains when interest rates
drop. There is high leverage. If rates go up, they can always hold
them.

Zeroes sometimes pay a better rate than coupon bonds (whether registered
or not). When a zero is bought for a tax deferred account, such as an
IRA, the imputed interest does not have to be reported as income, so the
paperwork is lessened.

Both corporate and municipalities issue zeroes, and imputed interest on
municipals is tax-free in the same way coupon interest on municipals is.
(The zero could be subject to AMT).

Some marketeers have created their own zeroes, starting with coupon
bonds, by clipping all the coupons and selling the bond less the coupons
as one product -- very much like a zero -- and the coupons as another
product. Even US Treasuries can be split into two products to form a
zero US Treasury.

There are other products which are combinations of zeroes and regular
bonds. For example, a bond may be a zero for the first five years of
its life, and pay a stated interest rate thereafter. It will be treated
as an OID instrument while it pays no interest.

(Note: The "no interest" must be part of the original offering; if a
cumulative instrument intends to pay interest but defaults, that does
not make this a zero and does not cause imputed interest to be
calculated.)

Like other bonds, some zeroes might be callable by the issuer (they are
redeemed) prior to maturity, at a stated price.


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

Subject: CDs - Basics

Last-Revised: 15 Mar 2003
Contributed-By: Chris Lott ( contact me )

A CD in the world of personal finance is not a compact disc but a
certificate of deposit. You buy a CD from a bank or savings & loan for
some amount of money, and the bank promises to pay you a fixed interest
rate on that money for a fixed term. For example, you might buy a
30-month CD paying 3% in the amount of $5,000. A bank may have a
minimum amount for issuing CDs like $1,000, but there is usually no
requirement to buy a CD with an even amount. Interest earned by a CD
may be paid monthly, quarterly, annually, or when the CD matures.
Interest paid during the CD's term is paid by check or deposited to
another account; it is never added to the amount of the CD (like in a
savings account), because the CD amount is fixed.

After you have purchased a CD, you can always redeem it before the
stated maturity date. However, if you cash out early, the bank will
impose a penalty in the amount of 3 or 6-months of interest payments,
depending on the term. This "penalty for early withdrawal" is due
whether any interest was paid or not.

As the name implies, a CD is usually a piece of paper (the certificate)
that states the interest rate and term (actually the maturity date).
Because CDs are issued by banks, a CD for less than $100,000 is insured
by the government (probably the FDIC program), so the investment is
essentially risk-free.

Some CDs can be bought and sold much like a stock or bond. If you buy a
CD through a brokerage house, you may be able to re-sell the CD through
them to avoid paying an early withdrawal penalty. These CDs usually
have significant minimum investment amounts (like $5,000) and require
round numbers (like multiples of 1,000).


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

Subject: CDs - Market Index Linked

Last-Revised: 15 Mar 2003
Contributed-By: Chris Lott ( contact me )

A market index linked CD (MILC) is a combination of a CD and a
stock-market investment. These instruments seek to add the possibility
of great returns to the security of CDs. They do this by pegging the
interest rate paid by the CD to the performance of some stock-market
index (i.e., they are linked to a market index). The term on these
instrument is usually around 5 years.

Like a conventional CD, the principal is fully insured by the federal
government, so an investor is guaranteed to receive 100% of the original
investment if the CD is held to maturity. Early withdrawal is possible,
but frequently constrained to certain dates each year. Further, an
investor is not guaranteed to receive 100% of the initial investment if
withdrawn early.

All interest is paid when the CD matures. However, there is no
guarantee that any interest will be paid. So there is very little
chance an investor will do very well, but there is a reasonable chance
of doing better than a conventional fixed-rate CD.

These notes have a quirky tax treatment. Although they pay no interest
annually, if the CD is held in a regular account, an investor must
nonetheless declare income from a market index linked CD every year. So
you're probably asking, the thing paid me nothing, what am I declaring!?
The amount to declare is based on the amount a comparable, conventional
CD of the same term would pay, based on information in the MILC. These
declared payments are added to the cost basis of the CD and the whole
mess is reconciled when the CD matures. Investors can avoid this hassle
by holding this instrument in a tax-deferred account such as an IRA.


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

Subject: Derivatives - Basics

Last-Revised: 6 Dec 1996
Contributed-By: Brian Hird, Chris Lott ( contact me )

A derivative is a financial instrument that does not constitute
ownership, but a promise to convey ownership. Examples are options and
futures. The most simple example is a call option on a stock. In the
case of a call option, the risk is that the person who writes the call
(sells it and assumes the risk) may not be in business to live up to
their promise when the time comes. In standarized options sold through
the Options Clearing House, there are supposed to be sufficient
safeguards for the small investor against this.

Before discussing derivatives, it's important to describe their basis.
All derivatives are based on some underlying cash product. These "cash"
products are:
* Spot Foreign Exchange. This is the buying and selling of foreign
currency at the exchange rates that you see quoted on the news. As
these rates change relative to your "home currency" (dollars if you
are in the US), so you make or lose money.
* Commodities. These include grain, pork bellies, coffee beans,
orange juice, etc.
* Equities (termed "stocks" in the US)
* Bonds of various different varieties (e.g., they may be Eurobonds,
domestic bonds, fixed interest / floating rate notes, etc.). Bonds
are medium to long-term negotiable debt securities issued by
governments, government agencies, federal bodies (states),
supra-national organisations such as the World Bank, and companies.
Negotiable means that they may be freely traded without reference
to the issuer of the security. That they are debt securities means
that in the event that the company goes bankrupt. bond-holders
will be repaid their debt in full before the holders of
unsecuritised debt get any of their principal back.
* Short term ("money market") negotiable debt securities such as
T-Bills (issued by governments), Commercial Paper (issued by
companies) or Bankers Acceptances. These are much like bonds,
differing mainly in their maturity "Short" term is usually defined
as being up to 1 year in maturity. "Medium term" is commonly taken
to mean form 1 to 5 years in maturity, and "long term" anything
above that.
* Over the Counter ("OTC") money market products such as loans /
deposits. These products are based upon borrowing or lending.
They are known as "over the counter" because each trade is an
individual contract between the 2 counterparties making the trade.
They are neither negotiable nor securitised. Hence if I lend your
company money, I cannot trade that loan contract to someone else
without your prior consent. Additionally if you default, I will
not get paid until holders of your company's debt securities are
repaid in full. I will however, be paid in full before the equity
holders see a penny. Derivative products are contracts which have
been constructed based on one of the "cash" products described above.
Examples of these products include options and futures. Futures are
commonly available in the following flavours (defined by the underlying
"cash" product):
* commodity futures
* stock index futures
* interest rate futures (including deposit futures, bill futures and
government bond futures) For more information on futures, please
see the article in this FAQ on futures.

In the early 1990s, derivatives and their use by various large
institutions became quite a hot topic, especially to regulatory
agencies. What really concerns regulators is the fact that big banks
swap all kinds of promises all the time, like interest rate swaps,
froward currency swaps, options on futures, etc. They try to balance
all these promises (hedging), but there is the big danger that one big
player will go bankrupt and leave lots of people holding worthless
promises. Such a collapse could cascade, as more and more speculators
(banks) cannot meet their obligations because they were counting on the
defaulted contract to protect them from losses.

All of this is done off the books, so there is no total on how much
exposure each bank has under a specific scenario. Some of the more
complicated derivatives try to simulate a specific event by tracking it
with other events (that will usually go in the same or the opposite
direction). Examples are buying Japan stocks to protect against a loss
in the US. However, if the usual correlation changes, big losses can be
the result.

The big danger with the big banks is that while they can use derivatives
to hedge risk, they can also use them as a way of taking ON risk. Not
that risk is bad. Risk is how a bank makes money; for example, issuing
loans is a risk. However, banks are forbidden from taking on risk with
derivatives. It's just too easy for a bank to hedge bonds with
derivatives that don't have the same maturity, same underlying security,
etc. so the correlation between the hedge and the risky position is
weak.


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

Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 6 of 20)

am 30.05.2005 06:30:04 von noreply

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 &copy; 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)

am 30.05.2005 06:30:05 von noreply

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 5 of 20)

am 30.05.2005 06:30:05 von noreply

Archive-name: investment-faq/general/part5
Version: $Id: part05,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 5 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: Derivatives - Black-Scholes Option Pricing Model

Last-Revised: 5 Jan 2001
Contributed-By: Kevin Rubash (arr at bradley.edu)

The Black and Scholes Option Pricing Model is an approach for
calculating the value of a stock option. This article presents some
detail about the pricing model.

The Black and Scholes Option Pricing Model didn't appear overnight, in
fact, Fisher Black started out working to create a valuation model for
stock warrants. This work involved calculating a derivative to measure
how the discount rate of a warrant varies with time and stock price.
The result of this calculation held a striking resemblance to a
well-known heat transfer equation. Soon after this discovery, Myron
Scholes joined Black and the result of their work is a startlingly
accurate option pricing model. Black and Scholes can't take all credit
for their work, in fact their model is actually an improved version of a
previous model developed by A. James Boness in his Ph.D. dissertation
at the University of Chicago. Black and Scholes' improvements on the
Boness model come in the form of a proof that the risk-free interest
rate is the correct discount factor, and with the absence of assumptions
regarding investor's risk preferences.

The model is expressed as the following formula.
C = S * N(d1) - K * (e ^ -rt) * N (d2)

ln (S / K) + (r + (sigma) ^ 2 / 2) * t
d1 = --------------------------------------
sigma * sqrt(t)

d2 = d1 - sigma * sqrt(t)

Where:
C = theoretical call premium
S = current stock price
N = cumulative standard normal distribution
t = time until option expiration
r = risk-free interest rate
K = option strike price
e = the constant 2.7183..
sigma = standard deviation of stock returns (usually written as
lower-case 's')
ln() = natural logarithm of the argument
sqrt() = square root of the argument
^ means exponentiation (i.e., 2 ^ 3 = 8)
(boy, HTML just isn't much good for formulas!)

In order to understand the model itself, we divide it into two parts.
The first part, SN(d1), derives the expected benefit from acquiring a
stock outright. This is found by multiplying stock price [S] by the
change in the call premium with respect to a change in the underlying
stock price [N(d1)]. The second part of the model, K(e^-rt)N(d2), gives
the present value of paying the exercise price on the expiration day.
The fair market value of the call option is then calculated by taking
the difference between these two parts.

The Black and Scholes Model makes the following assumptions.
1. The stock pays no dividends during the option's life

Most companies pay dividends to their share holders, so this might
seem a serious limitation to the model considering the observation
that higher dividend yields elicit lower call premiums. A common
way of adjusting the model for this situation is to subtract the
discounted value of a future dividend from the stock price.


2. European exercise terms are used

European exercise terms dictate that the option can only be
exercised on the expiration date. American exercise term allow the
option to be exercised at any time during the life of the option,
making american options more valuable due to their greater
flexibility. This limitation is not a major concern because very
few calls are ever exercised before the last few days of their
life. This is true because when you exercise a call early, you
forfeit the remaining time value on the call and collect the
intrinsic value. Towards the end of the life of a call, the
remaining time value is very small, but the intrinsic value is the
same.


3. Markets are efficient

This assumption suggests that people cannot consistently predict
the direction of the market or an individual stock. The market
operates continuously with share prices following a continuous Itt
process. To understand what a continuous Itt process is, you must
first know that a Markov process is "one where the observation in
time period t depends only on the preceding observation." An Itt
process is simply a Markov process in continuous time. If you were
to draw a continuous process you would do so without picking the
pen up from the piece of paper.


4. No commissions are charged

Usually market participants do have to pay a commission to buy or
sell options. Even floor traders pay some kind of fee, but it is
usually very small. The fees that individual investors pay is more
substantial and can often distort the output of the model.


5. Interest rates remain constant and known

The Black and Scholes model uses the risk-free rate to represent
this constant and known rate. In reality there is no such thing as
the risk-free rate, but the discount rate on U.S. Government
Treasury Bills with 30 days left until maturity is usually used to
represent it. During periods of rapidly changing interest rates,
these 30 day rates are often subject to change, thereby violating
one of the assumptions of the model.


6. Returns are lognormally distributed

This assumption suggests, returns on the underlying stock are
normally distributed, which is reasonable for most assets that
offer options.

For more detail, visit Kevin Rubash's web page:



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

Subject: Derivatives - Futures

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

A futures contract is an agreement to buy (or sell) some commodity at a
fixed price on a fixed date. In other words, it is a contract between
two parties; the holder of the future has not only the right but also
the obligation to buy (or sell) the specified commodity. This differs
sharply from stock options, which carry the right but not the obligation
to buy or sell a stock.

These days, all details of a futures contract are standardized, except
for the price of course. These details are the commodity, the quantity,
the quality, the delivery date, and whether the contract can be settled
in goods or in cash. Futures contracts are traded on futures exchanges,
of which the U.S. has eight.

Futures are commonly available in the following flavors (defined by the
underlying "cash" product):
* Agricultural commodity futures
A commodity future, for example an orange-juice future contract,
gives you the right to take delivery of some huge amount of orange
juice at a fixed price on some date. Alternately, if you wrote
(i.e., sold) the contract, you have the obligation to deliver that
OJ to someone.
* Foreign currency futures
For example, on the Euro.
* Stock index futures
Since you can't really buy an index, these are settled in cash.
* Interest rate futures (including deposit futures, bill futures and
government bond futures)
Again, since you cannot easily buy an interest rate, these are
usually settled in cash as well. Futures are explicitly designed
to allow the transfer of risk from those who want less risk to those who
are willing to take on some risk in exchange for compensation. A
futures instrument accomplishes the transfer of risk by offering several
features:
* Liquidity
* Leverage (a small amount of money controls a much larger amount)
* A high degree of correlation between changes in the futures price
and changes in price of the underlying commodity. In the case of
the commodity future, if I sell you a commodity future then I am
promising to deliver a fixed amount of the commodity to you at a given
price (fixed now) at a given date in the future.

Note that if the price of the future becomes very high relative to the
price of the commodity today, I can borrow money to buy the commodity
now and sell a futures contract (on margin). If the difference in price
between the two is great enough then I will be able to repay the
interest and principal on the loan and still have some riskless profit;
i.e., a pure arbitrage.

Conversely, if the price of the future falls too far below that of the
commodity, then I can short-sell the commodity and purchase the future.
I can (predumably) borrow the commodity until the futures delivery date
and then cover my short when I take delivery of some of the commodity at
the futures delivery date. I say presumably borrow the commodity since
this is the way bond futures are designed to work; I am not certain that
comodities can be borrowed.

Note that there are also options on futures! See the article on the
basics of stock options for more information on options.

Here are a few resources on futures.
* The Futures FAQ has quite a bit of information.

* The Futures Industry Association and the Futures Industry Institute
offer many educational materials.

* The Orion Futures Group offers a "Futures 101" primer.



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

Subject: Derivatives - Futures and Fair Value

Last-Revised: 11 Apr 2000
Contributed-By: Chris Lott ( contact me )

In the case of futures on equity indexes such as the S&P 500 contract,
it is possible to make a careful computation of how much a futures
contract should cost (in theory) based on the current market prices of
the stocks in the index, current interest rates, how long until the
contract expires, etc. This computation yields a theoretical result
that is called the fair value of the contract. If the contract trades
at prices that are far from the fair value, you can be fairly certain
that traders will buy or sell contracts appropriately to exploit the
differentce (also called arbitrage). Much of this trading is initiated
by program traders; it gets restricted (curbed) when the markets have
risen or fallen far during the course of a day.

Here are some resources about fair value of equity index futures.
* An example from the Chicago Mercantile Exchange about calculating
fair value:

* A long discussion (case study) about fair value, also from the
Chicago Mercantile Exchange:

* A few words from one of the program traders.



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

Subject: Derivatives - Stock Option Basics

Last-Revised: 26 May 1999
Contributed-By: Art Kamlet (artkamlet at aol.com), Bob Morris, Chris
Lott ( contact me ), Larry Kim (lek at cypress.com)

An option is a contract between a buyer and a seller. The option is
connected to something, such as a listed stock, an exchange index,
futures contracts, or real estate. For simplicity, this article will
discuss only options connected to listed stocks.

Just to be complete, note that there are two basic types of options, the
American and European. An American (or American-style) option is an
option contract that can be exercised at any time between the date of
purchase and the expiration date. Most exchange-traded options are
American-Style. All stock options are American style. A European (or
European-style) option is an option contract that can only be exercised
on the expiration date. Futures contracts (i.e., options on
commodities; see the article elsewhere in this FAQ) are generally
European-style options.

Every stock option is designated by:
* Name of the associated stock
* Strike price
* Expiration date
* The premium paid for the option, plus brokers commission.

The two most popular types of options are Calls and Puts. We'll cover
calls first. In a nutshell, owning a call gives you the right (but not
the obligation) to purchase a stock at the strike price any time before
the option expires. An option is worthless and useless after it
expires.

People also sell options without having owned them before. This is
called "writing" options and explains (somewhat) the source of options,
since neither the company (behind the stock that's behind the option)
nor the options exchange issues options. If you have written a call
(you are short a call), you have the obligation to sell shares at the
strike price any time before the expiration date if you get called .

Example: The Wall Street Journal might list an IBM Oct 90 Call at $2.00.
Translation: this is a call option. The company associated with it is
IBM. (See also the price of IBM stock on the NYSE.) The strike price is
90. In other words, if you own this option, you can buy IBM at
US$90.00, even if it is then trading on the NYSE at $100.00. If you
want to buy the option, it will cost you $2.00 (times the number of
shares) plus brokers commissions. If you want to sell the option
(either because you bought it earlier, or would like to write the
option), you will get $2.00 (times the number of shares) less
commissions. The option in this example expires on the Saturday
following the third Friday of October in the year it was purchased.

In general, options are written on blocks of 100s of shares. So when
you buy "1" IBM Oct 90 Call at $2.00 you actually are buying a contract
to buy 100 shares of IBM at $90 per share ($9,000) on or before the
expiration date in October. So you have to multiply the price of the
option by 100 in nearly all cases. You will pay $200 plus commission to
buy this call.

If you wish to exercise your option you call your broker and say you
want to exercise your option. Your broker will make the necessary
requests so that a person who wrote a call option will sell you 100
shares of IBM for $9,000 plus commission. What actually happens is the
Chicago Board Options Exchange matches to a broker, and the broker
assigns to a specific account.

If you instead wish to sell (sell=write) that call option, you instruct
your broker that you wish to write 1 Call IBM Oct 90s, and the very next
day your account will be credited with $200 less commission. If IBM
does not reach $90 before the call expires, you (the option writer) get
to keep that $200 (less commission). If the stock does reach above $90,
you will probably be "called." If you are called you must deliver the
stock. Your broker will sell IBM stock for $9000 (and charge
commission). If you owned the stock, that's OK; your shares will simply
be sold. If you did not own the stock your broker will buy the stock at
market price and immediately sell it at $9000. You pay commissions each
way.

If you write a Call option and own the stock that's called "Covered Call
Writing." If you don't own the stock it's called "Naked Call Writing."
It is quite risky to write naked calls, since the price of the stock
could zoom up and you would have to buy it at the market price. In
fact, some firms will disallow naked calls altogether for some or all
customers. That is, they may require a certain level of experience (or
a big pile of cash).

When the strike price of a call is above the current market price of the
associated stock, the call is "out of the money," and when the strike
price of a call is below the current market price of the associated
stock, the call is "in the money." Note that not all options are
available at all prices: certain out-of-the-money options might not be
able to be bought or sold.

The other common option is the PUT. Puts are almost the mirror-image of
calls. Owning a put gives you the right (but not the obligation) to
sell a stock at the strike price any time before the option expires. If
you have written a put (you are short a put), you have the obligation to
buy shares at the strike price any time before the expiration date if
you get get assigned . Covered puts are a simple means of locking in
profits on the covered security, although there are also some tax
implications for this hedging move. Check with a qualified expert. A
put is "in the money" when the strike price is above the current market
price of the stock, and "out of the money" when the strike price is
below the current market price.

How do people trade these things? Options traders rarely exercise the
option and buy (or sell) the underlying security. Instead, they buy
back the option (if they originally wrote a put) or sell the option (if
the originally bought a call). This saves commissions and all that.
For example, you would buy a Feb 70 call today for $7 and, hopefully,
sell it tommorow for $8, rather than actually calling the option (giving
you the right to buy stock), buying the underlying stock, then turning
around and selling the stock again. Paying commissions on those two
stock trades gets expensive.

Although options offically expire on the Saturday immediately following
the third Friday of the expiration month, for most mortals, that means
the option expires the third Friday, since your friendly neighborhood
broker or internet trading company won't talk to you on Saturday. The
broker-broker settlements are done effective Saturday. Another way to
look at the one day difference is this: unlike shares of stock which
have a 3-day settlement interval, options settle the next day. In order
to settle on the expiration date (Saturday), you have to exercise or
trade the option by Friday. While most trades consider only weekdays as
business days, the Saturday following the third Friday is a business day
for expiring options.

The expiration of options contributes to the once-per-quarter
"triple-witching day," the day on which three derivative instruments all
expire on the same day. Stock index futures, stock index options and
options on individual stocks all expire on this day, and because of
this, trading volume is usually especially high on the stock exchanges
that day. In 1987, the expiration of key index contracts was changed
from the close of trading on that day to the open of trading on that
day, which helped reduce the volatility of the markets somewhat by
giving specialists more time to match orders.

You will frequently hear about both volume and open interest in
reference to options (really any derivative contract). Volume is quite
simply the number of contracts traded on a given day. The open interest
is slightly more complicated. The open interest figure for a given
option is the number of contracts outstanding at a given time. The open
interest increases (you might say that an open interest is created) when
trader A opens a new position by buying an option from trader B who did
not previously hold a position in that option (B wrote the option, or in
the lingo, was "short" the option). When trader A closes out the
position by selling the option, the open interest either remain the same
or go down. If A sells to someone who did not have a position before,
or was already long, the open interest does not change. If A sells to
someone who had a short position, the open interest decreases by one.

For anyone who is curious, the financial theoreticians have defined the
following relationship for the price of puts and calls. The Put-Call
parity theorem says:
P = C - S + E + D
where
P = price of put
C = price of call
S = stock price
E = present value of exercise price
D = present value of dividends


The ordinary investor will occasionally see a violation of put-call
parity. This is not an instant buying opportunity, it's a reason to
check your quotes for timeliness, because at least one of them is out of
date.

My personal advice for new options people is to begin by writing covered
call options for stocks currently trading below the strike price of the
option; in jargon, to begin by writing out-of-the-money covered calls.

The following web resources may also help.

* For the last word on options, contact The Options Clearing
Corporation (CCC) at 1-800-OPTIONS and request their free booklet
"Characteristics and Risks of Listed Options." This 94-page
publications will give you all the details about options on equity
securities, index options, debt options, foreign currency options,
principal risks of options positions, and much more. The booklet
is published jointly by the American Stock Exchange, The Chicago
Board Options Exchange, The Pacific Exchange, and The Philadelphia
Stock Exchange. It's available on the web at:

* The Chicago Board Options Exchange (CBOE) maintains a web site with
extensive information about equity and index options. Visit them
at:

* The Orion Futures Group offers an "Options 101" primer.



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

Subject: Derivatives - Stock Option Covered Calls

Last-Revised: 17 July 2000
Contributed-By: Chris Lott ( contact me ), Art Kamlet (artkamlet at
aol.com), John Marucco

A covered call is a stock call option that is written (i.e., created and
sold) by a person who also owns a sufficient number of shares of the
stock to cover the option if necessary. In most cases this means that
the call writer owns at least 100 shares of the stock for every call
written on that stock.

The call option, as explained in the article on option basics , grants
the holder the right to buy a security at a specific price. The writer
of the call option receives a premium and agrees to deliver shares
(possibly from his or her holdings, but this is not required) if the
option is called. Because the call writer can deliver the shares from
his or her holdings, the writer is covered: there is no risk to the call
writer of being forced to buy and subsequently deliver shares of the
stock at a huge premium due to some fantastic takeover offer (or
whatever event that drives up the price).

Note the difference between selling something in an opening transaction
and selling something in a closing transaction. When you sell a call
you already own, you are selling to close a position. When you sell a
call you do not own (whether it is covered by a stock position or not),
you are selling to open the option position; i.e., you are writing the
call. You might compare this with selling stock short, where you are
selling to open a position.

A call writer is covered in the broker's opinion if the broker has on
deposit in the call writer's option account the number of shares needed
to cover the call. The call writer might have shares in his or her safe
deposit box, or in another broker's account, or in that same broker's
cash account -- this makes the investor covered, but not as far as the
broker is concerned. So the call writer might consider himself covered,
but what will happen if the call is exercised and the shares are not in
the appropriate account? Quite simply, the broker will think the call is
naked, and will immediately purchase shares to cover. That costs the
call writer commissions -- and the writer will still own the shares that
were supposed to cover the call!

A call is also considered covered if the call writer has an escrow
receipt for the stock, owns a call on the same stock with a lower strike
price (a spread), or has cash equal to the market value of the stock.
But a person who writes a covered call and doesn't have the sahres in
the brokerage account might be well advised to check with his or her
broker to make sure the broker knows all the details about how the call
is covered.

While the covered-call writer has no risk of losing huge amounts of
money, there is an attendant risk of missing out on large gains. This
is pretty simple: if a stock has a large run-up in price, and calls are
nearing expiration with a strike price that is even slightly in the
money, those calls will be exercised before they expire. I.e., the
covered call writer will be forced to deliver shares (known as having
the shares "called away").

If the call writer does not want the shares to get called away, he or
she can buy back the option if it hasn't been exercised yet. And then
the call writer can roll up (higher strike price) or roll over (same
strike price, later expiration date), or roll up and over. Of course
the shares could be bought on the open market and delivered, but that
would get expensive.

If you write a covered call and are concerned about indicating specific
shares to be delivered in case you are called, it may be possible to
have your broker write a note on the call to specify a vs date. The
call confirmation might read: "Covered vs. Purchase 4/12/97." In other
words the decision on which shares you are covering is made at the time
you write the call. This should be more than enough to prove your
intent. What your individual broker or brokerage service will do for
you is a business matter between them and you.

My personal advice for new options people is to begin by writing covered
call options for stocks currently trading below the strike price of the
option; in jargon, to begin by writing out-of-the-money covered calls.

For comprehensive information about covered calls, try this site:



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

Subject: Derivatives - Stock Option Covered Puts

Last-Revised: 30 May 2002
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact
me )

A covered put is a stock put option that is written (i.e., created and
sold) by a person who also is short (i.e., has borrowed and sold) a
sufficient number of shares of the stock to cover the option if
necessary. In most cases this means that the put writer is short at
least 100 shares of the stock for every put written on that stock.

The put option, as explained in the article on option basics , grants
the holder the right to sell a security at a specific price. The writer
of the put option receives a premium and agrees to buy shares if the
option is exercised. For an explanation of what it mans to borrow and
sell shares, please see the FAQ article on selling short .

Note the difference between selling something in an opening transaction
and selling something in a closing transaction. When you sell a put you
already own, you are selling to close a position. When you sell a put
you do not own, you are selling to open a position. So when you sell a
put in an opening transaction (you give an instruction to your broker
"Sell 1 put to open"), that is known as writing the put. You might
compare this with selling stock short, where you are selling to open a
position.

If you write a naked put, and the stock price goes way way down, you
have incurred a significant loss because you must buy the stock at the
strike price, which (in this example) is well above the current price.

If you write a covered put, that is you hold a short postion on the
underlying stock, then past the strike price the put is covered. For
every dollar the stock price goes down, the cost to you of getting put
(i.e., of buying the shares because the option gets exercised) is
exactly offset by the decrease in the stock you hold short. In other
words, for the covered put writer, the shares s/he is put balance the
shares s/he will have to deliver to close out the short position in
those shares, so it balances out pretty well. The put is covered.

Like the covered call, the covered put does not do a thing to protect
you against the rise (in this case) in price of the underlying stock you
hold short. But if the price of the stock rises, the put itself is
safe. So the put writer is covered from loss due to the put.

While the covered-put writer has no risk of losing huge amounts of
money, there is an attendant risk of missing out on large gains. This
is pretty simple: if a stock has a large fall in price, and puts are
nearing expiration with a strike price that is even slightly in the
money, those puts will be exercised before they expire. I.e., the
covered put writer will be forced to buy shares (known as "being put").


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

Subject: Derivatives - Stock Option Ordering

Last-Revised: 25 Jan 96
Contributed-By: Hubert Lee (optionfool at aol.com)

When you are dealing in options, order entry is a critical factor in
getting good fills. Mis-spoken words during order entry can lead to
serious money errors. This article discusses how to place your order
properly, and focuses on the simplest type of order, the straight buy or
sell.

There is a set sequence of wording that Wall Street professionals use
among themselves to avoid errors. Orders are always "read" in this
fashion. Clerks are trained from day one to listen for and repeat for
verification the orders in the same way. If you, the public customer,
adopt the same lingo, you'll be way ahead of the game. In addition to
preventing errors in your account, you will win the respect of your
broker as a savvy, street-wise trader. Here is the "floor-ready"
sequence:

After identifying yourself and declaring an intent to place an order,
clearly say the following:
[For a one-sided order (simple buy or sell)]
"Buy 10 Calls XYZ February 50's at 1 1/2 to open, for the day"

Always start with whether it is a buy or sell. When you do so, the
clerk will reach for the appropriate ticket.

Next comes the number of contracts. Remember, to determine the money
amount of the trade, you multiply this number of contracts by 100 and
then by the price of the option. In the above example, 10 x 100 x 1 1/2
= $1,500. Don't ever mention the equivalent number of underlying
shares. One client of mine used to always order 1000 contracts when he
really meant to buy 10 options (equivalent to 1000 shares of stock).

Thirdly, you name the stock. Call it by name first and then state the
symbol if you know it. Be aware of similar sounding letters. B, T, D,
E etc., can all sound alike in a noisy brokerage office. Over The
Counter stocks can have really strange option symbols.

The month of expiration comes next. Again, be careful. September and
December can sound alike. Floor lingo uses colorful nicknames to
differentiate. The "Labor Day" 50s are Sept options while the
"Christmas" 50s are the December series. But don't get carried away
with trying to use the slang. Don't ever use it to show off to a clerk.
Simply use it for accuracy (e.g. "the December as in Christmas 50s").

Then comes the strike price. Read it plainly and clearly. 15 and 50
sound alike as does 50 and 60.

Name the limit price or whether it is a market order. Qualify it if it
is something other than a limit or market order. For example, 1 1/2
Stop. Pet peeve of many clerks: Don't say "or better" when entering a
plain limit order. That is assumed in the definition of a limit order.
"Or better" is a designation reserved for a specific instance where one
names a price higher than the current market bid-ask as the top price to
be paid. For instance, an OEX call is 1 1/2 to 1 5/8 while you are
watching the President on CNN. He hints at a budget resolution and you
jump on the phone. You want to buy the calls but not with a market
order. Instead, you give the floor some room with an "1 7/8 or better
order". Clerks use this tag as a courtesy to each other to let them
know they realize the current market is actually below the limit price.
This saves them a confirming phone call.

Next is the position of the trade, that is, to Open or to Close. This
is the least understood facet. It has nothing to do with the opening
bell or closing bell. It tells the firm if you are establishing a new
position (opening) or offsetting an existing one (closing). Don't just
think that by saying "Buy", your firm knows you are opening a new
position. Remember, options can be shorted. One can buy to open or to
close. Likewise, one can sell to open or to close.

If your order has any restrictions, place them here at the end.
Examples are All or None, Fill or Kill, Immediate or Cancel, Minimum of
15 (or whatever you want). Remember, restricted order have no standing.
Unrestricted orders have execution priority.

Finally, state if the order is a day order or Good Till Canceled. If
you don't say, the broker will assume it to be a day order only, but the
client should mention it as a courtesy.

Very Important: Your clerk will read the order back to you in the same
way for verification. LISTEN CAREFULLY. If you don't catch an error at
this point, they can stick you with the trade.

Proper order entry can mean the difference between a successful
execution and a missed fill or a poor price. Doing it the right way can
save you precious seconds. Further, it will mean a better relationship
with your broker. The representative will act differently when he sees
a customer who knows what he is doing. The measure of respect given to
someone who knows how to give an order properly is considerable. After
all, you've just proven that you "speak" his language.

This article is Copyright 1996 by Hubert Lee. For more insights from
Hubert Lee, visit his site:



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

Subject: Derivatives - Stock Option Splits

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

When a stock splits, call and put options are adjusted accordingly. In
almost every case the Options Clearing Corporation (OCC) has provided
rules and procedures so options investors are "made whole" when stocks
split. This makes sense since the OCC wishes to maintain a relatively
stable and dependable market in options, not a market in which options
holders are left holding the bag every time that a company decides to
split, spin off parts of itself, or go private.

A stock split may involve a simple, integral split such as 2:1 or 3:1,
it may entail a slightly more complex (non-integral) split such as 3:2,
or it may be a reverse split such as 4:1. When it is an integral split,
the option splits the same way, and likewise the strike price. All
other splits usually result in an "adjustment" to the option.

The difference between a split and an adjusted option, depends on
whether the stock splits an integral number of times -- say 2 for 1, in
which case you get twice as many of those options for half the strike
price. But if XYZ company splits 3 for 2, your XYZ 60s will be adjusted
so they cover 150 shares at 40.

It's worth reading the article in this FAQ on stock splits , which
explains that the owner of record on close of business of the record
date will get the split shares, and -- and -- that anyone purchasing at
the pre-split price between that time and the actual split buys or sells
shares with a "due bill" attached.

Now what about the options trader during this interval? He or she does
have to be slightly cautious, and know if he is buying options on the
pre-split or the post-split version; the options symbol is immediately
changed once the split is announced. The options trader and the options
broker need to be aware of the old and the new symbol for the option,
and know which they are about to trade. In almost every case I have
ever seen, when you look at the price of the option it is very obvious
if you are looking at options for the pre or post-split shares.

Now it's time for some examples.
* Example: XYZ Splits 2:1
The XYZ March 60 call splits so the holder now holds 2 March 30
calls.
* Example: XYZ Splits 3:2
The XYZ March 60 call is adjusted so that the holder now holds one
March $40 call covering 150 shares of XYZ. (The call symbol is
adjusted as well.)
* Example: XYZ declares a 5% stock dividend.
Generally a stock dividend of 10% or less is called a stock
dividend and does not result in any options adjustments, while
larger stock dividends are called stock splits and do result in
options splits or readjustments. (The 2:1 split is really a 100%
stock dividend, a 3:2 split is a 50% dividend, and so on.)
* Example: ABC declares a 1:5 reverse split
The ABC March 10 call is adjusted so the holder now holds one ABC
March 50 call covering 20 shares.

Spin-offs and buy-outs are handled similarly:
* Example: WXY spins off 1 share of QXR for every share of WXY held.
Immediately after the spinoff, new WXY trades for 60 and QXR trades
for $40. The old WXY March 100 call is adjusted so the holder now
holds one call for 100 sh WXY @ 60 plus 100 sh WXY at 40.


* Example: XYZ is bought out by a company for $75 in cash, to holders
of record as of March 3.
Holders of XYZ 70 call options will have their option adjusted to
require delivery of $75 in cash, payment to be made on the
distribution date of the $75 to stockholders.

Note: Short holders of the call options find themselves in the same
unenviable position that short sellers of the stock do. In this sense,
the options clearing corporation's rules place the options holders in a
similar risk position, modulo the leverage of options, that is shared by
shareholders.

The Options Clearing Corporation's Adjustment Panel has authority to
deviate from these guidelines and to rule on unusual events. More
information concerning options is available from the Options Clearing
Corporation (800-OPTIONS) and may be available from your broker in a
pamphlet "Characteristics and Risks of Standardized Options."


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

Subject: Derivatives - Stock Option Symbols

Last-Revised: 21 Oct 1997
Contributed-By: Chris Lott ( contact me )

The following symbols are used for the expiration month and price of
listed stock options.

Month Call Put
Jan A M
Feb B N
Mar C O
Apr D P
May E Q
Jun F R
Jul G S
Aug H T
Sep I U
Oct J V
Nov K W
Dec L X


Price Code Price
A x05
U 7.5
B x10
V 12.5
C x15
W 17.5
D x20
X 22.5
E x25
F x30
G x35
H x40
I x45
J x50
K x55
L x60
M x65
N x70
O x75
P x80
Q x85
R x90
S x95
T x00


The table above does not illustrate the important fact that price code
"A", just to pick one example, could mean any of the following strike
prices: $5, $105, $205, etc. This is not so much of a problem with
stocks, because they usually split to stay in the $0-$100 range most of
the time.

However, this is particularly confusing in the case of a security like
the S&P 100 index, OEX, for which you might find listings of more than
100 different options spread over several hundred dollars of strike
price range. The OEX is priced in the hundreds of dollars and sometimes
swings wildly. To resolve the multiple-of-$100 ambiguity in the strike
price codes, the CBOE uses new "root symbols" such as OEW to cover a
specific $100 range on the S&P 100 index. This is very confusing until
you see what's going on.


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

Subject: Derivatives - LEAPs

Last-Revised: 30 Dec 1996
Contributed-By: Chris Lott ( contact me )

A Long-term Equity AnticiPation Security, or "LEAP", is essentially an
option with a much longer term than traditional stock or index options.
Like options, a stock-related LEAP may be a call or a put, meaning that
the owner has the right to purchase or sell shares of the stock at a
given price on or before some set, future date. Unlike options, the
given date may be up to 2.5 years away. LEAP symbols are three
alphabetic characters; those expiring in 1998 begin with W, 1999 with V.

LEAP is a registered trademark of the Chicago Board Options Exchange.
Visit their web site for more information:


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

Subject: Education Savings Plans - Section 529 Plans

Last-Revised: 25 Jan 2003
Contributed-By: Chris Lott ( contact me )

Tax law changes made in 2001 introduced a college savings plan commonly
called a "529 plan" (named after their section in the Internal Revenue
Code). These plans allow people to save for college expenses.

There are actually two types of 529 plans being offered by different
states. One kind is a pre-paid tuition plan; the other is a more
general savings vehicle. Participants in pre-paid plans are usually
strongly encouraged to use their credits at certain state schools, and
might not get full benefits if they choose an out-of-state school.
Participants in 529 savings plans can use their funds for any accredited
institution in any state.

Funds in the account, as in an IRA, grow free of taxes. Contribution
limits are high; each state sets its own limits. Very few states impose
any income limits (meaning that if you make too much money, you cannot
contribute to one of these plans). Anyone can contribute: parents,
grandparents, etc.

Different versions of 529 plans are offered in all 50 states, and there
is no restriction on state residency to use a state's plan. So for
example, if you live in Maine, you could invest in Hawaii's 529 plan.
However, the benefits may differ depending on the state where you live.
So if you are the Maine resident who is considering the Hawaii plan, you
should certainly ask about the Maine plan's benefits.

Many state plans offer significant benefits to state residents. A
resident may pay a lower management fee than an out-of-state plan
member. A state resident may be able to deduct 529 contributions from
his or her state taxable income, which reduces the amount of state
income tax due to their state. Note that companies marketing plans from
other states may conveniently "gloss over" these benefits.

One feature of these plans that makes them most attractive to many
people is the amount of control that the donor retains over the funds.
Unlike gifts made under a Uniform Gifts to Minors Act or a Coverdell
Education Savings Account, where the minor owns the funds, the intended
beneficiary of a 529 plan has no right to the money. In fact, many
states allow the donor to revoke the donation and get the money back
(although subject to various taxes and penalties).

A common complaint about 529 plans is the lack of choice in the
investments available for participants. State plans are usually managed
by some large financial institution. That institution may choose to
offer only load funds or other investments that charge fees higher than
the fees on comparable investments available outside the 529 plans.
Further, many plans restrict how often funds can be moved among the
investment choices, usually only once a year.

Withdrawals that are used to pay qualified expenses, including tuition,
fees, and certain other expenses are free of tax on any earnings. If
the money is withdrawn for any other purpose, both state and federal
income tax is due on any earnings, and further Uncle Sam demands a 10%
penalty on those earnings. (Of course tax law can change at any time;
the tax-free withdrawal provision is currently set to expire in 2010.)

These plans are suitable for many families but certainly not all. The
implications for financial aid computations are not clear and vary with
each educational institution. It's probably safe to say that if you
have enough income that you will never qualify for financial aid, then a
529 plan is exactly right for you.

If you have determined that a 529 plan is right for you, your job is not
done yet. Because there are so many plans out there, and so many sales
pitches from brokers and other financial institutions, choosing one can
be exceedingly difficult. Some items to research about these plans and
alternatives include the contribution limits (how much can you stash
away), the advantages you may attain, the range of investment choices,
and (last but certainly not least) the fees demanded by the account
custodian. You can draw parallels to the big debate over load versus
non-load mutual funds without really trying.

Here are a few web resources on 529 plans:
* Joe Hurley runs Saving For College LLC, a comprehensive guide to
529 plans on the web.

* The Motley Fool offers a comparison of Section 529 plans against
Coverdell Educational Savings Plans.



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

Subject: Education Savings Plans - Coverdell

Last-Revised: 25 Jan 2003
Contributed-By: Chris Lott ( contact me )

A Coverdell Education Savings Account (ESA), formerly known as an
Education IRA, is a vehicle that assists with saving for education
expenses. This article describes the provisions of the US tax code for
educational IRAs as of mid 2001, including the changes made by the
Economic Recovery and Tax Relief Reconciliation Act of 2001.

Funds in an ESA can be used to pay for elementary and secondary
education expenses, college or university expenses, private school
tuition, etc. I am told that the educational institution must be
accredited (which in this case means the school can participate in
various financial aid programs), but it does not have to be in the
United States. In other words, it appears that it's legal to pay
tuition at a foreign school using funds from an ESA as long as the
school is accredited.

An ESA may be established for any person who is under 18 years of age.
Contributions to this account are limited to $2,000 in 2002. Once the
beneficiary reaches 18, then no further funds may be contributed.
Annual contributions must be made by April 15th of the following year
(previously they had to be made by December 31st of the same year).

Although anyone may contribute to a minor's ESA, contributions are not
tax deductible, and further, contributions may only be made by taxpayers
who fall under the limits for adjusted gross income. As with many
provisions in the tax code, the limits are phased; the ranges are
95-110K for single filers and 150-160K for joint filers. Also,
contributions are not permitted if contributions are made to a state
tuition program on behalf of the beneficiary.

The major benefit of this savings vehicle is that the funds grow free of
all taxes. Distributions that are taken for the purpose of paying
qualified educational expenses are not subject to tax, thus saving the
beneficiary of paying tax on the fund's growth. Distributions that are
used for anything other than qualified educational expenses are treated
as taxable income and further are subject to a 10% penalty, unless a
permitted exception applies.

If the beneficiary reaches age 30 and there are still funds in his or
her ESA, they must either be distributed (incurring tax and penalties)
or rolled over to benefit another family member.

On a related note, changes made in 1997 to the tax code also permit
withdrawals of funds from both traditional IRAs and Roth IRAs for paying
qualified educational expenses. Basically, the change established an
exception so you can avoid the 10% penalty on distributions taken before
age 59 1/2 if they are for educational expenses.

It is possible to roll over funds from an ESA to a (new as of 2002) 529
plan. A roll-over from an ESA plan to a 529 plan is free of tax and
penalty as it is completed within 60 days and the account beneficiary is
the same.

The rules for ESAs changed in mid 2001 in the following ways:
* The contribution limit rises from $500 to $2,000 in 2002.
* Starting in 2002, funds can be used to pay for elementary and
secondary education, not just college/university, including private
schools.
* Income limits on those who can fund an ESA rise: married filers
will be limited starting at $190,000 starting in 2002.


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

Subject: Exchanges - The American Stock Exchange

Last-Revised: 19 Jan 2000
Contributed-By: Chris Lott ( contact me )

The American Stock Exchange (AMEX) lists over 700 companies and is the
world's second largest auction-marketplace. Like the NYSE (the largest
auction marketplace), the AMEX uses an agency auction market system
which is designed to allow the public to meet the public as much as
possible. In other words, a specialist helps maintain liquidity.

Regular listing requirements for the AMEX include pre-tax income of
$750,000 in the latest fiscal year or 2 of most recent 3 years, a market
value of public float of at least $3,000,000, a minimum price of $3, and
a minimum stockholder's equity of $4,000,000.

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 Chicago Board Options Exchange

Last-Revised: 19 Jan 2000
Contributed-By: Chris Lott ( contact me )

The Chicago Board Options Exchange (CBOE) was created by the Chicago
Board of Trade in 1973. The CBOE essentially defined for the first time
standard, listed stock options and established fair and orderly markets
in stock option trading. As of this writing, the CBOE lists options on
over 1,200 widely held stocks. In addition to stock options, the CBOE
lists stock index options (e.g., the S&P 100 Index Option, abbreviated
OEX), interest rate options, long-term options called LEAPS, and sector
index options. Trading happens via a market-maker system. For more
information, visit the home page:


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

Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 10 of 20)

am 30.05.2005 06:30:05 von noreply

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



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+ 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 7 of 20)

am 30.05.2005 06:30:05 von noreply

Archive-name: investment-faq/general/part7
Version: $Id: part07,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 7 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: Information Sources - Books

Last-Revised: 16 Jul 2001
Contributed-By: Chris Lott ( contact me )

This article offers a large list of books about investing and personal
finance, divided into four sections: books for beginners, books for
experienced investors, books for professional traders and speculators,
and finally books that I call war stories - insider's tales about the
world of finance. The lists are sorted by the author's last name within
each section.

Amazon
recommends: [IMAGE]


You can buy books right from here! Right now! Send a gift to someone who
has one of these books on their wish list! But enough hype. I've
enrolled as an Amazon.com associate, so if you buy any of the books that
are listed here from Amazon.com by using the links on this page, I get a
small referral fee. I've tried to find paperback (i.e., cheap) editions
of all the books for these links, but please let me know if I missed
one.

The best thing about the Amazon site is that each book listing includes
capsule summaries and reviews contributed by readers, so you might want
to click on the links to check out each book.



Featured Author for Beginners: Eric Tyson
Here are three books by Eric Tyson that are part of the "..for Dummies"
series. Readers praise his writing for its practical advice,
objectivity, and gentle humor. These books offer a great way to start
learning about personal finance and investing. Amazon sells these
titles for about $20 each including the shipping charges.

* Eric Tyson
Investing for Dummies (out of print, but available used)
* Eric Tyson and James C. Collins
Mutual Funds for Dummies
* Eric Tyson
Personal Finance for Dummies



Books for beginning investors
These books concentrate on personal finance, budgeting, and also offer
some introductory material on basic investment strategies.
* Barbara Apostolou, Nicholas G. Apostolou
Keys to Investing in Common Stocks (Barron's Business Keys)
* Ginger Applegarth
Wake Up and Smell the Money
* Janet Bamford, Jeff Blyskal, Emily Card, and Aileen Jacobson
The Consumer Reports Money Book: How to Get It, Save It, and Spend
It Wisely (3rd edn)
* Wayne G. Bogosian and Dee Lee
The Complete Idiot's Guide to 401(k) Plans
* Samuel Case
The First Book of Investing: The Absolute Beginner's Guide to
Building Wealth Safely
* David Chilton
The Wealthy Barber
* George S. Clason
The Richest Man in Babylon
* Jonathan Clements
25 Myths You'Ve Got to Avoid If You Want to Manage Your Money
Right: The New Rules for Financial Success
* John Downes and Jordan Elliot Goodman
Dictionary of Finance and Investment Terms
* Ric Edelman
The Truth About Money: Because Money Doesn't Come With Instructions
(2nd edition)
* Louis Engel
How to Buy Stocks
* David Gardner and Tom Gardner
You Have More Than You Think: The Motley Fool Guide to Investing
What You Have
* Alvin Hall
Getting Started in Stocks (3rd edn.)
* Ken Kurson
The Green Magazine Guide to Personal Finance: A No B.S. Book for
Your Twenties and Thirties
* Barbara Loos
I Haven't Saved a Dime, Now What?!
* James Lowell
Investing from Scratch: A Handbook for the Young Investor
* Peter Lynch and John Rothchild
Learn to Earn: A Beginner's Guide to the Basics of Investing and
Business
* Dale C. Maley
Index Mutual Funds: How to Simplify Your Financial Life and Beat
the Pros
* Kenneth M. Morris and Alan M. Siegel
The Wall Street Journal Guide to Understanding Money and Investing
* Kenneth M. Morris and Alan M. Siegel
The Wall Street Journal Guide to Understanding Personal Finance
* Kenneth M. Morris, Alan M. Siegel, and Virginia B. Morris
The Wall Street Journal Guide to Planning Your Financial Future
* W. Patrick Naylor
10 Steps to Financial Success: A Beginner's Guide to Saving and
Investing
* Suze Orman
The 9 Steps to Financial Freedom
* Kenan Pollack and Eric Heighberger
The Real Life Investing Guide
* Jonathan D. Pond
4 Easy Steps to Successful Investing
* Jane Bryant Quinn
Making the Most of Your Money
* Claude Rosenberg
Stock Market Primer
* John Rothchild
A Fool and His Money: The Odyssey of an Average Investor
* Alfred V. Scillitani
Basic Investing Guide For The New Investor (2nd edn.)
* Kathleen Sindell
Investing Online for Dummies (3rd edn.)

* Andrew Tobias
The Only Investment Guide You'll Ever Need
* Eric Tyson
Investing for Dummies
* Eric Tyson and James C. Collins
Mutual Funds for Dummies
* Eric Tyson
Personal Finance for Dummies
* Diane Vujovich
10 Minute Guide to the Stock Market



Books for intermediate investors
These books assume you're comfortable with the basics of stocks, mutual
funds, bonds, and other securities. They offer many investment
strategies: what to buy, what to sell, and when to do so.
* Ted Allrich and William O'Neil
The On-Line Investor: How to Find the Best Stocks Using Your
Computer
* Frank Armstrong
Investment Strategies for the 21st Century
This book is available from the author's web site at no charge,
although registration is required.
* Peter Bernstein
Against the Gods: The Remarkable Story of Risk
* Peter Bernstein
Capital Ideas: The Improbable Origins of Modern Wall Street
* John C. Bogle
Bogle on Mutual Funds
* John C. Bogle
Common Sense on Mutual Funds: New Imperatives for the Intelligent
Investor
* James W. Broadfoot
Investing in Emerging Growth Stocks
* Mary Buffett and David Clark
Buffettology: The Previously Unexplained Techniques That Have Made
Warren Buffett the World's Most Famous Investor
* Frank Cappiello
New Guide to Finding the Next Superstock
* Charles B. Carlson
Buying Stocks Without a Broker
* Samuel Case
Big Profits from Small Stocks: How to Grow Your Investment
Portfolio by Investing in Small Cap Companies
* Burton Crane
The Sophisticated Investor
* John M. Dalton
How the Stock Market Works
* Nicolas Darvas
How I Made 2,000,000 in the Stock Market
* William Donoghue
Mutual Fund Superstars
* David N. Dreman
Contrarian Investment Strategies: The Next Generation
* Stephen Eckett
Investing Online: Dealing in Global Markets on the Internet
* Kenneth Fisher
Super Stocks
* Norman G. Fosback
Stock Market Logic
* David Gardner and Tom Gardner
The Motley Fool Investment Workbook
* David Gardner and Tom Gardner
The Motley Fool Investment Guide: How the Fool Beats Wall Street's
Wise Men and How You Can Too
* Gary Gastineau
The Stock Options Manual
* Michael Gianturco
How to Buy Technology Stocks
* Braden Glett
Stock Market Stratagem: Loss Control and Portfolio Management
* Benjamin Graham and Warren E. Buffett
The Intelligent Investor: A Book of Practical Counsel
* Christopher Graja and Elizabeth Ungar
Investing in Small-Cap Stocks
* William Greider
Secrets of the Temple: How the Federal Reserve Runs the Country
* C. Colburn Hardy
The Fact$ of Life
* Peter I. Hupalo
Becoming an Investor: Building Wealth by Investing in Stocks,
Bonds, and Mutual Funds
* Investor's Business Daily
Investor's Business Daily Guide to the Markets
* David Kansas and James Cramer
The Street.Com Guide to Smart Investing in the Internet Era
* Harvey C. Knowles and Damon H. Petty
The Dividend Investor
* Robert Lichello
How to Make $1,000,000 in the Stock Market - Automatically
* Jeffrey B. Little and Lucien Rhodes
Understanding Wall Street
* Gerald M. Loeb
The Battle for Investment Survival
* Peter Lynch and John Rothchild
Beating the Street
* Peter Lynch and John Rothchild
One up on Wall Street also available: audio cassette edn.
* Burton Malkiel
A Random Walk Down Wall Street
This is a classic, and offers a highly readable argument for index
funds (also known as modern portfolio theory).
* Geoffrey A. Moore, Paul Johnson, and Tom Kippola
The Gorilla Game: An Investor's Guide to Picking Winners in High
Technology
* William J. O'Neil
How to Make Money in Stocks: A Winning System in Good Times or Bad
* James O'Shaughnessy
How to Retire Rich: Time-Tested Strategies to Beat the Market and
Retire in Style
* James P. O'Shaughnessy
Invest Like the Best: Using Your Computer to Unlock the Secrets of
the Top Money Managers
* James P. O'Shaughnessy
What Works on Wall Street: A Guide to the Best-Performing
Investment Strategies of All Time
* Carl H. Reinhardt, Alan B. Werba, and John J. Bowen
The Prudent Investor's Guide to Beating the Market
* Hildy Richelson and Stan Richelson
Straight Talk about Bonds and Bond Funds
* L. Louis Rukeyser
How to Make Money in the Stock Market
* Terry Savage
New Money Strategies for the 1990's
* Charles Schwab
How to be Your Own Stockbroker
* Steven R. Selengut
The Brainwashing of the American Investor
* Dhun H. Sethna and William O'Neil
Investing Smart: How to Pick Winning Stocks With Investor's
Business Daily
* Robert Sheard
The Unemotional Investor: Simple Systems for Beating the Market
* Jeremy J. Siegel
Stocks for the Long Run
* Michael Sincere and Deron Wagner
The Long-Term Day Trader
* John A. Tracy
How to Read a Financial Report
* John Train
New Money Masters
* Venita Vancaspel
Money Dynamics for the 1990s
* John G. Wells
Kiss Your Stockbroker Goodbye: A Guide to Independent Investing
* Martin E. Zweig and Morrie Goldfischer
Martin Zweig's Winning on Wall Street (revised and updated)



Books for expert investors, especially concerning technical analysis
These books are aimed at people who have a solid understanding of
finance and/or trade for a living. There are quite a few on technical
analysis for the "chartists" out there.
* Steven B. Achelis
Technical Analysis from A to Z
* Nicholas G. Apostolou
Keys to Investing in Options and Futures
* Robert C. Beckman
Elliott Wave Explained: A Real-World Guide to Predicting and
Profiting from Market Turns
* Jake Bernstein
The Compleat Day Trader: Trading Systems, Strategies, Timing
Indicators, and Analytical Methods
* Peter Bernstein (ed.)
The Portable MBA in Investment
* Tushar S. Chande and Stanley Kroll
The New Technical Trader: Boost Your Profit by Plugging into the
Latest Indicators
* Robert W. Colby and Thomas A. Meyers
Encyclopedia of Technical Market Indicators
* John C. Cox and Mark Rubenstein
Options Markets
* Thomas R. Demark
New Market Timing Techniques: Innovative Studies in Market Rhythm
and Price Exhaustion
* Mark Douglas
The Disciplined Trader
* Robert D. Edwards and John Magee
Technical Analysis of Stock Trends
* Alexander Elder
Trading for a Living: Psychology, Trading Tactics, Money Management
* Marc Friedfertig and George West
The Electronic Day Trader
* A. J. Frost, Robert J. Prechter, and Robert R. Prechter
Elliott Wave Principle: Key to Market Behavior
* Benjamin Graham and David L. Dodd
Security Analysis
* John C. Hull
Options, Futures, and Other Derivatives
* Jonathan E. Ingersoll
Theory of Financial Decision Making
* R. A. Jarrow
Modelling Fixed Income Securities and Interest Rate Options
* William L. Jiler
How Charts Can Help You in the Stock Market
* Jeffrey Katz and Donna L. McCormick
The Encyclopedia of Trading Strategies
* Charles Lebeau and David W. Lucas
Technical Traders Guide to Computer Analysis of the Futures Market
* John F. Magee
Analyzing Bar Charts for Profit
* Lawrence G. McMillan
Options as a Strategic Investment
* Robert Merton
Continuous Time Finance
* John J. Murphy
Technical Analysis of the Futures Markets
* John J. Murphy
Study Guide for Technical Analysis of the Futures Markets: A
Self-Training Manual
* Sheldon Natenberg
Option Volatility and Pricing: Advanced Trading Strategies and
Techniques
* Robert Pardo
Design, Testing, and Optimization of Trading Systems
* Robert R. Prechter and R. N. Elliott
R. N. Elliott's Masterworks: The Definitive Collection
* Martin J. Pring
Martin Pring's Introduction to Technical Analysis
* Martin J. Pring
Technical Analysis Explained
* Peter Ritchken
Options: Theory, Strategy, and Applications
* Robert P. Rotella
The Elements of Successful Trading
* William F. Sharpe, Gordon J. Alexander, and Jeffery V. Bailey
Investments
* Clifford Sherry
The Mathematics of Technical Analysis
* Victor Sperandeo
Trader Vic II : Principles of Professional Speculation
* Robert A. Taggart
Quantitative Analysis for Investment Management
* Nassim Taleb
Dynamic Hedging: Managing Vanilla and Exotic Options
* Michael P. Turner
Day Trading into the Millennium
* Stan Weinstein
Stan Weinstein's Secrets for Profiting in Bull and Bear Markets

Analysis, commentary, and war stories about investments
These books offer analysis, commentary, and war stories from finance
insiders about the trading and investment world. They probably won't
help you pick stocks, but they're fun to read if you're interested in
finance and markets.
* Po Bronson
Bombardiers
* Connie Bruck
The Predators' Ball: The Inside Story of Drexel Burnham and the
Rise of the Junk Bond Raiders
* Bryan Burrough and John Helyar
Barbarians at the Gate: The Fall of RJR Nabisco
* Daniel Fischel
Payback: The Conspiracy to Destroy Michael Milken and His Financial
Revolution
* Edwin Lefevre
Reminiscences of a Stock Operator
* Michael Lewis
Liar's Poker: Rising Through the Wreckage on Wall Street
* Charles MacKay, Josef De La Vega, and Martin S. Fridson
Extraordinary Popular Delusions and the Madness of Crowds and
Confusion De Confusiones
* Victor Niederhoffer
The Education of a Speculator
* Jim Rogers
Investment Biker: Around the World with Jim Rogers
* Robert J. Shiller
Irrational Exuberance
* James B. Stewart
Den of Thieves If you can't find what you're looking for on
Amazon.Com, you might check out The Trader's Library of Columbia, MD.
They maintain a web site that has over 600 investment titles.


Those who are just learning about the stock market may wish to have a
look at the article in the FAQ with advice for beginners .


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

Subject: Information Sources - Conference Calls

Last-Revised: 29 May 1999
Contributed-By: John Schott (jschott at voicenet.com)

Companies listed on the various stock exchanges have long held analyst
conferences to spread their message to the investment community. Often,
sponsors such as Hambrecht and Quist have held conferences where
investment professionals could hear many firms in several days. To
accomodate those who couldnÂ’t travel, the conference call allowed
hundreds of analysts to hear a presentation and ask questions in real
time. But access was usually restricted to investment professionals and
often involved long-distance toll charges. Occasionally a friendly
broker would loan you his access codes, some of which found their way to
the Internet. As a result, conferences could be swamped.

The Internet now provides a much more practical venue for the conference
call. With its low cost and ability to accomodate many listeners it is
now practical to open a conference call to almost anyone (at least to
listen). Many firms now do. For example, a recent article in the Wall
Street Journal related how IOMEGA does this as an efficient way to
control the irresponsible babble on Internet bulletin boards. People
posting idle chatter now attract accurate responces from others who have
heard the actual story on a conference call. As a result, the
irresponsible postings are controlled.

Naturally, investment professionals complain that this allows the novice
to access raw information that needs interpretation by someone more
knowledgable - namely such a professional. However, companies like the
ability to make one public statement, and then be free from goverment
limitations on how investment information must be released. And
individual investors like it too, as access to this information gets
them access to information that once only slowly reached the average
investor. Even Chairman Levitt of the SEC sides with the theory of
greater access for the masses. According to an article in the 24 May
1999 issue of the Wall Street Journal, the NASDAQ has even funded a
pilot program to pay for public access to conference calls. Firms such
as DELL and Cosco are early participants .

Using the Internet has many advantages besides the instantaneous
international release that results. It is possible to save the audio
files so that the call can be accessed later at a more convenient time.
Plus it would be possible to edit out meaningless portions to provide
sort of a "Cliff Notes" of each conference. Naturally, there are some
limitations. If everyone could ask a question, real brawls could result
as the conferences became uncontrolled. So most Internet systems limit
who can ask a question.

An outstanding advantage for the average investor is to witness directly
a firm's management in action. While the information might be the same,
an investor gains confidence in management that presents a virtuoso
performane over one that is defensive, hesitant, and obfuscative. The
details aside, the speed of responce and other items that donÂ’t get
incorporated in an analyst's report can add a lot to one's
understanding. Previously, a small investor's only such access might
have been at a company's annual meeting.

Several firms have opened to provide investment-related conference-call
services in one form or another over the Internet. Some require
membership and user fees, but the trend seems to be toward company
funding of the low cost service, and free or very low cost access by the
public. According to the WSJ article mentioned above, firms now
providing some for of access include: Vcall (Philadelphia),
broadcast.com (Dallas), c-call.com (Street Fusion, (San Fransisco), and
CCBN.com (Boston). Expect that more and more firms will offer the
public Internet conference call. Encourage firms you are interested in
to do so. This form of communication is yet another form of ultimate
corporate democracy.


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

Subject: Information Sources - Free to All Who Ask

Last-Revised: 28 Apr 1997
Contributed-By: Brook F. Duerr, Seshadri Narasimhan

Here are some tips about obtaining cheap or free info.



Local Companies
Look in your local newspapers for information and stories about the
companies in your immediate area. I have found that our local
papers carry some great articles about our local companies long
before the WSJ or other papers pick up on them. The local papers
tend to report very minute details that the "big" papers never
report. The local paper that I get covers insider buys/sells, IPOs
etc., management changes, detailed earnings reports, analyst
opinions, you name it.
Stocks on Call
A free, fax-back service with lots of stories about companies. The
information is biased because it is paid for by the listing
companies, but it is free, so you get what you pay for. The list
has been growing very rapidly, and they company drops the
information after it has been listed for 24-72 hours, so it pays to
call often. Some articles are only posted for one day. It takes
me about 5 minutes to get the 10 or so articles I want. They used
to publish a list in the papers, but the list is too long to do
that now. Once you have the list then you can call and get 3
stories per call sent directly to your fax. It is all handled by
computer (usually). You can call back and get 3 stories per call
for free. I have gotten some great tips here - nice, fast-growing,
small companies (and some F-500s too). Although Stocks on Calls is
automatically provided with your number (a feature of 800 service),
they state that they will not give your number away to third
parties. Contact them at 800-578-7888.
Pro-Info
A second free, fax-back service, different from Stocks on Call (see
above). This service places information into a computer so you can
access it at any time and it is always available. Pro-Info has
such things as Investor Packages, Latest Earnings Reports, news
releases and analysts reports. They cover about 100 companies and
the list is growing. The quality of the faxes is not great because
Pro-Info apparently scans the pages into the computer. Contact
them at 800-PRO-INFO (800-776-4636).
Stock Charts
I get at least one copy of Investor's Business Daily per week. The
Friday edition is particularly great. IBD is available in most
areas at newsstands, bookstores, etc. IBD is a good newspaper for
its charts.
Archive Information
For historical information, I save one copy of Barron's or WSJ or
IBD each month. If I see a company that I am suddenly interested
in then I can just open up those old editions and get some pretty
good historical data. IBD is great for this.
An Important Edition of The Wall Street Journal
I think it is imperative to get a copy of the WSJ that covers the
year in review. This edition comes out usually on the first
business day of the new year. It contains a lot of information
about how each stock has performed during that last year, including
the % movement of the stock during the past year. I get two copies
of this paper because I get so much out of them (one for work, one
for home).
SEC on Internet
This is the place where you can obtain Securities and Exchange
files (10-Ks, 10-Qs, you name it) on companies that file
electronically with the SEC. See the entry for information on the
Internet, elsewhere in this FAQ.
Archive list for ticker symbols
Available by accessing this URL:

(See the entry for information on the Internet, elsewhere in this
FAQ.)
Writing Letters
If you are interested in a company then by all means get their
address and write them a letter. If you have a non-discount broker
then they can get you the company's address. Otherwise go to
virtually any library and they will be able to help you find the
addresses you are interested in. When you write to a company, tell
them you are interested in investing in them and you want to learn
more about them. Ask for 10Ks, annual reports, 10Qs, quarterly
summaries, analyst reports and anything else they can send you.
Some companies will bury you with information if you just ask. Ask
them to add your name to their mailing list for future information.
Many companies maintain active mailing lists and so the information
will keep flowing to you. All this for only a stamp.
Public Registers Annual Report Service
This is a outfit that acts as a clearing house for mailing out
annual reports on companies. They have a huge list (several
thousand) companies that they work for, and they are a free
service. They also send out a newspaper called the "Security
Traders Handbook" and "The Public Register". These newspapers
contains wealth of information on earnings, IPOs, insider trades
etc. The price on the cover says $5.00, but I have received
several issues and have never received a bill (I wouldn't pay
anyway). You have to write to them to get on their mailing list.
The address is: Bay Tact Corporation; 440 Route 198; Woodstock
Valley, CT 06282. Write them a letter and ask them what services
they provide. They send out annual reports, but they do not carry
analysts reports and other news release type items. Try calling
them at 800 4ANNUAL.
Reader Service Cards in Investor's Daily or other Places
Another reason I like to get the Friday edition of IBD is because
they usually have a bunch of companies hyping themselves and
offering information if you send in a reader service card. This is
another great almost freebie. For a stamp you can usually find at
least 3-5 companies that are worth finding out about.
The Wall Street Journal's Annual Reports Service
According to their blurb, you can obtain the annual reports and, if
available, quarterly reports, at no charge for any companies for
which the 'club' symbol appears in the stock listings. (The 'club'
symbol is the same as the one on a playing card. Look at Section C
"Money and Investing" of any WSJ and you will see what I mean.)
These reports can be ordered by calling 800-654-CLUB. You can also
fax your request, giving the ticker symbols of the companies whose
reports you want, to 800-965-5679. It usually takes at least a
week to get the information to you.
Mutual fund companies
The companies' toll-free lines may be your best friend, if the
solution might involve investing money with them. Call them, state
your problem simply, and request follow-up information in writing.
I would be completely honest with them, just tell them if they give
the best service, you'll invest your money with them. Of course,
if your problem can't be solved, even tangentially, with mutual
funds, you should probably not waste your (and their) time.



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Subject: Information Sources - Investment Associations

Last-Revised: 10 Oct 1997
Contributed-By: Rajeev Arora, D. Laird, Art Kamlet (artkamlet at
aol.com), Jay Hartley (jay at concannon.llnl.gov), Doug Gerlach (gerlach
at investorama.com)

This article introduces several investment associations.
* AAII:
American Association of Individual Investors
625 North Michigan Avenue
Chicago, IL 60611-3110
+1 312-280-0170
Email:
Web:

A summary from their brochure: AAII believes that individuals would
do better if they invest in "shadow" stocks which are not followed
by institutional investor and avoid affects of program trading.
They admit that most of their members are experienced investors
with substantial amounts to invest, but they do have programs for
newer investors also. Basically, they don't manage the member's
money, they just provide information.

Membership costs $49 per year for an individual; with Computerized
Investing newsletter, $79. A lifetime membership (including
Computerized Investing) costs $490.

They offer the AAII Journal 10 times a year, Individual Investor's
guide to No-Load Mutual Funds annually, local chapter membership
(about 50 chapters), a year-end tax strategy guide, investment
seminars and study programs at extra cost (reduced for members),
and a computer user' newsletter for an extra $30. They also
operate a free BBS.


* NAIC:
National Association of Investors Corp.
P. O. Box 220
Royal Oak, MI 48068
Tel +1 810 583-NAIC, Fax +1 810 583-4880
Email:
Web:

The NAIC is a nonprofit organization operated by and for the
benefit of member clubs. The Association has been in existence
since the 1950's and states that it has over 633,000 members.

Membership costs $39 per year for an individual, or $35 for a club
and $14 per each club member. The membership provides the member
with a monthly magazine, details of your membership and information
on how to start a investment club, how to analyze stocks, and how
to keep records.

NAIC also offers software for fundamental analysis, discounts on
investing books, research information on member companies, and
other educational manuals and videotapes. A network of over 75
Regional Councils across the US provide local assistance.

In addition to the information provided, NAIC operates "Low-Cost
Investment Plan", which allows members to invest in participating
companies such as AT&T, Kellogg, Wendy's, Mobil and Quaker Oats.
Most don't incur a commission although some have a nominal fee
($3-$5).

Of the 500 clubs surveyed in 1989, the average club had a compound
annual growth rate of 10.8% compared with 10.6% for the S&P 500
stock index. Its average portfolio was worth $66,755.


* Investors Alliance:
The Investors Alliance, Inc.
219 Commerical Blvd.
Fort Lauderdale, FL 33308-4440
Tel 888-683-1181
Email:
Web:

Investors Alliance was formed to enhance the investing skills of
independent investors through research, education, and training.
They claim membership of over 65,000 investors in 22 countries.

Basic Membership is offered at $49 per year and includes twelve
monthly issues of the Investors Alliance Investor Journal, an
educational newsletter packed with valuable insights to maximize
your investment success. Computer Membership is offered at $89 per
year and includes a copy of Power Investor for Windows on CD-ROM
and free daily modem updates of the entire 16,000 security
database. New members at either level receive a free voucher for
two zero-commission stock trades from a leading discount broker.

The Investment FAQ is an associate of Investors Alliance. If you
use the link shown below to enroll in this club, a small referral
fee is paid to The Investment FAQ.



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Subject: Information Sources - Value Line

Last-Revised: 10 Aug 1997
Contributed-By: John Schott (schott at voicenet.com), Chris Lott (
contact me )

The Value Line Investment Survey is the grand-daddy of published
information about stocks of large companies (primarily U.S. companies
plus a few leading ADRs). It is a weekly, three-part publication, but
it takes 3 months to cycle through the full list of stocks covered. The
main document reviews one firm per page (over 100 per week), with a
description of the business, a chart showing the historical stock
performance, tables showing key financial data, plus a written
commentary about the prospects of the firm. They cover over 1700 stocks
in their normal edition, and over 5,000 in extended coverage offered at
higher prices. The weekly document also includes short notes on
important developments in covered stocks. A separate booklet updates
summary ratings and fundamental information on all of the 1700 stocks
each week. A third document highlights a stock of the week and gives
Value Line's views of the market. They also have a new CD-ROM based
service that duplicates the data in the hard copy edition and offers the
ability to search and compare stocks automatically. Several recent
reviews have critiqued the way the program works - but not the quality
nor quantity of the renowned Value Line data base.

Value Line proudly advertises their rating system. They divide stocks
into 5 classes (1 is best). Over the years, their #1 rated stocks have
significantly outperformed the markets (and each other group, its
subordinates, as well). Value Line has been highly regarded for the
both the quality and quantity of its data for decades. Almost the
Lingua Franca of investors, you'll find a well-thumbed copy in most
broker's offices, as well as many public and university libraries.

Value Line offers a special, 10-week trial subscription for US$75
(frequently discounted to $55) which will get you the full set of pages
plus a few updates. A six-month subscription currently costs $300, and
one year is $570. The CD-ROM trial subscription is $55 ($95 for the
5000+ stock version). One-year CD-ROM subscriptions cost up to $995.

Visit their web site at , or contact them the
old-fashioned way:

Value Line Publishing Inc.
220 East 42nd Street
New York, New York 1001-5891
800 535 9648 ext 2761
+1 212 907-1500




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Subject: Information Sources - Wall $treet Week

Last-Revised: 18 Feb 2003
Contributed-By: Chris Lott ( contact me )

Wall $treet Week With Louis Rukeyser was once a television program that
aired on the public broadcasting networks on Friday evenings After a
flap in June 2002, Louis Rukeyser left the program, which is now
produced jointly with Fortune magazine.

The program tries to help the individual investor understand the doings
of the stock market and invest wisely. The usual program features a
special guest and three regular guests. The "regular guests" are
investment analysts who appear regularly on W$W.

While Rukeyser was the host, he reported on the opinions of his
"Investment Elves," a group of 10 technical analysts who attempted to
forecast the market's path over the coming weeks. If you've ever heard
of the "Elve's Index," this is the source. Of course many of the elves
are also regular guests on the program.

A new program called Louis Rukeyser's Wall Street is carried by CNBC
every Friday night at 8:30 P.M. and 11:30 P.M. Eastern time, and is
repeated over the weekend on many public television stations.

Here are some web resources:
* The W$W home page, part of the Maryland Public Television web site:

* Rukeyser's web site includes information about his TV show.



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Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 14 of 20)

am 30.05.2005 06:30:06 von noreply

Archive-name: investment-faq/general/part14
Version: $Id: part14,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 14 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: Stocks - Researching the Value of Old Certificates

Last-Revised: 27 Feb 2000
Contributed-By: Ellen Laing (elaing at asu.edu), Jeff Kiss, Chris Lott (
contact me )

If you've found some old stock certificates in your attic, and the
company is no longer traded on any exchange, you will need to get help
in determining the value of the shares and/or redeeming the shares. The
basic information you need is the name of the company, the date the
shares were issued, and the state (or province in the case of Canadian
companies) in which the company was incorporated (all items should all
be on the certificate).

The most basic question to resolve is whether the company exists still.
Of course it might have changed names, been purchased by another
company, etc. Anyhow, a good first attempt at answering this question
is to call or write the transfer agent that is listed on the front of
each certificate. A transfer agent handles transfers of stock
certificates and should be able to advise you on their value.

If the transfer agent no longer exists or cannot help you, you might try
to contact the company directly. The stock certificates should show the
state where the company was incorporated. Contact the Secretary of
State in that state, and ask for the Business Corporations Section.
They should be able to give you a history of the company (when it began,
merged, dissolved, went bankrupt, etc.). From there you can contact the
existing company (if there is one) to find out the value of your stocks.

Here are some additional resources for researching old certificates.
* You might want to start gathering information on old securities
from Bob Johnson's web site, Goldsheet.

* Scripophily.com operates an old company research service. They
will research a company for a $39.95 fee, but if they do not find
any information, there is no charge.

* Old certificates may not represent ownership in any company, but
they can still have considerable value for collectors. See the
collection of old stock and bond certificates at Scripophily.com,
which is the Internet's largest buyer and seller of old stock and
bond certificates.

* You can consult the Robert D. Fisher Manuals of Valuable and
Worthless Securities. This is published by the R.M. Smythe
company, and should be available for use in a good reference
library. For expert assistance, contact R.M. Smythe in New York.
They specialize in researching, auctioning, buying, and selling
historic paper, and will find out if your stock has any value. But
of course this is not a free service; they charge $75 per issue.
Write them at 26 Broadway, Suite 271, New York, NY, 10004-1701 or
visit their web page.



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Subject: Stocks - Reverse Mergers

Last-Revised: 14 July 2002
Contributed-By: The SmallCap Digest (www.smallcapdigest.net)

A reverse merger is a simplified, fast-track method by which a private
company can become a public company. A reverse merger occurs when a
public company that has no business and usually limited assets acquires
a private company with a viable business. The private company "reverse
merges" into the already public company, which now becomes an entirely
new operating entity and generally changes name to reflect the newly
merged company's business. Reverse mergers are also commonly referred
to as reverse takeovers, or RTO's.

Going public (in any way) is attractive to companies because after going
public, the company can use its stock as currency to finance
acquisitions and attract quality management; capital is easier to raise
as investors now have a clearly defined exit strategy; and insiders can
create significant wealth if they perform.

The reverse merger is an alternative to the traditional IPO (initial
public offering) as a method for going public. Many people don't
realize there are numerous other ways for private company to become
publicly traded outside of the IPO. One widely used method is the
"Reverse Merger".

The reverse-merger method for going public is more prevalent than many
investors realize. One study estimates that 53% of all companies
obtaining public listings in 1996 did so through the "Reverse Merger".
The same study concluded about 30% of newly publicly listed companies
got there through Reverse Mergers in 1999. Percentages have recently
dropped because Wall Street Investment Banking firms have had a huge
appetite for IPOs in the late 90s. This led to many marginal companies
receiving enormous financial windfalls.

In a reverse merger, the original public company, commonly known as a
"shell company," has value because of its publicly traded status. The
shell company is generally recapitalized and issues shares to acquire
the private company, giving shareholders and management of the private
company majority control of the newly formed public company.

The RTO (reverse take over) method for going public has numerous
benefits for the private company when compared to the traditional IPO:
* Initial costs are much lower and excessive investment banking fees
are avoided.
* The time frame for becoming public is considerably shorter.

There are also several disadvantages of going public through the RTO as
compared to an IPO:
* There is no capital raised in conjunction with going public.
* There is limited sponsorship for the stock.
* There is no high powered Wall Street Investment Banking
relationship.
* The stock generally trades on a low exposure exchange.

Many highly successful companies have become public through the RTO
process. However, there some important negatives investors should be
aware of.

There is a much higher failure rate amongst RTO companies versus the
traditional IPO. Much smaller and less successful companies are able to
become public through the RTO, and many are badly undercapitalized.
Often these stocks trade very inefficiently in the absence of any
sponsorship or following.

There is a cottage industry of merchant bankers and entrepreneurs who
specialize in orchestrating reverse mergers. Unfortunately, there are
no barriers to entry in this field. Therefore, scams are common place.

Through various methods, scam artists manage to accumulate large
positions in the free trading shares of the shell company. An RTO is
consummated with a marginal private company, and the scam artists put
together a massive publicity campaign designed to create activity in the
stock. Unrealistic promises and absurd claims of corporate performance
find their way to the public. The enhanced trading volume allows the
scam artist to dump his shares on the unsuspecting public, most of whom
eventually lose their money once the newly formed public company fails.
This scam is commonly known as a "Pump and Dump".

Alternatively there a hundreds of examples of highly successful
companies which have yielded millions in profits for investors that have
gone public through the RTO. Many of these companies deserve exposure
to investors. Initial valuations can be reasonable, providing excellent
opportunities for individual investors to accumulate positions ahead of
Wall Street institutional money.

Here are some high-profile and successful RTOs:
* Armand Hammer, world renowned oil magnate and industrialist, is
generally credited with having invented the "Reverse Merger". In
the 1950s, Hammer invested in a shell company into which he merged
multi decade winner Occidental Petroleum.
* In 1970 Ted Turner completed a reverse merger with Rice
Broadcasting, which went on to become Turner Broadcasting.
* In 1996, Muriel Siebert, renown as the first woman member of the
New York Stock Exchange, took her brokerage firm public by reverse
merging with J. Michaels, a defunct Brooklyn Furniture company.
* One of the Dot Com fallen Angels, Rare Medium (RRRR), merged with a
lackluster refrigeration company and changed the entire business.
This was a $2 stock in 1998 which found its way over $90 in 2000.
* Acclaim Entertainment (AKLM) merged into non operating
Tele-Communications Inc in 1994.

For more insights into finance and the world of small-cap stocks, please
visit the SmallCap Network at:



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Subject: Stocks - Shareholder Rights Plan

Last-Revised: 3 Jun 1997
Contributed-By: Chris Lott ( contact me ), Art Kamlet (artkamlet at
aol.com)

A shareholder rights plan basically states the rights of a shareholder
in a corporation. These plans are generally proposed by management and
approved by the shareholders. Shareholder rights are acquired when the
shares are purchased, and transferred when the shares are sold. All
this is pretty straightforward.

The interesting question is why such plans are proposed by management.
This is probably best answered with an example. One example is rights
to buy additional shares at a low price, rights that first become
exercisable when a person or group aquires 20% or more of the common
shares of the company. In other words, if a hostile takover bid is
launched against the company, existing shareholders get to buy shares
cheaply. This serves to dilute the shares held by the unfriendly
parties, and makes a takeover just that much more difficult and
expensive.


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Subject: Stocks - Splits

Last-Revised: 26 Oct 1997
Contributed-By: Aaron Schindler, E. Green, Art Kamlet (artkamlet at
aol.com)

Ordinary splits occur when a publicly held company distributes more
stock to holders of existing stock. A stock split, say 2-for-1, is when
a company simply issues one additional share for every one outstanding.
After the split, there will be two shares for every one pre-split share.
(So it is called a "2-for-1 split.") If the stock was at $50 per share,
after the split, each share is worth $25, because the company's net
assets didn't increase, only the number of outstanding shares.

Sometimes an ordinary split is referred to as a percent. A 2:1 split is
a 100% stock split (or 100% stock dividend). A 50% split would be a 3:2
split (or 50% stock dividend). Each stock holder will get 1 more share
of stock for every 2 shares owned.

Reverse splits occur when a company wants to raise the price of their
stock, so it no longer looks like a "penny stock" but looks more like a
self-respecting stock. Or they might want to conduct a massive reverse
split to eliminate small holders. If a $1 stock is split 1:10 the new
shares will be worth $10. Holders will have to trade in their 10 Old
Shares to receive 1 New Share.

Theoretically a stock split is a non-event. The fraction of the company
that each share represents is reduced, but each stockholder is given
enough shares so that his or her total fraction of the company owned
remains the same. On the day of the split, the value of the stock is
also adjusted so that the total capitalization of the company remains
the same.

In practice, an ordinary split often drives the new price per share up,
as more of the public is attracted by the lower price. A company might
split when it feels its per-share price has risen beyond what an
individual investor is willing to pay, particularly since they are
usually bought and sold in 100's. They may wish to attract individuals
to stabilize the price, as institutional investors buy and sell more
often than individuals.

After a split, shareholders will need to recalculate their cost basis
for the newly split shares. (Actually, this need not be done until the
shares are sold, but in the interest of good record-keeping etc., this
seems like a good place to discuss the issue.) Recalculating the cost
basis is usually trivial. The shareholder's cost has not changed at
all; it's the same amount of money paid for the original block of
shares, including commissions. The new cost per share is simply the
total cost divided by the new share count.

Recalculating the cost basis only becomes complicated when a fractional
number of shares is involved. For example, an investor who had 33
shares would have 49.5 shares following a 3:2 split. The short answer
for calculating cost basis when a fractional share enters the picture is
... it depends. If the shares are in some sort of dividend reinvestment
plan, the plan will credit the account holder with 49 1/2 shares.
Fractional shares are very common in these sort of accounts. But if
not, the company could do any of the following:
* Issue fractional certificates (extremely unusual).
* Round up, and give the shareholder 50 shares (rare).
* Round down, and give the shareholder 49 shares. This happens among
penny stocks from time to time.
* Sell the fractional share and send the shareholder a check for its
value (perhaps taking a small fee, perhaps not). This is far and
away the most common method for handling fractional shares
following a split. Accounting for the cost basis of the first
three methods is trivial. However, accounting for the most common case,
the last one, is the most complicated of the options.

Let's continue with the example from above: 33 shares that split 3:2.
The original 33 shares and the post-split 49.5 shares have exactly the
same cost basis. To make it easy, assume the 33 shares cost a total of
$495. So the 49.5 post-split shares have a cost basis of $10 per share,
or $5 for the half share that is sold. The cash received "in lieu of"
the fractional share is the sales price of that fractional share. Say
the company sent along $8 for it.

The capital gain (long term or short, depending on the holding period of
the original shares) is $8 - $5 = $3. To account for this properly, the
following would be required.
* File a schedule D listing 0.5 shares XYZ Corp and use the original
acquisition date and date it was converted to cash and sold;
usually the distribution date of the split but the company will
tell you. Use $5 as cost basis and $8 as sales price and voila,
there is a $3 gain to declare.
* Reduce the cost basis of the remaining 49 shares by the cost of the
fractional share sold. ($5)
* The cost basis of the $49 shares becomes $495 - $5 = $490 (still
$10 per share).

Hopefully the preceding discussion will help with recalculating the cost
basis of shares following a split.

Now we'll go into some of the mechanics of splitting stock. The average
investor doesn't have to care about any of this, because the exchanges
have splits covered - there is absolutely no danger of an investor
missing out on the split shares, no matter when he or she buys shares
that will split. The rest of this article is meant for those people who
want to understand every detail.

Often a split is announced long before the effective date of the split,
along with the "record date." Shareholders of record on the record date
will receive the split shares on the effective date (distribution date).
Sometimes the split stock begins trading as "when issued" on or about
the record date. The newspaper listing will show both the pre- split
stock as well as the when-issued split stock with the suffix "wi."
(Stock dividends of 10% or less will generally not trade wi.)

Some companies distribute split shares just before the market opens on
the distribution date, and others distribute at close of business that
day, so there's not one single rule about the date on which the price is
adjusted. It can be the day of distribution if done before the market
opens or could be the next day.

For people who really are interested, here is what happens when a person
buys between the day after the T-3 date to be holder of record, and the
distribution date. (Aside: after a stock is traded on some date "T",
the trade takes 3 days to settle. So to become a share holder of record
on a certain date, you have to trade (i.e., buy) the shares 3 days
before that date. That's what the shorthand notation "T-3" above
means.) Remember that the holder of record on the record date will get
the stock dividend. And of course the price doesn't get adjusted until
the distribution date. So let's cover the case where a trade occurs in
between these dates.
1. The buyer pays the pre-split price, and the trade has a "Due Bill"
atttached. The due bill means the buyer is due the split shares
when they are issued. Sometimes the buyer's confirmation slip will
have "due bill" information on it.
2. In theory, on the distribution date, the split shares go to the
holder of record, but that person has sold the shares to the buyer,
and a due bill is attached to the sale.
3. So in theory, on the distribution date, the company delivers the
split shares to the holder of record. But because of the due bill,
the seller's broker delivers on the due bill, and delivers the
seller's newly received split shares to the buyer's broker, who
ultimately delivers them to the buyer. The fingers never left the
hand, the hand is quicker than the eye, and magic happens. In practice
no one really sees any of this take place.

In some cases, the company may request that its stock be traded at the
post-split price during this interval, or the market itself might decide
to list the post-split stock for trading. In such cases, the due bills
themselves are traded, and are called "when issued" or for spinoff
stock, "when distributed" stock. The stock symbol in the financial
columns will show this with a "-wi" or "-wd" suffix. But in most cases
it isn't worthwhile to do this.

Here are two sites that offer information about past, current, and
upcoming stock splits.
*
*


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Subject: Stocks - Tracking Stock

Last-Revised: 21 Jan 2000
Contributed-By: Chris Lott ( contact me )

A tracking stock is a special type of stock issued by a publicly held
company to track the value of one segment of that company. By issuing a
tracking stock, the different segments of the company can be valued
differently by investors.

For example, if an old-economy company trading at a P/E of about 10
happens to own a wildly growing internet business, the company might
issue a tracking stock so the market could value the new business
separately from the old one (hopefully at a P/E of at least 100). Those
high-flying stocks are awfully useful for making employees rich, and
that never hurts recruiting. Here's a real-world example. The stock
for Hughes Electronics (ticker symbol GMH) is a tracking stock. This
business is just the satellite etc. division of General Motors (ticker
symbol GM).

A company has many good reasons to issue a tracking stock for one of its
subsidiaries (as opposed to spinning it off to shareholders). First,
the company gets to keep control over the subsidiary (although they
don't get all the profit). Second, they might be able to lower their
costs of obtaining capital by getting a better credit rating. Third,
the businesses can all share marketing, administrative support
functions, a headquarters, etc. Finally, and most importantly, if the
tracking stock shoots up, the parent company can make acquisitions and
pay in stock instead of cash.

When a tracking stock is issued, the company can choose to sell it to
the markets (i.e., via an initial public offering or IPO) or to
distribute new shares to existing shareholders. Either way, the newly
tracked business segment gets a longer leash, but can still run back to
the parent corporation if times get tough.

All is not perfect in this world. Tracking stock is a second-class
stock, primarily because holders usually have no voting rights.

The following resources offer more information about tracking stocks.
* The Motley Fool wrote about tracking stocks on 7 September 1999.



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Subject: Stocks - Unit Investment Trusts and SPDRs

Last-Revised: 13 Jun 2000
Contributed-By: Chris Lott ( contact me )

A unit investment trust is a collection of securities (usually stocks or
bonds) all bundled together in a special vehicle that happens to be a
trust. Investors can buy tiny little pieces of the trust ("units"). So
although a UIT looks a bit like a mutual fund in that it bundles things
together and sells shares, the units are listed on an exchange and trade
just like stocks. The most well-known example is the Standard & Poors
Depositary Receipt (SPDR). These are also known as exchange-traded
funds (ETFs).

Below is a list of some of the common UITs/ETFs out there. All of these
are created by large financial institutions, and usually (but not
always) charge modest annual expenses to investors, commonly 0.2% (20
basis points) or less. (Any commissions paid to buy or sell them are
due to the broker, of course.)
* UIT that mimics the S&P 500. Named a Standard & Poors Depositary
Receipt (SPDR), commonly called a Spider or Spyder. Trades as SPY
on the AmEx and has a value of approximately 10% of the S&P 500
index. As of this writing, the trust has nearly $18 billion.
* UIT that mimics the NASDAQ 100 Index, commonly called a Qube.
Trades as QQQ on the AmEx and has a value of approximately 2.5% of
the NASDAQ 100 index. As of this writing, the trust has about $12
billion.
* UIT that mimics the Dow Jones Industrial Average. Named the Dow
Industrial Average Model New Depositary Shares, commonly called
DIAMONDS. Trades as DIA on the AmEx and has a value of
approximately 1% of the DJIA.
* Select sector SPDRs - these slice and dice the S&P 500 in various
ways, such as technology companies (symbol XLK), utilities (XLU),
etc. All are traded on the AmEx.

A UIT that mimics some index is in many ways directly comparable to an
index mutual fund. Like an index fund, it's diversified and always
fully invested. Like a stock, you can buy or sell a UIT at any time
(not just at the end of the trading day like a fund). And for the
serious traders out there, you can short many UITs on a downtick, which
you cannot do with stocks.

The following resources offer more information about UITs and SPDRs.
* The AmEx, where these securities trade, has some information. Look
in their "ETF" category.

Here is a direct link to their list of frequently asked questions
about ETFs:



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Subject: Stocks - Warrants

Last-Revised: 3 Jun 1997
Contributed-By: Art Kamlet (artkamlet at aol.com)

There are many meanings to the word warrant.

The marshal can show up on your doorstep with a warrant for your arrest.

Many army helicopter pilots are warrant officers, who have received a
warrant from the president of the US to serve in the Army of the United
States.

The State of California ran out of money earlier this year [1992] and
issued things that looked a lot like checks, but had no promise to pay
behind them. If I did that I could be arrested for writing a bad check.
When the State of California did it, they called these thingies
"warrants" and got away with it.

And a warrant is also a financial instrument which was issued with
certain conditions. The issuer of that warrant sets those conditions.
Sometimes the warrant and common or preferred convertible stock are
issued by a startup company bundled together as "units" and at some
later date the units will split into warrants and stock. This is a
common financing method for some startup companies. This is the
"warrant" most readers of the misc.invest newsgroup ask about.

As an example of a "condition," there may be an exchange privilege which
lets you exchange 1 warrant plus $25 in cash (or even no cash at all)
for 100 shares of common stock in the corporation, any time after some
fixed date and before some other designated date. (And often the issuer
can extend the "expiration date.")

So there are some similarities between warrants and call options for
common stock.

Both allow holders to exercise the warrant/option before an expiration
date, for a certain number of shares. But the option is issued by
independent parties, such as a member of the Chicago Board Options
Exchange, while the warrant is issued and guaranteed by the corporate
issuer itself. The lifetime of a warrant is often measured in years,
while the lifetime of a call option is months.

Sometimes the issuer will try to establish a market for the warrant, and
even try to register it with a listed exchange. The price can then be
obtained from any broker. Other times the warrant will be privately
held, or not registered with an exchange, and the price is less obvious,
as is true with non-listed stocks.

For more information about stock warrants, you might visit
.


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Subject: Strategy - Dogs of the Dow

Last-Revised: 10 Jul 1998
Contributed-By: Raymond Sammak, Chris Lott ( contact me ) Ralph Merritt

This article discusses an investment strategy commonly called "Dogs of
the Dow."

The Dow Jones Industrials represent an elite club of thirty titans of
industry such as Exxon, IBM, ATT, DuPont, Philip Morris, and Proctor &
Gamble. From time to time, some companies are dropped from the Dow as
new ones are added. By investing in stocks from this exclusive list,
you know you're buying quality companies. The idea behind the "Dogs of
the Dow" strategy is to buy those DJI companies with the lowest P/E
ratios and highest dividend yields. By doing so, you're selecting those
Dow stocks that are cheapest relative to their peers.

So here is the Dogs of the Dow strategy in a nutshell: at the beginning
of the year, buy equal dollar amounts of the 10 DJI stocks with the
highest dividend yields. Hold these companies exactly one year. At the
end of the year, adjust the portfolio to have just the current "dogs of
the Dow." What you're doing is buying good companies when they're
temporarily out of favor and their stock prices are low. Hopefully,
you'll be selling them after they've rebounded. Then you simply buy the
next batch of Dow laggards.

Why does this work? The basic theory is that the 30 Dow Jones Industrial
stocks represent well known, mature companies that have strong balance
sheets with sufficient financial strength to ride out rough times. Some
people use 5 companies, some use 10, some just one. You might call this
a contrarian's favorite strategy.

A 12/13/93 Barron's article discussed "The Dogs of the Dow." Barron's
claimed that using this strategy with the top 10 highest yielding Dow
stocks returned 28% for 1993, which was 2x the overall DJIA, 2x the
NASDAQ, 4x the S&P500 and better than 97% of all general US equity funds
(including Magellan). In the last 20 years, this strategy has lost
money in only 3 years, the worst a 7.6% drop in 1990. In the last 10
years, it has returned 18.26%.

Merrill Lynch offers a "Select 10 Portfolio" unit trust, which invests
in the top 10 yielding Dow stocks. Smith Barney/Shearson, Prudential
Securities, Paine Webber, and Dean Witter also offer it. It has a 1%
load and a 1.75% annual management fee, and they are automatically
liquidated each year (cash or rollover into next year, but capital gains
are realized/taxed). Minimum investment is $1,000.

A listing of the current "DOGS of the DOW" is updated every day on the
"Daily Dow" page that is part of the Motley Fool web site:



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Subject: Strategy - Dollar Cost and Value Averaging

Last-Revised: 11 Dec 1992
Contributed-By: Maurice Suhre

Dollar-cost averaging is a strategy in which a person invests a fixed
dollar amount on a regular basis, usually monthly purchase of shares in
a mutual fund. When the fund's price declines, the investor receives
slightly more shares for the fixed investment amount, and slightly fewer
when the share price is up. It turns out that this strategy results in
lowering the average cost slightly, assuming the fund fluctuates up and
down.

Value averaging is a strategy in which a person adjusts the amount
invested, up or down, to meet a prescribed target. An example should
clarify: Suppose you are going to invest $200 per month in a mutual
fund, and at the end of the first month, thanks to a decline in the
fund's value, your $200 has shrunk to $190. Then you add in $210 the
next month, bringing the value to $400 (2*$200). Similarly, if the fund
is worth $430 at the end of the second month, you only put in $170 to
bring it up to the $600 target. What happens is that compared to dollar
cost averaging, you put in more when prices are down, and less when
prices are up.

Dollar-cost averaging takes advantage of the non-linearity of the 1/x
curve (for those of you who are more mathematically inclined). Value
averaging just goes in a little deeper when the value is down (which
implies that prices are down) and in a little less when value is up.

An article in the American Association of Individual Investors showed
via computer simulation that value averaging would outperform dollar-
cost averaging about 95% of the time. "Outperform" is a rather vague
term. As best as I remember, whatever the percentage gain of dollar-
cost averaging versus buying 100% initially, value averaging would
produce another 2 percent or so.

Warning: Neither approach will bail you out of a declining market with
all of your monies intact, nor get you fully invested in the earliest
stage of a bull market.


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Subject: Strategy - Hedging

Last-Revised: 12 Dec 1996
Contributed-By: Norbert Schlenker

Hedging is a way of reducing some of the risk involved in holding an
investment. There are many different risks against which one can hedge
and many different methods of hedging. When someone mentions hedging,
think of insurance. A hedge is just a way of insuring an investment
against risk.

Consider a simple (perhaps the simplest) case. Much of the risk in
holding any particular stock is market risk; i.e. if the market falls
sharply, chances are that any particular stock will fall too. So if you
own a stock with good prospects but you think the stock market in
general is overpriced, you may be well advised to hedge your position.

There are many ways of hedging against market risk. The simplest, but
most expensive method, is to buy a put option for the stock you own.
(It's most expensive because you're buying insurance not only against
market risk but against the risk of the specific security as well.) You
can buy a put option on the market (like an OEX put) which will cover
general market declines. You can hedge by selling financial futures
(e.g. the S&P 500 futures).

In my opinion, the best (and cheapest) hedge is to sell short the stock
of a competitor to the company whose stock you hold. For example, if
you like Microsoft and think they will eat Borland's lunch, buy MSFT and
short BORL. No matter which way the market as a whole goes, the
offsetting positions hedge away the market risk. You make money as long
as you're right about the relative competitive positions of the two
companies, and it doesn't matter whether the market zooms or crashes.

If you're trying to hedge an entire portfolio, futures are probably the
cheapest way to do so. But keep in mind the following points.
* The efficiency of the hedge is strongly dependent on your estimate
of the correlation between your high-beta portfolio and the broad
market index.
* If the market goes up, you may need to advance more margin to cover
your short position, and will not be able to use your stocks to
cover the margin calls.
* If the market moves up, you will not participate in the rally,
because by intention, you've set up your futures position as a
complete hedge.

You might also consider the purchase out-of-the-money put LEAPS on the
OEX, as way of setting up a hedge against major market drops.

Another technique would be to sell covered calls on your stocks
(assuming they have options). You won't be completely covered against
major market drops, but will have some protection, and some possibility
of participating in a rally (assuming you can "roll up" for a credit).


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Subject: Strategy - Buying on Margin

Last-Revised: 19 Dec 1996
Contributed-By: Andrew Aiken (aiken at indy.net)

I have used margin debt to leverage my returns several times this year,
with successful results. At no time did my margin debt exceed 25% of my
net account equity. This is my personal comfort level, but yours may be
higher or lower depending on your risk tolerance, your portfolio return
vs. the interest rate on your debt, and your degree of bullishness
about your investments and general market conditions.

If I am using margin, I have tighter stop-loss limits. How much tighter
is determined by the amount of debt, the interest rate on the debt, and
the historical volatility of the stock.

Here are a few more suggestions:
* Never use margin unless you follow the market and your investments
on a daily basis, and you consider yourself well-informed about the
factors that could influence your asset value.
* Do not use margin debt as a long-term investment strategy.
* Have a clear idea of how long you plan to maintain the margin debt.
* Always have cash reserves outside of your brokerage account that
exceed your margin debt, so that you could pay off the debt at any
time, if necessary.
* If you maintain the debt for more that a few weeks, contribute cash
to your account on a monthly basis, so that you are paying off the
debt the same way one would pay off a credit card.
* Start with a small amount of debt relative to your account (5 -
10%), and use this as a benchmark for future actions.
* Have a stop-loss limit and a target sell price for all of the
investments in your leveraged account. Stick with your targets!
* Do not let the chance of a margin call exceed 5%. The assessment
of this probability should be made and adjusted regularly.
* Learn the techniques that the professional hedge fund managers use
in maintaining leveraged investments. This information is
available for free at the library. If this seems like too much
work, then do not use margin. These are just my opinions as an
individual investor. Whether or not you decide to use margin is a
personal decision.

I consider margin debt to be a tactic rather than a strategy. It is not
suitable for a long-term, buy-and-hold investor. The tactic has worked
for me so far, but I know several bright individuals who have been
burned by it.


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Subject: Strategy - Writing Put Options To Acquire Stock

Last-Revised: 22 Aug 2000
Contributed-By: Michael Beyranevand (mlb2 at Bryant.edu)

Is there a stock that you would like to purchase at a cheaper price than
its current quote? Would you be interested in receiving premiums months
before you have to purchase the stock? If these propositions sound
attractive to you, then writing puts to acquire stock is a strategy you
should consider in the future. This article explains the entire
procedure, as well as the associated risks and rewards.

When you write a put option you are giving the buyer of that option the
right (but not the obligation) to sell their stock to you at a
predetermined price at any time until a certain date. For giving the
buyer this luxury, he or she will in turn pay you a premium at the time
you write (i.e., sell) the option. If the buyer decides to exercise the
option then you must purchase the stock; conversely, if the option
expires unexercised then you still have the premium as your profit.

Let's work through an example. Let's say that you are bullish on
Ebay.com for the long-term with the current value of the stock at $52.
One option would be to fork over $5,200 and purchase 100 shares of the
stock and just hold on to them. Another option however would be to
write a Jan 01 45 put option, which is trading at about $8.50. This
means that at anytime between now and the third Saturday in January, you
might have to purchase 100 shares of E-Bay at $45 a share. For doing
this you are compensated $850 upfront (100 shares times $8.50).

Come January, one of two situations will occur. If the option has not
been exercised by then, your obligation is over and you have a profit of
$850. If the option is exercised (if you are put, to use the jargon),
you would pay $4,500 to own the 100 shares of the stock. After taking
into consideration that you were already paid a premium of $850, the
true cost for the 100 shares of E-Bay is only $3,650 or $36.50 a share.
You would in essence be purchasing the shares at a 30% discount to what
you would have normally paid had you just bought the 100 shares at the
market price.

Doesn't it seem too good to be true? You end up with either free money
or buying the stock at a discount. Well, there are some risks involved,
of course.

There are two significant risks in implementing this options strategy.
These situations occur if the stock shoots up or comes way down. No
matter how high the stock price goes up, the initial profits are limited
to just the premium received. So the upside potential is very much
limited in that sense. One way to combat this is to make sure that you
will be receiving a high enough premium to still be satisfied if the
stock soars before you purchase it.

The second risk is the situation if the stock plummets. Reversing your
position (i.e., buying back the option) is one possibility but an
expensive one at that. Your only other choice is to follow through with
your obligation: you purchase the stock at a premium to the current
market price. This loss can be offset by the fact that you were bullish
on the stock for the long run and you picked a price that you were
comfortable paying for the stock. If your intuition was correct than
it's only a matter of time before the stock rebounds to the price you
paid or beyond. But if something awful like accounting irregularities
are announced, you might incur significant losses.

This strategy is ideal for volatile stocks that you are interested in
holding for 5 or more years. They pay higher premiums because of their
volatility, and having a long-term horizon will minimize your risks.
Companies like Yahoo, E-Bay, AOL, EMC, Intel and Oracle would be ideal
for writing puts on.

Finally, please note that this strategy is not for everyone, and does
not guarantee anything. Speak with your broker to learn more about
writing puts and especially to learn if this strategy would fit with
your investment goals.


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Subject: Strategy - Socially Responsible Investing

Last-Revised: 23 Mar 2001
Contributed-By: Chris Lott ( contact me ), Ritchie Lowry (goodmoney1 at
aol.com), Reid Cooper (reid_cooper at hotmail.com)

Investors who pursue a strategy of socially responsible investing (SRI)
are making sure that their capital is used in a manner that aligns with
their personal ethical values--taking responsibility for what their
money is doing to the world around them. There are many different
definitions of what it means for an investment to be socially
responsible, but basically the strategy is to avoid companies that
damage the environment (either by treating nature or people poorly), and
to favor companies that provide positive goods and services. SRI is not
in any way a new idea. Adam Smith himself was concerned about the
issue, and the anti-trust and 19th century child labor debates hinged on
the same basic issues.

One of the simplest examples of a socially responsible investment is a
mutual fund that avoids so-called "sin" investments, namely companies
that are involved with liquor, tobacco, or gambling. However, the term
is sometimes applied to banks and credit unions based on their lending
practices, etc.

Does it work? This is a multi-faceted question. If the question is
whether a strategy of SRI achieves a good return on investment, the
answer seems to be that it does (see below for more details). If the
question is whether companies that are shunned by a SRI strategy have
difficulty in raising capital in the markets, I think the answer is no.
At least at the present, there are enough investors who pursue returns
without worrying about issues like a company's policies. However,
presumably investors are sleeping better at night knowing that they have
made a statement, however small, about their beliefs, and that factor
should not be neglected.

The following list of frequently asked questions was contributed by, and
is copyright by, Dr. Ritchie Lowry, maintainer of the GoodMoney site
(URL at end of this article).

1. What is SRI?

In one sense, SRI is just like traditional investing. Socially
concerned investors pursue the same economic goals as all
investors: capital gains, higher income and/or preservation of
capital for future needs. However, socially concerned investors
want one additional thing. They don't want their investments going
for things that cause harm to the social or physical environments,
and they do want their investments to support needed and
life-supportive goods and services.


2. What's the history of the movement?

The idea of combining social with financial judgments in the
investment process is not really that new. The oldest social
screen around is the sin screen: no tobacco, liquor or gambling
investments. This screen has been used for over a hundred years by
universities and churches. However, the current movement really
began during the Vietnam War when increasing numbers of investors
did not want their money going to support that war. After the war,
a number of corporate horror stories (including Hooker Chemicals
and the controversy concerning Love Canal, Firestone Tire &
Rubber's exploding 500-radial tires, A. H. Robins and the Dalkon
Shield, and General Public Utilities and Three Mile Island) added
fuel to the movement. The issue of American corporations doing
business in South Africa and with the government of that country
really pushed SRI into a full-blown social movement. It is
estimated that around $1 trillion is involved in some type of
social investing in the U.S. (about 10% of all total investments),
and the number of socially and environmentally screened funds have
increased from only a handful in the 1970s to over 100 by 1996.


3. How does one pick SRI stocks?

First, determine your financial goals. Second, pick several social
issues that are the most important to you. Don't try to solve all
the problems of the world at once. Next do research on those
corporations that appear to be the best investments in terms of
both your financial and social goals. For social information on
investments, there are a growing number of resources, most of which
are included in the GoodMoney site's directory.


4. What sorts of judgement calls are involved in the process?

Actually, the judgement calls are not that much different from the
judgments an investor has to make using only financial factors. No
investment is perfect in meeting every possible financial criteria.
If it were, everyone would be a millionaire. In the same way,
there is no such thing as corporate sainthood. However, you can
pick what have been called "the best-of-industry" or "the
try-harders." For example, making pharmaceuticals is a very dirty
business and pumps large quantities of carcinogens into the
environment. But, Merck & Company and Johnson & Johnson both have
pollution-control programs in place that go far beyond government
requirements, while other pharmaceutical companies do not.


5. What do the critics of SRI say?

Interestingly enough, SRI has been criticized from both the right
and the left. Wall Street and the traditional investment community
thinks it is liberal flakiness by people who hate capitalism. The
left thinks it is a cop-out to capitalism. Both criticisms
completely miss the point. SRI is about several things. It is
saying that any economic system, including capitalism, that lacks
an ethical component is due to destroy itself. In addition, SRI is
about personal empowerment and economic democracy. A corporation
doesn't belong to its executives, and money in a retirement fund
doesn't belong to the managers of the fund. It is time for
shareholders and others to take control of their money, not only
for profit but also to resolve some of the major economic and
social problems the world faces. This is probably why the
traditional business community, such as Fortune magazine, doesn't
like SRI.


6. Doesn't Wall Street claim that that an investor and a company
sacrifices returns and profits by mixing social with economic
judgments?

That is the traditional view, but on-going research suggests that
just the opposite may be true --- that doing well economically goes
hand-in-hand with doing good socially. For example, each year
Fortune magazine conducts a survey of America's Most Admired
Corporations. In March of 1997, the Corporate Reputations Survey
reported on the results for 431 companies. Fortune asked more than
13,000 executives, outside directors, and financial analysts to
rate (from zero for worst to 10 for best) the 10 largest companies
by revenues in their industry (if there were that many) for each of
8 criteria. Interestingly, only 3 of the criteria were purely
financial -- financial soundness, use of corporate assets, and
value as a long-term investment. The other 5 involved social
factors and judgments -- ability to attract, develop, and keep
talented people; community and environmental responsibility;
innovativeness; quality of management; and quality of products
and/or services. The average score for the 8 criteria was then
calculated. As has been the case in surveys for previous years,
companies favored by socially and environmentally concerned
investors did very well. For 1997 survey, 14 (compared to 12 for
the previous year) such companies finished in the top 50. Eleven
were repeaters from 1996. In addition, the February 24, 1997,
issue of Business Week reported on a study by Judith Posnikoff of
CalState Fullerton that found that the share prices of companies
whose planned pullouts from South Africa were announced in the
national press appreciated in the two or three days surrounding the
announcements. She concluded that the stocks produced "abnormally
positive" returns.


7. What's the future of SRI?

It is growing exponentially in numbers of individual and
institutional investors participating, in the amount of invested
money involved, and, most importantly, in the movement's ability to
persuade corporations to develop a sense of social responsibility
in the conduct of their businesses. The German philosopher Arthur
Schopenhauer put it this way:

There are three steps in the revelation of any truth: in
the first, it is ridiculed; in the second, resisted; in
the third, it is considered self-evident.

SRI is somewhere between the second and third steps.

Some resources for more information:
* The GreenMoney Journal's site

* Dr. Ritchie Lowry's site

* The RCC Group's site

* The Social Investment Forum (US) is a national nonprofit membership
organization promoting the concept, practice and growth of socially
responsible investing.

* SocialFunds.com has over 1000 pages of strategic content to help
you make informed investment decisions regarding socially
responsible investing.

* The Calvert Group is one of the largest SRI fund managers in the US
and offers a variety of investment services. It was the first to
offer a socially-screened global fund. Its web site is focused on
promoting itself, but it does provide general information on SRI
issues.

* Kinder, Lydenberg, Domini are the people behind the Domini 400
Social Index, the SRI equivalent to the S&P 500. Their web site
not only promotes the organization but also features an
international list of links to SRI web sites in Europe and North
America, among other Internet resources.

* Russell Sparkes's The Ethical Investor, originally published in
1995 by Harper Collins, London. It is out of print, but was once
available on the net and may survive; please let me know if you
find a site that has it.


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

Subject: Strategy - When to Buy/Sell Stocks

Last-Revised: 25 Nov 1993
Contributed-By: Maurice Suhre

This article presents one person's opinions on when to buy or sell
stocks. Your mileage will certainly vary.
* Stock XYZ used to trade at 40 and it has dropped to 25. Is it a
good buy?
A: Maybe. Buying stocks just because they look "cheap" isn't a
good idea. All too often they look cheaper later on. (Oak
Industries, in Cable TV equipment, used to sell in the 40s.
Lately, it's recovered from 1 to 3. IBM looked "cheap" when it
went from 137 or so down to 90. You know the rest.) 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.
Note that this situation is the same as trying to sell at the top,
except the situation is inverted. See the comments on "base
building" in the Technical Analysis section of the FAQ.


* I'd like to sell a stock since I have a good profit, but I don't
want to pay the taxes. What should I do?
A: Sell the stock and pay the taxes. Seriously, if you have
profits, the government wants their (unfair) share. Their hand
(via the IRS) is in your pocket. If you don't make any money, then
you won't owe the government anything.


* I have a profit in a stock and I want to sell at the exact top.
How do I do that?
A: If anybody knows how, they haven't told me. Some technical
indicators such as RSI can be helpful in locating approximate local
maxima. Fundamental valuations such as P/E or P/D can suggest
overvalued ranges.


* What are some guidelines for selling when you have a profit?
A: Since you can't pick the exact top, you either sell too soon or
too late. If you sell too soon, you may miss out on a substantial
up move. If you sell too late, then you will preserve most of the
last up move (unless you get caught in some sort of '87 type
crash). One mechanical rule advocated by Jerry Klein (LA area) is
this: If you have at least a 20 percent profit, use a (mental) stop
to preserve 80 percent of your profit. The technical analysis
approach is to determine a prior support level and set a stop
slightly below there. Marty Zweig's book has an excellent
discussion of trailing stops, both in setting them and how to use
them.


* It seems like stocks often drop excessively on just a little bit of
bad news. What gives?
A: One explanation is the "cockroach theory". If you see one
cockroach, there are probably a lot more around. If one piece of
bad news gets out, the fear is that there are others not yet
public. Similarly, if one stock in a group gets into trouble,
there is a suspicion that the others might not be far behind.


* I saw good news in the paper today. Should I buy the stock?
A: Not necessarily. Everyone saw the news in the paper, and the
stock price has already reflected that news.


* I don't want to be a short term trader. Can one of these computer
programs help me for the long term?
A: Possibly. If you have decided to buy and the stock is still
declining, a computer could help determine when a local bottom has
been reached. This sort of technical analysis is not infallible,
but the computations are somewhat awkward to do by hand calculator.
These programs aren't free, downloading the data isn't free, and
you will have to do some study to understand what the program is
telling you. If you are more or less ready to sell, the program
may be able to locate a local top. Ask your broker if he is using
any kind of computer analysis for buy/sell decisions. If you
already own a PC, then an analysis program might be cost effective.


* How does market timing apply to stocks? (I understand about
switching mutual funds using market timing signals).
A: Assuming that you think the market is "too high", you might a)
tighten up your stops to preserve profits, b) sell off some
positions to capture profits and reduce exposure, c) sell covered
calls to provide some downside protection, d) purchase puts as
"insurance", e) look for possible shorting situations, and/or f)
delay any new purchases. If you think the market is "too low",
then you might a) commit reserve money for new purchases and/or b)
take profits from prior shorting.


* Explain market action, group action, and individual stock action.
A: Every day, some stocks go up, some go down, and some are
unchanged. Market action applies to the general direction of the
market. Are most stocks going up or down? Are broad averages (S&P
500, etc.) going up or down? Group action refers to a specific
industry group. Biotechs may be "hot", technology may be "hot",
out of favor groups may be dropping. Finally, not all companies
within a rising group will be doing equally well -- some individual
stocks will have risen, some won't, some may even be sliding lower.


* How do I use this information (assuming I've got it)?
A: A strategy is to locate a rising group in a rising market. Look
for good companies in the group which haven't risen yet and
purchase one or more of them. The assumption is that the "best"
companies have already been bid up to full value and that some of
the remaining will be bid up. Avoid the poorest companies in the
group since they may not move at all.


* Should I look at a chart before I purchase a stock?
A: Definitely. In fact, raise your right hand and repeat after me:
"I will never purchase a stock without looking at a chart". Also,
"I will never purchase a stock in a Stage 4 decline." (See
technical analysis articles in this FAQ for details.) If you have a
full service broker, he should send you a chart, Value Line report,
and S&P report. If you can't get these, you aren't getting full
service. Value Line and S&P are probably available in your local
library.


* Do I need to keep looking at charts while I am holding my
positions?
A: Probably. You don't necessarily need to look a charts on a
daily basis, but it is difficult to set trailing stops [ref 1]
without looking at a chart. You can also get information about
where the price is relative to the moving averages.


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

Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 11 of 20)

am 30.05.2005 06:30:06 von noreply

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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always has the latest version, including in-line links. Please browse



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

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

* 401Kaf&eacute; is a community resource for 401(k) participants.



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

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 IRAÂ’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.



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

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



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

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.


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

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.


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

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.


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

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 companyÂ’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. ItÂ’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 12 of 20)

am 30.05.2005 06:30:06 von noreply

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



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Different terms and conditions apply to documents on The Investment
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The Investment FAQ is copyright 2003 by Christopher Lott, and is
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The plain-text version of The Investment FAQ may be copied, stored,
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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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--------------------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.


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

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.


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

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:



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

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 8 of 20)

am 30.05.2005 06:30:06 von noreply

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,
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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: 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 .


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

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.



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

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.


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

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.



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

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.


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

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.


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

Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 18 of 20)

am 30.05.2005 06:30:07 von noreply

Archive-name: investment-faq/general/part18
Version: $Id: part18,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 18 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
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Please send comments and new submissions to the compiler.

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

Subject: Trading - Direct Investing and DRIPs

Last-Revised: 24 Aug 2000
Contributed-By: John Levine (johnl at iecc.com), Paul Randolph (paulr22
at juno dot com), Bob Grumbine (rgrumbin at nyx.net), Cliff (cliff at
StockPower.com), Thomas Price (tprice at engr.msstate.edu), David
Sanderson (dws at ora.com), John Belt, Brett Kottmann (bkottmann at
webteamone.com)

DRIP stands for Dividend (sometimes Direct) Re-Investment Plan. The
basic idea is that an investor can purchase shares of a company directly
from that company without paying any commission. This is most commonly
done in a traditional DRIP by having all dividends paid on shares
immediately used to purchase more of the same shares (i.e., the
dividends are reinvested). Most plans also allow the investor to
purchase additional shares directly from the company every quarter.
Thus the two names for DRIP: Dividend/Direct Re-Investment Plan. But
note the "re" in re-investment: most DRIPs do not provide a way for an
investor to buy the first share.

DRIPs offer an easy, low-cost way for buying common stocks and
closed-end mutual funds. DRIPs are also a great way to invest a small
amount each month (dollar-cost averaging). Since most of us try to set
aside a little each month, this can work extraordinarily well. Yet
another good use of a DRIP is to give a small amount of stock as a gift.
You may not want to set up a brokerage account for your niece, but you
may want to give her 10 shares of Mattel. A DRIP account (structured as
a UTMA, see the article elsewhere in the FAQ) helps a minor benefit from
stock ownership and lets someone make additional purchases relatively
easily.

When you sell shares that were acquired via a DRIP, your cost basis is
simply the sum of the amounts you invested plus your reinvested
dividends. But because you have four small purchases per year, at
different prices, for as long as you own the stock, the actual
calculation of your cost basis can quickly become an accounting
nightmare. A program like Quicken or Microsoft Money can make this a
lot easier for you. (There's no reason the broker can't do it for you
since they have all the data, but no broker I know does.) Of course if
the DRIP is structured as a retirement account, a sale is not a taxable
event, and you don't need to calculate the cost basis. That leads
nicely to the next caveat. In order to participate in a DRIP inside an
IRA, the DRIP sponsor has to be willing to serve as IRA custodian. Some
will, some won't. That information is available in the DRIP prospectus,
from the company's IR department, or the transfer agent.

Traditional DRIPs are available as company-sponsored plans and from
large brokerage houses. These two arrangements are both similar and
different:

Company-sponsored DRIP
In this arrangement, once you have purchased at least one share,
dividends paid on all holdings are used to buy new shares. That
first share must be registered in your name, not in street name. A
common feature is that you can make additional purchases each
quarter at little or no additional cost (i.e., no commission or
fees). When you sell the shares, the company buys the shares back.
Note that a company-sponsored DRIP might be run by the company
directly, or by a bank. The latter arrangement tends to lead to
fees that quickly become onerous for small investors (more later).
Many companies sponsor DRIPs; lists are available through NAIC and
some brokerages.


Brokerage-house DRIP
In this arrangement, you pay a commission to buy the original
shares in your brokerage account (even retirement accounts), and
the brokerage buys new shares with the dividends paid by the stock
at no additional charge. Thus, your investment accumulates a
little at a time with no commission. When you sell the stock, they
sell the full shares (for a commission) and give you cash in lieu
for the fraction. Many brokerage houses offer this arrangement
today, including (just to name a couple) Charles Schwab and
Waterhouse.


Brokerage-house DRIP arrangements are pretty simple when compared to
company-sponsored DRIPs. The remainder of this article focuses on
company-sponsored DRIPs.

Once you've found a company with a DRIP, check out the plan terms.
Usually the transfer agent or company's investor relations (IR)
department will send you a copy of the plan information (the company's
IR department may be more responsive). Two transfer agents, American
Stock Transfer and Trust ( ) and Chase Mellon (
) have extensive plan info available online.
Although most of the information is available there, always verify any
details that are important to you with the transfer agent or IR
department before investing.

Here is a partial list of the things to check in the terms and
conditions of a DRIP. Some DRIPs are exactly and only that, a Dividend
Reinvestment Plan. If you intend to send in additional investments,
make sure that the plan allows optional cash payments. Also, some DRIPs
only accept contributions on a quarterly basis (when the dividend is
paid) or even annually or semi-annually. Plans that allow optional
investments at least monthly are much more convenient. Some DRIPs
charge you up to $5 (or more) per contribution. If you are interested
in one of those companies, then you may do just as well with a discount
brokerage account at $8/trade. Still, if you want to give stock to a
child or family member who doesn't have a brokerage account, paying
$5/purchase through a DRIP may not be a bad idea. Finally, check
whether the company issues new shares for your contribution or buys on
the open market. Issuing new shares dilutes shareholder value and is
therefore less appealing than buying on the open market.

Let's say the terms and conditions seem fair, and you want to get
started. So you need that first share and it must be registered in your
name. Once the shares are bought and issued to you, you then have to
get enrolled on your own. To purchase the first share at modest cost,
you have several options, as follows.
* If you have a brokerage account, you can just buy a few shares and
have the certificate issued (shares have to be in your name, not
held in street name in a brokerage account). This may or may not
be a low-cost approach. At Fidelity, a limit purchase order costs
you a $30 commission, and it's $15 to have a certificate issued.
If you have a Vanguard brokerage account, you can buy the stock for
a $20 commission, then have them issue the certificate for free.
Several brokerage houses (A G Edwards and Dean Witter, for example)
offer a special commission rate for purchases of single shares.
* Many clubs and other organizations will help you buy the first
share for a very reasonable charge. Naturally they all have web
sites; a partial list appears at the bottom of this article.
* A handful of companies sell their stock directly to the public
without requiring you to go through an exchange or broker even for
the first share. In that case, just get a copy of the form from
the IR department or transfer agent and send in a check. These
companies are all exchange listed as well, and tend to be
utilities.

Last but certainly not least, you may have asked yourself why all
companies don't sponsor direct investment plans. The short answer is
that it costs them too much. And now for the long answer..

Most companies, most of the time, aren't selling stock at all. For one
thing, issuing new shares requires registration with the SEC, at least
of the shelf variety, and that definitely costs money. Years ago, when
postage, supplies, and all the rest weren't so costly, a lot of
companies went ahead and did the necessary shelf registration for a
Dividend Reinvestment and Stock Purchase Plan, for the benefit of those
who already had at least a few shares registered in their own names, so
that those shareholders could increase their holdings over time. A
DRIP/SPP is a company-sponsored benefit for the shareholders, pure and
simple.

In recent years, legal fees have skyrocketed, postage alone has gone to
33c for an envelope in which to send a statement of account which costs
a bunch more to print than it used to, and the clerks and accountants
needed to keep track of such a program have also gotten a lot more
expensive. DRIP fees have gone up in existing DRIPs and there have been
very few companies actually setting up their own new DRIPs, most with
some kind of fee structure.

Many of these are designed much more for the purpose of generating fees
for the several large banking institutions that run them than for the
purpose of facilitating really small investors' interest in acquiring
fixed dollar amounts of stock. Let's face it, when they take $15 just
to open an account, insist on minimum investments in the mid-three to
low-four digit range, and then demand huge percentage fees every time a
dividend gets reinvested, a small investor gets a pretty bad deal.
Always (always) check the plan terms to make sure that you can't do
better with a DRIP arrangement at a discount brokerage house.

Here is a list of DRIP resources, including sources of information as
well as companies that will help you buy shares at very low cost.
* ShareBuilder.com, a service of Netstock Direct, lets you make
automatic periodic investments in over 4,000 companies and 68 Index
shares for just $4 per transaction. This is sometimes called
dollar-based investing, because you set the dollar amount to be
invested rather than the number of shares. Like any other DRIP,
you can own partial shares. The company bundles the orders from
members and makes bulk purchases once a week. The commission to
sell shares is $16 for market orders and $20 for limit orders. The
following "ShareBuilder" link will take you to their web site. If
you use the link and sign up with them, Chris Lott, the compiler of
The Investment FAQ, will earn a small commission.
(referral)

* PortfolioBuilder lets you make unlimited automatic repeat purchases
of over 550 stocks. Your investments are made in dollar amounts,
not shares, allowing for the purchase of fractional shares. Fees
are $150 annually (unlimited purchases that year), or $15 monthly
(unlimited purchases that month), or just $3 for a single
transaction.

* First Share is a buying club that helps investors obtain a single
share so they can participate in DRIPS. The annual membership fee
is $24. Members receive a membership handbook containing
information about direct investing, transferring shares and
registration of shares. For more information about First Share,
call 800-683-0743, +1 719-783-2929, or visit their web site.

* StockPower offers StockClick, a product that allows investors to
enroll in a direct stock purchase plan, purchase and sell stock,
and manage company stock online.

* The Moneypaper offers lists of DRIPs, an enrollment service, and
several publications. You can buy their Guide to Dividend
Reinvestment Plans, including a list of over one hundred companies
that offer DRIP's ($9). Call them at 800-388-9993 or visit their
web site.

* The Rothery Report from Norman Rothery includes a list of companies
that offer DRIPs and SPPs, compiled from a variety of publications,
with special emphasis on Canadian companies.

* The DRIP Advisor provides information and advice on Dividend
Reinvestment Programs.

* Buying Stocks Without a Broker by Charles B. Carlson
This book lists 900 companies/closed end funds that offer DRIPS.
Included is a profile of the company and some plan specifics.
These are: if partial reinvestment of dividends are allowed,
discounts on stock purchased with dividends, optional cash payment
amount and frequency, fees, and approximate number of shareholders
in the plan.


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

Subject: Trading - Electronically and via the Internet

Last-Revised: 8 Sep 1998
Chris Lott ( contact me )

Many brokerage houses offer an electronic communications path for
placing orders on the equities and options markets. In the past many
services offered dial-up access, but with the Internet reaching ever
larger numbers of people, access today is primarily via the 'net and
secure HTTP connections. Some of the services offer both, which can be
a big advantage if "www" translates into "world-wide wait" for you.

The primary motivation for using one of these services is lowering
commissions. Competition among the on-line brokerages has become
intense, and rates have dropped as low as $8 per trade. The only caveat
is that many on-line brokerages require a significant cash balance, even
as much as $10,000, before you can place trades.

Here's a few web resources with more information:
* The Securities Industry Association offers a brochure for investors
titled Online Investing Tips . Although it has only about 5 short
pages of information, the file is over 1Mb, and you will need a
copy of the free Adobe Acrobat reader to view it. It's available
from this page:

* The links page on the FAQ web site about trading has links to many
brokerage houses.

* If you'd like to compare the response times of the web brokers,
visit Keynote Systems and look for the Keynote Web Watch of broker
trading.



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

Subject: Trading - Free Ride Rules

Last-Revised: 12 Jul 1997
Contributed-By: Karl Denninger (karl at mcs.com), Timothy M. Steff (tim
at navillus.com)

When trading stocks, a "free ride" describes the case when you buy a
security at 10 and sell it a day later (or an hour later) at 12, without
having the free funds to cover the settlement of the trade at 10. This
activity is prohibited by the exchanges (e.g., NYSE Rule 431 forbids
member organizations from allowing their customers to day-trade in cash
accounts). If you trade in a cash account, you must be able to settle
the trade, even if you would take the profit from it in the same day.

Example:

Buy 1000 XXX at $10 on 7/10
Requires $10,000 free cash available to settle the trade.
Sell 1000 XXX at $15 on 7/11
It's a day later, and you will get $15,000 from the sale, but you
still must be able to settle the original purchase without the
proceeds of the sale for the first trade to be legit.


The rule on free rides should in no way be interpreted as a prohibition
on "day trading" (i.e., trading very rapidly in and out of a stock).
You can "day-trade" as much as you want, provided that you can settle
the trade. The short answer is that you must use a margin account if
you want to day-trade.

Being able to settle the trade means that you either have sufficient
cash in your account to pay for the shares, or sufficient reserve in
your margin account to cover the shares. Note that equity trades settle
3 market days after execution. Therefore, the window on short-term
trading is not one day but rather three; i.e., any close of a position
before settlement occurs would run into the same issue.

If you use cash, note that in a cash account you can spend a dollar only
once. That is to say if you start the day in cash, you can buy stock
and sell that stock -- and then are done trading for the day. If you
start in stock you can sell it, spend the cash for another position,
sell that position and then you are done.

If you use margin, keep in mind that your broker is allowed to delay the
credit for your sale until settlement if they so choose, keeping you
from using those funds for three days. If they are a market-making firm
or are selling their order flow they will likely obstruct your intra-day
and short term trading since it cuts into their bottom line. To
day-trade using a margin account, you need a broker that uses NYSE
day-trading rules for margin. Chances are your broker will have no idea
what you are talking about if you ask about this.

Unlike stocks, options settle the next day, which is both good and bad.
Option trading basically requires that the funds be there before you
place the trade, unless you like wiring funds around (and paying for the
privilege of doing so).


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

Subject: Trading - By Insiders

Last-Revised: 20 Oct 1996
Contributed-By: John R. Mashey (mash at senseipartners.com)

Insider trading refers to transactions in the securities of some company
executed by a company insider. Although a company insider might
theoretically be anyone who knows material financial information about
the company before it becomes public, in practice, the list of company
insiders (on whom newspapers print information) is normally restricted
to a moderate-sized list of company officers and other senior
executives. Smart companies normally warn all employees to be careful
when they trade, "just in case". The U.S. Securities and Exchange
Commission (SEC) has strict rules in place that dictate when company
insiders may execute transactions in their company's securities. All
transactions that do not conform to these rules are, in general,
prosecutable offenses under US securities law.

This article offers a primer on the rules that govern insider trading.
It focuses on a common insider's mechanism, namely stock options. While
I make no claim to be an expert on this, I was an officer for a few
years at a company that was private and went public, but that was in
1992, so a few rules may have changed since then.

Newspapers and other sources publish data about trades executed by
insiders. These sources include the following.
* Bloomberg.com publishes a column called "Insider Focus" that offers
information about people's insider transactions:

* The SEC

* Thomson Market Edge
In general, interpreting the data taken
solely from any of these sources is difficult. To do a thorough job,
you need the last couple years of annual reports so you can read the
fine print about executive compensation, special loans, extra covenants
about non-sale of stock around IPO, merger, acquisitions, etc. In fact,
the insider-trading sections of newspapers can be very misleading if you
don't know how to interpret them. Here are some examples that show why.

Insider purchases and sales are closely watched, for better or worse.
If you see insiders buying a lot of stock on the open market, this might
be worth investigating as a BUY signal ... although insiders are often
wrong. Another example is insider sales. If you see insiders in fairly
young companies selling stock, either by selling very cheap stock
they've had a while, or by same-day exercise of a stock option and
selling the resulting stock, this rarely means very much.

The list of stock still owned strangely doesn't mean very much either.
That is, sometimes readers get very excited if they see that Joe Blow,
CEO, has sold 10,000 shares and now owns 0. What is not obvious from
the paper is whether our friend Joe has no options left, is cashing out,
and about to leave. However, Joe might have vested options on a million
shares, and has thus sold 1% of his stock to buy a new house.
Obviously, the imputed meanings are rather different

The timing of sales also means relatively little. Silicon Valley
financial advisors tell people to sell some stock every year for tax
reasons. (More on this later in this article.) Normally, there are at
most 4 times during a year when an insider can sell stock anyway, and it
is easy for other events to knock this down to 1-2, or even 0. I've
heard of cases where people got stuck for 2 years post-IPO not being
able to sell any stock.

Now it's time for some detailed explanations.

If you are a founder of a company, or even an early employee, you will
likely get some stock options, or own stock at minuscule prices (i.e.,
like $.10/share on stock you hope will be worth at least $10 at IPO.) I
don't know how the rules are now, but they used to strongly encourage
actual purchase of some of that stock, at least 2 years in advance of a
potential IPO, in order to have stock that could get favorable capital
gains handling when sold 6 months after IPO. [When a company is
founded, of course, no one has the foggiest clue of the likely increase
in value ... although there are many hopes :-)]

When you get closer to IPO, stock option pricing gets closer to an IPO
price, which is usually adjusted via splits or reverse-splits to be in
the $10-$30 range.

Many companies continue to grant stock options after IPO, although the
prices are of course much higher, which tends to force some different
strategies. From tax-treatment, it is advantageous to spread this out,
as only a certain amount per year gets the favorable Incentive Stock
Option (ISO) treatment, any above gets a Non-Qualified Option treatment.

Silicon Valley companies use stock options extensively, and usually,
broadly across employees, not just for executives. [Which is why the
Valley went berserk with the proposed law that required charging the
bottom line for the "expected future value of stock options" :-) If
anyone can predict such a thing, they are really smart ... but even
worse, it would have discouraged broad use of stock options, which would
have been truly sad.]

If you have been in a high-tech startup, or even fairly early in, it is
likely that much of your net worth exists in stock ownership and options
of that company. It is far more complicated, and takes longer than
you'd expect, to get that money out without giving it to the IRS :-) [I
do first-in-first-out on option exercises ... I'm still working on some
I got in 1985...]

It is especially difficult to get money out if you are an insider, given
SEC rules, tax laws such as alternate minimum taxes, and lawsuit issues.
Company officers must be especially careful about lawsuit issues, and
should ask the lawyers about extra rules that aren't laws but offer some
insurance against lawsuits.

Insiders usually do no trades in month 1 and month 3 of a quarter for
the following reasons. (This leaves insiders just 4 months per year.)
During month 1, no trades are permitted until the quarterly report
appears, plus a few days for market to digest the results.
Theoretically, by the beginning of month 3 you know how the quarter will
be. This may be actually true in some businesses, but not others. In
some parts of the computer business, an awful lot of business is booked
during month 3, and shipped in the last 2 weeks, so people quite often
have no idea at this time whether they'll make the numbers or not. This
is especially true for high-end machines (like supercomputers, where
pure-supercomputer companies have occasionally had crazed fluctuations
because some $20M machine got held up a week). Right now, the
government shutdown and its effects on buying and export licenses is a
bit strange. Similar weirdnesses go on, for example, in some retail
businesses, where the Christmas season is crucial.

Insiders should avoid trades when in possession of material information
that might affect the stock, and is not yet public, at least partly
because it might or might not happen. For instance, somebody might be
negotiating a merger or some really major sale, and the lawyers will
tell you that you shouldn't trade then, to avoid lawsuits. This may
knock out some of the 4 months, and may be difficult to predict a year
in advance; that is, it is personally dangerous to say: "I expect to
sell stock 9 months from now." Don't count on it.

Insiders may make no trades when forbidden by covenants that are part of
IPOs or merger deals. There is usually a minimum of a 6-month block
after an IPO, and probably 3 after a merger.

I don't know if this rule is still around, but insiders do not usually
both buy and sell their stock in within the same 6 months. I think the
rule has been mellowed to allow purchase of options and sell them off,
but there used to be a terrible trap where you (a) sold some stock (b)
then, slightly less than 6 months later, were reminded that you had
options expiring. You exercised the options ... and blam some computer
at SEC nails you for illegal trading. [Years ago, advisors mentioned
some horror stories, whose details I forget, but whose import stuck.]

When considering the rules mentioned above, plus some other rules about
tax-treatment on pre-IPO stock options, the whole mess might be
paraphrased as: "You are in a maze of twisty little rules, all alike."
But in general, the rules (explicit and implicit) strongly discourage
insiders from trading (mixtures of buying and selling) their own stock
very often; since insiders usually have stock options, that means they
mostly sell.

Finally, some executive employment contracts have some really
complicated agreements, often involving loans made the company to the
executive to buy stock (so they can buy it when they aren't allowed to
sell any to get the money to buy it with), but also placing restrictions
on buying or selling stock.

Further complicating the picture for an ousider trying to interpret the
moves of insiders, financial advisors tell people that, no matter how
well they think the stock will do over the long run, they should sell
some % of what they have left every year. They advise this for
diversification, so they have the cash available, and to spread it out
to lessen the effects of the alternative minimum tax. We once had a
"class" in this, and the recommended percentage was 10%, but that was
years ago, and was not a hard rule, just a general idea.

Unlike "regular" people, if an insider needs some money quickly, s/he
cannot call their broker and sell some stock in the company on the spur
of the moment. In fact, they cannot even be guaranteed that a window of
opportunity to do so will necessarily be predictable. It may be that
with the changes to stockholder lawsuit rules, this will get a little
more rational; as it has been, lawyers have recommended extreme paranoia
regarding lawsuits, for good reason. (So, what insiders do is use
existing money, or quite often, borrow money with the options as
security ... which has often caused people trouble later on.)

Now on to the mechanics of exercising options as an insider. When you
exercise an option (i.e., purchase the stock), you can do one of two
things. First, you might do a same-day exercise, that is, purchase the
stock and immediately sell it, keeping the difference, and of course,
incurring a normal tax liability on the difference between option price
and exercise price. Non-qualified option treatment forces this. Or,
you might purchase the stock and keep it for a year, then sell it, thus
getting more favorable capital-gains treatment (at least sometimes) on
any gain. Of course, in doing so, you are subject to later price
fluctuations. If you are an insider, note that you may not be allowed
to sell when you'd like to, as described above.

So if the current stock price is $20, and you have 10,000 options, you
might go either route. If your option price is $.10, you might buy
shares and hold them, i.e., spend $1000. But if your option price is
$10 and you want to buy and hold the shares, then you need to come up
with $100,000. The only way to get that might be to sell some shares
you already own. If what you have is vested options, then you might
exercise some, and sell less, thus keeping some shares. This gets
tricky, as you have to sell enough to cover the purchase, cover the tax
liabilities, AND get some actual cash out! I'll continue with the
example, assuming you want to buy and hold the shares. You get $200K
(sell 10,000 shares @ $20), pay $100K (exercise the options @ $10),
leaving $100K. Probably approximately 40% goes to IRS and (here)
California, leaving $60K in cash to actually do something with.

Bottom line: founders often actually own lots of stock, sometimes so do
early employees. But, for many insiders (and in fact, not just legal
insiders, but other officers and actually, any employees who have
significant stock positions and/or legal advice that restricts the
timing of sales), the natural state of affairs gets to be (as the
absolute cost of options goes up):

* Have a bunch of vested options that account for a big chunk of
one's net worth.
* Do same-day exercise once or twice a year.
* Actually own zero shares.

And these are basically driven by SEC rules, legal advice, and tax laws,
not by short-term price fluctuations. [Note: anyone in high-tech
investing who doesn't expect short-term stock price fluctuations ... is
crazy :-)].

Thus, moderate sales by insiders ... simply don't mean much. It takes
work to know whether or not a sale is substantial. For instance, an
executive may have an employment contract that includes an $X loan
(where I've heard of $X in the millions), where they moved to the area,
wanted to buy a nice house, and the deal is that within N months of
being allowed to exercise options, they are required (or encouraged by
interest on the loan) to do so. This means that they'd better sell off
enough stock to cover the loan, and the taxes incurred from selling the
stock. The only way to figure this stuff out is to backtrack through
the annual reports and read the fine print.

OF COURSE, there have been cases where some insider sold a ton of stock
and should have known better... but by-and-large, the pattern in young
high-tech companies is that insiders gradually sell over time to move
more of their net worth into more diversified holdings and be able to
enjoy it :-)

A slightly different pattern shows up in more-established companies
where stock options are not as widespread, insiders were not founders or
early employees. Here, there are often key executives who do not have
large stock positions (either owned or vested options), and they may
decide their stock is undervalued and buy a bunch on the open market.

You can get lists of reported insider trades at Barron's Online (free,
but registration is required). Visit their site at



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Subject: Trading - Introducing Broker

Last-Revised: 31 Mar 1997
Contributed-By: Craig Harris

An Introducing Broker (IB) is a futures broker who delegates the work of
the floor operation, trade execution, accounting, etc. to a Futures
Commission Merchant (FCM). In this relationship, the FCM maintains the
floor operation and the IB maintains the relationship with retail
clients. This is efficient because the work of a floor operation vs.
the work of maintaining relationships and meeting the needs of retail
customers have different requirements.

Another way to think of an IB is that of a segmented firm. The IB is
not a middleman, but is in a partnership with the clearing firm. The
clearing firm manages the floor and back office ops, and the IB is free
to concentrate on his/her customers and their trading.

Several myths concerning IBs need debunking. First of all, the notion
that an introducing broker is a "middleman" or that fees or commissions
are necessarily higher is wrong. It's also wrong to say that an IB is a
branch office. Yes, an IB may have branch offices, but an IB is not a
branch office of a FCM. The IB is in a business partnership with an
FCM, each handling their own piece of the work.

When it comes to ordering, if you are trading through an IB, it need not
be any less efficient than trading with a vertically oriented firm that
does everything. When you call an IB with an order, s/he can relay that
order directly to the trading floor, or even give clients direct access
to the floor themselves. If you call one of the big, vertically
integrated firms your order is likely to take as many or more steps than
it would with an IB.

In terms of commissions, an IB may maintain a low overhead and that lets
him/her charge reasonable fees while maintaing a lot of support and
specialized service that a big discount firm simply can't provide.
There's more to trading than commissions, although most novices don't
understand that.

I would say that the bottom line in choosing a broker depends on several
factors:
* The type of trading you do
* The level of assistance and support you require
* Your ability to watch the markets all day Pick someone you are
comfortable with. Make sure you know who the clearing firm is. Call
the NFA and ask about any complaints or the disciplinary history of the
firm. Don't ever let yourself fall victim to a high pressure sales
pitch; that is in fact illegal. There are a lot of brokers out there,
take your time and make sure that the one you choose is a good fit for
you. There are plenty of good brokers out there.

There is one wrinkle, however. Your trades may experience price
improvement -- or may not -- depending on the large brokerage firm that
executes the trades you submit via your introducing broker. See the
article on price improvement in this FAQ for more details.


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Subject: Trading - Jargon and Terminology

Last-Revised: 23 Feb 2000
Contributed-By: Ed Krol (e-krol at uiuc.edu), Brook F. Duerr, Art
Kamlet (artkamlet at aol.com), Bob Grumbine (rgrumbin at nyx.net), Chris
Lott ( contact me ), Arthur Gibbs, Jason Hsu

Some common jargon that you should understand about trading equities is
explained here briefly. See other articles in the FAQ for more detailed
explanations on most of these terms.



AON, "all or none"
A buy or sell order with this designation loses normal order
priority if the amount of shares available doesn't match or exceed
the order size. There may be some specialized circumstances where
it could be useful, such as late in the day on a GTC entry (to
avoid a fractional fill such as 100 shares of a 1000 share order,
with resulting doubling of total commissions when the rest of the
order fills the following morning).
blue-chip stock
A valuable stock that has proven itself; i.e., has been around for
many years and has made piles of money. Examples are IBM, GE,
Ford, etc. The name derives from the chips used in poker, blue
always being the most valuable.
bottom fishing
Purchasing of stock declining in value, or of stocks that have
suffered drastic declines in their prices.
breakpoint
Mutual fund companies give volume-based percentage discounts in the
load fee charged to purchase shares. A breakpoint is the level of
investment, like $100,000, required to qualify for a discount.
broker
The term was first used around 1622 to mean an agent in financial
transactions. Originally, it referred to wine retailers - those
who broach (break) wine casks.
call money rate
Also called the broker loan rate, this is the interest rate that
banks charge brokers to finance margin loans to investors. The
broker charges the investor the call money rate plus a service
charge. Investors who buy on margin will pay this rate.
day order
Order to buy/sell securities at a certain price that expires if not
executed on the day it is placed.
diluted shares
A way of characterizing the number of outstanding shares that a
publically held company could have. The diluted shares measure is
the sum of the company's normally outstanding shares, the shares
that would be outstanding if every warrant & stock option were
exercised, and the shares that would be outstanding if every
security convertible into the stock (e.g., certain preferred
shares) were converted. This is sometimes used when computing
earnings per share numbers. A larger number of outstanding shares
means lower earnings per share, rather obviously; this is known as
"dilution of earnings" or computation of "fully diluted" earnings.
DNR, "do not reduce"
This is usually assumed unless you specify otherwise, but different
brokers may have different practices and some may require you to
specify DNR if you want it. What it deals with is how the order is
to be/not adjusted when dividends or other distributions occur.
For example a $1/share dividend on a stock for which you have
entered an order DNR brings the price closer to your bid or takes
it further away from your offer. Without the DNR specification, on
the ex-dividend date your order price is reduced by the amount of
the distribution.
elves index
Louis Rukeyser's index of the opinions on the general stock market
for the next 6 months. He polls 10 analysts, the same ones every
week, to ask what they think the general trend will be, namely
bullish (+1), neutral (0), or bearish (-1). The index range is -10
to +10.
FOK, "fill or kill"
This means do it now if the stock is available in the crowd or from
the specialist, otherwise kill the order altogether. I never have
found a situation to make use of that designation..
going long
Buying and holding stock.
going short
Selling stock short, i.e., borrowing and selling stock you do not
own with the intention of buying it later for less.
GTC, "good till cancelled"
Order to buy/sell securities at a certain price (a limit order);
the limit order stays in the market until you call specifically to
cancel it. Some brokers restrict the length of time a GTC can
remain open to "end of same month", "no more than 30 days" or some
such thing, but with most it becomes a permanent part of the book
until it gets executed or you cancel.
MIT, "market if touched"
Frequently used in the commodity futures pits. I seem to recall it
being available on exchange-traded stocks as well, but I've never
been such a hotshot as to use the designation *as such*. Instead,
when I see serious overhead resistance at some point and have
sufficient reason to want to unwind my position, I'll respond with
a limit order below the resistance to close out my position.
Similarly, when I see serious support and want to get into a
position, I'll respond with a limit order above the support to gain
entry. What I don't want to be doing is chasing the stock wildly
(what market orders tend to do) just because some specific price
got touched.
MKT, "at the market"
It doesn't matter how much you have to pay to buy nor how little
you get on a sale, just do it now .
overbought [oversold]
Judgemental adjective describing a market or stock implying That
people have been wildly buying [selling] it and that there is very
little chance of it moving upward [downward] in the near term.
Usually it applies to movement momentum rather than what the
security should cost.
over valued, under valued, fairly valued
Judgmental adjectives describing that a market or stock is
over/under/fairly priced with respect to what people believe the
security is really worth.
uptick
Uptick means the next trade is at a higher price than the previous
trade. Meaningful for the NYSE and AMEX; not so meaningful for OTC
markets (NASDAQ). Certain transactions can only be executed on an
uptick (e.g., shorting).
downtick
Downtick means the next trade is at a lower price than the previous
trade. See uptick.
plc An abbreviation of Public Limited Corporation. This means that the
company is not American, where "Inc." is used instead. PLC is used
by companies in many different countries, including Great Britain,
South Africa, Australia, Hong Kong, etc.
tender
tender (v), to provide, to offer for delivery. Frequently used as
a short version of "tender offer," which is a public invitation
extended to shareholders of a company by an organization that
wishes to buy the company (i.e., a bid to take control of the
company). Following a tender offer, shareholders who have accepted
the offer surrender ("tender") their shares in exchange for
payment.
treasury shares
Shares taken from the company treasury (not the US Treasury!).
Often occurs in the context of discussions about how companies
fulfill share purchases within DRIP accounts.
underwriting
When an investment banker brings a company to market in an IPO.
The banker agrees to purchase so many shares of ABC corp at $XX per
share, less fees, and will resell them to the public immediately.
However, the banker does not go it alone; just like an insurance
company, the banker often seeks others to share risk. The
companies that participate are collectively termed the
underwriters, since the job of the subsidiary investment bankers is
to lessen the banker's exposure to the risk that he cannot sell all
the shares he agreed to purchase. The group is collectively
referred to as the underwriting syndicate.
For more definitions of terms, visit these on-line gloassaries of
investment and finance-related terms:
* InvestorWords

* The Washington Post's Business Glossary



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Subject: Trading - NASD Public Disclosure Hotline

Last-Revised: 15 Aug 1993
Contributed-By: vkochend at nyx.cs.du.edu, yozzo at watson.ibm.com

The number for the NASD Public Disclosure Hotline is (800) 289-9999.
They will send you information about cases in which a broker was found
guilty of violating the law.

I believe that the information that the NASD provides has been enhanced
to include pending cases. In the past, they could only mention cases in
which the security dealer was found guilty. (Of course, "enhanced" is
in the eye of the beholder.)


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Subject: Trading - Buy and Sell Stock Without a Broker

Last-Revised: 27 Sep 1993
Contributed-By: Franklin Antonio, Henry Chan Desu (henryc at panix.com)

Yes, you can buy/sell stock from/to a friend, relative or acquaintance
without going through a broker. Call the company, talk to their
investor relations person, and ask who the Transfer Agent for the stock
is. The Transfer Agent is the person who accomplishes the transfer,
i.e., by issuing new certificates with the buyer's name on them. The
transfer agent is paid by the company to issue new certificates, and to
keep track of who owns the company's stock. The name of the Transfer
Agent is probably printed on your stock certificates, but it might have
changed, so it is best to call and check.

The back of the certificate contains a stock power, i.e., those words
that say you want the shares to be transferred. Fill out the transferee
portion with the desired name, address, and tax id number to be
registered. Sign the stock power exactly as the certificate is
registered: joint tenancy will require signatures from all the people
listed, stock that was issued in maiden name must be signed as such,
etc. In addition to signing, you must get your signature(s) guaranteed.
The signature guarantee is an obscure ritual. It is similar to a notary
public, but different. The people who can provide a signature guarantee
are banks and stock brokers who are members of an exchange. Now, your
stock broker might not be too happy to see you and help you when you are
trying to avoid paying a commission, so I suggest you get the guarantee
from your bank. It's very easy. Someone at the bank checks your
signature card to see if your signature looks right and then applies a
little rubber stamp. Also, if you have the time, have the transferee
fill out a W-9 form to avoid any TEFRA withholding. W-9 forms are
available from any bank or broker.

Then send it all to the transfer agent. The agent will usually
recommend sending securities registered mail and insuring for 2% of the
total value. For safety, many people send the endorsement in a separate
envelope from the stock certificate, rather than using the back of the
stock certificate (if you do this, include a note that says so.) SEC
regulations require transfer agents to comply with a 3 business day
turn-around time for 90% of the stock transfers received in good
standing. In a few days, the buyer gets a stock certificate in the
mail. Poof!

There is no law requiring you to use a broker to buy or sell stock,
except in certain very special circumstances, such as restricted stock,
or unregistered stock. As long as the stock being sold has been
registered with the SEC (and all stock sold on the exchanges, NASDAQ,
etc. has been registered by the company), then the public can buy and
sell it at will. If you go out and create yourself a corporation
(Brooklyn Bridge Inc), do not register your stock with the SEC, and then
start selling stock in your company to a bunch of individuals,
advertising it, etc, then you can easily violate many SEC regulations
designed to protect the unsuspecting public. But this is very different
than selling the ordinary registered stuff. If you own stock in a
company that was issued prior to the time the company went public,
depending on a variety of conditions in the SEC regulations, that stock
may be restricted, and restricted stock requires some special procedures
when it is sold.

In brief: I do not believe that the guy who offers on the net to sell
people 1 share of Disney stock is violating any rules. Just for full
disclosure: I'm not a lawyer.


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Subject: Trading - Non-Resident Aliens and US Exchanges

Last-Revised: 29 May 2002
Contributed-By: Chris Lott ( contact me ), Enzo Michelangeli (em at
who.net)

It is perfectly legal for non-resident aliens to trade equities on
exchanges in the United States using US brokerage houses directly. (A
"non-resident alien" (NRA) is the US government's name for a citizen of
a country other than the US who also lives outside the US.) The current
surge in availability of on-line brokerage services has effectively
eliminated the problems of different time zones and high telephone
charges, and has made it really easy for people living outside the US to
trade on US exchanges. This route is generally far cheaper as compared
to using any bank or brokerage house in the foreign country, and
therefore very attractive to many people.

Of course there are certain formalities concerning tax treatment of such
accounts, and these formalities must be clarified with the brokerage
house when the account is opened. Individuals who are not US citizens
must complete a W-8 form, which is a certificate of foreign status, and
return it to the brokerage house.

The specific rules of how these accounts are taxed are described in IRS
Publication 515 (Withholding of tax on non-resident aliens) and IRS
Publication 901 (Tax treaties). The tax treaty is especially important.
If the individual's country of residence has an agreement (tax treaty)
with the US government, those rules apply. For example, residents of
Germany should not have any tax withheld on interest or capital gains,
only for dividend payments. However, if the individual's country of
residence has no agreement with the US, then the individual should
complete the 1001 form (exemption form), and no tax will be withheld at
all.

I'm fairly certain that US citizens and green-card holders living abroad
are not required to fill out either of these forms, since these
individuals are required to report their world-wide income to the US
annually. And none of this applies to bona fide residents of the US,
regardless of citizenship, who are automatically subject to the US
taxation laws.

To avoid overseas telephone charges, the internet brokerages are clearly
the most attractive option. Most large brokerage firms accept foreign
clients, although some brokerage houses that offer trading via the
internet still require their customers to be US residents.

The following brokers once accepted non-resident aliens as customers:
Ameritrade, Datek, NDB, J.B. Oxford, and Schwab.

Various instruments sold by the US Treasury are also available for
purchase by NRAs. NRAs can buy, hold, and sell normal Treasury
instruments through the TreasuryDirect program, and will not be charged
any tax as long as they file a Form W-8BEN. However, the NRA must first
get an individual tax identification number (ITIN) by submitting a Form
W-7, which is required for opening a TreasuryDirect account. Second,
the account holder should really have an account at a US bank to allow
for direct payment of purchases and direct credit of interest and sales
proceeds. Finally, note that US Savings Bonds are not available to
NRAs.


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Subject: Trading - Off Exchange

Last-Revised: 20 June 1999
Contributed-By: John Schott (jschott at voicenet.com)

Anyone can trade stocks off the current set of stock exchanges, if only
on a person-to-person deal. This is not a far cry from the original
trading under the Buttonwood tree in New York in the 18th century.
Today, over 20% of the total volume on stocks traded on the NYSE and
NASDAQ exchanges occurs off the official exchanges. However, the
dealing is often on the 'non-exchanges' (often called electronic
communication networks or ECNs). INSTINET is perhaps the best known of
several ECNs now functioning. Most of these operations are members-only
operations that function both during and after the normal exchange
hours. All are electronic - that is, non-physical exchanges. Almost
all are direct, in that there are no intermediaries such as specialists
and market makers as on the NYSE and NASDAQ, respectively. So they
function much like two people meeting in a person-to-person deal. One
sells, the other buys. This sort of trade is efficient and economical
in that no intermediaries need to paid, but because there are no
intermediaries, there is much less liquididy than the traditional
exchanges where a third party can serve as a volume buffer. Thus ECNs
are ideally suited for the large block, sophisticated trader who wants
efficient execution with a minimal distruption in the trade price that
would occurr with public trading.

In todays internet world, several firms are planning to open such
off-exchange trading to the public. Much of the focus is toward after
hours trading. But once started, there is no limit to providing
24-hour, 7-day access. Perspective particiants range from Schwab to new
startups. The SEC promises that some of the organized off-exchange
operations can qualify as official exchanges. It was recently reported
that Datek's Island ECN had filed with the SEC to be recognized as an
official exchange.

One computerized system is even designed to provide total annomity:
neither the buyer or seller or the operator of the computer system knows
the identity of the two participants until after the system puts the two
in contact.


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

Subject: Trading - Opening Prices

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

The previous day's close, as well as any after-hour trading in a
security may have significant effects on the opening price, but that
isn't the whole story. Here's a quick summary of how the process for
determining the opening price works.

The basic problem is that the closing price from the previous trading
day is no longer a valid indicator of a stock's perceived value. News
may have appeared since the previous close, there may have been trading
on foreign exchanges that open before US domestic exchanges, and there
surely has been a flow of new and changed orders since the previous
close.

On the NYSE and ASE, the specialist determines the opening price by
looking at his/her "book." The specialists are supposed to select the
one price that clears out the maximum number of orders; i.e. by looking
at the buy and sell offers and choosing a single price will execute the
most orders (shares). But it is possible that today's book contains no
orders from yesterday - or at least none that might affect the opening.
So the specialist may have to make an educated guess to kick off initial
trading.

As a multi-market maker exchange, NASDAQ's computerized system opens
differently. Market makers perform a two stage round-robin opening.
First, each posts a single bid and asked price pair. This price can
signal each firms view of the security, its current desire to buy or
sell, or it may indicate that a firm is out of calibration with others
in the market. After all have seen the first round, each firm may
revise their postings once and trading starts as the executions flow to
"best" postings. And off the day's trading goes.

You may read about "gaps" in the opening price, or that trading in a
security began late. This commonly happens when news that was released
after the previous market close impacts a security's price. The opening
price in these cases differs sharply from the previous day's close,
either higher or lower. For example, a company may release unexpectedly
good earnings early in the morning just before the market opening. If
there is a potential price impact expected, the firm, its
specialist/market makers, or the exchange itself may delay the opening
to allow the news to reach as many people as possible before an opening
is made.

An extreme example of what a specialist may have to deal with happened
in February 1997. Mercury Finance (MFN) closed around 15 and opened the
next day near 1 1/2 due to extremely bad news overnight. (I am ignoring
what might have happened in after hours trading - but that would have
some effect.) Some poor souls might not have heard the bad news and left
open their old buy or sell orders at 14-15. The NYSE specialist could
potentially have opened the stock at $14, taken out those orders and
then done the next trades at 1 1/2 (or where-ever it did open: 1-3/8 or
1-5/8). But looking at the books, he eventually decided on a delayed
opening, allowing people time to assess the news and adjust open and new
orders accordingly. Once a pattern of orders emerged, the opening
occurred according to normal procedures. An unrevised open buy order
from yesterday executed at todays far lower price... An inattentive
market-price seller from yesterday would get today's sharply reduced
price, too.


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

Compilation Copyright (c) 2005 by Christopher Lott.

The Investment FAQ (part 13 of 20)

am 30.05.2005 06:30:07 von noreply

Archive-name: investment-faq/general/part13
Version: $Id: part13,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 13 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
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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,
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The plain-text version of The Investment FAQ may be copied, stored,
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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: Stocks - The Dow Jones Industrial Average

Last-Revised: 10 Mar 2003
Contributed-By: Norbert Schlenker, Chris Lott ( contact me )

The Dow Jones averages are computed by summing the prices of the stocks
in the average and then dividing by a constant called the "divisor".
The divisor for the Dow Jones Industrial Average (DJIA) is adjusted
periodically to reflect splits in the stocks making up the average. The
divisor was originally 30 but has been reduced over the years to a value
far less than one. The current value of the divisor is about 0.20; the
precise value is published in the Wall Street Journal and Barron's (also
see the links at the bottom of this article).

According to Dow Jones, the industrial average started out with 12
stocks in 1896. For all of you trivia buffs out there, those original
stocks and their fates are as follows: American Cotton Oil (traces
remain in CPC International), American Sugar (eventually became Amstar
Holdings), American Tobacco (killed by antitrust action in 1911),
Chicago Gas (absorbed by Peoples Gas), Distilling and Cattle Feeding
(evolved into Quantum Chemical), General Electric (the only survivor),
Laclede Gas (now Laclede Group but not in the index), National Lead (now
NL Industries but not in the index), North American (group of utilities
broken up in 1940s), Tennesee Coal and Iron (gobbled up by U.S. Steel),
U.S. Leather preferred (vanished around 1952), and U.S. Rubber (became
Uniroyal, in turn bought by Michelin). The number of stocks was
increased to 20 in 1916. The 30-stock average made its debut in 1928,
and the number has remained constant ever since.

Here are some of the recent changes.
* On 17 March 1997, Hewlett-Packard, Johnson & Johnson, Travelers
Group, and Wal-Mart joined the average, replacing Bethlehem Steel,
Texaco, Westinghouse Electric and Woolworth.
* In 1998, Travelers Group merged with CitiBank, and the new entity,
CitiGroup, replaced the Travelers Group.
* On 1 November 1999, Home Depot, Intel, Microsoft, and SBC
Communications joined the average, replacing Union Carbide,
Goodyear Tire & Rubber, Sears, and Chevron.
* Several stocks in the index have merged and/or changed names since
the last round of changes: Exxon became Exxon-Mobil after their
merger; Allied-Signal merged with Honeywell and kept the Honeywell
name; JP Morgan became JP Morgan Chase after their merger;
Minnesota Mining and Manufacturing offically became 3M Corp; and
Philip Morris renamed itself Altria.

The Dow Jones Industrial Average is computed from the following 30
stocks. The links on the ticker symbols will take you to the a page at
Yahoo that offers current quotes and charts, and the links on the names
will take you to the respective company's home page.

Ticker Company Name
MMM 3M Corporation
AA Alcoa
MO Altria (was Philip Morris)
AXP American Express
T AT&T
BA Boeing
CAT Caterpillar
C CitiGroup
KO Coca Cola
DD E.I. DuPont de Nemours
EK Eastman Kodak
XOM Exxon Mobil
GE General Electric
GM General Motors
HPQ Hewlett-Packard
HD Home Depot
HON Honeywell
INTC Intel
IBM International Business Machines
IP International Paper
JPM JP Morgan Chase
JNJ Johnson & Johnson
MCD McDonalds
MRK Merck
MSFT Microsoft
PG Procter and Gamble
SBC SBC Communications
UTX United Technologies
WMT Wal-Mart Stores
DIS Walt Disney


Here are a few resources from Dow Jones and Company:
* Dow Jones Indexes develops, maintains, and licenses over 3,000
market indexes for investment products.

* The current list of companies in the DJIA and their weightings.

* Frequently Asked Questions about the DJIA.



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

Subject: Stocks - Other Indexes

Last-Revised: 27 Jan 1998
Contributed-By: Rajiv Arora, Christiane Baader, J. Friedl, David Hull,
David W. Olson, Steven Pearson, Steven Scroggin, Chris Lott ( contact
me )

US Indexes:

AMEX Composite
A capitalization-weighted index of all stocks trading on the
American Stock Exchange.
NASDAQ 100
The 100 largest non-financial stocks on the NASDAQ exchange.
NASDAQ Composite
Midcap index made up of all the OTC stocks that trade on the Nasdaq
Market System. 15% of the US market.
NYSE Composite
A capitalization-weighted index of all stocks trading on the NYSE.
Russell 1000
The Russell 2000 Index measures the performance of the 2,000
smallest companies in the Russell 3000 Index, which represents
approximately 10% of the total market capitalization of the Russell
3000 Index. As of the latest reconstitution, the average market
capitalization was approximately $421 million; the median market
capitalization was approximately $352 million. The largest company
in the index had an approximate market capitalization of $1.0
billion. Visit their web site for more information:

Russell 2000
Designed to be a comprehensive representation of the U.S.
small-cap equities market. The index consists of the smallest 2000
companies out of the top 3000 in domestic equity capitalization.
The stocks range from $40M to $456M in value of outstanding shares.
This index is capitalization weighted; i.e., it gives greater
weight to stocks with greater market value (i.e., shares * price).
Visit their web site for more information:

Russell 3000
The 3000 largest U.S. companies. Visit their web site for more
information:

Standard & Poor's 500
Made up of 400 industrial stocks, 20 transportation stocks, 40
utility, and 40 financial. Market value (#of common shares * price
per share) weighted. Dividend returns not included in index.
Represents about 70% of US stock market. Cap range 73 to 75,000
million.
Standard & Poor's 400 (aka S&P Midcap)
Tracks 400 industrial stocks. Cap range: 85 million to 6.8
billion.
Standard & Poor's 100 (and OEX)
The S&P 100 is an index of 100 stocks. The "OEX" is the option on
this index, one of the most heavily traded options around.
Value Line Composite
See Martin Zweig's Winning on Wall Street for a good description.
It is a price-weighted index as opposed to a capitalization index.
Zweig (and others) think this gives better tracking of investment
results, since it is not over-weighted in IBM, for example, and
most individuals are likewise not weighted by market cap in their
portfolios (unless they buy index funds).
Wilshire 5000
The Wilshire 5000 consists of all US-headquartered companies for
which prices are readily available. This historically has excluded
pink sheet companies, but as the technology for data delivery has
improved, so has the list of names in the index, now over 7000.
Needless to say, some of these are quite small. The index is
capitalization weighted. Since several companies included in the
S&P 500 are headquartered outside of the U.S., it is not true that
the Wilshire 5000 contains the S&P 500. For more information about
the Wilshire indexes, visit their web site:


Non-US Indexes:

CAC-40 (France)
The CAC-Quarante, this is 40 stocks on the Paris Stock Exchange
formed into an index. The futures contract on this index is
probably the most heavily traded futures contract in the world.
DAX (Germany)
The German share index DAX tracks the 30 most heavily traded stocks
(based on the past three years of data) on the Frankfurt exchange.
FTSE-100 (Great Britain)
Commonly known as 'footsie'. Consists of a weighted arithmetical
index of 100 leading UK equities by market capitalization.
Calculated on a minute-by-minute basis. The footsie basically
represents the bulk of the UK market activity.
Nikkei (Japan)
"Nikkei" is an abbreviation of "nihon keizai" -- "nihon" is
Japanese for "Japan", while "keizai" is "business, finance,
economy" etc. Nikkei is also the name of Japan's version of the
WSJ. The nikkei is sometimes called the "Japanese Dow," in that it
is the most popular and commonly quoted Japanese market index.
JPN JPN is a modified price-weighted index that measures the aggregate
performance of 210 common stocks actively traded on the Tokyo Stock
Exchange that are representative of a broad cross section of
Japanese industries. Japanese prices are translated without a
currency conversion, so the index is not directly affected by
dollar/yen changes. JPN is closely related, but not identical, to
the Nikkei Index. Options are traded on US exchanges.
Europe, Australia, and Far-East (EAFE)
Compiled by Morgan Stanley.



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

Subject: Stocks - Market Volatility Index (VIX)

Last-Revised: 26 Jan 2003
Contributed-By: Jack Krupansky (jack "at" finaxyz.com), Chris Lott (
contact me )

The Market Volatility Index (VIX) is a measure of implied volatility in
trading of S&P 100 futures (specifically the OEX futures contract) on
The Chicago Board Options Exchange. The index is calculated based on
the prices of 8 calls and puts on the OEX that expire in approximately
30 days. Values for VIX tend to be between 5 and 100.

So what is 'implied volatility'? To understand this, first consider the
factors that go into the pricing of options. One of them is
'volatility'. It's simply the extent to which the price of something
has changed over a year, measured as a percentage. An option on a more
volatile stock or future will be more expensive. But options are just
like any other asset and as really priced based on the law of supply and
demand. If there is an excess of supply compared to demand, the price
will drop. Conversely, if there is an excess of demand, the price
rises. Since all the other parameters of the option price are
predictable or measurable, the piece that relates to demand can be
isolated. It's called the 'implied volatility'. Any excess or deficit
of demand would suggest that people have a difference in expectation of
the future price of the underlying asset. In other words, the future or
'expected volatility' will tend to be different from the 'historic
volatility'.

The CBOE has a rather complex formula for averaging various options for
the S&P 100 futures to get a hypothetical, normalized, 'ideal' option.
The volatility component can be isolated from the the price of this
ideal option. That's VIX. Although both 'put' and 'call' options are
included in the calculation, it is the 'put' options that lead to most
of the excess demand that VIX measures.

The VIX is said to to measure market sentiment (or, more interestingly,
to indicate the level of anxiety or complacency of the market). It does
this by measuring how much people are willing to pay to buy options on
the OEX, typically 'put' options which are a bet that the market will
decline. When everything is wonderful in the world, nobody wants to buy
put insurance, so VIX has a low value. But when it looks like the sky
is falling, everybody wants insurance in spades and VIX heads for the
moon. Practically, even in the most idyllic of times, VIX may not get
below 12 or 13. And even in the worst of panics, in 1998, VIX did not
break much above 60.

Many view the VIX as a contrarian indicator. High VIX values such as 40
(reached when the stock market is way down) can represent irrational
fear and can indicate that the market may be getting ready to turn back
up. Low VIX values such as 14 (reached when the market is way up) can
represent complacency or 'irrational exuberance' and can indicate the
the market is at risk of topping out and due for a fair amount of profit
taking. There's no guarantee on any of this and VIX is not necessarily
by itself a leading indicator of market action, but is certainly an
interesting indicator to help you get a sense of where the market is.

Here are some additional resources for the VIX:
* The current VIX number from Yahoo Finance

* A brief explanation from the CBOE
Options Corner of 30 Aug 2001
* James B. Bittman's book (at Amazon.com) on Trading Index Options

For more insights from Jack Krupansky, please visit his web site:



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

Subject: Stocks - Investor Rights Movement

Last-Revised: 24 Jun 1997
Contributed-By: Bob Grumbine (rgrumbin at nyx.net), Chris Lott ( contact
me )

The investor rights movement (sometimes called shareholder rights or
shareholder activism) involves people who try to use their shares to
make publically traded companies more accountable to their shareholders.
(Please don't confuse this issue with the topic of the rights of an
individual investor with respect to the broker or brokerage firm in case
of disputes, etc.) One of the most common goals that current investor
rights activists aim for is changing the election process of company
boards of directors so that each and every director is elected at once,
as opposed to the stagger system that is commonly used.

This article will give you a sense of the flavor, color, and some of the
directions of what's currently going on in the area of stockholder
rights. The key points: (1) you must have your shares registered in
your own name to have any real chance of participating; (2) having
gotten your shares registered, you need to read in detail every proposal
in the proxy statements sent by the companies (or by others in some
cases), to determine how to vote your own shares; and (3) if you have
the time and energy to attend some annual meetings personally, you
yourself can become a stockholder rights activist, voting not only your
own shares but any others for which you obtain proxies and, subject to
certain rules and procedures, even having your proposal(s) printed in
the annual proxy statements for other shareholders to read and vote
upon.

Ok, now the details. The absolute best sources of information about
investor rights activists are the proxy statements which each and every
one of the companies in which you own stock are required to send to you
each and every year as part of their process of getting their in-house
chosen directors elected. Some names stand out clearly as being the
kind of people you are looking for.

Ever since I was knee-high to a ticker tape, I have admired the work of
the Gilbert brothers and Wilma Soss, three of the longest-term most
dedicated activists for investor rights ever to grace the annual
meetings of major corporations. It has been more than 35 years since I
was knee-high to a ticker tape, so Lewis D. Gilbert and Wilma Soss have
both passed on. However, John J. Gilbert remains alive, well, and
active in promoting the stockholder right of cumulative voting for
directors, so that even in the most monolithic corporations held largely
by trustees indifferent to the legitimate interests of the real owners
of the shares, there can be elected at least some voice for the rights
and interests of actual owners.

A more recent activist on the single crucial issue of reinstating the
election of directors annually , instead of the stagger system, has been
Mrs. Evelyn Y. Davis, Watergate Office Building, 2600 Virginia Avenue
N.W., Suite 215, Washington, D.C. 20037. As in fact it has been used
in far too many instances, the stagger system facilitates incompetent or
malicious managers keeping effective control of boards of directors for
at least two years and sometimes longer beyond the time it becomes
obvious to stockholders that the existing board is acting outrageously
against the interests of the owners of the company. As she points out
in one of her proxy proposals, "the great majority of New York Stock
Exchange listed corporations elect all their directors each year" which
"insures that all directors will be more accountable to all shareholders
each year and to a certain extent prevents the self-perpetuation of the
Board." Rationally behaving directors have no legitimate worry about
getting elected every year. It is only those who are doing wrong
against the owners, or who intend to do so, who have any need for the
"stability" hogwash that so many staggered board companies spew forth as
justification for their anti-stockholder provisions.

Along with the general purpose activists, there are frequently holders
of stock in particular companies, sometimes even former officers or
directors, who conclude that the current actions or inactions of the
existing set of officers and directors are just plain wrong and need to
be redirected or changed, usually in some quite specific ways. To find
out about any of these you really must have your shares in all of the
companies that you own registered in your own name , so that you
yourself appear on the stockholder lists. To be sure, some of the
better quality brokers do make an effort to pass along mailings which
they are requested to send to you by the companies you own but in which
they hold the actual shares. Even those better quality people are
usually very delayed and you're going to miss most or all of the
individual company activists who see brokerage house shares as being
owned by people who just plain don't care about the real companies and
who aren't likely to read or understand any of the issues involved.
Rightly or wrongly, that does seem to be their view, and if you are
someone who actually does care about the companies you own, getting your
shares registered in your own name is the only way you're really going
to have a chance of being kept informed about what's going on.

Along with some who really are, or who have purported to be, concerned
about investor rights, you will also find many things included in the
proxy statements which look to me to be part of an "investor wrongs"
movement. I refer to things such as religious bigot groups insisting
that no American company do business with the nationals of any nation
which does not welcome their peculiar bigotries with open arms. I've
run across (and seen in action at annual meetings) so many of those
malicious anti-business twits, that I do feel the need to caution you
that not every proponent of issues for the annual stockholder's meeting
has even considered (1) the best interests of the company, (2) the best
interests of any stockholders other than their own peculiar set of
bigots, or (3) the fundamentally rational requirements for business
organizations to do business anywhere, let alone on a multinational
scale of activities. Just a cautionary note that I think desirable,
having referred you to the proxy statements as a source of contacts.

For more information on shareholder rights and activism, try these
sites:
* Corporate Governance: enhancing wealth creation through increased
accountability.

* Greenway Partners, shareholder activism for the 1990's and beyond.

* Infoseek's index.

* LENS is an activist money manager.



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

Subject: Stocks - Initial Public Offerings (IPOs)

Last-Revised: 7 Nov 1995
Contributed-By: Art Kamlet (artkamlet at aol.com), Bill Rini (bill at
moneypages.com)

This article is divided into four parts:
1. Introduction to IPOs
2. The Mechanics of Stock Offerings
3. The Underwriting Process
4. IPO's in the Real World

1. Introduction to IPOs

When a company whose stock is not publicly traded wants to offer that
stock to the general public, it usually asks an "underwriter" to help it
do this work. The underwriter is almost always an investment banking
company, and the underwriter may put together a syndicate of several
investment banking companies and brokers. The underwriter agrees to pay
the issuer a certain price for a minimum number of shares, and then must
resell those shares to buyers, often clients of the underwriting firm or
its commercial brokerage cousin. Each member of the syndicate will
agree to resell a certain number of shares. The underwriters charge a
fee for their services.

For example, if BigGlom Corporation (BGC) wants to offer its privately-
held stock to the public, it may contact BigBankBrokers (BBB) to handle
the underwriting. BGC and BBB may agree that 1 million shares of BGC
common will be offered to the public at $10 per share. BBB's fee for
this service will be $0.60 per share, so that BGC receives $9,400,000.
BBB may ask several other firms to join in a syndicate and to help it
market these shares to the public.

A tentative date will be set, and a preliminary prospectus detailing all
sorts of financial and business information will be issued by the
issuer, usually with the underwriter's active assistance.

Usually, terms and conditions of the offer are subject to change up
until the issuer and underwriter agree to the final offer. The issuer
then releases the stock to the underwriter and the underwriter releases
the stock to the public. It is now up to the underwriter to make sure
those shares get sold, or else the underwriter is stuck with the shares.

The issuer and the underwriting syndicate jointly determine the price of
a new issue. The approximate price listed in the red herring (the
preliminary prospectus - often with words in red letters which say this
is preliminary and the price is not yet set) may or may not be close to
the final issue price.

Consider NetManage, NETM which started trading on NASDAQ on Tuesday, 21
Sep 1993. The preliminary prospectus said they expected to release the
stock at $9-10 per share. It was released at $16/share and traded two
days later at $26+. In this case, there could have been sufficient
demand that both the issuer (who would like to set the price as high as
possible) and the underwriters (who receive a commission of perhaps 6%,
but who also must resell the entire issue) agreed to issue at 16. If it
then jumped to 26 on or slightly after opening, both parties
underestimated demand. This happens fairly often.

IPO Stock at the release price is usually not available to most of the
public. You could certainly have asked your broker to buy you shares of
that stock at market at opening. But it's not easy to get in on the
IPO. You need a good relationship with a broker who belongs to the
syndicate and can actually get their hands on some of the IPO. Usually
that means you need a large account and good business relationship with
that brokerage, and you have a broker who has enough influence to get
some of that IPO.

By the way, if you get a cold call from someone who has an IPO and wants
to make you rich, my advice is to hang up. That's the sort of IPO that
gives IPOs a bad name.

Even if you that know a stock is to be released within a week, there is
no good way to monitor the release without calling the underwriters
every day. The underwriters are trying to line up a few large customers
to resell the IPO to in advance of the offer, and that could go faster
or slower than predicted. Once the IPO goes off, of course, it will
start trading and you can get in on the open market.

2. The Mechanics of Stock Offerings

The Securities Act of 1933, also known as the Full Disclosure Act, the
New Issues Act, the Truth in Securities Act, and the Prospectus Act
governs the issue of new issue corporate securities. The Securities Act
of 1933 attempts to protect investors by requiring full disclosure of
all material information in connection with the offering of new
securities. Part of meeting the full disclosure clause of the Act of
1933, requires that corporate issuers must file a registration statement
and preliminary prospectus (also know as a red herring) with the SEC.
The Registration statement must contain the following information:

* A description of the issuer's business.
* The names and addresses of the key company officers, with salary
and a 5 year business history on each.
* The amount of ownership of the key officers.
* The company's capitalization and description of how the proceeds
from the offering will be used.
* Any legal proceedings that the company is involved in.

Once the registration statement and preliminary prospectus are filed
with the SEC, a 20 day cooling-off period begins. During the
cooling-off period the new issue may be discussed with potential buyers,
but the broker is prohibited from sending any materials (including Value
Line and S&P sheets) other than the preliminary prospectus.

Testing receptivity to the new issue is known as gathering "indications
of interest." An indication of interest does not obligate or bind the
customer to purchase the issue when it becomes available, since all
sales are prohibited until the security has cleared registration.

A final prospectus is issued when the registration statement becomes
effective (when the registration statement has cleared). The final
prospectus contains all of the information in the preliminary prospectus
(plus any amendments), as well as the final price of the issue, and the
underwriting spread.

The clearing of a security for distribution does not indicate that the
SEC approves of the issue. The SEC ensures only that all necessary
information has been filed, but does not attest to the accuracy of the
information, nor does it pass judgment on the investment merit of the
issue. Any representation that the SEC has approved of the issue is a
violation of federal law.

3. The Underwriting Process

The underwriting process begins with the decision of what type of
offering the company needs. The company usually consults with an
investment banker to determine how best to structure the offering and
how it should be distributed.

Securities are usually offered in either the new issue, or the
additional issue market. Initial Public Offerings (IPO's) are issues
from companies first going public, while additional issues are from
companies that are already publicly traded.

In addition to the IPO and additional issue offerings, offerings may be
further classified as:

* Primary Offerings: Proceeds go to the issuing corporation.
* Secondary Offerings: Proceeds go to a major stockholder who is
selling all or part of his/her equity in the corporation.
* Split Offerings: A combination of primary and secondary offerings.
* Shelf Offering: Under SEC Rule 415 - allows the issuer to sell
securities over a two year period as the funds are needed.

The next step in the underwriting process is to form the syndicate (and
selling group if needed). Because most new issues are too large for one
underwriter to effectively manage, the investment banker, also known as
the underwriting manager, invites other investment bankers to
participate in a joint distribution of the offering. The group of
investment bankers is known as the syndicate. Members of the syndicate
usually make a firm commitment to distribute a certain percentage of the
entire offering a nd are held financially responsible for any unsold
portions. Selling groups of chosen brokerages, are often formed to
assist the syndicate members meet their obligations to distribute the
new securities. Members of the selling group usually act on a " best
efforts" basis and are not financially responsible for any unsold
portions.

Under the most common type of underwriting, firm commitment, the
managing underwriter makes a commitment to the issuing corporation to
purchase all shares being offered. If part of the new issue goes
unsold, any losses are distributed among the members of the syndicate.

Whenever new shares are issued, there is a spread between what the
underwriters buy the stock from the issuing corporation for and the
price at which the shares are offered to the public (Public Offering
Price, POP). The price paid to the issuer is known as the underwriting
proceeds. The spread between the POP and the underwriting proceeds is
split into the following components:

* Manager's Fee: Goes to the managing underwriter for negotiating and
managing the offering.
* Underwriting Fee: Goes to the managing underwriter and syndicate
members for assuming the risk of buying the securities from the
issuing corporation.
* Selling Concession - Goes to the managing underwriter, the
syndicate members, and to selling group members for placing the
securities with investors.

The underwriting fee us usually distributed to the three groups in the
following percentages:

* Manager's Fee 10% - 20% of the spread
* Underwriting Fee 20% - 30% of the spread
* Selling Concession 50% - 60% of the spread

In most underwritings, the underwriting manager agrees to maintain a
secondary market for the newly issued securities. In the case of "hot
issues" there is already a demand in the secondary market and no
stabilization of the stock price is needed. However many times the
managing underwriter will need to stabilize the price to keep it from
falling too far below the POP. SEC Rule 10b-7 outlines what steps are
considered stabilization and what constitutes market manipulation. The
managing underwriter may enter bids (offers to buy) at prices that bear
little or no relationship to actual supply and demand, just so as the
bid does not exceed the POP. In addition, the underwriter may not enter
a stabilizing bid higher than the highest bid of an independent market
maker, nor may the underwriter buy stock ahead of an independent market
maker.

Managing underwriters may also discourage selling through the use of a
syndicate penalty bid. Although the customer is not penalized, both the
broker and the brokerage firm are required to rebate the selling
concession back to the syndicate. Many broke rages will further
penalize the broker by also requiring that the commission from the sell
be rebated back to the brokerage firm.

4. IPO's in the Real World

Of course knowing the logistics of how IPO's come to market is all fine
and dandy, but the real question is, are they a good investment? That
does tend to be a tricky issue. On one hand there are the Boston
Chickens and Snapples that shoot up 50% or 100%. But then there is the
research by people like Tim Loughran and Jay Ritter that shows that the
average return on IPO's issued between 1970 and 1990 is a mere 5%
annually.

How can the two sides of this issue be so far apart? An easy answer is
that for every Microsoft, there are many stocks that end up in
bankruptcy. But another answer comes from the fact that all the
spectacular stories we hear about the IPO market are usually basing the
percentage increase from the POP, and the Loughran and Ritter study uses
purchase prices based on the day after the offering hit the market.

For most investors, buying shares of a "hot" IPO at the POP is next to
impossible. Starting with the managing underwriter and all the way down
to the investor, shares of such attractive new issues are allocated
based on preference. Most brokers reserve whatever limited allocation
they receive for only their best customers. In fact, the old joke about
IPO's is that if you get the number of shares you ask for, give them
back, because it means nobody else wants it.

While the deck may seem stacked against the average investor. For an
active trader things may not be as bad as they appear. The Loughram and
Ritter study assumed that the IPO was never sold. The study does not
take into account an investor who bought an issue like 3DO (THDO -
NASDAQ), the day after the IPO and sold it in the low to mid 40's,
before it came crashing down. Obviously opportunities exist, however
it's not the easy money so often associated with the IPO market.

Portions of this article are copyright 1995 by Bill Rini.


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Subject: Stocks - Mergers

Last-Revised: 9 Apr 1997
Contributed-By: George Regnery (regnery at yahoo.com)

When one firm takes another over, or merges with another, a number of
things can happen to the firm's shares. The answer is, it depends.

In some cases, the shares of one company are converted to shares of the
other company. For instance, 3Com announced in early 1997 that it was
going to purchase US Robotics. Every US Robotics shareholder will
receive 1.75 shares of 3Com stock.

In other cases, one company simply buys all of the other company's
shares. It pays cash for these shares.

Another possibility, not very common for large transactions, is for one
company to purchase all the assets of another company. Company X buys
all of Company Y's assets for cash, which means that Company Y will have
only cash (and debt, if they had debt before). Of course, then company
Y is merely a shell, and will eventually move into other businesses or
liquidate.


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Subject: Stocks - Market Capitalization

Last-Revised: 11 Mar 1997
Contributed-By: Chris Lott ( contact me )

The market capitalization (or "cap") of a stock is simply the market
value of all outstanding shares and is computed by multiplying the
market price by the number of outstanding shares. For example, a
publically held company with 10 million shares outstanding that trade at
US$20 each would have a market capitalization of 200 million US$.

The value for a stock's "cap" is used to segment the universe of stocks
into various chunks, including large-cap, mid-cap, small-cap, etc.
There are no hard-and-fast rules that define precisely what it means for
a company to be in one of these categories, but there is some general
agreement. The Motley Fool offers these guidelines:
* Large-cap: Over $5 billion
* Mid-cap: $500 million to $5 billion
* Small-cap: $150 million to $500 million
* Micro-cap: Below $150 million According to these rules, the example
listed above would be a small-cap stock.

When reading a mutual fund prospectus, you may see the term "median
market cap." This is just the median of the capitalization values for
all stocks held by the fund. The median value is the middle value;
i.e., half the stocks in the fund have a market capitalization value
below the median, and the other half above the median. This value helps
you understand whether the fund invests primarily in huge companies, in
tiny companies, or somewhere in the middle.


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

Subject: Stocks - Outstanding Shares and Float

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

Data that are frequently reported about a stock are the number of shares
outstanding and the float. These two bits of information are not the
same thing, although they are closely related. In a nutshell, the
outstanding shares are those held by the public (but possibly restricted
from trading), and the float is the number of shares held by the public
and available to be traded.

If that was not clear, let's begin at the beginning. When a company
incorporates, the articles of incorporation state how many shares are
authorized. For example, the company NotLosingMoney.com could
incorporate and have 1,000,000 (one million) shares. This is the number
of authorized shares. At the moment of incorporation, these shares are
held in the company treasury (at least that's what people say); the
number of outstanding shares and the float are both zero.

Next our example company sells some percentage of the authorized shares
to the public, possibly via an inital public offering (IPO). The
company chooses to sell 10% of the authorized shares to the public. In
addition, as part of going public, the company grants 10% of the
authorized shares to employees etc., but these people cannot sell their
shares for six months. So after the IPO, the public (i.e., not the
company) holds 200,000 shares, and the rest is in the treasury. So we
say that the number of shares outstanding is 200,000. However, due to
various restrictions placed on the employees, their share holdings
cannot be traded. While the restriction on insiders (commonly called a
lockup) is in force, just 100,000 shares are available for trading, and
the float is just 100,000 shares.

You may have heard the term "thin float" in connection with an IPO.
This refers to the practice of allowing just a small percentage of the
authorized shares to be sold to the public in the IPO. In cases where
demand was high (and the supply was artificially low), the result was
large jumps in price on the first day of trading.

When a company buys back its own shares on the open market and returns
these shares to the company treasury, this reduces both the float and
the number of outstanding shares. If a company has sufficient cash to
purchase shares, in theory these purchases could eventually buy all the
shares outstanding, which is essentially the same as taking the company
private.

Perhaps it is obvious, but when a company splits its shares, the number
of authorized shares is affected by the split. For example, if a large
company had 100 million shares authorized and implemented a 2 for 1
split, then after the split the company has 200 million shares
authorized.


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Subject: Stocks - Preferred Shares

Last-Revised: 22 Oct 97
Contributed-By: John Schott (jschott at voicenet.com)

Preferred stocks combine characteristics of common stocks and bonds.
Garden-variety preferred shares are a lot like general obligation
bonds/debentures; they are called shares, but carry with them a set
dividend, much like the interest on a bond. Preferred shares also do
not normally vote, which distinguishes them from the common shares.
While today there are a lot of different kinds of hybrid preferred
issues, such as a call on the gold production of Freeport McMoran Copper
and Gold to the point where they will deliver it, this article will
consider characteristics of the most ordinary variety of preferred
shares.

In general, a preferred has a fixed dividend (as a bond pays interest),
a redemption price (as a bond), and perhaps a redemption date (like a
bond). Unlike a stock, it normally does not participate in the
appreciation (or drop) of the common stock (it trades like a bond).
Preferreds can be thought of as the lowest-possible grade bonds. The
big point is that the dividend must be paid from after-tax money, making
them a very expensive form of capitalization.

One difference from bonds is that in liquidation (e.g. following
bankruptcy), bond holder claims have priority over preferred shares,
which in turn have priority over common shares (in that sense, the
preferred shares are "preferred"). These shares are also preferred
(hence the name) with respect to payment of dividends, while common
shares may have a rising, falling or omitted dividends. Normally a
common dividend may not be paid unless the preferred shares are fully
paid. In many cases (sometimes called "cumulative preferred"), not only
must the current preferred dividend be paid, but also any missed
preferred dividends (from earlier time periods) must be made up before
any common dividend may be paid. (My father once got about a $70
arrearage paid just because Jimmy Ling wanted to pay a $0.10 dividend on
his common LTV shares.)

Basically, preferreds stand between the bonds and the common shares in
the pecking order. So if a company goes bankrupt, and the bond holders
get paid off, the preferreds have next call on the assets - and unless
they get something, the common shareholders don't either.

Some preferred shares also carry with them a conversion privilege (and
hence may be called "convertible preferred"), normally at a fixed number
of shares of common per share of preferred. If the value of the common
shares into which a preferred share may be converted is low, the
preferred will perform price-wise as if it were a bond; that is often
the case soon after issue. If, however, the common shares rise in value
enough, the value of the preferred will be determined more by the
conversion feature than by its value as a pseudo-bond. Thus,
convertible preferred might perform like a bond early in its life (and
its value as a pseudo-bond will be a floor under its price) and, if all
goes well, as a (multiple of) common stock later in its life when the
conversion value governs.

And as time has gone on, even more elaborate variations have been
introduced. The primary reason is that a firm can tailor its cost of
funds between that of the common stock and bonds by tailoring a
preferred issue. But it isn't a bond on the books - and it costs more
than common stock.

In general, you won't find a lot of information on the preferred shares
anywhere. Since they are in a never-never land, it is hard to analyze
them (they are usually somewhere low on the equity worth scale from the
common and bonds). So they can't really carry a P/E and the like.
Unfortunately, most come with the equivalent of the bonds indenture -
that is the "fine print" and you may have to get and read it to see just
what you have. (I once had preferreds that paid dividends in more
shares of itself and in shares of another preferred, but how Interco got
itself into bankruptcy is another story.)

There are other reasons why preferreds are issued and purchased. A lot
of convertibles are held by people who want to participate in the rise
of a hot company, but want to be insulated from a drop should it not
work out. Here's a different strategy. For example, I've got some
Williams Brothers Preferreds. They pay about 8.5% and are callable in
Fall, 1997. When I bought them (some years ago), they had just been
issued and were unrated (likely still are not). But Williams itself is
a well-run company with strong cash flow that then needed the money fast
to buy out a customer who was in trouble. So I bought these shares more
as I'd buy a CD. The yield is high, the firm solid - and likely they
will pull my investment out from under me someday. Meanwhile, it forms
a bit of my "ready cash" account. And I can always sell it if I want
to.

Problem is, with so many variants, there isn't always a preferred that
you'd want to buy at the current price to carry out some specific
strategy. Naturally, not every firm has them, the issues are often
thinly traded and may not trade on the exchange of the parent firms
common (or even be listed on any exchange).

If the preferred shares get called (i.e., converted), you normally
collect just as if common shares are bought out - in cash, no deduction.


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

Subject: Stocks - Price Basis

Last-Revised: 28 Oct 1997
Contributed-By: George Regnery (regnery at yahoo.com)

This article presents a bit of finance theory, namely the basis for a
stock's price.

A stock's price is equal to the net present value (NPV) of all expected
future dividends. (See the article elsewhere in the FAQ for an
explanation of the time value of money and NPV.) A company will plow its
earnings back into the company when it believes it can use this money
better than its investors, i.e., when the investment opportunities it
has are better than its investors have available. Eventually, the
company is going to run out of such projects: it simply won't be able to
expand forever. When it gets to the point where it cannot use all of
its earnings, either the company will pay dividends, it will build up a
cash mountain, or it will squander the money. If a company builds a
cash mountain, you'll see some investors demand higher dividends, and/or
the company management will waste the money. Look at Kerkorian and
Chrysler.

Sure, there are some companies that have recently built up a cash
mountain. Microsoft, for instance. But Gates owns a huge chunk of
Microsoft, and he'd have to pay 39.6% tax on any dividend, whereas he'd
have to pay only 28% (or perhaps 20%) on capital gains. But eventually,
Microsoft is going to pay a dividend on its common shares.

From a mathematical perspective, it's quite clear that a stock price is
equal to the NPV of all future dividends. For instance, the stock price
today is equal to the NPV of the dividends during the first year, plus
the discounted value of the stock in a year's time. In other words,
P(0) = PV (Div 1) + P(1). But the price in a year is equal to the NPV
of dividends paid during the second year plus the PV of the stock at the
end of two years. If you keep applying this logic, then the stock price
will become equivalent to the NPV of all future dividends. Stocks don't
mature like bonds do.

Of course it's also true that a stock's price is equal to whatever the
market will bear, pure supply and demand. But this doesn't mean a
stock's price, or a bond's price for that matter, can't have a price
that is determined by a formula. (Unfortunately, no formula is going to
tell you what dividend a company will pay in 5 years.) A bond's price is
equal to the NPV of all coupon payments plus the PV of the final
principal payment. (You discount at an appropriate rate for the risk
involved). Any investment's price is going to be equal to the NPV of
all future cash flows generated by that investment, and of course you
have to discount at the correct discount rate. The only cash flows that
investors in stocks get are from the dividends. If the price is not
equal to the NPV of all future cash flows, then someone is leaving money
on the table.


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Subject: Stocks - Price Tables in Newspapers

Last-Revised: 21 Apr 1997
Contributed-By: Bruce A. Werner (BruceWerner at yahoo.com), Chris Lott
( contact me )

Stock prices from the previous day's trading are printed in tables in
most newspapers Tuesday through Saturday, and the week's activity is
commonly summarized on Sunday. These tables use an extremely
abbreviated format, including footnotes to indicate various situations.
The tables are distributed by the Associated Press.

This article lists the most commonly used footnotes about stock prices,
the stock itself, and dividends (three parts in the following table), so
if your newspaper doesn't explain its tables, this might help. Sources
consulted for this information include the Baltimore Sun, the New Jersey
Star-Ledger, and others; your local paper will probably be similar,
although typesetting tricks like boldface etc. may vary across
different papers. The long and the short of it is you want your
companies to have lots of u's and never anything that starts with v (you
have to wonder about the use of adjacent letters).

Footnote Explanation
Price
d Price is a new 52-week low
u Price is a new 52-week high
x Ex-dividend (ex-rights) price
y Ex-dividend and sales in full
z Sales in full
Stock
g Dividend or earnings in Canadian currency
n New issue in the past 52 weeks (i.e., the high/low aren't true 52-week
figures)
pf Preferred shares
pp Holder owes installments of purchase price
rt Rights
s Split or stock dividend of more than 25% in the past 52 weeks
un Units
v Trading was halted on the primary market
vj Bankrupt, reorganizing, etc.
wd When distributed
wi When issued
wt Warrants
ww With warrants
xw Without warrants
Dividend
a Also extra(s)
b Annual rate plus stock div.
c Liquidating div.
e Declared or paid in preceding 12 months.
f Annual dividend rate increased.
i Declared or paid after stock dividend or split up
j Paid this year, div. omitted, deferred or no action taken at last
div. meeting.
k Declared or paid this year, an accumulative issue with div. in
arrears
r Declared or paid in preceding 12 months plus stock div.
t Paid in stock in preceding 12 months, est. cash value on ex-div. or
ex-dist. date
Other
boldface Stock's price changed 5% or more from previous day
underline Stock's trading volume equalled or exceeded 2 percent of the
total number of shares outstanding.
triangle Stock reached a 52-week high (pointing up) or low (pointing
down)



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Subject: Stocks - Price Data

Last-Revised: 30 Jan 2002
Contributed-By: Chris Lott ( contact me )

Many people have asked me "how can I get the closing price for stock XY
on date Z." A common variant is to get the close of the Dow Jones
Industrial Average (or other stock index) for some given date or range.
The answer is that you need to find a provider of historical data (also
called historical quotes). If all you need is the open, close, and
volume for a stock on some date, you're in luck, because this is
available at no charge on the web (see below). However, if you want
detailed data suitable for detailed analysis, such as the full report of
every trade, you probably will have to pay for it.

Don't forget that the most reliable way to find a stock's price on a
given day is to visit a library with good newspaper archives. Look up
the newspaper for the following day (most likely on microfilm) and print
the section from the financial pages where the closing price appears.
Print that page, and be sure to print the portion of the page showing
the date. This may be the best way for people who are trying to
establish a cost basis for some shares of stock.

Yahoo's historical stock price data goes back to about 1970. You can
download the data in spreadsheet format. They even use friendly ticker
symbols for the stock indexes (e.g., the ticker for the Dow Jones
Industrial Average is DJIA).



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Subject: Stocks - Replacing Lost Certificates

Last-Revised: 19 Feb 1998
Contributed-By: Richard Sauers (rsauers at enter.net), Bob Grumbine
(rgrumbin at nyx.net), Chris Lott ( contact me )

If a stock holder loses a stock certificate through fire, theft, or
whatever, shares registered in the stock holder's name (as opposed to
so-called "street name") can be replaced fairly quickly and easily.

To replace a lost certificate, begin by contacting the company's stock
transfer agent. If you don't know the transfer agent, contact the
company to find out; Value Line or Standard & Poor's Corporation Records
(probably available at your friendly local library) are a good source
for the contact addresses of the company itself.

Tell the transfer agent the approximate date the certificate was issued.
The transfer agent will ask you to post a bond, called a surety bond,
that indemnifies the transfer agent. The cost of the surety bond
required is typically 3% of the value of the certificate. (The transfer
agent will be able to recommend a surety company.) Once the bond is
posted, the transfer agent should be able to reissue the missing
certificate with no further ado.

If you hold shares in your name, you might consider preparing yourself
for this eventuality by keeping a copy of the stock certificate (it will
show the number, transfer agent, etc.) separate from the original.


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Subject: Stocks - Repurchasing by Companies

Last-Revised: 11 Nov 1996
Contributed-By: Bob Bose (bobbose at sover.net)

Companies may repurchase their own stock on the open market, usually
common shares, for many reasons. In theory, the buyback should not be a
short term fix to the stock price but a rational use of cash, implying
that a company's best investment alternative is to buy back its stock.
Normally these purchases are done with free cash flow, but not always.
What happens is that if earnings stay constant, the reduced number of
shares will result in higher earnings per share, which all else being
equal will result, should result, in a higher stock price.

But note that there is a difference between announcing a buyback and
actually buying back stock. Just the announcement usually helps the
stock price, but what really counts is that they actually buy back
stock. Just don't be fooled into believing that all "announced share
buybacks" are actually implemented. Some are announced just for the
short term bounce that usually comes with the announcement. Those types
of companies I would avoid as management is out to deceive their
shareholders.


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

Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 16 of 20)

am 30.05.2005 06:30:08 von noreply

Archive-name: investment-faq/general/part16
Version: $Id: part16,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 16 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: Tax Code - Non-Resident Aliens and US Holdings

Last-Revised: 26 Jan 2003
Contributed-By: Vladimir Menkov (vmenkov at cs.indiana.edu), Chris Lott
( contact me ), Enzo Michelangeli (em at who.net)

Non-resident aliens can hold investments in the United States quite
easily. A "non-resident alien" (NRA) is the U.S. government's name for
a citizen of a country other than the U.S. who also lives outside the
U.S. The only thing non-resident aliens have to be concerned about if
they have U.S. investments is taxation.

For example, if a non-U.S. national works in the U.S. for some period
of time and amasses a nice portfolio of stocks while here, that person
can hang on to the portfolio forever, no matter whether they continue to
live in the U.S. or not. But they will have to continue to deal with
the U.S. tax authority, the IRS.

Thanks to the U.S. Congress, the tax laws are complicated, and a
resident or nonresident alien must look carefully to find a tax advisor
who understands all the issues. Here's an overview.

A person is considered non-resident in the years when that person is in
the US fewer than 183 days; the actual rule is a little more complex,
and takes prior years into account; see IRS publication 519 for details.
Anyhow, in the years when a non-US citizen is considered a non-resident
for tax purposes, that person files the US tax return on form 1040 NR,
instead of regular 1040 (EZ, A), and pays tax on investment income
according to the following special rules.

* No tax on capital gains. This means that a brokerage or a mutual
fund should withhold nothing when selling shares. With respect to
mutual funds, long-term capital gain distributions are exempt as
well.
* No tax on bank interest. This means regular accounts with credit
unions, savings and loans, etc.
* No tax on portfolio interest. (It's not always easy to figure out
interest on what bonds qualifies as "portfolio interest", though.
Some readers have reported that brokerage firms are confused on
this issue, unfortunately.)
* 30% flat-rate tax on dividends. Generally this includes dividend
and short-term cap gain distributions by mutual funds. This rate
may be reduced by a tax treaty with your country of residence.
(Progressive taxation does not apply to NRAs; i.e., the first and
last dollars are taxed at the same rate.)
* 30% flat-rate tax on interest that neither is paid by a bank nor
qualifies as "portfolio interest." This rate may be reduced by a
tax treaty with the person's country of residence.
* No personal exemption or deductions can be applied against
investment income (which is, technically, "income not effectively
connected with your US trade or business"). Further, according to
the IRS, "if your sole U.S. business activity is trading
securities through a U.S. resident broker or other agent, you are
not engaged in a trade or business in the United States" so the
income is not effectively connected with a US trade or business.
* If the alien is a non-resident for the tax purposes in a given
year, but spends 183 days or more in the country, any capital gains
are also subject to the 30% flat tax. This is a fairly rare but
possible situation.

The issue of an investment paying dividends versus paying interest is
simple in case of stocks (dividends) and basic savings accounts
(interest), but what about money market accounts? Well, money-market
mutual funds pay dividends , while money-market bank accounts pay
interest , for the purposes of 1040 NR. However, if you have a money
market fund with a bank and the bank reports the income as dividends, it
is probably simplest to report the income exactly as the institution
reported it rather than try to fight it. I don't know why this isn't
straightforward, but for some reason it is not. For more information,
see IRS Publication 550, "Investment Income and Expenses." In the 2000
edition, the relevant language appears in the first column of page 5, in
the section "Interest Income," subsection "Taxable Interest - General."

Tax treaties are very important. If the individual's country of
residence has an agreement (tax treaty) with the US government, those
rules pretty much supersede the standard rules set by the Internal
Revenue Code. In particular, they often reduce the tax rate on interest
and dividend income.

While you are a non-resident alien, you are supposed to file Form W-8BEN
(it replaces older Forms W-8 and 1001) with each of your mutual funds or
brokers every 3 or 4 years, so that they will automatically withhold tax
from your investment income. Since you have to indicate your country of
residence for tax purposes on this form, the investment income payor
will know what tax treaty, if any, applies. In the spring, the payor
will send you a form 1042-S reporting your income, its type, and the tax
withheld.

If Forms W-8BEN have been filed and the appropriate tax has been
withheld, you won't need to send any money to the IRS with your 1040 NR
in April; in fact, you won't even need to file 1040 NR at all if you
don't have other US-source income. Note also that as a non-resident you
will not be eligible to claim standard deduction, or to claim married
status, or file form 1116 (foreign tax credit).

The IRS enacted some rules in late 2000 to establish "Qualified
Intermediary" status for foreign financial institutions. The rules did
not change tax liabilities, just made it more difficult for a person to
escape paying tax. To summarize, a financial institution must withhold
money from payments of US-source income to individuals outside the US
unless the institution qualifies for the newly introduced status of
"qualified intermediary", or unless the institution agrees to disclose
the list of all beneficiaries to the IRS. A financial institution is
eligible to apply for qualified intermediary status if it is in a
country that has been approved by the IRS as having acceptable
'know-your-customer' rules.

None of this discussion applies to resident aliens or to US citizens
living abroad. Once you are considered a bona fide resident of the
U.S., the tax rules that apply to U.S. citizens also apply to you.

Here are some IRS resources that offer all the details:
* IRS Publication 515, "Withholding of Tax on Non-Resident Aliens"

* IRS Publication 519, "U.S. Tax Guide for Aliens"

* IRS Publication 901, "Tax Treaties"

* IRS Tax Topic 851, "Resident and Nonresident Aliens"

* The IRS web site "Digital Daily" has a collection of information
for the International Taxpayer.

* The Digital Daily's area includes this article which focuses on the
taxation of capital gains Of nonresident aliens (the link is
unfortunately buried in another article).



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Subject: Tax Code - Reporting Option Trades

Last-Revised: 16 Aug 2000
Contributed-By: Michael Beyranevand (mlb2 at bryant.edu)

This article summarizes the rules for reporting gains and losses from
trading stock options. Like any other security transaction, even if you
get cash up front as in the case of shorting a stock or writing an
option, you do not declare a profit or loss until the transaction has
been closed out. Also note that ordinary options expire in 6 months or
less, so most gains or losses are short-term (but see below for an
exception in the case of writing covered calls). However, LEAPS can
have a lifetime of over 2 years (also see the article elsewhere in this
FAQ ), so gains or losses might be long-term for the purpose of the tax
code.



Buyers of Options
There are three different tax treatments that could occur when you
decide to buy a put or call option. The first is that you reverse
your position (sell the option) before the exercise date. If this
is the case, then you will have either a short-term (if held for
under 1 year) or long-term (if held for more than 1 year) capital
gain/loss to report.

The second tax treatment occurs if you allow the option to expire
unexercised. It would then be treated as either a short-term or
long-term loss based on the holding period of the option at the
expiration date.

The third tax treatment for buying options occurs when you decide
to exercise either your put or call option. If you exercise your
call (the right to buy stock) you add the cost of the call to the
cost basis of your stock. If you exercise a put (the right to sell
stock) then the cost of the put reduces your total amount realized
when figuring gain or loss on the sale of that stock.


Sellers of Options
There are also three tax treatments that could occur when you sell
a put or call option. The first possibility is that you reverse
your position on an option that you wrote. Then it would become
either be a short-term gain or loss. The difference between what
you sold it and bought it back at will determine the gain/loss
status.

The second possibility is that the option expires (it is not
exercised before the expiration date). In this scenario you would
report the premium received as a short-term capital gain in the
year the option expires.

The third situation is when the option is exercised (you are called
or put). In the case of a call, you add the premium to the sale
proceeds of the stock to determine a gain or loss on the sale of
the stock. The holding period of the stock (not the option!) will
determine if the gain is short term or long term. So if it was a
covered call, it might be short or long term. If it was a naked
call, the holding period will be brief (minutes?) and so it's a
short-term gain. In the case of a put that is exercised, the tax
situation is significantly more complex as compared to a call. To
determine if the premuim counts as income when the put is exercised
or if it just lowers the cost basis of the stock is determined by
many factors, just one of which is whether the put was in the money
or out of the money when it was written, and to what extent.
Novice put writers should consult with a professional tax advisor
for assistance.


For the last word on the tax implications of trading options, get IRS
Publication 550, _Investment Income and Expenses_.


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Subject: Tax Code - Short Sales Treatment

Last-Revised: 13 Aug 1999
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact
me )

Gains from a short-sale stock transaction are considered short-term
capital gains regardless of how long the position is held open. This
actually makes a kind of sense, since the only time you actually held
the stock was between when you bought the stock to cover the position
and when you actually delivered that stock to actually close the
position out. This length of time is somewhere from minutes to a few
days. (Please see articles elsewhere in this FAQ explaining short
sales, as well as long- and short-term capital gains.)

What do you do if a short sale is open at the end of a calendar year?
Brokerage houses report all sales (normal or short) on Form 1099-B as
"sales", so you might think that you have to report it on your Schedule
D to make the total sales number equal that reported to the IRS. But
since the position is still open, the sale was not a taxable event. You
sure don't want to pay tax on the amount of money you received when you
went short!

Here's one way to proceed. You can attach a statement along the
following lines to your Schedule D:



Attachment to 1998 Form 1040 Schedule D (Names & Social
security #)

Explanation of the difference between Forms 1099-B and
Schedule D Sales totals:

Forms 1099-B include $XXXX of short sales which were opened in
1998 and remained open on 31 December 1998.


Forms 1099-B Totals: $YYYY
less short positions
opened during 1998
remnaining open 12/31/98 ( $XXXX )
_______
Adjustment (if any) $WWWW
________
Schedule D Sales Totals $ZZZZ


Note that when the short positions are finally closed out, the brokerage
house will not make any indication on that year's 1099-B, but that's the
year when you have to report the gains or losses realized in the
transaction.


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Subject: Tax Code - Tax Swaps

Last-Revised: 12 Aug 1996
Contributed-By: Bill Rini (bill at moneypages.com), and other anonymous
contributors

A tax swap is an investment strategy usually designed for municipal bond
portfolios. It is designed to allow you to take a tax loss in your
portfolio while at the same time adjusting factors such as credit
quality, maturity, etc. to better meet your current needs and the
outlook of the market. A tax swap can create a capital loss for tax
purposes, can maintain or enhance the overall credit quality of your
portfolio, and can increase current income.

It's important to note that tax swaps are not for everyone. And as
always, you should consult with a tax professional before making any
investment desicion that is designed to produce tax benefits.

Here is an example of a hypothetical tax swap. I have not factored
accrued interest to keep the calculations fairly simple.

Current Bond - You will sell this bond to generate a capital loss.

$10,000 par value "ABC" Tax Free bond, A rated, with a coupon of 4.70%.
maturing 09/01/03 originally purchased for $10,000 (100) but with a
current market value of only $9030 (90.30).

Replacement Bond - The bond you will buy to replace your current bond.

$10,000 par value "XYZ" Tax Free bond, AAA rated, with a coupon of 5.20%
maturing 12/01/12 The current selling price of this bond is $8724
(87.24)
Sell "ABC" Bond $9030.00
Buy "XYZ" Bond $8724.00
--------
Difference: $306.00
The tax swap accomplished the following. First, you received $306.00
cash. Second, you upgraded the credit quality of your single-bond
portfolio from A to AAA. Third, you generated a capital loss of $970.00
(original purchase price minus the selling price). Fourth, you've
increased the bond's maturity and coupon, so its duration will be
greater. This swap will increase the portfolio's sensitivity to
interest rate changes, which may or may not be what the investor had in
mind. In particular, it might be not appropriate for a short-term
investment. If the bond is held to maturity, then no risk is assumed
other than default risk. (Although unrealized value would change
wildly, and perhaps that's taxable in some circumstance).

Portions of this article are copyright 1995 by Bill Rini.


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

Subject: Tax Code - Uniform Gifts to Minors Act (UGMA)

Last-Revised: 15 Feb 2001
Contributed-By: Art Kamlet (artkamlet at aol.com), Aaron Schindler, Mark
Eckenwiler, Brian Mork, Rich Carreiro (rlcarr at
animato.arlington.ma.us)

The Uniform Gifts to Minors Act (UGMA), called the Uniform Transfers to
Minors Act (UTMA) in some states, is simply a way for a minor to own
securities.

The UGMA/UTMA setup is commonly used to give monies to a minor. IRS
regulations allows a person to give many thousands of dollars per year
to any other person with no tax consequences (please see the FAQ article
on Estate and Gift Tax for current numbers). If the recipient is a
minor, the UGMA provides a way for the minor to own the assets without
involving an attorney to establish a special trust. When giving assets
to a minor using a UGMA/UTMA, the donor must appoint a custodian (the
trustee).

An UGMA/UTMA is a trust like any other trust except that the terms of
the trust are set in the state statute instead of being drawn up in a
trust document. Should a trustee fail to comply with the terms of the
UGMA/UTMA, this would expose the trustee to the same actions as a
trustee who fails to comply with the terms of a special drawn-up trust.

Why is a UGMA useful? The UGMA/UTMA offers a straightforward way for a
minor to own securities. In most (all?) states, minors do not have the
right to contract. So a minor could not be bound by any broker's
account agreement. If a broker took a minor's account, the minor, upon
reaching majority, could repudiate any losing trades and make the broker
eat them. Thus brokers and fund companies once refused to take minor's
accounts. UGMA/UTMA was basically a way of providing a form of
ownership that got around this problem, without forcing people to go
through the expense of having an attorney draw up a special trust.

To establish a UGMA/UTMA account, go to your friendly neighborhood
stockbroker, bank, mutual fund manager, or (close your eyes now: S&L),
etc. and say that you wish to open a Uniform Gifts (in some states
"Transfers") to Minors Act account.

You register it as:

[ Name of Custodian ] as custodian for [ Name of Minor ] under
the Uniform Gifts/Transfers to Minors Act - [ Name of State of
Minor's residence ]



You use the minor's social security number as the taxpayer ID for this
account. When you fill out the W-9 form for this account, it will show
this form. The custodian should certify the W-9 form.

The money now belongs to the minor and the custodian has a legal
fiduciary responsibility to handle the money in a prudent manner for the
benefit of the minor.

Handling the money "in a prudent manner" means that the custodian can
buy common stocks but cannot write naked options. The custodian cannot
"invest" the money on the horses, planning to donate the winnings to the
minor. And when the minor reaches the age at which the UGMA becomes
property of the minor (who is either 18 or 21 depending on the state and
not a minor any loger), the minor can claim all of the funds even if
that's against the custodian's wishes. Neither the donor nor the
custodian can place any conditions on those funds once the minor becomes
an adult.

You may be concerned about preventing a minor from blowing the college
fund on a Trans Am the moment the minor attains the turnover age and the
money is under their control. Legally there is nothing the custodian
(or anyone else) can do. Some may sugggest that a UGMA account can be
hidden from a minor, but this is a problem for two reasons. First, any
minor over age 14 is expected to sign his or her tax return and thus has
a good chance to notice the income from the account. Second and more
seriously, if the custodian fails to turn over money that is due to the
UGMA beneficiary, he or she breaches the statutory trust terms and is
liable for the consequences of that failure, just as any other trustee
would be, which may include surcharges and other sanctions from a court.

If it is any consolation, some states allow the donor to establish a
"turnover" age of 21 (instead of the default 18) by making an express
statement to that effect when the account is created. In other states,
the turnover age is 21 by default, and an express statement is required
to establish a lower turnover age.

The trustee can transfer funds between UGMA/UTMA accounts at will. For
example, this might be attractive if a UGMA seems to be underperforming
similar type accounts or if it lacks the services of other UGMA accounts
such as online access. The custodian is managing the funds on behalf of
the minor, and part of management is deciding where to place the funds
and with which bank, broker, or other fiduciary. The custodian must be
certain to maintain a paper trail showing that every dollar withdrawn
from one account was transferred to another account. If the UGMA
account is with a broker or mutual fund manager, and a transfer is
desired, contact the new broker or manager and they will arrange all the
paperwork for a direct transfer.

Given all the warnings above, there is a way to give money to a minor
and restrict the minor's access until you feel he or she is ready. The
mechanism is not a UGMA, however, but another sort of trust. Contact
American Century Investments for information about their GiftTrust fund.
The fund is entirely composed of trusts like this. The trust pays its
own taxes. Unfortunately, this company may not keep the trust as quiet
as you would like. When opening a Gift Trust, confirmation is sent to
the donor, but in their words, "Subsequent confirmations are sent to the
beneficiary's address." Further, they insist that Form 709 must be
filed, it's a future interest and does not qualify for 10,000 exclusion;
taxes must be paid now or consume part of lifetime $600,000 exemption.

A future interest is just what it says: an interest in something that a
person does not own until some time in the future. The American Century
GiftTrust is an example of that. I believe the terms of the account
state that money cannot be taken out of the account for any reason
(except death of beneficiary) until the account has been open for at
least 10 years. So the beneficiary does not actually truly own the
assets until some time in the future. However, in certain situations,
the *dis*qualified exemption of a future interest doesn't apply. In
other words a Form 709 is *sometimes* not necessary and the lifetime
$600K (which is crawling upwards these days) isn't dented. The IRS regs
list these disqualifications of the disqualifications (don't you just
love tax law?).

In contrast, a minor is considered to own (though he or she does not
control) the assets of an UGMA/UTMA account from the second assets are
placed into the account -- the assets can be used for his or her benefit
immediately. Therefore, gifts to an UGMA/UTMA are gifts of a present
interest and do qualify for the $10,000 annual gift exclusion.

With respect to gifts of a future interest (that are not eligible for
the $10K annual exclusion) or for gifts that are eligible but are over
$10K, a donor does not have the choice between paying gift tax and using
up some of his or her unified credit. The donor is required to use
unified credit first, only paying the gift tax once the unified credit
is exhausted. See the article elsewhere in this FAQ on estate and gift
taxes for more information.

Note that if the trustee acts in such a way as to give the IRS cause to
believe that no true gift was ever actually made, the IRS takes the
position that no gift was made and taxes all the income to the parent
instead of to the minor. But this is not unique to UGMA/UTMA.

On a related note, some accountants advise that one person should make
the gift and that a different person should be the custodian. The
reason is that if the donor and custodian are the same person, that
person is considered to exercise sufficient control over the assets to
warrant inclusion of the UGMA in his/her estate. For more info, see
Lober, Louis v. US, 346 US 335 (1953) (53-2 USTC par. 10922); Rev Ruls
57-366, 59-357, 70-348.

All of these are cited in the RIA Federal Tax Coordinator 2d, volume
22A, paragraph R-2619, which says (among other things) "Giving cash,
stocks, bonds, notes, etc., to children through a custodian may result
in the transferred property being included in the donor's gross estate
unless someone other than the donor is named as custodian."

Finally, a word about taxes. Income that accrues to a minor, such as
income from a UGMA account, is taxed as follows in tax year 2000.
Assuming the child has no other income and is under age 14, the first
$700 of investment income falls into the child's zero bracket. The next
$700 is taxed at 15%, and the rest is taxed at the parents' top bracket
.. (The expected numbers for tax year 2001 are both $750.) The tax on a
child's income imposed at the parents' top bracket is the so-called
"kiddie tax." If the child is 14 or over, the parent's tax situation
does not come into play at all. All the income is on the child's return
and he or she is taxed as an entity unto himself/herself. Always check
the Form 1040 instructions for the appropriate number to use for a given
tax year. Also note that IRS regulations require all minors 14 or older
to sign their own tax returns. Finally, please note that these tax
rules are for earned and unearned income for a minor; there is no
special tax treatment for UGMA accounts.


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Subject: Tax Code - Wash Sale Rule

Last-Revised: 11 Mar 2000
Contributed-by: Art Kamlet (artkamlet at aol.com), Rich Carreiro (rlcarr
at animato.arlington.ma.us)

A "wash sale" describes the situation in which you sell shares of some
security at a loss, and within 30 days you purchase substantially
identical securities. At face value, it looks like you took a loss on
an investment (would would be deductible from your gross income when you
do your taxes), yet you still own that investment, you just now have a
lower cost basis. Unfortunately, the IRS does not consider the loss
resulting from such a transaction to be deductible. If a sale is
considered to be a wash sale, the loss cannot be treated as a capital
loss on your federal tax return. In fact, the cost basis of the
securities purchased is increased by the amount of that disallowed loss.
The goal is to prevent someone from converting a paper loss into a real
loss while actually hanging onto that same position.

For the word from the horses mouth, here's a quote from IRS publication
550, "Investment Income and Expenses" (1990), p. 37:

Wash Sales:
You cannot deduct losses from wash sales or trades of stock or
securities. However, the gain from these sales is taxable.

A wash sale occurs when you sell stock or securities at a loss and
within 30 days before or after the sale you buy or acquire in a fully
taxable trade, or acquire a contract or option to buy, substantially
identical stock or securities. If you sell stock and your spouse or a
corporation you control buys substantially identical stock, you also
have a wash sale. You add the disallowed loss to the basis of the new
stock or security.

This rule includes normal purchases followed by sales (i.e., you go
long, then sell at a later date) as well as short sales and later
purchases.

Here's an extended example that may help clarify how the math must be
done. The rule is actually rather simple, but when lots of trades are
involved it can lead to very complicated situations.
1. 4/01/99 bought 100 at 120.
2. 5/01/99 sold 100 at 110
The loss was 10 x 100 = $1000.
3. 5/02/99 bought 100 at 95.
Causes a wash sale of loss on 5/01/99.
4. 5/03/99 sold 100 at 100.
The gain was 5 x 100 = $500, but you must add the wash sale $1000
into the basis of the purchase on 5/02/99, therefore this turns
into a loss of $500.
5. 5/10/99 bought 100 at (any price).
The sale on 5/03/99 is considered a wash sale even though it became
a loss by adding in a wash sale from a previous sale. Stated
differently, wash sales can create subsequent wash sales.

The IRS publication goes on explaining all those terms (substantially
identical, stock or security, ...). It runs on several pages, too much
to type in. You should definitely call IRS for the most updated ones
for detail. Phone number: 800-TAX-FORM (800-829-3676). Or visit their
web site at


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Subject: Technical Analysis - Basics

Last-Revised: 27 Jan 1998
Contributed-By: Maurice Suhre, Neil Johnson

The following material introduces technical analysis and is intended to
be educational. If you are intrigued, do your own reading. The answers
are brief and cannot possibly do justice to the topics. The references
provide a substantial amount of information.

First, the references; the links point to Amazon, where you can buy the
books if you're really interested.

1. John J. Murphy
Technical Analysis of the Futures Markets
2. Martin J. Pring
Technical Analysis Explained
3. Stan Weinstein
Stan Weinstein's Secrets for Profiting in Bull and Bear Markets

Now we'll introduce technical analysis and explain some commonly
mentioned aspects.

1. What is technical analysis?
Technical analysis attempts to use past stock price and volume
information to predict future price movements. Note the emphasis.
It also attempts to time the markets.


2. Does it have any chance of working, or is it just like reading tea
leaves?
There are a couple of plausibility arguments. One is that the
chart patterns represent the past behavior of the pool of
investors. Since that pool doesn't change rapidly, one might
expect to see similar chart patterns in the future. Another
argument is that the chart patterns display the action inherent in
an auction market. Since not everyone reacts to information
instantly, the chart can provide some predictive value. A third
argument is that the chart patterns appear over and over again.
Even if I don't know why they happen, I shouldn't trade or invest
against them. A fourth argument is that investors swing from
overly optimistic to excessively pessimistic and back again.
Technical analysis can provide some estimates of this situation.

A contrary view is that it is just coincidence and there is little,
if any, causality present. Or that even if there is some sort of
causality process going on, it isn't strong enough to trade off of.

A very contrary view: The past and future performance of a stock
may be correlated, but that does not mean or imply causality. So,
relying on technical analysis to buy/sell a stock is like relying
on the position of the stars in the atmosphere or the phases of the
moon to decide whether to buy or sell.


3. I am a fundamentalist. Should I know anything about technical
analysis?
Perhaps. You should consider delaying purchase of stocks whose
chart patterns look bad, no matter how good the fundamentals. The
market is telling you something is still awry. Another argument is
that the technicians won't be buying and they will not be helping
the stock move up. On the other hand (as the economists say), it
makes it easy for you to buy in front of them. And, of course, you
can ignore technical analysis viewpoints and rely solely on
fundamentals.


4. What are moving averages?
Observe that a period can be a day, a week, a month, or as little
as 1 minute. Stock and mutual fund charts normally are daily
postings or weekly postings. An N period (simple) moving average
is computed by summing the last N data points and dividing by N.
Moving averages are normally simple unless otherwise specified.

An exponential moving average is computed slightly differently.
Let X[i] be a series of data points. Then the Exponential Moving
Average (EMA) is computed by:
EMA[i] = (1 - sm) * EMA[i-1] + sm * X[i]

where sm = 2/(N+1), and EMA[1] = X[1].

"sm" is the smoothing constant for an N period EMA. Note that the
EMA provides more weighting to the recent data, less weighting to
the old data.


5. What is Stage Analysis?
Stan Weinstein [ref 3] developed a theory (based on his
observations) that stocks usually go through four stages in order.
Stage 1 is a time period where the stock fluctuates in a relatively
narrow range. Little or nothing seems to be happening and the
stock price will wander back and forth across the 200 day moving
average. This period is generally called "base building". Stage 2
is an advancing stage characterized by the stock rising above the
200 and 50 day moving averages. The stock may drop below the 50
day average and still be considered in Stage 2. Fundamentally,
Stage 2 is triggered by a perception of improved conditions with
the company. Stage 3 is a "peaking out" of the stock price action.
Typically the price will begin to cross the 200 day moving average,
and the average may begin to round over on the chart. This is the
time to take profits. Finally, the Stage 4 decline begins. The
stock price drops below the 50 and 200 day moving averages, and
continues down until a new Stage 1 begins. Take the pledge right
now: hold up your right hand and say "I will never purchase a stock
in Stage 4". One could have avoided the late 92-93 debacle in IBM
by standing aside as it worked its way through a Stage 4 decline.


6. What is a whipsaw?
This is where you purchase based on a moving average crossing (or
some other signal) and then the price moves in the other direction
giving a sell signal shortly thereafter, frequently with a loss.
Whipsaws can substantially increase your commissions for stocks and
excessive mutual fund switching may be prohibited by the fund
manager.


7. Why a 200 day moving average as opposed to 190 or 210?
Moving averages are chosen as a compromise between being too late
to catch much move after a change in trend, and getting whipsawed.
The shorter the moving average, the more fluctuations it has.
There are considerations regarding cyclic stock patterns and which
of those are filtered out by the moving average filter. A
discussion of filters is far beyond the scope of this FAQ. See
Hurst's book on stock transactions for some discussion.


8. Explain support and resistance levels, and how to use them.
Suppose a stock drops to a price, say 35, and rebounds. And that
this happens a few more times. Then 35 is considered a "support"
level. The concept is that there are buyers waiting to buy at that
price. Imagine someone who had planned to purchase and his broker
talked him out of it. After seeing the price rise, he swears he's
not going to let the stock get away from him again. Similarly, an
advance to a price, say 45, which is repeatedly followed by a
pullback to lower prices because a "resistance" level. The notion
is that there are buyers who purchased at 45 and have watched a
deterioration into a loss position. They are now waiting to get
out even. Or there are sellers who consider 45 overvalued and want
to take their profits.

One strategy is to attempt to purchase near support and take
profits near resistance. Another is to wait for an "upside
breakout" where the stock penetrates a previous resistance level.
Purchase on anticipation of a further move up. [See references for
more details.]

The support level (and subsequent support levels after rises) can
provide information for use in setting stops. See the "About
Stocks" section of the FAQ for more details.


9. What would cause these levels to be penetrated?
Abrupt changes in a company's prospects will be reacted to in the
stock market almost immediately. If the news is extreme enough,
the reaction will appear as a jump or gap in prices. More modest
changes will result, in general, in more modest changes in price.


10. What is an "upside breakout"?
If a stock has traded in a narrow range for some time (i.e. built
a base) and then advances above the resistance level, this is said
to be an "upside breakout". Breakouts are suspect if they do not
occur on high volume (compared to average daily volume). Some
traders use a "buy stop" which calls for purchase when a stock
rises above a certain price.


11. Is there a "downside breakout"?
Not by that name -- the opposite of upside breakout is called
"penetration of support" or "breakdown". Corresponding to "buy
stops," a trader can set a "sell stop" to exit a position on
breakdown.


12. Explain breadth measurements and how to use them.
A breadth measurement is something taken across a market. For
example, looking at the number of advancing stocks compared to
declining stocks on the NYSE is a breadth measurement. Or looking
at the number of stocks above their 200 day moving average. Or
looking at the percentage of stocks in Stage 1 and 2
configurations. In general, a technically healthy market should
see a lot of stocks advancing, not just the Dow 30. If the breadth
measurements are poor in an advancing sense and the market has been
advancing for some time, then this can indicate a market turning
point (assuming that the advancing breadth is declining) and you
should consider taking profits, not entering new long positions,
and/or tightening stops. (See the divergence discussion.)


13. What is a divergence? What is the significance?
In general, a divergence is said to occur when two readings are not
moving generally together when they would be expected to. For
example, if the DJIA moves up a lot but the S&P 500 moves very
little or even declines, a divergence is created. Divergences can
signify turning points in the market. At a major market low, the
"blue chip" stocks tend to move up first as investors becoming
willing to purchase quality. Hence the S&P 500 may be advancing
while the NYSE composite is moving very little. Divergences, like
everything else, are not 100 per cent reliable. But they do
provide yellow or red alerts. And the bigger the divergence, the
stronger the signal. Divergence and breadth are related concepts.
(See the breadth discussion.)


14. How much are charting services and what ones are available?
Commercial services aren't cheap. Daily Graphs (weekly charts with
daily prices) is $465 for the NYSE edition, $432 for the AMEX/OTC
edition. Somewhat cheaper for biweekly or monthly. Mansfield
charts are weekly with weekly prices. Mansfield shows about 2.5
years of action, Daily Graphs shows 1 year or 6 months for the less
active stocks. Of course there are many charts on the web. See
the article elsewhere in the technical analysis section of this FAQ
about free charts.

S&P Trendline Chart Guide is about $145 per year. It provides over
4,000 charts. These charts show one year of weekly price/volume
data and do not provide nearly the detail that Daily Graphs do.
You get what you pay for. There are other charting services
available. These are merely representative examples.


15. Can I get charts with a PC program?
Yes. There are many programs available for various prices. Daily
quotes run about $35 or so a month from Dial Data, for example. Or
you can manually enter the data from the newspaper.


16. What would a PC program do that a charting service doesn't?
Programs provide a wide range of technical analysis computations in
addition to moving averages. RSI, MACD, Stochastics, etc., are
routinely included. See Murphy's book [Ref 1] for definitions.
Frequently you can change the length of the moving averages or
other parameters. As another example, AIQ StockExpert provides an
"expert rating" suggesting purchase or short depending on the
rating. Intermediate values of the rating are less conclusive.


17. What does a charting service do that a PC doesn't?
Charts generally contain a fair amount of fundamental information
such as sales, dividends, prior growth rates, institutional
ownership.


18. Can I draw my own charts?
Of course. For example, if you only want to follow a handful of
mutual funds of stocks, charting on a weekly basis is easy enough.
EMAs are also easy enough to compute, but will take a while to
overcome the lack of a suitable starting value.


19. What about wedges, exhaustion gaps, breakaway gaps, coils, saucer
bottoms, and all those other weird formations?
The answer is beyond the scope of this FAQ article. Such patterns
can be seen, particularly if you have a good imagination. Many
believe they are not reliable. There is some discussion in Murphy
[ref 1].


20. Are there any aspects of technical analysis that don't seem quite
so much like hokum or tea leaf reading?
The oscillator set known as "stochastics" (a bit of a misnomer) is
based on the observation that a stock which is advancing will tend
to close nearer to the high of the day than the low. The reverse
is true for declining stocks. It compares today's close to the
highest high and lowest low of the last five days. This indicator
attempts to provide a number which will indicate where you are in
the declining/advancing stage.


21. Can I develop my own technical indicators?
Yes. The problem is validating them via some sort of backtesting
procedure. This requires data and work. One suggestion is to
split the data into two time periods. Develop your indicator on
one half and then see if it still works on the other half. If you
aren't careful, you end up "curve fitting" your system to the data.


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

Subject: Technical Analysis - Bollinger Bands

Last-Revised: 12 Oct 2000
Contributed-By: John Bollinger (BBands at BollingerBands.com)

While there are many ways to use Bollinger Bands, following are a few
rules that serve as a good beginning point.
1. Bollinger Bands provide a relative definition of high and low.
2. That relative definition can be used to compare price action and
indicator action to arrive at rigorous buy and sell decisions.
3. Appropriate indicators can be derived from momentum, volume,
sentiment, open interest, inter-market data, etc.
4. Volatility and trend have already been deployed in the construction
of Bollinger Bands, so their use for confirmation of price action
is not recommended.
5. The indicators used should not be directly related to one another.
For example, you might use one momentum indicator and one volume
indicator successfully, but two momentum indicators aren't better
than one.
6. Bollinger Bands can also be used to clarify pure price patterns
such as "M" tops and "W" bottoms, momentum shifts, etc.
7. Price can, and does, walk up the upper Bollinger Band and down the
lower Bollinger Band.
8. Closes outside the Bollinger Bands are continuation signals, not
reversal signals. (This has been the basis for many successful
volatility breakout systems.)
9. The default parameters of 20 periods for the moving average and
standard deviation calculations, and two standard deviations for
the bandwidth are just that, defaults. The actual parameters
needed for any given market/task may be different.
10. The average deployed should not be the best one for crossovers.
Rather, it should be descriptive of the intermediate-term trend.
11. If the average is lengthened the number of standard deviations
needs to be increased simultaneously; from 2 at 20 periods, to 2.5
at 50 periods. Likewise, if the average is shortened the number of
standard deviations should be reduced; from 2 at 20 periods, to 1.5
at 10 periods.
12. Bollinger Bands are based upon a simple moving average. This is
because a simple moving average is used in the standard deviation
calculation and we wish to be logically consistent.
13. Make no statistical assumptions based on the use of the standard
deviation calculation in the construction of the bands. The sample
size in most deployments of Bollinger Bands is simply too small for
statistical significance.
14. Finally, tags of the bands are just that, tags not signals. A
tag of the upper Bollinger Band is NOT in-and-of-itself a sell
signal. A tag of the lower Bollinger Band is NOT in-and-of-itself
a buy signal. For a free tutorial on Bollinger Bands, please visit



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

Subject: Technical Analysis - Black-Scholes Model

Last-Revised: 10 Apr 1997
Contributed-By: Kevin Lee (kevsterdtn at aol.com)

Black and Scholes are the mathmeticians who developed a model (formula)
that determines theoretical value of an option based on volatility and
time to expiration. Although this valuation is a theoretical value, it
is essentially the industry standard.


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

Subject: Technical Analysis - Commodity Channel Index

Last-Revised: 1 Apr 1997
Contributed-By: (anonymous), contact Chris Lott ( contact me )

The Commodity Channel Index (CCI) is a timing tool that works best with
seasonal or cyclical contracts. It keeps trades neutral in a sideways
moving market, and helps get in the market when a breakout occurs. A
moving average of the CCI can also be displayed. A constant number is
entered in the parameter screen to adjust the sensitivity of the index.
This will change the visual amplitude of the index lines.
FORMULAS: AVE = SUM OF LAST N PRICES / D
MEAN DEVIATION = SUM OF LAST (PRICE - AVE) / D
CCI = C * (PRICE - AVE) / MEAN DEVIATION
CCIAVE = OLD.CCIAVE + (SF * (CCI - OLD.CCIAVE))
SF: Smoothing Factor = 2 / (N + 1) where N = periods in ave,
or Smoothing Factor = 0 < SF < 1

PARAMETERS: 1st: Number of bars in the AVE average (ie. 5A).
Use the H,L,M,A study modifiers.
2nd: Multiplier constant C (usually 50-150).
3rd: Optional number of bars in the CCI average (ie. 3).
Example: 8,150,3

SCALE: Grid lines at the +100, 0 and -100 levels.

COLOR: 1st: CCI 2nd: Exponential average of CCI

HOW TO USE: Buy when CCI crosses ABOVE the +100 scale line.
Sell when CCI crosses BELOW the -100 scale line.



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

Subject: Technical Analysis - Charting Services

Last-Revised: 27 Apr 1997
Contributed-By: Joseph Shandling (jshandl at ucs.net)

Thanks to the many free quote servers on the net, you don't need to
subscribe to a data service or charting service just to get basic
charts. The following sites offer a whole range of charts for a
particular stock, as well as a lot of other information.

* Yahoo! Quotes at
Offers 3-month, 1-year, 2-year and 5-year charts. No registration
is required. Pages for a stock include links to research, SEC
filings, etc, etc.
* DailyStocks at
Offers various screens and many charts. No charge but registration
is required.


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

Subject: Technical Analysis - Data Sources

Last-Revised: 18 May 2002
Contributed-By: Zeyu Vicki Pei, Chris Lott ( contact me )

This article lists some sources of historical data. Note that
currencies are traded over-the-counter, there are no central exchanges
or market makers. Thus, currency closing prices are really just noisy,
"best guesses" collected from a number of different exchanges and
transactions.

* Yahoo has a fair amount of data, both for individual issues and for
indexes.

For information about what they provide, surf here:



* Investors Alliance
219 Commercial Boulevard, Fort Lauderdale, FL 33308, 305-491-5100,



* Micro Data
Offers closing prices on stocks, futures, indexes, mutual funds,
and money market funds in zipped ascii files, all for just $200 per
year.



* Bull & Bear of Italy offers historical data and end-of-date updates
for markets in Great Britain, Germany, France, Italy, Switzerland,
Holland, Belgium, Spain, Finland, USA, Japan, Australia, and
Singapore. Annual subscription is Euro400. Please visit their
site at


* Ed Savage (contact egsavage at yahoo.com) maintains a collection of
data. Stated purpose: "To collect publicly available market data
in one place so people can access it easily." Donate "freely
redistributable" data or access same at this URL:
It is NOT a
real-time, 15-min delay, or close-of-day quote server.


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

Subject: Technical Analysis - Elliott Wave Theory

Last-Revised: 12 Dec 1996
Contributed-By: (Original author unknown), Chris Lott ( contact me )

This article introduces Elliott Wave Theory.

background

R. N. Elliott "discovered" the wave theory in the early 1934. It is a
method for explaining stock market movements. Actually, Elliott wave
theory helps explain economics in general, but the stock market tends to
have three attributes that make it quite applicable:
1. It is a true free market (i.e., prices are not fixed by the
supplier, but rather set by the consumer).
2. It provides consistent and regular metrics that can be measured.
3. It is manipulated by a statistically significantly large group of
people.

Assumptions behind Elliott Wave theory

* The market is NOT efficient. Rather it is an inefficient market
place that is controlled by the whims of the masses. The masses
consistently overreact and will make things over and under priced
consistently. This was, and until recently, in direct opposition
to prevailing theories that the market place was an efficient
mechanism. The efficient marketplace was the theory that was
taught in B-schools and often continues to be taught until this
day.
* That if the above is true, then you should be able to do a
"sociological" survey of stock prices independent of other news
that effects stock prices. ie., you will be measuring the global
effects that the masses will have on the stock. (An interesting
aside. We have all observed that stock prices move independently
or in the opposite direction that news about the company, the
economy, or the stock would tend to let us believe. The general
explanation for this behavior is that the masses tend to listen for
the news they are ready to hear, and that the movement that
actually happens depends on other effects.)

General Principle of Elliott Waves

There are many things that have to be accounted for when doing e-wave
studies of stocks, and that one of the most difficult things to overcome
is the personal ability to separate your own emotions from affecting
your analysis. You as a person have the same types of fear/greed
internal mechanisms that affect the entire market place as a whole and
without being able to work to dismiss those emotions you will not be
able to sit in a position that allows you to understand and profit from
the sociological effects that you are measuring. That basic fear/greed
mechanism is so inbred to our existence that will keep the Elliott wave
a valid study regardless the number of people that know and understand
it.

This is an important point: Elliott Theory measures sociological
performance of the masses and these sociological functions are so
ingrained that even if individuals or many individuals are able to
understand and dismiss those actions the majority of the people will not
be able to.

Elliott waves describe the basic movement of stock prices. It states
that in general there will be 5 waves in a given direction followed by
usually what is termed and ABC correction or 5 waves in the opposite
direction.

Wave Description

The following wave description applies to a market moving upwards. In a
down market (perhaps the stock is truly overpriced and the market has
turned), you will generally see the same types of behavior in reverse
that you saw watching the stock on the way up.



Wave 1
The stock makes its initial move upwards. This is usually caused
by a relatively small number of people that all of the sudden (for
a variety of reasons real or imagined) feel that the previous price
of the stock was cheap and therefore worth buying, causing the
price to go up.
Wave 2
The stock is considered overvalued. At this point enough people
who were in the original wave consider the stock overvalued and
take profits. This causes the stock to go down. However in
general the stock will not make it to it's previous lows before the
stock is considered cheap again.
Wave 3
This is usually the longest and strongest wave. More people have
found out about the stock, more people want the stock and they buy
it for a higher and higher price. This wave usually exceeds the
tops created at the end of wave 1.
Wave 4
At this point people again take profits because the stock is again
considered expensive. This wave tends to be weak because their are
usually more people that are still bullish on the stock and after
some profit taking comes wave 5.
Wave 5
This is the point that most people get on the stock, and is most
driven by hysteria. People will come up with lots of reasons to
buy the stock, and won't listen to reasons not to. At this point
contrarians will probably notice that the stock has very little
negative news and start shorting the stock. And at this point is
where the stock becomes the most overpriced. At this point the
stock will move into one of two patterns, either an ABC correction
or starting over with wave 1.

An ABC correction is when the stock will go down/up/down in
preparing for another 5 way cycle up. During this time frame
volatility is usually much less then the previous 5 wave cycle, and
what is generally happening is the market is taking a pause while
fundamentals catch up. It is interesting to note here that you can
have many ABC corrections happening. For instance if the
fundamentals do not catch up you will have two ABC corrections and
then the stock will have a 5 wave down cycle. (Odd number of ABC
corrections lead to the stock going up, even numbers lead to the
stock going down.)


Length and quantity of the moves

People tend to think of something being too expensive or cheap for the
very same reasons that they think something is attractive or not
attractive. This subjective judgement is called aesthetics. A measure
of what is aesthetically pleasing has to do with fibonacci sequences.
They are all around us, they describe art, snail shells, galaxies,
flower petals, and yes, our own internal feelings of value.

The quantity of time and movement of a stock through a wave cycle tends
to measured reasonably well by fibonacci sequences. The measurement and
prediction of waves tends to be bound by these numbers and by the
fibonacci fractions (Roughly 5/8 and 1 5/8 and their inverses)

For more information, visit the Elliott Wave site:



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Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 15 of 20)

am 30.05.2005 06:30:08 von noreply

Archive-name: investment-faq/general/part15
Version: $Id: part15,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 15 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: Strategy - Survey of Stock Investment Strategies

Last-Revised: 20 Jan 2000
Contributed-By: John Price (johnp at sherlockinvesting.com)

This article offers a brief survey of several strategies that investors
use to guide their stock purchases and sales.

Before we start the survey, here's a golden rule of investing: Know why
you are buying a particular stock -- donÂ’t wait until its price goes up
or down to think about it. Many investors are not sure why they bought
a stock in the first place, so when a dramatic fall in price happens,
they're not sure what to do next.

Here's an example. Let's say you bought Intel. When you know why you
bought Intel you will have a stronger basis for knowing what to do when
its price goes up, or down, or even stays the same. So if Intel starts
to go down in price and you bought it as a momentum play, then you will
probably want to sell as quickly as possible. But if you bought it as
an undervalued stock, and if the fundamentals have not changed, then you
might want to buy more."

Of course, every investor and every stock presents a different reason
for contacting your broker. But we have to start somewhere, so here is
my analysis of the six main investment styles.



Brother-in-law investor
Your brother-in-law phones, or perhaps your stockbroker or the
investment writer for the regional newspaper. He has the scoop on
a great stock but you will have to act quickly. If you are likely
to buy in this situation, then you are a "brother-in-law investor."
Brother-in-law investors rely on the advice of other people to make
their decisions.


Technical investor
Moving averages, candlestick patterns, Gann charts and resistance
levels are the sort of things the technical investor deals with.
Technical investors were once called chartists because their
central activity was making and studying charts of stock prices.
Nowadays this is usually done on a computer where advanced
mathematics combines with grunt power to unlock past patterns and
correlations. The hope is that they will carry into the future.


Economist investor
This type of investor bases his decisions on forecasts of economic
parameters. A typical statement is "The dollar will strengthen
over the next six months, unemployment will decrease, interest
rates will climb -- a great time to get into bank stocks." Random
walk investor This is the area of the academic investor and is part
of what is called Modern Portfolio Theory. "I have no idea whether
stock XYZ will go up or down, but it has a high beta. Since I
donÂ’t mind the risk, IÂ’ll buy it since I will, on the average, be
compensated for this risk." At the core of this strategy is the
Efficient Market Hypothesis EMH. There are a number of versions of
it but they all end up at the same point: the current price of a
stock is what you should buy, or sell, it for. This is the fair
price and no amount of analysis will enable you to do any better,
says the EMH. With the Efficient Market Hypothesis, stock prices
are assumed to follow paths that can be described by tosses of a
coin.


Scuttlebutt investor This approach to investing was pioneered by
Philip Fisher and consists of piecing together information on
companies obtained informally through wide-ranging conversations,
interviews, press-reports and, simply, gossip. In his book Common
Stocks and Uncommon Profits, Fisher wrote:

Go to five companies in an industry, ask each of them
intelligent questions about the points of strength and
weakness of the other four, and nine times out of ten a
surprisingly detailed and accurate picture of all five
will emerge.

Fisher also suggests that useful information can be obtained from
vendors, customers, research scientists and executives of trade
associations.


Value Investor
In the fourth edition of the investment classic _Security
Analysis_, the authors Benjamin Graham, David Dodd, and Sydney
Cottle speak of the "attempts to value a stock independently of its
current market price". This independent value has many names such
as `intrinsic value,Â’ `investment value,Â’ `reasonable value,Â’ `fair
value,Â’ and `appraised value.Â’ They go on to say:

A general definition of intrinsic value would be "that
value which is justified by the facts, e.g., assets,
earnings, dividends, [and] definite prospects, including
the factor of management." The primary objective in using
the adjective "intrinsic" is to emphasize the distinction
between value and current market price, but not to invest
this "value" with an aura of permanence.

Value investing is the name given to the method of deciding on
individual investments on the basis of their intrinsic value as
contrasted with their market price.

This, however, is not the standard definition. Most authors refer
to value investing as the process of searching for stocks with
attributes such as a low ratio of price to book value or a low
price-earnings ratio. In contrast, stocks with high price to book
value or a high price-earnings ratio are called growth stocks.
Investors searching for stocks from within this universe of stocks
are called growth investors. These two approaches are usually seen
to be in opposition.

Not so, declared Warren Buffett. In the 1992 Annual Report of
Berkshire Hathaway he wrote, "the two approaches are joined at the
hip: Growth is always a component in the calculation of value,
constituting a variable whose importance can range from negligible
to enormous and whose impact can be negative as well as positive."


Conscious Investor
This type of investor overlaps the six types just mentioned.
Increasingly investors are respecting their own beliefs and values
when making investment decisions. For many, quarterly earnings are
no longer enough. For example, so many people are investing in
socially responsible mutual funds that the total investment is now
over one trillion dollars. Many others are following their own
paths to clarify their investment values and act on them. The
process of bringing as much honesty as possible into investment
decisions we call conscious investing.


Most people invest for different reasons at different times. Also they
donÂ’t fall neatly into a single category. In 1969 Buffett described
himself as 85 percent Benjamin Graham [Value] and 15 percent Fisher
[Scuttlebutt].

Whatever approach, or approaches, you take, the most important thing is
know why you bought a particular stock. If you bought a stock on the
recommendation of your neighbor, be happy about it and recognize that
this is why you bought it. Then you will be more likely to avoid the
"investor imperative," namely the following behavior: If your stock
rises, claim it as your ability; if it falls, pass on the blame.

Do all that you can to avoid going down this path. Write down why you
bought a stock. Tell your spouse your reasons. Tape them on your
bathroom mirror. Above all, if you want to be a successful investor,
donÂ’t kid yourself.

For more insights from John Price, visit his site:



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

Subject: Strategy - Value and Growth

Last-Revised: 23 Oct 1997
Contributed-By: Chris Lott ( contact me )

Investors will frequently read about value stocks (or value strategies)
as well as growth stocks (and growth strategies). These terms describe
reasons why people believe certain stocks will increase in value. This
article gives a brief summary.

The value strategy attempts to find shares of companies that represent
good value (i.e., value stocks). In other words, their stock prices are
lower than comparable companies, perhaps because the shares are out of
favor with Wall Street. Eventually, they believe, the market will
recognize the true value of the stock and run up the price. People who
believe in this strategy are sometimes called fundamentalists because
they focus on the fundamentals of the company. The grand champion of
this strategy is (was) Benjamin Graham, author of two classic investment
books, Security Analysis and The Intelligent Investor. Measures of
value may be a company's book value, earnings, revenue, brand
recognition, etc, etc.

The growth strategy attempts to find shares of companies that are
growing and will continue to grow rapidly (i.e., growth stocks). In
other words, their earnings are increasing nicely and the stock price is
increasing along with those earnings. People who believe in this
strategy are sometimes called momentum investors. They are sometimes
criticized for paying high prices for growth and ignoring fundamentals.
Measures of growth usually focus on the earnings growth.

With just a little bit of looking, it's easy to find mutual funds that
take one, the other, or a combined strategy.


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Subject: Tax Code - Backup Withholding

Last-Revised: 20 Mar 1997
Contributed-By: John Schott (jschott at voicenet.com)

Once the IRS declares you a "Bad Boy" (for having underpaid or been
negligent on your tax filings in other ways) they stick you with "Backup
Withholding."

What this means, essentially, is that any firm that deals with your
money in taxable tranactions is required to withhold (and submit to IRS)
31% of the proceeds of ANY transaction (on the assumption that the
entire amount is a taxable gain). Then, next year when you file, they
have all this money of yours, and you might be able to get it back if it
is in excess of your actual tax liability once they have themselves
determined it is indeed excess.

So if you trade often, 31% disappears each time and soon all of your
capital is held by the IRS.

I think that your time in the "penalty box" lasts for 5 years (I'm not
sure) if you remain faultlessly clean and petition to have it lifted.

In short - this is not something you want to get into. By the way,
there is a substantial penalty if you lie to the broker about whether
you are subject to this treatment.


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

Subject: Tax Code - Capital Gains Cost Basis

Last-Revised: 7 Jan 2000
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact
me )

This article discusses how to determine the cost basis of a security
according to the rules of the US tax code. The most common need for the
cost basis of a security like stock is to report the proper gain or loss
when that security is sold. This article sketches the issues for the
simple case (you bought a security) and a couple less simple cases (you
are given or inherit a security). Of course you might have not just one
share but instead many hundreds; the word "security" is used here for
simplicity.



You bought the security
The cost basis is simply the money you paid when you bought the
security, including any commissions that you paid to acquire that
security. For example, if you bought 10 shares of IBM at 100 and
paid $29.95 in commission to do so, your cost basis would be
1029.95. This example lists just a single purchase of a security.
If you accumulated stock over the course of many purchases, the
total cost basis is still just the cost of all the purchases
including commissions. The situation gets a bit more complex if
you sell only a portion of an investment; see the FAQ article about
computing capital gains for more information about this.


You were given the security
To oversimplify the issue, if the shares are given away at a gain,
the donor's cost basis and acquisition date are used. If the
shares are given away at a loss, the fair market value as of the
date of gift must be used to calculate a subsequent sale at a loss,
while the donor's cost basis must be used to calculate a subsequent
sale at a gain. In the case of a gift at a loss, which is later
sold at a loss, the date of the gift is used as the "acquisition
date" of that stock. All of this means that an individual can
transfer a gain but not a loss to another individual. Read on for
all the details.

The date when the gift is made is important. To figure the cost
basis, the fair market value (FMV) of the gift on the gift date
must be determined. A local library's microfilm archive might be
the best resource to find the value of shares on a particular date.
But be cautious about stock splits and other stock dividends! It's
wise to consult the S&P stock guide, the Value Line Investment
Survey, or the company that issued the shares for a history of the
stock price, stock splits and dividends, etc.

In the happiest and simplest case, the donor bought shares for a
pittance, and donated them to some lucky individual, maybe you,
after the shares had appreciated dramatically. That individual
immediately sold the shares. The fair market value (FMV) of the
shares on the gift date far exceeded the original cost basis, so
the recipient's cost basis is the same as the donor's cost basis
(possibly small, but definitely NOT zero).

For example, the donor's cost basis is $20, and the FMV on the date
of the gift is $100. The cost basis that the recipient must use is
$20. On the other hand if the shares were sold for only $5, the
same cost basis is used, and the loss is $15. In both cases, the
acquisition date that must be reported is the same as the donor's
acquisition date.

The other possibility, of course, is that the share's FMV on the
gift date was less than the original cost basis thanks to some
decline in value. In this case, the gift assumes a dual cost basis
that is not determined until the shares are sold. The donor's cost
basis must be used to determine the gain if the shares are sold at
a gain. The FMV on the date of the gift must be used if the shares
are sold at a loss.

For example, the donor's cost basis is $20, and the FMV on the date
of the gift is $10, thus establishing a dual cost basis. Here are
three possibilities.
* Case 1: If the shares are subsequently sold for $25, this is a
gain with respect to the donor's original cost basis and the
FMV, so the recipient consequently reports a gain of $5,
namely $25 (sales price) less 20 (donor's cost basis).
* Case 2: If the shares are sold for $8, this is a loss with
respect to the donor's original cost basis and the FMV, so the
recipient consequently reports a loss of $2, namely $8 (sales
price) less $10 (FMV on gift date).
* Case 3: Here's where it gets complicated. If the shares are
sold for $15, representing a loss with respect to the donor's
cost basis but a gain with respect to the FMV on the gift
date, what cost basis should the recipient use?
* If the donor's cost basis of $20 is used, this would
produce a loss for the recipient. However, the $20 can
be used only when the recipient has a gain, so that's
out.
* If the FMV of $10 is used, this would produce a gain for
the recipient. However, the $10 can be used only when
the recipient has a loss, so that's out too. Result: The
recipient has neither a gain or loss.

The acquisition date that must be reported depends on the cost
basis, and is pretty straightforward. If the donor's cost basis is
used, use the donor's acquisition date, and if the FMV on the date
of the gift is used, use the date of the gift.

The IRS is light on advice as to how to report a transaction where
the stock was given at a loss, and the sale produces neither gain
nor loss. If you report the net sales price and then show the cost
basis equal to the sales price, you end up with no gain. You can
choose to use either the date of gift or original date as your
acquisition date, since no gain or loss makes it a pretty much
"don't care" condition.


You inherit a security
The cost basis is simply the value of the security on the date of
the person's death who bequeathed that security to you. (The
accountant lingo for this is "when the stock was inherited, its
cost basis was stepped up to fair market value on date of death".)
The easiest way to get this is probably to look in a library's
archive (probably on microfiche or CD-ROM) of the Wall Street
Journal or the New York Times. Don't forget about stock splits
while doing the research.

In rare cases, the executor will choose to use an "alternate
valuation date" instead of date of death. The alternate valuation
date, always 6 months after death, can be chosen only when it will
reduce the estate tax, and if chosen, must be used for all property
of the estate. An executor who makes this election should notify
the heirs of the value used.

Note that when figuring capital gains taxes, inherited property is
always long term, per se. In fact if you glance at Pub 550 it asks
you to not use an acquisition date for inherited property but to
write "INH" to indicate it is inherited property.


Be careful of reinvested dividends! If a stock paid dividends and the
dividends were reinvested, computation of a fair cost basis requires a
bit of work. All reinvested dividends need to be added to the cost
basis, otherwise the cost basis will be much too low and the person who
sells the security will pay too much tax. If the dividend payment and
reinvestment records are not available, you need to reconstruct them.
Find out from old Wall Street Journals or New York Times financial
sections how much the dividend was each year since the stock was
acquired or inherited, and use the number of shares and price per share
on the dividend pay date. You might use a spreadsheet to show number of
shares each year, amount of dividend, price at time of reinvestment,
etc. This requires a good deal of researching the dividend amounts and
the share price.

If computing the cost basis of some security looks hopeless, here's an
alternative to consider: donate some or all the shares to charity. If
you normally make donations to your church, alumni association, or other
charity, it is quite easy to persuade them to accept stock instead of
cash. By doing so, you never have to calculate gains nor list the sale
as income on your tax return. Moreover, if the stock was held more than
a year (long-term gain), you get to itemize the charitable deduction at
fair market value on the date of gift. Note that stock gifted to
charity and held short term can be deducted at the lower of cost basis
or fair market value. This implies that stock bought with reinvested
dividends within a year of the gift would be limited to the lower of
fair market value or cost basis.

For the last word on the cost basis issue, see IRS Publication 551,
"Basis of Assets."


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

Subject: Tax Code - Capital Gains Computation

Last-Revised: 4 Aug 1998
Contributed-By: John Schott (jschott at voicenet.com), Art Kamlet
(artkamlet at aol.com), Chris Lott ( contact me ), Rich Carreiro (rlcarr
at animato.arlington.ma.us)

Gains made on equities (i.e., stocks or mutual funds) are subject to
capital gains taxes. In the simplest case, you bought a lot of shares
(either stocks or mutual funds) at some date, made no further
investments (took your dividends in cash), and finally sold the shares
at some later date. Your gain is simply the difference between your net
cost and net income, and you report that as a capital gain. This
article focuses on computing the amount of the gain (but not the amount
of tax you'll have to pay, see the article on capital gains tax rates
elsewhere in the FAQ for that).

Note that this article discusses only realized capital gains. Tax is
only due on a realized capital gain, never (at least not as of this
writing) on an unrealized capital gain. A realized capital gain is
money in your pocket. If you bought shares at 10 and sold at 20, you
realized a capital gain of $10 per share, and of course Uncle Sam (and
just about every other tax authority out there) wants a piece of the
action. An unrealized capital gain is a gain that you have on paper; in
other words, you bought a stock at 10, still hold the shares, and on
some date it's trading at 20. You have an unrealized capital gain as of
that date of $10 per share, and because it's unrealized, there are no
tax implications.

The first part of computing capital gains and gains taxes is determining
the cost basis of the securities that you sold. For more information on
that, see the FAQ article on computing cost basis . That article
discusses how to compute the cost basis if you inherit or are given some
stock or other equities.

Computing gains is simple for a sale of a single share, or a sale of a
single lot of shares. The situation becomes more complex if you
acquired several lots of shares at different prices. It's not so bad
for stocks, because when you sell shares of stock, you always, always,
always sell specific shares. But when you sell shares in a mutual fund,
things are not as simple. We'll cover these two cases next.
* Selling shares of stock.
For example, say you hold 200 shares of IBM, half of which you
bought at $40 and half at $50 (I should be so lucky). What price
should you use if you sell 100 shares?

In this simple example, it's your choice: either $40 or $50. But,
to be legal, you must specify to your broker precisely which lot
you are selling before you give the sell order. IRS Pub 550
clearly says that adequate specific identification of shares has
been made if you tell the broker at time of sale what shares are
being sold and if the broker so notes it on the confirmation slip.
Many brokers (especially as they now have years of computer
records) are able to mark that on your confirmation slip
automatically. But another way is to tell your broker and then get
him to sign a confirmation letter attesting to that fact. If you
don't do this, the IRS, in an audit, may reverse your decisions.

Note that the broker is under no obligation to accept a specific
shares order, but I personally would take my business to another
broker if I ran into that.

In any case, the key element in identifying specific shares to be
sold is that you've got to convince the IRS that you made your
choice of what shares to sell prior to the trade and convince the
IRS that you informed the broker of that choice (also prior to the
trade).

If you don't tell the broker, and get no information on the
confirmation slip, the specific shares you sell are the oldest
(sometimes called first-in first-out or FIFO).


* Selling shares of a mutual fund.

Mutual fund investors have to choose one of four possible methods
of computing their basis for sold shares. These are as follows.
1. Specific shares -- the investor decides which specific shares
are to be sold.
2. First-in-first-out (FIFO) -- the oldest shares are sold first
(this is actually a kind of specific shares).
3. Average cost, single category -- the basis of a share is the
average basis of all shares.
4. Average cost, double category (may now be triple category,
given the new capital gains law) -- shares are segregated by
holding period, the basis of a share in a given category is
the average basis of all shares in that category.

Investors may switch between (1) or (2) as they like, but once (3)
or (4) is chosen for a security, the investor must stick with that
method until he has entirely liquidated his position in the
security or receives IRS permission to change methods.

The following discussion details the average cost, single category
method (3), which is probably the most commonly used method.

The description that "the basis of a share is the average basis of
all shares" pretty much says it all. Despite this, the calculation
often confuses people, especially when additional purchases are
made subsequent to sales, and it can be laborious to keep track of
everything. Key points to remember are the following.
* Reinvestment of distributions are treated exactly like (and in
fact are) purchases.
* Every time a sale is made, the basis of every remaining share
becomes the average cost used in the sale calculation. A
share has no "memory" of what its previous basis values were.
* For purposes of computing holding period only, you are deemed
to be selling the oldest shares first. You have no choice in
the matter.

Various software packages such as Captool, by Captools Inc
(formerly Techserve) can do the computation for you. If I were
doing it manually (or using a spreadsheet) I'd probably do
something like the following.
1. Divide a piece of paper into six columns. Label them "Date",
"Number of shares", "Cost", "Total Shares", "Total Cost" and
"Average Cost".
2. Fill in the first three columns for all your purchases up to
the point of your first sale.
3. Now fill in the "Total Shares" column. Obviously, for the
first entry this will be equal to the number of shares bought.
For subsequent entries, it will be equal to the "Total Shares"
value of the previous entry plus the "Number of Shares" value
for the current entry.
4. Fill in the "Total Cost" column the same way.
5. Fill in the "Average Cost" value for the final entry by
dividing that entry's "Total Cost" value by its "Total Shares"
value. You could do this for every entry (and that would be
the easier thing to do in a spreadsheet) but only the average
cost as it existed right before a sale matters, and if you're
doing it manually why waste the time computing and writing
down numbers you won't need?
6. Now put in an entry for your first sale.
* Put down the date.
* Put the quantity of shares sold in the "Number of Shares"
entry as a *negative* number (you are selling them, after
all).
* Multiply "Number of Shares" by the average cost you got
in step (5) and enter that in the "Cost" column. This
will be negative -- as well it should -- since a sale
reduces your total basis by the basis of the shares that
are sold.
* Fill in "Total Shares" for this entry like you did in
step (3). Since "Number of Shares" for this entry is
negative, "Total Shares" will decrease as it should.
* Fill in "Total Cost" for this entry like you did in step
(4). Since "Cost" for this entry is negative, "Total
Cost" will decrease as it should.
* Note that your gain (or loss) on the sale is the sum of
your sales proceeds and the "Cost" value (which is a
negative number) of the sale entry.
7. If your next transaction is a sale, do it just like (6). If
your next transaction is a purchase:
* Put down the date.
* Put down the shares bought in the "Number of Shares"
column.
* Put down the cost in the "Cost" column.
* Fill in "Total Shares" as in step (3).
* Fill in "Total Cost" as in step (4).
* If desired, fill in average cost column. You only really
have to do this for a purchase entry that immediately
preceeds a sale entry.
8. Keep the sheet up to date with all purchases and sales as you
make them.

Note that this procedure only tells you the overall gain or loss on
a sale. You still have to determine the holding period for the
shares sold, and if multiple holding periods are involved,
apportion the gain or loss into each holding period.

As previously stated, you must consider the oldest remaining shares
to be the ones sold for this purpose. So if you sell N shares, go
back to your purchase records and mark off (physically or mentally)
the oldest remaining N shares (which may well be from different
purchases) and see what the holding periods are.

Here's an example for all of this:
* On 02/01/97 buy 100sh for $1000.
* On 08/01/97 buy 75sh for $1000.
* On 12/23/97 reinvest $600 of distributions getting 40sh.
* On 12/01/98 sell 200sh for $4000.
* On 12/24/98 reinvest $300 of distributions getting 14sh
* On 06/15/99 buy 100sh for $2000
* On 10/31/99 sell 50sh for $900

Date Nr Shares Cost Total Shares Total Cost AvgCost
02/01/97 100 $1000.00 100 $1000.00
08/08/97 75 $1000.00 175 $2000.00
12/23/97 40 $ 600.00 215 $2600.00 $12.0930
12/01/98 (200) ($2418.60) 15 $ 181.40
12/24/98 14 $ 300.00 29 $ 481.40
06/15/99 100 $2000.00 129 $2481.40 $19.2357
10/31/99 (50) ($961.79) 79 $1519.61


Since the basis of the shares sold on 12/01/98 was $2418.60 while
the proceeds of that sale were $4000, there was a $1581.40 gain on
the sale. The shares that were sold were the 100 shares purchased
02/01/97, the 75 shares purchased 08/08/97, and 25 of the forty
shares purchased 12/23/97. The 100 shares purchased 02/01/97 have
a holding period of over 12 months, the 75 shares purchased
08/08/97 also have a holding period of over 12 months, and the 25
shares sold out of the block of 40 purchased 12/23/97 have a
holding period of less than 12 months. Enter each piece in the
appropriate part of Schedule D, prorating the $2418.60 basis and
the $4000 proceeds across the pieces based on the number of shares
in each piece.

Now, since the basis of the shares sold on 10/31/99 was $961.79
while the proceeds were $900, there was a $61.79 loss on that sale.
The shares that were sold were the remaining 15 shares in the block
of forty purchased 12/23/97, the 14 shares purchased 12/24/98, and
21 shares from the block of 100 purchased 6/15/99. The 15 shares
purchased 12/23/97 have a holding period over 12 months, while both
the 14 shares purchased 12/24/98 and the 21 shares purchased
06/15/99 have holding periods under 12 months. Again, enter each
piece in the appropriate parts of Schedule D, prorating the $961.79
basis and the $900 proceeds.

Finally, there's a reporting shortcut. If you have multiple
purchase blocks in the same holding period category, you can
combine them into a single entry. Just write "various" for the
acquisition date and combine the basis and proceeds of the blocks
to get the basis and proceeds of the single entry. For example,
for the 10/31/99 sale, on the short-term part of Schedule D I would
combine the 14 12/24/98 shares and the 21 6/15/99 shares into a
single entry, reporting 35 shares, acquisition date of "various",
sell date of 10/31/99, basis of $673.25, proceeds of $630.00, and a
loss of $43.25.

And now you see why I use a piece of software to track all this and
generate reports for me :-).

Remember that the averaging method for computing cost basis applies only
to shares of mutual funds and does not apply to conventional stock
sales. A cost basis includes brokerage and all other costs specifically
attributable to holding the security. Be sure to correct your per-share
values for stock splits (see the article elsewhere in the FAQ for more
information about splits) and dividends, as well as any participation in
a DRIP.

Ok, hopefully by now you have computed the total gain on your equity
sales. Now you have to figure out how much tax you owe. Please see the
article in the FAQ on capital gains tax rates for more help.


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

Subject: Tax Code - Capital Gains Tax Rates

Last-Revised: 10 Jan 2001
Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us)

While reading misc.invest.*, you may have seen people talking about
"long-term gains" or "short-term losses." Despite what it sounds like,
they are not talking about investment strategies, but rather a
potentially important part of the United States tax code. All this
matters because the IRS taxes short- and long-term gains differently.

The "holding period" is the amount of time you held some security before
you sold it. For reasons explained later, the IRS cares about how long
you have held capital assets that you have sold. The holding period is
measured in months. The nominal start of the holding period clock is
the day after the trade date, not the settlement date. (I say nominal
because there are various IRS rules that will change the holding period
in certain circumstances.) For example, if your trade date is March 18,
then you start counting the holding period on March 19. On April 19
your holding period is one month. On May 19 your holding period is two
months, and so on.

With holding period defined, we can say that a short-term gain or
short-term loss is a gain or loss on a capital asset that had a holding
period of 12 months or less, and that a long-term gain or long-term loss
is a gain or loss on a capital asset that had a holding period of more
than 12 months.

Note that a short-sale is considered short-term regardless of how long
the position is held open. This actually makes a kind of sense, since
the only time you actually held the stock was between when you bought
the stock to cover the position and when you actually delivered that
stock to actually close the position out. This length of time is
somewhere from minutes to a few days.

Net capital gains and losses are fully part of adjusted gross income
(AGI), with the exception that if your net capital loss exceeds $3,000,
you can only take $3,000 of the loss in a tax year and must carry the
remainder forward. If you die with carried-over losses, they are lost.
Short-term and long-term loss carryovers retain their short or long-term
character when they are carried over.

Discussions from this point on talk about the various tax rates on
capital gains. It is important to note that these rates are only the
nominal rates. Because capital gains are part of AGI, if your AGI is
such that you are subject to phaseouts and floors on your itemized
deductions, personal exemptions, and other deductions and credits, your
actual marginal tax rate on the gains will exceed the nominal tax rate.

Short-term gains are taxed as ordinary income. Therefore, the nominal
tax rate will be whatever tax bracket you are in.

Long-term gains are a somewhat more complicated. The majority of people
will only have two rates to worry about -- 10% and 20%. Your long-term
gains are taxed at 10% if you are in the 15% bracket overall and 20% if
you are in any other bracket. The long-term gains are included when
figuring out what bracket you're in. However, the 10%/20% rate doesn't
apply to all long-term gains. Long-term gains on collectibles, some
types of restricted stock, and certain other assets are instead subject
to rate that is the lesser of your tax bracket or 28%. And certain
kinds of real estate depreciation recapture are taxed no higher than
25%. I do note that for 1998 only, many average investors will see some
so-called 28% gain. This will be from mutual fund capital gain
distributions made in the 1st quarter of 1998 for gains realized by the
fund in the closing months of 1997, when a different set of rules was in
place. Your fund should provide explanations when you receive 1099-DIV
forms in early 1999.

Another complication in long-term taxation arrives January 1, 2001. As
of that day (unless Congress changes things before than), lower rates
come into effect for gains having a holding period of over 60 months
(called the "ultra-long-term rate" here). The rates are 8% if you are
in the 15% bracket, 18% otherwise.

If the asset was acquired before 1/1/2001 it can never gain 8%/18%
(i.e., ultra-long-term) status (with exceptions) no matter how long it
is held. The exception is that you can mark the asset to market at its
fair market value on 1/1/2001. You will have to declare as income and
pay tax on any unrealized gain (and presumably get to deduct any
unrealized loss) on the asset. The holding period clock will also
reset. (This is the same as selling and repurchasing the asset without
actually doing so. It is currently unclear if wash sale rules will
apply to loss property marked to market).

There is yet another twist to this exception -- if you are in the 15%
bracket, the 8% rate is available to you as of 1/1/01, even if you did
not acquire the asset before 1/1/01. In any case, I strongly advise
researching the issue and talking to a tax professional before doing
something that is subject to this rule.

Here's a summary table:

Tax Bracket S-T Rate L-T Rate U-L-T Rate
15% 15% 10% 8%
28% 28% 20% 18%
31% 31% 20% 18%
36% 36% 20% 18%
39.6% 39.6% 20% 18%


As you can see, the ordinary income and short-term rate is over 100%
higher (39.6% vs. 18%) than the ultra-long-term rate and close to 100%
higher than the long-term rate. While you should never let the income
tax "tail" wag the prudent investing "dog," the ultra/long/short term
distinction is something to keep in mind if you are considering selling
at a gain and are getting close to one of the holding period boundaries,
especially if you are close to qualifying for long-term treatment.

Now what happens if you have both short-term capital gains and losses,
as well as long-term gains and losses? Do short-term losses have to
offset short-term gains? Do long-term losses have to offset long-term
gains? Well, the rules for computing your net gain or loss are as
follows.

1. You combine short-term loss and short-term gain to arrive at net
short-term gain (loss). This happens on Sched D, Part I.
2. You combine long-term loss and long-term gain to arrive at net
long-term gain (loss). This happens on Sched D, Part II.
3. You combine net short-term gain (loss) and net long-term gain
(loss) to arrive at net gain (loss). This happens on Sched D, Part
III.
* If you have both a short-term loss and a long-term loss, your
net loss will have both short-term and long-term components.
This matters if you have a loss carryover (see below).
* If you have both a short-term gain and a long-term gain, your
net gain will have both short-term and long-term components.
This matters because only the long-term piece gets the special
capital gains tax rate treatment.
* If you have a gain in one category and a loss in another, but
have a gain overall, that overall gain will be the same
category as the category that had the gain. If you have a
loss overall, that overall loss will be the same category as
the category that had the loss.
4. If you have a net loss and it is less than $3,000 ($1,500 if
married filing separately) you get to take the whole loss against
your other income. If the loss is more than $3,000, you only get
to take $3,000 of it against other income and must carry the rest
forward to next year. When taking the $3,000 loss, you must take
it first from the ST portion (if any) of your loss. The Capital
Loss Carryover Worksheet in the Sched D instructions takes you
through this.
5. If you have a net gain, the smaller of the net gain or the net
long-term gain will get the special tax rate. This happens on
Sched D, Part IV.


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

Subject: Tax Code - Cashless Option Exercise

Last-Revised: 12 June 2000
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact
me )

This article discusses the tax treatment of an employee's income that
derives from stock options, specifically the case in which an employee
exercises non-qualified stock options without putting any money down.

First, a digression. What is a non-qualified option? A non-qualified
stock option is the most popular form of stock option given to
employees. Basically, an employee who exercises a non-qualified option
to buy stock has to report taxable income at the time of the purchase,
and that income is taxed as regular income (not as a capital gain). In
contrast, an incentive stock option (ISO) dodges these tax bullets, but
is more complicated because employees who receive ISOs have to worry
about alternative minimum tax (AMT). Unfortunately some companies are
sloppy about naming, and use the term ISO for what are really
non-qualified stock options, so be cautious.

Next, what is a cashless exercise? Basically, this is a way for an
employee to benefit from his or her stock option without needing to come
up with the money to purchase the shares. Any employee stock option is
basically a call option with a very long expiration; hopefully it's also
deep in the money (also see the FAQ article on the basics of stock
options ). When a call option is exercised, the person who exercises it
has to pay to buy the shares. If, however, the person is primarily
interested in selling the shares again immediately, then a cashless
option becomes interesting. The company essentially lends the person
the money needed for the option exercise for the fraction of a second
that the person owns the shares.

In a typical cashless exercise of non-qualified stock options (you can
tell it is non-qualified because the W-2 form suddenly has a huge amount
added to it for stock option exercise), here is what happens. Let's use
E as the Option Exercise Price and FMV as the fair market value of the
shares. The employee needs to pay E as part of the option exercise.
But this is a cashless exercise, so the company (or, more likely, a
broker acting as the company's agent) lends the employee that amount (E)
for a few moments. The stock is immediately sold, for FMV. The broker
takes back the amount, E, loaned to the employee for the exercise, and
pays out the difference, FMV-E. The broker will almost certainly also
charge a commission.

Ok, now for those fortunate people who are able to do a cashless stock
option exercise, and choose to do so, how do they report the transaction
to the IRS? The company imputes income to the employee of the difference
between fair market value and exercise price, FMV-E. That amount is
added to the employee's W-2 form, and hopefully shows up in Box 14 with
a cryptic note such as STKOPT or whatever. The amount FMV-E is the
imputed income. Again, you will notice FMV-E is not only what the
broker paid out, it is also the imputed income amount that shows up in
the W-2 form.

The Schedule D sales amount reported by the broker is FMV minus any
commission. The employee's cost basis is the FMV. So the FMV is the
sales price, and the Schedule D for this transaction will show zero (if
no commission was charged) or a small loss (due to the commission).

In certain situations, FMV might differ slightly from the price at which
the shares were sold, depending on how the company does it, and if so,
the company should report the FMV to the employee. Then the Schedule D
must be completed appropriately to show the short-term gain or loss (the
difference between the sales price and FMV).

For extensive notes on stock and option compensation, visit the Fairmark
site with articles by Kaye Thomas:


Julia K. O'Neill offers an extensive discussion of the differences
between incentive stock options and non-qualified options:



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

Subject: Tax Code - Deductions for Investors

Last-Revised: 24 Oct 1997
Contributed-By: Art Kamlet (artkamlet at aol.com), David Ray

This article offers a brief overview of the deductions that investors
can claim when filing US tax returns.

The most significant one is losses. An investor may deduct up to
US$3,000 in net capital losses each year using the Form 1040 Schedule D.
Additional losses in a calendar year can be carried forward to the
following year. Note the key word in the first sentence: net capital
losses. For example, if you realized $5,000 in capital gains and $9,000
in capital losses during a tax year, you would have a net capital loss
for that year of $4,000. You could deduct $3,000 for that year, and
carry forward $1,000 of net loss to the following year's tax return.
Another example: if you realized a loss of 4,000 in one stock and a net
gain of 4,000 in a second stock, you could not deduct anything because
the net loss was zero.

What about margin interest? If you borrow money to purchase securities
(not tax-exempt instruments), and if you itemize deductions on Schedule
A, you can itemize as investment interest on Schedule A (Interest, not
Misc. deductions) the investment interest you actually paid, but only
to the extent you had that much investment income. Investment interest
that you cannot claim because you didn't have enough investment income
can be carried forward to the next year.

Investment income includes investment interest, dividends, and
short-term capital gains. You can elect to include mid- and long-term
capital gains, but if you do, you cannot choose to elect tax-favored
treatment of those gains.


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

aSubject: Tax Code - Estate and Gift Tax

Last-Revised: 6 Jan 2003
Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us), Art
Kamlet (artkamlet at aol.com), John Fisher (TaxService at aol.com),
Chris Lott ( contact me )

This article offers an overview of the estate and gift taxes imposed in
the United States. The main issue is the amount of money a person can
"gift" (used as a verb in this context) to another person without tax
consequences, as well as the tax consequences when that amount is
exceeded. The handling of estates is relevant and discussed with gift
taxes because transfers while a person is living (i.e., gifts) can
influence estate taxes.

Here's a brief summary. An estate of less than US$1,000,000 will not be
taxed in 2003 (although it depends on prior gifts, read on). A gift
recipient never has anything to worry about, no matter the size, because
gifts are not taxable income. A gift giver who gives less than $11,000
to any one individual in one year also has nothing to worry about. If a
person gives more than $11,000 to an individual in one year, then the
regulations discussed in the rest of this article must be followed
carefully. Finally, note that gifts are never deductable from a gift
giver's gross income.

A fundamental concept to understand here is the unified credit .
Roughly speaking, this is the amount of wealth that the IRS (well,
really the US Congress) allows a person to transfer without incurring
various tax obligations. As of this writing, the unified credit amount
for tax year 2003 is $1,000,000. But given the annual gift tax
exclusion amount of $11,000 (newly increased in 2002 from 10,000 in
prior years), the total amount that a person can effectively transfer to
another individual without triggering taxes is much larger. The term
"unified credit" is used because the credit is the "unified gift/estate
tax credit". This is a single, combined credit amount that is applied
against both gift and estate tax.

A person can gift fairly large amounts annually without affecting the
unified credit. Basically, any US taxpayer can gift up to $11,000 to a
single person in a tax year and there are no tax consequences: the gift
giver's lifetime unified credit is not affected, and the gift recipient
pays no tax. In fact, a person can make $11,000 gifts to as many
different people in a year as she or he likes with no tax consequences.
(See below; this number is indexed to inflation and will change over
time.) Spouses can give each other gifts of any amount without gift tax
filings. Finally, a husband and wife can gift anyone $22,000 without
gift tax consequences, but unless the husband gives 11,000 and the wife
gives 11,000 (e.g., they both write a check), they should file a Form
709a with the IRS and elect to use gift splitting.

What is gift splitting? Gift splitting means a husband and wife can
elect to treat a gift given by one of them as if half were given by each
of them. The implications are simple: If one spouse gives $22,000 to
someone during the year, and gift splitting is not elected, the IRS can
treat that as a 22,000 gift by just the one spouse, even if the funds
are drawn from a joint account. The IRS Form 709a can be filed for
notifying the IRS that gift splitting is elected. (The instructions for
the form are on the form itself.) This is a bit silly in many cases,
since in community property states, community property is automatically
considered split equally between each spouse, but that requires the IRS
to somehow know it came from community property funds and not from
non-community funds. So they require you to prove it, basically.

If a donor gives away more than $11,000 to a person (not a charity) in a
tax year, then the donor may owe gift tax, depending on the donor's
history of giving. After making a large gift, the donor is responsible
for filing a Form 709 declaring that gift and keeping a running,
lifetime total of the lifetime exclusion used. As long as the exclusion
is below the maximum, no gift tax is due. Once the exclusion reaches
the maximum, the donor calculates the tax due with Form 709 and attaches
a check (payable to the United States Treasury). So in a nutshell,
computation of gift tax is quite easy: just fill out the 709. If there
is some remaining lifetime gift tax exclusion remaining, then there is
no tax due. If there is no exclusion remaining, there is tax due. Note
that there is no way to pay gift tax and somehow "preserve" some amount
of lifetime exclusion; the system simply does not work that way.

Now we'll discuss the lifetime exclusion. Basically, the first $1
million of transfers in life and death are exempt from estate and gift
tax as of 2002 (and remains that way in 2003). However, it is not
handled in quite in the way that most people think. Most people (for
example) think that when someone who made no taxable transfers during
life dies, you total up the estate, subtract off any deductions, and
then subtract $1,000,000 and compute the tax on whatever (if anything)
is left. The way it actually works is that you subtract off any
deductions, compute the tax on that amount, and then apply against the
tax the unified credit of about $300,000 (this number needs to be
checked).

Of course the result is identical for most estates; the first $1 mil of
the estate is not taxed. But look what happens to the first dollar past
the limit. If the tax really was done the first way, the taxable estate
would be $1, and you'd be starting at the bottom of the estate tax
bracket structure. But what actually happens is that you compute the
tax on an estate of $1,000,001, which leaves you in the middle of the
bracket structure, and then subtract off the credit. So your marginal
rate is much higher under the way things actual work than it is under
the "naive" way.

A gift (used as a noun) in this article means a gift of present value .
A gift of present value is an unrestricted gift the receiver can use
immediately (if an adult, or immediately upon becoming an adult).
However, if a trust is set up for a child and the trust is payable to
the child only on the child's 25th birthday provided the child has
graduated from college and has no felony convictions, that gift is
considered restricted (it's not a gift of present value), so a 709 would
have to be filed starting at the first gift dollar.

Note that if securities or other non-cash instrument is given, the fair
market value of the securities on the gift date are used to determine
whether the gift tax rules apply.

Ok, time for an example: If an individual makes a gift of present value
of $41,000 in a year, the 30,000 above the 11k limit reduces the amount
of estate excluded from estate tax to the current limit less the 30,000.

Now another example: What happens if a wealthy married couple (we'll
call them Smith) gifts $44,000 to a less wealthy married couple (let's
call them Doe)? This is perfectly ok and has no tax consequences
provided things are done properly. Let's examine some of the
possibilities. If a single check is drawn on Mr. Smith's account and
deposited into Mrs. Doe's account, the very conservative amongst the
tax folk will point out that the gift was from Mr. Smith and not Mr.
and Mrs. Smith and further, even if the check was to both Doe's, it was
deposited into only one of the Doe's accounts, so it could be a gift of
44,000 from one person to another! Since the gift splitting rule is out
there, the moderately conservative tax experts would have separate
checks written to Mr. Doe and Mrs. Doe. The ultra conservative would
have four checks written of 11k each (the combinations are left as an
excercise for the reader :-). The use of four checks avoids the gift
splitting election as well as the worry about whose account it is
deposited in. (Since a spouse can gift unlimited amounts to the other
spouse, it really should not matter.)

Dramatic changes to the estate tax laws were made by the Economic Growth
and Tax Relief Reconciliation Act of 2001. In fact, that act repealed
the estate tax -- but with many caveats. The lifetime exclusion numbers
for the next ten years are as follows: $1 million in 2003; 1.5 million
in 2004 and '05, $2 million for 2006, '07, and '08, and finally $3.5
million in 2009. And in 2010, the estate tax is gone. But (don't you
just love Congress), in 2011 the estate tax comes back with a lifetime
exclusion of $1 million. This is how Congress balances its books. It's
anyone's guess what will actually happen by 2011. Note that the gift
tax was not repealed; the lifetime exclusion remains stuck at $1 million
after 2011. And the annual gift tax exclusion amount is $11,000 in
2003; because this number is indexed to inflation, it is difficult to
predict how this value will change in future years.

To recap one important issue, the blessed repicients of a gift never pay
any tax. Stated a bit differently, receipt of a gift is not a taxable
event. Of course if someone gives you securities, and you immediately
sell them, the sale is a taxable event. See the article elsewhere in
the FAQ about calculating cost basis for help with computing the number
used when reporting the sale to the IRS.

For more information about estate issues, visit Robert Clofine's site:



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

Subject: Tax Code - Gifts of Stock

Last-Revised: 20 Dec 1999
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact
me )

This article introduces some issues that crop up when making gifts of
stock. Gift taxes are an orthogonal but closely related issue; see the
article elsewhere in the FAQ for more details. Also see the FAQ article
on determining the cost basis of securities for notes on computing the
basis on shares that were received as a gift.

Occasionally the question crops up from a person who has nice stock
gains and would like to give some money to another person. Should the
stockholder sell stock and give cash, or give stock directly? It's best
to seek professional tax advice in this situation. If stock is given,
and the recipient needs cash so sells the shares immediately, the
recipient only keeps about 80% of the value after paying capital gains
tax. I.e., the gift came with a big tax bill. On the other hand, if
the stockholder sells some stock (perhaps to stay under the 10k annual
exclusion), that pushes up that person's annual income. If the
stockholder has a sufficiently high income, then the stock sale could
push that person across various thresholds, one for which itemized
deductions begin to be reduced, and the other where personal exemptions
begin to be phased out. In addition, higher income could possibly
trigger alternate minimum tax (AMT).


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

Compilation Copyright (c) 2003 by Christopher Lott.

The Investment FAQ (part 17 of 20)

am 30.05.2005 06:30:08 von noreply

Archive-name: investment-faq/general/part17
Version: $Id: part17,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 17 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: Technical Analysis - Information Sources

Last-Revised: 12 Dec 1996
Contributed-By: (Original author unknown), Chris Lott ( contact me )

This article lists some sources of information for technical analysis,
including books, magazines, and courses.

Books on Technical Analysis:

* Design, Testing, and Optimization of Trading Systems by Robert
Pardo. Published by John Wiley & Sons, Inc.
* The Disciplined Trader by Mark Douglas of NYIF - 1990. ISBN
0-13-215757-8
* Elliott Wave Principle by A. J. Frost and Robert Prechter, New
Classics Library, ISBN: 0-932750-07-9.
* Encyclopedia of Technical Market Indicators by Robert Colby and
Thomas Meyers, Dow Jones Irwin.
* Market Wizards by Jack Swager
* The Mathematics of Technical Analysis by Clifford Sherry, 1992
Probus Publishing, ISBN 1-55738-462-2
* New Market Wizards by Jack Swager
* Patterns for Profits by Sherman McClellan, Foundation for the Study
of Cycles, 900 W. Valley Rd. Suite 502, Wayne, PA 19087,
215-995-2120.
* Proceedings, Second Annual conference on Artificial Intelligence
Applications on Wall Street, Roy S. Freedman, Ed. NYC, April
19-22, 1993, Pub: Software Engineering Press, 973C Russell Ave,
Gaithersburg, MD 20879, (301) 948-5391.
* Secrets for Profiting in Bull and Bear Markets, by Stan Weinstein,
Dow Jones-Irwin.
* Technical Analysis, by Clifford Sherry, 1992 Probus Publishing,
ISBN 1-55738-462-2.
* Technical Analysis Explained, by Martin J. Pring, McGraw-Hill, 3rd
ed. 1991, ISBN 0-07-051042-3.
* Technical Analysis of the Futures Markets, by John J. Murphy of NY
Institute of Finance, Prentice Hall, 1986, ISBN 0-13-898008-X.
* Study Guide for Technical Analysis of the Futures Markets: A
self-training manual, by John Murphy (the most comprehensive book
on the subject).
* Technical Analysis of Stock Trends, by Edwards and Magee (a serious
study of classical charting techniques).
* The Major Works of R. N. Elliott, edited by Robert Prechter, New
Classics Library.
* Timing the Market: HOW TO PROFIT IN BULL AND BEAR MARKETS WITH
TECHNICAL ANALYSIS, by Weiss Research (a good introductory text for
those using METASTOCK PROFESSIONAL and want to make money with it).

Sources for books on technical analysis:
* TRADERS PRESS, INC., P.O. BOX 10344, Greenville, S.C. 29603,
(800)927-8222, (803)-298-0222, FAX: (803)-298-0221. Offer a 40+
page catalog, nice folks, great service. VI/MC/AX accepted.
* TRADER'S WORLD, 2508 Grayrock Street, Springfield, MO 65810,
(800)288-4266, (417) 298-0221. Puts out a quarterly magazine
(mostly junk) with discounted Technical Analysis books (usually 10%
cheaper than elsewhere). VI/MC/AX accepted.
* New Classics Library, Inc., P.O. Box 1618, Gainesville, GA 30503.

Books on options pricing:

* Continuous Time Finance, by Robert Merton
* The Elements of Successful Trading, by Rotella, Robert P., 1992
* Options as a Strategic Investment, by McMillan, Lawrence G., New
York Inst. of Finance, 2nd edition, 1986, ISBN 0-13-638347-5.
* Options Markets, by Cox, J.C and Rubenstein, M., Prentice-Hall,
1985.
* Options: Essential Trading Concepts and Trading Strategies, Edited
by The Options Intsitute, 1990, Business One Irwin, ISBN
1-55623-102-4.
* Options, Futures, and Other Derivative Securities, by Hull, J.,
Prentice-Hall, 1989.
* Options: Theory, Strategy, and Apllications, by Ritchken, P, Scott,
Foresman, 1987.
* Option Pricing, by Jarrow, R. A., Irwin, 1983.
* Option Volatility and Pricing Strategies, by Natenberg, Shelly
* Theory of Financial Decision Making, by Ingersoll

Magazines on technical analysis:

* Technical Analysis of Stocks & Commodities
4757 California Ave. SW, Seattle, WA 98116-4499, 800-832-4642,
(206) 938-0570. 1 yr. - $64.95 -- 12 issues
Everything explained at the level of the beginner, however you
should complete a course before getting this magazine. Best part
is building a library by buying the bound back issues -- worth
every penny.
* Futures - commodities, options & derivatives
800-221-4352 Ext. 1000
1 yr. - $39.00 - 12 issues
* NeuroVe$t Journal
Pub. by Randall B. Caldwell, PO Box 764, Haymarket, VA
22069-0764, email:
$75(US)/yr, published bi-monthly
* Traders Cataloge and Resource Guide
619-930-1050
$39.50 year.
* Traders World Magazine
1-800-288-4266
Published every 3 months, $15 per year



A self-paced course on technical analysis:

The Technical Analysis Course by Thomas Meyers
An introductory course covering: Stochastics, RSI, Trendline/chanels,
Support/resistance, Point and Figure, Oscillators, Moving averages,
Volume & Open Interest, Chart construction, Gaps, Reversal Patterns, and
Consolidation formations. Easy read for someone new that doesn't want
to be intimidated.


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

Subject: Technical Analysis - MACD

Last-Revised: 25 Nov 1998
Contributed-By: (Original author unknown), Chris Lott ( contact me ),
Jack Hershey (jhershey at primenet.com)

The Moving Average Convergence/Divergence (MACD) was invented by Gerald
Appel sometime in the sixties and comes in various flavors, but most are
based on a technique developed by McClellan (which he based on a
technique developed by Haurlan). The technique is to take the
difference between two exponential moving averages (EMA's) with
different periods. This produces what's generally referred to as an
oscillator. An oscillator is so named because the resulting curve
swings back and forth across the zero line.

Appel's version used the difference between a 12-day EMA and a 25-day
EMA to generate his primary series. This series was plotted as a solid
line. Then he took a 9-day EMA of the difference and plotted that as a
dotted line. The 9-day EMA trails the primary series by just a bit, and
trades are signalled whenever the solid line crosses the dotted line.

For more volatile markets, you may want to shorten the periods of the
EMA's. I seem to remember one trader that used an MACD on futures data
with 7-day and 13-day for the primary series and a 5-day EMA of that for
the trailing curve. I also know a fellow who runs an MACD on the adline
(advancing issues minus declining issues).


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

Subject: Technical Analysis - McClellan Oscillator and Summation Index

Last-Revised: 23 Dec 1997
Contributed-By: Tom McClellan

In 1969, Sherman and Marian McClellan developed the McClellan Oscillator
and its companion tool the McClellan Summation Index to gain an
advantage in selecting the better times to enter and exit the stock
market. This article gives a brief overview of the McClellan Oscillator
and Summation Index.

Every day that stocks are traded, financial publications list the number
of stocks that closed higher (advances) and that closed lower
(declines). The difference between these numbers is called the daily
breadth. The running cumulative total of daily breadth is known as the
Daily Advance-Decline Line. It is important because it shows great
correlation to the movements of the stock market, and because it gives
us another way to quantify the movements of the market other than
looking at the price levels of indices.

Another indicator is called the daily breadth. Each tick mark on a
daily breadth chart represents one day's reading of advances minus
declines. In order to identify the trend that is taking place in the
daily breadth, we smooth the data by using a special type of calculation
known as an exponential moving average (EMA). It works by weighting the
most recent data more heavily, and older data progressively less. The
amount of weighting given to the more recent data is known as the
smoothing constant.

We use two different EMAs: one with a 10% smoothing constant, and one
with a 5% smoothing constant. These are known as the 10% Trend and 5%
Trend for brevity. The numerical difference between these two EMAs is
the value of the McClellan Oscillator.

The McClellan Oscillator offers many types of structures for
interpretation, but there are two main ones. First, when the Oscillator
is positive, it generally portrays money coming into the market;
conversely, when it is negative, it reflects money leaving the market.
Second, when the Oscillator reaches extreme readings, it can reflect an
overbought or oversold condition.

While these two characteristics are very important, they merely scratch
the surface of what interpreting the Oscillator can reveal about the
stock market. Many more important structures are outlined in the book
Patterns For Profit by Sherman and Marian McClellan, available from
McClellan Financial Publications.

If you add up all of the daily values of the McClellan Oscillator, you
will have an indicator known as the McClellan Summation Index. It is
the basis for intermediate and long term interpretation of the stock
market's direction and power. When properly calculated and calibrated,
it is neutral at the +1000 level. It generally moves between 0 and
+2000. When outside these levels, the Summation Index indicates that an
unusual condition is taking place in the market. As with the
Oscillator, the Summation Index offers many different pieces of
information in order to interpret the market's action.

Among the most significant indications given by the Summation Index are
the identification of the end of a bear market and the confirmation of a
new bull market. Bear markets typically end with the Summation Index
below -1200. A strong rise from such a level can signal initiation of a
new bull market. This is confirmed when the Summation Index rises above
+2000. Past examples of such a confirmation have resulted in bull
markets lasting at least 13 months, with the average ones lasting 22-24
months.

The McClellans publish a stock market newsletter called The McClellan
Market Report. Sherman McClellan and his wife Marian McClellan were the
originators of the McClellan Oscillator; Tom McClellan is their son.

For more information, please contact Tom McClellan at (800) 872-3737, or
visit the web site at .


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

Subject: Technical Analysis - On Balance Volume

Last-Revised: 27 Feb 1997
Contributed-By: Y. D. Charlap, Scott A. Thompson (satulysses at
aol.com)

On Balance Volume is a momentum indicator that relates volume to price
changes. It is calculated by adding the day's volume to the cumulative
total when the security's price closes up, and subtracting the day's
volume when the price closes down. The scale is not of any value; only
the slope (i.e., the direction) of the line is of value.

The theory is that the trend of this indicator precedes price changes.
This indicator was pioneered by that famous (?) market maven Joseph
Granville.


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

Subject: Technical Analysis - Relative Strength Indicator

Last-Revised: 17 July 2000
Contributed-By: (Original author unknown), Chris Lott ( contact me ), C.
K. Krishnadas (ckkrish at cyberspace.org)

The Relative Strength Indicator (RSI) was developed by J. Welles Wilder
in 1978. This indicator is one of a family of indicators called
oscillators because it varies (oscillates) between fixed upper and lower
bounds. This particular indicator is supposed to track price momentum.

Wilkder's relative strength indicator is based on the observation that a
stock which is advancing will tend to close nearer to the high of the
day than the low. The reverse is true for declining stocks.

It's easy to confuse Wilder's relative strength indicator with other
relative strength figures that are published. Wilder's indicator
compares the price performance of a stock to that of itself and might be
more appropriately called an "internal strength index". Other similarly
named indicators compare a stock's price to some stock market index or
to another stock.

This indicator has evolved into several forms, but Wilder's RSI is
generally regarded as the most useful. The oscillator is indexed from 0
to 100, and like all oscillators it indicates overbought and oversold
readings. The RSI oscillator is most useful in a trading channel,
especially those with deeply pronounced crests and troughs. Trending
prices tend to distort overbought and oversold signals because indicator
readings will be skewed off-center from a neutral reading of "50".

Very basically, "buy" signals are considered to be readings of 30 or
less (the security is considered oversold) and "sell" signals are
considered to be RSI values of 70 or greater (the security is considered
overbought). Depending on the technician and price volatility, there
are various other qualifiers and nuances that can be incorporated into a
signal. For example, in very volatile markets, the bounds of 20 and 80
might be used to judge oversold and overbought conditions.

Another aspect of this indicator that is commonly varied is the period
over which the indicator is calculated. Wilder began with 14 periods,
but other values are common (e.g., 9 and 25).

The formula is as follows:
Average price change on up days
Relative Strength = ---------------------------------
Average price change on down days
The indicator (RSI) is calculated from the RS value as follows:
100
RSI = 100 - ------
1 + RS
Now that you have the general idea, you probably want to calculate some
RSI values for stocks you're following. Perhaps the easiest way is to
visit one of the web sites shown at the end of this article. But if
you're really determined to compute it yourself, here's one way to do
so.
RS = P / N

P = PS / n1 N = NS / n2

PS = Total of PCi values NS = Total of NCi values

PCi = positive price change NC = negative price change
for period i for period i

Pp = previous value of P Np = previous value of N
(initially 0) (initially 0)

n1 = number of times the price changed in the positive
direction in the last n periods. There will be n1 PCi
values to add together to get PS.

n2 = number of timee the price changed in the negative
direction in the last n periods. There will be n2 NCi
values to add together to get NS.

n = n1 + n2 (the number of periods in the RSI calculation)
Basically you can calculate both PCi and NCi for every day. One or both
of PCi and NCi will be zero. This makes it fairly straightforward to
enter the computation in a spreadsheet. To make it easy to count the
values in a spread sheet, use an "if" statement for each that will yield
blank if appropriate. Then use Excel's count() macro, which counts only
cells with numbers and ignores blanks. Here are the formulas; of course
you will have to replace "this_price" and "previous_price" by approprate
cell references.
* PCi:
IF( this_price - previous_price > 0, this_price - previous, "" )
* NCi:
IF( this_price - previous_price < 0, this_price - previous, "" )
The first non-zero period of PS and NS is computed by doing a simple
moving average of the PC and NC of the previous n periods according to
Wilder's formula.

Remember to skip the first n points before starting the RSI
calculations. Also remember that the first time PS and NS are
calculated, they are simple moving averages of the last n PC's and NC's
respectively. That's where most mistakes are made.

Here are some resources on RSI.
* The May 2000 issue of AAII Journal included a 5-page article about
RSI with examples (they have a two-week free trial membership).

* BigCharts offers a free interactive charting feature that includes
(among many others) RSI.

* The original book by J. Welles Wilder
New Concepts in Technical Trading Systems


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

Subject: Technical Analysis - Stochastics

Last-Revised: 25 Nov 1998
Contributed-By: (Original author unknown), Chris Lott ( contact me )

This article gives the formula for stochastics. The raw stochastic is
computed as the position of today's close as a percentage of the range
established by the highest high and the lowest low of the time period
you use. The raw stochastic (%K) is then smoothed exponentially to
yield the %D value. These calculations produce the original or fast
stochastics.
%K = 100 [ ( C - L5 ) / ( H5 - L5 ) ]
where: C is the latest close, L5 is the lowest low for the last five
days, and H5 is the highest high for the same five days
%D = 100 x ( H3 / L3 )
where: H3 is the three day sum of ( C - L5 ) and L3 is the 3-day sum of
( H5 - L5 )


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

Subject: Trading - Basics

Last-Revised: 1 Jan 2004
Contributed-By: Chris Lott ( contact me )

This article offers a very basic introduction to stock trading. It goes
through the steps of buying and selling shares, and explains the
fundamental issues of how an investor can make or lose money by buying
and selling shares of stock. This article will simplify and generalize
quite a bit; the goal is to get across the basic idea without cluttering
the issue with too many details. In some places I've included links to
other articles in the FAQ that explain the details, but feel free to
skip those links the first time you read over this.

You may know already that a share of stock is essentially a portion of a
company. The stock holders are the owners of a company. In theory, the
owners (stock holders) make money when the company makes money, and lose
money when the company loses money. Once there was age of internet
stocks where companies lost lots of money but the shareholders still
made lots of money (and then lost money themselves), but let's just say
that the main trick is to buy only stocks that go up.

Next we will walk through a stock purchase and sale to illustrate how
you, an investor in stocks, can make money--or lose money--by buying and
selling stocks.
1. One fine day you decide to buy shares of some stock, let's pick on
AT&T. Maybe you think that company will soon return to being the
all-powerful, highly profitable "Ma Bell" that it once was. Or you
just think their ads are cool. So now what?


2. Although there are many ways to buy shares of stock, you decide to
take the old-fashioned route of using an old-fashioned stock broker
who has an office in your town and (imagine!) takes your phone
calls. You open an account with your friendly broker and deposit
some good old-fashioned cash. Let's say you deposit $1,000.


3. You ask your broker about the current market price quoted for AT&T
shares. Your broker is a good broker, and like any good broker he
knows that AT&T's ticker symbol is the single letter 'T'. He
punches T into his quote request system and asks for the current
market price (supplied from the New York Stock Exchange, where T is
primarily traded), and out pops a price of 20.25 (stocks were once
quoted as fractions like 1/4 but are now done with decimals).
Looks like your $1,000 will buy almost 50 shares, but because this
is your very first stock trade, you decide to buy just 10 shares.


4. You ask your broker to buy 10 shares for you at the current market
price. In the lingo of your broker, you give a market order for 10
shares of T. Your broker is a nice guy and only charges a
commission on a single stock trade of $30 (not too bad for someone
who takes your phone calls). Your broker enters the order, and his
computer then figures the price you will ultimately pay for those
10 shares, which is 10 (the number of shares) times 20.25 (the
current price for the shares on the open market) for a total of
202.50, plus 30 (the broker's commission, don't forget he has to
eat too), for a grand total of $232.50.


5. Then magic happens: your broker instantly finds someone willing to
sell you 10 shares at the current market price of 20.25 and buys
them for you from that someone. Your broker takes money from your
account and sends it off to that someone who sold you the shares.
Your broker also takes his $30 commission from your account. In
the end, your hard-earned money is gone, and your account has 10
shares of AT&T. A (very small) fraction of the company, as
represented by those 10 shares, is now in your hands!

Now it's time for a few details, which you can safely skip if you
choose. The person who sold you the shares was a specialist
("spec") on the NYSE; for more information, look into the NYSE's
auction trading system . Roughly, a specialist is a type of
middleman and a member (like your broker) of the financial services
industry. After you give the order, the shares do not appear
instantly; they appear in your account three business days after
you gave the order (called "T+3"). In other words, trades settle
in three business days.

Please pardon a fair amount of oversimplification here, but the
trade and settlement procedures involved with making sure those 10
shares come to your account can happen in many, many different
ways. You're paying that commission so things are easy for you,
and indeed they are: for a relatively modest fee, your broker got
you the shares.

It may be important to point out here that AT&T, that big company
from Bedminster, New Jersey, did not participate in this stock
trade. Sure, their shares changed hands, but that's all. Shares
of publicly traded companies that are bought on the open market
never come from the company. Further, the money that you pay for
shares bought on the open market does not go to the company. Sure,
the company sold shares to the public at one point (an event called
a public offering), but your trade was done on the open market.

After the trade settles, then what? Your broker keeps some of the
$30 commission personally, and some goes to the company he works
for. The shares are in your brokerage account. This is called
holding shares "in street name." If you really want to hold the
stock certificates, your broker will be happy to arrange this, but
he will probably charge you about another $30. Since you feel
you've paid your broker enough already (and you're right), you
decide to leave the shares in your account ("in street name").


6. The next day, AT&T shares close at a price of 21, which is a rise
of $0.75. Great, you think, I just made $7.50. And in some sense
you're right. The value of your holdings has increased by that
amount. This is a paper gain or unrealized gain; i.e., on paper,
you're $7.50 wealthier. That money is not in your pocket, though,
and you do not need to tell the IRS. The IRS only cares about
actual (realized) gains, and you don't have any, not yet.


7. The following day, AT&T shares close at a price of 22. which is
another rise over the price you paid and a rise over the previous
day. Fantastic, you think, boy can I pick them, today I made
another $10! At this point, you have a paper gain of 10 times 1.75
which is 17.50. Not too bad for two days.


8. That evening you decide that maybe AT&T really isn't such a great
wireless phone company after all and it's time to sell. You make a
call the next morning, and although your broker is a bit surprised
to hear from you again so soon, he's obliging (after all, it's your
money). Again your broker asks for a quote of the current market
price for 'T.' The current market price for AT&T on the NYSE is
22.50 (wow, another rise). Your broker accepts your order to sell
T at the market. Again his computer figures the money you will
receive from the sale: 10 (the number of shares) times 22.50 (the
current market price) for a total of 225, less his commission of
30, for a grand total of 195.


9. Magic happens again: instantly your broker finds someone willing to
buy the 10 shares of AT&T from you at the current price, and sells
your shares to that someone. That someone sends you $225. Your
broker deducts his commission of $30 from the proceeds of the sale,
so eventually the shares of AT&T disappear from your account and a
credit of $195 appears. Note again that the company did not
participate in this trade, although shares (and fractional
ownership of the company represented by those 10 shares) changed
hands.

As explained above, that someone was a person at the NYSE called a
specialist ("spec"), a member of the financial services industry.
The trade will be settled in exactly 3 business days (upon
settlement, the shares are gone and you have the cash). Again I
apologize for the oversimplification here.


10. So you calculate the result. Gee, you think, the stock went up
every day.. and I paid $232.50.. but I only received $195.. and
pretty quickly you come to the inescapable conclusion that you lost
$37.50, even though you had a paper gain every day. This is the
problem with commissions: they reduce your returns. You paid over
15% of your capital in commissions, so although the share price
rose about that much in just a couple of days, you lost money
because the commissions exceeded the gains.


11. Eventually you do your taxes. You have a short-term capital loss
of $37.50 from this pair of trades. Depending on your tax
situation, you may be able to deduct your loss from your gross
income.

Now you should understand the basic mechanics of buying and selling
shares of stock, and you see the importance of commissions.

Just for comparison, let's run the numbers if you had bought 50 shares
instead of just 10 (maybe you found another few dollars). The purchase
price of (50 * 20.25) + 30 is 1042.50. The sales price of (50 * 22.50)
- 30 is 1095. The difference is $52.50 in your favor. What this says
is that commissions can really hurt the small investor, and is a good
reason for really small investors to consider investing via no-load
mutual funds or direct investment plans (DRIPs) .


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

Subject: Trading - After Hours

Last-Revised: 12 Feb 2004
Contributed-By: John Schott (jschott at voicenet.com), Chris Lott (
contact me ), P. Healy, James Owens

After-hours trading has traditionally referred to securities trading
that occurs after the major U.S. exchanges close. Until 1999,
after-hours trading in the U.S. was mostly restricted to big-block
trading among professionals and institutions. Much of this sort of
trading was supported by electronic trading networks (ECNs). One of the
oldest and best known ECN is Instinet, a network operated by Reuters
that helps buyers meet sellers (there's no physical exchange where
someone like a specialist works). Another is Island ECN, a relatively
new network that (interestingly) has applied to the SEC to be a new
stock exchange. With the advent of these ECNs where trades can take
place at any hour of any day, time and place have taken on a reduced
meaning.

Anyhow, until summer 1999, individual investors had no access to these
trading venues. And it was only natural that some investors clamored
for equal access to what the professionals had. Perhaps individuals
felt that they would be able to pick up bargins in the after-hours
trading as news announcements filter out and before stocks reopen on the
following day. While that is highly unlikely (prices fluctuate after
hours just as they do during the regular trading day), their wishes for
equal access have been granted.

As of early 2003, there are basically three types of before-hours and
after-hours markets, as follows.



U.S. exchange after-hour markets
The NYSE and ASE provide crossing sessions in which matching buy
and sell orders can be executed at 5:00 p.m. based on the
exchanges' 4:00 p.m. closing prices. The BSE and PSE have
post-primary sessions that operate from 4:00 to 4:15. CHX and PCX
operate their post-primary sessions until 4:30 p.m. Additionally
CHX has an "E-Session" to handle limit orders from 4:30 to 6:30p.m.
Foreign exchange after-hour markets
Several foreign exchanges also trade certain NYSE-listed stocks.
Hours are governed by those individual markets.
ECN after hour markets.
Electronic communication networks (ECNs) have allowed institutions
to participate in after-market trades since 1975; individuals
joined the party in 1999. Typically, extended-hour trades must be
done with limit orders.


A short list of typical brokers that offer ECN access and the extended
hours available is listed below. This list is meant to be illustrative,
not exhaustive.
* Ameritrade (via Island ECN)
Hours: 8am-8pm Eastern; limit orders only during extended hours.
* E*Trade (via Archipelago ECN)
Hours: 8am-8pm Eastern; limit orders only during extended hours.
Note that eextended-hours orders can be placed even during regular
market hours; these orders may be filled during normal or
extended-trading hours.
* Fidelity (via Redibook)
Hours: 7:30-915am and 4:15-8:00pm EST; restrictions on order types.
* Harris Direct (via Redibook ECN)
Hours: 8-9:15am and 4:15-7pm Eastern; limit orders only; round
lots.
* Schwab (via Redibook ECN)
Hours: 7:30-9:15am and 4:15-8pm Eastern, Monday - Friday; limit
orders only.
* TD Waterhouse (via ???)
Hours: 7:30-9:30am and 4:15-7:00pm EST

Most of the after-hours markets function as crossing markets. That is,
your order and my opposing order are filled only if they can be matched
(i.e., crossed). In an extreme example, the new Market XT requires ONLY
limit orders.

The concept of trading after exchange hours seems attractive, but it
brings with it a new set of problems. Most importantly, the traditional
liquidity that the daily market offers could suffer.

I want to digress into a quick review of the mechanisms on the NYSE and
NASDAQ that provide for liquidity and buffering, mechanisms that are
mostly absent on the ECNs. In the case of the New York exchange, the
specialist ("specs") there are required to act as buffers by buying and
selling for their own accounts. This serves to smooth out market
action. (Whether they do in times of stress is doubtful, but that's
another matter entirely.) In the case of the NASDAQ, an all-electronic
exchange, many firms may offer to "make a market" in a specific stock.
They post buy and sell offers on a computer system and when there is a
matching counter offer, the trade is made. Meanwhile, onlookers can see
the trading potential of all available bid and ask quotations - a
decidedly different situation than on the NYSE. But note that the
NASDAQ system has no buffering built in (no market maker is required to
buy or sell).

Now, in the new, non-exchange operations with limited information,
limited participation, and what is effectively unbuffered,
person-to-person trading, it's quite reasonable to expect that liquidity
will be poor. Unlike the NYSE's specialist system and the NAQDAQÂ’s
market-maker system, where the daily market can readily accomodate small
orders, the after-hours market will be quite different -- operations are
quite literally in the dark. What we can see is effectively a reduction
in apparent liquidity in normal trading as we slide down the trading
scale (from the NYSE to the after-hours ECNs). On the NYSE there
theoretically is always a bid and ask about the present market price,
but may not be the case in less liquid markets. Ultimately, as seems to
be the case on some ECNs today, we get to the basest market - you and I
trading privately. Either we agree or there is no transaction. It can
get to be a jungle.

Furthermore, Instinet, Island and all the other ECNs don't have a common
reporting structure as do NASDAQ and NYSE. That is, the prices and
volumes on one ECN might be different from that on another ECN. Since
only a few of the biggies have access to multiple ECNs there can be a
chance for arbitrage, which means buying in one place at one price and
selling substantially the same thing somewhere else for a different
price, all in essentially the same time frame in the case of ECNs.

The effect is widened spreads, irregular trading, and a chance for the
unwary (read you and me) to get slightly whacked.

There are other issues as well, of course. At night, the information
resources and public attention that the established exchanges offer
today will be operating at a low level. Today, Microsoft, Intel, or
Dell likely make important announcements during the quiet hours after
the exchanges close. That gives the investment community time to access
and evaluate the news. Now drop the same announcement into an
environment of several uncoordinated after-hours exchanges. Favorable
news may create such demand that it overwhelms the supply offered by now
reluctant sellers. Prices could zoom, only to crash back as more
sellers show up. Lack of full information and considered analysis could
make the daily gyrations of hot stocks like Amazon.com and new IPOs look
boring.

Making things yet less transparent, if I understand it correctly, trades
made on these markets are not part of the reported closing prices you
see in the newspapers. The data is apparently reported separately, at
least on professional-level data systems.

Finally, consider the effect on both the industry and private traders
who now face an extended trading day. Presumably the extended day will
offer even less time for reflection, research, and consideration. Do
the pros stay glued to the tube while eating carryout? Do they employ a
night shift to babysit things? And what about the day workers who now
come home to an evening of trading stress? Thus expanded market hours
may not be the blessing that some expect, only another hazard in today's
stressful life.

Meanwhile the SEC is pushing for some rules and regularity. To get the
blessing as a recognized exchange, expect that the SEC will insist on a
public ticker system (ultimately IÂ’d expect ONE unified quote system
incorporating all of todays exchange's and the ECNs.) Logically, this
leads to expectation of a unified market, and represents a significant
threat to existing markets like the NYSE.

Certain indications suggest that extended hours will become even more
extended (possibly approximating a 24 hour market) in the foreseeable,
though perhaps remote, future. In the past few years, market forces
have constricted efforts to further extend trading hours, but a strong
enough future bull market would almost certainly reverse that trend.

Finally, the term "after-hours" trading is becoming rapidly out of date.
Consider DCX (Daimler-Chrysler), which is traded in identical form on 11
worldwide exchanges in Asia, Europe, and the Americas. For this stock,
the winding down of the day's trading in New York seems an anticlimax to
a day that's already over in Tokyo.



Here are a few more resources with information.
* Instinet runs a site with some information about their operations.

* The Wall Street Journal gave an update on Friday, 27 August 1999 on
the front page of the Money and Investing section.


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

Subject: Trading - Bid, Offer, and Spread

Last-Revised: 1 Feb 1998
Contributed-By: Chris Lott ( contact me ), John Schott (jschott at
voicenet.com)

If you want to buy or sell a stock or other security on the open market,
you normally trade via agents on the market scene who specialize in that
particular security. These people stand ready to sell you a security
for some asking price (the "offer") if you would like to buy it. Or, if
you own the security already and would like to sell it, they will buy
the security from you for some price (the "bid"). The difference
between the bid and offer is called the spread. Stocks that are heavily
traded tend to have very narrow spreads (as little as a penny), but
stocks that are lightly traded can have spreads that are significant,
even as high as several dollars.

So why is there a spread? The short answer is "profit." The long answer
goes to the heart of modern markets, namely the question of liquidity.

Liquidity basically means that someone is ready to buy or sell
significant quantities of a security at any time. In the stock market,
market makers or specialists (depending on the exchange) buy stocks from
the public at the bid and sell stocks to the public at the offer (called
"making a market in the stock"). At most times (unless the market is
crashing, etc.) these people stand ready to make a market in most stocks
and often in substantial quantities, thereby maintaining market
liquidity.

Dealers make their living by taking a large part of the spread on each
transaction - they normally are not long term investors. In fact, they
work a lot like the local supermarket, raising and lowering prices on
their inventory as the market moves, and making a few cents here and
there. And while lettuce eventually spoils, holding a stock that is
tailing off with no buyers is analogous.

Because dealers in a security get to keep much of the spread, they work
fairly hard to keep the spread above zero. This is really quite fair:
they provide a valuable service (making a market in the stock and
keeping the markets liquid), so it's only reasonable for them to get
paid for their services. Of course you may not always agree that the
price charged (the spread) is appropriate!

Occasionally you may read that there is no bid-offer spread on the NYSE.
This is nonsense. Stocks traded on the New York exchange have bid and
offer prices just like any other market. However, the NYSE bars the
publishing of bid and offer prices by any delayed quote service. Any
decent real-time quote service will show the bid and offer prices for an
issue traded on the NYSE.

Related topics that are covered in FAQ articles include price
improvement (narrowing the spread as much as possible), stock crossing
by discount brokers (narrowing the spread to zero by having buyer meet
seller directly), and trading on the NASDAQ (in the past, that
exchange's structure encouraged spreads that were significantly higher
than on other exchanges).


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

Subject: Trading - Brokerage Account Types

Last-Revised: 23 Jul 2002
Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us), Chris
Lott ( contact me ), Eric Larson

Brokerage houses offer clients a number of different accounts. The most
common ones are a cash account, a margin account (frequently called a
"cash and margin" account), and an option account (frequently called a
"cash, margin, and option" account). Basically, these accounts
represent different levels of credit and trustworthiness of the account
holder as evaluated by the brokerage house.

A cash account is the traditional brokerage account (sometimes called a
"Type 1" account). If you have a cash account, you may make trades, but
you have to pay in full for all purchases by the settlement date. In
other words, you must add cash to pay for purchases if the account does
not have sufficient cash already. In sleepier, less-connected times
than the year 2002, most brokerage houses would accept an order to buy
stock in a cash account, and after executing that order, they would
allow you to bring the money to settle the trade a few days later. In
the age of internet trading, however, most brokers require good funds in
the account before they will accept an order to buy. Just about anyone
can open a cash account, although some brokerage houses may require a
significant deposit (as much as $10,000) before they open the account.

A margin account is a type of brokerage account that allows you to take
out loans against securities you own (sometimes called a "Type 2"
account). Because the brokerage house is essentially granting you
credit by giving you a margin account, you must pass their screening
procedure to get one. Even if you don't plan to buy on margin, note
that all short sales ("Type 5") have to occur in a margin account. Note
that if you have a margin account, you will also have a cash account.

An option account is a type of brokerage account that allows you to
trade stock options (i.e., puts and calls). To open this type of
account, your broker will require you to sign a statement that you
understand and acknowledge the risks associated with derivative
instruments. This is actually for the broker's protection and came into
place after brokers were successfully sued by clients who made large
losses in options and then claimed they were unaware of the risks. It's
my understanding that otherwise an option account is identical to a
margin account.

Please don't confuse the type of account with the stuff in your account.
For example, you will almost certainly have a bit of cash in a brokerage
account of any type, perhaps because you received a dividend payment on
a share held by your broker. This cash balance may be carried along as
pure cash (and you get no interest), or the cash may be swept into a
money market account (so you get a bit of interest). Presumably if you
have a margin account, the cash will appear there and not in your cash
account (see below for more details). It's an unfortunate fact that the
words are overloaded and confusing.

Margin accounts are the most interesting, so next we'll go into all the
gory details about those.

Access to margin accounts is more restrictive when compared to cash
accounts. When you ask for a margin account, your broker will (if he or
she hasn't already) run a credit check on you. You will also have to
sign a separate margin account agreement. The agreement says that the
broker can use as collateral any securities held in the margin account
whenever you have a debit balance (i.e., you owe the broker money).
Note that if you have a cash account with the same broker, securities
held in the cash account (often non-marginable securities) do not help
(nor can the broker sell them) if you have a debit balance in the margin
account. Conversely, securities in the cash account do not count
towards margin requirements.

Another key feature of the margin account agreement is the
"hypothecation and re-hypothecation" clause. This clause allows the
broker to lend out your securities at will. So the ability to borrow
money always comes with the trade-off that the broker can lend out
("hypothecate") securities that you hold to short-sellers. Although you
will pay the brokerage when you borrow money from them, the brokerage
house will *not* pay you (or in fact even notify you) if they borrow
your shares. This seems to be just the way things work. Also see the
article elsewhere in this FAQ about short selling for more information.

As a general rule, a margin account will have all marginable securities,
and a cash account will have all non-marginable securities. At some
brokerage houses, non-marginable securities can be held inside a margin
account (Type-2); however, those securities will not be included in the
calculation of margin buying power. The insidious element here is that
even though the non-marginable securities contribute nothing of value to
the margin calculation, those same securities -- if there is even $1 of
debit balance in the margin account -- will become registered as
"type-2" by virtue of simply residing within a Type-2 acount, and, thus,
can be made lendable to brokers for clients wishing to short-sell the
stock.

Having a margin account makes it possible to take a margin loan. You
can use a margin loan for anything you want. The primary uses are to
buy securities (called "buying on margin") or to extract cash from an
equity position without having to sell it (thus avoiding the tax bite or
the chance of missing a run-up). Some brokers will even give you debit
cards whose debit limit is equal to your maximum margin borrowing limit
(which is determined daily).

The terms under which you borrow the money (i.e., the interest rate you
must pay and the payment schedule) are determined by your portfolio.
Subject to various rules on the amount you can borrow (discussed later),
you just buy some securities and a loan will be automatically be
extended to you. Or if you need cash, you just tell your broker to send
you a check or you can use your margin account debit card. The interest
rate charged is rather low. It is usually 0-2% above the "broker call
rate" (which is usually at or below prime) quoted in the WSJ and other
papers. It can change monthly, and possibly more often, depending on
the details of your margin account agreement. It is probably lower than
the rate on any credit card you'll be able to find. Further, there is
no set payment schedule. Often, you don't even have to pay the
interest. However, your margin account agreement will probably say that
the loan can be called in full at any time by the broker. It will
probably also say that the broker can demand occasional payments of
interest. Your agreement will also give the broker the right to
liquidate any and all securities in your margin account in order to meet
a margin call against you.

The interest rate is so low because the loan is fairly low-risk to the
broker. First, the loan is collateralized by the securities in your
margin account. Second, the broker can call the loan at any time.
Finally, there are rules that set your maximum equity to debt ratio,
which further protects your broker. If you fall below the requirements,
you will have to deposit cash or securities and/or liquidate securities
to get back to required levels.

So you probably understand that it could be useful to get cash out of
your account without having to sell your holdings, but why would you
want to borrow money to buy more securities? Well, the reason is
leverage. Let's say you are really sure that XYZ is going to go up 20%
in 6 months. If you put $10000 into XYZ, and it performs as expected,
you'll have $12000 at the end of six months. However, let's say you not
only bought $10000 of XYZ but bought another $10000 on margin, and paid
8% interest. At the end of 6 months the stock would be worth $24000.
You could sell it and pay off the broker, leaving you with $14000 minus
$400 in interest = $13600 which is a 36% profit on your $10000. This is
significantly better than the 20% you got without margin.

But keep in mind what happens if you are wrong. If the stock goes down,
you are losing borrowed money in addition to your own. If you buy on
margin and the stock drops 20% in 6 months, it'll be worth $16000.
After paying off the debit balance and interest you'd be left with
$5600, a 44% loss as compared to a 20% loss if you only used your own
money. Don't forget that leverage works both ways.

The amount you can borrow depends on the two types of margin
requirements -- the initial margin requirement (IMR) and the maintenance
margin requirement (MMR). The IMR governs how much you can borrow when
buying new securities. The MMR governs what your maximum debit balance
can be subsequently.

The IMR is set by Regulation T of the Federal Reserve Board. It states
the minimum equity to security value ratio that must exist in your
account when buying new securities. Right now it is 50% of marginable
securities. This number has been as low as 40% and as high as 100%
(thus preventing buying on margin). What this means is that your equity
has to be at least 50% of the value of the marginable securities in your
account, including what you just bought. If your equity is less than
this, you have to put up the difference.

The definition of marginable stock varies from one brokerage house to
another. Many consider any listed security priced above $5 to be
marginable, others may use a price threshold of $6, etc.

Let's look at an example. If you have $10000 of marginable stock in
your account and no debit balance [thus you have $10000 in equity --
remember that MARKET VALUE = EQUITY + DEBIT BALANCE, a variant of the
standard accounting equation ASSETS = OWNER'S CAPITAL + LIABILITIES],
and buy $20000 more, your market value including the purchase is $30000.
Your initial required equity is 50% of $30000, or $15000. However, you
only have $10000 in equity, so you have a $5000 equity deficit. You
could send in a check for $5000 and you'd then be properly margined.

Let E and MV be equity and market value immediately after the purchase,
respectively (but before you make arrangements to be properly margined).
Let the equity deficit ED be the difference between the required equity
(which is MV*IMR) and current equity (E). Let E1 and MV1 be equity and
market value, respectively, after making arrangements to be properly
margined. The initial requirement means that E1/MV1 >= IMR. Let C, S,
and L be the amount of a cash deposit, a securities deposit, and a
securities liquidation, respectively.

1. You deposit cash:
E1 = E + C
MV1 = MV
So you need to solve (E+C)/MV >= IMR for C.

2. You deposit securities:
E1 = E + S
MV1 = MV + S
So you need to solve (E+S)/(MV+S) >= IMR for S.

3. You sell securities:
E1 = E
MV1 = MV - L
So you need to solve E/(MV-L) >= IMR for L.

Using ED [which we previously defined as (IMR*MV - E)], the answers are:
1. C = ED
2. S = ED/(1-IMR)
3. L = ED/IMR

If ED is negative (you have more equity than is required), then that
makes C, S, and L negative, meaning that you can actually take out cash
or securities, or buy more securities and still be properly margined.

So, now you know how much you can borrow to buy securities. Having
bought securities there is now a MMR you have to continue to meet as
your market value fluctuates or you pull cash out of your account. The
MMR sets the minimum equity to market value ratio that you can have in
your account. If you fall below this you will get a "margin call" from
your broker. You must meet the call by depositing cash and/or
securities and/or liquidating some securities. If you do not, your
broker will liquidate enough securities to meet the call. The MMR is
set by individual brokers and exchanges. The MMR set by the NYSE is
25%. Most brokers set their MMR higher, perhaps 30% or 35%, with even
higher MMRs on accounts that are concentrated in a particular security.

The MMR calculations are very similar to the IMR calculations. In fact,
just substitute MMR for IMR in the above equations to see what you'll
have to do to meet a margin call. However, here a negative ED does NOT
necessarily imply that you can make withdrawals -- the IMR rules govern
all withdrawals (though the Special Memorandum Account (SMA) adds some
flexibility).

For more details and examples of margin accounts, see the FAQ article
about margin requirements .


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

Subject: Trading - Discount Brokers

Last-Revised: 26 Jul 1998
Contributed-By: Many net.people; compiled by Chris Lott ( contact me )

A discount broker offers an execution service for a wide variety of
trades. In other words, you tell them to buy, sell, short, or whatever,
they do exactly what you requested, and nothing more. Their service is
primarily a way to save money for people who are looking out for
themselves and who do not require or desire any advice or hand-holding
about their forays into the markets. This article focuses on brokers
who accept orders for stock, stock option, and/or futures trades.

Discount brokering is a highly competitive business. As a result, many
of the discount brokers provide virtually all the services of a
full-service broker with the exception of giving you unsolicited advice
on what or when to buy or sell. Then again, some do provide monthly
newsletters with recommendations. Virtually all will execute stock and
option trades, including stop or limit orders and odd lots, on the NYSE,
AMEX, or NASDAQ. Most can trade bonds and U.S. treasuries. Most will
not trade futures; talk to a futures broker. Most have margin accounts
available. Most will provide automatic sweep of (non-margin) cash into
a money market account, often with check- writing capability. All can
hold your stock in "street-name", but many can take and deliver stock
certificates physically, sometimes for a fee. Some trade precious
metals and can even deliver them!

Many brokers will let you buy "no-load" mutual funds for a low (e.g.
0.5%) commission. Increasingly, many even offer free mutual fund
purchases through arrangements with specific funds to pay the commission
for you; ask for their fund list. Many will provide free 1-page
Standard & Poor's Stock reports on stocks you request and 5-10 page full
research reports for $5-$8, often by fax. Some provide touch-tone
telephone stock quotes 24 hours / day. Some can allow you to make
trades this way. Many provide computer quotes and trading; others say
"it's coming".

The firms can generally be divided into the following categories:

1. "Full-Service Discount"
Provides services almost indistinguishable from a full-service
broker such as Merrill Lynch at about 1/2 the cost. These provide
local branch offices for personal service, newsletters, a personal
account representative, and gobs and gobs of literature.
2. "Discount"
Same as "Full-Service," but usually don't have local branch offices
and as much literature or research departments. Commissions are
about 1/3 the price of a full-service broker.
3. "Deep Discount"
Executes stock and option trades only; other services are minimal.
Often these charge a flat fee (e.g. $25.00) for any trade of any
size.
4. Computer or Electronic
Same as "Deep Discount", but designed mainly for computer users
(either dial-up or via the internet). Note that some brokers offer
an online trading option that is cheaper than talking to a broker.

Examples of firms in all categories:

Full-Svc. Discount Discount Deep Discount Computer
Fidelity Aufhauser Brown Datek
Olde Bidwell Ceres E-broker
Quick and Reilly Discover National E-trade
Charles Schwab Scottsdale Pacific JB Online
Vanguard Waterhouse Stock Mart Wall St. Eq.
Jack White Scottsdale
The rest often fall somewhere between "Discount" and "Deep Discount" and
include many firms that cater to experienced high-volume traders with
high demands on quality of service. Those are harder to categorize.

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 be paying an SEC "tax" (e.g.
about $3.00) 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!

In general, you need to ask carefully about all the services above that
you may want, and find out what fees are associated with them (if any).
Ask about fees to transfer assets out of your account, inactive account
fees, minimums for interest on non-margin cash balances, annual IRA
custodial fees, per-transaction charges, and their margin interest rate
if applicable. Some will credit your account for the broker call rate
on cash balances which can be applied toward commission costs.

You may have seen that price competition has driven the cost of a trade
below $10 at many web brokers. How can they charge so little?
Discounters that charge deeply discounted commissions either make
markets, sell their order flow, or both. These sources of revenue
enable the cheap commission rates as they profit handsomely from trading
with your order or selling it to another. Market making is the answer.

In contrast, Datek is one of a kind. Datek owns the Island, an
electronic system that functions as a limit order book that gives great
order visibility and crosses orders within it as well as showing them to
the Nasdaq via Level II. Datek charges a fee from Island subscribers to
enter orders into their system. Island is their outside revenue, and is
far superior to selling order flow. Island is good for the customer,
selling order flow like the others is not.

Here are a few sources for additional information:
* The links page on the FAQ web site about trading has links to many
brokerage houses.

* "Delving Into the Depths of Deep Discounters," The Wall Street
Journal , Friday, February 3, 1995, pp. C1, C22.
* A free report on a broker's background can be requested from the
National Association of Securities Dealers; phone (800) 289-9999
* An 85 page survey of 85 discount brokers revised each October and
issued each January is available for $34.95 + $3.00 shipping from:
Andre Schelochin / Mercer Inc. / 379 W. Broadway, Suite 400 / New
York, NY 10012 / +1 (212) 334-6212


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

Compilation Copyright (c) 2005 by Christopher Lott.

The Investment FAQ (part 19 of 20)

am 30.05.2005 06:30:20 von noreply

Archive-name: investment-faq/general/part19
Version: $Id: part19,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 19 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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Investment FAQ or for any damages (whether direct or indirect,
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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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Please send comments and new submissions to the compiler.

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

Subject: Trading - Order Routing and Payment for Order Flow

Last-Revised: 25 Nov 1999
Contributed-By: Bill Rini (bill at moneypages.com), Terence Bergh, Chris
Lott ( contact me ), W. Felder

A common practice among brokerage firms is to route orders to certain
market makers. These market makers then "rebate" 1 to 4 cents per share
back to the brokerage firm in exchange for the flow of orders. These
payments are known as "payment for order flow" (PFOF). (The account
executive does not receive this compensation.) Order routing and PFOF
occurs in stocks traded on the NYSE, AMEX and NASDAQ. NYSE and AMEX
stocks traded away from the exchange are said to be traded "Third
Market."

Payment for order flow has been a mechanism that for many years has
allowed firms to centralize their customers' orders and have another
firm execute them. This allowed for smaller firms to use the economies
of scale of larger firms. Rather than staffing up to handle 1,000,
5,000 or so orders a day, a firm can send it's 1,000 or 5,000 orders to
another firm that will combine this with other firm's orders and in turn
provide a quality execution which most of the time is automated and is
very broad in nature. Orders are generally routed by computer to the
receiving firm by the sending firm so there is little manual
intervention with orders. This automation is an important part of this
issue. Most small firms cannot handle the execution of 3,000 or more
different issues with automation, so they send their orders to those
firms that can.

For example, Firm A can send it's retail agency orders to a NASDAQ
market maker or Third Market dealer (in the case of listed securities)
and not have to have maintain day-in and day-out the infrastructure to
"handle" their orders. In return for this steady stream of retail order
the receiving firm will compensate Firm A for it's relationship. This
compensation will generally come in the form of payment per share. In
the NASDAQ issues this is generally 2 cents, while in NYSE issues its 1
cent per share. Different firms have different arrangements, so what I
have offered is just a rule of thumb.

These "rebates" are the lifeblood of the deep discount brokerage
business. Discount brokerage firms can afford to charge commissions
that barely cover the fixed cost of the trade because of the payments
they receive for routing orders. But understand that payment for order
flow is not limited to discounters, many firms with all types of MO's
use payment for order flow to enhance their revenues while keeping their
costs under control. Also understand that if you require your discount
broker to execute your orders on the NYSE (in the case of listed
securities), you will find that the broker you are using will eventually
ask you to pay more in commissions.

Firms that pay for order flow provide a very important function in our
marketplace today. Without these firms, there would be less liquidity
in lower tier issues and in the case of the Third Market Dealers, they
provide an alternative to a very expensive primary market place i.e.
NYSE and ASE. For example if you take a look at Benard Madoff (MADF)
and learn what their execution criteria is for the 500 to 600 listed
issue that they make a market in, you would be hard pressed to find ANY
difference between a MADF execution and one executed on the NYSE. In
some cases it will even be superior. There are many Third Market Firms
that provide quality execution services to the brokerage community, DE
Shaw, Trimark are two others that do a great job in this field.
However, please realize that the third market community would have a
hard time existing without the quote, size and prints displayed by the
primary exchanges.

The firm that receives payment for its order flow must disclose this
fact to you. It is generally disclosed on the back of your customer
confirmation and regularly on the back of your monthly statement. This
disclosure will not identify the exact amount (as it will vary depending
on the order involved, affected by variables such as the market, limit,
NMS, spread, etc.), but you can contact your broker and ask how much was
received for your order if in fact payment was received for your order.
You will probably get a very confused response from a retail broker
because this matter (the exact amount i.e., 2 cents or 1.5 cents ) will
generally not be disclosed to your individual broker by the firm he/she
is employed by.

It is hard to "tell" if your order has been subject to payment. Look
closely at your confirmation. For example if the indicated market is
NYSE or ASE then you can be rest assured that no other payment was
received by your firm. If the market is something like "other" coupled
with a payment disclosure, your order may in fact be subject to payment.

There are two schools of thought about the quality of execution that the
customer receives when his/her order is routed. The phrase "quality of
execution" means how close was your fill price to the difference between
the bid/ask on the open market. Those who feel that order routing is
not detrimental argue that on the NASDAQ, the market maker is required
to execute at the best posted bid/ask or better. Further, they argue,
many market making firms such as Mayer Schweitzer (a division of Charles
Schwab) execute a surprising number of trades at prices between the
bid/ask. Others claim that rebates and conflict of interest sometimes
have a markedly detrimental affect on the fill price. For a lengthy
discussion of these hazards, read on.

To realize the lowest overall cost of trading at a brokerage firm, you
must thoroughly research these three categories:
1. The broker's schedule of fees.
2. Where your orders are directed.
3. If your NYSE orders are filled by a 19c-3 trading desk.

Category 1 includes "hidden" fees that are the easiest costs to
discover. Say a discount broker advertises a flat rate of $29.00 to
trade up to 5,000 shares of any OTC/NASDAQ stock. If the broker adds a
postage and handling fee of $4.00 for each transaction it boosts the
flat rate to $33.00 (14% higher). Uncovering other fees that could have
an adverse impact on your ongoing trading expenses requires a little
more digging. By comparing your broker's current fees (if any) for
sending out certificates, accepting odd-lot orders or certain types of
orders (such as stops, limits, good-until-canceled, fill-or-kill,
all-or-none) to other brokers' schedules of fees, you'll learn if you're
being charged for services you may not have to pay for elsewhere.

Category 2 is often overlooked. Many investors, especially those who
are newer to the market, are not aware of the price disparities that
sometimes exist between the prices of listed stocks traded on the
primary exchanges (such as the NYSE or AMEX), and the so-called "third
marketplace." The third marketplace is defined as listed stocks that are
traded off the primary exchanges. More than six recent university
studies have concluded that trades on the primary exchanges can
sometimes be executed at a better price than comparable trades done on
the third market.

Although there is nothing intrinsically wrong with the third market, it
may not be in your best interest for a broker to route all listed orders
to that marketplace. If you can make or save an extra eighth of a point
on a trade by going to the primary exchange, that's where your order
should be directed. After all, an eighth of a point is $125.00 for each
1,000 shares traded.

Here's how the third market can work against you: Say you decide to
purchase 2,000 shares of a stock listed on the NYSE. The stock
currently has a spread of 21 to 21 1/4. Your order, automatically
routed away from the NYSE to the third market, is executed at 21 1/4.
Yet at the NYSE you could have gone in-between the bid-ask and gotten
filled at 21 1/8, a savings of $250.00.

Only a few of the existing deep discount brokers will route your listed
stock orders to the primary exchanges. Most won't as a matter of
business practice even if asked to do so. The only way to be sure that
your listed stock orders are being filled on the primary exchanges is to
carefully scrutinize your confirmations. If your confirmation does not
state your listed order was filled on the NYSE or AMEX then it was
executed on the third market.

You run the greatest risk of receiving a bad fill -- or sometimes
missing an opportunity completely -- whenever you trade any of the
stocks added to the NYSE since April 26, 1979, and your trade is routed
away from the primary exchange onto the third market. Almost all AMEX
stocks run this risk.

Category 3 was understood only by the most sophisticated of investors
until recently. A 19c-3 trading desk is a (completely legal) method of
filling NYSE orders in-house, without exposing the orders to the public
marketplace at all. Yes, you'll get your orders filled, but not
necessarily at the best prices. NYSE stocks listed after April 26,
1979, sector funds (primarily "country" funds such as the Germany Fund
or Brazil Fund), and publicly-traded bond funds are the securities
traded at these in-house desks. Recently, the NYSE approached the
Securities Exchange Commission asking that Rule 19c-3, that allows this
trading practice, be repealed. Edward Kwalwasser, the NYSE's regulatory
group executive vice president stated flatly that, "The rule hasn't done
what the Commission thought it would do. In fact, it has become a
disadvantage for the customer."

Here's a scenario that helps explain the furor that has developed over
the 19c-3 wrinkle. Let's say that XYZ stock is trading with a spread of
9 1/2 to 9 3/4 per share on the floor of the NYSE. An investor places
an order to buy the stock and the broker routes that order away from the
NYSE to the internal 19c-3 desk. The problem emerges when the order
reaches this desk, namely that the order is not necessarily filled at
the best price. The desk may immediately fill it from inventory at 9
3/4 without even attempting to buy it at 9 5/8 for the customer's
benefit -- this is the spread's midpoint on the floor of the exchange.
Then, after filling the customer's order internally, the firm's trader
may then turn around and buy the stock on the exchange, pocketing the
extra 12 1/2 cents per share for the firm. Project this over millions
of shares per year and you can get an idea of the extra profits some
brokers are squeezing out at the expense of their trusting, but
ignorant, customers.

You can most likely resolve this dilemma between low commissions and
quality of execution by examining the volume of trades you do. If you
buy a few shares of AT&T once a year for your children, then the
difference in fees between a trade done by a discount broker as compared
to a full-service wire house will most likely dominate an 1/8 or even a
1/4 improvement in the fill price. However, if you work for Fidelity
(why are you reading this?) and regularly trade large amounts, then you
certainly have negotiated nicely reduced commissions for yourself and
care deeply about getting a good fill price.

Finally, the whole issue may become much less important soon. Under the
new rules for handling limit orders on the NASDAQ market, payment for
order flow is becoming more and more burdensome on execution firms.
With the advent of day trading, specialty firms that use the NASDAQ's
SOES execution system, along with other systems to "game" the market
makers, the ability of firms to pay others for their orders is becoming
increasingly difficult. This "gaming" of the market place is due to
different trading rules for different market participants (this issue by
itself can take hours to explain and has many different viewpoints).
Many firms have discontinued paying for limit orders as they have become
increasingly less profitable than market orders.

As of November 1999, the Wall Street Journal that payment for order flow
is a practice that is dying out fairly rapidly.

Note: portions of this article are copyright (c) 1996 by Terrence Bergh,
and are taken from an article that originally appeared in Personal
Investing News, March 1995.


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

Subject: Trading - Day, GTC, Limit, and Stop-Loss Orders

Last-Revised: 5 May 1997
Contributed-By: Art Kamlet (artkamlet at aol.com)

Day/GTC orders, limit orders, and stop-loss orders are three different
types of orders you can place in the financial markets. This article
concentrates on stocks. Each type of order has its own purpose and can
be combined.

* Day and GTC orders:
An order is canceled either when it is executed or at the end of a
specific time period. A day order is canceled if it is not
executed before the close of business on the same day it was
placed. You can also leave the specific time period open when you
place an order. This type of order is called a GTC order (good
'til cancelled) and has no set expiration date.


* Limit orders:
Limit orders are placed to guarantee you will not sell a stock for
less than the limit price, or buy for more than the limit price,
provided that your order is executed. Of course, you might never
buy or sell, but if you do, you are guaranteed that price or
better.

For example, if you want to buy XYZ if it drops down to $30, you
can place a limit buy @ $30. If the price falls to $30 the broker
will attempt to buy it for $30. If it goes up immediately
afterwards you might miss out. Similarly you might want to sell
your stock if it goes up to $40, so you place a limit sell @ $40.


* Stop-loss orders:
A stop-loss order, as the name suggests, is designed to stop a
loss. If you bought a stock and worry about it falling too low,
you might place a stop-loss sell order at $20 to sell that stock
when the price hits $20. If the next trade after it hits $20 is 19
1/2, then you would sell at 19 1/2. In effect the stop loss sell
turns into a market order as soon as the exchange price hits that
figure.

Note that the NASDAQ does not officially accept stop loss orders
since each market maker sets his own prices. Which of the several
market makers would get to apply the stop loss? However, many
brokers will simulate stop-loss orders on their own internal
systems, often in conjunction with their own market makers. Their
internal computers follow one or perhaps several market makers and
if one of them quotes a bid which trips the simulated stop order,
the broker will enter a real order (perhaps with a limit - NASDAQ
does recognize limits) with that market maker. Of course by that
time the price might have fallen, and if there was a limit it might
not get filled. All these simulated stop orders are doing is
pretending they are entering real stops (these are not official
stop loss orders in the sense that a stock exchange stop order is),
and some brokers who work for the firms that offer this service
might not even understand the simulation issue.

If you sell a stock short, you can protect yourself against losses
if the price goes too high using a stop-loss order. In that case
you might place a stop-loss buy order on the short position, which
turns into a market order when the price goes up to that figure.

Example:


Let's combine a stop loss with a limit sell and a day order.

XYZ - Stop-Loss Sell Limit @ 30 - Day Order Only


The day order part is simple -- the order expires at the end of the day.

The stop-loss sell portion by itself would convert to a sell at market
if the price drops down to $30. But since it is a stop-loss sell limit
order, it converts to a limit order @ $30 if the price drops to $30.

It is possible the price drops to 29 1/2 and doesn't come back to $30
and so you never do sell the stock.

Note the difference between a limit sell @ $30 and a stop-loss sell
limit @ $30 -- the first will sell at market if the price is anywhere
above $30. The second will not convert to a sell order (a limit order
in this case) until the price drops to $30.

You can also work these same combinations for short sales and for
covering losses of short stock. Note that if you want to use limit
orders for the purpose of selling stock short, there is an exchange
uptick rule that says you cannot short a stock while it is falling - you
have to wait until the next uptick to sell. This is designed to prevent
traders from forcing the price down too quickly.


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

Subject: Trading - Pink Sheet Stocks

Last-Revised: 2 Sep 1999
Contributed-By: Art Kamlet (artkamlet at aol.com)

A company whose shares are traded on the so-called "pink sheets" is
commonly one that does not meet the minimal criteria for capitalization
and number of shareholders that are required by the NASDAQ and OTC and
most exchanges to be listed there. The "pink sheet" designation is a
holdover from the days when the quotes for these stocks were printed on
pink paper. "Pink Sheet" stocks have both advantages and disadvantages.

Disadvantages:
1. Thinly traded. Can make it tough (and expensive) to buy or sell
shares.
2. Bid/Ask spreads tend to be pretty steep. So if you bought today
the stock might have to go up 40-80% before you'd make money.
3. Market makers may be limited. Much discussion has taken place in
this group about the effect of a limited number of market makers on
thinly traded stocks. (They are the ones who are really going to
profit).
4. Can be tough to follow. Very little coverage by analysts and
papers.

Advantages:
1. Normally low priced. Buying a few hundred share shouldn't cost a
lot.
2. Many companies list in the "Pink Sheets" as a first step to getting
listed on the National Market. This alone can result in some price
appreciation, as it may attract buyers that were previously wary.

In other words, there are plenty of risks for the possible reward, but
aren't there always?

The National Quotation Bureau maintains the list of pink-sheet stocks.
Their site gives the history of the pink-sheet listing service and
information about real-time quotes for OTC issues.


Online quotes are offered by the National Quotation Bureau for
registered users only.



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

Subject: Trading - Price Improvement

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

In a nutshell, price improvement means that your broker filled an order
at a price better than you might have expected from the bid and asked
prices prevailing at the time you placed the order. More concretely,
you were able to pay less than the asked price if you bought, and you
received better than the bid price if you sold. Two of the ways that
this happens imply extra work by your broker, the third is just luck.

First, a market order may be filled inside the spread. For example, a
market order for 100 sh of IBM means that your broker should just buy
the shares for you at the current asking price. If the price you pay is
less than the current asking price, you experienced price improvement

Second, a limit order may be filled better than the limit. For example,
if you wanted to buy 100 sh of IBM at a maximum price of 150, and you
were filled at 149 7/8, that's price improvement also.

And third, the market may simply have moved in your favor during the
time it took to route your order to the exchange, resulting in a lucky
saving for you.

Price improvement is extremely important to people who frequently trade
large blocks of stocks. These people care more about superior
executions (i.e., price improvement) than the brokerage house's
commission. After all, a 1/8-point improvement on a 1000-share trade
makes a $125 difference. So beware saving a penny on the commission and
losing a pound on the execution price.

It is difficult for the small investor to determine independently
whether his or her order was filled with price improvement or not. (I'm
assuming that the average small investor doesn't have access to a
live/delayed data feed.) However, there are several sources on the net
for intraday price charts that may help you analyze your fills. On a
lightly traded stock, spotting you own trade crossing the tape is easy -
and a minor thrill.

In theory, when you place an order with a broker, the broker should
search all possible places (be they markets or market makers) to get the
best possible execution price for you. This is especially true with
NASDAQ, where a host of market makers may trade in a given stock. In
fact, many brokers (especially discounters or so-called "introducing
brokers") simply dump their order on another firm for execution. This
broker may not be so diligent in checking out all possible sources, due
to a custom called "Payment for Order Flow" (PFOF). PFOF is a small
(typically $0.03-0.06/share) payment made by the executing broker to the
your broker for the privilege of handling the order. If you think about
it, the money can only come from someone's pocket - and it might be from
yours via a less than top-flight execution.

For many stocks, remember that there are a lot of places it may trade
beyond the exchange it is listed on. Some large firms are trade on
exchanges from Tokyo to London. Domestically, the same is true. For
example, the Philadelphia stock exchange specialists make a market
(i.e., offer quotes) on any stock listed on the NYSE. And then there
are alternate (mostly electronic markets), like Reuters' Instinet.

Moreover, big brokers often have a small inventory of actively traded
stocks they make a market in and can effectively cut-off (cross) an
order before it hits the exchanges. A brokerage house can also program
its computer to recognize when two orders flowing in from their regional
offices make a pairing that can be summarily crossed. Generally, the
broker keeps the spread, but some brokers give the advantage to the
customer. Most notable in this respect is Schwab's new "no spread"
trading system which crosses customer orders for participants. Instead
of executing your order on the normal markets immediately, Schwab routes
it to their "waiting room". If there is another order there that mates
with yours the trade is immediate - if not, you sit there until that
mating order shows up. In either case, Schwab takes its commission and
splits the spread with the two customers. It remains to be seen how
well this idea works. Evaluating the potential for a delayed trade and
the price volatility of the stock itself versus the spread savings will
make it difficult for an individual to decide whether to participate.

Due to the need for speed, your broker might be more interested in
moving the order (and generating some PFOF revenue) than delaying the
trade while looking around for a better price. For example, if you are
trying to beat an anticipated market move, paying an extra 1/8th to get
immediate execution can be a good investment.

Some regular and discount brokerage houses now advertise that they
automatically attempt price improvement on all orders placed with them.
One small West Coast discounter recently advertised that about 38% of
its order flow achieved price improvement.

All this discussion shows that price improvement requires a little more
work (and perhaps a little less profit) for the dealing brokers when
compared to straight trading. It also shows that you should understand
your broker's normal practice when you consider how and where to place
your orders.

Related topics include the recent SEC-NASDAQ settlement.


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

Subject: Trading - Process Date

Last-Revised: 23 Oct 1997
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact
me )

Transaction notices from any broker will generally show a date called
the process date. This is when the trade went through the broker's
computer. This date is nearly always the same as the trade date, but
there are exceptions. One exception is an IPO; the IPO reservation
could be made a week in advance and until a little after the IPO has
gone off, the broker might not know how many shares his firm was
allocated so doesn't know how many shares a buyer gets. A day or two
after the IPO has gone off, things might settle down. (The IPO
syndicate might be allowed to sell say 10% more shares than obligated to
sell - and might sell those even after the IPO date "as of" the IPO
date.) So a confirmation might list a trade date that is two days before
the process date. Other times the broker might have made an error and
admit to it, and so correct it "as of" the correct date. So the
confirmation slip might show August 15 as the process date of a trade
"as of" a trade date of August 12. It happens.


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

Subject: Trading - Round Lots of Shares

Last-Revised: 21 Mar 1998
Contributed-By: Art Kamlet (artkamlet at aol.com), buddyryba at
pipeline.com, Uncle Arnie (blash404 at aol.com)

There are some advantages to buying round lots, i.e., multiples of 100
shares, but if they don't apply to you, then don't worry about it.
Possible limitations on odd lots (i.e., lots that are not multiples of
100) are the following:
* The broker might add 1/8 of a point to the price -- but usually the
broker will either not do this, or will not do it when you place
your order before the market opens or after it closes.
* Some limit orders might not be accepted for odd lots.
* If these shares cover short calls, you usually need a round lot.
* If you want to write covered calls, you'll need a round lot. Other
than that, there's just nothing magic about selling 100 shares or 59
shares or any other number.

Don't be concerned that your order to buy or sell 59 shares won't be
considered until all 100-share orders are run. Your order doesn't just
sit there waiting for an exact match on stocks that trade actively.
Your order will likely just be swept into the specialist/market
makers/brokers trading account along with other items.

If you're buying very small numbers of stocks priced under $100 or so,
your biggest problem is to find a broker who will bother with the order
and give reasonable commission. The discounters may not touch the small
order or charge more - and a lot of bigger firms have minimum
commissions of $35 - 75 or so. Many firms want a minimum size account
to open one, too.

If you're trading penny stocks (commonly defined as having a price under
$5 per share), there may be additional restrictions. For example, one
reader reports that on the Toronto exchange, a round lot for an issue
priced under CDN$1 is 500 shares.

This seems like a good place to mention the terminology for very big
orders. Block trades are large trading orders (very round lots?), where
large is defined by the stock exchange. On the NYSE, a block trade is
any transaction in which 10,000 shares or more of a single stock are
traded, or a transaction with a value of $200,000 and up.

So why does an investor still hear so much about odd lots? Well, once
upon a time, there was a difference. At that time, if you wanted to
sell 100 shares, your order would be forwarded to an NYSE or AMEX floor
broker, who would then trek over to the trading area for that particular
stock and try to find a buyer. If you wanted to sell only 50 shares,
the floor broker would instead hoof it over to an odd lot broker. If
you were in a hurry and specified "no print," the odd lot broker would
buy the 50 shares at one eighth of a point below the posted bid price
for the stock. Otherwise, the trade would go through at one eighth off
the next trade (one quarter point if over $40/share). But all this is
ancient history.

The "odd lot differential" of one eighth or one quarter of a point was
one of the ways that the odd lot broker made money. But these days,
there are no odd lot brokers--and hence no odd lot differentials. Small
stock trades, whether for 50 shares or 100 shares, are handled by
computer rather than by people.

The only thing that's left of the odd lot broker system is a reluctance
by many people to place orders for less than 100 shares. At one time,
these orders were subject to the odd lot differential, so people learned
to avoid them whenever possible. The notion that orders of less than
100 shares were bad entered the investment world's folk lore, and like
many other sorts of folk wisdom, it has a remarkable ability to persist
even though it is no longer justified by the facts.


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

Subject: Trading - Security Identification Systems

Last-Revised: 8 Aug 2000
Contributed-By: Chris Lott ( contact me ), Peter Andersson (peter at
ebiz.com.sg)

This article lists some of the identification systems used to assign
unique numbers to securities that are traded on the various exchanges
around the world.
* CUSIP
A numbering system used to identify securities issued by U.S. and
Canadian companies. Every stock, bond, and other security has a
unique, 9-digit CUSIP number chosen according to this system. The
first six digits identify the issuer (e.g., IBM); the next two
identify the instrument that was issued by IBM (e.g., stock, bond);
and the last digit is a check digit. The system was developed in
the 1960's by the Committee on Uniform Security Identification
Procedures (CUSIP), which is part of the American Banker's
Association. For a full history and all the gory details of the
numbering system, see their web site:



* CINS
The CUSIP International Numbering System (CINS) is a close cousin
to CUSIP. Like CUSIP, it is a 9-digit numbering scheme that is
used by the US finance industry. Unlike CUSIP, the numbers are
used to identify securities that are traded or issued by companies
outside the US and Canada.


* EPIC
Commonly used on the UK stock market.


* ISID
The International Securities Identification Directory (ISID) is a
cross reference for the many different identification schemes in
use. ISID Plus seems to be an expanded version of ISID (allowing
more characters in the identifier).


* ISIN
An International Securities Identification Number (ISIN) code
consists of an alpha country code (ISO 3166) or XS for securities
numbered by CEDEL or Euroclear, a 9-digit alphanumeric code based
on the national securities code or the common CEDEL/Euroclear code,
and a check digit.

The Association of National Numbering Agencies (ANNA) makes
available International Securities Identification Numbers (ISIN) in
a uniform structure. More information is available at:



* QUICK
A numbering system used in Japan (anyone know more?).


* RIC
Reuters Identification Code, used within the Reuters system to
identify instruments worldwide. Contains an X character market
specific code (can be the CUSIP or EPIC codes) followed by .YY
where YY stand for the two digit country code. i.e IBM in UK would
be IBM.UK. More information is available at


* SEDOL
Stock Exchange Daily Official List. The stock code used to
identify all securities issued in the UK or Eire. This code is the
basis of the ISIN code for UK securities and consists of a 7-digit
number allocated by the master file service of the London Stock
Exchange.


* SICOVAM
A 5-digit code allocated to French securities (Socie'te'
Interprofessionelle pour la Compensation des Valeurs Mobili`eres).


* Valoren
Telekurs Financial, the Swiss numbering agency, assigns Valoren
numbers to identify financial instruments. This seems to be the
CUSIP of Switzerland. For much more information, visit the
handbook of world stock, derivative and commodity exchanges
(subscription required):



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

Subject: Trading - Shorting Stocks

Last-Revised: 9 Mar 2000
Contributed-By: Art Kamlet (artkamlet at aol.com), Rich Carreiro (rlcarr
at animato.arlington.ma.us)

Shorting means to sell something you don't own.

If I do not own shares of IBM stock but I ask my broker to sell short
100 shares of IBM I have committed shorting. In broker's lingo, I have
established a short position in IBM of 100 shares. Or, to really
confuse the language, I hold 100 shares of IBM short.

Why would you want to short?

Because you believe the price of that stock will go down, and you can
soon buy it back at a lower price than you sold it at. When you buy
back your short position, you "close your short position."

The broker will effectively borrow those shares from another client's
account or from the broker's own account, and effectively lend you the
shares to sell short. This is all done with mirrors; no stock
certificates are issued, no paper changes hands, no lender is identified
by name.

My account will be credited with the sales price of 100 shares of IBM
less broker's commission. But the broker has actually lent me the stock
to sell. No way is he going to pay interest on the funds from the short
sale. This means that the funds will not be swept into the customary
money-market account. Of course there's one exception here: Really big
spenders sometimes negotiate a full or partial payment of interest on
short sales funds provided sufficient collateral exists in the account
and the broker doesn't want to lose the client. If you're not a really
big spender, don't expect to receive any interest on the funds obtained
from the short sale.

If you sell a stock short, not only will you receive no interest, but
also expect the broker to make you put up additional collateral. Why?
Well, what happens if the stock price goes way up? You will have to
assure the broker that if he needs to return the shares whence he got
them (see "mirrors" above) you will be able to purchase them and "close
your short position." If the price has doubled, you will have to spend
twice as much as you received. So your broker will insist you have
enough collateral in your account which can be sold if needed to close
your short position. More lingo: Having sufficient collateral in your
account that the broker can glom onto at will, means you have "cover"
for your short position. As the price goes up you must provide more
cover.

When you short a stock you are essentially creating a new shareholder.
The person who held the shares in a margin account (the person from whom
the broker borrowed the shares on the short seller's behalf) considers
himself or herself a shareholder, quite justifiably. The person who
bought the (lent) shares from the the short seller also considers
himself or herself a shareholder. Now what happens with the dividend
and the vote? The company sure as heck isn't going to pay out dividends
to all of these newly created shareholders, nor will it let them vote.
It's actually fairly straightforward.

If and when dividends are paid, the short seller is responsible for
paying those dividends to the fictitious person from whom the shares
were borrowed. This is a cost of shorting. The short seller has to pay
the dividend out of pocket. Of course the person who bought the shares
might hold them in a margin account, so the shares might get lent out
again, and so forth; but in the end, the last buyer in the chain of
borrowing and shorting transactions is the one who will get the dividend
from the company Tax-wise, a short seller's expense of paying a dividend
to the lender is treated as a misc investment expense subject to the 2%
of AGI floor. It does not affect basis (though I believe there is an
exception that if a short position is open for 45 days or less, any
dividends paid by the short seller are capitalized into basis instead of
being treated as an investment expense -- check the latest IRS Pub 550).

Voting of shares is also affected by shorting. The old beneficial owner
of a share (i.e., the person who lent it) and the new beneficial owner
of the share both expect to cast the vote, but that's impossible--the
company would get far more votes than shares. What I have heard is that
in fact the lender loses his chance to vote the shares. The lender
doesn't physically have the shares (he's not a shareholder of record)
and the broker no longer physically has the shares, having lent them to
the short seller (so the broker isn't a shareholder of record anymore,
either). Only a shareholder-of-record can vote the shares, so that
leaves the lender out. The buyer, however, does get to vote the shares.
Implicit in this is that if you absolutely, positively want to guarantee
your right to vote some shares, you need to ask your broker to journal
them into the cash side of your account in time for the record date of
the vote. If a beneficial owner whose broker lent out the shares
accidentally receives the proxy materials (accidentally because the
person is not entitled to them), the broker should have his computers
set up to disallow that vote.

Even if you hold your short position for over a year, your capital gains
are taxed as short-term gains.

A short squeeze can result when the price of the stock goes up. When
the people who have gone short buy the stock to cover their previous
short-sales, this can cause the price to rise further. It's a death
spiral - as the price goes higher, more shorts feel driven to cover
themselves, and so on.

You can short other securities besides stock. For example, every time I
write (sell) an option I don't already own long, I am establishing a
short position in that option. The collateral position I must hold in
my account generally tracks the price of the underlying stock and not
the price of the option itself. So if I write a naked call option on
IBM November 70s and receive a mere $100 after commissions, I may be
asked to put up collateral in my account of $3,500 or more! And if in
November IBM has regained ground and is at $90, I would be forced to buy
back (close my short position in the call option) at a cost of about
$2000, for a big loss.

Selling short is seductively simple. Brokers get commissions by showing
you how easy it is to generate short term funds for your account, but
you really can't do much with them. My personal advice is if you are
strongly convinced a stock will be going down, buy the out-of-the-money
put instead, if such a put is available.

A put's value increases as the stock price falls (but decreases sort of
linearly over time) and is strongly leveraged, so a small fall in price
of the stock translates to a large increase in value of the put.

Let's return to our IBM, market price of 66 (ok, this article needs to
be updated). Let's say I strongly believe that IBM will fall to, oh, 58
by mid-November. I could short-sell IBM stock at 66, buy it back at 58
in mid-November if I'm right, and make about net $660. If instead it
goes to 70, and I have to buy at that price, then I lose net $500 or so.
That's a 10% gain or an 8% loss or so.

Now, I could buy the IBM November 65 put for maybe net $200. If it goes
down to 58 in mid November, I sell (close my position) for about $600,
for a 300% gain. If it doesn't go below 65, I lose my entire 200
investment. But if you strongly believe IBM will go way way down, you
should shoot for the 300% gain with the put and not the 10% gain by
shorting the stock itself. Depends on how convinced you are.

Having said this, I add a strong caution: Puts are very risky, and
depend very much on odd market behavior beyond your control, and you can
easily lose your entire purchase price fast. If you short options, you
can lose even more than your purchase price!

One more word of advice. Start simply. If you never bought stock start
by buying some stock. When you feel like you sort of understand what
you are doing, when you have followed several stocks in the financial
section of the paper and watched what happens over the course of a few
months, when you have read a bit more and perhaps seriously tracked some
important financials of several companies, you might -- might -- want to
expand your investing choices beyond buying stock. If you want to get
into options (see the article on options ), start with writing covered
calls. I would place selling stock short or writing or buying other
options lower on the list -- later in time.


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

Subject: Trading - Shorting Against the Box

Last-Revised: 5 Jul 1998
Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us)

This article discusses a strategy that once helped investors delay a
taxable event with relative ease. Revisions made to the tax code by the
act of 1997 effectively eliminated the "Short Against The Box" strategy
as of July 27, 1997 (although not totally - see the bottom of this
article for a caveat).

Shorting-against-the-box is the act of selling short securities that you
already own. For example, if you own 200 shares of FON and tell your
broker to sell short 200 shares of FON, you have shorted against the
box. Note that when you short against the box, you have locked in your
gain or loss, since for every dollar the long position gains, the short
position will lose and vice versa.

An alternative way to short against the box is to buy a put on your
stock. This may or may not be less expensive than doing the short sale.
The IRS considers buying a put against stock the same as shorting
against the box.

The name comes from the idea of selling short the same stock that you
are holding in your (safety deposit or strong) box. The term is
somewhat meaningless today, with so many people holding stock in street
name with their brokers, but the term persists.

The obvious way to close out any short-against-the-box position is to
buy to cover the short position and to sell off the long. This will
cost you two commissions. The better way is to simply tell your broker
to deliver the shares you own to cover the short. This transaction is
free of commission at some brokers.

The sole rationale for shorting-against-the-box is to delay a taxable
event. Let's say that you have a big gain on some shares of XYZ. You
think that XYZ has reached its peak and you want to sell. However, the
tax on the gain may leave you under-withheld for the year and hence
subject to penalties. Perhaps next year you will make a lot less money
and will thus be in a lower bracket and therefore would rather take the
gain next year. Or maybe you have some other reason.

Or perhaps you think, "This is great! I have a stock that I've held for
9 months but I think it has peaked out. Now I can lock in my gain, hold
it for 3 more months, and then get a long-term gain instead of a
short-term gain, saving me a bundle in taxes!"

Bzzt. The answer is absolutely NOT! Unfortunately, the IRS has already
thought of this idea and has set the rules up to prevent it. From IRS
Publication 550:



If you held property substantially identical to the property
sold short for one year or less on the date of short sale or
if you acquire property substantially identical to the
property sold short after the short sale and on or before the
date of closing the short sale, then:

* Rule 1. Your gain, if any, when you close the short sale
is a short-term capital gain; and
* Rule 2. The holding period of the substantially
identical property begins on the date of the closing of
the short sale or on the date of the sale of this
property, whichever comes first.



So if you have held a stock for 11 months and 25 days and sell short
against the box, not only will you not get to 12 months, but your
holding period in that stock is zeroed out and will not start again
until the short is closed. Note that your holding period is not
affected if you are already holding the stock long-term.

The 1997 revisions to the tax code define (or extend) the idea of
"constructive sales." A constructive sale is a set of transactions which
removes one's risk of loss in a security even if the security wasn't
actually disposed of. Shorting against the box as well as certain
options and futures transactions are defined as being constructive
sales. And any constructive sale is interpreted as being the same as a
real sale, which is why this strategy is no longer effective (don't you
hate it when the rules change in the middle of the game?).

For those who have read this far, there does appear to be a small
loophole in the 1997 revisions that permit shorting against the box to
delay a taxable event. If you have a short against the box position and
then buy in the short within 30 days of the start of the tax year and
leave the long position at risk for at least 60 days before ofsetting it
again, the constructive sales rules do not apply. So it appears that
you can continue shorting against the box to defer gains, but you have
to temporarily cover the short and be exposed for at least 60 days at
the beginning of each and every year.


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

Subject: Trading - Size of the Market

Last-Revised: 26 Apr 1997
Contributed-By: Timothy M. Steff (tim at navillus.com), Chris Lott (
contact me )

The "size of the market" refers to the number of shares that a
specialist or market maker is ready to buy or sell. This number is
quoted in round lots of 100 shares; i.e., the last two zeros are
dropped. The size of the market information is supplied with a quote on
professional data systems. For example, if you get a quote of "bid 10,
offer 10 1/4, size 10 X 10" this means that the person or company is
willing to buy 10 round lots (i.e., 1,000 shares) at 10, or sell you
1,000 shares at 10 1/4.

Specialists report size, they do not create it. It seems that different
specialists report the size in approximately three ways:
1. Some are very precise; if a quote is 10x10 and 100 trades the
offer, the size then becomes 10x9.
2. Some use what seems to be a convention number. That is if there
the size is 50x100 the specialist is reporting at least 5,000
shares bid but less than 10,000, and at least 10,000 shares offered
but less than 25,000.
3. Some seem to have no discernable method as the trading seems to be
unrelated to the reported size. Thousands of shares trade the bid,
the price and size remain the same, for example. The floor brokers
in front of the specialist may be more important than the specialist in
this regard; the specialist is not necessarily a party to the trade as
is an OTC market-maker; the brokers may or may not put their orders into
the specialists' limit order book, or may cancel their orders in the
book later. The floor brokers are able to change the size by bidding
and offering, and cancelling existing orders, thereby affecting how
others trade.

On the NASDAQ, which is not an auction market, size is usually reported
as 500 X 500.


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

Subject: Trading - Tick, Up Tick, and Down Tick

Last-Revised: 27 Aug 1999
Contributed-By: Chris Lott ( contact me )

The term "tick" refers to a change in a stock's price from one trade to
the next (but see below for more). Really what's going on is that a
comparison is made between trades reported on the ticker. If the later
trade is at a higher price than the earlier trade, that trade is known
as an "uptick" trade because the price went up. If the later trade is
at a lower price than the earlier trade, that trade is known as a
"downtick" trade because the price went down.

On a traditional stock exchange like the NYSE, there is a single
specialist for each stock, so this measure can be calculated based on
the trade data. On the NASDAQ, the tick measure is calculated based on
the trades reported (which might well be out of order, delayed, etc.)

Something called the "tick indicator" is a market indicator that tries
to gauge how many stocks are moving up or down in price. The tick
indicator is computed based on the last trade in each stock.

Note that certain transactions, namely shorting a stock, can only be
executed on an up tick, so this measure is used to regulate the markets
(it's not just of academic curiosity). Interestingly, on the NASDAQ,
the restriction on short sales is not done based on the tick but rather
based on the change in the BID on a stock; i.e., from the stream of bid
data. All Market Makers and ECN's who trade on NASDAQ have their change
in bids reported one at a time. For example, if a NASDAQ issue trades
at 100 then next trades at 101 but at the same time the bid goes from
101 to 100 15/16, that would cause a down tick for the purpose of
regulating short sales. The last trade was higher than the trade before
(so the traditional tick indicator is positive), but a drop in the bid
from 101 to 100 15/16 caused the would result in short sales being
prohibited.

The Wall Street Journal publishes a short tick indicator table daily
with the UP/DOWN cumulative ticks (tick-volume) for selected (i.e.,
leading) stocks.


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

Subject: Trading - Transferring an Account

Last-Revised: 9 Jan 1997
Contributed-By: anonymous; please contact Chris Lott ( contact me )

Transferring an account from one brokerage house to another is a simple,
painless process. The process is supported by the Automated Customer
Account Transfer (ACAT) system. To transfer your account, you fill out
an ACAT form in cooperation with your new broker. The new broker will
generally require a copy of your statements from the old brokerage
house, plus some additional proof of identity. The transfer will be
made within about 5-10 business days for regular accounts, and 10-15
business days for IRA and other types of qualified retirement accounts.
The paperwork starts the process, but thereafter it's all done
electronically.

There is one caveat. Some brokerage houses charge fees as high as $50
to close IRA accounts. Other houses (Quick & Reilly is one) will
reimburse you some fixed amount to cover those fees. Be sure to ask,
the answer may delight you.


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

Compilation Copyright (c) 2005 by Christopher Lott.

The Investment FAQ (part 20 of 20)

am 30.05.2005 06:30:23 von noreply

Archive-name: investment-faq/general/part20
Version: $Id: part20,v 1.4 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 20 of 20. The web site
always has the latest version, including in-line links. Please browse



Terms of Use

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Different terms and conditions apply to documents on The Investment
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The Investment FAQ is copyright 2005 by Christopher Lott, and is
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The plain-text version of The Investment FAQ may be copied, stored,
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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: Trading - Can You Trust The Tape?

Last-Revised: 10 July 1999
Contributed-By: John Schott (jschott at voicenet.com), Chris Lott (
contact me )

Considering that there is big money involved in every trade, it is no
wonder that a great deal of effort is made to insure the accuracy and
completeness of each day's trading records. Yet despite this effort,
there are cases where the trading tape you see on your computer,
intraday charts, and in end-of-day data is not really telling a totally
accurate story.

To settle each day's trading obligations (shares and/or money), each
brokerage maintains a large "back office" function to ensure that each
trade is accurately recorded and reported. In fact, months after,
Standard and Poors publishes large reference volumes that list the
official day's prices (Open,-High,-Low,-Close) and volume for each
security traded on the NYSE, AMEX, and NASDAQ. Yet, the contemporaneous
data you get from your Internet or other data provider may not reflect
just what happened on any given day.

What can go wrong with the data? The answer is that a variety of
factors, some of them mistakes, can put bad or misleading data into the
stream. Consider the following cases.
1. After-hours trading
Transactions after hours (trades marked .T and "as of" trades) are
generally not included in the price and volume information that is
published daily. On the NASDAQ, volume data for after-hours
trading is integrated into the statistical record next day with a
24 hour cut-off. Price data for after-hours trading is not
integrated into the statistical record. Volume data reported
outside of 24 hours and price data are recorded for surveillance
purposes only.


2. Out of order reporting
On the NYSE and AMEX, there is only one specialist to report
orders. On the NASDAQ, the floor is spread electronically over the
world. So time stamped execution reports don't necessarily flow
into the reporting systems in order. Sometimes there is an
advantage for participants in delaying a report beyond the
exchange-mandated minimums - for example, when someone is urgently
trying to move a big block quietly. But most of the problems are
simply due to the chaos that is the exchange day.

Stocks trade everywhere - on multiple worldwide exchanges, on
electronic exchanges, at brokerage houses, and if two of us want,
behind the local hamburger joints just after the 2am close. Many
years ago, when this diffusing trend started, the NYSE made it a
rule that any trading by any member firm had to be reported on the
exchange even if the trade was executed elsewhere. And that rule
applies today. So the Merrill Lynch office in Tokyo, Rome or
London can handle a trade on one if the local markets in IBM, while
the traders in New York are still sound asleep - and report that in
hours (days) later.

Eventually those trades, and others crossed in local offices of
exchange members, filter onto the NYSE tape at some time during the
trading day. This would also be true of trades crossed by the
Merrill Lynch office in Dallas during NYSE hours. Those trades
make the tape sometime - but not always in order of trading or
nearly in real time. And these trades may appear potentially
outside the boundaries of the exchange-mandated maximum delay.

Trades in Nasdaq listed securities by foreign broker/dealers that
are not NASD members are outside NASD/Nasdaq jurisdiction and would
not be reported except if they involved some organization that had
a trade reporting requirement under U.S. securities regulations.
Some firms exist specifically to provide the large trader with
discrete private placements which largely go unreported.

If you are confused, consider the poor specialist who arrives early
only to find a variety of trade reports from Tokyo to London that
don't match yesterdays prices nor the orders on his book - where do
you open the stock? (See the article "Trading - Opening Price"
elsewhere in this FAQ for more discussion of that issue.)


3. Errors do happen
If you every get a chance to see a live exchange ticker you will
get to see the errors, too. Sometimes it is merely a misplaced
trade reported way out of order. Perhaps it is an incorrect price
or volume reported later as a correction. And then there are
trades that just didn't happen for one reason or another -
cancellations, repudiations, double fills, etc. They show up on
the ticker, but some information gathering systems have no way to
back them nicely out of the days activities. Some are not
discovered until days later in the back offices.

Simple data entry errors still happen. Looking at an interday
chart, one sometimes sees a single transaction far off the run of
contemporary trades. Quite often the offset is $3 or $30, which is
a clear signal that someone hit the wrong row of keys on a numeric
key pad. Those errors show up in the interday charts all the time
and often make the end-of-day quotes.

Even the floor traders get involved. When four or five people are
competing for a specialist's attention, it is not hard for several
people to hear the specialists "Done 500" as a fill of their order.
So two orders become one or one becomes two executions. Naturally
they all get corrected eventually - but does the tape ever show it?


4. Is volume really volume?
On the NYSE and AMEX when the specialist crosses an order and
reports 1000 shares traded, we all assume that this means 1000 sold
and 1000 bought (even if one party to the trade is the specialist
himself). But there are complaints that NASDAQ reported volume may
be far higher than the actual public trading. It is likely that
this is true given the multiple competing market makers, most of
whom actively trade for their own accounts. Sensing a trend, such
a market maker may sell stock not owned or scarf up offered stock
with the intention of laying off the stock on his competitors later
- something the NYSE/AMEX specialist really can't do. If you watch
intraday volume, you'll occasionally see such trading pairs pass
across the tape with a few minutes separation - some may represent
real trading, some merely various forms of market maker transfers.


5. Teasing the market
Technical analysts look for breakouts and other signals in their
data. And the wolves on Wall Street know that. Occasionally they
have a chance to push a few trades through to tip an indicator one
way or the other. Often this happens near the end of a quiet day.
Considering the spread, merely whether the last trade of the day is
on the buy or sell side is often enough to bias the day's technical
indicators. Recently I tried a $12 experiment on a NYSE stock that
had held one price for almost six hours of NYSE trading. I wanted
to see if the prevailing executions were on the buy or sell side.
My 100 share order 1/8th point off that price brought a quick
day-ending burst of trades - at successively different prices.
Someone with real malevolence could do even more to trigger a
technical move. A dramatic example of off-exchange trading
occurred on 26 Feb 97. After a 17-month battle, noted investor Carl
Ichan sold off his entire 19.9-million share holding of RJ Nabisco
Holdings (RN). He did this in an after-hours deal with Goldman Sachs at
$36.75, a $1 price concession from that day's close. It is unknown if
Goldman Sachs held the block for eventual distribution or acted for
another firm. Trading was 2.4M shares on 26 Feb and 4.6M and 3.3M on
the following two days, respectively, likely due to other arbitragers
moving out of the stock. Interestingly, the stock price held, closing
only 1/8th below the deal price. So this block never showed up on the
tape nor in your TA program's data base. Although this transaction
became public knowledge via a timely SEC filing and extensive press
coverage, other large block trades may be effectively masked from public
view.

Perhaps there is only one real lesson to be gained from understanding
these and other forms of data inaccuracies that can creep onto the tape.
It is that technical analysts should not regard all reports on the tape
as gospel.


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

Subject: Trading - Selling Worthless Shares

Last-Revised: 26 May 1999
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott ( contact
me )

If you hold shares that have become worthless, maybe because the company
has ceased operations, you are probably interested in deducting the full
cost basis of that position when you do your taxes. And, since you're
already in the hole, you probably want to do this without throwing any
more money away. This article discusses ways you can prove to the IRS
that the shares really are worthless.

The simplest and best way to close out any position, of course, is to
sell it, even if you only get a dollar. But who is going to pay you
even a lousy buck for worthless shares?

If you hold the share certificates, you can probably convince one of
your friends or (deep breath) relatives to buy them from you for $1.
(You can give back the $1, buy the proud new owner a drink, etc.) Then
list the $1 as your selling price on your tax form. If your friend
really wants to take official possession of the shares, he or she must
send in the properly signed share certificates to the stock transfer
agent, but of course if the company really is gone, the transfer agent
is not going to do anything (no money, no work).

If your broker holds the shares (the shares are held "in street name"),
selling them to a friend isn't such a good deal because taking delivery
of the certificates will cost you about $25 (depending on the brokerage
house, of course). And you sure don't want to pay a brokerage
commission to get rid of your worthless shares. Many brokers have a
plan to let their good customers sell them worthless stock for $1 or 1c
for the lot. If you are a good customer, and stock is with the broker,
ask. You should be able to negotiate some solution that will be
satisfactory to both sides.

If for whatever reason you cannot sell the worthless shares, then you
will need to obtain documentation that will convince the IRS that the
stock really, truly had no value at some point in time, and close the
position at that same time. This will relieve you of the burden of
selling the shares. It's very important that you can demonstrate beyond
a doubt the year that the shares became worthless. When you do your
taxes, you would write "12/31" as the date of sale and "worthless" (or
0) as the sales price. For example, if the company has delisted the
shares or closed down completely, a letter from your broker or even a
letter from the company might be sufficient to establish the year in
which the shares became worthless.

Interestingly, if you had shares that became worthless, and you declared
them worthless, took the loss, yet hung on to the shares, you're OK if
they later regain value. The IRS now anticipates that a stock you kept
while declaring it to be worthless later rises from the dead. In that
case, no need to amend, but use the worthless date as the acquisition
date and 0 as the cost basis. So in this regard they are pretty
lenient.

Note that if a company's stock goes worthless, you should declare this
event in the year it becomes worthless. If you have to file an amended
return (1040X) later, you have 7 years to do so, unlike 3 years for most
other 1040X filings.

As you can see, it's far simpler to sell the shares for a pittance than
to demonstrate that they are worthless, so that's probably the way to go
if you can manage it. Although this does not establish the year in
which the shares became worthless, it does give you a clear sale at a
very low price, and that's always simple to explain.

One last caveat. Don't confuse a bankrupt company with a completely
defunct company. Many companies continue operating while in bankruptcy
proceedings, and their stock continues to trade. So the stock by
definition is not worthless. In the newspaper listings, the prefix 'vj'
is often used to indicate such companies. For example, when this
article was first drafted, vjRAYtc (Raytech) closed at 4/38. However, a
bankrupt company does not always have a low share price. About 25 years
ago John Manville Co. was hit with asbestos lawsuits, and filed for
bankruptcy to protect them against these suits. Except for the
potential liabilities of the law suits, they had an enormously healthy
balance sheet and their stock continued to trade high. More recently,
about 1991 Columbia Gas of Ohio filed for bankruptcy to get out of some
unfortunate long-term contracts they had written for natural gas
purchases. Their stock continued to trade, generally in the $30 range,
until they finally emerged with a favorable court ruling.


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Subject: Trivia - Bull and Bear Lore

Last-Revised: 29 Jul 1994
Contributed-By: David W. Olson, Jon Orwant, Chris Lott ( contact me )

This information is paraphrased from The Wall Street Journal Guide to
Understanding Money and Markets by Wurman, Siegel, and Morris, 1990.

One common myth is that the terms "bull market" and "bear market" are
derived from the way those animals attack a foe, because bears attack by
swiping their paws downward and bulls toss their horns upward. This is
a useful mnemonic, but is not the true origin of the terms.

Long ago, "bear skin jobbers" were known for selling bear skins that
they did not own; i.e., the bears had not yet been caught. This was the
original source of the term "bear." This term eventually was used to
describe short sellers, speculators who sold shares that they did not
own, bought after a price drop, and then delivered the shares.

Because bull and bear baiting were once popular sports, "bulls" was
understood as the opposite of "bears." I.e., the bulls were those people
who bought in the expectation that a stock price would rise, not fall.

In addition, the cartoonist Thomas Nast played a role in popularizing
the symbols 'Bull' and 'Bear'.

Finally, Don Luskin wrote a nice history of these terms for
TheStreet.com on 15 May 2001.



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Subject: Trivia - Presidential Portraits on U.S. Notes

Last-Revised: 28 Apr 1994
Contributed-By: Paul A. Rydelek, Chris Lott ( contact me )

Just in case you were curious, here is a list of the presidential
portraits and other decoration on U.S. Currency and Treasury
instruments.

Den. Portrait Embellishment on back
$1 George Washington Great Seal of U.S.
$2 Thomas Jefferson Signers of the Declaration
$5 Abraham Lincoln Lincoln Memorial
$10 Alexander Hamilton U.S. Treasury
$20 Andrew Jackson White House
$50 Ulysses S. Grant U.S. Capitol
$100 Benjamin Franklin Independence Hall
$500 William McKinley Ornate denominational marking
$1,000 Grover Cleveland Ornate denominational marking
$5,000 James Madison Ornate denominational marking
$10,000 Salmon P. Chase Ornate denominational marking
$100,000 Woodrow Wilson Ornate denominational marking


U.S Treasury instruments:

Den. Savings Bond Treas. Bills Treas. Bonds Treas. Notes
$50 Washington Jefferson
$75 Adams
$100 Jefferson Jackson
$200 Madison
$500 Hamilton Washington
$1,000 Franklin H. McCulloch Lincoln Lincoln
$5,000 Revere J.G. Carlisie Monroe Monroe
$10,000 Wilson J. Sherman Cleveland Cleveland
$50,000 C. Glass
$100,000 A. Gallatin Grant Grant
$1,000,000 O. Wolcott T. Roosevelt T. Roosevelt
$100,000,000 McKinley



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Subject: Trivia - Getting Rich Quickly

Last-Revised: 18 Jul 1993
Contributed-By: James B. Reed

Take this with a lot of :-) 's.

Legal methods:
1. Marry someone who is already rich.
2. Have a rich person die and will you their money.
3. Strike oil.
4. Discover gold.
5. Win the lottery.

Illegal methods:
1. Rob a bank.
2. Blackmail someone who is rich.
3. Kidnap someone who is rich and get a big ransom.
4. Become a drug dealer.

For the sake of completeness:

"If you really want to make a lot of money, start your own
religion."
- L. Ron Hubbard



Hubbard made that statement when he was just a science fiction writer in
either the 1930s or 1940s. He later founded the Church of Scientology.
I believe he also wrote Dianetics.


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

Subject: Trivia - One-Letter Ticker Symbols on NYSE

Last-Revised: 13 Aug 2004
Contributed-By: Art Kamlet (artkamlet at aol.com), Doug Gerlach (gerlach
at investorama.com)

Some of the largest companies listed on the New York Stock Exchange have
1-letter ticker symbols, and some relatively unknowns do also. Not all
of the one-letter symbols are obvious, nor does a one-letter symbol mean
the stock is a blue chip, a US corporation, or even well known.

Originally when the symbol had to be written down on transaction slips,
it was faster to write down the real big companies, like T (Telephone),
F (Ford), K (Kellogg), G (Gillette), X (Steel), and Z (once Woolworth).
But later just anyone it seems was able to get 1-letter symbols. Yet
when Chrysler (C) was absorbed by Daimler to become DCX, note that
Citicorp (which had just merged Citibank with Travelers) jumped to claim
the C for themselves.

This page shows all of the one-letter ticker symbols listed on the NYSE.
Since the US exchanges avoid overlaps, this means that only the NYSE
uses one-letter ticker symbols. This list was current as of the
last-revised date (above), but due to changes it may be out of date by
the time you read it.

In the following list, the ticker links will take you to the appropriate
page at Yahoo! Finance with a current quote and price chart.

Ticker Company
A Agilent Technologies (split-off from H-P; previously Astra AB)
B Barnes Group
C Citigroup (previously, Chrysler had 'C')
D Dominion Resources
E Ente Nazionale Idrocarburi SpA (ADR)
F Ford Motor Company
G Gillette
H None - formerly Harcourt General
I None - formerly First Interstate Bancorp - ostensibly reserved (see
below)
J None - formerly Jackpot Enterprises
K Kellogg
L Liberty Media
M None - formerly M-Corp, ostensibly reserved (see below)
N Inco, Ltd.
O Realty Income Corp
P None - formerly Phillips Petroleum
Q Qwest Communications
R Ryder Systems
S Sears, Roebuck & Company
T AT&T Corp
U None - formerly US Airways
V Vivendi Universal
W None - formerly Westvaco
X US Steel
Y Alleghany Corp.
Z None - formerly Woolworth


The Chairman of the New York Stock Exchange has publicly said that he is
holding the symbols "M" and "I" for two companies he hopes to convince
to switch from Nasdaq to the NYSE -- Microsoft and Intel.


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

Subject: Trivia - Stock Prices in Sixteenths

Last-Revised: 22 Jan 1997
Contributed-By: DJS Highlander, infras at aol.com

The tradition of pricing stocks in fractions with 16 as the denominator
takes its roots from the fact that Spanish traders some 400 years ago
quoted prices in fractions of Spanish Gold Doubloons. A Doubloon could
be cut into 2, 4, or even 16 pieces. Presumably, it was too difficult
to split those 1/16 wedges any further, or prices today might be quoted
in 32'nds! Using fractions as a means of quoting prices was popular for
a couple of hundred years thereafter, and as the NYSE is more than 200
years old, there's the link!

If you really want to get specific, the Spaniards counted on their
fingers (as did everyone else, for the most part!) and did not include
the thumb in the 'low end' process because it was used to keep track of
the quarters. Two thumbs = doubloon. Both hands = doubloon, in eight
pieces (pieces of eight!). You could manage all sorts of good slave
deals from this mathematical base (other deals, too, of course).

Well, the Spaniards formulated all this as a simplification of the
decimal method used by the rest of Europe which was derived from the old
Roman way of doing things - which was taken from the Greeks - which was
taken from the Persians - who got it from the Chaldeans. That takes us
back to about 5000 BC and an interesting coin called the Dinar - which
was parsed into tenths.

According to the Hammarabi Code, the Dinar was worth today's equivalent
of about $325 (ie., an ounce of gold - only it weighed slightly more).
Within their agricultural economy, it was a piece of metal (more easily
transportable) equal in value to a bushel of wheat, which, according to
the Code, weighed 1 Stone (the Sumerian Standard), which, by our
standards, weighed about 60 pounds.

To Sumerize (pun), an ounce of gold was equal to about 60 pounds of
wheat in value. This was established since it was obviously easier to
carry a bag of gold to the other side of the empire to exchange for a
large quantity of, say, wool, than it was to caravan several tons of
wheat for the same purpose. And so on.

The whole process probably dates back even farther, but the Code of
Hammarabi is basically the oldest known documentation of such things.


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Subject: Warning - Wade Cook

Last-Revised: 23 Feb 1998
Contributed-By: G. S. Reedy

Wade Cook runs seminars, priced around $3,500, that explain his
strategies for investing, with emphasis on writing covered calls. Much
of the same information is available in his book, The Wall Street Money
Machine .

Don't be fooled by Wade Cook's book. I read it, did some studies of
covered calls. Most cheap covered calls are written on stocks that are
in the process of declining in price. According to postings in
Dejanews, some people admit to having lost a bundle following Wade
Cook's trading programs. When I read his book, some of it seemed too
good to be true. And, as the old axiom says, "If it seems too good to
be true, it probably is."

I had a conversation with a commodity trader several years ago. He told
me that he was continually amazed at people who had demonstrated
expertise in their respective fields, and were somewhat successful at
their work. Then, they would read a book about commodity trading and
think that they could start making a living at it. Basically, the same
principle applies to trading stock options. Go slow, crawl before you
walk, walk before you run. To use a baseball analogy, go for base hits
first. The triples and home runs will come with practice.

You might also want to check the article elsewhere in this FAQ entitled
"Advice - Paying for Advice."

For more information, check out these sources:
* An article by Dan Colarusso of TheStreet.com that appeared on 16
August 2000.

* An article by James Surowiecki of the Motley Fool that appeared on
Slate on 18 September 1997.

* An article by Randy Befumo of the Motley Fool that appeared on 5
October 1997.

* An article that appeared in the Washington Times on 30 December
1997.
* At one time Gary Wall maintained a collection of information about
Wade Cook on his web site.



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Subject: Warning - Charles Givens

Last-Revised: 20 Jan 2003
Contributed-By: Jeff Mincy (mincy at rcn.com), Chris Hynes, Chris Lott (
contact me )

Charles J. Givens was a self-styled financial planner, investment
educator, and investment guru who once appeared in info-mercials on
late-night television to tell the world about the fortunes he had made
and lost, free seminars run by his associates, and the Charles J.
Givens Organization. He died in 1998, but one of his organizations,
International Administrative Services Inc. (IAS), lives on.

Givens' organization offers investment education and advice through
seminars and publications. He wrote several best-selling books:
* Wealth Without Risk (1988)
* Financial Self-Defense (1990)
* More Wealth Without Risk (1991)

As of this writing, a trial membership in his organization is offered
for about $50. The organization publishes a monthly newsletter.
Telephone advice is also offered to members. Their web site address is
given below.

Givens is regularly lauded by his fans for teaching people how to
navigate the world of personal finance and investments. However, his
critics point out that his advice is generally simplistic and sometimes
contradictory. All examples (below) are taken from Wealth Without Risk,
as cited in Reference (4).
Simplistic: number 210, don't buy bonds when interest rates are rising.
Contradictory: number 206, do not put your money in vacant land;
number 245, invest your IRA or Keogh money in vacant land.

Givens offers quite a bit of helpful advice but contrary to the titles
of his books, his ideas can be extremely risky. For example, some of
his suggestions about insurance, especially dropping uninsured motorist
coverage from one's automobile insurance, may leave people underinsured
and vulnerable in case of an accident unless they are very careful about
reading their policies and asking hard questions. On the other hand,
some people are arguably over-insured, which is why Givens makes these
recommendations. These people could certainly benefit from reading
their policies carefully and asking the insurance agent some hard
questions, but wholesale advice to drop coverage is risky.

He also makes aggressive interpretations of tax law, interpretations
which might get one in trouble with the IRS. Not that the IRS is
perfect, but not all people may be comfortable with Givens'
interpretations.

The Givens organization has lost several court cases. For example, in
December 1993, the Attorney General of Florida issued a complaint
against Charles J. Givens alleging that certain of his practices
violated Florida's Deceptive and Unfair Trade Practices Act. Among the
claims challenged by the Florida AG was that Givens misrepresented that
his programs provided purchasers with successful and legal financial
strategies that would enable them to make money. The case was resolved
in 1995 when Givens agreed to pay $377,000 to cover refunds and the cost
of the Florida investigation. Givens also agreed to stop making certain
claims about the value of his teachings and to make full refunds to
anyone who requests them within three days of receiving his materials.
In 1996, the Givens organization lost a class-action case in California
in which the Givens Organization was ordered to pay over $14 million to
the members of the class.

Prospective followers of Givens must, absolutely must, read about
successful lawsuits against Givens as well as his criminal convictions
and other disclosures about him and his organization. See below for
exact references.

In conclusion: his advice is simply not appropriate for everyone.

References:

1. Smart Money , August 1993.
2. The Wall Street Journal, ``Pitching Dreams,'' 08/05/91, Page A1.
3. The Wall Street Journal, ``Enterprise: Proliferating Get-Rich Shows
Scrutinized,'' 04/19/90, Page B1.
4. The Wall Street Journal, ``Double or Nothing,'' 02/15/90, Page A12.
5. Superior Court of the State of California, County of San Diego,
Case No. 667169: Cella Gutierrez, et al. vs. Charles J. Givens
Organization Inc., et al., Trial date 04/12/96.
6. The IAS Financial Education organization (successor to the Charles
J. Givens Organization).

7. KYC News, short for 'Know Your Customer', publishes investigative
information on financial crime in its newsletters and web site.
They make available a facts and findings document from the clerk of
the U.S. Bankruptcy Court in Orlando, Florida about Givens and
others, dated April 2003.



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Subject: Warning - Dave Rhodes and Other Chain Letters

Last-Revised: 6 Sep 1994
Contributed-By: Mark Hall, George Wu, Steven Pearson, Chris Lott (
contact me )

Please do NOT post the "Dave Rhodes", "MAKE.MONEY.FAST", or any other
chain letter, pyramid scheme, or other scam to the misc.invest.* groups.

Pyramid schemes are fraud. It's simple mathematics. You can't
realistically base a business on an exponentially-growing cast of new
"employees." Sending money through the mails as part of a fraudulent
scheme is against US Postal regulations. Notice that it's not the
asking that is illegal, but rather the delivery of money through the US
mail that the USPS cares about. But fraud is illegal, no matter how the
money is delivered, and asking that delivery use the US Mail just makes
for a double whammy.

Note that when someone posts this nonsense with their name and home
address attached, it's fairly simple for a postal inspector to trace the
offender down.

Although the "Dave Rhodes" letter has been appearing almost weekly in
misc.invest as of this writing, and it's getting pretty old, it's mildly
interesting to see how this scam mutates as it passes through various
bulletin boards and newsgroups. Sometimes our friend Dave went broke in
1985, sometimes as recently as 1988. Sometimes he's now driving a
mercedes, sometimes a cadillac, etc., etc. The scam just keeps getting
updated to keep up with the times.

To close on a funny note, here's a quote from the "Ask Mr. Protocol"
column of the July 1994 (v. 5, n. 7) SunExpert magazine:

Rhodes (n) - unit of measure, the rate at which the same
annoying crud is recycled by newcomers to the net.




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Subject: Warning - Ken Roberts

Last-Revised: 28 May 1999
Contributed-By: Conrad Bowers (cpbow at earthlink.net), J. Johnson

This article is a response to a message saying that the Ken Roberts
course is a good introduction to commodity trading (the message
originated on an AOL site but was quoted on the Motley Fool investment
site). According to one of the writers of that thread, Ken Roberts is
now advertising on radio with ads saying you can turn $5000 into lots of
money. Some of the comments below would apply to just about any
technique if you're starting with a small amount of money.

In my opinion, Roberts does not adequately warn of the risks about
trading commodities. Most of his first course is a pep talk about how
easy it is. In reality surveys have shown that some 90% of people stop
trading within about a year. Most stop because they have depleted more
of their capital than they can bear and keep on trading. Remember these
differences about commodities as compared to stocks:
1. Unlike the stock market, in commodities for every dollar won there
is a dollar lost in the markets. Most lose, a few are consistent
big winners. Remember you are competing against people that have
done this a long time, people that do it full-time, and
suppliers/users that use the commodity full-time. Unless you're
sure you going to beat these pros the first time, you better trade
with money you don't need.

While you dream of what the money you hope to generate will do for
you, don't lose sight of the initial odds against you. With time I
believe an individual can learn to trade successfully. But if you
don't survive the training period, you will have had a very
expensive education.


2. Highly leveraged; You can lose more than your entire investment if
you get in a position that's way too large for your account,
particularly if you get locked into it by 'limit moves'. These
happen occasionally in a number of commodities. (You can hedge
with options, though.) The more common problem is cumulative
losses. Someone who starts out with $5000 will have difficulty
placing stops that won't get hit by market 'noise' (short-term
fluctuations). If they place more reasonable stops, then it will
be a large percentage of their account. It's probably possible to
start with $5K, but you either have to be lucky enough to build the
account up before it gets wiped out, or you have to be disciplined
enough to trade very small positions and not the more lucrative
commodities. (Having seen my account dwindle 80%, I am trying to
rebuild it on this basis; some recovery with options, currently
pretty flat trading "small" commodities.)

The Ken Roberts course does teach how to calculate the dollar
differences a price move will profit/cost you. However, the is an
almost complete lack of discussion about the proper amount to risk. To
pitch a course to investors with only $5K with no discussion of risk
strategy is outrageous. His video repeatedly asks interviewees, would
you recommend this course for a struggling family/single parent, etc.
That is enough of a misrepresentation that I believe it should be
regulated.

I got interested in commodities through his course, TWMPMM I. I
actually didn't use his entry techniques so I won't fault those. I
fault him, the fax service I did use, and myself for my not
understanding risk control. I didn't risk a huge amount per trade
(never more than 10%, usually less) but I still overtraded enough that
my account bottomed out at less than 20% of the starting value. Of
course that's when the profitable trades came along but I couldn't take
them. Roberts' entry techniques (particularly one of the two) would
typically risk MORE than I did. If someone with a large account
followed his techniques with proper risk control in a diversified mix of
markets, it might work. There is no test of his entries so I don't know
if they are profitable or not. It's sending new people off into the
markets with small accounts and no risk management training that's
outrageous.

He does do a good job of stressing paper trading. However, three months
is good for introducing you to the daily process and stresses of
decision making. It is not a valid test of any strategy. Only by
testing a strategy over quite a long time of historical data, can you
tell if it works. He publishes no indication this is so. Often, people
hit a couple good trades in the paper trading stage, and they are sure
they're ready to make it. I think 6 months to 1 year of reading and
paper trading is necessary. Wish I had!! For the money you can get
several much better books, rather than one course that is literally more
than half hype.

The claim that the first course is complete is false. Want to know
about options? Buy the TWMPMM II course. Want to know about entering
already existing trends? Buy a bonus pack (or get it with a one year
renewal). In other words, if you're frustrated that you seem to be
losing your account just send in $95 or $195 more for the solution.
Want to learn how Ken really trades himself? Attend a $2000 seminar.
Not satisfied with a subscription? -sorry, prorated refund requests
refused (I tried).

Bottom line: If you don't know what you're doing you're gonna lose! If
you're looking for someone else to do the brain work, expect to lose!
Only you know how important your money is and how you want it to grow.
And, oh by the way, don't get greedy!

For other opinions, check out extensive discussions on the
misc.invest.futures news group; if the thread is not currently active
just type 'Ken' and 'Roberts' into a Dejanews search and you will get a
screenful.


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Subject: Warning - Selling Unregistered Securities

Last-Revised: 29 Mar 1995
Contributed-By: Michael R. Mitchell (mitchel4 at ix.netcom.com)

Under the U.S. Securities Laws, specifically The Securities Act of
1933, the mere offer to sell a security -- unless there is an effective
registration statement on file with the SEC for the offer -- via the
Internet can be a felony subjecting the offeror to a 5 year federal
prison term. See the Securities Act of 1933, Section 5(c) Of course,
sales and deliveries after sale of unregistered securities is unlawful
(Section 5(a)) as is failure to deliver a prospectus (Section 5(b)).

Listen to an example from my own experience as a securities lawyer in
Los Angeles. Many years ago a young man came into my office and asked
my advice about whether he could advertise in the Hollywood Reporter for
investors in a movie he wanted to make.

I explained to him that such a course would be fraught with peril for
him because it would violate the federal securities laws. He said,
"Everybody does it; there are a bunch of ads soliciting people to invest
in movies there every day." He said, "Well, I'm going to do it."

About a week later, he phoned me up and said he had got a letter from
the SEC requiring him to refund any money he had collected and requiring
him to visit the LA office of the SEC. It appears that the SEC reads
the Hollywood Reporter. It also reviews the Internet newsgroups.

Certain transactions are exempted from the prohibition (See Section 4)
and certain securities are exempted from the prohibition (See Section
3). How a security is defined is set forth in Section 2(1) -- and
includes, among other things, any note, stock, bond, investment
contract, put call, straddle, option, etc.

You can determine whether a registration statement is or was in effect
as to a security by accessing the free SEC Edgar search machine at this
URL:



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Compilation Copyright (c) 2005 by Christopher Lott.