Understanding the Stock Market: How to Buy Stocks

Understanding the Stock Market:

How to Buy Stocks

InvestingDaily.com

Chapter 1Welcome to Investing ..................................1

Defining Your Investment Goals

Chapter 2The ABCs of Stocks .....................................1

Why And How A Company Issues StockHow Risky Are You?Types Of StockPicking A StockIncome Or GrowthMajor ExchangesIndexes: Keeping Track Of InvestmentsOver-The-Counter Stocks

Chapter 3 Broker Basics .............................................4

Full Service vs. DiscountCommissions And FeesMinimum Initial DepositCustomer ServiceResearchMutual Funds And Other Choices

Chapter 4 The ABCs Of Bonds ...................................6

Bond BackgroundFinding Your Method

Chapter 5 Bond Basics ................................................7

Different Strokes For Different Folks When Rates Go Up, Bonds Come DownThe Importance Of Credit RatingsSources of Information

Chapter 6 Bond Mutual Funds ....................................9

Foreign Bond Funds Chapter 7 Junk Bonds ...............................................10

Chapter 8 Convertible Securities: The Stock and Bond Hybrid .....................10 Chapter 9 Muni ABCs .................................................11

General Obligation BondsRevenue Bonds

Chapter 10 Mutual Fund ABCs ...................................12

What Is A Mutual Fund?

Chapter 11 Funds That Match Your Personal Style ...12 Chapter 12 Open-end And Closed-end ......................15

Comparing FundsAccounting For RiskThe Benefits Of Mutual FundsMutual Fund Drawbacks

Chapter 13 Nuts & Bolts ..............................................17

How Share Prices Are DeterminedProspectusFees And ExpensesRedemption FeesManagement, Administrative Fees And Transaction CostsRecord Keeping

Chapter 14 Exchange Traded Funds ..........................19

What’s An ETF? ETFs vs. Mutual FundsRisks

Chapter 15 Glossary ....................................................21

Table of ConTenTs

1 www.InvestingDaily.com Understanding the Stock Market: How to Buy Stocks

Before you begin investing in the stock market, you first have to understand what a stock is. A stock—or share—

is basically ownership in a com pany. The more shares you have, the more owner ship you have in the company.

As a shareholder of a particular company, you also receive voting rights. You get one vote per share of stock you own. As a shareholder, you get to vote on the board of directors as well as on other important matters the company is deciding on.

Why and How a Company Issues Stock A company will issue stock in order to generate revenue—

this revenue is then used to pay off debt, expand the com-pany or research and develop new products. In order for a company to issue stock, it must first go through an initial public offering (IPO), otherwise known as “going public.”

There are two types of IPOs—startup companies and pri-vate companies that wish to go public. The company will first hire one of Wall Street’s major stock brokerage firms to underwrite the company. The brokerage’s investment bank-ers then deter mine how many shares of stock to issue and at what price. The brokerage also builds up investor interest in the company before it goes public. Like wise, company insid-ers have the opportunity to pur chase shares before public investors.

It’s wise as a new investor to avoid IPOs. Generally you’ll end up buying when prices are high and you’ll be forced to

sell when they’re low. A great example of this was during the Internet boom in the late 1990s. Many Internet companies went public and investors purchased lots of stock, sending stock prices sky high. However, a few years later, investor interest and demand collapsed. Many investors were forced to sell after the stocks had dropped.

How Risky Are You? It’s important to determine your risk tolerance before you

start investing. For a younger investor, taking larger risks in the stock market won’t matter as much because he/she has years before retire ment. However, for an investor nearing retirement, high-risk investing may not be the best option.

Understand there will always be risks no matter what type of investment you make. There are a number of conditions that will affect a stock’s per formance from investors’ percep-tions of the stock’s value, to various market conditions, to world events to the company’s performance and manage-ment, among other things. Even if you invest your money in a high-yielding savings or money-market account—extreme-ly low-risk options—you face inflationary risks.

You have the risk of losing everything in the stock market. Yet if you don’t invest at all, you risk missing out on great opportunities. There will always be risks. To be a sound investor, you have to learn to recognize and minimize your risks.

Investing is an important aspect of anyone’s finan cial life. It’s a way to save for retirement, earn extra income if

you’re already retired or to put your child through college with.

But to many new investors, learning to invest is a daunt-ing task. There are numerous questions that need answering. This report will delve into the various aspects of investing, from defining your investment goals and determining your risk tolerance to detailing the various types of investments in the markets.

Defining Your Investment Goals Investors, from the beginner to the seasoned pro,

shouldn’t enter into any investment without a partic ular purpose in mind. That purpose could range from planning

for retirement to saving for a child’s education to preserv-ing existing assets and earning extra income. Often, you may have two or more goals to consider; in that case, you may choose a dif ferent investment for each of your goals.

Before you make your choice, ask yourself these two important questions:

• When do you plan to use the money you’re investing?

• What’s your risk tolerance?

By answering these questions, you can identify the correct investment to match your needs, time frame and personal approach to investing. Let’s look more closely at the latter question.

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CHAPTER ONE

Welcome to Investing

CHAPTER TwO

The ABCs of Stocks


Diversification is also important to minimizing your risks—don’t put your eggs all in one basket. As we detail the basics of stocks, bonds and mutual funds, we’ll look at the risks associated with each, as well as where conservative and more risky investors should put their money.

However, if you do decide to invest in a new IPO, make sure to read the company’s prospectus, a legally bind-ing document it files with the Securities and Exchange Commission (SEC). The prospectus details the company’s future plans as well as its cur rent financial conditions.

Types of Stock There are two main types of stock a company can offer—

common and preferred. Common stock is the No. 1 securi-ty in the stock market. Every company that issues stock first issues com mon stock. Also, when the financial media refers to how stocks fared in the market on any particular day, they are always referring to common stock.

However, later in a company’s life, management may decide it needs to raise more capital, such as for expansion or an acquisition. To do so, it could issue more common shares. However, doing so would dilute each stockowner’s share of future earnings. A better option may be for the company to offer preferred stock.

Preferred stock shareholders receive greater rights than common stock shareholders. For instance, preferred holders will always receive their divi dend before common stockhold-ers. And should the company have financial problems and be forced to liquidate assets, preferred shareholders receive pay-ment for their shares before common shareholders.

However, preferred shareholders may not receive voting rights. They also receive a fixed dividend and don’t partici-pate in the growth of the business. But they have greater safety with their investment and usually earn a higher divi-dend yield than common stock.

Picking a Stock So you want to invest in the stock market, but how do

you know which stocks to pick? Investors focus on a company’s long-term value in rela-

tion to its current stock price. Traders, on the other hand, are more focused on a company’s stock price alone and how short-term supply and demand pressures are affecting it. As an investor, you should believe in the company in which you’re investing. Do you like its products? Are you happy with the way management is running the company? Does it have strong financials, low debt and a solid strategy for the future?

These are questions you should ask when you’re evaluat-ing a potential stock to purchase. Once you have found a few companies that you believe have a significantly higher value than the stock price, your best strategy is to buy and hold. When you buy and hold for the long term, you gener-ally overlook the daily ups and downs in the market and pay more attention to the company’s long-term performance. And bar ring any major catastrophes, you’ll watch the value of your investment increase during the longer haul.

Short-term traders look to make quick profits. They buy stock that they expect to increase in a brief period of time and then sell out of it before it drops.

For instance, a short-term trader may purchase a stock that is trading at $14, expecting it to rise to $15 or $16, generally within a day or two. Should the stock drop in price quickly, the trader will sell fast and cut losses. Consistently predicting short-term price movements is very difficult. It also requires a significant time commitment where you pay close attention to the stock market generally and the price of your particular profit exits and stop losses.

Income or Growth Every company goes through a life cycle. It may start

out as a growth stock but later in its life, change to be an income stock. Such companies are typically mature and gen-erate more cash than they can use profitably to expand their business. Consequently, income stocks pay sharehold ers this excess cash in the form of dividends. Older, retired individu-als will often invest in income-gener ating stocks to pay for their monthly living expenses.

Income stocks are great for conservative investors. They tend to be less volatile in price fluctu ations, both down AND up. Likewise, should the stock fall, your dividend will help reduce your losses.

However, income stocks aren’t without downside and risk. First, you do have to pay taxes on your divi dends, which are considered taxable income. Also, you face inflationary risks if the company doesn’t increase shareholders’ dividends yearly.

Growth stocks are companies with faster earnings growth, usually 15 percent-plus a year. Growth stocks gen erally fall in more volatile sectors, such as high tech or oil and gas exploration. The company is focused on growing its earn-ings, so any money it brings is reinvested back into the busi-ness to expand operations. Dividend payouts are unlikely.

Growth stocks tend to ebb and flow more sharply than income stocks. They’re also usually younger companies. Although their businesses may not be fully flushed out, their growth potential can cause their share prices to increase many times over.

However, as happened during the Internet boom and bust of 1996-2002, they are volatile. Should investor interest decrease, growth stocks can drop quickly.

Major Exchanges Trading has been around for centuries. From the earliest

days, humans have been bartering with each other. As this became more sophisticated, buyers and sellers found a more common area to meet at. In 1792, buyers and sellers met under a buttonwood tree on Wall Street in New York City. This gathering eventually grew in popular ity until the group formed the New York Stock Exchange (NYSE), giving these buyers and sellers an organized way to trade stock.

Although the NYSE became a formalized trading exchange, not all companies were large enough to qualify for listing there. During the 1830s brokers of these smaller stocks formed their own exchange outside on the curb.


These curbside brokers didn’t move inside until 1921 and the exchange was officially named the American Stock Exchange (AMEX) in 1953. In 2008, the AMEX was acquired by the NYSE and is now called NYSE Amex, but remains a separate exchange.

In 1971, the first electronic stock exchange was opened—the National Association of Securities Deal ers Automated Quotation System, commonly referred to as the Nasdaq. Computers created a faster-paced trading system.

Today, these are the three major exchanges in the U.S. and a total of 14 national stock exchanges. In addition, foreign countries throughout the world operate their own exchanges.

Indexes: Keeping Track of Investments When you’re investing in the stock market, it’s impor-

tant to keep track of the way the stock mar ket is moving. One easy way to do this is by watching the various indexes. Although there are hundreds of indexes, the four most popular indexes are the Standard and Poor’s (S&P) 500, the Dow Jones Industrial Average, the Nasdaq 100 and the Russell 2000.

The Dow tracks 30 stocks from the most important sec-tors of the market. The Dow is price weighted. That means that whichever stocks have the higher prices per share have a heavier weighting on the Dow average.

The Nasdaq 100 lists the 100 largest non-financial com-panies in the Nasdaq Composite and is a proxy for technol-ogy stocks. The S&P 500 tracks 500 stocks selected by a committee at S&P to represent the stock market’s industry groups. The Russell 2000 tracks the 2000 stocks in the Russell 3000 with the lowest market cap and is a proxy for small-cap stocks. These last three indexes are market-cap weighted, mean ing those stocks that have a larger market cap (stock price times number of shares outstanding) carry a heavier weighting. For more on market cap, see the glossary.

Over-The-Counter Stocks An over-the-counter (OTC) equity security is any equity

that isn’t listed or traded on a national securi ties exchange. The OTC market has a reputation as a “Wild West-style, any thing goes outpost,” which is well earned. It’s where scammers, goons and hucksters ply their trades; it’s also where legitimate foreign operators like Swiss food company

Nestle (Other OTC: NSRGY.PK) choose to market their shares. In other words, the OTC market is home to com-panies high, low and in-between. The highest quality tier is the OTCQX and it goes down from there.

It’s also the American market of choice for many Canadian-based companies that don’t want to be subjected to the regulatory morass and con siderable expense a Nasdaq or NYSE listing entails. These guys—real companies with real revenues run by real people—have fully exposed them-selves according to the requirements of the Toronto Stock Exchange (TSX) and Canadian regulatory bodies.

The two competing venues for OTC stocks are the Pink Sheets (www.otcmarkets.com), a pri vately owned infor-mation service, and the Nasdaq-run OTC Bulletin Board (www.otcbb.com).

The origins of the Pink Sheets date back to 1904, when the National Quotation Bureau began it as a paper-based, inter-dealer quotation service linking competing market makers in OTC securities across the country.

The publication was printed on long, narrow sheets of pink paper; hence, the “Pink Sheets.” Since that time, the Pink Sheets have been the central resource for trading infor-mation on OTC stocks and bonds.

The OTCBB is a relative upstart, beginning operations only in June 1990, and was intended to bring some trans-parency to the OTC marketplace. It’s a regulated quotation service that displays real-time quotes, last-sale prices and vol-ume information in OTC equity securities.

Because the SEC exerts very little power over the OTC markets, the Pink Sheets and the OTCBB can attract crooks and quick-buck scammers.

Pink Sheet-listed issuers aren’t required to register secu-rities with the SEC or keep their reporting requirements current. Nor are issuers required to file financial or other company information.

In contrast, OTCBB companies are subject to periodic fil-ing requirements with the SEC.

The 2002 Sarbanes-Oxley Act imposed new regu latory, auditing and board requirements, adding tens of thousands of dollars to the cost of being a public company. Plus, CEOs must personally guar antee a company’s financial statements.

“Sarbox” has caused many legitimate foreign companies to delist from the major U.S. exchanges and move to the OTC marketplace.

http://www.sec.gov/divisions/marketreg/mrexchanges.shtml

http://www.otcmarkets.com/otcguide/investors_market_tiers.jsp

http://www.otcbb.com


The person most people think of as a stockbroker is actu-ally a registered representative or an account executive

working for a broker-dealer of securities. A broker-dealer and its account executives make money through commis-sions on securities transac tions. A fee is charged whenever you buy or sell. But they don’t set up a long-term financial plan for you.

This is an important factor to consider: If you’re seeking advice on balancing your real estate hold ings, life insurance coverage, cash and securities, then you need to look for a registered investment adviser (sometimes called a finan-cial planner), who will charge a fee for drawing up a total financial plan for you. The financial planner may work with an account executive to manage your securities holdings in har mony with your total financial plan. Make sure that your investment advisor has a “fiduciary” duty to operate in your best interests. Many so-called advisors are only required to offer “suitable” investments, not the best investments. Such advisors aren’t suitable for anyone.

Full Service v. Discount The first thing you should consider is whether you want a

full-service broker or a discount broker. If you do all of your own investment research, then use a discount broker. That will save you a considerable amount of money over time.

Discount brokers execute trades for about one-twentieth the amount that full-service brokers often charge. Where dis-count brokers typically charge less than $10 for an individual online trade, you’ll probably pay $100 or more for the aver-age trade done through the typical full-service broker.

Full-service firms provide “advice” and often charge annu-al main tenance fees through which they grant themselves a generous slice of your assets, say about $150 a year or more. Alternatively, full-service brokerages might grant unlimited free trades in an account, but will charge you a “wrap fee” equal to a few percentage points of your total assets per year. In other words, full-service brokerages provide help at a very high cost.

Do you get twenty times the value by using one of those expensively dressed souls who work for Merrill Lynch, Morgan Stanley Smith Barney, UBS and others?

Most brokers who give advice are just glorified salesmen, shopping around their brokerage house’s stock picks or pricey mutual funds. Why shouldn’t they? Brokers get paid a percentage (the commission) for every sale they make. By receiving commissions on each trade, their com pensation is closely tied with how often their clients’ accounts are traded. In other words, part of the commission you pay to the firm may wind up directly in your broker’s pocket. It’s a conflict of interest.

Whether you’re ready to open your first discount broker-age account or simply wondering if you’re getting the best

service for your money from your current one, here are some issues to consider.

Commissions and Fees Cheaper is not always better—the price per trade at a

discount broker may also indicate the level of customer service that comes with it. If you aren’t trading in and out of stocks very often and you’re not too concerned about whether your trade is exe cuted within 15 seconds or two minutes, there really isn’t a significant difference among the discount brokers charging $5 to $10 per online trade. If you go much cheaper than that, you may have trouble getting someone on the telephone to answer any questions you have. And if you’re paying much more than that, you should expect near-flawless service.

Furthermore, if you aren’t comfortable trading over the Internet, be prepared to pay much higher commissions. Some discount brokers charge up to five times as much for a telephone order.

Beyond the trading commissions, you’ll find that broker-ages may charge other fees, including fees for transferring assets into the account, fees for closing an account, IRA cus-todian fees, wire trans fer fees, account inactivity fees, annual fees and fees for not maintaining a minimum balance. If you know your needs, you won’t end up paying for serv ices you don’t need.

Minimum Initial Deposit If you’re just starting out, consider what you’ll be able

to comfortably invest initially. Some brokers have account minimums, so find the one that best fits your budget.

Customer Service You should put some time into researching a broker’s

service before you sign on the dotted line. In the case of discount brokers, customer service includes web site perfor-mance and interface. Check out each brokerage’s web site. Is the inter face intuitive? Can you find what you’re looking for without having to click 65 links? Is it speedy?

If talking to a live human is important to you, test their phone service. Does the brokerage answer the phone promptly? Is there an office nearby, just in case you need to talk face-to-face? You’ll definitely want to see how the bro-kerage does at sending you all relevant material you ask for online.

What if the Internet breaks? Sometimes you may not have access to a computer. Check out whether the brokerages you’re considering also have touch-tone phone trading and how that works. Sometimes you just might want to place an order through a real, live person, and many discount broker-ages offer that option, too.

CHAPTER THREE

Broker Basics


If you want to consolidate your PINs and pen nies, think about looking for a brokerage account that can accommo-date your banking needs. Many brokers now offer: money market sweeps; check writing and bill payment; Visa cards; direct deposit; and ATM cards. Your cash will typically attract higher interest rates in a brokerage money market account versus the typical savings or checking account.

Research Some brokerages market their research as a real plus.

That’s fine, but you probably don’t want to pay for it. There’s plenty of research available on the Internet. Some of the offerings include analyst reports, real-time quotes, and detailed financial data.

Mutual Funds And Other Choices No-load mutual funds can be purchased directly from

mutual fund companies, so unless you’re a mutual fund

trading addict, the availability of thou sands of mutual funds in one location probably shouldn’t affect which broker you choose. While you may purchase some no-load mutual funds from discount brokers without paying a transaction fee, some brokers do charge a fee for funds—so be sure to check on this before making a purchase. And, of course, if there’s a particular mutual fund family that you’re set on using, make sure that the brokerage you select offers that family of funds.

All the brokerages offer stocks traded on the major exchanges, and most will offer equity mutual funds. But there are a number of other investment vehicles that you may wish to use. If you’re somebody interested in risking your hard-earned money on over-the-counter (OTC) stocks, you’ll have to see which brokerages offer them. Other choices such as bonds, futures, and options are not available through every brokerage. Determine what you expect you’ll need, and act accordingly.


Bond Background Historically, most investors have bought bonds for

income. They pick a solid company’s bonds and hold on for the long haul, regardless of what happens to their prices. Then, when the bonds come due or mature, they cash them in at their “face” values.

This strategy is fine, provided you don’t need the money anytime soon. As long as the company remains solvent, its bonds will always be paid off at a set price (their face val-ues), regardless of infla tion. Meanwhile, your income stream will remain constant, at the rate at which you bought the bond.

At their core, bonds are interest rate-sensitive investments. Most pay a fixed rate of interest over their lifetimes. The value of this income stream to investors varies with changes in interest rates and inflation.

Bond prices, therefore, fluctuate with changes in interest rates and inflation. When interest rates and inflation rise, the income stream bonds generate is worth less, so bond prices fall. On the other hand, when interest rates and inflation fall, bonds’ income streams are worth more, so bond prices rise. Con sequently, unless you hold bonds until they mature, your total returns will depend heavily on what’s going on with interest rates and inflation.

For example, from October 1993 to the end of 1994, rising inflation and interest rates slashed bond prices. That gave investors a great opportu nity to buy bonds for income and capital gains in 1995, as slowing inflation and falling interest rates pushed bond prices up, handing out big prof-its. Bond returns were generally weaker in 1996, but the Asian crisis of 1997 and 1998 drove investors out of stocks and into bonds. Interest rates on long-term bonds dropped well below 5 percent for the first time ever and bond returns went through the roof before dropping again throughout 1999 in the face of a growing economic recovery.

Today, bonds are at a crossroads. They’ve rallied sharply since the financial crisis of 2008-09 as the world economy experienced the worst economic recession since the 1930s. As a result, bonds aren’t the bargains they once were, but they do have merit for portfo lios if chosen carefully.

Finding Your Method The most conservative investors will want to focus most

on bond mutual funds, which give you the broadest possible diversification. That includes closed-end mutual funds, funds

that trade on major exchanges like shares of stock rather than minting new shares to the public.

Aim for those selling for less than the value of their assets, giving you the possibility of a triple play from high income, capital appreciation of bonds and the narrowing of their dis-counts.

Like U.S. bonds, foreign bonds are affected by inter-est rate swings. However, foreign paper has one major risk that U.S. securities don’t: They’re denominated in foreign currencies rather than in U.S. dollars. Consequently, they can be affected by exchange rate swings as well as by inter-est rate trends. The effect can be especially severe in less-developed areas, for example Asia or Latin Amer ica. Here, political and economic events can trigger stampedes out of currencies that can devastate bondholders, such as what hap-pened during the financial crisis of 1997-98 and 2008-09. Even foreign bond mutual funds can be hurt by unexpected events. These should be only a small part of your overall bond investment, unless you’re a real dice-roller.

Junk bonds are one type of bond with a bad name. But they’re definitely worth considering dur ing a strong econo-my. These are securities issued by less creditworthy compa-nies. Consequently, their prices are affected by the perfor-mance of the underlying firms, more so than interest rates.

We look at convertible securities—bonds that are exchangeable into a set number of shares of the issuing company’s stock. As a result, they rise in value when the issuing com pany’s stock rises. This gives them the ability to benefit from faster economic growth, which boosts their value.

Resource-rich convertibles are potential benefi ciaries of both higher commodity prices and faster economic growth. That’s because they’re convertible into the stock of natu-ral resource-pro ducing companies. All four of these bond groups stand to throw off monster gains and high income in the coming months, with just slightly more risk than higher-quality bonds.

We examine municipal bonds, an area that’s rapidly becom-ing an investment minefield. But the potential rewards are better than ever. As always, munis are free of federal income taxes, as well as state and local taxes in the areas where they’re issued. Munis have suffered from concerns about their credit quality, as well as from inflation fears. Many munis will be a trap for investors. How ever, there are fine alternatives, par-ticularly in the mutual funds area.

CHAPTER fOuR

The ABCs of Bonds


Before getting into the dynamics of bonds, let’s get to the basics—namely, what exactly is a bond? A bond is a

way for corporations (or a government institution) to bor-row money to finance invest ments. Rather than borrow-ing from a bank to raise money, or for that matter issuing stock, a company borrows directly from investors. A bond is simply a promise to repay a certain amount of money on a given date.

When you buy a $1,000 bond with a 20-year matu rity at a 6 percent annual interest rate, for example, you’re essen-tially buying a commitment from that company to repay you the $1,000 (the principal) at the end of 20 years, plus $1,200 in interest. Interest payments are normally distrib-uted every six months, in the form of “coupons,” during the 20-year period. The interest rate on the bond typically is determined by whatever long-term interest rates are in the overall bond market when the bond is issued.

Mind you, even though you bought a bond, you don’t have to hold on to it for the entire 20 years. You’re per-fectly free to sell it to another investor. Five years after buying the bond, for example, you may need some cash in an emergency and sell it.

People are buying and selling bonds to each other all the time, and this makes up the bulk of the bond market. You don’t have to buy a newly issued bond.

Different Strokes for Different Folks There are several ways to invest in bonds. Which you

choose will depend on what risks you’re willing to take, what tax bracket you’re in and how much you need income. How much of each group of bonds you buy will depend on your own situa tion. Investors in higher tax brackets—i.e., more than a 30 percent marginal tax rate—will prob-ably want to focus on municipal bonds, which are typically exempt from federal taxes and state taxes where issued.

When Rates Go Up, Bonds Come Down One of the most commonly misunderstood aspects of

bonds is that when interest rates go up, the face value of bonds comes down. On the surface, it would seem just the opposite: After all, because you earn money on a bond from the interest it yields, wouldn’t you earn more if inter-est rates go up?

The reason this isn’t the case is because the interest rate on your particular bond is fixed; it doesn’t change as prevailing interest rates change. If you want a bond with a higher interest rate, you’d have to buy a newly issued bond.

Let’s get back to that $1,000 bond you’re selling after five years of owning it. Assuming interest rates are still at 6 percent, you could fetch $1,000 for it (the “par value”). But there’s the catch. Interest rates aren’t likely to be the

same as when you bought the bond. If interest rates have gone up to, say, 8 percent by the end of that five-year peri-od, the face value of the bond would be worth only $750.

The reason for the price decline is because no one would pay more than $750 for your bond. If they did so, they’d be forfeiting profits they could make by buying a $1,000 bond with an 8 percent interest rate.

If someone bought your bond for $750, the yield on their investment would be 8 percent (because they’re get-ting a 6 percent yield on a $1,000 bond). Buying a bond like this—at a price lower than its face value—is buying it at discount. In this case, it would have a $250 discount.

Of course, the dynamic works both ways. When inter-est rates go down, your $1,000 bond yielding 6 percent is worth more. If interest rates are 4 per cent, you could get a handsome $1,500 for it. To cal culate the value of your bond, divide its annual yield by the prevailing interest rate. In our example, divide $60 by 0.04. The result is $1,500.

What if interest rates go up and you don’t want to sell your bond, and instead hang on to it for the full 20 years? Even though you’d get your $1,000 back plus the 6 per-cent annual interest, you wouldn’t nec essarily come out ahead. That’s because inflation could eat away your profits.

If inflation averages more than 6 percent during those 20 years, you’ve lost money—in the sense that the real value of your investment has decreased. That $1,000 (plus interest) would buy less at the end of 20 years than at the beginning. Conversely, if inflation averages less than 6 per-cent during those 20 years, the real value of your invest-ment has gone up. (For simplicity’s sake, we’ve left out the effect of taxes in these examples.)

Keep in mind that bond issuers frequently include a “call date” in the bond agreement, allow ing them to redeem your bond in a few years in the event that interest rates fall significantly. This allows them to avoid having to pay much more than the prevailing interest rate.

The Importance of Credit Ratings Like stocks, bonds aren’t 100 percent safe. When you

buy a 20-year bond, you have to be confident that the company that issued it will stay in business. U.S. Treasury bonds are the safest kind because, barring societal collapse, the government will be in business in 20 years. The bonds of large “blue chip” companies are also good bets for 20 years down the road.

Smaller companies, however, are riskier invest ments because they’re more likely to go out of business or become unable to meet their obliga tions. To help make up for this risk, the interest rate on their bonds is higher. And if something happens to the company that makes it a riskier investment, that company’s existing bonds are likely to be sold at a discount—even if interest rates haven’t changed.

CHAPTER fivE

Bond Basics


Standard & Poor’s and Moody’s rate bonds according to their safety. For Stan dard & Poor’s, ratings range from the safest bonds—AAA—to bonds in default—D. The peck-ing order is AAA, AA, A, BBB, BB, B, CCC, CC, C and D. Moody’s ratings are as follows: Aaa, Aa, A, Baa, Ba, B, Caa, Ca and C. Your broker should be able to tell you the ratings for a particular bond, or you can get them from the ratings agencies’ monthly reports, available by calling the numbers above.

The highest ratings indicate that the issuer’s abil ity to meet its principal and interest obligations is extremely strong. Midway through the pecking order, namely A-rated bonds, the issuers are still considered strong companies but are vulnerable to the ups and downs of the economy, which could make it more difficult to meet obligations.

BBB and Baa bonds are the lowest investment grade and are issued by companies whose ability to meet obligations is adequate, but who are much more vulnerable to eco-nomic changes than higher grades. Bonds rated lower than BBB and Baa are considered more specula tive, normally referred to as junk bonds.

Note that because rating agencies are paid by the issuers of the securities being rated, there is an inherent conflict of interest and the rating agencies often blunder by assign-ing ratings that are too high. Enron, for example, had an investment grade credit rating from all three major credit rating agencies less than a week before it filed for bank-ruptcy in December 2001.

The most infamous example of rating agency mistakes occurred most recently during the 2008-09 financial crisis, when structured pools of sub-prime mortgages to which

the rating agencies had given the highest triple-A ratings ended up defaulting as the housing market collapsed. You can read all about it at www.fcic.gov.

Sources of Information Most large daily newspapers provide their read ers with

some coverage of the bond markets. In The New York Times and The Wall Street Journal, for instance, the cover-age is mainly done in columns titled “Credit Markets.”

The Associated Press and other news agencies also have bond market stories on their wire serv ices; these are avail-able on Web sites such as Yahoo! Finance, Marketwatch and Bloomberg, and are often published by daily newspapers.

These columns feature analyses of daily trad ing activities as well as discussions about current interest rate scenarios. The perspective offered in these columns can give most investors an idea about what the market is thinking, what its fears are and which securities offerings have done well.

While many investors might not pay close atten tion to these columns or even have access to this news coverage, the information discussed there is extremely important to most serious and active fixed-income investors.

In addition to reporting, many newspapers include daily price lists of actively traded U.S. Treasury securi ties and corporate bond prices. The net asset value of many mutual fund shares is also listed.

Besides newspapers, there are a number of mag azines that specifically devote themselves to finan cial news. These include Barron’s, The Bond Buyer, The Economist, Grant’s Interest Rate Observer, Institutional Investor and Investment Dealers’ Digest.


For small investors, you just can’t beat bond funds for their ease of investment: low initial mini mum invest-

ments, no bid/ask spreads, instant diversification, profes-sional management, the list goes on and on. Funds are far easier to buy and sell than individual bonds. Minimum required invest ments are also much lower.

One general rule of thumb when picking funds: Never buy a bond fund with a sales load (fee charged when pur-chasing or selling a fund). There are always no-load funds and ETFs that have done just as well, and more of your money goes to work for you right away. You should also look for bond funds that charge low expenses.

The only real disadvantage of bond mutual funds com-pared to individual bonds is that their income yields can vary. The reason is that fund managers adjust their portfo-lios in order to maxi mize total returns, rather than income. A particu larly bearish manager, for example, could shift out of longer-term bonds, which yield more but also are affected more by interest rates swings, to shorter-term bonds.

Also, an untimely switch by a fund manager from one type of bonds to another could leave you out of a bull market or subject you to some severe bear mar ket pain, even if you’ve made the right market call.

Consequently, investors who can afford to hold a diversi-fied portfolio of individual bonds (at least eight different issues)—and who plan to hold their bonds to maturity, have a priority for income rather than total returns, or who don’t mind more active trading—may be better off with individual bonds rather than funds.

Foreign Bond Funds International bond funds are an easy way to cash in on

the global bond boom if you lack the time or money to buy individual bonds. Foreign bond funds give you instant diver-sification over several coun tries, maturities and issues.

That’s vital to reducing the political and eco nomic risks associated with going global. Funds also provide manage-ment expertise and allow you to own issues that may be impossible or prohibi tively expensive to buy individually.

And while foreign bond accounts require at least $20,000 to avoid exorbitant bid/ask spreads, com missions and fees, funds can be purchased with as little as $1,000—less for IRAs.

On the negative side, even no-load fund yields are reduced by management expenses. Many man agers also run with the herd, sticking with the same markets even buying the same bonds as their colleagues. Naturally, that leaves them vulnerable to the same traps.

The key to maximizing foreign bond funds’ potential and dodging the occasional perils they send your way is to pick conservatively. That means buying funds that invest in coun-tries with high real interest rates, flat yield curves, fiscal and monetary stability, positive investment flows, a positive bal-ance of trade, low inflation and low event risk.

Funds should also be relatively diversified between world regions Asia/Pacific, Europe and the Americas just as a bal-anced global bond port folio should. Of course, fund inves-tors must ulti mately rely on the discretion of the managers, and even the most current portfolio data available is usually months out of date. The solution is to stick with funds that have held down losses in bear markets.

CHAPTER Six

Bond Mutual Funds


High-yield or junk bonds are issued by corpora tions with low credit ratings (rated BB or less). The issuing compa-

nies may lack a long operating his tory or their ability to meet their interest and princi pal obligations may be somewhat in doubt. But to attract investors, they’re forced to offer a higher rate of interest on their bonds than those paid on investment-grade bonds of comparable maturities.

Junk bonds have a risk profile similar to common stocks and are at the opposite extreme from Treasuries in terms of safety.

Junk bonds’ high yields make up for their risk. Despite their unflattering beginning during the 1980s, junk bonds have outperformed high-grade bonds over time. Their interest rates were four to five percentage points above those of AAA-rated bonds. Losses because of default reduced yields on junk bond

portfolios by about 1.6 percentage points in typical years and 4 to 4.5 percentage points during major recessions.

Because of the risk of default, it’s important to have a good-sized portfolio of junk bonds. Owning fewer than 10 junk bonds is treading in the waters of speculation, not investment.

The biggest risk to junk is a recession, which puts weaker companies in jeopardy. But well-chosen junk should reward investors with high income and capital gains, both from falling interest rates and from improvement in bonds’ credit quality.

Given the relative risk of junk, conservative play ers will want to stick with junk bond mutual funds, which give you instant diversification. More aggres sive investors can nibble on individ-ual junk bonds, which promise big-time gains as the underlying companies return to good financial health.

Convertibles are bonds that you can convert to shares common stock. The time to do this is when the stock

reaches the “conversion price”— the point at which the stock is well above (usually 15 to 30 percent) its price when the bond is offered for sale.

Prices of convertibles move based on both interest rates and a company’s stock price. They offer the potential for growth and also a measure of safety. The profit potential on them is higher than that of conventional bonds and they’re less risky than stocks.

Investors like convertibles because they pay higher yields than most stocks, and because a con vertible’s value doesn’t drop as much as the corre sponding stock when the stock price falls. The advantage for companies of issuing convert-ible bonds is that, if the bonds are converted to stock, com-panies’ debt vanishes. Also, convertibles carry lower interest rates than regular bonds.

Convertible securities are a popular low-cost way for small companies to raise cash to finance business activities. For investors, convertibles pay bond-like yields while offering the potential for capital appreciation if a company’s stock price rises. In a nutshell, convertibles offer the poten tial for very high rewards with little risk.

A convertible bond is like owning a bond with an option to switch into a specified number of shares of the issuing company’s common stock at a later date. There are also convertible preferred stocks that are convertible into shares of the com mon stock.

Because they pay high yields, convertibles offer downside protection in a declining stock market. And if interest rates are

rising, convert ibles generally don’t fall as much as bonds. But convertibles are often misunderstood and over looked by inves-tors. These investments are diffi cult to understand, and there’s a decided lack of information available regarding convertibles.

Convertibles are a great investment when the outlook for the stock market is unclear and returns in the bond market are small. That’s because if the underlying common stock appreci ates down the road, convertible shareholders will enjoy a large portion of that gain—something you won’t get holding a bond. In the meantime, you’ll earn a fat yield.

The tradeoff when buying a convertible instead of a bond is that the convertible security is gener ally considered a “subordinated debenture.” In plain English, that means if the company goes bankrupt, the bondholders would be paid off before shareholders of the convertible.

Convertible bonds trade at a pre mium to their value if they were switched into common stock. Convertibles trad-ing at low premiums to their conversion value occur when the stock price is above the bond’s conversion price and conversion is likely. These convertibles tend to behave like stocks. In contrast, convertibles trading at large premiums to their conversion value occur when the stock price is below the bond’s conversion price and conversion is unlike-ly. These convertibles act more like bonds and are more interest rate sensitive.

Most convertibles feature “call” provisions. This means that the issuer can forcibly redeem them at a predeter mined price. For these reasons it may be best to leave investing in convertibles up to the pros and go the mutual fund route.

CHAPTER SEvEN

Junk Bonds

CHAPTER EigHT

Convertible Securities: The Stock/Bond Hybrid


Municipal securities represent loans to a state, a legally constituted political subdivision of a state or a U.S.

territory. They’re issued to raise capital to finance public works and construction projects that benefit the general public.

Examples include construction and mainte nance of streets and highways, water distribution and sewage systems, and public welfare and health services. There are only two major cate gories of municipal securities issues: general obliga-tion bonds (secured by local tax dollars, both property and income) and revenue bonds (secured by revenue other than tax dollars).

The interest on most municipal securities is exempt from federal income taxation. The federal government doesn’t tax the debt obligations of municipalities. In many cases munici-pal bonds are also exempt from state income tax for inves-tors who live in the state where the bond is issued or who purchase bonds issued by a US territory.

The tax advantage of municipal bonds allows municipali-ties to offer the bonds at lower interest rates than the rates of taxable bonds. The result is municipal bonds are more attractive to investors in high tax brackets than those in lower brackets.

The greatest advantage a tax-exempt bond offers an inves-tor is tax-free income. In the wake of changes in federal tax laws, these bonds provide one of the few remaining tax shel-ters. In addition, the liquidity of the secondary tax-exempt market has offered many investors the chance to earn some large principal gains. Just like the corporate market, tax-exempt securities are sold to numerous institutional and individual investors every day.

General Obligation Bonds General obligation bonds (GOs) are issued by state and

local governments and are secured by local tax dollars, both property and income, which can be raised to meet princi-pal and interest payments if nec essary. This type of security is the basic tax-exempt bond sold by school districts and municipalities across the country.

GO holders have a legal claim to the revenues received by a municipal government for payment of the principal and

interest due them. GOs are used to raise funds for those municipal capital improvements that typically don’t pro-duce revenues (remodeling a volunteer fire department, for example).

Because general obligation bonds are backed by the taxing powers of the municipal issuer, they must be approved by taxpayers voting in a referen dum. Interest earned on GOs is exempt from fed eral taxes as well as the taxes of the gov-ernments within the state in which the securities are issued. Interest is normally paid twice a year on the bonds and the coupon rates typically are lower than rev enue bonds with similar investment risk.

Revenue Bonds Revenue bonds are payable only from the earn ings of spe-

cific revenue-producing enterprises. The quality of revenue bonds is determined by sources of revenue, feasibility stud-ies, maturity structure, call provisions, application of rev-enues and other agree ments. The taxing power of a local or state govern ment doesn’t back up the bonds if the revenue stream doesn’t meet the debt service requirements.

Revenue bonds are sold to finance the con struction of public utilities, airports, toll roads, economic development, housing, state student loan programs, college dorms, sta-diums and health care facilities. They’re the more common form of municipal issue and can be used to finance any municipal function that generates income. The sources of revenue for interest and principal payments come from tolls, concessions, fees for operations and rental payments.

Typically a municipality might create a bond authority, which is given the responsibility for the issuance of bonds and the collection of revenues that will be used to pay bondholders’ principal and interest.

As with all fixed-income securities, the investor is likely to be concerned about the chances that a revenue stream will not provide enough cash flow to meet principal and interest payments. Some rev enue bonds are considered to be highly risky investments that are damaged during economic down-turns, whereas others are considered safer than GO bonds because they are backed by very stable and real assets.

CHAPTER NiNE

Muni ABCs


What is a Mutual Fund? A mutual fund is a pool of money controlled by an invest-

ment company that raises money from shareholders and invests it in stocks, bonds or virtually any other type of legal investment. You can think of a mutual fund as a group of people with similar investment goals putting their money together to increase their profits. They hire a pro fessional manager to invest that money. The man ager must be able to adapt to sudden changes in the financial climate and adjust the fund’s hold ings accordingly.

The ease with which mutual funds allow investors to access all sorts of asset classes has resulted in tor rid growth. In the late 1940s, there were about 100 mutual funds in existence, with assets totaling about $2 billion. At the end of 1970 there were 361 funds with assets approaching $50 billion. The industry has exploded since then: Today there are over 7,000 funds, with assets exceeding $11 trillion.

But it’s up to each investor to personally craft his or her portfolio to their risk tolerance and objectives. With that in mind we’ve given a brief synopsis of the different funds available to investors below.

Since different funds are designed to meet different objectives, the first step is to identify the correct type of

mutual fund—one that matches your needs and personal investing approach.

Mutual funds fall into three general categories:

Equity Funds—These invest solely in shares of common stocks.

Fixed-income Funds—These purchase corpo rate or govern-ment securities offering fixed rates of return.

Balanced Funds—These invest in a combina tion of stocks and bonds.

But these categories are only the beginning. Within each is an entire spectrum of choices. There are a great variety of equity funds. Here are some of the options:

Aggressive Growth: These funds are invested in stocks of emerging or turnaround firms that generally don’t pay cash dividends. The major fund objective is the pursuit of capital gains. Aggressive growth funds can use options, buy stocks on margin and carry out other risky activi ties. Profit potential is above average but risk exposure is very high. Aggressive growth funds can be highly volatile. They’re best suited for investors still building their wealth and with a long time horizon.

Balanced: Allocates money between stocks and bonds. The typical balanced allocation is 60% stock and 40% bond. These funds aim to conserve capital as well as seek income and growth. Growth potential is moderate to high, and your risk exposure is average.

Convertible Securities: Invests in convert ible bonds and preferred stocks. A convertible bond can be converted into shares of common stocks at the option of the holder. One of the appeals of convertibles is that typically when stock prices rise, these bonds tend to follow suit. However, when stock prices fall, bond prices usu ally remain flat. Generally, inves-tors can expect higher-than-average current yields and less price volatility than in an equity income fund.

Corporate Bond: If you’re investing any amount less than $100,000 at a time, you’re better off with a mutual fund than with individual corpo rate bonds. These funds allocate capital among bonds of varying investment grades and expiration dates, including some government issues. Your income potential depends on movement of interest rates and bond quality.

Note that there’s an opposite relationship between the prices of these funds and interest rates. When interest rates fall, share prices rise and vice versa.

Asset Allocation Funds: Managers shift from stocks to bonds to money market instruments, depending on eco-nomic and market conditions. Your returns depend on the manager’s ability to time the mar kets. Heavy trading “account churners” (man agers who buy and sell investments constantly) can lower your returns.

Ginnie Mae or GNMA: Invests in pools of mortgages backed by the Government National Mortgage Association, though the funds themselves aren’t government guaranteed. As with bond funds, share values can rise when interest rates drop. Problems arise when mortgage holders refinance mort-gages at lower rates, reducing your chances for capital gains.

CHAPTER TEN

Mutual Fund ABCs

CHAPTER ElEvEN

Funds That Match Your Personal Style


Global Bond: Buys corporate and government bonds from around the world. Profit potential is high but so is risk exposure—subject to whims of the world marketplace, cur-rency fluctuations, politi cal uncertainty and the like.

Growth: Purchases common shares of well-established firms with above-average growth rates. Fund managers are more interested in stock price appreciation than dividends. The idea behind growth funds is that while stock prices may fluctu ate over the short run, they have historically pro-duced the greatest gains over the long term. These funds move with the stock market. Growth funds are best-suited to investors who are in for the long haul-planning for retire-ment over a period of sev eral years or longer.

Growth And Income: These are more conserva tive than the pure growth funds. Managers purchase a combination of stocks offering long-term growth and a steady stream of dividend income. The more conservative the growth and income fund, the more it invests in income-producing securities, while funds emphasizing more growth are a bit more aggressive. By investing a portion of assets in bonds and divi dend-paying stocks these funds receive income that moderates the effects of daily price swings in the stock mar-ket. Before buying a fund, make sure the mix of growth potential and income matches what you’re looking for.

High-Yield Bond: Invests in low-rated “junk bonds” (generally rated BB or lower). Profit potential comes from dividend income. As the econ omy expands, demand for junk bonds will pick up because issuers will be more likely to meet their obligations. Conversely, when the economy slows or enters a recession, junk bonds fair poorly. These funds are for risk lovers only.

Income-Bond: Managers buy certificates of debt issued by corporations, the U.S. Treasury, federal agencies and state and local governments. Some bond income funds also invest in instruments issued by foreign companies and govern-ments. They’re for safety oriented investors seeking income in the form of dividends.

Income-Equity: Fund managers pursue a high level of cur-rent income for shareholders by invest ing primarily in stocks with good dividend-paying records. These funds are safe and conservative.

International Equity: Managers invest at least two-thirds of their portfolio in stocks outside the U.S. Profit potential includes income from stock price appreciation, dividends and currency fluctua tions. Downside risk includes suscep-tibility to cur rency swings and political instability. Yet the prospect of profits is high because managers can go where the action is. Risk exposure is consider ably above average.

Long-Term Municipal Bond: These funds hold bonds issued by states, cities and towns that are generally exempt from federal taxes, and in some cases state and local taxes too. If you fall within the highest income tax bracket, chanc-es are you could benefit from investing in a tax-free fund. Profit potential depends on interest rates and bond quality.

Money Market: Managers invest in short-term debt from

the government, major banks and the safest corporations. Typically, these securities mature in less than 90 days. Money market funds are very conservative investments, and are considered to be the equivalent of cash. Money markets are the most popular type of fund today, or whenever there’s eco nomic uncertainty.

Money market funds are designed to offer investors two major benefits: stability of princi pal—you won’t lose any of your principal; and reg ular income. The risk in money markets is extremely low. The major drawback is that you get mediocre returns, only a little above those of a savings account.

The problem is exacerbated in today’s environ ment, with short-term interest rates still relatively low. Even if you’re a very conservative investor, it’s a good idea to consider income funds and bond funds rather than just money mar-kets.

Option/Income: Managers purchase securities paying regu-lar dividends, then augment income by writing call options on the portfolio. Investor profit potential is good, but top performers will get “called” away if the market skyrockets. These are risky funds with complex strategies; read the pro-spectus care fully before buying.

Precious Metals: These funds typically hold two-thirds of their portfolios in gold, silver or other precious metals. Many also invest in the shares of mining companies, which tend to correlate strongly with the metals market. Some funds limit their investments to geographic regions, while others invest globally. Investor returns are at the mercy of metals prices and can be quite volatile. If you think inflation is about to accelerate, it’s a good time to consider metals funds.

Sector: Fund managers buy stocks of a certain industry such as biotech, utilities, health care, etc. These funds aren’t diversified among industries so share prices are subject to the condition of the sector. Pros suggest investors buy four or five top-quality stocks in a specific sector rather than a sector fund. Why? In an effort to diversify, fund managers typically load up on the bad and the ugly along with the good.

But if you believe a certain industry is about to take off and you don’t have the time or inclination to research a group of stocks, sector funds can be useful. Your profit prospects are good because your eggs are in one basket. That’s the down-side, too: Top performers one year can be dogs the next. Just ask long-term biotech investors, who watched their 1992 holdings fall into an abyss after reaching new highs in 1991. Ditto for financial sector funds in 2007-2008.

Small-Cap Stock: This type of fund concentrates on com-panies that are much smaller than the tradi tional blue chips such as Johnson & Johnson or ExxonMobil. The fund man-ager picks stocks he or she considers to be undiscovered gems and potential superstars, so your risk exposure ranges from above average to very high. In fact, there’s the danger that some of the manager’s picks will disappear com pletely. These funds are for adventurous investors.


Short-Term Municipal Bond: Known as tax-free money-market funds, they invest in securities issued by states and localities. Interest payments are usually exempt from fed-eral income tax. Investor return is derived from dividend income, so there is no capital gains potential here.

Single-State Municipal Bond: Portfolio managers hold bonds of one state so that residents can earn income exempt from federal, state, even local city taxes in certain cases. Your profit potential and risk exposure depend on the term of the bonds and the economy of the particular state.

Stock Index: A basket of stocks that mirror the perfor-mance of well-known stock indexes such as the Standard & Poor’s 500. Your profit potential mirrors that of the market

as a whole; if you think the stock market is about to drop sharply, it’s a good time to sell one of these funds short. Index funds are almost always fully invested, leaving little cash to sit and earn nothing. They also have minimal turn-over of investments, which reduces the taxable capital gains. Another benefit is that, due to the simplicity of man aging these funds, expenses tend to be very low com pared with other funds.

U.S. Government Income: Invests in vehicles backed by the federal government, including agency securities like Ginnie Maes and Treasury bonds. Profit potential depends on interest rates; like corpo rate bonds, share prices rise when interest rates fall.


There are two kinds of mutual funds: open-end funds, which have a varying number of shares, and closed-end

funds, which have a fixed number of shares. Open-end funds constantly issue new shares for new

investors and redeem (buy back) shares from existing inves-tors when they want to leave the fund. Sometimes funds will “close” to new investors, at which time they stop issuing new shares. Pur chases of open-end mutual funds are gener-ally made directly through the fund, without any extra fees for brokers. When an investor purchases shares, payment is made to the fund and new shares are issued. This is the most popular type of fund offered today.

Closed-end funds are publicly traded mutual funds. During the 1920s, closed-end funds were the dominant type of pooled investment, becoming less popular with the com-ing of open-end funds. But in recent years, closed-end funds have enjoyed renewed popularity.

Here’s how a closed-end fund works: After the ini-tial public offering, fund shares are traded on one of the major stock exchanges or in the over-the-counter market like regular stocks. Ordinarily, publicly traded funds have a fixed number of shares, mean ing the price will appreciate as demand increases for the fund. This can result in a premium for the fund, above its net asset value (NAV).

Shares of closed-end funds are purchased through a bro-ker, just like a stock. This means you’ll pay a commission just as you would when buying or selling any other security. Closed-end funds can be particularly advantageous when they’re selling at a discount to their NAV.

Comparing Funds When you decide which category of mutual fund you want

(e.g., small cap, bond fund or sector fund), you’ll want to compare the fund’s perform ance with that of its competitors.

There are several factors you should pay spe cial attention to, including the fund’s fees, man agement and performance.

• Fees—Make sure they’re not high compared with those of competitors. Find funds with low expense ratios. For domestic stock funds, stay under expense ratios of 1.50 percent, and for bonds stay under 1 percent. There’ll sometimes be exceptions but these are good guidelines. Remember, expense ratios come right off your returns, so keeping them low means better returns.

• Management—Invest in funds that have a con sistent per-formance at least through the last three years as well as a manager that’s been around for that period of time. You can make exceptions for man agers that have recently switched funds but have a substantial number of years managing money. But investors should be very careful about sticking with funds where the manager has left the fund.

• Performance—Avoid chasing funds with short-term “hot” performance. Academic studies have shown that investors

who put their money into the top-performing fund for a short period of time like a year are setting themselves up for a disappoint ment. Funds that are at the top of the perfor-mance list for one year are likely to be ones where a man-ager took a big chance and got lucky. That typically doesn’t repeat itself over time. It’s especially impor tant to look at fund performance in both bear and bull markets to get an idea how a fund performs through an entire market cycle. Good time periods to use for bear market performance include the second half of 1990, 1994, the third quarter of 1998, 2002, 2008, and the first quarter of 2009.

Accounting For Risk Last, don’t look at performance in a vacuum. When exam-

ining performance, the most important factor to look at is how much risk the fund took to generate its returns. One way to determine that is to look at a fund’s Sharpe ratio. It’s calculated by taking a fund’s total return over a period of time, subtracting the risk free rate—which is the T-bill return over the same period of time—and then dividing by a fund’s standard deviation.

The higher the Sharpe ratio, the better the fund’s return on a risk-adjusted basis. Once you get the number, see how it compares with the S&P 500 or other relevant index as well as to other funds you’re considering buying.

The Benefits Of Mutual Funds There are many reasons investors own mutual funds. For the

individual investor, mutual funds pro vide the benefit of having someone else manage your investments, maintain records for you and diversify your resources into many different areas that otherwise may not be available or affordable to you. Reasons for owning shares of a mutual fund include the following:

• Diversification—The most successful investors are those who avoid putting all their eggs into one basket. By its very nature a mutual fund is diversified—assets are invested in many different securities, as long as they agree with the stated objectives of the fund. What’s more, there are many different types of mutual funds, with dif ferent investment objectives, levels of growth potential and risk that allow you to diversify your own portfolio even further.

The beauty of funds is that they allow you access to a broad spectrum of investments, no matter what the size of your bankroll. Funds allow investors to create a diversified investment portfolio without having to own the individual stocks or bonds them selves. The fund manager chooses a mix of many different securities, within the fund’s stated goals, so that the performance of any one particular secu rity shouldn’t have an enormous effect on the fund. This safely distributes the fund’s risk exposure among many securities.

Compare this situation to buying securities directly: Suppose you invest a large portion of your portfolio in a sin-

CHAPTER TwElvE

Open-End and Closed-End


gle stock or bond. The value of your portfolio will depend heavily on how that security per forms. If one price falls, your portfolio could lose a significant portion of its value. It’s, of course, possible to create a diversified portfolio of your own. But when you factor in the costs of broker fees and the time you spend doing research on many different companies, the fund advantage becomes apparent.

• Professional Management—Mutual funds are run by pro-fessional portfolio managers, searching out the best securities available for the fund. That choice of securities is, of course, also controlled by the fund’s stated investment objectives.

Professional management is a somewhat over stated ben-efit. Why? Management is “professional” only if it produces a return that outperforms the market. Anyone can fail. Nevertheless, research indicates that a mutual fund will often perform poorly if its manager is replaced, which may be why funds don’t like to reveal management changes. The Securities and Exchange Commission (SEC) is currently looking into new disclosure rules to address this problem.

But once a manager has established a solid track record, investing in his or her no-load fund is a superb way to get top-quality management at no cost. The key is to keep track of any changes at the helm.

• Liquidity—Another benefit of mutual funds is the abil-ity to move money into and out of your account with ease. Unlike CDs, where your money is tied up for a period of time, mutual funds are designed so that access to your money is as easy as a phone call. Moving money from one mutual fund to another, withdrawing funds at a moment’s notice and writing checks on your account are just some of the benefits of the liquid ity of mutual funds.

• Low Trading Costs—Mutual funds buy and sell securities in large blocks, thus reducing their trading or commission costs. This benefit passes through to the investor. Imagine the commissions you’d pay to buy or sell each of the securi-ties held within the portfolio of a diversified mutual fund!

• Retirement Planning—Most funds are available in several different types of accounts, including retirement plans like Individual Retirement Accounts (IRAs) and 401Ks.

• Dollar Cost Averaging—Since mutual funds can be pur-chased in small amounts and at regular intervals, they’re ideal vehicles for “dollar cost aver aging”—buying a set dol-lar amount of shares each month, resulting in more shares being purchased when their price is down.

• Automatic Reinvestment—This allows your fund to use all your dividends and capital gains dis tributions to buy more shares. Using this method effectively compounds your investment in much the same way that interest compounds at your local savings bank. What’s more, most dividend reinvest ment plans charge no sales commissions.

• Automatic Withdrawal—If you’re recently retired, you may find that your pension and Social Security benefits don’t stretch far enough to main tain the standard of living you would like. One solution is to take advantage of the automatic withdrawal plans offered by many mutual funds.

If the shares in your fund account exceed the mini mum set value (typically $5,000 or $10,000), you can elect to receive monthly or quarterly pay ments in a specified amount of $100 or more. Fill ing out some simple paperwork is all that it takes to get started. Before you elect to use an auto matic withdraw-al plan, make sure that your princi pal will outlast both you and your spouse. If you’re withdrawing more each year than you’re earning, your assets will eventually be exhausted. It’s best to play it safe and withdraw only what you need.

• Ease of Investment—Buying a fund is easier than opening a bank account. Simply call the fund (almost all have 800 numbers), ask if the fund is for sale in your state and request a new account appli cation. If you have questions after you receive the prospectus and application, telephone the fund once again. Most funds are extremely responsive and want to help investors open new accounts.

• Special-Purpose Funds—Innovations during the past two decades have made funds available in almost every type of security imaginable. Regard less of the type of investment you seek, there’s likely to be a mutual fund to serve you.

• Fund Switching—You can buy or sell a fund over the telephone or Internet. Major fund families may be able to help you 24 hours a day. Many investment companies allow you to switch from one load fund to another within the fund family without paying an additional sales charge; some even allow you to reallocate invest ments among multiple funds without regard to minimum initial invest-ment thresholds. This service allows investors to switch objec tives with minimum hassle and usually at no cost. A popular operation is for investors to switch between growth funds and conservative money market funds in an effort to reduce risk in an uncertain market. Keep in mind, however, that many fund families discourage short-term trading by charging a redemption fee if you switch out of a fund too quickly (e.g., prior to the end of a 60-day holding period).

• Less Paperwork—Investment companies do most of the paperwork for their shareholders, total ing gains and losses for each investor at the end of the year for tax purposes. Funds do all of the day-to-day chores; all you do is give them the money.

Mutual Fund Drawbacks It’s important to consider the possible down side of mutu-

al funds as well as their advantages. Aside from loads and fees, the main drawback to mutual funds is that you have no influence over the decision-making process. You can’t telephone your fund manager and suggest she purchase this stock or that bond. That’s why evaluating the manager’s track record is so important.

Also, a fund can switch managers and give no warning to the investors. A brilliant stock picker may be replaced by a mediocre analyst. In fact, the manager who succeeds a stel-lar predecessor almost always disappoints, simply because there’s a limited number of brilliant stock pickers out there.

So you have to keep an eye on your fund and be ready to shop around for a new one.


Mutual funds can be purchased directly from invest-ment companies, at banks, insurance compa nies and

through stockbrokers. Ownership comes in the form of shares. As a shareholder, you own a certain number of fund shares, depending entirely on how much money you’ve invested in the fund.

Closed-end funds are traded in the marketplace just like stocks. They must be purchased and sold directly through a broker who’ll charge his standard commission fee.

To buy shares of no-load open-end funds, you can either deal with the investment company directly or you can pur-chase shares through “fund supermarkets” offered by several discount brokerages. The advantage of purchasing funds through a broker is that all of your funds are reported on the same statement, which makes it easier to keep track of your fund asset allocation. A potential disadvantage is that the bro-ker may charge you an extra commis sion for the service.

A few fund companies require no minimum investment at all. Still, most funds demand that you put up an initial stake of at least $1,000. Initial minimums for IRA accounts are usually much less, allowing investors to throw in as little as $50 at regular intervals.

How Share Prices Are Determined Prices are based on the net asset value (NAV) per share—

the value of all investments owned by the fund, divided by the shares outstanding. With an open-end, fund investors pay the NAV per share, plus commissions if any. With a closed-end fund investors may pay more or less than the NAV depending on the popularity of that fund at any given time.

Prospectus Many investors approach the prospectus as a dull chore

and only give it a cursory review. That’s a big mistake. Even if you already own a fund, you should carefully read the prospectus. The Securi ties and Exchange Commission requires funds to give one to each prospective buyer; funds also make them available upon request.

If the prospectus reveals that your returns haven’t been commensurate with risks, you should consider moving into another fund. Indeed, a com mon cause of dissatisfaction is when a fund’s invest ment objective doesn’t match the inves-tor’s needs. That objective—and the risks of achieving it—are spelled out in the prospectus.

Other essential data to look for include: mini mum initial investment and subsequent require ments; services, such as the fund’s exchange pol icy, automatic investment program or check writing privileges; and fees. Always reported, in table for mat, are all expected expenses. Fees are broken down into two groups: shareholder transaction fees and annual fund operating expenses.

If a fund calls itself “no-load,” make sure it doesn’t impose

a contingent deferred sales charge (CDSC) or a higher annual expense ratio than a share class that does charge a load. If it does, it’s not a true no-load fund. About 40 fund families offer two or three classes of shares in the same fund. Class A shares typically have a front-end sales load, while Class B shares usually have a CDSC that starts at 5 or 6 percent and declines over a period of years until it finally disappears and the Class B shares convert to Class A shares. Class C shares usually impose only a one-year CDSC, but they don’t convert to Class A shares and investors must keep paying the higher annual expense ratios in perpetuity for as long as they own the fund. B and C shares often look like the better deal, since all of your money goes to work right from the start. But don’t be fooled; in exchange for no upfront load, Class B and C shares charge CDSCs and impose higher expense ratios and “12b-1” marketing fees.

Even if you hold the fund for more than five years, your returns may be higher in the Class A shares. Some funds also charge for switching assets among their funds, typically within a specified time frame. If you plan to move in and out of related funds often, check the cost and the permit-ted number of moves per year in the prospectus. Also, don’t overlook any loads attached to reinvested dividends, a func-tion most funds provide for free.

The “Total Fund Operating Expenses” line is the sum of all operating expenses. For stock funds, total expenses aver-age about 1.25 percent; the average bond fund’s expenses are 0.75 percent. Established, diversified funds that charge more are limiting your returns. Funds must report in the prospectus the effect of expenses on a hypo thetical $1,000 earning 5 percent annually over various time frames. If expenses are excessive, consider another fund.

The “Investment Objective and Policies” section spells out the fund’s goal and outlines the types of investments management can buy. The “Purchases, Redemption and Exchanges” section explains where to call or write to buy shares, redeem holdings or switch assets among funds.

Fees And Expenses Mutual fund fees and expenses can vary enor mously. The

most outrageous type is called a sales load, where funds charge a commission each time you buy shares. Loads fluc-tuate from less than 3 per cent to a maximum of 8.5 percent; those charging the most are usually purchased from brokers.

Mutual funds that don’t have any sales charges are called “no load” funds. These funds, and there are hundreds of them, typically sell their shares directly to the investor. All funds charge a management fee to cover the costs of man-aging the fund. Many investors are unaware of it because they don’t pay this fee directly. Instead it’s calculated into a fund’s share price every day (share prices are “net” of fees and other expenses).

CHAPTER THiRTEEN

Nuts & Bolts


Redemption Fees A few mutual funds also assess a redemption fee that you

pay when you redeem—sell—your shares. These charges range from 1 percent up to more than 5 percent of the amount of the sale. Some redemption fees are imposed sole-ly to discourage investors from frequent trading, which can actually be viewed as a good thing for long-term investors since frequent trading can increase a fund’s expenses.

Certain funds have redemption fees on a declining scale. They take 5 percent of your money the first year, 4 percent the second, etc., ending after about five years. The longer you hold these funds, the lower the deferred sales charges. Redemption fees are slightly preferable to sales charges because income can be earned on the extra money until redemption. Still, it’s worth shopping around to find quality funds that put all your money to work for you.

A few funds levy a reloading charge on reinvest ment from capital gains distributions. The maxi mum permissible reload-ing charge is 7.25 percent of the total investment amount. So after a $100 capi tal gains distribution, $7.25 would be retained by the fund as a selling fee.

The charges to promote and advertise the fund to pro-spective investors are called 12b-1 fees. These typically range as high as 1.25 percent of the value of your investment annually and are now levied by more than half of all funds.

Some mutual funds charge fees to compensate brokers for servicing accounts of investors that bought fund shares through their firms. These charges are usually about 0.25 percent per year of the value of your investment. Savvy investors will avoid this fee by purchasing shares from the mutual fund directly.

Management, Administrative Fees and Trans action Costs

These charges include:

Transaction costs incurred by the fund in buying and •selling securities.

Operating expenses such as rent, phones, employee •expenses, etc.

Portfolio management fees paid to fund man agers. •

All of these costs vary from fund to fund, but should be no more than 1 percent to 1.5 percent of total assets per year.

Record Keeping As of now, brokers are only required to report the

gross proceeds from sales, which is pretty useless by itself. Consequently, keeping accurate records of your mutual fund purchases is a must. Always keep on file the date and number of all shares purchased, plus the price paid for each of those shares. Also record the date on which shares were sold, as well as the number and price of any shares sold.

These records should also be kept for all rein vested divi-dends. Most people end up paying more in taxes than is necessary, simply because they fail to include reinvested dividends in their cost basis. So they end up paying taxes on them twice.

Many funds provide this information in their monthly or quarterly statements, and all funds include this informa-tion on the annual IRS 1099-B forms. For more on mutual funds and taxes, pick up a free copy of IRS Publication 564, “Mutual Fund Distri butions.”

Relief from all this red tape is on the way. In October 2008, Congress passed the Emergency Economic Stabilization Act, which requires brokers to report “adjusted” cost basis for taxable accounts to the IRS and taxpayers via Form 1099-B starting with tax year 2011. The adjusted cost basis is the original cost basis and any adjustments due to corpo-rate actions such as stock splits and dividend payments. The legislation applies to securities acquired on or after the effec-tive dates as follows:

January 1, 2011, for equities

January 1, 2012, for mutual funds, ETFs and dividend reinvestment plans (DRIPs)

January 1, 2013, for other securities (including fixed income and options)

The legislation also requires that the new Form 1099-B indicate if the gain or loss is short- or long-term, and the amount of any loss disallowed under the wash sale rules.


The first exchange-traded fund (ETF) made its debut in 1993 on the American Stock Exchange. The first day’s

trading volume: a little more than 1 million shares. Fast forward 17 years and that same ETF, the S&P 500

Depository Receipt (NYSE: SPY), now trades on the NYSE and rou tinely trades more than 200 million shares in a day. And ETFs have grown in number from just 1 in 1993 to several hundred today. Many of these ETFs trade in excess of 50 million shares on a daily basis.

Clearly, ETFs have exploded in popularity. And there’s good reason for that: these securities offer investors an opportunity to diversify their holdings among many stocks in an extremely low-cost man ner. ETFs have opened up a number of strategies to the individual investor that were previously only available to professional money managers running multi-million dollar accounts.

Before we delve into the myriad advantages of ETFs, let’s review what they are, how they’re traded and the best strate-gies for using the funds.

What’s an ETF? Similar to index mutual funds, ETFs are simply baskets of

stocks that trade as a single security on the major exchanges. Unlike mutual funds, ETFs trade just like stocks on the major exchanges; they can be bought and sold at any time during normal mar ket hours. They have symbols and are quoted on all the major financial websites and in most major busi ness newspapers. When buying these funds you will pay the same commission to your broker that you’d pay to buy any other stock.

But when you buy an ETF you’re actually buying up to hundreds or thousands of individual stocks. Take the S&P 500 Depository Receipts as an example. This ETF, com-monly called “Spiders,” represents own ership in all 500 companies that make up the S&P 500 index.

Think of how expensive it would be to buy all those stocks separately. Even if you paid just $10 in commissions on each stock, you’re looking at $5,000 in commissions alone to make all those transac tions—that’s a big hit indeed. With the Spiders you simply buy all 500 stocks in one sim-ple transaction.

There are now ETFs available covering just about every imaginable sector, industry, country and index. For example, you can purchase a bas ket of 15 major US retailers by pur-chasing the Retail HOLDRs (AMEX: RTH). And while it’s tough for investors to buy many major Japanese stocks directly, you can purchase a diversified basket of stocks trading in Tokyo by buying the iShares MSCI Japan Index (NYSE: EWJ).

ETFs are available covering Hong Kong, China, Singapore, Italy, France, Brazil and many other developed and developing markets around the globe. Prior to the

advent of ETFs, individual investors had limited access to these mar kets. International diversification can lower the overall risk of your portfolio; these funds have opened up a brand new market for retail investors unavailable just a few years ago.

ETFs even provide investors with access to alternative investments. For example, the SPDR Gold Trust (NYSE: GLD) tracks the performance of gold bullion. And, there are a host of ETFs that offer exposure to both the corpo rate and government bond markets.

Most ETFs are also extremely cost effective. An ETF typically charges an expense ratio of 0.85 percent or less annually for specialized indexes and 0.35 percent or less for broad-based indexes. The Vanguard S&P 500 ETF (NYSE: VOO) features an expense ratio of only 0.06 percent. These expense ratios are far less than the amount typically charged by major mutual funds.

ETFs vs. Mutual Funds ETFs don’t replace actively-managed mutual funds and

such mutual funds will never disappear from the investing landscape. However, ETFs do hold some major advantages.

Mutual funds can be purchased only once per day. All investors wishing to purchase a mutual fund on a given day will receive the same price. They are not traded actively on an exchange and you cannot see price updates during the course of a trading day. And some funds will charge a fee for redeeming (selling) the fund within a certain time frame.

ETFs offer the advantage of what’s known as liquidity. Liquidity means that you can buy or sell an ETF easily at any time during the trading day. You’re now forced to wait to sell—you can buy and sell funds even within a single trading day.

Furthermore, the minimum purchase amount for most ETFs is a single share (Merrill Lynch HOLDRs require a 100-share minimum). Many mutual funds require a minimum invest ment of $1,000, $2,000 or even $10,000 to get into the fund. That’s not the case with ETFs—in most cases you can buy a single ETF share. That means that you can scale your invest ment to reflect the overall size of your portfolio.

ETFs are also normally more tax efficient since the fund can redeem large institutional investors through a tax-free “in-kind” exchange rather than by selling securities for cash. In addition, some mutual funds impose sales charges, redemption fees for selling out of the fund quickly, as well as 12b-1 marketing fees.

Mutual funds do offer a few possible advantages as well. The vast majority of ETFs aren’t actively managed. In other words, there’s no manager evaluating the fun damentals of the stocks in the ETF and buying or selling accordingly. ETFs simply track the perform ance of a sector, industry of broad basket of stocks from a particular region. Some actively-

CHAPTER fOuRTEEN

Exchange Traded Funds


managed mutual funds beat the market, whereas index ETFs never do. A majority of actively-managed mutual funds underperform the market, however, so you need to choose wisely if you plan on playing the market-beating game.

And mutual funds also offer a chance to regu larly make low-cost contributions. With most funds, you can add a cer-tain amount of money each month to the fund for no cost at all. Some funds allow investors to add as little as $50 on a regular basis for free. With ETFs, however, every time you add to your position you will incur a commission charge for buying the ETF. However, some brokers (TD Ameritrade, Zecco, Fidelity, Schwab, and Vanguard) are now offering commission-free trading on a limited number of ETFs.

Risks ETFs vary greatly in terms of risk. Risk reflects the price

volatility of the stocks inside the ETF. For example, the Consumer Staples SPDRs (NYSE: XLP) represent ownership is a broad bas ket of higher-quality food, beverage and every-day household products companies.

These companies tend to move slowly—they neither rise as fast as the markets during rallies nor fall as quickly when the market sells off. By contrast, the PowerShares Nasdaq 100 trust (NasdaqGM: QQQQ) and Semiconductor

HOLDRs (AMEX: SMH) are well known for extreme vol-atility—these ETFs represent ownership in a basket of fast-moving tech and semiconductor shares respectively.

If used properly, however, ETFs can reduce the overall risk of your portfolio through diversifica tion. For example, foreign markets don’t always move in the same direction as the U.S. market. By owning ETFs that hold Japanese or European shares, you will hedge your U.S. holdings.

And when the market is weak, you can also run into the consumer staples or bond ETFs—these will help shield your portfolio from volatility.

What’s more, because all ETFs hold baskets of securities, company-specific risk is less important. Wal-Mart might miss its earnings numbers and gap lower; that will hit the Retail HOLDRs but not as badly as if you simply owned Wal-Mart stock directly.

When using ETFs as part of your investment strategy, think diversification; consider buying ETFs from many different categories. For exam ple, consider purchasing at least one for-eign-stock ETF, a major U.S. stock index ETF, a bond ETF and a low-correlation hedge such as the SPDR Gold Trust or a general commodity ETF. This type of allocation will offer you exposure to sev eral relatively unrelated markets—the diversifica tion will lower the risk of your portfolio.


accrued interest The amount of interest that has accumulated from the

date of the last interest payment to the date a bond is sold. Interest accrues until the day of settlement, not the day that an investor agrees to purchase a bond. See “settle ment” for a further explanation.

advance decline line A ratio of the number of stocks advancing in price versus

the number declining in price over a period of time. It’s an indicator of general mar ket direction that’s considered posi-tive if advanc ing issues outnumber declining issues.

alpha Measure of an investment’s total return in excess of what

is expected given its price volatility relative to the overall market (i.e, beta). Positive alpha suggests that the invest-ment manager has stock-picking skill. It’s based on aver age annual percentage returns relative to the broad market. Term is most often used in refer ence to mutual funds.

American Depository Receipts (ADR) A receipt for the shares of a foreign corpora tion held in

the vault of a US bank that entitles the shareholder to all dividends and capital gains. Instead of purchasing actual shares of a foreign stock on a foreign market, Americans can buy shares in the U.S. in the form of an ADR. ADRs are composed of some multiple or fraction of actual foreign shares held by U.S. financial institutions called American Depository Shares (ADS).

annuity A contract sold by life insurance companies that promises

a fixed or variable payment to the pur chaser according to a specified payout plan. Investment gains in deferred annui-ties accumulate tax free until withdrawal, but withdrawals are taxed at ordinary income tax rates, and not treated as capital gains. There is also usually some sort of guaranteed return of principal in exchange for an annual insurance fee. Like IRAs, early with drawals are almost always penalized. A fixed annuity pays fixed, constant pay ments for a specified time. The pur-chaser has no control over the investments used to generate the guaranteed fixed return. In contrast, a variable annuity’s payout is not constant, but varies depending upon the invest-ment performance of the securities chosen by the purchaser.

Immediate pay ment annuities are bought with a single pay-ment and start paying interest and a portion of principal to the purchaser immediately, with no deferral period. Payments may be for a specified period (e.g., five years) or for the life of the purchaser.

appreciation The increase in the value of an asset such as a stock, bond,

commodity or real estate as deter mined by increases in the public market price of the security.

arbitrage Profiting from price discrepancies when the same secu-

rity, currency or commodity is pur chased in one market and immediately resold in another. A trader who does this is an arbitrager.

ask price The price at which a security or commodity is offered for

sale. Also the per-share price at which mutual fund shares are offered to the pub lic, usually the net asset value per share plus any sales charges.

assets Everything a company or person owns. Capital assets

include long-term assets, those that will last longer than one year. Fixed assets include buildings, equipment and land, which are often considered part of capital assets.

Current assets include cash, short-term invest ments, accounts receivable, unused raw materi als and inventories of finished but unsold prod ucts. Intangible assets include pat-ents, brand names, and goodwill.

balance sheet A financial report showing the status of a com pany’s

assets, liabilities and owners’ equity. A balance sheet is only a snapshot of a company at one particular time and must be compared with prior balance sheets.

basis point The smallest measure used in quoting yields on bonds and

notes. One basis point is 0.01 percent of yield. One hun-dred basis points equal 1 per centage point.

bear market A prolonged period of falling prices. A bear mar ket in

stocks is usually brought on by the antici pation of declin-ing economic activity or serious inflation. A bear market in bonds is usually caused by rising interest rates.

bellwether bond A bond whose yield is used to gauge price trends in the

overall credit market. Usually the 10-year U.S. Treasury note.

CHAPTER fifTEEN

Glossary


beta The measure of the historical volatility of an investment

against an independent index, such as the S&P 500. The S&P 500 is assigned a beta of 1.00.

Investments with betas above 1.00 are more volatile than the S&P 500; below 1.00 are less volatile.

bid-ask spreadDifference between what dealers pay for a secu rity (bid

price) and what they charge investors for the same security (ask price). Individual investors buy at the ask price and sell at the bid price.

Big Board The New York Stock Exchange.

blue chip A common stock of a nationally known company that

has a long record of profit growth, dividend payment and a reputation for quality manage ment, products, and services.

bond Debt certificate issued by a government or corpo ration.

Usually states the amount of the loan, inter est to be paid, repayment time and collateral pledged if the debt can’t be repaid. Generally, a debt security issued with more than 10 years to maturity is a bond. Debt certificates with maturities 10 years or shorter are called notes and maturities shorter than a year are called bills.

long bond: Shorthand for a 30-year U.S. Treasury bond.

general obligation bond (GO): Municipal bond backed by no specific rev enue source, but rather by the taxing authority of the issuing govern ment itself. See also revenue bond.

junk bond: Bond with a speculative credit rating. They have a greater risk of default and therefore pay higher yields than other bonds.

convertible bond: Bond that may be exchanged for a specific amount of stock in the company that issued it at a specified strike price.

municipal bond (muni): Bond issued by a state, county, city, town or territory or an authorized agency for one of these government units. These bonds are exempt from federal income tax. They may also be free of state and local taxes if held by someone living in the issuing area.

revenue bond: Bond backed only by the revenue of an air-port, highway, stadium or other facility that was built with the money raised.

savings bond: U.S. government bond with face value denom-inations ranging from $50 to $10,000 for Series EE bonds and $50 to $5,000 for I bonds.

unsecured bond: Guaranteed only by the reputation, good faith and credit of the issuer. Also known as debentures.

secured bond: Bond backed by a specific asset or assets.

zero-coupon bond: Bond that sells at a discount to face value, pays no current inter est and matures at face value. Taxes are usually due on accrued interest even though the owner doesn’t actually receive any cash until maturity.

bond ratings The two most widely used ratings are done by Moody’s

Investors Services and Standard & Poor’s. Moody’s has nine ratings ranging from Aaa to C. S&P uses seven ratings from AAA to D. See also Standard & Poor’s and Moody’s.

book-entry issuance A centralized record-keeping for the holding and account-

ing of securities. Rather than receiving a certificate, the investor receives a state ment indicating that he owns the security.

book value The value of a business’ net assets as shown on its balance

sheet. Also the net worth of a busi ness (difference between total assets and total liabilities). Based on purchased prices, not current market value.

broker Person who acts as an intermediary between a buyer and

a seller, usually charging a commis sion. A discount broker charges lower commis sions than full-service brokers, who may also provide research and investment advice.

bull market A prolonged rise in the prices of stocks, bonds or com-

modities.

callable bonds Bonds redeemable by the issuer before maturity at a

set price. Bonds are usually called when inter est rates fall enough for the issuer to save money by offering new bonds at lower rates.

capital gain, capital loss Profit or loss on an investment when it is sold. Capital

gains on investments held 366 days or longer are taxed at lower rates.

capital gains distribution For a mutual fund, payment to shareholders of net capital

gains from the sale of portfolio securi ties.

capital growth An increase in the market value of securities.


cash equivalent Short-term investments that can be easily sold for cash.

Includes U.S. government securities, short-term commercial paper and short-term municipal and corporate notes.

cash flow An analysis of all the changes that affect a com pany’s cash

account during an accounting period. This usually includes all changes in oper ations, investments and financing. When more cash comes in than goes out, it’s known as posi tive cash flow. Cash flow directly relates to a company’s ability to pay dividends.

certificate of deposit (CD) A low-risk debt instrument issued by a bank that has a

conservative yield in exchange for safety. Institutional CDs are issued in denominations of $100,000 or more, and indi-vidual CDs start as low as $100. Maturities range from a few weeks to several years.

closed-end fund A type of mutual fund that has a fixed number of shares,

usually on a major stock exchange. Unlike open-end funds, closed-end funds don’t issue and redeem shares on a con-tinuous basis. Closed-end funds often sell at a discount to their net asset value because of unrealized tax liabilities, high expenses, and lack of investor confidence in management.

closed fund A mutual fund that has become so large that it is no lon-

ger willing to sell shares to new investors.

commercial paper Short-term corporate debt with maturities ranging from

one to 270 days.

commission Fee charged by a broker or other salesperson when buying

or selling an investment.

commodities Bulk goods such as grains, metals, oil, gas, and foods.

Traded on futures exchanges or in ETF form.

common or preferred stock Units of ownership of a public corporation. Common

stockholders have the right to vote at the stock holders meet-ings, and may receive dividends. Preferred stockholders usu-ally don’t have voting rights, but receive dividends at a spec-ified rate and have preference over common stockholders in the payment of dividends and in the event of liquidation.

conglomerate A corporation composed of a variety of different businesses.

Consumer Price Index (CPI) This measures changes in consumer prices, as determined

by a monthly survey of the U.S. Bureau of Labor Statistics. CPI components include housing costs, food, transportation and electricity. Also known as the cost of living index.

contrarian An investor who does the opposite of what most investors

are doing at any particular time.

corporation A legal entity, normally a business, which is chartered by a

U.S. state or the federal govern ment and that’s separate and distinct from those who own it. It’s regarded by the courts as an “artificial person” and may own property, incur debts or sue and be sued. It has limited liability and easy transfer of ownership through sales of stock shares.

correction A short-term price movement in the opposite direction of

a long-term trend.

coupon Fixed interest payment on a debt security that the issuer

promises to pay to the holder until matu rity, expressed as an annual percentage of face value. With many bonds—particu-larly older municipal bonds—the investor just clips a coupon from the bond every time interest is due and mails it to the bond issuer’s paying agent.

currency futures Contracts in the futures markets that are for deliv ery in a

major currency, such as US dollars. Cor porations that sell products around the world can hedge their currency risk with these futures.

cyclical stock A stock that rises quickly when the economy turns up and

falls quickly when the economy turns down. Examples are housing, autos and paper. Non-cyclical companies such as food and drug companies aren’t as affected by economic changes.

debenture A general debt obligation backed only by the issuer’s

promise to repay the debt.

debt-equity ratio Total liabilities divided by total common shareholder equi-

ty. This shows to what extent the company can pay creditors claims in the event of liquidation.

default Failure of a debtor to make timely payments of interest

and principal.


deflation A decline in the prices of goods and services.

depreciation A decrease in the value of property through wear, dete-

rioration or obsolescence, which can be written off against earnings.

discount The percentage below net asset value at which shares sell.

discount rate The interest rate that the Federal Reserve charges member

banks for loans, using govern ment securities as collateral. This provides a floor on interest rates, since banks set their loan rates above the discount rate. Less important than the federal funds rate, which is the overnight lending rate mem-ber banks charge each other. Falling interest rates usu ally give the stock market a boost. Rising rates usually hurt the stock market.

dividend A distribution of earnings to shareholders paid in the form

of money or company stock. Divi dends are usually paid on a quarterly basis and are considered taxable income.

dividend reinvestment plan (DRIP) An automatic reinvestment of shareholder divi dends into

more shares (including fractions) of a company’s stock. With most companies these investments are made without incurring any brokerage or commission fees. Some compa-nies offer reinvestment plans that allow the shareholder to reinvest at a slight discount to the actual share price. Some brokers offer pseudo-DRIPs for their customers.

dividend yield A stock’s annual dividend divided by its share price.

dollar-cost averaging (DCA) A strategy whereby an investor invests the same dollar

amount on a regular basis regardless of the price. When share prices are higher, the investor purchases fewer shares than when share prices are lower. Very common among employees who invest a portion of their salary every month in the company 401K plan.

Dow Jones Industrial Average (DJIA) 30-stock index of blue-chip industrial stocks. Unlike the

market-cap weighted S&P 500, the DJIA is price-weighted.

downside risk The probability and potential magnitude of an investment

losing value.

downtick When a security is sold at a price below that of the preced-

ing sale.

downturn Shift of an economic or stock market cycle from rising to

falling.

earnings per share (EPS) A portion of a company’s profit allocated to each out-

standing share of common stock.

ex-dividend The period during which a new stock purchaser is not

entitled to a dividend that the stock is scheduled to pay. To receive a dividend payment, one must be a shareholder of record by the dividend’s record date. The last day to qualify is three trading days prior to the record date. Consequently, the first day a stock trades ex-dividend is two trading days prior to the record date. Typically, a stock’s price gradually rises as the dollar amount of the dividend begins to accrue, and then falls by the dividend amount on the first day that a stock trades ex-dividend. Market events can reduce or mag-nify the price effect of the ex-dividend date.

expense ratio In mutual funds, annual expenses, including all costs of oper-

ation, divided by the fund’s average net assets for the year.

Federal Funds rate Interest rate charged by banks with excess reserves at a

Federal Reserve district bank to banks needing overnight loans to meet reserve requirements. The Federal Funds rate is the most sensitive indicator of the direction of interest rates, since it is set daily by the market.

floating exchange rate A foreign currency system in which exchange rates

between two currencies are allowed to fluctuate in response to changes in the world economy.

free cash flow The excess money available to a company after subtracting

its maintenance capital expenditures and corporate acquisi-tions from its operating cash flow. A company with excess cash can pay dividends, buy back shares, and grow its busi-ness. Free cash flow is a sign of a solid company.

free cash flow yield A measure of how high the stock’s dividend yield would

be if the company used all its excess cash to pay dividends. To determine a company’s free cash flow yield, subtract cap-ital spending and corporate acquisitions from cash flow, then divide the result by the stock’s current share price.


fundamental analysis Analysis of a company’s management, competitive posi-

tion, business risk, balance sheet, income state ment, and statement of cash flows in order to determine its intrinsic value. Investors try to determine whether a stock’s market price is higher or lower than its intrinsic value. A stock is undervalued if its market price is below its intrinsic value and overvalued if its market price is above its intrinsic value. Also see techni cal analysis.

futures contract An agreement to buy or sell a specific amount of a com-

modity or financial instrument at a particu lar price on a future date.

goodwill The value of a business in patronage, reputation, brand

names over and beyond its book value. In a merger between two corporations, the amount the purchasing firm paid for the goodwill of the other is subtracted (i.e., amortized) from the purchasing firm’s earnings over a multiyear period.

greenmail Practice whereby outsiders buy blocks of a com pany’s

stock and then entice the company to buy the shares back at a premium to avoid a takeover.

gross domestic product (GDP) The total value of a nation’s annual output of goods and

services within the domestic economy. Calculated quarterly by the Department of Commerce.

gross profit The difference between the selling price of an item or

service and the expenses directly attrib uted to it, such as the costs of labor and raw materials.

hard money investmentsInvestments in precious metal bullion, bullion certificates

and bullion coins, particularly those of gold and silver.

hedging Strategy used to offset investment risk. A perfect hedge is

one that eliminates the possibility of a future gain or loss.

illiquid Not readily convertible into cash.

income statement Financial statement showing all a company’s sources of

earnings and expenses, both cash and non-cash.

individual retirement account (IRA) A personal retirement account consisting of cash, stocks,

bonds, mutual funds, life insurance policies, etc., that an employed person in the U.S. can set up with a tax-deductible deposit. The allowable amount that can now be deducted annually is $5,000 for individuals and $10,000 for couples, provided income is within certain limits. After 2010, these limits will be indexed to inflation.

inflation An increase in the prices of goods and services. Often mea-

sured by the Consumer Price Index and the Producer Price Index.

Infrastructure An economy’s basic facilities, e.g., roads, air ports, water

supplies, schools and universities, medical services, etc.

initial public offering (IPO) A corporation’s first offering of stock to the public.

insider A person with access to information before it’s announced

to the public. Usually the term refers to officers and direc-tors of companies.

insolvent Unable to pay debts when they are due.

institutional investor An organization that trades large amounts of securities,

such as mutual fund companies, hedge funds, banks or pen-sion funds.

interest rates, short term, long term Long-term rates are considered to be the yields of debt

instrument with maturities of more than one year. The U.S. Treasury’s 10-year note is the benchmark for long-term rates. Short-term rates are considered to be the yields on bills or certifi cates of deposit (CDs) with maturities of less than one year. Yields of 90-day Treasury bills are the bench-mark for short-term interest rates.

intermediate term The time between the short and the long term, usually

three to 12 months.

investment grade Term used to describe bonds suitable for invest ment by

conservative investors. Minimum credit rating of BBB-.

issuer A company or government entity that borrows money by

selling a bond or other fixed-income instrument to investors.


junk bond A bond with a credit rating of BB+ or lower. Junk bonds

are also known as high-yield bonds.

Keogh plan Tax-deferred retirement plan for self-employed persons.

lagging indicator A statistic on the economy that rises or falls after econom-

ic growth has risen or fallen.

leading indicator A statistic that anticipates trends in the economy.

lenderA person or company that extends credit to a borrower

with the expectation of being repaid, usually with interest. Someone who invests in bonds is a lender.

leverage Use of borrowed funds to enhance the return on an

investment.

liabilities All claims against a corporation. These include accounts

payable, wages and salaries due but not paid, dividends declared payable, taxes payable and fixed obligations such as bonds or loans.

limited partnership An organization composed of a general partner who man-

ages a project, and limited partners who invest money but have limited liability and aren’t involved in day-to-day man-agement. Usu ally established to provide tax benefits. Master limited partnerships are limited partnerships that trade like stocks on an exchange.

limit order Order to buy a security up to a specific price. A broker

will only trade the securities within the price restriction.

liquidity The ability to sell a publicly-traded security for cash with-

out affecting the market price.

load A sales charge paid by an investor when pur chasing or sell-

ing particular mutual funds or annuities.

long To go long is to purchase a stock, bond or commodity for

investment or speculation. See also selling short.

long bond A bond that matures in more than 10 years. Since these

bonds commit investors’ money for a long time long bonds usually pay a high yield and expose them to higher risk. The most com monly mentioned is the U.S. Treasury 30- year bond.

long-term debt On a company’s balance sheet, debt that a company is not

required to pay back for more than a year.

long-term gain, long-term loss Profit or loss on securities when the time between buying

and selling is longer than 365 days.

M1 A major component of money supply. M1 includes all

currency in circulation, bank demand deposits, savings accounts, credit union share drafts, and nonbank travelers checks.

M2Includes all of M1 plus overnight repurchase agreements

issued by commercial banks, overnight eurodollars, time depos-its under $100,000, and money market mutual fund shares.

M3 Includes all of M1 and M2 plus large deposits, institu-

tional shares in money market mutual funds and term repur-chase agreements.

macroeconomics Analysis of a nation’s economy as a whole.

margin The amount of cash an investor is required to deposit with

a broker when borrowing to buy securi ties. Margin require-ments are usually 50 percent of the value purchased on stock transactions, and less for commodity futures or currency trades.

market capitalization Total value of outstanding common shares of stock. Price

per share times number of shares outstanding.

market price Last reported price at which a security was sold on an

exchange.

market timing Opposite of “buy and hold” investing. A trading strategy

based on the belief that one can determine beforehand when the overall market is going to fall. The trader’s investment


account is periodically liquidated to cash in hopes of avoid-ing market declines. High risk that the trader will get out at the wrong time and miss market advances and investment gains.

maturity date Date on which the principal amount of a note, draft,

acceptance, bond or other debt instrument becomes due and payable.

microeconomics Study of behavior of basic economic units such as compa-

nies, industries or households.

money market instruments Negotiable, short-term debt securities that are typically

low risk and highly liquid. Treasury bills are the best known money market instru ment. Other such securities include commer cial paper and certificates of deposit.

money supply Total stock of money in the economy. Different measures

include M1, M2, M3 and L, with M1 being the most spe-cific and L the broadest.

mortgage Debt instrument by which the borrower (mort gagor)

gives the lender (mortgagee) a lien on property as security for the repayment of a loan. If the loan defaults, the lender can take control of the property and sell it to recover the loan amount. Mortgages normally apply to real estate.

moving average Average price of a security over a specific number of days,

weeks, or months. The average price is continually updated, adding the latest price data and eliminating the oldest price data. The most commonly used moving averages are the 50-day moving average and the 200-day moving average. Securities trading at prices above these moving averages are considered to be in an uptrend and are in a downtrend when trading below them.

mutual fund A fund operated by an investment company that raises

money from shareholders and invests it in stocks, bonds, options, commodities or money market securities. Mutual funds offer the advan tages of diversification and professional manage ment. Most charge a management fee of about 1 percent or less for these services.

balanced funds hold bonds and/or preferred stocks in vary-ing ratios to common stocks to maintain stability of capital and income. Closed-end funds trade on an exchange and have a fixed number of outstand ing shares that trade like stocks.

Gold mutual funds invest in gold bullion or shares of gold mining concerns.

Growth funds invest in growth stocks with the goal of pro-viding capital appreci ation for the fund’s shareholders over an extended period. These funds are usually more volatile than money market or income funds.

Income funds invest for cash returns such as divi dends and interest to provide a good cash yield for investors.

Index funds’ portfolios match those of a broad-based index such as the S&P 500 Index. Performance mirrors the index as a whole minus expenses.

Money market funds invest in commercial paper, government securities, CDs and other highly liquid and safe securities. Municipal bond funds invest in securities that are exempt from federal taxes.

No-load funds don’t charge a com mission for buying and selling its shares.

Open-end funds issue new shares at value of assets whenever new investment comes in.

Sector funds invest in a specific industry, such as utilities.

Nasdaq Used to be an acronym for National Association of

Securities Dealers Automated Quotation sys tem, but now it’s a word in its own right. Nasdaq is a comput erized trad-ing network composed of a multitude of dealers offering bid and ask prices. This is in contrast to the New York Stock Exchange which uses a centralized specialist system.

national debt Debt owed by the federal government and com posed of

Treasury bills, Treasury notes and Treasury bonds.

net asset value (NAV)The NAV, in the case of no-load mutual funds, is the

market price. This price is determined by taking the closing market value of all securities plus any cash or other assets and subtracting all liabilities, then dividing the result by the total number of shares outstanding.

net income, net profit A company’s remaining earnings after all taxes and

expenses have been deducted.

net worth The total value of a company after all long- and short-

term debts are deducted from the company’s assets. For a corporation, net worth is also called stockhold ers’ equity or net assets.


no-load fund A fund that has no sales or commission charges when pur-

chasing or redeeming shares. See also load.

options The right to buy or sell the underlying asset at a specified

price during a specified period. A call option gives the holder the right, but not an obligation, to buy a security within a specified time at an agreed-upon price. A put option gives the holder the right, but not the obligation, to sell a security within a specified time at an agreed-upon price.

overbought, oversold Description of a security or a market that’s expe rienced

an unexpectedly sharp rise or fall in price and is thus vulner-able to a sharp move in the opposite direction of the current trend (i.e., a cor rection).

par value Equal to the face value of a security; the principal amount

that a debt security will pay a lender at maturity.

penny stock A stock that typically sells for less than a dollar per share.

These are often failed companies with an erratic his tory of revenues and earnings whose stocks are more volatile than larger, more established firms.

premiumFor bonds, the amount by which a bond sells above its

par value.

present value Value today of a future payment discounted at an appro-

priate discount rate.

price-to-earnings ratio (P/E) A measure of a security’s value. The price of a share of

stock divided by earnings per share for a 12-month period. It tells investors how much they are paying for a company’s current earn ings. The higher the P/E, the more investors expect earnings to grow.

prime rate The lowest interest rate banks charge their largest corpo-

rate customers for loans.

Producer Price Index (PPI) Measure of change in wholesale prices as released monthly

by the U.S. Bureau of Labor Statistics.

profit-taking Action by traders to cash in on gains earned on a market

rise. This pushes prices down, but usually only temporarily.

program trading Institutional buying of stocks based on a computer algo-

rithm, not based on a human being’s judgment. Such trading can sometimes, by its sheer volume and speed, increase market volatility like it did during the “Flash Crash” of May 2010.

prospectus Formal written offer to sell securities that explains a pro-

posed business enterprise or the facts con cerning an existing one that an investor needs to make informed decisions. A prospectus for a mutual fund must describe the history of the fund, managers’ backgrounds, fund objectives, a finan-cial statement, fees on a sample investment, etc.

proxy statementA document which the SEC requires a company to send

to its shareholders that provides material facts concerning matters on which the shareholders will vote. Shareholders can mail back a proxy card, appointing management to represent them at the meeting and instruct management to vote their shares in accordance with their wishes. This allows shareholders to participate in voting at the meeting, whether or not they decide to attend.

pure play A company that is devoted to one line of business.

Opposite of a conglomerate.

raider Individual or corporate investor who intends to take

control of a company by buying a control ling interest in its stock and installing new man agement. Think Carl Icahn (real) or Gordon Gekko (fictional).

real estate investment trust (REIT) A company that manages a portfolio of real estate to earn

profits for shareholders. REITs make investments in real estate properties such as shopping centers, office build-ings, and apartment complexes. In exchange for paying out almost all of their earnings as dividends, they are treated as pass-through entities and are exempted from corporate tax.

real interest rates Current interest rates minus the inflation rate. This gives

investors in bonds and other fixed-rate investments their actual return after inflation has been factored in.

recession At least two consecutive quarters of negative economic

growth as measured by GDP.

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return Profit or gain on an investment.

return on equity (ROE) Earnings divided by shareholders’ equity.

revenue The amount of money a company takes in, including

interest earned and receipts from sales, services provided, rents and royalties. Never use earnings as a synonym for rev-enue; these are completely different. Earnings are revenues minus expenses.

Standard & Poor’s 500 (S&P) The market capitalization-weighted index of 500 of the

largest and most liquid stocks in the U.S. Includes stocks from both the New York Stock Exchange and Nasdaq.

sales charge Fee paid to a brokerage house or mutual fund to buy an

investment.

selling short When an investor borrows a stock from a broker in a mar-

gin account, then immediately sells the stock. While waiting for the price to fall, the investor pays the broker interest on the amount of the stock that was borrowed. The investor hopes that the borrowed stock will fall in price so that he will be able to repurchase the stock at a cheaper price than he sold it for. This is a way to profit in a market where stock prices are declining.

secondary market The aftermarket where both buyers and sellers of a securi-

ty are third parties unrelated to the initial transaction involv-ing the issuer of the security.

secured debt Debt guaranteed by the pledge of assets or other collateral.

sentiment indicators Measures of the bullish or bearish mood of investors.

Analysts often look at extreme readings of investor senti-ment as con trary indicators. When investors are extremely bullish, all motivated buyers have already bought and there is nobody left to push the market higher, which forces moti-vated sellers to offer a lower price to entice less motivated buyers. This results in a market drop. When investors are extremely bearish, all motivated sellers have already sold and there is nobody left to push the market lower, which forces motivated buyers to offer a higher price to entice less moti-vated sellers. This results in a market rise.

settlement The delivery of stock to the investor and the pay ment of

cash to the seller. Settle ment occurs in three trading days.

Short-term debt Borrowed money that must be repaid in a year or less.

split An increase in a corporation’s number of outstand ing

shares of stock without any change in equity or market value at the time of the split. Example: If a shareholder held 100 shares of a $50 stock and it splits 2-for-1, the shareholder will now have 200 shares at a price of $25.

spot market Commodities market in which goods are sold for cash and

delivered immediately. Opposite of futures market.

spot price Current delivery price of a commodity traded in the spot

market.

spreads Simultaneous purchase and sale of different futures or

options contracts. Investors are betting that the price differ-ences will either widen or narrow.

stock An ownership interest in a corpora tion represented by

shares that are a claim on the issuers’ earnings and assets. There are two kinds: common and preferred.

common stock entitles the shareholder to vote in elections of directors and other matters discussed at share holder meet-ings. Usually, common stock has more potential for appre-ciation than preferred stock.

preferred stock usually doesn’t grant voting rights, but it has prior claim on earnings and assets. Holders of preferred stock receive divi dends before common stockholders.

stop loss Customer order to a broker to sell an investment if its

price falls below a predetermined level. It’s used to limit losses from an investment.

street name Describes securities held in the name of a bro ker or third

party instead of the customer.

target price Price a stock is expected to reach within a speci fied period

of time.


tax shelter Method used by investors to legally avoid or reduce tax

liabilities. Retirement accounts like 401Ks and IRAs are tax shelters, as are annuities and MLPs.

technical analysis Research into the demand and supply of securi ties based

on past trading activity. Technical analysts project future stock direction after studying stock charts and volume. See also fundamental analysis.

30-day wash rule IRS rule stating that losses on a sale of an invest ment may

not be used as losses for tax purposes if the same investment is bought within 30 days before or after the date of sale.

tick The minimum unit for upward or downward movement in

a security’s price.

trader Anyone who buys or sells goods or services for profit.

Colloquially, this refers to short-term buy ing and selling.

trading range A stock’s historical price movement between the high-

est and lowest prices at which it has traded for a given time period.

trailing earnings A company’s most recent actual earnings results, often for

the past 12 months.

Treasury bills (T-bills) Short term securities with maturities of one year or less

issued at a discount from par value. Many floating rate loans and variable rate mortgages have interest rates tied to the yield of these bills. See also interest rates, Treasury bonds.

Treasury bonds (T-bonds) Long term debt instruments with maturities of more than

10 years. The 30-year U.S. Treasury bond is the most wide-ly followed T-bond. See also interest rates, Treasury bills.

trend Any direction of price movement that is continu ous and

consistent.

turnaround Favorable reversal in the fortunes of a company, market or

economy in general.

12b-1 A charge assessed by mutual funds to pay for promotional

and marketing expenses taken directly from fund assets. Named after SEC rule 12b-1.

underwriter A securities dealer who purchases bonds directly from the

issuer for resale to investors.

upside potential Amount of upward price movement an investor or analyst

expects in a particular stock, bond or commodity.

uptick When a security is sold at a higher price than it was on the

previous trade.

uptrend Consistent and continuous upward price move ment for an

investment.

volume Total amount of an investment traded in a partic ular

period of time.

warrant A type of option usually issued with a bond or preferred

stock that entitles the shareholder to buy a certain amount of common stock at a spec ified price, within a specific period of time. The time until expiration for a warrant is usually longer than the time until expiration for an exchange-traded option.

yield The annual rate of return on an investment, as paid in div-

idends or interest. It is obtained by dividing the 12-month dividend or interest pay ment by the investment’s price.

yield to maturity A yield measurement that accounts for the compounded

interest earned on the bond through the maturity date, as well as any capital gain or loss from the bond returning its par value at maturity. The yield that will most often be quoted by the bond salesmen will refer to a worst case situa-tion. In other words, if a bond can be redeemed (i.e., called) prior to its stated maturity date, say in 10 years rather than 30 years, the quoted yield will reflect the early redemption value of the bond in 10 years.

zero-coupon bond A bond that pays no interest, but is issued at a deep dis-

count price, which will appreciate to par value at maturity. Tax is usually due on a zero-coupon’s annual appreciation despite the fact that the zero’s owner does not receive any cash until maturity.

Documents

Understanding the Stock Market: How to Buy Stocks