Some thoughts on investing
Ted Williams, PhD

List of Sections

1. Introduction
2. Overview
3. Some Basics
4. Coping with Risk
5. Taxes
6. Investing in Mutual Funds
7. OnLine Stock Brokers and Market Makers
8. Financial Advisers
9. Picking Stocks to Buy/Sell
10. Selling a Stock Short
11. Picking Bonds to Buy/Sell
12. Roth IRA
13. Direct Investing
14. Social Investing
15. Buying an Annuity
16. Summary
17. References
18. Summary of Links
19. Glossary of Investment Terms

Introduction

Some caveats:

• I do not recommend or endorse any security, product, or company mentioned here. I am describing my own experiences which may, or may NOT, be applicable to your situation.
• I do not provide investment advice. NEVER accept any advice or recommendation, including the information provided here, without first performing your own independent verification.
• The opinions expressed here are not necessarily those of NOCCC or of my employer.
• I am not an expert on investing. I invite you to add your own insights to this discussion.

In case you have occasion to refer to any information provided here, this presentation is available on my web site, www.tlwilliams.net, article 0102pInvesting.

It is hard for me to know where everyone is at in their investing career. Some of you are experts, others are beginners. In order to offer something for everyone, I will briefly review the basics and then move on to some more advanced topics. If you are a more experienced investor, stay tuned for the upcoming June presentation on investing 0106pInvesting.html.

Overview

After a brief introduction into the risk and costs in investing, I discuss some rules-of-thumb for setting investing goals. To reach these goals, we will review the essential ingredients to investing, CDs, MMFs, mutual funds, on-line stock brokers and investment methods.

Several investment techniques are discussed, but one tried and true method for successful investing involves taking the following steps in the order shown:

• Eliminate debt, especially unsecured debt.
• Participate in tax-sheltered retirement plans (401Ks, Roth IRAs) to the extent allowed by law.
• Invest regularly over a long period of time.
• Invest part of your money cash equivalents such as CDs (Certificates of Deposit), MMFs (Money Market Funds), or short-term bond funds.
• Invest part of your money in a low-cost index fund, such as one of the Vanguard Index Funds
• To reduce risk (but with lower gain), increase the portion of your investment in MMFs and CDs.
• In addition, put all of the money that you will need in the next few years into CDs and MMFs.
• To increase your gain (but with more risk), invest in a few very carefully selected stocks. If they fall in price, sell them promptly. If they rise in price, increase your investment in these stocks.

Invest in a low-cost mutual fund in good times and stay in cash during the bad times. As the time that you plan to spend some of your investment approaches, move a larger portion of your investments into cash equivalents.

Some Basics

Needs at Retirement
One purpose for investing is to provide funds for retirement. At retirement, a maximum withdrawal of 3-5% per year from an investment account can be tolerated without exhausting the investment prematurely. For example, suppose that:

• $10,000 / year is required from your investment funds at retirement (measured in current dollars).
• Inflation at 4% year for will double the amount required in 18 years. Thus, the current $10,000 required yearly will translate into a $20,000 requirement in 18 years.
• 4% / year can safely withdrawn from the investment.

Thus, $500,000 is required to yield 4% ($20,000) / year. During retirement, at least the next 2-4 years of withdrawals (about $80,000) should be kept in cash equivalents. If the market turns down, funds will be available from your short-term bonds, CDs and MMFs. The remainder should be invested conservatively to preserve capital. For example, 50% in the Vanguard 500 Index fund and 50% in the Vanguard Balanced Index fund. The balanced fund consists of 58% in stocks and the remainder in bonds.

Stocks
Stocks are an ownership share in the company. Stocks may pay a dividend at one or more times per year. The price of one share of stock may rise or fall over time. Historically, the price of stocks in general have risen (discounting the effect of inflation) by 7.2%. This return exceeds the average yield of bonds, CDs or MMFs.

Unfortunately, there have been extended periods 1929-1933, 1970-1976 when the price of most stocks fell. Further, inflation will reduce the buying power of the money that you are paid for the stock when the stock is sold. If a company goes bankrupt, the value of the stock may fall to zero.

Bonds
A corporate bond is an IOU from a company. Most are sold in $1000 denominations with a specified maturity date. At maturity, the company promises to pay back the full amount of the bond. In addition, a specified interest is paid on the bond every six months. If the bond is callable, the company may choose to pay you back early (this will happen if interest rates drop).

A bond held to maturity is worth exactly $1000 (unless the company goes bankrupt, in which case the bond may become worthless). You may sell a bond on the open market, but there are transaction costs, mark ups, and the value of the bond my be lower (or higher) than the value at maturity.

CDs (Certificate of Deposit)
A CD is an IOU from a financial institution, such as a bank or a credit union. At the end of a specified term (usually 1-5 years) the bank will repay you the full amount of the CD plus a specified interest accrued over the term of the CD. If the bank is a member of the FDIC (Federal Deposit Insurance Corporation), you are guaranteed by the US Government to be repaid the face amount of the CD (up to $100,000) even if the bank goes bankrupt. Thus, the risk associated with a CD is less than with a bond. If the CD is callable, the bank may choose to pay you back early if it is to their advantage.

CDs have very low risk, but the return tends to be lower than stocks or bonds.

MMFs (Money-Market Funds)
An MMF is much like a bank account that pays interest. Unlike a CD, the amount of interest paid will vary from day to day. In addition, you are free to deposit or withdraw funds from the account at any time (there may be fees or penalties for transactions that exceed some limits). If the bank is a member of the FDIC (Federal Deposit Corporation) the funds are insured by the US Government up to $100,000. Mutual fund MMFs are not usually insured by the US Government.

MMFs have very low risk and your funds are readily available at any time, but the return tends to be lower than CDs or bonds.

• Capital Risk. Stocks may fall in value. Bonds may default. In either case, you may lose all or a portion of the money that you invest in stocks or bonds.
• Interest-rate Risk. The value of a bond is subject to changes in the current interest rate (see explanation below). If you hold a bond to maturity, the interest-rate risk is avoided.
• Inflation Risk. The buying power of $1.00 in the future may not buy as much as it does today. The higher the rate of inflation, the faster that faster your investment will lose value.

Interest-rate Risk
If you hold a bond until maturity (for the full period of the bond), then the value of a $1000 bond is exactly $1000. If you wish to sell a bond before it matures, then it may be worth more or less than $1000. For example, suppose a bond yields 4% for the remaining 20 years and the current yield on a new 20 year bond is 8%. No one is going to pay $1000 to get just half the current yield. In fact, the bond will sell for about $500 so that the new owner will receive about same interest as the current yield on his investment. On the other hand, if interest rates fall from 8% to just 4%, then the bond will nearly double in value because it has double the yield of a current bond.

The following table shows the effect of the above risks on the investments described above:

Coping with Risk

Risk can be controlled by asset allocation. If you put 100% of your savings in CDs, Treasuries, and MMFs your risk will be limited to inflation risk. At the same time, your average return will be limited to about 2%-3% after inflation. On the other hand, if you invest in stocks, your risk will be higher, but your return will be better than any other option (stocks did better in 80% of all 10 year periods). Next, lets look at choosing some middle ground in between these extremes.

Asset Allocation
You can limit your risk in any given year by adjusting your asset allocation. Consider the following policy which is initiated at the beginning of every year:

• Invest 50% in cash equivalents (short-term bonds, CDs and MMFs)
• Invest 50% in a few growth stocks or in a mutual stock fund.
• If your stock investments fall by 30% or more, sell the remaining stocks
• If your stock investments rise, buy more stock.

If the worst should happen, the total loss due to a 30% loss in stocks is a 15% loss in your overall portfolio. Of course, you could limit the loss to a smaller amount if you choose to reduce your stock holdings before these investments fall by 30%. This loss is somewhat offset by the interest earnings made by your cash equivalents. You can adjust these ratios to your specific tolerance to risk. Of course, as you increase the amount in cash equivalents, you decrease your return if stock prices should rise.

Guidelines
When selecting an allocation, achieve an overall balance. There is no need to balance each account, such as a 401K or an IRA. In fact, tax-deferred accounts should be weighted toward stocks because the higher average earnings will be protected from taxes. Taxable accounts should be weighted toward cash-equivalents. I have a selected the following conservative approach to asset allocation:

• Young Investors. Young investors (those with a 10 year or greater investment horizon) can be invested 75% in stocks.
• Approaching Retirement (or other investment goal). Rotate into short-term bonds and CDs. Put the money needed in the next couple years into cash equivalents. Move 40%-60% of your total investments into bonds or bond funds. Keep all the rest in stocks to maintain capital appreciation.

Taxes

State and Federal income taxes can take a huge bite out of your profits. Here are the basics for those who own CDs, stocks and bonds directly:

• Interest earned on CDs and bonds are taxed as ordinary income.
• Corporate tax is paid by the company on any dividends. Then, the recipient of the dividend pays taxes again. (If these earnings become part of an estate above the deductible amount, the same dividend is taxed A THIRD TIME.)
• If a stock or bond appreciates in value, the increase in value is taxed as ordinary income if it is held less than twelve months. The increase is taxed as a capital gain if it is held for twelve months or more.

The taxes do not have to be paid until the investment is sold. So, if a stock is held for ten years, no taxes is paid for ten years. Gains in the value of the stocks in a portfolio that have not been sold, are referred to as unrealized gains.

Earnings in a Roth IRA are not subject to Federal (and probably State) income taxes. Taxes on earnings in a traditional IRA are deferred until the earnings are withdrawn.

Mutual Funds and Taxes
Mutual funds (not held in a tax-deferred account such as an IRA) also are subject to taxes. If the mutual fund manager sells a stock, the realized gains are subject to taxes. The capital gains are distributed to the owners of the mutual fund at one or more times a year. The taxes on these gains are passed to the participants in the mutual fund.

You can control the tax bite on your own portfolio of stocks. For example, stocks held for more than 12 months are taxed at the more favorable capital gain rate. You do not have this same control over mutual funds.

If the manager fund buys and sells stocks frequently, almost all of the gains in the fund are distributed as short-term gains right away.

The consequences can be substantial. Even worse, if you purchase a mutual fund just before the capital gains are distributed, you will be subject to the taxes for the entire year, even though you did not actually receive any of these gains!

Consider what happens if a mutual fund has billions of dollars of unrealized gains at the time that you purchase shares in the mutual fund. If the mutual fund manager sells these stocks you again will be subject to the taxes on these gains even if the value of your shares drops dramatically. This happened in the year 2000. Mutual funds did very well in 1999 and many funds held these appreciated stocks well into 2000. Unfortunately, the market fell dramatically in 2000 so the managers sold these stocks as stock prices began to fall. If you were unfortunate enough to buy shares in these funds in early 2000, you were hit with huge tax costs later in the year even though the value of the mutual fund shares that you purchased fell dramatically.

Here is what you can do to minimize these effects if you buy mutual funds:

• Stick to funds with low turnover to minimize short-term gains. Most index funds have low turnover. The fund manager only needs to add or drop a stock from the portfolio if the index itself is modified.
• Do not purchase shares in a fund just before a capital gains distribution is made.
• Do not purchase shares in a fund that has accumulated a large unrealized gain in the previous year.
• Buy mutual funds that are managed to minimize tax consequences.

The potential difference can be substantial. If the stock market rises by 10% and the expenses average 2%, the pretax return is 8% and the typical tax bite is 1.5%, which yields a 6.5% after-tax return. A low cost index fund with .2% expenses and .8% tax bite yields 9% return. An investment yielding 6.5% doubles about every 11 years. An investment yielding 9% doubles about every 7 years.

Investing in CDs and MMFs

Considerations
Use CDs to invest money that you may need in 1-5 years. Just select the maturity date prior to the time that you will need the money. At maturity, the bank will pay you the amount of the original investment plus the total accrued interest.

What to Watch for

• Make sure that the bank is a member of the FDIC and that the security that you are purchasing is covered by FDIC.
• Limit the CDs at any one institution to the maximum insured amount (currently $100,000).
• Make sure that the CD is NOT callable. If interest rates rise, you lose. If interest rates fall, you lose (the bank will call the CD and then issue a new one at the lower rate).
• A substantial penalty is charged if you withdraw the money early. Be sure to review the terms of the agreement.
• If you do not provide other arrangements, the bank will probably automatically roll the CD over into a new CD at the current rate.

How to Buy
The purchase of a CD is usually quite simple. Nationwide rates are usually better than local rates. Shop around, don't just roll your CD into a new CD at the same institution.

• Select the amount and the length of the term of the CD. CDs for $50,000 or more typically pay more than CDs for lower amounts.
• Select an institution (see below) where you wish to purchase the CD.
• Check out the institution (see notes above).
• Apply for a CD at the institution. The application is very simple.
• Send a check or wire-transfer the amount you wish to invest.
• At the end of the term, be sure to provide clear instructions to the bank about the distribution of the proceeds.

Where to Buy
Here are some places to look for the best rates:

• Sunday Register. The "Your Money" section of the Sunday register has a article title "Banks vs Money Funds" It lists the financial institutions nationwide that provide the most attractive rates for MMFs and CDs.
• bankrate.com. Bankrate.com will search for the best rates nationwide. Currently, the service is free.

Investing in Mutual Funds

Considerations
Use mutual funds to invest money for the long term. Mutual funds are attractive for those who wish to invest and forget. Historically, investors who just invest regularly in a growth stock fund over a long period do well. If you do not feel confident that you can withstand the emotional ups and downs of the market, just invest a portion of your savings regularly in an index fund and ignore the market.

On the other hand, mutual funds charge annual operating fees that varies from .2% to 3% (or more) of the total amount invested. Some funds also have a sales charge (called a load) on the purchase or sale of shares in the fund. In addition, mutual funds may impose transaction fees and other fees (about 0.5% of total amount invested) on the participants. Notice that the fee is on the total amount invested even if your account loses money. Mutual funds let you absorb all the risk.

What to Watch Out for

• Read the prospectus. Check out the annual operating expenses, sales charges and fees. Check out the turnover rate. Typical index fund turnover rates are less than 10%.
• Check the capital distribution date (usually in December). Be wary of buying a large number of shares just before a capital distribution (only applies to taxable accounts).
• Don't try to time the market. Just keep investing regularly. The best time to invest is when the market is depressed and others are selling.
• Mutual funds often have a minimum investment amount of about $3000 ($1000 on IRAs). Plan to have at least the minimum amount to invest.
• Most mutual fund companies have a web site. Be sure to visit the web site to see what services are available.

How to Buy
The purchase of a mutual fund is usually quite simple:

• Decide on your asset allocations as discussed above. For example you may choose to have 30% in short-term bonds, 20% in a balanced fund, and 50% in an index stock fund.
• Using one of the resources mentioned below to select a mutual fund company. You may wish to consult one or more of the books on investing listed below. I especially like Bogle's book.
• Select one or more funds based upon the information you have gathered.
• Contact the company, read the prospectus, fill out the application, and mail the application back with a check.

How to Shop
Here are some places to look for information on mutual funds:

• www.morningstar.com - a comprehensive site with lots of information. Morningstar ranks mutual funds (using stars) that you may find helpful.
• www.vanguard.com - Vanguard pioneered low-cost funds. They set the standard for efficiency by which other mutual funds are compared.

My Choices
I have selected the following mutual funds based upon their stability and low cost. The annual expense ratio is shown in parentheses:

• MMF - Vanguard Prime MMF (VMMXX) (.33%)
• Bond Fund - Vanguard Total Market Bond Index Fund (VBMFX) (.21%)
• Stock Fund - Vanguard 500 Index Fund (VFINX) (.18%)

Remember, low cost index funds have outperformed other mutual funds 80% of the time. Note that there are many other index funds. If the S&P 500 index is too tame for you, consider index funds that focus on health care or pharmaceuticals.

Ranking Funds
Another approach is to select funds that have been highly rated by several agencies. Here are some places to look for ratings:

• Morningstar.com - Morning star has ratings of mutual funds.
• Wall Street Journal - The Friday edition of the Journal has ratings of mutual funds
• Valueline - The Valueline Mutual Fund Survey contains ratings of mutual funds.

OnLine Stock Brokers and Market Makers

Here is what happens when buy a stock through a stock broker:

• An order to buy is placed with the stock broker.
• The stock broker passes the order on to one of several market makers who actually complete the trade. The market maker finds a seller who is willing to sell stock at the price you are willing to buy. Note that different market makers may trade the stock at different prices at the same time.

The market maker charges the buyer more (the bid price) than the seller receives (the ask price) and pockets the difference. A typical spread between the bid and ask price is 1/16 of a dollar. On a typical day, over 1 billion shares are traded in the United States. At a spread of 1/16, the market makers take in over 62 million dollars a DAY.

What Stock Brokers Do
I don't have much nice to say about stock brokers. Read "License to Steal" for a chilling account about how stock brokers take advantage of their clients. Here is how a stock broker makes money:

• Transaction fees - Stock brokers charge a fee to buy or sell stock.
• Kickbacks - Stock brokers channel trades to those market makers who pay them the most for the privilege of conducting their trades. Better yet, some stock brokers, such as Schwab, are also market makers so they collect the entire spread in addition to their other fees.
• Margin interest - Stock brokers are willing to lend you money to invest while they hold your securities as collateral. They charge a substantial interest on the amount of the loan.

In sum, stock brokers make money on trades, so it is in their interest to encourage you to make as many trades as possible. Unless you have iron-like discipline, you may want to stick to regular investments through a mutual fund.

Considerations
Here are some considerations in selecting a stock broker:

• Margin accounts. You cannot sell-short (see below) unless you have a margin account. It is risky and dangerous to invest on margin. I have a margin account, but I never invest on margin under any circumstances.
• Local offices. It is convenient if your broker has local offices where you can make deposits, fill out applications, get help.
• Transaction costs. Transaction costs are important. Check the costs for market orders, limit orders, and short sales.
• Efficiency. Are your trades made at the best possible price? It is difficult to determine efficiency (stock brokers are very evasive on this issue).

The Cost of a Trade
Here is how you could determine the real cost of a trade. Buy a stock and then sell it immediately. The difference between the initial purchase amount and the proceeds of the sale are the round-trip cost of the trade. But, this is not the whole story. With a different broker that uses a different market maker, you might have paid less for the stock or you may have been able to sell the same stock for more. It is difficult to determine the real cost of a trade.

What to Watch for

• Safety. Brokers are typically insured through SIPC.
• Ratings. Check the ratings through www.gomez.com.
• Ease of use. Are trades easy to make?
• Hours of service. When can you speak to an agent?
• IRAs. Do they provide self-directed IRAS and self-directed Roth IRAs?
• Custodial accounts. Do they provide custodial accounts? custodial IRAs?
• Deposits and withdrawals. Are deposits and withdrawals quick and easy to make?
• Internet. Do they provide on-line service?
• Bonds. Can you buy/sell bonds on-line?

How to Open an Account

• Select the criteria that are important to you.
• Check the ratings of stock brokers (www.gomez.com) before you select a broker.
• Contact the broker, fill out the application (they will require bank references).
• Mail in the application with a check or take the application to your local office.

Making Trades
Making online trades is fairly straightforward. Here are your options:

• Order.
The order may be to buy, sell, sell short, buy to cover. See the notes below on short sales for a discussion on selling a stock short.
• Symbol. You have to know the market symbol for stock you wish to trade. Look up the symbol in the newspaper, or conduct a search at www.fool.com for the stock by name. For example, the stock symbol for Corning is GLW.
• Quantity. The quantity can the number of whole shares you wish to trade. You normally must have the money to buy stock in your account within a day or two of the trade. You normally must have the stock in your account in order to sell the stock.
• Order type. The order type can be market, limit, or stop.
• Market Order. A buy will be made at the current bid price. A sale will be made at the current ask price. Don't place market orders when the market is not open. When the market does open, you may get a price much lower or higher than you expected.
• Limit Order. The trade will be made at the price specified or better or it will not be made at all. A great way to automatically buy stock at a target price.
• Stop Order. Your order will be automatically converted to market order if the stock price reaches a specified price. For example, suppose that you place a stop order to sell at 18. If the stock price falls to 18, a market order to sell will be made. If the stock continues to fall and if the market maker is not responding, the trade might be made at a price lower than 18. If you placed a limit order to sell under the same conditions, the trade would be made right away if the price is above 18. If limit order is made after the stock falls below 18, a limit order to sell will not be made at all.
• Time in force. The time that the order is in effect.
• Day Order. The order is only good until the next time that the market closes. If the market is not currently open, the order goes into effect when the market opens. If the trade cannot be made, the order is automatically cancelled.
• Good 'til Cancelled. The order remains in effect until the trade is made or until you cancel the order.

Put Options
The owner of a put option may sell a specified number of shares of stock at a specified price over a specified period. Your stock broker will buy or sell (called "writing an option") options for you. For example suppose that the current price of Dell is 32. Further, suppose that you buy a put option for 1000 shares at a strike price of $30.00 for the next two years. If the stock price rises in price, the option is worthless and you lose the amount of money that you paid for the put option. If the stock price falls below $30.00 any time in the next 2 years, you can obtain shares of this stock a lower price and then exercise the put option to sell this stock at a profit. See comments in the upcoming June presentation on investing (0106pInvesiting) on using puts to hedge a stock position.

Financial Advisers

I have a very dim view of financial advisers. They are often paid by commission, so it is in their best interest to sell you something that has a handsome commission (for them, not you). They are never going to recommend a low-cost index fund or a self-directed IRA through a discount on-line broker.

Ever wonder why these so-called experts are busy making TV appearances, giving seminars, and writing books instead of getting very rich investing their own money in the market? Frankly, if a financial adviser really knew how to make money in the stock market, he/she would be way too busy making money to waste their time handing out advice. For example, Louis Rukeyser on PBS publishes a newsletter with his stock picks. I was amused to learn that his portfolio (like almost all others) has not performed as well as the S&P 500 stock index.

I've had the privilege of meeting a few real experts. They do not disclose their methods and they do not hand out advice. An effective strategy will become ineffective if too many people use it. So they never advertise.

Unfortunately, the situation is worse than I have portrayed. Many advisers are in the pump and dump business. They tout a stock that they already own (or their company is trying to sell). The price goes up and then these advisers sell ahead of the others. This explains why there are 100 buy recommendations being made by these advisers for every sell recommendation.

Picking Stocks to Buy/Sell

Some economists have claimed that the stock market is efficient. That is, no investment strategy will work better than selecting stocks at random. I do not believe that this is true. Several strategies have proved successful over a period of time. In addition, several studies have shown that the stock market will rise too far (farther than an efficient market would) during an upswing and will fall too far during a downswing. In some respects, the market is similar to a Ponzi scheme. Irrational exuberance drives the market to dizzy heights, then an oil shock, bad weather, uncertainty (an election outcome, etc.), government intervention (rising Fed interest rates, punitive trade bills) tip consumer sentiment the other way and the market falls to abysmal lows.

If you invest regularly, you will notice that you make the most money in the irrational upswing just before a crash (end of 1999). Further, by buying stocks at the bottom in a depressed market, cheap stock becomes very profitable. Thus, you should hold on to stocks even if the market becomes overvalued and you should also buy stocks after the market has fallen precipitously. It is easy to become emotional in these swings and do the wrong thing. Most investors buy low and sell high. They sell their winners and stick with their losers. One way to cope with this volatile situation is to sell losers promptly, invest more in winners and keep a portion of your holdings in cash equivalents.

What the Experts Do
Expert investing groups have economists, financial gurus, computer scientists, and statisticians on staff. They have lots of compute power and databases with detailed stock information stretching back decades. They use artificial intelligence, genetic algorithms combined with extensive testing to ferret out inefficiencies in the market. Once an opportunity is discovered, they quickly take advantage of the temporary situation and then move on. These operations don't advertise, and they don't solicit customers. They are too busy making money. You are up against formidable competition.

What You Can Do
If you are not satisfied with investing regularly in an index fund, you may want to consider some strategies that I describe in my upcoming June presentation.

What to Do in a Panic
Unfortunately there is not much you can do. You must anticipate that trades will be difficult during a market during a steep fall in stock prices (i.e., a crash). Market makers are forced by law to keep the market orderly by buying stock during a rapid fall, but they know that they will lose money if they do this, so they obey the law by making as few trades as possible. In turn, the stock brokers can only complete a portion of the pending transactions until the panic subsides.

See the above comments on irrational exuberance for a list of warning signs to watch for. In the last quarter of 1999, stocks were extremely overvalued and warning signs were becoming ever more evident. A conservative investor might choose to move to a more defensive position (put more money in cash equivalents). On the other hand, stocks soared at the end of 1999, just before a dramatic downturn in 2000.

Selling a Stock Short

One must open a margin account with a stock broker in order to sell a stock short. Scottrade.com requires a minimum of $2000 to open a margin account. To keep the trading costs within reason, you should invest at least $1000 in every trade. Stock brokers vary greatly in their ability to conduct short sales of thinly traded stocks. You may have to try several different stocks before you can find one that the broker is willing to sell short. Basically, a short sale entails the following steps taken by the stock broker when you submit a short sale request:

• Short sales are made in multiples of 100 shares.
• The broker locates and borrows stock from a current owner of the stock.
• The broker requires that the cash in your account must exceed 50% of the cost of the borrowed stock.
• The broker then sells the borrowed stock on the next uptick (rise in price) of the stock.
• The proceeds from the sale is now added to your account less the cost of the trade ($7.00)
• The broker insists that the cash in your account exceeds 140% of the current value of the stock. For stocks between $5/share and $12.50/share, the margin requirement is $5/share.
• If the price stock increases above this minimum level, the broker has the right to sell the stock at this higher price without your permission.
• No daily interest is paid by the broker on the proceeds of the short sale.
• Under unusual circumstances, the broker may request that you return the borrowed stock; however, normally, you may continue the loan indefinitely.

At some future date, you can "cover" the short sale by purchasing the stock at the current price. At this point, the broker does the following:

• The broker buys the stock at the market price or the price that you designated if it is a limit order.
• The broker deducts the cost of the stock and the trading fee ($7.00) from your account.
• The broker returns the borrowed stock to the owner.
• Your account now is credited with the original amount of the short sale less the cost of the stock less the cost of the two trades (the sale of the stock and the purchase of the replacement stock).

If the price of the stock falls, the replacement stock costs less than the amount received by the short sale. You make the difference (less the trading costs). If the price of the stock rises, you lose money.

Some things to watch for Here are some precautions that I take on short sales:

• Never short a stock whose price is below $20.00.
• Select stocks that are likely to fall in value.
• Avoid short sales of a stock that is volatile (wide price fluctuations).
• Avoid short sales of the stock of a company that is a likely to be acquired (the stock price can rise dramatically if the company is bought out).
• Short at least 15 stocks at a time. You will reduce your risk by selecting several stocks from several industries.
• Cover your short sales if the stock price rises by more than 20% (cut your losses). Hold your short position on stocks whose price is falling (run your winners).
• If the overall market shows signs of recovery, it may be time to cover your short positions.

Upticks SEC rules require that the sale of stock in a short sale can only be made on an uptick (the stock trades at a higher price than the previous sale). If the stock is falling continuously, the sale is delayed. In the meantime, the stock price falls so that the amount of the original short sale that is credited to your account is less than the initial price of the stock. This rule has a detrimental effect on short sales. However, this rule does not apply to exchange-traded funds such as SPDRS, QQQs, etc.

You can use short sales as a hedge. By buying some stocks and selling others short, you will be in a position to make money if the general market rises or if the general market falls.

Roth IRA

It is hard to overemphasize the advantages of a Roth IRA. Everyone who is not taking advantage of the Roth IRA (who qualifies) is missing a great opportunity. For those under 40 years of age, the Roth IRA is a simple and effective way to guarantee a comfortable retirement. Check out the following sites for more information:
www.senate.gov/~finance
www.schwab.com
www.rothira.com

Who Qualifies
Among the requirements for opening a Roth IRA:

• Individuals with an adjusted gross income of less than $95,000.
• Individuals with at least $2000 of earned income (or whose spouse has $2000 of earned income). This limit rises to $3000 in 2002 ($3500 if you are over the age of 50).
• There are no age limits on contributing to an account.
• An individual qualifies even if one has a 401K or 403B plan at work.

Considerations
Keep the following facts in mind:

• You may convert a traditional IRA or roll a 401K into an Roth IRA. You have to pay taxes on the amount converted, but all subsequent earnings are tax free. Withdrawals made in the first 5 years after conversion are subject to a substantial penalty. The tax bite is substantial, but subsequent earnings are tax free (even for your beneficiaries)!
• You may establish a self-directed Roth IRA with a stock broker. You may purchase stocks, mutual funds. You cannot open a margin account or sell stock short.
• You may open a custodial, self-directed Roth IRA account for children who have earned income of the amount invested.
• Parents may hire their child with no Social Security or tax obligation. The child may have up to $4300 income without filing a tax return. So, a parent can pay a child $2000 ($3000 in 2002) salary with NO tax consequences to the parent or the child.
• Currently, contributions to a Roth IRA are limited to $2,000 per year ($3000 in 2001). (The limit will rise to $5000 in 2004. A regular investment of $5,000 per year will grow to an enormous amount of money over time.
• There are no mandatory withdrawals during your lifetime.

Qualified Withdrawals
You may withdraw money from a Roth IRA without penalty or tax under the following circumstances:

1. All contributions that you have made (some restrictions apply to conversions from a traditional IRA).
2. After the age of 59 1/2
3. Disability
4. Purchase of the first home (up to $10,000)
5. Withdrawls for qualified educational expenses are subject to tax but no penalty

Benefits
The benefits are enormous. Qualified withdrawals may be made with no penalties and no Federal taxes (state tax may apply). Refer to the links mentioned above for the rules on conversions.

Suppose that you invest $2000/yr at 10% return for 10, 20, 30, 40, or 50 years. The amount that you will accrue in your account is as follows:

Even at $2,000/year a 10 year old can accrue millions of dollars by the age of 60! These amounts will double if you invest $4,000 each year.

Inheritance
Here are some important facts about inheritance of a Roth IRA:

• The age of the original accountholder is not a factor when determining the payout schedule to a beneficiary.
• A surviving spouse can roll the deceased's Roth IRA into his/her Roth IRA without any penalties or restrictions.
• In the discussion below, T is the total amount in the Roth IRA account as of 12/31 of the previous year.
• LE is the life expectancy of the oldest beneficiary as of the birthday of the oldest beneficiary in the year following the death of the original accountholder. LE is reduced by one each year thereafter.

A beneficiary of a Roth IRA may do either of the following:

1. Withdraw the assets by 12/31 of the fifth year following the original accountholder's death (a poor choice).
2. Withdraw an amount of at least T / LE in the year following the inheritance. T is the total in the account as of 12/31 of the previous year. LE is reduced by 1 at the end of each year. Each year thereafter, the minimum withdrawl is T / LE.

Note, that all withdrawals are qualified. There are no age restrictions on an inherited Roth IRA! If the beneficiary has a life expectancy of 10 years in the year after the account holder's death, then 10% of the end-of-year account value must be withdrawn the next year. The next year 1/9th of the year-end total must be withdrawn and so on for up to 8 more years. A beneficiary (except for the spouse) cannot make contributions to an Inherited IRA (but he/she can have a separate IRA). If the beneficiary does not need the money, it is best to leave the money in the IRA as long as possible because the returns earned by the IRA continue to be TAX FREE even after the original accountholders death.

Summary Here is a simple retirement plan:

• Open a self-directed Roth IRA with a stock broker (that allows investments in mutual funds, etc.) or open a Roth IRA with a low-cost mutual fund company.
• Just put $5,000 (allowed after 2004), year after year, into a low-cost index fund or other long-term investment.

It is just that simple to provide a comfortable retirement for you or your children or your grandchildren.

Picking Bonds to Buy/Sell

A bond is similar to an IOU. When you purchase a bond, you are lending money to a corporation, or government agency. In return for the loan, the company promises to pay you a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it "matures", or comes due. Bonds are rated by independent rating companies such as Moodys and Standard & Poors. A bond with a higher rating (A, AA, AAA) will usually pay a lower interest than bonds with a lower rating. Of course, a bond with a higher rating is more likely to be repaid at maturity.

You may buy a new bond issued by a corporation (or a government agency) or you may buy an existing bond sold by a third party prior to the bond's maturity. The yield on a bond is the ratio of yearly interest paid by bond divided by the cost of the bond. A bond that pays an interest greater than the current interest rate on new bonds will sell at a premium (a price greater than the face value of the bond). A bond with a lower interest rate will sell at a discount (a price lower than the face value).

Considerations
Those with a fairly long horizon will do best in stocks. Those nearing retirement should gradually move an increasing percentage of their money into bonds and cash equivalents. Money that you will need in the next few years should be in cash equivalents (CDs, MMFs). By the time that you retire plan to have 20% (for those that can tolerate risk) to 50% in bonds and the rest should remain in stocks to maintain your earning power.

You can either invest in bond funds or you can buy bonds. If you buy bonds directly and hold them to maturity, you avoid any interest rate risk. Of course, you still face capital risk (due to bankruptcies) and inflation risk. Here are some of the pros and cons of investing in a bond fund:

• Since the fund owns a large number of bonds, there is less risk from an occasional company going bankrupt.
• Bond funds charge an annual fee that varies from about 0.3% to 3% of the total amount of the money in the bond fund. The annual fee may be a substantial portion of your earnings.
• Since bond funds constantly buy and sell bonds, they are subject to interest rate risk.
• If a bond fund has had some capital appreciation in the past year, you may be subject to a big tax bite if you purchase shares in the fund just before a distribution of gains (typically in December).
• The price of your shares in a bond fund will fall if interest rates rise, but the price will rise if interest rates fall. The effect is most pronounced for long-term funds.

Some other considerations in buying bonds directly:

• Buy bonds with staggered maturities. That way you will never have all of your bonds mature at the moment when interest rates are very low.
• Bonds usually pay interest every six months. If you depend upon the interest for a steady income, you may wish to buy bonds over six successive months. That way, you will receive some payments every week
• The amount of interest is higher for bonds with a low S&P or Moody's rating. I make it a rule to only invest in ratings of A or higher to keep the risk low.
• Compare bond yields with CDs. Since CDs are guaranteed (up to $100,000) by the US Government, a CD yielding 7% is preferable to a corporate bond yielding 7%.
• Treasury bonds may be purchased directly at no cost (up to $100,000) from www.treasurydirect.gov. The yield is barely above inflation, but the risk is nil. If you purchase treasuries from treasury direct, plan to hold the bonds to maturity.
• Municipal bonds (munis) pay a lower interest rate, but the interest payments are exempt from federal income taxes. Munis offer no advantage unless they are in a taxable account and if your incremental income is subject to a high tax rate.
• I avoid callable bonds. If interest rates drop, the company will pay off the bond prematurely. Then, one must buy another bond just when rates have dropped. It is a lousy deal.

What to Watch for
If you buy bonds directly from a stock broker, be aware of the following:

• The transaction fee charged by the stock broker when you purchase the bond.
• The markup. That is, the broker charges more for a bond than the amount that they have to pay. This amounts to a hidden transaction fee.
• If you do not hold the bond until maturity, the stock broker will charge a second transaction fee to sell the bond.
• Bonds usually pay interest every six months. Be aware of the way that the interest payments are paid. You can either have the payments forwarded to you or you may wish to have the proceeds added to your account.
• Most stock brokers do not publish the current sale price of a bond. About the only way to determine the price of a bond that you wish to sell is to call the broker and inquire. As more people demand online quotes, this situation may improve.

How to Buy
To invest in a bond fund, just follow the steps listed above for investing in any mutual fund. Vanguard has a very low cost index bond fund (check out this fund at www.vanguard.com). The purchase of a bond from a stock broker is usually straightforward. Etrade.com, Scottrade.com, and others sell bonds at much lower fees than full-service brokers.

• Select a stock broker, preferably an online broker that charges low fees and low markups.
• Set up an account with this broker and then log on to their web site.
• Go to the trading section of the site and select corporate bonds.
• Most sites let you select a range of bond ratings, a range of yields, and a range of maturities. Make these selections to get a list of bonds that are of interest. Make your final choice by selecting strong companies that are not likely to default.
• Bonds usually sell in denominations of $1000 each. It may be less expensive to buy several bonds at the same time. Be sure to buy a variety of bonds to reduce your losses in case a company defaults on its bonds.

Where to Buy
Here are some places to look for the best rates:

• www.etrade.com
• www.scottrade.com
• www.investinginbonds.com
• www.bondresources.com

Hedging
There are several ways to reduce your risk. They all entail reducing your average return:

• Buy some stock and sell other stock short. If the market goes up, the buys will tend to make money and if the market falls, the short sales will tend to make money.
• Buy some stock and then purchase a put option on the same stock. (See the discussion above on put options.) If the stock price rises, you will make money on your stock position (less the cost of the put option). If the stock price falls below the strike price of the put option, you put option guarantees that you can sell the stock at the strike price.

Direct Investing

It is possible to buy stock directly through DRIPs (Dividend Reinvestment Plans) and DSPs (Direct Stock Purchase). These plans are offered by many companies to allow the purchase of stock (sometimes at a discount) on a regular basis. Often dividends are automatically reinvested in additional stock. The cost of these plans is typically low. You can check out the details of these plans at the web sites listed below.

Considerations
Direct stock purchase plans have all of the same challenges as the purchase of stocks through a stock broker. However, there are a couple of differences to consider:

• You will have to have a separate account for each stock that you purchase which imposes an extra administrative burden.
• Fees are typically lower than with a stock broker and sometimes stocks can be purchased at a discount.
• This method of investment requires extra discipline over just buying a stock index fund on a regular basis. It is harder to achieve long-term gains by sticking to a simple investment plan.

What to Watch for

• Above all, select companies that you are willing to invest in for a long term.
• It has been my experience that tech stocks are not usually good long-term investments.
• Check out the fees and restrictions imposed by the company.

Where to Buy
Below are some web sites where you can search for companies that offer DRIPs and DSPs.

• www.netstockdirect.com - lists 1600 plans with information about each.
• www.sharebuilder.com - a lot like a stock broker.
• www.buyandhold.com - a stock broker that facilitates a buy-and-hold strategy.

Social Investing

Some are interested in encouraging companies to be socially responsible by buying stocks of companies that support their ideals. I would like to offer a contrarian view. Why not just buy stock in companies that don't support your views? The money that you spend goes to the current owner of the stock, not to the company itself. Further, as a stockholder, you can more effectively bring your viewpoint to the offending company.

Considerations
By limiting the range of stocks that you are willing to buy, you limit your opportunities. Further, your social goals may interfere with your financial goals. I focus my investing on financial goals and exercise my social goals separately. That way, my long-term investing approach is not compromised or confused by other considerations.

Where to Buy
Here are some places to find out more about social investing:

• www.realassets.org/social_investing/ - social investing basics, using screens.
• www.goodmoney.com - scroll down to select forums, lists of stocks.
• www.better-investing.org - all about investment clubs.

Annuities and Life Insurance

Life insurance companies offer a wide variety of packages that combine investing with insurance. They are almost always very expensive (the actual costs are hard to determine) and they invariably lock you in to a situation which may become very uncomfortable as the economy and your situation evolves. If you have young dependents, buy inexpensive term insurance. If you want to invest, avoid expensive life insurance packages. The only exception to this rule applies to those who are very rich who can use life insurance packages to achieve some tax advantages.

Annuities. You can purchase an annuity that gives you a lifetime income. It seems attractive, but the costs are high and the yield on your investment is typically low. In addition, inflation can further erode the purchase power of your annuity. Unless you are in a high tax bracket, annuities are a poor choice.

Summary

Considerations
Here are some considerations in deciding what to do:

• Time. Compound interest can generate enormous wealth over time. To take advantage of this effect, you must employ a consistent strategy for an extended period.
• Money. Some discretionary funds must be available for investing. Invest regularly over time.
• Discipline. "A winner focuses, a loser strays". Select a strategy that you are comfortable with and stick to it.

Concerns
Here are your enemies that you must guard against:

• Financial Advisors. Real experts aren't going to seek you out. Advisors have an agenda (to make money for themselves, build fame, or increase their ego) that rarely works to your advantage. Following the advice of one advisor after another precludes a consistent winning strategy.
• Inflation. Inflation reduces the buying power of your investment. To get ahead, after-tax earnings must exceed inflation.
• Taxes. State and local taxes, estate taxes, sales taxes. The list goes on and on. Taxes is the elephant in the dining room that mutual funds hope you do not notice. The Roth IRA and 401K retirement plans are your best weapon to reduce the tax bite.
• Fees. Transaction fees, front-end loads, back-end loads, annual expenses can take a huge bite out of your earnings. Less noticeable, but more insidious, are markups, kickbacks, and spreads between the bid and asked price. Read the prospectus of any fund. Make sure that the fund offers low annual fees and a low turnover. Use TreasuryDirect to avoid fees when purchasing treasuries.
• FUD, fear, uncertainty, and doubt. Many just succumb to these emotions and put their money under the mattress (or in a savings account). They panic every time that their investments take a hit. The best antidote is to keep a percentage of your money in cash equivalents (CDs, MMFs) and invest the rest regularly in a low-cost index fund. Just invest regularly over time. Do not even look at your account except to fill out your tax forms.

Conclusions
Here is a summary of my investing strategy:

• Eliminate debt, especially unsecured debt.
• Participate in tax-sheltered retirement plans (401Ks, Roth IRAs)
• Invest regularly over a long period of time.
• Invest part of your money in cash equivalents such as short-term bond funds, CDs (Certificates of Deposit) and MMFs (Money Market Funds).
• Invest part of your money in a low-cost index fund, such as one of the Vanguard index Funds
• To reduce risk (but with lower gain), increase the portion of your investment in cash equivalents.
• To increase your gain (but with more risk), purchase a few stocks that have great promise.
• Promptly sell your losers and invest increasing amounts in your winners.
• Pick a conservative strategy and stick with it over an extended period.

Several more aggressive strategies are described in my upcoming presentation in June. You may view this presentation at www.tlwilliams.net, article 0106pInvesting.

References

Books. Here are a few references for those who wish to explore investing further:

• Investing in Mutual Funds. "Common Sense on Mutual Funds" by John Bogle, Wiley 1999. Good insights into index funds, asset allocation, transaction costs, and tax considerations by the founder of Vanguard.
• Valuing Companies. "Valuing Wall Street" by Smithers and Wright, McGraw-Hill 2000. Explains why stocks were extremely overvalued starting in 1998. A cautionary tale.
• Professional Investors. "The Predictors" by Bass, Holt 1999. How professional investors operate. Traders must compete with these experts.
• Stock Market Factors. "The Inefficient Stock Market" by Haugen, Prentice-Hall1 1999. Explains some factors that affect the stock market. Why big, liquid, well-known stocks generally perform better.
• Stock Market Factors. "A Random Walk Down Wall Street" by Malkiel, Norton 1996. Why investing based on factors such as those described in the above book are controversial.
• Investing in Mutual Funds. "4 Easy Steps to Successful Investing" by Pond, Avon 1997. Somewhat simplistic investment advice, typical of many, many books on investing.
• Attitude. "Millionaire Mind" by T. J. Stanley, Andrews McMeel Publishing 2000. Stanley interviews hundreds of millionaires to uncover what differentiates millionaires from the pack.

Summary of Links

Here are a few web sites (in alphabetical order) that I found of value:

• www.aaii.org - American Association of Individual Investors. An organization that helps individual investors. They have local clubs and lots of useful literature.
• www.bankrate.com - finds the best rates for CDs (Certificates of Deposit) and MMFs (Money Market Funds).
• www.better-investing.org - all about investment clubs.
• www.bondresources.com - lots of info on bonds.
• www.buyandhold.com - a stock broker that facilitates a buy-and-hold strategy.
• www.fool.com - lots of advice on investing.
• www.gomez.com - rates companies including stock brokers.
• www.goodmoney.com - scroll down to select forums, lists of stocks.
• www.hoovers.com - analysis of industry sectors.
• www.hulbertdigest.com - Rates financial newsletters.
• www.investinginbonds.com - advice from the Bond Market Association.
• www.money.com - lists 50 top financial sites.
• www.moneycentral.msn.com - select investor, quotes, options to get detailed information on options. Powerful stock screening tool.
• www.morningstar.com - rates mutual funds, ETFs (Exchange Traded Funds), and stocks.
• www.netstockdirect.com - lists 1600 plans with information about each.
• www.quote.com - investment tools, message boards, stock and mutual fund information.
• www.quote.yahoo.com - lots of investing info.
• www.ragingbull.com - message boards, financial news, quotes.
• www.realassets.org/social_investing/ - social investing basics, using screens.
• www.rothira.com - a very comprehensive site on the Roth IRA
• www.schwab.com - good info on investing, including information on the Roth IRA
• www.senate.gov/~finance - official info on the Roth IRA.
• www.sharebuilder.com - a lot like a stock broker.
• www.valueline.com - lots of stock information. The Hulbert Digest rates their Portfolio I as one of the few portfolios that outperforms the S&P 500 stock index over an extended period. They offer an introductory 13 week subscription for $55.
• zacks.com - stock analysis and stock ratings.

Here are a few companies (in alphabetical order) that offer investing services:

• www.etrade.com - a low-cost stock broker
• www.scottrade.com - a low-cost stock broker that sells mutual funds, stocks, bonds, etc.
• www.treasurydirect.gov - a very low-cost way to buy treasury bills, treasury notes and treasury bonds. Never buy treasuries from a stock broker.
• www.vanguard.com - offers low-cost mutual funds.
• www.wsj.com - lots of investing advice.

Glossary of Investment Terms

APY - Annual Percent Yield

The total amount of interest paid per year divided by the amount of the loan.

Callable

The issuer of a callable bond or callable CD may pay off the debt prematurely, cheating you out of the higher interest rate that you would otherwise receive.

Cash equivalents

CDs or MMFs.

CD - Certificate of Deposit

A CD may be purchased from banks and other institutions. The bank repays the CD with interest on a specified date in the future.

Equity

Stocks or other ownership in a company.

FDIC - Federal Deposit Insurance Corporation

A federal agency that guarantees all deposits up to $100,000 in any member institution.

Traditional IRA

A tax-sheltered account that you can open with a stock broker or other financial institution. Your contributions to an IRA are tax deductible.

MMF - Money Market Fund

A savings account that pays daily interest. The interest rate varies depending upon the current interest rates. If the institution is a member of the FDIC, deposits are insured up to $100,000.

Portfolio

A collection of stocks or other securities (a portfolio may be owned by an individual, or it may be a list suggested by a financial adviser).

Roth IRA

A tax-sheltered account that you can open with a broker or other financial institution. If you qualify, you can contribute up to $2000/year ($3000 in 2002 or $3500 in 2002 if you are over 50). Qualified distributions are tax free including all of the earnings and all of your contributions! There is no mandatory withdrawals during your lifetime and an Roth IRA can be passed on to your beneficiaries who can also make tax free withdrawals.

Treasuries

IOUs issued by the US Government. Treasuries are very safe, and the interest paid by treasuries is not subject to state income taxes.

Uptick

A stock trade at a price that is higher than the previous price.

This presentation may be viewed at www.tlwilliams.net.
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Last update: July 31, 2001