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Subject: The Investment FAQ (part 14 of 20)

This article was archived around: 21 May 2006 04:23:40 GMT

All FAQs in Directory: investment-faq/general
All FAQs posted in: misc.invest.misc, misc.invest.stocks, misc.invest.technical, misc.invest.options
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Archive-name: investment-faq/general/part14 Version: $Id: part14,v 1.61 2003/03/17 02:44:30 lott Exp lott $ Compiler: Christopher Lott
The Investment FAQ is a collection of frequently asked questions and answers about investments and personal finance. This is a plain-text version of The Investment FAQ, part 14 of 20. The web site always has the latest version, including in-line links. Please browse http://invest-faq.com/ Terms of Use The following terms and conditions apply to the plain-text version of The Investment FAQ that is posted regularly to various newsgroups. Different terms and conditions apply to documents on The Investment FAQ web site. The Investment FAQ is copyright 2003 by Christopher Lott, and is protected by copyright as a collective work and/or compilation, pursuant to U.S. copyright laws, international conventions, and other copyright laws. The contents of The Investment FAQ are intended for personal use, not for sale or other commercial redistribution. The plain-text version of The Investment FAQ may be copied, stored, made available on web sites, or distributed on electronic media provided the following conditions are met: + The URL of The Investment FAQ home page is displayed prominently. + No fees or compensation are charged for this information, excluding charges for the media used to distribute it. + No advertisements appear on the same web page as this material. + Proper attribution is given to the authors of individual articles. + This copyright notice is included intact. Disclaimers Neither the compiler of nor contributors to The Investment FAQ make any express or implied warranties (including, without limitation, any warranty of merchantability or fitness for a particular purpose or use) regarding the information supplied. The Investment FAQ is provided to the user "as is". Neither the compiler nor contributors warrant that The Investment FAQ will be error free. Neither the compiler nor contributors will be liable to any user or anyone else for any inaccuracy, error or omission, regardless of cause, in The Investment FAQ or for any damages (whether direct or indirect, consequential, punitive or exemplary) resulting therefrom. Rules, regulations, laws, conditions, rates, and such information discussed in this FAQ all change quite rapidly. Information given here was current at the time of writing but is almost guaranteed to be out of date by the time you read it. Mention of a product does not constitute an endorsement. Answers to questions sometimes rely on information given in other answers. Readers outside the USA can reach US-800 telephone numbers, for a charge, using a service such as MCI's Call USA. All prices are listed in US dollars unless otherwise specified. Please send comments and new submissions to the compiler. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Stocks - Researching the Value of Old Certificates Last-Revised: 27 Feb 2000 Contributed-By: Ellen Laing (elaing at asu.edu), Jeff Kiss, Chris Lott ( contact me ) If you've found some old stock certificates in your attic, and the company is no longer traded on any exchange, you will need to get help in determining the value of the shares and/or redeeming the shares. The basic information you need is the name of the company, the date the shares were issued, and the state (or province in the case of Canadian companies) in which the company was incorporated (all items should all be on the certificate). The most basic question to resolve is whether the company exists still. Of course it might have changed names, been purchased by another company, etc. Anyhow, a good first attempt at answering this question is to call or write the transfer agent that is listed on the front of each certificate. A transfer agent handles transfers of stock certificates and should be able to advise you on their value. If the transfer agent no longer exists or cannot help you, you might try to contact the company directly. The stock certificates should show the state where the company was incorporated. Contact the Secretary of State in that state, and ask for the Business Corporations Section. They should be able to give you a history of the company (when it began, merged, dissolved, went bankrupt, etc.). From there you can contact the existing company (if there is one) to find out the value of your stocks. Here are some additional resources for researching old certificates. * You might want to start gathering information on old securities from Bob Johnson's web site, Goldsheet. http://www.goldsheetlinks.com/obsolete.htm * Scripophily.com operates an old company research service. They will research a company for a $39.95 fee, but if they do not find any information, there is no charge. http://www.oldcompany.com/ * Old certificates may not represent ownership in any company, but they can still have considerable value for collectors. See the collection of old stock and bond certificates at Scripophily.com, which is the Internet's largest buyer and seller of old stock and bond certificates. http://www.scripophily.com * You can consult the Robert D. Fisher Manuals of Valuable and Worthless Securities. This is published by the R.M. Smythe company, and should be available for use in a good reference library. For expert assistance, contact R.M. Smythe in New York. They specialize in researching, auctioning, buying, and selling historic paper, and will find out if your stock has any value. But of course this is not a free service; they charge $75 per issue. Write them at 26 Broadway, Suite 271, New York, NY, 10004-1701 or visit their web page. http://www.rm-smythe.com --------------------Check http://invest-faq.com/ for updates------------------ Subject: Stocks - Reverse Mergers Last-Revised: 14 July 2002 Contributed-By: The SmallCap Digest (www.smallcapdigest.net) A reverse merger is a simplified, fast-track method by which a private company can become a public company. A reverse merger occurs when a public company that has no business and usually limited assets acquires a private company with a viable business. The private company "reverse merges" into the already public company, which now becomes an entirely new operating entity and generally changes name to reflect the newly merged company's business. Reverse mergers are also commonly referred to as reverse takeovers, or RTO's. Going public (in any way) is attractive to companies because after going public, the company can use its stock as currency to finance acquisitions and attract quality management; capital is easier to raise as investors now have a clearly defined exit strategy; and insiders can create significant wealth if they perform. The reverse merger is an alternative to the traditional IPO (initial public offering) as a method for going public. Many people don't realize there are numerous other ways for private company to become publicly traded outside of the IPO. One widely used method is the "Reverse Merger". The reverse-merger method for going public is more prevalent than many investors realize. One study estimates that 53% of all companies obtaining public listings in 1996 did so through the "Reverse Merger". The same study concluded about 30% of newly publicly listed companies got there through Reverse Mergers in 1999. Percentages have recently dropped because Wall Street Investment Banking firms have had a huge appetite for IPOs in the late 90s. This led to many marginal companies receiving enormous financial windfalls. In a reverse merger, the original public company, commonly known as a "shell company," has value because of its publicly traded status. The shell company is generally recapitalized and issues shares to acquire the private company, giving shareholders and management of the private company majority control of the newly formed public company. The RTO (reverse take over) method for going public has numerous benefits for the private company when compared to the traditional IPO: * Initial costs are much lower and excessive investment banking fees are avoided. * The time frame for becoming public is considerably shorter. There are also several disadvantages of going public through the RTO as compared to an IPO: * There is no capital raised in conjunction with going public. * There is limited sponsorship for the stock. * There is no high powered Wall Street Investment Banking relationship. * The stock generally trades on a low exposure exchange. Many highly successful companies have become public through the RTO process. However, there some important negatives investors should be aware of. There is a much higher failure rate amongst RTO companies versus the traditional IPO. Much smaller and less successful companies are able to become public through the RTO, and many are badly undercapitalized. Often these stocks trade very inefficiently in the absence of any sponsorship or following. There is a cottage industry of merchant bankers and entrepreneurs who specialize in orchestrating reverse mergers. Unfortunately, there are no barriers to entry in this field. Therefore, scams are common place. Through various methods, scam artists manage to accumulate large positions in the free trading shares of the shell company. An RTO is consummated with a marginal private company, and the scam artists put together a massive publicity campaign designed to create activity in the stock. Unrealistic promises and absurd claims of corporate performance find their way to the public. The enhanced trading volume allows the scam artist to dump his shares on the unsuspecting public, most of whom eventually lose their money once the newly formed public company fails. This scam is commonly known as a "Pump and Dump". Alternatively there a hundreds of examples of highly successful companies which have yielded millions in profits for investors that have gone public through the RTO. Many of these companies deserve exposure to investors. Initial valuations can be reasonable, providing excellent opportunities for individual investors to accumulate positions ahead of Wall Street institutional money. Here are some high-profile and successful RTOs: * Armand Hammer, world renowned oil magnate and industrialist, is generally credited with having invented the "Reverse Merger". In the 1950s, Hammer invested in a shell company into which he merged multi decade winner Occidental Petroleum. * In 1970 Ted Turner completed a reverse merger with Rice Broadcasting, which went on to become Turner Broadcasting. * In 1996, Muriel Siebert, renown as the first woman member of the New York Stock Exchange, took her brokerage firm public by reverse merging with J. Michaels, a defunct Brooklyn Furniture company. * One of the Dot Com fallen Angels, Rare Medium (RRRR), merged with a lackluster refrigeration company and changed the entire business. This was a $2 stock in 1998 which found its way over $90 in 2000. * Acclaim Entertainment (AKLM) merged into non operating Tele-Communications Inc in 1994. For more insights into finance and the world of small-cap stocks, please visit the SmallCap Network at: http://www.smallcapnetwork.net --------------------Check http://invest-faq.com/ for updates------------------ Subject: Stocks - Shareholder Rights Plan Last-Revised: 3 Jun 1997 Contributed-By: Chris Lott ( contact me ), Art Kamlet (artkamlet at aol.com) A shareholder rights plan basically states the rights of a shareholder in a corporation. These plans are generally proposed by management and approved by the shareholders. Shareholder rights are acquired when the shares are purchased, and transferred when the shares are sold. All this is pretty straightforward. The interesting question is why such plans are proposed by management. This is probably best answered with an example. One example is rights to buy additional shares at a low price, rights that first become exercisable when a person or group aquires 20% or more of the common shares of the company. In other words, if a hostile takover bid is launched against the company, existing shareholders get to buy shares cheaply. This serves to dilute the shares held by the unfriendly parties, and makes a takeover just that much more difficult and expensive. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Stocks - Splits Last-Revised: 26 Oct 1997 Contributed-By: Aaron Schindler, E. Green, Art Kamlet (artkamlet at aol.com) Ordinary splits occur when a publicly held company distributes more stock to holders of existing stock. A stock split, say 2-for-1, is when a company simply issues one additional share for every one outstanding. After the split, there will be two shares for every one pre-split share. (So it is called a "2-for-1 split.") If the stock was at $50 per share, after the split, each share is worth $25, because the company's net assets didn't increase, only the number of outstanding shares. Sometimes an ordinary split is referred to as a percent. A 2:1 split is a 100% stock split (or 100% stock dividend). A 50% split would be a 3:2 split (or 50% stock dividend). Each stock holder will get 1 more share of stock for every 2 shares owned. Reverse splits occur when a company wants to raise the price of their stock, so it no longer looks like a "penny stock" but looks more like a self-respecting stock. Or they might want to conduct a massive reverse split to eliminate small holders. If a $1 stock is split 1:10 the new shares will be worth $10. Holders will have to trade in their 10 Old Shares to receive 1 New Share. Theoretically a stock split is a non-event. The fraction of the company that each share represents is reduced, but each stockholder is given enough shares so that his or her total fraction of the company owned remains the same. On the day of the split, the value of the stock is also adjusted so that the total capitalization of the company remains the same. In practice, an ordinary split often drives the new price per share up, as more of the public is attracted by the lower price. A company might split when it feels its per-share price has risen beyond what an individual investor is willing to pay, particularly since they are usually bought and sold in 100's. They may wish to attract individuals to stabilize the price, as institutional investors buy and sell more often than individuals. After a split, shareholders will need to recalculate their cost basis for the newly split shares. (Actually, this need not be done until the shares are sold, but in the interest of good record-keeping etc., this seems like a good place to discuss the issue.) Recalculating the cost basis is usually trivial. The shareholder's cost has not changed at all; it's the same amount of money paid for the original block of shares, including commissions. The new cost per share is simply the total cost divided by the new share count. Recalculating the cost basis only becomes complicated when a fractional number of shares is involved. For example, an investor who had 33 shares would have 49.5 shares following a 3:2 split. The short answer for calculating cost basis when a fractional share enters the picture is .. it depends. If the shares are in some sort of dividend reinvestment plan, the plan will credit the account holder with 49 1/2 shares. Fractional shares are very common in these sort of accounts. But if not, the company could do any of the following: * Issue fractional certificates (extremely unusual). * Round up, and give the shareholder 50 shares (rare). * Round down, and give the shareholder 49 shares. This happens among penny stocks from time to time. * Sell the fractional share and send the shareholder a check for its value (perhaps taking a small fee, perhaps not). This is far and away the most common method for handling fractional shares following a split. Accounting for the cost basis of the first three methods is trivial. However, accounting for the most common case, the last one, is the most complicated of the options. Let's continue with the example from above: 33 shares that split 3:2. The original 33 shares and the post-split 49.5 shares have exactly the same cost basis. To make it easy, assume the 33 shares cost a total of $495. So the 49.5 post-split shares have a cost basis of $10 per share, or $5 for the half share that is sold. The cash received "in lieu of" the fractional share is the sales price of that fractional share. Say the company sent along $8 for it. The capital gain (long term or short, depending on the holding period of the original shares) is $8 - $5 = $3. To account for this properly, the following would be required. * File a schedule D listing 0.5 shares XYZ Corp and use the original acquisition date and date it was converted to cash and sold; usually the distribution date of the split but the company will tell you. Use $5 as cost basis and $8 as sales price and voila, there is a $3 gain to declare. * Reduce the cost basis of the remaining 49 shares by the cost of the fractional share sold. ($5) * The cost basis of the $49 shares becomes $495 - $5 = $490 (still $10 per share). Hopefully the preceding discussion will help with recalculating the cost basis of shares following a split. Now we'll go into some of the mechanics of splitting stock. The average investor doesn't have to care about any of this, because the exchanges have splits covered - there is absolutely no danger of an investor missing out on the split shares, no matter when he or she buys shares that will split. The rest of this article is meant for those people who want to understand every detail. Often a split is announced long before the effective date of the split, along with the "record date." Shareholders of record on the record date will receive the split shares on the effective date (distribution date). Sometimes the split stock begins trading as "when issued" on or about the record date. The newspaper listing will show both the pre- split stock as well as the when-issued split stock with the suffix "wi." (Stock dividends of 10% or less will generally not trade wi.) Some companies distribute split shares just before the market opens on the distribution date, and others distribute at close of business that day, so there's not one single rule about the date on which the price is adjusted. It can be the day of distribution if done before the market opens or could be the next day. For people who really are interested, here is what happens when a person buys between the day after the T-3 date to be holder of record, and the distribution date. (Aside: after a stock is traded on some date "T", the trade takes 3 days to settle. So to become a share holder of record on a certain date, you have to trade (i.e., buy) the shares 3 days before that date. That's what the shorthand notation "T-3" above means.) Remember that the holder of record on the record date will get the stock dividend. And of course the price doesn't get adjusted until the distribution date. So let's cover the case where a trade occurs in between these dates. 1. The buyer pays the pre-split price, and the trade has a "Due Bill" atttached. The due bill means the buyer is due the split shares when they are issued. Sometimes the buyer's confirmation slip will have "due bill" information on it. 2. In theory, on the distribution date, the split shares go to the holder of record, but that person has sold the shares to the buyer, and a due bill is attached to the sale. 3. So in theory, on the distribution date, the company delivers the split shares to the holder of record. But because of the due bill, the seller's broker delivers on the due bill, and delivers the seller's newly received split shares to the buyer's broker, who ultimately delivers them to the buyer. The fingers never left the hand, the hand is quicker than the eye, and magic happens. In practice no one really sees any of this take place. In some cases, the company may request that its stock be traded at the post-split price during this interval, or the market itself might decide to list the post-split stock for trading. In such cases, the due bills themselves are traded, and are called "when issued" or for spinoff stock, "when distributed" stock. The stock symbol in the financial columns will show this with a "-wi" or "-wd" suffix. But in most cases it isn't worthwhile to do this. Here are two sites that offer information about past, current, and upcoming stock splits. * http://www.street-watch.com * http://www.e-analytics.com/splitd.htm --------------------Check http://invest-faq.com/ for updates------------------ Subject: Stocks - Tracking Stock Last-Revised: 21 Jan 2000 Contributed-By: Chris Lott ( contact me ) A tracking stock is a special type of stock issued by a publicly held company to track the value of one segment of that company. By issuing a tracking stock, the different segments of the company can be valued differently by investors. For example, if an old-economy company trading at a P/E of about 10 happens to own a wildly growing internet business, the company might issue a tracking stock so the market could value the new business separately from the old one (hopefully at a P/E of at least 100). Those high-flying stocks are awfully useful for making employees rich, and that never hurts recruiting. Here's a real-world example. The stock for Hughes Electronics (ticker symbol GMH) is a tracking stock. This business is just the satellite etc. division of General Motors (ticker symbol GM). A company has many good reasons to issue a tracking stock for one of its subsidiaries (as opposed to spinning it off to shareholders). First, the company gets to keep control over the subsidiary (although they don't get all the profit). Second, they might be able to lower their costs of obtaining capital by getting a better credit rating. Third, the businesses can all share marketing, administrative support functions, a headquarters, etc. Finally, and most importantly, if the tracking stock shoots up, the parent company can make acquisitions and pay in stock instead of cash. When a tracking stock is issued, the company can choose to sell it to the markets (i.e., via an initial public offering or IPO) or to distribute new shares to existing shareholders. Either way, the newly tracked business segment gets a longer leash, but can still run back to the parent corporation if times get tough. All is not perfect in this world. Tracking stock is a second-class stock, primarily because holders usually have no voting rights. The following resources offer more information about tracking stocks. * The Motley Fool wrote about tracking stocks on 7 September 1999. http://www.fool.com/specials/1999/sp990907tradingstocks.htm --------------------Check http://invest-faq.com/ for updates------------------ Subject: Stocks - Unit Investment Trusts and SPDRs Last-Revised: 13 Jun 2000 Contributed-By: Chris Lott ( contact me ) A unit investment trust is a collection of securities (usually stocks or bonds) all bundled together in a special vehicle that happens to be a trust. Investors can buy tiny little pieces of the trust ("units"). So although a UIT looks a bit like a mutual fund in that it bundles things together and sells shares, the units are listed on an exchange and trade just like stocks. The most well-known example is the Standard & Poors Depositary Receipt (SPDR). These are also known as exchange-traded funds (ETFs). Below is a list of some of the common UITs/ETFs out there. All of these are created by large financial institutions, and usually (but not always) charge modest annual expenses to investors, commonly 0.2% (20 basis points) or less. (Any commissions paid to buy or sell them are due to the broker, of course.) * UIT that mimics the S&P 500. Named a Standard & Poors Depositary Receipt (SPDR), commonly called a Spider or Spyder. Trades as SPY on the AmEx and has a value of approximately 10% of the S&P 500 index. As of this writing, the trust has nearly $18 billion. * UIT that mimics the NASDAQ 100 Index, commonly called a Qube. Trades as QQQ on the AmEx and has a value of approximately 2.5% of the NASDAQ 100 index. As of this writing, the trust has about $12 billion. * UIT that mimics the Dow Jones Industrial Average. Named the Dow Industrial Average Model New Depositary Shares, commonly called DIAMONDS. Trades as DIA on the AmEx and has a value of approximately 1% of the DJIA. * Select sector SPDRs - these slice and dice the S&P 500 in various ways, such as technology companies (symbol XLK), utilities (XLU), etc. All are traded on the AmEx. A UIT that mimics some index is in many ways directly comparable to an index mutual fund. Like an index fund, it's diversified and always fully invested. Like a stock, you can buy or sell a UIT at any time (not just at the end of the trading day like a fund). And for the serious traders out there, you can short many UITs on a downtick, which you cannot do with stocks. The following resources offer more information about UITs and SPDRs. * The AmEx, where these securities trade, has some information. Look in their "ETF" category. http://www.amex.com/ Here is a direct link to their list of frequently asked questions about ETFs: http://www.amex.com/etf/FAQ/et_etffaq.htm --------------------Check http://invest-faq.com/ for updates------------------ Subject: Stocks - Warrants Last-Revised: 3 Jun 1997 Contributed-By: Art Kamlet (artkamlet at aol.com) There are many meanings to the word warrant. The marshal can show up on your doorstep with a warrant for your arrest. Many army helicopter pilots are warrant officers, who have received a warrant from the president of the US to serve in the Army of the United States. The State of California ran out of money earlier this year [1992] and issued things that looked a lot like checks, but had no promise to pay behind them. If I did that I could be arrested for writing a bad check. When the State of California did it, they called these thingies "warrants" and got away with it. And a warrant is also a financial instrument which was issued with certain conditions. The issuer of that warrant sets those conditions. Sometimes the warrant and common or preferred convertible stock are issued by a startup company bundled together as "units" and at some later date the units will split into warrants and stock. This is a common financing method for some startup companies. This is the "warrant" most readers of the misc.invest newsgroup ask about. As an example of a "condition," there may be an exchange privilege which lets you exchange 1 warrant plus $25 in cash (or even no cash at all) for 100 shares of common stock in the corporation, any time after some fixed date and before some other designated date. (And often the issuer can extend the "expiration date.") So there are some similarities between warrants and call options for common stock. Both allow holders to exercise the warrant/option before an expiration date, for a certain number of shares. But the option is issued by independent parties, such as a member of the Chicago Board Options Exchange, while the warrant is issued and guaranteed by the corporate issuer itself. The lifetime of a warrant is often measured in years, while the lifetime of a call option is months. Sometimes the issuer will try to establish a market for the warrant, and even try to register it with a listed exchange. The price can then be obtained from any broker. Other times the warrant will be privately held, or not registered with an exchange, and the price is less obvious, as is true with non-listed stocks. For more information about stock warrants, you might visit http://www.stockwarrants.com/ . --------------------Check http://invest-faq.com/ for updates------------------ Subject: Strategy - Dogs of the Dow Last-Revised: 10 Jul 1998 Contributed-By: Raymond Sammak, Chris Lott ( contact me ) Ralph Merritt This article discusses an investment strategy commonly called "Dogs of the Dow." The Dow Jones Industrials represent an elite club of thirty titans of industry such as Exxon, IBM, ATT, DuPont, Philip Morris, and Proctor & Gamble. From time to time, some companies are dropped from the Dow as new ones are added. By investing in stocks from this exclusive list, you know you're buying quality companies. The idea behind the "Dogs of the Dow" strategy is to buy those DJI companies with the lowest P/E ratios and highest dividend yields. By doing so, you're selecting those Dow stocks that are cheapest relative to their peers. So here is the Dogs of the Dow strategy in a nutshell: at the beginning of the year, buy equal dollar amounts of the 10 DJI stocks with the highest dividend yields. Hold these companies exactly one year. At the end of the year, adjust the portfolio to have just the current "dogs of the Dow." What you're doing is buying good companies when they're temporarily out of favor and their stock prices are low. Hopefully, you'll be selling them after they've rebounded. Then you simply buy the next batch of Dow laggards. Why does this work? The basic theory is that the 30 Dow Jones Industrial stocks represent well known, mature companies that have strong balance sheets with sufficient financial strength to ride out rough times. Some people use 5 companies, some use 10, some just one. You might call this a contrarian's favorite strategy. A 12/13/93 Barron's article discussed "The Dogs of the Dow." Barron's claimed that using this strategy with the top 10 highest yielding Dow stocks returned 28% for 1993, which was 2x the overall DJIA, 2x the NASDAQ, 4x the S&P500 and better than 97% of all general US equity funds (including Magellan). In the last 20 years, this strategy has lost money in only 3 years, the worst a 7.6% drop in 1990. In the last 10 years, it has returned 18.26%. Merrill Lynch offers a "Select 10 Portfolio" unit trust, which invests in the top 10 yielding Dow stocks. Smith Barney/Shearson, Prudential Securities, Paine Webber, and Dean Witter also offer it. It has a 1% load and a 1.75% annual management fee, and they are automatically liquidated each year (cash or rollover into next year, but capital gains are realized/taxed). Minimum investment is $1,000. A listing of the current "DOGS of the DOW" is updated every day on the "Daily Dow" page that is part of the Motley Fool web site: http://www.fool.com/DDow/DDow.htm --------------------Check http://invest-faq.com/ for updates------------------ Subject: Strategy - Dollar Cost and Value Averaging Last-Revised: 11 Dec 1992 Contributed-By: Maurice Suhre Dollar-cost averaging is a strategy in which a person invests a fixed dollar amount on a regular basis, usually monthly purchase of shares in a mutual fund. When the fund's price declines, the investor receives slightly more shares for the fixed investment amount, and slightly fewer when the share price is up. It turns out that this strategy results in lowering the average cost slightly, assuming the fund fluctuates up and down. Value averaging is a strategy in which a person adjusts the amount invested, up or down, to meet a prescribed target. An example should clarify: Suppose you are going to invest $200 per month in a mutual fund, and at the end of the first month, thanks to a decline in the fund's value, your $200 has shrunk to $190. Then you add in $210 the next month, bringing the value to $400 (2*$200). Similarly, if the fund is worth $430 at the end of the second month, you only put in $170 to bring it up to the $600 target. What happens is that compared to dollar cost averaging, you put in more when prices are down, and less when prices are up. Dollar-cost averaging takes advantage of the non-linearity of the 1/x curve (for those of you who are more mathematically inclined). Value averaging just goes in a little deeper when the value is down (which implies that prices are down) and in a little less when value is up. An article in the American Association of Individual Investors showed via computer simulation that value averaging would outperform dollar- cost averaging about 95% of the time. "Outperform" is a rather vague term. As best as I remember, whatever the percentage gain of dollar- cost averaging versus buying 100% initially, value averaging would produce another 2 percent or so. Warning: Neither approach will bail you out of a declining market with all of your monies intact, nor get you fully invested in the earliest stage of a bull market. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Strategy - Hedging Last-Revised: 12 Dec 1996 Contributed-By: Norbert Schlenker Hedging is a way of reducing some of the risk involved in holding an investment. There are many different risks against which one can hedge and many different methods of hedging. When someone mentions hedging, think of insurance. A hedge is just a way of insuring an investment against risk. Consider a simple (perhaps the simplest) case. Much of the risk in holding any particular stock is market risk; i.e. if the market falls sharply, chances are that any particular stock will fall too. So if you own a stock with good prospects but you think the stock market in general is overpriced, you may be well advised to hedge your position. There are many ways of hedging against market risk. The simplest, but most expensive method, is to buy a put option for the stock you own. (It's most expensive because you're buying insurance not only against market risk but against the risk of the specific security as well.) You can buy a put option on the market (like an OEX put) which will cover general market declines. You can hedge by selling financial futures (e.g. the S&P 500 futures). In my opinion, the best (and cheapest) hedge is to sell short the stock of a competitor to the company whose stock you hold. For example, if you like Microsoft and think they will eat Borland's lunch, buy MSFT and short BORL. No matter which way the market as a whole goes, the offsetting positions hedge away the market risk. You make money as long as you're right about the relative competitive positions of the two companies, and it doesn't matter whether the market zooms or crashes. If you're trying to hedge an entire portfolio, futures are probably the cheapest way to do so. But keep in mind the following points. * The efficiency of the hedge is strongly dependent on your estimate of the correlation between your high-beta portfolio and the broad market index. * If the market goes up, you may need to advance more margin to cover your short position, and will not be able to use your stocks to cover the margin calls. * If the market moves up, you will not participate in the rally, because by intention, you've set up your futures position as a complete hedge. You might also consider the purchase out-of-the-money put LEAPS on the OEX, as way of setting up a hedge against major market drops. Another technique would be to sell covered calls on your stocks (assuming they have options). You won't be completely covered against major market drops, but will have some protection, and some possibility of participating in a rally (assuming you can "roll up" for a credit). --------------------Check http://invest-faq.com/ for updates------------------ Subject: Strategy - Buying on Margin Last-Revised: 19 Dec 1996 Contributed-By: Andrew Aiken (aiken at indy.net) I have used margin debt to leverage my returns several times this year, with successful results. At no time did my margin debt exceed 25% of my net account equity. This is my personal comfort level, but yours may be higher or lower depending on your risk tolerance, your portfolio return vs. the interest rate on your debt, and your degree of bullishness about your investments and general market conditions. If I am using margin, I have tighter stop-loss limits. How much tighter is determined by the amount of debt, the interest rate on the debt, and the historical volatility of the stock. Here are a few more suggestions: * Never use margin unless you follow the market and your investments on a daily basis, and you consider yourself well-informed about the factors that could influence your asset value. * Do not use margin debt as a long-term investment strategy. * Have a clear idea of how long you plan to maintain the margin debt. * Always have cash reserves outside of your brokerage account that exceed your margin debt, so that you could pay off the debt at any time, if necessary. * If you maintain the debt for more that a few weeks, contribute cash to your account on a monthly basis, so that you are paying off the debt the same way one would pay off a credit card. * Start with a small amount of debt relative to your account (5 - 10%), and use this as a benchmark for future actions. * Have a stop-loss limit and a target sell price for all of the investments in your leveraged account. Stick with your targets! * Do not let the chance of a margin call exceed 5%. The assessment of this probability should be made and adjusted regularly. * Learn the techniques that the professional hedge fund managers use in maintaining leveraged investments. This information is available for free at the library. If this seems like too much work, then do not use margin. These are just my opinions as an individual investor. Whether or not you decide to use margin is a personal decision. I consider margin debt to be a tactic rather than a strategy. It is not suitable for a long-term, buy-and-hold investor. The tactic has worked for me so far, but I know several bright individuals who have been burned by it. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Strategy - Writing Put Options To Acquire Stock Last-Revised: 22 Aug 2000 Contributed-By: Michael Beyranevand (mlb2 at Bryant.edu) Is there a stock that you would like to purchase at a cheaper price than its current quote? Would you be interested in receiving premiums months before you have to purchase the stock? If these propositions sound attractive to you, then writing puts to acquire stock is a strategy you should consider in the future. This article explains the entire procedure, as well as the associated risks and rewards. When you write a put option you are giving the buyer of that option the right (but not the obligation) to sell their stock to you at a predetermined price at any time until a certain date. For giving the buyer this luxury, he or she will in turn pay you a premium at the time you write (i.e., sell) the option. If the buyer decides to exercise the option then you must purchase the stock; conversely, if the option expires unexercised then you still have the premium as your profit. Let's work through an example. Let's say that you are bullish on Ebay.com for the long-term with the current value of the stock at $52. One option would be to fork over $5,200 and purchase 100 shares of the stock and just hold on to them. Another option however would be to write a Jan 01 45 put option, which is trading at about $8.50. This means that at anytime between now and the third Saturday in January, you might have to purchase 100 shares of E-Bay at $45 a share. For doing this you are compensated $850 upfront (100 shares times $8.50). Come January, one of two situations will occur. If the option has not been exercised by then, your obligation is over and you have a profit of $850. If the option is exercised (if you are put, to use the jargon), you would pay $4,500 to own the 100 shares of the stock. After taking into consideration that you were already paid a premium of $850, the true cost for the 100 shares of E-Bay is only $3,650 or $36.50 a share. You would in essence be purchasing the shares at a 30% discount to what you would have normally paid had you just bought the 100 shares at the market price. Doesn't it seem too good to be true? You end up with either free money or buying the stock at a discount. Well, there are some risks involved, of course. There are two significant risks in implementing this options strategy. These situations occur if the stock shoots up or comes way down. No matter how high the stock price goes up, the initial profits are limited to just the premium received. So the upside potential is very much limited in that sense. One way to combat this is to make sure that you will be receiving a high enough premium to still be satisfied if the stock soars before you purchase it. The second risk is the situation if the stock plummets. Reversing your position (i.e., buying back the option) is one possibility but an expensive one at that. Your only other choice is to follow through with your obligation: you purchase the stock at a premium to the current market price. This loss can be offset by the fact that you were bullish on the stock for the long run and you picked a price that you were comfortable paying for the stock. If your intuition was correct than it's only a matter of time before the stock rebounds to the price you paid or beyond. But if something awful like accounting irregularities are announced, you might incur significant losses. This strategy is ideal for volatile stocks that you are interested in holding for 5 or more years. They pay higher premiums because of their volatility, and having a long-term horizon will minimize your risks. Companies like Yahoo, E-Bay, AOL, EMC, Intel and Oracle would be ideal for writing puts on. Finally, please note that this strategy is not for everyone, and does not guarantee anything. Speak with your broker to learn more about writing puts and especially to learn if this strategy would fit with your investment goals. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Strategy - Socially Responsible Investing Last-Revised: 23 Mar 2001 Contributed-By: Chris Lott ( contact me ), Ritchie Lowry (goodmoney1 at aol.com), Reid Cooper (reid_cooper at hotmail.com) Investors who pursue a strategy of socially responsible investing (SRI) are making sure that their capital is used in a manner that aligns with their personal ethical values--taking responsibility for what their money is doing to the world around them. There are many different definitions of what it means for an investment to be socially responsible, but basically the strategy is to avoid companies that damage the environment (either by treating nature or people poorly), and to favor companies that provide positive goods and services. SRI is not in any way a new idea. Adam Smith himself was concerned about the issue, and the anti-trust and 19th century child labor debates hinged on the same basic issues. One of the simplest examples of a socially responsible investment is a mutual fund that avoids so-called "sin" investments, namely companies that are involved with liquor, tobacco, or gambling. However, the term is sometimes applied to banks and credit unions based on their lending practices, etc. Does it work? This is a multi-faceted question. If the question is whether a strategy of SRI achieves a good return on investment, the answer seems to be that it does (see below for more details). If the question is whether companies that are shunned by a SRI strategy have difficulty in raising capital in the markets, I think the answer is no. At least at the present, there are enough investors who pursue returns without worrying about issues like a company's policies. However, presumably investors are sleeping better at night knowing that they have made a statement, however small, about their beliefs, and that factor should not be neglected. The following list of frequently asked questions was contributed by, and is copyright by, Dr. Ritchie Lowry, maintainer of the GoodMoney site (URL at end of this article). 1. What is SRI? In one sense, SRI is just like traditional investing. Socially concerned investors pursue the same economic goals as all investors: capital gains, higher income and/or preservation of capital for future needs. However, socially concerned investors want one additional thing. They don't want their investments going for things that cause harm to the social or physical environments, and they do want their investments to support needed and life-supportive goods and services. 2. What's the history of the movement? The idea of combining social with financial judgments in the investment process is not really that new. The oldest social screen around is the sin screen: no tobacco, liquor or gambling investments. This screen has been used for over a hundred years by universities and churches. However, the current movement really began during the Vietnam War when increasing numbers of investors did not want their money going to support that war. After the war, a number of corporate horror stories (including Hooker Chemicals and the controversy concerning Love Canal, Firestone Tire & Rubber's exploding 500-radial tires, A. H. Robins and the Dalkon Shield, and General Public Utilities and Three Mile Island) added fuel to the movement. The issue of American corporations doing business in South Africa and with the government of that country really pushed SRI into a full-blown social movement. It is estimated that around $1 trillion is involved in some type of social investing in the U.S. (about 10% of all total investments), and the number of socially and environmentally screened funds have increased from only a handful in the 1970s to over 100 by 1996. 3. How does one pick SRI stocks? First, determine your financial goals. Second, pick several social issues that are the most important to you. Don't try to solve all the problems of the world at once. Next do research on those corporations that appear to be the best investments in terms of both your financial and social goals. For social information on investments, there are a growing number of resources, most of which are included in the GoodMoney site's directory. 4. What sorts of judgement calls are involved in the process? Actually, the judgement calls are not that much different from the judgments an investor has to make using only financial factors. No investment is perfect in meeting every possible financial criteria. If it were, everyone would be a millionaire. In the same way, there is no such thing as corporate sainthood. However, you can pick what have been called "the best-of-industry" or "the try-harders." For example, making pharmaceuticals is a very dirty business and pumps large quantities of carcinogens into the environment. But, Merck & Company and Johnson & Johnson both have pollution-control programs in place that go far beyond government requirements, while other pharmaceutical companies do not. 5. What do the critics of SRI say? Interestingly enough, SRI has been criticized from both the right and the left. Wall Street and the traditional investment community thinks it is liberal flakiness by people who hate capitalism. The left thinks it is a cop-out to capitalism. Both criticisms completely miss the point. SRI is about several things. It is saying that any economic system, including capitalism, that lacks an ethical component is due to destroy itself. In addition, SRI is about personal empowerment and economic democracy. A corporation doesn't belong to its executives, and money in a retirement fund doesn't belong to the managers of the fund. It is time for shareholders and others to take control of their money, not only for profit but also to resolve some of the major economic and social problems the world faces. This is probably why the traditional business community, such as Fortune magazine, doesn't like SRI. 6. Doesn't Wall Street claim that that an investor and a company sacrifices returns and profits by mixing social with economic judgments? That is the traditional view, but on-going research suggests that just the opposite may be true --- that doing well economically goes hand-in-hand with doing good socially. For example, each year Fortune magazine conducts a survey of America's Most Admired Corporations. In March of 1997, the Corporate Reputations Survey reported on the results for 431 companies. Fortune asked more than 13,000 executives, outside directors, and financial analysts to rate (from zero for worst to 10 for best) the 10 largest companies by revenues in their industry (if there were that many) for each of 8 criteria. Interestingly, only 3 of the criteria were purely financial -- financial soundness, use of corporate assets, and value as a long-term investment. The other 5 involved social factors and judgments -- ability to attract, develop, and keep talented people; community and environmental responsibility; innovativeness; quality of management; and quality of products and/or services. The average score for the 8 criteria was then calculated. As has been the case in surveys for previous years, companies favored by socially and environmentally concerned investors did very well. For 1997 survey, 14 (compared to 12 for the previous year) such companies finished in the top 50. Eleven were repeaters from 1996. In addition, the February 24, 1997, issue of Business Week reported on a study by Judith Posnikoff of CalState Fullerton that found that the share prices of companies whose planned pullouts from South Africa were announced in the national press appreciated in the two or three days surrounding the announcements. She concluded that the stocks produced "abnormally positive" returns. 7. What's the future of SRI? It is growing exponentially in numbers of individual and institutional investors participating, in the amount of invested money involved, and, most importantly, in the movement's ability to persuade corporations to develop a sense of social responsibility in the conduct of their businesses. The German philosopher Arthur Schopenhauer put it this way: There are three steps in the revelation of any truth: in the first, it is ridiculed; in the second, resisted; in the third, it is considered self-evident. SRI is somewhere between the second and third steps. Some resources for more information: * The GreenMoney Journal's site http://www.greenmoney.com/ * Dr. Ritchie Lowry's site http://www.goodmoney.com/ * The RCC Group's site http://www.inusa.com/srinvest/ * The Social Investment Forum (US) is a national nonprofit membership organization promoting the concept, practice and growth of socially responsible investing. http://www.socialinvest.org * SocialFunds.com has over 1000 pages of strategic content to help you make informed investment decisions regarding socially responsible investing. http://www.socialfunds.com/ * The Calvert Group is one of the largest SRI fund managers in the US and offers a variety of investment services. It was the first to offer a socially-screened global fund. Its web site is focused on promoting itself, but it does provide general information on SRI issues. http://www.calvertgroup.com * Kinder, Lydenberg, Domini are the people behind the Domini 400 Social Index, the SRI equivalent to the S&P 500. Their web site not only promotes the organization but also features an international list of links to SRI web sites in Europe and North America, among other Internet resources. http://www.kld.com * Russell Sparkes's The Ethical Investor, originally published in 1995 by Harper Collins, London. It is out of print, but was once available on the net and may survive; please let me know if you find a site that has it. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Strategy - When to Buy/Sell Stocks Last-Revised: 25 Nov 1993 Contributed-By: Maurice Suhre This article presents one person's opinions on when to buy or sell stocks. Your mileage will certainly vary. * Stock XYZ used to trade at 40 and it has dropped to 25. Is it a good buy? A: Maybe. Buying stocks just because they look "cheap" isn't a good idea. All too often they look cheaper later on. (Oak Industries, in Cable TV equipment, used to sell in the 40s. Lately, it's recovered from 1 to 3. IBM looked "cheap" when it went from 137 or so down to 90. You know the rest.) Wait for XYZ to demonstrate that it has quit going down and is showing some sign of strength, perhaps purchasing in the 28 range. If you are expecting a return to 40, you can give up a few points initially. Note that this situation is the same as trying to sell at the top, except the situation is inverted. See the comments on "base building" in the Technical Analysis section of the FAQ. * I'd like to sell a stock since I have a good profit, but I don't want to pay the taxes. What should I do? A: Sell the stock and pay the taxes. Seriously, if you have profits, the government wants their (unfair) share. Their hand (via the IRS) is in your pocket. If you don't make any money, then you won't owe the government anything. * I have a profit in a stock and I want to sell at the exact top. How do I do that? A: If anybody knows how, they haven't told me. Some technical indicators such as RSI can be helpful in locating approximate local maxima. Fundamental valuations such as P/E or P/D can suggest overvalued ranges. * What are some guidelines for selling when you have a profit? A: Since you can't pick the exact top, you either sell too soon or too late. If you sell too soon, you may miss out on a substantial up move. If you sell too late, then you will preserve most of the last up move (unless you get caught in some sort of '87 type crash). One mechanical rule advocated by Jerry Klein (LA area) is this: If you have at least a 20 percent profit, use a (mental) stop to preserve 80 percent of your profit. The technical analysis approach is to determine a prior support level and set a stop slightly below there. Marty Zweig's book has an excellent discussion of trailing stops, both in setting them and how to use them. * It seems like stocks often drop excessively on just a little bit of bad news. What gives? A: One explanation is the "cockroach theory". If you see one cockroach, there are probably a lot more around. If one piece of bad news gets out, the fear is that there are others not yet public. Similarly, if one stock in a group gets into trouble, there is a suspicion that the others might not be far behind. * I saw good news in the paper today. Should I buy the stock? A: Not necessarily. Everyone saw the news in the paper, and the stock price has already reflected that news. * I don't want to be a short term trader. Can one of these computer programs help me for the long term? A: Possibly. If you have decided to buy and the stock is still declining, a computer could help determine when a local bottom has been reached. This sort of technical analysis is not infallible, but the computations are somewhat awkward to do by hand calculator. These programs aren't free, downloading the data isn't free, and you will have to do some study to understand what the program is telling you. If you are more or less ready to sell, the program may be able to locate a local top. Ask your broker if he is using any kind of computer analysis for buy/sell decisions. If you already own a PC, then an analysis program might be cost effective. * How does market timing apply to stocks? (I understand about switching mutual funds using market timing signals). A: Assuming that you think the market is "too high", you might a) tighten up your stops to preserve profits, b) sell off some positions to capture profits and reduce exposure, c) sell covered calls to provide some downside protection, d) purchase puts as "insurance", e) look for possible shorting situations, and/or f) delay any new purchases. If you think the market is "too low", then you might a) commit reserve money for new purchases and/or b) take profits from prior shorting. * Explain market action, group action, and individual stock action. A: Every day, some stocks go up, some go down, and some are unchanged. Market action applies to the general direction of the market. Are most stocks going up or down? Are broad averages (S&P 500, etc.) going up or down? Group action refers to a specific industry group. Biotechs may be "hot", technology may be "hot", out of favor groups may be dropping. Finally, not all companies within a rising group will be doing equally well -- some individual stocks will have risen, some won't, some may even be sliding lower. * How do I use this information (assuming I've got it)? A: A strategy is to locate a rising group in a rising market. Look for good companies in the group which haven't risen yet and purchase one or more of them. The assumption is that the "best" companies have already been bid up to full value and that some of the remaining will be bid up. Avoid the poorest companies in the group since they may not move at all. * Should I look at a chart before I purchase a stock? A: Definitely. In fact, raise your right hand and repeat after me: "I will never purchase a stock without looking at a chart". Also, "I will never purchase a stock in a Stage 4 decline." (See technical analysis articles in this FAQ for details.) If you have a full service broker, he should send you a chart, Value Line report, and S&P report. If you can't get these, you aren't getting full service. Value Line and S&P are probably available in your local library. * Do I need to keep looking at charts while I am holding my positions? A: Probably. You don't necessarily need to look a charts on a daily basis, but it is difficult to set trailing stops [ref 1] without looking at a chart. You can also get information about where the price is relative to the moving averages. --------------------Check http://invest-faq.com/ for updates------------------ Compilation Copyright (c) 2003 by Christopher Lott.