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Subject: The Investment FAQ (part 2 of 20)

This article was archived around: 20 Jun 2006 04:24:13 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/part2 Version: $Id: part02,v 1.62 2005/01/05 12:40:47 lott Exp lott $ Compiler: Christopher Lott
The Investment FAQ is a collection of frequently asked questions and answers about investments and personal finance. This is a plain-text version of The Investment FAQ, part 2 of 20. The web site always has the latest version, including in-line links. Please browse 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 2005 by Christopher Lott, and is protected by copyright as a collective work and/or compilation, pursuant to U.S. copyright laws, international conventions, and other copyright laws. The contents of The Investment FAQ are intended for personal use, not for sale or other commercial redistribution. The plain-text version of The Investment FAQ may be copied, stored, made available on web sites, or distributed on electronic media provided the following conditions are met: + The URL of The Investment FAQ home page is displayed prominently. + No fees or compensation are charged for this information, excluding charges for the media used to distribute it. + No advertisements appear on the same web page as this material. + Proper attribution is given to the authors of individual articles. + This copyright notice is included intact. Disclaimers Neither the compiler of nor contributors to The Investment FAQ make any express or implied warranties (including, without limitation, any warranty of merchantability or fitness for a particular purpose or use) regarding the information supplied. The Investment FAQ is provided to the user "as is". Neither the compiler nor contributors warrant that The Investment FAQ will be error free. Neither the compiler nor contributors will be liable to any user or anyone else for any inaccuracy, error or omission, regardless of cause, in The Investment FAQ or for any damages (whether direct or indirect, consequential, punitive or exemplary) resulting therefrom. Rules, regulations, laws, conditions, rates, and such information discussed in this FAQ all change quite rapidly. Information given here was current at the time of writing but is almost guaranteed to be out of date by the time you read it. Mention of a product does not constitute an endorsement. Answers to questions sometimes rely on information given in other answers. Readers outside the USA can reach US-800 telephone numbers, for a charge, using a service such as MCI's Call USA. All prices are listed in US dollars unless otherwise specified. Please send comments and new submissions to the compiler. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Advice - Beginning Investors Last-Revised: 1 Aug 1998 Contributed-By: Steven Pearson, E. Green, Chris Lott ( contact me ) Investing is just one aspect of personal finance. People often seem to have the itch to try their hand at investing before they get the rest of their act together. This is a big mistake. For this reason, it's a good idea for "new investors" to hit the library and read maybe three different overall guides to personal finance - three for different perspectives, and because common themes will emerge (repetition implies authority?). Personal finance issues include making a budget, sticking to a budget, saving money towards major purchases or retirement, managing debt appropriately, insuring your property, etc. Appropriate books that focus on personal finance include the following (the links point to Amazon.com): * Andrew Tobias The Only Investment Guide You'll Ever Need * Eric Tyson Personal Finance for Dummies (4th edn.) * Janet Bamford et al. The Consumer Reports Money Book: How to Get It, Save It, and Spend It Wisely (3rd edn) (out of print; used copies available) Another great resource for learning about investing, insurance, stocks, etc. is the Wall Street Journal's Section C front page. Beginners should make a special effort to get the Friday edition of the WSJ because a column named "Getting Going" usually appears on that day and discusses issues in, well, getting going on investments. If you don't want to spend the dollar or so for the WSJ, try your local library. What I am specifically NOT talking about is most anything that appears on a list of investing/stock market books that are posted in misc.invest.* from time to time. This includes books like Market Logic, One Up on Wall Street, Beating the Dow, Winning on Wall Street, The Intelligent Investor, etc. These are not general enough. They are investment books, not personal finance books. Many "beginning investors" have no business investing in stocks. The books recommended above give good overall money management, budgeting, purchasing, insurance, taxes, estate issues, and investing backgrounds from which to build a personal framework. Only after that should one explore particular investments. If someone needs to unload some cash in the meantime, they should put it in a money market fund, or yes, even a bank account, until they complete their basic training. While I sympathize with those who view this education as a daunting task, I don't see any better answer. People who know next to nothing and always depend on "professional advisors" to hand-hold them through all transactions are simply sheep asking to be fleeced (they may not actually be fleeced, but most of them will at least get their tails bobbed). In the long run, an individual is the only person ultimately responsible for his or her own financial situation. Beginners may want to look further in The Investment FAQ for the articles that discuss the basics of mutual funds , basics of stocks , and basics of bonds . For more in-depth material, browse the Investment FAQ bookshelf with its recommended books about personal finance and investments. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Advice - Buying a Car at a Reasonable Price Last-Revised: 1 Aug 2001 Contributed-By: Kyle Busch (kbusch at velocity.net) Before making a purchase, especially a large one, most buyers ponder an equation that goes something like: What is it going to cost me, and will that equal what I am going to get? Consider that equation when buying your next vehicle. Naturally, you want to get the most vehicle for the money you spend. Here are several tips that will help you to get more for your money. First, and foremost, consider eliminating some of the steep depreciation cost incurred during the first three years of vehicle ownership by purchasing a 2- to 3- year-old used vehicle. The price can be further reduced by paying cash. However, if you need to finance your next vehicle purchase, consider doing the following to keep its cost closer to the "as if you were paying cash" figure. * Take the time to carefully identify your current and your future transportation needs, and choose an appropriate vehicle.Transportation represents different things to different people. For some drivers, it represents status in society. Other drivers place greater emphasis on reliably just getting from point A to points B and C. The more closely that you match your driving needs with the vehicle you buy, the more driving pleasure you will experience and the more likely you will want to hold on to the vehicle. If you can't fully identify your transportation needs or the vehicle that can best satisfy them, consult the April issue of Consumer Reports at a public library. The publication groups vehicles into categories, provides frequency-of-repair information for many vehicles, and gives vehicle price information. It is a good idea to identify 2 or 3 vehicles in a particular category that meet your transportation needs.This enables some latitude when shopping for the vehicle. = * Identify how much you can afford to spend per month on transportation. A rule of thumb suggests that the cost to rent an apartment per month should not be greater than 25 percent of your monthly net pay.The cost of an auto loan should not exceed 10 to 12 percent of your monthly net pay. In some instances, leasing a vehicle could be a better option than taking out a loan. * The vehicle down payment should be the largest possible, and the amount of money borrowed the lowest possible. In addition, borrowing money for the shortest period of time (i.e., a 24-month loan rather than a 48-month loan) will reduce the overall cost of the loan. * Identify the various loan sources such as banks, savings and loans, credit unions, and national lenders (i.e., go online to ask jeeves.com and specify "automobile financing sources"). In regard to national financing vs. local financing, it can be useful to determine what the cost of a loan would be from the national sources, but accept a loan from a local source if the loan cost is comparable or nearly comparable between the two. Compare the APR (annual percentage rate) that each of the sources will charge for the loan. The cost of a loan is negotiable. Therefore, be certain to inform each source what the others have to offer. In addition to the loan's APR, remember to also compare the other costs associated with a loan, such as loan insurance and loan processing costs. * Be certain to read and understand any fine print contained in the loan contract. Insist that the loan contract gives you the option of making payments early and that the payments will be applied on the loan principle with no penalty or extra cost if you payoff the loan early. * Do not settle for a vehicle that does not entirely meet your transportation needs because of low dealer or manufacturer incentive financing.Sometimes dealers or manufactures offer extremely low APR financing on vehicles that the dealer is having a hard time selling. That's why it helps to have initially identified the correct vehicle before encountering the sales pitches and other influences of buying a vehicle. Kyle Busch is the author of Drive the Best for the Price: How to Buy a Used Automobile, Sport-Utility Vehicle, or Minivan and Save Money . To find out more about the author and this book visit: http://www.drivethebestbook.com --------------------Check http://invest-faq.com/ for updates------------------ Subject: Advice - Errors in Investing Last-Revised: 2 Aug 1999 Contributed-By: Chris Lott ( contact me ), Thomas Price (tprice at engr.msstate.edu) The Wall Street Journal of June 18, 1991 had an article on pages C1/C10 on Investment Errors and how to avoid them. As summarized from that article, the errors are: * Not following an investment objective when you build a portfolio. * Buying too many mutual funds. * Not researching a one-product stock before you buy. * Believing that you can pick market highs and lows (time the market). * Taking profits early. * Not cutting your losses. * Buying the hottest {stock, mutual fund} from last year. Here's a recent quote that underscores the last item. When asked "What's the biggest mistake individual investors make?" on Wall $treet Week, John Bogle, founder and senior chairman of Vanguard mutual funds, said "Extrapolating the trend" or buying the hot stock. On a final note, get this quote on market timing: In the 1980s if you were out of the market on the ten best trading days of the decade you missed one-third of the total return. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Advice - Using a Full-Service Broker Last-Revised: 23 Mar 1998 Contributed-By: Bill Rini (bill at moneypages.com), Chris Lott ( contact me ) There are several reasons to choose a full-service broker over a discount or web broker. People use a full-service broker because they may not want to do their own research, because they are only interested in long-term investing, because they like to hear the broker's investment ideas, etc. But another important reason is that not everybody likes to trade. I may want retirement planning services from my broker. I may want to buy 3 or 4 mutual funds and have my broker worry about them. If my broker is a financial planner, perhaps I want tax or estate advice on certain investment options. Maybe I'm saving for my newborn child's education but I have no idea or desire to work out a plan to make sure the money is there when she or he needs it. A huge reason to stick with a full-service broker is access to initial public offerings (IPOs). These are generally reserved for the very best clients, where best is defined as "someone who generates lots of revenue," so someone who trades just a few times a year doesn't have a chance. But if you can afford to trade frequently at the full-service commission rates, you may be favored with access to some great IPOs. And the real big one for a lot of people is quite simply time . Full service brokerage clients also tend to be higher net worth individuals as well. If I'm a doctor or lawyer, I can probably make more money by focusing on my business than spending it researching stocks. For many people today, time is a more valuable commodity than money. In fact, it doesn't even have to do with how wealthy you are. Americans, in general, work some pretty insane hours. Spending time researching stocks or staying up on the market is quality time not spent with family, friends, or doing things that they enjoy. On the other hand some people enjoy the market and for those people there are discount brokers. The one thing that sort of scares me about the difference between full service and discount brokers is that a pretty good chunk of discount brokerage firm clients are not that educated about investing. They look at a $20 commission (discount broker) and a $50 commission (full service broker) and they decide they can't afford to invest with a full service broker. Instead they plow their life savings into some wonder stock they heard about from a friend (hey, it's only a $20 commission, why not?) and lose a few hundred or thousand bucks when the investment goes south. Not that a broker is going to pick winners 100% of the time but at least the broker can guide or mentor a beginning investor until they learn enough to know what to look for and what not to look for in a stock. I look at the $30 difference in what the two types of brokerage firms charge as the rebate for education and doing my own research. If you're not going to educate yourself or do your own research, you don't deserve the rebate. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Advice - Mutual-Fund Expenses Last-Revised: 16 Feb 2003 Contributed-By: Austin Lemoine This article discusses stealth erosion of wealth, more specifically how mutual-fund expenses erode wealth accumulation. Mutual fund expense ratios, and similar investment-related fees, can seriously erode wealth accumulation over time. Those fees and expenses are stealthy, and they go largely unnoticed by investors while steadily diminishing the value of their investments in both up and down markets. What you pay for investing in a mutual fund, exclusive of any sales charges, is indicated by the "expense ratio" of the fund. The expense ratio is the percentage of mutual fund assets paid for operating expenses, management fees, administrative fees, and all other asset-based costs incurred by the fund, except brokerage costs. Those expenses are reflected in the fund's net asset value (NAV), and they are not really visible to the fund investor. The reported net return equals the fund's gross return minus its costs. (And expense ratios do not account for every cost mutual fund investors bear: additional costs include any sales charges, brokerage commissions paid by the fund and other significant kinds of indirect trading costs.) Mutual fund expense ratios range from less than 0.20 percent for low-cost index funds to well over 2 percent for actively managed funds. The average is 1.40 percent for the more than 14,000 stock and bond mutual funds currently available, according to Morningstar. In dollar terms, that's $14 a year in fees for each $1,000 of investment value; or a net value of $986. That might not seem like a big deal, but over time fees compound to erode investment value. Let's say the gross return in real terms (after inflation) of a broadly diversified stock mutual fund will be 7 percent a year, excluding expenses. (The 7 percent figure is consistent with returns for the U.S. stock market from 1802 through 2001, as reported in Jeremy Siegel's book, Stocks for the Long Run, 3rd edition.) Say the fund has an expense ratio of 1.25 percent. And say you invest $1,000 in the fund at the start of every year. (The figure of $1,000 is arbitrary, and investment values below can be extrapolated to any annual contribution amount.) Compounding at 7 percent, your gross investment value would be $6,153 after 5 years; $14,783 after 10 years; $43,865 after 20 years; $101,073 after 30 years; and $213,609 after 40 years. But with a 1.25 percent expense ratio, your investment compounds at 7.0 minus 1.25 or 5.75 percent, not 7 percent. So your investment would actually be worth $5,931 after 5 years; $13,776 after 10 years; $37,871 after 20 years; $80,015 after 30 years; and $153,727 after 40 years. Fund expenses account for the difference in value over time, with greater expenses (and/or lower returns) having a greater negative impact on net investment value. That 1.25 percent expense ratio consumes $222 (or 3.6 percent) of the $6,153 gross value over 5 years; 6.8 percent of gross value over 10 years; 13.6 percent over 20 years; and 20.8 percent over 30 years. Over 40 years, the $59,882 of fund expenses devour 28.0 percent of the $213,609 gross value. In other words, only 72.0 percent of gross investment value is left after 40 years, a withering erosion of wealth. By contrast, let's say there's a broad-based index fund with 7 percent real return but a 0.25 percent expense ratio. Putting $1,000 at the start of each year into that fund, the 0.25 percent expense ratio would consume just 2.9 percent of gross investment value after 20 years. Over 40 years, index fund expenses would total $13,759, a modest 6.4 percent of gross value; so that the fund would earn 93.6 percent of gross value. With expenses included, investment value is 30 percent higher after 40 years with the lower cost fund. (Even lower expense ratios can be found among lowest-cost index funds and broad-based exchange-traded funds. And funds with higher expenses do not outperform comparable funds with lower expenses.) Over the next ten to twenty years, expense ratios and similar fees could be a huge millstone on wealth accumulation and wealth preservation. To see why, let's review what's happened since March 2000. Like a massive hurricane, the stock market has inflicted damage on almost every portfolio in its path. From the peak of March 2000 to the lows of early October 2002, it's estimated that falling stock prices wiped out over $7 trillion in market value. While the market has moved off its lows, we hope the worst is over. How long will the market take to "heal itself?" It could take a long time. A growing consensus holds that stocks just won't deliver the returns we grew accustomed to from 1984 to 1999. If history is a guide, real stock returns could average 2 to 4 percent a year over the 10 to 20 years following March 2000. If lower expectations for stock returns materialize, mutual fund fees and expenses will have an even greater adverse impact on wealth accumulation, and especially on wealth preservation and income security at retirement. Let's say you'll want $40,000 income from your 401(k) assets without drawing down principal. If real investment return is 4 percent you'll need $40,000 divided by 0.04 or $1 million principal. But if you're paying 1 percent in fees your real return is 3 percent, so you'll need $40,000 divided by 0.03 or $1.333 million principal; and if 2 percent, $2 million. The arithmetic is brutal! It's clear that mutual fund costs and similar fees can be detrimental to investment values over time. Fund sales charges exacerbate the problem. Consider investing in lower-cost funds wherever possible. For more insights from Austin Lemoine, please visit the web site for Austin Lemoine Capital Management: http://www.austinlemoine.com/ --------------------Check http://invest-faq.com/ for updates------------------ Subject: Advice - One-Line Wisdom Last-Revised: 22 Aug 1993 Contributed-By: Maurice Suhre This is a collection of one-line pieces of investment wisdom, with brief explanations. Use and apply at your own risk or discretion. They are not in any particular order. Hang up on cold calls. While it is theoretically possible that someone is going to offer you the opportunity of a lifetime, it is more likely that it is some sort of scam. Even if it is legitimate, the caller cannot know your financial position, goals, risk tolerance, or any other parameters which should be considered when selecting investments. If you can't bear the thought of hanging up, ask for material to be sent by mail. Don't invest in anything you don't understand. There were horror stories of people who had lost fortunes by being short puts during the 87 crash. I imagine that they had no idea of the risks they were taking. Also, all the complaints about penny stocks, whether fraudulent or not, are partially a result of not understanding the risks and mechanisms. If it sounds too good to be true, it probably is [too good to be true]. Also stated as ``There ain't no such thing as a free lunch (TANSTAAFL).'' Remember, every investment opportunity competes with every other investment opportunity. If one seems wildly better than the others, there are probably hidden risks or you don't understand something. If your only tool is a hammer, every problem looks like a nail. Someone (possibly a financial planner) with a very limited selection of products will naturally try to jam you into those which s/he sells. These may be less suitable than other products not carried. Don't rush into an investment. If someone tells you that the opportunity is closing, filling up fast, or in any other way suggests a time pressure, be very leery. Very low priced stocks require special treatment. Risks are substantial, bid/asked spreads are large, prices are volatile, and commissions are relatively high. You need a broker who knows how to purchase these stocks and dicker for a good price. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Advice - Paying for Investment Advice Last-Revised: 25 Apr 1997 Contributed-By: Chris Lott ( contact me ) I'm no expert, but there's a simple rule that you should use to evaluate all advice that is offered to you, especially advice for which someone who doesn't know you is asking significant sums of money. Ask yourself why the person is selling or giving it to you. If it sounds like a sure ticket to riches, then why is the person wasting their time on YOU when they could be out there making piles of dough? Of course I'm offering advice here in this article, so let's turn the tables on me right now. What's in it for me? Well, if you're reading this article from my web site, look up at the top of the page. If you have images turned on, you'll see a banner ad. I get a tiny payment each time a person loads one of my pages with an ad. So my motivation is to provide informative articles in order to lure visitors to the site. Of course if you're reading this from the plain-text version of the FAQ, you won't see any ads, but please do stop by the site sometime! ;-) So if someone promises you advice that will yield 10-20% monthly returns, perhaps at a price of some $3,000, you should immediately get suspicious. If this were really true - i.e., if you pay for the advice you'll immediately start getting these returns - you would be making over 300% annually (compounded). Hey, that would sure be great, I wouldn't have a day job anymore. And if it were true, wouldn't you think that the person trying to sell it to you would forget all about selling and just watch his or her money triple every year? But they're not doing that, which should give you a pretty good idea about where the money's being made, namely from you . I'm not trying to say that you should never pay for advice, just that you should not overpay for advice. Some advice, especially the sort that comes from $15 books on personal finance and investments can easily be worth ten times that sum. Advice from your CPA or tax advisor will probably cost you a 3 or even 4-digit figure, but since it's specialized to your case and comes from a professional, that's probably money well spent. It seems appropriate to close this article with a quote that I learned from Robert Heinlein books, but it's probably older than that: TANSTAAFL - there ain't no such thing as a free lunch. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Advice - Researching a Company Last-Revised: 3 Jun 1997 Contributed-By: George Regnery (regnery at yahoo.com) This article gives a basic idea of some steps that you might take to research a company. Many sites on the web will help you in your quest for information, and this article gives a few of them. You might look for the following. 1. What multiple of earnings is the company trading at versus other companies in the industry? The site http://www.stocksmart.com does this comparison reasonably well, and they base it on forward earnings instead of historical earnings, which is also good. 2. Is the stock near a high or low, and how has it done recently. This is usually considered technical analysis. More sophisticated (or at least more complicated) studies can also be performed. There are several sites that will give you historical graphs; one is Yahoo. http://biz.yahoo.com/r/ 3. When compared with other companies in the industry, how much times the book value or times sales is the company trading? For this information, the site http://www.marketguide.com is a good place to start. 4. Does the company have good products, good management, good future prospects? Are they being sued? Do they have patents? What's the competition like? Do they have long term contracts established? Is their brand name recognized? Depending on the industry, some or all of these questions may be relevant. There isn't a simple web site for this information, of course. The Hoover's profiles have some limited information to at least let you get a feel for the basics of the company. And the SEC has lots of information in their Edgar databank. 5. Management. Does the company have competent people running it? The backgrounds of the directors can be found in proxy statements (14As) in the Edgar database. Note that proxies are written by the companies, though. Another thing I would suggest looking at is the compensation structure of the CEO and other top management. Don't worry so much about the raw figure of how they are paid -- instead, look to see how that compensation is structured. If the management gets a big base but bonuses are a small portion, look carefully at the company. For some industries, like electric utilities, this is OK, because the management isn't going to make a huge difference (utilities are highly regulated, and thus the management is prevented from making a lot of decisions). However, in a high tech industry, or many other industries, watch your step if the mgmt. gets a big base and the bonus is insignificant. This means that they won't be any better off financially if the company makes a lot of profits vs. no profits (unless, of course, they own a lot of stock). This information is all in the proxies at the SEC. Also check to see if the company has a shareholder rights plan, because if they do, the management likely doesn't give a damn about shareholder rights, but rather cares about their own jobs. (These plans are commonly used to defend against unfriendly takeovers and therefore provide a safety blanket for management.) These suggestions should get you started. Also check the article elsewhere in this FAQ on free information sources for more resources away from the web. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Advice - Target Stock Prices Last-Revised: 25 Jun 2000 Contributed-By: Uncle Arnie (blash404 at aol.com) A target price for a stock is a figure published by a securities industry person, usually an analyst. The idea is that the target price is a prediction, a guess about where the stock is headed. Target prices usually are associated with a date by which the stock is expected to hit the target. With that explanation out of the way.. Why do people suddenly think that the term du jour "target price" has any meaning?? Consider the sources of these numbers. They're ALWAYS issued by someone who has a vested interest in the issue: It could be an analyst whose firm was the underwriter, it could be an analyst whose firm is brown-nosing the company, it could be a firm with a large position in the stock, it could be an individual trying to talk the stock up so he can get out even, or it could be the "pump" segment of a pump-and-dump operation. There is also a chance that the analyst has no agenda and honestly thinks the stock price is really going places. But in all too many cases it's nothing more than wishful guesswork (unless they have a crystal ball that works), so the advice here: ignore target prices, especially ones for internet companies. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Analysis - Amortization Tables Last-Revised: 16 Feb 2003 Contributed-By: Hugh Chou This article presents the formula for computing monthly payments on loans. A listing of thed full series of payments (principal and interest) that show how a loan is paid off is known as a loan amortization table. This article will explain how these tables are generated for the U.S. system in which interest is compounded monthly. First you must define some variables to make it easier to set up: P = principal, the initial amount of the loan I = the annual interest rate (from 1 to 100 percent) L = length, the length (in years) of the loan, or at least the length over which the loan is amortized. The following assumes a typical conventional loan where the interest is compounded monthly. First I will define two more variables to make the calculations easier: J = monthly interest in decimal form = I / (12 x 100) N = number of months over which loan is amortized = L x 12 Okay now for the big monthly payment (M) formula, it is: J M = P x ------------------------ 1 - ( 1 + J ) ^ -N where 1 is the number one (it does not appear too clearly on some browsers). So to calculate it, you would first calculate 1 + J then take that to the -N (minus N) power, subtract that from the number 1. Now take the inverse of that (if you have a 1/X button on your calculator push that). Then multiply the result times J and then times P. Sorry for the long way of explaining it, but I just wanted to be clear for everybody. The one-liner for a program would be (adjust for your favorite language): M = P * ( J / (1 - (1 + J) ** -N)) So now you should be able to calculate the monthly payment, M. To calculate the amortization table you need to do some iteration (i.e. a simple loop). I will tell you the simple steps : 1. Calculate H = P x J, this is your current monthly interest 2. Calculate C = M - H, this is your monthly payment minus your monthly interest, so it is the amount of principal you pay for that month 3. Calculate Q = P - C, this is the new balance of your principal of your loan. 4. Set P equal to Q and go back to Step 1: You thusly loop around until the value Q (and hence P) goes to zero. Programmers will see how this makes a trivial little loop to code, but I have found that many people now surfing on the Internet are NOT programmers and still want to calculate their mortgages! Note that just about every PC or Mac has a spreadsheet of some sort on it, and they are very good tools for doing mortgage analysis. Most of them have a built-in PMT type function that will calculate your monthly payment given a loan balance, interest rate, and the number of terms. Check the help text for your spreadsheet. Please visit Hugh Chou's web site for a calculator that will generate amortization tables according to the forumlas discussed here. He also offers many other calculators: http://www.hughchou.org/calc/ --------------------Check http://invest-faq.com/ for updates------------------ Subject: Analysis - Annual Reports Last-Revised: 31 Oct 1995 Contributed-By: Jerry Bailey, Chris Lott ( contact me ) The June 1994 Issue of "Better Investing" magazine, page 26 has a three-page article about reading and understanding company annual reports. I will paraphrase: 1. Start with the notes and read from back to front since the front is management fluff. 2. Look for litigation that could obliterate equity, a pension plan in sad shape, or accounting changes that inflated earnings. 3. Use it to evaluate management. I only read the boring things of the companies I am holding for long term growth. If I am planning a quick in and out, such as buying depressed stocks like BBA, CML, CLE, etc.), I don't waste my time. 4. Look for notes to offer relevant details; not "selected" and "certain" assets. Revenue and operating profits of operating divisions, geographical divisions, etc. 5. How the company keeps its books, especially as compared to other companies in its industry. 6. Inventory. Did it go down because of a different accounting method? 7. What assets does the company own and what assets are leased? If you do much of this, I really recommend just reading the article. The following list of resources may also help. * John A. Tracy has written an an easy-to-read and informative book named How to Read a Financial Report (4th edn., Wiley, 1993). This book should give you a good start. You won't become a graduate student in finance by reading it, but it will certainly help you grasp the nuts and bolts of annual reports. * IBM offers a web site with much information about understanding financial reports: http://www.ibm.com/FinancialGuide/ --------------------Check http://invest-faq.com/ for updates------------------ Subject: Analysis - Beta and Alpha Last-Revised: 22 Oct 1997 Contributed-By: Ajay Shah ( www.igidr.ac.in/~ajayshah ), R. Shukla (rkshukla at som.syr.edu), Bob Pierce (rbp at investor.pgh.pa.us) Beta is the sensitivity of a stock's returns to the returns on some market index (e.g., S&P 500). Beta values can be roughly characterized as follows: * b less than 0 Negative beta is possible but not likely. People thought gold stocks should have negative betas but that hasn't been true. * b equal to 0 Cash under your mattress, assuming no inflation * beta between 0 and 1 Low-volatility investments (e.g., utility stocks) * b equal to 1 Matching the index (e.g., for the S&P 500, an index fund) * b greater than 1 Anything more volatile than the index (e.g., small cap. funds) * b much greater than 1 (tending toward infinity) Impossible, because the stock would be expected to go to zero on any market decline. 2-3 is probably as high as you will get. More interesting is the idea that securities MAY have different betas in up and down markets. Forbes used to (and may still) rate mutual funds for bull and bear market performance. Alpha is a measure of residual risk (sometimes called "selecting risk") of an investment relative to some market index. For all the gory details on Alpha, please see a book on technical analysis. Here is an example showing the inner details of the beta calculation process: Suppose we collected end-of-the-month prices and any dividends for a stock and the S&P 500 index for 61 months (0..60). We need n + 1 price observations to calculate n holding period returns, so since we would like to index the returns as 1..60, the prices are indexed 0..60. Also, professional beta services use monthly data over a five year period. Now, calculate monthly holding period returns using the prices and dividends. For example, the return for month 2 will be calculated as: r_2 = ( p_2 - p_1 + d_2 ) / p_1 Here r denotes return, p denotes price, and d denotes dividend. The following table of monthly data may help in visualizing the process. (Monthly data is preferred in the profession because investors' horizons are said to be monthly.) Nr. Date Price Div.(*) Return 0 12/31/86 45.20 0.00 -- 1 01/31/87 47.00 0.00 0.0398 2 02/28/87 46.75 0.30 0.0011 . ... ... ... ... 59 11/30/91 46.75 0.30 0.0011 60 12/31/91 48.00 0.00 0.0267 (*) Dividend refers to the dividend paid during the period. They are assumed to be paid on the date. For example, the dividend of 0.30 could have been paid between 02/01/87 and 02/28/87, but is assumed to be paid on 02/28/87. So now we'll have a series of 60 returns on the stock and the index (1...61). Plot the returns on a graph and fit the best-fit line (visually or using some least squares process): | * / stock | * * */ * returns| * * / * | * / * | * /* * * | / * * | / * | | +------------------------- index returns The slope of the line is Beta. Merrill Lynch, Wells Fargo, and others use a very similar process (they differ in which index they use and in some econometric nuances). Now what does Beta mean? A lot of disservice has been done to Beta in the popular press because of trying to simplify the concept. A beta of 1.5 does not mean that is the market goes up by 10 points, the stock will go up by 15 points. It doesn't even mean that if the market has a return (over some period, say a month) of 2%, the stock will have a return of 3%. To understand Beta, look at the equation of the line we just fitted: stock return = alpha + beta * index return Technically speaking, alpha is the intercept in the estimation model. It is expected to be equal to risk-free rate times (1 - beta). But it is best ignored by most people. In another (very similar equation) the intercept, which is also called alpha, is a measure of superior performance. Therefore, by computing the derivative, we can write: Change in stock return = beta * change in index return So, truly and technically speaking, if the market return is 2% above its mean, the stock return would be 3% above its mean, if the stock beta is 1.5. One shot at interpreting beta is the following. On a day the (S&P-type) market index goes up by 1%, a stock with beta of 1.5 will go up by 1.5% + epsilon. Thus it won't go up by exactly 1.5%, but by something different. The good thing is that the epsilon values for different stocks are guaranteed to be uncorrelated with each other. Hence in a diversified portfolio, you can expect all the epsilons (of different stocks) to cancel out. Thus if you hold a diversified portfolio, the beta of a stock characterizes that stock's response to fluctuations in the market portfolio. So in a diversified portfolio, the beta of stock X is a good summary of its risk properties with respect to the "systematic risk", which is fluctuations in the market index. A stock with high beta responds strongly to variations in the market, and a stock with low beta is relatively insensitive to variations in the market. E.g. if you had a portfolio of beta 1.2, and decided to add a stock with beta 1.5, then you know that you are slightly increasing the riskiness (and average return) of your portfolio. This conclusion is reached by merely comparing two numbers (1.2 and 1.5). That parsimony of computation is the major contribution of the notion of "beta". Conversely if you got cold feet about the variability of your beta = 1.2 portfolio, you could augment it with a few companies with beta less than 1. If you had wished to figure such conclusions without the notion of beta, you would have had to deal with large covariance matrices and nontrivial computations. Finally, a reference. See Malkiel, A Random Walk Down Wall Street , for more information on beta as an estimate of risk. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Analysis - Book-to-Bill Ratio Last-Revised: 19 Aug 1993 Contributed-By: Timothy May The book-to-bill ration is the ratio of business "booked" (orders taken) to business "billed" (products shipped and bills sent). A book-to-bill of 1.0 implies incoming business = outgoing product. Often in downturns, the b-t-b drops to 0.9, sometimes even lower. A b-t-b of 1.1 or higher is very encouraging. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Analysis - Book Value Last-Revised: 23 Mar 1998 Contributed-By: Art Kamlet (artkamlet at aol.com) In simplest terms, Book Value is Assets less Liabilities. The problem is Assets includes, as stated, existing land & buildings, inventory, cash in the bank, etc. held by the company. The problem in assuming you can sell off these assets and receive their listed value is that such values are accounting numbers, but otherwise pretty unrealistic. Consider a company owning a 40 year old building in downtown Chicago. That building might have been depreciated fully and is carried on the books for $0, while having a resale value of millions. The book value grossly understates the sell-off value of the company. On the other hand, consider a fast-changing industry with 4-year-old computer equipment which has a few more years to go before being fully depreciated, but that equipment couldn't be sold for even 10 cents on the dollar. Here the book value overstates the sell-off value. So consider book value to be assets less liabilities, which are just numbers, not real items. If you want to know how much a company should be sold off for, hire a good investment banker, which is often done on take-over bids. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Analysis - Computing Compound Return Last-Revised: 12 Dec 2004 Contributed-By: Paul Randolph (paulr22 at juno dot com), Chris Lott ( contact me ) This article discusses how to compute the effective annual percentage rate earned by a single investment after a number of years have passed. A related concept called "average annual return" is frequently seen when reading about mutual funds but is computed very differently; it is discussed briefly at the end of this article. Another related concept called "internal rate of return" is used to calculate the percentage rate earned by an investment made as a series of purchases, such as monthly investments in a mutual fund; also see the article on that topic elsewhere in this FAQ. To calculate the compound return on an investment, just figure out the factor by which the original investment multiplied. For example, if $1,000 became $3,200 in 10 years, then the multiplying factor is 3,200/1,000 or 3.2. Now take the 10th root of 3.2 (the multiplying factor) and you get a compound return of 1.1233498, which means approximately 12.3% per year. To see that this works, note that 1.233498 raised to the 10th power equals 3.2. Here is another way of saying the same thing. This calculation assumes that all gains are reinvested, so the following formula applies: TR = (1 + AR) ** YR where TR is total return (present value/initial value), AR is the compound annualized return, and YR is years. The symbol '**' is used to denote exponentiation (e.g., 2 ** 3 = 8). To calculate annualized return, the following formula applies: AR = (TR ** (1/YR)) - 1 Thus a total return of 950% in 20 years would be equivalent to an annualized return of 11.914454%. Note that the 950% includes your initial investment of 100% (by definition) plus a gain of 850%. For those of you using spreadsheets such as Excel, you would use the following formula to compute AR for the example discussed above (the common computer symbol used to denote exponentiation is the caret or hat on top of the 6). = TR ^ (1 / YR) - 1 where TR = 9.5 and YR = 20. If you want to be creative and have AR recalculated every time you open your file, you can substitute something like the following for YR: ( (*cell* - TODAY() ) / 365) Of course you will have to replace '*cell*' by the appropriate address of the cell that contains the date on which you bought the security. Don't confuse a compound return with something called an average annual return, which is a simple arithmetic mean (also see the FAQ article on this topic). That method simply adds the annual rates and divides by the number of years. For example, 5% one year and 10% the next year, average is 7.5% over those two years. Let's compare the two methods with a contrived example. You invest $100. After one year, you have $200, which means in that first year, the investment returned 100%. At the end of the second year, you have $100, which means in that second year, the investment lost 50%. (In short, you're back where you started.) Do the calculations for the compound return and you'll get 0%. Calculate the average annual return and you get 25%. So this contrived example yields a big difference. However, common scenarios yield less striking differences, and the average annual return is a useful approximation. Here's the one thing to remember from this article. When you read an investment company's statements about their "average return", you should check carefully just exactly what they calculated. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Analysis - Future and Present Value of Money Last-Revised: 28 Jan 1994 Contributed-By: Chris Lott ( contact me ) This note explains briefly two concepts concerning the time-value-of-money, namely future and present value. Careful application of these concepts will help you evaluate investment opportunities such as real estate, life insurance, and many others. Future Value Future value is simply the sum to which a dollar amount invested today will grow given some appreciation rate. To compute the future value of a sum invested today, the formula for interest that is compounded monthly is: fv = principal * [ (1 + rrate/12) ** (12 * termy) ] where fv = future value principal = dollar value you have now termy = term, in years rrate = annual rate of return in decimal (i.e., use .05 for 5%) Note that the symbol '**' is used to denote exponentiation (2 ** 3 = 8). For interest that is compounded annually, use the formula: fv = principal * [ (1 + rrate) ** (termy) ] Example: I invest 1,000 today at 10% for 10 years compounded monthly. The future value of this amount is 2707.04. Note that the formula for future value is the formula from Case 1 of present value (below), but solved for the future-sum rather than the present value. Present Value Present value is the value in today's dollars assigned to an amount of money in the future, based on some estimate rate-of-return over the long-term. In this analysis, rate-of-return is calculated based on monthly compounding. Two cases of present value are discussed next. Case 1 involves a single sum that stays invested over time. Case 2 involves a cash stream that is paid regularly over time (e.g., rent payments), and requires that you also calculate the effects of inflation. Case 1a: Present value of money invested over time. This tells you what a future sum is worth today, given some rate of return over the time between now and the future. Another way to read this is that you must invest the present value today at the rate-of-return to have some future sum in some years from now (but this only considers the raw dollars, not the purchasing power). To compute the present value of an invested sum, the formula for interest that is compounded monthly is: future-sum pv = ------------------------------ (1 + rrate/12) ** (12 * termy) where * future-sum = dollar value you want to have in termy years * termy = term, in years * rrate = annual rate of return that you can expect, in decimal Example: I need to have 10,000 in 5 years. The present value of 10,000 assuming an 8% monthly compounded rate-of-return is 6712.10. I.e., 6712 will grow to 10k in 5 years at 8%. Case 1b: Effects of inflation This formulation can also be used to estimate the effects of inflation; i.e., compute the real purchasing power of present and future sums. Simply use an estimated rate of inflation instead of a rate of return for the rrate variable in the equation. Example: In 30 years I will receive 1,000,000 (a megabuck). What is that amount of money worth today (what is the buying power), assuming a rate of inflation of 4.5%? The answer is 259,895.65 Case 2: Present value of a cash stream. This tells you the cost in today's dollars of money that you pay over time. Usually the payments that you make increase over the term. Basically, the money you pay in 10 years is worth less than that which you pay tomorrow, and this equation lets you compute just how much less. In this analysis, inflation is compounded yearly. A reasonable estimate for long-term inflation is 4.5%, but inflation has historically varied tremendously by country and time period. To compute the present value of a cash stream, the formula is: month=12 * termy paymt * (1 + irate) ** int ((month - 1)/ 12) pv = SUM --------------------------------------------- month=1 (1 + rrate/12) ** (month - 1) where * pv = present value * SUM (a.k.a. sigma) means to sum the terms on the right-hand side over the range of the variable 'month'; i.e., compute the expression for month=1, then for month=2, and so on then add them all up * month = month number * int() = the integral part of the number; i.e., round to the closest whole number; this is used to compute the year number from the month number * termy = term, in years * paymt = monthly payment, in dollars * irate = rate of inflation (increase in payment/year), in decimal * rrate = rate of return on money that you can expect, in decimal Example: You pay $500/month in rent over 10 years and estimate that inflation is 4.5% over the period (your payment increases with inflation.) Present value is 49,530.57 Stefan Heizmann offers a calculator for NPV on the web. http://www.IRRQ.com/us Two small C programs for computing future and present value on a PC are also available, which may be convenient if you have a large amount of data. See the article Software - Archive of Investment-Related Programs in this FAQ for more information. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Analysis - Goodwill Last-Revised: 18 Jul 1993 Contributed-By: John Keefe Goodwill is an asset that is created when one company acquires another. It represents the difference between the price the acquiror pays and the "fair market value" of the acquired company's assets. For example, if JerryCo bought Ford Motor for $15 billion, and the accountants determined that Ford's assets (plant and equipment) were worth $13 billion, $2 billion of the purchase price would be allocated to goodwill on the balance sheet. In theory the goodwill is the value of the acquired company over and above the hard assets, and it is usually thought to represent the value of the acquired company's "franchise," that is, the loyalty of its customers, the expertise of its employees; namely, the intangible factors that make people do business with the company. What is the effect on book value? Well, book value usually tries to measure the liquidation value of a company -- what you could sell it for in a hurry. The accountants look only at the fair market value of the hard assets, thus goodwill is usually deducted from total assets when book value is calculated. For most companies in most industries, book value is next to meaningless, because assets like plant and equipment are on the books at their old historical costs, rather than current values. But since it's an easy number to calculate, and easy to understand, lots of investors (both professional and amateur) use it in deciding when to buy and sell stocks. --------------------Check http://invest-faq.com/ for updates------------------ Compilation Copyright (c) 2005 by Christopher Lott.