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Subject: The Investment FAQ (part 9 of 20)

This article was archived around: 21 May 2006 04:23:39 GMT

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Archive-name: investment-faq/general/part9 Version: $Id: part09,v 1.61 2003/03/17 02:44:30 lott Exp lott $ Compiler: Christopher Lott
The Investment FAQ is a collection of frequently asked questions and answers about investments and personal finance. This is a plain-text version of The Investment FAQ, part 9 of 20. The web site always has the latest version, including in-line links. Please browse 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: Mutual Funds - Distributions and Tax Implications Last-Revised: 27 Jan 1998 Contributed-By: Chris Lott ( contact me ), S. Jaguiar, Art Kamlet (artkamlet at aol.com), R. Kalia This article gives a brief summary of the issues surrounding distributions made by mutual funds, the tax liability of shareholders who recieve these distributions, and the consequences of buying or selling shares of a mutual fund shortly before or after such a distribution. Investment management companies (i.e., mutual funds) periodically distribute money to their shareholders that they made by trading in the shares they hold. These are called dividends or distributions, and the shareholder must pay taxes on these payments. Why do they distribute the gains instead of reinvesting them? Well, a mutual fund, under The Investment Company Act of 1940, is allowed to make the decision to distribute substantially all earnings to shareholders at least annually and thereby avoid paying taxes on those earnings. And, of course, they do. In general, equity funds distribute dividends quarterly, and distribute capital gains annually or semi-annually. In general, bond funds distribute dividends monthly, and distribute capital gains annually or semi-annually. When a distribution is made, the net asset value (NAV) goes down by the same amount. Suppose the NAV is $8 when you bought and has grown to $10 by some date, we'll pick Dec. 21. On paper you have a profit of $2. Then, a $1 distribution is made on Dec. 21. As a result of this distribution, the NAV goes down to $9 on Dec. 22 (ignoring any other market activity that might happen). Since you received a $1 payment and your shares are still worth $9, you still have the $10. However, you also have a tax liability for that $1 payment. Mutual funds commonly make distributions late in the year. Because of this, many advise mutual fund investors to be wary of buying into a mutual fund very late in the year (i.e., shortly before a distribution). Essentially what happens to a person who buys shortly before a distribution is that a portion of the investment is immediately returned to the investor along with a tax bill. In the short term it essentially means a loss for the investor. If the investor had bought in January (for example), and had seen the NAV rise nicely over the year, then receiving the distribution and tax bill would not be so bad. But when a person essentially increases their tax bill with a fund purchase, it is like seeing the value of the fund drop by the amount owed to the tax man. This is the main reason for checking with a mutual fund for planned distributions when making an investment, especially late in the year. But let's look at the issue a different way. The decision of buying shortly before a distribution all comes down to whether or not you feel that the fund is going to go up more in value than the total taxable event will be to you. For instance let's say that a fund is going to distribute 6% in income at the end of December. You will have to pay tax on that 6% gain, even though your account value won't go up by 6% (that's the law). Assuming that you are in a 33% tax bracket, a third of that gain (2% of your account value) will be paid in taxes. So it comes down to asking yourself the question of whether or not you feel that the fund will appreciate by 2% or more between now and the time that the income will be distributed. If the fund went up in value by 10% between the time of purchase and the distribution, then in the above example you would miss out on a 8% after-tax gain by not investing. If the fund didn't go up in value by at least 2% then you would take a loss and would have been better off waiting. So how clear is your crystal ball? For someone to make the claim that it is always patently better to wait until the end of the year to invest so as to avoid capital gains tax is ridiculous. Sometimes it is and sometimes it isn't. Investing is a most empirical process and every new situation should be looked at objectively. And it's important not to lose sight of the big picture. For a mutual fund investor who saw the value of their investment appreciate nicely between the time of purchase and the distribution, a distribution just means more taxes this year but less tax when the shares are sold. Of course it is better to postpone paying taxes, but it's not as though the profits would be tax-free if no distribution were made. For those who move their investments around every few months or years, the whole issue is irrelevant. In my view, people spend too much time trying to beat the tax man instead of trying to make more money. This is made worse by ratings that measure 'tax efficiency' on the basis of current tax liability (distributions) while ignoring future tax liability (unrealized capital gains that may not be paid out each year but they are still taxed when you sell). So what are the tax implications based on the timing of any sale? Actually, for most people there are none. If you sell your shares on Dec. 21, you have $2 in taxable capital gains ($1 from the distribution and $1 from the growth from 8 to 9). If you sell on Dec. 22, you have $1 in taxable capital gains and $1 in taxable distributions. This can make a small difference in some tax brackets, but no difference at all in others. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Fees and Expenses Last-Revised: 28 Jun 1997 Contributed-By: Chris Lott ( contact me ) Investors who put money into a mutual fund gain the benefits of a professional investment management company. Like any professional, using an investment manager results in some costs. These costs are recovered from a mutual fund's investors either through sales charges or operation expenses . Sales charges for an open-end mutual fund include front-end loads and back-end loads (redemption fees). A front-end load is a fee paid by an investor when purchasing shares in the mutual fund, and is expressed as a percentage of the amount to be invested. These loads may be 0% (for a no-load fund), around 2% (for a so-called low-load fund), or as high as 8% (ouch). A back-end load (or redemption fee) is paid by an investor when selling shares in the mutual fund. Unlike front-end loads, a back-end load may be a flat fee, or it may be expressed as a sliding scale. A sliding-scale means that the redemption fee is high if the investor sells shares within the first year of buying them, but declines to little or nothing after 3, 4, or 5 years. A sliding-scale fee is usually implemented to discourage investors from switching rapidly among funds. Loads are used to pay the sales force. The only good thing about sales charges is that investors only pay them once. A closed-end mutual fund is traded like a common stock, so investors must pay commissions to purchase shares in the fund. An article elsewhere in this FAQ about discount brokers offers information about minimizing commissions. To keep the dollars rolling in over the years, investment management companies may impose fees for operating expenses. The total fee load charged annually is usually reported as the expense ratio . All annual fees are charged against the net value of an investment. Operating expenses include the fund manager's salary and bonuses (management fees), keeping the books and mailing statements every month (accounting fees), legal fees, etc. The total expense ratio ranges from 0% to as much as 2% annually. Of course, 0% is a fiction; the investment company is simply trying to make their returns look especially good by charging no fees for some period of time. According to SEC rules, operating expenses may also include marketing expenses. Fees charged to investors that cover marketing expenses are called "12b-1 Plan fees." Obviously an investor pays fees to cover operating expenses for as long as he or she owns shares in the fund. Operating fees are usually calculated and accrued on a daily basis, and will be deducted from the account on a regular basis, probably monthly. Other expenses that may apply to an investment in a mutual fund include account maintenance fees, exchange (switching) fees, and transaction fees. An investor who has a small amount in a mutual fund, maybe under $2500, may be forced to pay an annual account maintenance fee. An exchange or switching fee refers to any fee paid by an investor when switching money within one investment management company from one of the company's mutual funds to another mutual fund with that company. Finally, a transaction fee is a lot like a sales charge, but it goes to the fund rather than to the sales force (as if that made paying this fee any less painful). The best available way to compare fees for different funds, or different classes of shares within the same fund, is to look at the prospectus of a fund. Near the front, there is a chart comparing expenses for each class assuming a 5% return on a $1,000 investment. The prospectus for Franklin Mutual Shares, for example, shows that B investors (they call it "Class II") pay less in expenses with a holding period of less than 5 years, but A investors ("Class I") come out ahead if they hold for longer than 5 years. In closing, investors and prospective investors should examine the fee structure of mutual funds closely. These fees will diminish returns over time. Also, it's important to note that the traditional price/quality curve doesn't seem to hold quite as well for mutual funds as it does for consumer goods. I mean, if you're in the market for a good suit, you know about what you have to pay to get something that meets your expectations. But when investing in a mutual fund, you could pay a huge sales charge and stiff operating expenses, and in return be rewarded with negative returns. Of course, you could also get lucky and buy the next hot fund right before it explodes. Caveat emptor. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Index Funds and Beating the Market Last-Revised: 26 May 1999 Contributed-By: Chris Lott ( contact me ) This article discusses index funds and modern portfolio theory (MPT) as espoused by Burton Malkiel, but first makes a digression into the topic of "beating the market." Investors and prospective investors regularly encounter the phrase "beating the market" or sometimes "beating the S&P 500." What does this mean? Somehow I'm reminded of the way Garrison Keillor used to start his show on Minnesota Public Radio, "Greetings from Lake Woebegon, where all the women are beautiful and all the children are above average" .. but I digress. To answer the second question first: The S&P 500 is a broad market index. Saying that you "beat the S&P" means that for some period of time, the returns on your investments were greater than the returns on the S&P index (although you have to ask careful questions about whether dividends paid out were counted, or only the capital appreciation measured by the rise in stock prices). Now, the harder question: Is this always the best indicator? This is slightly more involved. Everyone, most especially a mutual fund manager, wants to beat "the market". The problem lies in deciding how "the market" did. Let's limit things to the universe of stocks traded on U.S. exchanges.. even that market is enormous . So how does an aspiring mutual fund manager measure his or her performance? By comparing the fund's returns to some measure of the market. And now the $64,000 question: What market is the most appropriate comparison? Of course there are many answers. How about the large-cap market, for which one widely known (but dubious value) index is the DJIA? What about the market of large and mid-cap shares, for which one widely known index is the S&P 500? And maybe you should use the small-cap market, for which Wilshire maintains various indexes? And what about technology stocks, which the NASDAQ composite index tracks somewhat? As you can see, choosing the benchmark against which you will compare yourself is not exactly simple. That said, an awful lot of funds compare themselves against the S&P. The finance people say that the S&P has some nice properties in the way it is computed. Most market people would say that because so much of the market's capitalization is tracked by the S&P, it's an appropriate benchmark. You be the judge. The importance of indexes like the S&P500 is the debate between passive investing and active investing. There are funds called index funds that follow a passive investment style. They just hold the stocks in the index. That way you do as well as the overall market. It's a no-brainer. The person who runs the index fund doesn't go around buying and selling based on his or her staff's stock picks. If the overall market is good, you do well; if it is not so good, you don't do well. The main benefit is low overhead costs. Although the fund manager must buy and sell stocks when the index changes or to react to new investments and redemptions, otherwise the manager has little to do. And of course there is no need to pay for some hotshot group of stock pickers. However, even more important is the "efficient market theory" taught in academia that says stock prices follow a random walk. Translated into English, this means that stock prices are essentially random and don't have trends or patterns in the price movements. This argument pretty much attacks technical analysis head-on. The theory also says that prices react almost instantaneously to any information - making fundamental analysis fairly useless too. Therefore, a passive investing approach like investing in an index fund is supposedly the best idea. John Bogle of the Vanguard fund is one of the main proponents of a low-cost index fund. The people against the idea of the efficient market (including of course all the stock brokers who want to make a commission, etc.) subscribe to one of two camps - outright snake oil (weird stock picking methods, bogus claims, etc.) or research in some camps that point out that the market isn't totally efficient. Of course academia is aware of various anomalies like the January effect, etc. Also "The Economist" magazine did a cover story on the "new technology" a few years ago - things like using Chaos Theory, Neural Nets, Genetic Algorithms, etc. etc. - a resurgence in the idea that the market was beatable using new technology - and proclaimed that the efficient market theory was on the ropes. However, many say that's an exaggeration. If you look at the records, there are very, very few funds and investors who consistently beat the averages (the market - approximated by the S&P 500 which as I said is a "no brainer investment approach"). What you see is that the majority of the funds, etc. don't even match the no-brainer approach to investing. Of the small amount who do (the winners), they tend to change from one period to another. One period or a couple of periods they are on top, then they do much worse than the market. The ones who stay on top for years and years and years - like a Peter Lynch - are a very rare breed. That's why efficient market types say it's consistent with the random nature of the market. Remember, index funds that track the S&P 500 are just taking advantage of the concept of diversification. The only risk they are left with (depending on the fund) is whether the entire market goes up and down. People who pick and choose individual companies or a sector in the market are taking on added risk since they are less diversified. This is completely consistent with the more risk = possibility of more return and possibility of more loss principle. It's just like taking longer odds at the race track. So when you choose a non-passive investment approach you are either doing two things: 1. Just gambling. You realize the odds are against you just like they are at the tracks where you take longer odds, but you are willing to take that risk for the slim chance of beating the market. 2. You really believe in your own or a hired gun's stock picking talent to take on stocks that are classified as a higher risk with the possibility of greater return because you know something that nobody else knows that really makes the stock a low risk investment (secret method, inside information, etc.) Of course everyone thinks they belong in this camp even though they are really in the former camp, sometimes they win big, most of times they lose, with a few out of the zillion investors winning big over a fairly long period. It's consistent with the notion that it's gambling. So you get this picture of active fund managers expending a lot of energy on a tread mill running like crazy and staying in the same spot. Actually it's not even the same spot since most don't even match the S&P 500 due to the added risk they've taken on in their picks or the transaction costs of buying and selling. That's why market indexes like the S&P 500 are the benchmark. When you pick stocks on your own or pay someone to manage your money in an active investment fund, you are paying them to do better or hoping you will do better than doing the no-brainer passive investment index fund approach that is a reasonable expectation. Just think of paying some guy who does worse than if he just sat on his butt doing nothing! The following list of resources will help you learn much, much more about index mutual funds. * An accessible book that covers investing approaches and academic theories on the market, especially modern portfolio theory (MPT) and the efficient market hypothesis, is this one (the link points to Amazon): Burton Malkiel A Random Walk Down Wall Street This book was written by a former Princeton Prof. who also invested hands-on in the market. It's a bestseller, written for the public and available in paperback. * IndexFunds.com offers much information about index mutual funds. The site is edited by Will McClatchy and published by IndexFunds, Inc., of Austin, Texas. http://www.indexfunds.com * The list of frequently asked questions about index mutual funds, which is maintained by Dale C. Maley. http://www.geocities.com/Heartland/Prairie/3524/faqperm5.html --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Money-Market Funds Last-Revised: 16 Aug 1998 Contributed-By: Chris Lott ( contact me ), Rich Carreiro (rlcarr at animato.arlington.ma.us) A money-market fund (MMF) is a mutual fund, although a very special type of one. The goal of a money-market fund is to preserve principal while yielding a modest return. These funds try very, very, very hard to maintain a net asset value (NAV) of exactly $1.00. Basically, the companies try to make these feel like a high-yield bank account, although one should never forget that the money-market fund has no insurance against loss. The NAV stays at $1 for (at least) three reasons: 1. The underlying securities in a MMF are very short-term money market instruments. Usually maturing in 60 days or less, but always less than 180 days. They suffer very little price fluctuation. 2. To the extent that they do fluctuate, the fund plays some (legal) accounting games (which are available because the securities are so close to maturity and because they fluctuate fairly little) with how the securities are valued, making it easier to maintain the NAV at $1. 3. MMFs declare dividends daily, though they are only paid out monthly. If you totally cash in your MMF in the middle of the month, you'll receive the cumulative declared dividends from the 1st of the month to when you sold out. If you only partially redeem, the dividends declared on the sold shares will simply be part of what you see at the end of the month. This is part of why the fund's interest income doesn't raise the NAV. MMFs remaining at a $1 NAV is not advantageous in the sense that it reduces your taxes (in fact, it's the opposite), it's advantageous in the sense that it saves you from having to track your basis and compute and report your gain/loss every single time you redeem MMF shares, which would be a huge pain, since many (most?) people use MMFs as checking accounts of a sort. The $1 NAV has nothing to do with being able to redeem shares quickly. The shareholders of an MMF could deposit money and never touch it again, and it would have no effect on the ability of the MMF to maintain a $1 NAV. Like any other mutual fund, a money-market fund has professional management, has some expenses, etc. The return is usually slightly more than banks pay on demand deposits, and perhaps a bit less than a bank will pay on a 6-month CD. Money-market funds invest in short-term (e.g., 30-day) securities from companies or governments that are highly liquid and low risk. If you have a cash balance with a brokerage house, it's most likely stashed in a money-market fund. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Reading a Prospectus Last-Revised: 9 Aug 1999 Contributed-By: Chris Stallman (chris at teenanalyst.com) Ok, so you just went to a mutual fund family's (e.g., Fidelity) web site and requested your first prospectus. As you anxiously wait for it to arrive in the mail, you start to wonder what information will be in it and how you'll manage to understand it. Understanding a prospectus is crucial to investing in a mutual fund once you know a few key points. When you request information on a mutual fund, they usually send you a letter mentioning how great the fund is, the necessary forms you will have to fill out to invest in the fund, and a prospectus. You can usually just throw away the letter because it is often more of an advertisement than anything else. But you should definitely read the prospectus because it has all the information you need about the mutual fund. The prospectus is usually broken up into different sections so we'll go over what each section's purpose is and what you should look for in it. Objective Statement Usually near the front of a prospectus is a small summary or statement that explains the mutual fund. This short section tells what the goals of the mutual fund are and how it plans to reach these goals. The objective statement is really important in choosing your fund. When you choose a fund, it is important to choose one based on your investment objective and risk tolerance. The objective statement should agree with how you want your money managed because, after all, it is your money. For example, if you wanted to reduce your exposure to risk and invest for the long-term, you wouldn't want to put your money in a fund that invests in technology stocks or other risky stocks. Performance The performance section usually gives you information on how the mutual fund has performed. There is often a table that gives you the fund's performance over the last year, three years, five years, and sometimes ten years. The fund's performance usually helps you see how the fund might perform but you should not use this to decide if you are going to invest in it or not. Funds that do well one year don't always do well the next. It's often wise to compare the fund's performance with that of the index. If a fund consistently under performs the index by 5% or more, it may not be a fund that you want to invest in for the long-term because that difference can mean the difference of retiring with $200,000 and retiring with $1.5 million. Usually in the performance section, there is a small part where they show how a $10,000 investment would perform over time. This helps give you an idea of how your money would do if you invested in it but this number generally doesn't include taxes and inflation so your portfolio would probably not return as much as the prospectus says. Fees and Expenses Like most things in life, a mutual fund doesn't operate for free. It costs a mutual fund family a lot of money to manage everyone's money so they put in some little fees that the investors pay in order to make up for the fund's expenses. One fee that you will come across is a management fee, which all funds charge. Mutual funds charge this fee so that the fund can be run. The money collected from the shareholders from this fee is used to pay for the expenses incurred from buying and selling large amounts of shares in stocks. This fee usually ranges from about 0.5% up to over 2%. Another fee that you're likely to encounter is a 12b-1 fee. The money collected from charging this fee is usually used for marketing and advertising the fund. This fee usually ranges between 0.25-0.75%. However, not all funds charge a 12b-1 fee. One fee that is a little less common but still exists in many funds is a deferred sales load. Frequent buying and selling of shares in a mutual fund costs the mutual fund money so they created a deferred sales charge to discourage this activity. This fee sometimes disappears after a certain period and can range from 0.5% up to 5%. When you are looking through a prospectus, be sure that you look over these fees because even if a mutual fund performs well, its growth may be limited by high expenses. How to Purchase and Redeem Shares This section provides information on how you can get your money into the mutual fund and how you can sell shares when you need the money out of the fund. These methods are usually the same in every fund. The most common method to invest in a fund once you are in it is to simply fill out investment forms and write a check to the mutual fund family. This is probably the easiest but it often takes a few days or even a week to have the funds credited to your account. Another method that is common is automatic withdrawals. These allow you to have a certain amount which you choose to be deducted from your bank account each month. These are excellent for getting into the habit of investing on a regular basis. Wire transfers are also possible if you want to have your money invested quickly. However, most funds charge you a small fee for doing this and some do not allow you to wire any funds if you do not meet their minimum amount. The fund will also provide information on how you can redeem your shares. One common way is to request a redemption by filling out a form or writing a letter to the mutual fund family. This is the most common method but it isn't the only one. You can also request to redeem your shares by calling the mutual fund itself. This option saves you a few days but you have to make sure the fund has this option open to the shareholders. You can also request to have your investment wired into your bank account. This is a very fast method for redeeming shares but you usually have to pay a fee for doing this. And like redeeming shares over the phone, you have to make sure the mutual fund offers this option. Now that you understand the basics of a prospectus, you're one step closer to getting started in mutual funds. So when you finally receive the information you requested on a mutual fund, look it over carefully and make an educated decision if it is right for you. For more insights from Chris Stallman, visit http://www.teenanalyst.com --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Redemptions Last-Revised: 5 May 1997 Contributed-By: A. Chowdhury On the stock markets, every time someone sells a share, someone buys it, or in other words, equal numbers of opposing bets on the future are placed each day. However, in the case of open-end mutual funds, every dollar redeemed in a day isn't necessarily replaced by an invested dollar, and every dollar invested in a day doesn't go to someone redeeming shares. Still, although mutual fund shares are not sold directly by one investor to another investor, the underlying situation is the same as stocks. If a mutual fund has no cash, any redemption requires the fund manager to sell an appropriate amount of shares to cover the redemption; i.e., someone would have to be found to buy those shares. Similarly, any new investment would require the manager to find someone to sell shares so the new investment can be put to work. So the manager acts somewhat like the fund investor's representative in buying/selling shares. A typical mutual fund has some cash to use as a buffer, which confuses the issue but doesn't fundamentally change it. Some money comes in, and some flows out, much of it cancels each other out. If there is a small imbalance, it can be covered from the fund's cash position, but not if there is a big imbalance. If the manager covers your sale from the fund's cash, he/she is reducing the fund's cash and so increasing the fund's stock exposure (%), in other words he/she is betting on the market at the same time as you are betting against it. Of course if there is a large imbalance between money coming in and out, exceeding the cash on hand, then the manager has to go to the stock market to buy/sell. And so forth. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Types of Funds Last-Revised: 12 Aug 1999 Contributed-By: Chris Lott ( contact me ) This article lists the most common investment fund types. A type of fund is typically characterized by its investment strategy (i.e., its goals). For example, a fund manager might set a goal of generating income, or growing the capital, or just about anything. (Of course they don't usually set a goal of losing money, even though that might be one of the easist goals to achieve :-). If you understand the types of funds, you will have a decent grasp on how funds invest their money. When choosing a fund, it's important to make sure that the fund's goals align well with your own. Your selection will depend on your investment strategy, tax situation, and many other factors. Money-market funds Goal: preserve principal while yielding a modest return. These funds are a very special sort of mutual fund. They invest in short-term securities that pay a modest rate of interest and are very safe. See the article on money-market funds elsewhere in this FAQ for an explanation of the $1.00 share price, etc. Balanced Funds Goal: grow the principal and generate income. These funds buy both stocks and bonds. Because the investments are highly diversified, investors reduce their market risk (see the article on risk elsewhere in this FAQ). Index funds Goal: match the performance of the markets. An index fund essentially sinks its money into the market in a way determined by some market index and does almost no further trading. This might be a bond or a stock index. For example, a stock index fund based on the Dow Jones Industrial Average would buy shares in the 30 stocks that make up the Dow, only buying or selling shares as needed to invest new money or to cash out investors. The advantage of an index fund is the very low expenses. After all, it doesn't cost much to run one. See the article on index funds elsewhere in this FAQ. Pure bond funds Bond funds buy bonds issued by many different types of companies. A few varieties are listed here, but please note that the boundaries are rarely as cut-and-dried as I've listed here. Bond (or "Income") funds Goal: generate income while preserving principal as much as possible. These funds invest in medium- to long-term bonds issued by corporations and governments. Variations on this type of fund include corporate bond funds and government bond funds. See the article on bond basics elsewhere in this FAQ. Holding long-term bonds opens the owner to the risk that interest rates may increase, dropping the value of the bond. Tax-free Bond Funds (aka Tax-Free Income or Municipal Bond Funds) Goal: generate tax-free income while preserving principal as much as possible. These funds buy bonds issued by municipalities. Income from these securities are not subject to US federal income tax. Junk (or "High-yield") bond funds Goal: generate as much income as possible. These funds buy bonds with ratings that are quite a bit lower than high-quality corporate and government bonds, hence the common name "junk." Because the risk of default on junk bonds is high when compared to high-quality bonds, these funds have an added degree of volatility and risk. Pure stock funds Stock funds buy shares in many different types of companies. A few varieties are listed here, but please note that the boundaries are rarely as cut-and-dried as I've listed here. Aggressive growth funds Goal: capital growth; dividend income is neglected. These funds buy shares in companies that have the potential for explosive growth (these companies never pay dividends). Of course such shares also have the potential to go bankrupt suddenly, so these funds tend to have high price volatility. For example, an actively managed aggressive-growth stock fund might seek to buy the initial offerings of small companies, possibly selling them again very quickly for big profits. Growth funds Goal: capital growth, but consider some dividend income. These funds buy shares in companies that are growing rapidly but are probably not going to go out of business too quickly. Growth and Income funds Goal: Grow the principal and generate some income. These funds buy shares in companies that have modest prospect for growth and pay nice dividend yields. The canonical example of a company that pays a fat dividend without growing much was a utility company, but with the onset of deregulation and competition, I'm not sure of a good example anymore. Sector funds Goal: Invest in a specific industry (e.g., telecommunications). These funds allow the small investor to invest in a highly select industry. The funds usually aim for growth. Another way of categorizing stock funds is by the size of the companies they invest in, as measured by the market capitalization, usually abbreviated as market cap. (Also see the article in the FAQ about market caps .) The three main categories: Small cap stock funds These funds buy shares of small companies. Think new IPOs. The stock prices for these companies tend to be highly volatile, and the companies never (ever) pay a dividend. You may also find funds called micro cap, which invest in the smallest of publically traded companies. Mid cap stock funds These funds buy shares of medium-size companies. The stock prices for these companies are less volatile than the small cap companies, but more volatile (and with greater potential for growth) than the large cap companies. Large cap stock funds These funds buy shares of big companies. Think IBM. The stock prices for these companies tend to be relatively stable, and the companies may pay a decent dividend. International Funds Goal: Invest in stocks or bonds of companies located outside the investor's home country. There are many variations here. As a rule of thumb, a fund labeled "international" will buy only foreign securities. A "global" fund will likely spread its investments across domestic and foreign securities. A "regional" fund will concentrate on markets in one part of the world. And you might see "emerging" funds, which focus on developing countries and the securities listed on exchanges in those countries. In the discussion above, we pretty much assumed that the funds would be investing in securities issued by U.S. companies. Of course any of the strategies and goals mentioned above might be pursued in any market. A risk in these funds that's absent from domestic investments is currency risk. The exchange rate of the domestic currency to the foreign currency will fluctuate at the same time as the investment, which can easily increase -- or reverse -- substantial gains abroad. Another important distinction for stock and bond funds is the difference between actively managed funds and index funds. An actively managed fund is run by an investment manager who seeks to "beat the market" by making trades during the course of the year. The debate over manged versus index funds is every bit the equal of the debate over load versus no-load funds. YOU decide for yourself. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Mutual Funds - Versus Stocks Last-Revised: 10 Aug 1999 Contributed-By: Maurice E. Suhre, Chris Lott ( contact me ) This article discusses the relative advantages of stocks and mutual funds. Question: What advantages do mutual funds offer over stocks? Here are some considerations. * A mutual fund offers a great deal of diversification starting with the very first dollar invested, because a mutual fund may own tens or hundreds of different securities. This diversification helps reduce the risk of loss because even if any one holding tanks, the overall value doesn't drop by much. If you're buying individual stocks, you can't get much diversity unless you have $10K or so. * Small sums of money get you much further in mutual funds than in stocks. First, you can set up an automatic investment plan with many fund companies that lets you put in as little as $50 per month. Second, the commissions for stock purchases will be higher than the cost of buying no-load funds :-) (Of course, the fund's various expenses like commissions are already taken out of the NAV). Smaller sized purchases of stocks will have relatively high commissions on a percentage basis, although with the $10 trade becoming common, this is a bit less of a concern than it once was. * You can exit a fund without getting caught on the bid/ask spread. * Funds provide a cheap and easy method for reinvesting dividends. * Last but most certainly not least, when you buy a fund you're in essence hiring a professional to manage your money for you. That professional is (presumably) monitoring the economy and the markets to adjust the fund's holdings appropriately. Question: Do stocks have any advantages compared to mutual funds? Here are some considerations that will help you judge. * The opposite of the diversification issue: If you own just one stock and it doubles, you are up 100%. If a mutual fund owns 50 stocks and one doubles, it is up 2%. On the other hand, if you own just one stock and it drops in half, you are down 50% but the mutual fund is down 1%. Cuts both ways. * If you hold your stocks several years, you aren't nicked a 1% or so management fee every year (although some brokerage firms charge if there aren't enough trades). * You can take your profits when you want to and won't inadvertently buy a tax liability. (This refers to the common practice among funds of distributing capital gains around November or December of each year. See the article elsewhere in this FAQ for more details.) * You can do a covered write option strategy. (See the article on options on stocks for more details.) * You can structure your portfolio differently from any existing mutual fund portfolio. (Although with the current universe of funds I'm not certain what could possibly be missing out there!) * You can buy smaller cap stocks which aren't suitable for mutual funds to invest in. * You have a potential profit opportunity by shorting stocks. (You cannot, in general, short mutual funds.) * The argument is offered that the funds have a "herd" mentality and they all end up owning the same stocks. You may be able to pick stocks better. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Real Estate - 12 Steps to Buying a Home Last-Revised: 19 Sep 1999 Contributed-By: Blanche Evans Why do you want to make a change? Are you ready to start a family, plant your own garden? Do you feel you've finally "arrived" at your company? Maybe a raise, or a bonus, or a baby on the way has made you think about living in a home of your own. Whatever the reason you are thinking about a home, there are 12 steps you will inevitably take. If you do them in the right order, you will save yourself time, frustration, and money. For example, if you start shopping for homes on the Internet without knowing how much you can spend, you will not only waste time looking at the wrong homes, but you may ultimately be disappointed at what you can actually afford. 1. FIND OUT HOW MUCH YOU CAN SPEND The first thing you need to do is figure out what kind of home you want to buy and how much you can afford to pay in monthly installments. Keep in mind that the results of your calculations will only be an estimate. Until you have chosen a home and the type of loan you want, and communicated with a lender, you can only use the calculated amount to help you determine a price range of homes you want to preview. 2. GET PRE-APPROVED FOR A LOAN Either go to a mortgage broker or a direct lender and find out for certain the size of mortgage for which you can qualify. The pre-approval letter the lender issues you will help you be taken more seriously by agents and sellers because they will recognize you as someone who is prepared to buy. If you want a larger mortgage or better rate, investigate the government sites such as HUD. 3. HIRE AN AGENT, PARTICULARLY A BUYER'S AGENT Using an agent can help you in numerous ways, especially because you are already paying for those services in the purchase price of the home. Both the seller's agent and the buyer's agent are paid out of the transaction proceeds that are included in the marketing price of the home. If you don't take advantage of an agent, you are paying for services you aren't getting. If you are planning to buy a home available through foreclosure or a for-sale-by-owner (FSBO), you can still use the services of an agent. Agents will negotiate with you on their fees and the amount of service you will receive for those fees, and you can arrange for them to be paid out of the transaction, not out of your pocket. Start by narrowing the field. If you are interested in a certain neighborhood in your town, find out who the experts are in that area of town. They will be better informed and more attuned to the "grapevine," and are better positioned to network with other agents in the same area. Contrary to popular belief only 20 percent of homes are actually sold through newspaper ads. The other 80 percent are sold through networking among agents. If you are relocating to a new city, ask agents in your own town to refer you to agents in your new area. They will be happy to do so, because if you buy a home from their referral, they will receive a referral fee, so they are motivated to make certain you find the right agent to assist you in buying a home. 4. SIGN A BUYER'S AGREEMENT Again, if you find an agent you like, go all the way and sign a buyer's representation agreement. This agreement means that you will have one agent representing you as a buyer. The agreement empowers the agent to not only search out the latest Multiple Listing Service list, but to seek alternative means of finding you a home, including searching foreclosures and homes for sale by owner. With a signed agreement, the agent becomes a fiduciary and must act, by law, in your best interests. 5. BE AWARE OF YOUR LIKES AND DISLIKES As you shop for homes, keep in mind what you like and don't like and pass along your feelings to the agent. You should feel comfortable looking at numerous homes, but neither you nor your agent is interested in wasting time on homes that aren't appropriate. Like any relationship, your home will not be perfect. If you are finding that most of your criteria is met, it shouldn't be long before you find the right home. Think in terms of possibilities as well as what you see is what you get. Perhaps a home isn't move-in perfect, but with a little work it could be the home for you. Don't let cosmetic or minor remodeling problems discourage you. Many remodeling jobs add tremendous value to a home. If you remodel a kitchen, for example, you may receive as much as a 128 percent return on your investment. Talk with your agent, friends, relatives, and contractors and find out what it will cost to remodel the home the way you want it. 6. WRITE A CONTRACT When you find the home you want, you will write a contract, either through your agent or your attorney, or on your own. Your offer should spell out what you are willing to pay for and what you are not, when you want to close, and when you want to take possession of the home. Your contract should be contingent upon getting an inspection and evaluating the results. If the inspection reveals a big problem, you and the seller can renegotiate the purchase price if you are still interested in buying. 7. GET THE LOAN UNDERWAY As soon as the seller agrees to the contract, you must start following through on your loan. Take the contract to the lender and let it start the loan process in earnest. If you have been preapproved, much of the legwork has already been done and your loan will process more quickly. 8. THE HOME WILL BE APPRAISED The lender will arrange to have the home appraised, which may affect whether the loan is granted. But the likelihood of a homeselling for more than a lender is willing to lend is slim. The real estate industry not only keeps up with how quickly homes sell, but how much they sell for in an area. Most lenders will have a ceiling on the amount of square feet per home they will lend in a certain neighborhood. If a home is overpriced, it will quickly be obvious. You can then go back to the seller and renegotiate. 9. THE HOME IS INSPECTED In many markets, you will have the inspection after the contract is signed, rather than before. This is a better protection for the buyer. The inspection can reveal some nasty shocks, though. Your inspector may find a major problem with the furnace or the foundation. These are problems that must be fixed or the home cannot be conveyed. The seller then has to arrange to pay for the repairs, or have the repairs paid for out of the contract proceeds via a mechanic's lien. Before you can truly set the closing date, the repairs have to be made and approved by the buyer. 10. NEGOTIATIONS CONTINUE AS YOU GET READY TO MOVE As you find a mover, pack your things, and arrange days off a work around the closing date, you will find that things can still change. It is the most intense, nerve-wracking time of the transaction -- waiting for the other shoe to drop. You think you may have addressed all the issues and closing will proceed without any other hitches, but negotiations still continue as you reevaluate the inspection report, or find out the chandelier you thought was included is actually excluded from the contract. As you revisit the home to show your relatives, your hopes raise, even through your doubts that the home will ever be yours increase. 11. CLOSING -- BE PREPARED FOR ANYTHING TO HAPPEN Until closing, and even during closing, anything can happen. You find out that your closing costs are higher than you thought they would be because some additional service fees have been added by the lender. A glitch could come out in your credit report that delays the sale; a problem the owner was supposed to fix wasn't repaired in time; the homeowner can decide that she or he doesn't want to pay for the home warranty after all; the appraisal may come in the day before closing and be short of the asking price of the home. If so, the buyer, seller, and their agents have to figure out how to make up the shortfall. Do they lower the price of the home? Do the agents pay for the difference out of their commissions? How will last-minute problems be handled? The negotiating table is an emotionally explosive place. That is why closings are generally held in private rooms with the buyers and sellers separated. 12. YOU GET THE KEYS It's all over. The home is yours. Congratulations. This article was excerpted from homesurfing.net: The Insider's Guide to Buying and Selling Your Home Using the Internet , by Blanche Evans. Copyright 1999 by Dearborn Financial Publishing. Reprinted by permission of the publisher Dearborn, A Kaplan Professional Company. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Real Estate - Investment Trusts (REITs) Last-Revised: 8 Dec 1995 Contributed-By: Braden Glett (glett at prodigy.net) A Real Estate Investment Trust (REIT) is a company that invests its assets in real estate holdings. You get a share of the earnings, depreciation, etc. from the portfolio of real estate holdings that the REIT owns. Thus, you get many of the same benefits of being a landlord without too many of the hassles. You also have a much more liquid investment than you do when directly investing in real estate. The downsides are that you have no control over when the company will sell its holdings or how it will manage them, like you would have if you owned an apartment building on your own. Essentially, REITs are the same as stocks, only the business they are engaged in is different than what is commonly referred to as "stocks" by most folks. Common stocks are ownership shares generally in manufacturing or service businesses. REITs shares on the other hand are the same, just engaged in the holding of an asset for rental, rather than producing a manufactured product. In both cases, though, the shareholder is paid what is left over after business expenses, interest/principal, and preferred shareholders' dividends are paid. Common stockholders are always last in line, and their earnings are highly variable because of this. Also, because their returns are so unpredictable, common shareholders demand a higher expected rate of return than lenders (bondholders). This is why equity financing is the highest-cost form of financing for any corporation, whether the corporation be a REIT or mfg firm. An interesting thing about REITs is that they are probably the best inflation hedge around. Far better than gold stocks, which give almost no return over long periods of time. Most of them yield 7-10% dividend yield. However, they almost always lack the potential for tremendous price appreciation (and depreciation) that you get with most common stocks. There are exceptions, of course, but they are few and far between. If you invest in them, pick several REITs instead of one. They are subject to ineptitude on the part of management just like any company's stock, so diversification is important. However, they are a rather conservative investment, with long-term returns lower than common stocks of other industries. This is because rental revenues do net usually vary as much as revenues at a mfg or service firm. REITNet, a full-service real estate information site, offers a comprehensive guide to Real Estate Investment Trusts. http://www.reitnet.com --------------------Check http://invest-faq.com/ for updates------------------ Compilation Copyright (c) 2003 by Christopher Lott.