Tag: Investment terms

Funding college for grandchildren

The most popular tax advantaged plans to pay for college education ar called “529 Plans.”  They allow people to put money into tax sheltered accounts which, if they are withdrawn for educational expenses are tax free.

Grandparent-owned 529 accounts offer distinct advantages.  Grandparents concerned about estate taxes can move large sums from their estate, tax-free. They can help trim college costs for their progeny. And there’s security knowing that money in 529 plans can be redeemed, if necessary, often with a modest tax bill.

One other advantage the 529 Plan has is that the grandparent stays in control of the money in the plans to insure that it’s used for the purpose it was intended.   With the high cost of college education today, many grandparents who have the ability will be willing to put money aside for their grandchildren’s education rather than gifts of games or toys.

What is an asset class?

Financial professionals constantly talk about asset classes, but what does that mean?  In the broadest sense, asset classes refer to a group of securities that have similar risk/return characteristics.  So, for example, in the broadest terms, stocks, bonds and cash represent the three most common asset classes.  Each has different risk and return characteristics and behave differently in response to a variety of economic and political events.  Stocks react most to corporate profitability, bonds to interest rates and cash to inflation.     That does not mean that these are the only issues that these assets react to but they are the predominant ones.

Most managers divide these broad assets classes into subgroups that act differently at different times.  Stocks, for example, can be divided into large cap, small cap, foreign or domestic.  Bonds can be subdivided into government, agency, municipal, corporate, foreign or domestic.  These classes can be divided again into their own subgroups.   The challenge for the investor is to find ways of participating in these investments.  This is where the expertise of the professional investment advisor comes into play.

Why is this important?  Because investment management is often about risk control and this is often achieved by balancing various assets classes to achieve the degree of risk to which a portfolio is subjected.  Modern portfolio theory demonstrates that investment with low correlation to the rest of the portfolio can lower over-all volatility even if the underlying investment itself is volatile.

 

The risks of bond investing.

For many investors, bonds are more mysterious than stocks.  Most people know that a bond is a loan and you are the lender. Who’s the borrower? Usually, it’s either the U.S. government, a state, a local municipality or a big company like General Motors. All of these entities need money to operate — to fund the federal deficit, for instance, or to build roads and finance factories — so they borrow capital from the public by issuing bonds.

There are several risks that you take when you buy a bond (or to put it another way, lend your money).

  • The first risk that you need to be concerned about is “credit risk.”  This is the risk that the bond issuer (the borrower) can’t pay the interest or principal back.  You may know how that works if you lend money to a friend.  It works exactly the same way in the bond world.  If a bond issuer can’t pay, the bond is said to be in “default.”  At that point you cannot be sure if you will get any of your money back.
  • A second risk with bonds is known as “interest rate risk.”  When a bond is issued it has a stated interest rate which is usually fixed for the life of the bond.   If interest rates go up during the bond’s lifetime, the value of the bond will go down.  If you need to sell it during this time you may get back less than you paid.
  • A third risk is the erosion of your “purchasing power.”  When you buy a bond, your money has a known purchasing power.  As an example, you know that you can get a cup of coffee at most places for about $1.25 (more at Starbucks) .   If you buy a bond that does not come due for 30 years you can be fairly sure that that same cup of coffee will cost a lot more due to inflation.  Yet if you buy the typical bond for $1000, you will get back $1000 at maturity and that may not buy nearly as many cups of coffee.  That lost purchasing power needs to be offset by the interest payment you receive.

This is a greatly simplified discussion of bond risk, but it gives you a starting point to try to determine how bond investing should be viewed.

What is an IPO?

An “IPO” or “initial public offering” is the first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded.

An example if the recent offering to the public of the common stock of Facebook.  This company was private until it decided to offer it shares to the general public and allow itself to be traded on a major exchange.  From Investopedia.

In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), the best offering price and the time to bring it to market.

The benefit to the founders of the company is that it gives them the ability to sell part of their stake in the company to the public, often making them millionaires or even billionaires overnight.   It also provides the company with much more capital than it previously had for purposes of expansion and growth.

The benefit to the public is their ability to participate in the company’s growth alongside the founding shareholders.

IPOs should be viewed with a great deal of caution.

IPOs can be a risky investment. For the individual investor, it is tough to predict what the stock will do on its initial day of trading and in the near future because there is often little historical data with which to analyze the company. Also, most IPOs are of companies going through a transitory growth period, which are subject to additional uncertainty regarding their future values.

Investors in the IPO of Facebook found this out when the excitement and hype surrounding its initial offering resulted in such a demand for the stock that people were willing to pay much more for the stock than was warranted.

What is an option?

An option is a contract to buy or sell a specific financial product officially known as the option’s underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists.

Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices – whether to buy or sell and whether to choose a call or a put – based on what you want to achieve as an options investor.

Options can be used to generate added income from securities, like stocks that you already own. The most common of these are “covered call options.”   They can also be used as a temporary insurance policy against a decline in the price of a stock or the market as a whole.  The most common of these are known as “protective puts.”

Options are complex instruments that require a sophisticated understanding of securities, and while some options can be used to reduce risk, others can create large amounts of risk.

What is a dividend?

Experienced investors know all about dividends but we thought it would be a good idea to explain dividends to newer investors.  And perhaps even experienced investors can learn something new here.

A dividend is money that corporations pay our to shareholder.  Older, established US companies will pay dividends to shareholders based on what they expect to be able to pay on a regular basis.  Dividends are usually paid out quarterly, although there are exceptions and investors should be aware of that.  American companies try to maintain the same dividend from quarter to quarter even if earnings fluctuate.  Many raise the dividend as they become more profitable.   This is not the case for foreign corporations whose dividends can be irregular and based on the profit for the quarter or the year.

Not all corporations pay dividends.  Most corporations in their start-up phase use their income to invest in the business for growth.  Shareholders in these growing businesses are rewarded by watching their stock price appreciate if the company is successful.  But after a while a company will reach a limit on its rate of growth and decide to reward its shareholder with a steady income.  There are some issues with dividends however  and they have to do with the tax treatment of dividends that differ from the tax treatment of capital gains.

Unlike interest payments to bondholders, corporations cannot deduct dividends as a business expense.  For this reason, corporations pay out dividends from after-tax profits.  When a stockholder receives a dividend, he also owes taxes in the dividend income.  For this reason, dividend income is generally considered to be taxed twice, one at the corporate level and once at the individual level.  For example, if a corporation earns $100 it can be taxed  up to 39.2%.  That leaves $60.80 that can be sent to shareholders as a dividend.  If all of it is distributed as dividends, the maximum tax rate on qualified dividends is currently 15%, leaving the shareholder with $51.68.  Next year the special 15% rate will be repealed exposing your dividend to a maximum of 43.4%, tax, leaving you with $34.41.  Of course these rates apply only to the top tax brackets but they do illustrate how taxes can affect what people have left to spend and why they change their behavior to avoid excessive taxation.

There are a few other things that investors should be aware of when investing in dividend paying stocks and that has to do with dates.  A corporation will announce its dividend on one date.  It wil also announce what is known as the “ex-dividend date.” 

A stock’s ex-dividend date is the first day an owner can sell the stock without losing the rights to its upcoming dividend. Obviously, it’s also the first day a buyer who purchases the stock will not receive that same dividend. A good way to remember how the ex-dividend date works is to think of it as a synonym for “without dividend.”

A third date is the “pay date”  which is the date on which the shareholder actually receives the dividend.

 

What is a preferred stock?

From Investopedia:

A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights.

Why are investors interested in preferred stock?  It’s all about income.  “Preferreds” (as they are generally referred to) usually pay higher dividends than common stock and have a higher yield than the same company’s bonds.  If the company gets into financial trouble preferred dividends have to be paid before common dividends can be paid.  If a company is liquidated, preferred stock holders are ahead of common stockholders if there are any assets  left to be distributed.

What are the downsides of Preferreds?  They do not have voting rights.  They rank below bank loans, bond holders and most other obligations of corporations except for common stock.  Most “retail class” preferred stocks are issued at $25 per share and usually have “call” provisions.  That means that the issuer can redeem them for “par” ($25) after a number of years.  This “call” is usually not exercise-able for 5 years, but can be exercised by the issuer any time after that.   This means that the price of a preferred stock can drop if the company that issued it gets into financial trouble, but will not rise much above $25 during it’s lifetime.

Bottom line, common stock is purchased for growth, preferred stock is purchased for income.  Choosing Preferreds requires a sophisticated knowledge of that particular market.  If you are interested, be sure to work with an RIA who know this market.

What is common stock?

A share of common stock represents partial ownership in a corporation.

When people get together to form a company one of the issues to be decided is who owns how much of the company.  For example, let’s say three people form a company.  Person “A” puts in $500, “B” puts in $300 and “C” puts in $200.  If the company is formed as a corporation, “A” would get half the shares, “B” would get 30% and “C” would get 20%.   The number of total shares that are issued is largely arbitrary.  The owners can decide that the corporation will issue a million shares.  If that’s the case, “A” would get 500,000 shares, “B” 300,000 and “C” 200,000.

Generally in small companies the people who put up the money receive shares in the company and then form a “Board of Directors.”  The board makes the policy decisions for the corporation which the company’s management is directed to carry out.

Each shareholder gets one vote for every share of stock he owns when voting on issues coming before the board.

As the company gets larger it may decide to “go public.”  That means that it will allow the general public to buy an ownership stake in the corporation.  To “go public” requires the company to jump through many regulatory hoops to be legally allowed to sell some of its shares in what is called an “initial public offering.”  Once the decision is made, the company also has to decide where its shares should be traded.  The most common markets are the New York Stock Exchange (NYSE) or the NASDAQ (the “over the counter market”).  While the NYSE is the most prestigious  the NASDAQ  is where some of the biggest companies – like Microsoft and Apple –  are traded.   It is  easier to get listed on the NASDAQ so most companies “go public” there.

Once a company is “publicly traded” the owners of these shares have the same voting rights as the founders, one vote for every share they own.

Owners of common stock reap most of the benefits if a company is successful and have the most to lose if a company fails.  But that is an issue for another day.

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