The Investment FAQ (part 1 of 20)

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Christopher Lott

Apr 17, 2004, 7:28:30 AM4/17/04
Archive-name: investment-faq/general/part1
Version: $Id: part01,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

This is the table of contents for the plain-text version of
The Investment FAQ, and is the first part of a 20-part posting.
Please visit The Investment FAQ web site for the latest version:

The Investment FAQ is a collection of articles about investments and
personal finance, including stocks, bonds, mutual funds, options,
discount brokers, information sources, life insurance, etc. Although
the FAQ is more of a reference than a tutorial, if you pick your
articles carefully, the FAQ can serve as a comprehensive, unbiased
introduction to investing.

Terms of Use

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The Investment FAQ is copyright 2003 by Christopher Lott, and is
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Investment FAQ or for any damages (whether direct or indirect,
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Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
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Advice - Beginning Investors part 2
Advice - Buying a Car at a Reasonable Price part 2
Advice - Errors in Investing part 2
Advice - Using a Full-Service Broker part 2
Advice - Mutual-Fund Expenses part 2
Advice - One-Line Wisdom part 2
Advice - Paying for Investment Advice part 2
Advice - Researching a Company part 2
Advice - Target Stock Prices part 2
Analysis - Amortization Tables part 2
Analysis - Annual Reports part 2
Analysis - Beta and Alpha part 2
Analysis - Book-to-Bill Ratio part 2
Analysis - Book Value part 2
Analysis - Computing Compound Return part 2
Analysis - Future and Present Value of Money part 2
Analysis - Goodwill part 2
Analysis - Internal Rate of Return (IRR) part 3
Analysis - Paying Debts Early versus Making Investments part 3
Analysis - Price-Earnings (P/E) Ratio part 3
Analysis - Percentage Rates part 3
Analysis - Risks of Investments part 3
Analysis - Return on Equity versus Return on Capital part 3
Analysis - Rule of 72 part 3
Analysis - Same-Store Sales part 3
Bonds - Basics part 3
Bonds - Amortizing Premium part 3
Bonds - Duration Measure part 3
Bonds - Moody Bond Ratings part 3
Bonds - Municipal Bond Terminology part 4
Bonds - Relationship of Price and Interest Rate part 4
Bonds - Tranches part 4
Bonds - Treasury Debt Instruments part 4
Bonds - Treasury Direct part 4
Bonds - U.S. Savings Bonds part 4
Bonds - U.S. Savings Bonds for Education part 4
Bonds - Value of U.S. Treasury Bills part 4
Bonds - Zero-Coupon part 4
CDs - Basics part 4
CDs - Market Index Linked part 4
Derivatives - Basics part 4
Derivatives - Black-Scholes Option Pricing Model part 5
Derivatives - Futures part 5
Derivatives - Futures and Fair Value part 5
Derivatives - Stock Option Basics part 5
Derivatives - Stock Option Covered Calls part 5
Derivatives - Stock Option Covered Puts part 5
Derivatives - Stock Option Ordering part 5
Derivatives - Stock Option Splits part 5
Derivatives - Stock Option Symbols part 5
Derivatives - LEAPs part 5
Education Savings Plans - Section 529 Plans part 5
Education Savings Plans - Coverdell part 5
Exchanges - The American Stock Exchange part 5
Exchanges - The Chicago Board Options Exchange part 5
Exchanges - Circuit Breakers, Curbs, and Other Trading part 6
Exchanges - Contact Information part 6
Exchanges - Instinet part 6
Exchanges - Market Makers and Specialists part 6
Exchanges - The NASDAQ part 6
Exchanges - The New York Stock Exchange part 6
Exchanges - Members and Seats on AMEX part 6
Exchanges - Ticker Tape Terminology part 6
Financial Planning - Basics part 6
Financial Planning - Choosing a Financial Planner part 6
Financial Planning - Compensation and Conflicts of Interest part 6
Financial Planning - Estate Planning Checkup part 6
Information Sources - Books part 7
Information Sources - Conference Calls part 7
Information Sources - Free to All Who Ask part 7
Information Sources - Investment Associations part 7
Information Sources - Value Line part 7
Information Sources - Wall $treet Week part 7
Insurance - Annuities part 8
Insurance - Life part 8
Insurance - Viatical Settlements part 8
Insurance - Variable Universal Life (VUL) part 8
Mutual Funds - Basics part 8
Mutual Funds - Average Annual Return part 8
Mutual Funds - Buying from Brokers versus Fund Companies part 8
Mutual Funds - Distributions and Tax Implications part 9
Mutual Funds - Fees and Expenses part 9
Mutual Funds - Index Funds and Beating the Market part 9
Mutual Funds - Money-Market Funds part 9
Mutual Funds - Reading a Prospectus part 9
Mutual Funds - Redemptions part 9
Mutual Funds - Types of Funds part 9
Mutual Funds - Versus Stocks part 9
Real Estate - 12 Steps to Buying a Home part 9
Real Estate - Investment Trusts (REITs) part 9
Real Estate - Renting versus Buying a Home part 10
Regulation - Accredited Investor part 10
Regulation - Full Disclosure part 10
Regulation - Money-Supply Measures M1, M2, and M3 part 10
Regulation - Federal Reserve and Interest Rates part 10
Regulation - Margin Requirements part 10
Regulation - Securities and Exchange Commission (U.S.) part 10
Regulation - SEC Rule 144 part 10
Regulation - SEC Registered Advisory Service part 10
Regulation - SEC/NASDAQ Settlement part 10
Regulation - Series of Examinations/Registrations part 10
Regulation - SIPC, or How to Survive a Bankrupt Broker part 10
Retirement Plans - 401(k) part 11
Retirement Plans - 401(k) for Self-Employed People part 11
Retirement Plans - 403(b) part 11
Retirement Plans - 457(b) part 11
Retirement Plans - Co-mingling funds in IRA accounts part 11
Retirement Plans - Keogh part 11
Retirement Plans - Roth IRA part 11
Retirement Plans - SEP IRA part 11
Retirement Plans - Traditional IRA part 12
Software - Archive of Free Investment-Related Programs part 12
Software - Portfolio Tracking and Technical Analysis part 12
Stocks - Basics part 12
Stocks - American Depositary Receipts (ADRs) part 12
Stocks - Cyclicals part 12
Stocks - Dividends part 12
Stocks - Dramatic Price Changes part 12
Stocks - Holding Company Depositary Recepits (HOLDRs) part 12
Stocks - Income and Royalty Trusts part 12
Stocks - Types of Indexes part 12
Stocks - The Dow Jones Industrial Average part 13
Stocks - Other Indexes part 13
Stocks - Market Volatility Index (VIX) part 13
Stocks - Investor Rights Movement part 13
Stocks - Initial Public Offerings (IPOs) part 13
Stocks - Mergers part 13
Stocks - Market Capitalization part 13
Stocks - Outstanding Shares and Float part 13
Stocks - Preferred Shares part 13
Stocks - Price Basis part 13
Stocks - Price Tables in Newspapers part 13
Stocks - Price Data part 13
Stocks - Replacing Lost Certificates part 13
Stocks - Repurchasing by Companies part 13
Stocks - Researching the Value of Old Certificates part 14
Stocks - Reverse Mergers part 14
Stocks - Shareholder Rights Plan part 14
Stocks - Splits part 14
Stocks - Tracking Stock part 14
Stocks - Unit Investment Trusts and SPDRs part 14
Stocks - Warrants part 14
Strategy - Dogs of the Dow part 14
Strategy - Dollar Cost and Value Averaging part 14
Strategy - Hedging part 14
Strategy - Buying on Margin part 14
Strategy - Writing Put Options To Acquire Stock part 14
Strategy - Socially Responsible Investing part 14
Strategy - When to Buy/Sell Stocks part 14
Strategy - Survey of Stock Investment Strategies part 15
Strategy - Value and Growth part 15
Tax Code - Backup Withholding part 15
Tax Code - Capital Gains Cost Basis part 15
Tax Code - Capital Gains Computation part 15
Tax Code - Capital Gains Tax Rates part 15
Tax Code - Cashless Option Exercise part 15
Tax Code - Deductions for Investors part 15
aSubject: Tax Code - Estate and Gift Tax part 15
Tax Code - Gifts of Stock part 15
Tax Code - Non-Resident Aliens and US Holdings part 16
Tax Code - Reporting Option Trades part 16
Tax Code - Short Sales Treatment part 16
Tax Code - Tax Swaps part 16
Tax Code - Uniform Gifts to Minors Act (UGMA) part 16
Tax Code - Wash Sale Rule part 16
Technical Analysis - Basics part 16
Technical Analysis - Bollinger Bands part 16
Technical Analysis - Black-Scholes Model part 16
Technical Analysis - Commodity Channel Index part 16
Technical Analysis - Charting Services part 16
Technical Analysis - Data Sources part 16
Technical Analysis - Elliott Wave Theory part 16
Technical Analysis - Information Sources part 17
Technical Analysis - MACD part 17
Technical Analysis - McClellan Oscillator and Summation Index part 17
Technical Analysis - On Balance Volume part 17
Technical Analysis - Relative Strength Indicator part 17
Technical Analysis - Stochastics part 17
Trading - Basics part 17
Trading - After Hours part 17
Trading - Bid, Offer, and Spread part 17
Trading - Brokerage Account Types part 17
Trading - Discount Brokers part 18
Trading - Direct Investing and DRIPs part 18
Trading - Electronically and via the Internet part 18
Trading - Free Ride Rules part 18
Trading - By Insiders part 18
Trading - Introducing Broker part 18
Trading - Jargon and Terminology part 18
Trading - NASD Public Disclosure Hotline part 18
Trading - Buy and Sell Stock Without a Broker part 18
Trading - Non-Resident Aliens and US Exchanges part 18
Trading - Off Exchange part 19
Trading - Opening Prices part 19
Trading - Order Routing and Payment for Order Flow part 19
Trading - Day, GTC, Limit, and Stop-Loss Orders part 19
Trading - Pink Sheet Stocks part 19
Trading - Price Improvement part 19
Trading - Process Date part 19
Trading - Round Lots of Shares part 19
Trading - Security Identification Systems part 19
Trading - Shorting Stocks part 19
Trading - Shorting Against the Box part 19
Trading - Size of the Market part 19
Trading - Tick, Up Tick, and Down Tick part 19
Trading - Transferring an Account part 19
Trading - Can You Trust The Tape? part 20
Trading - Selling Worthless Shares part 20
Trivia - Bull and Bear Lore part 20
Trivia - Presidential Portraits on U.S. Notes part 20
Trivia - Getting Rich Quickly part 20
Trivia - One-Letter Ticker Symbols on NYSE part 20
Trivia - Stock Prices in Sixteenths part 20
Warning - Wade Cook part 20
Warning - Charles Givens part 20
Warning - Dave Rhodes and Other Chain Letters part 20
Warning - Ken Roberts part 20
Warning - Selling Unregistered Securities part 20

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Compiler's Acknowledgements:
My sincere thanks to the many contributors for their efforts.

Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Apr 17, 2004, 7:28:33 AM4/17/04
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

Terms of Use


Please send comments and new submissions to the compiler.

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Subject: Mutual Funds - Distributions and Tax Implications

Last-Revised: 27 Jan 1998
Contributed-By: Chris Lott ( contact me ), S. Jaguiar, Art Kamlet
(artkamlet at, 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

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

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

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

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 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 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

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

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

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

* offers much information about index mutual funds.
The site is edited by Will McClatchy and published by IndexFunds,
Inc., of Austin, Texas.

* The list of frequently asked questions about index mutual funds,
which is maintained by Dale C. Maley.

--------------------Check for updates------------------

Subject: Mutual Funds - Money-Market Funds

Last-Revised: 16 Aug 1998
Contributed-By: Chris Lott ( contact me ), Rich Carreiro (rlcarr at

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 for updates------------------

Subject: Mutual Funds - Reading a Prospectus

Last-Revised: 9 Aug 1999
Contributed-By: Chris Stallman (chris at

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

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.


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

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

--------------------Check 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 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

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 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

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
* 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 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.

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

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.


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


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.


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.


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.


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.


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.


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.


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.


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.


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.


It's all over. The home is yours. Congratulations.

This article was excerpted from 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 for updates------------------

Subject: Real Estate - Investment Trusts (REITs)

Last-Revised: 8 Dec 1995
Contributed-By: Braden Glett (glett at

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

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.

--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Apr 17, 2004, 7:28:33 AM4/17/04
Archive-name: investment-faq/general/part10
Version: $Id: part10,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 10 of 20. The web site

always has the latest version, including in-line links. Please browse

Terms of Use


Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Real Estate - Renting versus Buying a Home

Last-Revised: 21 Nov 1995
Contributed-By: Jeff Mincy (mincy at, Chris Lott ( contact me )

This note will explain one way to compare the monetary costs of renting
vs. buying a home. It is extremely prejudiced towards the US system.
A few small C programs for computing future value, present value, and
loan amortization schedules (used to write this article) are available.
See the article "Software - Investment-Related Programs" elsewhere in
this FAQ for information about obtaining them.

1. Abstract
* If you are guaranteed an appreciation rate that is a few points
above inflation, buy.
* If the monthly costs of buying are basically the same as renting,
* The shorter the term, the more advantageous it is to rent.
* Tax consequences in the US are fairly minor in the long term.

2. Introduction
The three important factors that affect the analysis the most are the
1. Relative cash flows; e.g., rent compared to monthly ownership
2. Length of term
3. Rate of appreciation

The approach used here is to determine the present value of the money
you will pay over the term for the home. In the case of buying, the
appreciation rate and thereby the future value of the home is estimated.
For home appreciate rates, find something like the tables published by
Case Schiller that show changes in house prices for your region. The
real estate section in your local newspaper may print it periodically.
This analysis neglects utility costs because they can easily be the same
whether you rent or buy. However, adding them to the analysis is
simple; treat them the same as the costs for insurance in both cases.

Opportunity costs of buying are effectively captured by the present
value. For example, pretend that you are able to buy a house without
having to have a mortgage. Now the question is, is it better to buy the
house with your hoard of cash or is it better to invest the cash and
continue to rent? To answer this question you have to have estimates for
rental costs and house costs (see below), and you have a projected
growth rate for the cash investment and projected growth rate for the
house. If you project a 4% growth rate for the house and a 15% growth
rate for the cash then holding the cash would be a much better

First the analysis for renting a home is presented, then the analysis
for buying. Examples of analyses over a long term and a short term are
given for both scenarios.

3. Renting a Home.

Step 1: Gather data
You will need:
* monthly rent
* renter's insurance (usually inexpensive)
* term (period of time over which you will rent)
* estimated inflation rate to compute present value
(historically 4.5%)
* estimated annual rate of increase in the rent (can use
inflation rate)

Step 2: Compute present value of payments
You will compute the present value of the cash stream that you will
pay over the term, which is the cost of renting over that term.
This analysis assumes that there are no tax consequences (benefits)
associated with paying rent.

3.1 A long-term example of renting

Rent = 990 / month
Insurance = 10 / month
Term = 30 years
Rent increases = 4.5% annually
Inflation = 4.5% annually
For this cash stream, present value = 348,137.17.

3.2 A short-term example of renting

Same numbers, but just 2 years.
Present value = 23,502.38

4. Buying a Home

Step 1: Gather data.
You need a lot to do a fairly thorough analysis:
* purchase price
* down payment and closing costs
* other regular expenses, such as condominium fees
* amount of mortgage
* mortgage rate
* mortgage term
* mortgage payments (this is tricky for a variable-rate
* property taxes
* homeowner's insurance (Note: this analysis neglects
extraordinary risks such as earthquakes or floods that may
cause the homeowner to incur a large loss due to a high
deductible in your policy. All of you people in California
know what I'm talking about.)
* your marginal tax bracket (at what rate is the last dollar
* the current standard deduction which the IRS allows

Other values have to be estimated, and they affect the analysis

* continuing maintenance costs (I estimate 1/2 of PP over 30
* estimated inflation rate to compute present value
(historically 4.5%)
* rate of increase of property taxes, maintenance costs, etc.
(infl. rate)
* appreciation rate of the home (THE most important number of

Step 2: Compute the monthly expense
This includes the mortgage payment, fees, property tax, insurance,
and maintenance. The mortgage payment is fixed, but you have to
figure inflation into the rest. Then compute the present value of
the cash stream.

Step 3: Compute your tax savings
This is different in every case, but roughly you multiply your tax
bracket times the amount by which your interest plus other
deductible expenses (e.g., property tax, state income tax) exceeds
your standard deduction. No fair using the whole amount because
everyone, even a renter, gets the standard deduction for free.
Must be summed over the term because the standard deduction will
increase annually, as will your expenses. Note that late in the
mortgage your interest payments will be be well below the standard
deduction. I compute savings of about 5% for the 33% tax bracket.

Step 4: Compute the present value
First you compute the future value of the home based on the
purchase price, the estimated appreciation rate, and the term.
Once you have the future value, compute the present value of that
sum based on the inflation rate you estimated earlier and the term
you used to compute the future value. If appreciation is greater
than inflation, you win. Else you break even or even lose.

Actually, the math of this step can be simplified as follows:

/periods + appr_rate/100\ ^ (periods *
prs-value = cur-value * | ----------------------- |
\periods + infl_rate/100/

Step 5: Compute final cost
All numbers must be in present value.
Final-cost = Down-payment + S2 (expenses) - S3 (tax sav) - S4 (prop

4.1 Long-term example Nr. 1 of buying: 6% apprecation

Step 1 - the data
* Purchase price = 145,000
* Down payment etc = 10,000
* Mortgage amount = 140,000
* Mortgage rate = 8.00%
* Mortgage term = 30 years
* Mortgage payment = 1027.27 / mo
* Property taxes = about 1% of valuation; I'll use 1200/yr =
100/mo (Which increases same as inflation, we'll say. This
number is ridiculously low for some areas, but hey, it's just
an example!)
* Homeowner's ins. = 50 / mo
* Condo. fees etc. = 0
* Tax bracket = 33%
* Standard ded. = 5600 (Needs to be updated)

* Maintenance = 1/2 PP is 72,500, or 201/mo; I'll use 200/mo
* Inflation rate = 4.5% annually
* Prop. taxes incr = 4.5% annually
* Home appreciates = 6% annually (the NUMBER ONE critical

Step 2 - the monthly expense
The monthly expense, both fixed and changing components:
Fixed component is the mortgage at 1027.27 monthly. Present value
= 203,503.48. Changing component is the rest at 350.00 monthly.
Present value = 121,848.01. Total from Step 2: 325,351.49

Step 3 - the tax savings
I use my loan program to compute this. Based on the data given
above, I compute the savings: Present value = 14,686.22. Not much
when compared to the other numbers.

Step 4 - the future and present value of the home
See data above. Future value = 873,273.41 and present value =
226,959.96 (which is larger than 145k since appreciation is larger
than inflation). Before you compute present value, you should
subtract reasonable closing costs for the sale; for example, a real
estate broker's fee.

Step 5 - the final analysis for 6% appreciation
Final = 10,000 + 325,351.49 - 14,686.22 - 226,959.96
= 93,705.31

So over the 30 years, assuming that you sell the house in the 30th year
for the estimated future value, the present value of your total cost is
93k. (You're 93k in the hole after 30 years, which means you only paid

4.2 Long-term example Nr. 2 of buying: 7% apprecation
All numbers are the same as in the previous example, however the home
appreciates 7%/year.
Step 4 now comes out FV=1,176,892.13 and PV=305,869.15
Final = 10,000 + 325,351.49 - 14,686.22 - 305,869.15
= 14796.12

So in this example, 7% was an approximate break-even point in the
absolute sense; i.e., you lived for 30 years at near zero cost in
today's dollars.

4.3 Long-term example Nr. 3 of buying: 8% apprecation
All numbers are the same as in the previous example, however the home
appreciates 8%/year.
Step 4 now comes out FV=1,585,680.80 and PV=412,111.55
Final = 10,000 + 325,351.49 - 14,686.22 - 412,111.55
= -91,446.28

The negative number means you lived in the home for 30 years and left it
in the 30th year with a profit; i.e., you were paid to live there.

4.4 Long-term example Nr. 4 of buying: 2% appreciation
All numbers are the same as in the previous example, however the home
appreciates 2%/year.
Step 4 now comes out FV=264,075.30 and PV=68,632.02
Final = 10,000 + 325,351.49 - 14,686.22 - 68,632.02
= 252,033.25

In this case of poor appreciation, home ownership cost 252k in today's
money, or about 700/month. If you could have rented for that, you'd be

4.5 Short-term example Nr. 1 of buying: 6% apprecation
All numbers are the same as long-term example Nr. 1, but you sell the
home after 2 years. Future home value in 2 years is 163,438.17
Cost = down+cc + all-pymts - tax-savgs - pv(fut-home-value - remaining
= 10,000 + 31,849.52 - 4,156.81 - pv(163,438.17 - 137,563.91)
= 10,000 + 31,849.52 - 4,156.81 - 23,651.27
= 14,041.44

4.6 Short-term example Nr. 2 of buying: 2% apprecation
All numbers are the same as long-term example Nr. 4, but you sell the
home after 2 years. Future home value in 2 years is 150,912.54
Cost = down+cc + all-pymts - tax-savgs - pv(fut-home-value - remaining
= 10,000 + 31,849.52 - 4,156.81 - pv(150912.54 - 137,563.91)
= 10,000 + 31,849.52 - 4,156.81 - 12,201.78
= 25,490.93

5. A Question

Q: Is it true that you can usually rent for less than buying?

Answer 1: It depends. It isn't a binary state. It is a fairly complex
set of relationships.

In large metropolitan areas, where real estate is generally much more
expensive than elsewhere, then it is usually better to rent, unless you
get a good appreciation rate or if you are going to own for a long
period of time. It depends on what you can rent and what you can buy.
In other areas, where real estate is relatively cheap, I would say it is
probably better to own.

On the other hand, if you are currently at a market peak and the country
is about to go into a recession it is better to rent and let property
values and rent fall. If you are currently at the bottom of the market
and the economy is getting better then it is better to own.

Answer 2: When you rent from somebody, you are paying that person to
assume the risk of homeownership. Landlords are renting out property
with the long term goal of making money. They aren't renting out
property because they want to do their renters any special favors. This
suggests to me that it is generally better to own.

6. Conclusion

Once again, the three important factors that affect the analysis the
most are cash flows, term, and appreciation. If the relative cash flows
are basically the same, then the other two factors affect the analysis
the most.

The longer you hold the house, the less appreciation you need to beat
renting. This relationship always holds, however, the scale changes.
For shorter holding periods you also face a risk of market downturn. If
there is a substantial risk of a market downturn you shouldn't buy a
house unless you are willing to hold the house for a long period.

If you have a nice cheap rent controlled apartment, then you should
probably not buy.

There are other variables that affect the analysis, for example, the
inflation rate. If the inflation rate increases, the rental scenario
tends to get much worse, while the ownership scenario tends to look

--------------------Check for updates------------------

Subject: Regulation - Accredited Investor

Last-revised: 1 May 2000

Contributed-By: Chris Lott ( contact me )

The SEC has established criteria for preventing people who perhaps
should know better from investing in unregistered securities and other
things that are less well known than stocks and bonds. For example, if
you've ever been interested in buying into a privately held company, you
have probably heard all about this. In a nutshell, for an individual to
be considered a qualified investor (also termed an accredited investor),
that person must either have a net worth of about a million bucks, or
have an annual income in excess of 200k. Companies who wish to raise
capital from individuals without issuing registered securities are
forced to limit their search to people who fall on the happy side of
these thresholds.

To read the language straight from the securities lawyers, follow this

--------------------Check for updates------------------

Subject: Regulation - Full Disclosure

Last-revised: 30 Jan 2001

Contributed-By: Chris Lott ( contact me )

The full disclosure rules, also known as regulation FD, were enacted by
the SEC to ensure the flow of information to all investors, just just
well-connected insiders. Basically the rule says that publically held
companies must disclose all material information that might affect
investment decisions to all investors at the same time. The intent was
to level the playing field for all investors. Regulation FD became
effective on 23 October 2000.

What was life like before this rule? Basically there was selective
disclosure. Before regulation FD, companies communicated well with
securities analysts who followed the company (the so-called back
channel), but not necessarily as well with individual investors.
Analysts were said to interpret the information from companies for the
public's benefit. So for example, if a company noticed that sales were
weak and that earnings might be poor, the company might call a group of
analysts and warn them of this fact. The analysts in turn could tell
their big (big) clients this news, and then eventually publish the
information for the general public (i.e., small clients). Put simply,
if you were big, you could get out before a huge price drop, or get in
before a big move up. If you were small, you had no chance.

Now, information is made available without any intermediaries like
analysts to interpret (or spin) it before it reaches the public. There
have been some very noticeable consequences of forcing companies to
grant all investors equal access to a company's material disclosures at
the same time. For example, company conference calls that were once
reserved for analysts only are now accessible to the general public.
Another example is that surprises (e.g., earnings shortfalls) are true
surprises to everyone, which leads to more frequent occurrences of large
changes in a stock's price. Finally, now that analysts no longer have
an easy source of information about the companies that they follow, they
are forced to do research on their companies - much harder work than
before. Some have predicted wide-spread layoffs of analysts because of
the change.

Timely information (i.e., disclosures) are filed with the SEC in 8-K
documents. Note that disclosures can be voluntary (i.e., planned) or
involuntary (i.e., goofs). In either case, the new rule says that the
company has to disclose the information to everyone as quickly as
possible. So an 8-K might get filed unexpectedly because a company exec
accidentally disclosed material information during a private meeting.

Here are some sites with more information.
* FDExpress, a service of Edgar. Subscription required to access
company filings.
* CCBN, a company that provides investor relations services.

--------------------Check for updates------------------

Subject: Regulation - Money-Supply Measures M1, M2, and M3

Last-Revised: 4 Jan 2002
Contributed-By: Ralph Merritt

The US Federal Reserve Board measures the money supply using the
following measures.

M1 Money that can be spent immediately. Includes cash, checking
accounts, and NOW accounts.
M2 M1 + assets invested for the short term. These assets include
money- market accounts and money-market mutual funds.
M3 M2 + big deposits. Big deposits include institutional money-market
funds and agreements among banks.

The pamphlet "Modern Money Mechanics," which explains M1, M2, and M3 in
gory detail, was once available free from the Federal Reserve Bank of
Chicago. That pamphlet is no longer in print, and the Chicago Fed
apparently has no plans to re-issue it. However, electronic copies of
it are out there, and here's one:

--------------------Check for updates------------------

Subject: Regulation - Federal Reserve and Interest Rates

Last-Revised: 25 Apr 1997
Contributed-By: Jeffrey J. Stitt, Himanshu Bhatt, Nikolaos Bernitsas,
Joe Lau

This article discusses the interest rates which are managed or
influenced by the US Federal Reserve Bank, a collective term for the
collection of Federal Reserve Banks across the country.

The Discount Rate is the interest rate charged by the Federal Reserve
when banks borrow "overnight" from the Fed. The discount rate is under
the direct control of the Fed. The discount rate is always lower than
the Federal Funds Rate (see below). Generally only large banks borrow
directly from the Fed, and thus get the benefit of being able to borrow
at the lower discount rate. As of April 1997, the discount rate was

The Federal Funds Rate is the interest rate charged by banks when banks
borrow "overnight" from each other. The funds rate fluctuates according
to supply and demand and is not under the direct control of the Fed, but
is strongly influenced by the Fed's actions. As of April 1997, the
target funds rate is 5.38%; the actual rate varies above and below that

The Fed adjusts the funds rate via "open market operations". What
actually happens is that the Fed sells US treasury securities to banks.
As a result, the bank reserves at the Fed drop. Given that banks have
to maintain at the Fed a certain level of required reserves based on
their demand deposits (checking accounts), they end up borrowing more
from each other to cover their short position at the Fed. The resulting
pressure on intrabank lending funds drives the funds rate up.

The Fed has no idea of how many billions of US treasuries it needs to
sell in order for the funds rate to reach the Fed's target. It goes by
trial and error. That's why it takes a few days for the funds rate to
adjust to the new target following an announcement.

Adjustments in the discount rate usually lag behind changes in the funds
rate. Once the spread between the two rates gets too large (meaning fat
profits for the big banks which routinely borrow from the Fed at the
discount rate and lend to smaller banks at the funds rate) the Fed moves
to adjust the discount rate accordingly. It usually happens when the
spread reaches about 1%.

Another interest rate of significant interest is the Prime Rate, the
interest that a bank charges its "best" customers. There is no single
prime rate, but the commercial banks generally offer the same prime
rate. The Fed does not adjust a bank's prime rate directly, but
indirectly. The change in discount rates will affect the prime rate.
As of April, 1997 the prime rate is 8.5%.

For an in-depth look at the Federal Reserve, get the book by William
Greider titled Secrets of the temple: How the Federal Reserve runs the
country .

--------------------Check for updates------------------

Subject: Regulation - Margin Requirements

Last-Revised: 26 May 2002
Contributed-By: Chris Lott ( contact me ), John Marucco

This article discusses the rules and regulations that apply to margin
accounts at brokerage houses. The basic rules are set by the Federal
Reserve Board (FRB), the New York Stock Exchange (NYSE), and the
National Asssociation of Securities Dealers (NASD). Every broker must
apply the minimum rules to customers, but a broker is free to apply more
stringent requirements. Also see the article elsewhere in the FAQ for
an explanation of a margin account versus a cash account .

Buying on margin means that your broker loans you money to make a
purchase. But how much can you borrow? As it turns out, the amount of
debt that you can establish and maintain with your broker is closely
regulated. Here is a summary of those regulations.

The Federal Reserve Board's Regulation T states how much money you may
borrow to establish a new position . Briefly, you may borrow 50% of the
cost of the new position. For example, $100,000 of cash can be used to
buy $200,000 worth of stock.

The NYSE's Rule 431 and the NASD's Rule 2520 both state how much money
you can continue to borrow to hold an open position . In brief, you
must maintain 25% equity for long positions and 30% equity for short
positions. Continuing the example in which $100,000 was used to buy
$200,000 of stock, the account holder would have to keep holdings of
$50,000 in the account to maintain the open long position. The best
holding in this case is of course cash; a $200,000 margined position can
be kept open with $50,000 of cash. If the account holder wants to use
fully paid securities to meet the maintenance requirement, then
securities (i.e., stock) with a loan value of $50,000 are required. See
the rule above - you can only borrow up to 50% - so to achieve a loan
value of $50,000, the account holder must have at least $100,000 of
fully paid securities in the account.

If the value of the customer's holdings drops to less than 25% of the
value of open positions (maybe some stocks fell in price dramatically),
than the brokerage house is required to impose a margin call on the
account holder. This means that the person must either sell open
positions, or deposit cash and/or securities, until the account equity
returns to 25%. If the account holder doesn't meet the margin call,
then four times the amount of the call will be liquidated within the

Here are a few examples, showing Long Market, Short Market, Debit
Balance, Credit Balance, and Equity numbers for various situations.
Remember, Equity is the Long Market Value plus the Credit Balance, less
any Short Market Value and Debit Balance. (The Current Market Value of
securities is the Long Market value less the Short Market value.) The
Credit Balance is cash - money that is left over after everything is
paid and all margin requirements are satisfied. This is supposed to
give a feel for how a brokerage statement is marked to market each day.

So in the first example, a customer buys 100,000 worth of some stock on
margin. The 50% margin requirement (Regulation T) can be met with
either stock or cash.

To satisfy the margin requirement with cash , the customer must deposit
50,000 in cash. The account will then appears as follows; the "Equity"
reflects the cash deposit: Long
Market Short
Market Credit
Balance Debit
100,000 0 0 50,000 50,000

To satisfy the margin requirement with stock , the customer must deposit
marginable stock with a loan value of 50,000 (two times the amount of
the call). The account will then appears as follows; the 200,000 of
long market consists of 100,000 stock deposited to meet reg. T and
100,000 of the stock purchased on margin: Long
Market Short
Market Credit
Balance Debit
200,000 0 0 100,000 100,000

Here's a new example. What if the account looks like this: Long
Market Short
Market Credit
Balance Debit
20,000 0 0 17,000 3,000
The maintenance requirement calls for an equity position that is 25% of
20,000 which is 5,000, but equity is only 3,000. Because the equity is
less than 25% of the market value, a maintenance (aka margin) call is
triggered. The call is for the difference between the requirement and
actual equity, which is 5,000 - 3,000 or 2000. To meet the call, either
2,000 of cash or 4,000 of stock must be deposited. Here is what would
happen if the account holder deposits 2,000 in cash; note that the cash
deposit pays down the loan. Long
Market Short
Market Credit
Balance Debit
20,000 0 0 15,000 5,000

Here is what would happen if the account holder deposits 4,000 of stock:
Market Short
Market Credit
Balance Debit
24,000 0 0 17,000 7,000

Ok, now what happens if the account holder does not meet the call? As
mentioned above, four times the amount of the call will be sold. So
stock in the amount of 8,000 will be sold and the account will look like
this: Long
Market Short
Market Credit
Balance Debit
12,000 0 0 9,000 3,000

In the case of short sales, Regulation T imposes an initial margin
requirement of 150%. This sounds extreme, but the first 100% of the
requirement can be satisified by the proceeds of the short sale, leaving
just 50% for the customer to maintain in margin (so it looks much like
the situation for going long). To maintain a short position, rule 2520
requires margin of $5 per share or 30 percent of the current market
value (whichever is greater).

Let's say a person shorts $10,000 worth of stock. They must have
securities with a loan value of at least $5,000 to comply with
regulation T. In this example, to keep things simple, the customer
deposits cash. So the Credit Balance consists of the 10,000 in proceeds
from the short sale plus the 5,000 Regulation T deposit. Remember that
market value is long market value minus short market value, and because
we gave our customer no securities in this example, the "long market"
value is zero, making the market value negative. Long
Market Short
Market Credit
Balance Debit
0 10,000 15,000 0 5,000

While we're discussing shorting, what about being short against the box?
(Also see the FAQ article about short-against-the-box positions .) When
an individual is long a stock position and then shorts the same stock, a
separate margin requirement is applicable. When shorting a position
that is long in an account the requirement is 5% of the market value of
the underlying stock. Let's say the original stock holding of $100,000
was purchased on margin (with a corresponding 50% requirement). And the
same holding is sold short against the box, yielding $100,000 of
proceeds that is shown in the Credit Balance column, plus a cash deposit
of $5,000. The account would look like this: Long
Market Short
Market Credit
Balance Debit
Initial position 100,000 50,000 50,000
Sell short 0 100,000 105,000 100,000 5,000
Net 100,000 100,000 105,000 150,000 55,000

Customer accounts are suppsed to be checked for compliance with
Regulation T and Rule 2520 at the end of each trading day. A brokerage
house may impose a margin call on an account holder at any time during
the day, though.

Finally, special conditions apply to day-traders. Check with your

Here are some additional resources:
* Detailed guides from NASD
* The full text of Regulation T

--------------------Check for updates------------------

Subject: Regulation - Securities and Exchange Commission (U.S.)

Last-revised: 22 Dec 1999
Contributed-By: Dennis Yelle

Just in case you want to ask questions, complain about your broker, or
whatever, here's the vital information:

Securities and Exchange Commission
450 5th Street, N. W.
Washington, DC 20549

Office of Public Affairs: +1 202 272-2650
Office of Consumer Affairs: +1 202 272-7440

SEC policy concerning online enforcement:

A web-enabled complaint submission form:

E-Mail address for complaints:

--------------------Check for updates------------------

Subject: Regulation - SEC Rule 144

Last-Revised: 6 June 2000
Contributed-By: Bill Rini (bill at, Julie O'Neill (law

The Federal Securities Act of 1933 generally requires that stock and
other securities must be registered with the Securities and Exchange
Commission (the "S.E.C.") prior to their offer or sale. Registering
securities with the S.E.C. can be expensive and time-consuming. This
article offers a brief introduction to SEC Rule 144, which allows for
the sale of restricted securities in limited quantities without
requiring the securities to be registered.

First it's probably appropriate to explain the basics of restricted
securities. Restricted securities are generally those which are first
issued in a private placement exempt from registration and which bear a
restrictive legend. The legend commonly states that the securities are
not registered and cannot be offered or sold unless they are registered
with the S.E.C. or exempt from registration. The restrictive legend
serves to ensure that the initial, unregistered sale is not part of a
scheme to avoid registration while achieving some broader distribution
than the initial sale. Normally, if securities are registered when they
are first issued, then they do not bear any restrictive legend and are
not deemed restricted securities.

Rule 144 generally applies to corporate insiders and buyers of private
placement securities that were not sold under SEC registration statement
requirements. Corporate insiders are officers, directors, or anyone
else owning more than 10% of the outstanding company securities. Stock
either acquired through compensation arrangements or open market
purchases is considered restricted for as long as the insider is
affiliated with the company. For example, if a corporate officer
purchases shares in his or her employer on the open market, then the
officer must comply with Rule 144 when those shares are sold, even
though the shares when purchased were not considered restricted. If,
however, the buyer of restricted securities has no management or major
ownership interests in the company, the restricted status of the
securities expires over a period of time.

Under Rule 144, restricted securities may be sold to the public without
full registration (the restriction lapses upon transfer of ownership) if
the following conditions are met.

1. The securities have been owned and fully paid for at least one year
(there are special exceptions that we'll skip here).
2. Current financial information must be made available to the buyer.
Companies that file 10K and 10Q reports with the SEC satisfy this
3. The seller must file Form 144, "Notice of Proposed Sale of
Securities," with the SEC no later than the first day of the sale.
The filing is effective for 90 days. If the seller wishes to
extend the selling period or sell additional securities, a new form
144 is required.
4. The sale of the securities may not be advertised and no additional
commissions can be paid.
5. If the securities were owned for between one and two years, the
volume of securities sold is limited to the greater of 1% of all
outstanding shares, or the average weekly trading volume for the
proceeding four weeks. If the shares have been owned for two years
or more, no volume restrictions apply to non-insiders. Insiders
are always subject to volume restrictions.

The most recent rule change of Feb 1997 reduced the holding periods by
one year. For all the details, visit the SEC's page on this rule:

For more insights from Julie O'Neill about the SEC's Rule 144, please
visit the Fleming and O'Neill web site:

--------------------Check for updates------------------

Subject: Regulation - SEC Registered Advisory Service

Last-revised: 9 Jan 1996
Contributed-By: Paul Maffia (paulmaf at

Some advisers will advertise with the information that they are an
S.E.C. Registered Advisory Service. This does not mean a damn thing
except that they have obeyed the law and registered as the law requires.
All it takes is filling out a long form, $150 and no convictions for
financial fraud.

If they attempt to imply anything in their ads other than the fact they
are registered, they are violating the law. Basically, this means that
they can inform you that they are registered in a none-too-prominent
way. If the information is conveyed in any other way, such as being
very prominent, or using words that convey any meaning other than the
simple fact of registration; or implying any special expertise; or
implying special approval, etc., they are violating the law and can
easily be fined and as well as lose their registration.

--------------------Check for updates------------------

Subject: Regulation - SEC/NASDAQ Settlement

Last-Revised: 26 Feb 1997
Contributed-By: John Schott (jschott at, Chris Lott (
contact me )

The SEC's settlement with NASDAQ in late 1996 will almost certainly
impact trading and price improvement in a favorable way for small
investors. The settlement resulted in rule changes that are intended to
improve greater access to the market for individual investors, and to
improve the display and execution of orders. The changes will be
implemented in several phases, with the first phase beginning on 10 Jan
1997. Initially only 50 stocks will be in the program, but in
subsequent steps in 1997, the number of stocks will be expanded to cover
all NASDAQ stocks.

This action began after many people complained about very high spreads
in some shares traded on the NASDAQ market. In effect,the SEC
contention was that some market makers possible did not publically post
orders inside the spread because it impacted their profit margins.

Here are some of the key changes that resulted from the settlement.
* All NASDAQ market makers must execute or publicly display customer
limit orders that are (a) priced better than their public quote or
(b) limit orders that add to the size of their quote.
* All investors will have access to prices previously available only
to institutions or professional traders. These rules are expected
to produce more trading inside the spread, so wide spreads may become
less common. But remember, a market maker or broker making a market for
a stock has to be compensated for the risk they take. They have to hold
inventory or risk selling you stock they don't have and finding some
quickly. With a stock that moves about or trades seldom, they have to
make money on the spread to cover the "bad moves" that can leave them
holding inventory at a bad price. Reduced spreads may in fact force
less well capitalized or managed market makers to leave the market for
certain stocks, as there may be less chance for profit.

It will definitely be interesting to see how the spreads change over the
next few months as the NASDAQ settlement is phased in on more and more

--------------------Check for updates------------------

Subject: Regulation - Series of Examinations/Registrations

Last-revised: 30 Sep 1999
Contributed-By: Charlie H. Luh, Chris Lott ( contact me )

The National Association of Securities Dealers (NASD) administers a
series of licensing examinations that are used to qualify people for
employment in many parts of the finance industry. For example, the
Series 7 is commonly (although somewhat incorrectly) known as the
stockbroker exam. The following examinations are offered:

* Series 3 - Commodity Futures Examination
* Series 4 - Registered Options Principal
* Series 5 - Interest Rate Options Examination
* Series 6 - Investment Company and Variable Contracts Products Rep.
Translation: qualifies sales representatives to sell mutual funds
and variable annuities.
* Series 7 - Full Registration/General Securities Representative
Translation: qualifies sales representatives to sell stocks and
bonds. Variations include:
* Securities Traders (NYSE)
* Trading Supervisor (NYSE)
* Series 8 - General Securities Sales Supervisor
* Branch Office Manager (NYSE)
* Series 11 - Assistant Representative/Order Processing
* Series 15 - Foreign Currency Options
* Series 16 - Supervisory Analyst
* Series 22 - Direct Participation Program Representative
* Series 24 - General Securities Principal
* Series 26 - Investment Company and Variable Contracts Principal
* Series 27 - Financial and Operations Principal
* Series 28 - Introducing B/D/Financial and Operations Principal
* Series 39 - Direct Participation Program Principal
* Series 42 - Options Representative
* Series 52 - Municipal Securities Representative
* Series 53 - Municipal Securities Principal
* Series 62 - Corporate Securities Representative
* Series 63 - Uniform Securities Agent State Law Examination
* Series 65 - Uniform Investment Advisor Law Examination

The following NASD resources should help.
* The procedures for becoming a member of NASD, including details
about registering personnel through the Central Registration
Depository (CRD).
* The NASD's CRD call center: +1 (301) 590-6500
* The NASD home page.

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Subject: Regulation - SIPC, or How to Survive a Bankrupt Broker

Last-Revised: 26 May 1999
Contributed-By: Art Kamlet (artkamlet at, Dave Barrett

The U.S. Securities Investor Protection Corporation (SIPC) is a
federally chartered private corporation whose job is to insure
shareholders against the situation of a U.S. stock-broker going

The National Association of Security Dealers requires all of their
member brokers to have SIPC insurance. Many brokers supplement the
limits that SIPC insures ($100,000 cash and $500,000 total, I think-- I
could be wrong here) with additional policies so you are covered up to
$1 million or more.

If you deal with discount houses, all brokerages, their clearing agents,
and any holding companies they have which can be holding your assets in
street-name had better be insured with the S.I.P.C. You're going to pay
a modest SEC tax (less than US$1) on any trade you make anywhere, so
make sure you're getting the benefit. If a broker goes bankrupt it's
the only thing that prevents a total loss. Investigate thoroughly!

The bottom line is that you should not do business with any broker who
is not insured by the SIPC.

--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Apr 17, 2004, 7:28:34 AM4/17/04
Archive-name: investment-faq/general/part8
Version: $Id: part08,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 8 of 20. The web site

always has the latest version, including in-line links. Please browse

Terms of Use


Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Insurance - Annuities

Last-Revised: 20 Jan 2003
Contributed-By: Barry Perlman, Chris Lott ( contact me ), Ed Zollars
(ezollar at

An annuity is an investment vehicle sold primarily by insurance
companies. Every annuity has two basic properties: whether the payout
is immediate or deferred, and whether the investment type is fixed or
variable. An annuity with immediate payout begins payments to the
investor immediately, whereas the deferred payout means that the
investor will receive payments at a later date. An annuity with a fixed
investment type offer a guaranteed return on investment by investing in
government bonds and other low-risk securities, whereas a variable
investment type means that the return on the annuity investment will
depend on performance of the funds (called sub-accounts) where the money
is invested. Based on these two properties with two possibilities each,
there are four possible combinations, but the ones commonly seen in
practice are an annuity with immediate payout and fixed investments
(often known as a fixed annuity), and an annuity with deferred payout
and variable investments (usually called a variable annuity). This
article discusses fixed annuities briefly and variable annuities at some
length, and includes a list of sources for additional information about

Fixed Annuities
The idea of a fixed annuity is that you give a sum of money to an
insurance company, and in exchange they promise to pay you a fixed
monthly amount for a certain period of time, either a fixed period or
for your lifetime (the concept of 'annuitization'). So essentially you
are converting a lump sum into an income stream. Whether you choose
period-certain or annuitization, the payment does not change, even to
account for inflation.

If a fixed-period is chosen (also called a period-certain annuity), the
annuity continues to pay until that period is reached, either to the
original investor or to the investor's estate or heirs. Alternatively,
if the investor chooses to annuitize, then payments continue for a
variable period; namely until the investor's death. For an investor who
annuitized, the insurance company pays nothing further after the
investor's death to the estate or heirs (neither principal nor monthly
payments), no matter how many (or how few) monthly payments you

Fixed annuities allow you some access to your investment; for example,
you can choose to withdraw interest or (depending on the company etc.)
up to 10% of the principal annually. An annuity may also have various
hardship clauses that allow you to withdraw the investment with no
surrender charge in certain situations (read the fine print). When
considering a fixed annuity, compare the annuity with a ladder of
high-grade bonds that allow you to keep your principal with minimal
restrictions on accessing your money.

Annuitization can work well for a long-lived retiree. In fact, a fixed
annuity can be thought of as a kind of reverse life insurance policy.
Of course a life insurance contract offers protection against premature
death, whereas the annuity contract offers protection for someone who
fears out-living a lump sum that they have accumulated. So when
considering annuities, you might want to remember one of the original
needs that annuitities were created to address, namely to offer
protection against longevity.

Another situation in which a fixed annuity might have advantages is if
you wish to generate monthly income and are extremely worried about
someone being able to steal your capital away from you (or steal
someone's capital away from them). If this is the case, for whatever
reason, then giving the capital to an insurance company for management
might be attractive. Of course a decent trust and trustee could
probably do as well.

Variable Annuities
A variable annuity is essentially an insurance contract joined at the
hip with an investment product. Annuities function as tax-deferred
savings vehicles with insurance-like properties; they use an insurance
policy to provide the tax deferral. The insurance contract and
investment product combine to offer the following features:
1. Tax deferral on earnings.
2. Ability to name beneficiaries to receive the balance remaining in
the account on death.
3. "Annuitization"--that is, the ability to receive payments for life
based on your life expectancy.
4. The guarantees provided in the insurance component.

A variable annuity invests in stocks or bonds, has no predetermined rate
of return, and offers a possibly higher rate of return when compared to
a fixed annuity. The remainder of this article focuses on variable

A variable annuity is an investment vehicle designed for retirement
savings. You may think of it as a wrapper around an underlying
investment, typically in a very restricted set of mutual funds. The
main selling point of a variable annuity is that the underlying
investments grow tax-deferred, as in an IRA. This means that any gains
(appreciation, interest, etc.) from the annuity are not taxed until
money is withdrawn. The other main selling point is that when you
retire, you can choose to have the annuity pay you an income
("annuitization"), based on how well the underlying investment
performed, for as long as you live. The insurance portion of the
annuity also may provide certain investment guarantees, such as
guaranteeing that the full principal (amount originally contributed to
the account) will be paid out on the death of the account holder, even
if the market value was low at that time.

Unlike a conventional IRA, the money you put into an annuity is not
deductible from your taxes. And also unlike an IRA, you may put as much
money into an annuity as you wish.

A variable annuity is especially attractive to a person who makes lots
of money and is trying, perhaps late in the game, to save aggressively
for retirement. Most experts agree that young people should fully fund
IRA plans and any company 401(k) plans before turning to variable

Should you buy an annuity?
The basic question to be answered by someone considering this investment
is whether the cost of the insurance coverage is justified for the
benefits that are paid. In general, the answer to that question is one
that only a specific individual can answer based on his or her specific
circumstances. Either a 'yes' or 'no' answer is possible, and there may
be much support for either position. People who oppose use of annuities
will point out that it is unlikely (less than 50% probability) that the
insurance guarantees will pay off, so that the guarantees are expected
to reduce the overall return. People who favor use of annuities tend to
suggest that not buying the guarantees is always an irresponsible step
because the purchaser increases risk. Both positions can be supported.
But the key issue is whether the purchaser is making an informed
decision on the matter.

Now it's time for some cautionary words about the purchase of annuities.
Many experts feel that annuities are a poor choice for most people when
examined in close detail. The following discussion compares an annuity
to an index fund (see also the article on index funds elsewhere in this

Variable annuities are extremely profitable for the companies that sell
them (which accounts for their popularity among sales people), but are a
terrible choice for most people. Most people are much better off in an
equity index fund. Index funds are extremely tax efficient and provide,
overall, a much more favorable tax situation than an annuity.

The growth of an annuity is fully taxable as income, both to you and
your heirs. The growth of an index fund is taxable as capital gains to
you (which is good because capital gains taxes are always lower than
ordinary income) and subject to zero income tax to your heirs. This
last point is because upon inheritance the asset gets a "stepped up
basis." In plain English, the IRS treats the index fund as though your
heirs just bought it at the value it had when you died. This is a major
tax advantage if you care about leaving your wealth behind. (By
contrast the IRS treats the annuity as though your heirs just earned it;
they must now pay income tax on it!)

If you remove some money from the index fund, the cost basis may be the
cost of your most recent purchase (or if the law is changed as the
administration currently recommends, the average cost of your index
investments). By contrast, any money you remove from an annuity is
taxed at 100% of its value until you bring the annuity's value down to
the size of what you put in. (The law is more favorable for annuities
purchased before 1982, but that's another can of worms.)

Tax considerations aside, the index fund is a better investment. Try to
find some annuities that outperformed the S&P 500 index over the past
ten or twenty years. Now, do you think you can pick which one(s) will
outperform the index over the next twenty years? I don't.

Annuities usually have a sales load, usually have very high expenses,
and always have a charge for mortality insurance. The expenses can run
to 2% or more annually, a much higher load than what an index fund
charges (frequently less than 0.5%). The insurance is virtually
worthless because it only pays if your investment goes down AND you die
before you "annuitize". (More about that further on.) Simple term
insurance is cheaper and better if you need life insurance.

Annuities invest in funds that are difficult to analyze, and for which
independent reports, such as Morningstar, are not always available.

Annuity contracts are very difficult for the average investor to read
and understand. Personally, I don't believe anyone should sign a
contract they don't understand.

Annuities offer the choice of a guaranteed income for life. If you
choose to annuitize your contract (meaning take the guaranteed income
for life), two things happen. One is that you sacrifice your principal.
When you die you leave zero to your heirs. If you want to take cash out
for any reason, you can't. It isn't yours anymore.

In exchange for giving all your money to the insurance company, they
promise to pay you a certain amount (either fixed or tied to investment
performance) for as long as you live. The problem is that the amount
they pay you is small. The very small payoff from annuitizing is the
reason that almost no one actually does it. If you're considering an
annuity, ask the insurance company what percentage of customers ever
annuitize. Ask what the payoff is if you annuitize and you'll see why.
Compare their payoff to keeping your principal and putting it into a
ladder of U.S. Treasuries, or even tax-free munis. Better yet, compare
the payoff to a mortgage for the duration of your expected lifespan. If
you expect to live to 85, compare the payoff at age 70 to a 15-year
mortgage (with you as the lender).

For a fixed payout you would be better off putting your money into US
Treasuries and collecting the interest (and keeping the principal).

Now let's consider a variable payout, determined by the performance of
your chosen investments. The problem here is the Assumed Interest Rate
(AIR), typically three or four percent. In plain English, the insurance
company skims off the first three to four percent of the growth of your
investments. They call that the AIR. Your monthly distribution only
grows to the extent that your investment grows MORE than the AIR. So if
your investment doesn't grow, your monthly payment shrinks (by the AIR).
If your investment grows by the AIR, your monthly payment stays the
same. When the market has a down year, your monthly payment shrinks by
the market loss plus the AIR.

If you do decide to go with an annuity, buy one from a mutual fund
company like T. Rowe Price or Vanguard. They have far superior
products to the annuities offered by insurance companies.

Annuities in IRAs?
Occasionally the question comes up about whether it makes sense to buy a
variable annuity inside a tax-deferred plan like an IRA. Please refer
to the list of four features provided by annuities that appears at the
top of this article.

The first, income deferral, is utterly irrelevant if the annuity is held
in an IRA or retirement account. The IRA and plan already provides for
the deferral and, in fact, distributions are governed by the provisions
of Section 72 applicable to IRA retirement plans, not the general
annuity provisions. I would go so far as to tell anyone who has someone
trying to sell them one of these products in a plan based on the tax
benefits to run as fast as possible away from that adviser. S/he is
either very misinformed or very dishonest.

The second, beneficiary designation, is also a nonissue for annuities in
a retirement account. IRAs and qualified plans already provide for
beneficiary designations outside of probate, for better or worse.

The third, annuitization, is potentially valid, since that is one method
to convert the IRA or plan balance to an income stream. Of course,
nothing prevents you from simply purchasing an annuity at the time you
desire the payout rather than buying a product today that gives you the
option in the future.

I suppose it is possible that the options in the product you buy today
may be superior to those that you expect would be available on the open
market at the time you would decide to "lock it in" or you may at least
feel more comfortable having some of these provisions locked in.

Finally, the fourth feature involves the actual guarantees that are
provided in the annuity contract. To take care of an obvious point
first: the guarantees are provided by the insurance carrier, so clearly
it's not the level of FDIC insurance that is backed by the US
Government. But, then again, only deposits in banks are backed by this
guarantee, and the annuity guarantees have generally been good when
called upon.

Normally, any guarantee comes at some cost (well, at least if the
insurer plans to stay in business [grin]) and the cost should be
expected to rise as the guarantee becomes more likely to be invoked.
Some annuities are structured to be low cost, and tend to provide a bare
minimum of guarantees. These products are set up this way to
essentially, provide the insurance "wrapper" to give the tax deferral.

I would note that if, in fact, the guarantees are highly unlikely to be
triggered and/or would only be triggered in cases where the holder
doesn't care, then any cost is likely "excessive" when the guarantee no
longer buys tax deferral, as would be the case if held in a qualified
plan. Note that the "doesn't care" case may be true if the guarantee
only comes into play at the death of the account holder, but the holder
is primarily interested in the investment to fund consumption during

What this means is that you need a) a full and complete understanding of
exactly what promise has been made to you by the guarantees in the
contract and b) a full understanding of the costs and fees involved, so
that you can make a rational decision about whether the guarantees are
worth the amount you are paying for them.

It's theoretically possible to find a guarantee that would fit a
client's circumstance at a cost the client would deem resaonable that
would make the annuity a "good fit" in a retirement plan. Some problems
that arise are when clients are led to believe that somehow the annuity
in the retirement plan gives them a "better" tax deferral or somehow
creates a situation where they "avoid probate" on the plan. A good
agent is going to specifically discuss the annuitization and investment
guarantee features when considering an annuity in a plan or IRA and will
explicitly note that the first two (tax deferral and beneficiary
designation) don't apply because it's in the plan or IRA.

Additional Resources
1. Raymond James offers a free and independent resource with
comprehensive information about annuities.
2. Client Preservation & Marketing, Inc. operates a web site with
in-depth information about fixed annuities.
3. Scott Burns wrote an article "Why variable annuities are no match
for index funds" at MSN Money Central on 15 June 2001.
4. rated annuity comparison shopping sites on 5 May 00.
Also look for the links to two articles by Vern Hayden with
arguments for and against variable annuities.
5. Cornerstone Financial Products offers a site with complete
information about variable annuities, including quotes,
performance, and policy costs.
6. "Annuities: Just Say No" in the July/August 1996 issue of Worth
7. "Five Sad Variable Annuity Facts Your Salesman Won't Tell You" in
the April 5, 1995 Wall Street Journal quarterly review of mutual
8. helps investors choose annuities with instant
quotes and an annuity shopper's library that has extensive
information about annuities.

--------------------Check for updates------------------

Subject: Insurance - Life

Last-Revised: 30 Mar 1994
Contributed-By: Joe Collins

[ A note from the FAQ compiler: I believe that this article offers sound
advice about life insurance for the average middle-class person.
Individuals with a high net worth may be able to use life insurance to
shelter their assets from estate taxes, but those sorts of strategies
are not useful for people with an estate that falls under the tax-free
amount of about a million dollars. Your mileage may vary. ]

This is my standard reply to life insurance queries. And, I think many
insurance agents will disagree with these comments.

First of all, decide WHY you want insurance. Think of insurance as
income-protection, i.e., if the insured passes away, the beneficiary
receives the proceeds to offset that lost income. With that comment
behind us, I would never buy insurance on kids, after all, they don't
have income and they don't work. An agent might say to buy it on your
kids while its cheap - but run the numbers, the agent is usually wrong,
remember, agents are really salesmen/women and its in their interest to
sell you insurance. Also - I am strongly against insurance on kids on
two counts. One, you are placing a bet that you kid will die and you
are actually paying that bet in premiums. I can't bet my child will
die. Two, it sounds plausible, i.e., your kid will have a nest egg when
they grow up but factor inflation in - it doesn't look so good. A
policy of face amount of $10,000, at 4.5% inflation and 30 years later
is like having $2,670 in today's dollars - it's NOT a lot of money. So
don't plan on it being worth much in the future to your child as an
investment. In summary, skip insurance on your kids.

I also have some doubts about insurance as investments - it might be a
good idea but it certainly muddies the water. Why not just buy your
insurance as one step and your investment as another step? - its a lot
simpler to keep them separate.

So by now you have decided you want insurance, i.e., to protect your
family against you passing away prematurely, i.e., the loss of income
you represent (your salary, commissions, etc.).

Next decide how LONG you want insurance for. If you're around 60 years
old, I doubt you want to get any at all. Your income stream is largely
over and hopefully you have accumulated the assets you need anyway by

If you are married and both work, its not clear you need insurance at
all if you pass on. The spouse just keeps working UNLESS you need both
incomes to support your lifestyle (more common these days). Then you
should have one policy on each of you.

If you are single, its not clear you need life insurance at all. You
are not supporting anyone so no one cares if you pass on, at least

If you are married and the spouse is not working, then the breadwinner
needs insurance UNLESS you are independently wealthy. Some might argue
you should have insurance on your spouse, i.e., as homemaker, child care
provider and so forth. In my oponion, I would get a SMALL policy on the
spouse, sufficient to cover the costs of burying them and also
sufficient to provide for child care for a few years or so. Each case
is different but I would look for a small TERM policy on the order of
$50,000 or less. Get the cheapest you can find, from anywhere. It
should be quite cheap. Skip any fancy policies - just go for term and
plan on keeping it until your child is own his/her own. Then reduce the
insurance coverage on your spouse so it is sufficient to bury your

If you are independently wealthy, you don't need insurance because you
already have the money you need. You might want tax shelters and the
like but that is a very different topic.

Suppose you have a 1 year old child, the wife stays home and the husband
works. In that case, you might want 2 types of insurance: Whole life
for the long haul, i.e., age 65, 70, etc., and Term until your child is
off on his/her own. Once the child has left the stable, your need for
insurance goes down since your responsibilities have diminished, i.e.,
fewer dependents, education finished, wedding expenses done, etc

Mortgage insurance is popular but is it worthwhile? Generally not
because it is far too expensive. Perhaps you want some sort of Term
during the duration of the mortgage - but remember that the mortgage
balance DECLINES over time. But don't buy mortgage insurance itself -
much too expensive. Include it in the overall analysis of what
insurance needs you might have.

What about flight insurance? Ignore it. You are quite safe in airplanes
and flight insurance is incredibly expensive to buy.

Insurance through work? Many larger firms offer life insurance as part
of an overall benefits package. They will typically provide a certain
amount of insurance for free and insurance beyond that minimum amount is
offered for a fee. Although priced competitively, it may not be wise to
get more than the 'free' amount offered - why? Suppose you develop a
nasty health condition and then lose your job (and your benefit-provided
insurance)? Trying to get reinsured elsewhere (with a health condition)
may be very expensive. It is often wiser to have your own insurance in
place through your own efforts - this insurance will stay with you and
not the job.

Now, how much insurance? One rule of thumb is 5x your annual income.
What agents will ask you is 'Will your spouse go back to work if you
pass away?' Many of us will think nobly and say NO. But its actually
likely that your spouse will go back to work and good thing - otherwise
your insurance needs would be much larger. After all, if the spouse
stays home, your insurance must be large enough to be invested wisely to
throw off enough return to live on. Assume you make $50,000 and the
spouse doesn't work. You pass on. The Spouse needs to replace a
portion of your income (not all of it since you won't be around to feed,
wear clothes, drive an insured car, etc.). Lets assume the Spouse needs
$40,000 to live on. Now that is BEFORE taxes. Lets say its $30,000 net
to live on. $30,000 is the annual interest generated on a $600,000
tax-free investment at 5% per year (e.g., munibonds). So this means you
need $600,000 of face value insurance to protect your $50,000 current
income. These numbers will vary, depending on interest rates at the
time you do your analysis and how much money you spouse will need,
factoring in inflation. But the point is that you need at least another
$600,000 of insurance to fund if the survivng spouse doesn't and won't
work. Again, the amount will vary but the concept is the same.

This is only one example of how to do it and income taxes, estate taxes
and inflation can complicate it. But hopefully you get the idea.

Which kind of insurance, in my humble opinion, is a function of how long
you need it for. I once did an analysis of TERM vs WHOLE LIFE and based
on the assumptions at the time, WHOLE LIFE made more sense if I held the
insurance more than about 20-23 years. But TERM was cheaper if I held
it for a shorter period of time. How do you do the analysis and why
does the agent want to meet you? Well, he/she will bring their fancy
charts, tables of numbers and effectively lead you into thinking that
the biggest, most expensive policy is the best for you over the long
term. Translation: lots of commissions to the agent. Whole life is
what agents make their money on due to commissions. The agents
typically gets 1/2 of your first year's commissions as his pay. And he
typically gets 10% of the next year's commissions and likewise through
year 5. Ask him (or her) how they get paid.

If he won't tell you, ask him to leave. In my opinion, its okay that
the agents get commissions but just buy what you need, don't buy some
huge policy. The agent may show you compelling numbers on a $1,000,000
whole life policy but do you really need that much? They will make lots
of money on commissions on such a policy, but they will likely have sold
you the "Mercedes Benz" type of policy when a Ford Taurus or a Saturn
sedan model would also be just fine, at far less money. Buy the life
insurance you need, not what they say.

What I did was to take their numbers, review their assumptions (and
corrected them when they were far-fetched) and did MY analysis. They
hated that but they agreed my approach was correct. They will show you
a 12% rate of return to predict the cash value flow. Ignore that - it
makes them look too good and its not realistic. Ask him/her exactly
what they plan to invest your premium money in to get 12%. How has it
done in the last 5 years? 10? Use a number between 4.5% (for TBILL
investments, quite conservative) and 8-10% (for growth stocks, more
risky), but not definitely not 12%. I would try 8% and insist it be
done that way.

Ask each agent these questions:
1. What is the present value of the payment stream represented by the
premiums, using a discount rate of 4.5% per year (That is the
inflation average since 1940). This is what the policy costs you,
in today's dollars. Its very much like paying that single number
now instead of a series of payments over time. If they disagree
with 4.5%, remind them that since 1926, inflation has averaged 3.5%
(Ibbotson Associates) and then suggest they use 3.5% instead. They
may then agree with the 4.5% (!) The lower the number, the more
expensive the policy is.
2. What is the present value of the the cash value earned (increasing
at no more than 8% a year) and discounting it back to today at the
same 4.5%. This is what you get for that money you just paid, in
cash value, expressed in today's dollars, i.e., as if you got it
today in the mail.
3. What is the present value of the life insurance in force over that
same period, discounted back to today by 4.5%, for inflation. That
is the coverage in effect in today's dollars.
4. Pick an end date for comparing these - I use age 60 and age 65.

With the above in hand from various agents, you can see fairly quickly
which is the better policy, i.e., which gives you the most for your

By the way, inflation is slippery and sneaky. All too often we see
$500,000 of insurance and it sounds great, but at 4.5% inflation and 30
years from now, that $500,000 then is like $133,500 now - truly!

Have the agent do your analysis, BUT you give him the rates to use,
don't use his. Then you pick the policy that is the best value, i.e.,
you get more for your money. Factor in any tax angles as well. If the
agent refuses to do this analysis for you, get rid of him/her.

If the agent gets annoyed but cannot fault your analysis, then you have
cleared the snow away and gotten to the truth. If they smile too much,
you may have missed something. And that will cost you money.

Never agree to any policy unless you understand all the numbers and all
the terms. Never 'upgrade' policies by cashing in a whole life for
another whole life. That just depletes your cash value, real cash
available to you. And the agent gets to pocket that money, literally,
through new commissions. Its no different that just writing a personal
check, payable to the agent.

Check out the insurer by going to the reference section of a big
library. Ask for the AM BEST guide on insurance. Look up where the
issuer stands relative to the competition, on dividends, on cash value,
on cost of insurance per premium dollar.

Agents will usually not mention TERM since they work on commission and
get much more money for Whole Life than they do for term. Remember, The
agents gets about 1/2 of your 1st years premium payments and 10% or so
for all the money you send in over the following 4 years. Ask them to
tell you how they are paid- after all, its your money they are getting.

Now why don't I like UNIVERSAL or VARIABLE? Mainly because with Whole
Life and with TERM, you know exactly what you must pay because the
issuer must manage the investments to generate the appropriate returns
to provide you with the insurance (and with cash value if whole life).
With UNIVERSAL and VARIABLE, it becomes YOU who must decide how and
where to invest your premium income. If you guess badly, you will have
to pay a higher premium to cover those bad decisions. The insurance
companies invented UNIVERSAL and VARIABLE because interest rates went
crazy in the early 80's and they lost money. Rather than taking that
risk again, they offered these new policies to transfer that risk to
you. Of course, UNIVERSAL and VARIABLE will be cheaper in the short
term but BE CAREFUL - they can and often will increase later on.

Okay, so what did I do? I bought both term and whole life. I plan to
keep the term until my son graduates from college and he is on his own.
That is about 10 years from now. I also bought whole life (NorthWestern
Mutual Life, Milwaukee, WI) which I plan to keep forever, so to speak.
NWML is apparently the cheapest and best around according to A.M. BEST.
At this point, after 3 years with NWML, I make more in cash value each
year than I pay into the policy in premiums. Thus, they are paying me
to stay with them.

Where do you buy term? Just buy the cheapest policy since you will tend
to renew the policy once a year and you can change insurers each time.
Check your local savings bank as one source.

Suppose an agent approaches you about a new policy and wishes to update
your old ones and switch you into the new policy or new financial
product they are offering? BE CAREFUL: When you switch policies, you
close out the old one, take out its cash value and buy a new one. But
very often you must start paying those hidden commissions all over
again. You won't see it directly but look carefully at how the cash
value grows in the first few years. It won't grow much because the
'cash' is usually paying the commissions again. Bottom line: You
usually pay commissions twice - once on the old policy and again on the
new policy - for generally the same insurance. Thus you paid twice for
the same product. Again - be careful and make sure it makes sense to
switch policies.

A hard thing to factor in is that one day you may become uninsurable
just when you need it, i.e., heart attack, cancer and the like. I would
look at getting cheap term insurance but add in the options of
'guaranteed convertible' (to whole life) and 'guarranteed renewable'
(they must provide the insurance). It will add somewhat to the cost of
the insurance.

Last thought. I'll bet you didn't you know that you are 3x more likely
to become disabled during your working career than you to die during
your working career. How is your short term disability insurance
looking? Get a policy that has a waiting period before it kicks in.
This will keep it cheaper. Look at the exclusions, if any.

These comments are MY opinion and not my employers. All the usual
disclaimers apply and your mileage may vary depending on individual

Sources for additional information:
* Consumers Reports printed an in-depth, three-part series in their
Jul/Aug/Sep 1993 issues.
* Many sites on the web offer life insurance quotes. Here are a few
that have been rated highly by consumer advocates. Also see the
article in the New York Times of 1 August 2001. , , , , , .

--------------------Check for updates------------------

Subject: Insurance - Viatical Settlements

Last-Revised: 19 Aug 1998
Contributed-By: Gloria Wolk ( ), Chris Lott (
contact me )

A viatical settlement is a lump sump of cash given to terminally ill
people (viators) in exchange for the death benefits of their life
insurance. Along with so much of the English language, the name has its
origins in a Latin word, viaticum , which means provisions for a journey

These settlements are attractive to a viator (seller) because the person
gets a significant amount of money that will ease the financial stress
of their final days. Viatical settlements are attractive to investors
for their potentially high -- but not guaranteed -- rates of return.

The way it works in the simplest case is the investor pays some
percentage of the face value of the policy, let's say 50% just to pick a
number, and in return becomes the beneficiary of the policy. The
investor is then responsible for paying the premiums associated with the
life insurance policy. Upon the demise of the viator, the investor
receives the death benefit of the life insurance policy. If the viator
dies shortly after the transaction is completed, the investor makes a
large amount of money. If the viator survives several years past the
predicted life expectancy, the investor will lose money.

Like any other deal, there are risks to both parties. For the viator,
the main risk is settling at too low a price. For the investor, there
are risks of not receiving the full death benefit if the insurance
company goes bankrupt, not receiving any death benefit if the insured
committed fraud on the insurance application, etc.

As of this writing, a few honest and a number of less-than-scrupulous
companies market viatical settlements to viators and investors. Be
careful! This investment is not regulated, so there is little or no
protection for investors.

Here are a few tips for potential viators.

* Are you holding back from medical treatment, thinking this will
give you a larger viatical settlement? Don't. It won't get you
more money. Viatical providers take into account Investigational
New Drugs (INDs) when they price policies. Even if you never took
any and don't plan to, they expect viators will try anything that
gives hope, and they price accordingly.
* Was your policy resold by the viatical company? If so, you have no
obligation to a second buyer -- unless you signed an agreement to
extend obligations to future owners. This is like selling a car:
If you sell the car to B and B resells it to C, you have no
obligation to C.
* Be sure to check with your insurer to find out if your policy
includes Accelerated Death Benefits. If so, and if you qualify,
you will get much more money -- and it will be paid faster. This
applies to some group term life as well as individual policies.
* Are you are a member of a Credit Union? Credit Unions may be a
source of information about and referrals to licensed viatical
* Don't apply to only one viatical company -- even if the referral
was made by your doctor, lawyer, insurance agent, social worker, or
credit union. If you ignore this advice, you're likely to get
thousands of dollars less. Here are a few tips for potential
investors in viatical settlements.
* Are you thinking of using your IRA for viatical investments? Don't.
No matter what viatical sales promoters tell you, life insurance as
an IRA investment is prohibited by the Internal Revenue Code. And,
if you have a self-directed IRA, you are fully responsible for
investment decisions.
* Are you thinking of buying a policy that is within the
contestability period? Don't. If the viator committed fraud on the
application and the insurer discovers this, you could be left with
nothing more than a return of premiums. Gloria Wolk's site offers
much information about viatical settlements.

--------------------Check for updates------------------

Subject: Insurance - Variable Universal Life (VUL)

Last-Revised: 26 Jun 2000
Contributed-By: Ed Zollars (ezollar at, Chris Lott (
contact me ), Dan Melson (dmelson at

This article explains variable universal life (VUL) insurance, and
discusses some of the situations where it is appropriate.

Variable universal life is a form of life insurance, specifically it's a
type of cash-value insurance policy. (The other types of cash value
life insurance are whole, universal, and variable life.) Like any life
insurance policy, there is a payout in case of death (also called the
death benefit). Like whole-life insurance, the insurance policy has a
cash value that enjoys tax-deferred growth over time, and allows you to
borrow against it. Unlike either term or traditional whole-life
insurance, VUL policies allow the insured to choose how the premiums are
invested, usually from a universe of 10-25 funds. This means that the
policy's cash value as well as the death benefit can fluctuate with the
performance of the investments that the policy holder chose.

Where does the name come from? To take the second part first, the
"universal" component refers to the fact the premium is not a "set in
stone" amount as would be true with traditional whole life, but rather
can be varied within a range. As for the first part of the name, the
"variable" portion refers to the fact that the policy owner can direct
the investments him/herself from a pool of options given in the policy
and thus the cash value will vary. So, for instance, you can decide the
cash value should be invested in various types of equities (while it can
be invested in nonequities, most interest in VUL policies comes from
those that want to use equities). Obviously, you bear the risk of
performance in the policy, and remember we have to keep enough available
to fund the expenses each year. So bad performance could require
increasing premiums to keep the policy in force. Conversely, you gain
if you can invest and obtain a better return (at least you get more cash

If a VUL policy holder was fortunate enough to choose investments that
yield returns anything like what the NASDAQ saw in 1999, the policy's
cash value could grow quite large indeed. The cash value component of
the policy may be in addition to the death benefit should you die (you
get face insurance value *plus* the benefit) *OR* serve to effectively
reduce the death benefit (you get the face value, which means the cash
value effectively goes to subsidize the death benefit). It all depends
on the policy.

A useful way to think about VUL is to think of buying pure term
insurance and investing money in a mutual fund at the same time. This
is essentially what the insurance company that sells you a VUL is doing
for you. However, unlike your usual mutual fund that may pass on
capital gains and other income-tax obligations annually, the investments
in a VUL grow on a tax-deferred basis. Uncle Sam may get a taste
eventually (if the policy is cashed in or ceases to remain in force),
but not while the funds are growing and the policy is maintained.

We can talk about the insurance component of a VUL and about the
investment component. The insurance component obviously provides the
death benefit in the early years of the policy if needed. The
investment component serves as "bank" of sorts for the amounts left over
after charges are applied against the premium paid, namely charges for
mortality (to fund the payouts for those that die with amounts paid
beyond the cash values), administrative fees (it costs money to run an
insurance company (grin)) and sales compensation (the advisor has to
earn a living). How this amount is invested is the principal difference
between a VUL and other insurance policies.

If you own a VUL policy, you can borrow against the cash value build-up
inside the policy. Because monies borrowed from a VUL policy that is
maintained through the insured's life are technically borrowed against
the death benefit, they work out tax free. This means a VUL owner can
borrow money during retirement against the cash value of the policy and
never pay tax on that money. It sounds almost too good to be true, but
it's true.

A policy holder who choose to borrow against the death benefit must be
extremely careful. A policy collapses when the cash value plus any
continuing payments aren't enough to keep the basic insurance in force,
and that causes the previously tax-free loans to be viewed as taxable
income. Too much borrowing can trigger a collapse. Here's how it can
happen. As the insured ages, Cost of Insurance (COI) per thousand
dollars of insurance rises. With a term policy, it's no big deal - the
owner can just cancel or let it lapse without tax consequences, they
just have no more life insurance policy. But with a cash value policy
such as VUL there is the problem of distributions that the owner may
take. Say on a policy with a cash value of $100,000 I start taking
$10,000 per year withdrawals/loans. Say I keep doing this for 30 years,
and then the variability of the market bites the investment and the cash
value gets exhausted. I may have put say 50,000 into the policy -
that's my cost basis, and I took that much out as withdrawals. But the
other $250,000 is technically a loan against the death benefit, and I
don't have to pay taxes on it - until there's suddenly no death benefit
because there's no policy. So here's $250,000 I suddenly have to pay
taxes on.

Once the policy is no longer in force, all the money borrowed suddenly
counts as taxable income, and the policy holder either has taxable
income with no cash to show for it, or a need to start paying premiums
again. At the point of collapse, the owner could be (reasonably likely)
destitute anyway, so there may be very little in the way of real
consequences, but if there are still assets, like a home, other monies,
etcetera, you see that there could be problems. Which is why cash value
life insurance should be the *last* thing you take distributions from in
most cases (The more tax-favored they are, the longer you put off
distributions.) What all this means is that the cash surrender value of
the VUL really isn't totally available at any point in time, since
accessing it all will result in a tax liability. If you want to
consider the real cash value, you need realistic projections of what can
be safely borrowed from the policy.

This seems like a good time to mention one other aspect of taxes and
life insurance, namely FIFO (first-in first-out) treatment. In other
words, if a policy holder withdraws money from a cash-value life
insurance policy, the withdrawal is assumed to come from contributions
first, not earnings. Withdrawals that come from contributions aren't
taxable (unless it's qualified money, a rare occurence). After the
contributions are exhausted, then withdrawals are assumed to come from

Computing the future value of a VUL policy borders on the impossible.
Any single line projection of the VUL is a) virtually certain to be
wrong and b) without question overly simplistic. This is a rather
complex beast that brings with it a wide range of potential outcomes.
Remember that while we cannot predict the future, we know pretty much
for sure that you won't get a nice even rate of return each year (though
that's likely what all VUL examples will assume). The date when returns
are earned can be far more important than the average return earned. To
compare a VUL with other choices, you need to do a lot of "what ifs"
including looking at the impacts of uneven returns, and understand all
the items in the presentation that may vary (including your date of
death (grin)).

While I hate to give "rules of thumb" in these areas, the closest I will
come is to say that VUL normally makes the most sense when you can
heavily fund the policy and are looking at a very long term for the
funds to stay invested. The idea is to limit the "drag" on return from
the insurance component, but get the tax shelter.

Another issue is that if you will have a taxable estate and helping to
fund estate taxes is one of the needs you see for life insurance, the
question of the ownership of the insurance policy will come into play.
Note that this will complicate matters even further (and you probably
already thought it was bad enough (grin)), because what you need to do
to keep it out of your estate may conflict with other uses you had
planned for the policy.

Note that there are "survivor VULs", insuring two lives, which are
almost always sold for either estate planning or retirement plan
purposes (or both). The cost of insurance is typically less than an
annuity's M&E charges until the younger person is in their fifties.

A person who is considering purchasing a VUL policy needs to think
clearly about his or her goals. Those goals will determine both whether
a VUL is right tool and how it should be used. Potential goals include:
* Providing a pool of money that will only be tapped at my death, but
will be used by my spouse.
* Providing a pool of money that will only be used at my death, but
which we want to use to pay estate taxes.
* Providing a pool of money that I plan to borrow from in old age to
live on, and which will, in the interim, provide a death benefit
for my spouse.

Once the goals are clear, and you've then determined that a VUL would be
something that could fulfill your goals, you then have to find the right

--------------------Check for updates------------------

Subject: Mutual Funds - Basics

Last-Revised: 11 Aug 1998

Contributed-By: Chris Lott ( contact me )

This article offers a basic introduction to mutual funds. It can help
you decide if a mutual fund might be a good choice for you as an

If you visit a big fund company's web site (e.g.,,
they'll tell you that a mutual fund is a pool of money from many
investors that is used to pursue a specific objective. They'll also
hasten to point out that the pool of money is managed by an investment
professional. A prospectus (see below) for any fund should tell you
that a mutual fund is a management investment company. But in a
nutshell, a mutual fund is a way for the little guy to invest in, well,
almost anything. The most common varieties of mutual funds invest in
stocks or bonds of US companies. (Please see articles elsewhere in this
FAQ for basic explanations of stocks and bonds.)

First let's address the important issue: how little is our proverbial
little guy or gal? Well, if you have $20 to save, you would probably be
better advised to speak to your neighborhood bank about a savings
account. Most mutual funds require an initial investment of at least
$1,000. Exceptions to this rule generally require regular, monthly
investments or buying the funds with IRA money.

Next, let's clear up the matter of the prospectus, since that's about
the first thing you'll receive if you call a fund company to request
information. A prospectus is a legal document required by the SEC that
explains to you exactly what you're getting yourself into by sending
money to a management investment company, also known as buying into a
mutual fund. The information most useful to you immediately will be the
list of fees, i.e., exactly what you will be charged for having your
money managed by that mutual fund. The prospectus also discloses things
like the strategy taken by that fund, risks that are associated with
that strategy, etc. etc. Have a look at one, you'll quickly see that
securities lawyers don't write prose that's any more comprehensible than
other lawyers.

The worth of an investment with an open-end mutual fund is quoted in
terms of net asset value. Basically, this is the investment company's
best assessment of the value of a share in their fund, and is what you
see listed in the paper. They use the daily closing price of all
securities held by the fund, subtract some amount for liabilities,
divide the result by the number of outstanding shares and Poof! you have
the NAV. The fund company will sell you shares at that price (don't
forget about any sales charge, see below) or will buy back your shares
at that price (possibly less some fee).

Although boring, you really should understand the basics of fund
structure before you buy into them, mostly because you're going to be
charged various fees depending on that structure. All funds are either
closed-end or open-end funds (explanation to follow). The open-end
funds may be further categorized into load funds and no-load funds.
Confusingly, an open-end fund may be described as "closed" but don't
mistake that for closed-end.

A closed-end fund looks much like a stock of a publically traded
company: it's traded on some stock exchange, you buy or sell shares in
the fund through a broker just like a stock (including paying a
commission), the price fluctuates in response to the fund's performance
and (very important) what people are willing to pay for it. Also like a
publically traded company, only a fixed number of shares are available.

An open-end fund is the most common variety of mutual fund. Both
existing and new investors may add any amount of money they want to the
fund. In other words, there is no limit to the number of shares in the
fund. Investors buy and sell shares usually by dealing directly with
the fund company, not with any exchange. The price fluctuates in
response to the value of the investments made by the fund, but the fund
company values the shares on its own; investor sentiment about the fund
is not considered.

An open-end fund may be a load fund or no-load fund. An open-end fund
that charges a fee to purchase shares in the fund is called a load fund.
The fee is called a sales load, hence the name. The sales load may be
as low as 1% of the amount you're investing, or as high as 9%. An
open-end fund that charges no fee to purchase shares in the fund is
called a no-load fund.

Which is better? The debate of load versus no-load has consumed
ridiculous amounts of paper (not to mention net bandwidth), and I don't
know the answer either. Look, the fund is going to charge you something
to manage your money, so you should consider the sales load in the
context of all fees charged by a fund over the long run, then make up
your own mind. In general you will want to minimize your total
expenses, because expenses will diminish any returns that the fund

One wrinkle you may encounter is a "closed" open-end fund. An open-end
fund (may be a load or a no-load fund, doesn't matter) may be referred
to as "closed." This means that the investment company decided at some
point in time to accept no new investors to that fund. However, all
investors who owned shares before that point in time are permitted to
add to their investments. (In a nutshell: if you were in before, you
can get in deeper, but if you missed the cutoff date, it's too late.)

While looking at various funds, you may encounter a statistic labeled
the "turnover ratio." This is quite simply the percentage of the
portfolio that is sold out completely and issues of new securities
bought versus what is still held. In other words, what level of trading
activity is initiated by the manager of the fund. This can affect the
capital gains as well as the actual expenses the fund will incur.

That's the end of this short introduction. You should learn about the
different types of funds , and you might also want to get information
about the various fees that funds can charge , just to mention two big
issues. Check out the articles elsewhere in this FAQ to learn more.

Here are a few resources on the 'net that may also help.
* Brill Editorial Services offers Mutual Funds Interactive, an
independent source of information about mutual funds.
* FundSpot offers mutual fund investors the best information
available for free.
* The Mutual Fund Investor's Center, run by the Mutual Fund Education
Alliance, offers profiles, performance data, links, etc.

--------------------Check for updates------------------

Subject: Mutual Funds - Average Annual Return

Last-Revised: 24 Jun 1997
Contributed-By: Jack Piazza (seninvest at

The average annual return for a mutual fund is stated after expenses.
The expenses include fund management fees, 12b-1 fees (if applicable),
etc., all of which are a part of the fund's expense ratio. Average
annual returns are also factored for any reinvested dividend and capital
gain distributions. To compute this number, the annual returns for a
fixed number of years (e.g., 3, 5, life of fund) are added and divided
by the number of years, hence the name "average" annual return. This
specifically means that the average annual return is not a compounded
rate of return.

However, the average annual returns do not include sales commissions,
unless explictly stated. Also, custodial fees which are applied to only
certain accounts (e.g., $10 annual fee for IRA account under a stated
amount, usually $5,000) are not factored in annual returns.

--------------------Check for updates------------------

Subject: Mutual Funds - Buying from Brokers versus Fund Companies

Last-Revised: 28 Dec 1998
Contributed-By: Daniel Pettit (dalacap at, Jim Davidson
(jdavidso at, Chris Lott ( contact me ), Michael
Aves (michaelaves at

Many discount brokerage houses now offer their clients the option of
purchasing shares in mutual funds directly from the brokerage house.
Even better, most of these brokers don't charge any load or fees if a
client buys a no-load fund. There are a few advantages and
disadvantages of doing this.

Here are a few of the advantages.
1. One phone call/Internet connection gets you access to hundreds of
2. One consolidated statement at the end of the month.
3. Instant access to your money for changing funds and or families,
and for getting your money in your hand via checks (2-5 days).
4. You can buy on margin, if you are so inclined.
5. Only one tax statement to (mis)file.
6. The minimum investment is sometimes lower.

And the disadvantages:
1. Many discount brokerage supermarket programs do not even give
access to whole sectors of the market, such as high-yield bond
funds, or multi-sector (aka "Strategic Income") bond funds.
2. Most discount brokers also will not allow clients to do an exchange
between funds of different families during the same day (one trade
must clear fist, and the the trade can be done the next day).
3. Many will not honor requests to exchange out of funds if you call
after 2pm. EST. (which of course is 11am in California). This is
a serious restriction, since most fund families will honor an
exchange or redemption request so long as you have a rep on the
phone by 3:59pm.
4. You pay transaction fees on some no-load funds.
5. The minimum investment is sometimes higher.

Of course the last item in each list contradict each other, and deserve
comment. I've seen a number of descriptions of funds that had high
initial minimums if bought directly (in the $10,000+ range), but were
available through Schwab for something like $2500. I think the same is
true of Fidelity. Your mileage may vary.

--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Apr 17, 2004, 7:28:35 AM4/17/04
Archive-name: investment-faq/general/part11
Version: $Id: part11,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 11 of 20. The web site

always has the latest version, including in-line links. Please browse

Terms of Use


Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Retirement Plans - 401(k)

Last-Revised: 9 Dec 2001
Contributed-By: Ed Nieters (nieters at, David W. Olson,
Rich Carreiro (rlcarr at, Chris Lott ( contact
me ), Art Kamlet (artkamlet at, Ed Suranyi, Ed Zollars (ezollar

This article describes the provisions of the US tax code for 401(k)
plans as of mid 2001, including the changes made by the Economic
Recovery and Tax Relief Reconciliation Act of 2001.

A 401(k) plan is a retirement savings plan that is funded by employee
contributions and (often) matching contributions from the employer. The
major attraction of these plans is that the contributions are taken from
pre-tax salary, and the funds grow tax-free until withdrawn. Also, the
plans are (to some extent) self-directed, and they are portable; more
about both topics later. Both for-profit and many types of tax-exempt
organizations can establish these plans for their employees.

A 401(k) plan takes its name from the section of the Internal Revenue
Code of 1978 that created them. To get a bit picky for a moment, a
401(k) plan is a plan qualified under Section 401(a) (or at least we
mean it to be). Section 401(a) is the section that defines qualified
plan trusts in general, including the various rules required for
qualifications. Section 401(k) provides for an optional "cash or
deferred" method of getting contributions from employees. So every
401(k) plan already is a 401(a) plan. The IRS says what can be done,
but the operation of these plans is regulated by the Pension and Welfare
Benefits Administration of the U.S. Department of Labor.

For example, the Widget Company's plan might permit employees to
contribute up to 7% of their gross pay to the fund, and the company then
matches the contributions at 50% (happily, they pay in cash and not in
widgets :-). Total contribution to the Widget plan in this example
would be 10.5% of the employee's salary. My joke about paying in cash
is important, however; some plans contribute stock instead of cash.

There are many advantages to 401(k) plans. First, since the employee is
allowed to contribute to his/her 401(k) with pre-tax money, it reduces
the amount of tax paid out of each pay check. Second, all employer
contributions and any growth in the capital grow tax-free until
withdrawal. The compounding effect of consistent periodic contributions
over the period of 20 or 30 years is quite dramatic. Third, the
employee can decide where to direct future contributions and/or current
savings, giving much control over the investments to the employee.
Fourth, if your company matches your contributions, it's like getting
extra money on top of your salary. Fifth, unlike a pension, all
contributions can be moved from one company's plan to the next company's
plan, or a special IRA, should a participant change jobs. Sixth,
because the program is a personal investment program for your
retirement, it is protected by pension (ERISA) laws, which means that
the benefits may not be used as security for loans outside the program.
This includes the additional protection of the funds from garnishment or
attachment by creditors or assigned to anyone else, except in the case
of domestic relations court cases dealing with divorce decree or child
support orders (QDROs; i.e., qualified domestic relations orders).
Finally, while the 401(k) is similar in nature to an IRA, an IRA won't
enjoy any matching company contributions, and personal IRA contributions
are subject to much lower limits; see the article about IRA's elsewhere
in this FAQ.

There are, of course, a few disadvantages associated with 401(k) plans.
First, it is difficult (or at least expensive) to access your 401(k)
savings before age 59 1/2 (but see below). Second, 401(k) plans don't
have the luxury of being insured by the Pension Benefit Guaranty
Corporation (PBGC). (But then again, some pensions don't enjoy this
luxury either.) Third, employer contributions are usually not vested
(i.e., do not become the property of the employee) until a number of
years have passed. Currently, those contributions can vest all at once
after five years of employment, or can vest gradually from the third
through the seventh year of employment.

Participants in a 401(k) plan generally have a decent number of
different investment options, nearly all cases a menu of mutual funds.
These funds usually include a money market, bond funds of varying
maturities (short, intermediate, long term), company stock, mutual fund,
US Series EE Savings Bonds, and others. The employee chooses how to
invest the savings and is typically allowed to change where current
savings are invested and/or where future contributions will go a
specific number of times a year. This may be quarterly, bi-monthly, or
some similar time period. The employee is also typically allowed to
stop contributions at any time.

With respect to participant's choice of investments, expert (sic)
opinions from financial advisors typically say that the average 401(k)
participant is not aggressive enough with their investment options.
Historically, stocks have outperformed all other forms of investment and
will probably continue to do so. Since the investment period of 401(k)
savings is relatively long - 20 to 40 years - this will minimize the
daily fluctuations of the market and allow a "buy and hold" strategy to
pay off. As you near retirement, you might want to switch your
investments to more conservative funds to preserve their value.

Puzzling out the rules and regulations for 401(k) plans is difficult
simply because every company's plan is different. Each plan has a
minimum and maximum contribution, and these limits are chosen in
consultation with the IRS (I'm told) such that there is no
discrimination between highly paid and less highly paid employees. The
law requires that if low compensated employees do not contribute enough
by the end of the plan year, then the limit is changed for highly
compensated employees. Practically, this means that the employer sets a
maximum percentage of gross salary in order to prevent highly
compensated employees from reaching the limits. In any case, the
employer chooses how much to match, how much employees may contribute,
etc. Of course the IRS has the final say, so there are certain
regulations that apply to all 401(k) plans. We'll try to lay them out

Let's begin with contributions. Employees have the option of making all
or part of their contributions from pre-tax (gross) income. This has
the added benefit of reducing the amount of tax paid by the employee
from each check now and deferring it until the person takes the pre-tax
money out of the plan. Both the employer contribution (if any) and any
growth of the fund compound tax-free. These contributions must be
deposited no more than 15 business days after the end of the month in
which they were made (also see the May 1999 issue of Individual Investor
magazine for a discussion of this).

The interesting rules govern what happens to before-tax and after-tax
contributions. The IRS limits pre-tax deductions to a fixed dollar
figure that changes annually. In other words, an employee in any 401(k)
plan can reduce his or her gross pay by a maximum of some fixed dollar
amount via contributions to a 401(k) plan. An employer's plan may place
restrictions on the employees that are stricter than the IRS limit, or
are much less strict. If the restrictions are less strict, employees
may be able to make after-tax contributions.

After-tax contributions are a whole lot different from pre-tax
contributions. In fact, by definition an employee cannot contribute
after-tax monies to a 401(k)! Monies in excess of the limits on 401(k)
accounts (i.e., after-tax monies) are put into a 401(a) account, which
is defined to be an employee savings plan in which the employee
contributes after-tax monies. (This is one way for an employee to save
aggressively for retirement while still enjoying tax-free growth until
distribution time.) If an employee elects to make after-tax
contributions, the money comes out of net pay (i.e., after taxes have
been deducted). While it doesn't help one's current tax situation,
funds that were contributed on an after-tax basis may be easier to
withdraw since they are not subject to the strict IRS rules which apply
to pre-tax contributions. When distributions are begun (see below), the
employee pays no tax on the portion of the distribution attributed to
after-tax contributions, but does have to pay tax on any gains.

Ok, let's talk about the IRS limits already. First, a person's maximum
before-tax contribution (i.e., 401(k) limit) for 2001 is $10,500 (same
as 2000, but will change in 2002). It's important to understand this
limit. This figure indicates only the maximum amount that the employee
can contribute from his/her pre-tax earnings to all of his/her 401(k)
accounts. It does not include any matching funds that the employer
might graciously throw in. Further, this figure is not reduced by
monies contributed towards many other plans (e.g., an IRA). And, if you
work for two or more employers during the year, then you have the
responsibility to make sure you contribute no more than that year's
limit between the two or more employers' 401k plans. If the employee
"accidentally" contributes more than the pre-tax limit towards his or
her 401(k) account, the employer must move the excess, or the excess
contribution amount due to a smaller limit imposed by an imbalance of
highly compensated employees, into a 401(a) account.

Next there are regulations for highly compensated employees. What are
these? Well, when the 401(k) rules were being formulated, the government
was afraid that executives might make the 401(k) plan at their company
very advantageous to themselves, but without allowing the rank-and-file
employees those same benefits. The only way to make sure that the plan
would be beneficial to ordinary employees as well as those "highly
compensated," the law-writers decided, was to make sure that the
executives had an incentive to make the plan desirable for those
ordinary employees. What this means is that employees who are defined
as "highly compensated" within the company (as guided by the
regulations) may not be allowed to save at the maximum rates. Starting
in 1997, the IRC defined "highly compensated" as income in excess of
$80,000; alternately, the company can make a determination that only the
top 20% of employees are considered highly compensated. Therefore, the
implementation of the "highly compensated employee" regulations varies
with the company, and only your benefits department can tell you if you
are affected.

Finally the last of the IRS regulations. IRS rules won't allow
contributions on pay over a certain amount (the limit was $170,000 in
2001, and will change in 2002). Additionally, the IRS limits the total
amount of deferred income (i.e., money put into IRAs, 401(k) plans,
401(a) plans, or pension plans) each year to the lesser of some amount
($30,000 in 1996, and subject to change of course) or 25% of your annual
compensation. Annual compensation defined as gross compensation for the
purpose of computing the limitation. This changes an earlier law; a
person's annual compensation for the purpose of this computation is no
longer reduced by 401(k) contributions and salaray redirected to
cafeteria benefit plans.

The 401(k) plans are somewhat unique in allowing limited access to
savings before age 59 1/2. One option is taking a loan from yourself!
It is legal to take a loan from your 401(k) before age 59 1/2 for
certain reasons including hardship loans, buying a house, or paying for
education. When a loan is obtained, you must pay the loan back with
regular payments (these can be set up as payroll deductions) but you
are, in effect, paying yourself back both the principal and the
interest, not a bank. If you take a withdrawal from your 401(k) as
money other than a loan, not only must you pay tax on any pre-tax
contributions and on the growth, you must also pay an additional 10%
penalty to the government. There are other special conditions that
permit withdrawals at various ages without penalty; consult an expert
for more details. However, in general it's probably not a good idea to
take a loan from your own 401(k) simply because your money is not
growing for you while it is out of your account. Sure, you're paying
yourself some bit of interest, but you're almost certainly not paying

Participants who are vested in in 401(k) plans can begin to access their
savings without withdrawal penalties at various ages, depending on the
plan and on their own circumstances. If the participant who separates
from service is age 55 or more during the year of separation, the
participant can draw any amount from his or her 401(k) without any
calculated minimums and without any 5-year rules. Depending on the
plan, a participant may be able to draw funds without penalty at or
after age 59 1/2 regardless of whether he or she has separated from
service (i.e., the participant might still be working; check with the
plan administrator to be sure). The minimum withdrawal rules for a
participant who has separated from service kick in at age 70 1/2. Being
able to draw any amount and for any length of time without penalty
starting at age 55 (provided the person has separated from service) is
one of the least understood differences between 401ks and IRAs. Note
that this paragraph doesn't mention "retire" because the person's status
after leaving service with the company that has the 401(k) doesn't seem
to be relevant.

Anyone who has separated from service from a company with a 401(k), and
is entitled to withdraw funds without penalty, may take a lump sum
withdrawal of the 401(k) into a taxable account, and depending on their
age may use an income averaging method. Currently anyone eligible may
use an averaging method which spreads the lump sum over 5 years, and if
born before 1937, may average over 10 years. Or, if a lump sum is
chosen, it can be immediately rolled into an IRA (but they withhold tax)
-- or transferred from the 401(k) custodian to an IRA custodian, and the
account will continue to grow tax deferred.

Note that 401(k) distributions are separate from pension funds. Like
IRAs, participants in 401(k) plans must begin taking distributions by
age 70 1/2. Also, the IRS imposes a minimum annual distribution on
401(k)s at age 70 1/2, just to guarantee that Uncle Sam gets his share.
However, there's an exception to the minimum and required distribution
rules: if you continue to work at that same company and the 401(k) is
still there, you do not have to start withdrawing the 401(k).

Since a 401(k) is a company-administered plan, and every plan is
different, changing jobs will affect your 401(k) plan significantly.
Different companies handle this situation in different ways (of course).
Some will allow you to keep your savings in the program until age
59 1/2. This is the simplest idea. Other companies will require you to
take the money out. Things get more complicated here, but not
unmanageable. Your new company may allow you to make a "rollover"
contribution to its 401(k) which would let you take all the 401(k)
savings from your old job and put them into your new company's plan. If
this is not a possibility, you may roll over the funds into an IRA.
However, as discussed above, a 401(k) plan has numerous advantages over
an IRA, so if possible, rolling 401(k) money into another 401(k), if at
all possible, is usually the best choice.

Whatever you do regarding rollovers, BE EXTREMELY CAREFUL!! This can not
be emphasized enough. Legislation passed in 1992 by Congress added a
twist to the rollover procedures. It used to be that you could receive
the rollover money in the form of a check made out to you and you had a
60 days to roll this cash into a new retirement account (either 401(k)
or IRA). Now, however, employees taking a withdrawal have the
opportunity to make a "direct rollover" of the taxable amount of a
401(k) to a new plan. This means the check goes directly from your old
company to your new company (or new plan). If this is done (ie. you
never "touch" the money), no tax is withheld or owed on the direct
rollover amount.

If the direct rollover option is not chosen, i.e., a check goes through
your grubby little hands, the withdrawal is immediately subject to a
mandatory tax withholding of 20% of the taxable portion, which the old
company is required to ship off to the IRS. The remaining 80% must be
rolled over within 60 days to a new retirement account or else is is
subject to the 10% tax mentioned above. The 20% mandatory withholding
is supposed to cover possible taxes on your withdrawal, and can be
recovered using a special form filed with your next tax return to the
IRS. If you forget to file that form, however, the 20% is lost.
Naturally, there is a catch. The 20% withheld must also be rolled into
a new retirement account within 60 days, out of your own pocket, or it
will be considered withdrawn and subject to the 10% tax. Check with
your benefits department if you choose to do any type of rollover of
your 401(k) funds.

Here's an example to clarify an indirect rollover. Let us suppose that
you have $10,000 in a 401k, and that you withdraw the money with the
intention of rolling it over - no direct transfer. Under current law
you will receive $8,000 and the IRS will receive $2,000 against possible
taxes on your withdrawal. To maintain tax-exempt status on the money,
$10,000 has to be put into a new retirement plan within 60 days. The
immediate problem is that you only have $8,000 in hand, and can't get
the $2,000 until you file your taxes next year. What you can do is:
1. Find $2,000 from somewhere else. Maybe sell your car.
2. Roll over $8,000. The $2,000 then loses its tax status and you
will owe income tax and the 10% tax on it.

Caveat: If you have been in an employee contributed retirement plan
since before 1986, some of the rules may be different on those funds
invested pre-1986. Consult your benefits department for more details,

The rules changed in mid 2001 in the following ways:
* The 2001 contribution limit of $10,500 per year rises to $11,000 in
2002, then $12,000 in 2003, a lucky $13,000 in 2004, $14,000 in
2005, and finally $15,000 in 2005. Thereafter the limit is indexed
for inflation.
* Vesting periods for employer's matching contributions are shortened
starting in 2002. Monies will vest after 3 years of service
(compare with 5 years now), or can be vested gradually from the
second through the sixth year (compare with 3..7 years now).
* Beginning in 2002, a catch-up provision is available to employees
who are over 50 years old. This provision allows these employees
to contribute extra amounts over and above the limit in effect for
that year. The additional contribution amount is $1,000 in 2002
and increases by $1,000 annually until it reaches $5,000 in 2006;
thereafter, it increases $500 annually.
* Participants are supposed to be able to move between plans (like
when switching employers) more easily than now. I believe it makes
roll-overs from a 401 to a 403 plan possible.
* A new option for 401(k) participants appears in 2002. This option
is being called a Roth-style 401(k); it allows deductions to be
taken after-tax in exchange for the right to withdraw (like a Roth
IRA) both contributions and earnings without tax at some distant
point in the future.

Finally, here are some resources on the web that may help.
* The Pension and Welfare Benefits Administration of the U.S.
Department of Labor offers some (although not much) information.
* A brief note from the IRS
* Fidelity offers an introduction to 401k plans
* 401Kafé is a community resource for 401(k) participants.

--------------------Check for updates------------------

Subject: Retirement Plans - 401(k) for Self-Employed People

Last-Revised: 23 Jan 2003
Contributed-By: Daniel Lamaute, Chris Lott ( contact me ),

This article describes the provisions of the US tax code for the 401(k)
plan for Self-Employed People, also called the Solo 401(k). These plans
were established by the Economic Growth and Tax Relief Reconciliation
Act of 2001.

A Solo 401(k) plan provides a great tax break to the smallest business
owners. In addition to the possibility to shelter from taxes a large
portion of income, some Solo 401(k) plans offer a loan feature for
cash-strapped small business owners.

Eligibility for a Solo 401(k) plan is limited to those with a small
business and no employees, or only a spouse as an employee. This
includes independent contractors with earned income, freelancers, sole
proprietors, partnerships, Limited Liability Companies (LLC) or

The key benefits of the Solo 401K plan include:
* High limits on contributions: The limits for elective salary
deferrals and employer contributions enable sole proprietors in tax
year 2003 to contribute up to the lesser of 100% of aggregate
compensation or $40,000 ($42,000 if age 50 or older).
* Contributions are fully-tax deductible and are based on
compensation or earned income.
* Assets can be rolled from other plans or IRA’s to a Solo 401K.
There is no limit on roll-overs.
* The account holder can take a loan that is tax-free and penalty
free from the Solo 401K, if allowed by the plan, up to the lesser
of 50% or $50,000 of the account balance.

The contribution limits depend on how the business is established:
* For businesses that are not incorporated, the employer and salary
deferral contributions are based on the net earned income.
Contributions are not subject to federal income tax, but remain
subject to self-employment taxes (SECA). The owner receives a tax
deduction for both salary deferral and employer contributions on
IRS Form 1040 at filing time. The maximum contribution limit is
calculated based on salary (max deferral of about $12,000) and
profit sharing (to get you up to the current max contribution).
* For corporations, the employer contribution is based on the W-2
income and is contributed by the business. The maximum employer
contribution is 25% of pay. It is not subject to federal income
tax or Social Security (FICA) taxes. The salary deferral
contributions are withheld from your pay and are excluded from
federal income tax but are subject to FICA. The business receives
a tax deduction for both salary deferral and employer
contributions. The maximum elective salary deferral amount for
2003 is 100% of pay up to $12,000 ($14,000 if age 50 or older).

Fees for establishing and maintaining the Solo-401(k) type accounts vary
by plan provider and administrator. The plan providers are mostly
mutual fund companies with loaded funds. The plan fees are also a
function of the features of the Solo-401(k). For example, plans fees
tend to be less expensive if they have no loan feature. Plans that
allow assets other than mutual funds in the plan would also be more
costly to maintain. On average, the cost to set up and maintain a
Solo-401(k) is modest for a 401(k) plan; fees on various plans range
from $35 to $1,200 per year.

A solo 401(k) offers several key advantages when compared to Keogh plans
(see the article elsewhere in the FAQ). The solo 401(k) allows higher
contribution limits for most individuals, allows for catch-up salary
deferral contributions (for those 50+ years), and allows loans to

Rather than raiding their 401K to finance their business - and paying a
big penalty to the IRS - small business owners can take a tax-free loan
and keep their hard earned money working for them. This plan offers
small business owners all the benefits of a big-company 401K without the
administrative expense and complexity.

Small business owners should ask their accountants about this plan and
how it may benefit them. Each Solo 401K must be set up no later than
December 31 of the calendar year to be eligible for tax deductions in
that tax year.

Please visit Daniel Lamaute's web site for more information. There he
offers a Solo-401(k) plan with no set up fee and an administration fee
of $100 per year. That plan includes the loan feature; plan investments
are restricted to mutual funds by Pioneer Investments.

--------------------Check for updates------------------

Subject: Retirement Plans - 403(b)

Last-Revised: 29 Jan 2003
Contributed-By: Joseph Morlan (jmorlan at

A 403(b) plan, like a 401(k) plan, is a retirement savings plan that is
funded by employee contributions and (often) matching contributions from
the employer.

403(b) plans are not "qualified plans" under the tax code, but are
generally higher cost "Tax-Sheltered Annuity Arrangements" which can be
offered only by public school systems and other tax-exempt
organizations. They can only invest in annuities or mutual funds. They
are very similar to qualified plans such as 401(k) but have some
important differences, as follows.

The rules for top-heavy plans do not apply.

Employer contributions are exludable from income only to the extent of
employees "exclusion allowance." Exclusion allowance is the total
excludable employer contribution for any prior year minus 20% of annual
includible compensation multiplied by years of service (prorated for
part-timers). Whew! I have no idea what this means. In my own case
there is no extra employer contribution, but rather a salary reduction
agreement. So the so-called employer contribution is actually my own
contribution. At least I think it is.

Employer contributions must also be the lesser of 25% of compensation or
$30,000 annually. Excess contributions are are includible in gross
income only if employee's right to them is vested. I also don't know
what this means.

Contributions to a custodial account invested in mutual funds are
subject to a special 6% excise tax on the amount by which they exceed
the maximum amount excludable from income. (This sounds scary as the
calculation for excludable income seems quite complex. E.g. I already
have another tax-deferred retirment plan which probably needs to be
calculated into the total allowed in the 403b).

The usual 10% penalty on early withdrawal and the 15% excise tax on
excess distributions still apply as in 401(k) plans.

As of 2002, an individual may participate in a 403(b) plan and a 457(b)
plan at the same time.

NOTE: The above is my paraphrasing of the U.S. Master Tax Guide for
1993. Recent changes in the laws governing 401(k)-type arrangements
have made these available to non-profit institutions as well, and this
has made the old 403(b) plans less attractive to many. The following
sites address the new law and compare 401(k) with 403(b) plans:
* The following is a link to the IRS special publication on 403b

--------------------Check for updates------------------

Subject: Retirement Plans - 457(b)

Last-Revised: 29 Jan 2003

Contributed-By: Chris Lott ( contact me )

A 457(b) plan is a non-qualified, tax-deferred compensation plan offered
by many non-profit institutions to their employees. This plan, like a
401(k) or 403(b) plan, allows you to save for retirement.

Contributions are made from pre-tax wages, and the Internal Revenue Code
sets the maximum contribution limits. The limit for 2003 is the lesser
of $12,000 or 100% of an employee's salary. Catch-up provisions apply
to those 50 or older; these people can contribute an extra $2,000.

Because contributions are made before tax, naturally this means that
taxes are due when withdrawals are made. However, these plans do not
impose a penalty on early withdrawals.

Funds in a 457(b) plan can be rolled into another 457(b) plan if you
change employers. Alternately, a 457(b) account can be rolled into a
different type of retirement-savings plan such as an IRA or a 401(k).

As of 2002, an individual may participate in a 457(b) plan and a 403(b)
plan at the same time.

--------------------Check for updates------------------

Subject: Retirement Plans - Co-mingling funds in IRA accounts

Last-Revised: 19 Feb 1998
Contributed-By: Art Kamlet (artkamlet at, Paul Maffia (paulmaf

The term "co-mingling" refers to mixing monies that were saved under
different plans within a single IRA account. You may co-mingle as much
as you want within your IRAs. Although the bookkeeping is not a
problem, there are disadvantages; one example is discussed below.
Remember that you can have as many IRA accounts as you wish, although
there are strict limits on contributions to IRA accounts; see the FAQ
article on ordinary IRA accounts for more details.

The most common situation where co-mingling becomes an issue is if you
have what is known as a "conduit" IRA. This happens if you change
employers, and in doing so, move monies from the old employer's 401(k)
plan into an IRA account in your name. If the IRA is funded with only
401(k) monies, then it is called a conduit IRA. Further, if a later
employer allows it, the entire chunk can be transferred into a new

Of course you can mix (co-mingle) the conduit monies with monies from
other IRA accounts as much as you want. The major disadvantage of
co-mingling is that if your 401(k) monies get co-mingled with non-401(k)
monies, you can never place the original monies from the old 401(k) back
into another 401(k). You may also want to read the article on 401(k)
plans in the FAQ.

Hre's a summary of the issues that might motivate you to maintain
separate IRA accounts:

1. Legitimate investment needs such as diversification.
2. Estate planning purposes
3. With passage of the new tax law, to keep your Roth IRA money
separate from regular IRA money and/or Education IRA money.
4. And of course to keep 401K rollover monies separate if you want to
retain the ability to reroll as noted above.

--------------------Check for updates------------------

Subject: Retirement Plans - Keogh

Last-Revised: 23 Apr 1998
From: A. Nielson, Chris Lott ( contact me ), James Phillips

A Keogh plan is a tax-deferred retirement savings plan for people who
are self-employed, and is much like an IRA. The main difference between
a Keogh and an IRA is the contribution limit. Although exact
contribution limits depend on the type of Keogh plan (see below), in
general a self-employed individual may contribute a maximum of $30,000
to a Keogh plan each year, and deduct that amount from taxable income.
The limits for IRAs are much less, of course.

The following information was derived from material T. Row Price sends
out about their small company plan. There are three types of Keogh
plans. All types limit the maximum contribution to $30K per year, but
additional constraints may be imposed depending on the type of plan.

Profit Sharing Keogh
Annual contributions are limited to 15% of compensation, but can be
changed to as low as 0% for any year.
Money Purchase Keogh
Annual contributions are limited to 25% of compensation but can be
as low as 1%, but once the contribution percentage has been set, it
cannot be changed for the life of the plan.
Paired Keogh
Combines profit sharing and money purchase plans. Annual
contributions limited to 25% but can be as low as 3%. The part
contributed to the money purchase part is fixed for the life of the
plan, but the amount contributed to the profit sharing part (still
subject to the 15% limit) can change every year.

Like an IRA, the Keogh offers the individual a chance for his or her
savings to grow free of taxes. Taxes are not paid until the individual
begins withdrawing funds from the plan. Participants in Keogh plans are
subject to the same restrictions on distribution as IRAs, namely
distributions cannot be made without a penalty before age 59 1/2, and
distributions must begin before age 70 1/2.

Setting up a Keogh plan is significantly more involved then establishing
an IRA or SEP-IRA. Any competent brokerage house should be able to help
you execute the proper paperwork. In exchange for this initial hurdle,
the contribution limits are very favorable when compared to the other
plans, so self-employed individuals should consider a Keogh plan

--------------------Check for updates------------------

Subject: Retirement Plans - Roth IRA

Last-Revised: 31 Jan 2003
Contributed-By: Chris Lott ( contact me ), Paul Maffia (paulmaf at, Rich Carreiro (rlcarr at

This article describes the provisions of the US tax code for Roth IRAs
as of mid 2001, including the changes made by the Economic Recovery and
Tax Relief Reconciliation Act of 2001. Also see the articles elsewhere
in the FAQ for information about the Traditional IRA .

The Taxpayer Relief Act of 1997 established a new type of individual
retirement arrangement (IRA). It is commonly known as the "Roth IRA"
because it was championed in Congress by Senator William Roth of
Delaware. The Roth IRA has been available to investors since 2 Jan
1998; provisions were amended by the IRS Restructuring and Reform Act of
1998, signed into law by the president on 22 July 1998. Plans were
amended again in 2001. This article will give a broad overview of Roth
IRA rules and regulations, as well as summarize the differences between
a Roth IRA and an ordinary IRA.

A Roth individual retirement arrangement (Roth IRA) allows tax payers,
subject to certain income limits, to save money for use in retirement
while allowing the savings to grow tax-free. All of the tax benefits
associated with a Roth IRA happen when withdrawals are made:
withdrawals, subject to certain rules, are not taxed at all. Stated
differently, Roth IRAs convert earnings (dividends, interest, capital
gains) into tax-free income. There are no tax benefits associated with
contributions (no deductions on your federal tax return) because all
contributions to a Roth IRA are made with after-tax monies.

Funds in an IRA may be invested in a broad variety of vehicles (e.g.,
stocks, bonds, etc.) but there are limitations on investments (e.g.,
options trading is restricted, and buying property for your own use is
not permitted).

The contribution amounts are limited to $3,000 annually (as of 2003) and
may be restricted based on an individual's income and filing status. In
2003, an individual may contribute the lesser of US$3,000 or the amount
of wage income from US sources to his or her IRA account(s). A notable
exception was introduced in 1997, namely that married couples with only
one wage earner may each contribute the full $3,000 to their respective
IRA accounts. These limits are quite low in comparison to arrangements
that permit employee contributions such as 401(k) plans (see the article
on 401(k) plans in this FAQ for extensive information about those

There are absolutely no limits on the number of IRA accounts that an
individual may have, but the contribution limit applies to all accounts
collectively. In other words, an individual may have 34 ordinary IRA
accounts and 16 Roth IRA accounts, but can only contribute $3,000 total
to those accounts, divided up any way he or she pleases (perhaps $40
each, but that's a lot of little checks).

Taxpayers are permitted to contribute monies to a Roth IRA only if their
income lies below certain thresholds. However, participation in any
other retirement plan has no influence on whether a person may
contribute or not. More specifically, a person's Modified Adjusted
Gross Income (MAGI) must pass an income test for contributions to the
Roth IRA to be permitted. The 2003 income tests for individuals filing
singly, couples with filing status Married Filing Jointly (MFJ), and
couples living together with filing status Married Filing Separately
(MFS) look like this:

* MAGI less than 95k (MFJ 150k, MFS 0k): full contribution allowed
* MAGI in the range 95-110k (MFJ 150-160k), MFS 0-10k: partial
contribution allowed
* MAGI greater than 110k (MFJ 160k, MFS 10k): no contribution
allowed. That's right, the limits on married couples who file
separate tax returns are pretty darned low.

A bit of trivia: the Roth contribution phaseout, like the phaseout for
the deductibility of ordinary IRA contributions, has a kink in it. As
long as the MAGI is within the phaseout range, the allowable
contribution will not be less than $200, even though a strict
application of the phaseout formula would lead to an amount less than
$200. So as your MAGI works its way into the phaseout, your
contribution will drop linearly from $2000 down to $200, then will stay
at $200 until you hit the end of the phaseout, where it then drops to

Annual IRA contributions can be made between January 1 of that year and
April 15 of the following year. Because of the extra three and a half
months, if you send in a contribution to your IRA custodian between
January and April, be sure to indicate the year of the contribution so
the appropriate information gets sent to the IRS. Remember,
contributions to a Roth IRA are never deductible from a taxpayer's
income (unlike a traditional IRA).

The rules for penalty-free, tax-free distributions from a Roth IRA
account are fairly complex. First, some terminology: a Roth account is
built from contributions (made annually in cash) and conversions (from a
traditinal IRA); earnings are any amounts in the account beyond what was
contributed or converted. The rule are as follows:
* Contributions can be withdrawn tax-free and penalty-free at any
* There is 5-year clock 'A'. Clock 'A' starts on the first day of
the first tax year in which any Roth IRA is opened and funded.
* Earnings can be withdrawn tax-free and penalty-free after Clock 'A'
hits 5 years and a qualifying event (such as turning 59.5,
disability, etc.) occurs.
* Additional 5-year clocks 'B', 'C', etc. start running for each
traditional IRA that is converted to a Roth IRA. Each clock
applies just to that conversion.
* If you are under age 59.5 when a particular conversion is done, and
you withdraw any conversion monies before the clock associated with
that particular conversion hits 5 years, you are hit with a 10%
penalty on the withdrawn conversion monies. If you are over age
59.5 when you did the conversion, no penalty no matter how soon you
withdraw the monies from that conversion.
* The order of withdrawals (distributions) has been established to
help investors. When a withdrawal is made, it is deemed to come
from contributions first . After all contributions have been
withdrawn, subsequent withdrawals are considered to come from
conversions. After all conversions have been withdrawn, then
withdrawals come from earnings. I believe the conversions are
taken in chronological order.
* All Roth IRA accounts are aggregated for the purpose of applying
the ordering rules to a withdrawal.

A huge difference between Roth and ordinary IRA accounts involves the
rules for withdrawals past age 70 1/2. There are no requirements that a
holder of a Roth IRA ever make withdrawals (unlike a traditional IRA for
which required minimum distribution rules apply). This provision makes
it possible to use the Roth IRA as an estate planning tool. You can
pass on significant sums to your heirs if you choose; the account must
be distributed if the holder dies.

What the Roth IRA allows you to do, in essence, is lock in the tax rate
that you are currently paying. If you think rates are going nowhere but
up, even in your retirement, the Roth IRA is a sensible choice. But if
you think your tax rate after retirement will be less, perhaps much
less, than your current tax rate, it might be wiser to stick with a
conventional IRA. (To be picky, you really need to think about the tax
rate when you are eligible to take tax-free, penalty-free distributions,
which is age 59 1/2.)

Should you use a Roth IRA at all? Answering this question is tricky
because it depends on your circumstances. In general, experts agree
that if you have a 401(k) plan available to you through your employer,
you should max out that account before looking elsewhere. Otherwise, if
you are allowed to put money in a Roth IRA at all (i.e., if your income
is below the limits), then making contributions to a Roth IRA is always
preferable over making contributions to a nondeductible IRA. You pay
the same amount of taxes now in both cases, because neither is
deductible, but you don't pay taxes on withdrawal from the Roth (unlike
withdrawals from an ordinary IRA). The only exception here is if you're
going to need to pull the money out before the minimum holding period of
5 years.

Holders of ordinary IRA accounts will be permitted to convert their
accounts to Roth IRA accounts if they meet certain criteria. First,
there is a limit on MAGI of $100K for that individual in the year of the
conversion, single or married. Second, taxpayers whose filing status is
married filing separately may not convert their ordinary IRA accounts to
Roth accounts.

Tax is owed on the amount transferred, less any nondeductible
contributions that were made over the years. In more detail: the
current law allows the income (i.e., withdrawal) resulting from a
conversion in 1998 to be divided by 4 and indicated as income in equal
parts on 1998--2001 tax returns (the technical corrections bill changed
this from mandatory to optional). Conversions made in 1999 and
subsequent years will be fully taxed in the year of the conversion.
Deductible contributions and all earnings are taxed; non-deductible
contributions are considered return of capital and are not taxed.

If you convert only a portion of your IRA holdings to a Roth IRA, the
IRS says that these withdrawals are considered to be taken ratably from
each ordinary IRA account. You compute the rate by finding the ratio of
deductible to non-deductible contributions (also known as computing your
IRA basis). This ignores growth or shrinkage of the account's value.
For example, if you stashed $9,000 in deductible contributions and
$3,000 in non-deductible contributions for a total of $12,000 in
contributions to your ordinary IRA, your basis would be 25% of the total
contributions. When you make a withdrawal, 25% will considered to be
from the non-deductible portion and 75% from the deductible portion (and
hence taxable). Not certain whether the proper way to say this is that
your basis is 25% or 75%, but you get the idea.

The technical corrections bill of 1998 added a provision that investors
could unconvert (and possibly recovert) with no penalty to cover the
case of a person who converted, but then became ineligible due to
unexpected income. This opened a loophole: it put no limit on the
number of switches back and forth. With the decline in the markets of
1998, many people unconverted and reconverted to establish a lower cost
basis in their Roth IRA accounts. The IRS issued new regulations in
late October, 1998 that disallow this strategy effective 1 Nov 98, but
grandfather any reconversions that predate the new regulations. Under
the new regulations, IRA holders are allowed just one reconversion.

If you are eligible to convert your ordinary IRA to a Roth IRA, should
you? Again answering this question is non-trivial because each
investor's circumstances are very different. There are some
generalizations that are fairly safe. Young investors, who have many
years for their investments to grow, could benefit handsomely by being
able to withdraw all earnings free of tax. Older people who don't want
to be forced to withdraw funds from their accounts at age 70 1/2 might
find the Roth IRA helpful (this is the estate planning angle). On the
other hand, for people who have significant IRA balances, the extra
income could push them into a higher tax bracket for several years,
cause them to lose tax breaks for some itemized deductions, or increase
taxes on Social Security benefits.

The following illustrated example may help shed light on the benefits of
a Roth IRA and help you decide whether conversion is the right choice
for you. The numbers in this example were computed by Vanguard for
their pages (see the link below). In many situations the differences
between the two types of accounts is quite small, which is perhaps at
odds with the hype you might have seen recently about Roth IRAs. But
let's let the number speak for themselves.

We're going to compare an ordinary deductible IRA with a Roth IRA. Each
begins with $2,000, and we'll let the accounts grow for 20 years with no
further contributions. We'll assume a constant rate of return of 8%,
compounded annually, just to keep things simple. We'll also assume the
contribution to the ordinary IRA was deductible because otherwise the
Roth is a clear winner. Here's the situation at the start; we assume
the 28% tax bracket so you have to start by earning 2,778 just to keep
What Ordinary IRA Roth IRA
Gross wages 2,778 2,778
Contributions 2,000 2,000
Taxable income 778 2,778
28% federal tax 218 778
What's left 560 0
So at this point, the ordinary IRA left some money in your pocket, but
the Feds and the Roth IRA took it all. But we're not going to spend
that money, no sir, we're going to invest it at 8% too, although it's
taxed, so it's really like investing it at 72% of 8%, or about 6%.
After 20 years we withdraw the full amount in each account. What's the
What Ordinary IRA Roth IRA
Account balance 9,332 9,332
28% federal tax 2,613 0
What's left 6,719 9,332
Outside investment 1,716 0
Net result 8,435 9,332
So this worked out pretty well for the Roth IRA. A key assumption was
that the use of the same tax rate at withdrawal time. If the tax rate
had been significantly less, then the Ordinary IRA would have come out
ahead. And of course you had the discipline to invest the money that
the ordinary IRA left in your hands instead of blowing it in Atlantic

I hope that this example illustrated how you might run the numbers for
yourself. Before you do anything, I recommend you seriously consider
getting advice from a tax professional who can evaluate your
circumstances and make a recommendation that is most appropriate for

If you've decided to convert your ordinary IRA to a Roth IRA, here are
some tips offered by Ellen Schultz of the Wall Street Journal
(paraphrased from her article of 9 Jan 1998).

Pay taxes out of your pocket, not out of your IRA account.
If you use IRA funds to pay the taxes incurred on the conversion
(considered a withdrawal from your ordinary IRA), you've lost much
of the potential tax savings. Worse, those funds will be
considered a premature distribution and you may be hit with a 10%
Consider converting only part of your IRA funds.
This decision is up to you. There is no requirement to convert all
of your accounts.
Conversion amounts don't affect your conversion eligibility.
When you convert, the withdrawal amount does not count towards the
100k limit on income.

As a final note, you should be careful about any fees that the trustee
of your Roth IRA account might try to impose. For comparison,
Waterhouse offers a no-fee Roth IRA.

Just for the record, a number of changes were made in 1998 to the
original Roth provisions ("technical corrections"). One problem that
was corrected was that the original law included a tax break for
conversion Roth accounts. Specifically, there was no penalty on early
withdrawals from conversion accounts. This means that any money
converted (and any earnings after conversion) to a Roth from an ordinary
IRA could be withdrawn at any time without penalty, so you could roll to
a Roth IRA and use your ordinary IRA money immediately without penalty.
The technical corrections bill corrected this by requiring that 5 years
elapse after conversion before any sums can be withdrawn. Also, under
the wording of the original law, the minimum 5-year holding period for a
Roth conversion account was based on the date of the last deposit into
that account. One of the consequences of the second problem was that
the IRS was insisting on keeping the conversion accounts separate from
contribution (new money) accounts so as to minimize the potential damage
(tax collection-wise) if the correction was not made (but of course it
was). Another change lowered the already low income test for couples
filing MFS from 15k to 10k.

The rules changed in mid 2001 in the following ways:
* The contribution limit of $2,000 per year maximum rises to $3,000
in 2002; reaches $4,000 in 2005, and finally hits $5,000 in 2008.
* Investors over 50 can contribute an extra $500 per year (in 2002)
and eventually an extra 1,000 (in 2006) per year; this is called a
catch-up provision.

Here's a list of sources for additional information, including on-line
calculators that will help you decide whether you should convert an
ordinary IRA to a Roth IRA.

* Kaye Thomas maintains a site with an enormous wealth of information
about the Roth IRA.
* Brentmark Software offers a Roth IRA site that provides technical
and planning information on Roth IRAs.
* The Roth IRA Advisor provides guidelines for IRA owners and 401(k)
participants to optimize the benefits of their retirement plans.
Written by James Lange, CPA.
* Vanguard offers a considerable amount of information about the new
tax laws and Roth IRA provisions, including detailed analyses of
the two accounts, on their web site:
Also see the Vanguard page that discusses conversions:
* And also try the Vanguard calculator (no, they're not sponsoring me

* An article about Roth IRAs from SenInvest:
* A collection of links to sites with yet more information about Roth
IRAs, with emphasis on mutual fund holders:
* A conversion calculator from Strong Funds:

For the very last word on the rules and regulations of Roth IRA
accounts, get IRS Publication 553.

--------------------Check for updates------------------

Subject: Retirement Plans - SEP IRA

Last-Revised: 16 Feb 2003
Contributed-By: Edward Lupin, Daniel Lamaute (

A simplified employee pension (SEP) IRA is a written plan that allows an
employer to make contributions toward his or her own (if self-employed)
or employees' retirement, without becoming involved in more complex
retirement plans (such as Keoghs). The SEP functions essentially as a
low-cost pension plan for small businesses.

As of this writing, employers can contribute a maximum of 25% of an
employee's eligible compensation or $40,000, whichever is less. Be
careful not to exceed the limits; a non-deductible penalty tax of 6% of
the excess amount contributed will be incurred for each year in which an
excess contribution remains in a SEP-IRA.

Employees are able to exclude from current income the entire SEP
contribution. However, the money contributed to a SEP-IRA belongs to
the employee immediately and always. If the employee leaves the
company, all retirement contributions go with the employee (this is
known as portability).

The IRS regulations state that employers must include all eligible
employees who are at least age 21 and have been with a company for 3
years out of the immediately preceding 5 years. However, employers have
the option to establish less-restrictive participation requirements, if

An employer is not required to make contributions in any year or to
maintain a certain level of contributions to a SEP-IRA plan. Thus,
small employers have the flexibility to change their annual
contributions based on the performance of the business.

For calendar year corporations with a March 15, 2003 tax filing
deadline, SEP-IRA contributions must be made by the employer by the due
date of the company’s income tax return, including extensions. The
contributions are deductible for tax year 2002 as if the contributions
had actually been contributed within tax year 2002.

Sole proprietors have until April 15, 2003, or to their extension
deadline, to make their SEP-IRA contribution if they want a 2002 tax

The SEP-IRA enrollment process is an easy one. It’s generally a two
page application process. The employer completes Form 5305-SEP. The
employee completes the IRA investment application usually supplied by a
mutual fund company or some other financial institution which will hold
the funds. Nothing has to be filed with the IRS to establish the
SEP-IRA or subsequently, unlike many other retirement plans that require
IRS annual returns.

--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Apr 17, 2004, 7:28:36 AM4/17/04
Archive-name: investment-faq/general/part14
Version: $Id: part14,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plain-text
version of The Investment FAQ, part 14 of 20. The web site

always has the latest version, including in-line links. Please browse

Terms of Use


Please send comments and new submissions to the compiler.

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Subject: Stocks - Researching the Value of Old Certificates

Last-Revised: 27 Feb 2000
Contributed-By: Ellen Laing (elaing at, Jeff Kiss, Chris Lott (
contact me )

If you've found some old stock certificates in your attic, and the
company is no longer traded on any exchange, you will need to get help
in determining the value of the shares and/or redeeming the shares. The
basic information you need is the name of the company, the date the
shares were issued, and the state (or province in the case of Canadian
companies) in which the company was incorporated (all items should all
be on the certificate).

The most basic question to resolve is whether the company exists still.
Of course it might have changed names, been purchased by another
company, etc. Anyhow, a good first attempt at answering this question
is to call or write the transfer agent that is listed on the front of
each certificate. A transfer agent handles transfers of stock
certificates and should be able to advise you on their value.

If the transfer agent no longer exists or cannot help you, you might try
to contact the company directly. The stock certificates should show the
state where the company was incorporated. Contact the Secretary of
State in that state, and ask for the Business Corporations Section.
They should be able to give you a history of the company (when it began,
merged, dissolved, went bankrupt, etc.). From there you can contact the
existing company (if there is one) to find out the value of your stocks.

Here are some additional resources for researching old certificates.
* You might want to start gathering information on old securities
from Bob Johnson's web site, Goldsheet.
* operates an old company research service. They
will research a company for a $39.95 fee, but if they do not find
any information, there is no charge.
* Old certificates may not represent ownership in any company, but
they can still have considerable value for collectors. See the
collection of old stock and bond certificates at,
which is the Internet's largest buyer and seller of old stock and
bond certificates.
* You can consult the Robert D. Fisher Manuals of Valuable and
Worthless Securities. This is published by the R.M. Smythe
company, and should be available for use in a good reference
library. For expert assistance, contact R.M. Smythe in New York.
They specialize in researching, auctioning, buying, and selling
historic paper, and will find out if your stock has any value. But
of course this is not a free service; they charge $75 per issue.
Write them at 26 Broadway, Suite 271, New York, NY, 10004-1701 or
visit their web page.

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Subject: Stocks - Reverse Mergers

Last-Revised: 14 July 2002
Contributed-By: The SmallCap Digest (

A reverse merger is a simplified, fast-track method by which a private
company can become a public company. A reverse merger occurs when a
public company that has no business and usually limited assets acquires
a private company with a viable business. The private company "reverse
merges" into the already public company, which now becomes an entirely
new operating entity and generally changes name to reflect the newly
merged company's business. Reverse mergers are also commonly referred
to as reverse takeovers, or RTO's.

Going public (in any way) is attractive to companies because after going
public, the company can use its stock as currency to finance
acquisitions and attract quality management; capital is easier to raise
as investors now have a clearly defined exit strategy; and insiders can
create significant wealth if they perform.

The reverse merger is an alternative to the traditional IPO (initial
public offering) as a method for going public. Many people don't
realize there are numerous other ways for private company to become
publicly traded outside of the IPO. One widely used method is the
"Reverse Merger".

The reverse-merger method for going public is more prevalent than many
investors realize. One study estimates that 53% of all companies
obtaining public listings in 1996 did so through the "Reverse Merger".
The same study concluded about 30% of newly publicly listed companies
got there through Reverse Mergers in 1999. Percentages have recently
dropped because Wall Street Investment Banking firms have had a huge
appetite for IPOs in the late 90s. This led to many marginal companies
receiving enormous financial windfalls.

In a reverse merger, the original public company, commonly known as a
"shell company," has value because of its publicly traded status. The
shell company is generally recapitalized and issues shares to acquire
the private company, giving shareholders and management of the private
company majority control of the newly formed public company.

The RTO (reverse take over) method for going public has numerous
benefits for the private company when compared to the traditional IPO:
* Initial costs are much lower and excessive investment banking fees
are avoided.
* The time frame for becoming public is considerably shorter.

There are also several disadvantages of going public through the RTO as
compared to an IPO:
* There is no capital raised in conjunction with going public.
* There is limited sponsorship for the stock.
* There is no high powered Wall Street Investment Banking
* The stock generally trades on a low exposure exchange.

Many highly successful companies have become public through the RTO
process. However, there some important negatives investors should be
aware of.

There is a much higher failure rate amongst RTO companies versus the
traditional IPO. Much smaller and less successful companies are able to
become public through the RTO, and many are badly undercapitalized.
Often these stocks trade very inefficiently in the absence of any
sponsorship or following.

There is a cottage industry of merchant bankers and entrepreneurs who
specialize in orchestrating reverse mergers. Unfortunately, there are
no barriers to entry in this field. Therefore, scams are common place.

Through various methods, scam artists manage to accumulate large
positions in the free trading shares of the shell company. An RTO is
consummated with a marginal private company, and the scam artists put
together a massive publicity campaign designed to create activity in the
stock. Unrealistic promises and absurd claims of corporate performance
find their way to the public. The enhanced trading volume allows the
scam artist to dump his shares on the unsuspecting public, most of whom
eventually lose their money once the newly formed public company fails.
This scam is commonly known as a "Pump and Dump".

Alternatively there a hundreds of examples of highly successful
companies which have yielded millions in profits for investors that have
gone public through the RTO. Many of these companies deserve exposure
to investors. Initial valuations can be reasonable, providing excellent
opportunities for individual investors to accumulate positions ahead of
Wall Street institutional money.

Here are some high-profile and successful RTOs:
* Armand Hammer, world renowned oil magnate and industrialist, is
generally credited with having invented the "Reverse Merger". In
the 1950s, Hammer invested in a shell company into which he merged
multi decade winner Occidental Petroleum.
* In 1970 Ted Turner completed a reverse merger with Rice
Broadcasting, which went on to become Turner Broadcasting.
* In 1996, Muriel Siebert, renown as the first woman member of the
New York Stock Exchange, took her brokerage firm public by reverse
merging with J. Michaels, a defunct Brooklyn Furniture company.
* One of the Dot Com fallen Angels, Rare Medium (RRRR), merged with a
lackluster refrigeration company and changed the entire business.
This was a $2 stock in 1998 which found its way over $90 in 2000.
* Acclaim Entertainment (AKLM) merged into non operating
Tele-Communications Inc in 1994.

For more insights into finance and the world of small-cap stocks, please
visit the SmallCap Network at:

--------------------Check for updates------------------

Subject: Stocks - Shareholder Rights Plan

Last-Revised: 3 Jun 1997
Contributed-By: Chris Lott ( contact me ), Art Kamlet (artkamlet at

A shareholder rights plan basically states the rights of a shareholder
in a corporation. These plans are generally proposed by management and
approved by the shareholders. Shareholder rights are acquired when the
shares are purchased, and transferred when the shares are sold. All
this is pretty straightforward.

The interesting question is why such plans are proposed by management.
This is probably best answered with an example. One example is rights
to buy additional shares at a low price, rights that first become
exercisable when a person or group aquires 20% or more of the common
shares of the company. In other words, if a hostile takover bid is
launched against the company, existing shareholders get to buy shares
cheaply. This serves to dilute the shares held by the unfriendly
parties, and makes a takeover just that much more difficult and

--------------------Check for updates------------------

Subject: Stocks - Splits

Last-Revised: 26 Oct 1997
Contributed-By: Aaron Schindler, E. Green, Art Kamlet (artkamlet at

Ordinary splits occur when a publicly held company distributes more
stock to holders of existing stock. A stock split, say 2-for-1, is when
a company simply issues one additional share for every one outstanding.
After the split, there will be two shares for every one pre-split share.
(So it is called a "2-for-1 split.") If the stock was at $50 per share,
after the split, each share is worth $25, because the company's net
assets didn't increase, only the number of outstanding shares.

Sometimes an ordinary split is referred to as a percent. A 2:1 split is
a 100% stock split (or 100% stock dividend). A 50% split would be a 3:2
split (or 50% stock dividend). Each stock holder will get 1 more share
of stock for every 2 shares owned.

Reverse splits occur when a company wants to raise the price of their
stock, so it no longer looks like a "penny stock" but looks more like a
self-respecting stock. Or they might want to conduct a massive reverse
split to eliminate small holders. If a $1 stock is split 1:10 the new
shares will be worth $10. Holders will have to trade in their 10 Old
Shares to receive 1 New Share.

Theoretically a stock split is a non-event. The fraction of the company
that each share represents is reduced, but each stockholder is given
enough shares so that his or her total fraction of the company owned
remains the same. On the day of the split, the value of the stock is
also adjusted so that the total capitalization of the company remains
the same.

In practice, an ordinary split often drives the new price per share up,
as more of the public is attracted by the lower price. A company might
split when it feels its per-share price has risen beyond what an
individual investor is willing to pay, particularly since they are
usually bought and sold in 100's. They may wish to attract individuals
to stabilize the price, as institutional investors buy and sell more
often than individuals.

After a split, shareholders will need to recalculate their cost basis
for the newly split shares. (Actually, this need not be done until the
shares are sold, but in the interest of good record-keeping etc., this
seems like a good place to discuss the issue.) Recalculating the cost
basis is usually trivial. The shareholder's cost has not changed at
all; it's the same amount of money paid for the original block of
shares, including commissions. The new cost per share is simply the
total cost divided by the new share count.

Recalculating the cost basis only becomes complicated when a fractional
number of shares is involved. For example, an investor who had 33
shares would have 49.5 shares following a 3:2 split. The short answer
for calculating cost basis when a fractional share enters the picture is
.. it depends. If the shares are in some sort of dividend reinvestment
plan, the plan will credit the account holder with 49 1/2 shares.
Fractional shares are very common in these sort of accounts. But if
not, the company could do any of the following:
* Issue fractional certificates (extremely unusual).
* Round up, and give the shareholder 50 shares (rare).
* Round down, and give the shareholder 49 shares. This happens among
penny stocks from time to time.
* Sell the fractional share and send the shareholder a check for its
value (perhaps taking a small fee, perhaps not). This is far and
away the most common method for handling fractional shares
following a split. Accounting for the cost basis of the first
three methods is trivial. However, accounting for the most common case,
the last one, is the most complicated of the options.

Let's continue with the example from above: 33 shares that split 3:2.
The original 33 shares and the post-split 49.5 shares have exactly the
same cost basis. To make it easy, assume the 33 shares cost a total of
$495. So the 49.5 post-split shares have a cost basis of $10 per share,
or $5 for the half share that is sold. The cash received "in lieu of"
the fractional share is the sales price of that fractional share. Say
the company sent along $8 for it.

The capital gain (long term or short, depending on the holding period of
the original shares) is $8 - $5 = $3. To account for this properly, the
following would be required.
* File a schedule D listing 0.5 shares XYZ Corp and use the original
acquisition date and date it was converted to cash and sold;
usually the distribution date of the split but the company will
tell you. Use $5 as cost basis and $8 as sales price and voila,
there is a $3 gain to declare.
* Reduce the cost basis of the remaining 49 shares by the cost of the
fractional share sold. ($5)
* The cost basis of the $49 shares becomes $495 - $5 = $490 (still
$10 per share).

Hopefully the preceding discussion will help with recalculating the cost
basis of shares following a split.

Now we'll go into some of the mechanics of splitting stock. The average
investor doesn't have to care about any of this, because the exchanges
have splits covered - there is absolutely no danger of an investor
missing out on the split shares, no matter when he or she buys shares
that will split. The rest of this article is meant for those people who
want to understand every detail.

Often a split is announced long before the effective date of the split,
along with the "record date." Shareholders of record on the record date
will receive the split shares on the effective date (distribution date).
Sometimes the split stock begins trading as "when issued" on or about
the record date. The newspaper listing will show both the pre- split
stock as well as the when-issued split stock with the suffix "wi."
(Stock dividends of 10% or less will generally not trade wi.)

Some companies distribute split shares just before the market opens on
the distribution date, and others distribute at close of business that
day, so there's not one single rule about the date on which the price is
adjusted. It can be the day of distribution if done before the market
opens or could be the next day.

For people who really are interested, here is what happens when a person
buys between the day after the T-3 date to be holder of record, and the
distribution date. (Aside: after a stock is traded on some date "T",
the trade takes 3 days to settle. So to become a share holder of record
on a certain date, you have to trade (i.e., buy) the shares 3 days
before that date. That's what the shorthand notation "T-3" above
means.) Remember that the holder of record on the record date will get
the stock dividend. And of course the price doesn't get adjusted until
the distribution date. So let's cover the case where a trade occurs in
between these dates.
1. The buyer pays the pre-split price, and the trade has a "Due Bill"
atttached. The due bill means the buyer is due the split shares
when they are issued. Sometimes the buyer's confirmation slip will
have "due bill" information on it.
2. In theory, on the distribution date, the split shares go to the
holder of record, but that person has sold the shares to the buyer,
and a due bill is attached to the sale.
3. So in theory, on the distribution date, the company delivers the
split shares to the holder of record. But because of the due bill,
the seller's broker delivers on the due bill, and delivers the
seller's newly received split shares to the buyer's broker, who
ultimately delivers them to the buyer. The fingers never left the
hand, the hand is quicker than the eye, and magic happens. In practice
no one really sees any of this take place.

In some cases, the company may request that its stock be traded at the
post-split price during this interval, or the market itself might decide
to list the post-split stock for trading. In such cases, the due bills
themselves are traded, and are called "when issued" or for spinoff
stock, "when distributed" stock. The stock symbol in the financial
columns will show this with a "-wi" or "-wd" suffix. But in most cases
it isn't worthwhile to do this.

Here are two sites that offer information about past, current, and
upcoming stock splits.

--------------------Check for updates------------------

Subject: Stocks - Tracking Stock

Last-Revised: 21 Jan 2000

Contributed-By: Chris Lott ( contact me )

A tracking stock is a special type of stock issued by a publicly held
company to track the value of one segment of that company. By issuing a
tracking stock, the different segments of the company can be valued
differently by investors.

For example, if an old-economy company trading at a P/E of about 10
happens to own a wildly growing internet business, the company might
issue a tracking stock so the market could value the new business
separately from the old one (hopefully at a P/E of at least 100). Those
high-flying stocks are awfully useful for making employees rich, and
that never hurts recruiting. Here's a real-world example. The stock
for Hughes Electronics (ticker symbol GMH) is a tracking stock. This
business is just the satellite etc. division of General Motors (ticker
symbol GM).

A company has many good reasons to issue a tracking stock for one of its
subsidiaries (as opposed to spinning it off to shareholders). First,
the company gets to keep control over the subsidiary (although they
don't get all the profit). Second, they might be able to lower their
costs of obtaining capital by getting a better credit rating. Third,
the businesses can all share marketing, administrative support
functions, a headquarters, etc. Finally, and most importantly, if the
tracking stock shoots up, the parent company can make acquisitions and
pay in stock instead of cash.

When a tracking stock is issued, the company can choose to sell it to
the markets (i.e., via an initial public offering or IPO) or to
distribute new shares to existing shareholders. Either way, the newly
tracked business segment gets a longer leash, but can still run back to
the parent corporation if times get tough.

All is not perfect in this world. Tracking stock is a second-class
stock, primarily because holders usually have no voting rights.

The following resources offer more information about tracking stocks.
* The Motley Fool wrote about tracking stocks on 7 September 1999.

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Subject: Stocks - Unit Investment Trusts and SPDRs

Last-Revised: 13 Jun 2000

Contributed-By: Chris Lott ( contact me )

A unit investment trust is a collection of securities (usually stocks or
bonds) all bundled together in a special vehicle that happens to be a
trust. Investors can buy tiny little pieces of the trust ("units"). So
although a UIT looks a bit like a mutual fund in that it bundles things
together and sells shares, the units are listed on an exchange and trade
just like stocks. The most well-known example is the Standard & Poors
Depositary Receipt (SPDR). These are also known as exchange-traded
funds (ETFs).

Below is a list of some of the common UITs/ETFs out there. All of these
are created by large financial institutions, and usually (but not
always) charge modest annual expenses to investors, commonly 0.2% (20
basis points) or less. (Any commissions paid to buy or sell them are
due to the broker, of course.)
* UIT that mimics the S&P 500. Named a Standard & Poors Depositary
Receipt (SPDR), commonly called a Spider or Spyder. Trades as SPY
on the AmEx and has a value of approximately 10% of the S&P 500
index. As of this writing, the trust has nearly $18 billion.
* UIT that mimics the NASDAQ 100 Index, commonly called a Qube.
Trades as QQQ on the AmEx and has a value of approximately 2.5% of
the NASDAQ 100 index. As of this writing, the trust has about $12
* UIT that mimics the Dow Jones Industrial Average. Named the Dow
Industrial Average Model New Depositary Shares, commonly called
DIAMONDS. Trades as DIA on the AmEx and has a value of
approximately 1% of the DJIA.
* Select sector SPDRs - these slice and dice the S&P 500 in various
ways, such as technology companies (symbol XLK), utilities (XLU),
etc. All are traded on the AmEx.

A UIT that mimics some index is in many ways directly comparable to an
index mutual fund. Like an index fund, it's diversified and always
fully invested. Like a stock, you can buy or sell a UIT at any time
(not just at the end of the trading day like a fund). And for the
serious traders out there, you can short many UITs on a downtick, which
you cannot do with stocks.

The following resources offer more information about UITs and SPDRs.
* The AmEx, where these securities trade, has some information. Look
in their "ETF" category.
Here is a direct link to their list of frequently asked questions
about ETFs:

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Subject: Stocks - Warrants

Last-Revised: 3 Jun 1997

Contributed-By: Art Kamlet (artkamlet at

There are many meanings to the word warrant.

The marshal can show up on your doorstep with a warrant for your arrest.

Many army helicopter pilots are warrant officers, who have received a
warrant from the president of the US to serve in the Army of the United

The State of California ran out of money earlier this year [1992] and
issued things that looked a lot like checks, but had no promise to pay
behind them. If I did that I could be arrested for writing a bad check.
When the State of California did it, they called these thingies
"warrants" and got away with it.

And a warrant is also a financial instrument which was issued with
certain conditions. The issuer of that warrant sets those conditions.
Sometimes the warrant and common or preferred convertible stock are
issued by a startup company bundled together as "units" and at some
later date the units will split into warrants and stock. This is a
common financing method for some startup companies. This is the
"warrant" most readers of the misc.invest newsgroup ask about.

As an example of a "condition," there may be an exchange privilege which
lets you exchange 1 warrant plus $25 in cash (or even no cash at all)
for 100 shares of common stock in the corporation, any time after some
fixed date and before some other designated date. (And often the issuer
can extend the "expiration date.")

So there are some similarities between warrants and call options for
common stock.

Both allow holders to exercise the warrant/option before an expiration
date, for a certain number of shares. But the option is issued by
independent parties, such as a member of the Chicago Board Options
Exchange, while the warrant is issued and guaranteed by the corporate
issuer itself. The lifetime of a warrant is often measured in years,
while the lifetime of a call option is months.

Sometimes the issuer will try to establish a market for the warrant, and
even try to register it with a listed exchange. The price can then be
obtained from any broker. Other times the warrant will be privately
held, or not registered with an exchange, and the price is less obvious,
as is true with non-listed stocks.

For more information about stock warrants, you might visit .

--------------------Check for updates------------------

Subject: Strategy - Dogs of the Dow

Last-Revised: 10 Jul 1998
Contributed-By: Raymond Sammak, Chris Lott ( contact me ) Ralph Merritt

This article discusses an investment strategy commonly called "Dogs of
the Dow."

The Dow Jones Industrials represent an elite club of thirty titans of
industry such as Exxon, IBM, ATT, DuPont, Philip Morris, and Proctor &
Gamble. From time to time, some companies are dropped from the Dow as
new ones are added. By investing in stocks from this exclusive list,
you know you're buying quality companies. The idea behind the "Dogs of
the Dow" strategy is to buy those DJI companies with the lowest P/E
ratios and highest dividend yields. By doing so, you're selecting those
Dow stocks that are cheapest relative to their peers.

So here is the Dogs of the Dow strategy in a nutshell: at the beginning
of the year, buy equal dollar amounts of the 10 DJI stocks with the
highest dividend yields. Hold these companies exactly one year. At the
end of the year, adjust the portfolio to have just the current "dogs of
the Dow." What you're doing is buying good companies when they're
temporarily out of favor and their stock prices are low. Hopefully,
you'll be selling them after they've rebounded. Then you simply buy the
next batch of Dow laggards.

Why does this work? The basic theory is that the 30 Dow Jones Industrial
stocks represent well known, mature companies that have strong balance
sheets with sufficient financial strength to ride out rough times. Some
people use 5 companies, some use 10, some just one. You might call this
a contrarian's favorite strategy.

A 12/13/93 Barron's article discussed "The Dogs of the Dow." Barron's
claimed that using this strategy with the top 10 highest yielding Dow
stocks returned 28% for 1993, which was 2x the overall DJIA, 2x the
NASDAQ, 4x the S&P500 and better than 97% of all general US equity funds
(including Magellan). In the last 20 years, this strategy has lost
money in only 3 years, the worst a 7.6% drop in 1990. In the last 10
years, it has returned 18.26%.

Merrill Lynch offers a "Select 10 Portfolio" unit trust, which invests
in the top 10 yielding Dow stocks. Smith Barney/Shearson, Prudential
Securities, Paine Webber, and Dean Witter also offer it. It has a 1%
load and a 1.75% annual management fee, and they are automatically
liquidated each year (cash or rollover into next year, but capital gains
are realized/taxed). Minimum investment is $1,000.

A listing of the current "DOGS of the DOW" is updated every day on the
"Daily Dow" page that is part of the Motley Fool web site:

--------------------Check for updates------------------

Subject: Strategy - Dollar Cost and Value Averaging

Last-Revised: 11 Dec 1992
Contributed-By: Maurice Suhre

Dollar-cost averaging is a strategy in which a person invests a fixed
dollar amount on a regular basis, usually monthly purchase of shares in
a mutual fund. When the fund's price declines, the investor receives
slightly more shares for the fixed investment amount, and slightly fewer
when the share price is up. It turns out that this strategy results in
lowering the average cost slightly, assuming the fund fluctuates up and

Value averaging is a strategy in which a person adjusts the amount
invested, up or down, to meet a prescribed target. An example should
clarify: Suppose you are going to invest $200 per month in a mutual
fund, and at the end of the first month, thanks to a decline in the
fund's value, your $200 has shrunk to $190. Then you add in $210 the
next month, bringing the value to $400 (2*$200). Similarly, if the fund
is worth $430 at the end of the second month, you only put in $170 to
bring it up to the $600 target. What happens is that compared to dollar
cost averaging, you put in more when prices are down, and less when
prices are up.

Dollar-cost averaging takes advantage of the non-linearity of the 1/x
curve (for those of you who are more mathematically inclined). Value
averaging just goes in a little deeper when the value is down (which
implies that prices are down) and in a little less when value is up.

An article in the American Association of Individual Investors showed
via computer simulation that value averaging would outperform dollar-
cost averaging about 95% of the time. "Outperform" is a rather vague
term. As best as I remember, whatever the percentage gain of dollar-
cost averaging versus buying 100% initially, value averaging would
produce another 2 percent or so.

Warning: Neither approach will bail you out of a declining market with
all of your monies intact, nor get you fully invested in the earliest
stage of a bull market.

--------------------Check for updates------------------

Subject: Strategy - Hedging

Last-Revised: 12 Dec 1996
Contributed-By: Norbert Schlenker

Hedging is a way of reducing some of the risk involved in holding an
investment. There are many different risks against which one can hedge
and many different methods of hedging. When someone mentions hedging,
think of insurance. A hedge is just a way of insuring an investment
against risk.

Consider a simple (perhaps the simplest) case. Much of the risk in
holding any particular stock is market risk; i.e. if the market falls
sharply, chances are that any particular stock will fall too. So if you
own a stock with good prospects but you think the stock market in
general is overpriced, you may be well advised to hedge your position.

There are many ways of hedging against market risk. The simplest, but
most expensive method, is to buy a put option for the stock you own.
(It's most expensive because you're buying insurance not only against
market risk but against the risk of the specific security as well.) You
can buy a put option on the market (like an OEX put) which will cover
general market declines. You can hedge by selling financial futures
(e.g. the S&P 500 futures).

In my opinion, the best (and cheapest) hedge is to sell short the stock
of a competitor to the company whose stock you hold. For example, if
you like Microsoft and think they will eat Borland's lunch, buy MSFT and
short BORL. No matter which way the market as a whole goes, the
offsetting positions hedge away the market risk. You make money as long
as you're right about the relative competitive positions of the two
companies, and it doesn't matter whether the market zooms or crashes.

If you're trying to hedge an entire portfolio, futures are probably the
cheapest way to do so. But keep in mind the following points.
* The efficiency of the hedge is strongly dependent on your estimate
of the correlation between your high-beta portfolio and the broad
market index.
* If the market goes up, you may need to advance more margin to cover
your short position, and will not be able to use your stocks to
cover the margin calls.
* If the market moves up, you will not participate in the rally,
because by intention, you've set up your futures position as a
complete hedge.

You might also consider the purchase out-of-the-money put LEAPS on the
OEX, as way of setting up a hedge against major market drops.

Another technique would be to sell covered calls on your stocks
(assuming they have options). You won't be completely covered against
major market drops, but will have some protection, and some possibility
of participating in a rally (assuming you can "roll up" for a credit).

--------------------Check for updates------------------

Subject: Strategy - Buying on Margin

Last-Revised: 19 Dec 1996
Contributed-By: Andrew Aiken (aiken at

I have used margin debt to leverage my returns several times this year,
with successful results. At no time did my margin debt exceed 25% of my
net account equity. This is my personal comfort level, but yours may be
higher or lower depending on your risk tolerance, your portfolio return
vs. the interest rate on your debt, and your degree of bullishness
about your investments and general market conditions.

If I am using margin, I have tighter stop-loss limits. How much tighter
is determined by the amount of debt, the interest rate on the debt, and
the historical volatility of the stock.

Here are a few more suggestions:
* Never use margin unless you follow the market and your investments
on a daily basis, and you consider yourself well-informed about the
factors that could influence your asset value.
* Do not use margin debt as a long-term investment strategy.
* Have a clear idea of how long you plan to maintain the margin debt.
* Always have cash reserves outside of your brokerage account that
exceed your margin debt, so that you could pay off the debt at any
time, if necessary.
* If you maintain the debt for more that a few weeks, contribute cash
to your account on a monthly basis, so that you are paying off the
debt the same way one would pay off a credit card.
* Start with a small amount of debt relative to your account (5 -
10%), and use this as a benchmark for future actions.
* Have a stop-loss limit and a target sell price for all of the
investments in your leveraged account. Stick with your targets!
* Do not let the chance of a margin call exceed 5%. The assessment
of this probability should be made and adjusted regularly.
* Learn the techniques that the professional hedge fund managers use
in maintaining leveraged investments. This information is
available for free at the library. If this seems like too much
work, then do not use margin. These are just my opinions as an
individual investor. Whether or not you decide to use margin is a
personal decision.

I consider margin debt to be a tactic rather than a strategy. It is not
suitable for a long-term, buy-and-hold investor. The tactic has worked
for me so far, but I know several bright individuals who have been
burned by it.

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Subject: Strategy - Writing Put Options To Acquire Stock

Last-Revised: 22 Aug 2000
Contributed-By: Michael Beyranevand (mlb2 at

Is there a stock that you would like to purchase at a cheaper price than
its current quote? Would you be interested in receiving premiums months
before you have to purchase the stock? If these propositions sound
attractive to you, then writing puts to acquire stock is a strategy you
should consider in the future. This article explains the entire
procedure, as well as the associated risks and rewards.

When you write a put option you are giving the buyer of that option the
right (but not the obligation) to sell their stock to you at a
predetermined price at any time until a certain date. For giving the
buyer this luxury, he or she will in turn pay you a premium at the time
you write (i.e., sell) the option. If the buyer decides to exercise the
option then you must purchase the stock; conversely, if the option
expires unexercised then you still have the premium as your profit.

Let's work through an example. Let's say that you are bullish on for the long-term with the current value of the stock at $52.
One option would be to fork over $5,200 and purchase 100 shares of the
stock and just hold on to them. Another option however would be to
write a Jan 01 45 put option, which is trading at about $8.50. This
means that at anytime between now and the third Saturday in January, you
might have to purchase 100 shares of E-Bay at $45 a share. For doing
this you are compensated $850 upfront (100 shares times $8.50).

Come January, one of two situations will occur. If the option has not
been exercised by then, your obligation is over and you have a profit of
$850. If the option is exercised (if you are put, to use the jargon),
you would pay $4,500 to own the 100 shares of the stock. After taking
into consideration that you were already paid a premium of $850, the
true cost for the 100 shares of E-Bay is only $3,650 or $36.50 a share.
You would in essence be purchasing the shares at a 30% discount to what
you would have normally paid had you just bought the 100 shares at the
market price.

Doesn't it seem too good to be true? You end up with either free money
or buying the stock at a discount. Well, there are some risks involved,
of course.

There are two significant risks in implementing this options strategy.
These situations occur if the stock shoots up or comes way down. No
matter how high the stock price goes up, the initial profits are limited
to just the premium received. So the upside potential is very much
limited in that sense. One way to combat this is to make sure that you
will be receiving a high enough premium to still be satisfied if the
stock soars before you purchase it.

The second risk is the situation if the stock plummets. Reversing your
position (i.e., buying back the option) is one possibility but an
expensive one at that. Your only other choice is to follow through with
your obligation: you purchase the stock at a premium to the current
market price. This loss can be offset by the fact that you were bullish
on the stock for the long run and you picked a price that you were
comfortable paying for the stock. If your intuition was correct than
it's only a matter of time before the stock rebounds to the price you
paid or beyond. But if something awful like accounting irregularities
are announced, you might incur significant losses.

This strategy is ideal for volatile stocks that you are interested in
holding for 5 or more years. They pay higher premiums because of their
volatility, and having a long-term horizon will minimize your risks.
Companies like Yahoo, E-Bay, AOL, EMC, Intel and Oracle would be ideal
for writing puts on.

Finally, please note that this strategy is not for everyone, and does
not guarantee anything. Speak with your broker to learn more about
writing puts and especially to learn if this strategy would fit with
your investment goals.

--------------------Check for updates------------------

Subject: Strategy - Socially Responsible Investing

Last-Revised: 23 Mar 2001
Contributed-By: Chris Lott ( contact me ), Ritchie Lowry (goodmoney1 at, Reid Cooper (reid_cooper at

Investors who pursue a strategy of socially responsible investing (SRI)
are making sure that their capital is used in a manner that aligns with
their personal ethical values--taking responsibility for what their
money is doing to the world around them. There are many different
definitions of what it means for an investment to be socially
responsible, but basically the strategy is to avoid companies that
damage the environment (either by treating nature or people poorly), and
to favor companies that provide positive goods and services. SRI is not
in any way a new idea. Adam Smith himself was concerned about the
issue, and the anti-trust and 19th century child labor debates hinged on
the same basic issues.

One of the simplest examples of a socially responsible investment is a
mutual fund that avoids so-called "sin" investments, namely companies
that are involved with liquor, tobacco, or gambling. However, the term
is sometimes applied to banks and credit unions based on their lending
practices, etc.

Does it work? This is a multi-faceted question. If the question is
whether a strategy of SRI achieves a good return on investment, the
answer seems to be that it does (see below for more details). If the
question is whether companies that are shunned by a SRI strategy have
difficulty in raising capital in the markets, I think the answer is no.
At least at the present, there are enough investors who pursue returns
without worrying about issues like a company's policies. However,
presumably investors are sleeping better at night knowing that they have
made a statement, however small, about their beliefs, and that factor
should not be neglected.

The following list of frequently asked questions was contributed by, and
is copyright by, Dr. Ritchie Lowry, maintainer of the GoodMoney site
(URL at end of this article).

1. What is SRI?

In one sense, SRI is just like traditional investing. Socially
concerned investors pursue the same economic goals as all
investors: capital gains, higher income and/or preservation of
capital for future needs. However, socially concerned investors
want one additional thing. They don't want their investments going
for things that cause harm to the social or physical environments,
and they do want their investments to support needed and
life-supportive goods and services.

2. What's the history of the movement?

The idea of combining social with financial judgments in the
investment process is not really that new. The oldest social
screen around is the sin screen: no tobacco, liquor or gambling
investments. This screen has been used for over a hundred years by
universities and churches. However, the current movement really
began during the Vietnam War when increasing numbers of investors
did not want their money going to support that war. After the war,
a number of corporate horror stories (including Hooker Chemicals
and the controversy concerning Love Canal, Firestone Tire &
Rubber's exploding 500-radial tires, A. H. Robins and the Dalkon
Shield, and General Public Utilities and Three Mile Island) added
fuel to the movement. The issue of American corporations doing
business in South Africa and with the government of that country
really pushed SRI into a full-blown social movement. It is
estimated that around $1 trillion is involved in some type of
social investing in the U.S. (about 10% of all total investments),
and the number of socially and environmentally screened funds have
increased from only a handful in the 1970s to over 100 by 1996.

3. How does one pick SRI stocks?

First, determine your financial goals. Second, pick several social
issues that are the most important to you. Don't try to solve all
the problems of the world at once. Next do research on those
corporations that appear to be the best investments in terms of
both your financial and social goals. For social information on
investments, there are a growing number of resources, most of which
are included in the GoodMoney site's directory.

4. What sorts of judgement calls are involved in the process?

Actually, the judgement calls are not that much different from the
judgments an investor has to make using only financial factors. No
investment is perfect in meeting every possible financial criteria.
If it were, everyone would be a millionaire. In the same way,
there is no such thing as corporate sainthood. However, you can
pick what have been called "the best-of-industry" or "the
try-harders." For example, making pharmaceuticals is a very dirty
business and pumps large quantities of carcinogens into the
environment. But, Merck & Company and Johnson & Johnson both have
pollution-control programs in place that go far beyond government
requirements, while other pharmaceutical companies do not.

5. What do the critics of SRI say?

Interestingly enough, SRI has been criticized from both the right
and the left. Wall Street and the traditional investment community
thinks it is liberal flakiness by people who hate capitalism. The
left thinks it is a cop-out to capitalism. Both criticisms
completely miss the point. SRI is about several things. It is
saying that any economic system, including capitalism, that lacks
an ethical component is due to destroy itself. In addition, SRI is
about personal empowerment and economic democracy. A corporation
doesn't belong to its executives, and money in a retirement fund
doesn't belong to the managers of the fund. It is time for
shareholders and others to take control of their money, not only
for profit but also to resolve some of the major economic and
social problems the world faces. This is probably why the
traditional business community, such as Fortune magazine, doesn't
like SRI.

6. Doesn't Wall Street claim that that an investor and a company
sacrifices returns and profits by mixing social with economic

That is the traditional view, but on-going research suggests that
just the opposite may be true --- that doing well economically goes
hand-in-hand with doing good socially. For example, each year
Fortune magazine conducts a survey of America's Most Admired
Corporations. In March of 1997, the Corporate Reputations Survey
reported on the results for 431 companies. Fortune asked more than
13,000 executives, outside directors, and financial analysts to
rate (from zero for worst to 10 for best) the 10 largest companies
by revenues in their industry (if there were that many) for each of
8 criteria. Interestingly, only 3 of the criteria were purely
financial -- financial soundness, use of corporate assets, and
value as a long-term investment. The other 5 involved social
factors and judgments -- ability to attract, develop, and keep
talented people; community and environmental responsibility;
innovativeness; quality of management; and quality of products
and/or services. The average score for the 8 criteria was then
calculated. As has been the case in surveys for previous years,
companies favored by socially and environmentally concerned
investors did very well. For 1997 survey, 14 (compared to 12 for
the previous year) such companies finished in the top 50. Eleven
were repeaters from 1996. In addition, the February 24, 1997,
issue of Business Week reported on a study by Judith Posnikoff of
CalState Fullerton that found that the share prices of companies
whose planned pullouts from South Africa were announced in the
national press appreciated in the two or three days surrounding the
announcements. She concluded that the stocks produced "abnormally
positive" returns.

7. What's the future of SRI?

It is growing exponentially in numbers of individual and
institutional investors participating, in the amount of invested
money involved, and, most importantly, in the movement's ability to
persuade corporations to develop a sense of social responsibility
in the conduct of their businesses. The German philosopher Arthur
Schopenhauer put it this way:

There are three steps in the revelation of any truth: in
the first, it is ridiculed; in the second, resisted; in
the third, it is considered self-evident.

SRI is somewhere between the second and third steps.

Some resources for more information:
* The GreenMoney Journal's site
* Dr. Ritchie Lowry's site
* The RCC Group's site
* The Social Investment Forum (US) is a national nonprofit membership
organization promoting the concept, practice and growth of socially
responsible investing.
* has over 1000 pages of strategic content to help
you make informed investment decisions regarding socially
responsible investing.
* The Calvert Group is one of the largest SRI fund managers in the US
and offers a variety of investment services. It was the first to
offer a socially-screened global fund. Its web site is focused on
promoting itself, but it does provide general information on SRI
* Kinder, Lydenberg, Domini are the people behind the Domini 400
Social Index, the SRI equivalent to the S&P 500. Their web site
not only promotes the organization but also features an
international list of links to SRI web sites in Europe and North
America, among other Internet resources.
* Russell Sparkes's The Ethical Investor, originally published in
1995 by Harper Collins, London. It is out of print, but was once
available on the net and may survive; please let me know if you
find a site that has it.

--------------------Check for updates------------------

Subject: Strategy - When to Buy/Sell Stocks

Last-Revised: 25 Nov 1993
Contributed-By: Maurice Suhre

This article presents one person's opinions on when to buy or sell
stocks. Your mileage will certainly vary.
* Stock XYZ used to trade at 40 and it has dropped to 25. Is it a
good buy?
A: Maybe. Buying stocks just because they look "cheap" isn't a
good idea. All too often they look cheaper later on. (Oak
Industries, in Cable TV equipment, used to sell in the 40s.
Lately, it's recovered from 1 to 3. IBM looked "cheap" when it
went from 137 or so down to 90. You know the rest.) Wait for XYZ
to demonstrate that it has quit going down and is showing some sign
of strength, perhaps purchasing in the 28 range. If you are
expecting a return to 40, you can give up a few points initially.
Note that this situation is the same as trying to sell at the top,
except the situation is inverted. See the comments on "base
building" in the Technical Analysis section of the FAQ.

* I'd like to sell a stock since I have a good profit, but I don't
want to pay the taxes. What should I do?
A: Sell the stock and pay the taxes. Seriously, if you have
profits, the government wants their (unfair) share. Their hand
(via the IRS) is in your pocket. If you don't make any money, then
you won't owe the government anything.

* I have a profit in a stock and I want to sell at the exact top.
How do I do that?
A: If anybody knows how, they haven't told me. Some technical
indicators such as RSI can be helpful in locating approximate local
maxima. Fundamental valuations such as P/E or P/D can suggest
overvalued ranges.

* What are some guidelines for selling when you have a profit?
A: Since you can't pick the exact top, you either sell too soon or
too late. If you sell too soon, you may miss out on a substantial
up move. If you sell too late, then you will preserve most of the
last up move (unless you get caught in some sort of '87 type
crash). One mechanical rule advocated by Jerry Klein (LA area) is
this: If you have at least a 20 percent profit, use a (mental) stop
to preserve 80 percent of your profit. The technical analysis
approach is to determine a prior support level and set a stop
slightly below there. Marty Zweig's book has an excellent
discussion of trailing stops, both in setting them and how to use

* It seems like stocks often drop excessively on just a little bit of
bad news. What gives?
A: One explanation is the "cockroach theory". If you see one
cockroach, there are probably a lot more around. If one piece of
bad news gets out, the fear is that there are others not yet
public. Similarly, if one stock in a group gets into trouble,
there is a suspicion that the others might not be far behind.

* I saw good news in the paper today. Should I buy the stock?
A: Not necessarily. Everyone saw the news in the paper, and the
stock price has already reflected that news.

* I don't want to be a short term trader. Can one of these computer
programs help me for the long term?
A: Possibly. If you have decided to buy and the stock is still
declining, a computer could help determine when a local bottom has
been reached. This sort of technical analysis is not infallible,
but the computations are somewhat awkward to do by hand calculator.
These programs aren't free, downloading the data isn't free, and
you will have to do some study to understand what the program is
telling you. If you are more or less ready to sell, the program
may be able to locate a local top. Ask your broker if he is using
any kind of computer analysis for buy/sell decisions. If you
already own a PC, then an analysis program might be cost effective.

* How does market timing apply to stocks? (I understand about
switching mutual funds using market timing signals).
A: Assuming that you think the market is "too high", you might a)
tighten up your stops to preserve profits, b) sell off some
positions to capture profits and reduce exposure, c) sell covered
calls to provide some downside protection, d) purchase puts as
"insurance", e) look for possible shorting situations, and/or f)
delay any new purchases. If you think the market is "too low",
then you might a) commit reserve money for new purchases and/or b)
take profits from prior shorting.

* Explain market action, group action, and individual stock action.
A: Every day, some stocks go up, some go down, and some are
unchanged. Market action applies to the general direction of the
market. Are most stocks going up or down? Are broad averages (S&P
500, etc.) going up or down? Group action refers to a specific
industry group. Biotechs may be "hot", technology may be "hot",
out of favor groups may be dropping. Finally, not all companies
within a rising group will be doing equally well -- some individual
stocks will have risen, some won't, some may even be sliding lower.

* How do I use this information (assuming I've got it)?
A: A strategy is to locate a rising group in a rising market. Look
for good companies in the group which haven't risen yet and
purchase one or more of them. The assumption is that the "best"
companies have already been bid up to full value and that some of
the remaining will be bid up. Avoid the poorest companies in the
group since they may not move at all.

* Should I look at a chart before I purchase a stock?
A: Definitely. In fact, raise your right hand and repeat after me:
"I will never purchase a stock without looking at a chart". Also,
"I will never purchase a stock in a Stage 4 decline." (See
technical analysis articles in this FAQ for details.) If you have a
full service broker, he should send you a chart, Value Line report,
and S&P report. If you can't get these, you aren't getting full
service. Value Line and S&P are probably available in your local

* Do I need to keep looking at charts while I am holding my
A: Probably. You don't necessarily need to look a charts on a
daily basis, but it is difficult to set trailing stops [ref 1]
without looking at a chart. You can also get information about
where the price is relative to the moving averages.

--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Apr 17, 2004, 7:28:36 AM4/17/04
Archive-name: investment-faq/general/part12
Version: $Id: part12,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 12 of 20. The web site

always has the latest version, including in-line links. Please browse

Terms of Use


Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Retirement Plans - Traditional IRA

Last-Revised: 24 Jan 2003
Contributed-By: Chris Lott ( contact me ), Dave Dodson, David Hinds
(dhinds at, Rich Carreiro (rlcarr at, L. Williams (taxhelp at, John
Schussler (jeschuss at, John Lourenco (decals at

This article describes the provisions of the US tax code for traditional

IRAs as of mid 2001, including the changes made by the Economic Recovery
and Tax Relief Reconciliation Act of 2001. Also see the articles

elsewhere in the FAQ for information about Roth IRA and Education IRA

An individual retirement arrangement (IRA) allows a person, whether
covered by an employer-sponsored pension plan or not, to save money for
use in retirement while allowing the savings to grow tax-free. Stated
differently, a traditional IRA converts investment earnings (interest,
dividends, and capital gains) into ordinary income.

Funds in an IRA may be invested in a broad variety of vehicles such as
stocks, mutual funds, and bonds. Because an IRA must be administered by
some trustee, most people are limited to the investment choices offered
by that trustee. For example, an IRA at a bank at one time pretty much
was limited to CDs from that bank. Similarly, if you open an IRA
account with a mutual-fund company, that account is probably restricted
to owning funds run by that company. Certain investments are not
allowed in an IRA, however; for example, options trading is restricted
and you cannot go short.

IRA contributions are limited, and the limits are quite low in
comparison to arrangements that permit employee contributions such as a
401(k) (see the article elsewhere in the FAQ for extensive information
about those accounts). For tax year 2002, an individual may contribute

the lesser of US$3,000 or the amount of wage income from US sources to

his or her IRA account(s). In other words, an individual may have both
a traditional and a Roth IRA, but can only contribute $3,000 total to
those accounts, divided up any way he or she pleases.

There is one notable exception that was introduced in 1997, namely a
provision for a spousal IRA. Under this provision, married couples with

only one wage earner may each contribute the full $3,000 to their

respective IRA accounts. Note that total contributions are still
limited to the couple's total gross income, so you cannot contribute $3k
each if together you earned less than $6k.

Annual IRA contributions can be made between January 1 of that year and
April 15 of the following year. Because of the extra three and a half
months, if you send in a contribution to your IRA custodian between
January and April, be sure to indicate the year of the contribution so
the appropriate information gets sent to the IRS.

Many people can deduct their IRA contributions from their gross income.
Eligibility for this deduction is determined by the person's modified
adjusted gross income (MAGI), the person's filing status on their
1040(-A, -EZ) form, and whether the person is eligible to participate in
an employer-sponsored pension plan or contributory plan such as a
401(k). To compute MAGI, you include your federally taxable wages
(i.e., salary after any 401(k) contributions), investment income,
business income, etc., then subtract your adjustments (not to be
confused with deductions) other than the proposed IRA deduction. In
essence, the MAGI is the last line on the front side of a Form 1040 with
no IRA deductions.

Anyhow, if your filing status is single, head of household, or
equivalent, the income test has limits that are lower when compared to
filing status married filing jointly (MFJ). These income tests are
expressed as ranges. Briefly, if your MAGI is below the lower number,
you can deduct everything. If your MAGI falls within the range, you can
deduct some portion of your IRA contribution. And if your MAGI is above
the upper number, you cannot deduct any portion. (No longer does
coverage of one spouse by an employer-maintained retirement plan
influence the other's eligibility.) The income tests for 1998 look like

* Not covered by a pension plan: fully deductible.
* Covered by a pension plan:
* MAGI less than 30k (MFJ 50k): fully deductible
* MAGI in the range 30-40k (MFJ 50-60k): partially deductible
* MAGI greater than 40k (MFJ 60k): not deductible

If your filing status is "Married Filing Separately" (MFS), then the
income restriction is much tighter. If your filing status is MFS and
both spouses have a MAGI of $10,000 or more, then neither spouse can
deduct an IRA contribution.

It's important to understand what it means to be "covered" by a pension
plan. If you are eligible for a defined benefit plan, that's enough;
you are considered covered. If you are eligible to participate in a
defined contribution plan, then either you or your employer must have
contributed some money to the account before you are considered covered.
IRS Notice 87-16 gives all the gory details about who is considered
covered by a pension plan.

Here's an excerpt from Fidelity's IRA disclosure statement concerning
retirement plans.

An "employer-maintained retirement plan" includes any of the
following types of retirement plans:
* a qualified pension, profit-sharing, or stock bonus plan
established in accordance with Section 401(a) or 401(k)
of the Code.
* a Simplified Employee Pension Plan (SEP) (Section 408(k)
of the Code).
* a deferred compensation plan maintained by a governmental
unit or agency.
* tax sheltered annuities and custodial accounts (Section
403(b) and 403(b)(7) of the Code).
* a qualified annuity plan under Section 403(a) of the
Code. You are an active participant in an
employer-maintained retirement plan even if you do not have a
vested right to any benefits under your employer's plan.
Whether you are an "active participant" depends on the type of
plan maintained by your employer. Generally, you are
considered an active participant in a defined contribution
plan if an employer contribution or forfeiture was credited to
your account under the plan during the year. You are
considered an active participant in a defined benefit plan if
you are eligible to participate in the plan, even though you
elect not to participate. You are also treated as an active
participant for a year during which you make a voluntary or
mandatory contribution to any type of plan, even though your
employer makes no contribution to the plan.

If you can't deduct your contribution, think about making a full
contribution to a Roth IRA (see the article elsewhere in this FAQ for
more information). The power of untaxed, compound interest should not
be underestimated. But if you insist on making a non-deductible
contribution into a traditional IRA in any calendar year, you must file
IRS form 8606 with your return for that year.

For tax purposes, each person has exactly one (1) regular IRA. It may
be composed of as many, or as few, separate accounts as you wish. There
are basically only four justifiable reasons for having more than one
regular IRA account:
1. Legitimate investment purposes such as diversification.
2. Estate planning purposes.
3. Preserving roll-over status. If you have rolled a former
employer's 401K money into an IRA and you wish to retain the right
to re-roll that money into a new employer's 401k, plan (if allowed
by that new plan), then you must keep that money in a separate
4. Added flexibility when making penalty-free early withdrawals from
your IRA via the "substantially equal payments" method, since there
are IRS private letter rulings (which, admittedly, are only binding
on the addressees) that strongly hint the IRS takes the position
that for this purpose, you can make the calculation on an
account-by-account basis. See your tax professional if you think
this applies to you. In short, you cannot separate deductible and
nondeductible IRA contributions by keeping separate IRA accounts. There
simply is no way to keep money from deductible and non-deductible
contributions "separate." As far as the IRS is concerned, when you go to
withdraw money from an IRA, all they care about is the total amount of
non-deductible contributions (your "basis") and the total current value
of your IRA's. Any withdrawal you make, regardless of whether it is
from an account that was started with deductible or non-deductible
contributions, will be taxed the same, based on the fraction of the
current value of all your IRA's that was already taxed. Stated more
formally, whether or not you put deductible and non-deductible IRA
contributions into the same account, IRS says that any subsequent
withdrawals are considered to be taken ratably from each, regardless of
which account you withdraw from.

Here's an example. Let's say that you go so far as to have IRA accounts
with 2 different companies and alternate years as follows:
* Odd years: contribute the maximum deductible amount to fund A and
deduct it all.
* Even years: contribute $2000 to fund B and deduct none of it.
(Yes, you are allowed to decline taking an IRA deduction you are
eligible for. You just need to include the actual amount of
contributions you made - the amount you're deducting on Form 8606.)
Given the above scheme, there is no possibility of nondeductible
contributions (NDC) actually being in fund A, all of them went directly
into fund B. If fund A is $12,000 with $0 from nondeductible
contributions, and fund B is $18,000 (you put more in) with $6,000 from
nondeductible contributions, and you roll fund B to a Roth, the Form
8606 calculation goes as follows:

Total IRA = $12,000 + $18,000 = $30,000
Total NDC = $0 + $6,000 = $6,000
Ratio = $6,000 / $30,000 = 1/5
Amount transferred = $18,000
NDC transferred = 1/5 of $18,000 = $3,600.

Unfortunately, you can't just say "All of my nondeductible contributions
are in fund B" (even though it's demonstable that this must be so) and
pay taxes on $18,000 - $6,000 = $12,000. You have to go through the
above math and pay taxes on $18,000 - $3,600 = $14,400.

So, once you make a non-deductible contribution, you're committed to
doing the paperwork when you take any money out of the IRA. On the
upside, the tax "problem" never gets any more complicated. You don't
have to keep track of where different contributions came from: all you
need to do is keep track of your basis, the sum of all your
non-deductible contributions. This number is on the most recent Form
8606 that you've filed (the form serves as a cumulative record, perhaps
once of the more taxpayer-friendly forms from the IRS).

Occasionally the question crops up as to exactly why people cannot go
short (see the article elsewhere in the FAQ explaining short sales) in
an IRA account. The restriction comes from the combination of the
following three facts. First, the law governing IRAs says that if any
part of an IRA is used as collateral, the entire IRA is considered
distributed and thus subject to income tax and penalties. Second, the
rules imposed by the Federal Reserve Board et al. say that short sales
have to take place in a margin account. Third and finally, margin
accounts require that you pledge the account as collateral. So if you
try to turn an IRA into a margin account, you'll void the IRA; but
without a margin account, you can't sell short.

Withdrawals can be made from a traditional IRA account at any time, but
a 10% penalty is imposed by the IRS on withdrawals made before the magic
age of 59 1/2. Note that taxes are always imposed on those portions of
withdrawals that can be attributed to deductible contributions.
Withdrawals from an IRA must begin by age 70 1/2. There are also
various provisions for excess contributions and other problems.

The following exceptions define cases when withdrawals can be made
subject to no penalty:

* The owner of the IRA becomes disabled or dies.
* A withdrawal program is set up as a series of "substantially equal
periodic payments" (known as SEP) that are taken over the owner's
life expectancy. Part of the deal with SEP is that the person also
must continue to take that amount for a period of 5 years before he
or she is allowed to change it.
* The funds are used to pay unreimbursed medical expenses that exceed
7.5% of the owner's adjusted gross income.
* The funds are used to pay medical insurance premiums provided the
owner of the IRA has received unemployment for more than 12 weeks.
* The funds are used to pay for qualified higher-education expenses.
* The funds are used to pay for a first-time home purchase, subject
to a lifetime maximum of 10,000. Note that a husband and wife can
both take distributions from their IRAs for a total of 20k to apply
to a first-time home purchase (lots of strings attached, read IRS
publication 590 carefully).

When an IRA account holder dies, the account becomes the property of the
named beneficiary, and is subject to various minimum distribution rules.

The IRS issued new regulations in April 2002 for minimum distributions
from traditional IRAs. The rules (which are retroactive to 1 April
2001) simplify the old, complex rules and reduce the minimum
distribution amounts for many people. First, IRA trustees are required
to report minimum required distributions to the IRS each year (to make
certain Uncle Sam gets his share). Second, account holders can name
beneficiaries at practically any time -- even after the death of the
account holder. Third, major changes were made to the calculation of
required minimum distributions. According to the 2002 rules, the IRA
owner is required (as before) to begin minimum distributions at age 70
and 1/2, or suffer tax penalties. However, these distributions are
calculated based on one of three new tables:
1. Single Life Table: This (depressingly) is used after the owner
2. Joint and Last Survivor Table: Used when the named beneficiary is a
spouse younger than the owner by at least 10 years (lucky them).
3. Uniform Lifetime Table: Used in nearly all other cases (i.e., when
the named beneficiary is close in age to the owner).

The traditional IRA permits a distribution to be treated as a rollover.
This means that you can withdraw money from an IRA account with no tax
effect as long as you redeposit it (into any of your IRA accounts, not
necessarily the one you took the money from) within 60 days of the
withdrawal. Any monies not redeposited are considered a distribution,
subject to income tax and the penalty tax if applicable. You are
permitted one rollover every 12 months per IRA account.

The rules changed in mid 2001 in the following ways:

* The contribution limit is $3,000 in 2002; reaches $4,000 in 2005,

and finally hits $5,000 in 2008.

* Investors over 50 can put an extra $500 per year (in 2002) and

eventually an extra 1,000 (in 2006) per year; this is called a
catch-up provision.

Order IRS Publication 590 for complete information. You can also get a
PDF version of Pub 590 from the IRS web site:

--------------------Check for updates------------------

Subject: Software - Archive of Free Investment-Related Programs

Last-Revised: 20 Aug 1996

Contributed-By: Chris Lott ( contact me )

This article lists two archives of investment-related programs. Most of
these programs are distributed in source-code form, but some include
binaries. Anyhow, if all that is available is source, then before you
can run them on your PC at home you will need a C compiler to create
executable versions.

Ed Savage maintains an archive of programs which are available here:

The compiler of this FAQ maintains an archive of programs (both source
code and PC binaries) for a number of investment-related programs. The
programs include:

* 401-calc: compute value of a 401(k) plan over time
* commis: compute commisions for trades at selected discount brokers
* fv: compute future value
* irr: compute rate of return of a portfolio
* loan: calculate loan amortization schedule
* prepay: analyze prepayments of a mortgage loan
* pv: calculate present value
* returns: analyze total return of a mutual fund
* roi: compute return on investment for mutual funds

These programs are available from The Investment FAQ web site at URL .

--------------------Check for updates------------------

Subject: Software - Portfolio Tracking and Technical Analysis

Last-Revised: 2 Jul 2001

Contributed-By: Chris Lott ( contact me )

Many software packages are available that support basic personal finance
and investment uses, such as managing a checkbook, tracking expenses,
and following the value of a portfolio. Using a package can be handy
for tracking transactions in mutual funds and stocks, especially for
active traders at tax time. Many packages support various forms of
technical analysis by drawing charts using historical data, applying
various T/A decision rules, etc. Those packages usually include a large
amount of historical data, with many provisions for fetching current
data via the 'net.

With the advent of online banking, many banks are offering software at
no charge, so be sure to ask locally.

This page lists a few resources that will help you find a package to
meet your needs.
* A decent collection of links for portfolio software is available on
The Investment FAQ web site:
* A yearly compendium is part of AAII's Computerized Investing
* Anderson Investor's Software, 130 S. Bemiston. Ste 101, St.
Louis MO 63105, USA; Sales 800-286-4106, Info 314-918-0990, FAX
* Nirvana Systems of Austin, TX specializes in investment- and
finance-related software. +1 (512) 345-2545, 800-880-0338.
* Money$earch maintains a collection of links to software packages.
The following URL will run a search on their site so you get the
latest results.
* is an online showcase for technologies and services
in the banking and finance industry. The target users are
primarily those in the banking and finance community responsible
for purchasing software and hardware technology.

--------------------Check for updates------------------

Subject: Stocks - Basics

Last-Revised: 26 Aug 1994
Contributed-By: Art Kamlet (artkamlet at, Edward Lupin

Perhaps we should start by looking at the basics: What is stock? Why
does a company issue stock? Why do investors pay good money for little
pieces of paper called stock certificates? What do investors look for?
What about Value Line ratings and what about dividends?

To start with, if a company wants to raise capital (money), one of its
options is to issue stock. A company has other methods, such as issuing
bonds and getting a loan from the bank. But stock raises capital
without creating debt; i.e., without creating a legal obligation to
repay borrowed funds.

What do the buyers of the stock -- the new owners of the company --
expect for their investment? The popular answer, the answer many people
would give is: they expect to make lots of money, they expect other
people to pay them more than they paid themselves. Well, that doesn't
just happen randomly or by chance (well, maybe sometimes it does, who

The less popular, less simple answer is: shareholders -- the company's
owners -- expect their investment to earn more, for the company, than
other forms of investment. If that happens, if the return on investment
is high, the price tends to increase. Why?

Who really knows? But it is true that within an industry the
Price/Earnings (i.e., P/E) ratio tends to stay within a narrow range
over any reasonable period of time -- measured in months or a year or

So if the earnings go up, the price goes up. And investors look for
companies whose earnings are likely to go up. How much?

There's a number -- the accountants call it Shareholder Equity -- that
in some magical sense represents the amount of money the investors have
invested in the company. I say magical because while it translates to
(Assets - Liabilities) there is often a lot of accounting trickery that
goes into determining Assets and Liabilities.

But looking at Shareholder Equity, (and dividing that by the number of
shares held to get the book value per share) if a company is able to
earn, say, $1.50 on a stock whose book value is $10, that's a 15%
return. That's actually a good return these days, much better than you
can get in a bank or C/D or Treasury bond, and so people might be more
encouraged to buy, while sellers are anxious to hold on. So the price
might be bid up to the point where sellers might be persuaded to sell.

A measure that is also sometimes used to assess the price is the
Price/Book (i.e., P/B) ratio. This is just the stock price at a
particular time divided by the book value.

What about dividends? Dividends are certainly more tangible income than
potential earnings increases and stock price increases, so what does it
mean when a dividend is non-existent or very low? And what do people
mean when they talk about a stock's yield?

To begin with the easy question first, the yield is the annual dividend
divided by the stock price. For example, if company XYZ is paying $.25
per quarter ($1.00 per year) and XYZ is trading at $10 per share, the
yield is 10%.

A company paying no or low dividends (zero or low yield) is really
saying to its investors -- its owners, "We believe we can earn more, and
return more value to shareholders by retaining the earnings, by putting
that money to work, than by paying it out and not having it to invest in
new plant or goods or salaries." And having said that, they are expected
to earn a good return on not only their previous equity, but on the
increased equity represented by retained earnings.

So a company whose book value last year was $10 and who retains its
entire $1.50 earnings, increases its book value to 11.50 less certain
expenses. The $1.50 in earnings represents a 15% return. Let's say
that the new book value is 11. To keep up the streak (i.e., to earn a
15% return again), the company must generate earnings of at least $1.65
this year just to keep up with the goal of a 15% return on equity. If
the company earns $1.80, the owners have indeed made a good investment,
and other investors, seeking to get in on a good thing, bid up the

That's the theory anyway. In spite of that, many investors still buy or
sell based on what some commentator says or on announcement of a new
product or on the hiring (or resignation) of a key officer, or on
general sexiness of the company's products. And that will always

What is the moral of all this: Look at a company's financials, look at
the Value Line and S&P charts and recommendations, and do some homework
before buying.

Do Value Line and S&P take the actual dividend into account when issuing
their "Timeliness" and "Safety" ratings? Not exactly. They report it,
but their ratings are primarily based on earnings potential, performance
in their industry, past history, and a few other factors. (I don't
think anyone knows all the other factors. That's why people pay for the

Can a stock broker be relied on to provide well-analyzed, well thought
out information and recommendations? Yes and no.

On the one hand, a stock broker is in business to sell you stock. Would
you trust a used-car dealer to carefully analyze the available cars and
sell you the best car for the best price? Then why would you trust a
broker to do the same?

On the other hand, there are people who get paid to analyze company
financial positions and make carefully thought out recommendations,
sometimes to buy or to hold or to sell stock. While many of these folks
work in the "research" departments of full-service brokers, some work
for Value Line, S&P etc, and have less of an axe to grind. Brokers who
rely on this information really do have solid grounding behind their

Probably the best people to listen to are those who make investment
decisions for the largest of Mutual Funds, although the investment
decisions are often after the fact, and announced 4 times a year.

An even better source would be those who make investment decisions for
the very large pension funds, which have more money invested than most
mutual funds. Unfortunately that information is often less available.
If you can catch one of these people on CNN for example, that could be

--------------------Check for updates------------------

Subject: Stocks - American Depositary Receipts (ADRs)

Last-Revised: 19 Feb 2002
Contributed-By: Art Kamlet (artkamlet at, George Regnery
(regnery at

An American Depositary Receipt (ADR) is a share of stock of an
investment in shares of a non-US corporation. The shares of the non-US
corporation trade on a non-US exchange, while the ADRs, perhaps somewhat
obviously, trade on a US exchange. This mechanism makes it
straightforward for a US investor to invest in a foreign issue. ADRs
were first introduced in 1927.

Two banks are generally involved in maintaining an ADR on a US exchange:
an investment bank and a depositary bank. The investment bank purchases
the foreign shares and offers them for sale in the US. The depositary
bank handles the issuance and cancellation of ADRs certificates backed
by ordinary shares based on investor orders, as well as other services
provided to an issuer of ADRS, but is not involved in selling the ADRs.

To establish an ADR, an investment bank arranges to buy the shares on a
foreign market and issue the ADRs on the US markets.

For example, BigCitibank might purchase 25 million shares of a non-US
stock. Call it EuroGlom Corporation (EGC). Perhaps EGC trades on the
Paris exchange, where BigCitibank bought them. BigCitibank would then
register with the SEC and offer for sale shares of EGC ADRs.

EGC ADRs are valued in dollars, and BigCitibank could apply to the NYSE
to list them. In effect, they are repackaged EGC shares, backed by EGC
shares owned by BigCitibank, and they would then trade like any other
stock on the NYSE.

BigCitibank would take a management fee for their efforts, and the
number of EGC shares represented by EGC ADRs would effectively decrease,
so the price would go down a slight amount; or EGC itself might pay
BigCitibank their fee in return for helping to establish a US market for
EGC. Naturally, currency fluctuations will affect the US Dollar price
of the ADR.

BigCitibank would set up an arrangement with another large financial
institution for that institution to act as the depositary bank for the
ADRs. The depositary would handle the day-to-day interaction with
holders of the ADRs.

Dividends paid by EGC are received by BigCitibank and distributed
proportionally to EGC ADR holders. If EGC withholds (foreign) tax on
the dividends before this distribution, then BigCitibank will withhold a
proportional amount before distributing the dividend to ADR holders, and
will report on a Form 1099-Div both the gross dividend and the amount of
foreign tax withheld.

Most of the time the foreign nation permits US holders (BigCitibank in
this case) to vote their shares on all or most issues, and ADR holders
will receive ballots which will be received by BigCitibank and voted in
proportion to ADR Shareholder's vote. I don't know if BigCitibank has
the option of voting shares which ADR holders failed to vote.

The depositary bank sets the ratio of US ADRs per home country share.
This ratio can be anywhere, and can be less than or greater than 1.
Basically, it is an attempt to get the ADR within a price that Americans
are comfortable with, so upon issue, I would assume that most ADRs range
between $15 and $75 per share. If, in the home country, the shares are
worth considerably less, than each ADR would represent several real
shares. If, in the home country, shares were trading for the equivalent
of several hundred dollars, each ADR would be only a fraction of a
normal share.

Now, concerning who sets the price: yes, it floats on supply and demand.
However, if the US price gets too far off from the price in the home
country (Accounting for the currency exchange rate and the ratio of ADRs
to home country shares), then an arbitrage opportunity will exist. So,
yes, it does track the home country shares, but probably not exactly
(for there are transaction costs in this type of arbitrage). However,
if the spread gets too big, arbitragers will step in and then of course,
the arbitrage opportunities will soon cease to exist.

Having said this, however, for the most part ADRs look and feel pretty
much like any other stock.

The following resources offer more information about ADRs.
* Citicorp offers in-depth information about ADRs:
* JP Morgan runs a web site devoted to ADRs (with a truly lovely
legal disclaimer you must accept before visiting the site):
* Site-By-Site offers information about specific ADR issues:
* CoBeCo lists background information and current quotes for ADRs:

--------------------Check for updates------------------

Subject: Stocks - Cyclicals

Last-Revised: 9 Apr 1995
Contributed-By: Bill Sullivan (sully at

Cyclical stocks, in brief, are the stocks of those companies whose
earnings are strongly tied to the business cycle. This means that the
prices of the stocks move up sharply when the economy turns up, move
down sharply when the economny turns down.


Cyclical companies: Caterpillar (CAT), US Steel (X), General Motors
(GM), International Paper (IP); i.e., makers of products for which the
demand curve is fairly flexible.

Non-Cyclical companies: CocaCola (KO), Proctor & Gamble (PG), and Quaker
Oats (OAT); i.e., makers of products for which the demand curve is
fairly inflexible; after all, everyone has to eat!

--------------------Check for updates------------------

Subject: Stocks - Dividends

Last-Revised: 29 Sep 1997
Contributed-By: Art Kamlet (artkamlet at, Rich Carreiro (rlcarr

A company may periodically declare cash and/or stock dividends. This
article deals with cash dividends on common stock. Two paragraphs also
discuss dividends on Mutual Fund shares. A separate article elsewhere
in this FAQ discusses stock splits and stock dividends.

The Board of Directors of a company decides if it will declare a
dividend, how often it will declare it, and the dates associated with
the dividend. Quarterly payment of dividends is very common, annually
or semiannually is less common, and many companies don't pay dividends
at all. Other companies from time to time will declare an extra or
special dividend. Mutual funds sometimes declare a year-end dividend
and maybe one or more other dividends.

If the Board declares a dividend, it will announce that the dividend (of
a set amount) will be paid to shareholders of record as of the RECORD
DATE and will be paid or distributed on the DISTRIBUTION DATE (sometimes
called the Payable Date).

Before we begin the discussion of dates and date cutoffs, it's important
to note that three-day settlements (T+3) became effective 7 June 1995.
In other words, the SEC's T+3 rule states that all stock trades must be
settled within 3 business days.

In order to be a shareholder of record on the RECORD DATE you must own
the shares on that date (when the books close for that day). Since
virtually all stock trades by brokers on exchanges are settled in 3
(business) days, you must buy the shares at least 3 days before the
RECORD DATE in order to be the shareholder of record on the RECORD DATE.
So the (RECORD DATE - 3 days) is the day that the shareholder of record
needs to own the stock to collect the dividend. He can sell it the very
next day and still get the dividend.

If you bought it at least 3 business days before the RECORD date and
still owned it at the end of the RECORD DATE, you get the dividend.
(Even if you ask your broker to sell it the day after the (RECORD DATE -
3 days), it will not have settled until after the RECORD DATE so you
will own it on the RECORD DATE.)

So someone who buys the stock on the (RECORD DATE - 2 days) does not get
the dividend. A stock paying a 50c quarterly dividend might well be
expected to trade for 50c less on that date, all things being equal. In
other words, it trades for its previous price, EXcept for the DIVidend.
So the (RECORD DATE - 2 days) is often called the EX-DIV date. In the
financial listings, that is indicated by an x.

How can you try to predict what the dividend will be before it is

Many companies declare regular dividends every quarter, so if you look
at the last dividend paid, you can guess the next dividend will be the
same. Exception: when the Board of IBM, for example, announces it can
no longer guarantee to maintain the dividend, you might well expect the
dividend to drop, drastically, next quarter. The financial listings in
the newspapers show the expected annual dividend, and other listings
show the dividends declared by Boards of directors the previous day,
along with their dates.

Other companies declare less regular dividends, so try to look at how
well the company seems to be doing. Companies whose shares trade as
ADRs (American Depositary Receipts -- see article elsewhere in this FAQ)
are very dependent on currency market fluctuations, so will pay
differing amounts from time to time.

Some companies may be temporarily prohibited from paying dividends on
their common stock, usually because they have missed payments on their
bonds and/or preferred stock.

On the DISTRIBUTION DATE shareholders of record on the RECORD date will
get the dividend. If you own the shares yourself, the company will mail
you a check. If you participate in a DRIP (Dividend ReInvestment Plan,
see article on DRIPs elsewhere in this FAQ) and elect to reinvest the
dividend, you will have the dividend credited to your DRIP account and
purchase shares, and if your stock is held by your broker for you, the
broker will receive the dividend from the company and credit it to your

Dividends on preferred stock work very much like common stock, except
they are much more predictable.

Tax implications:

* Some Mutual Funds may delay paying their year-end dividend until
early January. However, the IRS requires that those dividends be
constructively paid at the end of the previous year. So in these
cases, you might find that a dividend paid in January was included
in the previous year's 1099-DIV.

* Sometime before January 31 of the next year, whoever paid the
dividend will send you and the IRS a Form 1099-DIV to help you
report this dividend income to the IRS.

* Sometimes -- often with Mutual Funds -- a portion of the dividend
might be treated as a non-taxable distribution or as a capital
gains distribution. The 1099-DIV will list the Gross Dividends (in
line 1a) and will also list any non-taxable and capital gains
distributions. Enter the Gross Dividends (line 1a) on Schedule B.

* Subtract the non-taxable distributions as shown on Schedule B and
decrease your cost basis in that stock by the amount of non-taxable
distributions (but not below a cost basis of zero -- you can deduct
non-taxable distributions only while the running cost basis is
positive.) Deduct the capital gains distributions as shown on
Schedule B, and then add them back in on Schedule D if you file
Schedule D, else on the front of Form 1040.

Finally, just a bit of accounting information. Earnings are always
calculated first, and then the directors of a company decide what to do
with those earnings. They can distribute the earnings to the
stockholders in the form of dividends, retain the earnings, or take the
money and head for Brazil (NB: the last option tends to make the
stockholders angry and get the local district attorney on the case :-).
Utilities and seasonal companies often pay out dividends that exceed
earnings - this tends to prop up the stock price nicely - but of course
no company can do that year after year.

--------------------Check for updates------------------

Subject: Stocks - Dramatic Price Changes

Last-Revised: 18 Sep 1994
Contributed-By: Maurice Suhre, Lynn West, Fahad A. Hoymany

One frequently asked question is "Why did my stock in X go down/up by
this large amount in the past short time ?

The purpose of this answer is not to discourage you from asking this
question in misc.invest, although if you ask without having done any
homework, you may receive a gentle barb or two. Rather, one purpose is
to inform you that you may not get an answer because in many cases no
one knows.

Stocks surge for a variety of reasons ranging from good company news,
improving investors' sentiment, to general economic conditions. The
equation which determines the price of a stock is extremely simple, even
trivial. When there are more people interested in buying than there are
people interested in selling, possibly as a result of one or more of the
reasons mentioned above, the price rises. When there are more sellers
than buyers, the price falls. The difficult question to answer is, what
accounts for the variations in demand and supply for a particular stock?
Naturally, if all (or most) people knew why a stock surges, we would
soon have a lot of extremely rich people who simply use that knowledge
to buy and sell different stocks.

However, stocks often lurch upward and downward by sizable amounts with
no apparent reason, sometimes with no fundamental change in the
underlying company. If this happens to your stock and you can find no
reason, you should merely use this event to alert you to watch the stock
more closely for a month or two. The zig (or zag) may have meaning, or
it may have merely been a burp.

A related question is whether stock XYZ, which used to trade at 40 and
just dropped to 25, is good buy. The answer is, possibly. Buying
stocks just because they look "cheap" isn't generally a good idea. All
too often they look cheaper later on. (IBM looked "cheap" at 80 in 1991
after it declined from 140 or so. The stock finally bottomed in the
40's. Amgen slid from 78 to the low 30's in about 6 months, looking
"cheap" along the way.) Technical analysis principles suggest to wait

for XYZ to demonstrate that it has quit going down and is showing some
sign of strength, perhaps purchasing in the 28 range. If you are

expecting a return to 40, you can give up a few points initially. If
your fundamental analysis shows 25 to be an undervalued price, you might
enter in. Rarely do stocks have a big decline and a big move back up in
the space of a few days. You will almost surely have time to wait and
see if the market agrees with your valuation before you purchase.

--------------------Check for updates------------------

Subject: Stocks - Holding Company Depositary Recepits (HOLDRs)

Last-Revised: 16 July 2000

Contributed-By: Chris Lott ( contact me )

A Holding Company Depositary Receipt (HOLDR) is a fixed collection of
stocks, usually 20, that is used to track some industry sector. For
example, HOLDRs exist for biotech, internet, and business-to-business
companies, just to pick some examples. A HOLDR is a way for an investor
to gain exposure to a market sector with at a low cost, primarily the
comission to purchase the HOLDR. All HOLDR securities trade on the
American Stock Exchange; their ticker symbols all end in 'H'.

Although a HOLDR may sound a bit like a mutual fund, it really is quite
different. One important difference is that nothing is done to a HOLDR
after it is created (mutual funds are usually managed actively). So,
for example, if one of the 20 companies in a HOLDR gets bought,
thereafter the HOLDR will have just 19 stocks. This keeps the annual
expenses very low (currently about $0.08 or less per share).

So maybe a HOLDR is much more like a stock? Yes, but also with some
differences. Like stocks, HOLDRs can be bought on margin or shorted.
But unlike stocks, investors can only buy round lots (multiples of 100
shares) of HOLDR securities. So buying into a HOLDR can be fairly
expensive for a small investor.

Interestingly, an owner of a HOLDR is considered to own the stocks in
the HOLDR directly, even though they were purchased via the HOLDR. So
the HOLDR holder (sorry, bad joke) receives quarterly and annual reports
from the companies directly, receives dividends directly, etc. And, if
the investor decides it's a good idea (and is willing to pay the
associated fees), he or she can ask the HOLDR trustee to deliver the
shares represented by the HOLDR; the HOLDR then is gone (cancelled), and
the investor holds the shares as if he or she had purchased them

Merrill Lynch created the first HOLDR in 1998 to track the Brazilian
phone company when it was broken up. Merrill (or some other big
financial institution) serves as the trustee, the agency that purchases
shares in the companies and issues the HOLDR shares. When a HOLDR is
first issued, the event is considered an IPO.

Here are a few resources with more information.
* The Merrill Lynch site:
* The printed a comprehensive introduction to HOLDRs in
June 2000:

--------------------Check for updates------------------

Subject: Stocks - Income and Royalty Trusts

Last-Revised: 24 Jul 2001
Contributed-By: John Carswell (webmaster at

Income and Royalty Trusts are special-purpose financing vehicles that
are created to make investments in operating companies or their cash
flows. Investors supply capital to a trust, a legal entity that exists
to hold assets, by purchasing "trust units". The trust then uses these
funds to purchase an interest in the operating company. The trust then
distributes all its income to holders of the trust units.

Income and Royalty trusts are neither stocks nor bonds, although they
share some of their characteristics. Investment trusts are created to
hold interests in operating assets which produce income and cash flows,
then pass these through to investors. A "trust" is a legal instrument
which exists to hold assets for others. A "trust" investment which uses
a trust (the legal entity) to hold ownership of an asset and pass
through income to investors is called a "securitization" or an
"asset-backed security".

The trust can purchase common shares, preferred shares or debt
securities of an operating company. Royalty trusts purchase the right
to royalties on the production and sales of a natural resource company.
Real estate investment trusts purchase real estate properties and pass
the rental incomes through to investors.

Royalty and Income Trusts are attractive to investors because they
promise high yields compared to traditional stocks and bonds. They are
attractive to companies wishing to sell cash flow producing assets
because they provide a much higher sale price, or proceeds, than would
be possible with conventional financings. The investment
characteristics of both types of trusts flow from their structure. To
understand the risks and returns inherent in these investments we must
go beyond their promised yield and examine their purpose and structure.

Cashflow Royalty Created!

For example, let's say that we own an oil company,CashCow Inc., that has
many mature producing oil wells. The prospect for these wells is fairly
mundane. With well known rates of production and reserves, there is not
much chance to enhance production or lower costs. We know that we will
produce and sell 1,000,000 barrels per year at the prevailing oil price
until it runs out in a forecasted 20 years. At the current price of $25
per barrel, we will make $25,000,000 per year until the wells run dry in

We're getting a bit tired of the oil business. We want to sell. Our
investment bank, Sharp & Shooter, suggest that we utilize a royalty
trust. They explain the concept to us. CashCow Inc., our company,
sells all the oil wells to a "trust", the CashCow Royalty Fund. The
trust will then pay CashCow Inc a management fee to manage and maintain
the wells. The CashCow Royalty Fund then gets all the earnings from the
wells and distributes these to the trust unit holders. We ask, "Why we
just wouldn't sell shares in our company to the public". Sharp &
Shooter tells us that we will get more money by setting up the trust
since investors are "starved for yield". We agree.

Sharp & Shooter then do the legals and proceed with an issue. They
offer a cash yield of 10%, based on their projections for oil prices,
the cost structure, and management fee to CashCow Inc. This means they
hope to raise $250,000,000. We're rich!!

Yield to the Poor Tired Investment Masses

What about the poor tired investment masses? Starving for yield in the
low interest rate revolution, the CashCow Royalty Fund lets them have
their investment cake and eat it too. Thanks to the royalty courtiers
of Sharp & Shooter, yield starved investors can buy a piece of a "high
yield" investment. Sounds a bit strange, but the royalty trust turns
the steady income that made the operating company CashCow Inc.
financially mundane and boring into a scintillating geyser of high

Since the operating company, CashCow Inc., no longer has to explore for
oil or develop technologies to increase production, its expenditures
will be much lower under the royalty trust structure. Remember, the
purposes of the trust is to pay out the earnings from the oil sales
until the oil fields are exhausted. No more analysts and shareholders
complaining about "depleting" resources. Paying out the steadily
depleting oil sales are now the idea. This means that none of the
revenues and profits from production have to be expended on securing new
supplies. The continuing operations of CashCow Inc. can be downsized
now that maintenance is the only need. No more exploration department,
huge head office staff, or worldwide travel bills.

The investor, who might shun a low dividend yield of 3% on an oil stock
or worry about the risk of a lower grade corporate bond, sees the bright
lights of high yield beckoning. Our $25,000,000 in revenues is only
reduced by a management contract of $1,000,000 paid to the now shrunken
CashCow Inc. to keep the fields maintained. All the earnings will be
passed through to the CashCow Royalty Trust which will be taxed in the
hands of the investors. We can offer a 10% yield to the trust unit
holders which means that we can raise $250,000,000.

What's Wrong with this Investment Picture?

One of the first questions to ask about an investment is, "What's in it
for them?". Why would the owners of CashCow Inc. part with their
$25,000,000 in income? Not just to provide a higher yield for the yield
starved investment masses. Logically, the owners of an operating
company would only sell their interest if they could use the money to
more effect somewhere else. Think about it for a minute. If the owner
of CashCow Inc. can take $250,000,000 and put it into another
investment with a higher yield, it should be done. The fixed return of
10% on established, tired wells might be a tad low next to the upside on
a new oil field, or a well diversified portfolio of growth stocks.

Another question to ask is,"Why didn't the owner just sell the company
to another oil company?". The simple answer is that they get more money
by selling to the income trust. Which begs the question, "Why is the
price so high?". Other companies realize that the price of oil goes up
and down and that the price of $25 a barrel today is very high compared
to the $10 it was a few years ago. At $10 per barrel, the cash flow
would only be $10,000,000 a year. That is why the prospectus for these
trust deals talks about 'forecasted' revenues and earnings. The other
oil companies also realize that 'proven reserves' has an element of
guesswork, and that there might be less oil in the ground, or it may be
'more difficult to recover' than expected.

All this means that the 10% "yield" is not fixed in stone, as we now
realize. As with all investments, we must take our time and do our
analysis. As Uncle Pipeline says, "It's all in the cash flows!"

For more insights from the Financial Pipeline, visit their site:

--------------------Check for updates------------------

Subject: Stocks - Types of Indexes

Last-Revised: 10 Jul 1998
Contributed-By: Susan Thomas, Chris Lott ( contact me )

There are three major classes of indexes in use today in the US:

Equally weighted price index
An example is the Dow Jones Industrial Average.
Market capitalization weighted index
An example is the S&P500 Industrial Average.
Equally weighted returns index
The only one of its kind is the Value-Line index.

The first two are widely used. All my profs in the business school
claim that the equally weighted return indexs is weird and don't
emphasize it too much.

Now for the details on each type.

Equally Weighted Price Index
As the name suggests, the index is calculated by taking the average
of the prices of a set of companies:
Index = Sum (Prices of N companies) / divisor
In this calculation, two questions crop up:

1. What is "N"? The DJIA takes the 30 large "blue-chip"
companies. Why 30? Well, you want a fairly large number so
the index will (at least to some extent) represent the entire
market's performance. Of course, many would argue (and
rightly so) that 30 is a ridiculously small number in today's
markets, so a case can be made that it's more of a historical
hangover than anything else.

Does the set of N companies change across time? If so, how
often is the list updated (with respect to the companies that
are included)? In the case of the DJIA, yes, the set of
companies is updated periodically. But these decisions are
quite judgemental and hence not readily replicable.

If the DJIA only has 30 companies, how do we select these 30?
Why should they have equal weights? These are real criticisms
of the DJIA-type index.

2. The divisor is not always equal to N for N companies. What
happens to the index when there is a stock split by one of the
companies in the set? Of course the stock price of that
company drops, but the number of shares have increased to
leave the market capitalization of the shares the same. Since
the index does not take the market cap into account, it has to
compensate for the drop in price by tweaking the divisor. For
examples on this, look at pg. 61 of Bodie, Kane, and Marcus,
Investments . The DJIA actually started with a divisor of 30,
but currently uses a number around 0.3 (yes, zero point 3).

Historically, this index format was computationally convenient. It
just doesn't have a very sound economic basis to justify it's
existence today. The DJIA is widely cited on the evening news, but
not used by real finance folks. I have an intuition that the DJIA
type index will actually be BAD if the number of companies is very
large. If it's to make any sense at all, it should be very few
"brilliantly" chosen companies. Because the DJIA is the most
widely reported index about the U.S. equity markets, it's
important to understand it and its flaws.

Market capitalization weighted index
In this index, each of the N companies' price is weighted by the
market capitalization of the company.
Sum (Company market capitalization * Price) over N
Index =
Market capitalization for these N companies
Here you do not take into account the dividend data, so effectively
you're tracking the short-run capital gains of the market.

Practical questions regarding this index:

1. What is "N"? I would use the largest N possible to get as
close to the "full" market as possible. By the way, in the
U.S. there are companies that make a living on only
calculating extremely complete value-weighted indexes for the
NYSE and foreign markets. CMIE should sell a very complete
value-weighted index to some such folks.

Why does S&P use 500? Once again, a large number of companies
captures the broad market, but the specific number 500 is
probably due to historical reasons when computating over
20,000 companies every day was difficult. Today, computing
over 20k companies for a Sun workstation is no problem, so the
S&P idea is obsolete.

2. How to deal with companies entering and exiting the index? If
we're doing an index containing "every single company
possible" then the answer to this question is easy -- each
time a company enters or exits we recalculate all weights.
But if we're a value-weighted index like the S&P500 (where
there are only 500 companies) it's a problem. For example,
when Wang went bankrupt, S&P decided to replace them by Sun --
how do you justify such choices?

The value-weighted index is superior to the DJIA type index for
deep reasons. Anyone doing modern finance will not use the DJIA
type index. A glimmer of the reasoning for this is as follows: If
I held a portfolio with equal number of shares of each of the 30
DJIA companies then the DJIA index would accurately reflect my
capital gains. But we know that it is possible to find a portfolio
which has the same returns as the DJIA portfolio but at a smaller
risk. (This is a mathematical fact).

Thus, by definition, nobody is ever going to own a DJIA portfolio.
In contrast, there is an extremely good interpretation for the
value weighted portfolio -- it yields the highest returns you can
get for its level of risk. Thus you would have good reason for
owning a value-weighted market portfolio, thus justifying it's

Yet another intuition about the value-weighted index -- a smart
investor is not going to ever buy equal number of shares of a given
set of companies, which is what the equally weighted price index
tracks. If you take into consideration that the price movements of
companies are correlated with others, you are going to hedge your
returns by buying different proportions of company shares. This is
in effect what the market capitalization weighted index does, and
this is why it is a smart index to follow.

One very neat property of this kind of index is that it is readily
applied to industry indexes. Thus you can simply apply the above
formula to all machine tool companies, and you get a machine tool
index. This industry-index idea is conceptually sound, with
excellent interpretations. Thus on a day when the market index
goes up 6%, if machine tools goes up 10%, you know the market found
some good news on machine tools.

Equally weighted returns index
Here the index is the average of the returns of a certain set of
companies. Value Line publishes two versions of it:

* The arithmetic index:
( VLAI / N ) = Sum (N returns)

* The geometric index:
VLGI = { Product (1 + return) over N } ^ { 1 / n },
which is just the geometric mean of the N returns.

Notice that these indexes imply that the dollar value on each company
has to be the same. Discussed further in Bodie, Kane, and Marcus,
Investments , pg 66.

--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Apr 17, 2004, 7:28:37 AM4/17/04
Archive-name: investment-faq/general/part18
Version: $Id: part18,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 18 of 20. The web site

always has the latest version, including in-line links. Please browse

Terms of Use


Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Trading - Discount Brokers

Last-Revised: 26 Jul 1998
Contributed-By: Many net.people; compiled by Chris Lott ( contact me )

A discount broker offers an execution service for a wide variety of
trades. In other words, you tell them to buy, sell, short, or whatever,
they do exactly what you requested, and nothing more. Their service is
primarily a way to save money for people who are looking out for
themselves and who do not require or desire any advice or hand-holding
about their forays into the markets. This article focuses on brokers
who accept orders for stock, stock option, and/or futures trades.

Discount brokering is a highly competitive business. As a result, many
of the discount brokers provide virtually all the services of a
full-service broker with the exception of giving you unsolicited advice
on what or when to buy or sell. Then again, some do provide monthly
newsletters with recommendations. Virtually all will execute stock and
option trades, including stop or limit orders and odd lots, on the NYSE,
AMEX, or NASDAQ. Most can trade bonds and U.S. treasuries. Most will
not trade futures; talk to a futures broker. Most have margin accounts
available. Most will provide automatic sweep of (non-margin) cash into
a money market account, often with check- writing capability. All can
hold your stock in "street-name", but many can take and deliver stock
certificates physically, sometimes for a fee. Some trade precious
metals and can even deliver them!

Many brokers will let you buy "no-load" mutual funds for a low (e.g.
0.5%) commission. Increasingly, many even offer free mutual fund
purchases through arrangements with specific funds to pay the commission
for you; ask for their fund list. Many will provide free 1-page
Standard & Poor's Stock reports on stocks you request and 5-10 page full
research reports for $5-$8, often by fax. Some provide touch-tone
telephone stock quotes 24 hours / day. Some can allow you to make
trades this way. Many provide computer quotes and trading; others say
"it's coming".

The firms can generally be divided into the following categories:

1. "Full-Service Discount"
Provides services almost indistinguishable from a full-service
broker such as Merrill Lynch at about 1/2 the cost. These provide
local branch offices for personal service, newsletters, a personal
account representative, and gobs and gobs of literature.
2. "Discount"
Same as "Full-Service," but usually don't have local branch offices
and as much literature or research departments. Commissions are
about 1/3 the price of a full-service broker.
3. "Deep Discount"
Executes stock and option trades only; other services are minimal.
Often these charge a flat fee (e.g. $25.00) for any trade of any
4. Computer or Electronic
Same as "Deep Discount", but designed mainly for computer users
(either dial-up or via the internet). Note that some brokers offer
an online trading option that is cheaper than talking to a broker.

Examples of firms in all categories:

Full-Svc. Discount Discount Deep Discount Computer
Fidelity Aufhauser Brown Datek
Olde Bidwell Ceres E-broker
Quick and Reilly Discover National E-trade
Charles Schwab Scottsdale Pacific JB Online
Vanguard Waterhouse Stock Mart Wall St. Eq.
Jack White Scottsdale
The rest often fall somewhere between "Discount" and "Deep Discount" and
include many firms that cater to experienced high-volume traders with
high demands on quality of service. Those are harder to categorize.

All brokerages, their clearing agents, and any holding companies they

have which can be holding your assets in "street-name" had better be

insured with the S.I.P.C. You're going to be paying an SEC "tax" (e.g.
about $3.00) on any trade you make anywhere , so make sure you're
getting the benefit; if a broker goes bankrupt it's the only thing that

prevents a total loss. Investigate thoroughly!

In general, you need to ask carefully about all the services above that
you may want, and find out what fees are associated with them (if any).
Ask about fees to transfer assets out of your account, inactive account
fees, minimums for interest on non-margin cash balances, annual IRA
custodial fees, per-transaction charges, and their margin interest rate
if applicable. Some will credit your account for the broker call rate
on cash balances which can be applied toward commission costs.

You may have seen that price competition has driven the cost of a trade
below $10 at many web brokers. How can they charge so little?
Discounters that charge deeply discounted commissions either make
markets, sell their order flow, or both. These sources of revenue
enable the cheap commission rates as they profit handsomely from trading
with your order or selling it to another. Market making is the answer.

In contrast, Datek is one of a kind. Datek owns the Island, an
electronic system that functions as a limit order book that gives great
order visibility and crosses orders within it as well as showing them to
the Nasdaq via Level II. Datek charges a fee from Island subscribers to
enter orders into their system. Island is their outside revenue, and is
far superior to selling order flow. Island is good for the customer,
selling order flow like the others is not.

Here are a few sources for additional information:
* The links page on the FAQ web site about trading has links to many
brokerage houses.
* Gomez ranks more online brokers, but please be aware that many of
the sites that they rank are also clients of Gomez.
* "Delving Into the Depths of Deep Discounters," The Wall Street
Journal , Friday, February 3, 1995, pp. C1, C22.
* A free report on a broker's background can be requested from the
National Association of Securities Dealers; phone (800) 289-9999
* An 85 page survey of 85 discount brokers revised each October and
issued each January is available for $34.95 + $3.00 shipping from:
Andre Schelochin / Mercer Inc. / 379 W. Broadway, Suite 400 / New
York, NY 10012 / +1 (212) 334-6212

--------------------Check for updates------------------

Subject: Trading - Direct Investing and DRIPs

Last-Revised: 24 Aug 2000
Contributed-By: John Levine (johnl at, Paul Randolph (paulr22
at juno dot com), Bob Grumbine (rgrumbin at, Cliff (cliff at, Thomas Price (tprice at, David
Sanderson (dws at, John Belt, Brett Kottmann (bkottmann at

DRIP stands for Dividend (sometimes Direct) Re-Investment Plan. The
basic idea is that an investor can purchase shares of a company directly
from that company without paying any commission. This is most commonly
done in a traditional DRIP by having all dividends paid on shares
immediately used to purchase more of the same shares (i.e., the
dividends are reinvested). Most plans also allow the investor to
purchase additional shares directly from the company every quarter.
Thus the two names for DRIP: Dividend/Direct Re-Investment Plan. But
note the "re" in re-investment: most DRIPs do not provide a way for an
investor to buy the first share.

DRIPs offer an easy, low-cost way for buying common stocks and
closed-end mutual funds. DRIPs are also a great way to invest a small
amount each month (dollar-cost averaging). Since most of us try to set
aside a little each month, this can work extraordinarily well. Yet
another good use of a DRIP is to give a small amount of stock as a gift.
You may not want to set up a brokerage account for your niece, but you
may want to give her 10 shares of Mattel. A DRIP account (structured as
a UTMA, see the article elsewhere in the FAQ) helps a minor benefit from
stock ownership and lets someone make additional purchases relatively

When you sell shares that were acquired via a DRIP, your cost basis is
simply the sum of the amounts you invested plus your reinvested
dividends. But because you have four small purchases per year, at
different prices, for as long as you own the stock, the actual
calculation of your cost basis can quickly become an accounting
nightmare. A program like Quicken or Microsoft Money can make this a
lot easier for you. (There's no reason the broker can't do it for you
since they have all the data, but no broker I know does.) Of course if
the DRIP is structured as a retirement account, a sale is not a taxable
event, and you don't need to calculate the cost basis. That leads
nicely to the next caveat. In order to participate in a DRIP inside an
IRA, the DRIP sponsor has to be willing to serve as IRA custodian. Some
will, some won't. That information is available in the DRIP prospectus,
from the company's IR department, or the transfer agent.

Traditional DRIPs are available as company-sponsored plans and from
large brokerage houses. These two arrangements are both similar and

Company-sponsored DRIP
In this arrangement, once you have purchased at least one share,
dividends paid on all holdings are used to buy new shares. That
first share must be registered in your name, not in street name. A
common feature is that you can make additional purchases each
quarter at little or no additional cost (i.e., no commission or
fees). When you sell the shares, the company buys the shares back.
Note that a company-sponsored DRIP might be run by the company
directly, or by a bank. The latter arrangement tends to lead to
fees that quickly become onerous for small investors (more later).
Many companies sponsor DRIPs; lists are available through NAIC and
some brokerages.

Brokerage-house DRIP
In this arrangement, you pay a commission to buy the original
shares in your brokerage account (even retirement accounts), and
the brokerage buys new shares with the dividends paid by the stock
at no additional charge. Thus, your investment accumulates a
little at a time with no commission. When you sell the stock, they
sell the full shares (for a commission) and give you cash in lieu
for the fraction. Many brokerage houses offer this arrangement
today, including (just to name a couple) Charles Schwab and

Brokerage-house DRIP arrangements are pretty simple when compared to
company-sponsored DRIPs. The remainder of this article focuses on
company-sponsored DRIPs.

Once you've found a company with a DRIP, check out the plan terms.
Usually the transfer agent or company's investor relations (IR)
department will send you a copy of the plan information (the company's
IR department may be more responsive). Two transfer agents, American
Stock Transfer and Trust ( ) and Chase Mellon ( ) have extensive plan info available online.
Although most of the information is available there, always verify any
details that are important to you with the transfer agent or IR
department before investing.

Here is a partial list of the things to check in the terms and
conditions of a DRIP. Some DRIPs are exactly and only that, a Dividend
Reinvestment Plan. If you intend to send in additional investments,
make sure that the plan allows optional cash payments. Also, some DRIPs
only accept contributions on a quarterly basis (when the dividend is
paid) or even annually or semi-annually. Plans that allow optional
investments at least monthly are much more convenient. Some DRIPs
charge you up to $5 (or more) per contribution. If you are interested
in one of those companies, then you may do just as well with a discount
brokerage account at $8/trade. Still, if you want to give stock to a
child or family member who doesn't have a brokerage account, paying
$5/purchase through a DRIP may not be a bad idea. Finally, check
whether the company issues new shares for your contribution or buys on
the open market. Issuing new shares dilutes shareholder value and is
therefore less appealing than buying on the open market.

Let's say the terms and conditions seem fair, and you want to get
started. So you need that first share and it must be registered in your
name. Once the shares are bought and issued to you, you then have to
get enrolled on your own. To purchase the first share at modest cost,
you have several options, as follows.
* If you have a brokerage account, you can just buy a few shares and
have the certificate issued (shares have to be in your name, not
held in street name in a brokerage account). This may or may not
be a low-cost approach. At Fidelity, a limit purchase order costs
you a $30 commission, and it's $15 to have a certificate issued.
If you have a Vanguard brokerage account, you can buy the stock for
a $20 commission, then have them issue the certificate for free.
Several brokerage houses (A G Edwards and Dean Witter, for example)
offer a special commission rate for purchases of single shares.
* Many clubs and other organizations will help you buy the first
share for a very reasonable charge. Naturally they all have web
sites; a partial list appears at the bottom of this article.
* A handful of companies sell their stock directly to the public
without requiring you to go through an exchange or broker even for
the first share. In that case, just get a copy of the form from
the IR department or transfer agent and send in a check. These
companies are all exchange listed as well, and tend to be

Last but certainly not least, you may have asked yourself why all
companies don't sponsor direct investment plans. The short answer is
that it costs them too much. And now for the long answer..

Most companies, most of the time, aren't selling stock at all. For one
thing, issuing new shares requires registration with the SEC, at least
of the shelf variety, and that definitely costs money. Years ago, when
postage, supplies, and all the rest weren't so costly, a lot of
companies went ahead and did the necessary shelf registration for a
Dividend Reinvestment and Stock Purchase Plan, for the benefit of those
who already had at least a few shares registered in their own names, so
that those shareholders could increase their holdings over time. A
DRIP/SPP is a company-sponsored benefit for the shareholders, pure and

In recent years, legal fees have skyrocketed, postage alone has gone to
33c for an envelope in which to send a statement of account which costs
a bunch more to print than it used to, and the clerks and accountants
needed to keep track of such a program have also gotten a lot more
expensive. DRIP fees have gone up in existing DRIPs and there have been
very few companies actually setting up their own new DRIPs, most with
some kind of fee structure.

Many of these are designed much more for the purpose of generating fees
for the several large banking institutions that run them than for the
purpose of facilitating really small investors' interest in acquiring
fixed dollar amounts of stock. Let's face it, when they take $15 just
to open an account, insist on minimum investments in the mid-three to
low-four digit range, and then demand huge percentage fees every time a
dividend gets reinvested, a small investor gets a pretty bad deal.
Always (always) check the plan terms to make sure that you can't do
better with a DRIP arrangement at a discount brokerage house.

Here is a list of DRIP resources, including sources of information as
well as companies that will help you buy shares at very low cost.
*, a service of Netstock Direct, lets you make
automatic periodic investments in over 4,000 companies and 68 Index
shares for just $4 per transaction (less for custodial accounts).
This is sometimes called dollar-based investing, because you set
the dollar amount to be invested rather than the number of shares.
Like any other DRIP, you can own partial shares. The company
bundles the orders from members and makes bulk purchases once a
week. The commission to sell shares is $20. The following
"ShareBuilder" link will take you to their web site. If you use
the link and sign up with them, Chris Lott, the compiler of The
Investment FAQ, will earn a small commission. (referral)

* PortfolioBuilder lets you make unlimited automatic repeat purchases
of over 550 stocks. Your investments are made in dollar amounts,
not shares, allowing for the purchase of fractional shares. Fees
are $150 annually (unlimited purchases that year), or $15 monthly
(unlimited purchases that month), or just $3 for a single