The Investment FAQ (part 1 of 20)

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Christopher Lott

Mar 18, 2004, 4:16:16 AM3/18/04
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

The following terms and conditions apply to the plain-text version of
The Investment FAQ that is posted regularly to various newsgroups.
Different terms and conditions apply to documents on The Investment
FAQ web site.

The Investment FAQ is copyright 2003 by Christopher Lott, and is
protected by copyright as a collective work and/or compilation,
pursuant to U.S. copyright laws, international conventions, and other
copyright laws. The contents of The Investment FAQ are intended for
personal use, not for sale or other commercial redistribution.
The plain-text version of The Investment FAQ may be copied, stored,
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provided the following conditions are met:
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+ Proper attribution is given to the authors of individual articles.
+ This copyright notice is included intact.


Neither the compiler of nor contributors to The Investment FAQ make
any express or implied warranties (including, without limitation, any
warranty of merchantability or fitness for a particular purpose or
use) regarding the information supplied. The Investment FAQ is
provided to the user "as is". Neither the compiler nor contributors
warrant that The Investment FAQ will be error free. Neither the
compiler nor contributors will be liable to any user or anyone else
for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it. Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
information given in other answers. Readers outside the USA can reach
US-800 telephone numbers, for a charge, using a service such as MCI's
Call USA. All prices are listed in US dollars unless otherwise

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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

Mar 18, 2004, 4:16:16 AM3/18/04
Archive-name: investment-faq/general/part2
Version: $Id: part02,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 2 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: Advice - Beginning Investors

Last-Revised: 1 Aug 1998
Contributed-By: Steven Pearson, E. Green, Chris Lott ( contact me )

Investing is just one aspect of personal finance. People often seem to
have the itch to try their hand at investing before they get the rest of
their act together. This is a big mistake. For this reason, it's a
good idea for "new investors" to hit the library and read maybe three
different overall guides to personal finance - three for different
perspectives, and because common themes will emerge (repetition implies
authority?). Personal finance issues include making a budget, sticking
to a budget, saving money towards major purchases or retirement,
managing debt appropriately, insuring your property, etc. Appropriate
books that focus on personal finance include the following (the links
point to

* Janet Bamford et al.
The Consumer Reports Money Book: How to Get It, Save It, and Spend
It Wisely (3rd edn)
* Andrew Tobias
The Only Investment Guide You'll Ever Need
* Eric Tyson
Personal Finance for Dummies

Another great resource for learning about investing, insurance, stocks,
etc. is the Wall Street Journal's Section C front page. Beginners
should make a special effort to get the Friday edition of the WSJ
because a column named "Getting Going" usually appears on that day and
discusses issues in, well, getting going on investments. If you don't
want to spend the dollar or so for the WSJ, try your local library.

What I am specifically NOT talking about is most anything that appears
on a list of investing/stock market books that are posted in
misc.invest.* from time to time. This includes books like Market Logic,
One Up on Wall Street, Beating the Dow, Winning on Wall Street, The
Intelligent Investor, etc. These are not general enough. They are
investment books, not personal finance books.

Many "beginning investors" have no business investing in stocks. The
books recommended above give good overall money management, budgeting,
purchasing, insurance, taxes, estate issues, and investing backgrounds
from which to build a personal framework. Only after that should one
explore particular investments. If someone needs to unload some cash in
the meantime, they should put it in a money market fund, or yes, even a
bank account, until they complete their basic training.

While I sympathize with those who view this education as a daunting
task, I don't see any better answer. People who know next to nothing
and always depend on "professional advisors" to hand-hold them through
all transactions are simply sheep asking to be fleeced (they may not
actually be fleeced, but most of them will at least get their tails
bobbed). In the long run, an individual is the only person ultimately
responsible for his or her own financial situation.

Beginners may want to look further in The Investment FAQ for the
articles that discuss the basics of mutual funds , basics of stocks ,
and basics of bonds . For more in-depth material, browse the Investment
FAQ bookshelf with its recommended books about personal finance and

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

Subject: Advice - Buying a Car at a Reasonable Price

Last-Revised: 1 Aug 2001
Contributed-By: Kyle Busch (kbusch at

Before making a purchase, especially a large one, most buyers ponder an
equation that goes something like: What is it going to cost me, and will
that equal what I am going to get?

Consider that equation when buying your next vehicle. Naturally, you
want to get the most vehicle for the money you spend. Here are several
tips that will help you to get more for your money.

First, and foremost, consider eliminating some of the steep depreciation
cost incurred during the first three years of vehicle ownership by
purchasing a 2- to 3- year-old used vehicle.

The price can be further reduced by paying cash. However, if you need
to finance your next vehicle purchase, consider doing the following to
keep its cost closer to the "as if you were paying cash" figure.
* Take the time to carefully identify your current and your future
transportation needs, and choose an appropriate
vehicle.Transportation represents different things to different
people. For some drivers, it represents status in society. Other
drivers place greater emphasis on reliably just getting from point
A to points B and C. The more closely that you match your driving
needs with the vehicle you buy, the more driving pleasure you will
experience and the more likely you will want to hold on to the

If you can't fully identify your transportation needs or the
vehicle that can best satisfy them, consult the April issue of
Consumer Reports at a public library. The publication groups
vehicles into categories, provides frequency-of-repair information
for many vehicles, and gives vehicle price information. It is a
good idea to identify 2 or 3 vehicles in a particular category that
meet your transportation needs.This enables some latitude when
shopping for the vehicle. =

* Identify how much you can afford to spend per month on
transportation. A rule of thumb suggests that the cost to rent an
apartment per month should not be greater than 25 percent of your
monthly net pay.The cost of an auto loan should not exceed 10 to 12
percent of your monthly net pay. In some instances, leasing a
vehicle could be a better option than taking out a loan.

* The vehicle down payment should be the largest possible, and the
amount of money borrowed the lowest possible. In addition,
borrowing money for the shortest period of time (i.e., a 24-month
loan rather than a 48-month loan) will reduce the overall cost of
the loan.

* Identify the various loan sources such as banks, savings and loans,
credit unions, and national lenders (i.e., go online to ask and specify "automobile financing sources"). In regard
to national financing vs. local financing, it can be useful to
determine what the cost of a loan would be from the national
sources, but accept a loan from a local source if the loan cost is
comparable or nearly comparable between the two. Compare the APR
(annual percentage rate) that each of the sources will charge for
the loan. The cost of a loan is negotiable. Therefore, be certain
to inform each source what the others have to offer. In addition
to the loan's APR, remember to also compare the other costs
associated with a loan, such as loan insurance and loan processing

* Be certain to read and understand any fine print contained in the
loan contract. Insist that the loan contract gives you the option
of making payments early and that the payments will be applied on
the loan principle with no penalty or extra cost if you payoff the
loan early.

* Do not settle for a vehicle that does not entirely meet your
transportation needs because of low dealer or manufacturer
incentive financing.Sometimes dealers or manufactures offer
extremely low APR financing on vehicles that the dealer is having a
hard time selling. That's why it helps to have initially
identified the correct vehicle before encountering the sales
pitches and other influences of buying a vehicle. Kyle Busch is
the author of Drive the Best for the Price: How to Buy a Used
Automobile, Sport-Utility Vehicle, or Minivan and Save Money . To find
out more about the author and this book visit:

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

Subject: Advice - Errors in Investing

Last-Revised: 2 Aug 1999
Contributed-By: Chris Lott ( contact me ), Thomas Price (tprice at

The Wall Street Journal of June 18, 1991 had an article on pages C1/C10
on Investment Errors and how to avoid them. As summarized from that
article, the errors are:
* Not following an investment objective when you build a portfolio.
* Buying too many mutual funds.
* Not researching a one-product stock before you buy.
* Believing that you can pick market highs and lows (time the
* Taking profits early.
* Not cutting your losses.
* Buying the hottest {stock, mutual fund} from last year.

Here's a recent quote that underscores the last item. When asked
"What's the biggest mistake individual investors make?" on Wall $treet
Week, John Bogle, founder and senior chairman of Vanguard mutual funds,
said "Extrapolating the trend" or buying the hot stock.

On a final note, get this quote on market timing:

In the 1980s if you were out of the market on the ten best
trading days of the decade you missed one-third of the total

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

Subject: Advice - Using a Full-Service Broker

Last-Revised: 23 Mar 1998
Contributed-By: Bill Rini (bill at, Chris Lott ( contact
me )

There are several reasons to choose a full-service broker over a
discount or web broker. People use a full-service broker because they
may not want to do their own research, because they are only interested
in long-term investing, because they like to hear the broker's
investment ideas, etc. But another important reason is that not
everybody likes to trade. I may want retirement planning services from
my broker. I may want to buy 3 or 4 mutual funds and have my broker
worry about them. If my broker is a financial planner, perhaps I want
tax or estate advice on certain investment options. Maybe I'm saving
for my newborn child's education but I have no idea or desire to work
out a plan to make sure the money is there when she or he needs it.

A huge reason to stick with a full-service broker is access to initial
public offerings (IPOs). These are generally reserved for the very best
clients, where best is defined as "someone who generates lots of
revenue," so someone who trades just a few times a year doesn't have a
chance. But if you can afford to trade frequently at the full-service
commission rates, you may be favored with access to some great IPOs.

And the real big one for a lot of people is quite simply time . Full
service brokerage clients also tend to be higher net worth individuals
as well. If I'm a doctor or lawyer, I can probably make more money by
focusing on my business than spending it researching stocks. For many
people today, time is a more valuable commodity than money. In fact, it
doesn't even have to do with how wealthy you are. Americans, in
general, work some pretty insane hours. Spending time researching
stocks or staying up on the market is quality time not spent with
family, friends, or doing things that they enjoy. On the other hand
some people enjoy the market and for those people there are discount

The one thing that sort of scares me about the difference between full
service and discount brokers is that a pretty good chunk of discount
brokerage firm clients are not that educated about investing. They look
at a $20 commission (discount broker) and a $50 commission (full service
broker) and they decide they can't afford to invest with a full service
broker. Instead they plow their life savings into some wonder stock
they heard about from a friend (hey, it's only a $20 commission, why
not?) and lose a few hundred or thousand bucks when the investment goes
south. Not that a broker is going to pick winners 100% of the time but
at least the broker can guide or mentor a beginning investor until they
learn enough to know what to look for and what not to look for in a
stock. I look at the $30 difference in what the two types of brokerage
firms charge as the rebate for education and doing my own research. If
you're not going to educate yourself or do your own research, you don't
deserve the rebate.

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

Subject: Advice - Mutual-Fund Expenses

Last-Revised: 16 Feb 2003
Contributed-By: Austin Lemoine

This article discusses stealth erosion of wealth, more specifically how
mutual-fund expenses erode wealth accumulation.

Mutual fund expense ratios, and similar investment-related fees, can
seriously erode wealth accumulation over time. Those fees and expenses
are stealthy, and they go largely unnoticed by investors while steadily
diminishing the value of their investments in both up and down markets.

What you pay for investing in a mutual fund, exclusive of any sales
charges, is indicated by the "expense ratio" of the fund. The expense
ratio is the percentage of mutual fund assets paid for operating
expenses, management fees, administrative fees, and all other
asset-based costs incurred by the fund, except brokerage costs. Those
expenses are reflected in the fund's net asset value (NAV), and they are
not really visible to the fund investor. The reported net return equals
the fund's gross return minus its costs. (And expense ratios do not
account for every cost mutual fund investors bear: additional costs
include any sales charges, brokerage commissions paid by the fund and
other significant kinds of indirect trading costs.)

Mutual fund expense ratios range from less than 0.20 percent for
low-cost index funds to well over 2 percent for actively managed funds.
The average is 1.40 percent for the more than 14,000 stock and bond
mutual funds currently available, according to Morningstar. In dollar
terms, that's $14 a year in fees for each $1,000 of investment value; or
a net value of $986. That might not seem like a big deal, but over time
fees compound to erode investment value.

Let's say the gross return in real terms (after inflation) of a broadly
diversified stock mutual fund will be 7 percent a year, excluding
expenses. (The 7 percent figure is consistent with returns for the U.S.
stock market from 1802 through 2001, as reported in Jeremy Siegel's
book, Stocks for the Long Run, 3rd edition.) Say the fund has an expense
ratio of 1.25 percent. And say you invest $1,000 in the fund at the
start of every year. (The figure of $1,000 is arbitrary, and investment
values below can be extrapolated to any annual contribution amount.)

Compounding at 7 percent, your gross investment value would be $6,153
after 5 years; $14,783 after 10 years; $43,865 after 20 years; $101,073
after 30 years; and $213,609 after 40 years. But with a 1.25 percent
expense ratio, your investment compounds at 7.0 minus 1.25 or 5.75
percent, not 7 percent. So your investment would actually be worth
$5,931 after 5 years; $13,776 after 10 years; $37,871 after 20 years;
$80,015 after 30 years; and $153,727 after 40 years. Fund expenses
account for the difference in value over time, with greater expenses
(and/or lower returns) having a greater negative impact on net
investment value.

That 1.25 percent expense ratio consumes $222 (or 3.6 percent) of the
$6,153 gross value over 5 years; 6.8 percent of gross value over 10
years; 13.6 percent over 20 years; and 20.8 percent over 30 years. Over
40 years, the $59,882 of fund expenses devour 28.0 percent of the
$213,609 gross value. In other words, only 72.0 percent of gross
investment value is left after 40 years, a withering erosion of wealth.

By contrast, let's say there's a broad-based index fund with 7 percent
real return but a 0.25 percent expense ratio. Putting $1,000 at the
start of each year into that fund, the 0.25 percent expense ratio would
consume just 2.9 percent of gross investment value after 20 years. Over
40 years, index fund expenses would total $13,759, a modest 6.4 percent
of gross value; so that the fund would earn 93.6 percent of gross value.
With expenses included, investment value is 30 percent higher after 40
years with the lower cost fund. (Even lower expense ratios can be found
among lowest-cost index funds and broad-based exchange-traded funds.
And funds with higher expenses do not outperform comparable funds with
lower expenses.)

Over the next ten to twenty years, expense ratios and similar fees could
be a huge millstone on wealth accumulation and wealth preservation. To
see why, let's review what's happened since March 2000.

Like a massive hurricane, the stock market has inflicted damage on
almost every portfolio in its path. From the peak of March 2000 to the
lows of early October 2002, it's estimated that falling stock prices
wiped out over $7 trillion in market value. While the market has moved
off its lows, we hope the worst is over.

How long will the market take to "heal itself?" It could take a long
time. A growing consensus holds that stocks just won't deliver the
returns we grew accustomed to from 1984 to 1999. If history is a guide,
real stock returns could average 2 to 4 percent a year over the 10 to 20
years following March 2000.

If lower expectations for stock returns materialize, mutual fund fees
and expenses will have an even greater adverse impact on wealth
accumulation, and especially on wealth preservation and income security
at retirement.

Let's say you'll want $40,000 income from your 401(k) assets without
drawing down principal. If real investment return is 4 percent you'll
need $40,000 divided by 0.04 or $1 million principal. But if you're
paying 1 percent in fees your real return is 3 percent, so you'll need
$40,000 divided by 0.03 or $1.333 million principal; and if 2 percent,
$2 million. The arithmetic is brutal!

It's clear that mutual fund costs and similar fees can be detrimental to
investment values over time. Fund sales charges exacerbate the problem.
Consider investing in lower-cost funds wherever possible.

For more insights from Austin Lemoine, please visit the web site for
Austin Lemoine Capital Management:

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Subject: Advice - One-Line Wisdom

Last-Revised: 22 Aug 1993
Contributed-By: Maurice Suhre

This is a collection of one-line pieces of investment wisdom, with brief
explanations. Use and apply at your own risk or discretion. They are
not in any particular order.

Hang up on cold calls.
While it is theoretically possible that someone is going to offer
you the opportunity of a lifetime, it is more likely that it is
some sort of scam. Even if it is legitimate, the caller cannot
know your financial position, goals, risk tolerance, or any other
parameters which should be considered when selecting investments.
If you can't bear the thought of hanging up, ask for material to be
sent by mail.
Don't invest in anything you don't understand.
There were horror stories of people who had lost fortunes by being
short puts during the 87 crash. I imagine that they had no idea of
the risks they were taking. Also, all the complaints about penny
stocks, whether fraudulent or not, are partially a result of not
understanding the risks and mechanisms.
If it sounds too good to be true, it probably is [too good to be true].
Also stated as ``There ain't no such thing as a free lunch
(TANSTAAFL).'' Remember, every investment opportunity competes with
every other investment opportunity. If one seems wildly better
than the others, there are probably hidden risks or you don't
understand something.
If your only tool is a hammer, every problem looks like a nail.
Someone (possibly a financial planner) with a very limited
selection of products will naturally try to jam you into those
which s/he sells. These may be less suitable than other products
not carried.
Don't rush into an investment.
If someone tells you that the opportunity is closing, filling up
fast, or in any other way suggests a time pressure, be very leery.
Very low priced stocks require special treatment.
Risks are substantial, bid/asked spreads are large, prices are
volatile, and commissions are relatively high. You need a broker
who knows how to purchase these stocks and dicker for a good price.

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Subject: Advice - Paying for Investment Advice

Last-Revised: 25 Apr 1997
Contributed-By: Chris Lott ( contact me )

I'm no expert, but there's a simple rule that you should use to evaluate
all advice that is offered to you, especially advice for which someone
who doesn't know you is asking significant sums of money. Ask yourself
why the person is selling or giving it to you. If it sounds like a sure
ticket to riches, then why is the person wasting their time on YOU when
they could be out there making piles of dough?

Of course I'm offering advice here in this article, so let's turn the
tables on me right now. What's in it for me? Well, if you're reading
this article from my web site, look up at the top of the page. If you
have images turned on, you'll see a banner ad. I get a tiny payment
each time a person loads one of my pages with an ad. So my motivation
is to provide informative articles in order to lure visitors to the
site. Of course if you're reading this from the plain-text version of
the FAQ, you won't see any ads, but please do stop by the site sometime!

So if someone promises you advice that will yield 10-20% monthly
returns, perhaps at a price of some $3,000, you should immediately get
suspicious. If this were really true - i.e., if you pay for the advice
you'll immediately start getting these returns - you would be making
over 300% annually (compounded). Hey, that would sure be great, I
wouldn't have a day job anymore. And if it were true, wouldn't you
think that the person trying to sell it to you would forget all about
selling and just watch his or her money triple every year? But they're
not doing that, which should give you a pretty good idea about where the
money's being made, namely from you .

I'm not trying to say that you should never pay for advice, just that
you should not overpay for advice. Some advice, especially the sort
that comes from $15 books on personal finance and investments can easily
be worth ten times that sum. Advice from your CPA or tax advisor will
probably cost you a 3 or even 4-digit figure, but since it's specialized
to your case and comes from a professional, that's probably money well

It seems appropriate to close this article with a quote that I learned
from Robert Heinlein books, but it's probably older than that:

TANSTAAFL - there ain't no such thing as a free lunch.

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Subject: Advice - Researching a Company

Last-Revised: 3 Jun 1997
Contributed-By: George Regnery (regnery at

This article gives a basic idea of some steps that you might take to
research a company. Many sites on the web will help you in your quest
for information, and this article gives a few of them. You might look
for the following.
1. What multiple of earnings is the company trading at versus other
companies in the industry? The site does
this comparison reasonably well, and they base it on forward
earnings instead of historical earnings, which is also good.
2. Is the stock near a high or low, and how has it done recently.
This is usually considered technical analysis. More sophisticated
(or at least more complicated) studies can also be performed.
There are several sites that will give you historical graphs; one
is Yahoo.
3. When compared with other companies in the industry, how much times
the book value or times sales is the company trading? For this
information, the site is a good place to
4. Does the company have good products, good management, good future
prospects? Are they being sued? Do they have patents? What's the
competition like? Do they have long term contracts established? Is
their brand name recognized? Depending on the industry, some or all
of these questions may be relevant. There isn't a simple web site
for this information, of course. The Hoover's profiles have some
limited information to at least let you get a feel for the basics
of the company. And the SEC has lots of information in their Edgar
5. Management. Does the company have competent people running it? The
backgrounds of the directors can be found in proxy statements
(14As) in the Edgar database. Note that proxies are written by the
companies, though. Another thing I would suggest looking at is the
compensation structure of the CEO and other top management. Don't
worry so much about the raw figure of how they are paid -- instead,
look to see how that compensation is structured. If the management
gets a big base but bonuses are a small portion, look carefully at
the company. For some industries, like electric utilities, this is
OK, because the management isn't going to make a huge difference
(utilities are highly regulated, and thus the management is
preventing from making a lot of decisions). However, in a high
tech industry, or many other industries, watch your step if the
mgmt. gets a big base and the bonus is insignificant. This means
that they won't be any better off financially if the company makes
a lot of profits vs. no profits (unless, of course, they own a lot
of stock). This information is all in the Proxies at the SEC.
Also check to see if the company has a shareholder rights plan,
because if they do, the management likely doesn't give a damn about
shareholder rights, but rather cares about their own jobs. (These
plans are commonly used to defend against unfriendly takeovers and
therefore provide a safety blanket for management.) These
suggestions should get you started. Also check the article elsewhere in
this FAQ on free information sources for more resources away from the

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Subject: Advice - Target Stock Prices

Last-Revised: 25 Jun 2000
Contributed-By: Uncle Arnie (blash404 at

A target price for a stock is a figure published by a securities
industry person, usually an analyst. The idea is that the target price
is a prediction, a guess about where the stock is headed. Target prices
usually are associated with a date by which the stock is expected to hit
the target. With that explanation out of the way..

Why do people suddenly think that the term du jour "target price" has
any meaning?? Consider the sources of these numbers. They're ALWAYS
issued by someone who has a vested interest in the issue: It could be an
analyst whose firm was the underwriter, it could be an analyst whose
firm is brown-nosing the company, it could be a firm with a large
position in the stock, it could be an individual trying to talk the
stock up so he can get out even, or it could be the "pump" segment of a
pump-and-dump operation. There is also a chance that the analyst has no
agenda and honestly thinks the stock price is really going places. But
in all too many cases it's nothing more than wishful guesswork (unless
they have a crystal ball that works), so the advice here: ignore target
prices, especially ones for internet companies.

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Subject: Analysis - Amortization Tables

Last-Revised: 16 Feb 2003
Contributed-By: Hugh Chou

This article presents the formula for computing monthly payments on
loans. A listing of thed full series of payments (principal and
interest) that show how a loan is paid off is known as a loan
amortization table. This article will explain how these tables are
generated for the U.S. system in which interest is compounded monthly.

First you must define some variables to make it easier to set up:

P = principal, the initial amount of the loan
I = the annual interest rate (from 1 to 100 percent)
L = length, the length (in years) of the loan, or at least the length
over which the loan is amortized.

The following assumes a typical conventional loan where the interest is
compounded monthly. First I will define two more variables to make the
calculations easier:

J = monthly interest in decimal form = I / (12 x 100)
N = number of months over which loan is amortized = L x 12

Okay now for the big monthly payment (M) formula, it is:
M = P x ------------------------

1 - ( 1 + J ) ^ -N
where 1 is the number one (it does not appear too clearly on some

So to calculate it, you would first calculate 1 + J then take that to
the -N (minus N) power, subtract that from the number 1. Now take the
inverse of that (if you have a 1/X button on your calculator push that).
Then multiply the result times J and then times P. Sorry for the long
way of explaining it, but I just wanted to be clear for everybody.

The one-liner for a program would be (adjust for your favorite
M = P * ( J / (1 - (1 + J) ** -N))
So now you should be able to calculate the monthly payment, M. To
calculate the amortization table you need to do some iteration (i.e. a
simple loop). I will tell you the simple steps :

1. Calculate H = P x J, this is your current monthly interest
2. Calculate C = M - H, this is your monthly payment minus your
monthly interest, so it is the amount of principal you pay for that
3. Calculate Q = P - C, this is the new balance of your principal of
your loan.
4. Set P equal to Q and go back to Step 1: You thusly loop around
until the value Q (and hence P) goes to zero. Programmers will see
how this makes a trivial little loop to code, but I have found that many
people now surfing on the Internet are NOT programmers and still want to
calculate their mortgages!

Note that just about every PC or Mac has a spreadsheet of some sort on
it, and they are very good tools for doing mortgage analysis. Most of
them have a built-in PMT type function that will calculate your monthly
payment given a loan balance, interest rate, and the number of terms.
Check the help text for your spreadsheet.

Please visit Hugh Chou's web site for a calculator that will generate
amortization tables according to the forumlas discussed here. He also
offers many other calculators:

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Subject: Analysis - Annual Reports

Last-Revised: 31 Oct 1995
Contributed-By: Jerry Bailey, Chris Lott ( contact me )

The June 1994 Issue of "Better Investing" magazine, page 26 has a
three-page article about reading and understanding company annual
reports. I will paraphrase:

1. Start with the notes and read from back to front since the front is
management fluff.
2. Look for litigation that could obliterate equity, a pension plan in
sad shape, or accounting changes that inflated earnings.
3. Use it to evaluate management. I only read the boring things of
the companies I am holding for long term growth. If I am planning
a quick in and out, such as buying depressed stocks like BBA, CML,
CLE, etc.), I don't waste my time.
4. Look for notes to offer relevant details; not "selected" and
"certain" assets. Revenue and operating profits of operating
divisions, geographical divisions, etc.
5. How the company keeps its books, especially as compared to other
companies in its industry.
6. Inventory. Did it go down because of a different accounting
7. What assets does the company own and what assets are leased?

If you do much of this, I really recommend just reading the article.

The following list of resources may also help.
* John A. Tracy has written an an easy-to-read and informative book
named How to Read a Financial Report (4th edn., Wiley, 1993). This
book should give you a good start. You won't become a graduate
student in finance by reading it, but it will certainly help you
grasp the nuts and bolts of annual reports.
* ABC News offers the following article:
* IBM offers a web site with much information about understanding
financial reports:

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Subject: Analysis - Beta and Alpha

Last-Revised: 22 Oct 1997
Contributed-By: Ajay Shah ( ), R. Shukla
(rkshukla at, Bob Pierce (rbp at

Beta is the sensitivity of a stock's returns to the returns on some
market index (e.g., S&P 500). Beta values can be roughly characterized
as follows:

* b less than 0
Negative beta is possible but not likely. People thought gold
stocks should have negative betas but that hasn't been true.
* b equal to 0
Cash under your mattress, assuming no inflation
* beta between 0 and 1
Low-volatility investments (e.g., utility stocks)
* b equal to 1
Matching the index (e.g., for the S&P 500, an index fund)
* b greater than 1
Anything more volatile than the index (e.g., small cap. funds)
* b much greater than 1 (tending toward infinity)
Impossible, because the stock would be expected to go to zero on
any market decline. 2-3 is probably as high as you will get.

More interesting is the idea that securities MAY have different betas in
up and down markets. Forbes used to (and may still) rate mutual funds
for bull and bear market performance.

Alpha is a measure of residual risk (sometimes called "selecting risk")
of an investment relative to some market index. For all the gory
details on Alpha, please see a book on technical analysis.

Here is an example showing the inner details of the beta calculation

Suppose we collected end-of-the-month prices and any dividends for a
stock and the S&P 500 index for 61 months (0..60). We need n + 1 price
observations to calculate n holding period returns, so since we would
like to index the returns as 1..60, the prices are indexed 0..60. Also,
professional beta services use monthly data over a five year period.

Now, calculate monthly holding period returns using the prices and
dividends. For example, the return for month 2 will be calculated as:
r_2 = ( p_2 - p_1 + d_2 ) / p_1
Here r denotes return, p denotes price, and d denotes dividend. The
following table of monthly data may help in visualizing the process.
(Monthly data is preferred in the profession because investors' horizons
are said to be monthly.)

Nr. Date Price Div.(*) Return
0 12/31/86 45.20 0.00 --
1 01/31/87 47.00 0.00 0.0398
2 02/28/87 46.75 0.30 0.0011
. ... ... ... ...
59 11/30/91 46.75 0.30 0.0011
60 12/31/91 48.00 0.00 0.0267
(*) Dividend refers to the dividend paid during the period. They are
assumed to be paid on the date. For example, the dividend of 0.30 could
have been paid between 02/01/87 and 02/28/87, but is assumed to be paid
on 02/28/87.

So now we'll have a series of 60 returns on the stock and the index
(1...61). Plot the returns on a graph and fit the best-fit line
(visually or using some least squares process):

| * /
stock | * * */ *
returns| * * / *
| * / *
| * /* * *
| / * *
| / *
+------------------------- index returns

The slope of the line is Beta. Merrill Lynch, Wells Fargo, and others
use a very similar process (they differ in which index they use and in
some econometric nuances).

Now what does Beta mean? A lot of disservice has been done to Beta in
the popular press because of trying to simplify the concept. A beta of
1.5 does not mean that is the market goes up by 10 points, the stock
will go up by 15 points. It doesn't even mean that if the market has a
return (over some period, say a month) of 2%, the stock will have a
return of 3%. To understand Beta, look at the equation of the line we
just fitted:

stock return = alpha + beta * index return

Technically speaking, alpha is the intercept in the estimation model.
It is expected to be equal to risk-free rate times (1 - beta). But it
is best ignored by most people. In another (very similar equation) the
intercept, which is also called alpha, is a measure of superior

Therefore, by computing the derivative, we can write:
Change in stock return = beta * change in index return

So, truly and technically speaking, if the market return is 2% above its
mean, the stock return would be 3% above its mean, if the stock beta is

One shot at interpreting beta is the following. On a day the (S&P-type)
market index goes up by 1%, a stock with beta of 1.5 will go up by 1.5%
+ epsilon. Thus it won't go up by exactly 1.5%, but by something

The good thing is that the epsilon values for different stocks are
guaranteed to be uncorrelated with each other. Hence in a diversified
portfolio, you can expect all the epsilons (of different stocks) to
cancel out. Thus if you hold a diversified portfolio, the beta of a
stock characterizes that stock's response to fluctuations in the market

So in a diversified portfolio, the beta of stock X is a good summary of
its risk properties with respect to the "systematic risk", which is
fluctuations in the market index. A stock with high beta responds
strongly to variations in the market, and a stock with low beta is
relatively insensitive to variations in the market.

E.g. if you had a portfolio of beta 1.2, and decided to add a stock
with beta 1.5, then you know that you are slightly increasing the
riskiness (and average return) of your portfolio. This conclusion is
reached by merely comparing two numbers (1.2 and 1.5). That parsimony
of computation is the major contribution of the notion of "beta".
Conversely if you got cold feet about the variability of your beta = 1.2
portfolio, you could augment it with a few companies with beta less than

If you had wished to figure such conclusions without the notion of beta,
you would have had to deal with large covariance matrices and nontrivial

Finally, a reference. See Malkiel, A Random Walk Down Wall Street , for
more information on beta as an estimate of risk.

Here are a few links that offer information about beta.
* Barra Inc. offers historical and predicted beta values for stocks
that make up the major indexes. Visit this URL:
* For a brief discussion of using Beta and Alpha values to pick
stocks, visit this URL:

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Subject: Analysis - Book-to-Bill Ratio

Last-Revised: 19 Aug 1993
Contributed-By: Timothy May

The book-to-bill ration is the ratio of business "booked" (orders taken)
to business "billed" (products shipped and bills sent).

A book-to-bill of 1.0 implies incoming business = outgoing product.
Often in downturns, the b-t-b drops to 0.9, sometimes even lower. A
b-t-b of 1.1 or higher is very encouraging.

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

Subject: Analysis - Book Value

Last-Revised: 23 Mar 1998
Contributed-By: Art Kamlet (artkamlet at

In simplest terms, Book Value is Assets less Liabilities.

The problem is Assets includes, as stated, existing land & buildings,
inventory, cash in the bank, etc. held by the company.

The problem in assuming you can sell off these assets and receive their
listed value is that such values are accounting numbers, but otherwise
pretty unrealistic.

Consider a company owning a 40 year old building in downtown Chicago.
That building might have been depreciated fully and is carried on the
books for $0, while having a resale value of millions. The book value
grossly understates the sell-off value of the company.

On the other hand, consider a fast-changing industry with 4-year-old
computer equipment which has a few more years to go before being fully
depreciated, but that equipment couldn't be sold for even 10 cents on
the dollar. Here the book value overstates the sell-off value.

So consider book value to be assets less liabilities, which are just
numbers, not real items. If you want to know how much a company should
be sold off for, hire a good investment banker, which is often done on
take-over bids.

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Subject: Analysis - Computing Compound Return

Last-Revised: 30 Dec 1995
Contributed-By: Paul Randolph (paulr22 at juno dot com)

To calculate the compounded return on an investment, just figure out the
factor by which the original investment multiplied. For example, if
$1000 became $3200 in 10 years, then the multiplying factor is 3200/1000
or 3.2. Now take the 10th root of 3.2 (the multiplying factor) and you
get a compounded return of 1.1233498 (12.3% per year). To see that this
works, note that 1.1233498 ** 10 = 3.2 (i.e., 1.233498 raised to the
10th power equals 3.2).

Here is another way of saying the same thing. This calculation assumes
that all gains are reinvested, so the following formula applies:
TR = (1 + AR) ** YR
where TR is total return (present value/initial value), AR is the
compound annualized return, and YR is years. The symbol '**' is used to
denote exponentiation (2 ** 3 = 8).

To calculate annualized return, the following formula applies:
AR = (TR ** (1/YR)) - 1
Thus a total return of 950% in 20 years would be equivalent to an
annualized return of 11.914454%. Note that the 950% includes your
initial investment of 100% (by definition) plus a gain of 850%.

For those of you using spreadsheets such as Excel, you would use the
following formula to compute AR for the example discussed above (the
common computer symbol used to denote exponentiation is the caret or hat
on top of the 6).
= TR ^ (1 / YR) - 1
where TR = 9.5 and YR = 20. If you want to be creative and have AR
recalculated every time you open your file, you can substitute something
like the following for YR:
( (*cell* - TODAY() ) / 365)
Of course you will have to replace '*cell*' by the appropriate address
of the cell that contains the date on which you bought the security.

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Subject: Analysis - Future and Present Value of Money

Last-Revised: 28 Jan 1994
Contributed-By: Chris Lott ( contact me )

This note explains briefly two concepts concerning the
time-value-of-money, namely future and present value. Careful
application of these concepts will help you evaluate investment
opportunities such as real estate, life insurance, and many others.

Future Value
Future value is simply the sum to which a dollar amount invested today
will grow given some appreciation rate.

To compute the future value of a sum invested today, the formula for
interest that is compounded monthly is:
fv = principal * [ (1 + rrate/12) ** (12 * termy) ]

fv = future value
principal = dollar value you have now
termy = term, in years
rrate = annual rate of return in decimal (i.e., use .05 for

Note that the symbol '**' is used to denote exponentiation (2 ** 3 = 8).

For interest that is compounded annually, use the formula:
fv = principal * [ (1 + rrate) ** (termy) ]


I invest 1,000 today at 10% for 10 years compounded monthly.
The future value of this amount is 2707.04.

Note that the formula for future value is the formula from Case 1 of
present value (below), but solved for the future-sum rather than the
present value.

Present Value
Present value is the value in today's dollars assigned to an amount of
money in the future, based on some estimate rate-of-return over the
long-term. In this analysis, rate-of-return is calculated based on
monthly compounding.

Two cases of present value are discussed next. Case 1 involves a single
sum that stays invested over time. Case 2 involves a cash stream that
is paid regularly over time (e.g., rent payments), and requires that you
also calculate the effects of inflation.

Case 1a: Present value of money invested over time.
This tells you what a future sum is worth today, given some rate of
return over the time between now and the future. Another way to
read this is that you must invest the present value today at the
rate-of-return to have some future sum in some years from now (but
this only considers the raw dollars, not the purchasing power).

To compute the present value of an invested sum, the formula for
interest that is compounded monthly is:
pv = ------------------------------
(1 + rrate/12) ** (12 * termy)

* future-sum = dollar value you want to have in termy
* termy = term, in years
* rrate = annual rate of return that you can expect,
in decimal


I need to have 10,000 in 5 years. The present value of
10,000 assuming an 8% monthly compounded rate-of-return
is 6712.10. I.e., 6712 will grow to 10k in 5 years at

Case 1b: Effects of inflation
This formulation can also be used to estimate the effects of
inflation; i.e., compute the real purchasing power of present and
future sums. Simply use an estimated rate of inflation instead of
a rate of return for the rrate variable in the equation.


In 30 years I will receive 1,000,000 (a megabuck). What
is that amount of money worth today (what is the buying
power), assuming a rate of inflation of 4.5%? The answer
is 259,895.65

Case 2: Present value of a cash stream.
This tells you the cost in today's dollars of money that you pay
over time. Usually the payments that you make increase over the
term. Basically, the money you pay in 10 years is worth less than
that which you pay tomorrow, and this equation lets you compute
just how much less.

In this analysis, inflation is compounded yearly. A reasonable
estimate for long-term inflation is 4.5%, but inflation has
historically varied tremendously by country and time period.

To compute the present value of a cash stream, the formula is:
month=12 * termy paymt * (1 + irate) ** int ((month - 1)/
pv = SUM
month=1 (1 + rrate/12) ** (month - 1)

* pv = present value
* SUM (a.k.a. sigma) means to sum the terms on the
right-hand side over the range of the variable
'month'; i.e., compute the expression for month=1,
then for month=2, and so on then add them all up
* month = month number
* int() = the integral part of the number; i.e., round
to the closest whole number; this is used to compute
the year number from the month number
* termy = term, in years
* paymt = monthly payment, in dollars
* irate = rate of inflation (increase in
payment/year), in decimal
* rrate = rate of return on money that you can expect,
in decimal


You pay $500/month in rent over 10 years and estimate
that inflation is 4.5% over the period (your payment
increases with inflation.) Present value is 49,530.57

Two small C programs for computing future and present value are
available. See the article Software - Archive of Investment-Related
Programs in this FAQ for more information.

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

Subject: Analysis - Goodwill

Last-Revised: 18 Jul 1993
Contributed-By: John Keefe

Goodwill is an asset that is created when one company acquires another.
It represents the difference between the price the acquiror pays and the
"fair market value" of the acquired company's assets. For example, if
JerryCo bought Ford Motor for $15 billion, and the accountants
determined that Ford's assets (plant and equipment) were worth $13
billion, $2 billion of the purchase price would be allocated to goodwill
on the balance sheet. In theory the goodwill is the value of the
acquired company over and above the hard assets, and it is usually
thought to represent the value of the acquired company's "franchise,"
that is, the loyalty of its customers, the expertise of its employees;
namely, the intangible factors that make people do business with the

What is the effect on book value? Well, book value usually tries to
measure the liquidation value of a company -- what you could sell it for
in a hurry. The accountants look only at the fair market value of the
hard assets, thus goodwill is usually deducted from total assets when
book value is calculated.

For most companies in most industries, book value is next to
meaningless, because assets like plant and equipment are on the books at
their old historical costs, rather than current values. But since it's
an easy number to calculate, and easy to understand, lots of investors
(both professional and amateur) use it in deciding when to buy and sell

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

Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Mar 18, 2004, 4:16:18 AM3/18/04
Archive-name: investment-faq/general/part4
Version: $Id: part04,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 4 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: Bonds - Municipal Bond Terminology

Last-Revised: 7 Nov 1995

Contributed-By: Bill Rini (bill at

These definitions of municipal bond terminology are at best
simplifications. They should only be used as a stepping stone, leading
to further education about municipal bonds.

Act of 1911 and 1915
Used for developments within a particular district and are secured
by special assessment taxes set at a fixed dollar amount for the
life of the bond. 1911 Act Bonds are secured by individual
parcels, while 1915 Act Bonds are secured by all properties within
the district.
Ad Valorem Tax
A tax based on the value of the property
Advance Refunding
The replacement of debt prior to the original call date via the
issuance of refunding bonds.
Authority (Lease Revenue)
A bond secured by the lease between the authority and another
agency. The lease payments from the "city" to the agency are equal
to the debt service.
Callable Bond
A bond that can be redeemed by the issuer prior to its maturity.
Usually a premium is paid to the bond owner when the bond is
Certificate of Participation (COP)
Financing whereby an investor purchases a share of the lease
revenues of a program rather than the bond being secured by those
revenues. Usually issued by authorities through which capital is
raised and lease payments are made. The authority usually uses the
proceeds to construct a facility that is leased to the
municipality, releasing the municipality from restrictions on the
amount of debt that they can incur.
Crossover Refunded
The revenue stream originally pledged to secure the securities
being refunded continues to be used to pay debt service on the
refunded securities until they mature or are called. At that time,
the pledged revenues pay debt service on the refunding securities.
Discount Bond
A bond that is valued at less than its face amount.
Double Barrelled
Bonds secured by the pledge of two or more sources of repayment.
Face Value
The stated principal amount of a bond.
General Obligations
Voter approved bonds that are backed by the full faith, credit and
unlimited taxing power of the issuer.
Mello Roo's
Bonds used for developments that benefit a particular district
(schools, prisons, etc.) and are secured by special taxes based on
the assessed value of the properties within the district. Tax
assessment is included on the county tax bill.
Par Value
The face value of a bond, generally $1,000.
Premium Bond
A bond that is valued at more than its face amount.
The amount owed; the face value of a debt.
Redevelopment Agency (Tax Allocation)
Bonds secured by all of the property taxes on the increase in
assessed valuation above the base, on properties in the project.
Revenue Bonds
Bonds secured by the revenues derived from a particular service
provided by the issuer.
Sinking Fund
A bond with special funds set aside to retire the term bonds of a
revenue issue each year according to a set schedule. Usually takes
effect 15 years from date of issuance. Bonds are retired through
either calls, open market purchases, or tenders.
Taxable Equivalent Yield
The taxable equivalent yield is equal to the tax free yield divided
by the sum of 100 minus the current tax bracket. For example the
taxable equivalent yield of a 6.50% tax free bond for someone in
the 32% tax bracket would be:
6.5/(100-32) = 0.0955882 or 9.56%
YieldA measure of the income generated by a bond. The amount of
interest paid on a bond divided by the price.
Yield to Maturity
The rate of return anticipated on a bond if it is held until the
maturity date.

This article is copyright 1995 by Bill Rini. For more insights from
Bill Rini, visit The Syndicate:

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

Subject: Bonds - Relationship of Price and Interest Rate

Last-Revised: 28 Oct 1997
Contributed-By: Rich Carreiro (rlcarr at, Chris

Lott ( contact me )

The basic relationship between the price of a bond and prevailing market
interest rates is an inverse relationship. This is actually pretty
straightforward. For example, if you have a 6% bond (this means that it
pays $60 annually per $1000 of face value) and interest rates jump to
8%, wouldn't you agree that your bond should be worth less now if you
were to sell it?

If this isn't clear, think about it this way. If the rate of interest
being paid on newly issued bonds stands at 8%, a bond buyer would get
paid $80 annually for each $1,000 investment in one of those bonds. If
that bond buyer instead bought your old 6% bond for the price you
originally paid, that bond would yield $20 less per year when compared
to bonds on the market. Clearly that's not a very attractive offer for
the buyer (although it would be a great deal for you).

To quantify the inverse relationship between the price and the interest
rate, you really need the concept of the present value of money (also
see the article elsewhere in the FAQ on this topic). Computing present
value figures helps you answer questions like "what's better, $95 today
or $100 one year from now?" The beginnings of it go something like this.

Pretend that you have $100. Also pretend that you can invest it in
something that will pay a 5% annual return. So, one year from now you

$100 * (1 + 0.05) = $105

This can be turned around. Let's say that you want to know how much
money you need to have today in order to have $200 a year from now, if
you can earn 5%:

X * (1 + 0.05) = $200 or X = $200/(1 + 0.05) = $190.48

Therefore, we can say that the present value of $200 one year from now,
assuming a "discount rate" (this is what the assumed interest rate in a
present-value calculation is called) of 5% is $190.48.

But what if you wanted to know how much you needed today to have $200
two years from now, again assuming you could earn 5%? Here's the

[ X * (1 + 0.05) ] * (1 + 1.05) = $200

X represents the original amount, and the quantity "X * (1 + 0.05)"
represents the amount after 1 year. Solving for X we get:

X = 200/(1 + 1.05)^2 = $181.41

So, the present value of $200 two years hence, at a discount rate of 5%
is $181.41. It should be clear that the present value of $200 N years
from now at a discount rate of 5% is:

PV = 200/(1 + 0.05)^N

And this can be generalized to the present value of an amount C, N years
from now, at a discount rate of r:

PV = C/(1 + r)^N

Now you can combine these. Let's say I promise to pay you $300 a year
from today and $500 two years from today. What could I have paid you
today that would have made you just as happy as what I promised? Assume
you can earn 7% on your money. To solve this, just sum the present
value of each payment. This sum is called the "net present value" (NPV)
of a series of cash flows.

NPV = $300/(1+0.07) + $500/(1+0.07)^2 = $717.09

So, given the 7% discount rate, the payments I scheduled are equivalent
to a payment of $717.09 made today.

Let's get a little fancier. What if I'm willing to promise to pay you
$50 per year for 4 years, starting a year from now, and further promise
to pay you $1000 five years from now. What's the most you'd be willing
to pay me now to make you that promise. Assume a discount rate of 6%.

NPV = $50/(1+0.06) + $50/(1+0.06)^2 + $50/(1+0.06)^3 +
$50/(1+0.06)^4 + $1000/(1+0.06)^5 = $920.51

Let's say you want to wait until tomorrow. You have a dream that night
that makes you believe that you'll now be able to earn 10% on your
money. When I come back to you, you now tell me you'll only pay me

NPV = $50/(1 + 0.10) + $50/1.1^2 + $50/1.1^3 + $50/1.1^4 +
$1000/1.1^5 = $779.41

My promise is now worth quite a bit less. You should be able to see
that if your dream had led you to believe you could earn less on your
money, then my promise would have been worth more to you than it did

At this point, it's probably clear that my "promise" is effectively what
a bond is -- I'm agreeing to pay you a fixed amount each year (actually,
the bond would pay half that fixed amount twice a year) and then the
principal amount at maturity. Given what you think you can earn on your
money, the price you should pay for the bond is well-defined. The
question is what affects what you think you'll be able to earn on your
money? Fed policy might. What you think the chances of inflation are
might. Lots of other things might. This is where the fun starts. :-)

Also note that you can turn the equation around. Let's say that you
have a $1000 bond paying $75 per year. The bond matures in 10 years.
Someone is willing to sell it to you for $850. What will I have earned
on my investment? The net present value equation always holds, so $850
equals the net present value of the yearly payments and principal

Obviously, since we know everything except the discount rate, this
equation must define the discount rate that makes it true. The problem
is that the rate cannot be simply calculated. You must make a guess,
compute the net present value, see how different it is from $850, use
that to adjust your guess, and try again until the sides of the equation
balance. The discount rate you come up with is called the "internal
rate of return" (IRR) and in the bond world is called the "yield to
maturity" (YTM). In fact, if you know the initial value of some
portfolio, all cash flows into and out of the portfolio, and the final
value of the portfolio, you can compute your IRR, thus answering the
common misc.invest.* question of "I put $N into a fund on date X, but
then added $D on date Y and $F on date W. My account is today worth $B.
What's my return?"

As a final note, here's a bit of a stumper to spring on someone:
Assuming you could earn 5% on your money, would you rather be paid $1000
annually (first payment is today, next is a year from now, etc.) forever
(assume you are immortal :-) or $25000 today? Believe it or not, you
should take the $25000 today. Here's the analysis why.

NPV = $1000 + $1000/1.05 + $1000/1.05^2 ...
NPV = $1000*(1 + 1/1.05 + 1/1.05^2 + ...)

A math reference book can tell you (or you might remember or derive it)
that the infinite sum:

1 + x + x^2 + x^3 + ... = 1/(1 - x) if |x| < 1

In this case, x = 1/1.05, so

NPV = $1000*[1/(1 - 1/1.05)] = $21000

So believe it or not, you'd be better off taking $25000 today then
taking $1000 per year forever, given the 5% discount rate assumption.

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

Subject: Bonds - Tranches

Last-Revised: 22 Oct 1997
Contributed-By: (anonymous), Chris Lott ( contact me )

A 'tranche' (derived from the French for 'slice') is used in finance to
define part of an asset that is divided (sliced, hence the term) into
smaller pieces. A common example is a mortgage-backed security. One
bank may only be interested in the payments at the longer end of the
security's maturity, while another investment firm may want only the
cash flows due in the near term. An investment bank can split the
original asset into 'tranches' where each party (the bank and the
investment firm) receive rights to the expected cash payments for
particular periods. The two new assets are repriced, and the investment
bank usually makes a tidy profit. This can be done with many assets,
the goal being better marketablity of typically larger assets. If you
want more information on how this is used in specific, I would think
there would be data on the debt of less developed countries that has
been consolidated, then sold in 'tranches' to investors in the developed
worlds. The London Club is a group of commercial creditors which holds
claim on the debt of Russia, for example.

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

Subject: Bonds - Treasury Debt Instruments

Last-Revised: 1 Jan 2002
Contributed-By: Art Kamlet (artkamlet at, Dave Barrett, Rich
Carreiro (rlcarr at

The US Treasury Department periodically borrows money and issues IOUs in
the form of bills, notes, or bonds ("Treasuries"). The differences are
in their maturities and denominations:

Bill Note Bond
Maturity up to 1 year 1--10 years 10--30/40 years
Denomination $1,000 $1,000 $1,000
Minimum purchase $1,000 $1,000 $1,000

Treasuries are auctioned. Short term T-bills are auctioned every
Monday. The 4-week bill is auctioned every Tuesday. Longer term bills,
notes, and bonds are auctioned at other intervals.

T-Notes and Bonds pay a stated interest rate semi-annually, and are
redeemed at face value at maturity. Exception: Some 30 year and longer
bonds may be called (redeemed) at 25 years.

T-bills work a bit differently. They are sold on a "discounted basis."
This means you pay, say, $9,700 for a 1-year T-bill. At maturity the
Treasury will pay you (via electronic transfer to your designated bank
checking account) $10,000. The $300 discount is the "interest." In this
example, you receive a return of $300 on a $9,700 investment, which is a
simple rate of slightly more than 3%.

The best way for an individual to buy or sell Treasury instruments is
via the US Treasury's "TreasuryDirect" program, which provides for
no-fee/low-fee transactions. Please see the article elsewhere in this
FAQ for more information about using the TreasuryDirect program. Of
course treasuries can also be bought and sold through a bank or broker,
but you will usually have to pay a fee or commission to do this, not to
mention maintain an account.

Treasuries are negotiable. If you own Treasuries you can sell them at
any time and there is a ready market. The sale price depends on market
interest rates. Since they are fully negotiable, you may also pledge
them as collateral for loans. (Note that if the securities are held by
the Treasury as part of their TreasuryDirect service, then they cannot
be used as collateral.)

Treasury bills, notes, and bonds are the standard for safety. By
definition, everything is relative to Treasuries; there is no safer
investment in the U.S. They are backed by the "Full Faith and Credit"
of the United States.

Interest on Treasuries is taxable by the Federal Government in the year
paid. States and local municipalities do not tax Treasury interest
income. T-bill interest is recognized at maturity, so they offer a way
to move income from one year to the next.

The US Treasury also issues Zero Coupon Bonds. The ``Separate Trading
of Registered Interest and Principal of Securities'' (a.k.a. STRIPS)
program was introduced in February 1986. All new T-Bonds and T-notes
with maturities greater than 10 years are eligible. As of 1987, the
securities clear through the Federal Reserve's books entry system. As
of December 1988, 65% of the ZERO-COUPON Treasury market consisted of
those created under the STRIPS program.

However, the US Treasury did not always issue Zero Coupon Bonds.
Between 1982 and 1986, a number of enterprising companies and funds
purchased Treasuries, stripped off the ``coupon'' (an anachronism from
the days when new bonds had coupons attached to them) and sold the
coupons for income and the non-coupon portion (TIGeRs or Strips) as
zeroes. Merrill Lynch was the first when it introduced TIGR's and
Solomon introduced the CATS. Once the US Treasury started its program,
the origination of trademarks and generics ended. There are still TIGRs
out there, but no new ones are being issued.

Other US Debt obligations that may be worth considering are US Savings
Bonds (Series E/EE and H/HH) and bonds from various US Government
agencies, including the ones that are known by cutesy names like Freddie
Mac, as well as the Mae sisters, Fannie, Ginnie and Sallie.

Historically, Treasuries have paid higher interest rates than EE Savings
Bonds. Savings Bonds held 5 years pay 85% of 5 year Treasuries.
However, in the past few years, the floor on savings bonds (4% under
current law) is higher than short-term Treasuries. So for the short
term, EE Savings Bonds actually pay higher than treasuries, but are
non-negotiable and purchases are limited to $15,000 ($30,000 face) per

US Government Agency Bonds, in general, pay slightly more interest but
are somewhat less predictible than Treasuries. For example,
mortgage-backed-bond returns will vary if mortgages are redeemed early.
Some agency bonds, technically, are not general obligations of the
United States, so may not be purchased by certain institutions and local
governments. The "common sense" of many people, however, is that the
Congress will never allow any of those bonds to default.

In October 2001, the Treasury Department announced that it was
suspending issuance of the 30-year bond and had no plans to issue that
security ever again.

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

Subject: Bonds - Treasury Direct

Last-Revised: 2 Oct 2001
Contributed-By: Art Kamlet (artkamlet at, Bob Johnson, Rich
Carreiro (rlcarr at

Treasury securities can be purchased directly from the US Treasury using
a service named "TreasuryDirect." The minimum purchase for any Treasury
security that can be obtained via the TreasuryDirect program is $1,000.
There are no fees for accounts below $100,000; accounts in excess of
that sum are charged a $25 annual fee. Interest payments can be made
directly to an individual's TreasuryDirect account. Further, mature
Treasury securities can be used to purchase new ones. Investors can do
business with the TreasuryDirect program via the web, phone, or plain
old mail.

The "Direct To You" services offered by the US Treasury have made
transactions in the TreasuryDirect program very attractive for private
investors. First, the Treasury can debit a bank account for the amount
of the purchase after the instrument's price is set by the auction (the
"Pay Direct" service). This means that an investor pays exactly the
right amount, unlike the old system in which an investor was forced to
send in a check for the full face value and wait for a refund. Second,
investors can sell instruments before their maturity dates using the
"Sell Direct" service. The Treasury charges $34 for brokering the sale
of a Treasury instrument, which reportedly is less than the fee charged
by banks and brokerage houses. The instrument is sold using the Federal
Reserve Bank of Chicago, which is responsible for getting a fair price.
Third, holders of Treasury instruments can reinvest funds from maturing
instruments simply by using the telephone or the web along with the
information that appears on a notice sent to holders of maturing
instruments (the "Reinvest Direct" service).

Investors can get more information about the TreasuryDirect program
either by calling 800-722-2678 or visiting the web site:

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

Subject: Bonds - U.S. Savings Bonds

Last-Revised: 4 Mar 2003
Contributed-By: Art Kamlet (artkamlet at, Gordon Hamachi, Rich
Carreiro (rlcarr at, M. Persina, David
Capshaw, Paul Maffia (paulmaf at, J. Zinchuk (jzinchuk at, Chris Lott ( contact me )

This article describes US Savings Bonds issued by the US Treasury, and
discusses how they can be purchased or redeemed. Because the US
Treasury changes the rules for these bonds periodically, this article
also gives some information about determining the yields of bonds issued
over the past 30 years.

US Savings bonds are obligations of the US government. Interest paid on
these bonds is exempt from state and local income taxes. Savings Bonds
are not negotiable instruments, and cannot be transferred to anyone at
will. They can be transferred in limited circumstances, and there could
be tax consequences at the time of transfer.

Two types of US Savings Bonds are offered, namely Series EE Bonds and
I Bonds. The I Bond was introduced in 1998 and is indexed for
inflation. The Treasury plans to sell both types of bonds on an ongoing
basis; there are no plans for one or the other to be phased out.

US Savings bonds can be purchased from commercial banks, through an
employer via payroll deductions, or (naturally) over the internet. Most
commercial banks act as agents for the Treasury; they will let you fill
out the purchase forms and forward them to the Treasury. You will
receive the bonds in the mail a few weeks later. See the foot of this
article for the web site that allows on-line purchases.

Savings bonds can be redeemed (cashed in) at many banks or directly with
a branch of the Federal Reserve Bank. Using your bank, credit union, or
savings and loan is probably the fastest way to cash a bond, but be
certain to call ahead to ask (you might need to bring certain
documentation). In some cases, the bank may send the bonds to the Fed,
which will slow things down. If your bank will not cooperate, contact
the appropriate Fed branch to redeem bonds by mail or via the web (see
links at the end of this article).

Series EE bonds are purchased at half their face value or denomination.
So you would purchase a $100 Series EE Bond for $50. I Bonds are
purchased at face value or denomination. So you would purchase a $100
I Bond for $100.

You can buy up to $15,000 (your cost; actually $30,000 face value) of
Series EE Bonds per year. If you buy bonds with a co-owner, the two of
you can together buy up to twice that limit, but even so, no more than
$30,000 (face amount) in EE bonds purchased in one calendar year may be
attributed to one co-owner (so you cannot evade the limits by using many
different co-owners). You can buy up to $30,000 of I Bonds per year.
The Series EE andI Bond limits are independent of each other, meaning an
individual could give Uncle Sam up to $45,000 annually to buy bonds.

Series EE Bonds earn market-based rates that change every 6 months.
There is no way to predict when a Series EE bond will reach its face
value. For example, a Series EE Bond earning an average of 5% would
reach face value in 14 1/2 years while a bond earning an average of 6%
would reach face value in 12 years.

I Bonds are an accrual-type security. In English, this means that
interest is added to the bond monthly. The interest is paid when the
bond is cashed. An I Bond earns interest for as long as 30 years. The
interest accrues on the first day of the month, and is compounded
semiannually. The earnings rate of an I Bond is determined by a fixed
rate of return plus a semiannual inflation rate. The fixed rate (as the
name might imply) remains the same for the life of an I Bond. The
semiannual inflation rate (the bonus) is announced each May and
November, and is based on the Consumer Price Index (CPI), as calculated
by the wizards at the Bureau of Labor Statistics (ooh!).

Series EE Bonds and I Bonds issued after 1 February 2003 must be held
for at least 12 months before they can be cashed (bonds issued before
then could be cashed anytime after 6 months). If an investor cashes an
I Bond within the first five years, the investor is penalized by losing
three months worth of interest. For example, if you cash an I Bond
after exactly twelve months, you will receive just nine months worth of
interest. This "feature" of the I Bond is supposed to encourage
long-term investment.

Series EE Bonds absolutely should be cashed before their final maturity
dates for the following reasons. Firstly, if you fail to cash the
Series EE bond (or roll it over into an Series HH Bond) before the
critical date, you will be losing money because the bond will no longer
be earning interest. Secondly, under IRS regulations, tax is due on the
interest in the year the bond is cashed or it reaches final maturity.
If you hold the bond beyond 12/31 of the final-maturity year, then when
you finally get around to cashing it, you will not only owe the tax on
the earnings, but interest and penalties besides. Thirdly, once the
bond passes its final maturity date (as for example a year later) you
cannot roll the proceeds into an HH to further postpone tax on the
accumulated interest.

Interest on a Series EE/E Bond or I Bond can be deferred until the bond
is cashed in, or if you prefer, can be declared on your federal tax
return as earned each year. When you cash the bond you will be issued a
Form 1099-INT and would normally declare as interest all funds received
over what you paid for the bond (and have not yet declared). This is
what they mean by deferring taxes.

If you with to defer the tax on the interest paid by a Series EE Bond at
maturity yet further, you can do so by using the proceeds from cashing
in a Series EE Bond to purchase a Series HH Savings bond (prior to 1980,
H Bonds). You can purchase Series HH Bonds in multiples of $500 from
the proceeds of Series EE Bonds. Series HH Bonds pay interest every 6
months and you will receive a check from the Treasury. When the HH bond
matures, you will receive the principal, and a form 1099-INT for that
deferred EE interest.

At the time of purchase, a bond can be registered to a single person
("single ownership"), registered to two people ("co-ownership"), or can
be registered to a primary owner and a beneficiary ("beneficiary"). In
the case of co-ownership, either named individual can do whatever they
like with the bond without consent for the other person; if one dies,
the other becomes the single owner. In the case of beneficiary
registration (bond is marked POD for "payable on death"), the primary
owner controls the bond, and ownership passes to the beneficiary if the
primary owner dies.

Ownership of Series EE bonds (but not I-Bonds) can be transferred, for
example if a grandparent wants to give a grandchild some money. A
transfer in ownership (called a "reissue" by the US Treasury) where a
living person who was an owner relinquishes all ownership of a bond is a
taxable event. This means that the person giving the bonds (the
"principal owner") incurs a tax liability for the accrued interest up to
the date of transfer and must pay Uncle Sam. It's essential to keep
good records until the time when the beneficiary finally cashes the
bonds in. Recall that all interest on the bond is paid when it's cashed
in. Because someone paid some tax on that interest already, the person
cashing the bond should not pay tax on the full amount. Alternatively,
the grandparent could just add the grandchild as a co-owner, which
doesn't result in anyone incurring a tax liability at the transfer.

Interest from Savings Bonds can excluded if used to pay higher education
expenses such as college tuition. Please see the article elsewhere in
the FAQ for more details.

If your Savings Bonds are lost, stolen, mutilated, or destroyed, give
prompt notice of the facts to the Department of the Treasury, Bureau of
the Public Dept, Parkersburg, WV 26106-1328, and a list, if possible, of
the serial numbers (with prefix and suffix letters), the issue dates
(month and year) and the denominations of the bonds. Show all names and
addressed that could have appeared on the bonds, along with the owner's
Social Security number, and whether the bond numbers and issue dates are
known. The more information that you are able to provide, the quicker
the Treasury will be able to replace your bonds.

Before describing the specific conditions that apply to Series EE bonds
issued on various dates, it's important to understand the terminology
that is used in these explanations. The following list should help.
Warning: this gets complicated quickly, thanks to your friends at the US

* Issue date: The first day of the month of purchase. Shown on the
face of the bond. (The bond face may also show the date on which
the Treasury processed an application and printed the bond, but
that's not the issue date.)
* Nominal original maturity (date): The date at which a Series EE
Bond reaches its face value. The applicable rates need only exceed
the guaranteed rate (see below) by a small amount for the actual
original maturity date to occur earlier than the nominal first

For Series EE Bonds issued prior to 1 May 1995, the actual first
maturity date depends on the minimum guaranteed rate of interest
that prevails during its life! This period (date) ranges from 9 yrs
8 months for bonds issued prior to 11/86 to 18 years for those
issued since the guaranteed rate was lowered to 4% in 1994. For
bonds purchased prior to 1 Dec 1985, the nominal original maturity
date will be the stated interest rate on the bond divided into 72.
Over the years that date varied from 9 yrs. 6 months to 12 years.
that means minimum guaranteed rates of 6 to 7.5%, except for the
oldest E bonds whose rates (for those still not having reached
final maturity) can be as low as 4%.
* Final maturity (date): the date following which the bond no longer
earns any interest (see discussion above about cashing bonds before
this date).
* Guaranteed minimum rate during original maturity: the minimum
interest rate that the US treasury will pay you on the bonds, no
matter what the market rate may be. This can either be stated as
an interest rate (from which the nominal original maturity date can
be calculated) or as a nominal original maturity date (from which
the minimum guaranteed rate can be calculated). Note that the
Treasury states this guaranteed minimum rate as the overall yield
from issuance, not as the minimum rate for each six-month period.
For example, if a bond paid 8% for some period of time but the
overall guaranteed yield is 4%, then depending on interest rates
and markets, the bond might pay just 1% for some six-month periods
without violating the minimum-rate guarantee.
* Crediting of interest: Prior to 1 May 1995, interest was credited
monthly, and calculated to the first day of the month you cash it
in (up to 30 months, and to the previous 6 month interval after).
Bonds issued after 1 May 1995 and all earlier bonds entering any
extended maturity period after 1 May 1995 will only earn interest
from that point on every six months. For bonds issued after 1 May
1995 or for earlier bonds entering any extended maturity period
after that date, you cash them as soon as possible after any 6
month anniversary date, because cashing a bond any time between any
two 6th month anniversary dates loses all interest since the last 6
month anniversary date.

The following list attempts to clarify the rules that apply to Series E
or EE Bonds that were issued in various time periods. Note that the
rule changes generally change the game only for bonds that are issued
after the rule change. Outstanding Series E Bonds and Savings Notes as
well as Series EE Bonds issued in general continue to earn interest
unter the terms of their original offerings, even as they enter
extension periods.

* Series E bonds issued before 1980

These bonds are very similar to EE bonds, except they were
purchased at 75% of face value. Everything else stated here about
EE bonds applies also to E bonds.

* Series EE Savings bonds issued 1 November 1982 -- 31 October 1986

These bonds have a minimum rate of 7.5% through their maturity
period of 9 yrs 7 mos. If these bonds entered a period of extended
maturity prior to March 1993, they would earn the prevailing market
based rates, or a minimum of the 6.0% guaranteed rate until the
next extended maturity period begins. If these bonds enter a
period of extended maturity after March 1993, they will earn the
prevailing market based rates, or at least the minimum 4.0%
guaranteed rate for the remainder of their life.

* Series EE Savings bonds issued 1 November 1986 -- 28 February 1993

The bonds are subject to the same rules discussed earlier; i.e.,
they earn the 6% guaranteed rate until they reach face value (which
may be before their 12th anniversary depending on prevailing
rates), after which they will earn the prevailing market based
rates, or at least the minimum 4.0% guaranteed rate for the
remainder of their life.

* Series EE Savings bonds issued 1 March 1993 -- 30 April 1995

If held at least 5 years, these bonds have a minimum rate of 4%,
and this rate is guaranteed through their original maturity of 18
years. These EE bonds will earn a flat 4% through the first 5
years rather than the short-term rate, and the interest will accrue
semiannually. Any bond issued before 1 May 1995 will earn a
minimum of 4% after it enters its next extended maturity period.

* Series EE Savings bonds issued 1 May 1995 -- 30 April 1997

These bonds will earn market-based rates from purchase through
original maturity. They will earn the short-term rate for the
first five years after purchase and will earn the long-term rate
from the fifth through the seventeenth year. The bonds will
continue to earn interest after 17 years for a total of 30 years at
the rates then in effect for extensions. If the market-based rates
are not sufficient for a bond to reach face value in 17 years, the
Treasury will make a one-time adjustment to increase it to face
value at that time. Therefore, you are guaranteed that a bond will
be worth its face value as of 17 years of its purchase date. This
equates to a minimum interest rate of 4.1%. If the market-based
rates are higher than this, the bond will be worth more than its
face value after 17 years.

The short-term rate is 85% of the average of six-month Treasury
security yields. A new rate is announced and becomes effective
each May 1 and November 1. The May 1 rate reflects market yields
during the preceding February, March, and April. The November 1
rate reflects market yields during the preceding August, September,
and October.

The long-term rate is 85% of the average of five-year Treasury
security yields. A new rate is announced and becomes effective
each May 1 and November 1. The May 1 rate reflects market yields
during the preceding November through April and the November 1 rate
reflects market yields during the preceding May through October.

Effective 1 May 1995:
The short-term rate is 5.25%
The long-term rate is 6.31%

Interest will be added to the value of the bonds every six months.
Bonds will increase in value six months after purchase and every
six months thereafter. For example, a bond purchased in June will
increase in value on December 1 and on each following June 1 and
December 1. When investors cash their bonds they will receive the
value of the bond as of the last date interest was added. If an
investor redeems a savings bond between scheduled interest dates
the investor will not receive interest for the partial period.

* Series EE Savings bonds issued 1 May 1997 -- present

The latest Treasury program made three significant changes to the
prior system. First, the market rates on which the savings bond
rate are calculated will be long-term rates, rather than a
combination of short-term and long-term rates. Second, all bonds
will earn 90 percent of the average market rate on 5-year Treasury
notes. (This ends the two-tier system that was in place since
1995, as described above.) Finally, interest on savings bonds will
accrue monthly, instead of every six months. This will eliminate
the problem of an investor losing up to five months interest by
redeeming a savings bond at the wrong time. But of course there's
a catch. To encourage longer term holdings of savings bonds, a
three-month interest penalty is imposed if a savings bond is
redeemed within the first five years.

Finally, we'll try to summarize the preceding discussion in a table.

Nom. orig. Final Guar min rate Interest
Issue date maturity maturity orig. maturity credited
before Nov ? yrs 40 yrs ?.?% monthly
1 Nov 1982 9 yrs 7 mos 30 yrs 7.5% monthly
31 Oct 1986
1 Nov 1986 12 yrs 30 yrs 6.0% monthly
28 Feb 1993
1 Mar 1993 18 yrs 30 yrs 4.0% monthly
30 Apr 1995
1 May 1995 17 yrs 30 yrs 4.1% biannually
30 Apr 1997
1 May 1997 TBD 30 yrs TBD% monthly

For current rates, you may call 1-800-4US-Bonds (1-800-487-2663) within
the US. You can call any Federal Reserve Bank to request redemption
tables for US Savings Bonds. You may also request the tables from The
Bureau of Public Debt, Bonds Div., Parkersburg, WV 26106-1328.

Here a few web resources that may help.

* The official US Savings Bonds web site offers a huge amount of
information, as well as a way to purchase Series EE (denominations
50 to 1000) and I Bonds (denominations 50 to 500) with a visa or
master card. This web site can also help you calculate the Current
Redemption Value (CRV) of any bond.
* The Treasury's Bureau of the Public Debt maintains another
government web site with comprehensive information about savings
bonds (includes information about branches of the Federal Reserve
Bank): .
* The Savings bond Wizard help you manage your own Savings Bond
inventory. It's a PC program, available free of charge:
* Another site that offers assistance with savings bond issues:

[ Compiler's note: These disgustingly complex regulations come from many
of the same people who developed the US Tax Code. See any
similarities?? Sheesh! ]

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

Subject: Bonds - U.S. Savings Bonds for Education

Last-Revised: 27 Aug 2001
Contributed-By: Jackie Brahney (info at

You can use your U.S. Savings Bonds towards your child's education and
exclude all the interest earned from your federal income. This is
sometimes known as the Tax Free Interest for Education program. Here
are some basics on how the Education Savings Bond program works.

You can exclude all or a portion of the interest earned from savings
bonds from your federal income tax. Qualified higher education
expenses, incurred by the taxpayer, the taxpayers spouse or the
taxpayer's dependent at a institution or State tuition plans (see below)
have to incur in the same calendar year the bonds are cashed in.

The following qualifications and exclusions apply.

1. Only Series EE or I Bonds issued in 1990 and later apply; "Older"
bonds cannot be exchanged towards newer bonds.
2. When purchasing bonds to be used for education, you do NOT have to
declare that at the time of purchase that will be using them for
education purposes.
3. You can choose NOT to use the bonds for education if you so choose
at a later date.
4. You must be at least 24 years old when you purchase(d) the bonds.
5. When using bonds for a child's education, register the bonds in
your name, NOT the child's name.
6. A child CAN NOT be listed as a CO-OWNER on the bond.
7. The child can be a beneficiary on the bond and the education
exclusion can still apply.
8. If you are married, a joint return MUST be filed to qualify for the
education exclusion.
9. You are required to report both the principal and the interest from
the bonds to pay for qualified expenses
10. Use Form 8815 to exclude interest for college tuition.

Here are a few frequently asked questions.

Does everyone in every income bracket qualify?
No. The interest exclusion at the highest level is available to
married couples (who file jointly) starting at $83,650 with a
modified gross income and is eliminated at $113,650 or more in tax
year 2001. For single filers, the exclusion begins to reduce at
$55,750 and is eliminated at $70,750 or more in tax year 2001.
These income limitations apply to the year you use the bonds, and
NOT when you purchase the bonds.

What Institutions Qualify for the Exclusion?
Post secondary institutions, colleges, universities, and various
vocational schools. The schools qualify must participate in
federally assisted programs (ex. They offer a guaranteed student
loan program). Beauty or secretarial schools and proprietary
institutions usually do not apply.

What are Qualified Expenses?
Tuition and fees, for any course or educational program that
involves sports, games or hobbies, lab fees and other required
course expenses that relate to an educational degree or
certificate-granting program. These expenses must be incurred
during the same tax year in which the bonds are cashed in. Note:
Room/board expenses, books, and expendable materials (pens,
notepads, etc.) do not qualify.

A bit of advice: when purchasing bonds that you think will be used for
educational purposes, purchase them in small denominations. That way
you won't have to cash in more bonds than are necessary to pay the
current college tuition expenses. Remember, any excess monies you
receive from cashing in some savings bonds that EXCEED the tuition bills
may create a taxable event when you file your federal tax return.
(Savings Bonds are always exempt from State and Local/City taxes.)

Here are some resources on the web that can help.
* The Treasury Department's web site:
* The bond experts at

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

Subject: Bonds - Value of U.S. Treasury Bills

Last-Revised: 24 Oct 1994
Contributed-By: Dave Barrett

The current value of a U.S. Treasury Bill can be found using the Wall
Street Journal. Look in the WSJ in the issue dated the next business
day after the valuation date you want, specifically in the "Money and
Investing" section under the headline "Treasury Bonds, Notes, and
Bills". There you need to look for the column titled "TREASURY BILLS".
Scan down the column for the maturity date of your bill. Then examine
the "Bid" and "Days to Mat." values. The necessary formula:

Current value = (1 - ("Bid" / 100 * "Days to Mat." / 360)) * Mature

For example, a 13-week treasury bill purchased at the auction on Monday
June 21 appears in the June 22, 1994 WSJ in boldface as maturing on
September 22, 1994 with an "Asked" of 4.18 and 91 "Days to Mat.". Its
selling price on Wedesday August 31, 1994 appeared in the September 1,
1994 Wall Street Journal as 20 "Days to Mat." with 4.53 "Bid". A
$10,000 bill would sell for:
(1 - 4.53/100 * 20/360) * $10,000 = $ 9,974.83
minus any brokerage fee.

The coupon yield for a U.S. Treasury Bill is listed as "Ask Yld." in
the Wall Street Journal under "Treasury Bonds, Notes and Bills". The
value is computed using the formula:

couponYield = 365 / (360/discount - daysToMaturity/100)

Discount is listed under the "Asked" column, and "couponYield" is shown
under the "Ask Yld." column. For example, the October 21, 1994 WSJ
lists Jan 19, '95 bills as having 87 "Days to Mat.", and an "Asked"
discount as 4.98. This gives:
365 / (360/4.98 - 87/100) = 5.11%
which is shown under the "Ask Yld." column for the same issue.
DaysToMaturity for 13-week, 26-week, and 52-week bills will be 91, 182,
and 364, respectively, on the day the bill is issued.

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

Subject: Bonds - Zero-Coupon

Last-Revised: 28 Feb 1994

Contributed-By: Art Kamlet (artkamlet at

Not too many years ago every bond had coupons attached to it. Every so
often, usually every 6 months, bond owners would take a scissors to the
bond, clip out the coupon, and present the coupon to the bond issuer or
to a bank for payment. Those were "bearer bonds" meaning the bearer
(the person who had physical possession of the bond) owned it. Today,
many bonds are issued as "registered" which means even if you don't get
to touch the actual bond at all, it will be registered in your name and
interest will be mailed to you every 6 months. It is not too common to
see such coupons. Registered bonds will not generally have coupons, but
may still pay interest each year. It's sort of like the issuer is
clipping the coupons for you and mailing you a check. But if they pay
interest periodically, they are still called Coupon Bonds, just as if
the coupons were attached.

When the bond matures, the issuer redeems the bond and pays you the face
amount. You may have paid $1000 for the bond 20 years ago and you have
received interest every 6 months for the last 20 years, and you now
redeem the matured bond for $1000.

A Zero-coupon bond has no coupons and there is no interest paid.

But at maturity, the issuer promises to redeem the bond at face value.
Obviously, the original cost of a $1000 bond is much less than $1000.
The actual price depends on: a) the holding period -- the number of
years to maturity, b) the prevailing interest rates, and c) the risk
involved (with the bond issuer).

Taxes: Even though the bond holder does not receive any interest while
holding zeroes, in the US the IRS requires that you "impute" an annual
interest income and report this income each year. Usually, the issuer
will send you a Form 1099-OID (Original Issue Discount) which lists the
imputed interest and which should be reported like any other interest
you receive. There is also an IRS publication covering imputed interest
on Original Issue Discount instruments.

For capital gains purposes, the imputed interest you earned between the
time you acquired and the time you sold or redeemed the bond is added to
your cost basis. If you held the bond continually from the time it was
issued until it matured, you will generally not have any gain or loss.

Zeroes tend to be more susceptible to prevailing interest rates, and
some people buy zeroes hoping to get capital gains when interest rates
drop. There is high leverage. If rates go up, they can always hold

Zeroes sometimes pay a better rate than coupon bonds (whether registered
or not). When a zero is bought for a tax deferred account, such as an
IRA, the imputed interest does not have to be reported as income, so the
paperwork is lessened.

Both corporate and municipalities issue zeroes, and imputed interest on
municipals is tax-free in the same way coupon interest on municipals is.
(The zero could be subject to AMT).

Some marketeers have created their own zeroes, starting with coupon
bonds, by clipping all the coupons and selling the bond less the coupons
as one product -- very much like a zero -- and the coupons as another
product. Even US Treasuries can be split into two products to form a
zero US Treasury.

There are other products which are combinations of zeroes and regular
bonds. For example, a bond may be a zero for the first five years of
its life, and pay a stated interest rate thereafter. It will be treated
as an OID instrument while it pays no interest.

(Note: The "no interest" must be part of the original offering; if a
cumulative instrument intends to pay interest but defaults, that does
not make this a zero and does not cause imputed interest to be

Like other bonds, some zeroes might be callable by the issuer (they are
redeemed) prior to maturity, at a stated price.

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

Subject: CDs - Basics

Last-Revised: 15 Mar 2003

Contributed-By: Chris Lott ( contact me )

A CD in the world of personal finance is not a compact disc but a
certificate of deposit. You buy a CD from a bank or savings & loan for
some amount of money, and the bank promises to pay you a fixed interest
rate on that money for a fixed term. For example, you might buy a
30-month CD paying 3% in the amount of $5,000. A bank may have a
minimum amount for issuing CDs like $1,000, but there is usually no
requirement to buy a CD with an even amount. Interest earned by a CD
may be paid monthly, quarterly, annually, or when the CD matures.
Interest paid during the CD's term is paid by check or deposited to
another account; it is never added to the amount of the CD (like in a
savings account), because the CD amount is fixed.

After you have purchased a CD, you can always redeem it before the
stated maturity date. However, if you cash out early, the bank will
impose a penalty in the amount of 3 or 6-months of interest payments,
depending on the term. This "penalty for early withdrawal" is due
whether any interest was paid or not.

As the name implies, a CD is usually a piece of paper (the certificate)
that states the interest rate and term (actually the maturity date).
Because CDs are issued by banks, a CD for less than $100,000 is insured
by the government (probably the FDIC program), so the investment is
essentially risk-free.

Some CDs can be bought and sold much like a stock or bond. If you buy a
CD through a brokerage house, you may be able to re-sell the CD through
them to avoid paying an early withdrawal penalty. These CDs usually
have significant minimum investment amounts (like $5,000) and require
round numbers (like multiples of 1,000).

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

Subject: CDs - Market Index Linked

Last-Revised: 15 Mar 2003

Contributed-By: Chris Lott ( contact me )

A market index linked CD (MILC) is a combination of a CD and a
stock-market investment. These instruments seek to add the possibility
of great returns to the security of CDs. They do this by pegging the
interest rate paid by the CD to the performance of some stock-market
index (i.e., they are linked to a market index). The term on these
instrument is usually around 5 years.

Like a conventional CD, the principal is fully insured by the federal
government, so an investor is guaranteed to receive 100% of the original
investment if the CD is held to maturity. Early withdrawal is possible,
but frequently constrained to certain dates each year. Further, an
investor is not guaranteed to receive 100% of the initial investment if
withdrawn early.

All interest is paid when the CD matures. However, there is no
guarantee that any interest will be paid. So there is very little
chance an investor will do very well, but there is a reasonable chance
of doing better than a conventional fixed-rate CD.

These notes have a quirky tax treatment. Although they pay no interest
annually, if the CD is held in a regular account, an investor must
nonetheless declare income from a market index linked CD every year. So
you're probably asking, the thing paid me nothing, what am I declaring!?
The amount to declare is based on the amount a comparable, conventional
CD of the same term would pay, based on information in the MILC. These
declared payments are added to the cost basis of the CD and the whole
mess is reconciled when the CD matures. Investors can avoid this hassle
by holding this instrument in a tax-deferred account such as an IRA.

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

Subject: Derivatives - Basics

Last-Revised: 6 Dec 1996
Contributed-By: Brian Hird, Chris Lott ( contact me )

A derivative is a financial instrument that does not constitute
ownership, but a promise to convey ownership. Examples are options and
futures. The most simple example is a call option on a stock. In the
case of a call option, the risk is that the person who writes the call
(sells it and assumes the risk) may not be in business to live up to
their promise when the time comes. In standarized options sold through
the Options Clearing House, there are supposed to be sufficient
safeguards for the small investor against this.

Before discussing derivatives, it's important to describe their basis.
All derivatives are based on some underlying cash product. These "cash"
products are:
* Spot Foreign Exchange. This is the buying and selling of foreign
currency at the exchange rates that you see quoted on the news. As
these rates change relative to your "home currency" (dollars if you
are in the US), so you make or lose money.
* Commodities. These include grain, pork bellies, coffee beans,
orange juice, etc.
* Equities (termed "stocks" in the US)
* Bonds of various different varieties (e.g., they may be Eurobonds,
domestic bonds, fixed interest / floating rate notes, etc.). Bonds
are medium to long-term negotiable debt securities issued by
governments, government agencies, federal bodies (states),
supra-national organisations such as the World Bank, and companies.
Negotiable means that they may be freely traded without reference
to the issuer of the security. That they are debt securities means
that in the event that the company goes bankrupt. bond-holders
will be repaid their debt in full before the holders of
unsecuritised debt get any of their principal back.
* Short term ("money market") negotiable debt securities such as
T-Bills (issued by governments), Commercial Paper (issued by
companies) or Bankers Acceptances. These are much like bonds,
differing mainly in their maturity "Short" term is usually defined
as being up to 1 year in maturity. "Medium term" is commonly taken
to mean form 1 to 5 years in maturity, and "long term" anything
above that.
* Over the Counter ("OTC") money market products such as loans /
deposits. These products are based upon borrowing or lending.
They are known as "over the counter" because each trade is an
individual contract between the 2 counterparties making the trade.
They are neither negotiable nor securitised. Hence if I lend your
company money, I cannot trade that loan contract to someone else
without your prior consent. Additionally if you default, I will
not get paid until holders of your company's debt securities are
repaid in full. I will however, be paid in full before the equity
holders see a penny. Derivative products are contracts which have
been constructed based on one of the "cash" products described above.
Examples of these products include options and futures. Futures are
commonly available in the following flavours (defined by the underlying
"cash" product):
* commodity futures
* stock index futures
* interest rate futures (including deposit futures, bill futures and
government bond futures) For more information on futures, please
see the article in this FAQ on futures.

In the early 1990s, derivatives and their use by various large
institutions became quite a hot topic, especially to regulatory
agencies. What really concerns regulators is the fact that big banks
swap all kinds of promises all the time, like interest rate swaps,
froward currency swaps, options on futures, etc. They try to balance
all these promises (hedging), but there is the big danger that one big
player will go bankrupt and leave lots of people holding worthless
promises. Such a collapse could cascade, as more and more speculators
(banks) cannot meet their obligations because they were counting on the
defaulted contract to protect them from losses.

All of this is done off the books, so there is no total on how much
exposure each bank has under a specific scenario. Some of the more
complicated derivatives try to simulate a specific event by tracking it
with other events (that will usually go in the same or the opposite
direction). Examples are buying Japan stocks to protect against a loss
in the US. However, if the usual correlation changes, big losses can be
the result.

The big danger with the big banks is that while they can use derivatives
to hedge risk, they can also use them as a way of taking ON risk. Not
that risk is bad. Risk is how a bank makes money; for example, issuing
loans is a risk. However, banks are forbidden from taking on risk with
derivatives. It's just too easy for a bank to hedge bonds with
derivatives that don't have the same maturity, same underlying security,
etc. so the correlation between the hedge and the risky position is

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

Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Mar 18, 2004, 4:16:19 AM3/18/04
Archive-name: investment-faq/general/part5
Version: $Id: part05,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 5 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: Derivatives - Black-Scholes Option Pricing Model

Last-Revised: 5 Jan 2001
Contributed-By: Kevin Rubash (arr at

The Black and Scholes Option Pricing Model is an approach for
calculating the value of a stock option. This article presents some
detail about the pricing model.

The Black and Scholes Option Pricing Model didn't appear overnight, in
fact, Fisher Black started out working to create a valuation model for
stock warrants. This work involved calculating a derivative to measure
how the discount rate of a warrant varies with time and stock price.
The result of this calculation held a striking resemblance to a
well-known heat transfer equation. Soon after this discovery, Myron
Scholes joined Black and the result of their work is a startlingly
accurate option pricing model. Black and Scholes can't take all credit
for their work, in fact their model is actually an improved version of a
previous model developed by A. James Boness in his Ph.D. dissertation
at the University of Chicago. Black and Scholes' improvements on the
Boness model come in the form of a proof that the risk-free interest
rate is the correct discount factor, and with the absence of assumptions
regarding investor's risk preferences.

The model is expressed as the following formula.
C = S * N(d1) - K * (e ^ -rt) * N (d2)

ln (S / K) + (r + (sigma) ^ 2 / 2) * t
d1 = --------------------------------------
sigma * sqrt(t)

d2 = d1 - sigma * sqrt(t)

C = theoretical call premium
S = current stock price
N = cumulative standard normal distribution
t = time until option expiration
r = risk-free interest rate
K = option strike price
e = the constant 2.7183..
sigma = standard deviation of stock returns (usually written as
lower-case 's')
ln() = natural logarithm of the argument
sqrt() = square root of the argument
^ means exponentiation (i.e., 2 ^ 3 = 8)
(boy, HTML just isn't much good for formulas!)

In order to understand the model itself, we divide it into two parts.
The first part, SN(d1), derives the expected benefit from acquiring a
stock outright. This is found by multiplying stock price [S] by the
change in the call premium with respect to a change in the underlying
stock price [N(d1)]. The second part of the model, K(e^-rt)N(d2), gives
the present value of paying the exercise price on the expiration day.
The fair market value of the call option is then calculated by taking
the difference between these two parts.

The Black and Scholes Model makes the following assumptions.
1. The stock pays no dividends during the option's life

Most companies pay dividends to their share holders, so this might
seem a serious limitation to the model considering the observation
that higher dividend yields elicit lower call premiums. A common
way of adjusting the model for this situation is to subtract the
discounted value of a future dividend from the stock price.

2. European exercise terms are used

European exercise terms dictate that the option can only be
exercised on the expiration date. American exercise term allow the
option to be exercised at any time during the life of the option,
making american options more valuable due to their greater
flexibility. This limitation is not a major concern because very
few calls are ever exercised before the last few days of their
life. This is true because when you exercise a call early, you
forfeit the remaining time value on the call and collect the
intrinsic value. Towards the end of the life of a call, the
remaining time value is very small, but the intrinsic value is the

3. Markets are efficient

This assumption suggests that people cannot consistently predict
the direction of the market or an individual stock. The market
operates continuously with share prices following a continuous Itt
process. To understand what a continuous Itt process is, you must
first know that a Markov process is "one where the observation in
time period t depends only on the preceding observation." An Itt
process is simply a Markov process in continuous time. If you were
to draw a continuous process you would do so without picking the
pen up from the piece of paper.

4. No commissions are charged

Usually market participants do have to pay a commission to buy or
sell options. Even floor traders pay some kind of fee, but it is
usually very small. The fees that individual investors pay is more
substantial and can often distort the output of the model.

5. Interest rates remain constant and known

The Black and Scholes model uses the risk-free rate to represent
this constant and known rate. In reality there is no such thing as
the risk-free rate, but the discount rate on U.S. Government
Treasury Bills with 30 days left until maturity is usually used to
represent it. During periods of rapidly changing interest rates,
these 30 day rates are often subject to change, thereby violating
one of the assumptions of the model.

6. Returns are lognormally distributed

This assumption suggests, returns on the underlying stock are
normally distributed, which is reasonable for most assets that
offer options.

For more detail, visit Kevin Rubash's web page:

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

Subject: Derivatives - Futures

Last-Revised: 30 Jan 2001

Contributed-By: Chris Lott ( contact me )

A futures contract is an agreement to buy (or sell) some commodity at a
fixed price on a fixed date. In other words, it is a contract between
two parties; the holder of the future has not only the right but also
the obligation to buy (or sell) the specified commodity. This differs
sharply from stock options, which carry the right but not the obligation
to buy or sell a stock.

These days, all details of a futures contract are standardized, except
for the price of course. These details are the commodity, the quantity,
the quality, the delivery date, and whether the contract can be settled
in goods or in cash. Futures contracts are traded on futures exchanges,
of which the U.S. has eight.

Futures are commonly available in the following flavors (defined by the
underlying "cash" product):
* Agricultural commodity futures
A commodity future, for example an orange-juice future contract,
gives you the right to take delivery of some huge amount of orange
juice at a fixed price on some date. Alternately, if you wrote
(i.e., sold) the contract, you have the obligation to deliver that
OJ to someone.
* Foreign currency futures
For example, on the Euro.
* Stock index futures
Since you can't really buy an index, these are settled in cash.
* Interest rate futures (including deposit futures, bill futures and
government bond futures)
Again, since you cannot easily buy an interest rate, these are
usually settled in cash as well. Futures are explicitly designed
to allow the transfer of risk from those who want less risk to those who
are willing to take on some risk in exchange for compensation. A
futures instrument accomplishes the transfer of risk by offering several
* Liquidity
* Leverage (a small amount of money controls a much larger amount)
* A high degree of correlation between changes in the futures price
and changes in price of the underlying commodity. In the case of
the commodity future, if I sell you a commodity future then I am
promising to deliver a fixed amount of the commodity to you at a given
price (fixed now) at a given date in the future.

Note that if the price of the future becomes very high relative to the
price of the commodity today, I can borrow money to buy the commodity
now and sell a futures contract (on margin). If the difference in price
between the two is great enough then I will be able to repay the
interest and principal on the loan and still have some riskless profit;
i.e., a pure arbitrage.

Conversely, if the price of the future falls too far below that of the
commodity, then I can short-sell the commodity and purchase the future.
I can (predumably) borrow the commodity until the futures delivery date
and then cover my short when I take delivery of some of the commodity at
the futures delivery date. I say presumably borrow the commodity since
this is the way bond futures are designed to work; I am not certain that
comodities can be borrowed.

Note that there are also options on futures! See the article on the
basics of stock options for more information on options.

Here are a few resources on futures.
* The Futures FAQ has quite a bit of information.
* The Futures Industry Association and the Futures Industry Institute
offer many educational materials.
* The Orion Futures Group offers a "Futures 101" primer.

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

Subject: Derivatives - Futures and Fair Value

Last-Revised: 11 Apr 2000

Contributed-By: Chris Lott ( contact me )

In the case of futures on equity indexes such as the S&P 500 contract,
it is possible to make a careful computation of how much a futures
contract should cost (in theory) based on the current market prices of
the stocks in the index, current interest rates, how long until the
contract expires, etc. This computation yields a theoretical result
that is called the fair value of the contract. If the contract trades
at prices that are far from the fair value, you can be fairly certain
that traders will buy or sell contracts appropriately to exploit the
differentce (also called arbitrage). Much of this trading is initiated
by program traders; it gets restricted (curbed) when the markets have
risen or fallen far during the course of a day.

Here are some resources about fair value of equity index futures.
* An example from the Chicago Mercantile Exchange about calculating
fair value:
* A long discussion (case study) about fair value, also from the
Chicago Mercantile Exchange:
* A few words from one of the program traders.

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

Subject: Derivatives - Stock Option Basics

Last-Revised: 26 May 1999
Contributed-By: Art Kamlet (artkamlet at, Bob Morris, Chris
Lott ( contact me ), Larry Kim (lek at

An option is a contract between a buyer and a seller. The option is
connected to something, such as a listed stock, an exchange index,
futures contracts, or real estate. For simplicity, this article will
discuss only options connected to listed stocks.

Just to be complete, note that there are two basic types of options, the
American and European. An American (or American-style) option is an
option contract that can be exercised at any time between the date of
purchase and the expiration date. Most exchange-traded options are
American-Style. All stock options are American style. A European (or
European-style) option is an option contract that can only be exercised
on the expiration date. Futures contracts (i.e., options on
commodities; see the article elsewhere in this FAQ) are generally
European-style options.

Every stock option is designated by:
* Name of the associated stock
* Strike price
* Expiration date
* The premium paid for the option, plus brokers commission.

The two most popular types of options are Calls and Puts. We'll cover
calls first. In a nutshell, owning a call gives you the right (but not
the obligation) to purchase a stock at the strike price any time before
the option expires. An option is worthless and useless after it

People also sell options without having owned them before. This is
called "writing" options and explains (somewhat) the source of options,
since neither the company (behind the stock that's behind the option)
nor the options exchange issues options. If you have written a call
(you are short a call), you have the obligation to sell shares at the
strike price any time before the expiration date if you get called .

Example: The Wall Street Journal might list an IBM Oct 90 Call at $2.00.
Translation: this is a call option. The company associated with it is
IBM. (See also the price of IBM stock on the NYSE.) The strike price is
90. In other words, if you own this option, you can buy IBM at
US$90.00, even if it is then trading on the NYSE at $100.00. If you
want to buy the option, it will cost you $2.00 (times the number of
shares) plus brokers commissions. If you want to sell the option
(either because you bought it earlier, or would like to write the
option), you will get $2.00 (times the number of shares) less
commissions. The option in this example expires on the Saturday
following the third Friday of October in the year it was purchased.

In general, options are written on blocks of 100s of shares. So when
you buy "1" IBM Oct 90 Call at $2.00 you actually are buying a contract
to buy 100 shares of IBM at $90 per share ($9,000) on or before the
expiration date in October. So you have to multiply the price of the
option by 100 in nearly all cases. You will pay $200 plus commission to
buy this call.

If you wish to exercise your option you call your broker and say you
want to exercise your option. Your broker will make the necessary
requests so that a person who wrote a call option will sell you 100
shares of IBM for $9,000 plus commission. What actually happens is the
Chicago Board Options Exchange matches to a broker, and the broker
assigns to a specific account.

If you instead wish to sell (sell=write) that call option, you instruct
your broker that you wish to write 1 Call IBM Oct 90s, and the very next
day your account will be credited with $200 less commission. If IBM
does not reach $90 before the call expires, you (the option writer) get
to keep that $200 (less commission). If the stock does reach above $90,
you will probably be "called." If you are called you must deliver the
stock. Your broker will sell IBM stock for $9000 (and charge
commission). If you owned the stock, that's OK; your shares will simply
be sold. If you did not own the stock your broker will buy the stock at
market price and immediately sell it at $9000. You pay commissions each

If you write a Call option and own the stock that's called "Covered Call
Writing." If you don't own the stock it's called "Naked Call Writing."
It is quite risky to write naked calls, since the price of the stock
could zoom up and you would have to buy it at the market price. In
fact, some firms will disallow naked calls altogether for some or all
customers. That is, they may require a certain level of experience (or
a big pile of cash).

When the strike price of a call is above the current market price of the
associated stock, the call is "out of the money," and when the strike
price of a call is below the current market price of the associated
stock, the call is "in the money." Note that not all options are
available at all prices: certain out-of-the-money options might not be
able to be bought or sold.

The other common option is the PUT. Puts are almost the mirror-image of
calls. Owning a put gives you the right (but not the obligation) to
sell a stock at the strike price any time before the option expires. If
you have written a put (you are short a put), you have the obligation to
buy shares at the strike price any time before the expiration date if
you get get assigned . Covered puts are a simple means of locking in
profits on the covered security, although there are also some tax
implications for this hedging move. Check with a qualified expert. A
put is "in the money" when the strike price is above the current market
price of the stock, and "out of the money" when the strike price is
below the current market price.

How do people trade these things? Options traders rarely exercise the
option and buy (or sell) the underlying security. Instead, they buy
back the option (if they originally wrote a put) or sell the option (if
the originally bought a call). This saves commissions and all that.
For example, you would buy a Feb 70 call today for $7 and, hopefully,
sell it tommorow for $8, rather than actually calling the option (giving
you the right to buy stock), buying the underlying stock, then turning
around and selling the stock again. Paying commissions on those two
stock trades gets expensive.

Although options offically expire on the Saturday immediately following
the third Friday of the expiration month, for most mortals, that means
the option expires the third Friday, since your friendly neighborhood
broker or internet trading company won't talk to you on Saturday. The
broker-broker settlements are done effective Saturday. Another way to
look at the one day difference is this: unlike shares of stock which
have a 3-day settlement interval, options settle the next day. In order
to settle on the expiration date (Saturday), you have to exercise or
trade the option by Friday. While most trades consider only weekdays as
business days, the Saturday following the third Friday is a business day
for expiring options.

The expiration of options contributes to the once-per-quarter
"triple-witching day," the day on which three derivative instruments all
expire on the same day. Stock index futures, stock index options and
options on individual stocks all expire on this day, and because of
this, trading volume is usually especially high on the stock exchanges
that day. In 1987, the expiration of key index contracts was changed
from the close of trading on that day to the open of trading on that
day, which helped reduce the volatility of the markets somewhat by
giving specialists more time to match orders.

You will frequently hear about both volume and open interest in
reference to options (really any derivative contract). Volume is quite
simply the number of contracts traded on a given day. The open interest
is slightly more complicated. The open interest figure for a given
option is the number of contracts outstanding at a given time. The open
interest increases (you might say that an open interest is created) when
trader A opens a new position by buying an option from trader B who did
not previously hold a position in that option (B wrote the option, or in
the lingo, was "short" the option). When trader A closes out the
position by selling the option, the open interest either remain the same
or go down. If A sells to someone who did not have a position before,
or was already long, the open interest does not change. If A sells to
someone who had a short position, the open interest decreases by one.

For anyone who is curious, the financial theoreticians have defined the
following relationship for the price of puts and calls. The Put-Call
parity theorem says:
P = C - S + E + D
P = price of put
C = price of call
S = stock price
E = present value of exercise price
D = present value of dividends

The ordinary investor will occasionally see a violation of put-call
parity. This is not an instant buying opportunity, it's a reason to
check your quotes for timeliness, because at least one of them is out of

My personal advice for new options people is to begin by writing covered
call options for stocks currently trading below the strike price of the
option; in jargon, to begin by writing out-of-the-money covered calls.

The following web resources may also help.

* For the last word on options, contact The Options Clearing
Corporation (CCC) at 1-800-OPTIONS and request their free booklet
"Characteristics and Risks of Listed Options." This 94-page
publications will give you all the details about options on equity
securities, index options, debt options, foreign currency options,
principal risks of options positions, and much more. The booklet
is published jointly by the American Stock Exchange, The Chicago
Board Options Exchange, The Pacific Exchange, and The Philadelphia
Stock Exchange. It's available on the web at:
* The Chicago Board Options Exchange (CBOE) maintains a web site with
extensive information about equity and index options. Visit them
* The Orion Futures Group offers an "Options 101" primer.

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

Subject: Derivatives - Stock Option Covered Calls

Last-Revised: 17 July 2000
Contributed-By: Chris Lott ( contact me ), Art Kamlet (artkamlet at, John Marucco

A covered call is a stock call option that is written (i.e., created and
sold) by a person who also owns a sufficient number of shares of the
stock to cover the option if necessary. In most cases this means that
the call writer owns at least 100 shares of the stock for every call
written on that stock.

The call option, as explained in the article on option basics , grants
the holder the right to buy a security at a specific price. The writer
of the call option receives a premium and agrees to deliver shares
(possibly from his or her holdings, but this is not required) if the
option is called. Because the call writer can deliver the shares from
his or her holdings, the writer is covered: there is no risk to the call
writer of being forced to buy and subsequently deliver shares of the
stock at a huge premium due to some fantastic takeover offer (or
whatever event that drives up the price).

Note the difference between selling something in an opening transaction
and selling something in a closing transaction. When you sell a call
you already own, you are selling to close a position. When you sell a
call you do not own (whether it is covered by a stock position or not),
you are selling to open the option position; i.e., you are writing the
call. You might compare this with selling stock short, where you are
selling to open a position.

A call writer is covered in the broker's opinion if the broker has on
deposit in the call writer's option account the number of shares needed
to cover the call. The call writer might have shares in his or her safe
deposit box, or in another broker's account, or in that same broker's
cash account -- this makes the investor covered, but not as far as the
broker is concerned. So the call writer might consider himself covered,
but what will happen if the call is exercised and the shares are not in
the appropriate account? Quite simply, the broker will think the call is
naked, and will immediately purchase shares to cover. That costs the
call writer commissions -- and the writer will still own the shares that
were supposed to cover the call!

A call is also considered covered if the call writer has an escrow
receipt for the stock, owns a call on the same stock with a lower strike
price (a spread), or has cash equal to the market value of the stock.
But a person who writes a covered call and doesn't have the sahres in
the brokerage account might be well advised to check with his or her
broker to make sure the broker knows all the details about how the call
is covered.

While the covered-call writer has no risk of losing huge amounts of
money, there is an attendant risk of missing out on large gains. This
is pretty simple: if a stock has a large run-up in price, and calls are
nearing expiration with a strike price that is even slightly in the
money, those calls will be exercised before they expire. I.e., the
covered call writer will be forced to deliver shares (known as having
the shares "called away").

If the call writer does not want the shares to get called away, he or
she can buy back the option if it hasn't been exercised yet. And then
the call writer can roll up (higher strike price) or roll over (same
strike price, later expiration date), or roll up and over. Of course
the shares could be bought on the open market and delivered, but that
would get expensive.

If you write a covered call and are concerned about indicating specific
shares to be delivered in case you are called, it may be possible to
have your broker write a note on the call to specify a vs date. The
call confirmation might read: "Covered vs. Purchase 4/12/97." In other
words the decision on which shares you are covering is made at the time
you write the call. This should be more than enough to prove your
intent. What your individual broker or brokerage service will do for
you is a business matter between them and you.

My personal advice for new options people is to begin by writing covered
call options for stocks currently trading below the strike price of the
option; in jargon, to begin by writing out-of-the-money covered calls.

For comprehensive information about covered calls, try this site:

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

Subject: Derivatives - Stock Option Covered Puts

Last-Revised: 30 May 2002
Contributed-By: Art Kamlet (artkamlet at, Chris Lott ( contact
me )

A covered put is a stock put option that is written (i.e., created and
sold) by a person who also is short (i.e., has borrowed and sold) a
sufficient number of shares of the stock to cover the option if
necessary. In most cases this means that the put writer is short at
least 100 shares of the stock for every put written on that stock.

The put option, as explained in the article on option basics , grants
the holder the right to sell a security at a specific price. The writer
of the put option receives a premium and agrees to buy shares if the
option is exercised. For an explanation of what it mans to borrow and
sell shares, please see the FAQ article on selling short .

Note the difference between selling something in an opening transaction
and selling something in a closing transaction. When you sell a put you
already own, you are selling to close a position. When you sell a put
you do not own, you are selling to open a position. So when you sell a
put in an opening transaction (you give an instruction to your broker
"Sell 1 put to open"), that is known as writing the put. You might
compare this with selling stock short, where you are selling to open a

If you write a naked put, and the stock price goes way way down, you
have incurred a significant loss because you must buy the stock at the
strike price, which (in this example) is well above the current price.

If you write a covered put, that is you hold a short postion on the
underlying stock, then past the strike price the put is covered. For
every dollar the stock price goes down, the cost to you of getting put
(i.e., of buying the shares because the option gets exercised) is
exactly offset by the decrease in the stock you hold short. In other
words, for the covered put writer, the shares s/he is put balance the
shares s/he will have to deliver to close out the short position in
those shares, so it balances out pretty well. The put is covered.

Like the covered call, the covered put does not do a thing to protect
you against the rise (in this case) in price of the underlying stock you
hold short. But if the price of the stock rises, the put itself is
safe. So the put writer is covered from loss due to the put.

While the covered-put writer has no risk of losing huge amounts of
money, there is an attendant risk of missing out on large gains. This
is pretty simple: if a stock has a large fall in price, and puts are
nearing expiration with a strike price that is even slightly in the
money, those puts will be exercised before they expire. I.e., the
covered put writer will be forced to buy shares (known as "being put").

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

Subject: Derivatives - Stock Option Ordering

Last-Revised: 25 Jan 96
Contributed-By: Hubert Lee (optionfool at

When you are dealing in options, order entry is a critical factor in
getting good fills. Mis-spoken words during order entry can lead to
serious money errors. This article discusses how to place your order
properly, and focuses on the simplest type of order, the straight buy or

There is a set sequence of wording that Wall Street professionals use
among themselves to avoid errors. Orders are always "read" in this
fashion. Clerks are trained from day one to listen for and repeat for
verification the orders in the same way. If you, the public customer,
adopt the same lingo, you'll be way ahead of the game. In addition to
preventing errors in your account, you will win the respect of your
broker as a savvy, street-wise trader. Here is the "floor-ready"

After identifying yourself and declaring an intent to place an order,
clearly say the following:
[For a one-sided order (simple buy or sell)]
"Buy 10 Calls XYZ February 50's at 1 1/2 to open, for the day"

Always start with whether it is a buy or sell. When you do so, the
clerk will reach for the appropriate ticket.

Next comes the number of contracts. Remember, to determine the money
amount of the trade, you multiply this number of contracts by 100 and
then by the price of the option. In the above example, 10 x 100 x 1 1/2
= $1,500. Don't ever mention the equivalent number of underlying
shares. One client of mine used to always order 1000 contracts when he
really meant to buy 10 options (equivalent to 1000 shares of stock).

Thirdly, you name the stock. Call it by name first and then state the
symbol if you know it. Be aware of similar sounding letters. B, T, D,
E etc., can all sound alike in a noisy brokerage office. Over The
Counter stocks can have really strange option symbols.

The month of expiration comes next. Again, be careful. September and
December can sound alike. Floor lingo uses colorful nicknames to
differentiate. The "Labor Day" 50s are Sept options while the
"Christmas" 50s are the December series. But don't get carried away
with trying to use the slang. Don't ever use it to show off to a clerk.
Simply use it for accuracy (e.g. "the December as in Christmas 50s").

Then comes the strike price. Read it plainly and clearly. 15 and 50
sound alike as does 50 and 60.

Name the limit price or whether it is a market order. Qualify it if it
is something other than a limit or market order. For example, 1 1/2
Stop. Pet peeve of many clerks: Don't say "or better" when entering a
plain limit order. That is assumed in the definition of a limit order.
"Or better" is a designation reserved for a specific instance where one
names a price higher than the current market bid-ask as the top price to
be paid. For instance, an OEX call is 1 1/2 to 1 5/8 while you are
watching the President on CNN. He hints at a budget resolution and you
jump on the phone. You want to buy the calls but not with a market
order. Instead, you give the floor some room with an "1 7/8 or better
order". Clerks use this tag as a courtesy to each other to let them
know they realize the current market is actually below the limit price.
This saves them a confirming phone call.

Next is the position of the trade, that is, to Open or to Close. This
is the least understood facet. It has nothing to do with the opening
bell or closing bell. It tells the firm if you are establishing a new
position (opening) or offsetting an existing one (closing). Don't just
think that by saying "Buy", your firm knows you are opening a new
position. Remember, options can be shorted. One can buy to open or to
close. Likewise, one can sell to open or to close.

If your order has any restrictions, place them here at the end.
Examples are All or None, Fill or Kill, Immediate or Cancel, Minimum of
15 (or whatever you want). Remember, restricted order have no standing.
Unrestricted orders have execution priority.

Finally, state if the order is a day order or Good Till Canceled. If
you don't say, the broker will assume it to be a day order only, but the
client should mention it as a courtesy.

Very Important: Your clerk will read the order back to you in the same
way for verification. LISTEN CAREFULLY. If you don't catch an error at
this point, they can stick you with the trade.

Proper order entry can mean the difference between a successful
execution and a missed fill or a poor price. Doing it the right way can
save you precious seconds. Further, it will mean a better relationship
with your broker. The representative will act differently when he sees
a customer who knows what he is doing. The measure of respect given to
someone who knows how to give an order properly is considerable. After
all, you've just proven that you "speak" his language.

This article is Copyright 1996 by Hubert Lee. For more insights from
Hubert Lee, visit his site:

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

Subject: Derivatives - Stock Option Splits

Last-Revised: 23 Apr 1998

Contributed-By: Art Kamlet (artkamlet at

When a stock splits, call and put options are adjusted accordingly. In
almost every case the Options Clearing Corporation (OCC) has provided
rules and procedures so options investors are "made whole" when stocks
split. This makes sense since the OCC wishes to maintain a relatively
stable and dependable market in options, not a market in which options
holders are left holding the bag every time that a company decides to
split, spin off parts of itself, or go private.

A stock split may involve a simple, integral split such as 2:1 or 3:1,
it may entail a slightly more complex (non-integral) split such as 3:2,
or it may be a reverse split such as 4:1. When it is an integral split,
the option splits the same way, and likewise the strike price. All
other splits usually result in an "adjustment" to the option.

The difference between a split and an adjusted option, depends on
whether the stock splits an integral number of times -- say 2 for 1, in
which case you get twice as many of those options for half the strike
price. But if XYZ company splits 3 for 2, your XYZ 60s will be adjusted
so they cover 150 shares at 40.

It's worth reading the article in this FAQ on stock splits , which
explains that the owner of record on close of business of the record
date will get the split shares, and -- and -- that anyone purchasing at
the pre-split price between that time and the actual split buys or sells
shares with a "due bill" attached.

Now what about the options trader during this interval? He or she does
have to be slightly cautious, and know if he is buying options on the
pre-split or the post-split version; the options symbol is immediately
changed once the split is announced. The options trader and the options
broker need to be aware of the old and the new symbol for the option,
and know which they are about to trade. In almost every case I have
ever seen, when you look at the price of the option it is very obvious
if you are looking at options for the pre or post-split shares.

Now it's time for some examples.
* Example: XYZ Splits 2:1
The XYZ March 60 call splits so the holder now holds 2 March 30
* Example: XYZ Splits 3:2
The XYZ March 60 call is adjusted so that the holder now holds one
March $40 call covering 150 shares of XYZ. (The call symbol is
adjusted as well.)
* Example: XYZ declares a 5% stock dividend.
Generally a stock dividend of 10% or less is called a stock
dividend and does not result in any options adjustments, while
larger stock dividends are called stock splits and do result in
options splits or readjustments. (The 2:1 split is really a 100%
stock dividend, a 3:2 split is a 50% dividend, and so on.)
* Example: ABC declares a 1:5 reverse split
The ABC March 10 call is adjusted so the holder now holds one ABC
March 50 call covering 20 shares.

Spin-offs and buy-outs are handled similarly:
* Example: WXY spins off 1 share of QXR for every share of WXY held.
Immediately after the spinoff, new WXY trades for 60 and QXR trades
for $40. The old WXY March 100 call is adjusted so the holder now
holds one call for 100 sh WXY @ 60 plus 100 sh WXY at 40.

* Example: XYZ is bought out by a company for $75 in cash, to holders
of record as of March 3.
Holders of XYZ 70 call options will have their option adjusted to
require delivery of $75 in cash, payment to be made on the
distribution date of the $75 to stockholders.

Note: Short holders of the call options find themselves in the same
unenviable position that short sellers of the stock do. In this sense,
the options clearing corporation's rules place the options holders in a
similar risk position, modulo the leverage of options, that is shared by

The Options Clearing Corporation's Adjustment Panel has authority to
deviate from these guidelines and to rule on unusual events. More
information concerning options is available from the Options Clearing
Corporation (800-OPTIONS) and may be available from your broker in a
pamphlet "Characteristics and Risks of Standardized Options."

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

Subject: Derivatives - Stock Option Symbols

Last-Revised: 21 Oct 1997

Contributed-By: Chris Lott ( contact me )

The following symbols are used for the expiration month and price of
listed stock options.

Month Call Put
Jan A M
Feb B N
Mar C O
Apr D P
May E Q
Jun F R
Jul G S
Aug H T
Sep I U
Oct J V
Nov K W
Dec L X

Price Code Price
A x05
U 7.5
B x10
V 12.5
C x15
W 17.5
D x20
X 22.5
E x25
F x30
G x35
H x40
I x45
J x50
K x55
L x60
M x65
N x70
O x75
P x80
Q x85
R x90
S x95
T x00

The table above does not illustrate the important fact that price code
"A", just to pick one example, could mean any of the following strike
prices: $5, $105, $205, etc. This is not so much of a problem with
stocks, because they usually split to stay in the $0-$100 range most of
the time.

However, this is particularly confusing in the case of a security like
the S&P 100 index, OEX, for which you might find listings of more than
100 different options spread over several hundred dollars of strike
price range. The OEX is priced in the hundreds of dollars and sometimes
swings wildly. To resolve the multiple-of-$100 ambiguity in the strike
price codes, the CBOE uses new "root symbols" such as OEW to cover a
specific $100 range on the S&P 100 index. This is very confusing until
you see what's going on.

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

Subject: Derivatives - LEAPs

Last-Revised: 30 Dec 1996

Contributed-By: Chris Lott ( contact me )

A Long-term Equity AnticiPation Security, or "LEAP", is essentially an
option with a much longer term than traditional stock or index options.
Like options, a stock-related LEAP may be a call or a put, meaning that
the owner has the right to purchase or sell shares of the stock at a
given price on or before some set, future date. Unlike options, the
given date may be up to 2.5 years away. LEAP symbols are three
alphabetic characters; those expiring in 1998 begin with W, 1999 with V.

LEAP is a registered trademark of the Chicago Board Options Exchange.
Visit their web site for more information:

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

Subject: Education Savings Plans - Section 529 Plans

Last-Revised: 25 Jan 2003

Contributed-By: Chris Lott ( contact me )

Tax law changes made in 2001 introduced a college savings plan commonly
called a "529 plan" (named after their section in the Internal Revenue
Code). These plans allow people to save for college expenses.

There are actually two types of 529 plans being offered by different
states. One kind is a pre-paid tuition plan; the other is a more
general savings vehicle. Participants in pre-paid plans are usually
strongly encouraged to use their credits at certain state schools, and
might not get full benefits if they choose an out-of-state school.
Participants in 529 savings plans can use their funds for any accredited
institution in any state.

Funds in the account, as in an IRA, grow free of taxes. Contribution
limits are high; each state sets its own limits. Very few states impose
any income limits (meaning that if you make too much money, you cannot
contribute to one of these plans). Anyone can contribute: parents,
grandparents, etc.

Different versions of 529 plans are offered in all 50 states, and there
is no restriction on state residency to use a state's plan. So for
example, if you live in Maine, you could invest in Hawaii's 529 plan.
However, the benefits may differ depending on the state where you live.
So if you are the Maine resident who is considering the Hawaii plan, you
should certainly ask about the Maine plan's benefits.

Many state plans offer significant benefits to state residents. A
resident may pay a lower management fee than an out-of-state plan
member. A state resident may be able to deduct 529 contributions from
his or her state taxable income, which reduces the amount of state
income tax due to their state. Note that companies marketing plans from
other states may conveniently "gloss over" these benefits.

One feature of these plans that makes them most attractive to many
people is the amount of control that the donor retains over the funds.
Unlike gifts made under a Uniform Gifts to Minors Act or a Coverdell
Education Savings Account, where the minor owns the funds, the intended
beneficiary of a 529 plan has no right to the money. In fact, many
states allow the donor to revoke the donation and get the money back
(although subject to various taxes and penalties).

A common complaint about 529 plans is the lack of choice in the
investments available for participants. State plans are usually managed
by some large financial institution. That institution may choose to
offer only load funds or other investments that charge fees higher than
the fees on comparable investments available outside the 529 plans.
Further, many plans restrict how often funds can be moved among the
investment choices, usually only once a year.

Withdrawals that are used to pay qualified expenses, including tuition,
fees, and certain other expenses are free of tax on any earnings. If
the money is withdrawn for any other purpose, both state and federal
income tax is due on any earnings, and further Uncle Sam demands a 10%
penalty on those earnings. (Of course tax law can change at any time;
the tax-free withdrawal provision is currently set to expire in 2010.)

These plans are suitable for many families but certainly not all. The
implications for financial aid computations are not clear and vary with
each educational institution. It's probably safe to say that if you
have enough income that you will never qualify for financial aid, then a
529 plan is exactly right for you.

If you have determined that a 529 plan is right for you, your job is not
done yet. Because there are so many plans out there, and so many sales
pitches from brokers and other financial institutions, choosing one can
be exceedingly difficult. Some items to research about these plans and
alternatives include the contribution limits (how much can you stash
away), the advantages you may attain, the range of investment choices,
and (last but certainly not least) the fees demanded by the account
custodian. You can draw parallels to the big debate over load versus
non-load mutual funds without really trying.

Here are a few web resources on 529 plans:
* Joe Hurley runs Saving For College LLC, a comprehensive guide to
529 plans on the web.
* The Motley Fool offers a comparison of Section 529 plans against
Coverdell Educational Savings Plans.

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

Subject: Education Savings Plans - Coverdell

Last-Revised: 25 Jan 2003

Contributed-By: Chris Lott ( contact me )

A Coverdell Education Savings Account (ESA), formerly known as an
Education IRA, is a vehicle that assists with saving for education
expenses. This article describes the provisions of the US tax code for
educational IRAs as of mid 2001, including the changes made by the
Economic Recovery and Tax Relief Reconciliation Act of 2001.

Funds in an ESA can be used to pay for elementary and secondary
education expenses, college or university expenses, private school
tuition, etc. I am told that the educational institution must be
accredited (which in this case means the school can participate in
various financial aid programs), but it does not have to be in the
United States. In other words, it appears that it's legal to pay
tuition at a foreign school using funds from an ESA as long as the
school is accredited.

An ESA may be established for any person who is under 18 years of age.
Contributions to this account are limited to $2,000 in 2002. Once the
beneficiary reaches 18, then no further funds may be contributed.
Annual contributions must be made by April 15th of the following year
(previously they had to be made by December 31st of the same year).

Although anyone may contribute to a minor's ESA, contributions are not
tax deductible, and further, contributions may only be made by taxpayers
who fall under the limits for adjusted gross income. As with many
provisions in the tax code, the limits are phased; the ranges are
95-110K for single filers and 150-160K for joint filers. Also,
contributions are not permitted if contributions are made to a state
tuition program on behalf of the beneficiary.

The major benefit of this savings vehicle is that the funds grow free of
all taxes. Distributions that are taken for the purpose of paying
qualified educational expenses are not subject to tax, thus saving the
beneficiary of paying tax on the fund's growth. Distributions that are
used for anything other than qualified educational expenses are treated
as taxable income and further are subject to a 10% penalty, unless a
permitted exception applies.

If the beneficiary reaches age 30 and there are still funds in his or
her ESA, they must either be distributed (incurring tax and penalties)
or rolled over to benefit another family member.

On a related note, changes made in 1997 to the tax code also permit
withdrawals of funds from both traditional IRAs and Roth IRAs for paying
qualified educational expenses. Basically, the change established an
exception so you can avoid the 10% penalty on distributions taken before
age 59 1/2 if they are for educational expenses.

It is possible to roll over funds from an ESA to a (new as of 2002) 529
plan. A roll-over from an ESA plan to a 529 plan is free of tax and
penalty as it is completed within 60 days and the account beneficiary is
the same.

The rules for ESAs changed in mid 2001 in the following ways:
* The contribution limit rises from $500 to $2,000 in 2002.
* Starting in 2002, funds can be used to pay for elementary and
secondary education, not just college/university, including private
* Income limits on those who can fund an ESA rise: married filers
will be limited starting at $190,000 starting in 2002.

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

Subject: Exchanges - The American Stock Exchange

Last-Revised: 19 Jan 2000

Contributed-By: Chris Lott ( contact me )

The American Stock Exchange (AMEX) lists over 700 companies and is the
world's second largest auction-marketplace. Like the NYSE (the largest
auction marketplace), the AMEX uses an agency auction market system
which is designed to allow the public to meet the public as much as
possible. In other words, a specialist helps maintain liquidity.

Regular listing requirements for the AMEX include pre-tax income of
$750,000 in the latest fiscal year or 2 of most recent 3 years, a market
value of public float of at least $3,000,000, a minimum price of $3, and
a minimum stockholder's equity of $4,000,000.

In 1998, a merger between the NASD and the AMEX resulted in the
Nasdaq-Amex Market Group.

For more information, visit their home page:

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

Subject: Exchanges - The Chicago Board Options Exchange

Last-Revised: 19 Jan 2000

Contributed-By: Chris Lott ( contact me )

The Chicago Board Options Exchange (CBOE) was created by the Chicago
Board of Trade in 1973. The CBOE essentially defined for the first time
standard, listed stock options and established fair and orderly markets
in stock option trading. As of this writing, the CBOE lists options on
over 1,200 widely held stocks. In addition to stock options, the CBOE
lists stock index options (e.g., the S&P 100 Index Option, abbreviated
OEX), interest rate options, long-term options called LEAPS, and sector
index options. Trading happens via a market-maker system. For more
information, visit the home page:

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

Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Mar 18, 2004, 4:16:19 AM3/18/04
Archive-name: investment-faq/general/part7
Version: $Id: part07,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 7 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: Information Sources - Books

Last-Revised: 16 Jul 2001

Contributed-By: Chris Lott ( contact me )

This article offers a large list of books about investing and personal
finance, divided into four sections: books for beginners, books for
experienced investors, books for professional traders and speculators,
and finally books that I call war stories - insider's tales about the
world of finance. The lists are sorted by the author's last name within
each section.

recommends: [IMAGE]

You can buy books right from here! Right now! Send a gift to someone who
has one of these books on their wish list! But enough hype. I've
enrolled as an associate, so if you buy any of the books that
are listed here from by using the links on this page, I get a
small referral fee. I've tried to find paperback (i.e., cheap) editions
of all the books for these links, but please let me know if I missed

The best thing about the Amazon site is that each book listing includes
capsule summaries and reviews contributed by readers, so you might want
to click on the links to check out each book.

Featured Author for Beginners: Eric Tyson
Here are three books by Eric Tyson that are part of the "..for Dummies"
series. Readers praise his writing for its practical advice,
objectivity, and gentle humor. These books offer a great way to start
learning about personal finance and investing. Amazon sells these
titles for about $20 each including the shipping charges.

* Eric Tyson
Investing for Dummies (out of print, but available used)
* Eric Tyson and James C. Collins
Mutual Funds for Dummies

* Eric Tyson
Personal Finance for Dummies

Books for beginning investors
These books concentrate on personal finance, budgeting, and also offer
some introductory material on basic investment strategies.
* Barbara Apostolou, Nicholas G. Apostolou
Keys to Investing in Common Stocks (Barron's Business Keys)
* Ginger Applegarth
Wake Up and Smell the Money
* Janet Bamford, Jeff Blyskal, Emily Card, and Aileen Jacobson

The Consumer Reports Money Book: How to Get It, Save It, and Spend
It Wisely (3rd edn)

* Wayne G. Bogosian and Dee Lee
The Complete Idiot's Guide to 401(k) Plans
* Samuel Case
The First Book of Investing: The Absolute Beginner's Guide to
Building Wealth Safely
* David Chilton
The Wealthy Barber
* George S. Clason
The Richest Man in Babylon
* Jonathan Clements
25 Myths You'Ve Got to Avoid If You Want to Manage Your Money
Right: The New Rules for Financial Success
* John Downes and Jordan Elliot Goodman
Dictionary of Finance and Investment Terms
* Ric Edelman
The Truth About Money: Because Money Doesn't Come With Instructions
(2nd edition)
* Louis Engel
How to Buy Stocks
* David Gardner and Tom Gardner
You Have More Than You Think: The Motley Fool Guide to Investing
What You Have
* Alvin Hall
Getting Started in Stocks (3rd edn.)
* Ken Kurson
The Green Magazine Guide to Personal Finance: A No B.S. Book for
Your Twenties and Thirties
* Barbara Loos
I Haven't Saved a Dime, Now What?!
* James Lowell
Investing from Scratch: A Handbook for the Young Investor
* Peter Lynch and John Rothchild
Learn to Earn: A Beginner's Guide to the Basics of Investing and
* Dale C. Maley
Index Mutual Funds: How to Simplify Your Financial Life and Beat
the Pros
* Kenneth M. Morris and Alan M. Siegel
The Wall Street Journal Guide to Understanding Money and Investing
* Kenneth M. Morris and Alan M. Siegel
The Wall Street Journal Guide to Understanding Personal Finance
* Kenneth M. Morris, Alan M. Siegel, and Virginia B. Morris
The Wall Street Journal Guide to Planning Your Financial Future
* W. Patrick Naylor
10 Steps to Financial Success: A Beginner's Guide to Saving and
* Suze Orman
The 9 Steps to Financial Freedom
* Kenan Pollack and Eric Heighberger
The Real Life Investing Guide
* Jonathan D. Pond
4 Easy Steps to Successful Investing
* Jane Bryant Quinn
Making the Most of Your Money
* Claude Rosenberg
Stock Market Primer
* John Rothchild
A Fool and His Money: The Odyssey of an Average Investor
* Alfred V. Scillitani
Basic Investing Guide For The New Investor (2nd edn.)
* Kathleen Sindell
Investing Online for Dummies (3rd edn.)

* Andrew Tobias
The Only Investment Guide You'll Ever Need
* Eric Tyson

Investing for Dummies
* Eric Tyson and James C. Collins
Mutual Funds for Dummies

* Eric Tyson
Personal Finance for Dummies

* Diane Vujovich
10 Minute Guide to the Stock Market

Books for intermediate investors
These books assume you're comfortable with the basics of stocks, mutual
funds, bonds, and other securities. They offer many investment
strategies: what to buy, what to sell, and when to do so.
* Ted Allrich and William O'Neil
The On-Line Investor: How to Find the Best Stocks Using Your
* Frank Armstrong
Investment Strategies for the 21st Century
This book is available from the author's web site at no charge,
although registration is required.
* Peter Bernstein
Against the Gods: The Remarkable Story of Risk
* Peter Bernstein
Capital Ideas: The Improbable Origins of Modern Wall Street
* John C. Bogle
Bogle on Mutual Funds
* John C. Bogle
Common Sense on Mutual Funds: New Imperatives for the Intelligent
* James W. Broadfoot
Investing in Emerging Growth Stocks
* Mary Buffett and David Clark
Buffettology: The Previously Unexplained Techniques That Have Made
Warren Buffett the World's Most Famous Investor
* Frank Cappiello
New Guide to Finding the Next Superstock
* Charles B. Carlson
Buying Stocks Without a Broker
* Samuel Case
Big Profits from Small Stocks: How to Grow Your Investment
Portfolio by Investing in Small Cap Companies
* Burton Crane
The Sophisticated Investor
* John M. Dalton
How the Stock Market Works
* Nicolas Darvas
How I Made 2,000,000 in the Stock Market
* William Donoghue
Mutual Fund Superstars
* David N. Dreman
Contrarian Investment Strategies: The Next Generation
* Stephen Eckett
Investing Online: Dealing in Global Markets on the Internet
* Kenneth Fisher
Super Stocks
* Norman G. Fosback
Stock Market Logic
* David Gardner and Tom Gardner
The Motley Fool Investment Workbook
* David Gardner and Tom Gardner
The Motley Fool Investment Guide: How the Fool Beats Wall Street's
Wise Men and How You Can Too
* Gary Gastineau
The Stock Options Manual
* Michael Gianturco
How to Buy Technology Stocks
* Braden Glett
Stock Market Stratagem: Loss Control and Portfolio Management
* Benjamin Graham and Warren E. Buffett
The Intelligent Investor: A Book of Practical Counsel
* Christopher Graja and Elizabeth Ungar
Investing in Small-Cap Stocks
* William Greider
Secrets of the Temple: How the Federal Reserve Runs the Country
* C. Colburn Hardy
The Fact$ of Life
* Peter I. Hupalo
Becoming an Investor: Building Wealth by Investing in Stocks,
Bonds, and Mutual Funds
* Investor's Business Daily
Investor's Business Daily Guide to the Markets
* David Kansas and James Cramer
The Street.Com Guide to Smart Investing in the Internet Era
* Harvey C. Knowles and Damon H. Petty
The Dividend Investor
* Robert Lichello
How to Make $1,000,000 in the Stock Market - Automatically
* Jeffrey B. Little and Lucien Rhodes
Understanding Wall Street
* Gerald M. Loeb
The Battle for Investment Survival
* Peter Lynch and John Rothchild
Beating the Street
* Peter Lynch and John Rothchild
One up on Wall Street also available: audio cassette edn.
* Burton Malkiel

A Random Walk Down Wall Street

This is a classic, and offers a highly readable argument for index
funds (also known as modern portfolio theory).
* Geoffrey A. Moore, Paul Johnson, and Tom Kippola
The Gorilla Game: An Investor's Guide to Picking Winners in High
* William J. O'Neil
How to Make Money in Stocks: A Winning System in Good Times or Bad
* James O'Shaughnessy
How to Retire Rich: Time-Tested Strategies to Beat the Market and
Retire in Style
* James P. O'Shaughnessy
Invest Like the Best: Using Your Computer to Unlock the Secrets of
the Top Money Managers
* James P. O'Shaughnessy
What Works on Wall Street: A Guide to the Best-Performing
Investment Strategies of All Time
* Carl H. Reinhardt, Alan B. Werba, and John J. Bowen
The Prudent Investor's Guide to Beating the Market
* Hildy Richelson and Stan Richelson
Straight Talk about Bonds and Bond Funds
* L. Louis Rukeyser
How to Make Money in the Stock Market
* Terry Savage
New Money Strategies for the 1990's
* Charles Schwab
How to be Your Own Stockbroker
* Steven R. Selengut
The Brainwashing of the American Investor
* Dhun H. Sethna and William O'Neil
Investing Smart: How to Pick Winning Stocks With Investor's
Business Daily
* Robert Sheard
The Unemotional Investor: Simple Systems for Beating the Market
* Jeremy J. Siegel
Stocks for the Long Run
* Michael Sincere and Deron Wagner
The Long-Term Day Trader
* John A. Tracy

How to Read a Financial Report

* John Train
New Money Masters
* Venita Vancaspel
Money Dynamics for the 1990s
* John G. Wells
Kiss Your Stockbroker Goodbye: A Guide to Independent Investing
* Martin E. Zweig and Morrie Goldfischer
Martin Zweig's Winning on Wall Street (revised and updated)

Books for expert investors, especially concerning technical analysis
These books are aimed at people who have a solid understanding of
finance and/or trade for a living. There are quite a few on technical
analysis for the "chartists" out there.
* Steven B. Achelis
Technical Analysis from A to Z
* Nicholas G. Apostolou
Keys to Investing in Options and Futures
* Robert C. Beckman
Elliott Wave Explained: A Real-World Guide to Predicting and
Profiting from Market Turns
* Jake Bernstein
The Compleat Day Trader: Trading Systems, Strategies, Timing
Indicators, and Analytical Methods
* Peter Bernstein (ed.)
The Portable MBA in Investment
* Tushar S. Chande and Stanley Kroll
The New Technical Trader: Boost Your Profit by Plugging into the
Latest Indicators
* Robert W. Colby and Thomas A. Meyers
Encyclopedia of Technical Market Indicators
* John C. Cox and Mark Rubenstein
Options Markets
* Thomas R. Demark
New Market Timing Techniques: Innovative Studies in Market Rhythm
and Price Exhaustion
* Mark Douglas
The Disciplined Trader
* Robert D. Edwards and John Magee
Technical Analysis of Stock Trends
* Alexander Elder
Trading for a Living: Psychology, Trading Tactics, Money Management
* Marc Friedfertig and George West
The Electronic Day Trader
* A. J. Frost, Robert J. Prechter, and Robert R. Prechter
Elliott Wave Principle: Key to Market Behavior
* Benjamin Graham and David L. Dodd
Security Analysis
* John C. Hull
Options, Futures, and Other Derivatives
* Jonathan E. Ingersoll
Theory of Financial Decision Making
* R. A. Jarrow
Modelling Fixed Income Securities and Interest Rate Options
* William L. Jiler
How Charts Can Help You in the Stock Market
* Jeffrey Katz and Donna L. McCormick
The Encyclopedia of Trading Strategies
* Charles Lebeau and David W. Lucas
Technical Traders Guide to Computer Analysis of the Futures Market
* John F. Magee
Analyzing Bar Charts for Profit
* Lawrence G. McMillan
Options as a Strategic Investment
* Robert Merton
Continuous Time Finance
* John J. Murphy
Technical Analysis of the Futures Markets
* John J. Murphy
Study Guide for Technical Analysis of the Futures Markets: A
Self-Training Manual
* Sheldon Natenberg
Option Volatility and Pricing: Advanced Trading Strategies and
* Robert Pardo
Design, Testing, and Optimization of Trading Systems
* Robert R. Prechter and R. N. Elliott
R. N. Elliott's Masterworks: The Definitive Collection
* Martin J. Pring
Martin Pring's Introduction to Technical Analysis
* Martin J. Pring
Technical Analysis Explained
* Peter Ritchken
Options: Theory, Strategy, and Applications
* Robert P. Rotella
The Elements of Successful Trading
* William F. Sharpe, Gordon J. Alexander, and Jeffery V. Bailey
* Clifford Sherry
The Mathematics of Technical Analysis
* Victor Sperandeo
Trader Vic II : Principles of Professional Speculation
* Robert A. Taggart
Quantitative Analysis for Investment Management
* Nassim Taleb
Dynamic Hedging: Managing Vanilla and Exotic Options
* Michael P. Turner
Day Trading into the Millennium
* Stan Weinstein
Stan Weinstein's Secrets for Profiting in Bull and Bear Markets

Analysis, commentary, and war stories about investments
These books offer analysis, commentary, and war stories from finance
insiders about the trading and investment world. They probably won't
help you pick stocks, but they're fun to read if you're interested in
finance and markets.
* Po Bronson
* Connie Bruck
The Predators' Ball: The Inside Story of Drexel Burnham and the
Rise of the Junk Bond Raiders
* Bryan Burrough and John Helyar
Barbarians at the Gate: The Fall of RJR Nabisco
* Daniel Fischel
Payback: The Conspiracy to Destroy Michael Milken and His Financial
* Edwin Lefevre
Reminiscences of a Stock Operator
* Michael Lewis
Liar's Poker: Rising Through the Wreckage on Wall Street
* Charles MacKay, Josef De La Vega, and Martin S. Fridson
Extraordinary Popular Delusions and the Madness of Crowds and
Confusion De Confusiones
* Victor Niederhoffer
The Education of a Speculator
* Jim Rogers
Investment Biker: Around the World with Jim Rogers
* Robert J. Shiller
Irrational Exuberance
* James B. Stewart
Den of Thieves If you can't find what you're looking for on
Amazon.Com, you might check out The Trader's Library of Columbia, MD.
They maintain a web site that has over 600 investment titles.

Those who are just learning about the stock market may wish to have a
look at the article in the FAQ with advice for beginners .

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

Subject: Information Sources - Conference Calls

Last-Revised: 29 May 1999
Contributed-By: John Schott (jschott at

Companies listed on the various stock exchanges have long held analyst
conferences to spread their message to the investment community. Often,
sponsors such as Hambrecht and Quist have held conferences where
investment professionals could hear many firms in several days. To
accomodate those who couldn’t travel, the conference call allowed
hundreds of analysts to hear a presentation and ask questions in real
time. But access was usually restricted to investment professionals and
often involved long-distance toll charges. Occasionally a friendly
broker would loan you his access codes, some of which found their way to
the Internet. As a result, conferences could be swamped.

The Internet now provides a much more practical venue for the conference
call. With its low cost and ability to accomodate many listeners it is
now practical to open a conference call to almost anyone (at least to
listen). Many firms now do. For example, a recent article in the Wall
Street Journal related how IOMEGA does this as an efficient way to
control the irresponsible babble on Internet bulletin boards. People
posting idle chatter now attract accurate responces from others who have
heard the actual story on a conference call. As a result, the
irresponsible postings are controlled.

Naturally, investment professionals complain that this allows the novice
to access raw information that needs interpretation by someone more
knowledgable - namely such a professional. However, companies like the
ability to make one public statement, and then be free from goverment
limitations on how investment information must be released. And
individual investors like it too, as access to this information gets
them access to information that once only slowly reached the average
investor. Even Chairman Levitt of the SEC sides with the theory of
greater access for the masses. According to an article in the 24 May
1999 issue of the Wall Street Journal, the NASDAQ has even funded a
pilot program to pay for public access to conference calls. Firms such
as DELL and Cosco are early participants .

Using the Internet has many advantages besides the instantaneous
international release that results. It is possible to save the audio
files so that the call can be accessed later at a more convenient time.
Plus it would be possible to edit out meaningless portions to provide
sort of a "Cliff Notes" of each conference. Naturally, there are some
limitations. If everyone could ask a question, real brawls could result
as the conferences became uncontrolled. So most Internet systems limit
who can ask a question.

An outstanding advantage for the average investor is to witness directly
a firm's management in action. While the information might be the same,
an investor gains confidence in management that presents a virtuoso
performane over one that is defensive, hesitant, and obfuscative. The
details aside, the speed of responce and other items that don’t get
incorporated in an analyst's report can add a lot to one's
understanding. Previously, a small investor's only such access might
have been at a company's annual meeting.

Several firms have opened to provide investment-related conference-call
services in one form or another over the Internet. Some require
membership and user fees, but the trend seems to be toward company
funding of the low cost service, and free or very low cost access by the
public. According to the WSJ article mentioned above, firms now
providing some for of access include: Vcall (Philadelphia), (Dallas), (Street Fusion, (San Fransisco), and (Boston). Expect that more and more firms will offer the
public Internet conference call. Encourage firms you are interested in
to do so. This form of communication is yet another form of ultimate
corporate democracy.

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

Subject: Information Sources - Free to All Who Ask

Last-Revised: 28 Apr 1997
Contributed-By: Brook F. Duerr, Seshadri Narasimhan

Here are some tips about obtaining cheap or free info.

Local Companies
Look in your local newspapers for information and stories about the
companies in your immediate area. I have found that our local
papers carry some great articles about our local companies long
before the WSJ or other papers pick up on them. The local papers
tend to report very minute details that the "big" papers never
report. The local paper that I get covers insider buys/sells, IPOs
etc., management changes, detailed earnings reports, analyst
opinions, you name it.
Stocks on Call
A free, fax-back service with lots of stories about companies. The
information is biased because it is paid for by the listing
companies, but it is free, so you get what you pay for. The list
has been growing very rapidly, and they company drops the
information after it has been listed for 24-72 hours, so it pays to
call often. Some articles are only posted for one day. It takes
me about 5 minutes to get the 10 or so articles I want. They used
to publish a list in the papers, but the list is too long to do
that now. Once you have the list then you can call and get 3
stories per call sent directly to your fax. It is all handled by
computer (usually). You can call back and get 3 stories per call
for free. I have gotten some great tips here - nice, fast-growing,
small companies (and some F-500s too). Although Stocks on Calls is
automatically provided with your number (a feature of 800 service),
they state that they will not give your number away to third
parties. Contact them at 800-578-7888.
A second free, fax-back service, different from Stocks on Call (see
above). This service places information into a computer so you can
access it at any time and it is always available. Pro-Info has
such things as Investor Packages, Latest Earnings Reports, news
releases and analysts reports. They cover about 100 companies and
the list is growing. The quality of the faxes is not great because
Pro-Info apparently scans the pages into the computer. Contact
them at 800-PRO-INFO (800-776-4636).
Stock Charts
I get at least one copy of Investor's Business Daily per week. The
Friday edition is particularly great. IBD is available in most
areas at newsstands, bookstores, etc. IBD is a good newspaper for
its charts.
Archive Information
For historical information, I save one copy of Barron's or WSJ or
IBD each month. If I see a company that I am suddenly interested
in then I can just open up those old editions and get some pretty
good historical data. IBD is great for this.
An Important Edition of The Wall Street Journal
I think it is imperative to get a copy of the WSJ that covers the
year in review. This edition comes out usually on the first
business day of the new year. It contains a lot of information
about how each stock has performed during that last year, including
the % movement of the stock during the past year. I get two copies
of this paper because I get so much out of them (one for work, one
for home).
SEC on Internet
This is the place where you can obtain Securities and Exchange
files (10-Ks, 10-Qs, you name it) on companies that file
electronically with the SEC. See the entry for information on the
Internet, elsewhere in this FAQ.
Archive list for ticker symbols
Available by accessing this URL:
(See the entry for information on the Internet, elsewhere in this
Writing Letters
If you are interested in a company then by all means get their
address and write them a letter. If you have a non-discount broker
then they can get you the company's address. Otherwise go to
virtually any library and they will be able to help you find the
addresses you are interested in. When you write to a company, tell
them you are interested in investing in them and you want to learn
more about them. Ask for 10Ks, annual reports, 10Qs, quarterly
summaries, analyst reports and anything else they can send you.
Some companies will bury you with information if you just ask. Ask
them to add your name to their mailing list for future information.
Many companies maintain active mailing lists and so the information
will keep flowing to you. All this for only a stamp.
Public Registers Annual Report Service
This is a outfit that acts as a clearing house for mailing out
annual reports on companies. They have a huge list (several
thousand) companies that they work for, and they are a free
service. They also send out a newspaper called the "Security
Traders Handbook" and "The Public Register". These newspapers
contains wealth of information on earnings, IPOs, insider trades
etc. The price on the cover says $5.00, but I have received
several issues and have never received a bill (I wouldn't pay
anyway). You have to write to them to get on their mailing list.
The address is: Bay Tact Corporation; 440 Route 198; Woodstock
Valley, CT 06282. Write them a letter and ask them what services
they provide. They send out annual reports, but they do not carry
analysts reports and other news release type items. Try calling
them at 800 4ANNUAL.
Reader Service Cards in Investor's Daily or other Places
Another reason I like to get the Friday edition of IBD is because
they usually have a bunch of companies hyping themselves and
offering information if you send in a reader service card. This is
another great almost freebie. For a stamp you can usually find at
least 3-5 companies that are worth finding out about.
The Wall Street Journal's Annual Reports Service
According to their blurb, you can obtain the annual reports and, if
available, quarterly reports, at no charge for any companies for
which the 'club' symbol appears in the stock listings. (The 'club'
symbol is the same as the one on a playing card. Look at Section C
"Money and Investing" of any WSJ and you will see what I mean.)
These reports can be ordered by calling 800-654-CLUB. You can also
fax your request, giving the ticker symbols of the companies whose
reports you want, to 800-965-5679. It usually takes at least a
week to get the information to you.
Mutual fund companies
The companies' toll-free lines may be your best friend, if the
solution might involve investing money with them. Call them, state
your problem simply, and request follow-up information in writing.
I would be completely honest with them, just tell them if they give
the best service, you'll invest your money with them. Of course,
if your problem can't be solved, even tangentially, with mutual
funds, you should probably not waste your (and their) time.

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

Subject: Information Sources - Investment Associations

Last-Revised: 10 Oct 1997
Contributed-By: Rajeev Arora, D. Laird, Art Kamlet (artkamlet at, Jay Hartley (jay at, Doug Gerlach (gerlach

This article introduces several investment associations.
American Association of Individual Investors
625 North Michigan Avenue
Chicago, IL 60611-3110
+1 312-280-0170

A summary from their brochure: AAII believes that individuals would
do better if they invest in "shadow" stocks which are not followed
by institutional investor and avoid affects of program trading.
They admit that most of their members are experienced investors
with substantial amounts to invest, but they do have programs for
newer investors also. Basically, they don't manage the member's
money, they just provide information.

Membership costs $49 per year for an individual; with Computerized
Investing newsletter, $79. A lifetime membership (including
Computerized Investing) costs $490.

They offer the AAII Journal 10 times a year, Individual Investor's
guide to No-Load Mutual Funds annually, local chapter membership
(about 50 chapters), a year-end tax strategy guide, investment
seminars and study programs at extra cost (reduced for members),
and a computer user' newsletter for an extra $30. They also
operate a free BBS.

National Association of Investors Corp.
P. O. Box 220
Royal Oak, MI 48068
Tel +1 810 583-NAIC, Fax +1 810 583-4880

The NAIC is a nonprofit organization operated by and for the
benefit of member clubs. The Association has been in existence
since the 1950's and states that it has over 633,000 members.

Membership costs $39 per year for an individual, or $35 for a club
and $14 per each club member. The membership provides the member
with a monthly magazine, details of your membership and information
on how to start a investment club, how to analyze stocks, and how
to keep records.

NAIC also offers software for fundamental analysis, discounts on
investing books, research information on member companies, and
other educational manuals and videotapes. A network of over 75
Regional Councils across the US provide local assistance.

In addition to the information provided, NAIC operates "Low-Cost
Investment Plan", which allows members to invest in participating
companies such as AT&T, Kellogg, Wendy's, Mobil and Quaker Oats.
Most don't incur a commission although some have a nominal fee

Of the 500 clubs surveyed in 1989, the average club had a compound
annual growth rate of 10.8% compared with 10.6% for the S&P 500
stock index. Its average portfolio was worth $66,755.

* Investors Alliance:
The Investors Alliance, Inc.
219 Commerical Blvd.
Fort Lauderdale, FL 33308-4440
Tel 888-683-1181

Investors Alliance was formed to enhance the investing skills of
independent investors through research, education, and training.
They claim membership of over 65,000 investors in 22 countries.

Basic Membership is offered at $49 per year and includes twelve
monthly issues of the Investors Alliance Investor Journal, an
educational newsletter packed with valuable insights to maximize
your investment success. Computer Membership is offered at $89 per
year and includes a copy of Power Investor for Windows on CD-ROM
and free daily modem updates of the entire 16,000 security
database. New members at either level receive a free voucher for
two zero-commission stock trades from a leading discount broker.

The Investment FAQ is an associate of Investors Alliance. If you
use the link shown below to enroll in this club, a small referral
fee is paid to The Investment FAQ.

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Subject: Information Sources - Value Line

Last-Revised: 10 Aug 1997
Contributed-By: John Schott (schott at, Chris Lott (
contact me )

The Value Line Investment Survey is the grand-daddy of published
information about stocks of large companies (primarily U.S. companies
plus a few leading ADRs). It is a weekly, three-part publication, but
it takes 3 months to cycle through the full list of stocks covered. The
main document reviews one firm per page (over 100 per week), with a
description of the business, a chart showing the historical stock
performance, tables showing key financial data, plus a written
commentary about the prospects of the firm. They cover over 1700 stocks
in their normal edition, and over 5,000 in extended coverage offered at
higher prices. The weekly document also includes short notes on
important developments in covered stocks. A separate booklet updates
summary ratings and fundamental information on all of the 1700 stocks
each week. A third document highlights a stock of the week and gives
Value Line's views of the market. They also have a new CD-ROM based
service that duplicates the data in the hard copy edition and offers the
ability to search and compare stocks automatically. Several recent
reviews have critiqued the way the program works - but not the quality
nor quantity of the renowned Value Line data base.

Value Line proudly advertises their rating system. They divide stocks
into 5 classes (1 is best). Over the years, their #1 rated stocks have
significantly outperformed the markets (and each other group, its
subordinates, as well). Value Line has been highly regarded for the
both the quality and quantity of its data for decades. Almost the
Lingua Franca of investors, you'll find a well-thumbed copy in most
broker's offices, as well as many public and university libraries.

Value Line offers a special, 10-week trial subscription for US$75
(frequently discounted to $55) which will get you the full set of pages
plus a few updates. A six-month subscription currently costs $300, and
one year is $570. The CD-ROM trial subscription is $55 ($95 for the
5000+ stock version). One-year CD-ROM subscriptions cost up to $995.

Visit their web site at , or contact them the
old-fashioned way:

Value Line Publishing Inc.
220 East 42nd Street
New York, New York 1001-5891
800 535 9648 ext 2761
+1 212 907-1500

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Subject: Information Sources - Wall $treet Week

Last-Revised: 18 Feb 2003

Contributed-By: Chris Lott ( contact me )

Wall $treet Week With Louis Rukeyser was once a television program that
aired on the public broadcasting networks on Friday evenings After a
flap in June 2002, Louis Rukeyser left the program, which is now
produced jointly with Fortune magazine.

The program tries to help the individual investor understand the doings
of the stock market and invest wisely. The usual program features a
special guest and three regular guests. The "regular guests" are
investment analysts who appear regularly on W$W.

While Rukeyser was the host, he reported on the opinions of his
"Investment Elves," a group of 10 technical analysts who attempted to
forecast the market's path over the coming weeks. If you've ever heard
of the "Elve's Index," this is the source. Of course many of the elves
are also regular guests on the program.

A new program called Louis Rukeyser's Wall Street is carried by CNBC
every Friday night at 8:30 P.M. and 11:30 P.M. Eastern time, and is
repeated over the weekend on many public television stations.

Here are some web resources:
* The W$W home page, part of the Maryland Public Television web site:
* Rukeyser's web site includes information about his TV show.

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Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Mar 18, 2004, 4:16:19 AM3/18/04
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

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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

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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.

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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.

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

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

Mar 18, 2004, 4:16:18 AM3/18/04
Archive-name: investment-faq/general/part6
Version: $Id: part06,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 6 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: Exchanges - Circuit Breakers, Curbs, and Other Trading

Last-Revised: 2 Aug 2002
Contributed-By: Chedley A. Aouriri, Darin Okuyama, Chris Lott ( contact
me ), Charles Eglinton

A variety of mechanisms are in place on the U.S. exchanges to restrict
program trading (i.e., to cut off the big boy's computer connections)
whenever the market moves up or down by more than a large number of
points in a trading day. Most are triggered by moves down, although
some are triggered by moves up as well.

The idea is that these curbs on trading, also known as collars, will
limit the daily damage by restricting activities that might lead towards
greater volatility and large price moves, and encouraging trading
activities that tend to stabilize prices. Although these trading
restrictions are commonly known as circuit breakers, that term actually
refers to just one specific restriction.

These changes were enacted in 1989 because program trading was blamed
for the fast crash of 1987. Note that the NYSE defines a Program Trade
as a basket of 15 or more stocks from the Standard & Poor's 500 Index,
or a basket of stocks from the Standard & Poor's 500 Index valued at $1
million or more.

Trading restrictions affect trading on the New York Stock Exchange
(NYSE) and the Chicago Mercantile Exchange (CME) where S&P 500 futures
contracts are traded. When these restrictions are triggered, you may
hear the phrase "curbs in" if you listen to CNBC.

Here's a table that summarizes the trading restrictions in place on the
NYSE and CME as of this writing. The range is always checked in
reference to the previous close. E.g., a move of up 200 and down 180
points would still be an up of 20 with respect to the previous close, so
the first restriction listed below would not be triggered. Any curb
still in effect at the close of trading is removed after the close;
i.e., every trading day starts without curbs.

Note that the "sidecar" rules were eliminated on Tuesday, February 16,

Restriction Triggered by
NYSE collar (Rule 80A) DJIA moves 2%
CME restriction 1 S&P500 futures contract moves 2.5%
CME restriction 2 S&P500 futures contract moves 5%
CME restriction 3 S&P500 futures contract moves 10%
NYSE circuit breaker nr. 1 DJIA moves 10%
NYSE circuit breaker nr. 2 DJIA moves 20%
NYSE Circuit breaker nr. 3 DJIA moves 30%

Now some details about each.

NYSE Collar (Rule 80A): Index arbitrage tick test
Rule 80A provides that index arbitrage orders can only be executed
on plus or minus ticks depending on which way the DJIA is. In the
parlance of the NYSE, the orders must be "stabilizing." This rule
only effects S&P 500 stocks, and is also known as the "uptick
downtick rule" because it restricts sells to upticks and buys to
downticks. In other words, when the market is down (last tick was
down), sell orders can't be executed at lower prices. In an up
market (last tick was up), buy orders can't be executed for higher
prices. This collar is removed when the DJIA retraces its gain or
loss to within approximately 1% of the previous close. As of 3Q02,
the collar is imposed at 180 points and removed when the DJIA
retraces its position to within 90 points of the previous day's

CME Restrictions
Trading in the S&P500 futures contract is halted just for a few
minutes if the prices moves 2.5%, 5%, or 10% from the previous
close. Because restrictions on the NYSE effectively shut down
trading in this futures contract, there is little need for
additional restrictions on the CME.

NYSE Circuit Breakers
These restrictions are also known as "Rule 80B." The first version
of this rule, adopted in 1988, set triggers at 250 DJIA points and
400 DJIA points. These restrictions are updated quarterly to
reflect the heights to which the Dow Jones Industrial Average has

* 10% decline (950 points for 3Q02)
The first circuit breaker is triggered if the DJIA declines by
approximately 10%. The restrictions that are put into place
-- if any -- depend on the time of day when the circuit
breaker is triggered. If the trigger occurs before 2pm
Eastern time, trading is halted for 1 hour. If the trigger
occurs between 2 and 2:30pm Eastern, trading is halted for 30
minutes. If the trigger occurs after 2:30pm Eastern time, no
restrictions are put into place. (This restriction was first
used during the afternoon of 27 Oct 97.) Note that there is no
similar restriction to the downside; nothing is done if the
Dow rallies 10%.

* 20% decline (1900 DJIA points for 3Q02)
The second circuit breaker is triggered if the DJIA declines
by approximately 20%. The restrictions that are put into
place again depend on the time of day when the circuit breaker
is triggered. If the trigger occurs before 1pm Eastern time,
trading is halted for 2 hours. If the trigger occurs between
1 and 2pm Eastern, trading is halted for 1 hour. If the
trigger occurs after 2pm Eastern time, the NYSE ends trading
for the day. Again there is no similar restriction to the
downside; nothing is done if the Dow rallies 20%.

* 30% decline (2850 DJIA points for 3Q02)
The third circuit breaker is triggered if the DJIA declines by
approximately 30%. The restriction is very simple: the NYSE
closes early that day. And like the other cases, again no
restrictions are imposed if the Dow rallies 30%.

The circuit breakers cut off the automated program trading initiated by
the big brokerage houses. The big boys have their computers directly
connected to the trading floor on the stock exchanges, and hence can
program their computers to place direct huge buy/sell orders that are
executed in a blink. This automated connection allows them to short-cut
the individual investors who must go thru the brokers and the
specialists on the stock exchange.

Statistical evidence suggests that about 2/3 of the Mar-Apr 1994 down
slide was caused by the program traders trying to lock in their profits
before all hell broke loose. The volume of their trades and their very
action may have accelerated the slide. The new game in town is how to
outfox the circuit breakers and buy or sell quickly before the 50-point
move triggers the halting of the automated trading and shuts off the

Here are sources with more information:
* HL Camp & Company offers a concise summary of program trading
collars including current numbers on their web site.
* The Chicago Mercantile Exchange publishes their equity index price
* The NYSE publishes press releases every quarter with the numbers
for that quarter's circuit breakers.
* The NYSE's glossary includes definitions of the term "Circuit

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

Subject: Exchanges - Contact Information

Last-Revised: 13 Aug 1993

Contributed-By: Chris Lott ( contact me )

Here's how to contact the stock exchanges in North America.
* American Stock Exchange (AMEX), +1 212 306-1000,
* ASE, +1 403 974-7400

* Montreal Stock Exchange (MSE), +1 514 871-2424
* NASDAQ/OTC, +1 202 728-8333/8039,
* New York Stock Exchange (NYSE), +1 212 656-3000,
* The Philadelphia Stock Exchange (PHLX),
* Toronto Stock Exchange (TSE), +1 416 947-4700
* Vancouver Stock Exchange (VSE), +1 604 689-3334/643-6500

If you wish to know the telephone number for a specific company that is
listed on a stock exchange, call the exchange and request to be
connected with their "listings" or "research" department.

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

Subject: Exchanges - Instinet

Last-Revised: 11 May 1994
Contributed-By: Jeffrey Benton (jeffwben at

Instinet is a professional stock trading system which is owned by
Reuters. Institutions use the system to trade large blocks of shares
with each other without using the exchanges. Commissions are slightly
negotiable but generally $1 per hundred shares. Instinet also runs a
crossing network of the NYSE last sale at 6pm. A "cross" is a trade in
which a buyer and seller interact directly with no assistance of a
market maker or specialist. These buyer-seller pairs are commonly
matched up by a computer system such as Instinet.

Visit their web site:

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

Subject: Exchanges - Market Makers and Specialists

Last-Revised: 28 Jan 1994
Contributed-By: Jeffrey Benton (jeffwben at

Both Market Makers (MMs) and Specialists (specs) make market in stocks.
MMs are part of the National Association of Securities Dealers market
(NASD), sometimes called Over The Counter (OTC), and specs work on the
New York Stock Exchange (NYSE). These people serve a similar function
but MMs and specs have a number of differences. See the articles in the
FAQ about the NASDAQ and the NYSE for a detailed discussion of these

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

Subject: Exchanges - The NASDAQ

Last-Revised: 6 June 2000
Contributed-By: Bill Rini (bill at, Jeffrey Benton
(jeffwben at, Chris Lott ( contact me )

NASDAQ is an abbreviation for the National Association of Securities
Dealers Automated Quotation system. It is also commonly, and
confusingly, called the OTC market.

The NASDAQ market is an interdealer market represented by over 600
securities dealers trading more than 15,000 different issues. These
dealers are called market makers (MMs). Unlike the New York Stock
Exchange (NYSE), the NASDAQ market does not operate as an auction market
(see the FAQ article on the NYSE). Instead, market makers are expected
to compete against each other to post the best quotes (best bid/ask

A NASDAQ level II quote shows all the bid offers, ask offers, size of
each offer (size of the market), and the market makers making the offers
in real time. These quotes are available from the Nasdaq Quotation
Dissemination Service (NQDS). The size of the market is simply the
number of shares the market maker is prepared to fill at that price.
Since about 1985 the average person has had access to level II quotes by
way of the Small Order Execution System (SOES) of the NASDAQ.
Non-professional users can get level II quotes for $50 per month. In
May 2000, the Nasdaq announced a pilot program that would reduce this
fee to just $10 per month.

SOES was implemented by NASDAQ in 1985. Following the 1987 market
crash, all market makers were required to use SOES. This system is
intended to help the small investor (hence the name) have his or her
transactions executed without allowing market makers to take advantage
of said small investor. You may see mention of "SOES Bandits" which is
slang for people who day-trade stocks on the NASDAQ using the SOES. A
SOES bandit tries to scalp profits on the spreads. Visit
for more on that topic.

A firm can become a market maker (MM) on NASDAQ by applying. The
requirements are relatively small, including certain capital
requirements, electronic interfaces, and a willingness to make a
two-sided market. You must be there every day. If you don't post
continuous bids and offers every day you can be penalized and not
allowed to make a market for a month. The best way to become a MM is to
go to work for a firm that is a MM. MMs are regulated by the NASD which
is overseen by the SEC.

The brokerage firm can handle customer orders either as a broker or as a
dealer/principal. When the brokerage acts as a broker, it simply
arranges the trade between buyer and seller, and charges a commission
for its services. When the brokerage acts as a dealer/principal, it's
either buying or selling from its own account (to or from the customer),
or acting as a market maker. The customer is charged either a mark-up
or a mark-down, depending on whether they are buying or selling. The
brokerage can never charge both a mark-up (or mark-down) and a
commission. Whether acting as a broker or as a dealer/principal, the
brokerage is required to disclose its role in the transaction. However
dealers/principals are not necessarily required to disclose the amount
of the mark-up or mark-down, although most do this automatically on the
confirmation as a matter of policy. Despite its role in the
transaction, the firm must be able to display that it made every effort
to obtain the best posted price. Whenever there is a question about the
execution price of a trade, it is usually best to ask the firm to
produce a Time and Sales report, which will allow the customer to
compare all execution prices with their own.

In the OTC public almost always meets dealer which means it is nearly
impossible to buy on the bid or sell on the ask. The dealers can buy on
the bid even though the public is bidding. Despite the requirement of
making a market, in the case of MM's there is no one firm who has to
take the responsibility if trading is not fair or orderly. During the
crash of 1987 the NYSE performed much better than NASDAQ. This was in
spite of the fact that some stocks have 30+ MMs. Many OTC firms simply
stopped making markets or answering phones until the dust settled.

Academic research has shown that an auction market such as the NYSE
results in better trades (in tighter ranges, less volatility, less
difference in price between trades). When you compare the multiple
market makers on the NASDAQ with the few specialists on the NYSE (see
the NYSE article), this is a counterintuitive result. But it is true.

In 1996 the NASDAQ was investigated for various practices. It settled a
suit brought against it by the SEC and agreed to change key aspects of
how it does business. Forbes ran a highly critical article entitled
"Fun and Games" on the NASDAQ. This was once available on the web, but
has vanished.

Related topics include price improvement, bid and ask, order routing,
and the 1996 settlement between the SEC and the NASDAQ. Please see the
articles elsewhere in this FAQ about those topics.

In 1998, a merger between the NASD and the AMEX resulted in the
Nasdaq-Amex Market Group.

For more information, visit their home page:

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

Subject: Exchanges - The New York Stock Exchange

Last-Revised: 4 June 1999
Contributed-By: Jeffrey Benton (jeffwben at, Chris Lott (
contact me )

The New York Stock Exchange (NYSE) is the largest agency auction market
in the United States. Visit their home page:

The NYSE uses an agency auction market system which is designed to allow
the public to meet the public as much as possible. The majority of
volume (approx 88%) occurs with no intervention from the dealer.
Specialists (specs) make markets in stocks and work on the NYSE. The
responsibility of a spec is to make a fair and orderly market in the
issues assigned to them. They must yield to public orders which means
they may not trade for their own account when there are public bids and
offers. The spec has an affirmative obligation to eliminate imbalances
of supply and demand when they occur. The exchange has strict
guidelines for trading depth and continuity that must be observed.
Specs are subject to fines and censures if they fail to perform this
function. NYSE specs have large capital requirements and are overseen
by Market Surveillance at the NYSE. Specs are required to make a
continuous market.

Most academic literature shows NYSE stocks trade better (in tighter
ranges, less volatility, less difference in price between trades) when
compared with the OTC market (NASDAQ). On the NYSE 93% of trades occur
at no change or 1/8 of a point difference. It is counterintuitive that
one spec could make a better market than many market makers (see the
article about the NASDAQ). However, the spec operates under an entirely
different system. The NYSE system requires exposure of public orders to
the auction, the opportunity for price improvement, and to trade ahead
of the dealer. The system on the NYSE is very different than NASDAQ and
has been shown to create a better market for the stocks listed there.
This is why 90% of US stocks that are eligible for NYSE listing have

A specialist will maintain a narrow spread. Since the NYSE does not
post bid/ask information, you need to check out the 1-minute tick to
figure out the spread. In other words, you'll need access to a
professional's data feed before you can really see the size of the
spread. But the structure of the market strongly encourages narrow
spreads, so investors shouldn't be overly concerned about this.

There are 1366 NYSE members (i.e., seats). Approximately 450 are
specialists working for 38 specialists firms. As of 11/93 there were
2283 common and 597 preferred stocks listed on the NYSE. Each
individual spec handles approximately 6 issues. The very big stocks
will have a spec devoted solely to them.

Every listed stock has one firm assigned to it on the floor. Most
stocks are also listed on regional exchanges in LA, SF, Chi., Phil., and
Bos. All NYSE trading (approx 80% of total volume) will occur at that
post on the floor of the specialist assigned to it. To become a NYSE
spec the normal route is to go to work for a specialist firm as a clerk
and eventually to become a broker.

The New York Stock Exchange imposes fairly stringent restrictions on the
companies that wish to list their shares on the exchange. Some of the
guides used by the NYSE for an original listing of a domestic company
are national interest in the company and a minimum of 1.1 million shares
publicly held among not fewer than 2,000 round-lot stockholders. The
publicly held common shares should have a minimum aggregate market value
of $18 million. The company should have net income in the latest year
of over $2.5 million before federal income tax and $2 million in each of
the preceding two years. The NYSE also requires that domestic listed
companies meet certain criteria with respect to outside directors, audit
committee composition, voting rights and related party transactions. A
company also pays significant initial and annual fees to be listed on
the NYSE. Initial fees are $36,800 plus a charge per million shares
issued. Annual fees are also based on the number of shares issued,
subject to a minimum of $16,170 and a maximum of $500,000. For example,
a company that issues 4 million shares of common stock would pay over
$81,000 to be listed and over $16,000 annually to remain listed. For
all the gory details, visit this NYSE page:

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

Subject: Exchanges - Members and Seats on AMEX

Last-Revised: 2 Aug 1999
Contributed-By: Jon Feins (proclm at, J. Bouvrie (fnux

Most exchanges allow you to buy seats (become a member) without being a
registered securities dealer. You would not, however, be allowed to use
the seat to transact business on that exchange. You would be allowed to
lease out the seat and would thus own the seat as an investment.

Here's the disclaimer right up front: I have been negotiating seat
leases for investors for the last 5 years. My expertise is mainly on
the American Stock Exchange (AMEX) and New York Stock Exchange (NYSE).
I spent 5 years on the floor of the NYSE and NYFE before going to the
AMEX for 3 years as a floor broker/trader.

Anyone can purchase a seat on a major stock exchange as an investment
and lease it to either a floor trader, specialist, or floor broker.
Most people do not realize that they can do this without any background
and without taking a test. You do not even have to be a registered rep.
or registered with the SEC. The return is between 12%-20% of the
current seat prices depending on the supply and demand at the time the
lease is negotiated.

The AMEX currently has a very high demand for leases. The last leases I
negotiated were at a variable rate of 1 5/8%/month (19.5% per year) of
the average seat sales as posted by the exchange in their monthly
bulletin. AMEX seats are currently quoted $565,000/bid -
$690,000/offer. The last contracted sale was for $660,000 on 15 July
1999. You can call the AMEX's 24 hour market line 877-AMEXSEAT to hear
the latest quote. Amex seats can be put in an IRA or a Keogh Plan
making the investment even more appealing.

In late 1996, the AMEX approved a rule allowing individuals to own more
than one seat. Since then seats have been slowly going up. Call the
AMEX market line (212-306-2243) for the current price.

There are only 661 regular seats and 203 Option Principal Memberships
(OPM) on the AMEX. Every Specialist and Floor Broker needs a regular
membership to do business. A Trader can use either an OPM or a regular
seat. If a trader wants to trade listed AMEX stocks (s)he needs to use
a regular seat.

When applying for an AMEX membership you need to fill out an application
which consists of:
1. Information about the person applying for membership.
2. Authorization form for orally bidding for or offering the
3. Personal financial statement.
4. Completed U-4 for for background check along with a fingerprint
5. Acknowledgement of non-eligibility of gratuity fund form.

After completing the paperwork a non-refundable application fee of $500
must be submitted to the exchange. About a week after processing your
application you will be able to buy/bid for a seat. Other costs
involved with the purchase of a seat on the AMEX include a one time
transfer fee of $2,500 (If/when you sell the seat the buyer of your seat
has to pay this transfer fee). When the seat is leased out a transfer
fee of $1,500 is paid by the lessee. Your total costs are:
1. Purchase price of the seat.
2. $500 application fee.
3. One-time $2,500 transfer fee.
4. $24.50 Finger print processing fee.

When you sell the seat there are no costs, and the exchange will send
you a check for the full selling price which they collect from the buyer
of your seat.

In the deals that I broker, once an investor has purchased the seat I
find a lessee. All my leases require a letter of indemnity from the
clearing house of the lessee. A clearing house (Merrill Lynch, Paine
Webber, Bear Stearns etc...) is used by the lessee to clear the trades
they execute. Whether the lessee is a trader, specialist or a floor
broker they must use a clearing house who charges them commissions for
each of their trades and is liable for their losses. If a person who is
worth $100,000 dollars loses $500,000 dollars the clearing house is
liable for the losses of the other $400,000. The letter of indemnity
from the clearing house states that they do not view the seat as
collateral. In addition to this letter of indemnity, I only lease to
people who are employed by a well-capitalized firm which also signs the
lease as a guarantor. My leases have attorney reviewed modifications
which further protect the interests of the owner of the seat. Just like
a person who rents a house needs to be careful of who they lease to, so
does the lessor of a seat.

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

Subject: Exchanges - Ticker Tape Terminology

Last-Revised: 19 Sep 1999
Contributed-By: Keith Brewster, Norbert Schlenker, Richard Sauers
(rsauers at, Art Kamlet (artkamlet at

Every stock traded on the world's stock exchanges is identified by a
short symbol. For example, the symbol for AT&T is just T. These
symbols date from the days when stock trades were reported on a ticker
tape. Ticker symbols are still used today as brief, unambiguous
identifiers for stocks. Similar abbreviations are used for stock
options and many other securities.

Ticker symbols get reused on different exchanges, so you'll sometimes
see a qualification ahead of the ticker symbol. For example, the symbol
"C:A" refers to a company traded on one of the Canadian exchanges
(Toronto, to be exact) with the symbol A. The stock quote services on
the web usually understand this notation. It's probably no surprise
that the North American-centric services pretty much assume that
anything unqualified is traded on a U.S. exchange; I've found that they
do not accept something like "NYSE:T" even though they perhaps should.

A few stock ticker symbols include a suffix, which seems to
differentiate among a company's various classes of common stock. Somem
of the quote services allow you to enter the ticker and suffix all run
together, while others require you to enter a dot between the ticker and
the suffix. For an example, try AKO, classes A and B.

Now that you understand a bit about the ticker symbol, there's some more
explanation required to understand what appears on the "ticker tape"
such as those shown on CNN or CNBC.
Ticker tape says: Translation (but see below):
NIKE68 1/2 100 shares sold at 68 1/2
10sNIKE68 1/2 1000 shares sold at "
10.000sNIKE68 1/2 10000 shares sold at "
The extra zeroes for the big trades are to make them stand out. All
trades on CNN and CNBC are delayed by 15 minutes. CNBC once advertised
a "ticker guide pamphlet, free for the asking", back when they merged
with FNN. It also has explanations for the futures they show. You can
also see an explanation on the web at this URL:

However, the first translation is not necessarily correct. CNBC has a
dynamic maximum size for transactions that are displayed this way.
Depending on how busy things are at any particular time, the maximum
varies from 100 to 5000 shares. You can figure out the current maximum
by watching carefully for about five minutes. If the smallest number of
shares you see in the second format is "10s" for any traded security,
then the first form can mean anything from 100 to 900 shares. If the
smallest you see is "50s" (which is pretty common), the first form means
anything between 100 and 4900 shares.

Note that at busy times, a broker's ticker drops the volume figure and
then everything but the last dollar digit (e.g. on a busy day, a trade
of 25,000 IBM at 68 3/4 shows only as "IBM 8 3/4" on a broker's ticker).
That never happens on CNBC, so I don't know how they can keep up with
all trades without "forgetting" a few.

NASDAQ uses a "fifth letter" identifier in its ticker symbols. Four
letter symbols, and five letter symbols in instances of multiple issues
listed by the same company, are listed in newspapers and carried on the
ticker screen by CNBC and CNN. These symbols are required to retrieve
quotes from quote servers.

Here's the complete list of the NASDAQ fifth-letter identifiers with
brief descriptions:

Symbol Meaning
A Class A
B Class B
C exempt from NASDAQ listing qualifications for limited period
D new issue
E delinquent in required SEC filings
F foreign
G First convertible bond
H Second convertible bond (same company)
I Third convertible bond (same company)
J Voting
K Nonvoting
L misc situations, including second class units, third class warrants,
or sixth class preferred stock
M Fourth class preferred (same company)
N Third class preferred (same company)
O Second class preferred (same company)
P First class preferred (same company)
Q in bankruptcy proceedings
R Rights
S Shares of beneficial interest
T with warrants or rights
U Units
V When issued and when distributed
W Warrants
X mutual fund
Y American Depositary Receipts
Z misc situations, including second class of warrants, fifth class
preferred stock or any unit, receipt or certificate representing a
limited partnership interest.

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

Subject: Financial Planning - Basics

Last-Revised: 22 Oct 1997
Contributed-By: James E. Mallett (jmallett at

One complaint I often hear is that an individual would like to invest
but they do not have any money. Financial planning may help many people
to overcome this lack of ability to save for investment. With proper
planning perhaps you will be able to establish goals and save money to
meet these goals. While you can start this personal financial planning
yourself, you may soon discover that it will pay you to find a Certified
Financial Planner to help in the process.

This article gives a short primer on how to start personal financial
planning for yourself.

To begin the financial planning process, you need specific financial
goals. By specific goals, I mean to establish a date to meet the goal
and a savings plan that meets your goals. At first these goals may seem
unobtainable but continuing the planning process will enable you to
evaluate these goals and modify as necessary.

Next you need to track your expenses and income until you can develop a
yearly statement (cash/flow statement). To see where you are currently,
list the value of all your assets and what you owe. Subtract your debts
from your assets and you have your current net worth (balance sheet).
You should update these statements yearly.

Once you have established your income and expenses you can develop a
budget. Your aim in establishing a budget is to attempt to increase
your income and/or reduce your expenditures so that you have savings to
meet your initial goals. If on the first try you are short of funds, do
not despair.

Try looking at your taxes to see if they can be reduced. Consult a tax
attorney if necessary. Analyze your debt to see if it can be
consolidated into a lower interest rate loan. Perhaps a home equity
loan might fit the bill. Next review your consumption patterns. Are
your financial goals worth driving an older automobile; are you shopping
for the best prices; and what current expenses that you have are

By getting your finances in order, you will gain funds to save and
invest toward your goals. If you do not have sufficient funds to meet
your goals, modify them. Look for opportunities in the future to
reestablish these goals. Seek the aid of financial professionals,
educate yourself with personal finance books and magazines.

Here are a few resources on financial planning.
* James E. Mallett's site about financial planning:
* The International Association for Financial Planning offers a sales
pitch and some information on their site:

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

Subject: Financial Planning - Choosing a Financial Planner

Last-Revised: 20 Apr 1998
Contributed-By: James E. Mallett (jmallett at

Virtually anyone with moderate wealth or a decent income could benefit
from the services of a financial planner. By a financial planner, I
mean someone with the expertise to produce a comprehensive financial
plan for an individual household. This plan should cover the
household's financial goals, budget, insurance and risk review, asset
allocation, retirement plan, and a review of an estate plan. Such
detailed planning is unlikely to be meet by brokers and agents
interested in commissions on financial products they sell.

A financial planner has a broad knowledge of areas such as tax planning,
investments, and estate law but is unlikely to be the financial
professional you require in these individual areas. Rather the
financial planner can help coordinate your financial planning with your
accountant, insurance agent, investment professional, and estate lawyer.
The broad expertise that a professional financial planner possesses will
help insure that your financial goals are met and that all areas of your
financial life are reviewed.

Hiring a planner will help you avoid expensive financial mistakes that
could seriously damage your financial health. It would not be difficult
for most financial planners to find serious gaps in most household
finances, gaps that are easily worth the cost of the planner's services.
Even individuals with expert knowledge in one finance field such as
investments can overlook areas such as insurance or estate planning.
Few people have the time, desire, or expertise to do a complete
financial plan for themselves.

Saying that most would benefit from using a financial planner is not to
imply that there are not wide differences in abilities and costs among
planners. Few areas will pay richer rewards for the public than gaining
basic knowledge in personal finance. If one is not careful, fees and
commissions could negate much, if not all, of the benefit of using a
financial planner. This article lists a few issues to consider when
choosing a financial planner.

The first step in looking for a financial planner is to limit your
search to someone who is certified in financial planning. Two
certifying associations that I would recommend are the Certified
Financial Planner and the Personal Financial Specialist (given to
qualifying Certified Public Accountants). The second step is to seek
out recommendations from people that you respect for names of financial
planners and interview these planners. Your aim is to find someone who
meets your needs and who will look after your interests. A problem that
exists in selecting financial professionals is that what is in your best
interest may fall a distant second to what is in their interest of
making a profit.

The third question you need to ask is how does the financial planner
receive compensation and what will this compensation cost you annually.
In calculating the costs, one must consider fees, commissions,
transaction costs, and (if any) what are the annual fees of the
financial products that they recommend (such as mutual fund management
fees). It is quite possible that after adding sales loads and
management fees, the after-expense return that you receive from equities
will not justify the risk. Recent high market returns have served to
mask the fleecing of many American investors.

Financial planners fall into two broad types: fee-only financial
planners and commission and/or fee-based financial planners. While some
give the nod automatically to fee-only financial planners, it will
depend on your particular circumstances as to which one will be best for

If you only need a comprehensive financial plan and you are willing to
invest your funds yourself, than a fee-only financial planner who
charges by the hour may be your best choice. If you want the financial
planner to manage your money, than many fee-only financial planners have
moved to an asset-based fee, normally 0.5% to 1.5%, of your assets. Two
factors should be kept in mind. One is that this fee is charged
annually. Second, most financial planners put your funds to work in a
mutual fund and that means you continue to pay the mutual fund another
management fee annually. Since evidence and theory suggest that none of
these efforts will result in outperforming an index mutual fund, one
might wonder why not go directly there and save about 2% in management
fees. Plus, on average, you will have a mutual fund that will
outperform most professionals.

With commission-based financial planners, individuals run the risk that
the commissions charged on the financial products that they recommend
will add greatly to the cost of the financial planning. The risk of
conflict of interest arises when the planner receives greater
compensation based on what financial products that they recommend. It
may be possible, however, for some individuals that the free or
reduced-cost financial plan would not be offset by the higher
commissions. For example, the one-time load on the mutual fund might be
cheaper than paying the annual 1.5% fee to a fee-based financial
planner. You must compare all of these costs when deciding which
financial planner is the best for you.

Given this information on financial planners, it is clear that knowledge
on the consumer's part is very important. While many households will
spend a great deal of time shopping for an automobile, the decision of
whom to trust with their wealth too is often made without much thought.
As a result Americans spend many billions more on financial services
than what is really needed.

For more insights from James E. Mallett about financial planning,
please visit his site:

For a list of 10 questions you should ask before hiring a financial
planner, visit this government site:

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

Subject: Financial Planning - Compensation and Conflicts of Interest

Last-Revised: 19 Apr 2000
Contributed-By: Ed Zollars (ezollar at

This article discusses the primary ways that financial planners are paid
for their services, and illustrates the biases and conflicts of interest
that invariably are present in each compensation scheme.

Hourly rate
When a financial planner is paid an hourly rate, he or she may have
a bias towards selling the client more advice than is needed,
and/or selling additional hourly services to the client. However,
the actual financial product sold to the client, or even if any is
sold at all, is a matter of indifference. A practical problem is
that this advice, if done properly (thorough investigation by
adviser into the entire background of the client) is going to be
very expensive because it needs to be customized to the client.
Thus, we see very little of this type of advice except for
specialized areas (like taxation, business law, etc.).

Flat rate
If a financial planner is paid a flat rate, he or she may have a
bias towards giving the client canned advice in order to gain
efficiencies. That can lead to not tailoring the advice to the
specific situation because that adds (uncompensated) time to the
engagement. Additionally, there's a bias towards selling
additional services not included in the initial package. Again,
generally indifference as to whether a sale is closed on an actual
investment, or which investment actually gets chosen. The
advantage to the client is that he or she knows the cost going in.

Percent of assets under management paid annually
If a financial planner receives each year a percentage of assets
under management, he or she may have a bias towards keeping as much
under management as possible, thus leading to some bias against
using funds for other purposes (including paying down debt). This
structure may also encourage the advising of riskier ventures,
since they present the adviser with the potential for higher
compensation. Obviously, the client does have to put some assets
under management (so there is a bias to do something), but the
particular investments are a matter of indifference.

Commissions on sales
When a planner receives a commission on any product sold to the
client, this can lead to a bias towards closing the sale on a
product that will pay the adviser a commission and discouraging the
acquisition of products that won't pay this adviser a commission.
Since advice is offered as a method to encourage the client to get
moving towards a buy, these advisers tend to be rather thorough in
raising issues that relate to their products (finding needs). Will
tend to have a bias to be less thorough in raising issues for which
the solution doesn't involve their product (so in estate planning
there will be lots of talk about ILITs or CRUTs, but little talk
about FLPs, AB trusts, etc.). A practical advantage is that
because the client can simply walk away, this can be the least
expensive way to get a good quick general education on the subject
at hand. Also, many investments sold by commissioned salespeople
spread the fee over a number of years, so it becomes a payment on
the installment plan that may allow some people to receive advice
they need.

Note that any competent professional will actively control for any bias
introduced by the compensation mechanism. Therefore, none of the issues
raised here represent an insurmountable flaw of a particular method of
compensation. Too often this sort of analysis can degnerate into a
mudslinging contest that suggests there is only one right way to handle
every situation, which is simply not the case.

In the end, a client of a financial planner should ask/recognize the
ways by which the planner gets paid, and use that information to note
any bias that might be present in the advice given.

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

Subject: Financial Planning - Estate Planning Checkup

Last-Revised: 20 June 1999
Contributed-By: Nolo Press

This article is copyright &copy; Nolo Press 1999 and was reprinted with
specific permission. For more great, free information about legal
matters, visit their website:

Lots of Americans haven't made even a simple will, to say nothing of a
more comprehensive plan to avoid probate or save on estate taxes. And
even those who have thought about what should happen to their property
when they eventually shuffle off to Nirvana haven't updated their plan
in many years. We're not going to nag, but we are going to chime in
with a few suggestions as to what your estate plan should look like. Oh
yes, in case you're new to this area, estate planning is simply a fancy
term for the process of arranging for what will happen to your property
(estate) if a particularly large and lethal brick falls on your head.

Depending on your age, health, wealth and innate level of cautiousness,
you may not need to do much at all in the way of estate planning. And
even if you do decide you need a will or a trust, you probably won't
need a lawyer. Especially if you aren't dripping with Picassos or fat
investment accounts, it is easy and safe to prepare most basic estate
planning documents yourself. Just learn what you're doing by using a
good self-help book or piece of software.

We've arranged our tips by some broad categories of family situation and
age. As they say, check all that apply. But keep in mind that age is
an imprecise proxy for life expectancy, which is affected by all sorts
of other factors--heavy smoking while participating in extreme sports
and driving a motorcycle, for example. It's up to you to add or
subtract a few years, based on your health and lifestyle.

You're 25 and Single
What are you doing reading about estate planning? You're supposed
to be surfing the Net or dancing until dawn. But you might as well
keep reading; this won't take long.

At your age, there's not much point in putting a lot of energy into
estate planning. Unless your lifestyle is unusually risky or you
have a serious illness, you're very unlikely to die for a long,
long time.

If you're an uncommonly rich 25-year-old, though, write a will.
(Bricks can fall on anyone.) That way you can leave your
possessions to any recipient you choose--your boyfriend, your
favorite cause, the nephew who thinks you're totally cool. If you
don't write a will, whatever wealth you leave behind will probably
go to your parents. Think about it.

You're Paired Up, But Not Married
If you've got a life partner but no marriage certificate, a will is
almost a must-have document. Without a will, state law will
dictate where your property goes after your death, and no state
gives anything to an unmarried partner. Instead, your closest
relatives would inherit everything.

Other options to make sure that your partner isn't left out in the
cold after your death is to own big-ticket items, such as houses
and cars, together in "joint tenancy" with right of survivorship.
Then, when one of you dies, the survivor will automatically own
100% of the property.

You Have Young Children
Having children complicates life--but then, you already know that.
Estate planning is no exception. Here's what to think about.

First, write a will. Nothing fancy--just a document that leaves
your property to whomever you choose and names a guardian for your
children. The guardian will take over if both you and the other
parent are unavailable. That's an unlikely situation, but one
that's worth addressing just in case. If you fail to name a
guardian, a court will appoint someone--possibly one of your

The other big reason to write a will is that if you don't, some of
your property may go not to your spouse, but directly to your
children. When given a choice, most people prefer that the money
go to their spouse, who will use it for the kids. The problem with
the children inheriting directly is that the surviving parent may
need to get court permission to handle the money--a waste of time
and money in most families.

Second, think about buying life insurance so the other parent will
be able to replace your earnings if that damn brick chooses you.
Term life insurance is relatively cheap, especially if you're young
and don't smoke. You can shop for the best bargain by consulting
free services that compare the rates of lots of companies. Look
for their ads in personal finance magazines.

You're Middle-Aged and Know the Names of at Least Three Mutual Funds
If you've made it to a comfortable time in life--you've accumulated
some material wealth and enough wisdom to let you know that other
things matter, too--you will probably want to take some time to
reflect on what you will eventually leave behind.

But given that you may well live another 30 or 40 years, there is
no need to obsess about it. Chances are your conclusions will be
different in ten or 20 years, and your estate plan will change

To save your family the cost (and hassles) of probate court
proceedings after your death, think about creating a revocable
living trust. It's hardly more trouble than writing a will, and
lets everything go directly to your heirs after your death, without
taking a circuitous and expensive detour through probate court.

While you're alive, the trust has no effect, and you can revoke it
or change its terms at any time. But after your death, the person
you chose to be your "successor trustee" takes control of trust
property and transfers it according to the directions you left in
the trust document. It's quick and simple.

There are other, even easier ways to avoid probate: you can turn
any bank account into a "payable-on-death" account simply by
signing a form (the bank will supply it) and naming someone to
inherit whatever funds are in the account at your death. You can
do the same thing, in 29 states, with securities. (Ask your broker
if your state has adopted a law called the Uniform
Transfer-on-Death Securities Registration Act.)

If you have enough property to worry about federal estate taxes,
think about a tax-avoidance trust as well. Currently, estates
worth more than $650,000 are taxed; that amount will increase to $1
million by 2006. Most estates are never subject to tax, but if
estate tax does take a bite, it can be a big one. Tax rates now
start at 37% and rise to 55% for estates worth more than $3

One way to reduce estate tax is to give away property before your
death. After all, if you don't own it, it can't be taxed. But in
2002, gifts larger than $11,000 per year per recipient are subject
to gift tax, which applies at the same rates as does estate tax.
Still, an annual gifting plan can reduce the size of even a big
estate, especially if you have a covey of kids and grandkids.
Gifts to your spouse (as long as he or she is a U.S. citizen),
gifts that directly pay tuition or medical bills, or gifts to a
tax-exempt organization are exempt from gift tax.

Another way to cut taxes is to create certain kinds of trusts. The
most common, the AB trust, is one that couples use. Each spouse
leaves property to their children--with the crucial condition that
the surviving spouse has the right to use the income that property
produces for as long as he or she lives. In some circumstances,
the surviving spouse may even be able to spend principal. By 2006,
an AB trust will shield up to $2 million from estate tax.

Charitable trusts, which involve making a gift to a charity and
getting some payments back, can also save on both estate and income
tax. There are many other varieties of trusts; learn about them on
your own, and then have an experienced estate planning lawyer draw
up the documents you decide on.

You're Elderly or Ill
Now is the time to take concrete steps to establish an estate plan
pronto. It's also a good idea to think about what could happen
before your death, if you become seriously ill and unable to handle
your own affairs.

First, the basics: Consider a probate-avoidance living trust and,
if you're concerned about estate taxes, a tax-saving trust. (These
devices are discussed just above.) Write a will, or update an old

Then, although no one wants to do it, take a minute to think about
the possibility that at some time, you might become incapacitated
and unable to handle day-to-day financial matters or make
healthcare decisions. If you don't do anything to prepare for this
unpleasant possibility, a judge may have to appoint someone to make
these decisions for you. No one wants a court's intervention in
such personal matters, but someone must have legal authority to act
on your behalf.

You can choose that person yourself, and give him or her legal
authority to act for you, by creating documents called durable
powers of attorney. You'll need one for your financial matters and
one for healthcare. (Some states allow the two to be combined, but
it's usually not a good idea. They're used in completely different
situations.) You choose someone you trust to act for you (called
your attorney-in-fact) and spell out his or her authority. If you
wish, you can even state that the document won't have any effect
unless and until you become incapacitated. Once signed and
notarized, it's legally valid, and your mind can be at ease.

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

Compilation Copyright (c) 2003 by Christopher Lott.

Christopher Lott

Mar 18, 2004, 4:16:17 AM3/18/04
Archive-name: investment-faq/general/part3
Version: $Id: part03,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 3 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: Analysis - Internal Rate of Return (IRR)

Last-Revised: 25 June 1999
Contributed-By: Christopher Yost (cpy at, Rich Carreiro
(rlcarr at

If you have an investment that requires and produces a number of cash
flows over time, the internal rate of return is defined to be the
discount rate that makes the net present value of those cash flows equal
to zero. This article discusses computing the internal rate of return
on periodic payments, which might be regular payments into a portfolio
or other savings program, or payments against a loan. Both scenarios
are discussed in some detail.

We'll begin with a savings program. Assume that a sum "P" has been
invested into some mutual fund or like account and that additional
deposits "p" are made to the account each month for "n" months. Assume
further that investments are made at the beginning of each month,
implying that interest accrues for a full "n" months on the first
payment and for one month on the last payment. Given all this data, how
can we compute the future value of the account at any month? Or if we
know the value, what was the rate of return?

The relevant formula that will help answer these questions is:
F = -P(1+i)^n - [p(1+i)((1+i)^n - 1)/i]
In this formula, "F" is the future value of your investment (i.e., the
value after "n" months or "n" weeks or "n" years--whatever the period
over which the investments are made), "P" is the present value of your
investment (i.e., the amount of money you have already invested), "p" is
the payment each period, "n" is the number of periods you are interested
in, and "i" is the interest rate per period. Note that the symbol '^'
is used to denote exponentiation (2 ^ 3 = 8).

Very important! The values "P" and "p" should be negative . This
formula and the ones below are devised to accord with the standard
practice of representing cash paid out as negative and cash received (as
in the case of a loan) as positive. This may not be very intuitive, but
it is a convention that seems to be employed by most financial programs
and spreadsheet functions.

The formula used to compute loan payments is very similar, but as is
appropriate for a loan, it assumes that all payments "p" are made at the
end of each period:
F = -P(1+i)^n - [p((1+i)^n - 1)/i]
Note that this formula can also be used for investments if you need to
assume that they are made at the end of each period. With respect to
loans, the formula isn't very useful in this form, but by setting "F" to
zero, the future value (one hopes) of the loan, it can be manipulated to
yield some more useful information.

To find what size payments are needed to pay-off a loan of the amount
"P" in "n" periods, the formula becomes this:
p = ------------
(1+i)^n - 1
If you want to find the number of periods that will be required to
pay-off a loan use this formula:
log(-p) - log(-Pi - p)
n = ----------------------

Keep in mind that the "i" in all these formula is the interest rate per
period . If you have been given an annual rate to work with, you can
find the monthly rate by adding 1 to annual rate, taking the 12th root
of that number, and then subtracting 1. The formula is:
i = ( r + 1 ) ^ 1/12 - 1
where "r" is the rate.

Conversely, if you are working with a monthly rate--or any periodic
rate--you may need to compound it to obtain a number you can compare
apples-to-apples with other rates. For example, a 1 year CD paying 12%
in simple interest is not as good an investment as an investment paying
1% compounded per month. If you put $1000 into each, you'll have $1120
in the CD at the end of the year but $1000*(1.01)^12 = $1126.82 in the
other investment due to compounding. In this way, interest rates of any
kind can be converted to a "simple 1-year CD equivalent" for the
purposes of comparison. (See the article "Computing Compound Return"
for more information.)

You cannot manipulate these formulas to get a formula for "i," but that
rate can be found using any financial calculator, spreadsheet, or
program capable of calculating Internal Rate of Return or IRR.

Technically, IRR is a discount rate: the rate at which the present value
of a series of investments is equal to the present value of the returns
on those investments. As such, it can be found not only for equal,
periodic investments such as those considered here but for any series of
investments and returns. For example, if you have made a number of
irregular purchases and sales of a particular stock, the IRR on your
transactions will give you a picture of your overall rate of return.
For the matter at hand, however, the important thing to remember is that
since IRR involves calculations of present value (and therefore the
time-value of money), the sequence of investments and returns is

Here's an example. Let's say you buy some shares of Wild Thing
Conservative Growth Fund, then buy some more shares, sell some, have
some dividends reinvested, even take a cash distribution. Here's how to
compute the IRR.

You first have to define the sign of the cash flows. Pick positive for
flows into the portfolio, and negative for flows out of the portfolio
(you could pick the opposite convention, but in this article we'll use
positive for flows in, and negative for flows out).

Remember that the only thing that counts are flows between your wallet
and the portfolio. For example, dividends do NOT result in cash flow
unless they are withdrawn from the portfolio. If they remain in the
portfolio, be they reinvested or allowed to sit there as free cash, they
do NOT represent a flow.

There are also two special flows to define. The first flow is positive
and is the value of the portfolio at the start of the period over which
IRR is being computed. The last flow is negative and is the value of
the portfolio at the end of the period over which IRR is being computed.

The IRR that you compute is the rate of return per whatever time unit
you are using. If you use years, you get an annualized rate. If you
use (say) months, you get a monthly rate which you'll then have to
annualize in the usual way, and so forth.

On to actually calculating it...

We first have the net present value or NPV:

NPV(C, t, d) = Sum C[i]/(1+d)^t[i]

C[i] is the i-th cash flow (C[0] is the first, C[N] is the
d is the assumed discount rate.
t[i] is the time between the first cash flow and the i-th.
Obviously, t[0]=0 and t[N]=the length of time under
consideration. Pick whatever units of time you like, but
remember that IRR will end up being rate of return per chosen
time unit.

Given that definition, IRR is defined by the equation: NPV(C, t, IRR) =

In other words, the IRR is the discount rate which sets the NPV of the
given cash flows made at the given times to zero.

In general there is no closed-form solution for IRR. One must find it
iteratively. In other words, pick a value for IRR. Plug it into the
NPV calculation. See how close to zero the NPV is. Based on that, pick
a different IRR value and repeat until the NPV is as close to zero as
you care.

Note that in the case of a single initial investment and no further
investments made, the calculation collapses into:

(Initial Value) - (Final Value)/(1+IRR)^T = 0 or
(Initial Value)*(1+IRR)^T - (Final Value) = 0
Initial*(1+IRR)^T = Final
(1+IRR)^T = Final/Initial
And finally the quite familiar:
IRR = (Final/Inital)^(1/T) - 1

A program named 'irr' that calculates IRR is available. See the article
Software - Archive of Investment-Related Programs in this FAQ for more

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

Subject: Analysis - Paying Debts Early versus Making Investments

Last-Revised: 14 July 2000
Contributed-By: Gary Snyder, Thomas Price (tprice at,
Chris Lott ( contact me ), John A. Weeks III (john at

This article analyzes the question of whether you should apply any extra
cash you might have lying around to making extra payments on a debt, or
whether you should instead leave the debt on its regular payment
schedule and invest the cash instead. An equivalent question is whether
you should cash out an existing investment to pay down debt, or just let
it ride. We'll focus on the example of a first mortgage on a house, but
the analysis works (with some changes) for a car loan, credit-card debt,

Before we compare debts with investments, it's important to frame the
debate. A bit of financial planning is appropriate here; there are
several articles in the FAQ about that. To start with, an individual
should have an emergency fund of 3-6 months of living expenses.
Emergency funds need to be readily available (when was the last
emergency that you could plan for), like in a bank, credit union, or
maybe a money market fund. And most people would not consider these
investments. So the first thing to do with cash is arguably to
establish this sort of rainy-day fund. If you have to cash out a stock
to get this fund, that's ok; remember, emergencies rarely happen at
market tops.

Before we run numbers, I'd like to point out two important issues here.
The most important issue to remember is risk. Making early payments to
a loan exposes you to relatively few risks (once the loan is paid, it
stays paid), but two notable risks are liquidity and opportunity. The
liquidity risk is that you might not have cash when you need it (but see
above for the mitigation strategy of a rainy-day fund). The opportunity
risk is the possibility that a better opportunity might present itself
and you would be unable to take advantage of it since you gave the bank
your extra cash. And when you invest money, you generally expose
yourself to market risk (the investment's price might fall) as well as
other risks that might cause you to lose money. Of course the other
important issue (you probably guessed) is taxes. The interest paid on
home mortgages is deductable, so that acts to reduce the cost of the
loan below the official interest rate on the loan. Not true for
credit-card debt, etc. Also, monies earned from an investment are
taxed, so that acts to reduce the return on the investment.

One more caveat. If you simply cannot save; i.e., you would cash out
the investments darned quick, then paying down debt may be a good
choice! And owning a home gives you a place to live, especially if you
plan to live in it on a modest income.

Finally, all you can do in advance is estimate, guess, and hope. No one
will never know the answer to "what is best" until long after it is too
late to take that best course of action. You have to take your shot
today, and see where it lands tomorrow.

Now we'll run some numbers. If you have debt as well as cash that you
will invest, then maintaining the debt (instead of paying it) costs you
whatever the interest rate on the loan is minus whatever you make from
the investment. So to justify your choice of investing the cash,
basically you're trying to determine whether you can achieve a return on
your investment that is better than the interest rate on the debt. For
example, you might have a mortgage that has an after-tax rate of 6%, but
you find a very safe investment with a guaranteed, after-tax return of
9% (I should be so lucky). In this case, you almost certainly should
invest the money. But the analysis is never this easy -- it invariably
depends on knowing what the investments will yield in the future.

But don't give up hope. Although it is impossible to predict with
certainty what an investment will return, you can still estimate two
things, the likely return and the level of risk. Since paying down any
debt entails much lower risk than making an investment, you need to get
a higher level of return to assume the market risk (just to name one) of
an investment. In other words, the investment has to pay you to assume
the risk to justify the investment. It would be foolish to turn down a
risk-free 10% (i.e., to pay off a debt with an after-tax interest rate
of 10%) to try to get an after-tax rate of 10.5% from an investment in
the stock market, but it might make very good sense to turn down a
risk-free 6.5%. It is a matter of personal taste how big the difference
between the return on the investment and the risk-free return has to be
(it's called the risk premium), but thinking like this at least lets you
frame the question.

Next we'll characterize some investments and their associated risks.
Note that characterizing risk is difficult, and we'll only do a
relatively superficial job it. The purpose of this article is to get
you thinking about the options, not to take each to the last decimal

Above we mentioned that paying the debt is a low-risk alternative. When
it comes to selecting investments that potentially will yield more than
paying down the debt, you have many options. The option you choose
should be the one that maximizes your return subject to a given level of
risk (from one point of view). Paying off the loan generates a
rock-solid guaranteed return. The best option you have at approximately
this level of risk is to invest in a short-term, high-grade corporate
bond fund. The key market risk in this investment is that interest
rates will go up by more than 1%; another risk of a bond fund is that
companies like AT&T will start to default on their loans. Not quite
rock-solid guaranteed, but close. Anyway, these funds have yielded
about 6% historically.

Next in the scale of risk is longer-term bonds, or lower rated bonds.
Investing in a high-yield (junk) bond fund is actually quite safe,
although riskier than the short-term, high grade bond fund described
above. This investment should generate 7-8% pre-tax (off the top of my
head), but could also lose a significant amount of money over short
periods. This happened in the junk bond market during the summer of
1998, so it's by no means a remote possibility.

The last investment I'll mention here are US stock investments.
Historically these investments have earned about 10-11%/year over long
periods of time, but losing money is a serious possibility over periods
of time less than three years, and a return of 8%/year for an investment
held 20 years is not unlikely. Conservatively, I'd expect about an 8-9%
return going forward. I'd hope for much more, but that's all I'd count
on. Stated another way, I'd choose a stock investment over a CD paying
6%, but not a CD paying 10%.

Don't overlook the fact that the analysis basically attempted to answer
the question of whether you should put all your extra cash into the
market versus your mortgage. I think the right answer is somewhere in
between. Of course it's nice to be debt free, but paying down your
debts to the point that you have no available cash could really hurt you
if your car suddenly dies, etc. You should have some savings to cushion
you against emergencies. And of course it's nice to have lots of
long-term investments, but don't neglect the guaranteed rate of return
that is assured by paying down debt versus the completely unguaranteed
rate of return to be found in the markets.

The best thing to do is ask yourself what you are the most comfortable
with, and ignore trying to optimize variables that you cannot control.
If debt makes you nervous, then pay off the house. If you don't worry
about debt, then keep the mortgage, and keep your money invested. If
you don't mind the ups and downs of the market, then keep invested in
stocks (they will go up over the long term). If the market has you
nervous, pull out some or all of it, and ladder it into corporate bonds.
In short, each person needs to find the right balance for his or her

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

Subject: Analysis - Price-Earnings (P/E) Ratio

Last-Revised: 27 Jan 1998
Contributed-By: E. Green, Aaron Schindler, Thomas Busillo, Chris Lott (
contact me )

P/E is shorthand for the ratio of a company's share price to its
per-share earnings. For example, a P/E ratio of 10 means that the
company has $1 of annual, per-share earnings for every $10 in share
price. Earnings by definition are after all taxes etc.

A company's P/E ratio is computed by dividing the current market price
of one share of a company's stock by that company's per-share earnings.
A company's per-share earnings are simply the company's after-tax profit
divided by number of outstanding shares. For example, a company that
earned $5M last year, with a million shares outstanding, had earnings
per share of $5. If that company's stock currently sells for $50/share,
it has a P/E of 10. Stated differently, at this price, investors are
willing to pay $10 for every $1 of last year's earnings.

P/Es are traditionally computed with trailing earnings (earnings from
the past 12 months, called a trailing P/E) but are sometimes computed
with leading earnings (earnings projected for the upcoming 12-month
period, called a leading P/E). Some analysts will exclude one-time
gains or losses from a quarterly earnings report when computing this
figure, others will include it. Adding to the confusion is the
possibility of a late earnings report from a company; computation of a
trailing P/E based on incomplete data is rather tricky. (I'm being
polite; it's misleading, but that doesn't stop the brokerage houses from
reporting something.) Even worse, some methods use so-called negative
earnings (i.e., losses) to compute a negative P/E, while other methods
define the P/E of a loss-making company to be zero. The many ways to
compute a P/E may lead to wide variation in the reporting of a figure
such as the "P/E for the S&P whatever." Worst of all, it's usually next
to impossible to discover the method used to generate a particular P/E
figure, chart, or report.

Like other indicators, P/E is best viewed over time, looking for a
trend. A company with a steadily increasing P/E is being viewed by the
investment community as becoming more and more speculative. And of
course a company's P/E ratio changes every day as the stock price

The price/earnings ratio is commonly used as a tool for determining the
value the market has placed on a common stock. A lot can be said about
this little number, but in short, companies expected to grow and have
higher earnings in the future should have a higher P/E than companies in
decline. For example, if Amgen has a lot of products in the pipeline, I
wouldn't mind paying a large multiple of its current earnings to buy the
stock. It will have a large P/E. I am expecting it to grow quickly.

PE is a much better comparison of the value of a stock than the price.
A $10 stock with a PE of 40 is much more "expensive" than a $100 stock
with a PE of 6. You are paying more for the $10 stock's future earnings
stream. The $10 stock is probably a small company with an exciting
product with few competitors. The $100 stock is probably pretty staid -
maybe a buggy whip manufacturer.

It's difficult to say whether a particular P/E is high or low, but there
are a number of factors you should consider. First, a common rule of
thumb for evaluating a company's share price is that a company's P/E
ratio should be comparable to that company's growth rate. If the ratio
is much higher, then the stock price is high compared to history; if
much lower, then the stock price is low compared to history. Second,
it's useful to look at the forward and historical earnings growth rate.
For example, if a company has been growing at 10% per year over the past
five years but has a P/E ratio of 75, then conventional wisdom would say
that the shares are expensive. Third, it's important to consider the
P/E ratio for the industry sector. For example, consumer products
companies will probably have very different P/E ratios than internet
service providers. Finally, a stock could have a high trailing-year P/E
ratio, but if the earnings rise, at the end of the year it will have a
low P/E after the new earnings report is released. Thus a stock with a
low P/E ratio can accurately be said to be cheap only if the
future-earnings P/E is low. If the trailing P/E is low, investors may
be running from the stock and driving its price down, which only makes
the stock look cheap.

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

Subject: Analysis - Percentage Rates

Last-Revised: 15 Feb 2003

Contributed-By: Chris Lott ( contact me )

This article discusses various percentage rates that you may want to
understand when you are trying to choose a savings account or understand
the amount you are paying on a loan.

Annual percentage rate (APR)
In a savings account or other account that pays you interest, the
annual percentage rate is the nominal rate paid on deposits. This
may also be known as just the rate. Most financial institutions
compute and pay out interest many times during the year, like every
month on a savings account. Because you can earn a tiny bit of
interest late in the year on the money paid out as interest early
in the year, to understand the actual net increase in account
value, you have to use the annual percentage yield (APY), discussed

In a loan or other arrangement where you pay interest to some
financial institution, you will also encounter annual percentage
rates. Every loan has a rate associated with it, for example a 6%
rate paid on a home mortgage. Federal lending laws (Truth in
Lending) require lenders to compute and disclose an annual
percentage rate for a loan as means to report the true cost of the
loan. This just means that the lender is supposed to include all
fees and other charges with the note rate to report a single
number, the APR. This sounds great, but it doesn't actually work
so well in practice because there do not appear to be clear
guidelines for lenders on what fees must be included and which can
be omitted. Some fees that are usually included are points, a loan
processing fee, private mortgage insurance, etc. Fees that are
usually omitted include title insurance, etc. So the APR of a loan
is a useful piece of data but not the only thing you should
consider when shopping for a loan.

Annual percentage yield (APY)
The annual percentage yield of an account that pays interest is the
actual percentage increase in the value of an account after a
1-year period when the interest is compounded at some regular
interval. This is sometimes called the effective annual rate. You
can use APY to compare compound interest rates. The formula is:
APY = (1 + r / n ) ^ n - 1
where 'r' is the interest rate (e.g., r=.05 for a 5% rate) and 'n'
is the number of times that the interest is compounded over the
course of a year (e.g., n=12 for monthly compounding). The symbol
'^' means exponentiation; e.g., 2^3=8.

For example, if an account pays 5% compounded monthly, then the
annual percentage yield will be just a bit greater than 5%:
APY = (1 + .05 / 12 ) ^ 12 - 1
= 1.0042 ^ 12 - 1
= 1.0512 - 1
= .0512 (or 5.12%)

If interest is compounded just once during the year (i.e.,
annually), then the APY is the same as the APR. If interest is
compounded continuously, the formula is
APY = e ^ n - 1
where 'e' is Euler's constant (approximately 2.7183).

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

Subject: Analysis - Risks of Investments

Last-Revised: 15 Aug 1999
Contributed-By: Chris Lott ( contact me ), Eugene Kononov (eugenek at

Risk, in general, is the possibility of sustaining damage, injury, or
loss. This is true in the world of investments also, of course.
Investments that are termed "high risk" have a significant possibility
that their value will drop to zero.

You might say that risk is a measure of whether a surprise will occur.
But in the world of investments, positive as well as negative surprises
happen. Sometimes a company's revenue and profits explode suddenly and
the stock price