The Biggest Rip-Off Fees of All

A few days ago, I was reading through the commission schedule of a major East Coast bank and was shocked to find that customers were charged $25 per position, up to ten stocks for a maximum of $250, for “safe keeping” fees on the stocks in their account.

Now that we are in an age where stock certificates are rare, there is virtually no effort involved with a broker keeping track of the companies in which you hold shares. For an investor with, say, $50,000 in assets, this represents a frictional expense of 1/2 of 1%! Add on the management fees that are taken out of mutual funds that you never see directly, and it’s not hard to understand why so many investors have a difficult time matching, much less beating, the market.

To add insult to injury, if you wanted to avoid these fees and request a paper certificate, the same firm would likely charge you $25 to $50 to get what rightfully belongs to you! Even more salt in the wound? Many companies offer direct stock purchase plans and dividend reinvestment plans that won’t charge you a penny for having stocks safely held with the transfer agent.
The bottom line is this: You should not be paying custodial or safe keeping fees for the right to hold stocks in your account. This is simply a way for hidden charges to ring the cash register at the broker, banks, or wealth management firm at your expense. Demand these fees be waived or you might just need to consider taking your business elsewhere.

Junk Bonds - The Sexiest Investment

A Short & Simple Lesson in the Danger and Allure of Junk Bonds

You know you shouldn't. Your CPA wouldn't approve. Your wife would be furious if she found out. The guilt would consume you. Still, you can't help casting a lustful glance at junk bonds with their 10-12% coupons. Just remember flashy investments usually go up in smoke, and when these babies fall, they fall hard. They're called "junk" for a reason.
Lately, I've received a lot of emails about junk bonds and how (if) to invest in them. Here's a short and to-the-point lesson in what they are and whether you should add them to your portfolio.

The Fundamentals of Junk Bonds

Bond rating agencies such as Fitch, Standard and Poors, and Moody's assign ratings to debt issues. So-called investment grade bonds have a rating of BBB or higher. By assigning such a rating, the agency is saying that it believes, based on the company's current financial position, interest coverage ratio, and economic outlook, that the chance is default is not substantial. These issues often have a history of long, uninterrupted interest payments to bondholders.

Non-investment grade issues, on the other hand, are those that have been assigned a rating of BB or lower. These obligations possess a much higher risk for default or loss of principal. The companies that issue these "junk" bonds must somehow entice investors to risk their money. In order to do this, they offer a much higher coupon rate (e.g., 10%) than their investment
counterparts (e.g., 5 1/2%). Ironically, this increases the inherent risk because the companies that are least able to afford high interest charges pay double or triple their better-capitalized counterparts. Every bond in the world falls into one of two categories... investment and non-investment grade. There is a huge of difference between the two. Investment grade usually have a rating of BBB or higher. It is a safe bet to assume that they posses solid fundamentals, a stable balance sheet, and are not in serious risk of default or bankruptcy. Most have a long track record of making steady interest payments to their bondholders.

Junk bonds were tremendously popular in the generation of leveraged buyouts and corporate liquidations (otherwise known as the 1980's). Lately, they have staged a slight comeback with a potentially disastrous outcome. Small investors are buying them without fully understanding the risks they carry (and once they do figure it out, it will already be too late.)

Fallen Angels vs. Junk Bonds

In the course of business history, good companies have sometime experienced troubles that caused their debt ratings to be slashed. The company's bond issues plummet as a result. These type of issues are known as "fallen angels". They differ from junk bonds in that they were issued as investment grade and fell from grace. Purchasing fallen angels, if done intelligently, is far less speculative than acquiring junk bonds with the hope of holding them until maturity. This type of operation should be left to those who are able to evaluate a corporation's financials and reasonably estimate the potential outcome of the situation.
The Bottom Line on Junk Bonds
Avoid them like the plague unless you know what you are doing. If you do purchase them, do so with full understanding that unless you have substantial quantitative reasons to believe your purchase promises a safety of principal, you are speculating, not investing.

ting Non-Cash Producing Assets

On November 25th, The Wall Street Journal reported that Great Britain was refining the rules for its personal retirement savings accounts to include collectibles such as fine wine, vacation homes, and art. The new guidelines, set to take effect on April 6th, 2006, raise interesting questions about investing in non-traditional asset classes regardless of your nationality. Are such commitments intelligent or playing with fire?

Investing Non-Cash Producing Assets

As you learnt in the Time Value of Money articles, the intrinsic value of any asset is all of the free, unrestricted future cash that it will generate discounted back to the present at an

appropriate rate. What about assets that don’t generate any cash, such as bottles of wine or fine art? In this case, you must consider the total net price you think you can command at the time of the sale. You must then calculate your Compound Annual Growth Rate based upon how long it takes you to sell. If the figure is substantially more than you expect to make from any of your other investments, it may be worth considering as long as it is within your circle of competence (more on that later).

The danger is that collectibles are subject, to a large degree, to the individual tastes and preferences of the populace at the time. What makes a Rembrandt or a Picasso worth $20 million, $50 million, or $100 million? Simply the fact that others will pay such prices. Unlike a car wash or chain of burger restaurants, there is no underlying cash stream upon which the value is based. With the latter type of investment, it doesn’t matter if the real estate market crashes – you can still rely upon the customers who are generating cash for you. There’s also the issue of theft; you can’t exactly throw a building into the back of a pickup truck and make a break for it like you can with a case of valuable wine.

For that reason, you may want to insist upon an additional margin of safety. A rare book set that you follow, normally trading at $2,000, may be compelling at $1,800. If you come across it for $900, however, you have left yourself ample room for attractive investment returns even if the item were to suffer a substantial shrinkage in value. Such opportunities are ephemeral, yet they do occur from time to time.

Your Circle of Competence

Long-time readers of the site know that I am a big fan of Warren Buffett’s concept of the “circle of competence”. The basic crux of the philosophy is that you never stray beyond your level of understanding when allocating capital. A person who works in the oil industry probably understands exploration and the economics of refining. A person who works in entertainment can probably have an intelligent idea of the direction of content delivery in the next ten years and how it will affect the major networks and media conglomerates. Both individuals have clear circles of competence; if they focus their investments on those areas they understand, they are likely to do better than if they blindly accepted a portfolio of stocks recommended by a high pressure broker. On Wall Street, there is a well-told story about a man who became so familiar with the economics of the American Water Works Company that he knew the cost and profit every time a toilette flushed. He spent his entire life buying and selling this one, single stock and died a multi-millionaire.

Obviously, it is not a wise policy to hold your entire net worth in a single stock. The idea of focusing your attention on areas that you are likely to have an advantage over the competition, however, is likely to serve you well. If you are a molecular biologist, you are probably going to have a much easier time evaluating than research and development pipeline at a major pharmaceutical company than you are estimating the excavation costs for gold mining stocks.

Your asset allocation should reflect that – including in the area of rare collectibles.
A few tips to remember:

1. Do your homework well before you are confronted with the opportunity to buy.
2. Be honest with yourself about where your circle of competence ends. Flattering yourself by imaging your expertise to be larger than it really is exposes you to the risk of overpayment.
3. Don’t allow yourself to be afraid of missing an opportunity. Far better to miss riches than ruin yourself.
4. Cynicism can be a very profitable trait in investing. Always ask yourself, “What Could Go Wrong?” before making any investment.

The Five Components of an Investors Required Rate of Return

In financial theory, the rate of return at which an investment trades is the sum of five different components. They are:

1. The Real Risk-Free Interest Rate

This is the rate to which all other investments are compared. It is the rate of return an investor can earn without any risk in a world with no inflation.

2. An Inflation Premium

This is the rate that is added to an investment to adjust it for the market’s expectation of future inflation. For example, the inflation premium required for a one year corporate bond might be a lot lower than a thirty year corporate bond by the same company because investors think that inflation will be low over the short-run, but pick up in the future as a result of the trade and budget deficits of years past.

3. A Liquidity Premium

Thinly traded investments such as stocks and bonds in a family controlled company require a liquidity premium. That is, investors are not going to pay the full value of the asset if there is a very real possibility that they will not be able to dump the stock or bond in a short period of time because buyers are scarce. This is expected to compensate them for that potential loss. The size of the liquidity premium is the dependent upon an investor’s perception of how active a particular market is.

4. Default Risk Premium

How likely do investors believe it is that a company will default on its obligation or go bankrupt? Often, when signs of trouble appear, a company’s shares or bonds will collapse as a result of investors demanding a default risk premium. If someone were able to acquire assets that were trading at a huge discount as a result of a default risk premium that was too large, they could make a great deal of money. Many professional money managers actually bought shares of Enron’s corporate debt during the now-famous meltdown of the energy-trading giant. In essence, they bought $1 of debt for only a few pennies. If they can get more than they paid in the event of a liquidation or reorganization, it can make them very, very rich.

K-Mart is a wonderful example. Prior to its bankruptcy, hedge fund manager Eddie Lampert and distressed debt expert Marty Whitman of Third Avenue Funds, bought an enormous portion of the retailer’s debt. When the company was reorganized in bankruptcy court, the debt holders were given equity in the new company. Lampert then used his new controlling block of K-Mart stock with its improved balance sheet to start investing in other assets.

3. Maturity PremiumThe further in the future the maturity of a company’s bonds, the greater the price will fluctuate when interest rates change. That’s because of the maturity premium. Here’s a very simplified version to illustrate the concept: Imagine you own a $10,000 bond with a 7% yield when it is issued that will mature in 30 years. Each year, you will receive $700 in interest in the mail. Thirty years in the future, you will get your original $10,000 back. Now, if you were going to sell your bond the next day, you

Four Investing Mistakes to Avoid

Investing Mistake 1: Spreading your investments too thin

Over the past several decades, Wall Street has preached the virtues of diversification, drilling it into the minds of every investor within earshot. Everyone from the CEO to the delivery boy knows that you shouldn't keep all your eggs in one basket - but there's much more to it than that. In fact, many people are doing more damage than good in their effort to diversify. Like everything in life, diversification can be taken too far. If you split up $100 into one hundred different companies, each of those companies can, at best, have a tiny impact on your portfolio. In the end, the brokerage fees and other transaction costs may even exceed the profit from your investments. Investors that are prone to this "dig-a-thousand-holes-and-put-a-dollar-in-each" philosophy would be better served by investing in an index fund which, by its very nature, is made up of many companies. Additionally, your returns will mimic those of the overall market in almost perfect lockstep.

Investing Mistake 2: Not accounting for time horizon

The type of asset in which you invest should be chosen based upon your time frame. Regardless of your age, if you have capital that you will need in a short period of time (one or two years, for example), you should not invest that money in the stock market or equity based mutual funds. Although these types of investments offer the greatest chance for long-term wealth building, they frequently experience short-term gyrations that can wipe out your holdings if you are forced to liquidate. Likewise, if your horizon is greater than ten years, it makes no sense for you to invest a majority of your funds in bonds or fixed income investments unless you believe the stock market is grossly overvalued.

Investing Mistake 3: Frequent trading

I can name ten investors on the Forbes list, but not one person who made their fortune from frequent trading. When you invest, your fortune is tied to the fortune of the company. You are a part-owner of a business; as the company prospers, so do you. Hence, the investor who takes the time to select a great company has to do nothing more than sit back, develop a dollar cost averaging plan, enroll in the DRV or dividend reinvestment programand live his life. Daily quotations are of no interest to him because he has no desire to sell. Over time, his intelligent decision will pay off handsomely as the value of his shares appreciates.

A trader, on the other hand, is one who buys a company because he expects the stock to jump in price, at which point he will quickly dump it and move on to his next target. Because it is not tied to the economics of a company, but rather chance and human emotion, trading is a form of gambling that has earned its reputation as a money maker because of the few success stories (they never tell you about the millionaire who lost it all on his next bet... traders, like gamblers, have a very poor memory when it comes to how much they have lost).

Investing Mistake 4: Fear based decisions

The costliest mistakes are usually fear based. Many investors do their research, select a great company, and when the market hits a bump in the road - dump their stock for fear of losing money. This behavior is absolutely foolish. The company is the same company as it was before the market as a whole fell, only now it is selling for a cheaper price. Common sense would dictate that you would purchase more at these lower levels (indeed, companies such as Wal-Mart have become giants because people like a bargain. It seems this behavior extends to everything but their portfolio). The key to being a successful investor is to, as one very wise man said, "..buy when blood is running in the streets."

The simple formula of "buy low / sell high" has been around forever, and most people can recite it to you. In practice, only a handful of investors do it. Most see the crowd heading for the exit door and fire escapes, and instead of staying around and buying up a company for ridiculous levels, panic and run out with them. True money is made when you, as an investor, are willing to sit down in the empty room that everyone else has left, and wait until they recognize the value they left behind. When they do run back in, you will be holding all of the cards. Your patience will be rewarded with profit and you will be considered "brilliant" (ironically by the same people that called you an idiot for holding on to the company's stock in the first place).

Surviving a Roller Coaster Stock Market

Surviving a Roller Coaster Stock Market

There have been a number of research papers proving that investors, as a whole, experience far lower returns than the stock market itself as a result of frequent trading. It's not difficult to see why: Men and women, with no training in finance, attempting to manage their own 401k, Roth IRA, or Traditional IRA, or retirement accounts, panic when faced with volatility. After building up an investment portfolio over decades of work, a drop in stock prices of only ten or twenty percent can lead to tens, or even hundreds, of thousands of dollars in paper losses.

For an experienced investor with little or no debt, such a drop would be a non-event. They would know why they own the companies they hold, have estimated the future profitability, and calculated that into a discounted cash flow formula that gives them a rough idea of what their rate of return should be provided the variables they plugged in are accurate or conservatively projected. In fact, these investors (what have been called "true" investors) would welcome price drops, even if it meant half of their net worth disappeared from their monthly statements. I can tell you with absolute certainty that, all else being equal, if Berkshire Hathaway were to fall from $120,000 per share to $50,000 per share compared to its $72,000 per share book value, I would not for a moment lament the paper loss in my net worth, but rather back up the truck and attempt to buy as many shares as possible, even selling off other assets to fund the acquisition. There's a good chance the folks at my office would have to stop me from doing cartwheels. That's because I know the company, how it generates its cash, and have a rough approximation, adjusted on a rolling basis, of its intrinsic value.

In this article, I'm going to attempt to lay an intellectual foundation to help you think differently about stock market volatility, as well as provide you with some tips and tricks that might help traversing the stormy seas of Wall Street a whole lot easier.

Lay the Foundation

First, and please correct me if I'm wrong here, but you probably want to retire comfortably. You work hard, and want to be rewarded for that work; because of that, I want you to bookmark your page right here and take a moment to lay the foundation of what we're going to discuss by reading How to Think About Stock Prices, Price is Paramount, and Defensive Investing: Building a Portfolio for Volatile Markets. These three pieces of content will arm you with some background that allows me to go further in this discussion, making it easier to serve you better.
It's All About the History Books

Bill Gross, arguably the greatest pure bond investor alive today, has said that if he were only able to study one book, it would be a comprehensive history of the financial markets. That's because it can provide a framework for understanding financial psychology. Most people make the mistake of thinking that investing success is related to intelligence. I want you to repeat after me: Being a successful investor isn't about intelligence. Isaac Newton, one of the most brilliant minds the human race has ever produced, was wiped out in the Dutch Tulip Bubble.
A good place to start is the Ibbotson & Associates Stocks, Bonds, Bills, and Inflation Classic Yearbook. Although it costs around $100 per hard bound copy, it provides data about market levels and returns for more than a century. A quick glance, and you'll be comforted to see that over periods of ten years or longer, the stock market almost always performs well, especially when coupled with a dollar cost averaging plan that allows you to take advantage of low prices and fat dividend yields.

Some Checkpoints to Lower Your Risk

If you are worried about risk management and not necessarily generating maximum returns (which most likely describes 99% of the readers), here are some things to consider:

· The price-to-earnings ratio of your portfolio is no more than 10% higher than the market as a whole.

· The price-to-earnings ratio of your portfolio is no higher than twenty.

· You have a diversified base of stocks and bonds appropriate for your distance from
retirement (you should own more and more fixed income or cash equivalents as you approach the end of your working career).

· Focus on mutual funds with low expense ratios, good historical performance ratings and established management who invest in the funds they manage.

· If you are interested in long-term (five years or more) returns that are competitive, stop moving assets around in your retirement account. You don't know more than the market, and you aren't experienced enough to make rational judgment calls. Stick to your plan, continue your contributions, and wait until retirement. Unless there is a fundamental deterioration in the underlying asset, the stupidest time to sell anything is after it has fallen in price.
Get Competent Professional Advice

If you don't know what to do or feel completely lost, seek out a competent, well respected, and conservative financial adviser or planner. You want someone who has a good record and can explain, in one short paragraph, the rational for each investment held in your portfolio. You want someone who values your needs and listens to you; what good is it to have someone managing the money for which you work so hard if they don't understand what it is you are trying to accomplish?

Why It Might Be a Horrible Mistake to Sell Out During a Down Market

f you are more than five years away from retirement, your 401(k) was invested in a broadly diversified, low-cost index fund, and you’ve sold off your assets as the market has collapsed, you have made a very, very stupid long-term decision. Believe me, I wish it could be sugar coated, but you’ve effectively just dumped your ownership of great American businesses such as Johnson & Johnson, Coca-Cola, Wal-Mart Stores, and General Electric to value investors at a fraction of their intrinsic value. After years of diligently building your wealth, you’ve turned them over to hedge fund managers, well-heeled executives, and disciplined personal investors that have the emotional strength to ignore volatility and instead do what makes sense five or ten years from now.

The worst part: You sold because other people were selling their stocks (many of them involuntarily due to margin calls). It’s the grown up version of the classic question posed by nearly every mother in history – if your friends jumped off a bridge, would you? Do you really think that Pepsi is going to sell less soft drinks and potato chips over the next twenty years because of a recession? Sure, as Warren Buffett has said, short-term profits are going to get hit at nearly all companies throughout the economy. The long-term health of the United States should continue to trend upward given our social, economic, and legal structures. Just as stocks have been the greatest source of wealth since the market meltdown in 1973 and 1974, they should continue to be the best vehicle for long-term over the next thirty years.

Instead, for those of you who have time to wait out the volatility, it might be a good idea to consider drastically increasing your retirement contributions while the market is falling. Of course, this is only a possibility if you’ve been following all the rules that are constantly espoused by financial advisors such as Suze Orman by establishing an emergency fund, staying out of credit card debt, owning your home, and living well within your means. Otherwise, you simply won’t be able to afford to take advantage of the current prices. (This, it should be noted, is one of the reasons by the rich get richer – when things go south, they can pick up assets on the cheap.)

How do I actually make money from a stock?

How do I actually make money from a stock?” If you’ve ever wondered how the mechanics actually work, print this article, grab a hot cup of coffee, get comfortable in your favorite reading chair, and prepare to learn the basics of common stock.

It's Simple, Really
When you buy a share of stock, you are buying a piece of a company. Imagine that Harrison Fudge Company, a fictional business, has sales of $10,000,000 and net income of $1,000,000. To raise money for expansion, the company’s founders approached a Wall Street underwriting firm (an investment banker) and had them sell stock to the public. They might have said, “Okay, we don’t think your growth rate is great so we are going to price this so that future investors will earn 9% on their investment plus whatever growth you generate … that works out to around $11,000,000+ value for the whole company ($11 million divided by $1 million net income = 9% return on initial investment.)” Now, we’re going to assume that the founders sold out completely instead of issuing stock to the public

The underwriters may say, “You know, we want the stock to sell for $25 per share because that seems affordable so we are going to cut the company into 440,000 pieces, or shares of stock (440,000 shares x $25 = $11,000,000.) That means that each “piece” or share of stock is entitled to $2.72 of the profit ($1,000,000 profit ÷ 440,000 shares outstanding = $2.72 per share.) This figure is known as Basic EPS (short for earnings per share.) In other words, when you buy a share of Harrison Fudge Company, you are buying the right to your pro-rata profits. Were you to acquire 100 shares for $2,500, you would be buying $272 in annual profit plus whatever future growth (or losses) the company generated. If you thought that a new management could cause fudge sales to explode so that your pro-rata profits would be 5x higher in a few years, then this would be an extremely attractive investment.

What Makes It a Bit More Complicated

What muddies up the situation is that you don’t actually see that $2.72 in profit that belongs to you. Instead, management and the Board of Directors have a few options available to them, which will to a large degree determine the success of your holdings:

1. It can send you a cash dividend for some portion or the entirety of your profit. This is one way to “return capital to shareholders.” You could either use this cash to buy more shares or go spend it any way you see fit.

2. It can repurchase shares on the open market and destroy them. For a great explanation of how this can make you very, very rich in the long-run, read Stock Buy Backs: The Golden Egg of Shareholder Value.

3. It can reinvest the funds into future growth by building more factories, stores, hiring more employees, increasing advertising, or any number of additional capital expenditures that are
expected to increase profits. Sometimes, this may include seeking out acquisitions and mergers.

4. It can strengthen the balance sheet by reducing debt or building up liquid assets.

Which way is best for you? That depends entirely upon the rate of return management can earn by reinvesting your money. If you have a phenomenal business – think Microsoft or Wal-Mart in the early days when they were both a tiny fraction of their current size, paying out any cash dividend is likely to be a mistake because those funds could be reinvested at a high rate. There were actually times during the first decade after Wal-Mart went public that it earned more than 60% on shareholder equity. That’s unbelievable. (Check out the DuPont desegregation of ROE for a simple way to understand what this means.) Those kinds of returns typically only exist in fairy tales yet, under the direction of Sam Walton, the Bentonville-based retailer was able to pull it off and make a lot of associates and stockholders rich in the process.

Mutual Funds 101: What They are and How They Work

The brain-child of Wall Street, mutual funds are perhaps the easiest and least stressful way to invest in the market. In fact, more new money has been introduced into funds during the past few years than at any time in history. Before you jump into the pool and select a mutual fund in which to invest, you should know exactly what they are and how they work.

What is a mutual fund?

Put simply, a mutual fund is a pool of money provided by individual investors, companies, and other organizations. A fund manager is hired to invest the cash the investors have contributed. The goal of the manager depends upon the type of fund; a fixed-income fund manager, for example, would strive to provide the highest yield at the lowest risk. A long-term growth manager, on the other hand, should attempt to beat the Dow Jones Industrial Average or the S&P 500 in a fiscal year (very few funds actually achieve this; to find out why, read Index Funds - The Dumb Money Almost Always Wins).

Closed vs. Open-Ended Funds, Load vs. No-Load

Mutual funds are divided along four lines: closed-end and open-ended funds; the latter is subdivided into load and no load.

· Closed-End Funds This type of fund has a set number of shares issued to the public through an initial public offering. These shares trade on the open market; this, combined with the fact that a closed-end fund does not redeem or issue new shares like a normal mutual fund, subjects the fund shares to the laws of supply and demand. As a result, shares of closed-end funds normally trade at a discount to net asset value.

· Open-End Funds A majority of mutual funds are open-ended. In simple terms, this means that the fund does not have a set number of shares. Instead, the fund will issue new shares to an investor based upon the current net asset value and redeem the shares when the investor decides to sell. Open-end funds always reflect the net asset value of the fund's underlying investments because shares are created and destroyed as necessary.

Load vs. No Load A load, in mutual fund speak, is a sales commission. If a fund charges a load, the investor will pay the sales commission on top of the net asset value of the fund’s shares. No load funds tend to generate higher returns for investors due to the lower expenses associated with ownership.

What are the benefits of investing through a mutual fund?

Mutual funds are actively managed by a professional money manager who constantly monitors the stocks and bonds in the fund's portfolio. Because this is his or her primary occupation, they can devote considerably more time to selecting investments than an individual investor. This provides the peace of mind that comes with informed investing without the stress of analyzing financial statements or calculating financial ratios.

How do I select a fund that's right for me?

Every fund has a particular investing strategy, style or purpose; some, for instance, invest only in blue chip companies. Others invest in start-up businesses or specific sectors. Finding a mutual fund that fits your investment criteria and style is absolutely vital; if you don't know anything about biotechnology, you have no business investing in a biotech fund. You must know and understand your investment.

After you’ve settled upon a type of fund, turn to Morningstar or Standard and Poors (S&P). Both of these companies issue fund rankings based on past record. You must take these rankings with a grain of salt. Past success is no indication of the future, especially if the fund manager has recently changed.

How do I begin investing in a fund?

If you already have a brokerage account, you can purchase mutual fund shares as you would a share of stock. If you don't, you can visit the fund's web page or call them and request information and an application. Most funds have a minimum initial investment which can vary from $25 - $100,000+ with most in the $1,000 - $5,000 range (the minimum initial investment may be substantially lowered or waived altogether if the investment is for a retirement account such as a 401k, traditional IRA or Roth IRA, and / or the investor agrees to automatic, reoccurring deductions from a checking or savings account to invest in the fund.
The importance of dollar-cost averaging

The dollar-cost averaging strategy is just as applicable to mutual funds as it is to common stock. Establishing such a plan can substantially reduce your long-term market risk and result in a higher net worth over a period of ten years or more.

Understanding Bond Duration

Holders of bonds face a distinct set of risks that may be less obvious to the uninitiated. Thankfully, one of the biggest risks in the bond market - interest rate risk - is easy to determine, using a concept called duration. It's possible to approximate how much a bond's price is likely to rise or fall when interest rates change, a level of certainty that stock investors will appreciate. So before you go out and buy a 30-year Treasury bond in the mistaken belief that it's risk-free, consider its duration.

A Basic Bond

Before diving in, let's take a simple example of a company that wants to borrow $100. It issues a bond that it sells for $100. To attract investors, the issuer of the bond offers to pay $4 a year to holders of the bond, and will do so for 10 years. At that time, the bond matures, and the bold holder gets $100 back. In the parlance of the world of fixed income, we can say that the bond has a face value of $100, a coupon rate of 4% and a maturity of 10 years.

There are many risks to the holder of the bond. The best known may be the risk that the issuer of the bond can't afford to make interest payments or return the principal. But a default, as this scenario is known, isn't the only risk.

Interest Rate Risk
But even a bond with virtually no chance of default - for instance, bonds issued and backed by the US Government - still have risks. Going back to our simple example, let's say that the day after the bond is issued, interest rates rise to 5%. The owner of that bond might kick herself. If she had waited a day, she could have bought a bond that paid 5% a year. That makes her bond less valuable, and this will be reflected if she tries to sell the bond to someone else. She may not be able to get back her $100.

The seesaw relationship between interest rates and bond prices is a fundamental concept of bonds. But some bonds have greater sensitivity to changes in interest rates. Bond investors don't have to guess at this exposure. A bond's modified duration, a figure derived from several factors, measures this risk and tells the investor how its price is likely to change when market interest rates go up or down. A bond with a duration of six years would be expected to fall 6% in price for every 1% increase in market interest rates.

Elements of Duration
The concept of duration is straightforward: It measures how quickly a bond will repay its true cost. The longer it takes, the greater exposure the bond has to changes in the interest rate environment.

Here are some of factors that affect a bond's duration:

· Time to maturity: Consider two bonds that each cost $1,000 and yield 5%. A bond that matures in one year would more quickly repay its true cost than a bond that matures in 10 years. As a result, the shorter-maturity bond would have a lower duration and less price risk. The longer the maturity, the higher the duration.

· Coupon rate: A bond's payment is a key factor in calculating duration. If two otherwise identical bonds pay different coupons, the bond with the higher coupon will pay back its original cost quicker than the lower-yielding bond. The higher the coupon, the lower the duration.
Using Duration to Your Advantage

Knowing the duration of a bond, or a portfolio of bonds, gives an investor an advantage in two important ways:

· Speculating on interest rates: Investors who anticipate a decline in market interest rates - as a result of, for instance, a simulative rate cut by the Federal Reserve - would try to increase the average duration of their bond portfolio. Likewise, investors who expect the Fed to raise interest rates would want to lower their average duration.

· Matching risk to your tastes: When selecting from bonds of different maturities and yields, or comparing bond mutual funds, duration allows you to quickly determine which bonds are more sensitive to changes in market interest rates, and to what degree.

Calculating Duration

Start by determining the value of a bond's yearly cash flow, adjusted to give greater value to payments that are made sooner rather than later. Divide that figure by its price to calculate its duration. Online calculators make this easy.

Bonds 101

What Are They?

Say you are in the grocery store with a friend on a Thursday afternoon and see something you need for your house; a broom for example. Although you get your paycheck the next day, you ask your shopping buddy to borrow a few dollars so you can purchase the broom now, in return for which you will not only pay them back tomorrow, but buy them dinner as well. Your friend, finding these terms acceptable, loans you the money and you purchase the item.

This is, in essence, what happens in the corporate world when a company issues bonds. Generally, as a business grows, it doesn't generate enough cash internally to pay for the supplies and equipment necessary to keep it growing. Because of this, most businesses have one of two options. They can either 1.) sell a portion of the company to the general public by issuing additional shares of stock, or they can 2.) issue bonds. When a company issues bonds, it is borrowing money from investors in exchange for which it agrees to pay them interest at set intervals for a predetermined amount of time. In essence, it is the same thing as a mortgage only you, the investor, are the bank.

Why Would Anyone Invest in Bonds?

Most everyone knows that over the long-run, nothing beats the stock market. This being the case, why would anyone invest in bonds? Although they pale in comparison to equities in the long run, bonds have several traits that stocks simply can't match.

First, capital preservation. Unless a company goes bankrupt, a bondholder can be almost completely certain that they will receive the amount they originally invested. Stocks, which are subordinate to bonds, bear the brunt of unfavorable developments.

Secondly, bonds pay interest at set intervals of time, which can provide valuable income for retired couples, individuals, or those who need the cash flow. For instance, if someone owned $100,000 worth of bonds that paid 8% interest annually (that would be $8,000 yearly), a fraction of that interest would be sent to the bondholder either monthly or quarterly, giving them money to live on or invest elsewhere.

Bonds can also have large tax advantage for some people. When a government or municipality issues various types of bonds to raise money to build bridges, roads, etc., the interest that is earned is tax exempt. This can be especially advantageous for those whom are retired or want to minimize their total tax liability.

Bracketed Orders

One thing to consider: If you're planning on holding a particular investment for an extended period of time because you believe its long-term potential is substantial or that it is undervalued, placing a trailing stop order may not be a sensible course of action. As an asset class, stocks are notorious for their collective and individual volatility; the road is certainly bumpy. Yet, you may not be able to profit from your convictions because your trailing stop orders could be triggered as a result of ordinary volatility. If you have any doubts or questions, consult your financial advisor.

Bracketed Orders

Bracketed orders go one step further than trailing stop orders. Just like the latter, you set a trailing stop as either a percentage or fixed spread (recall that on the previous page, our trailing stop was $2 for Hershey). In addition, however, you can establish an upper limit that, when reached, will result in the stock being sold.
Going back to our Hershey Chocolate example, let’s now assume you placed a bracketed order with a trailing stop level of $2 per share and an upper limit of $65 per share. The bracketed order will behave exactly the same as the trailing stop order, with the $2 trailing stop automatically ratcheting up as the price increases. The difference? When and if Hershey hits $65, the bracketed order will automatically convert into a market order and should be immediately executed by your broker.