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Investment Choices
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Investing In Stocks
There are two types of stock shares: common and preferred. When you own a public company's common stock, you are entitled to vote in the election of company officers and on other important matters, and often you receive dividends on your shares. Common stock is usually riskier than preferred stock. Because of this, it offers greater potential returns and losses.
As a shareholder of preferred stock, you would not usually have voting rights, but you would receive a fixed dividend, which would be paid to you before common stockholders are paid. But owners of preferred stock pay for that privilege--usually your dividends wouldn't increase when the company's profits increase. When a company does well, the price of its preferred stock tends to underperform its common shares. However, when a company fails, preferred stockholders are ahead of common stockholders in recouping their investment.
The stock price is the amount at which you can buy one share of a public company's stock at a given moment. Outside events can make the price of a stock rise or fall. For instance, if another company or a big investor wants to buy the company you're invested in, the company's share price could rise quickly on that news. On the other hand, if your investment is in a pharmaceutical company and its competitor wins government approval for a drug similar to one that your company manufactures, the company's stock price might tumble. Other forces that can affect stock prices include interest rates, national and international issues or events, foreign exchange rates, financial forecasts, and new technologies. Retail stocks, for example, are subject to declines during recessions.
The terms Large-cap, mid-cap, and small-cap refers to the issuing company’s market capitalization, that is the overall value of all shares of the company’s stock. Stocks are also categorized by the way they perform. Growth stocks are shares of companies that have exhibited relatively fast growth in earnings, which generally causes the stock price to go up. Keep in mind, though, that growth stocks are the most volatile and are just as likely to go down in price quickly. That's because growth companies are typically in new or fast-growing industries such as the high-tech sector. Growth stocks are considered riskier and often pay you lower or no dividends but appeal to investors who will accept more volatility and risk in hopes of a greater appreciation in share price over time.
Income stocks, on the other hand, are characterized as those that would pay you high and regular dividends. Stable and well-established industries, including utilities and financial institutions, typically produce income stocks. Blue chip stocks is the name applied to large, well-known, well-established companies with good reputations.
Value stocks are those considered to be selling at lower prices or “undervalued” because the companies that issue these shares have had business setbacks or are out of favor with investors. Value stocks have been known to outperform growth stocks in slow markets — and vice versa. But there is still a risk with value stocks because not all companies recover from setbacks. Stocks are often referred to by a combination of the characteristics discussed above, such as shares of a “small-cap value” stock or of a “mid-cap growth” stock.
Dividends are the distribution of a company's profit or earnings back to the company's shareholders, or stockholders--the people and firms that have purchased that company's stock. Dividends are another way you can share in a company's growth; they are usually distributed quarterly. Most companies offer dividend reinvestment plans, which means that instead of paying you by sending you a check or depositing the money into your account, the amount of the dividend is used to buy more shares of the company's stock in your name. This is a good way to increase your investment in the company over time. Utilities are an example of an industry with traditionally high dividend rates. Growth stocks and small cap stocks, on the other hand, tend to offer little, if any, dividends to their shareholders, as any profit the company makes is poured back into the growing company.
When selecting stocks, it's good to keep in mind factors that could influence the company's performance--and, therefore, the investment.
Investing In Bonds
Bonds are actually loans that investors -- individuals like you, as well as institutions -- make to the federal government, state governments, municipalities, companies, and government agencies. Investors who buy bonds become bondholders, or lenders. Bondholders get an "I.O.U." from the issuer of the bond, but the bondholder doesn't have any ownership rights like stockholders do. Generally, bonds are fixed-income securities because they pay you, as the bondholder, a predetermined interest rate (also called "coupon rate"), regularly, that is set when the bond is issued. However, some bonds are issued with variable rates that can be affected by external economic factors. The borrower or issuer promises to pay back the loan in full on the maturity date. All bonds have set maturity dates--the date when it must be paid back to investors at its face amount, called "par value. "
Bonds are usually sold in $1,000 units. Like its interest rate, a fixed-income bond's term is set when it is issued. Short-term bonds are usually one year or less. Intermediate-term bonds run 2 to 10 years and long-term bonds are generally for at least 20 to 40 years. In most cases, the longer the term, the higher the interest rate paid. Just as bank certificates of deposit (CDs) pay higher interest rates for the right to keep your money for a longer term than an ordinary savings account, so do bonds. Be aware, however, that the risk level increases the longer the bond is held because of its vulnerability to interest rate fluctuations and inflation, over time.
Different Types of Bonds
Private corporations issue corporate bonds to raise money for capital expenditures, operations, and acquisitions. Corporate bond interest is taxable and the prices are well publicized (usually in newspapers), so it's easy to know what the bonds are worth. As with stocks, investing in corporate bonds carries risk. The value of the bond may change depending on changes in the company's credit rating and, in the event of a corporate bankruptcy, holders of corporate bonds suffer significant losses.
U.S. Treasury bonds are long-term debt instruments that pay for various government operations and are applied toward the national debt. Unlike stock and corporate bonds, Treasury bonds are backed by the full faith and credit of the U.S. government, which means that the resources of the United States would make sure that your investment was repaid, making them relatively secure investments.
Municipal bonds issued by states, cities, counties, and towns pay for public works projects like new schools and highways. Your investment in municipal bonds is generally exempt from federal income taxes, and in many states, from state income taxes, too. This may be advantageous if you are in a high tax bracket. A tax-free bond usually has a lower yield than a taxable bond. You can determine your net (after tax) yield from a taxable bond by subtracting the amount of yield from your marginal tax rate. (Your marginal tax rate is based on your filing status).
Secured bonds are backed by collateral that the issuer may sell to repay you if the bond is defaulted on at maturity. Unsecured bonds, called debentures, are backed by the promise and good credit of the bond's issuer. A convertible bond may at some time be exchanged for other securities from the issuing company under specified conditions.
Understanding Your Bond Investment
Interest rates affect bond prices--though, inversely. Usually, bond prices move in the opposite direction of national interest rates; when interest rates rise, bond prices fall. For example: you buy a 10-year, $1,000 bond issued at 7 percent today. Five years later, you want to sell that bond, but now interest rates have risen to 9 percent and new bonds are paying 9 percent. Few people would want to buy a $1,000 bond paying only 7 percent. So, you would probably have to sell that $1,000 bond for less than $1,000 to make up for the higher interest rate now being paid on other bonds.
Bond ratings measure credit risk. Several private agencies, such as Moody's and Standard & Poor's, rate bonds based on their assessment of underlying risk that the issuer may not be able to pay back the bond's principle and interest. The better the rating, the lower the interest the bond will usually pay. Generally the higher the yield, the greater the risk. Remember: in extreme cases, the issuer of the bond can suspend interest payments or default entirely. Issuers can also buy back, or "call," the bonds before maturity if interest rates fall. You should study the call provisions thoroughly before buying a bond.
Finally, some bonds, like U.S. Treasuries and municipals bonds, require large minimum investments, usually $10,000.
Investing In Mutual Funds
Over the past decade, mutual funds--which are invested in everything from stocks and bonds to commodities and money market securities--have attracted millions of investors seeking both income and capital appreciation. According to a recent study, investments in mutual funds have tripled since 1990. Today, more than 88 percent of investors own shares in mutual funds. Nearly half of all investors own all their stocks through mutual fund shares and do not own any stocks in individual firms.
A mutual fund is simply a pool of money invested for you by an investment firm in a variety of instruments like stocks, bonds, or government securities. Each mutual fund is different in its make-up and philosophy. As an investor, you should look for funds with objectives and risk levels that match yours. If you're interested in a diversified mutual fund covering a single class of investments, there are many broad-based funds that invest in a wide variety of stocks. If you prefer to stick with single industries, you might consider sector funds such as real estate investment trusts (REITs), technology, and telecommunication funds, among others. Mutual funds are also a good way to invest in foreign stocks. Some funds own hundreds of different securities, while others may own only a few dozen.
The two most common types of mutual funds are equity funds that invest primarily in common stocks and fixed-income funds or "bond funds" that typically invest in bonds or money market securities. Less common are "balanced funds" invested in both equity and debt.
Most mutual funds require a minimum initial investment, sometimes as low as $250. Mutual fund shares trade like stocks, rising and falling in price depending on investor interest and the performance of stocks in the fund. The Net Asset Value (NAV) of a mutual fund indicates its value or price per share. Like stocks, mutual funds are liquid, meaning they can be bought and sold easily. Before investing in a mutual fund, find out if it's a load or no-load mutual fund. Load funds charge a sales commission; no-load funds don't. When you pay a sales commission going in, that's called a front-end load. A commission paid when you sell is known as a back-end load. The advantage to a load fund is that there is usually staff available to explain the fund to you and advise you as to the appropriate time to buy more shares, or sell. If you're a new investor, it might be worth paying the commission for the extra guidance. With some no-load funds, a staff person merely takes your order to buy or sell, or can only offer limited support--you are fully responsible for understanding the investment.
Many mutual fund rates don't account for shareholder tax liability. Your actual return after-taxes might wind up much lower than the pre-tax one cited in the magazine or newspaper article rating the mutual funds. Remember, funds with high pre-tax returns don't necessarily offer the best after-tax returns. Not all funds create the same taxes for the investor. Smart investors look for the best total return.
A mutual fund that frequently trades its holdings pays more taxes than a fund that holds its investments long term. Unless you are invested in an Individual Retirement Account (IRA) or other tax-exempt account, you have to pay taxes whenever your fund sells a stock and profits. The more profitable the trades, the more taxes paid. Some fund managers count on attractive short-term returns to attract new investors. If your mutual fund investment is for your retirement, then tax liability may not be important for you now.
Index funds are mutual funds that are more conservative in their approach; they try to match their performance to the performance of the stock or bond markets as a whole. By purchasing the same securities held in an index such as Standard and Poor's 500 or the Russell 2000, these funds match the return on the markets they index.
Futures And Options
Futures and options are not for most individual long-term investors. Futures commit the investor to buy or sell a commodity like wheat or silver on a set day for a set price. If the market value of the commodity increases, you profit. If it falls, you could lose all of your investment and more. There is great opportunity and great risk. That's why new investors tend to leave the futures markets to professionals or more experienced investors.
Options are an owner's right to buy or sell a specific item, like a stock, for a set price during a certain period of time. You can buy the right to purchase a security, say, for $50 during the next three months. If the stock increases in value, the option is worth more. If it falls, the option can expire, worthless. Options are traded in stocks, currencies, stock indexes, Treasury bills, and bonds.
Employer-Sponsored Retirement Plans
A good place to start investing for retirement is with your employer-sponsored retirement plan. Among these plans are defined contribution plans, such as the 457, the 403(b), and perhaps the most familiar, the 401(k). If your employer offers a retirement plan, you should consider participating in it, as it is one of the easiest and most beneficial means of helping you save for your retirement. It is also one of the best ways to defer paying taxes on your investments.
Contributing to a 401(k) is simple; your employer deducts the amount you designate from your pay, before federal taxes--in other words, the amount you contribute to the plan lowers your taxable income. In many companies, the employer matches all or part of your contribution. Let's say you make $4,000 each month and contribute 6 percent to your 401(k) plan account, or $240.00 If your employer's plan offers a 50 percent match--that is, half of the 6 percent you designate--your employer would put $120 into your 401(k) account for you each month.
As the employee, you usually get to choose how much you want to contribute within the restrictions of your particular plan; however, your employer or its plan administrator will manage the account. Many 401(k) plans also allow you to direct how the funds in your account are invested within the choices allowed by the plan. It is important that you read all the information provided to you about the plan and consult the plan administrator, if necessary, to ask questions and discuss the details. To learn more about 401(k)s, please read Smart 401(k) Investing.
A 403(b) plan is similar to a 401(k), but is offered to employees of public and private school systems--K through college--and non-profit, tax-exempt organizations, such as churches, libraries, etc. Your plan administrator can explain how it works and how it differs from the 401(k).
The 457 plan, offered only to state and local government employees, allows you to set aside a portion of your pay for use later--generally in retirement. You are not taxed on that income now; you pay taxes later, when you withdraw the money from the plan. A 457 plan reduces your current income taxes, while helping you save for retirement, and allows your earnings to accumulate tax-deferred.
Individual Retirement Accounts
You're probably already familiar with individual retirement accounts (IRAs). These tax-deferred accounts have been around since 1984 to help working people save for retirement.
Most IRAs allow you to direct how funds in your account are invested. You may be able to invest the funds in a variety of ways, including individual stocks and bonds, annuities, and mutual funds, though there are some restrictions on how you invest your IRA funds. Also, as long as you don't contribute more than your annual limit (see chart below), you may diversify your IRA funds among different types of investments. Additionally, you cannot use your life insurance policies to fund your IRA.
There are two types of IRAs - traditional and Roth.
Traditional IRA: The earnings on your IRA are taxed-deferred. Depending on how much money you earn, you may be eligible to deduct your IRA contribution from your gross income for tax purposes. But, there are penalties for withdrawing money from your traditional IRA before you reach the age of 59 1/2, and withdrawals will be taxed as ordinary income.
Roth IRA: This type of IRA was named after former Senator William Roth of Delaware, who championed the Taxpayer Relief Act of 1997. Eligibility is determined by the amount of your annual income. You may not deduct contributions to your Roth IRA from your taxable income, but growth in your Roth IRA is tax-free.
If you have had your Roth IRA for more than five years, you may be able to withdraw earnings from your Roth IRA without paying penalties and/or taxes, if: you have reached the age of 59 1/2, you become fully disabled, or you are using the money to buy your first home ($10,000 life-time limit). You may also withdraw from your Roth IRA to pay for college -- you will have to pay taxes on that withdrawal, but you will not be subject to the penalty for premature withdrawal.
In some cases, you may convert your traditional IRA to a Roth IRA, but you will have to pay income taxes on the converted amount not previously taxed. As with any retirement investment, you should consult a financial professional to learn all the details.
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