Financial Guides Archive - Page 2 of 11 - Private Tax Solutions

Many investors who trade through online brokerage accounts assume they have a direct connection to the securities markets. But they don’t. When you press “enter,” your order is sent over the Internet to your broker – who in turn decides which market to send it to for execution. A similar process occurs when you call your broker to place a trade.

While trade execution is usually seamless and quick, it does take time. And prices can change quickly, especially in fast-moving markets. Because price quotes are only for a specific number of shares, investors may not always receive the price they saw on their screen or the price their broker quoted over the phone. By the time your order reaches the market, the price of the stock could be slightly – or very – different.

No SEC regulations require a trade to be executed within a set period of time. But if firms advertise their speed of execution, they must not exaggerate or fail to tell investors about the possibility of significant delays.

To avoid buying or selling a stock at a price higher or lower than you wanted, place a limit order rather than a market order. A limit order is an order to buy or sell a security at a specific price. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. When you place a market order, you can’t control the price at which your order will be filled.

You want to buy the stock of a “hot” IPO that was initially offered at $9, but don’t want to end up paying more than $20 for the stock. Place a limit order to buy the stock at any price up to $20. By entering a limit order rather than a market order, you will not be caught buying the stock at $90 and then suffering immediate losses as the stock drops later in the day or the weeks ahead.

Your limit order may never be executed because the market price may quickly surpass your limit before your order can be filled. But by using a limit order you also protect yourself from buying the stock at too high a price.

Just as you have a choice of brokers, your broker generally has a choice of markets in which to execute your trade:

• For a stock listed on an exchange, such as the New York Stock Exchange (NYSE), your broker may direct the order to that exchange, to another exchange (such as a regional exchange), or to a firm called a “third market maker.” A “third market maker” is a firm that stands ready to buy or sell a stock listed on an exchange at publicly quoted prices. As a way to attract orders from brokers, some regional exchanges or third market makers will pay your broker for routing your order to that exchange or market maker – perhaps a penny or more per share for your order. This is called “payment for order flow.”

Upon the opening of a new account and on an annual basis, firms must inform customers in writing whether they receive payment for order flow and, if they do, a detailed description of the type of payments. Firms must also disclose on trade confirmations whether they receive payment for order flow and that customers can make a written request to find out the source and type of the payment as to that particular transaction.

• For a stock that trades in an over-the-counter (OTC) market, such as the NASDAQ, your broker may send the order to a “NASDAQ market maker” in the stock. Many NASDAQ market makers also pay brokers for order flow. Note: A “market maker” is a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price. You’ll most often hear about market makers in the context of the NASDAQ or other “over the counter” (OTC) markets. Market makers that stand ready to buy and sell stocks listed on an exchange, such as the New York Stock Exchange, are called “third market makers.” Many OTC stocks have more than one market-maker.

Market-makers generally must be ready to buy and sell at least 100 shares of a stock they make a market in. As a result, a large order from an investor may have to be filled by a number of market-makers, perhaps at different prices.

• Your broker may route your order – especially a “limit order” – to an electronic communications network (ECN) that automatically matches buy and sell orders at specified prices. A “limit order” is an order to buy or sell a stock at a specific price.
• Your broker may decide to send your order to another division of your broker’s firm to be filled out of the firm’s own inventory. This is called “internalization.” With this option, your broker’s firm can make money on the “spread” – the difference between the purchase price and the sale price.

Many firms use automated systems to handle the orders they receive from their customers. In deciding how to execute orders, your broker has a duty to seek the best execution reasonably available for its customers’ orders. That means your broker must evaluate the orders it receives from all customers in the aggregate and periodically assess which competing markets, market makers, or ECNs offer the most favorable terms of execution.

The opportunity for “price improvement” – which is the opportunity, but not the guarantee, for an order to be executed at a better price than what is currently quoted publicly – is an important factor a broker should consider in executing its customers’ orders. Other factors include the speed and the likelihood of execution.

You enter a market order to sell 500 shares of a stock. The current quote is $20. Your broker may be able to send your order to a market or a market maker where your order would have the possibility of getting a price better than $20. If your order is executed at $20 1/16, you would receive $10,031.25 for the sale of your stock – $31.25 more than if your broker had only been able to get the current quote for you.

Of course, the additional time it takes some markets to execute orders may result in your getting a worse price than the current quote – especially in a fast-moving market. So your broker is required to take into account any trade-off between providing its customers’ orders with the possibility of better prices and the extra time it may take to do so.

If for any reason you want to direct your trade to a particular exchange, market maker, or ECN, you may be able to call your broker and ask him or her to do this. But some brokers may charge for that service.

Some brokers now offer active traders the ability to direct orders in NASDAQ stocks to the market maker or ECN of their choice.

On November 15, 2000, the SEC adopted new rules aimed at improving public disclosure of order execution and routing practices. Beginning April 2001, all market centers that trade national market system securities must make monthly, electronic disclosures of basic information concerning their quality of executions on a stock-by-stock basis, including how market orders of various sizes are executed relative to the public quotes and information about effective spreads – the spreads actually paid by investors whose orders are routed to a particular market center. In addition, market centers will disclose the extent to which they provide executions at prices better than the public quotes to investors using limit orders.

The new rules also require brokers that route orders on behalf of customers to disclose quarterly the identity of the market centers to which they route a significant percentage of their orders. In addition, the rule mandates that brokers respond to the requests of customers interested in learning where their individual orders were routed for execution during the previous six months.

With this information now readily available, you can better learn where and how your firm executes its customers’ orders and what steps it takes to assure the best execution.

Ask your broker about the firm’s policies on payment for order flow, internalization, or other routing practices – or look for that information in your account agreement. You can also write to your broker to find out the nature and source of any payment for order flow it may have received for a particular order.

If you’re comparing brokerage firms, ask each how often it obtains price improvement on customers’ orders. And then consider that information in deciding with which firm you will do business.

Let’s say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you’ll earn a 50 percent return on your investment. But if you bought the stock on margin – paying $25 in cash and borrowing $25 from your broker – you’ll earn a 100 percent return on the money you invested. Of course, you’ll still owe your brokerage $25 plus interest.

The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let’s say the stock you bought for $50 falls to $25. If you fully paid for the stock, you’ll lose 50 percent of your money. But if you bought on margin, you’ll lose 100 percent, and you still must come up with the interest you owe on the loan.

Caution: In volatile markets, investors who put up an initial margin payment for a stock may, from time to time, be required to provide additional cash if the price of the stock falls. Investors have been shocked to learn that a broker has the right to sell the securities that were bought on margin – without any notification, and at a potentially substantial loss to the investor.

Caution: If your broker sells your stock after the price has plummeted, then you’ve lost out on the chance to recoup your losses if the market bounces back.

Margin accounts can be very risky and they are not for everyone. Before opening a margin account, be aware that:

• You can lose more money than you have invested;
• You may have to deposit additional cash or securities in your account on short notice to cover market losses;
• You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and
• Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.

You can protect yourself by knowing how a margin account works and what happens if the price of the stock purchased on margin declines.

Tip: Your broker charges you interest for borrowing money; take into account how that will affect the total return on your investments.

Tip: Ask your broker whether it makes sense for you to trade on margin in light of your financial resources, investment objectives, and tolerance for risk.

To open a margin account, you must sign a margin agreement. The agreement may either be part of your account agreement or separate. The margin agreement states that you must abide by the rules of the Federal Reserve Board, the New York Stock Exchange, the Financial Industry Regulatory Authority (FINRA), and the firm where you have set up your margin account.

Caution: Carefully review the agreement before signing.

As with most loans, the margin agreement explains the terms and conditions of the margin account. The agreement describes how the interest on the loan is calculated, how you are responsible for repaying the loan, and how the securities you purchase serve as collateral for the loan. Carefully review the agreement to determine what notice, if any, your firm must give you before selling your securities to collect the money you have borrowed.

The Federal Reserve Board and many self-regulatory organizations (SROs), such as the NYSE and FINRA, have rules that govern margin trading. Brokerage firms can establish their own requirements as long as they are at least as restrictive as the Federal Reserve Board and SRO rules.

Here are some of the key rules you should know:

Before You Trade – Minimum Margin. Before trading on margin, the NYSE, and FINRA, for example, requires you to deposit with your brokerage firm a minimum of $2,000 or 100 percent of the purchase price, whichever is less. This is known as the “minimum margin.” Some firms may require you to deposit more than $2,000.

Amount You Can Borrow – Initial Margin. According to Regulation T of the Federal Reserve Board, you may borrow up to 50 percent of the purchase price of securities that can be purchased on margin. This is known as the “initial margin.” Some firms require you to deposit more than 50 percent of the purchase price.

Tip: Not all securities can be purchased on margin.

Amount You Need After You Trade – Maintenance Margin. After you buy stock on margin, the NYSE and FINRA require you to keep a minimum amount of equity in your margin account. The equity in your account is the value of your securities less how much you owe to your brokerage firm. The rules require you to have at least 25 percent of the total market value of the securities in your margin account at all times. The 25 percent is called the “maintenance requirement.” In fact, many brokerage firms have higher maintenance requirements, typically between 30 to 40 percent and sometimes higher, depending on the type of stock purchased.

Example: You purchase $16,000 worth of securities by borrowing $8,000 from your firm and paying $8,000 in cash or securities. If the market value of the securities drops to $12,000, the equity in your account will fall to $4,000 ($12,000 – $8,000 = $4,000). If your firm has a 25 percent maintenance requirement, you must have $3,000 in equity in your account (25 percent of $12,000 = $3,000). In this case, you do have enough equity because the $4,000 in equity in your account is greater than the $3,000 maintenance requirement.

But if your firm has a maintenance requirement of 40 percent, you would not have enough equity. The firm would require you to have $4,800 in equity (40 percent of $12,000 = $4,800). Your $4,000 in equity is less than the firm’s $4,800 maintenance requirement. As a result, the firm may issue you a “margin call,” since the equity in your account has fallen $800 below the firm’s maintenance requirement.

If your account falls below the firm’s maintenance requirement, your broker generally will make a margin call to ask you to deposit more cash or securities into your account. If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm’s maintenance requirement.

Tip: Your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm’s maintenance requirement. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.

• Margin accounts involve a great deal more risk than cash accounts, where you fully pay for the securities you purchase. You may lose more than your initial investment when buying on margin. If you cannot afford to do so, then margin buying is not for you.
• Read the margin agreement, and ask your broker questions about how a margin account works and whether it’s appropriate for you to trade on margin. Your broker should explain the terms and conditions of the margin agreement.
• Know how much you will be charged on money you borrow from your broker, and know how these costs affect your overall return.
• Remember that your brokerage firm can sell your securities without notice to you when you don’t have sufficient equity in your margin account.

Asset allocation is based on the proven theory that the type or class of security you own is much more important than the particular security itself. Asset allocation is a way to control risk in your portfolio. The risk is controlled because the six or seven asset classes in the well-balanced portfolio will react differently to changes in market conditions such as inflation, rising or falling interest rates, market sectors coming into or falling out of favor, a recession, etc.

Asset allocation should not be confused with simple diversification. Suppose you diversify by owning 100 or even 1,000 different stocks. You really haven’t done anything to control risk in your portfolio if those 1,000 stocks all come from only one or two different asset classes–say, blue chip stocks (which usually fall into the category known as large-capitalization, or large-cap, stocks) and mid-cap stocks. Those classes will often react to market conditions in a similar way they will generally all either go up or down after a given market event. This is known as “correlation.”

Similarly, many investors make the mistake of building a portfolio of various top-performing growth funds, perhaps thinking that even if one goes down, one or two others will continue to perform well. The problem here is that growth funds are highly correlated-they tend to move in the same direction in response to a given market force. Thus, whether you own two or 20 growth funds, they will tend to react in the same way.

Not only does it lower risk, but asset allocation maximizes returns over a period of time. This is because the proper blend of six or seven asset classes will allow you to benefit from the returns in all of those classes.

Asset allocation planning can range from the relatively simple to the complex. It can range from generic recommendations that have no relevance to your specific needs (dangerous) to recommendations based on sophisticated computer programs (very reliable although far from perfect). Between these extremes, it can include recommendations based only on your time horizon (still risky) or on your time horizon adjusted for your risk tolerance (less risky) or any combination of factors.

Tip: Most mutual fund families, brokerage firms and financial service companies offer computerized asset allocation analysis. Unfortunately, many of them, in recommending a specific portfolio of mutual funds or stocks, include only funds in their family (in the case of fund families) or those on which they receive the highest commissions (in the other cases). However, these may not be the best-performing investments. Don’t undercut the benefit of a sophisticated asset allocation analysis by allowing yourself to be steered into funds or stocks that are based on biased recommendations.

Computerized asset allocations are based on a questionnaire you fill out. Your answers provide the information the computer needs to become familiar with your unique circumstances. From the questionnaire will be determined:

• Your investment time horizon (mainly, your age and retirement objectives).
• Your risk threshold (how much of your capital you are willing to lose during a given time frame), and
• Your financial situation (your wealth, income, expenses, tax bracket, liquidity needs, etc.).
• Your goals (the financial goals you and your family want to achieve).

The goal of the computer analysis is to determine the best blend of asset classes, in the right percentages, that will match your particular financial profile.

At this point, the “efficient frontier” concept comes into play. It may sound complex, but it is a key to investment success.

Note: For an in-depth discussion of this important concept, see The Efficient Frontier, below.

The securities that exist in today’s financial markets can be divided into four main classes: stocks, bonds, cash, and foreign holdings, with the first two representing the major part of most portfolios. These categories can be further subdivided by “style.” Let’s take a look at these classes in the context of mutual fund investments:

Equity Funds: The style of an equity fund is a combination of both (1) the fund’s particular investment methodology (growth-oriented, value-oriented or a blend of the two) and (2) the size of the companies in which it invests (large, medium and small). Combining these two variables – investment methodology and company size – offers a broad view of a fund’s holdings and risk level. Thus, for equity funds, there are nine possible style combinations, ranging from large capitalization/value for the safest funds to small capitalization/growth for the riskiest.

Fixed Income Funds: The style of a domestic or international fixed-income fund is to focus on the two pillars of fixed-income performance – interest-rate sensitivity (based on maturity) and credit quality. Thus, fixed-income funds are split into three maturity groups (short-term, intermediate-term, and long-term) and three credit-quality groups (high, medium and low). These groupings display a portfolio’s effective maturity and credit quality to provide an overall representation of the fund’s risk, given the length and quality of bonds in its portfolio.

Simply stated, financial advisors build asset allocation models by (1) taking historic market data on classes of securities, individual securities, interest rates, and various market conditions; (2) applying projections of future economic conditions and other relevant factors; (3) analyzing, comparing and weighting the data with computer programs; and (4) further analyzing the data to create model portfolios.

There are three key areas that determine investment performance for each asset class:

1. Expected return. This is an estimate of what the asset class will earn in the future-both income and capital gain-based on both historical performance and economic projections.
2. Risk. This is measured by looking to the asset class’s past performance. If an investment’s returns are volatile (vary widely from year to year), it is considered high-risk.
3. Correlation. Correlation is determined by viewing the extent in which asset classes tend to rise and fall together. If there is a high correlation, a decision to invest in these asset classes increases risk. The correct asset mix will have a low correlation among asset classes. Correlation coefficients are calculated by looking back over the historical performance of the asset classes being compared.

Tip: The ideal asset allocation model for you will change over time, due to changes in your portfolio, market conditions and your individual circumstances. There will probably be shifts in the percentages allocated to asset classes, and possibly some changes in the asset classes themselves.

It’s important to be informed about asset allocation so as to avoid the “cookie cutter” approach that many investors end up accepting. Many of the asset allocations performed today take this “one size fits all” approach.

There are all sorts of investment recommendations, but the question is whether they are suitable for you. Regardless of the approach you take, be sure that an asset allocation takes into account your financial profile to the extent feasible.

The “efficient frontier” concept is a key to investment success. A graph demonstrating the efficient frontier is shown below.

Any expected return (left side of graph) carries with it an expected risk (bottom of graph). This risk-reward relationship varies from individual to individual. Conservative investors cannot tolerate more than a low level of risk, and are willing to accept a return commensurate with that level of risk. More aggressive investors are willing to tolerate higher levels of risk in the expectation of higher returns.

The efficient frontier is a line on the graph that represents a series of optimal risk-return relationships. That is, every dot on the line represents the highest return for a given level of risk or, stated conversely, the lowest risk for a given rate of return. Conservative investors will aim for a spot on the left side of the efficient (low return, low risk) while aggressive investors will aim for the right side (high return, high risk). If your portfolio (present or proposed) falls on the efficient frontier line, it has an optimal risk-return relationship, but nonetheless still may not be suitable for you because it may be too aggressive or too conservative. Your portfolio should be at that spot on the efficient frontier that approximates your particular risk-return goal.

Note: The efficient frontier is the result of mathematical calculations of expected risk and return. Risk is shown in levels of standard deviation, a commonly used measure of volatility.

As shown on the graph, if you are willing to tolerate an expected risk (standard deviation) of, say, 12, then you can reasonably (not definitely) expect an approximate return of 10 percent over a period of time (Portfolio C) – if your portfolio is efficient.

It is unlikely, over time, that returns will be higher than those shown on the efficient frontier. Of course, you may, in specific instances, achieve a higher return than that shown, but your average return over time will generally not exceed the amount shown.

If your portfolio falls below the efficient frontier, then it is “inefficient” in that it exposes you to too much risk for the specified return or, conversely, provides too low a return for the specified risk. Unfortunately for investors, most portfolios fall substantially below the efficient frontier.

Example: Portfolio A represents an inefficient portfolio in that it falls below the efficient frontier, meaning that the investor might reasonably expect a return of 10 percent for a risk of 25. However, if the investor is comfortable with that risk level, he can theoretically increase his return to 12 percent with no increase in risk by making his portfolio efficient (i.e., modifying it to resemble Portfolio B, which is on the efficient frontier). Conversely, if he wants to lower his risk, he can maintain the 10 percent return while reducing the risk to 12 (by modifying his portfolio to resemble Portfolio C on the efficient frontier).

Portfolio D is also efficient (as are B and C, all on the efficient frontier), but represents a portfolio that will enjoy a lower return with lower risk.

Caution: A diversified portfolio does not assure a profit or protect against loss in a declining market.

Caution: Asset allocation will not guarantee a profit or protect you from loss however, it may provide a hedge against risk and create opportunities in both bull and bear markets.

The term “securities” encompasses a broad range of investments, including stocks, corporate bonds, government bonds, mutual funds, options, and municipal bonds. Investment contracts, through which investors pool money into a common enterprise managed for profit by a third party, are also securities. Securities may be traded on an organized exchange or traded “over the counter” between investors.

Exchanges

Securities are bought and sold in a number of different markets. The best known are the New York Stock Exchange and the American Stock Exchange, both located in New York City. In addition, six regional exchanges are located in cities throughout the country.

A corporation’s securities may be traded on an exchange only after the issuing company has applied to the exchange and met any listing standards relating, for example, to the company’s assets, number of shares publicly held, and number of stockholders. Organized markets for other instruments, including standardized options, impose similar restrictions. The exchanges facilitate a liquid market for securities where buyers and sellers are brought together. Listing on an exchange, however, does not constitute approval of the securities or provide any assurance as to risk and return.

Over-The-Counter

Many securities are not traded on an exchange but are traded over the counter (OTC) through a large network of securities brokers and dealers. In the National Association of Securities Dealers’ Automated Quotation System (NASDAQ), which is run by the Financial Industry Regulatory Authority (FINRA), trading in OTC stocks is done via on-line computer listings of bid, which asks prices and completes transactions.

Like the exchanges, NASDAQ has listing standards that must be met for securities to be traded in that market. Similar to an exchange it provides a “meeting place” for buyers and sellers. The typical investor generally will not know whether their security is bought or sold through an exchange or over the counter. The investor engages a broker who arranges the transaction in the appropriate market at the desired price.

Brokers

If you buy or sell securities on an exchange or over the counter, you will probably use a broker, and your direct contact will be with a registered representative. The registered representative often called an account executive or financial consultant, must be registered with FINRA, a self-regulatory organization whose operations are overseen by the Securities and Exchange Commission (SEC), and with the states in which the broker is conducting business. The registered representative is the link between the investor and the traders and dealers who actually buy and sell securities on the floor of the exchange or elsewhere.

How are the stock prices that appear in the financial section of the newspaper arrived at? Market prices for stocks traded over the counter and for those traded on exchanges are established in somewhat different ways.

Exchange Prices

The exchanges centralize trading in each security at one location, on the floor of the exchange. There, auction principles of trading set the market price of a security according to current buying and selling interests. If such interests do not balance, designated floor members known as specialists are expected to step in to buy or sell for their own account, to a reasonable degree, as necessary to maintain an orderly market.

Over the Counter (OTC)

In the OTC market, brokers acting on behalf of their customers (the investors) contact a brokerage firm which holds itself out as a market-maker in the specific security, and negotiates the most favorable purchase or sale price. Commissions received by brokers are then added to the purchase price or deducted from the sale price to arrive at the net price to the customer.

In some cases, a customer’s brokerage firm may itself act as a dealer, either selling a security to a customer from its own inventory or buying it from the customer. In such cases, the broker hopes to make a profit on the purchase and sale of the security, but no commission is charged. Instead, a retail “mark-up” is added to the price charged by the firm when a customer buys securities and a “mark down” is deducted from the price paid by the firm when a customer sells securities.

Bid and Ask Prices

In both cases, a stock is quoted in terms of bid and ask. The bid is the price at which the market or market maker is willing to buy the security from you. Similarly, the ask is the price at which the market or market maker is willing to sell the security to you. Not surprising, the ask price is higher than the bid price. The difference between the two is called the spread. For example, if a stock is quoted 18-18 ¼, this means that the investor could sell the stock for $18 a share or purchase the stock for $18.25. The higher the spread the more the market maker profits and the higher the cost is to investors. Heavily traded securities typically have narrow spreads while infrequently traded securities can have wide spreads.

Investors’ money is protected in three ways: by federal laws and regulations that are enforced by the SEC (Securities and Exchange Commission); by self-policing in the industry; and by state law.

Under federal securities laws, those engaged in the business of buying and selling securities have a great deal of responsibility for regulating their own behavior through SROs (self-regulatory organizations) operating under the oversight of the SEC. These SROs include all of the exchanges; the FINRA; the Municipal Securities Rulemaking Board (MSRB), which establishes rules that govern the buying and selling of securities offered by state and local governments; and other organizations concerned with somewhat less visible activities such as the processing of transactions.

The SROs are responsible for establishing rules governing trading and other activities, setting qualifications for securities industry professionals, regulating the conduct of their members, and disciplining those who fail to abide by their rules.

In addition, the federal securities laws provide investors with certain protections, including the ability to sue if they have been harmed as a result of certain violations of those laws.

Many brokerage firms require that their customers sign an agreement containing an arbitration clause when they open a brokerage account. If you sign an agreement with an arbitration clause, you are agreeing to settle any future disputes with the broker through binding arbitration, instead of through the courts.

Arbitration proceedings are administered by the SROs, and the rules that apply in arbitration proceedings are specified by each SRO. Although the SEC oversees the arbitration process, it cannot intervene on behalf of, or directly represent individual investors. Nor can the SEC modify or vacate an arbitration decision. The grounds for judicial review are very limited.

Further protection for investors is provided by state laws designed to regulate the sale of securities within state boundaries.

The Function of the SEC

The SEC, an independent agency of the U.S. Government, was established by Congress in 1934 to administer the federal securities laws. It is headed by five Commissioners, appointed by the President, who direct a staff of lawyers, accountants, financial analysts, and other professionals. The staff operates from its headquarters in Washington, D.C. and from five regional offices and six district offices in major financial centers throughout the country.

The SEC’s principal objectives are to ensure that the securities markets operate in a fair and orderly manner, that securities industry professionals deal fairly with their customers, and that corporations make public all material information about themselves so that investors can make informed investment decisions. The SEC accomplishes these goals by:

• Mandating that companies disclose material business and financial information;
• Overseeing the operations of the SROs;
• Adopting rules with which those involved in the purchase and sale of securities must comply; and
• Filing lawsuits or taking other enforcement action in cases where the law has been violated.

Despite the many protections provided by federal and state securities laws and SRO rules, it is important for investors to remember that they have the ultimate responsibility for their own protection. In particular, the SEC cannot guarantee the worth of any security. Investors must make their own judgments about the merits of an investment.

What Companies Must Disclose

Before any company offers its securities for sale to the general public (with certain exceptions), it must file with the SEC a registration statement and provide a “prospectus” to investors. In its registration statement, the company must provide all material information on the nature of its business, the company’s management, the type of security being offered and its relation to other securities the company may have on the market, and the company’s financial statements as audited by independent public accountants. A copy of a prospectus containing information about the company and the securities offered must be provided to investors upon or before their purchase. In addition, most companies must continue to update (quarterly and annually), in filings made with the SEC, this disclosure information to ensure an informed trading market.

The SEC reviews registration statements and periodic reports for completeness, but the SEC does not review every detail and verification of each statement of fact would be impossible. However, the securities laws do authorize the SEC to seek injunctives and other relief for registration statements containing materially false and misleading statements.

Persons who willfully violate the securities laws may also be subject to criminal action brought by the Department of Justice leading to imprisonment or criminal fines. The laws also provide that investors may be able to sue to recover losses in the purchase of a registered security if materially false or misleading statements were made in the prospectus or through oral solicitation. Investors must seek such recovery through the appropriate courts since the SEC has no power to collect or award damages or to represent individuals.

How the SEC Supervises Industry Professionals

Another important part of the SEC’s role is supervision of the securities markets and the conduct of securities professionals. The SEC serves as a watchdog to protect against fraud in the sale of securities, illegal sale practices, market manipulation, and other violations of investors’ trust by broker-dealers, investment advisers, and other securities professionals.

In general, individuals who buy and sell securities professionally must register with the appropriate SRO, meet certain qualification requirements, and comply with rules of conduct adopted by that SRO. The broker-dealer firms for which they work must, in turn, register with the SEC and comply with the agency’s rules relating to such matters as financial condition and supervision of individual account executives. In addition, broker-dealer firms must also comply with the rules of any exchange of which they are a member and, usually, with the rules of the FINRA.

The SEC can deny registration to securities firms and, in some cases, may impose sanctions against a firm and/or individuals in a firm for violation of federal securities laws (such as, manipulation of the market price of a stock, misappropriation of customer funds or securities, or other violations). The SEC polices the securities industry by conducting inspections and working in conjunction with the securities exchanges, the FINRA, and state securities commissions.

You should be as careful about buying securities as you would be about any other costly purchase. The vast majority of securities professionals are honest, but misrepresentation and fraud do take place. Observe the following basic safeguards when “shopping” for investments:

• Never buy securities offered in unsolicited telephone calls or through “cold calls.” Ask for information in writing before you decide. Check on the credentials of anyone who tries to sell you securities.

Tip: Beware of salespeople who try to pressure you into acting immediately.

• Don’t buy on tips or rumors. Not only is it safer to get the facts first, but also it is illegal to buy or sell securities based on “inside information” which is not generally available to other investors.
• Get advice if you don’t understand something in a prospectus or a piece of sales literature.

Tip: Be sure you understand the risks involved in trading securities, especially options and those purchased on margin. Be skeptical of guarantees or promises of quick profits. There is no such thing, at least not without an accompanying increase in risk.

• Remember that prior success is no guarantee of future success in an investment arrangement.
• With tax-sheltered investments, partnerships, and other “liquid” investments be sure to ask about the liquidity and understand that there may not be a ready market when you want to sell.
• Don’t speculate. Speculation can be a useful investment tool for those who can understand and manage the risks involved and those who can afford to lose money, but it is dangerous for most people.

Tip: For the average investor, more conservative investment strategies are generally appropriate.

Professional guidance can be very helpful in developing a sound investment program.

Two broad categories of securities are available to investors: equity securities, which represent ownership of a part of a company and debt securities, which represent a loan from the investor to a company or government entity. Within each of these types, there are a wide variety of specific investments. In addition, different types can be combined (e.g., through mutual funds) or even split apart to form derivative securities.

Each type has distinct characteristics plus advantages and disadvantages, depending on an investor’s needs and investment objectives. In this section, we provide an overview of the most common classes of investment securities.

Stocks

The type of equity securities with which most people are familiar is stock. When investors buy stock, they become owners of a “share” of a company’s assets. If a company is successful, the price that investors are willing to pay for its stock will often go up and shareholders who bought stock at a lower price then stand to make a profit. If a company does not do well, however, its stock may decrease in value and shareholders can lose money. The rise in the price of a stock is termed appreciation or “capital gain.” The stockholder is also entitled to dividends, which may be paid out from the company. Investors, therefore, have two sources of profit from stock investments, dividends, and appreciation. Some stocks pay out most of their earnings as dividends and may have little appreciation. These stocks are sometimes referred to as income stocks. Other stocks may pay out little or no dividend, preferring to reinvest earnings within the company. Since all of an investor’s potential earnings comes from appreciation these stocks are sometimes referred to as growth stocks. Stock prices are also subject to both general economic and industry-specific market factors. There is no guarantee of a return from investing in stocks and hence there is risk incurred in investing in this type of security.

As owners, shareholders generally have the right to vote on electing the board of directors and on certain other matters of particular significance to the company. Under the federal securities laws, most companies must send to shareholders a proxy statement providing information on the business experience and compensation of nominees to the board of directors and on any other matter submitted for shareholder vote. This information is required so that stockholders can make an informed decision on whether to elect the nominees or on how to vote on matters submitted for their consideration.

Stock investments are typically common stock, which is the basic ownership share of a company. Some companies also offer preferred stock, which is another class of stock. Preferred stock typically offers some set rate of return (although it is still not guaranteed), and pays dividends before dividends are paid for common stock. Preferred stock may not, however, participate in as much upside as common stock. If a company does really well, preferred stockholders may receive the same dividend as any other year while common stockholders reap the rewards of a great year.

Corporate Bonds

The most common form of corporate debt security is the bond. A bond is a certificate promising to repay, no later than a specified date, a sum of money which the investor or bondholder has loaned to the company. In return for the use of the money, the company also agrees to pay bondholders a certain amount of “interest” each year, which is usually a percentage of the amount loaned.

Since bondholders are not owners of the company, they do not share in dividend payments or vote on company matters. The return on their investment is not usually dependent upon how successful the company is. Bondholders are entitled to receive the amount of interest originally agreed upon, as well as a return of the principal amount of the bond if they hold the bond for the time period specified.

Companies offering bonds to the public must file with the SEC a registration statement, including a prospectus containing information about the company and the security.

Government Bonds

The U.S. Government also issues a variety of debt securities, including Treasury bills (commonly called T-bills), Treasury notes, and U.S. Government agency bonds. T-bills are sold to selected securities dealers by the Treasury at auctions.

Government securities can also be purchased from banks, government securities dealers, and other broker-dealers.

Similar to corporate bonds, these bonds pay interest and the amount of principal at maturity. Some bonds, such as Treasury Bills, may not pay cash interest. Instead, the bond is purchased at a discount and the interest is built into the amount the investor receives at maturity. Contrary to popular belief investors must pay income tax on U.S. government bond interest.

Municipal Bonds

Bonds issued by states, cities, or certain agencies of local governments such as school districts are called municipal bonds. An important feature of these bonds is that the interest a bondholder receives is not subject to federal income tax. In addition, the interest is also exempt from state and local tax if the bondholder lives in the jurisdiction of the issuing authority. Because of the tax advantages, however, the interest rate paid on municipal bonds is generally lower than that paid on corporate bonds.

Municipal bonds are exempt from registration with the SEC; however, the MSRB establishes rules that govern the buying and selling of these securities.

Stock Options

A stock option is a type of derivative security and refers to the right to buy or sell something at some point in the future. There are a wide variety of these specialized instruments such as futures, options, and swaps. Most are not appropriate for the average investors. The type of options with which we are concerned here are standardized, exchange-traded options to buy or sell corporate stock.

These options fall into two categories:

• “Calls,” which give the investor the right to buy 100 shares of a specified stock at a fixed price within a specified time period, and
• “Puts,” which give the investor the right to sell 100 shares of a specified stock at a fixed price within a specified time period.

While options are considered by many to be very risky securities, if used properly they can actually reduce the risk of a portfolio. Generally, if you are bullish on a stock (i.e. you expect the price to go up), you buy a call option. The price you pay is called the premium. You would purchase a put option if you are bearish on a stock (i.e. you expect the price to go down). If the stock moves in the right direction you can profit handsomely. If it doesn’t you lose the premium that you paid. Buying puts and calls is not a risky strategy, but selling puts and calls is. One exception is selling a call option on a stock you already own. This is known as a “covered call.” This actually reduces the overall risk of your portfolio in exchange for you giving up some of your upside.

Mutual Funds

Companies or trusts that principally invest their capital in securities are known as investment companies or mutual funds. Investment companies often diversify their investments in different types of equity and debt securities in the hope of obtaining specific investment goals. When you invest in a mutual fund, the fund invests in individual equity and debt securities. There’s no need to make individual purchase and sale decisions. Mutual funds also provide an easy way to diversify a portfolio. Rather than purchasing 50 stocks yourself, you can purchase a single mutual fund.

Related Guide: For more detailed information, please see the Financial Guide INVESTING IN MUTUAL FUNDS: Time-Tested Guidelines.

Investors sometimes pool money into a common enterprise managed for profit by a third party. This is called an investment contract. Such enterprises may involve anything from cattle breeding programs to movie productions. This is often done through the establishment of a limited partnership in which investors, as limited partners, own an interest in a venture but do not take an active management role. Some of these securities have been issued in the past primarily for purposes of reducing income tax liability. Such opportunities are limited today. Care should be taken in investing in these securities since they can be illiquid and require a great deal of expertise. Consult with your financial advisor before investing in these types of investments.

Real Estate Investment Trust (REIT)

Real estate investment trusts are set up in a fashion similar to mutual funds. Instead of investing in stocks or bonds, however, REIT investors pool their funds to buy and manage real estate or to finance real estate construction or purchases. Real estate limited partnerships are also common. This is a way to get diversification from real estate investment without the headaches of property ownership and management.

Asset Allocation

Asset allocation is the process of allocating your investments among several broad categories, including stocks, corporate bonds, and government bonds and is extremelyimportant in investment success. In fact, portfolio selection should generally be based on asset allocation, whether formal or informal. This process can be complicated, but computer programs are available to assist in performing the allocation.

Related Guide: For a discussion of this very important concept, please see the Financial Guide ASSET ALLOCATION: How To Diversify Your Assets For Maximum Return

One of the most basic relationships in investing is that between risk and reward. Investments that offer potentially high returns are accompanied by higher risk factors. It is up to you to decide how much risk you can assume. Always keep in mind your current and future needs.

Risk

There are many types of risk. The one most people think of is market risk, which is the risk that market prices can fluctuate. If you have a short investment horizon, generally something less than five years, this risk is important since the market could be down at the time you most need the money. On the other hand, if you have a long time horizon, for example when saving for retirement, you may be unconcerned with market risk. The investment has the opportunity to come back prior to the time you need the funds.

Another risk, which many people don’t think about, is purchasing power risk. This is the risk that your investment will not keep up with inflation and you will not be able to maintain your desired standard of living. A bank CD, for example, might pay interest of 3 percent and have no market risk. Your principal does not fluctuate in value and you are insured against loss. However, if inflation exceeds 3 percent you will lose purchasing power.

Tip: In general, prospective investors should avoid “risky” investments unless they have a steady income, adequate insurance, and an emergency fund of readily accessible cash.

Tip: U.S. Treasury bills, notes, and bonds are the safest possible investments.

You need to assess how much risk you can tolerate. In general the longer your investment horizon the greater the amount of risk you can afford to take. Your financial advisor can assist you in measuring your risk tolerance.

Risk can also be reduced through diversification. Rather than buying one stock, buy a basket of 20 to 30 stocks. This reduces your overall risk. You can also reduce risk by combining different investment types such as stocks, corporate bonds, and government bonds. These securities are not highly correlated, in other words, they tend not to go up or down at the same time.

Return

Why would one want to take on more risk? Because it generally comes with a higher expected return. While stocks may have the greatest market risk, they have also had the highest market return over the long haul. Stock returns have averaged between 10 and 11 percent since the early part of this century. Corporate bonds, on the other hand, have averaged between 6 and 7 percent, and government bonds closer to 5 percent. As you can see the lower the risk the lower the expected return. You must balance the amount of risk you are willing to tolerate with the amount of return you expect to achieve. There is no such thing as a high return/low-risk investment.

You should first assess your current resources and future goals because this will assist you and your advisors in determining what rate of return is necessary to achieve your goals, and how much risk you can tolerate. Here is a suggested checklist:

• Assess your current financial resources. How much do you have to invest?
• Assess your future financial resources. Do you have an excess of income over expenses that can be invested?
• Determine your financial goals. How much money do you need and when do you need it?
• Determine the rate of return you need to achieve your goals.
• Determine how much risk you can tolerate based upon your time horizon and personal preferences.
• Choose an appropriate asset allocation to achieve the desired risk/return relationship. How should you allocate your investment among the various classes of investments?
• Choose the individual securities within each asset class. Which securities should you buy?

Once you have decided what percentage of your assets should go in each asset class, you need to select the appropriate individual securities. For each security, you must evaluate its unique risk and its expected return. There are a number of sources of information about specific securities that you can explore, but generally, the most important of these for mutual funds and new stock issues is the prospectus. The prospectus is the security’s selling document, containing information about costs, risks, past performance (if any) and the investment goals. The prospectus is obtained from the company or mutual fund or from your financial advisor. Read it and exercise your judgment carefully, before you invest.

In the case of a mutual fund, there is also a Statement of Additional Information (SAI). A SAI is sometimes referred to as Part B of the prospectus and explains a fund’s operations in greater detail than the prospectus. It’s also possible to get a clearer picture of a fund’s investment goals and policies by reading its annual and semi-annual reports to shareholders. If you ask, the fund must send you a SAI and/or its periodic reports; however, this process is time-consuming and requires a great deal of time and expertise.

Here are the top mistakes that cause investors to lose money unnecessarily.

1. Using a Cookie-Cutter Approach

Most investors, along with many of the people who advise the, are satisfied with a one-size-fits-all investment plan. The “model portfolio” is useless to most investors. Your individual needs as an investor must govern any plans you make for investment. For instance, how much of your investment can you risk losing? What is your investment timetable…are you retired, a young professional, or middle-aged? The allocation of your portfolio’s assets among various types of investments, including Treasuries, blue-chip stocks, equity mutual funds, and other, should match your needs perfectly.

2. Taking Unnecessary Risks

You do not have to risk your capital to make a decent return on your money. There are many investments that offer a return that beats inflation and more-without unduly jeopardizing your hard-earned money. For instance, Treasuries, the safest possible investment, offer a decent return with virtually no risk. Blue-chip preferred stocks, common stocks, and mutual funds offer high returns with a fairly low level of risk.

3. Allowing Fees and Commissions to Eat Up Profits

Many investors allow brokers’ commissions and other return-eating costs to cut into their returns. Professionals need to be compensated for their time; however, you should make certain that the fees you are paying are appropriate for the services performed.

4. Not Starting Early Enough

Many investors are not cognizant of the power of interest compounding. By starting out early enough with your investment plan, you can invest less, and still, come out with double or even quadruple the amount you would have had if you started later. Another way to look at it is that by investing as much as possible earlier on, you’ll be able to meet your goals and have more current cash on hand to spend.

5. Ignoring the Cost of Taxes

Every time you or your mutual fund sells stocks, there is a capital gains tax to pay. Unless you are in a tax-deferred retirement account, taxes will eat into your profits, therefore, you should invest in funds that have low turnover (i.e., funds in which shares are bought and sold less frequently). Your portfolio, overall, should have a turnover of 10 percent or less per year.

6. Letting Emotion Govern Your Investing

Never give in to pressure from a broker to invest in a “hot” security or to sell a fund and get into another one. The key to a successful portfolio lies in planning, discipline, and reason. Emotion and impulse have no role to play in investing. Similarly, do not be too quick to unload a stock or fund just because it slips a few points. Try to stay in a security or fund for the long haul. On the other hand, when it’s time to unload a loser, then let go of it.

Finally, do not fall prey to the myth of “market timing.” This is the belief that by getting into or out of a security at exactly the right moment, we can retire rich. Market timing does not work. Instead, use the investment strategies that do work: a balanced allocation of your portfolio’s assets among securities that suit your individual needs, the use of dividend reinvestment programs and other cost-saving strategies, and a well-disciplined, long-haul approach to saving and investment.

• The SEC

Most companies whose stock is traded over the counter or on a stock exchange must file “full disclosure” reports on a regular basis with the SEC. The annual report (Form 10-K) is the most comprehensive of these. It contains a narrative description and statistical information on the company’s business, operations, properties, parents, and subsidiaries; its management, including their compensation and ownership of company securities: and significant legal proceedings which involve the company. Form 10-K also contains the audited financial statements of the company (including a balance sheet, an income statement, and a statement of cash flow) and provides management’s discussion of business operations and prospects for the future.

Companies file regular reports with the SEC in a computer database known as EDGAR. For example, a company declaring bankruptcy will file a form 8-K that tells where the case is pending and which chapter of bankruptcy was filed. You can access EDGAR through your computer at: www.sec.gov. If you don’t have access to a computer, your public library may have a computer you can use. You can also request a copy of Form 8-K or any other reports that the company files with the SEC, see “How to Request Public Documents.” Or, you can visit the SEC’s Public Reference Room, 100 F Street NE, Washington, DC 20549. You might also be able to get copies of SEC filings from your full-service stockbroker, or the company itself.

Other sources of information filed with the SEC include public or law libraries, securities firms, financial service bureaus, computerized on-line services, and the companies themselves.

American Association of Individual Investors Offers a collection of Investor Guides provides you with a continuing stream of “how-to” investment knowledge and guidance.

625 N. Michigan Avenue
Chicago, IL 60611
Tel: 800-428-2244

Investment Company Institute (an organization promoting public understanding of mutual funds)

1401 H Street NW, Suite 1100
Washington, DC 20005
Tel: 202-326-5800

Mutual Fund Education Alliance (pricing and performance information on thousands of mutual funds plus news and educational information about fund investing.

Ask

The lowest price a broker asks customers to pay for a security.

Beneficial Owner

The true owner of a security which may, for convenience, be recorded under the name of a nominee.

Bid

The highest price a broker is willing to pay for a security.

Bond

A certificate that is evidence of a debt in which the issuer promises to repay a specific amount of money to the bondholder, plus a certain amount of interest, within a fixed period of time.

Broker-Dealer

An entity engaged in the business of buying and selling securities.

Call

The right in options contracts to buy underlying securities at a specified price at a specified time. It also refers to provisions in bond contracts that allow issuers to buy back bonds prior to their stated maturity.

Cash Account

A type of account with a broker-dealer in which the customer agrees to pay the full amount due for the purchase of securities within a short period of time, usually five business days.

Closed-end Fund

A type of investment company whose securities are traded on the open market rather than being redeemed by the issuing company.

Commission

The fee charged by a broker-dealer for services performed in buying or selling securities on behalf of a customer.

Discretionary Account

A type of account with a broker-dealer in which the investor authorizes the broker to buy and sell securities, selected by the broker, at a price, amount, and time the broker believes to be best.

Dividend

A payment by a corporation to its stockholders, usually representing a share in the company’s earnings.

Equity Security

An ownership interest in a company, most often taking the form of corporate stock.

Face Value

The amount of money that the issuer of a bond promises to repay to the bondholder on or before the maturity date.

Form 8-K

A current report required to be filed with the SEC if a certain specified event occurs, such as a change in control of the registrant, acquisition or disposition of assets, bankruptcy or receivership, or another material event. Form 8-K is required to be filed within 15 days of the event.

Form 10-K

The designation of the official audited financial report and narrative which publicly owned companies must file with the SEC. It shows assets, liabilities, equity revenues, expenses, and so forth. It is a reflection of the corporation’s condition at the close of the business year, and the results of operations for that year.

Form 10-Q

Quarterly reports containing interim information, which is “material” and important for investors to know. These must be filed with the SEC.

Interest

The payment a corporate or governmental issuer makes to bondholders in return for the loan of money.

Investment Company

A company engaged primarily in the business of investing in securities.

Margin Account

A type of account with a broker-dealer, in which the broker agrees to lend the customer part of the amount due for the purchase of securities.

Money Market Account

Generally, a mutual fund which typically invests in short-term debt instruments such as government securities, commercial paper, and large denomination certificates of deposit of banks.

Mutual Fund

A pool of stocks, bonds, or other securities purchased by a group of investors and managed by a professional/registered investment company. The investment company itself is also commonly referred to as a mutual fund.

NASDAQ

National Association of Securities Dealers Automated Quotation System (NASDAQ) is a system that provides broker-dealers with bid and ask prices for some securities traded over the counter.

Net Asset Value

The dollar value of one share of a mutual fund at a given point in time, which is calculated by adding up the value of all of the fund’s holdings and dividing by the number of outstanding shares.

No-load Fund

A type of mutual fund that offers its shares directly to the public at their net asset value with no accompanying sales charge.

Odd Lot

Fewer than 100 shares of stock.

Open-end Fund

A type of investment company that continuously offers shares to the public and stands ready to buy back such shares whenever an investor wishes to sell.

Option

A contract providing the right to buy or sell something often 100 shares of corporate stock at a fixed price, within a specified period of time.

Over the Counter (OTC)

A market for buying and selling stock between broker-dealers over the telephone rather than by going through a stock exchange.

Prospectus

The document required to be furnished to purchasers of newly registered securities, which provides detailed information about the company issuing the securities and about that particular offering.

Proxy

A written authorization given by shareholders for someone else to cast their votes on such corporate issues as election of directors.

Proxy Statement

A document which the SEC requires a company to send to its shareholders (owners of record) that provides material facts concerning matters on which the shareholders will vote.

Put

The right, in an options contract, to sell underlying securities at a specified price at a specified time.

Quotation (or Quote)

The price at which a security may be bought or sold at any given time.

Registered Securities

Stocks or bonds or other securities for which a registration statement has been filed with the SEC.

REIT

Real Estate Investment Trust, a type of company in which investors pool their funds to buy and manage real estate or to finance construction or purchases.

Restricted Securities

Stocks or bonds which were issued in a private sale or other transaction riot registered with the SEC.

Round Lot

Generally, one hundred shares of stock or multiples of 100.

Specialist

A member of a stock exchange who operates on the trading floor buying and selling shares of particular securities as necessary to maintain a fair and orderly market.

Stock

An ownership interest in a company, also known as “shares” in a company.

Street Name

A name other than that of the beneficial owner (e.g., a broker-dealer) in which stock may be recorded, usually to facilitate resale.

Unit Investment Trust

A type of investment company with a fixed unmanaged portfolio, typically invested in bonds or other debt securities in which the interests are redeemable.

Yield

Generally, the return on an investment in a stock or bond, calculated as a percentage of the amount invested.