CHAPTER 11 INVESTMENT PLANNING

LEARNING OBJECTIVES

After completing this chapter, you should be able to do the following:

  Identify the types and uses of investment vehicles available to a personal financial planner.

  Compare and contrast the various types of cash and cash equivalents.

  Compare and contrast government, municipal, corporate (secured and unsecured), and mortgage-backed bonds.

  Distinguish between the general features of common stock and preferred stock.

  Differentiate between open-end and closed-end funds.

Introduction

The last chapter covered some basic concepts behind investments. The focus was primarily the mechanics of investment planning from the perspective of the personal financial planner: the role of the personal financial planner, different business models for providing investment guidance, and the investment planning process itself. In this chapter, the focus will be on actual investment planning from an investor perspective as we examine investment strategies and the types of investments available.

The concept of time value of money, as introduced in chapter 3, is foundational to investment planning. An investor, given a choice between receiving $10,000 today or $10,000 at a future date, will choose to receive the $10,000 today. The investor must be compensated when asked to delay receipt of a sum of money. The compensation an investor receives for delaying receipt of a sum of money, in this example, the $10,000, is called the investment return.

The return on an investment is not without risk. Not only must investors be promised a return on their investments to be willing to delay receipt of that return, they must be informed about the likelihood of any adverse outcomes or losses of all or a portion of their investment. This information is part of the risk management process.

Investment planning is actually more about risk management than the pursuit of investment returns. If the personal financial planner is able to correctly assess the investor’s risk tolerance and create a portfolio to match, the returns will be consummate with the actual risk taken by the investor. This chapter will illustrate many—but not all—types of investments, and the various ways to measure risk in an investment portfolio.

Capital Markets

The best place to start a discussion of investments is with capital markets. Capital is almost any financial asset or the value of that asset. Capital could be cash in a bank account or a more tangible item such as real estate. Capital markets are financial markets established for the buying and selling of securities. Possibly the most well-known capital market is the U.S. stock market. In capital markets, capital is directed from retail and institutional investors to users of capital, such as businesses, governments, and individuals. The suppliers of capital desire maximum returns on their capital investments at the lowest possible risk. Users of capital want to obtain the capital at the lowest possible cost.

Capital markets are divided into primary and secondary markets. Primary markets issue new stocks and bonds to investors, and secondary markets trade in those existing securities. Capital markets are essential for an economy to function efficiently.

Indexes are used to track the performance of capital markets or sectors of those markets. There are indexes for almost every conceivable sector of the economy and capital market. Exhibit 11-1 shows some of the more well-known ones.

EXHIBIT 11-1	MARKET INDEXES

EFFICIENT MARKET HYPOTHESIS

Types of Investment Vehicles

Now that we know where investment securities are bought and sold, let’s take a look at what types of investment vehicles are available. In the last chapter, we noted that securities include much more than just stocks and bonds. However, most investment vehicles really do fall into the broad categories of stocks and bonds. These categories of securities form the foundation for dozens of types of investment vehicles. No one investment vehicle is better than the other; each serves its own purpose. This section is meant to be an overview of the types of investment vehicles and not an in-depth analysis. We’ll start with some of the simplest investment vehicles—cash and cash equivalents.

CASH AND CASH EQUIVALENTS

Cash and cash equivalents serve two broad needs—as an emergency reserve account, with between three and six months of investor living expenses; and as an asset class for the investor’s portfolio. Cash and cash equivalents have the ability to reduce volatility (sudden changes in value) in an investment portfolio. This asset class is characterized by liquidity (the ability to be easily converted to cash) and stability of principal (little or no risk to value) but is subject to inflation risk. The earnings on cash and cash equivalents rarely exceed the inflation rate. Let’s take a look at some of the more common types of cash and cash equivalents.

Money Market Deposit Account

A money market deposit account (MMDA) is an interest-earning account with limited transaction privileges at a bank or credit union. Depositors are limited to six transfers or withdrawals each month, with no more than three transactions as checks written against the account. As an account at a bank or credit union, an MMDA qualifies for FDIC deposit insurance of up to $250,000.

Certificate of Deposit

A certificate of deposit (CD) is a special type of deposit account with a bank or credit union that typically offers a higher interest rate than an MMDA. Because it is an account at a bank or credit union, the CD qualifies for FDIC insurance of up to $250,000. A CD is an investment of a single sum of money for a fixed period of time, usually from six months up to five years. The issuing bank pays interest, either at regular intervals or at the end of the CD’s term. If the CD is redeemed prior to its maturity, the depositor may have to pay an early withdrawal penalty or forfeit a portion of the interest earned.

Money Market Fund

A money market fund is not an MMDA. A money market fund holds a collection of short-term debt investments such as government securities, CDs, commercial paper (short-term commercial debt), and other highly liquid and low-risk securities. The average maturity of investments in a money market fund is less than 90 days. This short duration also serves to limit risk. A money market fund pays a dividend that generally reflects a short-term interest rate. This type of fund has no FDIC insurance.

A money market fund attempts to maintain a net asset value (NAV) of $1 per share, with only the dividend yield rising or falling. However, a money market fund’s per share NAV may fall below $1 if the short-term debt investments held by the fund perform poorly. Like other cash and cash equivalents, a money market fund is subject to inflation risk. A money market fund provides liquidity for investors with a potentially higher return than a CD or an MMDA. As exhibit 11-2 shows, money market funds may be classified by the type of debt owned by the fund.

EXHIBIT 11-2	TYPES OF MONEY MARKET FUNDS

Treasury Bill

A Treasury bill (T-bill) is a short-term debt obligation backed by the full faith and credit of the U.S. government with a maturity of less than one year. A T-bill is a discount security, which means it is issued at a discount from its face value. The earnings of the T-bill is the difference between the purchase price and the T-bill’s face value (par value). For example, an investor pays $950 for a $1,000 T-bill; when the T-bill matures, the investor is paid the T-bill’s face value, $1,000. The earnings on this T-bill is $50. T-bills do not pay a fixed amount of interest (known as a coupon, which we discuss later in the chapter).

The interest on the T-bill is determined by the discount rate, which is established when the T-bill is auctioned. Interest income is exempt from local and state income tax, but is subject to federal income tax. T-bills trade in the over-the-counter secondary market and are subject to inflation risk.

Commercial Paper

Commercial paper is an unsecured, short-term debt instrument issued by a corporation for the financing of accounts receivable, inventories, and meeting the corporation’s short-term liabilities. The maximum maturity date for commercial paper is 270 days but averages between 30 to 50 days. Corporations issue commercial paper because it is a lower-cost alternative to a bank loan. Like a T-bill, commercial paper is sold at a discount, with the yield coming in the form of an accrual to par value. Because commercial paper is subject to the issuer’s ability to pay, the yield is slightly higher than a money market fund. The typical purchaser of commercial paper is an institutional investor like a money market fund.

GUARANTEED INVESTMENT CONTRACT

A guaranteed investment contract (GIC) is a fixed-income investment issued by an insurance company. The GIC becomes an obligation of the issuing life insurance company and provides a fixed rate of return at a set maturity date. The GIC’s creditworthiness is determined by the general account assets of the insurance company that issued it. GICs are typically purchased by qualified plans as an alternative to a money market fund because the yield is higher.

BOND

A bond is essentially a loan made by the purchaser of the bond to the bond issuer. These loans are for a fixed amount of time, known as a term. The amount loaned is known as the principal—this is the face value of the bond, also known as its par value. Bonds usually pay a coupon—which, as we noted in the section on T-bills, is a fixed amount of interest—at regular intervals (typically semi-annually). At the end of a bond’s term, known as the maturity date of the bond, the entity issuing the bond repays the principal to the bondholder.

A newly issued bond usually sells at its par value, but then the value of a bond moves inversely to current interest rates. (For example: An investor purchased a 20-year bond at face (par) value. The coupon (interest rate) for the bond was 4 percent. Subsequent to the purchase of the 4 percent bond, interest rates for new bonds went up to 6 percent. If the bondholder wanted to sell the 4 percent bond, he would have to sell it for less than par value, because new bonds are paying a higher interest rate. The converse is true as well. If new bonds were being issued with a lower coupon, then the value of the 4 percent bond would go up. Convexity is a measure of how great an increase or decrease in a bond’s price will occur as a result of a change in interest rates.

Bond duration is a measurement of how many years it will take for the price of a bond to be repaid by its internal cash flows (its coupon payments). It is an important measure for investors to consider because bonds with higher durations or lower coupon payments carry more risk and have higher price volatility than bonds with lower durations or higher coupon payments.

A bond may be created in registered or bearer form. A registered bond is in an electronic format, and the coupon and principal repayment are paid to the owner of record. Bearer bonds function much the same as cash; whoever has physical possession of the bond receives the coupon and principal repayment at maturity.

Credit risk is an important consideration in bond valuation. All bonds are subject to credit risk, with the exception of government bonds and certain government agency securities. Credit risk is the potential that the entity issuing the bond defaults on, or does not make, the bond repayment. The greater the risk, the higher the yield that a bond must pay to compensate investors for that risk.

Bond rating agencies evaluate the creditworthiness of both the bond and the bond’s issuers. The two primary bond rating agencies are S&P and Moody’s. As shown in table 11-1, each company uses a letter-based rating system to indicate along a continuum whether a bond carries a low or high default risk and whether or not the issuer of the bond is financially stable. A bond’s rating is critical because the rating affects the interest rate that companies and government agencies pay on bonds that they issue. The higher the bond rating, the lower the coupon that has to be paid. There is a potential conflict of interest between the rating agencies and the bond issuers because the issuers pay the agencies to provide the ratings.

TABLE 11-1	BOND LETTER RATINGS

S&P		MOODY’S
AAA	High-quality investment grade	Aaa
AA, BBB	Medium-quality investment grade	Aa, Baa
BB, B, CCC, CC, C	Low-quality non-investment grade	Ba, B, Caa, Ca
D	Bonds in default	C

Investment grade bonds have a credit rating of BBB or higher by S&P, and Baa or higher by Moody’s. Bonds with this level of creditworthiness are much more likely to be able to pay interest and repay principal. These bonds are very liquid and often sell at a premium.

Non-investment grade bonds, also referred to as high-yield or junk bonds, have a credit rating of BB or lower by S&P, and Ba or lower by Moody’s. This segment of the bond market enables non-investment grade companies to obtain capital. Issuers of bonds in this segment of the market pay a higher coupon in order to attract buyers for their bonds.

Bonds are classified based on the issuing entity. The main types of bonds we will examine are U.S. government bonds, agency bonds, municipal bonds, and corporate bonds.

U.S. Government Bonds

U.S. government bonds are those issued by the federal government of the United States. These types of bonds include the following:

•Treasury notes (T-notes) and Treasury bonds (T-bonds)

•Treasury inflation-protected securities (TIPS)

•Series EE savings bonds

•Series I savings bonds

T-notes and T-bonds are issued by the U.S. Treasury and are backed by the full faith and credit of the U.S. government. Unlike T-bills, T-notes and T-bonds make a semi-annual coupon or interest payment. T-notes are issued in terms of two, three, five, seven, and 10 years; T-bonds are issued in a term of 30 years. Interest is exempt from local and state income tax, but is subject to federal income tax.

In some cases, the individual interest and principal components of eligible T-notes and T-bonds are sold as separate securities. Separate trading of registered interest and principal of securities (STRIPS) separates the principal repayment and each coupon payment into a separate security. For example: A 10-year T-note consists of one principal repayment and 20 interest payments (two coupons per year for 10 years). Once converted to a STRIPS, the single bond becomes 21 separate fixed-income securities. STRIPS are not sold directly to investors by the U.S. Treasury, rather they are purchased by financial institutions that create these interests and sell them to individual investors.

Treasury inflation-protected securities (TIPS) are designed to provide protection against inflation. The interest rate for the coupon is fixed and set at auction. The principal component of TIPS increase with inflation and decrease with deflation, as measured by the Consumer Price Index (CPI). This inflation adjustment occurs twice each year, and the fixed coupon is applied to the inflation-adjusted value. Like the principal, coupon payments rise with inflation and fall with deflation. When the TIPS mature, the purchaser is paid the adjusted principal or original principal, whichever is greater.

Series EE savings bonds (EE) are an affordable investment for individuals of modest means. An EE may be purchased for as little as $25. The EE is purchased at par value, and interest is accrued and paid at redemption. Interest stops accruing after 30 years. Interest earnings are subject to federal income tax but are exempt from state and local income tax. Additionally, interest on EE is excludable from gross income if proceeds are used to pay for qualified higher education expenses (as discussed in chapter 15). An EE is not a marketable security, and it may not be transferred.

Series I savings bonds (I-bonds) are inflation-indexed securities issued at face value and are available in denominations of $25-$1,000. The interest rate is composed of two parts—a fixed base rate and an inflation adjustment. The fixed rate component remains constant for the life of the bond. The inflation adjustment component is updated every six months to track inflation as measured by the CPI. Interest is calculated monthly and compounded semiannually, for 30 years. An I-bond is issued in electronic form only and is not transferable. The interest income exclusion for higher education costs is available for an I-bond (as discussed in chapter 15). An I-bond is nonmarketable and nontransferable.

Agency Bond

An agency bond is issued by either an agency of the U.S. government or a government-sponsored enterprise (GSE), which is a federally chartered corporation with public shareholders. Because GSEs are public corporations and not a part of the federal government, GSE bonds are not backed by the full faith and credit of the U.S. government. However they are implicitly backed through lines of credit.

EXAMPLES OF AGENCIES AND GSES

Consider this example on mortgage-backed securities issued by the GNMA. Mortgage-backed securities (MBS) are an investment in a pool of mortgage loans. They are commonly referred to as pass-through securities, as the principal and interest of the underlying mortgage loans passes through to the investor. The GNMA guarantees principal and interest payments on MBS insured by the FHA, Veterans Administration (VA), and U.S. Department of Agriculture Rural Development. Mortgage-backed securities issued by the GNMA are therefore a direct-guarantee of the U.S. government.

Municipal Bond

The issuer of a municipal bond is a public entity such as a city, county, school district, or state, and this type of loan funds public projects such as the construction of highways, hospitals, and schools. Municipal bond interest income is generally federal income-tax free. Residents of a state with a state income tax may usually exclude the bond interest from state income tax. However, there are exceptions. Municipal bond interest income on obligations of a U.S. territory, possession, or any political subdivision is exempt from federal, state, and local income tax. This last type of municipal bond is referred to as triple tax-exempt.

Exhibit 11-3 shows the three main types of municipal bonds.

EXHIBIT 11-3	TYPES OF MUNICIPAL BONDS

Some municipal bonds may carry insurance against default, which serves to mitigate their credit risk and reduce the coupon that must be paid. Major insurers of municipal bond insurance include Ambac Financial (originally known as the American Municipal Bond Assurance Corporation), Financial Guaranty Insurance Company (FGIC), and MBIA Inc.

Corporate Bond

Unlike the other types of bonds we have seen, a corporate bond is a debt instrument issued by a public company. The source of the coupon payments, as well as the repayment of the principal sum, is from the current and future revenue of the company. A company’s physical assets may also be used as collateral for a corporate bond. A corporate bond is considered a higher risk than a U.S. government bond and as a result, the interest rates paid to investors will be higher. The interest income is taxable as ordinary income and any gain on the sale of a bond is taxed at capital gains tax rates.

A callable bond is a type of bond that the issuer of the bond has a right to “call back” at a predetermined price and date prior to maturity. For example, a 20-year bond may have the potential to be called after 10 years. When a bond is called, the bond is retired, and in many instances, it is replaced with a new issue (refunded) at a lower coupon rate. The call feature is common to lower-rated corporate bonds. The call feature is an economic risk to the bond purchaser and, as a result, the bond issuer has to pay a higher coupon to attract buyers.

A convertible bond is a hybrid security. The bond provides the bond owner with the right to convert the bond into a specified quantity of shares of the bond issuer’s common stock. The bond’s value is based upon both the interest rate the bond is paying, and the amount of the issuer’s common stock to which it may be converted.

One debt instrument often confused with a corporate bond is a debenture, which is not secured by physical assets or collateral and is an obligation of the corporation backed only by the creditworthiness of the company. The yield is higher than corporate bonds with similar terms backed by hard assets, and these, in turn, may fall within either the investment grade or high yield categories.

STOCK

Stocks represent an ownership interest in a public corporation. Each share of stock is a unit of ownership in the issuing company. Stock can either be common or preferred. Common stock typically allows the owner (stockholder) to vote in the selection of company directors and other important corporate matters, and to receive dividends. Preferred stock more closely resembles a fixed-income security, such as a bond, in its risk and return profile because it has a fixed dividend rate. Holders of preferred stock have no voting rights but are entitled to receive dividends before common stockholders in the event of financial difficulties of the corporation. Additionally, the claims of preferred stockholders take precedence over the claims of those who own common stock in the event that a corporation fails and is liquidated.

The following list features several types of preferred stock:

•Callable preferred stock provides a right to the issuer of the preferred stock. The issuer has the right to redeem shares in exchange for those with a lower dividend payment.

•Convertible preferred stock provides a right to convert the preferred shares into common stock.

•Cumulative preferred stock provides a right to any past dividend payments missed; those dividends are to be paid in full before holders of common stock receive any dividend payments.

•Participating preferred stock provides a right to participate in the issuer’s corporate profits.

Market capitalization is the total dollar market value of all of a company’s outstanding shares, both common and preferred. Market capitalization is calculated by multiplying a company’s outstanding shares by the current market price of a single share. Market capitalization is divided into three broad categories:

•Large-cap. $10 billion or more

•Mid-cap. $2 billion-$10 billion

•Small-cap. Less than $2 billion

Stockholders and potential stockholders can learn about corporations through their reports. Stockholders receive annual reports that explain the previous year’s activities, provide financial data, and present an analysis by independent auditors. The SEC also requires corporations to file additional reports, such as the following:

•Form 10Q quarterly report

•Form 10K annual report with audited financial statement

•Form 8-K report of significant events

The SEC has an electronic system to provide investors with this information.

MUTUAL FUND

As discussed, investing is risky business. If an investor were to purchase a single company’s stock, and that company failed, the investor would lose their entire investment. A solution is to purchase the stock of several companies and reduce the risk of a company failure affecting the entire investment portfolio. However, new investors do not have sufficient capital to diversify their holdings across several companies. A mutual fund allows for diversification by pooling the capital of many investors in order to purchase more securities and reduce the risk of the investment portfolio.

Managers of mutual funds purchase a portfolio of securities, and individual investors purchase shares in the fund. The value of each fund share depends on the value of the securities owned by the fund. Mutual funds are essentially substituting the judgment of the fund manager for the judgment of the individual investor when it comes to purchasing securities.

The most common type of mutual fund is the open-end mutual fund. This type of fund sells shares to the public on a continual basis. The capitalization or value of the fund is continually changing as new investors buy additional shares, and some existing shareholders cash in by redeeming their shares back to the fund. The shares are nonnegotiable, redeemable securities. Open-end funds will buy back their shares from investors at any time for the NAV per common share. The NAV is calculated by dividing the total market value by the number of outstanding common shares of the fund. This is done on a daily basis because both total market value and number of outstanding common shares change frequently.

An open-end fund will compensate brokers to sell their shares. The fund will impose a fee to the investor, a portion of which will be used to compensate the broker. The fee is referred to as a sales charge or sales load. The fund may charge a front-end sales charge or a back-end (contingent deferred) sales charge. The back-end sales charge is imposed when an investor redeems his or her shares.

Open-end funds called no-load funds do not charge a sales load. However, they are permitted to charge purchase fees, redemption fees, exchange fees, and account fees. It is possible that these fund expense fees may exceed the fees of a load fund.

Unlike the shares of an open-end mutual fund, the shares of a closed-end mutual fund are not continually being purchased and redeemed as investors move in and out of the fund. A closed-end fund’s shares trade in the secondary market and are listed on stock exchanges or trade over-the-counter. The shares often sell at a premium or discount to the fund’s NAV. A share of a closed-end fund more closely resembles a share of an individual security.

EXCHANGE TRADED FUND

Similar to mutual funds, an exchange-traded fund (ETF) is a publicly traded security that represents a portfolio of assets (bonds, foreign currency, oil futures, physical gold, stock, and so on). What sets an ETF apart, however, is that its investment objective is to track the performance of an index, sector, or region. A region is geographical. An example of a regional ETF would be BRIC (Brazil, Russia, India, and China) ETF. The ETF invests in the capital markets of these countries.

REAL ESTATE

As noted earlier in the chapter, not all investment vehicles are bonds and stocks—real estate, for example. Real estate, of course, refers to purchasing land or buildings as an investment. Because real estate is not affected by the same factors that affect the valuation of stocks and bonds, it makes a good choice for a diversified investment portfolio. There are several avenues to add real estate to an investment portfolio, but the two most popular are investor-managed real estate and real estate investment trusts.

Investor-managed real estate can either be unimproved real estate (raw land) or improved real estate (income-producing property). With raw land, the real estate investment is held for capital appreciation, and there is no current income tax benefit to the investor. Raw land can produce negative cash flow due to costs of insurance, property taxes, and upkeep of the property. On the other hand, improved real estate typically generates income. Income-producing properties include commercial, industrial, and residential. Investor-managed real estate is considered an illiquid investment.

A publicly traded real estate investment trust (REIT) is similar to a closed-end fund or investment company. Like a closed-end investment company, a REIT is publicly traded; however, the REIT manages a portfolio of real estate, short-term construction loans, and mortgages, instead of stocks and bonds. A REIT pays shareholders dividends from income and capital gains distributions. Organized as a trust, a REIT avoids corporate taxation if at least 75 percent of the REIT’s income is from real estate investments. Also, up to 15 percent of the REIT’s income may be generated from securities, like a GNMA. If a REIT distributes 90 percent or more of net investment income to shareholders, it will only pay corporate tax on the undistributed portion. If a REIT fails to distribute 90 percent, then all the net investment income is taxable. Exhibit 11-4 shows the two types of REITs.

EXHIBIT 11-4	TWO TYPES OF REIT

ALTERNATIVE INVESTMENTS

The last type of investment vehicle to explore is simply known as alternative investments. Alternative investments encompass a broad variety of asset types, which traditionally are divided into two categories—derivatives and tangible assets. Generally, a derivative is something based on another source; therefore, the value is derived from the value of the underlying investment upon which it is based.

In investment portfolios, derivatives are usually based on stock, stock market index, interest rate, foreign currency, and government bonds. Derivatives have the potential to reduce risk and enhance return. The most familiar derivative is the options contract. An options contract provides the purchaser of the contract with a right to buy or sell a security at a specific price. An options contract provides an investor with a low-cost means to participate in the capital market and a cost-effective way to reduce risk and potentially enhance an investment portfolio’s return. Options are traded on exchanges such as the Chicago Board Options Exchange.

There are two types of option contracts. The first type is a call option. This is a contract that provides an investor with a right, but not the obligation, to purchase a security, or other asset, at a specified price within a predetermined period of time. The second type is a put option. A put option is a contract that provides an investor with a right, but not an obligation, to sell a security or other asset at a specific price within a specific period of time.

The second category of alternative assets are tangible assets—actual physical goods. The most common tangible assets used as investments are collectibles such as antiques, art, coins, stamps, vintage automobiles, and wine. With collectibles, the possibility exists to realize substantial gain if the item in question has potential for appreciation due to its uniqueness. Collectibles typically rise sharply in value during inflationary periods, when people are trying to move assets from paper money as an inflation hedge. Because the returns on collectibles and other tangible assets are not necessarily affected by the same factors that affect returns on financial assets, these assets can diversify a portfolio, and therefore reduce overall risk. One item to note relates to the taxation of collectibles. Net capital gains from selling collectibles are taxed at a maximum 28 percent rate, as opposed to the maximum 20 percent rate for securities.

Investment Valuation

Now that we understand more about which investment vehicles are available, it is necessary to discuss factors that go into selecting them for an investment portfolio. How does an investor decide whether a particular investment is worth making? That decision starts with determining the value of a given investment. If an investment doesn’t provide any value or the promise of a profit to an investor, then it isn’t likely to be a particularly useful investment. Three main methods for investment valuation are the capital asset pricing model, arbitrage pricing theory, and technical and fundamental analysis.

•Capital Asset Pricing Model (CAPM). CAPM states that an investor needs to be compensated for the time value of capital (money) invested and the additional risk for making the investment. In the CAPM, the expected return of a security, or a portfolio of securities, equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or exceed the required return, then the investment should not be purchased.

•Arbitrage Pricing Theory (APT). APT, like CAPM, is an asset pricing model. APT presumes that an asset is mispriced if its current price is different from the price predicted by APT. The asset’s current price should equal the sum of all future cash flows discounted at the APT rate. Arbitrageurs use the APT to create profit by taking advantage of mispriced securities. The arbitrageur sells the asset that is relatively too expensive and uses the proceeds to buy one that is relatively too cheap.

•Technical and Fundamental Analysis. Technical analysts look at the price movement of a security and use this data to predict its future price movements to determine whether it should be bought or sold. Technical analysis assumes the market value of the asset is a reflection of the supply and demand for that asset, and any analysis into the company is of little or no benefit. Fundamental analysis primarily involves looking at a company’s revenue, expenses, assets, liabilities, and other financial aspects. Fundamental analysts use this information to gain insight into a company’s future performance.

Investment Strategies

Determining the value of investments is a good place to start in the process of deciding which investments to make, but it is only a start. Many other factors come into play, including risk assessment, time frame, and investment goals. All of these factors make investment planning somewhat tricky, so it helps to have a formal investment strategy in place.

From the previous chapter, one way to formalize the investment strategy is to create an investment policy statement (IPS). However, in addition to the more formal IPS, an investor may simply chose to follow a strategy, or style of investing. Investment strategies may be categorized as either passive or active management. Passive management uses index mutual funds and exchange-traded funds to gain exposure to various asset classes and segments of the market. Investors who favor passive management believe that financial markets are efficient, and over time it is impossible to outperform the market as a whole. The benefit of passive investing is its cost-efficiency. Investors who use active management fundamentally believe that the market is inefficient and that the use of an investment manager to make investment decisions will provide returns, net of fees, in excess of the market’s return. Other investment strategies include, market timing, dollar-cost averaging, systematic withdrawal plan, bond ladder, option strategies, short selling, and the use of margin.

MARKET TIMING

Market timing is an active management approach to investing. The investment manager attempts to provide returns in excess of the overall market by switching assets between cash and the market. The premise in market timing is to purchase securities when they are at a market low and then sell the securities when they are at a market high. The demonstrated ability to accurately predict securities prices has yet to be proven. The investor is purchasing the services of an individual who is making an educated guess in an attempt to outperform the market, net of his or her fees.

DOLLAR-COST AVERAGING

Dollar-cost averaging is a passive management approach to investing. Dollar-cost averaging is the process of investing a fixed dollar amount into an investment (mutual fund, ETF, and so on) at pre-determined intervals. The amount of money invested at each interval remains constant over time, but the number of shares purchased varies based on the market value of the shares at the time of a purchase. It is anticipated that over time more shares will be purchased at a lower cost.

SYSTEMATIC WITHDRAWAL PLAN

A systematic withdrawal plan is analogous to dollar-cost averaging. It is a passive management approach where withdrawals are made from an investment account at a fixed amount on a fixed date. A systematic withdrawal plan may reduce the single period price risk associated with withdrawing large amounts at a single time from an investment account. For example: It is more risky for a retiree to make a single withdrawal from an IRA than 12 withdrawals each year. The risk of making a withdrawal on the lowest point of the year is mitigated by spreading the withdrawals over 12 months.

BOND LADDER

A bond ladder is an investment portfolio of bonds with staggered maturity dates. Bonds with shorter durations have less fluctuation in value, which offset the greater price volatility of bonds with longer durations. Because of the mix of returns due to bonds with both short and long durations, the bond ladder offers the potential for higher yields over time, as opposed to a strictly short-term bond portfolio. As bonds mature they provide cash with which to purchase longer dated bonds, maintaining the portfolio’s original structure and duration.

OPTION STRATEGIES

A straddle is the combination of a put option and a call option with the same exercise price and expiration date. The presumption is the investor will make a profit as long as there is a significant change in the value of the underlying security—either up or down in value. Losses could be unlimited, making such a strategy often imprudent.

A collar is a protective options strategy used to protect a gain in a stock owned by an investor. A costless collar consists of a long put position (the investor owns the underlying stock) and short call position (the investor does not own the underlying stock). The sale of the call provides capital to purchase the put. The collar is costless because the put is purchased with the proceeds from the sale of the call.

SHORT SELLING

If an investor believes the price of a security will decline and he or she does not own the security, the investor may sell the security short. Short selling involves purchasing borrowed shares, selling them, and—ideally—returning to the lender the shares which experienced a decrease in price. The maximum loss is potentially unlimited if the price of the stock rises. Exhibit 11-5 illustrates the mechanics of a short sale.

EXHIBIT 11-5	SHORT SALE

EXAMPLE

MARGIN ACCOUNT

Within limits, investments may be purchased on credit. This investment strategy is accomplished by using a margin account. Margin accounts are set up in the name of the brokerage firm with the brokerage firm as the nominal owner and the investor as the beneficial owner. To establish a margin account at a brokerage firm, the investor needs to complete a margin agreement, which has the following three parts:

•The credit agreement discloses loan terms from the broker-dealer.

•The hypothecation agreement allows the broker-dealer to pledge the client’s margin securities as collateral to a bank which in turn lends money to the broker-dealer based upon the securities’ value.

•The loan consent form allows the firm to lend the client’s margin securities to other clients or broker-dealers, often for short selling.

Chapter Review

Investment planning is complex. Many of the terms and concepts are foreign to the investor. The personal financial planner needs to be as much a teacher as he or she is a planner when it comes to investments. Knowledge allows an investor to overcome fear and to avoid the knee-jerk reactions that might be disastrous to an investment portfolio. Investment planning is risk management. If the personal financial planner is able to correctly assess an investor’s risk tolerance, then an investment portfolio can be created to address the client’s financial goals, as well as his or her attitude toward risk.

CASE STUDY REVISITED

Upon first glance, it appears Alice and Robert Reed have not been served well.

1. Only 10 percent of their investable assets are liquid—$200,000 in mutual funds. The remainder of their investment assets are non-traded or private investments with no liquidity.

2. Half of their investable assets are partnership interests in two strip malls (which are illiquid).

3. Seventy-five percent of their assets are in real estate (the two strip malls and $500,000 in REIT).

4. Their investment portfolio is not diversified.

5. They have not taken advantage of tax-deductible contributions to qualified retirement plans.

6. They have little or no opportunity for income tax management in retirement because the majority of their assets generate current income and not long-term capital gains.

ASSIGNMENT MATERIAL

REVIEW QUESTIONS

1. Investors in real estate seek which objective?

A. High correlation with common stock.

B. Liquidity.

C. Long-term growth.

D. Low correlation with inflation.

2. A money market fund would most likely NOT contain

A. Certificates of deposit.

B. Commercial paper.

C. Treasury bills.

D. Treasury bond.

3. Which is correct about collectibles?

A. “Collectible” describes a narrow category of asset.

B. Uniqueness is not a consideration.

C. Collectibles typically rise sharply in value during inflationary periods.

D. Returns on collectibles are positively correlated with returns on financial assets.

4. Treasury bills are

A. A long-term debt obligation.

B. Backed by the full faith and credit of the U.S. government.

C. A face-value security.

D. Interest income subject to local and state income tax.

5. Investments in rare coins include which benefit?

A. Appreciation potential.

B. Liquidity.

C. Increased investment portfolio risk.

D. Deflation hedge.

6. Rank the following from the lowest to the highest credit risk.

I. Certificate of deposit with six-month maturity date.

II. Money market fund.

III. Tax-exempt money market fund.

IV. Treasury bills.

A. I, II, III, IV.

B. II, I, III, IV.

C. III, II, I, IV.

D. IV, I, II, III.

7. Which are true about TIPS?

I. The interest payment is constant, and the principal is adjusted for inflation or deflation.

II. The interest payment is variable, and the principal is adjusted for inflation or deflation.

III. The interest rate is fixed.

IV. The interest rate is variable.

A. I, III.

B. I, II.

C. II, III.

D. III, IV.

8. A client has had an unanticipated event which has depleted his emergency reserves. He needs an additional $10,000 and has to sell one of his municipal bonds. The following bonds have similar ratings and coupons. Which one would you advise the client to sell?

A. Board of Education bond (GO/no insurance).

B. City infrastructure bond (GO/no insurance).

C. Hospital bond (revenue/no insurance).

D. Toll road bond (revenue/MBIA).

9. Which statement is correct regarding an REIT?

I. Mortgage REITS can only invest in long-term mortgages.

II. Both equity and mortgage REITS distribute at least 90 percent of their net investment income.

III. The income of an equity REIT is derived from the difference between net rental income and interest paid on loans.

IV. The income of a mortgage REIT is derived from the spread between the lending rate to developers and borrowing rate from banks.

A. I, II, III.

B. I, II, IV.

C. II, III, IV.

D. I, III, IV.

10. Which is a type of preferred stock?

A. Dividend-preferred.

B. Convertible-preferred.

C. Profit-preferred.

D. Nonparticipating.

INTERNET RESEARCH ASSIGNMENTS

1. Download and read the following article from 1952: “Portfolio Theory,” by Harry M. Markowitz in The Journal of Finance, Vol. 7, No. 1. 77–91. What thoughts or observations come to mind?

2. Visit the Treasury Direct® website: What is the myRA Account?

3. The Securities Industry and Financial Markets Association (SIFMA) sponsors a website called InvestinginBonds.com. Complete the investor’s checklist (Learn More Tab/What You Should Know). What observations did you make about yourself when completing the checklist?

4. Visit the SEC’s EDGAR website and look up any company of your choice. What information is available for that company?

5. What risk assessment tools are available on the Internet? Complete one of them and determine your risk tolerance.