C HAPTER 11

1. CHAPTER11 Investing Basics and Evaluating Bonds “If a little money does not go out, great money will not come in.” -- Confucius

2. The Answer is… “A Voluntary Tax on Stupid People” What is the Question?

3. Silly, the Question is… “What is the Lottery?” A Voluntary Tax on Stupid People

4. What are the Odds of Winning? • The odds of winning the California Mega Millions Jackpot are 176 million to 1 • “But somebody has to win, right?” • Yes, but that somebody will not be you! • If a person purchases 50 lottery tickets each week, he or she will win the Mega Millions Jackpot about once every 50,000 years • “Let’s see. $50 per week at 10% for 50,000 years…”

5. Speaking of Odds… • Astronomers have located an asteroid that is possibly on a collision course with Earth • The asteroid could hit the Earth in 2029 • Triggering untold destruction and the end of tens of thousands of species, including the human race • The odds of the asteroid hitting the Earth are currently set at 300 to 1 • But those odds will probably lessen as more is learned about the asteroid’s orbit So Why Aren’t the Nations Preparing for This!?

6. Because It Ain’t Gonna’ Happen! And You Ain’t Gonna’ Win Da’ Lottery! So Start Saving Now But, of course, if the asteroid does hit, we will have plenty of warning for you to go out and spend all your savings on a really great time! Now, let’s get serious…

7. Establishing Investment Goals • You already know the #1 Financial Goal: • “Spend Less Than You Earn” • “Live Beneath Your Means” • “Make Love, Not Loans” • “Pay Yourself First” • “Frugal, Frugal, Frugal!” • If Goal #1 is followed, everything else is easy! • For each investment goal, assess the time frame • Is it short-term, intermediate-term, or long-term • Choose an appropriate investment for the time frame • This chapter gives you a thumb-nail view of each type • With an emphasis on bond investments • We will look at some of the others in detail later on Which one is your favorite?

8. They are important but not essential Essentials Before Investing Or so says our book… • Work to balance your budget • Pay off high interest credit card debt first • Start an emergency fund you can access quickly • Three to nine months of living expenses I simply do not agree with the concept of an “emergency fund” of three to nine months of living expenses. As long as you have access to cash via a home equity line of credit, for example, there is no good reason to keep $20,000 to $30,000 or more in a savings account earning 0.01%. Instead, use the money to pay down high interest debt, especially credit card debt. P.S. The Wealthy Barber agrees with me. P.P.S. You are adequately insured, right? Exceptions: Salespeople and the self-employed

9. First: Some Investment Terms • Safety – Guarantee of return of principal • Risk – Uncertainty about an outcome • Inflation risk • Interest rate risk • Business failure risk • Market risk • Global investment risk • Liquidity • Ability to buy or sell an investment quickly without substantially affecting the investment’s value “I am not so much concerned with the return on my money as I am with the return of my money.” --Will Rogers What is your tolerance for risk? (http://njaes.rutgers.edu/money/riskquiz/) Unfortunately, you can’t know until you have some skin in the game … and then lose some skin!

10. “Where Do I Get the Money to Invest?” Pay Yourself First • Take advantage of employer-sponsored retirement programs [401(k), 403(b), etc.] • These come right out of your paycheck • Take advantage of automatic contributions from your checking or savings account [Roth IRA] • Schedule them to occur right after you normally receive your paycheck • They work like a pay raise, only in reverse

11. “How Much Do I Need?” • Start small! • “Can you afford $50 per month?” • Small amounts invested regularly become large amounts over time • Obviously, the more the better • But it is better to get started with a small amount now than to lazily dream of a day when you’ll be able to put away far more – Get Started Now! • You can always increase the amount • Try to increase the amount each year • Especially when you get a pay raise

12. Regular Taxable Accounts versus Tax-Qualified Accounts Account Statement Examples “Cash” Bonds Bonds Stocks Hard Assets Options Stocks “Cash” Futures Margining Real Estate Mutual Funds Shorting Mutual Funds Tax-Qualified Account Taxable Account a.k.a. Retirement Accounts, Education Accounts, MSA  HSA a.k.a. Regular account All contributions are post-tax dollars Most are pre-tax; Some are post-tax Strict limits on contributions No limit on contributions Strict limits on investment types No limits on investment types Tax-deferred (pre-tax) or Tax-free (post-tax) Pay taxes every year on gains Although there are many subtle and not-so-subtle differences, the major differences are how they are taxed by the IRS, how much money you can contribute, and what you can have in the account.

13. Major Investment Alternatives • Stocks Dividends & Capital Gains – 8%-10% – long-term • Bonds Interest & Principal – 4%-8% – long/intermediate • “Cash”Interest & Principal – 2%-5% – short-term • a.k.a. Short-term investments, guaranteed, safety of principal • Annuities Fixed 2%-6%, Variable 2%-8% – BOHICA! • Real Estate Rent & Capital Gains – 7%-8% – long-term • Other Investment Alternatives… • …That I hope you will avoid … • Unless you know exactly what you are doing or are willing to lose a good chunk of your money or, preferably, both • Derivatives (options, futures, etc.), hard assets, precious metals, art & collectibles, starting a business, etc.

14. “So What IsYourChoice?” • If the goal is long-term (example: retirement), then my choice is high-quality stocks • Although some people prefer bonds because they are less risky than stocks (or a combination of both) • If the goal is intermediate-term, then bonds or REITs make sense • If the goal is short-term, you have no choice but to use a guaranteed short-term “cash” investment such as a money market account • Although bonds close to maturity could also work • The “Others” never make sense except for a small percentage of the population

15. “So I am buying stocks and bonds. Great! How do I get started?” • Well, actually, you don’t… • Buy the stocks and bonds, that is… • For the vast majority of people, the best investments are mutual funds that buy the stocks and bonds for them • Professional money management • Diversification “But you got me all excited about buying stocks and bonds all by myself! Besides, in their commercials on TV, Ameritrade and Scottrade show everyday, hard-working Americans just like me happily and profitably buying and selling stocks all the time.”

16. Let me ask you a few questions… • Do you have the discipline, courage and brains to buy when everyone else is selling and sell when everyone else is buying? • Do you have a strong background in finance, business, marketing, economics, politics and history? • Are you a part of a global research team stationed all around the world? • Do you have the time and resources to visit in person the companies you intend to invest in? • Plus their customers, competitors and suppliers? • Do you have enough money to buy at least 20 or more stocks representing various sectors of the economy? • Most importantly, do you have a knack or intuition for recognizing unrecognized value?

17. Your results? • If the answer to two or more of the previous questions is, “No” (especially the last two: money for 20 or more stocks & an intuitive eye for value) • Stay away from individual stocks! • Bonds are also difficult since bond traders usually deal in tens of thousands of dollars per trade • (The exceptions are government bonds bought directly from www.treasurydirect.gov) • Mutual Funds are your Best Bet • And if it means anything to you, virtually all of my family’s financial investments (and my clients’) are in mutual funds (>99%) • I certainly can’t answer “Yes” to all those questions

18. Mutual Funds (a.k.a. Investment Company) STOCKS BONDS “CASH” Balanced mutual funds Bond mutual funds Stock mutual funds Money market mutual funds a “mutual” fund (investment company) Professional Money Management Diversification

19. “So, How Do I Pick a Mutual Fund?” • Pick a Mutual Fund that… • Invests in high-quality stocks or bonds • Is well-diversified across several industries and sectors of the economy and countries of the world • Has a long-term perspective and a manager or (better yet) a management team with many years of experience • Avoid companies that “shuffle” their managers every few years (which is virtually all of them!) • Has been around for decades and performed consistently well in both good and bad markets More about choosing a good mutual fund when we get to Chapter 13.

20. “How Do I Purchase a Mutual Fund?” • Normally, a little bit at a time • Virtually all mutual funds will allow you to start an automatic investment plan with as little as $25 to $50 per month • Either through your employer (401k, 403b, etc.) • Or from your checking or savings accounts (IRA, Roth IRA) • The ones that won’t are specialized funds that you normally don’t want to deal with anyway • Minimum purchases of $1,000 to $25,000 or more Investing a fixed amount ($50, $100, etc.) periodically is called “dollar cost averaging.”

21. Dollar Cost Averaging • A system of buying an investment at regular intervals with a fixed dollar amount • $50 per month, $100 per month, etc. • With Dollar Cost Averaging, there is always “Good News” • “The market is up! Good News!” • Your account is worth more • “The market is down! Good News!” • Next month, you will get more shares at a lower price when the $50 or $100 comes out of your paycheck or checking account Yippee! Huh?!

22. “But Now It All Sounds So Boring…” • In the investment world, Boring is Good! • After you have built a solid foundation of high-quality stock or bond investments through mutual funds, then you can “play the market” • I used to call it my “Vega$ Fund” • Take no more than 5% to 10% of your financial assets and choose your own stocks • Be prepared for “volatility” • “Volatility” is the investment world’s euphemism for large losses – Buy a stock for $12, sell it for 30¢ • I kept my “Vega$ Fund” to no more than 1% of our total portfolio, by the way

23. Coming Attractions • Chapter 11 (continued) – Bonds • Chapter 12 – Stocks • Chapter 13 – Mutual Funds • Lecture Notes – Real Estate & the “Others” We will examine all of these in more detail Plus… • Chapter 14 – Retirement & Estate Planning

24. Investments: What are ___? Investment companies that pool investors' money and invest in a diversified portfolio of securities. Investors get diversification and professional money management. • short-term securities (a.k.a. “cash”) • stocks • bonds • mutual funds The correct answer is (D). Investment company is the legal term; mutual fund is the popular term.

25. Investments: What are ___? Represent ownership in a corporation. Investors receive dividends and capital gains (or capital losses). • real estate • stocks • bonds • short-term securities (a.k.a. “cash”) The correct answer is (B). Stock investors are part-owners of corporations.

26. Investments: What are ___? Fixed-income securities that represent loans to corporations, municipalities (state & local governments & agencies), and the Federal government. Investors receive interest and a promise to repay the loan. • real estate • stocks • bonds • short-term securities (a.k.a. “cash”) The correct answer is (C). Bonds are “fixed-income” investments.

27. Investments: What are ___? Investments with very little risk, and correspondingly, very little return. They are usually guaranteed or pretty darned close. There is a huge opportunity cost if you leave your money here for the long-term. • real estate • stocks • bonds • short-term securities (a.k.a. “cash”) The correct answer is (D). Low risk, low return.

28. What are Reasonable Expectations? What are reasonable expectations of returns from the following investments? • stocks • bonds • short-term securities • real estate • mutual funds • the “others” 8% - 10% 4% - 8% 2% - 5% 7% - 8% ? -?

29. Investing in Bonds • Bonds represent loans to… • Companies (Corporate bonds) • State & local municipalities (Municipal bonds, “Muni’s”) • Federal government (Treasury bonds, “Governments”) • Bondholders receive interest on the loan • Loan is repaid (Bond is redeemed) in 1 to 30 years • Bondholders are first in line for repayment if there is default on the loans (after taxes & payroll expenses) • Bond prices are less volatile but still fluctuate (?) • Average returns over decades – 4% to 8% • Intermediate-term to long-term investments • (But there is a way for bonds to be short-term)

30. Why Do Investors Buy Bonds? • For interest income • Investors know the interest rate • Interest will be paid to investors twice a year • Bond face amount will be repaid at maturity • Although there is always the risk of default • Normally, the risk of default is very, very small • If the risk is high, the bonds are usually referred to as “non-investment grade bonds” (a.k.a. “junk bonds”) • Appreciation of bond value • May be able to sell the bond to someone else at a higher price if the interest rate on the bond is higher than the market rate (“Huh?” “Later…”)

31. Why Sell Bonds When an entity sells bonds, it is borrowing money. • To raise money to operate or expand • Examples: Build a new factory, expand into a new country, build new or upgrade older schools, bridges, finance a war, etc. – Big ticket items • Can get better interest rates than if they went to a bank or other money-lending entity • Also, sometimes the bond issuer can’t go to a bank! • (Can you imagine the Federal government asking your local credit union for a $900 billion loan to invade Iraq?) Almost every election year in California, the voters are asked to approve a “bond proposition” for parks, schools, water projects, transportation, emergency and public safety equipment, etc. The State of California then sells the bonds to pay for the project and must pay the interest and pay back the principal over 30 years.

32. Why Sell Bonds (continued) • In the case where the bond issuer is a corporation, sometimes it is difficult, not advantageous or impossible to sell stock • And the interest is a tax-deductible expense for corporations • Whereas dividends to stock shareholders are not • To take advantage of “financial leverage” • Use other people’s money to make your money Bonds are “debt financing.” Corporations, municipalities, or the Federal government borrow for many of the same reasons that individuals borrow for – to finance their operations. Stocks are “equity financing.” A corporation is selling a piece of itself to finance the operations of the company. (Governments do not issue stocks because they can not sell pieces of themselves.)

33. Characteristics of Bonds • Written pledge to repay a specified amount (face value, par value) of money with interest • The face value is the dollar amount that the bondholder will receive when the bond matures • Normally in $1,000 denominations (up to $10,000) • Bondholders receive interest payments every six months at the stated interest rate • The legal conditions are described in the bond indenture • The indenture is the loan agreement • The trustee is the bondholders’ representative

34. Types of Bonds • Mortgage-backed bonds(“Secured”) • A bond that is secured by various assets of the issuing firm • A mortgage bond is like a homeowner’s home mortgage • If the bond issuer does not pay, the asset is seized • Debenture bonds(“Unsecured”) • Most bonds are debenture bonds • Backed only by the reputation of the issuer • A debenture bond is like a credit card • If the bond issuer does not pay, the bond investors must go after whatever assets or income they can find • Convertible bonds (only corporate bonds) • Can be exchanged, at the owner’s option, for a specified number of shares of common stock

35. Call Feature of Bonds • Corporations and municipalities can sometimes “call in” (buy back) outstanding bonds from current bondholders before the maturity date • Treasuries (Federal bonds) are never callable • Most agree not to call in their bonds for the first 5 to 10 years after they are issued • a.k.a. Deferred Call, Call Protection Period • Bonds are called if the interest rate they are paying is higher than the going rate • It is the same idea as when a homeowner refinances his/her home mortgage loan

36. Bonds and Taxes • Bond interest is normally taxed at your marginal tax rate • Always true of corporate bonds • However, municipal bonds are not subject to Federal income taxes and … • Federal bonds are not subject to state income tax • This is an important feature for wealthy investors • Must look at the Taxable Equivalent Yield • Some municipal bonds are “double-tax free” • If from your state, also exempt from state taxes • Careful! If you are subject to the AMT, the interest income from some municipal bonds is no longer exempt from Federal taxes

37. Taxable Equivalent Yield Tax-Exempt Yield 1.0 – Your Federal marginal tax rate Example: 6% yield, 25% tax bracket Taxable equivalent yield = 0.06 1.0 - 0.25 = 0.08 = 8% Federal income tax free municipal bonds

38. Taxable Equivalent Yield (continued) Tax-Exempt Yield 1.0 - Your combined marginal tax rate (Federal & state) Example: 6% yield, 25% Fed, 8% state Taxable equivalent yield = 0.06 1.0 – (0.25+0.08) = 0.0895 = 8.95% If you purchase bonds from your state, they are usually “double tax-free.” Federal & state income tax free.

39. Making the Decision to Buy or Sell a Bond • Can the corporation, municipality, or Federal government... • Pay back the face value at maturity? • Will you receive interest payments until maturity? • What is the bond’s rating? (Kinda’ like your credit score) • Ratings range from AAA to D (AAA, AA, A, BBB, BB, etc., D) • BB or below is “non-investment grade” • Also called a “junk bond” or speculative bond • Rated by one of the rating agencies • Standard and Poor’s, Moody’s, Fitch’s Think of the ratings as “idiot lights” on your car’s dashboard. By the time the agency downgrades the bond to C or D, it is already too late!

40. Bonds and Interest Rates • Inverse relationship • As interest rates fall, bond prices rise • As interest rates rise, bond prices fall • Since the interest rate of your bond does not change (the interest rate is fixed), the price of the bond changes to reflect the change in interest rates within the financial industry (the price of the bond is not fixed) • Great source of confusion and consternation to many in and out of the investment world When interest rates fall, …bond prices rise, and vice-versa.

41. Bonds and Interest Rates:Example • Bond paying 10% • The bond’s face value is $1,000 • The bond’s interest per year is $100 • 10% of $1,000 = $100 • Interest rates fall to 5% • Now, investors have to pay $2,000 to get the same amount of interest • 5% of $2,000 = $100 • The result is your bond is now worth more than it once was (capital gain if sold) • The bond could be sold at a high premium Interest rates fall? Bond prices rise!

42. Bonds and Interest Rates:Example (continued) • Bond paying 5% • The bond’s face value is $1,000 • The bond’s interest per year is $50 • 5% of $1,000 = $50 • Interest rates rise to 10% • Now, investors only have to pay $500 to get the same amount of interest • 10% of $500 = $50 • The result is your bond is now worth less than it once was (capital loss if sold) • The bond would be sold at a large discount Bond prices fall! Interest rates rise?

43. Bond Pricing: Problem 1 Juan Zapata-Tyme bought a corporate bond paying 8% four years ago. Today, corporate bonds that are like Juan’s bond are paying 6%. Would Juan be able to sell his bond for more than he paid for it, less than he paid for it, or the same amount he paid for the bond? • He could sell it for more than he paid for it • He could sell it for less than he paid for it • He could sell it for the same that he paid for it The correct answer is (A). If interest rates go down, bond prices go up. The bond would sell at a premium.

44. Bond Pricing: Problem 2 L. Coco bought a Treasury bond paying 5% two years ago. Today, like Treasury bonds are paying 7%. Would Señor Coco be able to sell his bond for more than he paid for it, less than he paid for it, or the same amount he paid for it? • He could sell it for more than he paid for it • He could sell it for less than he paid for it • He could sell it for the same that he paid for it The correct answer is (B). If interest rates go up, bond prices go down. The bond would sell at a discount.

45. Bonds and Interest Rates (continued) • The relationship of bonds and interest rates is why a bond will have different quoted rates • Nominal Rate (a.k.a. Coupon Rate) • This is the rate that the bond pays on the original amount of the loan (usually in $1,000 increments) • Current Yield • This is the true rate of interest that the bond buyer is currently getting since it reflects the premium or discount price the buyer had to pay • Yield to Maturity • This is the yield you would receive if you were to hold onto the bond until it matures • If the Nominal Rate, Current Yield and the Yield to Maturity are all the same, the bond is said to be selling at par • There is no premium nor is there a discount

46. Dollar Amount of Annual Interest Current Market Value Current % Yield of a Bond (continued) A bond selling at a premium has a current yield lower than its stated nominal rate Example: 6%, $1100 market value Current yield = $60 $1100 = 0.0545454  5.45%

47. Dollar Amount of Annual Interest Current Market Value Current % Yield of a Bond A bond selling at a discount has a current yield higher than its stated nominal rate Example: 6%, $900 market value Current yield = $60 $900 = 0.06667  6.67%

48. Yield to Maturity Face value - Market value Number of periods Face value + Market value 2 Example: 6%, Selling at $900, 10-year maturity $1,000 - $900 10 years $1000 + $900 2 = 0.074 = 7.4% $ Amt Annual Interest + $60 + ¡Aye, Paquito!

49. Primary and Secondary Bond Markets • Primary bond market • Buy via an investment bank or company representative • www.treasurydirect.gov • Secondary bond market • Buy through a broker from another investor who wants to sell it, and pay a commission Very few small investors participate in the bond markets. Bond traders normally deal in the millions of dollars and want you to pony up at least $25,000, preferably $100,000 or more. The major exceptions are Federal Treasury bonds. The small investor is welcome at www.treasurydirect.gov.

50. Bond Mutual Funds • Most small investors are better served by investing in a bond mutual fund • Professional Money Management • Diversification • Bond Traders are used to buying and selling in the millions • Smallest transactions are in the $10,000’s • The mutual fund managers and pension fund managers can get a much better deal because of their size Although it is very easy to buy Treasury bonds directly from the Federal government at www.treasurydirect.gov