At any age, but especially when you’re in your 40s or 50s, retirement planning should be your first priority. If your employer-sponsored retirement accounts are where they should be, however, and your payments are all under control, you might be thinking about some other types of investments. After all, retirement is expensive, and, to be assured that you have the money you need, you may need some good investments outside of your at-work plans.
Investing, as you probably know, encompasses a variety of opportunities and vehicles. It’s as simple as putting money in a savings account at 2 percent interest, or as complex as the commodities market.
This chapter looks at investing in terms of stocks and bonds, with some information about mutual funds thrown in, as well. If you’re a seasoned investor with a portfolio the size of the Manhattan phone book, you might just want to skim over the information included here as a basic review. If you’re new to the world of stocks and bonds, you’ll want to pay careful attention.
We frequently hear people talking about the stock market. When the market was great in the late 1990s, everybody wanted to talk about the market and how well their investments were doing. People quit their jobs to become day traders, those steel-nerved folks who watch the market carefully, buying and selling stock in hopes of hitting it big and making tons of money. More people invested in the market than ever before, fueling the economy and keeping stockbrokers extremely busy.
Don’t Go There
If you’ve ever entertained the notion of day trading, forget about it. It’s a dangerous business, and most people don’t know enough about the stock market to be effective in day trading.
In these days of market plunges, however, many investors aren’t quite so anxious to talk about their stocks. Folks are still day trading, but many of them have given up the dream and gone back to “real” jobs. Stockbrokers are still busy, but these days a lot of that business entails reassuring clients.
So just what is this thing called the stock market, and how does it work? Why does it rise dramatically one day, only to take a plunge the next?
The stock market is a generic term that encompasses the trading of securities. The security can be a bond or a stock, and it’s traded on an exchange. There are three major exchanges in the United States.
Formed in 1792, the New York Stock Exchange (NYSE) is the largest organized stock exchange in this country. Companies must meet certain requirements in order to be listed on the NYSE, so not all stocks are traded there.
If you want to buy a stock, your broker will relay your wish, either by telephone or the Internet, to a member of his firm who’s on the floor of the NYSE. The order will then go to another broker on the floor who specializes in trading the particular stock you want to buy, and he’ll make the trade for you. You can actually visit the NYSE and watch all the action.
The National Association of Securities Dealers Automated Quotation System, or NASDAQ, on the other hand, trades exclusively with computers. The trading is not conducted in a central location like the NYSE, but from different locations, via computers.
A third stock exchange, the American Stock Exchange, or AMEX, was known before 1951 as the American Curb Exchange. That’s because trading was conducted on the curb of Wall and Broad streets in New York City. The AMEX does not have as stringent requirements as the NYSE, which makes it attractive to many smaller companies.
The overall performance of the stock market is evaluated in different ways. The Dow Jones Industrial Average is one measure of the market, and the one we most often hear about.
The Dow Jones Industrial Average is a composite, or group, of 30 selected stocks with a daily average. If the average price of the stocks goes up, the Dow Jones Industrial Average goes up for that day. If the average price of those 30 stocks goes down, we say the Dow Jones is down. Trading depends on many factors, and the stock market can have major fluctuations in its averages. The 30 stocks change infrequently, decided upon by a group of members of the New Stock Exchange. Mergers between large firms (like Mobil and Exxon becoming Mobil Exxon) require the addition of a new company onto the Industrial Average. Cisco was added in early 2000.
When the stock market experiences an upward trend, we call it a bull market. When the trend is continuously downward, it’s a bear market.
Stocks represent ownership, or equity, in a public corporation. When you buy the stock of a particular company, you’re actually buying a tiny piece of the business. If the company prospers, you as a stockholder share in its profits (frequently in the form of dividends) and benefit from any rise in the market value of its stock. Conversely, if the company runs into problems, the value of your investment could decline.
Because their prices tend to fluctuate suddenly and sometimes sharply, stocks are considered more risky than bonds or cash investments. Over time, however, stocks have offered the highest returns of the three asset classes—as well as the best hedge against inflation.
So how do you know what stocks to buy, and when you should buy them?
Unless you’re a real daredevil with lots of money to play around with, it’s a good idea to invest your money in industries and companies that are stable, with good earning histories. Sure, you might be tempted to buy a few stocks in a sexy, new firm that’s just starting up, or sink some of your money in a hot, new growth industry, and that’s fine. The majority of your money, however, should go to buy stock that is tried and true.
There may be opportunity for increased profits in more risky stocks, but you should look for those that have reasonable price-to-earnings ratios. Price-to-earnings (P/E) ratios determine how the market is pricing a company’s stock, and can help you to get an idea of the strength of a company.
Don’t Go There
Don’t be persuaded to jump on the bandwagon and invest all, or most of your money in one area—technology stocks come to mind. It’s never a good idea to put all your eggs into one basket, regardless of how good the basket looks at the time.
While it’s fine to invest some of your money in companies in these industries, it’s not a good idea to rely only on growth industries.
There is risk involved whenever you buy stock, but some stock involves less risk than others. The risk of the stock you own going up and down in value because the entire stock market goes up and down is called systematic risk. Chances are, if the entire stock market drops by 10 percent, the stocks you own will decrease in value, as well. And the same is true if the overall market value increases. You can minimize the effects of systematic risk by investing in other forms of securities, such as bonds.
Unsystematic risk is that which affects only a particular business or industry. The good news is that diversifying your portfolio can minimize unsystematic risk. That means that you have a variety of investments in different types of companies and industries. If one sector of the stock market experiences a major downturn, you’ll still have stocks in other areas to offset your losses.
So when you’re looking for companies in which to invest, make sure you mix them up. Your portfolio should include a mixture of some of the many kinds of stock. Blue-chip stock, for instance, is that of the tried and true companies such as IBM and General Motors. Companies experiencing unusual growth issue growth stocks. Emerging market stocks are those in new markets, in the United States and around the world.
You can find out a lot about companies in whose stock you’re interested by checking out their financial statements in their annual reports. You also should look at some of the company’s ratios, including price to earnings (P/E), earnings per share (EPS), return on investment (ROI), and return on equity (ROE). Pay special attention to a company’s profitability and how much debt it has.
Investors have been trying since investing began to time when they buy, trade, and sell stock. Even experienced investors, however, get hung up when they try to time the market. Ideally, you want to buy stock when the price is low, and sell it when the price is high.
Realistically, however, you should buy when you (and your financial advisor, if you have one) feel the time is right. Trying to time the market might be interesting, but it rarely pays off. The best time to buy stock is after you’ve explored your options, researched the companies, and decided that the stock is right for you.
Anyone who’s got money in the stock market these days has been through some trying times lately. After the longest period ever of sustained gains, the market is behaving as moodily as a teenaged girl with no date for the dance.
It’s tempting, at times like these, to unload your stocks and put your money back into your savings account. You shouldn’t, however, be in a hurry to sell stock that you feel is not performing as well as it should. Give it some time to see if it’s going to bounce back. If the entire market is in a slump, chances are that your stocks will be slumping along with it.
The one piece of advice a financial advisor will give when the market dips is to not panic. In some ways, investors are like poker players. Even when the game isn’t going the way they’d like it to, they’ve got to sit tight, stay cool, and hang on to their cards (or stocks).
Trading stock occurs when you execute a buy or sell order, either with a broker or online, and the broker sends a message to the New York Stock Exchange for execution of the trade.
That’s not to say, however, that there is never a reason to sell stocks. If you have stocks that have increased in value, and you want or need money for a good reason, then selling the stock is a reasonable thing to do.
If the stock you own turns out to be a big loser, it also makes sense to get rid of it. Be sure, though, that the stock really is bad, not just stock that’s not doing well at the moment. There are investor services that can tell you how your stocks are doing, and why, or you can check out a periodical such as Investors Business Daily. Two investor services you can access on the Internet are Moody’s Investor Service at www.moodys.com, and the Value Line’s Investment Survey at www.valueline.com.
If you think the price of your stock is as high as it’s going to go, it’s a good idea to sell it before the price begins to drop. Predicting if your stock has hit its peak requires that you conduct fundamental analysis. Fundamental analysis is a system that evaluates a company’s overall condition, based on various criteria that measure the health of the company.
You shouldn’t sell stock simply because you’re bored and want something that’s more exciting. Nor should you sell because you’re nervous about the overall condition of the stock market. Unless you’re only months away from retirement and are going to need the money you have invested, hang in there, and trust that better days are ahead.
If you do sell stock, you’ll need to consider the capital gains or losses that you may incur. Naturally, we all hope to sell our stock for more than we paid for it. If you hold an investment for less than one year, however, you may pay big taxes on your profits. Gains or losses from an investment of less than one year are considered short term. Short-term gains and losses are netted against each other, and short-term gains are taxed at your regular tax rate. If you’re in the 28-percent tax bracket, you’ll have to pay 28 percent on your gains. As you can see, short-term gains are expensive.
If you hold an investment for more than a year, the gain or loss is considered long-term. Long-term gains and losses are netted against each other, too, but the tax on them isn’t quite as hefty as with short-term gains. If you’re in a 15 percent tax bracket, net long-term capital gains are taxed at 10 percent. If you’re in the 28 percent or greater bracket, your capital gains are taxed at 20 percent. This tax advantage makes it desirable to hold assets for more than a year, particularly if you’re in a higher tax bracket.
Just so you don’t think that stocks are the only game in town, let’s have a quick look at the bond market.
Bonds are the most common lending instruments traded on a securities market. A lending instrument is when you loan your money with the understanding that you’ll get it back—with interest—after a specified time. The bond issuer promises to pay the investor a specific amount of interest for a period of time, and to repay the principal at maturity.
If a company issues a $10,000 bond that will pay 6.5 percent interest and is due on June 15, 2004, and you invest in that bond, what you’re actually doing is lending the company $10,000 until June 15, 2004. Meanwhile, the company has promised to pay you 6.5 percent, or $650 each year, on your $10,000.
An important characteristic of bonds to keep in mind is that if the interest rate drops, the value of your bond increases. If the interest rate rises, the value of your bond drops.
Bonds are basically different than stocks because they’re lending investments rather than owning investments. If bonds are purchased prudently from secure firms or municipalities, bonds that are held to maturity are far less risky than owning a stock.
When the value of bond increases, it’s called a premium bond. When the value decreases, it’s called a discounted bond.
They’re also different in that, while stocks represent ownership in a company, bonds are issued by the U.S. Treasury, U.S. government agencies, corporations, and state or local governments.
You normally can sell stock anytime you want. If you buy bonds, however, you might have to wait until the maturity date if you don’t want to risk losing money.
Not all bonds are created equal. Government bonds are considered to be safer than corporate bonds because they’re backed by government guarantee. Corporate bonds, on the other hand, are issued by corporations and traditionally pay more interest than government bonds.
High-yield bonds, also known as junk bonds, are issued primarily by corporations, and considered to be riskier than standard bonds, but they pay more. Municipal bonds are those issued by state, local, or county governments; hospitals; and colleges. The interest you earn on these types of bonds is not subject to federal income tax. Depending on where you live, it may not be subject to state or local taxes, either.
If your portfolio contains only stocks, you should consider buying some bonds for the purpose of diversification. Bond returns tend to fluctuate less sharply than stock returns, and bonds could help to reduce your portfolio’s overall volatility.
Bonds usually are safer investments than stocks. You should know, however, that there have been companies that were unable to repay their bonds at maturity. That’s called credit risk, and it does happen. Some other risks associated with bonds are . . .
Having said all that, it’s hard to imagine that bonds are considered a safer investment than stocks, but it’s true. Remember that government bonds are backed by a U.S. government guarantee, which makes them particularly safe. And some bonds issued by states and municipalities are usually tax free, which makes them particularly attractive to many investors.
When you begin to invest in individual bonds, decide which risk is greatest to you, and work with your financial advisor to find the best choice for your objectives.
Mutual funds, which pool your money with that of many other investors to buy stocks, bonds, and other securities, often take a back seat to stocks and bonds when folks start thinking about investing.
They happen, however, to be a very important investment vehicle. Mutual funds can be compared to pies. If the value of the mutual fund goes down, the pie—including your piece of it—gets smaller. If the value increases, the pie gets bigger. Some benefits of mutual funds are:
We love mutual funds, and think they’re great investments. They are not, however, perfect. Some disadvantages include:
If you’re investing in mutual funds, be sure to coordinate the securities they include with what you already have in your retirement accounts. You don’t want to lean too much in any one direction, so make sure you have a good balance.
There are four categories of mutual funds:
Mutual funds are a good investment tool for investors who don’t want to be involved in the investment process, or who can’t afford to hire a money manager.
An individual retirement account, or IRA, is a tax-deferred account, which means you don’t pay any taxes on it until you withdraw from the fund. Your investment earnings compound tax-free for as long as they’re invested. This enables your account to grow faster than it would if the money was subject to annual taxes on income and capital gains.
In some cases, your contribution to an IRA is also tax deductible. This applies if you’re not an active participant in an employer-sponsored plan—such as a 401(k)—or if your modified adjusted gross income is below a certain threshold. For 2001, the threshold is $33,000 for single filers, and $53,000 for joint filers. Partial deductions are allowed on incomes up to $43,000 for single filers and $63,000 for joint filers (in 2001). These figures are going up each year until 2008.
If your contributions to a traditional IRA aren’t tax deductible, you should consider looking around for another type of investment, possibly a Roth IRA.
IRAs used to be the darling of investment vehicles. Folks couldn’t get enough of them until the late 1980s, when lawmakers ruined the fun by imposing all kinds of restrictions on IRAs.
Still, many people contribute to IRAs as a means of retirement savings. Anyone under age 701⁄2 who has earned income from wages or a salary may contribute to a traditional IRA. You may make annual contributions of up to $2,000, or 100 percent of your earned income, whichever is less. These limits will increase in stages until you’re able to contribute $5,000 per year in 2008 and after.
A married couple with only one spouse working outside the home may currently contribute a total of $4,000 into separate IRAs, provided the “wage-earning spouse” has at least $4,000 in earned income. Neither spouse’s IRA may receive more than $2,000 annually.
Contributions for a given year must be made no later than the tax-filing deadline for that tax year. For example, you may make your 2001 contribution any time between January 1, 2001, and April 15, 2002.
A problem with IRAs is that, if you withdraw money before you turn 591⁄2, you have to pay income tax on the money, plus a 10 percent penalty tax. There are certain conditions that allow you to withdraw money from your IRA without penalty, such as if you need it to pay for medical expenses, you become disabled, or you purchase your first house.
While your money remains tax free for as long as it remains in the IRA account, your assets aren’t shielded from taxes forever. When you withdraw money, you’ll have to pay ordinary income tax on your investment earnings. The long period of tax deferral that occurs while your money is invested, however, makes the taxes you have to pay when you withdraw your money easier to take.
In addition, people who are 50 years or older will be permitted, beginning in 2002, to make special “catch-up” contributions to their IRAs. If you’re over 50, you’ll be able to toss in $500 more until 2006, when the amount jumps to $1,000 more.
Roth IRAs are fairly new—and they’re interesting investment tools. They’re exciting for investors because, if held for the required time period, the funds you take out are tax-free. Funds you put in a Roth IRA are not tax deductible, but the withdrawals are tax-exempt, and you don’t have to wait until you’re 591⁄2 to get them, nor do you have to begin taking the money from the Roth IRA at 701⁄2.
In addition to being beneficial during retirement, Roth IRA income is a boon to those who might inherit it. One of the biggest drawbacks to traditional IRAs, annuities, and qualified retirement plans is that at death, the accumulated deferred income tax is taxable to the beneficiary.
Until recently, a nonspouse beneficiary had to take a large tax liability within five years of receiving the money. If you inherited $200,000 from your father’s IRA, for instance, you could pay taxes on the entire amount during the year your dad died, or you could pay tax on approximately $40,000 every year afterward for five years.
The tax law changed in 2001, however, and now, if there is a proper beneficiary designation, the deferral can continue for the lifetime of the beneficiary, based on life expectancy.
The beneficiary will need to take minimum distributions over his lifetime, but he can control the amount he receives, along with the accompanying taxes.
A single person with an adjusted gross income of not more than $100,000, or a married couple that files jointly and has an income of $150,000 or less, can each contribute up to $2,000 of earned income each year to a Roth IRA.
You also can contribute up to $2,000 to a Roth IRA of a nonworking spouse (or a spouse with low earnings), but total contributions to an individual’s traditional and Roth IRAs must not exceed $2,000 in any tax year. As with traditional IRAs, however, your allowed contribution to a Roth IRA will increase to $5,000 a year by 2008.
Because your contributions to a Roth IRA are after-tax dollars, you can withdraw your contributions at any time, without paying any taxes or penalties. If you withdraw earnings from an account that is less than 5 years old, however, you may pay ordinary income tax, plus an additional penalty tax of 10 percent.
As with a traditional IRA, there are exceptions to the rule, and instances in which you would not be penalized for withdrawing from an account that’s less than five years old.
As stated above, one of the major benefits of a Roth IRA is that you are not required to take minimum distributions after age 701⁄2. If you do not need income from your Roth IRA, you can let your money continue to grow tax-free. Your beneficiary, however, must take required minimum distributions.
You can convert your traditional IRA to a Roth IRA if you file a single or joint tax return reporting an adjusted gross income of $100,000 or less for the tax year of the conversion. Keep in mind, however, that you’ll owe taxes (but no penalty) on the conversion.
A Simplified Employee Pension—Individual Retirement Account (SEP-IRA) is a plan that allows owners of small businesses and people who are self-employed to set aside money for retirement through tax-deferred investment accounts. A SEP-IRA is funded solely by employer contributions (which are tax-deductible as a business expense). The SEP-IRA really is an employer-sponsored plan, but we included it in this section in order to keep it with the other IRA information.
The owner of a small business can contribute up to $30,000, or 15 percent of each employee’s compensation to the employee’s SEP-IRA account. The amount of the contribution can vary from year to year, and a contribution is not necessary every year. It’s not difficult to set up a SEP-IRA, but there are rules and restrictions that apply.
Employees cannot contribute to a SEP-IRA themselves, but they’re immediately vested once an account has been opened in their name, and can withdraw their employer’s contributions at any time. A penalty may apply if funds are taken prematurely.
If you’re self-employed, a SEP-IRA can be a real bonus. Under the Economic Growth and Tax Relief Reconciliation Act of 2001, you can base your annual contribution on income up to $200,000.
As you can see, investment opportunities are many, but you’ve got to do your homework in order to make good decisions about where to put your money.