What are we investing in?

What Are We Investing In?

In order to have a clear understanding of building a portfolio, it's a good idea to learn some fundamentals so that you can effectively determine the kinds of assets you want to invest in.

This section covers the basics.

Just click on any of the items to receive a description.

What is a stock?
What is a bond?
Hybrid securities
The Markets
Why Prices Rise or Fall
Mutual Funds
Group Annuity Contracts
Technical Stock Analysis
Fundamental Stock Analysis
Other Management Techniques

What is a stock?
A share of common stock represents one share of the ownership of a corporation. Ownership of the company allows participation in the voting for the direction the corporation will take. Shareholders vote for the members of the Board of Directors, and other issues of importance.

The proportion of a company that the share of stock represents depends on how many shares of stock the company has outstanding. If the company has only one share outstanding, that single share of stock owns the company. On the other hand, if the company has 57 million shares outstanding, a single share is a small fraction of the ownership.

In publicly traded companies, the market value of the shares is the same for everyone on a per share basis. One share has the same value for the individual investor and for the person or institution which owns thousands of shares.

Buying shares of stock in a company is done so that the purchaser may participate in the business on an ownership basis. If the business is successful, the hope is that the company will distribute dividends to the shareholder from the profits it earns, and that the price of the shares purchased will increase (appreciate) because the business is successful.

If the business is not successful, it is possible that the shareholders will lose all or a portion of their investments. If the company loses money, the value of a share of stock will normally go down, since it worth less now than when the company made money. If the company goes bankrupt, the shareholders usually end up with nothing.

So the majority of the risk or reward of the company is placed on the shareholders.

What is a Bond?
A bond is a loan to a corporation purchased by an investor who wishes to receive interest payments on bond.

Corporations who issue bonds do so to raise additional capital for their companies to invest in plants, equipment and other assets to produce revenue for the firm. The bonds are usually issued for long term periods of from 10 to 30 years. The bond has a maturity date, which is the date when the corporation who issued the bond will redeem it at its face value.

The bond will normally have a stated rate of interest which will be paid, and those payments are usually paid twice per year, or semi-annually. So the investor should receive two interest payments each year until the bond matures, and then the original principal is paid back. Investors normally buy bonds since they do pay interest, and the dates of the payments are usually very predictable.

Just as there are risks associated with owning stocks, there are risks in owning bonds.

First, there is a "credit" risk. If the corporation does poorly, or goes out of business, it is possible to lose all or a part of the investment, and interest payments may be delayed or missed. The credit risk to the investor is whether the company can make the interest payments over the long term, and then be able to redeem the bond when it matures.

There is an interest rate risk, in that when the bond is issued it is paying a fixed rate of interest that will not change. Interest rates over the long term of the bond, however, are bound to change. Thus, the holder of a bond may find the bond worth less than its face value if interest rates are higher than the interest being paid on the bond.

When a corporation fails, however, bondholders have a priority to the assets of the corporation over the stockholders. So bondholders would be in line to receive payments before the common stock holders.

Hybrid Securities
The business of finance is no different than any other in trying to find ways to satisfy the needs of consumers. Car companies make several different models to appeal to the largest number of buyers. Financial firms are no different in their development of financing strategies. Each consumer invests for a different reason, whether it is for income, capital appreciation or a combination of both.

So companies issue hybrid securities to help satisfy the investment needs of as many buyers as possible. Among the possible types of hybrid securities, but by no means all of the combinations:

Preferred Stock

Preferred Stock is stock that pays a specified dividend on an annual or quarterly basis. The dividend is usually cumulative, meaning if it is delayed when due, it is accumulated to be paid later.

Convertible Bonds

Convertible Bonds are bonds that have a specified interest rate and a maturity date, but that may be converted into common stock at a predetermined price. That gives the bondholder the ability to receive interest payments, and the option to convert the bond into shares of ownership at a later date.

Preferred Convertible Stock

Convertible Preferred Stock is stock that pays dividends, but like the convertible bond can be converted to common stock at some later date.

There are many other combinations that are possible, but these five are the most common types of financing in use today.

The Markets
Once a company has issued its stock, a publicly traded company's shares are traded on an exchange. The major exchanges are the New York Stock Exchange, The American Stock Exchange, and the NASDAQ Stock Exchange. Which exchange the stock trades in is based on a number of factors. Each exchange has minimum criteria that must be met to trade on these exchanges. Daily volume and share price is important issues to the exchanges.

Once listed on one of the exchanges, the price of the shares is subject to an auction process. The number of buyers and sellers desiring to trade the stock dictate the price. The exchanges have mechanisms in place to help provide liquidity in share prices, but essentially the laws of supply and demand prevail.

Bonds are traded much in the same manner. Buyers and sellers in an auction format dictate the prices based on current interest rates, credit risk, and many other factors.

Prices on the exchanges, and of individual stocks and bonds fluctuate during the trading day depending on economic reports, market news, rumors, speculation, and a whole host of other factors.

Why Prices Rise or Fall
The goal of a corporation is to earn money or own extremely valuable assets or both. When a corporation earns money, the total earnings are divided by the number of outstanding shares to derive an earnings per share number.

When the earnings per share rises, the price of the stock usually rises. Many of the fundamental analysis ratios used by money managers are focused on the earnings per share a corporation earns. These earnings, which are reported every three months, are watched by all investors as a key to the company's health and direction. If you haven't read the section on fundamental stock analysis, we would highly recommend it.

Beyond earnings, there are many other reasons the prices of stocks go up or down. General market conditions have much to do with individual stock prices.

The overall economy also impacts prices. When unemployment is low, more workers have more money to spend, which increases sales. Increased sales, it is hoped, increases earnings per share.

General news, and news specific to a company or industry also move prices. If a drug company develops a new drug that takes the public by storm, it will typically cause the stock to move up. Watch closely the other members of the same industry, as many of those shares move up as well.

The amount of information available on companies is substantial, and many individuals and professional managers spend thousands of man-hours pouring over this information. Entire industries have sprung up to provide this information, so it is an important part of our economy.

Mutual Funds
With all of the available information, the number of companies to follow, and all of the factors that can affect stock prices, many investors find it easier to invest using the services of professional money managers.

A mutual fund is a pool of money managed by a professional money manager for the benefit of the shareholders. Mutual funds are highly regulated and monitored closely by the investing public and many ratings agencies.

A mutual fund has an investment objective. That objective is clearly stated so that individuals with similar objectives may invest in the fund. As an example, a fund may have an objective of providing current income through investment in US Government guaranteed bonds. An investor who desires to invest in aggressive growth stocks would not invest in this fund, but it would be an excellent choice for the buyer who wants income and security.

The primary advantages of mutual funds for the average investor are:

Professional Management, where professionals make all decisions with how the fund is managed.

Diversification of Assets, due to the fact that most mutual funds have holdings in a substantial number of different securities to minimize the impact of changes in one security on the portfolio.

Liquidity since it is easy to get funds liquidated from a mutual fund.

Because of these features, mutual funds are used substantially in 401k and profit sharing plans. Individual participants have access to large amounts of information, and the ability to move their account from fund to fund as they desire.

Group Annuity Contracts
Life insurance companies have developed a product for 401k and profit sharing plans called a group annuity contract. This contract takes in funds in segregated accounts, and invests in mutual funds. These contracts provide many of the same benefits as mutual funds. In fact, many of the mutual funds available to the general investor are offered in many of the group annuity contracts.

One word of caution. Group annuity contracts have unit values that differ from the underlying mutual fund shares. Group annuity contracts have sub-accounts designed to invest in a named mutual fund. The sub-accounts themselves have a unit price, and when a contribution is made to the sub-account for you, you are purchasing units in that sub-account first. Then the sub-account purchases shares of the mutual fund specified.

Example: Annuity Contract Sub-account High Growth

Unit value of sub-account is $54.22 Your contribution of $100.00 purchases 1.844338 units of High Growth sub-account

The High Growth Account then purchases shares in XYZ Growth Fund, which is the specified mutual fund for the account. XYZ Growth shares are purchased at $61.08, so in effect, your contribution is represented by 1.637197 shares of the mutual fund.

In point of fact, all shares of the fund being purchased are held in a pooled account. The above illustration is designed to show you that looking in the newspaper for your mutual fund, and having the prices be considerably different between the paper and your statement.

The illustration shown does not apply to a fund that is internally managed by the insurance company. In that case, the unit values are the correct net asset value of the fund.

Other Useful Techniques
Some additional useful money management techniques in a 401k or profit sharing plan are discussed here. Mutual funds are not necessarily shelf assets, which are purchased and forgotten. A mutual fund fund manager has an objective to fulfill, and must invest assets based on that objective.

The first technique is known as dollar cost averaging. This is the oldest and simplest method of investing, and is the preferred method of mutual fund companies. The fund manager maintains the investment objective of the fund, and is not bothered by substantial redemptions in the fund. Redemptions occur when shareholders liquidate their funds and move the money elsewhere.

In short, dollar cost averaging is the systematic deposit of similar amounts over a long period of time into the same investment vehicle. This is normally a natural event in a 401k plan, where deposits are made monthly, usually into the same investment accounts.

The following illustration shows how dollar cost averaging works.

The assumed investment is $100.00 per month into the same account. The chart shows the price of the shares being purchased, the number of shares purchased, and the cumulative investment and shares owned The illustration period is 48 months.

The chart shows the impact of rising prices, an increase of 15% from the beginning of the period, as well as declining prices from the highs of the illustration.

The goal of dollar cost averaging is to keep the average share price of the cumulative shares in a narrow range. In this manner the investment can benefit from sharp movements in price, while sharp declines in price do not have a devastating impact.

The chart attached to the illustration shows the market value of the shares compared to the cumulative value of the investment.

The second technique is fund switching, sometimes known as market timing. This method of management tries to switch from fund to fund using technical and fundamental analysis to determine the direction of the market.

This technique is the least favorite management tool for mutual fund managers, since they must liquidate holdings to pay off transfers when liquidations occur. Similarly, they must re-invest in their core portfolio when transfers come back into the fund.

We are illustrating a chart on Abbott Labs for the period August 1999 to February 2001. On the chart are displayed the daily price bars for the stock, along with a 50 day moving average of those prices. In fund switching, the investor uses analysis to determine the most opportune times to move from fund to fund to maximize their performance.

On the chart are placed possible entry and exit points from Abbott Labs. In the first case, an exit is signaled in mid-September of 1999 at about $42.00 per share. From there, the stock fell to just below $30.00 and started an uptrend in March of 2000, when an entry signal came into play. No other true signals for long term investors came into play until December of 2000.

Note that signals other than simple moving averages should be used in analyzing the charts and making moves.

Mutual funds give the same kind of signals, even though they are comprised of many different stocks. Watching those signals can spell investing success for the participant in a retirement plan.