Investment Planning
The Basics

People make investments for a number of reasons. Most are accumulating funds to achieve some specific goal. Most financial goals involve investing capital so that it will grow as much as possible over a period of time. For this reason, it is very important to understand the basics of investment planning in order to invest wisely.

How do I...
Get Started

Ask yourself these questions:

• What will be the source of my investment capital? (Where will the money come from to invest?)

• What is (are) my investment goal(s)? There may be one or more goals that you wish to fund. Remember, for a goal to be meaningful, it must be specific and have a time horizon. Some common financial goals include creating a current income stream; saving for a down payment on a residence or vacation home; saving for children’s college education; accumulating sufficient capital to start a business; or funding major home improvements. But the most frequently mentioned reason for investing among Americans surveyed is saving for retirement.

• What is my time horizon? Are you investing for a few months; a few years; or for the distant future? The answer to this question will have an impact on the appropriate investment selections.

• How much will be needed to fund my goal(s)? Future Value methods may be used to determine how much is needed.

Once these questions are answered, the next step will be to determine which investment vehicles will best achieve these goals.

Are there different...
Kinds of Investments

There are many investment vehicles available. But in general, all forms of investments may be divided into "Debt" and "Equity" investments. Anytime you allow someone to use your money to make money, it is considered a "debt" investment. This category would include bank certificates of deposit; bonds (of all types); fixed annuities; cash value of whole or universal life insurance; notes receivable; etc. "Equity" investments actually allow you to take an ownership position and include stocks, real estate, tangible assets such as gold; and collectibles such as art, antiques, etc.

Debt investments usually involve little, if any, risk of principal, and low to moderate returns. These returns are derived from interest and/or dividends. Equity investments expose all of your investment capital to the risk of losing your principal, and generally derive most of their investment return from appreciation of the value of the underlying asset (capital gains).

What should I consider when...
Selecting an Investment

Although there are numerous factors that may be considered, some of the most important are:

• Risk
• Rate of Return
• Impact of Taxes on Return
• Marketability and Liquidity
• Diversification

There are many kinds of risk in investing. Some forms of risk may be more important to you as an investor than others. If you learn to identify each of these types of risk, you can then determine which of these have importance as you structure your investment portfolio.

• Risk of Principal – If the investment selected performs poorly, the amount of money which was invested can be lost, in part or in whole.

• Market/Volatility Risk – The value of the investment selected may move up or down due to changes in the particular financial market your investment is participating in.

• Purchasing Power Risk – This is uncertainty over the future purchasing power of the income and principal from a selected investment. This is created by changes in the general price level of the economy.

• Interest Rate Risk – Investments which are providing fixed income (such as bonds, CDs, etc). will experience changes in price as interest rates increase and decrease. In general, a rise in market interest rates tends to cause a decline in market prices for existing securities and conversely, a decline in interest rates tends to cause an increase in market prices for existing securities, thus creating an inverse relationship with the general level of interest rates.



Example You have purchased a bond paying 5% with a 5-year maturity. It is now year three of the five-year period, and you wish to sell your bond. However, interest rates are now at 7%. How easy will it be for you to find a purchaser for your 5% bond when there are many 7% bonds available on the market? Not very easy! You would probably have to "discount" your 5% bond (that is, sell it for less than you purchased it) in order to attract any buyers; therefore, the value of your bond has decreased, in an inverse relationship to interest rates which have increased over that same time period.



• Tax Risk – This involves the potential tax consequences involved with a particular investment to include federal and state income, estate, inheritance and gift taxes.

Expected future return is what causes an investor to select an investment. And, since the purpose of investing is to earn a return sufficient to fund your goal(s), you should understand how you would receive this return. It may take a variety of forms to include interest, dividends, rental income, business profits, and capital gains. The total amount of earnings on an investment is "total return". And this is generally broken down into two main components:

• Current Income – income received regularly over the course of the investment (dividends, interest or rent)
• Capital Gains – the increase in the market value of the specific investment vehicle. This return is generally not received or recognized until the asset is sold.

Another factor affecting Rate of Return is the potential effect of compounding (earning interest on interest). If interest, dividends, etc. are allowed to remain in the investment and in turn, receive the benefit of future growth, the result is compounding.

The interaction between these first two factors creates the Risk/Return Trade Off. The amount of risk associated with a given investment vehicle is directly related to its expected return. This is known as the "Universal Rule of Investing". So, theoretically, the more risk you are willing to take, the higher return you should expect to receive. To give you some perspective, a "risk-free" rate of return would be an investment that provides a positive return with zero risk (i.e. a 90-day US Treasury bill). This is often used as a benchmark against which other investments are measured. As risk is increased, so should return potential.

It has been said that it doesn’t matter what you get; only what you get to keep! For this reason, it is very important to differentiate between the Return received from an investment and its "after-tax" Return.

There are several considerations here:

• An investment may yield income that is currently taxable as ordinary income, such as interest on Certificates of Deposit, corporate bonds, etc. In this case, the After-Tax Yield is going to be less than its Current Yield (interest rate). This can be determined by multiplying the current yield by "1" minus the investor’s income tax rate.

• An investment may yield income that is tax exempt, such as interest from some municipal bonds. So, the after-tax yield for a fully tax-exempt investment equals the Current Yield.

• An investment may yield returns that are taxable only when realized and recognized as capital gains. This time, Mr. Fletcher, purchased shares common stock of ABC Pharmaceutical Company. The stock has paid no dividends, but it has increased in price from $10 per share to $20 per share during the past year. In this situation, Mr. Fletcher will not have a taxable event until he sells his shares, since he has not "realized" his capital gain of $10 per share yet.

  Further, due to favorable capital gains treatment, when the shares of stock are finally sold, the tax rate will be lower than the tax rate would have been had the shares produced dividends which would have been taxed as ordinary income.

  These were very simple examples, when in fact, the implications of tax treatment of investment income can be very complex. Your professional tax and investment adviser will assist you in determining the impact of your investment positioning on your personal tax situation.

These terms are sometimes used synonymously, but they are not the same thing.

• Marketability refers to the degree to which there is an active market in which an investment can be readily traded.


• Liquidity refers to the ability to readily convert an investment into cash without losing any of the principal invested. An investment with liquidity has a highly stable price.

Some investments are neither marketable nor liquid; others are marketable, but not liquid; or liquid, but not marketable; while others are both marketable and liquid.




Example Checking and savings accounts do not have a market where they can be readily bought and sold; therefore, they have limited marketability; but they are very liquid. Stocks which are traded on one of the exchanges have high marketability, since they can generally be sold with little or not difficulty or waiting; however, a sale may result in loss of principal, which would not create pure "liquidity". Real estate has neither liquidity nor marketability because it generally takes a significant amount of time to sell real estate, and it cannot necessarily be sold at its original purchase value.

Although marketability and liquidity are desirable, it is often necessary to have a "trade-off", since highly marketable or liquid assets usually yield less than less marketable or illiquid investments. So, an important question for you to consider, is "Is marketability or liquidity important enough to give up some yield?" This, of course, depends on your overall situation.

Diversification is an important investment policy to consider in constructing a portfolio. It refers to the defensive strategy of spreading investment dollars into several different investments in order to minimize risk. There are numerous types of diversification. You might diversify between stocks and bonds (equity and debt); between liquid and non-liquid investments; between one investment objective and another; etc.

The principal of diversification is that the prices or values of all differing investment opportunities do not go up or down at the same time or in the same magnitude, so an investor can protect at least a portion of his/her investment assets by diversifying.

Should I select...
Debt Investments
What kinds of debt investments (fixed income securities) should you consider for your portfolio, and how will they impact your investment return? Fixed income securities promise the investor a stated amount of income periodically. The most common fixed income investments include:

• Corporate Bonds
• Convertible Bonds
• Zero Coupon Bonds
• Municipal Bonds
• US Treasury bills, notes and bonds
• Preferred Stocks and Convertible Preferred Stocks
• Savings Accounts
• Certificates of Deposit


Bonds

What Are the Investment Characteristics of Bonds?

A bond is a fixed income security that provides investors with secure and regular sources of current income. It is a negotiable long-term debt instrument of the issuer that carries certain obligations. There is no ownership position in bonds. Interest is usually paid semi-annually. Bonds can also generate a capital gain if the bond is sold prior to its maturity for more than its original par value (the value which will be paid in full at maturity.)

What Types of Bonds are there?

Bonds may first be classified by their type of issue.

• Secured Issues – These are "senior bonds" which are backed by a legal claim on some specific property of the issuer. For example, mortgage bonds would be secured by real estate; equipment and trust certificates would be secured by equipment.
• Unsecured Issues – These are "junior bonds" which are only backed with the general promise of the issuer to pay and are not secured in any way.

Bonds may also be classified as "callable" or "non-callable". Callable bonds contain a provision allowing its issuer to retire the bond earlier than its maturity date. This right must be specified in the original bond offering, and most callable bonds prohibit recall during a specified period of time. The issuing corporation can usually exercise the call provision at any time after a specified date. A "call premium" (such as one year’s interest) is generally payable to the investor, if the bond is called.

Bonds may also be classified by the nature of the Issuer of the bond.

• Treasury Bonds – These are bonds issued by the US government, and are fully backed by the faith and credit of the US government. They create one of the largest bond markets in the world. They are sold in $1,000 denominations (except 2 and 3-year issues that are $5,000 minimums) and all issues are non-callable. Treasuries are exempt from state and local income taxes. These instruments include:
  
  Treasury Bills – Maturities of 30 to 360 days
  Treasury Notes – Maturities of 2 to 10 years
  Treasury bonds – Maturities of more than 10 years and up to 30 years


• Agency Bonds – These instruments are issued by political subdivisions of the US Government, and are not obligations of the US Treasury, although some may contain government guarantees. Interest may be paid monthly, quarterly, semi-annually or annually, depending on issue. Their returns are usually slightly higher than Treasuries, and the most common include FNMAs/"Fannie Maes" (issued by the Federal National Mortgage Assn.); and FHLMCs / "Freddie Macks" (issued by the Federal Home Loan Bank) and SLMAs / "Sallie Maes" (issued by the Student Loan Marketing Assn.). These instruments may or may not be exempt from state and local income taxes.


• Municipal Bonds – These are issues of states, counties, cities, and other political subdivisions such as school districts and water and sewer districts. Interest is usually free from federal income taxation, and thus they are frequently called "Tax-Free Bonds". Municipals are usually " "serial obligations" (broken down into a series of smaller bonds, each with its own maturity and coupon rate. Common municipal bonds include:


• Revenue Bonds – These are serviced from the income generated from income producing projects such as toll roads, civic centers, etc. The issuer is generally not required to pay if revenues do not reach a sufficient level; therefore these bonds are very risky.
• General Revenue Bonds – These bonds are backed by the full faith and credit of the issuing municipality, and may or may not be guaranteed by the state or an insurance company.

An investor’s tax bracket is a big determinant as to whether or not a municipal bond purchase should be considered. Since these bonds are generally lower yielding than fully taxable bonds, you must compare their yield to the comparable fully taxable yield (what you would have to get on a taxable bond to provide the same net investment result)

The formula for comparing this return is:

FULLY TAXABLE EQUIVALENT YIELD = YIELD OF MUNICIPAL BOND DIVIDED BY (1 – TAX RATE).

Example If Mr. Edwards, who is in the 39.6% tax bracket was considering the purchase of a municipal bond with a rate of 6%, and a fully taxable bond with a rate of 8%, his calculation would look like this: Fully taxable equivalent yield = .06 divided by (1 - .396) = .0993 So, the municipal bond would have a better selection, since in order to get the same after-tax return, a taxable bond would have to yield 9.93% interest, and the bond he is considering is only paying 8%. This example would look quite different if Mr. Edwards were in 15% bracket: Fully taxable equivalent yield = .06 divided by (1 - .15) = .07058 In this case, the taxable bond at 8% would be a better deal, since the municipal bond’s after- tax equivalent rate is only slightly over 7%. So, obviously the higher the tax bracket of the investor, the more likely it is that a municipal bond purchase will compare favorably to a taxable bond purchase.



• Corporate Bonds – These are bonds issued by the non-government-sponsored corporations. They include industrials, public utilities, rail and transportation entities and financial issues. Corporate bonds usually are sold in $1,000 denominations and are usually issued with maturities of from 5 to 10 years, but can go up to 30 years. Their yields are generally higher than Treasuries, and a wide variety of issues are available. Most are non-callable for the first 5 to 10 years.
• Zero Coupon Bonds – These are bonds issued without coupons. (There is no interest paid until maturity on these bonds.) Zeros are issued by corporations, municipalities, federal agencies or the US Treasury. They may be packaged into trusts and sold under the names of "TIGRS", "CATS" and "LIONS". They are sold at a deep discount from par values and then increase in value over time, at a compound rate of return, so that at maturity, they are worth much more than the initial investment. Although interest is not being paid, IRS treats accrued interest as taxable on an annual basis.

One very important factor in selecting bond investments is the knowledge that not all bond holdings are equal, in terms of risk and reward. Bonds issued or guaranteed by the US Government Bonds are generally considered to be the safest of investments. Other bonds will have varying levels of safety and stability.

Rating services such as Moody’s and Standard and Poors provide ratings on bonds, and are readily available to the public. Ratings are expressed by letter grades, designating its investment quality. Obligations that are awarded one of the top four ratings are considered "investment grade" bonds. By the fifth rating level, the speculative element is significant and by the seventh rating, the speculative element dominates. These ratings are based on default risk exposure and the financial strength of the issuer. Generally, the lower the rating the higher the yield on the bond, since it is considered riskier.

The "price" of a bond is a function of its coupon (stated interest rate); its maturity (when repayment of principal is promised) and the movement of market interest rates. Generally, the longer the term of the bond, the higher the yield. Additionally, the riskier the bond, the higher the yield.

If the bond is sold prior to maturity, it is subject to market risk. If interest rates have increased since its issue, it will be a "discount bond" (sold for less than its par/face value). If interest rates have decreased, it will be a premium bond (sold for more than its par/face value).

What Are the Investment Characteristics of Preferreds and Convertibles?

Preferreds and Convertibles are hybrids, securities, possessing characteristics of both stocks and bonds.

Preferred stocks hold a position senior to common stock, but following the claim of bondholders. They usually carry a fixed dividend, and as such, as considered to be fixed income securities. When the dividends are "cumulative", any dividends that have not been paid in previous years must be paid before current dividends can be paid on the common stock. They do not have fixed maturity dates.

Convertibles are debt instruments that may be converted to a certain number of shares of the issuing company’s common stock within a stipulated time in the future.

Other types of fixed-income investments include Commercial Paper (short-term promissory notes of well-known corporate borrowers); Certificates of Deposit (interest-bearing negotiable evidence of time deposit with banks); and Savings Accounts (highly save and liquid investment accounts offered by banks and other financial institutions. These securities usually have lower yields than many other forms of fixed rate investments due to their short-term nature and high liquidity. They are frequently used to hold emergency funds or those dollars earmarked for a short-term need.