Analyzing mutual funds

As you begin your search for mutual funds, make sure that your performance evaluation produces meaningful results. Performance is important because good, long-term earnings enable you to maximize your investments and ensure that your money is working for you. Gauging future performance is not an exact science. When you evaluate funds, check out the Morningstar and ValueLine mutual fund newsletters, both available at the library or online (www.morningstar.com and www.valueline.com). A fund’s prospectus, which you can request from a fund’s toll-free phone number, also outlines the important features and objectives of the fund. As an additional check on your selection process, compare all your choice funds before making a final decision; avoid choosing one fund in isolation. A single fund can look spectacular until you discover it trails most of its peers by 10%. Look for the following information when you select mutual funds:

• One-, three-, and five-year returns: These numbers offer information on the fund’s past performance. A look at all three can give you a sense of how well a fund fared over time and in relation to similar funds.
• Year-to-date total returns: This is a fund’s report card for the current year, minus operating and management expenses. The numbers can give you a sense of whether earnings are in line with competing funds, out in front, or trailing.
• Maximum initial sales charges, commissions, or loads: Unlike stocks and bonds, mutual funds have builtin operating and management expenses. These expenses are in addition to any commission you may pay to a broker or financial planner to buy a fund. A sales charge on a purchase, sometimes called a load, is a charge you pay when you buy shares. You can determine the sales charge (load) on purchases by looking at the fee and expense table in the prospectus. No-load funds don’t charge sales loads. There are no-load funds in every major fund category. However, even no-load funds have ongoing operating and management expenses. Go for lower-priced funds or no-load mutual funds, which by definition must have expenses no higher than 0.25%. Load funds can have charges of up to 5.75%. What that means is that you must deduct that 5.75% from any annual performance a fund turns in. If it’s 10%, you can expect to earn 4.25% after you pay the load or commission.
• Annual expenses: Also called annual operating expense ratios (AOERs), these costs can sap your performance. Before you settle on one fund, review the numbers on at least a few competitors to determine if the fund’s expenses are in line with typical industry charges. In general, the more aggressive a fund, the more expenses it incurs trading investments. Before you invest in a particular fund, be cautious if it has an extremely high AOER compared to that of similar funds. To develop a sense of how expenses can take a big bite out of earnings over the years, consider this example: A $10,000 investment earns 10% over 40 years with a 1% expense ratio, which yields a return of $302,771. The same investment with a 1.74% expense ratio returns $239,177, or $63,594 less.
• Manager’s tenure: Consider how long the current fund manager (or managers) has been managing the fund. If it’s only been a year or two, take that into consideration before you invest — the five-year record that caught your eye may have been created by someone who has already moved down the road. Fund managers move around a often. In an ideal world, your funds are handled by managers with staying power.
• Portfolio turnover: This tells you how often a fund manager sells stocks in a the course of a year. Selling stocks is expensive, so high turnover over the long run will probably hurt performance. If two funds appear equal in all other aspects, but one has high turnover and the other low turnover, by all means choose the fund with low turnover.
• Underlying fund investments: For your own sake, take a look at the top five or ten stocks or bonds that a fund is investing in. For example, a growth fund may be getting its rapid appreciation from a high concentration in fairly risky technology stocks, or a global fund may have more than 50% of its holdings in U.S. stocks. Neither of these strategies is a mortal sin if you know about and can live with it. If you can’t, keep looking for a fund that matches your goals. Looking at underlying investments not only helps minimize your surprises as markets and economies shift, but also enables you to create a balanced portfolio.

Considering different types of mutual funds

As you prepare to invest in mutual funds, you need to decide which type of funds best suits your goals and tastes. Basically, you have the following four types of mutual funds to consider:

• Stocks funds, which invest in stocks
• Bond funds (also considered income funds), which invest in bonds
• Balanced funds, also called hybrid funds, which invest in both stocks and bonds
• Money market funds, which invest in short-term investments

Each of these groups presents a wide variety of funds with different characteristics from which to choose. To help you further refine your search to match fund investments to your goals, the following lists offer a general look at some different types of funds available.
Stock funds include:

• Aggressive growth funds: Managers of these funds are forever on the lookout for undiscovered, unheralded companies, including small and undervalued companies. The goal is to get in when the stock is cheap and realize substantial gains as it soars skyward. That dream doesn’t always come true. But if you’re willing to accept above average risk, you may reap above-average gains.
• Growth funds: These funds are among the mainstays of long-term investing. They own stocks in mostly large- or medium-sized companies whose significant earnings are expected to increase at a faster rate than that of the rest of the market. These growth funds do not typically pay dividends. Several types are available, including large-, medium-, and small-company growth funds.
• Value funds: Managers of these funds seek out stocks that are underpriced — selling cheaply, relative to the stock’s true value. The fund’s manager believes that the market will recognize the stock’s true price in the future. Stock price appreciation is long term. These funds don’t typically turn in outstanding performance when the stock market is zooming along, but tend to hold their value a good deal more than growth funds when stock prices slide. That’s why value funds are generally believed to be good hedges to more growth-oriented mutual funds. These funds come in large-, medium-, and small company versions.
• Equity income funds: These funds were developed to balance investors’ desires for current income with some potential for capital appreciation. These fund managers invest mostly in stocks — often blue chip stocks — that pay dividends. They usually make some investments in utility companies, which are also likely to pay dividends.
• Growth and income funds: These funds seek both capital appreciation and current income. Growth and income are considered equal investment objectives.
• International and global funds: These two funds may sound like the same type of mutual fund, but they’re not. International funds invest in a portfolio of only non-U.S. stocks (international securities). Global funds, also called world funds, can also invest in the U.S. stock markets. In fact, during the 1990s, many global funds handed in remarkable performances not because of their international stock-picking prowess, but because they concentrated the bulk of their assets in U.S. stocks. This is a prime example of the importance of understanding how fund managers are investing your money. I talk more about how to make this determination in the next section.
• Sector funds: The managers of these funds concentrate their investments in one sector of the economy, such as financial services, real estate, or technology. Although these types of funds may be a good choice after you’ve already built a portfolio that matches your investment plan, they have greater risk than almost any other type of fund because these funds concentrate their investments in one sector or industry. If you’re uncomfortable with the potential for significant losses, make sure that a sector fund only accounts for a small percentage of your portfolio — say, less than 10%. Remember, however, that if you invest in a balanced portfolio, your other investments should hold their own if only one industry is impacted.
• Emerging market funds: The managers of these funds seek out the stocks of underdeveloped countries and economies in Asia, Eastern Europe, and Latin America. Finding undiscovered winners can prove advantageous, but an emerging market fund — also known as an emerging country fund — isn’t a recommended mainstay for new investors because of the potential for loss. When these countries and economies suffer economic decline, they can create significant investor losses.
• Single-country funds: As their name implies, the managers of these funds look for the stock winners of one country. Unless you have close relatives running a country somewhere and have firsthand knowledge about that land’s economic prospects, you’re wise to steer clear of these funds. The reason is simple: They have unmitigated risk from concentration in one area. For example, when Japan’s economy declined in 1998, it sent mutual funds that invested exclusively in that country’s companies tumbling by more than 50%.
• Index funds: The managers of these funds invest in stocks that mirror the investments tracked by an index such as the Standard & Poors 500. Some of the advantages of investing in index funds include low operating expenses, diversification, and potential tax savings. More than 150 funds, including growth companies, track a variety of different indexes. Although they don’t necessarily rely on the performance of any one company or industry to buoy their performance, they do invest in equities that represent a market — such as the U.S. stock market. If and when that market dips, as the U.S. market did by 20% in 1987, index funds can be hit pretty hard.

Bond funds are less risky than stock funds, but also less rewarding. You can choose from the following types of bond funds:

• Corporate
• Municipal
• U.S. Treasury bonds
• International bond funds
• Mortgage bond funds

Balanced funds are another investment option. These funds are a mix of stocks and bonds that are also called blended or hybrid funds. Generally, managers invest in about 60% stocks and 40% bonds. Balanced funds are appealing to investors because even in bear markets, their bond holdings still allow them to pay dividends. (A bear market is generally defined as a market in which stock prices drop 20% or more from their previous high.)
Money market funds are arguably the least volatile type of mutual fund. Fund managers invest in things such as short term bank CDs, U.S. Treasury bills, and short-term corporate debt issued by established and stable companies. This type of mutual fund is ideal for people who may need to use the money to buy something in the short term like a down payment on a home. These funds are also a convenient place to pool money for future investment decisions.

Defining Mutual Funds

A mutual fund is managed by an investment company that invests (according to the fund’s objectives) in stocks, bonds, government securities, short-term money market funds, and other instruments by pooling investors’ money. Mutual funds are sold in shares. Each share of a fund represents an ownership in the fund’s underlying securities (the portfolio).
By law, mutual funds must calculate the price of their shares each business day. Investors can sell their shares at any time and receive the current share price, which may be more or less than the price they paid.
When a fund earns money from dividends on the securities it invests in or makes money by selling some of its investments at a profit, the fund distributes the earnings to shareholders. If you’re an investor, you may decide to reinvest these distributions automatically in additional fund shares. A mutual fund investor makes money from the distribution of dividends and capital gains on the fund’s investments. A mutual fund shareholder also can potentially make money as the fund’s share per share (called net asset value, or NAV) increases in value.

NAV of a mutual fund = (Assets - Liabilities) ÷ Number of shares in the fund

(Assets are the value of all securities in a fund’s portfolio; liabilities are a fund’s expenses.) The NAV of a mutual fund is affected by the share price charges of the securities in the fund’s portfolio and any dividend or capital gains distributions to its shareholders.
Unless you’re in immediate need of this income, which is taxable, reinvesting this money into additional shares is an excellent way to grow your investments.
Shareholders receive a portion of the distribution of dividends and capital gains, based on the number of shares they own. As a result, an investor who puts $1,000 in a mutual fund gets the same investment performance and return per dollar as someone who invests $100,000.
Mutual funds invest in many (sometimes hundreds of ) securities at one time, so they are diversified investments. A diversified portfolio is one that balances risk by investing in a number of different areas of the stock and/or bond markets. This type of investing attempts to reduce per-share volatility and minimize losses over the long term as markets change. Diversification offsets the risk of putting your eggs in one basket, such as technology funds.
A stock or bond of any one company represents just a small percentage of a fund’s overall portfolio. So even if one of a fund’s investments performs poorly, 20 to 150 more investments can shore up the fund’s performance. As a result, the poor performance of any one investment isn’t likely to have a devastating effect on an entire mutual fund portfolio. That balance doesn’t mean, however, that funds don’t have inherent risks: You need to carefully select mutual funds to meet your investment goals and risk tolerance. The performance of certain classes of investments — such as large company growth stocks — can strengthen or weaken a fund’s overall investment performance if the fund concentrates its investments within that class. If the overall economy declines, the stock market takes a dive, or a mutual fund manager picks investments with little potential to be profitable, a fund’s performance can suffer.
Unfortunately, unless you have a crystal ball, you have no way to predict how a fund will perform, except to look at the security’s underlying risk. If a fund has existed long enough to build a track record through ups and downs, you can review its performance during the last stressful market. Fortunately for all investors, some companies use a statistical measure called standard deviation, which measures the volatility in the fund’s performance. The larger the swings in a fund’s returns, the more likely the fund will slip into negative numbers.
Companies that track funds’ standard deviations include Morningstar Mutual Funds and Value Line Inc., which are mutual fund reporting and ranking services whose newsletters are available in most libraries. You can visit their Web sites at www.morningstar.com and www.valueline.com, respectively.

What’s new about the Roth IRA

If your income is below $ 110,000 (single) or $ 160,000 (married and filing jointly), you can contribute $2,000 a year to a Roth IRA — and this contribution is permitted even if you participate in other pension or profit-sharing plans. The Roth IRA, introduced in 1998, offers the benefit of tax free withdrawals (if you are 591⁄2 and the account has been held at least five years). If you choose a Roth IRA, your $2,000 contribution comes out of income you’ve already paid taxes on (that is, earnings). That’s very different from the traditional IRA, in which your contribution may come from pretax earnings.
Like a traditional IRA, the funds contributed to a Roth IRA accumulate tax-free. The big difference is that if you are 591⁄2 and have held the Roth IRA for five years, you never pay tax on the money you withdraw. That means that the earnings on the $2,000 you contribute annually are tax-free.
If your income is more than $ 110,000 and you’re single, or if you’re married and you and your spouse have a combined income of over $160,000, you’re not eligible for a Roth IRA. Another advantage of the withdrawal requirements of a Roth IRA is that you’re not required to take your money out of a Roth IRA when you reach 701⁄2 as you are with traditional IRAs. In fact, you can leave the money and all the earnings to your heirs, if you want to. This allowance enables you to control the timing and the pace of your withdrawals from the account, potentially allowing the funds to stay there, growing tax-free, for more years.
Investors can contribute to both a traditional IRA and a Roth IRA; however, the total contribution to the two accounts can’t exceed the $2,000 annual limit. Many financial advisors say that if you are young and in a low tax bracket, you should probably open a Roth IRA and fund it with the full $2,000 every year. For most people, it’s not worth debating over the two because only those who have relatively low incomes or no other active retirement plans can take advantage of the deductibility of the traditional IRA.

The key benefits of traditional IRA

If you choose a traditional IRA, your contributions may be tax-deductible, while your savings grow and compound tax deferred until you withdraw them at retirement. In certain situations, your entire contribution to a traditional IRA can be tax deductible, meaning that you get to subtract the amount that you contribute from your income, reducing the amount of taxes you have to pay overall. The rules for this tax benefit are as follows:

• If you’re single and don’t have an employer-sponsored retirement plan, the full $ 2,000 is deductible on your income tax return.
• If you’re single and covered by an employer-sponsored plan, you can contribute up to $2,000 and deduct the full amount if your annual adjusted gross income is $30,000 or less. (Annual adjusted gross income is defined as your gross income, less certain allowed business-related deductions. Deductions include alimony payments, contributions to a Keogh plan, and in some cases, contributions to an IRA.) If your income is between $30,000 and $40,000, the deduction is prorated. If you make more than $40,000, you can contribute, but you get no deduction. These numbers gradually increase to $50,000 for taking the full deduction and to $60,000 for taking no deduction, until the year 2005.
• If you’re married and file your tax returns jointly, you have an employer-sponsored plan, and your annual adjusted gross income is $50,000 or less, you can deduct the full amount. The figure is prorated from $50,000 to $60,000. After $60,000, you can’t take any deduction. By 2007, the income allowances will increase to $80,000 for taking the full deduction and $100,000 for taking no deduction.
• If your spouse doesn’t have a retirement plan at work, and you file a joint tax return, the spouse can deduct his or her full $2,000 contribution until your joint income reaches $ 150,000. After that, the deduction is prorated until your joint income is $160,000, at which time you can’t deduct the IRA contribution.
• Non-income earning spouses can also open IRAs, and the annual contribution for a married couple filing jointly is $4,000 or 100% of earned income, whichever is less, with a $2,000 maximum contribution for each spouse. Funds generally can’t be taken from a traditional IRA before age 591⁄2 without paying a penalty. If you take money out, taxes and a 10% penalty are imposed on the taxable portion of the distribution.

You can make some withdrawals without paying a penalty. Money can be taken penalty-free if you use it for a first-time home purchase or for higher education fees. You can also withdraw penalty-free in the event of death or disability, or if you incur some types of medical expenses.
After you turn age 701⁄2, you are required to take money from your traditional IRA account, either in the form of a lumpsum payout or a little at a time; withdrawing a little at a time allows you to extend the benefit of the tax shelter.

Individual Retirement Account Investment Introduction

An Individual Retirement Account (IRA) is a tax-saving program (established under the Employee Retirement Security Act of 1974) to help Americans invest for retirement. Anyone who earns money by working can contribute up to $2,000 a year, or 100% of your income, whichever is less. If you don’t have access to a 401(k) or other retirement plan, or if you’ve calculated that your current plan won’t completely cover your retirement needs, then an IRA can help. IRAs offer tax-deferred growth — you don’t pay any tax on it or the money that it earns for you until you withdraw it during retirement.

You set up your IRA on your own with a bank, mutual fund, or brokerage firm. Like a 401(k), you can invest your IRA money in almost anything you can think of, from aggressive growth stocks to conservative savings accounts. Some financial planners advise that you use your IRA for investments that produce the highest income, such as stocks paying high dividends, because you defer the taxes. Another tactic is to put the IRA funds into riskier high-growth investments, such as stocks or certain types of mutual funds, because you don’t touch the funds until retirement and can always switch them to safer investments as you get older.
I suggest investing in an IRA for the following reasons:

• If your employer doesn’t offer a 401(k) plan
• If you’ve calculated that your current retirement plan won’t completely cover your estimated retirement needs, consider investing in an IRA — if you qualify
• To invest in high-yield investments — such as stocks paying high dividends — because your investment dollars are tax-deferred
• To invest in higher risk investments, such as stocks and certain mutual funds, if you don’t plan to retire for years to come (by doing so you commit to taking the chance of receiving higher gains for your investment dollar)

You can choose from two types of IRAs: traditional IRA and Roth IRA

Getting out of a 401(k)

When you retire or leave your company, you can leave your 401(k) invested as it is, roll it over into another retirement account (such as an IRA, which I talk about in the section “Investing in Individual Retirement Accounts,” later in this chapter), or withdraw it. People usually face some penalties and an income tax liability for withdrawing the money. You can claim funds from the 401(k) without a penalty after age 591⁄2.
When you’re in your 20s and 30s, retirement may seem impossibly far off — so far off, in fact, that it’s hard to imagine planning for it now. However, start saving for your retirement, and the sooner the better. In 1998, the Social Security Administration estimated that Social Security will provide less than a quarter of the amount you’ll need to pay for housing, food, and other living expenses in your retirement. If you want to retire in comfort, you will have to provide for yourself.

Deciding where to put your 401(k) money

Most 401(k) plans offer a variety of investments, including mutual funds, stock funds, and bond funds. Deciding which of these investments to put your money in takes research. You don’t have to put all your 401(k) money into one investment vehicle. Unless your research tells you otherwise, you should invest only a certain percentage of your money in a high-risk investment, such as stocks. Also note that most 401(k) plans offer mutual funds whose “risk” ranges from conservative to aggressive.
To determine what percentage of your money to invest in stocks, many financial advisors recommend that you subtract your age from 100. For example, if you’re 25, you should have 75% of your 401(k) money in stocks.

Investing in 401(k)s

If you earn employment income from a for-profit company, you may have the option of putting money in a 401(k), a retirement account that appreciates without taxation until you retire or leave the company. (Not all companies sponsor plans, especially small companies, and 401(k)s are not available to state and municipal workers — check with your employer to see if your company offers this plan.) With a 401(k), the employee contributes pretax salary to the plan. Generally, a 401(k) allows you to contribute a certain percentage of your income each year to the plan. Companies often match a portion of their employees’ contributions to the 401(k). Many employers add 25 cents or even 50 cents more to each dollar an employee chooses to contribute. A typical formula is for an employer to match 50% of what an employee puts in, up to 6% of his or her salary. The plan may also allow an employee to make after tax contributions.
Money that is contributed to the company’s 401(k) is then invested in various, predetermined ways. Many plans typically provide between four and seven investment options, including mutual funds, stocks, and bonds. Usually, a plan offers at least one stock fund, a balanced fund, a bond fund or fixed income account, and maybe a money market account.
Note that individual stocks and bonds are not allowed in 401(k) plans. One exception is the company’s own stock. For example, General Motors employees can purchase that company’s stock in the General Motors 401(k) plan. The plan lets you decide which investments you want to put your 401(k) money in. You can put all of your contribution into one investment, or you can specify percentages of your contribution to be invested in several of the investment choices. This point is where you can face some risk — it’s up to you to decide where to put your money. Because your contributions to a 401(k) are excluded from your reported income, they are tax-deferred from federal and state income taxes. By using a 401(k), you get an immediate tax deduction for your contribution. A third or more of the average person’s 401(k) contribution represents money he or she would have had to pay in federal and state taxes. The beauty of the 401(k) is that the money gets to work for you, rather than the government, in the years ahead. Plus, the money grows over the years without taxation.
If you’re not already convinced that a 401(k) can be a great investment, here are some other compelling benefits to consider:

• Many plans offer an automatic payroll deduction feature You never miss the money you contribute and payroll deduction makes investing easier.
• Professionals manage the investment choices in most plans.
• Most plans allow access to money in an emergency.
• Account services keep you informed with regular reports. You may even have access to a toll-free number to call for information.
• Your money can go with you from job to job. Even after you leave your employer, you can roll your retirement money into other tax-deferred retirement accounts, such as an IRA.

Unlike a traditional pension plan (which promises a set dollar figure in benefits when you retire), the amount of money your 401(k) provides upon retirement is determined by how much is invested and the way it grows. The regular account statements you’ll receive offer an indication of your likely return, but there’s no way to predict how much you’ll get until the day you actually retire.
Deciding not to participate because you don’t want to cut back on your take-home pay or telling yourself retirement is a long way off may prove to be a big mistake. You risk ending up without enough money after you retire.

Starting with Savings Accounts

Savings accounts are a form of investment — a very safe form. Although many banks don’t pay interest on checking accounts, all banks pay interest on savings accounts. For the most part, interest rates offered for savings accounts differ only slightly from institution to institution. Prior to the start of banking deregulation in 1986, banks used to pay 5% daily interest on all savings accounts because federal regulation specified that amount. Unfortunately, 5% interest rates on savings accounts are history. Today, the average savings account earns about 2% daily interest.
Assume that you’ve made an initial investment of $100 and faithfully add $50 per month for the next five years.
Although the amount in your savings account reaches $3,262.88 — $162.88 more than the amount you actually contributed — the actual buying power of that investment is only $2,814.59, due to the rate of inflation. That’s $2,814.59 more than you would have had, had you not committed to socking away some money for the future. But as investments go, you wouldn’t want to rely wholeheartedly on a savings account because the return on your investment is so low. Of course, factors such as the interest rate and rate of inflation play a major role in how well your money does in this type of investment vehicle.
Web sites such as www.bankrate.com and financial magazines such as Money publish lists of the highest-paying savings accounts each month.
Some banks offer the incentive of earning additional interest on a savings account by using a tiered account system. This system enables you to earn higher interest if your account balance is consistently over an amount specified by the bank. This amount is usually at least $1,000, but it may be higher. Most banks charge a monthly or quarterly maintenance fee for a savings account. Some tack on an additional fee if your balance falls below a required minimum. In addition, you might be required to keep a savings account active for a specified time or face penalties.
What makes savings accounts such a safe investment? If the bank has Federal Deposit Insurance Corporation (FDIC) insurance, your savings account is backed by the full strength and credit of the federal government. If the institution fails, Uncle Sam sees that you get your savings back — up to $100,000. As with any other insurance, you may sleep better knowing that it’s there in the worst-case scenario. Although putting your money in a savings account has serious limitations if it’s your one and only investment strategy, having some of your money in a cash reserve makes sense.

Seeking Another Safe Haven: Money Market Accounts

Money market accounts and savings accounts are nearly identical, except that money market accounts offer better interest than a savings account. Money market accounts also offer some check-writing privileges. In exchange for these benefits, most institutions require a high minimum balance for money market accounts, averaging between $500 and $2,500.
Don’t confuse money market accounts with money market funds. Both money market accounts and money market funds are used to “park” cash and still maintain liquidity. Money market funds, however, are a type of mutual fund. To learn about money market funds, turn to Chapter 3. Money market accounts, offered by banks, savings and loans, and credit unions, are a good way to keep money that you may need to get your hands on in a hurry. Money market accounts earn more interest than you would with a savings account without risking a loss in value (which could be the case if you put the same money into stocks and had to turn them into cash quickly). For medium-term expenses, such as saving for a down payment on a car or furniture, a money market account can be a good choice. Money market accounts can also be a good place to put the three months’ salary that you set aside for emergencies. Money market accounts function like a checking account in that you can write a minimum number of checks (usually three) on the account each month. However, in some cases, money market account holders are allowed to make unlimited free deposits and withdrawals from ATMs in their network.

If you only write a couple of checks a month, a money market account might be worth considering. But usually a hefty fee ($10 to $20) is charged if an account holder writes more than the number of checks permitted. Any additional interest a money market account allows you to earn will quickly be chewed up if you have to pay for extra checks. Some people use a non-interest-bearing checking account for paying regular bills, and then keep their larger reserve in a money market account to gain a higher rate of return. In fact, some financial institutions offer to link a money market account with a checking account, so if your regular checking account doesn’t have sufficient funds to cover a check, the institution automatically transfers money from the money market account to the checking account. Interest rates for money market accounts vary widely and depend on the amount you deposit. When money market accounts were created in 1982, people could earn 10% or more interest on them. During the next 10 years, interest rates for money market accounts bobbed up and down but never got back to the early rates.
When you open an account, you get the prevailing interest rate as set by the bank. Most banks change the rate once a week — every Monday morning, for example — and they give you a phone number to call to check the rate. Your rate may improve if you deposit more funds, but often you have to reach a threshold of $15,000 or $30,000 to see a significant increase in your rate.

Investing in Certificates of Deposit

If your savings grow to the point where you have more money than you think you need anytime soon, congratulations! One of the places you can consider depositing some of the balance is a certificate of deposit (CD). A CD is a receipt for a deposit of funds in a financial institution. Like savings accounts and money market accounts, CDs are investments for security.
With a CD, you agree to lend your money to the financial institution for a number of months or years. You can’t touch that money for the specified period of time without being penalized.
Why would a financial institution need you to loan it money? Typically, institutions use the deposits they take in to fund loans or other investments. If an institution primarily issues car loans, for example, it’s apt to pay attractive rates to lure money to four-year or five-year CDs, the typical car-loan term.
Generally, the longer you agree to lend your money, the higher the interest rate you receive. The most popular CDs are for six months, one year, two years, three years, four years, or five years. There is no fee for opening a CD. By depositing the money (a minimum of $500) for the specified amount of time, the financial institution pays you a higher rate of interest than if you put your money in a savings, checking, or money market account that offers immediate access to your money. When your CD matures ( comes due), the institution returns your deposit to you, plus interest. The institution notifies you of your CD’s maturation by mail and usually offers the option to roll the CD over into another CD. When your CD matures, you can call your institution to find out the current rates and roll the money into another CD, or transfer your funds into another type of account. Most institutions give you a grace period, ten days or so, to decide what to do with your money when the CD matures.
At an FDIC-insured financial institution, your investment is guaranteed to be there when the CD matures. Financial advisors say that CDs make the most sense when you know that you can invest your money for one year, after which you’ll need the money for some purchase you expect to make. The main reward of investing in CDs is that you know for sure what your return will amount to and can plan around it, because CD rates are usually set for the term of the certificate. Be sure to check on the interest rate terms, though, because some institutions change their rate weekly. For example, after buying a house in early fall, my friend Mark made plans to have the exterior repainted the following spring (a short-term goal). In October, he received a nice $4,000 bonus from work. Knowing that he might be tempted to spend that money on dinners and CDs (the musical kind), Mark invested that $4,000 in a six-month certificate of deposit with a 4.6% interest rate. When spring rolled around, his CD matured, and he received $4,092. That amount he gained in interest may not sound like a lot, but it’s about twice as much as he would have received had he deposited the money in a typical savings account. And it’s possibly $92 more than he would have had if he had kept the money in his regular, non-interest-bearing checking account.

The major risk is that interest rates can rise sharply before your CD matures. That situation costs you the opportunity to earn more on your money through some other form of investment. The interest rates paid on CDs are contingent on many factors. In general, they tend to mirror the interest rates in the general market. Most bank CDs are tied to the rates paid on treasury notes and treasury bills. (Treasury rates are the rates offered by the Federal Reserve when they issue treasury obligations.) If the two-year treasury note pays a good rate, interest rates on the bank’s CDs tend to be at a good rate, too. It pays to shop around for CD specials to get the best interest rate. Remember to check out the rates at savings and loans and credit unions. Credit unions typically pay up to half of a percentage point higher interest on CDs, whereas savings and loans generally pay more than banks but less than credit unions.

If you want your money back before the end of the CD’s term, you will be heavily penalized, usually with the loss of six months’ worth of interest. A second drawback is that CDs are taxable. Whatever interest you earn, you must pay taxes on at both the federal and state levels. However, assuming that you’re not in a high tax bracket, the taxes shouldn’t be a huge consideration for most people starting out. If rates are low, you may want to purchase shorter-term CDs and wait for rates to rise. This way, you won’t be tying up your funds for long periods of time while rates might be climbing. As another option, some banks might allow you to add money to a CD account at the interest rate of that particular day. The advantage to this method is that if you open the account on a day when the rate is low, you can increase your earnings by adding money at a higher rate, later.

Understanding Risk and Reward

What has drawn you to investing? Maybe it’s the raging stock market of the 1990s. Or maybe you’re enticed by the idea that you can put your money to work for you by investing it. Although the benefits of investing are often made clear in success story after success story in advertisements, magazines, newspapers, and online Web sites devoted to investing, it’s important to remember that there is no gain without potential pain. That means that when you invest your money, you can lose part or all of it.
Actually, rewards and risks are usually closely related. The greater an investment’s potential for reward, the greater the potential for risk and actual loss. The high-flying stock that earned a 100% return last month is probably the very same stock that will tumble (and tumble hard) in the months and years ahead. The same goes for bonds and mutual funds and, potentially, even real estate.
You must take on some risk in order to reap the benefits of investing. That’s the bad news. The good news is that sometimes, over time, a decent investment may bounce back and make investors whole again.

What’s the best I can hope for?

The best you can hope to achieve with an investment depends on the nature of the investment. Some investments — such as savings accounts and certificates of deposit (CDs) — offer stable, secure returns. Other — such as stocks, bonds, and mutual funds — depend
entirely on market conditions. A return is an investment’s performance over time. It’s easy to calculate the best-case scenario with vehicles such as savings accounts and CDs. On the other hand, you can never predict with 100% accuracy what kind of return you will get with more volatile investments such as stocks, bonds, and mutual funds. You can, however, see how these investments have performed in the past. Recent history has many investors believing that the markets can only go up. If you look at returns on some stock investments, you can understand why. For example, the top-performing stock in 1998, which was an online Web site called Amazon.com, racked up staggering returns of 966% in 1998. If you were lucky enough to invest $1,000 at the end of 1997, your money would have been worth $10,664 a year later. That’s probably the best oneyear return any investor can ever hope for — and then some. The next-best-performing 24 stocks in 1998 returned between 164% and 896%. The best-performing stock mutual funds returned well over 70%. In sharp contrast, the best corporate bonds returned more than 15%. Still, if the average stock returns about 10% a year, 1998 was quite a year for many investors.
In fact, the year capped off a decade-long boom for the stock market in which the top-performing stock (Dell Computer Corp.), over the ten-year period from 1988 to 1999, gave investors a very pleasing 79% average annual return. Equally noteworthy, the next best 24 top-performing stocks returned 43% to 69% in the same period.
On average, however, stocks, bonds, and mutual funds don’t give investors these kinds of returns. Large company stocks returned only about 18% during the past decade. Corporate bonds gave investors about 10.8% in the same period.

What’s the worst-case scenario?

You’ve heard about the best you can hope for, now what about the worst? The worst performer in 1998 cost investors a frightening 83%. In other words, $1,000 would have been worth just $170 by the end of the year. You can lose all of your money in an investment if a company declares bankruptcy.

What’s a realistic course?

The good news is that if you try to choose your investments carefully — and subsequent chapters of this book give you the tools to do this — you should be able to minimize your losses. Ideally, your losses from any one investment may even be offset by the successes of your other investments. The emphasis should be on choosing investments carefully, which means that your expectations need to be realistic, too. Stocks have returned an average annual return of about 10% since the 1930s, so aiming for a 15% or 20% return is unrealistic. Corporate bonds returned about 6% in the same time period, so a 12% long-term average annual return from bonds isn’t realistic.
Of course, if you’re completely uncomfortable with the prospect of losing money, or if you need your money before five years, then investment vehicles such as stocks and bonds aren’t for you. You’re better off putting your money into safer, more liquid places such as bank accounts, certificates of deposits, and money market accounts.

Realizing Gains through Compounding

Starting out as a first-time investor doesn’t require a whole lot of money, which means that you don’t need to wait until you’ve accumulated a large reserve of ready cash. You may ask: Why the big rush to start investing?

The answer is simple: You want to begin earning compound interest as soon as you can.

Compound interest is actually the interest you earn on your interest. For example, if you invested $10,000 and earned 10% interest in the next year, your interest income would be $1,000. If you earned 10% again the following year, the $100 you would earn on the $1,000 (in interest you earned in the current year) would be considered compound interest.
Compounding is a compelling reason to start and keep investing for the long-term because money left untouched reaps the greatest reward from compounding. To determine how many years it will take to double your money as a result of compounding, you can use the Rule of 72. Just follow these steps:
1. Determine what interest rate you think your money will earn.
2. Divide 72 by that interest rate.
The number you get is the number of years it will take to double your money.
For example, suppose that you believe you’ll earn 8% annually in the coming years. If you divide 72 by 8, you can see that doubling your money will take nine years.

Focusing on a Goal

You can take the first step toward creating your investment plan by asking yourself a simple question: What do I want to accomplish? Actually, this step is your single most important move toward ensuring that your investment plan has a sound foundation. After all, these goals are the reason that you’re launching a personal investment plan. So don’t shirk off this exercise. Dream away.
Perhaps you’ve always wanted to travel around the world or build a beach-front chalet. Or maybe you are interested in going back to school or starting your own business. Write down your goals. Your list of goals can serve as a constant reminder that you’re on the course to success. Don’t forget the necessities, either. If you have kids who plan to go to college, you need to start preparing for that expenditure now. Your retirement plans fall into this category as well — now is the time to start planning for it. If you’re older, in retirement, or just plain more conservative

Separate your goals into long-, mid-, and short-term time frames based on when you expect or need to achieve the goal. For example:

• Buying a vacation home or retiring 10 or more years from now is a long-term goal.
• Sending your child to college in 5 to 10 years is a midterm goal.
• Buying a car in the next 1 to 4 years because you know your current model is likely to be on its last legs is a short-term goal.

As you jot down your goals, also write down their costs. Use your best “ guesstimate;” or if you’re not sure, search the newspaper for, say, the cost of a beach-front home that approximates the one you want to purchase. Leave the “Time and Monthly Investment” category alone for now — that column represents the next step, which I tell you about shortly.
Okay, now for the tricky part. How much do you need to invest each month and over what period of time to achieve your goals?
Of course, you need to know an approximate rate of return before you can plan. Your rate of return will differ, depending on the sort of investment you choose. Research can help you accurately estimate your rate of return.
If you’re older, in retirement, or just plain more conservative (and like keeping a good bit of your money in accounts or investments that earn less interest), you may want to use a lower estimated interest rate in your calculations to reflect your situation.
If you’re investing in another type of asset —real estate, for example — a realtor in your area can tell you the appreciation rate or the annual rate of return for properties in your area. You can use that rate as a gauge to estimate what you’re likely to earn in future years.
For determining how much you need to sock away annually to meet your goals over a specific period of time, using a scientific calculator is easiest.

Starting Your Savings Now

Throughout the rest of this blog, I tell you about different types of investments that match your investment goals. To start out with any sort of investment, you need a cash reserve —and the amount varies, depending on your investment choice.
As you’re doing your research and deciding which investments match your goals, start putting away $100 a month in an account earmarked for investment. By the time you determine the investing opportunities that best fit your needs, you should be well on your way to affording your investment. Watching your dollars multiply can serve as motivation in itself: Your investment accounts may become as or more important to you than some of the other expenses that have eaten up your money in the past.
If you’re the type who’s been saving gobs of cash in a bureau drawer for a long time and now want to start earning real interest, you’re one step ahead of the pack. You have the discipline. Now what you need is the knowledge and the tools. The following sections give you the tools you need to select investments and create an investment plan to meet all of your goals, including retirement. You also get the information you need to monitor your investments, so you can keep your plan on track.