C HAPTER 11

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

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

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

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

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

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

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

8. They are important but not essential Essentials Before Investing Or so says our book… • Work to balance your budget • Pay off high interest credit card debt first • Start an emergency fund you can access quickly • Three to nine months of living expenses I simply do not agree with the concept of an “emergency fund” of three to nine months of living expenses. As long as you have access to cash via a home equity line of credit, for example, there is no good reason to keep $20,000 to $30,000 or more in a savings account earning 2%. Instead, use the money to pay down high interest debt, especially credit card debt. P.S. The Wealthy Barber agrees with me. P.P.S. You are adequately insured, right? Exceptions: Salespeople and the self-employed

9. First: Some Investment Terms • Safety – Guarantee of return of principal • Risk – Uncertainty about an outcome • Inflation risk • Interest rate risk • Business failure risk • Market risk • Global investment risk • Liquidity • Ability to buy or sell an investment quickly without substantially affecting the investment’s value “I am not so much concerned with the return on my money as I am with the return of my money.” --Will Rogers What is your tolerance for risk? (Page 340) Unfortunately, you can’t know until you have some skin in the game … and then lose some skin!

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

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

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

13. Types of Investment Accounts • Taxable Accounts (a.k.a. Regular Accounts) • All interest, dividends, capital gains, and rent are taxable each year • Best for short-term or intermediate-term investments but can also be used for long-term • Tax-Qualified Accounts (a.k.a. Retirement Accounts, Education Accounts, MSAs  HSAs) • Tax-deferred – Pay no taxes until you withdraw the funds (normally in retirement) • Best for intermediate-term or long-term investments (but mostly for long-term) Account Statement Examples

14. Types of Retirement Accounts • Pre-tax Contributions • 401(k), 403(b) for private & public employees • Traditional IRA for everyone • SEP-IRA, SIMPLE IRA and Keogh for self-employed or those working for small business • Tax Break Now • Deduct contributions from income tax • Pay taxes in retirement (when tax bracket is lower) • Post-tax Contributions • Roth IRA for everyone, Roth 401(k), Roth 403(b) • Tax Break Later (Tax-Free in Retirement!) • Annuities (pre-tax and post-tax)

15. A Pre-tax Contribution Lowers Your Taxes Now Examples: IRA, 401(k) / 403(b) But the whole $100 still goes into your account!

16. “So What’s the Catch?” • You pay income tax on any amounts withdrawn in retirement • But people in retirement are usually in a lower tax bracket • If you withdraw the funds before retirement… • You pay the income tax, and • You pay a 10% penalty! • Exceptions for first home purchase, higher education expenses and medical disability • This is a long-term investment • Don’t even think about dipping into it for a car, vacation, etc. (A first home or higher education? Okay)

17. A Post-tax Contribution Gives You No Tax Break Now Examples: Roth IRA, Roth 401(k) So Why Bother Contributing to a Roth IRA?

18. “Because a Roth IRA is So Cool!” • Tax-Free in Retirement is a Golden Opportunity • No other investment choice comes close! • Eventually, I think they will probably be gotten rid of • Plus, you can withdraw the contributions at any time with no penalty • You have already paid taxes on the contributions • This makes the Roth IRA also an excellent intermediate-term investment account • Purchase of a house or other high-ticket item • Great for college expenses • Currently not used in Financial Aid calculations

19. But Contributing to a Roth Can Be Tricky for High Income Earners • Limitations on Roth IRAs Contributions • Only single taxpayers with an AGI of $105,000 or less and married couples with an AGI of $167,000 or less can fully contribute to a Roth IRA • If you do not qualify, Congratulations! • But you can contribute to a Roth IRA anyway • If you find that you have made over the limit, you can “recharacterize” the contributions into a Traditional IRA (which does not have the same limitations) before you file your taxes • And then you convert the Traditional IRA to a Roth • I know. I know. Who voted for these bozos? • Oh, yeah. We did …

20. Education Savings Accounts • 529 Plans • Works like a Roth IRA • Post-tax dollars • No tax on earnings as long as you use the money for higher education • High penalty if you use the money for any other purpose • Coverdell Education Plans (nee Education IRA) • Like the 529 plan, only much worse • But if you use either of these plans, then you can’t take advantage of the Hope and Lifelong Learning Educational Tax Credits (Gee, Thanks!) 529 plans were set to expire in 2011 but have been extended indefinitely.

21. Medical Savings AccountsHealth Savings Accounts • Medical Savings Accounts (MSAs) • Tax-deductible contributions • Pre-tax dollars • No tax on withdrawals as long as you use the money for medical purposes • High penalty if you use the money for any other purposes • Only available to self-employed and those working for small business • They are now changing to … • Health Savings Accounts (HSAs) • Anyone can have one, not just self-employed or small businesses

22. Review: Types of Investment Accounts • Taxable Accounts (a.k.a. Regular Accounts) • Tax-Qualified Accounts (a.k.a. Retirement Accounts, Educational Savings Accounts, MSAs, HSAs) • Pre-tax Contributions – tax-deferred • Traditional IRA, 401(k), 403(b), etc. • Post-tax Contributions – tax-free • Roth IRA, Roth 401(k), Roth 403(b) • This is where the types of investments reside • They are not the investments! Okay. Now, What Do We Invest In? (In other words, what investments do we put in our taxable or tax-qualified accounts?)

23. Investment Alternatives • Stocks – “You are an Owner” • Bonds – “You are a Loaner” • “Cash” – “You are Guaranteed” • a.k.a. Short-term investments • Annuities – “Have we got a (bad) deal for you!” • Real Estate – “Yes, but it is not without risk” • Other Investment Alternatives… • …That I hope you will avoid • Unless you know what you are doing or are willing to lose a good chunk of your money or, preferably, both

24. Investment Alternatives: Stocks • Stocks represent ownership in companies • Benefits include… • Stockholders are owners and share in the success of the company (capital gains) • Shareholders receive distribution of company’s earnings (dividends) • Stock Prices are Volatile • But you knew that already, didn’t you? • Average returns over decades – 8% to 10% • Best overall long-term investment returns • Stocks are long-term investments Fancy term for “You can lose a lot of money!”

25. Investment Alternatives: Bonds • Bonds represent loans to… • Companies (Corporate bonds) • State & local municipalities (Municipal bonds) • Federal government (Treasury bonds) • Bondholders receive interest on the loan • Loan is repaid (Bond is redeemed) in 1 to 30 years • Bondholders are first in line for repayment if there is default on the loans • Bond prices are less volatile but still do fluctuate • Average returns over decades – 4% to 8% • Intermediate-term to long-term investments

26. Investment Alternatives: “Cash” • Better term is “Short-term Investments” • a.k.a. “Short-term Instruments, short-term vehicles” • Guaranteed Return of Principal • Savings Accounts, Certificates of Deposit (CDs), Money Market Accounts • Money Market Mutual Funds • Not guaranteed but pretty darned close • Average returns over decades – 2% to 5% • Currently, they are paying the lowest rates in over 50 years – less than 1% (some zero!) to 2% • Huge Opportunity Cost • These are short-term investments

27. Investment Alternatives: Annuities • An annuity is a financial contract written by an insurance company that provides you with a regular income for a specified time • For the rest of your life or • For 10-year, 20-year, etc. periods • Guaranteed contracts that will continue to pay your heirs if you die before the end of the time period • People buy annuities to supplement retirement income and to shelter income from taxes

28. Investment Alternatives: Annuities (continued) • Those who expect to live longer than average benefit most from annuities • But if you die one month after you have signed up for the annuity, the life insurance company keeps all the money! Great deal, huh? • “No problem!” sez Mr. InsuranceMan. “You can choose a definite payout period … but we will pay you less.” • Annuities are tax-deferred investment plans • Contributions are after-tax money but earnings are tax-deferred • You pay taxes on the earnings when you draw the money out (The contributions are returned tax-free)

29. Investment Alternatives: Annuities (continued) • Suffice to say that annuities are for people who have already put as much money as they can into all other retirement options, already have plenty of investments outside of retirement accounts and still have plenty of money to invest • “Money to burn” goes into an annuity • Even then, they are not the best investment options • Average returns over decades • Fixed annuities – 2% to 6% – bonds • But they have a guaranteed minimum payout (2% to 3%) • Variable annuities – 2% to 8% – stocks & bonds • Can lose money – no guaranteed minimum

30. Investment Alternatives:Real Estate • Real Estate is Tricky but can be Very Profitable • Real Estate is an illiquid investment • Purchase and manage rental property, or • REIT’s (Real Estate Investment Trust) • Trade like stocks – liquid • They manage the real estate for you • You receive the rent and any capital gains • Minus the REIT’s management fees, of course • Average returns over decades – 7% to 8% • Uh, San Diego is a notable exception • But as we have seen, some people have literally lost everything in the recent crash • Intermediate-term to long-term investments

31. Investment Alternatives:The “Others” • Derivatives: Options, Futures, and Commodities • Very, very risky • They derive their value from another investment (?) • These are speculations(gambling), not investments • Precious Metals and Gems • If you believe the global economy is going to fall apart anytime soon, buy these in large quantities • Even De Beers now admits that diamonds are awful investments • Collectibles, Antiques, Fine Art, Coins & Stamps • It may be fun, but do not call it investing • Unless you know exactly what you are doing! • None of these are eligible for retirement accounts • Does that tell you anything?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

49. Why Sell Bonds When an entity sells bonds, it is borrowing money. • To raise money to operate or expand • Examples: Build a new factory, expand into a new country, build new or upgrade older schools, bridges, finance a war, etc. – Big ticket items • Can get better interest rates than if they went to a bank or other money-lending entity • Also, sometimes the bond issuer can’t go to a bank! • (Can you imagine the Federal government asking your local credit union for a $600 billion loan to invade Iraq?) Almost every election year in California, the voters are asked to approve a “bond proposition” for parks, schools, water projects, transportation, emergency and public safety equipment, etc. The State of California then sells the bonds to pay for the project and must pay the interest and pay back the principal over 30 years.

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