Personal Finance Questions: Investing in Bonds and Other Alternatives

Question: Discuss three reasons why dollar-cost averaging is an important concept to investors
If you buy stock over an extended period, it's less likely that all your money will be invested right before a market crash.
- Dollar-cost averaging keeps you from trying to 'time the market' in an attempt to wait for the lowest possible price before buying
- Identifying the lowest price is virtually impossible to do, although admittedly, it is awfully tempting to try.

Most importantly, dollar-cost averaging forces disciplined investing
- If you are regularly investing in stocks, the practice becomes part of your budgeting and planning process.


Question: What are the four basic investment questions a potential investor should answer before investing?
Value: Is this a good price for the stock?
Quality: Is this firm in a position that will allow profitability in the future?
Strengths and Weaknesses: Are this firm's strengths and weaknesses likely to get better or worse?
Threats and Opportunities: Are this firm's threats and opportunities likely to get better or worse?


Question: How do the three common investment strategies differ? Which is good if you want to avoid being killed rather than make a killing in the market?
- Dollar cost averaging occurs when you buy a fixed dollar amount of stock at specified intervals to level out the ups and downs of prices
- It is the best strategy for avoiding being killed rather than to make a killing
- The buy-and-hold idea aims at avoiding timing the market, minimizes brokerage fees and costs, postpones capital gains taxes, and is simple to carry out.
- A dividend reinvestment plan allows you to accumulate wealth by automatically reinvesting dividends (rather than spend them) without any brokerage fees
- Without reinvesting the dividends, your wealth will be limited to the stock's capital gains.


Question: Briefly describe the SWOT analysis
The SWOT analysis is a framework for analyzing a firm or its common stock
- The analysis forces you to consider a firm's internal strengths and weaknesses and external opportunities and threats
- A benefit of the analysis is that it allows you to better anticipate changes that might occur in the company.


Question: Discuss the concept of using beta for investing in stocks.
beta is a mathematical process to quantify or identify an individual stock's risk relative to the overall stock market risk
- It is a coefficient that amplifies or magnifies the individual stock's potential price movements relative to the overall market's price movements
- If a stock has a beta of 1.5, then this tells us that if the average or typical stock increased by % then this stock should average a 15% increase in its market price
- Beta is a function of risk
- For investors with a low propensity for risk they should avoid stocks with high beta coefficients
- Investors with a willingness to speculate should look for high beta stocks to invest in, realizing that they may lose all or most of their investment.


Question: Can you explain the risk-return trade-off with common stocks?
Stocks have more risk than other investments, but at the same time have more potential return associated with them
- By diversifying your portfolio, you reduce the risk of downs ruining your ups
- By diversifying you can diversify away some risk and by holding for the long term they can become even less risky.


Question: Your friend wants you to seriously consider investing in bonds like she did - Why?
- When interest rates decline, the price of bonds rises
- Bonds reduce risk through diversification
- Bonds also produce steady current income
- They can be a safe investment when held for the long term to maturity.


Question: Provide an explanation of the basic bond terminology and features.
A bond has a par value, or face value, which is the amount that will be returned to the bondholder at maturity
- Bonds pay a percentage of their par value annually in the form of coupon interest rates
- A legal agreement, called an indenture, is created between the issuing firm and the bond trustee who represents the bondholders
- Bonds have a call provision to recall bonds when the interest rates drop so the issuer can make more money
- To protect the issuer and the investor, a sinking fund may be established by the issuer to set aside money to pay off bonds at maturity.


Question: What is the purpose of the call provision on some bonds?
Many times the issuing company needs to raise outside financial capital when the market rates of interest are high, forcing the company to offer a high coupon rate to make the bonds attractive
- The high coupon rates mean than the company must pay out a large amount of money to the bondholders
- The call provision allows the company to refinance their debt at a lower coupon rate meaning they will save money on the coupon payments.
- When the market rates of interest fall, they can sell new bonds with a lower coupon rate and use the proceeds from the new bond issue to call the older, more expensive bonds.


Question: Outline, with a brief description, the different types of bonds
- Corporate bonds: issued by corporations as either secured or unsecured
- Treasury bonds: risk-free bonds issued by the federal government
- Agency bonds: issued by federal agencies, such as the FNMA and the FHLB
- Pass-through certificates: a Ginnie Mae is a federally insured mortgage
- Treasury inflation-indexed bonds
- U.S - series EE bonds: savings bonds with variable interest and low denominations
- Municipal bonds: city, county, and state bonds funded by projects and taxes
- Zero coupon bonds: bonds with no interest sold at a deep discount from par value
- Junk bonds: low-rated, high-yield bonds rated BB or lower, mostly from new firms


Question: Why are the tax implications of investing in bonds more involved than the tax implications of investing in common stock?
Common stock is pretty straight forward when it comes to paying taxes on their returns.
With stock, you either have a capital gain or loss and possibly dividend income, both of which are obviously taxable sources of income
- With the many different types of bonds, some are taxable bonds and, similar to stocks, you either have a capital gain or loss and interest income, all of which are obviously taxable
- However, with U.S
- Treasuries, their may be tax liabilities on certain sources of income, either capital gains or rate adjustments with TIPS
- Municipal bonds are similar except it also depends on where you live and what State issued the bonds
- There may not be a Federal tax liability but there may be different State tax liabilities.


Question: Make a list and check it twice to tell how to select a good bond
- Think how taxes will affect the investment.
- Keep the inverse relationship in mind.
- Avoid losers and do not worry about picking winners.
- Consider only high-quality bonds.
- Buy when first issued, not in the secondary market.
- Avoid bonds that are more likely to be called.
- Match the bond's maturity to your investment time horizon.
- Stick to large issues.
- Go with Treasury bonds when in doubt.


Question: There are dangers present in bond investing - Tell everyone what they all are
If interest rates rise, bond prices will fall
- When the issuer experiences financial problems, the bondholder may be paid or may lose out
- If interest rates fall, rather than experience price appreciation, the bond may be called
- If you need to sell your bonds early, you may have a problem selling them at a reasonable price, particularly if they are bonds issued by a small corporation
- Finding a good investment outlet for the interest you receive may be difficult and your accumulation will be limited to the bond's par value
- (You will lose compounding and the time value of money.)


Question: When interest rates rise, bond values drop, and when interest rates drop, bond values rise. Using this inverse relationship, develop a two-part strategy for the bond investor
When an investor expects interest rates to rise, put money in very short-term bonds.
When the investor expects interest rates to decline, purchase very long-term maturities that are not callable.


Question: How do you determine a bond's valuation?
The simplest way is to use a financial calculator
- It will add the present value of the interest payments to the present value of repayment of par at maturity.


Question: Tell what you will find in a bond listing in the Wall Street Journal
The name of the bond will be listed in the first column in alphabetical order
- Next, you will see the current yield, followed by the volume of trading during the previous day
- The fourth and fifth columns list the closing price that day and the net change in the closing price from the day before that, respectively.


Question: How would you go about rating bonds as a possible investment?
Practically speaking, the first thing to consider is the bond rating and how that fits with the investor's risk tolerance profile
- Second, compare the bond yield, consisting of two parts
- Look at the ratio of the annual interest payment to the bond's market price, known as the current yield
- Also look at the yield to maturity, which is the true yield
- If these suit you, next consider the bond rating, which is a reflection of the bond's risk and the company's performance
- Last, read the quote listings in the Wall Street Journal to see the daily movements.


Question: What risks are you assuming with preferred stock that you would not have with common stock and bonds? Be specific
- When interest rates rise, the value of the preferred stock drops
- When interest rates drop, the value of the preferred stock rises and the preferred stock is called away from the investor
- The investor does not participate in the capital gains that common stockholders receive
- This investment does not have the safety of bond interest payments, because preferred stock dividends can be passed without the risk of bankruptcy.


Question: Describe the features and characteristics of preferred stock as discussed in your textbook
I know that a firm can issue multiple classes of preferred stock, each with a different set dividend
- The cumulative feature, which gets all of my unpaid dividends in arrears caught up, protects me from omitted dividends
- The adjustable rate allows the value of my stock to remain relatively constant
- I know that not all stock is cumulative or has an adjustable rate
- I can purchase convertible stock that can be exchanged for common stock.
I can purchase callable preferred stock, but it may be called in when interest rates drop.


Question: Compare and contrast preferred stock with bonds and common stock
Preferred stock is often called a hybrid or combination security, leaning more closely toward bonds
- It is similar to common stock because it has no fixed maturity date and not paying dividends will not bring on bankruptcy
- It is similar to bonds in that its dividends are of a fixed size and are paid before common stock dividends are paid
- It also carries no voting rights
- Preferred stockholders do not share in any profit growth of the firm, but are limited to their stated annual dividends
- This means, just as with a bond, if the firm has a great year and earns a lot of money, your stock dividend does not change.


Question: Why does preferred stock not have the potential for capital gains like common stock does?
Capital gains represent the earnings growth of a company reflected in the market price of its stock
- Preferred shareholders receive preferential treatment in the payment of dividends but these dividends are normally fixed
- As the company's profits grow, the preferred dividends do not grow accordingly
- The market price of preferred stock is determined by these fixed dividends
- The growth in earnings is then passed on to the common stockholders in the form of increased dividends or retained earnings for more growth
- Growing earnings leads to increased market demand for the common stock which leads to bigger capital gains potential.


Question: Provide a list of direct and indirect real estate investments - Which one is best for the average investor? direct ? vacation home, commercial property, apartment, duplex, developed or undeveloped land, speculative building Indirect ? partnerships that buy and manage property (syndicates) and investment companies that pool the money of many investors and invest in real estate (REIT)
The most attractive real estate alternative for the novice is the real estate investment trust or REIT.


Question: What, if any, are the pros and cons of speculating in precious metals, precious gems, and collectibles?
When timed correctly, these speculations can provide a nice return and you can escape the cons of other types of investments
- The major problem here is that their value is based upon supply and demand and does not generate a return
- Sometimes we may be tempted to sink money into these areas because of emotion or greed
- It is anybody's guess what might happen to them in the future.


Question: When is it OK to speculate?
It is OK to speculate when you have some extra money to lose
- It is not OK to speculate with money that you can't afford to lose because it will interfere with your standard of living or achieving you long term savings and investment goals
- Speculating is just liking gambling at a Casino
- It can be very exciting and pleasurable when done responsibly with a few extra dollars that you can afford to lose
- Sometimes you win but most times you lose most or all of your money
- Speculating is just too risky for your important money.
Don't risk your long term financial security by gambling.


Question: How can you improve your chances when investing in bonds?
As with investing in common stock, investing in bonds should be preceded by establishing goals

- This will determine your asset allocation and how much of your savings should go into bonds.

For the sake of diversification, don't discount the value of holding some bonds
- Their lower interest rates may seem boring when the stock market is riding high, but you'll appreciate them when they slow the downward spiral of your portfolio during a market downturn.

Understand taxes and bonds
- While the tax-free nature of municipal bonds is great, bonds aren't of value to everyone

- Compute the equivalent taxable yield for your tax bracket before you choose them
- If you are in a low bracket, you may find that you can earn enough interest with taxable alternatives to pay the taxes and still come out ahead
- If you are attempting to avoid state income tax, buy municipals issued by your state of residence.

Be aware of the potential downside of bonds
- Consider how you would react if interest rates rose and the value of your bonds dropped, and also keep in mind the fact that shorter-term bonds drop less in price when interest rates climb
- Let's face it: Interest rates are at historical lows, as of 2015, but someday they're going to rise.