Selena Maranjian - The Motley Fool Money Guide
Selena Maranjian - The Motley Fool Money Guide
Selena Maranjian - The Motley Fool Money Guide
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iii
About
the Author
Selena Maranjian is a senior writer at The Motley Fool. She lives in New
Hampshire with her two dogs. (Whoops! Scratch that — that’s every other
writer.) Armed with a Wharton MBA and a Masters in Teaching from Brown
University, one of Selena’s missions in life is to render the incomprehensi-
ble comprehensible. She writes the Fool’s nationally syndicated weekly
newspaper feature and has also written Investment Clubs: How to Start and
Run One the Motley Fool Way and co-written The Motley Fool Investment
Tax Guide.
iv
Acknowledgments
Few Foolish products are created alone. Foolishness is all about communi-
ty — about people conversing and learning together, asking and answer-
ing questions, sharing opinions, and making each other laugh. Even though
I have an MBA, most of what I know about investing and personal finance
was learned in Fooldom. Most of what you’ll read in this book also comes
from Fooldom, directly or indirectly.
I’m grateful to the many community members of the Fool who spend time
on our discussion boards, sharing their wisdom. I’m also indebted to my
many Fool colleagues, from whom I’ve learned much. I hesitate to name any
names, but when it comes to personal finance and tax issues, Roy Lewis and
Dave Braze are the ones who’ve most often made me look smart. Much of
this book’s car buying and home buying information, as well as the glos-
sary, is drawn from the work of Bill Barker, Paul Maghielse, and David
Wolpe. The colleagues who’ve taught me about investing are too numerous
to name.
Many Fools worked hard helping make this book a reality, heroically read-
ing and reviewing every page and making it a much better work than it
otherwise would have been. I thank them most sincerely: Brian Bauer, Reg-
gie Santiago-Bobala, Alissa Territo, Robyn Gearey, and Debora Tidwell.
Thanks to Alicia Abell as well, for her guidance as the book was shaped.
v
For my family,
who made me who I am,
INTRODUCTION ..................................................................................................xi
vii
Foreword by
David Gardner
Every year, The Motley Fool executes its own April Fool’s Day prank. We
design each of the pranks in accordance with our public mission: to edu-
cate, to amuse, and to enrich. That means the jokes themselves must not
only be funny, but must also teach people to make better financial decisions.
Our 1998 joke provided a perfect example. On our home page at Fool.com,
as evening blended into early morning on April 1, 1998, we put up a pub-
lic apology, front and center. “We’ve been telling you for five years now
that most mutual funds underperform the market averages,” it began. “We
were wrong.”
We were of course completely right. In case you didn’t already know, the
vast majority (on the order of more than 80%) of managed stock mutual
funds have in fact lost to the market’s average over the past five years! It’s
one of the most damning statistics out there — that mutual funds managed
rather expensively by humans do worse, after fees, than the stock market’s
average performance each year. Given that you’re paying fees to a man-
ager, do you not find it pretty shocking and disappointing to be paying
someone to lose to the market for you? And not enough people know this,
which is the educational purpose of our joke, once we came clean.
Anyway, we claimed in this April Fool’s apology that we’d been wrong,
wrong, wrong. You see, we had been misreading a graph, we said. For five
years, we had been looking at a graph of these numbers that had, unbe-
knownst to us, been printed upside-down. So rather than 80% of all mu-
tual funds losing to the market, our April Fool’s letter stated that 80% of
mutual funds had actually beaten the market. And we had been telling all
our customers to steer clear of managed mutual funds as a bad idea! Egg
all over our faces.
No, the singular aim of this Foreword is to get across to you that if you don’t
“know it all,” you’re not alone! In fact, you might be surprised to learn of
the company you keep…
Later that day, April 1, 1998, a vice president of a regional brokerage firm
in Charlotte, NC who also hosts a popular regular radio broadcast in that
city dispensing financial advice — castigated The Motley Fool for being so
wrong about mutual funds. We’ll call him “Fanny.” In 10 minutes of radio
we will never forget, we listened to Fanny explain to his listeners how he
knew we had always been wrong about mutual funds, that 80% of them
had beaten the market, that we were completely wrong and that our apol-
ogy wasn’t even enough. “If I had my way,” Fanny said in an emotionally
charged address, “I’d put those guys up against a wall and shoot ‘em.”
That’s right, a man who had risen to become VP at a regional brokerage firm
and a daily radio personality dispensing financial advice to a large South-
ern city had actually fallen for our joke.
He had actually believed that 80% of all mutual funds were beating the
market! (He’d “known” we were wrong.) This Wise “expert” who held
sway over the money management of many did not himself even realize
how poorly managed mutual funds had performed. Given his career focus,
you’d think he’d have had his eye on the ball, especially given his senior
level. You’d think so, wouldn’t you? Without ever intending to actually
bait professionals with our April Fool’s joke, we had snared a big shot who
actually lacked a simple knowledge of one of the financial world’s most
basic truths.
In her introduction, Selena calls it a secret that most of us don’t know much
about personal finance and investing. Guess what? She writes: “Most of
your friends, relatives, neighbors, and colleagues probably feel the same
way. Just as you’re pretending that your financial house is in order, so
are they.”
And don’t believe a word you read on our site on April first. But you’ll be
surprised who does!
— David Gardner
No, it’s a different secret… and a big one. Here are some of its facets:
• I don’t know much about personal finance and I know even less
about investing.
• I have no idea what kind of insurance I need or what “market cap-
italization” means.
• I haven’t planned for my retirement because I don’t know how.
• I’m just a big financial ignoramus.
If any or all of these ring true for you, you’re not alone. Far from it. Most of
your friends, relatives, neighbors, and colleagues probably feel the same way.
Just as you’re pretending that your financial house is in order, so are they.
You shouldn’t feel bad about this secret. It’s not your fault. Very few peo-
ple are ever taught these things in school. Don’t think that it’s a hopeless
situation, either. You can learn this stuff. It’s not difficult or mysterious, and
the Fool is here to help you. The Motley Fool exists to help people learn
about and manage anything financial. This book is here to serve you — to
answer all those questions you’re too embarrassed to ask, to make you think
about some issues that need your attention, to help you save money when
you spend, and to help you make money when you invest.
xi
Much of the information in this book is drawn from the Fool’s nationally
syndicated weekly newspaper feature. At the time of this writing, rough-
ly 200 large and small newspapers across the U.S. and Canada carry it. (If
your local paper isn’t among them, just give the editor a friendly jingle and
ask for it.) I write most of the feature, and I’ve often heard from readers that
they crave a compilation of the information in it. This is the answer to those
requests. It’s not exactly a compilation, though, as half of the content is new
and the other half is revised and updated.
I hope you find answers to most or all of your financial questions in this
book. If any questions are left unanswered, come visit us at Fool.com, where
you can ask more questions and get speedy responses.
What is Foolishness?
Keep in mind as you read this book that, to us, “Foolish” is a positive adjective. The Motley
Fool takes its name from Shakespeare. In Elizabethan drama, the Fool is usually the only one
who can tell the king the truth without losing his head — literally. We Fools aim to tell you truth,
too — that you can learn enough about money and investing to build a secure financial fu-
ture for yourself. To learn more about The Motley Fool, drop by our website at www.Fool.com
or on America Online at keyword: FOOL.
Personal Finance
CHAPTER ONE
ANSWERS TO YOUR QUESTIONS ABOUT
Saving and
Budgeting
At The Motley Fool, one of our main goals is to get everyone
on Earth investing and building a financially secure future.
It’s a tall order, we know. Lots of people are not even close to
the point where they are ready to begin investing, though.
Instead, they need to focus on generating more money to in-
vest. Enter the world of saving and budgeting.
Most of us would rather poke ourselves in the eye than sit down and
plan a budget. Many would rather slam a door on their hand than
actually live according to a budget. That’s just wrong thinking, though.
We should budget with delight. We should even have trouble get-
ting to sleep at night, as we eagerly anticipate tending to our budget
in the morning.
3
cut back. Knowledge is power, and going through the budgeting
process gives you a lot of self-knowledge.
A budget is all about tracking and reporting all your sources and
amounts of income, and all your uses of income. It should answer the
questions “Where’s all my money coming from and how much is
there?” and “Where’s it all going?”
Before you get started, and to make the process more suspenseful and
fun, jot down how much you think you’re spending on food, enter-
tainment, travel, clothing, charity, investing, etc. Then record how
much you want to spend on them.
Next, gather information. For one to three months, record all your fi-
nancial inflows and outflows. (One month will do, but a few more will
maximize accuracy.) Try to account for big expenses that occur once or
twice a year, such as car insurance, too. Jot down how much they amount
to per month. During this two- or three-month period, save every single
receipt you get for any expense. If you don’t normally ask for or keep re-
ceipts, do so during this period. Also, carry a small notebook to write
down any cash transactions. If you spend a few dollars for coffee at a local
coffee shop each morning, jot down each time you do so. If you do some
odd jobs for a few extra dollars now and then, record that too.
Make sure you’re accounting for all your expenses. Even a $12 check
written for a magazine subscription should be counted. As you’re clas-
sifying expenses, notice that some of them are fixed, while others are
more flexible.
Now, step back and see what you’ve got. You should be looking at a
fascinating detailed record of where your money comes from and where
it goes. Compare your actual expenses with your initial estimates and
see how close you were. Assess whether you’re saving and investing
as much as you want to. See what changes you need to make in your
habits to meet your goals.
Perhaps you can hit your savings goal simply by cutting out HBO and
your subscription to People magazine. Buy a water filter instead of end-
less jugs of bottled water. Use a fan sometimes instead of air condition-
ing. You might be able to save a tidy sum by giving slightly less-extrav-
agant gifts. Also, don’t assume that fixed expenses are completely fixed.
You might be able to refinance a loan at a lower rate. Or, a little com-
parison-shopping might turn up a less-expensive insurance policy.
A later chapter in this book addresses living below your means. Once
you decide that you need to cut back on spending in some areas, you’ll
find lots of useful tips there.
I’ll include a worksheet here that you might use — or just use as an
example. Know that you might get more value by making a worksheet
of your own, where you can be more specific. For example, if you lump
Enter all figures as monthly amounts. You’ll need to adjust some. (For
example, if you pay $300 twice a year for car insurance, you’d enter
$50 per month.) Fill out amounts for two or three months.
Both Intuit and Microsoft also offer money management tools online
at their websites, www.quicken.com and www.moneycentral.msn.com,
respectively. Fool.com offers many similar features, as well.
It varies widely, of course. Where you live is a major factor in how lit-
tle you can manage to pay for some products and services. Car insur-
ance, for example, can cost very little in some regions, and an arm and
a leg in others. Likewise, housing costs can be sky-high in some parts
of the country and quite reasonable elsewhere.
Here are some very rough guidelines on how much of your after-tax
income you might aim to spend on various categories:
Grab a calculator. Let’s say that you earn $45,000 per year after taxes
and spend $3,000 per year on food. Take $3,000 and divide it by
$45,000. You’ll get 0.07. Take that, multiply it by 100 and tack a “%”
sign on the end. Voila — the answer is 7%. Here’s the formula:
It’s certainly smart to have some emergency funds available for un-
pleasant surprises that occasionally rear their ugly heads. (Your em-
ployer relocates to Siberia and your spouse isn’t keen on moving, so
you’re out of work. Your child is discovered to be a tuba prodigy and
you suddenly need to cough up a lot of money for costly Tuba Camp
— and a costly tuba.)
You shouldn’t park any emergency money in stocks. That’s too volatile
a place for short-term money. Keeping it in a savings account that earns
little interest isn’t so hot either, though. You have other options. You
could keep the money in a money market fund, which will pay you
more than a savings account. You might also park the money in short-
term certificates of deposit (CDs) or bonds, perhaps staggered so that
a portion of it is always close to maturity.
Here’s another option, if you don’t have any or much credit card debt. You
might decide to charge expenses on your credit card, up to a certain
amount, if you run into temporary trouble. Be careful with this approach,
though. If you keep a significant balance on your credit card and are
charged a steep interest rate, a bad situation can get worse quickly.
If you have a brokerage account chock full of stocks, you might be able
to borrow what you need from your brokerage, on margin. People usu-
ally borrow on margin from brokerages to buy addition stock, but you
can borrow for pretty much any purpose. Your portfolio serves as col-
lateral. Just be careful — if you borrow a lot and your stocks suddenly
plunge in value, you’ll be hit with a “margin call” and may end up los-
ing some of your stocks. We recommend only using margin sparing-
ly, if you use it at all.
Instead of just sitting them down for an abstract lesson (or worse, a
sermon that has them rolling their eyes), get them involved in your
own budgeting. Show them how much the family is spending on var-
ious items and what your goals are. Explain what things such as cable
TV and lawn-care services cost. You and your kids can work togeth-
er to decrease some spending — or at least to keep expenses within
your budget. They may even be more understanding when you have
to say no to a plea for a new toy.
One big problem many people face is that, while they may mean to save
and invest 10% of their salary, by the end of the month they don’t
have that much left. They have good intentions, but not enough dis-
cipline. There’s a well-worn maxim that addresses this problem: Pay
yourself first. In other words, take out money for saving and invest-
ing as soon as you get your paycheck. Then you can use what’s left for
your other needs.
Credit Cards
and Debt
There are few things as insidious as credit card debt. You can
probably take out a car loan for around 9%, but credit cards
are eager to charge you twice as much or more for the privi-
lege of borrowing from them. Many people get caught up in
the spiral of credit card debt. Once they rack up a lot of debt,
the best they can usually manage is paying the interest. If
they’re not very disciplined, their debt just keeps rising. Worse
still, credit card companies are targeting college kids now. Too
many young people graduate from college with a degree, a
lumpy futon, and several thousand dollars in credit card debt.
Talk about an inauspicious beginning!
There are three credit-reporting bureaus that keep credit records on us:
You should be able to contact any or all of them to get a copy of your
credit report. Some experts recommend getting all three reports, as
some information may have been reported to just one bureau. Last time
we checked, you could order a copy of your combined credit report
from all three bureaus at www.truelink.com.
13
In some circumstances, getting a report from one of these bureaus is
free — such as if you live in certain states (Colorado, Georgia, Mass-
achusetts, Maryland, New Jersey, and Vermont, last time we checked),
or within 60 days of being denied credit, employment, insurance, or
rental housing. Otherwise, it may cost you about $8 per report, or more
for a three-in-one combined report.
You can have them corrected. Somewhere in the report, often at the
end, there should be instructions on how to dispute anything that you
believe is an error.
That information will remain on your report for seven to 10 years (usu-
ally seven, but 10 for bankruptcies). You can still lessen the sting of
that information, though, by paying your bills on time. Credit is-
suers tend to give more weight to your recent bill-paying history, so
a clean record for the last year or two can make a real difference.
According to the Federal Trade Commission, these are often scams. The
credit bureau Experian concurs, noting that “consumers pay so-called
credit clinics hundreds and even thousands of dollars to ‘fix’ their
credit report, but only time can heal bad credit.”
Not all debt is alike — and not all debt is bad. It’s very reasonable to
carry a mortgage, a car loan, etc. You simply need to pay attention to
the cost of the debt. If you’re carrying revolving debt on a credit card
that’s charging you 18% per year, you’re in a bad situation. If your
Another consideration is what else you might do with the money you’d
use to pay off a low-interest loan. Imagine that you’ve borrowed $5,000
at 6% and you now have the money to pay it off in full. You could
do so, but consider the alternative. If you’re bullish about a stock or
two and are fairly sure that, over the next five years or so, you’ll earn
at least 15% on them per year, on average, then you might choose to
keep the loan and pay it off gradually, as you originally planned. You
might take the $5,000 and invest it. If the stocks perform as expected,
you’ll be earning more than you’re paying out in interest.
That’s why mortgages, for example, are not necessarily a bad thing.
If your mortgage rate is low, it makes perfect sense to keep paying it
off gradually. (If your rate is high, consider refinancing it, if you can.)
Mortgage interest brings with it some tax benefits, too.
Aim to pay off all your credit card charges in full each month. If you’re
in too deep to do that, visit our debt area online at www.Fool.com/Cred-
it to learn more about your options. One is to try renegotiating your
interest rate. If you have a sound credit history and explain that you’ll
be moving your debt elsewhere if your rate isn’t lowered, the credit
card company may knock it down a few percentage points. That can
make a big difference.
Credit cards may be convenient, but they can devour your financial
future. Use them carefully.
• Continually remind yourself that credit cards are not mere con-
veniences. Accumulating charges on many credit cards is like tak-
ing out a 16% to 21% loan.
There’s no harm in asking. Call your card company and explain that
you’d like them to waive the fee and that, if they won’t, there are plen-
ty of cards with no fee you can switch to. With some companies, it’ll
work; with others, it won’t.
There sure is. Many spots on the Web offer just such information. One
good place to start (and probably to finish) is www.bankrate.com. It
offers a wealth of information to help you get the best deals on all kinds
of loans, credit cards, and accounts. Click on “Credit Cards” there, and
you’ll be able to find lists of the best credit card deals, with interest
rates and grace periods detailed for you. You’ll find more informa-
tion at sites such as www.cardtrak.com.
Look for a credit card with no annual fee. If you’re Foolishly planning to
pay off the balance each month, the interest rate on the card won’t be of
paramount importance. Do pay attention to the grace period, though, and
aim to get a card with at least a 25-day grace period. That’s the period of
time when you don’t accrue interest charges on your new balance. The
longer the grace period, the more time you have to send in your check.
If you’re not going to be able to pay off your balance each month, look
for a card that excludes new purchases from the interest calculation
period. That means they don’t base the interest charges on two months
of billing cycles. Some cards are set up to calculate interest that way,
and it ends up costing you more.
College can be great. No parents nagging you with curfews. You can
eat ice cream for breakfast and popcorn for dinner, if you like. And,
best of all, America’s banks keep offering you credit cards!
Now, even if you don’t accumulate any more debt, it will take you more
than 43 years to pay off the balance if you just make minimum pay-
ments. Holy guacamole! All told, you will have paid nearly $18,000
just for the privilege of charging $5,000. No wonder the banks keep
sending you unsolicited credit card applications.
Here’s another danger. Let’s say that you’re fired up to invest in stocks,
but you still owe that $5,000, paying 18% annual interest on it. If your
$5,000 stock investment nets you an 11% return, you’re still losing
money — 11% in, 18% out. Investing doesn’t work well if you’re deep
in debt at high interest rates.
Don’t worry, though. We’re not going to tell you to use credit cards only
as shoehorns, eye patches, and after-dinner snacks. It’s okay to have a
credit card. Just make sure that you’re only charging what you can af-
ford to pay, and that you pay the bills off in full each month. Choose
your cards carefully, using an electron microscope to read the fine print.
Look for a low interest rate; no annual fee; no unreasonable penalties;
and a protected, interest-free grace period. Then, when the bill arrives,
take five minutes and scrutinize your statement for mysterious charges.
Yup. By law, consumers can’t be held responsible for more than $50
if they are the victims of fraud and report the theft promptly. So, you
should contact the card company as soon as you notice that a card has
been lost or stolen.
There are three main credit bureaus in the United States, and they’ve
agreed that if someone contacts one of them and asks to be removed
from junk mail (er, “direct mail”) lists and telemarketing phone lists,
they’ll all honor the request. Call them at: 888-5-OPT-OUT. Here are
the three and their websites: Equifax (www.equifax.com), Experian
(www.experian.com), and Trans Union (www.tuc.com).
While we’re on the subject, you can opt-out of even more junk mail
and telemarketing calls by contacting the Direct Marketing Associa-
tion (DMA). Here are the addresses:
Opting-out through the DMA won’t stop mail from local merchants,
religious and charitable associations, professional and alumni associ-
ations, politicians, and companies with which you conduct business.
To stop those, you’ll have to contact each organization directly.
Websites
• www.nfcc.org
• www.debtproofliving.com
• www.Fool.com/credit
Books
• How to Get Out of Debt, Stay Out of Debt and Live Prosperously by
Jerrold Mundis
• 10 Minute Guide to Beating Debt by Susan Abentrod
• Downsize Your Debt by Andrew Feinberg
• Credit Card & Debt Management by Scott Bilker
• Credit Card Debt by Alexander Daskaloff
Insurance
The thought of insurance may not get your heart racing, but
if you ever find yourself looking at a grease spot on the asphalt
where you last saw your car or at the smoldering remains of
your home, and you’re not insured, you’ll find your heart rac-
ing plenty. Insurance is not a luxury, but a necessity. It’s not
something to put off thinking about, it’s something to deal with
now. It’s not just for your car and health. There are other forms
of insurance you should consider, as well. So read through this
section and you’ll be prepared to get your insurance house
in order — and to save some money on it in the process.
23
Okay, I was just kidding about that last one. There are a host of other
kinds of insurance, though, such as pet insurance, “pre-need” (fu-
neral) insurance, etc. And, within the categories listed above, you’ll
typically find many sub-categories, such as whole life insurance and
term life insurance.
An insurance policy’s premium is the amount you have to pay for the
policy. For car insurance, as an example, your premium might be $800
per year (or more or less, depending on many things). The premium is
the amount you pay to keep the policy in force.
The deductible is the amount or portion that you will have to pay on
any claim. For example, let’s say that you have a car insurance policy
with a $250 deductible. If you have a small accident and the repair will
cost $600, you’ll have to pay the first $250 of that, and your insurance
policy should cover the rest. If you have another mishap a few months
later, you’ll again have to pay the first $250 of the cost.
The lower the deductible you choose, the higher your premium will
be. So, unless you are particularly accident prone, it’s often smart to
carry a fairly steep deductible to lessen the cost of the policy. A good
rule of thumb is to determine how much you could afford to pay out-
of-pocket, without causing severe financial hardship, if you have a
claim. Then make that amount (or the closest option offered by the
Before you agree to any insurance policy, ask about and make sure you
understand what limitations there are to claims being paid, so you
don’t pay for insurance that won’t serve your needs.
Finally, many people, after paying into a policy for years and years,
will stop paying for it due to some short-term budget crisis. This is
rarely a smart move, as insurance is vital and they’re leaving them-
selves unprotected. If years go by and you don’t have any claims, you
might feel like you’ve been pouring money down a drain, but you
haven’t. All that time, you’ve been protected against financial loss —
which could have happened during the time period.
Insurance • 25
33 What’s the difference between whole life and term life
insurance?
These are the two main forms of life insurance you should understand.
(It’s also good to learn about universal and variable, which are varia-
tions of whole life insurance.)
With term insurance, you’re covered only during the life of the pol-
icy, while you’re paying the premiums. If you carry a term life in-
surance policy for 50 years, regularly pay the premiums, and then
quit paying and die a year later, you’re out of luck. (Well, you’d be
out of luck regardless — but, in this case, your beneficiaries are out
of luck, too.)
• Annual renewable term gives you the option of renewing your pol-
icy regularly, but at increasing premium rates.
With universal and variable insurance, the higher the initial assumed
rate of return, the lower the annual payments will be. This is how some
unscrupulous agents can sign you up—through very attractive poli-
cies based on unreasonable assumptions. Since most insurers invest to
a great degree in bonds, be skeptical of any promised universal rates
much higher than the 30-year Treasury rate. With variable insurance,
since most mutual funds have trouble beating the S&P 500’s average
historical return of 10-12% per year, we’d be skeptical of any projected
rates in that neighborhood.
For most people, it probably makes the most sense to stick to term
insurance. Buy just as much insurance as you need, and only for as
long as you need it. With term insurance, you won’t be paying any-
thing extra as an “investment.” Instead, put the money you save on
premiums into better long-term investments — such as stock market
index funds, stocks you’ve selected on your own, or whatever you’re
most comfortable with. Your own investments are likely to outperform
any investment an insurance company makes for you. By combining
term insurance with investments on your own, you’ll be minimizing
your insurance costs and maximizing your investment potential.
Insurance • 27
Another plus for term insurance is that it’s a very competitive seg-
ment of the insurance business, with companies lowering costs to win
customers.
You’re actually the one best able to answer that question. Ignore blan-
ket formulas that suggest you need something like five to 10 times your
annual income. Each person’s situation is different. Look at insur-
ance not as a lottery-like payoff, but as filling a specific need. If you’re
insuring your own life, you need to think about the financial impact
of your demise on your family. Take out a pen and paper. List yourself
and the members of your family. List how much money comes in from
various sources. List how much is needed by various people each year.
Think about how these numbers will change over time.
For example, let’s say you contribute $45,000 per year to your fami-
ly, and your spouse contributes $40,000. That’s the extent of your fam-
ily’s income. Perhaps you have two teenage children. Take a deep breath
and begin imagining the unimaginable. What if you and your income
stream disappear from the picture? Will your spouse and children
get by on just the $40,000? Think about how much additional income
they’d need. If your kids are in their late teens, they’re probably not
too far away from being able to support themselves. You’d need greater
insurance coverage if the kids were still toddlers.
Think about the contributions you would have been making over
the years to any college funds or to your retirement nest egg. You’ll
want your insurance policy to fill those gaps. Are you also supporting
your mother-in-law? If so, you’ll want to make sure that she isn’t left
in the lurch should you get run over by a bus.
You also have to consider additional expenses your spouse will face
as a single parent. With two toddlers or an aging parent to sup-
port, for example, will she be able to pay for the extra childcare
help she’ll need, maybe a lawn-care service for the house, daytime
help for her mother, and still be able to work if you die? If not,
you need insurance to cover her lost income and the added ex-
penses she’ll face.
You might take advantage of some online calculators that help you
estimate your insurance needs. State Farm’s website offers one at
www.statefarm.com/jscript/cashneed.htm. Poke around New York
Life’s website at www.newyorklife.com and you’ll find another. Don’t
use these as more than general tools, though. They shouldn’t be mak-
ing any decisions for you. That’s what the gray matter between your
ears is for!
Think of it this way: If you’re 35 years old, earning $50,000 per year,
and become disabled for the rest of your life, you’ll be losing roughly
$1.5 million in income from age 35 to 65. Disability insurance serves to
help make up for that loss. (Being disabled from age 35 to 65 will also
mean that you’ll miss out on something like 7,500 or more hours of of-
fice meetings, too. Unfortunately, insurance can’t make up for this. Sorry.)
We often worry about and plan for death, but we tend to give little
thought to the possibility of an extended period of disability. If you
make your living as a chimney sweep and you suffer a bad wrist break,
you’ll likely be unable to work for quite a while. Here’s where disability
insurance would kick in, protecting you from that loss of income.
Insurance • 29
or stop after a number of months or years. Many people are cov-
ered by their employers. Check and see what coverage your com-
pany offers you, and evaluate whether it’s good enough. You may
want to purchase additional coverage, either through your employer
or separately.
Take a gander at this table. It shows how likely you are to become dis-
abled for various periods of time before you reach 65 years of age,
depending on your current age:
If you are now for 6 months for 1 year for 2 years for 5 years
25 35% 22% 17% 13%
30 33 21 16 13
35 31 20 16 13
40 28 18 15 12
45 25 17 14 11
50 14 12 17 10
As you can see, even if you’re 40, the odds are nearly one in five
that you’ll be disabled for an entire year. The higher odds for
younger people might surprise you, too. But, remember that child-
birth and recovery are considered medical disabilities for women
and can last six months or more. Disability insurance is a danger-
ous thing to ignore.
It varies by policy, so make sure you understand the terms of any cov-
erage you have or are considering. With some policies, they’re in ef-
fect only until you can be employed in some way. So, if you were a den-
tist and, after being on disability awhile, you regain enough mobility
If you can find them, look for policies that are guaranteed and non-
cancelable. Guaranteed means the payment is fixed. Non-cancelable
means that the policy will remain in effect as long as you keep pay-
ing the premiums.
Examine the policy’s definition of “disabled” and make sure it’s what
you want. Ideally, you’ll want it to cover any disability related to work-
ing in your current occupation.
Finally, carefully evaluate how the policy will pay you, in the event
that it needs to. Make sure that the payment will increase as your in-
come increases. (If you buy the policy when you’re earning $30,000
and become disabled when you’re earning $45,000, you don’t want
your benefit based on the initial salary.) Some policies offer riders that
will permit the payment to increase with inflation, as well.
Check out how long the policy will pay you. A good one will cover
you until you reach retirement age. Others may stop after five or 10
years. See what percentage of your salary the policy will pay. Some pay
60% or less, others pay 75% or more.
One good way to save money on the policy is by increasing the wait-
ing period. Some policies kick in very soon after you become disabled.
Others require a waiting period of up to several months. You’ll typi-
cally have to pay more for more immediate coverage. But, if you’re pre-
pared with a bit of an emergency nest egg, you can opt for a lengthy
waiting period to reduce your cost. Invest the savings and you might
well surpass the value of that little nest egg.
Insurance • 31
40 What is long-term care insurance for, really?
Many people assume it’s for nursing home care, and it often is, but
that’s not all. It can also cover at-home care. Basically, it’s there to help
you if you’re having at least a certain amount of trouble performing
“daily living” activities such as bathing, dressing, eating, transferring
in or out of a bed or chair, and using the toilet. To a lesser degree, it
can also aid in activities such as managing money, doing heavy or light
housework, taking medications, shopping, preparing meals, and using
the telephone. It will typically pay a certain amount per day, which
may cover all or part of your needs.
Possibly. Here are some scary statistics to help you take this issue se-
riously:
• At 65, the average person’s chances of being admitted to a nursing
home at some point in the future are more than 4 in 10. (Source:
Long-Term Care Campaign)
• One person in three who turned 65 in 1990 will stay a year in a nurs-
ing home. One person in 10 will stay five years or more. (Source: Na-
tional Association of Insurance Commissioners)
• In 1994, 7.3 million Americans needed long-term care services at an
average cost of nearly $43,800 per year. By 2000, this number will
rise to 9 million Americans at nearly $55,750 per year and, due to
inflation, by 2060 it will skyrocket to 24 million Americans pay-
ing more than $250,000 per year to receive long-term care. (Source:
Long Term Care Insurance National Advisory Council)
As with all scary statistics, though, take them with a large grain
of salt, as they can be and often are misleading. For more on this
topic, see the article “Those Dratted Statistics Made Easier” written
by The Motley Fool’s retirement expert Dave Braze. The article may
be found at the following web address, if you have the stamina to
type it in:
www.Fool.com/retirement/retireeport/2000/retireeport000222.htm.
If you’re fairly wealthy, you may not need this insurance. Figure out
what the kind of nursing home care you’d want would cost, and see
how many years you could easily pay for it. If it won’t present that
much of a problem, you may be better off not paying out hefty pre-
miums to cover expenses you might not incur, since you have alter-
native means of paying for them should they materialize.
Insurance • 33
43 Do you have any tips for buying long-term care insurance?
First, these policies vary widely in terms of cost, what they cover, and
when they will actually pay. This makes it very tough to compare them.
One good strategy is to start early. If you wait until you’re 75, the
cost will be fairly steep. Many policies allow you to buy in your 50s
and enjoy a fixed premium for the rest of your life. This can be a good
deal. It’s also smart, because you can suffer ill health at any time and,
once you do, you may have trouble getting long-term care insurance.
Better to sign up while you’re still healthy, if possible.
If at all possible, get a policy that hikes the amount of your benefit
to keep pace with inflation. This is especially important if you’re buy-
ing the insurance relatively early in life. You may not need it for 20
or 25 years. But, when you need it, you don’t want it to have become
a pittance.
As with disability insurance, you can decrease your cost if you’re will-
ing to accept a lengthened waiting period between when the need oc-
curs and when the benefits kick in. You might also limit the policy’s
payments to include only part of a nursing home’s costs, planning to
make up the difference with Social Security or some other income or
savings.
Your age and your driving record are two biggies. The more experi-
ence you have driving, the fewer accidents and traffic violations you’re
likely to have. The more tickets and convictions for violations you have,
the steeper your premiums will be.
The car’s model, age, and how you use it are additional factors. A 1999
Maserati 3200 GT is likely to command higher rates than a 1977 Dodge
Dart. Insurers may also factor in annual mileage driven and how much
the car is driven for business vs. pleasure.
Where you drive and park your car also matters. People living in cities
tend to pay higher rates than people in the suburbs or small towns do.
That’s because of higher crime rates and higher costs of repairs or med-
ical expenses.
Insurance • 35
46 How can I save money on a car insurance policy?
One simple thing you can do is increase the amount of your deductible.
The lower your deductible, the higher your premiums. Ask yourself
how likely you are to incur expenses, and how often that might occur.
Compare that with the extra amount you’re paying on your policy. For
many people, it makes sense to carry a deductible of about $500 and
pay lower premiums. Hiking a deductible from $200 to $500 can some-
times save you 15-30%.
Many insurers will give you a significant discount (up to 10%) if you
hold more than one policy with them. So, look into buying both auto
and home insurance from the same insurer. Whichever company you
choose, make sure you investigate all possible discounts. Some in-
surers will knock off a few dollars for safety devices such as airbags
or anti-theft devices such as passive engine disablers.
Oddly enough, paying a little more for your policy can save you money,
too. Most policies, for a few dollars per month, will pay for a rental
car should your car be damaged and unusable. This can be a big sav-
ings, so it’s something to think about. Something else to include is cov-
erage that protects you if an uninsured or underinsured motorist hits
you. (According to some experts, as many as half or more of all mo-
torists fall into these categories.) Most policies offer a degree of cover-
age in this area, but it might not be as much as you need or want.
With renter’s insurance, you decide how much total dollar value of
property you want to insure. Some policies will pay you enough to
cover the depreciated value of various items at the time of loss, while
others will cover replacement costs. This can be a big deal. Let’s say
you bought a computer for $2,500 a few years ago and it’s now worth
$250 (don’t laugh — this isn’t an extreme situation!). It’s suddenly ru-
ined by water dripping onto it from an apartment above you. One pol-
icy might pay you just the $250 that it’s worth, while another policy
may pay you enough to buy a new computer with similar features.
Renter’s insurance can cost as little as $100 or less per year. Compared
with the losses you might incur, it can be well worth it.
Insurance • 37
• You might be able to save money by getting renter’s insurance from
the company that insures your car. Insurers often offer discounts
for multiple-policy holders.
• You might also pay a lower rate if your rental property has a bur-
glar alarm, sprinkler system, fire alarm, or smoke detectors.
There’s too much to cover in detail here, but basically homeowner’s in-
surance covers two things: your personal property and your person-
al liability. Just about any homeowner should carry this insurance.
If you have a mortgage on your home, the lender will be listed on your
homeowner’s policy and will require you to carry the policy because
it protects the lender against non-payment of the mortgage balance. If
your house burns to the ground, you have little incentive to keep pay-
ing that mortgage. After all, there’s no “house” any more. That’s why
your mortgage company will be the first to be paid on the loss because,
technically, they “own” the house (the structure and land) until the
mortgage is paid off.
Ask the insurer what they show as the total value of your personal
property. Usually it’s an estimate the insurance company makes based
As noted earlier, based on where you live and the number of rooms in
your house, the insurance company assumes you have a certain amount
of clothing and other possessions. So, if the claims are within reason,
there usually isn’t too much trouble as long as you can provide rea-
sonable descriptions and cost estimates for your possessions. If you
lose everything, the insurance company will generally cut you a check
for the total estimate they used for your policy coverage, not an item-
by-item payment.
That being said, most people who experience significant losses due to
fires and other disasters find that they have a difficult time remem-
bering everything in each room, let alone model numbers and de-
scriptions. A great way to prevent having to remember every detail
is to make use of a camcorder (yours or one borrowed from a friend).
You might be surprised at just how many individual items you actu-
ally own! Walk through your house and videotape the contents, de-
scribing things as you film. Open drawers, closets, and cabinets to film
Insurance • 39
the contents. Turn appliances around and videotape model numbers
and other characteristics. Show measurements and describe the ma-
terials things are made of that might not be apparent on videotape (e.g.,
a leather chair versus vinyl, an oil painting versus a print, a granite
countertop versus ceramic tile, etc.), to help place an accurate value
on your possessions.
Insurance • 41
57 How should I calculate how much personal liability insur-
ance I need in various insurance policies?
A good rule of thumb is to ask yourself how much you have to lose if
you’re sued. Add up the value of your home, your belongings, and
your financial assets. Tack on more for the cost of legal defense. (In
some cases, the insurance company will take care of providing a lawyer.)
You want to be sure that a lawsuit won’t wipe you out or cause se-
vere financial strain.
If your total assets are substantial, ask your insurance company about
an “umbrella” personal liability policy. Umbrella policies generally offer
much more liability coverage ($1 million or more) at lower premiums
than individual policies such as homeowner’s, renter’s, and automobile.
Sometimes you’ll find the best prices by skipping the middleman (the
agent). But, some agents still offer competitive prices, and the best
among them will give you sound advice and guide you through the
learning process.
If you find a good agent who’s providing a valuable service to you, you
might buy through him. If you haven’t met such an agent, though,
don’t be afraid to explore the world of insurance online.
Pet insurance can be extremely worthwhile, but consider your own sit-
uation first. Without it, you face the possibility of one day having to
fork over hundreds of dollars to repair Buster’s leg or, worse yet, hav-
ing to decide whether to spend thousands of dollars to save Frisky’s life.
The value really depends on the type of pet you have, its age and health
(some breeds, older pets, and pets with chronic or terminal illnesses
are usually not approved for coverage), and what your personal feel-
ings about pet healthcare are. You may have personal limits to what ex-
traordinary measures you are willing to consider for a pet, or you may
be willing to do absolutely anything possible to treat an unexpected
health problem. In the latter case, pet insurance premiums are fairly
reasonable, ranging from $100 to $300 per year. The premiums can in-
crease as much as 50% as your pet ages (usually after 9 years of age for
dogs and 11 years for cats).
More and more companies are now offering pet insurance to employ-
ees. If yours doesn’t and you are interested in the option, ask your
human resources department to look into it. In the meantime, check
out insurers such as Veterinary Pet Insurance (www.petinsurance.com
and 800-872-7387) and Premiere Pet Insurance (www.ppins.com and
877-774-2273).
You’ll find another good resource in the websites of many major in-
surance companies. There’s a host of consumer information at AIG’s
www.aigdirect.com site, for example, if you poke around. You’ll also
Insurance • 43
find info at sites such as www.allstate.com, www.chubb.com,
www.newyorklife.com, www.statefarm.com, and www.metlife.com.
To find the website of any other major company, try looking it up at
company information site www.hoovers.com or via a search engine
such as www.google.com.
Buying a Car
Vroom vroom! You can go through all of your life having
bought a house just once, but you’ll likely buy a car five to
10 times — if not more. Add all those expenses together, and
they’ll probably amount to the cost of a house. Buying a car
involves a significant amount of money. Don’t enter into an
agreement to buy anything with wheels and cup holders until
you’ve read through at least this chapter. You can probably
save hundreds, if not a thousand or more, dollars on your next
purchase with some of the tips and strategies that follow.
Don’t think of cars as investments. For most of us, they’re simply nec-
essary means of transportation. Remember — good investments ap-
preciate over time. Cars, on the other hand, tend to decrease in value
over time. That’s why it’s generally true that the less you spend on cars,
the better. That doesn’t mean that you should always buy the cheap-
est available car. Spending a little more on a car that will be reliable
and last a long time can be a very smart strategy.
It depends on the make, model, and year. Some vehicles remain high-
ly desirable in the used car market, so they depreciate more slowly.
45
In general, expect your new set of wheels to lose 20% or more of its
value in its first year. (Some vehicles drop by twice as much.) In fact,
a car loses a big chunk of its value as soon as you drive it off the lot!
In year two, expect a loss of around 15%. Year three: roughly 13%.
Year four: about 12%. If you buy a $20,000 Mazdolet Vroomster, it
may be worth just $8,500 in only 5 years — with depreciation amount-
ing to $11,500.
If you buy new cars and drive them for only a few years before trad-
ing them in for other new cars, you’ll be taking big depreciation hits.
The longer you can safely and reliably drive your car, the longer you’re
putting off spending a big chunk of change for something that will
quickly depreciate.
But, think of how much it cost for the first two years: It went from
$20,000 to $13,000 in value, costing about $3,500 per year. If you
bought it new and only drove it for two years, that’s what it would
have cost you (excluding maintenance and repairs, of course).
If you buy a car new and drive it for many years, the average cost
per year drops considerably. And, if you buy a good used car and drive
it for many years, the cost falls further still. This is clearly a simplified
example, but it offers some useful food for thought.
Here’s one way. Take a sheet of paper and draw a vertical line one third
of the way from the left. You’ll have two columns now, the first half as big
as the second. In the first column, list all the kinds of vehicles there are:
• Sub/compact
• Family sedan or station wagon
• Sports car/coupe/convertible
• Minivan
• Sport utility vehicle
• Pickup truck
• Full-size van or conversion van
• Luxury sedan
In the right hand column, jot down answers to the following questions:
• How many miles per year do you think you’ll drive the vehicle?
• How much time, on average, do you think you’ll spend in it each
day?
• What type of driving will you be doing? (What percentage of the
time will it be on city roads, highways, off-road?)
• How much can you afford to spend?
• List all the reasons you want and need the vehicle (such as for com-
muting, shuttling kids to activities, camping, antiquing on week-
ends, etc.).
Now, begin reconciling the two lists and eliminating the vehicle types
that don’t meet your needs. If you spend a lot of time buying antique
furniture, for example, or transporting large animals between zoos,
you probably won’t want a small sports car with leather seats. If you
drive 90% of the time in the city or in heavy, slow traffic, you might
not want a gas-guzzler or something that’s difficult to park.
Your goal is to get down to one vehicle category. Once you do that, you
can begin narrowing the field even further.
Buying a Car • 47
66 If I’m trying to figure out how much a car will cost me over
its life, what should I take into account?
Some trim models of the same car get placed into higher-premium
“sports car” categories by insurance companies, and the cost differ-
ence to insure them can really pack a punch to your wallet. Call your
insurance company and get an estimate on insurance premiums before
you finalize a car purchase, so you won’t face any surprises. If a car
does seem to cost a lot more to insure than you expected, ask the in-
surance company why. They may help you choose another model with
more reasonable premiums.
Since a car loses much of its value in its first few years, it can make a lot
of sense to stick to buying just used cars. In an ideal world, buying
used cars will save you a lot of money. But, the world is not ideal. If
you’re not too savvy about cars and their inner workings, you might
get taken advantage of. Used cars are riskier than new ones. You never
Still, for some people, buying used cars is the way to go. Here are some
questions to ask yourself, to see if you’re among this group:
• Am I a skilled negotiator?
• Am I good at determining the real value of things?
• Do I enjoy shopping for vehicles and scouring car lots?
• Am I mechanically inclined, or do I have access to someone handy
with cars?
• Am I patient?
The more “yes” answers you have, the more suited you are to used
vehicles.
Even if your answers were mostly “no,” you might still tap the used
vehicle market, via the many dealers now offering “re-warranted” off-
lease vehicles.
If you plan to explore the used vehicle market, a very helpful web-
site to check out is www.carfax.com — especially before you final-
ize a purchase. Private sellers and often, sadly, even car dealerships
have been found guilty of repairing “salvage” (seriously damaged)
vehicles, taking them across state lines, registering them and getting
a “clean” title in the new state, and then putting them up for sale
without revealing their true history to prospective buyers. The car
you think is one heck of a great deal might have been pulled from
a swamp a couple of months ago in another state. Jot down the ve-
hicle identification number (VIN) of any car you’re seriously inter-
ested in buying and run it through Carfax’s free “Instant Lemon
Check” service. It could keep you from being taken by unscrupu-
lous car sellers trying to unload some sour automotive citrus fruit (if
you catch our drift).
Buying a Car • 49
Notice that I haven’t mentioned visiting dealerships. That’s intentional.
If you end up deciding to use our “Fool Fax-a-thon” method (which
is described later), it’ll be to your advantage not to have visited local
dealerships. Also, stepping foot onto dealership lots means that you’ll
soon be sweet-talked by salespeople who’ll be telling you what you
want before you’ve made up your own mind. Don’t let them play their
tricks on you — they do this for a living.
Fortunately, there are many resources online where you can learn more
about cars than you can imagine. (A big bunch of them are listed a few
questions later.) Your goal is to winnow down your list of candidates
to just three models. Some websites offer nifty search functions, where
you can specify features you want and will get a list of models fit-
ting those specs.
As you narrow the list, keep in mind the factors most important to you.
These might include: price, safety, reliability record, resale value, re-
sponsiveness, size, mileage rates, and the ability to turn heads. See
which models are closest to your perfect vehicle.
In our Buying a Car area online, we’ve got a very detailed checklist
that you can print out and take with you. You can view the checklist
at www.Fool.com/car/step7car.htm. In the meantime, here’s an ab-
breviated overview of what to examine:
• Drive Train Performance and Acceleration. Pay attention to how
well the car accelerates and shifts gears, and how it takes hills. Lis-
ten for any noises.
• Ride Comfort & Suspension Systems. See if the ride is too hard,
too soft, too bumpy, too smooth, or just right. See how it handles
itself when you shift gears, change speeds, or brake.
• Cabin Noise Levels. Pay attention to all the noises you can. Start
with the fan off, vents shut, and the radio off. Listen for engine noise,
road and tire noises, wind noise, buzzes, squeaks, rattles, vibrations,
etc. Open and close various windows and the sunroof, if there is one.
Make sure there aren’t any worrisome or annoying noises.
• Overall Impressions. Now it’s time for the big picture. Is the car
a pleasure to drive, or a pain? Are you comfortable and can you
see well in all directions? Jot down a list of all the details that stand
out as big plusses and big minuses. You’ll want to refer to these later.
Yes, indeedily doodily. Much of the examination that you should un-
dertake is best done while the vehicle is parked. Below is a quick
overview of the kinds of things to check out. It’s best if you do this on
your own or with a friend — ask any salesperson breathing down your
neck to leave you alone for a little while.
Buying a Car • 51
isfactory, whether the space is roomy enough, and whether the color
scheme is pleasing. Also, spend some time in the driver’s seat, mak-
ing sure all the controls are logically laid out, easily reachable, and
whether the line of sight is good. Test the sound system and vari-
ous buttons and levers (e.g., the windows, turn signals, wipers, etc.).
If things like cup holders and glove compartment layout are im-
portant to you, check them out. Don’t forget to try all the seats in
the vehicle for comfort, support, and elbow room.
• Exterior Fit, Finish, and Color. Here you want to consider whether
the color appeals to you; how practical the design is inside and out;
how well pieces fit together; how easy it is to operate the doors,
trunk, and hood; are there any paint or surface imperfections… and
so on.
71 What tips can you offer for dealing with car salespeople?
Well, for starts, have the proper perspective. Remember that you only
buy a car once every few years, but these people negotiate sales all day
long, every day, for years. Who’s more skilled at this game? You’re clear-
ly at a disadvantage.
Some tips:
• Remember that you have the upper hand.
• Think about this old adage from the world of negotiations: “Who-
ever speaks next, loses.”
• Don’t offer any more information about yourself than you have to.
The more a saleswoman knows, the more she can tailor a strategy
to you.
• Rein in any enthusiasm. No drooling in the showroom. Don’t let the
If you can type the following long web address into your browser,
you’ll find a special collection of articles we ran online — confes-
sions of a former car salesman. It’s full of some shocking revelations
about what goes on at dealerships:
www.Fool.com/Specials/1999/sp990309CarConfessions.htm
The best advice I can offer you, if you don’t look forward to nego-
tiating with a salesperson, is: don’t do it! That’s right — you actu-
ally don’t have to. At the Fool, we’ve developed a nifty way to keep
the car-buying advantage in your court the whole time. It’s our Fool
Fax-a-thon.
Glad you asked! It’s a crafty strategy you can use to shift the bargaining
power back to you. Once you know exactly what car (and options) you
want to buy, gather the fax numbers of the appropriate dealers clos-
Buying a Car • 53
est to you — and get yourself to a fax machine. Ideally, you’ll want a
list of at least one or two dozen dealerships. The more you include, the
better chance you have of getting a great price. If there aren’t too many
dealerships in your immediate area, spread your net wider. You won’t
mind driving 90 minutes once to pick up a great bargain.
Ideally, you won’t have shopped at the dealerships you fax to. If you
have shopped at one, and took up the time of a salesperson there, then
it’s not really right to go behind the salesperson’s back with the Fax-
a-thon. If you’ve not shopped the dealership, address your fax to the
fleet manager, and ask that any sale be considered a “house sale,” which
is non-commissioned. If you have shopped at one, perhaps address
your fax to the salesperson you spoke to at that dealership.
Once you’re all ready with fax numbers and names, fax a letter to all
the dealers (ideally a dozen or two — the more you include, the bet-
ter price you’re likely to get). In it, specify exactly what car you want
to buy, including all the options, the color, etc. Include your fax num-
ber (but not your phone number) and invite them to fax you an item-
ized price offer, including options, fees, and taxes. This way, you can
compare apples to apples when the bids arrive.
Online at the Fool, we’ve heard from many people who’ve saved thou-
sands of dollars using this tactic. Give it a shot!
(date)
I am looking to buy a new car this week. On the second page of this
fax, please find a listing of the specific vehicle features I’d like in-
cluded with the vehicle when I make my purchase.
If you bid, please include all costs, and itemize these costs specifi-
cally to the options that I have listed on the next page. The bid should
also include an itemized listing of all other fees and tax liabilities, in-
cluding dealership preparation fees, title costs, and licensing fees.
Any bid that is incomplete or not per the option listing will not be
considered in my purchase decision. If you have an option pack-
age alternative or other changes, please list these as a separate bid
and note the exact specifics of the changes in the bid.
I have not “shopped” your dealership in more than one year, and
have had no sales contact with any employees operating in the deal-
ership’s interest during that time. Because of this, please consider
this bid to be a “house sale.” In addition to that, I will accept no bids
after (time) on (date).
I thank you for your time and interest. If you choose to bid, please
fax your fully itemized bids to (your first name) at (XXX) XXX-XXXX.
I look forward to doing business with you.
(your signature)
(your name printed here)
Buying a Car • 55
Note: Make sure that you do not include your phone number. You don’t
want to negotiate over the phone. You just want to receive faxed bids.
Here’s how the system typically works. The manufacturer ships a bunch
of Rocket 900XZs to the dealership. The dealership is billed at and pays
the invoice price. Once a Rocket is sold, the manufacturer deposits a
certain percentage of the vehicle price into a kitty for the dealer. This
is the “holdback” percentage, which varies but is usually between 2%
and 5%. You’ll find the holdback percentage for any particular vehi-
cle listed at many of the auto supersites online.
Regularly, perhaps once per quarter, the manufacturer clears out the
kitty and sends the dealer a check. This holdback system permits the
dealer to swear to you that he’s paying a certain invoice price for the
vehicle, while not mentioning that he gets a certain percentage of that
price back. On a $20,000 car, a 3% holdback comes to $600 — and
it’s an amount you don’t have to surrender in full to the dealer.
There are additional incentives for dealers, as well, which you can
learn about by doing a little digging online or in trade magazines
such as Automotive News. As a very rough example, imagine that
you’re looking at a vehicle with an invoice price of $20,000 and an
MSRP of $22,000. A dealer might be telling you that he’ll give it
to you for just $20,500, fully $1,500 off the MSRP. But, he might not
be mentioning that he’s getting a $600 holdback, plus a special deal-
er incentive of $1,000. (Here and there, some special dealer incen-
tives amount to several thousand dollars.) In other words, the
$20,000 car is really costing him $18,400 and he’s asking $20,500 of
you — looking for a whopping $2,100 profit. Naturally, car sales-
people have to earn a living, but that profit sure looks larger than it
needs to be.
Don’t mention your trade-in until you’ve finished negotiating the price
of your new car. Bringing it in early will only allow the salesperson to
confuse you by making the negotiation more complicated. Once you
have a firm price for the new car, you can make arrangements for the
trade-in, and then attend to financing matters.
For some people, leasing makes sense. But, for many it doesn’t. If you
plan to keep your car for a long time, buying is often the best choice.
But if you’re short on cash, or don’t plan to own a car for many years,
sometimes leasing is smarter. If there’s much chance that you’ll dam-
age the vehicle (not so unlikely, with a truck), you might get socked
with extra charges if you lease — after all, vehicles coming off leases
are later sold. If your credit rating isn’t too hot, buying might be best,
as good credit is often required for leases.
As you compare leasing vs. buying, consider these costs and factors
as they relate to each option:
• What’s your initial outlay?
• How much will you be paying while you possess the vehicle?
• What final costs are there, at the end of your possession period?
• What options rights do you have, if you’re leasing, and what will
they cost you?
• Will you be able to deduct any of these expenses?
Buying a Car • 57
The ins and outs of leasing can get fairly complicated. Take some time
to do some research before opting to lease. You can learn a lot more
about leasing at these sites:
• www.edmunds.com/edweb/leasingby.html
• www.ricedelman.com/planning/basics/buylease.asp
• www.consumerlaw.org/consumer/lease.html
• www.carbuyingtips.com/lease.htm
• www.Fool.com/car/step11car.htm
Once again, a little preparation will serve you well. If all you do is
ask the dealer to arrange financing for you, you’re not likely to get
a great interest rate on your loan. If you shop around, though, you’ll
be surprised at the range of rates available to you. Your bank, cred-
it union, or other local banks can offer loans, as can some car in-
surance providers such as State Farm. Your local AAA office can help
you out, too. And, of course, online is perhaps the easiest place to
comparison-shop.
Once you have a good rate, you might take it to your dealer and see
if he can beat it. He’ll often be willing to do so.
Kelly Blue Book: The standard source for new and used car prices:
• www.kbb.com
Buying a Car • 59
CHAPTER FIVE
ANSWERS TO YOUR QUESTIONS ABOUT
Buying a Home
Buying a home can be traumatic. For starters, it’s a compli-
cated process. You’re relying on all kinds of professionals you
never dealt with before — like real estate agents, home in-
spectors, and mortgage bankers. You’re talking about enor-
mous sums of money, as the houses you’ll look at cost much
more than you make in an entire year. It’s scary. But, it does-
n’t have to be that scary. Take some time to read through the
information in this chapter and some of the follow-up resources
listed. The more you know, the calmer you’ll be, and the bet-
ter decisions you’ll make.
This is a good question, and one that mortgage lenders seek to answer
before qualifying you for a mortgage. To get an answer, you might
apply some formulas lenders use — like the front-end and back-end
ratios. The front-end ratio addresses your ability to afford mortgage
payments, and the back-end ratio addresses your debt load. Let’s look
at an example:
Imagine that your gross income is $4,000 per month and you owe
$1,000 per month in debt — perhaps for your car, student loans, and
some credit card debt.
Lenders will typically want you to spend no more than 29% or 30%
of your income on your mortgage. This is the front-end ratio. In this
61
example, 29% of $4,000 is roughly $1,200, so a lender might assume
that you can reasonably pay as much as $1,200 per month in mortgage
payments.
Once you know how much you can afford for a down payment and
how much you can pay each month, you just need to plug them into
a formula. You can do this at our online home-buying area (at
www.Fool.com/house), where we’ve got calculators and worksheets to
help you with much of the mathematical gymnastics involved.
There’s no single best amount, and it will likely vary according to your
situation. Mortgage lenders typically like to have you pay 20% or more
down (which means you’re only financing 80% of your purchase price),
but some special loan plans can get that down payment into the low
single digits. By using private mortgage insurance (see the next ques-
tion for more information on PMI), you can also swing a down pay-
ment that’s less than 20% of your home’s purchase price.
INCOME
Salary, tips, wages
Dividends and interest from investments
Bonuses
Any other income
Total Income
EXPENSES
Income taxes
Social Security taxes
Other taxes
Savings
Food
Insurance
Health bills not covered by insurance
Car loan
Car expenses (gas, maintenance, repairs)
Credit card bills
School loans
Other loans
Child care
Clothing
Education expenses
Entertainment
Vacations/travel
Charity
Miscellaneous
Total Expenses
RECONCILIATION
Total income
Less total expenses -
Discretionary income =
Note that this worksheet is just for you, not a lender. It has more information than they
need to know. Note also that current rent or mortgage payments are left out of the ex-
penses because they’ll be replaced by your new home purchase arrangements.
Buying a Home • 63
If you’re fairly flush with funds at the moment, and you work in a pro-
fession where you never know exactly how much you’ll make in any
given year, you might consider paying more than 20% as a down pay-
ment. The higher the down payment you make, the lower your mort-
gage loan and, therefore, the lower your monthly payments will be.
Of course, it’s also reasonable to pay only as much as you need to, and in-
vest the rest. It’s up to you. Just remember that you need to be comfortable
with the amount you’re putting down and with your monthly payments.
If you opt for mortgage insurance, once you have 20% equity in your
home, you should be able to cancel the insurance. (An appraisal may
be required beforehand, though.) In our online home-buying area,
we’ve got a calculator that will help you explore how to reduce mort-
gage insurance costs.
(An important thing to understand about PMI is that the 20% equi-
ty threshold relates to your home’s value, not necessarily 20% of the
mortgage amount. If you get a great deal and buy your home below
market value, buy a fixer-upper and fix it up to increase its value, or
pick an area that suddenly becomes popular and appreciates in value
rapidly, your mortgage amount might be very different from the value
of your home. If you are required to pay for PMI, keep tabs on the
changing value of your home.)
That’s a smart thing to do. Flip back to the chapter on credit cards and
debt, where you’ll find details on how to go about doing that — as well
That may be a good strategy. Let’s say you buy a house and then have
to sell it within two to three years. The various buying and selling costs
alone will probably be a significant amount of money. Will the house have
appreciated enough to cover those costs? It’s possible, but not likely. Be-
sides, in the first years when you’re paying off a traditional mortgage,
your payments are mostly going towards interest, not towards building
equity (paying off the principal balance). So, after living in the house for
only a few years, you’ll probably technically own just a tiny part of it.
Buying a Home • 65
Although it may appear that your interest rate is the one officially list-
ed on your mortgage, it’s not necessarily a reflection of the actual rate
you’ll have paid over the life of the loan. You should incorporate the
effect of points into the rate. For example, if your mortgage is for
$150,000 and you pay a total of two points, then you’re really paying
$153,000.
30-year Mortgage Flexibility: you can pay more You’ll pay more in interest
when you have more and over the life of the loan
pay it off in fewer than 30 (often twice as much as
years with a 15-year mortgage)
These are the two main types of mortgages — the Coke and Pepsi,
the cats and dogs, of the home-lending world.
Again, I point you to our online calculators, which can answer such
questions as “Which is better: fixed or adjustable?” (They can be found
online at: www.Fool.com/house/worksheets/worksheets.htm)
A mortgage broker sets you up with a mortgage. There are other ways
to get mortgages, though: via banks, credit unions, savings and loans,
and mortgage bankers. In exchange for setting up the mortgage, most
lenders charge origination fees. Mortgage brokers charge a broker’s fee
(and are sometimes compensated by the lenders they work with, as
well). More than half of all mortgages in America originate with mort-
gage brokers.
Depending on the fee they charge and the kind of deal they can get
for you, mortgage brokers are sometimes your best bet. They have
access to a wide variety of lenders and programs and can be espe-
Buying a Home • 67
cially helpful if your credit history is checkered or if you have any
other special circumstances.
So, should you go with a mortgage broker or not? It depends. See what
your alternatives are and go with the best deal you can find. It may
well be with a mortgage broker. It’s smart to do a bit of research be-
fore talking to mortgage brokers, though. You’ll delay their hard sell
and you’ll be more informed as you listen to them.
Mortgage brokers tend to charge higher closing fees. A fee of $700 isn’t
uncommon, but you might also see some charge as much as $1,200.
Make sure you learn of all fees before making any decisions.
First, start with your bank, savings and loan, or credit union. (If you
are eligible to join a credit union, but haven’t, look into it — they
can offer very competitive rates. And, with many, you simply have
to open an account with as little as a single dollar to join.)
Next, if you’re without a computer, get your local newspaper and scour
the real estate section, looking at other banks’ ads. If you do have a
computer, things are much easier. (And, actually, even if you’re un-
wired at home, you might avail yourself of a computer at a friend’s
home or your public library.)
It’s best to do this before you even begin house hunting. You’ll have
a leg up, knowing exactly what you can afford, and you’ll clearly strike
You should not only shop for a mortgage before you shop for a house
— you should also get “pre-approved.” With a pre-approval or pre-
qualification letter in hand, you’ll be in a stronger negotiating posi-
tion when it comes time to negotiate a purchase.
Pre-approval is a bigger deal. It means the lender has checked out your
employment and salary information, your credit record, your assets, and
your debts. Many lenders don’t charge for pre-approvals, but some do.
It’s a “seller concession” that can save you some money. (But, not nec-
essarily 6% of the home’s value.) Here’s how it works, in an example
swiped from our online Buying a Home area:
Imagine that you and the seller agree on the price of the house at,
say, $200,000. You then ask the seller for a 6% seller concession. What
this means is that you add (up to) 6% to the price of the house. That’s
right, you’re now going to pay $212,000 for that house — but the sell-
er is going to give you that $12,000 back when the sale takes place.
You’re going to use that money to cover all of your closing costs.
Buying a Home • 69
mortgage. Since your mortgage interest is tax-deductible, these costs
have effectively become tax write-offs.
In addition, you don’t have to come up with all that extra cash at set-
tlement. Your down payment will be somewhat higher, (if you’re put-
ting down 20%, then in the current example your down payment
would be $42,400, versus $40,000) and, of course, your mortgage pay-
ments will be higher, but it ends up saving you money.
The seller has no reason to refuse this — after all, the agreed-to price
is still the same.
The catch is that the house has to appraise for the higher value. If
the appraiser comes back and tells you that this house won’t appraise
for more than $200,000, you can’t do it.
Let’s look into this a little further. Say you buy the house for $200,000.
Your $40,000 down payment leaves you needing a $160,000 mortgage.
You get a 30-year loan at 8%. Your monthly payments for principal
and interest are $1,174.
Now, say you decide to use the 6% seller concession strategy. You buy
this house for the price of $212,000. You put down 20%, and this leaves
you needing a $169,600 mortgage. Your monthly payments will be
$1,244, or $70 more per month. Is it worth it?
However, remember that’s $12,000 less out of your pocket at the time
of closing. If you take $12,000 and invest it at 10% (less than the mar-
ket average has returned over the past 35 years), then your money will
Naturally, you’ll want to run the numbers for your particular loan to
see whether it would be worth it for you.
Note: there are certain rules under certain mortgages as to what the
seller can actually pay for at closing. If you get $12,000 from the sell-
er and all of your costs are $12,000, this does not necessarily mean that
you won’t have to pay anything. Be sure to ask your lender what costs
the seller may cover.
You might “assume” the existing mortgage on the house you’re buy-
ing, if there is one. This is a good deal if the existing mortgage is at a
lower rate than prevailing interest rates. To do this, you’ll need to make
sure the existing mortgage is “assumable” or transferable. And, you’ll
have to cough up whatever difference there is between the purchase
price and the outstanding debt. You might do this by tapping your
nest egg, if it’s large enough, or by taking out a second mortgage.
Why would a seller take on this kind of risk? It’s actually not that risky.
The house is the collateral. Default on the loan, and the seller keeps
the house — just like a bank would. Sellers might also appreciate get-
ting regular checks from you over time, rather than a lump-sum pay-
ment — it’ll be an additional income stream. And, depending on the
seller’s circumstances, this arrangement might also save him some cap-
ital gains tax. One caveat is that sellers typically will want a shorter
Buying a Home • 71
term than the traditional 30-year mortgage.
You might also save some money by playing with points and other
elements of the mortgage. Maybe pay more discount points and get a
valuable lower rate. Perhaps consider a 15-year mortgage instead of
a 30-year one. (Of course, if you’d rather pay less each month with a
30-year mortgage and invest the rest in something like stocks, it could
be better than a shorter-term mortgage — especially if your interest
rate is low.)
It’s also effective to pay off your mortgage sooner than you’re sched-
uled to. The more you pay, the less you owe. And, the less you owe,
the less interest you’ll pay.
Finally, remember that mortgage lenders want your business and will
usually compete to get it. Don’t be afraid to negotiate. Let one know
what another is offering you. Don’t assume that published rates are
final. If your credit record is good, you’ll be in a particularly strong
position to negotiate. Knocking a quarter percent off a published in-
terest rate is a reasonable goal.
The plus side of working with an agent is that he has access to a wide
variety of available properties. He’s also well versed in the home-buy-
ing process and can guide you through the various legal and admin-
istrative steps.
Still, it doesn’t hurt to look. As time goes by, these sites will proba-
bly be showcasing more and more homes. Here are some websites where
you can check out available FSBO homes — or list your own!
• www.sellyourhomeyourself.com
• www.fsbonetwork.com
• www.owners.com
• www.forsalebyowner.com
• www.fsboonline.com
If you take the FSBO path, you’ll still probably have to fork over some
fees to various professionals, such as lawyers, to guide you through
administrative formalities. But, these fees will likely pale in compari-
son to what you’d spend taking the road more traveled.
Not exactly. Someone with a real estate license is a licensed real es-
tate professional, or an agent. This person may also be a REALTOR®,
but isn’t necessarily one.
Buying a Home • 73
CIATION OF REALTORS®, which has trademarked the word “RE-
ALTOR®.” I’ll use the word “agent” from now on, as I don’t want to
run out of my allotted supply of capital letters or cause any eyestrain.
A real estate broker, meanwhile, has had additional training and holds
a different license. Don’t think that you need a broker and not an agent.
Either can serve you very well. Although many people casually refer
to those who show and sell homes as brokers, they’re often actually
agents. Most people use the terms interchangeably.
A buyer broker represents the buyer and not the seller. Many peo-
ple don’t realize that traditional real estate agents are working for the
seller of a property. Yes, they’re working with you, perhaps spending
many days showing you dozens of homes. But, they’re devoted more
to the interests of the seller than to your interests. The simple reason
for this is economics — their pay (commission) for completing the sale
is a percentage of the actual selling price they extract from your pock-
ets. Therefore, it’s to their advantage to sell the house at a higher rather
than a lower price.
Also, since the traditional agent represents the seller, if you were to
mention to an agent as he showed you a lovely domicile that you’ll offer
$130,000 and will pay no more than $140,000, don’t be surprised if
that information gets to the seller. (Of course, there are indeed plen-
ty of agents who’ll knock themselves out for you and get you a great
house at a good price. Just understand how the industry is set up
and what you may be up against.)
All that said, one way to circumvent dealing with agents who pledge
allegiance to the seller is to work with a “buyer broker.” It’s becom-
ing more and more common for people to use the services of a buyer
broker. With a buyer broker, you agree from the outset on what her
fee will be (some restrictions may apply, depending on the state). It
will usually come out of the proceeds from the sale, so you won’t have
to actually cough anything up to cover it. There’s still an incentive for
the broker to favor a higher sale price, but there are ways to work
around that.
Finally, make sure you’re familiar with exactly what you’re spelling out
in the contract. Understand the terms. Are you expected to pay any-
thing if a satisfactory purchase doesn’t happen? Are there any hidden
fees or expenses? Have you agreed to mow the agent’s lawn for a year
or pay for his daughter’s braces if a deal doesn’t go through?
Buying a Home • 75
the ready, or at least a lot of information stored in her noggin.
• Keep looking. If you don’t find someone you like at first, take the
time to continue looking. The more agents you check out, the greater
the odds that you’ll find one you really like who serves you well.
Yup. Be very clear about what you’re looking for in a home. Make a list
for yourself and for the agent of what your new home must have (4
bedrooms, a big yard, at least two bathrooms, etc.) and what would be
nice to have (a swimming pool, a nearby polka hall).
Also, honor any agreements. If you’re not to use other agents, don’t.
If agents get wind that you’re not playing by the rules, they may put
a lot less effort into serving you. This goes beyond rules, too. Just be
honest. If you’re using two agents, let them know. (Don’t feel that you
have to sign any exclusive representation agreement. You might find
it best to use several agents at first, until you settle on one you like best.)
First off, you might look up the going prices for similar homes in the
same area. You can do this fairly easily at http://Fool.home-
pricecheck.com, if you’re online. If you’re not, then call up the local
government offices, such as city hall. The sale prices of homes should
be a matter of public record. (Tax assessors’ offices can tell you the ap-
praised value of local homes, but while these are sometimes very close
to reasonable selling prices, they’re also sometimes too high or too low.)
Your agent can be a valuable resource here, too. He should be able to
provide information on comparable sales prices for the area.
Next, determine how “hot” the local market is. If demand for housing
is high (sometimes referred to as a “seller’s market”), you won’t have
too much bargaining power. Homes priced reasonably will sell quick-
ly, for a price close to the asking price. In some super-hot markets,
homes may even sell above the asking price, as buyers compete with
other buyers. In a slow-paced market (sometimes referred to as a
Check out the market history of the home. Has it been for sale for a
long time? Has the price been reduced over time? If so, when was
the last asking-price reduction? (If reductions are a pattern, and it’s
been a while since the last one, the sellers may be mulling over another
reduction.) Have there been any offers on the house? If so, for how
much? Find out if others who made an offer are still interested, or if
they were rejected (and why!).
Buying a Home • 77
make sure that the offer is “contingent” on your securing financing.
It should also be contingent on the property being cleared by the home
inspector you hire.
Setting a time limit can also be a good idea. You can make your offer
good for 24 or 48 hours, preventing the seller from stalling and wait-
ing for a higher offer.
If you’re serious about the offer, you can make it more enticing by giv-
ing your agent an “earnest money” deposit toward the price of the
house. It can be a few thousand dollars, or even as much as 10% of the
price, depending on what you’re comfortable with. Your agent should
apply it toward the house purchase if the sale goes through, and con-
vert the check into confetti if it doesn’t.
First off, don’t use one referred by a traditional agent, as the agent is
aligned with the seller of the house. If you’re using a buyer broker, it’s
fine to go with a referral from him. But, also get references from the
inspector. (If he’s reluctant to provide them, say sayonara.)
Check out whomever you plan to use with the American Society of
Home Inspectors (ASHI) (gesundheit!) to make sure he’s got sufficient
training and experience. Find out what will be covered in the in-
spection — in detail.
Make sure that you can accompany him on the inspection, and do ac-
company him, observing what he does. In addition, you want him to
carry “errors and omissions” insurance, which will cover you in the
event that he goofs and misses something costly.
Today, often for just a few dollars, you can purchase or ask the sell-
er to provide a “home warranty” — insurance that covers unfore-
seen repairs for the first year or so after you buy the house. Most
of these policies are contingent on a home inspection being per-
formed by an inspector the insurance company trusts, but they
offer great peace of mind. Many real estate agents and sellers are
offering these policies as part of the sale to reduce liability for
• Escrow fees: Escrow is where the payment for your home will re-
side while you and the seller get everything settled. There are fees
for this service, though. Think of them as room rates at the Escrow
Hotel.
• Legal fees: Not everyone needs the services of a lawyer, but if your
transaction is too complicated for boilerplate forms, you’ll want
an attorney preparing some paperwork.
• Title insurance: This covers you in case the unlikely happens and
the person who sold you the house didn’t really own it.
• Appraisal fees: This will slap a fair market value on your home —
important for tax purposes and for the mortgage company to ap-
prove your loan.
Buying a Home • 79
• Tax service fees: These are to make sure that your taxes get paid.
• Pest inspection fee: New homes don’t normally require this, but
older homes do.
Sadly, these aren’t necessarily the only fees you’ll pay. But, they’re most
of them.
They fluctuate along with other interest rates. Interest rates are affected
chiefly by inflation and the market for debt (notes, bills, and bonds,
among other instruments). With inflation extremely low in recent years,
we’ve enjoyed low interest rates. But, if signs of inflation begin to pop
up, it’s expected that the Federal Reserve, will hike up short-term in-
terest rates via an adjustment in the rate of interest on “federal funds.”
The “fed funds” rate is the interest rate a bank can charge another bank
for use of its excess money. The Fed can also change the “discount rate,”
or the rate paid by a bank to borrow short-term funds from the Fed.
The prime rate and other rates (such as mortgage rates) are based pri-
marily on these two interest rates.
The Fed raises these interest rates when the economy appears to be
growing too briskly, which can spur inflation. When the economy is
sluggish, the Fed might cut these rates to give American enterprise a
boost. Lower rates give companies and people (including homebuy-
Sometimes very much so. You may think of your house as an invest-
ment. Unfortunately, you probably won’t see the return on that in-
vestment until you’re loading up the white Cadillac for the big move
to Sarasota. There’s a more-immediate way you can make some money
off your house, though: refinance your mortgage.
Your first step is to assess the myriad mortgage costs involved — such
as the origination fee, discount points, the appraisal, the credit report,
processing, title insurance, and the escrow fee.
Next, check out available loans and interest rates (made easy at web-
sites like www.homeshark.com). Consider what “points,” if any, you
might have to pay. A point is equal to 1% of the value of your loan.
It’s paid upfront when you close the loan.
Interest rates lower by one or even half a percentage point can result
in whopping interest savings over 15 to 30 years, depending on how
much you borrow.
Buying a Home • 81
For example, $100,000 borrowed at 7% instead of 8% for 30 years will
save about $25,000 over the length of the loan. If you invest the extra
$69 a month in the S&P 500, at the S&P’s historical 11% annual return,
in 30 years you would have roughly $180,000. You owe it to yourself to
crunch some numbers and see if refinancing makes sense for you.
To ensure that you can afford more than a corrugated aluminum shack
when the time comes to buy a home, any money that you expect to
need within five years or so should not be invested in the stock mar-
ket. You should take great comfort and encouragement from the fact
that the stock market has averaged an annual 11% return for most of
this century. But, that rate of return is an average over the long haul.
From year to year, anything can happen.
There are many online sites where you can brief yourself on the home-
buying process and find useful resources. Here are a few helpful sites:
• www.homebuying.about.com/realestate/homebuying
• www.realtor.com
• www.Fool.com/house
These sites can guide you to finding lenders or real estate agents:
• www.Fool.com/house/mortgage
• www.homestore.com
• www.eloan.com
• www.realtor.com
• www.lendingtree.com
• www.MortgageIT.com
Here you can check out various regions, as well as their crime rates,
quality of life, etc.:
• www.homefair.com
• www.bestplaces.net
• http://local.yahoo.com
• www.bestsmalltowns.com
This is where you can hook up with any local Chamber of Commerce.
If you’re not online, call the Chamber of Commerce in any area of in-
terest and they will often be willing to send you information on the
services and characteristics of their city or town:
• www.uschamber.com/mall
There are far too many to list. Here are a bunch that should prove help-
ful to you, though:
• The Home Buyer’s Kit by Edith Lank
• The Home Seller’s Kit by Edith Lank
• Buy Your First Home by Robert Irwin
• All About Escrow and Real Estate Closings by Sandy Gadow
• How to Sell Your Home Without a Broker by Bill Carey, Suzanne Kiff-
man, and Chantal Howell Carey
• House Selling For Dummies by Eric Tyson and Ray Brown
Buying a Home • 83
• Home Buying for Dummies by Eric Tyson and Ray Brown
• Mortgages for Dummies by Eric Tyson and Ray Brown
• Retirement Places Rated by David Savageau
Paying for
College
It can be expensive to pay for a college education, but it will
cost your child more if he doesn’t go to college. The prospect
of forking over many tens of thousands of dollars over a few
years can be frightening, especially if you’ve got several whip-
persnappers. But, don’t let yourself be paralyzed by fear. With
a little reading up and strategizing, you can put together a
sound plan. This chapter covers some of the highlights of pay-
ing for college and gives you leads to many online resources
where you can learn even more.
You might point out the differences between high school and col-
lege. Some kids may assume that college is very much like their regi-
mented high school. Point out the freedoms at college: She’ll have much
more latitude in choosing courses to take and she can focus primari-
ly on subjects that interest her. Her schedule will vary widely, too.
Some days she may have no courses until noon. Most courses may only
meet three times a week. These are interesting details that not every
youngster is aware of.
Play up the social angle, as well. She’ll meet many, many new friends.
She’ll be in a community where almost everyone is roughly her age.
85
Colleges typically feature scores of clubs, sports, and other activi-
ties. She’s not likely to be bored. Instead of being out in the working
world, she’ll be among new friends, taking many courses that inter-
est her and enjoying a rich social life.
Finally, another compelling tidbit is financial. Point out how much dif-
ference a college education will make to her earning power for the rest
of her life. Explain how most good jobs today require at least a college
education. Share this eye-opening table with her, and you may find
that she’s suddenly thinking of law school!
It’s worth thinking twice about private universities, which can cost
several times what public schools cost. Some private schools have
prestigious names, which can open some doors, or at least give a bit
of shine to a resume. But, a hard-working, clever student at a pub-
lic university can achieve just as much. Besides a college’s name, grad-
uate schools or employers will be looking at courses taken, grades,
recommendations from faculty members, initiative taken, achieve-
ments, and so on.
Well, within reason (because many have application fees), the more the
merrier. If she only applies to five, she may just get into one or two.
That’s okay, as long as she’s sure those are ones that she really likes.
But, between the time she submits applications and hears back from
schools, she may have changed her mind a little.
110 Tuition costs seem to be rising awfully fast. How much will
college cost in the years ahead?
You’re not imagining things. The cost of a college education has been
increasing faster than the rate of inflation lately. (The growth rate does
seem to finally be tapering off, though.) Here’s one set of estimates of
future costs, courtesy of The College Board:
First, get an idea of how much money you’re going to need and how
long you have until you need it. The table in the last Q&A should help
with that. Then you’ll have an idea of how much money you’re going
to need to save and how much you’ll need it to grow.
Start saving early — as early as possible. The more time your money has
to grow, the more it will grow. (In other words, to reach a certain dollar-
amount goal, by investing earlier you’ll have to invest fewer of your own
dollars.) Here are some scenarios to consider:
• Invest $2,000 per year beginning when your child is 8 and, if you
earn 11% annually, you’ll end up with $45,000 by the time he’s 18.
• Invest $5,000 per year beginning when your child is 10 (earning 11%
annually) and you’ll have more than $80,000 by the time he’s 18.
• Invest $3,000 per year in the stock market, from the time of your
child’s birth. If it grows at the market’s long-term average annual
rate of around 11% per year, by the time he’s ready for college, you’ll
have a little more than $140,000.
These are just rough guidelines. During the years that you’re investing,
the market might do significantly better or worse than average. In ad-
dition, if you’re investing in individual stocks instead of market index
funds, you’ll more certainly fare differently than the market average.
Companies selected carefully can do much better than average.
To help you figure out your own particular situation, take advantage of
online calculators that will do the math for you. You’ll just need to plug
in some numbers. Here’s where you’ll find some of these calculators:
• www.finaid.org/calculators
• www.salliemae.com/calculators
The longer the time period until you’ll need the money, the more risk
you can take. Here’s a typical set of guidelines that some financial plan-
ners might offer you:
• Birth to School Age: 100% growth stocks. You have more time,
• Age 6 to 13: You might want to think about making a few more “pru-
dent” selections. 70% stocks, 30% bonds.
• Age 14-18: You want things to continue to grow, but you also want
to protect yourself from market volatility. Consider 30% bonds, 20%
stocks, and 50% money market funds.
• College Age: You want to be able to access the money easily and not
have it drop in value. Consider putting the vast majority of it into
a safe, interest-bearing account like a money market fund. For funds
earmarked to be spent a year or two down the road, certificates of
deposit are a good idea.
113 Do you have any general tips regarding saving and plan-
ning for college?
114 My kid is very close to college age, and I’ve got very little
saved. What do you suggest?
Fret not. Junior isn’t doomed to a life of flipping burgers. There are
several things you can do to improve your situation.
For starters, Junior might delay going to college for one or more years. If
the idea of working for a bit right out of high school appeals to him, it can
be a smart move. Both he and you can save money for college as he works.
We offer more tips on this topic in Fooldom online, in step four of our
Paying for College collection at:
www.Fool.com/money/payingforcollege/payingforcollege.htm.
FAFSA stands for Free Application for Federal Financial Aid. If you’re
only going to bother with one financial aid form, this is the one to both-
er with. It’s required by all colleges that offer financial aid, and is
also mandatory for most federal student aid programs. For some fed-
eral plans, though, you’ll need to file additional forms. These excep-
tions include the Federal Family Education Loan, (FFEL), the Stafford
Loan, and the Direct or FFEL Plus Loan.
You can get FAFSA forms in the fall at your youngster’s high school.
However, you’re not to submit them until after January 1. (Aim to sub-
mit them just after January 1, as some funds are first-come, first-served.)
Get the form as early as you can, so that you can begin gathering the
required information.
Once you submit the forms, you’ll receive a Student Aid Report (SAR)
that should be checked for accuracy. It will state your “Expected Fam-
ily Contribution” (EFC), which is how much money you’re expected
to contribute toward your child’s education. The schools you apply to
will get copies of the results and will base some or all of their financial
aid decisions on the information it contains.
You can fill out the FAFSA form online, if you want. For details on how
and why you might do it, visit: www.fafsa.ed.gov
116 What other forms are there to fill out besides the FAFSA?
Well, the Financial Aid PROFILE form (formerly known as the “FAF”)
is required by some colleges. In addition, many colleges have their own
financial aid application forms. See what’s required at every school
your young one is applying to. (Or, better yet, have her check!)
The money to pay for all those biology books, dorm rooms, and late-
Here are some websites where you can look up scholarships that are
available:
• www.finaid.org/scholarships
• www.collegeboard.org/fundfinder/html/ssrchtop.html
• www.fastweb.com
• www.uncf.org (the United Negro College Fund)
• www.hispanicfund.org (the Hispanic College Fund)
• www.collegescholarships.com
• www.college-scholarships.com (this is different from the site above)
• http://search.cashe.com
And here are some (of countless) books on paying for college and the
In these few pages, we’ve only touched on the many facets of plan-
ning for college. Spend some time with the above resources and you’ll
learn a lot more. The more you learn, the more you’ll likely save.
Banking Foolishly
One way to save money is to eat lobster only twice a week,
instead of five times. Another way is to rent a movie to enjoy
at home instead of forking over half your paycheck to the
Googleplex down the road just to see one movie and enjoy a
medium tub of popcorn. You may not have realized, though,
that you can also save money by banking Foolishly. This
chapter will offer a few tips to help you rethink your bank-
ing habits.
119 Is this topic really such a big deal? Can’t I just focus on
investing?
If you minimize the money you spend on banking and maximize the
money you get from your bank, you’ll have more money to invest.
Banking is big business. Think of Las Vegas, with all its lights and
cheap buffets — it’s all subsidized by people losing lots of money, fork-
ing over chips and nickels endlessly. There’s a bit of a parallel there
to the banking world.
Drop in on many banking offices and you’ll see expensive marble and
fancy furnishings. Think about this for a second and you’ll realize that,
if the bank were trying to offer you the absolute best value, there would
probably be just a canvas tent with some folding chairs serving as your
local branch office.
95
That may seem extreme, but some new banks today are surpassing that
extreme, establishing banks in the ether, on the Internet only. We’ll
talk about them soon. Until then, consider that:
• According to a 1999 Bankrate.com survey, savings account interest
rates averaged a paltry 1.7%, compared to around 2% or more for
money market accounts and 4.4% for 6-month CDs.
• According to 1999 FDIC data, savings accounts are just about the
nation’s favorite place to park money, as they hold a whopping $1.61
trillion. Money market accounts, which offer higher rates, held just
$913 million — that’s only 1/1,763 of what savings accounts hold.
Jeepers!
• In 1997, as Congress considered “Fair ATM Fees” legislation, sen-
ators noted that the average American was spending $155 on ATM
fees each year, sometimes paying as much as $3 to withdraw $20.
Bankrate.com forecasts that consumers will pay $2 billion to use
ATMs in 2000.
121 Is there any place online where I can look up the locations
of surcharge-free ATMs?
There are several websites where you can search for the machines clos-
est to you. Here are some:
• www.surchargefreeatm.com
• www.theco-op.org/index-ns.html
• www.know-where.com/intercept
• www.sum-atm.com
Not necessarily. Banks are often coming up with ways to tease cus-
tomers into the front door. They may offer extra-low introductory
interest rates, or free checking, or a number of other things. In many
cases, some other fees or higher interest rates make up for the free
checking. When comparing banks, you need to closely examine all the
services you’ll be using.
123 How can I figure out how good or bad my bank is for me?
Banking Foolishly • 97
WHAT’S YOUR BANK COSTING YOU?
Fee Month 1 Month 2 Month 3
ATM surcharges
“Foreign” ATM fees
Other ATM fees
Overdraft fees
Monthly maintenance fees
Check printing fees
Deposit/other slips
Call center charges
Debit card fees
Low-balance penalties
Per-check charges
Return check/NSF fees
Money order fees
Traveler’s check fees
Other bank fees
Once you’re done, total everything and see how much of your money
is going to your bank. There’s a good chance that you’ll look at this
worksheet and gasp in unhappy surprise. If so, there are two things
you can do to improve the situation:
a. Make some changes in your behavior.
b. Make some changes in your banking — perhaps by changing
banks.
Different banks are best for different people for different reasons.
What’s best for you depends on what services you need and what your
habits are. Use the worksheet below to help you. Cross out any items
you don’t need, so that you focus only on what’s important to you.
Add any items relevant to you that aren’t on the list. (If you plan to
compare many banks, you might want to make a few photocopies of
this list first, or just reproduce it by hand on some note paper.)
This worksheet will help you explore your options, enabling you to
compare a bunch of contenders in one handy place. You’ll see that bank
charges for different things vary considerably. Prioritize the things that
are most important to you (the services you need most often, in the
order of their importance) and find the bank that charges the least for
those services.
Also, consider other providers for some services. Use a discount bro-
ker for brokerage services. Buy money orders at the local conven-
ience store rather than using pricey cashier’s checks. Use your AAA
membership to buy traveler’s checks there instead of at the bank.
Shop around for the lowest-cost credit card. These are just a few ways
to save.
Banking Foolishly • 99
125 When I’m checking out a bank, what questions should I
seek answers to?
126 What are some common mistakes that people make with
banking?
Many common mistakes result from not looking at the big picture, and
just focusing on one attractive aspect of a banking service.
Another big mistake is keeping too much money at your local bank,
especially in savings accounts and other accounts that pay paltry in-
For example, let’s say that Sonia has managed to save $6,000 in her sav-
ings account. (Way to go, Sonia!) She’s not yet ready to invest in stocks,
so she’s content earning a little interest. But, her savings account is
paying her just 1.75% per year. For $6,000, that amounts to just $105.
She should consider some other options.
If she assumes that she won’t need $2,000 of that money for at least
two years, she could park it in a 2-year CD earning, let’s say, 6.5%.
That will amount to $130 in the first year. If she won’t need another
$2,000 for at least one year, it could earn 6.25% in a 1-year CD, amount-
ing to $125 in the first year. She might park another $1,000 in a 3-
month CD (renewing it every quarter), earning 5% or $50. So, the
$5,000 she shuffled out of her savings account will bring her a total of
$305 that first year, instead of $105. Not bad! (Oh, and let’s not for-
get an additional $17.50 on the $1,000 still in her savings account.)
You’ll see both numbers used when banks advertise their offerings.
The APR is simply the rate of interest paid on something. The APY is
more informative for Fools, because it tells you what to expect from
the rate. They’re different because the APY takes into account how
often interest is applied.
Here’s a very rough and simplified example. Let’s say that an account
where you keep $10,000 pays you an APR of 6%. If the interest is com-
pounded/applied just once a year, you’d earn $600 at the end of the year.
But, most interest compounds much more often than once a year. Typ-
ically, it’s more like monthly, weekly, or daily. Let’s imagine that your
account compounds interest monthly. If so, at the end of the year you’ll
end up with more than $600. That’s because when the first month’s in-
terest was added (perhaps it was something in the neighborhood of
0.5%), you immediately had more than $10,000 in your account, after
just one month. And, more was added each month. So, each time the
The APY reflects how much your investment will grow over the whole
year. If you’re looking at two different accounts with the same APR,
they may reward you differently, according to how often the interest
is compounded. But, when you’re looking at APYs, you’ve got apples
and apples. If a bank is advertising something without disclosing its
APY, ask what it is.
Advantages
• They’re owned by their members, and are non-profit.
• They offer competitive interest rates, usually beating the best rates
from local banks.
• Their service is often better, too. If you turn to a traditional bank
for guidance, you might not be told everything you should know,
as that’s not always in the bank’s best interest. But, credit unions
have no reason not to help you as much as they can.
• Credit unions offer more and more services these days. Many offer
credit cards, debit cards, mortgages, new and used car loans, check-
ing, and more.
• At many credit unions, you need just $1 to open an account, qual-
ifying you to take advantage of their many services.
Disadvantages
• Credit unions typically have few branch offices and few, if any,
ATMs. To circumvent the ATM problem, many credit unions have
formed networks of surcharge-free ATMs that members can use.
• Not all are insured. The National Credit Union Administration in-
sures roughly 97% of credit union member deposits up to $100,000,
but a few credit unions remain uninsured. Before signing up with
a credit union, ensure that it’s insured.
• Some credit unions don’t return cancelled checks to you. But then,
these days, many traditional banks have stopped doing this, too.
Learn more about credit unions at the website of the Credit Union Na-
tional Association: www.cuna.org. That’s also where you can search
for credit unions in your neighborhood. Not everyone is eligible to
join one, but tens of millions of Americans are — so don’t assume you’re
out of luck. You may be able to join one through your employer, com-
munity, religious group, or some other association. If your employer
isn’t affiliated with a credit union, consider asking your benefits of-
fice to look into developing an affiliation.
There’s always Uncle Mort, who’ll be happy to keep your money for you
under his porch. But, he has raccoon problems, so he’s probably not your
best bet. You’re not out of luck, though. You can get many or all of your
banking needs serviced at places other than traditional banks.
Also, not everyone realizes it, but many brokerages today offer bank-
ing services. TD Waterhouse is one example. If you have a brokerage
account there, any money not invested in securities is “swept” regu-
larly into a money market account, where it will earn more than it
would at a bank. In addition, as these brokerages are also banks, you
can enjoy check-writing privileges, credit cards, electronic banking,
First, it goes by many names, such as: online banking, Internet bank-
ing, PC banking, home banking, and electronic banking.
Online banking permits you to pay bills online, transfer money be-
tween accounts, and access account information at any time. Anoth-
er perk is that if you use an Internet-only bank, you can access it wher-
ever you are. You can move from Anchorage to Tampa and not have to
change banks.
Since online banks don’t have all the expenses that traditional banks
do (such as marble columns and red carpets), they can typically offer
more-competitive interest rates. These days, as online banks try to at-
tract more customers, they’re frequently offering extra-special rates
and deals. Keep an eye out.
There are various degrees of online banking. You may have a tradi-
tional checking account at a traditional, hundred-year-old bank, but
if it offers some online services, you might find that you can begin
checking your account balances online. If so, you’ll be doing some on-
line banking. At the other end of the spectrum, you might move all
your money to an Internet-only bank, and take care of all your bank-
ing needs online. There’s a range of possibilities.
Online banking isn’t for everyone — yet. But it might be for you. Take
some time to research it a bit. You can read more on it at:
www.Fool.com/money/banking/online/one.htm.
The following sites will dazzle you with an array of very useful guid-
ance and lots of information on various banks and their offerings. These
include online and traditional banks.
• www.bankrate.com
• www.banking.about.com
• www.gomez.com
Of course. Use direct deposit with your paycheck. It saves time and
some banks will give you free checking if you use it.
Don’t order checks from your bank, which might charge as much as
$25 for 200 checks. You can get the same thing for a fraction of the
price through services such as www.currentchecks.com (800-204-2244)
or www.checksinthemail.com (877-397-1541). Many of these services
guarantee that your bank will accept their checks, since many banks
use the same companies for printing checks.
Living Below
Your Means
The title of this chapter might depress you, as you imagine
people scrimping and saving by taking baths together as a fam-
ily and making salads from lawn clippings. Fear not, though.
In the following pages you’ll stumble across many suggestions
that will help you save money fairly painlessly. Read through
them and act on the ones that appeal to you. Some are silly
and extreme, and others will make you wonder, “Why didn’t
I think of that?” You may even find that you enjoy saving
money in a few categories because you can spend more on
things that matter more to you. In addition, the more you save,
the more you can invest.
135 How much of a difference will all these tips really make?
They add up. If you save just $50 per month (only about $1.75 per day),
that will amount to $600 per year, and $6,000 in 10 years — nothing
to sneeze at.
Invest that same $50 each month, and you’ll do even better. If it grows
at the historical stock market average of about 11% per year, it’ll
amount to nearly $80,000 in 25 years. All that from a brown bag lunch
here, and some coupons clipped there.
So, take some time to read through this chapter — perhaps jotting
down or circling the tips that appeal most to you. You certainly don’t
107
have to act on all of them.
Dieting isn’t your only option. Here are a bunch of good ideas:
• Use coupons at the supermarket, or at least focus your purchases on
items that are on sale.
• Cook twice as much as you need, and freeze half. Then, when you
Obviously, opting for canned tuna now and then instead of Chilean sea
bass will save you a few pennies. But there are other possibilities, too:
• Take your own water to work instead of buying bottled water reg-
ularly. Better yet, encourage your employer to look into providing
filtered water for everyone.
• Take your own coffee to work, too, in a thermos.
• When you’re hungry for a snack, consider drinking a glass of water
first. That should decrease or even eliminate your hunger.
• Take brown-bag lunches to work. Leftovers from dinner the night
before make great lunches.
• Have friends over for dinner instead of going out to a restaurant.
Well, you can plan ahead and buy your cigarettes in cartons when
they’re on sale, rather than one pack at a time. But, you’ll save a lot
more money by quitting. Consider what the real cost of smoking is:
Imagine that you’re 35 years old, you smoke one pack a day, and each
pack costs you, on average, about $3. Multiply $3 by 365 days, and
you’re looking at an annual cost of $1,095.
Let’s see what would happen if you took this $1,095 and invested it in
the stock market, earning the historical average return of 11% per year.
In 30 years, you’d have $25,067. If you invested $1,095 in the market
each year for 30 years, you’d end up with a whopping $218,000. Yowza.
Madeline Houston
Three months, three weeks, four days, 11 hours, 8 min-
utes and 5 seconds. 3288 cigarettes not smoked, saving
$557.29. Life saved: 1 week, 4 days, 10 hours, 0 minutes.
Rebecca Wolfe
Ten months, two weeks, two days, 1 hour, 30 minutes and
58 seconds. 9601 cigarettes not smoked, saving $1,248.24.
Life saved: 4 weeks, 5 days, 8 hours, 5 minutes.
Imagine this future signature that might end your own posts:
Me
5 years, one month, one week, 1 day, 2 hours, 4 minutes
and 13 seconds. 56,406 cigarettes not smoked, saving
$7,344. Life saved: 24 weeks, 28 days, 1 hour, 9 minutes.
Well, for starters, you might stop giving your gerbils dollar bills to
chew on. There are many other profitable tweaks you can make to your
lifestyle, too. The long list below is just a beginning.
• Take stock of your common activities and note which ones cost you
One fun thing to do is to establish a family game night, where you just
play board and card games with each other. If you don’t have a fami-
ly, plan game nights with friends. Here are some other ideas:
• Have some regular reading time, when all of you read some books
or magazines or newspapers. It’s good for the kids and good for you.
And, it doesn’t cost much, either.
• Buy a family pass to the local zoo or amusement park, if you plan to
go there frequently.
• Spend time at public parks.
• This may sound off-the-wall, but if you have the space outside and
the interest, consider getting some chickens. It can be fun for the
kids, and you’ll have fresh eggs.
• Make your own baby food. In a food processor or blender, puree
canned fruits and vegetables (preferably separately) with a little
water or juice from the can. (Make sure you’re not using products
Do your holiday and birthday gift shopping throughout the year. You
may find some perfect presents at good prices four months away from
the gift-giving time, and that will save you from having to buy a less-
perfect, more-expensive gift later. Here are some more tips:
• Wrap gifts in the comics from your Sunday paper or aluminum foil.
• If you’re sending flowers to someone, contact a florist near them and
order a bouquet directly. This is usually considerably cheaper than
using a national service such as FTD. If you’re ordering flowers for
someone in a hospital far away, try calling the hospital gift shop
— they can often send a nice bouquet or plant to the patient up-
stairs for less than you’d pay ordering from a national florist.
• Some very special gifts can be quite affordable. Consider having a
T-shirt, mug, or calendar made for a friend or relative from a favorite
photo. Photos themselves make wonderful gifts. Grandparents, for
example, will likely treasure a collection of family photos more than
a new waffle iron.
• Make your own customized calendar gifts for others by buying a
calendar of the upcoming year and pasting your own photos over
the ones it comes with.
• For people who have everything, consider giving a gift to a chari-
ty in their name.
• Assemble a booklet of your favorite and most successful recipes
Care for the clothes you buy properly. Don’t, and you’ll end up with
things like pants shrunk too small to wear or your spiffy red socks
bleeding onto your nice new white shirt.
• When you’re ready to get rid of old clothing, donate it to an or-
ganization such as the Salvation Army or Goodwill, where you can
get an itemized receipt to file with your taxes. A pile of old cloth-
ing and shoes (not to mention other household goods) can represent
a small windfall in charitable tax deductions.
• Consider buying some clothes for your kids slightly too large. They’ll
likely quickly grow into them and will get to wear them a little bit
longer than if you’d bought something smaller.
• Seek out hand-me-down clothing for your younger children from
friends, neighbors, and relatives.
• Convert old t-shirts and pajamas into useful rags by cutting them up.
• Shop for clothes at the end of the season, when you’ll find the best
discounts. Parkas will often be cheaper in February than in No-
vember. (Of course, you might find some exceptional sale prices dur-
ing the season, as well.)
148 Where can I find even more handy tips for saving money?
There are lots of places. Here are a few online addresses to visit:
• www.cheapskatemonthly.com
• www.stretcher.com
There are a bunch of useful books you might read, as well. (Consid-
er getting them at your local library, though, instead of a bookstore!)
• The Complete Tightwad Gazette by Amy Dacyzyn
• The Wealthy Barber by David Chilton
• Your Money or Your Life by Joe Dominguez and Vicki Robin
• Getting a Life by Jacqueline Blix and David Heitmiller
• Living Cheaply with Style by Ernest Callenbach
• The More-With-Less Cookbook by Doris Longacre and Mary E.
Showalter
• The Complete Cheapskate by Mary Hunt
• Frugal Families: Making the Most of Your Hard Earned Money by
Jonni McCoy
• Penny Pinching 1999 by Lee Simmons and Barbara Simmons
• The Frugal Almanac by Melodie Moore
• The Best of Living Cheap News by Larry Roth
• Wealth on Minimal Wage by James W. Steamer
• The Millionaire Next Door: The Surprising Secrets of America’s
Wealthy by Thomas J. Stanley and William D. Danko
Last, but not least, drop by the Fool.com’s “Living Below Your Means”
discussion board, where our community of Fools is always coming
up with new ideas.
Well, I’m smarter than a doorknob, for sure, but I must confess that
most of these tips come from members of the Fool’s online communi-
ty. We’ve got thousands of folks hanging out on our discussion boards
online, where they ask and answer questions, share thoughts and tips,
and amuse each other.
Taxes
One of the main tax themes that we like to emphasize in
Fooldom is that taxes shouldn’t be attended to just in April. If
you want to minimize what you fork over to Uncle Sam, you
need to bone up a bit on tax issues and make some strategic
decisions throughout the year. This modest chapter offers up
just a few of the many tax issues about which you should be
aware. It closes with some pointers on where you can learn
even more.
150 Can you explain the tax process? How is the final amount
of tax I owe calculated?
It all begins with income — which, for most of us, is automatically re-
ported to the IRS. Our employers report what was paid to us as salary.
Our banks report interest we earned. Our brokerages report dividends
paid to us and stocks that we sold (for which we’ll need to calculate
our gains or losses). You may need to report additional income sources,
too — such as tips, gambling winnings, business income, rental in-
come, alimony income... or the million dollars you won on that DMV-
Castaway show after being locked up in a Department of Motor Ve-
hicles office for three months with a dozen strangers and a registration
to renew. (Just remember, we thought of it first.)
Total all your income for the year, and you’ll be looking at what’s called
your “gross income.” To this, you now make “adjustments.”
121
• Subtract whatever amount you contributed to qualifying IRA or
other retirement accounts.
• Subtract any alimony payments you made and any moving expenses
that qualify.
• If you’re self-employed, subtract half of the self-employment tax
you paid.
• Subtract any qualified student loan interest paid, and any medical
savings account deduction.
Once you’ve made all your adjustments, you’ll be left with a very im-
portant sum: your “adjusted gross income,” or AGI. The AGI is used
throughout your tax return — expect it to pop up all over the place
like the little critter in carnival “Whack-a-Mole” games. It’s used to
determine limitations on a number of tax issues, including exemptions,
deductible IRA contributions, and itemized deductions.
From your AGI, you now claim your exemptions and make your de-
ductions. You can take either an itemized deduction or a standard
deduction — whichever is greater. The standard deduction ranges
from about $3,500 to $7,000, depending on your filing status.
You’re entitled to one exemption for yourself, plus one each for your
spouse and/or dependents, if you have them. The exemption is a set
amount that you’re permitted to deduct from your income, reducing
the sum on which you’re taxed. Exemption levels are tied to inflation
and change from year to year, usually increasing.
Once you’ve taken your exemptions and deductions, you’re left with
your “taxable income.” It’s this number that determines your tax. (You
just flip to the tax charts, which tell you, for example, that if your tax-
able income is at least $35,300, but less than $35,350, and you are sin-
gle, your tax is $6,596.)
Sound simple enough? It is. Except that we’re not done yet. Although
you may think this is the total amount of tax that Uncle Sam would
like you to cough up, there are still a few steps to go.
You now take the tax due on your taxable income and subtract any
credits. Then you add any other taxes. Credits are usually for children,
the elderly, the disabled, adoptions, or foreign taxes paid. Other taxes
You’re not going to sit down and write a check for this amount, though,
because there’s one step left. Remember all that money withheld from
your paycheck every payday? Or the estimated tax payments you’ve
already made? Items like these are subtracted from your total tax, leav-
ing you with either a positive or negative number. If the number is
positive, it’s what you have to make a check out for. If it’s negative,
you can expect a tax refund in that amount.
Your marginal tax rate is the rate at which your last and your next dol-
lar of taxable income are taxed. It’s not the rate at which all your dol-
lars are taxed. It’s the maximum rate you’re paying on any of your dol-
lars of taxable income. If you’re single, for example, according to the
rules at the time of this writing, your marginal tax rate would be 15%,
28%, 31%, 36%, or 39.6%.
Remember that your marginal tax rate only deals with the specific tax
on your income. As you know, there are other taxes that you may have
to pay — such as self-employment taxes, alternative minimum tax, and
even penalty taxes on retirement plan distributions. There are also
credits that you may benefit from, such as the child tax credit, the de-
pendent care credit, or the education credits.
So, after the jumble of other taxes and credits, your marginal tax rate
may lose a bit of its importance. Which is why you’ll want to take a
peek at your effective tax rate. Your effective tax rate reveals the av-
erage rate of taxation for all your dollars. It’s your total tax obliga-
tion (including your income tax and any other additional taxes and/or
credits), divided by your total taxable income.
Taxes • 123
After all is said and done, it is very likely that your effective tax rate
will be higher or lower than your marginal rate.
Not exactly. The tax form you prepare and mail in isn’t the only one
you’re ever allowed to file for that year. After you’ve filed the regular
return, if you need to, you can file an amended return, via form
“1040X.” In fact, you can even amend an amended return. You’re per-
mitted to amend your return until three years have passed since the
date the original return was filed (or its due date). Also, if any of your
changes affect your adjusted gross income, you’ll probably want to
amend your state return, too. Contact your state tax department for
the appropriate forms.
For example, imagine that it’s the year 2039 and the rules regarding
amended return deadlines haven’t changed. A woman named Hester
files her return for the tax year 2038 on April 4, 2039 — 11 days be-
fore the filing deadline of April 15, 2039. She’ll have three years in
which to amend her return. The last day on which she can file an
amendment will be April 15, 2042, three years after the initial due date.
Taxes • 125
154 What documents do I need to keep after I’ve filed my re-
turn, and how long do I need to hang on to them?
Keep your copy of the tax return forever. You never know when it’ll
come in handy. Remember that, in many cases, the IRS destroys the
original returns after four or five years. It’s always best to have your
copy to fall back on.
Remember when you put that new roof on your rental property in
1987? Well, you’d better still have that receipt — and keep it with
receipts for the other improvements to that property for at least three
years after you sell it. In cases like this, it is very possible that you’ll
have records 10, 20, 25 years old or older. It’s not uncommon — if
you’re retaining your records appropriately.
Many people think so. It’s becoming more and more common for peo-
ple to use inexpensive software to prepare their tax returns. Now you
can even bypass the software and prepare returns on the Internet for
a modest fee. With these programs, you end up printing filled-out tax
forms, which you sign and then mail in, perhaps with a check attached.
There are, of course, some disadvantages. The main one is that you
have to trust the software, even though you’re still the one responsi-
ble for filing your return. There’s always a small chance that the soft-
ware caused an error — or that you provided an incorrect number and
generated the error yourself. (Of course, even manually prepared re-
turns may contain errors.)
Taxes • 127
Still, you might do well to at least try it once. Consider using it as a
crosscheck for yourself one year — fill out your return the old-fash-
ioned way, and then do it electronically. Compare the results and you’ll
get a much better feeling for how accurate and/or helpful the software
is. You can choose whether you want to file your original return or the
computer-generated one, and you’ll probably have an idea of which
approach you want to use the following year.
You can read more about available software at the company websites
— and, in many cases, you can get demo versions there as well. Keep
in mind that you can often prepare your return online without even
buying the software — by paying a fee online instead.
You can check out the main tax-preparation programs at these sites:
• www.turbotax.com
• www.taxcut.com
157 How much am I allowed to gain from the sale of stock be-
fore I must pay capital gains tax on it?
Uncle Sam’s hand is out as soon as you make your first dollar. How-
ever, you can offset some of the gain with any losses from sales of stock.
As of the time of this writing, there are two holding periods for cap-
Taxes • 129
ital assets sold on or after January 1, 1998. Assets held for a year or
less are considered short-term. Those held for more than one year are
considered long-term.
The difference can be enormous. If you hold a security for 12¹⁄₂ months
and then sell, you’ll likely pay just 20% tax on the gains. If you sell
after holding only 11¹⁄₂ months, though, you’ll be taxed at your or-
dinary income rate, which can be as high as 39.6%. So, you might pay
almost twice as much in taxes.
Beginning January 1, 2001, the maximum capital gains rates for assets
held more than five years are 8% and 18% (rather than 10% and 20%).
If you’re normally in the 28% (or higher) tax bracket, if you qualify,
your capital gains rate could be reduced from 20% to 18%. Likewise,
if you’re in the 15% tax bracket, your long-term capital gains rate could
fall as low as 8%. (Keep reading, though. As with most tax-related top-
ics, this isn’t as simple as it might appear. Sigh.)
The 18% rate only applies to assets with holding periods that begin
on or after January 1, 2001 — no sooner. Using simple math, you can
see that your long-term benefit will not kick in until 2006 at the ear-
liest — when you actually sell the qualifying asset and meet your more-
than-five-year holding period requirement.
For taxpayers in the 15% tax bracket, however, the five-year hold-
ing period begins on the date of actual purchase — and you are not re-
It’s a little more complicated than that. You’ll have to “net” long-term
gains and losses separately from short-term gains and losses. Then
you’ll net the long result with the short result. Consider this amus-
ing example from an article that Fool community member Peter The-
lander wrote on our website:
Long John Silver sold two stocks so far this year. Both were held for
more than a year, so they are long-term items. Long John had a gain
of $1,000 on his investment in BadCatch.com — an Internet startup sell-
ing trout and salmon online to unlucky fisherman — and a $600 loss
on Fish-R-Us — a retailer of fish-shaped toys for kids. Subtract the loss
from the gain and we find that he has a net $400 long-term gain.
Now, let’s say that he sells two more stocks before year-end. His in-
vestment in Mackerel Industries has turned out to be a real stinker.
So, he unloads it for a $300 short-term loss. And, Minnow, Inc. turned
a small short-term gain of $50. Net these two items together, and Long
John has a $250 short-term loss.
Finally, we net the short-term items with the long-term items and find
that Long John has a net $150 long-term gain.
160 What are the most common results when you’re netting
long-term and short-term capital gains and losses, and do
they all get the same treatment?
Here’s concise explanation from our online Tax Center, written by Peter
Thelander:
Taxes • 131
• Long-term gain with short-term gain
• Long-term loss with short-term gain
• Long-term gain with short-term loss
• Long-term loss with short-term loss
Whenever you place an order to buy or sell a security with your bro-
ker, there will be a “trade date” and “settlement date” recorded. The
trade date, which is the date that the order was executed, is the one that
counts for tax purposes. The settlement date is just the date when the
cash or securities from the transaction are plunked into your account.
You can only calculate your gain (or loss) once you sell the stock. First
you’ll need to figure out your “cost basis,” though. Let’s say you bought
100 shares of Excelsior Hair Growth Enterprises (ticker: SPROUT) at
$25 each, paying your broker a $20 commission. Your total cost was
$2,520 ($2,500 plus $20). That means your cost basis per share was
$25.20. If you sell 50 of the shares a little later at $30 each, the pro-
ceeds will be $1,500 less another $20 commission, for a total of $1,480,
or $29.60 per share. Therefore, your capital gain per share is $29.60
minus $25.20, or $4.40.
Once you’ve determined your gain, you need to figure out how long you
held the asset, to see if it will be taxed as a short-term or long-term gain.
Taxes • 133
that the distribution took place. Using your original cost basis in the
shares, you can now compute your loss.
Some brokerages will offer you a quicker alternative, buying all your
shares of the stock for a penny. They do it to help out their customers
and because, over time, some of the shares may actually be worth more
than the penny they paid for them.
By selling the shares, you have a closed transaction with the stock and
can declare a tax loss. Your friend, relative, or broker, for a pittance,
has just bought a place mat or birdcage liner.
It might seem that your son’s profit is just $10 per share, but our friends
at the IRS don’t see it that way. A recipient’s cost basis (and holding
period) for a gift of stock is the same as the donor’s. So, although your
son received the stock at $100 per share and held it just one month,
his cost basis is $50 per share, and his holding period is 13 months. He
The gift is not tax deductible by you, as it’s not a charitable contri-
bution. You’re currently allowed to give up to $10,000 to any person,
per year, tax-free.
Under the wash sale rules, if you sell a stock for a loss and buy it back
within 30 days, the loss cannot be claimed for tax purposes. Don’t
worry, though — the loss isn’t lost forever. You do get to claim it, just
not now. The disallowed loss is added to the cost of the repurchased
stock, and it’s claimed when the stock is finally disposed of in a non-
wash-sale way. You can avoid the rules entirely, though, by always
waiting 31 days before jumping back into any stock.
You must prove the cost of your shares when you sell them. If you can’t,
the IRS may not allow you a “cost basis” with which to reduce your
sale price and compute your gain on the shares. Your entire sales price
may end up subject to capital gain taxes. (Gulp!)
The broker’s records may be long gone now. But, if you purchased shares
directly from a company, it may have a record of the transaction. If not,
you might try to reconstruct a record by finding the canceled check
and the stock’s price when you bought it, to determine how many shares
you originally bought. Document your process in case Uncle Sammy
wants to have a discussion (read: audit) with you about it. If your ar-
guments and analysis seem reasonable, you may be fine.
Taxes • 135
Ideally, though, always hang on to your purchase records of stock,
property, and other assets.
Since this is such a big tax break, make sure you plan your home sale
carefully to ensure that you qualify. This includes living in it for the
required amount of time. Proper planning can save tens of thousands
of tax dollars. Improper planning can cost you just as much.
168 Are there any special year-end tax tips you can offer?
One thing you can do is take advantage of your credit card. If you
Expenses are only deductible in the year in which they’re actually paid
(or, in the case of credit cards, charged). Checks should be dated and
mailed in the year that you claim the deduction. When they clear the
bank doesn’t matter.
Taxes • 137
tions and getting answers 24 hours a day.
• The Fool also offers tax advice in print, in the form of our book, The
Motley Fool Investment Tax Guide.
Retirement
Retirement is a topic that bridges the personal finance and in-
vesting sections of this book. It’s hard to reach a comfortable
retirement without having engaged in some savvy investing.
The second part of this book will help you tackle many in-
vesting topics. In the meantime, this short chapter will give
you a little perspective on some issues to consider as you plan
for retirement.
170 How can I figure out how much I need to save and invest
for my retirement?
139
bonds and you’re expecting it to grow 20% per year, you’ll prob-
ably end up with a nasty surprise.)
6. What’s your risk tolerance? Are you comfortable investing your
long-term money in stocks? Stocks are riskier than bonds, but
offer the chance of higher returns.
These are just some of the considerations you’ll need to ponder. Once
you’ve thought about them for a bit, spend some time reading up on
retirement issues and perhaps plugging some numbers into online
retirement calculators.
Consider this scenario from Dave Braze, the Fool’s retirement expert:
So, what’s the answer? There’s one solution that might work. It’s called
asset allocation.
You’ve got three main options when it comes to parking your moolah:
stocks, bonds, and cash. The theory is that when one market seg-
ment is down, another may be up, and vice versa. So, by dividing your
money (not necessarily in equal parts) among all three segments, you
shouldn’t see all your money shrink at once. You’ll have decreased your
downside risk, while still maintaining some upside risk.
How much money should you have in each category? Well, one age-
old guideline recommended that you should subtract your age from
100 and devote that portion to stocks. Therefore, a 50-year-old would
have 50% of her portfolio in stocks and a 70-year-old only 30%. As
people started living longer, the number to subtract from became 110.
This isn’t a baseless approach, but it’s wrong to assume that we’re
all alike in everything except age. This rule’s results won’t be right
for everyone. It’s best to take some time and assess your particular sit-
uation carefully, to determine the right allocation mix — one that
should generate the income and portfolio growth required for the rest
of your life.
Retirement • 141
A helpful way to approach the problem is to jot down how much you
have, how much you want to withdraw each year, how quickly you
expect your nest egg to grow invested in your various options, and
how long your money needs to last. The stock market, on average over
the past few decades, has gained about 11% or so annually. Meanwhile,
fairly conservative bonds have offered between 3% and 6% annual-
ly, while in real terms cash can actually lose value over time if it does
not outperform the rate of inflation.
This is a critical question. You want to live comfortably, but not so com-
fortably now that you end up eating government surplus cheese in
your last years.
Many formulas will help you plan, but they rely on average rates of re-
turn and inflation. Over the long term, an average rate should work,
especially when you’re still saving for retirement. Unfortunately, ac-
tual year-to-year results won’t be the same as the average and, for re-
tirees in some time periods, those yearly variations may prove devas-
tating. In other words, one 15-year period might average a 14% annual
return, while another 15-year period might average just 2%. The longer
the time period you’re dealing with, the less the overall average re-
turn rate should fluctuate.
You can read more about the Trinity professors’ study here:
• www.scottburns.com/wwtrinity.htm
• www.Fool.com/retirement (check out the “Managing Retirement”
section)
Retirement • 143
174 What is an IRA?
A new option, introduced in 1997, is the Roth IRA, which works a lit-
tle differently and offers different benefits.
Many hail the Roth IRA as the greatest tax break ever invented, but
there are some important issues to consider before jumping on board.
Like other IRAs, the Roth allows you to accumulate funds for retire-
ment and to enjoy some tax advantages at the same time. While tra-
ditional IRAs are tax-deferred, Roth IRAs are designed to be tax-ex-
empt. Traditional IRAs permit you to contribute pre-tax dollars; Roth
IRAs accept only already-taxed dollars.
Let’s say you’re 35 years old and you invest $2,000 of your post-tax in-
come into a Roth IRA each year, starting today. You earn a 12% annual
return for the next 30 years until you retire at 65. By then, your con-
tributions would have grown to about $600,000. With a Roth, that’s
your take-home pay. With a regular IRA, you would pay taxes on any
withdrawals, netting just $510,000, assuming a 15% tax bracket dur-
ing retirement, or merely $432,000 if you are still in the 28% brack-
et. So far, this is very convincing. But, remember that if the $2,000 had
The Roth IRA isn’t an unequivocal godsend. It makes the most sense
if you’ve maxed out all your other tax-deferred options, such as your
401(k). There are more benefits and limitations to consider before you
decide whether the Roth is for you. You can get details on these from
your local tax professional, from the IRS at 800-829-1040, and also at
Fooldom online (www.Fool.com/taxes).
176 Can IRAs hold investments other than mutual funds, such
as individual stocks?
Retirement • 145
177 If my IRA is invested in mutual funds and I want to shift
that into an index fund or stocks, can I do that?
If your IRA is with a mutual fund family, you can probably switch be-
tween its own funds with minimal charge. You might pay steeper fees
to switch to other funds, and may not be permitted to invest in indi-
vidual stocks at all.
The only time it might not be so great is if the matching money is going
into something you’re not comfortable with. If it’s going into stock in
the company, and you’re very uncomfortable about the company’s fu-
ture, then perhaps you’re getting a 50% return that will soon become
a 0% return. That’s an extreme example, though. And, even in that case,
the money that you socked away can be in a safer place, growing.
Keep emergency money separate. Invest only what you don’t ex-
pect to need for at least five years. (Note: There’s a penalty on with-
drawals before age 59¹⁄₂ ).
Retirement • 147
If your employer matches your contributions to any degree, take full
advantage of the available matching — it’s free money.
Stocks might be scary but, over the long run, they perform best, by
far. Unfortunately, more than two-thirds of 401(k) money is in low-
yielding bond or money market funds, where it grows very slowly.
Your best stock-fund bet is a stock market index fund, which con-
tinually beats the majority of mutual funds and has lower annual fees,
to boot. If your 401(k) plan doesn’t include such a fund as an option,
urge your payroll professional to have one added. Every 401(k) plan
in the nation should include a stock market index fund.
Leave your money in the plan for as long as possible. This delays the
ultimate tax bite and permits maximum growth. Don’t borrow from
your account unless it’s an emergency.
181 I see you prefer index funds to all other mutual funds. But,
there’s no index fund among the funds I can invest in
through my 401(k) plan. Am I stuck?
Well, given the concerns about whether and when Social Security
funds will run out and how the program might be changed, it’s not en-
tirely unreasonable to think of it as Social Insecurity. Nevertheless, the
program currently remains intact, and you’d be smart to look into what
you might expect from it in retirement.
Even if you’re not too close to retiring, you can get a record of your So-
cial Security earnings history detailed year-by-year, as well as esti-
mates of the benefits that you may qualify for, now or later. You’ll sim-
ply need to fill out Form SSA-7004, which also goes by the name
“Request for Social Security Statement.” You can access an electronic
version of this form online at the SSA website, or you can call the SSA
at 800-772-1213.
183 What are some resources for learning more about retire-
ment issues?
Retirement • 149
CHAPTER ELEVEN
ANSWERS TO YOUR QUESTIONS ABOUT
Divesting—
Giving to Charity
If you manage your finances well and invest successfully, you’ll
be on track to enjoy a comfortable retirement. If you start early
enough and raise your children to be savvy about money and
investing, they’ll likely be financially independent for the rest
of their lives. This is all the more reason to look into how you
can best give some of your wealth away to those less fortunate.
151
er all the non-monetary gifts you could give. You might volunteer,
for example. Or donate things such as used clothing, computers,
and cars to charities that can use them. (If you do, make sure to
get a receipt for tax purposes.)
• Don’t give money to some organization that cold-calls you. Always
investigate them first. There are many hucksters out there calling
people and wheedling donations out of them. Some shifty outfits
beg for donations of cars, too.
• If you end up donating your car to an enterprise that isn’t formally tax-
exempt (qualifying under IRS section 501(c)(3)), your deduction won’t
be valid. So, look into how legitimate a charity is before giving away
your clunker. Also, it’s up to you, the donor, to place a value on the ve-
hicle. You want it to be accurate, so you might look it up in the Kelly
Blue Book at the time of donation. (Look it up many months later, and
the vehicle will probably be worth less.) If it’s worth more than $500,
you’ll have to file an additional tax form Form 8283. If it’s worth more
than $5,000, you’ll need to include a qualified written appraisal.
• If you donate $250 or more to any charity, you’ll need to receive and
keep a receipt for tax purposes.
• Keep records of your donations. If you fail to do this, you might end
up at year end totaling donations in your check register and real-
izing that you gave to some organizations much more often than you
thought you did.
• Realize that “tax-exempt” is not the same as “tax-deductible.” A tax-
exempt organization doesn’t have to pay taxes. But, donations to it
may still not be tax-deductible. You can ask to see a copy of a char-
ity’s tax-exemption paperwork, and some proof that deductions
are tax-deductible.
185 What should I look for in a charity and how should I evalu-
ate one?
First, learn what exactly it does with the donations it receives. What
problems is it addressing, and how does it aim to solve or lessen them?
If possible, learn about the successes the organization has had in the
past and the lessons it’s gleaned from mistakes. Find out what plans
it has for the future — what are its goals, its new initiatives?
Examine its financial record. Ideally, the charity will have a website
In addition, you can dig deeper. Even if an organization says that 75%
of its income goes toward its good works, see if you can get an itemized
breakdown of that. The organization might be including a sheet of ed-
ucational facts in its fund-raising mailings, and counting that as program
work instead of marketing. A term to look out for is “public education”
— that’s often used for items that are essentially fund-raising in nature.
Ask for or look up the organization’s most recent annual report and
IRS Form 990 filing. These should offer important details about where
money comes from and goes. Inquire whether the charity is registered
with federal, state, or local authorities.
You can look up the charity’s record with one or more of the watch-
dog organizations that evaluate charities. You might also contact the
Better Business Bureau or the local Attorney General’s office, to see
if there have been any complaints about the organization.
If they’re evading questions you ask, that’s also a bad sign. If they’ve
called you, ask for some printed material or their web address. If they’re
not forthcoming, and insist on communicating by phone, again this is
not auspicious.
Sometimes you’ll get called and asked for donations to a charity you
know well. You might still be careful, though. Sometimes these or-
ganizations hire telemarketing companies to raise money, in which case
the telemarketers might be taking a third or more of whatever you do-
nate for themselves, before passing on what’s left to the charity. Ouch.
If you’re suspicious about a call, you might hang up and then look up the
charity’s number separately. Call and ask whether they authorized the call.
188 Can you tell me about the merits of giving stock instead of
cash to charity?
The tax advantages can make donating stock instead of cash very
worthwhile. Here’s how it works, if you’re ready to donate stock.
First, note whether you’ve held the stock for one year or less (short-
term), or for more than a year (long-term). Then, figure out its fair mar-
ket value (FMV). This is what you would receive from the sale of the
stock on the day you make the charitable contribution. It doesn’t mean
you have to sell the stock then — just figure out its value on that date.
With stock held for the short-term, you can claim as a contribution
and deduct the FMV less the amount it has appreciated since you’ve
held it. In most cases, this means that your deduction is basically your
initial cost basis for the stock. So, stock bought for $800, held for the
short-term, and donated when it’s worth $1,000 amounts to an $800
charitable deduction.
If the sale of the stock on the day of the contribution would result in
a long-term capital gain, you can generally deduct the full FMV of
the stock. For example, if you’ve held 150 shares for more than one
year and they’re worth $10 each on the day you donate them, you can
probably deduct $1,500.
Your main decision is whether to sell the stock and donate the pro-
For the most part, yes, very much so. You just want to make sure be-
fore you send any confidential information through a website that
it’s using some sort of secure encryption. You can usually tell with most
web browsers, because there will be a little icon that changes, such
as an unlocked padlock suddenly becoming a locked padlock, or a bro-
ken key becoming a whole key.
Take some time to poke around the website first. There will likely be
a link to information on its security technology, or perhaps the secu-
rity issue will be tackled in a “Frequently Asked Questions” document.
Oh, yes! For several years running, we’ve held online annual charity
drives — with our readers and the company together contributing
more than a million dollars to fight hunger, poverty, and disease.
Foolanthropy expects.
Foolish charities are not paternalistic. When possible, they don’t give
expecting nothing in return. Instead, they aim to confer a sense of
ownership on those whom they serve, expecting beneficiaries to be
participate in their own assistance. They foster a sense of personal
responsibility.
Participatory relief:
• www.habitat.org
• www.secondharvest.org
There are a bunch of clever new websites which collect large sums
of money for great causes in innovative ways. Some of the best ex-
amples are:
• www.thehungersite.com
• www.therainforestsite.com
• http://rainforest.care2.com
At these sites, you simply click on a button and a few cups of food will
be delivered to a hungry person, or a few square feet of the rainfor-
est will be saved. You send no money — it’s all paid for by advertisers.
All they want is for you to click one button with your mouse, after
which you’ll see a few small ads. (You’ll make their day by clicking on
and investigating any of the ads, but that’s not required.)
You can also look into donating some of your expertise to causes you
care about. Perhaps you can help a small organization build a database
or create a website. Maybe you’re a marketing maven with some fund-
raising advice to share.
Death, Funerals,
& Estate Planning
This is a dreary topic, but if you want to be financially re-
sponsible to yourself and your loved ones, it needs your atten-
tion. Consider that, after your home and vehicle, a funeral is
likely to be your next most-costly expense. It doesn’t have to
be, though, if you’re informed and prepared. Similarly, estate
planning is something we often fail to attend to, and our sur-
vivors suffer for it. A failure to plan and prepare can cost your
loved ones much stress, time, and even hundreds of thousands
of dollars. This chapter offers many useful tips on funerals, but
it just scratches the surface of the estate-planning iceberg.
161
If you’re thinking to yourself, “Jeepers… that includes just about
everyone,” you’re right.
Many things:
• It lets you designate who will inherit which of your assets.
• It lets you name a guardian for your children and an executor of
your estate. (The executor can be an individual you know or a trust
company.)
• It lets you specify when your children will receive what. Otherwise,
an 18-year-old may end up receiving his entire inheritance before
he’s mature enough to keep from spending it all on stereos and cars.
• It lets you save money by waiving the probate bond, which will oth-
erwise be required.
• It can let you authorize the sale of some of your assets during pro-
bate administration. This can be important, because sometimes such
a sale is necessary to raise money needed to pay taxes and expens-
es related to death.
• It can permit your business to continue operating.
• It can save you some money in taxes.
“Probate is a legal process that takes place after someone dies. It in-
cludes:
• Proving in court that a deceased person’s will is valid (usually a rou-
tine matter)
• Identifying and inventorying the deceased person’s property
• Having the property appraised
• Paying debts and taxes, and
• Distributing the remaining property as the will directs.”
There are many ways to avoid probate, and you’d be best served by
reading up on the topic and then consulting a professional. In brief,
though, one way to avoid probate is through a living trust or a life
estate trust. With a trust, you’re actually formally transferring the title
of various properties to your heirs before you die. You retain control
over it while you’re alive, but it technically belongs to the trust. Once
you die, a trustee passes it on to your specified heirs. This tends to
be a fairly quick and simple process.
It’s a state that you don’t want to die in. Dying intestate means that
you’ve passed on to the great beyond without leaving behind a will or
trust. In such cases, your friendly state government takes over and fol-
lows strict procedures. You might have preferred to leave everything
to certain relatives, but the state will follow prescribed inheritance for-
mulas. These formulas are designed to do what’s right for the average
person, but they’re not always right for every person.
Dying intestate often means that, not only does your estate end up
in probate, but it may spend years there, as various heirs litigate. This
is clearly an undesirable situation (unless you never really liked your
family). To make matters worse, probate proceedings are usually a mat-
ter of public record, so any family fighting may become a matter of
public knowledge. Yuck.
And books:
• J.K. Lasser’s Estate Planning for Baby Boomers and Retirees: A Com-
prehensive Guide to Estate Planning by Stewart H. Welch
• Plan Your Estate: Absolutely Everything You Need to Know to Protect
Your Loved Ones by Denis Clifford, Cora Jordan
• Pass It on: A Practical Approach to the Fears and Facts of Planning
Your Estate by Nancy Randolph Greenway and Barbara J. Shotwell
• The Complete Book of Wills, Estates & Trusts by Alexander A. Bove
• The Complete Idiot’s Guide to Wills and Estates by Stephen M. Maple
• The Artful Dodger’s Guide to Planning Your Estate by Thomas Hart
Hawley
• Death & Taxes: The Complete Guide to Family Inheritance Planning
by Randell C. Doane and Rebecca G. Doane
The downside, and a reason to think twice before plunking down pre-
need money, is that it tends to be a lot of money. And, it could be
Websites:
• www.xroads.com/~funerals
• www.talks.com/library/nd100198.html
• www.clearfieldshops.com/chmc/preplan.html
• www.post-gazette.com/regionstate/19990525deathplanning2.asp
Books:
• Before It’s Too Late — Don’t Leave Your Loved Ones Unprepared by
Sue L. Thompson and Emily J. Oishi
• In the Checklist of Life: A Working Book to Help You Live & Leave
This Life! by Lynn McPhelimy
• At Journey’s End: The Complete Guide to Funerals and Funeral Plan-
ning by Abdullah Fatteh with Naaz Fatteh
You can save them a lot of trouble by putting down in writing for them
the following information:
• Your financial portfolios: List what you own and specify names of
brokerages or institutions and account numbers. If your spouse isn’t
a joint owner, you can simplify estate issues by making him or her
a co-owner.
• Details on bank accounts and safety deposit boxes.
If you fear that your survivors (likely your children) won’t agree on
who gets what when you’re gone, you can elect to be very specific in
your will. Alternatively, you might have some family discussions and
decide together who gets what. Make a list of family valuables and
heirlooms and come to a mutual agreement regarding who gets what.
On a less financial note, there are some things you can do now that will
probably make your family and descendents very happy:
• Preserve your life story. Take some time to write down the story of
your life. You might fill a notebook with it or type it into a word
processor. You can also record it on audiocassettes or a videocassette.
• If you’re one of the few people who can put names to faces in old
photographs, take some time to label these photos.
• Buy or rent a video recorder and record at least several hours of your
family talking and sharing. One day one or more of you will be gone
and the tape(s) will be treasured. (Camcorders aren’t just for filming
babies — they great for filming grandma, too!)
This is a great question. You can save a lot of money if you do a little
research. Over the last few years, the death-care industry has become
dominated by a few companies that buy local funeral homes. (You may
not realize it, but your local funeral home may be owned by one of
these giants.) As competition has decreased, prices have increased.
Of course, this isn’t all that’s involved. It’s just what a funeral director
would typically be involved in. Here are some additional expenses:
Possible Additional Expenses Estimated Cost
Cemetery plot $500 to several thousand dollars
$350 to $1,500, depending on the
Opening and closing the grave
time and day of the week
Headstones, statues, or markers $500 to several thousand dollars
Consider it. It’s a lot less costly than traditional burials, and is more
One benefit is that you (or your loved one) won’t end up in a cemetery,
but instead the remains can be buried or scattered in places that have
special meaning, such as your church’s memorial garden or a favorite
mountain.
This is a wonderful and vital thing to do. You or a loved one might
be gone, but by donating organs and tissues, something good can re-
sult from the death. Someone with a desperate need for a heart, or
cornea, or liver (among many things) can have a dream come true. In
many cases, it’s an actual matter of life or death. There are long lists of
critically ill people waiting for organs, and there aren’t enough organs
to go around.
• Acceptable donors range in age from newborns to senior citizens.
• If you want to donate your organs, you’ll need to: (a) indicate that
on your driver’s license, (b) carry an organ donor card, and (c) tell
your family. Informing your family of your wishes is vital, because
sometimes there can be confusion at the time of death.
A final option you might consider is donating your entire body to sci-
ence. There are several benefits to total body donation. For starters,
it can lead to medical progress. At the very least, a body can be used
to train future doctors. It can also be used in research. Both healthy
and sick bodies can be used. Another benefit is financial. By donating
a body, there’s usually no need to buy a casket or cemetery plot, or
to pay for cremation. Some schools or institutions will cremate or bury
the body for you after the research is concluded. If you’re interested
in donating your body to a particular institution, contact it.
210 Where can I learn more about planning for funerals and
death?
Websites:
• www.funerals.org
• www.nfda.org/resources/index.html
• www.efmoody.com/miscellaneous/funeral.html
• www.dragonet.com/funeral/index2.htm
• www.cremation.org
• www.webcaskets.com
• www.discountcasket.com/headlines.html
Books:
• Profits of Death: An Insider Exposes the Death Care Industries by
Darryl J. Roberts
• The Affordable Funeral: Going in Style, Not in Debt: A Consumer’s
Guide to Funeral Arrangements & the Funeral Industry by R. E.
Markin
• Before It’s Too Late — Don’t Leave Your Loved Ones Unprepared by
Sue L. Thompson and Emily J. Oishi
• In the Checklist of Life: A Working Book to Help You Live & Leave
This Life! by Lynn McPhelimy
• At Journey’s End: The Complete Guide to Funerals and Funeral Plan-
ning by Abdullah Fatteh with Naaz Fatteh
• Final Celebrations: A Guide for Personal and Family Funeral Plan-
ning by Kathleen Sublette and Martin Flagg
• Dealing Creatively With Death: A Manual of Death Education and
Simple Burial by Ernest Morgan
• Coming to Rest: A Guide to Caring for Our Own Dead, an Alternative
to the Commercial Funeral by Julie Wiskind and Richard Spiegel
Investing
CHAPTER THIRTEEN
ANSWERS TO YOUR QUESTIONS ABOUT
The Basics
Once you have your personal finance house in order, it’s time
to think about investing. Part One of this book is focused on
helping you minimize how much you spend and maximize
your savings. Part Two aims to help you increase your wealth.
177
It’s hard for me to avoid steering you to Fool.com, as that’s where you’ll
find a wealth of educational fare, all written in an easy-to-understand
style and with a sense of humor. (We don’t want people nodding off
mid-article, you see.) Other good ways to learn about investing and
the business world are through books and magazines. Start with a book
or two by Peter Lynch (a former superstar Fidelity mutual fund man-
ager) and/or by David and Tom Gardner, Fool co-founders.
Preferred stock isn’t really for individual investors, though. The shares
are usually purchased by other corporations, which are attracted by
the dividends that give them income taxed at a lower rate. Corpora-
tions also like the fact that preferred stockholders’ claims on compa-
ny earnings and assets have a higher priority than those of common
stockholders. Imagine that the One-Legged Chair Co. (ticker: WOOPS)
goes out of business. Many people or firms with claims on the com-
pany will want their due. Creditors will be paid before preferred stock-
holders, but preferred stockholders have a higher priority than com-
mon stockholders.
Sometimes a company will “call” its bond, paying back the principal
early. All bonds specify whether and how soon they can be called. Fed-
Once issued, bonds can be traded among investors, with their prices
rising and falling in reaction to changing interest rates. For example,
when rates fall, people bid up bond prices. If banks are offering 6%,
an 8% bond starts looking good.
Stocks outperform bonds even when you eliminate the 19th century
data. According to Ibbotson & Associates, from 1926 to 1996 (notice
that includes the Great Depression years), U.S. Treasury bills returned
an average of 3.7% per year, compared with 5.6% for long-term cor-
porate bonds, 10.7% for large-company stocks, and 12.6% for small-
company stocks. If you had invested $5,000 in T-bills 50 years ago, it
would now be worth $30,754. Growing at 10.7% in stocks, it would
be worth $806,030.
For long-term investors, stocks offer the best potential for growth. Still,
it’s smart to understand how bonds work before you dismiss them.
Most people are familiar with zero coupon bonds in the form of U.S.
Savings Bonds. You buy them at a discount to the face value, hold them
for a specified time period, and then cash them in at face value. In a
nutshell, that’s how zero coupon bonds (or “zeroes”) work.
With a zero coupon bond, you don’t receive any interest payments,
but the amount you lend is smaller than the amount you’ll receive at
maturity. Thus, a zero coupon bond could pay you the equivalent of
5% per year by having you pay $6,139 today to receive $10,000 in
10 years.
Bonds come with a variety of maturity periods. The long bond is the
U.S. government’s 30-year bond. Its yield is the one often cited by
the media when interest rates are being discussed. Treasury notes
are shorter-term, maturing in two, five, or ten years. Treasury bills (or
T-bills) mature in 13, 26, or 52 weeks. The minimum purchase amount
for most of these instruments is $1,000.
Yes, it does have some risk. Shares of stock are valued based on the
value of the companies that issued them. If you buy stock in the Whoa
Nellie Brake Co. (ticker: HALTT) and it declares bankruptcy, you’re
probably going to lose money. Most well-known companies don’t sud-
denly go out of business, though. (Think of Coca-Cola, IBM, Wal-Mart,
and the like.) Look at a graph of the stock market average over many
years and you’ll see that it’s a zig-zaggy line. The zigging and zag-
ging is volatility, and those downward zags can create risk. But step
back and look at the graph and you’ll see that the jagged line slopes
upward over the long haul. Despite the risk, it gradually gains in value.
The longer your investing horizon, the more likely the stock market
is to rise, and the less risk there is of losing money. In the short term,
anything can happen — including market corrections and crashes.
One or all of your holdings could fall by 20% tomorrow. If you’re
holding on for years, you can ride out downturns. If you plan to sell
in 15 or 20 years, what happens this year isn’t a big risk to you.
• Increase your knowledge. The more you know, the less chance you
have of making mistakes. Too many people buy companies merely
on “hot” stock tips from friends or strangers. Sometimes they don’t
even know what the company does.
• Learn about investing. Read all you can. Start with books by Peter
Lynch. Read Berkshire Hathaway Chairman Warren Buffett’s let-
By reducing your risk, you’ll increase your chances of doing very well.
Imagine that you buy 100 shares of International Alphabet Corp. (tick-
er: ABCDE) for $50 per share. You spend $5,000 total (plus perhaps $12
commission to your discount broker). Let’s say that ABCDE is paying
a $2 per share dividend when you buy it. That means that as long as
you hold on to your shares, you’ll be paid $2 for each share annually
— that’s $200 per year. Over time, companies typically increase their
dividends. So 10 years from now, you might be receiving $5 per share,
or $500 per year. Each year that you hold the stock, you’ll be paid a
dividend. Not every company pays a dividend. This is fine — some
companies are growing quickly and need that money, and they may
more than make it up to you via price appreciation.
Let’s look at price appreciation now. Recall that you bought your shares
of International Alphabet for $50 per share. Well, 10 years from now
they may be trading at $130 per share (that’s about 10% growth per
year). If so, then they would be worth $13,000. You spent $5,000 for
them originally, so if you were to sell, you’d make a profit of $8,000 (on
which you’d pay capital gains tax). And if there had been dividend
payments all along, that’s icing on the cake.
Don’t let the 100% loss possibility frighten you too much, though. If
you’re researching companies before investing, selecting financially
healthy firms with track records of growth, and are keeping up with
their developments, you’re unlikely to lose large chunks of your in-
vestment. Remember also that losses only occur when you sell. Even
good companies go through occasional slumps, so it’s often best to pa-
tiently ride them out.
Investing isn’t like gambling; you’re not playing against the house. Out
in Las Vegas, if you lose a bet that money goes right into casino cof-
fers. But, on Wall Street, when a company’s stock price declines, no-
body necessarily directly benefits from the loss. Let’s say you own
shares of the Velvet Elvis Art Factory Inc. (ticker: KINGG). If the stock
drops 20% one day, you haven’t technically lost any money — un-
less you sell the stock. You still have the same number of shares you
owned yesterday. The shares are each worth a little less today, though.
When a stock tumbles, its value isn’t redistributed. It merely shrinks.
That said, there are people who profit when certain stocks fall. These
folks do something called “shorting” a stock, where they profit if a
stock price drops. Shorting will be discussed later in this book.
Instead, take the time to learn how to evaluate companies. Learn how
to read financial statements. Assess P/E ratios along with many other
numbers. Read widely about companies that interest you, ideally in
industries that you’re familiar with and would enjoy keeping up with.
In the rest of this book, you’ll come across many things to consider
when evaluating a company. You’ll also be pointed to many resources
(check the resources in the Appendix, too).
The more you learn, the better your investment decisions and per-
formance are likely to be.
It’s not just you. At Fool HQ, we often shake our heads in bemusement
at reporters who exclaim, “The Dow was up 100 points today!” We’re
dismayed because the media usually refers to market moves in points,
when it’s the percentages that really matter.
For much of 2000, the Dow Jones Industrial Average (which compris-
es the stocks of 30 blue-chip companies) hovered around 10,000. On
March 16, it rocketed up 499 points, which was a 5% move. Com-
pare this with 1987, though, when the Dow stood around 2,247 be-
fore plunging 508 points in a single day. That represented a whopping
23% move. As the Dow heads into ever-higher territory in the future,
500-point drops or pops will become more common and less mean-
ingful. Be prepared for bigger numbers, too. When the Dow is at 20,000,
a 5% rise or fall will mean 1,000 points.
Stock prices are listed in dollars per share. They’re not always in whole
numbers, though. The world of stock prices is full of fractions, all the way
down to 64ths, and occasionally even smaller. So, if the film-editing firm
Splice Girls Inc. (ticker: SPLIC) is listed at 28, that means it last traded at
$28 per share. Similarly, 15 17/32 means 15.53125 or $15.53 per share.
(The stock market is in the process of switching from fractions to deci-
mals, but the decimals will still reflect prices per share in dollars.)
Imagine that shares of Spackle World (ticker: SPACK) close around $30
each at the end of trading one day. Then Spackle announces that it has
recently experienced amazing growth in sales and that it expects to
report record earnings next month. All of a sudden, there may be a
surge in demand for Spackle World shares. The very next shares to
trade may go for $35 each or more. The price won’t necessarily inch
its way up.
Similarly, if Spackle World announces that it’s going to file for bank-
ruptcy, then there will likely be many more sellers than buyers, and the
price will quickly drop considerably lower. If the stock is immediately
perceived to be worth just pennies per share, it’s not going to sell for $29
per share, then $28, then $27, etc. It’ll immediately be worth a lot less.
It’s all a balance between supply and demand, between what people
are willing to pay or accept.
As a stock is sold off, its price falls. While those who are selling don’t
want to own it at the current price, there are always others who think
differently, seeing it as a bargain. Consider a stock racing upward on
a wave of enthusiasm. For every buyer with great expectations, some-
one is selling, deciding that the stock price is too rich to be sustainable.
This may seem like a pittance, but it adds up. If you own 200 shares
of a company that’s paying $2.50 per share in annual dividends, you’ll
receive $500 per year from the company.
Note that, for months or years at a time, a dividend will hold steady.
But, the yield can fluctuate daily. That’s because a stock’s price fluc-
tuates. As a stock price rises, the dividend yield falls, and vice versa.
If Ford shares, for example, suddenly doubled in price to $102, the yield
would be halved, to 2% ($2 divided by $102 is 0.02). If Ford stock
fell to $30 per share, its yield for those buying it at $30 would be 6.7%.
You can find some hefty dividend yields among companies whose stock
prices have tumbled. At the time of this writing, for example, R. J.
Reynolds Tobacco Holdings pays about $3 per share in annual divi-
dends. With its stock trading around $30 per share, that’s a whopping
10% dividend yield! Be careful, though. If you’re attracted to an un-
usually high dividend yield, you should probably study the compa-
ny carefully to make sure it’s not in so much trouble that a dividend
cut is around the corner.
Lastly, know that not all companies pay dividends. Younger and quick-
ly growing companies in particular prefer to plow extra cash back into
operations.
A little attention paid to dividends can really pay off. You may think
If you bought Ford when its annual dividend was $2, you’re very like-
ly to get that $2 payout every year, regardless of what happens to the
stock price. (Struggling companies may decrease or eliminate their div-
idends, but they try like heck not to, because it looks really bad. Firms
aim to maintain or increase their dividends over time.) Couple stock ap-
preciation with dividends, and you’ve got an appealing combination.
But wait — remember that dividends aren’t static and permanent. Com-
panies raise them regularly. A few years down the line, perhaps STAIN
is trading at $220 per share. If the dividend yield is still 3%, the com-
pany is paying out $6.60 per share (0.03 times $220 equals $6.60). Note:
$6.60 is a 3% yield for anyone buying the stock at $220, but since you
bought it at $100, to you it’s a 6.6% yield. You paid $100 for each share
and each one is kicking out $6.60 to you.
Decades pass. Your initial 10 shares have split into 80 shares, each cur-
rently priced at $120. Your initial $1,000 investment is now valued at
$9,600. The yield is still 3%, paying $3.60 per share ($3.60 divided by
$120 equals 0.03, or 3%). Since you own 80 shares, you receive a whop-
ping $288 per year. Think about this. You’re earning $288 in dividends
in one year on a $1,000 investment. That’s 29% return per year (and
growing) — without even factoring in any stock price appreciation. The
dividend yield for you has gone from 3% to 29%, all because you just
hung on to those shares of a growing company. That’s security! Even
if the stock price drops, you’re still likely to get that 29% payout.
Would you believe fractions of a share? If you buy stock directly from
a company, such as through a dividend reinvestment plan, your money
often buys fractions of shares at a time. For example, a $50 investment
would buy you 0.67 shares of a $75 stock. When buying stock through
a broker, you can buy as little as one share at a time. Just pay atten-
tion to commissions — if you buy one $40 share of stock and pay a
$25 commission, you’re not doing yourself a favor.
It’s tragic that many people put off investing for years, thinking they’re
not rich enough to benefit from the stock market. You don’t need to
have $1,000 or more before you start investing. You don’t have to buy
100 shares at a time. You can buy 17 shares or 9 shares — or even frac-
tions of shares, using some services.
Why the misunderstanding? Well, the notion is just a little out of date,
that’s all. See, historically, full-service brokers charged very high com-
missions, with extra charges for purchases that weren’t made in “round
lots,” or multiples of 100. So 100 was viewed as the minimum num-
ber of shares you had to buy to avoid incredibly high commissions.
Today, however, commissions at discount brokers are much more rea-
sonable and people can affordably purchase any amount of shares
they’d like... including just one.
233 If I can only save a few dollars a week, can I still invest? Is
investing worth it for those of us with limited means?
Many people think they’ll never join the investing set. They assume
they don’t have enough money to start, but investing isn’t just for
the rich. If you have just $20 or $30 per month to invest in stocks, you
can do so, thanks to dividend reinvestment plans (“Drips”).
234 I see that “Drips” let you reinvest dividends to buy addi-
tional shares of stock. What’s the big deal about reinvest-
ing dividends? Why not just take those few dollars as cash,
and enjoy them?
One of the best things about Drips is that they allow you to have all or
part of your dividends reinvested into additional shares of company
stock, even if the dividends just buy fractions of shares. This might not
Consider Ford Motor Co. If you bought some shares of it at the end of
1980 and hung on for 18 years, to the end of 1998, they would have
appreciated nearly 3,900% (22.7% annually). That’s amazing enough.
But, get this — if you’d been reinvesting dividends to purchase more
shares, your total return would skyrocket to 12,300%, or 30.7% per
year! An initial $1,000 investment would have grown to $39,000 with-
out reinvesting dividends and $124,000 with reinvested dividends. (This
doesn’t even take into account Ford’s spin-offs during that period.)
Over the same 18-year period, Pfizer advanced 22.3% annually with-
out reinvestment and 25.3% with it. J.P. Morgan shares grew 12.3%
without reinvestment and 17% with it. Coca-Cola appreciated 24%
without reinvestment, and 27% with it. Over a decade or two, these
differences can make a big difference in your investment returns.
Not much. These are attractive options that Foolish investors should
consider. They permit you to get started investing with as little as $20,
and they have some advantages over traditional dividend reinvestment
and direct investment plans. With Drips, it frequently takes weeks and
some paperwork before you can buy or sell stock. Last time we
checked, BUYandHOLD was executing trades twice daily and Share-
Builder once or twice a week. That’s a big difference.
These services operate very much like regular brokerages, but with
a few notable differences. For starters, they don’t buy and sell shares
of a stock throughout the day. Instead, they accumulate orders and
place large consolidated orders according to a schedule. This means
that buyers and sellers can’t expect to trade at any exact price that they
may want to specify. This shouldn’t be a big deal, though. As long as
you’re planning to hang on to your shares for years, paying a smidgen
more than you expected shouldn’t be the end of the world. And, in
many cases, you’ll pay a smidgen less.
To learn more about these companies’ services, fees, risks, and ad-
vantages, poke around their websites and ask them any questions you
have. As with everything important, read all the fine print.
Money you won’t need for five or more years will likely grow fastest
in stocks. According to Ibbotson & Associates, from 1926 to 1996, U.S.
Treasury bills returned an average of 3.7% per year, long-term cor-
porate bonds returned 5.6%, and stocks averaged about 11% per year.
Of course, note that returns are far from guaranteed in the stock mar-
ket, while Treasury bill interest rates are guaranteed. The more risk
you take with investments, the higher the returns can be.
A private company is one that’s privately owned. Its owners don’t have
to reveal much about their business. And, most of us investors can’t
invest in it.
A public company is one that has sold a portion of itself to the public, via
an initial public offering (IPO) of shares of its stock. If it’s an American
company trading on an American stock exchange, it’s required to file quar-
terly financial reports with the Securities and Exchange Commission (SEC).
These reports are also made available to shareholders and the public. A
public company can’t keep mum about how much it made in sales last year.
It must report information like that — its revenues, cost of sales, tax ex-
penses, administration costs, debt load, cash levels, and so on.
Take a gander at these biggies: Levi Strauss, Cargill, M&M Mars, Ber-
United Parcel Service was private until recently, as was Goldman Sachs.
So, just because an established firm is private doesn’t mean it’ll always
be private.
241 Can you explain all those terms that describe different
kinds of companies, such as “cyclical”?
Investing and personal finance principles are largely the same for
There are thousands of clubs across America, with more than 38,000
alone registered with the National Association of Investors Corp.
(NAIC). Clubs typically have 10 to 20 members and meet once a month.
Members each contribute about $20 to $75 monthly to a pooled ac-
count, research stocks individually or in small groups, present their
findings to the group, and vote on investments.
Clubs are ideal for beginning investors, as members can learn togeth-
er in a comfortable group setting. But even savvy investors can ben-
efit from clubs, as they leverage valuable resources like time. Imag-
ine that you’re an experienced investor and you only have enough time
to research one company each month — 12 per year. If you band to-
gether with a dozen similar investors and each of you researches and
presents a dozen companies per year, you’ll each learn about 144 com-
panies, not just 12. That’s leverage!
Many folks who go about investing on their own fall prey to un-Fool-
ish ways. They may act on an acquaintance’s hot stock tip or try to
time the market, jumping in and out of stocks on hunches. Investment
club members, meanwhile, are more circumspect. They’re usually
bound by their partnership agreement to study a stock carefully be-
fore voting on whether to invest in it. Clubs tend to own such solid,
leading enterprises as General Electric, ExxonMobil, PepsiCo, and
Intel, hanging on for years, not months or weeks. These kinds of habits
can lead to market-beating performances.
They’re a terrific idea. The only problem is that minors can’t trade
stocks on their own. Still, teens can form clubs to learn together and
can form and maintain a mock portfolio on their own. Once they find
and research companies they want to own, they can do so individu-
ally, with a parent acting as custodian of their account.
Well, the stock market’s historical growth rate in this century is about
11% per year. So, if you save $75 per month and invest $450 every six
months in the S&P 500, history suggests it will grow to roughly $60,000
in 20 years.
You can invest in the S&P 500 through an S&P 500 index fund. That’s
a type of mutual fund offered by many fund companies, such as Van-
guard. Another way is through “Spiders.” Spiders work more like a
stock, have the ticker symbol (SPY), and you can buy small amounts.
Each is valued at approximately 1/10 of the S&P 500 index. If you’re
investing small amounts in Spiders, make sure you use a discount bro-
kerage with low commissions — you don’t want to pay $40 in fees to
invest $450. Some commissions are now as low as $7 or less.
252 If my child saves $500 per year starting when he’s 18, can
he turn it into a million dollars in his lifetime? I want to ex-
plain to him how money can grow.
253 I’m middle-aged and don’t earn much money. Can I really
invest? And would my investments really ever amount to
much?
It’s never too late (or early!) to begin investing. For a little inspiration,
look to the amazing story of Anne Scheiber. Most people haven’t heard
of her, but she’s one of the world’s greatest investors. In 1932, Ms.
Scheiber was a 38-year-old IRS auditor. Intrigued by the stock mar-
ket, she forked over most of her life savings to her brother, a young
stockbroker on Wall Street, who lost it.
Determined to try again, but this time relying on herself, she saved
$5,000 and invested it back into stocks in 1944. By the time she died
in 1995 (at the age of 101), her money had grown to $20 million. How’d
she do it?
Well, for starters, she was a long-term, involved investor. She didn’t
buy a stock today and sell it tomorrow. She attended shareholder meet-
ings and followed her companies closely. She bought big consumer-
brand companies like PepsiCo, Schering-Plough, Chrysler (now Daim-
lerChrysler AG), and Coca-Cola, and she reinvested her dividends. She
placed her faith — and her money — in these growing companies and
watched their earnings grow higher over decades. And when she died,
Anne donated it all to Yeshiva University in New York.
Anne wasn’t totally Foolish, though, as she didn’t stop to smell the
roses enough. Those who knew her say she was a recluse in her small,
rent-controlled apartment. Never married and painfully frugal, she
Let’s go through the math and see. (Don’t be alarmed — I’m talking
simple multiplication and division here.)
Think of a stock you’re interested in buying. Let’s say it’s Exotica Foods
(Ticker: ICK), famous for its popular Tripe Tarts. Now, let’s answer a
few questions.
1. What is Exotica’s share price? $50
2. How many shares do you want to buy? 20
3. What’s the value of that purchase? $50 x 20 shares = $1,000
4. How much does your broker charge? Let’s say $25 per trade
5. What percentage of the investment is the commission?
$25/$1,000 = 0.025, or 2.5%
Let’s take another example. Say that you want to buy $400 of Par Domes
Inc. (ticker: UNDRPR), a chain of indoor golf courses — and your bro-
ker charges a $30 commission. That comes out to 7.5% ($30/$400 =
0.075 or 7.5%). Ouch! If your original goal for your Par Domes in-
vestment was a 15% return, you’d now have to earn more than 22%
after commissions to get there because you’re starting out 7.5% in the
hole! (Pardon the pun.)
If your funds are limited, check whether the company offers a direct
stock purchase plan, allowing you to bypass brokers entirely. Not all
companies have them, but an increasing number do. Aim to pay no
more than 2% in commissions.
255 I keep reading that the Wall Street bull run is over and
we’re heading into a recession. What’s the long-term small
investor to do? I’ve got 20 years until retirement. Do I pre-
tend to be smart and sell? Or do I hang in there?
As long as your money isn’t needed in the near future, you’re proba-
bly best off remaining in stocks for the long haul. If the market crash-
es, you’ll have time to ride out the recovery.
Let’s define our terms first. Chat rooms are where people can “talk”
online in real time, typing interactive “conversations.” Only people
who are there at the same time are communicating with each other.
With chats, there often isn’t any record of who said what once the chat
is finished. It’s a somewhat ephemeral form of communication.
• Not investing soon enough. You’re rarely too young or too old to
invest. Kids have the most to gain from many decades of stock ap-
preciation, but even retirees can benefit from leaving in stocks what-
ever money they won’t need for five or ten years.
• Investing in what you don’t understand. The more familiar you are
with how companies you invest in work and how well they’re per-
forming, the fewer unpleasant surprises you’re likely to encounter.
• Not tracking your returns. Shrug off this duty at your own peril.
You always want your investment returns to be (in the long run)
beating a benchmark or market average such as the S&P 500. Oth-
erwise, you might as well match it by investing in an index fund.
Perhaps the worst mistake is never taking the time to learn about in-
vesting. You’re not making that one, though, if you’re reading and
thinking about the topics in this book!
Wall Street’s
Ways
Wall Street’s ways are mysterious, and this has served the fi-
nancial services industry rather well over the years. The less
you know and understand about how stock markets, broker-
ages, and investment banks work, the more likely you’ll be
to let professionals manage your money. You don’t have to
be in the dark anymore, though. This chapter will explain
some of the workings of the financial establishment.
It all started in the early 1600s when the Dutch had a colony called
“New Amsterdam” on what is now Manhattan. It was even then a
region devoted to commercial enterprises, with much trading going
on. When the Dutch began to fear trouble from English colonies to the
north, they built a wall to protect themselves. Unfortunately for the
Dutch though, the attack did come, but by sea. New Amsterdam be-
came New York, and in New York City you’ll now find Wall Street where
the wall used to stand.
New York’s commercial spirit flourished, as did the city itself. Philadel-
phia was also thriving, and that’s where America’s first stock mar-
ket was established, in 1790. The New York Stock Exchange (NYSE)
came soon after. The NYSE traces its origins to some traders meet-
ing regularly under a buttonwood tree in 1792. It was formally or-
ganized in 1817.
209
Today the term “Wall Street” often refers to the financial establish-
ment. Many of America’s (and the world’s) financial institutions are
based in New York City on and around Wall Street, but you’ll find many
that are located elsewhere.
Brokers are agents who take and fill your orders to buy and sell stocks
and other securities. They charge commissions for these services, and
in some cases they also offer you advice and make recommendations.
Every morning there was a “Squawk Box” call from the home office
on Wall Street, listing stocks upgraded or downgraded by analysts that
day. These represented reasons to call clients and urge them to buy
or sell (generating all-important commissions). The brokers were up-
dated weekly on new investments to push, such as complicated op-
tions strategies or limited partnerships that could be pitched as tax
shelters. They were also given lists of stocks that the firm held in in-
ventory and needed to get rid of. These were to be aggressively sold
This is just one broker’s experience, but from what we’ve heard, it’s a fair-
ly common one. It’s true that many brokers are good people who do well
for their clients. But, sadly, many are simply salespeople, ringing up com-
missions to get ahead. We think this represents an unacceptable con-
flict of interest. Financial professionals should be compensated based on
how well they manage your money, not how often they churn it.
It usually is. Most brokerages park your extra wampum in money mar-
ket funds, where you’ll earn monthly returns that are a little better
than those from a savings account.
You’ve got a cold call on your hands when a broker you don’t know
calls you out of the blue, usually interrupting your dinner, to urge you
to buy some security.
If you’ve already had a run-in with a cold caller from the dark side, re-
port the incident. You can do so by calling the SEC at 202-942-9634 or
going to their website at www.sec.gov. Or you can contact the North
American Securities Administrators Association (NASAA) and ask for
the contact information for your local securities regulator. NASAA can
be reached at 1-888-846-2722 and at www.nasaa.org.
You can learn more about how to deal with cold callers by visiting
www.nasdr.com/2560.htm — and you can complain about unscrupu-
lous ones there, too. The Securities and Exchange Commission (SEC) also
offers some good guidance on the topic. Pop over to the SEC website at
www.sec.gov/consumer/search.htm and search for the term “cold call.”
Here’s some info on cold calls, drawn from both of those sites:
• You don’t have to accept these calls. You can just say you’re not in-
terested and hang up. You can also ask to be put on any firm’s “Do
Not Call” list.
• Cold callers should introduce themselves, promptly offering their
name, the name of the firm they represent, their firm’s address and
phone number, and that they’re calling to sell you something.
• Cold callers should not threaten or frighten you, and shouldn’t be
annoying you by calling again and again. They should be polite.
• Be very concerned if they’re using high-pressure sales maneuvers
on you. Don’t believe that you “Must act today!” Be extremely skep-
tical of any “once-in-a-lifetime opportunity” and any “guaranteed”
returns, especially very high returns.
• A cold caller should be happy to send you written information on
any investment that they recommend.
If your stocks are held in street name, that does not mean they aren’t
owned by you and aren’t insured. It’s merely an artificial classification
designed to facilitate trading. Consider that, as of the end of 1999,
fewer than half of IBM’s 1.4 million shareholders had shares registered
in their own name. The rest owned shares through brokerages, banks,
and other financial institutions.
Indexes aren’t things you invest in, though. To meet the needs of peo-
ple interested in investing in various indexes, index mutual funds were
created. If you want to invest in a certain index, for example, you would
invest in an index fund based on it.
Created in 1896 by Charles Dow, who also established The Wall Street
Journal, the “Dow” is an index of 30 major American companies cho-
sen to represent U.S. industry. It’s probably the world’s best-known
index.
The 30 companies that make up the Dow don’t change much from year
to year. In fact, typically, many years go by with no change at all. Still,
every now and then a few companies are ejected from the Dow to make
room for some upstarts. Of the original component companies, Gen-
eral Electric is probably the only name familiar to most investors today.
Laclede Gas, Distilling & Cattle Feeding, Tennessee Coal & Iron, and
American Cotton Oil are no longer the blue chips they once were.
Alcoa IBM
American Express Intel
AT&T International Paper
Boeing Johnson & Johnson
Caterpillar McDonald’s
Citigroup Merck
Coca-Cola Microsoft
Disney Minnesota Mining &
DuPont Manufacturing (3M)
Eastman Kodak Morgan, J.P., Chase and Co.
ExxonMobil Phillip Morris
General Electric Procter & Gamble
General Motors SBC Communications
Hewlett-Packard United Technologies
Home Depot Wal-Mart Stores
Honeywell
The list could change at any time, but it doesn’t change too often. This
list may remain correct for years. For the latest on the Dow’s compo-
nent companies, head to: http://averages.dowjones.com/home.html
(note: no “www”).
Today, though, most stocks don’t trade at such lofty levels — thanks
to events such as stock splits. To get from current stock price levels to
the larger index number, a number called the “divisor” is used. Here’s
how it works. If General Electric falls four points, you just divide four
by the divisor (which is adjusted frequently, and was 0.17677618
last time we checked). This shows that this drop will decrease the DJIA
by 22.6 points (4 divided by 0.17677618 equals 22.6). The overall av-
erage is calculated by adding up the current stock prices of the 30
stocks, and then dividing by the divisor.
There are many more indexes. Some are for international regions such
as Latin America or the Far East. Others address sectors such as utili-
ties, semiconductors, the Internet, and fried chicken. (Just kidding
about the chicken.)
The NYSE, as it’s commonly referred to, is the oldest stock exchange
in the United States, tracing its roots back to a partnership agree-
ment in 1792. It’s the seemingly chaotic place you often see in the back-
ground behind reporters on CNBC. Roughly a billion shares of stock
trade hands on the NYSE each day.
The Nasdaq was created in 1971 as the world’s first electronic stock
market. It was originally an acronym for the National Association of
Securities Dealers Automated Quotation system. Today, it considers
“Nasdaq” a word, and refers to itself as the Nasdaq Stock Market. You
can learn about it at the Nasdaq website, www.nasdaq.com.
If you’re a good Fool, though, you won’t pay much attention to the hub-
bub, since options and futures represent contracts based on short-term
pricing rather than long-term business growth. You’ll find the Fool’s fa-
vorite triple witches gathered around a boiling cauldron — in Macbeth.
First, much of the stock trading each day occurs between large insti-
tutions, such as pension funds and mutual funds. To determine which
stocks to buy and which stocks to sell, these institutions rely on the
research and opinions of analysts.
It might make more sense if you imagine a retail situation, where you’re
A Fortune magazine article from July 2000 pointed out, “Of the 33,169
buy, sell and hold recommendations made by stock analysts last year,
only 125 were pure sells. That’s 0.3%.” Also amazing is that 23,551
of the recommendations were “buy” or “strong buy” — fully 71%.
Clearly, analysts tend to wax positive in their ratings.
It’s smart to not put much stock in these ratings. Still, though, many
analysts do offer excellent research. In preparing their reports, ana-
lysts typically speak with corporate executives, model expected per-
formance, and make estimates of future earnings per share (EPS). Al-
though analyst reports are often reserved for company clients, you can
sometimes get copies from your brokerage, from the company that was
analyzed, or from online services such as www.multexinvestor.com.
The ratings changes often strike us as weird, too. Consider the dif-
ference between “buy” and “outperform.” If a company will outper-
form, shouldn’t you buy? And what about “accumulate”? How can
you accumulate without buying? The difference between “buy” and
“strong buy” is similarly confusing — either way, the advice appears
to be that you should pick up some shares.
In other words, take a stroll down Wall Street and listen intently, and
you might hear the sound of stockbrokers and money managers shak-
ing and shuffling your portfolio. The system is flawed, both for stock-
brokers and mutual fund managers, and as a result the portfolios of in-
dividual investors can suffer. Billions of dollars are lost each year due
to churning.
You see, many stockbrokers are paid based on the number of trades
they make in your account, not on how well that account performs.
Even if your broker is good and has your money invested in growing
companies, she might still frequently be moving you out of one good
Commissions aren’t the only things hurting the churned investor. Con-
sider taxes. Any stocks you’ve held for more than a year get taxed at
the preferable long-term capital gains rate, which is 20% for most peo-
ple. Short-term gains are taxed at your ordinary income tax rate, which
can be as high as 39%, almost twice as much as long-term capital gains
taxes. If your account or fund is being churned, you’re probably pay-
ing more in taxes than you’d want to.
Hedge funds grew quickly in popularity in the ‘90s, more than dou-
bling in number. While the word “hedge” might conjure up images of
investors cautiously hedging their bets, hedge funds are often extra-
risky, extra-volatile investment vehicles that demand huge upfront in-
vestments, sometimes in the millions. You’re unlikely ever to invest
in one, but it’s good to understand what they are and aren’t — if only
to impress colleagues at the water cooler.
Let’s leaf through some of their qualities. Like mutual funds, hedge
funds comprise the pooled money of multiple investors, which is then
invested by a professional money manager. However, unlike mutual
funds, hedge funds are not regulated by the Securities and Exchange
Commission, are not permitted to advertise, and their managers don’t
have to be registered investment advisers. In addition, they’re not open
to any investor: Only “accredited investors” need apply. These are folks
earning upwards of $200,000 per year and who are worth more than
a million smackers.
Most options expire within a few months. Warrants, however, are usu-
ally good for a few years, until the company “calls” them. Calling es-
sentially forces holders to exercise the warrants by buying the stock
at the pre-set price.
Like options, warrants are more volatile than their underlying stocks.
Their appeal is that your money can buy you many more warrants than
shares of stocks. This leverage can help you make more moolah than
if you simply bought the stock, but it’s also a lot riskier, as your war-
rants can end up close to worthless if the market doesn’t go your way.
So, next time you hear of a whisper number, know that those seek-
ing it out are asking just about anyone for their guess — even Fools!
The term “overbought” suggests that too many people were trying to
buy the stock, sending the share price higher than it should be. The
guru is essentially making a short-term call on a stock price, which
is most likely futile.
287 Why would a stock close at one price on one day, but then
commence trading the next day a few dollars lower?
Stocks often open higher or lower if there’s been some major news
released after the market close the day before. For example, if the un-
derwater dress shoe company Wet Loafer Inc. (ticker: SQSHY) an-
nounced it was recalling all its wingtips, many more sell orders than
buy orders might accumulate overnight. Before trading begins, the
share price would probably be adjusted southward, to better match
buys with sells.
You just need to familiarize yourself with the information they pres-
ent. Let’s review a typical online stock quote. Here’s one for General
Electric supplied by America Online in January of 2001:
GE - GENL ELECTRIC
Exchange:..........................NYSE comp
Delay:................................at least 20 minutes
Last Price:..........................44.375 at 12:51 EST
Change: .............................Down 1.1875 (-2.61%)
High:.................................46.25 at 9:34 EST
Low:..................................43.75 at 12:10 EST
Here’s the same listing, with some explanatory comments after each
line item:
GE - GENL ELECTRIC
This is the company’s ticker symbol and its name.
Exchange:..........................NYSE comp
GE trades on the NYSE (vs. Nasdaq or somewhere else).
Open: ................................45.9375
The shares began trading at $45.9375 each today.
Volume: .............................12,155,300
So far 12,155,300 shares have changed hands today.
52-Week High:...................60.50
In the last year, the highest GE stock has traded was $60.50.
52-Week Low:....................41.64.
In the last year, GE’s lowest stock price was $41.64.
Yield:.................................1.40%
GE’s current dividend yield (annual dividend divided by current
stock price) is 1.40%.
EPS: ..................................1.22
GE’s earnings per share over the last year have totaled $1.22.
Newspaper stock listings are very similar. They’ll usually contain many,
but not all, of the above items. Newspapers also list stock informa-
tion as of the previous day’s close, whereas online quotes are updat-
ed continually throughout each trading session.
The “10.000s” means 10,000 shares of BLAH have traded. For trades
of 10,000 or more, the comma is changed to a period. If fewer than
10,000 shares are traded, the number is rounded to the nearest hun-
dred and the last two zeros are removed. So BLAH 9s15 3/8 means 900
shares traded at a price of $15 3/8 per share. If no number of shares
is indicated, it means that it’s a “round lot” of 100 shares or an “odd
lot” rounded to 100. (Please remember that I didn’t make up this logic
— I’m just trying to explain it.)
It’s a large order that has been placed in the stock market. The New
York Stock Exchange defines it as an order involving at least 10,000
shares or amounting to at least $200,000 in total market value. The
Nasdaq defines it as generally 10,000 shares or more.
It’s nice that the proverbial “little guy” will have the same trading op-
portunities as the big banks, but these new opportunities shouldn’t
get any Fool’s heart beating faster. As super-investor Warren Buffett
has explained, he’d be perfectly happy with a market that just opened
one day per year. Solid investment portfolios are very often the re-
sult of infrequent trading.
You might see order imbalances happen whenever there’s very good
or bad news related to a company, and suddenly many people want in
or out of its stock.
Instituted after the 1987 stock market crash, circuit breakers were de-
signed to slow down market activity during major declines and surges.
For example, when the Dow Jones Industrial Average moves a cer-
Some Fools don’t pay much attention to valuation and fair values. They
figure that if they’re buying truly high-quality companies and are plan-
ning to hold on to the stock for decades, then it shouldn’t matter if
they bought at a price that was ahead of itself. They point out that
many wonderful companies appeared overvalued according to con-
ventional measures, and people who avoided these companies based
on valuation ended up missing great investment opportunities.
Other Fools disagree, believing that it can only help if you take the
time to learn various valuation measures and if you focus your in-
vestments on stocks that appear undervalued. It’s true that this ap-
proach should minimize your downside risk. These Fools would have
You might think that when you buy stock you’re getting those shares
directly from a shareholder who’s selling, but that isn’t quite the case.
Nasdaq-traded stocks are bought and sold through market makers.
Maintaining a fluid market, they earn their keep by pocketing some
or all of the spread between the purchase and sale price (“bid and
ask price”). Market makers typically keep some shares in inventory,
too. That way, if someone wants to buy shares and no one wants to sell
at that time, the market maker can sell from inventory.
The fact that your brokerage is a specialist for the stock merely means
that it buys and sells the stock for people. It may even result in bet-
ter prices for you. When a brokerage has to rely on someone else to ex-
ecute a trade, it often costs the customer more.
Understanding
Stocks
Once you have a handle on what a stock is and a rudimen-
tary understanding of how the stock market works, you’re
ready to learn more about how stocks behave. This chapter
addresses stocks in more detail, explaining how you should
think about them and some basic ways to measure them.
If a company’s profits keep growing, its stock price will follow suit
— eventually. Corporate earnings drive stocks in the long run. In
the short run, though, there are many different reasons stock prices
flitter up and down. Some of these reasons matter and some don’t. It
does help, though, to understand the factors that can move a stock.
233
• News about the company’s ongoing business operations. Landing a
monstrous new, long-term contract bodes well, as does news that
the company’s methodical global expansion is proceeding at a rate
15% ahead of plans.
Some things that move stocks that we Fools ignore, or even chuckle at:
• Gurus on television or in financial magazines speculating that a com-
pany might be bought out at a premium price.
• Company insiders selling some shares.
• Soothsayers divining future stock prices by looking at charts of price
movements.
• Crowds of people snapping up shares of “hot” stocks without un-
derstanding the industries involved.
Remember also that stock prices often rise or drop on rumors or hype
— or for no reason at all. Perhaps a bird flapped its wings extra hard
flying over the Zambezi River in Zambia and that set off a domino-like
chain of events, eventually leading to people buying more shares than
usual of a stock this morning. (This is a rather remote possibility, but
hey — you never know.)
Sometimes stocks will also rise or drop just because other stocks in the
same industry are rising or dropping. And if most of the market is
slumping or surging, it will take many stocks along with it for the ride.
Don’t sweat these small day-to-day moves. Focus on quarterly and an-
nual earnings performance and the growth of the business over the
next few years. Short-term pricing on the stock market can be irra-
tional, but long-term values are driven by business growth.
299 I’ve noticed that stocks jump in price when they’re added
to the S&P 500 Index. Why is this, and is there any way to
learn which companies will be added in the future?
You’ve noticed correctly. When it was announced a few years ago that
America Online would be added to the S&P 500, its shares quickly rose
about 12%. More recently, news that handheld computer maker Palm
Inc. had been tapped for an S&P 500 berth caused the stock to pop
13% in after-hours trading.
Don’t be that hasty, though. Wall Street’s research can be very sound,
but acting on recommendations such as “buy” or “sell” often isn’t a
good idea. Instead, pore through the earnings report and, if you still
think the company has solid growth ahead, keep those penguins on ice.
It all depends on the particulars. Let’s say you own shares in Office Au-
tomation Services Co. (ticker: ZIPZIP), which is growing quickly and
doing very well. Both you and Wall Street expect continued rapid
increases in sales and earnings.
Then one day the company announces that it’s buying a typewriter
retailer called Typewriter Land Inc. (ticker: QWERTY). Clearly, Type-
writer Land is a less dynamic business. It’s likely to slow down Of-
fice Automation’s progress. This is why some analysts will downgrade
Office Automation — because it’s now a less attractive company. You
might not be as eager to hang on to your shares, as well.
Well, they should move just on news, but history has shown us that
rumors or vague announcements can also have major effects. Con-
sider, for example, Amazon.com, which reported in 1999 that the
next day it would make a big announcement. Immediately, its shares
rocketed ahead more than 20%. Then, the next day, after the ac-
tual announcement that it would begin selling home improvement
items, video games, software, and gifts, the shares quickly lost half
that gain.
Well, you’d think the stock price would move only after the facts were
out, wouldn’t you? But stocks often move on nothing more than ru-
mors, and once the stock price begins moving northward, more peo-
ple tend to jump into the fray, pushing it higher. By the time the news
is revealed or the rumor confirmed, a re-evaluation of its likely impact
For example, imagine that people following McDonald Farms Inc. (tick-
er: EIEIO) have determined that sales really picked up in recent months.
The stock price may have been steadily moving up as more people piled
into it, excited by the company’s growth prospects. Let’s say McDon-
ald suddenly reports that earnings rose 40% in the last quarter, more
than the company had forecast. If that’s what investors were expect-
ing, the stock might not move much on the news. But, if investors were
expecting a significantly higher or lower growth rate, you might see
the stock jump up or down.
There sure is. When you buy shares of stock or even a mutual fund,
it’s natural to start cheering the market on. After all, the old maxim
says to buy low and sell high. It’s not that simple, though.
Buffett continues, “But, now for the final exam: If you expect to be a
net saver during the next five years, should you hope for a higher or
These words should ring true for anyone investing for the long haul
— especially those just starting out. If you’ve just plunked your first
thousand dollars into the stock market and plan to keep adding to it
over the next decades, you’ll benefit from falling prices in the short
term. And by investing for more than 10 years, you smooth out the
risk of owning common stocks.
You can learn a lot from Buffett’s engaging letters to shareholders. Read
them online at http://www.berkshirehathaway.com.
That’s like asking, “Should I eat this peanut butter and jelly sandwich
before or after Mom cuts it in half?”
Stocks don’t become more inexpensive when they split. True, you get
more shares. But, each is worth less. Imagine that you own 100 shares
of Sisyphus Transport Corp. (ticker: UPDWN). They’re trading at $60
each for a total value of $6,000. When Sisyphus splits 2-for-1, you’ll
own 200 shares, worth about $30 each. Total value: (drum roll, please)
$6,000. Yawn.
Some people drool over stocks about to split, thinking the price will
surge. Stock prices sometimes do pop a little on news of splits, but
Well, one reason is so that the price will remain psychologically ap-
pealing. Reducing a stock’s price makes some investors think (incor-
rectly) that it’s a better value.
Sometimes, not splitting would mean that few people could afford even
a single share. If, in its 80-odd-year history as a public company, Coca-
Cola had never once split its stock, one share would be priced at more
than $300,000 today. Not too many people could afford even a single
share. In fact, Coke has split so many times in its history that if you
had bought just one share when it went public in 1919, you’d have
more than 4,600 shares today.
Some companies split their stock fairly frequently, while it’s a rare event
for others. It largely depends on how rapidly the stock price is rising.
Warren Buffett’s Berkshire Hathaway has never split its stock. Accord-
ingly, a share of Berkshire stock was trading for around $57,000 at
the time of this writing. Buffett did spin off a lower-priced class of shares
at one point, though — called “Class B shares” and sporting the tick-
er symbol BRK.B — to help investors of more modest means buy in.
With stocks, just as with any purchase, examine what you’re getting
for the price. Study the company and compare the stock price to other
numbers, such as earnings. A low price might be inviting, but a $200
stock can be a better bargain than a $20 stock — and can be an even
better buy than a $2 stock. If your funds are limited, you can just buy
It’s always fun to suddenly own more shares, but splits are like getting
four quarters for a dollar. They’re not cause for celebration.
There’s no fast rule. Some companies split their stock at relatively low
prices, such as $30, while others split after the price passes the $100
mark. Some rarely split, and trade well into three digits. Stock might
be split merely to increase the number of shares outstanding, perhaps
to meet a stock exchange requirement.
Stock splits are minor mathematical events that change numbers, but
not value.
Let’s say that the Dodgeball Supply Co. (ticker: WHAPP), trading at
$50 per share, has reported $2.50 per share in earnings for the last year,
and pays a $1.50 annual dividend. If it splits 2-for-1, the number of
shares outstanding will double and will trade around $25 each. (Share-
holders will own twice as many shares valued at about half their pre-
split price.) Its previous earnings per share (EPS) will also be halved,
to $1.25, and its annual dividend will be $0.75 per share.
If the stock’s fair value had been $60 pre-split, it will be about $30
post-split. Its price-to-earnings ratio shouldn’t change, as both the
price and the EPS components have decreased in the same proportion.
Its total market value is also unchanged.
You still get them if you buy between the two dates. The record date
is mainly for accounting purposes and has no direct effect on the in-
dividual investor. Those who own shares on the day of the actual split,
the pay date, get the benefit of the split shares. As long as you hold
shares when the stock splits, you’ll get your due.
311 I know the Fool avoids penny stocks, yet I see that your
Rule Breaker Portfolio bought shares of America Online at
46 cents each. What gives?
You’re looking not at hypocrisy, but at the effect of stock splits. The
Rule Breaker Portfolio bought the stock at roughly $58 per share in
1994. Since then, it has split 2-for-1 seven times. Divide $58 by two
seven times, and you get… just about 46 cents. Next time AOL splits
2-for-1, the cost basis will be just over 22 cents per share.
Let’s say the Light Saber Defense Systems Co. (ticker: ZHOOM ) pays
out $3 per year in dividends and trades today at $100 per share. The
yield is 3% (3 divided by 100 equals 0.03 or 3%). Drop the share price
3/100 = 0.03 = 3%
3/75 = 0.04 = 4%
3/120 = 0.025 = 2.5%
Notice what happens if we keep the stock price steady at $100 per
share and change the annual dividend amount from $2 to $3, and then
to $4:
2/100 = 2%
3/100 = 3%
4/100 = 4%
The higher the dividend dollar amount in relation to the stock price,
the higher the dividend yield, and vice versa. The higher the stock
price in relation to the dividend dollar amount, the lower the dividend
yield, and vice versa.
313 I read somewhere that dividends are taxed twice. Is this re-
ally true?
It’s true. Consider Spray-On Socks Inc. (ticker: PFFFT). Let’s say it rakes
in $100 million in sales one year and, after subtracting expenses, re-
tains $20 million as its operating profit. Well, Uncle Sam doesn’t just
pat the company on the back. He demands his share in taxes. Corpo-
rate income tax rates can reach 35% or higher. So, perhaps $13 mil-
lion will remain after taxes as net profit.
This is one reason why investors might prefer to see a company using
its money to build more value for shareholders without paying out
dividends. It’s also why some companies are reducing dividends, opt-
You might think it would be a neat trick to buy such stocks just be-
fore they go ex-dividend, so that you can quickly profit from the div-
idend amount. But stock prices get adjusted downward around the ex-
dividend date to compensate for the upcoming dividend payout. As
Snidely Whiplash would mutter, “Curses! Foiled again!”
Several things could happen. If the firm is bought out for cash, you
might receive a check for your shares. If it’s bought with stock or
there’s a merger involving a stock swap, your shares might be replaced
with shares of another company. The number of shares you get will
be prescribed by an announced formula. Some deals involve both
stock and cash.
As long as the purchase price is fair and the deal makes strategic sense,
shareholders shouldn’t suffer. If, for example, Chocolate Inc. (ticker:
CHOCO), valued at $500 million, buys Peanut Butter Inc. (ticker: PNUT-
TY) by issuing $100 million in stock, then an investor would want the
acquisition to increase the combined company’s earnings by at least
20%. That’s the amount of new stock Chocolate Inc. is issuing. In trans-
actions like this, companies typically pay a premium for the acquired
company up front, hoping that mixing peanut butter with chocolate
will create even greater earnings down the road.
Companies are now required to report earnings per share (EPS) in two
formats: basic and diluted. Focus on diluted numbers, as they take into
account stock options, warrants, preferred stock, and convertible debt
securities. These can be converted into common stock, diluting the
Insider holdings are generally a good thing. Executives who own 30%
of a company, for example, are motivated to make it succeed. The best
employees and executives work harder when they work for themselves.
As shareholders, they can see a one-to-one correlation between their
efforts on the job and their compensation. Insiders buying shares is
also usually a good sign, as it means they expect the shares to rise.
Don’t be alarmed by insider sales, though, unless there’s a lot of them.
Institutions, such as mutual funds and pension funds, are major play-
ers. They buy or sell in large chunks, and whether a stock is in or
Small firms usually have relatively few shares outstanding, and their total
worth is modest. Imagine Scruffy’s Chicken Shack (ticker: BUKBUK). It
has 20 million shares outstanding, valued at $5 each. (Total market value:
$100 million.) Institutions that might typically buy $10 million worth of
shares cannot do so with Scruffy’s without buying fully 10% of the
entire company, something they’re often prohibited from doing.
Some investors might worry about this, thinking that it’s a bad sign.
But the truth is that insider selling isn’t necessarily something to fret
about. Let’s think about why Fred might be selling.
Another reason many executives sell their shares is that stock options
are the major component of their compensation package. This is par-
ticularly true at upstart technology companies. Some of these man-
agers have worked for the company for a long time and have been fed
stock options by the board of directors instead of big salaries. In many
cases, they have most of their wealth tied up in stock, without much
cash lying around. For them, cashing in some options is a fairly rou-
tine thing to do.
Insider buying is a much better sign. After all, managers don’t buy
shares of stock unless they’re believers. But, next time someone shouts
that insiders are selling a stock you own, don’t jump ship without
doing a little research first.
All the shares a company has issued are its “shares outstanding.” Com-
pany insiders may hold some, while the public owns the rest. Insid-
er shares are usually held for a long time and are not traded too often,
while shares in public hands trade more frequently. The shares owned
by the public represent the “float.”
There are two meanings. With companies, liquidity refers to their cash,
as well as assets that can be quickly converted into cash (such as cer-
tificates of deposit, money market funds, and investments in stocks
and bonds). Companies with high liquidity are less risky, but they
might also grow slowly, as assets that could be put to work increasing
sales are instead kept easily available.
When you go to your local used car dealer to unload your beloved 1991
Schnauzer 900ZX, the dealer will probably buy your trusty heap for
fewer dollars than he plans to sell it for on the used car market. That’s
understood — the difference is his profit. Wall Street has a similar dy-
namic, and it’s called the “spread.”
The spread is the difference between “bid” and “ask” prices. The “bid”
is the price that someone is willing to pay to buy a security, while
the “ask” is the price at which a security is offered for sale. On ex-
Nasdaq spreads have often been on the wide side, historically. Recently,
though, regulations and pressure have nudged them down. Never-
theless, it’s still smart to check what the spread is when buying or sell-
ing any stock.
Spreads are unavoidable, but you can keep them from eating too much
of your long-term savings. Limit their bite by not trading too frequently
and by shunning infrequently traded stocks.
325 I’ve seen shares of a stock jump when the company an-
nounces massive layoffs. Why would that happen?
News like this doesn’t always pump up share prices, though. When East-
man Kodak made a similar announcement, its stock fell nearly 6%. (A
little later, Kodak stock rose on news of further layoffs.) It all depends
whether the market believes the layoffs are a promise of greater opera-
tional efficiency or a sign of a long-term downturn in the business.
326 Please explain how the rise or fall of their stock prices af-
fects companies. A company issuing stock gets its money
when the stock is issued. After that, when its shares are
sold, the money goes from the buyer to the seller, not to
the company, right?
Yup. The stock price still matters, though. Executives and employees
holding stock or options benefit when the stock rises. If the compa-
ny wants to issue more stock, it will want to do so when the price is
higher rather than lower, to generate more capital for fewer shares.
If the company is buying another company with its stock, the high-
er the price of its stock, the more bang it gets for each share.
Researching
and Evaluating
Companies
When it comes time to buckle down and examine a compa-
ny closely to see if it deserves any of your hard-earned in-
vestment dollars, there are lots of measures to consider. This
chapter will help you make sense of many terms, numbers,
and ratios. It should prove useful as you wend your way
through various financial statements. It will also help you zero
in on companies that deserve a close examination.
When examining a company, too often people get bogged down in details
prematurely. It’s vital to evaluate the big picture, to make sure that the
company you’re looking at is a first-class operation and one you’d be proud
to own in your portfolio. Here are some marks of great companies.
251
over again, such as cheeseburgers and shampoo, instead of items
bought only sporadically, like cars or garbage disposals.
A brand consulting outfit called Interbrand Group tracks and lists the
most valuable brands in the world each year. You can read more about
its surveys at its website: www.interbrand.com.
Here are the top 20 international brands for 2000, along with what In-
terbrand estimates to be the market value of each brand:
1. Coca-Cola.............................$73 billion
2. Microsoft Windows..............$70 billion
3. IBM.....................................$53 billion
4. Intel ....................................$39 billion
5. Nokia ..................................$39 billion
6. General Electric ...................$38 billion
7. Ford ....................................$36 billion
8. Disney .................................$34 billion
9. McDonald’s..........................$28 billion
10. AT&T ..................................$26 billion
It’s interesting to keep up with changes in this list from year to year,
as it can offer clues about how aggressively various companies and in-
dustries are growing. Nokia, for example, is a relative newcomer, yet
its ranking is extremely high. It’s clear that it has firmly established it-
self in the minds of people the world over. Intel’s position is interest-
ing, because people rarely knew what company made the component
parts of the computers they bought. Yet, through its “Intel Inside”
ad campaign, Intel made itself a household name and, more impor-
tantly, got people looking for its name when buying a computer.
It’s smart to not take what you read at face value. Be skeptical. We often
do this when reading words — but we should think critically when
reading about numbers, too. Here are some examples of how things are
not always what they seem.
Consider that many companies will report “record earnings.” This isn’t
always as impressive as it sounds. Feline Footwear (ticker: MEOWW), for
example, might earn a record $3 per share in 1996. If it earns $3.01 in 1997,
$3.02 in 1998, and $3.03 in 1999, each of those will also be “record earn-
ings,” but they’ll represent meager growth. You need to examine how quick-
ly a company’s earnings are growing. But, this alone isn’t enough, either.
Imagine Yamburgers Inc. (ticker: YAMBS), which reports that its revenues
advanced 200% over the past year. That’s more telling than “record
growth,” and would intrigue most investors. Check to see what the ac-
tual revenue numbers are, though. Perhaps Yamburgers has been strug-
gling, and took in only $300,000 in 1998. Growth of 200% would put it
at $900,000 in 1999. That’s still mighty tiny. It’s important to consider com-
panies in the proper context. A behemoth such as Wal-Mart can’t double
earnings as quickly as a small upstart can. It’s usually easier to double $10
million than $10 billion. As companies grow larger, their growth rates tend
to slow down. You can’t keep tripling each year forever.
You should always check your work by doing it a second time. You
might approach it from a different direction, too, to decrease your
chances of repeating an error. So, if you were adding a list of five num-
bers, you might start from the bottom of the list the second time.
If you’re not used to working with math and big numbers too often,
check out the following ways of writing the same number:
$6,344,175,000
$6,344,175 (in 000s, or thousands)
$6,344 (in millions)
$6.344 (in billions)
Keep all numbers in the same format and the formulas should work
smoothly.
332 What are “Rule Breaker” companies, and how can I find
some?
In David and Tom Gardner’s book, The Motley Fool’s Rule Breakers,
Rule Makers, they discuss two powerful kinds of investments: com-
panies that break all the rules, changing the status quo — and the kind
of company they sometimes grow into, one that makes the rules for
others to follow. Here’s a look at some Rule Breaker characteristics:
Look for good management, like the steel company Nucor (yes, steel!),
led by Ken Iverson, which became a world-class powerhouse by rev-
olutionizing steel production processes.
It’s also a good sign when the financial media, not seeing the big pic-
ture, calls a firm “overvalued.” (Barron’s asks about America Online:
“Short on Value?” Great!)
Those who invest in Rule Breakers consciously take on lots of risk, believing
that for the experienced and Foolish, high risk will lead to high reward.
Rule Breaker companies succeed by breaking all the rules. The most suc-
cessful among them grow up to become dominant Rule Makers, able to
call the shots in their industry and generate great value for shareholders.
To identify Rule Makers, look for the No. 1 brand name in an indus-
try. What companies come to mind when you think of chocolate,
ketchup, diamond rings, and microprocessors? We suspect that most
people will name Hershey, Heinz, Tiffany, and Intel.
Cash is king with Rule Makers. You want to see plenty of it (and lit-
tle debt) on the balance sheet. A low “Flow Ratio” is also key, reveal-
ing that the company is managing cash flow effectively by demand-
ing payment quickly, but paying its obligations slowly. (The Flow Ratio
is explained in more detail later in this book.)
This process likely continues, with the company issuing more stock as
it acquires more companies. Let’s say that an acquisition target com-
pany’s stock price is valued by the market at about 10 times earn-
ings. If it generates $5 million in annual earnings, the roll-up might
buy it for about $50 million in cash and stock. Meanwhile, the roll-up
itself might be enjoying a valuation on the stock market of about 20
or 30 times earnings. In this way, the roll-up is immediately recog-
nizing a higher value for its purchase than it paid.
One problem with roll-ups is that they’re often run by people more
adept at sales and promotion than at running large and growing busi-
nesses. Management may have little experience in the industry or with
managing full-scale operations of dozens of companies. Integrating the
businesses can be extremely difficult.
Not all roll-ups are to be avoided, but study them closely before jumping in.
Bought and sold like regular stocks, tracking stocks are usually issued
by companies with several different lines of business. They serve as
an attractive alternative to spinning off divisions.
The appeal of tracking stocks is that they can help investors see a com-
pany’s full value. For example, perhaps AT&T thought that investors
were just thinking of it as a fuddy-duddy giant telephone company. It
recently issued a tracking stock for its wireless unit, AT&T Wireless
Group, drawing attention to its dynamic wireless operations. The rea-
soning is that these operations may be accorded a higher value than if
they remained embedded in regular AT&T stock. Higher-valued shares
can be used as currency when the company wants to buy another firm
or forge an alliance.
If you dare type in the following long Web address, you can learn more
about tracking stocks here:
www.Fool.com/EveningNews/foth/1999/foth990316.htm.
The financial statements there will tell you how quickly sales are grow-
ing, how the company is financing its growth, how much profit it’s
making, and much more. Pay attention to trends, to see if the firm’s fi-
nancial health is improving or declining. Compare the company with
its industry peers, too, to see how it stacks up.
Remember that you can improve your chances for success if you’re ac-
tually a consumer of Wookie Cookies and are familiar with the com-
pany’s offerings. Also, talk about the business with other investors,
perhaps in an investment club.
Don’t neglect online resources. Most major companies these days have
websites that feature an investor information section, with press re-
leases, financial statements, annual reports, and answers to frequently
asked questions (sometimes abbreviated “FAQ”). Investor information
sites like ours also offer a wealth of information on companies and
communities of investors sharing information. (Visit
http://quote.Fool.com for company research tools and www.Fool.com
for everything else.)
(Usually you’ll be listening to a recording of the call, not the live call.)
This is a terrific way to stay in touch with your holdings. If your com-
pany hasn’t opened up access to its quarterly call, give it a call, express
your displeasure, and remind it that the Securities and Exchange Com-
mission (SEC) frowns on selective disclosure of material information.
To get phone numbers of companies trading on the New York Stock Ex-
change (NYSE), call the exchange at 212-656-3000. The Nasdaq can be
reached at 202-728-8039 and the American Stock Exchange (AMEX) at
212-306-1490. At many local libraries, Value Line also has phone num-
bers. You can also visit http://quote.Fool.com and look up a company’s
“snapshot” — which will include its phone number. A visit to other sites,
such as www.marketguide.com, will also turn up the phone number.
Remember also that if you’re online, you can bypass calling the com-
pany and just gather all the information you need there.
342 How can I find out when particular companies are expect-
ed to unveil their quarterly earnings reports?
One good way is to call the company and ask, or call your brokerage
and let them find out for you. If you’re online, click over to the Fool’s
quotes and data area at http://quote.Fool.com, where we’ve got an earn-
ings calendar that tracks recent and upcoming earnings reports.
Grab a company’s 10-K report, which is issued once a year along with
its annual report. These documents detail a company’s financial and
operational progress and also address risks facing the business.
For example, Internet company Yahoo!’s recent 10-K cites many risk
factors. The stock price is volatile, and the company’s operating his-
tory is limited. The firm’s growth strategy depends on things beyond
its control, such as the market’s adoption of the World Wide Web as
an advertising medium. Most revenues come from advertising, which
is seasonal and has short-term contracts. The firm “depends substan-
tially on third parties for several critical elements of its business, in-
cluding technology and infrastructure, content development, and dis-
tribution activities.”
All companies have risks. Don’t let them scare you away, but do con-
sider them.
For your own personal balance sheet, you’d list all your assets, subtract
your debts and obligations, and end up with your net worth. Compa-
The balance sheet has three main parts: assets, liabilities, and share-
holder equity. Assets are set equal to — or in balance with — liabili-
ties and shareholder equity. The funny thing is, though, some assets
can be bad and some liabilities can be good. Here’s why.
Take a gander at assets. In this category, you’ll find items such as “cash
and cash equivalents” and “short-term investments.” That’s how much
unused gunpowder the company has. These assets are good, but most
other assets are not as good. Consider “accounts receivable.” That’s money
from sales the company hasn’t yet received and can’t use. “Inventory”
reports how much product is in various stages of preparation. It’s cash
tied up in materials and products that haven’t yet been sold. Not so good.
Glancing at the balance sheet, we see $101.7 million in cash and cash
equivalents, up 45% from the previous year. A growing pile of cash
is generally promising.
You usually want to see little or no debt. Between 1997 and 1998, Star-
bucks’ long-term debt plummeted from $169 million to $1.8 million.
That’s good. If debt was substantial, we might peek at the footnotes to
check out the interest rates. Low rates would indicate that the firm
is financing operations effectively.
It’s also good to measure inventory turnover, which reflects how many
times per year the firm sells out its inventory. Take 1998’s cost of goods
sold (sometimes abbreviated COGS) (from the income statement) of $578
million, and divide it by the average of 1997 and 1998 inventory ($120
million and $143 million averaged is $131.5 million). This gives us a
turnover of 4.4, up a smidgen from last year’s 4.3. The higher the bet-
ter, so no worries here.
Accounts receivable are less rosy. They rose 63%, outpacing sales
growth. Normally, this might be a concern, but Starbucks has been
expanding its range of activities. New non-retail business lines have
been added, altering its usual receivables pattern.
Many investors focus only on sales and earnings growth. While that’s
First, the bad. If a company is saddled with a lot of debt, it’s locked
into making interest payments. If it doesn’t have the cash to cover these
payments, it’s in deep doodoo. Many individuals can probably relate
to this, having experienced the dark side of debt when racking up
charges on credit cards.
Now, the good. Consider that most people would never be able to buy
their homes without taking on debt with a mortgage. Without car and
school loans, many of us would probably be driving clunkers and tak-
ing correspondence courses we found on matchbook covers.
Debt can be helpful for businesses, too. Many great companies, such
as Federal Express and the Walt Disney Co., came to life because of
early loans to their founders. Established companies also can make
good use of debt, borrowing to expand operations and grow their busi-
ness. Interest payments also decrease a company’s taxable income, as
they’re deductible. Investors willing to consider companies with debt
need to evaluate whether the debt taken on is manageable and whether
the capital raised and invested is earning more than it costs.
When companies need money, they typically have two main choices:
They can issue more stock or take on debt. Issuing stock can dilute
the value of existing shares. Debt can sometimes be more efficient, as
its after-tax cost can be much cheaper than equity.
All things being equal, though, we prefer to see little debt on a bal-
ance sheet. Companies that can grow without using debt or issuing
Companies with piles of cash have a lot of flexibility to act quickly when
various opportunities arise, but many successful companies manage
down their cash balances to near zero. They use the money to buy back
shares and acquire other companies, among other things. If they sud-
denly need some cash, they draw on lines of credit available to them.
You might be surprised at just how much cash some companies have
on hand. As of June 2000, Microsoft had nearly $24 billion in cash and
cash equivalents sitting in its coffers. Fellow giant Wal-Mart, mean-
while, had just $1.4 billion in April of 2000, while America Online had
$2.5 billion as of June 2000. At the other end of the spectrum are com-
panies such as Gillette, which had just $101 million on hand as of March
2000. Different companies manage their cash in different ways, with
varying degrees of success.
Let’s say that Acme was calculated to be worth $20 million, but Road-
Let’s look at the income statement for fiscal year 1999 for Coca-Cola.
We’ll compare our findings with some numbers from PepsiCo’s 1999
income statement. Just remember that the two companies are not in
identical businesses — while Coca-Cola is pretty much just a beverage
company, PepsiCo’s business includes substantial snack food opera-
tions (from Frito-Lay, for example).
At the top, as with every income statement, you’ll find net sales (some-
times called revenues). Coca-Cola’s “net operating revenues” are $19.8
billion. From now on, as we work down the income statement, vari-
ous costs will be subtracted from the revenues, leaving different lev-
els of profit. These are called “margins” and are an important item
for investors to evaluate.
The item you’ll find just under revenues is “cost of goods sold” (some-
times abbreviated as COGS or called cost of sales), which represents
the cost of producing the products or services sold. For Coca-Cola, it’s
To find the gross profit margin, simply divide the gross profit by rev-
enues. $13.8 billion divided by $19.8 billion yields a gross profit mar-
gin of 70%. (Compare results with industry peers. For example, gross
margin is 60% for PepsiCo.)
Finally, after items such as taxes and interest payments are account-
ed for, we come to net income, near the bottom of the statement. Coca-
Cola’s is $2.4 billion. Divide that by revenues and you get a net prof-
it margin of 12%. (PepsiCo: 10%.) The last part of the income statement
is where the company divides its net income by shares outstanding,
to arrive at earnings per share (EPS).
Compare all these margins with those from previous years. Increasing
margins indicate increasing efficiency and profitability. Check out the
margins of the company’s competitors. Is the firm more efficient than
its peers? Look for significant changes in revenues, SG&A (selling, gen-
eral, and administrative) expenses, and costs of goods sold.
And, finally, note that margins vary widely by industry. Software com-
panies, for example, tend to have high margins, while retailers tend to
have low ones.
The cash flow statement shows how much money a company is real-
ly making as it works through operations, makes investments, and bor-
rows money.
The statement breaks cash inflows and outflows into three categories:
operations, investments, and financing. Some operating activities in-
clude purchases or sales of supplies, and changes in payments expected
and payments due. Investing activities include the purchase or sale of
equipment, buildings, property, companies, and securities such as
stocks or bonds. Financing activities include issuing or repurchasing
stock and issuing or reducing debt.
Examine the various line items, though, and see how they have changed
compared to past years. You may notice, for example, that “payments
of debt” double or triple from one year to another. This shows the firm
increasingly paying off debt. “Purchase of company stock” would re-
flect a company buying back some of its own shares, to increase the
You’re right. Within the financial statements, names for some items
vary from one company to another. Don’t let this confuse you. If you’re
looking for “Revenues,” for example, just know that the same thing
might also be called “Sales.” See the list on the next page. (This list is
by no means comprehensive. It’ll just give you an idea of the variation
you’ll likely run across.)
Major corporations (and even many minor ones) typically have vari-
ous subsidiaries and lines of business. Some companies are more for-
mally considered “holding companies,” if they own the securities of
other firms. (A classic example of a holding company is Warren Buf-
fett’s Berkshire Hathaway, which owns GEICO Direct Auto Insurance,
See’s Candies, and the Dexter Shoe Company, among other companies.)
When a company reports “consolidated” numbers, it has simply com-
bined the results from all its various operations into one report.
Enter the run rate. Take the most recent quarter’s sales. Let’s say they’re
$30 million (up from $25 million the quarter before and $21 million
before that). Multiply that by four and you’ll have the company’s cur-
rent run rate for sales: $120 million. It’s not a forecast or a measure
of past sales — it’s a reflection of the current level of annualized sales.
Let’s consider an example. Imagine the Wicker Sink Co. (ticker: SIEVE),
with sales of $12 million in 1996 and $48 million in 1999. If you have
a slightly fancy calculator, it might actually sport a feature that cal-
culates growth percentages for you. If not, here’s what to do to fig-
ure out the revenue growth rate in this example:
Divide $48 million by $12 million and you’ll get 4. This means that
sales quadrupled, or increased by a growth multiple of 4. That does-
n’t translate to a gain of 400%, though. (After all, doubling is a gain
Another way to approach it is to take the $48 million and subtract the
$12 million to get $36 million, which represents the growth. Divide
it by $12 million and you’ll get 3. Multiply that by 100 and you’ve got
300%. Same answer.
$48 million - $12 million = $36 million
$36 million / $12 million = 3
3 x 100 = 300
300 + a percentage sign = 300%
One last valuable step is to annualize the growth rate. In other words,
to figure out roughly by how much Wicker Sink’s sales are growing
each year. To do this, we first need to figure out the time period in-
volved. From 1996 to 1999 is three years, so we’ll be taking the third,
or cube, root of the growth multiple. (If the time period were five years,
you’d raise the multiple to the 1/5 power. For 8.4 years, it would be the
1/8.4 power. Two-year periods are easy — you just take the square root.)
It is tricky stuff, until you get used to it. Practice it a little and you’ll
be happy you did. And don’t feel bad if you can’t get the hang of it too
quickly. It doesn’t always come easily to everyone. Join many other
Fools online at our discussion boards, where you can ask for help when
you’re confused. (Head to http://boards.Fool.com and pop into “The
Information Desk” or “Investors’ Roundtable.”)
Sometimes the company itself can tell you. Try giving its investor re-
lations department a call. Another good resource is your public library,
where librarians should be able to help you look up the price in news-
paper archives or elsewhere. Online, hop over to www.financial-
web.com/market or use the Fool’s data service, at http://quote.Fool.com.
You’re right — there are a lot of measures. If you’re foolish (with a small
“f”), you might only look at the price-to-earnings (P/E) ratio. Fools
(with a capital “F”) will consider many measures, such as profit mar-
gins, cash from operations, earnings growth rates, and return on eq-
uity.
The more measures you learn about, though, the more confused you
may become. Try thinking about it this way: As you study a compa-
ny, there are two key questions that need to be answered by the in-
formation you gather:
1. Is this a high-quality company that I’d love to own a piece of?
2. Is the price right to buy it now?
It’s probably simpler than you think. The P/E ratio is a measure that com-
pares a company’s stock price to its earnings per share (EPS), usually for
the previous 12 months. You can think of it as a fraction, with the stock
price on top and the EPS on the bottom. Alternatively, tap the price into
your calculator, divide by EPS, and voila — the P/E.
361 A low P/E ratio for a company is a good sign, though, right?
362 I’ve seen some sky-high P/E ratios. How can a company
have a price-to-earnings ratio of 1,000?
Remember that the P/E ratio is a simple fraction — the company’s stock
price divided by its earnings per share (EPS). As long as there are no
earnings (such as with start-ups, or companies temporarily or per-
manently in trouble), the bottom of the fraction is zero and a P/E can’t
be calculated. But, as soon as a tiny bit of profit occurs, the fraction
suddenly comes alive. With a bigger number on top (the stock price)
and a very small bottom number (the EPS), the P/E is large.
If the company’s stock currently trades at $77 per share and has $1 per
share in annual earnings, its P/E is 77. Let’s say it is growing rapidly,
though, and is expected to earn $3.50 next year. If so, the projected
P/E for that year is 22 ($77 divided by $3.50 is 22).
364 What are “multiples” and what role do they play in evalu-
ating a company?
Expected earnings growth coupled with P/E multiple growth can offer
a powerful one-two punch. Imagine a stock trading at $10 per share
— 10 times its EPS of $1. As earnings grow, the stock price will like-
ly increase to maintain the multiple. For example, when earnings are
$2 per share, the stock price should be near $20. But, if the multiple
is also growing, the price is likely to increase even more. If a reason-
able multiple is perceived to be more like 15 and the earnings are $2
per share, the stock should eventually approach $30 per share.
You bet. If you read analyses of various companies, you’ll see refer-
ences to price-to-sales multiples, book value multiples, cash flow mul-
tiples, and more. It’s instructive to compare a company’s various mul-
tiples with those of its competitors.
366 How can a firm’s earnings per share rise when its earnings
are flat?
This can seem puzzling, but it happens when the number of shares falls.
Imagine that the Free-Range Onion Co. (ticker: BULBS) has 10 million
shares outstanding and earns $20 million in a quarter, making earnings
per share (EPS) $2. If it spends some of its cash to buy back a million
shares and then earns $20 million again in the next quarter, its EPS has
suddenly risen to $2.22 (20 million divided by 9 million equals 2.22.).
While share buybacks are generally good, as they boost the value of
each remaining share of stock, ideally they shouldn’t be the only driv-
er of EPS growth.
The solution is a simple one. Focus on net income. Share buybacks re-
duce the number of shares outstanding. When the number of shares
decreases, the earnings per share rise. To get a handle on what’s hap-
pening without regard to buybacks, just examine the total net income.
Basic EPS is net income, less any preferred stock dividends, divided
by the weighted average number of common stock shares outstanding
during the reporting period. Diluted EPS takes into account stock op-
tions, warrants, preferred stock, and convertible debt securities, all of
which can be converted into common stock. These common stock
equivalents represent the potential claims of other owners on earn-
ings, and show the investor how much of the company’s earnings she’s
entitled to, at a minimum.
Since many firms issue gobs of stock options, the new rules will help
investors more accurately determine how much of the company’s earn-
ings they’re entitled to, and will impart a sense of what stock options
actually cost a shareholder. The change will also align U.S. accounting
standards with international standards being developed, ultimately
helping investors compare companies around the globe.
That’s when you should focus on other measures instead. (And, be-
sides, you should always be looking at other measures, anyway.) Check
out revenues, for example, and revenue growth rates, and margins,
and debt levels, and competitive positioning, and brand strength,
among many other things. You essentially want to evaluate whether
the company is on the path to profitability, and how well it’s execut-
ing its strategy.
370 Is it smart to look for stocks whose share prices are trading
near their 52-week lows and to consider selling ones trad-
ing near their highs?
A company whose stock is trading near its 52-week low might make
a profitable investment... or not. The price alone doesn’t offer enough
information. The company might be a great one temporarily facing
some trouble, in which case it could be well worth your while to re-
search it further. Alternatively, it might be careening to its demise and
about to burst into flames. A company going down in flames will hit
Selling a stock at its all-year high isn’t generally a good idea. Think
of wonderful companies that have rewarded shareholders for many
years. They set new highs all the time, despite occasional bumps in the
road. Sell now and you might miss out on future gains.
Take the current assets of $8.2 billion and subtract the current in-
ventory of $7.1 billion. Divide the result, $1.1 billion, by current li-
abilities of $4.1 billion and you get 0.27. Yikes. Low ratios, such as
those below 1.00, can be cause for concern, especially for smaller com-
panies with less access to bank loans.
A year earlier, at the end of fiscal 1998, Kmart’s ratio was 0.35, so its
financial health, according to this measure, has been worsening. Looks
like Martha Stewart and Jaclyn Smith have their work cut out for them!
Consider Microsoft Corp., for example. Its recently reported book value
Book value can even be a poor indicator of fair value for a heavily
industrial company. Imagine a firm that owns a lot of land and many
buildings. Over the years, the value of these assets is depreciated on
the balance sheet, eventually to zero. But these assets are rarely worth-
less and can even appreciate in value over time. Such a company might
actually be worth a lot more than its book value (while other compa-
nies can be worth much less). For these reasons, it often makes sense
to largely ignore book value.
Compare a company’s inventory levels with those from the year be-
It’s a measure that will give you a sense of how quickly a company’s prod-
ucts are flying off the shelves. Here’s how you’d crunch this number:
From the company’s income statement, find the “cost of goods sold”
(or COGS). You’ll want the last 12 months’ worth. If the fiscal year
has just ended, you can use the figures in the annual report or 10-K re-
port. If it’s mid-year, just re-create the last year’s results by adding to-
gether the numbers from the last four quarters’ reports. Once you have
this number, jot it down.
Next, you calculate the average value of inventory for the 12-month
period you’re looking at. If, for example, you’re using the cost of goods
sold for the 1999 fiscal year, you want to take the inventory value from
the end of fiscal 1998 and average it with the inventory value from the
end of 1999. This way, your numbers address the same time period
— the duration of fiscal 1999.
Once you have the cost of goods sold, divide it by the average inven-
tory, and you’ll get the inventory turnover rate. A company with high
and growing inventory turnover rates would appear to be well man-
aged, freeing up its working capital for other uses.
375 Can you explain why you generally think low inventory lev-
els are good and high ones are bad? This doesn’t make
sense to me.
While a high inventory level might make a company appear well posi-
tioned to meet demand, it can be risky: demand may suddenly plunge.
Indeed, a large inventory may signal that demand has already slackened.
Products end up sitting on the shelves all the time. Fashion trends
Anything left sitting on a warehouse shelf costs money to hold and risks
not being sold. Efficient companies generally try to maintain low lev-
els of inventory. These levels permit quick reaction to market changes
and minimize the chances the company will get stuck with extra goods.
Imagine the Beehive Wig Co. (ticker: WHOAA). With the accrual
method, if it has shipped 1,000 crates of wigs, but hasn’t yet received
payment for them, those sales still appear on the income statement.
The checks “in the mail” get reported as “accounts receivable” on the
balance sheet.
Dig out the company’s annual report or its latest earnings report and
look at the balance sheet. Is there more long-term debt than cash?
Many companies carry a lot of debt successfully, but you could look
into whether management is borrowing more than it can pay.
Look at the income statement and compare numbers over the past few
years. Have sales and earnings been growing consistently? A smooth
Invest in companies only after you make sure their highly compen-
sated executives are earning their keep.
A company’s return on equity (ROE) reflects the productivity of the net as-
sets (assets minus liabilities) a company’s management has at its disposal.
To calculate return on equity, take one year’s (or four quarters’) worth
of earnings (often referred to as “net income”) from the income state-
ment. Next, look at shareholders’ equity on the balance sheet. Re-
To finally arrive at the ROE, divide the year’s earnings by the aver-
age shareholders’ equity. (Whew!)
Gillette’s ROE fell to 23% in 1998 from 31% in 1997. It appears that
executives at this consumer-product conglomerate are improving the
use of shareholders’ capital. (Of course, taking the time to look farther
back will reveal an ROE of 23% in 1996 and 30% in 1995, so while
33% is the best result in quite a while, it hasn’t been rising in a straight
line. Net income itself has also bounced up and down.)
It’s the percentage of net income the firm pays out to shareholders as
dividends. If Buzzy’s Broccoli Beer (ticker: BROCB) pays $1.00 per year
in dividends and sports earnings per share (EPS) of $4.00, its payout
ratio is 25% ($1.00 divided by $4.00 equals 0.25, or 25%).
This shows what the company is doing with its money. If you see that
a company is returning 75% of its earnings to shareholders, then lit-
Someone who lives near an Ethan Allen factory might visit it late at
night and on the weekend, to count cars in the parking lot and see if
workers are toiling overtime. They might report on discussions with
local employees and suppliers. You and others across the country can
don trench coats and visit retail outlets, checking to see how many
customers are placing orders and how successful the product mix ap-
pears to be. You can interview store workers, too. Assembled togeth-
er, this information should be quite revealing.
Next, imagine a company that raises needed funds only by issuing more
stock. This is an appealing option when the stock market is hopping;
cash is generated with little effort. The downside to equity financing,
384 What is the “Flow Ratio”? I know that it’s used in Rule
Maker investing, but I don’t know how to calculate it or
what it means.
It’s a handy measure you can calculate using a company’s balance sheet
that reveals how effectively cash flow is managed. Here’s the formula:
Any result below about 1.25 is admirable, so 1.83 is not ideal. (The
lower the Flow Ratio the better.) Still, a little more number crunch-
ing will reveal that a year earlier, Harley-Davidson’s Flow Ratio stood
at 2.06, so it’s clearly dropping, which is a good sign.
Meanwhile, current liabilities, after you subtract debt, are usually dom-
inated by accounts payable. That’s money a company owes and can
temporarily use — interest-free. Industry-dominating companies often
wield enough clout to demand favorable payment terms. A high num-
ber for this part of the Flow Ratio is preferred.
If you’re wondering how low a Flow Ratio can go and how some well-
known companies stack up, here are some recent numbers (as of mid-2000):
Yahoo!..........................0.34
Microsoft .....................0.49
America Online ............0.86
Intel.............................0.93
Coca-Cola .....................1.03
Nokia...........................1.19
Gap..............................1.34
Pfizer ...........................1.77
Like the Flow Ratio, the Cash King Margin is a key measure used in
the Fool’s Rule Maker investing strategy. It is essentially like the net
profit margin, except that instead of using net income from the income
statement as the measure of income, it uses operating cash flow from
It’s not that companies are maliciously lying on their income state-
ments, but accounting rules do allow various kinds of manipulation.
For example, a company might record as sales whatever product it has
shipped. Half of these items may end up returned, though, or perhaps
some customers will end up stiffing the company. In these cases, sales
at the top line will be, in a sense, overstated — and the resulting bot-
tom-line earnings will be skewed.
Cash from operations, as reported on the cash flow statement, isn’t eas-
ily manipulated. It’s based on actual cash inflows and outflows. It’s a
much purer number, and can make it easier for an investor to compare
apples to apples when studying various companies.
Some notes:
• Operating cash flow might go by a different name on a company’s
cash flow statement. It’s often listed as “Net cash provided by [or
used by] operating activities.”
• Capital expenditures are often listed as “Additions to [or subtrac-
tions from] property and equipment” in the investing activities sec-
tion of the cash flow statement. They include major equipment pur-
chases, factory construction, and other big-ticket items.
• By subtracting capital expenditures, we can see how profitable the
business is on its own, without regard to capital expenses.
When evaluating a company’s Cash King Margin, you can smile at any
result over 10% and grin widely at any that tops 15%. Here are a
few results for some well-known companies, as of mid-2000, just to
give you a little perspective:
Microsoft .....................60%
That’s still very little perspective, though. If you were really inter-
ested in one of these companies, you’d want to see what the trend
has been for its Cash King Margin, as well as for many other measures.
And you’d want to compare a company’s numbers with those of its
competitors.
Still, consider the amazing Microsoft figure above. It means that every
dollar the company took in generated about 60 cents in cold, hard cash
for the company’s coffers.
Examine the statement of cash flows, too, to see how the company’s
cash is being generated. Look at how much investment is required to
create earnings. Generally, you want to see most cash coming from on-
going operations — the stuff produced and sold — and not from the
issuance of debt or stock.
Also worth a closer look are the companies’ margins. These include
gross margins, operating margins, net margins, and the Cash King Mar-
gin. Higher gross margins might suggest that a firm has a more pro-
You could also examine return on equity and return on assets, compar-
ing companies in the same industry. See which firm is generating more
dollars of earnings for each dollar of capital invested in the business.
Check previous years’ numbers, to see whether the trend is positive.
Basically, the more angles you examine a company from, the better.
The more information you gather, the more sure you’ll likely be of your
decision to invest or not to invest.
But, perhaps while net losses increased 317%, revenues grew more
briskly, up 350%. If you’re willing to consider companies that are not
yet making money, this is a promising sign. Many investors believe
that, for emerging start-ups like FreshFish.com, this is the time to plow
money into advertising and into growing the business. They reason
that the time for profits is later, once the company has amassed a huge
seafood-by-mail-loving customer base.
It sure is. The Internet has revolutionized investing, giving folks on Main
All investors should explore these online resources. If you don’t have
Advanced
Research Topics
If you hunger to learn more about researching companies, this
chapter covers a few higher-level investing topics. It’s a short
chapter, though. If I addressed all the possible topics in this
book in great depth, you’d have to haul it around with a fork-
lift. So, permit this chapter to give you a taste of the kinds of
things you can learn with a little more digging. I’ll conclude
it with a pointer to some good resources for learning more.
You’re smart to think about and evaluate an industry when you are as-
sessing a company within it. In his book Competitive Strategy, Har-
vard Business School professor Michael Porter lays out five competi-
tive forces that affect an industry.
299
are only a few airplane suppliers (such as Boeing and Airbus). It’s
more difficult in that situation to play one against the other, try-
ing to strike a bargain. If there were many suppliers, they’d likely
be competing more for your business, which might result in lower
costs for you.
Take these things into consideration and you may be able to zero in on
the most attractive company in the industry. Alternatively, you might
learn that the entire industry just isn’t as attractive as you thought.
Learn more about researching companies at www.multex.com and
www.Fool.com/research.
One way to think about what you’re paying for a company is to look
at its price-to-earnings (P/E) ratio. Another way is to calculate the
inverse of that, which is its earnings yield.
To calculate Fryyndar and Ulf’s earnings yield, just reverse the P/E ratio,
dividing the annual EPS by the current stock price ($3 divided by $111
equals 0.027, or 2.7%). Compared to risk-free Treasury bond interest
rates (of roughly 6% at the time of this writing), this doesn’t appear to
be a bargain. But remember: Whereas bond rates are fixed, earnings typ-
ically grow. Imagine that FANDU is expected to increase earnings 10%
per year. If so, in 10 years its EPS should grow to $7.78. Assuming we
bought shares when they were at $111, the earnings yield for us has now
become 7%, considerably better ($7.78 divided by $111 is 0.07, or 7%).
It can be instructive to see how long it takes for the growing earn-
ings yield to pass the current 30-year bond rate. FANDU passes it with-
in nine years.
You may remember that earlier in this book I explained that market
capitalization (the current stock price multiplied by the number of
shares outstanding) can also serve as a price tag for a company. That’s
true, but market cap ignores debt, and with some companies debt is
substantial and changes the picture significantly. Enterprise value is
a modification of market cap, incorporating debt.
By the same token, imagine that you have two companies with equal
market caps of $50 billion and no debt. One has negligible cash and
cash equivalents onhand, and the other has $5 billion in cash in its
coffers. If you bought the first company for $50 billion, you’d have a
company worth, presumably, $50 billion. But if you bought the sec-
ond company for $50 billion, it would have cost you just $45 billion,
since you instantly have $5 billion in cash.
Let’s examine Kmart, using its quarterly earnings report from April
2000. Its 481 million shares, at a recent stock price of about $7, yield
a market cap of $3.4 billion. To that, we add its $1.9 billion in debt and
subtract its $0.35 billion in cash and cash equivalents. The result is
$4.95 billion, a significantly higher number than the market cap.
Debt can make a big difference. If you paid $3.4 billion for Kmart, you
would actually end up with a total bill of $4.95 billion, because the
company comes with a lot of debt. The enterprise value reminds all in-
vestors, large and small, that debt is a cost to the business.
Think of it this way. If you invest $9 for 10 years and it turns into $10,
you’ve achieved a total return of 11.1%. That might look good, but
that’s 11.1% over a 10-year period. It amounts to only about 1% per
year. Sheesh — even a passbook savings account can beat that, and
it’s even insured. Investors should always consider where else they
might invest their greenbacks, and what other kinds of returns they
might expect.
Back to our dollar machine. Let’s say you expect a rate of return equal
to the stock market’s historic rate of about 11% growth per year. If so,
you might decide to pay just $3.52 for the machine. $3.52 invested for
10 years, earning 11% annually, becomes $10. (You would probably
be outbid by someone else, though... someone who realized that she
could reinvest those dollars elsewhere at the end of each year.)
The dollar machine is not just a fantasy. It’s very much like companies
in which you buy stock. The price you’d pay for the machine today
is its “intrinsic value.” Companies also have intrinsic value, or “fair
value” (based primarily on earnings), and investors need to keep this
in mind when buying stock in them. Pay attention to a company’s earn-
ings and dividend payout.
Companies are valued on the profits they earn. When buying stock,
you don’t want to end up paying too much for a dollar machine.
Despite its usefulness, the PSR should never be the only number you
crunch.
The PSR can sometimes give you a nice context for a company’s value
relative to its industry peers, but while sales growth is great, those
sales must be transformed into meaningful and rising earnings to
make shareholders happy. Some companies have massive and grow-
ing revenues, but little earnings to show for it. How much a com-
pany earns from its sales will eventually drive the value of the busi-
ness and the stock.
You’re right. For starters, it’s based largely on sales (a.k.a. revenues),
but all dollars taken in as sales are not equal. Some companies have
hefty profit margins and keep much of their sales dollars as earnings.
Other companies have small margins and keep very little as profit. In
addition, the PSR ignores debt. A company’s debt load should factor
into your assessment of it.
Enterprise Value
Enterprise Value-to-Sales Ratio = ———————————
Trailing 12-Month Revenues
Now that we have a net profit margin of 0.0327 and an asset turnover
of 2.74, we multiply them to get a return on assets of 9%. This shows
that Wal-Mart creates nine cents of earnings from each dollar of assets.
By comparison, Kmart’s ROA over the same time was 2.75%.
There is. You can simply divide net income (though sometimes operating
income is used) for a period by the average total assets for the period.
Buying &
Selling Stocks
If you’re relatively new to the investing scene, you may find
yourself confused by brokerage terminology and procedures.
This chapter will help you understand the ins and outs of bro-
kerages and the various ways that you can buy and sell stock.
400 Can you explain the difference between full-service and dis-
count brokers?
You have a similar choice with brokerages, deciding between the full-
service broker and the increasingly popular discount broker.
309
as they don’t like to publish rate schedules. It’s safe to say, though, that
for many of their customers, commissions run up to 5% or more of the
value of a trade. For example, it might cost a couple of hundred dol-
lars to buy or sell $8,000 of stock. (To be fair, though, some of them
have introduced lower rates recently.)
At the other end of the spectrum, offering little in the way of advice
or handholding, are discount brokers such as Charles Schwab and
Ameritrade. They’re the local steakhouses of the brokerage industry,
charging roughly $8 to $30 per trade. Some charge even less.
Assess what services you need from a broker and how much you’re
willing to spend. If you’re a do-it-yourself investor, get thee to a dis-
count broker. You’ll probably save enough for a meal at Chez Maurice.
Fees are one big factor to examine. Find out how much you’ll be charged
in commissions for various transactions and services. Since many dis-
Some of these factors are more important than others. For example, if
you trade only twice a year, commission costs might not matter as
Many brokerages even surpass SIPC levels of insurance. But there might
be a shady brokerage or two out there that somehow isn’t insured. Ask
your brokerage (or prospective brokerage) for clarification on what in-
surance protection it offers.
You certainly can. That’s how most online brokerage account holders
handle it. You mail in a check and it’s credited to your account. Then
you can place orders by phone, over the Internet, or in person. If your
brokerage has a local office, you can drop by and deposit money in per-
son, as well. Most brokerages also permit electronic transfer of funds.
405 When trading stocks on the Internet, how can you be sure
that the price you see is the one you end up paying?
First, know that the stock prices listed in newspapers and online sim-
ply reflect the price at which the stock last traded. The next trade could
occur at a higher or lower price — sometimes a significantly higher or
lower price — depending on supply and demand. You’re not out of
luck, though. You can control the price you pay by placing a certain
type of order, called a limit order. There are several main types of or-
ders, each with advantages and disadvantages.
406 What are the different kinds of orders I can place with my
broker?
You have many choices. Here are the main ones to understand:
Market order: This is for immediate execution at the best price avail-
able when the order reaches the marketplace. This is the most com-
mon type of order and is nearly always filled, since no price is spec-
ified. As an example, you might call your broker and bark into the
phone, “Buy me 75 shares of Scrunchie Manufacturing (ticker:
SCRNCH) at the market!”
Day Order: This order terminates automatically at the end of the busi-
ness day if it hasn’t been filled.
GTC (Good ‘til Cancelled): This order remains in effect until cancelled
by the customer or executed by the broker. It doesn’t typically remain
in effect forever, though; many brokerages cancel GTC orders after a
month or two.
Stop Limit Order: This is similar to a stop order, but it becomes a limit
order instead of a market order when the price is reached or passed.
If you place a “sell 100 XYZ $55 stop limit” order, if XYZ drops to $55
per share or below, the order becomes a limit order to sell 100 shares
at no less than $55.
Note that there are trade-offs with each option. Selling at the market
means your shares will probably be sold quickly, but the price may
be a little higher or lower than you expected (and on some occasions,
considerably higher or lower). With a limit order, you specify the limit
of what you’re willing to pay or accept, but you risk not getting any
takers at your price.
You’re describing either a “stop loss” or “stop limit” order. The “stop”
activates the order if shares sink to a certain price ($40 in your ex-
ample). The stop loss order immediately sells the shares at the best price
it can, while the stop limit will only sell if the shares are at $40 or above.
Here are the risks: if, perhaps due to bad news, the shares suddenly
fall below $40 overnight and don’t rise above that, the stop-loss will
sell your shares for less than $40, while the stop-limit order won’t
sell the shares at all.
You’re probably familiar with the maxim, “Buy low, sell high.” You
might not know it, but if you’ve spied a stock you’re pretty sure will
drop, there’s an interesting way you might profit from its fall. You’d re-
Here’s how it works. Let’s say that an Internet fan club, GroverCleve-
land.com (ticker: GROVY), has gone public. Despite much media hoopla,
you have little faith in it and expect the stock to sink. You call your
brokerage and say that you want to short GROVY. The brokerage will
“borrow” shares from a GroverCleveland.com shareholder’s account
and proceed to sell them for you at the current high price. Then, once
the share price drops, you’ll “cover” your short by buying shares on
the market at a lower price; to replace the ones you borrowed. If you
shorted GROVY at $35 and covered when it fell to $20, you made $15
per share (less commissions).
This technique sounds weird, but it’s perfectly acceptable and done
often. Shorting can be beneficial because:
• With shorts in your portfolio, you might profit from both rising and
falling stocks. If you see a great and growing company, you can buy
shares in it. If you see a stinker, you can profit by betting against it.
• Shorting can bolster a portfolio. If the market takes a big drop, your
shorts should boost your portfolio’s performance.
• If the stock price rises, you lose. With shorts, you can only earn
up to 100%, since a stock price can’t fall lower than zero. But, if
your short keeps rising, your downside is theoretically unlimited.
Since you can actually lose more than 100% of your money, you
need to keep a very close eye on any shorted stocks.
• Shorting is based on short-term expectations, and Foolish investors
generally prefer to focus on the long term.
• It bucks the overall long-term upward trend of the market.
• If you short a company’s stock, you’ll have its management work-
ing against you to make the company succeed, perhaps with new
financing, partnerships, or products.
• If the stock you shorted pays dividends, you’ll be required to pay
the dividend to the shareholder whose shares you borrowed. (Your
broker should take care of this.)
A short squeeze is when those who are short a stock bail out en masse,
driving the stock price up as they buy shares to replace the ones they
borrowed when shorting.
Yes, you can — and you must. The expenses incurred in purchasing
or selling a capital asset (stock, in this example) are capital expenses,
and are required to be added to or subtracted from the cost basis of
the stock for tax purposes.
Let’s say you buy $3,000 of stock and pay $50 in commission and other
charges. Your actual cost is $3,050. You sell the stock later, when it’s
worth $4,000, paying another $50 to the brokerage. Your “net” sales
price, or proceeds (generally, the amount reported to you by your bro-
ker at year-end on your Form 1099B), would be $3,950 ($4,000 less
$50). On your tax return, you would report a gain of $900 ($3,950 less
$3,050 equals $900.)
Note that you’ve not had to pay tax on that $100 in commissions — so
you’ve probably saved at least $20.
On the Fool’s discussion boards, one of the most read and recommended
posts is from a reader named “globalstreamer,” detailing how he lost
his entire portfolio, $60,000, in two weeks — by getting carried away
with margin. Only experienced investors should use margin. Although
you’re currently allowed to borrow up to 50% of what your actual
holdings are worth, it’s smart to limit yourself to no more than around
20%, if you borrow on margin at all.
Mutual Funds
You’ve surely heard of mutual funds, and you very likely in-
vest in them, but do you really understand what they are and
how they operate? Do you know for sure whether they belong
in your portfolio? Have you met the friend of the Fool, the index
fund? This chapter will help you tackle these questions.
Imagine this scenario: You have only $500 to invest. You believe that
it’s risky to invest in only one stock, but you also know that you should-
n’t spread yourself too thin with that amount of money. But what if
you gathered 20 friends who each had $500? Together you’d have
$10,000, enough to invest in several stocks without commission costs
running too high. Nice job. Uh-oh, now who decides what to buy and
when to sell? Ah, another problem.
Perhaps your group chooses to pay some guy in a bow tie and sus-
penders to manage it for you. If so, then you’ve essentially got a mu-
tual fund on your hands. A mutual fund is thousands of people’s money,
pooled together by an investment company and invested in stocks,
bonds, and other things, all managed for you by Wall Street profes-
sionals — for a sometimes hefty fee, of course.
321
417 I’m confused by the many different kinds of mutual funds
out there, such as “Growth and Income,” “Equity Income,”
and “Fixed Income.” How do these differ, and what other
kinds of funds are there?
There are a few key words to understand. Fixed income means bonds.
Equity means stocks. Income funds aim to generate regular payoffs for
shareholders through dividends from stocks and/or bond interest.
Growth funds don’t try to generate income; instead, they tend to seek
stock price appreciation. Sometimes you may see the term “Balanced”
used, which means that the fund is about half stocks and half bonds,
generally. There are many variations of these kinds of funds.
“Index funds” mimic indexes. An S&P 500 index fund, for example,
will contain stocks in the 500 companies that make up the S&P 500
index — in the same proportion as the index. These are passively man-
aged funds, as opposed to actively managed ones, because there’s no
manager subjectively evaluating and selecting stocks. Instead, it’s just
a matter of making sure that at all times the fund contains the appro-
priate stocks in the appropriate proportions.
Just about. NAV stands for “net asset value.” To understand what it is,
know that mutual fund prices don’t fluctuate during the day. Since
funds are composed of many different securities, fund companies wait
until the end of trading each day, and then they add up the current
market value of all their holdings. They then subtract the fund’s ex-
penses for the day, such as commissions paid. The result is divided by
the number of shares of the fund that exist — and that’s the NAV.
421 Is looking for funds with above average returns the best
way to pick mutual funds?
Very likely not. Think about it this way. You’re a smart cookie — you
know that many mutual funds aren’t too impressive. So, you look at
lists of mutual funds and check their returns over the past few years.
You invest only in the ones that have done well over the last year or sev-
eral years, the ones that beat the market average. This sounds like a rea-
sonable approach, but it’s flawed. Here are some things to think about:
It might shock you to learn that, according to Lipper data, only 17% of
all open-end equity funds outperformed the market average (as meas-
ured by the S&P 500 index) over the five years from March 1995 to March
2000. Over the last decade, only about 20% of funds outperformed it.
So, what to do? Well, consider investing in an index fund. If you can’t
otherwise beat the market average, you can meet it (and outperform
the vast majority of mutual funds) by investing in a market index fund.
Many companies, such as Vanguard, offer these. We like funds that
track the S&P 500 or the broader “total market.”
422 I’ve heard that it’s not a good thing when a mutual fund
gets really big. How does this hurt its performance?
For starters, you’d have to keep 5% to 10% of the fund’s value in cash,
to cover withdrawals when people sell shares. You also wouldn’t be able
to invest more than 5% of the fund’s value in any one stock, limiting
you to no fewer than 20 stocks. Typically, mutual funds invest in 50-200
different companies, a far cry from the six to 15 stocks that Fools with
Even if your fund limits itself to owning the minimum number of stocks,
other problems still arise. Let’s return to your imaginary $30 billion fund.
Imagine that you want to (and can) spend 10% of its value, $3 billion,
on Polaroid. Oops. Polaroid’s entire market value (at the time of this writ-
ing) is less than $1 billion. Your $3 billion would buy more than the
entire company. Also, if you’re limited — as many managers are — to
not buying more than 10% of any one company, then you could spend
only $90 million on Polaroid. It’s hard to avoid spreading yourself too
thin when $90 million is merely a drop in your mutual fund’s bucket.
Pity the mutual fund managers. Working with much less freedom and
a lot more money than we have, the odds are stacked against them. It’s
no surprise that most of them underperform the market average.
A high turnover ratio doesn’t necessarily mean you shouldn’t buy a par-
ticular fund. According to recent Morningstar mutual fund data, the
five top-performing mutual funds for the past five years sported turnover
ratios ranging from 115% to 753%. Just know that, in theory, the high-
er the ratio, the higher the tax burden and commission costs.
424 Can you explain the various fees that mutual funds charge?
Virtually all fund fees fall in two categories: load and expense ratio. A
load is a one-time sales charge. Front-end loads are levied when you
deposit money into a mutual fund, and back-end loads, also called re-
demption fees, are exacted when you withdraw money. A typical load
is around 3%. As an example, we tossed a dart at a bunch of funds
and it landed on the Seligman Communications and Information Fund
— Class A. (Classes B and D have different fee structures.) This fund
has a 4.75% front-end load, so if you want to put $10,000 into it, $475
would be deducted from your money upfront.
Loads exist to support brokers and aggressive sales efforts that bring
more money into the fund and into the fund company coffers. This isn’t
usually in your best interest as an investor, so Fools should favor no-
load funds. These often fare better than load funds and have lower
expense ratios, to boot.
With no-load funds, you just need to focus on the expense ratio. Chairs,
computers, catered holiday parties, and other administrative costs that
support the fund are included in this annual fee. Two of its compo-
nents are often reported separately: 12b-1 and management fees. The
Index funds, which the Fool recommends for investors who want to in-
vest in mutual funds, typically sport very low fees and outperform most
other funds. The Vanguard Total Stock Market Index Fund (ticker:
VTSMX), for example, has no load and a piddly annual expense ratio
of 0.20%. With a $10,000 investment, that amounts to just $20. Your
money has a much better chance of growing if 99.8% of it is left to grow.
425 Why do you make such a fuss about mutual fund fees?
Because they really make a big difference. Imagine that you’ve invested
$10,000 in a fund that charges a 2% management fee. In 30 years, if
that investment grew at 12% per year on average, it would become
$174,000. Not bad. But suppose you’d plunked that money into a fund
with just a 1% fee. In 30 years at 12%, it would grow to $229,000.
That’s a $55,000 difference!
For example, the Kitten Kaboodle Fund (ticker: MEOWX) might have
spent the last few months languishing. Rather than reveal that it holds
large positions in poorly performing companies, the manager might
sell off some regrettable holdings and load up on recent market dar-
lings — to look good. This is window dressing.
427 I know that you Fools recommend index funds, but what
exactly are they and what’s so great about them?
Wall Street mutual fund managers want you to believe you’d be lost
without their savvy stock-picking skills. Just read some fund ads: “You
may not have the time or expertise to choose and manage your in-
vestments… [let] our investment professionals do the rest.”
Over the last seven decades, through rallies and recessions, the stock
market has gained an average of about 11% per year. A thousand dol-
lars in an S&P 500 index fund that matched this performance would
have grown to $13,585 in 25 years and to $184,565 in 50 years — just
from a single initial $1,000 deposit. Another great thing about index
funds is that, once you put your cash into them, you can ignore them
and tend to your garden. (And, to think that someone said you don’t
have the time or expertise to choose and manage your investments!)
The index fund is the first rung on the Foolish investment ladder. If you’re
not yet comfortable picking stocks on your own, you really have to ask
yourself why you would not begin with an index fund. It relies on the
long-term growth of great American companies, rather than the long-term
ability of most mutual fund managers to underperform the market.
You can invest directly in an index fund or you can participate via
your 401(k) plan at work. If your plan doesn’t offer an index fund, it
should. Visit your plan administrator and show her this Q&A.
Index funds have grown very popular, as more people have learned
how they outperform more than three-quarters of their mutual fund
brethren. Accordingly, many fund companies now offer them.
Here’s just a smattering of the many funds available, with some info
on them, as of the end of 2000:
Ticker
TickerSymbol NameofofFund
Symbol Name FundMinimum
Minimum Annual Fees Phone #
Initial Deposit Annual Fees Initial
Phone #
Deposit
Technically, you’re not the shareholder — the mutual fund is. Usual-
ly, only a legal representative of the fund (such as the manager) can
represent the fund as the shareholder of record. Still, it doesn’t hurt
to ask. Give the company a call, ask for the Investor Relations de-
partment, and inquire whether you can attend.
You now have 51.36 shares. Your cost basis is $100 each for the first
50 and $110 for the 1.36 shares. Whenever you sell the shares, Uncle
Sam will tax you on their appreciation beyond their cost basis. Tax
rates vary by holding period, though, so make sure you keep track
of exactly how long you’ve held each share. You may want to con-
sult your friendly local tax professional for advice tailored to your
particular situation.
A mutual fund doesn’t pay taxes on capital gains of stocks sold dur-
ing the year. You do. Funds report distributions of income from divi-
dends, interest, and capital gains (net of losses) to the fund’s share-
holders (and to the IRS) on Form 1099.
Imagine that on Monday, you buy 100 shares of the Ominously Over-
diversified Mutual Fund (ticker: OOMFX) at $30 each, for a total of
$3,000. Let’s say that the fund had previously announced a $2 distri-
bution for each share, to occur on Tuesday. This means it sends you $2
per share, or $200, and your $30 shares are now worth $28. (Note that
100 times $28 is $2,800, which when added to $200 yields your orig-
inal $3,000 investment.) It’s not exactly six of one, a half dozen of
the other. That $200 distribution counts as income to you, and you’ll
be taxed on it.
By buying just before the distribution, you end up paying some taxes
needlessly. Most stock funds declare dividends and capital gains dis-
tributions either every three or six months, or every year. It’s best to
find out when a fund’s distribution will take place and avoid buying
in right before it happens.
This isn’t an issue for money market funds, bond funds, or funds in
tax-deferred accounts such as IRAs or 401(k)s.
Managing Your
Portfolio
It might seem like all you need to know about investing is how
to study a company’s financial health and its prospects for
growth. That’s certainly critical, but it’s also important to give
a lot of thought to how you manage your portfolio. There are
decisions to be made regarding how you add money to your
holdings, when to sell stock, and how to evaluate your port-
folio’s performance, among other things. This chapter looks
at these kinds of topics.
We do, in the form of our 13 Steps to Investing Foolishly. Here they are,
paraphrased:
1. Understand Foolishness. See the myths of Wall Street debunked.
Investing isn’t too mysterious or difficult for you. You can take
control of your financial destiny. Experts and gurus aren’t like-
ly to help you as much as you’d think. Learn what Foolish in-
vesting is all about.
2. Settle your finances. Dig your way out of any credit card debt.
You’re not ready to start investing until you’ve paid off any high
interest debt.
3. Set expectations. Learn what to expect from the stock market.
Evaluate how your investments have been doing compared to
the market.
335
4. Consider index funds. They’re good places to move money that
has been sitting in underperforming mutual funds and good places
for you to accumulate money if you’re not yet ready to select in-
dividual stocks on your own. They’ll permit you to earn while
you learn. Those who have no interest in learning more about in-
vesting might just stop at index funds and leave it at that. With
index funds you’ll be assured of performing just about as well
as the overall market average.
5. Consider investing via Drips (dividend reinvestment plans) or di-
rect investing plans, which permit you to regularly sock away
small amounts of money.
6. Open a discount brokerage account if you haven’t already done so.
7. Plan for retirement. Assess and maximize your current retirement
saving plans, and learn more about 401(k) plans and IRAs.
8. Gather information on companies that you’re thinking of invest-
ing in. This can and should come in the form of financial state-
ments issued by the company, news releases, online discussion
board posts, and more.
9. Learn to evaluate businesses. Learn to decipher financial state-
ments and crunch some numbers.
10. Consider Rule Maker investing, which focuses on large success-
ful companies that are setting the rules in their industries. It’s dis-
cussed a little earlier in this book, and you can learn much more
about it in The Motley Fool Rule Breakers, Rule Makers book and
at www.rulemaker.Fool.com.
11. Consider small-cap companies and the more aggressive (and risky)
Rule Breaker investing strategy, which invests in companies that
succeed by breaking all the rules. You can learn more about it
in the book mentioned above and at www.rulebreaker.Fool.com.
12. Learn about advanced investing issues, such as options, day trading,
technical analysis, margin, and shorting. You’re best off steering clear
of some or all of these, and using others only in moderation.
13. Get fully Foolish. Register at Fool.com if you haven’t already done
so, and explore whatever nooks and crannies you haven’t yet dis-
covered. Participate in our online community, sharing and gath-
ering information.
There are many “portfolio allocation formulas” out there, and some Wall
Street brokerages make headlines and incite market panic when they
announce changes to their recommended mix of stocks, bonds, and
cash. We chuckle when financial advisors announce they’re changing
the ideal portfolio mix from something like 47% stocks to 49% stocks.
Such tweaking seems utterly silly, racking up commission charges when
people have to buy and sell to readjust their portfolios.
Any funds that you’ll need to use in the near future (emergency money
or money needed within five years) should be in something safe like
CDs, money market funds, or perhaps bonds. Whatever’s left over is
likely to grow most quickly in stocks.
When learning about investing, you’ll often read about the importance
of diversification. Well, true, it’s important. But, it’s almost as bad to
be overdiversified as underdiversified.
Let’s look at some examples to see how this works. Imagine that your
portfolio consists of just two stocks, A and B. You have $5,000 tied
up in each, for a total of $10,000. If A’s stock price suddenly drops to
half what you paid, your portfolio’s value sinks to $7,500. It falls by
25%, just because of one stock’s move. That’s exposing yourself to
quite a bit of risk.
This is called “averaging down,” and it often isn’t a good idea. There’s
very likely a good reason why the stock is dropping. An exception
to this rule would be if the market has significantly overreacted to some
news, sending shares down to levels you don’t believe are justified.
This might happen when a solid company has a short-term problem,
as Intel did in 1994 with its flawed Pentium chip. Before you average
down on any stock, do double the homework.
Mock portfolios are great tools for people new to investing and for
those trying out new investing methods. You simply go through all the
With a mock portfolio, you can gain confidence and comfort in your
stock-picking ability. You can learn from mistakes you didn’t techni-
cally make, and learn from successes, as well.
For example, you might purchase $500 worth of a stock every three
months. You’d do this regardless of the stock price, buying 10 shares
when the price is $50 (10 times $50 is $500) and eight shares when
it’s $60 (eight times $60 is $480).
The beauty of this system is that when the stock slumps you’re buy-
ing more, and when it’s pricier you’re buying less. It’s an especially
good way to accumulate shares if your budget is limited. (Buying reg-
ularly through dividend reinvestment plans, or “Drips,” is a form of
dollar-cost averaging.) Don’t drown in commission costs, though —
dollar-cost average only if you can keep commissions below 2% or if
you’re buying through direct-purchase plans.
Call the company and ask for an investor’s package, which should sup-
ply a lot of information in the form of an annual report, press releases,
and other reports. (You might also look up these documents online at
the company’s own website or at www.freeEdgar.com.) If you can’t get
You can also check on whether there have been any complaints lodged
against the company (or any security) by contacting the North Amer-
ican Securities Administrators Association. Give them a call at 888-
846-2722 or point your Web browser to www.nasaa.org.
The math involved does scare some people, so let’s run through an ex-
ample. Imagine Ethel, who begins the year with a portfolio valued at
$10,000. At year-end, it’s worth $14,000. Let’s see how it grew:
Divide $14,000 by $10,000, and you get 1.4. Subtract 1 and you have
0.4. Multiply that by 100, tack on a % sign, and voila — you’ve got
a 40% increase. It’s that simple, sometimes.
If Ethel added to her investment during the year, though, as many peo-
ple do, things get more complicated. Let’s say Ethel plunked $2,000 of
her hard-earned savings into this portfolio during the year. This means
her investments didn’t really appreciate by 40%. The total value of her
portfolio did, but partly because of the money she added. Even if the
stock prices didn’t budge, her contributions would have resulted in
a 20% increase.
Your trusty calculator can give you an approximate value. Just take
the portfolio’s end value and subtract half the net additions made. Di-
Once you know your holdings have appreciated a certain amount, com-
pare that to a benchmark such as the Standard & Poor’s 500. If your
portfolio rocketed ahead 15% in 1999, you may have rejoiced. But the
market (as measured by the S&P 500) was up about 20% for the year,
so you underperformed it. Aim to beat the market — or, with the help
of index funds, to at least meet the market average.
First up, the taxman. Let’s say that Marge is in the 28% tax bracket, so
she forks over 28% to Uncle Sam, keeping 72%. Take her 16% return and
multiply it by 0.72 and you get 11.5%. That’s Marge’s after-tax return. For
investors in higher brackets, the effects can be even more profound. (Next
time a friend who invests money short-term tells you her returns, ask her
what her tax bracket is. It might look like she’s earning a higher return
than you are — until you figure in taxes. And commissions. One way to
reduce the tax bite is to hold stocks longer than one year to qualify for
long-term capital gains tax rates, which top out at 20% currently.)
Next up, Old Man Inflation. Money is worth less as time marches on
and prices rise. While your investment grows and takes two or three
steps forward each year, inflation makes it take one step back. Let’s say
inflation was 2.5% during the year of Marge’s investment. Taking her
11.5% after-tax return and subtracting 2.5% yields an after-tax, in-
flation-adjusted return of 9%. (This effect can wipe out much of a
money market fund’s return.)
It’s a very good idea to regularly reflect on your investing turkeys. Some
turkeys are companies you never should have invested in. Other turkey
investments can occur with solid companies, if you sell their stock
for a loss. A turkey postmortem should impart some valuable lessons.
With current holdings that are in the red, you need to figure out if more
patience is required or if you have a hopeless turkey on your hands.
Are you holding on just hoping to decrease your loss? That reason-
ing, like a turkey, doesn’t fly. Imagine that you bought $5,000 worth of
Year-3000 Solutions Inc. (ticker: 3KFIX) and it’s now worth $3,000. You
realize the company has little merit and you’re out $2,000. You may
be hanging on, hoping for a small rise in 3KFIX to make back some of
that $2,000 loss, but you’re probably better off putting that remain-
ing $3,000 to work in another stock with better prospects. You should
park that $3,000 where you think it will grow the fastest. Remember:
You want your money in the most promising investments you can find.
It’s also very beneficial to examine your turkeys of yore. Make a list of
all the stocks you’ve sold and the prices at which you sold them. Check
and see how they’re priced today. (This might be painful, so have some
ice cream or cookies on hand for comfort.)
If most of the stocks have since recovered and are doing well, you prob-
ably should have hung on. Investors often jump ship prematurely, at
the first inkling of possible trouble. Remember that many terrific stocks
go through periodic slumps.
Take note of how many turkeys you’ve sold. If you’ve got a big flock
of them, you may have jumped into too many stocks without doing
sufficient research first. If most of your turkeys are actually still in your
One mark of successful investors is that they take the time to think
about investing and to learn from their successes and screw-ups.
446 Is it really best to buy and hold stocks, or can you do well
trading more frequently?
Barber and Odean studied the trading of more than 60,000 households
with accounts at a major discount brokerage from 1991 through 1996.
They learned that the average household had a net annualized geo-
metric mean return of about 15.3%, compared with a market gain of
17.1%. Bummer. Even worse, the fifth of the households that traded
most often realized merely a 10% yearly gain.
The professors concluded that these folks were losing to the market
because they were trading too much. The average household turned
over, or “churned,” 80% of its stock portfolio each year. This means
that a portfolio valued at $10,000 had $8,000 worth of stocks bought
Well, first off it’s not always easy to discern exactly what is or isn’t a
high-quality company. And, even big, established names such as Nike
can experience protracted slumps. In the short term, you’re never guar-
anteed smooth sailing.
We’ll assume that you’re still bullish on SHHHH, but that you also have
high expectations for Terri’s Tye-Dyed Togas (ticker: TOGAZ). Let’s also
assume that your expectations are correct —both will end up doubling
within a year! Here are two possible scenarios for you:
1. You hang on to your SHHHH shares and they double, becom-
ing worth $40,000.
2. You sell your $20,000 of SHHHH shares to buy shares of TOGAZ.
Let’s say that you’re in the 31% tax bracket. That means $3,100
of your $10,000 gain will go to our friend Uncle Sam (unless you
hold SHHHH for more than a year, in which case $2,000 of your
gain would go to Uncle Sam). Out of the $20,000 of shares you
sold, you now have $16,900 to reinvest in TOGAZ. You do so, and
within a year, it’s doubled and is worth $33,800.
This should give you an idea of what happens when you trade fre-
Of course, if you think that SHHHH has run its course or you no longer
have any faith in its future prospects, then you should sell your shares
and move on to better prospects.
A little psychology review might help. Think back to that Psych 101
course you took freshman year in college. Dust off your memories of
behavioral psychologist B. F. Skinner.
You may recall that the “Skinner box” featured a contraption that
rewarded rats with food pellets when they pressed a lever. (Yes, this
really relates to investing. Keep reading.) Skinner conditioned rats to
expect a pellet whenever they pressed this lever. Rats also learned to
expect pellets when they were dispensed according to a fixed sched-
ule, such as for every third or ninth press of the lever.
You might have guessed by now where this is heading. Think of all the
bad habits that investors sometimes develop, such as buying penny
stocks or studying charts of stock price movements. Chances are, there
was at least one occasion that served as positive reinforcement for this
behavior. Maybe you bought one penny stock and beat the odds, dou-
bling your money with it. If so, you may be continuing to buy penny
stocks over and over again, losing money each time, because you’ve
been conditioned to expect a reward — eventually.
This effect is even more pronounced in casinos and with lottery tick-
Those who persist with bad habits, such as acting on hot stock tips,
are likely to get burned much more often than they’re rewarded. Don’t
let one positive reinforcement lead you to a lifetime of negative ones.
Focus on fundamentals, such as a company’s quality and its growth
rates, and you’ll take much of the guesswork out of investing.
450 Why can’t someone buy shares of stocks that are about to
pay dividends, and then sell them the day after they pay?
That may sound good, but it won’t make you rich. When a dividend
is paid, a stock’s price is adjusted downward to reflect the company’s
reduced value due to the dividend payment. With small dividends,
this isn’t often noticeable. But, with hefty payouts, you’ll see the stock
price suddenly drop, to make up for the value paid out to sharehold-
ers as a dividend.
You’re right to think of the long run, but there is a difference. You may
make less money if you’re buying an overvalued company.
You could also give serious thought to selling if you find a much more
compelling stock in which to invest. If your Foolish calculations sug-
gest that a stock you own is now fairly valued and another stock ap-
pears to be undervalued by 50%, transferring your dollars might make
sense. Again, though, consider tax effects.
At the beginning, it’s simple. Your first steps should be to get out of
debt, read broadly about investing, and perhaps invest your initial dol-
lars in an index fund.
But once you begin looking into picking individual stocks on your
own, you may run into some contradictions. For example:
1) Don’t waste your time trying to time the market. Always remain
invested in stocks.
2) Don’t be afraid to stay out of the market, at least partially, for a
while. Wait for the fat pitches.
And:
1) Let your winners run.
2) Rebalance your portfolio when one or more stocks come to dom-
inate it in a big way.
Life is complicated: Prepare a tax return, study physics, and raise chil-
dren.
455 Why does the stock market often drop when there’s good
economic news reported? That doesn’t seem to make sense.
It’s often related to interest rates. Alan Greenspan and his buddies at
the Federal Reserve set short-term interest rates, trying to keep in-
flation at bay and promote a healthy economic environment. When
positive economic news is released, such as lower unemployment fig-
ures, rising wages, or growing national productivity, the specter of
possible inflation is raised. Economies growing too quickly can spur
inflation, with too much currency in the marketplace leading to the
weakening of the dollar and rising prices.
351
456 Why do bonds fall in value when interest rates rise?
To be precise, the prices of existing bonds will fall when interest rates
rise. The prices of newly issued bonds are fixed. But let’s back up a bit.
Higher interest rates mean that companies are likely to borrow less,
produce less, and thus earn less. (This is because higher interest rates
make it more expensive to borrow.) Since stock prices are tied to how
much a company can earn, higher interest rates theoretically cause
stock prices to fall. This, coupled with rising bond interest rates, makes
bonds more attractive to investors.
Imagine 5% bonds with 10 years left until maturity that originally sold
for $1,000 each. If you buy these bonds now, you’ll be getting $50 per
year from each of them and then $1,000 at maturity. But, if interest rates
have risen since those bonds were issued, and you can buy new 10-year
bonds that pay you 10%, that amounts to $100 per year per $1,000 in-
vested. You would obviously be willing to pay more for the 10% bonds
than the 5% ones. So, the price of 5% bonds will fall. It will fall to the
point where $1,000 invested in the 5% bond will bring you same total
yield-to-maturity as $1,000 invested in the new 10% bond.
By one common definition, you have a recession when the nation’s eco-
nomic output (Gross Domestic Product) declines for at least two con-
secutive quarters. Recessions are often accompanied by rising unem-
ployment and decreasing consumer spending. To answer the question
of what causes them, I thought I’d see what an online search engine
would offer me when I typed in “cause recession.” Here are just some
of the many articles and Web pages it returned:
• Y2K may cause global recession…
• Fed mistake could cause recession…
• Increase in oil prices can cause recession…
• Stock market fall unlikely to cause recession…
• Analysts say stock sell-off may cool the economy and cause recession…
• Households saving more will cause recession…
• Overspending and high taxes could cause recession…
Hmm… well, that last item appears to be dental and not economic in
nature... but, otherwise, the tidbits above should demonstrate that a
wide variety of things are often linked to recessions. Causes might
be internal (e.g., interest rate changes) or external (e.g., wars, finan-
cial crises elsewhere in the world, etc.). Economists vary on their views
of what causes recessions. At any given time, you’ll likely find some
people who think we’re heading toward a recession and some people
who think we’re moving away from one.
You’d think that a strong dollar would be good for American companies
— but that’s not always the case. A strong dollar can cause trouble for
companies with extensive international operations, such as Procter & Gam-
ble or McDonald’s. These firms receive a big chunk of their revenues in
the form of rubles, pesos, and francs. If the dollar is strong, when the time
comes to exchange those currencies for U.S. dollars, they’ll get fewer dol-
lars for the foreign currencies — and fewer dollars means lower earnings.
Silicon Valley, in the San Francisco Bay area, is home to many very large
Consider PieMart Inc. (ticker: GOBBL). Stores can’t keep these pies
in stock. To meet demand, it needs to make a heck of a lot more pies.
It should hire more workers and build more factories, but poor PieMart
doesn’t have much cash.
The company isn’t doomed, though. It can borrow from a bank. It can
issue bonds (borrowing money from individuals or institutions and
promising to pay the lenders back with interest). It can find some
wealthy person or company interested in investing in PieMart. Or, it
can go public, issuing shares of stock. Companies often use many or
all of these options. They frequently secure venture capital funding,
for example, a few years before going public. And until they attract
venture capital dollars, they may rely on bank loans.
461 Is it true that when a company goes public, its insiders can’t
sell their shares for a certain period of time? Why is this?
This is called the lock-up period. It typically runs for 90 days to a year
and offers outside investors some measure of protection. If the newly
public firm has some skeletons in the closet, insiders who know about
them can’t act on their “inside” knowledge and quickly sell shares be-
fore the public learns the bad news. Some companies set extra-long
lock-up periods, to show their faith in the company and to inspire con-
fidence in public shareholders.
When going public via an IPO, a company typically selects one or more
lead investment banks to complete the offering, or “underwriting,”
process. The lead underwriters typically select a “syndicate” — a group
of other investment banks and brokerages (perhaps 10 or so) to help
sell and distribute the shares. Each syndicate bank usually receives a
small portion of the shares being offered to the public.
Your brokerage was probably not in the syndicate for the IPO you were
interested in. Note that, even if it were, you might not have been deemed
worthy of some shares. Since each syndicate member only gets a rela-
tively small number of shares, they may just go to major customers (usu-
ally institutional investors). The rest of the customers who desperate-
ly want shares will have to buy them on the open market from investors
who got some initial shares and want to sell them immediately.
Most IPOs don’t do well at first. Some spike up quickly, and then slump
for a year or two, while others never really spike much at all. We avoid
investing in IPOs, preferring to observe how the business does in its first
public year. With thousands of public companies out there, why pin
your hopes on a firm that usually doesn’t have much of a track record?
Few things can work investors into a frenzy like the prospect of a com-
pany’s first foray into the stock market. Feeding the excitement are
spectacular debuts like that of Internet software company Netscape in
1995. Shares were priced at $28 each, but due to high demand they
began trading at an incredible $71 per share before settling down to
$58 per share at the end of the day.
Plus, remember that individual investors seldom are able to buy IPOs
at their offering price. The IPO shares of decent companies largely
go to institutional investors and mutual funds. This means you’ll be
buying the shares on the open market and not at the offering price. In
cases where a popular IPO’s price skyrockets, you’d likely be buying
near the high, not the low.
There are many great companies that have been trading for a year or longer;
we prefer to dig for our truffles in that field instead of chasing after IPOs.
It’s true that executive salaries can seem astronomical, and stock op-
tions are often considered in the numbers you see reported. (Indeed,
many small start-up firms compensate executives primarily through
stock options, as it conserves cash and can be tax-advantageous to the
executives, too.)
Some, like Warren Buffett, don’t buy this reasoning, though. They
argue that option-holders are not exposed to the downside risk of own-
ing a piece of the company, like shareholders are. They explain that
management might add little value, but still see earnings (and most
likely the stock price) increase. These folks would rather see execu-
tives paid based on how well they maximize a company’s growth and
profitability.
466 Can you tell me what a CFO does? I find many of these
top executive positions mysterious.
The chief financial officer (CFO) is responsible for all things financial
at the firm. This includes determining what the company’s financial
needs are and will be, how best to finance those needs, and informing
all stakeholders (investors, creditors, analysts, employees, management)
of the firm’s financial condition.
She is also focused on creating and maintaining the best mix of in-
ternal cash, debt financing, and equity financing for the company (this
is the company’s “capital structure”). As part of those responsibilities,
she plans and oversees the forecasting and budgeting process, main-
tains relationships with funding sources such as commercial and in-
vestment banks, and oversees the process of developing and commu-
nicating the quarterly and annual financial statements.
Some high-profile hostile takeover bids have included IBM for Lotus,
Johnson & Johnson for Cordis, and Hilton for ITT.
When companies spot the grim reaper in their rearview mirror, they can
file for Chapter 11 bankruptcy protection. This allows them to contin-
ue operating while a trustee is appointed to develop a plan to turn the
company around. If you think the company will get its act together, you
might want to hang on to those shares. If you’re skeptical or have a bet-
ter place to invest the money, you should consider selling. Roughly half
of the companies that enter Chapter 11 protection ultimately recover;
however, stockowners are often diluted by the bankruptcy actions.
With any stock holding, you never have a tax loss until you actually
sell the shares. Up to that point, the loss hasn’t technically happened
yet and is called a “paper loss” (though the sleepless nights it may
cause are very real).
Un-Foolish
Investing
At The Motley Fool, we embrace a range of investing styles and
principles. Online, we maintain several real-money portfolios
that employ different strategies. Our Rule Maker strategy seeks
out growing giants that manage their cash well. Our Rule
Breaker strategy is more aggressive, seeking out upstart com-
panies that promise to change their industries — or the world.
We also support investors seeking out companies trading at at-
tractive valuations, and we believe that investing via dividend
reinvestment plans (or “Drips”) can be effective. Is there any-
thing we don’t believe in? You bet. This chapter covers some
of the many approaches to investing that we avoid.
469 It seems that a lot of people are day trading these days. Is
it worth learning more about?
Day trading may look like investing, but it’s far from it.
Investors (at least good Foolish ones) study businesses, carefully buy
stock, and hold on for the long term — usually years or decades.
They consider themselves part owners of real businesses. Day traders,
meanwhile, spend most hours that the market is open glued to mon-
itors — tracking stocks and placing orders. They typically place
scores of orders each day and hold each stock for no more than a few
hours. Many ignore company fundamentals, focusing only on what
might make the stock price move in the very short term.
361
So, how well do day traders perform? A recent study by the North
American Securities Administrators Association suggests that only
about 11.5% might trade profitably. (Of course, trading “profitably”
does not even mean that they will beat the S&P 500, a performance
available via the purchase of an index fund at very low cost.)
The people who appear to be making the biggest killing in day trad-
ing are those running day trading firms. These outfits provide day
traders with trading equipment and charge them commissions for each
trade. With each customer trading all day long, the coffers fill quick-
ly. Regulators are investigating this industry.
Understand that people who trade stocks online are by no means nec-
essarily day traders. Accessing brokerages online makes sense for most
people, especially when commissions for online trades are so low.
Resist articles you may see here or there profiling a successful day trad-
er. Know that for every success there are countless failures. Don’t let
yourself or those you care about get sucked into day trading.
470 If most people who day trade lose most or all of their
money, why would anyone in their right mind ever do it?
You can blame the usual suspects — greed and ignorance. You can
also throw in overconfidence. The research of finance professors Ter-
rance Odean, Brad Barber, and Simon Gervais has linked overconfi-
dence to frequent trading, and frequent trading to diminished in-
vestment returns. They suggest that traders tend to give themselves
more credit for successful trades than unsuccessful ones, thereby be-
coming overconfident.
If you invested in the stock market from 1963 through 1993, it would
have yielded an average annual return of 11.83%. That should seem
pretty good.
But here’s the amazing part. The period of 1963 through 1993 includes
7,802 days. If you were out of the market (not invested in it) for the
10 days when the market rose the most, your average annual return
would only be 10.17%. If you sat out the 30 best days, your return
would plunge to 8%. Up that to the 90 best days, and you’re down to
a mere 3.28%.
Most of the market’s gains seem to occur on just a few days. This means
anyone who tries to time the market is at risk of missing out on sub-
stantial gains. While some will suggest that there are dangerous times
to be in the market, it’s probably more dangerous to be out of it.
In 1995, the market (as measured by the S&P 500) advanced a whop-
ping 37.5%. Some prognosticators suggested that 1996 would give
back some of that gain. Had you sat out 1996, you’d have missed out
The lesson is clear: If you hang on for the long term, you’ll be in the
market on days when it counts — and able to ride out the occasional
downturns.
472 I’ve heard a lot about penny stocks, but I am not sure what
they are. Do they really cost a penny? Are they a good idea
for someone who doesn’t have a lot of money to invest?
In the days of yore, these stocks often did cost only a penny per share.
Today, any stock selling for under $5 per share might be considered
a penny stock. They often represent companies with less-than-stel-
lar track records promising great success around the corner. (Revo-
lutionary gold deposit detectors! A cure for the common cold!)
Penny stocks are dangerous because people think low prices mean bar-
gains and that they’d be better off spending their $250 on 100 shares
of a penny stock than on seven shares of, say, McDonald’s.
Imagine that you buy 100 shares of a $0.60 stock and one share of a
$60 stock. If each of them double in value, you’ll have 100 shares of
a $1.20 stock, worth $120, and one share of a $120 stock, worth $120.
You would have gained no advantage by buying the lower-priced stock.
A $60 or $25 or $100 stock is more likely to double in value and hold
its value for the long term than a typical penny stock.
Most penny stocks are selling for a low price for a reason. Because of
“Beware of technical analysis, my son! The jaws that bite, the claws
that catch!” Had Lewis Carroll been an investing aficionado, he might
have cautioned investors about technical analysis, instead of the Jab-
berwock and Jubjub bird. He didn’t, though, so permit me.
Technicians have defined many patterns in the charts they study, im-
buing them with much significance. There’s a head-and-shoulders pat-
tern and a cup-and-handle pattern. Perhaps next we’ll see an ostrich-
and-eggbeater pattern. These patterns do exist, but they don’t
necessarily mean anything. Imagine someone discovering that on pres-
idential election days, whenever the skies above Fresno were cloudy,
Republican candidates won. Like many patterns, this would be a ran-
domly occurring one, a coincidence. For you to bet any of your hard-
earned savings on this would be nothing more than gambling.
Investors who use technical analysis are really betting on the psy-
chology of the market, as they scrutinize investor behavior. They try
to determine where the big, institutional money is going so they can
put their cash in the same places. Imagine Warren Buffett trying to fol-
low this short-attention-span crowd instead of seeking, buying, and
holding great companies for the long-term. Imagine the taxes and com-
missions.
It’s amazing to think that technicians might study a stock chart, see
474 I’ve seen come-ons from various gurus who claim that
they can teach me ways to get rich quick. Are they worth
investigating?
If someone offers to show you, for a fee, how to get rich in a few weeks
or months, we hope that you’ll turn and run away. Unfortunately, some
Americans are doing the opposite. They’re buying how to make-mil-
lions books, attending expensive seminars, calling 900-numbers for fi-
nancial guidance, and subscribing to costly newsletters.
A man named Wade Cook, for example, has spoken of earning 20% to
40% returns — monthly. Let’s do a little math and see how realistic
this is. If you take a single dollar and compound it at 20% monthly for
15 years, you’ll have $179 trillion. Last time we checked, that was more
than seven times the Gross Domestic Product of the entire world, more
than the total market value of all goods produced and services ren-
dered globally in an entire year. This kind of result from investing a
single dollar should seem a little unrealistic.
If any of these financial gurus were using their own systems to in-
vest their own money for any significant period of time, they would
long ago have appeared on lists of the richest Americans. Indeed, they’d
have purchased most of our solar system. Instead, they appear to be
For the best way to accumulate wealth, look at two of America’s great-
est financial successes. Bill Gates snagged the top spot by hanging
on to shares of his ever-growing Microsoft stock. Warren Buffett bought
into great businesses and held on. Both have publicly stated that among
the qualities that have driven them to success, two stand out: patience
and perseverance. How reassuringly Foolish.
There are two main types of options: calls and puts. A call gives you
the right to buy a set number of shares, at a set price, within a cer-
tain period of time (often just a few months). For this right, you pay
a price premium. Puts are similar, but give you the right to sell shares.
If you sell, you make a $1,000 profit, right? Nope. You paid $600 for
the options alone, remember? So, your profit is down to $400 — less,
when you account for trading commissions.
Options can be risky. If WOOFF stays at $55 or falls, your $600 would
be entirely lost. It has to top $61 per share — $55 plus $6 — by Oc-
tober for you to profit.
Some folks like options because of the leverage they offer. They point
out that, if you only have $1,000, you can only buy 20 shares of a
$50 stock. Alternatively, that $1,000 could buy many more options
tied to hundreds of shares of stock. True enough. With options, though,
timing is critical. If things don’t go your way in a short time frame,
your option will expire worthless.
Options are not for beginning investors, and only those who under-
stand the ins and outs of options should even consider them.
We’re getting into advanced investing stuff here. Selling covered calls
is indeed not as risky as buying call options. For example, imagine that
you own 100 shares of Amalgamated Thought Co. (ticker: HMMMM),
and you “write” a covered call option for those 100 shares. This means
you sell the call to someone (let’s say for $5 per share, or $500) giv-
You’re betting that the shares won’t trade above $80 within the life
of the option. If Amalgamated Thought only rises to, say, $70, in the
time period, the call buyer won’t exercise the option and you’ll get
to keep that $500. The buyer, meanwhile, is betting the stock will surge
soon. If it does, perhaps passing $90, she’ll exercise the option, pay-
ing you $80 per share. Your upside on the option is a $500 profit re-
gardless of how the stock performs. But, if the option is exercised, you
lose those shares. Worse, you have to sell them at a below-market rate
and must pay any capital gains taxes that apply, too. Rats.
477 Can you explain what futures are and why they’re important?
There are also S&P 500 futures, based on the S&P 500. Each day the
party who bet wrong is obligated to pony up cash based on the price
of the S&P 500. Futures are bought by some investors to protect them-
selves against unfavorable price swings or by speculators betting on
where the market is going. They can be very risky.
One lottery ticket here and there won’t hurt anyone, but too many peo-
ple are buying too many tickets. It’s a massive and destructive industry.
Consider Abner, who spends $50 per month on the lottery. That’s $600
per year. If that money were invested and grew at the stock market’s
11% average annual growth rate, it would become more than $100,000
after 30 years (and some $350,000 after 40 years!). That’s just the av-
erage return of the stock market. Fools who carefully select individ-
ual companies to invest in should be able to beat that.
State governments have a higher calling. They’d serve the public bet-
ter by scaling back or eliminating their lottery advertising. Oddly
enough, casinos, which typically take 10 times less from a bet than lot-
teries do, live with tight advertising regulations.
Potpourri
You can’t categorize everything in life. A stroll through your
local video store, for example, may have you scratching your
head, wondering to yourself, “Why is Tootsie a drama?
Shouldn’t it be filed as a comedy?” In this chapter you’ll find
answers to questions that don’t fit easily in any other chapter.
They’re not less important, just less classifiable, involving top-
ics such as tulips, REITs, and foreign stocks.
Take a deep breath. There are a lot of things you should keep track of.
Ideally, you might get a fireproof box to store them in, or perhaps a safe
deposit box at your bank for some of them. You might also consider mak-
ing a set of copies of them and storing them at a family member or friend’s
home. That way, if something happens to your home, you’ll have these
important papers. Here are the kinds of things you’ll want to keep:
• Real estate paperwork. This includes mortgage papers, the deed/title
to your home, and records of any major capital improvements or re-
pairs to your home.
• An inventory of your valuable possessions. Go through your home
and make a list of all your furniture, jewelry, electronics, and more.
Jot down what you paid for them and keep any receipts for them
that you may have. Better still, consider taking photos or a video-
tape of these items, too. These will all prove invaluable should you
have to fill out insurance papers after a fire or burglary.
• Tax papers. Keep copies of your tax returns for the past several years
371
— ideally you might keep copies for every year that you file. They
may prove useful or at least interesting one day. Hang on to sup-
porting documentation for three to seven years, as well.
• Insurance policies that are still active. (You needn’t keep records
of expired policies.)
• Investment records — keep statements from your broker, and trade
confirmations, too.
That said, there are lots of resources online where you can learn more
about SRI. Click over to these sites, for example:
• www.socialinvest.org, www.socialfunds.com
• www.betterworld.com/BWZ/9604/product.htm
There are many mutual funds catering to this niche, too. (As with most
funds, not all have stellar records.)
Let’s say that you work for Rubber Chicken Catering Inc. (ticker:
CHEWY). You’re issued 1,000 employee stock options with a strike (or
“exercise”) price of $10 each. A few years later, the shares are trad-
ing at $35. At this point, you decide to “exercise” your options.
Since your options carry a strike price of $10, you’re entitled to buy
up to 1,000 shares at $10 each — not the $35 that they’re currently
going for on the open market. If you exercise all of them, you’ll fork
over to your company $10,000 for 1,000 shares and they’ll immedi-
ately be worth $35,000. You can hang on to them as long as you like,
or quickly cash out for a $25,000 profit.
As you might suspect, it’s not exactly quite this simple. There are many
tax issues to consider, and your option plan might have some special
features. Read the plan carefully. You might also read Kaye Thomas’s
book, Consider Your Options, or drop by his website at www.fair-
mark.com.
Nasdaq stocks have four-letter ticker symbols. If there’s a fifth letter, it’s
there to signify something. Here are the letters you’re most likely to see:
• A and B refer to class A or B of the company’s stock.
• E is for companies delinquent in filing reports with the Securities
and Exchange Commission.
• F designates a foreign company.
• Q indicates that the firm is in bankruptcy proceedings.
• Y is for foreign stocks trading as American Depositary Receipts (ADRs).
Potpourri • 373
483 What is “beta”?
Let’s say the stock of Wart-B-Gone (ticker: XWART) has a beta of 1.2.
If the market as a whole advances 10% in a given period, we can ex-
pect Wart-B-Gone to advance 12%. If the market falls 20%, Wart-B-
Gone can be expected to fall 24%.
That seems relevant enough and sounds professional enough that The
Motley Fool ought to support an intense focus on beta, right? Nope.
We’re contrary here, as well. Since we prefer to hold stocks for the long
term, short-term volatility doesn’t faze us. Wart-B-Gone could have a
beta of 2.5, even, and we might still happily buy it — if we planned
to hang on for years and years and had high expectations. Many stocks
that have proven to be wonderful long-term investments have been
very volatile in the short run.
486 Why do some REITs have terrific dividend yields while others
don’t? Is there any reason not to invest in high-yield REITs?
If a yield looks too good to be true, it probably is. Remember that the mar-
ket sets the price of the stock, and as a stock’s price drops, its yield rises.
Potpourri • 375
be paid. However, Russian government bond yields have hovered
around 30% or more. Since investors are not so sure they’ll end up
being paid, they’ll demand a higher yield before taking the chance.
If you invest in a REIT yielding 10%, things may well turn out hunky-
dory (or not). But, if you go for one kicking out 18% to 30%, you’re
buying into income streams that other folks find rather doubtful. You’ll
want to do enough research to be pretty sure you’re right.
But, think again. There are compelling reasons to be wary of foreign stocks.
For starters, the United States is one of the most demanding countries
when it comes to the information that publicly traded companies are re-
quired to disclose. However, most other countries don’t have as demand-
ing a regulatory environment as we have in the U.S. for financial disclo-
sure. In addition, different countries have different accounting practices,
which can make assessing their financial performance very difficult.
In the words of my fellow Fool Bill Mann, “The companies that make
up the FOOL 50 are in the vanguard of the trends that will define com-
merce in the next decades. They possess a gold-plated brand name, a
tradition of innovation, a superior use of technology, and a culture
Potpourri • 377
of accountability to their shareholders. They also, as a group, repre-
sent the globalization of the American economy. The FOOL 50 contains
eight companies that are domiciled outside of the United States, and
an additional 19 that are American companies that derive more than
50% of their income from international operations. As the economies
of the world continue to meld into one, we expect that, more and more,
this index will reflect the composite nature of the global marketplace.”
You can learn more about the FOOL 50, by popping over to
www.Fool.com/now50/now50.htm.
Plans such as 401(k)s and IRAs are generally more effective for sock-
ing away money for retirement. Consider maxing those out before look-
ing at variable annuities. Take the time to learn more about annuities
before putting any money into one.
This is exactly the way not to invest. Even if you make some money
at it, brokerage commissions and taxes will kill you. Investors are bet-
ter served finding their own stock ideas within industries they un-
derstand well than in gathering ideas from the typical newsletter.
Potpourri • 379
491 What is the “random walk theory”?
It says that a stock’s next move is not predictable and not based on past
moves. Burton Malkiel discusses it in detail in A Random Walk Down
Wall Street. He concludes that people (or animals, presumably) choos-
ing stocks randomly could do as well as the pros — and advocates
investing in index funds.
Well, if you want to make sure you end up in a first-class nursing home
with round-the-clock care, you should think about getting your kids
involved in investing — now. Kids have a colossal edge over the rest
of us when it comes to investing: They have time.
Consider that if you’re 35 years old, you might stay invested in stocks
for only 30 to 40 years. But, if you’re 15, you’ve got 50 to 60 years.
Here’s an example: Let’s say that Tiffany saves part of her allowance
and flips burgers or baby sits to earn even more. She manages to save
about $10 per week and invests $500 each year for 11 years, from age
14 to 24. She socks it away in the stock market and forgets about it
until age 65. (We’ll assume that the investments in this example grow
at the historical market average of 11% per year.)
Now, her friend Trevor, who’s the same age, puts off investing until
much later. Beginning at age 40, he invests $5,000 each year for 25
years. Believe it or not, Trevor won’t be able to catch up with Tiffany.
It’s mathematically true. In her 11 years, she saved and invested a total
of $5,500, and poor Trevor saved and invested a whopping $125,000.
By the time they turn 65, Tiffany’s money will have grown to $705,688,
beating Trevor’s $634,994.
How can she possibly have come out ahead? It’s because of time.
Tiffany’s money grew for 50 years, roughly twice as long as Trevor’s
did. And she was ahead of him every single year.
This eye-popping example demonstrates that it’s never too early to start
investing. How much money you start with isn’t as important as how
Potpourri • 381
many years you have to invest that money — each year can make a
big difference at the back end.
It might be too late to get your kids into that prestigious kinder-
garten, but you can still give them a great edge in life by introduc-
ing them to investing when they’re young. With time on their side,
they’re positioned to reap the greatest benefit from the magic of com-
pounded growth.
Before plunking actual money into stocks, though, play and experi-
ment together. Here are some suggested activities:
1. Build a mock portfolio. Have your kids make a list of companies
that interest them. At home, in their classrooms, at the mall, and
on TV, they’ll find ideas such as America Online, Nike, Gap, Dis-
ney, Ford, Coca-Cola, Mattel, Hasbro, McDonald’s, Wal-Mart,
ExxonMobil, General Electric, Black & Decker, Nordstrom, and
more. Have them list 10 to 20 companies on a sheet of paper, with
ticker symbols, current stock prices, and today’s date. Every week
or so, have them record the latest prices. Calculate the gains or
losses regularly. Such short-term stock price movements aren’t
terribly meaningful, but they can help a child understand how
the market works.
2. Follow the companies together. Scan newspapers and magazines
for stories about the businesses. If McDonald’s is promoting 55-
cent burgers, watch to see if this will be a good move that brings
in more sales, or a bad one that decreases total profits. Note how
news affects stock prices.
3. Eventually, help your child actually invest money. You can open
a joint brokerage account, with you acting as custodian. Or in-
formally “sell” some of your own shares to your child. If you own
some shares of PepsiCo, for example, you can “sell” two shares to
your child at its current price. If you’re about to buy 100 shares
of ExxonMobil and your child wants to buy a share or two herself,
you can buy 101 or 102 shares. (Yes, really. You don’t have to buy
in “round lots” of 100.) Once your child turns 18, she can open her
own brokerage account and you can transfer her shares into it.
Kids can’t have brokerage accounts of their own. You can still get them
started early, though. Here’s how:
You can set up a trust fund. You’ll have to manage it yourself or pay
someone to do so. It eventually becomes the property of your child,
but he or she can’t take control of it until reaching an age you speci-
fy (even something like 43).
497 Where can teens learn about stocks, mutual funds, and
investing?
It’s hard to go wrong with Peter Lynch’s books. For many years Lynch
managed Fidelity Investments’ mammoth mutual fund, Magellan, with
stellar results. All his books are very readable, but his Learn to Earn is
Potpourri • 383
the one geared to young people.
Have your youngsters click over to our online area for young investors,
too — it’s at www.Fool.com/teens.
A similar scenario has often played out with analyst conference calls.
Each quarter, publicly traded companies report earnings, issuing press
releases. Within a few hours (and sometimes even before the release),
executives of these companies would be on the horn with Wall Street
analysts, answering questions and offering additional information in
private conference calls.
The good news for individual investors is that the times have been
changing. It’s now common to see a company publish a phone num-
ber that anyone can use to hear a replay of the conference call. Some
companies offer transcripts or recordings of calls on their websites.
Better still, the Securities and Exchange Commission (SEC) has also
been on board with the Foolish mission of leveling the playing field
for the individual investor. The SEC recently approved a new “Fair
Disclosure” rule that bans public companies from alerting analysts and
major investors to important changes before disclosing that informa-
It’s still a little unclear exactly how companies will respond to the new
ruling. Some may decide to share less information with anyone. We
hope that most companies will simply begin disclosing information
more fairly, to all.
499 Who was Benjamin Graham? I hear his name now and
then, but am not familiar with him.
Potpourri • 385
The data he tapped was publicly available via corporate financial state-
ments and the Standard & Poor’s Stock Guide (available for free from
many brokerages).
500 Are there really 500 questions and answers in this book?
There are now. Thanks for reading this far! I hope you enjoyed the
book and found it useful.
Appendices
APPENDIX A
Resources for
More Information
I hope that you’ve enjoyed this book and that it has helped
you become savvier in managing your money. Here are some
more resources that might be useful:
The Motley Fool You Have More Than You Think by David and Tom Gardner
This is a great introductory book, focusing primarily on personal finance topics such as getting
out of debt, saving money, spending prudently, and beginning investing. It’s perfect for anyone
who’s not sure they have what it takes to take control of their financial future. It makes a strong
case for why you should plan and invest.
The Motley Fool Rule Breakers, Rule Makers by David and Tom Gardner
This book offers a detailed explanation of how brothers David and Tom Gardner go about choos-
ing companies in which to invest. One looks for companies that break rules and the other for
firms that make rules. This book will teach you a lot about how to evaluate businesses by looking
at the big picture and by drilling down into some numbers.
389
The Motley Fool’s Investment Tax Guide by Roy Lewis and Selena Maranjian
To minimize the amount you fork over to Uncle Sam each April, you should really be attending to
various tax matters throughout the year. This book is a fairly comprehensive introduction to tax
issues relevant to most Fools: investing, children, education, homes, retirement, home offices,
and more. It’s written in an amusing manner and explains many tax issues in an easy-to-understand
way, employing many examples.
Investment Clubs: How to Start and Run One the Motley Fool Way by Selena Maranjian
If you’re thinking of starting an investment club, this short book will prove very helpful. It offers a
long list of issues for you to consider and topics to discuss with your friends both before and after
you form your club. It also includes a sample partnership agreement, bylaws, agenda, and tax forms.
Personal Finance:
Note that you’ll find many more book (and website) recommendations in the Personal Finance sec-
tion of this book. The books on this list offer more general, less targeted information.
A Glossary
for Investors
10-Q — A financial report companies submit on American Stock Exchange (AMEX) — The AMEX
a quarterly basis to the SEC. It’s unaudited. is the United States’ second-largest floor-based
stock exchange. In 1998, the AMEX merged
10-K — An audited report that public corpora- with the Nasdaq, to form the Nasdaq-Amex
tions file annually with the SEC. It contains de- Market Group.
tailed year-end financial results and discussions
of the company’s operations. Amortization — The systematic repayment (e.g.,
monthly, quarterly, or yearly) of a debt or loan,
12b-1 Fee — A mutual fund fee that covers pro- such as a bond or mortgage, over a specific time
motional expenses such as advertising. period. Amortization also refers to the gradual
reduction in book value of an intangible asset,
401(k) — A retirement savings vehicle offered by to reflect its resale or redemption value.
many employers. Given their tax advantages and
the possibility of corporate matching (read: FREE Annual Report — Report issued each year by
MONEY), 401(k) plans are well worth consider- public companies that includes information
ing. Nonprofits have almost identical 403(b) plans, about the company’s business and its financial
and local and state governments offer 457 plans. performance.
Accounts Payable — Money owed by a compa- Asset — Anything that has monetary value and
ny to suppliers, creditors, and others. This ap- could be sold or converted into money. Typical
pears as a liability on the balance sheet. personal assets include stocks, real estate, jew-
elry, art, cars, and bank accounts.
Accounts Receivable — Money owed to a com-
pany by customers that have purchased goods Asset Allocation — Dividing investment dollars
and/or services on credit. Accounts receivable among various asset classes — typically among
is listed as an asset on the balance sheet, as it cash investments, bonds, and stocks — to best
is a number that will (presumably) be turned match your goals, time horizon, and temperament.
into cash by the company as the receivables are
paid off. Back-End Load — A back-end load is a sales fee
charged by some mutual funds when an investor
American Depositary Receipt (ADR) — A ne- sells fund shares.
gotiable certificate representing shares of a for-
eign stock. It’s typically held by a U.S. bank and Basis (or Cost Basis) — The total amount paid
traded on a U.S. stock exchange. by an investor for a security. It’s used, together
393
with the proceeds from the sale of the securi- Broker — One who sells financial products.
ty, to calculate capital gains for tax purposes. (Whether in insurance, real estate, or stocks, most
brokers work under compensation structures that
Basis Point — Most often used when discussing often are at direct odds with the best interests
changes in interest rates. One basis point is of their clients. When using a broker, you should
1/100th of a percentage point. Twenty-five basis always find out how he or she is compensated.)
points is 0.25%, or a quarter of a percentage point.
Bull — A person with a positive or optimistic out-
Bear — A person with a generally pessimistic out- look toward the general market, a market seg-
look on the market, a market sector, or a spe- ment, or a particular stock.
cific stock.
Bull Market — A market that has been gaining
Bear Market — When the overall market loses value.
value over a period of time. There is no “official”
definition of what makes a bear market, though Buy-and-Hold — A strategy that involves buying
many feel a drop of at least 10% is needed. A shares of companies with the intention of keep-
drop of something less than 10% is often called ing those holdings for a long time, preferably
a “correction” (even though the term “correction” decades, and participating in the long-term suc-
is never used when the market moves up 10%). cess of being a partial owner of the business un-
derlying the stock.
Beta — A measure of the relative volatility of a
stock or other security as compared to the volatil- Capital — A business’ cash or property, or an in-
ity of the entire market. A beta above 1.0 shows vestor’s pile of cash.
greater volatility than the overall market, and
a beta below 1.0 reflects less volatility. Capital Appreciation — One of the two components
of total return, capital appreciation is how much the
Bid-Ask Spread — The difference between what underlying value of a security has increased. If you
a buyer is willing to pay (bid) for a security and bought a stock at $10 per share and it has risen
the seller’s asking price (ask). to $13, you have enjoyed a 30% return or appreci-
ation on the original capital you invested. Dividend
Blue-Chip Stocks — Stocks of established com- yield is the other component of total return.
panies with strong records of rewarding share-
holders. Examples include General Electric, Coca- Capital Expenditures — The cost of purchasing
Cola, Ford Motor Company, and Johnson & long-term assets, such as property, plants, and
Johnson. equipment, during a particular period.
Board of Directors — A group of people elected Capital Gain/Loss — The difference between the
by a corporation’s shareholders to oversee the proceeds from the sale of an asset and its orig-
management of the company. The board mem- inal purchase cost (or “basis”).
bers meet several times each year, are paid in
cash and/or stock, and take on legal responsi- Capital Gains Distributions — Payments made
bility for corporate activities. to mutual fund shareholders for gains realized
through purchases and sales by the mutual fund.
Bond — An interest-bearing or discounted debt se- (Because these capital gains distributions are
curity issued by corporations, governments, or oth- sometimes substantial, check with the mutual
ers (such as David Bowie — really). A bond is es- fund you are considering investing in and avoid
sentially a loan made by an investor to an issuer. buying shares of a mutual fund just prior to its
capital gains distribution.)
Book Value — A company’s assets, minus any li-
abilities and intangible assets, divided by the Capitalization — See Market Capitalization.
number of shares outstanding. It’s an account-
ing concept, not a measure of the company’s Cash Account — A brokerage account that settles
true value. transactions on a cash basis with no opportuni-
ty for the account holder to use credit (margin).
Commercial Paper — A promissory note issued by Day Trader — Day traders are in and out of the
a large company to secure short-term financing. market many times during the course of one
trading session and often do not hold a position
Commission — A fee charged by a broker for ex- in any stocks overnight.
ecuting a transaction.
Depreciation — This is an accounting action re-
Commodities — Goods such as grains, precious quiring no cash. It involves gradually decreasing
metals, and minerals traded in large amounts on the recorded value of an asset over its useful life
a commodities exchange. by charging amounts against earnings.
Common Stock — A security representing par- Discount Broker — A brokerage that executes or-
tial ownership in a corporation. ders to buy and sell securities at lower commis-
sion rates than a full-service brokerage. See
Compounding — When an investment generates www.brokerage.Fool.com for more info.
earnings on reinvested earnings.
Diversification — The strategy of buying a range
Dollar-Cost Averaging — Regularly plunking Fair Value — This is the theoretical price at which
equal amounts of money into an investment. a company is valued “correctly.” Analysts often
The money deducted from your paycheck if you disagree about what this number is for any given
participate in your company’s 401(k) program is company. A company’s stock may be trading
an example of dollar-cost averaging. The idea is above or below its perceived fair value.
that regular periodic investments allow you to
buy more shares when a stock price is low and Federal Reserve — The central bank of the Unit-
fewer shares when a stock price is high. ed States. The Federal Reserve (or “Fed”) over-
sees money supply, interest rates, and credit. The
Dow Jones Industrial Average (Dow or DJIA) — Federal Open Market Committee (FOMC) is the
The oldest and most widely known index of the 12-member policy-making arm of the Fed that
stock market. The “Dow” represents the average sets monetary policy, chiefly by setting interest
of 30 actively traded major American companies. rates. It also buys and sells government securi-
ties, which increase or decrease the nation’s
Earnings (or Losses) — Earnings, also known money supply.
as net income or net profit, are what’s left over
from revenues after a company covers all its Fiscal Year — A 12-month accounting period that
costs and pays all its bills. (In the case of some may or may not correspond to the calendar year.
companies, this will result in losses.) Many companies begin and end their “fiscal”
years on dates other than January 1st and De-
Earnings Per Share (EPS) — To allow for apples- cember 31st. Often this is done to facilitate fi-
to-apples comparisons, those who look at earn- nancial reporting or perhaps to better represent
ings use EPS. You calculate the earnings per share cyclical or seasonal characteristics of the com-
by dividing a company’s net income by the num- pany’s revenues. Sometimes it is just manage-
ber of shares it currently has outstanding — but ment preference not to have the fiscal year-end
you shouldn’t even have to bother, as most com- accounting chores (which are more substantial
panies report their EPS. than for quarterly reports) falling in the tradi-
tional winter holiday season.
Emerging Markets Fund — A mutual fund that
invests in countries with developing economies Fixed-Income Fund — A mutual fund that invests
such as those in Latin America and Asia (ex- in bonds.
cluding Japan).
Futures/Futures Contract — A contract to buy Initial Public Offering (IPO) — A company’s first
or sell a specific amount of a commodity or se- offering of common stock to the public.
curity for a specific price at a specific point in
the future. Institutions — Institutional investors include pen-
sion funds, insurance funds, mutual funds, and
Gross Margin — This is a preliminary profit meas- hedge funds. These are the big players in the
ure, reflecting how much of every dollar of sales stock market.
a company keeps after the cost of sales is sub-
tracted. Calculate it by taking gross profits (rev- Inventory — Inventory represents raw materials,
enues minus cost of goods sold) for a period, and near-finished products, and finished goods that
dividing by the revenues for the same period. a company has not yet sold. You’ll find it listed
as an asset on a company’s balance sheet.
Growth and Income Fund — A mutual fund that
pursues long-term growth of capital, as well as Junk Bond (High-Yield Bond) — A bond issued
current dividend income from stocks. This de- by a company with relatively high chances of de-
scribes most stock mutual funds at some level, faulting. To compensate for the extra risk, the
but the term is used to distinguish these funds interest rate is set relatively high.
from ones that are more exclusively aimed at in-
vesting in growth stocks (“aggressive” or Liabilities — Outstanding debts.
“growth” funds) or more stable funds, designated
as income funds. Limit Order — An order to buy or to sell a se-
curity at a specific price or better. Example: “Buy
Growth Stock Fund — A mutual fund that em- 200 shares of Microsoft at $65.” This would
phasizes acquiring companies believed to be rap- be placed when Microsoft is trading above $65
idly growing earnings and sales. Growth stocks a share, and the purchaser is interested in wait-
usually have little or no dividend, as they are still ing for a better price, and accepting the possi-
at a stage in their businesses where they are rein- bility that his preferred price will not ever be
vesting most or all of their earnings into the fur- available, in which case the order will not be
ther development of the business. filled. See Market Order.
High-Yield Bonds — See junk bonds. Load — A sales fee or commission charged when
you buy or sell mutual fund shares. When a
Income Fund — A mutual fund that invests in fund’s (front-end) load is 5%, for every $100 you
bonds and companies paying significant dividends. invest, you’re only getting $95 invested into the
Preferred Stock — A class of stock that is given Return on Equity (ROE) — Return on equity is a
preference over common stock in regard to the measure of how much in earnings a company
payment of dividends or — heaven forbid — any generates in four quarters compared to its share-
liquidation of the company. Preferred stock is holder’s equity. It is measured as a percentage
paid dividends at a specified rate, but will gen- and serves as one measure of profitability.
erally not carry the voting rights that common
stock does. Revenues (Sales) — Revenues are monies that a
company collects from customers in exchange
Price-to-Earnings (P/E) Ratio — The share price for products or services.
of a stock divided by its earnings per share (EPS)
over the past year. Roth IRA — Roth IRAs are retirement accounts
in which contributions to the account are not
Prime Rate — The interest rate that lenders tax-deductible, but withdrawals are tax-free as
charge their very best, most-reliable customers. long as certain conditions are met.
Principal — The original cash placed into an in- Round Lot (Even Lot) — A group of shares of
vestment. stock traded in a multiple of 100, or $1,000 or
$5,000 worth of bonds.
Prospectus — A legal document usually written
in extraordinarily tedious language that provides S&P 500 Index (Standard & Poor’s 500 Index)
information about a potential investment, such — An index of 500 of the biggest publicly trad-
as discussions of its investment objectives and ed companies in the United States. The S&P 500
policies, past performance, risks, and costs. is generally thought of as the best measurement
of the overall U.S. stock market, though the
Real Estate Investment Trust (REIT) — REITs are a Wilshire 5000 is a more complete index.
specialized form of equity that allows investors to
own a portion of a group of real estate properties. SEC — See Securities and Exchange Commission.
Real Return — The inflation-adjusted returns of Secondary Offering — When a company offers a
Spiders — S&P 500 Depositary Receipts, trading Treasury Bill (T-bill) — A short-term discounted
under the ticker symbol SPY, are colloquially known security issued by the U.S. government, matur-
as “Spiders.” They’re stock-like securities made ing in 13, 26, or 52 weeks.
up of the components of the S&P 500 index, trad-
ing at one-tenth of its value. You can buy and sell Treasury Bond (T-bond) — A long-term securi-
shares of Spiders just as you would stocks. ty issued by the U.S. government, with a ma-
Index
A Ask price, defined, 248
Accounts payable, defined, 393 Asset allocation, defined, 393
Accounts receivable, defined, 393 Asset, defined, 393
Accrual method, in sales, 287 Asset turnover, calculation of, 306
Acid-test ratio, defined, 283 AT&T, 252, 260
ADRs. See American Depositary Receipts
ADSs (American Depositary Shares), 219 B
AIG, website, 43 Balanced fund, defined, 322
All-or-none (AON) orders, 314 Bankruptcy, and share value, 359
Allstate Insurance Co., website, 44 Banks and banking
Amazon.com, 236, 256, 258 alternatives to, 99, 103–104
American Depositary Receipts (ADRs) annual percentage rate (APR), defined, 101–102
defined, 219, 393 annual percentage yield (APY), defined,
ticker symbol, 374 101–102
American Depositary Shares (ADSs), 219 ATMs
American Express, 253 avoiding fees, 96–97
American Institute of Philanthropy, website, 153 and banking online, 103
American International Group, 378 and credit unions, 102
American Society of Home Inspectors (ASHI), check ordering, 106
78 compounding of interest, 101–102
American Stock Exchange (AMEX), 393 costs associated with, 95–96
phone number, 262 credit unions, advantages and disadvantages,
America Online, 241, 257, 268, 293, 295, 357 102–103
Amgen, Inc., 256, 378 errors, common, 100–101
Amortization, defined, 393 Internet banks, 103, 104
Analysis of Financial Statements (Bernstein), 298 evaluation of, 105
Analysts information sources on, 105–106
fair value estimates, 230–231 safety of, 105
research by, 220 records, retention of, 126
sell- vs. buy-side, 219–220 savings accounts, 96
Annual reports. See Earnings reports selecting a bank, 97–100
Annuities, variable, 378–379 Barber, Brad, 343, 344, 362
AON (All-or-none) orders, 314 Bartering, as savings strategy, 113
Arbitrage, defined, 232 Basis point, defined, 394
403
Bear, defined, 394 for children, 383
Bear market, defined, 195, 394 idle funds in, 211
Ben & Jerry’s, Inc., 258 insurance on, 312
Berkshire Hathaway Corp., 198, 239, 272, 378 Budgets, personal. See also Money-saving ideas
Bernstein, Leopold A., 298 calculation of percentages, 8
Beta, defined, 374, 394 importance of, 3–4
Bid-ask spread, defined, 394 information sources on, 11, 390
Bid price, defined, 248 living within, 10–11
Block trades, defined, 228 psychology of, 4
Board of directors, defined, 394 savings, locating, 5
Bonds setting up, 4–5
calls, 179–180 software for, 7
corporate, 179 teaching children about, 10
defined, 179–180, 394 typical, 7–8
junk, 179, 397 worksheet for, 5–7, 6f
long, 181 Buffett, Warren, 182–183, 198, 229, 237, 238,
municipal, 179 239, 358, 365, 367, 385–386
performance (vs. stocks), 180, 194–195 Bull, defined, 394
price of, and interest rates, 352 Bull market, defined, 195, 394
Treasuries, 179 Burger King, Inc., 258
Treasury bills, 181, 400 Burial. See Funeral and burial
Treasury bonds, 181, 400–401 Burn rate, defined, 307
Treasury notes, 181, 401 Business model, defined, 253
U.S. Savings Bonds, 180–181 Buy-side analysts, defined, 219–220
yield calculations, 180
zero-coupon, 180–181 C
Book value Calculations
as company evaluation tool, 283–284 asset turnover, 306
defined, 394 avoiding errors in, 255
Brand names bond yield, 180
importance of, 252, 257 credit card interest, 18
market value of, 252–253 days sales outstanding (DSO), 286
Braze, Dave, 33, 35, 140–141 earnings yield, 300–301
Broker. See Stockbrokers enterprise value (EV), 301–302
Brokerage(s). See also Commissions; Stockbro- estimated taxes, 128
kers flow ratio, 292–293
banking services, 103–104 growth rates, 274–275
and company ratings, 220, 235 income taxes, 121–123
conflicts of interest, 210, 221, 231 inventory turnover, 285
coverage of stocks, defined, 220 net asset value (NAV), 323
discount, 205 percentages, 8
advantages of, 336 profitability, 270
evaluation of, 313 profit margins, 270
services and commissions, 309–310 return on assets (ROA), 305–306
full service return on equity (ROE), 288–289
defined, 397 return on portfolio, 340–341
services and commissions, 309–310 working capital, 306–307
information sources on, 392 Campbell Soup Co., 295
online Capital appreciation, defined, 394
deposits to, 312 Capital, defined, 394
reviews of, 313 Capital expenditures, defined, 394
and trading price, 313 Capital structure
orders, types and functions, 313–315 as company evaluation tool, 291–292
Brokerage accounts defined, 291
Z
ZDNet, Inc., 260
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3) Type in what youre looking for. The word or phrase that youre looking for
should pop up highlighted in the PDF.
4) To skip to the next time the word or phrase appears, you can either go to
Edit/Find Again, or hold down the Ctrl+G (Apple+G on Mac) keys.
Find Backward: If your current view is page 30 and the check box is enabled,
the Find tool will search backward from page 30.
5) Any questions or comments, please contact: [email protected].