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    Stocks - Basics.doc Stocks - Basics.doc Document Transcript

    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 Stocks - Basics Perhaps we should start by looking at the basics: What is stock? Why does a company issue stock? Why do investors pay good money for little pieces of paper called stock certificates? What do investors look for? What about Value Line ratings and what about dividends? To start with, if a company wants to raise capital (money), one of its options is to issue stock. A company has other methods, such as issuing bonds and getting a loan from the bank. But stock raises capital without creating debt; i.e., without creating a legal obligation to repay borrowed funds. What do the buyers of the stock -- the new owners of the company -- expect for their investment? The popular answer, the answer many people would give is: they expect to make lots of money, they expect other people to pay them more than they paid themselves. Well, that doesn't just happen randomly or by chance (well, maybe sometimes it does, who knows?). The less popular, less simple answer is: shareholders -- the company's owners -- expect their investment to earn more, for the company, than other forms of investment. If that happens, if the return on investment is high, the price tends to increase. Why? Who really knows? But it is true that within an industry the Price/Earnings (i.e., P/E) ratio tends to stay within a narrow range over any reasonable period of time -- measured in months or a year or so. So if the earnings go up, the price goes up. And investors look for companies whose earnings are likely to go up. How much? There's a number -- the accountants call it Shareholder Equity -- that in some magical sense represents the amount of money the investors have invested in the company. I say magical because while it translates to (Assets - Liabilities) there is often a lot of accounting trickery that goes into determining Assets and Liabilities. But looking at Shareholder Equity, (and dividing that by the number of shares held to get the book value per share) if a company is able to earn, say, $1.50 on a stock whose book value is $10, that's a 15% return. That's actually a good return these days, much better than you can get in a bank or C/D or Treasury bond, and so people might be more encouraged to buy, while sellers are anxious to hold on. So the price might be bid up to the point where sellers might be persuaded to sell. A measure that is also sometimes used to assess the price is the Price/Book (i.e., P/B) ratio. This is just the stock price at a particular time divided by the book value. What about dividends? Dividends are certainly more tangible income than potential earnings increases and stock price increases, so what does it mean when a dividend is non-existent or very low? And what do people mean when they talk about a stock's yield? To begin with the easy question first, the yield is the annual dividend divided by the stock price. For example, if company XYZ is paying $.25 per quarter ($1.00 per year) and XYZ is trading at $10 per share, the yield is 10%. A company paying no or low dividends (zero or low yield) is really saying to its investors -- its owners, "We believe we can earn more, and return more value to shareholders by retaining the earnings, by putting that money to work, than by paying it out and not having it to invest in new plant or goods or salaries." And having said that, they are expected to earn a good return on not only their previous equity, but on the increased equity represented by retained earnings. So a company whose book value last year was $10 and who retains its entire $1.50 earnings, increases its book value to 11.50 less certain expenses. The $1.50 in earnings represents a 15% return. Let's say that the new book value is 11. To keep up the streak (i.e., to earn a 15% return again), the company must generate earnings of at least $1.65 this year just to keep up with the goal of a 15% return on equity. If the company earns $1.80, the owners have indeed made a good investment, and other investors, seeking to get in on a good thing, bid up the price. February 2005: Stocks, Bonds and the Markets Page 1 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 That's the theory anyway. In spite of that, many investors still buy or sell based on what some commentator says or on announcement of a new product or on the hiring (or resignation) of a key officer, or on general sexiness of the company's products. And that will always happen. What is the moral of all this: Look at a company's financials, look at the Value Line and S&P charts and recommendations, and do some homework before buying. Do Value Line and S&P take the actual dividend into account when issuing their "Timeliness" and "Safety" ratings? Not exactly. They report it, but their ratings are primarily based on earnings potential, performance in their industry, past history, and a few other factors. (I don't think anyone knows all the other factors. That's why people pay for the ratings.) Can a stock broker be relied on to provide well-analyzed, well thought out information and recommendations? Yes and no. On the one hand, a stock broker is in business to sell you stock. Would you trust a used-car dealer to carefully analyze the available cars and sell you the best car for the best price? Then why would you trust a broker to do the same? On the other hand, there are people who get paid to analyze company financial positions and make carefully thought out recommendations, sometimes to buy or to hold or to sell stock. While many of these folks work in the "research" departments of full-service brokers, some work for Value Line, S&P etc, and have less of an axe to grind. Brokers who rely on this information really do have solid grounding behind their recommendations. Probably the best people to listen to are those who make investment decisions for the largest of Mutual Funds, although the investment decisions are often after the fact, and announced 4 times a year. An even better source would be those who make investment decisions for the very large pension funds, which have more money invested than most mutual funds. Unfortunately that information is often less available. If you can catch one of these people on CNN for example, that could be interesting. Source : Financing4All.com Tools http://www.financing4all.net/stocks-and-investing/investor-basics.html Bond Basics: What are Bonds? Have you ever borrowed money? Of course you have! Whether it was hitting our parents up for a few bucks to buy candy or asking the bank for a mortgage, most of us have borrowed money at some point in our life. Just like people need money, so do companies and governments. A company needs funds to expand into new markets while governments need money for everything from infrastructure to social programs. The problem large organizations run into is that they typically need far more money than the average bank can provide. The solution is to raise money by issuing bonds (or other debt instruments) to a public market. Thousands of investors then each lend a portion of the capital needed. Really, a bond is nothing more than a loan of which you are the lender. The organization that sells a bond is known as the issuer. You can think of it as an IOU given by a borrower (the issuer) to a lender (the investor). Of course, nobody would loan their hard-earned money for nothing. The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This "extra" comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed, known as February 2005: Stocks, Bonds and the Markets Page 2 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 face value, is called the maturity date. Bonds are known as fixed-income securities because you know the exact amount of cash you'll get back, provided you hold the security until maturity. Say for example you buy a bond with a face value of $1000, a coupon of 8%, and a maturity of ten years. This means you'll receive a total of $80 ($1000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you'll receive two payments of $40 a year for ten years. When the bond matures after a decade you'll get your $1000 back. Debt Versus Equity Bonds are debt whereas stocks are equity. This is the important distinction between the two securities. By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership comes with voting rights and the right to share in any future profits. By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). The primary advantage of being a creditor is a higher claim on assets than that of shareholders. That is, in the case of bankruptcy a bondholder will get paid before a shareholder does. The bondholder, however, does not share in the profits if a company does well--he or she is entitled only to the principal plus interest. To sum it up, there is generally less risk in owning bonds compared to owning stocks, but this comes at the cost of a lower return. Why Bother With Bonds? It's an investing axiom that stocks return more than bonds. In the past this has generally been true for time periods of at least ten years or more. This, however, doesn't mean that you shouldn't invest in bonds. Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market. Take two situations where this may be true: 1) Retirement - The easiest example to think of is an individual living off a fixed income. This person simply cannot afford to lose his/her principal as income from it is required to pay the bills. 2) Shorter time horizons - Say a young executive is planning to go back for an MBA in three years. It's true that the stock market provides the opportunity for higher growth, which is why his/her retirement fund is mostly in stocks, but the executive cannot afford to take the chance of losing the money going towards his/her education. Because money is needed for a specific purpose in the relatively near future, fixed-income securities are likely the best investment. These two examples are clear cut, and they don't represent all investors. Most personal financial advisors advocate maintaining a diversified portfolio and changing the weightings of asset classes throughout your life. For example, in your 20s and 30s a majority of wealth should be in equities. In your 40s and 50s the percentages shift out of stocks into bonds until retirement, when a majority should be in the form of fixed income. Zero Coupon Bond A debt security traded at a deep discount from face value. It is traded at a deep discount because the bond pays no interest. The profit is realized when the bond is February 2005: Stocks, Bonds and the Markets Page 3 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 redeemed at maturity for its full face value. A zero coupon bond can be issued at a discount, or it may be stripped of its coupons by a financial institution and then repackaged as a zero coupon bond. Also known as an accrual bond. Source: Investopedia http://www.investopedia.com/university/bonds/bonds1.asp Compounding The ability of an asset to generate earnings that are then reinvested and generate their own earnings. Making interest on interest, the power of compounding interest is truly magical. At 15% interest for 25 years, $10,000 would grow to $330,000! Source: http://www.investopedia.com/terms/c/compounding.asp Individual Retirement Account - IRA An IRA is a retirement investing tool that can be either an Individual Retirement Account or an Individual Retirement Annuity. There are several types of IRAs: Traditional IRAs, Roth IRAs, SIMPLE IRAs, and SEP IRAs. Traditional and Roth IRAs are established by individual taxpayers, who are allowed to contribute 100% of compensation (Self-employment income for Sole proprietors and partners) up to a specified maximum dollar amount. Contributions to the Traditional IRA may be tax-deductible depending on the taxpayer's income, tax- filing status, and coverage by an employer-sponsored retirement plan. Roth IRA contributions are not tax-deductible. SEPs and SIMPLEs are retirement plans established by employers. Individual participant's contributions are made to SEP IRAs and SIMPLE IRAs. Eventual withdrawal is taxed as income, including the capital gains, but since your income is likely less once you retire, you will be taxed at a lower rate. Source: http://www.investopedia.com/terms/i/ira.asp What Is a Mutual Fund? A mutual fund, also called an investment company, is an investment vehicle which pools the money of many investors. The fund's manager uses the money collected to purchase securities such as stocks and bonds. The securities purchased are referred to as the fund's portfolio. When you give your money to a mutual fund, you receive shares of the fund in return. Each share represents an interest in the fund's portfolio. The value of your mutual fund shares will rise and fall depending upon the performance of the securities in the portfolio. Like a shareholder in a corporation, you will receive a proportional share of income and interest generated by the portfolio. You can receive these February 2005: Stocks, Bonds and the Markets Page 4 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 distributions either in cash or as additional shares of the fund. As a shareholder, you also have certain shareholder voting rights. A mutual fund's portfolio is managed by a professional money manager. The manager's business is to choose securities which are best suited for the portfolio. Be aware, however, that even a profes sional money manager cannot insure against a loss of principal. The mutual fund manager will invest in many different securities. This diversification of portfolio assets means that you as an investor have not pinned all your hopes on one company's success. Also, because the portfolio holds many securities, the negative impact that any one company may have on the fund is diminished. While diversification is a benefit of mutual fund investing, a mutual fund is still impacted, either favorably or unfavorably, by the ups and downs of the market in general. Mutual funds provide a relatively easy way to invest. Most funds have a minimum investment of $1000. In addition, a mutual fund stands ready to buy back, or redeem, your shares at any time. This liquidity allows you to get your money when needed. There is no guarantee, however, that your shares at the time of redemption will not have decreased in value. Types of Mutual Funds The types of mutual funds vary according to the fund's investment objective. A fund's investment objective will usually seek capital gains (gains from the sale of portfolio securities), income (interest and dividends earned on the portfolio securities) or a combination of both. While not a comprehensive list of all mutual funds, the basic types of funds are described below. Money Market: A money market fund seeks safety of principal by investing in high quality, short-term securities. This type of fund is designed with the aim that an investor's principal should not decrease in value. There is no guarantee, how ever, that this will always be the case. A money market fund seeks to provide a regular distribution of income which is determined by short-term interest rates. Growth: A growth fund invests primarily in the common stock of well established companies. This type of fund may invest for long-term capital gains and is not intended for an investor who seeks income. Aggressive Growth: Like a growth fund, an aggressive growth fund will invest primarily in common stock for long-term capital gains. An aggressive growth fund may invest in the common stock of small companies, out-of-favor companies or companies in new industries. It, therefore, has a higher degree of risk than a basic growth fund. Income: An income fund invests in either corporate, government, or municipal debt securities. A debt security is an obligation which pays interest on a regular basis. Hence, this type of fund is designed for investors who desire periodic income payments. There are, however, substantial differences and varying degrees of risk among income funds depending on the credit quality of the debt issuer, the maturity of the debt instrument, and prevailing interest rates. High Income: This category of income fund seeks to achieve a high degree of income by investing a material portion of its portfolio in below investment grade debt securities or junk bonds. These funds have a high degree of risk and should be purchased by investors who can incur the risk of loss of principal. Balanced: A balanced fund, as the name implies, invests for both growth and income. The fund will invest in both equity and debt securities. A balanced fund seeks to provide long-term growth through its equity component as well as income to be generated by the portfolio's debt securities. Source: State of Massachusettes http://www.state.ma.us/sec/sct/sctprs/prsamf/amfidx.htm Investment FAQ http://www.cobeconet.com/invest-faq/stocks.html SmartMoney.com Tools February 2005: Stocks, Bonds and the Markets Page 5 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 http://www.smartmoney.com http://www.smartmoney.com/tools/?nav=DropTabs - Map of the Market - Portfolio Tracker Financing4All.com Tools http://www.financing4all.net/ - Financing and Investment Learning and Tools online resource. Derivatives - A collective term for securities whose prices are based on the prices of another (underlying) investment. The main derivatives are: • futures • options • swaps • warrants • convertibles The attractions of derivatives from an investor's point of view are: 1. Large profits (but also losses) can be made on a small stake, because they offer 'leverage'. 2. Because derivatives are essentially a bet on which way the price of the underlying instrument is going, you can make money whether the market goes up or down, which is not true if you invest in shares where you only make a profit if the share price rises. 3. Derivatives can be used to reduce the risk (or hedge) of an investment in the underlying instrument. In general, derivatives are high-risk investments and not suitable for the ordinary investor. Source: http://www.numa.com/ (see Financial Glossary) Derivatives - Basics A derivative is a financial instrument that does not constitute ownership, but a promise to convey ownership. Examples are options and futures. The most simple example is a call option on a stock. In the case of a call option, the risk is that the person who writes the call (sells it and assumes the risk) may not be in business to live up to their promise when the time comes. In standarized options sold through the Options Clearing House, there are supposed to be sufficient safeguards for the small investor against this. Before discussing derivatives, it's important to describe their basis. All derivatives are based on some underlying cash product. These "cash" products are: • Spot Foreign Exchange. This is the buying and selling of foreign currency at the exchange rates that you see quoted on the news. As these rates change relative to your "home currency" (dollars if you are in the US), so you make or lose money. February 2005: Stocks, Bonds and the Markets Page 6 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 • Commodities. These include grain, pork bellies, coffee beans, orange juice, etc. • Equities (termed "stocks" in the US) • Bonds of various different varieties (e.g., they may be Eurobonds, domestic bonds, fixed interest / floating rate notes, etc.). Bonds are medium to long-term negotiable debt securities issued by governments, government agencies, federal bodies (states), supra- national organisations such as the World Bank, and companies. Negotiable means that they may be freely traded without reference to the issuer of the security. That they are debt securities means that in the event that the company goes bankrupt. bond-holders will be repaid their debt in full before the holders of unsecuritised debt get any of their principal back. • Short term ("money market") negotiable debt securities such as T-Bills (issued by governments), Commercial Paper (issued by companies) or Bankers Acceptances. These are much like bonds, differing mainly in their maturity "Short" term is usually defined as being up to 1 year in maturity. "Medium term" is commonly taken to mean form 1 to 5 years in maturity, and "long term" anything above that. • Over the Counter ("OTC") money market products such as loans / deposits. These products are based upon borrowing or lending. They are known as "over the counter" because each trade is an individual contract between the 2 counterparties making the trade. They are neither negotiable nor securitised. Hence if I lend your company money, I cannot trade that loan contract to someone else without your prior consent. Additionally if you default, I will not get paid until holders of your company's debt securities are repaid in full. I will however, be paid in full before the equity holders see a penny. Derivative products are contracts which have been constructed based on one of the "cash" products described above. Examples of these products include options and futures. Futures are commonly available in the following flavours (defined by the underlying "cash" product): • commodity futures • stock index futures • interest rate futures (including deposit futures, bill futures and government bond futures) For more information on futures, please see the article in this FAQ on futures. In the early 1990s, derivatives and their use by various large institutions became quite a hot topic, especially to regulatory agencies. What really concerns regulators is the fact that big banks swap all kinds of promises all the time, like interest rate swaps, froward currency swaps, options on futures, etc. They try to balance all these promises (hedging), but there is the big danger that one big player will go bankrupt and leave lots of people holding worthless promises. Such a collapse could cascade, as more and more speculators (banks) cannot meet their obligations because they were counting on the defaulted contract to protect them from losses. All of this is done off the books, so there is no total on how much exposure each bank has under a specific scenario. Some of the more complicated derivatives try to simulate a specific event by tracking it with other events (that will usually go in the same or the opposite direction). Examples are buying Japan stocks to protect against a loss in the US. However, if the usual correlation changes, big losses can be the result. The big danger with the big banks is that while they can use derivatives to hedge risk, they can also use them as a way of taking ON risk. Not that risk is bad. Risk is how a bank makes money; for example, issuing loans is a risk. However, banks are forbidden from taking on risk with derivatives. It's just too easy for a bank to hedge bonds with derivatives that don't have the same maturity, same underlying security, etc. so the correlation between the hedge and the risky position is weak. Source:Investopedia February 2005: Stocks, Bonds and the Markets Page 7 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 http://www.investopedia.com/offsite.asp?URL=http://invest-faq.com/articles/deriv-basics.html ++++++++++++++++++++++++++++++++++++++++++ Risk Tolerance An investor's ability to handle declines in the value of his/her portfolio. Source: http://www.investorwords.com Risk tolerance basically is the amount of psychological pain you're willing to suffer from your investments. For example, if your risk propensity is high, you might feel fairly comfortable investing in futures contracts or other types of securities that can go up and down like a roller coaster. But if your tolerance for risk is low, you should stick to more conservative investments that aren't subject to wild swings in value. No investment is worth losing sleep over. Source: http://moneycentral.msn.com Why do stock prices change after news reports? Stock prices move up and down every minute due to fluctuations in supply and demand. If more people want to buy a particular stock, its market price will increase. Conversely, if more people want to sell a stock, its price will fall. This relationship between supply and demand is tied into the type of news reports that are issued at any particular moment. Negative news will normally cause individuals to sell stocks. Bad earnings reports, poor guidance, economic and political uncertainty, and unexpected unfortunate occurrences will translate to selling pressure and a decrease in stock price. Positive news will normally cause individuals to buy stocks. Good earnings reports, increased guidance, new products, and good economic and political indicators translate into buying pressure and an increase in stock price. But, it's not easy, if at all possible, to capitalize on news. The effect new information has on a stock is dependant upon the extent to which it is unexpected. This is because the market is always building future expectations into prices. For example, if a company comes out with high unexpected profits, the stock's price will likely jump. But, if that same profit was expected by a majority of investors, the stock's price will likely remain the same. This profit would have already been factored into the stock price. Thus, it's not just news but unexpected news that helps drive prices. Source: http://www.investopedia.com/default.asp How to Read a Stock Ticker If you've ever watched financial programs on CNBC or CNNfn, you've probably noticed the numbers scrolling along the bottom of the TV screen. This is known as a stock ticker, a technology that has evolved from its initial invention by Thomas Edison. February 2005: Stocks, Bonds and the Markets Page 8 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 This refers to the unique characters used to identify the Ticker Symbol company. This is the volume of the trade being quoted. Abbreviations Shares Traded are K = 1,000, M = 1,000,000 and B = 1,000,000,000 Price Traded The price per share for the particular trade. Shows whether the price was higher or lower than the Change Direction previous day's closing price. Change Amount The difference in price from the previous day's close. On many tickers, colors are also used to distinguish what the stock is trading at. Here is the color code used by most TV stations: Green: indicates the stock is trading higher than the most recent close. Red: indicates the stock is trading lower than the most recent close. Blue or White: means the stock is unchanged from the most recent closing price. Because there are literally millions of trades done on over 10,000 different stocks every day, it's impossible to report every single trade on the ticker tape. Most ticker tapes will select which trades to show based on factors such as volume, trading activity, price change, and how widely held a stock is. Source: http://www.investopedia.com/default.asp February 2005: Stocks, Bonds and the Markets Page 9 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 Assess Your Level of Risk Tolerance The following questionnaire is designed to help you assess your level of risk tolerance. Questionnaire results can serve as a guide to choosing the investments that complement your financial goals. Discuss the results with your financial advisor. No matter what type of investor you are, it is important to diversify. That means distributing your money across different types of investments so that you’re not putting all your eggs in one basket. You may place some of your funds in conservative financial vehicles with a guaranteed rate of return, while putting additional money in aggressive investments that carry more risk but have a possibility of greater returns. February 2005: Stocks, Bonds and the Markets Page 10 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 Circle the answer that best describes your response. Agree Strongly= 1 pt. Agree Somewhat= 2 pts. Disagree = 3 pts. Agree Agree Disagree Strongly Somewhat 1. Preservation of capital is most important to me. 1 2 3 2. I would accept a lower yield on my bond investments in 1 2 3 exchange for the relative safety of government securities. 3. Although emerging growth stocks offer high potential return, I would prefer a portfolio of established, high-quality 1 2 3 equity securities. 4. I would choose share price stability over higher current 1 2 3 return. 5. Portfolio diversification is an important investment 1 2 3 consideration. 6. I would accept a lower current yield if I could access my 1 2 3 money at any time. 7. I would choose U.S. government bonds versus stocks as 1 2 3 my primary long-term investment. 8. I would choose current liquidity over higher, long-term 1 2 3 total return. Score Risk Tolerance InvestmentApproach 8-12 pts. Lower Conservative • Concerned with capital preservation • Liquidity (easily converted into cash) • Wish to avoid market's ups and • Preservation of capital downs 13-17 pts. Moderate Moderate • Have more available income • Income • Capital appreciation • Emphasis on capital appreciation • Total return 18-24 pts. Higher Aggressive • Have both time and money to ride • Maximum capital appreciation out the market's ups and downs • Seek maximum growth and appreciation Source: http://www.financing4all.net/stocks-and-investing/assess-your-level-of-risk-tolerance.html 8 Rules for Investing Success Before becoming a great investor, you must understand many critical basic concepts. Here are several to help you deploy your moolah successfully: 1. Time is your greatest ally. If you earn just 8% on average on your investments, you February 2005: Stocks, Bonds and the Markets Page 11 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 can increase your wealth some sevenfold in 25 years and tenfold in 30 years. Let the miracle of compounded returns help make you wealthy. 2. Know what you do and don't know. Stay within your circle of competence, but expand it by filling in the holes in your knowledge -- whether you need to increase your knowledge of an industry or learn how to read a balance sheet. (You'll find guidance in our How-to Guides and online seminars and in accounting books.) 3. Know what your company does. Too many people have no idea what some of the companies they own actually do. With many high-tech companies, such as Lucent (NYSE: LU), Cisco Systems (Nasdaq: CSCO), or General Electric (NYSE: GE), understanding all they do can be easier said than done. You must know your company's products or services, and how it stacks up against competitors. Otherwise, it's very hard to evaluate future prospects. 4. Know your company's expected growth rate as it affects how you should value a business. A price-to-earnings (P/E) ratio, for example, is meaningless without such context. 5. Know your company's market capitalization. Having a sense of its relative size permits you to gauge how big a business it is in relation to competitors. 6. Know your tolerance for pain. Don't put all your eggs in too few baskets, or in baskets that keep you from being able to sleep at night. Be prepared for some inevitable losses. 7. Study your company's balance sheet. Check out its cash and debt situation. Make sure accounts receivable (money owed the company) and inventory aren't growing faster than sales, as it suggests things are getting out of control. 8. Assess the safety of your company's profits well into the future. How strong are the competitive pressures facing your company? Does it have sustainable advantages or will low barriers to entry permit newcomers to quickly set up shop and compete? Source: The Motley Fool Newsletter http://www.fool.com +++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ From: The Motley Fool Newsletter By Rex Moore February 5, 2004 Einstein once said that compound interest was "the greatest mathematical discovery of all time." Or maybe Yogi Berra said that. At any rate, Albert and Yogi got it only half right: Compound interest, combined with time, is one of the most powerful forces in the universe. And you can quote me on that. The examples I'm about to give will amaze and delight you, and should give you motivation to open a Drip or IRA or 401(k) or to continue contributing if you already have them. If you're a teacher, you should read this to your class. If you're a parent, you should read it to your kids. February 2005: Stocks, Bonds and the Markets Page 12 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 Time saves you money Imagine you're a 21-year-old, just starting your first post-college job (just play along). The human resources director asks if you want to start contributing to the 401(k) plan. The correct answer? You should jump up and down, hug him, and scream, "YES! YES!" In almost no circumstance should you not begin saving and investing in that situation. Let's say you're looking to retire in about 40 years, at the age of 61. You've decided a nest egg of $800,000 will do. By starting now and earning a modest 8% compound annualized growth rate (CAGR) over that time, you'll need to contribute $2,859 each year to reach your goal. If you wait 10 years to start saving, however, you'll have to pump $6,539 into your plan annually, or more than twice as much. If you're able to achieve a 10% annualized return, roughly what the market has averaged over the years, you'll need to contribute only $1,643 each year, but $4,421 if you wait a decade. Time makes you a better investor Using the same example, a person starting at the age of 31 and earning 10% per year can't match the returns of a 21-year-old starter earning 8%. In fact, the 31-year-old would have to earn better than a 12% CAGR in order to be able to contribute the same $2,859 and still reach $800,000 by the age of 61. Put another way, beginning 10 years earlier in this example is like adding 4% per year to your investing skills, which is huge over the long term. Thus, starting early can help forgive less-than-average investing skills. Here's an even more powerful illustration. Two 51-year-olds are talking at a party about their 401(k) plans: EarlyBird Johnson: I've earned a compounded rate of 8% over the past 30 years. LateComer Larry: What a coincidence, so have I! EarlyBird: Yes, I started contributing $2,500 a year when I was 21, but had to stop when I was 30. I've not contributed since, although the money continued to grow in my account. LateComer: I, too, contributed $2,500 a year! However, I didn't start until I was 30. So, now that we're both 51, I've been contributing for 21 years, and you contributed only nine years. How much is in your account? EarlyBird: Let's see... $169,723. How much is in yours? LateComer (stunned): Uh.... just $136,142. The lesson is clear: Never talk to anyone named "EarlyBird" at a party. Oh, yes... and start investing early. For, you see, gentle investor, the nine-year penalty is even more severe than you think. EarlyBird contributed a total of just $22,500 over the nine years, while LateComer shelled out $62,500 over 21 years -- and still came up well short! The lesson became even clearer when the two suddenly sober party animals sat down with pencil and calculator. How many more years of $2,500 contributions, LateComer wondered, would it take until he surpassed EarlyBird's total? Assuming both continued to earn 8% annually, would it take three years? Five years? Well, February 2005: Stocks, Bonds and the Markets Page 13 of 14
    • Mt. Bethel Personal Finance Workshop – Part 1 of 3 no. In fact, after 10 more years -- 31 years after EarlyBird stopped contributing and LateComer started -- LateComer will still be behind, $333,034 vs. EarlyBird's $366,415. Believe it or not, the story is still the same after the 50th year. And the 75th: EarlyBird LateComer Year Savings Cum. Contr. Savings Cum. Contr. 9 $33,716 $22,500 $0 $0 30 169,723 22,500 136,142 52,500 40 366,415 22,500 333,034 77,500 50 791,071 22,500 758,109 102,500 75 5,417,627 22,500 5,389,275 165,000 99 34,354,155 22,500 34,354,634 225,000 Assumes 8% CAGR; no adjustment for taxes It's not until the 99th year, 90 years after LateComer started pumping in $2,500 annually, that he will be able to surpass EarlyBird's total. At that point, LateComer will have contributed a grand total of $225,000, compared to EarlyBird's paltry payout of $22,500. And it's all because of EarlyBird's head start. (Of course, by then, LateComer will have long since stopped caring after racking up millions in savings.) So, if you're not socking some money away on a regular basis, start now. Every month you wait will cost you big money many years down the road. Fool co-founder Tom Gardner once said, "The best time to start investing was yesterday. The next best time is today." That doesn't mean you should rush right out and buy a bunch of penny stocks, or any stocks you haven't thoroughly researched. It takes a while before you know if a Cisco (Nasdaq: CSCO) or Intel (Nasdaq: INTC) or General Electric (NYSE: GE) is for you. But it does mean you should contribute to your 401(k) if you're not already, and invest outside your retirement plan if you can. (With the usual caveat that this is money you won't need for several years... five at least.) Don't worry about individual stocks; start with an index fund and move to individual stocks only when -- if -- you're ready to. (And Tom has several good ideas for you in each issue of his Hidden Gems newsletter.) You can "drip" into an index fund just as well as you can drip into Johnson & Johnson (NYSE: JNJ) or PepsiCo (NYSE: PEP). Remember, time may be the single most important factor to your investing success. An early start means a below-average investor can earn a bigger pile of cash than an excellent investor. Just get started, because time is money. February 2005: Stocks, Bonds and the Markets Page 14 of 14