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July 14, 2004

Bonds and Interest Rate Changes

With interest rates at such low levels, you might be wondering what could happen to your bond portfolio if interest rates rise. Basically, interest rate changes affect bond prices as follows:
  • Interest rates and bond prices move in opposite directions. The price of a bond will decrease in value when interest rates rise and increase in value when interest rates fall. The price of an existing bond changes to provide the same return as an equivalent, newly issued bond at prevailing interest rates. If interest rates are higher than the rate on an existing bond, the existing bond becomes less valuable because of the lower interest payments, causing the price to decrease. Since you receive the full principal value at maturity, holding a bond until maturity eliminates the impact of interest rate changes.

  • Interest rate changes have a more dramatic effect on bonds with longer maturities. Since long-term bonds have a longer stream of interest payments that don't match current interest rates, their price must change more to compensate for those interest rate changes.

  • Bond price changes are less significant for bonds with higher coupon rates. Bonds with coupon interest rates near or above current interest rates will experience the least amount of price fluctuation. By understanding the effects of interest rate changes on bond prices, you can make more informed decisions regarding your bond portfolio.

Consider Dollar Cost Averaging to Reduce Investment Volatility

We all know we should buy low and sell high, but determining when that occurs is difficult. Thus, consider using a strategy like dollar cost averaging to help with those decisions.

Dollar cost averaging involves investing a set amount of money in the same investment on a periodic basis. For instance, instead of investing a lump sum in one stock immediately, you might invest $2,000 in that stock at the beginning of every month.

Utilizing this strategy can provide several benefits:

  • Dollar cost averaging requires the discipline to invest consistently, regardless of market fluctuations. Thus, it reinforces the habit of regularly setting aside money for investing.

  • For many investors, one of the more difficult aspects of implementing an investment strategy is deciding when to invest. Fear of investing at a market high can keep investors waiting on the sidelines. With a dollar cost averaging program, you just follow the plan and invest on a periodic basis, without trying to time the market.

  • Since you are investing a fixed amount of money, you purchase more shares when prices are lower and fewer shares when prices are higher. Thus, your average cost per share is typically lower than the average market price per share over the same time period.

  • Since you are spreading your investment over a period of time, it keeps you from investing all your money at a market high.

Dollar cost averaging, however, does not ensure a profit or protect against loss in declining markets. Before starting a dollar cost averaging program, you should consider your financial ability to continue purchases through periods of low price levels.

The Basics of Stock Market Indexes

Historically, stock market indexes have been closely watched as an indicator of the market's overall performance. While that role is still important, the number of stock market indexes has grown explosively as mutual funds and investment managers search for relevant indexes to use as benchmarks to compare performance. Indexes are also increasingly used as the base for investment products, allowing investors to invest in defined segments of the market without purchasing all of the underlying stocks in the index.

Indexes can be computed in different ways. Some, like the Dow Jones Industrial Average (DJIA), are calculated using an arithmetic average. The prices of stocks are added and then divided by the number of securities in the index, although the divisor is adjusted over time for splitting of shares, distribution of stock dividends, and to account for company substitutions in the index. These indexes do not adjust for the company's total market value, so stocks with the highest share prices have more impact on the index. Other indexes, such as the Standard & Poor's 500 (S&P 500), use market-value weighting, factoring in the differences in individual stocks' market value by multiplying the price of each by the number of shares outstanding. Thus, major corporations have a greater influence on the index than small companies.

Another important calculation difference is whether the index is a capital return or total return index. A capital return index, such as the DJIA and the S&P 500, only reflects changes in the shares of the stocks in the index. Total return indexes, such as the Russell 2000 and the Wilshire 5000, calculate both share price changes and dividend reinvestment.

Some of the major stock market indexes include:

The Dow Jones Industrial Average is comprised of 30 large-company stocks. All of the companies are billion-dollar giants, with no small- or medium-sized firms in the index. Despite the small number of companies in the index, the index is the oldest and most widely quoted measure of the U.S. stock market.

The Standard & Poor's 500 is comprised of 500 large-company stocks trading on the New York Stock Exchange, the American Stock Exchange, and Nasdaq, covering a wide variety of industries. This index is considered more representative of the U.S. stock market than the DJIA. Additionally, various component indexes are calculated from this index, including the 400 industrials, 40 utilities, 20 transportation companies, and 40 financial stocks.

The Nasdaq Composite Index follows the approximately 5,000 stocks that trade on Nasdaq. This index is generally viewed as a good benchmark for technology stocks.

The Russell 2000 Index is viewed as a good benchmark for the performance of smaller-company stocks. The stocks in the index include the 2,000 lowest-capitalization stocks from the Russell 3,000, which includes the 3,000 largest-capitalization stocks in the U.S. stock market.

The Wilshire 5000 Index, despite its name, consists of over 6,000 stocks, including almost all stocks traded on major exchanges, and gives the broadest view of the U.S. stock market.

If you want to compare your investments' performance to an index, select one that tracks the same types of stocks you hold in your portfolio. Keep in mind, however, that indexes do not incur any trading costs or taxes.

Measuring a Stock's Risk - Market Risk & Nonmarket Risk

Basically, stocks are subject to two types of risk - market risk and nonmarket risk. Nonmarket risk, also called specific risk, is the risk that events specific to a company or its industry will adversely affect the stock's price. For instance, an increase in the cost of oil would be expected to adversely affect the stock prices of the entire oil industry, while a major management change would only affect that company. Market risk, on the other hand, is the risk that a particular stock's price will be affected by overall stock market movements.

Nonmarket risk can be reduced through diversification. By owning several different stocks in different industries whose stock prices have shown little correlation to each other, you reduce the risk that nonmarket factors will adversely affect your total portfolio.

No matter how many stocks you own, you can't totally eliminate market risk. However, you can measure a stock's historical response to market movements and select those with a level of volatility you are comfortable with. Beta and standard deviation are two tools commonly used to measure stock risk.

Beta

Beta, which can be found in a number of published services, is a statistical measure of the impact stock market movements have historically had on a stock's price. By comparing the returns of the Standard & Poor's 500 (S&P 500) to a particular stock's returns, a pattern develops that indicates the stock's exposure to stock market risk.

The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market and has a beta of 1. A stock with a beta of 1 means that, on average, it moves parallel with the S&P 500 - the stock should rise 10% when the S&P 500 rises 10% and decline 10% when the S&P 500 declines 10%. A beta greater than 1 indicates the stock should rise or fall to a greater extent than stock market movements, while a beta less than 1 means the stock should rise or fall to a lesser extent than the S&P 500. Since beta measures movements on average, you cannot expect an exact correlation with each market movement.

Calculating your portfolio's beta will give you a measure of its overall market risk. To do so, find the betas for all your stocks. Each beta is then multiplied by the percentage of your total portfolio that stocks represents (i.e., a stock with a beta of 1.2 that comprises 10% of your portfolio would have a weighted beta of 1.2 times 10% or .12). Add all the weighted betas together to arrive at your portfolio's overall beta.

Standard Deviation

Standard deviation, which can also be found in a number of published services, measures a stock's volatility, regardless of the cause. It basically tells you how much a stock's short-term returns have moved around its long-term average return. The most common way to calculate standard deviation is to figure the deviation from an average monthly return over a three-, five-, or 10-year period and then annualize that number. Higher standard deviations represent more volatility. In statistical terms, 68% of the time the stock's range of returns will fall within one standard deviation of the average return, while 95% of the time the stock's range of returns will fall within two standard deviations.

Consider this example. Assume you own a stock with an average return of 10.2% and a standard deviation of 15%. Sixty-eight percent of the time you can expect your return to fall within a range of -4.8% to 25.2%, while 95% of the time you can expect your return to fall within a range of -19.8% to 40.2%. (This example is provided for illustrative purposes only and is not intended to project the performance of a specific investment.)

These two measures can provide important information about a stock's volatility. If your portfolio is riskier than you realized, you might want to take steps to reduce that risk. When investing, you might want to take a look at a stock's risk first.

Watch Out for These Investing Mistakes

Investing is a gradual process - purchasing investments and selling others as the years go by. After a period of years, this can result in a mixture of investments that don't fit your overall investment strategy.
  • You don't use an asset allocation strategy. Many investors select individual investments over the years, not considering the overall makeup of their portfolio. Add up all your investments and calculate what portion is invested in each investment category. The basic categories are stocks, bonds, and cash, but each category also has many subcategories. Since subcategories can have different risk levels (i.e., blue chip and growth stocks have very different risk levels), review subcategories as well. Assess your current allocation and determine whether it fits your personal situation.

  • You have too many investments that aren't adding diversification to your portfolio. Diversification helps reduce the volatility in your portfolio, since various investments will respond differently to economic events and market factors. Yet it's common for investors to keep adding investments to their portfolio that are similar in nature. This does not add much in the way of diversification, while making the portfolio more difficult to monitor. Before adding an investment to your portfolio, make sure it will further diversify your investments. (Keep in mind that diversification does not ensure a profit or protect against losses in a declining market.)

  • Your portfolio's return is lower than benchmark returns. While everyone likes to think their portfolio is beating the market averages, many investors simply aren't sure. Review the return of each component in your portfolio, comparing it to a relevant benchmark. While you may not want to sell an investment that has underperformed for a year or two, at least monitor closely any investments that significantly underperform their benchmarks. Next, calculate the overall rate of return for your portfolio and compare it to a relevant benchmark. Include all your investments - those in taxable accounts and in your retirement accounts. Also be sure to compare your actual return to the return you targeted when setting up your investment program. If you aren't achieving your targeted return, you risk not reaching your financial goals. Now honestly assess how well your portfolio is performing. Are major changes needed to get it back in shape?

  • You trade too frequently without adequate research. In this fast-paced investment world, it's tempting to trade often based simply on other people's recommendations. Yet, besides the tax and trading costs associated with frequent trades, several studies have shown that frequent traders often underperform those who trade less frequently. Instead, purchase investments you are willing to hold for the long term.

  • You don't consider income taxes when investing. Ordinary income taxes on short-term capital gains and interest can go as high as 35%, while long-term capital gains and dividend income are taxed at rates not exceeding 15% (5% if you are in the 10% or 15% tax brackets). Using strategies that defer income for as long as possible can make a substantial difference in the ultimate size of your portfolio. Some strategies to consider include utilizing tax-deferred investment vehicles (such as 401(k) plans and individual retirement accounts), minimizing portfolio turnover, selling investments with losses to offset gains, and placing assets generating ordinary income or that you want to trade frequently in your tax-deferred accounts.

 

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