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October 12, 2005

Bond Investing Misconceptions

There are several misconceptions regarding bond investing. Four common misconceptions about bond investing, include the following:

  1. It’s difficult to assess the safety of a particular bond. U.S. Treasury securities are the safest bonds, because they carry the full faith and backing of the United States government. Municipal and corporate bonds have more risk, but their credit rating is typically assessed by at least one of the four major credit rating agencies. The rating agencies evaluate the financial health of the issuer and rate the bonds according to their ability to repay their debt obligations. Bonds with one of the top four credit ratings are considered investment grade, while bonds with lower ratings are considered non-investment grade or high-yield bonds. While ratings are not a guarantee of a particular bond’s quality, they do give you an overall feel for the credit quality of a particular bond. Keep in mind that the credit rating of a bond can change over time. Thus, after purchase, you should continue to monitor the bond’s credit rating.

  2. Bonds tie up your funds until they mature. You can sell a bond prior to its maturity date, but interest rate changes can significantly affect the bond’s market value. A bond’s price rises when interest rates fall and declines when interest rates rise. That occurs so an existing bond’s price provides the same yield to maturity as an equivalent, newly issued bond paying prevailing interest rates. Thus, if you sell before maturity, you may incur a gain or loss on the transaction. You can eliminate the effects of interest rate changes by holding the bond to maturity, when you will receive the full principal value. Although you can’t control interest rate changes, you can limit the effects of those changes by selecting bonds with maturity dates close to when you need the principal. In many cases, you may not know exactly when that will be, but you probably know whether you are investing for the short, intermediate, or long term.

  3. Bonds are a long-term investment. Bonds can be purchased with maturity dates ranging from several weeks to several decades. Thus, you can purchase a bond that fits your particular time frame. You do not need to select a maturity date of several decades when purchasing a bond.

  4. You shouldn’t invest in bonds if you are concerned about inflation. Since bonds typically pay a fixed amount of interest and principal, the purchasing power of those payments decreases due to inflation, which is a major risk for intermediate- and long-term bonds. Investing in short-term bonds reduces inflation’s impact, since you are frequently reinvesting at prevailing interest rates. You can also consider inflation-indexed securities issued by the U.S. government, which pay a real rate of return over inflation.

Get a Plan for Your Retirement

Have you given much thought to retirement lately? Don’t make the mistake of thinking about what you would like to do when you retire, and ignoring how you’re going to finance that retirement. Start planning now, following these key steps:

  • Determine how much income you’ll need for retirement. First, decide how you’ll spend your retirement years. Do you want to travel extensively or are you content to stay at home pursuing inexpensive hobbies? Will you remain in your current home or move to a different city? Do you want to retire totally or will you work part-time? Depending on your plans, you may need anywhere from 70% to over 100% of your current income. If retirement is so far away that you’re not sure what you want to do, use a range of retirement income assumptions, such as 70% at the low end, 90% in the middle range, and 110% at the high end.

  • Decide when you want to retire. Although many people want to retire early, supporting yourself for those additional years may make that difficult to achieve. You may want to work longer to save the amounts needed or consider part-time employment after retirement.

  • Estimate your current retirement benefits. Assess how much you’re likely to receive from Social Security and company pension plans. Over the years, these benefits have been providing a smaller percentage of retirement income, so use conservative estimates.

  • Total your current retirement savings. Prepare a net worth statement to help you determine how much you currently have saved for retirement. Also consider other financial needs that must be met, such as paying for a child’s college education or providing nursing home care for an elderly parent. These needs can seriously reduce assets left for retirement.

  • Develop your retirement savings plan. Based on the above factors and your estimate of long-term inflation, you can make a reasonable estimate of your total capital needs at retirement. You can then calculate how much you need to save on a monthly, quarterly, or annual basis.

    Don’t give up if you can’t afford to save the amount needed. You can start out saving what you can and increase your savings in subsequent years. You can also revise your retirement plans. Reducing your financial needs, delaying your retirement date, or working part time after retirement can substantially change the amount needed for retirement.

  • Review your retirement plan annually. This allows you to assess your progress and make any needed changes.

October 11, 2005

A Look at Price/Earnings (P/E) Ratios

Price/earnings (P/E) ratios are a common measure of stock value, both for individual stocks and the overall market. Calculating a P/E ratio is straightforward — it is simply the price of a single share of stock divided by the company’s per share earnings. For example, a stock selling at $50 per share with $2 per share of earnings would have a P/E ratio of 25. However, P/E ratios can be calculated using different earnings numbers. Trailing P/E ratios, which are typically reported in newspapers, use earnings per share for the most recent four quarters, while forward P/E ratios use forecasts of future earnings per share.

To understand what a P/E ratio represents, consider what it means in terms of how much you would pay for a business you want to purchase. The value of that business would be largely determined by how much income it generates and how long it would take to recover the purchase price with that income. You might be willing to pay four or five times earnings (for a P/E ratio of 4 or 5), realizing it would take that many years to recover the purchase price. However, if you felt earnings had the potential to increase significantly in future years, you might be willing to pay a higher multiple of current-year earnings.

When considering public companies, it seems reasonable that well-established businesses growing in a fairly predictable pattern would command a higher P/E ratio than a small private business. Since you don’t have the risks or responsibilities that come with owning a business, you would probably pay a premium. Typically, companies with higher growth rates command higher P/E ratios.

The difficulty is deciding what a reasonable P/E ratio is for a particular company or for the overall stock market. For individual companies, investors’ expectations about future earnings affect the P/E ratio. Confidence that a company will improve its profitability or remain profitable generally results in a higher P/E ratio. If profits are threatened or weak, the P/E ratio is likely to drop. P/E ratios for the overall market change based on broad market conditions and investors’ views about how desirable stocks are compared to other investments.

There is no absolute measure of what P/E ratio should be paid for a given company with a given growth rate. P/E ratios can fluctuate significantly over time and among companies and industries. It generally helps to follow the P/E ratios of stocks that interest you, along with companies in similar industries, to develop a feel for how the P/E ratios fluctuate. Reviewing a company’s P/E ratio for prior years can also be helpful. If a company’s growth rate in the past is expected to continue in the future and market conditions are similar, you might not expect much change in P/E ratios. But you also must evaluate whether changes to the company, its industry, or the overall stock market would cause an increase or decrease in the company’s P/E ratio.

One way to evaluate P/E ratios is to consider a company’s current P/E ratio divided by its historical P/E ratio. If it is much lower than 1, you might want to investigate why. It could mean the business is in decline or having other problems. It may also imply that the stock is reasonably priced now. If the value is much higher than 1, carefully assess whether you want to invest at this time. You may want to wait until the P/E ratio returns to a more historical level.

You can also divide a company’s current P/E ratio by the market’s overall P/E ratio. If that figure is much higher than 1 (and thus higher than the overall market), you should evaluate whether the company’s prospects justify that valuation.

The Basics of 1031 Real Estate Property Exchanges

If you have business or investment property you’d like to sell, take a look at the 1031 exchange rules before doing so. These rules allow you to sell one property and purchase another of “like kind”, deferring any gains. “Like kind” means the property must be used for business or investment purposes, which could include apartment buildings, office buildings, industrial buildings, commercial buildings, rental housing units, raw land, farms, and ranches. You do not have to sell and buy the exact same type of property. Thus, you could sell undeveloped land and purchase a commercial building, deferring the gain. Or you could sell the building used in your business and purchase an apartment complex, again deferring the gain.

To defer the entire gain, the replacement property must be of greater value than the property you are selling, and all your equity must go back into the replacement property. Otherwise, part of the gain will be taxable. You do not have to purchase the new property from the same person who purchases your property. For the exchange to qualify as tax deferred, you must document your intention to exchange properties in the purchase agreement, not take constructive receipt of the sale proceeds, identify replacement properties within 45 days, and acquire the replacement property by the earlier of 180 days after the first sale’s closing or the due date of your tax return, including extensions, for the year of the sale.

Typically, the most difficult part of a 1031 exchange is identifying the new property within the allotted time frame. Now, the Internal Revenue Service (IRS) allows the purchase of the new property before the sale of the original property.

If you want to sell your property and get out of real estate altogether, then a 1031 exchange would not be appropriate. However, if you have other goals, such as trading up or owning a different type of property, then a 1031 exchange may help you defer gains from the sale.

For instance, this tax rule can be used to help acquire a retirement home. Start out purchasing a small investment property. You can sell it at a later date and purchase a more expensive property, deferring the gains. You can continue this process until you eventually purchase your retirement home. However, before living in the home, you must first rent it out so the gain will be deferred. While there are no clear-cut rules on how long the home must be rented, the IRS has validated a two-year period. After that, you can move into your retirement home and use it as your principal residence. As long as you live in the home for two of the last five years before selling it, you could then sell the home and exclude up to $250,000 of gain if you are single and $500,000 of gain if you are married filing jointly.

You may want to consider purchasing a real estate software program to assist you in making this decision. ManagingMoney.com’s Investment Management Software Center offers an excellent 1031 Exchange Analysis software program. This is a comprehensive real estate analysis program for you to use in the evaluation of commercial real estate properties.

Coming to Terms with Stocks

With all of the volatility in the stock market over the past several years, it can be difficult to determine how to devise an investment strategy to help achieve your financial goals. To help you determine a reasonable rate of return to expect on your stock investments, it might be helpful to review some “facts” about the stock market:

  • The stock market’s historical return can change dramatically depending on the period considered. For instance, from 1926 to 2004 (79 years), the average return for the stock market as measured by the Standard & Poor’s 500 (S&P 500) was 10.4%. Change that period to 1955 to 2004 (50 years) and the return changes to 10.9%, 13.5% from 1980 to 2004 (25 years), and 12.1% from 1995 to 2004 (10 years).*

  • The market tends to revert to the mean. There is a tendency for the stock market, when it has an extended period of above- or below-average returns, to revert back to the average return. Thus, following an extended period of above-average returns in the 1990s, the stock market experienced a significant downturn, helping to bring the averages back in line.

  • History may not be a good predictor of future returns. The expected rate of return for your investment program is typically based on an analysis of past returns, since no one can predict future returns. However, it’s important to realize that those returns may not be replicated in the future. During much of the stock market’s history, the United States was in a substantial growth phase as it grew from a struggling nation into a superpower. Growth in the future may not approach those levels, which could dampen stock returns.

  • The pattern of actual returns affects your investment balance. Even if you get the average rate of return exactly right, your portfolio’s balance will depend on the pattern of actual returns during that period. Some years will experience higher-than-average returns, while other years will have lower or even negative returns. If you experience high returns in the early years, your portfolio’s value will be lower than if those returns occurred in the later years. If you encounter negative returns in the early years, you will have a higher balance than if those negative returns came in the later years.

  • Historical returns do not include several items that investors must deal with. Two of the most significant items not accounted for in historical returns are inflation and taxes. Over the long term, from 1926 to 2004, inflation averaged 3.0%.* Short-term capital gains are taxed at ordinary income tax rates of up to 35%, while long-term capital gains and dividend income are taxed at 15% (5% for taxpayers in the 10% or 15% tax bracket) .

  • Investors have a difficult time earning historical returns. Several studies found that investors’ returns tend to lag the overall market. A recent study found that investors in the New York and American stock exchanges experienced annual returns that were 1.3% lower than market returns from 1926 to 2002, while Nasdaq investors experienced annual returns that were 5.3% lower from 1973 to 2002 (Source: Money, September 2004).

What does all this mean to an investor? When designing an investment program, use a conservative estimated rate of return, since it may be difficult to earn the historical returns of the past. It’s easier to start out with a lower rate of return and find out later that your actual return is higher, which means you just need to save less.

Consider these strategies:

  • Save more of your income. If you can’t count on returns to provide growth in your portfolio, you should compensate by saving more of your income. That may mean you’ll need to work overtime or take on a second job to provide additional income. Another strategy is to reduce your living expenses and save the reductions.

  • Invest in a tax-efficient manner. Taxes are often a significant investment expense, so using strategies to defer the payment of taxes can make a substantial difference in your portfolio’s ultimate size. Utilize tax-deferred investment vehicles, such as 401(k) plans and Individual Retirement Accounts, which defer the payment of taxes until withdrawn. Or emphasize investments generating capital gains or dividend income rather than ordinary income. Minimize turnover in your portfolio, so unrealized gains can grow for many years.

  • Adequately diversify your investment portfolio. Typically, you do not know which asset class will perform best on a year-to-year basis. Diversification is a defensive strategy — it helps protect your portfolio during market downturns and helps reduce your portfolio’s volatility. Diversify your investment portfolio among a variety of investment categories, such as stocks, bonds, cash, real estate, and other alternatives. Also diversify within investment categories.

  • Consider international investments. Since U.S. stocks have outperformed international stocks for an extended period, international investments have gone out of favor. But no one knows whether this trend will continue in the future, so it may be prudent to include international investments in your portfolio. Before investing in international stocks, assess how much of your portfolio to allocate to this asset class. Keep in mind that international investing may not be suitable for everyone. In addition to the risks associated with domestic investing, international investing has unique risks, including currency fluctuations, political and social changes, and greater share price volatility.

  • Evaluate your portfolio’s performance annually. By evaluating your portfolio on an annual basis you can make necessary changes in a more timely manner. If returns are lower than you targeted, you can make any necessary adjustments to your strategy to compensate for these variations in return.

* Source: Stocks, Bonds, Bills, and Inflation 2005 Yearbook. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results.


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