Category Archives: Investment Planning

What is a stock index?

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A stock index is a list of stocks that are created to represent a certain segment of the market.

A stock index is not an investment, although there are investments that are designed to mimic stock indexes.  More on that in a future post.   For a definition of a stock, see my prior post where I answered the question “What is a stock?”

Stock index – segmenting the market

Let’s take the United States stock market as an example, it can be segmented many different ways; Large Company stocks, Mid-Sized Company stocks, Small Company stocks, Large Company Value stocks, Small Company Growth stocks, the list could go on and on.  There is even a St. Louis Stock Index called the Bloomberg St. Louis Index.  One or more indexes (or lists of stocks) can be created for each of these segments.

What the purpose of a stock index

The purpose of a stock index is to give you a quick measurement of the performance of that segment of the market that day and over time.

Large Company Stock index

Even within one segment of the market, there can be more than one index created to represent that segment of the market.  Take the United States Large Company stock market for example, three common indexes that represent the US Large Company stock market are:

  • Dow Jones Industrial Average: “The Dow”, 30 companies on the list, does not represent all industries
  • S&P is 500: 500 of the largest companies in the US; covers 75% of the US equities
  • Russell 1000: approximately 1000 of the largest companies in the US; covers 92% of the US equities

Dow Jones, S&P and Russell are all companies that compile the list of stocks that comprise each respective index.

With lists that range from 30 stocks to 1000 stocks to represent the Large Company stock market it is easy to see why the indexes do not move in lock step.

The Dow or S&P 500

According to The Dow Jones Indexes website, the Dow was one of the first market indicators, which is probably why it is quoted every day, it is tradition.  However, 30 stocks is not a very good representation of the overall Large Company stock market, especially considering it is not representing all industries.  That is why you also hear the S&P 500 index quoted as well.  There are some days in which one of these indexes ends the day down, and the other ends the day up, even though they both represent the Large Company stock market.  They can not measure the segment in exactly the same way since they are looking at two different lists of stocks.

St Louis stock index

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Did you know that there is an index designed to measure the St. Louis economy?  You may have heard of the S&P 500 index which is a list of the largest 500 companies in the United States, and that watching the performance of this group of 500 companies will give you an idea of the direction of the overall large company market in the United States.  There is a similar list of companies that attempts to represent the St. Louis economy; the Bloomberg St. Louis Index.

Bloomberg St. Louis Index Members 

As of this date, there are 47 companies on the Bloomberg St. Louis Index.  You will notice that while most of the companies are headquartered here, not all of them are headquartered in St. Louis, but they must have a large presence here.  They also must have a minimum market capitalization of $15 million.  Market capitalization means the number of outstanding shares times the share price.

Who is Bloomberg?

When I first started in the investment business, more than 20 years ago, Bloomberg was a company that provided news and research to investment professionals through a “Bloomberg Machine”.  They were very expensive and only a few people in the firm had them.  In the places where I worked, it was usually the bond traders, because the Bloomberg Machine was also the way to find out the bond prices and one way for bond traders to communicate with other firms.  But the bond traders could also use the Bloomberg Machines to pull up news and the most amazing charts for me.  Please remember, this was before internet and e-mail.  My firms always gave me a computer with a subscription to another news and charting service called Reuters, but the Bloomberg Machines really had the good stuff back then.  But now, because of the internet, Bloomberg is so much more.  Everyone can get news and research from Bloomberg, which is the way it should be!  And, Bloomberg still has Bloomberg Machines for the bond traders and they still charge investment firms for premium research.

What does the St. Louis Index tell us?

Looking at the St. Louis index can tell you if the St. Louis market is moving in the same or different direction as the rest of the US markets.   The St. Louis Index has small and large companies on the list so it would make sense to look at the performance vs. a small cap index such as Russell 2000 and a large cap index such as S&P 500.  It would also give you a sense of the cycles of the publically traded St. Louis companies by tracking the performance over time.  With as diverse of an economy as St. Louis has, I would not draw too many conclusions about the overall St. Louis economy based on these 47 publicly traded companies.  Remember as you drive around town, that many of the businesses that you see are privately held and not part of an index like this.  However, it is another interesting perspective to add to your research.

Annuity Questions Answered

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So many new clients come to me already owning an annuity or several annuites, and they do not understand them or know what types of fees are in them.  I went back through my e-mails to clients and looked through the types of questions I get about annuities and thought I would answer some of them here by explaining some of the concepts around annuities.

An annuity is a product offered through insurance companies.  It is tax deferred, which means the income and earnings from the investment stay in the account and are not reported on your tax return each year.  That is the good news.  The bad news is that when you take the money out of the account, it is taxed at your income tax rate, which could actually be at a higher rate than the rate you would have paid if you hadn’t had your money invested in an annuity, depending on the type of annuity you have.  However, the tax deferral is a nice benefit.

Fixed Annuity

With a fixed annuity you get a specific interest rate for a specific time period.  Sometimes you will get a higher rate for the first year and then a lower rate for the remaining years, but you know this when you make your initial purchase.

Variable Annuity

A variable annuity offers you the opportunity to invest in mutual funds.  There are annuities that invest in multiple fund families, including index fund families.

Death Benefit

This is an insurance product, so one feature, or “insurance rider” that some of these products have is something called a Death Benefit.  Sometimes the Death Benefit value can be more than the Account Value.  Each product’s Death Benefit works differently.  Sometimes it is as simple as saying the Death Benefit is the greater of current market value or what you invest minus withdrawls.  Or it might have a Step Up feature.  For example each year on the anniversary of the purchase date the value is recorded and the highest annual value or current market value is the Death Benefit if you pass away.

1035 exchange

One nice benefit to this type of product is that you are allowed to move from one insurance company to another without any tax consequences.  Doing this is called a 1035 exchange (that is the IRS name for the procedure of moving the money, it seems like they put code numbers in the names of all of their procedures).  If you cashed the money in you would have to pay taxes on the gains.  If you just move it to another annuity, then you can continue to defer the taxes.

Fees

When looking at annuities be sure to compare fees.  Fees are quoted in percentages.  It is extremely important to convert the percentages to actual dollars based on the amount you are investing because when you do that you can sometimes see thousands of dollars of difference in fees between two annuities that when just looking at percentages seem to be pretty similar in fee structure.  I would always rather see my clients with that money in their account rather than give it to an insurance company unnecessarily.

Surrender charges

A surrender charge is a fee you pay the insurance company if you take your money out in the first few years after you have had the annuity.  A seven year surrender charge schedule is very common, for example the first year surrender charge would be 6%, the second year would be 5%, and so on until the surrender charge went away.  You might be surprised to know that there are annuities that do not have surrender charges!  So if you have an annuity and you are in the position of having to decide what to do with it, you can 1035 exchange it to an annuity that does not have a surrender charge.  Most people are not aware of that.

IRA annuity

If you have an annuity that is an IRA, you can always move it directly to an IRA, and forgo the extra layer of fees that you find in an annuity.  Things to consider before doing that: 1) are there surrender charges? 2) is the death benefit greater than the current value of the account?

Learn more about your annuity by reading the statement and the prospectus.  If you don’t have the prospectus, many of them can be found online by Googleing the product name.  If that does not work, give the customer service department a call, they will be happy to e-mail or mail you a copy of the prospectus which has the fee and investment information.

Peter Cottontail Makes A Lousy Financial Advisor!

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Oh, I know he’s beloved by millions. And I can’t wait to bite off those chocolate bunny ears he will bring me on Sunday. But let’s face it; you wouldn’t want to get your financial advice from someone who puts all his eggs in one basket! You have probably heard that old adage, but do you know what it means?

Portfolio Diversification

Have you ever been in rush hour traffic and the lane you are in is practically stopped but the other lanes around you are moving faster. So you decide to switch lanes, but as soon as you change lanes, your new lane slows down and the lane you were in finally speeds up. That’s the problem with only being able to make one choice at a time, you have to pick the right one or you lose. With investments it is even trickier because there are so many different areas in which to invest. Luckily, with investments, you do not have to choose just one. You can diversify, and put a little bit of money in each area so that you are sure to be invested in the best performing area but you do not have all of your money invested in the worst performing area either.

Asset Classes

So what are these areas of investing that we are talking about? A portfolio should be diversified, or spread out, among stocks, bonds, and cash. Whether you should invest in an asset class or how much depends on your particular situation.

Depending on your situation, your stock portion can be divided up among the following asset classes:
* Large Company, United States stocks
* Mid-Sized Company, United States stocks
* Small Sized Company, United States stocks
* Developed International stocks
* Emerging Markets stocks

Depending on your situation, your bond portion can be divided up among the following asset classes:
* Short Term Bonds
* Intermediate Term Bonds
* Long Term Bonds

Portfolio Rebalancing

You have probably seen the investment pie charts, either in your work retirement plan materials or if you have an investment account, in the materials they provided you. Have you ever wondered “Why is it that everyone keeps telling me to use these darn pie charts?” Each different color of the pie chart represents a different asset class and that illustrates the diversification of the portfolio. So once you pick your asset classes and populate them with investments you are done right? Not so fast!

Annual Portfolio Rebalancing: The most important part!

The marketing materials give you the pie charts; they just don’t tell you how to use them. And that is a shame because, when used properly, in a disciplined fashion, they can take a lot of the stress out of market downturns. Here’s how.

Picture your pie chart, let’s say that your pie chart tells you that you should have 35% in Large Company United States stocks and that area of the market has had a terrific year and you have watched that portion grow from 35% to 38% to 40% to 45% in a year’s time! “Wow”, you say, “I have finally found an investment that makes money!” So human nature tells us, “Add more money to it”. But not so fast. Haven’t we all heard that to make money we are supposed to “Sell High and Buy Low”? Well, fortunately for us, the pie chart is going to help us do that. More on that in a minute.

Picture your pie chart again, let’s say that your pie chart tells you that you should have 15% in Small Company United States stocks and the market has not been kind to small companies this year. You watched your Small Company slice of pie shrink from 15% to 12% to 10%. Your first instinct might be to sell this investment because it didn’t do as well as the others. But that is not what you should do, instead, you should “Buy Low”. Without a plan, human nature makes us do the wrong thing at the wrong time.

Now that does not mean you buy a poor quality investment, speaking to the topic of diversification again when you buy a single stock it can go out of business, when you buy an investment that represents an entire asset class, such as an S&P 500 index fund, it is highly unlikely that all 500 companies will disappear at once.

Annual rebalancing is simply the discipline to evaluate the portfolio once a year to look for changes in the quality of any of the investments and then to check to see if your asset allocation (slices of pie) have gotten out of alignment over the year. If they are more than a few percent off, make some changes. Please keep in mind there may be tax consequences, unless you can make the adjustments in retirement accounts.

What Annual Rebalancing will do for you:

1) Help you sell high (the best performing asset classes) so you can take your money off the table.

2) Help you sell high so you can protect yourself if when “the bubble bursts”.  Have you ever noticed that it is often the investments that have gained the most, that end up falling the most when the market corrects?

3) Help you buy low (the underperforming asset classes), when prices are low.

4) Helps you prepare for when the underperformer rebounds.
2008 worst performing asset class was MSCI Emerging Markets -53.18%
2009 best performing asset class was MSCI Emerging Markets +79.02%

5) Removes emotion! Emotion has you selling when you should buy and buying when you should sell. But having a diversified portfolio and using a pie chart with an annual rebalancing plan will get you through every type of market cycle.

What are stocks and why should you invest in them?

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What is a stock?
The ownership of a publicly traded corporation is separated into shares of common stock, which is a type of investment. When you invest in common stock (buy shares) you become a partial owner (shareholder) of a corporation and you take on some of the risks and rewards of being an owner of a company. Equity is another word for stock.

Why buy stock?
To make money.  Although, you can lose the money you invest, that is the potential reward vs. risk of stock investing. There are two opportunities to make money on stocks 1) capital gains and 2) dividends.

Capital Gains and Capital Losses
The dollar value per share of stock will fluctuate up and down depending on the perceived value of the share of stock. Stock is sold in an environment where there are buyers and sellers and it is their perception of the value of the stock that drives the price up and down. The buyers and sellers are observing many variables, some of which are directly tied to the stock itself, some of which are related to the stock’s competitors, some variables pertain to the U.S. economy as a whole, and some variables pertain to markets overseas. There are so many factors that go into the daily fluctuation of the price of the stock; it isn’t just the underlying value of the corporation itself that determines the share price of a stock.

If you buy a stock for $10 per share and sell it for $15 per share you have a capital gain of $5 per share.  Congratulations, you have made money on your investment! Don’t get too excited though, Uncle Sam wants his cut.  You will have to claim the income on your tax return. If you have held the investment for less than a year (short term capital gains); it will be taxed at your income tax rate. But it isn’t all bad news; for investments that were held longer than a year (long term capital gains); the 2012 capital gains tax rates are lower than income tax rates; 15% for those in the 25% income tax bracket or higher and 0% for those in the 15% income tax bracket or lower.

If however, you buy a stock for $10 and you sell it for $8, then you have a capital loss of $2, you have lost money on your investment. Uncle Sam lets you write losses against gains, and then write off $3,000 of capital losses against income as a capital loss deduction and then carryover any remaining loss to be used in future years.

See the www.irs.gov website for details.

Dividends
One of the rewards of being a shareholder includes participating in the earnings of the company, if they are paid out, in the form of dividends. Keep in mind that sometimes companies keep their earnings to invest back into the company with the goal of improving the company.

Shareholders also have the opportunity to vote on the election of board of director members and mergers and acquisitions.