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CONTRIBUTORS

Matt BarthelAndrew Bary

Randall ForsythJack Hough

Michael KahnJohn Kimelman

Jack OtterSarah Max

Updated 1/24/17

BUILD INGWEALTH

A G U I D E T O S M A R T E R I N V E S T I N G

Copyright 2017 Dow Jones & Company, Inc. All rights reserved.

Building Wealth: A Guide to Smarter Investing

Introduction . . . . . . . . . . . . . . . . . . . . 3

Chapter 1: Envision Success Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 First Steps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

Chapter 2: Saving Turn on Auto-Pilot . . . . . . . . . . . . . . . . . . . . . . . . .6

Chapter 3: Getting Advice Finding an Advisor . . . . . . . . . . . . . . . . . . . . . . . .8 Rise of the Machines . . . . . . . . . . . . . . . . . . . . . . .9

Chapter 4: Asset Allocation Eat Your Free Lunch . . . . . . . . . . . . . . . . . . . . . . 12 Build Your Foundation . . . . . . . . . . . . . . . . . . . . . 13

Chapter 5: Funds Active vs Passive . . . . . . . . . . . . . . . . . . . . . . . .16 ETFs: How to Choose . . . . . . . . . . . . . . . . . . . . . 17 Closed-End Funds . . . . . . . . . . . . . . . . . . . . . . .18

Chapter 6: Stocks Equities 101 . . . . . . . . . . . . . . . . . . . . . . . . . . .20 How to Shop for Stocks . . . . . . . . . . . . . . . . . . . .21 How Charts Can Make You A Better Investor . . . . . .23 How to Find Hidden Values . . . . . . . . . . . . . . . . . .26

Chapter 7: Bonds Fixed Income 101 . . . . . . . . . . . . . . . . . . . . . . . .29 Bond Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . .32 Building a Bond Ladder . . . . . . . . . . . . . . . . . . . .33

Chapter 8: Options Options 101 . . . . . . . . . . . . . . . . . . . . . . . . . . .35

Chapter 9: Income Investing What to Do With Cash . . . . . . . . . . . . . . . . . . . . .37 How to Use Options for Income . . . . . . . . . . . . . . .37

Chapter 10: Liquid Alternatives Beyond Stocks and Bonds . . . . . . . . . . . . . . . . . .43

Chapter 11: Annuities Annuities 101 . . . . . . . . . . . . . . . . . . . . . . . . . .47

Glossary . . . . . . . . . . . . . . . . . . . . . . 50

Table of Contents


Thanks very much for downloading this e-book and for reading Barron’s. We’re

hoping this effort will provide some smart investing lessons for beginners and give valu-able perspective to more experienced inves-tors as well.

I think we have achieved both missions. But you are the ultimate judge. Please tell us what you like about this e-book, and more important, what you don’t like. Your advice will help us make the second edition even better. You can contact us at [email protected].

The first step in investing is to decide why you are investing. For most people, the answer is to pay for retirement or their chil-dren’s education.

The second step is to set goals: How much money would you like to amass and by what date?

Step three is setting a range of possible amounts you could set aside each week to be invested. Here, it’s best to remember a simple fact: The more you save now, the more you will have to spend later.

Step four is the investing part: What annual returns will you need to achieve your goal? In today’s market, your expected annual return will likely fall between 1% and 10%.

With a 1% target, you’d be investing all your money in super-safe shorter-term bonds, a route that few professionals would recom-mend. At the other end of the spectrum, one of the few ways to achieve 10% annual returns is to invest in super-fast growth stocks, and very few professionals would recommend that route.

Most investors will fall between the two extremes, aiming for annual returns of 4% to 7% a year through a mix of stocks and bonds, either held directly or through mutual funds or exchange-traded funds, known as ETFs. This e-book can help you decide, either on your own or with your financial advisor, how to make investments that will meet your goals and let you sleep soundly at night. The key is to accept an amount of risk that you are comfortable with.

The writers and editors at Barron’s have more than 1,000 years of collective investing experience. We’ve distilled that down into 10 chapters, ranging from stocks to bonds, from options to alternative investments. Whether you are a beginner or an experienced pro, we hope this book can give you the knowledge you need to help you achieve your dreams.

Your Dreams, Our Advice

Ed FinnEditor and President, Barron’s

DECEMBER 2016


BARRON’S BUILDING WEALTH 6

ObjectivesYou are probably reading this book because you like the idea of building wealth. We agree, and for 95 years and counting, Bar-ron’s has been helping readers do exactly that. But before forging ahead with an investment plan, there’s an important step that many people skip – they don’t spend enough time setting objectives. We speak to financial advisors whose clients have accounts ranging from thousands to hun-dreds of millions of dollars, and in each case, they start by asking what the money is for.

Having a clear vision of what you want to achieve with your savings vastly increases the odds of success. For starters, different goals require different strategies. The college tui-tion account won’t be invested the same way as your retirement savings. Some investors will be more focused on preserving wealth, while others will take more risk, in search of growth.

Second, a clear vision of your objectives makes it easier to stay on track. Anyone who has ever forced herself out of a warm bed for an early morning workout knows that having a fitness goal helps motivate those trips to the gym. So it is with savings. By knowing exactly what you want to achieve, you’ll be more likely to maintain the disci-pline necessary to get there.

And by tailoring your investment

strategies to an ultimate goal, you reduce the anxiety that comes with the inevita-ble market downturns. Knowing that your retirement savings, for example, will be invested for decades should make it easier to ride out the storm. Money that you’ll be tapping sooner, meanwhile, will be invested more conservatively, so the dips will be shallower.

Once you have set your goals, the next step is to figure out what you’ll need to achieve them. Use an online calculator such as those offered by Fidelity and Vanguard to see whether you are on track for retirement. The appropriately named savingforcollege.com will help you determine those needs. You’ll have to make some educated guesses – such as future inflation rates and invest-ment returns. Our best guess is that both will be below average in the near term at least. And don’t sweat the fact that you can’t know the future exactly. By making all the right moves with every variable that you can control, you are vastly improving the odds in your favor.

First Steps

Establish a baseline Before setting goals, figure out where you are right now. You’ll need an accurate finan-cial statement that lays out in some detail your assets and liabilities. You can figure it out on your own, but a good template is a mortgage application, which may ask ques-tions that would not occur to you.

Envision Success

Having a clear vision

of what you want

to achieve with

your savings vastly

increases the odds

of success.



Set your goals Once you have a snapshot of your financial situation, you have to project it into the future. How much will you earn over the life of the plan? What will your major expenses be and when will they occur? Think pur-chase of a house, children’s college tuition, and retirement. You may also want to pro-vide startup money for your own business or funds to help you care for elderly parents, or a sunny-day fund to buy yourself a boat. Don’t forget to account for inflation, which increases future costs, and taxes, which diminish future purchasing power. While many expenses will require a lump sum, keep in mind that for retirement you’ll need a pool of money that will produce sufficient income for the rest of your life.

Consider (or adjust) your risk toleranceFinancial advisors will often try to deter-mine your stomach for risk and tailor a portfolio accordingly. On the one hand, this is a sensible way to head off panic during bear markets, which can result in portfolio-decimating decisions to sell at the bottom. But there is a fundamental flaw in this approach: Reducing risk means lower-ing future returns (more on this later). So the real question is not what risk level you are comfortable with, but rather what risk level is necessary to achieve your goals. If you cannot sleep at night with that portfo-lio, then your only options are to save more money or set a less-ambitious goal.

When 401(k) plans were first introduced, most people were too conservative. The investments they chose were safe enough, but their returns were not sufficient to cre-ate the nest egg they really needed. In the raging bull market of the late 1990s, many people became super-aggressive trying to get rich quickly and forgetting the old Wall Street adage: Bulls and bears make money, hogs get slaughtered. Recent statistics sug-gest that millennials, shell-shocked by the

market turmoil of the past 16 years, are also investing too conservatively.

Get helpYou can do a very rough sketch of your objectives in less than an hour with the help of an online calculator. Fidelity offers a good one; so do many other brokerages. Start with a 20-, 30-, or 40-year timeline. List the major expenses you expect to encounter along the way.

Estimating your retirement budget is not as difficult as it may seem. Your living expenses may go down, but health-care costs are likely to increase. To meet these expenses, you will have income from Social Security and possibly from part-time work. The balance will be income from your 401(k) and IRA. Suppose you need your portfolio to generate $80,000 a year in addi-tion to your other sources of income. If you assume investments yielding 4% a year, you will need a nest egg of roughly $2 million the day you retire. Of course, nothing is quite that simple. For many investors, there are tax and estate considerations that are well worth the cost of professional help.

The real question is

not what risk level

you are comfortable

with, but rather

what risk level is

necessary to achieve

your goals.


SavingTurn on Auto-PilotWhile compounded annual returns will do wonders to boost your net worth, you do have to have money to make money. We’ll share a few thoughts on how to boost your savings rate, but as a first step, think back on your objectives and make them as specific as possible.

Don’t just save for a generic state called retirement. Imagine the freedom, and joy, that wealth can buy you once your daily routine doesn’t involve heading to the office. If travel is among your goals, picture exactly where you will go. Put a photo of that desti-nation in your wallet or on the shelf above your desk. This exercise isn’t about collecting the most green rectangles. It’s about how the sun looks rising over the Mediterranean from the balcony of your hotel room on the Amalfi coast.

Here are some ways to help you save more.

AutomateImagine if your company sent an email every pay period asking how much you wanted to take out of your check to put in your 401(k). You wouldn’t have much of a retirement account. All it required was that one act of discipline – setting up your account – and the money started to flow. That’s why behavioral economists urge companies to make 401(k) participa-tion automatic, giving employees the ability to opt out, rather than offering the chance to opt in.

Do the same with all savingsSet up an automatic transfer from your checking account to the kids’ 529 plans for college savings. Do the same with a brokerage account, so that every two weeks you are transferring a bit of cash from your operating account to your wealth-building account.

Start nowThe longer the hill, the bigger the snowball will be by the time it rolls all the way down. The longer your investments compound, the larger they will grow. For example: A recent graduate making $32,000 at age 23 needs only to put aside 5% of his salary in year one – about $30 a week – bumping the savings rate to 13% within five years to have a $1.2 million nest egg by age 65. And that’s before a company match. We’re assuming a 7% annual return, which is lower than the past 40 years, and 2% annual raises, which is probably conservative for someone that young.

If you were to wait until age 32 to begin 401(k) contributions, however, and followed the same schedule of investments and increases, you would have a nest egg of only $600,000 by age 65, half of what’s possible by starting nine years earlier. Because the benefits of compounding really kick in after a few decades, every year you delay makes a big difference.

Pull out your phoneIt won’t surprise you to know there are apps for this. If you’re the kind of person who might use a savings app, you are intimately familiar with Google, so we won’t go into great detail here. But to take just one example, Acorns will automatically round up your debit card purchases and deposit the change in a sav-ings account. If you spend $2.25 on a Starbucks coffee, you’ll also divert 75¢ into savings. In 2046 you’ll have no memory of that coffee, but you’ll be glad that you spent three decades saving your pennies.


401(k)10% contributions on a $50k salary, assuming 4% return

*Excludes employer match, and assumes a 1% annual salary increase

25 30 35

$630k

$560k

$325k

65AGE WHEN OPENED



Hire an AdvisorDo you know who Ivan Ljubicic is? Unless you’re a devoted tennis fan, probably not. Roger Federer hired him as a coach at the beginning of the 2016 season. As a player Lju-bicic never reached the heights that Federer has achieved, but even the greatest tennis player in history thought he could benefit from a guiding hand.

By the same logic, a financially savvy Barron’s reader can benefit from a financial advisor. It’s not just the knowledge an advisor brings to the table – although that is import-ant. Merely the fact of working with an expert partner is likely to improve your financial picture. If you’ve ever had a good trainer at the gym, you know that outcomes improve when you have an expert guide you through the steps.

Good advisors serve many purposes. For starters, they offer a reality check. Behavioral studies have shown that we tend to be over-confident in all walks of life – men underesti-mate their odds of having a heart attack, and virtually everyone describes himself or herself as a better-than-average driver. By definition, half of them are wrong.

An advisor will force you to face tough questions – what if you lose your job? What if market returns are subpar? What if that heart attack is debilitating, but not deadly?

A lot of emotions are tied up in our views

on money, and emotions, namely fear and greed, lead to bad investing decisions. One financial advisor told us that her most useful role was as a psychiatrist. She talked clients off the ledge when the markets were tumbling and offered a reality check when euphoria set in, helping people stick to their financial plan. A Vanguard study found that advisors added an average of 3% a year to investment returns over the long term. Half of the savings came from behavioral coaching alone. The next big-gest benefit came from periodic rebalancing. That means selling assets that have done well and buying those that have performed poorly, an emotionally trying, but financially reward-ing, practice.

Some advisors focus entirely on your invest-ment portfolio, while “holistic” advisors will help with all aspects of your financial life. The latter approach has practical benefits – if your advisor’s relationship with a mortgage banker, for example, shaves a quarter point off your interest rate, that savings will cover a nice chunk of the advisor’s fee. A holistic approach also better reflects reality. Your 401(k) and the 529 plans for your children should be con-sidered in relationship to your cash flow, real estate holdings and tax liabilities. It makes little sense to consider them in isolation.

When looking for an advisor, start by word of mouth. Ask friends about their experiences. Interview multiple advisors, and always ask how they get paid. We recommend an advi-sor who adheres to the “fiduciary” standard, which means he has to put your interest ahead of his own. That’s connected to the

Getting Advice

Behavioral

studies have

shown that

we tend to be

overconfident in

all walks of life.

Virtually everyone

describes himself

or herself as

a better-than-

average driver. By

definition, half of

them are wrong.



compensation question – it stands to reason that someone earning a flat fee or a percent-age of assets has less incentive to sell you bad financial products than someone who makes a commission by selling those prod-ucts. Before hiring anyone, be sure to check their Form ADV, which will list any regu-latory infractions in their history. And as a further safety measure, be sure they use a third-party custodian to hold your funds. Bernie Madoff held client funds in his own custody. That didn’t work out for clients.

What those letters meanAdvisors come with an alphabet soup of let-ters after their names. The Financial Indus-try Regulatory Authority (FINRA) lists more than 150 professional designations. Many have value, but some are hyper-specialized and others require very little time or effort to obtain. (We know one advisor who got his dog named as a top advisor, just to prove a point.)

Here are a few of the more rigorous and respected designations:

Chartered Financial Analyst (CFA)One of the toughest designations to obtain, requiring an advisor to pass three six-hour exams that together require about 750-900 hours of study over three years. This desig-nation is on a par with an advanced college degree, and those holding a CFA have shown proficiency in a wide range of financial disciplines, including economics, accounting, portfolio management and ethical behavior.

Certified Financial Planner (CFP)This designation is aimed specifically at the discipline of financial planning. Advisors must complete a CFP Board-approved edu-cational program, which amounts to about 18

semester hours in various areas of financial planning, plus a course that draws all the learning together. There is also a final exam and a continuing education requirement of 30 hours every two years.

Certified Investment Management Analyst (CIMA)Your advisor is the gatekeeper between you and an industry that really wants to sell you stuff, not all of it in your best interest. The curriculum behind this designation is aimed at helping advisors analyze asset manage-ment, investment policy and risk manage-ment, and reflects an advisor’s skills in evaluating investment managers and others who provide financial products. Obtaining a CIMA takes about nine months and includes about 250 hours of study and passing two exams. It also requires completion of a program at a top-20 business school and 40 hours of continuing education every two years.

Registered Investment Advisor (RIA)Not a designation, but still an abbrevia-tion worth knowing. RIAs are independent financial advisors – a group that has long stood in contrast to the advisors who work for the large brokerage houses. Indepen-dent advisors are governed by the SEC and by the fiduciary standard, meaning that they are legally obliged to look out for their clients’ best interests. There was a time where this fiduciary duty was a huge point of differentiation between RIAs and bro-kerage-house advisors. The brokerage-firm advisors are governed by FINRA, and are not held to a fiduciary standard. But this is changing, as new rules are set to take effect in April 2017 requiring advisors of all stripes to act as fiduciaries on retire-ment-account assets. RIAs and broker-age-house advisors each have their benefits and drawbacks. RIAs generally occupy the higher ground on matters of client best interest and lower fees, but the brokerage houses are moving toward fiduciary models

Before hiring

anyone, be sure to

check their Form

ADV, which will

list any regulatory

infractions in their

history. And as

a further safety

measure, be sure

they use a third-

party custodian to

hold your funds.


and also tend to have a larger reserve of research and investing resources at their disposal.

Rise of the MachinesWhile there are a lot of good reasons to

hire a financial advisor, there’s also a case to be made for hiring a robot instead. “Robo-ad-visors” are a new breed of software that cre-ates a low-cost portfolio for you and tweaks it over time to adjust to a changing market and even cut your tax bill.

A Silicon Valley startup called Betterment launched the first robo-advisor in 2010. More recently the concept has gone mainstream, as big financial companies such as Charles Schwab and Vanguard have begun offering automated investment advice.

In many ways, robots are the ideal inves-tors. They don’t suffer from fear or greed and they don’t charge much. The logic of software-driven low-cost indexing, which aca-demic research has proven to be an excellent strategy, appeals to millennials whose forma-tive years included the dot.com bust and the financial crisis. (And it’s not just Silicon Val-ley wunderkinds who are going for robos. A Schwab survey found that 40% of millennials and Gen-Xers would prefer a portfolio based on an algorithm to one based on a human advisor’s decisions.)

Now, for many people, hiring the right (human) financial advisor is still the smartest money move they can make. But good advice is often expensive, and finding the right finan-cial advisor can turn into a long-term project. There’s nothing wrong with hiring Siri to manage your money while you search for a human replacement.

The basic investment philosophy behind most robos is the same. Rather than try to pick stocks or other assets that will beat the market, they spread their bets widely among stocks and bonds around the globe, which smooths the ride since some investments tend to rise while others fall. Usually they use exchange-traded funds, which have low fees and are tax efficient. Most robos periodically rebalance to the original asset allocation, which requires selling securities that have done well and buying more of the duds. That’s a winning strategy over the long term, but it’s painful and counterintuitive, so it’s a good job to outsource to a computer.

Some human advisors build similar ETF portfolios, but they tend to charge around 1% or more. Price may be the robos’ single biggest advantage: They charge around 0.25%, or $125 on a $50,000 investment.

The savings adds up over time. Consider a 30-year-old with a $50,000 retirement account that earns an average of 7% through an advi-sor whose fees, plus the fees on his underlying

“Robo-advisors”

are a new breed

of software that

creates a low-

cost portfolio for

you and tweaks

it over time

to adjust to a

changing market

and even cut your

tax bill.

Source: Barron’s, May 23, 2015

Sample Robo-Advisor Portfolios

OtherIntl BondsU.S. BondsIntl StocksU.S. Stocks

Betterment CharlesSchwab VanguardWealthfront

http://www.barrons.com/articles/robo-advisors-take-on-wall-street-1432349473



funds, add up to 1.5% a year (that’s on the cheap side). Assuming no more investments in that account, at age 65 the investor would have $314,500. At a robo total fee of 0.5%, given the same investment and same rate of return, the account would be worth $448,000. That mere 1% a year would reduce total returns by $133,500.

For all their advantages over humans, robos fall short in many ways. They make lousy psychiatrists, a crucial role when the market goes crazy. Vanguard’s robo, in fact, includes a human advisor who oversees the account and is available to talk panicked investors out of rash decisions. And it’s not only in a market crash that a human advisor is useful. The robot doesn’t know that you have a special-needs child or that your boss is a jerk and you are one mistake away from getting fired. In both cases, a good human advisor would adjust your financial plan to account for the special circumstances.

Still, the best advisors don’t typically take on clients with less than $1 million in invest-able assets – and often require far more. The robos are bringing efficient portfolio management to the masses, for a fraction of what traditional advisors charge.

Betterment and fellow robo firm Wealth-front aim to keep it simple; both web sites ask users just a handful of questions about their goals, risk tolerance, and investment horizon. From there, algorithms calculate a recommended asset allocation. After fund-ing the account with an online transfer, a client’s assets are automatically split among several ETFs. The process takes less than 10 minutes and can be done with zero human interaction. Asset allocations are regularly rebalanced and both firms promise tax-loss harvesting, until now the domain of high-er-end accounts. Tax-loss harvesting means selling assets that have fallen, locking in a tax break, and then reinvesting in a similar asset so that you maintain your exposure to the market.

Vanguard takes an even simpler approach. A young, aggressive investor might end up in just two funds, a total-market U.S. stock fund and its international counterpart.

Sure, there might be better investment plans out there. But it’s certain there an infinite number of inferior ones.



Eat Your Free LunchAs you set out to build an investment portfo-lio, you will need to accept one reality – there are no (meaningful) returns without risk. Investors who own volatile investments are compensated by a “risk premium,” which refers to excess return over risk-free assets, usually Treasury bonds.

This is why money that you need to spend in the near term should not be invested in stocks. There is roughly a 49% chance the stock market will go down tomorrow – not great odds. But the farther you look out, the better the odds that the market will go up. Over the next 10 years, the odds are north of 99% that the market will be higher.

This gives disciplined individual inves-tors an advantage over many professional money managers. During a market panic, for instance, mutual funds are often forced to sell falling stocks in order to meet redemptions. This forced selling sends prices down further. But you don’t have to sell; on the contrary, you can buy stocks at a discount from those who need to liquidate.

There are ways to reduce your risks in the market, and that’s a good place to start a discussion of portfolio construction.

Nobel Prize-winning economist Harry Markowitz is known for developing something

called Modern Portfolio Theory, which is the basic philosophy behind many investment plans. We won’t get too deep into it here, other than to mention Markowitz’s update of the econo-mists’ credo that “there ain’t no such thing as a free lunch.” Markowitz said “the only free lunch is diversification.” By that he meant when you build a portfolio, you can reduce your risk without reducing returns, simply by diver-sifying your investments.

Since Markowitz wrote his PhD thesis in 1952, it has become far easier and cheaper to build a diversified portfolio. In fact, one exchange-traded fund, the Vanguard Total World Stock ETF (VT), will give you exposure to virtually every stock market in the world, right down to its 0.1% exposure to Qatar. With one more ETF you can get exposure to the entire U.S. bond market. Another fund will give you exposure to most foreign bond mar-kets. The three funds charge a small fraction of a percentage point in fees. With those three funds, in a 60/40 or 70/30 ratio of stocks/bonds, you would outperform most investors, who sacrifice returns to fees and trading costs.

To illustrate the value of this sort of diver-sification, consider the period often referred to as the “lost decade” by the financial press. From Jan. 1, 2000, to Dec. 31, 2009, the S&P 500 index fell from 1,469.25 to 1,115.10. Even with dividends reinvested, you would have lost 0.95% a year. You’ll hear sales reps quote that dismal record to justify all sorts of strategies, from annuities to gold to long/short strategies.

Asset Allocation

There are no

meaningful

returns without

risk. Investors

who own volatile

investments are

compensated by

a “risk premium,”

which refers to

excess return

over risk-free

assets, usually

Treasury bonds.



But a diversified investor holding a portfo-lio of U.S. and international stocks and bonds had a very different experience. Consider a $100,000 retirement account bolstered with annual, end-of-year contributions of $10,000, spread across three index funds: 36% in the Vanguard Total Stock Market Index (VTSMX), 24% in the Total International Stock Index (VGTSX), and 40% in the Total Bond Mar-ket Index (VBMFX). By rebalancing annually to maintain that allocation, you would have earned an average of 4.3% a year. By add-ing other asset classes you would have done even better. The Vanguard Precious Metals and Mining Fund (VGPMX), for example, shot up 18% annualized, and the Vanguard REIT Index Fund (VGSIX) returned 10% annualized.

Most Americans are underinvested in international stocks – by one estimate, only 8% of U.S. retirement assets are invested overseas. Simply by boosting your alloca-tion to foreign stocks you can increase your chances of good returns in the coming years. U.S. stocks have outperformed their foreign peers since the Great Recession; odds are that trend will reverse at some point in the coming years.

In what follows we will review the various security types that make up a diversified portfolio, and then recommend some asset allocations tailored for different goals.

Build Your FoundationAny student of football knows that a team can’t succeed unless it develops a great game plan and then sticks with it.

It’s not enough for the coach to send the quarterback onto the field with a few plays at a time and then hope for the best. Whether it’s the desired ratio of runs to passes or the way the defense sets up for third-down-and-long situations, a team needs a set of guiding

principles that will take it through all 60 minutes.

Think of asset allocation as the game plan of investing. That game plan is far more important than having, say, an all-star wide receiver in football or shares in a hot growth stock in your retirement portfolio.

“A client might sit down with me for the first time and say, ‘I want to own shares of Facebook,’ ” says Peter Rohr, a managing director with the The Rohr Group, a Phila-delphia, Pa.-based wealth management firm with $2.9 billion in assets. “That’s when I say, ‘Hold on, before you build a house, you need to build a solid foundation.’ ”

And building a solid foundation is actually a lot easier than figuring out what the next hot growth stock is. In fact, it’s so simple and straightforward that you could create an asset-allocation plan using one side of a cocktail napkin.

An asset-allocation plan simply shows what percentage of one’s investable assets should be in stocks, bonds, cash, and other assets. Increasingly, investors are using low-cost index funds such as exchange-traded funds as proxies for various asset classes.

The stock portion of an asset-allocation plan might be divvied up among shares of companies based in the U.S., in developed foreign countries, and in emerging markets. The bond or fixed-income portion might be split among Treasuries, corporate bonds, emerging-market bonds, bank certificates of deposit, or, in the case of taxable accounts, municipal bonds. The current low-inter-est-rate environment makes bond asset allo-cation particularly important; see the Bonds chapter for more on that subject.

Some investors are even using gold, or an ETF equivalent, and real estate investment trusts as additional categories in an asset-al-location plan.

Once percentage targets are established for each asset in the plan, it’s then important to maintain those levels over time to respond to performance changes in the marketplace.

An asset-allocation

plan simply shows

what percentage

of one’s investable

assets should be in

stocks, bonds, cash,

and other assets.


This process is called “rebalancing” and we’ll elaborate more on that point later.

Today, many leading mutual-fund companies such as Vanguard, Fidelity, and Pimco have created asset-allocation funds so that investors can leave the work to others. These funds are also known by other industry names such as “life-cycle” or “target-date” funds, since they try to provide investors with a mix of assets based on an investor’s age, appetite for risk, and investment goals.

The Vanguard Target Retirement 2030 Fund (VTHRX) is an example of an asset-allocation fund. With a 14-year time horizon (as of 2016) until the shareholder expects to reach retire-ment, the fund had an allocation of 74% stocks and 26% bonds. In the coming years, the fund will gradually shift to a heavier bond exposure, reflecting the individual’s need for more capital preservation and less risk. Keep in mind that investors still need growth after retiring, so the stock allocation won’t go to zero at age 65.

Investors who want a more individualized approach to asset allocation can easily create their own plans, working on their own, or through a personal advisor, or even one of the new breed of “robo-advisors,” (For more on robos, see the previous chapter.) Check out the adjacent pie charts that Rohr, a Bar-ron’s Top 100 Advisor, created for us. They

represent asset allocation plans for three model investors of different ages.

Given the obvious importance of asset allo-cation, it might come as a surprise that this approach has only been in wide use by U.S. investors for just a couple of decades.

For most of the 20th century, investors didn’t construct and maintain portfolios using asset-allocation plans. They basically picked individual stocks and bonds, often based on tips from advisors, friends, and family. In those years – before readily available information on individual stocks helped create more efficient markets – it was much easier for investors in the know to beat the market by gaining an edge over the rest of us. In an age when investing was often little more than taking advantage of tips, asset allocation wasn’t even in the lexicon of most investors.

The concept got a major lift with the publication in 1986 of a landmark study that concluded asset allocation was the primary determinant of a portfolio’s return variability, with individual security selection and mar-ket-timing playing much smaller roles. And in recent years, other research has challenged


Young Professional

Age 30

50%Large Cap Stocks

5%Emerging Market Stocks

15%Fixed Income

3%REITs

5%Cash

12%Dev Intl

10%Small Cap

Stocks

Married with childrenAge 40

44%Large Cap Stocks

5%Cash/Gold

5%Other

30%Fixed Income

10%Dev Intl

10%Small Cap

Stocks

Empty NesterAge 65

34%Large Cap Stocks

10%Cash/Gold

8%Other

30%Fixed Income

7%Dev Intl

6%Small Cap Stocks

For most of the

20th century,

investors didn’t

construct

and maintain

portfolios using

asset-allocation

plans. They

basically picked

individual stocks

and bonds, often

based on tips

from advisors,

friends, and

family.



the asset-allocation premise. The debate will go on, but asset allocation’s importance to investing at this point is a settled matter.

Many investors still think that picking the right stocks is the key to investment success. Most of the truly great investors of our age, such as Warren Buffett, achieved success by owning individual companies and their shares, not through simple asset allocation.

But how many Warren Buffetts can you name? Most investors lack the time, patience, and skill needed to consistently pick winning stocks. You have much higher odds of success building your investing house with the bricks and mortar of asset allocation.

The good news is that coming up with an asset-allocation plan is easier and less time-consuming than the work needed to assess the intrinsic value of a company, a necessary prerequisite to picking stocks that will beat the market over the long term.

While the charts on the previous page nicely illustrate the concept of asset alloca-tion, they perhaps simplify the process just a bit. After all, not all 30-year-old singles would necessarily have the stomach to endure the volatility that comes with putting 77% of their assets in stocks, especially if they saw a family member burned by the 2008 financial crisis. And a 65-year-old nearing retirement who hasn’t saved enough might opt for a higher stock weighting than 55%.

So before deciding on an asset-allocation plan, it’s important to take your own invest-ment temperature. Many robo-advisors allow you to create an asset allocation by answering several straightforward ques-tions designed to assess your tolerance for

taking risk, your time horizon for needing to cash out all or part of your funds, and your broader investment objectives. Keep in mind that it’s very hard to accurately assess your risk tolerance when the market has been going up for years and memories of losses are fading.

Allan Roth, a certified financial planner in Colorado Springs, Co., says he likes to ask clients: “What would you do if stocks fell 50 percent?” The healthy answer to the ques-tion is: buy more stocks.

And that’s where rebalancing comes into play. To maintain an asset-allocation plan, an investor or her advisor needs to react to rising and falling market values of various asset classes by realigning them with previ-ously agreed-upon targets.

There is no single tried-and-true approach to rebalancing. Some rebalance every six months or once a year by trimming big gains in one asset class and purchasing more of an underperforming asset. Others, like Roth, will rebalance when an asset class rises or falls by a certain percentage. (Roth uses six percentage points as his trigger.)

Others like Chris Brightman, chief invest-ment officer of Research Affiliates and a co-manager of two Pimco asset-allocation funds, recommend doing as little selling as possible, focusing instead on using buying to help bring asset values in line with stated target levels. Selling, after all, can create more capital-gains taxes for a portfolio than might be necessary.

Whatever your approach to rebalanc-ing, there’s research showing that doing it enhances returns and is vastly preferable to taking no action beyond merely setting up an asset-allocation plan.

“Asset allocation is the second most important investment decision,” says Roth. “It’s the commitment to stick with it that is most important.”

Most investors lack

the time, patience,

and skill needed to

consistently pick

winning stocks.

You have much

higher odds of

success building

your investing house

with the bricks and

mortar of asset

allocation.


Active vs. PassiveFor most investors, mutual funds or exchange-

traded funds are the best way to get broad exposure to the stock market. Funds are bas-kets of stocks, so they provide instant diversi-fication, and fees have been falling for years, allowing investors to keep more of their returns.

Fund investors have a choice between two basic approaches: “passive” funds, which sim-ply hold every stock in an unmanaged index (such as the Standard & Poor’s 500 index of the biggest stocks in the U.S.), or actively managed funds, run by stockpickers who try to beat the market. In recent years, investors have poured money into passive indexes. Pick-ing stocks that outperform the market is quite hard, made harder by the fact that the active fund manager has to beat the market by more than his fee in order for shareholders to come out ahead.

Stacks of academic research have shown that most managers don’t clear this hurdle; in 22 of the past 26 years, the average actively managed fund has underperformed its bench-mark. A big reason for the underperformance is fees – 1.14% for the average actively man-aged large-cap fund, compared with less than half that for passively managed funds, going as low as 0.03% for some broad-market exchange-traded funds.

For investors just starting out, indexing makes a lot of sense. While it may be possible to build a slightly better portfolio, it is certain that there many ways to do far worse.

For investors who want to try to beat the market with actively managed funds, there are certain attribute of good funds to look for.

First and foremost is fees. Research by Morn-ingstar has found that the single best indicator of whether a fund can beat the market is low fees. It stands to reason that you are likely to have better returns if you are able to keep more of your money, which then compounds in your favor over time. What’s more, low fees are an indicator that the fund shop has investors’ best interests at heart. Another hallmark of outper-forming funds is that the managers are heavily invested in their own portfolios. Again, it stands to reason: Having skin in the game should rein-force their commitment to good returns.

Here’s one more thing to look for. Research led by Martijn Cremers at the University of Notre Dame has demonstrated that funds with high active share – a measure of how much a portfolio deviates from the benchmark – are most likely to beat the market. Of course, being different from a benchmark isn’t every-thing; the manager must also be right. That often correlates with conviction – outperform-ing funds with high active share tend to have fewer holdings and low turnover. Low turn-over has another benefit: Less selling means fewer tax hits for investors holding the funds in taxable accounts.

The rise of passive investing has coincided with the popularity of exchange-traded funds. Unlike mutual funds, which trade only once a day, based on the value of their holdings when the market closes, ETFs trade like stocks on an exchange. They often have lower expenses


Picking stocks

that outperform

the market

is quite hard,

made harder

by the fact that

the active fund

manager has to

beat the market

by more than his

fee in order for

shareholders to

come out ahead.

Funds



than mutual funds, and because of their structure, they don’t pass capital gains to shareholders, so they are more tax efficient. Originally, ETFs were launched as passive vehicles, simply holding the constituents of indexes. In recent years fund companies have launched more exotic portfolios, not always to the benefit of investors.

ETFs: How to ChooseThe surge in popularity of passive investing has been driven, in part, by a relatively new product – exchange-traded funds. ETFs are similar to mutual funds in that they are a basket of stocks, but unlike funds they are traded on an exchange. Their structure gives them one big advantage over mutual funds for investors in taxable accounts – capital gains are not passed on to the investor until he sells. With a mutual fund, by contrast, you could get hit with a capital gains liability even if the fund loses money while you own it.

ETFs tend to have lower fees as well; in fact the cheapest of them charge less than one-tenth of a percentage point. Compare that with the average actively managed mutual fund, which charges more than one percentage point. Over time that cost savings compounds in your favor, and can add up to hundreds of thousands of dollars over a life-time of investing.

The financial industry touts as a selling point the fact that you can trade ETFs at any time the market is open. That’s dif-ferent from a mutual fund, which is priced at the end of the day based on the closing prices of the assets it holds. We’re not sure ease of trading is actually an advantage – it can tempt trigger-happy investors to try to time the market. Researchers at Vanguard, in fact, found that ETF owners were more

than twice as likely as mutual-fund investors to log onto their accounts every single day, something they probably wouldn’t do unless they had a finger on the trading button.

While the first ETF was launched in 1993, it wasn’t until a decade later that the format really took off. There are now more than 6,000 funds holding north of $3 trillion. BlackRock and Vanguard are the biggest providers.

More isn’t necessarily better when it comes to fund offerings. You could build a fine core portfolio with just three simple funds: Van-guard S&P 500 ETF (VOO), Vanguard Total World Stock Index ETF (VT) and iShares Core U.S. Aggregate Bond ETF (AGG).

Because ETFs allow you to invest by sector, you can execute investing strate-gies at very low cost. Say, for instance, you think demographic trends bode well for the healthcare industry. You can buy a fund that owns the whole sector, such as the Vanguard Health Care ETF (VHT), or you can narrow your horizon to biotech with the iShares Nasdaq Biotechnology ETF (IBB). Using an ETF reduces your risk by allowing you to avoid stock-specific risk, which is heightened in that industry.

Constructing a portfolio of ETFs will also allow you de-emphasize a sector. A tech industry executive, for example, already has enormous exposure to the booms and busts of Silicon Valley. So she might own every sector except for tech, since she’ll do just fine when the Nasdaq is soaring, but would like to insulate her portfolio for those peri-ods when her industry is facing tough times.

One word of warning: Avoid niche funds. You really don’t need the Nashville Area ETF (NASH) or the PureFunds Video Game Tech ETF (GAMR). Be especially careful with tough-to-access markets such as high-yield municipal bonds, frontier markets, and microcap stocks. Selling pressure weighs more heavily on ETFs in these areas, and here the ETF structure proves more costly than a mutual fund. Sellers in a panic should

ETF owners were

more than twice as

likely as mutual-

fund investors to log

onto their accounts

every single day,

something they

probably wouldn’t

do unless they had a

finger on the trading

button.



expect to sell anywhere from 1% to 5% lower than the net asset value of the ETF’s components.

In recent years, ETF providers have started rolling out funds based on indexes that are weighted by fundamental factors, such as revenue or price-to-book ratio, instead of the traditional market value weighting. The argument against market weighting is that when stock prices are inflated by a bubble, you’re buying the bub-ble. And that’s true; it’s a reality of tradi-tional indexing. But there’s little evidence so far that a different approach will outper-form over the long term. There’s probably no harm, and perhaps an advantage, in diversifying your portfolio beyond mar-ket-cap weighting, but don’t mistake it for a crash-avoidance guarantee.

Closed-End FundsAs with exchange-traded funds, closed-end funds are bought and sold like stocks on exchanges, but the similarity pretty much ends there.

Just like stocks, closed-end funds issue a fixed number of shares in an initial public offering, which then trade in the secondary market. ETFs can issue and redeem shares as demand for them waxes and wanes, just as mutual funds do, which tends to keep ETFs’ market prices in close proximity to the value of their holdings.

By contrast, prices of CEFs’ shares can diverge from their net asset values, occasion-ally to trade at a premium but more often a discount, which is where the fun starts. Moreover, CEFs frequently use leverage – borrowing money to buy more assets – which can boost returns but will augment risk.

The ability to pay high yields has always been a big part of the attraction of CEFs, especially in the past few years, with short-term interest rates near zero. Income-ori-ented investors can find funds paying double-digit yields. Value investors, for their

part, can turn up CEFs selling at discounts of 10% or more, which effectively means buy-ing a dollar’s worth of assets for 90¢ or less.

There are no free lunches here, however. A rise in interest rates can cut CEFs in two ways: first, by reducing their payouts as their borrowing costs rise, then by lowering the value of their securities holdings, espe-cially interest-sensitive ones such as bonds.

Those risks always loom in the back-ground for all leveraged investments. But for investors willing to take those risks, CEFs exploit the low-interest-rate environment.

By borrowing at below 1% or less, a lever-aged municipal-bond CEF can take a portfo-lio of 3% munis and produce a tax-free yield of 4.5%, which is twice what the iShares National Muni Bond ETF (MUB) yields. For an investor in a 35% tax bracket, the muni CEF yield is worth almost 7% on a taxable investment.

Taxable CEFs can produce actual dou-ble-digit yields in a variety of ways, each of which comes with its own set of risks. Invest-ing in junk bonds is an obvious route. Other high-yielding and popular assets are junk bonds’ first cousins, leveraged bank loans, as well as emerging-market bonds. While leverage increases the risk of these already risky assets, the closed-end structure offers a significant advantage. Unlike open-end mutual funds or ETFs, CEFs never have to meet shareholder redemptions, and they are never forced to dump securities in bad markets (which is precisely when those redemptions tend to come).

There also is a definite income tilt among equity CEFs that goes beyond those investing in preferred stocks, real estate investment trusts, and master limited partnerships.

In addition to using leverage, many equity CEFs use options strategies to boost income.

CEFs’ shares can

diverge from their

net asset values,

occasionally to

trade at a premium

but more often a

discount, which is

where the fun starts.


The most popular tack is to sell call options against the stock portfolio, which produces pre-mium income but sacrifices some appreciation potential.

Don’t assume that a CEF actually earns the distribution it pays out. Part of it can represent a return of capital, which can mean the CEF is just returning shareholders’ money. Paying out more than a CEF earns can augur a distribu-tion cut. But some funds contend maintaining a steady payout to investors seeking income will lead to a higher valuation. It’s a complicated question. If return of capital eats into net asset value, you’re just getting back your investment, not a return on that investment.

If you’re aware of those caveats, closed-end funds have attractions. Some are near clones of open-end mutual funds offered by the same firm. For instance, both the Templeton Global Income CEF (GIM) and the Templeton Global Bond fund (TPINX) have Franklin Templeton’s star interna-tional bond manager, Michael Hasenstab, as the lead manager. One key difference: At the time of this writing in late 2016, investors could buy the closed-end version at a discount to NAV of more than 11%, while buyers of the open-end fund paid a sales load of up to 4.25% on the NAV. In other words, you could buy $100 of assets in much the same portfolio for $88.39 or for $104.25.

On the other hand, some CEFs can trade at substantial premiums to NAV. The Pimco Global StocksPLUS & Income fund (PGP) commands an 83.77% premium to its NAV, perhaps because of its double-digit yield. But its share price dropped about 10% after Pimco announced a 20% reduction in its monthly distribution.

What CEF investors seek are the dollar bills selling for 90 cents and paying above-average yields. Those bargains are becoming fewer and further between. They are still available, but it takes some looking.

You can scan the tables of closed-end funds

that appear weekly in Barron’s. Another useful resource is CEFConnect, a web site run by Nuveen, a big purveyor of CEFs. It offers a screening function that lets users assemble lists of CEFs based on various criteria, including asset class, returns, discounts or premiums, and distribution yields. There also are links to the fund sponsors’ own sites, which usually provide good information on the CEF.

In addition, CEFConnect shows a statistical measure called a Z-score. Some CEFs almost always trade below NAV, so a discount is the norm. A negative Z-score indicates if a CEF is cheaper than usual, and vice versa. The Z-scores and return info come from fund data provider Morningstar, which also has coverage of CEFs.

None of that information can predict what might happen if the market turns against CEFs. The “taper tantrum” of 2013, when the Federal Reserve said it would begin to wind down its securities purchases, was an example of how CEFs can get whacked by rate worries. Some plunged by more than 20% in price and to steep discounts to NAVs. Indeed, some of the strong returns recently are the result of digging out of the hole into which they fell before.

In addition, many CEFs are small, and as a result tend to be illiquid. Limit orders can help to prevent investors from buying too high or selling too low in a volatile market.

By now, it should be apparent that closed-end funds require lots of hands-on involvement. Most investors and their advisors opt for ETFs and mutual funds, which are the investment equivalent of a digital music download – sim-ple and straightforward. In addition, CEFs’ expense ratios – typically 1% or more, which may include the cost of borrowing – usually are higher than those of ETFs.

Closed-end funds are more complicated but potentially more rewarding. Just as not all music lovers want to deal with the hassles of vinyl LPs, not all investors are willing to do the homework to find bargains in CEFs. But if you’re looking for high yields at a discount, it may be worth it.


Closed-end

funds are more

complicated

but potentially

more

rewarding.


Building Wealth: A Guide to Smarter InvestingCHAPTER 6 BUILDING WEALTH: A GUIDE TO SMARTER INVESTING

Equities 101Stocks represent shares of ownership in a corporation. Their usual purpose in a portfo-lio is to provide appreciation and, over many decades, they have been the most productive assets for building wealth for almost all inves-tors. Some equities also pay dividends, which are never guaranteed. That said, in recent years bond yields have fallen so far that dividends offer more income, and, for many investors, a preferable tax rate. Owners of preferred stock receive dividends on a priority basis, but usually do not have voting rights in the company. As a general rule, stocks are riskier than bonds.

In building a diversified portfolio, inves-tors tend to look at equities in these large categories:

Domestic vs. internationalThe stock of U.S. companies constitutes about half the value of all world equities. Tradition-ally, Americans have neglected the other 50%, but this is now changing, influenced by the growing importance of the global economy. A growing number of foreign companies are listed on American stock exchanges in the form of American Depository Receipts, or ADRs, which trade like domestic stocks. Most large American brokerages are also members of multiple foreign exchanges.

Industry sectorsDifferent industries tend to perform differ-ently under different economic conditions or expectations. These relationships are not perfect, but they do provide generally reliable indications. For example, financial institutions are sensitive to interest-rate changes, and food and health care companies are likely to be more resistant to economic downturns than factory equipment manufacturers.

Market valueOften referred to as market capitalization, this is the total market value of the compa-ny’s stock. There are times when the mar-ket clearly favors small- and/or medium-cap stocks over large ones. And, of course, vice versa. Over the long term, academic research suggests that small-cap stocks outperform large ones, especially when the universe is narrowed to small-caps.

Value investing Value investors seek to buy stocks that they believe are underpriced by the market. These companies may be out of favor because of the economic cycle, or because they have suffered setbacks such as disappointing earnings or unexpected competition. Whatever the reason, value investors are looking for stocks whose low prices are temporary. The idea is that cur-rent perceptions about the stock do not reflect its potential and that eventually the market will recognize the company’s true value.

There are several ways to identify stocks that may be undervalued. The most common is to look for stocks with a price-to-earnings

Stocks

Stocks provide

appreciation

and, over many

decades, they

have been the

most productive

assets for

building wealth

for almost all

investors.



ratio (P/E) lower than that of the market average or the average of selected peer companies. Investors also look at the ratio of price to book value and price to sales.

Once an undervalued company has been identified, the next step is to estimate its true value. One way is to calculate the present value of future cash flows. Most individual investors rely on professionals to make both the necessary estimates and the calculations. Keep in mind that all the play-ers in the market have access to those same estimates, so they are baked into the price of the stock. Sometimes negative sentiment can depress share prices below what their fundamentals would suggest; such condi-tions can present contrarian investors with opportunity.

Growth investingGrowth investors look for companies whose sales and earnings are expected to increase at a faster rate than that of the market average or the average of their peers. The key difference between the growth and value philosophies is that the former places much more emphasis on a company’s revenue, unit sales and market share, and somewhat less on earnings. Thus, growth investors tend to buy stocks that are already in favor and to pay prices that are relatively high in terms of P/E ratio. In the bull market of the late 1990s, growth investors tended to do very well, and growth returned to favor after the Great Recession, as companies such as Ama-zon (AMZN) and Netflix (NFLX) outperformed. In 2016, value stocks seemed to be gaining traction again.

By its nature, growth investing relies heavily on a “story” or a theory as to the forces behind a company’s projected growth. But disciplined growth investors pay atten-tion also to the same fundamentals used

by value investors. Often they set explicit growth targets and time frames. The danger is that even the best story may not work out on schedule. A quarter or two of earnings disappointments can result in a dramatic selloff and a lengthy period of skepticism.

Growth at a reasonable priceAs the name implies, the “GARP” approach combines elements of value and growth investing, seeking to buy companies whose prices don’t fully reflect their solid growth prospects. For example, a company might be stuck in an out-of-favor industry sector but have new products in the pipeline that could propel it into a more attractive category. The particular emphasis given to growth and value varies considerably, although one or the other is usually clearly dominant. Among pro-fessional investors, GARP is sometimes used as an exception to give a value manager more flexibility to buy higher-priced stocks.

How to Shop for StocksWhen thinking about how to buy stocks, it’s probably best to start with the most success-ful investor of all time: Warren Buffett, CEO of Berkshire Hathaway.

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Buffett favors understandable businesses with good balance sheets, high returns, reasonable valuations, and strong market positions. Among his other insights is to be selective: “You don’t need to swing at every pitch,” he has said. He also thinks that the best ideas often are simple ones, saying that unlike diving, investing offers no rewards “for degree of difficulty.”

Buffett’s approach has led him to such long-term winners as Coca-Cola (KO), Amer-ican Express (AXP) and Wells Fargo (WFC). That said, even Buffett has struggled in recent years. Shares of Coke and American Express have flat-lined as the once-broad “moats” (a favorite Buffett phrase) that separate them from rivals have eroded. Wells Fargo, meanwhile, got hit with an account-opening scandal. Buffett’s largest investment in recent years, IBM (IBM), has badly lagged the market. His investment tra-vails just show the difficulty of the game.

At Barron’s, we take a flexible approach to selecting the companies that we profile favorably that incorporates Buffett’s insights. We tend to favor value stocks (those with low price-to-earnings or price-to-book ratios) but also write favorably about growth companies (those with rapid earnings and revenue growth).

Below are a few of the rules that we follow (and, yes, occasionally break). Before you buy a stock, subject it to these tests.

Paying for GrowthWhen buying growth companies, look for dominant businesses and don’t overpay. Try not to pay more than 25 or 30 projected earn-ings a year out. As 2016 came to a close, the overall market looked pricey, and yet there were a more than a few companies that fit that bill. They included Google parent com-pany Alphabet (GOOG), Facebook (FB), Apple (AAPL), Visa (V), Mastercard (MA), Disney (DIS), Home Depot (HD) and Microsoft (MSFT).

If you pay more than 25 or 30 times for-ward earnings even for an excellent company,

you are vulnerable to the slightest earnings or revenue disappointment. And even if growth pans out, the stock may not appre-ciate as investors worry about sustainability and the price-to-earnings multiple contracts. Under Armour (UA) is a great apparel com-pany yet its stock slid 25% in the first 11 months in 2016. Why? It started the year with a forward P/E of more than 60. When it revealed a slowdown in its growth – natural as a company gets larger – investors decided it no longer merited that sky-high valuation.

Be careful about fads. Fitbit (FIT) and GoPro (GPRO) fell sharply from their highs as consumer enthusiasm waned for activity trackers and action cameras. Also be wary of fashion-oriented companies with high stock-market valuations. Retailers focused on one name brand, such as Kate Spade (KATE), Coach (COH) and Michael Kors (KORS), have suffered in a saturated market. Better to stick with diversified apparel and accesso-ries makers like VF Corp. (VFC) and LVMH (LVMHF), parent of luxury goods maker Louis Vuitton. Instead of betting that one designer will continue to excite consumers, you’ll be aligning yourself with successful operat-ing companies that have succeeded even as tastes changed.

Sometimes, companies with meager current earnings and desirable franchises can pay off. Barron’s has made the case for Madison Square Garden (MSG), owner of the New York Knicks and Rangers, and for Liberty Braves Group (BATRK), a tracking stock for the Atlanta Braves. Both companies traded at a sizable discount to the estimated value of their assets in 2016. Time will tell if these values get realized.

Assessing valueWhen selecting value-oriented stocks, try to find those with some earnings growth or

The best ideas

often are simple

ones... unlike diving,

investing offers no

rewards “for degree

of difficulty.”



alternatively, select ones that are valued so cheaply relative to book value or earnings that they don’t need much growth to be good investments. A rock-bottom valuation would be less than 75% of book value or eight times earnings.

Financial companies make up the larg-est component of the value-stock universe. When investing in big banks and insurers, try not to pay a big premium relative to tangible book value – a conservative mea-sure of shareholder equity that excludes goodwill and other intangible assets stem-ming from acquisitions. In theory, book value should approximate liquidation value, offering a floor under the stock price. If you can buy a solid financial company at tangible book value, it has a good chance of working. Try not to pay much more than 1.5 times tangible book or 15 times cur-rent-year earnings.

This strategy can pay off in a big way as these stocks tend to be highly cyclical. As the economy ebbs and flows, investors get an opportunity to buy financials cheaply. Bar-ron’s wrote favorably on Goldman Sachs (GS) in mid-2016 after it was battered on Britain’s vote to leave the European Union and traded around $142, a discount to tangible book. With financials back in vogue after Donald Trump’s election win, Goldman shares were up nearly 50%. Note that some financial stocks can stay cheap for a long time – more than seven years after the financial crisis, Citigroup (C) still fetched about 90% of tan-gible book.

The price-to-book guidelines for financials using book value don’t apply to asset-light financial companies like Visa and Master-card, which benefit from the steady growth of debit- and credit-card transactions at the expense of cash. They trade at much higher price-to-book multiples.

Another point: Don’t be put off by a high absolute stock price, which in and of itself has nothing to do with valuation. A triple-digit share price simply reflects an unwillingness of management to split shares. Focus on the stock price relative to earnings – and book value when relevant.

In fact, stocks with high absolute prices sometimes are inexpensive relative to cheaper brethren in the same industry because many investors recoil at a high stock price. Berkshire is the best example. Buffett has refused to split the A shares (BRK.A) – although the company created lower-priced class B shares (BRK.B) about 20 years ago. Not buying the A shares in the 1970s and 1980s when they traded in the hundreds or even thousands of dollars was a huge mistake, with Berkshire at $237,000 and less than 1.5 times its book value in late 2016. A lesser-known stock with a high abso-lute price – $560 in late 2016 – but a reason-able valuation is the well-managed insurer Alleghany (Y).

Sector pros and consPharmaceutical stocks can be tough to assess because their prospects often hinge on the success of new drugs, which can be hard for most investors to analyze. The formerly hot Bristol-Myers Squibb (BMY) fell from favor after its main immune-oncol-ogy drugs for cancer treatment had disap-pointing clinical trial results. Health-care companies with less exposure to new drug approvals include Johnson & Johnson (JNJ), Abbott Laboratories (ABT), and Medtronic (MDT). They yield 2% to 3%. Try to avoid paying more than 20 times earnings for a drug stock.

Dividend plays such as utilities and tele-com stocks can be rewarding even without much stock-price appreciation. These stocks go in and out of favor, and sold off after Donald Trump was elected and investors seemed to expect rising interest rates. (Rising rates make the dividend payouts

Don’t be put off by a

high absolute stock

price, which in and

of itself has nothing

to do with valuation.

A triple-digit share

price simply reflects

an unwillingness of

management to split

shares. Focus on the

stock price relative

to earnings – and

book value when

relevant.



relatively less attractive.) A broad sector exchange-traded fund such the Utilities Select SPDR (XLU) offers a good way to play electric utilities. Despite their stodgy reputa-tion, most big utilities offer mid-single-digit annual earnings growth – not bad consider-ing their 4% dividends. One important thing to look for before buying telecoms and utili-ties: dividend coverage, which reflects their ability to continue to make payments. Try to find stocks whose dividends aren’t more than 60% or 70% of earnings.

Consumer stocks, after a long run, also sold off in the run up to, and following, the Trump election. Big, well-known companies like Coca-Cola, Procter & Gamble (PG), and Unilever (UN) were yielding 3% or more in late 2016 and traded for about 20 times for-ward earnings. That’s not particularly cheap, but think of them like bonds with increasing dividends.

A final rule for picking stocks? Patience. It can take time for the market to come around to your thesis. Trading in and out of shares is rarely a formula for success.

How Charts Can Make You a Better

Investor

Chart reading, or technical analysis, is sometimes compared to fortune telling, and not always favorably. But many investors incorporate it into their decision-making process – sometimes in concert with their fundamental analysis. Technical analysis is really just a way to graphically represent a stock’s journey and assess whether the mar-ket thinks it can still go farther.

The approach is based on the premise that when trying to predict where prices are going, it is helpful to know where they have been. By plotting the closing prices of stocks each day, we can see at a glance not only what the price of the stock is but how it got there. Sure, stock X is trading at $65, up 50 cents, but was it $60 last week or $70?

Knowing if a market is moving up or down helps investors buy only those shares that have the odds stacked in their favor. The bottom line in all markets, whether they are financial, real estate, or breakfast cereal, is that when demand is greater than sup-ply, prices will rise. A chart with a posi-tively sloped price line is exhibiting excess demand. It is far better to buy a stock when demand is greater than supply – and its price is on the upswing – than the other way around.

Apple of the chartsConsider Apple (AAPL). From 2013 through early 2015, its chart showed a very strong stock in a bullish trend (see Chart 1). Back then, doubting the company’s prowess for innovation was a mistake, as every pullback was met with even stronger buying. Apple could do no wrong.

However, as 2015 developed, the stock stalled. It moved sideways in a narrow trad-ing range, but it never could push to new highs, and that told us that buying and selling pressure was more or less equal. Something was clearly different, although there were no signals that anything was wrong – at least not yet.

In July of that year, the stock dipped to a six-month low below the bottom of the trading range. It did rally one more time, but after the July 21 close, it reported disappointing iPhone sales and a weaker-than-expected earnings outlook. The stock tumbled. This time, the market was not in a forgiving mood.

While the charts did not predict the news, they did suggest something was wrong. And when the stock dipped below its early July low, the market told us that the trend had changed. It believed Apple’s best days were behind it, at least for the fore-seeable future.

The bottom line in

all markets, whether

they are financial,

real estate, or

breakfast cereal, is

that when demand

is greater than

supply, prices will

rise.



Gold standardCharts work well for commodities, too. In 2011, gold was enjoying a powerful bull mar-ket, and the web was rife with ads offering to buy everyone’s gold jewelry and even the fillings from their teeth (see Chart 2). Fears abounded that the Federal Reserve’s cam-paign to flood the economy with liquidity would damage the U.S. dollar. Since gold and the dollar usually have an inverse rela-tionship, that was thought sufficient to pro-pel the price of gold to $2,000 per ounce – or even $5,000 – from its then-current $1,900.

Later that year, gold dropped below the trend line that had supported the rally for several years. In other words, the series of higher highs and higher lows ended and the market told us that something was now wrong with precious metals and the stocks of companies that mine them. The days of the latest gold rush were now numbered.

When gold dipped to $1,500 per ounce, it was not a sign that it was cheap. After all, if investors liked it in early 2011 at $1,500, they should appreciate their second chance to buy at that lower level. Unlike in pre-vious years, however, the trend was now falling. The price was the same, but the

trend was different – and knowing that one fact, thanks to the charts, would have saved investors a lot of sleepless nights.

Charts are not mysterious. They are tools that allow us to identify major trends and quickly see when it’s time to change strat-egies. They do not predict the future, of course, but they are valuable in determining the probability of success, whether we buy, sell, or hold.

Friendly trendSimply stated, a chart of stock prices plots the price traded over a specific period and allows us to see how an investment grew or shrank. This helps us assess the most important part of a stock’s life – its trend. Is the stock moving higher or lower over time?

As Will Rogers wrote nearly a century ago, “Buy stocks that go up; if they don’t go up, don’t buy them.” Little did he know that he nailed the most important part of investing and one of the most quoted mantras of today, namely, “The trend is your friend.”

Does it really matter what the trend is? A stock can trade at the same price in a rising trend one month and in a falling trend the next. Did the stock go on sale or is some-thing different? This is vital information, and in most cases all we have to do is glance at the chart to glean it.

Same pricedifferent trend

Chart 2: Gold Price

Oct2009 Jun2013

Same pricedifferent trend

Chart 1: Apple Share Price

Oct2014 Apr2015

harts are not

mysterious. They

are tools that allow

us to identify major

trends and quickly

see when it’s time to

change strategies.



Let’s examine a stock with a readily iden-tifiable trend. Amazon.com (AMZN) began a powerfully bullish trend in February 2016 (see Chart 3). There were small dips along the way, but looking at the chart now, it is easy to draw a straight line connecting those dips to form a rising trendline.

Trendlines can be drawn simply by looking at the chart, by applying advanced math and statistics, and by everything in between. The important point is that a bullish stock rises over time, and the line moves from lower left on the chart to upper right.

Of course, all good trends come to an end. Amazon lost its way in 2015 following a pre-vious strong rising trend (see Chart 4).

Importance of momentumThe next question: How do we know when a stock might cease its ascent? We never know in advance, and therefore selling at the very highest price is a rare feat. We can only have confidence that a bullish trend turned bearish well after the fact, but there are technical tools measuring momentum, volume, and other factors to help us make that call in a timely manner.

Momentum indicators are derivatives of price action much like acceleration is a derivative of speed in physics. As a car decelerates, an observer on the side of the road does not know if the car’s engine died

or a red light is just up ahead. In the stock market, a chart watcher does not know if the company’s fundamentals have changed or if the market is simply reacting to some out-side factor, such as interest rates or politics.

It does not matter why the stock deceler-ates, only that it tells us it may be time to take action. In the Amazon chart, we can see the relative strength index changing direction before the stock’s price peaked in December 2015. That is a warning sign for investors. So is the change in cumulative volume, an indicator that measures trading volume on up days minus trading volume on

Chart 5: Peabody Energy Price

brief awakening

bankruptcytrend

Chart 4: Amazon.com Price

divergence at the top divergence

at the bottom

Cumulative volume


Oct2015 Oct2016

May2015 Apr2016

Jun2015 May2016

Chart 5: Peabody Energy Price

brief awakening

bankruptcytrend


divergence at the top divergence

at the bottom

Cumulative volume


Oct2015 Oct2016

May2015 Apr2016

Jun2015 May2016



down days. Rising cumulative volume tells us the bulls are winning.

In 2015 these indicators combined to sug-gest that perhaps something was wrong with Amazon’s stock – and indeed, shortly after it hit what was an all-time high, a fundamental analyst downgraded the stock and problems in China came to the fore. Amazon then dropped more than 30% in five weeks.

The charts did not know that such a move was coming. All they could do is warn that January was not a good time to be in the stock. Then in February, the relative strength index once again warned that a change might be coming.

Granted, it would take an astute chart reader to play these turns and capture the best of these moves. However, if your other research into the stock was still positive after it fell so much, the charts would have told you later in February that the coast was once again clear. Again, it was not the abso-lute bottom, but it certainly was better than riding the entire decline to a loss.

The strategy works for weak stocks, too. Coal stocks were under pressure in 2015, and the trend in one of the sector’s larger stocks, Peabody Energy (BTUUQ), was clearly in decline (see Chart 5). It was tempting to think that the coal industry was quite cheap and that the need for coal was not going away anytime soon.

There was a brief awakening in the stock in March 2016, but the big trend never wavered. Just as quickly as Peabody rallied, it fell back, and the next month the company declared bankruptcy. A low price is not necessarily cheap, and the trend can help us know the difference.

That is really all you need to know about charts to get started. There are countless other tools that measure the madness of crowds (sentiment), the best months or years

to buy (cycles), price structures (triangles and other price patterns), and even if the stock market’s soldier stocks are following the leaders (breadth). However, none of those things measure our success as inves-tors. Only price – the difference between purchase and sale – goes into the bank at the end of the day.

How to Find Hidden ValuesThere are nearly 16,000 stocks traded on

the New York Stock Exchange and Nasdaq alone, and more than 100,000 worldwide – far too many for an investor to spend even five minutes on each. One way to start the search for investment opportunities is to use software that reduces that vast universe to a handful of stocks worthy of further research.

For example, a recent screen for midsize U.S. companies with rising earnings esti-mates and shares that trade at less than 20 times earnings turned up just over 100 names. Restricting results to just companies whose earnings estimates have climbed by a few percent or more shortens the list to several dozen.

Some of those stocks will be unfamiliar, and that’s much of the point. Investors who focus all of their attention on stocks they recognize run the risk of buying shares that are newsy but not necessarily attractive.

Free stock screeners abound on the Inter-net, including ones from Google Finance, Yahoo! Finance, Zacks and Finviz.com. More powerful ones from Morningstar, AAII.com and others are available to subscribers. Bro-kers such as Fidelity and Schwab provide screening software for account holders. Bar-ron’s writers have access to pricey profes-sional platforms like Bloomberg and FactSet. There are many others. Most offer preset screens that users can run at the push of a button and also allow users to build their own screens.

Basic screeners allow users to select companies using a simple menu of measures,



operators and values: trailing price-to-earnings ratios below 20, for example. More advanced ones allow users to fine-tune their measures and make detailed comparisons: price-to-earnings ratios that are below their industry averages, based on consensus earn-ings estimates for the next four quarters that exclude one-time items like restructur-ing charges.

The best screeners offer a full menu of financial data so users can build measures that go beyond those in common use. For example: A company’s research and develop-ment spending subtracts from its earnings right away, but tends to boost profits over time as projects come to fruition. That means companies that suddenly ramp up their research look worse today but better in the future – a fine setup for bargain hunters. Why not screen for companies with rising R&D and an attractive price-to-R&D ratio?

That’s not a sudden hunch. It’s based in part on a study published in 2001 in the Jour-nal of Finance co-authored by Josef Lakon-ishok, then a professor and now co-founder of LSV Asset Management, which oversees $94 billion. The best clues for screening have a proven record of working and a commonsense explanation for why they work.

Cheap stocks tend to outperform over long time periods, and for the simplest of reasons, judging by studies on the subject. Investors tend toward excess. They punish company flaws too severely and reward strengths lavishly. Cheaply priced companies that outperform don’t typically do so because they suddenly turn things around and thrive. Many simply end up achieving ho-hum results rather than dire ones, leaving Wall Street pleasantly surprised. Investors can screen for cheap shares by comparing share prices, market values, or enterprise values to fundamental measures of value such as revenue, earnings, free cash flow, the book value of assets, or dividend payments.

Not all cheap stocks are good deals, of course. They key is to hunt among screen

survivors for ones that look unfairly pun-ished or likely to fix their problems soon.

Prosperity is a good thing to screen for, but be careful. High profit margins sound like something that makes a stock attractive, but the market tends to price in things we already know, and margins are one of those measures that tend to revert to historical averages over time, as thriving companies attract competitors. Better to screen for com-panies whose margins are subpar but rising. Healthy returns on invested capital are a sign that companies can reinvest today’s winnings at attractive rates.

Patience, wrote Ambrose Bierce, is a minor form of despair, disguised as a virtue. Investors who hope to be not only right, but right soon, can screen for signs of momen-tum. Upside earnings surprises and rising earnings estimates are examples. Be sure that revenues are surprising, too, to find companies that are winning business rather than just cutting costs. A rising share price sounds like something value investors ought to avoid, but not necessarily. The combina-tion of a reasonable valuation and recent gains could be a sign that the market is coming around to the idea that a stock is worth more, and that more gains could follow.

Be sure to look at debt levels, whether as part of a screen or afterward, when drilling down on screen results. There are one-off items to screen for, too. There’s insider buying. Top executives, board members and key shareholders must report purchases of their company’s shares – the ones made with personal rather than corporate cash. Among these, top executives are most worth watch-ing. One thing to note: The fact that an insider is selling is not necessarily a warn-ing sign. Maybe the CEO simply decided he wanted a new yacht. But when the bosses



are buying, that usually suggests optimism among those in the know.

Screeners can also sort by analyst recom-mendations – Buy, Hold, Sell and the like. Searching for companies with loads of Buys might seem like a good idea, but there’s little evidence that consensus analyst rec-ommendations predict returns. Changes in recommendations are more interesting, and there’s research to suggest investors should pay attention when an analyst with a good record suddenly moves to a Buy when most of the herd says Hold.

There are many more things investors can screen for, including a sudden acceleration in revenue growth or dividends that look too low relative to free cash flow, and thus likely to rise. Also look for warning signs, such as paper profits that chronically exceed cash ones.

But hold on. Why bother picking stocks in the first place? After all, investors have been fleeing actively managed mutual funds for lower-cost index funds after reading for years that most stockpickers underperform the market.

But that doesn’t mean you can’t out-perform. It just means it’s quite difficult. Financial research continues to uncover stock market anomalies, or factors that aren’t supposed to predict handsome returns but do. The findings suggest that enterpris-ing investors can do better with a portfolio of quality stocks, or at least a handful of stocks, to complement their funds. These investors might be viewed as heretics in the new era of indexing, but remember, indexing only works to the extent that stock prices reflect real-world developments. And stock prices only do that to the extent that stock-pickers take shots on beating the market. The more the world sticks to indexes, the less competition for stockpickers.


Fixed Income 101Bonds are the other big slice of the traditional asset allocation pie. Unlike stocks, in which the investor owns a share of the company, bonds are IOUs. They represent a debt of the issuer and pay interest at given rates and on given schedules. Because they have noth-ing to do with owning a stake in the issuing company, they pay interest even if there is no money to pay dividends to stockholders. The interest must be paid on schedule and the principal must be repaid on maturity. Because of the predictability of the payments, inves-tors historically have used bonds to provide a steady stream of income.

Today, with interest rates just slightly above historic lows, that income is not very generous. However, bonds play a second role in a portfo-lio: shock absorber. They tend to be less vola-tile than stocks, and to hold up better in times of market turmoil. That makes them a ready supply of liquidity for investors who don’t want to sell stocks at depressed levels, or may even want to sell bonds to buy stocks on sale.

Depending on interest rate trends, bonds appreciate, or depreciate, in value. That means you may be able to get more, or less, than face value on the open market at any given time. The issuer is obligated to pay the face value at maturity, however.

Bonds are considered more conservative investments than stocks and, as a general rule, their return will be correspondingly lower. That said, there is an extraordinary variety of terms and conditions applying to bonds, and it is always important for investors to read the fine print.

The yield curve Under normal circumstances, the yield curve is simply a graphic expression of the idea that an investor should receive a premium for lending money for longer periods of time. The length of time to maturity is plotted on the horizontal axis and the yield on the vertical. Thus the expectation is that the curve will slope upward, left to right. However, this rela-tionship can and often is distorted by many factors including supply and demand. An inverted or downward sloping curve suggests that short-term interest rates are high and can be expected to come down (or that long-term rates are too low). An inverted yield curve is considered a harbinger of a recession, though there have been false alarms.

Government bonds, both domestic and foreign, come in a range of denominations and maturities. In the U.S., Treasury bills are short-term (less than one year) instruments denominated in amounts from $1,000 to $1 million. They accumulate interest but do not actually pay it until they mature. Because there is virtually no possibility that the gov-ernment will default, they pay a low interest


Bonds

Because of the

predictability of

the payments,

investors

historically have

used bonds to

provide a steady

stream of income.



rate, often referred to as the “risk-free rate,” which is used to evaluate other invest-ments. Treasury notes are two- to 10-year instruments, and Treasury bonds are issued for up to 30 years. Both pay interest semi-annually. You can purchase Treasuries from brokers or directly from the Treasury. In addition, federal agencies such as the Farm Credit Administration, quasi-federal orga-nizations such as Fannie Mae, and local governments all issue bonds. They may be backed by the “full faith and credit” of the issuer or by a specified revenue stream, such as, say, water authority revenues or mort-gage payments.

The private sector also issues bonds, which generally pay a higher interest rate than government issues since companies have a higher chance of bankruptcy.

Among the most common corporate and government bonds are the following:

Asset-backed bondsBonds backed by specified collateral, which will be sold to pay lenders in the event of default.

Callable bondsBonds mainly issued by corporations and municipalities whose principal may be repaid to the investor at specified times before stated maturity. A bond is likely to be called if interest rates go down below the level at the time of issuance. When a bond is called, investors cannot easily find a replacement that has the same yield and quality.

ConvertiblesCorporate bonds the investor can exchange for stock at specified times and exchange rates. (A few convertibles are exchangeable at the issuer’s initiative, but these usually pay higher interest rates.)

Floating-rate bondsBonds bearing an interest rate that is adjusted periodically, usually in relation to a well-known benchmark rate. These have been popular at a time of ultra-low interest rates, but are not foolproof. For instance, if the bond is pegged to short-term rates, but only long-term rates are rising, it can become less attractive to investors, and its price can fall.

Subordinated bondsBonds that will be repaid only after the repayment of more senior debt. Since they are riskier, they pay a higher interest rate.

Zero-coupon bondsBonds that pay the interest all at once upon maturity. Thus, they are purchased at a deep discount from their face value – the differ-ence represents the interest. Zeroes are often used by investors seeking to accumu-late savings for a well-defined future need, such as college tuition.

This list is not exhaustive and there are different, sometimes unique terms and con-ditions that can apply within each of these categories.

Key factors to considerThree important variables apply to all bonds and are worth understanding even if you

YIELD CURVE

1-YR

1%

2%

3%

3-YR 5-YR 20-YR10-YR

NORMAL(Growth)

MUNICIPAL BONDS

are issued by

cities and towns.

The hallmark of

municipal bonds is

that their interest

is federal tax free,

and therefore they

are particularly

popular with high-

income investors.

(The higher your

tax rate, the bigger

the benefit of the

tax break.) Note

that munis make

more sense for your

taxable accounts –

all money you take

out of a 401(k) or

IRA will be taxed

at the same rate,

regardless of how it

was invested.



don’t plan to buy individual bonds: quality, yield and taxes.

QualityHow confident can you be that you will receive your interest payments on time and that the principal will be paid at maturity? The answers depend upon the creditworthi-ness of the issuer.

Very few investors are capable of doing their own credit research, so they rely on rating agencies such as Moody’s and Stan-dard & Poor’s. There are similar but not identical scales to rate all bonds except those of the U.S. government, which are assumed to be of the highest quality. Credit ratings range from Aaa (Moody’s) or AAA (S&P), which is given to the debt of the most creditworthy issuers, to C, which is the lowest-rated level of high yield (junk) bonds. Moody’s adds a D category for bonds that are already in default. (You can buy D’s at a deep discount in the hope that the issuer will recover. For the most part, however, this sort of thing is better left to professionals.)

Keep in mind that Moody’s and S&P are not infallible. During the housing bubble they assigned top ratings to nearly worth-less mortgage bonds.

Quality ratings influence the rate the bonds pay. It is not uncommon for a C-rated junk bond to pay a rate 50% above that paid by a triple A-rated bond. Investors demand the greater yield in return for the risk. One of the risks of bond investing is the pos-sibility that the rating of an issuer will be downgraded during the life of a bond. When that happens, the value of the bond declines accordingly. The opposite happens if the credit rating is upgraded. These are import-ant considerations in actively managed port-folios but less so for buy-and-hold investors. If a bond is held to maturity, the investor will be paid the full face value, as long as the issuing company remains solvent.

The maturity of a bond is the date the principal or face amount will be repaid to

the investor. Since bonds can be bought and sold many times after they are issued, the time to maturity is usually more important than the maturity itself. Under most cir-cumstances, for bonds of equal quality, the longer the time to maturity, the higher the yield. This compensates the investor for the risk of inflation, which increases the longer the bond is held. When there are anomalies in the bond market, this simple relationship can change, presenting the investor with new challenges or new opportunities.

YieldThe interest rate paid by a bond, expressed as a percentage of the face amount. A 3% rate on a $10,000 bond means $300 a year in interest. But investors rarely pay the exact face amount for the bond. Depending on sup-ply, demand, and market rates at the time of purchase, investors may buy it at either a premium or a discount.

So for example, if rates on identical bonds rose to 4%, no investor would pay $10,000 to get a 3% payout when he could buy a bond paying 4%. So price on the older, 3%, bond would fall to $7,500. That 3% payout on $7,500 is $400, the same as 4% of $10,000.

Thus, the current yield is the interest rate shown on the coupon divided by the price the investor actually paid for the bond.

TaxesBond interest payouts are considered income, and taxed at the same rate as your salary or other earned income. For tax plan-ning purposes, assume that the tax rate is your highest marginal rate. Note that capital gains and losses on bonds get the same tax treatment as any other capital gains or losses. So if you held a bond for more than a year and sold it for a profit, it would be taxed at long-term capital gains rates, which

Munis are frequently

backed by the “full

faith and credit” of

the issuer which,

in effect, means its

full taxing power.

They carry lower

interest rates than

comparable non-

municipal bonds,

but this is generally

more than offset by

the tax advantage.

Investors who buy

bonds issued by

their home state can

get even greater

tax advantages, by

avoiding state and

local taxes as well.



for high-income investors are lower than ordinary income rates.

Many financial advisors recommend that high salary individuals – anyone in the 28% tax bracket or above – hold the bond portion of their portfolios as much as possible in their tax-advantaged accounts, such as IRAs and 401(k)s. Stocks, meanwhile, can be more effi-cient in taxable accounts since dividends get favorable tax treatment. What’s more, stocks are more volatile, offering investors more opportunity to sell at a loss, lock in a tax deduction, and buy similar (but not identical!) assets to maintain steady exposure to the market.

Bond FundsBond investors are in a tough spot. Over

the course of a 35-year bull market, interest rates slid downhill from dramatic highs – 10-year Treasury Notes yielded north of 15% in 1981 – to below 1.4% in 2016. In Europe and Japan, some bonds have negative yields, an unprecedented occurrence. Those older, higher-yielding bonds became more and more valuable as interest rates fell.

While we don’t know what will come next, it is mathematically impossible to repeat the gains in the coming years that we have seen in recent decades. Not only will bonds offer little to no appreciation, and possibly paper losses, they will kick off precious little income in the meantime.

So for now, investors have little choice but to make the best decisions with the things they can control: costs and diversification. Mutual funds offer the easiest path to diver-sification, but they do have one disadvantage. Let’s get that out of the way first.

A debate rages among people who worry about this stuff: Is it better to own individ-ual bonds or bond funds? With an individual

bond, you get 100 cents on the dollar when it matures (assuming the issuer doesn’t default). The knock on funds is that, because they are constantly buying and selling bonds, they have no maturity date. Therefore if rates are rising, the value of the fund goes down, and you might have to sell the shares for less than you paid.

While the criticism is accurate, there are quite a few caveats. For starters, you’ll need at least $500,000 in the bond portion of your portfolio to achieve sufficient diversity and the scale to absorb transaction costs. Short of that, you’re better off in funds. What’s more, a bond fund can take advantage of rising rates by constantly buying bonds with higher coupons. But say you own a $10,000 bond paying 3% interest and rates rise to 4%. The semi-annual payouts of about $150 won’t be enough to buy a new, higher-yielding bond. And finally, while it’s true you will get your money back if you hold a bond to maturity, you still suffered opportunity cost – you were unable to invest that $10,000 in a new, high-er-paying bond without selling and taking the loss.

Now, for those who go the fund route, remember your two lodestars: low costs, and diversification.

To achieve maximum diversity, build a portfolio of both index funds and actively managed funds, U.S. and international.

US 10-yr Treasury Yield

1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

5%

10%

15%


With indexes, go cheap and go big. The Vanguard Total Bond Market (VBMFX) fund is based on the basic benchmark, the Barclays U.S. Aggregate. Because that fund is heavy on U.S. government bonds, you can boost your yield and spread your risk with the Vanguard Intermediate-Term Investment Grade (VFICX) fund. Add the Vanguard Total International Bond Index (VTIBX) fund and you’ve covered the globe. Those three funds are good core holdings. One prob-lem with index investing and bonds, however: Most indexes are weighted by the size of the issuer. So that means investors have the most exposure to the entities with the most debt. Not necessarily a great strategy.

If interest rates do rise – and reversion to the mean suggests that will happen – a good active manager may be able to anticipate the move and protect you from the worst of it. Even within active management, you might want to diversify, say by going with an active fund benchmarked against the Barclays index, such as Pimco Total Return (PTTAX), or, if you have a bigger risk appetite, the DoubleLine Total Return Bond (DBLTX).

“Unconstrained” bond funds, meanwhile, don’t track the indexes and can outperform if the manager makes the right call. The managers often base their decisions on where they think economic growth and interest rates are heading, and where they spot opportunities for return. That’s great if it works, but there are no guarantees. One good example: BlackRock Strategic Income Opportunities fund (BASIX).

For actively managed international exposure, con-sider funds such as Templeton Global Bond (TPINX) and T. Rowe Price Emerging Markets Bond (PREMX).

The higher your income, the bigger the advantage of the federal tax-free payouts from municipal bonds. A muni fund makes sense for your taxable accounts (you forfeit the tax advantage if you own munis in a tax-advantaged retirement account). If you live in a high-tax state such as California or New York, con-sider state-specific funds, which are also exempt from state and city taxes.

Two other options are discussed elsewhere in this book: Closed-end funds, which can boost your yield through leverage, are covered in a previous section, and for conservative investors, or those who may need the cash soon, short-term bond funds offer a good place to

get a little more income than savings accounts offer. We’ll take a look at them in the next section.

Building a Bond Ladder To avoid the problem of owning bonds in a fund –

suffering the loss of capital as rising rates ding the net asset value of the portfolio – investors can buy individual bonds and hold them to maturity. The best way to do it is with what’s known as a bond “ladder,” so named because it consists of bonds that mature in successive years, typically starting in a year or two out to 20 years or longer.

There is no set formula; indeed, the ability to customize a ladder is one of its advantages. And it satisfies one of the oldest precepts of investing – not putting all your eggs in one basket.

With bond yields at historic lows, investors in fixed-income securities face a dilemma. Buying short-term bonds means reaping minuscule yields. Buying long-term bonds would mean locking in low yields and risking losses if or when yields rise. As explained earlier, bond prices move inversely to yields, and the longer the maturity of the bond, the bigger the poten-tial drop.

At the time of this writing in fall 2016, a 30-year U.S. Treasury bond yielded just 3%, not an inspiring return over the next three decades. But if yields were to rise to 3.5%, the older, lower-yielding bond’s price would drop 9%. A 10-year Treasury note yielding 2% would lose more than 8% if yields jumped one per-centage point (100 basis points). And a 1.75% five-year note would drop 4.6% were its yield to climb one percentage point.

Of course, the opposite would occur if yields were to decline dramatically, resulting in a sharp rally. Anything can happen in this crazy world of zero and negative interest rates. All that can be said with cer-tainty is nobody has any idea.

One important note: Even if the bond is held to maturity and suffers price losses only on paper, you still forgo the opportunity to earn higher returns if yields rise. So in one sense the advantage of a ladder




over a bond fund is illusory, as you still suf-fer the opportunity cost.

Hunkering down in stable, short-term maturities will eliminate the chance of los-ing money if interest rates rise, but it also means settling for measly yields, around 1% currently. Buying longer bonds garners higher yields but at the greater risk of losses if yields rise.

A bond ladder helps to get around that conundrum. Assembling an ascending ladder of bond maturities avoids locking all your cash into low yields, but also allows you to earn some higher income.

The key to the ladder is that the bonds on the lower rungs will mature earlier, say in a year or two, and the principal can then be reinvested in a longer bond due in 10, 15, 20, or however many years best suit your circumstance. If yields have risen since the short bond was purchased, you’d be invest-ing at the new, higher yield.

Typically, shorter-term bonds yield less than intermediate- or long-term bonds. Plotting that on a graph produces the yield curve, explained earlier in this chapter.

As time passes, bonds age just as we do. A three-year bond in a year will be a two-year bond. This “roll down” in the yield bolsters the return from the ladder portfolio, since you will have had the advantage of the higher-yielding three-year for the preceding year.

That’s really more important to managers of bond funds, which maintain a roughly unchanged average maturity, replacing older bonds as they age with longer securities. That means bond funds (with rare excep-tions) never promise you’ll get your money back on a specified date, as bonds them-selves do.

So here’s how one professional constructs a laddered portfolio. He bought $100,000 in bonds maturing each year from two years out to 15 years, which produced an average maturity somewhere in the middle. This can be done with corporates, municipals, Trea-suries, or even bank certificates of deposit. Corporates and munis also involve credit risk, which makes security selection import-ant. Treasuries and federally insured CDs don’t have that credit risk.

Treasuries might be the best bet for inves-tors who aren’t assembling a big laddered portfolio. You can purchase notes and bonds from Treasury Direct when they’re auc-tioned. Every month brings a sale of two-, three-, five-, seven-, 10-, and 30-year issues, which should provide most rungs of a ladder.

Treasuries also can be purchased in the secondary market, and some online discount brokers let you buy them free of charge. Plus, with exchange-traded funds taking over so many investment sectors, it’s not surprising that ETFs with targeted matu-rity dates have emerged. These can be assembled into a ladder, but as Barron’s has pointed out, these ETFs do entail an extra cost in terms of ongoing annual expenses, ranging from 10 to 43 basis points. While that’s less than what many traditional bond funds charge, in the current low-yield envi-ronment every basis point counts.

Expenses aside, a bond ladder provides a steady, if unsatisfying, income plus the certainty of the return of capital on a predetermined date. It also gives investors the flexibility to adjust to interest rates in coming years, whatever they may be.



Options 101Sooner or later, most investors realize that

the stock market doesn’t always follow the script. Good stocks don’t always advance. Bad stocks don’t always fall. Wall Street’s analysts and strategists, it turns out, have very cloudy crystal balls.

One thing is certain: This quasi-invisible force known as volatility is always lurking, threatening to disrupt the market’s delicate equilibrium.

Investors have two primary ways to respond. They can sit tight and act like long-term investors. Time tends to reward this approach, though behavioral research has shown that it is difficult to practice.

Many investors never hold stocks long enough to benefit from the fact that the market rises over time. They typically buy too late and sell too early. They routinely “greed in” and “panic out” of stocks. They hold stocks for just a few years – or worse, a few months – rather than carefully curating a portfolio over decades, which means most investors behave like salmon swimming upstream. They struggle against the stock market’s natural rhythms (and sometimes get eaten by bears).

Fortunately, they can use options to more effectively navigate the stock market. A well-placed put or call can make all the difference.

Options have been around for centuries, but the investment product has been listed on exchanges only since April 26, 1973, when the Chicago Board Options Exchange (CBOE) opened for business. Ever since, the options

market has enjoyed extraordinary growth. In 2000, for example, about 1 million options traded each day. In 2016, about 15 million options trade each day, and daily trading volume often exceeds 20 million contracts on days when the Federal Reserve rate-setting committee meets or some other major event takes place.

Who uses options? More than you might think. There’s a good chance that your mutual fund manager relies on options to manage his stock portfolio. Same for pension-fund managers, executives with concentrated stock positions, stockbrokers, registered invest-ment advisors, and even many self-directed investors.

All of these types of investors have this in common: They know that a well-placed options contract can turn the unpredictability of investing into a defined outcome.

Puts vs. callsFirst, let’s define some basic terms and concepts.

We all know that stocks rise and fall. Hence, people are willing to trade the rights to buy or sell a stock – and that is a good definition of an options contract.

All options have expiration dates. After a certain date, the contract ceases to exist. This means you have to be right on a stock’s price movement within a certain period of time to profit from an option.

There are two types of options. A call option gives investors the right to buy a stock at a certain price and time. A put option gives investors the right to sell a stock at a certain price and time.

Options

Good stocks

don’t always

advance. Bad

stocks don’t

always fall. Wall

Street’s analysts

and strategists,

it turns out,

have very cloudy

crystal balls.


An easy way to remember the difference between puts and calls is that a call gives you the right to “call in” a winning stock, while a put gives you the right to “put off” a bad stock on someone else.

Puts and calls are the basic building blocks of the options market, and they give investors extraordinary flexibility in dealing with stocks. Investors can use combinations of puts and calls to express practically any view that they have about stocks, indexes, and exchange-traded funds. But everything begins with two simple trades: buying a call or a put.

Say that you want to buy 100 shares of Amazon.com (AMZN) because you think the company is taking over the world. You use Amazon’s services, as does every-one you know, but you don’t have a spare $84,000 to buy 100 shares of the stock.

This is where options come in. A call option gives you the right, but not the obligation, to buy 100 shares for less money than it costs to buy the stock. All you have to do is determine at what price you want to buy the stock and how long you want to own the contract.

When Amazon was trading around $833, for exam-ple, it cost $81 to buy the January $900 call that expires in January 2018. You could have picked a call that expired in a few months, too, but remember – we are using options to implement conservative invest-ment goals.

Our goal with Amazon is simple. We like the stock and think it will rally higher, and we want to carve out enough time for that to happen. So we picked an expi-ration that is far out in the future to provide plenty of time, and opportunity, for the stock to advance. (Keep in mind that call owners do not receive stock dividends. That doesn’t apply to Amazon, which pays no dividend, but it does to many other stocks.)

If Amazon’s stock keeps advancing – perhaps because it keeps reporting great earnings – the call will increase in value. If the stock were to hit $1,100, the call that cost $81 would be worth $200. If you want, you can exercise the call – that is, turn it into stock – at the $900 strike price. In essence, you get to buy the stock at $900 even though it is sharply higher.

But if you’re like many options investors, you’re not

going to do that. Instead, you’re going to sell your call and pocket the hefty profit, and look for another Amazon call to trade.

Therein lies the power and attraction of options. If everything turns out how you planned, you can control stocks for a little bit of money. You limit your risk to the amount of money it takes to buy the call, without forsaking the opportunity to earn a big return.

But what happens, you rightly ask, if Amazon’s stock does not behave as anticipated when you bought the call? This is important. If the stock price is below the strike price, the trade fails and you will lose money.

Let’s take the flip side of this Amazon trade. Let’s say that many years ago you wisely (or luckily) bought 100 shares at a price of $200. You have an extraor-dinary profit that exceeds $600 a share. Yet you are worried that the stock price is so high that it will be hard for the price to rally, or that Amazon may have trouble when it releases its next few earnings reports.

But you don’t want to sell. You don’t have any better investment ideas, and you think that Amazon will keep innovating and changing how people inter-act with the world. This is where puts come into play. Investors buy puts when they want to protect stock that they own from losing value.

With Amazon’s stock at $833, you could have bought the January $750 put that expires January 2018 for $69.25. Until the contract expires, your Amazon stock is hedged. This means that if the stock price falls, the loss would be offset by an increase in the value of the put. Remember, puts increase in value when stock prices decline. So if Amazon’s stock falls to $600, the put is worth $150. If the stock never declines, the money spent on the put is lost.

Though we used Amazon as an example, not all options premiums are so expensive. Many are $5 or less. This reflects the fact that most stocks trade between $30 and $60. Also, many people pick options that expire in three months or less. When you buy an options contract with an expiration date farther in the future, you spend more money because time equals risk.

Another way to use options is to sell puts and calls to generate income on stocks that are already in your portfolio. We’ll take a look at that strategy in the next section of this book.




What to Do With CashThe average bank savings account was yielding 0.06% as 2016 came to an end. In layman’s terms, that means if you park $10,000 in a bank for a year you’ll earn enough to buy a cup of coffee or two. At a recent Barron’s conference, Mary Ann Bartels, head of portfolio strategies at Merrill Lynch Wealth Management, said her analysts had gone back to 3,000 B.C., the time of the Pharaohs, and had not found a period with rates this low. We know Barron’s readers are frustrated, especially retirees trying to live off income from their portfolios.

But we also heed the warning of the late, great financial newsletter writer Ray DeVoe, who said, “More money has been

lost reaching for yield than at the point of a gun.” This is an especially important reminder when it comes to cash that you plan to tap in the near future. If you can’t afford to lose it, consider these safe ways to get a better payout than you’ll get at your bank. In the next section we’ll also cover some higher-yielding, higher-risk invest-ment options for money you plan to keep invested for long enough to ride out market storms.

High-yield savingsDespite the lousy rates at most banks, a few, mostly online, offer a little over 1%. That’s $100 on a $10,000 investment in the first year. Still not great, but more than nothing. Ally and Synchrony banks are consistently top payers, and they are FDIC insured, so there is virtually no risk. You can find the best current rates at Bankrate.com or DepositAccounts.com. Just make sure the bank you choose is FDIC insured. Check credit union rates too. Credit unions are nonprofits operated for their members rather than shareholders and high-priced executives, so they often offer higher rates. Just make they are insured by the National Credit Union Administration, the equivalent

Income Investing

INTEREST EARNED

Savings Account ($60)

High-Yield ($1050)

CD ($2583)

$10,000 Principal over 10 years

0 105



of the FDIC.

Certificates of DepositAn equally safe place to stash cash is a CD, which pays higher rates the longer you agree to tie up your money. If you are reluctant to tie up your cash for a long time, check the early withdrawal penalty. At the time of this writing, the best rate on a five-year CD we could find was 2.3%.

If you pull the money out early, you pay a penalty of six months’ interest. So if you take it out after a year, you still earn more than you would on the top-yielding savings accounts. But if you don’t need the cash, just leave it in there, and keep getting the higher payouts. You would earn $1,204.13 in five years on a $10,000 investment. If interest rates keep falling, you’ll feel like a genius, because no one will be offering 2.3% any more. If rates spike, just pull out the cash, pay the penalty, and invest at a better rate.

Money markets If you have an investment account at a bro-kerage, it’s hard to put that cash in savings or a CD. But if you let it sit in the default money market account, you’ll earn next to nothing. As a result of new money market regulations that were enacted in response to the Great Recession, however, some money market payouts rose in late 2016. Shop around for better options. The Vanguard Prime Money Market Fund (VMMXX), for instance, yielded 0.60% at the time of this writing.

Short-term bondsShort-term bond funds offer a nice risk/reward middle ground, where for a very limited risk, you can boost your income. When the government or blue-chip corpo-rations want to borrow money for a short

period – say three, six, or 12 months – they issue bonds, which means you are lending them cash in return for a little interest. The Vanguard Short-Term Bond ETF (BSV) pays about 1.3%. The Pimco Enhanced Short Maturity Active ETF (MINT) pays about 1.4%. If interest rates rise, these funds can take a temporary dip in value, but then as they start buying new bonds with higher yields, investors benefit from the bigger payout.

Tax-free bond fundsWhen cities and towns borrow money, they issue bonds that make federal-tax-free payouts. The rates tend to be low, but hey, they are tax-free. Recently, thanks to some unusual dynamics in the world of bonds, these tax-free bonds started paying slightly more than their taxable equivalents. Consider the Vanguard Tax-Exempt Money Market Fund (VMSXX), which paid around 0.6% at the time of this writing in late 2016. Residents of high-tax states such as New York or Califor-nia should look for state-specific funds, like the Vanguard New York Tax-Exempt Money Market Fund (VYFXX), because they’ll also avoid state and local taxes as well as federal. The higher your income, the higher your tax rate, and therefore the bigger the benefit you get from tax-free investments. For example, high earners in New York would need a yield of 1.3% to pocket the equivalent of the tax-free New York money market fund.

Just remember there’s no reason to buy tax-advantaged funds in a tax-deferred retirement account such as an IRA. When you start withdrawing the money, you’ll pay ordinary income tax rates, regardless of the underlying investments.

How to Use Options for IncomeAnother way to generate income in this

zero-rate environment is to use stock options.

Investors often think of options as risky investments, but that misconception largely



reflects the media attention given to spec-ulators. Because options can be used to potentially make a lot of money on a small bet, these speculators make wild-eyed trades because they have heard investment charla-tans talk about triple-digit returns.

Often overlooked, but within the grasp of most investors, is using options to create income with conservative strategies. Selling options against stocks that you own, or want to own, for example, is a proven method for enhancing returns and reducing risk. The strategy is so simple that most brokerage firms allow people who have never traded options to start with that very approach.

You can think about selling puts and calls as generating a “conditional dividend.” What is the condition? That you are willing to buy or sell the stock if it is below or above the strike price at expiration.

Before we get into the nitty-gritty of this income-generating strategy, it’s important to define our terms. The options industry uses a lot of different words to basically describe the same, or similar, ideas. If you don’t understand the jargon, you will get confused. As we detailed earlier, everything starts with puts and calls, the building

blocks of the options market. A put gives you the right to sell a stock at a certain time and price. A call gives you the right to buy a stock at a certain time and price.

To generate income with options, we don’t buy puts or calls – we sell them. And we’re going to sell them against stocks that we already own, or stocks we want to buy. We will cover some basic concepts to help you determine which route you should take. Then we’ll walk through the various steps to show you how to generate income with options.

Most people buy stocks because they think their price will increase. The natural position of most investors is thus said to be “long.” If they were “short,” they would be betting stock prices are declining, a risky strategy since stocks go up more often than they go down, and because your potential losses are theoretically infinite. Instead, investors often buy puts to offset the risk that their stocks will decline. If stock prices decline, put prices rise.

This almost always means that put pre-miums are more expensive than justified. We don’t need to get too deep into pricing dynamics, but be aware that persistent demand for puts generally creates a “fear premium” in varying degrees at various times.

Call prices tend not to persistently trade with the same kind of premiums as bearish puts. They can, and do, trade with a “greed premium,” but for the most part calls are reasonably priced. Just as with stocks, most people buy calls because they think stock prices will rise.

Other investors, however, like selling calls to generate income or to monetize higher price targets – and that keeps the call mar-ket in a decent state of equilibrium. Fewer investors sell puts. It can be riskier if done improperly, and it usually requires more

Options Jargon

When you sell calls against stock, it is called a “buy-write,” an “over-write,” or a

“covered call.” All three terms basically describe selling a call against a stock

position. The buy-write strategy refers to buying stock and simultaneously

selling a call. The over-write and covered-call strategies describe selling an

option against stock that you already own. (Where does the “write” lingo come

from? Before options were electronically traded, brokers wrote out contract

specifications on paper contracts.)

When you sell puts against stock, it is called either a “naked put” or a “cash-

secured put.” A naked put describes selling a put on a stock that you do not

own. (The position is “naked” because the options are not “covered” by stock.)

A cash-secured put involves depositing the money, which you would otherwise

spend to buy a stock, into a brokerage account and then selling a put. The put

is secured by the cash.



money upfront – and that makes selling puts an attractive strategy to consider.

Deciding if you will sell calls or puts largely depends on your goals. If you want to potentially buy a stock at a lower price, sell puts. If you want to potentially sell a stock at a higher price, sell calls. Both trades generate income and reduce risk. The amount of income is limited to what you receive for selling the option. The money received also partially hedges the stock.

Now let’s focus on two widely used strat-egies: selling calls against stocks you own, and selling puts against stocks you want to buy. These are examples of the over-write and the cash-secured put.

The over-write is used by a wide range of investors, from mutual fund managers to individuals. It’s popular with money manag-ers who tend to have price targets on every stock that they buy. In other words, smart investors have already set a sale price when they buy a stock. If they bought a stock at $20, they could have a $30 sale price. In that example, they would systematically sell $30 strike calls against the stock to enhance income – effectively getting paid for owning the stock.

The over-write is such a mainstay strategy that options that expire in three months are often said to form the buy-write market. It is here, three months into the future, that prices are often the best and liquidity often the deepest. Investors will still do just fine at closer expirations, and even more-distant ones, but three months out is a market sweet spot.

The standard income-generation trade is selling options that expire in three months and that have strike prices 5% to 10% higher than the current stock price. Other inves-tors sell calls that expire weekly, reasoning that they can make more money repeatedly

selling calls, but that is an approach best left to more seasoned traders.

A good rule of thumb is selling only options that are priced at $1 or more. It is also important to understand that you may miss out on a big rally if you sell calls against a stock. This is the principal draw-back to the strategy. In the market, anyone who has a hot stock called away from them is said to experience “upside regret.”

Let’s use Alibaba Group Holding (BABA), the Chinese Internet retailer, as an example of how an investor might over-write a stock position to generate income. When you sell a call, you are telegraphing to other inves-tors that you think the stock is not likely to advance. If it does advance, you are willing to sell at the strike price. In other words: Don’t sell calls on stocks you are not willing to sell.

In late October 2016, when Alibaba was at $103.94, an investor could sell the January 2017 $110 call for $3.75 or the January $115 call for $2.31. Both premiums are attractive, so how do you pick?

If you are confident the stock will not rise above $110 by January, or you are willing to sell at an effective price of $113.75 (strike price plus the premium received for selling the call), pick the January $110 call. If you want to put more space between the stock and strike price, sell the January $115 call. If the stock never advances above the strike, the money received for selling the call can be kept. If the stock surges, you must sell the stock or cover the call – that is, buy it back – at a higher price.

When you sell a call, you are essentially saying that you do not think a stock price will rise above the call strike price. Some-times this works out beautifully, and you simply pocket the money that you received for selling the call and collect a nice income.

But sometimes the unexpected happens – and this is why you should never sell call options on stocks you are not willing to sell. Sometimes the stock that you thought was



stalled rallies higher. If this happens, you have two choices. You can simply let the stock be “called away” at the strike price, or you can buy back the call. If you buy back the call, the value will have increased, perhaps dramatically, because the call is suddenly “in the money,” that is, valuable and in demand.

The options premium, to be clear, rep-resents the income. Because each options contract represents 100 shares of stock, mul-tiply the call premium by 100. So the $3.75 premium received for the January $115 call is actually $375.

Whenever you trade options – and this applies equally to puts and calls – you must take time to understand what stock-centric events are covered by the expiration date.

Events move stocks. Events represent risk. Events represent opportunity. You must have a view of how a stock might respond to those events before trading options. After all, options do not exist in their own world. They are derivatives, and they derive their value and life from the associated stocks, their sectors, and the broader market.

Alibaba’s January 2017 expiration, for example, covered its earnings on Nov. 2, its Singles Day global shopping extravaganza on Nov. 11, and the lead-up to its late-January earnings. The choice for investors was to decide if the premiums, which were substan-tial, were meaningful enough at a time when several events could have caused the stock to rally and forced call sellers to part with the shares or buy back the call at a higher price.

You may have bought into Alibaba at a sharply lower price, and having the stock called away might be just fine. The answer is ultimately personal. Always remember that options trades are the sum of many parts.

Now, let’s flip this whole equation around. There’s nothing wrong with selling calls. It’s probably how most investors get their feet wet in the options market, but selling puts is one of the greatest strategies in existence

– provided you remain properly disciplined, and capitalized.

If you were to quiz investors who reg-ularly use options, you’d find that most routinely sell puts. Why? Selling puts lets investors monetize the fear of other inves-tors. It is such a seductive strategy that many pension funds and major institutional investors routinely sell puts to generate income. The risk – which can be managed – is that you must be willing to buy the associated stock if the price drops below the strike price. If you sell a put with a $30 strike price, and the stock falls to $10, you must buy the stock at $30 or cover the put – that is, buy it back at top dollar.

When you sell a put, you are essentially saying that you do not think a stock price will decline. In fact, some strategists believe that selling puts is the single most bullish options trade that exists. So you should never sell put options on stocks you are not willing to buy. Sometimes, the stock that you thought was ready to rocket higher actually plummets. If this happens, you have two choices: You can let the stock be “put to you” at the strike price, or you can buy back the put. If you buy back the put, the value will have increased, perhaps dramatically, because the put is suddenly in the money.

For this reason, many investors incor-rectly think that selling puts is incredibly risky. They are not entirely incorrect, but they are glossing over a nuanced subject. If you sell “naked puts” – puts not covered by a stock – you are indeed taking on a great deal of risk.

Just consider the previous example. If the stock sinks, you will be on the hook for a lot of money to cover the put. This is what’s called “downside regret,” and you will feel like the world is collapsing upon you. Some-how, it seems the entire market knows when



you are short, and it seems that everyone rises up to make life extra-difficult. The way to get around this is simple: Make sure you have enough money in your brokerage account to actually buy the stock, which is the definition of a cash-secured put.

This cash-secured put strategy works well on stocks that investors want to buy on pull-backs. Many investors sell puts that expire in three months or less with prices that are 5% to 10% below the associated stock’s price.

Back to Alibaba. Let’s say that you’ve watched in wonder as the stock has defied an army of skeptics, rising some 28% in 2016 through Oct. 31, about four times more than the Standard & Poor’s 500 index. You’ve done your research and you have a good sense of the events that are packed into the January 2017 expiration.

With Alibaba’s stock trading just below a 52-week high, you are concerned about paying top price. What if Alibaba’s earnings aren’t that great, and the stock declines? What if China releases bad economic data and the stock plummets? To reshape that risk, and potentially pocket some added income, you can sell cash-secured puts.

When the stock was around $103.80, Alib-aba’s January $95 put was bid around $2.78, and the January $97.50 put was bid around $3.55. If the stock keeps advancing, you can keep the put premiums.

Ideally, the stock is just below the put strike price at expiration, and then rockets higher. That would allow you to buy the stock at an effective price of $92.22 if you sold the $95 strike.

The key risk to selling puts – and you should keep this thought running in a loop in your brain – is that the stock falls far below the put strike price. But this is the magic of the cash-secured put write. The risk is actu-ally identical to buying stock. As expiration

approaches, the loss on an in-the-money put increases dollar-for-dollar with the decline in the underlying shares. What else declines dollar-for-dollar with a drop in the underly-ing issue? A long position in the underlying stock does. Thus, the downside is the same.

You might think that selling puts and calls to generate income is esoteric. If you reg-ularly sell puts and calls for that purpose, you might even be a little annoyed that one of Wall Street’s great secrets is getting this kind of attention. But the fact is that one day it is possible that no investor will ever buy a stock without first selling a put, or sell a stock without also selling a call.

In May 2016, Morningstar, which millions of individuals rely on to evaluate mutual funds, created a category for options-trad-ing funds that consistently sell puts and calls as part of their main strategy. The classification essentially represents a Good Housekeeping Seal of approval on the income-generation strategy, which should help it gain even broader approval.

In addition, many mutual funds are chang-ing their investment charters so that their managers can use options to reshape risk and generate income. Pension funds are also increasingly using options. Since the finan-cial crisis, some of those massive funds have fired stock managers and instead invested in funds that sell puts and calls. Meanwhile, two of the world’s largest financial firms, Goldman Sachs Group and BlackRock, have started telling their clients that options should be considered assets just like stocks and bond.

What is the strategy both of those firms recommend? Selling puts and calls.

One word of warning: By definition, options involve a lot of short-term gains. That means a tax hit, especially for inves-tors in the top brackets. One way to avoid the problem is to use options strategies in tax-advantaged accounts.



Liquid Alternatives

Beyond Stocks and BondsInvestors, like generals, are sometimes guilty of preparing for the last war. So far this has been true of the increasingly popular category of mutual funds known as liquid alternatives, which has attracted more than $300 billion in assets. The liquid alt label has been slapped on a broad range of strategies, but the basic idea is to provide downside protection, even if that means giving up gains in bull markets. Many of these funds were launched in the wake of the 2008 market crash. As of this writing we’d been in a fairly strong bull mar-ket for seven years, so while these funds don’t have a great track record, they also haven’t been given much of an opportunity to prove themselves.

Alternative strategies can include a simple long/short approach, in which a fund man-ager buys stocks he likes and bets against those he doesn’t, or something as esoteric as currency plays or as downright mystifying as managed futures. A glance at Morningstar’s report on fund returns by category shows middling numbers for liquid alts, with most returns over the past three years between 2% and -1%. They also tend to have fairly high expense ratios, leaving less for investors.

Before investing in any of these strategies, the first question to ask is what you want an alternative to do. Then ask, could you achieve similar results more cheaply by simply building a portfolio of stocks and bonds? One argument in favor of alternative strategies is the extremely low yields on bonds. Inves-tors get little upside if rates stay low, and the value of their bond portfolio will fall if yields spike. That, admittedly, is a lousy risk/reward proposition, and could lead investors to search for funds that will fulfill the tradi-tional bond role of portfolio shock absorber while also offering some upside.

Here’s a look at a few of the main categories of liquid alts.

MultistrategyIf you’re going to go with just one alterna-tive fund, this is probably the right category. It’s also sometimes referred to as multi-asset or multi-alternative. While there are many flavors under this banner, those managed by multiple managers tend to offer the biggest diversification benefits.

Not to be confused with funds of funds, which bundle pre-existing funds, a multiman-ager fund is typically a portfolio of separate accounts. This helps keep fees in check, gives the manager more control, and provides individual subadvisors with more leeway

The basic idea

of liquid alts is to

provide downside

protection, even if

that means giving

up gains in bull

markets.


to run their strategies. Look for a fund that works with outside subadvisors who have expertise in their respective niches.

Many of these funds give investors access to vet-eran hedge fund managers and strategies not avail-able in a mutual fund format. That’s the case with the Litman Gregory Masters Alternative Strategies fund (MASNX), which works with outside managers specializing in different strategies, including merger arbitrage and nonagency mortgage-backed securi-ties. Launched in 2011, it aims to deliver equity-like returns with lower volatility, and returns have ranged from 9% in 2012 to -1% in 2015, beating its peers every year.

Long/shortManagers of these funds take positions in stocks that they (or their algorithms) like and bet against stocks that seem overpriced. If those shares decline, the funds make money. Many people use this strategy simply as a stock investment that will hold up better in bear markets.

Long/short funds can vary greatly by style, process, asset class, and sector. The range of outcomes can be extreme, depending on the amount the portfolio is long versus short, known as its “net” exposure; the amount of money it has borrowed to short the stocks; and its particular strategy.

Market-neutralThese funds also short stocks, but they aim more at muting market risk than typical long/short funds do. They’re also typically quantitative funds; in other words, an algorithm – not the manager – is choosing which stocks to buy and which to short. Market-neu-tral funds attempt to deliver consistent, though not shoot-the-lights-out, returns, regardless of what the broad market is doing. Morningstar classifies funds as market-neutral if they have “beta” at or below 0.3%. Beta is a measure of volatility – a beta of 1 means that a stock moves in concert with the market, a beta of zero means it has no correlation.

The $1.9 billion Vanguard Market Neutral fund

(VMNFX) uses quantitative models to score stocks based on fundamental factors, such as valuation and growth, relative to their peers. Its long-term returns (2.7% a year for 15 years) are modest, but it has held up much better than the market in times of turmoil. It was down 8% in 2008 when the market plummeted, and up 5% in 2015 when the market was up just 1%. The fund’s low 0.25% expense ratio is unheard of in this group.

Other funds in this category focus on mergers and acquisitions as a way to pick up modest returns in any kind of market. The $1.6 billion Merger fund (MERFX) takes advantage of price differences that come up in the process of a merger, spinoff, or similar corporate restructuring. The fund is designed for stability. Its average annual return over the past 15 years is 2.8%; in 2008, it was down just 2.3%.

Managed futuresThese funds are insurance policies. If disaster doesn’t strike, you’ll make a little money – low-single-digit returns after accounting for their typically high fees – but their real value is their ability to hold up in a sus-tained downturn. That doesn’t mean investors won’t ever see red. Often these funds are designed to hedge against a 20% drop in the market, not the first 5%.

Managed-futures funds typically trade options in markets around the world and across four major asset classes – equity indexes, government bond futures, currencies, and commodities. Most use a strategy called trend following, betting that there will be more of the same. If the market is moving up, they’ll have a long bias; if it’s falling, they’ll be short. When the market is fickle, managed-futures strategies tend to lag or lose money in the short term, until a clear trend emerges.

One final pointBased on recent history, liquid alts don’t look like a good option for most investors. If you goal is to preserve your cash, you can do that with a low-fee short-term bond fund or cash. You won’t see much return, but then liquid-alt investors haven’t seen much either. In the meantime you won’t lose money to fees and you’ll have dry powder to buy stocks during the next crash.BARRON’S BUILDING WEALTH

46



Among the 60+ set, there may be no sexier come-on than “guaranteed lifetime income.” After investors have spent decades saving for retirement, devising a plan to spend that money without it running out becomes a hot pursuit.

Yet the same army of Baby Boomers – and many if not most financial advisors – who swoon over the thought of guaranteed lifetime income are often loath to consider the one financial product that elegantly delivers just that: an annuity. In one recent survey, just 15% of folks in or near retirement placed a high value on annuities.

With plenty of good reason. Stripped down to its core value, an annu-

ity is an insurance policy. You fork over a chunk of money to an insurance company and choose when the income payments start. You can fund an annuity over time, with periodic investments; many 403(b) retirement plans offer an annuity as an investment option. If you want payments to start immediately, you can purchase a single premium immediate annuity (SPIA). Another option is to purchase a deferred-income annuity, also known as a longevity annuity, where you delay when you start the payouts. You can wait a year or two, or a decade or two or three. The longer you defer, the higher your payout will be when you do begin to receive monthly income.

Fixed-index annuities – also known as equity index annuities – give you a payout that will capture a small portion of any stock market upside, without any downside. Variable annuities are sold more as an investment than an insurance product. Premiums are invested in mutual funds you choose. The future value of your payouts is tethered to how well your variable portfolio performs.

There are lots of options, and that’s where the frustration and confusion can set in. The problem is that the insurance industry has been hell bent on turning this “simple” insur-ance product into a convoluted morass that often mixes a basic insurance contract with different types of investment-linked options that add complexity and cost. That leads to the first rule of an annuity purchase: Think of annuities as insurance – for instance insur-ance against outliving your savings. Don’t think of annuities as investments.

If you want to invest money today that can provide income in the future, a portfolio of low-cost index mutual funds or ETFs can be much cheaper than investing in a variable annuity, where the annual cost for the insur-ance and the underlying mutual funds can top more than 2%.

Fixed-index annuities have been selling like hotcakes of late, thanks to an alluring prop-osition (read: “sales pitch”) that your money will grow along with stock market gains, but with no downside. But in fact, your upside is capped at just 3% to 4%. That’s not noth-ing, but it’s far below what the market has

Annuities 101

Stripped down

to its core value,

an annuity is an

insurance policy



delivered over most historical time periods. And, importantly, it’s a fact often not clearly called out by less scrupulous agents on the prowl for the higher commissions paid for many annuities that combine insurance with investing. “There is a direct correlation between commissions and the complexity of how a given annuity works,” warns annu-ity specialist Stan Haithcock, aka Stan the Annuity Man.

Even the experts can be flummoxed when they try to unpack how some invest-ment-linked annuities work. David Blanch-ett, Morningstar’s director of retirement research, has earned both the Certified Financial Planner and Certified Financial Analyst designations. Yet he recalls after wading through a prospectus of hundreds of pages he still had questions about a partic-ular annuity. The two people he spoke to at the insurer gave him differing information. “If they can’t explain it to me, as an expert, it’s hard to see how an individual will be able to figure it out,” says Blanchett, whose Ph.D. dissertation included work on the value of annuities.

Value Without the Risk Now that we’ve gotten the warnings out of the way, here’s the good news: There are some very straightforward, plain-vanilla annuity products that deliver great value – fixed payments guaranteed for life – without the landmines.

And if you’re on the fence because you aren’t comfortable with forking over con-trol of a chunk of your retirement savings, rest assured that you can purchase a “cash refund” or “return of premium” option on many policies that will pay back your benefi-ciaries any portion of your original premium that hasn’t already been paid out to you when you die. For a price, of course.

For example, New York Life says 73 is the average age when people purchase an immediate fixed annuity. (Immediate means your payouts start right away.) At that age, a male who pays a $100,000 premium and isn’t concerned about a refund would qual-ify for a $670 monthly guaranteed payout for life based on recent interest rates. If he wants the “cash refund” option, however, the payout would be about $100 less a month.

One important point to consider before buy-ing an annuity: “Make the most of the annuity you already have,” says Blanchett, referring to the fact that Social Security retirement benefits are at their essence an annuity. You get paid for life. And there’s a very valuable annual cost-of-living adjustment built into the deal. Delaying when you start to receive Social Security entitles you to a higher bene-fit. Each year you delay between age 62 – the youngest age you can collect Social Security retirement benefits – and age 70 entitles you to a guaranteed higher payment.

Annuities you purchase can then be a valu-able piece to add to your retirement income puzzle. “It doesn’t have to be confusing,” says Haithcock. “You need to answer two questions: What do you want your money to contractually provide you, and when do you want the contract guarantees to start?”

That often comes down to two scenarios. One popular use of annuities is to fill

in any gap between your expected retire-ment living expenses and what you can expect from Social Security and perhaps an old-fashioned pension. For instance, let’s say you estimate your living costs will be $4,000 a month and your Social Security and pension income will bring in around $3,500 a month. Adding an annuity that will provide $500 a month in guaranteed income means you can sleep better knowing your basic needs are taken care regardless of market gyrations.

Bonus: Knowing that your basic needs are covered gives you the freedom to be more aggressive with your remaining investments.



A single-premium immediate annuity (SPIA) is one option if you are retiring today: You hand over money to the insurer and the checks start coming right away. You can also purchase a fixed annuity where the payouts begin at a future date. Immediate annuities.com provides free quotes.

David Littell, a professor at The Ameri-can College of Financial Services, says even arcane fixed-index annuities that come with an income rider can be a smart solution to round out the income you want to cover your basic living expenses. But it’s imperative to work with a financial advisor (who does not receive commissions) who will run the num-bers and make a recommendation based on what is best for you, not what pays the high-est commission. And stick to the big-name insurers. State insurance guaranty funds serve as a backstop if an insurer falls into trouble, but you don’t want to have to deal with that. (Check Barron’s annual ranking of the Top 50 Annuities.)

Prospering While Living Long Annuities can also be a great hedge against what financial planners call longevity risk. The rest of us call it “living so long you run out of money.” After years of diligent saving you may be plenty confident your portfolio can support you for at least 20 years. But if the idea of it supporting you for an extended retirement of 25 or 30 years gets you antsy, a deferred-income annuity (DIA) can be a smart solution.

As the name implies, with a DIA you make a premium payment today and delay when the payouts begin. The value of later-life peace of mind (for you and your children) comes with a reduced price tag. For example, a 65-year-old woman who buys a $100,000 immediate annuity would be paid about $500 a month for life (plus a cash refund for her heirs). But if she wants to insure against the cost of living an extra long life, a deferred-income annuity might be a better product. If she spends $100,000 on

a DIA at 65 but doesn’t start collecting until age 80, the payout would be about $1,900 a month. If she delays until age 85, she would get a monthly check for about $3,200.

Needless to say, there is a possibility you won’t live long enough to take out as much as you put in. That’s why it is important to now think of these annuities as insurance, rather than investments. You may not collect on a homeowner’s policy either if your house doesn’t burn down, but that’s not a reason to forgo the insurance.

If a longevity annuity sounds appealing, consider purchasing one with money from your 401(k) or Traditional IRA, which has extra benefits thanks to a 2014 change in tax law. A Qualified Longevity Annuity Con-tract (QLAC) allows you to use up to 25% of your retirement pot (up to a maximum of $125,000) to purchase an annuity where pay-ments don’t have to begin until age 85. Some investors will like the fact that the QLAC premium reduces the size of your retirement pot that is used to calculate your required minimum distribution at age 70½.

The actual payout of any annuity is based primarily on your life expectancy. But inter-est rates also play a role. Higher rates mean the insurance company gets a better return on your money (and you have more attractive income options), so the monthly payouts rise.

Since as of this writing interest rates appear to be heading higher, there’s a good case to be made for not going all in on an annuity immediately. Instead, use dollar-cost averaging and purchase contracts over a few years. That way, if rates rise, you’ll get at least some of the benefit as payouts increase.

“There’s no magic age or time at which to purchase an annuity,” says Littell. “If you have the money to lock in guaranteed income, now is always a good time to buy yourself peace of mind.”


Glossary

Active management: An investing approach where the portfolio manager makes specific investments on an ongoing basis with the aim of outperforming a benchmark such as the Standard & Poor’s 500 or the Barclays U.S. Aggregate Bond Index.

Annuity: An insurance policy that entitles investors to regular payments over time, typically for the remain-der of their lives.

Alpha: In academic portfolio theory, alpha measures the extent to which the return of a portfolio varies from its expected return. A portfolio is expected to return what the market returns multiplied by its sen-sitivity to the market, in essence, its risk vs. that of the market. The latter measure is called Beta. Alpha is used to measure the value added by the portfolio manager.

American Depository Receipt (ADR): A vehicle for buying and selling non-U.S. equities. An ADR is a tradable receipt certifying that the underlying shares are on deposit at a bank in the issuing company’s home country.

Asset allocation: The division of investment dollars among different asset classes.

Asset class: In general, a related group of assets (things of value) or securities. In addition to financial assets such as stocks and bonds, asset classes (and subclasses) include real estate, precious metals, jew-els, artwork and collectibles.

Appreciation: Growth in the value of an asset as measured by its selling price. Used in distinction to income.

Basis point: One one-hundredth of one percentage point. If, for example, the market goes up by 1.5% and a portfolio goes up at the same time by 1.6%, the portfolio has outperformed the market by 10 basis points.

Beta: A measure of an investment’s volatility, the degree to which its price has varied relative to the price of the relevant market. Beta is extremely sensitive to the time period for which it is measured. Thought by many portfolio theorists to be the best measure of risk.

Bond: A tradable security recording the terms and conditions of a loan made by an investor to a borrower.

Capital: An asset, usually money, that is invested or put at risk for future gain.

Capital gain or loss: An increase or decrease in the sale value of an asset.

Cash flow: Cash and equivalents received or spent by a company during a given period. In a financial report, the income statement is designed to show whether a company would have been profitable if its revenue had matched neatly with related expenses during a given time period, whereas the cash flow


statement shows actual money that changed hands. The first tells a story about growth. The second pro-vides a check on whether collections are timely and financial strength is improving.

Certified Financial Planner (CFP): A professional des-ignation for financial advisors, aimed specifically at the discipline of financial planning. Advisors must complete a CFP Board-approved educational pro-gram, including coursework, an exam, and continuing education.

Closed-end fund: An investment that issues a fixed number of shares in an initial public offering, which then trade in the secondary market. Prices of closed-end funds’ shares can diverge from their net asset values, occasionally to trade at a premium but more often a discount. CEFs frequently use leverage – bor-rowing money to buy more assets – to boost returns.

Commercial paper: Negotiable short-term corporate debt, usually 90 days or less.

Common stock: A share of ownership in a company.

Consensus estimate: The average of analyst predic-tions for a company metric, like earnings per share, for a future period, such as the next quarter or the current fiscal year.

Convertible: A bond or debenture (a bond backed by specific collateral) that can be converted under stated circumstances to equity or a preferred stock than can be converted to common stock.

Cost basis: Usually what an investor paid for a security which, subtracted from the selling price, represents the capital gain or loss. In an estate, the value of the asset on the date the estate came into existence calculated in one of several ways.

Coupon: The fixed periodic interest paid by a bond, so called because bonds once were issued with detachable interest coupons that could be deposited in a bank as they came due.

Discounted cash flow: The projected cash flow from an

investment, discounted for the time value of money. Used to estimate a fair price to pay today, which can be compared with the actual price.

Dividend: A distribution to a company’s shareholders. Quarterly cash payments are common, but dividends can also be paid semi-annually or annually and in the form of stock.

Dividend reinvestment: A program through which cash dividends are automatically used to buy more shares of the stock or fund.

Dollar-cost averaging: An investing approach in which you regularly (typically monthly or quarterly) buy a given investment. By this approach you end up buy-ing more shares of the asset when the price is lower and fewer when its price is higher.

Efficient Market Theory: The idea that stock prices quickly and accurately reflect all available informa-tion that could affect them. The corollary to this idea is that you can’t beat the market. EMT comes in several flavors of rigor and is the basis for the belief that, in the long term, investors are better off buying index funds rather than trying to outperform the index.

Equity: In finance, ownership. Holders of equity provide the risk capital that is committed to the business and, in turn, own the assets of the corpora-tion after its liabilities have been discharged. There are several kinds of equity, including common stock, preferred stock, non-voting but which has a priority claim on dividends, and preferred convertible stock, which can be converted into common stock.

Exchange-traded fund: An investment fund that is traded on an exchange, typically consisting of a bas-ket of stocks or bonds.

Face value: The amount a bond will pay back at maturity, also called its Par Value. Not to be confused with the par value of stock, which is usually an insignificant amount used for account-ing purposes. Bonds are often bought and sold at a premium or discount from face value. Interest is


stated as a percentage of face value, but yield is the percentage you actually earn on what you pay for the bond.

Financial ratio: One financial value expressed relative to another. A price-to-earnings ratio of 25 means that the price of one share of the stock is 25 times the company’s earnings per share over four quarters, either past or projected.

529 plan: An education savings plan operated by a state or educational institution, with tax advan-tages to make it easier to save for college or other post-secondary education.

Fixed income: In investing, used to describe bonds or other instruments that pay fixed rates of interest over stated time periods.

401(k) plan: A common type of defined contribution savings plan that forms the basis of the retirement programs of many eligible workers. The employee may put aside part of his or her salary before taxes up to a certain maximum each year. The employer may also make a contribution. The assets appreciate tax free until they are drawn down at retirement. Many plans have features that allow participants to borrow money without paying taxes. A 403(b) plan is similar but is restricted to employees of non-profit, tax-exempt organizations. A 457 plan is restricted to state and municipal workers and is often used as a supplement to a defined benefit pension plan.

Fundamental analysis: A method for determining the actual value of a company’s equity and the degree to which that value is reflected in the current price of the stock. The basic methodology of the value investor.

Futures: Contracts that obligate the holder to accept delivery of a specified quantity of a commodity or other item at a specified future time.

Future values: The final compounded value of a series of prior cash flows. Used, among many other things, to calculate the final value of periodic investment program: How much will you have after 10 years

if you save $100 a week at 5% annual compound interest?

Growth investing: An investing methodology that looks for companies whose sales and earnings are expected to increase at a faster rate than that of the market average or the average of their peers.

Growth at a Reasonable Price (“GARP”): An investing approach that combines elements of value and growth investing, seeking to buy companies whose prices don’t fully reflect their solid growth prospects.

Hedge fund: A limited partnership created to invest in various markets often using considerable leverage. So-called because traditional hedge funds used deriv-atives of various kinds to hedge risk.

Income: Payments, usually periodic, received from interest and dividends.

Index: A basket of securities used as a benchmark for the category. For example, the Standard & Poor’s 500 index is used to track the stock performance of large U.S. companies.

Index fund: A mutual fund designed to mimic the per-formance of an index.

Individual Retirement Account (IRA): One of several types of accounts designed to encourage people to save for retirement and other major expenses by exempting any earnings from income tax until withdrawals are made. A regular IRA may be funded with pretax dollars if the investor has no other retirement plan or earns less than a given amount. A Roth IRA is funded with after-tax dollars but approved withdrawals are not taxed.

Leverage: Increasing one’s exposure to an asset by borrowing. Stocks may be bought on margin, a transaction in which the broker lends the investor up to 50% as collateral. Thereafter, the account must stay above a maintenance level of collateral, no lower than 25% for stocks. A stock decline could result in a margin call, where the investor must add cash or securities or else sell at a loss.


Limit order: A buy or sell order to be executed at a specified price or better.

Limited Partnership: A company organized to under-take specified kinds of investment programs, usually for a defined period of time such as 10 years. The general partner organizes, manages and administers the investments in return for a fee. Limited part-ners purchase participation units from a broker or other intermediary. Limited partnerships have fewer disclosure requirements than mutual funds and are usually much less liquid.

Liquidity: The ease with which an asset can be con-verted to cash. Listed equities are highly liquid while mutual funds are only slightly less so.

Market capitalization: The total value of a company’s outstanding common stock. In other words, the value placed on the company by investors.

Market order: An order to buy or sell stock, to be exe-cuted immediately at the current market price.

Master Limited Partnership (MLP): A publicly traded limited partnership that has two classes: limited partners and general partners. Investors who buy MLP units become limited partners. MLPs are known for their high payouts, which are a result of the partnerships’ tax-advantaged structure. MLPs distribute a high percentage of their profit to share-holders, who are able to defer much of the tax owed on distribution. The vast majority of MLPs operate in the energy and natural-resources industry.

Modern Portfolio Theory: An investing approach that stresses the trade-off between risk and reward and creating optimal, diversified portfolios based on esti-mated long-term returns for a given amount of risk.

Money-market fund: A mutual fund that invests in low-risk, short-term securities such as U.S. Treasury bills and commercial paper, with the goal of main-taining a stable share price.

Mutual fund: An investment type that pools investors’ money into one fund to purchase stocks, bonds, and

other securities. The price of the fund, known as the Net Asset Value, is determined by the total value of the securities in the fund, divided by the number of shares outstanding.

Options: An option contract enables the holder to buy or sell a fixed quantity of a security at a set, or strike price, within a specified period. A call gives the holder the right to buy the security, while a put gives the right to sell the security within the speci-fied time. Strategies vary widely in risk. For exam-ple, some are meant to generate extra income from stock portfolios, while others are used for all-or-noth-ing bets on share price movements.

Passive management: An investing strategy that tracks a market index or other benchmark.

Preferred stock: A hybrid investment instrument, com-bining elements of stocks and bonds, that allows the holder to receive a fixed dividend. If a company fails, holders of preferred stock have priority over the com-pany’s assets relative to holders of common stock.

Present value: The current value of an investment that matures in the future, after discounting the expected return at an assumed rate of interest and adjusting for the probability of its payment or receipt. The rate of interest assumed may be any current rate or any required rate of return.

Price-to-book ratio: The ratio of a company’s stock price to its book value, i.e. the net value of assets on its balance sheet.

Price-to-earnings ratio: The ratio of a company’s stock price to its earnings per share over four quarters, past or projected.

Put option: A type of option that gives the holder the right to sell a security within the specified time. The seller of a put typically expects the price of the underlying stock to hold above the striking price, enabling him to profit from the premium obtained without having to buy the stock.

Real Estate Investment Trust (REIT): A type of security


that invests in real estate and passes the profits on to shareholders as income. Many REITs trade on exchanges.

Registered Investment Advisor (RIA): An independent financial advisor. RIAs are governed by the SEC and by the fiduciary standard, meaning that they are legally obliged to look out for their clients’ best interests.

Risk tolerance: An investor’s willingness and/or ability to accept risk.

Robo-advisor: A service that provides automated financial advice based on algorithms, with little to no human input.

Screen: A tool for searching through large numbers of companies to isolate those meeting one or more specified financial criteria.

Secondary market: An exchange or other mechanism for trading securities following their initial issuance.

Striking price: The price at which an option can be exercised.

Target-date fund: Asset-allocation funds that are designed to be a complete, one-stop investment. These funds invest in stocks and bonds and some-times other assets, gradually shifting the mix toward a more conservative allocation as they near the “tar-get” year in its name. Investors choose a fund closest to their expected retirement date, whether five, 10, or nearly 50 years out.

Technical analysis: A method of studying past trends and patterns in share price movements and trading volume to predict future returns.

Value investing: An investing approach that tries to identify stocks that are temporarily underpriced by the market. The idea is that current perceptions about the stock do not reflect its potential and that eventually the market will recognize the company’s true value.

Venture fund: A limited partnership set up to invest seed capital in private startup companies. Some such funds specialize in given industry sectors, others in different stages of financing.

Wash sale: A sale of a security, usually stocks, to establish a loss for tax purposes, followed by a repurchase of the same stock. If a stock is sold at a loss, investors must wait a minimum of 31 days before buying it back if they want to deduct that loss on their tax return. They also can’t buy more of the same stock less than 31 days before they sell their current holdings for a loss.

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