AskDong

Sorry to any readers who may have been inconvenienced yesterday. I upgraded from version 2.1 of Wordpress to 2.6. This upgrade was not quite as easy as my last upgrade, almost all attributable to the fact that I skipped over a few different iterations. The takeaway lesson is to upgrade more frequently. I was inspired to make this upgrade in order to use the WordPress app on my iPhone. While I don’t want to get to technical as it interest nobody but myself, I was surprised how the information available to solve the problem was less than stellar regarding what seemed like a common problem.

My Wordpress Categories Dissapearred!
Somewhere between WordPress 2.1 and WordPress 2.6, Wordpress got rid of the wp_categories table and replaced it with wp_terms, and wp_terms_taxonomy. Plunging directly into the belly of the beast (i.e. myPhpAdmin), I found that while my ids were there and correct, all the names and descriptions were gone. As a result I had to “manually” update all the rows with the right information. When I did a google of the problem, I found what I needed to know. But with all apologies to David Cumps, his solution of manually editing each category didn’t fly with me. I have too many categories, and I am fundamentally a lazy person. However, I credit his solution to pointing me to the root of problem and what I needed to do. I did have the backup logs for my database, and by using them and some excel string parsing I was able to create update statements for wp_terms and wp_term_taxononomy that hopefully has fixed the problem. Now, if I can only get my category cloud back…

In the last part of this series, I covered what stock was. Today I cover Mutual Funds. While mutual funds are actually more complex conceptually than stocks, they are also a more appropriate investment vehicle for beginner investors.

Most people have heard of mutual funds, and a good percentage understand the basic concept behind them. Mutual funds are investments that pool together money from many different investors to purchase stocks, bonds, and other assets. Conceptually a mutual fund is not so different from getting 50 of your friends together to put in some amount and handing it over to one friend to make all the investment decisions. The benefit is diversification, and simplicity. For example let’s say I had $120 to invest. I could take that $120 and buy one share of Apple Computer stock, or buy nearly one share of the Vanguard 500 Index Mutual Fund (VFINX). In the case of the former I would have all my money riding on the future of one company, and in the latter I would be diversely invested across the 500 different companies that make up the S&P 500.

Comparing the performance of AAPL and the S&P 500 over the last three months, the advantage of diversification is clear.

Chart courtesy of BigCharts.com

The benefit of diversification is not higher returns, but lower risk. Risk in the investment sense is the high probability of negative returns. Investing in single stock can bring great returns as the case with AAPL over the last 5 years, however at at given time a single stock can also decline dramatically as AAPL shares have done over the last two month. AAPL has declined by well over 30%, while the S&P 500 is only down a little over 5%. Generally speaking the greater the risk, the greater the potential gain and loss. Diversification can lead to better returns without carrying as much risk.

Mutual Funds structurally can be broken into two types:

• Close Ended Mutual Funds - These Mutual funds take in money from investors and then close to fund to outflows and inflows. They trade like stocks with a value that might be above or below the actual value of the assets the fund owns.
• Open Ended Mutual Funds - These funds are open and can take in new funds and sell assets to fund redemptions. The fact that a fund may be Open Ended does not mean the fund is open to new investors. Often times mutual funds companies will close a popular fund to new investors to prevent the fund from growing to a unwieldy size. Closing a fund in such a manner does not make the fund close-ended as current investors are allowed to both buy and redeem shares. Open ended fund are brought at sold at what the underlying assets are worth on any given day. Each day a N.A.V. (net asset value) is caculated and that’s what shares of the fund can be purchased or sold.

What a mutual fund actually invests in varies widely depending on the mission and stated purpose of the fund. Categorically however funds can be broken in two broad categories:

• Index Funds - Index Funds track different Indexes such as the S&P 500, the Wilshire 5000, the Morgan Stanley Emerging Market Index, and many more. There are generally speaking no investment decisions to be made as the purpose of the fund is to merely own the assets that compromise the index.
• Actively Managed Funds - Actively managed funds buy and sell assets on the whim of the portfolio manager(s) in charge. That said many actively managed funds have stated purpose and restrictions that are incorporate into the bylaws of the mutual fund. For example the Prudent Bear Fund, BEARX, is a bear market fund which means it tries to make money by betting the market will fall. It’s stated purpose is capital appreciation through mostly short selling equities.

Mutual Fund Expenses
So what’s the catch? Mutual funds are a great tool for investors to quickly diversify and somewhat simplify the ongoing decision making. It’s easier to pick a few funds than to engage in active trading of different stocks. For this service, mutual funds charge a little something off the top - they charge a percentage of the amount invested. Index Funds such as those run by Vanguard and Fidelity charge very little, less than .15% a year, while actively managed funds can charge easily in excess of 1% annually.  In addition some open ended fund charge a sales comission (called a load) on purchase while some charge that load upon sale.

There’s understandably a great deal of confusion on the subject of inflation and some of it’s measurements, CPI (Consumer Price Index) and core CPI. I think we all know inflation when feel the pinch of it on our wallets. Houses prices have gone up. As have food and gas prices. Yet those prices are not considered a part of core CPI. Funny considering food, shelter, and transportation are the core expenditures for most households.

What we typically think of as inflation is not the same thing that worries the Federal Reserve who is given the mandate to control inflation and keep economic growth chugging along. Inflation as thought of by the Federal Reserve is almost purely a monetary issue. The federal reserve is worried about the inflation caused by too many dollars chasing to few goods and services, and not worried about too few goods and services chasing too many dollars - if that makes sense. So for example if the economy were humming along great, and people and businesses are able to borrow money easily and cheaply this can lead to excess inflation. Easy credit allows more “money” to flow through the economy, and when times are good it leads businesses and people to potentially bid up prices too much as they compete for goods and services.

The Core CPI doesn’t include food and energy products even though for many families these are core expenditures. Food and Energy prices are generally determined more by supply than demand, and the supply of those products are volatile and subject to many external factors that are not inherent to the economy, weather being the most notable. The Federal Reserve tends to look at only the Core CPI values when making monetary decisions. The Fed effectively controls the money supply in the U.S. It has certain tools, most notably it’s ability to set the discount rate (the rate it allows banks to borrow from it) to control the money supply. The other tools are: Open Market activity (i.e selling Government Bonds and therefore creating new “money”), and determining the reserve requirement (the amount that Banks needs to hold against deposits that cannot be lent out).

The other big problem with inflation as measured by CPI and and most measure of inflation is that the index relies on a basket of goods and services. While the government takes a scientific approach to this problem, inherently this is a bit of subjective problem. Should the basket of goods be the same as the basket of good from 1880? I think that’s where many including myself unduly blame the CPI for being understated measure of inflation. The CPI certainly does have problems, but it’s inherently difficult to capture the lifestyle creep of the last century that is pervasive in American society. We don’t just pay more for stuff, we pay more for more stuff.

In the last part of this series, I discussed Fixed Income Investments. Today I turn the discussion to Stocks. People are generally far more interested in stocks than they are in bonds. While some have made fortunes in the bond world. The more famous names are those who have their fortunes in the world of stocks. There are the investors; Warren Buffet, Peter Lynch, and the now tarnished star of Eddie Lampert. In addition to the investors there are more importantly the entrepreneurs who’s fortunes have been tied to the stock in the companies they founded. Bill Gates, Larry Ellison, Sergey Brin, and Larry Page are the name today. But in the past it was the likes of Ray Kroc and Henry Ford. While the times have changed, the fundamental nature of stocks have not.

Stocks merely represent a ownership shares in a company. However typically when we talk about stocks in the investment sense, we talk about shares of publicly traded companies. Public companies agree to certain account conventions and rules of disclosure for privilege of allowing it’s shares to trade on public exchanges such as the New York Stock Exchange. There are two primary reason for companies go “public.” 1) to raise capital to grow the business 2) to allow the original investors to cash out (at least some portion). More often than a not a company will go public both reasons as is typical with a tech start up. A technology start-up both needs to capital from an Initial Public Offering (IPO) to grow the business, and allow for the initial investors, typically venture capital firms, an easy method to quickly earn a return on a investment.

A share in company represents exactly that a share of the company. Let’s take for example Google which has a share price as of 2/12/08 $518.09. Google has a total of 312.8 Million shares outstanding. One share therefore represents 1/312,800,000 of the company. The total market cap (or total worth) of Google is $518.09 X 312,800,000 or about 160 billion dollars. While one would think that the intrinsic value of a company should not really change very much day to day or minute to minute. However in the case of public companies it does. Everyday shares exchange hands and at any given time those shares are worth only as much as what the next person who wants to buy is willing to pay. For that reason Google has lost about 40 billion in value over the last 2 months despite running the same business it has ever run.

For most people stocks, though not individually but in a vehicles such as Mutual Fund, should make up the bulk of one’s investment portfolio. Historically speaking U.S. equities have returned between 9 and 10% annually, far outpacing fixed income. Of course if you were to look at how those returns were delivered, it’s not smooth ride of 10% year in and year out.

So what do you look for investing in stocks. While I have my own metrics, mostly based my reading of the Intelligent Investor, stock picking is difficult. Few professionals consistently beat the market, and many academics believe it’s outright impossible to do so. I’ll save the arguments on beating the market for another day.

Two weeks ago, I said I was starting a series on investments. Start the series I did and little else. That was two weeks ago, and only now I am publishing this the 2nd Part, Fixed Income Investments.

The name fixed income is the term used in the financial industry, but rarely used outside of the industry. Fixed income as the name would suggest implies a fixed or determined income stream. Fixed income investments more simply stated are investments that pay interest. What really is interest though? Interest is nothing more than the fee charged for the privilege of borrowing money. At heart when anyone makes a fixed income investment, they are effectively lending money. I know when I go to the ATM and make a deposit into my savings account, I don’t think I’m making a loan. Yet, that’s exactly what I’ve done. I’ve loaned the bank money, and for that Citibank is willing to pay me interest. If I loan my friend money and charge him interest, I cannot easily sell that loan to someone else. However if I am able to package (securitize) that loan, i.e. put in some standard form that makes it easy to buy and sell then that loan becomes a bond. Corporations, governments, and rock stars issue bonds to borrow money.

Every fixed income has one part that will always be the same, the principal. The principal is just the money that is initially invested. What differs between fixed income investments are: term (time of investment), default risk, tax treatment and lastly the interest which is often determined by the other three factors. While there are dozens if not hundreds of different fixed income investments to be made, they can all be adequately described along those 4aforementioned axes. Below is my best representation of that 4 dimensional space as 3 dimensional abstract on 2 dimensional surface.

The interest paid on a fixed income investment is function of the term (length), credit quality (default risk), and tax treatment (tax exempt or non tax exempt). Generally speaking, the longer the term or the amount of time that you must lock up in an investment, the better the interest rate. That’s why a 5 Year CD is paying out something like 3.6% while a 1 year CD only pays out 3.5% today. The spread between the 5 year and 1 year CD is usually wider but the current economic conditions (i.e. a likely looming recession) have compressed that spread. The higher the risk that a borrower will default, the higher the interest rate required.

Some Typical Fixed Income Investments

• Savings Account - Plain old savings account that pay a variable rate of interest, no restrictions on withdrawal
• CDs - Certificate of Deposit. Bank issued certificates guaranteeing set level of interest for a set term for the same guarantee of term.
• Treasury Bills and Bonds - Federal (U.S.) Government bonds of differing length
• Corporate Bonds - Bonds issued by corporation. Credit Quality varies with the corporation
• Municipal Bonds - Bonds issued by local governments are exempt from federal taxes (some are subject to AMT), and generally local taxes if owned by a local.

Most people think of fixed income investments as safe and conservative. Plain vanilla FDIC insured bank accounts and CDs would fall in that safe and conservative category. Fixed income investments unless the issuer defaults pays a guaranteed level of interest, no less no more. However when we talk about the more complex fixed income securities that trade, there can be both greater risk and reward because of the ability to buy and then resell that investment.

Let’s say for example I pay $1000 for a bond that pays $100 in interest a year. At the time of purchase I’m basically getting 10% in interest. One of the most important and basic principles to understand about bonds is the price of the bonds move inversely with the interest rate. The higher the interest rate, the lower the price and vice versa. Though the payment or coupon is fixed, the price of the bond is not. There is no guarantee someone else will pay me $1000 for that bond. Why can that be the case?

• Prevailing interest rates rise or drop. Why would someone pay me $1000 for a bond when interest rates have gone up to 15% - someone could get a new bond that paid more. The only way to sell my bond is for me to the lower the price to $666.66 which would make the $100 coupon equivalent to a 15% return.  The same logic applies if interest rates drop to 5% but in reverse.   I would only sell my bond for $2000 knowing the $100 coupon is 5% of two thousand.
• The credit quality of the issuer changes. Embedded into the price of debt is the risk that the entity borrowing the money will never pay back the principal or any of the interest. Companies and Government both face the risk of bankruptcy and that risk changes, and lenders demand to be compensated for that risk. As a result if I own a bond from company A and all of sudden it starts losing massive amounts of money, anyone I sold that bond would require that I lower the price enough (and therefore raise the interest payments) to compensate them for that risk.
• Tax Law Change. Typically buyers of municipal bonds are willing to accept to lower interest rate payment because they aren’t paying taxes on the interest. So if all of sudden the income tax were eliminated Municipal bond issuers would not be able to offer lower interest payments and expect to compete

Individual investors are usually better of stick with the less riskier fixed income investments, CDs and Government Bonds. If as an investor you want to venture further, there are plenty of very well run bond mutual funds. Investing in individual corporate or municipal bonds is generally not cheap, and more complex.