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Frequently Asked Questions (FAQS);faqs.337



Value Averaging adjusts the amount invested, up or down, to meet a
prescribed target.  An example should clarify:  Suppose you are going
to invest $200 per month and at the end of the first month, your $200
has shrunk to $190.  Then you add in $210 the next month, bringing the
value to $400 (2*$200). Similarly, if the fund is worth $430 at the
end of the second month, you only put in $170 to bring it up to the
$600 target. What happens is that compared to dollar cost averaging,
you put in more when prices are down, and less when prices are up.

Dollar Cost Averaging takes advantage of the non-linearity of the 1/x
curve (for those of you who are more mathematically inclined).  Value
Averaging just goes in a little deeper when the value is down (which
implies that prices are down) and in a little less when value is up.
An article in the American Association of Individual Investors showed
via computer simulation that value averaging would outperform dollar-
cost averaging about 95% of the time. "Outperform" is a rather vague
term.  As best as I remember, whatever the percentage gain of dollar-
cost averaging versus buying 100% initially, value averaging would
produce another 2 percent or so.

Warning: Neither approach will bail you out of a declining market nor
get you in on a bull market.

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Subject: Direct Investing and DRIPS
From: [e-mail], [e-mail],
    [e-mail], [e-mail]

DRIPS are an easy, low cost way of buying stocks.  Various companies
(lists are available through NAIC and some brokerages) allow you to
purchase shares directly from the company.  By buying directly, you
avoid brokerage fees. However, you must nearly always purchase the
first share through a broker or other conventional means; successive
shares can then be bought directly. Shares can be purchased either
through dividends or directly by sending in a check.  Thus the two
names for DRIP: Dividend/Direct Re-Investment Plan. The periodic
purchase also allows you to automatically dollar-cost-average the
purchase of the stock.

The latest Money Magazine (Nov or Dec 92) reports that the brokerage
house A.G. Edwards has a special commission rate for purchases of
single shares. They charge a flat 16% of the share price, or about
$6 for Disney.

Published material on DRIPS:
 + _Guide to Dividend Reinvestment Plans_
   Lists over a one hundred companies that offer DRIP's.  The number
   given for the company is 800-443-6900; the cost is $9.00 (charge to CC)
   and they will send you the DRIPs booklet and a copy of a newsletter
   called the Money Paper.

 + _Low cost/No cost investing_ (author forgotten)
   Lists about 300-400 companies that offer DRIPs.

 + _Buying Stocks Without a Broker_ by Charles B. Carlson.
   Lists 900 companies/closed end funds that offer DRIPS.  Included is a
   profile of the company and some plan specifics.  These are: if partial
   reinvestment of dividends are allowed, discounts on stock purchased
   with dividends, optional cash payment amount and frequency, fees,
   approximate number of shareholders in the plan.

 [ Compiler's note:  It seems to me that a listing of the hundreds or
   more companies that offer DRIPS belongs in its own FAQ, and I will not
   reprint other people's copyrighted lists.  Please don't send me lists
   of companies that offer DRIPS. ]

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Subject: Future and Present Value of Money
From: [e-mail]

This note explains briefly two concepts concerning the time-value-of-money,
namely future and present value.

* Future value is simply the sum to which a dollar amount invested today
will grow given some appreciation rate.  The formula for future value
is the formula from Case 2 of present value (below), but solved for the
future-sum rather than the present value.  In this formulation, the
appreciation rate is computed monthly.

    To compute the future value of a sum invested today, the formula is:
    fv = principal * (1 + (rrate / 100) / 12) ** (12 * termy)
    where
        principal = dollar value you have now
        termy     = term, in years
        rrate     = annual rate of return, in percent

    Example of calculating the future value of an invested sum:
    I invest 1,000 today at 10% for 10 years.  The future value
    of this amount is 2707.04.

* Present value is the value in today's dollars assigned to an amount of
money in the future, based on some estimate of inflation and rate-of-return
over the long-term.  A reasonable estimate for long-term inflation is 4.5%.
In this analysis, inflation is compounded yearly and rate-of-return is
calculated based on monthly compounding.

Two cases of present value are discussed next. Case 1 involves a single
sum that stays invested over time.  Case 2 involves a cash stream that is
paid regularly over time (e.g., rent payments).

Case 1: Present value of money invested over time.  This tells you what a
        future sum is worth today, given some inflation rate over the time
        between now and the future.  Another way to read this is that you
        must invest the present value today at the rate-of-return to have
        some future sum in some years from now (but this only considers the
        raw dollars, not the purchasing power).

    To compute the present value of an invested sum, the formula is:
                future-sum
    pv =   --------------------------------------
           (1 + (rrate/100) / 12) ** (12 * termy)
    where
    future-sum = dollar value you want in termy years
    termy = term, in years
    rrate = annual rate of return on money that you can expect, in percent

    Example:
    In 30 years I will receive 1,000,000 (a gigabuck).  What is
    that amount of money worth today (what is the buying power)
    assuming a rate of inflation of 4.5%?  The answer is 259,895.65

    Example:
    I need to have 10,000 in 5 years.  The present value of 10,000
    assuming a rate-of-return of 8% is 6712.10.  I.e., 6712 will
    grow to 10k in 5 years at 8%.

Case 2: Present value of a cash stream.  This tells you the cost in
    today's dollars of money that you pay over time.  Usually the
    payments that you make increase over the term.  Basically, the
    money you pay in 10 years is worth less than that which you pay
    tomorrow, and this equation lets you compute just how much.

    To compute the present value of a cash stream, the formula is:
         month = 12*termy   paymt  * (1 + irate/100) ** int ((month - 1)/ 12)
    pv = SUM                -------------------------------------------------
         month = 1               (1 + (rrate/100) / 12) ** (month - 1)
    where
    month = month number
    termy = term, in years
    paymt = monthly payment, in dollars
    irate = rate of inflation (increase in payment per year), in percent
    rrate = rate of return on money that you can expect, in percent
    int() function = keep integral part; used to compute yr nr from mo nr

    Example:
    You pay $500/month in rent over 10 years and estimate that inflation
    is 4.5% over the period (your payment increases with inflation.)
    Present value is 49,530.57

I wrote two small C programs for computing future and present value; send
email to [e-mail] if you are interested.

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Subject: How Can I Get Rich Really Quickly?
From: [e-mail]

Take this with a lot of :-) 's.

Legal methods:
  1. Marry someone who is already rich.
  2. Have a rich person die and will you their money.
  3. Strike oil.
  4. Discover gold.
  5. Win the lottery.

Illegal methods:
  6. Rob a bank.
  7. Blackmail someone who is rich.
  8. Kidnap someone who is rich and get a big ransom.
  9. Become a drug dealer.

For completeness sakes:
 10. "If you really want to make a lot of money, start your own religion."
                - L. Ron Hubbard

Hubbard made that statement when he was just a science fiction writer in
either the '30s or '40s.  He later founded the Church of Scientology.
I believe he also wrote Dianetics.

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Subject: Hedging
From: [e-mail]

Hedging is a way of reducing some of the risk involved in holding
an investment.  There are many different risks against which one can
hedge and many different methods of hedging.  When someone mentions
hedging, think of insurance.  A hedge is just a way of insuring an
investment against risk.

Consider a simple (perhaps the simplest) case.  Much of the risk in
holding any particular stock is market risk; i.e. if the market falls
sharply, chances are that any particular stock will fall too.  So if
you own a stock with good prospects but you think the stock market in
general is overpriced, you may be well advised to hedge your position.

There are many ways of hedging against market risk.  The simplest,
but most expensive method, is to buy a put option for the stock you own.
(It's most expensive because you're buying insurance not only against
market risk but against the risk of the specific security as well.)
You can buy a put option on the market (like an OEX put) which will
cover general market declines.  You can hedge by selling financial
futures (e.g. the S&P 500 futures).

In my opinion, the best (and cheapest) hedge is to sell short the
stock of a competitor to the company whose stock you hold.  For example,
if you like Microsoft and think they will eat Borland's lunch, buy MSFT
and short BORL. No matter which way the market as a whole goes, the
offsetting positions hedge away the market risk.  You make money as
long as you're right about the relative competitive positions of the
two companies, and it doesn't matter whether the market zooms or crashes.

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Subject: Investment Associations (AAII and NAIC)
From: [e-mail], [e-mail]

AAII:    American Association of Individual Investors
    625 North Michigan Avenue
    Chicago, IL 60611

A summary from their brochure: AAII believes that individuals would do
better if they invest in "shadow" stocks which are not followed by
institutional investor and avoid affects of program trading.  They
admit that most of their members are experienced investors with
substantial amounts to invest, but they do have programs for newer
investors also.  Basically, they don't manage the member's money, they
just provide information.

They offer the AAII Journal 10 times a year, Individual Investor's guide
to No-Load Mutual Funds annually, local chapter membership (about 50
chapters), a year-end tax strategy guide, investment seminars and study
programs at extra cost (reduced for members), and a computer user'
newsletter for an extra $30.  They also operate a free BBS.

NAIC:    National Association of Investors Corp.
    1515 East Eleven Mile Road
    Royal Oak, MI 48067
    1-313-543-0612

The NAIC is a nonprofit organization operated by and for the benefit
of member clubs.  The Association has been in existence since the 1950's
and has around 110,000 members.

Membership costs $32.00 per year for an individual or $30 for a club
and $9.00 per each club member.  The membership provides the member
with a monthly newsletter, details of your membership and information
on how to start a investment club, how to analyze stocks, and how to
keep records.

In addition to the information provided, NAIC operates "Low-Cost
Investment Plan", which allows members to invest in participating
companies such as Disney, Kellogg, McDonald's, Mobil and Quaker Oats...
Most don't incur a commission although some have a nominal fee ($3-$5).

Of the 500 clubs surveyed in 1989, the average club had a compound
annual growth rate of 10.8% compared with 10.6% for the S&P 500 stock
index...It's average portfolio was worth $66,755.

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Subject: Life Insurance
From: [e-mail]

This is my standard reply to life insurance queries.  And, I think many
insurance agents will disagree with these comments.

First of all, decide WHY you want insurance.  Think of insurance as
income-protection, i.e. if the insured passes away, the beneficiary
receives the proceeds to offset that lost income.  With that comment
behind us, I would never buy insurance on kids, after all, they don't
have income and they don't work.  An agent might say to buy it on your
kids while its cheap - run the numbers, the agent is usually wrong.
And I am strongly against this on two counts.  One, you are placing a
bet that you kid will die and you are actually paying that bet in
premiums.  I can't bet my child will die.  Two, it sounds plausible,
but factor inflation in - it doesn't look so good.  A policy of face
amount of $10,000, at 4.5% inflation and 30 years later is like having
$2,670 in today's dollars - it's NOT a lot of money.  So don't plan on
it being worth much in the future to your child as an investment.

I have some doubts about insurance as investments - it might be a good
idea but it certainly muddies the water.

So you have decided you want insurance, i.e. to protect your family against
your passing away prematurely, i.e. the loss of income you represent.

Next decide how LONG you want insurance for.  If you're around 60 years
old, I doubt you want to get any at all.  Your income stream is largely
over and hopefully you have accumulated the assets you need anyway by now.

If you are married and both work, its not clear you need insurance at
all if you pass on.  The spouse just keeps working UNLESS you need both
incomes to support your lifestyle.  Then you should have one policy on
each of you.

If you are single, its not clear you need it at all.  You are not sup-
porting anyone so no one cares if you pass on, at least financially.

If you are married and the spouse is not working, then the breadwinner
needs insurance UNLESS you are independently wealthy.

If you are independently wealthy, you don't need it because you already
have the money you need.  You might want it for tax shelters but that is
a very different topic.

Suppose you have a 1 year old child, the wife stays home and the husband
works.  In that case, you might want 2 types of insurance: Whole life
for the long haul, i.e. age 65, 70, etc., and Term until your child is
off on his/her own. Once the child has left the stable, your need for
insurance goes down since your responsibilities have diminished, i.e.
fewer dependents, education finished, wedding expenses done, etc

Do you have a mortgage? Perhaps you want some sort of Term during the
duration of the mortgage - but remember that the mortgage balance
declines over time. But don't buy mortgage insurance itself - much too
expensive. Include it in the overall analysis of what insurance needs
you might have.

Now, how much insurance?  One rule of thumb is 5x your annual income.
What agents will ask you is 'Will your spouse go back to work if you
pass away?' Many of us will think nobly and say NO.  But its actually
likely that your spouse will go back to work and good thing - otherwise
your insurance needs would be much larger.  After all, if the spouse
stays home, your insurance must be large enough to be invested wisely to
throw off enough return to live on.  Assume you make $50,000 and the
spouse doesn't work.  You pass on.  The Spouse needs to replace a
portion of your income (not all of it since you won't be around to feed,
wear clothes, drive an insured car, etc.).  Lets assume the Spouse needs
$40,000 to live on.  Now that is BEFORE taxes.  Lets say its $30,000 net
to live on.  $30,000 is the annual interest generated on a $600,000
tax-free investment at 5% per year (i.e. munibonds).  So this means you
need $600,000 of face value insurance to protect your $50,000 current
income.

This is only one example of how to do it and income taxes, estate taxes
can complicate it.  But hopefully you get the idea.

Which kind of insurance IMHO is a function of how long you need it for.
I once did an analysis of TERM vs WHOLE LIFE and based on the assumptions
at the time, WHOLE LIFE made more sense if I held the insurance more than
about 20-23 years.  But TERM was cheaper if I held it for a shorter period
of time.  How do you do the analysis and why does the agent want to meet
you?  Well, he/she will bring their fancy charts, tables of numbers and
effectively snow you into thinking that the biggest, most expensive
policy is the best for you over the long term.  Translation: mucho
commissions to the agent.  Whole life is what agents make their money on
due to commissions.  The agents typically gets 1/2 of your first year's
commissions as his pay.  And he typically gets 10% of the next year's
commissions and likewise through year 5.  Ask him how he gets paid.  If
he won't tell you, ask him to leave.

What I did was to take their numbers, review their assumptions (and
corrected them when they were far-fetched) and did MY analysis.  They
hated that but they agreed my approach was correct.  They will show you
a 12% rate of return to predict the cash value flow.  Ignore that - it
makes them look too good and its not realistic.  Ask him/her exactly what
they plan to invest your premium money in to get 12%.  How has it done in
the last 5 years? 12? Use a number between 4.5% (for TBILL investments,
ultra- conservative) and 10% (for growth stocks, more risky), but not
definitely not 12%.  I would try 8% and insist it be done that way.

Ask each agent:
1)-what is the present value of the payment stream represented by my
premiums, using a discount rate of 4.5% per year (That is the inflation
average since 1940).  This is what the policy costs you, in today's
dollars. Its very much like paying that single number now instead of a
series of payments over time.
2)-what is the present value of the the cash value earned (increasing
at no more than 8% a year) and discounting it back to today at the same
4.5%. This is what you get for that money you just paid, in cash value,
expressed in today's dollars, i.e. as if you got it today in the mail.
3)-What is the present value of the life insurance in force over that
same period, discounted back to today by 4.5%, for inflation.  That is
the coverage in effect in today's dollars.
4)-Pick an end date for comparing these - I use age 60 and age 65.

With the above in hand from various agents, you can see fairly quickly
which is the better policy, i.e. which gives you the most for your money.

By the way, inflation is slippery and sneaky.  All too often we see
$500,000 of insurance and it sounds great, but at 4.5% inflation and 30
years from now, that $500,000 then is like $133,500 now - truly!

Have the agent do your analysis, BUT you give him the rates to use, don't
use his.  Then you pick the policy that is the best value, i.e., you get
more for your money.  Factor in any tax angles as well.  If the agent
refuses to do this analysis for you, get rid of him/her.

If the agent gets annoyed but cannot fault your analysis, then you have
cleared the snow away and gotten to the truth.  If they smile too much,
you may have missed something.  And that will cost you money.

Never agree to any policy unless you understand all the numbers and all
the terms.  Never 'upgrade' policies by cashing in a whole life for
another whole life.  That just depletes your cash value, real cash
available to you.  And the agent gets to pocket that money, literally,
through new commissions.

Check out the insurer by going to the reference section of a big library.
Ask for the AM BEST guide on insurance.  Look up where the issuer stands
relative to the competition.

Agents will usually not mention TERM since they work on commission and
get much more money for Whole Life than they do for term.  Remember,
figure the agents gets fully 1/2 of your 1st years premium payments and
10% or so for all the money you send in over the following 4 years.  Ask
them to tell you how they are paid- after all, its your money they are
getting.

Now why don't I like UNIVERSAL or VARIABLE?  Mainly because with Whole
Life and with TERM, you know exactly what you must pay because the issuer
must manage the investments to generate the appropriate returns to
provide you with the insurance (and with cash value if whole life).
With UNIVERSAL and VARIABLE, it becomes YOU who must decide how and where
to invest your premium income.  If you guess badly, you will have to pay
a higher premium to cover those bad decisions.  The insurance companies
invented UNIVERSAL and VARIABLE because interest rates went crazy in the
early 80's and they lost money.  Rather than taking that risk again, they
offered these new policies to transfer that risk to you.  Of course,
UNIVERSAL and VARIABLE will be cheaper in the short term but BE CAREFUL -
they can and often will increase later on.

Okay, so what did I do? I bought both term and whole life.  I plan to
keep the term until my son graduates from college and he is on his own.
That is about 11 years from now.  I also bought whole life (NorthWest
Mutual) which I plan to keep forever, so to speak.  NWM is apparently
the cheapest and best around according to A.M.BEST.

Where do you buy term? Just buy the cheapest policy since you will tend
to renew the policy once a year and you can change insurers as each time.

Also:   A hard thing to factor in is that one day you may become
uninsurable just when you need it, i.e. heart attack, cancer and the like.
I would look at getting cheap term insurance that is a bit more but then
you can keep renewing, even if ill, or you can convert to whole life.

Last thought.  I'll bet you didn't you know that you are 3x more likely
to become disabled during your working career than you to die during your
working career.  How is your short term disability insurance looking?
Get a policy that has a waiting period before it kicks in.  This will
keep it cheaper.  Look at the exclusions, if any.

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Compilation Copyright (c) 1992 by Christopher Lott, [e-mail]
--
Christopher Lott    [e-mail]   [phone], -3331 Fax
Post: FB Informatik - Bau 57, Universitaet KL, W-6750 Kaiserslautern, Germany
Xref: bloom-picayune.mit.edu misc.invest:33570 news.answers:4573
Newsgroups: misc.invest,news.answers
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From: [e-mail] (Christopher Lott)
Subject: misc.invest FAQ on general investment topics (part 2 of 2)
Message-ID: <[e-mail]>
Followup-To: misc.invest
Summary: Answers to frequently asked questions about investments.
         Should be read by anyone who wishes to post to misc.invest.
Originator: [e-mail]
Keywords: invest, stock, bond, money, faq
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Nntp-Posting-Host: bogner.informatik.uni-kl.de
Reply-To: [e-mail]
Organization: University of Kaiserslautern, Germany
References: <[e-mail]>
Date: Mon, 14 Dec 1992 05:00:43 GMT
Approved: [e-mail]
Expires: Mon, 11 Jan 1993 05:00:06 GMT
Lines: 1016

Archive-name: investment-faq/general/part2
Last-modified: Fri Dec 11 10:33:32 MET 1992
Compiler: Christopher Lott, [e-mail]

This is the general FAQ for misc.invest, part 2 of 2.

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TABLE OF CONTENTS FOR THIS PART
    Money-Supply Measures M1, M2, and M3
    Options on Stocks
    P/E Ratio
    Renting vs. buying a place to live
    Shorting Stocks
    Stock Index Types
    Stock Index - The Dow
    Stock Indexes - Others
    Stock Splits
    Ticker Tape Terminology
    Treasury Direct
    Uniform Gifts to Minors Act (UGMA)
    Warrants
    Zero-Coupon Bonds

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Subject: Money-Supply Measures M1, M2, and M3
From: [e-mail]

M1: Money that can be spent immediately.  Includes cash, checking accounts,
    and NOW accounts.

M2: M1 + assets invested for the short term.  These assets include money-
    market accounts and money-market mutual funds.

M3: M2 + big deposits.  Big deposits include institutional money-market
    funds and agreements among banks.

"Modern Money Mechanics," which explains M1, M2, and M3 in gory detail,
is available free from:
        Public Information Center
        Federal Reserve Bank of Chicago
        P.O. Box 834
        Chicago, Illinois 60690

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Subject: Options on Stocks
From: [e-mail]

First, an option is a contract between buyer and seller.

The option is connected to something, such as a listed stock or an
exchange index or futures contracts or real estate.  For simplicity,
I will discuss only options connected to listed stocks.

The option is designated by:
       - Name of the associated stock
       - "strike price"
       - Expiration Date

       - The option costs a "premium" to buy, plus brokers commission.

The two most popular types of options are Calls and Puts.

    Example:  The Wall Street Journal might list an
                IBM Oct 90 Call @ $2.00

    Translation:  This is a Call Option

                  The company associated with it is IBM
                    (See also the price of IBM stock on the NYSE)

                  The option expires on the third Saturday
                      following the third Friday of October, 1992.
                     (an option is worthless and useless once it expires)

                  The strike price is $90.00  If you own this option
                  you can buy IBM @ $90.00, even if it is then trading on
          the NYSE @$100.00 (I should be so lucky!)

                  If you want to buy the option it will cost you $2.00
                  plus brokers commissions.   If you want to sell
                  the option you will get $2.00 less commissions.

In general, options are written on blocks of 100s of shares.  So when
you buy "1" IBM Oct 90 Call @ $2.00 you actually are buying a contract
to buy 100 shares of IBM @ $90 per share ($9,000) on or before the
expiration date in October.   You will pay $200 plus commission to buy
the call.

If you wish to exercise your option you call your broker and say you
want to exercise your option.  Your broker will arrange for the person
who sold you your option ( a financial fiction:  A computer matches up
buyers with sellers in a magical way) to sell you 100 shares of IBM for
$9,000 plus commission.

If you instead wish to sell (sell=write) that option you instruct your
broker that you wish to write 1 Call IBM Oct 90s, and the very next day
your account will be credited with $200 less commission.

If IBM does not reach $90 before the call expires, the option writer
gets to keep that $200 (less commission)   If the stock does reach above
$90, you will probably be "called."

If you are called you must deliver the stock.  Your broker will sell
your IBM stock for $9000 (and charge commission).  If you owned the
stock, that's OK. If you did not own the stock your broker will buy the
stock at market price and immediately sell it at $9000.  Commissions
each way.

If you write a Call option and own the stock that's called "Covered
Call Writing."  If you don't own the stock it's called "Naked Call
Writing."   It is quite risky to write naked calls, since the price of
the stock could zoom up and you would have to buy it at the market price.

My personal advice for new options people if to begin by writing
covered call options for stocks currently trading below the strike
price of the option (write out-of-the-money covered calls).

When the strike price of a call is above the current market price of
the associated stock, the call is "out of the money" and is "in
the money" when the stock price is below the call's strike price.

Most regular folks like you and me do not exercise our options; we
trade them back, covering our original trade.  Saves commissions and
all that.