Get Ready for the Next Round of Bond Pain

By MICHAEL A. POLLOCK

It's one of the biggest fears of bond investors today: What will happen if interest rates take off and bond prices plunge?

It's time to stop worrying and start acting. There are steps investors can take to minimize the damage of rising rates, while still enjoying the advantages that bonds bring to a portfolio.

Journal Report

Have questions about how to prepare for rising interest rates? Tune in Monday, August 5 at 3 p.m. Eastern for an interactive video chat with advice from three experts.

The bond selloff this spring provided a stark preview of how bond mutual funds and exchange-traded funds might perform if rates mount a sustained rise. Bond investors were rattled in June amid fears that the Federal Reserve would move much sooner than expected to scale back its massive bond purchases, which are intended to hold down yields and spark economic activity. As the 10-year Treasury jumped more than one percentage point to above 2.7%, long-maturity bond funds tracked by Morningstar Inc. MORN +0.85% lost some 7.5% in value from early May through early July, even after taking into account interest income. Bond yields and prices move in opposite directions. (The benchmark Treasury yielded 2.6% as of late Friday.)

In June, stunned by losses in what many had thought was a safe asset class, investors yanked a monthly record of more than $81 billion from fixed-income mutual funds and ETFs, according to TrimTabs Investment Research.

Bailing out is one way to avoid further rate risk. But particularly for people worried about volatility in stocks, "fixed income still has a place," says Jonathan Mackay, senior fixed-income strategist at Morgan Stanley Wealth Management MS -1.94% . "You just have to be much more tactical and nuanced."

Here are some questions to help investors get a handle on how much their bond portfolio may be at risk, and how to reduce that risk—including a shift to bond funds that may actually do well amid rising rates.

How quickly will rates rise?

Everyone wishes they knew with certainty. But fund managers generally believe the recent more-than-one-point rise in the 10-year Treasury yield was much bigger than was justified, given that the economy is still growing at a sluggish rate, unemployment remains high and inflation remains tame.

Most believe that eventually the 10-year yield will rise more as the Fed pulls back support for the bond market and as growth picks up, with that yield perhaps moving up to around 3.5% or 4%. But that isn't expected to happen until sometime next year or beyond, because the Fed is likely to pare back its stimulus only gradually, they say. Fed Chairman Ben Bernanke appeared to echo those points in remarks before a congressional committee in mid-July.

Morgan Stanley rate strategists see the 10-year yield remaining in a range of 2% to 2.75% this year.

What is the rate risk in each specific bond fund?

Each bond fund and ETF has its own degree of interest-rate sensitivity, which can vary significantly, depending on the maturities and types of bonds a fund owns.

The standard measure is called "duration." The higher the duration, the bigger the potential drop in a fund's value as rates rise.

Investors can calculate the potential decline by finding a fund's duration on its website. Multiply that number by a hypothetical increase in yields.

For example, if a fund has a duration of four years and if yields were to rise by one percentage point, its portfolio could lose 4% in value—although the net loss would be reduced by the interest paid by the fund's bonds.

Although funds with the longest maturities can be the riskiest, even short-term bonds are affected by rising rates.

The two-year Treasury has a duration of around 1.8, so if its yield rose by a half percentage point, its value would decline nearly 1%.

Does the risk of losses magnify as rates increase?

It can. The intermediate-maturity bond funds that sold well in recent years own a lot of bonds backed by pools of residential mortgage loans. They are rate-sensitive, and that sensitivity grows as yields rise, says Michael Temple, director of U.S. credit research at Boston-based Pioneer Investments.

When yields rise, homeowners have less incentive to refinance mortgages early. And because the loans end up having longer lives, so do the mortgage bonds they back.

This spring, as the maturity appeared to be extending for many mortgage bonds, their average duration grew to 5.2 years from 3.7 years, based on the mortgage-securities component of the Barclays U.S. Aggregate Bond Index. Another one-point rise in yields would lift that sensitivity closer to six, bond strategists say.

Long-maturity, tax-free municipals face a similar issue: When rates rise, that lowers the likelihood that issuers will "call," or redeem, the bonds early to refinance them.

The market factors in the greater probability that the bonds will trade all the way to maturity, which could be as long as 20 or 30 years, says Warren Pierson, managing director at the Baird Advisors unit of Robert W. Baird & Co., Milwaukee.

This spring, the rate sensitivity of 22-year to 30-year munis rose to 14 from around 11, and it could grow to 15 or 16 if yields rise by another point, Mr. Pierson says. That poses the threat of a 15%-plus drop in the value of such bonds, before interest, on a one-point rate rise.

How can investors protect themselves?

The main strategy: consider holding more shorter-term bonds. Rate risk is key in deciding whether to overhaul your bond portfolio, says Bob Auwaerter, head of fixed income at Vanguard Group.

"If your portfolio consists solely of long-term bond funds because you have been trying to maximize yields, it's time to get into a more balanced portfolio with short and intermediate bonds or bond funds," Mr. Auwaerter says.

Christine Hurtsellers, chief investment officer for fixed income at ING Investment Management, Atlanta, advises investors to take advantage of dips in yields to unload some of their exposure to riskier, long maturities.

One ETF that focuses on short-maturity corporate bonds is iShares Barclays 1-3 Year Credit Bond, CSJ -0.02% which has a rate sensitivity of under two. It yields 0.9%, and it is up 0.4% this year through July even as many other types of funds have fallen in value.

Some investors may prefer actively managed funds that can adjust their portfolio duration based on the market. Lord Abbett Short Duration Income has a rate sensitivity of slightly more than two, and it also has returned 0.4% so far for the year. The fund yields about 2.4%.

FPA New Income, which yields about 3.4%, has a rate sensitivity of two. It has lagged behind peers at times when bonds were rallying, but hasn't had a negative annual return in its 29 years. Tom Atteberry, a portfolio manager at First Pacific Advisors LLC, says a key reason is that the fund keeps rate sensitivity very low.

Would bond diversification help?

It might. There are considerable opportunities. Better-performing categories from early May through early July included floating-rate bank-loan funds, down 0.5%, and nontraditional bond funds—which have much more flexibility in strategies they use—down 2.3%.

Investors also can add bonds that don't trade as closely in sync with rate-sensitive Treasurys, says Priscilla Hancock, a managing director at J.P. Morgan Asset Management. For instance, high-yield corporate bonds from below-investment-grade issuers trade more on concerns about credit quality than moves in rates.

"Usually, if rates are going up, it's because the economy is doing better," she says. "In that case, high-yield bonds also are going to do better."

Possible choices are USAA High Income, up 5% this year through July, or Federated High Income Bond, up 3.4%.

Or consider a diversified income fund whose manager spreads money in various markets and who can rein in rate risk when it makes sense.

Nuveen Strategic Income has a negative 0.7% return so far this year, but ranks in the top 7% of Morningstar's intermediate-term bond group for 10 years. Loomis Sayles Strategic Income, up 5.1% this year through July, also is a strong long-term performer.

Mr. Pollock is a writer in Ridgewood, N.J. Email him at reports@wsj.com.

How to Buy a Stock

Investors most commonly buy and trade stock through brokers.

You can set up an account by depositing cash or stocks in a brokerage account. Firms like Charles Schwab and Citigroup's Smith Barney unit offer brokerage accounts that can be managed online or with a broker in person. If you prefer buying and selling stocks online, you can use sites like E-Trade or Ameritrade. Those are just two of the most well-known electronic brokerages, but many large firms have online options as well.

Once you open an account you will tell your broker how many and what types of stocks you'd like to purchase. The broker executes the trade on the your behalf. In turn, he or she earns a commission, normally several cents per share. Online trading sites typically charge lower commission fees, because most of the trading is done electronically.

After selecting the stocks that you want to purchase, you can either make a "market order" or a "limit order." A market order is one in which you request a stock purchase at the prevailing market price. A limit order is when you request to buy a stock at a limited price. For example, if you want to buy stock in Dell at $60 a share, and the stock is currently trading at $70, then the broker would wait to acquire the shares until the price meets your limit.

While purchasing stocks through a broker has its advantages, there are other ways to buy stock. You can purchase stocks directly through the company. Sites like DRIPInvestor.com will show a list of companies that allow direct-buy of stocks.

Investor Education Resources

Investor Education & Trading Resources

One of the main contributors to these tutorials is a Wall Street veteran of over 10 years. David C. Arena has traded for Morgan Stanley Dean Witter and TD Waterhouse. He has also been a professional foreign currency and commodities broker and has been on the floor of the New York and American Stock Exchanges. He currently only trades for his own account and does not handle any retail clients. Through his corporation, IFG, Inc., he offers some of the best investment related products and services available. In this tutorial, we will list these products and services and where you can purchase them, as well as, Mr. Arena's personal list of books and resources that he feels every investor should have. Simply click on the links below for more information.

#1 Options Trading Course:

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• Learn secrets and tips to profitable option trading that have in the past been reserved for a select group of professional traders, institutional investors and high net worth individuals

#1 Options Advisor:

http://www.1optionsadvisor.com -We offer option trading alert services based on our proprietary strategies and research. These trading alerts will be sent to subscribers in real time via email. Alerts will include the date and time we are entering the trade, the symbol of the underlying security, type of option, strike price and any price limits. We will also continue to send updates when we enter any stop loss orders or trailing stop loss orders and will finally update subscribers when we exit the position including a summary of the gain/loss of the trade.

The following are the two option strategies available:  

OPTION BUYER

The Option Buyer service provides trade alerts based on our strategy of buying undervalued calls and puts. The key to this strategy is finding option premiums that are well undervalued compared to the normal market price of that particular option. We also look at volatility of the underlying security and the probability of it moving enough to hit our target returns at any time prior to expiration. This strategy is appropriate for any level of investment.

NAKED PUT WRITER

The Naked Put Writer service provides trade alerts based on our strategy of writing overvalued naked puts. The key to this strategy is finding option premiums that are well overvalued compared to the normal market price of that particular option considering we are receiving the premium with this particular strategy. Furthermore, we are looking at the probability of the underlying stock finishing above the strike price at expiration. We also look at some fundamental data with this strategy to assure that we are selecting stocks that we would want to hold short to medium term if assigned. This strategy is suggested for investors with $10,000 or more in available capital along with a margin account.

Stock Analysis

Economic Factors

The following terms pertaining to the economy are often considered when analyzing markets and investments. 

Business Cycle - the business cycle has four phases: expansion, peak, recession and trough. These cycles create price changes, which lead to changes in total spending in relation to the amount of goods and services being produced. 

Inflation - Inflation is a gradual rise in prices and resulting decreasing in purchasing power. It is normally associated with economic expansion and a low unemployment figure.

Deflation - Deflation is a decline in prices, where production exceeds demand. Deflation normally occurs during recessions and leads to a rise in unemployment.

Gross National Product (GNP) or Gross Domestic Product (GDP) - This statistic measures all goods and services produced in the U.S. In a full year. GNP can be expressed in the following ways:

• Money GNP, using inflated dollars
• Real GNP, measured in 1972 dollars. Real GNP is considered a more realistic measure, as it is adjusted for the effects of inflation. Recession-means 6 months of declining GNP. 

Depression - Means 6 quarters of declining GNP

Consumer Price Index (CPI) - This indicator of the change in prices of goods and services is published by the U.S. Bureau of Labor Statistics. Included in the index are food, transportation, medical care, entertainment and other items purchased by households and individuals.

Balance of Payments - This is a summary of money flowing in and out of the U.S.

If the U.S. Is spending more for imported goods and services than it receives for goods it exports, a deficit results. If the US received more money by selling goods in foreign markets than it spent on imports, the deficit would decrease. A decrease in the balance of payments raises the federal deficit;an increase in the balance of payments would reduce the deficit.

 Money Supply - This is the total amount of available money and credit in the US. The Federal Reserve Board attempts to control money and credit to create a stable, growing economy. The following are the most significant components of the money supply for the purposes of analyzing investment markets.

M-1 - includes all currency in circulation plus demand deposits. Demand deposits are those which depositors may withdraw at any time (on demand) without prior notice, such as business and personal checking accounts at commercial banks.

M-2 - includes M-1 plus overnight eurodollars (dollars trading overseas), overnight repurchase agreements, money market shares, savings deposits held by thrift institutions and time deposits in commercial banks. A time deposit is one that the depositor agrees to leave in the bank for a set period of time. (time deposits earn a specific amount of interest;if funds are withdrawn sooner than agreed, interest is forfeited).

 The Federal Reserve Board computes the M-1 measure weekly and publishes it each Thursday afternoon. The M-2 figure is published on the last Thursday of each month.

 Prime Rate - This is the rate of interest banks charge their best customers, usually well established companies, to borrow money.

Call Rate - This is the rate of interest banks charge brokerage firms to borrow money, also referred to as the broker loan rate. Brokerage firms often borrow to extend credit for margin accounts. The loans are collateralized by securities and referred to as "call loans"

Intermediation - This is the process whereby investors deposit funds in commercial banks and savings and loans. These "intermediaries" in turn to invest the funds in bonds or other securities with yields higher than the rates they are paying depositors.

Disintermediation - This is the process whereby investors withdraw funds on deposit with banks and savings and loans, and invest directly in securities with higher rates of return. 

The Federal Reserve Board and Monetary Policy

The Federal Reserve System, the nation's central bank, was established in 1908 as an independent agency of the federal government. The US is divided into 12 Federal Reserve Districts. The Federal Reserve's Board of Governors is responsible for coordinating the activities of the 12 district banks. The Board has seven members who are appointed by the President and confirmed by the Senate. In recent years, the goals of the Federal Reserve Board ("Fed") have been to reduce the federal deficit, promote economic growth and control inflation. The following are its three primary tools for implementing monetary policy.

Open Market Operations

Open market operations are the Fed's most effective short term monetary control. Using open market operations, the Fed can effect changes in the economy by increasing or decreasing the money supply. Open market operations consist of buying or selling US government securities, primarily treasury bills. The Fed may also purchase or sell treasury notes and bonds. When the Fed buys government securities, it pays for them with funds which are channeled into commercial banks. This increases the banks' deposits and adds to their funds available for loans.

 To tighten the money supply, the Fed sells government securities to banks and securities dealers, who pay for them using demand deposits held by commercial banks. The withdrawals reduce the amount of money banks are able to lend.

 The Federal Open Market Committee (FOMC) oversees the Fed's open market operations. Members of the FOMC include the seven governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York and the presidents of four other district banks represented on a rotating basis. While each member of the FOMC has one vote, the Chairman of the Board of Governors traditionally plays a decisive role in formulating policy, and acts as chief spokesman for the system.

 The FOMC meets approximately once a month to review economic conditions, goals and guidelines for open market operations. At the end of its meeting, it issues directives to the manager of the Fed's open market account in New York to buy or sell government securities.

 Discount Rate

This is the rate of interest the Fed charges commercial banks for borrowed funds. Borrowing from the Fed's "discount window" is intended to help banks in emergency situations;it is not to be used as an inexpensive means of borrowing to generate profits. If the Fed considers bank borrowing excessive, it may discourage it by raising the discount rate.

An increase in the discount rate tightens the money supply;a decrease eases the money supply. Because the discount rate affects the cost of borrowed funds throughout the banking system, it has a significant impact on short term interest rates. Changes in the discount rate are made infrequently and are usually considered a strong indication of a shift or reversal in monetary policy.

Reserve Requirements

A reserve requirement is the percentage of its deposits a bank must keep on reserve with the Fed. Demand deposits are volatile, and therefore have a higher reserve requirement than time deposits, which remain in banks for longer periods of time.

The higher the reserve requirement, the less banks can lend. An increase in reserve requirements makes money less available;a decrease in reserve requirements has the opposite effect.

In summary, if the Fed wishes to decrease the availability of money and credit, it sells government securities in the open market. When banks and dealers pay the Fed for securities they have purchased, substantial amounts of money are taken out of the banking system, resulting in tighter money and credit. If the Fed wishes to increase the availability of money and credit, the FOMC, through its trading desk, will buy government securities in the open market. When the Fed pays the banks and nonbank dealers for the securities, the result is an injection of funds into the banking system, making money and credit more available.

Any method or tool that creates additional money for the banking system is inflationary;any method or tool that shrinks the amount available in the banking system is deflationary. It should be noted that the amount of money banks can lend depends not only on the Federal Reserve's policy of ease or restraint, but also on the banks' ability to attract money from depositors. The greater a bank's deposits, the greater it's lending ability and the more profit it will make on loans;the less deposits it attracts, the less money it will have to lend.

The Federal Reserve System and Securities Markets

In addition to open market operations and changes in the discount rate and reserve requirements, the Fed has several other methods of controlling the cost and availability of funds. These include raising and lowering margin requirements for loans to purchase securities.

The Securities and Exchange Act of 1934 gave the Federal Reserve Board the power to determine the amount of credit extended by brokerage firms and banks for the purchase of securities. Regulation T of the Federal Reserve System governs margin lending by brokerage firms;Regulation U covers lending by banks. For several years, the "Reg T" margin requirements for initial stock purchases has been 50%.

Margin requirements are not as effective a tool for the Fed as the three methods described above. Margin requirements affect only the securities markets;open market operations, the discount rate and reserve requirements affect the entire banking system. 

Multiplier Effect

The multiplier effect is the magnifying effect of the Fed's monetary policy. As money is created by loans, and deposits are made with the borrowed funds, there is a multiplying effect as "money creates more money". For example, if a $10,000 loan from a bank is deposited in another bank, the second bank may lend the deposited funds less the reserve requirement.

For example, if the reserve requirement is 16%, the second bank must keep $1,600 and may lend $8,400. If this $8,400 is deposited into a third bank, the bank must keep 16% or $1,344 on reserve and may lend $7,056.

Theoretically, this process can continue through several banks, until many times the amount of the original $10,000 loan is added to available credit. If the above example were carried further, it would show that $10,000 of new money in the banking system creates approximately $62,500 in additional credit.

 A rough method of determining the amount of credit generated by a new deposit is to divide 100 by the reserve requirement as follows: 

Ex: 100/16% = 6.25, so the multiplier is 6.25 times

$10,000 new money injected into the banking system x 6.25 = $62,500 in credit.

The multiplier effect is accomplished through the commercial banking system, this is why banks are said to "manufacture money".

Fiscal Policy

Fiscal policy involves taxation and government spending. While Congress must approve fiscal policy, it is the Office of Management and Budget ("OMB") that conceives the strategy.

If the economy is at full employment, where an increase in government spending would only increase prices and lead to inflation, the government may adopt a policy of restraint. It can implement this policy by raising taxes or decreasing expenditures. If unemployment rises to a level where the nation's resources are under utilized, the government may respond with a fiscal policy to stimulate the economy. The results could be a decrease in taxation, an increase in government spending or both.

The system which requires interaction between the Federal Reserve's monetary policies and the government's fiscal policies is intended to curb inflation and deflation, thus minimizing the extremes of economic expansion and recession.

Fundamental Analysis

The focus of fundamental investment analysis is on a company's primary business and how it is managed. Industries are evaluated based on qualitative factors such as general outlook, foreign competition and the possible effects of the economy and fiscal policy. Individual companies are examined with respect to their products, profitability, financial structure, management and other internal considerations.

Industry Analysis

Industries develop through a cycle which consists of the following phases. 

Pioneering, characterized by rapid expansion; 

Maturity, where many small companies consolidate into a few large companies;and

Stabilization, where growth slows and a few companies remain.

As an industry evolves through these three phases, and growth potential is diminished, investors demand higher dividend payouts from individual companies within the industry.

Industries are classified as follows:

Defensive - A defensive industry is one that is relatively insensitive to changes in the economic environment. Demand for its products will remain fairly level regardless of the economy, interest rates or fiscal policy. Defensive industries include food, pharmaceuticals and utilities. 

Cyclical - Cyclical industries are those most affected by changes in the general economy and business cycles. Many cyclical industries are highly sensitive to interest rates. The automobile, housing and steel industries are among those considered cyclical.

Growth - A growth industry is one that is growing faster than the overall economy. Growth industries are characterized by accelerated research and development;dividend payouts, if any, are low. For most companies in growth industries, stock prices are influenced more by investor expectations of future performance than by economic factors. Current examples of growth industries include biotechnology, robotics, and telecommunications.

Fundamental analysts seek industries with positive aspects, and then examine individual companies within those industries to determine which have the best potential.

Qualified Plans/Retirement

Qualified Plans

Qualified Plans are used specifically by the Internal Revenue Code to designate certain retirement plans that meet the requirements of the codes. They include the following types of plans commonly used by employers: profit sharing plans, money purchase plans, defined benefit plans, Keoghs, stock bonus plans, annuity plans, bond purchase plans, cash or deferred arrangement (CODA)/401K plan, ESOP's or employee stock ownership plans.

These plans are highly promoted by the federal government as a supplement to the social security system. The tax benefits that they offer are much greater than other nonqualified retirement plans. These plans also cover the majority of employees in private businesses and corporations. The aggregate benefits of these plans at retirement sustain the livelihood of a large percentage of our retired workers.

 A recent study found that about 30% of corporate wealth in the United States is invested in retirement plan obligations, and the percentage is projected to increase to 40% and 50% in the next five and ten years respectively as our working population ages. A predominant percentage of the assets in these qualified plans are invested in securities;only a minor portion is invested in tangible properties such as real estate, gold coins, and precious metals.

Types of Retirement Plans

Defined Contribution Plans

These plans distinguish themselves by their contribution formulas. Their benefits accrue solely from: 

• a. amounts contributed to each participants account based on pre-set formula in relation to the participant's earnings, and 
• b. income, expenses, capital gains and losses per participant's account, and 
• c. shares of forfeitures from other participant's account due to nonvesting of benefit and other provisions in the trust document.

A defined contribution plan may be a profit sharing plan, money purchase, or a stock bonus plan. A profit sharing plan's contribution formula may be declared annually, and this allows the employer the flexibility to contribute any amount that its earning o reserve permits. The contribution formula for money purchase plans is set by the original adoption agreement or subsequent amendment to the trust documents. Therefore, the employer may be forced to contribute to the plan even in periods of low or negative cash flows.

All defined contribution plan contributions are based on a percentage of the employee compensation, usually the employee's W-2 wages if the company is on a calendar year basis.

Since the Tax Reform Act of 1986, profit sharing plans are no longer required to base their annual contributions on profit. Employers can contribute to employee accounts even if the company did not make any money for the year, so long as recurring contributions are intended to be made for future years.

Defined Benefit Plans

Any retirement plan other than a defined contribution plan is a defined benefit plan. These plans differ from defined contribution plans because the target retirement benefits of the plans are being used as factors to determine the current contribution levels for empoyees. Benefits are estimated by using the employee's years of service, compensation, and several other actuarial assumptions. They are never geared to the employer's profits as defined contribution plans are.

Actuarial assumptions are projections set up by mathematicians that specialized in statistics (actuaries) employed by insurance companies. They project benefits based on factors relating to the calculations on premiums, reserves, dividends, insurance, pension, and the annuity rates, using risk factors obtained from experience tables. These experience tables are compiled from both the companies' insurance claims history and other industry and general statistical data.

Defined benefit plans are usually more advantageous to older employees who are closer to retirement age, thus, having less time to accumulate the same benefits as other employees with similar earnings. 

General Qualification Requirements

•  A plan must be written, which is evidenced by the adoption of a plan and trust document. 

•  A plan must be in effect. Obtaining a "Determination Letter" from the IRS, and having plan assets go a long way in proving that the plan is in effect. 

•  A plan must be communicated to employees. This is easily accomplished by the delivery of "Notice to Employee" about the establishment of the plan, and a "Certificate of Participation" annually to the employees. 

•  A plan must be established by the employer. By signing the plan adoption agreement and corporate or business resolution, the employer agrees to set up a plan for the benefit of the employees. 

•  Contributions must be made by the employer, the employees or both. Contributions are usually made by the employer for the employees, but some plans also allow voluntary contribution by the employees up to the stature limitation. 

•  A plan must be for the exclusive benefit of the employees. 

•  A plan must be permanent. Any plan can be amended from time to time as circumstances change, but the plan must be for a permanent purpose. 

•  Any life insurance benefits must be incidental. The tax code limits on how much life insurance (term or whole life) an employee may purchase through his/her plan. 

•  Minimum participation standards must be met. This is especially emphasized in defined benefit and 401K plans. 

•  A plan must not discriminate in coverage. 

•  A plan must not discriminate in contributions or benefits on the basis of income or gender. 

•  Annuity payments under a plan must be available in the form of a joint and survivor annuity. 

•  Comprehensive vesting standards concerning the vesting of an employee's benefits must be followed. 

•  Minimum funding standards must be met. Contributions must be actuarially adequate to meet the projected benefit payments at retirement for defined benefit plans. An insurance policy from Pension Benefit Guarantee Corporation would have to be purchased to cover any future funding inadequacies. 

•  A plan must comply with the limitations on contributions and benefits. 

•  There must be no assignment of benefits. 

•  A plan must meet Social Security integration rules. Not all plans provide this integration. 

•  A plan must meet rules for merger, and consolidations. 

•  A plan must meet the rules for multi-employer plans. 

•  A plan must meet the rules pertaining to the reduction of benefits because of Social Security. 

•  A plan must fulfill plan termination requirements. 

•  A plan must fulfill special requirements for particular plans. 

•  A top heavy plan must contain contingency provisions. Top heavy and key employees in a plan creates special problems especially for small to medium sized plans.

Brokerage Firms

Brokerage Firms

This section will help you find out where the best place is to open an account. We will compare brokerage firms for the best deals and outline the benefits and features of each.

We do not suggest using a full service brokerage firm because they simply charge too much in fees and commissions. We suggest learning as much about investing, so you can trade on your own with an online brokerage firm. Several of these firms such as Charles Schwab and TD Waterhouse actually have many resources to help you select investments without the high cost. If you are just starting out and simply need advice from a full service broker or advisor, select a firm and broker you are comfortable with. Check into their background, ask questions as if you were interviewing them for a job. Several large full service firms are:

Morgan Stanley

Edward Jones

AG Edwards

Merrill Lynch

Below, we have outlined the features and benefits of some of the best online brokerage firms that have lower fees and commissions.

The following information is often updated, but it is always subject to change.

TD Waterhouse (http://www.tdwaterhouse.com)

TD Waterhouse is an excellent online brokerage firm. Online trading is easy and trade executions are fast. Pricing is in the middle, however, and they have several programs that give active traders further discounts on commissions if they meet certain levels.

Choice Program : If you have less then 18 trades per quarter and less than $250,000 in combined assets in your accounts, this is the program you would be eligible for. The option commission is $17.95 flat rate plus $1.75 per contract. So, if you traded 2 options, it would cost you $21.45. Market orders for stock trades is $17.95 and add $3 for limit or stop orders.

Premier Program : If you have more than 18 trades per quarter OR a minimum of $250,000 in assets in your accounts, you would be eligible for Premier. The option commissions are $12.00 flat rate plus $1.75 per contract. Market orders for stock are $12 with $3 added for limit and stop orders.

Premier Select : If you have 36-71 trades per quarter, you would be eligible for Premier Select. The option commissions are $9.95 flat rate plus $1.75 per contract. Market orders for stock are $9.95 with $3 added for limit and stop orders.

Premier Select Plus : If you have 72 trades or more per quarter, you would be eligible for Premier Select Plus. The commissions are the same as premier select.

You can also trade by touch tone phone for a higher rate, which is $35 for stock market orders and $35 flat rate plus $1.75 per contract for options and with an account officer by phone for $45 stock market orders and $45 flat rate plus $1.75 per contract for options.

TD Waterhouse's margin interest rates are as follows:

$1-$9,999 – Broker call + 3.25%

$10,000-$24,999 – Broker call + 2.75%

$25,000-$49,999 – Broker call + 2.25%

$50,000-$249,999 – Broker call + 1.75%

$250,000-$999,999 – Broker call + 1.25%

$1,000,000 Plus – Broker call + .75%

Broker call rate is updated and published in the Wall Street Journal every Tuesday.

A nice feature of TD Waterhouse is that they are one of the few online firms that also have branch offices. You can check and see if one of their 150 branches are near you by clicking this link and entering your zip code:

http://www.tdwaterhouse.com/home/outlet/index.html

TD Waterhouse offers a very convenient way to transfer money into your brokerage account called Transfer Direct. You can transfer as little as $100 and as much as $100,000 daily from any financial institution including your other brokerage accounts, bank accounts, etc. right online. They also have e-services, where you can obtain your account statements and 1099's right online and the have a free direct download service that allows you to import all your financial data from TD Waterhouse into Quicken or Microsoft Money.

Securities in your TD Waterhouse account are protected up to 150 million per customer.

There is also no minimum deposit required when opening a new account.

Options

Basic Options Education

By definition, an option is a contract between two parties which gives the owner (holder) the right to buy or sell a specific amount of an underlying interest at a specified price and by a specified time.

Options Terminology

Call Options - Calls give the buyer the right to purchase (for a limited time) the specific quantity of the underlying interest. A call would be purchased if the investor expected a rise in the market value of the underlying interest in the future.

EX: Jan MSFT 25 CALL would give the buyer or holder of that option the right to buy 100 shares of Microsoft stock at $25 per share up until the January expiration of the option contract, which is the Saturday following the third Friday of the month. The buyer or holder is bullish and hopes the market value of the stock is above $25 at expiration to make a profit. So, if the stock is trading at $28 at expiration, the buyer of the call option can exercise his right to buy the 100 shares at $25 and then immediately sell them in the open market for $28 and gain a $3 per share profit or $300 on that option contract.

Put Options - Puts give the buyer of the option the right to sell (for a limited time) the underlying interest according to the terms of the contract. A put would be purchased if the investor expected a future decline in the value of the underlying interest.

EX: Jan MSFT 25 PUT would give the buyer or holder the right to sell 100 shares of Microsoft at $25 per share up until the January expiration. The buyer or holder is bearish and hopes the market value of the stock declines at expiration to make a profit. So, if the stock is trading at $22 at expiration, the buyer of the put can exercise his right to sell 100 shares of the stock and then buy it back in the open market for $22 and gain $3 per share or $300 for that option contract.

Option Buyer - The person purchasing the option contract, also referred to as "long". The premium the buyer pays allows him/her the right to purchase the underlying interest at a specified price, for a limited time. The buyer (or holder) is the only one who can exercise the option.

Option Writer - The person selling the contract to the buyer, also referred to as "short". The seller is obligated to fulfill the terms of the contract if the holder exercised his/her option. The writer would be the investor on the other side of the trade in the above examples. They collect a premium for selling or writing the option and hope that the market value of the underlying stock stays the same or goes in the opposite direction by expiration. This way, they keep the premium without having to fulfill any obligation.

EX: A option writer sells a Jan 25 MSFT CALL to a buyer for $4 premium. This means they are collecting $4 times the 100 shares that 1 contract represents or $400. At expiration, the stock is selling for $22 and did not go in favor of the buyer who wanted the underlying stock to go up. Now, it makes no sense to exercise and buy a stock for $25 when the same stock in the open market only costs $22. Thus, the option expires worthless, the option buyer loses 100% of his premium ($400) and the option writer keeps the $400 without any obligation. The same is true of a put writer if the stock has increased above the strike price at expiration.

Just to clarify which side of the market everyone is on:

Call Buyer (holder) Bullish (market value of the stock must increase above strike)

Call Writer (seller) Bearish (market value of the stock must decrease below strike)

Put Buyer (holder) Bearish (market value of the stock must decrease below strike)

Put Writer (seller) Bullish (market value of the stock must increase above strike)

Exercise Price - Also known as the strike price. This is the dollar amount or value at which the seller agrees to deliver the underlying interest to the buyer. Strike prices (for stock options) are generally set at 2 ½ point intervals between $5 and $25, then 5 point intervals above that.

US Government Securities

Government securities and money market instruments are major components of the US financial system. They are the most widely owned types of securities among individual and institutional investors, and carry the lowest levels of investment risk. US Government securities, which consist of bills, notes and bonds are a significant source of financing for the US treasury. Various government agencies also issue debt securities, making credit available to such important segments of the economy as agriculture and housing.

The US money market includes short term government and agency obligations as well as various other debt instruments with maturities of less than one year. Billions of dollars in transactions take place in the money market each business day. It is a wholesale market for low risk, highly liquid short-term securities. While these securities are traded in large denominations, generally $100,000 or more, small investors participate indirectly in money market funds.

The US government raises money through debt offerings in order to meet expenses and finance the budget deficit. It issues both marketable and nonmarketable securities with maturities ranging from three months to 35 years. Once issued, after market trading of US government securities is handled by brokers and dealers in the over the counter market.

Government securities are backed by the full faith and credit of the federal governement. Because the government has unlimited taxing power, it can always raise taxes to finance it's debts. The US government has never defaulted on it's securities. Government securities (also known as treasury securities), are considered virtually risk-free, with the highest possible credit ratings. They are also highly liquid investments with an active secondary market for all types of issues.

While their interest is lower than corporate fixed income securities, the interest on government securities is exempt from state and local taxes. It is, however, fully taxable at the federal level. Capital gains on government securities are subject to all applicable taxes.

Marketable US government securities are traded in the primary market between the Federal Reserve System and several firms designated as primary dealers. These are large commercial banks and securities dealers which maintain a high level of activity in the government securities market. These dealers trade securities with each other, as well as with the public. Their transaction are generally made with very large accounts, such as banks, corporations and insurance companies.

Many other commercial banks and securities firms not designated as primary dealers handle government securities transactions in the secondary market.

Investment Companies

Investment Companies

Investment companies, also called portfolio intermediaries, are regulated by the Investment Company Act of 1940. The Act defines an investment company as a corporation or trust in which investors pool their funds, in order to obtain diversification and professional management. Investment companies invest this pooled money;their shareholders' investments are represented by stocks and bonds of other companies. Investors, instead of making decisions individually or seeking the advice of a broker, give the responsibility of managing their money to an investment company.

Most investment companies are organized as corporations;some have been established as trusts. A corporation is run by a board of directors, while a trust is generally supervised by a bank as trustee.

There are 3 different types of Investment Companies:

•  Face Amount Certificate Companies - are relatively rare. They issue a face amount certificate which in effect is a corporate version of a zero, purchased over an installment period not less than 2 years.

•  Unit Investment Trusts - are portfolios that once established are not actively traded. They are called fixed trusts and have no investment manager or board of directors. Investors buy units which are redeemed by the trust upon request. UIT's are usually based on some investment strategy or theory. A good example is the "Dogs of the Dow".

• Management Companies - are actively traded and are classified as open-end or closed-end as described below. Most popular mutual funds are open end management companies.

Mutual fund shareholders receive two types of cash distributions: dividends and capital gains. Dividends consist of income generated by the investments in the fund. Capital gains are earned when positions in the fund are sold at a profit.

Three Major Advantages:

• Diversification - the average individual investor, with limited assets, is often unable to diversify his holdings. By pooling funds with other investors, the individual is able to purchase an interest in a diversified portfolio of securities.

• Professional Management - Many investors lack sufficient knowledge or time to manage their own investments. By combining their assets with others in a mutual fund, they are able to secure the services of professional portfolio managers at a cost substantially lower than what each would pay individually.

• Liquidity-Liquidity is the ability to sell an asset at a reasonably predictable price and convert the asset to cash within a short period of time. Most mutual funds are liquid investments. Shareholders can usually sell or redeem their holdings on any business day at the market price and receive the proceeds within a week.

Municipal Securities

Municipal Securities

Municipal securities are debt obligations, both bonds and notes, issued by states, territories (such as Puerto Rico), political subdivisions (such as counties and cities), special districts (schools, water works, sewer systems, etc) and public agencies such as authorities and commissions.

United States government securities are NOT municipal securities.

They are issued to obtain funds to build or repair facilites such as streets, bridges, water works, power generating facilities and schools, or to meet other needs of the municipality. As with other debt securities, the issuer agrees to pay interest semiannually and to repay the principal at maturity. Municipal securities are exempt from the filing provisions of the Securities Act of 1933 and are therefore not registered with the SEC.

Tax Exemption

The interest received on municipal bonds is exempt from Federal income tax, however, the interest may be subject to state and local taxes. (the opposite is true with respect to US government securities, where the interest is exempt from state and local income taxes, but is subject to Federal income tax).

This means the Federal Government cannot tax local government, and the local government cannot tax the Federal government. This principal of reciprocal immunity from taxation stems from the dual levels of government in the United States and, while not in the constitution, has been upheld by the Supreme Court several times.

Most states will exempt the interest on bonds issued by political entities within their state, thus making these bonds "triple tax exempt" for residents of that state. For example, if a California resident purchases municipal bonds issued in California, the interest is exempt from Federal, state and local income taxes. If the same investor purchases the bonds issued in another state, such as NY, he or she is liable for California state and local income taxes on the interest.

Bonds issued by a commonwealth, territory or possession of the United States, such as the Commonwealth of Puerto Rico, US Virgin Islands or Guam are not subject to federal, state or local income taxes. They are therefore "triple tax exempt".

Please note that although interest on municipal securities is exempt from federal tax, and may be exempt from state and local taxes, any capital gain resulting from sale or redemption is subject to applicable taxes at the federal, state and local levels.

Maturities and Interest

Like other bonds previously discussed, municipal bonds have either short term or serial maturities.

Term Bonds - The entire issue matures at the same time. These are often used on projects with uncertain revenues, because none of the bonds are short term.

Serial Bonds - The issue matures over a period of several years. Serial maturities are often used for projects with a steady income stream. Serial bonds are quoted based on their yield to maturity. This is also called a basis quote.

 Serial Bonds with balloon maturities-are those where the largest number of bonds mature in a single year, known as the balloon year.

 The coupon rate, nominal rate, or stated interest rate, is shown on the face of a bond certificate as a percentage of par value. Par value for municipal bonds is $1,000.00. Interest on municipal bonds is paid semiannually, and payable dates are shown on the certificate. The maturity date (the date on which the principal must be repaid) is also stated on the face of the bond.

 Bonds in default trade without accrued interest, and are said to be "trading flat". Other bonds include: zeroes, and income or adjustment bonds, which pay interest only if earned.

Corporate Bonds

Corporate Bonds

While corporations issue stock as equity securities, they also issue bonds as debt securities. The owners of such bonds are in reality loaning the corporation money and thus become creditors of the corporation. As with any loan, the corporation promises to pay back the principal on a specific date in the future and in addition, they will make regular interest payments on the principal. The date that the principal is due is called the maturity date and is normally due and payable semiannually at a stated rate of interest. This stated rate of interest is the coupon or nominal rate. The interest paid to the bondholders is taxable as ordinary income. The standard denomination or par value for a bond is $1,000. So, if you have $10,000 worth of face value in bonds, you have 10 bonds.

Bonds are usually considered less risky than equity securities. The reason for this is that a corporation is obligated to pay the principal and interest according to schedule unlike stock where there is no legal obligation to pay dividends. Because bond interest is paid before stock dividends, bonds are called Senior securities and common stock is called Junior securities.

Many investors buy bonds of a company which has declared bankruptcy (or suspended interest payment) in order to take advantage of market fluctuations. Bonds which pay no interest, but continue to trade (buying and selling of the security) are "trading flat" and trade without accrued interest. This type of trading is highly speculative.

Types of Bonds

There are many classifications of bonds including secured, unsecured, registered, bearer, etc.

Fully Registered - The principal and interest are registered in the owner's name on the certificate and the transfer book. Only the registered owner can receive the scheduled payments and principal when due. When the bond's ownership changes through sales or transfer, the transfer agent will cancel the old certificate and issue a new one. This is the most common type of bond.

Registered to Principal - The owner's name is registered only on the company's books. The bond is issue with interest coupons, which must be sent in to receive payment. When the owner is due to receive an interest payment, he must clip the appropriate interest coupon and send it to the paying agent. In the case of ownership transfer, new certificates do not need to be issued because the bond has no name on it. The transfer agent will record the name of the new owner. The new owner will need to send in the interest coupons when they are due;the principal will be paid to the name that appears on the books at the time of maturity.

Bearer - these are also known as Coupon Bonds. There is no indication or reference to the bondholder on the certificate or on the books of the corporation. The bonds come with interest payment coupons attached, which must be clipped in order to receive payment. Principal is paid to the bearer of the certificate upon maturity.

Bearer bonds have not been issued for many years and as the name implies the principal is paid to the bearer of the bond. The investor must present proof of ownership.

Accounts and Margin

Accounts and Margins

A customer may buy securities either in cash, by paying the entire amount of the purchase or on margin by depositing the required amount and borrowing the balance from the brokerage firm. A new account form is required for all types of accounts with the following information from the owner of the account: Name, Address, Age, Marital Status, Occupation, Tax ID Number, Citizenship, Bank Reference, Listing of other brokerage accounts, Investment objectives, Relationship, if any, to the broker, Signature of the customer (s), broker and manager.

Joint Account Forms

Joint Tenants Agreement - This form establishes joint tenancy with rights of survivorship (JTWROS) between two parties to an account. Each party owns an undivided and equal interest in the account. In the event of death, his or her portion of the account belongs to the surviving party and bypasses the decedents estate.

Joint Tenants in Common - This agreement states the account is shared by two or more persons and specifies the percentage ownership of each. Upon death of any party, that person's equity in the account belongs to his or her estate.

Community Property Agreement - This establishes that funds and securities held in this account are the community property of a married couple.

Margin and Loan agreements

The margin agreements must be signed by the customer and returned to the firm prior to placing an order to buy on margin or sell short for the customer's account. When purchasing and maintaining securities on margin, the customer must agree to abide by exchange and Federal Reserve requirements. (again, margin will be handled in detail later).

Options Agreement

This agreement is required before options may be traded in a cash or margin account. The options agreement includes a statement of the client's net worth, liquid assets and investment experience. Brokerage firms require varying amounts of income and net worth depending on the types of option strategies a client intends to use. (Since our entire trading system uses specific option strategies, we will get into more detail later regarding these limits and how to get accounts open without necessarily proving any such figures). All customers opening an option account must receive the "full disclosure" document approved by the options exchanges and the Options Clearing Corporation (OCC) at or prior to the account being approved.

Limited Power of Attorney

This agreement allows someone other than the customer to place buy and sell orders in the account. However, the third party may not withdraw funds or securities from the account. This is commonly set up when an investment advisor or money manager is trading on the customer's behalf.

Introduction to Investing

Common Stock

Stock is issued by a corporation so they can raise funds to either expand or continue business operations. Stock in a privately held corporation is owned by very few investors. Stock in a publicly held corporation can be purchased by the public. Publicly held shares are either traded on an exchange, the most famous being the New York Stock Exchange (NYSE) or the over the counter (OTC) market like NASDAQ. If a stock symbol has three letters or less, it is traded on an exchange. (for example: C-Citigroup, Inc., BA-Boeing & WMT-Walmart) and if the symbol is four or five letters, it is traded OTC (for example: MSFT-Microsoft). Stocks traded by the public are very liquid, which means they are easy to buy and sell. Stock is known as an equity security because it represents ownership or equity in the corporation. Common stock is the most basic type of equity security and gives the buyer the right to participate in the earnings and assets of the company as well as voting rights and any dividends that are paid by the corporation.

Preferred Stock

Companies also issue preferred stock. The advantage of preferred stock is that it usually pays a stated dividend. The par value is normally $100, so that the dividend can be expressed as a percentage of par (IE: 5 ¼% preferred). There is also a market value to the stock and it trades, however, the value normally does not fluctuate as much as common stock. Preferred stock holders have no voting rights.

Market Value

The market value of a stock is the price listed multiplied with the number of shares that an individual owns. (For example: An investor owns 100 shares of a $50 stock, the market value is $5,000) Market value can fluctuate many times during a single day of trading and is dependent on supply and demand.

Categories of Stock

Blue Chip - High grade, high quality companies, major corporations, usually well established and have a track record of paying dividends and increasing earnings. An example would be General Electric (GE)

Defensive - Businesses which seem resistant to recession for example utility companies.

Income - Pays a higher than average dividend. Investors who seek consistent income that is higher than average would buy income stocks.

Growth - Market share, earnings and sales are expanding at a rate faster than average. Dividends are usually small because earnings are being reinvested back into the company for growth. Many technology companies are growth stocks.

Seasonal -Earnings fluctuate with the calendar and changing seasons. Retail stores are often seasonal.

Cyclical -Businesses such as automobile manufacturing and steel are cyclical. Earnings and stock price tend to fluctuate with the business cycles. Not the same as seasonal because the business cycle is not always in a one year cycle.

How to Invest in Stocks

Everyone wants to be financially secure. If you have a house, your house may be your biggest "asset" early on, but you will need to live in it for the rest of your life. Do you want a financially secure retirement or a vacation house in the South Pacific? You must invest your savings if you plan to retire comfortably.

1. Save. Before you can invest, you need money. Don't start investing until you have a secure job and six to twelve months of living expenses in a savings account, as an emergency fund, in case you lose your job. Learn how to budget your money and to spend your earnings wisely. Most investors have to be careful not to spend any of their profits, and to keep some aside for future use, and for retirement, as well as emergencies.

Be prepared to always live within or even below and not beyond your means. This will help to ensure that you always have enough money.

2Read. Before you start investing, you need a basic understanding of what a stock is, what it means to invest, and how to evaluate stocks. Get some basic books in stock investing. Aim to read every book on investing you can get your hands on. Here are some of the very best books and resources for all serious investors:

The Intelligent Investor by Benjamin Graham. Get this on audio CD, listen to it a few times, and it will make a lot of sense. Focus especially on Chapters 8 (market fluctuation) and 20 (margin of safety).

The Interpretation of Financial Statements by Benjamin Graham and Spencer B. Meredith. This is a short and concise treatise on reading financial statements.

Security Analysis by Benjamin Graham and David Dodd. This book is considered the bible of investing and will tell you how to analyze corporate finances thoroughly. You don't have time NOT to read it. Get this book now, and master everything in this book. That being said, due to its age (it was published in 1934, just after the great stock market crash), it lacks some modern aspects; in particular, it does not tell you anything about the cash flow statement.

Expectations Investing, by Alfred Rappaport, Michael J. Mauboussin. This highly readable book provides a new perspective on security analysis and is a good complement to Graham's book.

Common Stocks and Uncommon Profits (and other writings) by Philip Fisher. Warren Buffett once said he was 85 percent Graham and 15 percent Fisher, and that is probably understating the influence of Fisher on shaping his investment style.

One up on Wall Street and Beating the Street, both by Peter Lynch. They are easy to read, informative and entertaining.

The Essays of Warren Buffett, a collection of Warren Buffett's annual letters to shareholders. Warren Buffett made his entire fortune investing, and has lots of very useful advice for real people who want to invest. Warren Buffet has provided these to read online free: http://www.berkshirehathaway.com/letters/letters.html.

If you have some time left, you should also read Buffett's early letters to his partners from 1956 to 1969; they can (for example) be found at http://www.ticonline.com/buffett.partner.letters.html.

Buffetology, The New Buffetology and The Tao of Buffet, all by Mary Buffet and David Clark. These are basic books on the investment methods of Warren Buffett. The New Buffetology can be purchased on audio CD.

For a better biographic insight of Warren Buffet, read Buffett: The Making of an American Capitalist by Roger Lowenstein. This book will tell you how Buffett refined his investment style over the years and who he is.

The Secret Code of the Superior Investor, by James K Glassman. This is an excellent treatise on the importance of buy and hold.

Motley Fool and The Tycoon Report, both excellent online publications.

Wikinvest.com at http://www.wikinvest.com is a great place to find information on companies and concepts in the market. It is also helpful to conduct due diligence on the investment information sources themselves. Check out the performance and advice of websites, newsletters and blogs. One resource to conduct this research is at Greedreviews.com (http://www.greedreviews.com).

3Think. Warren Buffet says that after you think, then think again. Warren Buffet says that if he cannot fill out on a piece of paper several reasons to buy a stock, then he will not buy it.

4Practice. Trade stocks on paper before actually trading stocks with real money. Record your stock trades on paper, keeping track of dates of the trades, number of shares, stock prices, profit or loss, including commissions, taxes on dividend, and short or long term capital gains taxes you would have to pay for each trade. It is also helpful to record the reasons for each buy or sell decision. Calculate your net profit or loss less commissions and taxes for a meaningful period (1 year or more) and compare your results with the market index, such as the S&P 500. Do not start trading with real money until you are comfortable with your trading abilities.

5Open a stock brokerage account with a discount broker. No specific recommendation can be offered here, as the stock brokerage business is a rapidly changing field. Trial and error is probably the only way to find a good broker, but you should do your own due diligence by checking out their site and looking at reviews online. The most important factor to consider here is cost, namely, how much commission is charged, and what other fees are involved. Discount brokers generally charge commissions of less than $10 per trade, some as low as $1 per trade, and some offer a limited number of free trades per year, provided you meet certain criteria. Other than costs, you should also consider whether dividend reinvestment is offered (which is the best way to build up your positions), what research tools are offered, customer service, etc.

6Build a small portfolio of 10-50 stocks. Blue chip stocks are stocks of market leading companies known for quality, safety, and ability to generate profit in good times and bad, although they are generally fully priced and difficult to buy at a bargain price except in a severe bear market. Choose stocks of companies with proven records of profitability with at least some earning in each of the past ten years, pay at least some dividend in each of the past 15-20 years, at least 30 percent EPS growth over the past 10 years (using 3-year averages to smoothe out variations, for example, average EPS for years 2008-2010 compared to average EPS for years 1998-2000), low debt to equity (less than 1), and high interest coverage (at least 5).

Stay up-to-date with different value investing websites such as Motley Fool or Fallen Angel Stocks to see what kind of deals are out there.

If you do not have the time or inclination to learn about individual stocks, buying and holding no-load, low expense index funds forever using a dollar cost averaging strategy is best and outperforms most mutual funds, especially over the long term. The index funds with the lowest expensive ratio and annual turnover are best. For investors with less than $100,000 to invest, index funds are usually best. If you have more than $100,000 to invest, however, individual stocks are generally preferable to mutual funds, because all funds charge fees proportional to the size of the asset. Even the lowest fee index fund, Vanguard Total Stock Market Index Fund (VTI), has a 0.07% annual expensive ratio. This amounts to only $70 over 10 years for a $10,000 portfolio, but $700 over 10 years for a $100,000 portfolio, and $7,000 over 10 years for a $1,000,000 portfolio. If the expense ratio were 1.50% (typical for an average mutual fund), the fees would amount to $15,000 for a $100,000 portfolio, and a whopping $150,000 over 10 years for a $1,000,000 portfolio. See Decide Whether to Buy Stocks or Mutual Funds for more information whether individual stocks or mutual funds is better for you.

7Hold for the long term, at least 5-10 years, preferably forever. Avoid the temptation to sell when the market has a bad day or month or even year. On the other hand, avoid the temptation to take profit even if your stocks have gone up 50 percent, 100 percent, 200 percent, or more. As long as the fundamentals are still sound, do not sell. Just be sure to invest with money you don't need for five or more years. However, it does make sense to sell if the stock price appreciates too much above its value (see below), or if the fundamentals have drastically changed since purchase so that the company is unlikely to be profitable anymore.

8Hold on to the winners and do not add to the losers without good reason. Peter Lynch said that if you have a garden and every day you water the weeds and pick the flowers, that in one year you will have all weeds. Peter Lynch said that he was the best trader on Wall Street for 13 years because he picked the weeds and watered the flowers.

9Avoid stock tips. Do your own research and do not seek or pay attention to any stock tips, even from insiders. Warren Buffett says that he throws away all letters that are mailed to him recommending one stock or another. He says that these salesmen are being paid to say good things about the stock so that the company can raise money by dumping stocks on unsuspecting investors.

Likewise, don't watch CNBC or pay attention to any television, radio or internet coverage of the stock market. Focus on investing for the long term, 20 years, 30 years, 50 years, or more, and not get distracted by short term gyrations of the market.

10Invest regularly and systematically. Dollar cost averaging forces you to buy low and sell high and is a simple, sound strategy. Set aside a percentage of each paycheck to buy stocks every month. And remember that bear markets are for buying. If the stock market drops by 20 percent or more, move more cash into stocks, and move all available discretionary cash and bonds into stocks if the stock market drops by more than 50 percent. The stock market has always bounced back, even from the crash that occurred between 1929-1932.

11Consider selling portions of your holdings as a stock appreciates significantly, at least 50 percent to 300 percent, based on quality of the stock. Use upper limit for better quality stocks. Letting your winners run as long as the story is still good will increase your long-term chance for success. Warren Buffet says that you should hold winners forever, but if the price-to-book gets too high (above 100 is definitely too high), you should consider selling the stock.

12Consult a reputable broker, banker, or investment adviser if you need to. Never stop learning, and continue to read as many books and articles as possible written by experts who have successfully invested in the types of markets in which you have an interest. You will also want to read articles helping you with the emotional and psychological aspects of investing, to help you deal with the ups and downs of participating in the stock market. It is important for you to know how to make the smartest choices possible when investing in stock, and even if you do make the wisest decisions, to know how to deal with loss in the event that it happens.

How Stocks Work

Corporations

Any business that wants to sell shares of stock to private or public investors needs to become a corporation first. The legal process of turning a business into a corporation is called incorporation.

If you start your pizzeria with your own money (even if it's borrowed from the bank), then you've formed a sole proprietorship. You own the entire restaurant yourself, you get to make all of the decisions, and you keep all of the profits. If three people pool their money together and start a restaurant as a team, then they've formed a partnership. The three people own the restaurant themselves, sharing the profit and decision-making.

A corporation is different, and it's a pretty interesting concept. A corporation is a "virtual person." That is, a corporation is registered with the government, has its own Social Security number (called a federal tax ID number), can own property, sue and make contracts. (It can also be sued.) By definition, a corporation has stock that can be bought and sold; all of the owners of the corporation hold shares of stock in the corporation to represent their ownership. One characteristic of this "virtual person" is that it has an indefinite and potentially infinite life span.

There is a whole body of law that controls corporations. These laws are in place to dictate how a corporation operates, how it's organized, and how shareholders and the public get protection. For example, every corporation must have a board of directors. The shareholders in the company meet every year to vote on the people who will "sit" on the board. The board of directors makes the decisions for the company. It hires the officers (the president and other major officers of the company), makes the company's decisions and sets the company's policies. 

Consider the board of directors as the virtual person's brain: Even if a corporation has a single employee who also owns all of the stock in the corporation, it still has to have a board of directors.

Another reason that corporations exist is to limit the liability of the owners to some extent. If the corporation gets sued, it's the corporation that pays the settlement. The corporation may go out of business, but that's the worst that can happen. If you're a sole proprietor who owns a restaurant, and the restaurant gets sued, you're the one being sued. "You" and "the restaurant" are the same thing. If you lose the suit, then you can lose everything you own in the process.

A Stock Exchange

Let's get back to our pizzeria example. If you want to launch one and are interested in recruiting a pool of investors, where would you find these people? You could place an ad in the paper or online, or you could simply contact friends and family. But what if some of your initial investors decide a year later that they want to sell their shares? They would each have to go out and find a new buyer, which might prove difficult, especially if the company isn't performing very well.

A stock market solves this problem. Stocks in publicly traded companies are bought and sold at a stock market (also known as a stock exchange). The New York Stock Exchange (NYSE) is an example of such a market. In your neighborhood, you have a "supermarket" that sells food. The reason you go the supermarket is because you can go to one place and buy all of the different types of food that you need in one stop -- it's a lot more convenient than driving around to the butcher, the dairy farmer and the baker. The NYSE is a supermarket for stocks. The NYSE can be thought of as a big room where everyone who wants to buy and sell shares of stocks can go to buy and sell.

Modern stock exchanges make buying and selling easy. You don't have to actually travel to New York to visit the New York Stock Exchange. You can call a stock broker who does business with the NYSE, or you can buy and sell stocks online for a small fee.

There are three big stock exchanges in the United States:

NYSE - New York Stock Exchange

AMEX - American Stock Exchange

NASDAQ - National Association of Securities Dealers

If these exchanges didn't exist, buying or selling stock would be a lot harder. You'd have to place a classified ad in the newspaper, wait for a call and haggle on a price whenever you wanted to sell stock. With an exchange in place, you can buy and sell shares instantly.

Stock exchanges have an interesting side effect. Because all the buying and selling is concentrated in one place, and since it's all done electronically, we can track the constantly fluctuating price of a stock in real time. Investors can watch, for example, how a stock's price reacts to news from the company, media reports, national economic news and lots of other factors.

For example, all publicly traded companies need to issue quarterly earnings reports through the Securities and Exchange Commission (SEC). If those earnings are lackluster, shareholders might decide to sell some of their stock, which would lower the stock price. But if the newspaper reports an overall increase in the popularity of pizza, more people might buy shares and the price would go back up.

But before we delve too deeply into the intricacies of stock prices, let's talk about corporations. Even if you own your own pizza business, you can't sell stock in the company unless you become a corporation. We'll discuss that on the next page.