The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (42 page)

Of course, the preferred shareholders don’t always get their dividends either. This is what makes preferred stock a useful tool for companies that need to raise capital. Because preferred stock is a hybrid investment—not quite a stock, not quite a bond—companies have some flexibility in choosing to defer dividend payments when capital is running low. Preferred stocks are rated just like bonds, but they naturally come with lower ratings to begin with, and a company’s credit won’t be affected too significantly by holding off on dividend payments to preferred stockholders. (Doing the same thing to bondholders would be a default and carries major consequences.)

So preferred stockholders don’t have all the rights that bondholders have, and they also don’t have all the rights that common stockholders have. Most notably, preferred shareholders have no voting rights in the company, except in certain special circumstances. Also, preferred shares usually come with a call feature, which allows the company to repurchase the shares at its discretion.

If you want to buy a stock, you don’t walk down to Wall Street, hop on the trading floor and make your bid. You have to have a broker execute the trade for you. Traditionally, a broker offered an array of services for clients, getting to know their portfolios and providing research and investment advice, and charging heavy commission fees in return.

These full-service brokers are still in abundance, but a popular alternative that has developed in recent years is the
discount broker
. These brokers are for investors who don’t need or want the hand-holding of a full-service broker, and instead just need a way to execute trades based on their own research and analysis. Discount brokers often charge a very low, flat fee for trades, and often have very low minimum account balances, so they are a popular way to get involved in stock trading for people who aren’t ready for (or don’t want) a traditional broker. But they also pin all responsibility on the investor.

Another advantage of discount brokers is that, unlike many full-service brokerage firms, discount brokers don’t risk their own money in the market. This is important because accounts at a discount brokerage may be in less jeopardy in the event of a major market downturn. Plus, discount brokers sidestep the temptation to unload their own bad positions on their clients, a temptation that has gotten many full-service brokerage firms in trouble.

Whether to go with a full-service or discount broker is a personal decision, but if you’re going to go with a full-service broker, first, be sure they really know what they’re doing and have your best interests at heart. Furthermore, even though someone else is doing much of the work for you, you still have a responsibility to be an informed investor and to not let yourself be pressured into positions you know aren’t good for you. Before deciding on a full-service broker, it is important to check with the Central Registration Depository (CRD), which will provide you with information about an individual broker’s history, including employment history and any complaints filed by former clients, as well as any relevant information about brokerage firms.

If you decide to go with a discount broker and make your own trades (or even if you have a traditional broker and want to be better informed), you have a wealth of real-time information available to you thanks to the Internet. Looking at the data for a particular stock may be daunting, but the numbers aren’t really so complicated. You’ll see things such as the bid price (the last price a buyer was willing to pay for it) and the ask price (the last price a seller was willing to sell it for). You’ll probably also see the range of prices the stock has sold for over the last year, the average daily trading volume, and the price-to-earnings, or P/E, ratio. Most financial web sites have a key for you to look up the more difficult-to-understand numbers and how they’ve been calculated.

For those looking for a little more help with their investments, a registered investment adviser, or RIA, may be the answer. RIAs are basically money managers and will make decisions about your investments based on your goals and their own investment philosophy. RIAs often require large minimum investments, typically at least $100,000 and possibly going as high as several million dollars.

An RIA will manage your investments through your brokerage account, with authorization to buy and sell assets on your behalf. This sounds like a set-it-and-forget-it strategy, and indeed RIAs can make trades without notifying the client every time, but this doesn’t mean investors should forego all responsibility for their investments. It’s important to find an RIA who not only understands your financial goals but also shares your macroeconomic view of the near and longer-term future. And it is also important to stay up on what’s happening with your money and continually confirming that it’s in good hands.

RIAs collect their fees based on the total amount of funds under management, generally never more than 3 percent (usually around 1.5 percent). This gives an RIA a strong incentive to make money for clients because, unlike with a broker who collects fees based on commissions, the success of an RIA’s investments directly impacts the RIA’s fees. If your assets shrink, so does the RIA’s takeaway.

Be careful that your RIA does not overly crowd your portfolio with mutual funds. Aside from the problems with mutual funds, which we’ll get to later, remember that a mutual fund is a managed fund, and you are already paying your RIA for that. If your RIA heavily uses mutual funds, you are essentially being charged twice for management, paying double the fees.

In order to protect investors when their brokerage firms go bankrupt, Congress set up the Securities Investor Protection Corporation, or SIPC, in 1970. The SIPC is a nonprofit organization that collects insurance fees from member brokerage firms in return for insuring customer accounts up to $500,000 each. Any brokerage firm that is part of the National Association of Securities Dealers (NASD) is a member of the SIPC.

This provides some peace of mind for investors, and many brokers carry their own insurance on accounts in addition to the SIPC insurance. But the problem is that these insurance policies, like everything else, are designed with the rare occurrence in mind. They aren’t designed for a system-wide failure in the markets. This is a big reason why we prefer brokers that don’t risk their own money in the markets—they are more likely to survive the future Aftershock.

Short selling
is what some investors do when they think the price will go down. Short selling is effectively three transactions rolled into one. The first transaction is the sale of a stock at the current market price, or close to it. The second transaction is borrowing that stock—generally from the broker executing the trade—in order to give it to the buyer. Finally, the third transaction is buying the stock later when the loan period is over to repay the broker and hopefully make a profit (assuming the buying price is lower than the earlier selling price).

During the period between selling the borrowed stock and buying the stock to repay the loan, the investor has a “short” position in the stock or commodity. (In contrast, if the investor owned shares of the asset, that would be considered a “long” position.) If the asset price goes down during that period, the investor makes money by buying it for less than he or she sold it for. On the flip side, if the asset price unexpectedly goes up, the losses are potentially unlimited, since the short seller is obligated to buy the stock to pay back the original loan (plus any fees that might be associated with the loan).

Put options
are an alternative to short selling. An investor can purchase a put option on a security, which gives him or her the option to sell that security at a specified price (the
strike price
) to the seller of the option during a specified time period. If the price of the stock goes down during that time, the buyer of the put option can simply buy the stock and sell it to the other party at the agreed-upon price, pocketing the difference. If the price doesn’t go down and the buyer doesn’t exercise the option, the loss is limited to the price of the put option. A put option is the opposite of a call option, which gives the buyer the right to buy a security at a specified price.

Put options (and call options, for buying instead of selling) are generally limited to terms of a year at most.

LEAPS
are like put options for a longer period of time. LEAPS, which is short for long-term equity anticipation securities, can have terms extending more than two years. One quirk is that equity LEAPS always expire in January, so the term is determined by the expiration year of the option. The further out the expiration date is, the more expensive the option will be.

A bond is essentially a loan made to the bond issuer in exchange for future repayment of the principal of the loan plus interest. Various factors affect the interest rate offered on the loan, which were discussed in Chapter 5. Once a bond is issued, it may be sold and bought on the bond market, which adds layers of complexity for a number of reasons. Primary among these is the fact that current interest rates change, making previously issued bonds either more valuable or less valuable, depending on the details of the bond. In addition, other things change as well. For example, the creditworthiness of the bond issuers may change over time, which impacts the value of the bond on the bond market. Also, changes in the inflation rate matter, too, because if inflation goes up, it subtracts from the value of the bond.

Chapter 5 provides a basic explanation of bonds and the bond market. For this discussion, we will now focus on:

• The call
  
• U.S. Treasurys
  
• Zero-coupon bonds and Separate Trading of Registered Interest and Principal Securities (STRIPS)
  
• Treasury Inflation-Protected Securities (TIPS)
  
• Savings bonds
  
• Mortgage-backed securities
  
• Municipal bonds
  
• Corporate bonds
  
• Certificates of deposit
  
• Money market funds
  
• Bond sensitivity to changes in interest rates and inflation
  

Even if an investor does not sell a bond for a gain when prevailing interest rates go down, having a relatively high interest rate locked in is a pretty nice perk. This perk is eliminated if the bond has a
call
feature. Some indentures give the bond issuer the option of paying off the principal before the maturity date, thus ending the debt obligation and any future interest payments to the bondholder. In many cases, this option may be triggered at a certain length of time into the bond’s life span.

Why would a bond issuer want to do this? Just like if you wanted to pay off a mortgage early and refinance at a lower rate, the bond issuer would be at a great advantage by refinancing if interest rates go down. It’s easy to see that this feature benefits the bond issuer, and only the bond issuer. If interest rates go down, the issuer has every incentive to execute the call feature, refinance, and leave you to find another suitable investment. If interest rates go up, however, when you would
want
the call feature to be executed, the issuer has no motivation to refinance. The bond issuer can keep paying you at a lower interest rate until the maturity date. Many indentures may specify a premium to be paid in the event of a call, but it is sure to be paltry compared to the interest that would be earned over the remaining life span of the bond.

As the name suggests, U.S. Treasurys are bonds issued by the Treasury Department of the United States. When people talk about public debt in the United States, they are talking about outstanding U.S. Treasurys. Treasury securities are owned in huge amounts by big government agencies and corporations, such as the governments of China and Japan, as well as our own Federal Reserve, but these securities can be purchased by individual or institutional investors.

Backed by the full faith and credit of the U.S. government, U.S. Treasurys have traditionally enjoyed the highest investment grade awardable. As a result, they tend to offer among the lowest yields of any bonds, but this is acceptable to many investors, who view our Treasurys as risk free. This view took a small hit in the summer of 2011 when Standard & Poor’s downgraded the Treasurys credit rating to AA+, after 70 years at AAA, but U.S. Treasurys are still considered a rock-solid investment, especially given the current turmoil and potential risks in Europe.

Another reason why Treasury securities can afford to offer low yields is that the interest paid on them is not subject to state and local taxes. This makes Treasurys especially attractive to investors in states with high income tax rates, but less so to those in states like Texas or Washington with no individual income tax. Treasury interest is, however, subject to federal income tax.

Standard-issue Treasurys are divided into three categories based on their lengths of maturity.
Treasury bills
, or
T-bills
, usually range from 90 days to 12 months,
Treasury notes
from 2 to 10 years, and
Treasury bonds
up to 30 years. Keeping this terminology straight can be difficult, and you might hear some people use the terms interchangeably if they don’t know the difference. If you have trouble remembering which is which, the blanket term
Treasurys
works just fine (as long as you know when the maturity date is, of course).

Most Treasury securities make payments just like any other bond. T-bills, however, don’t make interest payments due to their short maturity. Instead, you buy the bill at a discount, and receive the full face value at the maturity date. The difference between the price you pay and the amount you receive is the interest.

A zero-coupon bond is just what it sounds like: a bond with no coupons. Interest is accrued and reinvested in the bond to be paid back in one sum at maturity. In many cases, this means taxes must be paid on the interest before the investor receives it. This drawback can be eliminated by purchasing zero-coupon bonds through an individual retirement account (IRA).