If you read the business pages or investment in mutual funds you will often hear portfolio managers described as “bottoms up” or “top down” in their investment approach.  Here is an explanation of “top down”.

The investor using a top down investment approach looks at the big picture. Macro economic variables such as the global economy and individual country statistics such as national GDP, trade balances, currency movements, inflation, interest rates, commodity price trends are used to determine where to invest and in what types of assets.

Although there is no statistical measure of political stability, it is just as important a factor in determining the risks involved in a country. Market sentiment is also another variable. Once these assessments are completed, asset allocations are then made in the country, group of countries, sector or currency.

The idea in a top down approach is to weigh broad macro variables and then shift investments accordingly i.e. to make money by shifting assets rather than by analyzing companies. Picking individual securities is usually the last step in this strategy.

For example, if economic and growth in China and Asia are deemed stronger than the USA, then an international investor will allocate more money to Asian counties by buying a handful of blue chips, country index funds or exchange traded funds or sector specific funds.

Alternatively in a top down sector analysis, if oil prices are expected to drop because of oversupply and declining demand, then you might consider buying airline stocks as they usually benefit from lower fuel costs.

The top down approach can also be used to make money from expected changes in interest rates and exchange rates of two countries. For example, if the Deutschmark is deemed undervalued relative to the US dollar, then it would make sense to overweight German securities and to make gains from a likely appreciation of the currency in addition to stock gains.

A top down strategy places importance on economic, market and industry cycles as they come in and out of favor. A downside is that a top down investor may lose out on spectacular gains from a rigorously researched stellar stock.

Photo Credit: Zest-pk

If you read the business pages or investment in mutual funds you will often hear portfolio managers described as “bottoms up” or “top down” in their investment approach.  Here is an explanation of “bottoms up” (and no, it nothing to do with alcohol).

In the bottom up investment approach, the details matter. An investor concentrates on the fundamental analysis of the company – its market prospects, sales growth, profitability, cash flow, debt ratio, price earnings valuations and dividend yield among other variables. Each company’s numbers are then compared to that of its competitors to decide which stock offers more upside potential.

Macro economic variables (such as inflation or national GDP) do not figure in the analysis, neither does market timing. The premise is that a well-run company will do well regardless of the economy. Investors usually start with a screening filter such as a low price-earnings ratio or PE relative to the market or sector.  Once the undervalued stocks are identified, your next step is to drill down to even finer details. The idea is to identify a handful of companies you feel confident about.

It is important to remember that in a bottom up strategy different valuation techniques are required for different industries. For example, in analyzing a drug company, it is necessary to estimate possible revenue streams not only from existing drugs, but also from new ones, and to estimate a fall in sales and loss of market share once a patent expires. It is also important to know what new drugs are in the pipeline and which ones are likely to get approval.

On the other hand, a small manufacturing company is relatively easy to analyze. Expected sales, pricing policies, competitive pressures, demographics, market share, cash flow, inventory and debt management are the appropriate metrics to consider.

Astute investors such as Warren Buffet know intimately how their stocks operate and understand precisely how the smallest changes will affect earnings. For example, in 1988 when most investors were still gloomy after the 1987 crash, Warren Buffet bought Coca Cola Company on the cheap, foreseeing its unshakeable growth prospects as a global company.

The hitch to this approach is that all stock prices are affected in a market downturn which is brought on by negative macro conditions, or a company’s stock price could be badly affected by an unforeseen event.

A recent example would be that the onset of swine flu not only badly affected sales of pork and pork products, it also marred cruise ship revenues. Royal Caribbean and Carnival had poor earnings due to the economic downturn and to people staying at home from health concerns.

Photo Credit:Bobcatnorth

In a previous post we discussed how a capital gain occurs when you sell an investment for a profit.  All capital gains are taxable in the year that you sell your investment so you can’t normally “defer” the gain to a future year and you also don’t have to worry about any capital gains on investments that haven’t been sold yet.

One very important tax rule to be aware of is that if you incur a capital gain on an investment owned less than one year – your capital gains taxes will be significantly higher than if you owned the investment for more than one year.  The capital gains on the short term investment will be taxed as normal income whereas the long term (greater than one year) gains will be taxed at a lower rate.

Capital loss taxes

Capital losses are not taxed since it is a loss rather than a gain.  Why is there such thing as a capital loss if there are no taxes involved you ask?  The answer is that you can use capital losses to offset capital gains to reduce your tax bill.  Capital losses can be carried forward indefinitely so they don’t have to be used in the year the investment was sold.

Offsetting example

John sold two stocks recently – one resulted in a capital gain of $3,000 which will be taxed at a rate of 15% ($450), the second stock was sold at a loss and created a $2,000 capital loss.

John can use the $2,000 loss to offset the equivalent amount of capital gains and reduce the taxable capital gain.  He subtracts the $2,000 loss from the $3,000 capital gain and only pays taxes on the difference – $1,000 so he will pay $150 of tax instead of $450.

If you make a profit on the investment then you will have a capital gain which is taxable.  If you lose money, then you will have a capital loss which is not taxable but can be used to offset capital gains if you have any.

Capital gain

A capital gain is the difference in the selling price of an investment and the purchase price minus transaction costs, if you sell for a higher price than you bought it at.

For example, let’s say you bought a mutual fund on the advice of the genius kid next door for $5,000 with a transaction cost of $50 and then sold it for $7,000 with a transaction cost of $50.  Since your selling price is higher than your purchase price, this will result in a capital gain.

To calculate the capital gain, you subtract the purchase price and transaction costs from the sale price.

Capital gains = sale price – purchase price – transaction costs

= $7,000 – $5000 – $100

= $1,900

Capital loss

What happens if the hot stock tip you heard at the coffee shop turned out to be a dud and you lost money?  In that case you will have a capital loss because you sold the stock for less than you paid for it.

For example if you buy an investment for $10,000 with a transaction cost of $25 and sell it for $9,200 with a transaction cost of $25.

Capital loss = sale price – purchase price – transaction costs = $9,200 – $10,000 – $50 = -$850.

You might notice that the formula is the same for both losses and gains.  If the answer is negative then you have a capital loss.  If the answer is positive then you have a capital gain.

This is a more advanced post concerning buying and selling stocks and etfs.  If you aren’t familiar with the subject then you might want to start with market orders and limit orders.

If you ever have need to buy/sell individual stocks or exchange traded funds then you should be familiar with the different types of orders.  The bid, ask and spread are more terms you should be familiar with.

In the stock market, buyers and sellers set their own prices.  Understanding the bid ask prices, spread and sizes will help you improve your execution skills.

The bid represents the price that a buyer is willing to pay for the stock. The ask is the price that sellers are willing to sell the stock at. There is always a gap between the two, the ask always being higher. This gap is called the bid ask spread.

For example if Joe wants to sell 100 shares of C (CityGroup) at $4.60 then he will “ask” for a price of $4.60.  If Susan happens to be in the market for 100 shares of the same company and she is willing to pay $4.55 per share then she will “bid” $4.55.  The difference between these two prices is called the spread.  This is not unlike a yard sale where someone might “ask” $2 for an item and someone else might “bid” 25 cents.  In a stock market there are lots of buyers and sellers so it’s quite likely that Susan and Joe will complete their deals with other participants.

However if you place a market order where there is no price specified then the buyer will end up paying the higher ask price. When selling, you receive the lower bid price. For a stock that trades regularly this is not really an issue since the spread is likely to be quite low.

Bid Ask Spread – market orders

For market orders the bid ask spread amount goes to the middleman and is kept by the specialist who is handling the transaction. The specialist gets paid to facilitate the coordinating and matching of the orders and to keep the market liquid.

The bid ask spread is a function of market demand and supply. In cases where a stock is relatively illiquid, you tend to see a wide spread.

If you trade online, you can see the bid ask prices. Be aware that because prices are dynamic and are constantly changing especially for active stocks, you may not get the price you see on the screen.

You can gain greater control over the price by inserting a limit order which specifies the price you are willing to either buy at or sell a security for.  Limit orders come with a time specification and carry a higher transaction cost than a market order.

Festival of Stocks

If you are not familiar with stock indexes then please read this post which explains what they are first. What is a stock index?

Stock indexes come in a variety of shapes and sizes.  The most common types of stock indexes are market value-weighted (S&P500) and price-weighted indexes (Dow Jones).  Some determining factors of various indexes include how many companies and which type of companies they cover.  In theory an index could include every company that trades publicly or any subset of those  companies.

• All company – Dow Jones Wilshire 5000 is an index of every publicly traded stock in the United States.
• Rank by size – Some indexes include just the largest companies according to the value of the company.  The Russell indexes include only the largest companies by value ie the Russell 1000 includes the largest 1000 publicly traded U.S. companies.
• Covering a specific sector – A sector refers to the industry that a company is in.  An example of a sector index would be the Dow Jones U.S. Financial Sector Index which includes companies from the financial services sector of the U.S. equity market such as banks and mutual fund companies.
• Rank by both – ie S&P 500 has the top companies by size in each major industry.

Can companies be added to or deleted from an index?

Regardless of how an index is put together, companies can be added or removed from the index.  If a company on an index goes out of business or is taken over by another company then it will be deleted from the index.  Conversely a company will be added to the index once it is meets the index requirements.

Why do I need to know this?

If you invest in index funds or ETFs this information is useful because most index funds and ETFs will base their investments on an stock/bond index of some sort.  It’s important to understand what the underlying index is based on and to make sure it fits your investment objectives.  You wouldn’t want to buy an index fund which only covers forestry companies when you actually wanted a broad-based index funds covering all the larger companies in the US.

How to find out more about the indexes behind your investments

There are plenty of good sources for this information but I use Morningstar which is one of the leaders in financial information. You can sign up for a free membership at Morningstar here or click on the banner below.

Municipal bonds come in both taxable and tax-exempt form. The tax-exempt municipal bonds are favored since the incomes they yield are free from federal and, in many instances, state and local income taxes for most investors.

Municipal bonds are available in two forms, General Obligation bonds (GO) and Revenue Bonds.

General obligation bonds are sold to raise immediate capital and are affirmed by the taxing power of the issuer while Revenue bonds, that are created to fund infrastructure projects, are backed by the revenue yielded by those projects. Both types of bonds are tax-free and especially attractive to investors because of the odds that the issuers will repay their debts.

Although purchasing municipals bonds is deemed as a conservative investment strategy, it is not entirely risk-free. The following risks are associated with these bonds:

• Credit Risk – If the issuer is not able to satisfy its financial obligations, it might fail to make regular interest payments and or not capable of paying back the principal upon maturity. Many municipal bonds are supported by insurance, thus securing repayment just in case of a default.
• Interest-Rate Risk – The rate will never change over the life of the bond and if interest rates rise on market, your bonds will be paying a lower rate as compared to the return on the newly issued bonds.
• Tax-Bracket Changes – Municipal bonds yield tax-exempt income, and pay lower interest rates than taxed bonds.
• Call Risk – Many bonds allow the issuer to repay all or a portion of the bond prior to the maturity date.
• Market Risk – The underlying price of a particular bond changes in response to market conditions.

It’s important to note that the risk of a bond issuer is usually considered to increase if the issuer is smaller.  Therefore a bond issued by a small city would be considered riskier than a bond issued by a large city.  Bonds issued by the US government would be considered the safest type of bonds.

Carnival of Road to Financial Planning

[Two common philosophies of stock investing are "value investing" and "growth investing" - growth investing will be covered in another post]

Most investors consider value investing to mean buying cheap or discounted stocks, but there is more to this investing strategy.

Value investing deals with the buying of stocks that have been neglected by the market and their price is lower than their real value. The problem of course is how do you know what the true value of a stock is?  Value investors typically pay extra attention to the fundamentals of the business in order to try to figure out if a stock is being under-valued by the markets.

The business fundamentals that value investors usually consider are the earnings growth, cash flow, dividends and book value. Most value investors invest for the long term and they tend to buy and hold stocks for long time periods – sometimes forever.  A common strategy of value investors such as Warren Buffett is to buy companies they like when the stock price has gone down.  The assumption is that if a company is a reasonable deal at one price, then it must be “on sale” if the price drops.

One of the risks of value investing is that the stock price might be heading downward because of problems at the company or in the industry.  If the problems are temporary and the stock jumps back up over time then the value investor will do well.  On the other hand if the investor has bought into a “value trap” then they will not be happy since the stock will keep going down.

Why do I need to know this?

A lot of mutual funds are slanted towards one investing style or the other.  You can usually (but not always) tell by the name of the fund – it might have the word “value” or “growth” in the name.  If you research the fund you should be able to figure out if it is one or the other or some combination of the two.

Value Investment Criteria

A value investor might look at some of the following to determine if a stock is a good value.

• The Price to Earnings (P/E) Ratio – This ratio varies from industry to industry but a value stock will have a p/e ratio that is low compared to other companies.

• The Debt to Equity Ratio – Debt can be a good tool when used properly but too much of a good thing can be bad.  This ratio also varies between industries.

This post was featured on the Personal Finance News Carnival Vol. 8.

Investing

Photo Credit:Bob Merco

• Zachary Scheidt presents Stage is Set for IPO Rebound posted at ZachStocks.
• ABC presents REITs (Real Estate Investment Trusts) – Invest In Real Estate The Easy Way posted at ABCs of Investing.
• D4L presents What?s Wrong With P&G? posted at Dividends Value.
• Mike Piper presents Should I Rollover my 401k into an IRA? posted at The Oblivious Investor.
• Paul Williams presents How Much Should I Save for Retirement? – Part 2: How Much Will I Need to Have Saved by Retirement? posted at Provident Planning.
• Helen presents The Three-Minute Portfolio posted at Affine Financial Services.
• Investing Toolkit presents Why Trade In The Forex Market? posted at Investing Toolkit.
• Manshu presents China ETF List posted at OneMint.

Debt and Credit

Photo Credit nutmeg15

• oneadvice presents Bankruptcy Advice: Bankruptcy Disadvantages posted at One Advice.
• CreditCardAssist presents Is a Black Card Really Worth the Price? posted at Credit Card Assist.
• NtJS presents 7 Ways Your FICO Score Does Not Control Your Life posted at not the jet set.
• Ray @ Financial Highway presents Basics of Credit Score and Credit Report and How often to Check posted at Financial Highway.
• Lynnae presents 5 Steps to Paying off Credit Cards posted at Being Frugal.net.
• Craig Ford presents Dave Ramsey: An Introduction For Newcomers posted at Money Help For Christians.
• FIRE Finance presents FIRE Finance: Credit Cards In Ireland and Associated Stamp Duties – A Top Personal Finance and Investing Blog for Early Retirement and Money Management! posted at FIRE Finance.
• The Smarter Wallet presents Equifax Credit Report and Score: Review of Equifax Products posted at The Smarter Wallet.
• CreditCardAssist presents Excellent Credit Requires Your Own Due Diligence posted at CreditCardAssist.com.
• Paul Kamp presents Changing the Rules: Side Effects of the Credit Card Legislation posted at Don’t Quit Your Day Job – Personal Finance, Economics and Investing.
• Kirk Sadler presents Paying Down Your Mortgage posted at Sadler’s Financial Blog.
• RC presents Some New Credit Card Rules Put in Place- What Will The Effect Be? posted at Think Your Way to Wealth.
• Roger presents Financial Lessons: Credit Cards | The Amateur Financier posted at The Amateur Financier.

Frugality and Saving Money

Photo Credit nutmeg15

• Todd Metheny presents The Cost of Having Children | The Personal Finance Playbook posted at The Personal Finance Playbook.
• Four Pillars presents Cash For Appliances Program – Upgrade Your Clunker of a Fridge, Washing Machine, Dishwasher posted at Quest For Four Pillars.
• J. Money presents Look Like a Million Bucks on a Budget posted at Budgets are Sexy..
  Hank presents The Opportunity Cost of Keeping Up With The Joneses Is Too Expensive posted at Own The Dollar.
• DR presents How to Stop Printer Ink Cartridges from Smearing Your Budget posted at The Dough Roller.
• vh presents How to deal with ants posted at Funny about Money.
• Silicon Valley Blogger presents Best High Interest Savings Accounts In Online Banking posted at The Digerati Life.
• Tom @ Canadian Finance blog presents Avoiding Fees Is Smart Finance | The Canadian Finance Blog posted at The Canadian Finance Blog.
• Matt Jabs presents Vermicomposting Worm Farm – DIY, Easy, and Frugal posted at Debt Free Adventure!.
• Miss Thrifty presents Bill Amberg Penguin Classics books – for a snip posted at Miss Thrifty.
• Jason presents To Save at College, Leverage Your Flagship University posted at Automatic Finances.
• Mr Credit Card presents Get $25 Gift Card For Test Driving Buick LaCrosse 2010 Model posted at Ask Mr Credit Card.

Career

Photo Credit Nick Humphries

• Jeff Rose presents Internships: Go for the Money or Experience? posted at Good Financial Cents.
• The Financial Blogger presents The Financial Blogger » Blog Archive » 5 Tricks for a Smooth Back to School – A lot of Changes This Year posted at The Financial Blogger.
• PT presents Changing Jobs for More Money – Is it Worth It? posted at PT Money.
• Linda Jones presents 100 Blog Posts You Should Read Before Going to Med School posted at Nursing Schools.net.

Economy

Photo Credit nutmeg15

• The Financial Blogger presents Cash for Clunkers Redux: Cash for Appliances posted at Mike.
• Darwin presents Corporate Pension Plan Shortfall – The Next Crisis? posted at Darwin’s Finance.
• Banker Saver presents On Bank Mergers and the Hostile Takeover posted at Banker Saver.
• Curt presents High Price of Gold is a Clear Sign That Inflation Is Not the Answer posted at PennyJobs.com.
• Zachary Scheidt presents Mixed Signals from Payroll Data posted at ZachStocks.

Income

Photo Credit nutmeg15

• Madison presents Ohio 529 College Advantage $25 – $100 Bonus posted at My Dollar Plan.
• Emily Simmons presents How to Have a Successful Yard Sale posted at Be In Health Now.

Other

Photo Credit nutmeg15

• Chris Holdheide presents John Commuta’s Transforming Debt Into Weatlh System Review posted at StumbleForward.com.
• MoneyNing presents How to Break Bad Habits posted at Money Ning.
• Bucksome presents 4 Reasons to Retire Elsewhere posted at Buck$ome Boomer’s Financial Path to Retirement.
• Miss M presents Do You Balance Your Checkbook? posted at M is for Money.

REITs usually have very high dividend payouts since no corporate income tax is paid by the REIT once the REIT pays out ninety percent of their taxable income to stockholders.

How to buy REITs

You can buy REITs directly on any stock exchange the same way you would buy an individual stock or ETF.  Unless you are willing to research the underlying holdings of various REITs you should consider just buying an index fund or ETF that contains REITs.  It is a lot easier than buying individual REITs and more diversified.  Vanguard has a ETF called VNQ which has a great selection of publicly traded REITs.  The expense ratio is 0.15%.  Vanguard also offers a REIT index fund which is similar to the ETF except you don’t have to pay for trading fees to buy or sell.  The expense ratio is 0.26%.  Both the Vanguard index fund and ETF have reasonable costs.

Advantages of REITs

REITs can be beneficial for investors for a number of reasons:

• Asset allocation – Real estate is considered an asset class separate from stocks and bonds so an investor can help balance their asset allocation by allocating a small percentage of their portfolio to real estate via REITs.  Typically 5% to 10% is a desired real estate allocation.
• Income – REITs usually pay out a decent income which can have low tax implications if most of it is return of capital.
• Diversification – Most investors can’t easily invest in real estate since it is expensive to buy a rental house or condo.  Buying into commercial real estate is impossible for the small investor.  REITs allow anybody to own some commercial real estate.
• Diversification part II – Larger REITs will have many properties in different geographic locations and tied to different industries which makes them more diversified than any one commercial property.
• Liquid – Since REITs trade like stocks they are very easy to buy and sell unlike buying or selling a real estate property.

Disadvantages of REITs

• Some individual REITs might not be that diversified so if you decide to purchase individual REITs – make sure you do your research.  If the REIT is too focused in one area or industry then it might be too risky.

Feel free to sign up for a free MorningStar membership which enables you to easily look up the information behind REIT index funds and exchange traded funds as well as the costs.

This post was featured on the Personal Finance News Carnival Vol. 8.

A 7% investment return is pretty decent – at that rate the original investment will double in 10 years.  This sounds great – all you have to do is save your money, get a reasonable rate of return and eventually you will a lot more money then you started with.  The only problem is – what happens if the things you like and need to spend money on go up by 7% as well?  In terms of your purchasing power – after 10 years,  it will be no greater than when you made your original investment.

On the other hand what if the costs of items you like to buy didn’t go up at all?  In that case, after 10 years you would be able to buy twice as much stuff as when you made your first investment.

Use real return for investment planning

The real return of an investment is defined as the total return minus inflation rate.  This can also be thought of as the “net return”.

Let’s say your portfolio has gone up at a rate of 6% per year for 20 years.  This is the total return.  Over that same time period, inflation was 2%.  To get the real return, we subtract 2% from 6% and get a real return of 4%.

Using the real return is the best way to measure your long term investment performance because shows the actual increase in purchasing power.

Carnival of Financial Planning.

Personal Finance News Carnival Vol. 8.

1031 Exchange

Fixed income investments are defined as securities that have a regular fixed return or payment associated with them such as bonds.

Here are some risks to consider when investing in fixed income investments.

Inflation – Because the payments on your investment are fixed, while they might be a fair rate at the time you purchased the investment, if interest rates go higher because of higher inflation then you will be essentially losing some money because you are only getting paid at a rate of 5% but someone who is buying a similar bond today would be getting a better rate.

Price fluctuations – Bonds are priced according to their coupon (or interest rate) and the length of time remaining until they come due.  If interest rates increase then the value of your bond will decrease if you try to sell it before it comes due.  Conversely, if interest rates decrease then the value of your fixed income investment should increase.

Government risk – For government bonds, you have to consider the possibility that the government won’t pay the interest or the principal.  In the case of US government bonds, that possibility is extremely remote.  However, what if you own bonds issued by a municipality?  or a foreign government such as Mexico?

Company risk – Bonds issued by companies are only as good as the companies behind them.  If you buy company bonds (or invest in bond mutual funds that do) then it is important to be diversified because one fact that separates company issued bonds from government issued bonds is that governments have the ability to increase taxes and raise more money which companies cannot do.