Why we need stocks and bonds

October 20, 2016

Believe it or not, Society is coming to the point where all capable people need to invest in stocks or bonds. So what are stocks and bonds, and why do we need them?

They are valuable certificates purchased from businesses by investors. Businesses need investors’ money to build and sell products to customers for a profit. Investors need the certificate to retrieve their money with a bonus payment. That bonus payment is an enticement to invest in businesses.

Stock and Bonds are different from each other. Stocks represent part ownership in a business. The stock owner hopes to collect portions of business profits called dividends and to eventually sell the stock certificate for a bonus amount. Bonds are written promises to refund investors’ money with an extra amount called interest. Both potentially offer individuals an extra source of money.

Markets for stocks and bonds will grow and endure for future generations.  More individuals will become investors out of necessity.  The details of investing are interesting and challenging.

Copyright © 2016 Douglas R. Knight


Book Review: Blue Chip Kids, what every child and parent should know about money, investing, and the stock market.

April 24, 2016

Blue Chip Kids, what every child and parent should know about money, investing, and the stock market. David W. Bianchi. John Wiley & Sons, Hoboken, 2015. 234 pages.

Author David W. Bianchi wrote this book for young people who are interested in spending money. He wrapped the uses of money into 3 important topics: 1) All about money; 2) Ways of investing money; and, 3) Stock markets.  Gambling was excluded from the discussion.

I was interested in learning to coach my granddaughter on ways investing money. Bianchi exposed me to very low-, very high-, and mid-range risks of investment (I wouldn’t advise my granddaughter to invest at either end of the spectrum!). Here’s my synopsis:

All about Money. “Rule #1: live within your means”.

Chapter 1 has one of the best sections in the book which describes ways of earning money throughout life. Money is a “currency”. Don’t be surprised to learn that there are many different currencies with constantly changing values. Chapter 2 describes ways of paying for things.

The best ways of borrowing money are discussed in Chapters 9-11. If you want to avoid a penalty, repay your debt on time. Payments of interest on loans are called coupons. Coupons are a cost to the borrower that are paid to the lender. Some borrowers must pay simple interest and others pay compound interest. Lenders usually prefer payments of compound interest.

Borrowers are expected to show that they are reliable (“credit worthy”) people. For example, bankers will ask to read your financial statement before giving you a loan. Your financial statement is a document that lists the total value of assets (things that you own) and liabilities (money that you owe). The difference between total assets and total liabilities is your net worth.

Governments earn money by charging taxes and selling bonds. Everybody has to pay taxes. Failure to pay any of the many taxes described in chapter 12 may lead to a government audit and penalty. Chapter 13 reveals that the U.S. Government owes 17 trillion dollars to lenders from around the world! All of us face serious consequences if our government fails to pay its debts! Meanwhile, we can protect our personal financial reputations by avoiding default and bankruptcy. Better yet, don’t borrow money. Create a budget to “live within your means”.

Chapter 15 explains the challenge of retirement, which is to continue paying bills after you stop working for a living! After you graduate from school to begin a career in early life, start saving for retirement later in life at age 60-75 years. The author wisely advises to “give yourself the ability to retire if you want to”. Your retirement income will come from retirement savings, social security, pension plans, and annuities.

Investing

Investing is all about risk and return. Treasury bonds are considered no-risk investments that return about 3% annually. The investment choices that Bianchi offered to his readers were stocks (chapters 3,8), options (chapter 5), funds (chapter 6), bonds (chapter 7), and private companies (chapter 14).

A Stock is a certificate of ownership, also called a security. Brokers don’t issue the certificate, they send a confirmation that serves as evidence of ownership. The market value of the stock usually rises when its company earns profits.

Options are contracts that guarantee the trade of an asset at a fixed price for a limited period of time. The seller earns a fee for guaranteeing the trade. The buyer pays the fee in turn for the right to execute the trade before expiration. The buyer may benefit by 1) using the option as an insurance policy, 2) exercising the option at a favorable price, or 3) trading the option in the options market.

A Fund is a pool of money collected from many investors to invest in a group of assets. The advantages of the fund are that investors don’t spend considerable time doing research and don’t spend large sums of money for a diversified portfolio. Among the types of funds are

  1. Index funds, which copy a security index and charge low fees for the service.
  2. Mutual funds, which don’t copy a security index and do charge several fees for the service.
  3. Hedge funds, which invest in anything and charge very high fees. Hedge funds have strict rules of eligibility and charge “2 and 20” fees (2% annual management fee and 20% management ‘tax’ on investment returns).

A Bond shows that you lent money to the company on condition that it returns the money, with interest, at the maturity date.  The bond’s face value is the original price (printed on the face of the bond); it is the redeemable amount!  The yield is the bond’s annual rate of return; Yield = Interest / Price.

A Private Company does not trade its stock in a public stock exchange. Private company stocks are illiquid because they don’t have an open market. Venture Capital and Private Equity firms buy stocks in private companies. Venture Capital is money invested in start-up companies. Private Equity firms inject money into established private companies in exchange for the companies’ stocks.

Stock market

Advice: It’s difficult to predict the ‘top’ and ‘bottom’ of market prices. Do homework to buy quality stocks at a reasonable price.

Chapter 3 explains that the stock market is a place for orderly buying and selling of stocks (and other securities). There are many stock markets that vary according to listed stocks and total market capitalization (‘market cap’ is the total value of the company’s shares).  Chapter 8 describes how to make stock-buying decisions, how to participate in the stock market, and how the market behaves.  David W. Bianchi, if I misread your book, then I apologize for citing 2 nearly insignificant errors that were made about investing in stocks:

  1. Contrary to statement, there is no P/E ratio = 0.  Ratios of x/0 are undefined.  Financial websites don’t report the P/E as a number when company earnings are negative or 0.
  2. A share buyback doesn’t raise the price per share of stocks; only trading activity in the market can raise the price.   A share buyback raises the earnings per share (eps), which then may raise the share price.

I believe your book is well worth reading.


#ETFscorecard_AGG, iShares Core Total U.S. Bond Market ETF

June 28, 2013

AGG holds a portfolio of investment-grade U.S. bonds and distributes monthly dividends.  The following profile shows that AGG is an established fund that operates at a high rate of turnover.

AGGprofile

The AGG scorecard (below) reveals a wealthy, experienced index fund that invests in a well-developed market for bonds.  The fund is tax inefficient due to the high rate of turnover of portfolio holdings.  The risks to portfolio underperformance are 1) erroneous sampling of the bond index, 2) erroneous judgment in management of the portfolio holdings, and 3) generic risks of investing in the bond market.

AGGscorecard

Fund operations

AGG is a registered investment company for tax purposes.  Its strategy is to invest 95% of capital in a diversified basket of U.S. investment grade bonds that serve as a representative sample of the benchmark index.  The portfolio’s profile is that of an average A credit rating of the issuers, average intermediate term bonds, average 4.86% effective duration, average 4.06% weighted coupon, and average $107.46 weighted price. The remaining 5% of capital resides in cash-equivalent securities and bonds excluded from the index.  Fund management may lend up to 33% of the underlying securities to outside investors.  High portfolio turnover rate will increase the Fund’s operating expenses.

The benchmark Index measures the performance of the total U.S. investment grade bond market.  The bonds must be USD denominated, non-convertible, and have a fixed rate.  The Index is updated monthly.

Fluctuating interest rates in the bond market may reduce the investment performance of the Fund.  In the case of declining interest rates, the Fund may replace Called bonds with those of lower interest rates.  During periods of rising interest rates, long-term bonds with low interest rates will effectively reduce the Fund’s income. Rising interest rates can also lower the market value of the bonds.  A portion of the Fund’s mortgage-backed securities are not issued by government agencies and are therefore not protected against default.

AGG is a good investment for diversifying your ETF portfolio.


ETF #scorecard: iShares JPMorgan Emerging Markets Bond Index Fund (nyse:EMB)

February 1, 2013

Summary

EMB is an index fund that invests in bonds issued by governments and businesses located in the emerging markets.  An income stream of about 3.8% annual yield is distributed to shareholders in monthly payments.  Exposure to EMB’s portfolio incurs the risks of geographic region, bond market fluctuation, and portfolio management.  EMB holds a riskier portfolio than the bond index fund AGG.

Snapshot

profile

Scorecard

scorecard

About the Index

The underlying index tracks the total return of fixed-rate and floating-rate bonds issued by governments and corporations in approximately 31 countries tagged as the emerging markets.  The bonds are U.S. dollar denominated and non-convertible.  The index is market-value weighted and rebalanced every month.

About the Fund

Strategy.  EMB’s objective is to match the performance of the Index before deduction of administrative costs, which are about 0.6% of the net asset value.  EMB’s strategy is to invest at least 90% of assets in securities of the underlying index by selecting a representative sample of the Index.  The fund may occasionally invest up to 20% of assets in various derivatives and cash-equivalent assets.

Tracking error.  Since inception the average annual total return of the fund’s net asset value underperformed the Index by a difference of 0.81 percentage points.  The cumulative net asset value underperformed the Index by a difference of 4.68 percentage points.

Primary risks:

  • Issuers may not pay the interest or repay the principal, especially if the bond is rated below investment grade.  About 54% of EMB’s bonds are rated below investment grade.
  • Bonds with longer maturity dates are more susceptible to loss of value from an increase in interest rate.
  • Issuers of callable bonds may repay the lender before maturity when the interest rates are declining.  The Fund may lose income by necessity of reinvesting the principal at a lower interest rate.

EMB’s portfolio is riskier than that of iShare’s AGG.  Here’s the comparison:

vs AGG

Price history. The following chart shows that EMB’s share price (thick blue line) increased by 17.7% compared to AGG’s (thin purple line) 7.3% climb during the past 5 years.

prices

The bond-buying program of central banks reduced the interest rates of government bonds, thus reducing the interest earned from investment grade bonds.  The reduced interest rates pushed bond prices up and bond yields down.  Today’s (1/30/2013) high bond prices are vulnerable to decreasing when the interest rates start to climb (i.e., interest rate risk).  The same reasoning applies to an increase in the bond funds’ weighted average coupon and effective duration.1   Ways of managing interest rate risk include

  • selling bonds now and venturing into other assets such as stocks.
  • reducing the effective duration of a bond portfolio
  • investing in high-yield corporate bonds and emerging-market government bonds

Emerging markets generate 40% of the global GDP and have only 10% sovereign debt, making it a good bet that emerging markets have enough revenue for debt service.1  From a survey of 141 emerging-market banks, results indicate that lending conditions are improving in the emerging markets despite a declining demand for commercial real estate loans and a growing number of non-performing loans.2,3 

Copyright © 2013 Douglas R. Knight

References

1.           Joe Light. The risk of safety. The Wall Street Journal, 1/25/2013.

2.           Sudeep Reddy.  Emerging-market loan view perks up. The Wall Street Journal, 1/29/2013.

3.           Emerging Markets Bank Lending Conditions Survey – 2012Q4.  IIF, Institute of International Finance.


My portfolio on 12/31/2011

January 14, 2013

Portfolio performance as of December 31, 2011.  Chart (below) displays the compound annual growth rate (CAGR) of my portfolio since December 31, 2006.  The S&P 500 TR is an index for the total return of the largest 500 U.S. stocks as determined by rankings according to market capitalization.  My portfolio is underperforming the Investment goal and the S&P 500 TR.

Perspective.  According to recent data, many hedge funds underperformed the S&P 500 during this time period.

Portfolio holdings.  Table data (below) show the year-end assets held in my portfolio.  Ticker is the stock exchange trading symbol.  % of Total Market Value is calculated by the formula “100 (year-end asset value/year-end portfolio value)”.


Directory of #market-index websites

September 5, 2012

Index

Bloomberg ticker

BofA Corporate Bond
DBIQ Emerging Markets USD Liquid Balanced Index DBLQBLTR:IND
DBIQ Optimum Yield Energy Index Excess Return DBENIX:IND
DBIQ Optimum Yield Precious Metals DBPMIX:IND
DBLCI Agriculture DBLCDBAE:IND
Dow Jones Precious Metals
Dow Jones US Oil & Gas Total Return DJUSENT:IND
Energy Select Sector IXE:IND
FTSE NAREIT All Residential Capped TFN17C:IND
FTSE NAREIT Idx, “Equity REITs, Total, Index” FNRE:IND
FTSE NAREIT Idx, “Mortgage REITS, Total, Index” FNMR:IND
HRFX Indices
IMF Commodity Price Indices- All Commodities
JP Morgan Emerging Markets Bond Index JPEICORE:IND
12-month London Interbank Offered Rate (LIBOR)
London Gold Market Fixing Ltd GOLDLNPM:IND
London Silver Market Fixing Ltd SLVRLN:IND
MSCI EM (Emerging Markets) MXEF:IND
MSCI US Broad Market MXUS:IND
MSCI US IMI Energy 25-50 Gross Return M2US5ENI:IND
MSCI US REIT RMZ:IND
Russell1000 RU10INTR:IND
Russell2000 RTY:IND
S&P 500 Energy Sector Index GICS Level 1 S5ENRS:IND
S&P Global1200 Energy Sector Index GICS Level 1 SGES:IND
S&P GSCI (goldman sachs commodities index) SPGSCITR:IND
S&P GSCI Precious Metals SPGSPMTR:IND
SP500 Total Return SPTR:IND
World Bank Commodities

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