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August 19, 2022

Types of Investments

In the previous course, you learned that all investments carry different levels of expected reward. Those differences are strictly due to the different risks associated with each asset. This course discusses various types of investments and the associated risks and rewards. While this is not an exhaustive list, it does cover most of the assets you will ever come into contact with while you're building your portfolios.


Stocks are one of the most common ways to invest in the capital markets. When people talk about buying or selling stock, they are usually talking about the "common" shares of stock as opposed to the "preferred" shares that we'll talk about in the next section.

When you buy common stock, you own a piece of the company. If you buy shares of Microsoft, you are actually part owner of Microsoft. Your percent ownership depends on how many shares you own in comparison to how many shares are available. For example, at the time of this writing, Microsoft has about 9.3 billion shares outstanding. If you own 100 shares of the company, you therefore own 100/9.3 billion percent of the company (which is nearly nothing). Regardless, you are technically in partnership with Bill Gates.


There are several benefits in owning stock. First, you have the potential for unlimited gains. There is no limit to the value of a company and, as part owner, you participate in all future gains of the company.

Second, as a stock owner, your risk is limited to the amount you have invested. While the investment may be large, the limited risk feature is a nice benefit. Just ask any of the CEOs of Enron. If you bought stock in Enron, you may have lost a significant portion of that investment but you will never serve jail time or be forced to pay restitution to other investors as an insider to the company.

Another benefit is that many stocks pay dividends. In fact, even if they don't pay one now, they theoretically must at some time and that's actually what gives a stock its value. If a company were formed that never had to return any money to investors, it would be a financial black hole and would be completely worthless.


Stock prices can be quite volatile so you're never really sure what your investment will be worth from day to day. It is this uncertainty that is probably the biggest drawback in owning stocks. For example, the drug manufacturer Merck recently faced a precipitous fall when they announced the withdrawal of the widely anticipated drug Vioxx. You can see the impact of the news in the following chart:

One day the stock was worth $45, the next day it fell below $33, which represents more than a 25% drop in value in one day. Price swings like this can be devastating. Imagine that you had a significant amount of money invested in this stock and needed that money for a down payment on a new home. Stock price swings can create - as well as destroy - wealth and that's why it's best to not put a significant portion of your wealth into any single stock - no matter how promising the reports may sound.

Another drawback is that it's much harder to understand individual company valuations and prices. Is Merck a good deal after it hit $33? Or is it going to fall further? There are so many factors that form the stock's value and it's tough to say which price represents a good buy - and which do not. And even if you have a grasp as to what value is right for a stock, you are still subjected to the risk that an insider is manipulating the books to make the company appear in better financial shape than it is.

The selection process for stocks is difficult too. There are nearly 10,000 stocks to choose from - which is right for you? To complicate it further, even if you do narrow down the list to a select few stocks, you must still monitor news, company reports, economic numbers, political environments, and industry trends to find determine if you should continue holding that stock. Proper stock analysis is very tough work.

While the rewards for owning stocks can be great, the most important consideration is the risk. It's because of these drawbacks that you shouldn't put a significant amount of your money into a single stock.

Historical Returns

The amount you make on your money is called a return. If you invest $100 and end up with $110 in one year, then your return is 10%. Investors love to look at statistics of "historical returns" as a way to measure what to expect in the future. For stocks, if you were to look back over the past 75 years or so, you'd find that the stock market has returned about 10% per year, on average. As with any average, there are fluctuations around that 10% number; some years returned far more than that while others actually lost money (had negative returns). So if you had invested in 1926 and held through 2001, you'd find that your money grew an average of 10% per year. Many investors use this benchmark as a predictor and assume that, if they hold for long periods of time, they will earn at about the same rate. Unfortunately, that's a misleading assumption. That 10% figure includes the effects of inflation, which we must back out of the equation if we're to compare apples to apples. Inflation during this period was about 3% per year, so the adjusted rate of return is more along the lines of 7% per year. This 7% figure is what economists call the "real return" since it more accurately measures the changes in your purchasing power and not the total number of dollars that you own.

There is another danger in using historical returns if you're selecting stocks as an investment vehicle. That is, these historical figures are based on a basket of stocks, that is, a large index such as the S&P 500 index. If you are buying only a few stocks, the 7% figure is even less likely to hold. Why? Because there's more risk. And if there's more risk, you're either going to end up with a much higher return - or much lower. The point is that you need to understand that historical returns do not necessarily apply to individual stocks. They are more representative of large baskets of stocks.


There are many ways to measure the risk of a stock. While it is probably safe to say that all stocks are risky, we need a way to measure the relative amounts of risk. Remember, when we speak of risk, we are talking about price instability, which is often called "volatility" by market professionals. If a stock is volatile, then that means its price tomorrow is likely to be very different from its price today - whether higher or lower. One way that investors use to assess the risk is to look at the Price to Earnings Ratio, or P/E ratio. If a stock is trading for $20 and earned 50 cents per share last quarter, the P/E would be $20/0.50 = 40. This P/E ratio would be considered relatively high since the historic levels hover around 14 to 16. The P/E ratio shows how much investors are willing to pay for one dollar in earnings. In our example, investors are willing to pay 40 times earnings, or 40 * 50 cents = $20 for the stock. While this ratio may appear to be high, we must really look at the industry averages rather than the overall average of 14 to 16. Some industries may command higher P/Es so it's not really fair to automatically assume that 40 is out of line. The more optimistic that investors are about the company, the higher amount they are willing to pay for one dollar of earnings and the P/E ratio rises in response.

Another measure of risk is more complicated and is called "beta." Beta is a measure of how a stock's returns measure up against a broad-based benchmark, which is usually the S&P 500 index. The S&P 500, by definition, has a beta of one. A stock with a higher beta rises and falls more rapidly by a factor of beta. A stock with a beta less than one will rise and fall less severely than the overall market. A stock with a beta of one is expected to mirror the overall movements of the market.

For example, assume that ABC stock has a beta of two while XYZ has a beta of one-half. If the S&P 500 rises 10% then we would expect ABC to be up 20% and XYZ up 5%. In other words, ABC returns at twice the rate while XYZ returns at half the rate of the broad based market. At first glance, it seems that high beta stocks are more desirable but, of course, the benefit of high betas can also destroy. If the S&P 500 falls 10%, then ABC is expected to fall 20% while XYZ is only expected to fall 5%.

Beta is calculated by using long-term averages and correlations. It does not mean, for example, that ABC must rise or fall by twice the amount of the broad-based market. It just says that ABC typically moves at about that rate. As market conditions and company outlooks change, so can beta. Just because your stock starts with a particular beta does not mean it will always stay there. Betas are a good way to determine if the stock you're investigating tends to move more or less than the overall market. The higher the beta, the greater the risk.

Why Buy

If stocks are so risky, then why do people buy them? The reason is usually for long-term returns. While there are no guarantees, if you wish to make money in the stock market, you need to have some exposure to stocks. People who invest for longer term reasons such as home buying, college, or retirement, will almost have to have some money tied to stocks.

How to Buy

Stocks are among the easiest assets to buy especially now with the Internet. All you need is an account with a brokerage firm and you're set. Most people buy shares in what are called "round lots" of 100 shares. The main reason is that it used to be far more expensive to buy fewer than 100 shares at a time but, with today's technology, that's not really true anymore. Most firms charge very low commissions, sometimes as little as $5, and they don't care if you buy one share or thousands. So don't think that you must buy in round lots. The better choice is to invest a dollar amount that you're comfortable with and let the share amount fall where it may. For example, if you have $5,000 to invest and want to buy a stock trading for $62, then buy $5,000/$62 = 80 shares. Don't spend your time looking for a stock trading for $50 just so you can buy 100 shares. That's letting the tail wag the dog. Instead, find companies that you're comfortable holding. The reason is that your money doesn't care how many shares are represented; it is only concerned with the return on that money. If your stock rises 10%, you will have $5,500. If it rises 20%, you will have $6,000. Notice that we do not need to take into account the number of shares! The only factor that matters to your money is the performance, or the return, of the stock - not on how many shares you own. Focus on the quality of the company and not the number of shares you can afford.


Stocks are generally considered very liquid, which simply means that you can buy or sell large dollar amounts without too much disruption in price. If you should need to withdraw a large amount from the market, you can do so quickly. However, if you sell shares of stock, there is a three-day waiting period for the money, which is called the settlement period. (Stocks used to have a five-day settlement but that was changed to a three-day settlement period in the mid nineties.) For stocks, the settlement period is now trade date plus three business days, or T+3. This means if you sell a stock on Monday, the money will be available three full business days later, or Thursday, assuming that none of the other days are holidays. So if you need to have cash out of the market by a certain day, be sure to take into account the settlement period. You'll need to sell the securities three business days before you need the money.

This settlement period also works for when buying stocks. If you wish to buy stock, most brokers will allow you to place the order without the money in the account. The reason is that you have three days to deliver the funds to the broker in order to meet settlement. Buying and selling stock is very easy. Once you decide on which stock you want to own, you can execute the order within seconds over the telephone or through the Internet.

Variables that Impact Price

There are many factors that cause stock prices to rise and fall and it's probably impossible to name them all. However, if you're a stock investor, there are several factors that you'll want to keep a close watch on.

First, make sure you follow company news and analyst ratings. You can find this information on nearly any quote service for no charge. The company news can keep you abreast of changes in the company such as earnings, new products, outlooks, and other information that will either confirm your reasons for buying the stock - or make you take a second look. Stock analysts follow select companies much closer than we ever could. They are privy to CEO conference calls and know nearly everything about what's going on with the company and industry. If they lower their ratings on a stock, you'll want to find out why, which can usually be found in published reports.

Interest rates are another important factor for stock prices. As interest rates rise, stock prices generally fall. While there are many explanations for this, the easiest is perhaps to realize that companies make money by spending money to create something of value. Whether it's building a new factory or just replenishing inventory, higher interest rates make it more costly for them to produce and that lowers their bottom line profits. As profits shrink, so does the value of the company. Of course, there may be companies that benefit from higher interest rates but overall, you will find that stock prices fall as interest rates rise.

Inflation is another factor to watch. If inflation is on the rise, you can bet that stock prices will fall for much the same reason as when interest rates rise. Inflation is nothing more than a rise in the general price levels. As price levels rise, then the bottom lines of corporations fall and so does their value.

Preferred Stock

A preferred stock is one that has priority over common stock on the distribution of earnings and assets. So if a company goes bankrupt, the preferred stockholders get paid before the common shareholders. Preferred stock actually works like a blend between common stock and a bond. If you buy a preferred stock, you receive a stated dividend at a specified interval (usually quarterly) for as long as you own the preferred stock. The company is not required to make these payments but, if they do, they must make them to the preferred shareholders before any money can be paid to common stockholders. Preferred stocks can be subdivided in to cumulative and non-cumulative. If you own a cumulative preferred and the company misses a payment, they must make up all past payments to the cumulative preferred holders before any payments can be made to the non-cumulative holders. (However, all preferred stocks, whether cumulative or non-cumulative, are subordinate to bonds). If you own a non-cumulative preferred and a payment is missed, then you're likely just out of luck and will never see that money.

Preferred stocks are usually issued by capital intensive companies such as utilities, airlines, automotives, and other large manufacturing businesses. Preferred stocks move in price more like a bond and are very responsive to changes in interest rates rather than company specific news. For example, if a significant announcement is made regarding the company, the common shares may spike through the roof whereas the preferred shares may just stay the same. The reason is that preferred holders do not get claims to future earnings other than their expected dividend payments. As long as the company appears solvent enough to continue making those payments, the preferred shares will stay about the same price. However, if interest rates move significantly, then you may see significant price changes in your preferred stock. For example, if you are holding a 10% preferred stock and interest rates fall, then on a relative basis, your 10% cash stream is more attractive since it will be harder to find those investments now that interest rates are falling. Investors will then bid up the price of the preferred stock. The reverse is true too if interest rates rise. As interest rates rise, investors will find investments with higher and higher returns and will be less interested in the 10% return, which means that the price has to be lowered to make it equally attractive as the new higher rate issues.

The point is that you should not buy preferred stock if you are expecting to profit from the growth of the company. Even though the word "preferred" sounds like it is better to own than the "common" stock, that's simply not true. They are two different investments for different means. If you are looking for income, preferred stock may be a great choice. But if you want to be part owner and participate in the growth of the company then common stock is the best bet.


Bonds are nothing more than an IOU issued by a company. Corporations borrow money in order to produce products or services and often need to borrow money to continue their operations. If the company issues a bond, they must repay a stated amount of interest to the bondholder at fixed intervals, usually every quarter. Why would a corporation issue a bond and commit to interest payments when they can raise money by issuing stock without the interest payments? The main reason is that issuing shares of stock dilutes the value of each share. If the company continues to do nothing but issue shares of stock, they end up cutting the company into so many pieces that each share is virtually worthless. If a corporation really believes it will profit from its products or services, it may be a better choice to issue bonds. If their forecasts are correct, they will be better off by paying a little interest on the bonds rather than having to split all the profits with others, which is what would happen if they issued more stock.

Basic Bond Mechanics

A key feature of bonds is that they have a stated maturity date. During this time, the issuer must make fixed equal payments. Once all payments are made, the bond has "matured" and the issuer's obligations are met. In a similar way, if you get a five-year car loan you have, in effect, issued a five-year bond. You receive cash to buy the car and are now obligated to make fixed equal payments over the five year period. Once all payments are made, the loan is no longer in effect and your obligation is over. The fixed payment that the bond issuer makes is called the "coupon" since many bonds used to attach coupons to the bottom of the bond that had to be clipped and mailed by the owner in order to redeem. Today, bond payments are all made electronically but the name "coupon" has stayed. If you buy a new bond, the coupon payments will be automatically deposited into your brokerage account.

Another key feature is that bonds have stated face values. You can usually buy bonds in $1,000 increments. If the face value if $5,000, then you will receive $5,000 at maturity, which is simply the return of your principal. In addition, you will receive the coupon payments as interest.

The price you pay for a bond depends on interest rates. For example, assume you buy a five-year newly issued $5,000 face bond today that pays a quarterly coupon of $125. You will receive four payments throughout each year for a total of $500. This means you're earning $500 per year for a $5,000 investment, or 10%. (We have simplified the math to demonstrate the concept. If this were actually the way the payments were made, your return would be higher than 10% since you received some of the money earlier in the year). This bond would be sold as a $5,000, 10% bond. In order to buy this bond, you would pay $5,000 for it and receive $5,000 back at maturity. Because you paid the face amount, this bond is said to be trading at "par value" or just "par." Any bond that sells for its face value is trading at par.

But if interest rates fall while you are holding this bond, then its value will rise. The reason is that other investors would prefer holding your higher rate bond than what they can get in the open market for new issues. In other words, if they buy a similar $5,000 face bond, their payments will be less than $125 since interest rates have fallen. Investors would prefer to have your higher coupon payments so will actively compete in the open market for that bond. When people compete for purchase and there is no more supply, the price must rise. If someone pays more than $5,000 for the bond, then the bond is trading at a premium. If you pay a premium for a bond, your net result at maturity will be lower than the stated interest amount. In this example, we are dealing with a 10% bond but if you pay more than $5,000 for it, your net return will be less than 10%. It may, for example, be only 9%. If so, we would say this is a 10% bond with a yield-to-maturity of 9%.

Conversely, if interest rates rise, the value of your bond will fall. Because bond prices move in the opposite direction of interest rates, we say there is an inverse relationship between interest rates and bond prices. As interest rates fall, bond prices rise; as interest rates rise, bond prices fall. If you buy a bond for less than face value, the bond is trading at a discount. Keep in mind that bond price fluctuations only affect the bond prices and therefore your total return if you sell the bond before maturity. If you hold the bond to maturity, you will get exactly $5,000 for it.

At first glance, it may appear to be better to buy bonds at a discount. There is something appealing about paying less than face value while still collecting the full coupon payments. However, you must remember that the reason the price fell is because interest rates have risen. The additional money you gain by receiving more than face value compensates you for the higher interest rates. If you buy a bond at a premium, you'll pay more than the face value and receive less at maturity, which seems like a negative attribute. However, you will also receive much higher interest payments than you normally would under the current interest rates. That's the reason investor's will pay the premium. The point is that it doesn't matter whether you pay a premium or a discount for a bond; what matters is the interest rate, maturity, and credit risk of the investment. If you want a 10% bond, it doesn't matter if you buy one at a discount or a premium; a 10% bond is a 10% bond.

The previous paragraphs describe the mechanics of Treasury notes (also called T-notes), Treasury bonds (also called T-bonds), and many corporate issues (bonds issued by publicly traded corporations). The only difference is that T-notes and T-bonds pay their interest semi-annually rather than quarterly. Treasury bills, however, work a little differently. For these short-term issues, the government pays no coupon payments. Instead, they are sold at a discount to face value. For example, if interest rates are 10% and you buy $5,000 face Treasury bill, you will pay $5,000/1.10 = $4,545 for it and collect $5,000 for it at maturity, which nets you a return of 10%. The additional money you receive on top of your $4,545 investment is considered the interest.

There is a class of bonds similar to Treasury notes called zero-coupon bonds. These notes are usually issued by corporations and municipalities. Just like Treasury notes, these bonds are sold at a discount from face value but the investor collects the full face value at maturity. However, due to the longer maturities, these bonds can be priced significantly below face value.

T-bills, T-notes, and bonds can all be purchased in $1,000 increments (although, at this time, no new bonds are being issued). But there are certainly T-bonds that are outstanding and available for purchase.


For the most part, bonds are the safest form of investing and that means that you'll get very little return on your money. If you have a large portfolio or are looking for a safe, supplemental income, then bonds may be your answer. You must understand that, even though the word "bonds" is associated with safe investing, there are many flavors to choose from and not all are necessarily safe. There are bonds issued by companies of questionable solvency that are usually "C" rated (or worse) by ratings agencies and are usually called "junk" bonds or "high yield" bonds. These bonds are highly speculative, which means their payoffs can be great - if they make it to maturity. But assuming you are investing in high quality corporate or guaranteed bonds then there are two big benefits: The first is that you have a fixed income stream to depend on. Second, you know that your principal (the amount you have invested) will someday be returned to you.


Despite the low-risk or guaranteed status of most bonds, there are drawbacks. The first is that you're not going to make a lot of money unless there is a tremendous fall in interest rates and you can sell your bonds for a nice capital gain. Another drawback is that you could certainly take a sizeable loss even though the bonds are guaranteed. Remember, the guaranteed return of principal only comes at maturity. If interest rates rise, the price of your bond falls. And if you need to sell it to raise money for some other purpose, then you could certainly end up with a loss even though you may be holding a "guaranteed" bond.

Historical Returns

It's difficult to say what the historical returns for bonds are since there are so many classifications and risk categories. But for most "investment quality" corporate bonds (i.e., not including junk bonds), the long-term returns have been around 4.5%.


While investment grade bonds have little risk in terms of lost principal, there are many types of risks involved with bond investing. The biggest risk is, of course, an adverse movement in interest rates. If you buy a bond and interest rates rise, the price of your bond falls. Once again, this does not affect the face value of the bond; you will get that returned to you at maturity if you hold it that long. But if you should need to sell the bond before maturity, you would take a loss if interest rates fall.

Reinvestment risk is another type of risk. In the previous example, we assumed you bought a $5,000 bond with quarterly coupons of $125 each. If we ignore the time value of money, we said this would be a 10% bond. One of the assumptions in saying that this is a 10% bond is that all payments of $125 throughout the life of the bond can be reinvested at 10% -- and that's a huge assumption. You may be able to get 10% on your $5,000 investment, but it's unlikely that you could also get that for the $125 coupon payment. Regardless, that is an assumption used to simplify the yield computations. If you are not able to reinvest your interest payments at the same rate as the bond, then you face "reinvestment risk," which simply means that your overall return will likely fall somewhat short of the stated return on the bond.

Some bonds have "call" features that allow the issuer to "call" the bond in, which is another way of saying that they wish to pay off the loan early. Using the car loan analogy that we used earlier, if you pay off your car early, then you have effectively "called" the loan. If you buy a long-term bond thinking that you have locked in the stated interest rate for that time, you may be in for a surprise if the issuer calls the bond and you receive your principal back much earlier. In doing so, you miss out on all of the interest payments that you were counting on. Not all bonds have call provisions but, if they do not, they will likely be able to issue the bond at a lower interest rate.

Credit risk is another type of bond risk. You may buy an investment quality bond only to find that, sometime later, the company's creditworthiness has fallen. The rating agencies will lower their credit ratings and the price of the bonds will fall. In this case, you could lose money even though interest rates didn't change. Instead, changes in the company have made the ratings slip and that's something completely out of your control or ability to forecast.

Below are some guidelines as to the investment ratings you may see on bonds:

  • AAA - Highest quality and least likely to default.
  • AA - High likelihood of repayment. These bonds with AAA bonds are considered "high grade bonds."
  • A - Fairly safe although there is some risk if conditions become quite difficult.
  • BAA or BBB - Anything with BAA or higher is called an "investment grade bond." BAA or BBB rated bonds are respectable qualities although the yields will be a little higher since there is a small possibility of default. Overall though, these are generally decent investments if you're looking for a little higher yield.
  • BA or BB - Bonds in this category (or lower) are considered "speculative." The company's ability to repay the loan is questionable.
  • B - These bonds are fairly speculative. Significant risk of default if conditions become difficult.
  • CAA or CCC - These bonds are highly speculative. Bonds with this ranking or lower are considered junk bonds.
  • CA or CC - There is a significant risk of default and are highly speculative.
  • C - A very probable risk of default.
  • D - Bonds in default.

Another real risk with bond investing is called inflation risk or purchasing power risk. When you buy a bond, you are really loaning money to the company. In doing so, you are giving up your ability to buy something today in exchange for buying more tomorrow. That's why the bond issuer must pay you back the face value plus interest. It is the additional interest payments that, at the time of the loan, appeared to make it worth your while to not spend today. For example, you may give up the purchase of wine today if you can get wine plus bread tomorrow. However, if prices rise during the time you are holding your bond, you might find that you cannot even buy wine when the bond matures - even though you have more dollars than when you started. This is what economists call inflation risk or purchasing power risk. In other words, even though you have more dollars after making the loan, you really have less purchasing power available with that money and are really worse off after making the loan.

Why Buy

Bonds are purchased for a variety of reasons. Probably the most common is preservation of capital. As stated before, if you have a lot of money, then you will likely shift your investment preferences toward bonds. Another reason is to guarantee an amount for a distant future use. For example, if you think you will need $50,000 for your child's college education, you might decide to buy a deep-discount bond that matures to $50,000 when your child enters college. Bonds also provide income streams, which is why you often hear of retirees holding onto bonds. These people have often acquired a sizeable amount of money while working and are more concerned about losing that than seeing it grow. In addition, they often need income to meet living expenses and the bond payments are reliable and steady. In fact, there are even some bonds or bond mutual funds (which we talk about later) that pay monthly dividends, which can be a nice benefit for retirees.

Bonds are also used for stock investors as a means of diversification. Even if your investment horizon is far off into the future, it's not safe to think you should only invest in stocks. Instead, you're better off buying some bonds too. That way, if the stock market crashes, money will flow to the safe investments - bonds - and your bond portfolio will help recoup the losses on your stocks. So while bonds are sometimes seen as a slow, boring way to invest, they are actually necessary for all investors to some degree.

How to Buy

You can buy bonds through most brokerage firms, banks, or other financial institutions. Treasuries, as stated earlier, can be purchased directly through the Treasury without a brokerage account. Most bonds can be purchased in $1,000 increments although municipal bonds are generally issued in $5,000 increments. In addition, some bond dealers may impose higher minimums. Regardless of how you purchase bonds, it's important to remember that it is the yield-to-maturity and maturity date that you should focus on rather than whether the bond is selling at a premium or a discount. Premiums and discounts are just the market's way of pricing all like bonds so that they have the same yield-to-maturity.

For most investors, bond mutual funds may be the way to invest. We'll talk about mutual funds later but, for now, just realize that you can buy into a basket of bonds that is managed by another firm. The benefits are tremendous. First, you get diversification by purchasing many bonds in one basket. Second, you can usually place much smaller dollar amounts into the fund, maybe as little as $100 (although the initial investment may be $500 or more).


Treasuries settle the following business day (T+1) while most others such as agency, municipal, and corporate bonds settle three business days after the trade date (T+3), which is the same for stocks. For treasuries, this means that you must have the payment to your broker by the close of business for the following business day after the trade. If you make the buy the bond on Monday, you must have the money to him by close of business on Tuesday (assuming that's a business day). For all other bonds, such as agency, corporate, or municipal, you have three business days to get the payment made. If you make a trade on Monday, you must have the money to him by close of business on Thursday.

Variables that Impact Price

The major factor affecting a bond's price is interest rates. The biggest source of fluctuations in price will likely come from changes in interest rates. But aside from that, there are other factors. For example, if the stock market begins a significant uptrend, especially after a long flat period, a lot of money may flow from bonds toward stocks as investors seek higher returns. As investors sell their bonds to shift into stocks, you will see bond prices fall. The reverse is true if the market falls and investors shift toward safe money. You will see a rise in bond prices. Other factors are the credit ratings. If a ratings agency suddenly reports a lower credit rating, you will likely see the price of your bond fall.

Mutual Funds

Mutual funds are basically a basket of stocks that are professionally managed. To understand the idea behind mutual funds, imagine that you have a wealthy uncle who has a multi-million dollar portfolio. He has a high level of investment knowledge and is able to go long or short, use futures or options to hedge, and pays very low commissions. If you are a beginning investor, these are all things that you will not be able to match. In addition, if you are investing on your own, you may have to invest $5,000 or more just to buy your first stock. But what if your uncle allowed you to "buy in" to his portfolio? You just pay him a sum of money that you wish to invest and you have effectively purchased a portion of his portfolio. He'll let you invest as little as $500. After that, there's nothing you need to do. He'll still manage it and you get all the benefits that you could not get by yourself.


If this sounds like a good idea, that's basically what you're doing when you buy a mutual fund. Mutual funds may not be as exciting as buying and selling individual stocks but they do offer many benefits that cannot be matched. For example, if you invest in mutual funds, you get an immediate benefit of diversification. If one of the stocks in the fund goes "belly up," there's a chance it will not affect the price of the fund at all. But if that happens to be the one stock you hold, you could be financially ruined. Holding many stocks so that the effect of one stock does not weigh too heavily on the whole is the idea behind diversification. There's no way you can get a good level of diversification for $500 on your own. That figure may be more along the lines of $25,000 minimum and probably more like $40,000 to $50,000. But with mutual funds, for a small investment, you get all the benefits of diversification plus professional management.

There are mutual funds for every investment category you can imagine - and then some. For instance, you can invest in index funds that follow the S&P 500 or Dow Jones Industrial Averages. These funds are passively managed, which just means the fund does not institute a system that attempts to beat these averages. Instead, it buys and sells stocks that comprise each index in the same proportions so as to mirror the index. If the index is up 10% that year, your mutual fund will be up nearly 10% as well. The reason we say "nearly" is because there are some small fund fees and the proportions they buy and sell may not exactly match those of the index. But the point is that it will be very, very close.

There are even some companies that provide leveraged funds that double the returns (or losses) of a particular index.

Most mutual funds, however, are actively managed, which means they are trying to outperform the group or sector by superior stock picking skill as well as market timing skills (when to buy and sell). Within the actively managed funds, you can buy "sector" funds that invest in things like technology, energy, biotech, financial, pharmaceutical, consumer retail, and gold. You can also find funds that invest in other countries such as the Asia, Latin America, or Russia. There are the "socially conscious" funds that do not invest in things like tobacco or alcohol. There are bond funds, real estate funds, and commodity funds. You can even get funds that invest in both stocks and bonds for you, which are usually called balanced funds. You get the point: There are funds for every type of investment style you can think of. Whether you are a new or experienced investor, mutual funds will play a part in your portfolios.


One of the drawbacks to mutual funds is that there are associated fees - and many of these are hidden. While these fees have come down quite dramatically, they are still present in many forms and you need to be aware of them when buying. These fees can be found in the prospectus, which is a legal document describing the characteristics of the fund, which must be presented to you before any licensed representative can talk to you about buying the fund. One section of the prospectus talks specifically about the expenses and they are outlined under "Shareholder Fees" and "Annual Operating Expenses."

Shareholder Fees are those fees associated with running the fund. One of the fees you'll want to watch out for are the "sales loads," which are basically commissions used to pay the selling brokers. Even if you buy these funds through the company, they may still charge you the load fee. Sales loads can be very expensive. In fact, the NASD (National Association of Securities Dealers) limits this load to 8.5%, which can be a large number if you're putting a lot of money into the fund. If this fee is paid to buy into the fund, it is called a "front load" fund.

Another fee is a "contingent deferred sales charge," or CDSC. These fees work like the front load but they are charged when selling the fund. Most funds that charge CDSC fees will calculate the value on your initial investment rather than on the current market value. However, that's not always the case so it's important to understand how all of these fees work if you're thinking of buying a load fund.

Some funds also charge a "purchase fee," which is considered separately from the front-end sales charge. Purchase fees are paid to the fund company to cover their expenses whereas front-load fees are used to pay the selling brokers.

There may also be "exchange fees" that are charged if you "exchange" on fund for another. Most mutual fund companies, however, will let you change from one of their funds to another without paying this exchange fee. Another fee you may see is an "account fee," which is a fee charged to cover their expenses with handling the account such as mailing statements etc.

Fees that fall under the "Annual Operating Expense" category include management fees and 12b-1 fees. Management fees are charged to pay the managers and others who run the fund. These fees range from a fraction of one-percent to several percentage points and can account for a significant portion of the fund's expenses.

Another category you will find under Annual Operating Expenses is the 12b-1 fee. These fees are charged by funds that are authorized by the SEC (Securities and Exchange Commission) under rule 12b-1 to charge such fees. These fees are used to cover expenses for advertising, mailing prospectuses, and other administrative procedures.

The one expense you'll want to check in the prospectus is the "Total Annual Operating Expense," which expresses the total expenses as a percentage of the funds average assets. That figure tells the picture in a nutshell.

Besides expenses, there are other drawbacks associated with mutual funds. One is that the fund managers who are performing well may end up leaving to go to another firm or start their own. So the manager that is responsible for a fund's performance may not be there shortly after you buy into it. It pays to check out who's responsible for the fund's performance and if they are still with the fund. To prevent this problem, many funds are now being managed by teams rather than by one person. Another disadvantage is that managers (or teams) develop styles and what works over some periods may not work in others. Just because the fund appears to be "doing well" does not mean that it will continue. For example, the "value investors" did very well for many years but posted horrible returns in the late 90s.

Other drawbacks are that mutual funds cannot short stocks. And when you're dealing in markets like the 2000 - 2004 periods this can be a real limitation on performance.

Another drawback is that the overwhelming number of mutual funds available (probably more than 7,000) make it a daunting task to sort and pick the right ones for your needs. Of course, there are computer sort programs that can narrow the search, but there is still a lot of work involved with making the right decision.

Mutual funds are also bound by a "charter" that dictates what they can and cannot buy. This is good in one sense in that it keeps the manager on track with the funds objective but, at the same time, can severely limit the manager's choices in certain markets.

Another problem is that funds often sell the losing stocks and buy "what's hot" at the end of each quarter. This way, investors who are interested in buying the fund will see they are holding the "good stocks" they've been hearing about and the fund manager appears to be doing a good job. However, in many cases, you'll find that the manager didn't own the stocks when it was hot and, instead, is only holding it after the fact so that the fund appears to be picking the best performers.

Taxes can be another problem. Fund managers do not know taking capital gains affects your tax situation and, if they sell, they may trigger a taxable event that may have been better off for you if it had been deferred. In fact, if you buy a fund near the end of the year and they make a distribution, you may have a taxable event.

No-Load Funds

Today, there are so many mutual funds that most investors shy away from load funds. They buy into a group of funds called "no load funds" which, as the name implies, do not charge any type of load fees. But even if you have a no-load fund, you can be sure that a management fee is charged. If you are thinking of buying a mutual fund with load fees, check if there is a no-load version even if it is offered by a different company. It may be worth the search.

Open-End or Closed-End?

The mutual funds we've been talking about so far are a class called open-ended funds. This just means that the mutual fund company is technically issuing new shares every time someone buys and buying back shares every time somebody sells. In other words, there is no theoretical limit as to the number of shares the company sell.

There is another class of funds called closed-end funds. These are technically a mutual fund that trades like a stock. Rather than having one (or a limited number) of closing prices per day, closed-end funds trade like a stock and have continuous bid and ask prices. Closed-end funds have a fixed number of shares and their price is determined by supply and demand for these shares. One of the big advantages with closed-end funds is that they can be bought or sold during the day. So for example, if you happen to see news that will adversely affect your mutual fund, you can sell it immediately if it is a closed-end fund. But if it is an open-ended fund, you may need to wait for the evening closing price and that means you could potentially lose significantly more money while waiting for the end of the day.

Despite their appeal, closed-end funds have drawbacks. The main drawback is that the NAV of the fund can, and often does, fall below the true NAV of the stocks they are holding. Because their price is determined by supply and demand, the closed-end funds can theoretically trade at a premium or a discount to NAV but, in most cases, they trade at a discount. While it may sound good to buy the funds at a discount, chances are you'll end up selling at a discount too. You can find funds trading at deep discounts in the Monday edition of The Wall Street Journal, in Barron's (a weekly journal you can pick up in news stands on Saturday), and the Saturday edition of the New York Times.

Historical Returns

It's impossible to say what the historical returns are, as a whole, for mutual funds. The reason is that there are so many classifications and each is taking a different set of risks. The best thing to check is the fund's history, whether online or in the prospectus, which will usually be broken down into a year-to-date, three year, five year, 10 year, and "since inception" return categories. While it may be interesting to check the short-term returns, you'll really want to focus on how they've performed over five-year and ten-year periods.


Because of the many stocks held in mutual funds, their risk is usually fairly low. However, there are many funds that specialize in speculation and their risks would be quite high. Another way to assess risk is to utilize ratings services such as Morningstar, which specializes in the ratings of mutual funds. Their website is www.morningstar.com, which shows the historical performances relative to the S&P 500 as well as several risk measures.

Why Buy

If you are investing for the long-haul, mutual funds will likely play an important role. They are not good short-term trading vehicles unless you're using some of the leveraged funds. Mutual funds are excellent way to diversify your portfolio efficiently.

How to Buy

Most mutual funds can be purchased either through a broker. If your broker does not carry the specific fund you're looking for, you should ask if there is another fund family they carry that offers a similar fund. If not, you can always purchase the fund directly through the mutual fund company. The downside is that you will have a separate account with them and receive separate statements regarding that fund rather than having it combined in your brokerage account.

Most mutual funds have one "settlement" price, which is called the "net asset value" or NAV. The NAV is similar to a closing price of a stock. While stocks have live prices posted at every second of the day, mutual funds usually only have just the single NAV, which is posted in the evening (there are some funds that post NAVs every hour but they are usually sector funds). Everybody who places a buy or sell order gets filled at that same NAV price. When you buy a mutual fund, you place an order with your broker to buy a specific dollar amount. You may, for example, say "put $500" into this fund today. If the NAV is $10, you will have $500/$10 = 50 shares of that mutual fund the following day. When you sell your shares, however, you must specify the number of shares you're willing to sell and let the dollar amount you receive fall where it may. So for mutual funds, you must "buy in dollars" and "sell in shares." This is important to remember when selling if you're trying to raise a specific number of dollars. You may need to sell of a few additional shares in order to make sure you get the amount of cash you need.

Mutual funds, unlike stocks, cannot be purchased or sold for limit prices (for example, buy only if I can get the shares for $30 or less). All mutual fund orders are "market orders," which means the orders will be executed but you will not be sure of what price until after the NAV is posted.

Selling Dividends

There is an illicit practice of some brokers you need to be aware of if you're shopping for mutual funds. Many funds pay dividends, which is simply cash paid to you usually on a quarterly basis. Let's say a fund has a NAV of $10 and pays a $1 dividend tomorrow. There are some brokers who will encourage you to buy the fund today since it will pay $1 on your money tomorrow thus apparently returning 10% on your money in a single day. The problem is that once the dividend is paid, the NAV is reduced by the amount of the dividend and will be $9 the next day. So for a $10 investment, you now have $9 in the mutual fund and $1 in cash - but that $1 is now taxable. Buying a mutual fund strictly for the reason of collecting the dividend only hurts you. The practice of pressuring customers to buy mutual funds because of an upcoming dividend is called "selling dividends" and is considered an illegal tactic by the NASD. Of course, it's tough to prove who said what and that's why many shady firms use this tactic. The best defense is to understand that buying a fund strictly for the dividend does not benefit you in any way but does benefit the broker.


Most mutual funds settle the following business day. For most brokerage firms, this means you must have the money in the account before you place the order. Most firms only require that the check be deposited in the account prior to ordering; they rarely require the check to be cleared before the order. If you need to raise cash by selling a fund, the cash will usually be available the following business day. It's a good idea to check with your broker because there are some funds that have three-day (or more) settlement periods. Again, if you are selling a fund to raise cash, it's a good idea to sell of a few more shares than what you think are necessary to raise the cash since the price may fall for that evenings closing price.

Variables that Impact Price

Because mutual funds are comprised of either stocks or bonds (or both), all the variables we've discussed under stocks and/or bonds will apply. Also, if you're holding sector funds (banking, energy, transportation, etc.) you'll want to keep tabs on how these industries are doing. You can usually find a sector index such as the BKX (banking industry) to get an idea of where the sector has been - and possibly where it's going.


Another investment you'll likely hear about is the Real Estate Investment Trust, or REIT (pronounced "reet"). REITs are similar to a closed-end mutual fund in that they trade like a stock on an exchange. However, REITs strictly invest in real estate. There are a couple of categories you'll want to be aware of. The first is the "equity" REIT, which buys and sells properties and is thus profiting from the equity ownership. Another is called "mortgage REITs" and, as their name implies, make their money from issuing mortgages and earning the money from the interest on the loans. Then there are they "hybrid" REITs that make their money from both the equity and mortgage sides of the business. REITs receive special tax considerations and, consequently, can offer high yields.

In order to qualify as a REIT, the company must pass these tests:

  1. REITs must be structured as a corporation with fully transferable shares.
  2. REITs must have at least 100 shareholders and must have less than 50 percent of the outstanding shares concentrated in the hands of five or fewer shareholders during last half of each taxable year.
  3. REITs must distribute at least 90 percent of its annual taxable income, excluding capital gains, as dividends to its shareholders.
  4. REITs must have at least 75 percent of its assets invested in real estate, mortgage loans, and shares in other REITs, cash, or government securities.
  5. REITs must derive at least 75 percent of its gross income from rents, mortgage interest, or gains from the sale of real property. And at least 95 percent must come from these sources, together with dividends, interest and gains from securities sales.
  6. Less than 30% of gross income can come from sale of real property held for less than four years.


One of the biggest benefits of REITs is that you can now easily invest in areas of real estate that may have previously been inaccessible to you such as office buildings, hotels, apartment complexes and shopping malls. In fact, you can even find REITS that specialize in areas such as residential, office and industrial, health care, self storage, and retail. There are even REITs that invest in local regions, which means you can, with a small investment, participate in the commercial real estate booms that may be occurring in your area. Another benefit is that many REITs offer dividend reinvestment plans (DRIPs), which means you can automatically have the dividends reinvested into additional shares usually at no cost to you.

The average dividend yield on REITs is about 8% and is roughly six times that of the Russell 2000 index. REITs also tend to have a low correlation with other assets and that makes them a great tool for hedging a portfolio. Even if you're not necessarily bullish on real estate, having some exposure to REITs can therefore make your portfolio less risky for the same amount of returns! Also, because properties generally rise with inflation, REITs provide a hedge against inflation too.

REITs offer tax benefits too. Because they are "pass through" security, they avoid the problem of double taxation. In other words, many corporations must pay taxes on their earnings and then distribute the remainder to you through dividends, which are then taxed again. REITs are structured to pass through nearly all earnings to investors, which means they are taxed only once at your level.


Any tax losses do not pass through to shareholders. Another drawback is that REITs must meet substantial operating restrictions; they are not as free to pick and choose investments as many mutual funds are.

Historical Returns

From January 1976 to June 1996, REITs returned 13.8%. During this same period, the S&P 500 returned 15.7% and long-term corporate bonds returned 10.2%.


When you buy a REIT, you must remember that they are a company in the business for profit; they are not just a portfolio of real estate assets. Therefore, you must monitor the decisions of management and realize that, while real estate may be doing well for a given period, the REIT could still falter if managed poorly.

Why Buy

REITs provide and excellent source of diversification since there is very little correlation between their returns and those of stocks or bonds. They are also an excellent way to gain exposure to the real estate market for very little money. If you think real estate in your area will boom, you can buy and sell houses on your own (which requires lots of time and money) or you can simply buy a REIT that specializes in your area. With REITs, a $1,000 investment will increase in value close to the proportion of real estate in your area. There's no way you could get that exposure for so little money.

How to Buy

REITs can be purchased through any brokerage firm. Unlike mutual funds that may not be carried by your broker, REITs are traded on public exchanges and anybody with a brokerage account can buy them. You will pay a normal stock commission for the transaction.


REITs settle in three business days just like stock. You therefore have three business days to deliver payment to your broker and, likewise, need to wait three business days to receive the cash once you sell. REITs are highly liquid and you can usually buy and sell large dollar amounts without disrupting the price.

Variables that Impact Price

The biggest variable affecting REITs is interest rates. When interest rates are low, people buy homes in large numbers. People who already own homes will usually "trade up" to a bigger home since they can now buy it for the same payments as the one they already own. In addition, because the monthly payments come down so much, you end up with a large pool of buyers that normally could not afford a home. The result is that you get a huge surge in demand for homes and no way to immediately increase the production on a proportional scale. The result is a big spike in home prices. Of course, home prices can crash too if there are sudden spikes in the interest rates. If you're holding REITs, you need to follow the news and analyst comments on potential interest rate movements.

Unit Investment Trusts

Unit investment trusts, or UITs, are a type of fund with some distinct differences between open-end or closed-end funds. UITs make a one-time offering on a fixed number of shares, or "units" and those are traded between investors. UITs have a termination date that is announced at the time the fund is created. These dates generally range from one year to thirty years. When the fund terminates, all remaining proceeds are distributed to investors. UITs have a pre-defined plan of action; they rarely are set up for active management that is trying to outperform the market. Instead, UITs have a stated goal and then hold the portfolio until maturity. If they do any kind of adjustments in the portfolio, they will follow a defined set of actions. In other words, if two separate managers were running the same fund, they should end up with the same results. The fund's performance should depend on its objectives and not on the manager's decisions. For example, there is a "Dogs of the Dow" UIT that follows a contrarian strategy by that same name. The idea is to buy the 10 worst performing stocks in the Dow (i.e., the "dogs"), which can be found by buying the stocks with the highest dividend yield and then holding them for a year. At the end of the year, that UIT is terminated and a new one is formed. The strategy was popularized by a recent book "Beating the Dow" by Michael O'Higgens. The author shows that this strategy returned an average of 18% from 1973 to 1989 as compared to 11% for the Dow over that same period. Rather than going out and buying all ten stocks on your own, you can simply invest a small amount into the UIT and the strategy will take care of itself.


Compared to mutual funds, UITs are more flexible in their strategies and can hold very few stocks, bonds, or whatever assets they choose. Mutual funds, on the other hand, must adhere to certain rules of diversification, which is why you will not find a "Dogs of the Dow" mutual fund. So UITs can open the doors to other investment opportunities that may not be offered by mutual funds. UITs usually distribute income, either monthly or quarterly, to its shareholders so they can be used as a source of income as well.


The price of a UIT is strictly determined by how many investors wish to hold the shares. Because there are a fixed number of units issued, the supply cannot change but investor demand certainly can. Mutual funds, on the other hand, determine their value by the value of all securities held in the portfolio less expenses. Mutual funds' values do not depend on demand. As money flows in and out of mutual funds, the size of the fund will grow and shrink but it has no bearing on the NAV. For UITs, money flowing in and out will directly affect their price.

Another drawback is that UITs are generally sold through dealers rather than on an exchange. This means the bid-ask spreads can be quite wide, which hurts if you should need to sell. But if you buy the UIT and hold it to maturity, then the spread is of no consequence.

Historical Returns & Risk

Because there are so many categories of UITs, it's impossible to say what the historical returns or overall risk is. That will be dictated by the fund's strategy.

Why Buy

Buy UITs when their investment strategy is in line with yours as well as the maturity date. If you buy and hold, you will achieve your goal for less money than trying to execute the strategy on your own.

How to Buy

UITs are usually purchased through a broker. These funds are not traded on an exchange so if you wish to buy one, you will not be able to place the order online. Instead, you'll have to speak to a broker to place the order.


Most of the UITs will settle within three business days although there may be some longer exceptions. Liquidity is weakened by the fact that only a few dealers stand by to purchase shares and that is reflected in the wide bid-ask spreads.

Exchange Traded Funds (ETFs)

There is a group of UITs called Exchange Traded Funds, or ETFs. These funds are simply UITs that trade on an exchange rather than through dealers. Among the more popular ETFs are DIA and SPY, which are ETFs on the Dow and S&P 500 indices, respectively. You can find out more about ETFs by going to the American Stock Exchange's website at www.amex.com and clicking the link that says "ETFs."


ETFs offer additional benefits over UITs. Most ETFs have lower expense ratios than their mutual fund counterparts. Also, ETFs are more cash efficient since mutual funds must keep some cash on hand to redeem shares if investors wish to sell. Consequently, that cash just ends up sitting there doing nothing. ETFs, on the other hand, are not buying and redeeming shares. Instead, investors are buying shares from each other and that means the ETF can utilize 100% of its cash.


When you buy or sell an ETF, you are faced with a bid-ask spread. Normally, these are quite low but they can adversely affect your performance if the spread is wide enough and you are buying and selling frequently. For mutual funds, there is no bid-ask spread; everybody is filled at the same price. ETFs won't track indices as well either. The reason is that the ETFs value is affected by the demand for the shares. Mutual funds, on the other hand, are always priced at NAV. Remember, ETFs can theoretically trade at a premium or discount to the value of the assets its holding while mutual funds always trade at the true value. Last, you can only buy and sell ETFs in whole share amounts whereas you can "split" shares with mutual funds and place a specific dollar and cents amount into the fund. You will not be able to do this with ETFs. With ETFs, you must buy a whole number of shares and let the dollar amount fall where it may.

How to Buy

ETFs can be purchased through your brokerage account and can even be traded online just like a stock. You are charged a normal stock commission to trade ETFs.


ETFs are generally highly liquid, which means they will have a small bid-ask spread. They will also settle in three business days just like a stock. Again, this means that if you sell the ETF, you will need to wait three business days before you can get a check for the proceeds.

Limited Partnerships

Limited partnerships are a form of business ownership. In a limited partnership, there are one or more "general partners" that are in charge of running the day-to-day operations of the business. The general partner(s) is liable for the actions of the business while the "limited" partners just contribute cash to fund their operations. If you invest in a limited partnership, you are acting as a limited partner, which means you are only liable for damages up to the amount you invested. If you invest $10,000 into a limited partnership then the most you can lose is $10,000. This is not true for the general partners. The general partners run the operation while the limited partners act as passive investors. In fact, if you are a limited partner, you cannot participate in the management of the company (other than to determine who will run it), otherwise you forfeit your limited liability status. This form of business ownership was created to give incentive for investors to contribute capital without the fear of unlimited liability.

Limited partnerships have limited life spans, just like UITs, although limited partnerships are generally shorter. They are formed to perform a specific goal and then terminated.

Limited partnerships used to be very popular in certain industries such as oil drilling, real estate, lease agreements, and movies. For example, in the early 1980s, the real estate and oil markets were booming and there is an estimated $130 billion of limited partnerships sold at that time.

Part of the appeal in forming a limited partnership was the tax benefits; however, much of those advantages have been removed since the Tax Reform Act of 1986. In fact, many limited partnerships were created for the sole purpose of generating tax losses. That was the reason many investors bought into them. It was not uncommon to see limited partnerships that had no apparent "economic benefit" but were still formed with the intent of generating passive losses for investors. (Passive losses are those that are generated without direct participation such as with a limited partnership.) Today, all limited partnerships must show that there is some sort of economic benefit in their formation. They cannot, for example, be formed for the purpose of drilling for oil in downtown Manhattan.


Perhaps one of the biggest benefits of limited partnerships is that they allow investors to invest in a business that is run by someone with an excellent track record in a specific area. For example, imagine that a multi-millionaire real-estate developer decides he wants to start a new development. He may seek funding from other investors, the limited partners, and then plan, organize, and run all operations. All you need to do is sit back and collect the money if things work out. If not, you're only at risk for what you invested. Note that this would not be possible to do with a mutual fund or UIT; they are set up for holding portfolios of securities. But with a limited partnership, you can invest into the business - even in an IRA (Individual Retirement Account).

Also, since they are taxed as a partnership, they are excluded from corporate tax.


While limited partnerships are excluded from corporate tax, this also creates a drawback; they must comply with partnership tax accounting. With partnerships, all profits filter down to you and you are taxed at your level. General partners must also contribute significant cash investments and, as stated earlier, have unlimited liability for the partnership's obligations.

Another drawback is that many limited partnerships have little or no marketable value. In some cases, "fair market" prices may only be 20% to 60% of the partnership's net asset value. Of course, this isn't a problem unless you need to sell but it is a potentially a significant drawback in holding a limited partnership.

Historical Returns & Risk

Because of the many various forms of limited partnerships, it's difficult to say what the historical returns are. However, in most cases, the risk is much higher than for investing in index funds such as the S&P 500 so investors should expect higher returns from limited partnerships than from broad-based indexes.

Why Buy

Because the tax benefits are virtually removed, it's best to not buy a limited partnership for the sole purpose of tax benefits. Buy them if you like the business opportunity it presents and you are willing to hold it to maturity. The reason it's important to hold it to maturity is because of the lack of liquidity, which is discussed shortly.

How to Buy

Limited partnerships are generally sold through retail brokers. Specifically, they are usually only available through the full service dealers such as Merrill Lynch rather than the commission discounters.


Limited partnerships are highly illiquid. This means that if you wish to sell before the maturity, you're most likely going to take a big, fat loss. There are probably 10% to 15% that trade with any regularity. Even those are traded through independent dealers who use their own clearinghouses. This is a step above taking it to a pawn shop for redemption. Bear in mind that this doesn't mean that limited partnerships are bad; it just means that if you need to sell before the enterprise is done, then you're most likely going to have trouble selling it and will, consequently, receive very little for it.

Hedge Fund

Hedge funds are probably the most speculative of all investments. Many times, these are limited partnerships that are formed to speculate in the markets by using derivatives and a lot of financial leverage. Hedge funds are allowed to go long or short, trade futures and options, use risk arbitrage, and other forms of speculation. But perhaps and even bigger reason is that these funds and their managers are largely unregulated. Neither the fund nor the managers are required to register with the SEC. This opens the doors for fraudulent people to start their own fund based on some wacky scheme to beat the market. Many of these are outright frauds trying to get your money. But there are many that are legitimate and so you need to really check out what the fund is supposed to do and who is running it before you place your money with them. Because of their speculative nature, many hedge funds are only open to sophisticated investors, which are called "accredited investors." According to the SEC, an accredited investor must meet one or more of the following criteria:

  • a bank, insurance company, registered investment company, business development company, or small business investment company;
  • an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
  • a charitable organization, corporation, or partnership with assets exceeding $5 million;
  • a director, executive officer, or general partner of the company selling the securities;
  • a business in which all the equity owners are accredited investors;
  • a natural person who has individual net worth, or joint net worth with the person's spouse, that exceeds $1 million at the time of the purchase;
  • a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
  • a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

Many of these funds also restrict their investors to small numbers; for example, some may only allow 100 investors. Because of the small numbers, many hedge funds require a minimum of $1,000,000 to invest with them. Despite these restrictions, the hedge fund business is big. There are currently over 8,000 different hedge funds with nearly $900 billion in assets.

There is a new breed of mutual funds that invests in hedge funds, which are known as "funds of funds" that attempt to diversify as well as allow non-accredited investors a way to invest in these assets.


  • Hedge funds may be able to generate profits in rising or falling markets due to their ability to go long and short as well as use derivatives.
  • Using hedge funds in a balanced portfolio will reduce overall portfolio risk and volatility but not harm your returns. This is because of the high degree of negative correlation hedge funds have with stocks. Hedge funds can provide diversification not available with stocks and bonds.
  • There are many hedge funds to meet a variety of needs.


  • Hedge funds charge enormous fees. In addition to the 1% or 2% operational fees, management's take is usually 20% of profits. This can seriously cut into the performance of the fund.
  • Hedge funds do not need to comply with the same standards of mutual funds. Consequently, there may be additional unforeseen risks.
  • While the performance of many funds may be impressive, they are not immune to risk. Remember, hedge funds are among the riskiest investments you can make. George Soros' Quantum fund was shut down in 2000 after taking enormous losses. This is the same fund that produced 30% gains for more than a decade. Long-Term Capital Management, which was run by PhDs and a Nobel Laureate had to be bailed out in 1998 by some of the largest banks to keep the financial system from crashing.

Historical Returns

Because of the various funds available, we can't say what the historical returns are overall. Just remember that these funds usually take high risk so it's not unusual for them to beat the market - and it's also not unusual for them to fold. Be careful in choosing your hedge funds!


As we said before, hedge funds are usually the most speculative of all investments. They are not regulated by the SEC, which makes it possible for people to start a hedge fund with little or no experience. Many hedge funds are started by day-traders with little experience but who want the thrill (not to mention the 20% management fee) of speculating in the markets with other people's money. This is not to say that all hedge funds are bad; there are many that are run by well-qualified people and have posted stellar track records. Just make sure you thoroughly check out the fund before investing.

Why Buy

Most people buy hedge funds as a means to speculate on the market. They want a professional trader to make leveraged investments and attempt to make big returns. This is one - but not the only - use for hedge funds. You can also buy them to diversify your holdings. Even though hedge funds are risky in nature, a little bit of money invested acts as a good hedge for a well-balanced portfolio.

How to Buy

Most hedge funds can be purchased through money managers, banks, or large brokerage firms such as Merrill Lynch or Prudential. Most of you online, discount brokers will not have access to them.

Money Markets

The financial markets are broadly categorized into two markets: Capital Markets and Money Markets. The capital market is classified by all investments for more than a one-year period while the money market is used for all investments less than one year. The money markets arise out of our necessity to match cash flows with short-term operations. Investors who have idle cash can invest in the money market by dealing directly with T-bills or other short-term instruments.

However, when you open an account with a brokerage firm, they will ask you to choose between several "money market" funds for your cash balances. These money market funds are similar to a mutual fund in that they invest in a pool of assets - usually 30, 60, or 90-day T-bills or other short-term products. The fund always maintains a net asset value (NAV) of $1. This means that the value of the fund is always equal to your cash balance. For example, if you deposit $1,000 to your brokerage account, it will most likely sit in a money market fund, which will show a value of $1,000. No matter what happens to the financial markets, this money market will always maintain the $1,000 value. It will not rise or fall with the overall market. Money markets generally pay interest in the form of dividends, which also fall into the money market. So the only time your money market balance will change (assuming you didn't add or withdraw money) is when interest is paid. Of course, with today's low rates, don't expect those interest payments to amount to much.

Some money markets invest in T-bills while others may use some tax-free instruments that pay a lower interest rate. But regardless of which money market you choose, the idea is the same: It is a place to park cash in between investments. There is no time frame on the money market either; you can leave the cash parked there for as long as you'd like.

Whenever you buy a stock or mutual fund, the money will automatically sweep out of the money market to pay for the trade. When you sell, the proceeds will automatically sweep into the money market. There is no commission to buy or sell from the money market.


The biggest benefit of money markets is that there are no price fluctuations. The cash is readily available and there are no commissions for moving money in and out.


Because the NAV is always maintained at $1, there is no way for your money to grow other than from the small amount of interest that is periodically paid.

Historical Returns

Money markets mostly invest in short-term guaranteed paper and may also buy short-term commercial paper (discussed later). This means that the historical returns of money markets will closely mirror that of the one-year, risk-free interest rates.


There is no risk by investing in money markets. Technically, there have been a few cases where the NAV dropped below $1 but that almost immediately led to the collapse of the brokerage firm. But if that happens, there is an insurance policy guarding your assets. If you do have a substantial amount of cash in money market or with a brokerage firm, you'll want to check what their policy covers in the event they go bankrupt. It's important to understand that these insurance policies do not guard against bad investments or adverse market moves; instead, they protect investors in the event the firm goes bankrupt.

Why Buy

Money markets are excellent investments for money that you know you'll need soon. You know the full dollar amount will be there and there are no commissions for getting the money out. Use money markets for cash that needs a safe parking place.

How to Buy

There is nothing you need to do other than be sure you have signed the account agreement to have a money market in your account. There is no charge for it but the firm needs in writing from you which money market you want. Incidentally, you are not required to have a money market to park cash. The downside to this is that you'll never receive any interest from it. Once the agreement is signed, the money will automatically sweep in and out of the account.


The cash settles next business day. If you need a check, you should call your broker the day before you need the check so that the funds can settle.

Variables that Impact Price

The NAV is always maintained at $1 so there are no variables that impact the price of a money market. However, short-term interest rates will certainly affect the amount of interest that is paid.

Commercial Paper

Corporations need to borrow short-term money to meet the needs of their daily operations. Most companies can get these loans through lines of credit at banks or through other sources. However, that can be costly as there are long processes and hefty brokerage fees associated with raising money through the capital markets. Instead, many of these corporations raise money by issuing short-term IOUs called commercial paper. They are backed by nothing other than the company's good faith to pay it back. Because of this, commercial paper fetches slightly higher interest and is usually only offered by the most credit worthy corporations in America. Commercial paper is sold at a discount and then matures to face value.


Commercial paper yields slightly higher interest rates than you can get in the money market and can also be purchased for very short maturities - usually as little as 2 days. You can also find paper for up to 270 days. Most commercial paper matures in 30 days.


Commercial paper is usually sold in $100,000 denominations but, in some cases, may be broken down into smaller amounts. A commission is usually charged in the form of a markup; in other words, it is built into the price. So commercial paper does come with a cost unlike money market funds.

Historical Returns

Commercial paper generally pays a little higher interest rate than the risk-free rate.


Although it is unsecured debt, commercial paper is still pretty safe. Throughout history, there have only been a few corporations that have defaulted on their commercial paper. Most large corporations' cash flows are pretty certain for the next nine months so it's unlikely that something that unforeseeable would occur. Commercial paper receives credit ratings through Standard and Poor's and Moody's.

Why Buy

Commercial paper is a good choice for those who wish to park cash in a liquid instrument but also want a little higher interest rate. For example, maybe you have a sizeable amount from the sale of a home and are not quite sure what to do with it. Rather than leave it in the money market, you might wish to investigate the rates that commercial paper is paying.

How to Buy

Commercial paper can be purchased through most brokerage firms.


Commercial paper settles the same business day. The pricing and availability of commercial paper depends on many factors but largely on the demands of the institutional buyers. If there are a lot of buyers, then the commercial paper will be very liquid.

Variables that Impact Price

There are many factors that can affect commercial paper but the most common are interest rates, credit ratings, and availability of competing products.


Options are a popular means of investing or speculating in the market. Options are contracts between two people - the buyer and seller - to buy and sell stock. There are two types of options: calls and puts. Call buyers have the right to buy stock at a fixed price while the call seller has the obligation to sell. Put options work in the other direction. The put owner has the right to sell stock at a fixed price while the put seller has the obligation to buy. Option contracts derive their value from the underlying asset (or index) and are consequently called derivative instruments.

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Options allow you to buy or sell stock for a fraction of the cost. This means that investors can spread their investment dollars over a wider range of investments thus diversifying their portfolio. The amount you spend on an option is also the maximum you can lose. This property makes options a great money management tool since you know up front what your maximum loss is. This is not true for stock investing.


Options convey rights to buy stock (with calls) or sell stock (with puts). If you buy an option, you are not required to use it. However, you must pay for this option in the form of a time premium, which means that your total cost to buy or sell the stock is increased. Another drawback is that options expire and this means that the time premium you pay for the option slowly gets chipped away with the passage of time. In other words, part of its value is lost with each passing day for no other reason than the passage of time. This time decay property of options does not exist for stocks. Because of the time decay, owners of options need to have the underlying stock move quickly in order to be profitable. Again, this is not required for the stock owner. If you own stock, you will make money regardless of how long it takes for the stock to move - as long as it moves in your favor. This is not true for the option owner. You could buy a call option and lose money even though the stock rises.

Historical Returns

There are not many long-term studies on the performance of options. But one thing is for sure: Their returns will be far more volatile than the underlying stocks or indices. One study published in the Journal of Financial and Strategic Decisions (Vol. 13, No. 1) cites that the S&P 500 during 1986 to 1989 had returns ranging from -1.7% to 5.4% while the at-the-money call options posted between -64% and 48% for the same period. Because of the leverage with options, their potential returns are much higher than the underlying assets and this necessarily means that they will exhibit far greater swings in prices - both positive and negative.


The risk in options is purely a function of how they are used. It is certainly possible to use options in a gambling type manner as well as protective insurance. It all depends on which side of the trade you are taking and what your goals are. For example, a speculator may sell a put option because he has a gut feeling the stock is going to rise; this is a highly speculative use of selling puts. Another investor may actually wish to buy the stock. He may sell a put as a way of getting paid to acquire a stock he was willing to buy anyway. This would obviously be a conservative use of the put option. Two people selling puts on the same underlying stock can have vastly different risk profiles. This is why it is so important to study and understand options and strategies as the risk involved in options is highly dependent on how they are used.

Why Buy

Options are a great way to speculate or hedge your positions in the market. If price volatility is a concern, you may wish to hedge with puts. If you have some speculative money, then options may provide a way to control a lot of stock while limiting your downside risk.

How to Buy

Options can be purchased through most brokerage firms. However, they will require that you fill out a separate application before you trade. Depending on the option approval level for which you are approved, you can select from various strategies. Option can be bought and sold just as easily as stock.


Options settle the next business day. This means that if you sell an option, you can get your cash the following business day.

Variables that Impact Price

Any variable that impacts the stock's price will obviously affect the option's price. However, in addition to those variables, there is the effect of time decay that can greatly affect an option's price. Once again, this variable is not present with stock prices so it can be a tough concept for new traders. Another variable is the volatility or the jumpiness of stock prices. If stock prices become more uncertain and we see bigger price swings during the day, then all option prices become more expensive. These are covered in more detail in our option course.


Futures contracts are one of the oldest forms of derivative instruments. A derivative instrument is one whose value is tied to another. The option contracts discussed in the previous section are derivative instruments as well but this does not mean they are the same thing as futures contracts. Options give buyers rights to buy and sell stock while futures contracts are obligations to buy and sell. If you buy a futures contract, you will pay a small percent of the stock or commodities value but then must take delivery of the underlying asset - assuming you do not close out the contract prior to expiration. In other words, if you buy a futures contract and then sell it, you are not obligated to take delivery. Buying futures contracts is similar to buying something on layaway since you place a small deposit on it but then must take delivery at expiration. However, if you buy a futures contract and the underlying stock or commodity rises, you can profit from that move by simply selling the contract. As with options, this means you can buy and sell stocks or commodities by depositing only a fraction of what the asset is really worth.


There are several benefits associated with trading futures contracts rather than the underlying asset. First, if you buy a futures contract, your account is credited daily with cash - assuming the underlying asset is moving in your favor. If you buy the contract, your account is credited with cash every day the asset rises. The amount of the credit depends on the size of the move and the number of contracts you own. Conversely, if you short a contract and the underlying asset falls, your account will be credited daily too.

Because you get daily credits for favorable movements in the underlying, a futures contract is more cash efficient than the underlying. For example, if you buy a stock and it rises, you have an unrealized gain. The only way to get your profit is to sell it. But if, instead, you owned a futures contract, your account would be credited with cash on a daily basis effectively "cashing in" on your profits but allowing you to stay in the position.

Futures contracts also allow you to control a given number of shares for less money. Investors and traders can therefore spread their risk out over many stocks for the same amount of money.

Futures contracts also allow traders to move from long to short instantly. For instance, if you own 1,000 shares of stock and wish to go short 1,000 shares, you must first sell your 1,000 shares and then enter a separate order to sell short. And before you can short those shares, you'll need to get approval from stock loan - assuming they can even locate the shares to borrow.

But with futures contracts, the process is much simpler. The number of futures contracts does not depend on the number of shares in the underlying; it only depends on how many people are willing to buy and sell the underlying. Therefore, you know that futures contracts will always be available to short. So if you're long 10 futures contracts (1,000 shares) and wish to go short 10, you only need to enter one order to sell 20 contracts and that makes you short 10 contracts at that instant.


The daily crediting of cash to your account works in the reverse direction too. If the underlying asset moves adversely, then your account will be debited some cash. Once again, the amount of the debit depends on the size of the move and the number of contracts you own. Some traders, however, view this as a benefit since it forces you to make a daily decision on whether or not to hold the contract. If you own the underlying stock, it's easy to talk yourself into holding the position even when it's losing. But if you see cash debited from your account on a daily basis, it will certainly make you think twice about holding the futures contract. Any daily debits will force you to actively decide if you wish to continue holding the position - and that can be a good thing.

Historical Returns

The historical returns on futures contracts will be a magnified version of the underlying stock or commodity. The reason is that the futures contract is an agreement to buy or sell the underlying so it is directly tied to that asset; the overall variability will be the same. However, because the trader only places a small fraction of the cost of the commodity, the gains and losses will be magnified.

You can learn more about single-stock futures contracts by taking our free course.

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