Alternatives to Commercial Banks

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In an earlier post, I offered guidance on choosing a bank for your savings.  Even the smallest investors, however, have alternatives.  Savings banks, though fewer than they once were, might suit some people better.  Credit unions can also take small deposits and support larger ones, too.  This post considers these two alternatives.  (A later post will take up how the U.S. government offers secure savings bonds and will also touch on the growth of exclusively on-line banking.)

Mutual Savings Banks

These resemble commercial banks.  You need to examine much the same issues as discussed in my September 2, 2018 post on commercial bank savings.  (Use the above link if you want a refresher.)  Otherwise, savings banks have fewer lines of business and they focus more on the saver.  Effectively, all they do is collect savings deposits and then lend them out — usually to mortgage borrowers.  They do not have stockholders as do commercial banks.  Rather, depositors in effect have an ownership stake in the bank proportional to the size of their deposits.  After expenses, the managements of these banks pay out in interest to their depositors all the returns from their lending.

Such arrangements appeal to many.  These depositors feel they’ll get better treatment and earn more than they would in a commercial bank, where the first obligation of management is to its stockholders and not to its depositors.  But other considerations may offset these advantages:

  • Though figures vary, most savings banks do not pay higher rates on their deposits than commercial banks.
  • Because savings banks tend to be smaller than commercial banks, they are less convenient, having fewer ATM stations, for example, and less of a presence elsewhere in the country, and certainly abroad. Many savings banks allow access to the same ATM networks as commercial banks, but that arrangement forces you to use another institution’s ATM. Find out if any savings bank you’re considering has such networking arrangements and what fees are involved.
  • All these drawbacks are particularly applicable when it comes to foreign exchange transactions.
  • Because savings banks otherwise tend to be smaller institutions, safety considerations cut both ways: Their smaller size suggests they have more limited resources to meet difficulties, but at the same time, they are less likely to encounter the problems that might face broad-based commercial banks when they venture into more exotic activities.
  • Because savings banks do not trade on public stock exchanges, it is harder than with commercial banks to get information on the strength of their finances.  Credit rating agencies have little interest in them.  However, such information is available from the Federal Deposit Insurance Corporation (FDIC) at www.fdic.gov.  Also, Veribanc (veribanc.com) includes ratings on savings banks and will provide them to you for a fee.

Credit Unions

Credit unions appeared in the early 1900s.  They were designed to help working people who couldn’t qualify for loans at commercial banks.  Members of the credit union pooled their funds to establish not-for-profit cooperatives with the aim of lending to one another.  Because credit unions lack any concern for profit and stockholder return, they typically paid a little more on deposits than commercial banks, though the returns vary from union to union.  This difference has grown less significant of late.

By law, credit unions must form themselves around what the authorities call a “common bond,” usually employees of one company or government agency or members of the same church or club or even people who just live in the same neighborhood.  Depositors, rather than establish an account, as they would at a commercial or savings bank, buy shares in the union.  The value of their account is expressed as shares, though, practically speaking, these are much like bank deposits.   In smaller credit unions, member volunteers do most of the work, while larger unions maintain paid professional staffs.

As with savers at mutual savings banks, savers at credit unions say they feel more comfortable than at commercial banks.  They anticipate higher rates than at for-profit institutions, and they like the sense that, as members, they are the main focus of the union, especially compared to a large commercial bank.

There are drawbacks, however, especially with smaller credit unions, and they are similar to those of savings banks. Credit unions cannot offer the range of services available from commercial banks and they also lack the convenience of having many locations and a broad network of ATMs, as well as relationships with other financial institutions.  Smaller unions, run by inexperienced volunteers, may feel inadequately staffed.

Safety

 Most mutual savings banks have FDIC insurance under exactly the same terms as commercial banks: each depositor is insured for up to $250,000.  Make sure the savings bank you are considering is a member of the FDIC.  Although credit unions cannot participate in FDIC arrangements, they can acquire insurance through the National Credit Union Insurance Fund (NCUIF) run by the federal government’s National Credit Union Administration (NCUA).  It offers depositors (shareholders) insurance on deposits up to $250,000.  State-chartered credit unions may use the NCUIF or have state or private insurance for their depositors.  If you are considering a credit union, find out which insurance, if any, it carries.

Aside from insurance questions, assessing the finances of these institutions is a bit more difficult than with commercial banks.  As in the case of savings banks, credit rating agencies have little interest in evaluating unions because of their mutual character – that is the absence of stockholders. You can find out about credit union finances on the NCUA website.  www.ncua.gov.

What About Investment Clubs?

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Several readers have had questions about investment clubs.  They are coming from both beginning investors, who hope they will learn by joining one, and more experienced investors, hoping that a club will allow them to show their stuff.  The answer to both questions is, “Yes” — beginning investors can learn a lot in a club and the more sophisticated can increase the breadth of their investment action.  But not all clubs are created equal.  Some function better than others, both for learning and for investment success.  Here’s a guide for choosing a club or even starting one.

Investment clubs are surely the most enjoyable way to invest your money, and they can offer an investment education as well.  Most are private groups of 15 or at most 20 members, who pool their resources to invest, usually buying stocks but sometimes also bonds and more exotic investment instruments.  (Subsequent posts will focus on different investment vehicles, explaining what they are and how to buy and sell them.  A recent post on stock basics began that process.)

Organization 

Clubs typically organize themselves around a community, a church, a synagogue, an adult education center, or even just a neighborhood group.  They require monthly payments (which can range upwards from $20) into a common fund.  They meet regularly, usually twice a month, to discuss investing and consider sell and buy decisions.

Most clubs appoint or elect officers to establish an administrative structure along these lines:

  • A president who sets meeting dates, plans activities, and runs discussions.
  • A vice president to fill in for an absent president.
  • A treasurer who controls the club’s brokerage and banking accounts and places all buy and sell orders
  • A secretary to remind members of meetings and keep complete minutes. This last function is critical.  Investment discussions can become complicated.  Because not all investments work out as well as others, it is essential to know which members said what and when — not to assign blame, which would surely destroy the club, but to learn from past mistakes.
  • A “director of research” or “education officer” who distributes research material among members, perhaps invites guest speakers, and arranges field trips to broker presentations, for instance, or even the headquarters of a firm in which the club has a stake or is considering one.

If there are no clubs in your area, you can establish one.  Make sure the members are compatible.  Investment discussions inevitably involve disputes, and it is crucial that members know how to handle these in a productive manner.  It is also important that at least some members have investment experience beyond sometimes reading The Wall Street Journal or The Financial Times.  Actual experience in an investment firm or a broker would be ideal.

Best Practice

During the 2008-09 financial crisis, many clubs lost a lot of money and disbanded, experiences that left behind much disillusionment. But there is nothing inherent to clubs that makes them more vulnerable than any other investment arrangement.  (Many professional investors also lost a lot of money during the crisis.)  The best approach is not to dismiss the idea of clubs but rather to ensure that the ones you join maintain clear guidelines on how they invest and how they control risk.  These guidelines can limit losses even in the worst of times and even blunt, if not completely eliminate, conflict among club members.  Guidelines might include:

  • Procedures to receive new members and for members to withdraw their funds.
  • To determine when the club will reinvest dividends and interest payments and when it will distribute them among the members.
  • Which newsletters and research materials the club will use and at what interval it will reconsider these subscriptions.
  • The establishment of risk guidelines up front that:
    • Insure adequate diversification among different sorts of assets (of which more in subsequent posts) the club should determine the maximum proportion of the club’s assets that it can hold in a single stock or bond.  As a rule of thumb, the upper limit should seldom exceed 5 percent.
    • Determine exactly what sorts of investment vehicles it will and will not use — stocks, bonds, foreign securities, real estate, and the like.  (More on each of these in coming posts.)
    • With an eye to controlling losses, how much volatility or loss it would tolerate in any holding before reconsidering it.  (Some clubs set an automatic sell, called a “stop-loss order,” when a holding reaches this point.)

Guidance on best investment practice for clubs is available from umbrella organizations.  The largest is Better Investing, www.betterinvesting.org. It claims five million investors.  For a small fee per club member, your club can join Better Investing.  It will offer training and educational material, considerable investment research, discounts on subscriptions, and the ability to buy general liability insurance, which could become desirable as the assets involved grow.  The Securities and Exchange Commission (SEC) also has information on investment clubs at www.sec.gov/reportspubs/investor-publications/investorpubsinvclubhtm.html.

You might also seek more general and in-depth investment insight at ProsperAmerica.  You will find its website at www.prosperamerica.org

Stock Basics

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Stocks remain a popular investment vehicle and with good reason – they amount to a wager on the economy’s future.  Equities, as stocks are often called, rise and fall according to all the particulars that affect corporate profits — but basically they rise when the economy has promise and fall during recessions or when investors otherwise doubt the economy’s prospects.  Because stock prices can at times move violently, investors, unless they are lucky timing their purchases and sales, will realize their best payoff over the longer term.  The longer you can wait for the returns, the more stocks you will have in your investment portfolio.  (More on this in a later post.)  

What Are Stocks?

Stocks are a partial ownership in all that the issuing firm owns and earns.  Companies issue stock to raise money, usually for expansion.  This money is called equity capital.  

There is no limit to how many shares a company can issue. Managements that prefer to limit ownership in just a few hands issue relatively few shares.  Companies with expansion plans that require a lot of financial capital often issue thousands of shares.  There are benefits and disadvantages to either approach.  Using equity (stocks) instead of borrowed capital (money) can make the company more financially stable.  In hard times, the firm has to pay lenders even if it makes no money, but shareholders can claim only a share of the profits.  The disadvantage of issuing more shares is that they dilute the value of existing shareholders.

The most common sort of stock is called, not surprisingly, common stock.  These entitle their owners to any distribution of company profits, called dividends.  Owners are also entitled to elect board members and vote on other basic matters of ownership.  Each share gets one vote, not each shareholder.  The largest shareholders generally have control of the company’s decisions.  Companies sometimes issue preferred shares.  These tend to command more generous dividends than common shares and usually stand before common shares should the company suffer bankruptcy, but they typically lack voting rights.

Making Money in Stocks

Stocks offer two ways to make money:

  1. Dividends are periodic cash payments (almost always quarterly) that management pays shareholders out of the firm’s profits, what financial people usually refer to as earnings.  Dividends are entirely at the discretion of the corporation’s board of directors.  Usually, the board makes its decision based on how much the company has earned and what other uses it has for the money — say investing in new facilities.  Companies that are growing fast and need to invest to keep up with their expanding business pay low or no dividends.  Slower growing firms with less need for the money pay higher dividends.
  2. A more important way of making money in stocks is price appreciation.  This is determined solely in the market where investors trade available shares of stock. Neither management nor the board of directors has any direct control over this activity.  If the company is doing well, earnings are growing, and there is a promise of further growth, people will want to own a piece of that action and their buying bids up the price of the stock.  This works in reverse if the firm faces trouble.  Appreciation can also reflect dividends.  Higher dividends will often attract buyers whose demand prompts price appreciation.

The Roots of Price Fluctuations

Stock prices fluctuate as investors alter their expectations of future profits.  Financial theory holds that the fair price of a stock is only a reflection of the flow of future dividends and the earnings that might support future dividends.  That future flow is discounted, because dollars you have today can be invested and earn money, whereas future dollars are inevitably uncertain and cannot earn until they are paid.  A well-regarded algorithm, called the “dividend discount equation” calculates a fair price for a stock by so discounting prospective earnings and dividends.  Anything that improves a company’s profits next to the expectations previously built into its price will to raise that stock’s price.  Anything that makes the future look more problematic tends to drive its price down.

A number of factors can influence these calculations, some general, some specific to the industries in which the company operates, some specific to the company.  A complete list would fill several volumes, but here are seven main issues that move stock prices:

(1) The Economy

Because profits generally follow overall economic activity, an improved economic picture promotes a general rise in stock prices, called a rally or a bull market.  Economic clouds prompt stock price declines, called a correction or a bear market. Because no one can know the future, stock investors continually assess economic trends and revise their opinions accordingly. The flow of news is continual.  The list of indicators, statistical or otherwise, is too long for this space and absorbs the attention of thousands who work in the industry, making it very hard for an individual to get ahead of the market’s regular reassessments.

The movement of interest rates also has an effect.  Because lower interest rates make borrowing cheaper and so more likely that consumers will spend and business expand, they usually signal an economic pickup that tends to lift stock prices.  An interest rate increase, because it has the opposite economic effect, tends to depress stock prices.  Interest rates also feed directly into stock valuations. Because higher interest rates offer better ways for your dollars to earn, they prompt investors to discount future dollars more severely, depressing stock prices.  An interest rate decline has an opposite effect.

(2) The Industry

Even more than changing perceptions of the general economy, industry-specific considerations move stock prices.  Are oil prices rising?  That’s good for those who produce oil and who service the oilrigs.  It’s bad for those who use oil — airlines and truckers, for instance.  A technological breakthrough may benefit some at the expense of others.  A bumper wheat crop abroad will hurt American wheat farmers by depressing the prices their harvest can command, but it could help food processing firms who buy grain. These few examples only hint at the constant flow of industry information that just as constantly changes market opinion and moves stock prices.

(3) Legislation and Regulation

Here, too, the flow of news is endless.  If Washington, for instance, were to support a major infrastructure-rebuilding program, prospects for construction firms would improve and their stock prices would rise accordingly.  A decision to step up defense spending would definitely boost prospects among defense contractors and so the prices of their stocks.  The Affordable Care Act (ACA) improved prospects for health care insurers (at least initially) by driving millions of new customers their way.  But such news can cut the opposite way.  The adverse effect of such spending on Washington’s finances might negatively impact stock prices by threatening to push up interest rates or taxes or both.

Regulation, at the national, state, or city level, can have its own effects.  Environmental rules will enhance the prospects of some firms at the expense of others, say solar over coal.  Stricter financial regulations after the crash of 2008-09 had a powerful effect on financial firms, especially smaller ones.  Safety regulations raise costs for some firms and industries but create opportunities to those that sell products to help other firms comply with those regulations.  Here, too, the flow of information constantly changes investor assessments of the future and thus stock prices.

(4) News About Staff

If a company hires someone with widely recognized ability, investors may expect an improvement in the company’s fortunes and buy its stock, pushing up its price.  The loss of a key executive can raise questions about the future and so depress the company’s stock price.  A large number of departures, even of not-so-famous, middle-level employees, can raise questions about the firm’s ability to manage and so push down its stock price.

Scandals also move prices.  A staff member who runs afoul of the law can depress the company’s stock price by increasing investor worries over fines or other legal actions. This sort of news tends to break suddenly, creating violent swings in stock prices.  Bad news for one firm, of course, might also lift the prospects of its competitors and so of their stock prices.

(5) The Firm’s Product Line

Any change in product line, positive or negative, will move the company’s stock in a sympathetic direction.  Drug companies are particularly vulnerable.  Bringing new drugs to market is a very lengthy process, and failure could cost these firms dearly.  Lawsuits involving pharmaceutical companies are more expensive than in other industries. But a successful new drug, sometimes referred to as a “blockbuster drug,” can lift profit prospects dramatically and the company’s stock price with it. Drugs are just one example.

(6) Natural and Political Events

Stock prices also respond to geopolitics and natural events. Revolution, war, elections, and natural disasters anywhere can disrupt business and affect stock prices.  Tariffs, much in the news today, can help the firms protected by them and hurt those who have to face them.  An earthquake could wipe out an industrial operation.  Even if insured, the firm’s stock price would suffer because the company would have lost its ability to engage in otherwise lucrative businesses.  If the disaster is large enough, that company’s insurers might find themselves facing huge payouts that could bring down their stock prices.  For investors, reassessment is always continual as is the movement of stock prices.

(7) Buybacks, Mergers, and Acquisitions

Management may from time to time decide to use retained earnings to buy back their own stock on the market.  Typically, it is done in lieu of raising dividends.  Such additional demand for the stock will tend to raise its price.  But when the buyback program ends, the sudden drop in demand for the stock can depress its price.

Mergers and acquisitions (M&A) happen for all sorts of reasons.  They usually generate a lot of drama and so a great deal of media attention. Sometimes the buyer sees what the financial community calls “synergies,” meaning that the business of the acquired firm has many similarities to that of the acquirer and hence opportunities for efficiencies or market dominance.  Sometimes the merger occurs between two quite different parties that see a way to diversify their respective product lines.  Some acquisitions are hostile— meaning that the firm being bought resists the transaction.   Others are amicable— meaning that both parties like the idea of merging.  The effect on stock prices varies depending on the structure of the deal, which can become very complicated.  Generally, the buyer’s stock suffers and the stock they are buying rises, at least initially.  This often happens in a hostile acquisition, as the buyers will try to blunt opposition by raising the price they offer for the other’s stock.

Getting into the Action

Taking all this into account, you might well ask why any individual investor would risk stock ownership.  Such a hesitation is understandable.  But an investor who will not need the money for a long time and has basic confidence in the firm’s management and its products can feel secure that its stock will rise over the long term.  There are also ways to enlist professional help in making all these continual assessments. More on these options in subsequent posts

First Steps for a New Investor

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For many, investing seems to happen in a foreign place where the inhabitants speak a strange language.  Most don’t know where to begin, and it’s easy to understand why:  They don’t teach this stuff in school.  One thing, however, is clear.  Unless you entered life with a trust fund, investing starts with small savings and the cultivation of the savings habit.  So let’s start at the beginning, with techniques for saving and how to plan your investment scheme.

Developing the Saving Habit

Too many of us procrastinate.  It’s easy to convince yourself that setting aside only a few dollars will make little difference compared to some “urgent” household or personal need. While sometimes these needs can be genuinely important, most are usually an excuse to put off saving and seek immediate gratification instead.  It might help you resist temptation to realize that every dollar you save each week or even each month will start growing beyond what you are depositing, what I call building on itself.  And soon the increased savings will offer their own gratifications.  The effort will also help you strengthen your saving habit, which, in most cases, is more than half the battle.

Here are seven tips to get in the habit of saving:

  1. Put aside all your loose change in a jar at the end of the day.  Better yet, add a dollar or five dollars into the jar each evening.  Such small amounts can quickly become a significant contribution to your savings. And most of the time it’s money that you won’t miss.
  2. Leave your credit cards at home.  Paying with cash will put a cap on how much you spend at a given time.  And if you have to run home to get the card, it might give you time to rethink an unnecessary expenditure.
  3. Contribute to stock purchase plans and reinvest the dividends.  Many companies allow employees to use part of their paychecks to buy the firm’s stock through automatic deductions.  This is money you might otherwise spend.  If you are in such a program, reinvest the dividends instead of taking them in cash.  This is a good rule to follow with any stock you own.
  4. Consider savings as you would any regular expense — like bills from the electric company or mortgage payments.  Set a dollar amount, say 1 percent of your take-home pay, or better yet 5 percent if you can, and “pay” that into your savings account each paycheck.
  5. Use automatic savings plans.  Some employers offer plans that take a designated amount of your paycheck to buy you U.S. government savings bonds (more on these in later posts).  Ask your bank if it can automatically transfer a designated amount each month from your checking to your savings account.
  6. Keep putting money aside even after you have paid off a loan or a mortgage.  Continue to write a check every month for the same amount, or at least a good portion of it, and put it into your savings.  This is money that you have long learned to live without, so you can increase your wealth painlessly.
  7. Occasionally give yourself a reward.  Saving is hard, and its payoff is often years in the future.  So once or twice a year, designate one month’s set aside for a little extra spending. Take the family out to dinner or buy something special for yourself or someone you love. It will give you something to look forward to that is nearer in time than the ultimate use of your savings.

Make a Plan 

Though saving and investment plans vary as much as individual desires and goals, one element should appear in every plan: an emergency fund, a pool of cash for unforeseen events, like sudden medical problems, appliance repairs, or possible unemployment. Ideally, set aside 3 to 6 months income to cover such needs. The money should go into what financial people call a “liquid vehicle,” one that you can access immediately such as a bank savings account or other easily accessible vehicles that I will describe in subsequent posts.  Once in place, this saved money will work for you: by building on itself through bank interest and by protecting you and your loved ones from harm.  Importantly, it will also give you confidence to take the next steps.

Once you have established this basic source of security, and the habit of saving, you can begin focusing on personal wants and needs. There is no right answer here. Much depends on your age, income, family circumstances, and interests. The money should serve your desires as well as your needs.  Some goals are very long term, like a young person saving for retirement.  Others are not quite that far off, like college for a newborn or buying a home, or starting a new business.  Still others may be more immediate, like buying a new car or kitchen.  All are legitimate, but each requires a different investment strategy.

To organize your thinking, create a small chart like the one at the end of this section.  It can link each need to an investment goal.  List your savings goals on the left.  I offer a few examples.  Yours will be different.  Next, fill in the likely cost.  You can research this on the Internet but in the case of housing for example, you may also want to do a bit more research about what it will cost when you are ready to buy.  Next, determine when you expect to need the money.  Count the months to that date and divide the cost by the number of months to see how much you’ll have to put aside each month.

The “months to go” will reflect where you are in your financial life.  A parent starting a college fund for a newborn, will be looking at an 18-year time horizon (216 months) before he or she needs the money.  Other goals will reflect more personal preferences.  If you think your car will last only another year, you’ll have to save for the replacement in only twelve months.  Plans to marry in two years will give you 24 months to accumulate the desired funds.  If planning reveals that your goal requires more savings a month than you can support, you might have to adjust your lifestyle, delay the target date, or even abandon this particular goal.  Harsh as these tradeoffs may seem, they are simply facts of life that no one can ignore.

                                                               Planning Guide                   

Goal Cost Date Months to Go Set Aside Each Month
Car Purchase:
Purchase of Home Entertainment System:
Money for a Good Vacation:
Funds to Buy a New Kitchen:
Purchase of a Home:
Money for a Retirement Nest Egg:  

 

 

Executing the Plan — Time is on Your Side

The further in the future your target date is, the less harsh the tradeoffs.  Remember that everything you save earns interest or dividends that over time will build the fund alongside your monthly savings contributions.  Because you are paid this interest not only on your contributions but also on the interest previously accumulated, what financial people call compounding, the longer you can wait before using the money, the more your savings or investment plan will help you accumulate.  These earnings will defray the burden of the monthly set aside.  Two examples:

One:  You need $20,000 for a car and a year to get the money.  Here, returns from investments will contribute only a small part of the total. In this example, it will require a set aside of about $1,629 a month.  Even if the savings account pays 5 percent, it would earn only about $88 over the course of the year. So most of the money would have to come from your monthly savings contributions.

Two:  With longer-term projects, however, earnings from savings and investments can contribute considerably more.  Say you are one of a newly married couple that wants to buy a $250,000 home in 15 years. To meet your goal entirely from setting money aside, you would have to save $1,389 a month.  But after five years of saving at that rate, your accumulated investment account would amount to $83,333.  At 5 percent interest, it would earn $4,723 a year from then on and more each successive year from the accumulated interest as well as your contributions.  That income alone would effectively substitute for over three months of future savings every year.  After ten years, you would have accumulated $166,666.  At a 5 percent interest return, it would earn $10,784 a year, enough to pay over seven months’ required savings.  These would amount to a major contribution toward your goal of home ownership. This is why time is on your side. The table at the end of this post lays out the accumulations of savings and interest year by year.

With even longer time horizons — say retirement savings — the contribution from investment income becomes even more significant. Over 30 years, in fact, the accumulated earnings from the investments would actually exceed the total of monthly set-asides.  In the example of the home purchase, the annual earnings from accumulated savings already by the fifteenth year would have come close to surpassing the annual savings need originally calculated.

 

                                    Interest Earnings Help Savings Accumulate

Years Yearly Savings Set Aside[1] Earnings on Savings[2] Total Available[3]
1 $16,667 $16,667
2 $16,667 $833 $34,167
3 $16,667 $1,708 $52,542
4 $16,667 $2,627 $71,835
5 $16,667 $3,592 $92,094
6 $16,667 $4,605 $113,365
7 $16,667 $5,668 $135,700
8 $16,667 $6,785 $159,152
9 $16,667 $7,958 $183,776
10 $16,667 $9,189 $209,632
11 $16,667 $10,482 $236,780
12 $16,667 $11,840 $265,285
13 $16,667 $13,264 $295,216
14 $16,667 $14,762 $326,644
15 $16,667 $16,332 $359,643

 

[1]$1,389 a month for 12 months = $16,667.

[2]Five percent on the account amount of the previous year.

[3]Savings set aside plus the earnings on the accumulated savings.

 

How Private Is Private Equity?

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I have received a lot of questions on private equity: what is it, and can an ordinary investor get involved?  The answer to the second question is Yes, and I will return to it at the end of this post.  As for the first question: Both private equity (PE) and its cousin venture capital (VC) are at base a lot more straightforward than they appear in the financial media.

How Do They Work? 

Both PE and VC take a large enough stake in a company to run it and, presumably, use their expertise to make that company more profitable, all with an eye to selling it in the future at a substantial profit.

Venture capital firms usually focus on smaller startups in less mature industries.  They help the operation prosper by bringing financial, administrative, and operational skills that the firm’s founders may lack.  Once they have the fledgling firm operating properly, VC investors sell their stake at a profit, often when the firm lists itself on one of the world’s stock exchanges as a publicly traded company in what is called an initial public offering (IPO).  Most VC firms work with their own capital and borrowed funds and do not take on outside investors

Private equity firms do essentially the same thing but on a bigger playing field.  They take a large enough stake, often in a publicly traded firm, to bring the firm into private ownership, at which point they no longer have to make the public disclosures demanded by the organized stock exchanges.  This, incidentally, is where the “private” in private equity comes from. It does not necessarily imply that the PE firms themselves are private or secretive or exclusive, though some of them are.  They take their purchases off the public exchanges to make big changes over sometimes long periods while avoiding the questions and complaints that the management of a public company would have to endure.  Once the improvements become evident and it is running smoothly and presumably now far more profitably, the PE company reintroduces it as a publicly traded firm, presumably at a substantial profit.

How Do They Do It?

Because PE firms, unlike VC operations, target established, publicly traded firms, you might wonder what special expertise they can add — after all, these targets have run their businesses more or less successfully for years.  PE firms can improve profitability in four major ways:

  1. PE investors have experience with other firms that can bring new and useful practices to the management of the target.
  2. By aligning the interests of management with that of ownership, they can overcome institutional resistance to these supposedly more efficient and profitable practices.
  3. By taking companies private, they can focus on needed, longer-term projects by removing the scrutiny imposed on publicly traded companies, in particular the publication of their quarterly earnings.
  4. They can pare down bloated management compensation schemes.

Participation and Financing

Most PE firms only allow investors considered qualified by the Securities Exchange Commission (SEC).  These are people with sufficient background or investment experience to, in the SEC’s estimation, make informed judgments on whether the firms involved and deals arranged are suitable for them.   Even given these strictures and the big bucks involved, smaller investors can participate in private equity operations because several actually list as public companies.  You can buy stock in them.  Two of the most prominent are The Blackstone Group and Kohlberg Kravis Roberts.

 

Shams, Scams, and Frauds: Pump and Dump

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The best protection against any investment scam is to remember that if an investment looks too good to be true, it almost certainly is.  Most investment frauds lure their victims by promising returns that are simply unbelievable. A good investment track record is attractive.  A fabulous one is suspect.  When offered something that seems extremely desirable, always ask yourself:

  1. Why would someone who can secure such returns want to share them?
  2. Why would that person want to share them with me in particular?

An effective shyster will have plausible answers to these questions and others, but a little thought should revel the danger in what the scammer is proposing.

It is simply impossible to itemize all the scams set to trap the unwary.  They are as broad and varied as human imagination.  Here I outline one of the most common and so most destructive:

How Pump and Dump Works 

This is an old game.  The swindler is frequently a broker who begins by buying a thinly traded stock with the firm’s own funds.  Because the stock is thinly traded, his or her buying pushes the price up smartly.  At the same time, the broker’s sales force promotes the stock as a great buy. Frequently, the con involves glowing reports placed on the broker’s website.  The unsuspecting — day traders and others — read the glowing reports or hear the sales pitch over the phone, see how the price is rising, and put in their orders.  This additional buying pushes the price up even faster, giving the promoter an ample profit on his or her earlier buying, at which time the con artist sells and ends the sales promotion.  Those sales and the sudden end to the hype reverses the upward momentum of the stock, and the price falls, leaving the people who succumbed to the con with losses.

Hollywood has produced several films about pump and dump artists. They typically glamorize what is in reality a grubby business, but behind the slick veneer Hollywood does show the fundamental nature of the abuses, the deceit, and the complete disregard of others and for common decency.  These films also show more sex and better-looking people than exists in the real world, especially in such ugly operations.

Targeting the Most Vulnerable

The saddest part of these swindles is how they target those least able to cope with the losses — financially unsophisticated people, especially the elderly who may have substantial savings but not much financial experience or expertise.  Court cases show the lengths to which some of these con artists go to target their promotions:

  • They will read obituaries to identify surviving spouses who might have received a large insurance check and at the same time face emotional strains that make the person easier to confuse. (See an earlier blog on coming into money.)
  • These swindlers are well aware that retirees often get substantial sums from retirement plans or from the sale of a family home, larger amounts than these people have ever handled. (See an earlier blog on coming into money.)
  • The con artists are also well aware that the elderly often live alone and have no one to help them think twice about an impulse planted by an Internet notice or an enthusiastic phone call.

How to Protect Yourself

Whether dealing with this particular game or one of hundreds of other scams, people can protect themselves.  Here are half a dozen tips:

  1. Remember again that any investment that looks too good to be true almost surely is.
  2. Collect names and addresses. Visit the promoter’s office. If the person on the other end of the phone refuses or makes excuses, take that as a bad sign.
  3. Insist on getting details in writing. Ignore claims about too much urgency for such things.
  4. Never give information about yourself, your bank account or your finances to anyone who has solicited you whether on the phone, via email, or any other way.
  5. Check on the firm soliciting you. The Internet makes this easier than it once was.
  6. Check with the authorities:  
    • See if the broker soliciting your is registered in the state where you live.  The North American Securities Administrators Association can help with this. www.nasaa.org.
    • The SEC requires securities firms to register.  It’s website can provide information.  sec.gov/edgar.shtml.
    • The SEC also provides information on brokers that have run into trouble with the authorities in the past. You can check this out at sec.gov/investor/broker/htm.
    • The SEC also offers guides on what questions to ask and how to file a complaint. sec.gov/oieal/complaint.html.
    • If you think you have been swindled, the Consumer’s Action Handbook from the Federal Citizen Information Center can guide you through the steps to take at pueblo.gsa.gov.

 

How You Should Choose a Bank

Choosing a Bank

For this post, I thought it would help to go back almost to the beginning.  Your first step, after you have saved a bit (techniques for that in another post) is to put that money to work for you where it can earn something.  A savings account at a bank is the obvious, though not the only place.  Even among banks, not all are the same.  Here is some guidance for making your choice:

Convenience

It would be foolish to choose a bank simply because it is near your home, but it is a consideration nonetheless.  While factoring in this convenience, also consider if that bank has branches near where you work.   That may be more important, since you are more likely to be there when the bank is open than at home.  Find out if the bank has branches in other cities, especially those that you visit often.

What They Pay

These days, banks offer little interest on savings accounts, less than 1 percent, in fact, and in some cases considerably less.  That will change. In time, interest rates will rise. The Federal Reserve, or Fed, as it is called in financial circles, has plans to raise them, perhaps to 3.0 percent or higher.  Small savers will benefit as that occurs, because the banks will respond by raising what they pay on their accounts.  But that will take time. Savers for now have no choice but to accept low rates. Still, there is more to choosing a bank for your savings than just the rate paid or the convenience of a branch.

Fees and Services

To make your decision, you should check out the banks in your area with a personal visit.  Talk to the person in charge of new accounts.  Describe your financial needs and listen carefully to his or her responses.  Among the issues the bank’s representative will describe, or should, are the conditions attached to newer accounts and what other services the bank offers.  Take notes and gather all written material available at the bank and on the Internet.  Study these and make comparisons of each bank to the others.  Here are matters on which you should focus:

  • Minimum deposit requirements.  The bank might pay different interest rates on different accounts, usually higher for those that require higher minimums.
  • Online services.  Almost all financial institutions these days have online services, but not all reach the same standard.  See if the bank allows you to deposit checks online, arrange bill paying, and other services.  If it does, this could save you a lot of time.
  • Help desk.  Find out if you must visit the bank in person if you have a question or whether it has Internet or telephone service. Usually, the level of service rises with the size of the account.
  • Penalties.  Banks often charge fees or reduce your interest if your balance falls below a certain amount.  This has become especially important in these times of low interest rates.  Identify how large these penalties are and when the bank would levy them.  This will not only prepare you, but it will help you plan to avoid such expenses. Penalties might also occur if you fail to make deposits or withdrawals for a long time, or if you make a lot of small withdrawals.  Find out and plan accordingly.
  • Yield.  Banks typically advertise two interest rates paid on deposits: the “annual rate”and the “effective rate.”  The difference reflects how often interest is calculated and credited to your account.  The effective rate includes a consideration of how frequently the bank credits your account with the interest.  The more often it does so, the more each calculation will earn interest on the interest already paid.  Find out.
  • Automatic savings.  Some banks will transfer a specific amount from your checking account to your savings account automatically each month. Find out if the bank offers such a service and if it involves a fee.
  • Favorable loan, credit card, and mortgage rates.  Some banks offer depositors favorable terms and rates on loans or mortgages.  Find out if you have access to such an arrangement. It might involve a larger minimum deposit.
  • Currency exchange.  The most cost effective way to get foreign currency is through an ATM in the country you are visiting.  Not all banks charge the same rates and conversion fees on such transactions.  Especially if you expect to spend significant time abroad, find out what each bank charges.
  • Overdraft charges.  Most banks will enroll accounts in their overdraft program.  It automatically advances you funds to cover checks you accidentally write in excess of your balance.  Without such an advance, your checks might “bounce” or, even if the check is honored, face a hefty fee. An overdraft program can protect you.  Find out how it works.  The program itself very likely has charges.  Find out what they are, under what circumstances the bank might charge you, and how quickly the bank will notify you so that you can take action to minimize any costs.  The best protection, of course, is to keep your checking account balanced and avoid overdrafts altogether.
  • Fees on automatic teller machines.  These have largely disappeared, but check to make sure.  Also, find out what fee the bank charges to use the ATMs of other banks or to use a credit card at the ATM machine.  Here are three additional tips on the use of ATMs:
    1. Each bank will set a limit or how much cash you can withdraw from an ATM at any one time. You should know this to calculate how many trips to the ATM it will take for you to amass larger amounts should you need them.
    2. Since most banks post interest at 3:00 pm each business day, try to make your withdrawal later in the afternoon so that your interest calculation for that day will occur on as much money as possible.
    3. All ATMs ask you to create a personal identification number, or PIN, that you must key into the machine to do the transaction.  Never give your PIN to anyone. Nor should you keep it anywhere on your person.  It should be easy to remember.  Do not use your birthday.  Hackers are onto this practice.

Safety

Make sure any bank you consider is federally insured. The Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per depositor, no matter how many accounts you have with that bank.  For more information, visit the FDIC website, www.fdic.gov.  The FDIC also provides information on banks’ relative financial strengths.  The Federal Reserve, which is the country’s primary bank regulator, runs a series of what it calls “stress tests” on how each bank would cope in a difficult financial environment.  Its website, www.federalreserve.gov, and financial media cover the results of these tests thoroughly.  Credit rating agencies, Moody’s, Standard and Poor’s, and Fitch, will, for a fee, provide information on bank finances.  Visit their websites: www.moodys.comwww.standardandpoors.com, and www.fitchratings.com. The private firm, Veribanc, also reports on bank safety ratings, www.veribanc.com.

Which to Pay First

Which to Pay First

In response to my last post about what to do with surplus cash, an insightful reader asked whether it is best to pay off credit cards first or student loans.  Definitely, pay the cards first.  The most onerous student loan debt carries a lower interest rate than the least burdensome credit card.  Pay the cards off first, starting with those that charge the highest rates.  Only then should you turn to the student loans.

Student loans, burdensome as they are, often carry attractive terms.  In such cases you might consider investing the surplus cash and using the income from those investments to meet the regular student loan payments.  This way, the student loan payments cease to burden your everyday income, presumably from your job, and possibly even earn a little extra.  If you pay off the student debt, you do, of course, get relief, but no chance of that little extra from your investments.  With credit cards, the cost of borrowing is so high that there is no chance investing what would pay them off can earn more or even enough to cover the cost.  Best to use the surplus cash to pay off the cards as completely as you possibly can.

This was a good question, I look forward to others from other readers. 

So…You’ve Come Into Some Money…

So...You've Come Into Some Money?

Just suppose you receive a windfall: an inheritance, a legal settlement, or the transfer of pension funds when you retire.  Though more money is always better than less, such money flows do impose hard decisions. Many people feel insecure about what to do.  They frequently don’t know what decisions they need to make.  Here are the necessary steps to guide you:

First Steps

First, decide whether the windfall is sufficient to change your lifestyle or simply improve it.

Rule of Thumb: You need investable funds amounting to between 15 to 20 times your annual income in order to quit your job and pursue a life of leisure.

If the windfall and your other savings approach such an amount, you must take two further steps:

  • See an accountant or a tax lawyer to understand the tax implications of the money you have received.
  • Find a reliable financial planner to invest the funds in a diversified conservative portfolio such that it can securely support your new lifestyle. (In later posts I will discuss how to build such a portfolio.)

Two Following Steps

If the windfall does not come up to 15-20 times your yearly income, you will need to make some perhaps difficult personal decisions for yourself and/or your family:

  • Pay off your credit card debt. Interest charges here can be the most onerous short of a loan shark.  The most effective thing you can do with any surplus funds is to discharge these obligations.  Start with the credit cards that charge the highest rates.  (This figure should appear prominently on your card statement.)
  • Identify your critical spending needs. These would be the things you wanted to do before the windfall but couldn’t afford. You may need a new car or a second car. Your home may need repairs you have had to put off.  Perhaps your family or friends need a helping hand.  You, your spouse, or significant other may need a good vacation.  This is a partial list, but it should give the idea. After you’ve made the list, estimate the costs and then put those monies in a safe, relatively liquid account from which you can quickly withdraw them.  (In future posts, I’ll examine such accounts and discuss how to choose one that is best for you.)

Three Additional Decisions

If funds remain in the windfall, you will need to decide three big matters:

  • The Mortgage: If you own your home, you may want to use some of the funds to pay off the mortgage. How much depends on how much you can expect to earn from investing the funds.  If the investments earn less after tax than the interest on the mortgage, then the windfall is well used to pay it off.  If those investments can earn more, then you would do better to invest the funds and maintain the mortgage.  If the difference is close, your desire for security may reasonably sway you to paying it off.

Here’s an example.  Say you have inherited enough so that after “critical expenses” you have $250,000 left.  Say also you have an outstanding mortgage on your house of just that amount and the interest is 5 percent.  The mortgage, aside from payments on principal, costs you $12,500 a year.  If you are taxed at about 30 percent and deduct the interest expense from your tax bill, the after-tax mortgage expense comes to $8,750 a year.  At the time of this writing, an investor can reasonably expect a conservative portfolio to return about 6 percent a year––about $15,000 on the $250,000 windfall.  You will pay 30 percent in taxes ($4,500), giving you an after-tax return of $10,500 a year ($15,000-$4,500).  This significantly exceeds the after-tax annual mortgage expense, so unless owning the house outright is very important to you psychologically, you would do well to leave the mortgage in place and invest the money.  Of course, this is just an example.  Each person or family has specifics that could change the conclusion.

If you are renting or own a place that seems inadequate to your needs, you can legitimately use the money to buy a better place.  How much you dedicate to this–– whether you buy outright or put it down on a mortgage––hinges on the calculation just described.

  • Educating the Kids: A child’s education involves a simpler calculation.  You should have an idea what schooling after high school will cost, and how many years you have to accumulate the funds.  Assuming an annual investment return of 6 percent, you can calculate on any computer or business calculator how much you need to put to work in an investment to accumulate to what you’ll need when your child is ready.  This will tell you how much of the windfall you will need for this purpose.

Again a numerical example might help clarify.  Say you have one child who is five years old when you receive the windfall and that so far you have saved nothing for his or her higher education.  You estimate that by the time your child is ready to attend a state college in some thirteen years, the cost will be $30,000 a year––$120,000 for four years of study.  At 6 percent a year, the calculator will tell you that some $56,000 put to work in investments today will accumulate to what you need in 13 years.  Now you know what portion of the windfall need to go to the college account.  (More specifics on these in a later post.)

  • Retirement Savings: Funding for retirement is the most open-ended question.  Any investment you make instead of paying off the mortgage will contribute to your retirement.  Depending on your age and nearness to retirement, the amounts needed will vary, as will the appropriate kinds of investments.  (A future post will cover this material.)  But generally there is more flexibility here than with the mortgage or school decisions.  Of course, the bigger your retirement pool of assets, the better, so always dedicate as much as you reasonably can to retirement.  You may want to pay for your child’s education, but at the same time you probably don’t want to rely on support from your offspring in your old age.

 

A NOTE TO MY READERS: IF YOU HAVE A FINANCIAL ISSUE YOU’D LIKE ME TO DISCUSS, LET ME KNOW. IF I THINK IT HAS GENERAL APPEAL, I’LL DEVOTE A FUTURE ESSAY TO IT.

What Is ‘Bite-Size’ Investing?

My approach here contradicts to the get-rich-quick schemes promised preposterously by so many websites and the jargon-laden technical discussions designed intentionally to confuse.  Instead, I offer the individual investor a step-by-step approach to investment success, served up in understandable, easily digestible, bite-sized pieces.

I begin small, as do most individual investors, offering a system for saving and choosing a bank or alternative institution.  From this straightforward base, we continue to investment clubs and other ways to get better returns on your savings.

Once you have accumulated enough capital, you can proceed to stocks and bonds.  I explain their fundamental nature and properties, how markets value them and why prices fluctuate from day to day and year to year. From that base, I explain a reliable and low-maintenance approach to investing in stocks and bonds.  From here, I move on to explain in straightforward and simple language more exotic investment devices, including options, futures, foreign investment, currencies, private equity, hedge funds, venture capital and more.

Along the way, I offer warnings, generally against too much emotion and the temptation to be too much clever.  I also describe popular scams, some of which Hollywood has dramatized such as the pump-and-dump scheme of The Wolf of Wall Street, and others that have made headlines, such as Bernie Madoff’s Ponzi scheme.

The blog posts will not necessarily “go in order” because not every investor starts from the same place. But each will instruct.  Some posts will describe how to choose a bank. Others will answer the question what does a hedge fund hedge or how private is private equity.  One will explain how to start an investment club. A more systematic approach is better suited to a book than a blog.