Investment Strategies

The world of investing can seem mind-boggling for a beginning investor. How do you decide what type of security to invest in? Should you choose stocks, bonds or a combination of investments? What about mutual funds? How do you choose a particular fund, stock or bond? How do you assess the risk to your money?

This Financial Guide provides a starting point for inexperienced investors. It describes how securities markets work, what protections are afforded, the general types of securities available, the interaction of risk and reward and how to select the investments appropriate for your risk tolerance.

How Securities Are Bought and Sold

The term "securities" encompasses a broad range of investments, including stocks, corporate bonds, government bonds, mutual funds, options, and municipal bonds. Investment contracts, through which investors pool money into a common enterprise managed for profit by a third party, are also securities. Securities may be traded on an organized exchange or traded "over the counter" between investors.

Exchanges

Securities are bought and sold in a number of different markets. The best known are the New York Stock Exchange and the American Stock Exchange, both located in New York City. In addition, six regional exchanges are located in cities throughout the country.

A corporation's securities may be traded on an exchange only after the issuing company has applied to the exchange and met any listing standards relating, for example, to the company's assets, number of shares publicly held, and number of stockholders. Organized markets for other instruments, including standardized options, impose similar restrictions. The exchanges facilitate a liquid market for securities where buyers and sellers are brought together. Listing on an exchange, however, does not constitute approval of the securities or provide any assurance as to risk and return.

Over-The-Counter

Many securities are not traded on an exchange but are traded over the counter (OTC) through a large network of securities brokers and dealers. In the National Association of Securities Dealers' Automated Quotation System (NASDAQ), which is run by the National Association of Securities Dealers (NASD), trading in OTC stocks is done via on-line computer listings of bid, which asks prices and completes transactions.

Like the exchanges, NASDAQ has listing standards that must be met for securities to be traded in that market. Similar to an exchange it provides a "meeting place" for buyers and sellers. The typical investor generally will not know whether their security is bought or sold through an exchange or over the counter. The investor engages a broker who arranges the transaction in the appropriate market at the desired price.

Brokers

If you buy or sell securities on an exchange or over the counter, you will probably use a broker, and your direct contact will be with a registered representative. The registered representative, often called an account executive or financial consultant, must be registered with the National Association of Security Dealers (NASD), a self-regulatory organization whose operations are overseen by the Securities and Exchange Commission (SEC), and with the states in which the broker is conducting business. The registered representative is the link between the investor and the traders and dealers who actually buy and sell securities on the floor of the exchange or elsewhere.

How Prices are Established

How are the stock prices that appear in the financial section of the newspaper arrived at? Market prices for stocks traded over the counter and for those traded on exchanges are established in somewhat different ways.

Exchange Prices

The exchanges centralize trading in each security at one location, on the floor of the exchange. There, auction principles of trading set the market price of a security according to current buying and selling interests. If such interests do not balance, designated floor members known as specialists are expected to step in to buy or sell for their own account, to a reasonable degree, as necessary to maintain an orderly market.

Over the Counter (OTC)

In the OTC market, brokers acting on behalf of their customers (the investors) contact a brokerage firm which holds itself out as a market-maker in the specific security, and negotiate the most favorable purchase or sale price. Commissions received by brokers are then added to the purchase price or deducted from the sale price to arrive at the net price to the customer.

In some cases, a customer's brokerage firm may itself act as a dealer, either selling a security to a customer from its own inventory or buying it from the customer. In such cases, the broker hopes to make a profit on the purchase and sale of the security, but no commission is charged. Instead, a retail "mark up" is added to the price charged by the firm when a customer buys securities and a "mark down" is deducted from the price paid by the firm when a customer sells securities.

Bid and Ask Prices

In both cases, a stock is quoted in terms of bid and ask. The bid is the price at which the market or market maker is willing to buy the security from you. Similarly, the ask is the price at which the market or market maker is willing to sell the security to you. Not surprising, the ask price is higher than the bid price. The difference between the two is called the spread. For example, if a stock is quoted 18-18 ¼, this means that the investor could sell the stock for $18 a share or purchase the stock for $18.25. The higher the spread the more the market maker profits and the higher the cost is to investors. Heavily traded securities typically have narrow spreads while infrequently traded securities can have wide spreads.

How Your Securities are Protected

Investors' money is protected in three ways: by federal laws and regulations that are enforced by the SEC (Securities and Exchange Commission); by self-policing in the industry; and by state law.

Under federal securities laws, those engaged in the business of buying and selling securities have a great deal of responsibility for regulating their own behavior through SROs (self-regulatory organizations) operating under the oversight of the SEC. These SROs include all of the exchanges; the NASD; the Municipal Securities Rulemaking Board (MSRB), which establishes rules that govern the buying and selling of securities offered by state and local governments; and other organizations concerned with somewhat less visible activities such as the processing of transactions.

The SROs are responsible for establishing rules governing trading and other activities, setting qualifications for securities industry professionals, regulating the conduct of their members, and disciplining those who fail to abide by their rules.

In addition, the federal securities laws provide investors with certain protections, including the ability to sue if they have been harmed as a result of certain violations of those laws.

Many brokerage firms require that their customers sign an agreement containing an arbitration clause when they open a brokerage account. If you sign an agreement with an arbitration clause, you are agreeing to settle any future disputes with the broker through binding arbitration, instead of through the courts.

Arbitration proceedings are administered by the SROs, and the rules that apply in arbitration proceedings are specified by each SRO. Although the SEC oversees the arbitration process, it cannot intervene on behalf of, or directly represent individual investors. Nor can the SEC modify or vacate an arbitration decision. The grounds for judicial review are very limited.

Further protection for investors is provided by state laws designed to regulate the sale of securities within state boundaries.

The Function of the SEC

The SEC, an independent agency of the U.S. Government, was established by Congress in 1934 to administer the federal securities laws. It is headed by five Commissioners, appointed by the President, who direct a staff of lawyers, accountants, financial analysts, and other professionals. The staff operates from its headquarters in Washington, D.C. and from five regional offices and six district offices in major financial centers throughout the country.

The SEC's principal objectives are to ensure that the securities markets operate in a fair and orderly manner, that securities industry professionals deal fairly with their customers, and that corporations make public all material information about themselves so that investors can make informed investment decisions. The SEC accomplishes these goals by:

• Mandating that companies disclose material business and financial information;
• Overseeing the operations of the SROs;
• Adopting rules with which those involved in the purchase and sale of securities must comply; and
• Filing lawsuits or taking other enforcement action in cases where the law has been violated.

Despite the many protections provided by federal and state securities laws and SRO rules, it is important for investors to remember that they have the ultimate responsibility for their own protection. In particular, the SEC cannot guarantee the worth of any security. Investors must make their own judgments about the merits of an investment.

What Companies Must Disclose

Before any company offers its securities for sale to the general public (with certain exceptions), it must file with the SEC a registration statement and provide a "prospectus" to investors. In its registration statement, the company must provide all material information on the nature of its business, the company's management, the type of security being offered and its relation to other securities the company may have on the market, and the company's financial statements as audited by independent public accountants. A copy of a prospectus containing information about the company and the securities offered must be provided to investors upon or before their purchase. In addition, most companies must continue to update, in filings made with the SEC, this disclosure information quarterly and annually to ensure an informed trading market.

The SEC reviews registration statements and periodic reports for completeness, but the SEC does not review every detail and verification of each statement of fact would be impossible. However, the securities laws do authorize the SEC to seek injunctive and other relief for registration statements containing materially false and misleading statements.

Persons who willfully violate the securities laws may also be subject to criminal action brought by the Department of Justice leading to imprisonment or criminal fines. The laws also provide that investors may be able to sue to recover losses in the purchase of a registered security if materially false or misleading statements were made in the prospectus or through oral solicitation. Investors must seek such recovery through the appropriate courts, since the SEC has no power to collect or award damages or to represent individuals.

How the SEC Supervises Industry Professionals

Another important part of the SEC's role is supervision of the securities markets and the conduct of securities professionals. The SEC serves as a watchdog to protect against fraud in the sale of securities, illegal sale practices, market manipulation, and other violations of investors' trust by broker-dealers, investment advisers, and other securities professionals.

In general, individuals who buy and sell securities professionally must register with the appropriate SRO, meet certain qualification requirements, and comply with rules of conduct adopted by that SRO. The broker-dealer firms for which they work must, in turn, register with the SEC and comply with the agency's rules relating to such matters as financial condition and supervision of individual account executives. In addition, broker-dealer firms must also comply with the rules of any exchange of which they are a member and, usually, with the rules of the NASD.

The SEC can deny registration to securities firms and, in some cases, may impose sanctions against a firm and/or individuals in a firm for violation of federal securities laws (such as, manipulation of the market price of a stock, misappropriation of customer funds or securities, or other violations). The SEC polices the securities industry by conducting inspections and working in conjunction with the securities exchanges, the NASD, and state securities commissions.

Protecting Yourself

You should be as careful about buying securities as you would be about any other costly purchase. The vast majority of securities professionals are honest, but misrepresentation and fraud do take place. Observe the following basic safeguards when "shopping" for investments:

• Never buy securities offered in unsolicited telephone calls or through "cold calls". Ask for information in writing before you decide. Check on the credentials of anyone who tries to sell you securities.

Tip: Beware of salespeople who try to pressure you into acting immediately.

• Don't buy on tips or rumors. Not only is it safer to get the facts first, but also it is illegal to buy or sell securities based on "inside information" which is not generally available to other investors.
• Get advice if you don't understand something in a prospectus or a piece of sales literature.

Tip: Be sure you understand the risks involved in trading securities, especially options and those purchased on margin. Be skeptical of guarantees or promises of quick profits. There is no such thing, at least not without an accompanying increase in risk.

• Remember that prior success is no guarantee of future success in an investment arrangement.
• With tax-sheltered investments, partnerships, and other "liquid" investments, be sure to ask about the liquidity and understand that there may not be a ready market when you want to sell.
• Don't speculate. Speculation can be a useful investment tool for those who can understand and manage the risks involved and those who can afford to lose money, but it is dangerous for most people.

Tip: For the average investor, more conservative investment strategies are generally appropriate.

Professional guidance can be very helpful in developing a sound investment program.

Types of Investments

Two broad categories of securities are available to investors: equity securities, which represent ownership of a part of a company and debt securities, which represent a loan from the investor to a company or government entity. Within each of these types, there are a wide variety of specific investments. In addition, different types can be combined (e.g., through mutual funds) or even split apart to form derivative securities.

Each type has distinct characteristics plus advantages and disadvantages, depending on an investor's needs and investment objectives. In this section, we provide an overview of the most common classes of investment securities.

Stocks

The type of equity securities with which most people are familiar is stock. When investors buy stock, they become owners of a "share" of a company's assets. If a company is successful, the price that investors are willing to pay for its stock will often go up and shareholders who bought stock at a lower price then stand to make a profit. If a company does not do well, however, its stock may decrease in value and shareholders can lose money. The rise in the price of a stock is termed appreciation or "capital gain." The stockholder is also entitled to dividends, which may be paid out from the company. Investors, therefore, have two sources of profit from stock investments, dividends and appreciation. Some stocks pay out most of their earnings as dividends and may have little appreciation. These stocks are sometimes referred to as income stocks. Other stocks may pay out little or no dividend, preferring to reinvest earnings within the company. Since all of an investors potential earnings comes from appreciation these stocks are sometimes referred to as growth stocks. Stock prices are also subject to both general economic and industry-specific market factors. There is no guarantee of a return from investing in stocks and hence there is risk incurred in investing in this type of security.

As owners, shareholders generally have the right to vote on electing the board of directors and on certain other matters of particular significance to the company. Under the federal securities laws, most companies must send to shareholders a proxy statement providing information on the business experience and compensation of nominees to the board of directors and on any other matter submitted for shareholder vote. This information is required so that stockholders can make an informed decision on whether to elect the nominees or on how to vote on matters submitted for their consideration.

Stock investments are typically common stock, which is the basic ownership share of a company. Some companies also offer preferred stock, which is another class of stock. Preferred stock typically offers some set rate of return (although it is still not guaranteed), and pays dividends before dividends are paid for common stock. Preferred stock may not, however, participate in as much upside as common stock. If a company does really well, preferred stockholders may receive the same dividend as any other year, while common stockholders reap the rewards of a great year.

Corporate Bonds

The most common form of corporate debt security is the bond. A bond is a certificate promising to repay, no later than a specified date, a sum of money which the investor or bondholder has loaned to the company. In return for the use of the money, the company also agrees to pay bondholders a certain amount of "interest" each year, which is usually a percentage of the amount loaned.

Since bondholders are not owners of the company, they do not share in dividend payments or vote on company matters. The return on their investment is not usually dependent upon how successful the company is. Bondholders are entitled to receive the amount of interest originally agreed upon, as well as a return of the principal amount of the bond, if they hold the bond for the time period specified.

Companies offering bonds to the public must file with the SEC a registration statement, including a prospectus containing information about the company and the security.

Government Bonds

The U.S. Government also issues a variety of debt securities, including Treasury bills (commonly called T-bills), Treasury notes, and U.S. Government agency bonds. T-bills are sold to selected securities dealers by the Treasury at auctions.

Government securities can also be purchased from banks, government securities dealers, and other broker-dealers.

Similar to corporate bonds, these bonds pay interest and the amount of principal at maturity. Some bonds, such as Treasury Bills, may not pay cash interest. Instead the bond is purchased at a discount and the interest is built into the amount the investor receives at maturity. Contrary to popular belief investors must pay income tax on U.S. government bond interest.

Municipal Bonds

Bonds issued by states, cities, or certain agencies of local governments such as school districts are called municipal bonds. An important feature of these bonds is that the interest a bondholder receives is not subject to federal income tax. In addition, the interest is also exempt from state and local tax if the bondholder lives in the jurisdiction of the issuing authority. Because of the tax advantages, however, the interest rate paid on municipal bonds is generally lower than that paid on corporate bonds.

Municipal bonds are exempt from registration with the SEC; however, the MSRB establishes rules that govern the buying and selling of these securities.

Stock Options

A stock option is a type of derivative security and refers to the right to buy or sell something at some point in the future. There are a wide variety of these specialized instruments such as futures, options and swaps. Most are not appropriate for the average investors. The type of options with which we are concerned here are standardized, exchange-traded options to buy or sell corporate stock.

These options fall into two categories:

• "Calls", which give the investor the right to buy 100 shares of a specified stock at a fixed price within a specified time period, and
• "Puts", which give the investor the right to sell 100 shares of a specified stock at a fixed price within a specified time period.

While options are considered by many to be very risky securities, if used properly they can actually reduce the risk of a portfolio. Generally, if you are bullish on a stock (i.e. you expect the price to go up), you buy a call option. The price you pay is called the premium. You would purchase a put option if you are bearish on a stock (i.e. you expect the price to go down). If the stock moves in the right direction you can profit handsomely. If it doesn't you lose the premium that you paid. Buying puts and calls is not a risky strategy, but selling puts and calls is. One exception is selling a call option on a stock you already own. This is known as a "covered call." This actually reduces the overall risk of your portfolio in exchange for you giving up some of your upside.

Mutual Funds

Companies or trusts that principally invest their capital in securities are known as investment companies or mutual funds. Investment companies often diversify their investments in different types of equity and debt securities in hope of obtaining specific investment goals. When you invest in a mutual fund, the fund invests in individual equity and debt securities. There's no need to make individual purchase and sale decisions. Mutual funds also provide an easy way to diversify a portfolio. Rather than purchasing 50 stocks yourself, you can purchase a single mutual fund.

Related Guide: For more detailed information, please see the Financial Guide INVESTING IN MUTUAL FUNDS: Time-Tested Guidelines.

Investment Contracts and Limited Partnerships

Investors sometimes pool money into a common enterprise managed for profit by a third party. This is called an investment contract. Such enterprises may involve anything from cattle breeding programs to movie productions. This is often done through the establishment of a limited partnership in which investors, as limited partners, own an interest in a venture but do not take an active management role. Some of these securities have been issued in the past primarily for purposes of reducing income tax liability. Such opportunities are limited today. Care should be taken in investing in these securities since they can be illiquid and require a great deal of expertise. Consult with your financial advisor before investing in these types of investments.

Real Estate Investment Trust (REIT)

Real estate investment trusts are set up in a fashion similar to mutual funds. Instead of investing in stocks or bonds, however, REIT investors pool their funds to buy and manage real estate or to finance real estate construction or purchases. Real estate limited partnerships are also common. This is a way to get diversification from real estate investment without the headaches of property ownership and management.

Asset Allocation

Asset allocation is the process of allocating your investments among several broad categories, including stocks, corporate bonds, and government bonds and is extremelyimportant in investment success. In fact, portfolio selection should generally be based on asset allocation, whether formal or informal. This process can be complicated, but computer programs are available to assist in performing the allocation.

Related Guide: For a discussion of this very important concept, please see the Financial Guide ASSET ALLOCATION: How To Diversify Your Assets For Maximum Return

Risk vs. Return

One of the more basic relationships in investing is that between risk and reward. Investments that offer potentially high returns are accompanied by higher risk factors. It is up to you to decide how much risk you can assume. Always keep in mind your current and future needs.

Risk

There are many types of risk. The one most people think of is market risk, which is the risk that market prices can fluctuate. If you have a short investment horizon, generally something less than five years, this risk is important since the market could be down at the time you most need the money. On the other hand, if you have a long time horizon, for example when saving for retirement, you may be unconcerned with market risk. The investment has the opportunity to come back prior to the time you need the funds.

Another risk, which many people don't think about, is purchasing power risk. This is the risk that your investment will not keep up with inflation and you will not be able to maintain your desired standard of living. A bank CD for example might pay interest of 3% and have no market risk. Your principal does not fluctuate in value and you are insured against loss. However, if inflation exceeds 3% you will lose purchasing power.

Tip: In general, prospective investors should avoid "risky" investments unless they have a steady income, adequate insurance, and an emergency fund of readily accessible cash.

Tip: U.S. Treasury bills, notes, and bonds are the safest possible investments.

You need to assess how much risk you can tolerate. In general the longer your investment horizon the greater the amount of risk you can afford to take. Your financial advisor can assist you in measuring your risk tolerance.

Risk can also be reduced through diversification. Rather than buying one stock, buy a basket of 20 to 30 stocks. This reduces your overall risk. You can also reduce risk by combining different investment types such as stocks, corporate bonds and government bonds. These securities are not highly correlated, in other words, they tend not to go up or down at the same time.

Return

Why would one want to take on more risk? Because it generally comes with a higher expected return. While stocks may have the greatest market risk, they have also had the highest market return over the long haul. Stock returns have averaged between 10 and 11% since the early part of this century. Corporate bonds on the other hand have averaged between 6 and 7%, and government bonds closer to 5%. As you can see the lower the risk the lower the expected return. You must balance the amount of risk you are willing to tolerate with the amount of return you expect to achieve. There is no such thing as a high return/low risk investment.

Planning Techniques

You should first assess your current resources and future goals because this will assist you and your advisors in determining what rate of return is necessary to achieve your goals, and how much risk you can tolerate. Here is a suggested checklist:

• Assess your current financial resources. How much do you have to invest?
• Assess your future financial resources. Do you have an excess of income over expenses that can be invested?
• Determine your financial goals. How much money do you need and when do you need it?
• Determine the rate of return you need to achieve your goals.
• Determine how much risk you can tolerate based upon your time horizon and personal preferences.
• Choose an appropriate asset allocation to achieve the desired risk/return relationship. How should you allocate your investment among the various classes of investments?
• Choose the individual securities within each asset class. Which securities should you buy?

Security Selection

Once you have decided what percentage of your assets should go in each asset class, you need to select the appropriate individual securities. For each security you must evaluate its unique risk and its expected return. There are a number of sources of information about specific securities that you can explore, but generally, the most important of these for mutual funds and new stock issues is the prospectus. The prospectus is the security's selling document, containing information about costs, risks, past performance (if any) and the investment goals. The prospectus is obtained from the company or mutual fund or from your financial advisor. Read it and exercise your judgment carefully, before you invest.

In the case of a mutual fund, there is also a Statement of Additional Information (SAI). An SAI is sometimes referred to as Part B of the prospectus, and explains a fund's operations in greater detail than the prospectus. It's also possible to get a clearer picture of a fund's investment goals and policies by reading its annual and semi-annual reports to shareholders. If you ask, the fund must send you an SAI and/or its periodic reports; however, this process is time-consuming and requires a great deal of time and expertise.

Six Investing Pitfalls to Avoid

Here are the top mistakes that cause investors to lose money unnecessarily.

1. Using a Cookie-Cutter Approach

Most investors, along with many of the people who advise the, are satisfied with a one-size-fits-all investment plan. The "model portfolio" is useless to most investors. Your individual needs as an investor must govern any plans you make for investment. For instance, how much of your investment can you risk losing? What is your investment timetable...are you retired, a young professional, or middle-aged? The allocation of your portfolio's assets among various types of investments, including Treasuries, blue-chip stocks, equity mutual funds, and other, should match your needs perfectly.

2. Taking Unnecessary Risks

You do not have to risk your capital to make a decent return on your money. There are many investments that offer a return that beats inflation-and more-without unduly jeopardizing your hard-earned money. For instance, Treasuries, the safest possible investment, offer a decent return with virtually no risk. Blue-chip preferred stocks, common stocks, and mutual funds offer high returns with a fairly low level of risk.

3. Allowing Fees and Commissions to Eat Up Profits

Many investors allow brokers' commissions and other return-eating costs to cut into their returns. Professionals need to be compensated for their time; however, you should make certain that the fees you are paying are appropriate for the services performed.

4. Not Starting Early Enough

Many investors are not cognizant of the power of interest compounding. By starting out early enough with your investment plan, you can invest less, and still come out with double or even quadruple the amount you would have had if you started later. Another way to look at it is that by investing as much as possible earlier on, you'll be able to meet your goals and have more current cash on hand to spend.

5. Ignoring the Cost of Taxes

Every time you or your mutual fund sells stocks, there is a capital gains tax to pay. Unless you are in a tax-deferred retirement account, taxes will eat into your profits, therefore you should invest in funds that have low turnover (i.e., funds in which shares are bought and sold less frequently). Your portfolio, overall, should have a turnover of 10% or less per year.

6. Letting Emotion Govern Your Investing

Never give in to pressure from a broker to invest in a "hot" security or to sell a fund and get into another one. The key to a successful portfolio lies in planning, discipline, and reason. Emotion and impulse have no role to play in investing. Similarly, do not be too quick to unload a stock or fund just because it slips a few points. Try to stay in a security or fund for the long haul. On the other hand, when it's time to unload a loser, then let go of it.

Finally, do not fall prey to the myth of "market timing." This is the belief that by getting into or out of a security at exactly the right moment, we can retire rich. Market timing does not work. Instead, use the investment strategies that do work: a balanced allocation of your portfolio's assets among securities that suit your individual needs, the use of dividend-reinvestment programs and other cost-saving strategies, and a well-disciplined, long-haul approach to saving and investment.

Government and Non-Profit Agencies

• The SEC

Most companies whose stock is traded over the counter or on a stock exchange must file "full disclosure" reports on a regular basis with the SEC. The annual report (Form 10-K) is the most comprehensive of these. It contains a narrative description and statistical information on the company's business, operations, properties, parents, and subsidiaries; its management, including their compensation and ownership of company securities: and significant legal proceedings which involve the company. Form 10-K also contains the audited financial statements of the company (including a balance sheet, an income statement, and a statement of cash flow) and provides management's discussion of business operations and prospects for the future.

Companies file regular reports with the SEC in a computer database known as EDGAR. For example, a company declaring bankruptcy will file a form 8-K that tells where the case is pending and which chapter of bankruptcy was filed. You can access EDGAR through your computer at:www.sec.govIf you don't have access to a computer, your public library may have a computer you can use. You can also request a copy of Form 8-K, or any other reports that the company files with the SEC, see "How to Request Public Documents". Or, you can visit the SEC's Public Reference Room, 100 F Street NE, Washington, DC 20549. You might also be able to get copies of SEC filings from your full-service stockbroker, or the company itself.

Other sources of information filed with the SEC include public or law libraries, securities firms, financial service bureaus, computerized on-line services, and the companies themselves.

American Association of Individual Investors Offers a collection of Investor Guides provides you with a continuing stream of "how-to" investment knowledge and guidance.

625 N. Michigan Avenue
Chicago, IL 60611
Tel: 800-428-2244

Investment Company Institute (an organization promoting public understanding of mutual funds)

1401 H Street NW, Suite 1100
Washington, DC 20005
Tel: 202-326-5800

Mutual Fund Education Alliance) (pricing and performance information on thousands of mutual funds plus news and educational information about fund investing.

Glossary

Ask

The lowest price a broker asks customers to pay for a security.

Beneficial Owner

The true owner of a security which may, for convenience, be recorded under the name of a nominee.

Bid

The highest price a broker is willing to pay for a security.

Bond

A certificate that is evidence of a debt in which the issuer promises to repay a specific amount of money to the bondholder, plus a certain amount of interest, within a fixed period of time.

Broker-Dealer

An entity engaged in the business of buying and selling securities.

Call

The right in options contracts to buy underlying securities at a specified price at a specified time. Also refers to provisions in bond contracts that allow issuers to buy back bonds prior to their stated maturity.

Cash Account

A type of account with a broker-dealer in which the customer agrees to pay the full amount due for the purchase of securities within a short period of time, usually five business days.

Closed-end Fund

A type of investment company whose securities are traded on the open market rather than being redeemed by the issuing company.

Commission

The fee charged by a broker-dealer for services performed in buying or selling securities on behalf of a customer.

Discretionary Account

A type of account with a broker-dealer in which the investor authorizes the broker to buy and sell securities, selected by the broker, at a price, amount, and time the broker believes to be best.

Dividend

A payment by a corporation to its stockholders, usually representing a share in the company's earnings.

Equity Security

An ownership interest in a company, most often taking the form of corporate stock.

Face Value

The amount of money that the issuer of a bond promises to repay to the bondholder on or before the maturity date.

Form 8-K

A current report required to be filed with the SEC if a certain specified event occurs, such as: a change in control of the registrant, acquisition or disposition of assets, bankruptcy or receivership, or other material event. Form 8-K is required to be filed within 15 days of the event.

Form 10-K

The designation of the official audited financial report and narrative which publicly owned companies must file with the SEC. It shows assets, liabilities, equity revenues, expenses, and so forth. It is a reflection of the corporation's condition at the close of the business year, and the results of operations for that year.

Form 10-Q

Quarterly reports containing interim information, which is "material"-important for investors to know. These must be filed with the SEC.

Interest

The payment a corporate or governmental issuer makes to bondholders in return for the loan of money.

Investment Company

A company engaged primarily in the business of investing in securities.

Margin Account

A type of account with a broker-dealer, in which the broker agrees to lend the customer part of the amount due for the purchase of securities.

Money Market Account

Generally, a mutual fund which typically invests in short-term debt instruments such as government securities, commercial paper, and large denomination certificates of deposit of banks.

Mutual Fund

A pool of stocks, bonds, or other securities purchased by a group of investors and managed by a professional/registered investment company. The investment company itself is also commonly referred to as a mutual fund.

NASDAQ

National Association of Securities Dealers Automated Quotation System (NASDAQ) is a system that provides broker-dealers with bid and ask prices for some securities traded over the counter.

Net Asset Value

The dollar value of one share of a mutual fund at a given point in time, which is calculated by adding up the value of all of the fund's holdings and dividing by the number of outstanding shares.

No-load Fund

A type of mutual fund that offers its shares directly to the public at their net asset value with no accompanying sales charge.

Odd Lot

Fewer than 100 shares of stock.

Open-end Fund

A type of investment company that continuously offers shares to the public and stands ready to buy back such shares whenever an investor wishes to sell.

Option

A contract providing the right to buy or sell something often 100 shares of corporate stock-at a fixed price, within a specified period of time.

Over the Counter (OTC)

A market for buying and selling stock between broker-dealers over the telephone rather than by going through a stock exchange.

Prospectus

The document required to be furnished to purchasers of newly registered securities, which provides detailed information about the company issuing the securities and about that particular offering.

Proxy

A written authorization given by shareholders for someone else to cast their votes on such corporate issues as election of directors.

Proxy Statement

A document which the SEC requires a company to send to its shareholders (owners of record) that provides material facts concerning matters on which the shareholders will vote.

Put

The right, in an options contract, to sell underlying securities at a specified price at a specified time.

Quotation (or Quote)

The price at which a security may be bought or sold at any given time.

Registered Securities

Stocks or bonds or other securities for which a registration statement has been filed with the SEC.

REIT

Real Estate Investment Trust, a type of company in which investors pool their funds to buy and manage real estate or to finance construction or purchases.

Restricted Securities

Stocks or bonds which were issued in a private sale or other transaction riot registered with the SEC.

Round Lot

Generally, one hundred shares of stock or multiples of 100.

Specialist

A member of a stock exchange who operates on the trading floor buying and selling shares of particular securities as necessary to maintain a fair and orderly market.

Stock

An ownership interest in a company, also known as "shares" in a company.

Street Name

A name other than that of the beneficial owner (e.g., a broker-dealer) in which stock may be recorded, usually to facilitate resale.

Unit Investment Trust

A type of investment company with a fixed unmanaged portfolio, typically invested in bonds or other debt securities in which the interests are redeemable.

Yield

Generally, the return on an investment in a stock or bond, calculated as a percentage of the amount invested.

"Buying on margin" is borrowing money from your broker to buy a stock and using your investment as collateral. Investors generally use margin to increase their purchasing power so that they can own more stock without fully paying for it. But margin exposes investors to the potential for higher losses.

This Financial Guide discusses the basics of buying on margin, some of the pitfalls inherent in margin buying, whether this financial tool is for you and how you can best use it.

How Does Margin Work?

Let's say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you'll earn a 50 percent return on your investment. But if you bought the stock on margin - paying $25 in cash and borrowing $25 from your broker - you'll earn a 100 percent return on the money you invested. Of course, you'll still owe your brokerage $25 plus interest.

The downside to using margin is that if the stock price decreases, substantial losses can mount quickly. For example, let's say the stock you bought for $50 falls to $25. If you fully paid for the stock, you'll lose 50% of your money. But if you bought on margin, you'll lose 100%, and you still must come up with the interest you owe on the loan.

Caution: In volatile markets, investors who put up an initial margin payment for a stock may, from time to time, be required to provide additional cash if the price of the stock falls. Investors have been shocked to learn that a broker has the right to sell the securities that were bought on margin - without any notification, and at a potentially substantial loss to the investor.

Caution: If your broker sells your stock after the price has plummeted, then you've lost out on the chance to recoup your losses if the market bounces back.

The Risks

Margin accounts can be very risky and they are not for everyone. Before opening a margin account, be aware that:

• You can lose more money than you have invested;
• You may have to deposit additional cash or securities in your account on short notice to cover market losses;
• You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and
• Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.

You can protect yourself by knowing how a margin account works and what happens if the price of the stock purchased on margin declines.

Tip: Your broker charges you interest for borrowing money; take into account how that will affect the total return on your investments.

Tip: Ask your broker whether it makes sense for you to trade on margin in light of your financial resources, investment objectives, and tolerance for risk.

Read Your Margin Agreement

To open a margin account, you must sign a margin agreement. The agreement may either be part of your account agreement or separate. The margin agreement states that you must abide by the rules of the Federal Reserve Board, the New York Stock Exchange, the National Association of Securities Dealers, Inc., and the firm where you have set up your margin account.

Caution: Carefully review the agreement before signing.

As with most loans, the margin agreement explains the terms and conditions of the margin account. The agreement describes how the interest on the loan is calculated, how you are responsible for repaying the loan, and how the securities you purchase serve as collateral for the loan. Carefully review the agreement to determine what notice, if any, your firm must give you before selling your securities to collect the money you have borrowed.

Know the Margin Rules

The Federal Reserve Board and many self-regulatory organizations (SROs), such as the NYSE and NASD, have rules that govern margin trading. Brokerage firms can establish their own requirements as long as they are at least as restrictive as the Federal Reserve Board and SRO rules.

Here are some of the key rules you should know:

Before You Trade - Minimum Margin. Before trading on margin, the NYSE and NASD, for example, require you to deposit with your brokerage firm a minimum of $2,000 or 100 percent of the purchase price, whichever is less. This is known as the "minimum margin." Some firms may require you to deposit more than $2,000.

Amount You Can Borrow - Initial Margin. According to Regulation T of the Federal Reserve Board, you may borrow up to 50 percent of the purchase price of securities that can be purchased on margin. This is known as the "initial margin." Some firms require you to deposit more than 50 percent of the purchase price.

Tip: Not all securities can be purchased on margin.

Amount You Need After You Trade - Maintenance Margin. After you buy stock on margin, the NYSE and NASD require you to keep a minimum amount of equity in your margin account. The equity in your account is the value of your securities less how much you owe to your brokerage firm. The rules require you to have at least 25 percent of the total market value of the securities in your margin account at all times. The 25 percent is called the "maintenance requirement." In fact, many brokerage firms have higher maintenance requirements, typically between 30 to 40 percent and sometimes higher, depending on the type of stock purchased.

Example: You purchase $16,000 worth of securities by borrowing $8,000 from your firm and paying $8,000 in cash or securities. If the market value of the securities drops to $12,000, the equity in your account will fall to $4,000 ($12,000 - $8,000 = $4,000). If your firm has a 25 percent maintenance requirement, you must have $3,000 in equity in your account (25 percent of $12,000 = $3,000). In this case, you do have enough equity because the $4,000 in equity in your account is greater than the $3,000 maintenance requirement.

But if your firm has a maintenance requirement of 40%, you would not have enough equity. The firm would require you to have $4,800 in equity (40% of $12,000 = $4,800). Your $4,000 in equity is less than the firm's $4,800 maintenance requirement. As a result, the firm may issue you a "margin call," since the equity in your account has fallen $800 below the firm's maintenance requirement.

Margin Calls

If your account falls below the firm's maintenance requirement, your broker generally will make a margin call to ask you to deposit more cash or securities into your account. If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm's maintenance requirement.

Tip: Your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm's maintenance requirement. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.

• Margin accounts involve a great deal more risk than cash accounts, where you fully pay for the securities you purchase. You may lose more than your initial investment when buying on margin. If you cannot afford to do so, then margin buying is not for you.
• Read the margin agreement, and ask your broker questions about how a margin account works and whether it's appropriate for you to trade on margin. Your broker should explain the terms and conditions of the margin agreement.
• Know how much you will be charged on money you borrow from your broker, and know how these costs affect your overall return.
• Remember that your brokerage firm can sell your securities without notice to you when you don't have sufficient equity in your margin account.

In recent years, interest in investment clubs has grown tremendously. This Financial Guide tells you what you need to know about investors' clubs before getting involved with one.

An investment club is a group of people who pool their money to make investments. Usually, investment clubs are organized as partnerships. After the members study different investments, the group decides to buy or sell based on a majority vote. Club meetings can be educational in nature, and each member may actively participate in investment decisions.

SEC Laws That Might Apply

Investment clubs do not usually need to register, or to register the offer and sale of their own membership interests, with the SEC. But since each investment club is unique, each club should decide if it needs to register and comply with securities laws.

We'll discuss two securities laws that might apply to investment clubs:

• Under the Securities Act of 1933, membership interests in the investment club may be securities. If so, the offer and sale of membership interests could be subject to Federal regulation.
• Under the Investment Company Act of 1940, an investment club may be an investment company, and subject to regulation.

When Registration Is Required Under the Securities Act of 1933

Since the 1933 Securities Act requires registration of the offer and sale of most securities, the investment club must register if its membership interests are "securities." Generally, a membership interest is a security if it is an "investment contract."

Generally, a membership interest is an investment contract if members invest and expect to make a profit from the entrepreneurial and managerial efforts of others.

Tip: If every member in an investment club actively participates in deciding which investments to make, membership interests in the club would probably not be considered securities. On the other hand, if the club has any inactive members, it may be considered to be issuing securities.

Sometimes offers and sales of securities do not have to be registered because they are exempt under the law. For example, a non-public offering is exempt.

When Registration Is Required Under the Investment Company Act of 1940

An investment club must register with the SEC as an investment company under the Investment Company Act of 1940 if all of the following three apply:

1. The club invests in securities,
2. The club issues membership interests that are securities (see above), and
3. The club is not able to rely on an exclusion from the definition of "investment company."

Example: A "private investment company" may not need to register with the SEC. To qualify as a private investment company, an investment club:

• Must not make, nor propose to make, a public offering of its securities, and
• Must not have more than 100 members.

An announcement that a club is looking for new members might be considered a public offering, but the analysis is made on a case-by-case basis.

Tip: An attorney with experience in securities law can help the club determine whether its membership interests are securities, and whether the club is making a public offering of those securities.

Applicability of the Investment Advisers Act of 1940

If an adviser is compensated for providing advice regarding the club's investments, the adviser may need to register under the Investment Advisers Act of 1940. Also, if one person chooses investments for the club, that person may have to register as an investment adviser.

In general, a person who has $25 million or more in assets under management is required to register with the SEC under the Investment Advisers Act of 1940.

A person managing less than $25 million may be required to register under the securities laws of the state or states in which the adviser transacts business.

Neither the Investment Advisers Act of 1940 nor many state laws require registration for advisers with small numbers of clients.

Applicable State Laws

State securities laws often differ from federal securities laws.

Tip: It is a good idea to seek the advice of a securities attorney or to contact the securities regulator for the state in question before getting involved with an investment club.

One of the most important questions you face when changing job is what to do with the money in your 401(k) because making the wrong move could cost you thousands of dollars or more in taxes and lower returns.

Let's say you put in five years at your current job. For most of those years, you've had the company take a set percentage of your pre-tax salary and put it into your 401(k) plan.

Now that you're leaving, what should you do? The first rule of thumb is to leave it alone. You have 60 days to decide whether to roll it over or leave it in the account. Resist the temptation to cash out. The worst thing an employee can do when leaving a job is to withdraw the money from their 401(k) plans and put it in his or her bank account. Here's why:

If you decide to have your distribution paid to you, the plan administrator will withhold 20% of your total for federal income taxes, so if you had $100,000 in your account and you wanted to cash it out, you're already down to $80,000.

Further, if you're younger than 59 ½, you'll face a 10% penalty for early withdrawal come tax time. Now you're down another 10% from the top line, to $70,000.

In addition, because distributions are taxed as ordinary income, at the end of the year you'll have to pay the difference between your tax bracket and the 20% already taken out. For example, if you're in the 33% tax bracket, you'll still owe 13%, or $13,000. This lowers the amount of your cash distribution to $57,000.

But that's not all. You also might have to pay state and local taxes. Between taxes and penalties, you could end up with little over half of what you had saved up, short-changing your retirement savings significantly.

What are the Alternatives?

If your new job offers a retirement plan, then the easiest course of action is to roll your account into the new plan before the 60-day period ends. This is known as a “rollover” and is relatively painless to do. Contact The 401(k) plan administrator at your previous job should have all of the forms you need.

The best way to roll funds over from an old 401(k) plan to a new one is to use a direct transfer. With the direct transfer, you never receive a check and you avoid all of the taxes and penalties mentioned above and your savings will continue to grow tax-deferred until you retire.

One word of caution: Many employers require that you work a minimum period of time before you can participate in a 401(k). If that is the case, one solution is to keep your money in your former employer's 401(k) plan until the new one is available. Then you can roll it over into the new plan. Most plans let former employees leave their assets several months in the old plan.

60-Day Rollover Period

If you have your former employer make the distribution check out to you, the Internal Revenue Service considers this a cash distribution. The check you get will have 20% taken out automatically from your vested amount for federal income tax.

But don't panic. You have 60 days to roll over the lump sum (including the 20%) to your new employer's plan or into a rollover individual retirement account (IRA). Then you won't owe the additional taxes or the 10% early withdrawal penalty.

Note: If you're not happy with the fund choices your new employer offers, you might opt for a rollover IRA instead of your company's plan. You can then choose from hundreds of funds and have more control over your money. But again, to avoid the withholding hassle, use direct rollovers.

Leave It Alone

If your vested account balance in your 401(k) is more than $5,000, you can usually leave it with your former employer's retirement plan. Your lump sum will keep growing tax-deferred until you retire.

However, if you can't leave the money in your former employer's 401(k) and your new job doesn't have a 401(k), your best bet is a direct rollover into an IRA. The same applies if you've decided to go into business for yourself.

Once you turn 59 ½, you can begin withdrawals from your 401(k) plan or IRA without penalty and your withdrawals are taxed as ordinary income.

You don't have to start taking withdrawals from your 401(k) unless you retire after age 70 ½. With an IRA you must begin a schedule of taxable withdrawals based on your life expectancy when you reach 70 ½, whether you're working or not.

Information is the investor's best tool when it comes to investing wisely. But accurate information about "microcap stocks" -- low-priced stocks issued by the smallest of companies, often called "penny stocks" -- may be difficult to find. Many microcap companies do not file financial reports with the SEC, so it's hard for investors to get the facts about the company's management, products, services, and finances. When reliable information is scarce, wrongdoers can easily spread false information about microcap companies, making profits while creating losses for unsuspecting investors.

This Financial Guide gives you the basics about microcap or "penny" stocks, discusses how to find information on them, and points out what "red flags" to watch out for.

What is a Microcap Stock?

The term "microcap stock" applies to companies with low or "micro" capitalizations, meaning the total value of the company's stock. Microcap companies typically have limited assets. For example, in recent cases where the SEC suspended trading in microcap stocks, the average company had only $6 million in net tangible assets - and nearly half had less than $1.25 million. Microcap stocks tend to be low priced and trade in low volumes.

Where do Microcap Stocks Trade?

Many microcap stocks trade in the "over-the-counter" (OTC) market and are quoted on OTC systems, such as the OTC Bulletin Board (OTCBB) or the "Pink Sheets."

• OTC Bulletin Board. The OTCBB is an electronic quotation system that displays real-time quotes, last-sale prices, and volume information for many OTC securities not listed on the NASDAQ or a national securities exchange. Brokers who subscribe to the system can use the OTCBB to look up prices or enter quotes for OTC securities.

Caution: Although the NASD oversees the OTCBB, the OTCBB is not part of the NASDAQ. Wrongdoers often claim that an OTCBB company is a NASDAQ company to mislead investors.

• The "Pink Sheets." The Pink Sheets - named for the color of paper they've historically been printed on - are a weekly publication of a company called the National Quotation Bureau. They are updated daily electronically. Brokers who subscribe to the Pink Sheets can find out the names and telephone numbers of the "market makers" in various OTC stocks - meaning the brokers who commit to buying and selling those OTC securities. Unless your broker has the Pink Sheets or you contact the market makers directly, you'll have a difficult time finding price information for most stocks quoted in the Pink Sheets.

How Are Microcap Stocks Different From Other Stocks?

Microcap stocks differ from other stocks in a number of ways:

Lack of Public Information. The biggest difference between a microcap stock and other stocks is the amount of reliable, publicly available information about the company. Larger public companies file reports with the SEC that any investor can get for free from the SEC's website. Professional stock analysts regularly research and write about larger public companies, and it's easy to find larger companies' stock prices. In contrast, information about microcap companies can be extremely difficult to find, making them more vulnerable to investment fraud schemes.

Note: The SEC has proposed new rules that will increase the amount of information brokers must gather about microcap companies before quoting prices for their stocks in the OTC market.

No Minimum Listing Standards. Companies that trade their stocks on major exchanges and in the NASDAQ must meet minimum listing standards. For example, they must have certain minimums when it comes to net assets, and minimum numbers of shareholders. In contrast, companies on the OTCBB or the Pink Sheets do not have to meet any minimum standards.

Risk. While all investments involve risk, microcap stocks are among the most risky. Many microcap companies are new, with no track record. Some of these companies have no assets or operations. Others have products and services that are still in development or have yet to be tested in the market.

Which Companies File Reports With the SEC?

In general, the federal securities laws require all but the smallest of public companies to file reports with the SEC. A company can become "public" in one of two ways - by issuing securities in an offering or transaction that's registered with the SEC or by registering the company and its outstanding securities with the SEC. Both types of registration trigger ongoing reporting obligations, meaning the company must file periodic reports that disclose important information to investors about its business, financial condition, and management.

This information is a treasure trove for investors: it tells you whether a company is making money or losing money and why.

Tip: You'll find this information in the company's quarterly reports on Form 10-Q, annual reports (with audited financial statements) on Form 10-K, and periodic reports of significant events on Form 8-K.

A company must file reports with the SEC if:

• It has 500 or more investors and $10 million or more in assets; or
• It lists its securities on the following stock markets:
• American Stock Exchange
• Boston Stock Exchange
• Cincinnati Stock Exchange
• Chicago Stock Exchange
• NASDAQ
• New York Stock Exchange
• Pacific Exchange
• Philadelphia Stock Exchange

Currently, only about half of the 6,500 companies whose securities are quoted on the OTCBB file reports with the SEC.

Note: In January 1999, the SEC approved a new NASD rule allowing the NASD to require that all OTCBB companies file updated financial reports with the SEC or with their banking or insurance regulators. The new rule now applies to all companies on the OTCBB. Companies refusing to file with the SEC or their banking or insurance regulators cannot remain on the OTCBB.

With few exceptions, companies that file reports with the SEC must do so electronically using the SEC's EDGAR system. EDGAR stands for electronic data gathering and retrieval. The EDGAR database is available on the SEC's Web site at www.sec.gov. You'll find many corporate filings in the EDGAR database, including annual and quarterly reports and registration statements. Any investor can access and download this information for free from the SEC's Web site.

Caution: As with any information, SEC filings should be read with a questioning and critical mind.

Which Companies Don't Have to File Reports With the SEC?

Smaller companies - those with less than $10 million in assets - generally do not have to file reports with the SEC. But some smaller companies, including microcap companies, may choose voluntarily to register their securities with the SEC. As described above, companies that register with the SEC must also file quarterly, annual, and other reports.

Offering Requirements and Exemptions

Any company that wants to offer or sell securities to the public must either register with the SEC or meet an exemption. Here are two of the most common exemptions that many microcap companies use:

• "Reg. A" Offerings. Companies raising less than $5 million in a 12-month period may be exempt from registering their securities under a rule known as Regulation A. Instead of filing a registration statement through EDGAR, these companies need only file a printed copy of an "offering circular" with the SEC containing financial statements and other information.

• "Reg. D" Offerings. Some smaller companies offer and sell securities without registering the transaction under an exemption known as Regulation D. Regulation D exempts from registration companies that seek to raise less than $1 million dollars in a twelve-month period. It also exempts companies seeking to raise up to $5 million, as long as the companies sell to 35 or fewer individuals or any number of "accredited investors" who must meet high net worth or income standards. In addition, Regulation D exempts some larger private offerings of securities. While companies claiming an exemption under Reg. D don't have to register or file reports with the SEC, they must still file what's known as a "Form D" within a few days after they first sell their securities. Form D is a brief notice that includes the names and addresses of owners and stock promoters, but little other information about the company.

Tip: You may be able to find out more about Reg. D companies by contacting your state securities regulator.

Unless they otherwise file reports with the SEC, companies that are exempt from registration under Reg. A, Reg. D, or another offering exemption, do not have to file reports with the SEC.

Why Public Information Is So Important?

Many of the microcap companies that don't file reports with the SEC are legitimate businesses with real products or services. But the lack of reliable, readily available information about some microcap companies can open the door to fraud. It's easier to manipulate a stock when there's little or no information available about the company.

Microcap fraud depends on spreading false information. Here's how some perpetrators carry out their scams:

• Questionable Press Releases. Con artists often issue press releases that contain exaggerations or lies about the microcap company's sales, acquisitions, revenue projections, or new products or services.

• Paid Promoters. Some microcap companies pay stock promoters to recommend or "tout" the microcap stock in supposedly independent and unbiased investment newsletters, research reports, or radio and television shows. The federal securities laws require the newsletters to disclose who paid them, the amount, and the type of payment. But many con artists fail to do so and mislead investors into believing they are receiving independent advice.

• Internet Fraud. Con artists often distribute junk e-mail or "spam" over the Internet to spread false information quickly and cheaply about a microcap company to thousands of potential investors. They also use aliases on Internet bulletin boards and chat rooms to hide their identities and post messages urging investors to buy stock in microcap companies based on supposedly "inside" information about impending developments at the companies.

• "Boiler Rooms" and Cold Calling. Dishonest brokers set up "boiler rooms" where a small army of high-pressure salespeople use banks of telephones to make cold calls to as many potential investors as possible. These strangers hound investors to buy "house stocks" - stocks that the firm buys or sells as a market maker or has in its inventory.

Tip: Never buy stock in response to a cold call.

Some Common Penny Stock Fraud Schemes

Microcap fraud schemes can take a variety of forms. Here's a description of the two most common:

The Classic "Pump and Dump" Scheme. It's common to see messages posted on the Internet that urge readers to buy a stock quickly or to sell before the price goes down, or a telemarketer will call using the same sort of pitch. Often the promoters will claim to have "inside" information about an impending development or to use an "infallible" combination of economic and stock market data to pick stocks. In reality, they may be company insiders or paid promoters who stand to gain by selling their shares after the stock price is pumped up by the buying frenzy they create. Once these con artists sell their shares and stop hyping the stock, the price typically falls, and investors lose their money.

The Off-Shore Scam. Under a rule known as "Regulation S," companies do not have to register stock they sell outside the United States to foreign or "off-shore" investors. In the typical off-shore scam, an unscrupulous microcap company sells unregistered Reg. S stock at a deep discount to con artists posing as foreign investors. These con artists then sell the stock to U.S. investors at inflated prices, pocketing huge profits, which they share with the microcap company insiders. The flood of unregistered stock into the U.S. eventually causes the price to plummet, leaving unsuspecting U.S. investors with enormous losses.

Note: The SEC recently strengthened Reg. S to make this type of fraud harder to conduct.

How Do I Get Information About Microcap Companies?

If you're working with a broker or an investment adviser, you can ask your investment professional if the company files reports with the SEC and to get you written information about the company and its business, finances, and management. Be sure to carefully read the prospectus and the company's latest financial reports.

You can also get information on your own from these sources:

• From the company. Ask the company if it is registered with the SEC and files reports with us. If the company is small and unknown to most people, you should also call your state securities regulator to get information about the company, its management, and the brokers or promoters who've encouraged you to invest in the company.

• From the SEC. A great many companies must file their reports with the SEC. Using the EDGAR database, you can find out whether a company files with the SEC, and get any reports you're interested in. For companies that do not file on EDGAR, check with the SEC's Public Reference Room to see whether the company has filed an offering circular under Reg. A.

• From your state securities regulator. We strongly urge you to contact your state securities regulator to find out whether they have information about a company and the people behind it. Look in the government section of your phone book or visit the website of the North American Securities Administrators Association to get the relevant name and phone number. Even though the company does not have to register its securities with the SEC, it may have to register them with your state. Your regulator will tell you whether the company has been legally cleared to sell securities in your state.

• From other government regulators. Many companies, such as banks, do not have to file reports with the SEC. But banks must file updated financial information with their banking regulators.

• From reference books and commercial databases. Visit your local public library or the nearest law or business school library. You'll find many reference materials containing information about companies. You can also access commercial databases for more information about the company's history, management, products or services, revenues, and credit ratings. But there are a number of commercial resources you may consult, including: Bloomberg, Dun & Bradstreet, Hoover's Profiles, Lexis-Nexis, and Standard & Poor's Corporate Profiles.

• The Secretary of State Where the Company Is Incorporated. Contact the secretary of state where the company is incorporated to find out whether the company is a corporation in good standing. You may also be able to obtain copies of the company's incorporation papers and any annual reports it files with the state.

Caution: If you've been asked to invest in a company but you can't find any record that the company has registered its securities with the SEC or your state, or that it's exempt from registration, call or write your state's securities regulator or the SEC immediately with all the details. You may have come face to face with a scam.

Steps You Should Take Before Investing

To invest wisely and avoid investment scams, research each investment opportunity thoroughly and ask questions. These simple steps can make the difference between profits and losses:

1. Find out whether the company has registered its securities with the SEC or your state's securities regulators.

2. Make sure you understand the company's business and its products or services.

3. Read the most recent reports the company has filed with its regulators and pay attention to the company's financial statements, particularly if they are not audited or not certified by an accountant. If the company does not file reports with the SEC, be sure to ask your broker for what's called the "Rule 15c2-11 file" on the company. That file will contain important information about the company.

4. Check out the people running the company with your state securities regulator, and find out if they've ever made money for investors before. Also ask whether the people running the company have had run-ins with the regulators or other investors.

5. Make sure the broker and his or her firm are registered with the SEC and licensed to do business in your state. And ask your state securities regulator whether the broker and the firm have ever been disciplined or have complaints against them.

Also, watch out for these "red flags":

• SEC Trading Suspensions. The SEC has the power to suspend trading in any stock for up to 10 days when it believes that information about the company is inaccurate or unreliable. Think twice before investing in a company that's been the subject of an SEC trading suspension.

• High Pressure Sales Tactics. Beware of brokers who pressure you to buy before you have a chance to think about and investigate the "opportunity." Dishonest brokers may try to tell you about a "once-in-a-lifetime" opportunity or one that's based on "inside" or "confidential" information. Don't fall for brokers who promise spectacular profits or "guaranteed" returns. These are the hallmarks of fraud. If the deal sounds too good to be true, then it probably is.

• Assets Are Large But Revenues Are Small. Microcap companies sometimes assign high values on their financial statements to assets that have nothing to do with their business. Find out whether there's a valid explanation for low revenues, especially when the company claims to have large assets.

• Odd Items in the Footnotes to the Financial Statements. Many microcap fraud schemes involve unusual transactions among individuals connected to the company. These can be unusual loans or the exchange of questionable assets for company stock, which may be discussed in the footnotes.

• Unusual Auditing Issues. Be wary when a company's auditors have refused to certify the company's financial statements or if they've stated that the company may not have enough money to continue operating. Also question any change of accountants.

• Insiders Own Large Amounts of the Stock. In many microcap fraud cases - especially "pump and dump" schemes - the company's officers and promoters own significant amounts of the stock. When one person or group controls most of the stock, they can more easily manipulate the stock's price at your expense. You can ask your broker or the company whether one person or group controls most of the company's stock, but if the company is the subject of a scam, you may not get an honest answer.

Caution: Don't deal with brokers who refuse to provide you with written information about the investments they're promoting.

Caution: Never tell a cold caller your social security number or numbers for your banking and securities accounts.

Caution: Be extra wary if someone you don't know and trust recommends foreign investments.

1. Save As Much As You Can As Early As You Can.
   Though it's never too late to start, the sooner you begin saving, the more time your money has to grow. Gains each year build on the prior year's -- that's the power of compounding, and the best way to accumulate wealth.

2. Set Realistic Goals.
   Project your retirement expenses based on your needs, not rules of thumb. Be honest about how you want to live in retirement and how much it will cost. Then calculate how much you must save to supplement Social Security and other sources of retirement income.

3. A 401(k) Is One Of The Easiest And Best Ways To Save For Retirement.
   Contributing money to a 401(k) gives you an immediate tax deduction, tax-deferred growth on your savings, and -- usually -- a matching contribution from your company.

4. An IRA Can Also Give Your Savings A Tax-Advantaged Boost.
   Like a 401(k), IRAs offer huge tax breaks. There are two types: a traditional IRA offers tax-deferred growth, meaning you pay taxes on your investment gains only when you make withdrawals, and, if you qualify, your contributions may be deductible; a Roth IRA, by contrast, doesn't allow for deductible contributions but offers tax-free growth, meaning you owe no tax when you make withdrawals, but contributions are not deductible.

5. Focus On Your Asset Allocation More Than On Individual Picks.
   How you divide your portfolio between stocks and bonds will have a big impact on your long-term returns.

6. Stocks Are Best For Long-Term Growth.
   Stocks have the best chance of achieving high returns over long periods. A healthy dose will help ensure that your savings grows faster than inflation, increasing the purchasing power of your nest egg.

7. Don't Move Too Heavily Into Bonds, Even In Retirement.
   Many retirees stash most of their portfolio in bonds for the income. Unfortunately, over 10 to 15 years, inflation easily can erode the purchasing power of bonds' interest payments.

8. Making Tax-Efficient Withdrawals Can Stretch The Life Of Your Nest Egg.
   Once you're retired, your assets can last several more years if you draw on money from taxable accounts first and let tax-advantaged accounts compound for as long as possible.

9. Working Part-Time In Retirement Can Help In More Ways Than One.
   Working keeps you socially engaged and reduces the amount of your nest egg you must withdraw annually once you retire.

10. There Are Other Creative Ways To Get More Mileage Out Of Retirement Assets.
    You might consider relocating to an area with lower living expenses, or transforming the equity in your home into income by taking out a reverse mortgage.

Roth IRAs differ from other tax-favored retirement plans, including other IRAs (called "traditional IRAs"), in that they promise complete tax exemption on distribution. There are other important differences as well, and many qualifications about their use. This Financial Guide shows how they work, how they compare with other retirement devices--and why YOU might want one, or more.

With most tax-favored retirement plans, the contribution to (i.e., investment in) the plan is deductible, the investment compounds tax-free until distributed, and distributions are taxable as received. There are variations from this pattern, as with 401(k)s where the exemption for salary diverted to a 401(k) takes the place of a deduction and for after-tax investments where invested capital is tax-free when distributed.

With a Roth IRA, there's never an up-front deduction for contributions. Funds contributed compound tax-free until distributed (standard for all tax-favored plans) and distributions are completely exempt from income tax.

How Contributions Are Treated

The 2014 annual contribution limit to a Roth IRA is $5,500 (same as 2013). An additional "catch-up" contribution of $1,000 (same as 2013) is allowed for persons age 50 or over bringing the contribution total to $6,500 for certain taxpayers. To make the full contribution, you must earn at least $5,500 in 2014 from personal services and have income (modified adjusted gross income or MAGI) below $114,000 if single or $181,000 on a joint return in 2014. The $5,500 limit in 2014 phases out on incomes between $114,000 and $129,000 (single filers) and $181,000 and $191,000 (joint filers). Also, the $5,500 limit is reduced for contributions to traditional IRAs though not SEP or SIMPLE IRAs.

You can contribute to a Roth IRA for your spouse, subject to the income limits above. So assuming earnings (your own or combined with your spouse) of at least $11,000, up to $11,000 ($5,500 each) can go into the couple's Roth IRAs. As with traditional IRAs, there's a 6% penalty on excess contributions. The rule continues that the dollar limits are reduced by contributions to traditional IRAs.

How Withdrawals Are Treated

You may withdraw money from a Roth IRA at any time; however, taxes and penalty could apply depending on timing of contributions and withdrawals.

Qualified Distributions

Since all your investments in a Roth IRA are after-tax, your withdrawals, whenever you make them, are often tax-free. But the best kind of withdrawal, which allows earnings as well as contributions and conversion amounts to come out completely tax-free, are qualified distributions. These are withdrawals meeting the following conditions:

1. At least 5 years have elapsed since the first year a Roth IRA contribution was made or, in the case of a conversion, since the conversion occurred and
2. At least one of these additional conditions is met:

• The owner is age 59 ½.
• The owner is disabled.
• The owner has died (distribution is to estate or heir).
• Withdrawal is for a first-time home that you build, rebuild, or buy (lifetime limit up to $10,000).

Note: A distribution used to buy, build or rebuild a first home must be used to pay qualified costs for the main home of a first time home buyer who is either yourself, your spouse or you or your spouse's child, grandchild, parent or other ancestor.

Non-Qualified Distributions

To discourage the use of pension funds for purposes other than normal retirement, the law imposes an additional 10% tax on certain early distributions from Roth IRAs unless an exception applies. Generally, early distributions are those you receive from an IRA before reaching age 59 1/2.

Exceptions. You may not have to pay the 10% additional tax in the following situations:

• You are disabled.
• You are the beneficiary of a deceased IRA owner.
• You use the distribution to pay certain qualified first-time homebuyer amounts.
• The distributions are part of a series of substantially equal payments.
• You have significant unreimbursed medical expenses.
• You are paying medical insurance premiums after losing your job.
• The distributions are not more than your qualified higher education expenses.
• The distribution is due to an IRS levy of the qualified plan.
• The distribution is a qualified reservist distribution.

Part of any distribution that is not a qualified distribution may be taxable as ordinary income and subject to the additional 10% tax on early distributions. Distributions of conversion contributions within a 5-year period following a conversion may be subject to the 10% early distribution tax, even if the contributions have been included as income in an earlier year.

Ordering Rules for Distributions

If you receive a distribution from your Roth IRA that is not a qualified distribution, part of it may be taxable. There is a set order in which contributions (including conversion contributions) and earnings are considered to be distributed from your Roth IRA. Order the distributions as follows.

1. Regular contributions.
2. Conversion contributions, on a first-in-first-out basis (generally, total conversions from the earliest year first). See Aggregation (grouping and adding) rules, later. Take these conversion contributions into account as follows:
• Taxable portion (the amount required to be included in gross income because of conversion) first, and then the
• Nontaxable portion.
3. Earnings on contributions.

Disregard rollover contributions from other Roth IRAs for this purpose.

Aggregation (grouping and adding) rules.

Determine the taxable amounts distributed (withdrawn), distributions, and contributions by grouping and adding them together as follows.

• Add all distributions from all your Roth IRAs during the year together.
• Add all regular contributions made for the year (including contributions made after the close of the year, but before the due date of your return) together. Add this total to the total undistributed regular contributions made in prior years.
• Add all conversion and rollover contributions made during the year together. For purposes of the ordering rules, in the case of any conversion or rollover in which the conversion or rollover distribution was made in 2011 and the conversion or rollover contribution was made in 2012, treat the conversion or rollover contribution as contributed before any other conversion or rollover contributions made in 2012.

Add any recharacterized contributions that end up in a Roth IRA to the appropriate contribution group for the year that the original contribution would have been taken into account if it had been made directly to the Roth IRA.

Disregard any recharacterized contribution that ends up in an IRA other than a Roth IRA for the purpose of grouping (aggregating) both contributions and distributions. Also disregard any amount withdrawn to correct an excess contribution (including the earnings withdrawn) for this purpose.

Example: On October 15, 2007, Justin converted all $80,000 in his traditional IRA to his Roth IRA. His Forms 8606 from prior years show that $20,000 of the amount converted is his basis. Justin included $60,000 ($80,000 - $20,000) in his gross income. On February 23, 2007, Justin makes a regular contribution of $4,000 to a Roth IRA. On November 7, 2007, at age 60, Justin takes a $7,000 distribution from his Roth IRA.

• The first $4,000 of the distribution is a return of Justin's regular contribution and is not includible in his income.
• The next $3,000 of the distribution is not includible in income because it was included previously.

Distributions after Owner's Death

Qualified distributions after the owner's death are tax-free to heirs. Nonqualified distributions after death, which are distributions where the 5-year holding period wasn't met, are taxable income to heirs as they would be to the owner (the earnings are taxed), except there's no penalty tax on early withdrawal. However, an owner's surviving spouse can convert an inherited Roth IRA into his or her own Roth IRA. This way, distribution can be postponed, so that nonqualified amounts can become qualified, and the tax shelter prolonged.

Roth IRA assets left at death are subject to federal estate tax, just as traditional IRA assets are.

Converting From a Traditional IRA or Other Eligible Retirement Plan to a Roth IRA

The conversion of your traditional IRA to a Roth IRA was the feature that caused most excitement about Roth IRAs. Conversion means that what would be a taxable traditional IRA distribution can be made into a tax-exempt Roth IRA distribution. Starting in 2008, further conversion or rollover opportunities from other eligible retirement plans were available to taxpayers.

Conversion Methods

You can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used.

You can convert amounts from a traditional IRA to a Roth IRA in any of the following three ways.

• Rollover. You can receive a distribution from a traditional IRA and roll it over (contribute it) to a Roth IRA within 60 days after the distribution.
• Trustee-to-trustee transfer. You can direct the trustee of the traditional IRA to transfer an amount from the traditional IRA to the trustee of the Roth IRA.
• Same trustee transfer. If the trustee of the traditional IRA also maintains the Roth IRA, you can direct the trustee to transfer an amount from the traditional IRA to the Roth IRA.

Note: Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, rather than opening a new account or issuing a new contract.

Prior to 2008, you could only rollover (convert) amounts from either a traditional, SEP, or SIMPLE IRA into a Roth IRA. You can now roll over amounts from the following plans into a Roth IRA. A qualified pension, profit-sharing or stock bonus plan (including a 401(k) plan),

• An annuity plan,
• A tax-sheltered annuity plan (section 403(b) plan),
• A deferred compensation plan of a state or local government (section 457 plan), or
• An IRA.

Any amount rolled over is subject to the same rules for converting a traditional IRA into a Roth IRA. Also, the rollover contribution must meet the rollover requirements that apply to the specific type of retirement plan.

There is a cost to the rollover. The amount converted is fully taxable in the year converted, except for the portion of after-tax investment in the traditional IRA. So you must pay tax now (though there's no early withdrawal penalty) for the opportunity to withdraw tax-free later, an opportunity that can extend to your heirs.

Starting in 2010, conversion is now allowed to all taxpayers. The prior income restriction allowing conversion only for taxpayers of income (again, MAGI) of $100,000 or less in the conversion year has been terminated. All taxpayers are able to convert a regular IRA to a Roth IRA starting in 2010. The conversion is a taxable distribution, which can be taken into income in the conversion year or averaged over the next two years. The conversion will not be subject to the 10% early distribution penalty.

Undoing a Conversion to a Roth IRA

Since everyone recognizes that conversion is a high-risk exercise, the law and liberal IRS rules provide an escape hatch: You can undo a Roth IRA conversion by what IRS calls a "re-characterization". This move, by which you move your conversion assets from a Roth IRA back to a traditional IRA, makes what would have been a taxable conversion into a tax-free rollover between traditional IRAs. Re-characterization can be done any time until the due date for the return for the year of conversion.

Tip: One reason to do this would be where you find you've exceeded the $100,000 income ceiling for Roth IRA conversions.

Tip: Another reason to do this, dramatized by a volatile stock market, is where the value of your portfolio drops sharply after the conversion.

Example: If your assets are worth $180,000 at conversion and fall to $140,000 later, you're taxed on up to $180,000, which is $40,000 more than you now have. Undoing-re-characterization-avoids the tax, and gets you out of the Roth IRA.

Can you undo one Roth IRA conversion and then make another one-a reconversion? Yes-once, subject to these requirements: Reconversion must take place in the tax year following the original conversion to Roth IRA, and the reconversion date must also be more than 30 days after the previous recharacterization transfer from the Roth IRA back to the traditional IRA.

Withdrawal Requirements

You are not required to take distributions from your Roth IRA at any age. The minimum distribution rules that apply to traditional IRAs do not apply to Roth IRAs while the owner is alive. However, after the death of a Roth IRA owner, certain of the minimum distribution rules that apply to traditional IRAs also apply to Roth IRAs

Also, unlike traditional IRAs (but like other tax-favored retirement plans), a Roth IRA owner who continues working may continue to contribute to the Roth IRA.

Retirement Savings Contributions Credit

Also known as the saver's credit, this credit helps low and moderate income workers save for retirement. Taxpayers age 18 and over who are not full-time students and can't be claimed as dependents, are allowed a tax credit for their contributions to a workplace retirement plan, traditional or Roth IRA if their modified adjusted gross income (MAGI) in 2014 for a married filer is below $60,000 ($59,000 in 2013). For heads-of-household MAGI is below $45,000 ($44,250 in 2013) and for others (single, married filing separately) it is below $30,000 ($29,550 in 2013). These amounts are indexed for inflation each year. The credit, up to $1,000, is a percentage from 10-50% of each dollar placed into a qualified retirement plan up to the first $2,000. The lower the MAGI is, the higher the credit percentage, resulting in the maximum credit of $1,000 (50% of $2,000).

Note: Both you and your spouse may be eligible to receive this credit if you both contributed to a qualified retirement plan and meet the adjusted gross income limits.

The following table details the percentage of Saver's credit based on Adjusted Gross Income (AGI):

 

 

 


Note: The saver's credit is available in addition to any other tax savings that apply. Further, IRA contributions can be made until April 15 of the following year and still be considered in the current tax year.

Use in Estate Planning

Though Roth IRAs enjoy no estate tax relief, they are already figuring in estate plans. The aim is to build a large Roth IRA fund-largely through conversion of traditional IRAs-to pass to beneficiaries in later generations. The beneficiaries will be tax exempt on withdrawals (of qualified distributions) and the Roth IRA tax shelter continues by spreading withdrawal over their lifetimes.

Long-term planning with Roth IRAs. If you would be allowed a deduction for a contribution to a traditional IRA, contributing to a Roth IRA means surrendering current tax reduction for future tax reduction (to zero) for qualified distributions. This can be presented as an after-tax return-on-investment calculation involving assumed future tax rates. The higher the projected tax rate at withdrawal, the more tax Roth IRA saves.

Comparable considerations apply to conversions to Roth IRAs. Here the taxpayer incurs substantial current tax cost (directly or indirectly reducing the amount invested) for future tax relief to the taxpayer or an heir. So the return on investment resulting from conversion increases as projected future rates rise.

A key element in making such projections is the possibility that current and future federal deficits will lead to future tax rate increases-a factor which would tend to encourage current Roth IRA investment and conversion. On the other hand, there's the question whether Roth IRA benefits currently promised will survive into future decades.

Highly sophisticated planning is required for Roth IRA conversions. Consultation with a qualified advisor is a must. Please call us if you have any questions.