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Education Articles

What is a 401k?

March 29, 2009 | Education | No Comments
401k

A 401k is a retirement plan offered by many U.S. companies to employees. The name 401K comes from the section of the Internal Revenue Code governing the retirement plan.

The biggest benefit of a 401k plan is that the contributions are pre-taxed.  This means the money you deposit in the plan isn’t taxed until you withdraw the money, hopefully at retirement. Money in a 401K plan can earn interest and grow tax-deferred.  

When you enroll in a 401k plan money is automatically deducted from an employee’s paycheck and deposited into the plan.

Investment Options
Most 401K plans allow you to invest in stocks, mutual funds, bonds, money markets, annuities, guaranteed investment pools, company stock or hybrids (i.e., mutual fund that invests in stocks and bonds) of these instruments. Most 401K plans will offer a list of different investment instruments to pick from and may rank them based on risk.

Company Match
Some companies, mostly large companies, will entice employees to invest in 401k plans by offering a company match.  Employers will contribute additional money into an employee 401k account that matches a portion of their contribution.  Some companies will match dollar-for-dollar up to certain percentage, while others will match a specified percentage of an employee contribution. The current contribution limit for employers is 6% of the employee’s pre-tax compensation.

Vesting Period
Some companies have a vesting period for when an employee will get the money matched in their plan.  As an example, a company may require for an employee to be employed at the company for at least 5 years to be vested; meaning the employee will get all the company match dollars deposited into their account.  If the employee leaves before the 5 years, they may lose all matched dollars or get an amount that is pro-rated based on years of service.

Withdrawal

Money is generally withdrawn from a 401k plan for 5 reasons: retirement, reaching age 59 1/2, termination of employment, disability or death.  Some plans allow employees to borrow money from their account and pay themselves back with interest.

Maximum and Catch-Up Contributions
Currently, the maximum dollar amount by law an employee can contribute to their 401k plan from pre-tax pay is $16,500 per year and the catch-up contribution limit is $5,500 per year. Catch-up contribution allows plan participants that reach age 50 before the calendar year is over to make additional catch up contribution limits on a pre-tax basis.

What is a Subprime Mortgage?

March 25, 2009 | Education | Mortgage Loans | No Comments
subprime-mortgage

A subprime mortgage is a type of loan given to borrowers with poor credit histories; often below a 600 FICA Score.

As a result of poor credit scores, these borrowers do not qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge higher interest rates, above the prime lending rate.

There are several types of subprime mortgage available. However, the most common type of adjustable rate mortgage (ARM) charges a fixed interest rate and then converts to a floating rate based on an index such as LIBOR, plus a margin. The most popular types of ARMs include the 3/27 and 2/28 ARMs.

A 2/28 ARM has a fixed rate for the first two years and then the interest rate adjusts for the next 28 years, which completes the full 30 year term of the loan.  While a 3/27 ARM has a fixed rate for the first 3 years and then adjusts for the next 27 years. The 3/27 mortgage gives a longer period of fixed payments but comes with a slightly higher rate than a 2/28 arm would.

ARMs can be misleading because of the initial lower interest rate. However, when mortgages reset to the higher variable rate, mortgage payments increase significantly. This is the main reason that has caused the sharp increase in the number of subprime mortgage foreclosures that has lead to the current mortgage melt down.

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What is a Derivative (Security)?

March 23, 2009 | Education | No Comments
derivatives-investing

If you watch the financial market one invest vehicle we always hear of is “derivative”.  So what’s a derivative? A derivative is a security whose price is dependent upon or derived from one or more underlying assets.

A derivative itself is a contract between two or more parties and its value is determined by fluctuations in the underlying asset, which include stocks, bonds, commodities, currencies, interest rates, forward contracts, options, and market indexes. Derivatives are mostly characterized by high leverage.

Derivatives are normally used to hedge risk, however, can also be used for speculative purposes. As an example, a Japanese investor who purchases shares of an American company off of an American exchange with U.S. dollars will be exposed to exchange-rate risk while holding that stock.

To hedge the exchange-rate risk, the investor purchases currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Yen (Japanese currency).

Related Article:  What is a Hedge Fund?

What is a Hedge Fund?

March 22, 2009 | Education | No Comments
hedgefunds

Hedge funds are private investments that use various nontraditional investing strategies to try to offset investment risk, an approach known as “hedging”. Hedge funds are attractive to investors because they can provide consistent returns even in a bad market.

Hedge Funds vs. Mutual Funds

Unlike a mutual fund, hedge funds are managed more aggressively and can take speculative positions in derivative securities such as options, shorting selling stocks and other relatively obscure or sophisticated vehicles.  As a result, hedge funds can make money when the market is falling.  Mutual funds, on the other hand, cannot take highly leveraged positions and are typically safer and rely on the market going up to make money. 

Additionally, the SEC (Securities and Exchange Commission) doesn’t have strict rules for hedge funds as with traditional mutual funds.  Hedge fund managers can manage the fund and create portfolios any way they want and do not have to provide information about performance or holdings.  Additionally, there are no rules about pricing, so investors may not be able to determine the value of their investment at any particular time.  As a result, there is really no way to tell the risk level of a particular hedge fund. 

Hedge Fund Requirements

Hedge funds typical require a minimum investment of $1 million; however, there are “lite” hedge funds that are more affordable.  Not everyone qualifies to invest in hedge funds.  According to SEC guidelines, hedge fund investors must be “accredited”, which means you must have a net worth of at least $1 million.  Additionally, you must have an individual income of at least $200,000 for the past 2 years or you and spouse must have a joint income of at least $300,000 for the past 2 years.

Downside to Hedge Funds

Hedge fund fees are much higher than traditional mutual funds, typically charging 1% or 2% of assets plus 20% of profits, which kicks in after a certain threshold.

Because hedge fund managers typically buy and sell frequently so investors will incur higher short term capital gain taxes.  Hedge funds are better suited for retirement accounts where tax consequences don’t matter. 

Another limitation of hedge funds is the lack of liquidity.  Your money may be locked up for up to 5 years, although it’s typically 1 year.  After you must provide 45 days notice if you want to make any withdrawals and you maybe limited to the amount of times you can make withdrawals.  Some hedge funds only allow you to make a withdrawal only once per month.

Fore more information about hedge funds visit:

Stock Buy / Sell Order Types Defined

March 18, 2009 | Education | Stocks | No Comments
buy-stocks

If you are new to buying or selling stocks then you should be familiar with the various buy and selling options available to you.  Below is an explanation of the different buy/sell options:

Market Order – order to buy or sell a stock immediately at the best available current price; no price can be specified in this order. This order guarantees execution, but does not guarantee execution price.

Be wary of using market orders on stocks with a low average daily volume: in such market conditions the ask price can be a lot higher than the current market price (resulting in a large spread). In other words, you may end up paying a whole lot more than you originally anticipated. It is much safer to use a market order on high-volume stocks versus low-volume stocks. Buy market orders are executed generally at the ASK price.

Limit Order  – order to buy or sell a stock at a particular price. The purchase or sale will not happen unless you get your price. Limit orders give you control over your entry or exit point by fixing the price, which can be helpful.

Stop Order – order to buy or sell a security when its price surpasses a particular point, limiting the investor’s loss or locking in his or her profit. Once the market price surpasses the predefined entry/exit point, the stop order becomes a market order, and is then handled as defined under the definition of a market order.

This type of order is also referred to as a “stop-loss order”. Stops are not a definite guarantee of getting the desired entry/exit points. For instance, if a stock gaps down then the trader’s stop order will be triggered (or filled) at a price significantly lower than expected.

Stop Limit – order used to open or close a position by buying if the market rises or selling if the market falls, but that turns into a limit order when the stop price is triggered. Stop limit orders have a stop price and a limit price. When the stop price is triggered, the limit order is activated.

The stop price for buy orders is placed above the current market price. The stop price for sell orders is placed below the current market price. The stop price does not need to be the same as the limit price. Just as with a limit order, the stop limit order will be filled at the limit price or better, but may not be filled at all.

Trailing Stop  – order that continually adjusts the stop price based on changes in the market price. A trailing stop to sell raises the stop price as the market price increases, but does not lower the stop price when the market price decreases.

A trailing stop to buy lowers the stop price as the market price decreases, but does not increase the stop price as the market price increases. In both cases, the stop “trails” the market price. When the stop price is reached, the order becomes a market order. The same risk of market orders applies to trailing stops.

Trailing Stop Limit – order type that works the same way as the trailing stop, only instead of a market order being sent to the exchange, a limit order will be sent to the exchange. With this order, you will be able to stipulate the worst price you are willing to accept for a fill. There is no guarantee that you will be filled, though, as the price may gap through your limit price.

Market on Close – order that buys or sells at the market price at the close of trading. You must submit the order by 2:40 pm CT. The same risk of market orders applies to MOC orders.

Limit on Close – order that buys or sells at a limit price at the close of trading. You must submit the order by 2:40 pm CT. The order can be filled at the limit price or better, but is not guaranteed a fill.

Good Till Canceled – order instructs your broker to keep the order active until you cancel it. Obviously, you use this order with other order types to specify a time frame for the order.  Some brokers have limits on how long they will hold a GTC order.

Day Order – any order that is not a good till canceled order. If your broker does not fill your order that day, you will have to re-enter it the next day.

All or None – order states you want the entire order filled or none of the order filled. You would use this type of order for thinly traded stocks.