Market risk is a chance that an investor takes. No matter what the long-term prospects of an investment or its probable intrinsic value, an asset may trade at any price in the market. A trading price is determined by the interactions of buyers and sellers. If there is more buying than selling of an asset, its price will rise; if there is more selling than buying, its price will fall. This means that an investment’s price can rise, fall and bounce around. The extent of these movements is usually described by the term volatility.

We describe Pacific Gas and Electric Company’s stock as having low volatility because it has relatively small price fluctuations, whereas a highly volatile investment like Google stock will be subject to relatively larger price swings. Because the extent and timing of these bounces is unpredictable, the possibility exists that any asset could trade for a price that is lower than you might rationally expect. For investors, these bounces can be a source of concern when they create unrealized losses in a portfolio.

The real risk to investors, however, is that they might need to sell an asset at a relatively low price, thus turning an unrealized loss into a realized one. Also, investors may be forced to write off an asset if it loses its entire market value (traded value equals zero).

Nobody can predict the future. Therefore, we can only estimate when and by how much market sentiment might reverse itself, which types of assets might recover, and which become permanently impaired, as perhaps Citigroup could be. Because investors demand compensation for this risk, a portfolio of more volatile assets will often produce higher long-term gains than a portfolio of less volatile ones, but not always.

We mitigate volatility by diversifying. Because we do not expect all assets to move up and down in lockstep, we smooth out portfolio returns by investing in a broad range of assets. Diversification allows us to balance the ups with the downs and to limit the impact of any asset going to zero. We do not put all our eggs in one basket lest the basket turns out to resemble Citigroup at the end of 2008.

About the author: Elisabeth Kashner is an analyst with Contango’s Investment Strategy Group. She graduated from the University of San Francisco with an MS in financial analysis.

From Contango Capital Advisors, Inc.’s The Capital Advisor newsletter, Spring 2009.

*Artwork from ramsey everydaypants under Creative Commons license at Flickr.com.

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An important way to reduce the risk of investing is to diversify your investments. Diversification is akin to “not putting all your eggs in one basket.” For example, if your portfolio only consisted of stocks of technology companies, it would likely face a substantial loss in value if a major event adversely affected the technology industry.

There are different ways to diversify such a portfolio:
*You could invest in the stocks of companies belonging to other industry groups.
*You can allocate your portfolio among different categories of stocks, such as growth, value, or income stocks.
*You may include bonds and cash investments in your asset-allocation decisions (potential bond categories include government, agency, municipal, and corporate bonds).
*You might also diversify by investing in foreign stocks and bonds.

Diversification requires you to invest in securities whose investment returns do not move together. In other words, their investment returns have a low correlation. The correlation coefficient is used to measure the degree to which returns of two securities are related. For example, two stocks whose returns move in lockstep have a coefficient of +1.0. Two stocks whose returns move in exactly the opposite direction have a correlation of -1.0. To effectively diversify, you should aim to find investments that have a low or negative correlation.

A simple way to achieve diversification is with mutual funds and ETFs, or exchange traded funds. Mutual funds hold hundreds of securities in their portfolios. This provides a diversification advantage. You do face yearly management expenses with mutual funds, which typically run around 1.5% of your investment each year.

On the other hand, ETFs are instruments that are traded like stocks but they hold securities, such as stocks or bonds, like a mutual fund (typically to replicate an index, such as the S&P 500 or the Dow Jones Industrial Average), but annual costs are typically much lower. Though not as varied or usually as flexible as mutual funds, these investment vehicles can be an easy method to achieve diversification in investing.

To learn more about mutual funds and ETFs, call one one of Zions Direct’s investment advisers at 800-524-8875 and they will be happy to assist you.

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INVESTING IN BONDS |

Investing in bonds offers more protection than stocks. In the event a company defaults on its bonds or goes bankrupt, bond investors get repaid ahead of shareholders. This lower risk is a big reason that the investment rates of return on bonds are significantly lower than they are on stocks.

Bonds are also called fixed income securities because they pay interest that is fixed at a coupon rate. (Although there are bonds whose coupon rates are variable, most bonds have a fixed rate.) As a result, the amount of interest income is fixed over the term of the bond. For bond investors, who are generally more conservative than stock investors, these predictable cash flows allow them to sleep at night.

For example, say you have a $1,000 bond that has a 5-year term and coupon rate of 7%. This bond would generate $70 a year in interest for each of the next five years. Since it is conventional for bonds to pay interest every six months, this means you receive $35 in interest twice a year. From an investing point of view, this is preferable: you pocket the income sooner, and have a chance to reinvest it. This reinvested income is an important part of a bond’s total return.

Companies often prefer to sell bonds instead of stock since they are allowed to deduct the interest expense on bonds from their taxable income. When they sell bonds, companies hire an investment bank. Investment banks compete aggressively to earn lucrative underwriting fees.

However, investment banks also collaborate often as a syndicate to sell a bond issue, splitting the underwriting fees. The syndicate’s lead manager gets the largest share of fees, the largest share of the bond issue, and the most prestige. Co-managers receive a smaller share of fees, commensurate with a smaller share of the bond issue. Many underwriting deals involve more than one lead manager, and as many as a dozen co-managers.

The underwriting syndicate prices a bond issue by looking at interest rates of bonds with similar characteristics. Usually, this means looking at the yields of bond issues by companies with a similar credit rating as the bond issuer. If the issuer has a lower credit rating, the syndicate will likely have to add a spread to compensate investors for the extra perceived risk.

For example, if ABC Co. has an investment-grade rating, it can likely sell its bonds at the same yield as the recently issued bonds of XYZ Co., which also has an investment-grade rating. However, if ABC has a lower rating, the syndicate will likely have to add some basis points to increase the yield to a level that entices risk-averse investors. The size of the bond issue, as well as the general level of buying interest by market participants, will also influence the bond issue’s pricing.

How does an understanding of the bond underwriting process help you? Remember, the coupon rate of the bond is likely to have been fixed previously. As a result, a change in market interest rates results in the bond’s issue price moving away from its par value. Instead, it may sell at either a discount or premium to par value.

For example, assume an issue of 5-year bonds that is priced to have a yield-to-maturity of 10% is sold at par value. This implies that the market interest rate for bonds with similar characteristics is also 10%. If interest rates for bonds with similar characteristics fell to 9.5%, however, investors would be willing to pay a premium for a chance to receive a 10% coupon. In fact, they would be willing to pay up to $1,014 for each $1,000 bond, since that bond price results in a yield-to-maturity of 9.5%.

If interest rates for similar bonds rose to 10.5%, investors would require a discount for the bonds. This is because the market rate of 10.5% results in a bond with a 10% coupon being less attractive. In order to entice investors, the syndicate would have to lower the issue price to at least $974.

These changes in bond price illuminate a basic relationship of bonds: prices and bond yields move in opposite directions. When bond prices rises, yields fall. When bond prices fall, yields rise. What causes bond prices to rise or fall? Higher inflation, or the prospect of higher inflation, is the main culprit. When inflation is likely, investors demand a higher yield to compensate them for an anticipated loss in the value of their bonds.

The risk of bond prices falling from a higher expected inflation is called inflation risk. The Federal Reserve is likely to increase interest rates if it thinks inflation is likely to harm the economy. If the Fed hikes the fed funds target rate and discount rate, investors’ expectations prove accurate. The risk of market interest rates rising is called interest rate risk. Higher inflation is the usual reason for higher rates, but a change in supply-demand conditions can also affect interest rates.

A bond’s return is measured by its yield. The major ways of measuring yield are:

* Yield-to-maturity. A bond’s yield-to-maturity is the return you earn on a bond if you buy today and hold to maturity. It is the interest rate that sets the price you pay for the bond equal to the sum of its future coupon interest payments and value at maturity. Yield-to-maturity assumes that the bond’s coupon interest is reinvested at the same interest rate as the yield-to-maturity.

In fact, investors routinely sell bonds before they mature. In this case, a bond’s yield is best measured by its total return. Total return shows a bond’s rate of return over the time you hold the bond, and includes all capital gains and coupon interest income. Total return requires you to make an explicit assumption about the reinvestment rate you receive on your coupons.

* Yield-to-call. This is the yield you earn on a callable bond if you buy it today and hold it until its first call date. Companies choose to issue callable bonds because of their flexibility. If interest rates decline following the bond issue, it can call the bonds and refinance at a lower interest rate. Callable bond investors are compensated for this risk by receiving a premium for their bonds.

* Current yield. This is a snapshot of a bond’s value. It is the bond’s coupon rate divided by its current price. Since bond prices often change many times a day, the current yield also changes constantly.

The yield curve shows yields-to-maturity for a specific type of bond over a range of maturity terms. For example, the yield curve for U.S. Treasury securities shows the yields for Treasury bills and bonds over a range of 3 months to 30 years.

If you connect the dots that represent yields-to-maturity over the range of bond terms, you will see that shape of a yield curve usually slopes upward. This is called a normal yield curve. The opposite of a normal yield curve is an inverted yield curve. An inverted yield curve only occurs once in awhile. It shows that yields on longer-term bonds are lower than on short-term bonds, and is generally a signal that interest rates are reaching their peak. This occurs as investors, anticipating lower interest rates, favor bonds with longer maturities. This preference drives down their prices relative to the prices of bonds with shorter maturities. A flat yield curve shows, roughly, a straight line. This suggests that yields-to-maturity change little, regardless of maturity.

The yield curve changes shapes daily, often dramatically over the course of an economic cycle. A bond’s yield curve flattens when interest rates are at, or near, their highs. It also flattens if there is an imbalance in the supply of, and demand for, the bond. Conversely, a bond’s yield curve steepens when interest rates are headed higher, or for similar imbalances in the supply-demand relationship of the bond.

There are four major bond categories, including:

* Government bonds. Treasury bonds and their kin, inflation-protected Treasury securities, make up the government bond market in the U.S. The interest that you earn on these securities is exempt from state income tax. Treasury securities are considered the safest of bonds worldwide, since the risk of the U.S. government defaulting on its debt is essentially zero. However, the supply of Treasury securities is dwindling as the government pays down debt and reduces the sizes of new issues. The bond market has relied on the Treasury bond market as a benchmark for pricing other bonds. As a result of this drying-up in the supply of Treasurys, agency bonds appear likely to serve as a benchmark in the future.

The national treasuries of most countries sell government bonds. These usually have nicknames, the way U.S. government bonds are called Treasurys. For example, government bonds in the U.K. are called gilts. Government bonds in Japan are called JGBs. Government bonds in Germany are called bunds.

You can also invest in U.S. savings bonds. These are government securities sold in denominations of as little as $25. There are three types of savings bonds: Series EE, Series HH, and Series I bonds. Series HH bonds are no longer issued by the U.S. Treasury, but the existing bonds continue to accrue interest. For more information, see the U.S. Treasury’s TreasuryDirect program.

* Corporate bonds. Companies of all sizes and industries sell corporate bonds. A company’s credit rating determines how cheaply it can sell its bonds to investors. Credit rating agencies assign an investment-grade rating to bonds of companies with the most financial resources and that are least likely to default on their debt. Investment-grade bonds pay smaller spreads over a benchmark bond than do below-investment grade bonds. These bonds are sometimes called “junk” bonds, because of their greater risk of default.

Some corporations also sell convertible and exchangeable bonds. Convertible bonds allow investors to convert the value of their bonds into shares of the company, if and when the price is good to do so. Exchangeable bonds allow investors to swap their bonds for shares of another company’s stock.

* Agency bonds. Government-sponsored enterprises such as Fannie Mae and Freddie Mac sell agency bonds. Fannie Mae and Freddie Mac are private corporations that focus on buying and selling residential mortgage securities. While the U.S. government does not explicitly guarantee the bonds of Fannie Mae and Freddie Mac, their size and importance in the economy makes the chance of their default extremely unlikely. As a result, their bonds are considered only slightly more risky than Treasury securities. The government does guarantee bonds sold by Ginnie Mae, Sallie Mae, and some other federal housing agencies.

Agency bonds are often structured in a complicated way. Residential mortgages and credit card receivables often serve as the collateral for these bonds. A risk is that the borrowers of these mortgages and credit cards will pay off their loans if interest rates begin to fall. This is called prepayment risk. Prepayment risk means that an investor in these bonds is repaid sooner than expected, and is forced to reinvest this amount at an interest rate that is usually lower.

* Municipal bonds. Municipal bonds, or “munis,” are issued by state and local governments. A revenue muni bond repays investors from the revenues directly earned from the project the bond is financing. These include bonds for transportation and other infrastructure-related projects. A general-obligation muni bond is a muni bond that will repay investors from the general tax coffers of the issuing authority. Interest on muni bonds is exempt from federal income tax. Residents of states who buy muni bonds issued by that state may be able to exempt interest income from state income taxes as well. This is called a double-exempt muni bond.

The larger your tax bracket, the greater the tax advantage of investing in muni bonds. For example, if you’re in the 25% income tax bracket, a 5.5% yield on a muni bond is equivalent to a taxable yield of 7.33%. This is called the taxable-equivalent yield. If you buy a muni bond that falls into the double-exempt category, the yield advantage is even higher. For example, if you pay a state income tax rate of 10%, your combined tax burden is 35%. This makes a double-exempt bond even more attractive. That 5.5% yield has a new, higher taxable-equivalent yield of 8.46%.

Zero-coupon bonds, or “zeros,” are issued at a steep discount to their par value. Instead of receiving coupon interest, investors earn imputed interest. For example, if you buy a 10-year zero-coupon bond that is discounted at an annual interest rate of 8%, you would pay $463. A year later, the bond’s price would rise to $500. This $37 appreciation in the first year represents imputed interest. The IRS also requires that you report this as taxable income. Since you owe taxes on money you don’t actually receive until the bond’s maturity, some financial planners advise that you buy zero-coupon bonds for tax-advantaged accounts. These include retirement accounts such as IRAs and 401(k) plans.

*Artwork from imeusdesign under Creative Commons license at Flickr.com.

THE ESSENTIAL BUDGET |

Many of us fail to see the relationship between budgeting and saving. Budgeting is a process that starts by setting spending targets that help you to stay within your means. A personal budget is useful in controlling personal expenses.

Reasons for having a personal budget usually change over time. In our 20s, we focus on repaying debts or saving for a down payment on a home. We may want to budget in order to set aside several thousand dollars for a trip around the world. In our 30s and 40s, budgeting is important to help pay for our children’s living and college expenses. By the time we enter our 50s, saving for retirement becomes a major financial goal.

Budgeting is the cornerstone of saving. No personal budget often means an inability or unwillingness to identify a potential source of regular savings. A personal budget imposes some discipline on adhering to a savings plan.

Some important steps in setting up a personal budget include:

* Select a period to measure. A monthly budget often works best. Most of us pay our rent, mortgage, and utility bills monthly. It is also the period that many of us get paid. If you are paid every two weeks, you can add the amounts to determine a monthly figure.
* Calculate net cash flow for the period. Your personal net cash flow subtracts your cash expenses (cash outflows) from you cash income (cash inflows). If you charge with your credit card, add those charges to your cash expenses. Using your credit card is only a means of postponing cash outflows. While you’re at it, be sure to add the little items, like those $4 lattes and video store trips. These items easily add up to $100 or more in a month.
* Keep records. Accurate records will help you to keep a history of several budgeting periods. You can string together 12 months of budgets to create an annual budget. You can use your budget records to compare actual and budgeted spending. The differences in actual and budgeted spending are called variances. Be as precise in your record keeping as you can afford to be.
* Monitor and review. Your records help you to compare how well you budget. The key is to identify positive budget variances—where your budgeted cash outflows are less than your actual cash outflows. These variances are a source of funds to save and invest. For example, if you budget $1,500 in monthly cash outflows but routinely only have cash outflows of $1,400, you have identified a source of savings worth $100 a month.
* Save for an emergency fund. As you gradually find you can save each month, you may want to first set aside enough for an emergency fund. An emergency fund consists of three to six months of savings. An emergency fund is also called a rainy-day fund and should be used only to pay for unanticipated financial setbacks. These setbacks may include losing a job, becoming ill, or suffering the death of a family member.
* Invest regularly. A personal budget may have led you to identify a way to save $100 a month. Investing this extra $100 every month lets you take advantage of dollar-cost averaging. Dollar-cost averaging is a basic principle of investing. Studies consistently show that, over time, dollar-cost averaging buys shares at a cheaper price than if you attempted to time your purchases. In addition, your regular contributions fuel the compounded growth of your investments.

The six tables, below, show how even amounts of as little as $25 or $50 can grow if invested every month. Investment horizons range from one to 30 years. Interest rates range from 2% to 5%. For example, $50 invested at 5% every month for the next five years will grow to $3,400.

The tables also illustrate the benefit of compounding. For example, $25 invested for five years at 5% grows to $1,700. However, $25 invested for 10 years at 5% grows to $3,882. This is an extra $482 of compounded interest that you earn during those five years.

Since your emergency fund serves a vital purpose, you want to have access to the funds. At the same time, you want to earn interest on these funds. As a result, you should plan to invest it in only the most liquid and safest of investments. These investments include CDs, savings deposits, and money market accounts. All of these instruments are insured by the FDIC for currently up to $250,000 per depositor per institution (until 31 December 2009). Money market mutual funds are not guaranteed by the FDIC.

An effective investing technique for your emergency fund is laddering. First, you divide your investments into roughly equal amounts. Next, you deposit these amounts in short-term CDs of different maturities. The length of maturity terms should be spaced at intervals that don’t jeopardize your access to at least some of your emergency fund at any given time.

For example, you may wish to divide $4,000 of a $5,000 fund into four equal parts, keeping $1,000 in an account you can access immediately. Next, you may consider investing $1,000 each in a 3-, 6-, 9-, and 12-month CD. As each CD matures, you extend, or roll over, the CD for one year. This allows you to establish a stream of CD investments that mature every three months. If you ever need more than $1,000 of your fund, the longest you would have to wait (unless you paid a fee for early redemption) would be three months.

*Artwork from imeusdesign under Creative Commons license at Flickr.com.