Archive-name: investment-faq/general/part5
Version: $Id: faq-p5,v 1.35 1996/09/18 12:47:54 lott Exp lott $
Compiler: Christopher Lott, cml@cs.umd.edu

This is the general FAQ for misc.invest, part 5 of 7.

Compilation copyright (c) 1996 by Christopher Lott.  Use and copying
of this information, distribution of the information on electronic
media, and preparation of derivative works based upon this information
are permitted, so long as the following conditions are met:
    + No fees or compensation are charged for this information,
      excluding charges for the media used to distribute it.
    + Proper attribution is given to the authors of individual articles.
    + This copyright notice is included intact.

Disclaimer: This information is made available AS IS, and no
warranty is made about its quality or correctness.

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Subject: Misc - Investment Jargon
Last-Revised: 28 May 1996
From: jhsu@eng-nxt03.cso.uiuc.edu, e-krol@uiuc.edu, duerr@horta.mmm.com,
	dennis@netcom.com, gibbs@andrews.edu, kamlet@infinet.com  

Some common jargon is explained here briefly.  See other articles
in the faq for more detailed explanations on most of these terms.

bottom fishing:	purchasing of stock declining in value

broker:		The term was first used around 1622 to mean an agent in
		financial transactions.  Originally, it referred to wine
		retailers - those who broach (break) wine casks.

day order:	Order to buy/sell securities at a certain price that
		expires if not executed on the day it is placed.

elves index:    Louis Rukeyser's index of the opinions on the general stock
		market for the next 6 months.  He polls 10 analysts, the same
		ones every week, to ask what they think the general trend will
		be, namely bullish (+1), neutral (0), or bearish (-1).  The
		index range is -10 to +10.

going long:	Buying and holding stock

going short:	Selling stock short, i.e., borrowing and selling stock you
		do not own with the intention of buying it later for less.

GTC order:	Order to buy/sell securities at a certain price that is
		"Good Until Canceled", i.e., never expires.

overbought: 	Judgemental adjective describing a market or stock implying
 [oversold] 	That people have been wildly buying [selling] it and that
		there is very little chance of it moving upward [downward]
		in the near term.  Usually it applies to movement momentum
		rather than what the security should cost.

over valued, under valued, fairly valued: judgmental adjectives describing
		that a market or stock is over/under/fairly priced with 
		respect to what people believe the security is really worth.

uptick: 	Uptick means the next trade is at a higher price than the
		previous trade.  Meaningful for the NYSE and AMEX; not so
		meaningful for OTC markets (NASDAQ).  Certain transactions
		can only be executed on an uptick (e.g., shorting).

downtick: 	Downtick means the next trade is at a lower price than the
		previous trade.  See uptick.


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Subject: Misc - Real Estate Investment Trusts (REITs)
Last-Revised: 8 Dec 1995
From: CJXG40A@prodigy.com

REITs are companies invested in real estate holdings. You get a share of 
the earnings, depreciation, etc from the portfolio of real estate 
holdings that the REIT (Real Estate Investment Trust)  owns. Thus, you 
get many of the same benefits of being a landlord without too many of the 
hassles. You also have a much more liquid investment than you do when 
directly investing in real estate. The downsides are that you have no 
control over when the company will sell its holdings or how it will 
manage them, like you would have if you owned an apartment building on 
your own.

Essentially, REITs are the same as stocks, only the business they are 
engaged in is different than what is commonly referred to as "stocks" by 
most folks. Common stocks are ownership shares generally in manufacturing 
or service businesses. REITs  shares on the other hand are the same, just 
engaged in the holding of an asset for rental, rather than producing a 
manufactured product.  In both cases, though, the shareholder is paid 
what is left over after business expenses, interest/principal, and 
preferred shareholders' dividends are paid. Common stockholders are 
always last in line, and their earnings are highly variable because of 
this. Also, because their returns are so unpredictable, common 
shareholders demand a higher expected rate of return than lenders 
(bondholders). This is why equity financing is the highest-cost form of 
financing for any corporation, whether the corporation be a REIT or mfg 
firm.

An interesting thing about REITs is that they are probably the best 
inflation hedge around. Far better than gold stocks, which give almost no 
return over long periods of time. Most of them yield 7-10% dividend yield.
 However, they almost always lack the potential for tremendous price 
appreciation (and depreciation) that you get with most common stocks. 
There are exceptions, of course, but they are few and far between.

If you invest in them, pick several REITs instead of one. They are 
subject to ineptitude on the part of management just like any company's 
stock, so diversification is important. However, they are a rather 
conservative investment, with long-term returns lower than common stocks 
of other industries. This is because rental revenues do net usually vary 
as much as revenues at a mfg or service firm.


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Subject: Options - Basics
Last-Revised: 21 Sep 1994
From: a_s_kamlet@att.com

An option is a contract between a buyer and a seller.  The option
is connected to something, such as a listed stock, an exchange index,
futures contracts, or real estate.  For simplicity, I will discuss
only options connected to listed stocks.

The option is designated by:
	- Name of the associated stock
	- Strike price
	- Expiration date
	- The premium paid for the option, plus brokers commission.

The two most popular types of options are Calls and Puts.

    Example:  The Wall Street Journal might list an 
                IBM Oct 90 Call @ $2.00

    Translation:  This is a Call Option

	The company associated with it is IBM.
	(See also the price of IBM stock on the NYSE.)

	The strike price is $90.00  If you own this option,
	you can buy IBM @ $90.00, even if it is then trading on
	the NYSE @ $100.00 (I should be so lucky!)

	The option expires on the third Saturday following
	the third Friday of October, 1992.
	(an option is worthless and useless once it expires)

	If you want to buy the option, it will cost you $2.00
	plus brokers commissions.   If you want to sell the option,
	you will get $2.00 less commissions.

In general, options are written on blocks of 100s of shares.  So when
you buy "1" IBM Oct 90 Call @ $2.00 you actually are buying a contract
to buy 100 shares of IBM @ $90 per share ($9,000) on or before the
expiration date in October.   You will pay $200 plus commission to buy
the call.

If you wish to exercise your option you call your broker and say you
want to exercise your option.  Your broker will arrange for the person
who sold you your option (a financial fiction:  A computer matches up
buyers with sellers in a magical way) to sell you 100 shares of IBM for
$9,000 plus commission.

If you instead wish to sell (sell=write) that option you instruct your
broker that you wish to write 1 Call IBM Oct 90s, and the very next day
your account will be credited with $200 less commission.

If IBM does not reach $90 before the call expires, the option writer
gets to keep that $200 (less commission)   If the stock does reach above
$90, you will probably be "called."

If you are called you must deliver the stock.  Your broker will sell
your IBM stock for $9000 (and charge commission).  If you owned the
stock, that's OK. If you did not own the stock your broker will buy
the stock at market price and immediately sell it at $9000.  You pay
commissions each way.

If you write a Call option and own the stock that's called "Covered
Call Writing."  If you don't own the stock it's called "Naked Call
Writing."   It is quite risky to write naked calls, since the price of
the stock could zoom up and you would have to buy it at the market price.

My personal advice for new options people if to begin by writing
covered call options for stocks currently trading below the strike
price of the option (write out-of-the-money covered calls).

When the strike price of a call is above the current market price of
the associated stock, the call is "out of the money," and when the
strike price of a call is below the current market price of the
associated stock, the call is "in the money."

Most regular folks like you and me do not exercise our options; we
trade them back, covering our original trade.  Saves commissions and
all that.

The other common option is the PUT.  If you buy a put from me, you
gain the right to sell me your stock at the strike price on or before
the expiration date.  Puts are almost the mirror-image of calls. 

For more information, call 1-800-OPTIONS to request their free booklet
"Characteristics and Risks of Listed Options."


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Subject: Options - How to order
Last-Revised: 25 Jan 96
From: optionfool@aol.com

When you are dealing in options, order entry is a critical factor in
getting good fills.  Mis-spoken words during order entry can lead to
serious money errors.  This article discusses how to place your order
properly, and focuses on the simplest type of order, the straight buy
or sell.  

There is a set sequence of wording that Wall Street professionals use
among themselves to avoid errors.  Orders are always "read" in this
fashion.  Clerks are trained from day one to listen for and repeat for
verification the orders in the same way.  If you, the public customer,
adopt the same lingo, you'll be way ahead of the game.  In addition to
preventing errors in your account, you will win the respect of your
broker as a savvy, street-wise trader.  Here is the "floor-ready"
sequence:

After identifying yourself and declaring an intent to place an order,
clearly say the following:

[For a one-sided order (simple buy or sell)]

"Buy 10 Calls XYZ February 50's at 1 1/2 to open, for the day"

Always start with whether it is a buy or sell.  When you do so, the
clerk will reach for the appropriate ticket.

Next comes the number of contracts.  Remember, to determine the money
amount of the trade, you multiply this number of contracts by 100 and
then by the price of the option.  In the above example, 10 x 100 x 
1 1/2 = $1,500.  Don't ever mention the equivalent number of underlying
shares.  One client of mine used to always order 1000 contracts when
he really meant to buy 10 options (equivalent to 1000 shares of stock).

Thirdly, you name the stock.  Call it by name first and then state the
symbol if you know it.  Be aware of similar sounding letters.  B, T,
D, E etc., can all sound alike in a noisy brokerage office.  Over The
Counter stocks can have really strange option symbols.

The month of expiration comes next.  Again, be careful.  September and
December can sound alike.  Floor lingo uses colorful nicknames to
differentiate.  The "Labor Day" 50s are Sept options while the
"Christmas" 50s are the December series.  But don't get carried away
with trying to use the slang.  Don't ever use it to show off to a
clerk.  Simply use it for accuracy (e.g. "the December as in Christmas
50s").

Then comes the strike price.  Read it plainly and clearly.  15 and 50
sound alike as does 50 and 60.

Name the limit price or whether it is a market order.  Qualify it if
it is something other than a limit or market order.  For example, 
1 1/2 Stop.  Pet peeve of many clerks: Don't say "or better" when
entering a plain limit order.  That is assumed in the definition of a
limit order.  "Or better" is a designation reserved for a specific
instance where one names a price higher than the current market
bid-ask as the top price to be paid.  For instance, an OEX call is 1
1/2 to 1 5/8 while you are watching the President on CNN.  He hints at
a budget resolution and you jump on the phone.  You want to buy the
calls but not with a market order.  Instead, you give the floor some
room with an "1 7/8 or better order".  Clerks use this tag as a
courtesy to each other to let them know they realize the current
market is actually below the limit price.  This saves them a
confirming phone call.

Next is the position of the trade, that is, to Open or to Close.  This
is the least understood facet.  It has nothing to do with the opening
bell or closing bell.  It tells the firm if you are establishing a new
position (opening) or offsetting an existing one (closing).  Don't
just think that by saying "Buy", your firm knows you are opening a new
position.  Remember, options can be shorted.  One can buy to open or
to close.  Likewise, one can sell to open or to close.

If your order has any restrictions, place them here at the end.
Examples are All or None, Fill or Kill, Immediate or Cancel, Minimum
of 15 (or whatever you want).  Remember, restricted order have no
standing.  Unrestricted orders have execution priority.

Finally, state if the order is a day order or Good Till Canceled.  If
you don't say, the broker will assume it to be a day order only, but
the client should mention it as a courtesy.

Very Important: Your clerk will read the order back to you in the same
way for verification.  LISTEN CAREFULLY.  If you don't catch an error
at this point, they can stick you with the trade.

Proper order entry can mean the difference between a successful
execution and a missed fill or a poor price.  Doing it the right way
can save you precious seconds.  Further, it will mean a better
relationship with your broker.  The representative will act
differently when he sees a customer who knows what he is doing.  The
measure of respect given to someone who knows how to give an order
properly is considerable.  After all, you've just proven that you
"speak" his language.

This article is Copyright 1996, Hubert Lee, optionfool@aol.com.


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Subject: Options - Splits
Last-Revised: 4 Mar 1996
From: kamlet@infinet.com

When a stock splits, call and put options are adjusted accordingly.
In almost every case the Options Clearing Corporation (OCC) has
provided rules and procedures so options investors are "made whole"
when stocks split.  This makes sense since the OCC wishes to maintain
a relatively stable and dependable market in options, not a market in
which options holders are left holding the bag every time that a
company decides to split, spin off parts of itself, or go private.

A stock split may involve a simple, integral split such as 2:1 or 3:1,
it may entail a slightly more complex (non-integral) split such as
3:2, or it may be a reverse split such as 4:1.  When it is an integral
split, the option splits the same way, and likewise the strike price.
All other splits usually result in an "adjustment" to the option. 

Example:  XYZ Splits 2:1  
    The XYZ March 60 call splits so the holder now holds 2 March 30
    calls. 

Example:  XYZ Splits 3:2
    The XYZ March 60 call is adjusted so that the holder now holds one
    March $40 call covering 150 shares of XYZ. (The call symbol is
    adjusted as well.)

Example:  XYZ declares a 5% stock dividend.
    Generally a stock dividend of 10% or less is called a stock
    dividend and does not result in any options adjustments, while
    larger stock dividends are called stock splits and do result in
    options splits or readjustments. (The 2:1 split is really a 100%
    stock dividend, a 3:2 split is a 50% dividend, and so on.) 

Example:  ABC declares a 1:5 reverse split
    The ABC March 10 call is adjusted so the holder now holds one ABC
    March 50 call covering 20 shares.

Spin-offs and buy-outs are handled similarly:

Example:  WXY spins off 1 share of QXR for every share of WXY held.
    Immediately after the spinoff, new WXY trades for 60 and QXR
    trades for $40.  The old WXY March 100 call is adjusted so the
    holder now holds one call for 100 sh WXY @ 60 plus 100 sh WXY at 40.

Example:  XYZ is bought out by a company for $75 in cash, to holders
    of record as of March 3.  Holders of XYZ 70 call options will have
    their option adjusted to require delivery of $75 in cash, payment
    to be made on the distribution date of the $75 to stockholders.

    Note: Short holders of the call options find themselves in the
    same unenviable position that short sellers of the stock do.   In
    this sense, the options clearing corporation's rules place the
    options holders in a similar risk position, modulo the leverage of
    options, that is shared by shareholders.

The Options Clearing Corporation's Adjustment Panel has authority to
deviate from these guidelines and to rule on unusual events.

More information concerning options is available from the Options
Clearing Corporation (800-OPTIONS) and may be available from your
broker in a pamphlet "Characteristics and Risks of Standardized
Options."


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Subject: Options - Symbols
Last-Revised: 12 Sep 1993
From: di236@cleveland.Freenet.Edu

Stock options use the following symbols.

	Month  Call    Put
	-----  ----    ---
	Jan	A	M
	Feb	B	N
	Mar	C	O
	Apr	D	P
	May	E	Q
	Jun	F	R
	Jul	G	S
	Aug	H	T
	Sep	I	U
	Oct	J	V
	Nov	K	W
	Dec	L	X

   Price Code	Price
   ----------	-----
	A	x05
	U	7.5
	B	x10
	V	12.5
	C	x15
	W	17.5
	D	x20
	X	22.5
	E	x25
	F	x30
	G	x35
	H	x40
	I	x45
	J	x50
	K	x55
	L	x60
	M	x65
	N	x70
	O	x75
	P	x80
	Q	x85
	R	x90
	S	x95
	T	x00


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Subject: Regulation - Money-Supply Measures M1, M2, and M3
Last-Revised: 11 Dec 1992
From: merritt@macro.bu.edu

M1: Money that can be spent immediately.  Includes cash, checking accounts,
    and NOW accounts.

M2: M1 + assets invested for the short term.  These assets include money-
    market accounts and money-market mutual funds.

M3: M2 + big deposits.  Big deposits include institutional money-market
    funds and agreements among banks.

"Modern Money Mechanics," which explains M1, M2, and M3 in gory detail,
is available free from:
        Public Information Center
        Federal Reserve Bank of Chicago
        P.O. Box 834
        Chicago, Illinois 60690


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Subject: Regulation - Federal Reserve and Interest Rates
Last-Revised: 8 May 1994
From: 0009655@hac.com, bhatt@ticipa.pac.sc.ti.com, dprnxb@inetg1.ARCO.COM, 
	joelau@panix.com 

This article discusses the interest rates which are managed or
influenced by the US Federal Reserve Bank, a collective term for
the collection of Federal Reserve Banks across the country.

The Discount Rate is the interest rate charged by the Federal Reserve
when banks borrow "overnight" from the Fed.  The discount rate is
under the direct control of the Fed.  The discount rate is always
lower than the Federal Funds Rate (see below).  Generally only large
banks borrow directly from the Fed, and thus get the benefit of being
able to borrow at the lower discount rate.  As of May 1994, the
discount rate was at 3.00%.     

The Federal Funds Rate is the interest rate charged by banks when
banks borrow "overnight" from each other.  The funds rate fluctuates
according to supply and demand and is not under the direct control of
the Fed, but is strongly influenced by the Fed's actions.  As of May
1994, the target funds rate is 3.75%; the actual rate varies above and
below that figure.  Fed actions in 1&2Q94 have focused on this rate.

The Fed adjusts the funds rate via "open market operations".  What
actually happens is that the Fed sells US treasury securities to
banks.  As a result, the bank reserves at the Fed drop.  Given that
banks have to maintain at the Fed a certain level of required reserves
based on their demand deposits (checking accounts), they end up
borrowing more from each other to cover their short position at the 
Fed.  The resulting pressure on intrabank lending funds drives the 
funds rate up.

The Fed has no idea of how many billions of US treasuries it needs to
sell in order for the funds rate to reach the Fed's target.  It goes
by trial and error.  That's why it takes a few days for the funds rate
to adjust to the new target following an announcement. 

Adjustments in the discount rate usually lag behind changes in the
funds rate.  Once the spread between the two rates gets too large
(meaning fat profits for the big banks which routinely borrow from the
Fed at the discount rate and lend to smaller banks at the funds rate)
the Fed moves to adjust the discount rate accordingly.  It usually
happens when the spread reaches about 1%. 

Another interest rate of significant interest is the Prime Rate, 
the interest that a bank charges its "best" customers.  There is no
single prime rate, but the commercial banks generally offer the same
prime rate.  The Fed does not adjust a bank's prime rate directly, 
but indirectly.  The change in discount rates will affect the prime
rate.  

For an in-depth look at the Federal Reserve, read _Secrets of the temple:
how the Federal Reserve runs the country_, by William Greider. 


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Subject: Regulation - Securities and Exchange Commission (U.S.)
Last-revised: 4 Jun 1994
From: dennis@netcom.com

Just in case you want to ask questions, complain about your broker,
or whatever, here's the vital information:

	Securities and Exchange Commission
	450 5th Street, N. W.
	Washington, DC 20549

Office of Public Affairs:   +1 202 272-2650
Office of Consumer Affairs: +1 202 272-7440


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Subject: Regulation - SEC Rule 144
Last-Revised: 7 Nov 1995
From: Bill Rini <billman@centcon.com>

SEC Rule 144 allows for the sale of restricted securities in limited
quantities.  Rule 144 generally applies to corporate insiders and
buyers of private placement securities that were not sold under SEC
registration statement requirements.  

Corporate insiders are officers, directors, or anyone else owning
10% or more of the outstanding company securities.  Stock either
acquired through compensation arrangements or open market purchases is
considered restricted for as long as the insider is affiliated with
the company.  If, however, the buyer has no management or major
ownership interests in the company, the restricted status of the
securities expires over a period of time.

Under Rule 144, restricted securities may be sold to the public
without full registration (registration is completed upon transfer of
ownership) if the following conditions are met. 

1.  The securities have been owned and fully paid for for at least two
    years, or upon the death of the owner. 

2.  Current financial information must be made available to the buyer.
    Companies that file 10K and 10Q reports with the SEC satisfy this
    requirement. 

3.  The seller must file Form 144, "Notice of Proposed Sale of
    Securities," with the SEC no later than the first day of the sale.
    The filing is effective for 90 days.  If the seller wishes to extend
    the selling period or sell additional securities, a new form 144
    is required. 

4.  The sale of the securities may not be advertised and no additional
    commissions can be paid. 

5.  If the securities were owned for between two and three years, the
    volume of securities sold is limited to the greater of 1% of all
    outstanding shares, or the average weekly trading volume for the
    proceeding four weeks.  If the shares have been owned for three
    years or more, no volume restrictions apply to non-insiders.
    Insiders are always subject to volume restrictions. 

This article is copyright 1995 by Bill Rini.


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Subject: Regulation - SEC Registered Advisory Service
Last-revised: 9 Jan 1996
From: paulmaf@eskimo.com

Some advisers will advertise with the information that they are an
S.E.C. Registered Advisory Service.  This does not mean a damn thing
except that they have obeyed the law and registered as the law requires.
All it takes is filling out a long form, $150 and no convictions for
financial fraud.

If they attempt to imply anything in their ads other than the fact
they are registered, they are violating the law.  Basically, this means
that they can inform you that they are registered in a none-too-prominent
way.  If the information is conveyed in any other way, such as being very
prominent, or using words that convey any meaning other than the simple
fact of registration; or implying any special expertise; or implying
special approval, etc., they are violating the law and can easily be
fined and as well as lose their registration.


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Subject: Regulation - Series of Examinations/Registrations
Last-revised: 15 Nov 1995
From: cluh@blue.weeg.uiowa.edu

The following series of examinations/registrations are available:

Series  3 - Commodity Futures Examination
        4 - Registered Options Principal
        5 - Interest Rate Options Examination
        6 - Investment Company and Variable Contracts Products Rep.
        7 - Full Registration/General Securities Representative
          - Securities Traders (NYSE)
          - Trading Supervisor (NYSE)
        8 - General Securities Sales Supervisor
          - Branch Office Manager (NYSE)
       11 - Assistant Representative/Order Processing
       15 - Foreign Currency Options
       16 - Supervisory Analyst
       22 - Direct Participation Program Representative
       24 - General Securities Principal
       26 - Investment Comapny and Variable Contracts Principal
       27 - Financial and Operations Principal
       28 - Introducing B/D/Financial and Operations Principal
       39 - Direct Participation Program Principal
       42 - Options Representative
       52 - Municipal Securities Representative
       53 - Municipal Securities Principal
       62 - Corporate Securities Representative
       63 - Uniform Securities Agent State Law Examination
       65 - Uniform Investment Advisor Law Examination


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Subject: Regulation - SIPC, or How to Survive a Bankrupt Broker
Last-Revised: 1 Sep 1994
From: Arthur.S.Kamlet@att.com, barrett@asgard.cs.colorado.edu

The U.S. Securities Investor Protection Corporation (SIPC) is a federally
chartered private corporation whose job is to insure shareholders against
the situation of a U.S. stock-broker going bankrupt. 

The National Association of Security Dealers requires all of their
member brokers to have SIPC insurance.   Many brokers supplement the
limits that SIPC insures ($100,000 cash and $500,000 total, I think--
I could be wrong here) with additional policies so you are covered up
to $1 million or more.

If you deal with discount houses, all brokerages, their clearing agents,
and any holding companies they have which can be holding your assets
in street-name had better be insured with the S.I.P.C.  You're going
to be paying an SEC tax (about US$3.00) on any trade you make anywhere,
so make sure your getting the benefit; if a broker goes bankrupt it's
the only thing that prevents a total loss.  Investigate thoroughly!

The bottom line is that you should not do business with any broker who
is not insured by the SIPC.


-----------------------------------------------------------------------------

Subject: Retirement Plan - 401(k)
Last-Revised: 7 Jan 1995
From: nieters@crd.ge.com, dolson@baldy.den.mmc.com

A 401(k) plan is an employee-funded, retirement savings plan.  It
takes its name from the section of the Internal Revenue Code of
1986 which created these plans.  An employer will typically match
a certain percent of the amount contributed to the plan by the
employee, up to some maximum.  Note: I have been looking at my 401(k)
in pretty good detail lately, but this article is subject to my
standard disclaimer that I'm not responsible for errors or poor advice.

Example: the employee can contribute up to 7% of gross pay to the
	 fund, and the company matches this money at 50%.  Total
	 contribution to the plan is 10.5% of the employee's salary.

Pre-tax contributions: Employees have the option of making all or part
of their contributions from pre-tax (gross) income.  This has the added
benefit of reducing the amount of tax paid by the employee from each
check now and deferring it until you take this pre-tax money out of
the plan.  Both the employer contribution (if any) and any growth of
the fund compound tax-free until age 59-1/2, when the employee is
eligible to receive distributions from the plan.  

Pre-tax note: Current law allows up to a maximum of 15% to be deducted
from your pay before federal income and (in most places) state or local
income taxes are calculated.  There are IRS rules which regulate
withdrawals of pre-tax contributions and which place limits on pre-tax
contributions; these affect how much you can save.

After-tax contributions: If you elect to save any of your contributions
on an after-tax basis, the contribution comes out of your pay after
taxes are deducted.  While it doesn't help your current tax situation,
these funds may be easier to withdraw since they are not subject to the
strict IRS rules which apply to pre-tax contributions.  Later, when
you receive a distribution from the 401(k), you pay no tax on the
portion of your distribution attributed to after-tax contributions.

Contribution limits: IRS rules won't allow contributions on pay over
a certain amount (limit was $228,860 in 1992, and is subject to change).
The IRS also limits how much total pre-tax pay you can contribute
(limit was $8,728 in pre-tax money in 1992, and is subject to change).
Employees who are defined as "highly compensated" by the IRS (salary
over $60,535 in 1992 - again, subject to change) may not be allowed to
save at the maximum rates.  Your benefits department should notify you
if you are affected.  Finally, the IRS limits the total amount contributed
to your 401(k) and pension plans each year to the lesser of some amount
($30,000 in 1992, and subject to change of course) or 25% of your annual
compensation.  This is generally taken to mean the amount of taxable
income reported on your W-2 form(s).

Advantages: Since the employee is allowed to contribute to his/her
401(k) with pre-tax money, it reduces the amount of tax paid out of
each pay check.  All employer contributions and fund gains (or losses)
grow tax-free until age 59-1/2.  The employee can decide where to
direct future contributions and/or current savings.  If your company
matches your contributions, it's like getting extra money on top of
your salary.  The compounding effect of consistent periodic contributions
over the period of 20 or 30 years is quite dramatic.  Because the
program is a personal investment program for you, the benefits may
not be used as security for loans outside the program.  This includes
the additional protection of the funds from garnishment or attachment
by creditors or assigned to anyone else except in the case of domestic
relations court cases dealing with divorce decree or child support
orders.  While the 401(k) is similar in nature to an IRA, an IRA won't
enjoy any matching company contributions, and personal IRA contributions
are subject to various limitations; see the article about IRA's elsewhere
in this FAQ.

Disadvantages: It is "difficult" (or at least expensive) to access
your 401(k) savings before age 59-1/2 (see next section).  401(k) plans
don't have the luxury of being insured by the Pension Benefit Guaranty
Corporation (PBGC).  (But then again, some pensions don't enjoy this
luxury either.)

Investments: A 401(k) should have available different investment
options.  These funds usually include a money market, bond funds of
varying maturities (short, intermediate, long term), company stock,
mutual fund, US Series EE Savings Bonds, and others.  The employee
chooses how to invest the savings and is typically allowed to change
where current savings are invested and/or where future contributions
will go a specific number of times a year.  This may be quarterly,
bi-monthly, or some similar time period.  The employee is also
typically allowed to stop contributions at any time.  

Accessing savings before age 59-1/2: It is legal to take a loan from
your 401(k) before age 59-1/2 for certain reasons including hardship
loans, buying a house, or paying for education.  When a loan is obtained,
you must pay the loan back with regular payments (these can be set up
as payroll deductions) but you are, in effect, paying yourself back
both the principal and the interest, not a bank.  If you take a
withdrawal from your 401(k) as money other than a loan, not only must
you pay tax on any pre-tax contributions and on the growth, you must
also pay an additional 10% penalty to the government.  In short, you
can get the money out of your 401(k) before age 59-1/2 for something
other than a loan, but it is expensive to do so.  

Accessing savings after age 59-1/2: At age 59-1/2 you are allowed to
access your 401(k) savings.  This can be done as a lump sum distribution
or as annual installments.  If you choose the latter, money not withdrawn
from the 401(k) can continue to grow in the fund.  401(k) distributions
are separate from pension funds.

Changing jobs: Since a 401(k) is a company administered plan, if you
change or lose jobs, this can affect your savings.  Different companies
handle this situation in different ways.  Some will allow you to keep
your savings in the program until age 59-1/2.  This is the simplest
idea. Others will require you to take the money out.  Things get more
complicated here.  Your new company may allow you to make a "rollover"
contribution to its 401(k) which would let you take all the 401(k)
savings from your old job and put them into your new company's plan. 
If this is not a possibility, you may have to look into an IRA or other
retirement account to put the funds.  

Whatever you do regarding rollovers, BE EXTREMELY CAREFUL!!  This can
not be emphasized enough.  Recent legislation by Congress has added a
twist to the rollover procedures.  It used to be that you could receive
the rollover money in the form of a check made out to you and you had
a period of time (60 days) to roll this cash into a new retirement
account (either 401(k) or IRA).  Now, however, employees taking a
withdrawal have the opportunity to make a "direct rollover" of the
taxable amount of a 401(k) to a new plan.  This means the check goes
directly from your old company to your new company (or new plan). 
If this is done (ie. you never "touch" the money), no tax is withheld
or owed on the direct rollover amount. 

If the direct rollover option is not chosen, i.e., a check goes through
your grubby little hands, the withdrawal is immediately subject to a
mandatory tax withholding of 20% of the taxable portion, which the old
company is required to ship off to the IRS.  The remaining 80% must be
rolled over within 60 days to a new retirement account or else is is
subject to the 10% tax mentioned above.  The 20% mandatory withholding
is supposed to cover possible taxes on your withdrawal, and can be
recovered using a special form filed with your next tax return to the IRS. 
If you forget to file that form, however, the 20% is lost.  Naturally,
there is a catch.  The 20% withheld must *also* be rolled into a new
retirement account within 60 days, out of your own pocket, or it will be
considered withdrawn and subject to the 10% tax.  Check with your benefits
department if you choose to do any type of rollover of your 401(k) funds.  

Here's an example to clarify an indirect rollover.  Let us suppose that you
have $10,000 in a 401k, and that you withdraw the money with the intention
of rolling it over - no direct transfer.  Under current law you will receive
$8,000 and the IRS will receive $2,000 against possible taxes on your
withdrawal.  To maintain tax-exempt status on the money, $10,000 has to
be put into a new retirement plan within 60 days.  The immediate problem is
that you only have $8,000 in hand, and can't get the $2,000 until you file
your taxes next year. What you can do is:
  1.  Find $2,000 from somewhere else.  Maybe sell your car.
  2.  Roll over $8,000.  The $2,000 then loses its tax status and you
      will owe income tax and the 10% tax on it.

Epilogue: If you have been in an employee contributed retirement plan
since before 1986, some of the rules may be different on those funds
invested pre-1986.  Consult your benefits department for more details,

Expert (sic) opinions from financial advisors typically say that
the average 401(k) participant is not aggressive enough with their
investment options.  Historically, stocks have outperformed all other
forms of investment and will probably continue to do so.  Since the
investment period of 401(k) savings is relatively long - 20 to 40
years - this will minimize the daily fluctuations of the market and
allow a "buy and hold" strategy to pay off.  As you near retirement,
you might want to switch your investments to more conservative funds
to preserve their value.


-----------------------------------------------------------------------------

Subject: Retirement Plan - IRA 
Last-Revised: 17 Aug 1994 
From: cml@cs.umd.edu

An individual retirement arrangement (IRA) is a plan that allows a
person, whether covered by a pension plan or not, to save towards
his/her retirement while allowing the savings to grow tax-free.  
Funds in an IRA may be invested in a broad variety of vehicles 
(stocks, bonds, etc.) but there are limitations on investments 
(no options trading or buying land).

Contributions are limited, and the limits are quite low in comparison
to other retirement plans such as a 401(k).  Depending on a person's
income and coverage by a retirement plan, the IRA contributions may
additionally be deducted from one's gross income, thereby reducing 
the amount of income subject to taxation.

Limits on contribution: Each individual may contribute the *lesser* 
of US$2,000 or the amount of wage income from US sources.  Married
couples with only one wage earner may contribute to a second IRA
account called a "spousal IRA."  The limit on contributions to both
the primary and spousal accounts is US$2,250 total, and naturally
the US$2,000 ceiling still applies (e.g., $1 & $2,249 is not allowed).

Limits on deduction: You may be able to deduct your entire IRA
contribution, but this depends on your gross income and whether you
*or* your spouse are/is covered by a pension plan at work.  These
are the 1993 limits for a married couple filing jointly:

Neither spouse covered by a retirement plan: fully deductible.

One or both are covered by a retirement plan:
        Income   <40k: fully deductible
	       40-50k: partially deductible
		 >50k: not deductible

The IRS is pretty bone-headed about their definition of being
"covered" by a pension plan.  If you work for a company for just 
one day in a tax year, and that company offers its employees a 
pension plan, then even if you were not vested in that plan, did not 
contribute, and will never see a penny from them, the IRS considers 
you to be covered by a pension plan in that tax year.  

The US Congress has been toying for years with various proposals to
loosen IRA restrictions.  Among other things, they have mentioned
using IRA monies to pay for college, to finance a first-time home
purchase, etc.  However, as of this writing, none of those proposals
are law.

There is currently a 10% penalty on withdrawals before age 59 1/2.
There are various provisions for excess contributions and other
problems.  Withdrawals from an IRA must begin by age 70 1/2. 
Order IRS Publication 590 for complete information.


-----------------------------------------------------------------------------

Subject: Retirement Plan - SEP-IRA
Last-Revised: 30 Mar 1994
From: lupin@weitek.com

A simplified employee pension (SEP) IRA is a written plan that allows an
employer to make contributions toward his or her own (if self-employed)
or employees' retirement, without becoming involved in more complex
retirement plans (such as Keoghs).

Contributions are deductible from income in the year paid or for the
prior year up until the tax return deadline, including extensions.  The
contribution limit is 15% of net earnings, or $30,000, whichever is
less.  However, for self-employed persons the deduction affects the
income and thus only 13.0435% (15%/115%) may be contributed.  A
nondeductible penalty tax of 6% of the excess amount contributed will
be incurred for each year in which the excess contribution remains in
your SEP-IRA.

A SEP-IRA is established much like a regular IRA through stock brokers
or mutual funds and may be invested in the same manner as an individual
IRA.  See IRS Publication 560 for additional information.


-----------------------------------------------------------------------------

Subject: Stocks - Basics
Last-Revised: 26 Aug 1994
From: a_s_kamlet@att.com, lupin@weitek.COM

Perhaps we should start by looking at the basics:  What is stock?
Why does a company issue stock?  Why do investors pay good money
for little pieces of paper called stock certificates?  What do
investors look for?  What about Value Line ratings and what about
dividends?

To start with, if a company wants to raise capital (money) one of
its options is to issue stock.  It has other methods, such as
issuing bonds and getting a loan from the bank.  But stock raises
capital without creating debt, without creating a legal obligation
to repay those funds.

What do they buyers of the stock -- the new owners of the company --
expect for their investment?  The popular answer, the answer many
people would give is: they expect to make lots of money, they expect
other people to pay them more than they paid themselves.  Well, that
doesn't just happen randomly or by chance (well, maybe sometimes it
does, who knows?)

The less popular, less simple answer is: shareholders -- the
company's owners -- expect their investment to earn more, for
the company, than other forms of investment.  If that happens, if
the return on investment is high, the price tends to increase.  Why?

Who really knows?  But it is true that within an industry the
Price/Earnings ratio tends to stay within a narrow range over any
reasonable period of time -- measured in months or a year or so.

So if the earnings go up, the price goes up.  And investors look for
companies whose earnings are likely to go up.  How much?

There's a number -- the accountants call it Shareholder Equity --
that in some magical sense represents the amount of money the
investors have invested in the company.  I say magical because while
it translates to (Assets - Liabilities) there is often a lot of
accounting trickery that goes into determining Assets and
Liabilities.

But looking at Shareholder Equity, (and dividing that by the number
of shares held to get the book value per share) if a company is
able to earn, say,  $1.50 on a stock  whose book value is $10,
that's a 15% return.  That's actually a good return these days, much
better than you can get in a bank or C/D or Treasury bond, and so
people might be more encouraged to buy, while sellers are anxious to
hold on.  So the price might be bid up to the point where sellers
might be persuaded to sell.

What about dividends?  Dividends are certainly more tangible income
than potential earnings increases and stock price increases, so what
does it mean when a dividend is non-existent or very low?  And what
do people mean when they talk about a stock's yield?

To begin with the easy question first, the yield is the annual dividend
divided by the stock price.  For example, if company XYZ is paying $.25
per quarter ($1.00 per year) and XYZ is trading at $10 per share, the
yield is 10%.

A company paying no or low dividends (zero or low yield) is really
saying to its investors -- its owners, "We believe we can earn more,
and return more value to shareholders by retaining the earnings, by
putting that money to work, than by paying it out and not having it
to invest in new plant or goods or salaries."   And having said that,
they are expected to earn a good return on not only their previous
equity, but on the increased equity represented by retained earnings.

So a company whose book value last year was $10 and who retains its
entire $1.50 earnings, increases its book value to 11.50 less
certain expenses.  That increased book value - let's say it is now
$11 -- means the company must earn at least $1.65 this year just
to keep up with its 15% return on equity.  If the company earns
$1.80, the owners have indeed made a good investment, and other
investors, seeking to get in on a good thing, bid up the price.

That's the theory anyway.  In spite of that, many investors still
buy or sell based on what some commentator says or on announcement
of a new product or on the hiring (or resignation) of a key officer,
or on general sexiness of the company's products.  And that will
always happen.

What is the moral of all this:  Look at a company's financials,
look at the Value Line and S&P charts and recommendations, do some
homework before buying.

Does Value Line and S&P take the actual dividend into account
when issuing its "Timeliness" and "Safety" ratings?  Not exactly.
They report it, but their ratings are primarily based on earnings
potential, performance in their industry, past history, and a few
other factors.  (I don't think anyone knows all the other factors.
That's why people pay for the ratings.)

Can a stock broker be relied on to provide well-analyzed, well
thought out information and recommendations?  Yes and no.

On the one hand, a stock broker is in business to sell you stock.
Would you trust a used-car dealer to carefully analyze the 
available cars and sell you the best car for the best price?
Then why would you trust a broker to do the same?

On the other hand, there are people who get paid to analyze company
financial positions and make carefully thought out recommendations,
sometimes to buy or to hold or to sell stock.  While many of these
folks work in the "research" departments of full-service brokers,
some work for Value Line, S&P etc, and have less of an axe to grind.
Brokers who rely on this information really do have solid grounding
behind their recommendations.

Probably the best people to listen to are those who make investment
decisions for the largest of Mutual Funds, although the investment
decisions are often after the fact, and announced 4 times a year.

An even better source would be those who make investment decisions
for the very large pension funds, which have more money invested
than most mutual funds.  Unfortunately that information is often
less available.  If you can catch one of these people on CNN for
example, that could be interesting.


-----------------------------------------------------------------------------

Subject: Stocks - American Depository Receipts (ADRs)
Last-Revised: 11 Dec 1992
From: a_s_kamlet@att.com

An American Depository Receipt (ADR) is a share of stock of an investment
in shares of a non-US corporation.

For example, BigCitibank might purchase 25 million shares of a non-US
stock. Call it EuroGlom Corporation (EGC).  Perhaps EGC trades on the
Paris exchange, where BigCitibank bought them.  BigCitibank would then
register with the SEC and offer for sale shares of EGC ADRs.

EGC ADRs are valued in dollars, and BigCitibank could apply to the
NYSE to list them.  In effect, they are repackaged EGC shares, backed
by EGC shares owned by BigCitibank, and they would then trade like any
other stock on the NYSE.

BigCitibank would take a management fee for their efforts, and the
number of EGC shares  represented by EGC ADRs would effectively
decrease, so the price would go down a slight amount;  or EGC itself
might pay BigCitibank their fee in return for helping to establish a
US market for EGC.  Naturally, currency fluctuations will affect the
US Dollar price of the ADR.

Dividends paid by EGC are received by BigCitibank and distributed
proportionally to EGC ADR holders.  If EGC withholds (foreign) tax on
the dividends before this distribution, then BigCitibank will withhold
a proportional amount before distributing the dividend to ADR holders,
and will report on a Form 1099-Div both the gross dividend and the
amount of foreign tax withheld.

Most of the time the foreign nation permits US holders (BigCitibank in
this case) to vote their shares on all or most issues, and ADR holders
will receive ballots which will be received by BigCitibank and voted in
proportion to ADR Shareholder's vote.  I don't know if BigCitibank has
the option of voting shares which ADR holders failed to vote.

Having said this, however, for the most part ADRs look and feel pretty
much like any other stock.


-----------------------------------------------------------------------------

Subject: Stocks - Cyclicals
Last-Revised: 9 Apr 1995
From: sully@postoffice.ptd.net

A brief definition:

Cyclical stocks are the stocks of those companies whose earnings
are strongly tied to the business cycle (i.e., move up sharply when
the economy turns up, move down sharply when the economny turns down).

Examples:

Cyclicals:  Caterpillar (CAT), US Steel (X), General Motors (GM),
	    International Paper (IP)
	    (i.e., makers of products for which the demand curve 
	    is fairly flexible.)

Non-Cyclical: CocaCola (KO), Proctor & Gamble (PG), OAT
	    (i.e., makers of products for which the demand curve 
	    is fairly inflexible; after all, everyone has to eat!)


-----------------------------------------------------------------------------

Subject: Stocks - Dividends
Last-Revised: 17 Apr 1995
From: a_s_kamlet@att.com, rlcarr@animato.pn.com

A company may periodically declare cash and/or stock dividends.
This article deals with cash dividends on common stock.  Two
paragraphs also discuss dividends on Mutual Fund shares.  A
separate article elsewhere in this FAQ discusses stock splits
and stock dividends.

The Board of Directors of a company decides if it will declare a
dividend, how often it will declare it, and the dates associated
with the dividend.  Quarterly payment of dividends is very common,
annually or semiannually is less common, and many companies don't
pay dividends at all.  Other companies from time to time will
declare an extra or special dividend.  Mutual funds sometimes
declare a year-end dividend and maybe one or more other dividends.

If the Board declares a dividend, it will announce that the dividend
(of a set amount) will be paid to shareholders of record as of the
RECORD DATE and will be paid or distributed on the DISTRIBUTION
DATE (sometimes called the Payable Date).

Before we begin the discussion of dates and date cutoffs, it's
important to note that as of 7 June 1995, in accordance with the SEC's
"T+3" rule, all stock trades will have to settle in 3 business days. 
The rule in force until then is 5 business days.

In order to be a shareholder of record on the RECORD DATE you must
own the shares on that date (when the books close for that day).
Since virtually all stock trades by brokers on exchanges are
settled in 3 (business) days, you must buy the shares at least
3 days before the RECORD DATE in order to be the shareholder of
record on the RECORD DATE.  So the (RECORD DATE - 3 days) is the
day that the shareholder of record needs to own the stock to
collect the dividend.  He can sell it the very next day and still
get the dividend.  

If you bought it at least 3 business days before the RECORD date
and still owned it at the end of the RECORD DATE, you get the
dividend.  (Even if you ask your broker to sell it the day after
the (RECORD DATE - 3 days), it will not have settled until after
the RECORD DATE so you will own it on the RECORD DATE.)

So someone who buys the stock on the (RECORD DATE - 2 days) does
not get the dividend. A stock paying a 50c quarterly dividend might
well be expected to trade for 50c less on that date, all things
being equal.  In other words, it trades for its previous price,
EXcept for the DIVidend.  So the (RECORD DATE - 2 days) is often
called the EX-DIV date.  In the financial listings, that is
indicated by an x.

How can you try to predict what the dividend will be before it is
declared?

Many companies declare regular dividends every quarter, so if you
look at the last dividend paid, you can guess the next dividend
will be the same.  Exception: when the Board of IBM, for example,
announces it can no longer guarantee to maintain the dividend, you
might well expect the dividend to drop, drastically, next quarter.
The financial listings in the newspapers show the expected annual
dividend, and other listings show the dividends declared by Boards
of directors the previous day, along with their dates.

Other companies declare less regular dividends,  so try to look at
how well the company seems to be doing.   Companies whose shares
trade as ADRs (American Depository Receipts -- see article elsewhere
in this FAQ) are very dependent on currency market fluctuations, so
will pay differing amounts from time to time.

Some companies may be temporarily prohibited from paying dividends
on their common stock, usually because they have missed payments on
their bonds and/or preferred stock.

On the DISTRIBUTION DATE shareholders of record on the RECORD date
will get the dividend.  If you own the shares yourself, the company
will mail you a check.  If you participate in a DRIP (Dividend
ReInvestment Plan, see article on DRIPs elsewhere in this FAQ) and
elect to reinvest the dividend, you will have the dividend credited
to your DRIP account and purchase shares, and if your stock is held
by your broker for you, the broker will receive the dividend from
the company and credit it to your account.

Dividends on preferred stock work very much like common stock,
except they are much more predictable.

Tax implications:

Some Mutual Funds may delay paying their year-end dividend until
early January.  However, the IRS requires that those dividends be
constructively paid at the end of the previous year.  So in these
cases, you might find that a dividend paid in January was included
in the previous year's 1099-DIV.

Sometime before January 31 of the next year, whoever paid the
dividend will send you and the IRS a Form 1099-DIV to help you
report this dividend income to the IRS.

Sometimes -- often with Mutual Funds -- a portion of the dividend
might be treated as a non-taxable distribution or as a capital gains
distribution.  The 1099-DIV will list the Gross Dividends (in line 1a)
and will also list any non-taxable and capital gains distributions. 
Enter the Gross Dividends (line 1a) on Schedule B.

Subtract the non-taxable distributions as shown on Schedule B
and decrease your cost basis in that stock by the amount of
non-taxable distributions (but not below a cost basis of zero --
you can deduct non-taxable distributions only while the running
cost basis is positive.)     Deduct the capital gains distributions
as shown on Schedule B, and then add them back in on Schedule D if
you file Schedule D, else on the front of Form 1040.


-----------------------------------------------------------------------------

Subject: Stocks - Dramatic Price Changes
Last-Revised: 18 Sep 1994
From: lwest@futserv.austin.ibm.com, suhre@trwrb.dsd.trw.com, fahad@cs.pitt.edu

One frequently asked question is "Why did &my_stock go [down][up] by
&large_amount in the past &short_time?"

The purpose of this answer is not to discourage you from asking this
question in misc.invest, although if you ask without having done any
homework, you may receive a gentle barb or two.  Rather, one purpose
is to inform you that you may not get an answer because in many cases
no one knows.

Stocks surge for a variety of reasons ranging from good company news,
improving investors' sentiment, to general economic conditions.  The
equation which determines the price of a stock is extremely simple,
even trivial.  When there are more people interested in buying than
there are people interested in selling, possibly as a result of one or
more of the reasons mentioned above, the price rises.  When there are
more sellers than buyers, the price falls.  The difficult question to
answer is, what accounts for the variations in demand and supply for a
particular stock?  Naturally, if all (or most) people knew why a stock
surges, we would soon have a lot of extremely rich people who simply
use that knowledge to buy and sell different stocks. 

However, stocks often lurch upward and downward by sizable amounts
with no apparent reason, sometimes with no fundamental change in the
underlying company.  If this happens to your stock and you can find no
reason, you should merely use this event to alert you to watch the
stock more closely for a month or two.  The zig (or zag) may have
meaning, or it may have merely been a burp.

A related question is whether stock XYZ, which used to trade at 40 and
just dropped to 25, is good buy.  The answer is, possibly.  Buying
stocks just because they look "cheap" isn't generally a good idea. 
All too often they look cheaper later on.  (IBM looked "cheap" at 80
in 1991 after it declined from 140 or so.  The stock finally bottomed
in the 40's. Amgen slid from 78 to the low 30's in about 6 months,
looking "cheap" along the way.)  Technical analysis principles suggest
to wait for XYZ to demonstrate that it has quit going down and is
showing some sign of strength, perhaps purchasing in the 28 range. 
If you are expecting a return to 40, you can give up a few points
initially.  If your fundamental analysis shows 25 to be an undervalued
price, you might enter in.  Rarely do stocks have a big decline and a
big move back up in the space of a few days.  You will almost surely
have time to wait and see if the market agrees with your valuation
before you purchase.


-----------------------------------------------------------------------------

Subject: Stocks - Types of Indexes
Last-Revised: 11 Dec 1992
From: susant@usc.edu

There are three major classes of indices in use today in the US.  They are:

A - equally weighted price index
	(an example is the Dow Jones Industrial Average)
B - market-capitalization-weighted index
        (an example is the S&P Industrial Average)
C - equally-weighted returns index
        (the only one of its kind is the Value-Line index)

Of these, A and B are widely used.  All my profs in the business school
claim that C is very weird and don't emphasize it too much.

+ Type A index:  As the name suggests, the index is calculated by taking the
average of the prices of a set of companies:

            Index =  Sum(Prices of N companies) / divisor

In this calculation, two questions crop up:

1. What is "N"?  The DJIA takes the 30 large "blue-chip" companies.  Why 30? 
I think it's more a historical hangover than any thing else.  One rationale
for 30 might be that a large fraction of market capitalization is often
clustered in largest 50 companies or so.

Does the set of N companies change across time?  If so, how often is the
list updated (wrt companies)?  I suspect these decisions are quite
judgemental and hence not readily replicable.

If the DJIA only has 30 companies, how do we select these 30?  Why should
they have equal weights?  These are real criticisms of the DJIA type index.

2. The divisor is not always equal to N for N companies.  What happens to
the index when there is a stock issue by one of the companies in the set? 
The price drops, but the number of shares have increased to leave the market
capitalization of the shares the same. Since the index does not take the
latter into account, it has to compensate for the drop in price by tweaking
the divisor.  For examples on this, look at pg. 61 of Bodie, Kane, & Marcus,
_Investments_ (henceforth, BKM).

Historically, this index format was computationally convenient.  It doesn't
have a very sound economic basis to justify it's existence today.  The DJIA
is widely cited on the evening news, but not used by real finance folks.

I have an intuition that the DJIA type index will actually be BAD if the
number of companies is very large.  If it's to make any sense at all, it
should be very few "brilliantly" chosen companies.

+ Type B index:  In this index, each of the N company's price is weighted by
the market capitalization of the company.

        Sum (Company market capitalization * Price) over N companies
Index = ------------------------------------------------------------
	    Market capitalisation for these N companies

Here you do not take into account the dividend data, so effectively you're
tracking the short-run capital gains of the market.

Practical questions regarding this index:

1. What is "N"?  I would use the largest N possible to get as close to the
"full" market as possible.   BTW in the US there are companies who make a
living on only calculating extremely complete value-weighted indexes for
the NYSE and foreign markets.  CMIE should sell a very-complete value-weighted
index to some such folks.

Why does S&P use 500? Once again, I'm guessing that it's for historical
reasons when computation over 20,000 companies every day was difficult and
because of the concentration of market capitalization in the largest lot
of companies.  Today, computation over 20k companies for a Sun workstation
is no problem, so the S&P idea is obsolete.

2.  How to deal with companies entering and exiting the index?  If we're
doing an index containing "every single company possible" then the answer
to this question is easy -- each time a company enters or exits we recalculate
all weights.  But if we're a value-weighted index like the S&P500 (where there
are only 500 companies) it's a problem.  Recently Wang went bankrupt and S&P
decided to replace them by Sun -- how do you justify such choices?

The value weighted index is superior to the DJIA type index for deep reasons. 
Anyone doing modern finance will not use the DJIA type index.  A glimmer of
the reasoning for this is as follows:  If I held a portfolio with equal number
of shares of each of the 30 DJIA companies then the DJIA index would accurately
reflect my capital gains.  BUT we know that it is possible to find a portfolio
which has the same returns as the DJIA portfolio but at a smaller risk. 
(This is a mathematical fact).

Thus, by definition, nobody is ever going to own a DJIA portfolio.  In
contrast, there is a extremely good interpretation for the value weighted
portfolio -- it's the highest returns you can get for it's level of risk. 
Thus you would have good reason for owning a value-weighted market portfolio,
thus justifying it's index.

Yet another intuition about the value-weighted index -- a smart investor is
not going to ever buy equal number of shares of a given set of companies,
which is what index type a. tracks.  If you take into consideration that the
price movements of companies are correlated with others, you are going to
hedge your returns by buying different proportions of company shares.  This
is in effect what the index type B does and this is why it is a smarter index
to follow.

One very neat property of this kind of index is that it is readily applied to
industry indices.  Thus you can simply apply the above formula to all machine
tool companies, and you get a machine tool index.  This industry-index is
conceptually sound, with excellent interpretations.  Thus on a day when the
market index goes up 6%, if machine tools goes up 10%, you know the market
found some good news on machine tools.

+ Type C index:  Here the index is the average of the returns of a certain
set of companies. Value Line publishes two versions of it: 

  * the arithmetic index :  (VLAI/N) =  1  * Sum(N returns)
  * the geometric index :  VLGI  = {Product(1 + return) over N}^{1/n},
    which is just the geometric mean of the N returns.

Notice that these indices imply that the dollar value on each company has
to be the same.  Discussed further in BKM, pg 66.


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Compilation Copyright (c) 1996 by Christopher Lott, cml@cs.umd.edu
-- 
Christopher Lott	Compiler of the FAQ for misc.invest, misc.invest.stocks
cml@cs.umd.edu		http://www.cs.umd.edu/users/cml/
