Tuesday, June 30, 2009

Rule of 72

First off, the "rule" of "72" is not a rule in the sense of "rules and regulations." It is simply a quick rule-of-thumb method of calculating future value. If you take a rate of return and divide it into 72, the answer tells you how many years it will take for your money to double. At 9%? Eight years. 72 / 9 = 8. Or, you can take the number of years in which you need the money to double and divide that into 72. The answer here gives you the required rate of return. If you want your money to double in 4 years--good luck. 72 / 4 = 18, and you aren't getting a compouned 18% return anywhere legal.
So, the Series 65/66 could easily throw a smart-aleck question like this one at you, and I'd like you to be ready for it, like a big-league hitter smiling as a rookie pitcher tries to jam him up high and inside. Ready? Let's take a look anyway:

Melody's goal is to invest $2,000 today into an aggressive growth mutual fund. At the end of her 10-year time horizon, Melody expects the account to be worth roughly $8,000. The approximate compounded rate of return required is:
A. 7.2%
B. 10.3%
C. 14.4%
D. 27.4%

EXPLANATION: using the "rule of 72" you immediately hit a speed bump when you realize that melody doesn't just want the money to double--she wants it to double twice in 10 years. Typical Series 65/66 brushback pitch. Oh well. 7.2% would be the answer if she wanted the money to double once in 10 years. I guess the rate needs to be twice as high, right? 14.4% approximately.

Saturday, June 27, 2009

Investment Adviser Rep Registration

Mary Ellen represents a federal covered investment adviser in State A, with her main office there. Once a month, as she passes through State B on her way to work, she meets with 4 financial planning clients at a diner to discuss investing strategies. Therefore
A. Mary Ellen need not register in State B due to the number of clients there
B. Mary Ellen must register in State B
C. Mary Ellen need not register in State B as she has no place of business there
D. Mary Ellen may register with either State A or State B

EXPLANATION: Mary Ellen does have a place of business in State B, so the number of clients is irrelevant.

Friday, June 26, 2009

Prospectus Delivery

It's Friday morning and, as usual, I'm at the FINRA website looking for rule changes and recent disciplinary actions that relate to testable points. And, as usual, it only took a few seconds to find what I'm looking for.

Remember that the Securities Act of 1933 and the Uniform Securities Act are predicated on full disclosure of material facts in the offer and sale of securities and in the solicitation and rendering of investment advice. When investors are mislead or kept in the dark about important facts, the regulators get bent out of shape, as well they should. This morning I see that a fine broker-dealer recently got its wrists slapped over their failure to deliver prospectuses in a large number of transactions. You can read the announcement at the link below. Also, note that in most IPOs these days, the issuer can simply post the prospectus online, but for ETFs and mutual funds, a hard copy prospectus still needs to be delivered.

Enjoy. I'm off to the office to prepare for the Friday Free Broadcast.

The announcement is at:

Thursday, June 18, 2009

Defining Investment Advisers

Which of the following professionals least likely meets the definition of an "investment adviser"?

A. an accountant who charges only a nominal fee to help tax clients with allocation strategies for their retirement accounts
B. an individual who writes a financial newsletter for compensation to a group of subscribers in several states
C. a financial planner
D. an insurance agent who occasionally provides financial planning services to his clients

EXPLANATION: according to the so-called "three-pronged approach" developed by the SEC's Release IA-1092, the individual has to be giving advice that is specific to the client's situation in order to meet the definition of "investment adviser." The writer of a financial newsletter is just a publisher/writer enjoying his First Amendment rights. Of course, an adviser who never meets face-to-face with clients would still be an adviser if he wrote up his personalized recommendations and sent them to each of his clients. The key here is the specificity--is the adviser writing to a general audience, or is he advising individuals based on their unique situations? The newsletter writer is just a publisher, not an adviser. The accountant is crossing the line by charging to help with investments. The financial planner is the perfect example of an investment adviser. And the insurance agent becomes an adviser as soon as he holds himself out as a professional who provides financial planning services. The only caveat there is that if the financial advice had absolutely nothing to do with securities, the insurance agent would escape the definition of "investment adviser." But that would require him to talk only about, say, credit cards, personal budgeting, real estate, and fixed annuities.

Wednesday, June 17, 2009

Fundamental vs. Technical

Basically, fundamental analysis involves looking at a particular company, while technical analysis only looks at the company's stock price, or the stock market overall. While a fundamental analyst looks at financial statements to see if XYZ is selling products, making a profit, increasing shareholder equity, etc., a technical analyst couldn't care less about the company itself. A technical analyst just wants to see where XYZ's stock has been trading and figure out where it's headed next by looking at volume, charts, moving averages, etc. A fundamental analyst doesn't try to determine what a company's stock is going to do over the short-term. Instead, a fundamental analyst tries to buy an ownership stake in a great company that should grow in value over time. Price-to-earnings, price-to-book, dividend payout ratios, profit margins, etc. are concerns of the fundamental analyst. Support, resistance, breakouts, volume, and moving averages are concerns of the technical analyst. If he studies data on a company's financials, he's a fundamental analyst. If he studies market data on the company's stock price, he's a technical analyst.
Which one is more likely to lead to profits?
That's way beyond the scope of the exam, assuming anyone could answer the question in the first place. But I kind of like the results that Warren Buffett and Charlie Munger, Peter Lynch, and the "Motley Fools" have shown with fundamental analysis. A successful technical analyst? He'd probably be glad to sell you a once-in-a-lifetime-educational-opportunity that will show you how to earn millions trading the stock market for just $3,999.99.

More on Duration

We're probably going a little overboard here, but let's take a quick look at the actual formula used to calculate duration. Not that I think you'll have to calculate it on the exam, but the concept becomes clearer by fussing with the formula a little. Remember that duration is a weighted average of a bond's cash flows--the longer you have to wait to receive a significant part of your bond investment back, the higher the duration. Let's say you buy a 2-year T-note with a 5% yield. If so, you would receive exactly four interest payments and one principal payment. The total amount of money received would be $1,100. The formula would look like this:

.5($25/$1,100) + 1($25/$1,100) + 1.5($25/$1,100) + 2($25/$1,100) + 2($1,000/$1,100)

That might look crazy at first, but if we break it down, it makes perfect sense. The little ".5," "1," "1.5" and so on are representing the income payments received at the first half-year, the first year, the first year-and-a-half, etc. In parentheses, we see that the income received is a percentage of the total $1,100 that will be returned to the investor. At the very end, $1,000 of principal is returned, along with the last income payment of $25. The duration turns out to be just a little less than 2 (1.92 approximately), and, of course, if the number were higher than 2, we messed up. As the test question might say, the duration of a bond paying interest is always lower than the term to maturity. But, a zero coupon bond's duration equals the maturity. Looking at the formula above, we see that it would have to. You would only have one entry on a zero coupon bond, since it only makes one payment.

For fun, run the calculation with a bond paying 10%, and you'll see that the duration is lower with a higher coupon rate. The bond would be paying ($50/$1,200) with each interest payment and returning ($1,000/$1,200) at maturity, making the duration on this bond/note approximately 1.86.

Ah, there. Now I can get some sleep.

Monday, June 15, 2009

Duration, Interest Rate Risk

A customer just emailed me for clarification on a very tough practice question:

Which of the following securities would react the most to a change in interest rates?
A. 10-year corporate subordinated debenture
B. 11-year AAA-rated municipal bond
C. 20-year US Treasury bond
D. 20-year US Treasury STRIP

EXPLANATION: this question is about "duration," which is a measure of a bond's interest-rate risk. The textbook definition is "a weighted average of a bond's cash flows." Sounds tough at first, but it really isn't. A "weighted average" means that we give more points to certain items than others, as in school, when homework might = 10% of your grade, 40% for the midterm, and 50% for the final exam. But, rather than focus on the "weighted average" part, just remember the "cash flow" part, which is key to understanding duration. You don't have to calculate duration, but if you did, you would give more weight to certain income payments than others. What's important here is a general understanding that it is "safer" to hold bonds that pay out big income streams--it calms people down when they're getting $120 a year on a 12% bond. But, if they're getting $40 a year on a 4% bond (after paying $1,000 for the bond), that could make them a little nervous. So, bonds with high coupon rates have lower durations (less interest rate risk) than bonds with chinsy little coupon rates. Also, the longer the term on the bond, the more nervous investors are about holding it.
So, in this question we look for the longest term to maturity, which is 20 years. One of these bonds has the highest duration--is the most sensitive to interest rate changes. If we have a 20-year T-bond and a 20-year STRIP, we have to remember that zero coupons pay NO cash flow--so they have to have a higher duration than bonds of equal maturities that DO pay cash flow. Duration is founded on the concept that investors will receive part or all of the principal they paid for the bond through the interest payments received--the faster that happens, the safer it is to hold the bond. Even if it's only a 3% nominal yield on a U S Treasury bond, after 20 years, you'd collect $600 on a 20-year bond. On a 20-year zero coupon (strip), you'd still be waitin' and a hopin' you receive the par value upon maturity. So, the test wants you to know that a 20-year bond paying interest will always have a lower duration than a 20-year zero coupon. Similarly, if you loaned $1,000 to a friend, would you rather have him pay back $100 a month or give him 5 years to pay it all back in a lump sum?
Me, I'd be a lot more laid back receiving payments regularly.


Saturday, June 6, 2009

Investment Adviser Registration Requirements

Here is a likely question on your Series 65 or 66 exam:

If an investment adviser is properly registered in State X, where it maintains its main office, and the adviser is also registered in State Y, what is true if the Administrator of State Y requires higher net capital than what is required in State X?
A. The Adviser must obtain a surety bond to cover State Y's requirement
B. State Y can not have a higher requirement than State X
C. The adviser does not need to comply with the higher requirement in State Y
D. The SEC must provide no-action relief to the adviser

EXPLANATION: you'll find this rule in the Investment Advisers Act of 1940, and it makes perfect sense. If the adviser is properly registered in State X and meets the state's financial requirements, the firm can not be forced to meet the other state's higher requirement. Similary, a state regulator can not tell a federal covered adviser that their net capital isn't high enough--that's the SEC's job.


Wednesday, June 3, 2009

Practice Question - Real Return

Here is the sort of question that makes virtually all Series 65 and 66 candidates cringe at the testing center. With all the details provided, the question can hit you hard at first. Remember, your job at the testing center is to take a deep breath, then hit back.

What is your investor's real rate of return for holding the XYZ Light Corporation's 20-year bond with the following features:

  • Coupon rate 5%, paid semi-annually
  • Rating A-
  • Maturity date December 1, 2016
  • CPI 2%
  • Par value $1,000
  • Purchase price 90
  • Call date January 1, 2019
  • Call price 101 3/8.

    A) 5.00%.
    B) 3.50%.
    C) 2.50%.
    D) 4.50%.

    EXPLANATION: once you decide to ignore the credit rating, the par value, the call date, and the call price, you can start solving the question. Take the $50 in annual income divided by the $900 purchase price, which is 5.5%. Then, reduce that by the 2% rate of inflation (CPI) and choose 3.5%. Typical Series 65 question--like a bully, it seems scary at first. Then you learn how to deal with it, and, eventually, it ceases to be a problem.


Tuesday, June 2, 2009


I've mentioned that the exit strategy for my little foray into margin loans is the inevitable rise of Hospira common stock. If Hospira rises to $55, I can sell my 90 shares, pay back the margin loan and continue to hold the other shares I currently hold in an IRA. But, what is this "Hospira" I keep referring to? It's a former unit of Abbott Labs, which is another stock I own (and love). Hospira was spun off from the parent comany, which is where I got my initial dose of the stock. Later, when I became the executor of my mother's estate, I purchased 270 shares, or 90 for me and each of my two sisters. Hospira is a very simple, straightforward company--basically, they make injectables and I.V. systems for use in hospitals, clinics, and in-home care. In the past five fiscal years, their sales/revenue came in at about $2.64 billion, $2.62 billion, $2.68 billion, $3.43 billion, and $3.63 billion. Their net income (profit) has been anywhere from $107 million to $321 million most recently. The stock is not trading expensively--like most stocks these days--at only 13 times earnings. It earns $2.61 per share but--like many companies--pays no dividends. How do you make money on a stock that pays no dividends? You wait for it to rise in value, at which point you can sell for a capital gain or, perhaps, the company eventually does start paying dividends, making it both a growth and an income investment. From a technical standpoint, the short interest is very low in the stock; only about 2.5% of the shares have been sold short. The 52-week high is about $42; the 52-week low is about $21. Lately, it's on an uptrend: +7% last 5 days, +8% last 30 days, +15% last 60 days. What does this all mean for my chances of Hospira rising to $55 or higher, allowing me to sell and pay back the $5,000 I borrowed from my margin account? No idea. Luckily, the exam doesn't expect you to know something like that. The exam just wants you to have an idea what earnings and P/E ratios might be, which stocks are generally more volatile and which are generally more stable, that sort of thing. Being able to relate some of this exam material to the real world will give you a big edge when studying, so I encourage you to look up some of your favorite companies and look for testable points. Glance at the income statement, click on the "overview," and have yourself as much fun as I'm currently having at about 5 AM on a cold, dreary morning in early June.