Friday, April 30, 2010

Roth IRA question

Which of the following can a 72-year-old individual earning $20,000 annually not do in a Roth IRA?
A. continue to make non-tax-deductible contributions
B. make tax-deductible contributions to the account
C. elect to take no distributions
D. change the beneficiary

EXPLANATION: sometimes the wording of a test question can make an otherwise simple concept seem difficult. But, if you patiently read the answer choices and eliminate the ones you can eliminate, you usually end up with the advantage. What's tricky here is that true statements must be eliminated. Let's find three true statements, then. I like to start with the short statments like Choice D. Ask yourself, why couldn't somebody change a beneficiary? No reason, so D is eliminated. What about Choice C--can this person delay taking money out of the account? The government isn't going to tax the money coming out of a Roth, so there's no requirement to start taking distributions at age 70 1/2. C is true and, therefore, must be eliminated. Yes, it's tricky to have to eliminate true statements, which is why the exam likes to force you to do exactly that. What about Choice A, could a 72-year-old with earned income still contribute to a Roth? Yes. Not a Traditional IRA, but a Roth, yes. So, Choice A is eliminated.
Leaving us with the right answer . . .


Wednesday, April 21, 2010

What the heck is a mutual fund anyway?

The last post drew a comment from a long-time reader of this blog. Rather than answer the question in the comments section, I thought I would use it for a blog post. Daniel is now in the business and asks me the following question:

How can I define/describe mutual funds to a "normal" person? I know the financial definition of it, but I can't seem to reword it properly.

RESPONSE: I would tell investors first that they could always purchase shares of stock or individual bonds all by themselves without going through a mutual fund. Trouble is, if they only have a few hundred or a few thousand dollars, they will not be diversified that way, and it is very inefficient to purchase less than $100,000 worth of bonds due to the high markups or commissions that brokers charge. Rather than invest a few hundred or thousand dollars into just a couple of stock issues or one bond issue that could easily end up defaulting, most investors prefer to buy shares of a portfolio that is already diversified and run by a team of professional investors. We call these portfolios "mutual funds" because each investor mutually owns his percentage of each security in the portfolio. Now, a few hundred or a few thousand dollars can be invested and provide the investor with immediate diversification--it is safer to own little pieces of, say, 100 different stocks or bonds, versus putting all the money an investor has to invest into just a couple of stocks or bonds. Also, a mutual fund investor can liquidate some shares without losing the diversification he enjoys. If he, on the other hand, owned shares of stock, he would have to decide which issue to sell, and if he liquidated all of his GE, his diversification would be lost. In exchange for the diversification and the professional management mutual fund investors sometimes pay sales charges to buy or sell the shares and always pay expenses (management fees, 12b-1 fees usually, and other expenses). If the expenses are reasonable, it's a fair bet that most investors are better served through mutual funds as opposed to trying to pick stocks and bonds on their own.

In the textbooks I often describe a mutual fund as a big "portfolio pie" that serves up as many slices as investors want to buy. Every investor mutually owns his percentage of the portfolio pie. If the ingredients of the pie go up in value, so does the value of the investor's holding. If the ingredients (stocks and bonds) pay dividends and interest to the portfolio, that also makes the slices owned by the investor much sweeter/more valuable. If investors want to turn their slices of pie into cash, the mutual fund will do so any day the markets are open. There's no guarantee as to what a share will be worth on any given day, but that's always true of the investment world.

Tuesday, April 13, 2010

Administrative enforcement actions

The powers of the securities Administrator tend to generate a few questions on both the Series 65 and 66. Since most candidates struggle with anything connected to the Uniform Securities Act, let's make sure you understand the fundamentals. How would you answer a practice question like the following?

Which of the following Administrative orders is most severe?
A. cease & desist
B. suspension
C. cancellation
D. revocation

EXPLANATION: a good test question writer knows how to mess with the people who dared to come to the exam center without sufficient preparation--let's give these people three choices that sound pretty darned severe. Cease & desist sounds pretty harsh, but it's also an order that can be issued before a hearing has been granted and held and is often just a formal warning from the Administrator to cut it out. A cancellation is definitely final, but it's issued when a registrant dies, leaves the state, goes out of business, or is declared mentally incompetent. Nobody violated the Act necessarily--a cancellation is a "non-punitive order," meaning it does not provide a form of punishment. The "Administrator" in my state is also in charge of driver's licenses. If you're an inveterate lead-foot, you may already sense that a "revocation" is more serious than a "suspension" of your license, right? That's why the answer is the order of "revocation." An order of revocation from the Administrator is like a "bar" order from FINRA. Game over. Find a new career. We've seen what you have to offer, and you won't be offering any securities or investment advice anymore.