In each of the next several issues we will cover very simple but effective money management techniques that can be used to help ensure you are financially protected. These comments should not be interpreted as absolute rules and should be modified to reflect varying risk tolerance, marital status, or income levels. We are not investment advisors and no one can predict the future, however, some basics of money management will go a long way towards bringing some order to your financial life. We'll address many topics over the next several issues. If there are follow-up questions or particular topics that you'd like addressed, please feel free to contact us so we can respond to your needs.

When we talk about investments what kind of investment vehicles do we mean? You've probably heard about futures or derivatives or limited partnerships. That is far beyond our scope, and probably also far beyond the level of risk that many members feel comfortable accepting. We want to focus on simple investments that protect against the major investment risks. Those risks are illiquidity, deflation, and inflation.

Illiquidity is the concept of being able to get at your money quickly without any penalties. Therefore, a first step should be to establish or maintain a permanent, liquid account. This could be a checking account, a savings account, a NOW account, or a money market fund. You need to make sure that the account allows you to write small sized checks (some will allow only checks greater than, say, $250). Also, make sure your account pays interest. Accounts at banks and credit unions are insured up to $100,000. If your cash funds exceed $100,000, then open a second account at a second bank.

However, you don't want to have too much invested in a cash account. These accounts typically pay interest rates lower than you can receive on other types of accounts. So, how much is the correct amount? Each member must decide depending upon a "comfort level". Do you like to have easy access for emergencies? Are you disciplined enough to allow a cash balance to exist without tapping into it for frivolous spending? An often cited rule of thumb is to maintain 3 to 6 months' of take-home pay in cash. Another rule that we like can be applied to all our members: Divide your age by 5. That is the percentage of your total investments which should be devoted to cash.

Example 1. Assume a member is age 30 with investments totaling $60,000. Divide 30 by 5, or 6% of all funds should be in cash. Total investments are $60,000, so 6% of $60,000 would mean that $3,600 would be invested in interest bearing, insured cash accounts.

Example 2. A recent widow age 60 with insurance proceeds and other investments totaling $400,000. Divide 60 by 5, or 12% of all funds should be in cash. Total investments are $400,000, so 12% of $400,000 would mean that $48,000 would be invested in interest bearing, insured cash accounts. For some this might be too much, but you can always reduce the balance as you become more comfortable managing your money through asset allocation. By allocating a percentage of your funds to an insured bank account, or money market fund you can earn interest income and still maintain access to some of your cash. Because cash does not earn interest rates much above inflation rates, you should limit the amount of funds held in cash to a level that is comfortable to you. These accounts provide liquidity, but because they don't beat inflation by much, our next issue will address how you can allocate other funds to keep you ahead of the risk of inflation.

In the previous issue, we discussed how to use cash and other liquid investments to protect against financial uncertainty. By allocating a percentage of your funds to an insured bank account, or money market fund, you can earn interest income and still maintain access to some of your cash.

Cash does not earn interest rates much above inflation rates. Therefore, you should limit the amount of funds held in cash to a level that is comfortable to you or to meet expected short-term requirements. These accounts provide liquidity, but they don't beat inflation by much, if at all. If you don't maintain your purchasing power with inflation, you risk losing your standard of living.

Every investment has risk; the type of risk differs by the type of investment. In the case of stocks or stock mutual funds, price volatility most often scares investors. If you buy stocks, you own part of the company whose shares you have bought and derive benefits of ownership. Those benefits vary depending upon the fortunes of the company. Investors may receive dividends from the profits, if any. Companies can and do raise, lower, or eliminate dividends. Investors also receive capital appreciation (if the stock goes up in value) or capital depreciation (if the stock goes down).

While the price reported in the financial news reflects changes in value, you would neither gain nor lose unless you sold the shares you own. Consider an example of a company which, not many years ago, paid a substantial and reliable dividend. The company made profits and paid part of those profits to shareholders through dividends. Investors perceived the prospects for the company to be positive, so the price per share grew to around $130.

Later, the company's prospects were thought to be less positive, so investors sold the stock driving the price per share down to around $100. As those perceptions were realized, the company reduced the dividend. The price declined further, settling around $45 per share. Now the company is doing much better. The dividend has stabilized and the price has recovered to around the $110 per share range. The purpose of this illustration is to show how investing in equities, such as stocks or stock mutual funds, carries two variable returns: (1) the dividend is not guaranteed and (2) the price per share fluctuates. This differs from the money market funds we discussed in the previous issue. With money market funds, the interest rate fluctuates, similar to dividends on stocks. However, with money market funds, the principal is fixed. With stocks, both the dividend and the principal fluctuate.

With such uncertainty, why would anyone risk their capital by buying stocks? The answer lies in one of the most dangerous risks faced by members-INFLATION. Over long holding periods, say 10 years and longer, stocks have generally returned about 5% to 6% above the rate of inflation. An allocation to equities (stocks or stock mutual funds) allows members to protect against the ravages of inflation. How much should that allocation be?

A general rule that we like is: subtract your age from 100. That is the percentage of your total investments which should be devoted to equities. For example, assume a member is just starting a career and is 30 years old with money market funds and other investments totaling $20,000. Subtract 30 from 100, or 70% of all funds, should be in equities. Total investments are $20,000, so 70% of $20,000 would mean that $14,000 would be invested in assets, which fluctuate, but historically have protected against inflation.

For some members, this might be too much, but you can always start with a smaller amount and increase it as you become more comfortable with equities.

As members age, there is usually less tolerance for price fluctuation and certainly less time to recover from market declines. The percentage of one's portfolio devoted to equities would decline. However, even at age 80, using this rule of thumb, 20% of funds would remain invested in equities.

In this article and the previous edition, we've shown how to protect against illiquidity (by using cash) and inflation (using equities). We've also provided some rules of thumb to offer a framework for allocating investments by percentage:

Cash (checking accounts plus money markets) Age divided by 5

Equities (stocks plus stock mutual funds) 100 - age

In the next article, we'll describe a third investment vehicle to augment cash and equities. We'll also introduce methods by which you can implement these concepts in day-to-day actions. The important step is to formulate a long range plan which protects against the major risks. Inflation is one of those risks. A diversified portfolio of stocks has protected against inflation. Therefore, until a rather advanced age, each portfolio should include some stock.

In the first article of this series we discussed the overall concept of where to place money. In money management terminology that is called asset allocation. By allocating a percentage of your funds to an insured bank account, or money market fund you can earn interest income and still maintain immediate access to some of your investment portfolio. Because cash does not earn interest rates much above inflation rates, you should limit the amount of funds held in cash to a level that is comfortable to you. One rule of thumb for the percentage of assets allocated to cash is to divide your age by 5. Cash accounts provide liquidity, but they don't beat inflation by much. You can allocate other funds to keep you ahead of the risk of inflation.

In the second article we discussed allocation to stocks (or stock mutual funds) which allows survivors to protect against the ravages of inflation. For stocks or mutual funds one often cited rule is: Subtract your age from 100. The result is the percentage of your total investments which should be devoted to stocks and/or stock mutual funds. In those first two articles we showed how to protect against illiquidity (using money market funds) and inflation (using stocks or mutual funds). We provided some rules of thumb to offer a framework for allocating investments by percentage. To illustrate, for a member aged 40, the percentages would be:

A simple approach is to place funds in certificates of deposit (CD) at a bank. A CD guarantees a fixed interest rate of return for a fixed period. CDs are insured up to $100,000 by the Federal Deposit Insurance Corporation. So long as the amount in the CD remains below $100,000 the account is fully insured. Using an example of a 40 year old member with $160,000 total investments, 32% or $51,200 would be committed to fixed income, CDs in this example. First, (though not a limiting factor in this example) consider investing no more than about $90,000 at a single bank so that the accumulated interest and initial principal will not exceed the $100,000 insured level. An alternative, cumbersome approach uses multiple account names to increase the insured coverage. Second, spread your CDs across time. This will allow you to access your money as CDs mature and avoid locking up all your CDs at a given interest rate. By "laddering" CD maturity dates a CD matures each year. To implement the ladder, the initial commitments might look like this:

Remember, each member is different and money management techniques must be modified to meet differing needs. These rules of thumb should not be viewed as the only or the approved solution. Now that we've covered the three types of investments (cash, fixed income, and equities) our next article in the series will address the basics of stock mutual fund investing.

In the first article of this series we discussed the overall concept of where to place money. In money management terminology, this is called asset allocation. By allocating a percentage of your funds to an insured bank account, or money market fund, you can earn interest income and still maintain immediate access to some of your investment portfolio. Because cash does not earn interest rates much above inflation rates, you should limit the amount of funds held in cash to a level that is comfortable to you. One rule of thumb for the percentage of assets allocated to cash is to divide your age by five.

In the second article we discussed allocation to stocks (or stock mutual funds) which, over long periods, have protected against the ravages of inflation. For stocks or stock mutual funds, one often cited rule is: subtract your age from 100. The result is the percentage of your total investments which would be devoted to stocks and/or stock mutual funds.

In those first two articles we showed how to protect against illiquidity (using money market funds) and inflation (using stocks or stock mutual funds). We provided some rules of thumb to offer a framework for allocating investments by percentage. To illustrate, for a member aged 40, the percentages would be:

Cash accounts for 8% of the portfolio; stock for 60%; total of 68%. In the third article we described using bank CDs as a third investment vehicle to augment cash and stocks. In this article we explain the basics of using taxable bonds for the same purpose but with a bit more volatility and return.

Bonds are debt instruments issued by the Government or by corporations. For this article we're using only US government securities as examples. For maximum safety (and a bit lower yield than corporate bonds), one can invest in US Treasury issues, either bonds or notes. Notes are sold with maturities of 2, 3, 5 or 10 years; bonds are 30 year maturities.

For this article, the distinction between a note and a bond is not relevant. These issues carry the full faith and credit of the US Government. Ultimately, the interest and principal payment are guaranteed by the taxing authority of the government. If a bond is bought and held to maturity, the interest rate and principal repayment are pre-determined. However, if a bond is sold before maturity, the value can be greater or less than the original purchase price.

Bond values move in the opposite direction of interest rates. If interest rates go up, the value of bonds goes down, and vice versa. The responsiveness of price to interest rate changes is greater with longer bonds than with shorter bonds. Duration is used to measure the price change relative to interest rate change. A higher duration indicates a greater price volatility relative to interest rate changes. However, if held to maturity, this fluctuation in value has little impact. Bonds are not CDs; they have a fixed interest rate like CDs, but the fluctuating value of bonds makes them different from CDs. Another difference is the tax treatment. While income from US bonds is fully taxable at the federal level, states do not tax the income. For members subject to state income tax, this added benefit should be considered.

If US Treasury issues make sense for you, how do you buy them? Obviously, brokerage firms can buy them on your behalf for, typically, modest fees. Alternatively, you can buy them yourself directly from the US Treasury. Contact the Treasury Department, Bureau of Public Debt, Washington, DC 20239-0001, or call (202) 874-4000. The following chart summarizes the offerings:

Remember, each member is different and money management techniques must be modified to meet differing needs. These rules of thumb should not be viewed as the only or the approved solution. Because this article expanded upon fixed income aspects, it delayed the scheduled article on stock mutual fund investing. We will cover that subject in the next article.

First, with mutual funds, capital gain distributions cannot be controlled. Typically, each year mutual funds recognize some capital gains. Those gains are distributed to shareholders of the fund and are taxable. Investors cannot determine the timing of the capital gains distributions. A fund must distribute reportable gains. In some years, funds may have taken capital gains and distributed those taxable gains even though the fund overall had declined in value. This can occur when a fund sells stocks for gains but retains stocks which have declined in value.

Second, annual management fees cannot be avoided. Every mutual fund has a management fee, or expense ratio. Expense ratios range from about 0.2% to about 1.5%, with 1.0% being a fairly common approximate annual cost. This annually recurring fee is not a load. Mutual fund shareholders pay the mutual fund company to buy and sell the underlying stocks, administer record keeping, and report taxable distributions. To avoid tax timing and management fee disadvantages, some investors prefer to buy and own stocks individually.

By owning the stock individually, an investor incurs a tax liability only when the stock is sold. For example, 100 shares of a company bought at $20 per share, or $2,000 plus brokerage commission (say $50) would total $2,050. If the stock rises, for example to $50 per share, no capital gain need be recognized even though the 100 shares are now worth $5,000. Continuing this example, a sale of the 100 shares at $50 per share, or $5,000 minus the brokerage commission (say $70), would net a total of $4,930. The taxable capital gain would be $2,880 [$4,930 - $2,050]. By deciding when to sell, a direct investor can control when this $2,880 capital gain would subject to taxation.

The expense ratio of a mutual fund can be reduced or eliminated by direct ownership. Shares held in a brokerage account, or street name, may be charged a modest annual fee; shares delivered to an investor in certificate form would not be charged any management fee. However, the management must still be done; the investor can avoid the expense ratio but must accept the management responsibility personally.

Most investors buy individual stocks through stock brokers. Brokers can be divided broadly into three categories: full service, discount and electronic. A full service broker provides information, investment advice and personal service for a fee. A discount broker reduces the fee but usually provides limited information and usually no advice. The investor usually must simply provide an order for the discount broker to execute. Electronic brokerage firms now provide stock transaction execution for very low costs. These services provide pure stock purchase or sale execution and require investors to be comfortable with electronic ordering. Any one of these three brokerage alternatives to a mutual fund can eliminate the tax timing issue. Depending upon the degree of service desired, they may significantly reduce the annual mutual fund management fee.

Is there a way to eliminate both the tax timing issue and the management/brokerage fee? Almost. Investors can now buy shares directly from some companies. Many companies, including Exxon, McDonald's, Lucent Technologies, allow individuals to buy shares without any broker. Most direct purchases from a Dividend Reinvestment Plan (DRIP) require a minimum initial investment of $25 to $250. The company or DRIP administrator collects purchase deposits and then buys the stock once or twice a month. Subsequent purchases are made by check.

Not all direct purchase DRIPs use the Direct Purchase Plan Clearinghouse, but you can obtain a prospectus on up to five companies by calling 1-800-774-4117. The company selling the stock pays for the service so there is no cost to the investor for requesting the information. Most companies will charge a fee of a few dollars for transactions.

For investors interested in direct purchase of international stocks, traded as American Depository Receipts or ADRs, the Bank of New York operates the Global BuyDIRECT service. Similar to the Clearinghouse, investors can order a prospectus on up to five international companies by calling 1-800-345-1612. Whether buying direct shares in a US company or direct ADRs in an international company, DRIPS typically offer reinvestment of dividends, optional cash purchases in small amounts, and automatic periodic purchases for those interested.

How can the Association help with personal investments? Call the Member Service Department at 1-800-336-4538 ext. 360 to participate in the Financial Awareness Service (FAS). FAS provides information, not advice. It's one of the many benefits included in your membership.

Throughout this series of articles we have discussed basic concepts of money management, such as understanding one’s risk tolerance, asset allocation, diversification, and simplicity. Many investors find money management intimidating because of jargon or complexity. Therefore, keep it simple.

How can an investor achieve diversity but also keep it simple? We have discussed using mutual funds as a simple way to hold stocks or bonds, indirectly. We reviewed the importance of maintaining a small but safe cash reserve for emergencies. Recall some simple rules for percentage allocation of one’s portfolio (illustrated for a 40-year-old):