Setting up your financial goals
Money has little to do with some of our most important personal goals. These include spending more time with family, doing volunteer work, or developing a hobby. Yet, other personal goals clearly can be defined as financial goals. These include:

• Paying off your debts. By establishing a repayment plan, you can repay your debts in a systematic fashion. A repayment plan may take years. It requires discipline to control your spending. For example, to pay off $5,000 in credit card debt at 14% interest requires monthly payments of $240 for the next two years. That's assuming you make no additional charges. As long as you owe, you sacrifice other financial goals for the sake of paying creditors.
• Saving for a down payment on a home. You may be thinking about buying your first home in a few years. The normal size of a down payment is 20% of the home purchase price. At today's home prices, this means saving somewhere in the range of $25,000 to $50,000. To save $25,000, you would have to set aside just over $4,000 a year for each of the next five years, if you can earn an 8% rate of return.
• Saving for a child's college education. For the school year that began in August 2006, the average yearly tuition bill at public four-year colleges or universities rose 6.3% to $5,836, the College Board said in its latest survey. For private institutions, tuition prices rose 5.9% to $22,218 a year. By setting aside $260 every three months for the next 15 years, invested at 8%, you will have saved $30,000. This should make a considerable dent in the future cost of your child's college education. This assumes you use a college savings plan or other tax-advantaged account.
• Saving for retirement. For most of us, saving for retirement is our most important financial goal. We may live 20 or 30 years after we stop working. Financial planners strongly advise against depending entirely on the income you receive from Social Security. To maintain a comfortable living, you may decide you want to save $500,000 in another 30 years.
  
  Fortunately, you can invest with a tax-deferred account such as an IRA or 401(k) plan. In addition to postponing any taxes until the future, these accounts offer compounded growth. For example, if you invest $5,000 a year for 30 years at 8% in an IRA, the account will grow to almost $567,000. If you were to save with a taxable account and were in the 25% tax bracket, however, the amount would only reach about $395,000. This is the power of compounding you receive by using a tax-advantaged account.

Finally, keep in mind that it's quite common to have more than one financial goal. It's important to identify all of them, and set up a savings plan for each goal.

Investing Basics

Your investment profile
To get an idea of your investment profile, start by calculating your investment horizon. This is the number of years that you can invest. Your investment horizon depends on your financial goal. Your goal may be to save for college, retirement, or a down payment on a home. Each goal has its own investment horizon.

For example, saving for retirement at age 60 when you're 25 gives you an investment horizon of 35 years. The longer the investment horizon, the longer you can save and benefit from compounding.

Next, estimate your risk tolerance. Your risk tolerance is your willingness to accept some volatility in the rate of return of your investments in exchange for a chance to earn a higher return. If you expect a higher rate of return, you should be willing to accept a higher degree of risk. This is called the risk-return trade-off.

To get an idea of your risk tolerance, take a few minutes to complete the following risk tolerance quiz

Source: Securities Industry Association.

Add the number of points for all seven questions. Add one point if you choose the first answer, two if you choose the second answer, and so on. If you score between 25 and 28 points, consider yourself an aggressive investor.

If you score between 20 and 24 points, your risk tolerance is above average. If you score between 15 and 19 points, consider yourself a moderate investor. This means you are willing to accept some risk in exchange for a potential higher rate of return.

If you score fewer than 15 points, consider yourself a conservative investor. If you have fewer than 10 points, you may consider yourself a very conservative investor.

This is one example of a short quiz used by financial institutions to help you estimate your risk tolerance. For specific investment advice, you should consult a financial adviser.

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Rule of 72
Rule of 72 is an investing rule of thumb that explains how long it takes to double your savings, approximately, for a given savings rate. To use the rule:

1. Start with the number 72.
2. Divide by the rate of return you expect to earn.
3. This is your investment horizon, or number of years you need to double your savings.

For example, if the interest rate you earn is 7.2%, you would double your money in about 10 years:

1. Start with the number 72.
2. Divide by 7.2 to get a result of 10.
3. You would need approximately 10 years, or 120 months, to double your savings.

Let's calculate an example of the rule:

Rule of 72 does not include adjustments for income taxes or inflation. Rule of 72 also assumes that you compound your interest yearly. If you compounded more frequently, you will reach your goal sooner.

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

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

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


Some important steps in setting up a personal budget include:

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

The six tables, below, show how even amounts of as little as $25 or $50 can grow if invested every month. Investment horizons range from one to 30 years. Interest rates range from 5% to 8%. For example, $50 invested at 5% every month for the next five years will grow to $3,400.

The tables also illustrate the benefit of compounding. For example, $25 invested for five years at 8% grows to $1,837. However, $25 invested for 10 years at 8% grows to $4,574. This is an extra $900 of compounded interest that you earn during those five years.

Since your emergency fund serves a vital purpose, you want to have access to the funds. At the same time, you want to earn interest on these funds. As a result, you should plan to invest it in only the most liquid and safest of investments. These investments include CDs, savings deposits, and money market accounts. All of these instruments are insured by the FDIC for up to $100,000 per depositor per institution. Money market mutual funds are not guaranteed by the FDIC. However, money market funds seldom drop in value because of the high quality of their investments.

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

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

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Debt management
Many of us seek to invest at the same time that we pay off our debts. A failure to manage debt often hinders us in pursuing such major financial goals as saving for retirement or a down payment on a home. The following interest-rate management principles can help you to understand what's at stake:

• Consumer debt offers no tax breaks. You cannot take a tax deduction for interest you pay on auto loans, credit cards, or other forms of consumer debt. Interest you pay on most mortgage and home equity debt, as well as on student loans, may be tax-deductible.
  
  Tax-deductible interest lowers your effective interest rate of borrowing. To calculate, multiply the stated interest rate by a factor of 1 minus your income tax bracket. For example, if you are in the 25% tax bracket and pay 10% on a home equity loan, your effective rate is 7.5%.
• Pay off higher-interest debt first. If you're using a debt repayment plan, pay off debt with the highest interest rate before all others. (Be sure to maintain scheduled debt payments on other borrowings, however.) Make a table of your debts, ranked in descending order by the effective interest rate. Here's a format you can use:

• Consider the opportunity cost of paying off debt. For example, say you have $5,000 and you're deciding whether to invest or repay debt. From the table, above, you see that you can pay your entire credit card balance, as well as pay down $3,000 of your auto loan.
  
  If the opportunity cost of debt reduction is investing in a 6% CD, paying off debt is the better deal. You manage to wipe out $5,000 in debt that has an average combined interest rate of 12%. You should only consider investing if you can earn a rate of return of at least 12%.
  
  Investing at a higher rate of return than your cost of borrowing is called leveraging. Leveraging can be risky. The rate of return you earn can drop unexpectedly, making your cost of borrowing higher than your return. Additionally, your borrowing costs may rise when your rate of return is unchanged.
• Focus on after-tax returns when making the repay debt-or-invest decision. Unless you invest with a tax-deferred account, you will owe income taxes on your investments. You may even owe capital gains taxes. If you invest with a taxable account, be sure to calculate your after-tax return.
  
  For example, if your pretax return is 8%, and you're in the 25% tax bracket, your effective rate of return is 6%. To decide between investing and repaying debt, compare the 6% return and the effective rate on your debts.

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Risk and return
Risk is the uncertainty that you may not earn your expected return on your investments. For example, you may expect to earn 20% on your stock mutual fund every year, but your actual rate of return may be much lower.

For example, the S&P 500 index averaged yearly gains of about 28% for the five years that ended in 1999. In 2000, however, the index declined more than 9% and in 2001 declined another 12%. Bonds, meanwhile, performed better than stocks for the first time since 1990. The S&P 500 index was back in the black in 2003 through 2005, averaging nearly a 15 annual return%.

The peril of investing in the stock market between 2000 and 2002 underscores the risk-return trade-off. The risk-return trade-off requires that you accept more risk in exchange for the chance to earn a higher rate of return. If unwilling, you should expect to earn a lower return. Conservative investors, for example, are less willing to lose 10% of their investments in exchange for the chance to earn a higher rate of return. Aggressive investors, on the other hand, are willing to accept this risk in exchange for the chance to earn higher returns.

Some investors argue that the late-1990s was a unique period where a unique set of factors drove stock market indexes to record highs. The Internet allowed millions of individuals to buy and sell stocks and mutual funds for the first time. Venture capital firms plowed billions of dollars into companies that went on to sell shares in initial public offerings. In addition, American businesses spent billions of dollars on information technology. This combination of factors may have led investors to lose sight of the risk-return tradeoff.

The following table shows how the risk-return relationship has held over the long term. Annual rates of return are shown for stocks, bonds, and cash for the 50 years ended in 1996:

Source: American Association of Individual Investors

The table shows that, of the three major asset classes, stocks offered the greatest rates of return over the long term, but stocks were also the most volatile. Divided into holding periods of five years, stocks lost 2.4% in their worst period. Bonds and cash never lost money in any of the periods.

To some degree, you can reduce risk by hedging or diversifying your investments. However, the risk-return trade-off steers investors with little or no risk tolerance toward making smaller allocations to stocks than investors with a high degree of risk tolerance.

Major types of risk include:

• Investment risk. Investment risk is the chance that your investment value will fall. Standard deviation is commonly used to measure investment risk. It shows a stock or bond's volatility, or the tendency of its price to move up and down from its average. As standard deviation increases, so does investment risk.
  
  A common measure of portfolio risk is the beta coefficient. Beta is a value that ranges from +1.0 to -1.0. A portfolio with a beta of +1.0 earns a rate of return that is identical to that of the benchmark index used to compare the portfolio's return. A portfolio with a beta of -1.0 earns a rate of return that is exactly opposite to that of the benchmark index. By investing in securities that have a low or negative beta, you can diversify your investment risk.
• Market risk. Market risk is the chance that the entire market where your investment trades will fall in value. Market risk cannot be diversified.
• Interest rate risk. Interest rate risk is the chance that interest rates will change while you hold an investment. Higher rates result in lower returns on stocks and bonds, but higher returns on interest-paying investments.
• Inflation risk. Bonds are especially vulnerable to inflation risk. This is because a bond's coupon payment is usually a fixed amount. When inflation rises, the present value of the coupon falls. Stocks have less risk since dividends can be adjusted for inflation.
• Industry risk. Industry risk is the chance that a set of factors particular to an industry group drags down the industry's overall investment performance. For example, cold weather might adversely affect the retail industry or a cutback in capital spending might adversely affect the information technology industry.
• Credit risk. Credit risk is the chance that the company selling bonds is unable to make debt payments. As a result, the company may default on its debt or have to file for bankruptcy.
• Liquidity risk. Liquidity risk is the chance that your stock or bond investment cannot be sold easily because of a lack of buyers. Such a security is called a thinly-traded security. As a result of a lack of liquidity, you may have to sell the investment at a price below its fair value.
• Currency risk. When you buy a company's stocks or bonds, you are buying a piece of that company's business operations. If the company sells products in other countries, you also face the same currency risk the firm faces. The company may or may not hedge its currency risk.
  
  Currency risk exists in some mutual funds that invest in stocks and bonds of companies outside the U.S. For example, if you buy shares of a mutual fund that invests in Japanese companies, and the Japanese yen falls in value, the dollar value of your fund shares also drops. If the fund has not hedged its currency exposure, it will face a loss in the value of its yen-denominated investments when it repatriates income to the U.S.
• Prepayment risk. Prepayment risk affects investors of bonds that are backed by thousands of mortgage loans or millions of dollars of credit-card receivables. Prepayment risk is the chance that borrowers repay debts ahead of schedule. As a result, investors are repaid sooner than expected and have to invest these prepayments when interest rates may not be as high. Borrowers refinance when interest rates decline, increasing prepayment risk.
  

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

There are different ways to diversify a portfolio whose holdings are concentrated in one industry. You might invest in the stocks of companies belonging to other industry groups. You might allocate your portfolio among different categories of stocks, such as growth, value, or income stocks. You might include bonds and cash investments in your asset-allocation decisions. Potential bond categories include government, agency, municipal, and corporate bonds. You might also diversify by investing in foreign stocks and bonds.

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

As you increase the number of securities in your portfolio, you reach a point where you've likely diversified as much as reasonably possible. Financial planners vary in their views on how many securities you need to have a fully diversified portfolio. Some say it is 10 to 20 securities. Others say it is closer to 30 securities.

In either case, you'll still pay a lot in brokerage commissions to put together such a portfolio. For example, if the average trade costs $30, assembling a 10-stock portfolio would cost $300 in commissions. Surely, a cheaper way must exist to achieve diversification benefits.

Mutual funds offer diversification at a lower cost. You can buy no-load mutual funds from an online broker. Often, you can buy shares of a fund directly from the mutual fund, avoiding a commission altogether. Mutual funds often require an initial investment of between $1,000 and $2,500. However, they generally allow subsequent investments of as little as $25. The Web site of the Investment Company Institute has a list of mutual funds and their toll-free numbers.

Mutual funds hold hundreds of securities in their portfolios. This provides a diversification advantage that's hard to beat. You do face yearly expenses with mutual funds. Management and marketing fees make up most of the fund's operating expenses, which total about 1.5% of your investment each year.

In spite of yearly fees, owning shares of five or 10 mutual funds with different investment objectives may provide great diversification benefits at a lower cost than building a portfolio of individual stocks and bonds.

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Asset allocation
Asset allocation is the process of spreading your investments across the three major asset classes of stocks, bonds, and cash.

Asset allocation is a very important part of your investment decision-making. Professional financial planners frequently point out that asset allocation decisions are responsible for most of your investment returns.

Asset allocation begins with setting up an initial allocation. First, you should determine your investment profile. Specifically, this requires you to assess your investment horizon, risk tolerance, and financial goals:

• Investment horizon. Also called time horizon, your investment horizon is the number of years you have to save for a financial goal. Since you're likely to have more than one goal, this means you will have more than one investment horizon. For example, saving for your five-year-old daughter's college has an investment horizon of 12 years. Saving for your retirement in 30 years has an investment horizon of 30 years. When you retire, you will want to have saved a lump sum that is large enough to generate earnings every year until you die.
• Risk tolerance. Your risk tolerance is a measure of your willingness to accept a higher degree of risk in exchange for the chance to earn a higher rate of return. This is called the risk-return trade-off. Some of us, naturally, are conservative investors, while others are aggressive investors.
  
  Generally, the younger you are, the higher your risk tolerance and the more aggressive you can be. As a result, you can afford to allocate a higher percentage of your investments to securities with more risk. These include aggressive growth stocks and the mutual funds that invest in them. A more aggressive allocation is viable because you have more time to recover from a poor year of investment returns.
• Financial goals. Your financial goals are also an important consideration in deciding on an initial allocation. For example, if you want to save $40,000 for your daughter's college in another 12 years, you will have to invest more aggressively than if your goal is only $20,000.
  
  If you invested $2,000 at the beginning of each of the next 12 years in a college savings plan, invested at an annual rate of return of 8%, you would reach your goal of $40,000. If you thought you needed $60,000, however, you would have to either invest $2,950 a year, or increase your expected rate of return to 13.5%.

Generally, younger and aggressive investors allocate 70% to 100% of their portfolios to stocks, with the remainder in bonds and cash. Conservative investors allocate 40% to 60% in stocks, 30% to 50% in bonds, and the remainder in cash. Moderate investors allocate somewhere between the allocations of aggressive and conservative investors.

To make an initial allocation, you need to build a portfolio of individual securities, mutual funds, or both. In general, mutual funds provide more diversification benefit for the buck.

How you choose to precisely allocate among the major asset classes depends, in part, on other factors. For example, if interest rates are expected to rise, you might allocate a greater percentage to money market mutual funds, CDs, or other bank deposits. If rates are headed lower, you may choose to allocate more to stocks or bonds.

Financial planners suggest that you rebalance, or reallocate, your portfolio from time to time. They differ in their views on how often you should reallocate. It may be once a year, or it may be every three to six months. At a minimum, reallocation lets you update any changes in your investment profile, or to take advantage of a change in interest rates. Rebalancing often involves nothing more than a "fine-tuning" of your current allocations. For example, a conservative investor may decide to shift 5% of her portfolio from stocks to cash to take advantage of higher rates that money market funds may be offering.

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Investing & taxes
As an investor, you pay income taxes and capital gains taxes on your investments. How much you owe depends on how the income is earned. You owe income taxes on interest earned on bonds. You also pay income taxes on dividends earned on stocks and mutual funds.

You may earn income from investments as diverse as precious metals, business partnerships, or collectibles. However, this topic focuses on taxation of stocks, bonds, and mutual funds.

Generally, if you sell a security at a higher price than you paid, you earn a capital gain. If you sell at a lower price than you paid, you have a capital loss. The length of time that you hold your investment, or holding period, determines whether you have a long- or short-term capital gain or loss. If you hold a security for more than one year (i.e., 366 days), it is considered a long-term capital gain. Short-term capital gains are those that you earn on sales of securities held one year or less.

Long-term capital gains are taxed at a lower rate than your regular income. For all but the lowest income tax bracket, investors pay a long-term capital gains tax rate of 15%. Investors in the 15% tax bracket pay a long-term rate of 5%. Short-term capital gains are taxed as regular income. Capital gains are calculated by subtracting the basis from the price for which you sell the investment.

What kinds of income do stocks, bonds, and mutual funds generate, and how is this income taxed?

• Taxation on stocks. Stocks generate taxable income as dividends and capital gains which are both taxed at the same favorable rate. Generally, growth stocks don't pay dividends. Instead, they create wealth through a rise in their share prices. Income stocks, on the other hand, generate regular dividend income. Most stocks fall in between growth and income categories.
• Taxation on bonds. Bonds are sometimes called fixed-income securities. This is because most bonds have a fixed coupon rate. As a result, interest income is usually a constant amount over the bond term. Bonds also generate capital gains. Investors that buy a bond at a discount and hold it to maturity face a capital gain. Investors that buy a bond at a premium and hold it to maturity face a capital loss.
• Taxation on mutual funds. With mutual funds, taxes are more complicated. You buy and sell shares of most mutual funds at the fund's net asset value, or NAV. (Unless you're buying a closed-end mutual fund, in which case you often pay a discount or premium.) You pay taxes on three components: short-term capital gains, long-term capital gains, and dividends.
  
  Two factors have significant tax implications for mutual fund investors. One is the timing of buying fund shares. A fund manager buys and sells securities in the fund's portfolio when it's necessary to buy back shares from existing shareholders or to lock in a profit. Mutual funds are required to pass these dividends and capital gains on to shareholders at least once a year. This usually occurs in the last quarter of the calendar year. When you buy a mutual fund's shares, you may also be subject to capital gains tax for capital gains paid to other shareholders, even if you only recently purchased the shares. To avoid being stuck with a capital-gains tax bill on gains you didn't receive, you may wish to buy shares of a fund after it has made a capital gains distribution. The fund will disclose whether it has or has not yet made distributions for the current year.
  
  The second factor is a fund's tax efficiency. Looking at a fund's tax efficiency can help you to see if the investment manager is making buy-and-sell decisions that minimize your tax bill. One way of evaluating a fund's efficiency is to look at its portfolio turnover ratio. A higher turnover ratio means the fund trades its portfolio more often, incurring more capital gains. A portfolio turnover ratio of 100% means that, on average, the fund trades every security in its portfolio once a year.
  
  To help you pick funds that generate less in capital gains, you may want to consider evaluating a fund's after-tax rate of return. As of February 2002, the SEC requires all mutual funds to report after-tax returns. Initially, funds are only required to report after-tax returns for the highest income tax bracket.

Investing has other tax rules, including:

• The "wash-sale" rule. The "wash-sale" rule is aimed at preventing investors from selling a security to lock in a capital loss, immediately buying it back at a lower price. The IRS prohibits you from using the capital losses to offset capital gains if you buy back the same security within 30 days. Instead, you may wish to buy a security with a similar investment objective or similar risk characteristics to the one you sold.
• Offsetting capital gains with losses. The IRS allows you to offset your capital gains with capital losses. If your losses exceed your gains, you can offset up to $3,000 of your regular income in a year. For larger amounts of capital losses, you can carry them forward to future years. This is called the capital loss carryover rule.

Some additional ways to reduce your taxes from investing include:

• Investing in a tax-advantaged account. A tax-advantaged account allows you to defer taxes on your investments until you take money out of the account. In the case of a Roth IRA, you can avoid taxes on your earnings if you keep the account open for at least five years and don't take out money before age 59-1/2.
• Staying abreast of inflation. Inflation is a hidden tax that erodes the value of your investment. Inflation in the U.S. over the last 10 years has been relatively tame, averaging less than 3% per year. However, even this amount, over several years, starts to cut into your returns. To adjust for inflation, you can subtract the yearly percentage rate from your return. This is a good approximation. For example, if a stock returns 9% when inflation is at 3%, the inflation-adjusted rate of return is 6%.

One way to hedge against inflation is to buy Treasury Inflation-Protected Securities, or TIPs. These are government bonds that pay a fixed rate of return. Each year, the U.S. Treasury adjusts the principal amount based on a rate that equals the consumer price index. For example, after the first year, a $1,000 TIP would be adjusted to a new maturity value of $1,030. As a result of the larger principal, your coupon payment would also be larger.

• Invest in muni bonds and their mutual funds. The interest that you earn on municipal bonds, muni bond funds, and some tax-exempt money market mutual funds is exempt from federal income taxes. Interest income earned on muni bonds is often exempt from state income taxes for investors who are residents of the state issuing the bonds.

To calculate a muni bond's taxable-equivalent yield, divide the tax-exempt yield by a factor of 1 minus your tax bracket. For example, if you are in the 25% tax bracket, this factor is 0.75. A taxable-equivalent yield on a tax-exempt fund that yields 4.5% is 6%.

• Choose investments that don't generate dividends. Most notably, these include growth stocks and the mutual funds that invest in them. Also, you should remember that zero-coupon bonds don't pay coupon interest. However, the IRS requires you to report the amount of imputed interest as taxable income. You can avoid this tax liability by investing in zero-coupon bonds with a tax-advantaged account.

Taxes on your investments are complicated and often unique to your situation. This topic aims at identifying some of the major tax consequences of investing. You may wish to consult a financial or tax adviser before making any investment decisions.

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Investing in stocks
When you buy shares of a company's stock, you take an ownership stake in that company. As a result, stocks are also called equities. As a shareholder, the entire amount of your investment is at risk. You may lose up to the entire amount if the company fails. However, you also enjoy an opportunity that your shares will increase in value many times over the years.

The size of your equity stake depends on the number of shares you own and number of shares the company has issued. For example, if you own 1,000 shares of a company that has 1 million shares issued and outstanding, your stake is one-tenth of 1 percent. If the company's shares double to 2 million, your stake has been diluted. You now hold one-twentieth of 1 percent. A 2-for-1 stock split doubles both the number of total shares and your shares. As a result, your share is unchanged. Some stock splits have odd ratios, such as 3-for-2 or 5-for-4. In any case, a stock split protects your share in the company, since you receive additional shares in the same proportion as all other shareholders.

As a shareholder, you are entitled to receive income that the company distributes as dividends. Since U.S. companies are required to report earnings results to shareholders every three months, you usually receive dividends at the same interval (unless the company doesn't pay a dividend.)

For example, a company may pay out 20% of its profits each quarter to shareholders. If dividends equal $1 a share, your stake would result in $1,000 of dividend income. If the share price were $80, your dividend yield would equal 5%. This is because a $1-per-share dividend in a quarter suggests a total dividend of $4 for the year, assuming no growth. This $4 divided by the current share price of $80 results in a 5% dividend yield.

While you earn dividends when you own stocks, you earn capital gains when you sell them. You earn a capital gain if you sell a stock for more than its basis. The capital gain is the amount on which you owe capital gains taxes. Since 2003, dividends have been taxed at the same rate as your capital gains.

Many companies have dividend reinvestment plans, or DRIPs. Companies offer DRIPs to encourage you to reinvest your dividends. Reinvesting is a way of buying additional shares of the stock. For example, if you were to reinvest the same $1,000 of dividends in additional shares when the share price is $80, you could buy an additional 12.5 shares. DRIPs also reduce or eliminate brokerage commissions and other transaction fees. They also let you take advantage of dollar-cost averaging.

A company often has two classes of stock: common and preferred. If your shares have voting rights, it's likely they are common shares. Voting rights allow you to vote for members of the company's board of directors and on other important corporate matters. In a proxy vote, you can often assign your voting rights to a shareholder group of your choice. As a rule, preferred shares do not have voting rights. Preferred shares are often placed with large investors for strategic financial reasons. Not too many issues of preferred shares trade on the stock market, and it's unlikely that you'll own them as an individual investor.

Investing in stocks is an important part of the asset-allocation process. Over time, stocks have earned an investment return that is substantially higher than bonds or cash. Professional financial planners and advisers routinely recommend an allocation to stocks of at least half an investor's portfolio value. These are guidelines for a conservative investor. For aggressive investors, a recommended allocation is often 70% or more of a portfolio's value.

When making an investment decision, you need to make realistic assumptions about your expected return. Over long periods, stocks average a yearly rate of return of about 11%. However, these long-term returns are well below the average annual returns of above-20% that investors received over a five-year period through 1999. Financial experts suggest you be conservative in estimating your expected rate of return.

The stock market in the U.S. consists of several thousand stocks. Several thousand more exist outside of the U.S. Major categories include growth, income, value, cyclical, and foreign stocks.

Stocks are also identified by their market capitalization. The three major categories are large-, small-, and mid-cap stocks.

Stock indexes are often used as a barometer of investment performance for the stock market. Stock indexes are put together from a group of stocks whose characteristics, overall, represent a major segment of the stock market. One requirement is that they are widely traded among investors, or have a high degree of liquidity. Investors routinely use major indexes to gauge how well their portfolios are doing, in a process called benchmarking. Major stock indexes in the U.S. include the S&P 500, NASDAQ Composite, Dow Jones Industrial Average, and Russell 2000 indexes. The S&P 500 is the most widely used benchmark index for investors.

There are different approaches to picking stocks. Three major approaches include:

• Fundamental analysis. Traders who use fundamental analysis believe a company's future ability to increase revenues, profits and cash flow determines its share price. Fundamental analysis evaluates the basic economic and industry forces that shape a company's growth. It also analyzes the firm's financial statements. Within the fundamental analysis framework, some investors prefer a "top-down" approach that starts with an analysis of the economy. Others prefer a "bottom-up" approach that starts with an analysis of the company's financial statements.
• Technical analysis. Traders who focus on technical analysis believe a company's past share price and volume of shares traded determines the future direction of its share price. Technical analysis is a mathematical approach that is also used in the foreign exchange and futures markets to determine future prices.
• Index investing. For investors who are happy to earn a rate of return that matches the overall market, index investing is the preferred approach. Index investing is a passive approach to investing. Since it mimics the composition of a major stock index, there is little trading of stocks. As a result of the little trading required, index investors incur less in fees than do active traders who use the fundamental or technical approach.

The share price of a company often rises sharply if it is the target of an acquisition or merger from a stronger suitor. Generally, acquisition announcements boost the share price of the company to be acquired. The share price of the acquiring company generally drops on the news, as investors react to an anticipated drag on future profits.

For example, on May 1, 2001, Pulte Homes Corp. and Del Webb Corp. announced an $800 million merger, with Pulte Homes agreeing to pay a little less than one of its shares for each share of the developer of active-retirement communities. In trading on the New York Stock Exchange that day, Pulte's shares fell 9%, while shares of Del Webb rose more than 13%.

Companies sell their shares to outside investors for the first time in an initial public offering. An IPO is a chance for a company to raise substantial cash to grow faster. It is also a chance for business owners to earn a return on their investment, after a mandatory lock-up period expires. However, IPOs are famous for burning investors, especially individuals. They often generate an initial buzz of excitement when shares first begin trading. However, after an initial "pop" in share price, companies that complete an IPO are soon judged by their abilities to generate revenue, profits, and cash flow.

To buy shares, you need to have a brokerage account. This requires opening an account with a brokerage firm that is licensed to buy and sell stocks. You can use a full-service brokerage or a discount brokerage. Full-service brokers provide more service than discount brokers. Discount brokers tend to focus on the bare-bones features of trading, and thereby charge low brokerage commissions.

Some full-service brokerages also offer a discount-brokerage service. Some Internet-based brokerages focus exclusively on the discount market. The Securities and Exchange Commission (SEC) regulates all securities trading and registration in the U.S., including the supervision of brokerage firms. The SEC fines those firms that break the rules and identifies the improprieties that result in the fine.
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Investing in bonds
Investing in bonds offers more protection than stocks. In the event a company defaults on its bonds or goes bankrupt, bond investors get repaid ahead of shareholders. This lower risk is a big reason that the investment rates of return on bonds are significantly lower than they are on stocks.

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

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

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

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

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

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

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

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

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

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

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

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

• Yield-to-maturity. A bond's yield-to-maturity is the return you earn on a bond if you buy today and hold to maturity. It is the interest rate that sets the price you pay for the bond equal to the sum of its future coupon interest payments and value at maturity. Yield-to-maturity assumes that the bond's coupon interest is reinvested at the same interest rate as the yield-to-maturity.
  
  In fact, investors routinely sell bonds before they mature. In this case, a bond's yield is best measured by its total return. Total return shows a bond's rate of return over the time you hold the bond, and includes all capital gains and coupon interest income. Total return requires you to make an explicit assumption about the reinvestment rate you receive on your coupons.
• Yield-to-call. This is the yield you earn on a callable bond if you buy it today and hold it until its first call date. Companies choose to issue callable bonds because of their flexibility. If interest rates decline following the bond issue, it can call the bonds and refinance at a lower interest rate. Callable bond investors are compensated for this risk by receiving a premium for their bonds.
• Current yield. This is a snapshot of a bond's value. It is the bond's coupon rate divided by its current price. Since bond prices often change many times a day, the current yield also changes constantly.

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

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

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

There are four major bond categories, including:

• Government bonds. Treasury bonds and their kin, inflation-protected Treasury securities, make up the government bond market in the U.S. The interest that you earn on these securities is exempt from state income tax. Treasury securities are considered the safest of bonds worldwide, since the risk of the U.S. government defaulting on its debt is essentially zero. However, the supply of Treasury securities is dwindling as the government pays down debt and reduces the sizes of new issues. The bond market has relied on the Treasury bond market as a benchmark for pricing other bonds. As a result of this drying-up in the supply of Treasurys, agency bonds appear likely to serve as a benchmark in the future.
  
  The national treasuries of most countries sell government bonds. These usually have nicknames, the way U.S. government bonds are called Treasurys. For example, government bonds in the U.K. are called gilts. Government bonds in Japan are called JGBs. Government bonds in Germany are called bunds.
  
  You can also invest in U.S. savings bonds. These are government securities sold in denominations of as little as $25. There are three types of savings bonds: Series EE, Series HH, and Series I bonds. Series HH bonds are no longer issued by the U.S. Treasury, but the existing bonds continue to accrue interest. For more information, see the U.S. Treasury's TreasuryDirect program.
• Corporate bonds. Companies of all sizes and industries sell corporate bonds. A company's credit rating determines how cheaply it can sell its bonds to investors. Credit rating agencies assign an investment-grade rating to bonds of companies with the most financial resources and that are least likely to default on their debt. Investment-grade bonds pay smaller spreads over a benchmark bond than do below-investment grade bonds. These bonds are sometimes called "junk" bonds, because of their greater risk of default.
  
  Some corporations also sell convertible and exchangeable bonds. Convertible bonds allow investors to convert the value of their bonds into shares of the company, if and when the price is good to do so. Exchangeable bonds allow investors to swap their bonds for shares of another company's stock.
• Agency bonds. Government-sponsored enterprises such as Fannie Mae and Freddie Mac sell agency bonds. Fannie Mae and Freddie Mac are private corporations that focus on buying and selling residential mortgage securities. While the U.S. government does not explicitly guarantee the bonds of Fannie Mae and Freddie Mac, their size and importance in the economy makes the chance of their default extremely unlikely. As a result, their bonds are considered only slightly more risky than Treasury securities. The government does guarantee bonds sold by Ginnie Mae, Sallie Mae, and some other federal housing agencies.
  
  Agency bonds are often structured in a complicated way. Residential mortgages and credit card receivables often serve as the collateral for these bonds. A risk is that the borrowers of these mortgages and credit cards will pay off their loans if interest rates begin to fall. This is called prepayment risk. Prepayment risk means that an investor in these bonds is repaid sooner than expected, and is forced to reinvest this amount at an interest rate that is usually lower.
• Municipal bonds. Municipal bonds, or "munis," are issued by state and local governments. A revenue muni bond repays investors from the revenues directly earned from the project the bond is financing. These include bonds for transportation and other infrastructure-related projects. A general-obligation muni bond is a muni bond that will repay investors from the general tax coffers of the issuing authority. Interest on muni bonds is exempt from federal income tax. Residents of states who buy muni bonds issued by that state may be able to exempt interest income from state income taxes as well. This is called a double-exempt muni bond.
  
  The larger your tax bracket, the greater the tax advantage of investing in muni bonds. For example, if you're in the 25% income tax bracket, a 5.5% yield on a muni bond is equivalent to a taxable yield of 7.33%. This is called the taxable-equivalent yield. If you buy a muni bond that falls into the double-exempt category, the yield advantage is even higher. For example, if you pay a state income tax rate of 10%, your combined tax burden is 35%. This makes a double-exempt bond even more attractive. That 5.5% yield has a new, higher taxable-equivalent yield of 8.46%.
  
  Zero-coupon bonds, or "zeros," are issued at a steep discount to their par value. Instead of receiving coupon interest, investors earn imputed interest. For example, if you buy a 10-year zero-coupon bond that is discounted at an annual interest rate of 8%, you would pay $463. A year later, the bond's price would rise to $500. This $37 appreciation in the first year represents imputed interest. The IRS also requires that you report this as taxable income. Since you owe taxes on money you don't actually receive until the bond's maturity, some financial planners advise that you buy zero-coupon bonds for tax-advantaged accounts. These include retirement accounts such as IRAs and 401(k) plans.

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Investing in mutual funds
A mutual fund is an investment company that sells shares and invests the proceeds in a portfolio of securities. These securities include stocks, bond, cash, or other asset classes.

Two significant benefits of investing in mutual funds are diversification and lower transaction costs. By investing in the securities whose prices do not move together, the fund achieves a level of diversification at a lower price than what you would pay to diversify with individual securities. Mutual funds often manage billions of dollars for investors. Their size allows them to spread out brokerage commissions and other transaction fees, or even negotiate lower fees. This results in lower transaction costs for you.

Finally, buying shares in a mutual fund gives you access to the trading decisions of a team of analysts and portfolio managers. Although some funds rely on one fund manager to make the investing decisions, most funds use a team-based approach that includes the views of other fund managers. Analysts pore over extensive financial data and research to make well-informed decisions. They often use modeling and other software tools that you likely don't have access to.

A mutual fund's prospectus explains to potential investors the fund's investment objective. (See a table of fund categories.) The investment objective describes the types of securities the mutual fund invests in. This helps to you to evaluate the investment risk of the fund. (See a table of fund categories, by degree of risk.) Important information on a fund's expenses is also included in the prospectus.

Like stocks and bonds, the Securities and Exchange Commission regulates the mutual fund industry. However, unlike bank deposits such as CDs or money market accounts, the FDIC does not guarantee mutual fund investments.

Mutual funds are required to distribute their income to shareholders once a year. As a result, shareholders rather than the fund pay taxes on the fund's earnings. Mutual funds distribute dividends and interest that they receive from their investments. They also distribute capital gains that they incur when they sell investments. When a fund buys back its shares, it usually has to sell holdings to raise cash. These sales may result in a tax bill that is also passed on to shareholders. Depending on the length of time the fund holds an investment, a capital gain is classified for tax purposes as a short- or long-term gain. (The cutoff is one year).

A fund's tax-efficiency indicates the size of the tax bill it incurs. A mutual fund's portfolio turnover ratio is also a fairly good indicator of tax efficiency. In general, the higher the ratio is, the lower the tax efficiency. Since February 2002, the SEC has required all funds to report after-tax returns for fund shareholders. Investors who use a tax-advantaged account can defer, or avoid, paying taxes on mutual fund distributions. Similarly, buying tax-exempt money market and municipal bond funds allows you to minimize taxes.

Shares of mutual funds are bought and sold at the fund's net asset value. A fund's NAV is calculated by subtracting the fund's liabilities from its assets, and dividing by the number of shares of the fund. For example, a fund with $101 million in assets, $1 million in liabilities and 10 million shares has a NAV of $10.

Some mutual funds have sales charges, or loads, that you pay when you buy or redeem (sell) shares. If a fund has more than one class of shares, chances are each class is used to distinguish shares that charge a front-end load from those that charge a back-end load.

Not all funds have loads, however. There are thousands of no-load mutual funds. Given a choice of paying a load versus not paying one, the answer seems clear. However, some funds with loads have better investment performance than no-load funds. It may be worth paying a load if you think you'll earn a higher investment return over the long term.

To discourage you from selling your shares of a fund too soon, most funds impose a redemption fee.

In addition to loads, some mutual funds also charge annual fees. These are explained in the fund prospectus. These include management and 12(b)-1 fees. Together with any miscellaneous fees, these make up the fund's operating expense ratio. The operating expense ratio is stated as a percentage of the fund's assets. It is generally in the range of 1 to 2 percent of fund assets.

Mutual funds come in two basic packages: open-end and closed-end. A third structure, unit investment trusts, is beyond the scope of this topic. Open-end mutual funds buy back shares whenever a current shareholder wants to sell them. In addition, they sell shares whenever a new investor wants to buy into the fund. For example, if 1,000 shareholders each held 100 shares, the fund's total number of shares is 100,000. If a large shareholder were to buy 100,000 shares, the mutual fund would sell new shares. Now there would be 200,000 shares. According to the Investment Company Institute, open-end funds had more than $10.28 trillion in assets at the end of November 2006:

Source: Investment Company Institute

Closed-end mutual funds have a limited supply of shares. To buy or sell shares of a closed-end fund, you place an order with a broker. As a result of the interaction of supply and demand for shares of closed-end funds, their share prices often deviate from their NAVs. Assets invested in closed-end funds were about $286 billion at the end of September 2006, according to the ICI. Because of the dominance of open-end funds, the ICI calls open-end funds "mutual funds."

Mutual funds come in four main types: stock, bond, balanced, and money market funds. Bond and money market funds are further divided into taxable and tax-exempt funds. The investment performance of a stock or bond fund is measured by total return. For money market funds, performance is measured by simple and compounded yields. Because they invest in short-term securities, a money market fund's average maturity in days is also included in its investment performance.

Index mutual funds invest in a portfolio of securities that mirrors a benchmark index and are called passive funds. Index funds generate a smaller capital-gains tax bill, since the fund only buys and sells shares when the index changes. As a result, index funds also have lower expense ratios than funds that are actively managed. Exchange-traded funds, or ETFs, are newcomers. These index funds sell shares whose price changes throughout the day depending on the way a stock's price does. This gives ETFs more liquidity than a regular mutual fund, which is only priced once a day. Judging by the billions of dollars that they have attracted over a relatively short period, ETFs appear likely to succeed as a useful financial product.

The following shows five mutual fund categories, listed by 33 different investment objectives:

Source: Investment Company Institute, "Mutual Fund Fact Book."

The following shows mutual funds by risk-return trade-off. In the first column, funds with the highest degree of investment risk are shown at top. In the third column, funds that are safest are shown at top. A mutual fund's risk is determined by the risk of securities held in its portfolio:

Source: Investment Company Institute, "Guide to Mutual Funds."