August 2012: ACap ReCap
1. How can I invest in commodities?
This is a great question, especially since you have probably heard me say that commodities are a fantastic way to diversify your portfolio from the traditional stocks and bonds, and they protect your portfolio from inflation. So how do you go about investing in commodities? First, commodities are broken up into two segments: hard and soft. Hard commodities are mined (think of gold and silver), while soft commodities are consumed (such as wheat, corn, etc.). There are essentially three ways to own commodities: the physical commodity itself, through futures, or through a fund. Owning gold coins is an example of a physical holding, while trading a futures contract is a more advanced investment strategy. However, for most investors, the best way to get exposure to commodities is through a mutual fund or ETF. I recently published an article on the Financial Planning Association blog; click here for the article and a more in-depth overview of each investment strategy.
2. What are options and how can I trade them?
I most frequently hear this question from people whose friends are “making money” trading options, and they want to get in on the action, especially when the market is volatile. Options are an advanced trading strategy and should only be used by experienced investors who fully understand the mechanics of options. Regardless of what anyone tells you, options are risky; it’s the exception, not the norm, for investors to consistently make money trading options. That said, an option is a contract between two parties to either buy (call) or sell (put) an asset at a pre-determined price within a specific time. The key word is option; the owner of the option has the option, not the obligation, to exercise their contract. If an option owner has the right to buy an asset for $10 and the asset is now worth $20, the option owner has made money. If the asset has declined in value to $5, the option owner simply lets their option expire and does nothing. This is a simplistic example of a call option. There are many other examples, and their strategies can be very complex. Your friends who profess to have made money trading options are most likely either not accurately calculating their returns, are not fully disclosing their losses, or a combination of the two. Stay tuned for a more in-depth article on some real life examples of how options work.
3. Why does a bond’s price move in the opposite direction of interest rates?
The inverse relationship between interest rates and bonds is one of the hardest financial concepts for many investors, and even beginning finance students, to grasp because it seems counterintuitive. A simple bond is issued by a company or government with a promise to pay a set interest rate for a defined period of time. The interest rate and term of the bond are fixed and written in the contract (known as debenture), so the only thing that can change is the price. For example, assume Ford issues a 10 year bond at 5 percent per annum. If you purchased that bond when it was first issued by Ford, you would buy it for $1,000, receive $50 every year, and $1,050 when the bond matures in 10 years. Now let’s assume interest rates declined to 2 percent just after you bought the bond; Ford is still paying you 5 percent, but the market interest rate is now 2 percent. You could sell your bond for more than $1,000 ($1,278 to be exact) because the Ford bond is paying $50 versus $20 (current market rate) for every $1,000. The same would hold true if interest rates rose above 5 percent. This is why bond prices move inversely with interest rates.
4. What if I contribute to a Roth IRA and then my income increases?
The Roth IRA is a great way to save for retirement because your money grows completely tax-free. Unfortunately, not everyone qualifies for the Roth IRA because of income eligibility rules. If you contributed to a Roth IRA in the beginning of the year and then realized your income was higher than expected, or you married and your combined income disqualifies you, the Roth IRA contribution will have to be reversed. The process to reverse a Roth IRA contribution is easy. All you have to do is fill out a form offered by your custodian (such as Scottrade) and they will reverse it for you. However, just because your income is too high doesn’t mean you are completely shut out of a Roth IRA; click here for an article on the backdoor Roth IRA for high income earners.
5. What is the difference between APR and APY?
This is a fantastic question and one that applies to anyone who has a loan or savings account, which is pretty much all of us. Annual Percentage Rate (APR) is the annual rate of return without compounding interest, while Annual Percentage Yield (APY) takes into consideration compounding that occurs during the year; if interest is compounded annually, APR and APY are equal. Banks and credit card companies use this slight distinction as a marketing tool. If you apply for a credit card, the bank will quote you APR even though the actual APY is higher; but if you’re opening a savings account, the same bank will quote you the APY because it’s higher. Let’s look at a real life example, Bank of America offers a 12.99 percent (APR) credit card with interest compounded monthly, however the APY is actually 13.79 percent because the interest on your balance accrues monthly. Bank of America also offers a savings account with a quoted APY of .15 percent, but the actual APR is .10 percent. Watch out for the sleight of hand.
Ara Oghoorian, CFA, CFP® is the president and founder of ACap Asset Management, Inc., a “Fee-Only” investment management firm located in Los Angeles, CA specializing in helping doctors and physicians make sound financial decisions. Contact Ara at firstname.lastname@example.org or on the web at www.acapam.com for a complimentary consultation.