IFYF Unit 8 Review Question Answers

• Introduction
• Unit 1: Basic Building Blocks of Successful Financial Management
• Unit 2: Investing Basics
• Unit 3: Finding Money to Invest
• Unit 4: Ownership Investments
• Unit 5: Fixed-Income Investing
• Unit 6: Mutual Fund Investing
• Unit 7: Tax-Deferred Investments
• Unit 8: Investing Small Dollar Amounts
• Unit 9: Getting Help: Investing Resources
• Unit 10: Selecting Financial Professionals
• Unit 11: Investment Fraud

• Study Guide
• Action Steps
• Monthly Investment Messages
• Glossary

Unit 8

Investing With Small Dollar Amounts Review Questions & Answers

1.What are the basic prerequisites, or requirements, that you should meet prior to starting an investment program?

An investment program offers you the benefit of earning more return than what is typically paid by a certificate of deposit (CD) or a savings account. Before you start to invest, you should have:

• Reduced household debt (interest paid could exceed investment earnings)
• Purchased adequate insurance (uninsured losses could consume your investment)
• Established an emergency fund to cover expenses for at least 3 months

2.List, and briefly explain, three sources of “free” money or financial gains available when contributing to a tax-deferred employer retirement plan.

Participation in a tax-deferred employer retirement plan offers three financial benefits to the employee, even with small dollar contributions.

• Employer match. Not all employers offer a match, but any contribution of employer dollars as a match for employee contributions is truly “free” money that an employee otherwise would not have received. Strive to save enough for retirement to get the full employer match available.

• Pre-tax dollars are used, thus reducing your current year tax liability. Saving a $1,000 for retirement reduces your annual taxable income by $1,000, meaning you avoid the taxes. If you are in the 25% marginal tax bracket, that means you saved $250. Thinking of it another way, the federal government contributed $250 to your retirement—or more “free” money.

• Taxes on investment earnings are deferred until the time of withdrawal, which means the money stays in your retirement account where it can continue to earn more returns for the future. The increased growth of the principal over time represents more “free” money.

3.Under what conditions might you consider investing in an IRA?

A traditional (deductible or non-deductible) IRA offers the advantage of tax-deferred growth while a Roth IRA offers the advantage of tax-deferred growth and tax-free withdrawals. See Unit 7 or the resources cited in Unit 8 to help determine which IRA might best meet your needs. You should consider investing in an IRA if you:

• do not have an employer-provided retirement plan;
• have made the maximum allowable contribution to their retirement plan; or
• are seeking another tax-advantaged, or tax-deferred, investment option.

4.Name three strategies for acquiring stocks with small dollar purchase amounts. What restrictions, or limitations, on purchases might apply?

Purchasing stock has become more easy and affordable for the small dollar investor, despite some limitations. Consider the following options:

• Investment clubs charge monthly dues of $25 to $100 that are pooled for club stock purchases. Members may have the option to invest additional amounts beyond the required dues. Purchases are restricted to the stocks agreed upon by the club. (For more information on investment clubs, see Unit 9.)

• Online trading is accessible to the investor with as little as $1,000 to open an account, although higher minimums are more typical (e.g., $2,500 to $15,000). Small dollar investors are limited by the company share price, and any other restrictions established by the online brokerage. (For more information on online trading, see Unit 9.)

• Direct stock purchases from the company using a dividend reinvestment plan (DRIP) or a direct-purchase plan (DPP) are increasing in availability. Companies may require an initial minimum stock purchase of $1,000, but subsequent investments or optional cash payments (OCPs) can be made with amounts as small as $25. Small dollar investors are limited to the companies that offer such plans, but the number of companies is increasing.

5.Compare and contrast a dividend reinvestment plan (DRIP) and a direct-purchase plan (DPP) for stock.

Both DRIP and DPP plans offer the benefit of purchasing stock directly from a company for a relatively low cost. Although a small fee may be charged, you avoid the commission typically paid on stock purchases. (Note: the per-share commission is typically higher on small trades than on large trades.) Some companies also offer shares at a discounted price, often by as much as 3% to 5%, on initial purchases as well as the OCPs, or optional cash payments for future purchases. To participate in a DRIP, you usually need to first acquire shares through another source, but future purchases using quarterly dividends or additional OCPs occur directly with the company. For companies offering a DPP, the first share of stock can be purchased directly from the company. Both DRIP and DPP plans can be used to set up an IRA, although annual fees (e.g., $25 or $50) are typically charged. Bypassing the broker saves money, but makes the investor responsible for all research and selection. Be sure to do your homework to select quality companies. Fewer companies offer “no load stock” or DPPs than offer DRIPs.

6.List the options for fixed-income investments for small dollar investors. For each, cite a major caveat, or warning, that applies as well as relevant tax considerations.

Several fixed-income investments are available to the small-dollar investor. With the exception of zero coupon bonds, which generally require a face value minimum purchase of $5,000, the following can be purchased for less. However, each has investor caveats that should be considered:

• Treasury bills, notes, and bonds (minimum purchase of $100 and multiples of $100)
  • Interest rate risk, if sold prior to maturity

• Corporate bonds (generally require $1,000 per bond)
  • Conservative investors are cautioned to buy only “investment grade” bonds rated BBB or better.

• Zero coupon bonds
  • “Phantom interest” is taxable annually although it is not received until maturity.

• U.S. Series EE (minimum purchase of $25 for a $50 bond) and I Bonds (minimum purchase of $50 for a $50 bond)
  • 3 month interest penalty for early withdrawal prior to five years after purchase

Interest earned on Treasury securities, as well as U.S. Series EE and I Bonds, is exempt from state and local income taxes. For qualified taxpayers, Series EE and I Bonds used for education expenses may have the earnings exempt from federal taxation. Treasury bills, like Series EE bonds, are sold at a discount and interest and principal are returned at maturity. Treasury notes and bonds pay interest semi-annually.

Interest earnings on corporate bonds and “zeros” are subject to federal, state, and local taxation. Both corporate bonds and “zeros” pay interest semi-annually, but only the corporate bond interest is received. Because the “zeros” are sold as a discount bond, the interest is returned with the principal at maturity. To avoid taxation on earnings that are not truly received, zero coupon bonds are often recommended for tax-deferred retirement accounts.

7.What is a unit investment trust (UIT)? Typically, what combinations of securities might be purchased in a UIT?

Unit investment trusts are a diversified portfolio of professionally selected securities that are sold by brokerage firms to investors in units. A unit typically costs $1,000. UITs usually represent only one category of investment assets such as a group of bonds or a group of stocks. Municipal bonds or Government National Mortgage Association (GNMA) bonds are often packaged in a UIT. Similarly selected stocks, such as “The Dow Ten” made up of the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), may be packaged into a UIT. Portfolios that might be worth $100,000 or more are available to the investor for a $1,000 unit cost. UITs give the small investor an opportunity to own securities that would otherwise be far beyond their investment capacity.

Unlike mutual funds, UITs are not “professionally managed,” but are professionally selected portfolios that do not change. Given the sales commission charged, units are most cost effective if held until the trust is dissolved. Bond UITs end with the maturity of the bonds, while equity UITs may have a specified timeframe for the equities to be sold and the funds distributed. Owners periodically share in the income generated and eventually in the value of the trust assets (upon maturity or sale) proportionate to the number of units owned. With Ginnie Mae UITs, interest and principal from the underlying mortgage portfolio are distributed to the owners monthly.

8.Both UITs and mutual funds offer investors relatively low-cost access to a portfolio of securities beyond their individual investment capacity. What is a mutual fund and how does it operate?

Unlike a UIT portfolio, a mutual fund portfolio is not static. It is a diversified, professionally managed portfolio that is sold to the public in units called shares. The share price can vary daily with the performance and value of the securities held by the investment company. Managers may be constantly monitoring and trading the securities. Similarly, unless a fund is closed to new investors, it may be taking in money for new shares and redeeming shares from current shareholders at all times.

Mutual funds set their own purchase and redemption policies, but generally require a minimum investment to open an account. Critical to a fund selection is the expense ratio, or percentage of fund assets deducted for annual management and operation expenses. A low expense ratio, historical performance, the minimum amount required for opening an account, and the investment objective of the fund are key components to consider when selecting a fund.

9.Mutual funds typically require a minimum amount to open an account. What exceptions to these rules might allow an investor to open an account with a smaller amount?

The amount required to open a mutual fund account varies with the individual company and can range from as little as $250 to several thousand dollars (e.g, $10,000 or more). Regardless of this requirement, most mutual fund companies will open an account with less than the required minimum, if the account fits one of the following exceptions:

• Retirement accounts (e.g., SEP or IRA)
• Custodial accounts or Uniform Gifts/Transfers to Minors Act accounts
• Automatic investment plan accounts that are funded by automatic withdrawals from a checking or savings account or payroll deduction

Accounts established with these exceptions may also require smaller subsequent investment minimums than those required for a typical account.

10.What is the benefit of a “hybrid” fund? List, and briefly describe, three types of “hybrid” mutual funds that combine asset categories (stocks, bonds, cash) into one account.

“Hybrid” funds offer the advantage of broad market diversification by combining stock, bond, and cash asset categories into one account. In addition, both domestic and foreign securities may be included. In addition to market diversification, some “hybrid” funds offer a range of portfolios matched to different risk tolerance levels. Descriptions of three examples of “hybrid” funds, designed to meet unique needs of the investor, follow:

• Balanced funds combine high quality, dividend-paying stocks and investment grade corporate bonds or government securities. Balanced funds are managed to accomplish the objectives of moderate growth in value (share price), moderate growth in income, and preservation of capital.

• Asset allocation funds combine cash, stocks, and bonds, with the percentage of the portfolio in each asset class determined by the fund manager in response to changing market conditions. Asset class changes are targeted to maximize earnings.

• Life-cycle funds combine cash, stocks, and bonds, but the portfolio may be managed in one of two ways. First, the portfolio may be continually rebalanced to maintain a targeted asset allocation model. The asset allocation model and the associated risk tolerance are matched to the “ideal” portfolio to accomplish a range of goals from aggressive growth (e.g., young investor) to preservation of value and production of income (e.g., older, retired investor). The “ideal” or target portfolios match the investment needs of a typical household as it moves through the life cycle. In the second approach, the portfolio is managed and rebalanced over time to reflect the changing needs of a household from growth to preservation. These funds are often identified by a future date in the name of the fund (e.g., 2025).

11.How is a “fund of funds” different from an index fund? What is the benefit for the small dollar investor?

A “fund of funds” is, as the name implies, a mutual fund made up of shares of other mutual funds in the same mutual fund company, or what is referred to as the same “family of funds.” Owning a fund of funds offers broad diversification, but the fund may be limited to one asset class as opposed to the “hybrid” funds that combine categories of assets.

The portfolio of an index fund mirrors the market index for which it is named. (See Units 4 and 6 for more information.) The Standard and Poor’s 500 stock index fund includes only the 500 stocks that make up the index, while a total stock market fund would include a representative sample of almost 7,000 small, medium and large companies. Numerous index funds are available and offer the small-dollar investor the opportunity for broad market diversification and lower expenses than most actively managed funds.

12.Should the small dollar investor attempt to follow, or just ignore, portfolio diversification and dollar cost averaging strategies?

Diversification reduces risk and should be of paramount importance to the small dollar investor who cannot afford avoidable losses. In fact, a number of the investment products considered in this unit have “built in” diversity. Mutual funds offer the greatest opportunity for broad market diversification with one product, but UITs offer diversification within one asset category. With careful planning, and attention to a portfolio that matches your risk tolerance and time horizon (concepts discussed in Unit 2), an investor can accumulate a diversified portfolio built with small dollar initial, and subsequent, investments.

Dollar cost averaging is a strategy for building your portfolio on the principle of disciplined purchases that are devoid of emotion and market timing. In fact, regular purchases through a DPP or DRIP plan, mutual fund automatic investment plans, or payroll deductions for savings bonds are all examples of dollar-cost averaging. In short, the small as well as the large investor is well advised to follow a dollar cost averaging strategy to accumulate a diversified portfolio of investments.