Investment Explained   Investment for UK citizens has traditionally involved a Building Society deposit account. However, since the success of the privatization issues a vast number of UK citizens are now investing in the stock market, some directly via the Internet. These pages are an attempt to explain the different types of asset class available to investors in the UK.   Copyright 2000 everythingexplained.com

P1   Equities   Equities - Ordinary Shares These are the most popular for private investors and represent the area of greatest potential reward. However the golden rule of all investment is that reward goes hand in hand with risk - the greater the potential reward, the greater the risk. That said, equities have traditionally outperformed Building Society deposits over time as investors are purchasing a "live Dynamic" asset as opposed to a static deposit account. There are several different criteria to consider when investing in equities, including the size of the company, the sector, growth potential, and the income (dividend yield). First you must decide whether you require capital gains or income as your primary objective. If income (dividend yield) is the primary objective, sectors such as utilities (i.e. Electricity, Power, and Water companies) usually offer the best bet. These stocks have fairly predictable behavior patterns and as such offer a low but steady rate of growth. Many utilities offer yields well above that of Government Bonds, but with a crucial difference, that the yield on a conventional government bond is fixed for its life, whereas a utility is more like an index linked gilt, as over time the dividends should increase due to inflation and profit growth. top If Capital gain is the primary objective, generally speaking smaller companies have the ability to grow faster than big ones, but are also more likely to fail (risk versus reward). Also within the equity market different sectors carry differing levels of risk and reward. For example, an oil exploration company is obviously a higher risk business than a Biscuit manufacturer, but one that offers much greater potential reward if successfully captured. It is up to each individual to determine the level of risk that they are comfortable with. Risk diversification is strongly recommended.top In selecting a Portfolio of Equities the main aim is to achieve a balance of risk spread amongst a variety of sectors - never put all your eggs in one basket. However the most successful Portfolio will be one that contains companies that have the highest rates of growth. How then does an Investor go about selecting a Portfolio of companies which will "grow" at an above average rate? One method is to examine the "track record" of a selection of companies over say the last 5 years to assess the growth in EPS (Earnings Per Share). Modern computer technology now makes it much easier to recognize and analyze the historic growth rates of a wide variety of companies. This in theory should distinguish companies with competent management. However two important points must be fully understood: 1) A good historic track record is only a guide to future prospects. There is absolutely no guarantee that because a company has shown above average growth for the past 5 years that it will do so for the next 5 years.top  2) Any share that has a strong historic growth record will be highly rated by the market and as a result the share price will reflect the historic growth record, i.e. the shares will be expensive relative to slower growing companies. The stock market is brutal in its treatment of "star performers" that fail to keep up the high growth momentum. A second method is to jump onto New Industries (hopefully before everyone else). This approach can be very successful - witness the rise and rise of Mobile telephone companies that have gone from no where 10 years ago to being some of the world's largest companies. However some new industries never quite live up to the hype and it will be very interesting to see in a few years time how some of the internet stocks make out over the longer term. New Industries by definition involve an act of faith and are much more risky than established companies - hence the higher reward if they come good.top A third approach for the more active investor is "sector rotation". The investment business is similar to the fashion business in that entire sectors move in or out of favour at what seems at times to be totally illogical behavior by the market. A "value investor" would seek to profit from this illogical behavior by selling sectors that have become expensive and buying sectors that have become cheap i.e. are currently out of favour. This type of activity can be very rewarding if pursued in a competent manner. It is probably more soundly based than "momentum plays" which tend to be the opposite i.e. buying rising shares and dumping falling shares. Momentum players risk buying at the top and selling at the bottom. However "value investors" have to be prepared to sit on underperforming sectors for a period of time whilst waiting for their view to come good. There is of course no guarantee that yesterdays "dog" will become tomorrows "star performer".top Other factors that may influence a companies share price are assets (i.e. real estate), debt, corporate restructuring (i.e. potential takeovers) and cyclical factors. Of these debt is an especially crucial variable. The most common cause of corporate failure is excessive levels of debt. It is advisable to avoid shares where the level of debt is excessive (i.e. ideally debt should not be more than 40% of Net Assets). One interesting variable is that of cycles. Many sectors, e.g. oil and metals have strong cyclical tendencies where the shares reflect the cyclical influences that stimulate price movement in the underlying product prices. As oil shares are deemed high risk (high beta) any successful study of underlying cyclical forces affecting oil prices can be immensely rewarding. Another factor to take into account is the level of the market as a whole. If the market (i.e. the FTSE 100 or the Dow) were thought to be too high then it would be prudent to delay purchasing shares until the market has fallen to a more appropriate level. Many experts pontificate about the level of the market and very few get it right on a consistent basis.top Lastly, although smaller companies have he ability to grow faster than the big ones, the shares of these companies are not as liquid (i.e. they can be difficult to buy and sell - especially sell in a falling market). This needs to be borne in mind before purchase. Preference Shares Although these are called shares they are in reality a fixed income investment (unless they are a convertible preference). They pay a fixed dividend every year and the holder receives no benefit from any upside in the ordinary shares. Also in the winding up of an insolvent company, the preference shareholders rank below the bondholders in any pay out but above the ordinary shareholders. As a result preference shares offer some of the highest yields around. As with all Corporate Bonds marketability can be a problem. One advantage for a corporation considering purchasing preference shares is that the dividend is franked income, that is that it has already suffered corporation tax at source. This means that preference dividends (as with ordinary dividends) are effectively free of tax to a corporate holder.top

Copyright 2000 everythingexplained.com While every care has been taken to ensure accuracy of the content of this site, no responsibility can be taken for any errors or omissions. Viewers are strongly advised to check information published with individual institutions, and to take legal advice, where appropriate, before entering into transactions. All interest rates are correct at the time of going to press. The information here is only for your general information and use and is not intended to address your particular requirements. Specifically, the information does not constitute any form of advice or recommendation by us and is not intended to be relied upon by you in making (or refraining to make) any specific investment or other decisions. Appropriate independent advice should be obtained before making any such decision. Neither we nor any of our site-writers make any warranties expressed or implied, as to the accuracy, adequacy, quality or fitness for any particular purpose of this information for a particular purpose or use and all such warranties are expressly excluded to the fullest extent that such warranties may be excluded by law. You bear all risks from any uses or results of using any of this information. You are responsible for validating the integrity of any information received over the internet.

P2   Explanations   Financial Jargon Explained   Here is where we give you a simple guide to the meanings of some of the terms used in today's capital markets. . Just click on a term you want to understand - in the Index section choose one of the words underlined in blue - and you will be taken to the right part of this page for that term.   Index     Accumulation Units ADR AIM Amortisation Annuity Arbitrage Bear Market Beta Bid-Offer Spread Bid price Blue Chip Bonus Issue Bull Market CAC 40 Capital Employed Cash Flow CREST DAX Dividend Dividend Yield Dow Jones Industrial Average Earnings Yield FTSE 100 GDR Gross Redemption Yield Insider Dealing Investment Club Market Cap Net Asset Value Offer price Personal Equity Plan P/E Ratio Return on Capital Employed Rights Issue SETS Stag Stamp Duty TESSA XD Yield Curve Yield Gap Definitions   Accumulation Units These appear in unit trusts where income is re-invested by purchasing more units in the fund top ADR American Depository Receipt, this is a receipt issued by a US bank that holds the underlying shares. ADRs are used by non-US investors to trade on Wall Street. top AIM The Alternative Investment Market is a vehicle for listing smaller companies where the listing requirements are less stringent than a full listing. top Amortisation An annual charge taken through the profit and loss account that allows for the gradual write down in the value of an asset, over the expected life of the asset. top Annuity A policy issued by an Insurance company on retirement that guarantees a fixed rate of income for the remainder of your life. top Arbitrage Professional activity aimed at exploiting differences in price between two markets, i.e. London and Johannesburg for Gold shares. top Bear Market A Bear market is a market where the underlying trend is downwards. top Beta A measure of share price volatility, and hence risk. Share prices with a high Beta tend to be more volatile than shares with a low Beta. top Bid-Offer Spread This is the difference between the bid price (the price at which the holder can sell the shares) and the offer price The price at which the purchaser can buy the shares). top Bid price This is the price at which an investor sells an underlying asset. top Blue Chip A share in a large, well established company, e.g. Members of the FTSE 100. top Bonus Issue An issue of extra shares to existing holders free of charge. The market capitalisation is unchanged, however as the price falls to reflect the extra shares. top Bull Market A Bull market is a market where the underlying trend is upwards. These trends can stay in place for several years. top CAC 40 French Index of the forty major French companies. top Capital Employed The total value of all the assets being used by the business to make money. This is calculated as total assets less total liabilities. top Cash Flow Cash flow is the lifeblood of any business. Free cash flow is calculated after deductions of interest payments and tax. top CREST This is an electronic system used to settle up share purchases. top DAX German Index of major companies. top Dividend A distribution from a company to a shareholder usually in cash, although shares and other assets can also be distributed. top Dividend Yield This is the amount of income per every £100 invested (as a percentage) and as such is comparable to the rate of interest offered by a Building Society deposit account. As price rises, yield falls and vice versa. top Dow Jones Industrial Average Index of leading 30 US companies top Earnings Yield The Earnings yield is different from the dividend yield. The dividend yield is the amount a shareholder receives as his/her annual income, expressed as a percentage. The Earnings yield is the company profits relative to the share price; i.e. it is the inverse of the P/E ratio. top FTSE 100 An Index of the leading 100 UK shares weighted by market capitalization. As a geometric Index large movements in 1 or 2 of the biggest constituents can deliver a disproportionate move in the entire index. top GDR Global Depositary Receipt, similar to an ADR but used for international stocks traded in London as well. top Gross Redemption Yield This is roughly the return available on a bond taking into account the current income plus any capital gain or loss to redemption (in reality it is a very complex discounted cash flow measure which needs a computer to work out). top Insider Dealing This is where shares are bought or sold at the same time as you have privileged information that is price sensitive. It is illegal, but prosecutions are quite rare. top Investment Club This is a group of private investors that meet to discuss and implement investment strategy on a pooled basis. top Market Cap Market Capitalization is the total value of the entire company, i.e. the sum required to purchase all the outstanding shares. top N.A.V. (Net Asset Value) Net Asset value is calculated by stock market analysts to indicate the asset backing of a particular share. For example, an oil exploration company's N.A.V is calculated by working out the total value of all it's oil wells and dividing by the number of shares in issue. However this calculation requires certain assumptions to be made. For example, how much could the assets fetch in a "fire sale"? Alternatively a company may own some prime real estate that is in the books at considerably below market value. top Offer price This is the price at which an investor purchases an underlying asset. top Personal Equity Plan (PEP) From 1987 to April 1999, investors could put up o £9,000 per year into UK equities free of income and Capital Gains tax. They have now been replaced with ISAs, but PEPs already in existence can continue with their tax-exempt status. top P/E Ratio This is the price of a share relative to the earnings of the company. It is used for comparative purposes. A low P/E is considered "cheap" whilst a high P/E is considered "expensive". However a low P/E can also be considered "unwanted" whereas a high P/E can indicate "investor demand". As with much to do with the stock market, beauty is in the eye of the beholder. An easy way to understand P/E ratio is that if you purchase a company (i.e. all the shares) on a P/E of 8, it will take you 8 years to recoup your purchase cost. top Return on Capital Employed A the name suggests, this is the return on capital employed and is defined as the profit before interest and tax divided by total assets less current liabilities. top Rights Issue This is an offer for existing shareholders to subscribe for extra share usually at a discount. top SETS The Stock Exchange Electronic Trading Service (SETS) is the formal name for the electronic trading system introduced by the London Stock Exchange in 1997. top Stag A short term speculator who subscribes for new issues with the intention of a quick sale and profit. top Stamp Duty A tax payable on share and property purchases in the UK. top TESSA Tax exempt Special Savings Account. Now replaced by ISAs (Individual Savings Account) top XD This is the date that determines the ownership of the dividend (usually a semi-annual affair). The owner of the shares on ex/dividend day is the legal owner of the dividend. top Yield Curve A graph showing the shape of Bond yields of differing maturities. top Yield Gap Difference between the yield on government bonds and the yield on equities. top Copyright 2000 everythingexplained.com While every care has been taken to ensure accuracy of the content of this site, no responsibility can be taken for any errors or omissions. Viewers are strongly advised to check information published with individual institutions, and to take legal advice, where appropriate, before entering into transactions. All interest rates are correct at the time of going to press. The information here is only for your general information and use and is not intended to address your particular requirements. Specifically, the information does not constitute any form of advice or recommendation by us and is not intended to be relied upon by you in making (or refraining to make) any specific investment or other decisions. Appropriate independent advice should be obtained before making any such decision. Neither we nor any of our site-writers make any warranties expressed or implied, as to the accuracy, adequacy, quality or fitness for any particular purpose of this information for a particular purpose or use and all such warranties are expressly excluded to the fullest extent that such warranties may be excluded by law. You bear all risks from any uses or results of using any of this information. You are responsible for validating the integrity of any information received over the internet.

P3   Questions   On this page we invite you to send us questions. We cannot guarantee to have answers for you, but we will try to help. Some of the questions asked will be listed here, if we think that the questions and answers are of sufficient general interest. However, we cannot give you individual replies or advice, since we are not authorised to do so in this way. Our answers will be aimed at people that have a problem of a specific type, but without naming either individuals or organisations. Our answers will be those that apply to the best of our knowledge, but questioners should take specific advice before relying on our answers. What we will try to do is to enable you to ask the right questions of advisers and to understand the answers and the implications of those answers. Please fill in this form if you have a question you would like answered, or e-mail us at  [email protected] . To Ask Questions: First Name Surname E-mail Address Questions for this Website   Previous Questions Asked: 1. 2. 3.   Copyright 2000 everythingexplained.com

P4   Try These Sites     Whilst browsing the Internet we occasionally come across excellent sites. We will list these for your future reference.           Copyright 2000 everythingexplained.com

P5   Mission Statement   Explain everything simply.   We have found that if you can't explain something simply, either you don't understand it or you are trying to hide something. We at everythingexplained.com will try to guide you through the pitfalls in life, which we ourselves may have stumbled into from time to time, so that you do not have to repeat our mistakes. We have many years of consuming, investing and generally experiencing life between us. Our contributors, who we have invited to write certain sites, have specialist knowledge of those areas and also have many years of experience. By using our sites, we hope you will be able to find answers to questions that you wouldn't dream of asking, because you would be afraid of looking stupid or might lay yourself open to being taken advantage of. We also think that the subjects we cover and the questions we are trying to answer beforehand for you are those that it seems to be assumed you will 'pick up' as you go along. These things are not generally taught in schools or colleges and represent a steep learning curve when you finally find that you are caught up in them. If you find something that you think we have not covered, or have not covered well enough - let us know. Send us an e-mail. Our e-mail address is  [email protected]. Copyright 2000 everythingexplained.com

P6   Bonds   Bonds The other main asset class is Bonds, either Government Bonds (Gilts) or Corporate Bonds issued by our leading companies. Gilts Conventional Gilts carry a fixed coupon and a known price at redemption (usually par, i.e. £100). The advantage of Gilts is that they can offer a more attractive rate of return than a Building Society deposit account but again the risks must be considered. 1) Security of capital - because Gilts are issued by the government they are the safest of all investments in that respect, as the default risk is negligible.top 2) Price fluctuation - the risk with Gilts lies in the price fluctuation. Although a bond may be issued at par (100) and redeemed at par (100) for a fixed period (say 10 years) the price can fluctuate in the meantime. Complete security of capital invested can only be guaranteed if the bond is held to maturity. 3) Tax treatment - the income received is taxed at source (25%) and higher rate taxpayers are required to make up the difference at the end of the tax year. Capital gains are not subject to tax (up to a large limit) for private investors, but this is a two edged sword. As with all investments that promise freedom from capital gains tax losses are non-allowable.top Corporate Bonds These are similar to Gilts, but with a higher default risk. Companies can go bust unlike the government. To compensate for this higher risk a higher return is available in the form of a higher yield. Bonds are graded as to their safety. G7 Government Bonds are all AAA, as are some "Supra Nationals" such as the World Bank and European Investment Bank. Next in line are AA Bonds, usually issued by large companies, and so on. The Bonds are graded by Rating Agencies such as Moody's or Standard and Poors, and the ratings can change up and own during the life of the Bond. Many Institutions are prevented from owing bonds below the AA rating. A further problem with Corporate Bonds is marketability. Whilst a healthy two-way market exists in the mainstream Government Bonds, this is not always the case for Corporate Bonds, which can be difficult to buy or sell during the life of the bond. Tax treatment is also less favorable than for Gilts, although this is equalized via the higher yield. Corporate Bonds therefore carry greater risk but offer greater return than Government Bonds.top Index linked Bonds (Gilts) These are Bonds issued mainly by the Government that do not pay a fixed coupon. Instead the "Start up coupon" is increased in line with inflation over the life of the bond. Also the proceeds on redemption are calculated to deliver full index linking over the life of the Bond. The main difference between conventional and index linked bonds are as follows; 1) The income stream on index linked Gilts is not predetermined, as we do not know the future rate of inflation, whereas with conventional Gilts the exact amount is known in advance. 2) The Redemption value is also not known for the same reason, whereas conventional Gilts redeem at par (100) The advantage is that the holder is protected against inflation in a way that holders of traditional bonds are not. However this index linking only fully works if the bond is held to maturity. All bonds fluctuate between issue and maturity and index linked bonds are no exception.top The holders of index linked Gilts receive coupons, which are linked to the Retail Prices Index. If inflation rises then so does the nominal value of the coupon in order to compensate the investor for the erosion of the value of money caused by rising retail prices. The redemption value of the bond is also linked to the RPI. The longer dated index bonds require a very large move in the price to deliver a significant change in the real yield. For example, to change the yield on Treasury 2.5% 2024 by 1% requires a move in the market price by approximately 24 points. Although this particular bond has a theoretical duration of 19, implying a very volatile bond, this is extremely misleading, as the real yield is much more stable than nominal yields on conventional Gilts. Coupons are subject to income tax for tax-paying investors. Any capital Gain (inflation uplift) used to be tax-free to all investors but this has now been amended to an indexation tax whereby the gain due to inflation is tax-free. Any gains over and above the rate of inflation are now taxed.top Convertible Bonds These are a "half way house" between a Bond and an Equity, but in reality are much closer to a bond. Like bonds they carry a fixed coupon and a maturity date. The difference is that they can be converted into shares of the underlying company at a pre-determined formula, usually once a year. This conversion (at the option of the holder) usually involves a loss of income (the shares yield less than the bonds) and a capital loss (the convertible bond usually trades at a price premium to the equity due to the higher income). The main advantage with convertible bonds is that the holder can participate in the upside of the shares if the company starts to do well, whilst maintaining a fixed income investment. Again, as with all investments, risk offsets reward. A higher yielding convertible bond can either be because the company is not highly graded or because the "conversion premium" is high. The conversion premium is the percentage capital excess of the bond over the underlying equity. This is usually determined by the difference in income between the yield on the convertible bond and the dividend yield on the shares.top A convertible bond with a high conversion premium will require a large rise in the price of the underlying shares to trigger a significant movement in the convertible bond. A convertible bond with a low conversion premium has a closer relationship with the underlying shares and will generally show greater correlation to movement in the underlying share price.  top Copyright 2000 everythingexplained.com

P7   Derivatives Derivatives These are financial instruments whose values or properties are 'derived' from other products. The products can be real, like oil, or themselves derived from real products. Options An Option is a derivative of an underlying instrument that gives the holder of the option the right, but not the obligation to either purchase (a Call Option) or sell (a Put option) a predetermined amount at a predetermined price for a set period of time after which the option will expire. The usual type of option is 'European' style option. This can be exercised only at the end of the option period. European style options account for 90% of all professional option activity. The other type of Option is an 'American' style option, which allows the holder to exercise the option at any time during the option period. American options are more expensive than European style options and are not used very much by professional option dealers as any unused stub of option left over after exercise is effectively given away. It is akin to hiring a car for 20 days and returning the car to the Hire Company after 12 days. top Options are usually quoted either 'at' or 'out of' the money. An 'at the money' option is one where the market price and the strike price are the same. An 'out of the money' option is where the strike price is away from the current market price. Options can also be quoted 'in the money' which is where the strike price includes an element of the market price, i.e. the option contains intrinsic value. Most options are Exchange traded options, these as the name suggests are options traded on a recognized Exchange. However, some options are 'over the counter' options which are effectively a private contract between a willing buyer and a willing seller. Options are valued using a variety of mathematical formulae. The most popular is the Black Scholes option pricing model, developed by Professor Myron Scholes and Fisher Black.top Formula used to assist with the valuation of an option include: A) Volatility   (Historic) volatility is used to calculate the value of the option premium. Obviously the more volatile the underlying instrument the greater the value of the option.   Implied volatility is an assessment of future volatility using known inputs.  B) Delta   This is the rate of change of the option premium with respect to a change in the underlying asset. An 'at the money' option has a delta of 50%top  C) Gamma   This is the rate of change in the delta.  D) Theta This represents the time decay of the option premium over the life of the option. As the option approaches expiry the rate of time decay accelerates. Warrants A warrant is similar to an option but usually lasts for a much longer period. As with options they give the purchaser of the warrant the right but not the obligation to purchase the underlying asset (usually shares).top Financial Futures These are derivatives of Bonds, Commodities, Currencies or leading Indices. Unlike options they carry the obligation to purchase or sell at a pre-determined date in the future. Indeed being long (or short) a future carries the same risk and reward as being long (or short) the underlying instrument. The crucial difference is that financial futures can be traded on margin (a small fraction of the contract price, updated on a 24-hour basis) and therefore are an ideal tool for speculation/ hedging purposes.top

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P8   General   General The following are some of the more general investment products available. Unit Trusts Unit trusts are a collective (i.e. pooled) investment vehicle that enables Private investors to own a wide spread of investments without the need to individually purchase a large portfolio of different shares. Basically the unit trust manager will sell units in a fund to various clients and the pooled monies will be invested in the market. These funds are "open ended" funds. This means that investors can always purchase units in the fund at the offer price. Redemption takes place at the bid price (the lower of the two prices quoted) and the difference goes on fees. Also an annual management fee is charged. top Many different Specialist and Generalist funds exist, run by a vast array of unit trust managers. Specialist magazines regularly plot the track record of these funds and prior research on which fund to invest in is strongly recommended. Unit Trusts (unlike Investment Trusts) fully reflect the value of the underlying investments less any fees. Investment Trusts Investment Trusts are similar to Unit Trusts but with several crucial differences. Like Unit trusts they are a pooled investment vehicle that enables private investors to own a diverse spread of shares. A crucial difference is that the investor purchases shares in the investment trust as opposed to units in the fund. Whereas the unit trust always reflects the value of the underlying assets (less fees) the value of investment trusts depends on the share price of the investment trust on the stock market. It is usual for investment trusts to trade at a discount to their N.A.V (Net Asset Value) and is an important for investors to understand this. The size of the discount varies on a day to day basis depending on supply and demand for the shares of the investment trust. Also the regulations regarding investment trusts are less stringent than for unit trusts (i.e. investment trusts are allowed to borrow money, whilst unit trusts are not). As a result, investment trusts are more suitable for sophisticated investors who understand the various factors involved.top Tracker Funds These are funds that "track", i.e. replicate the movement in a particular index, such as the FTSE 100. As the FTSE 100 is a geometric index, trackers can result in excessive concentration in the top 3 or 4 stocks. National Savings National savings accounts are issued by the government and include Savings Certificates, Children's Bonus Bonds, and Premium Bonds. Capital is guaranteed with a rate of Interest paid on either a fixed or index linked basis depending on the type of scheme. With regard to the risk against reward calculation, this type of investment is low risk and thus low reward, akin to Building Society deposit accounts. This type of investment provides additional reward to standard Building Society Accounts through tax efficiency. ISAs (Individual Savings Accounts) ISAs have replaced TESSAs (Tax Exempt Special Savings Accounts) and PEPs (Personal Equity Plans) and effectively allow private individuals to invest a maximum amount every fiscal year in a tax-exempt mixture of Equities and deposit accounts. With regard to the Equity element these can be self-select or via a management fund, in which case it is important to find out what the management fees are. Only UK Equities with a full stock exchange listing are eligible. AIM or OFFEX listed stocks are not allowed in an ISA.top

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Copyright 2000 everythingexplained.com   Please fill in this form if you have a question you would like answered, or e-mail us at  [email protected] . To Ask Questions: First Name Surname E-mail Address Questions for this Website