Resources at International Financial Securities Regulatory Commission

Borrowing to Invest: Understanding Leverage

The International Financial Securities Regulatory Commission created this guide to help you understand how leverage is used in investing. It is intended as an overview of borrowing to invest. Before you invest with borrowed money, make sure you understand the risks of using a leverage strategy in your portfolio.

What is Leverage?

Leveraged investing is defined as borrowing money to finance an investment. You are familiar with the concept of leverage if you’ve ever:

•Borrowed money to make additional contributions
•Used a credit line for investing
•Bought securities on margin from an investment dealer
Both individuals and companies use leverage as an investment strategy; a company with a lot of debt is considered highly leveraged. Leverage can be an effective way to boost returns in your investment portfolio, but you should also understand the potential consequences of borrowing to invest.

Leverage magnifies your losses as well as your gains, and you must be able to withstand those losses if you are going to use borrowed money to invest. The leveraged investment should be suitable to your investment goals and objectives and consistent with the “know your client” information that you have provided to your dealer or adviser. It is both your responsibility and your adviser’s to ensure that you understand the investment, and are comfortable with the risk level.
Can You Handle the Risk?

Is leverage right for you? Ask yourself these questions:

•Do you understand the risks of borrowing to invest?
•Can you afford to lose the collateral you pledged as security for the loan?
•Do your leveraged investments fit your risk tolerance profile?
•Are you able to comfortably pay back your loan?
•What are the interest and repayment terms of your loan?
•Are you monitoring interest rates and inflation? Do you understand their effects on your return?
•How much money will you lose in your worst-case scenario? Can you afford it?
•Are you aware of the tax consequences that apply to your investment?

Lesson #1: The Secured Investment Loan

John Doe uses $50,000.00 from a bank line of credit to buy stocks. He secures the credit line using his home as collateral. This type of investment is a form of leverage, because John is using borrowed funds to finance his investment in stocks. John hopes that the value of his investment will increase to the point where he earns more from the investment than he is paying toward the interest on the line of credit.

If John’s investment decreases in value, he still has to make his monthly line of credit payment at the amount he originally negotiated. If John cannot make his monthly payment, he may have to sell the shares even if they have decreased in value. If the value of the shares does not cover the balance owing, he may be forced to sell his home.

Any asset used as collateral, including your house, can be taken by your creditor to satisfy the debt.

Lesson #2: The Mutual Fund Loan

Larry has $75,000 saved for his retirement, which is five years away. Concerned that his savings will not support his lifestyle, Larry consults with a mutual fund salesperson. He tells Larry that a lender will match the amount of Larry’s investment with a $75,000 loan, which he can use to invest in more mutual funds.

According to the salesperson, Larry will easily be able to make the monthly interest payments on the loan by selling a small portion of the mutual funds each month. In this example we assume that fund companies allow 10% of holdings to be sold each year without triggering deferred sales charges.

This strategy will only work if the value of the new mutual funds steadily increases. If the funds decrease, Larry will still have to make the interest payments on the borrowed money. Larry should also realize that the mutual fund salesperson receives a commission check for the initial sale of the funds, and may receive ongoing commission (trailer fees). Larry might also consider whether he wants to go into debt for an investment that can fluctuate in value, considering his approaching retirement.

Investors should always be in a position to be able to pay for investment loans out of cash flow. Closely consider the fees associated with this type of investment. Many investors use leverage in this way to contribute more money and generate a higher tax refund. A common strategy is to use the tax refund to pay off or pay down the loan, decreasing the amount of interest payable.

Advanced Leverage Techniques

Buying on Margin

When you buy securities on margin, you pay for a portion of the value of the securities purchased, and borrow the rest of the money from a registered investment dealer. Under federal securities laws, your investment dealer can only loan you a set of percentage of the value of your investment, known as the maximum loan value. The maximum loan value depends with the type of securities you are buying.

What Are the Risks of Borrowing on Margin?

If the value of your loan exceeds the allowed loan value, the dealer makes a margin call, requesting that you deposit more money into your account to protect the loan. If you cannot meet the margin call, the dealer can sell some or all of your investment, even at a loss, to make up the shortfall.

In times of market decline, margin borrowing can be a quick way to lose money. While you can buy more securities using margin than you could without a loan, you could lose more than what you paid for the investment. You should be prepared to deposit more money on short notice, in order to meet margin requirements in a fluctuating market.

Short Selling

Short selling is a leveraging strategy that lets you take advantage of market declines. If you think the price of a security is going to drop, you can borrow shares of that security from your investment dealer and sell them at the current high price. If the share price falls, you can purchase the shares at the lower price on the open market and “return” the borrowed shares to your dealer. You profit by selling shares at the higher price, and buying at the lower price.

What are the Risks of Short Selling?

You are speculating that the security value will fall, so you can lose money if the value rises instead. Margin requirements for short selling are much higher than typical margin borrowing, because of the risk of using borrowed shares.

When borrowing on margin, understand what your obligations are, and ensure that you can meet those obligations. If you cannot pay the interest or meet a margin call on your account, the investment dealer has the right to sell your securities, even at a loss. It is not a good idea to use short selling unless your cash flow can easily cover potential losses.

How to Buy and Sell Stocks

Okay, so you’ve decided you want to try investing in the stock market, but how do you actually go about buying and selling stocks?

Well, there are two main ways you can go about trading stocks. The first to work with a financial adviser or salesperson that is registered with the International Financial Securities Regulatory Commission. Based on his training, knowledge of the various available stocks, and the quality of research his firm and other firms may do on companies, the salesperson should be able to recommend stocks that meet your objectives. He must work for a company that is also registered as an investment dealer and the firm must also be registered.

The second method is to go directly to a company registered as an investment dealer instead of going to a registered salesperson for advice first. Many people have self-directed accounts at discount brokerages and manage their own portfolios. But you need to be pretty savvy to be able to sift through all the information that’s available out there on various investments and then decide where to invest your money.

Whether you deal with a salesperson at a dealer, or buy and sell online or over the phone, there are some key decisions you have to make with respect to making your trade orders.

The price of stocks and bonds can change from second to second throughout the day, depending on how much investors are willing to pay for them. Both the amounts you pay for them and make back when you sell later on can depend on how quickly your order is processed, or what instructions you give your dealer to handle your order.

Market Orders and Limit Orders

Placing a “market” order gives your dealer permission to buy or sell stocks for you at whatever the price for the stock is at the time.

On the other hand, placing a “limit” order gives you more control over the price your salesperson or dealer buys or sells at, but your order may not be filled right away.

A limit order allows you to set a price limit for the stock your salesperson is trying to buy or sell for you. You will not end up paying more than the limit. If you’re selling some of your stock, the order will go through at or above the price you set, so you’ll never end up selling your stock for less than you expected. If the price of the stock is not within your ‘limit order,’ you may not end up buying or selling the stock at all.

Types of Limit Orders

You can increase your chances of the order going through by placing a certain type of limit order. For example, a “day” order can be placed, but is only good for the day the order is entered. When an “open” order is placed, it is good for a maximum of 30 days, or a GTC (good till cancelled) order can be placed, and is good until it is cancelled by you.

Orders will only be processed if you either have money in your brokerage account, or have arranged for a margin account which allows you to borrow money from the dealer for part of your investments.

If you buy a stock, the value of your investment will increase or decrease depending on a variety of factors that can affect the price of the stock, including the wellbeing of the company, the economy, and the amount of stock available to be traded.

Investing and the Internet – Be Alert to Signs of Fraud

The internet can be an invaluable tool for investors and offers a wealth of information about financial markets and personal investing. News services, government agencies, stock exchanges, mutual fund companies, securities and financial advisers have established literally hundreds of websites that provide up-to-date information on investing and products. With just a few keystrokes, an investor with a computer and modem can have access to more educational materials and current market data than ever before.

Investors who venture into the online world, however, should keep in mind that the power of the Internet is also being exploited by investment con artists and fast-buck operators who want nothing more than to separate you from your hard earned money.
The International Financial Securities Regulatory Commission has mounted important new programs to stop cyber-fraud, but there are still many places on the Internet for swindlers to set up shop. This does not mean that cyberspace should be avoided, but it does mean that investors should be alert to improper practices such as:

Unregistered Trading

The law requires that people in the business of trading or advising in securities be registered or licensed in the state or territory in which they do business. Increasingly, dealers from abroad are advertising their services over the Internet and the World Wide Web and are accepting clients and conducting business in jurisdictions where they are not registered.

Online Touts and Promotions

Online bulletin boards, news groups and discussion groups dedicated to investment topics can be effective forums for investors to share ideas about personal finance. Unfortunately, some con artists have used these forums to tout specific securities for their own enrichment. Frequently using aliases, these con artists post messages calculated to spark interest in a security, usually one that is traded on a venture capital or over-the-counter market.

The messages sometimes take the form of testimonials or fake conversations. They often include unsupported share price predictions or ‘hot tips’ about important news that has not been publicly disclosed. What the messages do not disclose is that the person is hyping the security only for personal gain.

Misrepresentations

Information that appears on a computer is not necessarily true. Regulators are receiving an increasing number of complaints about misrepresentations in investment information distributed through the internet or by email.

Often the misinformation has been posted anonymously or through an alias, making it difficult to determine its origin. In other cases, the mis-statements are made by companies or financial advisers who do not take the same care in preparing electronic communications as they would in preparing an official filing for regulators.

Manipulation

Through anonymous online touts and misrepresentations, cyber-schemers have used the internet to help them artificially run-up the price of thinly traded securities.

•Unwary investors read about hot tips, huge potential profits and limited risk, but they aren’t told that the vast majority of shares are held by a small group of people who are behind the hype and promotion.
•As investors rush to the market to ‘get in on the ground floor,’ the inside group cashes in, selling its cheap shares into the rising market.
•When the hype-fueled share price falters, the promoters may blame unnamed short sellers and may inflict even more damage on victims by urging them to ‘average down’ by buying additional shares as the price drops.
•The security often disappears from sight soon after, and investigators are left to post plaintive messages: “Whatever happened to Company X?” These manipulative schemes have been played out for decades, but the internet makes it easier for fraudsters to reach a wide audience of unsuspecting investors.

Illegal Distributions

The power of the internet has tempted many new ventures to try to sell securities to the public illegally. The general rule is that securities can be distributed to the public only after the regulators have vetted the company’s. Even then, the securities must be distributed through a registered dealer.

New schemes are being uncovered regularly in which companies are advertising and selling securities to the public via the Internet without having filed a prospectus and without fulfilling the legal requirement to provide investors with detailed information about the company and its securities.

Protecting Yourself Against Online Fraud

Some of the abusive investment schemes in cyberspace are indistinguishable from those that have been used elsewhere for decades. The online world, however, represents an enormous advance in the ability of con artists to victimize the unwary.

Some simple precautions can keep you from becoming a victim.

Don’t believe everything you read.

•Evaluate the information you get online in the same way that you would a whispered hot tip from a stranger.
•Exercise healthy skepticism and remember how easy it is for people to disguise their identities online.
•Keep in mind that investment schemers will often talk up projects in remote corners of the globe that can’t be easily checked out, or use endless technical jargon that can only be understood by experts Don’t assume you know whom you are talking to.
•Bulletin boards and discussion group participants may not be who they say they are.
•Those who recommend specific securities may have not investment qualifications and may well have ulterior motives.

Don’t assume that your online service provider polices its investment bulletin boards.

•Most don’t.
•The volume of postings often swamps the ones that try.
•Often there is nothing to stop a con-artist from posting one or 100 pitches for a swindle Don’t buy thinly traded, little known securities on the basis of online information.
•These are the securities most susceptible to manipulation.
•Unlike blue-chip stocks, the price of thinly traded, low priced shares can be moved significantly through relatively small strategic trades, this is why online hype usually concerns little known junior companies.
•Always take the time to do your own research based on reputable information sources Don’t get suckered by claims made about ‘inside information’.
•Investment bulletin boards and discussion groups are riddled with supposed hot tips that are sure to send some stock soaring in value
•Ask yourself, “If this is such great news, why are they telling me?”
•These hot tips are seldom, if ever, true.
•Even if they are true, trading on inside information is illegal.

Be on the lookout for conflicts of interest.

•Some of the people who analyze and recommend securities online are being paid by the company whose shares they are recommending. Some disclose this fact, while others make no mention of their conflicts of interest.
•Make sure you know why someone is enthusiastic about an investment opportunity Make sure that the security has been qualified for sale and is being sold by a person properly registered with your securities regulator.
•Securities regulations designed to protect investors from fraud and abuse do apply in cyberspace.
•The failure of companies, dealers or advisers to comply with regulations is often a red flag highlighting a potential investment scam.
•Your securities regulator can tell you whether an individual or company is registered to trade or advice in your area and whether the company selling the securities has filed a prospectus.

Ten Tips to Keeping Track of Your Investments

With our busy lives, it’s often difficult to keep track of our investments. You may find that you only review them once a year. However, it’s important that you keep on top of your finances and review on a regular basis. Here are some tips to help you.

1.      Read and keep all your financial documents.

This includes your account statements and prospectuses. These contain important information about your investments, any associated risks and your returns. Many investors are now offered simplified prospectuses that are easier to read and understand.

2.     Check your trade confirmations against your account statements, and report any discrepancies.

Look for any unapproved transactions or fees. It’s important that you catch and resolve any errors immediately. This is much better than having to resolve things months down the road.

3.     If you don’t receive regular account statements, follow up immediately.

This is often the first sign that you are the victim of identity theft. Con artists who steal your mail get lots of information about you, and are then able to apply for credit in your name. If you suddenly stop receiving your regular statements, report it immediately.

4.     When you speak with your adviser, take notes.

You should keep records of all your conversations, including your instructions and your adviser’s advice.

5.     Ask questions about your investments.

If you don’t understand something, speak up. Verify the information with a credible source.

6.     Even if you don’t trade online, consider getting Internet access to your account.

Internet access allows you to review your account whenever you want. It’s much easier to monitor your account if you can check it online at anytime. Periodically check the balance of your portfolio and bank account. This allows you to track your returns and enables you to catch problems early on.

7.      Meet with your adviser and visit the firm.

While many transactions can be made over the phone, it’s important to meet with your adviser at least once. This helps you develop a relationship and understand their investment philosophy. Check out the firm and ensure you feel comfortable having them handle your account.

8.     Conduct independent research on your investments.

Read financial statements, and learn about the company’s business risks before you invest.

9.     Periodically review your portfolio.

Make sure it matches your current investment objectives. Most investors find that their objectives change over time. Ensure that your adviser understands your current financial situation and has developed an appropriate plan.

10. Check registration by calling your securities regulator

Anyone selling securities or providing advice on securities has to be registered with a regulator. Find out if they are registered, what they are registered to sell, and if there are terms and conditions attached with their registration.

Are Your Money Styles a Match?

For couples planning their wedding, financial considerations don’t end once the caterer’s been paid. In fact, deciding on a wedding budget is just the first of many important financial decisions you will make together. To build a strong financial future, you must first understand your own individual approach to money management and then compromise to determine your approach as a couple.

Following are the money styles

The Savvy Saver

The only thing you can recall more quickly than your phone number is your bank balance. You know your budget and you stick to it. You understand that borrowing is an important and useful tool if it is managed carefully. You have goals for the future and a plan to get there. Saving is a top priority for you. You beef up your savings before you splurge on a cute pair of shoes or a cool gadget for your car. You’ve got top-notch financial habits that will put you in excellent shape for the future. Just remember that it’s OK to splurge now and then! Being financially prudent to ensure a prosperous tomorrow doesn’t have to come at the expense of those little luxuries that keep you happy today.

Sometimes Savvy, Sometimes Super Shopper

You approach financial issues like a restaurant menu. A little voice tells you that you should have the ‘side salad’ instead of the ‘baked potato with sour cream.’ Sometimes you listen, sometimes you don’t. You often know what you should be doing with your finances, and at times you are quite disciplined about budgeting and saving, but you can also let it slide when the call of the mall becomes too enticing. You have some idea of your expenses, and know how much money you should be setting aside for any big, upcoming expenses, such as a wedding or a first house. You should write out a manageable budget and find a way to stick to it. The trick for you will be identifying the things that have knocked you off course in the past and develop a proactive plan, like setting aside a certain amount of fun money each week to save towards the splurge items.

“The next round’s on me!”

Tax-efficient investing, portfolio diversification, asset allocation – all incredibly boring topics to you; they just get in the way of more important subjects that occupy your day. Your budgeting plan doesn’t go beyond the next one or two paychecks. You’ve felt the pinch of debt, most likely to do with your credit cards. You need to take a careful look at your finances and develop a long-term budget. Reviewing your plan with a financial adviser makes good sense. Having never stuck to a budget in the past, you will need to work hard at developing some discipline. It would be a wise move to set up automatic withdrawals (weekly or monthly) for your savings to make it easier to stick with your plan.

What’s Next?

Not surprising, most couples have slightly different takes on life, and money is no different. You don’t have to have the same money style as your spouse. But, it’s important for you to recognize the differences and find ways to compromise.

Seeking the help of a financial adviser can be useful for couples with similar or very different money styles. Money is an emotional issue and an adviser can offer an impartial viewpoint that is based on financial expertise – not family politics. If you’ve already found an adviser and have taken steps to discuss your future finances, good for you! Best wishes for a long and happy future together!

Penny Stocks

Penny stocks are low-priced stocks that typically start out at less than one dollar per share. They are sold on the premise of significant potential growth.

Very often, companies issuing penny stocks are new to the market. They may not have been in business long enough to establish a proven track record or credible financial history. Another characteristic may be an inexperienced management team. These factors undermine market reception and the ease with which penny stocks can be traded.

Anyone investing in penny stocks should be aware that – when they may want to sell his or her stock – a market may not exist. Penny stocks are ‘priced low’ for a reason.

Despite their bargain basement price, penny stocks are high risk. Unless you have the financial resources to withstand the loss of your initial investment and target returns, penny stocks are not for you.

Get the Facts

Why is it so important to get the facts?

Penny stocks are extremely vulnerable to manipulation. Promoters intent on misleading or defrauding investors are counting on you not to do your homework.

A common scam is the “pump and dump.” In this situation, a promoter accumulates an inventory of penny stocks. Using high-pressure sales techniques, the stock is ‘pitched’ to clients. Clients (or investors) are found by any means in the interest of making a market. In the course of events, the price of the penny stock will rise (possibly to several dollars per share). As long as the promoter is able to locate new investors or encourage current clients to increase his or her holdings at a higher price, the scam continues. All the while, the promoter profits. When the scam has run its course, the stock becomes illiquid and the price falls. Hapless investors are left holding the now-worthless stock.

Where to Go for Information

Unscrupulous promoters are inventive and persistent. Using any means possible, they may spread false information. It pays to double-check their claims through other sources.

Corporate information comes in many forms including:

•Annual and quarterly reports
•Financial statements
•Prospectuses

These can be obtained from the public library system, your dealer or adviser, and stock exchanges.

Stock exchanges have minimum listing requirements that a company must meet before its securities can be traded on that exchange. Among other things, these requirements relate to a company’s finances, management, and share ownership. If a company is not able to meet these minimum requirements, they may trade on the over-the-counter market. The over-the-counter markets consist of a network of dealers who trade among each other either on behalf of individual investors or themselves.

The Changing Markets

Traditionally, penny stocks trade on junior exchanges or over-the-counter markets. Investors benefit from a well regulated, fair and accessible market with enhanced protection through uniform regulatory standards, consistent enforcement, and improved market information.

How Will I Recognize a Penny Stock Scam?

There are a few tell-tale signs:

Unsolicited telephone calls. Be skeptical of an unknown salesperson calling to offer you “a fantastic investment opportunity.
Promises of a great rate of return. No dealer or adviser can guarantee an exceptional rate of return, and the law prohibits promises of such future returns.
High-pressure sales tactics. Do not be pressured into making hasty investment decisions.
Claims of little or no risk. If the projected rate of return is high, the associated risk is likely to be high as well.
Offers to discount commissions. Commissions that are charged for sales of penny stocks are often at rates higher than normal.
Claims of “inside” information. It is illegal to trade on the basis of confidential or “inside” information. The penalties of insider trading can be severe.
Reluctance to provide shareholder information. A salesperson should not hesitate to provide you with the information, which may include a prospectus that is necessary for you to make an informed decision.

The International Financial Securities Regulatory Commission has pursued and shut down long-standing securities firms for conducting “pump and dump” scams. Whether it’s a cold call or a well-known firm in the community, gets an independent opinion, or do your own research. The International Financial Securities Regulatory Commission is at the forefront of investor protection but you can make a difference by understanding how the market works.

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