Do You Understand Investments?

Published Monday, July 2, 2012 at: 7:00 AM EDT

People who find themselves owning complex investment vehicles often leave the driving to the professionals. And that’s perfectly acceptable, but even “passengers” should have a basic understanding of how a particular investment works—especially when it’s your hard-earned money on the line.

Consider a retiree who’s looking into purchasing an annuity. Is it an investment product, an insurance product, or both? Will the annuity continue to pay income to heirs if the owner dies? Is the principal protected in case of a severe economic downturn? Surprisingly, many investors—including owners of annuities—are stumped by these basic questions.

Other commonly used terms often befuddle investors. Do you know the difference between an “annual effective yield” and an “average annual yield”? How about an “annual percentage yield”? It’s important to distinguish among different types of yield so you can make valid comparisons of investments.

Do you consider yourself an investment expert? Here are a few simple questions—with the answers below—to see how you measure up.

1. An insurance company generally begins payments under an annuity when:

a) The accumulation phase begins. 
b) The accumulation phase ends. 
c) The annuity owner dies. 
d) The annuity owner retires.

2. Payments under a variable annuity are based on:

a) Fluctuations in the current interest rate. 
b) Fluctuations in the current inflation rate. 
c) Performance of underlying stocks.  
d) Performance of the Standard & Poor’s (S&P) 500 index.

3. An annual effective yield is described best as:

a) The annual return before interest is compounded. 
b) The annual return after interest is compounded.
c) The annual return before inflation. 
d) The annual return after inflation.

4. The average annual yield often is used to:

a) Compare the past performance of mutual funds. 
b) Distinguish Treasury bills from Treasury notes. 
c) Factor in the tax-free element of municipal bonds. 
d) Account for a guaranteed minimum-income benefit.

5. When you buy Treasury bills at auction, the rate is:

a) Based on the current interest rate for loans.  
b) Based on the S&P 500.  
c) Equal to par. 
d) Discounted from face value.

6. A “private activity bond” is best described as:

a) A corporate bond eligible for capital-gain treatment. 
b) A corporate bond exempt from income tax.  
c) A municipal bond that is completely taxable.  
d) A municipal bond that can trigger alternative minimum tax (AMT) problems.      

7. An exchange-traded fund (ETF):

a) Trades like stocks.
b) Trades like mutual funds. 
c) Involves trades between major stock exchanges. 
d) Involves trades between different currencies.  

Answers: 1-b; 2-c; 3-b; 4-a; 5-d; 6-d; 7-a

This article was written by a professional financial journalist for McCarthy Asset Management, Inc and is not intended as legal or investment advice.

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