If you ever wanted to buy shares of L’Oreal, you probably were introduced to the idea of an American Depository Receipt. American Depository Receipts, or ADRs, are constructs that allow you to purchase ownership interest (stock) in foreign companies on the domestic stock market.

It’s actually a pretty simple construct. The ADR is a certificate issued by a US depository bank and represents a share (could be a fraction, whole, or multiple shares) of a foreign stock the bank is holding overseas. The ADRs are issued in terms of US dollars but the underlying security is still held in the country of origin’s currency. The whole point of ADRs is that it makes it easier and more convenient to own foreign shares. Instead of having to open a brokerage account overseas, transfer the funds, convert them into the local currency, and then make the purchase - you just buy an ADR. (that’s just one-way, so double that headache). You can tell if a stock is traded as an ADR because it will generally have (ADR) next to its name (as L’Oreal does on Google Finance).

From the operations perspective of yourself, the investor, there is no difference between buying and selling shares of stock and ADRs. You just need to be aware that in addition to all the risks associated with investing in the domestic stock market, you’re introducing currency and country risk into your portfolio. Currency risk refers to the exchange rate of the dollar and the local currency. Country risk refers to the risk associated with changes in the local country’s economy. In the domestic stock market, all holdings are in dollar and you’re contained within the US economy (for the most part, though the World Is Flat) so you don’t have to account for currency and country risk (from the local country).

(If you want to get technical, an ADR is the actual certificate where as an American Depository Share, ADS, is the actual share. An ADR can represent multiple ADSs. In colloquial use, ADR refers to both.)

According to Wikipedia, the first ADR was introduced by JPMorgan in 1927 for a British retailer named Selfridges&Co. The largest depository bank is the Bank of New york Mellon.

According to historical records, the post-war return of the stock market has been around 12%. It’s a number that has used over and over again (more often people use the 10% value) as the benchmark for stock returns and project of future results, since it’s better than pulling a number out of thing air. However, yesterday afternoon I had the pleasure of reading Warren Buffet’s 2007 Letter to Shareholders of Berkshire Hathaway (if you’ve never read one, you should because it is both informative and entertaining, 2008’s is a mere 21 pages long and chocked full of fun facts).

On Page 18, right after Buffett chastizes 498 of the Fortune 500 for not recording stock options as expenses on their books, he starts talking about the Dow returning 5.3%, compounded annually, in the 20th Century. Wow, what happened to this 10% business? Why are we using it as a benchmark if the Dow’s return over the last hundred years (arguable, the last hundred years starting 8 years ago) is a meager 5.3%? I don’t know, but even assuming 5.3% is pushing it.

Buffett goes on to illustrate that a 5.3% annualized gain going forward would mean the Dow would have to pierce 2,000,000 (that’s two million!) by the end of 2099. That’s working with only 5.3%. If you want 10% annually then you’ll need the Dow to hit 24,000,000 by 2100. Twenty four million…

Though, nominal numbers are merely that, nominal. If you asked someone at the start of the 20th Century if the Dow was going to grow from 66 to 11,497 (especially after you told them the horrors that would come during the Great Depression), they probably would’ve laughed too. So, will Warren Buffett’s prediction that a 10% is outlandish and unreasonable hold true?

I don’t know but I’ll tell you what… while historical returns are not indicative of future results, Warren Buffett’s historical returns are better than my historical returns so I’m siding with him on this one.

I heard this “tip” the other day involving how you could take advantage of the market downturn. Each year, you’re permitted to give up to $12,000 to someone else as a gift absolutely tax free. If you give more than $12,000 to one person, you’re personally obligated to declare it and pay taxes on the gift (yep, it’s in reverse of what you’d expect). So, the suggestion is then to give your depreciated shares as a gift now, before the shares are likely to rebound, so that you can make the most of your gift.

Sound like a crazy idea? (It sounds crazy to me) It’s not so crazy if you subscribe to the idea that the stock market will always appreciate in the long run (if you don’t, then you better not have any shares of anything!), but it’s certainly one way to find a silver lining in this ugly stock market cloud we’ve been under!

The Mechanics

If you are actually going to do this, this is how you do it right. These steps are different than if you gift appreciated property (stock is considered property), so please follow them carefully. You will need to do the following to properly document the gifting of your shares:

1. Obviously, give the shares to your beneficiary.
2. Document the fair market value of the shares by writing a gift letter that indicates the gift and its fair market value at the time of the gifting.

Appreciated vs. Depreciated

The is a big difference between donating appreciated stock and depreciated stock. If the stock has appreciated, the recipient has to claim the appreciation when it is sold. People often take advantage of this by gifting appreciated stock to their children, or family members in a lower tax bracket. With depreciated stock, no one gets to claim the loss. So, it might make more immediate sense to sell the stock, recognize the loss, then give the money to your beneficiary and then have them buy the shares back.

To be honest, I wouldn’t do it. I like crazy, out of the box thinking as much as the next person, but this one doesn’t seem to make much sense to me. It makes more sense to claim the loss against any gains that year, then give the money. The recipient can always buy the shares on the open market and pay the commission.

(Photo by rednuht)

Late last year, when there was blood in the streets, a well known discount broker (Company A) was said to be on the verge of bankruptcy and the stock tanked 50% in one day. Not only did it tank 50% but the prognosis on the street, at least perpetuated by mainstream media, was that company was hosed and that they were going under. They didn’t have a rich history of being able to fight off adversity, they were relatively new in the financial business and lots of people figured they’d collapse. SIPC insurance would have to be initiated to save accounts and it was going to be yet another one of the casualties of the sub-prime mess. Would you have sensed that the market had panicked and bought shares? Or would you have joined the bandwagon and watched the shares fall into oblivion?

Now consider this scenario. Several months later, an 85 year old investment firm (Company B), well known throughout the world, looked to be royally screwed as traders were concerned that the firm wouldn’t be able to fund future transactions. Their lifeblood, capital, appeared to be bleeding out as investors were pulling out their funds in the firm. Until their last quarter, they had never posted a loss. That’s 85 years worth of straight profits. On a Friday, their shares fell 10% to a five year low of around $57. By Monday, they closed at $30 on those same credit concerns. Did you see this as the market offering a huge discount on a valuable commodity? Or did you see it as the end of pretty good eight-five year old run?

Well, if you guessed, based on the setup, that Company A recovered and that Company B didn’t… you’d be quite astute. You’d be more astute if you made those determinations as the events were unfolding, rather than right now. Company A was E*Trade, which was the impetus for a topic focused on what would happen if your brokerage went bankrupt. Company B was Bear Stearns. JP Morgan Chase recently announced that they’d buy the firm for $2.30 a share, with funding from the Federal Reserve. While the ink isn’t dry yet on that deal, it was announced this past weekend in conjunction with a weekend 25 basis point cut by the Federal Reserve (an event almost as rare as Halley’s Comet, the last weekend rate cut announcement was October 6th, 1979).

The moral of this story is that you shouldn’t even buy individual stocks based on (emotionally-charged) news. The broader corollary to that moral is that you shouldn’t buy individual stocks without careful inspection of its fundamentals, but avoiding emotionally-charged news is always a great first step.

For the record, I thought E*Trade was going under and Bear Stearns would be fine. I didn’t buy shares of either because I’ve been burned (and rewarded) in the past about ignorantly buying on bad news (now I stick to index funds like a good boy!). In the past, I bought Enron because I thought people were over-reacting but one can never underestimate the pervasiveness and severity of outright fraud. I was rewarded when I bought shares of Xerox in 2000 when it was in single digits because I figured a firm with that storied a history probably was going to make it (or at least be acquired). Though it’s like they say, tell your kid that the stove is hot won’t sear in the message quite like actually touching it.

Usually when one company offers to buy another company, it offers a premium on the current stock price and the stock price jumps up pretty close to the offered price. The difference in the current price and the buyout price, that “pretty close” number, includes a variety of factors. Those factors include the risk that the deal won’t be approved by regulators or shareholders, the time value of money (a deal that will close tomorrow has less of a discount versus a deal to close in a year), or a whole host of other factors. The shareholders that held the stock before wind of this pending offer are generally happy since their shares will appreciate more than they expected. Some investors consider buying the stock because there still is a little bit of difference between the current share price and the offered price. It seems like a sure thing right? Wrong.

When Bank of America offered to buy Countrywide Financial, it offered absolutely no premium. It offered $7.16 a share on January 11th. Shares of Countrywide are only trading at $4.27 right now… why not snap up shares of CFC at $4.27 and pick up what appears to be a nice healthy premium for your money? You might not want to do that because Countrywide is going to be investigated by the FBI. Woah! That wasn’t in the list of “factors” I listed above and that’s because it’s not something you typically associate with a buy out! If the FBI finds something bad, Bank of America can still back out.

As Ron Popeil would say, but wait there’s more… let’s say you heard about the Microsoft offer of cash and stock for Yahoo, pricing each share at around $31. Let’s say you decided to snatch up a few shares of Yahoo on the buy-out offer because you wanted to make a few bucks and because you thought the buy-out made sense. Then Yahoo tried to find additional suitors to increase the sale price only to find out no one else was truly interested. In the interim, Yahoo and Microsoft stock prices fell so the original offer wasn’t as high, a scenario not mentioned in the list. The underlying offer, since it was pegged to an asset whose value changed, changed as time passed!

So, if you hear of a buy-out and are considering to snatch up some “sure thing” money, think twice. There are a lot of factors and scenarios out there that you may not be taking into account. The market has figured it out and that’s why there’s a difference in the first place.

This guest article is courtesy of Tyler of Dividend Money, a personal finance blog with a heavy focus towards dividend investing.

For those of you who are new to investing or are just starting out in the world of investing in stocks, there is a lower-risk strategy that has been proven to be very powerful in producing long term returns.

This strategy is known as dividend growth investing. While it is not glamorous, there have been several books written about dividend investing and many successful investors have followed this model.

Dividend investing is geared toward those of us who are not huge risk takers and have the patience to slowly watch the increases in dividends filter into our brokerage accounts.

The concept behind the dividend growth model of investing is to buy solid, reasonably priced companies with a track record of raising their dividend year after year.

This model is thought to be prudent due to the fact that the incremental increases in the dividend rate will ultimately increase one’s dividend yield as a percentage of the purchase price. It is also thought that the increases in dividend rate will support higher stock prices over the long term as income investors search for attractive yields.

This strategy is suitable for conservative investors and income investors who want to protect against inflation. It is thought that the increases in dividend rate can be viewed as a hedge against inflation because of the additional income that the dividend increases provide.

The majority of the companies that fall into this category are relatively stable and very large in nature. Many large financial, insurance, telecom, and utility companies have a reputation for increasing their dividends on at least a yearly basis.

I’ve previously written a primer on how to select the best dividend growth stocks that will be helpful if you think that dividend investing is right for you.

I think that as you investigate dividend growth investing, you will find that it has its merits and I believe you will be pleasantly surprised with the strategy.

This post comes from Mike of Quest for Four Pillars, “another Canadian Financial Blog,” that traces its namesake to none other than the Four Pillars of Investing by William Bernstein.

In the blogosphere there seems to be a lot of excitement about peer-to-peer lending which is the ability to lend money to other individuals through companies such as Prosper and Lending Club. While I can understand how some investors will always be interested in a new investment product I don’t really understand the widespread excitement and interest level for this one.

Some of the things people should think about when considering P2P lending:

Diversification

Lending to one person is kind of like investing in a very small risky stock such as a junior mining company or a startup biotech company. You really don’t know much about that borrower and if something happens to them such as a medical emergency then your loan to them might be at risk. You can mitigate this risk by lending using a portfolio plan but I suggest that while this does reduce your risk, it doesn’t change the basic asset class which is still quite risky. A portfolio of p2p loans is like a mutual fund with numerous junior mining companies). You reduce the risk of any one company failing but aren’t protected against events that affect all junior mining companies ie falling metal prices.

One of the big risks that I would be concerned about is if interest rates go up. Presumably people who borrow on p2p are people who can’t get the loan from a bank at a normal rate - I would assume these people have already maxed out their credit or at a minimum have a lot of debt which makes them very vulnerable if interest rates increase.

Same as the old bank

Brip Blap wrote an interesting post on P2P which indicates that the lender “is the bank”. I have to disagree with this because I think Prosper or Lending Club is the bank. The only thing that really changes is that the p2p lender gets to choose who the borrower is which is not the case when you give money to a regular bank to get interest. Another issue I have is that Prosper and CL seem to be spending a lot of money to get clients - advertising, free money giveaways. Where does this money come from? As far as cutting out the middle man - P2P institutions charge for the loans so I don’t really see how they are very much different from banks.

Statistics

Another concern I have is that I think the interest rates are too good to be true. If a borrower is willing to take my money for 10% then I know that they couldn’t get that same loan at a bank. This is problematic for two reasons -

1. The banks are far better at analyzing debtor risk than you or I (too bad they couldn’t analyze subprime securitization loans) so if they don’t feel the person is worth the risk at 10% then you are not getting a deal - you are getting a high risk loan.
2. If the person seems to have reasonable credit then they might have maxed out all their available credit which implies to me that their credit score is meaningless in that situation.

The fact that p2p has not been around very long also means that any default rates are probably understated. A loan can go into default at any time in the three year term so looking at default rates before three years is not going to be very accurate. Also - with the default rates do they do it by time periods? ie years? if not then any new loans will decrease the default rate dramatically.

Taxation

In the US, interest income is treated as regular income for taxation purposes. Dividends and capital gains are given preferential treatment and you will pay less than than on interest. You will be better off taxation wise to have all three of those investment types in a tax-sheltered account such as a 401(k) or ROTH account. If however you have investments in a taxable account then ideally it should not be fixed income such as bonds or P2P loans. Since P2P loans are not eligible for tax sheltered accounts then the extra taxes will reduce returns significantly.

Asset allocation

Asset allocation or the type of assets you invest in (ie stocks, bonds, cash) is a critical step in the investment process. Personally I have 25% of my investments in fixed income and 75% in equities (stocks). Regardless of the expected rate of return, P2P lending is considered fixed income and it should fit into your desired asset allocation.

Basic economics

If something is too good to be true then it probably isn’t. Currently you can get approximately 4% interest on guaranteed certificates or accounts. If you invest in P2P loans and have an expected return of 10% then that puts you in a much higher risk level and there is a reasonable chance that you could lose 10% or more (much like equities).

Bottom line

I have no plans to invest in p2p loans anytime soon because they don’t fit my investment plan. I do want to make it clear that I’m not suggesting that p2p loans should be avoided or that they are a bad thing. If you know what you are investing in and it fits your investment objectives then go ahead and lend away!

This post comes from Mike of Quest for Four Pillars, “another Canadian Financial Blog,” that traces its namesake to none other than the Four Pillars of Investing by William Bernstein.

A lot of inexperienced investors who invest in stocks either through mutual funds, index fund, ETFs or owning the stocks directly want great returns with minimal or no losses in the bad times. Unfortunately this isn’t possible for the simple reason that you can’t get great rewards in the equity game without taking great risks. Risk means that your investment could go either way. Your stock fund might get 10% this year or 30% or -30%. In 1929 the Dow lost 90% of it’s value - I’m sure that was a bit of a downer and not just for guys stepping off windowsills.

Should you just buy GICs and not worry about the ups and downs of the markets? I would not recommend that because there is no guarantee that fixed income products will keep up to inflation.
Here are some of the things you can do to invest in the stock markets and get a good night’s sleep at the same time.

Own some fixed income - This could include bonds, gics, high interest savings accounts etc. When the market is crashing this part of your portfolio will hold steady and will reduce your decrease in portfolio value. How much you own is based on your tolerance for volatility.

Diversify - A lot of ex-Enron employees couldn’t sleep at night because their skyrocketing retirement accounts made them giddy - until the company went bankrupt and they were left with nothing. The idea behind diversification is to keep your many eggs in many baskets. If your investment in a buggy whip company isn’t doing so well then perhaps your automaker stocks will make up for it. If your telegraph stocks are dipping then maybe your phone company investments will make up for that.
You need to look at your investments and understand if you are diversified or not.
Things to diversity by are:

* Company - one rule is not to have more than 10% of your portfolio in one company, especially if you work for that company.
* Industry - owning 12 bank stocks is not diversified - The US market has a lot of different industries so buying a broad market index fund or ETF is very diversified.
* Country - although a good part of the S&P500 profits come from overseas - it doesn’t hurt to add some more foreign exposure.
* Currency - this kind of goes with the country diversification. While some people would prefer to purchase currency neutral foreign funds it’s not a bad idea to own different currencies.

Treat your portfolio like a portfolio - When looking at your gains or losses - do it for the whole portfolio and not each security. If you are properly diversified some of the investments will be doing better than others most of the time. If you own ten mutual funds and two of them are cratering but the other eight are doing well then you are doing well.

History - Research the history of the stock market or read the following statement. Stock market goes up, stock market goes down - over the long run, stock market goes up. If you sell when it goes down and then buy on the way up then you are buying low and selling high - don’t do this. Another thing to be aware of is past bubbles - the more you know about them the more you can avoid them.

Keep track of your portfolio performance - If your portfolio goes up 15% per year for the last four years and then drops 20% this year - should you panic? No - you haven’t ‘lost’ anything and your best bet is to hang on.

Ignore the media - The media is not there for your education or to keep you informed. Their job is to sell newspapers, ads etc and that’s it. If the market falls 2% then it’s a “mini-crash”, if it goes up 2% then it’s a “strong day on Wall street”.

I remember someone saying that if you left the design of elevator buttons to the financial media, there would be no “Up” and “Down” buttons – they would read “SOAR!” and “PLUNGE!”. — Where Does All My Money Go

I’m a fan of the casinos. I don’t know whether its the pumped in oxygen, the bright lights, the sounds of excitement and joy, or the free drinks flowing throughout… but I love going to casinos. Sometimes I win, sometimes I lose, but I almost always have a good time putting my hard earned money on a felt table and seeing if it’ll grow and multiply. When I go to casinos, I usually bring a set amount I’m willing to lose, say a few hundred bucks, and then I enjoy myself. I understand that when I go to a casino, I’m there to have a good time; I’m not there to make money.

Sadly, the stock market is nothing like that. It’s pressing a few keys on your keyboard or clicking a few buttons with your mouse. The transactions happen with no fanfare, there is often little anticipation, yet if you try to time the market or day-trade… you’re essentially gambling. Why would anyone gamble if you can’t at least get some free drinks out of it?

What always surprises me is that so many smart people try to play the stock market as if it were a game at a casino. People try to time the market by buying it on the way up and selling at the peak. People try to sell their shares when the market is going down so they can cut their losses or re-buy later. It’s not as if the vast majority of experts aren’t advising against it. The latest is the manager of Yale’s endowment, David F. Swensen, who says you should keep things simple by advising that you “use index funds, exchange-traded funds and other low-cost instruments, and stick to your long-term asset allocation — even when the markets are in tumult.”

Who else has advised index funds? Vanguard’s John Bogle recommends them. Warren Buffett of Berkshire Hathaway, the Oracle of Omaha, has also advised them. With a panel like that, why do people choose to pick their own stocks?

It’s the thrill. It’s the excitement. How fun is it to say you made $500 this week on the stock market because you made a great trade? How fun is it to buy a stock prior to its earnings announcement and then see if you guessed right? If that sounds like you, then recognize that you’re gambling on the stock market.

It’s no different than if you put down $500 on black or put it all on a hand of three card poker… do the brokerages give you a free meal or a free room if you lose big? Probably not… if I were you, keep the gambling in the casinos where you get a little more enjoyment out of it!

(Photo by shalmaneser)

LendingClub is another player in the growing peer to peer lending marketplace and one that I signed up with despite my reservations with the whole peer to peer lending craze. I was tempted because online savings account interest rates have fallen sharply lately because the Fed lowered the target funds rate so quickly and because they have a signup bonus with very easy requirements. (If you get referred to LendingClub and become a borrower or lender, you get $25. If you deposit $1,000 and start lending, that bonus increases to $50; both referrer and referee get the same bonus)

Account Signup

The signup process was easy and I had an account up and running within minutes. Setting up my account so I could begin lending was also trivial, a four step process of entering my personal information, bank information, and some association information (school I went to, employer, etc. but these were optional). The account process proceeds with the typical bank account verification process of small deposits.

Default Rates

It appears that LendingClub’s default rate and other lending stats are rosier than the likes of Prosper and others, but that could be because they are much newer to the game. Techcrunch did a brief writeup on LendingClub and noted the same thing about the default rates, expecting them to rest close to what Prosper was seeing. Ultimately it appears that both should have similar statistics with regard to late payments, defaults, and other lending related statistics. If you think LendingClub borrowers are on the whole “better” than Prosper, I would take a step back and re-evaluate because they will be roughly the same.

Tax Headaches

I don’t know how LendingTree sends out tax forms but it sounds like dealing with taxes from Prosper loans is a huuuuuge pain.

Next Steps

I had talked about opening up a Prosper account and I went through the motions of opening a LendingClub account, but I’m not sure if I’m ready to lend any money (or do I want to deal with handling the taxes, considering I’d be lending so little). I went through Moolanomy’s affiliate link to he was able to score a $25 for the trouble (I did too), so all was not lost. It’s interesting they would pay out commissions even if you don’t actually lend any money (if you verify a bank account, they pay out a commission) but I’m not complaining.