There was a time when only the wealthy and well connected could invest in the stock market. Then IRAs and 401(k) plans ushered in a new era of the “common man” investor. Flash forward a bit more, to the Internet age, and we have a grand democratization of the stock market.

Not too long ago, you had to be one of the aristocracy to have access to what the power elite could dabble in: options, shorts, foreign exchange (forex), margin, commodities futures, to name a few.

But thanks to the Internet and the information age bringing investing to the masses, all that has changed. You can buy stock options through dozens of online brokerages like TD Ameritrade, Charles Schwab and ShareBuilder. Similar availability exists with foreign exchange markets, shorts and commodities futures.

When retail investors began purchasing shares in mutual funds in the 1970s, Forbes magazine was able to print the returns and expenses of every fund available. But now there are over 9,000 mutual funds on the market. When ETFs were first available in the 1990s, there were a handful and most were simple index tracking funds. Now there are over 700, many with elaborate weighting algorithms and some are straight actively managed funds.

But just because you can make use of these tools and techniques, doesn’t mean you should.

When it comes to saving for retirement, college or building your estate to pass on to future heirs, the tried and true stocks, bonds and mutual funds (and index ETFs) work just fine. The key isn’t how fancy or esoteric your investment vehicle is, but how you allocate your assets.

Take trading on margin for example. Margin is simply investing with borrowed money, usually from the brokerage. You borrow the money at a specified interest rate, and agree to pay it back with interest – hopefully once you’ve earned more from your investments than the cost to borrow. Margin amplifies returns, but it also magnifies losses, and you could end up owing more than you have. For this reason, it’s best left alone by the individual investor.

Another needlessly risky technique is shorting. Shorting is a bet that an asset will go down in value. At least in terms of individual stock, shorting puts the investor at odds with management. Knowing a particular stock is a dog, and not worth its trading price is one thing, but timing when the market will realize this is quite another.

But the real reason short selling is so risky is that you have virtually limitless amounts to lose. Consider this:

“You short 300 shares at $45 per share. Your broker deposits $13,500 in your account. Two weeks later, the price has fallen to $35 per share. You instruct your broker to “cover” your short or buy 300 shares to replace those you sold.

Your broker buys 300 shares at $35 per share and deducts $10,500 from your account to pay for the shares. The broker replaces the borrowed shares and you have a profit of $3,000 ($13,500 – $10,500 = $3,000). I have ignored commissions and so on to keep the math simple.”

Sounds great, you pocket a quick and easy 3k in profit. But here’s what happens when you guess wrong:

” You short 300 shares at $35 for $13,500. However, instead of falling like all reason and logic suggests, the stock rises and rises fast.

Before you know it, the stock is at $55 per share. You get a call from your broker, who is getting nervous. Your account for short selling is a margin account and if the stock goes too high, you will have to deposit more money or cover the short by buying the stock.

You decide to cut your loses and cover the short by buying the stock at $55 per share for $16,500. Since you only have $13,500 in your account, you have to come up with another $3,000 out of your pocket to make things right. You suffer a $3,000 loss. “

But what if the stock rockets past $55 a share. A stock can only lose so much money, and most stable companies don’t go to 0. But a share price can rise a long way before it starts to turn, and that can add up to big losses when you’re short.

For these reasons and more, you’re probably better off sticking to the simpler approach of The Simple 7 or the super simple One Minute Portfolio.

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It seems counter intuitive, that choosing the wrong kind of savings account for your child’s college fund could actually cost your child more, but that’s the world we live in – make the wrong choice, and your child may lose thousands of dollars in financial aid come enrollment time.

According to Robert Helgeson, director of financial aid for Valparaiso University in Indiana:

“If a parent has $100,000 in assets, the government is going to expect them to contribute $6,000 of it to education. If a student has $100,000 in assets, the government will expect $20,000.”

So, you can see where you stash your money is just as important as how much you stash.

According to the U.S. Department of Education, the student can have up to $3,000 saved in a checking or savings account in their name without losing any financial aid, but every dollar above that takes 20 cents away from any federally funded scholarships and grants junior would have been eligible for. After that, the money would be subtracted from federally funded loans.

Here are 3 places to safely shield your college savings without causing the loss of any aid.

529 college plans

This is perhaps the most popular method among younger parents. 529 plans are much like 401(k) or IRA plans, except you’re saving money for college instead of retirement. But the idea is the same. You contribute money to the plan, set your desired allocations for the money (choose between stock, bond and money market funds), and the money grows tax free – provided it is only used for education related expenses. An added perk to many plans is that if you live in the state that offers the plan, you can often deduct your contributions from your state income tax bill. 529 plans offer flexibility in determining the “owner” of the plan as well, since the parent can control who the beneficiary is. This means that if junior decides he’s going to the #1 party school, and he doesn’t really know what for, you can keep the funds from him until he gets his act straight.

529 plans do carry some restriction though. For example, the funds can only be withdrawn tax-free for educational expenses. Also, the funds available for allocation are limited.

UGMA and UTMA Custodial Accounts for Minors

The Uniform Transfers to Minors Act (or Uniform Gifts to Minors Act) provide a alternative methods of transferring ownership of cash and other financial assets to children who are too young to handle such assets, that may be simpler, cheaper and faster than a trust. Before the 529 plan became ubiquitous, the UGMA and UTMA accounts were often used as a means for parents and grandparents to provide savings for children and grandchildren.

According to the IRS, the first $950 in gains is tax-free, the second $950 is taxed at the child’s income tax rate and the remainder is taxed at the parent’s income tax rate. As you can see, the tax benefits are not nearly as robust as they are in a 529 plan, but the UGMA and UTMA custodial accounts place no restrictions on what the money can be used for. This can be good or bad, depending on your situation. For example, the child becomes the sole beneficiary of the assets in the account at age 18 or 21 (depending on the state you live in), so there’s no way to make sure junior spends that money on college and not a trip across Europe.

Roth IRA

The Roth IRA is an Individual Retirement Account in which you pay taxes on the contributions, but not on the withdrawals – ever. So what’s in doing in a list of college savings accounts? I’m glad you asked.

Once the child has an earned income, he can open a Roth IRA. Once the child turns 18, he has sole control of the account, so here again the parents lose control over what the money is spent on. One important restriction on the Roth is that withdrawals can only be made on the earnings after the child turns 59½. BUT, contributions can be withdrawn tax free at any time. So, if you’re looking at stashing a large sum of money for college, a Roth is a great way to shield the money from financial aid formulas and give the child a head start on retirement savings, since any money earned after the contributions will continue to grow tax free since it can’t be withdrawn until the child turns 59½.

Conclusion.

It seems that the custodial account is really a dinosaur when it comes to savings vehicles for children, but the 529 and Roth can be incredibly beneficial. If you’re a young family, with only a modest amount of money available to contribute on a steady basis, the 529 plan is probably the best choice. But if you come into an inheritance, or the grandparents want to make a one-time gift and you don’t mind the possibility of your child being able to use the money for something other than college, a Roth IRA is definitely worth a look.

Photo © by alancleaver_2000

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Here are 3 small cap stocks that you probably haven’t heard of, but they each have at least a 25% increase in sales over last year – a time in which most companies have seen sales take a big hit.

K12.

Market Cap: $548 million
Estimated sales growth for current year: 26%

K12 (LRN) provides online high school courses for home schooled children. Almost half the states in the U.S. have approved their curriculum for use in online public schools. Enrollment for U.S. students is free, but foreign students pay to enroll. The stock currently trades at 30 times estimated 2009 earnings, but in this “Great Recession”, stocks with this kind of growth are rare.

Health Grades.

Market Cap: $133 million
Estimated sales growth for current year: 31%

Health Grades (HGRD) provides information on doctors, hospitals and nursing homes to patients. The information even contains ratings from past patients. Visitors to the company’s web site (HealthGrades.com) can access basic information in exchange for giving their own opinion of their doctor. More detailed reports can be purchased for around $13 and the company also receives fees from hospital marketing services. The majority of sales are currently to hospitals, although sales to patients is growing more rapidly.

Though the share price of Health Grades is up 80% this year, it trades around 20 times estimated 2009 earnings.

InterDigital

Market Cap: $937 million
Estimated sales growth for current year: 32%

InterDigital (IDCC) licenses high-speed data transfer technology to cell phone makers. They’ve had some legal disputes with Nokia, but analysts think things will be settled by a licensing deal with Nokia. InterDigital holds $6 per share in cash, and expects $3 per share in payments form Samsung. Shares are trading at 14 times estimated 2009 earnings.

Obviously, small cap aggressive growth stocks carry much more risk than large cap stocks and broad based index funds. But then, they also carry the potential for much higher return. Just do your research and know what you’re buying.

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