How to Read a Prospectus
Before you set up a home entertainment system or assemble a new addition to the furniture in the living room, you take a little time to read the instructions to ensure you complete the project flawlessly. Before a coach sends her team out into the field or onto the court, she unveils a game plan that will lead her team to victory. Before a pilot takes off from a runway, he spends as much time it takes to reviews the flight plan to make sure the plane never veers off course. I think you know where we’re going with this.
Before you dive headfirst into the world of financial investing, you have to take the time and make the effort to learn more about exactly how you plan to allocate your hard-earned money. Risk lurks beneath any investment, whether you decide to put your money into a lifestyle-focused retirement fund or sock cash away in a stock offered by a company operating overseas. How do you minimize the risk of investing in financial assets?
The answer is by reading the prospectus that accompanies every type of financial investment option.
Overview of a Prospectus
After the stock market crash of 1929, the United States federal government went into high gear to pass dozens of reforms that would eventually produce balance within the delicate American financial system. One of the most important reforms pertained to the issuance of securities. The Securities Act of 1933 started securities reform by requiring publicly held American companies to disclose financial data and information to investors. Another law passed by the United States Congress the following couple of years established the requirement for American companies to provide every investor with a prospectus.
What Does a Prospectus Have to Include?
As a legally valid document that a company or a mutual fund manager must present investors, a prospectus must contain several sections that educate investors about the security under consideration. The United States Congress enacted provisions that clearly define what must be included in a prospectus.
- Company background and history
- Current financial data for the company or mutual fund
- Type of security
- Total number of shares available for investors
- Underwriting financial institution
- Any information concerning the awarding of dividends
Whether you are planning to fund an IRA or a 401(k), or whether you are looking for a way to generate additional income, you should refer to a prospectus to determine whether an investment makes financial sense based on several factors, such as risk tolerance, long-term financial goals, and the overall strategy for financial asset allocation.
You do not have to read a prospectus from the first word to the last word, but you should have a thorough understanding of what a company or mutual fund puts in the summary section of the investing blueprint.
Types of Prospectuses
There are two general categories of prospectuses: preliminary and final. Before a company or a mutual fund releases a prospectus, it will issue what is referred to as a preliminary prospectus. A preliminary prospectus, although not etched in stone, gives investors a glimpse into the financial information required to make a sound investment decision. When the time comes to offer an investment option, a final prospectus is presented to investors. The final prospectus is a much more detailed look at the characteristics of an investment option.
There are also several different types of prospectuses:
A stock or a bond prospectus typically starts with a summary section that describes the company business model, as well as the reasons for the issuance of the security. After the summary comes a much more detailed section of information that includes the number of shares available for investors, as well as the class of the shares offered by the company. You will have the opportunity to evaluate the financial data presented by the issuing company as well. The most important section describes the risk factors associated with investing in the security and how the company plans to use the revenue generated by the sale of the security. It is a good idea for any investor to have a basic knowledge of how to analyze financial reports.
Mutual Fund Prospectus
Mutual fund prospectuses differ from stock and bond prospectuses in several ways. First, a mutual fund prospectus will present information concerning the past performance of the fund. It will also list the managers of the fund, which is an important factor for investors to consider before deciding whether to invest in a particular mutual fund. The similarities between a bond/stock and a mutual fund prospectus include the issuer’s financial objectives and a projection of the investment option’s future performance.
Components of a Prospectus
Knowing how to read a prospectus starts with gaining insight into how a prospectus should be organized.
Information about the Issuer
You have one or more compelling reasons for why you want to save money for an investment into a security or a mutual fund. However, you need to discover which company or mutual fund out there matches your acceptable level of financial risk and possesses the credentials that match your investing criteria. One of the most important components of a prospectus is the section that describes the company or mutual fund offering the investment option. You need to know about the history of the issuer, the goals of the issuers, and the assets the issuer holds. Read the section called “Certain Considerations,” which describes the risks associated with the performance of the investment option.
Information about the Stock, Bond, or Mutual Fund
After reading the section presenting information about the issuer, you want to pay attention to the section describing the investment option. The section should include information like the number of shares or the number of bond certificates offered. You should also learn the price of the bond, the stock, or the mutual fund. A prospectus should include the underwriter of the investment vehicle and how the company offering the investment option plans to use the money raised from the sale of the stock, the bond, or the mutual fund.
The prospectus for a mutual fund will include more information than the information you read in a prospectus for a bond or a stock. For example, a mutual fund prospectus should present information about past results, as well as the fees and expenses associated with managing the mutual fund.
How to Read a Prospectus
Investing in a stock, a bond, or a mutual fund is an exercise of investing in yourself. Since this all about you, it is essential that you know how to read the blueprint presented for an investment option. The primary objective of reading a prospectus is to determine whether the stock, the bond or the mutual fund matches your tolerance for risk and that it matches your short-term and long-term financial objectives.
First, you need to read the summary presented by the company or the mutual fund offering the investment option. After you read the summary, the next step for how to read a prospectus involves reviewing the risk associated with investing in the bond, the stock, or the mutual fund. As we mentioned, companies and mutual funds are obligated by federal securities laws to reveal risk factors. If the risk associated with an investment vehicle does not match your tolerance for financial risk, then you stop reading the prospectus and move on to other investment options.
If your risk tolerance matches the risks associated with investing in a bond, a stick, or a mutual fund, then you want to read the section explaining how the issuer plans to use the proceeds from the sale of the security or the mutual fund. For example, you might feel much more comfortable investing in a company that plans to use the proceeds generated by the sale of a security to raise cash for expansion. Beware the company that plans to use the proceeds from the sale of a security to pay down debt. For a mutual fund, read the prospectus to determine whether the securities within the fund align with your investment strategy.
The Bottom Line
Far too many investors get burned because they didn’t spend the time and make the effort to research a stock, a bond, or a mutual fund. Knowing how to read a prospectus will give you the information you need to make a sound investment decision.