on account of market microstructure frictions, transaction prices may deviate from the equilibrium price, generating transaction costs. As we have noted, the bid–ask spread is a frequently used indicator of market liquidity. This differential is an important component of trading costs, often referred to as implicit transaction costs to distinguish them from explicit costs such as brokerage fees and taxes. We will offer different measures of the spread, each one focusing on a different interpretation.

The quoted spread, or the difference between the best ask and best bid prices offered by liquidity suppliers, is an estimate of the costs that a generic investor incurs for a round-trip transaction, i.e. a purchase followed by a sale. On the other hand, the realized spread is an estimate of the gain a market-maker can expect to make from two consecutive transactions. We show that the two definitions coincide when transaction costs consist solely in order-processing costs. We will also show that the difference between the quoted and the realized spread, which is always positive or at least zero, is a positive function of adverse selection and inventory costs. This difference can also be affected by the number of transactions at prices within the spread, as well as by order fragmentation. Furthermore, we will provide a definition of the effective spread, which is twice the difference between the transaction price and the midpoint of the quoted bid–ask spread and is therefore a better proxy of transaction costs when quoted prices are not binding.

Fund organizations run many funds. They call themselves fund “families.”  Studies show that marketing, not high returns, increases funds under  management over the long-term. The fund families send you newsletters  and have Web sites. Every article is designed to encourage you to ignore  the results you have gotten and buy more product. Your mailbox will also be  stuffed with bulletins about new funds, account statements, proxy statements,  and tax statements. The more money you have with the family, the  higher the level of service and status you can achieve within the family. You  can move up from ordinary to preferred to gold to platinum to admiralty.

Switching funds within the fund group is convenient and quick. To switch  from a rival fund, they will even do all the paperwork for you. But moving  out of the family is discouraged. If you are dissatisfied with one of their  funds, they hope your sense of loyalty and desire for convenience will cause  you to buy another fund within the family. Retaining your mutual funds is  their primary goal.

Some funds close to new investors. This gives existing investors the  illusion that they own an exclusive product, which discourages them from  selling. Some funds also impose penalties for early withdrawals. This keeps  your money under management and creates a steady income stream for the  fund manager.

As with any good dysfunctional family, there are many secrets. You  cannot find out what stocks your fund owns more than every six months,  and then only 45 days after the six-month period ends. Nor can you get any  information explaining why one manager was fired and another hired. Even  mutual fund watchdogs such as Lipper and Morningstar cannot obtain this  information. It is as if this is not your money but the family’s money.

If you have family abandonment issues, mutual fund investing will be  troublesome. Seeking approval and support for your emotional deficiencies  will cause you to stay with poor funds when better returns are available  elsewhere. Severe depression could follow.

You can invest a small amount of money (and a lot of hard work and well-spent time) in a small business and see it grow into a business that is worth a million in seven years. I’ve done it many times. I’ve coached people who have done it. Stories are published in magazines every month about people who have done it.

But let’s be frank. With only $18,000 to $25,000 to invest, it won’t be easy. That’s why I like to encourage Early to Rise readers who are at this first wealth-building stage to focus most of their time and efforts on building their income. Doubling your income in a year or two is entirely possible if you follow the advice I gave you in previous posts. And if you double your income and don’t double your lifestyle, you’ll have a lot more money left over to ensure the success of your small side business.

Here are five things I recommend if you are in this situation:

1. Find a way to radically increase your salary by making yourself radically more valuable at work.
2. Resist the temptation to spend more money as your income rises.
3. Put some of your savings down on an undervalued, small, single-family house, fix it up fast, and sell it for a profit.
4. Reinvest that original capital plus the profit in another buyand-flip deal. Keep doing this until it becomes a very pleasant habit.
5. Invest another portion of your savings in a part-time, weekend business. Sell a product or service you know and understand.

Make sure you are not a pioneer. Unless there are others actively selling the same thing, you don’t want to be in the market. The idea is to enter an active market with a better/cleverer/cheaper version of what others are selling. Sell only by direct response—print, mail, and Internet. Go carefully and learn from your mistakes.

I’m bullish on entrepreneurship. And I’m at least as bullish on real estate. Stocks are much riskier than real estate—to me—because (1) I’ve lost money investing in stocks and/or stock funds time and again and (2) I’ve seen so many others lose money. Again, I do believe that the stock market has been and will continue to be a pretty good long-term investment. But long term as far as the market goes is a 10- to 20-year time frame. Since we are concerned with getting wealthy in 7 to 15 years (and since the market is currently overvalued, from a fundamentalist’s point of view), I don’t feel confident in stocks.

Nevertheless, since I began actively investing in real estate—about 11 years ago—I have never lost money on a single transaction. The worst two deals I’ve been in since my first big lesson (i.e., disaster) produced yields of 7 percent and 12 percent annually. And that’s not including tax benefits—which were significant. Most of the real estate investments I’ve made have been good to great.

You can reduce the risk in starting your own small business by sticking closely to what you already know. By “what you know,” I mean (1) the product or service you are selling and (2) the primary method by which you are going to sell it.

Serially successful entrepreneurs follow this formula. They spend thousands of hours figuring out how a particular business works—and once they understand it, they seldom jump into something entirely different.

My own rule for starting a new business is this: One baby step at a time. By that, I mean that I’m willing to try something new—but just a little new. If, for example, I’ve learned how to sell cat food with banner ads on the Internet, I might consider setting up a business that sells cat food with small ads in magazines. (That’s one baby step. If I can’t figure out magazine advertising, I can get out quickly and safely.) But I wouldn’t let myself get into a business that sold cat health-care products through direct mail—even if I could convince myself that I’m an expert in selling cat products. Selling cat health-care products through direct mail is simply too many steps away from my core competence.

If you develop expertise in a particular business and don’t stray too far from it, you’ll always feel confident that you can create a new business without taking a lot of risk.

Munis have tremendous tax advantages. Interest paid is not subject to federal, state, or local taxes. However, many savers will find the tax advantage caused them to invest outside their comfort zone. Calls, volatility, and insecure principal may be more than you can handle.

Trust issues are worse for muni funds than for other bond funds. Muni funds offer the advantage of diversification and professional management.

Unfortunately, the fees eat up as much as 25 percent of your interest. This is seldom worthwhile. Muni fund managers rarely outperform a list of unmanaged bonds. Many also try to rev up returns with lower credit issues, including junk munis, and borrow against the fund to increase investments in an attempt to time the market. These tactics are not likely to improve your sleep.

Occasionally, bond investors experience complete powerlessness. When interest rates and inflation rise dramatically, the value of bonds declines dramatically. If prospects are for continued high interest rates and inflation, bond interest will never compensate for lost purchasing power. In the 1960s, government bonds paid 5 percent or less in interest. During the 1970s, inflation averaged better than 8 percent. Bond investors who bought in the 1960s sat by powerless as the purchasing power of their principal and interest dwindled.

On the other hand, treasuries are the best asset class during extended periods of deflation. In the 1930s, treasury savers had to guard against grandiosity rather than inferiority. Treasuries were the best asset class.

Selling government bonds before maturity brings up feelings of regret if interest rates have risen and the bonds must be sold for less than face value. Commissions, as well as spreads, must also be paid.

Letting bonds mature eliminates both commissions and spreads. Still, when bonds mature, the saver is faced with the dilemma of what to do with the principal. For some, the answer is simple. Others experience anxiety.

Savers who fret over what to buy may be more comfortable in bond funds where the money manager makes all the buy decisions.

Often, managed funds turn out to be different than expected. Savers primarily want their principal returned when a note or bond matures. Some funds are managed without regard to principal fluctuations. Many savers have found the government fund they purchased paid out both principal and interest so that at the end there was no principal left. Alternatively, the manager of the fund borrowed extensively to juice the returns from the fund and instead lost a substantial portion of the principal. You are likely to feel betrayed if you unwittingly purchased a fund with fluctuating principal values.

Bond investors often experience regret and resentment when other asset classes have dramatic rises. Longer duration bonds cause the most distress. Savers who put money into 30-year Treasuries in 1994 received annual yields up to 8 percent. They had to stand by and watch as stocks returned better than 20 percent a year for the next five years. However, the dramatic decline in 2000-2001 may have given them some satisfaction.

Volatility is an issue with notes and bonds that mature in two or more years. Before OPEC, floating interest rates, interest rate swaps, floating exchange rates, budget surpluses, and electronic trading, treasury bonds had low volatility. Today, Treasuries can lose 20 percent of their value in a month. Savers waiting for bonds to mature will feel fear when they learn of the current value of their holdings. They must be able to process the fear and wait to maturity. Savers who cash out may have regrets and resentments when bond prices turn up again.

The complexity of purchase may lead you to rely on a salesperson. Government bonds are purchased from brokers, banks, and directly from the federal government. Buying from brokers and banks can bring up issues of trust. Whereas you may have a great degree of confidence that government bonds are secure and the tax consequences predictable, you may not trust that the product you are being sold benefits you as much as it benefits the salesperson. Buying treasuries directly from the federal government might also create fear. You may believe that with a salesperson holding your hand, you would find a better product at a better price.

Government notes and bonds are often sold in bundles as managed mutual funds, unmanaged index funds and trusts, or as closed-end mutual funds. Here the issues get more complex. Built-in resentment and regret are inevitable. Fees and commissions must be paid to mutual fund managers, brokers, and closed-end fund managers. These funds rarely do better than notes and bonds bought by an individual and held to maturity. It is easy to regret the fees paid for poorly performed services. Yet some savers feel the need to use professionals to pick bonds for them. They would have free-floating fear and worry if they were to construct a portfolio of bonds on their own. You must ask yourself how you are likely to react.

The range of emotion from government notes and bonds is similar to that for short-term securities. While many may be asking why corporate notes and bonds are not included here, the answer is simple. Corporate debt is risky. Only investors and speculators should consider it. U.S. government notes and bonds are for savers whose primary concern is the return of their principal and whose secondary concern is the receipt of interest. There is a
real possibility of losing some principal with corporate debt.

Before purchasing treasuries, you will be exposed to complexity. The possibilities in government bonds are great. You can invest for one year or 29 years or any period in between. Certain bonds, such as Series EE, H, and I have tax advantages. Interest rates differ for every maturity and every type of bond. For most notes and bonds, the principal value is fixed.

For inflation-indexed treasuries, known as TIPs, the principal value increases every year we experience inflation. The principal value of I bonds also adjusts with inflation. However, even though the principal value of most bonds or notes is fixed, bonds sell at prices higher or lower than the principal value, depending on the current level of interest rates and the supply and demand of similar bonds and notes. The mathematics of computing the proper price for a note or bond is complex.