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Capital Gain: The the profit derived from the selling price exceeding its initial purchase price. A realized capital gain is an investment that has been sold at a profit. An unrealized capital gain is an investment that hasn't been sold yet but would result in a profit if sold. Capital gain is often used to mean realized capital gain.
Negative Directional Indicator (-DI): When the ADX Indicator is selected, SharpCharts plots the Positive Directional Indicator (+DI), Negative Directional Indicator (-DI) and Average Directional Index (ADX). With the black, green and red color scheme on SharpCharts, -DI is the red line that measures the force of the down moves over a set period. The default setting is 14 periods.
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Overcoming Compoundings Dark Side
July 21 2012| Filed Under » Financial Theory, Interest Rates, Investing Basics, Portfolio Management, Stocks
Contrary to what we are led to believe, investors can only spend compound returns, not average returns. Nevertheless, the average returns are so often mentioned by those seeking to promote an investment approach. This practice can often mislead investors who dont understand how money is made and lost over a period of time, due to compounding, in markets that move up in one year and down in the next.
SEE: Accelerating Returns With Continuous Compounding
There are two factors that can have a significant impact on the realized returns experienced by investors: the dispersion of returns and the impact of negative returns. Read on to discover the impact these factors could have on your portfolio, and how you can use this knowledge to gain higher compound returns and avoid the negative side of compounding.
Back to Basics
First, lets review the mathematics used to calculate simple and compound averages. The simple return is the mathematical average of a set of numbers. The compound return is a geometric mean, or the single percentage, usually annual, that provides the cumulative effect of a series of returns. The compound return is the mathematical calculation describing the ability of an asset to generate earnings (or losses) that are then reinvested and generate their own earnings (or losses).
Lets say you invested $1,000 in the Dow Jones Industrial Average (DJIA ) in 1900. The average annual return between 1900 and 2005 for the DJIA is 7.3%. Using the annual average of 7.3%, an investor has the illusion that $1,000 invested in 1900 would become $1,752,147 at the end of 2005 because $1,000 compounded annually at 7.3% yields $1,752,147 by the end of 2005.
However, the DJIA was 66.08 at the beginning of 1900 and it ended at 10717.50 in 2005. This results in a compound average of 4.92%. In the market, you only receive compound returns, so $1,000 invested at the beginning of 1900 in the DJIA would result in only $162,547 by the end of 2005. (To keep things simple and relevant to the discussion, dividends, transaction costs and taxes have been excluded.)
What happened? There are two factors that contribute to the lower results from compounding: dispersion of returns around the average and the impact of negative numbers on compounding.
SEE: Using Historical Volatility To Gauge Future Risk
Dispersion of Returns
As the returns in a series of numbers become more dispersed from the average, the compound return declines. The greater the volatility of returns, the greater the drop in the compound return. Some examples will help to demonstrate this. Figure 1 shows five examples of how the dispersion of returns impacts the compound rate.
The first three examples show positive or, at worst, 0% annual returns. Notice how in each case, while the simple average is 10%, the compound average declines as the dispersion of returns widens. However, half the time the stock market moves up or down by 16% or more in a year. In the last two examples, there were losses in one of the years. Note that as the dispersion in returns grows wider, the compound return gets smaller, while the simple average remains the same.
Figure 1
This wide dispersion of returns is a significant contributor to the lower compound returns investors actually receive.
Impact of Negative Returns
It is obvious that negative returns hurt the actual returns realized by investors. Negative returns also significantly impact the positive impact compounding can have on your total return. Again, some examples will demonstrate this problem.
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In each of the examples in Figure 2, a loss is experienced in one year and the compound average return for the two years is negative. Of particular importance is the percent return required to break even after the loss. As the loss increases, the return required to break even grows significantly as a result of the negative effect of compounding.
Figure 2
Another way to think about the impact of negative returns on compounding is to answer this question, What if you invested $1,000 and in the first year you earned 20%, and then lost 20% the following year? If this up and down cycle continued for 20 years, it would create a situation that is not that different from what occurs in the market. How much would you have at the end of 20 years? The answer is a disappointing $664.83 - not exactly something to brag about next time youre at a party.
The impact of dispersion of returns and negative numbers can be deadly to your portfolio. So, how can an investor overcome the dark side of compounding and achieve superior results? Fortunately, there are techniques to make these negative factors work for you.
SEE: How To Calculate Your Investment Return
Overcoming the Dark Side of Compounding
Successful investors know that they must harness the positive power of compounding while overcoming its dark side. Like so many other strategies, this requires a disciplined approach and homework on the part of the investor.
As academic and empirical research has shown, some of a stocks price movements are due to the general trend of the market. When you are on the right side of the trend, compounding works for you, both in up markets as well as down markets. Therefore, the first step is to determine whether the market is in a secular (long-term or multi-year) bull or bear trend. Then invest with the trend. This also holds true for shorter term trends that take place within the secular trends.
SEE: The Utility Of Trendlines
During bull markets it is fairly easy to do well - the common quip is correct, a rising tide floats all boats. However, during a bear or flat market, different stocks will perform well at different times. In these environments, winning investors seek stocks that offer the best absolute returns in strong sectors. Investors must become good stock pickers rather than just investing in a diversified portfolio of stocks. In such cases, using the value approach to investing can have excellent results. It can also be useful to learn to short the market when the trend is down. Another strategy is to use bonds to build a ladder that provides a relatively safe return that can be used in a weak stock market environment.
During weak markets, when negative compounding can substantially harm your portfolio, it is even more important to employ proven capital management techniques. This starts with trailing stops to minimize losses and/or capture some profit from an investment. Another important technique is to rebalance your portfolio more frequently. Rebalancing capitalizes on short-term cycles in the financial markets. By selling part or all of the top performers in one asset class or sector, it provides capital to invest in new promising opportunities. A variation of this strategy is to sell part of your position when you have a quick gain to capture some profit and move the stop to or above your entry price. In every case, the investor is actively seeking to offset the negative side of compounding or even work with it.
The Bottom Line
Overcoming the dark side of compounding requires that an investor be an active manager of his or her portfolio. This requires learning the skills needed to recognize market trends, find appropriate investment opportunities and then employ proven capital management techniques. Overcoming the negative side of compounding and beating the market can a very satisfying experience, after all, its your money thats at stake.
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6 Factors That Influence Exchange Rates
Aside from factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a countrys relative level of economic health. Exchange rates play a vital role in a countrys level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched, analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investors portfolio. Here we look at some of the major forces behind exchange rate movements.
Overview
Before we look at these forces, we should sketch out how exchange rate movements affect a nations trading relationships with other nations. A higher currency makes a countrys exports more expensive and imports cheaper in foreign markets; a lower currency makes a countrys exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the countrys balance of trade, while a lower exchange rate would increase it.
Determinants of Exchange Rates
Numerous factors determine exchange rates , and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics, the relative importance of these factors is subject to much debate.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates . (To learn more, see Cost-Push Inflation Versus Demand-Pull Inflation.)
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. (For further reading, see What Is Fiscal Policy?)
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the countrys exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For more, see Understanding The Current Account In The Balance Of Payments.)
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding . While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the countrys debt rating (as determined by Moodys or Standard & Poors, for example) is a crucial determinant of its exchange rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a countrys exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the countrys exports. This, in turn, results in rising revenues from exports, which provides increased demand for the countrys currency (and an increase in the currencys value). If the price of exports rises by a smaller rate than that of its imports, the currencys value will decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
Conclusion
The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolios real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed, investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.
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The Challenges Of Investing In A Modern World
When writing about investing , people often make grand statements to the effect that investment basics havent changed in hundreds of years. This is true in the sense of buy low and sell high, but in every other sense, investing has changed. In this article well look at some of the unique challenges modern investors face.
SEE: The Basics Of Trading A Stock
The Volume and Speed of Information
Perhaps the most daunting challenge that modern investors struggle with is the sheer speed and volume of information. In the past, solid information about publicly traded companies was hard to come by outside of the annual and quarterly reports. The Wall Street Journal and a limited number of finance related publications attempted to collect business news and spread it to others, but this news moved to the greater public at the speed of print – if at all. In order to be reported, a story had to be significant; and even then, it had to be written up, printed and delivered.
Now, even obscure companies produce a constant stream of information, from the daily price fluctuations in the stock to announcements and posts on dedicated message boards. When information floods in, it can be difficult to pick out what is important. Several challenges follow from this main source, and well look at each in turn.
SEE: Information Overload: How It Hurts Investors
Finding the Right Resource
The difficulty of finding the right resource is tied to the challenge of too much information. As an investor, how do you find the good resources in the crowd? To be clear, having a large amount of choice and easy access to some truly excellent free resources is an overall win for the modern investor, but it can sometimes make research more daunting because of all the choices. Investing does deal in facts – such as the definition of a bond or the proper calculation of ROI - but opinion colors many areas, such as whether technicals matter more than fundamentals. With time, many investors learn to filter out information and create a select pool of reliable sources that match their investing tastes. Until then, however, it is hard to avoid being overwhelmed by the range and variety of opinion out there.
The Reactionary Market
Even if you have a good handle on quality information, you can still get burned when inaccurate information or basic uncertainty hits the market. Inaccurate information still hits the market, even though the time to correction/exposure is often shorter. Inaccuracies can be honest mistakes, malicious rumors or even financial fraud on the part ofcorporations . More importantly, the financial markets are so addicted to the constant information flow, that often an interruption in the flow or genuine moments of uncertainty can be worse than bad news.
SEE: Some Good News Is Bad News For Investors
Market reactions have always been extreme, but the increasingly global reach of information has given investors more reasons to overreact per hour than at any other time. It doesnt take a great leap of imagination to see good or bad consequences with every headline that pops up in the feed.
The Choices
When does choice become overwhelming? There are conflicting studies about the limits of the human mind when faced with a variety of choices. Research suggests that we chunk choices into a manageable few (3-8). This works in an ice cream shop with five types of vanilla, but the world of finance offers far more than eight types of stock investment , let alone the field of investment as a whole. When faced with all these choices, we find shortcuts to chunk our options down to a few. This is useful, but it may also lead to us discounting the better option. For example, someone looking for regular income may chunk their options down to dividend paying utility stocks when they may have been better served by a dividend ETF.
The Role of Advertising
The marriage of investments and advertising has been a boon and a bane to investors. On one hand, advertising has helped familiarize investors with the wider range of investment vehicles available today. The modern investor is more aware of the investments beyond stocks, bonds and term deposits. Most will be able to explain about mutual funds , index funds, ETFs, and probably options andmortgage backed securities as well.
Knowledge is a great thing, but advertising can sometimes push an investor toward an edge by hyping an investment that isnt necessarily the best fit. Take mutual funds for example. Quite often, an investor with a limited amount of capital is better off taking the lowest fee investment option (index fund or ETF) compared to higher-fee, professionally managed mutual funds. Advertising, however, can change this relatively straightforward math by playing up the advantages of professional management while failing to mention fees. So, if the professional manager is not up to snuff, then advertising has cost the investors market returns plus the management fee.
The Bottom Line
It is true that some investors have been successful using traditional methods and simply shutting their doors against the modern world. This list includes famous fund managers Warren Buffet and John Templeton. For most of us, however, the flow of information is comforting and helps us feel more confident in our decisions. The trick is finding the right balance when taking in information and turning it into action. In fact, most investors can survive the modern information barrage with some very traditional advice – measure twice, cut once. In other words, take the time to evaluate the information in front of you before making buy or sell decisions.
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The Advantages Of Bonds
Have you ever heard coworkers talking around the water cooler about a hot tip on a bond? We didnt think so. Tracking bonds can be about as thrilling as watching a chess match, whereas watching stocks can have some investors as excited as NFL fans during the Super Bowl. However, dont let the hype (or lack thereof) mislead you. Both stocks and bonds have their pros and cons. This article will explain the advantages of bonds and offer some reasons as to why you may want to include them in your portfolio.
A Safe Haven for Your Money
Those just entering the investment scene are usually able to grasp the concepts underlying stocks and bonds. Essentially, the difference can be summed up in one phrase: debt versus equity. That is, bonds represent debt and stocks represent equity ownership.
SEE: Stocks Basics Tutorial
This difference brings us to the first main advantage of bonds: In general, investing in debt is safer than investing in equity. The reason for this is the priority that debtholders have over shareholders. If a company goes bankrupt, debtholders are ahead of shareholders in the line to be paid. In a worst-case scenario, such as bankruptcy, the creditors (debtholders) usually get at least some of their money back, while shareholders often lose their entire investment.
In terms of safety, bonds from the U.S. government (Treasury bonds) are considered risk-free (there are no risk-free stocks). While not exactly yielding high returns (as of 2012, a 30-year bond yielded an interest rate of 2 to 3%), if capital preservation - which is a fancy term for never losing your principal investment - is your primary goal, then a bond from a stable government is your best bet. However, keep in mind that although bonds are safer as a rule, that doesnt mean they are all completely safe. There are also very risky bonds, which are known as junk bonds.
SEE: Junk Bonds: Everything You Need To Know
Watch: Understanding Bonds
Slow and Steady - Predictable Returns
If history is any indication, stocks will outperform bonds in the long run. However, bonds outperform stocks at certain times in the economic cycle. Its not unusual for stocks to lose 10% or more in a year, so when bonds make up a portion of your portfolio, they can help smooth out the bumps when a recession comes around.
There are always conditions in which we need security and predictability. Retirees, for instance, often rely on the predictable income generated by bonds. If your portfolio consisted solely of stocks, it would be quite disappointing to retire two years into a bear market. By owning bonds, retirees are able to predict with a greater degree of certainty how much income theyll have in their golden years. An investor who still has many years until retirement has plenty of time to make up for any losses from periods of decline in equities.
Better Than the Bank
Sometimes bonds are just the only decent option. The interest rates on bonds are typically greater than the rates paid by banks on savings accounts. As a result, if you are saving and you dont need the money in the short term, bonds will give you a relatively better return without posing too much risk.
College savings are a good example of funds you want to increase through investment, while also protecting them from risk. Parking your money in the bank is a start, but its not going to give you any return. With bonds, aspiring college students (or their parents) can predict their investment earnings and determine the amount theyll have to contribute to accumulate their tuition nest egg by the time college starts.
How Much Should You Put into Bonds?
There really is no easy answer to how much of your portfolio should be invested in bonds. Quite often, youll hear an old rule that says investors should formulate their allocation by subtracting their age from 100. The resulting figure indicates the percentage of a persons assets that should be invested in stocks, with the rest spread between bonds and cash. According to this rule, a 20-year-old should have 80% in stocks and 20% in cash and bonds, while someone who is 65 should have 35% of his or her assets in stocks and 65% in bonds and cash.
That being said, guidelines are just guidelines. Determining the asset allocation of your portfolio involves many factors, including your investing timeline, risk tolerance, future goals, perception of the market and income. Unfortunately, exploring the various factors affecting risk is beyond the scope of this article.
The Bottom Line
Misconceptions about bonds abound, but the fact is that bonds can contribute an element of stability to almost any portfolio. Bonds are a safe and conservative investment. They provide a predictable stream of income when stocks perform poorly, and they are a great savings vehicles for when you dont want to put your money at risk.
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Are You Investing Or Gambling?
Merriam-Webster dictionary defines gambling as:
1. a. to play a game for money or property
b. to bet on an uncertain outcome
2. to stake something on a contingency : take a chance.
When trading is looked at, gambling takes on a much more complex dynamic than what is presented in the definition. Many traders are gambling without even knowing it; trading in a way or for a reason that is completely dichotomous with success in the markets.
In this article we will look at the hidden ways in which gambling creeps into trading practices, as well as the stimulus that may drive an individual to trade (and possibly gamble) in the first place.
Hidden Gambling Tendencies
It is quite likely that anyone who believes they dont have gambling tendencies will not happily admit to having them if it turns out they are in fact acting on gambling impulses. And yet discovering of what drives us to take certain actions can create change within us as the underlying motivators are discovered by the conscious mind.
Before delving into gambling tendencies when actually trading, there is one tendency that is apparent in many people before trading even takes place. This same motivator continues to impact traders as they gain experience and become regular market participants.
Social Proofing
A person may not even have an interest in trading or investing within the financial markets, but social pressures induce them trade or invest anyway. This is especially common when large numbers of people are talking about investing in the markets (often during the final phase of a bull market). The person feels pressured to conform by their social circle. Thus they invest so as not to disrespect or disregard others beliefs or feel left out.
Buying some stocks or placing some trades in an effort to appease social forces is not gambling in and of itself if the person actually knows what they are doing, but entering into a financial transaction without a solid investment understanding is gambling... regardless of what the social media will portray. This person lacks the knowledge to exert control over the profitability of their choices. There are many variables in the market, and misinformation or disinformation within the investor or trader creates a gambling scenario. Until knowledge has been developed that allows the person to overcome the odds of losing, gambling is taking place with each transaction that occurs. (For a primer on how stocks work, check out our Stock Basics Tutorial.)
Contributing Gambling Factors
Once someone is involved in the financial markets , there is a learning curve, which based on the social proofing discussion above may seem like it is gambling. This may or may not be true based on the individual. Depending on how the person approaches the market will determine if they become a successful trader or remain a perpetual gambler in the financial markets. The following are two traits (among many) which are easily overlooked but contribute to gambling tendencies in traders.
Gambling (Trading) for Excitement
Even a losing trade can stir emotions and a sense of power or satisfaction, especially when related to social proofing. If everyone in a persons social circle is losing money in the markets, losing money on a trade will allow that person to enter the conversation with a story of their own. When a person trades for excitement or social proofing reasons, it is likely that they are trading in a gambling style rather than in a methodical and tested way. Trading the markets is exciting ; it links the person into a global network of traders and investors all with different ideas backgrounds and beliefs. Yet getting caught up in the idea of trading, the excitement, or emotional highs and lows is likely to detract from acting in a systematic and methodical way.(Learn about how emotions can interfere in trading by reading Master Your Trading Mindtraps.)
Trading to Win, and Not Trading a System
Trading in a methodical and systematic way is important in any odds based scenario. Trading to win seems like the most obvious reason to trade, after all, why trade if you cant win? But there is a hidden detrimental flaw when it comes to this belief and trading. While making money is desired overall result, trading to win can actually drive us further away from the realization of making money. If winning is our prime motivator, the following scenario is likely to play out: Jill buys a stock as she feels it is oversold compared to the rest of the market. The stock continues to fall, placing her in a negative position. Instead of realizing that the stock is not simply oversold and that something else must be going on here, she continues to hold the position, hoping it will come back so she can win (or even break even) on the trade. The focus on winning has forced the trader into the position where they dont get out of bad positions because to do so would be to admit they lost on that trade.
Good traders take many losses, they admit they are wrong and keep the damage small. Not having to win on every trade and taking losses when conditions indicate they should is what allows them to be profitable over many trades. Holding losing positions once original entry conditions have changed or turned negative for the trade means the trader is now gambling and no longer using sound trading methods (if they ever were).(Read about some of the common trading methodologies in our Stock-Picking Strategies Tutorial)
Conclusion
Gambling tendencies run far deeper than what most people initially perceive, and well beyond the standard definitions. Gambling can take the form of needing to socially prove ones self, or acting in a way to be socially accepted which result in taking action in a field they know little about. Gambling in the markets is often evident in people who do it mostly for the emotional high they receive from the excitement and action of the markets. Finally, not trading a system which is methodical and tested, but rather relying on emotion or a must-win attitude to create profits shows the person is gambling in the markets and unlikely to succeed over the course of many trades.
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Spotting Creative Accounting On The Balance Sheet
Accounting practices in the United States have improved over the years, but there are still plenty of ways that companies can manipulate their financial results. And not just in the usual ways - the balance sheet can even be used to store earnings for future periods! Evidence of these practices can be seen in restated earnings that can be devastating to the stock price. (For an introduction to the balance sheet , refer to our article: Reading The Balance Sheet.) Well explore why and how companies utilize creative accounting to overstate a companys assets or understate its liabilities. The result can be a misleading gauge of earnings power and financial condition. This article will explore simple ways that investors can uncover problems by simply looking at the companys financial statements and disclosures.
Why Boost the Balance Sheet?
Companies that manipulate their balance sheet are often seeking to increase their earnings power in future periods (or the current period) or create the appearance of a strong financial condition. After all, financially-sound companies can more easily obtain lines of credit at lowinterest rates , as well as more easily issue debt financing or issue bonds on better terms.
Overvaluing Assets
Provision for Doubtful Accounts
Accounts receivables play a key role in detecting premature or fabricated revenues, but they can also be used to inflate earnings on their own by way of the provision for doubtful accounts. Of course , the reserve for doubtful accountswill prove to be inadequate in the future if adversely modified, but accounts receivable will receive a temporary boost in the short term. Investors can detect when the reserves for doubtful accounts are inadequate by comparing accounts receivable to net income and revenue. When the balance sheet item is growing at a faster pace than the income statement item, then investors may want to look into whether or not the provision for doubtful accounts is adequate by further investigating.
Inventory Manipulation
Inventory represents the value of goods that were manufactured but not yet sold. When these goods are sold, the value is transferred over to the income statement as cost of goods sold. As a result, overstating inventory value will lead to an understated of cost of goods sold, and therefore an artificially higher net income, assuming actual inventory and sales levels remain constant.
One example of manipulated inventory was Laribee Wire Manufacturing Co., which recorded phantom inventory and carried other inventory at bloated values. This helped the company borrow some $130 million from six banks by using the inventory as collateral. Meanwhile, the company reported $3 million in net income for the period, when it really lost $6.5 million.
Investors can detect overvalued inventory by looking for telling trends, such as inventory increasing faster than sales, decreases in inventory turnover, inventory rising faster than total assets and falling cost of sales as a percentage of sales. Any unusual variations in these figures can be indicative of potential inventory accounting fraud.
Subsidiaries and Joint Ventures
When public companies make large investments in a separate business or entity, they can either account for the investment under the consolidation method or the equity method depending on their ability to control the subsidiary. Unfortunately, this leaves the door open to companies that want to conceal and manipulate the true performance of their subsidiaries or joint ventures.
Under the equity method, the investment is recorded at cost and is subsequently adjusted to reflect the share of net profit or loss and dividends received. While this is reported on the balance sheet and income statement, the method does limit the information available for investors. For example, a company could overstate interest coverage in order to change the leverage ratios of the subsidiary.
Investors should be cautious - and perhaps take a look at the auditors reliability - when companies utilize the equity method for accounting in situations where they appear to control the subsidiary. For example, a U.S.-based company operating in China through various subsidiaries in which it appears to exert control could create an environment ripe for manipulation.
Pension Obligations
Pension obligations are ripe for manipulation by public companies, since the liabilities occur in the future and company-generated estimations need to be used to account for them. Companies can make aggressive estimations in order to improve both short-term earnings as well as to create the illusion of a stronger financial position.
Companies can make themselves appear in a stronger financial position by changing a few assumptions to reduce the pension obligation. Because the pension benefit obligation is the present value of future payments earned by employees, these accounts can be effectively controlled via the discount rate. Increasing the discount rate can significantly reduce the pension obligation depending on the size of the obligation.
Meanwhile, companies can also use pension accounting in order to manipulate short-term earnings by artificially changing the net benefit cost, or the expected return on pension plan assets , on the income statement. While the estimate should be roughly the same as the discount rate, companies can make aggressive estimates that will then affect the income statement. An increase in the expected return on plan assets will reduce the pension expense in the income statement and boost net income. (For additional information, take a look at Analyzing Pension Risk.)
Contingent Liabilities
Contingent liabilities are obligations that are dependent on future events to confirm the existence of an obligation, the amount owed, the payee or the date payable. For example, warranty obligations or anticipated litigation loss may be considered contingent liabilities. Companies can creatively account for these liabilities by underestimating their materiality.
Companies that fail to record a contingent liability that is likely to be incurred and subject to reasonable estimation are understating their liabilities and overstating their net income or shareholders equity. Investors can avoid these problems by carefully reading a companys footnotes, which contain information about these obligations.
The Bottom Line
Companies can manipulate their balance sheets in many different ways, ranging from inventory accounting to contingent liabilities. However, investors can detect these practices by simply reading the financial statements a little more closely.
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Choosing Between Dollar-Cost And Value Averaging
As investors, we face a bit of a dilemma: we want high stock prices when we sell a stock, but not when we buy. There are times when this dilemma causes investors to wait for a dip in prices, thereby potentially missing out on a continual rise. This is how investors get lured away from investing and become tangled in the slippery science of market timing - a science that few people can hope to master.
In this article, we will look at two investing practices that seek to counter our natural inclination toward market timing by canceling out some of the risk involved: dollar cost averaging (DCA) and value averaging (VA).
Dollar Cost Averaging
DCA is a practice where an investor puts a set amount of money into investments at regular intervals, usually shorter than a year (monthly or quarterly). DCA is generally used for more volatile investments such as stocks or mutual funds, rather than for bonds or CDs, for example. In a broader sense, DCA can include automatic deductions from your paycheck that go into a retirement plan . For the purposes of this article, however, we will focus on the first type of DCA.
DCA is a good strategy for investors with a lower risk tolerance. If you have a lump sum of money to invest and you put it into the market all at once, then you run the risk of buying at a peak, which can be unsettling if the prices fall after the investment. The potential for this price drop is called a timing risk. With DCA, that lump sum can be tossed into the market in a smaller amount, lowering the risk and effects of any single market move by spreading the investment out over time.
For example, suppose that as part of a DCA plan you invest $1,000 each month for four months. If the prices at each months end were $45, $35, $35, $40, your average cost would be $38.75. If you had invested the whole amount at the start of the investment, your cost would have been $45 per share. By using a DCA plan, you can avoid timing risk and enjoy the low-cost benefits of this strategy by spreading out your investment cost.
DCA Pitfalls
All risk-reduction strategies have their tradeoffs, and DCA is no exception. First of all, you run the chance of missing out on higher returns if the investment continues to rise after the first investment period. Also, if you are spreading a lump sum, the money waiting to be invested doesnt garner much of a return by just sitting there. Still, a sudden drop in prices wont damage you as much as if you had put it all in at once.
Some investors who engage in DCA will stop after a sharp drop, cutting their losses; however, these investors are actually missing out on the main benefit of DCA - the purchase of larger portions of stock (more shares) in a declining market, thereby increasing their gains when the market rises again. When using a DCA strategy, therefore, it is important to determine whether the reason behind the drop has materially impacted the reason for the investment. If not, then you should stick to your guns and pick up the shares at an even better valuation than before.
Another issue with DCA is determining the period over which this strategy should be used. If you are dispersing a large lump sum, you may want to spread it over one or two years, but any longer than that may mean missing the general upswing in the markets as inflation chips away at the real value of the cash.
DCA may not, however, be the best choice for a long-term investment strategy. It may not even be the best choice for dispersing a lump sum.
Enter Value Averaging
One strategy that has started to gain favor is the value averaging technique, which aims to invest more when the share price falls and less when the share price rises. It is done by calculating predetermined amounts for the total value of the investment in future periods and then making an investment to match these amounts at each future period.
For example, suppose you determine that the value of your investment will rise by $500 each quarter as you make additional investments. In the first investment period, you would invest $500, say at $10 per share. In the next period, you determine that the value of your investment will rise to $1,000. If the current price is $12.50 per share, your original position comes to be worth $625 (50 shares times $15), which only requires you to invest $375 to put the value of your investment at $1,000. This is done until the end value of the portfolio is reached. As you can see in this example, you have invested less as the price has risen, and the opposite would be true if the price had fallen.
Therefore, instead of investing a set amount each period, a VA strategy makes investments based on the total size of the portfolio at each point. Below is an expanded example comparing the two strategies:
As you can see, the majority of shares are purchased at low prices. When prices drop and you put more money in, you end up with more shares (this happens with DCA as well, but to a lesser extent). Most of the shares have been bought at very low prices, thus maximizing your returns when it comes time to sell. If the investment is sound, VA will increase your returns beyond simply dollar cost averaging for the same time period. And it does so at a lower level of risk. Additionally, in certain circumstances, such as a sudden gain in the market value of your stock or fund, value averaging could even require you to sell some shares without buying any (sell high, buy low). Value averaging is a simple, mechanical type of market timing that helps to minimize timing risk.
The Bottom Line
Choosing between the two depends on your reasons. If it is the passive investing aspect of DCA that attracts you, then stick to it. Find a portfolio you feel comfortable with and put the same amount of money into it on a monthly or quarterly basis. If you are dispersing a lump sum, you may want to put your inactive cash into a money market account or some other interest-bearing investment. If you are feeling ambitious enough to engage in a little active investing every quarter or so, then value averaging may be a much better choice.
In both these cases, we are assuming a buy-and-hold strategy - you find a stock or fund that you feel comfortable with and purchase as much of it as you can over the years, selling it only if it becomes overpriced. Legendary value investor Warren Buffet has suggested that the best holding period is forever. If you are looking to buy low and sell high in the short term, by day trading and the like, then DCA and value averaging are of little use. If you invest conservatively, however, it may just provide the edge that you need to meet your goals
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How To Pick A Mutual Fund In A Troubled Market
The strong start to 2012 has come to a halt in the wake of more trouble in Europe. For the early part of 2012, the United States turned a temporary blind eye to what was going on in the eurozone, but all of that changed as tensions heated up with Spain and, once again, Greece. This caused European markets to fall under more pressure and lead to the North American markets return to a state of hypersensitivity; every comment that comes from the eurozone seems to drive North American markets lower, causing investors to question their next move.
If professional investors cant figure out the eurozone, how is the part-time or amateur investor going to make any sense of the current state of the markets? What if youre picking funds for your 401(k), rebalancing, or picking mutual funds for your personal accounts? What should you do in these troubling markets?
SEE: Pick The Winners At The Mutual Fund Track!
Think Long Term
When picking funds for your retirement accounts, your investing timeline is likely long-term. With as much as 30 years before you take money from your retirement accounts, funds that may not be attractive right now could be priced at a bargain. Many international funds, especially those focused on the eurozone, are cheap right now and may be an attractive long term investment if youre particularly optimistic on the outcome.
Know What Youre Buying
Theres no doubt that the global financial markets are highly volatile right now, but for the investor, its important to more deeply evaluate the state of the global financial system. An ETF that tracks the performance of Spain has lost 40% of its value over the past 12 months, but iShares MSCI Philippines ETF, the ETF that tracks the Philippines, has seen a gain of nearly 20%. Before investing in an international mutual fund , look at how the funds assets are invested.
SEE: Finding Fortune In Foreign-Stock ETFs
Dont Buy and Sell
Long-term investors dont buy and sell funds, they reallocate. Reallocating is a change in the way your funds are divided into different areas of your portfolio. When the eurozone found itself under intense economic pressure, some investors moved a portion of their money away from holdings that included the eurozone and invested more heavily in domestic stocks . When they believe that the eurozone has stabilized and other portions of their portfolio have topped out, they may reallocate money back to their international funds and out of domestic funds.
For those with little investing knowledge, reallocation should be performed with the help of a financial advisor, but completely selling a fund is best reserved for when you lose confidence in the funds ability to produce the returns you expect.
Focus on What You Can Control
Even the best investors cant control what the markets will do in the future. They dont know what the worlds politicians will decide next and they dont know if Greece will eventually exit the eurozone. Maybe the largest mistake made by inexperienced investors is trying to predict the future.
A better strategy is to focus on what you can control. You can control how much in fees you pay, you can pick funds with relatively low turnover, keeping the expenses of the fund at a minimum, and you can maintain appropriate diversification within your portfolio. Everything else is nothing more than an educated guess and guessing rarely results in profits.
SEE: The Evolution Of ETFs
The Bottom Line
What will happen in Europe tomorrow? Nobody knows, but that doesnt mean that you should avoid international funds altogether. Many represent great values for long term investors, but the eurozone and other international markets wont remain under pressure forever. If you find an international fund that fits into your investing goals, consider taking Warren Buffetts advice and buy while others are scared.
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Financial Footnotes: Start Reading The Fine Print
If theres one piece of advice we hear often, its that it is always good to read the fine print. Why should it be any different for a companys financial statements? If the income statement, balance sheet and statement of cash flow make up the core of a companys financial information, then the footnotes are the fine print that explain this core. (For more insight, read Understanding The Federal Reserve Balance Sheet.)
However, what is often not provided along with this wise advice is a set of instructions on exactly how to read a companys footnotes. This article will not only explain what footnotes are, but what they mean and how to use them to your financial benefit.
What Are Footnotes?
Pick up any financial report and youll always find references to the footnotes of the financial statements. The footnotes give a detailed description of the practices and reporting policies of the companys accounting methods along with the disclosure of additional information that cant be shown in the statements themselves. In other words, footnotes expand on the quantitative financial statements by providing qualitative information that allows for a greater understanding of a companys true financial performance over a specified time period.
The information in the footnotes can generally be split into two different areas. The first deals with the accounting methods that a company chooses to formulate its financial information, such as revenue recognition policies. The second deals with an expanded explanation of important company operational and financial results.
Accounting Methods
This area of the footnotes, which tends to be at the beginning of the notes, identifies and explains the major accounting policies of a business. These footnotes are broken into specific accounting areas (revenue, inventory, etc) which detail a companys policy with regard to that account and how its value is determined.
For example, one of the most important financial measures is revenue. In the footnotes, you will often find a revenue recognition note, which describes how a company determines when it has earned its revenue. Due to the often complex nature of business operations, the point at which a sale can be booked (put on the financial statements) is not always clear cut. This section will give an investor valuable insight into when a company books revenue. For example, Ford Motors recognizes a sale at the time that a dealership takes possession of a Ford vehicle.
What to Look for
There are two things to focus on when analyzing the accounting methods of a company found in the footnotes. The first thing is to look at a companys accounting method and how it compares to the generally accepted accounting method and industry standards. If the company is using a policy that differs from others in the industry or one that seems far too aggressive, it could be a sign that the company may be trying to manipulate its financial statements to cover up an undesirable event or give the perception of better performance.
In an example using revenue recognition at Ford Motors, lets assume that instead of booking revenue upon ownership transfer, Ford books the revenue when a car is produced. This strategy is far too aggressive because Ford cant ensure that dealerships will ever take possession of that car. Another example would be a magazine company that books all of its sales at the start of the subscription. In this case, the company has not performed its side of the sale (delivering the product) and should only book revenue when each magazine is sent to the subscriber.
The second item of importance that should be examined is any changes that have been made in an account from one period to the next and the effect it will have on the bottom-line financial statements. In the Ford example, imagine the company switched from the delivery method to the production method. Booking revenue before goods are transferred would increase the aggressiveness of Fords accounting. The companys financial statements would become less reliable because investors would not be sure how much of the revenue was derived from actual sales and how much represented product that was produced but not delivered by Ford.
It is important when tackling this area to first gain a basic understanding of the Generally Accepted Accounting Principles (GAAP) standards of computing financial information. This will allow you to identify when a company is not following this standard. (To learn more, see Fundamental Analysis Tutorial and Advanced Financial Statement Analysis Tutorial.)
Disclosure and Financial Details
The financial statements in an annual report are supposed to be clean and easy to follow. In order to maintain this cleanliness, other calculations are left for the footnotes. The disclosure segment gives details about long-term debt, such as maturity dates and interest rates , which can give you a better idea of how borrowing costs are laid out. It also covers details regarding employee stock ownership and stock options issued, which are also important to investors.
Other things mentioned in the footnotes include errors in previous accounting statements, looming legal cases in which the company is involved and details of any synthetic leases they may have. These types of disclosures are of the utmost importance to investors with an interest in the companys operations.
Another important focus when looking at the disclosure segment is what is left off of the financial statements. When a company is meeting accounting standards, the rules may allow them to keep a large liability off of the financial statements and report it in the footnotes instead. If investors skip the footnotes, they will miss these liabilities or risks the company faces.
For example, Dell transferred $2.5 billion in customer financing to a joint venture with Tyco, which effectively removed that money as a liability from their balance sheet. This made Dells liquidity numbers and capital structure seem better when, in fact, little had changed. But this information did not disappear from the balance sheet entirely - conscientious investors could have found it in the footnotes. (See Reading The Balance Sheet and Uncovering Hidden Debt for more information.)
Problems with Footnotes
Although footnotes are a required part of any financial statement, there are no standards for clarity or conciseness. Management is required to disclose information beyond the legal minimum to avoid the risk of being sued. Where this minimum lies, however, is based on managements subjective judgment. Furthermore, footnotes must be as transparent as possible without harmfully releasing trade secrets and other pertinent information about things that give the company its competitive edge. (To learn more, see Show And Tell: The Importance Of Transparency.)
Another problem with the footnotes is that sometimes companies attempt to confuse investors by filling the notes with legal jargon and technical accounting terms. Be suspicious if the description is difficult to decipher - the company may have something to hide. If you see situations in which the company is writing only a paragraph on a major event/issue, or using convoluted language to skirt it entirely, it may be wise to simply move on to another company.
Conclusion
Informed investors dig deep, looking for information that others typically wouldnt seek out. No matter how boring it might be, read the fine print - in the long run, youll be glad you did.
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Company Clone Cost Reveals True Value
One of the best tools in a value investors kit is one of the easiest to understand: the careful scrutiny of a companys books to figure out how much its assets are really worth. In a free-market economy a company should not be worth more than what it costs to reproduce an identical competitor. These reproduction costs are one of the most concrete ways to value a company, and can be crucial in helping investors make decisions.
In this article well take you through the steps of creating a hypothetical clone company. For companies that dont carry a massive amount of leverage, this can be a much more accurate representation of a companys true worth than the values found with the standard dividend discount model. (For an overview of company valuations, see Fundamental Analysis: A Brief Introduction To Valuation.)
DDMs Shaky Predictions
Theoretically the dividend discount model is one of the best ways to value any asset . Every future cash flow from an asset should be discounted back to the present and added together. It is a beautifully simplistic and correct conclusion. The problem is that it involves a staggering amount of speculation and is extremely susceptible to human error. First, the dividend discount model forces the user to correctly estimate future cash flows, and second, the user must use the correct rate. (For a detailed explanation, see Digging Into The Dividend Discount Model.)
Example - Problems with the DDM
Two investors look at dividend-paying XYZ Corp., which pays out $2 in dividends this year.
• Investor 1 believes the company is very strong in its market and will grow dividends at 10% a year. He also thinks the company is very stable, so he requires a rate of return of 12% (close to the long-term growth rate of the broader stock market ). Using the dividend discount model, he would value the company at $2 / (0.12 - 0.10) = $100.
• Investor 2 also believes that XYZ Corp.s dividends will grow at 10%, however he believes the company is slightly more risky compared to the market. He discounts by 14%, and values the company at $2 / (0.14 - 0.10) = $50.
While both investors are looking logically at the company, and their assumptions do not look very different on the surface, they come out with two wildly different valuations.
Adding Foundation to Valuation
If we could perfectly predict the future, there would be no risk in equities. All investors would simply earn the risk-free rate on any stock. This is obviously not the case, but more concrete valuations of stocks can be obtained. Putting in the time and effort of judging the true values ofassets and liabilities, we can judge the cost of reproducing a company. The concept is commonly used to value real estate, as in what would it cost to buy the land, pay the contractors, buy the supplies, etc. This can also be applied to many companies to get a more solid grasp of what it is truly worth.
When talking about reproducing a company, the company is taken to be a going concern, meaning that we believe the company will continue operating indefinitely and will not go out of business. If the company itself or the industry as a whole is no longer viable, the analysis would be ofliquidation value of the companys assets. If the company is viable, it can be an important step to look at how much it would cost to enter the industry and be on par with the company. This should be a closer estimation of the value of the company.
Begin With The Balance Sheet
When the company in question is a going concern, we can go methodically down the balance sheet and discern the true value of each category. (To learn what each section means and where it can be found, check out Breaking Down The Balance Sheet.)
Current assets
• Cash and cash equivalents - No adjustments should be made.
• Marketable securities - Since these are very short-term and actively traded, adjustments should not be necessary unless there has been a drastic swing in the market.
• Accounts receivable - This is usually given as a net number, reflecting an allowance for doubtful accounts. We do not need to do much here but can reduce it a little, maybe 10% to be safe, as a new entrant would likely get stuck with more bad accounts.
• Inventory - This is where the entries get a little more complicated. If inventory turnover is high or commoditized, we likely do not need to reduce it very much, if at all. The inventory turnover ratio will show this, and if turnover is low reducing the value of inventory would be prudent.
Example - Adjusting for a low turnover ratio
A toy factory with low inventory turnover would be a concern. If the company still has inventory of fad toys, those are likely worthless, and inventory value will have to be reduced. Looking through the companys past reports and press releases, we might find that the company was making a big bet and dedicated 25% of inventory to this product, meaning we will have to reduce inventory value by 25%. This is a time-consuming process, but luckily in most cases these current asset valuations do not do a whole lot to effect the final value. If, through this process we found that it would significantly change the companys value, we could take more careful measures.
Non-Current Assets
Long-term assets usually have much more impact and are also harder to value. Many fundamental things should be taken into consideration.
• Equipment - When valuing a companys equipment, ask yourself, is it out of date? To find out, look back in the companys financial statements to find when big purchases of equipment were made in the past. If a large investment was made one or two years ago, everything is likely to be up to date. If a food processing company made its last big investment in equipment 10 or 20 years ago, and there have been big improvements in processing technology, then a new entrant to the market could buy new and more advanced machinery that would give them an advantage over the current company. Knowledge of the industry would certainly help here, but some sleuthing, including looking through trade journals and industry news, can help glean the required knowledge.
• Property - This is another important piece of the puzzle. If a company owns valuable property that has appreciated substantially, it will be a hidden asset not shown on the books, but it should certainly be accounted for in the companys value. The companys largest plants will be most visible, either by searching through the companys website or annual report, and they will be the most important to value. The true value of real estate is estimable by many different measures, most likely by looking at comparable real estate and the markets where the companys properties are located. This is difficult, but can be vital.
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6 Terms To Warm The Coldest Wall Street Heart
Imagine traders walking hand-in-hand with buy-and-hold investors, analysts snuggling with economists, bulls and bears living in perfect harmony. Suddenly, the world is a beautiful place to live. February is the time for love. So, in keeping with the romance in the air, lets look at some love-related terms that would warm even the coldest Wall Street heart.
Sweetheart Deal
This term might make you think of two corporations at a diner table, sipping the same milkshake through separate straws while holding hands. Not quite. But the sweetheart deal may be the Wall Street equivalent. In a sweetheart deal, one company offers very attractive terms and conditions to another company or individual. It can be an acquisition or an attempt to lure in a new CEO.
A sweetheart deal can be a bad thing for shareholders because, if their company is being taken over, management may receive benefits (for example, buyout packages) while shareholders take a loss. If a sweetheart deal is obviously unethical and not in the interests of shareholders, legal action can be taken.
Risk Lover
If you spent your formative years as your neighborhoods daredevil, you may be a risk lover. Risk lovers in the investment world dont necessarily try to jump the school bus during recess, but they do make investments with uncertain outcomes. This type of investor doesnt love risk just for its own sake, but because the risk/return tradeoff dictates that with a greater exposure to risk comes a greater possibility of payout. This means that the return is huge when it happens, but that the chance that it will happen may be slimmer. The risk lovers opposite is the investor who is risk averse - he or she prefers investments with a more guaranteed payout, even if its smaller.
Sensitivity Analysis
No, were not talking about whether you write poetry and bring your sweetheart flowers and chocolates just because. Sensitivity analysis is a technique used to determine how a projected outcome is affected if one of the key predictions proves false. For example, you might try to determine how sensitive a movies box office profits are to lower-than-expected numbers during its opening weekend.
Friendly Hands
In the investing world, companies view friendly hands in a favorable light. This term refers to investors who buy a stock at the IPO and hold onto it for the long term, looking for long-term rewards rather than a short-term gain. Friendly hands help the company create a sense of stability right off the bat. Angel investors usually double as friendly hands. (Find out more about IPOs in The Murky Waters Of The IPO Market and IPO Basics Tutorial.)
Love Money
Love money is the money that startup businesses get from angel investors, usually friends and family. They may give money as a result of the strength of their love for the business owner , rather than the strength of his or her business plan. This type of money is hard to come by and can be very fickle in its affections. A business that gets it should be glad.
Teddy Bear Hug
A teddy bear hug can occur when a takeover company warns its target company in advance about the offer its about to make on its shares . If the price per share is extremely generous, and if the target company accepts, the deal is referred to as a bear hug. The target company, however, may turn down the offer in the hope of a higher price. If the acquiring company is a teddy bear, it will usually give in and raise the value of the offer. The idea is that the acquiring firm is soft like a teddy bear and wants to make everyone happy.
Happy Valentines Day!
There is plenty of love on Wall Street, even if its just in the romance language thats lavished on many of the complex relationships and business deals that happen there. Whether its a sweetheart deal, love money or a teddy bear hug, these terms suggest that theres a softer side to Wall Streets cut-throat, competitive - even if only on the surface.
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Nasdaq-100 Index Tracking Stock (Nasdaq:QQQQ)
This ETF represents the Nasdaq-100 Index, which consists of the 100 largest and most actively traded non-financial stocks on the Nasdaq, QQQQ offers broad exposure to the tech sector. Because it curbs the risk that comes with investing in individual stocks, the QQQQ is a great way to invest in the long-term prospects of the technology industry. The diversification it offers can be a huge advantage when theres volatility in the markets. If a tech company falls short of projected earnings, it will likely be hit hard. Between 2000 and 2004, QQQQ was by far the most heavily traded index fund.
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Can Investors Trust The P/E Ratio?
Few stock market metrics have cycled in and out of favor as often or as severely as the P/E ratio. Initially popularized by the legendary value investor Benjamin Graham (one of Warren Buffetts mentors), price/earnings ratios are used to assess the relative attractiveness of a potential investment. But these days, analysts are increasingly noting the P/E ratios flaws. Read on to find out what they are and what you can do to make sure youre doing a sound analaysis.
Whats a Good P/E Ratio?
In his book Security Analysis , Graham suggests that a P/E ratio of 16 is as high a price as can be paid in an investment purchase in common stock.
This does not mean that all common stocks with the same average earnings should have the same value, Graham explained. The common-stock investor will properly accord a more liberal valuation to those which have current earnings above the average, or which may reasonably be considered to possess better than average prospects.
Graham was also aware that different industries trade at different multiples based on their real or perceived growth potential. To the fabled investor, P/E ratios were not an absolute measure of value but, rather, a means of establishing a moderate upper limit that he felt was crucial in order to stay within the bounds of conservative valuation.
How the P/E Has Changed Over Time
Of course, this moderate upper limit was all but abandoned some 20 years after Grahams death, when investors flocked to buy any issue ending in com. Some of these companies sported P/E ratios best expressed in scientific notation. Even before the dotcom madness, however, there were those who felt that comparing a stocks price to its earnings was shortsighted at best, and pointless at worst.
The Contrarian View to the P/E
William J. ONeill, the founder of Investors Business Daily, asserts in How to Make Money in Stocks that contrary to most investors beliefs, P/E ratios were not a relevant factor in price movement.
To demonstrate his point, ONeill pointed to research conducted from 1953 to 1988 that showed the average P/E ratio for the best-performing stocks just prior to their equity explosion was 20, while the Dows P/E ratio for the same period averaged 15. In other words, by Grahams standards, these soon-to-be-superstar stocks were overvalued. (For related reading, see Cheap Stocks Can Be Deceiving.)
Does P/E Revert to Industry Norms?
Now, in theory, stocks that trade at high multiples will eventually revert back to the industry norm - and vice-versa for those issues sporting lower earnings-based valuations. Yet, at various points in history, there have been major discrepancies between theory and practice, with high P/E stocks continuing to soar while their cheaper counterparts stayed grounded, just as ONeill observed. On the other hand, the reverse has held true during other time intervals as well, and we cannot discredit Ben Grahams investment process either.
Whats more, over the last 20 years, there has been a gradual increase in P/E ratios as a whole, despite the fact that the stock market has been no more volatile than in years past. Using data presented by Yale University Professor Robert Shiller in his book Irrational Exuberance (first published in 2000), one finds that the price-earnings ratio for the S&P 500 Index reached historic highs toward the end of 2008 through the third quarter of 2009. Yet the index posted a remarkable 38% gain following the recession lows, despite abnormally high investment ratios.
Years Median P/E Ratio
1900-1910 13.4
1911-1920 10.0
1921-1930 12.8
1931-1940 16.2
1941-1950 9.5
1951-1960 12.6
1961-1970 17.7
1971-1980 10.4
1981-1990 12.4
1991-2000 22.6
2001-2010 22.4
Table: S&P 500 Index Median P/E Ratios
Source: Schiller, Robert. Irrational Exuberance [Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005]
Can the P/E Ratio Be Rescued?
So does this mean that ONeill is right and P/E ratios have no predictive value? Or that, in todays technology-driven economy, the ratios have become passe? Well, not necessarily. The key to effectively using P/E ratios, many experts claim, is to exam them over longer periods of time, while integrating forward-looking data like earnings estimates and the overall economic climate into the analysis.
One way of accomplishing this is through the use of PEG ratios. Made fashionable by famed money manager Peter Lynch, PEG ratios are similar to P/E ratios, but the ratio is divided by annual EPS growth to standardize the metric. Such a procedure is implemented because higher growth prospects justify a higher P/E ratio. In One Up on Wall Street, Lynch wrote, the P/E ratio of any company thats fairly priced will equal its growth rate. (If these numbers have you in the dark, these easy calculations should help light the way. Check out How To Find P/E And PEG Ratios.)
The World Without P/E
With that in mind, it is, perhaps, easier to understand why some investors virtually ignored earnings - or the lack thereof - altogether while gobbling up shares of the latest cyberspace sensation in the late 90s. Nonetheless, the question remains: Are P/E ratios still a valuable tool in making investment decisions or have they gone the way of the dodo bird?
Ben Levisohn, a financial journalist, believes it is the latter.
What is wrong with the P/E? He asks in the Wall Street Journal. In short, the e cant be trusted.
Levisohn notes that P/E ratios have generally declined during times of economic uncertainty and that thanks to the recent shift toward rapid-fire stock trading , the P/E ratio may be losing its relevance.
The emergence of exchange-traded funds in the past 10 years has allowed investors to make broad bets on entire baskets of stocks. And the ascendance of computer-driven trading is making macroeconomic data and trading patterns more important drivers of market action than fundamental analysis of individual companies, even during periods of relative calm, Levisohn argues.
Fundamental Analysts Still Like P/E
Others, especially those who follow a rigorous fundamental analysis approach to investing, disagree, citing the popping of the tech bubble as a prime example of the sticky mess investors can find themselves in when they dont take heed of earnings and price.
Still, some general observations in order:
1. It is best to compare P/E ratios within a specific industry. This helps to ensure that the price-earnings performance is not simply a product of the stocks environment.
2. Be wary of stocks sporting high P/E ratios during an economic boom. The old saying that a rising tide lifts all boats definitely applies to stocks - even many bad ones - so it is wise to be suspicious of any upward price movement that isnt supported by some logical, underlying reason outside of the general economic climate.
3. Be equally dubious of stocks with low P/E ratios that appear to be waning in prestige or relevance. In recent years, investors have seen a number of formerly solid companies hit the skids. In these instances, it is foolish to think that the price will magically increase to match the earnings and boost the stocks P/E ratio to a level consistent with the industry norm. It is far more likely that any P/E increase will be the direct result of eroding earnings, which isnt exactly the P/E bounce bullish investors are looking for.
Bottom Line
In closing, while investors are probably wise to be wary of P/E ratios, it is, perhaps, equally prudent to keep that apprehension in context. While P/E ratios are not the magical prognostic tool some once thought they were, they can still be valuable when used in the proper manner. (Make an informed decision about your investments with these easy equations.
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Why Monopoly Is A Terrible Finance Teacher
Monopoly is one of the most popular board games of all time. But with its plethora of inaccuracies, it doesnt offer the best lessons in real-world finance.
Monopoly does get some things right. The purpose of the game is to become the wealthiest player through buying, renting and selling of property, and prudent property ownership decisions are indeed a proven path to wealth. Players also learn that property values are largely based on location, and they receive economic lessons about scarcity, tradeoffs and making decisions with imperfect information.
Still, if youre hoping your kids will learn something about finance while theyre playing, here are a few of the games inaccuracies you may want them to be aware of.
Most Pricing Is Not Market Based
In Monopoly, prices for unimproved properties, houses and hotels are flat, and the rents players pay when landing on each others properties are fixed. The games property values are pre-established by a central authority (the bank) instead of fluctuating based on supply and demand like they do in real life - at least, in capitalist societies, and Monopoly is clearly capitalist. The rules do reflect reality somewhat, however, in that they allow players to negotiate trades for unimproved properties, railroads and utilities (but not houses or hotels), based on whatever values they agree upon.
Property Rights Are Unusual
When you buy an unimproved property, a house or a hotel in Monopoly, you buy it from the bank. In real life, only foreclosed properties are purchased from banks; properties are usually transferred between individual owners.
Monopoly players also must pay cash for land and structures instead of financing them with a mortgage. Mortgages are only used when players run into financial trouble; they may mortgage properties they own back to the bank for the mortgage price printed on the title deed card for that property. For example, a player who owned Kentucky Avenue, purchased for $220, could get $110 for the property by mortgaging it to the bank. While the property is mortgaged, the owner cannot collect rent. In real life, most people do not pay cash for properties; they use mortgages, and homeowners collect rent on mortgaged properties all the time.
Another aspect of property ownership unique to Monopoly is that players cannot improve their properties until they own all the properties of the same color, and players must build evenly across their properties. Players also have to build small structures (houses) before theyre allowed to build large structures (hotels). While real-life rules do restrict what improvements owners can make to their properties through city zoning laws, neighborhood deed restrictions and homeowners association requirements, there is no need to own two or three adjacent properties before building is allowed, and there is no requirement to build multiple small properties as precursors to a larger property.
Income Is Based on Luck, Not Skill
In Monopoly, you receive a $200 salary every time you pass Go. How often you pass Go depends on the luck of the numbers you roll with the dice and any Chance and Community Chest cards you draw that may help you move around the board. Income is also based on which properties you happen to land on and whether youre able to accumulate monopoly holdings of like-colored properties that allow you to collect rent from your opponents. Players get paid - and have to pay - when they randomly draw cards with instructions, such as Your building loan matures: Collect $150 and You have been elected chairman of the board: Pay each player $50.
In real life, the amount of money you earn is primarily based on skill development and hard work. Only a small percentage of the population (gambling winners and inheritance recipients) receives an income based on luck. The idea that income is based on luck is a self-defeating attitude which prevents many people from reaching their financial potential.
Taxes Are a Gamble
You never know how much income or property tax youll pay or when youll have to pay it in Monopoly, and taxes fall on players randomly rather than being based on their actual economic activities.
Monopoly players dont pay income taxes on a regular basis - only when they land on the Income Tax board space. If Monopoly were like real life, players would pay income tax each time they passed Go and collected $200; they would also pay it when they drew cards like Receive for services $25, From sale of stock you get $45 and You have won second prize in a beauty contest: Collect $10.
The way taxes are calculated in Monopoly isnt realistic, either. When a player lands on the Income Tax space, he or she may pay taxes of either $200 or 10% of net worth (including cash, land and buildings), but cannot first add up assets and then choose to pay the cheaper amount. In reality, while many provisions of the income tax code do provide for two or more ways to calculate tax liability, taxpayers often have the option to choose the calculation that results in the lowest liability. Furthermore, real-life income tax is based on income, not net worth.
Monopoly players also dont pay property taxes on a regular basis. Instead, players who draw an unfortunate Community Chest card get assessed for street repairs and must pay the bank $40 per house and $115 per hotel. There is no tax on unimproved property, but in real life, property taxes are based on the value of both land and improvements and must be paid on a semi-annual, annual or bi-annual basis.
School taxes, which are paid from property taxes in real life, also are based on chance in Monopoly. A Community Chest card instructs unlucky players to Pay school tax of $150. A more realistic game would instruct players to pay school taxes based on a percentage of the total value of all properties owned.
The Bank Can Make Permanent Errors in a Customers Favor
Monopoly has a chance card that states, Bank error in your favor: Collect $200. In real life, if the bank makes an error in your favor, it will only be temporary. If you spend money that was erroneously deposited into your account and dont repay it, youve committed theft. Youll have to repay the money and you could also be fined.
Wealth Is a Zero-Sum Game
The last player standing after all the others go bankrupt wins the game in Monopoly. This rule implies that wealth accumulation is a zero-sum game; only one person can achieve ultimate financial success and only if everyone else is destitute.
To be sure, there are plenty of critics of income inequality who believe this Monopoly rule contains a nugget of truth. They think that when the top 1% get richer, the other 99% consequently become poorer. This belief persists even among well-educated intellectuals and economists and is perpetuated by the media.
In reality, there is no limit to the amount of wealth that can be created in a free-market society where government regulation is limited to essential functions. The world could have billions of billionaires if that many people could figure out how to create a billion dollars worth of value. Your income need not fall for Warren Buffetts income to rise.
The Bottom Line
In the end, Monopoly is just a game, and even if some of its lessons about finance arent entirely accurate, at least it gives kids an awareness of things like mortgages, bankruptcy, property ownership, money management and taxes. They arent likely to get that awareness from most video games or television programs.
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Invest In Real Estate With $1,000 (Or Less)
Since the housing market peak in 2005, investing in real estate has been fraught with peril, to say the least. The commercial and residential real estate industries have struggled since, but as any contrarian will tell you, market downturns can offer appealing opportunities to pick up investments on the cheap. (For more, check out 10 Habits Of Highly Effective Real Estate Investors.)
The good thing for smaller or individual investors is that there is no need to buy individual properties. A number of alternatives exist that offer more liquid and diversified investment options. In other words, dont worry about having to take out a $250,000 loan or whether your credit score is high enough to garner a favorable interest rate . Here are some options to get you started in real estate for a fraction of what it would cost to buy an actual property.
Real Estate Investment Trust (REIT )
A real estate investment trust (REIT) represents one of the easiest ways for individual investors to gain exposure to real estate assets. A REIT is simply a security that invests in a basket of real estate assets or related securities such as mortgages or mortgage-backed securities (MBS).
There is a dizzying array of REIT investment out there for investors to choose from. For instance, certain REITs specialize in commercial real estate, such as Realty Income Corp(NYSE:O), shopping malls, such as Simon Property Group (NYSE:SPG), or even amusement parks, such as Cedar Fair (NYSE:FUN), though the latter officially trades as a limited partnership and has some different investment implications.
Another important consideration with REITs is that they must pay out 90% of their taxable profits as distributions. This allows them to avoid corporate income taxes and also means that investors tend to rely on REITs for what can be a generous yield.
It is also worth pointing out that since these firms must pay out most of their income to shareholders and need to invest in expensive real estate, they can have significant debt on the balance sheet. This is generally not a concern in normal economic conditions and revenue from rent received on their properties usually far exceeds debt-servicing costs, but it does mean that they can be hit during downturns in the economy. As with most industries, leverage is a double-edged sword.
Real Estate Funds
Investing in REITs may be especially appealing for stock pickers and those interested in bottom-up security selection. Others may find real estate funds more suitable. For starters, they are more diversified and lessen the likelihood that an individual firm will torpedo overall returns. They can also allow for more broad exposure across geographies, such as across the U.S. or even internationally, and can also spread bets across property types, be it commercial, residential or by industry.
Two funds that have performed well recently are the JPMorgan U.S. Real Estate Fund (SUSIX) and T. Rowe Price Real Estate Fund (TRREX). Ken Heebners CGM Realty Fund (CGMRX) bridges the gap between individual REIT and diversified fund approaches due to its more concentrated investment philosophy.
Additionally, more traditional bond funds can also invest exclusively in real estate assets. The Fidelity GNMA Fund (FGMNX) invests primarily in mortgages backed by the Government National Mortgage Association, which is also known as Ginnie Mae. The fund has a current yield of 2.78% and has garnered mid-single digit annual returns for investors over the past decade.
Private Equity
By definition, private equity (PE) is equity capital that does not trade on a public exchange. In essence, companies can either be public or private, but they are still companies that have operations and earn returns for shareholders.
Private equity investors generally specialize in managing pools of private companies. The line between the public and private realm is somewhat blurred as PE firms frequently buy public companies at a hefty premium and take them private. As with REITs, this can involve significant amounts of debt and needs to be taken into consideration when investing in the space.
Investing in a true PE fund is usually reserved for wealthy individuals and large institutions that are supposedly more sophisticated investors and have the ability to handle what is a very illiquid asset class. However, in recent years a number of PE firms have gone public, which means that retail investors can gain exposure to the space with very low investment amounts. Two firms in this space are Kohlberg Kravis & Roberts (NYSE:KKR) and The Blackstone Group (NYSE:BX). (To learn more, see Private Equity Opens Up For The Little Investor.)
Bottom Line
As with any investment, further due diligence is needed to determine if it meets your individual circumstances or if the investment is a decent value at current prices. You may also find better individual options in the general categories above. The overall takeaway is that there are many liquid, straightforward ways to play the real estate markets these days. Finally, down markets mean there are many potential deals out there, and real estate is generally a solid investment option during periods of high inflation.
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Issuers of ETFs
? AdvisorShares issues actively managed ETFs.
? Bips Investment Managers issues Bips (Beta Investment Performance Securities).
? BNP Paribas issues EasyETFs.
? BlackRock issues iShares.
? Charles Schwab offers several commission-free ETFs for its clients.
? Deutsche Bank issues db x-trackers ETFs, as well as managing PowerShares DB commodity- and currency-based ETFs.
? ETF Securities issues ETFs or specialised commodity ETCs.
? Global X Funds issues ETFs.
? Guggenheim Funds issues specialty Guggenheim Funds ETFs.
? Invesco issues PowerShares ETFs, as well as BLDRS based on American Depositary Receipts.
? Lyxor Asset Management issues Lyxor ETFs.
? Merrill Lynch issues HOLDRs.
? Source UK Services, a European joint-venture between Bank of America Merrill Lynch, Goldman Sachs, Morgan Stanley, Nomura and J. P. Morgan issues ETFs and ETCs
? State Street Global Advisors issues SPDRs.
? Van Eck Global issues Market Vectors ETFs.
? Vanguard Group issues Vanguard ETFs, formerly known as VIPERs.
Redefining Investor Risk
You have probably been told by many financial advisors that your risk tolerance should be a function of your investment time horizon. This belief is touted by almost everyone in the financial services industry, because it is predominately accepted that if you plan to invest for a long period of time, you can make more risky investments. However, before blindly accepting this theory as factual truth, lets look at four ways in which risk can be defined. After thinking about risk from these four different perspectives, you may reach a different conclusion about investing. (Forget the clichés and uncover how much volatility you can really stand. To learn more, see Personalizing Risk Tolerance.)
Risk Theory No.1: Risk is Reduced if You Have More Time to Recoup Your Losses
Some people believe that if you have a long time horizon, you can take on more risk, because if something goes wrong with your investment, you will have time to recoup your losses. When risk is looked at in this manner, risk does indeed decrease as the time horizon increases. However, if you accept this definition of risk, it is recommended that you keep track of the loss on your investment, as well as the opportunity cost that you gave up by not investing in a risk free security. This is important because you need to know not only how long it will take you to recoup the loss on your investment, but also how long it will take you to recoup the loss associated with not investing in a product that can generate a guaranteed rate of return, such as a government bond.
Risk Theory No.2: A Longer Time Horizon Decreases Risk by Reducing the Standard Deviation of the Investment
You may have also heard that risk decreases as the time horizon increases, because the standard deviation of an investments compounded average annual return decreases as the time horizon increases, due to mean reversions. This definition of risk is based on two important statistical theories. The first theory is known as the law of large numbers, which states that the likelihood of an investors actual average return achieving its long run historical average return increases as the time horizon increases – basically, the larger the sample size, the more likely the average results are to occur. The second theory is the central limit theorem of probability theory, which states that as the sample size increases, which in this context means as the time horizon increases, the sampling distribution of sample means approaches that of a normal distribution.
You may have to ponder theses concepts for a period of time before you comprehend their implications about investing. However, the law of large numbers simply implies that the dispersion of returns around an investments expected return will decrease as the time horizon increases. If this concept is true, then risk must also decrease as the time horizon increases, because in this case, dispersion, measured by variation around the mean, is the measure of risk. Moving one step further, the practical implications of the central limit theorem of probability theory stipulates that if an investment has a standard deviation of 20% for the one-year period, its volatility would be reduced to its expected value as time increases. As you can see from these examples, when the law of large numbers and the central limit theorem of probability theory are taken into account, risk, as measured by standard deviation, does indeed appear to decrease as the time horizon is lengthened.
Unfortunately, the application of these theories is not directly applicable in the investment world, because the law of large number requires too many years of investing before the theory would have any real world implications. Moreover, the central limit theorem of probability theory does not apply in this context because empirical evidence shows that a constant standard deviation is an inaccurate measure of investment risk, due to the fact thatinvestment performance , is typically skewed and exhibits kurtosis. This in turn means that investment performance is not normally distributed, which in turn nullifies the central limit theorem of probability theory. In addition, investmentperformance is typically subject to heteroskedasticity, which in turn greatly hinders the usefulness of using standard deviation as a measure risk. Given these problems, one should not postulate that risk is reduced by time, at least not based on the premise of these two theories. (For more information on how statistics can help you invest, check out Stock Market Risk: Wagging The Tails.)
An additional problem occurs when investment risk is measured using standard deviation, as it is based on the position that you will make a one-time investment and hold that exact investment over the length of the time horizon. Given that most investors employ dollar-cost averaging strategies that entail ongoing periodic investment contributions, the theories do not apply. This is because every time a new investment contribution is made, that portion is subject to another standard deviation than the rest of that investment. In addition, most investors tend to useinvestment products such as mutual funds, and these types of products constantly change their underlying securities over time. As a result, the underlying concepts associated with these theories do not apply when investing.
Risk Theory No.3: Risk Increases as the Time Horizon Increases
If you define risk as the probability of having an ending value that is close to what you expect to have at a certain point in time, then risk actually does increase as the time horizon increases. This phenomenon is attributed to the fact that the magnitude of potential losses increases as the time horizon increases, and this relationship is properly captured when measuring risk by using continuously compounded total returns. Since most investors are concerned about the probability of having a certain amount of money at a certain period of time, given a specific portfolio allocation, it seems logical to measure risk in this manner.
Based on Monte Carlo simulation observational analysis, a greater dispersion in potential portfolio outcomes manifests itself as both the probability up and down movements built into the simulation increase, and as the time horizon lengthens. Monte Carlo simulation will generate this outcome because financial market returns are uncertain, and therefore the range of returns on either side of the median projected return can be magnified due to compounding multi year effects. Furthermore, a number of good years can quickly be wiped out by a bad year.
Risk Theory No.4: The Relationship Between Risk and Time from the Standpoint of Common Sense
Moving away from academic theory, common sense would suggest that the risk of any investment increases as the length of the time horizon increases simply because future events are hard to forecast. To prove this point, you can look at the list of companies that made up the Dow Jones Industrial Average back when it was formed in 1896. What you will find is that only one company that was part of the index in 1896 is still a component of the index today. That company is General Electric. The other companies have been bought out, broken up by the government, removed by the Dow Jones Index Committee or have gone out of business.
More current examples that support this empirical position are the recent demise of Lehman Brothers and Bear Sterns. Both of these companies were well established Wall Street banks, yet their operational and business risks ultimately led them into bankruptcy. Given these examples, one should surmise that time does not reduce the unsystematic risk associated with investing. (This company survived many financial crises in its long history. Find out what finally drove it to bankruptcy. Read Case Study: The Collapse of Lehman Brothers.)
Moving away from a historical view of the relationship between risk and time to a view that may help you understand the true relationship between risk and time, ask yourself two simple questions: First, How much do you think an ounce of gold will cost at the end of this year? Second, How much do you think an ounce of gold will cost 30 years from now? It should be obvious that there is much more risk in trying to accurately estimate how much gold will cost in the distant future, because there are a multitude of potential factors that may have a compounded impact on the price of gold over time.
Conclusion
Empirical examples such as these make a strong case that time does not reduce risk. Given this position, investors should reach a very important conclusion when looking at the relationship between risk and time from the standpoint of investing. You cannot reduce your risk by lengthening your time horizon. Therefore, the only way you can mitigate the impact of unsystematic risk, is by developing a broadly diversified portfolio.
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Does Your Personality Match Your Trading Methods?
Traders often develop a certain set of skills that help them achieve success. Then, in an attempt to increase profits, they end up deviating from their expertise. This happens unconsciously, and traders often arent aware of their errors until there is a drop in profits. Expertise is not necessarily measured by the methods used but also the mental time frame used for decision-making. All traders have knowledge, but knowing when to put that knowledge into practice takes true expertise. Some traders are better at making split-second decisions, while others need to sort information logically. In the middle of these extremes are traders who make quick choices but are basing their decisions on long-term criteria, logic and education. How we make decisions in life should align with how we trade; if an alignment is not attained, any study and effort will be wasted.
Every one makes decisions in his or her way, yet there are common elements in the process. One key element is the time frame in which individuals make decisions. Some people are referred to as impulsive, while others are methodical. Then there are people who seem to be both. The type of person you are should match your trading method.
Some people make decisions in an instant. Even if they think something through, they are in a rush to pull the trigger on what was likely already decided even before deliberation took place. The traders making split second decisions likely have trades that only last seconds before another split second decisions determines the exit. These traders thrive as scalpers in the market place, getting in and out of positions largely on intuition, even though that intuition is based on a broad background of trading experience.(We look at different styles of scalping and how they can all be very profitable. Read Scalping: Small Quick Profits Can Add Up.)
Other traders require deliberation. They make decisions slowly and only after careful consideration. They deconstruct information and then try to rebuild it into a logical trade decision. These people resemble detectives gathering information to determine a suspect - or in this case - a trading decision. They will gravitate toward long-term investing or swing trading, where decisions can be made slowly and methodically.
In between the two extremes, there are people who accumulate a broad knowledge base but then must act on the information rapidly. In life and death situations, physicians must act in this way. While their training can be used to make methodical decisions, it can also be drawn on to make immediate decisions. This type of decision process pertains to many day traders, who generally arent scalpers or swing traders. These types of people (if they decide to day trade) make several trades a day based on a wide range of information or signals, but when the time comes, they react quickly and make the trade that their analysis and education has produced. (To learn more about day trading, check out Would You Profit As A Day Trader?)
When Trading Goes Awry
Traders who begin within their mental time frame will likely experience success early. Yet as traders mature, they will often try to incorporate other methods of trading to improve results, leading to a deterioration in performance. A scalper, for instance, begins to look at longer term moves and wants to catch more of the move. Therefore, the scalper still makes split-second decisions to get into positions, but then he or she must battle the instinct to exit quickly. Even though logic will dictate a longer term trend could bring more profit, the internal nature of split-second decision making will likely sabotage the traders patience. At this point, it is clear that the trader has abandoned his expertise (in this case, scalping) and will likely end up holding onto losses while chasing short-term profits to compensate. (Learn to overcome one of the biggest trading hurdles in Master Your Trading Mindtraps.)
Traders who do not begin in their niches will likely feel uncertain about what they should be trying to achieve and the strategy they are trying to implement. Unless drastic personal changes are made (or the trader is extremely disciplined when making uncharacteristic decisions), the career will likely not last long.
Why a Time Frame Matters in Trading
You may think that if a trading plan is in place, all a trader needs to do is follow it. While this is easily stated, the reality is much harder. Trading is no different from any other area of life. If what we are doing does not align with who we are, conflicts develop and it becomes easy to move off course. It is not a bad thing; our mistakes often tell us what we should be doing and how we should be trading.
Aligning Our Decision Process with Our Method
While our mistakes tell us a lot, the emotion of a situation can overshadow any potential lessons learned. After making a mistake, traders often ask themselves the same questions:
• Why am I always so impulsive? If youre asking yourself this question, you should move to a style that actually requires impulsive action, such as scalping.
• Why didnt I get in/out when I had to? If youre asking yourself this question, you should move to trading on a longer time frame, where exact entry and exit matters less.
Each of us is capable of making logical decisions in a split second, yet each of us gravitates towards a default method. How we are trained and live our lives will determine what our default is. Therefore, we can choose to change; an impulsive person can become more methodical and vice versa. However, trading should not be used as a method of practice for personality adjustment or self-improvement. Personal change can come without risking your finances.
Traders should make sure that the decision process used to get into a trade is also dictates the exit strategy; an impulsive entry will require an impulsive exit. A methodical entry requires a methodical exit.
The Bottom Line
Listen to your internal dialog after a trading mistake is made. Is there a recurrent regret after each error? If so, it likely stems from an aspect of your personality that is difficult to alter. Rather than struggling to reform your dispositions, try modifying your trading strategy to work with your mental time frame. A perceived weakness can easily be turned into strength - for example, using an impulsive nature to excel at scalping. Being methodical is not wrong either; it just requires a move to a long-term trading strategy. To make the best use of your expertise in the markets, align your trading with your current decision-making style.
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3. Counterparty risk (Risks Associated with ETFs)
A synthetic ETF has counterparty risk, because the counterparty is contractually obligated to match the return on the index. The deal is arranged with collateral posted by the swap counterparty. A potential hazard is that the investment bank offering the ETF might post its own collateral, and that collateral could be of dubious quality. Furthermore, the investment bank could use its own trading desk as counterparty. These types of set-ups are not allowed under the European guidelines, Undertakings for Collective Investment in Transferable Securities (UCITS), so the investor should look for UCITS III-compliant funds.
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